Insurance watchdog recognizes role of insured emissions in contributing to climate risk
By Yevgeny Shrago
On Monday, New York’s Department of Financial Services (DFS) released supervisory guidance for New York insurers on managing the risks from climate change. This makes DFS the first regulator in the U.S., state or federal, to lay out expectations for how financial institutions should think about the threat the climate crisis poses to their business. The guidance is an important step forward both for managing the risk insurers face, and for pushing them to reduce their own contribution to the climate crisis.
How does this guidance address the climate risk insurers face?
DFS reiterates the now established forms of climate risk. First, the physical risk from acute climate disasters and long-term shifts in weather patterns. Second, the transition risk from owning high emissions assets that will become worthless as the clean energy transition progresses.
What’s important is that it explicitly tells insurers to treat climate change as an unprecedented risk. In particular, DFS highlights how climate risks are hard to predict based on past experience, highly correlated, and manifest over many years. This makes them particularly dangerous to insurers, whose basic business model is to use past experience of losses to build a diverse portfolio of risks in a way that maximizes their profits in a 3-5 year window. To reduce their risk, DFS tells insurers they must use forward looking data and take the long view across their business. This informs the specific expectations discussed below.
DFS also recognizes that the climate crisis will disproportionately affect low-income communities and communities of color. To begin addressing this challenge, DFS encourages insurers to contribute just transition and climate adaptation efforts, and not to abandon communities who would be even more vulnerable to climate change if insurers stop covering them.
How will this guidance help mitigate the climate crisis?
The guidance recognizes the important role that insurers play in fueling the climate crisis, and the ways they could use that role to bring global emissions in line with science-based targets.
In particular, it says that one way insurers can mitigate climate-related risks is to reduce the coverage they provide to high-emissions projects, as well as the money they invest in them, in line with science-based targets . This is a critical acknowledgment that no other US regulator has made: that by enabling emissions, insurers are contributing to their own future losses.
DFS also encourages insurers to engage with their clients on developing science-based transition plans. It builds on this by pointing out the elevated risk of investing in fossil fuel companies that lack a credible transition plan.
Together, all of these statements lay the groundwork for pushing insurers toward divesting and withholding coverage from companies whose business does not align with science-based targets.
What specific steps must insurers take?
Regulators use supervisory guidance to communicate their expectations about how an insurance company will run its business in order to obey the law. Insurers will often change their policies or operations in order to make sure they don’t run afoul of new regulatory guidance. DFS expects insurers to incorporate climate risks into every level of their business, both by developing new ways of managing climate risks, and by incorporating them into their existing practices.
That starts at the top, with the expectation that an insurer’s board of directors understands the climate risks that the company faces. The board must also actively oversee the way that the insurer’s management team addresses those risks. Addressing those risks means more than just having a special climate team. DFS tells insurers to incorporate the dangers of climate change into the way they organize their business, making senior leaders responsible for managing those risks. It also expects them to think about the big picture of how a changing climate will affect their business and use it as part of their long term business planning process.
The guidance also calls on insurers to integrate the effects of climate change into all of their different risk management processes. That means calling out climate risk, identifying customers and investments that don’t have a credible transition plan, and building climate change’s effects into the tools they use to assess just how much risk they can take on. The guidance provides detailed explanations of how the climate crisis can worsen the standard types of risk that insurers face, such as credit risk, liquidity risk, market risk, and operational risk. It also encourages insurers to conduct scenario analysis of how different levels and manifestations of climate-driven risks can affect their business, and use them to assess how effective its plans for mitigating risks are in the face of unprecedented changes.
Finally, DFS expects insurers to disclose their climate risk both qualitatively and quantitatively, with sufficient detail to let the public understand the scope of the risk, and to encourage their customers to make similar disclosures.