This article has been written together with Armand De Vaugelas.
The recognition of pandemic-type risks as being highly disruptive is far from new to the insurance sector. Back in 2013, around 3,000 insurers took part in a poll to name the most extreme risks to their industry. The responses identified a pandemic from a new and highly infectious and fatal disease as the top threat. In January 2020, the World Economic Forum published its latest Global Risk Report. Once again, infectious diseases were ranked in the top 10 risks in terms of impact. Despite these alerts, the Covid-19 pandemic that hit the economic scene worldwide a few weeks later revealed most sectors, including the insurance sector, to be extremely unprepared.
Covid-19 and sustainability — a parallel to be drawn
Insurers’ first warnings on the relevance of the impacts of climate change date back to the 1970s. Since then, the issue has been widely recognized as one of the greatest risks to the insurance sector. Research has shown that around 25% of global financial markets are likely to suffer from climate change impacts. Given this prediction, insurers’ portfolios are evidently at risk.
However, we are witnessing a similar pattern to that seen with the Covid-19 crisis: risks have been clearly identified, but without sufficient counter-measures being taken. Large international insurance players are seemingly failing to make climate change and sustainability issues an absolute priority. In fact, climate risks are not yet taken into account in longer-term insurance market models. Nonetheless, with an estimated US$30 trillion in AuM, insurers have a decisive influence on the global economy and a major role to play in paving the way for sustainability issues to be addressed.
Where can the insurance industry start?
- Beyond divesting from ‘brown’ sectors and industries, as has already been partly done, set in place programs that initiate the transition to a low-carbon economy
- Place greater emphasis on policy updates and shifts in customer preferences
- Focus on the long-term impacts on assets (as the insurance industry is highly exposed to sustainability issues)
- Encourage improved non-financial disclosures in financial reporting and the securitization of infrastructure investments.
Stress tests for insurance portfolios
As similarities between pandemic and climate change crises are starting to be observed, so the first pandemic-related initiatives are emerging. The think tank 2° Investing Initiative (2DII) has been partnering with EU financial supervisors and in March 2020 introduced Covid-19 stress tests for insurance portfolios.
Due to the unprecedented challenges caused by the pandemic, 2DII is allocating resources specializing in climate change to the exercise. In fact, parallels between the two crises justify the relevance of utilizing existing climate change expertise in both scenario modelling and translation of extra-financial risks into stress tests to be used in the financial sector.
2DII has worked on what it calls “snap scenarios” to be used as Covid-19 stress tests which will be analyzed by the European Insurance and Occupational Pensions Authority (EIOPA) and applied to the portfolios of large insurers. Indicators used include, for example, equity prices, corporate default, unemployment and GDP, and have previously been determined by the European Systemic Risk Board.
The analysis so far consists of determining to what extent and in what way indicators could be affected over the upcoming three-year period in six different Covid-19 scenarios. The latter will then gradually be evolved using inputs and feedback, notably from supervisors, financial institutions and credit rating agencies.
The main objective of these scenarios will remain the analysis of the long-term risks applied to insurers’ investment portfolios, in order for them to become resilient to systemic crises.
Both Covid-19 and climate change are major global crises. But a pandemic will eventually reach an end, whereas global warming will only intensify. The insurance industry has an inherent interest in using the lessons learned from the current Covid-19 crisis to tackle sustainability risks while at the same time seizing long-term opportunities. Failing to address this challenge could be extremely costly, as half of the world’s GDP is estimated to be directly or indirectly dependent on nature and its services.
This article was originally published on kpmg.lu.