Climate risks in firms' Own Risk and Solvency Assessments (ORSAs) — Key considerations
While we are still waiting for specific climate risk considerations to the insurance capital framework, regulators are expecting all insurers to identify, assess and manage climate risk exposure in their ORSAs. Here’s what to consider when assessing the financial impact of climate risk and reflecting them in ORSAs.
This article is based on a publication from Deloitte UK.
At a glance
- Insurers will be expected to demonstrate continuous improvement in their ability to manage climate risk as regulators progress their work on climate-related risk capital considerations over the next year. Supervisors expect this progress to be reflected in firms’ Own Risk and Solvency Assessments (ORSAs).
- This article sets out our view of the key considerations for insurers as they identify, assess and manage their climate risk exposures, drawing on our client work and insights from UK and EU regulators.
- Regulators agree that as a first step insurers should identify all their climate risk exposures and conduct a rigorous assessment to understand which of those are material. This, coupled with the use of carefully designed climate scenarios, will give insurers a robust starting point in terms of determining any further action to manage these exposures.
- Until regulators clarify their stance in relation to integrating specific climate risk considerations into the insurance capital framework, the key regulatory objective remains to ensure that firms identify their climate risk exposures, size them and manage them effectively. Boards should satisfy themselves that they are holding adequate capital against all material risks they are exposed to, including those derived from climate change, as part of the ORSA process.
The ORSA landscape today
The ORSA remains a key document for both firms and their supervisors when it comes to understanding a firm’s risk exposures and how they are being managed. Boards use it as a tool to assess risks and solvency. For prudential supervisors it is one of the most important sources of information to determine the supervisory strategy for a firm. The PRA expects firms to identify their material climate exposures and demonstrate they understand and manage these risks effectively as part of their ORSA. Additionally, EIOPA will start monitoring compliance with its ORSA/climate opinion from March 2023. It is therefore essential that firms get it right.
According to a survey conducted alongside EIOPA’s opinion dated April 2021, climate risk analysis is absent in many insurers’ ORSAs. And, where it features, the analysis is often superficial, without considering the specific impact on the insurer’s business, or limited to short-term horizons. EIOPA recently found that only “a small minority of ORSAs (…) assessed climate change risk using scenario analysis”, and many firms described climate change risk in “generic terms without assessing (…) the specific impact on the firm”.
This is in line with our experience. In our experience, there is significant variation in terms of insurers’ use of climate scenario analysis in their ORSAs, though many have cited intent to develop these capabilities in future reports. Where climate risk has been featured, general insurers have typically focused on physical risks and the impact of more severe and frequent natural catastrophes, while life insurers have tended to focus on impacts on investment portfolios. Insurers across the board have also frequently referred to regulatory risks arising from increasing climate disclosures and supervisory requirements, as well as reputational risks.
Whilst we do expect insurers to have progressed in this area since EIOPA conducted its survey in the last year, we believe there is still much to do before the March 2023 deadline and beyond. With the UK starting to actively supervise firms against the expectations set out in its SS3/19 ‘Enhancing banks’ and insurers’ approaches to managing the financial risks from climate change’ from 2022, the story is similar for UK insurers.
The time to get this right is now. All insurers need to perform a materiality assessment of their climate risk exposures, and, where deemed material, outline in their ORSAs how they are capturing these risks in their solvency assessment and managing them. For many insurers, it is no longer sufficient to list climate risk as a distant ”emerging risk”; for many firms, this should be pulled out as a strategic risk with the potential to affect the business in both the short and long term.
A framework for bringing climate risk into the ORSA
Risk identification and materiality assessment
The first step is for insurers to identify all the climate risks they are exposed to, whether material or not. This exercise should be comprehensive and cover all lines of business on the liability side of the balance sheet, as well as all assets. Insurers should identify exposures to all three of the major climate risk categories: physical, transition and liability risks.
This is likely to be a significant exercise for many insurers and will involve a granular review of individual insurance policies and associated policy wordings to understand the scope of cover. We do not think it is necessary to describe this entire process in the ORSA, but supervisors will likely expect at least a high-level overview and conclusion to feature in the ORSA.
