Quantifying climate risk in insurance

For many in the insurance industry, grappling with the risks of climate change is nothing new. Indeed, there are some insurers whose business model viability depends on understanding the physical risks of climate change — where do some of the most damaging natural catastrophe events occur, how frequently do they occur, what could the projected losses of these extreme weather events be, and at what level should the reserves be set once the probability and severity of these risks have been modelled?

However, the risks of climate change go beyond the physical. In addition to the obvious examples of flood, hurricane and wildfire, insurers need to take account of the transition risks of climate change — the process whereby firms adjust to a low-carbon economy and contend with changes in regulation, the emergence of disruptive technology, and shifting societal preferences. 

Both physical and transition risks are of concern to financial regulators, and 2022 is the first year in which climate-related risk is being actively supervised in the UK as a prudential risk. And increased regulatory focus on the prudential impacts of climate change risk is not limited to the UK. Earlier this year EIOPA released its assessment of European non-life insurers' exposure to physical climate change risks and subsequently published advice on how firms can conduct materiality assessments and scenario analysis for both physical and transition risks. 

Below, we take stock of recent prudential regulatory updates for insurers across the UK and EU and consider what could be next as policymakers prepare for the Bank of England (BoE) and Prudential Regulation Authority (PRA) Climate and Capital Conference in October, and the UN's COP27 session in November.

As highlighted in SS3/19 and in its letters to CEOs in 2020 and 2022, this is the year when the PRA expects UK insurers to demonstrate that they have embedded regulatory expectations on climate change risk. Insurers — and not just those in the nat cat (natural catastrophe) space, but those operating across all lines of business in life and general insurance — will have to demonstrate compliance with the PRA's Supervisory Statement SS3/19. Regardless of lines of business offered, insurers must demonstrate that they have assessed the physical and transition risks of climate change and, if these are found to have a material impact on the balance sheet, should have appropriate risk management controls and management actions in place to mitigate the risks. 

Our previous article covered these expectations in more detail, but we now have the results of the BoE's Climate Biennial Exploratory Exercise (CBES) to provide some insight into how the market is stepping up to the task (see more on the CBES results here). 

The obvious question following the CBES exercise is whether the PRA will now seek to mandate any capital requirements for the management of climate-related risk. The PRA's 2021 Climate Change Adaptation Report stopped short of this, and there are a number of challenges surrounding this issue. Capital requirements should be risk-sensitive and therefore should not try to incentivise or disincentivise `green' or `brown' investments and underwriting; unfavourable treatment of `brown' investments in capital requirements could reduce financing that is vital for transition plans, and potentially push these investments into private equity houses, where there may not be the same level of shareholder or stakeholder scrutiny. Additionally, the calibration of capital requirements is typically based on historical data, whereas climate change risks will impact future trends. Despite these challenges, the PRA has noted that firms should incorporate judgements about their climate exposures when assessing their own capital requirements, as they do for other financial risks. The BoE stressed that CBES was not an exercise to determine how capital levels should be set within firms. However, now that we have a flavour for how insurers' profitability could be affected by climate change and know that the PRA considers more should be done on risk management frameworks, the question around mandatory capital requirements persists. The BoE/PRA Climate and Capital Conference will be an opportunity for regulators and industry to consider further the respective costs and benefits of this issue. 

Until then, insurers can take note of the BoE's expectation for firms to do more work in understanding and managing climate-related risk. Access to data (including interaction with counterparties to understand better their exposures and climate transition plans), modelling capabilities and the ability to conduct scenario analysis have all been highlighted as areas for improvement, and insurers should continue to demonstrate their analyses in their Own Risk and Solvency Assessments (ORSAs). 

