This blog considers what lessons insurers can learn from the Australian Prudential Regulation Authority’s (APRA’s) latest guidance on climate change.
On Friday 26 November 2021, APRA released its final prudential practice guide CPG 229 on climate change financial risks. This followed a consultation on the draft guide published in April 2021.
Although CPG229 does not impose new requirements on firms, it provides guidance, sets out examples of better practice and aims to assist institutions in managing climate-related risks and opportunities. The guide reflects the Financial Stability Board’s TCFD1 framework and good practice that APRA has observed in the market.
There are several similarities between the information in CPG 229 and the UK Prudential Regulation Authority’s (PRA) expectations set out in SS3/19:
- The same areas of governance, risk management, scenario analysis and disclosures are covered, and similar expectations are included in each of these sections.
- There is a focus on proportionality and materiality in both documents, with the majority of expectations being dependent on a firm’s size, exposure, business mix and complexity.
- Both are largely principles-based. For example, individual firms can decide the appropriate metrics, tools, methodologies, data and scenario design for their firm, rather than prescribing these specifically.
Whilst APRA’s guide is not prescriptive, takes a proportionate approach and does not impose new requirements for firms, it is another clear indicator of the direction of travel for the insurance industry. This comes at a similar time to other international developments such as the UK recently mandating TCFD disclosures for large companies, and EIOPA publishing its consultation on “application guidance on running climate change materiality assessment and using climate change scenarios in the ORSA”. And with the PRA’s upcoming expectation of firms to have “fully embedded their approaches to managing climate-related financial risks by the end of 2021”, the whole insurance industry is likely to have a close eye on further upcoming regulatory developments.
A principles-based approach
In its response paper following consultation on the draft guidance, APRA noted that requests for more prescription and guidance were common, to assist those that may be lacking adequate capabilities or resources and to improve comparability between institutions.
However, APRA has continued to maintain a principles-based approach to its guidance. This is broadly consistent with the PRA’s approach. For example, the PRA noted in its July 2020 Dear CEO letter that over-prescription of metrics, methodologies and targets at this stage could stifle firms’ innovation and analysis, as well as risking international fragmentation.
In our recent market review on climate change risk for non-life insurers, we found that most firms’ climate change risk management processes remain very much a work in progress. This lack of progress may prompt more intervention and rule setting from regulators, which would be a missed opportunity for the climate change response to be industry-led, rather than regulator-led.
However, the PRA did note in its Dear CEO letter that, over time, it expects there will be international convergence on metrics, methodologies and targets. It will be interesting to see how market practice evolves over the coming years and how industry standards develop.
Many firms are struggling with metrics and long-term scenario analysis, particularly given the difficulties with available data and modelling methodologies. These might be some possible areas of increased prescription in the coming years.
It is clear from APRA’s guide that despite the current limitations around data and modelling, doing nothing is not an option. Talking about scenario analysis and stress testing, APRA says that “the expectation of future improvements in approach is not a justification for delaying its use.” Similarly, in relation to disclosures, “a lack of absolute certainty in relation to climate risks’ future impacts should not be considered a reason to avoid disclosure of exposure to these risks.”
What is APRA’s view of good practice?
CPG 229 has four key sections: governance, risk management, scenario analysis and disclosures. Its views of best practice in each area cover a range of considerations for insurers, including:
- Governance – this includes board-level engagement, board training and roles and responsibilities. Firms should be taking both a short-term and a long-term view.
- Risk management – a firm should seek to identify, measure, monitor, manage and report on its exposure to climate risks. Eg developing both qualitative and quantitative metrics, setting climate-related targets, developing plans to mitigate and manage material risks and routinely reporting on material exposures to the board.
- Scenario analysis – a firm’s approach to scenario analysis is expected to evolve over time. Leading practice includes:
- considering both a shorter-term assessment (in line with current business planning cycles) and a longer-term assessment (potentially extending to 2050 or beyond)
- considering orderly and disorderly transitions to a lower-emissions economy
- incorporating both qualitative and quantitative factors
- assessing both physical and transition risks
- Disclosures – firms should consider whether additional voluntary disclosures could be beneficial, noting it is better practice for disclosures to be produced in line with the TCFD framework.
Key takeaways
APRA’s guidance is another sign of the direction of travel for the insurance industry. A useful first step would be to conduct a gap analysis comparing your current capabilities to APRA’s views of good practice.
Based on our experience in the UK, areas insurers typically struggle with include quantification of the financial risks, scenario analysis (particularly longer-term scenarios) and metrics. In collaboration with Ortec Finance and Cambridge Econometrics, we have developed state of the art methodologies for climate modelling. Please get in touch if you would like to discuss this or anything else related to climate change.
1 Task Force on Climate-related Financial Disclosures