The 2020s modern-day enterprise is characterised by heightened operating uncertainty, coupled with the need to adapt to an ever-changing environment. Environmental, Social and Governance (ESG) captures a wide dashboard of goals that consider enterprise value beyond conventional financial considerations. Within these goals is the global ambition to limit the planet's temperature rise to not more than 2 °C (and ideally 1.5 °C) to stave off the worst effects of climate change1.
Given their role of facilitating risk pooling and transfer, it is in insurers' interest to minimise the overall financial uncertainty of their policyholders. Increasingly, financial uncertainty is underpinned by environmental considerations, including climate change.
Why does climate change matter for insurers?
Climate change poses an imminent threat to both the short-term and long-term stability and sustainability of insurance operations. The Bank of England2 identifies three broad classes of climate risks, which may expose an entity to financial losses:
- Physical risks: This class captures
the direct financial losses and claims experience resulting from
greater claim frequency and / or severity due to weather events
(Natural Catastrophe [NAT CAT] perils) such as flooding, windstorms
and hail. This is coupled with related losses such as diminished
crop yields and business interruption. Examples include disrupted
supply chains due to NAT CAT activity, or lower occupancy levels of
a hospitality establishment (such as a ski resort) due to altered
climate patterns. This is already evident in the trend of increased
frequency and intensity of extreme weather events such as Hurricane
Dorian in 2019 and more recently the persistence of prolonged
droughts and increased fire risk in the Mediterranean3
such as seen in the 2021 heatwave and wildfires in Greece.
- Transition risks: The focus here is
on financial losses resulting from the transition away from a
carbon-based economy as insurers and insureds adapt to climate
change. Examples include the redundancy cost and financial losses
resulting from scaling down operations related to fossil fuel
usage. Some insurers for instance have ceased writing coal-related
risks to keep to nationally determined contributions (NDC)
commitments in line with the 1.5°C Glasgow Pact
objective.4 Transition risks also capture the cost of
complying with climate change-related legislation such as climate
change financial risk disclosures. Such disclosures may include
those recommended by the 'Task Force on Climate-related
Financial Disclosures' (TCFD), reporting under which is
mandatory for the UK's largest entities.
- Liability risks: Climate change could also expose insured entities to litigation and resulting damages from failing to comply with relevant climate change-related legislation or even failure to act. As a result, insurance undertakings may also be exposed to the resulting adverse liability losses, which may be latent for a while until the facts and circumstances leading to legal action materialise. An example of such, is the successful pursuit of Royal Dutch Shell by Friends of the Earth Netherlands ('Milieudefensie').
Focusing specifically on Non-Life Insurers, climate change can have far-reaching effects on the following impact areas, amongst others:
- Increased premiums and/or inability to find affordable
reinsurance capacity, due to greater exposure to NAT CAT events.
Increased NAT CAT exposure could also lead to increased risk
capital requirements, to be able to absorb financial losses that
are more frequent and more severe than previously envisaged.
Reduced reinsurance capacity could also lead to lower
risk-mitigation benefits in capital planning. Insurers that do not
factor climate change into their pricing may risk bearing the cost
of anti-selection resulting from market players that do select
based on climate-change risk exposures (e.g., catastrophic risk
zone / postcode rating in home or motor insurance).
- Potential financial exclusion of certain policyholders: for
instance, premiums levied on NAT-CAT prone policyholders may reach
unaffordable levels, or cover may not be within the insurer's
risk appetite at all.
- Increased burden on health insurers from greater heat stress,
poorer air quality (possibly resulting in greater incidence of
respiratory illnesses such as asthma), increased vector-borne
illnesses such as dengue fever and malaria (outside of their normal
geographical distribution), together with increased direct
casualties from NAT CAT events.
- Secondary impacts on investments resulting from greater financial market volatility brought about by greater resource scarcity, and the resulting inflationary pressures, socio-economic tension and stressed diplomatic ties.
For Life Insurers climate change may manifest in the following amongst others:
- Increased seasonal mortality (e.g., due to heat waves) possibly
net of less severe extreme cold-related deaths in winter.
- Changes in population demographics and their mortality /
morbidity characteristics. This occurs as migration patterns shift
to adapt to altered climates and environments.
- Greater investment uncertainty and potential insufficiency to
meet guaranteed returns.
- Greater accumulation of risk resulting in events of mass loss of life (subject to policy exclusions), inherent to increased NAT CAT activity.
What are the recent strides and regulatory changes that impact insurers with respect to climate change?
