Responding Toward Climate Control and Governance
By Jon Wu
International News, July 2023
Editors’ Note: This article is a summary of a presentation made by Lauren Chao[1] at the annual meeting of the Actuarial Institute of Chinese Taipei (AICT) on Nov. 30, 2022.
Under the United Nations Framework Convention on Climate Change (UNFCCC), the Conference of the Parties (COP) holds an annual meeting to discuss the progress and actions to take to mitigate climate-related risks. The 27th session of the COP (COP27)[2] was held Nov. 6–20, 2022 with 197 participating countries. Key takeaways from the conference include:
- Reconfirmation of limiting the increase in the global average temperature to below 1.5° C.
- Agreement on mitigation measures only include a coal phase down (instead of a phase out) and ignoring emissions from the use of gas and oil; and
- Development of a breakthrough on loss and damage funding for vulnerable developing countries suffering the most from the effects of climate change and reaching net zero emissions by 2050. About US$4 trillion per year needs to be invested in renewable energy.
To mitigate issues related to climate change, regulators from different jurisdictions already proposed various laws and regulations to impose taxes (e.g., carbon tax), and international organizations also recommended best practices to reduce impact from climate change. In doing so it is imperative that insurers have to establish a robust climate change risk management program to meet the challenge from climate change.
Reporting: Task Force on Climate-related Financial Disclosure (TCFD)
The Financial Stability Board (FSB)[3] created the TCFD to recommend four areas that represent core elements of how companies should disclose to support investors, lenders, and insurance underwriting in appropriately assessing and pricing a specific set of risks related to climate change. The four core elements are as follows:
- Governance
- Strategy
- Risk Management
- Metrics and Targets
Those four core elements are interrelated and supported by 11 recommended disclosures on the TCFD website.
The disclosure will help the public understand how reporting organizations think about and assess climate-related risks and opportunities.
Following the recommendations by TCFD, the Financial Supervisory Commission (FSC) developed a Guidance to the Insurers on Climate-Change related Financial Disclosure on Nov. 30, 2021 as follows:
- Governance
- The Board of Directors and senior management should ensure the company—at the time of formulating risk appetite, strategies, and operating plan—takes into account the identified climate-related risks and continuously monitors the climate-related management and risk disclosure.
- The Board of Directors may set up committees with clear roles and responsibilities between the committee and senior management.
- Roles and responsibilities of the Board of Directors and committees include:
- Management of climate-related risks. (Board of Directors has the ultimate responsibility).
- Approve and supervise the management structure and policies of climate-related risks.
- Confirm that climate-related risks are included in the qualitative or quantitative indicators of risk appetite.
- Ensure the Board of Directors have an appropriate understanding of climate-related risks and opportunities, regular reviews of the execution by the senior management, and sufficient climate-related training of the senior management.
- Roles and responsibilities of the senior management include:
- Formulate management structure and policies for climate-related risk.
- Confirm the effectiveness of the climate-related risk management structure and policy implementation.
- Establish an internal management process for climate-related risks.
- Ensure that the necessary measures are taken for the identified climate-related risks.
- Allocate appropriate climate-related risk management personnel and give necessary training.
- Report regularly to the Board of Directors or committees about the management of climate-related risk.
- Roles and responsibilities of the Board of Directors and committees include:
- Strategy
- Identify the financial impact of climate-related risks and opportunities on finance, sales product, and investment.
- Prioritize climate-related risks according to the criteria of significance.
- When setting annual strategies and goals such as sales, product, and investment, climate-related risk and opportunities should be taken into considerations.
- Review and adjust the management policies of climate related risks based on scenario analysis stress test results.
- Risk management
- Risk management and monitor
- Formulate assessment methods to identify the company’s own departments, counterparties, and customers with climate-related risks (including existing and potential counterparties and customers) and assess their impacts on the organization.
