Insurers are facing new requirements for sustainability-related disclosure that will prompt a review of their reporting processes and systems, as Barbara Jaworek explains
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Barbara Jaworek, Director, Product Management
The aim of the recent COP26 in Glasgow was to get global commitment to reduce CO2 emissions and cut the use of non-renewable energy sources. These global efforts to protect the climate will impact every industry and business function to a greater or lesser extent. For a financial reporting professional, the impact of this may soon materialise in the form of a comprehensive, globally consistent requirement to report on climate and other sustainability issues which may soon become enforceable in endorsing jurisdictions. During COP26, the IFRS Foundation announced the creation of the new International Sustainability Standards Board (ISSB) whose aim will be to issue global IFRS Sustainability Disclosure Standards. This milestone is an outcome of work started in 2019 to set a global baseline for sustainability disclosures.
The new ISSB standards will require insurers to disclose a variety of qualitative and quantitative information, including industry-specific metrics for insurers. This may require insurers to develop or adjust existing methodologies to capture data and model the impacts of climate and other sustainability risks on their financial performance. The new requirements are likely to result not only in changes to reporting processes and systems, but also to the way companies manage sustainability-related risks and incorporate them in their broader risk management strategy and decision-making processes.
A board is born
Until now, the IFRS Foundation was known as an oversight body of the International Accounting Standards Board (IASB) who issue International Financial Reporting Standards (IFRS). These standards have been broadly adopted by wide number of countries around the world as a basis for financial reporting of mostly public companies. The new ISSB will sit alongside the IASB, issuing independently new type of standards focussed on sustainability-related financial information. The ambition of the ISSB is to create a reporting framework that will achieve similar international recognition to IFRS, becoming a globally consistent set of compulsory reporting rules.
The ISSB acknowledges the efforts to date of various organisations and bodies to provide guidelines and best practices on sustainability-related reporting. It will build on this legacy by incorporating into its standards existing frameworks such as the recommendation of the Financial Stability Board's Task Force on Climate-related Financial Disclosures (TCFD). It is a well-known framework and many countries, including the G7 members, New Zealand, Switzerland, and China, which have already committed to implement it in the coming years for their large companies. Currently, many companies around the world use it on a voluntary basis for climate risk reporting. The ISSB standards will also incorporate the work of the Climate Disclosure Standards Board (CDSB) and the Value Reporting Foundation (VRF). These two organisations will merge with the ISSB next year which is an important step in unifying different sustainability reporting recommendations by bringing them under one roof.
Given the urgency to create a comprehensive global baseline of sustainability-related disclosures, the ability to build on existing disclosure frameworks rather than starting from scratch is a much-needed accelerator. The first step has been the work of the Technical Readiness Working Group (TRWG) consisting of representatives of many international organisations and global financial regulatory bodies. They have utilised existing frameworks and guidelines to prepare prototypes of the first two standards. These were published on the ISSB website on the same day the formation of the new Board was announced. It is expected that these prototypes will become the basis of exposure drafts prepared by the ISSB when it starts operating next year.
New reporting requirements on the horizon
The first of the prototypes sets the basis for the future General Requirements for Disclosure on Sustainability-related Financial Information. The aim of this disclosure will be to provide the users of general-purpose financial reporting (i.e. investors, lenders, and other creditors) with sustainability-related information required to assess the enterprise value of the reporting company in order to make investment decisions.
The second prototype deals specifically with one sub-set of sustainability-related disclosures, which is an exposure to climate- related risks and opportunities. It focuses on the impacts of such risks and opportunities on financial information such as the amount, timing and uncertainty of future short, medium, and long-term cash flows. Climate risks are distinguished by two categories that may be familiar to those already reporting under on TCFD recommendations:
- Physical risks due to climate change and its effects such as floods or droughts, which can result in financial implications; and
- Transition risks, such as costs of adaptation to climate change and new regulations.
Both prototype standards leverage the structure of the TCFD reporting framework, building risk and opportunity focussed disclosure requirements around four areas:
- Governance including processes, controls, and procedures to monitor and manage the climate and other sustainability- related risks
- Strategy for addressing these risks including a description of the current and anticipated impact on their business model, decision making, financial position, and financial performance. The required disclosures also include projections of changes of these impacts over time, and an analysis of the resilience of the entity's strategy and cash flows to significant risks
- Risk management, i.e. how existing and emerging risks are identified, assessed, managed, and mitigated Metrics and Targets to measure and monitor risks, including cross-industry and industry-based metrics, activity metrics and other KPIs. Companies will have to report on targets to mitigate risks or enhance opportunities, performance against these targets, and how progress is being measured.
