Transcript: Series 2 Episode 5: Insurance: Tackling climate and reforming Solvency II

Andrew Strange:

Hi everyone and welcome to our latest Risk & Regulation Rundown podcast episode. I am Andrew Strange, your regular host, and as last month, we are recording this remotely, so please note that it might impact the sound quality. In today's episode, we are discussing the regulatory landscape for insurers, from the impact of climate change to upcoming changes to the prudential rules. I am delighted to be joined by Rod Bryn-Hussey, a Director in our Insurance Risk and Regulation practice, and Anirvan Choudhury, a Senior Manager in our Regulatory Insights team.

Insurers are facing a packed regulatory agenda at the moment, dealing with challenges ranging from the impact of COVID-19 to the end of our Brexit transition period. We are also facing some important societal shifts too, such as responding to climate change.

Rod, would you be able to kick off by setting the scene on the climate change agenda?

Rod Bryn-Hussey:

Hi Andrew, yes sure. Whilst climate change is not a new phenomenon, the past five or ten years have seen an extensive amount of policy actions to tackle this issue. A good place to start is the Paris Agreement within the United Nations Framework Convention on Climate Change. Signed in 2015, 196 signatories have committed to three key aims.

The first one is holding the increase in global average temperature to well below two degrees above pre-industrial levels, and to even push this further by pursuing efforts to limit the temperature increase to 1.5, recognising that this will significantly reduce the risks and impacts of climate change.

The second is about increasing the ability to adapt to the adverse impacts of climate change and foster climate resilience and lower greenhouse gas emissions development in a manner that does not threaten food production.

Finally, making finance flows consistent with a pathway towards low greenhouse gas emissions and climate resilient development. COP26, which is a convention looking at climate change, it was due to be held this year, but unfortunately, it's become a victim of coronavirus. This conference is intended to bring the signatories together in order to speed up the action against climate change. It also acts as a five-year review point for progress, but this year each nation has agreed to devise a plan to cut their carbon emissions by the next conference.

Andrew:

Thanks Rod, a lot of those themes will be familiar to our listeners, both on a personal and on a business level. Indeed, I could think of PwC’s own commitment to net zero, for example. But how does that translate into regulatory expectations or indeed rules for firms, and what actions do they need to take to comply?

Rod:

For insurers, regulatory communications and discussions have been happening over the past 18 months really. The PRA released a supervisory statement SS319 in April 2019, highlighting expectations of the management of financial risks within insurers, focusing on governance, risk management, scenario testing and disclosures. After the PRA reviewed certain insurers’ plans to implement this towards the end of 2019 and indeed into 2020, it followed up with a Dear CEO letter in July 2020, highlighting areas of good practice that they've seen in the market, but also areas of concerns or development. The intention is that insurers will need to implement the requirements highlighted in SS319 by the end of 2021. So really time is running out for firms to successfully identify these risks and build them into processes before this date. Over the four areas of that regulation, we have seen the most progress in governance. Firms will need to ensure they have an appropriate governance structure in place to provide oversight and challenge of climate change risks, and an individual needs to hold the prescribed responsibility within the firm under SM&CR.

Our PwC survey, which we recently commissioned and will report on shortly, noted that this is usually the Chief Risk Officer, but actually we have seen some other roles being held, for example, the Chief Investment Officer or indeed, the CEO.

On the other hand, scenario testing appears to be a real key challenge for insurers. Firms are required to understand the quantitative impact on climate change risks, so that's both from a transitional risk lens or the risk of transition to a low carbon economy, or indeed for physical risks, which will worsen if we are unsuccessful transitioning to that low carbon economy. By their very nature, climate scenarios take longer to impact financial services companies, and emerge, aside from the often-quoted disorderly transition scenario. Collecting internal data has been challenging. Indeed, in our survey over 70% of respondents cited difficulties with forward looking model approaches and data.

Andrew:

That's interesting, and that scenario testing approach and some of the challenges there, does that have an impact on the Bank of England's climate risk stress test that will be held in June 2021? What does that mean for insurers?

Rod:

Yes, so it's fair to say the previous exercise in 2019, the LIST and GIST, they were definitely investigative stress tests, really seeking to understand where the industry was in terms of their approach, but also the potential size of risk for UK financial services. In this exercise, the PRA provided a significant amount of detail on the stresses, particularly on the asset side actually, there were lots of parameters in there, in a very detailed way, which may not be provided for the 2021 exercise.

