Insurance Industry Expected to Play Major Role in Addressing Climate Change Following COP26

THE EVOLUTION FROM VOLUNTARY DISCLOSURES TO MANDATORY REPORTING, STANDARD SETTING AND NET ZERO PLANS

The short era of voluntary climate change risk disclosures in the form of Task Force on Climate-Related Financial Disclosures (TCFD) reports seems to be drawing to a close. The United Kingdom is the first Group of Twenty (G20) country to require its largest companies and major banks and insurers to file climate disclosures, beginning in the spring of 2022. While applauding the progress made using TCFD disclosure templates, Dutch Central Banker and President of De Nederlandsche Bank Klaas Knot was quoted as saying, “The TCFD recommendations have gained enormous traction over the years…but the exercise now is reaching the limits of what can be achieved through a purely industry-led and voluntary framework. The time has come to take it to the next level, and the next level, in our view, is the development of the global minimum standard.”

UK Prudential Regulation Authority CEO Sam Woods commented on the Bank of England’s second climate adaptation report released shortly before COP26 began, noting that regulators may need to consider capital loading as part of their climate change insurance regulatory toolkits. “Under the existing regulatory capital framework, there is scope to use capital requirements to address certain aspects of climate-related financial risks,” Woods said.

In the Lloyd’s of London insurance market, managing agents will be required to prepare and submit “progress to net zero” plans, with pilot activity in 2022 and full-scale plans to be filed and approved by the market in 2023. On a parallel track, the UK Financial Conduct Authority will require insurers to submit plans to achieve net zero by 2050.

HEADED TOWARD A COMMON SUSTAINABILITY LANGUAGE?

Perhaps the biggest news for the financial sector (insurance included) at COP26 was the introduction of the International Sustainability Standards Board (ISSB), which was incubated over the last year by the International Financial Reporting Standards Foundation and designed to operate alongside the International Accounting Standards Board with a degree of governance independence. The ambition is to flesh out a “new baseline for sustainability disclosures” for investors. For most of this year, organization after organization, company after company, regulator after regulator—particularly US banking and securities regulators—have been decrying the lack of common standards, metrics and data to use in connection with describing and disclosing climate change risks. Whether financial services industry regulators internationally and, particularly, in the United States sign on to the ISSB or go their own way remains to be seen. It may not be surprising if US regulators and standard setters develop a US-centric language for disclosure of climate change risks for investors since we now have two financial accounting languages—the International Financial Reporting Standards (IFRS) and the generally accepted accounting principles (GAAP)—in use worldwide, with more-or-less acceptance by each of the other’s “equivalence.”

Also announced this month was the Common Ground Taxonomy, a joint effort by the European Union and China that’s still in early form and with many hurdles still to clear. Items such as developing a common set of industrial classifications still need to be negotiated, but the effort to make taxonomies “mutually intelligible” and to ultimately harmonize them should complement the development of common sustainability standards.

US DEVELOPMENTS

NEW YORK DEPARTMENT OF FINANCIAL SERVICES (DFS) FINALIZES “GUIDANCE FOR NEW YORK DOMESTIC INSURERS ON MANAGING THE FINANCIAL RISKS FROM CLIMATE CHANGE”

Two fundamentally important points about the DFS’ recently finalized climate change guidance (the Guidance) are in the title of the document. First, this work product is neither legislation nor a regulation promulgated to implement legislation. (The DFS website notes that no such regulation is contemplated at this time.) Second, while the Guidance applies to New York “domestic insurers” only, the DFS amended its enterprise risk management in Regulation 203 in August 2021 to add climate change to the list of risks that insurance holding companies and certain insurers should address in annual enterprise risk management (ERM) filings. Since holding companies can include non-New York domestic insurers that are merely “authorized” in the state, the Guidance is more broadly applicable than the title suggests. Domestics are insurers that are New York-chartered (i.e., insurers whose primary solvency and market conduct regulator is New York)—regardless if they are “licensed” or “admitted” in other states or not.

To the McDermott insurance group’s knowledge, no other state is developing anything similar to the Guidance or undertaking the kind of year-long development process that the DFS started last year around this time. The National Association of Insurance Commissioners (NAIC) has created a Climate and Resiliency Task Force with multiple “workstreams,” but it has not been made aware that NAIC leadership is pushing for it to follow in the footsteps of New York. Putting aside the possibility that catastrophic weather events could change political and regulatory positions in certain states, the outcomes of state, national and local elections next year and in 2024 will go a long way to clarify whether more states will emulate New York and whether the DFS, under new leadership, will continue down this path.

Development of climate change guidance at the federal level is another story. With federal financial regulators, banking, commodities and securities, as well as the Federal Insurance Office, all moving with deliberate speed to develop climate change regulatory frameworks, how much of that activity will apply to insurers or influence state insurance regulators will be an interesting plotline to follow next year.

