Better green than sorry – Why the prudential framework for insurers should integrate systemic climate risks

Climate change poses systemic risks to insurers and the broader financial system, yet the EU’s prudential framework for insurers remains ill-equipped to deal with these. While recent regulatory revisions have introduced some climate-related requirements, these fall short of a systemic approach. This policy brief calls for integrating systemic climate risks across the full range of insurers’ underwriting and investment activities and puts forward concrete actions to that end. The upcoming review of the EU’s macro-prudential framework for non-bank financial intermediation (NBFI) opens an unmissable window of opportunity to align insurers’ prudential policy with climate objectives and safeguard financial stability in an era of escalating climate risk.

Insurance plays a crucial (if often overlooked) role in the climate crisis. On the one hand, climate change weighs on insurers: the rising frequency and severity of natural disasters increases their liabilities and, at the same time, the slow progress towards a low-carbon economy creates transition climate risks that threaten insurers’ assets. On the other hand, insurers’ business influences the pace of the ongoing transition: within their underwriting activities, they may help the development of green technologies or decide instead to insure fossil-fuel projects, while within their investment activities they may opt for financing sustainable infrastructure or continue funding emission-intensive industries.

Prudential regulation for insurers so far fails to recognise the systemic nature of climate change. The latest revision of the prudential rules adopted by EU co-legislators in 2024 asks insurers to integrate climate into their internal risk management. However, these changes do not reflect the fact that the effects of climate change may go well beyond individual insurers and impact the wider financial and economic system. Therefore, EU rules need to enable insurers and their supervisors to address from the start the build-up and transmission of climate-related risks at a system-wide level.

The EU should seize the current window of opportunity to make the necessary changes. The upcoming review of the EU’s macro-prudential framework for non-bank financial intermediaries (NBFI) provides an opportunity to complement the regulatory toolkit for insurers with a dimension that captures systemic climate risks. In concrete terms, we propose to

• include the double materiality approach within insurers' climate transition plans
• incorporate climate risks in insurers’ capital requirements
• create a systemic risk capital buffer that has a clear climate dimension
• introduce limits to insurers’ environmentally harmful exposures, and
• run regular system-wide climate stress tests.
   

1   Problem description: Individual insurers do not take the systemic view

Like other corporations, insurers leave their own operational climate footprint – via buildings, staff, energy use – but these direct activities represent only a small part of their economic and financial relevance. The most significant climate risks and impacts stem in fact from their financial activities. This section explains how insurers are exposed to climate risks on both sides of their balance sheet. What’s more, risk transmission does not only flow one-sidedly from the climate to individual insurers: if insurance companies keep financing or insuring the development of high-carbon projects, they are contributing to ever-greater physical climate risks and thereby compounding future losses for themselves and their peers. What’s more, the increase in climate-related natural hazards drives insurers to either raise premiums or stop offering coverage altogether, creating a dangerous climate insurance protection gap.

1.1   Exposure to climate change

Insurers’ liabilities increase as the planet heats up. As risk underwriters and claims managers, insurers help individuals, corporations and the overall economy absorb losses and diversify risks. Insurers provide essential risk coverage for life, health, property and accident by underwriting, pooling, and diversifying risks before events occur. This enables individuals and businesses to manage risks they could not bear alone: without insurance, many investments, for example in energy infrastructure, would never come to pass. On the liability side, insurers face rising insurance claims linked to climate risks, including floods, storms, wildfires, droughts, and heatwaves. In 2024, extreme weather events were responsible for 93% of overall losses and 97% of insured losses. These acute perils are exacerbated by chronic climate change and environmental degradation, which increase vulnerability to disasters. This is true especially for Europe, which is now the fastest warming continent in the world.

Insurers’ assets are threatened by climate change. Insurers invest the premiums they receive from their clients in financial assets to fund future claims. As long-term institutional investors – especially in life insurance – they hold significant amounts of bonds, equities, real estate, infrastructure, and illiquid assets. On the asset side, insurers’ long-term investments are prone to depreciation if physical or transition climate risks materialize. Insurers’ assets are at risk of depreciation from transition changes linked to policy, legal, technological, and social factors, which can create stranded assets. These risks may develop gradually or suddenly, causing sharp asset repricing. Physical risks also create direct losses for physical investments and can indirectly affect portfolios through supply chain disruptions and productivity losses. Asset depreciation from the transition to sustainable practices often coincides with rising liabilities from increased claims due to climate change, resulting in significant capital losses. This differs from traditional financial risk management, where aligning assets and liabilities can mitigate market movements.

