Regulating for climate change in insurance

Regulators at global, regional and national levels are assessing the insurance sector's exposure to climate risks and requiring firms to conduct scenario analysis and take account of risks in their own risk and solvency assessments.

Insurers play a critical role in the global fight against climate change: they pay out claims when customers suffer losses caused by extreme weather; they have considerable capacity to make long-term investments in infrastructure to support climate change adaptation and mitigation; and their risk management expertise can help governments, companies and communities develop resilience.

Climate change also exposes insurers to heightened financial risks. More frequent and intense weather events can lead to higher claims and reduce the value of property investments. The transition to net zero impacts insurers' customers, particularly those businesses operating in carbon-intensive sectors either unable or unwilling to develop robust climate transition plans. As greener technologies become cheaper and governments introduce further policy measures, transition risks start to materialise within insurers' investment and underwriting portfolios. 

At the same time there are opportunities for the sector to support the transition, for example by tailoring their products to support the development of these emerging technologies and differentiating insurance premiums to incentivise more energy-efficient behaviours. 

Firms need to integrate climate change into business strategy, governance, risk management, investment and underwriting decision-making, product design, claims handling and operations.  Failure to act now might leave firms open to litigation, challenge from shareholders and regulatory pressure, and unable to adapt their business models to a changing business and economic environment.

IAIS sets a global tone

The IAIS¹ issued a statement in advance of the COP26 conference, confirming that it will urgently advance work to address risks and opportunities associated with climate change. It will seek to assist both supervisors and firms, and to ensure a consistent approach.

Its 2021 Global Insurance Market Report (GIMAR) finds that more than 35% of insurers' investment assets (including equities and corporate debt, loans and mortgages, sovereign bonds and real estate) could be considered “climate-relevant”, i.e. exposed to climate risks. Within the equities, corporate debt, and loans and mortgages asset classes, the majority of climate-relevant exposures relate to counterparties in the housing and energy-intensive sectors. However, there are significant regional differences in terms of balance sheet asset composition and climate-relevant exposures.

The IAIS has also developed scenarios to assess climate change impact on a forward-looking basis. Analysis of climate-related risks poses conceptual and methodological challenges, including a lack of understanding about the uncertain process of climate change and its non-linear effects, the forces influencing it and how these relate to financial sectors, and the lack of a globally consistent framework for measuring climate risk-related financial information.

The report finds that, under an orderly transition scenario, there would be a drop in insurers' available capital of around 7% to 8% of their required capital. That drop increases to over 14% under a disorderly transition scenario, and to almost 50% under a “too little, too late” scenario.

The IAIS reiterates recommendations from the IAIS/SIF² 2021 Application Paper:

• Supervisors should assess the relevance of climate-related risks for their supervisory objectives. They should collect quantitative and qualitative information on the insurance sector's exposure to, and management of, physical, transition and liability risks of climate change. 
• Climate-related risks should be considered for inclusion in insurers' own risk and solvency assessments. It is expected that insurers will adopt appropriate risk management actions to mitigate any identified risks.
• Insurers should assess the impact from physical and transition risks on their investment portfolio, as well as on their asset-liability management. A forward-looking view, including the use of scenarios, may help insurers gain a better understanding of the risks.
• Material risks associated with climate change should be disclosed by insurers, in line with Insurance Core Principle ICP 20 (Public Disclosure). Supervisors may use the recommended framework of the Task Force on Climate-Related Financial Disclosures when designing best practices or as input for setting their own supervisory objectives

EIOPA focuses on ORSA

Back in April 2021, the European Insurance and Occupational Pensions Authority (EIOPA) issued an opinion setting out its expectations of national supervisors on their supervision of insurers conducting climate-change scenario analysis as part of their Own Risk and Solvency Assessment (ORSA). In future, national supervisors will collect qualitative and quantitative data as part of their supervisory review, so they can better assess the short- and long-term climate change risks on the industry.

At present, only a minority of insurers assess climate change risks in the ORSA, usually limited to a short-term time horizon. A forward-looking management of these risks, EIOPA says, is essential to ensure the long-term solvency and viability of the industry. EIOPA expects insurers to evolve the sophistication of the scenario analyses, taking into account the size, nature and complexity of their climate-change risk exposures. The opinion provides practical guidance on how to select and use climate-change scenarios.

In September 2021, the European Commission adopted proposals requiring insurers to assess whether they have material exposures to climate change risks and, where this is the case, to assess the impact on the business at least every three years using at least two long-term climate-change risk scenarios: where the global temperature increase remains below or exceeds 2°C.

UK refines its expectations

The UK regulator has given insurers until the end of 2021 to embed fully the climate-related supervisory expectations it set out in 2019. These expectations include allocation of responsibility to a senior manager, board oversight of risks within overall business strategy and risk appetite, managing risks in line with risk appetite statements, conducting scenario analysis and developing an appropriate approach to climate disclosure. The regulator recognises challenges around capabilities, data and tools but expects firms to develop a proportionate approach and integrate within broader risk assessments by the end of this year.

Ten of the largest UK life and general insurers and 10 Lloyd's managing agents participated in the Bank of England's Climate Biennial Exploratory Scenario (CBES) exercise. They applied three scenarios to their balance sheet over a 30-year time horizon, to quantify the risks and to consider potential responses to those risks. The Bank of England expects to publish aggregated results by May 2022.

Potential changes to solvency rules

To date, regulators have been reluctant to incorporate `green supporting' and `brown penalising' factors in the quantification of capital requirements. Aside from challenges of definition and how to calibrate risk charges where there is limited historical data, there are concerns that regulatory capital regimes should not be used as a tool for internalising the cost of emissions or for creating policy incentives for greening the economy. But change may be on the way.

In its review of UK Solvency II, HM Treasury is keen to adapt the rules to support insurers in providing long-term capital and investing in infrastructure, venture capital, growth equity and other long-term productive assets, and to support investment in line with the Government's climate change objectives. The insurance industry has argued that one of the best ways to do this is through modifying the design of the risk margin and providing greater flexibility around the matching adjustment.

The European Commission proposes to give EIOPA a mandate to consider whether a dedicated prudential treatment of exposures to assets and activities associated with environmental and/or social objectives would be justified, and to submit a report the Commission on its findings by end-June 2023. EIOPA is also required to review the scope and calibration of standard formula parameters with respect to natural catastrophe at least every three years, taking into account the latest available evidence on climate science.

EIOPA has welcomed the European Commission's proposals. It believes the proposals will, more generally, contribute positively to a transition into a more sustainable economy and that insurers, in their role as investors and risk managers, can facilitate it.