Climate change has become a global challenge, and the insurance industry should play an important role in mitigating climate change and building a greener future. Specifically, insurance products can support sustainable development across industries and the exploration of energy-saving technological innovation. Also, the volume and longevity of insurance funds can support green innovation and development and the transformation of the economy.
As concern about the impact of climate change has spread, companies face stricter guidelines for information disclosure. For example, in 2021, government departments in nine jurisdictions announced that they will require or encourage industries, including the insurance industry, to meet the disclosure requirements of the Task Force on Climate-related Financial Disclosures (TCFD). To meet the new regulatory requirements, the insurance industry can use powerful analysis and decision-making tools for climate-change-risk-related asset and liability management as well as stress testing.
This article, the first of two on the topic of global climate change, takes a closer look at the significance of climate change for the insurance industry and recent regulatory responses, with a focus on China. Next month, Part 2 will explore ways that China’s insurance industry is carrying out climate-change risk stress testing to support the sustainable development of China’s insurance industry.
Climate Change and Its Effects Are Undeniably Real
According to the Sixth Assessment Report of the Intergovernmental Panel on Climate Change (IPCC), the IPCC’s latest, the average global temperature in 2020 has risen by 1.09 C above preindustrial levels. Since 1901, the global average sea level has risen by 0.2 meters.
The IPCC’s climate model projects that global average temperatures will continue to rise. Under different emission scenarios, by 2100 the temperature will reach 1.0 C to 5.7 C above preindustrial levels. Global warming will lead to a significant increase in all types of extreme climate events. China is a vulnerable area subject to the impacts of global climate change, with a warming rate significantly higher than the global average in the same period, as well as a sea level rise rate slightly higher than the global average (see Figure 1).
Figure 1: Global Climate Change’s Impact on China, Past and Projected
|Climate Change up to 2020||Projected Situation by 2100|
|Temperature||From 1951 to 2020, the average annual surface temperature warming rate in China was 0.26 C per 10 years.||The average temperature in China is forecasted to rise by 4–6 C (SSP3-7.0).|
|Sea level||From 1980 to 2020, the rate of sea level rise along China’s coast was 3.4 mm per year, higher than the global average in the same period.||By the end of the 21st century, the sea level in China’s sea area will be 0.4–0.6 m higher than in the 20th century.|
Source: Third National Assessment Report on Climate Change, IPCC AR6, 2019.
With China facing the severe socioeconomic consequences of climate change, the Chinese government announced that China will strive to reach its peak carbon dioxide emissions (CO2) by 2030 and achieve carbon neutrality by 2060. Therefore, it is crucial to carry out climate-change risk analysis and stress testing to develop a thorough understanding of climate-change risk exposure, provide references for policy formulation and promote the sustainable development of the insurance industry.
How Financial Regulators Are Addressing Climate-Change Risks
Besides their concern for climate risks, insurers are motivated by the increasing attention of communities and regulators. This is an international phenomenon, and China is by no means exempt.
Domestic and International Regulation to Address Climate Change
As ecological and environmental changes have a greater impact on the core businesses of financial institutions, the industry has come to recognize climate finance as the core concept of green finance. Financial risks related to climate change also have attracted more and more attention from societies around the world. In the past decade, regulators of the financial sector have issued a series of guidelines and regulatory documents to address the risks of climate change (see Figure 2).
