Net-Zero Initiatives

As the world grapples with upcoming climate change risks, insurers are steadily facing a multitude of pressures to adopt stronger climate ESG measures. These headwinds are currently coming from investors, industry self-determined norms, and national regulators.

Canadian regulatory pressures

On March 2023, the Canadian Office of the Superintendent of Financial Institutions (OSFI)¹ drafted a guideline ² stating that, “Climate change and the global response to the threats it poses have the potential to significantly impact the safety and soundness of federally regulated financial institutions, and the financial system more broadly”.

OSFI will require banks and large insurance companies to improve their climate-risk disclosures and put plans in place for the transition to a low-carbon economy. Their guidelines go on to suggest tying executive compensation to climate risk management.

While these guidelines are not legally binding, they are expected to be followed by the institutions under OSFI’s supervision. It will be very interesting to see what types of early KPIs boards will be tied to executive compensation with respect to climate risk management, and ultimately how those impact the quality of climate disclosures and the implementation of sound risk management practices.

Investor pressures

Interest from governments and policymakers in Environmental, Social, and Governance (ESG) focused finance, investment, and insurance has grown significantly around the world in recent years.

The Principles for Responsible Investment (PRI)³ , a United Nations group, on behalf of its growing number of signatories representing $120 Trillion AUM, issued a formal report⁴ which affirms that fund managers ought to incorporate ESG issues into their investment analysis and report on how they have implemented these commitments. The report emphasizes that systemic issues, such as climate change, have the potential to fundamentally shift investment rationality for specific sectors, industries, and geographic regions, ultimately leading to negative impacts on economic growth. As a result, the report argues that it is essential for fund managers to incorporate ESG into their investment strategies to ensure wise decision-making that aligns with fiduciary duties.

As finance policy shifts focus towards ESG investments, insurance underwriters looking for risk capital may soon need to align their operations to meet ESG standards to maintain broad access to capital.

What’s more, the increasing frequency and severity of natural disasters, which have doubled every five to seven years since the 1960s , have put added pressure on investors to require that underwriters incorporate ESG considerations into their operations to maintain a profitable underwriting book. As climate change continues to drive more extreme weather patterns, insurance companies will find themselves facing greater financial risk from natural disasters.

Industry self-imposed pressures

The need to transition the insurance industry towards incorporating ESG policies has led to the creation of the United Nations’ Principles for Sustainable Insurance (PSI) group in 2012. This group provides a global framework for the insurance industry to address ESG risks and opportunities. As the largest collaborative initiative between the UN and the insurance industry, PSI has played a crucial role in promoting the integration of ESG principles into the insurance industry.

One of PSI’s most significant initiatives is the Net Zero Insurance Alliance (NZIA), a group of insurers representing approximately 15% of the global premium volume (logo’s in figure below). By setting standards and establishing best practices, they are leading the way towards a sustainable and responsible insurance industry – on industry terms.

On January 17, 2023, the NZIA took a crucial step towards a net-zero insurance economy by formalizing a protocol that requires its members to publicly disclose their underwriting portfolio decarbonization targets by mid-2023. This move is a significant step towards greater transparency and accountability in the insurance industry, and it shows the industry’s commitment to reducing its carbon footprint.

Of note, NZIA affiliated insurers are now committing to reporting emissions associated with their underwriting portfolios, not just their own business operations and investment portfolios. This means that auto insurers will report emissions from the cars they insure, while property insurers will report the carbon footprint of the buildings they underwrite.

Impact of new disclosures and targets

Insuring high-emissions sectors may no longer be a safe bet to generate long-term returns for insurers. There is potential policy, legislative, and tax risks associated with these sectors that insurers must consider. This shift may result in low-emissions sectors becoming more dominant in the insurance marketplace, forcing insurers to specialize in these areas to remain relevant.

On the other hand, there is an opportunity for insurers to develop innovative insurance products that cater to the changing market demand. For example, insurers with expertise in solar power could create novelty insurance products in the solar energy field, such as protection against long term panel efficiency issues. By understanding the specific needs of nascent but growing sectors, early and active insurers will undoubtedly gain an important advantage over their lagging peers.

Active participation in the transition to a net-zero economy requires a new perspective on the sectors and subsectors within the insurance portfolio, and a deep understanding of their current operations, decarbonization pathways, and future revenue trajectories.

For most insurers, this holistic understanding will require a cultural shift in underwriting, claims, sales, and portfolio management. It will be interesting to see which industry players will come out ahead in this early game and what new disclosures and targets they will set for themselves.

References: