The physical and transition risks associated with climate change can impact the financial system significantly across all the classical risk categories, including credit, market, underwriting, and operational risk, in a highly correlated and systemic manner. As such, globally, financial regulators have been issuing guidelines for insurers to enhance their risk management of climate change in order to build resilience. The guidelines require qualitative and quantitative scenario analyses to ensure insurers understand the impacts on their financial condition and the longer-term relevance of their business model. Given the rapid emergence of regulatory requirements, many firms are working to upskill their companies’ internal capabilities and expedite their progress.
In Canada, the federal financial regulator, OSFI, recently issued guideline B-15 on Climate Risk Management, which will soon require insurers to provide public disclosures on their risk exposure and approach to addressing climate change risk. OSFI will conduct readiness assessments starting in 2023. Additionally, insurers must include a climate change scenario in their annual financial condition testing (FCT). By 2025, insurers will be expected to have evolved the sophistication of their scenario analyses to comply with the guideline.
This should be a consideration for insurers in the design of their climate change scenario analysis roadmap, but where should one start without boiling the ocean?
Sophistication in climate scenario analysis capabilities depends on ambition
Organizations are adopting varied approaches to develop climate change scenarios based not only on financial regulations but also on their ambition level for managing the risk. Advanced ambitions involve using scenario analysis to improve their financial climate-related disclosures, transition risk indicators, portfolio composition, client engagement and to inform climate targets.
Qualitative materiality risk assessment (QRA) is a good starting point
A qualitative risk assessment that establishes structure and taxonomy on climate risks may serve as a starting point. It enables a common language and understanding of the complex landscape of climate risks. It also lays the crucial groundwork in top-level risk identification for further deep-dive areas in quantitative scenario testing.
Quantitative scenario analysis is an appropriate subsequent step
Building out climate scenarios can be challenging due to the inherent uncertainty and the scope of highly correlated impacts which vary significantly across regions and sectors. As such, opting for a simple aggregate stress test with no sector differentiation would not be a meaningful exercise.
Four steps to quantitative scenario analysis
Step 1: Source publicly available scenarios
Firms can choose to use reference scenarios provided by third parties or create custom scenarios tailored to a specific business line. In 2022, the Network for Greening the Financial System (NGFS) scenarios were the most widely used across financial firms and their supervisors, with the high transition risk NGFS scenarios ranking as the most used across all firms.
Step 2: Select the most relevant scenarios
Given the five-year horizon for the FCT, life insurers focus on the NGFS scenario which carries the highest transition risk. For P&C insurers in climate vulnerable areas already facing the immediate physical risks impacts of the climate crisis, an extreme natural disaster surpassing recent climate patterns poses the most adverse scenario. Typically, for climate strategy setting and mitigation testing, longer term horizons between 10-30 years are tested
Step 3: Choose level of granularity (top down or bottom up)
The output of the NGFS climate change scenarios still needs to be translated into impacts to the asset and liability portfolios for each insurer. The level of granularity at which this is done determines the complexity and ultimately how useful the scenarios will be.
Step 4: Impact assessment & Analysis
Once impact results are available, a critical review is required in order to draw meaningful conclusions from the exercise. To this end, insurers should also reflect on the narrative, main assumptions, and limitations of the performed exercise.
This analysis and critical reflection may then be used to feed into public disclosures and regulatory submissions, informing risk strategy and resilience under the scenarios, as well as to highlight key aspects for further development.
Waiting offers no advantage
Scenario analysis tools and data will evolve over the next few years as they are deployed, but this is not a reason to wait. There is still much work needed to guide the application, to interpret the results and take actions where required.
It’s hard to make decisions based on things we have not experienced. As with all uncertainty, scenarios analysis has always been paramount to further understanding the risks and potential opportunities. In this paper, we offer examples of climate-related vulnerabilities and additional insights that insurers should consider to respond to the challenges and opportunities presented by climate change.