Assessing climate litigation risk for insurers

Who this blog is for

Board members and senior executives working across the EU and UK insurance industry, in particular those in risk, finance, legal, underwriting, actuarial and regulatory affairs teams.

At a glance

• Insurers that underwrite certain liability lines of business could be significantly exposed to losses through climate litigation due to legal action against their policyholders.
• Regulators across the EU and the UK are becoming more acutely aware of this and expect insurers to develop their understanding of climate litigation risk. A natural place to start is their Own Risk and Solvency Assessment (ORSA). Our four-step approach outlined in this blog explores how insurers can go about incorporating climate litigation risk into their ORSA process and report, drawing on expectations and guidance from EU and UK regulators.
• Relevant insurers should start by identifying all their material climate risk litigation exposures, gathering climate litigation data to understand legal precedent and comparing these cases against existing policy wordings.
• Developing appropriate scenarios and internal stress tests for the most material exposures in the ORSA will be key. What’s more, as regulators are likely to include litigation risk in future industry-wide stress tests, relevant insurers also need to get their house in order to be able to comply with climate litigation data and information requests.
• Insurers have many tools at their disposal to manage climate litigation exposures, including exclusions, reinsurance, and/or re-pricing. Firms should analyse their chosen strategy in their ORSA while also developing a proactive approach to improve their ability to capture the capital impact of climate litigation risk over time.

Overview

Climate litigation is on the rise globally. According to the Grantham Institute’s annual report, the cumulative number of legal actions related to climate change has more than doubled since 2015 (with 1,200 actions filed in the last eight years). While many of these actions have been brought against governments as a tool to enforce their climate commitments, more recently a number of actions have also been brought against energy companies as well as other corporate actors (including financial services firms). Insurers are not only exposed to climate litigation as corporate actors in their own right, but also through potentially increasing claims on their liability lines of business, which is the focus of this blog.

In this blog, we explore climate litigation risk using the four-step approach from our recent blog on how insurers can consider the financial risks of climate change and reflect them in their ORSAs. Firms that follow this (or an equivalent) approach will be able to demonstrate to regulators the steps they are taking to capture climate litigation risk in their ORSAs.

Figure 1: Four-step approach to reflect climate risk in ORSA

1. Risk identification and materiality assessment

Understanding why climate litigation could be an issue for insurers

To be able to conduct a risk identification and materiality assessment through the ORSA process, insurers need to understand whether and how climate litigation could be an issue for them.

A sudden and unexpected increase in the frequency and severity of liability claims pay-outs as a result of climate litigation could severely erode insurers’ profits, and ultimately, if not managed appropriately, capital. The PRA has pointed out that climate litigation could lead to “significant financial consequences”. The liability lines of business susceptible to climate litigation risk are mainly Directors’ and Officers’ (D&O), Errors and Omissions (E&O) and Professional Indemnity (PI) insurance.

Both regulators and firms are starting to pay more attention to the impact that growing levels of climate litigation could have on the insurance industry. In our experience, the most advanced insurers have already started to explore their own climate litigation risk exposures (some have held workshops, bringing together different stakeholders and experts, to understand the potential levels of risk in detail). Going forward, this is something that all insurers that have climate litigation exposures will need to do.

According to a BoE estimate, nearly 100% of D&O insurance policies would pay out in the event of a successful greenwashing claim against an insured. A D&O insurance policy could pay out if, for example, shareholders take legal action against company directors for greenwashing, such as misleading the market by underreporting climate exposures or overstating progress towards Net Zero.

Figure 2: Estimated share of PI and D&O insurance policies that may pay out in response if selected hypothetical legal cases were successful (Source: Bank of England Climate Biennial Exploratory Stress test (CBES) results)

Typical liability coverage also covers the legal costs of defending the insured policyholder, which means the policy may pay out irrespective of whether the policyholder is found liable. In addition to legal fees, typical coverage also includes settlement costs and certain financial losses arising from the litigation. Further complicating the process of identifying potential exposures is the fact that D&O, PI and E&O insurance policies are typically written on a claims-made basis. This means that, depending on the contract agreed between the insurer and the insured, the policy covers claims made during the policy period – even if the wrongful acts were committed earlier. The potential long tail of these lines of business keeps many supervisors up at night, and a reason that liability lines of business are almost always subject to regular, supervisory-led thematic reserve reviews, at least in the UK. What’s more, the uncertainty associated with these types of insurance contracts will drive up the price of insurance (and, according to some, already has).

Climate litigation could therefore represent a material risk to insurers that underwrite liability lines of business. Insurers need to start to identify and map out the litigation risks they are exposed to, adopting a risk-based approach to assess materiality amongst different groups of clients. The BoE stressed in its CBES feedback that “several insurers struggled to collate and aggregate the information necessary for a robust assessment of potential exposures”, and although annual re-pricing mitigates some of the risk of increasing climate litigation, new contracts could be at risk from a rapid shift in the legislative environment and expected professional standards. The UK Climate Financial Risk Forum (CFRF) also recently dedicated an entire chapter to climate risk litigation, providing a helpful starting point for insurers that want to understand and explore their potential exposures, and determine the level of materiality associated with them. At the EU level, EIOPA encourages relevant insurers to look at litigation risk through its Opinion on the supervision of the use of climate change risk scenarios in ORSA.