Second, insurers need to conduct a rigorous assessment to determine the materiality of their climate risk exposures. In our experience, many firms have yet to do this. Firms should map all material climate risks against the traditional prudential risk categories, including e.g. market and underwriting risk. Whilst there is no one-size-fits-all approach, insurers could use EIOPA’s illustrative example in Annex 3 of its opinion as a starting point. Building on EIOPA’s example, we have set out below a mapping table which non-life insurers could use to map various climate risks against traditional prudential risk categories. Insurers will need to adapt the climate risk categories on the left-hand side to their individual business model and based on their own materiality assessment; for example, all insurers will not be materially exposed to liability risk. But, once insurers have come up with their own table, it will provide them with a comprehensive view of exactly where their climate exposures are, and where they may need to take further action to manage the risks effectively.
Whilst not included in EIOPA’s original table, in our view, some insurers will have to look more closely at liability risks. Litigation could be directed both against insurance policyholders (including e.g. Directors' & Officers’ insurance), or against the insurer itself if it has neglected to deal with climate risk appropriately. Data suggests climate-related litigation is increasing internationally, while stress tests show that insurers struggle to collate and aggregate the information necessary for a robust assessment of potential exposures to climate litigation. Insurers with exposures to liability lines of business should engage a multi-disciplinary team (including legal, actuarial and claims representatives) to understand potential climate exposures and consider a wide range of legal interpretations of various policy wordings.
Firms will apply their own materiality thresholds depending on the nature of their business and overall risk appetite. As a general rule, however, EIOPA’s definition of materiality is “where ignoring the risk could influence the decision-making or the judgement of the users of the information”. Insurers should use this as a basis for forming their own materiality thresholds, which could be both qualitative (e.g. impact on brand credibility or trust through customer feedback) and quantitative (e.g. impact on revenue generation). For banks, ”income at risk” is a commonly used quantitative metric to assess financial materiality. Insurers could think about other suitable metrics, including for example % of Gross Written Premium (GWP) or reserves potentially exposed to climate risks.
Many insurers will have to invest in developing and training their second line of defence teams so that they can add insightful and robust challenge on climate risk as part of the ORSA content and overall process. This is essential for all the areas outlined in this blog, not least when it comes to the risk identification and materiality assessment, and, in our experience, there is still a lot of work for insurers to do in terms of upskilling their second line of defence capabilities.
Climate scenario design and stress testing
An EIOPA survey found that 87% of the 1682 surveyed firms did not make reference to climate change risk in scenarios in their ORSAs, despite supervisors pushing firms to do more in the last few years. The PRA, for example, explained scenario analysis “is a key tool that the PRA expects firms to employ” to assess financial risks from climate change in their ICAAPs and ORSAs. The Dutch National Bank has similarly said that it expects “insurers to analyse and describe the influence of (…) physical and transition risks on their risk profile, and if these risks are material, to set out a scenario for them in their ORSA”. Many of the most commonly used disclosure frameworks (including the Task Force on Climate-Related Financial Disclosures - TCFD - framework) also require firms to do climate scenario analysis.
Meanwhile, industry-wide stress test exercises, including the BoE’s CBES, the PRA’s 2019 insurance stress test and the ACPR’s pilot exercise, show that insurers still have a long way to go to in terms of designing climate scenarios and stress testing their exposures against those. Common challenges for insurers revolve around data and modelling, the reliance on third party vendors as well as understanding customers’ and counterparties’ climate exposures and transition plans (what we have referred to as “climate KYC”). Other issues include the long-term nature and horizon of climate risk (presenting a challenge for non-life firms with renewals in particular) as well as system-wide considerations such as the evolution of protection gaps, regulation and technology.
Insurers should use the results from the industry-wide stress tests both as a starting point to develop their own internal climate stress and scenario testing, and as a benchmark to understand where they are compared to peers. These exercises do not only provide insurers with different scenarios and parameters but also an indication as to what areas in relation to climate risk supervisors will scrutinise. While some smaller countries may currently struggle to review ORSA climate scenarios because their supervisory authorities lack the necessary expertise, this is not an excuse for inaction.
