Climate change poses a significant risk for society, companies and, hence, for the insurance industry. Both the underwriting and asset portfolio are exposed to this risk, from the physical perspective (e.g. damage to insurer's or policyholder's assets) and transition to a low-carbon economy perspective (e.g. depreciation of CO2-heavy sectors). To ensure that the insurance industry remains solvent and viable in the long term, climate change should be integrated into the insurer's risk management framework. As a minimum this means that insurers analyze in the Own Risk and Solvency Assessment (ORSA) the consequences of climate change to their risk profile. How to best start this integration and what needs to be considered in the ORSA?
The ORSA as a risk management and strategic tool
Given the high uncertainty associated with climate change, organizations are adopting scenario analysis techniques to understand, identify and analyze these risks. Scenario analysis considers a range of plausible futures and analyzes their potential impact on the organization. A scenario not only describes the outcome, but also the developments leading to that outcome, in order to complete the narrative of the scenario and ensure that it becomes tangible. They are pure hypothetical constructs: the purpose is not to predict the future, but rather to explore the impact of a range of possible futures. Scenario analysis enables the organization to move from a traditional risk management approach focused on short-term reactive mitigation to a more strategically focused risk management approach that incorporates both mitigation and adaptation to developments over time. In the context of climate-related risk, the importance of scenario analysis is explored in our practical insights report.
For insurers the natural place for scenario analysis is the Own Risk and Solvency Assessment in pillar 2 of the Solvency 2 legislation. The ORSA is a strategic instrument to identify risks but also opportunities, thereby increasing the insurer's resilience and supporting strategic decisions for the long term. Whereas until recently insurers were only intrinsically motivated to use scenario analysis to understand climate risk, by now the supervisor has detailed its expectations and has marked an end to the non-committal character of the current analyses of climate risk by insurers.
Following a public consultation on the subject in 2020, EIOPA has recently published its final opinion on the supervision of the use of climate change risk scenarios in the ORSA. This concerns an advice of EIOPA to the national supervisory authorities. Even more recently, the IAIS has released an application paper on the supervision of climate-related risks in the insurance sector, which argues along similar lines. In practice we expect that DNB will (largely) align its approach regarding the analysis of climate risk scenarios in the ORSA and the overall risk management system.
EIOPA's opinion includes the following expectations:
- Within the ORSA the material climate change risk exposures of the insurer should be identified and assessed, both qualitatively and quantitatively, on both the short (5-10 years) and long term (80 years, i.e. by the end of the century).
- At least two long-term climate scenarios should be considered when assessing the impacts of the identified risks.
- To further illustrate these two climate change scenarios, EIOPA mentions a global average temperature increase of less than 2°C (and preferably 1.5°C, to align with the EU commitments) versus a scenario in which this temperature increase is more than 2°C. Although these specific scenarios are outlined, insurers may also consider other scenarios if deemed more appropriate, but they should consider at least two scenarios with a sufficiently wide range of transition and physical risks.
- Given that the assessment is both on a short and long term, EIOPA expects that the national supervisory authorities will review both qualitative and quantitative data to cover both terms sufficiently.
- It is acknowledged that the long-term analyses may have a lower (quantitative) precision and will be executed less frequently.
- The quality of the analyses is expected to increase over time and EIOPA will start monitoring the application of the opinion by the national supervisory authorities in two years (May 2023). Hence, insurers have a clear deadline to give substance to EIOPA's opinion, in a way that integrates climate risk in the risk management framework, decision-making process and ORSA.
The TCFD framework as a guideline
EIOPA's opinion can be seen as an insurer-specific interpretation of the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD) on conducting climate-related scenario analysis. Within the insurance industry support for the TCFD recommendations has steadily increased since its publication in 2017, in particular among the larger insurers within Europe, Asia and the US. Now that EIOPA has provided this interpretation of the TCFD, a part of the non-committal character of the TCFD recommendations may have disappeared. However, due to the well-developed character of the TCFD, it remains a practical framework that can serve as guidance to implement EIOPA's opinion in the own organization.
The TCFD has developed a six-steps framework for applying scenario analysis to climate-related risks. These are summarized in the figure below and further explained by the TCFD in their reports. For insurers, some aspects are specific to their context. For example:
- In terms of governance, ownership of management of climate-related risks (and opportunities) will be distributed over many functions within the organization: e.g. first- and second-line risk management, asset-liability management, strategy, communication, compliance. As a result, also at board level the responsibility will be shared over multiple members.
- To assess the materiality of climate-related risks, it is useful to perform this assessment in terms that are already familiar to the insurer (e.g. market risk, underwriting risk, operational risk).
- The insurer should consider all threats to the organization, that are material now or in the future. The materiality of the threat depends on the specific profile of the insurer, such as the product offering (life, disability, P&C, health), the target clients (consumers, business) and the sectors and regions clients operate in.
For the ORSA, the key metric to measure the business impact (step 4) is the insurer's solvency level.
Getting to work?
The opinion of EIOPA clearly states that the risks to be considered should be those that are most material and relevant to the insurer. Furthermore, insurers keep discretion over the specifics of the scenarios to be assessed. Nevertheless, insurers have highlighted their concerns. These are underlying to the questions that each insurer has regarding how to implement EIOPA's opinion. For example:
- How to cope with the large uncertainty surrounding the subject?
- How to quantify climate-related risks in a correct and meaningful way, not only in the short term but especially in the long term?
- How to ensure to comply with the expectations within the two-year deadline?
Answering these questions and creating a thorough understanding of the opportunities of climate-related risks for one's own organization seems difficult. Nonetheless, it is important – in part due to timelines set by EIOPA – to not delay taking the first steps and to embrace the operational window that EIOPA has provided to start the analysis and refine it along the way. Having at hand EIOPA's suggestions in its opinion and the recommendations of the TCFD, insurers are provided with practical guidelines that direct their process.
KPMG can support accelerating this process even further. Following the steps in the TCFD framework requires an understanding of the insurance industry, risk management and actuarial risk modelling, and requires experience on the TCFD and their approach to scenario analysis. KPMG professionals have been a member of the TCFD from its inception and stand at the cradle of the current recommendations. We have developed a pragmatic and modular approach to support in each of the aforementioned TCFD steps. With a multidisciplinary team, KPMG is well positioned to assist in strengthening your climate-related scenario analysis and integration in the risk management framework. Because it is in line with expectations of regulators and, even more important, because having an approach to climate risk best prepares the organization to engage with opportunities in its future.