Insurers and the changing tide – APRA’s final prudential practice guide for CPG 229 and climate change

What is CPG 229?

As noted in our previous article, APRA released its final prudential practice guide CPG 229 Climate Change Financial Risks (CPG 229) on 26 November 2021. CPG 229 details what APRA considers sound practice from an institution in respect of climate change and the managing of associated financial risks. The guide deals with the financial impacts of climate change with respect to key areas including governance, risk management, scenario analysis and disclosure.

What does CPG 229 bring to the table?

APRA outlines its expectations regarding conduct by a prudent institution in respect of many areas of an institution’s business. APRA says that a prudent institution will consider both financial opportunities and financial risks of climate change when setting strategy. CPG 229 does not seek to impose strict obligations on institutions but rather guide them towards the management of risks and opportunities arising from climate change so that they are in line with APRA’s approach to other types of risk.

Figure 1 of CPG 229 provides an overview of APRA’s climate change financial risk guidance.

Figure 1. Overview of APRA’s climate change financial risk guidance

Source: Australian Prudential Regulation Authority, 2021

Financial risk is considered in three distinct categories - physical, transition and liability risks. A prudent institution will take a strategic and risk-based approach to the management of the various risks and opportunities arising from climate change. Institutions should understand that financial risk related to climate change are also interconnected with the other risks an institution will face. These include credit, market, operational, insurance, liquidity, and reputational risk which may in turn compound and increase overall climate change-related risks, and consequential loss and damage.

Figure 2 of CPG 229 provides an overview of climate change financial risks.

Figure 2. Climate change financial risks

                                   Source: Australian Prudential Regulation Authority, 2021

CPG 229 strengthens the governance requirements enshrined in CPS 510 and SPS 510. It states that prudent practice will involve a board seeking to understand and regularly assess current and future financial risks arising from climate change that affect the institution. It provides guidance as to how a prudent board and senior management could manage these risks and requirements

A prudent institution will consider climate change within its overall risk management framework and ensure that it can identify, measure, monitor, manage and report on its exposure to climate risks in a way relative to the size, business mix and complexity of the institution’s business operations.

Institutions should develop capabilities in climate risk scenario analysis and stress testing. Such practices will assist institutions in identifying risks in the short and longer term. This involves maintaining appropriate documentation of the methods used in scenario analyses and stress testing and an assessment of the limitations in such analyses.

An institution’s disclosures play a role in decision making, especially with respect to stakeholder investment into an institution. APRA says that a prudent institution should consider if additional voluntary disclosures could be beneficial in enhancing transparency and giving confidence to the wider market with respect to the institution’s approach to measuring and managing climate risks. Institutions must develop and evolve disclosure practices, regularly review disclosures for comprehensiveness, relevance, and clarity and to ensure that they are prepared to respond to changing and increased stakeholder expectations regarding climate-related disclosures.  APRA says the better practice is for any disclosures to be produced in line with the framework established by the Financial Stability Board Task Force on Climate related financial disclosures (TCFD).

What do insurers need to do?

Insurers should carefully consider and follow the guidance set out in CPG 229 and actively manage their operational and financial risks and strategy for climate change. Neglecting the mounting risks posed by climate change may also result in an increased risk of regulatory action, stakeholder litigation and reputational harm.

Insurers will already be considering the likely effect of climate-related financial risk on their business and reviewing their mitigation strategies for pre-existing risks associated with their business operations. These risks include market risk, liquidity risk, insurance risk and reputational risk.

In terms of market risk, insurers should contemplate the impact of climate change upon the pricing of their financial instruments. For example, an insurer should price their insurance policies for an evolving climate change landscape to reflect the associated financial risks.

Further it is increasingly important for insurers to regularly review and ensure that there is appropriate governance in place, at Board and senior management level, in relation to the ongoing identification and management of climate risks.

If you have any questions regarding compliance with CPG 229 or other climate change related regulatory or compliance matters, please feel free to contact Dean Carrigan at dean.carrigan@clydeco.com and Jacinta Studdert at jacinta.studdert@clydeco.com. For further information regarding climate change, please visit our website.