The transition from a high to low-carbon economy should present (re)insurers with a broad range of underwriting opportunities and challenges. (Re)insurers, in their role as institutional investors, can help mobilise funds to support the development and scalability of new technologies needed to accelerate decarbonisation Increasingly, given the accelerating pace of change in global operating environments, insurers that fail to embrace innovation may find it difficult to sustain long-term success and ultimately be subject to anti-selection and loss of relevance.
Ambitious plans to reduce carbon emissions, protect communities and natural habitats, and mobilise finance, agreed to by world leaders at the United Nations COP26 meeting, are likely to impact the (re)insurance industry, creating a range of opportunities and challenges.
The (re)insurance industry will need to be engaged as governments around the world look to implement legislative, regulatory, and practical measures designed to head-off potential future extreme climate scenarios.
In recent years, demand for increased disclosure on climate-related risks, including for (re)insurers, has been growing as investors, regulators, and lawmakers have acknowledged that these risks can be financially material and a potential threat to financial stability. A number of central banks and regulators, particularly in Europe, have imposed disclosure requirements to identify, monitor, and manage climate-related risks, along with broader environmental, social and governance (ESG) risks.
The UK Government confirmed in late October 2021 that the largest UK-registered companies and financial institutions will have to disclose climate-related financial data (via disclosures aligned with the Task Force on Climate-related Financial Disclosures) as early as April 2022. AM Best believes that additional clarity around disclosure requirements will allow for uniformity which is currently lacking.
Climate risk innovation – a source of underwriting opportunities for insurers
As risk carriers and managers, asset managers, and institutional investors, (re)insurers are in a position to make a unique contribution to the climate risk innovation that governments around the world are looking to encourage.
AM Best surveys on ESG attitudes found widespread recognition among life and property/casualty (re)insurers in Europe, Asia Pacific and the United States that the (re)insurance industry has a pivotal role to play in the ESG arena.
As the world transitions to a low carbon economy, the changing operating landscape is expected to impact both sides of (re)insurers’ balance sheets, and could present significant underwriting opportunities for (re)insurers that can embrace the shift and tailor their products accordingly, AM Best believes.
However, AM Best’s 2020 ESG survey found that only 48% of participants in Europe and Asia Pacific reported having identified and capitalised on opportunities in the ESG space, such as developing new products that incorporate social and environmental values. A similar survey conducted in the USA in 2021, revealed the number was even lower.
Nonetheless, AM Best expects (re)insurers to become increasingly innovative as they evolve to cater to the changing needs of societies. In this context, it is expected that existing insurance solutions and products will evolve, and new ones will emerge that address the evolving risk universe.
To name only a few, Lloyd’s has announced it will expand its insurance coverage to better support the “greener energy sector” and create new insurance products for electric vehicles. Zurich has expanded its commitment to underwrite renewable energy, whilst other large (re)insurers continue to develop their parametric offering. Although these initiatives are initially expected to be small relative to total business written, they may become more material over the medium- to long-term.
The article is reproduced from a Best’s Special Report with the kind permission of ICMIF Supporting Member AM Best. To access a copy of the full report, please click here.
Published January 2022
While underwriting opportunities exist, as with any new insurable risk, these will present underwriters with pricing challenges given their complex nature and lack of historical data. This risk of mispricing may be mitigated through the use of policy exclusions and limits. For example, as demand for renewable energy like solar increases, pricing needs to take into consideration the lack of data and assessment of damage ratios, as recent hailstorm damage of a solar windpark in Texas indicates.
Strengthening the resilience of policyholders through enhanced loss prevention, adaptation, and efficient claims payments are key areas where insurers can be most effective in supporting the ambitions of COP26. Even absent the discussions at COP26, innovation has been prominent in risk assessment and measurement. For example, some companies are now using drones in their underwriting and claims activities (particularly in the aftermath of a natural disaster).
Other examples of insurers’ innovation in their core role as risk managers, and which mutually benefit them and their clients, have included the enhanced modelling of climate risks, the use of more sophisticated early warning systems (in connection with natural catastrophe events), or the retrofitting of buildings to make them more resilient (such as to floods, for example).
In product design and distribution, AM Best is seeing increasing interest in parametric covers which are relatively easy to understand, reduce dispute risk and enable speedy indemnification of impacted communities. This is viewed as a particularly appealing solution to contribute to the development of micro-insurance (seen by many as another opportunity for the industry), and help to reduce the protection gap by providing affordable insurance solutions to underserved populations which are expected to be the most impacted by climate risk.
Long-term investment required to innovate
Significant investment in new technology and more innovation is needed if countries are to speed up their decarbonisation efforts, including better ways to store energy, cool and heat homes, and power vehicles. According to the International Energy Agency, half the low-carbon technologies the world needs to reach net zero by 2050 and limit warming to 1.5 degrees are still in the early development or prototype stages.
In their role as institutional investors, (re)insurers support the development and scalability of new technologies. AM Best has noted that (re)insurers are already playing an important role in the development of sustainable finance, notably through investment strategies for their large global asset portfolios, which may take the form of investing in assets like solar and wind parks.
