While negotiators, government representatives, and world leaders may dominate the headlines emerging from COP26 over the next two weeks, the insurance industry is likely to play a critical role behind the scenes, writes RMS’ Evan Cropper
Many insurers are already committed to the UN Race to Zero and COP26 will also see the formal launch of the Net Zero Insurance Alliance.
With so much activity around COP26, it’s important for the insurance industry to pay attention to the signals coming from the event.
The ability to translate commitments from industry leaders and governments into business strategy, will give insurers a head start on how to tackle the challenges that could manifest into new mandatory regulatory and financial disclosures, stress tests, and policy changes.
More importantly, these signals could provide a road map to new growth opportunities resulting from the risk of climate change.
So, while insurers traditionally rely on data-driven insights from catastrophe models to drive their underwriting and portfolio management strategies, COP26 presents an excellent opportunity for the broader industry to understand which way the wind is blowing for climate change risk management.
Below are a few areas insurers should pay attention to:
The transition from voluntary to mandatory financial reporting rules
Mark Carney and Michael Bloomberg announced the creation of the Task Force on Climate-Related Financial Disclosures (TCFD) at COP21 in 2015, and it is now the go-to framework for climate-related financial reporting.
The demand for TCFD disclosure is now enormous, growing 85 percent since 2019, with more than 1,500 supporters from 55 countries representing a market capitalization of US$12.8trn. Four-fifths of the top 1,100 global companies are now disclosing climate-related financial risks in line with some of the TCFD recommendations.
There are now calls to move away from voluntary climate disclosures. Mark Carney, now the UN special envoy for climate action, is calling on COP26 participants to follow New Zealand’s lead – the first country in the world to make TCFD-inspired reporting mandatory by 2023. The European Union is also working toward incorporating TCFD into mandatory climate-related reporting standards.
The International Financial Reporting Standards (IFRS) Foundation is looking to develop a global baseline sustainability reporting standard through its International Sustainability Standards Board (ISSB).
Writing in International Monetary Fund’s Finance and Development magazine, Carney said: “Now it is time for governments around the world to make TCFD disclosures mandatory and support the International Financial Reporting Standards Foundation’s intention to establish a new international sustainability standards board to produce a climate disclosure standard, based on the TCFD.”
The transition to and adoption of TCFD-inspired reporting could have a profound impact on the insurance industry.
Climate change presents unique risks to insurers who are managing transition risk within their investment portfolio (where carbon-intensive assets decline in value) and the physical impact of climate change on the frequency and severity of natural catastrophes, which could present significant shifts in how they manage their underwriting and risk.
With business models reliant on properly understanding and pricing risk, insurers need to know the near-term and long-term risk on their books and advance their tools and capabilities to properly assess how climate change could impact their risk pricing, portfolio management, and solvency requirements.
The role of insurers in closing the protection gap
Ahead of COP26, private finance is working hard to unleash the trillions of dollars of capital required to power toward net zero by the middle of the century.
One of the core goals for COP26 is to mobilize finance for developing countries that will be the most exposed to climate change – and the least able to fund mitigation. Progress has been made, but developed countries are being asked to deliver on their 2010 promise to raise at least $100bn every year in climate finance to support developing countries.
To help unlock this investment, insurers can play an important role in establishing insurance markets within developing countries to protect these valuable investments. Developing countries have long struggled with narrowing the protection gap – the difference between economic and insured losses. Whereas upper-income countries like the US have closed the protection gap to below 60 percent, lower-income countries have not seen significant improvement.
With the protection gap at 95 percent for most developing countries, a catastrophic event could be particularly devastating to the economy because most losses will not be insured. To make matters worse, according to the International Monetary Fund, the cost of natural disasters for small developing states is more than four times that for larger countries, relative to the size of their economies.
Making wise investments through public and private finance to get to net zero requires that every financial decision take the climate into account. To do this, there needs to be better understanding of both the near- and long-term physical risk of natural catastrophes exacerbated by a changing climate. With insurers and cat modellers on the front line of physical risk, the industry is best placed to play a key role of mitigating these risks with the use of data and analytics.
Action is well under way, with the creation of new products and markets building on the work of the Insurance Development Forum, the Coalition for Climate Resilient Investment, and other key initiatives to scale up resilient infrastructure spending and insurance coverage to close the insurance protection gap.
Updated climate change targets and priorities
The Paris Agreement was born at COP21 in Paris back in 2015, and 191 signatories agreed to work together to limit global warming to well below 2 degrees Celsius and aim for 1.5 degrees Celsius. The commitment to aim for 1.5 degrees is important because every fraction of a degree of warming can result in the tragedy of many more lives lost and livelihoods damaged.
Under the agreement, each signatory country committed to accelerate their national plans and to submit their emissions reductions targets, known as Nationally Determined Contributions (NDCs). They agreed that every five years they would revise plans to reflect their highest possible ambition at that time.
During COP26, signatory countries will present their updated 2030 NDC targets. Of the NDCs submitted so far, many will likely need to redouble their efforts to get near to net zero. Governments will look to act on these aggressive climate reduction goals and mandate actions, such as the UK government, that in 2019 reinforced its commitment, in law, to net zero by 2050.
Insurers need to be aware of any new country targets and the accompanying actions. One downstream impact of new targets could be increased climate change regulation and reporting. Already we have seen some regulators conduct scenario-based stress tests focused on climate change.
For instance, the UK Prudential Regulation Authority is undertaking the 2021 Climate Biennial Exploratory Scenario with insurers and banks to understand the impact of physical and transition climate change risk on their portfolios, and other regulators are following closely behind. Physical risk scenarios within such exercises could tighten to reflect net zero by 2050 or earlier.
Insurers understand environmental risk
Whatever emerges from COP26, insurers have a critical role to play in terms of assessing, modeling, financing, and mitigating environmental risks. Insurers have taken on climatic risk since the seventeenth century, where contracts struck at Lloyd’s coffee shop in London insured ships on the high seas. By analyzing and understanding the risk, you can price it and address it – and look for ways to reduce it through incentives.
We all look forward to seeing what comes out of COP26 and how it will impact the (re)insurance and cat modeling industry.
Evan Cropper is director of product marketing at RMS