I think Andrew Bailey is looking for the 2021 exercise to build on what's been done already, but also, if you think about the timelines, that's happening at the end of next year, which is when the regulation really needs to be built in. It's firms’ one chance to really use these models and data in anger. Andrew Bailey recently gave a speech on climate change and there were a couple of key facts that I pulled out, which I thought might be interesting.

The exercise will explore three different climate scenarios, and my reading of that would be an orderly transition, a disorderly transition, and effectively a no action scenario. They will test different combinations of physical and transitional risks over a 30-year period. They expect to use the exercise as a tool to size the risks faced in these scenarios and understand how different business models will be affected and how they respond. That's really key, particularly for things like improving firms’ risk management practices. He also made it very clear around the use of capital and understanding capital. He said, while it isn’t a tool for sizing internal capital requirements and buffers, it will be something that will inform potential approaches. For example, do we need to include this in our internal model, or do we indeed need to include it in the ORSA. The one thing I picked up around the forward-looking nature of scenarios is that it needs to consider an evolving risk profile. For example, property-backed assets may seem relatively safe, but appear less so under a 4-degree world due to the increased severity of weather events.

Another example is the assets that may look safe now, may appear risky under the lens of a transition to a low carbon economy, and vice versa really, traditional carbon intense assets may appear to conflict against good climate risk management. The efforts to decarbonise by these firms and create green energy may actually create a safer and higher returning asset. The last thing I want to comment on really on this was around the data challenge as we previously referred to. Our survey noted a mixture of qualitative and quantitative approaches were taken with initial attempts being more focused on the former due to data insufficiency. Andrew Bailey stressed that uncertainty and lack of data is not an excuse and emphasised the need for quantitative analysis.

Andrew:

That data challenge is something we see in so many areas of regulation nowadays, but more broadly what challenges do insurers face from the implementation of the regulation?

Rod:

It creates quite a lot of challenges for insurers - in the interest of time, I'll just touch on three. The first one, we've already slightly touched on, which is modelling and data challenges. The skill set required to model these takes a blend of a number of areas, so actuarial risk modelling, and also climate science. Firms will need to consider whether this is available internally or indeed they want to look to source that externally. It's not just the scenario testing, while that's important, it also feeds into risk monitoring, such that you can inform the board and senior management on their responsibilities. Therefore, getting the data is absolutely key for a number of areas.

I guess the second point is around, just having too much stuff on and the time available. The regulatory agenda, as you've already said, is packed with various developments and thinking about this alongside the broader environment of COVID-19, and also acquisitions and consolidation, which we are seeing in the insurance market. We've seen a number of firms set up programmes and bodies and projects of work to be able to meet the requirements at the end of 2021. But with these competing issues and requirements, we hope that firms are well set up to do it.

The final thing I would like to reflect on is the breadth of impact of climate change across the business in the context of those timelines. With the complexity of an insurer, and the inherent forward-looking nature, it creates significant challenges in quantification. For example, taking into account the impact of climate change on longevity risk in both unsuccessful and successful transitions. Furthermore, just a year to design and embed these changes across the four pillars we've discussed could be very challenging, particularly given the firm's own corporate calendar. Determining risk and scenario testing, implementing this into existing business planning processes, ORSA processes, and various risk management refreshes alongside strategic input can involve a number of people across the business and key processes. Therefore, prioritisation becomes absolutely key.

Andrew:

I certainly know what you mean about there being too much stuff on the regulatory agenda at the moment. My view would be, I’ve seen a number of initiatives by the regulator being perhaps delayed, or deferred, or no further work ongoing. That for me means that anything that is left on the regulator’s agenda must be really seriously and they must be really engaged with it.

As you said, there are interactions with other areas of regulation and rules, so in addition to assessing and managing climate risks, there is the whole ESG agenda as well which is a really important part of that climate picture. Indeed, we had a really good podcast on that this summer with a couple of key partners from PwC as well. How have insurers managed to consider this alongside other initiatives such as ESG?

Rod:

It's a really interesting question, Andrew. Most firms would have started from a compliance perspective, so seeing new regulation and wanting to comply with that. What this has done has actually led to much more interesting strategic conversations around the purpose of insurance companies and what they are intending to do in terms of ESG related issues. In my mind, solid climate change risk management and understanding is a key compliment to the successful consideration of ESG in an organisation. In the work that we are doing with our firms on initiatives such as TCFD reporting, climate change response creates a much more holistic consideration of ESG and not just compliance, but also driving value.

