Solvency II: Leading the way in managing sustainability risk

Contribution to the Eurofi Magazine - February 2022

Sustainability risks are of growing relevance for the investment and underwriting activities of insurers, as they can materialize, for example, through investment losses related to stranded assets, increased insured losses or reputational risks. In order to tackle climate change, insurers have set up important initiatives regarding their investment and underwriting activities, for example the Net-Zero Asset Owner Alliance and the Net-Zero Insurance Alliance, both focusing on the decarbonisation of economies to limit global warming. 

EIOPA’s work on sustainable finance reflects the important role of insurers as long-term investors and risk managers of a wide range of society’s risks, ensuring that the prudential framework reflects sustainability risks in the areas of solvency, consumer protection and financial stability in an adequate and risk-based manner.

As a risk-based forward looking framework Solvency II is capable of managing climate risks alongside the other risks faced by insurers. The tools used to measure and mitigate risks can for the most part also be applied to climate risks. For example, in 2021, the Solvency II framework has been adopted to include the prudential treatment of sustainability risks. The adopted amending regulations require the integration of sustainability risks in the risk management and governance of (re)insurance undertakings. Sustainability risks will need to be reflected in the investment and underwriting strategies of insurers and be monitored by the risk management as well as the actuarial function. As part of the prudent person principle, insurers will also need to take into account the potential long-term impact of their investment strategy and decisions on sustainability factors.

As sustainability risks, and climate change in particular, materialize in the insurers’ investment and underwriting activities, further steps towards a more sustainability-related framework need to be taken. EIOPA welcomes the two additional mandates on sustainability risks proposed by the European Commission as part of the review of the Solvency II Directive. 

The first mandate requires EIOPA to explore by 2023 the potential for risk differentials related to assets or activities associated substantially with environmental and social objectives or harm to such objectives. The existence and quantification of sustainability-related risk differentials is part of an ongoing debate and has attracted a lot of interest among politicians, supervisors, industry experts, NGOs and academics. The continuous improvements in the sustainability-related data disclosures by firms, for example through the Non-Financial Reporting Directive in the EU, widespread carbon-pricing schemes like the EU’s Emissions Trading System (EU ETS) and the increasing awareness of societies, firms and investors about sustainability risks, provide an increasing potential for climate-related risk differentials to become quantifiable. EIOPA will focus its analysis on specific asset classes that are substantially relevant for insurers’ investment decisions and, based on available data, findings and exchanges with the other ESAs, conclude whether a dedicated prudential treatment in Solvency II is justified. Given the expected increase in physical risk exposures due to climate change, EIOPA will also explore the potential for a dedicated prudential treatment of insurers’ underwriting exposures related to climate change adaptation.

The second proposed mandate requires EIOPA to regularly re-assess the appropriateness of the scope and the calibration of parameters of the standard formula with regard to natural catastrophe risk, and if necessary, provide an opinion on potential changes to the prudential framework. Given the continuous and evolving impact of climate change on the frequency and intensity of natural catastrophes, a regular re-assessment of the capital requirements for natural catastrophe risk is an important step to integrate the latest considerations on climate change with regard to perils and countries affected, and thereby to ensure the solvency of the insurance sector against rising physical risk exposures.

Moreover, EIOPA published in 2021 an opinion to include climate scenario analysis in the ORSA. It is essential to assess climate risks both in the short term, and also in the long-term using forward-looking scenario analysis to inform strategic planning and business strategy adequately. Recently proposed amendments to the Solvency II Directive by the European Commission reflect these considerations and as a next step, EIOPA will publish application guidance to facilitate the implementation of materiality assessments and climate change scenarios in the ORSA.

The Solvency II framework has made a lot of important progress to address sustainability risks. However, as sustainability risks continue to materialize in different ways, it is essential that Solvency II also continues to evolve to ensure that future sustainability risks challenges are appropriately captured.

Thanks to Fabian Regele for his contribution to this article.