NY DFS Issues Guidance on Managing the Financial Risks from Climate Change
Client Alert | 3 min read | 11.19.21
On November 15, 2021, the New York Department of Financial Services (“DFS”) issued its final guidance for New York Domestic Insurers on Managing the financial risks associated with climate change. This DFS guidance describes climate change as “one of the most critical risk-management issues of our generation,” and sets forth DFS’s expectations for how insurers should incorporate climate risk into their overall risk management with respect to underwriting and investment portfolios. DFS is the first U.S. financial regulator to issue a holistic set of expectations regarding the management of climate-related financial risks.
The DFS guidance focuses on physical risks due to the increasing frequency, severity, and volatility of weather-related events caused by climate change, and on risks arising out of the transition to a lower-carbon economy. As physical risks continue to intensify, they are expected to become more difficult to model, and more challenging for insurers to manage. Transition risks include the risk of stranded assets, asset devaluation, and additional liability through exposure to sectors with high transition risks, such as coal mining and other fossil fuels companies. In addition, the DFS guidance recognizes that climate change will disproportionately affect low income communities and communities of color, and will thus contribute to social inequality. Identifying and addressing the risks associated with climate change presents opportunities for insurers to encourage and facilitate resilience among these more vulnerable communities, and to encourage action and mitigation regarding climate change more generally.
In its guidance, DFS provides an overview of its expectations of insurers. Insurers should take a strategic approach to managing climate risk. This means integrating consideration of climate risk into the insurer’s governance structure, including assigning responsibility for climate risk issues to a board member or committee and to specific members of senior management; evaluating the appropriate time horizon to assess climate risk taking into consideration the insurers’ business lines and activities; embedding climate risks into existing risk management frameworks, including insurers’ Own Risk and Solvency Assessments (ORSA); and using scenario analysis that considers physical and transition risk considerations.
DFS reiterated its expectation, included in its earlier ORSA guidance, that insurers take a proportionate approach. An insurer’s approach to climate risks should be based on the specifics of the insurer’s business such as size, complexity, geographic distribution, business lines, investment strategies, and ability to devote resources to managing these risks. Consistent with a proportionate approach, DFS advises insurers to evaluate the materiality of particular climate risks, take a longer-term view than a typical risk management horizon, and consider the impact of their own general and operational business strategies.
The guidance discusses risk culture and risk management at some length, along with specific expectations for governance, organizational structure, and key principles for effective risk management frameworks. An insurer’s risk framework should include evaluation of physical and transition risks, but also credit risk, legal risk, liquidity risk, market risk, operational risk, pricing and underwriting risk, reputational risk, and strategic risk. DFS acknowledges that the time frame necessary for implementing these strategies may vary, but nevertheless expects that insurers’ approaches to climate risk will become more comprehensive and sophisticated over time. Finally, DFS expects insurers to develop an approach to public disclosure around climate risk.
In compiling this guidance, DFS reviewed comments to its interim proposed guidance, published in March 2021, from 45 parties, including industry trade groups, insurers, consumer advocates, climate experts, rating agencies, financial regulators, and individuals. According to DFS, its final guidance reflects consideration of these comments along with a variety of other sources, including insurers’ enterprise risk reports, ORSA summary reports, NAIC Climate Risk Disclosure Survey responses, Task Force of Climate-Related Financial Disclosure (TCFD) reports, and other materials and sustainability reports. DFS modeled its guidance in part on the work of international regulators and networks, including the Bank of England Prudential Regulation Authority, the International Association of Insurance Supervisors, the Sustainable Insurance Forum, the European Central Bank, and others.
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