Some insurers have used industry guidance from bodies such as the Geneva Association, to update their risk management frameworks to incorporate litigation risk. This includes categorising litigation into different case types and applying qualitative rankings to material lines of exposure. Others have developed heatmaps for certain lines of business to help identify impact trees and risk clusters over consecutive underwriting years.

Understanding your risk drivers

Insurers should explore in depth the elements that drive climate litigation risk to be able to map out their exposures. This will not only help them identify the potential risks but will also inform their assessment of which of the risks identified are material. Below we describe some of the main climate litigation risk drivers that insurers should consider.

Legal precedents and policy wordings: identifying potential climate litigation exposures for liability lines of business is challenging due to the evolving law in this area, limited number of applicable legal precedents, differences between jurisdictions in terms of substantive law and litigiousness, and difficulties in assessing policy wordings and exclusions. Insurance policy terms are often negotiated individually, and contracts will differ depending on the client and circumstances. This is exacerbated by the fact that most insurers lack established processes and risk management practices for monitoring, assessing and aggregating data around climate litigation risk.

This should not be a reason for inaction, however. Given the growth of climate litigation, more and more legal precedents are being set, providing insurers with important information on which to base their initial analysis, build their scenarios and carry out stress testing. The CFRF litigation risk chapter provides an overview of key litigation cases to watch, dividing them into different tiers depending on the potential impact they may have (Tier 1 being the cases that are the most plausible and would have the greatest impact on insurers). These cases, as well as the classification system, should help insurers build their own understanding of legal precedents, capturing historical information but also monitoring litigation cases on an ongoing basis. There are also publicly available climate litigation databases (including here) that firms can use to access and monitor relevant data. Once insurers have built a solid understanding of existing cases, they can then start assessing individual contract and policy wordings against the legal cases to identify and understand potential future exposures and take action to limit risk, where necessary.

Many insurers, following their risk exposure assessment, might choose to retain the exposure to climate litigation within the policy, re-pricing it to reflect the growing underlying risk. Where insurers make use of exclusions, they should ensure clear communication and disclosure to insurance distributors and potential policyholders on the scope of coverage and the level of protection offered by the insurance policy. EIOPA has been particularly clear around this in its recent Supervisory Statement on exclusions in insurance products related to risks arising from systemic events, expecting insurers to “provide all the necessary information to insurance distributors including (…) possible scenarios outlining when risks arising from relevant systemic events are covered and when not”.

Insurers should also look at their reinsurance programmes to manage litigation risk. Here, insurers need to review their current reinsurance programmes and structures (including type of contract and limits) to ensure they still provide appropriate coverage for the growing levels of climate litigation risk. In some cases, exclusions could be present in the reinsurance contracts, but not the contract between the primary insurer and the insured, creating a mismatch in coverage that could give rise to significant risk.

Knowing your customers: another important route to enable insurers to understand their climate litigation exposures is to gather data from their significant policyholders. According to the CFRF, this could include transition plans, emissions data and external communications. Performing this type of due diligence could help insurers understand the extent of their clients’ actual exposure to litigation risk – and therefore the potential for related future claims pay-outs.

Insurers should therefore spend time understanding their clients’ net zero strategies and transition plans. Insurers could also look at their clients’ climate disclosures to understand their sustainability journey and the public commitments they have made. In some instances, insurers may also want to work with their clients to support their net zero strategy, offering premium incentives (or similar) to facilitate their low-carbon transition. This will not only help clients on their net zero journey, but it may also reduce some clients’ vulnerability to successful climate litigation.

Grouping clients according to the level of legal risk they could face could be a helpful step in understanding and mapping out the various different climate litigation exposures. Carbon-intensive industries and clients might constitute one high-risk category of clients, for example, and insurers could take a more tailored and individual approach to deal with litigation risk here. For other types of clients, where litigation risk is present but not as acute, insurers could deal with exposures on a more thematic basis, introducing standard policy wordings to these types of policies.

Underwriting discipline, governance and controls: underpinning all this is the need for insurers to maintain appropriate governance and controls over their underwriting. The PRA has signalled its willingness to act where it sees shortcomings in relation to controls over underwriting.

Risk teams should be involved early and actively in the firm’s underwriting strategy, making sure that risks are appropriately understood and managed within the set risk appetite. Insurers need to ensure they have appropriate oversight and controls over the re-pricing process and policy wordings, including any exclusions. They should also focus on the oversight of their delegated authorities and brokers, which will be negotiating the more complex policies on behalf of policyholders.

Getting to grips with climate litigation is thus not just a regulatory issue, but also a commercial imperative. As corporates become increasingly aware of the risks associated with climate litigation, they are likely to want to expand their insurance coverage or increase limits. There is a clear opportunity for insurers here – but careful risk management and underwriting discipline are needed to seize it.