1.2   Contribution to climate change

Insurance companies insure and finance activities that fuel climate change to earn short-term profits, although this drives up their risks in future. While most insurers  no longer insure new coal projects, they continue to underwrite the expansion of the oil and gas industry. At the same time, insurance companies are often reluctant to provide coverage for the development and scaling-up of innovative green projects since new technologies often involve high degrees of uncertainty and lack the historical data insurers use to evaluate risks and set premiums. Further, when investing their clients’ premiums, insurers may prioritize traditional energy investments that have performed solidly in the past and are expected to keep doing so in the short to medium future. The continued reliance on and demand for fossil fuels can perpetuate their profitability and make investments in these assets appealing to insurers requiring stable returns to meet their liabilities. However, the long-term effects of financing and insuring high-carbon activities will hit insurers like a boomerang and drive up the number and severity of claims.

The insurance sector suffers from a classic collective action problem when it comes to addressing climate change. Protecting the climate, safeguarding financial stability and guaranteeing insurability of natural hazards are public goods, but no single insurance company can solve the problem of increasing physical and transition climate risks by itself. If only a handful of insurers incorporate climate risks into their investment and coverage decisions, competitors may continue harmful practices, benefiting from short-term profits by insuring higher-risk activities. As a result, efforts to take a more systemic view might seem unwise financially for insurers competing against go-it-alone rivals. The preference of individual economic actors for optimizing their risk-adjusted returns in the short-term instead of considering the long-term effects of climate change is, in the phrase coined by Mark Carney ten years ago, “the tragedy of the horizon”.

1.3   Emergence of a climate insurance protection gap

Insurers lack proper incentives for long-term risk management. Most property and accident insurance products operate on a one-year contractual horizon. Instead of engaging with clients on how to reduce climate risks, for example by upgrading a flood-damaged home to higher resilience standards, insurers prefer to either raise premiums or simply withdraw coverage. This trend is evident as well  in Europe, where for example Irish citizens can no longer insure their homes in areas subject to severe floods. Across the EU, only about a quarter of climate-related catastrophe losses are currently insured; in some countries, it is less than 5%. This climate insurance protection gap is expected to widen further owing to the increasing risk posed by climate change.

The climate insurance protection gap creates systemic risks. From the viewpoint of an individual insurer, the practice of setting prohibitive premiums or exiting contracts makes financial sense. However, if all insurers behave this way, this creates a lack of affordable and available insurance coverage with far-reaching financial, economic and fiscal consequences. Where natural disasters go uninsured, this can hamper rapid economic recovery and negatively impact government finances through a higher disaster relief burden, lower tax revenues, or direct physical damage to public assets such as bridges, railway tracks or power lines. Extreme climate events can also fuel systemic risk for the financial system itself, notably through reduced collateral values and loan repricing for financial institutions with a concentrated exposure in high-risk areas.

2   Existing EU regulation with regard to insurers’ climate risks and impact

The EU regulatory framework for insurers does not take the systemic view and lacks any European dimension. The Solvency II Directive contains the minimum set of requirements that insurers in the EU must fulfil. The European Insurance and Occupational Pensions Authority (EIOPA) serves as standard setter and contributes to the convergence of national supervisory practices by issuing technical standards as well as opinions and recommendations. Day-to-day supervision, however, is carried out by national financial supervisory authorities even for the largest EU insurance companies – in contrast to significant banks that are supervised by the European Central Bank.

The existing EU regulatory framework for insurers focuses exclusively on micro-prudential measures, such as solvency requirements and internal risk controls, applied at the level of individual institutions. Unlike for the banking sector (Table 1), no macro-prudential framework has been established for insurers – despite the introduction of such measures for banks in the aftermath of the global financial crisis, including additional capital buffers targeting systemic and other broad-based risks. This gap is further underscored by the fact that the Financial Stability Board (FSB) has not designated any global systemically important insurers (G-SIIs), in contrast to the designation of global systemically important banks (G-SIBs).