Back to New York: In late March 2021, we summarized the key points regarding the first iteration of New York regulators’ expectations as to managing the financial risks of climate change as follows:

• “…a general expectation that insurers should consider both current and future risks and plan to mitigate them in a manner that is proportionate to each insurer’s nature, scale and complexity.”
• “Integrate the consideration of climate risks into its governance structure. The insurer’s board should understand and be responsible for managing climate risks, which should be reflected in the company’s risk appetite and organizational structure.”
• “When making strategic and business decisions, consider the current and forward-looking impact of climate-related factors on its business environment in the short-, medium- and long-term.”
• “Incorporate climate risks into the insurer’s existing financial risk management, including by embedding climate risks in its risk management framework and analyzing the impact of climate risks on existing risk factors. Climate risks should be considered in the company’s [own risk and solvency assessment] ORSA.”
• “Use scenario analysis to inform business strategies and risk assessment and identification. Scenarios should consider physical and transition risks, multiple carbon emissions and temperature pathways, and short-, medium- and long-time horizons.”
• “Disclose its climate risks and consider the TCFD and other initiatives when developing its disclosure approaches. DFS intends to monitor compliance with these expectations as part of its supervisory activities.”
• “The DFS is aware of course that regulators in the European Union and the United Kingdom are much more advanced in the development of their climate change risk regulatory frameworks. The DFS says it will continue to work with international counterparts to ‘ensure consistency’ and ‘reduce the compliance burden.’”
• “The DFS says it is aware that over time insurers’ approaches to managing climate change risk will ‘mature’—starting with qualitative assessments using simple models but progressing to more quantitative analyses using more advanced models, incorporating more factors or variables and extending over longer time horizons. As to physical risks (i.e., on the  underwriting side), the maturation process will hinge in part on the development of better and better models by the usual vendors, as well as insurers’ internal models, perhaps augmented by public climate change models.”
• “On the transition risk side (i.e., investing), the proliferation of green standards makes comparability and consistency difficult to realize. Debate on this topic is widespread and intense. Stress testing and scenario analyses also seem to be at an early stage of development, and while the DFS is cognizant that some insurers may not be ‘ready to conduct a comprehensive and quantitative scenario analysis’ nevertheless the exercise is valuable for all insurers.”

Having reviewed the final version of the Guidance, the foregoing summary remains as valid as it was eight months ago, but the following points in the final version of the Guidance are worth mentioning:

• The final version seeks to reassure readers, if not senior managements, that climate risk is another risk that insurers must manage while also acknowledging the “unique challenges” presented by it.
• It also lists out all the climate change regulatory guidance and precedents from Europe but does not include US precedents.
• The final version repeats an environmental justice clarion call for insurers to “do their part to contribute to the low-carbon transition and climate adaptation efforts; support communities’ resilience to climate change, especially in disadvantaged communities that would be even more vulnerable to climate change if insurers stop insuring or investing in these communities; and work with the public sector to find ways to close the protection gap and ensure that insurance is available and affordable throughout the state.”
• “Materiality” of climate change risks should be consistent with materiality of other risks on which insurance regulators focus. The Guidance provides that insurers may consider as “material” a risk that involves 5% of policyholder surplus or .50% of total assets as set forth in the NAIC’s Financial Condition Examiners Handbook or, borrowed from the European Insurance and Occupational Pensions Authority, where “knowledge of the risk could influence the decisions of an insurer’s board, management, regulators, or other relevant stakeholders.” It is worth remembering, however, that that climate change risk is an “enterprise risk” and defined in various New York insurance law sections as “…any activity, circumstance, event, or series of events involving the insurer that, if not remedied promptly, is likely to have a material adverse effect upon the financial condition or liquidity of the insurer [or holding company or parent corporation], including anything that would cause the insurer’s risk-based capital to fall into company action level [in New York insurance laws], or that would cause further transaction of business to be hazardous to the insurer’s policyholders or creditors or the public.” Regardless, insurers should revisit materiality assumptions at least annually or whenever “significant changes” occur. It will be interesting to see whether other financial services regulators (e.g., the US Securities and Exchange Commission) or federal bank regulators view “materiality” through the same lenses.
• Timing: The DFS now says that by August 15, 2022, insurers need to 1) identify a board member to be responsible for the “oversight of the insurer’s management of climate risks” (and also identify at least one senior manager to handle such management) and 2) have “specific plans in place to implement the [DFS’] expectations relating to organizational structure.”
• “Expectations relating to organizational structure” include at least the following seven items:

1. Manage climate risks via existing ERM “control” functions (e.g., risk assessment, compliance, internal control, internal audit and actuarial);
2. Ensure accountability in “risk-based decision-making” vis-à-vis “climate risk limits and overseeing their implementation” by clearly defining/articulating management roles and responsibilities;
3. Integrate climate risk into all risk management processes in all “lines of business, operations and control functions”;
4. “Explicitly consider” climate change risks in ERM and ORSA reports (as Regulation 203 now requires);
5. “Conduct objective, independent, and regular internal reviews” on climate change risk management processes and report results to the Board;
6. “Develop the skill, expertise, and knowledge” needed to assess and manage climate risk—hiring new talent, expanding internal training or using outside consultants as necessary; and
7. Consider modifying management compensation policies and “align incentives with the strategy for managing climate risks and with performance against climate metrics.”

Two or three years from now, the DFS expects that insurers will refine their assessments of material climate risks, paying attention to both internal and external factors. The DFS also expects that insurers will publicly disclose material climate risks, including “related figures, metrics, and targets as well as the methodologies, definitions, and criteria used to make [the materiality] determination.”

Assuming Governor Kathy Hochul (D-NY) or another Democratic candidate is elected New York’s new governor next year, we will see how the “longer term” plays out for the implementation of the DFS’ wide-ranging plan to ensure that all New York domestic insurers weave climate risk management into the fabric of their organizations.

The DFS is set to host an informational presentation on the final Guidance on Monday, November 22. The McDermott insurance team will keep you updated on noteworthy items shared during the presentation.