Six areas for priority action
While COP26 in Glasgow may not have resulted in the level of government commitments that had been widely advocated, one thing it most definitely did do was shine a more intense light on the role of, and expectations for, financial institutions and the financial services industry as a whole in transitioning to net zero and assuming its social responsibilities. This was the first COP that the private sector has attended en masse and there was widespread recognition of the need for issues to be addressed in a joined-up way across the public and private sectors. Perhaps the most visible demonstration of that was that the group of 450 banks and insurers that are part of The Glasgow Financial Alliance for Net Zero (Gfanz) committed $130 trillion to tackle climate change between now and 2050.
The calls for greater finance sector transparency and an end to ‘greenwashing’ as part of the conference’s ‘Coal, Cash, Cars and Trees’ message resounded around many sessions and plenaries.
On the one hand, (re)insurers around the world can expect a further raft of climate-related regulatory and reporting obligations in the coming months and years, while COP26 will also almost certainly ramp up the pressures for action that were already building before the conference from a broad church of stakeholders, including employees and potential recruits.
But to focus only on climate ‘sticks’ is to miss the point.
Fundamentally, addressing climate change by reducing greenhouse gas emissions is a big opportunity for the insurance industry from several perspectives, as already recognised in the formation of the Net Zero Insurance Alliance, including how it generates investment income, how it underwrites risks and how it makes available contingent capital, and as a source of broader customer engagement and reputation enhancement. Commitments coming out of COP26, such as the goal of doubling spending on adaptation and resilience and initiatives such as the U.S., UK, EU Green Infrastructure commitment are definite positives for the insurance industry.
So, what can insurers be doing in the shorter term to get prepared and to capitalise on climate-related opportunities.
On the road to navigating climate transition Willis Towers Watson believes it is important to:
For this article, we’ve extracted six areas of priority action and investigation/investment that we believe will benefit insurers over the next year and beyond – as, really, the time for talking is over.
01
Quantification of the risks is fundamental and having a framework that appropriately reflects the nuances of climate risk is critical. Climate risk exposures vary depending on the level at which risks are assessed and insurance is a classic case where assessing risk at industry, individual company and individual asset level may results in materially different risk exposures.
In addition, individual company carbon footprints may be low but climate risk exposures will vary depending on the nature and location of the investment or underwritten business. For example, where an insurer insures a windfarm, the operating carbon footprint may be low (although the overall carbon footprint will also depend on the materials sourced and construction footprint) but the asset will still be exposed to physical climate risk. When assessing the investment risk associated with a windfarm asset, consideration needs to be given to both the physical and transition risk at individual asset level as well as the wider macro-economic and credit risks from climate change. It is critical that climate risk analysis considers both the top-down and bottom-up dynamics as well as the interdependencies between risks.
Insurers need to integrate proven analytics tools, natural catastrophe vendor models and methods that reflect the latest science to quantify their enterprise-level climate risk. Examples of potential outputs include hazard and climate-risk scoring and mapping, determination of hazard and climate-adjusted financial losses, and integration of analysis into existing tools and models to support areas like underwriting (life and non-life), risk management, reserving and the actuarial function.
The quantification challenge extends to scenario analysis to take account of how efforts to combat climate change, including measures to adapt and improve resilience, may impact risks in the short term (e.g. loss amounts for hurricane, flooding, wind, as well as impact of transition on economic risk) and longer term (e.g. sea level rise, frequency of severe weather events, long-term economic factors that impact physical risk as well as demographics such as mortality and morbidity).
Scenario development for climate change focuses on two parts. First, the determination of selected temperature, temporal and transition pathways (e.g. the Intergovernmental Panel on Climate Change (IPCC) climate scenarios), which refer to the amount of warming within a certain period of time, and the ability of policy and the economy to keep pace with the rate of change desired. Second, translating these impacts into a format that can be applied to the baseline risk from tools to models that the industry already uses, to equate a climate impact to a financial impact (i.e. climate risk or loss scenarios).
The key is to start the quantitative scenario analysis journey today but recognise that modelling techniques are evolving in parallel with climate science – so there should be flexibility and agility in the work to capture the interconnectedness of physical and transition risks and avoid analytical ‘black boxes’.
02
In one sense, climate risks are not new to insurers; they map onto existing categories of financial and non-financial risk such as credit, market, business, operational and legal risks that insurers have been managing for many years. But because climate risks are so systemic in nature, risk and opportunities registers will need to be updated with explicit consideration of physical climate risks, transition risks and, potentially, any foreseeable changes in legal and liability risks.