Table 1: Micro-prudential vs macro-prudential regulation as applied to EU banks

^{Source: Own elaboration.}

The latest revision of the EU regulatory framework for insurers brought some - but limited - progress with regard to taking on board climate risks. In 2024, the EU adopted amendments that, inter alia, integrate climate and sustainability risks into the Solvency II Directive (Box 1). As of 2027, insurers will be asked to conduct climate change scenario analyses, incorporate them in their internal risk and solvency management, and draw up climate transition plans outlining how they intend to adapt their business to an economy transitioning to net zero.

Box 1: Recent changes to the Solvency II Directive with relevance for climate and nature

While these changes are definitely important for making insurers consider climate risks at individual level, they fall short of introducing measures that would tackle the systemic dimension of climate change. The crucial role of insurance in the economic and financial system requires measures ensuring that individual insurers not only manage the financial risk which climate change poses to their own business but also consider the system-wide amplification effects of a disorderly transition. What’s more, the new Solvency II provisions on transition plans require insurers to look only at the risks that insurers are exposed to (outside-in) and largely fail to include the negative environmental impact caused by insurers themselves (inside-out). These requirements are similar to the ones applicable to banks, but they fall short of the double materiality approach enshrined in the Corporate Sustainability Reporting Directive (CSRD) which requires companies to consider both the risks posed by climate change and the companies' impact on  climate. Taken together, the latest Solvency II revision does nothing to solve insurers’ collective action problem when addressing climate change.

3   Incorporating the systemic nature of climate change into insurers’ regulatory framework

The review of the macro-prudential framework for non-bank financial intermediation (NBFI) offers a window of opportunity to address the systemic nature of climate risks for insurers. The Mission Letter for the EU Commissioner for financial services and the Savings and Investments Union, Maria-Luis Albuquerque, asks her to assess the adequacy of the EU macro-prudential framework for the NBFI sector - and this  extends to insurance companies. In order to gather feedback for the upcoming review, the Commission in 2024 held a targeted consultation. However, despite climate change being undoubtedly a systemic risk, the consultation document drafted by the Commission did not identify climate as one of the key vulnerabilities. To support climate change mitigation and adaptation, avoid economic losses, and preserve financial stability, the Commission should rectify the neglect of climate and nature when it presents its final legislative proposal for the review of the macro-prudential framework of NBFIs - and in particular insurers - later this term. There are several avenues the Commission can explore to address the systemic nature of climate change in the insurance sector. We propose a combination of measures, including the introduction of new macro-prudential tools and the adaptation of existing micro-prudential measures, to better reflect systemic climate risks.

3.1 Upgrading micro-prudential measures

First, the Commission should add the double materiality approach to insurers' climate transition plans. Climate transition plans are an important tool to make insurers consider physical and transition risks for their business. However, in order to take the systemic view, the existing Solvency II requirement to draw up transition plans should be expanded to adopt the double materiality standard enshrined in the CSRD so as to include insurers’ harmful environmental impact where this fuels climate change and exacerbates associated risks. Only when taking into account the potentially detrimental effects of their underwriting and investment policies can insurers ensure their practices reduce the systemic risks associated with climate change. While the CSRD is subject to review under the Sustainability Simplification Omnibus, neither the European Commission nor the majority of EU member states or Members of the European Parliament question the usefulness of its double materiality approach. Therefore, upgrading the Solvency II requirement for climate transition plans by adopting the CSRD's double materiality standard seems already to have political backing. What's more, aligning the two transition plan requirements would reduce the complexity of the EU regulatory framework and thus serve the Commission’s simplification agenda.

