Can insurance help drive a greener future?

Huw Evans writes for the Social Market Foundation’s publication, “How sustainable finance can tackle the climate emergency”, in association with the Chartered Banker Institute.

Few parts of the global economy have a bigger stake in tackling climate change than insurance and long-term savings. As providers of cover to households and business, the insurance industry is uniquely exposed to the immediate costs of failing to address climate change. Then, in the longer term, as risk managers and as institutional investors, our sector has the capacity to shape the future of energy provision.

Insurance protecting society from the impact of extreme weather

First, let us set aside from the outset any suggestion that the threat of climate change is overstated. Insurers across the globe, particularly in our world-leading major risk sector in London, know full well how very real the impact is. These are listed companies accountable to shareholders and they see the impact of climate change on their balance sheet first-hand.

As the leading international provider of cover for large-scale and specialist risks, the UK’s insurance sector sees the financial impact of extreme weather events across the globe. The London market bore the brunt of hurricanes Florence and Michael, which are believed to have resulted in insured losses of more than $10 billion.[i]

Association of British Insurers (ABI) members also see the impact in the domestic market of cover for homes and businesses across the UK, where – even in a year without a major flood – 2018 saw an extreme freeze that resulted in insurers paying a record amount for burst pipes: £194 million in a three-month period. A heatwave later in the year led to more than 10,000 households needing to claim for damage caused by subsidence, at a cost of more than £64 million.[ii]

One clear conclusion from recent experiences is that society needs to become more resilient to extreme weather, and insurance can play a role in that. In 2017, for example, while the spate of hurricanes resulted in record pay-outs, more than half of the overall estimated losses were not insured.[iii] Given that those worst affected by climate change, such as the flood plains of Bangladesh, will be the world’s poorest societies, there is an urgent social justice imperative to our work. Insurance gaps need to be identified, and filled before any future disasters, not in their aftermath.

Reflecting climate risk in financial regulation

Only so much can be done to manage the risks from extreme weather as they grow. The long-term prize must be reducing emissions and thus preventing unmanageable rises in global temperatures. This means changing how society generates and uses energy, and that costs money. Lots of it. The International Energy Agency (IEA) estimates that $3.5 trillion needs to be invested in the energy sector each year up to 2050, which is double the current level of investment. Alongside this, investment within ‘end-users’ (industry, transport, and buildings) needs to increase by ten times.[iv]

Given these sums, quite rightly, people want to know that financial services are using their power as investors to encourage businesses to take a long- term view of decarbonisation. And given that insurers also bear the costs of inaction, this would seem like an area where the stars are neatly aligned. With the right regulatory framework, the £1.9 trillion of assets managed by the UK’s insurance and long-term savings sector could play a major role in enabling that change.

The challenge, however, is that our sector’s primary obligation has to be to pay claims reliably and to provide pensions securely. Making sure that individual insurers can meet these aims is essential to the UK’s financial stability. Insurers invest in order to ensure they are equipped to meet these long-term liabilities. So, the criteria for decision-making on how our sector invests must be carefully thought through and recognise that it will take time to unwind long-term investment portfolios.

 We have therefore welcomed the Bank of England’s recent policy statement on managing the risks of climate change, which makes the UK the first country to make climate change a central part of financial regulation.[v] This is accompanied by detailed work programmes within both the Financial Conduct Authority (FCA) and Prudential Regulation Authority (PRA). This work has struck the right tone, recognising the areas where there is still uncertainty and that tackling climate change will therefore need to be a genuinely collaborative process between regulators and industry.

It is also worth emphasising that – whatever the long-term shape of financial regulation post-Brexit – the UK remains committed to the principles of the EU Solvency II regime, so decisions taken at EU-level will therefore have a major impact. Taken alongside the European Commission’s comprehensive Action Plan on Sustainable Finance and a forthcoming consultation by the European Insurance and Occupational Pensions Authority (EIOPA) on sustainable finance that will feed into the 2020 review of Solvency II, the Bank of England’s work could mark the beginning of a new chapter of finance’s relationship with climate change.

Enabling a step-change in investment practice

The emergence of a wide range of Environmental, Social and Governance (ESG) investment opportunities demonstrates the increased appetite for these asset classes. But, while increased year-on-year net sales for ESG investments provide encouragement that investors do see these as a viable option, they remain only a small part of the overall investment mix, with 1.2% of total assets under management within these classes.[vi]

The insurance industry is in a special position to help ESG investing grow – and it wants to. There is already evidence that, where there is scope to do so, insurers will make the switch to sustainable and ESG-compliant investments. Insurers and pension funds have made up the majority of early investors in the rapidly growing Green Bond market, with Aviva, for example, having invested £1.3 billion in the market.[vii], [viii]

But, while these early signs on ESG are encouraging, it will require a major long-term effort to switch from well-established investment practices to areas which, currently, do not benefit from observable market prices or external credit ratings. To go further, we need support from the regulatory regime because, currently, the sector does not have a free hand to switch where they invest their capital.

Realising our sector’s potential through the Prudential framework

The current Solvency II regime encourages firms to utilise government and corporate bonds as the majority of their investment mix, meaning most investment remains in the traditional sectors of energy, agriculture, and petrochemicals. Through the Bank of England’s work and the forthcoming EU Solvency II review, the ABI wants to work with regulators to ensure that, over time, this evolves to allow ‘impact investments’ into non-traditional sectors, including renewable energy infrastructure.

This certainly does not mean the PRA setting aside all of its concerns or deviating from a focus on financial stability. But, through joint work between the sector and the regulator, more could be done to highlight possible opportunities and ensure that regulation is not acting as an unintended disincentive.

Insurers are increasingly interested in infrastructure investments, as the long-term risk exposure is well matched to the long-term liabilities insurers cover. However, as it stands, they have limited ability to do so, as most of these are ‘greenfield’ projects that inherently contain exposure to construction risk. As a result, they incur capital charges within the Solvency II framework that make them unattractive; asset eligible criteria act as a further restriction on investing in them.

So, while in the short-term the PRA’s approach reflects the continued challenges associated with illiquid assets, including investing in ‘greenfield’ infrastructure projects and guiding firms accordingly, we see scope to overcome this.[ix] One key avenue is to adapt to different circumstances within different parts of the market.

While there will clearly always be certain circumstances where it would be inappropriate for insurers to make such investments, life insurers, for example, with their long-term investment horizon, pose a lower risk to financial stability and are therefore well-placed to invest in these illiquid assets, which they can hold onto during periods of market volatility.

The overall direction of the regulator’s work on climate change is positive; ABI members now have a good platform on which to work collaboratively to establish the areas where their investments can make the most impact. But a key challenge will be ensuring that the overall aim of facilitating green finance is integrated financial regulation, and not something seen as an addition on top. For insurers, that means moving away from a traditional approach to capital. Facilitating such a shift towards investing in the green economy would be an excellent example of regulation working together with industry as an enabler of change.