What gets measured, gets managed
“What gets measured, gets managed. Every major company should disclose how climate change affects its current business.” – Mark Carney, 2020 Reith Lecture.
For insurers, step-by-step guidance has been provided by the UN Environment Programme’s (UNEP) Principles for Sustainable Insurance Initiative and the Geneva Association’s (GA) Climate Change Risk Assessment for the Insurance Industry. The key takeaway can be summarised as follows: identify the risks then stress test through scenarios.
Actually carrying this out is not so simple. But these reports provide a roadmap to enable insurers to implement the recommendations of the Financial Stability Board’s Task Force on Climate Related Disclosures (TCFD) – the gold standard for climate change risk assessments and disclosures.
Following the widely adopted categorisation of risks into physical, transition and liability risks, the UNEP report takes each of these in turn and the GA report provides tailored guidance to property and life insurers.
Physical risks
The UNEP report states that first the step is to define the hazard, geography and line of business and then prepare an ‘impact pathway’. This enables the insurer to plot a course between the risk and its impact. Within the risk sits the hazard (e.g. flooding), vulnerability (how property is affected) and exposure to the risk (property location, terms and conditions of the policies).
The GA report recommends undertaking the risk assessment over both short term (2020-2030) and long term (2040-2050) time horizons as well as chronic (such as regular coastal flooding as sea levels rise) and acute risks. The importance of the use of projected weather data is stressed so that scenario analysis is future proofed. The more granular the data used, the more accurate the results will be for the insurer. Worked examples for floods and cyclones are provided for different jurisdictions to illustrate how the analysis works.
Consideration must also be given to feedback loops i.e. how the consequences/non-linear impacts of climate change interact, as well as the positive effects of new adaptive technologies. For this reason, the use of multiple scenarios over different temperature increases and time horizons is recommended.
Transition risks
Having to use mainly qualitative, rather than quantitative, data for transition risk scenario planning makes this more challenging. This summer, the Bank of England will set a number of insurers stress testing scenarios, imagining three possible futures and the UNEP report follows this approach i.e. a future, where:
- there is early policy action, so that the temperature increase is capped at 1.5 degrees Celsius above pre-industrial levels (as per the Paris Agreement) and the move to a low carbon economy is planned with transition risks managed;
- there is a maximum 1.5 degree increase, as above, but the transition is not implemented in a managed way prior to 2030, so more drastic action is required to reduce emissions; and
- no action, planned or otherwise, is taken so that the Paris target is not met and the planet’s temperature increases by 3 degrees in the second half of the century with catastrophic effects.
In gathering the necessary data, the report suggests that insurers use the resources they already have when underwriting long-tail risks and financial projections to better understand climate change risks. It is stressed that opportunities will also arise in the move to a decarbonised economy – in which the renewable energy sector (and insurers) in particular can capitalise. In addition, the insurance industry will inevitably create innovative insurance products. The GA report notes the growing expectation that the private sector (including insurers’ underwriting and investing practices) will take proactive steps to reduce carbon emissions. However, there are huge uncertainties associated with transition risks, not just the speed and control with which the transition happens but the effects of broader factors such as migration and geopolitical conflict.
Litigation risks
No claim against a private company for causing/contributing to climate change has been successful…yet. There are currently a number of cases before courts in the US and in Europe which may change this and the UNEP report helpfully sets these out. The UNEP report comments that litigation risk has received less attention than physical or transition risks and stresses that these risks must not be over-looked. Claims can arise both against insurers’ policyholders (which may then fall within the scope of cover) as well as insurers themselves if they fail to manage these risks, make appropriate disclosures to investors and/or fail to undertake rigorous assessments to identify (and then adapt/mitigate) the risks.
Cases may be brought by those affected by climate change against major carbon emitters or by stakeholders of companies accused of greenwashing/making misleading disclosures. An assessment of these risks must consider the litigation culture of that jurisdiction, the likelihood that cases brought might be successful and, if so, the level of potential damages awarded.
In summary
Both reports are well written, full of detail, worked examples and references to further materials. Many insurers are already well on their way when it comes to risk assessing, disclosures and stress testing through imagined future scenarios. Those insurers that have not yet embraced this will need to, and soon. Once risks are identified, steps can be taken to adapt and mitigate. Failure to do this could result in claims in the future – both against the insured and the insurer.
The GA report stresses that the evolving nature of climate science as well as these assessment methodologies means that the process is inevitability a work in progress. Nevertheless, given the severe consequences for all sectors of the economy and, indeed, the society in which we live, it is important to promote increased awareness of these risks and the need to invest time into developing assessment capabilities so that we can then manage what we measure.
This article was first published in Insurance Day.
