Short-term mandates, long-term risks: insurers face regulatory dilemma

General insurers are at the cutting edge of climate risk. As underwriters of flood, hurricane and fire mispricing this risk can be the difference between profit and loss.

Jessica Snowball, senior consultant at LCP, says: “Insurers have been modelling extreme weather events for decades, so they have a deep understanding of these risks and how to price for them.”

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As many general insurance policies are written for one year, insurers’ primary pricing-focus is over a one-year period. However, longer-term climate trends remain important for wider business considerations like reserves, reinsurance, capital and strategy.

In addition, pricing models must be responsive enough to the potential rapid changes in extreme weather risk brought about by climate change, says Lara Palmer, senior consultant at LCP.

If the models are not reactive enough, there is a risk of mispricing these risks. “This is vital to the long-term viability of a general insurer,” says Palmer.

Net zero targets

Given the sensitivity of some general insurers to climate change risk, it’s not surprising that many have adopted net zero targets.

For insurers, a net zero target is a commitment to reduce greenhouse gas emissions associated with the organisation’s operations, investments, and, where relevant, underwriting activity over time, typically in line with a broader net zero pathway.

Palmer says: “The scope of insurers’ net zero targets can vary.” For some insurers, they focus solely on operations, for others, on investments, and for others, they cover both assets and underwriting.

If these net zero targets are only focused on the assets side of the balance sheet and not the underwriting side – which is a core part of an insurer’s business – this can significantly limit their effectiveness.

Equally, having net zero targets that only apply to underwriting and not to assets, can make these targets less effective.

“For net zero targets to effectively cover an insurer’s exposure to climate change risk, they should ideally cover the whole balance sheet and be maintained over the long-term,” says Palmer.

Quantifying risk

While there are benefits to embedding net zero goals, making this a reality can be challenging.

Assessing the carbon emissions of an insurance company’s operations is the first step and the easiest to control. “An insurance company can, for example, reduce emissions from their offices and day-to-day operations,” says Snowball.

Applying net zero targets to investments is harder, but assessing the emissions of the underwriting side of the business is the most difficult.

Palmer says: “Measuring the emissions associated with an insurer’s underwriting business is tricky and has been an evolving area of market practice over the past several years.”

It’s challenging to define what proportion of the insureds’ emissions should be attributed to the insurance company, and how much of those emissions the insurance company is facilitating, Palmer adds.

“There is not yet a well-established approach to measuring the emissions associated with the underwriting side of the business,” says Palmer.

Snowball says: “The value chain associated with underwriting can be many layers deep, making it difficult to assess all the associated emissions.”

For example, when an insurer provides cover to an airline, steel manufacturer or energy company, it can be difficult to determine how much of that company’s emissions should be attributed to the insurer.

The risks are often shared across multiple insurers and reinsurers, adds Palmer.

Portfolio composition

Insurers match their investment horizon to the longevity of their insured risk – so general insurers portfolios are invested in short-dated assets.

To match the short-term nature of their risks and to comply with Solvency II regulations, general insurers invest in high-quality corporate and government bonds.

David Chapman, head of investment at Admiral Group, says: “The average length of our assets is three to four years to match our liabilities as well as plenty of assets with a maturity of less than a year which are typically money markets.”

Corporate bonds make up around 30% to 40%, cash or high credit quality short-dated assets around 30% with government debt making up 20% of the portfolio and the remaining around 10% invested in short-dated private market assets.

“Around half the balance sheet is split between liquidity government debt and high-quality liquidity substitutes like triple-A-asset-backed securities,” says Chapman.

In addition, the portfolio has a home currency bias. “We invest in developed eurozone or US treasuries and bonds but only when there is a yield-advantage which can then be hedged back to sterling,” adds Chapman.

Assets with a longer maturity would only be acquired to match a longer dated liability.

Managing climate change risk

“We predominately outsource our asset portfolio to asset managers so the most critical thing is to ensure they take the right level of risk,” says Chapman.

As a result, Admiral will need to know how an asset manager is factoring, for example, flood risk, to ensure this is not double up the risk held on the underwriting side, he adds.

With so much of the portfolio invested in government debt, Admiral expects its asset managers to tell them if there is material risk, says Chapman.

“There would need to be, for example, a serious particular flood risk, for us not to hold as many UK government bonds,” he adds.

On the corporate side, Admiral expects asset managers to carry out a risk assessment sector by sector, company by company to build a portfolio which does not have too high an exposure to a particular environmental factor like flood-risk.

This is also where the group net zero target for the asset management mandate is reflected.

“The first step is to carry out the ESG risk analysis to the corporate debt portfolio and then in addition we build in specific net zero targets,” says Chapman.

This does not necessarily correlate to, for example, flood risk but the asset managers are expected to invest in higher quality ESG companies to reduce the carbon intensity of these companies.

“We also want to asset managers to invest more in companies with credible forward-looking science-based targets,” adds Chapman.

By imposing these requirements on their asset managers, Admiral finds alignment with how it thinks about climate risks.

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