2. Scenario design and stress testing

Building your own capabilities

Insurers that have determined that their liability exposures could be material should prioritise developing and designing appropriate scenarios, informed by emerging climate litigation data and their own standard and non-standard policy wordings. According to the CFRF, these insurers should aim to come up with a set of scenarios where cases have been ruled in favour of the plaintiffs, compare them to existing liability contract wordings, and calculate the potential impact on overall losses. The CFRF also suggests that scenarios can be divided by line of business, asset-side or liability-side impacts, and jurisdiction, and that some insurers may want to assign likelihood probabilities to the set of scenarios, and an expected range of potential damages for each case. Once insurers have designed and performed stress tests, they should identify management actions that could help the firm in a situation of stress, or indeed pre-emptive actions that aim to avoid that situation altogether.

It should be noted that for some climate litigation exposures, there is no one-size-fits-all approach to scenario design and stress testing. When it comes to some high-risk clients and sectors, insurers will need to take a more tailored and targeted approach, reviewing specific policies and assessing risk on a more individual basis.

Preparing for industry-wide stress tests

Climate litigation and its impact on insurers are likely to feature in future industry-wide climate stress tests, requiring affected insurers to work quickly to be able to comply with regulatory information requests and data gathering. The 2021 CBES exercise was an opportunity for insurers to develop metrics to consider the impact of climate litigation risk. Some participants carried out a quantitative approach to assessing potential exposures to climate-related litigation risk in relation to certain lines of business such as D&O and PI insurance. Regulators have been clear this is the direction of travel for all insurers – i.e. that analysis should move from qualitative to more quantitative over time.

In the UK, the PRA has announced it will explore the implications of “contract certainty and the size of possible risks” in the context of climate litigation through its regular biennial stress tests (the next PRA insurance stress test will take place in 2024). Ahead of this, the PRA has been clear that UK insurers should develop appropriate data extraction and modelling techniques to enable regular testing of whether coverage intent is aligned to contract wording. In the EU, EIOPA will initiate a one-off climate change stress test in 2023. While we are still waiting for more details from EIOPA on this, it would not be surprising if EIOPA decided to include a climate litigation scenario in the stress test, given it has mentioned litigation risk in various climate-related publications over the last year or so.

3. Mitigation and adaptation

Two different strategies

Once insurers have identified and assessed their material climate risks through scenario design and stress testing, they have several tools at their disposal to manage their exposures. Insurers might choose to do this through one of two strategies (or sometimes both) – mitigation or adaptation – which both have a positive impact on the environment. Mitigation refers to “making the impact of climate change less severe by preventing or reducing the emission of greenhouse gases into the atmosphere”. Adaptation means “anticipating the adverse effects of climate change and taking appropriate action to prevent or minimise the damage they can cause”.

Mitigation: in some cases, insurers may decide to work to prevent or reduce the emissions of greenhouse gases by adjusting the terms of their insurance products or developing innovative solutions. In the case of climate litigation, insurers could, for example, provide premium rebates to policyholders that have ambitious net zero transition plans. To reduce greenwashing risk, they could also request external assurance over their clients’ ESG disclosures.

Adaptation: many insurers also offer insurance products that include or incentivise climate-related adaptation measures, primarily property but also crop and motor insurance. While it is more difficult to incorporate adaptation measures directly into litigation products, EIOPA specifically points to the fact that insurers, with their unique expertise in risk management, can play an important role in making society and the real economy more climate-resilient by providing dedicated risk assessments and advice. In the context of litigation, this could mean offering research or advice on the impact of climate change litigation on their clients’ business.

4. Capital adequacy assessment

Demonstrating continuous improvement over time is key

While regulators in the EU and the UK have not yet determined whether climate risk should be formally captured in Pillar 1 capital requirements, the PRA in particular has been clear that insurers need to identify their material exposures and demonstrate that they are “holding adequate capital against them where relevant” as part of their ORSA. Some insurers have already developed quantified loss scenarios for all lines of business with respect to climate-related litigation and categorised this as a non-modelled risk.

While not everyone is there yet, to demonstrate progress in this regard, insurers should take a proactive approach to monitoring the legal landscape as well as ongoing climate litigation cases and compare them against policy wordings. Following the materiality assessment and stress and scenario testing, insurers should devise a strategy to improve their ability to capture the capital impact of climate litigation risk over a multi-year period and reflect this in their ORSA. This will provide some assurance and demonstrate to supervisors that they are making some headway in terms of quantifying climate litigation exposures. While relevant insurers may choose to recognise climate litigation risk as a non-modelled peril in their internal models, ultimately, where insurers have identified material climate litigation exposures, supervisors will expect insurers to hold capital against them.

Conclusion

Climate litigation poses a serious risk to insurers that underwrite certain liability lines of business. Insurers should therefore, through their ORSA, identify their potentially material exposures, comparing legal precedent with contract wordings, and take immediate action where exposures exceed their risk appetite. Identifying and addressing the potential impact of climate litigation on liability lines of business is not just a regulatory expectation, but also a commercial imperative for relevant insurers given the level of risk involved.