The launch of a consultation paper on the approaches to managing financial risks arising from climate change will transform the way that organizations do business. But how should insurers react – and what are the risks?
The Prudential Regulation Authority (PRA) consultation paper on the financial risks of climate change, known as CP23/18, which was released on October 15 is a radical document. It outlines expectations towards effective governance, risk management, scenario analysis and disclosure. If it’s implemented, it will have wide ranging consequences both for insurers’ investment strategies and for risk management. It is vital to consider what these impacts might be and how insurers should react.
CP23/18 is part of a general wider regulatory trend across banks, insurers and direct benefit pension schemes requiring greater consideration and disclosure of sustainability and Environmental, Social and Governance (ESG) related issues. The paper follows on from the European Union commitments in the wake of the 2015 Paris Accords and the global agreement to hold the increase in average global temperatures to 2°C above pre-industrial levels, or less. In fact, the 1.5°C rise is being seen as a more important target in recent research, while the subsequent European Commission Action Plan on Financing Sustainable Growth and many other voluntary initiatives and statements of intent also add urgency.
Climate risks are financially material to insurers. Integrating these risks within ESG disclosure frameworks, where other factors are recognized to be non-financially material are contained, represents an important development.
The insurance liabilities from climate risk exposure are evident. There is an increased risk of flooding and extreme weather events increasing the level of insurance claims. Indeed, 2017 was the worst year on record, with wildfires in California and a series of hurricanes. But until now, the much wider financial risks that relate to the impact on assets have been largely overlooked by insurers.
However, it’s clear the PRA are taking this seriously. They want to see evidence of climate change-related financial risk being appropriately considered and reflected in written risk policies, board reports and Own Risk and Solvency Assessment (ORSA). Companies’ boards and executives as well as investment and risk professionals in the insurance industry have been put on notice to think about the relationship between climate change and financial risks. Some of the challenges they can expect are:
Who at board and executive level has responsibility for identifying and managing the financial risk from climate change under the Senior Management Function and their formal statement of responsibilities?
How is the attitude towards financial risks embedded within risk appetites and frameworks, including the insurers’ ORSA.
Have insurers appropriately identified and understood the possible financial risks from climate change? Do they differentiate between physical risks, such as floods and storms, the impact on supply changes and agriculture associated with a failure to achieve the 2°C target? Do they understand transition risks resulting from actions taken to shift to a low-carbon economy, such as regulation banning the use of fossil fuels or new technology disrupting old industries?
Methodologies and metrics are needed to quantify climate risks, and will be necessary for insurers to understand where an appropriate place for the balance between qualitative and quantitative approaches might be.
Scenario stress testing
Does scenario and stress testing appropriately incorporate the two different paths of physical and transitional risks, and the worst case scenario where action is taken too late, resulting in both physical risks and transitional risks being realized? Another complication is timeframes. More material impacts will manifest over a much longer term but short-term impacts must also be considered.
Impact on business strategy
How might firm’s business models and strategies be affected by climate change and what mitigating actions could they take and when? There are implications for underwriting and there will be increased claims for insurers to deal with as a result of climate driven changes.
Prudent Person Principle and investment strategy
The PRA has given a clear indication that risks arising from climate change are real. Therefore, they fall under the Prudent Person Principle meaning the consequences of climatic risk need to be incorporated into investment strategy. Has the risk of having stranded assets arising from climate change-related regulatory or legislative change adversely impacting certain investments and sectors been appropriately considered?
Additional disclosures will be needed in respect of insurers’ approach to the financial risk from climate change. With greater disclosure comes greater reputational risk and possible customer impact. The PRA has encouraged insurers to engage in wider initiatives such as the recommendations from the Taskforce on Climate-related Financial Disclosure.
The French have been particularly active in this area, with Article 173 of French law requiring major institutional investors and asset management companies to explain how they take ESG criteria into account in their risk management and investment policies which has changed the way they act. What can we learn from them?
Companies have until January 15, 2019 to respond to the PRA’s consultation paper, but experience suggests that there will be no radical revisions to the PRA’s thinking before it becomes a regulatory requirement. One thing seems clear: doing nothing will not be an option and there’s a risk of substantial financial loss if insurers do not act quickly enough.
There’s a growing interest in understanding how specific asset classes translate climate risk into financial risk in different ways. Whereas equity valuation embeds perpetuity considerations which, at least in theory, should capture long-term exposure, debt markets typically see shorter durations and lesser exposure. Either way, asset pricing should perhaps see the first, real impacts:
Analysis is well advanced to price climatic risk impacts into real assets valuations on two fronts:
- The physical risk exposure, such as the risk of flooding or an extreme weather event.
- The carbon footprint of the asset, and the risk of it becoming a stranded asset, something that’s already happening in sectors in the U.K., such as the buy to let market where properties now need to have minimum Energy Performance Certificate (EPC) rating.
Given the illiquid nature of many of these assets, swift action is imperative.
Some insurers have already made wide ranging changes to their liquid asset portfolios to add greater weigh to ESG, but others have yet to act. Key to moving forward is assessing an insurer’s asset portfolio and its levels and concentrations of exposure to physical and transitional risks from climate change, as virtually no sector of any industry is likely to be unaffected. But action is complex and there are many factors to consider. For example, the biggest extractors of fossil fuels are some of the biggest investors in renewable energy. How do you treat such firms?
Just as important is identifying where the opportunities are for investment. In a changing system, a company’s ability to adapt to the new terrain will be crucial. Given the importance of this subject, the clear regulatory interest and wider trends, we’ll be returning to this subject again in future blogs.