Climate Risk Assessment and Scenario Analysis: A Maturity Process from Qualitative to Quantitative Analysis

Background And Purpose

In October 2021, the Society of Actuaries Research Institute (SOA) formally launched its Catastrophe & Climate Strategic Research Program, building on several years of research on climate-related risk, including four principal launch projects and a series of research papers on environmental risk. In 2022, the SOA would like to extend this research in various ways, including investigation into the approaches used by actuaries to assess climate risk and develop related scenarios for analysis.

Following is an outline of perspectives on this topic, that we would like to explore through a research project:

• Climate risk assessment is a journey, with a considerable learning curve for practitioners; thus, it can be mapped on a maturity continuum.
• Why is climate risk assessment relevant? There is increasing interest from many stakeholders around disclosures including regulators, policymakers and (institutional) investors among others.
  • TCFD (the Taskforce on Climate-related Financial Disclosures) is also adding pressure, with some jurisdictions moving ahead with TCFD-aligned disclosures.
• The use of climate risk assessment is relatively nascent (late infancy stage).
  • Methodology frameworks suitable for translating climate scenarios into the vast array of financial risks are being developed.
  • Climate risk is unprecedented and complex, with many inter-dependencies and knock-on effects.
• Reliance on narratives (such as climate scenarios) and on long-term thinking and forward-looking approaches (like scenario analysis) are required given the high degree of uncertainty; yet this remains a novel approach for many practitioners who are used to traditional risk modeling.
  • Scenario analysis is a valuable risk management tool; yet it is not always understood by all stakeholders, it can have a different meaning among risk practitioners, and its effective application in the realm of climate-financial risks requires additional education and training.
  • For context, the purpose and use of scenario analysis is to test the resilience of the issuer’s strategy across various physical, transition and legal scenarios associated with climate change. It is part of a risk management process whose aim is to reduce losses, manage uncertainty and optimize decision-making to improve performance

Research Objective

The SOA Catastrophe & Climate Strategic Research Program Steering Committee (CCPSC) is seeking researchers to develop a resource guide for practitioners, focusing on how to approach and continuously refine climate risk assessment, by leveraging scenario analysis.

The following considerations may be relevant given the current context and the evolutionary pathway for climate risk assessment, and may be given further consideration as part of a proposal:

• Glide path approach / maturity process (overall approach)
  • Describe the maturity pathway for climate risk assessment, from a simple starting point to a more complex end goal with increasing level of sophistication.
    • A glide path approach from qualitative to quantitative assessment can help mitigate the initial upfront cost, resource availability and knowledge constraints usually associated with more sophisticated analysis, as well as other internal and/or external constraints.
    • Quantifying the financial impact of climate risks using scenario analysis as a tool remains the end goal, yet there are many gradients or maturity levels which can act as building blocks in the process which can and should be explored first given identified constraints, barriers, and gaps.
      • For instance, pathways of effects or transmission channels is foundational to assessing climate risks and their direct and indirect impacts; then, semi-quantitative assessment leveraging risk heat mapping can be used before escalating to a quantitative assessment.
      • Vulnerability assessment can also highlight areas more susceptible to climate risks and be part of any foundational climate risk assessment work.
  • Comprehensive climate risk assessment is a journey spanning multiple years and thus should be supported by a flexible framework with respect to evolving practices.
    • The availability, quality and granularity of decision-useful data and analytical tools are not always guaranteed and are constantly evolving.
      • The predictive power of historical data to guide future risk analysis is gradually declining, hence the need to incorporate new climate data and tools.
    • Climate risk may also be driven by beliefs, preferences and attitudes which can change over time.
    • Reporting practices and regulatory actions are also evolving, and market drivers are rapidly moving.
  • With high uncertainty, there can be power in narratives and qualitative analysis, particularly for stakeholder buy-in, to supplement any risk assessment which tends to leverage quantitative analysis.
  • The initial focus may be more about understanding how risk could behave if it materializes, and how key drivers of business performance may be (materially) impacted by climate risks specific to each scenario, before looking for a “right” number (assuming there is such right number).
• Glide path approach / maturity process for scenario analysis
  • Elaborate on the multiple dimensions of scenario analysis and potential pathways for deployment (e.g., the aim is not necessarily to model all dimensions in the first iteration, but to establish good/best practices in line with the glide path approach and ongoing refinement):
    • Number and type of climate scenarios (severe but plausible);
    • Reliance on bespoke vs off-the-shelf scenarios;
    • Time horizon(s);
    • Number and type of climate models used;
    • Type of climate risks;
    • Sector(s) and geography;
    • Transmission channels;
    • Breadth of financial impact (direct and indirect);
    • Exposures/portfolios (e.g., current vs. projected); tangibles and intangibles;
    • Inter-relationships among climate risks, and potential knock-on effects;
    • Reliance on management actions and additional resilience planning.
  • Scenario analysis is not a one-off exercise. Instead, it will be replicated over time as new signals and changes in risk drivers occur. There will also be some integration within a feedback loop.
  • As described in its Final Report, the TCFD allows both qualitative and quantitative scenario analysis: “Scenario analysis can be qualitative, relying on descriptive, written narratives, or quantitative, relying on numerical data and models, or some combination of both. Qualitative scenario analysis explores relationships and trends for which little or no numerical data is available, while quantitative scenario analysis can be used to assess measurable trends and relationships using models and other analytical techniques. Both rely on scenarios that are internally consistent, logical, and based on explicit assumptions and constraints that result in plausible future development paths.”
• Glide path approach / maturity process for risk analysis
  • Risk can be defined across many dimensions: hazard, exposure, vulnerability (sensitivity and adaptive capacity); again, a glide path approach could be used particularly around vulnerability.
  • Tipping points, non-linear impacts, and cascading effects characterize climate risks and may be integrated as part of a more complex analysis.
  • Importance of assessing knock-on effects and adopting systems thinking approach.
  • Understanding the difference between risk and uncertainty:
    • When the nature of the uncertainty we are facing is high, and numbers are not available, then process becomes key and so is the power of narrative.