- Set up a management and continuous monitoring mechanism for climate-related risk exposure. The departments, counterparties, and customers with major climate-related risks, establish relevant mechanisms to manage the identified climate-related risks, and encourage the counterparties and customers to take necessary measures to reduce their climate-related risks.
- For the climate-related risks identified by the company, follow the guidance of “Three lines of defense for the internal control in the insurance industry” to perform risk management. Roles and responsibilities of the Board of Directors and committees include:
- Scenario analysis and stress testing.
- Have the ability of qualitative and quantitative scenario analysis and stress testing to assess climate-related risks impact to the company.
- Set general scenarios and severe scenarios with qualitative or quantitative risk indicators and use them for short and long-term strategic planning and risk management purposes.
- Investment management
- Establish appropriate investment procedure management involving climate-related risks. For investments with higher climate-related risks, the company should have additional review procedures.
- Regularly access changes in climate-related risks and use them as a means of adjusting the invested asset position.
- Risk management and monitor
- Metrics and targets
- Set indicators for assessing and managing climate-related risks.
- Set goals for climate-related risk management.
- Formulate evaluation indicators for climate-related risk by the level of importance.
- Consider including the management of climate-related risk into performance measurement indicators.
Meanwhile, various organizations have asked companies to make climate-related disclosures:
- The U.S. Securities and Exchange Commission (SEC) issued a draft Enhancement and Standardization of Climate-related Disclosures on March 21, 2022, requiring companies to provide:
- Climate-related risk information that may have a significant impact on its business, operations, or financial situation.
- In the notes to the audited financial statements, disclose climate-related financial statement indicators, including the company's greenhouse gas emissions.
The draft is expected to be disclosed in fall 2023.
- The International Sustainability Standards Board (ISSB) from the IFRS Foundation published two guidelines of the Sustainability Disclosure Guidelines in June, 2023:
- S1 General Requirements for Sustainability-related Financial Information
- S2 Climate-related Disclosure Requirements
Both guidelines are based on the TCFD framework and include the Sustainability Accounting Standards Board’s (SASB) disclosure requirements.
- The European Financial Reporting Advisory Group (EFRAG) has developed an overall framework for future sustainability reporting based on the Corporate Sustainability Reporting Directive (CSRD):
- A first set of 12 draft European Sustainability Reporting Standards (ESRS) to the European Commission.
- The adoption by the European Commission is expected to be by the end of 2023.
- The first companies within the scope of the CSRD will have to apply ESRS starting Fiscial Year of 2024.
Information disclosure will eventually move towards global unified standards to improve the quality and credibility of disclosure.
Company Operational Resilience
Insurers should recognize climate-related risks are fundamentally changing the insurance industry going forward and at the same time, recognize the potential opportunities to mitigate climate-related risks. “Insuring the Climate Transition,” the final report on the project of UN Environment Programme’s Principles for Sustainable Insurance Initiative to pilot the TCFD recommendations, identified three main sources of the climate-related risk as physical risk, transitional risk and litigation risk.
From a physical risk viewpoint, the potential impact worldwide is shown as temperature increases by 1.5°C and 2.0°C.
In the recent year, various carbon price systems were proposed, such as the EU’s provisional agreement on Carbon Border Adjustment Mechanism (CBAM) (to be implemented in October 2023) and the US’s Clean Competition ACT (to be implemented in 2024). Taiwan is also proposing the Climate Change Response Law to assess companies with carbon taxes. In 2021, the World Bank created a map on climate-related regulations proposed in various areas.
In light of those upcoming cross-border laws and regulations, companies are facing the transition risk. They have to find ways to reduce carbon emissions to lower operating costs. Insurers have to price their products accordingly since it will affect the underlying cost to do business (from investment to underwriting).
