One of the many lessons learned from the COVID-19 pandemic is that (re)insurance companies’ exposure to an emerging/developing risk can evolve quickly once it starts interacting with other external factors, such as market, regulatory, legal and political risks. With that experience in mind, 2021 has seen a lot of activity from regulators with regard to how best to ensure the (re)insurance industry’s resilience to the short- and long-term effects of climate risk.
Some regulators also are exploring how (re)insurers can influence climate change by transitioning to green investments and incentivizing “green” policyholder behaviors. Additionally, regulators are looking at ways to reduce the protection gaps for those who are most at risk to be impacted by climate change. This article will address how regulators are exploring ways to assess (re)insurers’ financial stability, leverage (re)insurers’ ability to influence climate change and help people gain access to the coverage they need.
Assessing Financial Stability
A consistent objective—from state regulators to the National Association of Insurance Commissioners (NAIC) to the Federal Insurance Office (FIO)—is to ensure the financial solvency of (re)insurers with the ultimate goal to protect policyholders. Much of the focus has been on climate risk disclosures and the best vehicle for understanding how insurers currently manage this risk; identifying best practices for internal governance, modeling and scenario development; and supporting risk-based supervision.
The choices for disclosure and assessment have narrowed to:
- Continue with the NAIC Climate Risk Disclosure Survey. Adopted in 2010, this survey comprises nine yes/no questions and eight narrative questions across five main themes, asking insurers to describe how they address risks related to climate change in terms of mitigation, risk management and investments. Companies also are asked to describe their interaction with key stakeholders on the topic of climate change. The main disadvantages of this survey are that it has not been updated in some time and is not required for all companies. Furthermore, it does not collect quantitative information that can be assessed across companies. With that said, continuing with this survey—with some modifications and guidance—potentially could better reflect the unique needs of the U.S. insurance industry compared to a more broadly applied reporting mechanism that is designed to be applied across several industry sectors.
- Adopt the Task Force on Climate-related Financial Disclosures (TCFD) reporting standard. There has been a lot of discussion in the United States regarding the Financial Stability Board’s TCFD guidance, which recommends disclosures in four content areas: governance, strategy, risk management, and metrics and targets. Investors can leverage these disclosures to assess the impact of climate change on the valuation of a company. The EU Commission has requested compliance for companies with more than 500 employees. The main pushback for this format has been due to companies’ understanding and willingness to disclose climate risk information given confidentiality concerns. If instead the United States pursues its own climate disclosures, the costs and effort required for some companies to comply would increase given the potential for different metrics and standards.
- Explore/expand other reporting formats. The annual own risk and solvency assessment (ORSA) report is often mentioned given its widespread implementation, but it focuses on risks over the next one to three years, which may not reflect the long-term impacts of climate risk. Another option is adopting an approach similar to the CDP Group, a nonprofit charity that runs a global disclosure system for investors, companies, cities, states and regions to manage their environmental impacts. Its format is fully aligned with the TCFD recommendations and potentially offers more analytical capabilities since the responses are less open-ended.
Influencing Climate Change
Another key objective, as implied in the questions in the NAIC’s Climate Risk Disclosure Survey and explicitly expressed in the recent request for information (RFI) from the FIO, is how to “leverage the insurance sector’s ability to achieve climate-related goals.” The EU Commission introduced the concept of double materiality as part of its 2019 Non-binding Guidelines on Non-Financial Reporting Updates. Under this concept, (re)insurers are being asked to consider climate risk not only from the “outside-in” view—how the various aspects of climate change affect their portfolios—but also the “inside-out” view of how (re)insurers’ activities and portfolios contribute to climate change. It continued with this approach in its Corporate Sustainability Reporting Directive proposal in 2021.
In addition, the European Insurance and Occupational Pensions Authority (EIOPA) has proposed impact underwriting as an area in which insurers can influence climate change mitigation. Impact underwriting includes developing new products and markets as a way to incentivize policyholder behavior. In turn, some European regulators also have discussed varying capital charges as a way to encourage (re)insurers to transition from “brown” to “green” investments in their asset portfolios.
Reducing the Protection Gap
Climate change does not impact all members of society in the same way. This is true for both transition risks and physical risks.
As companies, including insurance companies, transition from carbon-intensive investments to more climate-friendly markets and products, traditionally underserved communities may see a decline in the availability and affordability of insurance. This may further compound the economic impact given the extent to which these communities may be heavily represented in “brown” industries or live in areas that are most vulnerable to the various impacts of climate change, such as extreme heat or severe weather events.
For example, an auto insurance company could incentivize more climate-friendly driving behaviors by varying rates based on commute length. However, this could disproportionately impact people who cannot afford to live near their workplace and must commute long hours for employment.
While health insurers often say their liability exposure to climate risk is minimal given that their contracts are one to two years and priced based on recent claims experience, what does that mean for long-term rate trends for groups most exposed to the effects of climate change, such as people who work outdoors or are unable to adapt quickly? Will this further exacerbate the protection gap between the insured, who generally have higher incomes and better health outcomes, and the general population?
Preparing for the Future
All of these objectives potentially increase the demands on (re)insurers’ resources, the extent of which will vary considerably by geographical scope, products offered and insurer type (i.e., large or small, public or private, and line of business). If your company hasn’t already started, I encourage you to take steps now to prepare. Some of the preliminary steps you can take include:
- Identify who is responsible for coordinating climate risk in your company.
- What roles do actuaries currently play?
- What are ways to ensure stakeholders are abreast of the latest industry and medical research?
- Assess your current liability exposure.
- Are some products and markets more or less vulnerable to climate risk?
- What is the time horizon of the potential impacts?
- What are the respective roles of physical, transition and liability risk?
- What are the direct and indirect impacts on your portfolio, and which are the most important?
- What internal data is available, and what would be needed to develop assumptions and monitor exposure going forward?
- What analytic and modeling tools are available or could potentially be needed?
- Communicate with stakeholders.
- Who are the key internal and external stakeholders? What are their objectives and needs?
- Are there ways to leverage information that can be adapted for multiple purposes?
- What challenges will there be around communicating the potential uncertainties?
Regardless of the ultimate approach and format of the climate risk guidance, exploring these questions—if you haven’t already done so—will provide a solid foundation.
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.
Copyright © 2021 by the Society of Actuaries, Schaumburg, Illinois.