Figure 2: Regulatory Actions for Sustainable Development and Climate-Change Risk Supervision
Former China Banking Regulatory Commission issues Green Credit Guidelines
Financial Stability Board (FSB) establishes Task Force on Climate-related Financial Disclosures (TCFD)
European Systemic Risk Board (ESRB) publishes Transition to a Low-Carbon Economy and Systemic Risk
Seven ministries and commissions, including People’s Bank of China, issue Guidelines for Establishing the Green Financial System
TCFD provides comprehensive disclosure recommendations around governance, strategy, risk management and climate-related risk assessment indicators and management objectives
Network for Greening the Financial System (NGFS) formed by central banks and financial supervisors
Insurance Asset Management Association of China releases Green Investment Guidelines
European Central Bank (ECB) issues Financial Stability Assessment report, which says climate risks can have adverse effects on financial institutions’ balance sheets, “especially when markets do not properly price climate risks, which can affect financial stability”
TCFD releases second status report, pointing out progress in implementation, greater financial risks posed by climate change and the need to accelerate implementation
Stock Exchange of Hong Kong (HKEX) issues Environmental, Social and Governance Guidelines
China Banking and Insurance Regulatory Commission (CBIRC) issues Guiding Opinions on Promoting the High-Quality Development of the Banking and Insurance Industry
NGFS publishes Guidance for Supervisors: Integrating Climate-Related Environmental Risks into Prudential Regulation
NGFS publishes NGFS Climate Scenarios for Central Banks and Supervisors and Guide to Climate Scenario Analysis for Central Banks and Supervisors
NGFS releases Overview of Environmental Risk Analysis of Financial Institutions and corresponding case studies
Five ministries and commissions, including China’s Ministry of Ecology and Environment, issue Guiding Opinions on Promoting Investment and Financing in Response to Climate Change
People’s Bank of China issues Guidelines on Environmental Information Disclosure for Financial Institutions to help financial institutions identify, quantify and manage environment-related financial risks and support transformation to a low-carbon economy and society
ECB announces launch of a climate risk stress test to assess banks’ ability to respond to financial and economic shocks caused by climate risks
International regulators have stressed the importance of climate and environmental risk research and related disclosures. Since the establishment of the TCFD by the Financial Stability Board (FSB) in 2015, an assessment and disclosure framework around climate scenario analysis gradually has emerged. The TCFD framework consists of four core elements that set out specific disclosure requirements for corporate climate-change-related strategy, governance, risk management, metrics and targets. For financial industries, including insurance, the task force has developed and updated supplementary guidelines based on specific types of business activities (see Figure 3 for detailed requirements). For strategy, insurance institutions should use scenario analysis to assess climate-related risks and opportunities, as well as the potential impact on their operations. At present, more than 1,500 financial institutions around the world have signed up as TCFD supporters, including institutional investors and banking and insurance institutions in China.
Figure 3: TCFD Supplementary Guidance Requirements for Insurance Institutions
|Strategy||Risk Management||Metrics and Targets|
*The TCFD’s currently preferred metric for assessing a portfolio’s carbon footprint is weighted average carbon intensity (WACI). This indicator calculates the average carbon intensity of a portfolio and is weighted based on the relative size of the investments in that portfolio.
Source: Implementing the Recommendations of the Task Force on Climate-related Financial Disclosures, Task Force on Climate-related Financial Disclosures, October 2021.
Research and Guidance on Measurement of Climate Risks
The G20 Green Finance Research Group in 2017 pointed out that financial markets are mainly facing physical and transition risks brought about by climate change—a situation that poses major challenges to the stability of the financial systems. Physical risk refers to the risk that climate change may cause events such as floods, crop damage or severe storms that seriously damage financial institutions’ balance sheets. This in turn will affect the financial system and macroeconomic indicators. Transition risk includes the risk that policies such as capping carbon emissions could trigger the repricing of high-carbon assets, potentially causing financial losses. For the insurance industry, the macroeconomic impact of climate change is likely to further influence medium- and long-term interest rates and demand for insurance products. Therefore, such potential impacts should be researched and tracked continuously.
In 2019, the Network for Greening the Financial System (NGFS), an international organization of central banks and regulators, issued A Call to Action: Climate Change as a Source of Financial Risk, noting that climate change has become an important source of financial risk. Subsequently, in its Guide for Supervisors: Integrating Climate-Related and Environmental Risks into Prudential Supervision, published in May 2020, the NGFS made clear that regulators require financial institutions to develop the necessary methods and tools, such as scenario analysis and stress testing, to determine the scale and level of physical and transition risks. The NGFS later issued Climate Scenarios for Central Banks and Supervisors and Guide to Climate Scenario Analysis for Central Banks and Supervisors, which describe the impact of climate-related risks on the economy. The reports also gave ideas on designing climate scenarios and conducting financial risk assessments, providing reference schemes for institutions wanting to analyze risks related to climate change.
Early Efforts at Stress Testing in China and Abroad
European countries have been deeply concerned about global climate change and related governance issues, so they have been among the first to explore stress testing for climate-change and environmental risks. The United Kingdom began studying the impact of climate change on risks in the insurance and banking sectors as early as 2015, followed by France and the Netherlands.
China’s large commercial banks have begun to explore the development of climate-change risk stress tests in specific industries or targeting certain business activities of some local branches. For example, they have been rolling out stress testing of climate and environmental risks for some carbon-intense industries and sensitive factors, to optimize the investment and financing structure, enact greener practices and consume less carbon. As a result, banks gradually are transforming from merely issuing information about climate-change risks to proactively managing those risks.
