The insurance industry is in a unique position in relation to the changing environment, as insurers not only pay claims to indemnify their insureds for climate-related damage, they also fund the economy through their significant investment portfolios. In jurisdictions where insurers and other corporates face heightened regulation requiring that they maintain a sophisticated understanding and management of climate risks, the liability exposure is increasing. With increasing expectations for all businesses to disclose the risks that they face from climate-change, whether these are financial or non-financial, insurance companies face third-party claims against insureds where disclosures have not been adequately made. For insurance companies therefore the claims exposure has recently shifted from liability for physical damage, towards liability for the failure of corporates to adequately assess, manage and disclose their vulnerability to a changing economy and changing customer expectations.
What risks do insurance companies face from climate change?
The risks that insurance companies face from climate change are threefold: physical risk, transition risk and liability risk.
The exposure to physical risks is well-understood. Insurers have a far more sophisticated understanding of climate risks than many other financial sectors. Insurers have been using tools to predict weather-related disasters for decades and they are exposed to claims whenever there is a flood, storm or drought. However, where these models use historical data, questions arise about whether modelling can keep up with the pace of changing weather patterns.
There is perhaps less awareness of the risk of indirect claims that arise as a result of weather-related incidents. When flooding, drought or storms damage businesses there are likely to be claims under business interruption policies or supply chain cover. The extent of liability under traditional commercial policies may not take into account these indirect claims or the correlation between different policies and different climate-related events (concentration of risk). Some policies may have ‘silent’ coverage (where a risk is captured by a policy inadvertently) for climate-related risks leading to significant unreserved losses.
Transition risks are the financial risks arising from the transition to a lower-carbon economy. Carbon-intensive energy production and manufacturing is being wound down to reduce emissions. The transition towards a low-carbon economy will impact insurers’ balance sheets as insurers must match the assets they hold to their underwriting liabilities. In order to meet these increased underwriting liabilities, insurers will rely upon their invested assets.
Avoiding investing in what have become stranded or devalued assets is one of the ways through which insurance companies may be able to reduce transition risks. Some insurance companies have announced that they will no longer invest in carbon-intensive industries in order to protect their ability to match liabilities to assets over a suitable time horizon. Others are changing their product offering to incentivise their insureds to replace “dirty assets” with green replacements in order to speed up the move to a carbon neutral economy. This shift towards sustainable assets, not only in terms of insurers own balance sheet but in terms of coverage, is profound.
Liability for third-party claims
Liability for third party claims falls into two distinct categories: the exposure that insurance companies face themselves and the exposure that they face from claims made against their insureds.
Insurance companies’ own exposure to climate change
Regulators expect insurance companies to manage their own exposure to climate change, whether the risk is physical, transition or liability. Insurance companies are expected to be transparent about where their exposure lies and demonstrate that they are managing the risks that they face from the transitioning economy. This means understanding their exposure to climate related claims and the impact of climate policies on their balance sheet. A failure to take into account any material risks could result in a regulatory body demanding that the company hold more regulatory capital. There is also exposure for the senior management of insurance companies as regulators require directors and officers to put into place adequate arrangements to manage the exposure of the insurer to the impact of climate change and other environmental, social and governance (ESG) risks. If insurance companies fail to take adequate steps to measure their exposure to climate change and other ESG concerns, regulators can intervene.
Claims under the policies that insurers write
Insurers face rising climate-related claims under property covers. However, as mentioned above, where modelling uses historical data and weather patterns are changing, older models may no longer be fit-for-purpose. ‘Once in a 100 year’ weather events are now becoming more frequent.
Insurers underwriting third-party liability policies for “dirty” energy producers or users, can be exposed to claims against their insureds for contributing to climate change. However, successful claimants must establish general causative links between the emissions and the type of effects suffered, and establish the individual causal link in relation to the claimant’s injury. Where the claim is for damage caused not by a specific environmental incident but ‘climate change’ in general, attribution of liability to any one carbon producer is likely to prove challenging. However with more claims attempting this and more data to support the attribution of climate change to carbon producing companies, the causative link might become easier to establish.
The landscape for third-party claims against insureds for management and governance errors in respect of climate change has developed over the past couple of years. The directors and officers of carbon-intensive industries and investment companies may be held personally accountable for failing to consider the impact of climate change in corporate strategy and decision-making and for failing to disclose information relating to climate risks. So too might other businesses that fail to take into account the impact of climate change on their advice to clients such as accountants, architects, engineers and those involved in the construction sector. Until recently the exposure to climate-related claims was in respect of the environmental impact of carbon-producing insureds, whether they were energy producers or business consumers. With greater regulatory reporting requirements however, the claims landscape is shifting towards liability for corporates (and their directors and officers) for not being sufficiently transparent about their exposure to the impact of climate change, and now more broadly ESG issues.
As companies increasingly become required by law to measure and report their exposure to climate-related risks, the risk of liability towards investors and other stakeholders will increase. For directors and officers, the new reporting obligations could lead to personal accountability. In the UK, all large companies will be required to report their climate exposures (in line with the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD)) by 2022. The IFRS has consulted on mandatory reporting standards for risks relating to climate change. In the US, the change in administration has hastened the pace of change towards greater reporting of exposures. The Acting Chair of the US Securities and Exchange Commission has consulted with staff over the adequacy of existing climate disclosures for investors and the public.
In the EU, the Non-Financial Reporting Directive obliges companies to report on a wide variety of ESG-related metrics, while the Taxonomy Directive established a classification system of environmentally sustainable economic activities. Following a number of initiatives to promote sustainability in financial services, European legislators propose to amend directives to ensure that sustainability is embedded into legislation to support the political ambition that Europe becomes the world’s first climate neutral continent by 2050. Amendments to suitability assessments under the Markets in Financial Instruments Directive and conflicts of interest and product oversight in the Insurance Distribution Directive seek to encourage sustainable investment and "long-termism" in financial products.
Businesses that fail to keep pace with the sustainability requirements or fail to disclose their exposure to climate risks may face class actions or derivative litigation as well as enforcement measures from regulators. As climate-reporting becomes market standard those businesses that reveal poor management of climate risk or are found to submit misleading statements face significant exposure.
At Norton Rose Fulbright, we have considerable experience in assembling and managing effective multi-disciplinary teams who can assist insurers with the range of issues they face over climate change. This can range from:
- Regulatory lawyers who can assess likely expectations of regulators and assist with meeting new requirements.
- A deep understanding of the climate change policy landscape, combined with specific insurance regulatory capabilities.
- Non-legal financial services risk consulting team, to assist with regulation compliance processes as well as project management.
- A unique technology consulting team who understands the most up-to-date developments in technology innovation, which includes scenario modelling
- A government relations and public policy team providing experience in identifying trends in the pipeline.
- Claims lawyers who review policy wording, but can also assist with climate-related claims and understand the liability issues associated with climate-related risk.
Please visit the NRF Institute to read our ‘Forecast for the Future’ series on climate risks and the insurance sector.
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