By Maria Van Der Heide, Head of EU Policy, ShareAction
“Code red for humanity” is how UN Secretary-General António Guterres described the conclusions by the Intergovernmental Panel on Climate Change (IPCC) about the state of the Earth’s climate. His words reflect not just academic predictions of the future, but also the reality of increasingly frequent and intense extreme weather events.
The list of deadly heatwaves and destructive floods in 2021 has been startling. As a sector, the insurance industry is heavily implicated in such events.
On the one hand, insurers are directly impacted by climate change induced catastrophes; their losses to cover the damage caused by so-called “natural disasters” were higher for the first half of 2021 than for any six-month period since 2011.
On the other, insurers have a vital role to play in helping communities and economies become low-carbon, climate-resilient and sustainable. Insurers in Europe are responsible for over €10.4 trillion of global assets under management. In their roles as risk managers and investors, insurers can choose to direct financial flows towards companies that have a positive impact on the world and away from those industries with the most harmful effects on people and the planet.
‘Solvency II’ is the EU’s legislative framework for insurance firms. The upcoming 2021 review of Solvency II offers the EU the opportunity to require that insurers consider sustainability risks in their investing and underwriting activities.
To do so meaningfully, we have seven recommendations outlined below. Our full briefing for policymakers can be found here.
1. Solvency II should include double materiality
It’s increasingly regarded as good practice for insurers to consider how environmental risks will impact them financially in their decision-making. But holding global warming to well under 1.5 degrees will require insurers to also consider the flipside: how their own business operations and investments are impacting climate change. This is known as ‘double materiality’.
We recommend the EU embeds ‘double materiality’ into the Solvency II framework. This will align the legislation with other key pieces of regulation that are contributing to the EU’s sustainable finance agenda, such as the Sustainable Finance Disclosure Regulation and the Corporate Sustainability Reporting Directive.
2. The EU should clarify the new ‘prudent person principle’
The ‘prudent person principle’ is a fundamental element of Solvency II which includes provisions on how insurance companies should invest their assets. In April 2021, the Delegated Regulation was changed in order to integrate sustainability considerations into the prudent person principle, which was a welcome step in the right direction. However, the principle can be interpreted differently by EU Member States because of its high-level nature and the lack of clarity about how to take account of sustainability risks.
We therefore recommend that sustainability considerations are fully integrated in the prudent person principle in the Solvency II Directive (level 1 legislation), given the requirements of the European Green Deal to incorporate sustainability into prudential regulation. It should also be made explicit that the prudent person principle requires the ‘double materiality’ approach described above.
3. The EU should embed responsible investor stewardship
Our research shows that only a small minority of insurers and their managers have robust stewardship strategies to ensure an ambitious engagement with clients they insure and companies they invest in.
We recommend that the EU mandates higher standards for investor stewardship. Solvency II should require stewardship policies, practices and reporting for investment and underwriting activities, and should cover environmental and human rights issues.
Clear engagement objectives should be set out as part of the stewardship policy. An escalation strategy should be disclosed for dealing with unsuccessful engagements with investee companies. This should include time-bound engagement objectives, a commitment to vote against the re-election of relevant board members or the remuneration policy, (co-)filing shareholder resolutions, pre-declaring the intention to vote in favour of shareholder resolutions, and sending an open letter to the company. Ultimately, it could involve divestment.
4. There needs to be better ESG standards for insurers’ underwriting policies
Insurers have the potential to be major actors in steering capital flows towards green investments and to avoid stranded assets. They can do this through their underwriting strategies as well as through their investments.
Our recent ranking of 70 of the world’s largest insurers shows that ESG performance in their underwriting processes is consistently poorer than in their investment activity.
We therefore recommend that the EU requires insurers to develop sustainability-related underwriting policies, practices and reporting in line with the European Insurance and Occupational Pensions Authority’s proposal on impact underwriting in the Solvency II framework.
5. Board oversight - tone from the top
In our Insuring Disaster report, we found no evidence of board-level involvement in responsible investment and underwriting for half of the insurers surveyed, and that most boards have not received any relevant training or incentives.
We can’t overstate the importance of setting the ‘tone from the top’ in terms of the culture and strategic purpose of a company.
We recommend that the Solvency II review clarifies the pivotal need for board-level oversight of the integration of sustainability strategies, rather than the senior level management committee of a firm.
We further recommend that the EU requires insurers to commit to working towards achieving net zero by 2050 or earlier, defining short- and medium-term targets, putting in place an effective strategy to meet those targets and publishing annual updates on their progress.
6. Strengthen reporting requirements
Current Solvency II reporting requirements do not include sustainability. Having the insurance industry report on at least climate-related issues - by following the financial disclosure obligations of the Taskforce on Climate-related Financial Disclosures (TCFD) - will allow regulators to understand insurers’ net zero strategy plans and ambitions.
We recommend that Solvency II requires disclosure in line with the TCFD recommendations, which would reflect the G7 commitment to making TCFD mandatory across the economy.
This should cover disclosure of insurers’ transition strategies and targets, including the underlying methodologies they use for setting targets and measuring the progress of their investment and underwriting portfolios, based on a range of scenarios and considering adaptation and risk reduction activities.
7. Capital requirements should reflect climate risks
It is widely accepted that some of the assets insurance companies currently invest in and insure expose them to climate change risks. However, key sustainability risks are currently not taken into account in the current Solvency II capital requirements and wider prudential framework.
In particular, the Solvency II prudential framework as it is does not reflect the acute risks associated with investing in or providing insurance policies to businesses involved in fossil fuel activities.
We recommend that insurers with equity and bond investments in fossil fuel industries be required to set aside more capital, which is consistent with the high sustainability risks inherent to such industries. Similarly, the higher risks that come with providing insurance coverage for fossil fuel industries should be fully reflected in the revised Solvency II prudential rules.