Q&A: How environmental risk impacts insurer credit ratings

Mark-Button,-Senior-Director,-S&P-Global-Ratings

In the wake of severe weather events – for example, 2017’s particularly destructive Atlantic hurricane season – climate-related risk is rising on the global agenda. It was a key theme at COP23 – the twenty-third annual United Nations Climate Change Conference – in November, and more recently at Climate Finance Day in France, at which actions taken by the financial sector to both combat and protect against climate change were considered.

In light of this, lenders and institutional investors are increasingly interested in how S&P Global Ratings incorporates environmental, social and governance (ESG) risks and opportunities into our insurer credit ratings analysis.

What are ESG credit risks?

ESG credit risks are environmental, social or governance risks that might affect an entity’s ability to meet its financial commitments. Within each element of ESG, there are many different types of risk. For example, environmental risk (the E of ESG) can include physical risk resulting from climate change, which as defined by the Task-Force on Climate-Related Financial Disclosures (TCFD), can be event driven (acute) – including increased severity of extreme weather events, such as cyclones, hurricanes or floods – or can result from longer-term shifts in weather patterns as a result of climate change (chronic).

Physical risks may have financial implications for organizations, such as direct damage to assets and indirect impacts from supply chain disruption. Organizations' financial performance may also be affected by changes in water availability, sourcing and quality; food security; and extreme temperature changes affecting organizations' premises, operations, supply chain, transport needs and employee safety.

Other examples of environmental risk include: transition risks (associated with the transition to a low-carbon, energy-efficient economic system), market risks (shifts in supply and demand for certain commodities, products, and services as climate-change is increasingly taken into account) and reputational risks (changing customer or community perceptions of an organization's contribution to or detraction from decarbonisation).

How do environmental factors figure into credit ratings?

An S&P Global Ratings issuer credit rating is a forward-looking opinion about an obligor's creditworthiness, which focuses on the obligor's capacity and willingness to meet its financial commitments. ESG risks and opportunities, which can affect the capacity and willingness of an entity to meet its financial commitments in many ways, are analysed by S&P Global Ratings using its ratings methodologies.

In some cases, our view of the materiality and visibility of ESG risks and opportunities, and how effectively an entity is mitigating those risks, may extend beyond our financial forecast time frame. These factors could still be captured in our qualitative rating considerations if we have a high degree of visibility and certainty about the risks and opportunities.

What about for insurer credit ratings?

Our analysis of ESG risks and opportunities is captured in several aspects of our insurance rating methodology.

In assessing an insurer's business risk profile, we analyse the risks inherent to the insurance markets in which it operates. Our insurance industry and country risk assessment incorporates our view of the insurance markets' economic, political and financial system risks; its regulatory framework; and its growth prospects--climate change could affect all of these factors. An insurer's competitive position may also be affected by exposure to ESG risks, which could affect the strength of the insurer's brand name and its profitability.

Our assessment of an insurer's financial risk profile includes our prospective view of capital adequacy. Applying our capital model criteria, we incorporate a risk charge to capture the impact of one-in-250-year annual catastrophe losses (that is, the level of annual losses that has a probability of 0.4% of being exceeded) in our capital model. Although climate change may affect the magnitude or frequency of such extreme weather events, there is no scientific agreement about the precise quantitative impact that the industry could use in its natural catastrophe models. The uncertainty in an insurer's capital and exposure management relating to catastrophe models could lead us to conclude that risks are understated in our capital analysis. This, in turn, weighs on our capital and earnings assessment.

The financial risk profile assessment also incorporates our analysis of the insurer's risk position. Here, we measure risks not captured in the capital and earnings analysis and risks that could make capital more volatile. If we conclude that exposure to climate change (or other ESG risks) is material and contributes to above-average volatility in prospective capital adequacy, we may revise down our risk position assessment.

Our ratings analysis incorporates our view of an insurer's management and governance and enterprise risk management (ERM), too. How well insurers prepare themselves to deal with the challenges presented by ESG risks could be a relevant consideration in these assessments.

Ultimately, S&P Global Ratings incorporates ESG factors into its analytics through the application of our methodologies, which enables our analysts to factor in short, medium and long-term impacts (both qualitative and financial) throughout their credit analysis. We will continue to monitor the impact of ESG factors – as we do all relevant factors – on an entity's credit profile and our view will evolve as new information becomes available, or as the issuer's fundamentals change.

By Mark Button, Senior Director, S&P Global Ratings