Extreme weather events exacerbated by climate change, such as the floods seen in Australia and South Africa or wildfires in Europe, quickly followed the heat. Therefore, questions about how our industry should react remain in mind.
Basically, there are two opposing risks that need to be managed: physical and transitional risks. In short, physical risk refers to the possibility of weather events increasing in frequency and severity, resulting in increased losses for insured portfolios. Transition risk refers to the risk arising from changing strategies, policies or investments as we move towards a zero-carbon world.
The modeling of physical risks in insurance is rapidly gaining in sophistication. Guy Carpenter created frequency and severity adjustments to the stochastic catalogs of catastrophe models to reflect the impacts of climate change at multiple levels of future warming for most material perils. Suppliers and individual companies have also undertaken such projects, both to meet regulatory requirements and to inform planning and business decisions. Increasingly, the need for reliable physical risk modeling is becoming a solved problem.
As a result of this exercise and looking at the science, we know that not all perils are affected to the same extent. Extreme precipitation and wildfires are most obviously influenced, but others, such as mid-latitude storms, are less so. Critical for companies making short-term business decisions, climate change currently contributes only a small share to annual insurance losses. Changes in exposure, demographic changes and inflation, among others, are more important factors. An internal study by Guy Carpenter found that climate change is likely to be responsible for an increase of around 1% per year in losses over the next decade.
Transition risk, including regulatory risk, has become the most pressing concern for many. Governments around the world are moving from voluntary reporting of climate-related financial risks to mandatory reporting. Among other developments, disclosures aligned with the Task Force on Climate-Related Financial Disclosures (TCFD) are or will soon be required in the UK, Switzerland, New Zealand, Singapore, China, Canada and France.
In the United States, 15 state regulators, representing nearly 80% of the national insurance market, will launch TCFD disclosure guidelines in 2022, with full compliance expected after several years. In Europe, current proposals include Solvency II updates requiring long-term assessments of climate change to be included in own risk and solvency assessment and the EU Corporate Sustainability Reporting Directive (CSRD) requiring full sustainability reporting from 2024.
The CSRD also incorporates the EU taxonomy, a green classification system for economic activities, which requires the disclosure of environmentally sustainable investments and gross non-life premiums written. This means that insurers and reinsurers will need greater transparency on the composition of their portfolios with regard to the activities covered by the taxonomy, in particular around treaty cases, where such data collection has not maybe not yet. This requirement impacts all insurance taken out in Europe by companies subject to the CSRD, which will be the vast majority, regardless of the location of the asset financed or insured. Guy Carpenter works closely with the market to create portfolio composition disclosure guidelines to help the market with consistency and transparency.
In addition to mandatory regulation, a number of insurers and reinsurers have joined the Net-Zero Asset Owners Alliance and the Net-Zero Insurance Alliance (NZIA), two bodies set up by the UN which respectively aim to decarbonise investments. and insurance portfolios.
The NZIA is new, formed in 2021, and accounts for 11% of global premium volume, according to its website. Currently, the organization is finalizing its method for calculating the carbon represented in underwriting portfolios and is expected to establish a framework in early 2023, with members submitting their own interim target by 2050 six months later. The development has the potential to be disruptive, as members represent a much larger share of the reinsurance market – more than half in premiums written – than the primary insurance market. The 2023 carbon accounting framework will only cover direct and optional insurance in the first iteration, so there is still time for adjustment on the treaty side.
Climate change and its impacts on our industry will remain a key topic in the years to come. In addition to the risks that need to be managed, there will be opportunities in the transition, such as the explosive growth of renewables providing investment and insurance opportunities. Best practices we’ve seen in the market include internal education, quantification of physical risks through modeling, and proactive preparation for the regulatory and policy changes that are sure to accompany the transition. Increased transparency, data collection and disclosure will be paramount, along with increased dialogue with stakeholders and counterparties.
Jessica Turner, PhD, ACII is Head of International Disaster Consulting at Guy Carpenter