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A Practical Guide for Insurers to Incorporate Climate Risk in Their Own Risk and Solvency Assessments (ORSA)

Written by Frans Kuys, Managing Consultant

Reviewed by Francis Furey, Managing Consultant

Introduction

On the 5th October 2020, the European Insurance and Occupational Pensions Authority (EIOPA) has published a consultation paper on the use of climate change risk scenarios in the Own Risk and Solvency Assessment (ORSA) in the form of a draft supervisory Opinion. The consultation is a follow-up to the Opinion on Sustainability within Solvency II released in September 2019 which recommended that (re)insurers should consider climate risks beyond the one-year time horizon within their system of governance, risk-management system and ORSA.

The goal of this opinion is to enhance convergence in the supervision of the use of climate change risk scenarios in the ORSA. EIOPA’s guidelines on the ORSA state that (re)insurers should apply a forward-looking assessment of the overall solvency needs, and should include a medium-term or long-term perspective as appropriate, since insurers will be impacted by climate change-related risks. The Opinion provides practical guidance on the selection and implementation of scenarios.

The final Opinion is expected to be published during the spring of 2021, once feedback from stakeholders has been considered. EIOPA will start monitoring the application of this Opinion two years after its publication.

Integration of climate change risk into the ORSA

Climate change poses a serious risk for society and for (re)insurers, with the harmful impact of global warming already being visible. Without further international climate action, global average temperatures and the associated physical risks will continue rising, resulting in increased underwriting risk of insurers, impacting asset values, and challenging their business strategies.

EIOPA expects (re)insurers to:

Integrate climate change risks in governance, risk-management system and the ORSA

Assess climate change risks in the short term

Assess climate change risks in the long-term using scenario analysis

 

The International Association of Insurance Supervisors (IAIS) has recently published its environmental policy, portraying clear objectives and metrics to measure its progress towards reducing its own carbon footprint. With this the IAIS has become the first global standard-setting body to do so, and set the example for others to follow.

Supervisory reporting and consistent disclosure

EIOPA states that (re)insurers should:

  • Present short- and long-term analysis of climate change risks in the ORSA including:
    • Overview of all material exposures.
    • Methods and main assumptions used in the risk assessment.
    • Quantitative and qualitative outcomes and conclusions of scenario analyses.
  • Ensure consistency between information disclosed in the ORSA report and its public disclosure of climate-related information under the European Commission’s Guidelines.
  • Report qualitative and quantitative data to enable the regulator to perform its supervisory review.

Evolution of climate change risk analyses

EIOPA observed that not many (re)insurers assessed climate change risk using scenario analysis in their ORSAs, mostly taking a short-term perspective.

Significant progress has recently been made in understanding climate change risk and developing methodologies to measure exposures, but it is still a new field and challenges will remain. EIOPA expects that scenario analysis will evolve as experience is gained and new methodologies become available.

Risk management framework for incorporating climate change risk in the ORSA

EIOPA provides guidance on some challenging issues that insurers may encounter when assessing climate change risk in the ORSA. Various guidance documents & overview papers are already available on this topic.

In this section we provide a 4-step risk management framework that can be applied when incorporating climate change risk in the ORSA, based on the guidelines provided by EIOPA.

Step 1: Climate risk identification

(Re)insurers should take a broad view of climate change risk, including all risks arising from trends or events caused by climate change. Climate change risk can be categorised into two risk drivers:

 

Policy Risks

Legal Risks

Technology Risks

Market Sentiment Risks

Reputational Risks

Includes risks arising from:

  • Energy efficiency requirements
  • Carbon-pricing mechanisms
  • Policies to encourage sustainable land use
 

Includes the risk of litigation for:

  • Failing to adapt to climate change
  • Failure to avoid / minimise adverse impacts on climate
 

If a technology with a less damaging impact on the climate replaces one with a more damaging impact.

 

If the preference of business consumers & customers shifts towards products & services that are less damaging to the climate.

 

The difficulty of attracting and retaining customers, employees, business partners and investors if a company has a reputation for damaging the climate.

 

Physical risks: risks arising from the physical effects of climate change

Acute Physical risks

Chronic physical risks

Risks arising from particular events (especially weather-related) that may damage production facilities & disrupt value chains e.g., storms, floods, fires or heatwaves.

Risks arising from longer-term changes in the climate, e.g., temperature changes, rising sea levels, reduced water availability, biodiversity loss and changes in land and soil productivity.

      

(Re)insurers should consider material risks, where materiality is assessed through a combination of qualitative and quantitative analyses:

Materiality assessment

Qualitative Analysis

Quantitative Analysis

Provides insight into the relevance of the main drivers of climate change risk in terms of the traditional prudential risk categories. A holistic view of the relevant types of climate change risks can be obtained from the mapping matrix.

Assessing the exposure of assets and underwriting portfolios to:

  • transition risk (e.g., based on carbon footprint)
  • physical risks (e.g., based on geographical location)

 

 

Insurers should consider the future impact of climate change on the frequency of those physical risks, and not prematurely conclude these risks are immaterial based on the current (re)insurance arrangements. Where it is concluded that a risk is immaterial, a justification should be included.

Step 2: Mapping the climate change risks to the traditional prudential risks

After identifying the material climate change risks that the (re)insurer is exposed to, these risks need to be mapped to the traditional prudential risk categories:

  • underwriting risk
  • market risk
  • credit and counterparty risk
  • operational risk
  • reputational risk
  • strategic risk

EIOPA provides a detailed mapping matrix that can be used when performing this step.

