Solvency in the age of emergency: how should new EU policy and the industry incorporate risk?

21 February 2023 – Both decisionmakers and insurers must together find a way of addressing the climate and ecological risks that complicate adaptation and mitigation strategies. The revision of EU Solvency rules could be a key opportunity to integrate sustainability in risk management of insurers, argue Ursula Woodburn and Nina Seega.

The world’s natural capital is declining at an unprecedented rate in human history as we enter an era of ‘ecological emergency.’ And as the likelihood and impact of extreme weather events increase, accompanying risks are exacerbated, making the decision-making process around adaptation and mitigation increasingly complicated. In light of this, both decisionmakers and insurers must find a way of addressing this evolving landscape.

Globally, there is a growing recognition of the planetary emergency and an increasing awareness within the financial sector, and within the insurance sector more specifically, of the economic risks posed by climate change and nature loss. The Taskforce for Nature-related Financial Disclosures will launch its market-led science-based framework in autumn 2023, which will support companies and financial institutions to integrate nature into decision making. And, for example, the Sustainable Insurance Forum and the Geneva Association have been publishing reports on how to start thinking about nature within the insurance industry. Re/insurers are therefore increasingly committing to promoting a nature-positive economy.

Policy responses need to mitigate the root cause of the increased risks (climate change and nature loss) as well as build resilience and preparedness within society and the global economy. The EU is among the frontrunners regarding climate action and environmental protection and is stepping up its efforts in the sustainable finance field.

The EU’s actions aimed at improving the insurance sector’s resilience to climate and nature-related risks notably include the review of the EU insurance rules. Both the Solvency II review, and the Framework for the recovery and resolution of insurance undertakings stem from the need to rethink and adapt the framework laid down by the Solvency II Directive in 2016 to help the Solvency framework better align with the Green Deal objectives.

“As it stands, the draft report is a missed opportunity in seeking to prepare the insurance industry for a changing climate and a fundamentally different operating environment that climate change will bring.”

The European Parliament is currently considering its position and the file is facing significant delays. The main point of contention remains the lack of ambition on sustainability issues in the draft report. The report considers that a firm’s own risk and solvency assessment will be sufficient to identify, measure and report on forward looking sustainability risks. However, a wide range of amendments have been tabled to address the shortcomings of the draft report regarding the inclusion of sustainability provisions. These notably include the need to align business model and strategy for underwriting portfolio with the objective of achieving climate neutrality in the EU by 2050 at the latest. Discussions further underlined the importance for risk management system to cover sustainability risks to which the insurance or reinsurance undertaking is exposed.

As it stands, the draft report is a missed opportunity in seeking to prepare the insurance industry for a changing climate and a fundamentally different operating environment that climate change will bring.

A recent survey highlighted that half of the re/insurers consider that nature-related risks are material for their underwriting business, but currently risks are not being sufficiently assessed in underwriting due to a lack of information, a lack of understanding and awareness around nature-related risks as well as lack of consistent regulatory guidance.

The revision of EU Solvency rules could therefore be an opportunity to ensure the integration of sustainability factors and risks in risk management of insurers.

Our recent research shows there are four approaches that insurers can adopt to reduce the impact on nature or contribute to its protection and restoration. Firstly, it underlines the importance of incentivising nature-positive behaviours with clients and customers. Insurers have the ability to foster preventative actions and influence the economy through many levers and can thus encourage nature-based solutions. Secondly, the report suggests innovating in asset protection. Insuring natural infrastructure based on these ecosystems’ value, is considered to be another way of promoting nature-positive practices, allowing the industry to be more resilient. Thirdly, it is essential to facilitate capital inflow towards nature-based solutions. Catastrophe bonds and other innovative instruments can be used to attract investments for nature-positive activities. Lastly, the report stresses the importance for insurers to engage with policy by collaborating with governments to foster better adaptation planning and risk management of nature-related risks.

With the re/insurance industry uniquely placed to foster societies’ understanding of nature-related risks, the sector has an opportunity to redefine its role to support risk management and risk mitigation. Clear regulation and supervision would support the industry in doing this. The Solvency II review is an opportunity to guarantee that insurers invest in more sustainable activities and increase their climate-resilience. To start with, the review has now been debated for some time and it would seem counterproductive for the European Parliament to continue to delay matters, a timeline should be agreed as soon as possible.

“With the re/insurance industry uniquely placed to foster societies’ understanding of nature-related risks, the sector has an opportunity to redefine its role to support risk management and risk mitigation. Clear regulation and supervision would support the industry in doing this.”

In addition, current proposals to raise the threshold for firms to be subject to the Directive and classification as ‘low risk’ profile firms could be problematic in achieving net zero alignment. It could result in an increasing use of captives by carbon intensive industries and a segment of the insurance industry focused on carbon intensive industries being excluded from supervision

The Solvency II review should instead deliver on critical issues such as strengthening the right structures for risk assessment and risk management in the industry (e.g. the nomination of a senior executive responsible for climate). It must guarantee sufficient monitoring of smaller insurers and captives for carbon industries (as insurance companies transitioning to captives going green may see a decrease in costs and an improvement in risk management), updates on risk assessment and asset classes to secure resilient and low carbon investments.

The finance sector is now moving on incorporating sustainability and increasingly the nature-based risks aspects across portfolios.  Through transition plans, insurers could align their business model to climate neutrality objectives. This review of EU insurance rules could support the broad roll-out of this across the industry and make certain that it is fit for the green transition and – critically – fit to finance this transition. It is time to provide the tools and guidance that can support insurers in playing a more active role in contributing to sustainable economic activities.