Fudging the numbers? Climate models, pricing and governance: what recent allegations mean for insurers

Recent reports suggesting some firms are applying downward pressure on the outputs of catastrophe risk models raise difficult questions that insurers’ boards and Senior Managers should consider now.

Concerns reach the press and the FCA

An article in the FT this week reported that a number of insurance professionals had raised concerns about catastrophe risk modelling.  

Catastrophe models help insurers estimate exposure to floods, hurricanes and wildfires across large portfolios and major projects.  

By its nature, this type of risk modelling involves a high level of uncertainty, and as a result analysts have to apply a level of judgement both as to the likelihood of climate events, and their impact. 

The problem is that analysts’ interpretation of the outputs directly informs the price of cover.  And the FT reports that modellers are sometimes asked to revisit their analysis in ways that bring premiums down, even where this underplays the disaster risk.

Modelling climate risk: uncertainty vs pressure  

Everyone accepts that catastrophe risk modelling involves real uncertainty, and it’s generally accepted that there can be legitimate reasons to rerun or refine an analysis. 

But that’s not the concern the FT is reporting on.  Rather, the suggestion is that some adjustments may go beyond legitimate judgement, for example by assuming flood defences that are not actually in place. 

If that is the case, then – as a legal opinion that the FT reports was shared with the FCA noted – this would be exceptionally serious.  It would cross the line from the legitimate application of judgement in a highly complex area, to a knowing breach of regulatory requirements.

Not only would there be a clear breach of internal controls, but both the PRA and the FCA are likely to be highly interested in the outcome.  The FCA, because the report suggests that the pressure could affect the long-term availability of cover in some areas, leading to increasing protection gaps and real-world impacts on consumers and businesses.  The PRA is likely to be interested both in what the practice tells it about the control environment for underwriting, and the wider prudential implications where cover has been written on a basis that does not reflect the level of risk returned by the modelling process.

The allegations remain untested, and the reporting does not identify any particular firm.  Even so, they are likely to sharpen regulatory interest in how pricing decisions are governed across the market.  The FCA in particular has said publicly that it encourages people with relevant information to come forward.

The rising temperature on climate risk

The FT report is likely to sharpen the regulators’ focus on climate risk more generally.  

In SS5/25, the PRA made clear, as it has for a number of years, that it considers climate risk to be a core risk across the UK financial sector.  It stressed that climate risk is likely to be systemic in nature and uncertain in scale and timing, and that insurers should consider how climate change might lead them to incur larger claims than might have been expected from historical experience.  

Earlier this month, the non-profit Inside Track published an open letter in which more than two dozen anonymous senior insurance executives raised concerns that short-term financial incentives may be leading the sector to underprice physical climate risk.

And the simple point is this: if climate risk is being systematically underpriced, the risk of contagion should a number of insurers suffer large claims following a climate event may be too large for the PRA to ignore.  

Controls and accountability

So, what next?

For most firms, this is likely to be a question of evidencing good governance rather than finding problems. Regulators are unlikely to want to second-guess individual modelling decisions unless there is evidence that inappropriate pressure was brought to bear on analysts in a systematic way. They are more likely to want to understand how firms’ control environments prevent pressure from being put on analysts in the first place, and who is responsible for overseeing those controls – particularly where that analysis has been delegated to a third party.

The Senior Managers and Certification Regime (SMCR) is the key to the second question. Solvency II firms and large non-directive firms must make sure that every activity, business area and management function has a Senior Manager with overall responsibility for it. The FCA has specifically noted that the person with overall responsibility for product pricing, where this is separate from underwriting, may need approval as a Senior Manager. The relevant PRA senior management functions include the Chief Risk, Chief Actuary and Chief Underwriting functions. 

Below Senior Manager level, the FCA regards underwriting as one of the most significant business units in an insurer and generally expects the heads of that unit to be certified (although the implications of the impending abolition of the certification regime - see our article here - will need to be worked through). The PRA expects firms to consider whether employees responsible for underwriting and pricing of products are key function holders or material risk takers. 

Where pressure is being brought to bear systematically on analysts to underprice catastrophe risk, the regulators are likely to want to understand what the relevant Senior Manager knew, and – if they were unaware – what this tells them about the adequacy of the firm’s overall control environment. 

As a result, firms may want to confirm that:

• model overrides are documented, explained and reviewed independently of the first line commercial teams;
• responsibility for underwriting, pricing and model governance is clearly reflected in Statements of Responsibilities and the management responsibilities map;
• the compliance function’s oversight, including its monitoring of how the first line addresses issues, extends to governance around pricing;
• remuneration and performance metrics support sound risk decisions; and
• the Senior Manager holding the Prescribed Responsibility for whistleblowing is satisfied that modelling teams feel able to raise concerns should they need to. 

Senior Managers who can point to clear management information and a record of appropriate challenge will be well placed to show they took reasonable steps to prevent contraventions from occurring in their area of responsibility.

Next steps

We think it likely that the FCA will make targeted enquiries, particularly in specialty lines, before deciding whether further work is needed. Given that pricing also feeds into reserving and capital, we expect the PRA may also take an interest. 

Most firms will already have strong frameworks in place.  But given the likely regulatory interest in this issue, and the very public reporting by the FT, firms may want to get out in front of this issue by reviewing pricing and speak-up arrangements now.   

A short, privileged review of model override practices, Senior Manager responsibilities, speak-up arrangements, and (where relevant) oversight of delegations is one proportionate way to confirm this. Doing so proactively will also ensure firms are well prepared to respond if the regulators make enquiries. 

Should systemic issues be uncovered, then advice should be sought on disclosure obligations under Principle 11 and Fundamental Rule 7.

We are regularly asked to review compliance and governance arrangements in the insurance sector and would be happy to discuss how we can assist.