Transition Risk

Last Updated: 3/20/204
Issue: Climate-related events associated risks are uncertain and can be difficult to predict. The most obvious and documented risks associated with climate change are “physical risks”, like an increase in the frequency and severity of severe weather events. These risks can manifest themselves suddenly (e.g., catastrophic flood, hurricane, or wildfire), or gradually over time (e.g., sea level rise or an increase in temperature). While some aspects of those risks can be predictable, there is increasing uncertainty about the location, frequency, and severity of these events.

The risks associated with climate change go beyond physical risks, however, a broad category of climate change risks called “transition risks” is receiving increased attention. Transition risk is the potential costs to society of evolving to a low carbon economy to mitigate climate change. These costs can arise from changes in public sector policies, innovation, and changes in the affordability of existing technologies (i.e., technologies that make renewable energies cheaper or allow for the removal of atmospheric greenhouse gas emissions), or investor and consumer sentiment towards a greener environment (e.g., a desire or requirement to divest of assets, such as the equity of companies with activities that hasten climate change). For transition risks, there is uncertainty about the future pathways for net-zero transition, which will potentially lead to adverse economic and societal impacts in a much shorter time frame than the physical risks from climate change.

For insurance companies, transition risk may arise primarily through their investment portfolios.  Transition risk is the primary climate risk exposure for life insurance companies since they typically do not provide insurance on properties exposed to physical risk.

Background: In 2017, the Task Force on Climate-Related Financial Disclosures (TCFD) released a landmark report with disclosure recommendations to help companies acquire better data to support well-informed capital allocation. This critical document has served as a framework and guide for capital markets to define and integrate climate-related risk analysis into their investment decisions. The TCFD identifies four key types of transition risk:

• Policy and Legal Risks
• Technology Risks
• Market Risks
• Reputation Risks

Because transition risks may be financially significant, the effects of transition risks have the potential to:

(1) erode market value and increase market volatility of certain assets resulting from changes in customer and community perceptions of companies’ contributions to or damage to a sustainable economy. 

(2) affect the availability and affordability of insurance products for certain sectors, such as industries engaged in fossil fuels.

(3) require increased spending for new investments in technology and processes for a smooth and adequate transition.

TCFD has released its fifth report in the series TCFD 2022 status report, The report finds that while global ambition to address climate change has increased over the last five years, recent extreme weather events around the world have amplified the need for an even greater concerted effort and faster progress. Consideration of the implications of climate change have become far more mainstream throughout financial markets since 2017 (following release of the TCFD report), and an increasing number of companies are publicly committing to net-zero emissions.

Relevant industry sectors such as energy production, utilities distribution, transportation (e.g., automobile, aviation, and railroad), agriculture, consumer goods production (non-energy, e.g., building materials), and financial institutions, along with the insurance sector, may proactively implement various strategies such as divestment, investment, and exclusion to mitigate the transition risk within their business operations and investment portfolios.

The role that state insurance regulators play with respect to climate risk involves more than simply ensuring financially strong insurance companies and a viable market; it also includes encouraging strong and resilient homes and communities.

Insurers are risk financers and, as such, are risk managers and risk mitigators. State insurance regulators are actively involved in the effort to help the public and private sectors to build more resilient communities. State insurance regulators encourage the use of innovative building materials, advanced technology, and risk mitigation methods to reduce the impact of climate risk across a broad spectrum of natural catastrophe risks. Most importantly, they work with insurers to design new and innovative products and establish partnerships with insurers to help guide and finance community efforts. 

State insurance regulators also continuously monitor the capital adequacy of insurers to ensure their ability to pay claims following catastrophic events. Most recently, based on the recommendations of the Climate and Resiliency (EX) Task Force, the NAIC’s Financial Condition (E) Committee is considering specific enhancements to the solvency oversight tools used by state insurance regulators that will expand the evaluation of an insurer’s exposure and response to climate-related financial risk, particularly in  transition risk. The Task Force is also evaluating viable approaches to scenario analysis and stress testing for insurers as the data necessary to conduct such exercises becomes available.