Climate Risk- Making it Simple for Insurers

Kendra Felisky, Senior Actuary and COO at Marcuson, suggests a pragmatic way for firms to respond to the PRA’s four Climate Change areas of focus.

Climate change is something that concerns us all, which includes insurance regulators.  Regulators around the world are asking more and more of insurers, not just the UK’s PRA.  But it seems to me that many general insurance firms are not fully appreciating the task at hand – they believe that climate change does not affect them due to the short-tailed nature of their business compared to life and pension insurers.

Then again, I can see insurance executives’ palpitations at the thought of another large compliance project and more points off the bottom line.

There must be a middle ground.  I propose that firms remind themselves of the processes and procedures they already have in place and utilise those to get ready to meet the PRA requirements.

First of all, what are the PRA’s requirements?  The PRA wants firms to have fully embedded their approaches to managing climate-related financial risks by the end of 2021 as described in the “Dear CEO” letter of July 2020. This means that by the end of 2021, each firm should be able to demonstrate that the expectations set out in SS3/19 have been implemented and embedded throughout the organisation as fully as possible.  The PRA does recognise though that firms may take a proportionate approach reflecting their exposure to climate-related financial risk and the complexity of its operations.

The PRA considers that the financial risks from climate change have distinctive characteristics which present unique challenges and a strategic approach is needed to preserve insurers’ solvency. These characteristics include that the risks:

  • are far-reaching in breadth and magnitude,
  • have uncertain and extended time horizons,
  • are foreseeable, and
  • their significance depends on short-term actions.

These climate-related financial risks can be separated into three categories: transition risks, physical risks and liability risks:

  • Transition risks arise from a transition to a low-carbon economy. Changes in policy, technology and market sentiment may drive changes in the value of assets and liabilities for banks and insurers. Drivers include government policies that increase the price of carbon emissions, rapid changes in the transportation market as is being seen for electric vehicles, and legal liability risks such as those seen in recent climate-related lawsuits.
  • Physical risks arise from acute and chronic shifts in climate patterns, which can lead to damage to assets, business disruption, and changes in individuals’ health and incomes, which may drive financial losses and potentially impair asset values.
  • Liability risks arise from parties who have suffered loss or damage from physical or transition risks and are seeking to recover losses from those they hold responsible, who, in turn, may seek to recover those losses from insurance policies, e.g. D&O coverages.

In May 2019, the PRA published “A framework for assessing financial impacts of physical climate change: A practitioner’s aide for the general insurance sector”.  This is essentially a step-by-step approach that replicates the risk management processes of identify – measure – evaluate solutions – implement – monitor.

The PRA repeatedly state that their expectations are that firms embed managing climate-related financial risks throughout the organisation. The PRA has said it will be paying particular attention to the metrics and targets that firms are using, their comparability and how they are incorporated into risk and governance frameworks.

I believe that the best and most efficient way to do this is to utilise the risk management processes and procedures already in place, but incorporate the climate-related financial risks as well.  This way it will be seen more as an evolution of work that is already being done instead of a new standalone project.

I set out below some thoughts on how this could be done using the PRA’s four areas of concern: governance, risk management, scenario analysis and disclosure.

Governance – The best way to have consideration of climate-related risk embedded within the organisation is to ensure that it is considered at every opportunity.  For example, when the annual cycle of review of items such as Terms of Reference, Policies, processes and procedures are being considered, make sure that the risks of climate change to the business are being considered.  Get the Company Secretarial function involved in reviewing and vetting reports to the board to check that climate risk is being addressed.  Present a process to the board and senior executives, as part of the overall annual processes, so they understand when and how climate risk will be presented to them for oversight and strategic direction.

Risk management – For general insurance firms, ensuring that climate-risk is embedded could be as simple as ensuring that climate risk is considered during the annual cycle of review of the risk management framework, in other words, the risk appetites, reporting, and monitoring.  It may be that it is proportionate to consider the implicit qualitative aspects to start until some actual data is able to be gathered to monitor on a quantitative basis.

Scenarios – The PRA has helpfully provided scenarios to consider, either through the 2020 scenarios required of the large insurers or the 2021 Biennial Exploratory Scenario (BES).  At a minimum, these should form the initial basis of scenario considerations for a general insurer.  Then, as these scenarios are being considered, the insurer can develop new ones if they feel there are more appropriate ones applicable to their business.

Disclosure – The Taskforce on Climate-related Financial Disclosures (TCFD) framework provides a basis for determining which disclosures are appropriate for each firm.  At least initially, firms have time to consider which disclosures are appropriate for their business.  It may be that internal disclosures could be rolled out and embedded first before appropriate external disclosures are disclosed.

Overall, I do think that firms can approach the requirements for climate-related financial risks in a pragmatic and considered manner that will satisfy the requirements of regulators and be useful for the business without costing a lot of money.

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