This blog is intended to be of most use to members who have not yet included any climate scenarios in their ORSA. However, it should be readily accessible to all risk professionals and may provoke some further thoughts for those further along with their ORSA considerations.
In April 2021, EIOPA issued its Opinion on the supervision of the use of climate change risk scenarios in the ORSA[i] (‘the EIOPA opinion’). In this they stated that “only a minority of insurers assess climate change risks in the ORSA using scenario analysis, usually limited to a short-term time horizon. Therefore, EIOPA considers it essential to foster a forward-looking management of these risks to ensure the long-term solvency and viability of the industry” and that “Climate change risks should be assessed not only in the short term but also in the long-term using scenario analysis to inform the strategic planning and business strategy. Insurers should subject material climate change risks to at least two long-term climate scenarios, where appropriate”.
This seemed consistent with the direction of the 2019 PRA Supervisory Statement (SS3/19)[ii] which recommended firms take the result of stress and scenario testing into account when setting out how they manage the financial risks from climate change in their risk appetite statements but was silent on the ORSA itself.
In Ireland, the Governor of the Central Bank of Ireland wrote to all Chairs and CEOs of Regulated Financial Service Providers in November 2021 outlining the CBI’s supervisory expectations regarding climate and other ESG issues[iii]. The five key focus areas identified included scenario analysis and stress testing.
It is clear from the above papers that scenario analysis is high on the regulatory agenda but also that regulators recognise the need for a risk-based and proportionate approach to assessing climate change. Analysis should focus on material risks and be used to inform strategic planning.
Having previously been part of the majority that EIOPA referred to – i.e. not assessing climate risks using scenario analysis, I thought it could be useful to share some lessons learned from my research into how to go about including climate change scenarios in the ORSA.
It is emphasised, that this is a point-in-time viewpoint. The impacts of and our understanding of Climate Change and its associated risks are constantly evolving, and it is expected that each practitioner will tailor any scenario analysis to their own risk profile and, most importantly, continue to develop their scenarios over time.
So where to start…
Firstly, it is important to get comfortable with the terminology to help in identifying what risks are most relevant to your own firm. For example, knowing your Transition risks from Physical risks and your Acute risks from Chronic risks. The EIOPA opinion gives a good definition of these risks and some useful examples of each for further consideration. Further detail can be found on the TCFD knowledge hub[iv] which provides links to more specific resources on each type of risk.
The next step is attempting to understand how climate change may unfold in the short and long term and link these potential outcomes back to your risk profile. The Network for Greening the Financial System (“NGFS”)[v] provides a framework for considering different plausible futures with detailed additional explanatory material to help understand how each scenario may apply. The NGFS is also working with key stakeholders to set out a more standardised set of scenarios and variables for disclosure and there is some anecdotal evidence of supervisors converging on a set of scenarios, at least partially informed by the NGFS approach.
The NGFS scenario portal referenced below can be used to help determine which pathways are most applicable to your risk profile and thus warrant further investigation. In addition, there is plenty of more granular data available on transition pathways, climate impacts and macro-financial indicators to support their analysis.
Newly educated on Transition risks, Physical risks and which type of future scenarios are of most interest to you, it is time to consider how to model the output.
As with all modelling, it is important to start by considering the objectives of the exercise. What risks are you most concerned with? What time horizon is most relevant to your firm? How well can your business model adapt in response to different scenarios? These types of questions can be explored using scenario analysis and the results communicated to the Board in the ORSA.
One possible approach is to consider a range of climate scenarios which model a combination of transition and physical risks over different time horizons. An alternative approach may be to use existing scenarios and layer additional climate considerations on top of the existing stresses. The EIOPA opinion provides a helpful appendix for the mapping of climate change risks to prudential risks.
A clear view of the risks and uncertainties to which the undertaking is exposed allows management to discuss and decide on actions to mitigate excessive risks and anticipate future management actions contingent on certain future events unfolding.
Key areas to consider:
When choosing scenarios, one needs to balance the complexity and accuracy of the scenarios against the time and effort required for modelling. Some key decisions to be made include:
- Time Horizon: The time horizon for climate change is highly uncertain. Modelling relatively small annual impacts may be desirable for informing management actions, however, it will be less useful for a capital stress exercise. For a stress quantification, it may be beneficial to assume a range of year 1 impacts rather than trying to develop a more theoretically accurate pathway. If following this approach, it is important to clearly communicate the artificial nature of the chosen stress.
- Standalone stress v Business wide: Being clear on your objective can help inform this choice. In reality, climate change is a risk driver rather than a standalone risk and likely touches all existing risk types to some extent or another. From this perspective, one could consider layering climate risk into existing scenarios. This may create more plausible pathways and help weave climate considerations into more areas of the business. Alternatively, treating climate risk as a standalone risk type, at least initially, can help clarify the potential magnitude of the risk and drive appropriate management responses.
- Longer term scenarios: Typically, ORSA scenarios follow the business planning time horizon. Looking at longer term scenarios, e.g. projected views for the next 30-50 years, may provide firms with strategic opportunities but also challenge current business models. For entities with a shorter risk profile, it may be appropriate to consider a qualitative analysis of long-term scenarios to begin with.
- Accuracy: Given the wide range of possible outcomes, the uncertainty over time-horizons and the scope for any impacts to be impacted by management actions, it may be appropriate to begin with a higher-level assessment rather than creating an overly complex model. Some simple deterministic stresses can help narrow down the key assumptions that require additional focus in future scenarios.
- Scenario Calibration: The resources mentioned here will guide you towards understanding the types of scenarios to consider but don’t readily translate into asset / liability shocks. It may be useful to look at the calibration of supervisory stress testing exercises to get a feel for possible levels of stress to consider. One such example is the Climate Biennial Exploratory Scenarios (“CBES”) produced by the Bank of England[vi].
- Review frequency: Whilst all ORSA scenarios should be reviewed annually, in many cases one might find that the existing stresses and scenarios remain appropriate. Given the evolving nature of the impacts of climate change and the effectiveness of any policy reactions, it is possible that the approach to scenario modelling may need to be updated more frequently than some traditional ORSA stresses.
As mentioned at the start, this blog is intended to be of more use to those entities who have not previously considered climate scenarios in their ORSA and are looking for some ideas on where to start. Actual scenarios chosen will need to be tailored to a given firms risk profile.
The following references are not specifically referenced in the blog but may provide some useful additional reading for the interested readers:
- Financial Conduct Authority Climate Financial Risk Forum https://www.fca.org.uk/transparency/climate-financial-risk-forum
- IFOA Life Board Climate Risk Working Party https://blog.actuaries.org.uk/blog/recommended-papers-embedding-climate-change-risks-life-insurer-risk-frameworks
- Intergovernmental Panel on Climate Change 2022 update on Sixth Assessment Report https://www.ipcc.ch/report/ar6/wg3/
Robert Fitzgerald is a member of the SAI and of the ERM committee.
The views of this article do not necessarily reflect the views of the Society of Actuaries in Ireland, the Enterprise Risk Management Committee, or the author’s employer.