Sustainability risks in regulatory capital

The treatment of sustainability risks by prudential regulators continues to be a hot topic, and EIOPA has added a new element to the debate with its discussion paper on the 'Prudential Treatment of Sustainability Risks (europa.eu)'.

While the paper is an exploratory exercise and not a call to action, it is significant because in it EIOPA proposes that the Solvency II framework is conceptually well placed to capture sustainability risks. It explores a number of ways that firms can manage the financial risks posed to their businesses and also the possibility of recognising sustainability risks under existing elements of the Solvency II balance sheet.

This latter point is important: it indicates a regulatory stance on the much-debated concept of capital requirements for sustainability risks. The industry is well-aware of the talking points here (challenges around calibration, time horizons, unintended consequences etc), but EIOPA's discussion paper does not consider adding new risk types to capital requirements — and, indeed, the capital requirements explored are not just in relation to holding 'brown' vs 'green' assets. EIOPA examines both the Standard Formula's prudential treatment of assets with high sustainability risks, and potentially increasing capital based on the structure of insurance liabilities.

The paper focuses specifically on:

• How transition risk exposures from insurers' investment portfolios might be recognised,
• How climate change adaptation measures in the design of insurance products might reduce risk exposure, and 
• How socially harmful activities might lead to financial losses and reputation risks for insurers.

In considering how best to recognise transition risks in assets, EIOPA offers suggestions on how insurers could classify their assets and use historical prices to consider what risk charge calibration might be appropriate when using the Standard Formula to calculate the Solvency Capital Requirement (SCR).

Classifying assets

For stocks and bonds, the paper explores two approaches that would classify assets according to their transition risk exposure. It then considers whether to incorporate differential risk charges into the SCR using historical price data.

• The first approach is sectoral, with an investee company's economic activity being the determinant of the level of transition risk — for example identifying insurers' investments in steel or fossil fuels companies and using this classification to measure the level of transition risk.
• The second approach is to identify company-specific environmental variables that allow for classification. This could involve firms using an investee company's disclosed EU Taxonomy data, ESG ratings or greenhouse gas (GHG) emissions data to determine transition risk.

In light of the difficulties in gathering GHG emissions data, and the separate challenges in obtaining consistent, comparative and meaningful ESG ratings, insurers will likely favour the first approach as they already have experience of sectoral approaches (e.g. the use of NACE codes).

For property assets, EIOPA discusses a risk classification system based on energy performance certificates (EPCs). It notes that 8% of EU insurers' investments are in real estate, meaning any potential changes to property values driven by energy efficiency could materially affect firms' balance sheets. It considers the use of EPCs to assess transition risk for residential and commercial real estate, and asks stakeholders to comment on whether they agree with this approach and have any quantitative evidence on the potential link between a building's energy efficiency and its market value on EU housing markets.

Prudential risk assessment

Following the classification and pricing stages, EIOPA considers methodologies for a forward-looking prudential risk assessment that factors in the future materialisation of climate-related risks. EIOPA notes existing assessments from other European regulators and explores:

• The different types of scenarios available to firms (e.g. Network for Greening the Financial System (NGFS) and International Energy Agency (IEA)).
• The utility of transition vulnerability factors (TVFs) — sector-specific climate risk measures introduced by De Nederlandsche Bank in 2018. 
• How to express transition risk differentials in terms of the 0.5% Value at Risk (VAR), and the Monte Carlo simulations that firms can apply.

Building on a number of its previous papers1, EIOPA has focused on climate adaptation measures and how these might reduce physical risk arising in non-life insurers' liabilities. It considers measures such as water-resistant walls, windows and doors, non-return valves on main sewer pipes against flood risk, and sandbags or domestic flood protection walls against flood risk.

EIOPA seeks views on the use of quantitative analysis to observe any significant differences in the prudential risks for insurance products with and without climate adaptation measures, and whether insurers should recognise any such differential when calculating their capital requirements. It hypothesises that adaptation measures could smooth the claims distribution by reducing the frequency or intensity of climate-related losses. Therefore, the absence of climate-related adaptation measures could suggest premium mispricing — and thus require capital to be held for premium risk.

This idea is significant as it focuses specifically on sustainability risk capital requirements for underwriting, not investment, decisions, and it does so using a risk type that is already on the Solvency II balance sheet. EIOPA also proposes to assess the potential for a new calibration of the non-life SCR parameters for premium risk in the Solvency II Standard Formula, using the Undertaking Specific Parameter (USP) methodology. There is no indication yet of how material this recalibration could be, but non-life insurers will want to consider how they should optimise their product offering in light of potential capital charges. Any changes to products could alter an insurer's commercial offering, and so non-life firms should consider how their wider business strategy might be affected.

Climate adaptation measures may also impact other elements of the SCR, for example through natural catastrophe risk, where expensive adaptation measures could increase the value of a property, thereby raising the sum insured and increasing the corresponding capital requirements. However, this is not a primary focus for now and EIOPA's priority appears to be the consideration of premium risk.

This section of EIOPA's paper explicitly maps social risks to existing Solvency II risk types:

• Underwriting risk — through workers' compensation, increased mortality or morbidity, increased losses under directors and officers (D&O) liability claims etc.
• Market risk — through asset price volatility, stranded assets due to investee reputational risk, equity or bonds in economic activity that damages health or housing etc.
• Operational risk — through inadequate or failing internal processes that do not allow insurers to act on previous signals of social risk.

It suggests that social objectives and risks should be conceptually similar to the treatment of climate-related risks — a recognition that 'ESG' goes beyond climate change, and perhaps a nod to the European political landscape where social objectives are increasingly being discussed.

However, EIOPA recognises the challenges around social objectives and risks, including the level of public debate about what these should be and how they can be measured and disclosed. It seeks feedback on this, and also on how corporate governance measures, such as remuneration and board composition, can help reduce the potential level of social risks.

EIOPA urges insurers to use their Own Risk and Solvency Assessments (ORSAs) as a starting point to investigate potential exposure to social risks. It also notes the need for both qualitative and quantitative analysis. If they are not already doing so, insurers should consider how social risks could affect their solvency ratios.

EIOPA invites comments on the paper until 5 March 2023, after which it will review the feedback and consult on policy implications (though it has been vague about timings). It is important to note that EIOPA has not yet received the mandate to make any changes to the prudential treatment of sustainability risks — while it has a mandate to report to the European Commission and can advise on changes, any amendments will need to be approved by the Commission.

In the meantime, insurers may want to assess the sustainability risks in their current portfolios and consider potential impacts on their solvency positions. Internal model firms may want to understand the implications of any Standard Formula changes on how they should design, calibrate and change their models in the future. And, for non-life firms in particular, EIOPA's exploration of increased premium risk capital may trigger internal reviews of how to optimise product structures in light of the possible capital charges, with firms looking to assess what any changes could mean for their wider business strategy.