2021 – Are You Prepared for the Sustainability Agenda?
2020 may be remembered as the year that the world struggled to respond to Covid-19. But what will we learn from the pandemic? We will certainly be better prepared for future outbreaks of disease, but will we turn our collective minds to other global systemic risks? The pandemic has taught us that, in a crisis, we can travel less, work differently, and better appreciate what we already have. Will we apply that crisis management to a longer-term risk: climate change?
This article will attempt to set the scene, then cover the risks, before understanding the key UK regulation, and finish by highlighting what insurers can do in the short term.
Why does climate change matter?
The UN expects that the world is heading for 3.2 degrees global temperature rise by the end of the century (compared to pre-industrial levels), even if current climate commitments are met. The globe has already experienced 1 degree of warming, and 2020 was confirmed as the joint warmest year on record, despite the lack of a major El Niño event (which has contributed to most previous warm years).
It is widely accepted (e.g. COP21 in Paris) that 2 degrees of warming is very risky, but 1.5 degrees is much more manageable. The temperature rise we experience is dependent on the total greenhouse gases we emit, which depends on how long it takes for the world to get to net-zero, and the path that we take. Against the backdrop of a growing global population with increasing energy demands, that means we need to significantly reduce energy use in richer countries as well as shift to renewable energy sources.
We are already seeing impacts of climate change, from increasing frequency and severity of wildfires in the Western US and Australia, through to unseasonal rains bringing agricultural devastation from swarms of locusts across East Africa. Global migration will increase, as poorer countries are more affected by climate change and lack the resources to adapt.
As the general public become more educated about the risks of climate change, consumer behaviour is adapting – we will see a growing preference for firms that are addressing climate change through targets and tangible action, and consumers will avoid organisations with negative press. Climate activists will have an impact, and so will individuals, e.g. the David Attenborough / Greta Thunberg effect and the rise of veganism.
The Risks for Insurers
Financial risks for insurers are often considered under three buckets: transition, physical, and liability.
Transition risks arise as we adjust to a low carbon economy. These will include:
- Shocks in the value of assets (equity and fixed income) of fossil fuel extractors, as assets that are on the balance sheet are deemed to be worthless, as they must stay in the ground or become liabilities themselves
- Regulatory changes regarding energy efficiency that impact the value of housing, factories and offices held in property portfolios
- Changes in asset valuations for companies that fail to disclose or adapt to their climate risks, or are litigated against
Physical risks cover the direct effects of climate change to investment assets and insured assets, including:
- Potential increased frequency or severity of extreme weather events, impacting property insurance (e.g. wildfires, windstorms)
- Increased flood risks due to sea level rise, that may cause increased insurance payouts or reductions in the value of property portfolios
- The effects of changes in global agriculture and food supply, as the global population struggles to adapt to increasing temperatures, drought, and lack of resilient crops
Liability risks arise where one party has suffered loss or damage due to climate change, and holds another party responsible, seeking compensation:
- Those who emit greenhouse gases may be sued by those who have suffered loss or damage. As attribution science improves, it is not unrealistic for cases to be won. One notable case of interest is Lliuya v RWE. As of May 2019, there were over 1,300 such climate change related cases.
- Asset owners who suffer a loss in the value of their investments due to climate change may sue the directors who took the wrong action, or failed to take the right action.
- Many areas of liability insurance may be affected, particularly Directors & Officers and Errors & Omissions. These risks may not crystallise for some time, and insurers may retain the risk for many years.
However, financial risks are not the only risks that insurers face regarding climate change. Reputational risk can arise from increased awareness amongst the public regarding an insurer’s underwriting portfolio, for example the Stop Adani protests targeting Lloyd’s of London this year. Operational risk can arise if an insurer’s functions are impacted by climate change, for example a flood-prone office.
It is likely that regulators will want their financial services industries to be systemically resilient to climate risks before the low carbon transition impacts the real economy. Relative to other global players, the Bank of England has taken a lead on climate-related risk management and reporting requirements. Mark Carney commented in 2014/15 that “the vast majority of [fossil fuel] reserves are unburnable”, and the PRA has recently published its supervisory statement (SS3/19) on requirements for banks and insurers to manage financial risks from climate change.
Key features of the PRA’s SS3/19 include (for implementation before the end of 2021):
- Governance, in particular an ownership of climate risk at Senior Management level and understanding at Board level
- Risk management, including risk identification, measurement, monitoring, management, mitigation and reporting
- Scenarios, over the short term and long term, including consideration of solvency and liquidity
- Disclosure, whether optional or mandatory, regarding financial climate risks
Other influential organisations include the ‘Taskforce on Climate-related Financial Disclosures’ (TCFD), and the ‘Network for Greening the Financial System’ (NGFS).
Those who focus on a one-year capital requirement (or an ORSA / to-ultimate capital with a slightly longer timescale) may argue that the crystallising of climate risk is sufficiently far away to be excluded from a model. However, they would be forgetting some key points:
- Man-made climate change is currently having an impact on the real world
- A risk that crystallises in 2050 may be identified and priced for in 2021
- Financial markets are currently turbulent, with significant potential for change coming from building back better programs post-pandemic
- The UK is hosting COP26 in 2021, which might accelerate the transition to a low carbon economy close to home
- It is feasible that we see successful litigation against major fossil fuel extractors or significant carbon emitters over the next few years
Should those considerations be factored into a capital model focused on the 1-in-200? It’s hard to argue against it.
What can be done?
Beyond ensuring compliance with regulatory requirements, insurers need to ask themselves what management actions they need to take in the short term. This will include:
- Leading, rather than following, the transition to lower greenhouse gas emissions
- Changes in investment strategy: similar to the choices available for individual investors, this can range from divesting from extractors and emitters, through to active investment in sectors that are key to the low carbon future (e.g. solar panel manufacturers)
- Product development: Who will insure the fleets of autonomous electric cars? Will elderly homeowners be incentivised to better insulate their homes by equity release providers?
- Regular monitoring of risks to re-price insurance as necessary, e.g. in light of wildfires / windstorms / flooding
Perhaps, the more pressing question to ask is “what will happen to the insurers that don’t act?”