Episode 173: Sneak peek on risk management from the 2023 ERM booklet (Part 1)

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Welcome to Seeing Beyond Risk, a podcast series from the Canadian Institute of Actuaries.

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I’m Chris Fievoli, actuary, communications and public affairs at the CIA. Thank you for listening to today’s episode.

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We would like to remind you that we have plenty of past episodes, so please subscribe and catch up on some that you may have missed. We can be found on Spotify, Apple Podcasts, and your favourite podcast platform.

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This is the first of two episodes in which we will be featuring the CIA’s recently released ERM Booklet, a series of essays that cover a wide range of risk management topics.

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We will be speaking to the authors of these essays to find out what ideas they have shared with us.

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Climate issues continue to be a concern for the actuarial profession, and as the world moves towards a more climate conscious environment, that transition can carry with it some additional risks.

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One of the authors of the article entitled Climate Transition Risk and Opportunity for Insurers is CIA member Fred Matte. He joins us now to tell us more about this concept.

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Thanks very much for joining us today.

Matte: 01:04

Good to be here, Chris. Thank you.

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The subject for your piece is climate transition risk. Can you just define this term for us and tell us what that includes?

Matte: 01:14

Sure. But first of all, I'd like to take a few seconds to acknowledge the contribution of my colleague Karen Grote, who's not with us today, but is the co-author of this article.

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Transition risk is one of the three main climate-related risk categories alongside physical risk and litigation risk, and all three are interrelated.

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Thus, to mitigate physical risk, or risks arising from increased frequency and severity of weather-related events (also called “acute risk”) or from longer-term shifts in climate patterns like sea-level rise (also called “chronic risk”), decarbonization is required.

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As we outline in the article, transition risk arises from this shift towards a low-carbon economy and resulting changes in public policies, technology and other socioeconomic pressures, like consumer preference.

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These risks can materialize through different channels. Examples could include economic growth being generated by emerging sectors leaving for the “obsolete sectors” with the financial impacts of transition by creating stranded assets, for instance.

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We also have increasing costs of doing business due to new policies and regulations requiring more sophisticated climate responses, or consumer preference shifting towards companies, including insurers here, that do business responsibly and sustainably, setting the scene for reputation damages for those who don't.

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And very quickly, just to complete the picture with litigation risk, the residual impacts of climate change from both physical and transition standpoints may generate liability or litigation risks, which materialize by claimants who have suffered loss and damage arising from climate change initiating actions against companies for non-consideration or absence of response to the impacts of climate change.

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Now, back to transition risk – and I'm going to conclude with this.

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Many actuaries that are listening, given the nature of their work, might be tempted to focus on the downside risk related to the climate transition, but I also really want to highlight that there are upside risks as well or opportunities that insurers should be on the lookout for.

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Indeed, as the transition unfolds and changes happen, there will be coverage gaps and capital needs that will lead to opportunities in the marketplace.

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Now one thing I noticed you said is that measuring climate transition risk is not the same as measuring carbon emissions.

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What are some of the ways that exposure to this risk can be quantified?

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That's correct, Chris. In fact, there is little correlation between greenhouse gas, or GHG emissions, and climate transition risk.

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And let me give a couple of real-life examples of some disconnection, if you will, between emissions and transition risks.

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On one hand, we have these high-emitting, low-risk sectors – example could be lithium mining – that are necessary for transition to happen.

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On the other hand, we have low-emitting, high-risk sectors. An example could be software companies providing the oil and gas industry with specific tools and products that may suffer from the transition if they're not addressing it from a strategic standpoint.

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This type of consideration goes beyond emissions and is super important in assessing climate transition risk.

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And in this article we briefly describe a bottom-up approach to measuring transition risk from an investment perspective, essentially, at the asset level or at the sector level.

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First, the approach would use research to look into how the transition and changes that it will drive – as we mentioned earlier – will impact market considerations like supply and demand, margins and capital intensity under different transition scenarios, whether it's an orderly or a disorderly transition.

