The nature of the assets in scope is likely the biggest driver of different outcomes. The UK’s large market for unit-linked assets accounts for about two-thirds of UK insurance assets, with a much higher equity allocation versus the general account. Because the IAIS exercise focuses only on general account assets, it will have a higher allocation to fixed income, which would lose much less market value.
The divergent results highlight an important aspect of climate scenario analysis: models may be methodologically advanced but are also in their infancy. The data has depth but still much room for improvement. As a result, outcomes should be a catalyst for more fundamental analysis, not a view of the absolute expected impact.
Who picks up the cost of investment losses? According to the CBES exercise, only a small fraction would fall on insurance company shareholders; the majority would fall on policyholders (or, in the case of European insurers using the Matching Adjustment under Solvency II, can be absorbed within the balance sheet*). This finding reinforces the importance of regulatory focus on this area—all prudential regulators have some variation on the objective of protecting policyholders.
Market specifics must be considered too. The UK’s unit-linked market is sizable, while those in many other regions are growing, as insurers have adapted their product sets to the low-interest-rate environment of the past 15 years. Within unit-linked products, investment risk sits with the policyholder; insurers must think carefully about how to demonstrate that they’re meeting their responsibilities for managing climate risk.
Regulators’ View: Managing Climate Risk Is Complicated…but Expected
The IAIS and PRA exercises reinforce that climate scenario analysis is critical. Regulators know the task is complex and will develop over time, but they expect insurers to adopt these approaches now in order to fully embed long-term climate–risk management into firm culture.
The IAIS and PRA aren’t the only regulatory bodies to act. The European Insurance and Occupational Pensions Authority, in an April 2021 opinion, outlined its expectations for national supervisors in overseeing insurers conducting climate change scenario analysis as part of their Own Risk and Solvency Assessment (ORSA).
This opinion was followed in December 2021 with a consultation on guidance to facilitate the implementation of materiality assessments and climate change scenario analysis in ORSA. A pilot exercise started in March 2022, with an imminent final publication likely to incorporate feedback from both the consultation and pilot exercise. France and Australia are among other examples of the regulatory push for progress.
How Insurers Can Get Ready for Climate-Related Regulatory Change
In our view, the direction of regulation is clear: regulators will expect insurers to embed forward-looking assessments of climate risk in their risk-management culture, with climate scenario analysis a key tool. Insurers can take several steps to achieve that goal and prepare for future regulatory change, including:
- Review the exercises described above in greater detail. The exercises are leading indicators of possible future requirements, and a path to understand how climate scenario analysis can provide a more comprehensive view of climate risk exposure.
- Scale efforts to the size and complexity of the business. A monoline insurer that backs liabilities with government bonds alone will likely find it easier to assess climate-change exposure than a globally exposed composite insurer would. Regulators will expect a proportional approach.
- Consider leveraging in-house expertise. An insurer’s investment department may be relatively new to this discipline, but other departments may be more advanced. Insurers (particularly reinsurers) have developed mechanisms to assess the impact of natural catastrophes in order to price risk accordingly. Connecting the dots internally can draw on existing expertise.
- Evaluate the time frame for assessing exposure. Insurers would typically consider forward-looking risk assessments in the context of a business-planning horizon. However, climate change may compel a much longer horizon.
- Assess risk appetite…and how it might change. The appetite for climate risk will likely evolve over time. Some risks may be avoidable, but the impact of climate change is so broad that many risks can’t be avoided. Those factors must be monitored and managed over time.
- Consider governance structures. The institutional structures that an insurer has in place should be designed to ensure that climate risk analysis is considered in the appropriate forums that enable actions to be taken.
- Review stakeholder disclosures. When developing climate risk monitoring processes, insurers should take account of the specific disclosures that policyholders, shareholders and regulators would find most useful.
- Understand asset managers’ approaches to climate risk. Engaging with asset managers provides insight on their processes for considering forward-looking climate change risks, as well as how managers are working to incorporate scenario analysis.
Asset Managers: A Critical Link in Assessing Insurers’ Climate Risk
Many insurance companies partner with external asset managers, relying on them for insights about portfolio climate risk exposures—and to manage portfolios based on those insights. In our view, this makes scenario analysis a vital tool in maintaining alignment of interests between investment managers and insurers.
Existing scenario analyses are a good start, but more development is needed before portfolio managers can fully implement models in decisions. Each provider has a unique approach to data and analysis, with different strengths and weaknesses. As AB evaluated providers, we applied wide-ranging criteria, including the models’ structure and inputs. We found it extremely helpful to partner with Columbia University’s Earth Institute during this process, given its academic expertise in climate change.
Investors also need to work closely with vendors to customize the tool to the specific needs of their investment process, rather than working with a standard version. And no matter how sophisticated a model may be, the human touch is critical. The skill and experience of analysts are vital cogs in interpreting and integrating the results, given models’ idiosyncrasies.
For example, an insurance company held within an investment portfolio may present limited exposure to physical risks based on the model’s output, which is derived from the insurer’s office locations. Fundamental analysis is necessary to go beyond the model’s outputs, evaluating the firm’s exposures to physical risks through its policy liabilities, which can be much broader in geographic scope.
Climate Value at Risk: Assessing the Costs
Similar to the IAIS and BoE exercises, we apply three transition scenarios: 1.5-, 2.0- and 3.0-degrees. We consistently apply an “aggressive” physical risk scenario across all three, because our work with Columbia faculty indicated that this is more aligned with todays’ scientific consensus. For our process, we chose a Climate Value at Risk (CVaR) measure (Display), which refers to the economic value of physical and transition risks plus opportunities from technological advancements related to patents and green revenues.
