For more than a decade US insurance regulators have required certain insurers to file climate risk disclosure reports. In recent years, financial regulators in Europe have begun climate change scenario testing while still requiring climate risk reporting. US insurance regulators have just voted to utilize scenario testing (at least for an initial three-year trial and for information only) beginning next year. This On the Subject summarizes the current state of play for US insurers with respect to climate reporting and financial risk analysis.

In May 2024, two sets of financial regulators – the Federal Reserve Board (Fed) and the French insurance regulator Autorité de Contrôle Prudentiel et de Résolution (ACPR) – published the results of their climate change scenario analyses or stress tests. The Fed’s pilot climate scenario analysis (CSA) involved six large banks while the ACPR’s second climate stress test covered 15 insurance groups responsible for roughly 90% of France’s market.

Also in May 2024, the New York State Department of Financial Services (NYDFS), which regulates both banks and insurers, assessed 83 regulated entities’ climate financial risk disclosures that were filed in 2022 and their progress in integrating climate risk considerations into their oversight and management in a report.

After comparing these three reports, we fast forward to August 2024 with a brief report on a controversial decision to implement a form of climate change scenario testing by the National Association of Insurance Commissioners (NAIC) that was taken during its recent Summer National Meeting in Chicago.

By way of background, we start this article by providing some international context concerning current and future climate financial risk regulation, particularly disclosure requirements.

In Depth

CLIMATE FINANCIAL RISK DISCLOSURE REPORTING

The Financial Stability Board (FSB) essentially sets policies for global financial systems. The FSB’s membership consists of 23 countries and 13 organizations/regulatory bodies, including the International Association of Insurance Supervisors (IAIS). In 2015, the FSB created the Task Force on Climate-Related Financial Disclosures (TCFD), which developed a climate financial risk framework consisting of four pillars: governance, strategy, risk management, and metrics and targets.

In 2022, the NAIC’s climate disclosure requirements became TCFD-aligned and many other regulators have either adopted or expressed support for the TCFD framework. However, the TCFD has since been disbanded and its oversight and monitoring duties have been taken up by the International Sustainability Standards Board (ISSB), which published its own disclosure standards that are largely consistent with the TCFD framework.

In its final status report published in October 2023, the TCFD summarized the state of climate risk disclosure as follows:

• “The percentage of companies disclosing TCFD-aligned information continues to grow, but more progress is needed. For fiscal year 2022 reporting, 58% of companies disclosed in line with at least five of the eleven recommended disclosures – up from 18% in 2020; however, only 4% of companies disclosed in line with all eleven recommendations.
• The percentage of companies reporting on climate-related risks or opportunities, board oversight, and climate-related targets increased significantly between fiscal years – by 26, 25, and 24 –percentage points, respectively. Between fiscal years 2020 and 2022.
• The majority of jurisdictions with final or proposed climate-related disclosure requirements specify that such disclosures be reported in financial filings or annual reports.
• Over 80% of the largest asset managers and 50% of the largest asset owners reported in line with at least one of the 11 recommended disclosures. Based on a review of publicly available reports, nearly 70% of the top 50 asset managers and 36% of the top 50 asset owners disclosed in line with at least five of the recommended disclosures.”

The FSB will continue its oversight activities with respect to climate risk disclosure throughout this year. Its 2024 workplan includes publication of at least two more reports:

• In July 2024, FSB published its “[s]tocktake of regulatory and supervisory initiatives related to the identification and assessment of nature-related financial risks.” This report summarizes the wide variety of approaches among regulators for assessing financial risk stemming from biodiversity damage and other nature-related risks.
• In November 2024, FSB will “[r]eport on progress in achieving consistent climate-related financial disclosures.”

Between now and the end of 2024 we can also expect to see climate risk policy statements or reviews of disclosure filings by regulated entities and/or scenario exercises/stress tests results from the UK Prudential Regulation Authority and the Bermuda Monetary Authority, among other regulators. US insurers that must file climate disclosure reports have until August 30, 2024, to do so.

NYDFS

NYDFS analyzed responses in each of the four TCFD pillars – governance, strategy, risk management, and metrics and targets during reporting years 2019 to 2021 based on insurer size and market segment (i.e., property and casualty, life, and health). At a high level, “[NY]DFS’s assessment of progress in implementing guidance expectations on a risk-weighted basis reflects that larger insurers have a higher relative impact, and generally have more available resources, than insurers in lower premium ranges. However, viewing the industry solely through a risk-weighted lens could mask the advances or weaknesses of small and medium-sized insurers.” Nevertheless, NYDFS’s report concluded that small- and medium-sized entities may have more concentrated climate risk by product line, geography, or sector.

NYDFS reported that the biggest improvement across property and casualty, life, and health insurers was with governance. “A key factor in that development was that the Department had set an August 15, 2022 implementation timeline for guidance expectations relating to governance,” NYDFS shared on its website.