Impacts on the insurance industry's reporting
Many insurers have already put a lot of effort into voluntarily incorporating climate and other sustainability-related disclosures in their reporting, following the TCFD's recommendations and other globally acknowledged guidelines. For such insurers, the prospect of new ISSB standards and their implementation by local governments equates to just a legal endorsement of established disclosure practices. However, in practice, the level of compliance with current voluntary guidelines varies across companies in terms of both the scope and the quality of disclosed information.
Some areas of future compulsory disclosures of many insurers may require changes not only to reporting data, systems, and processes, but also to the way they manage climate and other sustainability-related risks and include them in the overall governance and strategy of the organisation. If regulators require sustainability-related disclosures to be audited, it may increase the level of controls and scrutiny around their reporting process. Adding a new set of disclosure requirements to the existing IFRS standards will not only create the need for developing new reporting practices, but it may also impact those related to existing financial reporting. Information required by the ISSB standards will become part of general-purpose financial reporting, prepared with the same users in mind and using a similar concept of materiality.
All disclosure information should be connected and consistent, allowing end-users to understand the interactions and dependencies between sustainability-related financial disclosures and other information in the general-purpose financial reporting. Making a link between sustainability-related disclosures and financial projections will become necessary when preparing financial statements based on IFRS (or even based on local GAAP, if governments decide to supplement these requirements with the ISSB standards). Preparation of the new disclosures will have to be considered in current reporting timelines, as discussed later in
this article.
Data, systems, and processes
The new disclosure framework will require both qualitative (describing the risks and insurers' responses to them) and quantitative analysis such as:
- Projections on how the climate and other sustainability-related risks will impact future financial performance.
- Resilience of the entity's cash flows to significant risks; or
- Performance against targets to mitigate risks or enhance opportunities (including disclosing methods to calculate them, and whether they are based on external parameters or validated by third parties).
These disclosures will require a good understanding of the risks and opportunities in the sustainability space, informed by and aligned with up-to-date market consistent information on such risks.
New data will have to be collected and stored. Some of this data will be internal (such as the amount of capital deployed towards climate-related risks and opportunities or scope 1 greenhouse gas emissions) and will require new processes to capture such data at the required level of granularity and to aggregate these as appropriate. Other data will be sourced externally, e.g. from key suppliers, or market wide information such as current climate risks in particular parts of the world.
Insurers will also have to develop methodologies expanding current models that test sensitivity of cashflows and capital, to accommodate climate scenarios. The standard prototypes explicitly require the full range of possible outcomes, their likelihood, and potential impact to be considered when assessing the materiality of possible future events. In addition, the outcomes of such analysis will have to be translated into their likely impacts on the financial performance and future cash flows to allow users to make informed decisions.
Risk mitigation is another area where new calculation methods will have to be developed in order to disclose quantitative information about performance against targets. To achieve this, investors might favour external parameters to be used, in the same way third party validation is used to make the analysis more reliable.
Apart from cross-industry metrics such as the amount of assets or business activities vulnerable to physical or transition risks, the climate-related disclosures prototype prescribes three types of industry-based metrics that will apply to insurance business. These include:
- Incorporation of environmental, social, and governance (ESG) factors in investment management,
- Policies designed to incentivise responsible behaviour; and
- Environmental risk exposure.
The first two metrics recognise the role that insurers play in promoting sustainability by directing capital into ESG-conscious areas and incentivising health, safety and environmentally responsible behaviours. Together with a qualitative description of their approach to investment management and discussion of relevant product features, insurers will have to disclose quantitative information such as net premiums written related to energy efficiency and low carbon technology.
The environmental risk exposure disclosure requirement will apply in particular to non-life insurers. They will have to model and disclose their probable maximum loss (PML) from weather- related natural catastrophes, as well as total amount of monetary losses attributable to insurance pay-outs from modelled and non- modelled natural catastrophes. PMLs have been in widespread use in insurance companies for years, however, the main difference here is that few insurers currently incorporate a climate adjusted PML. As such, insurers will be required to update their natural catastrophe models to allow for climate-change scenarios. This may also impact their risk selection and exposure management.
Reporting timelines
The new IFRS Sustainability Disclosures will form part of an insurers general-purpose financial reporting. This means that all the new processes to collect data, run models, analyse their results and present them in form of disclosures useful for end- users will have to be incorporated into the general-purpose financial reporting timelines.
In addition, the prototypes extend the entity boundary concept and require, subject to materiality, the inclusion of sustainability information related to external parties such as key suppliers. As the suppliers will first need time to assess their own impacts, this dependence on external information can create additional constraints and pressures on an insurers' reporting cycle.
Given these additional burdens, insurers will have to find ways to accelerate the process of reporting the new disclosures if their current reporting deadlines are still to be met. For example, the collection and management of market-based climate risk data could be left to external providers.
