Insurance, regulation, and the transition to a net zero economy – Remarks by Gerry Cross, Director of Financial Regulation, Policy & Risk

Good afternoon. Thank you to Insurance Ireland for the opportunity to speak with you today on this very important topic.

Climate change is one of the defining issues of our time. The challenges associated with it have significant implications for the financial system, and for individual households and businesses. Governments and legislatures globally have made public policy decisions that commit society and the economy to transition urgently to a climate neutral future. In Ireland, there is a commitment in law to a 51% reduction in emissions by 2030, and to have net-zero emissions by no later than 2050.

The recent Intergovernmental Panel on Climate Change report stated that we are approaching irreversible levels of global heating, and that catastrophic impacts of climate change are becoming inevitable. As outlined in the recent report by the Environmental Protection Agency, based on current measures, Ireland will only achieve a 29% reduction in greenhouse gas emissions by 2030, well below the 51% commitment. There is an urgent need to realise the significant benefits from transitioning to a more sustainable economy. The insurance sector has a key role in this transition.

In this speech, I will cover the following topics, which are important for insurers from a climate perspective.

-          Role of insurance in society and the risk of increasing protection gaps

-          Greenwashing

-          Risk management, and supervisory observations

-          Central Bank climate change guidance 

Role of insurance in society

First, I think it is important to remind ourselves of the critical role that insurance plays in society. Insurers provide core financial services to consumers and businesses. Insurance gives consumers and businesses confidence by providing a safety net. Confidence to make investments, confidence to do business, confidence to buy a home or drive a car, or do any number of things that make up modern life. Insurance also protects consumers from the full impact of life’s most traumatic events. Insurance allows for the spreading of risk of large unpredictable events so society has a level of certainty and confidence to function. However, insurers cannot take on all risks. Where risks are too large, or too frequent, they become uneconomical to insure.

Climate change represents a source of risk to insurers’ business models. It is increasing the frequency and severity of extreme weather events across the globe. This increases the physical risks that insurers are exposed to in their underwriting portfolio. While the impact of physical risks resulting from climate change may be more severe in other countries, Ireland is not immune. There is scientific consensus that Ireland will face more and more severe flooding events, and so insurers with domestic risks also need to consider this and take appropriate action.

As the impacts of climate change intensify, this could lead to increased protection gaps. A protection gap is where for a particular risk type in a particular area, insurance coverage is either not available or so expensive as to be prohibitive. The impact of this is already being seen. For example, multiple insurers have cited the impact of climate change as one of the reasons for withdrawing home insurance cover in California.

The Central Bank is involved in a number of initiatives in relation to this issue of protection gaps. This work focuses on better understanding the current situation, and considering how any sub-optimality might be addressed. We have been actively involved in the work that the European Insurance and Occupational Pensions Authority (EIOPA) has been carrying out. We welcome the recent joint EIOPA / ECB staff paper^[1] which seeks to explore policy options to address protection gaps. The Central Bank are also members of the IAIS Protection Gap Taskforce. This is collecting information on global initiatives to address protection gaps, with a particular focus on the role of supervisors.

Protection gaps are a systemic issue that require system wide consideration. It is of course important that insurers always price effectively and well for the risks that they take on. Where risks and pricing become dislocated this leads to problems in the end.

However, as key participants in the financial system with an overall purpose to support the functioning of the economy and the financial wellbeing of citizens, it is also important that insurers take a joined up perspective in respect of the functioning of the insurance system as a whole.

To narrow protection gaps, we will all need to be thinking about the potential for joined-up, multi-stakeholder solutions.  As experienced risk managers and institutional investors, the insurance industry can play an important role in this regard. In particular, it should deploy its insights and expertise to support the efforts to think about how protection gap problems might be ameliorated and addressed. There is an opportunity to learn from leading practices internationally, and to discuss new and innovative solutions, as enhancing societal resilience to climate change is paramount.

Sustainable finance - getting it right

I have talked about the need for a multi-stakeholder approach to address protection gaps. The same is also true when it comes to sustainable finance generally.

We are reaching a point where many of the key pieces of sustainable finance legislation in the EU have been agreed, and are in force, or coming into force soon. This is a good point at which to take stock of where we are, what has been done, and to consider how we ensure that these legislative interventions operate effectively and with optimal impact to all our benefit.

One of the key areas where progress has been made is in relation to disclosures. At their core, sustainability disclosures, as required by the Sustainable Finance Disclosures Regulation (SFDR), are aimed at increasing transparency for investors in relation to the risks associated with investment products, and the integration of sustainability risks at the product and entity level. There are significant benefits associated with these new rules, but there are also challenges. Some of those challenges, in particular with data, will be addressed when the Corporate Sustainability Reporting Directive (CSRD) is implemented. But further work is required to make sure disclosures work for consumers and for the system.

