We summarise the proposals and how they aim to help firms to approach the resulting financial risks.
In April the PRA published a consultation paper (CP10/25) proposing updates to its first climate supervisory statement (SS3/19). These proposals aimed to help insurers manage the effects of climate change on their businesses.
The consultation paper was relevant to all UK insurance and reinsurance firms and groups. In other words, it targeted those within the scope of Solvency UK, including the Society of Lloyd’s and managing agents.
What was the background to the consultation?
SS3/19 was originally introduced to address firms’ need for a strategic approach to tackling the financial risks that arise from climate change. The statement set out how they should respond to these risks in four key areas: governance, risk management, scenario analysis and disclosure.
Firms have made progress in relation to climate-related risk management. But the extent to which it has been implemented varies. What’s more, there have been calls from across the industry for greater clarity on what is expected of them.
The PRA has highlighted a number of areas specific to insurers which are still evolving, and it is these that have driven the proposals. They include:
Risk management
- Current metrics do not directly quantify climate-related financial risk. This prevents insurers from accurately measuring and monitoring their climate exposure against their risk appetite.
- Climate risk is viewed by some insurers as a driver of existing risk, instead of a standalone.
Scenario analysis
- Firms are conducting analysis, but there is little evidence that the results are flowing through to decision making.
- Gaps have been identified in capabilities, data and tools. This means scenarios aren’t reflecting all risks on both sides of the balance sheet. For example, the impacts of transition risks on underwriting or investments are rarely considered.
- The impacts of a range of plausible future outcomes are not always taken into account, such as worst-case scenarios and potential tipping points and their implications.
The proposals also aim to further align the expectations with international standards, and with evolving science and understanding around climate change – both of which are ever changing areas.
What are the PRA’s proposals?
The proposed expectations focus on the five themes of governance, risk management, climate scenario analysis, data and disclosure.
Governance
- Management bodies should provide their board with the relevant information on climate-related risks, to help them understand the impact over different time horizons and scenarios
- The board should be provided with analysis of performance against their business strategy under a range of scenarios, demonstrating the resilience of the existing strategy
- The firm should be able to demonstrate how it has integrated its plans to meet any climate goals
- The board should agree climate-specific risk appetite statements for material climate-related risks
- Identification and management of these risks should be assigned to an appropriate level of seniority in the firm
- Risk should be incorporated into internal control frameworks across the ‘three lines of defence’
Risk management
- The firm should periodically carry out risk identification and assessment to identify material risks. It must substantiate any judgements made during this process
- The firm should undertake an assessment of climate-related risks arising from its material relationships with clients, counterparties, investees and policyholders. It must then determine how these interact with other climate-related risks included in the firm risk register
- Quantitative risk appetite metrics and limits for each material climate-related risk should be developed and periodically reviewed
- The firm should develop and employ an appropriate internal risk-reporting infrastructure to allow for reporting to the board and sub-committees
Climate scenario analysis
- Analysis should aim to capture all material climate-related risks
- The firm should be able to justify the selection of scenarios, and be aware of the limitations and uncertainties with the models used
- Scenarios selected should be matched and tailored to their objectives. These should cover a range of plausible future outcomes including both physical and transition risks
- Scenario analysis should be used in a proportionate manner for a range of purposes, including:
- setting and reviewing business strategy
- setting and reviewing risk appetite
- risk management approaches
- impacts on liquidity and solvency
- ability to pay policyholders.
- The firm should regularly review and update scenarios in line with modelling and scientific advances and the changing nature of the risks it faces
Data
- There should be strategic plans to manage and close any data gaps that have been identified, providing that they can be remedied by further investment
- The firm should have systems to collect and aggregate climate-related risk data as part of its IT infrastructure, along with processes to ensure the data is accurate and reliable
Disclosures
- References to Taskforce on Climate-related Financial Disclosures are to be replaced by references to UK Sustainability Reporting Standards, subject to endorsement in the UK
Note: this is not an exhaustive list of the PRA’s proposals.
What are the insurance-specific issues?
The PRA has also proposed some objectives which are specific to insurers and their operations. These include:
- Clarification that ORSAs should incorporate climate scenarios when climate-related risks are material
- Risk management frameworks for insurers should reflect climate-related risks
- Insurers should detail the investment and underwriting changes they would make in response to the risks, and which metrics and indicators they monitor to make those decisions
- Clarification that SCRs should reflect the impact of climate-related risks on underwriting, reserving, market, credit and operational risks. In particular, those insurers using the standard formula should continually consider its appropriateness if climate-related risk is material
What do firms need to do now?
Step 1 – Risk identification
- Carry out effective risk identification and assessment to determine the materiality of the climate-related risks
- Understand how the risks impact the resilience of the business model
- Support the risk identification process through scenario analysis
Step 2 – Risk management
- Develop a risk management response that is proportional to vulnerability to climate-related risk, using knowledge of the business and the outcomes of step 1
What are the next steps?
The consultation period ended on 30 July. To offer firms some transition time, the PRA suggests that supervisors do not ask firms to show work undertaken to meet the newly proposed objectives until six months after publication of the updated supervisory statement.
If you would like to discuss the implications of the PRA’s consultation on your business, please contact your usual PKF contact or the authors of this article, Tom Mounsey or Charlie Benton.
