Insurers - managing the financial risks of climate and environmental change

April 2024

Regulatory expectations around climate-related financial risk continue to be a significant concern for insurers. There are already challenging requirements which form part of 'business as usual' supervisory cycles for the PRA and EIOPA. Regulatory policy in this area continues to be a topic for discussion and is expected to evolve as climate risk modelling approaches and insurers' capabilities mature.

SS3/19 (PDF 0.88MB), the PRA's Supervisory Statement on Enhancing banks' and insurers' approaches to managing the financial risks from climate change, is now five years old and the PRA has committed to updating it this year. Although the PRA was one of the first prudential regulators to set expectations on climate risk, it has arguably been overtaken by its European counterpart both in terms of granularity of expectations and on the climate capital debate. EIOPA is consulting (PDF 2.8MB) on the prudential treatment of sustainability risks, presenting numerous options for capital requirements that reflect the potentially higher risk profile of fossil-fuel related stocks and bonds. At a global level, the IAIS has just released the third paper in a four-part consultation on managing climate-related risk, and the FSB's 2024 workplan continues its work on coordinating international efforts to address climate-related financial risk.

1) Possible climate capital requirements for EU insurers?

In December 2023, EIOPA published a consultation (PDF 2.8 MB) paper on the prudential treatment of sustainability risks. The paper analysed the potential link between prudential market risks and their exposure to transition risks. To reflect the potentially higher spread and equity risk profiles from fossil fuel-related stocks and bonds, EIOPA made several policy proposals — some of which included capital requirements: 

• Equities option 1: no changes to the Pillar 1 framework (this implies a neutral position on the level of risk posed by fossil fuel investments and does not accept the premise that they increase an insurer's risk profile).
• Equities option 2: treat fossil fuel-related stocks as Type 2 equity corresponding to a moderate increase in capital requirements for stocks currently classed as Type 1.
• Equities option 3: introduce a supplementary capital requirement of up to 17% in additive terms to the current capital charges, leading to a moderate increase in capital requirements.
• Bonds option 1: no changes to the Pillar 1 framework (also implies a neutral position on the level of risk posed by fossil fuel investments).
• Bonds option 2: introduce a rating downgrade for fossil fuel-related bonds. This would have a limited impact on solvency ratios because of insurers' low exposure to directly held bonds in the fossil fuels sector.
• Bonds option 3: introduce a supplementary capital charge of up to 40% in multiplicative terms to the current capital charges to maintain the SF's duration-rating-based mapping of capital charges. This would have a limited impact on solvency ratios because of insurers' low exposure to directly held bonds in the fossil fuels sector.

The Bank of England's (BoE's) 2023 report on climate-related risks and capital concluded that further work was required to assess whether there was a regime gap in the macroprudential framework. If such a gap is identified, further consultation will be required on the best way to address it before mandating any capital requirements. Alternatively, the PRA may continue to place the onus on firms to manage their capital levels appropriately via the principles-based supervisory framework, with robust SMF responsibility, and, in some cases, capital add-ons. 

2) More prescriptive expectations on the quantification of ESG risks 

In addition to its consultation on the prudential treatment of sustainability risks (see above), EIOPA is consulting on recalibrating its natural catastrophe (Nat Cat) standard formula (SF) parameters. It has proposed over 20 new country risk factors for flood, hail, earthquake, windstorm, and subsidence, and has also put forward options for the potential inclusion of wildfire, coastal flood and drought in future recalibrations of the Nat Cat SF. 

The proposals demonstrate EIOPA's advancing expectations for insurers to adequately quantify their physical risks. Insurers will want to review their exposures (both by territory and by perils insured) to understand how the proposals affect their balance sheets and whether this could trigger any commercial decisions on product scope and wording.  

To date, the PRA has not expressed an intention to recalibrate its Nat Cat SF parameters. 

3) Continued integration of climate-related risk into existing risk management frameworks

This message has been consistently repeated by supervisors. In the UK, the PRA (PDF 0.52 MB) noted that effective practice would include having a well-defined quantitative risk appetite statement (RAS) that aligned with the overarching risk management framework (RMF). Supervisors will expect firms to have made progress in embedding climate-related risk into their RMFs, and insurers should be prepared to demonstrate this if asked for evidence as part of their BAU supervision. Insurers should expect updates to SS3/19 to reflect lower tolerance for challenges such as data limitations, and expectations that gaps in risk management frameworks have been addressed.

4) More mature scenario analysis and stress testing capabilities

Supervisors have published many findings in this area, including a BoE bulletin on using scenario analysis to measure climate-related financial risks. Insurers should expect further focus on:

• Decision-useful scenario analysis — e.g. running scenarios that can help in making underwriting decisions.
• Use of scenario analysis to test the adequacy of their strategic response to climate change risks, e.g. by quantifying the impact of scenarios on profits and losses and regulatory capital.
• Extending macro scenarios provided by bodies such as the NGFS, and tailoring them to provide relevant asset-level analysis. 
• Ensuring that management actions resulting from scenario analysis are credible and can be executed in a stressed environment, even where other market participants are likely to be implementing similar actions.  
• Efforts to overcome data limitations when running scenarios, including using policyholder and counterparty data held by the insurer rather than relying on proxies.  
• Evidence of why selected data and assumptions are appropriate to a firms' specific business vulnerabilities. 