We welcome the comprehensive assessment of the SFDR announced by the Commission in December 2022^[2] and designed to look at aspects such as legal certainty, usability, and how the Regulation can play its part in greenwashing. There is much merit in a focus now on making the effort to ensure that pragmatism and usability remain to the fore as we move into the next phase. The flipside of this however is that the approach adopted by regulated firms should be one founded in outcomes, consistency of language and substance, and in an underpinning high quality culture.

If we look to other topics, transition planning is increasingly being discussed. We welcome the recent, excellent report by the Network for Greening the Financial System (NGFS)^[3] on transition planning. In this report they helpfully distinguish between risk-based transition planning on the one hand – which we would see as part of the existing requirements relating to good risk management. And transition plans on the other. These transition plans are strategy focussed plans, which aim to provide clarity on how the firms will meet specific climate and transition targets. Transition plans are currently not mandatory, but they are emerging as one of the key forward-looking tools that firms can use to translate climate targets into actions.  

We are very conscious that a lot is being asked of all firms at the moment. The sustainable finance legislative environment is multi-faceted in its scope and application. While each individual piece of legislation has a specific aim or purpose, it has been developed with the ultimate goal in mind of moving to a more sustainable, climate neutral society. This ultimate goal should remain front and centre in our thinking. Responding to sustainable finance legislation should not be seen as a compliance exercise, it should trigger actions that have an impact. Commitment to actions that have an impact will require cultural alignment within firms and an approach to the transition that reflects an appropriate level of pragmatism.

But this is not something that firms need to navigate on their own. In their recent publication, the European Commission talk about making sure the sustainable finance framework works for companies who want to invest in their transition to sustainability, but also about making the sustainable finance framework easier to use. The Central Bank is also committed to these goals. We are looking into what we can do to provide more clarity for firms, focusing on how we can work together to deliver meaningful impact.

Greenwashing

Consumer demand for sustainable products, particularly investment products, has seen rapid growth in recent years. Insurers have responded to this. This is to be welcomed. Life insurers manage a large amount of money for policyholders and consequently, if this is managed in a responsible and sustainable way, it has the potential to play a significant role in supporting the transition.

However, at the current time there is a mismatch between the supply and demand of sustainable investments. Supply of sustainable assets is not sufficient to meet demand. As a result, there may be a perceived competitive advantage to be gained by firms promoting their sustainability credentials, or the sustainable credentials of their products, which may in some instances may be mis- or over-stated. The challenge for both the Central Bank and industry is to ensure that financial services and products that make sustainability claims deliver on those claims. To do this, accurate and transparent disclosures are key. Without this, consumer trust in sustainable products will be eroded, and investment will not go to where it is needed.

The Central Bank welcomes the recent reports by the three European Supervisory Authorities on Greenwashing^[4]. These reports clearly show that greenwashing has the potential to have a significant negative impact on consumers. It also represents a reputational risk for insurers. In an insurance context, greenwashing can manifest, to differing degrees, at all stages of the insurance product lifecycle, and may be intentional or unintentional. Insurers should be vigilant to make sure that any sustainability claims they make are accurate, evidence based and clearly communicated. For consumers to have trust, and for insurers to play a meaningful role in the transition, sustainable products need to deliver on their sustainability claims.

As mentioned earlier, insurers have a significant role to play in developing products that support the transition. Greenwashing concerns should not become a reason for reducing that product offering. Insurers should be proactive in understanding the needs of consumers, and providing products that meet those needs. They should be thinking about selling products that enable sustainable actions, and facilitate sustainable economic activity. There is a significant opportunity there for insurers who respond to this consumer demand in a meaningful way.

Risk management and supervisory observations

Based on our supervisory engagement we see positives in the work that insurers are doing, with areas for improvement. While there is a good level of awareness of climate change risk, many insurers are still treating climate change as an emerging risk. From the wildfires in the USA and Canada, the heatwaves and temperature records being broken in Europe, and catastrophic flooding in Pakistan, the effects of climate change are being felt across the globe now. Climate change is no longer an emerging risk and insurers should be treating it as such.

In relation to risk management, we are seeing progress in relation to integrating climate change risk into risk management frameworks, but there is more work to do.

- Some insurers are more advanced in their management of climate change, however many others are only starting to consider the implications for their business and the insurance cover they provide.

- The risk to insurers’ business models has generally not been properly addressed. This is a key focus for the Central Bank’s climate change guidance,  which we will talk more about shortly.

- Insurers are generally not considering the impact climate change will have on reinsurance availability, product design, or their own operations.