Such investment allocations to green and sustainability-related projects may be a source of diversification for portfolios and prove a suitable match from a cash-flow point of view, notably enabling (re)insurers to cover their long-dated liabilities.
AM Best notes however that greener does not necessarily mean better, in terms of performance or credit quality. As such, to manage the potentially higher investment risk a number of (re)insurers choose to integrate ESG factors holistically within the investment portfolio rather than giving them complete priority over investment objectives.
Green bonds can also be a source of financing for (re)insurers, as demonstrated by the increase in green and sustainability-linked issuances in the (re)insurance sector in recent years. AM Best expects a growing number of (re)insurers to find a way, through ESG integration, to remain attractive to a wide and diversified pool of investors, which, in turn, should contribute to enhancing their financial flexibility.
The transition conundrum
Two of the key messages from COP26 have been the reiteration that any transition to a net zero economy will take time, and that it needs to be managed assiduously. Both of these messages present real challenges for the (re)insurance segment.
Campaigners have criticised some (re)insurers for what they claim is a lack of commitment to the net-zero agenda. It may be that a “slow and considered” response by a (re)insurer could be perceived in certain quarters as inaction, with a consequent risk to its reputation.
On the other hand, innovations that will enable the transition to a low carbon economy will likely require time before the benefits they bring are felt on a widespread basis. This means that some sectors that are transitioning will still need insurance cover in the meantime, despite not having the strongest ESG credentials. Some have been critical of the (re)insurance industry’s unwillingness to provide cover to certain risks, as these risks may remain uninsured.
As the risk universe and the (re)insurance solution required will not change overnight, (re)insurers may want to prepare for the future and be in a position to adapt their offer as new risks emerge and policyholders’ needs change. In this changing landscape, some sectors (like the coal industry) may find it increasingly difficult to find appropriate, sufficient or affordable insurance solutions as capacity is withdrawn as a result of the transition.
Shortage of insurance capacity could fuel business opportunities in the captive insurance space. At the same time, AM Best notes that the cost of cover could also fall back on taxpayers if sufficient capacity is unavailable and governments have to step in. This could prove problematic for lawmakers who have made pledges regarding the transition to a low-carbon economy and also to meet increasingly ambitious climate targets.
The Glasgow Climate Pact, which was signed by nearly 200 countries, suggests a growing momentum from governments globally to reduce emissions and manage the transition to a low carbon economy. In this context, AM Best believes that (re)insurers that embrace innovation are likely to be better positioned to grasp opportunities arising as the world transitions.
ESG and innovation factors in Best’s Credit Rating Methodology
Both ESG and Innovation are elements considered in AM Best’s Best’s Credit Rating Methodology (BCRM).
ESG
BCRM details how ESG factors, when material and relevant, can impact the creditworthiness of an insurer through each of the building blocks used in AM Best’s analysis – balance sheet strength, operating performance, business profile and enterprise risk management.
Some ESG risks, such as changing climate trends, are expected to become more pronounced (and therefore more relevant to the financial strength of (re)insurers) over the medium- to long-term. AM Best considers that companies that remain unaware of these emerging risks may be negatively affected if they have exposure and are unable to adapt to these over time.
Environmental factors are considered a severe threat to the balance sheet strength and operating performance of some insurers due to the potentially significant, rapid, and unexpected impact of weather-related losses.
In the context of environmental risk, AM Best generally classifies weather-related events (such as hurricanes, cyclones, wildfires, droughts, storms, and floods) as events affected by climate risk. AM Best expects insurers accepting weather-related risks to demonstrate that they can effectively manage them— including the impact of changing climate trends—and have the financial wherewithal to absorb associated potential losses.
For social factors, AM Best focuses primarily on changes in social behaviour and demographics, which offer both challenges and opportunities for insurers. Insurers that are attuned to customer needs, are innovative and have access to data will be more successful in defending their market position.
Alternatively, an insurer’s business profile may be negatively affected following an ESG-related scandal such as a data breach, which has the potential to damage the company’s reputation and brand. Such an incident could have repercussions on the company’s ability to generate new business and retain existing customers.
Governance factors are explicitly considered under the enterprise risk management building block for both financial and non-financial factors. AM Best’s evaluation of an insurer’s risk management framework takes a holistic view of the insurer’s risk management system and its associated strategies, processes, tools, and owners.
Innovation
AM Best also explicitly considers innovation under its business profile assessment.
AM Best’s definition of innovation is broad, as a multi-stage process whereby an organisation transforms ideas into new or significantly improved products, processes, services, or business models that have a measurable positive impact over time and enable the organisation to remain relevant and successful.
AM Best’s evaluation of a company’s innovation level is based on two elements:
- Innovation inputs – the components of a company’s innovation process – which encompasses leadership, culture, resources, and process and structure; and
- Innovation outputs – the impact of the company’s innovation efforts – which considers the results of innovation and its level of transformation.
The degree to which an innovation assessment will influence an AM Best credit rating depends on a variety of factors including the line of business, level of competition, an insurer’s unique strengths or weaknesses.
Details of AM Best’s approach to scoring an insurer’s innovation initiatives and its impact on business profile can be found in its Specialty Criteria Procedure, “Scoring and Assessing Innovation” (March 2020).
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