While COP26 in Glasgow may not have resulted in the level of government commitments that had been widely advocated before the latest UN climate summit, one thing it most definitely did was shine a light on the expectations for the financial services industry in moving to net zero.
The summit late last year 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 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 by 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 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 recognized 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., U.K., E.U. Green Infrastructure commitment are positives for the insurance industry.
So, what can insurers be doing in the shorter term to get prepared and to capitalize on climate-related opportunities.
Climate transition steps
On the road to navigating climate transition, WTW believes it is important to:
- Develop a climate strategy and a transition plan
- Roll out the strategy through product mix and new products for life and non-life, underwriting, reserving, capital modelling, investment and other policies and associated governance
- Quantify – carry out a comprehensive climate risk assessment
- Monitor, report and improve by including climate risk and ESG (environmental, social, governance) criteria in the risk management framework
See also: Time to Move Climate Risk Center-Stage
Six areas for action
Build on the current understanding of the effects of physical and transition risk on both assets and liabilities and lay foundations for future assessment
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 result 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.
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 key is to start the quantitative scenario analysis journey today but recognize that modeling techniques are evolving in parallel with climate science – so there should be flexibility and agility in the work to capture the connectedness of physical and transition risks and avoid analytical black boxes.
Understand the difference in commonly known large losses and losses related to climate
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 the role that stewardship can play, particularly on the asset side of the balance sheet, for example driving enhanced and robust ESG disclosures and using voting rights.
Integrating climate risk into wider enterprise risk management
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 affect the company, including its reputation, and how these are articulated, monitored and communicated on a continuing 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 products to provide coverage for green industries, many of whicj are in their infancy.
Adaptation impacts — assessing how business risks and opportunities may evolve through low carbon transition, based on future climate scenarios.
Define data requirements as part of the wider considerations around risk management, underwriting, investment and reporting
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 in the transition. Tools that WTW 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.
Map out a structure for oversight of climate risks and opportunity
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 toward net zero under way.
Report and engage on climate
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 – 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 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.
End of greenwashing
COP26 may not have achieved everything it was supposed to, but it did mark some 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 countries' 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. Perhaps most of all, COP26 signaled that any question of a phony 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.