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We would then quantify these impacts using the assumptions that are underpinning the traditional financial modelling techniques that are well known by many actuaries, like discounted cash flow models, and ultimately determine what would be the potential impacts on the value of assets and portfolios.

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Now, like other approaches, there are pros and cons.

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This one is quite comprehensive and granular enough so that it has the capacity to inform an investment strategy and help stakeholders identify opportunities and goes beyond just assessing risk.

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However, it requires lots of resources to get an in-depth understanding of business models, value chains, as well as market structure and outlook for multiple sectors of the economy.

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You know, especially for these smaller sized companies or insurers that do not have big teams to work on these matters.

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More accessible, though not as powerful option, is a top-down approach whereby we could translate climate transition scenarios into impacts on different asset classes held on investment portfolios and ultimately on investment returns.

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That said, I'm pretty comfortable to say that there is no easy way we can tackle climate transition risk, and there is not any one-size-fits-all solution.

Fievoli: 06:47

Yeah. One other thing I noticed is that you said P&C insurers should take a look at their high-carbon-emitting insureds that are in their book of business.

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Maybe tell us what that process looks like, and what can insurers do in response?

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As we just discussed, emissions and transition risks are different, but if I'm circling back to the first part of our discussion, decarbonization is still crucial to actually achieve the climate transition and hopefully avoid the worst impacts of global warming, right? And insurers have a role to play.

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But before discussing what decarbonization processes could look like for insurers, let's take a quick step back and remind ourselves what are the different types of emissions because it's quite important here.

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Let's start with scope 1 and 2 emissions, which are respectively direct emissions from operations and indirect emissions from the generation of purchased energy, such as electricity.

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Measuring and reducing scope 1 and 2 emissions requires quite a bit of work, but it is still the easy part of the journey, unfortunately. And this is not where most of an insurer’s overall emissions actually are, generally

speaking.

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Indeed, scope 3 emissions that arise from sources that are not owned or controlled by the insurer represent the bigger chunk of total emissions and a major challenge.

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The main sources of scope 3 emissions for P&C insurers are, again, generally speaking, insured emissions from its underwriting activities, financed emissions from its investment activities and emissions arising from its supply chain.

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So, I’ll speak to underwriting here, but I think it’s worth noting that many challenges are common to all three aspects.

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There are some limitations in terms of the availability and quality of data across sectors and geographies, which is partly due to the lack of standards, though this is being addressed with some recent developments that are on the way.

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And one good example is the International Sustainability Standard Board’s (or ISSB) climate disclosure standard that is expected to come out in a few weeks’ time, as we speak.

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So, perhaps when people are going to listen to this podcast, hopefully the guided standard is going to be out already.

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Now, in terms of accounting for insured emissions, the Partnership for Carbon Accounting Financials (or PCAF) proposes a framework that should definitely be useful for P&C insurers to get the big picture of their overall emissions.

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Once they get this big picture, insurers can then establish emissions reduction targets or commitments and a strategy that enables the achievement of those goals.

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And, the logical next step would then be to start with emitters that are the most significant or material from the insurance portfolio.

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And in this case I have in mind, I guess, the more obvious example of commercial insurance.

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And, in this regard, keeping in mind that net zero is the ultimate goal, we have the Net-Zero Insurance Alliance, or NZIA, that has released its target setting protocol, which could serve as a reference for insurers.

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It's not perfect; it's been criticized for different reasons, but I believe that this is a step in the right direction.

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And yet another challenge that insurers are facing or will face is finding the balance between achieving those climate-related goals and broader strategic or business objectives, as there can be a clash between the two along the way.

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So by way of a recap, new processes will be required to ensure that emissions-related initiatives get embedded into an insurer's business-as-usual activities.

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And it starts from the operational level through existing processes, whether it's underwriting, investment or claims, and which would include data collection, engagement with insureds and other key external stakeholders, among other things, all the way up to board and management levels so that governance, strategy, reporting and disclosure reflect these new initiatives.

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That's great. Interesting stuff.

