Climate Change Risk Management for insurers.

Climate change risks are relatively newly identified risks that insurers are facing. These risks can negatively impact both assets and liabilities of insurers. Already in 2018, the European Commission requested the European Insurance and Occupational Pensions Authority (EIOPA) to investigate how climate change risk could be integrated into the Solvency II Framework.

After various previous publications¹ of (draft) opinions, the investigation resulted in EIOPA’s opinion to include climate change risk scenarios in Own Risk and Solvency Assessment (ORSA)². It basically points out that forward-looking management of climate change risks is essential, and that EIOPA expects insurers to integrate climate change risk scenarios in their ORSA. EIOPA indicates it will start monitoring the application of this opinion two years after publication, i.e. as of April 2023. However, some National Competent Authorities already require insurers to take climate change risks into account.³

So, what will be expected of insurers?

In general terms, insurers are expected to:

• Integrate climate change risks in their system of governance, risk management system and ORSA
• Assess climate change risk in ORSA in the short and long term
• Disclose climate-related information

But what does this mean in practice? We will further explained this per topic.

Integrating climate change risks

The integration requirement ensures that climate change risk becomes an integral part of the day-to-day business and the risk management framework. The EIOPA opinion does not provide much detail on what this entails. Draft amendments to the delegated regulation, published by the European Commission, provide more insight into what insurers can expect.

The draft amendments relate especially to the implementing measures of the system of governance laid out in the Solvency II Directive. This means that responsibilities regarding climate change risk need to be clearly allocated towards the key functions within the organization, and appropriately segregated to ensure an effective system of governance.

This means climate change risk should be included in the following functions/processes:

• Risk Management
  For all the relevant risk management areas – covering both the asset and the liability side of the balance sheet, and including liquidity, concentration and operational risk – climate change risks need to be identified, measured, monitored, managed and reported on.
• ORSA
  The ORSA is a mandatory part of the required system of governance for insurers and will therefore also have to take climate risks into account. In order to properly assess the potential impact of climate change risks and the resilience of the insurers’ business model, these climate change risks need to be analyzed over a longer horizon. EIOPA has therefore advised to include climate change scenarios in the ORSA. This will be discussed in more detail in the next section of this article.
• Internal Control and Internal Audit
  Changes in the system of governance, risk management and ORSA to incorporate climate change risk also requires extension of the internal control system and the scope of internal audit.
• Actuarial Function
  The actuarial function will be responsible for the appropriateness of assumptions, methodologies and models used to assess the impact of climate change risks in underwriting. Especially in the context of ORSA and the assessment of the influence climate risk has on future reserving and capital needs. In addition, the actuarial function will be responsible for the sufficiency and quality of the data used within these calculations.

Consequently, written policies regarding risk management, internal control, internal audit, outsourcing (where relevant) and contingency plans need to be updated to include everything outlined above with regards to climate change risk.

Assess climate change risk in ORSA in the short and long term

Insurers will be required to assess climate change risk in ORSA by analyzing at least two climate scenarios. For the implementation we suggest a four-step approach, largely based on the guidance provided by EIOPA.

Step 1 – Risk identification

EIOPA expects insurers to take a broad view of climate change risks and include all risks stemming from trends or events caused by climate change. EIOPA provides a list of these risks, which distinguishes between:

• Transition risks
  These are defined as follows: ‘Risks that arise from the transition to a low-carbon and climate-resilient economy’. This includes the following aspects: Policy, Legal, Technology, Market sentiment and Reputational risks.
• Physical risks
  These are defined as: ‘risks that arise from the physical effects of climate change’ and are subdivided in acute and chronic physical risks.

Materialization of these risks for insurers will translate into impact on traditional risk categories, such as underwriting risk, market risk, credit and counterparty risk, operational risk, reputational risk and strategic risk. To help insurers get started with the implementation of climate change risks in ORSA, EIOPA has provided examples of a mapping in the annex of their opinion.

Step 2 – Materiality assessment

Insurers will be required to include all material climate change risks in ORSA. Under Solvency II, risks are considered material if ignoring the risk could lead to different decision making. This means that insurers are required to assess the materiality of each risk to determine whether these need to be included. If an insurer concludes that a certain climate change risk is immaterial, the insurer must be able to explain how that conclusion was reached.

The materiality assessment should be a combination of a qualitative and a quantitative analysis. The qualitative analysis is to provide insight in the relevance of the climate change risk drivers and the way they impact the traditional prudential risks (underwriting risk, market risk etc.). The quantitative analysis will be used to determine the extent to which assets and liabilities are exposed to transition and physical risks.

Step 3 – Defining scenarios

The inclusion of the forward-looking, risk-based approach to ORSA requires insurers to define a set of climate change risk scenarios. EIOPA expects insurers to assess material climate change risks utilizing ‘a sufficiently wide range of stress tests or scenario analysis, including the material short- and long-term risks associated with climate change’. The goal of these scenarios is to assess the resilience and robustness of the insurer’s business strategies, including the impact of risk mitigating measures.

