Important things Insurers need to know about Net Zero underwriting: The PCAF methodology

The key step towards insurers implementing their net zero transition plans, is being able to measure their entire carbon footprint, including their core underwriting activities. Being able to understand their baseline exposures is a precursor to actively managing their carbon budget, by engaging clients on how they can help insure the transition.

This article explores how the Partnership for Carbon Accounting Financials (PCAF) methodology works in practice, and the lessons gained to date in applying it to underwriting portfolios.

Insurance-related emissions are core to insurers’ transition plans

In our ‘The importance of net zero for Insurers’ article, we outlined how underwriting is the core process in an insurance organisation.  For any net zero programme to be credible, insurers need to make progress in addressing the impact of the organisations they chose to insure.

When it comes to calculating the carbon intensity of its underwriting portfolio, the PCAF guidance, published in November 2022, is particularly helpful for determining the current baseline footprint. Although this currently only applies to the commercial and motor insurance sector, one can imagine the boundaries of this analysis will gradually expand to encompass all aspects of insurance.

Understanding the implications of net zero

Regardless of the well-publicised departures from the net zero insurance alliance, the principle remains that all insurance organisations need to understand and manage the ‘insured’ emissions related to their portfolios — if they are to credibly deliver on their plans for transition to net zero. A recent McKinsey report suggests that underwriting emissions represent approximately 50% of a Property and Casualty (P&C) insurer’s total emissions (forming part of an organisation’s overall Scope 3 emissions), with the other major contributor being their investment portfolio.

Having said that, when it comes to underwriting, carbon intensity remains only one measure of a portfolio’s ESG performance. Insurers will be required to understand their overall portfolio exposures to climate risks, including physical, transition and litigation risks. Even in this case, the use of climate scenario modelling is crucial to determine how these risk exposures are anticipated to develop over time and manage it accordingly. 

Addressing multiple data challenges

High quality data related to clients’ emissions is clear and well-publicised challenge for insurers. Although there are multiple ESG providers and a lack of consistency in reporting standards. Typically, only the largest public or private organisations are disclosing greenhouse gas (GHG) reports related to their direct emissions (referred to as Scope 1 and 2 GHG emissions). Emission data for mid-sized organisations and small and medium sized enterprises (SMEs) can be problematic to collect, and even when disclosed, it is unlikely to have been subject to external assurance.

In our experience of working with insurance organisations, this is not a hurdle to make a start on measuring your baseline emissions. The answer is to establish estimates, by using the sector emission intensity factors developed by PCAF to support their methodology rollout.

However, this leads to some secondary risk factors when it comes to deploying data, namely entity matching. The PCAF methodology is based on insurers seeking to gather company-specific emission data in the first instance. Regardless of whether underwriters request this information directly from clients or rely on ESG-data providers for information, the first step is to ensure that the data captured applied to the correct legal entity. This involves correctly matching insured names to externally available data and ensuring that the appropriate level in large corporate legal entity structures has been chosen. The matching is likely to initially rely on manual intervention but may be enhanced over time by the application of data analytics techniques.

For insurance clients where specific data is not available, there is a need to rely on industry intensity factors provided by PCAF. This introduces a third level of data quality challenge, namely sector matching. In other words, every insured entity needs to be assigned to sectors and sub-sectors aligned to the PCAF emission factor database. This introduces a level of mis-matching risk, given that an insurance company’s underwriting systems may not be consistently using the industry coding of clients according to the European NACE (European Community Classification of Economic Activity), or North American Industry Classification System (NAICS), deployed within the PCAF database. There is likely to be a heavy reliance on manual matching certainly in the initial assessments. 

The PCAF methodology encourages the capture of data quality measures, with estimated data clearly scoring lower than directly reported information for each insurer. This will allow insurers to measure the gradual improvement in their data over time. This will also mean that their baseline calculation may need to be re-stated as new information and insights challenge the previously made assumptions. This simply reinforces the need for any disclosures to be based on a transparent description of the underlying assumptions.

Setting the appropriate calculation boundaries

The final challenge we have seen is the way the PCAF methodology requires insurers to exclude certain lines of business or client sectors because of the way the standards have been established. The easiest way to understand what exclusions apply, is dependent on the types of insurance with no agreed calculation methods, such as treaty reinsurance, as well as, surety bonds and other warranties. Generally, insurers do not have issues in segregating the segments of premium income. More problematic is the requirement to exclude publicly owned entities and financial institutions. It is not always obvious to identify state or local government owned entities, particularly in the education and social purpose sectors. Mainstream financial institutions, such as banks and insurers, are clearly captured by underwriters, but some asset managers and capture insurance companies, may be harder to accurately classify using system-based solutions.

Governance and assurance implications

Hopefully, this description of how the PCAF methodology works in practice, highlights that there are a number of underlying assumptions, manual interventions and judgement calls involved, in establishing a baseline carbon emission calculation for a typical underwriting portfolio. Any management, or board committee receiving the outcomes of this work are going to want to understand the robustness and maturity of the processes that produced this analysis. This implies that the sustainability teams undertaking the analysis will need to make sure that the adequately document the procedures followed and capture the internal controls applied, to ensure that the methodology is reproducible.

Over time, risk management and internal audit teams will want to engage with the process, to understand how the ‘greenwashing risks’ of disclosure misstatement are being managed, and whether these controls need to be strengthened over time. Particularly if stakeholders start to expect independent assurance from a third party to be provided in due course.

What does this analysis reveal?

This is the first time insurers have been able to undertake these calculations, given that the PCAF methodology was only published in late 2022. The major learning is that the process is time-consuming and needs a multi-functional approach to ensure that these various data challenges are appropriately managed.

Clearly the balance of contributions for any given insurer will depend on their own underwriting portfolio. Initial outcomes suggest that the largest contributors to insured emissions are not necessarily the ‘usual suspects’ of energy and utility sectors. Although these are clearly the most energy-intensive sectors, in global terms they do not command large premiums and their contributions are dwarfed by commercial motor and marine transportation sectors.

Insurers will be driven by their net zero commitments to establish a carbon budget and allocate capital to different lines of business within their portfolio — as seen in the asset management industry. This will drive underwriters to dig deeper into how credible individual insured’s transition plans prove to be over time. This in turn this will mean that underwriters needing to educate themselves about how understand and challenge insureds’ transition plan reports. Many insurers will seek to work with their clients to align themselves to their transition plans, whilst increasingly applying pressure to “brown industries” less willing to engage. The work done to evaluate their insurance-related emissions, is a key step in this transition plan activity.

How can we help?

Insurers should take the opportunity to evaluate the PCAF methodology and seek to apply it to their underwriting portfolios on their own terms before external pressure from stakeholders such as regulators and investors starts to be more widely applied. This will give them the opportunity to strategically reposition their mix of business, in the light of their capital allocation but also their carbon budgets. It will take time to understand how this is best done and gain confidence in the calculation outcomes. Through our practical and experienced team, we are helping insurers to establish and review their approaches to the evaluation of the insurance-related emissions, to ensure they maintain momentum on their transition planning towards net zero.

Please get in touch with Alex Hindson or your usual Crowe contact for more information.