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European regulators move to put sustainability at the heart of insurer performance

Insurance Consulting and Technology
Insurer Solutions

March 01, 2021

The EU’s Sustainable Finance Disclosure Regulation (SFDR) ensures that insurers and asset managers trading in the EEA are adequately assessing, integrating and reporting on climate risks.

The introduction of high-level aspects of the European Union (EU) Sustainable Finance Disclosure Regulation (SFDR) from March 2021 is a substantive step from pan-European insurance regulators and bodies towards ensuring that insurers - and all asset managers - trading in the EEA are adequately assessing, integrating and reporting on climate risks and other sustainability measures. But it’s certainly not the last that insurers will need to absorb and act upon.

From 10 March this year, insurers operating in the EEA (even if not located there) will have to abide by the core principles of SFDR. Amongst other things, these will require insurers to start demonstrating and implementing policies for the financial integration of sustainability risks and the alignment of remuneration policy with those risks. At a product level, they will also entail certain website and pre-contractual disclosures about sustainability impacts.

And while pan-European legislators and regulators may not have been as fast out of the blocks on climate and sustainability issues as in some jurisdictions, this first stage of SFDR is merely the first wave of an incoming tide of measures, all stemming from the EU Green Deal and Sustainable Finance Strategy that were introduced after the adoption of the United Nations Sustainable Development Goals in 2015.

Already in train are the regulatory technical standards (RTS) that will define in detail how regulators propose to interpret factors that contribute to improved sustainability and that are included in SFDR disclosures. The Joint Committee of the three European Supervisory Authorities (EBA, EIOPA and ESMA - ESAs1) delivered its draft report, 'Final Report on draft Regulatory Technical Standards', on the RTS to the European Commission on 2 February, which the Commission is expected to endorse within three months. Notably, this makes clear that these RTS will extend beyond climate to include a full gamut of potential environmental, social and governance (ESG) adverse impacts, in line with a general principle of ‘do not significantly harm’. Section 3, point 49 of the ESA report also confirms the previous expectation that the first SFDR disclosure reports will have to be reported from 1 January 2022.

The draft RTS include a mandatory reporting template (the “Principal adverse sustainability impacts statement”), that firms are required to publish and covers impacts of investment decisions on sustainability factors. The template includes several sustainability indicators, comprising, for example, greenhouse gas (GHG) emissions, carbon footprint, water and waste management, and the social and employee responsibility of firms’ investee companies. Dedicated templates for pre-contractual and periodic disclosure requirements for financial products are also part of the RTS.

Under Article 11, firms that do not consider sustainability factors, are required to provide clear reasons for not considering the adverse impacts of their investment decisions on sustainability factors.

Meanwhile, EIOPA has recently closed a consultation on the use of climate change risk scenarios in the Own Risk and Solvency Assessment (ORSA). Its draft supervisory opinion (ahead of the final opinion expected in Spring 2021) recommended insurers who are subject to material climate change risks use at least two long-term climate scenarios:

  • A climate change risk scenario where the global temperature increase remains below 2°C, preferably no more than 1.5°C, in line with the EU commitments; and
  • A climate change risk scenario where the global temperature increase exceeds 2°C.

This has recently been followed with the publication of a discussion paper on a methodology for the potential inclusion of climate change in the Solvency II standard formula when calculating natural catastrophe underwriting risk.

Furthermore, the European Parliament launched the Green Recovery initiative in April 2020, committed to implementing and supporting a package of initiatives that will act as accelerators of the transition to climate neutrality and healthier ecosystems in the long term.

And last, but by no means least, there is what is happening at individual country level. Joining the flood of pan-European measures are sustainability-focused initiatives from several national insurance regulators, including those in France, Germany, Ireland, The Netherlands and the UK.

Practical considerations

Perhaps not surprisingly then, we hear European companies saying they feel “almost lost” in the current torrent of sustainability-related consultation and technical advice and requirements.

