Climate risk has become a critical business issue, but a recent consultation by the European Insurance and Occupational Pensions Authority highlights confusion on how to assess it.
4 minute read
With the gradual uptick in average global temperatures, climate risk looms large for insurers around the world. Events linked to extreme temperature have been on a rising trend for the past seventy years,1 and insured losses from weather-related events have grown around five-fold since the 1980s.2 In certain regions and sectors, higher underwriting, as well as credit and market risks, are a reality. All the while, the low interest rate environment is challenging those investing to fund future claims and longer retirements.
As an insurer, we are absolutely in the firing line when it comes to dealing with the impacts of climate change
“As an insurer, we are absolutely in the firing line when it comes to dealing with the impacts of climate change,” according to Angela Darlington, CEO of Aviva UK Life.3 In her view, climate issues are moving from “something that may happen to other people to something that will happen – to us”.4
Figure 1: Global insured catastrophe losses
Figure 2: Number of relevant natural loss events worldwide
Climate change as systemic risk?
Meanwhile, debate continues about the pathways to a low-carbon world. With the European financial sector currently holding over €1 trillion of high carbon assets, it begs the question: could action to cut carbon emissions spark a sell-off, as the Governor of the Bank of England Mark Carney has warned?5 (See the scenarios set out below.)
A substantial fraction of fossil fuel assets might become stranded anyway, leapfrogged by low-carbon technologies
A rapid transition to a low-carbon world could take up to 25 per cent off the value of listed energy companies in Europe, according to Dutch consultancy Triple A Risk Finance.6 While regulatory changes won’t necessarily be a trigger, “a substantial fraction” of fossil fuel assets might become stranded anyway, leapfrogged by low-carbon technologies.7 Eye-catching headlines, like ‘Climate change could cause a new mortgage default crisis’, have also focused minds.8
Figure 3: Orderly or disorderly transition?
The need to be aware of potential pain points underpins plans by European regulators for climate risk stress tests.9 They form part of a wider debate on how insurers need to integrate risk considerations better, through forward-looking scenario analyses. While life insurers are mainly concentrating on the transition risks that might flow from the shift to a low-carbon economy, non-life companies are eying physical risks on the liability side.10
Capturing climate risk better
The European Insurance and Occupational Pensions Authority (EOIPA) is pushing for sustainability risk to be captured in internal models, in insurers’ Own Risk and Solvency Assessment (ORSA). Some are choosing to work from traditional risk metrics - for example, credit, equity, foreign exchange, interest rate risk - and then judging how those factors are affected by physical, transition and litigation risk. Others start with the risk buckets and work back from there.
Whether you start from one end or the others is, to some extent, a choice
“Whether you start from one end or the others is, to some extent, a choice,” according to Ben Carr, analytics and capital modelling director at Aviva. “It depends on your business and how the risks impact your specific exposures. Having said that, there are ways in which transition and physical risks manifest that probably wouldn’t be picked up from the traditional way you measure credit and other risk. There is additional work to be done to ensure those risks are captured appropriately on the balance sheet.” New measures like carbon value-at-risk are therefore also being defined.
Supporting the transition to a low-carbon economy
Climate considerations also fall under the umbrella of the Prudent Person Principle, which requires insurers to have a thorough understanding of their investments. This relies on accurate data, which has historically been in short supply.
The FSB is pressing for more transparency through guidelines agreed by its TCFD
To help, the Financial Stability Board (FSB) is pressing for more transparency through guidelines agreed by its Taskforce on Climate-related Financial Disclosures (TCFD). The idea is that better disclosure will improve capital allocation and create a more efficient market. But the TCFD is only part of the solution.
“If you imagine the metaphor of boiling a frog, what we are getting with the TCFD is a thermometer in the pan to see how hot the water is and whether the frog is dead yet. The TCFD doesn’t turn down the heat,” says Aviva Investors’ chief responsible investment officer Steve Waygood.
Cooling the temperature implies a step-change in investment practice. As the guardian of more than US$30 trillion of assets worldwide,11 the insurance industry could be pivotal in the transition to a greener world.
EIOPA has signalled that sustainability should be “operationalised via the concepts of environmental, social and governance (ESG) risks”.12 However, different approaches will be required, depending on the asset. For example, getting a handle on ESG risks is often more difficult for bondholders than shareholders, as there are fewer natural opportunities to engage. It may be harder still for investors in private assets, where subtle comparisons may need to be made.
We have tried to move beyond a black and white approach and have created a balanced ESG scorecard
“We have tried to move beyond a black and white approach, and have created a balanced ESG scorecard,” explains Al Denholm, solutions chief investment officer at Aviva Investors. “We try to identify the core indicators of ‘e’, ‘s’ and ‘g’ respectively, and weigh up the positives and negatives. We also look at the contribution to the UN Sustainable Development Goals. We may do an ESG gap analysis and decide to fund or purchase an asset if we can see a pathway to closing that gap in an efficient and cost-effective way.”
Call to action
All insurers are being urged to take immediate action to understand the climate risks they are carrying better. The regulations and approaches are still evolving, but an analytical step-change is needed to ensure the industry is adequately prepared for the risks associated with a volatile and warmer world.