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Are Insurance Firms Covered Against Climate Change?

Even experienced risk managers face stiff challenges in developing a comprehensive response.

A core competence of any insurance firm is to identify, manage and price long-term risk. This should mean insurers are well placed to factor climate-related risks into their business models, both in terms of the liabilities they manage for customers and the assets they manage themselves.

But climate change encompasses a plethora of interconnected risks. Drastic fluctuations in temperature, for example, can increase the risk of drought or intense precipitation, which will have knock-on impacts for insurers’ customers and investee companies, with severity depending on size, sector and geography.

The Task Force on Climate-related Financial Disclosures (TCFD) has sorted climate-related risks into three subcategories: physical, transitional and liability.

However, many insurers are approaching these subcategories in siloes, without fully accounting for how they connect, according to a report by Willis Towers Watson (WTW) and Wellington Management.

For example, insurers typically view physical risks according to their potential impact on liabilities in underwriting portfolios. In comparison, transition risks are viewed to have more of an impact on investment portfolios where “associated costs can lower security values”, the report said.

Insurers need to adopt a “holistic view” of how physical, transitional and liability-related climate risks may affect all arms of their business, the report noted. It added that the insurer’s approach will need to be clearly disclosed, demonstrating adherence to new guidance issued by bodies such as the New York Department of Financial Services, and the International Association of Insurance Supervisors (IAIS) and UN-convened Sustainable Insurance Forum (SIF).

High stakes

On the asset side of the balance sheet, successfully identifying, measuring and disclosing exposure to the full range of climate-related risks will require more reliable, comparable and transparent data from investee companies. It will also need improvements in scenario modelling and forward-looking indicators, according to experts. Insurers cannot improve the quality of data and analysis on their own, requiring support from policymakers, third-party vendors and standards setting bodies.

Nevertheless, insurance firms have great power and responsibility in the fight against climate change. By fully accounting for climate risk in their business strategies, they can influence the practices and plans of both customers and investee companies, in the latter case allocating capital to help firms either decarbonise their operations and products or offer climate-based solutions.

“Asset owners such as insurers can play a significant role in bringing the decarbonisation of the real economy forward. By shifting the institutional asset base of over US$80 trillion towards more sustainable investments, we can help fund the transition to a low-carbon economy. By working towards more climate-related information, we can enhance transparency and make the risks visible,” says Claudia Bolli, Head of Responsible Investing at Swiss Re.

But climate strategy is also a matter of enlightened self-interest for the insurance sector. Recognising, challenging and – if necessary – divesting from climate laggards could save insurers billions in losses, as they lower their exposure to potential stranded assets.

On the liabilities side of the business, by fully accounting for the three sub-categories of climate-related risks in their underwriting activities, insurers will cut out potential losses that could arise from the physical risks posed by climate change.

These are steep and rising. A 2020 report from insurance broker Aon noted that natural disasters caused US$3 trillion in economic damages between 2009-2019, costing insurers US$845 billion, well above the levels seen in the prior decade.

In response, insurers can advise and incentivise customers on how to mitigate physical risks and build greater resilience. But climate risk management can also entail withdrawal from business sectors that are contributing to climate change, something that many insurers have been slow to enact to date, despite increasing pressures.

Measurements and materiality

It is one thing to understand that your investments will be exposed to varying blends of physical, transitional and liability climate risks, but it is quite another to measure how they will impact portfolio performance.

It doesn’t help that there are “few agreed upon ESG investment standards or metrics that allow investors to accurately compare the climate-related performance of different investments”, says Lawrence Vousden, Head of Public Affairs and Sustainability for Zurich UK.

As part of Zurich Insurance Group, Zurich UK provides a suite of general insurance products, including business and property insurance. It manages £25 billion in pension and life insurance assets on behalf of its customers, compared to the group’s total US$395 billion in assets.

In a recent report, Zurich highlighted the need for governments to introduce globally consistent mandatory climate-related reporting standards as one of three priorities for discussion at COP26.

But insurers also need to look beyond how climate-related risks will impact their business and instead adopt a double materiality lens, considering how their “business operations could impact society, climate change and the environment more broadly”, according to a report published by NGO ShareAction.

As well as monitoring the impact of climate change on portfolio risks and values, this could mean insurers will have to consider more carefully the consequences of investing in more carbon-intensive companies. It could also add further to existing pressures to weigh how underwriting specific activities could contribute to climate change.

Many insurance firms are adding exclusions to their underwriting policies but some have argued they are not moving fast or far enough.

