Mark Cornelius looks at regulator warnings about the financial risks from climate change
Greenhouse gas emissions have increased markedly since the pre-industrial era, driven largely by economic and population growth. Atmospheric concentrations of carbon dioxide, methane and nitrous oxide are unprecedented in at least the last 800,000 years, and are extremely likely to have been the dominant cause of the 1°C increase in global average temperatures since 1850. The world faces real risks and dangers from climate change. But what has that got to do with a central bank or a financial regulator?
Climate change creates two channels of risk for insurance firms and banks - physical risks and transition risks. Physical risks can arise from specific weather-related events such as floods, wildfires or storms, but also from broader, longer-term shifts in climate, such as sea level rise and chronic heatwaves. This can lead to higher unexpected claims on insurers, damaging balance sheets. If physical risks are not insured, the burden of the losses will fall on households, public agencies and companies. Importantly, these risks can also have a negative impact on the financial assets of banks and insurers. This could happen from damage to property, but also from the interruption to the economy, which could affect corporate profits and thus a wider range of assets. In extreme circumstances, these risks could affect the value of sovereign debt.
Transition risks can arise from the process of adjustment towards a lower-carbon economy. To make that transition, there will have to be new government policies, changes to customer preferences, and the introduction of new technologies. These will have an impact on the value of financial assets; there is a real risk that some of the assets that insurers and banks hold could substantially fall in value.
Physical and transition risks affect balance sheets through familiar channels. They are subsets of risk categories such as credit, underwriting and reserving. The Prudential Regulation Authority (PRA) has recently issued a supervisory statement ('Enhancing banks' and insurers' approaches to managing the financial risks from climate change') about how we expect firms to manage these risks. We want firms to embed the consideration of the financial risks from climate change into their governance arrangements. As part of that process, the board should identify and allocate responsibility for financial risks from climate change to the existing senior management function most appropriate within the firm's organisational structure.
We want firms to incorporate the financial risks from climate change into existing risk management practice. Firms should use scenario analysis to inform strategy setting, and risk identification and assessment. Finally, we want them to develop an approach to disclosure on the financial risks from climate change.
Actuaries should reflect upon these expectations and engage in their organisation's response. The profession is likely to have valuable skills and experience to offer, especially in scenario analysis.
The PRA expects firms to have an initial plan in place to address the expectations and submit an updated senior management function form by Tuesday 15 October 2019.
The PRA's expectations are intentionally high level and not prescriptive. Addressing these risks will require new analytical approaches, lots of data, taxonomies and classification systems that are not yet fully developed. Much of this is new and complex, so we recognise that we do not yet know what best practice looks like.
We believe the PRA has a role to play as a facilitator in the development process. To that end, the PRA and the Financial Conduct Authority (FCA) have established the Climate Financial Risk Forum (CFRF) to support the integration of climate-related factors into financial decision-making. The CFRF brings together representatives from regulated firms, the PRA, the FCA and technical experts in order to develop analytical tools and techniques. The aim is to build capacity and share best practice. The CFRF has set up four working groups on risk management, scenario analysis, disclosure, and innovation. These working groups will produce practical guidance documents that will be shared with the industry.
The PRA is also undertaking stress tests for life and general insurance in 2019. These tests include some climate change scenarios that are designed to help develop a greater understanding of the risks.
Climate change affects the whole world, and it is inevitable that mitigating the financial risks will be best achieved through international cooperation. The Network for Greening the Financial System and the Sustainable Insurance Forum are facilitating that collaboration among central banks and regulators.
It is a rapidly developing area, and the PRA will be updating its expectations of firms in due course.
The Actuary's View
Actuaries, as trusted experts on financial risks, will be expected to assess the likely impact of, and appropriate responses to, climate change, in order to help manage those risks and meet the demands of regulators and investors. As a profession, we will want to carefully consider the impacts that climate-related risks have on our work.
The PRA's supervisory statement, targeted at banks and insurers, is the latest development in those regulatory demands. The statement draws on two channels of risk: physical risks and transition risks.
The 2014 IPCC assessment report gave a stark warning on the physical risks: "Continued emission of greenhouse gases will cause further warming and long-lasting changes in all components of the climate system, increasing the likelihood of severe, pervasive and irreversible impacts for people and ecosystems." Physical risks can be further sub-divided between chronic or acute risks. Acute physical risks can include changes in the frequency of large catastrophe events, where trends are difficult to identify, and an unrecognised non-linear trend may introduce unwanted bias into any future projections. Chronic risks might include changes in sea levels or impacts on long-term morbidity and mortality.
Until recently, transition risks may have been less well understood. However, as pointed out by the Australian Actuaries Institute Climate Change working group, transition risks (and opportunities) may arise from policy and legal changes, technological advancement, changes in demand or reputational risk.
Some literature describes a third channel - liability risks. Liability risks are often a direct consequence of either physical or transition risk. They can include liabilities arising from a failure to mitigate climate change, a failure to adapt to it, a failure to disclose the risks arising from it, or a failure to comply with emerging legislative or regulatory change. As transition and liability risks may include step-changes in the regulatory and legal environments, actuaries may need to consider how climate change could influence their past data, the likely impact it has on trends, and the outlook for the future. A recent paper from the profession, 'Climate Change for Actuaries: An Introduction', provides an excellent entry-level insight into these risks for those wanting to know more.
Climate change can be an uncomfortable subject. Some worry they need to become experts on climatology in order to provide appropriate advice. Others worry that the range of uncertainty is too great. It's important to recognise that actuaries are not expected to be climate change experts. However, where climate change introduces material financial risk or uncertainty, actuaries may wish to highlight it.
In May 2017, the IFoA issued a Risk Alert to this effect. It urged all actuaries to ensure that they understand, and are clear in communicating, the extent to which they have taken account of climate-related risks in any relevant decisions, calculations or advice they provide. Consistent with the PRA's supervisory statement, the Risk Alert sought to draw attention to the publication of the Task Force on Climate-related Financial Disclosures' recommendations for reporting climate-related financial information (including specific supplemental guidance for the financial sector). Effective and thoughtful disclosure will be essential to understanding and managing the financial risks of climate change.
To support members of the profession, IFoA's Resource and Environment (R&E) Board has produced a series of practical guides on the risks arising from climate change. The aim of the guides is to raise awareness of the topic, encourage discussion, catalyse further research and assist actuaries in thinking about how they develop their advice. At the time of writing, guides have been produced covering defined benefit and defined contribution pensions work, and further guides on general insurance, life insurance and investment are expected to be published over the coming months. These will be a useful reference point in addressing the requirements of the supervisory statement.
If you would like to do more to support the profession's work on climate change and other R&E issues, you can register your interest in R&E issues by logging into the profession's website and amending your preferences, attend one of the many R&E events organised by the profession, and volunteer to support the work of the R&E Board, its Research and CPD sub-committee, or one of its working parties.
Mark Rothwell Resource and Environment Board