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The Actuary The magazine of the Institute & Faculty of Actuaries

Skating on thin ice

It’s time for with-profits investment strategies to consider climate-related risks and opportunities, say Catherine Thorn and Sandy Trust



“The volatility of individual properties is hard to measure due to infrequent sales”

Although implicitly captured by the recent Prudential Regulation Authority (PRA) supervisory statement on climate change, with-profits is unusual in long-term savings as one area in which UK regulators have not explicitly specified requirements relating to the management of climate change as a material financial risk – as has happened with trust-based pensions, for example. 

Are actuaries who are not considering this at risk of breaching their regulatory responsibilities – as well as missing out on investment and customer engagement opportunities? 

With-profits regulations are lengthy, but the guiding principles can be paraphrased simply: run the fund well by securing good investment returns to provide fair, smoothed long-term returns for each generation of policyholders. 

Put another way, with-profits funds must meet the needs of current policyholders without compromising the needs of future policyholders. This is similar to the widely used definition of sustainable development: “Development which meets the needs of the present without compromising the ability of future generations to meet their own needs.”

Climate risk management in financial services

Climate change risks are now accepted to be financially material; already occurring; potentially impossible to hedge completely; interconnected in complex ways; foreseeable; and highly uncertain, in that the actions we take in the next decade will be critical to either avoiding or accelerating catastrophic climate change. 

However, climate is a new language for financial services. It is not well-understood, and not particularly welcomed by some. For many, consideration of longer-term risks and real-world impacts, such as climate change, represents a major shift from thinking about purely financial outcomes. 

Development of data, models and methodologies is rapid, meaning any long-term portfolio manager can assess climate risk in their portfolio at both a holding level and at a macro-economic level. Of course, models are not perfect – it is challenging to capture all the interactions between the Earth’s complex physical climate system and the financial system. Nonetheless, major global financial institutions are now using them to manage risk and disclose their approach.

A key first step is to formulate a climate policy that reflects Paris Agreement goals. Institutions can then move on to risk assessment. Strikingly, all of the institutions that have done the maths appear to have come to a similar conclusion: here is a material financial risk and opportunity that we should manage appropriately.

As well as the range of data, models and consultancy players in this space, there are significant resources available to support institutional investors, including the risk taxonomy and methodology of the Financial Stability Board’s Task Force on Climate-Related Financial Disclosures (TCFD, Figure 1), and guidance from the Principles for Responsible Investment initiative and membership groups such as the Institutional Investors Group on Climate Change.

Figure 1
Figure 1


Investment implications

In its 2015 policy briefing (bit.ly/33otRHs), the IFoA stated: “The cost of delay is high and early action on emissions will improve future options.” Recent developments have quantified the cost of delay – ie how expensive failure to achieve the Paris Goals could be. It is unlikely we will be able to successfully adapt to a world that warms much above 2°C. A recent scientific paper, Robust abatement pathways to tolerable climate futures require immediate global action, estimated climate damages that are many multiples (10x) of global world product if we fail to rapidly decarbonise our economy.

What does this mean for with-profits funds? Simply, that choosing a higher warming pathway will have severe macro-economic implications – interest rates, inflation, growth and so on are likely to be impacted. This in turn impacts the key assumptions that actuaries use to manage with-profits funds.

But what these high level macro-economic impacts disguise are the very different national, sectoral and stock-level impacts arising from the transition, and the physical risks associated with climate change. There are already winners and losers in the market. 

If your investment portfolios do not yet include consideration of climate factors, could you be taking risks you do not understand?

Conversely, significant opportunities exist for investing in mitigation and adaptation efforts. Elon Musk’s remuneration proposals at Tesla were based on astonishing growth projections, predicated on the company playing a meaningful role in the energy transition. Any long-term investor not alert to these opportunities may be missing out on returns.

There is no suggestion or implication that this involves giving up returns. An increasing amount of academic research shows that environmental, social and governance (ESG) aware investment does not impact returns. Many asset owners have concluded that mitigating climate risks and positioning for opportunity is completely aligned with their fiduciary duty to provide good returns to their beneficiaries.

The moral imperative

Financial services companies are also waking up to the fact that connecting with people through their values might lead to a different customer relationship. Few customers understand funds, and a 30% allocation to equities may not mean much to many. However, they do understand stewardship and engagement themes such as gender diversity, climate change and executive pay. By using these narratives, can the customer engagement paradigm be changed to make with-profits appealing? 

Ban Ki-moon said in 2015: “We are the last generation that can take steps to avoid the worst impact of climate change. Future generations will judge us harshly if we fail to uphold our moral and historical responsibilities.” The Intergovermental Panel on Climate Change´s 2018 special report (bit.ly/2A5BEhi) made clear that the window of opportunity for avoiding catastrophic climate change is shrinking rapidly, and that keeping the world’s warming as far below 2°C as we can is vastly preferable from a societal survival perspective.

Actuaries are well positioned to understand climate change. We understand probabilistic scenarios and long-term risks, and are comfortable with uncertainty. We have the technical skills, but we also often have responsibility for oversight and governance of large pools of assets, which can be used either to accelerate or mitigate climate change. We therefore have an enhanced responsibility. 

For example, a large with-profits fund can do things ordinary people cannot, such as invest in renewable energy. Conversely, such a fund can also finance the discovery of more fossil fuels by investing in the corporate debt of oil majors that are not transitioning to a low carbon future. By doing so, the fund is not only taking on investment risk as a consequence of the energy transition, but is also facilitating a very negative real-world impact. As actuaries, surely we need to own this responsibility and play our part in shaping a positive future for our species?

Regulatory vigour and taking action

The PRA, Financial Conduct Authority, Financial Reporting Council and The Pensions Regulator are heavily engaged with climate change, with a series of papers and initiatives taking place, including the July 2019 joint statement on climate change (bit.ly/2xI80Nu) that accompanied the government’s Green Finance Strategy (bit.ly/2KUNfUT). Globally, an increasing number of regulators are also moving and high-profile voluntary initiatives are being remarkably well supported. From a regulatory perspective the message is simple – here is a material financial risk that you should now be managing. So actuaries must:

  • Understand climate change risks – what they are and how they could impact the with-profits fund
  • Assess these risks – use appropriate tools and techniques to understand the impacts on the fund
  • Act – implement appropriate investment or hedging strategies and consider whether Principles and Practices of Financial Management should be updated to be explicit on material ESG risks, including climate change.

Given that the IFoA issued a risk alert to all actuaries on climate change in May 2017, those who fail to take these steps now may well, like polar bears, be skating on increasingly thin ice.

Catherine Thorn is with-profits actuary designate at ReAssure.

Sandy Trust is senior manager at Ernst & Young.