Preserving the full meaning of the O in the ORSA
EIOPA has recently on its website published a new application guidance on climate change materiality assessments and climate change scenarios in the ORSA. According to EIOPA, this latest application guidance of 2 August provides a detailed and practical basis on how to implement sustainable finance ambitions in practice. It gives insights into where undertakings have the possibility to address climate change risks in ORSA and provides examples using mock non-life and life undertakings, including concrete case studies to help insurers design the steps for the materiality assessment and to run climate change scenarios. By doing so, EIOPA intends to help lower implementation costs for insurers, in particular small and mid-sized ones, taking into account the size, nature and complexity of climate change risk exposures. Given that the (re)insurance industry will be impacted by climate change-related physical and transition risks, EIOPA believes it is important to encourage a forward-looking management of these risks to ensure the solvency and viability of the industry.
This application guidance (140 pages) is a follow-up from EIOPA’s Opinion on the supervision of the use of climate change risk scenarios in ORSA (“Opinion”), published in April 2021. A public consultation and a pilot exercise in which stakeholders were invited to participate preceded its publication. According to EIOPA “(d)uring the public consultation of the Opinion, nearly all respondents provided comments and suggestions on the application guidance for developing and including climate change risk scenarios in ORSA (Annex 5 of the Opinion). EIOPA therefore decided to elaborate on application guidance, seeing the advantages of developing and providing optional guidance for materiality assessment in the context of climate change, climate change scenario design and specifications using concrete case studies.” Pro memoria: EIOPA’s Opinion sets out supervisory expectations on the integration of the use of climate change scenarios by insurance undertakings in their ORSA.
A few observations
In September 2021, the European Commission published a proposal for a directive amending Directive 2009/138/EC (Solvency II). Some of the proposed amendments relate to the European Green Deal. In particular, paragraph 25 of Article 1 of that proposal introduces a new Article 45a on climate scenario analysis. The proposed provisions establish that undertakings will have to identify any material exposure to climate change risks and, where relevant, assess the impact of long-term climate change scenarios on their business in their ORSA. Undertakings classified as low-risk profile undertakings are exempted from scenario analyses. The Commission’s proposal implies thus, a contrario, that today such obligation is not yet part of the Solvency II framework.
In its Communication of 6 July 2021 on a Strategy for Financing the Transition to a Sustainable Economy, the Commission had committed to propose amendments to the Solvency II directive to consistently integrate sustainability risks in risk management of insurers by requiring climate change scenario analysis by insurers. And that is exactly what the Commission did in September 2021.
Today, the Commission’s proposal is still making its way through the co-legislation procedure. Consequently, there is as of yet no Article 45a obligation to identify any material exposure to climate change risks and, where relevant, assess the impact of long-term climate change scenarios on their business in an insurer’s ORSA. Under the proviso that the proposal of the Commission is acceptable on this point by both Council and European Parliament, it will however be 2025 or 2026 before such potential requirement is applicable to undertakings. Why then issue a (premature) Application Guidance before there is a legal obligation agreed by the co-legislators? Is this not putting the cart before the horse?
An Application Guidance is not the same as Guidelines in the meaning of Article 16 of the EIOPA Regulation. Guidelines have a comply-or-explain mechanism attached to it, and find their basis in the directives mentioned under Article 1,2 of the EIOPA regulation. An application guidance is not based on Article 16. It is not another named tool either under the EIOPA Regulation but that in itself is not a problem: under Article 29 of the EIOPA Regulation, EIOPA has received a broad competence to develop supervisory convergence tools. However, EIOPA – rightly so – explains in its guidance of 2 August that an Application Guidance is not a supervisory convergence tool in the meaning of Article 29 of the EIOPA Regulation either (and thus will not be part of the Supervisory Handbook). And even if it would be a supervisory convergence tool, quod non, which principle or requirement would need to be converged if there is no Level 1 obligation yet?
By way of comparison, Application Papers are also issued by the IAIS; these provide supporting material related to specific supervisory material (ICPs or ComFrame). Application Papers could be provided in circumstances where the practical application of principles and standards may vary or where their interpretation and implementation may pose challenges. Application Papers do not include new requirements, but provide further advice, illustrations, recommendations or examples of good practice to supervisors on how supervisory material may be implemented. The proportionality principle applies also to the content of Application Papers. With other words, application papers are supervisory convergence tools, and are issued once there is a standard. Doesn’t that seem logical?
What makes it all the more confusing is that EIOPA uses as justification that during the consultation on the Opinion (which is part of the Supervisory Handbook) “nearly all respondents provided comments and suggestions on the application guidance for developing and including climate change risk scenarios in ORSA.” Turning to the comments of the IRSG, after all the broadest spectrum of stakeholders, the IRSG welcomed any EIOPA effort to support the preparedness of insurers for assessing the impacts of climate change risks “whenever it does not lead to prescriptiveness and standardisation”. I noted however that the IRSG believes that “EIOPA’s consultation paper falls short of providing a compelling demonstration that the ORSA would always be the best tool and best reporting instrument to operate an insurer’s climate scenario analysis framework.” The IRSG further stressed that it is essential to preserve the full meaning of the “O” in the ORSA. A company’s own view of the risks is essential for business steering. EIOPA’s examples and good practices in terms of adverse scenarios assessment are welcomed, however insurers should have the flexibility to define their own scenarios. This is also a relevant consideration from the perspective of the proportionality principle. Further, the IRSG encourages EIOPA to continue to engage with insurers on this important topic to facilitate the design and development of meaningful climate-related scenario analysis. “One effective way to do this could be to create a forum where supervisors and industry representatives along with other key stakeholders on this topic could exchange views on good industry practices.” “Under ORSAs”, the IRSG continues, “(re)insurance undertakings identify, assess and challenge their entity specific risk drivers. Each specific risk profile requires a specific treatment. The number of variables underlying climate are certainly close to infinite, even more so when coupled with social, economic, technological, political situations and choices. It cannot be wise to rely on one or a couple of climate scenarios and think it provides a reliable work to inform upon. Additionally, all of this is still leaving an intimidating task to convert high-level all factored-in scenarios into applicable input for the actual risk drivers of an insurer’s risk profile.”
Despite the undoubtedly good intentions, the reference by EIOPA to its own Opinion, or suggestions and comments from stakeholders, do not replace the legal base of a directive.