In the second half of 2021, the People’s Bank of China organized a group of banking institutions to carry out climate-change risk stress testing, with the hope that financial institutions would actively assess and manage related risks through environmental risk analysis. However, the climate-change risk stress-testing model was very complex, and institutions lacked sufficient experience in obtaining historical data on climate-related risks and related transmission paths, so financial institutions still face challenges in stress testing climate-change risk. In 2020, the Hong Kong Monetary Authority (HKMA) introduced related requirements for banks, including climate scenario analysis and stress testing.
Actuaries’ Role in the Insurance Industry’s Response
As a risk manager, risk bearer and fund investor, the insurance industry gradually has carried out climate and environmental risk analysis and stress testing in recent years. For companies in the insurance industry, especially property insurance companies, one of the main businesses is to analyze and deal with the cost of losses caused by physical risks. The property insurance industry traditionally has had natural-disaster risk analysis systems or catastrophe models that companies can use as a basis for stress testing climate-change risks.
In recent years, various international insurance regulators and professional organizations have provided guidance on stress tests for climate-change risk:
- The International Association of Insurance Supervisors (IAA) and the UN Environment Sustainable Insurance Forum jointly released Thematic Report on the Impact of Climate Change on the Insurance Industry in July 2018. This report analyzes the relationship between climate-change risks and insurance core principles, summarizes the work done by insurance regulators in various regions to address climate-change risks and explores the need to consider the linkage between the asset and liability sides of the insurance business in climate-change risk stress testing.
- The European Insurance and Occupational Pensions Authority (EIOPA) published in June 2020 a discussion paper on stress-testing methods and principles for insurance companies. The first chapter is devoted to methods for insurers to use in conducting climate-change stress testing.
- The Geneva Association, a well-known international insurance think tank, published Climate Change Risk Assessment for the Insurance Industry: A Comprehensive Decision-Making Framework and Key Considerations for Both Ends of the Balance Sheet in February 2021. The report analyzes the impact of climate-change risks on the asset side of the insurance industry and on the liability side of the property and life insurance industry. It concludes by recommending that insurance companies adopt a combination of quantitative and qualitative methods to assess climate change within different periods while considering the potential impact of physical and transition risks on both sides of the balance sheet.
- In September 2021, the European Commission asked EIOPA to initiate a consultation process on revision of the rules on sustainability risks in Solvency II, which requires insurers to conduct climate-change risk scenario analysis.
- In November 2021, the British Institute of Actuaries published Climate-Related Risks: A Summary Report on Actuaries Engagement, which focuses on the critical role actuaries play in the insurance industry’s climate-change risk stress tests.
In recent years, large international insurance institutions have disclosed relevant information on climate-change risks in accordance with TCFD requirements. These institutions also have carried out climate-change risk stress tests aligned with the requirements of their regulators and improved relevant methodologies every year. On the asset side, a climate-change risk stress test is similar to stress testing in the banking industry: transition risk analysis focuses on the impact of the implementation of low-carbon investment strategies. On the liability side, the focus is on analyzing the impact of physical risks for property and health insurance businesses.
China’s Ping An Group has disclosed two TCFD reports covering its banking, insurance and asset management businesses. Under the group’s collective effort, the asset risk management and actuarial departments of each unit conduct climate-change risk testing and management on the asset and liability sides. From the views of both physical and transition risk, the departments identified different types of impact caused by climate change in the short, medium and long term. In the future, Ping An will conduct climate-change impact scenario analysis on the key industries, customers, objects of transaction and all assets.
Based on the climate-change risk stress-testing practices of international and Chinese insurance companies, actuaries and asset-liability management techniques reflect the characteristics of the insurance business. Thus, they play a key role in quantitative modeling work such as scenario modeling and stress testing. Climate stress-testing analysis is a complex undertaking and still at a relatively early stage. Therefore, many challenges remain, including how to measure the pricing impact of climate change on insurance products and how to obtain high-quality data. Actuaries can leverage their strengths to resolve difficulties in quantitative work by collaborating with other relevant experts, corporate departments and stakeholders. To show how, Part 2 of this article—to be published in a subsequent issue of The Actuary—will describe efforts already underway in China.
Statements of fact and opinions expressed herein are those of the individual authors and are not necessarily those of the Society of Actuaries or the respective authors’ employers.
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