Additionally, once exposures have been identified and risk management frameworks adapted, insurers should consider how their management actions can be more sophisticated and credible. One example is reinsurance: on an individual firm level, managing net exposure to climate risk via reinsurance seems like a credible action—but if this is replicated across the industry, then firms will need to consider seriously the availability and affordability of such cover. Likewise, withdrawing investment or underwriting from high-carbon sectors, such as fossil fuels, seems credible on an individual level — but if the pace of insurance/investment withdrawal is faster than the pace of emergence for alternative technologies (e.g. renewable energy), this could have wider macroeconomic impacts that may affect other parts of the balance sheet (e.g. any recessionary impacts on insurers' investments if there is wide-scale withdrawal of financial services to fossil fuel companies). 

Insurers therefore should consider the implementation challenges of their climate management actions, both with regard to scenario analysis and in their climate transition plans. They should recognise that other market participants may have similar actions in their plans (thereby losing any potential first-mover advantage), and be alert to the macroeconomic environment in which they operate.

In May this year, EIOPA published a report highlighting European non-life insurers' exposure to physical risk. The findings indicate that more work needs to be done. More than 50% of participants had not undertaken any climate change analyses, and a substantial number were unable to provide a qualitative assessment on global developments around climate change. Challenges around the availability and granularity of data were also a common theme. 

In August, EIOPA published its guidance on materiality assessments and scenario analysis in ORSAs. The guidance consists of non-binding suggestions, including example analyses so insurers can witness the practical application of this guidance. EIOPA's examples vary, showing how materiality assessments and scenario analysis for both physical and transition risk can be conducted using the following tools and datasets: Representative Concentration Pathways (RCPs) from the Intergovernmental Panel on Climate Change (IPCC), Shared Socio Economic Pathways (SSPs), Nomenclature of Economic Activities (NACE) codes, Paris Agreement Capital Transition Assessment (PACTA) tool, European Environment Agency (EEA) Discover Map Services, Climate Impact Explorer and a number of other data sources / tools. EIOPA cautions that firms should use alternative sources and methodologies if the suggested ones are not suitable to an insurer's portfolio exposures. Nonetheless, the technical application of these data sources provides helpful insights into regulatory expectations and gives firms useful practical guidance on how to conduct their analyses. 

Regardless of the datasets used or methodologies applied, for materiality assessments insurers are expected to follow a general approach that can be explained via this three-step process:

1. Define the business context (i.e. identify which areas of the business are exposed to climate risk)
2. Research the impacts of climate change on the business (i.e. distinguish between physical and transition risks, and elaborate on how the risk will affect various lines of business or balance sheet investments)
3. Assess relevance to the business (i.e. assess materiality for both sides of the balance sheet, including size of individual exposures and probability of risks crystalising)

EIOPA reminds firms that all climate-related risks should be considered in their assessments, even if those risks are not components of the standard formula (e.g. wildfire). Once the materiality assessments have been conducted, insurers should include the most material risks in their ORSA scenario analysis. Key points to note in relation to ORSAs are that:

They should include at least two long-term pre-determined climate change scenarios:

• The global temperature increase remains below 2°C, preferably no higher than 1.5°C
• The global temperature increase exceeds 2°C

Like materiality assessments, they should follow a three-step process that:

• Defines the scenario
• Transforms the scenario into climate change risks for the business
• Transforms the risks into financial losses

EIOPA recognises the challenges that insurers face, such as insufficient data granularity and difficulty in using the right climate modelling tools suited to a firm's own business exposure. Nevertheless, it asks firms to work around these challenges, and has set a baseline for how insurers should consider climate change risk in their ORSAs.

The expectations set by the PRA and BoE via the supervisory statement and CBES results, and the detailed technical guidance provided by EIOPA, help insurers to navigate supervisory requirements on climate change risk. However, significant questions remain around the expectations on climate capital. 

It is also worth noting that environmental risks affecting insurers go beyond climate change. To date, the `E' in ESG has focused on climate, but regulators are increasingly turning their attention to nature and biodiversity as areas of concern. The BoE has already signalled that it wants to increase its capabilities in this area, and the Taskforce on Nature-related Financial Disclosures (TNFD) will publish the third iteration of its framework in November ahead of the final launch in September 2023. It remains to be seen exactly how nature-related risks will feed into prudential frameworks, but insurers will want to stay close to developments in this space.