Good evening and thank you very much for inviting me as keynote speaker to this NGFS European Plenary Outreach. In my remarks today, I would like to concentrate on the insurance sector and its role in addressing climate-related risks. I will briefly discuss climate-related risks (in particular physical risks) and their impact on the economy, shed some light on the function of insurers in addressing these risks but also their exposure to them and discuss the role of supervisors, highlighting some of the work conducted by EIOPA. And I will also touch upon the use of climate scenarios, which is the next item on the agenda of this NGFS Plenary Outreach, hopefully setting the stage for a lively discussion with you today.
Let’s start briefly with physical risks. Such risks, be it extreme weather events or gradual long-term shifts in climate patterns, have significant and detrimental effects on the economy. We have seen it in Europe with the wildfires and drought this summer and flooding last year, just to mention a few recent examples. When physical risks materialise, they result in damages to properties and infrastructures; they interrupt business, affect productivity and can disrupt global supply chains. Losses from weather events reduce households’ wealth, consumption and business investments.
Despite the negative consequences of physical risks, you will be surprised to hear that only about 35 per cent of losses related to extreme weather events in Europe is insured. From a macroeconomic perspective, insurance has a key role in mitigating the impact of future extreme climate events by reducing the overall welfare loss, accelerating reconstruction and limiting the period of lower output. This is why the protection gap represents a real problem. So what can be done about physical risks and protection gaps?
Insurers do have a role to play. By underwriting physical risks, insurers contribute to the management of these risks in the economy and society and cover related losses. However, increasing physical risks will likely result in higher underwriting risk and, hence, rising insurance premia and changes in conditions. This raises the issue of affordability for policyholders and it could lead to reputational risks for insurers.
In addition, increasing coverage and insurance penetration might not be sufficient: the frequency and intensity of extreme climate-related events is expected to rise in the years to come. After a catastrophic event, insurance products could become unavailable for this type of event and those originally covering the risk (or being silent about it) are likely to exclude it explicitly. We have here a problem of insurability, which in turns exacerbates the protection gap.
To address affordability and insurability and minimise underwriting risk, adaptation and mitigation measures are crucial. (Re)insurers, as risk managers and underwriters, can contribute to climate adaptation and mitigation, supporting the insurability of climate change-related risks. They can incentivise policyholders to mitigate insured risks via risk-based pricing, contractual terms and underwriting strategy. This is what we call “impact underwriting”.
Let’s turn now to the role of supervisors. Supervisors can promote climate risk prevention and help identify risks and protection gaps. In doing so, they increase awareness of the risks and facilitate risk and protection gap management. Let me give you some examples of how we have done so at EIOPA.
We published a report on impact underwriting, inviting non-life insurers to include, in line with sound actuarial risk-based principles, climate risk considerations in their underwriting strategy and encourage consumers to minimise losses through appropriate product design.
The supervisory community can also increase consumer awareness through conduct supervision. We have talked about the protection gap. However, this is not the only gap. There is also an expectation gap, when policyholders expect a certain loss to be covered by their policy but this is actually excluded from it. EIOPA issued a consultation paper on a supervisory statement on exclusions of risks from systemic events, including natural catastrophes. To avoid the expectation gap insurers should communicate clearly with potential policyholders.
Besides promoting prevention, a key task for supervisors is the identification and management of risks and gaps. At EIOPA, we have been working on a dashboard of insurance protection gaps for natural catastrophes in the EU. We found that the protection gap varies significantly across Member States, with some being vulnerable to certain perils and at the same time recording limited insurance coverage. We are confident that the dashboard will increase awareness about the protection gap and support the implementation of pro-active prevention measures.
While the insurance sector can play a useful role in climate risk management through impact underwriting, it is also affected by climate change. With increasing climate-related hazards, the insurance sector balance sheet is exposed on the liability side via property, content and business interruption insurance contracts. Physical and transition risks impact on insurers’ balance sheet also on the asset side (just think about assets affected by natural catastrophes or investment in fossil fuels).
I would like to mention a relevant, yet worrying, finding of our report on European insurers’ exposure to physical risk: more than 50% of the insurers in the sample we assessed has not undertaken any climate change analyses and a substantial share of insurers only conducted high-level studies, which are lacking the needed depth and data granularity. This is a problem as the sector is affected by climate-related risk and its capacity to offer protection relies on its understanding of the consequences of climate events.
A good way for insurers to analyse the impact of climate change is to integrate climate change scenarios in their Own Risk and Solvency Assessment (ORSA). At EIOPA, we published an Opinion and Application Guidance on this. We drew on the NGFS climate scenarios to include concrete examples in the Guidance. We expect insurers to evaluate how climate-related physical and transition risks affect them in the short and long term. Only material risks should be tested against two long-term scenarios and we allow for some flexibility, notably on the update of the scenarios. Inclusion in ORSA, which is usually validated by the company’s board, should ensure that climate risks are considered in executive decision-making.
From the consultation we run on the application Guidance, we know that scenarios analysis raises challenges for insurers, notably the time horizon and data availability and quality. These are challenges common to other parts of the financial sector, including banks. The time horizon of climate change is significantly longer than the one normally employed in the ORSA. The difficulty is to reconcile the very long-term dynamics of climate change with the assessment of the impact on the company's current business model. This calls for a new approach to the analysis of climate change risks.
The quality and availability of data is an issue, but even more so is relevance. With climate risks increasing, estimations become blurred with uncertainty. If, based on unclear historical data, insurers underestimate climate risks, they might offer more attractive products, increasing their market share with possible systemic implications.
Climate scenarios are also very useful in climate stress testing to identify the channels through which risks affect the economy and spill over to the financial sector. The NGFS scenarios are an excellent tool to analyse the macroeconomic consequences of climate-related physical and transition risks in the long term. EIOPA, as part of the ECB-ESRB Project Team on climate risk monitoring, drew on NGFS-based scenarios to analyse the possible impact of climate change and insurance-specific losses.
However, we know that work remains to be done to ensure implementability of climate scenarios. Long-term scenarios allow for the inclusion of transition policies aimed at achieving the Paris Agreement but also present some limitations. They tend to smooth out shorter-term fluctuations and can underestimate acute physical risks. Short-term scenarios can complement long-term ones and address some of the challenges. We should not forget that the impact of climate events is already visible today (think about the current drought), so long-term scenarios can already be “real” in the short-term.
Besides, implementability requires the translation of key climate variables into variables that are relevant for the sector. However, the financial sector and the supervisory community are generally not climate scientists. For instance, insurers need to translate climate-induced changes in precipitation into changes in losses, which in turn are needed for pricing, reserving and business strategies. To do so, they usually rely on professional model vendors. Hence, going forward, it is important to link insurers with the modelling community.
Let me now conclude. We have seen that climate risks are increasingly affecting the economy, which often suffers from an insurance protection gap. Insurers, as risk managers and underwriters, can help mitigate climate risks and support insurability and affordability through appropriate product design but are also exposed to climate change. On our part, we supervisors can promote prevention, protect consumers and help identify and assess risks and gaps. Climate scenarios are an important tool to analyse the impact of climate change on the financial sector but challenges with implementation remain. This is why we are here today. I trust that my remarks gave you some food for thought for the remaining part of this NGFS Plenary. I wish you a fruitful discussion and I am happy to take questions.