Although some cross- industry metrics are entity-specific (e.g. proportion of executive management remuneration impacted by climate risks), some other metrics may benefit from access to pre-collected input information. For example, reporting on the amount of assets or business activities vulnerable to transition or physical risks require information on these risks which is not a company- specific but rather market wide, and could be outsourced to an external provider.
One option to accelerate the reporting process is its automation. For example this could take form of an integrated reporting tool combining the data management, modelling, and reporting units to prepare disclosures in agreed formats.
Where and when will the new standards apply
Similar to other IFRS standards, the new ISSB standards will be voluntary, minimum standards. To become a reporting requirement in a given jurisdiction, they will have to be adopted by governments into their local legislation. Any type of regional modifications, including carve-outs and additional requirements per jurisdiction are possible. However, one of the main objectives of implementing IFRS is to create global comparability so any modifications are expected to be an exception.
The ISSB and their future standards have already gained international support from organisations such as International Monetary Fund and United Nations, as well as global financial regulatory bodies like the Financial Stability Board and International Organization of Securities Commission. This creates an expectation that the ISSB standards may become as widely adopted as IFRS. For example, the UK Government has already declared its intention to endorse the ISSB standards to make them a core of the sustainability reporting regime in the UK. Both the US and the EU have also expressed support for the ISSB initiative, although they have not committed at this stage to adopting its standards in the future. The EU continues its work on the forthcoming Corporate Sustainability Reporting Directive which will provide EU-wide sustainability reporting standards. The way it will interact with the IFRS Sustainability Disclosure Standards is currently unknown, but it will be important in determining the global status of the ISSB standards.
The adoption timeline of the ISSB standards in each jurisdiction will be decided locally. Before that, the work on issuing the standards will have to commence. Currently hiring their key personnel, the ISSB plans to start to operate at the beginning of 2022. As a first step, the ISSB will conduct a public consultation to inform its work plan and to get feedback on the prototypes of the two future standards. This is similar to the due process followed in creation of IFRS. Typically, it requires 120 days comment period (with shorter periods allowed for narrow scope matters). If changes are required to the exposed drafts as a result of this consultation, public meetings may be held before final decisions being taken. The ISSB will therefore have a busy year ahead if they aim to issue the first batch of standards in 2022, as some expect.
The urgent need of global sustainability reporting standards means that the development process is likely to be accelerated compared to previous IFRS standards, especially since there is scope to shorten the drafting period because the work is building on existing frameworks. It also means that there is likely to be fewer contentious areas because it is more a question of enforcing the reporting practices that many entities are committed to adopt or are already applying on a voluntary basis. If so, it will help circumvent any lengthy delays due to fundamental changes needed to the draft requirements based on comments received as was the case for IFRS 17 Insurance Contracts.
Which companies will be obliged to report under the ISSB standards will depend on decisions taken by local endorsement bodies. For those deciding to accept the new standards, these will typically be mandatory for public and financial sector companies and their subsidiaries. However, given its importance, governments may decide that the sustainability and climate impact of smaller insurers should also be monitored, extending the requirements of the ISSB standards beyond the typical scope of IFRS reporters. In this case, proportionality will have to be applied, perhaps in the form of a separate set of reduced disclosures for SMEs, similar to current IFRS for SMEs.
What should insurers be doing now?
Those insurers who have already started disclosing climate and other sustainability information can start reviewing the scope and detail of their current disclosures to identify any gaps that will have to be addressed before the ISSB standards become effective. They should also closely monitor the work of the ISSB and use their opportunity to comment on the exposure drafts once they are issued.
The reporting processes, systems, and data currently in use will need to be reviewed and revised as necessary since the new requirements are likely to result in additional disclosure efforts. In particular, they will need to take time to:
- Identify risks and develop methodologies to analyse their current and future impact.
- Align their strategies, and the governance and risk management processes to address climate and other sustainability risks in a consistent manner with the new requirements.
- Determine if he assessment of materiality of sustainability-related information for the users of the financial statements requires new processes and methodologies to be developed.
Insurers should start planning for these coming changes by identifying key priorities and milestones, and assessing the required resources needed to support these steps.
Looking at the best practices around the current voluntary disclosures with recommendations such as TCFD are a good starting point. They can give an idea about the scope and granularity of the information required and how the scenario analysis was conducted.
Insurers should remember that climate change may create new risks as well as opportunities, for example, improving efficiency or developing new products. Information related to climate and other sustainability-related opportunities can positively impact decisions taken by investors, creditors, and lenders.
Above all, it should be remembered that the overarching goal of creating the ISSB and new standards is a common effort to transform businesses and align their strategies with the goal of reducing the climate change, saving the environment and creating an ethical fair society, much needed for everyone to thrive.
