Will climate risks be incorporated into cost of capital calculations under Solvency 2?

ESG and climate risks appear to be a real source of concern for most of those who responded to the request for information that the EIOPA conducted in order to prepare its opinion. The EIOPA rendered its opinion on 30th September; at this stage it advises undertakings to incorporate these risks only into their governance and risk management...

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ESG and climate risks appear to be a real source of concern for most of those who responded to the request for information that the EIOPA conducted in order to prepare its opinion. The EIOPA rendered its opinion on 30th September; at this stage it advises undertakings to incorporate these risks only into their governance and risk management, primarily via climate stress scenarios. But this could change as climate risk assessment models improve…

The EIOPA rendered its final technical advice on the methodology for integrating ESG and climate risks on 30th September, after collecting responses to the request for information it published in January 2019. Some 153 solo undertakings and 31 groups responded between January and March 2019, after which a consultation was held up until July 2019.

During the preparatory stages, the EIOPA had asked lots of questions in order to gauge whether investments identified as sustainable had different risk profiles to other investments, but its recommendations ultimately refer only to Pillars 2 and 3. The EIOPA believes there is not enough tangible evidence to justify and quantity a difference between sustainable and non-sustainable investments in terms of cost of capital, especially as calculations are calibrated based on value-at-risk on a 1-year horizon, a horizon that is somewhat incompatible with climate risks.

The EIOPA therefore recommends that insurance undertakings factor in climate risks primarily through scenario analyses embedded in their risk management, governance and ORSA [1] practices; they could thus identify and assess the climate change-related risks they would be exposed to in a forward-looking manner, and incorporate them into their strategies.

The EIOPA also recommends recalibrating natural catastrophe risk models every 3 to 5 years so as to factor in climate change more accurately. This is because such physical risk models are good at taking climate risks into consideration but need to improve further if they are to integrate climate change risks effectively.

However, during the Insurance and Climate Risk conference held a few days ago, the EIOPA’s chairman Gabriel Bernardino hinted that climate risk could be incorporated into Pillar 1 (to calculate capital requirements) in the near future once climate risk modelling has improved. Databases are being compiled to amass as much information as possible, which will help when it comes to building climate risk scenarios among other things. EU efforts to establish a taxonomy of different green activities could also be constructive.

The European Commission will use the EIOPA’s opinion when deciding on its Solvency 2 reform, which is due to be revealed before the end of 2020.

Noémie Hadjadj-Gomes , December 2019

Article also available in : English EN | français FR

Footnotes

[1] Own Risk and Solvability Assessment

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