Firms need to develop a structured approach to managing climate risks within long-dated asset portfolios, say Jonathan Lim, Sandy Trust and Ryan Allison.
As climate action accelerates this year, and with regulatory deadlines looming, there is a growing need for life insurers to embed climate change considerations into their management of long-term investments.
Risk assessments have led the way to date, with many firms building their understanding of physical and transition risks. Several firms have gone further, making net-zero commitments covering their asset portfolios.
More firms are likely to follow, as momentum builds around the Race to Zero campaign leading up to the COP26 climate summit later this year. Evidencing the delivery of these real-world impacts will be important to a range of stakeholders, including executives, as firms now begin to incorporate delivery into incentives.
Firms need to develop a strategic approach to climate change, and they can start by considering financials, regulation, and real-world impact.
Financials – risk and yield impacts on asset portfolios
To continue to price risk correctly and identify any hidden pockets of risk, a mechanism is required for assessing the impact of physical, transition and liability risks on long-dated assets. Climate risk assessment methodologies are improving rapidly, with advanced firms now incorporating these into investment processes – both pre-investment and for ongoing monitoring. Some firms are also using an internal carbon price to inform risk assessments.
Regulation – meeting expectations and matching adjustment implications
By December 2021, insurers are required to have met the Prudential Regulation Authority’s expectations on managing the financial risks of climate change. This will mean developing and embedding new metrics and targets into risk management systems, to evidence they have done so. The Department for Work and Pensions has set similar requirements, with larger pension schemes now needing to develop climate-related metrics, both financial and non-financial.
In addition, the Treasury’s review of Solvency II is exploring possible changes to the matching adjustment (MA) and other areas to better reflect climate risks and encourage sustainable investment. But what tools might the government use to incentivise firms? Should they be fiscal, capital, guarantee or subsidy based?
Questions for firms to consider when responding to the Treasury’s call for evidence include:
- Are restrictions in the MA eligibility of assets and ‘buy to hold’ criteria disincentivising sustainable investments?
- Should the fundamental spread reflect differences in transition risk between ‘green’ and ‘brown’ investments?
- Should climate risk be reflected in internal credit rating or capital models, and how material is climate risk in the context of other risks?
Real-world impact – supporting the Race to Zero
Some firms have made commitments to transition their own asset portfolios to net-zero emissions by 2050. This is likely to require a number of measures, including dialogue with investee companies to support them to commit to net zero (as BP have done), increased capital allocation to climate solutions such as clean energy, and selective divestment.
A key step is to understand where investments fit on a net-zero pathway. Firms must decide when it is no longer appropriate to finance the debt of companies or countries that are: (a) unwilling to support the transition to a low carbon economy, or (b) hindering progress (for example through large-scale deforestation, which also impacts biodiversity).
Alternative assets could play a growing role in the transition to net zero. Social housing and renewables are examples of asset classes that have delivered consistently attractive returns, are resilient to climate risks, deliver on net zero and have good long-term matching characteristics.
The views expressed in this article are those of the authors and do not necessarily reflect the views of their employers.
Jonathan Lim is a risk actuary at Canada Life
Sandy Trust is a sustainable finance lead at Ernst & Young and deputy chair of the IFoA Sustainability Board
Ryan Allison is a sustainable finance actuarial lead at Ernst & Young and a member of the IFoA Biodiversity and Natural Capital Working Party