The latest NYDFS assessment of insurers’ TCFD-aligned climate risk disclosures assigned grades using four broad categories: Yet to Start, Early Stage, Making Progress, or Good Progress. Property and casualty and life insurers all showed steady improvement from 2019 to 2021, however, in the strategy, metrics and targets, and risk management pillars, all insurers fell short of their improvement in the governance pillar. Health insurers lagged in all categories.

While the report ended on a positive note by saying, “[M]ost insurers are integrating consideration of climate risk into their processes to some degree,” it also acknowledged that “insurers still have more work to do to improve their ability to assess, measure and manage climate-related risks.”

SCENARIO TESTING AND THE NETWORK FOR GREENING THE FINANCIAL SYSTEM (NGFS)

In December 2017 eight central banks established the NGFS with the goal of “strengthening the global response required to meet the goals of the Paris agreement and to enhance the role of the financial system to manage risks and to mobilize capital for green and low-carbon investments in the broader context of environmentally sustainable development.” Currently, central bankers vastly outnumber insurance regulators, although multiple bank regulators also regulate insurers, including the Fed and NYDFS. NYDFS is the only member that is also a state insurance regulator, though the Federal Insurance Office and the Fed are also members. The NGFS develops scenarios for use by central banks seeking to support regulated entities in analyzing and understanding the impact of climate change on balance sheets. Several iterations of short- and long-term scenarios have been published, with the most recent set published at the end of 2023. It will be useful to see whether insurance regulators will utilize the NGFS scenarios “as is” without modifying them for use with insurers, regardless of if they are life or non-life insurers.

FEDERAL RESERVE BOARD

The Fed’s website explains that it had two objectives in pursuing its pilot CSA: learning about large banks’ “climate risk-management practices and challenges” and improving large banks’ (and financial regulators’) ability “to identify, estimate, monitor and manage climate-related financial risks.” The CSA report began by noting that “[p]articipating banks took a wide range of approaches in this exercise to consider the possible implications of different physical and transition risk scenarios. The exercise highlighted data gaps and modeling challenges that arise when estimating the financial impacts of highly complex and uncertain risks over various time horizons.”

The CSA report found, among other things, that:

• Participants’ differing business models, risk perceptions, completion of climate change scenario analyses in other jurisdictions, and differing access to data produced divergent approaches.
• Most of the banks turned to familiar credit risk models to judge the impact of physical and transition risks on business portfolios, assuming “that historical relationships between model inputs and outputs continue to hold as the climate and the structure of the economy evolve.”
• Data issues impacted results because there was a lack of reliable and consistent data points (e.g., for “building characteristics, insurance coverage, and counterparties’ plans to manage climate-related risks” (emphasis added).)
• Insurance plays (or should play) a significant role in risk mitigation for all participants in the economy, however, there are uncertainties as to the availability and affordability of insurance, with varying impacts on businesses and individuals.
• Assumptions matter when it comes to the scope and severity of shocks, insurance, and balance sheets.
• Measuring climate-related risks is “highly uncertain and challenging.” This increases the degree of difficulty in incorporating climate-related risks into existing risk management frameworks and produces differing results among participants for the same or similar parts of their business.

The CSA aims to push big banks to determine the biggest impacts on their businesses when it comes to (i) physical risks (e.g., acute (such as hurricanes and wildfires) and chronic (such as rising sea surface temperatures and sea levels) and (ii) so-called transition risks (i.e., the impact of reactions to climate change by key participants in economic activities, including those associated with reducing levels of greenhouse gas emissions).

The Fed selected various scenarios for the exercise to give banks “a range of plausible future outcomes.” The Fed then asked banks to apply these scenarios to residential and commercial real estate portfolios, looking at the impact of physical risks in real time and the impact of transition risks between 2023 and 2032, with the latter comparing results assuming current greenhouse gas reduction policies and the NGFS’s assumptions related to policies that would produce a 2050 net-zero environment.

ACPR

France’s second climate stress testing exercise focused on both life and non-life insurers. Using a “bottom up” approach, the ACPR (with insurer input) initially used recent NGFS scenarios – one near term (2027) and one longer term (2050) compared to a fictitious reference scenario in which neither physical nor transition risk factors were included – to measure balance sheet impacts (on both underwriting and investment results) of the assumed climate risk developments.

The short-term scenario assumed a series of “extreme” events, including convective storms and the breach of a dam because of torrential rains falling on drought-affected soils. It was further assumed that insurers would not mitigate balance sheet impacts (i.e., assuming a “static” balance sheet).

The long-term scenario assumed insurers could – and would – take steps to mitigate balance sheet impacts by raising product prices and taking other actions, such as reducing volumes in certain geographic areas. However, the impact of mitigation steps would differ depending on whether an “orderly” transition occurred (with a temperature increase being held to below 2° C above pre-industrial age levels) or a “disorderly” transition took place.

Regardless of short- vs. long-term scenarios, balance sheet impacts were substantial. On the short-term side, a 25% drop in solvency ratios contributed to a 28% nosedive in equity prices. On the long-term side, the balance sheet deterioration was more severe. French regulators also noted that insurers did not shift investment allocations materially despite “significant” climate exposure in their businesses.