More than presenting a finished product to regulators, firms should be able to demonstrate continuous improvement in their climate stress testing journey – in our view, the ORSA is the logical place to demonstrate this progress. Multiple supervisors, including the IAIS, have emphasised the need for firms to show a continuous and systematic improvement in their climate stress and scenario testing. EIOPA, for example, expects the scope, depth and methodologies of firms’ quantitative scenario analyses of climate risk to evolve over time and with more experience, and as new methodologies become available. For some smaller firms, this could mean starting out with more qualitative climate risk analysis, while gradually developing more sophisticated quantitative modelling techniques. Here, EIOPA’s application guidance aimed at helping smaller insurers with climate risk scenarios in their ORSAs could be helpful.
Mitigation and adaptation
Once material climate risks have been appropriately identified and assessed through stress and scenario testing, insurers have several tools at their disposal to manage their exposures. Insurers might chose to do this through exclusions or engagement, both within the insurance value chain as well as with insureds. These tools generally fall within one of two strategies (or sometimes both) – mitigation or adaptation. Mitigation refers to “making the impact of climate change less severe by preventing or reducing the emission of greenhouse gases into the atmosphere”, while adaptation means “anticipating the adverse effects of climate change and taking appropriate action to prevent or minimise the damage they can cause”.
Insurers can mitigate and/or adapt to climate risk by developing new, or adjusting the design of existing, insurance products to incentivise behaviours that make the impact of climate change less severe. Insurers can, for example, offer premium rebates to policyholders that produce less emissions (mitigation), or to those who implement risk prevention measures (adaptation). EIOPA has referred to this as “impact underwriting” and will investigate the potential incorporation of the impact underwriting concept in product design requirements, including through insurance distribution, product oversight and governance requirements.
Insurers can also adapt to climate risk by reflecting climate exposures in capital management and business strategies, including for example by incorporating the heightened level of risk into product pricing. Other common adaptation measures include using exclusions to eliminate climate risk from insurance policies or books of business altogether, or increasing the role reinsurance and retrocession play in their capital strategies. Insurers can also contribute to innovative measures to pool climate change risks, e.g. through Public-Private Partnerships or other industry collaborations.
Capital adequacy assessment
Regulators in the EU and the UK have not yet determined whether climate risk should be formally captured in Pillar 1 capital requirements. EIOPA has been asked by the EU Commission to explore how to incorporate climate into the insurance capital framework by June 2023. In the UK, the PRA is due to publish a report setting out its proposed approach by Q4 2022.
In the meantime, the PRA has been clear that insurers are required to identify their material exposures and demonstrate they are “holding adequate capital against them where relevant” as part of their ORSA. In order to demonstrate progress in this regard, insurers need to first develop a comprehensive understanding of their material climate risks exposures and come up with effective strategies to manage them, whether through mitigation or adaptation. The second step is for firms to come up with a proactive strategy to improve its ability to capture the capital impact of climate risks over a multi-year period.
While issues around data and modelling are commonly cited as constraints to performing an accurate capital impact assessment, supervisors have been clear that this is no excuse for inaction, and according to the PRA, firms must adopt “alternative approaches to address these gaps in the short to medium term”. Therefore, insurers should come up with near-term plans to address data and modelling issues and gaps, even if they are likely to change in the longer term. They should also put in place processes to monitor new market and technological developments in the area of climate risk in order to be able to update those plans as necessary. This will provide some assurance and demonstrate to supervisors that they are making some headway in terms of quantifying climate exposures.
All insurers will ultimately have to demonstrate, through their ORSA, their ability to assess and manage their material climate risks. While some insurers will be more exposed to climate risks than others, supervisors are expecting all firms to go through a similar exercise in order to reach that conclusion. Over the next year, as EU and UK regulators continue to investigate whether and, if so, how climate risks should be formally captured in the insurance capital framework, insurers will need to work on deepening their understanding and management of their climate risk related exposures.