London Market Monitor – 31 August 2022
Our August review of the markets and Solvency II discount rates.
Several years ago, regulators in many countries made it clear to insurers that they would need to incorporate climate change into their risk management and reporting. Even in locations where it is not yet required, many firms have a desire to begin measuring and mitigating the impacts of climate change on their businesses. However, insurers often find themselves buried in deadlines, driven by regulatory demands to complete reports and meet external requirements. It seems as if there’s no time left to deeply understand the actual impact of climate on risk, let alone craft a coherent response. Climate is a complex topic with significant uncertainty. Its potential impacts are broad, ranging from reputational risk to physical risk. Predicting climate change with any precision taxes the world’s most powerful supercomputers.
And although insurers recognize that it will affect them at some point, there are always more pressing matters to attend to. Unfortunately, while the effects of climate change might last far beyond our lifetimes, the window of action—the time when our decisions make a difference—may be quite short and immediate.
The result is that climate becomes siloed as something separate from everything else, so measuring and managing it adds to the operational burden. Organizations spend significant time and money measuring the risks associated with climate change at the level of individual properties, lives, or assets, as they might with mortality or flood risk. By limiting their thinking to existing data sets and measurement approaches, they often skip over the question of what effects are material to their business. Most unfortunate of all, while trying to meet regulatory deadlines they miss the window of action for real change.
Insurers can avoid this muddle by taking a different approach—a top-down view that starts by identifying what matters before measurement and quantification and plans for action. It starts with a simple question: What is your ambition with respect to climate change? The answer to this question should grow naturally out of your company mission. It is re-expressing that mission in a climate-aware way.
This clear statement informs the company’s risk measurement and mitigation strategies for climate change. Insurers of all kinds need to consider two kinds of missions: those that protect customers and the business from climate-related disruption, and those that might help solve the climate challenge directly. In many instances, it’s possible to do both at once.
For example, a whole-life insurer might have a mission of helping its policyholders live well in retirement. Insurers are quite used to looking at protecting assets from future disruptions, so the logical first step will be to begin incorporating climate change into their financial risk models. That work could also lead them to think more broadly and ask how climate change will affect the well-being of their customers reaching retirement age. This could lead the organization to find ways to make a difference to the course of climate change itself.
This approach leads the organization to quickly identify what is material to its business: those impacts that could prevent policyholders from living well in retirement. The company could quickly prioritize the material impacts and actions into short, medium, and long term.
This example is simplified, but not by much. When you begin with your mission and ambition, it focuses your efforts on the subset of risks that have the largest impact on your business and your stakeholders. By giving them a time horizon, you can prioritize how you respond. You can clearly identify which items to act on immediately and which require deeper planning and conversation. When you have an opportunity to purchase a data set or embark on a modeling project, you can evaluate it based on whether it will tell you anything new about material risks to your company and your customers, rather than just telling you more about climate impacts in general.
As in all things, there is often opportunity in risk as well. As the world shifts to new sources of energy and new ways of living and working, insurers can put their financial resources to work in ways that deliver high returns both for society and their bottom lines. That could mean investing in renewables, designing climate-aware insurance products, or seeking new partnerships inside and outside the industry.
As with any large and complex decision, organizations often find it difficult to come to consensus about how to respond to climate change. Faced with reams of charts and data, arcane expertise, and conflicting opinions, boards and executives may want to push climate-related decisions into the “tomorrow” pile indefinitely.
However, the mission-based approach is achievable through workshops and conversation. We have seen clients break through months of data-driven indecision by flipping the conversation on its head and asking, “Why should we care?” Once this central idea is established, it feeds into an understandable narrative around why the organization is taking certain actions—a set of principles rather than a volume of instructions. It becomes a story capable of inspiring, or at least guiding, the action of every employee.
It’s important not to get too caught up in perfecting the aspirational statement. It can be refined over time as the organization learns more about what aspects of climate change matter to the business and the mission. In this way, it is akin to the “minimum viable product” commonly used in software development.