- Insurers in Ireland have a significant reliance on group for reinsurance, expertise and capital. Group entities may have significant climate change expertise, and leveraging that resource is certainly something that we encourage. However, insurers should make sure that anything done at group level is appropriately tailored for the Irish insurer. Insurers should also appropriately understand and manage any risks arising from reliance on the group entity.

- Many insurers do not appear to be conducting sufficient stress and scenario testing, and it is often unclear how stresses have been developed and how they align with climate science.

What is the Central Bank doing?

Climate change is a strategic priority for the Central Bank. We have established a Climate Change Unit in order to centrally oversee the integration of climate and sustainability considerations into all of our financial regulation and financial stability activities.  We have also established a Climate Risk and Sustainable Finance Forum, which brings together a selection of industry stakeholders and climate scientists with the Central Bank, to build shared capacity and understanding of the implications of climate change and to share best practices. It is encouraging to see the insurance sector is actively engaging with this. The Central Bank sees open dialogue with insurers, and between insurers as important in developing solutions, addressing issues and moving towards actions that have a meaningful impact. While it is disappointing to see some insurers leaving the Net Zero Insurance Alliance, it is heartening to see that commitments by individual insurers remain strong.

Climate change guidance

This leads me to the Central Bank’s climate change guidance for the insurance sector. Chris will talk to the content in more detail, but first I want to explain a little why we decided to publish the guidance, and what we are looking to achieve.

To do this, it is useful to look back at a speech I gave 2 years ago on the techniques of good regulation.

First, there should be clarity as to the objectives. We have been talking to industry for a number of years in relation to climate change. From these discussions we understand that, while there is a willingness from insurers to take action, there is uncertainty on how to start. This was reinforced by the messages we received in response to our climate and emerging risks survey. To some extent this uncertainty has been driven by too much information. Too many reports to read, too many guidance documents setting out slightly different versions of what good looks like. That is why we believed there was value in the Central Bank setting out clear expectations. To have a reference point for insurers in Ireland to use. The guidance does not purport to cover everything that insurers might do in relation to climate change risk. Rather, it seeks to set a baseline of expectations for insurers to start and progress from.

Second, good regulation needs to be predictable and proportionate. It should be predictable in the way it is interpreted and implemented by supervisors, and proportionate based on nature, scale and complexity of the insurer. We are very conscious of this, and we have set out in the guidance, and in the principles underpinning the guidance how we will supervise. The guidance recognises proportionality by explicitly setting expectations that vary by size of insurer, and materiality of exposure to climate change risk.

Insurers are at different stages of development, and we will recognise this in our supervisory approach. We will take a proportionate approach to supervision. For some insurers we recognise that qualitative or simplified approaches are appropriate. However, we do expect all insurers to take action, and although simplified methods may be appropriate initially, we expect that these methods will develop and improve over time.    

Thirdly, good regulation needs to weigh the costs against the benefits. The Central Bank is very conscious that anything we publish has an associated cost for industry, even if, as in this case, it doesn’t introduce new requirements. This is why, in the consultation paper, we included a cost benefit analysis. As we set out in the consultation paper, failure to act now to address and mitigate climate change risk carries economic, social and environments risks and costs. Some of those risks may emerge over the short term, such as financial losses due to increased claims, whereas others will only emerge over the long term. Waiting for long term risks to emerge before taking actions may have serious consequences, and may ultimately increase the overall risks and associated costs. Failure to adapt and manage climate change risks now may threaten the solvency and indeed the viability of an insurer.

Finally, good regulation needs to have high quality stakeholder engagement. Understanding and engaging appropriately with stakeholders, to understand perspectives and concerns is key for the Central Bank. Being Open and Engaged is one of the Central Bank’s four strategic themes. Throughout the development of the climate change guidance, we have engaged with stakeholders from industry. As well as publishing a consultation paper, we had bilateral, informal workshops with financial services firms, industry and professional associations. We thank Insurance Ireland, and its members for their useful feedback as part of those sessions. This strong engagement has continued post publication. As well as having sessions like today, we are trying to think of new and creative ways of doing this. For example, we worked with the Insurance Institute to develop a practical, hands on workshop, focusing on materiality assessments. We are committed to working with, and listening to, industry going forwards.

Conclusion

In conclusion then. Climate change is both a clear and present risk and one of the defining issue of our time. We are in transition to a net zero economy. This is centrally important to the business of insurance. And the business of insurance is central to it. While some insurers are taking action, many are not yet getting to where they need to be. In my comments here, and in our recent climate change guidance, which Chris will now consider in further detail, we are seeking to embed the combination of clarity, commitment, pragmatism, and cultural alignment that we think are the key to success.

Thank you.