The financial impact of climate change

There is no doubt that ESG (environmental, social and governance) matters have been thoroughly discussed and dissected in recent years, and with each year this topic takes additional prominence on agendas, says SAIA Insurance Risks Technical Manager, Ms. Kabelo Paile, who further unpacks it for us below:

The deterioration of the environmental aspect of ESG has proven to have a devastating impact on the economy and livelihoods, with the example of the Knysna fires and the low dam levels due to insufficient rains that almost led to day zero in Cape Town. 

Given the impact of past weather-related climate change perils in South Africa and globally, the significance of assessing the impact of climate change can no longer be trivialised. Continuous extreme weather events globally are a predictor of the high probability of the next looming environmental catastrophe. The unknown variables are magnitude, scope, and timing. This bodes the question of how exposed and subsequently how prepared is South Africa? Consequently, the government’s response will further influence the impact on the non-life insurance industry’s sustainability. Climate change threatens the stability and sustainability of financial institutions, thus, a proactive and collaborative approach is key to showcase the resilience of the industry.

The increased frequency and severity of weather-related, large-scale damage in South Africa has demonstrated the importance of quantifying exposure and managing these risks. The interconnectedness of the insurance eco-system demonstrates that climate change in one area has a domino effect on other areas. An example of this being the erratic weather patterns which may lead to excessive or inadequate rainfall. 

These either contribute to floods, which may lead to loss/damage of property or droughts, which may lead to loss/damage of crop yields with both scenarios ultimately affecting the profitability and sustainability of the insurer and the economy. 

The industry is no stranger to localised effects of climate change such as geographical fires and or droughts. However, the possibility of national climate change-related risks threatens the long-term sustainability of the industry and may pose a conundrum to underwriters required to accurately predict and price these events. This has led to the possibility of insurers not being able to transfer certain catastrophic risks into the reinsurance market going forward. These uninsurable risks therefore will need to be managed or transferred solely to the government, to address the general societal challenges, and especially the most vulnerable, who will be prone to loss of assets due to such catastrophic events.

The South African Insurance Association (SAIA) is cognisant of the financial implications of climate change and has embarked on projects aimed at conducting research and collaboratively putting together possible solutions to address these risks. One of the topics raised by our members for further investigation is the possible risk of national water shortages/failure and its resultant effects on fire protection, business interruption and loss of crop yield etc. 

Reporting on these risks must consider the inequities in South Africa where there is very low non-life insurance penetration (i.e., those that are insured versus those that remain uninsured due to possibly the lack of affordability of insurance products and services) and under-insured or self-insured risk mechanisms further exasperate the difficulty to quantify the macroeconomic effect of an environmental catastrophe.

According to a McKinsey study, the value at stake from climate-induced catastrophes could, conservatively, increase from about two percent (2%) of the global Gross Domestic Product (GDP) to more than four percent (4%) of the global GDP by 2050, highlighting the importance of a proactive and collaborative approach to risk manage climate change risks.

The Prudential Authority conducted a climate risk survey in 2021 to determine the financial industry’s views as well as climate risk reporting. The results indicated that 74% of insurers surveyed believed that climate change has a significant impact on business. In addition, most participants believed that the climate-related risks would materialize within the next five (5) to ten (10) years and would have a material impact on strategy, operations, and business models. This reflects the drive from the industry to report on climate change to allow stakeholders and management to make decisions supported by critical and accurate data.

The Task Force on Climate-related Financial Disclosures (TCFD Task Force) was established in December 2015 by the then Financial Stability Board (FSB) to encourage climate-related disclosures as a standard reporting item by companies. The expectation is that these disclosures will promote better-informed investment and underwriting decisions if the climate-related risks are quantifiable. This reporting aims to identify the extent of exposure and quantify it to lead to more awareness of the financial impact of climate change events. 

The Task Force acknowledges that climate-related risks impact organisations differently, depending on their size, sector, location, etc and that in instances the full and quantifiable climate-related risks are not always easily identifiable, thus challenging to accurately report on this. Difficulty in reporting is mainly caused by:

• Limited knowledge of climate-related risks, thus consequently being unable to identify these risks;
• Inclination to identify risks in the short-term but not risks that could arise in the long term;
• Inherit inability to accurately quantify climate-related risks- i.e. a mammoth task.

The Taskforce aims to align voluntary disclosures in a consistent format across the board, as the benefit of accurate and consistent reporting will assist in the correct pricing of the risk. The seven (7) principles for effective disclosures are:   

1. Disclosures should represent relevant information
2. Disclosures should be specific and complete
3. Disclosures should be clear, balanced, and understandable
4. Disclosures should be consistent over time
5. Disclosures should be comparable among companies within a sector, industry, or portfolio
6. Disclosures should be reliable, verifiable, and objective
7. Disclosures should be provided on a timely basis

The disclosure is required in the following areas:

Governance

Recommended disclosures are essential for informing stakeholders about how senior management identifies, manages, and actions climate-related risks and opportunities. The PA survey found that 40% of insurers had discussed climate change at board level, either as a standing item on the agenda for a more focused discussion, or under a general item. There is room for improvement from the industry, as good governance leads to transparency and stakeholder confidence.

Strategy

Strategy drives operational decisions; thus, it is imperative that climate-related metrics be included in the strategy of the organisation. As per the PA survey, only 49% of insurers surveyed included climate change threats and opportunities in their strategy, however, a positive message is that over 80% noted the importance and indicated that future plans to incorporate climate change metrics in the strategy were underway.

Risk management

Risk management reporting supports the measurement of risk exposures as part of an organisation’s broader risk management. The risk management framework enables the identification and mitigation of material risks. It is imperative that a future focused view is established to identify not only current threats but also future emerging risks. 

Metrics and targets

Like governance, these metrics and targets identify information that is valuable for pricing. It is imperative that organisations have tools that can quantify future risks into the long term, preferably five (5) to ten (10) years into the future. The PA survey found the most used tool being stress testing in the form of scenario analysis.

Although the Task Force on Climate-related Financial Disclosures remains voluntary, SAIA supports the implementation of the recommendations of the Task Force. Soon investors and civil society will insist on tangible actions towards climate change risks. Not only will a lack of responsiveness damage the reputation and credibility of the industry, but likewise lack of responsiveness may lead to previously profitable pools of business shrinking as impacted by climate change-induced events.

In future there will be requirements to progress past risk transfer to risk mitigation, closer collaboration with the government will be required as some of these risks become difficult to price and insure. Lastly, product innovation will no doubt be required to keep up with the changing risk environment, since climate change poses a threat to the sustainability of the industry, there are opportunities in “green” sectors waiting to be explored.