Insurance firm risk, meet climate-related financial risk

The ultimate effect of investor pressures has been heightened attention from regulators. As a result, each of the Financial Stability Oversight Council (FSOC) constituent members has released climate-related financial risk initiatives.

The Securities and Exchange Commission (SEC), Commodity Futures Trading Commission, Federal Reserve, and U.S. Department of the Treasury (among others) are exploring their options , and all signs point to federal regulatory action, with public insurance firms subject to SEC requirements. The Treasury’s Federal Insurance Office (FIO) began with a request for information in August of 2021.

The Biden administration’s October 2021 “A Roadmap to Build a Climate-Resilient Economy” specifically calls out the role of FIO and the insurance sector in combatting climate change. The FSOC released its report on climate-related financial risk in October 2021. For the first time, the FSOC is recognizing that climate change is an emerging and increasing threat to U.S. financial stability. Moving in parallel, the National Association of Insurance Commissioners is building out its guidance and recommendations through its Climate and Resiliency Task Force. The New York State Department of Financial Services (NY DFS) has been the first mover at the state level, providing the New York Insurance Association with revised “Guidance for New York Domestic Insurers on Managing the Financial Risks From Climate Change.” Other state regulators are considering their own approaches.

Despite the march of state and national regulatory developments, as well as related and growing investor pressures, confusion regarding the basic concepts and definitions associated with climate-related financial risk persists. To summarize, climate-related financial risk refers specifically to the physical and transition financial risks caused by climate change.

• Physical risk is associated with climate-driven changes in natural disaster patterns that are either chronic or acute in nature. Such risk topics cover increases in damages associated with floods (acute), wildfire (acute), hurricanes (acute), and sea level rise (chronic), among other weather events that are statistically extreme under historical definitions.
• Transition risk refers to those risks associated with the transformation to a lower-carbon economy. Climate mitigation and adaptation measures would likely entail extensive policy, legal, technology, and market changes that ultimately are financial risks to insurance firms. For example, a potential future carbon pricing mechanism could reduce the value of insurance investments in high-carbon industries.

For insurance companies, these risks are expressed through more traditional metrics. While these risks might be strategic, operating, or reputational in nature, they are perhaps most saliently viewed through the familiar lenses of underwriting risk, investment risk, and market risk. To illustrate with a few examples, over time weather-related property claims will likely increase (underwriting risk), so-called stranded assets will likely lose value (market risk), and the probability of and loss given default on carbon-intensive fixed income assets will likely increase (investment risk).

If climate does represent an emerging risk, how should it be measured, and how should it be managed? As a starting point, an insurance company should designate a board member or board committee and senior management official to oversee the company’s approach to climate change. Because climate-related financial risks affect the entire insurance company, the enterprise risk management function should perform an enterprisewide risk assessment considering the impact of climate change on traditional risk categories. From the outset, it should be recognized that the level of risk is dynamic, with respect to both an insurance company’s decisions and changes in market and policy initiatives. Due to the complex and multivariate nature of this system, climate risk thought leaders (including the NY DFS and European regulators) are strongly encouraging future-looking balance sheet stress analysis under differing international climate response scenarios.

Given the complexity associated with both climate-related financial risk assessment and scenario analysis, establishing an approach can be challenging. Despite an overlap with traditional risk management, the uncertainty and unpredictability surrounding these tasks requires skills and knowledge novel to the insurance industry. Working with a third-party financial consultant with insurance industry expertise might be of value.

¹ “Larry Fink's 2020 Letter to CEOs,” BlackRock, Jan. 14, 2020.
² “Larry Fink's 2021 Letter to CEOs,” BlackRock, Jan. 26, 2021.