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Well, thanks very much for coming on the podcast today.

Matte: 11:18

My pleasure.

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Actuarial reserves necessarily need to take into account a number of risks, and inflation is definitely one of them.

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The paper, entitled Accounting for Inflation Risk in P&C Reserves discusses approaches for doing this, and we are joined today by CIA member Fiona So, one of the paper’s authors.

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Thanks very much for joining us today.

So: 11:38

Good afternoon, Chris. Thank you for the opportunity to participate in this podcast.

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I'm thrilled to be here.

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So, as we know, inflation is once again becoming a concern for both actuaries and general consumers.

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What can you tell us about the current inflationary environment?

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Well, according to Statistics Canada, in 2022, Canadians experienced inflation at an annualized rate of 6.8% – a contrast with the past decade of study and low inflation levels hovering around 1.7% annually.

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Notable historic high inflationary times in Canada include the 10 years of sustained high inflation averaging almost 10% from 1973 to 1982, and an all time high of almost 22% in June of 1920.

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While inflation is showing signs of slowing down in 2023, inflation remains at high levels than what actuaries are used to seeing since the early 90s, therefore bringing uncertainty in the assumptions used for estimating reserves.

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Having sound and adequate reserves is even more crucial in this current environment, as inadequate reserves could lead to inadequate coverage and pricing for the customers who would ultimately pay for inadequacies.

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So, for those of us that are not as familiar with the P&C practice area, can you explain how inflation impacts that business?

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Absolutely. Inflation impacts many aspects of the property and casualty business.

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It impacts pricing and premiums, investment income, reinsurance costs, claims costs, which then impact directly or indirectly the indemnity portion of a claim as well as the allocated and unallocated loss adjustment expenses.

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Reserving actuaries saw significant price increase on many of these things, impacting their estimates such as the cost of car replacement parts, salaries and medical and rehabilitation costs, just to name a few.

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Since P&C reserving actuaries are tasked with estimating the amount of reserves or the amount of money to set aside to pay claims, their work is highly impacted.

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Traditional P&C reserving methods are not ideal in changing inflationary environments, because reserves are projected as the historic inflationary impact is expected to continue into the future.

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In a high inflation environment, claims could potentially settle for more than they had in the past.

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So, while P&C insurers are currently working to implement optimized claims processes, tracking systems, new strategies, such as risk diversification and adjustments to pricing models to mitigate the effective inflation, adequate reserving remains an important element for those strategies and to remain competitive.

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One last thing that's important to note is that the impact of inflation on the P&C insurance industry can vary depending on the specific lines of business underwritten, geographic region and concentration and individual company strategies.

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And without getting too far into the details of the paper, I was hoping you could share the general approach that you used to model inflation for this article.

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So the basis of our paper centers around our current environment, the heightened level of uncertainty around the magnitude and length of sustained inflation, and the notion that the path may not necessarily be indicative of the future.

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Traditional P&C methods commonly used in estimating reserves rely on the assumption that historical inflation behaviours will continue into the future, but this method could be flawed if what we saw in the past is not what we believe is currently occurring, or expected to occur, in the future.

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Our approach considers making adjustments to historical data to allow historical data to be more suitable for estimating future ultimate claims.

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Adjusting for the impact of inflation is recommended under circumstances where there has been high inflation in recent years or high inflation is expected in the immediate future.

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Also, any time historic and future inflation levels are expected to differ, adjustments should be considered.

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Our paper explains our approach in accounting for inflation risk in reserves.

Fievoli: 15:52

That was great. Well, thank you very much for coming on the podcast today to talk about your paper.

So: 15:57

Thanks again, Chris. It was a pleasure.

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If you would like to read further, please visit the CIA website to download a copy of the booklet.

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Just a reminder that if you have ideas for a future episode or would like to contribute to our Seeing Beyond Risk blog, we would love to hear from

you.

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Contact information can be found in the show description.

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Until next time, I’m Chris Fievoli. Thank you for tuning in to Seeing Beyond Risk.