ESG in the insurance industry - Ep5

Transcript

Kyla: Hello and welcome to the fifth episode of the podcast series 'Engaging ESG'.

I am your host, Kyla Visser and in this episode we are going to be focusing on insurance companies - which is a new industry not yet covered in this series. 

Joining me in this episode is Charity Simamane, Associate Director in Assurance Services focusing on the insurance industry. Welcome to the discussion today.

Charity: Hi Kyla and your listeners, I am excited to talk to you today on this topical matter.

Kyla: Topical indeed! Taking a step back, I presume that ESG considerations are not a new concept to insurance entities as the insurance industry is accustomed to reflecting the effects of climate change in their underwriting and reserving practices?

Charity: That’s correct. Insurers have considerable experience in incorporating the effects of climate-related risks in their assumptions that could affect the amount that insurers will need to pay to settle insurance contract liabilities. There are two types of these risks being physical risk and transitional risk.

However, there is an increasing need to ensure that the financial statements tell a consistent and coherent story about how insurers incorporate assumptions about climate-related matters in key areas of the financial statements affected by climate-related risks.

What we are seeing is that investors need transparency about how insurers use information about climate-related matters, so they can fully assess the information in financial statements and allocate capital according to their objectives.

Kyla: That’s a very good point. As transparent disclosures would provide investors with enough information to understand:

• how climate-related risks, in particular physical and transition risks, are reflected in financial statements; and 
• the significant judgements and estimation of uncertainty regarding climate risks.

Before we get into the details, can you briefly explain what we mean when we refer to physical risk and transitional risks?

Charity: Thank you for bringing that up, Kyla, because understanding the differences is critical especially because transitional risks are less likely to affect claims liabilities in the short term. Differentiating the two is thus important.

Physical risks are the direct effect of climate-related changes and can affect the likelihood and severity of claims made under existing insurance contracts. They can either be chronic (which would be the long term effect of climate change) or acute, caused by a once-off physical event such as the floods we recently experienced in KZN or the Knysna fires.

In the non-life insurance space, these risks are relevant to both direct insurance and reinsurance. Both insurers and reinsurers were liable for damages caused by the floods in KZN and the fires in Knysna.  We’ve also seen instances where reinsurers no longer want to provide reinsurance relating to thermal assets (assets in the supply chain of coal fired power generation) due to its impact on the climate.

You may ask yourself, what about life insurance business? Well, physical risks such as drought and natural disasters we have seen on the continent can lead to a direct effect on mortality and as a result impacts mortality assumptions in the reserves for claims.

I have said a lot, but in short we’ve been dealing with physical risks over the years in the insurance industry, whereas transition risks are defined as risks which translate into the regulatory and social pressure to adapt operations and activities to mitigate climate change, in other words the policy changes and economic consequences of efforts to decarbonise the economy.

Kyla: That's insightful, thank you, Charity. Now that we understand what physical risks are and that these are the risks that significantly impact the amount insurers need to pay to settle insurance contract liabilities, can you elaborate a bit on how it specifically links with ESG?

Charity: Yes, sure

Generally customers are increasingly considering the ESG impact when purchasing products and services - the same is true for policyholders when buying insurance products.

If we consider the broad definition of physical risks from a customer's point of view, better understanding of these risks may impact their demand for coverage for such risks.

This will then lead to changes in product offerings, underwriting and pricing by insurers.

These changes ultimately impact the quantum of the insurance liability reserved for when the insurance event occurs.

Whereas for transition risks it is less likely to affect claims liabilities in the short term. However, transition risks may affect insurers through:

• Changes in migration patterns, which will cause demographic changes that affect all territories and will have consequent effects on assumptions about life insurance. For example, we are seeing semigration in South Africa, where employees are moving to different areas in South Africa, for example to coastal areas, to enhance their lifestyle, as they can work remotely.
• A shift in consumer preferences towards more sustainable products. Reputational risk can arise as consumers examine more closely the sustainability credentials of companies; and
• The effects these risks have on a company's operations, including the useful economic life of assets in use and whether internal process systems are advanced enough to deal with any ESG-related changes in the business.