Second, it should incorporate climate risks in insurers’ capital requirements. Insurers are required to hold capital in proportion to the risks they take on, yet the current regulatory framework largely overlooks climate-related risks. To absorb potential losses from the repricing of stranded assets or the physical damage caused by climate change – and to support efficient capital allocation – insurers should be required to account for the long-term impacts of climate change in both their underwriting and in their investment decisions. This entails two key measures. First, as the Council on Economic Policies argues, capital charges for underwriting risk should incorporate climate-related considerations to ensure that insurance premiums for high-carbon activities reflect their long-term negative externalities. Second, capital charges should also be increased for investments in environmentally harmful assets. While EIOPA has recommended applying such charges to exposures in the fossil fuel sector, this should be seen only as a starting point. For a more comprehensive approach, researchers from Amundi advocate for including other industries subject to transition risks and for applying the capital add-on only to companies that lack a credible climate transition plan.

3.2   Introduce new macro-prudential tools

Create a systemic risk capital buffer that has a clear climate dimension. In the banking sector, competent authorities may require certain groups of institutions – or even all institutions – to maintain a systemic risk capital buffer to address systemic risks in specific sectors or exposures which in principle include  climate risks, although this is not spelled out in the law. Building on this precedent, the EU should introduce a similar buffer for insurers and explicitly mandate competent authorities to apply it to address the systemic risks that climate change poses to the insurance sector. The buffer rate could be calibrated based on the pace of the transition to a clean economy and the evolving transition and physical climate risks insurers face. The slower the transition to net zero, the greater these risks become – and accordingly, the higher the systemic risk buffer should be. Given the cross-border nature of both the insurance business and climate change, it would be straightforward to strengthen the role of EIOPA and the European Systemic Risk Board (ESRB) to ensure an EU-wide level playing field in the application of the systemic risk buffer.

Introduce limits to insurers’ environmentally harmful exposures. To reduce the risks banks face from their exposures to “shadow banking” entities, they are required to set internal limits both on individual exposures (addressing micro-prudential concerns) and on their aggregate exposure (addressing macro-prudential concerns). Following this logic, any future macro-prudential toolkit for insurers should include limits on exposures to activities with significant negative impacts on climate and nature. This would yield a dual benefit: lowering insurers’ risk from any sudden and likely repricing of high-carbon assets, and reducing their contribution to climate change.

Run regular system-wide climate stress tests. The requirement introduced in the latest Solvency II revision for individual insurers to conduct climate scenario analyses every three years is a necessary step - but it remains insufficient to fully capture the systemic risks posed by climate change. To identify and mitigate potential spillover effects across the financial system and into the real economy, supervisors need a comprehensive, cross-sectoral view of how climate risks evolve under stress. In 2024, the European Supervisory Authorities (EBA, EIOPA, and ESMA), together with the ECB, conducted a one-off climate stress test covering insurers, banks, and investment funds, which revealed significant losses under heightened macroeconomic pressures. To maintain a forward-looking approach to insurers’ climate risk exposure, such system-wide climate stress tests should be conducted regularly, use more realistic scenarios, and fully capture the escalating impact of physical climate risks.

Closing the climate protection gap will require a wider policy effort. It is important to acknowledge that prudential regulation alone cannot close the growing climate insurance gap. Addressing this gap will require complementary reforms, including structural changes to insurance markets. Making multi-year insurance products mandatory - l along the lines of fire insurance in Japan - in all EU member states via the Directive on Insurance Distribution (IDD) could help overcome the misalignment between short-term insurance contracts and long-term investments in climate resilience. Mandatory insurance against natural hazards, as is already the case in France and now under discussion in Germany, would eliminate risk selection from insurers. In light of the system-wide risks that the climate insurance protection gap poses, all EU countries should require mandatory insurance against natural hazards. Last but not least, a public-private reinsurance scheme at European level could prevent insurers from withdrawing from certain jurisdictions entirely and complement national risk pooling mechanisms.

4   Conclusion

Integrating systemic climate risks into the prudential framework for insurance companies is essential. Climate change poses systemic risks not only to insurers but also to the broader financial system. This risk is so far inadequately addressed in the EU’s regulatory framework for the sector. EU policymakers should seize the upcoming review of the macro-prudential framework for NBFI to align policy with strict climate objectives and thereby help safeguard financial stability in an era of escalating climate risk.

_{Photo: CC Danist Soh, Source: Unsplash}