Climate risk for insurers

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

Climate risk for insurers

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 1: Global insured catastrophe losses
Source: ECB. Climate change and Financial Stability. May 2019

Figure 2: Number of relevant natural loss events worldwide

Figure 2: Number of relevant natural loss events worldwide
Source: ECB. Climate change and Financial Stability. May 2019

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?

Figure 3: Orderly or disorderly transition?
Source: ECB. Climate change and Financial Stability. May 2019

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.

References

  1. Laurie Laybourn-Langton, Lesley Rankin and Darren Baxter, ‘This is a crisis: Facing up to the age of environmental breakdown’, IPPR, 12 February 2019
  2. Mark Carney, ‘Breaking the Tragedy of the Horizon – climate change and financial stability’, Bank of England, 29 September 2015
  3. Subject to regulatory approval
  4. ‘Watch the launch of our new report for investors implementing the recommendations of the task force on climate-related financial disclosures (TCFD)’, United Nations Environment Programme Finance Initiative (UNEP FI), 10 May 2019
  5. Mark Carney, François Villeroy de Galhau and Frank Elderson, ‘Open letter on climate-related financial risks’, 17 April 2019
  6. Frank Van Alphen, ‘Cutting carbon emissions could cause losses of up to 25%, says consultant’, IPE, 25 September 2018
  7. J.-F. Mercure, H. Pollitt, J. E. Viñuales, N. R. Edwards, P. B. Holden, U. Chewpreecha, P. Salas, I. Sognnaes, A. Lam & F. Knobloch, ‘Macroeconomic impact of stranded fossil fuel assets’, Nature Climate Change, 2018
  8. ‘Climate change could cause a new mortgage default crisis’, Financial Times, 26 September 2019
  9. ‘PRA to include climate risks in stress tests for insurers’, PwC, April 2019
  10. ‘EIOPA issues opinion on sustainability within Solvency II’, European Insurance and Occupational Pensions Authority (EIOPA), 30 September 2019
  11. Peter Uhlenbruch, ‘Insuring a low carbon future. A practical guide for insurers on managing climate-related risks and opportunities’, ShareAction, Asset Owners Disclosure Project, September 2019
  12. Bridget MacDonnell, ‘EIOPA proposes changes to Solvency II and the IDD on climate change and sustainability for life and non-life insurers’, The Business of Risk, 11 February 2019

Important information

Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (Aviva Investors) as at 28 November 2019. Unless stated otherwise any view sand opinions are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Information contained herein has been obtained from sources believed to be reliable, but has not been independently verified by Aviva Investors and is not guaranteed to be accurate. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Nothing in this document, including any references to specific securities, assets classes and financial markets is intended to or should be construed as advice or recommendations of any nature. This document is not a recommendation to sell or purchase any investment.

In the UK & Europe this document has been prepared and issued by Aviva Investors Global Services Limited, registered in England No.1151805. Registered Office: St. Helen’s, 1 Undershaft, London, EC3P 3DQ. Authorised and regulated in the UK by the Financial Conduct Authority. Contact us at Aviva Investors Global Services Limited, St. Helen’s, 1 Undershaft, London, EC3P 3DQ. Telephone calls to Aviva Investors may be recorded for training or monitoring purposes. In Singapore, this document is being circulated by way of an arrangement with Aviva Investors Asia Pte. Limited for distribution to institutional investors only. Please note that Aviva Investors Asia Pte. Limited does not provide any independent research or analysis in the substance or preparation of this document. Recipients of this document are to contact Aviva Investors Asia Pte. Limited in respect of any matters arising from, or in connection with, this document.  Aviva Investors Asia Pte.  Limited, a company incorporated under the laws of Singapore with registration number200813519W, holds a valid Capital Markets Services Licence to carry out fund management activities issued under the Securities and Futures Act (Singapore Statute Cap. 289) and Asian Exempt Financial Adviser for the purposes of the Financial Advisers Act (Singapore Statute Cap.110). Registered Office: 1Raffles Quay, #27-13 South Tower, Singapore 048583.In Australia, this document is being circulated by way of an arrangement with Aviva Investors Pacific Pty Ltd for distribution to wholesale investors only. Please note that Aviva Investors Pacific Pty Ltd does not provide any independent research or analysis in the substance or preparation of this document. Recipients of this document are to contact Aviva Investors Pacific Pty Ltd in respect of any matters arising from, or in connection with, this document. Aviva Investors Pacific Pty Ltd, a company incorporated under the laws of Australia with Australian Business No. 87 153 200 278 and Australian Company No. 153 200 278, holds an Australian Financial Services License (AFSL 411458) issued by the Australian Securities and Investments Commission. Business Address: Level 30, Collins Place, 35 Collins Street, Melbourne, Vic 3000

The name “Aviva Investors” as used in this presentation refers to the global organization of affiliated asset management businesses operating under the Aviva Investors name. Each Aviva investors’ affiliate is a subsidiary of Aviva plc, a publicly- traded multi-national financial services company headquartered in the United Kingdom. Aviva Investors Canada, Inc. (“AIC”) is located in Toronto and is registered with the Ontario Securities Commission (“OSC”) as a Portfolio Manager, an Exempt Market Dealer, and a Commodity Trading Manager. Aviva Investors Americas LLC is a federally registered investment advisor with the U.S. Securities and Exchange Commission. Aviva Investors Americas is also a commodity trading advisor (“CTA”) and commodity pool operator (“CPO”) registered with the Commodity Futures Trading Commission (“CFTC”), and is a member of the National Futures Association (“NFA”).  AIA’s Form ADV Part 2A, which provides background information about the firm and its business practices, is available upon written request to: Compliance Department, 225 West Wacker Drive, Suite 2250, Chicago, IL 60606.