European insurers will need to adopt this mindset more quickly than most, as the European Financial Reporting Advisory Group (EFRAG) and Global Reporting Initiative (GRI) develop the EU sustainability reporting standards, which will incorporate double materiality.

Further, the EU’s Solvency II legislation, has recently been updated. The April 2021 changes, which will apply from August 2022, require insurers to integrate sustainability into their risk management, remuneration policies and overarching fiduciary duties.

Nonetheless, while some insurers still need to play catch up, “most have made great progress in the climate risk management of their own operations and investments,” counters Martin Weymann, Head of Sustainability, Emerging and Political Risk Management, at Swiss Re.

Using its Sustainable Business Risk Framework for both underwriting and investment, Swiss Re monitors the potential environmental and socio-economic impacts of its business transactions across eight sectors, including mining, oil and gas and thermal coal. The framework contains criteria and qualitative standards which aim to define when a transaction may present a sustainability risk.

Being proactive

There is plenty of guidance available for insurers looking to aid transition to a low-carbon economy, while also managing their own risks. For example, the Association of British Insurers has published its Climate Change Roadmap, which outlines how UK insurance firms can contribute to the country’s net-zero strategy.

Insurers joining the UN-convened Net Zero Asset Owner Alliance (NZAOA) and/or the Net Zero Insurer Alliance (NZIA) will also benefit from peer-level advice and tools for decarbonising their portfolios and business models.

The NZAOA commits an insurer’s investment arm to transitioning their portfolios to net-zero by 2050 or sooner, introducing interim decarbonisation targets every five years, as well as supporting both the TCFD and the Task Force for Nature-related Financial Disclosures (TNFD) frameworks and the UN Sustainable Development Goals (SDGs). The NZIA, founded in July, is for the underwriting side of the business.

As a member of NZAOA and NZIA, Vousden says Zurich will no longer underwrite or invest in companies that generate more than 30% of their revenue from mining thermal coal, electricity from coal or from the extraction of oil from oil sands.

Swiss Re has introduced a carbon intensity reduction target of 35% for its corporate bond and listed equity portfolio, to be achieved by 2025 (with 2018 as the base year). The insurer also recently signed a purchase agreement for the direct air capture and storage of its operational CO2, worth US$10 million over ten years, with Climeworks.

In lieu of sufficient levels of reliable quantitative data from issuers through voluntary or mandatory reporting regimes, insurers can up their engagement efforts to ensure investee companies are decarbonising, the ShareAction report highlighted.

Speaking at ESG Investor’s first Countdown to COP26 webinar, Pascal Zbinden, Co-Head of Strategic Asset Allocation and Markets at Swiss Re, noted that “data is clearly not perfect”. However, there is enough available for asset owners to make a start measuring risk. Investors can set intermediate targets to secure better quality data through avenues such as engagement, he said.

Notwithstanding the efforts of industry leaders, there is room for improvement overall. Only a “small minority” of insurers and their managers have robust stewardship strategies in place to help ascertain their engagement is “sufficiently ambitious”, ShareAction said.

For half of the 70 insurers surveyed, there was little to no evidence of board-level involvement in responsible investment and underwriting. Most boards had not received “any relevant training or incentives”, the non-profit said.

Part of the solution

Regulators are beginning to push for improved engagement, which should prompt insurers’ boards to prioritise climate-based stewardship.

For example, the Monetary Authority of Singapore (MAS) released its final guidelines on environmental risk management for asset managers and insurers earlier this year. MAS said insurers should engage with investee companies in order to better facilitate a greater awareness of environmental risks and to encourage more sustainable behaviours.

Before tackling climate risks in their portfolios, insurers need to make sure that climate is at the heart of their business strategies and a priority for their executive-level employees, according to WTW and Wellington. “Insurers have to bring their people with them,” the report said, proposing a four-part approach encompassing strategy and culture, skills and knowledge, rewards, and employee education.

“Addressing climate risk and improving resilience is a transformational change that goes to the heart of insurers’ people policies and practices in addition to how they manage risks and capital,” the report said.

Nonetheless, insurers shouldn’t be completely blinded by risk, but should look for opportunities, too, Swiss Re’s Weymann adds.

“As part of the inclusion pillar of our responsible investing approach, we target investments that contribute to the transition to net-zero and climate change mitigation. An effective way to achieve this is through investments in green bonds and real estate, as well as renewable infrastructure loans,” he says.

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