Climate risks become major regulatory concern for insurers

Introduction

Extreme weather events are getting worse. The rise of flooding, drought, typhoons and wildfires is linked to a rise in global temperature caused by human activity. The risks arising from climate change are recognized by supranational organizations, national governments and private enterprise as a significant threat to human life and to the economy. In 2015  consensus was reached that climate change should be limited to a change of no more than an increase of 2ºC by the end of the century. Since 2015 there has also been a marked change in public awareness of climate change. With greater public awareness has come an appetite to hold both governments and businesses to account for their contribution to the rise in temperatures. This accountability, we believe, will lead to increasing exposures for insurers, not just in terms of the policies underwritten but also in relation to the management of their business, with increasing regulatory requirements concerning climate related risk.

Insurers have a far more sophisticated understanding of climate risks than many other industry sectors – insurers have been using tools to predict weather-related disasters for decades and they are exposed to claims whenever there is a climate-related event (insured losses from Hurricane Katrina were estimate at US$35bn).¹ The insurance industry is in a unique position in relation to the changing environment as it not only pays claims to indemnify insureds for climate-related damage, it also funds the economy through significant investment portfolios.

Insurers may need to change business models, reassess product lines, have an investment strategy that takes into account the political and social expectations around carbon assets and green energy, and look at reporting and governance obligations that question how the business is responding to the threat of climate change. Having a clear strategy on adaptation, not just in terms of the increased risk of claims but the changing social and reputational expectations around managing temperature increases will be required.

In the past year, supervisory authorities such as the UK’s Prudential Regulatory Authority (PRA), have started to impose reporting obligations on insurers in respect of climate risks. It will no longer be possible to account for climate risk in generic terms; regulators will expect the risks to be captured and reported on the balance sheet; shareholders are raising their expectations in respect of how companies manage climate risks.

We consider the risks faced by the insurance industry and also take stock of regulatory expectations in respect of how climate risks are managed and disclosed.

What risks do insurers face from climate change?

The risks associated with climate change that insurance companies face are typically broken down into the following categories: physical risks, transition risks and liability risks. But these risks have correlations and cannot always be considered in isolation from each other.

Physical risks

Climate change is expected to lead to an increase in the frequency and severity of events that insurers cover under their policies. The rise in temperature may increase the frequency and intensity of heatwaves, wild fires, storms and flooding. The increased frequency of high sea levels and storm surges may increase claims in coastal regions. The changes in weather related events may affect the value of infrastructure assets that face higher risks of destruction or greater building costs to protect against climate-related risks.

There are also indirect risks associated with physical risk. When flooding, drought or storms damage businesses there may be claims under business interruption policies or supply chain cover. The extent of liability under these traditional commercial policies may not take into account the rise in claims linked to extreme weather events.  In 2011 flooding in Thailand caused US$45 billion of economic damage, resulting in US$12 billion indirect claims such as claims from manufacturing companies for losses due to supply chain interruption.  These business interruption claims cost Lloyd’s of London approximately £2.2 billion.

Transition risks

The Intergovernmental Panel on Climate Change (IPCC) has estimated that in order to maintain a 66 percent probability of keeping human-induced warming within the agree 2°C limit, global carbon emissions from 2011 must be limited to less than 1000 GtCO2. The IPCC estimates that “Baseline scenarios, those without additional mitigation, result in global mean surface temperature increases in 2100 from 3.7°C to 4.8°C compared to pre-industrial levels”.  Reaching the globally agreed goals of remaining within a 2°C rise in temperature would require substantial reductions in greenhouse gas emissions through large-scale changes in energy systems, other emission reductions and potentially land use.

For insurers, there are the physical risks set out above, which are likely to lead to more claims.  As we explain below, there is also likely to be an increase in claims arising out of climate change, across a range of product lines. In order to meet these increases underwriting liabilities, insurers will rely upon their invested assets. Climate change may impact the value of those assets. Real estate portfolios can be affected by weather related damage and lose value when they are situated in high risk areas.  It is anticipated that in order to reach the IPCC target of keeping human-induced warming within the agreed 2°C limit, certain carbon assets may become “stranded assets”, devalued or converted into liabilities on the balance sheet.

Financial markets may be affected long before the physical effects of a significant change in climate are felt. Assets becoming stranded in order to reach climate targets are an example of this.

Taking into account the balance sheet of insurance companies, a rise in liabilities (resulting in a fall in reserves) at the same time as a fall in asset values could have a profound effect on the insurer’s regulatory capital.

Liability risks (or litigation risks)

Insurers face two distinct areas of liability risk from climate change.

• Claims against the insurers in relation to the management of their own business.  How insurers manage their business can be the basis of a claim – especially where information given to shareholders or regulators is misleading or an individual director has breached a duty of care.
• Risks underwritten by insurers. The directors and officers of carbon-intensive industries or investment companies may be held personally accountable for failing to consider the impact of climate change in corporate strategy and business dealings or for failing to disclose information relating to climate risks. Regulatory reporting requirements are changing to include climate-risk information. Claims against energy companies may require insurers to defend liability claims against their insured.

Claims are not limited to carbon-intensive industries. Professionals such as architects, engineers and civil engineers can face liability claims where they fail to take climate risks into account in their designs if foreseeable damage to buildings occurs in extreme weather events.

Climate change has become a regulatory issue

Climate change is not just an underwriting concern or corporate responsibility concern. In the past couple of years a number of supervisory authorities have asked that climate change is taken into account as a governance and capital management issue.

In 2015, the UK’s PRA published a paper on the impact of climate change on the UK insurance sector. The objective of the 2015 report was to provide a framework for considering the risks arising from climate change, taking into account the PRA’s statutory objectives which are the safety and soundness of UK firms and the protection of policyholders. The report recognizes the three primary risk factors of physical, transition and liability risks. The PRA states that across these three risk factors “there is potential for climate change to present a substantial challenge to the business model of insurers”.²

In October 2018, the PRA published a consultation on banks’ and insurers’ approaches to managing the financial risks from climate change.³ While firms’ approaches are evolving from a corporate social responsibility perspective to also considering climate change as a financial risk, only a few firms have adopted a strategic approach to managing climate risks.

Following the consultation, the PRA published a supervisory statement setting out its expectations of how insurers embed the consideration of the financial risks arising from climate change in their governance arrangements and ensure that climate change is brought within existing risk management practices within the business. The supervisory statement requires that the boards of UK insurance firms should have clear responsibilities for managing the financial risks from climate change.

Responsibility for these risks should be allocated to an individual in a Senior Management Function. The PRA also expect firms to use long-term scenario analysis to inform business strategy and risk identification. Importantly, in the supervisory statement the PRA also sets expectations in respect of disclosure of financial risks arising as a result of climate change.

In May 2019, the PRA published a framework to assist insurers to assess the financial impact that increasing climate-related claims will have on insurers’ balance sheets.  The framework is intended to be used by firms as a starting point to assess the impact of climate change on business decisions and disclosure requirements. The framework includes recommendations in respect of how to define materiality so that firms can focus on climate risks that could have a material impact on business decisions and how to apply tools to assess the financial impact of future projections and how to report and action climate risks to decision makers within the business.

Conclusions

Insurers are likely to see an exponential rise in claims linked to extreme weather events as the climate changes. This rise will not only be seen in respect of property claims but also under construction, financial lines, professional indemnity and directors and officers policies.

How climate risks are managed by insurance companies has moved from the underwriting floor to the boardroom. The approach to the changing environment must be holistic and delivered through a top-down strategy that takes into account all the different risks that climate change poses to the industry.