One thing I can point to, which is an emerging thought leadership around how do customers become engaged with different products? In the insurance industry we struggle quite often to engage our customers, particularly younger generations with insurance products. Studies have shown that younger generations are more engaged with buying ESG compliant products, and then actually more incentivised to work for employers with solid ESG strategies. We see this in a number of insurers making public disclosures on becoming things like net zero, a process that will make significant inroads into the climate crisis. It will take quite a while for insurers to implement, but also actually it will begin to draw together some of these other strategic threads that we are seeing in the market.

Andrew:

Thanks Rod, it’s interesting, you brought up TCFD there, which of course is not just a UK initiative, and certainly in my world we have the Sustainable Finance Disclosure Regulation, which is a European piece of legislation that impacts firms as well. That interaction between UK and EU rules is one that firms are going to have to get their heads around increasingly over the coming months.

Actually, that brings us quite nicely on to one piece of insurance legislation, where the UK Government itself is looking to make some changes to the regime, now we've left the EU. In October this year, the Government issued a call for evidence, seeking views on how to tailor Solvency II to the UK market. Anirvan, can you just tell us about what the Government's objectives were for making any changes to the UK version of that regime?

Anirvan Choudhury:

Yes, Andrew, thank you. The Solvency II 2020 review that the UK Government has launched, has three main objectives that the Government is trying to reach. Number one, is to ensure that the UK remains an internationally competitive market for the insurance industry without compromising policyholder protection and safety and soundness. The second key objective that the Government is trying to achieve is to look at a way to create a prudential regime for insurers, that better enables insurance firms in the UK to contribute to the Government's objectives to provide long-term capital support for growth across the UK and to support the Government's climate change objectives.

Finally, the Solvency II review that the Government has launched also has interaction with something that you discussed in your previous podcast about allocation of responsibilities in the future regulatory framework between the Parliament, the Treasury and the financial services regulators.

Andrew:

Thanks Anirvan, clearly there's a lot of issues there driving it. What are the main changes that the UK is proposing to make to the regime?

Anirvan:

The changes that the UK Government is proposing cover ten different areas. Instead of running through all ten, what I will do is, I will break it up, group them between life insurance, other items that impact both general insurers and life insurers, and then look at competitiveness at the end.

Let's start with life insurance. The first major change that the UK Government is proposing is change to the risk margin. This is where the Government has been concerned that a lot of longevity risk, especially annuity writers, has been reinsured offshore. So the Government wants to change the risk margin, so that UK firms are less incentivised to reinsure longevity risk outside the UK. Also, they want to look at ways to reduce the size and the volatility of the risk margin. Second is the matching adjustment for life insurers. Here the Government is interested in looking at the eligibility of assets and liabilities that are included in the matching adjustment, and also look at how the matching adjustment can be changed to make it operational optimally, such as reviewing the approval process for matching adjustment.

Then finally, a unique feature for life insurers is the transitional provisions for technical provisions. This requires firms to maintain legacy systems, it’s quite costly for firms to calculate this. The Government wants to make the calculation of the transitional measures simpler and more cost effective for UK insurers.

Then quickly moving on to some of the other aspects that impact both life insurers and general insurers. One item is looking at the reporting requirements. The Government wants to reduce the amount of regulatory reporting that is required by insurance companies in the UK. This is also expected to reduce the cost of regulatory compliance.

Secondly, the Government is interested in reviewing the way the solvency capital requirement for insurance companies 5s calculated. Currently, the mechanism for calculating is very formulaic, so the Government is interested in bringing in more scope for planned supervisory judgment, and also to make certain changes that will support the Government’s climate change objective.

Beyond that, moving on to a couple of points specifically on competitiveness. The Government is proposing two changes. One is reviewing branch capital requirements, so after Brexit there is an expectation that the UK is likely to see more international branches being set up in the UK. They want to look at how the capital requirements from branches may be modified to make it an attractive destination for international insurers, and also looking at reducing the regulatory burden on new insurers, so reviewing whether there are any barriers to entry, creating a mobilisation phase where newer firms have some latitude in the early years regarding their regulatory requirements, and then the full set of regulatory requirements comes in 5n a more phased manner as the company grows in size. As I said, there are ten things covering a huge range of Solvency II issues, but this hopefully gives you an idea of some of the main highlights in the UK Government Solvency II review.

