EIOPA’s consultation paper on the formal integration of sustainability risks into both Solvency II and the Insurance Distribution Directive (IDD) details a number of proposed changes to regulation which may lead to challenges for insurers. The consultation closed to responses on 30 January 2019 and technical advice to the European Commission is expected by the end of April.
Of particular interest are the following three changes which have been proposed to the Solvency II Delegated Regulation:
1. The risk management function would explicitly be required to have a role in identifying and assessing sustainability risks.
2. The actuarial function opinion on the underwriting policy would need to address sustainability risks.
3. Sustainability risks would be integrated into the requirements governing investments under the ‘prudent person principle.’
This latest consultation is part of the wider package of measures on sustainable finance which the European Commission adopted in May 2018. EIOPA has also issued a call for evidence to collect information from insurers regarding the integration of sustainability risks in the assessment of assets and liabilities. EIOPA will prepare its draft opinion to the European Commission on sustainability within Solvency II for consultation during the second half of 2019.
The Commission’s request for advice from EIOPA includes various wider Solvency II aspects. For example, the opinion should also highlight where the calibration of the standard parameters in the market risk module of the standard formula do not sufficiently account for sustainability factors, with particular regard to the climate risk that insurers are exposed to via their investments and how it should be addressed.
What is meant by sustainability risk?
While there is no universal definition of sustainability risk for insurers, we see this risk as having two key aspects:
1. It is the specific risk (mainly to non-life insurers) of additional claims brought about by increased incidence of environmental events or natural disasters.
2. It is the more general risk associated with having business models and/or investments that fall outside of the definition of ‘sustainable,’ and that are therefore threatened by events, market forces and new regulation that arise as a result of a general shift towards sustainable investments and business models.
Sustainable investments can be defined as investments in an economic activity that contribute to an environmental, social or governance (ESG) objective1. Sustainability risks stem from these ESG factors and could affect both the investments and the liabilities of insurers.
The European Commission adopted a package of measures on sustainable finance in May 2018 including proposals aimed at establishing a unified EU classification system of sustainable economic activities. Further work at the European Commission level on this taxonomy is ongoing. Further details can also be found in the Commission’s proposal for a regulation on the establishment of a framework to facilitate sustainable investment.
EIOPA’s call for evidence2 includes the following additional background regarding sustainability risks:
‘Sustainability risks are operationalised via the concepts of environmental, social and governance risks.’
It further defines ESG factors as follows:
‘Environmental: factors that contribute to an environmental objective. Such objectives include climate change mitigation, climate change adaptation, sustainable use and protection of water and marine resources, transition to a circular economy, waste prevention and recycling, pollution prevention and control and protection of healthy ecosystems.
Social: factors that contribute to a social objective, and in particular to tackling inequality, an investment fostering social cohesion, social integration and labour relations, or an investment in human capital or economically or socially disadvantaged communities;
Governance: factors that contribute to good governance practices, and in particular companies with sound management structures, employee relations, remuneration of relevant staff and tax compliance.’
Challenges and opportunities for insurers
Explicitly integrating the above factors into the risk management framework may present a number of challenges for insurers. Under the current proposals, the risk management function will now need to address sustainability risks. A materiality assessment of sustainability may be required to enable companies to obtain clarity around their exposure. Risk management functions may need to develop sustainability risk limits and oversee their implementation.
The actuarial functions of non-life insurers will already be very aware of the challenges in quantifying and mitigating natural catastrophe risk, in particular given the impact of weather events on claims and hence profitability of products. Indeed, EIOPA is currently seeking experts to join a Network on Catastrophe Risks to strengthen and complement EIOPA’s expertise in this area. Under the current proposals, the risk and actuarial functions will be required to comment on these risks, which will be a challenge given the uncertainty in this area, particularly for companies that are still in the early stages of analysing these risks.
While the impact may be more subtle for life insurers, the actuarial function will need to consider the extent of comment that is appropriate on the potential impact of sustainability risk in its underwriting opinion—for example, where income from charges is based on asset values with exposure to sustainability risk, such as certain property or high-carbon investments (e.g., fossil fuel companies). From a risk perspective, sustainability risks on investments may appear to be covered by property, spread and equity risk capital requirements, for instance. However, the underlying drivers may be quite different to those of a property crash, for example, and so may well warrant separate analysis in order to aid understanding of how these risks may develop and emerge over time.
Companies’ investment policies will need to be updated to include specific references to ESG factors under the current proposals and further work may be required to ensure adherence to such policy changes.
Equally, the rise in prominence of sustainability considerations may offer opportunities for insurers. For example, there may be opportunities to launch specific products aimed at climate change; there may be opportunities to capitalise on regulatory incentives to invest in sustainable investments; or there may be opportunities to diversify investments by taking advantage of new investment opportunities around environmental initiatives, green energy and so on.
The proposed changes to the IDD include the addition of customers’ ESG preferences to the target market identification and product approval process. Such changes to the IDD could therefore lead to changes in product offerings and customer choices regarding investment funds.
Regardless of where the wider Solvency II review ends up, what is clear from this latest consultation paper is that EIOPA has an expectation that all insurers (both life and non-life) should already be considering sustainability risks given the requirement to cover all risks, both as part of the existing risk management framework and the Own Risk and Solvency Assessment (ORSA). Training and diversity of skill sets (including in areas such as ecology) are also referenced as potential measures companies may need to consider.
This is an area we expect to hear a lot more about—if not from a financial risk, investments and capital perspective, then potentially from a reputational risk perspective as transparency and environmental considerations become more and more topical.
1This is a paraphrase of the European Commission’s definition here: https://ec.europa.eu/info/law/better-regulation/initiative/1185/publication/238004/attachment/090166e5baea374d_en.
2EIOPA news release, op cit.