Embedding ESG-related risks into Solvency II assessments

11 April 2024 Consultancy.eu 3 min. read

With ESG increasingly at the forefront of strategic ambitions and regulatory compliance, risk managers in the in the insurance sector are being challenged to more deeply integrate climate-related risks into their risk models. Nihat Mammadli from RiskSphere outlines why and how this is changing the lens on traditional Solvency II assessments.

Ever since the launch of the Solvency II Directive, a comprehensive regulatory framework governing the European insurance industry, risk managers have been obliged to take into account how climate change could pose a risk to business operations.

Under Solvency II insurers are obliged to conduct their own Own Risk and Solvency Assessment (ORSA), which includes a forward-looking assessment of climate-related perils. The ORSA is submitted to the national supervisory authority, and insurers are expected to mitigate the climate-related risks identified.

Embedding ESG-related risks into Solvency II assessments

The rise of ESG over the past years has seen a wave of new rules and disclosures linked to climate considerations, with the EU Sustainable Finance Disclosure Regulation (SFDR) and regulation from the European Insurance and Occupational Pensions Authority (EIOPA) as the most notable examples.

These forms of regulation are driving a deeper integration of ESG factors into robust risk management practices. They are at the same time also changing the narrative for risk professionals, with the focus shifting from merely achieving compliance to a more proactive approach that adopts ESG as a catalyst for positive change.

This collaboration between regulatory frameworks and the industry’s pursuit of sustainability marks a transformative shift in approach.

Own Risk and Solvency Assessment

Within the context of Own Risk and Solvency Assessment and its consideration of climate-related risks, insurers often develop two specific models: transitional risk models and physical risk models.

Transitional risk models focus on assessing and quantifying the financial impacts associated with transitioning to a low-carbon economy or significant changes in the environmental landscape. These models evaluate risks stemming from regulatory shifts, market dynamics, technological advancements, and shifts in consumer behaviour linked to a more sustainable, low-carbon future.

They consider scenarios where regulations, policies, or market forces substantially change, impacting industries reliant on fossil fuels or contributing to high carbon emissions. By estimating potential financial exposures and vulnerabilities from transitioning to a more environmentally sustainable economy, these models facilitate insurers in assessing and preparing for various transition scenarios through simulations, stress testing, and scenario analysis.

On the other hand, physical risk models concentrate on assessing and quantifying the direct impacts of climate change-related events on insurers’ assets, liabilities, and operations. These models evaluate potential financial losses and operational disruptions arising from extreme weather events like floods, storms, wildfires, rising sea levels, temperature variations, and other climate-related phenomena.

Employing advanced analyses using climate data, catastrophe modelling, and sophisticated tools, physical risk models simulate the potential impact of climate-related events on insurance portfolios, infrastructure, and business continuity. By quantifying potential losses and vulnerabilities, insurers gain insights into their exposure to physical risks associated with climate change, aiding them in formulating effective strategies for mitigation and management.

Both transitional and physical risk models are crucial components of ORSA, enabling insurers to conduct comprehensive risk assessments that consider the evolving environmental landscape and its potential impact on their long-term financial sustainability and solvency.

These models aid insurers in understanding and proactively managing the complex interplay between climate-related risks and their business operations, helping them make informed decisions and adapt to the changing environmental dynamics.