BRUSSELS, 8 July 2021 – If Europe aims to boost financial sector resilience to sustainability risks as the Commission’s just-released renewed sustainable finance strategy outlines, then policy must integrate climate change-related risks in Solvency II capital requirements rules, a new Finance Watch report says.
The need to tackle unprecedented climate risks was acknowledged this week during the strategy unveiling, but unfortunately it failed to propose effective and impactful actions to sever the link between climate change and financial instability, including for the insurance sector. The Finance Watch report “Insuring the uninsurable: Tackling the link between climate change and financial instability in the insurance sector” argues that one of the strategy’s main objectives can be easily achieved by making some simple tweaks to the capital requirements rules of Solvency II, the prudential rulebook for insurers.
The paper warns that 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. To effectively tackle climate risks weighing on the insurance sector and wider financial system, the report provides policy solutions needed urgently to end the vicious circle – or doom loop – when insuring and investing in fossil fuel-related activities. 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 ⅚ 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).
Peter Norwood, Senior Research and Advocacy Officer at Finance Watch commented: “The reforms we propose are not designed to bring a revolution, but instead ensure that insurance companies are resilient against climate change-related risks. Material consequences stemming from these risks could emerge suddenly in a harsh way, putting the solvency of insurance companies and overall sector stability in jeopardy.”
The paper comes as the insurance industry continues to provide staggering amounts of investment and insurance coverage to fossil fuel assets. Among the largest categories of institutional investors worldwide, EU and US insurance companies alone invest some $600 billion in these so-called “dirty” assets. In addition, insurance coverage of fossil fuel operations earn the insurance sector $17.3 billion annually in premia. Fossil fuel assets which insurers invest in are likely to be partially or fully stranded in the transition to carbon neutrality. New fossil fuel assets are certain to become stranded as inferred by the International Energy Agency (IEA).
Climate change-related risks are already manifesting themselves, resulting in a world increasingly uninsurable, as evidenced by insurers withdrawing more and more insurance cover for natural catastrophes. Over time, this will lead to the collapse of the financial sector as a whole unless these risks are adequately weaved into the capital requirements rules of Solvency II. Measures communicated this week by the Commission in its “Strategy for Financing the Transition to a Sustainable Economy” to address this risk will not be effective. Climate change-related scenario analyses and improved ESG disclosures fail to catalyze the urgent shift for needed action. Integrating “scenario analyses” in insurers’ internal risk management system, for example, will not lead to any prudential actions given the radical uncertainty of climate events which render quantitative modelling unable to lead to actionable conclusions.
Norwood added: “Reams of data show the status quo is not sustainable, the focus of policymakers must shift immediately from trying to forecast and measure risk to moving to prevent it. Time is running out as the planet’s carbon budget will be exhausted in 10-15 years.”
Precautionary principle: An obligation for insurers
Insurers are already obliged under international and EU legislation to act with precaution under the “prudent person principle” of Directive 2009/138/EC (Solvency II) (Article 132). Insurers must only invest in assets whose risks can be properly identified and measured. Precaution is also laid out as a principle of governance by the UN Convention on Climate Change and the Treaty on the Functioning of the European Union, or TFEU.
He concluded: “Material consequences stemming from these risks could happen suddenly in a harsh way. Precaution now ensures the stability of the insurance sector and financial system as a whole. If not, insurance firms will feel the pinch when climate change risks pose heavy losses, leading to withdrawal of coverage and/or re-pricing contracts and more and more businesses in the real economy left uninsured. The financial and economic system, as well as society, simply cannot afford this.”
Notes to editors:
Finance Watch Report: Breaking the climate-finance doom loop
Finance Watch published in June 2020 a report showing how banking prudential regulation can tackle the link between climate change and financial instability. The report calls for immediate regulatory action to end the climate-finance doom loop, in which fossil fuel finance enables climate change, and climate change threatens financial stability in unpredictable ways.
Finance Watch letter to EU policy-makers to close ‘climate-finance doom loop’ through CRR, Solvency II upgrades
In May 2021, Finance Watch called on EU leaders not to miss the opportunity of the upcoming review of banking and insurance prudential legislation to properly integrate climate risk. The letter was sent along with the proposed amendments to CRR and Solvency II.
Finance Watch: Europe needs a more ambitious sustainable finance strategy
Finance Watch reacted on 7 July to the European Commission communication “Strategy for Financing the Transition to a Sustainable Economy”. Actions outlined in the strategy fall short on ambition, the association noted, and If pursued as tabled, Europe may miss the deadline set for its climate goals. This strategy misses on many fronts, including a chance to integrate sustainability into prudential rules and the need for a sea change in corporate behaviour to put the economy on the path to sustainability. The Commission approach runs counter to its own acknowledgment for Europe needing to take “unprecedented efforts to mitigate climate change, rebuild natural capital and strengthen resilience and wider social capital.” See letter.
The core strategy aim should tackle without delay much-needed integration of sustainability into corporate governance, including through mandatory sustainability targets and transition pathways, and prudential treatment of sustainability-related financial risks. EU lawmakers wield the necessary tools and mandate to act. A looming climate emergency requires Europe to be bold, impactful and take immediate actions. Achievable solutions exist, and Finance Watch offers many, including ideas to incorporate climate risks into the capital requirements rules for insurance companies as outlined in the report “Insuring the uninsurable: Tackling the link between climate change and financial instability in the insurance sector”.
Background on the Strategy for Financing the Transition to a Sustainable Economy
Communicated by the European Commission on 6 July, the strategy builds on the 2018 Commission Action Plan on financing sustainable growth which put in place the building blocks for the EU sustainable finance agenda. Via the strategy, the Commission reaffirms its commitment to deliver on the remaining actions stemming from the 2018 Action Plan and unveils new and follow-up actions, bearing in mind EU sustainability goals have evolved while the global context has changed since 2018.
In July 2020, Finance Watch responded to the Commission consultation on the Renewed Sustainable Finance Strategy putting forward its recommendations for the direction of travel and next actions needed.
Finance Watch work on Sustainable Corporate Governance
Finance Watch responded in February 2021 to the Commission consultation on sustainable corporate governance, calling on EU policy makers to adjust the corporate governance framework to integrate a set of incentives and obligations for companies to pursue sustainability. An ambitious EU legal framework is needed to require companies to integrate sustainability considerations within corporate strategies, business models, decision-making and oversight. These recommendations were reflected in a joint-NGO policy briefing published in June 2021, showing a unified vision on how to better embed sustainability into corporate governance in the context of the forthcoming European Commission initiative.
Finance Watch work on improving corporate and financial industry transparency
Finance Watch advocates for improved sustainability-related disclosures of corporates – financial and non-financial – and financial products. In June 2020, Finance Watch responded to the Commission consultation on the revision of the non-financial reporting directive (NFRD). In April 2021, Finance Watch reacted to the Commission sustainable finance package, including a proposal for a Corporate Sustainability Reporting Directive, revising the Non-Finance Reporting Directive. Finance Watch views were echoed in a joint NGOs’ statement published later that month.
About Finance Watch
Finance Watch is an independently funded public interest association dedicated to making finance work for the good of society. Its mission is to strengthen the voice of society in the reform of financial regulation by conducting advocacy and presenting public interest arguments to lawmakers and the public. Finance Watch’s members include consumer groups, housing associations, trade unions, NGOs, financial experts, academics and other civil society groups that collectively represent a large number of European citizens. Finance Watch’s founding principles state that finance is essential for society in bringing capital to productive use in a transparent and sustainable manner, but that the legitimate pursuit of private interests by the financial industry should not be conducted to the detriment of society.