Earlier this year, the Prudential Regulatory Authority ("PRA") published a supervisory statement (SS3/19) entitled "Enhancing banks' and insurers' approaches to managing the financial risks from climate change". In summary, the PRA requires financial institutions to develop their Senior Management Regime, addressing financial risks associated with climate change through the allocation of personal risk management responsibility. Compliance with the statement was required by no later than 15 October 2019.
All firms are vulnerable to risks associated with climate change, whether or not they are operating in an environmental sector. Management boards are expected to understand, analyse and manage the financial risks from climate change. Individuals may be held to account if they are unable to demonstrate that mitigation processes are in place and that the risks have been appropriately disclosed in financial statements.
By its recent statement, the PRA expects that financial institutions prepare a response to the financial risks of climate change that is "proportionate to the nature, scale, and complexity of its business". In particular, firms:
- must have clear roles and responsibilities for the board for this issue with responsibility for identifying and managing financial risks being allocated to an appropriate Senior Manager;
- will be expected to produce evidence that effective oversight of risk management and controls has been exercised; and
- are required to ensure that adequate resources and sufficient skills and expertise are devoted to managing the financial risks of climate change.
The expanded Senior Management Regime role is clearly defined, and the expectations of the PRA are simply put, but the PRA statement largely sets out a process driven approach, with little guidance on what realistic considerations the individual Senior Manager should have in mind when determining the most appropriate strategy for the business.
To explain what is meant by "financial risks for climate change", the statement refers to two primary types of risk - physical and transition:
- physical risks of climate change are those which relate to specific weather events (e.g. floods and wildfires) and give rise to, for example, impact on property and casualty insurance and/or damage to asset value affecting credit risks and underwriting security; and
- transition risks of climate change are those which arise from the process of movement towards a low-carbon economy and, for example, may relate to rapid technological change affecting the value of financial assets and/or companies' failure to mitigate financial impact of climate change by way of reduction in market value.
In order to demonstrate that a proportionate risk management response has been established, Senior Managers are expected to understand and use scenario-based analysis to review the short and long term financial risks to the business as a result of climate change. Where the potential impacts of the financial risks from climate change are assessed to be material, evidence will be required as to how the Senior Manager (/the firm) intends to mitigate the risk through a credible plan. In line with existing requirements to disclose material risks, firms are now required to consider disclosure of financial risks assessed in this category as well (including details of governance and risk management response).
With an eye on the potential consequences, directors must have a thorough understanding of the regulatory environment of climate change for their business. Senior Managers designated risk analysis and management obligations for the financial risks of climate change should take the implications of the role seriously, seeking external support on scenario analysis where possible. The Senior Manager taking responsibility for this function will need to have in mind the potential for significant personal liability and consider how best to ensure that any D&O liability insurance which they have is appropriate. In the worst case scenarios, the consequences of the PRA finding a regulatory breach against the Senior Manager can be severe, including criminal prosecution, fines and penalties, and disqualification as a director. As well as the potential for significant damage to reputation, dealing with the PRA's investigation (and any subsequent action taken) is likely to have substantial costs implications – Senior Managers will look to ensure access to (and funding for) the best defence possible. The PRA has also expressly stated in its rules that any fine or penalty issued will be uninsurable.
The Senior Manager may find that, alongside (or as a consequence of) any PRA investigation, they are also subject to civil proceedings – for example claims may be brought against the firm and/or its directors and officers for:
- breach of fiduciary duties in failing to consider the financial risks associated with climate change resulting in reduced corporate value;
- failure to comply with disclosure obligations; and
- inclusion of incorrect or misleading information as a consequence of inadequate or incomplete risk analysis in this area.
D&O insurers may consider the PRA's amendment to the Senior Managers Regime to be expected and foreshadowed. In recent years insurers and corporates have received increased public pressure for early recognition at board level of the potential future liabilities and an expectation for insurers to influence advance risk management from their insureds in this regard. This mandate from the PRA places climate change risk management firmly on the corporate governance agenda. Together with wider consideration of compliance with the various aspects of the Senior Mangers Regime, insurers should be willing to scrutinise the scenario analysis used, the response and mitigation policies compiled and satisfy themselves of the risk management adopted.
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