Insurance companies play a special role in creating climate change resilience—a role that was at the forefront of many discussions at the United Nations’ (UN) climate change summit, Conference of the Parties (COP26), held in Glasgow, Scotland, in November 2021.
“The UN’s Special Advisor to the Secretary-General on Climate Action Selwin Hart called on insurers to lead the way to greater resilience by increasing solutions for the poor and expanding coverage to fill protection gaps,” states a Lexology article by international law firm McDermott Will & Emery. “Eric Usher, the head of the UN Environment Programme Finance Initiative, elaborated, saying, ‘The insurance industry plays a three-part role as risk managers, insurers and investors which uniquely positions the industry to help support the building of climate-resilient economies.’”
Insurance companies bear an inordinate burden in paying out loss coverage for climate-related disasters.
Insurance broker AON says in a Reuters article that “insured losses from natural disasters hit a 10-year high of $42 billion in the first half of 2021.” To follow that record-setting first half of the year, Hurricane Ida caused destruction and flooding from the Gulf Coast all the way into the northeast in September, with losses in the neighborhood of $31 billion. The losses will continue to rise as a full accounting of the damages from the California wildfire season and the recent tornado outbreak across the Midwest is added.
The business model for insurance companies to be profitable is simple: Receive more in premium payments than are paid out in losses. To calculate risks, insurance actuators traditionally look at historical data to calculate future risks. Climate change risks create a situation that requires the insurance industry to utilize a new model without rules in a world where natural disasters are more severe and occur more frequently without rhyme or reason.
UN principles for sustainable insurance
For insurance to be a sustainable industry, it must reduce risk; create pioneering solutions; advance business performance; and contribute to social, economic, and environmental sustainability.
“As risk managers, risk carriers and investors, the insurance industry has a vital interest and plays an important role in fostering sustainable economic and social development,” states the UN Environment Programme Finance Initiative Principles for Sustainable Insurance website. “We believe that better management of [environmental, social, and governance (ESG)] issues will strengthen the insurance industry’s contribution to building a resilient, inclusive and sustainable society. However, many ESG issues are too big and complex and need widespread action across society, innovation and long-term solutions.”
More than 100 insurance companies across the world, including AEGON, AM Best, Lloyd’s Banking Group, Risk Management Solutions, and Zurich Insurance Group, have signed on as signatories to the UN program, which commits their companies to implement the principles:
- We will embed in our decision-making ESG issues relevant to our insurance business.
- We will work together with our clients and business partners to raise awareness of ESG issues, manage risk, and develop solutions.
- We will work together with governments, regulators, and other key stakeholders to promote widespread action across society on ESG issues.
- We will demonstrate accountability and transparency in regularly disclosing publicly our progress in implementing the principles.
Mandatory climate-related financial disclosures
To date, voluntary climate change risk disclosures were requested through Task Force on Climate-Related Financial Disclosures (TCFD) reports.
“The United Kingdom is the first Group of Twenty (G20) country to require its largest companies and major banks and insurers to file climate disclosures, beginning in the spring of 2022,” McDermott Will & Emory says. “While applauding the progress made using TCFD disclosure templates, Dutch Central Banker and President of De Nederlandsche Bank Klaas Knot was quoted as saying, ‘The TCFD recommendations have gained enormous traction over the years…but the exercise now is reaching the limits of what can be achieved through a purely industry-led and voluntary framework. The time has come to take it to the next level, and the next level, in our view, is the development of the global minimum standard.’
“UK Prudential Regulation Authority CEO Sam Woods commented on the Bank of England’s second climate adaptation report released shortly before COP26 began, noting that regulators may need to consider capital loading as part of their climate change insurance regulatory toolkits. ‘Under the existing regulatory capital framework, there is scope to use capital requirements to address certain aspects of climate-related financial risks,’ Woods said.
“In the Lloyd’s of London insurance market, managing agents will be required to prepare and submit ‘progress to net zero’ plans, with pilot activity in 2022 and full-scale plans to be filed and approved by the market in 2023. On a parallel track, the UK Financial Conduct Authority will require insurers to submit plans to achieve net zero by 2050.”
U.S. insurance initiatives
The New York Department of Financial Services (DFS) created a Climate Risk Division, announced on November 3, 2021, to coincide with COP26 Finance Day. The Division “will integrate climate risks into its supervision of regulated entities, support the industry’s growth in managing climate risks, coordinate with international, national, and state regulators, develop internal capacity on climate-related financial risks, support the capacity-building of peer regulators on climate-related supervision, and ensure fair access to financial services for all communities, especially those most impacted by climate change.”
On November 15, 2021, the DFS announced the issuance of final guidance to New York-regulated domestic insurers on managing the financial risks from climate change. The guidelines call for these insurers to:
- Integrate the consideration of climate risks into their governance structure at the group or insurer entity level. “This includes (1) adoption by the board of a written risk policy describing how the insurer monitors and manages material climate risks in line with its risk appetite statement, and (2) designation of a board member or committee of the board as responsible for the oversight of the insurer’s management of climate risks, as well as one or more members of senior management as responsible for the insurer’s management of climate risks,” according to a JD Supra article by Eversheds Sutherland.
- When making business decisions, consider the current and forward-looking impact of climate-related factors on their business using time horizons that are appropriately tailored to the insurers, their activities, and the decisions being made. “This includes documenting how its analysis is considered in its strategy-setting process, risk appetite framework and risk management and compliance processes,” Eversheds Sutherland continues.
- Incorporate climate risks into the insurers’ existing financial risk management, including by embedding climate risks in their risk management framework and analyzing the impact of climate risks on existing risk factors.
- Use scenario analysis to inform business strategies and risk assessment and identification.