The ACPR concludes with a judgment that climate change scenario testing remains a work in progress and the following statement: “…. regarding the scenarios used, the delayed transition scenario, although being the most disordered of the NGFS scenarios, still remains insufficiently adverse to generate changes in strategy or sufficient awareness, and undoubtedly leads to underestimating the potential impacts of climate change on financial stability.”

Two recent news reports might be relevant to this point. BloombergNEF recently reported that as much as $215 trillion will be needed between now and 2050 to meet the Paris Agreement’s global warming target of not exceeding 2 °C above pre-industrial temperatures. With the capital needs of the energy transition in mind, will other sectors (insurance included) have access to capital in line with historical levels to pay claims arising from catastrophe events and augment capital accounts after doing so? It is not certain whether current NGFS scenarios, particularly the longer-term disorderly transition scenarios, will capture possible climate-related capital market stresses that may impact the insurance industry. This leads us to a recent The Economist report that explained the negative feedback loop that has been created by lengthening fire seasons with more extreme wildfires worsened by climate changes (in turn adding massive amounts of carbon dioxide to the atmosphere). For example, wildfires in Canada in 2023 produced three times as much as the country’s industrial greenhouse gas emissions that year. Do the NGFS scenarios capture this developing dynamic?

Finally, from a societal point of view, assessing the impact of climate change on insurers’ balance sheets falls far short of assessing the impact of climate change on the US economy as a whole. A partial answer as to why this might be the case consists of the various, well-publicized “coverage gaps” regardless of peril (hurricane, flood, quake, wildfire, etc.). If take-up rates for floods in particular continue to hover around the high single digits or low double digits, depending upon the state the impact of climate change-induced flooding will not materially impact insurers. Instead, all insurers will be impacted by financial aid packages and higher taxes. And if more insurers cut back on property coverage in wind-prone coastal areas or in wildfire-prone zip codes, the remaining insurers will face rising costs because of their mandatory participation in state-run Fair Access to Insurance Requirements plans. More drastic regulatory changes could hinder capacity reductions but such actions risk prompting insurer exits from unfriendly state insurance markets. At the same time, as insurers continue to increase pricing in catastrophe-prone locales, take-up rates could fall, even for basic property protection, thus reducing insurer premium revenue. Do NGFS scenarios recognize these insurer-specific possibilities as the world warms?

NAIC: NEW CLIMATE-RELATED FINANCIAL RISK ANALYSIS

Throughout 2024, the NAIC has been considering whether and how to require property and casualty insurers to provide regulators with some indication of how and to what extent climate change scenarios, particularly for windstorms and wildfires, might impact current insurance portfolios. Earlier this month in Chicago the full NAIC membership voted to move ahead with physical risk scenario testing, but the vote was contested, with 12 states voting no and one state abstaining. The proposal that the regulators approved will require property and casualty insurers to use either commercially available “Climate Conditioned Catalogs” developed by modelling vendors or customized factors developed in-house by insurers. They then must choose one of two disclosure scenario options – time-based or frequency-based – to show the potential impact of hurricane and wildfire risks in 2040 and 2050 (assuming no changes in insurers’ portfolios of business, no changes in total insured values, no changes in reinsurance arrangements, and without adjusting for inflation). Reporting will begin in 2025 and conclude in 2027. Regulators said that the disclosures will be used for informational purposes only, not to develop new risk-based capital standards.

MOVING FROM SCENARIO ANALYSIS TO PRESCRIPTIVE CLIMATE CHANGE-RELATED REGULATION

Presumably to forestall criticism from anti-environmental, social, and governance (ESG) proponents, the Fed’s CSA executive summary includes this noteworthy disclaimer:

The Federal Reserve neither prohibits nor discourages financial institutions from providing banking services to customers of any specific class or type, as permitted by law or regulation. The decision regarding whether to make a loan or to open, close, or maintain an account rests with the financial institution, so long as the financial institution complies with applicable laws and regulations.

Climate change activists have long called on banks and insurers to commit to reducing credit and/or insurance protection for various energy industry participants, specifically those involved with the production, transportation, and use of coal. Leaders and legislators in states that produce fossil fuels have reacted negatively to such advocacy and, as a result, during the past several years we have seen (and will likely continue to see) many different types of anti-ESG legislation proposed or adopted in some 20 states around the country.

We have not seen explicit statements from US insurance regulators like the one by the Fed in its CSA report. Indeed, the NAIC’s National Climate Resilience Strategy, adopted in March 2024, stops short of calling on insurers to curtail coverage for energy companies, transportation industry users of fossil fuels, or heavy emitters of greenhouse gases, focusing instead on closing coverage gaps, reducing losses from natural catastrophes, and improving resilience. Additionally, nothing the NAIC said in Chicago during the debate about moving ahead with a limited climate risk scenario analysis suggests that the NAIC is about to grab onto a third rail of US climate change policymaking, despite being urged to do so by climate change activists and lobbyists.