Insurance regulation – Solvency II – is now under review in both the UK and the EU for the first time in years.
And there’s never been a better time for reform.
Risk management is at the heart of insurers’ business. But ironically, insurers are not adequately considering – and are in fact actively compounding – the greatest risk humanity faces today: climate change and its irreversible consequences.
The Net Zero Insurance Alliance is not net zero-aligned
The world’s largest insurers, including founding members of the Net Zero Insurance Alliance (NZIA), are fuelling billions into new fossil fuel projects. This is despite the fact the IEA warned back in 2021 that there can be no new fossil fuels in a pathway to net zero by 2050.
The NZIA is not net zero-aligned at all. Without mandatory sustainability requirements governing insurers, there’s a risk the insurance sector will overshoot 1.5C.
Solvency II is an opportunity to champion sustainable finance...
Solvency II is an ideal vehicle for mandatory sustainability rules.
Regulators have a real opportunity to supercharge the insurance sector’s progress towards net zero by mandating action on climate.
…but so far proposals have been lacking ambition
Lukewarm EU proposal threatened in the European parliament
In the EU, the European Commission issued its proposal for a review of Solvency II in September 2021, which included a welcome introduction of climate change scenario analysis for insurers.
Disappointingly however, the Commission failed to act on its commitment to consistently integrate the notion of double materiality across the financial system. Insurers should be required to assess not only the risks they face in relation to climate and sustainability issues, but also the impact that their own business activities have on people and planet. Insurers cannot on the one hand be managing everyone’s risks, and on the other be contributing carelessly to these risks.
Adequate risk management is another contentious issue on the table in the EU, with the Commission kicking the crucial question of capital requirements into the long grass.
In a letter just sent to EU policymakers, ShareAction, Finance Watch and 12 other organisations highlight that capital requirements – which are key for insurers to be able to withstand losses – must reflect climate-related financial risks. The letter also calls for mandatory sustainability targets and governance structures backed by credible and robust transition plans. Supervised stewardship and engagement through transition planning can help financial institutions reduce exposure to stranded assets. This set of straightforward measures would allow insurers to manage their own transition risks on the road to sustainability and would also mitigate the systemic risk of disruption from unabated climate change.
Now that the review proposal is being looked at in parallel by the EU’s 27 member states in the Council and by the European parliament, things could take on a different turn.
In what is seen by many as a provocation move, Markus Ferber, Member of the European Parliament in charge of the Solvency II file, has recently proposed to scrap all sustainability considerations from Solvency II. At a time when climate change is being felt worldwide more than ever, other political groups at the European parliament have voiced their surprise and concern over Ferber’s position.
Negotiations will be ongoing, with parliamentarians due to examine amendments to the proposal in early September.
The picture is even bleaker in the UK
Edie finds the UK is lagging behind the EU when it comes to sustainable finance and Solvency II is no exception. The Treasury’s proposals do not even mention climate.
Due to proposed changes to capital requirements, UK insurers would hold less capital meant to protect policyholders and the overall system should they fail. At a time when the economy faces multiple crises (inflation, cost of living, warming planet), this is an extremely risky strategy.
The Prime Minister stated that the reduction in capital requirements would free up funds that would be invested in UK infrastructure projects. But there is no guarantee this will happen. Given current trends of fossil fuel underwriting and investment, there’s nothing to suggest this money won't further fuel climate chaos.
The other proposed change concerns the ‘matching adjustment’. This affects how insurers can account for over £300bn of long-term assets and liabilities on their balance sheets. The adjustment incentivises insurers to invest in certain assets over others.
The obvious link to climate here would be to restrict investment in fossil fuels and boost funding for green alternatives. But once again, the Treasury has missed a savvy opportunity to place sustainability centre stage.
Sustainability should be placed at the heart of Solvency II regulation
We see four key ways policymakers could embed sustainability requirements into Solvency II legislation:
1. Higher capital requirements accounting for high-risk assets such as fossil fuels. This would disincentivise underwriting and investment of fossil fuels, and mean insurers are the ones gambling on these decisions, not the public.
2. Mandatory net zero transition plans and frequent regulatory scrutiny thereof. Without short-term plans of how to get there, 2050 net-zero targets risks being empty promises.
3. Streamlined ‘double materiality’ approach for insurers to assess their impact on climate. Insurers should report not just on the financially material risks of a changing climate, but how their financing decisions contribute to climate change.
4. Rigorous stewardship policies for investment and underwriting. Insurers must play a role in stewarding high-carbon companies to net-zero. Only a minority of insurers have robust stewardship strategies.
For more information, or if you are considering tabling amendments in the EU or responding to the UK’ consultation, please get in touch.