Actuarial Notes

Climate-Related Scenarios Applied to Insurers and Other Financial Institutions

By Rade Musulin, Eric Dal Moro, Sam Gutterman, Evelyn Yong and Tracey Zalk · International Actuarial Association · 2021

Study guide: Exam 6C

An IAA paper on applying climate-related scenarios to insurers and other financial institutions, and the challenges actuaries face in doing so. Prepared for the Climate Risk Task Force of the International Actuarial Association by a drafting group led by Rade Musulin and published in August 2021, it is the third paper in the task force's series: it takes the earlier "Introduction to Climate-Related Scenarios" to the level of an individual firm in a national jurisdiction. It was written in the first half of 2021, before the IPCC's Sixth Assessment Report, and is not an International Standard of Actuarial Practice.

On the syllabus

  • Exam 6C — objective C4; p. 1, pp. 18–19 (Section 2.1.3) and pp. 24–26 (Section 3).

Executive Summary

  • Scenario analysis is a core component of climate-related risk assessment and disclosure; the paper examines the challenges actuaries face in implementing it and outlines a range of possible approaches.
  • Climate scenarios from agencies such as the IPCC lack the specificity actuaries and firms need to model their risks; the paper suggests how to add it, using Australia for illustration.
  • Physical risks are frequently considered to develop over many years, while the timing and impact of transition and legal and reputational risks may be highly uncertain.
  • Three simplified case studies illustrate the concepts, and the paper hopes scenarios will become standardized enough to compare disclosures across firms, industries and countries.

Introduction

1 Sources of Information and Considerations for Reporting Financial Effects

  • 1.1 General Components of Scenarios
  • 1.2 Physical Risk Scenarios: The Climate Measurement Standards Initiative, Australia
  • 1.3 Transition Risk (and Opportunity)
  • 1.4 Legal and Reputational Risks
    • 1.4.1 Legal Risk
    • 1.4.2 Reputation Risk
  • 1.5 Other Sources of Information

2 Actuarial Considerations

  • 2.1 Actuaries Institute Australia Information Note for Appointed Actuaries
    • 2.1.1 Reinsurers
    • 2.1.2 Investment Management
    • 2.1.3 General Insurers
      • General insurers are exposed to physical risk through claims, through the values of their investments and through credit risk; physical risk also reaches workers' compensation through heat stress and pollution at work.
      • Transition considerations include new technologies such as battery-operated and autonomous vehicles, shifts in the industries underwritten, and sectors whose growth or contraction affects premium revenue; D&O and professional indemnity contracts carry liability risk from a firm's failure to address climate risk.
      • Annually renewable contracts let an insurer reprice or refuse to renew and recalibrate natural hazard prices frequently, but affordability and availability pressures mean Appointed Actuaries need to consider regulatory and reputational risks when premiums rise or coverage is limited.
      • For reserving, many physical risks are known at the time of loss, but long-tailed lines develop longer and changes in claim payment patterns can be hard to detect from historical data.
      • Natural hazard catastrophe modelling needs to go beyond replicating historical weather: capture current climate-related risks, segregate effects by geography, update exposures, allow for demand surge and business interruption, and consider non-linearity or step changes.
      • Time horizons: annual pricing and valuation use current risks with small annual increments; portfolio steering sensitivity-tests a trend or step change; the capital position and business rebalancing are tested under different climate scenarios.
    • 2.1.4 Life Insurers
    • 2.1.5 Health Insurers
  • 2.2 Other Actuarial Associations

3 Considering Interactions and Systematic Issues

  • Actuaries should consider the broader social, economic, political and technological environment in which a firm operates, and "systems thinking" is a useful tool for this.
  • The TCFD's October 2020 guidance describes exploratory scenarios, which explore a range of plausible futures (stress tests can fall here), and normative scenarios, which plot pathways to a set outcome (reverse stress testing is a variant).
  • Mapping IPCC outcomes onto liabilities and assets may miss the implicit assumption that markets, healthcare systems and supply chains keep functioning, the sequencing, correlation and cascading of effects, impacts on critical infrastructure, the correlation of assets with liabilities, and actions by one firm that create risk for another.
  • Example: property insurers raising prices may impair mortgage borrowers' ability to repay, and lenders reducing loans in high-risk areas shrinks the insurers' pool of customers.
  • Under the theory of fragility, systems that are occasionally stressed become resilient while systems that suppress volatility become fragile; developing scenarios requires multi-disciplinary teams.

4 Updating Scenarios and Integration with ERM Frameworks

5 Case Studies

  • 5.1 Crop Insurance in an Emerging Country
    • 5.1.1 Climate Change Impact on Key Agriculture Perils
    • 5.1.2 Climate Change Adaptation in Agriculture
    • 5.1.3 Methods and Data
    • 5.1.4 Climate Change-Driven Trends of Major Crop Yields
  • 5.2 Investing or Underwriting in a Region Dependent on Fossil Fuels: A Transition Example
    • 5.2.1 A Country Heavily Dependent on Fossil Fuels
    • 5.2.2 Climate Change's Impact on Qatar's Economy
    • 5.2.3 Scenario Construction
    • 5.2.4 Designated Timeframe
    • 5.2.5 National Policies, Transition Scenarios, and Macroeconomics
    • 5.2.6 Social and Technology Issues
    • 5.2.7 Investment Considerations
  • 5.3 Climate-Related Risks, Crop Failures, Food Prices, Supply Chains, and Fragility
    • 5.3.1 Food Price Crisis
    • 5.3.2 Floods and Global Automobile Parts Shortages
    • 5.3.3 Fragility

6 Next Steps

References

Sources