Recent statements from UK regulators remind insurers that despite being busy dealing with the immediate impacts of COVID-19 and Brexit, the complex and far-reaching financial risks from climate change must be addressed now. As insurers grapple with meeting the regulatory deadline to embed a climate change risk framework by the end of 2021, in this blog we detail how a failure to address these requirements will not only lead to compliance issues but also to potential financial and business risks, as well as missing out on opportunities.
Background to the PRA’s Dear CEO letter
Climate change has been an area of increasing interest for the Prudential Regulation Authority (PRA) since 2015 and in July 2020 it sent a ‘Dear CEO’ letter to every regulated insurer stating that they need to embed an approach to managing climate-related financial risks by the end of 2021. While insurers could be forgiven for focussing on more immediate short-term priorities during 2020, it is telling that the PRA has acted to communicate directly with CEOs regarding the detailed expectations it outlined in April 2019 within SS3/19, which we summarised in a previous blog. Within SS3/19, the PRA stated that:
- climate change was a material, complex and far-reaching financial risk;
- firms should take immediate action to ‘identify, measure, monitor, manage, and report on their exposure’;
- firms should allocate responsibility for the management of this risk to a suitable; individual in line with their approach to the Senior Manager and Certification Regime (SMCR); and
- firms should develop an implementation plan detailing how they would meet the PRA’s expectations.
Within the recent ‘Dear CEO letter’ the PRA identified a number of gaps between firms’ intentions and their expectations. The majority of firms have a lot of work to do during 2021 in order to meet the PRA’s expectations.
The PRA has signalled that it is embedding climate change-related financial risk into its supervisory approach and that it is engaging on the topic with individuals, such as SMFs and NEDs. Other regulators, including the Financial Conduct Authority (FCA) and European Insurance and Occupational Pensions Authority (EIOPA) have also published separate proposed requirements relating to climate change. EIOPA, for example, has proposed to mandate the inclusion of scenario testing on climate change in ORSA Reports as part of the Solvency II regulations, while the FCA recently proposed new rules requiring listed companies to improve climate change disclosures in line with the Task Force on Climate-related Disclosure (TCFD).
What should insurers do?
In order to make best use of the 12 months remaining before the PRA’s December 2021 implementation deadline, firms are using what remains of 2020 to seek Board approval to detailed Implementation Plans to meet the PRA’s expectations. We have been supporting insurance clients to respond according to the following timeline:
We are seeing SS3/19 Implementation Plans include workstreams on disclosure, investments, governance, risk management, scenario analysis, data and counterparty assessment. These plans bring together the good work undertaken to date into a defined plan that can show how far through you are and when initial implementation is complete.
A tangible starting point for ESG
Many insurers are viewing the PRA’s requirements regarding climate change as the first tangible aspect of growing market and regulatory interest in ‘Environmental, Social and Governance’ (ESG) considerations. Often talked about and theorised, ESG has appeared in Board packs of many insurers as an area of Emerging Risk.
The climate change lens, therefore, serves as a useful and definable starting point from which broader sustainability practices can be built upon and embedded. Many firms struggle with defining an overarching ‘ESG’ strategy but it is a natural evolution to move from a climate change strategy to one which considers broader aspects of sustainability.
Opportunities & risks
In addition to the financial risks of climate change, insurers should also consider the opportunities that climate change presents. The link between climate change and an increase in the scale and frequency of catastrophe losses is well understood. However, most insurers are yet to consider how some of the medium term implications of those events, such as changes in migration trends or resource availability, impact their risk profiles, product offerings and business plans.
Insurers should also consider how governmental responses to climate change may impact them. The UK government’s recent announcement of a ban from 2030 on the sale of new petrol and diesel fuelled vehicles is a part of the governmental measures which will be required to meet its commitment to achieve by net zero emissions by 2050. A forward-looking risk assessment to consider these potential transition risks around climate-change related government action will help firms be prepared to manage risks, and identify opportunities.
In the motor insurance market, for example, traditional motor insurance policies may lose relevance given the change in loss record and risk profile for Electric Vehicles, so a new competitive edge will be created for those carriers who can evolve to meet new market expectations. This is why in response to SS3/19, we have seen firms incorporating climate change considerations into their underwriting class reviews for 2021.
Integrating with broader regulatory focus areas
Within SS3/19, the PRA identified four areas of consideration by firms related to financial risks of climate change - governance, risk management, scenario analysis and disclosure. Strong and proactive firms are going beyond this and also considering how climate change impacts on broader regulatory focus areas relating to investment strategy and third party risk management, as we suggested would be prudent to do so in our previous blog.
The subsequent release of SS1/20 relating to the Prudent Person Principle enhanced the PRA’s expectations regarding the asset-side of the balance sheet and firms are now incorporating climate change considerations into their investment strategies. Some are categorising assets using geographic, sectoral or other characteristics and then considering strategic options for any assets which are identified as being exposed to climate change risk along with timelines to transition away from them. For insurers that outsource investment management, it can be a relatively ‘quick win’ to understand the steps their asset managers are taking to help meet the regulatory responsibilities contained within SS3/19.
Similarly, the release of the PRA and FCA’s consultations papers relating to operational resilience increased the focus on preventing supply chain disruption. Firms are now linking work-streams to consider the exposure material suppliers may have to climate change by incorporating climate change considerations into their oversight frameworks. These potential impacts of climate change on “clients, counter-parties, and organisations in which they invests or may invest” have led firms to include climate change considerations in their risk management framework beyond the supply chain. Insurers have, for example, proactively considered climate change exposure as part of credit assessments undertaken on investment counter-parties, as well as pre-bind underwriting assessments of potential assureds. Doing so can also highlight some of the opportunities which climate change presents, such as identifying potential risk exposures of clients or new investment opportunities in ‘underweight’ industries or geographic areas.
Consideration beyond 2021
It is important to gain assurance on the successful implementation and embedding of the framework, as well as viewing the YE2021 deadline as the beginning of a longer process to continue to iterate and evolve the framework. We have already seen some firms incorporate assurance planning into their SS3/19 Implementation Plans for 2020, which can help ensure that a sustainable and satisfactory framework has been implemented.
With the PRA’s newly imposed YE2021 deadline looming, Boards will be expected to demonstrate the actions they have taken against this important risk area.
It can be challenging for firms to interpret emerging guidance and expectations from various regulators, governments and standard setters, in what for many is a new, high profile and wide-reaching risk and compliance topic. As the focus on wider concepts of ESG increases, many firms are seeing their climate change framework as the first tangible output of ESG related work.
Our team has a proven track record of guiding firms to help meet this fast-changing regulatory landscape. We can help insurers meet PRA expectations relating to climate change, but can also draw on a variety of experts from our wider sustainability and ESG teams.
Please get in touch with any of listed authors to find out how we can help.