Integrating sustainability risks into insurance framework
The long-awaited 2020 Solvency II review is finally approaching the finish line. The new directive was published in the Official Journal of the European Union on 8 January and has come into force twenty days later. Member states will then have until January 2027 to transpose it into national law.
Most of the changes published in the directive were expected and in line with the draft compromise package already agreed in 2024. The major impacts are expected on the liability valuation side with the implementation of the new risk free curve extrapolation method, which will be phased in over five years, alongside the volatility adjustment. Both of these changes will increase liability values and negatively impact the insurance balance sheets, but this could be offset by some relief from a lower cost of capital in the calculation of the risk margin.
On the market risk SCR front, the main change is the introduction of the long-term equity investment, which replaces the duration based equity module. The eligibility criteria have been relaxed, reducing the capital charge by 22%. Both life and non-life companies could benefit from this change. The portfolio of long-term equity has to be clearly identified and managed separately. The undertaking needs to have the intention to hold these investments for over five years and demonstrate in the ORSA (Own Risk Solvency Assessment) that it will not be forced to sell under stressed conditions. Finally, it can be applied to OECD equity (not just EEA), listed or unlisted, and at fund level. The list of eligible collective investment schemes will be published in the upcoming delegated acts. This will support investments in alternative investment funds and public equities.
The delegated acts to be published will provide further details on other changes, such as interest rate risk module capital charges and ESG considerations.
In November 2024, The European Insurance and Occupational Pensions Authority (EIOPA) published the final report on the prudential treatment of sustainability risks within Solvency II. It is possible that the conclusions of this report will be implemented in the upcoming delegated acts. We summarise its key takeaways below.
Transition to net zero and market risk charges
There is a desire to accelerate the speed of transition to net zero of the insurance portfolio – but also to adequately capture the risks associated to climate change. In the current framework, those risks were solely treated under Pillar II as part of the Own Risk and Solvency Assessment (ORSA). However, a risk-based analysis combining both backward-looking (value at risk over a 10-year period) and forward-looking models (leveraging among others the scenarios of the network for greening of the financial system) provides strong evidence that additional market risk charges should be applied to assets that are particularly exposed to transition risk. The Solvency II framework is calibrated to capture the 1 in 200-year event; as such, a disorderly transition could have a significant impact on the real economy.
In a nutshell, the assets that are linked to fossil fuels will have an additional 17% shock added to equity solvency capital requirement (SCR) – bringing the shock for type 1 equity to 56%. This is in line with the outcome of the backward-looking value at risk analysis. Similarly, bonds will see their spread SCR charge increased by 40% (in multiplicative terms) which results from the forward-looking assessment.1
Sector identification, real estate, and investment impacts
To determine which assets are affected by this increase, the EIOPA relies on sector NACE codes to identify companies with activities linked to extraction of crude oil, natural gas and the mining of coal as their primary business. A more adequate approach would have been to assess individual asset’s exposure to greenhouse gas emissions and transition plans; however, the data is not complete and would have been highly impractical in terms of implementation.
As part of this report, real estate exposures have also been closely looked at, as there is evidence that low efficiency building suffer from price depreciation. Indeed, in some countries, low efficiency buildings cannot be rented out. This would imply significant enhancement work to improve energy efficiency.
The final two sections of the report looked at the non-life underwriting risk as well as social risks. More data would be required to reach any conclusion, these two areas are therefore left unchanged for the time being.
Insurer’s green investments have significantly increased over the years and the exposure to fossil fuel sectors should be minimal. The share of non-financial corporate bonds and equity investments that are taxonomy aligned and taxonomy eligible assets were 5.7% and 34.1% respectively in 2022 while it is now 10.7% and 48.6%.2 As such, we estimate that these changes will have a limited impact on Solvency ratios. The impact assessment of the proposed increased capital charges suggests solvency ratios might drop by just a couple of percentage points.
1 Source: Prudential Treatment of Sustainability Risks, Report, November 2024
2 Source: EIOPA, Insurers' green investments, November 2024
Author: Valerie Stephan, European Head of Insurance Strategy and Analytics, Global Insurance Solutions
