June 19, 2019

Focus: Regulators’ demand for action on climate change risk challenges insurers

The Prudential Regulatory Authority is expecting a root and branch overhaul of insurers’ approach to the financial risks posed by climate change.

One development that has not generated as many headlines but may have an equally dramatic impact on the sector was the publication by the Prudential Regulation Authority (PRA) of its supervisory statement, Enhancing banks’ and insurers’ approaches to managing the financial risks from climate change. This came hot on the heels of warnings last month from Bank of England governor, Mark Carney, about the severity of the threat posed by climate change to the financial sector, which he said needed urgent reforms to “raise the bar” on climate risk measurement to avoid economic catastrophe.

Many in the insurance industry have long been aware of the growing threat of climate change and re/insurers have been motivated to act through initiatives like ClimateWise. The PRA statement is set to ramp up insurers’ activities by setting out its expectations for firms to follow a strategic approach that considers how actions today affect future financial risks.

The PRA expects regulated firms’ approach should focus on four key areas: embedding the consideration of the financial risks from climate change in their governance arrangements; incorporating the financial risks from climate change into existing financial risk management practice; using (long-term) scenario analysis to inform strategy setting and risk assessment and identification; and developing an approach to disclosure on the financial risks from climate change.

The area that stands out most clearly is governance. The PRA expects each firm to appoint a senior manager, at board level, who will be responsible for identifying and managing financial risks from climate change. These individuals will have quite a task on their hands, starting with mapping out their company’s exposure to climate change risks. Exposure could affect both sides of the balance sheet: on the asset side – in terms of how those risks could impact them directly as major asset owners themselves and asset managers for others – and on the risk/underwriting side, which is at present the principal focus of the PRA.

Climate change risks fall into three broad categories: physical, transition and liability risks. Physical risks relate to the impact on asset values and insurance liabilities from damage to property as a direct result of severe weather events such as storms or floods, or indirectly from factors such as business interruption caused by disruption to global supply chains. Transition risks are financial risks that could arise from the shift to a lower-carbon economy as carbon-intensive financial assets are repriced, perhaps rapidly, potentially causing shocks to share prices. Liability risks come from parties that have suffered loss or damage from climate change and seek to recover losses from those they deem to have been responsible through their greenhouse gas emissions. Claims may also arise for loss or damage caused by failure to adequately adapt to, account for, mitigate or disclose climate risks (transition and physical) to businesses.

Meeting the PRA’s expectations could be a daunting task, especially given the deadline for compliance. Firms are required to have initial plans in place and to have submitted updated senior management function forms by October 15, 2019.

Helpfully however, there is an ever-increasing range of support and guidance available to those embarking on this journey from organisations including the Task Force on Climate-related Financial Disclosures, the Climate Disclosure Standards Board and the UN Environment Programme – Finance Initiative.

Alongside the supervisory statement, the PRA itself has issued guidance under which it sets out a six-stage framework regulated firms can follow by using existing tools and associated metrics to better assess, manage and report exposure to physical climate risks related to extreme weather events. The framework includes a number of case studies that illustrate how consideration of financial impacts from physical climate change can better inform insurers’ risk management decisions.

Insurers should be clear – this is not a superficial, box-ticking exercise on the part of the PRA. The PRA is expecting a root and branch overhaul of insurers’ approach to the risks posed by climate change.

This should be welcomed. Not only does it help to mitigate financial risks and protect insurers’ long-term prospects, but it positions the insurance industry to help make a broader contribution to better understanding, prediction and mitigation of the effects of climate change. There are opportunities here, too. For example, insurers’ modelling expertise can assist with climate risk mapping and there will be opportunities for new and innovative products designed to respond to climate risk. The gains from realising business opportunities related to climate change and the transition to a low-carbon economy have been estimated at $2.1trn.

The PRA’s supervisory statement is not the final word. It has said it will develop more granular requirements over time and the direction of travel is undeniably towards more stringent regulation, paving the way for the introduction of mandatory requirements.

With societal, market and regulatory pressure building and the Paris Agreement commitments applying from next year, other developments will follow. There are concerted efforts being made by nation states, international organisations, development banks, central banks and regulators towards weaving climate resilience into the fabric of the international financial system.

There are suggestions at some point in the future Solvency II capital requirements could be modified to help insurers unlock green finance. If some of insurers’ considerable assets could be redirected towards green investment this could make a significant difference. By fostering green investment on the asset side, insurers may contribute to reductions in the worst effects of climate change and reduce the losses on the underwriting side, a virtuous circle that many understand will be in the best long-term interests of the global insurance industry and the planet on which it operates. The focus right now for insurers needs to be on translating climate change awareness into action.

This article was first published in Insurance Day.