- Disclose their climate risks, and engage with the TCFD and other initiatives when developing their disclosure approaches.
Insurance companies impacted by these guidelines are required to have specific plans in place to implement these expectations by August 15, 2022.
The following points within the guidelines are also of interest:
- To ensure consistency across jurisdictions, international regulators have engaged in meaningful collaboration and coordination to develop international best practices. The DFS intends to continue to work closely with international and other U.S. regulators to reduce the compliance burden on insurers.
- “The DFS says it is aware that over time insurers’ approaches to managing climate change risk will ‘mature’—starting with qualitative assessments using simple models but progressing to more quantitative analyses using more advanced models, incorporating more factors or variables and extending over longer time horizons. As to physical risks (i.e., on the underwriting side), the maturation process will hinge in part on the development of better and better models by the usual vendors, as well as insurers’ internal models, perhaps augmented by public climate change models,” according to McDermott.
- “On the transition risk side (i.e., investing), the proliferation of green standards makes comparability and consistency difficult to realize. Debate on this topic is widespread and intense. Stress testing and scenario analyses also seem to be at an early stage of development, and while the DFS is cognizant that some insurers may not be ‘ready to conduct a comprehensive and quantitative scenario analysis’ nevertheless the exercise is valuable for all insurers,” McDermott adds.
The following items in the guidance are important points insurers should take note of, as summarized by McDermott:
- “The final version seeks to reassure readers, if not senior managements, that climate risk is another risk that insurers must manage while also acknowledging the ‘unique challenges’ presented by it.
- It also lists out all the climate change regulatory guidance and precedents from Europe but does not include US precedents.
- The final version repeats an environmental justice clarion call for insurers to ‘do their part to contribute to the low-carbon transition and climate adaptation efforts; support communities’ resilience to climate change, especially in disadvantaged communities that would be even more vulnerable to climate change if insurers stop insuring or investing in these communities; and work with the public sector to find ways to close the protection gap and ensure that insurance is available and affordable throughout the state.’
- ‘Materiality’ of climate change risks should be consistent with materiality of other risks on which insurance regulators focus. The Guidance provides that insurers may consider as ‘material’ a risk that involves 5% of policyholder surplus or .50% of total assets as set forth in the NAIC’s Financial Condition Examiners Handbook or, borrowed from the European Insurance and Occupational Pensions Authority, where ‘knowledge of the risk could influence the decisions of an insurer’s board, management, regulators, or other relevant stakeholders.’ It is worth remembering, however, that that climate change risk is an ‘enterprise risk’ and defined in various New York insurance law sections as ‘…any activity, circumstance, event, or series of events involving the insurer that, if not remedied promptly, is likely to have a material adverse effect upon the financial condition or liquidity of the insurer [or holding company or parent corporation], including anything that would cause the insurer’s risk-based capital to fall into company action level [in New York insurance laws], or that would cause further transaction of business to be hazardous to the insurer’s policyholders or creditors or the public.’ Regardless, insurers should revisit materiality assumptions at least annually or whenever ‘significant changes’ occur. It will be interesting to see whether other financial services regulators (e.g., the US Securities and Exchange Commission) or federal bank regulators view ‘materiality’ through the same lenses.”
The guidelines detail seven expectations for insurers related to organizational structure:
- Manage climate risks through their existing enterprise risk management functions, including risk assessment, compliance, internal control, internal audit, and actuarial functions (collectively, “control functions”).
- Ensure their organizational structure clearly defines and articulates roles, responsibilities, and accountabilities and that such organizational structure is reinforced by a risk culture that supports accountability in risk-based decision-making in setting climate risk limits and overseeing their implementation.
- Implement reliable risk management processes across lines of business, operations, and control functions, with clear steps to ensure the effectiveness and adequacy of climate risk integration.
- Explicitly consider climate risks (like other material risks) in risk management processes, including in enterprise risk reports and Own Risk and Solvency Assessment (ORSA) summary reports, as well as in the decision-making processes of senior management.
- Conduct objective, independent, and regular internal reviews of the functions and procedures for managing climate risks; report the findings of the reviews to the board; and adapt insurers’ functions, procedures, roles, and resources for managing climate risks, as necessary.
- Develop the skill, expertise, and knowledge required for the assessment and management of climate risks at the level of the board and employees, including senior management. This can be done through new hires, internal training, and/or the use of external consultants. The board and senior management should support resource allocation to this effort.
- Consider implementing remuneration policies to align incentives with the strategy for managing climate risks and with performance against climate metrics.
Global climate change approach
Transitioning to a decarbonized economy comes with an estimated $100 trillion investment. The Glasgow Financial Alliance for Net Zero (GFANZ), chaired by Mark Carney, brings together more than 250 financial institutions across Race to Zero initiatives from 32 countries, representing over $88 trillion in assets. These institutions include 128 asset managers from 21 countries, representing $43 trillion in assets under management; 53 banks from 27 countries, with $37 trillion in assets; and 70 asset owners and insurers from 16 countries, with over $8 trillion in assets under management. Each entity has made its own net-zero commitment, with potential overlap across initiatives, institutions, and assets.
“Having a global financial system where every professional decision takes climate change into account requires harnessing the full role of the insurance industry as risk managers, insurers and investors for climate action,” says Carney in a press release.
“Eight of the world’s leading insurers and reinsurers have established the UN-convened Net-Zero Insurance Alliance (NZIA) as founding members, committing to transition their insurance and reinsurance underwriting portfolios to net-zero greenhouse gas (GHG) emissions by 2050,” the press release continues. “As risk managers, insurers and investors, the insurance industry has a key role in supporting the transition to a net-zero economy.”