Step 3: Defining scenarios

A forward-looking, risk-based approach to the ORSA requires that risks identified are subjected to a wide range of stress tests or scenario analyses. This helps to assess the resilience and robustness of the business strategies under different developments of climate change risks over time and assists management in deciding on mitigating actions for excessive risks.

The first step in conducting a scenario analysis is to identify the range of relevant climate change scenarios including the main assumptions, the macroeconomic parameters, and the level of granularity at which the risks are assessed for each scenario. This step is vital in ensuring interesting and challenging scenarios that facilitate internal communication and discussion. The level of granularity applied will depend on the risk exposures identified and the modelling techniques available.

EIOPA specifies two long-term climate change risk scenarios that should be used as a minimum:

Scenario 1

Scenario 2

Global temperature increase remains below 2°C, preferably no more than 1.5°C, in line with Paris Agreement

Global temperature increase exceeds 2°C.

 

The scenarios will depend on the assessment of the materiality of climate change risk exposures and will differ from one insurer to another. Insurers can either consider publicly available scenarios or can develop the scenarios themselves or build on existing scenarios, which will require expertise and resources. There are numerous publicly available climate change scenarios that have been released, including publications by the Network for Greening the Financial System (NGFS), the Prudential Regulation Authority (PRA) in the UK and commercial data providers such as Twenty Four Seven.

Step 4: Modelling of risks

Modelling transition and physical impacts at granular level 

When modelling the climate change risks, (re)insurers have to translate the transition and physical impacts on asset prices and underwriting activities, since the publicly available climate scenarios do not always provide this information at high resolutions:

Transition impacts on assets

Physical impacts on assets

Physical impacts on underwriting activities

 
  • Several methodologies are available to estimate the impact of transition pathways on asset categories.
  • These generally assign a carbon-sensitivity to economic sectors or activities, which are used to differentiate the impact of a specific transition pathway on the overall economy and asset returns to the different sectors.
 
 
  • Physical risks can be difficult to translate to financial impacts on investments in companies - large companies often have activities in multiple locations and countries and extreme weather events / natural disasters may affect financial losses in complex ways due to supply chain effects.
  • Scoring models are available for companies and real estate investment trusts, ranking their sensitivity to physical risks.
 
 
  • Physical impacts need to be translated to changes in the frequency & severity of acute perils and chronic effects.
  • These changes are then converted into financial impacts on insurer’s underwriting portfolio in the relevant geographical areas.
 

 

Practical example for assessing the impact of physical risks (floods) on a non-life insurance portfolio

The potential impact of climate change on a non-life insurer covering flood risks can be assessed by using the JRC Peseta IV study on rising river flood risk in the EU.

The study assessed the impact of projected changes in frequency and severity of river floods on the expected annual damage (EAD) under various climate scenarios (1.5°C, 2°C and 3°C warming) and future socioeconomic conditions (2050 and 2100 economy), which were then transformed into financial losses for the entire economy. The study summarises the EAD for all EU countries under present conditions and under different combinations of the future socioeconomic conditions and climate scenarios.

The study can be used to assess exposure to regions that are strongly impacted by rising river flood and to estimate the impact of climate change on the insured losses in its underwriting portfolio, based on the projected change of overall economic losses under the various scenarios.

Changes to estimated losses under various scenarios can be derived by considering the changes in EAD presented in the study. The average annual loss (AAL) for a country under a specific scenario for temperature and socioeconomic conditions can be estimated by multiplying the AAL by the ratio of the EAD for that scenario divided by the base EAD.

For a more precise approach, insurers can consider regional rather than national level information and apply the same method to obtain the projected changes in EAD at regional level.

 

Projection period:

Insurers need to decide on the projection period to consider in performing the scenario analysis. For a short-term risk analysis, the scenarios or stresses can be applied to the current balance sheet without the need to project the balance sheet. Simplification techniques can also be applied whereby transition and physical events occurring in the future are assessed against the current balance sheet.

Alternatively, a partial scenario analysis can be performed that preserves the long-term character of climate change scenarios without projecting the full balance sheet by projecting simple ratios for different perils or geographic areas.

There are however important advantages of performing a full balance sheet projection, such as ensuring internal consistency, enhancing insights about the sustainability of business models and strategy, and ensuring feasibility of management decisions intended to mitigate asymmetric balance sheet shocks. The goal of long-term scenario analysis is not to provide detailed projections of all financial components, but to evaluate the business strategy across a range of scenarios and material climate change risk drivers.

How can Finalyse help you?

The opinion sets out EIOPA’s expectations of (re)insurers, to not only integrate climate change risks in the governance and risk-management systems and the ORSA, but also to assess these risks in the short term and in the long-term using scenario analysis.

Finalyse has extensive experience in risk management for insurance companies and can help you make sense of the climate risk puzzle:

  • Support with integrating climate change risks in the ORSA and scenario analysis:
    • Identification of material climate change risks exposure.
    • Mapping of the climate change risks to the traditional prudential risk categories.
    • Developing a range of scenario to be used in the scenario analysis.
    • Translation of transition and physical pathways into impacts on asset prices and underwriting activities.
    • Quantification and modelling of risks.
  • Gap Analysis: Perform a gap analysis detailing your situation against regulatory requirements and guidance published.
  • Roadmap: Developing a roadmap for the integration of climate change risks into ORSA, investment policies and other relevant elements.
  • Workshops: Conducting workshops with the objective to upskill the relevant stakeholders within your business on the topic of climate change risks.

 

 

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