Steve Waygood explains how insurers, policymakers and regulators can work together to manage the risks associated with climate change and encourage sustainable investment.
4 minute read
The insurance industry is more exposed than most to the destructive power of extreme weather but, as asset owners, insurers also have the power to make a difference. By working together, and encouraging action from policymakers and supervisors, the industry can help to collectively manage this existential risk.
The effect of climate change on the insurance industry is clear. In 2017 alone, economic losses caused by global natural disasters exceeded $330bn (€267bn)1. Insurers can help build resilience to the effects of climate change around the world, but there are still significant gaps in protection and these will only increase. Some in the industry have suggested that more than four degrees Celsius of warming this century would make the world "uninsurable2."
As long-term investors, insurers need to protect and grow investments, and play their part in bringing about a smooth transition to a “well below two-degree world” and meeting the promises made to customers.
Insurance industry needs regulatory action
It is time for regulators to use all the tools at their disposal to address the risks this poses to the financial stability of the insurance industry.
Currently, according to Solvency II, the main objective of the EU insurance and reinsurance regulation and supervision regime is “the adequate protection of policy holders and beneficiaries3.” Yet Solvency II could do more to emphasise the importance of long-term climate risk and incentivise sustainable investment, and therefore long-term growth.
In addition, allowing individual member states to introduce measures to encourage green investment risks undermining the single market for insurance, as different rules would apply to different insurers depending on where they are headquartered.
To address this issue, any changes made by the European Insurance and Occupational Pensions Authority (EIOPA) should seek to introduce sustainability through all three pillars of Solvency II.
At present, Solvency II does little to encourage individual insurers to decide whether to include climate risk in their risk frameworks, or to include climate risk within their Own Risk and Solvency Assessments (ORSAs), under Pillar 2. Nor does it encourage insurers to disclose climate relevant information under Pillar 3. Since climate change is a longer term, external risk, it will not necessarily be explicitly picked up in the content insurers choose to include in their Own Risk and Solvency Assessments (ORSAs).
Encouraging sustainable investments
EU Insurers represent a huge pool of capital for potential investment in sustainable jobs and growth and the European Commission (EC) has said that: “European insurers are the largest institutional investors in Europe’s financial markets. It is crucial that prudential regulation should not unduly restrain insurers’ appetite for long-term investments, while properly capturing the risks4.”
There are several ways in which the EC could begin to address the interrelated issues of how insurers protect policy holders and beneficiaries against climate risk and are encouraged to invest in long-term sustainable projects.
Pillar 1 – Financial Requirements
Since the introduction of Solvency II, there have been reductions to the Standard Formula capital charges for certain infrastructure investments. Further refinements should be made to the capital requirements to better incentivise sustainable investment for jobs and growth. This could be done by:
1. Ensuring EIOPA, as part of its opinion mandate, consider the ways in which the current system disincentivises investment in green finance. The EC should ask EIOPA to investigate the case for differential capital charges on more and less sustainable investments, using the taxonomy they are currently building as a guide. This taxonomy should result in the development of clear, coherent and consistent terminology. The capital requirements should incorporate a forward-looking prudential approach, which takes account of the latest scientific research on the impact of climate change.
The results of this analysis could be used to inform the recalibration of the Solvency II framework when it is reviewed in 2021.
2. Solvency II contains a Prudent Person Principle, a set of qualitative requirements used to govern investment decisions and asset allocation. During the 2021 review, the EC should explore how the Prudent Person Principle could be used to incentivise greater investment in sustainable areas and reduce unsustainable investments over time and in line with specified targets. The ultimate goal should be to encourage the managed transition of the EU economy to a two degree or below pathway.
Pillar 2 – Governance & Supervision
This should be revised to provide for the proportionate incorporation of climate risk in assessments conducted by insurance companies (based on their TCFD disclosures). This could be achieved by:
1. Instructing EIOPA to revise its current ORSA guidelines and add a section to Solvency II’s delegated regulations in the 2021 review to clarify that insurers should consider incorporating climate risk into their longer-term assessments where relevant.
2. Instructing EIOPA to work with national supervisors and climate risk experts to develop a range of core climate stress-testing scenarios insurers can use to assess the climate risks they are exposed to. This should build on the TCFD scenario planning currently being conducted by the insurance sector on a voluntary basis and turn it into stress tests that are embedded at the core of the prudential regime. The UK Prudential Regulation Authority has frequently expressed its intention that insurers incorporate climate risks into ORSAs and Solvency II more widely.
Pillar 3 – Reporting & Disclosure
European insurers should be mandated to disclose climate risk as part of Pillar 3 disclosures:
1. Alongside the wider work being undertaken in the EC to define and categorise “green” terminology, EIOPA should require insurers to provide asset reporting that is aligned to the taxonomy decided by the EU.
2. The EC should consider how to proportionally integrate the recommendations of the TCFD into the Solvency II reporting regime through amendments to the Solvency II Commission delegated act and the EIOPA guidelines. These amendments could be modelled on France’s Article 173, which requires investors to report on how climate change considerations are incorporated into their investment policies. This should be undertaken alongside wider efforts to incorporate TCFD recommendations throughout EU financial reporting regulations.
The insurance industry should focus on encouraging policymakers and supervisors to correct the market failure on climate change and help smooth the transition towards a “well below two-degree world”. This will require the EC, the Council, the European Parliament, EIOPA and national supervisors to work closely with stakeholders to introduce the changes.
Furthermore, the changes would need to target the most appropriate level of regulation for supervisors and insurers. Some of the interventions may require amendments to the Solvency II directive; while some propose changes to the EC’s delegated regulation, which could be incorporated into the EC’s planned reviews of various elements of Solvency II between 2018 and 2021; and others to the guidelines issued by EIOPA to national supervisors.
These Solvency II recommendations should be implemented alongside wider efforts to incorporate TCFD recommendations throughout EU financial reporting regulations, including in other relevant sectors, notably banking and asset management.
The proposals set out here are by no means the final word in addressing this issue. Other ideas and voices are essential to finding and constructing effective solutions. As insurers and investors, we are in the eye of the storm. We have an obligation to shareholders and to society beyond to be far-sighted on the issue and advocate for a prudential regulatory regime that is fit for purpose on climate risk.
This is an adapted version of an article first published in Insurance Asset Risk. The full article can be found here.