Strategic approach needed to manage climate change risk

The launch of a consultation paper on the approaches to managing financial risks arising from climate change will transform the way that organizations do business. But how should insurers react and what are the risks?

The UK’s Prudential Regulation Authority (PRA) consultation paper on the financial risks of climate change, known as CP23/18 and released in October, is a radical document. It outlines expectations towards effective governance, risk management, scenario analysis and disclosure. If implemented, it will have wide-ranging consequences for insurers’ investment strategies and risk management. It is vital to consider what these impacts might be and how insurers should react.

Climate risks are financially material to insurers and their integration within environmental, social and governance (ESG) disclosure frameworks represents an important development. The insurance liabilities from climate risk exposure are evident. There is an increased risk of flooding and extreme weather events increasing the level of insurance claims. But until now, the much wider financial risks that relate to the impact on assets have been largely overlooked by insurers.

However, it’s clear the PRA are taking this seriously. They want to see evidence of climate change-related financial risk being appropriately considered and reflected in written risk policies, board reports and Own Risk and Solvency Assessment (ORSA). Some of the challenges companies can expect are:

Governance - Who at board and executive level has responsibility for identifying and managing the financial risk from climate change under the Senior Management Function and their formal statement of responsibilities?

Risk framework - How is the attitude towards financial risks embedded within risk appetites and frameworks, including the insurers’ ORSA?

Risk identification - Have insurers appropriately identified and understood the possible financial risks from climate change? Do they differentiate between physical risks, such as floods and storms, the impact on supply changes and agriculture associated with a failure to achieve the 2°C target? Do they understand transition risks resulting from actions taken to shift to a low-carbon economy, such as regulation banning the use of fossil fuels or new technology disrupting old industries?

Data gathering - Methodologies and metrics are needed to quantify climate risks and for insurers to understand how to find the optimal balance between qualitative and quantitative approaches.

Scenario stress testing - Does scenario and stress testing appropriately incorporate the two different paths of physical and transitional risks, and the worst-case scenario where action is taken too late, resulting in both physical risks and transitional risks being realized?

Impact on business strategy - How might a firm’s business models and strategies be affected by climate change and what mitigating actions could they take and when?

Prudent Person Principle and investment strategy - Risks arising from climate change fall under the Prudent Person Principle, meaning the consequences of climatic risk need to be incorporated into investment strategy.

Disclosures - Additional disclosures will be needed in respect of an insurer’s approach to the financial risk from climate change. The PRA has encouraged insurers to engage in wider initiatives such as the recommendations from the Taskforce on Climate-related Financial Disclosure.

What next?

Companies have until January 15 to respond to the consultation paper, but experience suggests there will be no radical revisions to the PRA’s thinking. One thing seems clear: doing nothing is not an option and there’s a risk of substantial financial loss if insurers do not act quickly enough.

There’s a growing interest in understanding how different asset classes translate climate risk into financial risk. Whereas equity valuation embeds perpetuity considerations which should capture long-term exposure, debt markets typically see shorter durations and less exposure.

Real assets

Analysis is well advanced to price climatic risk impacts into real assets valuations on two fronts:

• The physical risk exposure, such as the risk of flooding or an extreme weather event.
• The carbon footprint of the asset, and the risk of it becoming a stranded asset, such as the UK’s buy-to-let market, where properties now need to have minimum Energy Performance Certificate (EPC) rating. Given the illiquid nature of many of these assets, swift action is imperative.

Liquid assets

Some insurers have made wide-ranging changes to their liquid asset portfolios to add greater weight to ESG, but others have yet to act. Key to moving forward is the assessment of an insurer’s asset portfolio and its levels and concentrations of exposure to physical and transitional risks from climate change. But action is complex and there are many factors to consider. For example, the biggest extractors of fossil fuels are some of the biggest investors in renewable energy. How do you treat such firms?

The ability to identify where the investment opportunities are is just as important. In a changing system, a company’s capacity to adapt to the new terrain will be crucial.

The above was an opinion piece written by Keith Goodby (pictured), a senior director of Willis Towers Watson’s Insurance Investment Solutions Group at Willis Towers Watson.