Climate risk disclosure has advanced rapidly over the last four years, since governor of the Bank of England Mark Carney highlighted the risks of climate change to the finance and insurance industries in his Tragedy of the Horizon speech. The focus on climate risk disclosure has driven demand for physical climate risk analytics in a range of sectors, spurred on largely by initiatives such as the Taskforce on Climate-related Financial Disclosures (TCFD) and regulators such as the Prudential Regulation Authority, which announced an insurance stress test in June 2019. Pressure is also growing from ratings agencies such as Moody’s for insurers to act.
Insurance is widely considered to be the sector with the most experience in assessing and managing the physical risks of climate change, such as floods and storms. And indeed the sector has sophisticated models and tools with which to estimate current risk and future losses and that can underpin insurers’ own solvency through more accurate risk analytics. However, to date there is limited evidence to show that these analytics are leading to more climate-resilient investment by insurers. The Asset Owners Disclosure Project finds that “Less than 0.5 per cent of assets invested by the world’s 80 largest insurers are in low-carbon investments …, despite the insurance sector being highly exposed to its financial risks”. Nor does purchasing insurance lead automatically to improved resilience to future climate risk.
There are currently two key issues surrounding insurers’ disclosure that need to be addressed.
1. Disclosure is not aimed at customers
To date, the primary audience for climate risk disclosures has been the investor community and regulators. While the TCFD has focused heavily on disclosing the climate risk exposure of investments to regulators and shareholders, there has been less focus on disclosure to individual insurance clients. Climate risk information is still struggling to find its way into customer relationships. These could be with individuals, businesses, governments or even other insurers. Consideration of future climate risk is not the norm in any of these categories. This is a missed opportunity, as those customer relationships determine risk levels today and in the future: decisions taken now influence climate risks, be it in terms of building new infrastructure or homes, locating business parks or manufacturing sites, or choosing suppliers and technologies according to carbon footprints – and therefore these decisions need to be managed. For insurers who aspire to be ‘trusted advisors’ to their customers this poses an opportunity to strengthen the customer relationship: through disclosing climate risk analytics, insurers could inform their customers’ decisions to reduce the risk exposure of their assets.
However, the sector struggles to translate its climate risk knowledge into an asset that establishes trusted customer relationships. The use of that knowledge is usually limited to a 12-month insurance renewal cycle, as acknowledged, for example, by Swiss Re in its financial filings. While some insurers have established climate risk advisory services for clients, this is far from mainstream. Market trends and insights from the industry have focused on navigating customer relationships through megatrends such as digital disruption as opposed to the current and future impact of climate change.
2. How insurers themselves are influencing risk levels is not being considered in their disclosure
Insurers also influence risk levels through their own business decisions, particularly via investment practices. Who they insure and where they invest has implications for future risk levels. Insurance customers have a right to know what happens to their insurance premium payment in terms of investment. Recent draft EU regulation reflects growing concerns from regulatory bodies that insurers need to engage closely with their customers to understand their environmental, social and governance (ESG) preferences, in order to inform how their insurance payments should be invested.
It is also important to recognise the limitations within insurers’ own ‘catastrophe models’ for calculating climate risk: they may not capture the full severity of the future risks, and this influences the responses taken to mitigate climate change and its impacts. Consensus is building around the inadequacy of the models, which forecast risk according to historic trends, premiums typically increasing year on year after events happen. Data tools have not yet been developed and diffused through the insurance industry to deliver robust analytics on future climate risk for their clients.
The June 2019 TCFD status report highlighted scenario analysis – understanding the resilience of a company to future climate scenarios – as a particular need. Understanding future climate risk at the level of individual assets (e.g. the risk to a specific factory) requires granular data on future climate projections. It will be challenging for the insurance industry to be transparent about these complex datasets and their implications. For instance, communicating to a client that a currently insured factory may become uninsurable five to ten years hence, based on projections, may not be well understood or received – and could lose the insurer the client’s business. This increases the need for – and potential benefits from – a trusted relationship between insurer and client.
