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Leading the parade – a forced march to the beat of a climate change drum

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EY’s James Maher, Insurance Sector Leader for EY Financial Services, writes about climate change for the January 2021 issue of Finance Dublin.

While it is hard to read a newspaper or website without bumping into a section on climate, climate change or its all-encompassing context of an environmentally and socially sustainable planet, it’s also fair to say we are only at the very start of the journey. We are in the phase where we are becoming aware and engaged at a pace and thus are testing our understanding and articulation of the complexities of the issue. While the global masses are getting with the programme we have the amplified voices of activists being added to the mix and now, perhaps more assuredly and determinedly, the voices of our politicians and regulators. As a financial services sector we have been orientating towards this not least under the auspices of the Network of Central Banks and Supervisors for Greening the Financial System (NGFS) and a host of other sector specific agencies and bodies such as the United Nations’ Principles for Responsible Investment (UNPRI); however now it seems like it’s all about to get real as voluntary initiatives and socially attuned but perhaps immature programmes give way to what will be an industrial grade transformation of financial services.

So what does that regulatory landscape look like and what aspects of the insurance value chain or insurance ecosystem does it impact?

The Prudential Regulatory Agenda – It’s all about timing

Depending on how close one is to the insurance sector and its extant climate exposures, concerns over the current resilience of balance sheets to climate change are perhaps unclear. That particular insight can only emerge from stress testing and scenario testing which is very much the phase that the industry is in at an overarching level and that individual companies are currently assessing. While it does not appear that there is an imminent or extant exposure from physical risks, the position is less clear for transition risks. Looking for example at a recent and preliminary report from the European Insurance and Occupational Pensions Authority (EIOPA) on the insurance industry, “Sensitivity analysis of climate change transition risks”, it would appear that due to diversification of asset portfolios, offsetting from gains in sectors such as renewals together with loss sharing by policyholders, the risk looks manageable. More pressing concerns for the sector arise from the second order impact of consequential impacts of climate transition on GDP and interest rate environments; in the same way that slow moving hurricanes do the most damage, so it is that the low-for-longer interest rate scenario is the real industry threat.

That said, it does not mean the prudential regulatory agenda has passed by climate risk; in fact, quite the opposite. Specifically, there are three areas related to climate risk that require consideration:

  • beyond the micro prudential risk agenda there is a clear macro prudential context that regulators are responding to, looking not just current market stability but also future market stability;
  • Access to financial services and in particular the extant insurance coverage gap; and
  • the growing recognition that climate risks are mispriced in the valuation of assets and liabilities by markets and as such whether precipitated by transition policies, such as carbon pricing or specific pricing for generalised volatility, there is a heightened sectoral valuation risk.

Looking to the first topic, where the micro prudential risk agenda morphs into the macro prudential agenda, it is apparent that there is an extension of scope wherein the purview is being extended into the future state to identify the stability and access to financial services in the future. This extension of the prudential agenda in time and scope is creating some areas of tension and debate in evolving regulation.

As a specific example, EIOPA is currently consulting on a wide range of themes related to the adaptation of Solvency II to reflect or respond to climate risk. There are clear areas of focus regarding the extension of natural catastrophe risk exposure across Europe over the near term, where for example flood risks are amplified in Northern Europe and drought risks are amplified in southern Europe. This would appear to be a very sensible area of focus and in particular the establishment of a framework for recalibration of the Natural Catastrophe risk module to recognise emergent changes in risk parameters makes clear sense.  Areas however that are more contentious, and the regulatory drift is perhaps less supported, are in the establishment of multi decade stress tests for insurers to capture the what-if scenarios very far into the future. This is an area of consideration where what is a micro prudential tool, the Own Risk and Solvency Assessment (ORSA), may be co-opted into a macro prudential space and is an area where there is likely to be resistance from industry.

