1 November 2018

Climate risk management: the heat is on

Managing financial risks from climate change is becoming an important issue for insurers. Ronan McCaughey speaks to firms about the tools they use to gauge climate risk - and how they plan to deal with this major global challenge

The insurance industry's engagement in climate risk has been, pardon the pun, a slow burn.

While some of the work done in the sector has been world-leading – in particular by the large reinsurers – there is no shortage of laggards when it comes to addressing climate change.

But pretty soon, everyone will be forced to raise their game. Regulations such as France's "Article 173" law have forced firms to disclose the climate consequences of their actions and investments.

Recently, UK regulators have set out their expectations on climate risk management.

Among their desires is that firms to consider "a range of quantitative and qualitative tools and metrics to monitor their exposure to financial risks from climate change".

What does this mean in reality? Keith Goodby, a director of Willis Towers Watson's insurance investment solutions group, says the regulator will "want to see evidence of climate change-related financial risk being appropriately considered and reflected in written risk policies, board reports and own risk and solvency assessment (ORSA)."

This will entail better governance: for example, firms will need to identify the board and executive level responsibilities for managing the risk.

Goodby also notes insurers will also have to improve their stress and scenario testing, ensuring the tests incorporate "physical" and "transitional" risks – the former arising from the actual effects of climate change, such as rising sea levels, and the latter arising from the transition to a low-carbon economy, such as the devaluation of investments in the fossil fuels sector.

Additional disclosures will be needed, and with that "comes greater reputational risk and possible customer impact," Goodby warns.

InsuranceERM contacted insurers to review the methods in place to measure and deal with financial risks from climate change.

Aviva's group chief risk officer, Angela Darlington, tells InsuranceERM the insurer welcomes the UK regulators' papers setting out their approaches to climate change.

Given that climate change is a significant risk, which no single firm can mitigate, Darlington says it is appropriate for financial regulators to give measured guidance on how key players in the industry can and should be acting to govern, measure and manage climate change risk.

She comments: "We look forward to further building up our own work in this area, engaging our peers and financial regulators to tackle this vital issue."

Aviva's climate-related financial disclosure for 2017 explains that its businesses work to different risk horizons in terms of its climate change strategy.

For example, its general insurance business has primarily an 18-month outlook and focuses on the physical impacts of climate change.

"We recognise that the increased severity and frequency of weather-related losses has the potential to turn events that could benefit our earnings, to ones that will negatively impact our profitability."

Consequently, large catastrophic losses are already explicitly considered in Aviva's economic capital modelling to ensure the insurer is resilient in such scenarios.

The firm adds that it continues to invest in flood mapping, predictive analytics and risk mitigation techniques to better understand the risks transferred to it.

Model behaviour

Zurich Insurance Group's head of sustainability risk, John Scott says the challenges of climate change are manifold for insurers and there is an urgency to act now as the physical risks of climate change "get worse in the long term".

One big issue is that insurance pricing tools, or capital modelling scenarios are essentially designed to analyse risk over the period of an annual business plan, or a five-year strategy.

"When we look at the risk modelling tools at our disposal, we obviously have basic tools like capital modelling and the ORSA process in Solvency II. The challenge with modelling climate change risks in the short term (one to three years) is that it is hard to see how one can create a scenario in a pillar 1 [capital requirement] analysis which is really going to have a significant impact on short-term capital and this means we need to understand and communicate climate risks within pillar 2 [ORSA] and 3 [reporting] activities," says Scott.

Scott adds: "In natural catastrophe modelling there are many commercially available models, but to truly understand and make this applicable to our own portfolio, we have also developed a proprietary model-of-models to help us understand a range of natural catastrophe peril regions."

In his view, the current science of "attribution" i.e. the influence of climate change on any one severe weather event is a long way from being truly understood. Linking climate models and natural catastrophe models "will require considerable further effort, akin to the multi-year efforts of climate modelling that led to the 2014 conclusion of the IPCC work identifying an anthropological influence on climate change."

John Scott is speaking at InsuranceERM’s Insurance & Climate Risk event in London on 3 December. Click here for more details

Rowan Douglas, Willis Towers Watson's head of capital, science and policy practice, says a new breed of cat models will evolve into climate risk models where event-sets are conditioned to take account of future projections of hazard distributions and changing locations, frequencies and severities of events.

"The tools will also begin to be deployed to re/insurers investment portfolios where the challenging factor will be the limited risk-related exposure information that is currently held – but in due course this will improve," he says.

Swiss Re's strategy

Swiss Re says its "managing climate and natural disaster risk" strategy comprises four pillars:

  • Advancing its knowledge of climate change risks, quantifying and integrating them into risk management and underwriting frameworks where relevant;
  • Developing products and services to mitigate or adapt to climate risk;
  • Raising awareness about climate change risks and advocating a worldwide policy framework for climate change;
  • Tackling its own carbon footprint and reporting annual emissions.

In its 2017 climate-related financial disclosure document, reinsurer says two board of directors' committees oversee implementation of the firm's climate change strategy.

The chairman's and governance committee has the overall task of monitoring the group's sustainability and climate actions. The investment committee reviews the asset management-related activities.

Swiss Re says it has an internal property risk modelling team of around 50 people that builds models for all relevant natural catastrophe risks.

The reinsurer says: "Using statistical data spanning 100 years, our models are capable of simulating probabilistic 'daughter' events that may have never occurred in reality but that may occur in the future."

Swiss Re also notes that regarding the long-term time horizon (2040), it expects a substantial need to adjust some of its weather risk models, based on current scientific knowledge.