5) Increased focus on the prudential impacts of greenwashing

In the wider sphere of sustainability regulation, reporting and disclosures have been a key driver of regulatory pressure for firms across financial services — as seen in the latest edition of the KPMG Regulatory Barometer. However, the reputational risks involved in making misleading sustainability claims (greenwashing), whether deliberate or not, and the associated litigation (PDF 0.37 MB) risk can all translate into prudential impacts. Given the increasing focus on greenwashing from regulators such as EIOPA and the FCA, it would seem logical for the PRA to also expect insurers to assess, manage and mitigate the balance sheet impacts of greenwashing accusations. 

6) Support for further disclosure requirements

The PRA has been consistently supportive of climate-related disclosures, recommending TCFD-aligned disclosures in SS3/19 (PDF 0.88MB). In 2024, there may be further support for the FCA's upcoming work to incorporate the Transition Plan Taskforce's (TPT's) disclosure framework and associated guidance, as well as the developing UK Sustainability Disclosures Standards (SDS) and UK Green Taxonomy, into in its disclosure requirements. 

On prudential disclosures, the PRA and EIOPA have yet to mandate granular climate-related requirements, although they expect material risks to be disclosed. One of EIOPA's sustainable finance activities (PDF 1MB) for 2022 — 2024 is to promote sustainability disclosures, and insurers will want to know if EIOPA  will follow the EBA by translating this into formal Pillar 3 requirements. 

7) Reflecting nature and wider ESG risks in prudential expectations

EIOPA already has a mandate to consider environmental-related and wider sustainability risks in its prudential expectations. The PRA does not currently set out any specific requirements on nature-related risk. However, the FCA's 2024-25 business plan referred to a `nature' regulatory principle coming into force, and a report is expected in April from the Green Finance Institute, providing a `first-of-its-kind UK Nature-Related Risk Inventory' that will estimate the dependency of UK banks and insurers on ecosystem services and present a methodology to translate these dependencies into financial risk. Additionally, the Global Association of Risk Professionals (GARP) has published its first global survey on nature-related financial risks, finding that there is increasing focus on nature but firms' maturity levels on strategic engagement is relatively low. Given increasing emphasis in this area, it is reasonable to expect that the PRA may move on this — potentially as part of the review of SS3/19. 

8) Calls for increased take up of Nat Cat insurance 

Insurers will not be surprised if EIOPA calls for a higher take-up of Nat Cat insurance by policyholders as part of its work to address protection gaps. It has conducted research into the limited uptake in the EU, finding that only a quarter of Nat Cat losses on the continent are insured. EIOPA may initiate both supply- and demand-side measures to increase insurance coverage across the EU, focusing on efforts insurers can make on:

• More standardised and easily comparable products in terms of coverage, exclusions and pricing structures;
• Streamlining the consumer journey during the purchasing process, including via digital channels; and
• Offering incentives such as premium discounts for implementing risk-mitigation measures. Public-private partnerships have previously been considered in this context, but with limited political appetite.  

9) Novel approaches to climate risk modelling 

A key challenge for insurers in climate risk modelling is the lack of a granular industry or regulatory standard on approaches and assumptions. This leads to variation in the level of sophistication of climate risk modelling approaches, making it difficult to compare risks across the industry, and a possibility that key risks are being under- or over-estimated across the sector. Insurers are making their own decisions on how to develop their modelling, including on issues such as dynamic balance sheet models, factoring in second-order effects such as impacts on supply chains, developing bespoke climate risk scenarios, and revisiting appetites in their underwriting portfolios. It will be interesting to see if prudential regulators announce granular expectations on modelling approaches and assumptions, beyond the high-level expectations already published.   

Supervisors too are looking at modelling capabilities that can assist in their analysis of climate-related risk. Project Gaia has been developed by the Bank for International Settlements (BIS) partnering with the Bank of Spain, the Deutsche Bundesbank and the ECB. Gaia is an artificial intelligence (AI) application that uses large language models to search and extract data from corporate climate-related disclosures, enabling quick and efficient analysis of climate-related risks in the financial system — the recent report (PDF 6.7MB) on the project included analysis of 20 key performance indicators (KPIs) for 187 financial institutions over five years. One possible next phase of Project Gaia is to make the tool publicly available to analysts to support the growing demand for climate-related data. Insurers should expect supervisors and analysts to make increasing use of such models to gauge the potential systemic financial risks of climate change.

10) Enhanced governance  

While not specific to financial services, the updated UK Corporate Governance Code (PDF 0.4MB)will require boards to not only monitor a company's risk management and internal control framework but also explain how they have measured its effectiveness through a declaration in their annual reports. Insurers will want to consider how these requirements will encompass their work on climate-related risks. 

Globally, the IAIS's current consultation proposes to strengthen its expectations on the role of the board. The IAIS emphasises that boards should be competent in understanding the physical and transition risks for insurers, and where boards do not have this expertise they should obtain it externally and demonstrate the competence, experience and independence of external expects. Additionally, senior management and board remuneration should be aligned with prudent risk-taking — including the sound management of climate-related risks.

KPMG in the UK has a dedicated Risk and Regulatory Advisory practice with extensive ESG and sustainability expertise. For more information, and to discuss your requirements please get in touch. 

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