Getting ideas into the field where they can be used and tested is more important than getting them exactly right. That's because first the window for action is so short in many cases. And second, because it is difficult or impossible to know exactly what level of aspiration is right until the organization tries it out. That’s why it’s best to begin with the most obvious, tangible actions first—the “low-hanging fruit”—to test the hypothesis about the organization’s climate goals.
Obviously, regulators are going to require the facts they need to make intelligent comparisons. There is still data gathering, modeling, and reporting work to be done. But the timeline for climate action should be based on the material risks to the organization, not an arbitrary date set by an industry body. Having a clear sense of mission accelerates delivery of the requisite materials by breaking through the “fog of war” inherent to complex risks.
In determining how to implement the aspiration, you can take a similar, story-based approach to scenario planning. In our workshops with clients, we create simple, two-page scenarios. The first page describes the context, the key actors, and the situation. The back page contains a range of scenarios—what happens if we do A? Or B? Or C? We stick to two pages so that a genuine conversation can take place about the macro-level consequences of various decisions.
Modeling and analytics are extremely valuable. They can uncover risks that no human being could discern in vast masses of data. At the same time, when it comes to climate change, most organizations have enough on their hands to prioritize and act on the most cogent risks. Narrative-based scenario planning gets you further, faster, than other methods. A 70%-good result that takes two weeks is better than a 95%-good result that takes two years, especially when time is of the essence.
One of the problems with regulators adding the risk associated with climate change to the books as a discrete line item is that enterprises then tend to treat it that way. It becomes a separate risk silo, taking its place alongside asset, underwriting, and operational risk. However, climate is less like a discrete risk category and more like a catalyst for other risks. It is more akin to macroeconomic risk—a large, complex, external risk with specific, local effects.
It is much simpler to look at existing enterprise risk management (ERM) categories and evaluate how climate will affect them. Take a climate category such as transition risk, for example—the impact of transitioning to an economy that uses less carbon. Studies have shown that companies with negative environmental externalities face higher costs of capital. This is not a discrete effect of climate change and does not require any climate modeling. It is a matter of reputational risk that affects financial risk.
Physical risk is another example. The potential impact on insured properties or real-estate assets would appear to be a more directly climate-related risk. However, it does not necessarily require the creation of a new department with a new focus on climate. Instead, insurers should be looking at how they can price climate change into their existing models. For example, the Milliman Climate Resilience Initiative and its partners are collaborating to use climate-informed forecasting models to help with this kind of holistic approach.
This approach also avoids the problem of framing the problem based on the available data, which can result in spending a lot of time on problems that are not especially relevant to the business. By nature, when climate is seen as a variable that affects other risks, one has an incentive to innovate the measurement and modeling approach to answer the question, instead of asking only what the data can answer. Measuring material risks directly might be more challenging initially but delivers greater insight and actionability in the end.
We desperately need climate scientists and actuaries to put their heads together and come up with innovative ways to model and mitigate the risks associated with climate change. However, if they are the only ones empowered to do so, the business can’t act fast enough.
We need to get everyone thinking about their role in achieving the organization’s climate goals. That’s another reason the mission and ambition are so powerful: anybody can understand them and connect them to their own role in the business. It doesn’t take an expert to evaluate which investments create externalities that are unfavorable to the mission. A data-science degree is not necessary to participate in a conversation about potential scenarios that might arise regarding the organization’s climate reputation.
Climate change-related risk awareness and resilience shouldn’t be locked up in some corporate ivory tower. To solve a challenge of this magnitude, encourage everyone in the organization to understand and contribute. If they already live the mission, the bridge to mission-driven climate resilience actions should be a short one.
This kind of openness has positive effects not only on the problem of climate change itself, but on your reputation as a firm that is putting its best foot forward. Increasingly, partners, customers, and employees both current and prospective demand climate transparency from the businesses they deal with. If you are taking clear action based on a coherent, mission-driven story, you will be well-placed to compete in a marketplace that won’t take “someday, somehow” for an answer.