The second point, access to financial services and access to insurance coverage, is an important topic and theme, albeit one that cannot be resolved by industry alone. Specifically, unchecked climate change will lead to withdrawal of capacity and/or increasing premiums, all of which will further reduce insurance penetration and coverage leaving the most vulnerable unprotected. This too is a key ambition for EIOPA to explore with industry, looking at pricing options, state schemes and abatement schemes. While not strictly a prudential matter it falls within the scope of pricing and underwriting and is certainly an important area of focus for the industry and the term “impact underwriting” will start to become a common if not commonly aligned term.

The final of the three points above is an overarching uncertainty of asset valuations and the scope for significant market price dislocations connected to policy changes, such as accelerated policy responses in areas such as tax or market access. This is already manifest in some market segments, such as coal, where access to finance and refinance capital as well as risk insurance are accelerating defaults in these areas. Whereas the expectation is that there is resilience in the insurance sector to such risk, it is an area for continued vigilance alongside a growing attention under the prudent person principle to ensure the appropriateness of investment universes.

Disclosures – a trojan horse

Sticking with the global regulatory agenda there has been in place a set of standards established under the auspices of the Financial Stability Board for the financial disclosure of climate risks by institutions. The Task Force on Climate-related Financial Disclosures (TCFD) published their report and recommendations in 2017; these TCFD standards are increasingly becoming or informing the international benchmark for climate disclosures and are something of a jumping off point for a range of standard setters and regulators in what is quite a fragmented domain.

The remit of these disclosures, encompassing Strategy, Governance, Risk Management and Measurements and Metrics, are wide ranging and comprehensive in nature. This is where the reference to a trojan horse comes in: in order to report on Strategy, Governance and Risk Management the enterprise needs to have in place a broad based and tangible set of policies, processes and attendant resources before they can coherently or comprehensively report on the same. In order to select KPI’s and to measure exposures, not just of the enterprise but of downstream exposures too, there needs to be a comprehensive set of methodologies, models and data sets together with related assurance. As such it is perhaps unwelcome but unsurprising that all but a very few elite level organisations can be reasonably considered as reporting both with breadth and with quality in accordance with the TCFD recommendations. The corollary of this being that the quality of disclosures is a prima facie indicator to regulators and broader stakeholders as to the level of maturity of the reporter.

Going green – a forced pace march?

Last but by no means least there is a very clear impetus to report or proclaim green credentials; not least as there is a clamour from stakeholders to have such credentials on display. But what happens when the readiness is not in accordance with the requirements of the reference standard to which adherence is desired or proclaimed? At this juncture there are a range of standards and standard setting agencies to which one could proclaim adherence, but to what extent are the processes and policies and related assurances in place?

This issue will come into even sharper focus following the publication of the EU taxonomy for sustainable activities last summer, which defined green activities as economic activities which significantly contribute to at least one of six predefined environmental objectives while doing no harm to the remaining activities.

Related to this there will be a specific requirement for insurers to report on KPIs pertinent to the Non Financial Reporting Directive as referenced in the taxonomy legislation. In this, EIOPA re consulting on KPIs related to Premium Income, Assets and Reserves as measures of stock and flow in the insurance industry.

As such the step into a green world is a step into a world of increasing compliance with new processes and standards with the attendant risks of noncompliance.

Conclusion

In conclusion, the Financial Services industry in general, and the insurance industry as the focus of this article, is on a forced pace march by regulation and policy to ensure that the sector supports wider policy objectives to protect our people and planet. It is also clear that there is no uniform catalyst from extant risk or opportunity to make such changes as without regulatory intervention it would be a slow and uneven adaptation by industry. What are likely to be the most effective tools in the regulatory armoury are those that pertain to governance, disclosure and product development, with a supporting role from a prudential regulatory agenda as risks start to amplify and accumulate unchecked. As such, there is perhaps merit in setting an internal pace of change and adoption, moving ahead of minimum compliance, ensuring a strategic response is adopted to what is a strategic challenge.

This article “Leading the parade – a forced march to the beat of a climate change drum” first appeared in the January 2021 issue of Finance Dublin. Don’t hesitate to reach out if you have a question.

James Maher

Insurance, Sector Leader
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