Recognising that a lot of the details behind these signals of intent from European legislators and regulators are still to be finalised, what, practically speaking, can insurers be doing to prepare for the raft of additional climate and sustainability reporting measures?

The following suggestions are valid incidentally if, as is quite possible, European requirements move towards convergence with the Taskforce for Climate-related Financial Disclosures (TCFD) that several countries, including the UK, have already indicated they will make mandatory for companies in the financial sector and beyond. Steps that insurers may need to take will include:

  • Assessing data and metrics that will support analysis and disclosure. Our recent analysis of UK and European insurers’ and asset managers’ public statements showed many have struggled in this area to date.
  • Considering how they will go about, or source, scenario analysis for climate risk identification, quantification, monitoring and reporting purposes (e.g. on physical and transitional risk). According to our recent survey of TCFD readiness in the UK, this is a key area where insurers believe they’ll need most help.
  • Reviewing asset holdings against ESG criteria, both from the point of view of their exposure to physical, transition and legal climate risks and from a social responsibility and reputational perspective.
  • Considering different ESG approaches as part of the investment process, from negative screening and corporate engagement to, for example, full ESG integration.
  • Reviewing the investment strategy for transitioning the investment portfolios to net-zero GHG emissions by 2050 for firms subscribing to commitments of the Net-Zero Asset Owner Alliance.
  • Assessing opportunities for stronger stewardship of investments along sustainability lines. Legislators and regulators recognise that insurers can wield considerable influence in their choices of assets.
  • Reviewing governance and control of sustainability issues.
  • Providing training to Board members and senior executives to understand how risks from ESG issues affect business strategy and performance.
  • Identifying public communications needs and a strategy for communicating a firm’s climate and ESG response.
  • Examining how remuneration and rewards policies are aligned with sustainability goals and risks.
  • Reviewing risk hedging and transfer arrangements.

Déja vu

This list may seem like a daunting prospect and, of course, it will bring new challenges. But while the nature of the risks – and opportunities - involved with climate and sustainability may be different, European insurers have faced a comparable challenge before, and in the not too distant past, in the form of Solvency II. They can use that experience to their advantage, bearing in mind that SFDR also comes with similar issues around proportionality.

Starting with gap analysis and taking a top down, bottom up risk management approach on climate and sustainability, as was typical of Solvency II preparations, is, we believe, a way for insurers to get where they will need to be. A few examples will illustrate what we mean.

Using the climate change scenarios developed by the IPCC (Inter-governmental Panel on Climate Change), companies can start to identify the physical, transition and liability risks to which they may be exposed – be they operational (as in weather threats to premises, for example, or in underwriting), reputational (perhaps from insuring certain industries) or investment-related (e.g. threats to infrastructure and climate-driven equity movements) – and enter and monitor them in their risk registers as they would have done for factors arising from Solvency II requirements.

Workshops and stress testing can again play a key role, not only in assessing the materiality of, and applying appropriate proportionality to, the risks identified from scenario analysis but also in evaluating opportunities.

In the investment space, Solvency II entailed reviewing asset holdings against a revised view of liabilities, asset/liability matching and pre-determined credit spreads. Sustainability legislation will involve doing the same through an ESG lens.

Then, consider EIOPA’s consultation on the specific inclusion of climate risks in the Solvency II ORSA. This simply extends the focus on embedding risk management that is intrinsic to the ORSA. The board level training to instil understanding of risks and the strategy reviews and development that were part of most insurers’ Solvency II preparations will therefore be valuable here too.

The need for proactivity

In these early days for insurance-focused climate and sustainability regulatory requirements across Europe, insurers that make the effort now to better understand the risks and plan for changes to their mid- to long- term strategies should be less likely to have to play catch up with the rapidly evolving regulatory environment. And rather than reinventing the wheel, the methodologies and processes used to implement Solvency II can be a useful starting point and way to progress.


Footnotes

1 European Banking Authority (EBA), European Insurance and Occupational Pensions Authority (EIOPA), Euopean Securities and Markets Authority (ESMA), European Supervisory Authorities (ESA)

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