Climate risks need to be communicated carefully to customers
The insurance industry claims to treat customer relationships with high importance. However, this stance is largely aspirational, with standardised products and automated services more likely than tailored interactions, particularly with regards to individual consumers. This has helped drive down insurance costs for many consumers, but can also create a false sense of security: availability and affordability of insurance can change quickly, and lack of transparency about current and future risk will threaten public trust in insurance, as recognised by the Chartered Insurance Institute. However, communicating current and future risk levels through price is often interpreted as a step too far, with governments stepping in through subsidised schemes to cushion risk pricing for those at high risk. Transparency about how risk is priced, and how risk reduction is taken into account by underwriters would go a long way to establish trust, as recently highlighted in the case of flood insurance in Ireland, as well as for the UK .
Insurers need to encourage and incentivise customers to build climate resilience
The insurance industry’s current business model does not provide long-term protection from a changing climate – assets insured today could become uninsurable over time and be lost. The risk of this happening could increase if insurance customers perceive that the very act of purchasing a policy provides resilience without their having to take further measures.
A critical challenge for the insurance industry is therefore how it incentivises its clients to invest in resilience measures. Without a trusting relationship between insurer and client, discussion of future risk, increasing premiums and uninsurable assets could be perceived to be the insurance industry merely passing the risk onto clients. Extending this customer relationship to map client data onto future climate risk in longer-term policies (beyond the typical 12 months) could appeal to insurers as a way of securing long-term customer relationships and therefore business. In turn, communicating future climate risk, along with potentially increasing premiums, could spur recipients of insurance to invest in resilience measures to keep their premiums manageable. Thus, insurance drives climate resilience rather than merely providing compensation.
This suggested approach would be particularly suited to insurance customers with large, fixed-location assets with lengthy payback periods. Customers such as national and local governments could be well placed to push for long-term relationships with insurers, and more willing to invest in long-term resilience measures. This could also suit fast-moving consumer goods companies with interdependent factories within a supply chain. Insurers could differentiate themselves from competitors in the eyes of these clients by building data sets on the site-specific, future climate risk of an individual client’s assets over a number of years.
Taking account of insurers’ own influence on risk levels
Insurers influence risk particularly through their investment practices, but customers do not see this connection and are unlikely to engage in discussion on investment.
However, insurers’ investment decisions must support the long-term solvency of the industry so that it can remain a viable tool to help manage future climate disasters. This means investing funds in a manner sensitive to climate risks and moving capital away from carbon-intensive investments now. In turn this will reduce the payouts required for events caused by rising temperatures.
As yet, insurers are not sufficiently sensitive to the risks that climate change poses to their investments, despite improving sentiments and public statements made through the TCFD. A shift towards longer-term, trusting customer relationships could open a discussion between customers and insurers on how their premium payments are invested. Support for such a move is apparent from the industry responses to a recent EU consultation on draft legislation on institutional investors’ responsibilities regarding sustainability, which proposed mandating discussion between insurer and client regarding the client’s ESG preferences.
Customer relationships could be used for broader discussion on sustainability
Companies may argue that there is limited demand or appetite for more sustainable insurance practices. However, expectations may change as public concern regarding climate change grows. A recent YouGov poll demonstrated that around a quarter (27 per cent) of Britons now name the environment in their top three issues facing the UK. Whether or not this concern will translate into willingness to switch to and pay for ‘greener’ products and services is, as yet, far from clear. Trust and confidence that firms take their responsibility seriously will be important for this to happen.
Looking forward, the growing focus on climate risk disclosure could be broadened to encompass both the future climate resilience of the customer’s assets, and the climate risks facing the capital the insurer is investing. This could lead to a new kind of long-term insurance service focused on transparent relationships that both drives resilience in the customer’s assets by accounting for future risk exposure, and assures the customer that their capital will be invested in a climate-risk-resilient manner. And it could greatly improve understanding of both the role insurance can play in managing and reducing climate risks, and how viable and sustainable the insurance business model is. Ultimately, this could lead to a more resilient insurance industry, more resilient insurance customers and a strengthened customer–insurer dynamic. However, the industry will need to reset its relationships in order to achieve this – and it needs to start now.
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