Andrew:

Thanks Anirvan. Certainly, it’s a massive shopping list and I've got two reflections on it. Firstly, slightly tongue in cheek, this is just a review, so do firms actually have to do anything at the moment, and what is the timeline for this, because there are a lot of things on that list. Then secondly, thinking particularly about that competitiveness of the UK point, is there a risk that the EU develops its own rules in a different way, so either in response to the UK competitiveness point or just that it develops its Solvency II rules, as it would anyway, and therefore there is an indirect influence on the UK rules that way?

Anirvan:

Yes Andrew, let's first look at the timelines. The UK Government’s review of Solvency II, the consultation period closes on 19 February 2021. Then simultaneously EIOPA is conducting a review of Solvency II. It is expected that EIOPA will publish its recommendation for proposed changes and submit those to the European Commission at the end of 2020 or early 2021. We have two sets of big-ticket regulatory changes and it is important for the industry to keep in mind that some of the changes at the European level might still influence the final direction or the final position that the UK takes on some of these changes. One example is the risk margin. As I mentioned, the UK Government is looking at it, EIOPA is looking at it, so it will be interesting to see if there is any convergence.

The next question, Andrew, that you asked was, these are reviews and what are the timelines, why should firms care? It's fair to say that some of the changes that are proposed, if you look at, for example, the UK Government’s proposed changes - changes to the risk margin, the matching adjustment - these are likely to have long-term business model, capital model, operating model impacts. For example, if the risk margin is changed in a way that it makes it less attractive for firms to reinsure risk offshore, then this might impact investment strategies, profitability drivers, and how firms manage their overall insurance portfolio going forward.

Although there is a timeline for the final changes to come in, it is probably still a few years out. Given the nature of the impact that these are likely to have across insurers’ financial statements, operating models, it's important for firms to stay abreast of the changes and think about how some of these changes might impact them in the long term, so they can continue to remain competitive in the insurance sector.

Andrew:

Rod, it feels to me that with your wider hat on, on a number of the issues you're talking to your clients about, is this all really aligned from a client perspective?

Rod:

It's a really interesting conundrum to ponder on. In reality, if you think about some of the key themes that we're seeing from a prudential perspective in insurance - and conduct, so operational resilience, Solvency II review, climate change liquidity, they are all about resilience and they are all about ensuring that insurers understand their risk profile and can manage it ahead of time. In some ways, they shouldn't really clash. Some reflections on how they fit together: climate change is a risk driver and it hits every part of your business. So in theory, having a good understanding of your climate change risks should then feed very nicely into your operational resilience. If we think about some of the physical risk implications, for example if our data centres go down, because they are on flood plains. The operational resilience framework gives you a tool to understand and monitor the operational implications of that. Similarly, actually with Solvency II, there are mechanisms in there and objectives around solid risk management, understanding the risk profile, and then actually looking to understand the capital implications of that of what insurers need to hold to mitigate that risk.

So in some respects that's very joined up and climate change should then naturally feed into that process. Actually, in some respects, it doesn't quite fit and there still needs to be things that are thought about. If we go back to capital, Andrew Bailey said in his recent speech around this that the 2021 stress test scenario testing exercise is not looking to understand or set capital buffers. Capital in an insurer under the Solvency capital requirement is based on a one in 200 year event over a year, whereas actually climate impacts and risks can emerge over 50, 100, or 150 years. So there is a natural conflict between what insurers would hold as capital to mitigate against this risk and the nature of the risk itself. In some respects, there should be some harmony between these regulatory regimes. In others, it comes back to my earlier point around bandwidth. You are going to have different people focusing on these areas, making sure they're joined up in a harmonious way, and being managed appropriately, is going to be a real challenge for our clients.

Andrew:

Thanks Rod, I will take the harmonious approach as the positive note to end on there.

Rod and Anirvan, thank you both very much for your time today and for a really interesting discussion. It's great to hear about how climate issues and Solvency II interact with that wider regulatory agenda, but it does seem like we are presenting quite a complex picture for firms.

And to our listeners, I hope you've also found this episode helpful. Please do share this podcast with your colleagues and subscribe to future episodes, and I'll be back in the New Year. Have a great Christmas break.