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UK regulator to hold senior managers to account for financial risks associated with climate change

Financial, Executive and Professional Risks (FINEX)
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By Francis Kean | July 19, 2019

The UK Prudential Regulatory Authority’s (PRA) supervisory statement (SS3/19) published in April 2019 lies at the meeting point of two seismic forces affecting director liability today: climate change and the drive towards personal accountability at board level.

Building on the Senior Managers Regime, and with a focus on managing financial risks from climate change, SSE3/19 requires banks and insurance companies by 15 October 2019 to have in place (among other things) updated senior management function (SMF) forms addressing this issue.

Background

As the PRA explains in the introduction to SS3/19, its review of the ways in which banks and insurance companies have approached climate change shows that “few firms are taking a strategic approach that considers how actions today affect future financial risks.” To put that right it states that it “expects firms to have clear roles and responsibilities for the board and its relevant sub-committees in managing the risk from climate change.”

A cornerstone of the Senior Managers Regime is the requirement on firms to submit appropriate Responsibility Statements. Up to 27 controlled functions covering every significant aspect of a firm’s operations must be allocated under the Regime to individual senior managers who must accept personal responsibility for one or more of them. From October 2019, climate change will be added to this list.

As SSE3/19 states: “…the board and the highest level of executive management should identify and allocate responsibility for identifying and managing financial risks from climate change to the relevant existing Senior Management Function(s) (SMF(s)) most appropriate within the firm’s organisational structure, enhancing banks’ and insurers’ approaches to managing the financial risks from climate change.”

It is up to each firm to decide which senior manager must assume this responsibility but an obvious question which this begs is whether banks and insurers necessarily have the right expertise to draw upon to achieve the desired objective. (In this respect, the issue is not dissimilar to the board skills gap firms are seeking to close with respect to cyber risk).

The devil is in the detail

SSE3/19 follows a well-trodden road in drawing a distinction between the physical and the transition risks associated with climate change. Into the first category fall the effects of extreme weather events as well as longer term shifts in the climate. In the latter are the risks associated with adjustment to climate change such as changes in policy and regulation, shifting sentiment and disruptive technology. Examples of the latter which are cited include:

  • Tightening energy efficiency standards for domestic and commercial buildings impacting the risk in banks’ buy-to-let lending portfolios
  • rapid technological change, such as the development of electric vehicles or renewable energy technology, affecting the value of financial assets in the automotive and energy sector
  • companies in the wider economy that fail to mitigate, adapt, or disclose the financial risks from climate change being exposed to climate-related litigation, which could impact their market value or lead to higher claims for insurers that provide liability cover to those companies.”

Both the virtue and the challenge with examples such as these are their all-encompassing nature. SSE3/19 is only 11 pages long. It contains no information or guidelines as to how firms are supposed to approach these complex issues at a strategic level and no doubt the PRA does not see this as its responsibility.

The threat of personal liability

The PRA has, however, carried out a more detailed analysis of the specific impact of climate change on the UK insurance sector. This was published in September 2015. It includes a section devoted to liability risks including directors and officers which contains some interesting findings in this context:

  • “Potential causes of action against directors and officers may include, for example, shareholder derivative actions for breach of statutory or fiduciary duties or seeking compensation for a loss of corporate value attributable to a failure to mitigate or adapt. Claims may also be based on a failure to disclose (or misleading disclosure) in relation to the risks associated with climate change, particularly as the requirements for related disclosure and reporting become more stringent.”
  • “…it would seem increasingly difficult to argue that impacts on corporate value arising from a failure to manage risks associated with climate change are not reasonably foreseeable – on the basis of prevailing scientific and economic evidence…..”
  • “…‘failure to adapt’ claims could be distinguishable from those arising from the corporate collapses relating to the global financial crisis, which were often viewed as ‘sudden’ and broadly ‘unforeseen’. Rather, such claims may be more closely analogous to other cases of alleged failure to manage structural or systemic transition risks.”

This makes salutary reading not simply for the D&0 insurers at whom it was originally aimed but also for board members in general and in particular for those who are contemplating the assumption of additional responsibilities in light of SS3/19.

Conclusion

Although there has been some climate related litigation to date both against companies and directors, this has so far been slower to take off and less successful than some predicted. It would be dangerous and wrong though to conclude that litigation risk is limited and/or restricted to obvious sectors such as energy. SS3/19 is an example of regulatory focus specifically on the financial risks relating to climate change for banks and insurers.

As the Bank of England warned in its 2015 analysis:

Liability risks may take a long time to crystallise compared to catastrophe claims as it can take years to establish whether the insured party was at fault and to determine the true amount of loss that has arisen as a result. The true cost of liability claims can often be uncertain and complex to determine. This is compounded by the fact that claims are commonly settled out of court – often for the sum insured.”

To put this in context, the same report reminds us that whereas catastrophe losses from Superstorm Sandy (2012) in the US were estimated at US$20-25 billion, asbestos related liability suits are estimated to have cost the insurance industry some US$85 billion.

Author

Francis Kean
Executive Director, FINEX Global Practice

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