Note that the above list is not meant to be exhaustive, but merely to provide considerations which may be relevant both to practitioners who are embarking on the climate risk assessment journey, as well as those further along the maturity pathway. Other considerations supporting a glide path approach in the following elements would also be relevant:

• Gradual integration of climate-related considerations with risk management frameworks (risk governance, risk appetite and enterprise policies, risk management cycle, risk management processes);
• Ongoing risk monitoring and model refinement;
• Linking climate risk assessment with climate resilience planning, climate adaption and climate opportunities for strategic decision-making; and
• Climate risk disclosures and communications, including limitations.

Other considerations which may be tailored to a more specific audience, and thus less general in nature, may also be researched, and these should be clearly identified in the proposal. Some examples, not limited to the following, may include a tailored approach based on:

• Regional focus;
• Selected groups of practitioners; or
• Specific exposures.

Proposal

To facilitate the evaluation of proposals, the following information should be submitted:

1. Resumes of the researcher(s), including any graduate student(s) expected to participate, indicating how their background, education and experience bear on their qualifications to undertake the research. If more than one researcher is involved, a single individual should be designated as the lead researcher and primary contact. The person submitting the proposal must be authorized to speak on behalf of all the researchers as well as for the firm or institution on whose behalf the proposal is submitted.
2. An outline of the approach to be used (e.g. literature search, model, etc.), emphasizing issues that require special consideration. Details should be given regarding the techniques to be used, collateral material to be consulted, and possible limitations of the analysis.
3. A description of the expected deliverables and any supporting data, tools or other resources.
4. Cost estimates for the research, including computer time, salaries, report preparation, material costs, etc. Such estimates can be in the form of hourly rates, but in such cases, time estimates should also be included. Any guarantees as to total cost should be given and will be considered in the evaluation of the proposal. While cost will be a factor in the evaluation of the proposal, it will not necessarily be the decisive factor.
5. A schedule for completion of the research, identifying key dates or time frames for research completion and report submissions. The CCPSC is interested in completing this project in a timely manner. Suggestions in the proposal for ensuring timely delivery, such as fee adjustments, are encouraged.
6. Other related factors that give evidence of a proposer's capabilities to perform in a superior fashion should be detailed.

Selection Process

The CCPSC will appoint a Project Oversight Group (POG) to oversee the project. The CCPSC is responsible for recommending the proposal to be funded. Input from other knowledgeable individuals also may be sought, but the CCPSC will make the final recommendation, subject to SOA leadership approval. The SOA's Research Project Manager will provide staff actuarial support.

Questions

Any questions regarding this RFP should be directed to Rob Montgomery, SOA Research Project Manager (phone: +1-740-258-2977; email: rmontgomery@soa.org

Notification Of Intent To Submit Proposal

If you intend to submit a proposal, please e-mail written notification as soon as practical, to Erika Schulty.

Submission Of Proposal

Please e-mail a copy of the proposal to Erika Schulty.

Proposals must be received no later than March 31, 2022. It is anticipated that all proposers will be informed of the status of their proposal by the end of April 2022.

Note: Proposals are considered confidential and proprietary.

Conditions

The selection of a proposal is conditioned upon and not considered final until a Letter of Agreement is executed by both the SOA and the researcher.

The SOA reserves the right to not award a contract for this research. Reasons for not awarding a contract could include, but are not limited to, a lack of acceptable proposals or a finding that insufficient funds are available. The SOA also reserves the right to redirect the project as is deemed advisable.

The SOA plans to hold the copyright to the research and to publish the results with appropriate credit given to the researcher(s).

The SOA may choose to seek public exposure or media attention for the research. By submitting a proposal, you agree to cooperate with the SOA in publicizing or promoting the research and responding to media requests.

The SOA may also choose to market and promote the research to members, candidates and other interested parties. You agree to perform promotional communication requested by the SOA which may include, but is not limited to, leading a webcast on the research, presenting the research at an SOA meeting, and/or writing an article on the research for an SOA newsletter.