Insurers will also benefit from starting to consider more proactively the role that stewardship can play, particularly on the asset side of the balance sheet, e.g. driving enhanced and robust ESG disclosures and using voting rights.
03
Because climate change intersects with so many risk categories, insurers’ and reinsurers’ risk-management frameworks will need to be holistic, establishing climate risk appetite and tolerance to provide the ‘guiding’ principles when balancing the needs of different stakeholders. Climate tilted enterprise risk management (ERM) frameworks will include:
Governance - including the board’s role in providing oversight of climate risk responses and defining management responsibility for climate risk and ESG integration.
Risk identification - identifying the key channels through which climate risks can impact the company, including its reputation, and how these are articulated, monitored and communicated on an ongoing basis.
Risk appetite and tolerance - forming a view as to the acceptable levels of risk (e.g. tail risk), including whether climate risk should be considered as a separate element or part of aggregate risk and whether aggregates are sufficient.
Risk measurement and reporting - including how to incorporate climate risk into financial risk models and reports and deciding on relevant data and metrics for decision making and monitoring.
Active management of risk exposures - aligning underwriting and investment strategies with both the near-term and long-term risks and opportunities. This could include dedicated investments in companies deemed to have a credible transition plan or developing innovative new products to provide coverage for green industries, many of whom are in their infancy.
Adaptation impacts - assessing how business risks and opportunities may evolve through low carbon transition, based on future climate scenarios.
04
As in so many other areas of insurance these days, data quality (at the ‘right’ level) is central to effectively manage climate risks. Insurers will need to (or will need help to) identify both relevant sources of internal data and the external data that align with climate strategy and that support business operations to transition. Tools that Willis Towers Watson has developed to assist with bringing a climate lens to underwriting and investment include Climate Transition Value at Risk, Climate Transition Pathways (CTP) and the Climate Transition Index.
The risks of insuring or reinsuring a coal mine as a single risk may be clear, although integrated action is still needed because simply declining cover may exacerbate unemployment and social inequality. But what about the majority of smaller risks or, for reinsurers, proportional reinsurance? You cannot successfully measure a portfolio and credibly say you are contributing to net zero if you only make your own portfolio zero. Insurers have to measure the change they engender as part of that.
In this context, it is absolutely crucial to define a measurable data requirement for ESG criteria, to define who will be in charge of populating these into the existing data warehouse system, and to adapt the data warehouse for access and monitorability.
05
Climate risk is an enterprise risk for insurers and is going to involve action across the people, risk and capital dimensions of its strategy. So, it needs executive ownership across the business to develop a coherent strategy, as well as specific goals (e.g. compensation targets) to assist in driving the delivery of net zero and wider ESG objectives.
That’s not to say that insurers can do everything in one year – far from it. But there’s certainly the opportunity to clarify responsibility and authority for aligning the business to its climate and ESG targets. As this will also involve focusing on whether the business culture and values support these goals, it will make sense to get the groundwork on taking your people with you towards net zero under way.
06
A good first step is, from our point of view, the production of an initial TCFD (Taskforce for Climate-related Financial Disclosure) report. The G7 conference prior to COP26 agreed that this should be mandatory by the end of 2025 anyway – and some countries are ahead of that schedule already. A real, perhaps under-appreciated, benefit of working through the TCFD reporting framework is that it forces companies to address many of the points we’ve raised in this article in a structured manner with a defined deadline, including the use of scenario analysis to understand the future changing nature of risk from strategy.
For many insurers, ESG transparency will also give positive momentum to building engagement with policyholders. Typically, there is rather limited contact with a policy holder - when taking out the policy, renewing it or making a claim. The bonding between company and policyholders might enter a different level based on climate and ESG engagement. It could be used to generate two-way interactions with customers and other stakeholders who expect business to step up and do its part in climate transition.
COP26 may not have achieved everything it was supposed to, but it did mark some significant milestones in attitudes to tackling climate change. There were concrete commitments to reduce greenhouse gas emissions by 45% by 2030, as compared with a 2010 baseline; the review of country’s commitments to reduce emissions was shortened from every five years to every year; and the words ‘net zero’ were included in the final accord for the first time. And perhaps most of all, it signalled that any question of a phoney war on climate is over for companies and institutions.
For insurers, it has reinforced wide ranging changes in the way businesses will need to be managed in the future. So, it’s time to focus on getting the basics right - things like who is in charge, what data and scenarios to access, what models to use, and what policies to adopt - so that individual companies are ready to take their climate journey.
