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Apr 2021

Climate change risk assessment for the insurance industry

Source: Asia Insurance Review | Mar 2021

Maryam GolnaraghiThe Geneva Association’s Dr Maryam Golnaraghi offers an holistic decision-making framework and key considerations for both sides of the balance sheet.
 
 
Over the last five years, actions for transitioning to a resilient low-carbon economy have been slowly gaining momentum within the public and private sectors globally, along with widespread recognition of climate change science and the associated socio-economic impacts.
 
A pivotal point was the launch of the Financial Stability Board’s Task Force on Climate-Related Financial Disclosure (TCFD), which provided principle-based guidance on climate-related financial disclosures based on climate-related risks, opportunities and scenario analysis. Growing adoption of TCFD recommendations in various industries points to the need to further develop and test sector-specific methodological approaches to climate risk assessment, including scenario analysis.
 
To reach the climate change goals set out in the Paris Agreement, dramatic changes in business models and everyday life are needed. Insurers are contributing significantly to the transition to a resilient low-carbon economy via leadership in pricing, modelling and offering protection against Nat CAT risk.
 
(Re)insurers are initiating and/or engaging in various intra- and inter-sectoral pilots through multi-lateral platforms to develop, assess and evaluate approaches to climate risk assessment linked to the TCFD.
 
In 2020, The Geneva Association (GA) established an industry-led Task Force on Climate Risk Assessment for the Insurance Industry, stepping up industry-level collaboration across global P&C and life (re)insurers and reinforcing the industry’s commitment to advance and accelerate the development of holistic methodologies and tools for conducting ‘meaningful’ and ‘decision-relevant’ climate risk assessment and scenario analysis.
 
The first report in the GA task force’s series offers an holistic decision-making framework for designing climate risk assessments for P&C and life (re)insurers for the liability and asset sides of the balance sheet, taking into consideration all aspects of climate change risk for distinct time horizons.
 
How does climate change impact the insurance industry?
Liability side – P&C insurers
The implications of climate change risk on P&C (re)insurers’ liability decision-making are provided in Table 1. It is important to reiterate that the vast majority of P&C (re)insurance contracts are (re)underwritten annually, allowing adjustment of the pricing, terms and conditions and product offerings to progressive climate change for the key portfolio on the liability side exposed to physical climate change.
 
Climate change risk and decision landscape for P&C (re)insurers – liability side
 
Importantly, exposure and vulnerability factors, such as population growth, urbanisation, an increasing concentration of people and assets in high-risk zones (e.g. coastlines and flood zones), development choices and supply-chain disruptions (caused by extreme events) distort and could mask any embedded climate change signal.
 
For P&C (re)insurers, the impact of transition risk will be driven by less predictable external forces such as public policy action (policy risk), court rulings (litigation risk), consumer/societal pressures (market risk) and technological advances to disrupt industries (technological risk), which must be carefully considered. The implications of these risks are detailed in the report.
 
P&C (re)insurers are also considering the expected long-term (e.g. 2030–2050) impacts for business strategy and growth purposes. The interlinkages of transition and physical risk need to be considered. One element within each pathway is how the magnitude and pace of action (or inaction) to transition may influence the trajectory of physical risks.
 
Liability side – life insurers
Over the long term (2030–2050), the impacts of physical and transition climate change risks are more uncertain for life (re)insurers. They could cause a rise in mortality through increased cardiovascular and respiratory illnesses, agricultural impacts that adversely affect diet and nutrition and an increased spread of infectious and vector-borne diseases. Conversely, transitioning to a low-carbon economy can have positive impacts on health and longevity, for example through reduced air pollution. 
 
Asset side – life and P&C insurers
Physical and transition risks impact investment-related decisions in multiple ways for P&C and life (re)insurers over the short- and long-term time horizons.
 
From a valuation perspective, investors are beginning to account for the effects that transitioning to lower-carbon economies may have on the long-term earning potential of carbon-intensive sectors (e.g. energy companies, automotive, chemicals and manufacturing). In kind, investors are also increasingly considering the impact of climate change when making investment acquisition and disposition decisions. Direct assets like real estate are being analysed through climate change adaptation and mitigation lenses.
 
Main findings
A summary of the report’s findings for (re)insurance companies and other stakeholders (e.g. regulators, rating agencies) is given below.
  1. The development of methodologies and tools that would produce meaningful and decision-useful information is a work in progress. These methodologies and tools need to be further developed, tested and evaluated to converge on robust solutions. Achieving consensus also takes time. Strengthened collaborations and proactive engagement across the insurance industry and between the industry and the regulatory community, rating agencies, the scientific community and other experts could significantly advance methodologies that produce meaningful and decision-relevant climate risk assessments and help shape future regulatory developments in this area.
  2. The design of a climate risk assessment approach must consider the potential for inherent uncertainties associated with the transitioning related to public policy, technology, markets and consumer behaviour to undermine the credibility and decision usefulness of data.
  3. A combination of qualitative and quantitative approaches for assessing climate change risk over the various time horizons is required. In the short term, a quantitative approach might lead to decision-relevant insights on certain elements of the balance sheet. Over longer-time horizons however, a qualitative approach, exploring changing boundary conditions beyond a climate change stress, will likely generate more decision-useful insights.
  4. Climate change risks vary across the insurance industry and by line of business. Table 1 provides more details on how physical and transition risks impact P&C and life (re)insurers over short- and long-term time horizons on both sides of the balance sheet. However, this will also depend on the company’s objectives and its specific business and investment portfolio mix.
  5. Climate risk assessment needs to be performed holistically across the company to ensure consistency, while recognising the different challenges in assessing climate change risks, taking into consideration the potential implications of both physical and transition risks on both sides of the balance sheet. Cross-company engagement also allows for leveraging internal expertise and enhancing company-wide understanding of the potential severity and implications of climate change risk. Companies embarking on this journey should start from a limited set of scenarios (mostly qualitative) that cover the two time horizons.
  6. (Re)insurers, as risk managers and investors, play an important role in understanding the risks associated with climate change and educating stakeholders on how climate change will impact society. The results of (re)insurers’ research, risk modelling, underwriting and investments, could not only complement but also inform the broader actions that are needed by governments, policymakers, regulators, corporations and society as a whole. A 
 
Dr Maryam Golnaraghi is director climate change and emerging environmental topics with The Geneva Association.
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