Derived from the physical and transition risks, companies that pollute the environment will be subject to litigation risk. With increasing litigation cases, at the Paris “One Planet Summit” in December 2017, eight central banks and supervisors established the Network of Central Banks and Supervisors for Greening the Financial System (NGFS). The purpose of the NGFS is to perform analytical work and develop scenarios on green finance:
- Orderly scenarios assume climate policies are introduced early and become gradually more stringent. Both physical and transition risks are relatively subdued.
- Disorderly scenarios explore higher transition risk due to policies being delayed or divergent across countries and sectors. Carbon prices are typically higher for a given temperature outcome.
- Hot house world scenarios assume that some climate policies are implemented in some jurisdictions, but global efforts are insufficient to halt significant global warming. Critical temperature thresholds are exceeded, leading to severe physical risks and irreversible impacts like sea-level rise.
- Too little, too late scenarios would assume that a late transition fails to limit physical risks. While no scenarios have been specifically designed for this purpose, this space can be explored by assuming higher physical risk outcomes for the disorderly scenarios.
Evaluating the risks and scenarios, the insurers can find opportunities for sustainable operating models, especially from underwriting and investment fronts. The insurers should identify the relevant entity, transformation and liability risks inherent in their business portfolio, assess the impact of their underwriting strategies, and formulate policies and procedures. How insurance companies consider climate-related risks in underwriting risks may depend on various factors (such as the duration of the contract, the frequency and severity of climate events, the impact of risks on their policies, reinsurance agreements, etc.). Meanwhile, the insurers should develop guidelines to incorporate climate-related risks into investment operations.[3]
- Underwriting front
- Climate-related risks in underwriting policies
- The geographic area, economic level or business level assessed as having a high climate-related risk.
- The process of identifying and evaluating major climate-related risks inherent in new business applications and effective insurance policies.
- The use of climate research reports, climate risk models, and other analytical tools in the underwriting decision-making process.
- Climate-related risks in underwriting assessments
- The policyholder's record and commitment in managing climate-related risks.
- Each policyholder has the ability and willingness to reduce identified climate-related risks.
- Policy duration (the impact of climate risks on short-term and long-term policies should be assessed).
- Impose underwriting conditions on certain types of policy commodities, requiring policyholders who are assessed to pose a higher risk due to climate impacts to take measures to reduce these risks.
- Climate-related risks faced by underwriting monitoring
- Due to evolving legal norms and increased litigation related to climate-related risks, certain policies may face greater liability risks and must be monitored.
- Develop appropriate tools and indicators to monitor the concentration of climate-related risks faced by its underwriting.
- Climate-related risks in underwriting policies
- Investment front
- Disclose how climate-related risks and opportunities should be included in investment decisions (such as the company's overall investment policy or individual target investment strategy).
- Disclose the evaluation and handling of portfolio decisions (for example, real estate investment since these assets are more vulnerable to sea level rise, floods, wildfires and other natural disasters).
- Disclose the decision-making factors of investing in innovative technology funds or companies, how the current investment diversification and regional asset allocation respond to climate risks, and the actions taken to address climate risks and their financial impacts.
- Disclose how to incorporate climate-related risks into investment portfolio decisions and processes, and the potential impact of a high-carbon investment portfolio on capital adequacy.
Summary
Insurers must play an active role in climate-related issues. It starts from the acknowledgement of climate-related risks and identifying, monitoring, and mitigating climate-related risks. Insurers should:
- Establish governance in dealing with climate-related risks, opportunities, and strategies.
- Identify and address systemic risks arising from and adjust policies accordingly.
- Enhance transparent disclosure of information, build consensus internally, and demonstrate commitment externally.
- Develop and support Sustainable Development Goals (SDGs) insurance products and solutions.
Statements of fact and opinions expressed herein are those of the individual authors and are not necessarily those of the Society of Actuaries, the editors, or the respective authors’ employers.
Jon Wu, FSA, MAAA, CERA, is chair of the SOA International Section, a member of SOA CFE exam track committee, and a member of ORSA/ERM committee of American Academy of Actuaries (AAA). He can be reached at jzwu101@gmail.com.