Planning strategically to address risk provides an insurer with sustainability and growth through this evolution of change.
Current and proposed regulations
Current and proposed regulations related to climate risk in the insurance industry have developed significantly. The New York Department of Financial Services (NYDFS) was the first insurance regulator to issue climate risk-related guidance for insurers domiciled in New York state. The NYDFS issued guidance on Nov. 15, 2021, on the climate change impact on financial risk to provide insurers direction for developing a strategic road map to address climate risk. The initial steps of the guidance focus on board governance and putting a strong organizational structure in place. Compliance with the initial steps of the guidance is expected by Aug. 15, 2022, with full implementation required within three to five years.
At its spring meeting on April 8, the National Association of Insurance Commissioners (NAIC) revised its Climate Risk Disclosure Survey (NAIC survey) to adopt a new climate risk disclosure standard that aligns with the Task Force on Climate-Related Financial Disclosures (TCFD) disclosure framework. Insurers with premiums of more than $100 million in 14 states (California, Connecticut, Delaware, Maine, Maryland, Massachusetts, Minnesota, New Mexico, New York, Oregon, Pennsylvania, Rhode Island, Vermont, Washington) and the District of Columbia are required to complete the survey and submit a TCFD-compliant report by Nov. 30, 2022. The new standard is expected to grow to roughly 400 the list of insurance companies that provide TCFD-compliant reports, compared to the 28 TCFD-compliant reports in 2021.
The revised NAIC survey is structured around the four TCFD-focused areas: governance, strategy, risk management, and metrics and targets. Additionally, the NAIC survey includes voluntary closed-ended questions that individual states can choose to include to support the narrative responses to the four TCFD focus areas. As the standards are new for 2022, exceptions regarding NAIC survey content exist for the current reporting year. Insurers that completed a TCFD before the standard adoption can submit as is. Insurers that have not completed a TCFD should complete the NAIC survey to best of their abilities or include information in their TCFD filing. Insurance companies are expected to address the entire TCFD-aligned NAIC survey, with submissions due by Aug. 31, 2023.
During a special session in April 2022, the Connecticut Insurance Department issued a proposed bulletin providing guidance for Connecticut domestic insurers on managing the financial risk related to climate change. The objectives of the bulletin are consistent with developments in the industry, and the bulletin has guidance similar to the NYDFS and NAIC. The bulletin is expected to be implemented similarly to NYDFS guidance – requiring board governance and organizational structure plans by Jan. 1, 2023.
Risk considerations for an insurance company
The new climate guidance calls for insurers to assess risk more holistically, a marked change from the narrower traditional emphasis on underwriting risk. This broader universe includes:
- Asset-liability risk management. What are the physical and transition risks within the company?
- Investment risk. Does the investment policy currently consider investments that are environmentally unsustainable or located in areas prone to physical risks? What are the transition risk drivers that could result in investment losses? Are there opportunities to invest in new energy, and has the investment committee considered the potential impact of such a transition?
- Reinsurance risk. How is climate change going to affect the reinsurance market and, therefore, affect reinsurance risk? As the market hardens, will there be an option for reinsurance coverage? Will reinsurers provide coverage without an active ESG policy in place?
- Operational risk. Is the company located within high-risk geographical areas? Does the company have substantial coverage for business interruption risk related to climate risk?
- Reputational risk. What are the company’s strategic goals related to net-zero carbon emissions? Is the company forecasted to meet the goals?
- Regulatory risk. Is the company in compliance with the regulatory standards? What additional policies and procedures does the company need to implement to meet these standards?
- Governance risk. Does the board and C-suite understand the risk and impact to the organization? Is there a top-down communication to the employees in implementation efforts?
- Third-party risk. How do suppliers and vendors manage risks that could impact the company?
Internal audit considerations
The internal audit function should consider risk organizationally, especially with the increase in proposed and adopted regulatory guidance and because the potential exposure will have significant impact on the areas within the scope of audit. Adopting ESG into the internal audit plan can help provide a strategic road map for growth and sustainability through its implementation. Internal audit should consider initiating, reviewing, tracking, and monitoring ESG-related goals and metrics; collaborating with other departments on policy documents; ensuring accuracy and completeness of ESG reporting; and assessing controls.
Internal audit should be involved throughout the process of a company building its strategic road map for ESG implementation. The board of directors will rely on internal audit to continue to provide verification of testing performed through the planning, implementation, and execution phases of the plan. A sound control environment should be implemented to support the metrics and verify that data used within the disclosures is complete and accurate. Adopting an ESG-related initiative is a significant endeavor for companies, and it is imperative to collaborate with internal audit to appropriately address, test, and mitigate the risk through the process.
External audit considerations
External audit also needs to consider climate change-related risks as they relate to ESG.
Currently, a direct impact on the financial statements for the external audit process does not exist for most insurers. Despite this, insurers need to consider the March 21, 2022, SEC proposed regulation on climate change disclosures, which would appear in registration statements and annual reports as soon as 2023. The proposed rules have implications across an organization, including for boards, management, and internal audit. Independent auditors also will play a key role. As in the past, once the SEC issues guidance for public companies, the Financial Accounting Standards Board (FASB) likely will follow, resulting in disclosures for private companies as well.
Boards of directors should focus on strategic planning as it relates to ESG. An external auditor needs to understand this planning and analyze its impact on the financial statements.
Additionally, no clear path exists for determining materiality related to the impacts of climate change. For insurance companies, this lack of guidance means that management will need to recognize and quantify the risks and the overall impact these risks could have on a company’s surplus. Simply stating that the impact of climate change to the organization’s financial statements is considered immaterial will not suffice moving forward.
Unprepared insurers risk unplanned tax losses on their financial statements. This risk can be managed through tax planning. The overall financial statement risk as it relates to climate change and the strategic plan to mitigate these risks should be communicated and planned with the tax compliance group. Additionally, stakeholders are pressuring companies to consider transparency as well as building social trust in their reporting instead of just complying with the regulations. Investors also look to tax due diligence for ESG purposes. Other countries have started implementing tax transparency reporting requirements, and the European Union published a draft report for social taxonomy suggesting a future classification system using metrics on tax transparency and nonaggressive tax planning. Transparency with tax disclosures is listed as a core component of the ESG reporting metrics in the World Economic Forum’s 2020 White Paper. Additionally, the SEC is evaluating reporting requirements.
Preparing for the future
Dealing with uncertainty related to climate change is not new for insurers. Market shifts in response to new and proposed regulations are expected, but insurers can be better prepared by planning strategically and embracing the changes.