EIOPA states that insurers may develop their own climate scenarios or build on existing ones and provides a number of sources of publicly available scenarios containing pathways for physical and transition risks. The decision for internal scenario development versus building on publicly available may depend on many factors like expected materiality or company size. For example, the underwriting risk for a life insurer is probably less exposed to transition risk than the underwriting risk for a non-life insurer, and a smaller insurer may not have sufficient expertise and resources.

The scenarios must project a multitude of external factors to properly capture the effects of climate change risks. Factors such as demographics (e.g. in case of natural disasters), economic development (e.g. as a result of technological breakthrough) and government policies to reduce carbon emissions, just to name a few. The climate change scenario set should contain at least two long-term climate scenarios:

• Global temperature increase remains below 2◦C, preferably no more than 1.5◦C, in line with Paris Agreement;
• Global temperature increase exceeds 2◦C.

In addition, a reference scenario is needed to be able to determine the impact of the stress scenarios.

The assessment is to be performed for several time horizons. Given the nature of climate change risks, horizons need to be in the order of decades. EIOPA provides examples for length of time horizons, ranging from instantaneous (‘current climate change’) to projected views of climate change for the next 80 years (‘long-term climate change’).

Step 4 – Climate change risk modeling

Modeling climate change risks in ORSA introduces two challenges:

• Assessment of transition and physical risk impacts
  Materialization of transition and physical risks will have to be translated to impact on assets and liabilities. In a discussion paper, EIOPA provides examples of different methodologies for the assessment of transition impacts on assets, that have already been developed by academics, research institutes and regulators⁴. In general, these methodologies use carbon-sensitivities of financial instruments to assess the impact of climate change risk scenarios.
  The basis for the determination of physical risks is the change in temperature over time. This change needs to be translated into impact on frequency and severity of acute natural disasters (e.g. storms, floods, fires or heatwaves) and chronic effects (e.g. rising sea levels, reduced water availability, biodiversity loss and changes in land and soil productivity). The next step is to translate these effects into impact on assets and liabilities. The translation into financial impact on companies in which insurers invest can especially be challenging. Larger companies often have a greater diversity of activities and are more spread out geographically. In addition, companies will not only be hindered by the materialization of physical risks in their own activities, but their supply chain can also be affected. However, some scoring models already exist in which companies are ranked based on their sensitivity to physical risks.⁵
• Long-term multi-period modelling
  Incorporation of the climate change risk scenarios in ORSA aims to assess the viability of current business models and strategies and the adequacy of the insurers’ solvency. For longer horizons, insurers may use a lower precision for balance sheet projections and conduct assessment at a lower frequency than short-term risk assessments.
  The lower precision allows for simplifications as long as the long-term character of the climate change scenarios is preserved. Simplifications may include projecting simple ratios instead of full balance sheets, or assessment of climate change impact on assets and technical provisions in isolation. However, projection of the full balance sheet ensures internal consistency and may provide much more information, especially when assessing the impact of potential management actions to mitigate the impact of climate change risks.

Disclose climate-related information

Insurers are expected to provide explanation on the short- and long-term climate change risk analysis in the ORSA report. This should include:

• An overview of all material risks, how materiality is assessed and an explanation for each risk that is considered immaterial.
• The methods and assumptions used by the insurer in both the materiality assessment of the climate change risks and in ORSA.
• The outcomes and conclusions of the scenario analysis, both quantitative and qualitative.

In addition, climate change risk related disclosures should be consistent with the Non-Financial Reporting Directive (NFRD).⁶

How can Zanders help?

As mentioned in the introduction, climate change risks are relatively new to the insurance sector. The same holds for other financial industries like the banking sector and asset management sector. As a consultancy firm for the financial industry, we support various types of financial institutions with the implementation of ESG and climate-related strategies and regulations. In doing so, we can benefit from our experience gained in the insurance, banking and asset management sectors.

We can assist with the implementation of climate change risk management, including:

• Identification of climate change risk exposures and materiality assessment
• Integration of climate change risks in your system of governance and risk management system
• Incorporate climate change risk into your ORSA, including
  • Mapping climate change risks to traditional prudential risk categories
  • Development of climate change risk scenarios
  • Climate change risk modelling
• Support in setting up or adjusting disclosures

Sources

_{[1] Previous EIOPA publications related to climate change risk:}

• _{Opinion on Sustainability within Solvency II, 30 September 2019}
• _{draft Opinion on the supervision of the use of climate change risk scenarios in ORSA, 5 October 2020}

_{[2] Opinion on the supervision of the use of climate change risk scenarios in ORSA, 19 April 2021}

_{[3] See:}

• _{DNB>Insurers>Prudential supervision> Q&A Climate-related risks and insurers (February 2021)}
• _{PRA: Supervisory Statement 3/19 – Enhancing banks’ and insurers’ approaches to managing the financial risks from climate change (April 2019)}

_{[4] Second Discussion Paper on Methodological principles of insurance stress testing, 24 June 2020
[5] See footnote 4
[6] Guidelines on non-financial reporting: Supplement on reporting climate-related information, 17 June 2019}