Kyla: Those are definitely valuable points to consider. Under transitional risks you touched briefly on operations; my understanding is that insurers are also significant holders of financial instruments in the global economy.  This means insurers will need to reflect the effect of climate-related risks in the measurement, and impairment assessment for financial assets held to back the liabilities.

Is my understanding correct?

Charity: You are spot on Kyla, from a measurement perspective when instruments are measured at fair value, consideration should be given to a market participants' views as this might include assumptions about climate-related risk as it relates to fair value.

Matters to consider is whether fair value measurements using observable inputs might already appropriately reflect market participant views of any climate change inputs as opposed to valuation models for items not traded in an active market.

On the latter, considerations would need to be made to ensure that the valuation adequately represents market participants' assumptions.

Where instruments are not measured at fair value, one should not forget to take into account climate-related risks when determining the expected credit losses.

Lastly,

• insurers may be subject to possible actions by regulators as they respond to ESG risks, for example whether they may disregard certain assets for regulatory reporting purposes; and
• They may need to respond to the consequences of investor demand for ESG-linked assets, and increasing consumer interest in the investments that insurers make to back insurance policies.

The implication is that insurers may face reputational damage by investing in financial and non-financial assets without considering the ESG implications of such assets.

Kyla: Earlier in our conversation you mentioned that there is an increased need for the financial statements to tell a consistent, coherent story about how insurers incorporate assumptions about climate-related matters. In other words, sufficient disclosures as it relates to climate-related matters are thus crucial.

You further touched on the fact that the assumptions about climate-related risks affect the measurement of insurance contract liabilities and measurement of financial and non-financial assets held by insurers to enable them to meet their obligations to policyholders.

This means that insurers will need to consider how climate-related risks affect the application of a number of IFRS Standards, can you elaborate on this for us?

Charity: Kyla, I think it is important to note that IFRS Standards do not refer explicitly to climate-related matters. However, in terms of the education material on the effects of climate-related matters on financial statements issued in August 2020 by the International Accounting Standards Board companies must consider climate-related matters in applying IFRS where the effect of those matters is material in the context of the financial statements taken as a whole.

Information is material if omitting, misstating or obscuring it could reasonably be expected to influence decisions that primary users of financial statements make on the basis of those financial statements. For example, information about how management has considered climate-related matters in preparing a company’s financial statements might be material with respect to the most significant judgements and estimates that management has made.

You are correct in saying that insurers will need to consider how climate-related risks affect the application of a number of IFRS Standards. In particular IFRS 4/ should I say IFRS 17 as it is imminent for insurers relating to the measurement of insurance liabilities, IFRS 9 for insurer’s financial assets, IAS 36 for any impairment on non-financial assets and IAS 1 for presentation in the financial statements, are particularly relevant.

Kyla: Thank you for that confirmation Charity, I think the requirements of these standards are fairly familiar to us. Can you please explain how climate-related risks interact with these disclosure requirements?

Charity: Climate change can introduce significant uncertainty about the future. Given the significance of financial instruments and insurance contracts on the balance sheets of insurers, transparent disclosure about those uncertainties and assumptions is thus important.

IFRS 4 and IFRS 17 require an insurer to disclose information that enables users of its financial statements to evaluate the nature and extent of risks arising from insurance contracts. Such disclosures should include the extent to which climate change affects the risks arising from insurance contracts, and hence the assumptions used to measure insurance contracts.

I know this is mouthful, in short, to comply the disclosures should include:

• objectives, policies and processes for managing climate risks arising from insurance contracts; and
• information about risk exposures, concentrations of risk, and how these are managed; and disclosure of the significant judgements and any changes as it relates to climate risks.

Kyla: What I am taking from this is that while these standards requirements do not specifically refer to climate-related matters, they could be relevant where climate-related matters are material to the company’s financial position and performance.

Charity: Yes, exactly! It is the only way we can achieve transparent financial reporting.

Kyla: We’ve covered a lot in today’s podcast. We’ve started with some considerations of types of climate-related risks relating to insurers. We’ve also discussed how climate-related risks impact different line items in the financial statements and the related disclosure requirements for specific IFRS standards.

Thank you for all your insights Charity, it was lovely having you here today.

Charity: It’s a pleasure, it was great chatting today.

Kyla: “This podcast is brought to you by PwC. All rights reserved. PwC refers to the South African member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This podcast is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.”