A Finance Watch report on how to tackle the link between climate change and financial instability in the insurance sector.
This Finance Watch report explores policy action needed as part of the European Commission’s Renewed Sustainable Finance Strategy to ensure insurance sector resilience to sustainability risks. The paper argues that measures policymakers are currently focusing on, such as climate change-related scenario analyses and improved ESG disclosures, will not be effective in meeting this aim. Instead, climate change-related risks need to be integrated into the capital requirements rules of Solvency II, the prudential rulebook for insurers.
The insurance industry threatens its own survival by ignoring the risks inherent in climate change, now universally recognised as a major threat to financial stability. Current capital requirements rules of Solvency II do not take account of the micro- and macroprudential risks associated with insurers investing in fossil fuel assets and underwriting insurance to entities engaged in new fossil fuel exploration and production.
To effectively tackle climate risks weighing on the insurance sector and wider financial system, changes to capital requirements rules under the Solvency II Directive must occur that take account of climate change-related risks to ensure financial stability:
- Existing fossil fuel assets should be treated the same way as exposures deemed highly risky under current Solvency II capital requirements rules, meaning capital charges of 49% should be applied to equity investments in existing fossil fuel assets and the credit quality step rating of 5/6 should be applied to investments in existing fossil fuel bonds.
- A capital charge of 100% should be applied to investments in new fossil fuel assets, namely new fossil fuel exploration and production – both for bond and equity investments. This is necessary given that new ventures speed up climate change-related risks and are at a high risk of becoming fully stranded as highlighted by the recent International Energy Agency (IEA) report calling for all new investments in fossil fuel assets to stop immediately. For the same reasons, a 100% loss should be assumed when calculating the technical provisions required to settle the insurance and reinsurance obligations arising from coverage of policyholders taking part in new fossil fuel ventures.
- Fossil fuel investments should also be made ineligible for the Matching Adjustment (MA).