Kirsty Finlayson and Jeremy Irving offer some practical steps for insurers to ensure compliance on climate-related risk management
By the end of 2021, insurers will need to demonstrate compliance with the Prudential Regulation Authority’s (PRA) Supervisory Statement 3/19 (SS3/19) on managing climate risks in the form of both ‘acute’ events (such as floods) and ‘chronic’ longer-term phenomena (such as higher average temperatures).
SS3/19 emphasises the PRA’s expectations with regard to insurers’ actions on climate risks in governance; risk management; scenario analysis; and disclosure.
In particular, the PRA has specified that it expects insurers to take “proportionate” steps in view of business operations and to see clear “evidence” of the following:
- Governance: insurers should “understand and assess” climate risks and “address and oversee” them within the entire business strategy.
- Risk management: insurers should “identify, measure, monitor, manage and report” on exposure to climate risks.
- Scenario analysis: insurers should “address a range of outcomes relating to different transition paths to a low-carbon economy, and a path where no transition occurs”, with both short- and longer-term assessment.
- Disclosure: insurers will need 4. Disclosure: insurers will need to consider whether action needs to be taken to “enhance transparency” as well as “recognise the increasing possibility that disclosure will be mandated in more jurisdictions”.
Insurers will need a clear understanding of ‘physical’ and ‘transition’ climate risks and their interactions between different business lines, economic sectors, physical geographies and legal jurisdictions:
- Physical risks include acute and chronic meteorological or geographical phenomena.
- Transition risks are those arising from “adjustment towards a low-carbon economy”, such as developments in public policy, technology, new legal authorities and changes to the interpretation of previous authorities.
SS3/19 draws out emerging issues for insurers that are implicit within existing risk management obligations – including the need for insurers to include climate risks in their ‘Own Risk and Solvency Assessments’ (ORSA). However, on this point, insurers should note that the Climate Financial Risk Forum (CFRF), a group co-chaired by the PRA and Financial Conduct Authority (FCA) to engender best practice in climate risks management across the finance sector, has observed:
- The “ORSA time horizon is typically shorter than the timespan over which climate risks will evolve…”
- The “standard formula [for solvency capital requirements] does not explicitly consider climate change risk [which means that]… internal models… may cover climate risks more appropriately”.
In June 2020, the CFRF published its own guide to “climate-related financial risk management”, accounting for SS3/19. The risk management chapter distils climate risk management into seven areas:
- Data and tools
- Training and culture
- Challenges, barriers and gaps.
Areas one, five and seven may require a greater degree, number and magnitude of concrete changes by insurers to maintain good or best practice.
Data and tools
Data and tools to measure climate risks will require increasing scope, sophistication, accuracy, comprehensiveness and clarity. Where scientific data is not yet adequate for the accurate estimation or delineation of climate risks, insurers should use reasonable proxies and assumptions. Practical steps include:
- Instructing external experts and providers to supplement insurers’ own work.
- Internal data, models and assumptions, including:
o ‘Hazard maps’ of climate risk locations
o Catastrophe models on climate risk locations, risk types and exposures
o ‘Scores’ with regard to climate risks and their effects, for example:
● The Insurers CRO Forum has developed a ‘red’ (high), ‘amber’ (medium) and ‘yellow’ (low) scale to measure expected impact of risk within its 2020 Risk Radar.
● The European Commission Technical Expert Group has produced a report on climate benchmarks and disclosures, in which it recommends evaluations of ‘green’ (contributors to the energy transition) and ‘brown’ (based on fossil fuels) activities and measures.
- Client/distributor/supplier questionnaires for due diligence and data harvesting on climate risk exposures and modelling.
Training and culture
Expanding awareness and knowledge across an insurer’s workforce and agents, with a particular focus on senior managers, is also important. Practical steps include:
- Clearly articulated links between:
o The insurer’s overall ‘purpose’ (such as the insurer as an engine or vessel of social, legal and regulatory ‘good conduct’ – see the FCA 26 November 2020 speech).
o Its climate risk management strategy (as per the governance section above) – in particular, climate risks should be recognised and treated as a discrete financial risk category, to be addressed independently of broader environment, social and governance risk management methodologies.
- Instructing specialist third parties to provide relevant training.
- Developing internal training programmes and forums (such as live or virtual ‘lunch and learn’ or ‘town hall’ sessions), as well as intranet portals and online platforms to publicise the insurer’s strategy and to gain insights and engagement from personnel.
- Engaging with industry working groups and initiatives, such as ClimateWise and the Sustainable Insurance Forum.
Taking the steps above will involve a significant investment of time and other resources, and there are various intrinsic and extrinsic challenges to their successful execution.
Extrinsic obstacles primarily derive from the economic environment caused by the Covid-19 pandemic. Climate risks are unlikely to be the priority of boards in 2021, but this may change as a result of:
- COP26 – the UN Climate Change Conference UK 2021, scheduled for 1-12 November in Glasgow.
- The next CFRF meeting due in this first quarter of 2021, which is expected to devise an agreed programme of deliverables and next steps with an eye on COP26.
Intrinsic obstacles include a general shortage of manageable data. This shortage inevitably breeds uncertainty about future circumstances, which in turn may stimulate an understandable inclination to ‘park’ difficult decisions in the face of potentially expensive changes. In this regard:
- Climate risks may not emerge for many years – insurers’ risk assessment periods may not match climate risk timeframes, which could span decades.
- There are also limited tangible and obvious ‘upside’ incentives to refocus or reconfigure business strategies, models and investments on sustainable assets.
Regulators’ perspectives on climate risk management are clearly premised on the widely held scientific assessment that climate risks are increasing and accelerating. Despite the immediately apparent challenges, insurers have a range of guidance available to them meet regulatory requirements.
As has been seen from the Covid-19 pandemic, shortcomings in risk identification – and in the conceptualisation of scenarios or consequences – can mean shortcomings in preparation for and response to those consequences.
It is clear that regulators do not expect insurers to be ‘part of the problem’ in relation to climate risks – and may even see insurers as being ‘part of the solution’.
Kirsty Finlayson is an associate and Jeremy Irving is partner and head of financial services at law firm Browne Jacobson LLP
Image Credit | IKON
- The board has responsibility for the long-term “health and resilience” of the insurer; the board’s knowledge of climate risks can be achieved through “governance committees”, “designated individuals” and arrangements that assist employees in understanding climate risks and their employer’s approach. Practical steps include:
- Updating board committee terms of reference to include climate risks.
- Providing relevant board committee(s) with regular updates on the insurer’s progress in preparing for climate risks and performance against risk-reporting metrics.
- Board review, and challenge to the executive, with regards to:
o Unexpected climate risks
o Strategy for:
- Short-term scenarios (three to five years)
- Medium-term scenarios (10 years)
- Long-term (30-year) scenarios
o Assessments of:
- The rating/materiality of climate risks
- Outcomes of scenario analysis
o Compliance with new regulatory, reputational and legal requirements.