Few industries are quite so occupied with the risks of climate change as the insurance industry. And there is a good reason for that: the financial risks of climate change can be a huge burden for insurers on both sides of the balance sheet.

In the previous century, when insurers considered climate risks it was usually enough to calculate the probability and potential amount of claims for earthquakes, storms, wildfires, flooding and droughts and formulate their insurance policies to reflect this. Physical risks (see info box “Types of sustainability risks”) manifested themselves in the form of environmental damage to the houses of policyholders, for instance, which the insurers paid for. This placed a burden on the liabilities side of the balance sheet, and of course still does today.

There is now also an increased focus on insurers’ investments, which are on the asset side of the balance sheet. This rising level of interest is in part due to the fact that insurance corporations are increasingly gearing their investment portfolios towards ESG (environmental, social and governance) criteria (see issue 2/2019 of BaFinPerspectives). And investments are not spared from physical risks either. This can be illustrated by real estate: if an insurer’s investment property is damaged by flooding, this could have a negative impact on the insurer’s rental income from the property – without even considering the write-down of the property value. It is also possible that the flooding might affect not the insurer’s property but instead a property owned by a real estate company in which the insurer holds shares.

Unlike physical risks, transition risks do not have a physical impact on an object; they would instead manifest themselves, in the case of real estate, as a drop in the value of a building or in the building no longer being insurable. Transition risks can pose a particular threat when they are not factored in or priced in. The resulting underestimate or overestimate in the value of an investment leads to inefficient capital allocation.

To mitigate the negative consequences of incorrect pricing and to quantify environmental risks, the Task-Force on Climate-related Financial Disclosures (TCFD, see info box “Task Force on Climate-Related Financial Disclosures”) advises financial companies to use stress tests and scenario analysis to assess and disclose their climate risks (see info box “Climate stress test”). The TCFD recommendations published in June 2017 are now supported by almost 800 industrial companies, financial institutions and organisations from around the world, including BaFin. BaFin is looking closely at the methods available to companies for the quantification of physical and transition risks in their investments.

Climate stress tests among insurers

Climate stress tests put insurers in a position to better identify, assess, monitor, manage and control their environmental risks. They are not yet used across the board. Of the insurers and reinsurers in Germany and institutions for occupational retirement provision (IORPs) that are subject to BaFin’s supervision, around six percent use climate stress tests in their investment risk management, according to an industry survey conducted last year (see July 2018 edition of the BaFinJournal – only available in German).

In this risk-conscious industry, the ability to assess the sustainability risks associated with investments is vital. In recent years, insurers have increasingly been integrating ESG criteria into their systems of governance and – as part of this – have been seeking ways of measuring their environmental risks. Climate stress tests are one way of doing this.

As the insurers are responsible for their own risk management, they are obliged to examine whether the insurer-specific stress tests appropriately model the key sustainability risks. They need to independently improve methods and tools to ensure that these can model the sustainability risks in the long term (see May 2018 edition of the BaFinJournal – only available in German). Many insurers use analysis tools from external providers or combine their own tools with external ones. However, the market for ESG analysis comprises not only commercial providers but also non-governmental organisations, research institutions and authorities.

Impact of the assumptions

A stress test is a very company-specific matter, and the decisions a company makes are highly individual. Not only the choice of method but also the choice of the underlying assumptions is significant. These assumptions include, for example, the time horizon for the stress test. The data used, the choice of scenarios and the identification of relevant risk drivers have a considerable effect on the results. The assumptions reflect the risk profile of the company and the choices it makes regarding which risks to confront in a virtual scenario. The company is not subject to any particularly specific limitations and can take several alternative scenarios into consideration, based on different combinations of assumptions. From this it obtains a variety of different quantitative results that it then needs to interpret qualitatively in order to derive recommendations for action from them.

Insurers’ experiences

Given the increasing importance of climate stress tests and scenario analysis, BaFin contacted insurers and IORPs and, during on-site supervisory interviews, obtained an understanding of the importance of stress tests and scenario analysis in insurers’ investments. Some employees of insurers that are already working on climate stress tests reported a generally positive correlation between sustainability and long-term returns. However, this is somewhat offset by the high costs of ESG integration, for instance due to the use of external data. The industry also considers the lack of harmonisation in sustainability analysis to be a problem: because there are not yet any regulatory rules, the different providers arrive at different conclusions with the methods and approaches they use. The same is true for the approaches that the insurers have developed themselves.

BaFin has found that insurers are working hard on dealing not only with sustainability in general but also with the measurement of climate risk in particular. As it is a complex issue and the insurers use different assumptions, there are also differences in their experience. BaFin will continue its work regarding climate stress tests and carry on its dialogue with the industry. Its Guidance Notice on Dealing with Sustainability Risks has a separate chapter on stress tests. This guidance notice is currently under consultation (see announcement “Nachhaltigkeitsrisiken” (Sustainability Risks) – only available in German).