Regulatory and industry-wide bodies have already started taking action. Consistent with a global ESG-oriented drive, regulators are now defining expectations of what regulated entities need to factor in when considering climate change risks.
The European Insurance Regulatory body, EIOPA, has issued guidance in the form of the "Opinion on the supervision of the use of climate change risk scenarios in ORSA" (EIOPA-BoS-21-127) (EIOPA, 2021). This concerns the integration of climate change risks, both in the long- and short-term planning horizons, as part of the entity's Own Risk and Solvency Assessment (ORSA) process.
EIOPA recommends that particular consideration is given to the three primary risks inherent to climate change that are expected to impact undertakings, that is physical, transition and liability risks.
EIOPA therefore recommends that the entity amongst other things:
- Conducts a sufficiently detailed assessment of material climate
change risks.
- Conducts, where appropriate, subject to the materiality of
identified risks, "a sufficiently wide" range of stress
or scenario analyses, taking into account both short- and long-term
outlooks. This is to include at a minimum, two long-term oriented
scenarios:
- A climate change risk scenario where the global temperature increase remains below 2°C, preferably no more than 1.5°C, in line with the EU commitments; and
- A climate change risk scenario where the global
temperature increase exceeds 2°C.
- Considers the relevant methods and main assumptions used in its assessment and the necessary data requirements to conduct such analyses.
In July 2021 EIOPA issued its "Report on non-life underwriting and pricing in light of climate change" (EIOPA-BoS-21/259) (EIOPA, 2021) concerning the implications of climate change on general insurance premium setting and underwriting risk acceptance.
It acknowledges the potential implications on rate-setting and reinsurance availability, and the sustainability of cover of NAT-CAT exposed business, including potential rate increases and 'crowding-out' of certain cover, in view of persistent adverse climate-change related experience.
Emphasis is placed on the importance of impact underwriting practices. Simply put, these constitute initiatives taken by insurers to incentivise policyholders to take on preventative measures to reduce their carbon footprint and exposure to climate risk.
EIOPA recommends that the entity takes account of the implications on climate change in its pricing and underwriting strategy. This could entail:
- Assessing the acceptability of current underwriting and
exposure limits in view of the increased potential for adverse
underwriting experience.
- Assessing the tenability of current reinsurance and
retrocession arrangements in view of the same.
- Underwriting action and risk mitigation activities that could help reduce adverse climate-change experience and NAT CAT loss exposure.
The industry has responded to the increased prevalence of NAT CAT events through Government-backed / industry-tariff supported Natural Catastrophe Pools such as Flood Re in the UK and the French 'Caisse Centrale de Réassurace' (CCR).
What is needed to comply and be proactive on climate change? How can actuaries help?
Increased regulatory demands from insurers mandate not only policy re-design and increased compliance monitoring efforts but also enhanced modelling efforts to help embed the impact of climate change in pricing and product design, together with capital budgeting.
Actuaries are multi-disciplinary professionals skilled in assessing and quantifying the implications of risk. They are therefore naturally disposed to facilitate collaboration between various organisational functions. Amongst other things their role can include:
- Analysis of current climate change-exposed risks
across the undertaking's operations.
- Making use of geographically referenced data to
facilitate the analysis of climate change and NAT CAT exposures,
similar to natural catastrophic modelling endeavours.
- Performing gap analyses as to how climate change
may be considered as part of the entity's pricing, reserving
and capital modelling considerations, together with its reinsurance
programme selection.
- Synthesising and parameterising suitable
ORSA-climate change related scenarios.
- Performing model impact assessment.
- Helping model representative risk scenarios to model asset portfolio returns5.
Footnotes
1The 2021 Conference of Parties 'COP26' and the resulting Glasgow Pact build upon the 2015 Paris Agreement, which resulted in signatories committing to a strategic target of maintaining global temperature increases to under 2°C. As of 2021 the Glasgow Pact revises this target to at least not more than 1.5°C. To achieve this, individual members have committed to actions known as nationally determined contributions (NDCs).
2BoE (2019) https://www.bankofengland.co.uk/knowledgebank/climate-change-what-are-the-risks-to-financial-stability [accessed on 25/04/2022].
3The Greek wildfires in 2021 were one particular instance highlighted by the IPCC (Intergovernmental Panel on Climate Change)'s Sixth Assessment report in August 2021 (IPCC,2021).
4Adapted from the IFoA Climate Change Working Party (2020) Climate Change for Actuaries: An Introduction.
5International Actuarial Association (2022) Application of Climate-Related Risk Scenarios to Asset Portfolios.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.