Building a useful “what if”: Arium’s approach to modeling a hypothetical climate related management liability scenario

Climate change and the regulatory and market responses to it are creating new liability risks, as climate-related lawsuits against companies become increasingly common worldwide.^[1]Climate change liability can manifest in multiple ways, depending on the plaintiffs' legal arguments and their reasons for targeting a given company. For example, "climate lawsuits" may include litigation focused on companies' climate-related disclosures, or cases alleging that companies directly contributed to climate change through their emissions. This article focuses on climate liability related to corporate management, including companies' financial disclosures and risk management practices.

Over the past several years, more companies have launchedefforts to disclose their material risks related to climate change, in step with increasing interest from investors and industry groups such as the Task Force on Climate-Related Financial Disclosures.[2] Since 2021, regulators in the United Kingdom and European Union have passed regulations mandating climate risk disclosures for a large swath of companies.[3]

In the United States, these disclosures are now mandatory for most companies doing business in California, and the Securities and Exchange Commission is seeking to implement nationwide climate disclosure rules.[4] This growing scrutiny increases the risk shareholder lawsuits should a company's climate risk disclosures be deemed inadequate-or if shareholders believe that company directors have mismanaged climate risks. These suits may only seek non-monetary relief, such as changes to a company's climate risk management strategy, but if the company has suffered a related loss such as a stock drop, shareholders may sue for monetary damages as well.

Thus far, litigation over climate risk management and disclosures doesn't appear to be accumulating into a systemic and severe liability event. However, climate litigation is rapidly evolving. Insurers and reinsurers can still benefit from understanding how such an uncertain liability risk could plausibly materialize into a large-loss event and what the resulting impacts on their books might be.

Verisk's Arium team creates quantified scenarios for emerging liability risks that have the potential to accumulate into systemic and severe losses across insurer, reinsurer, and broker books. The team recently released a hypothetical scenario that allows carriers to quantify their potential losses from a systemic and severe climate management-related liability event for the purposes of stress testing, responsive portfolio/exposure management, and underwriting guidelines. This scenario provides views of potential losses in the US, the UK, and the EU, drawing on research into the litigation trends and relevant regulations in each region. The key components of developing such a scenario include the narrative, the exposed industries, and a statistical model to simulate how losses might accumulate across those exposed industries.

Narrative

The team determined that a severe and systemic climate management liability event would have to be sparked by a climate-related "shock," which could play out in multiple ways. There may be rapid regulatory shifts towards stricter emissions standards and/or a rapid voluntary transition to green energy in particular industries, among other potential triggers-all of which could expose some companies as having mismanaged or failed to disclose their climate risks. This shock event is assumed to take place over five years.

This shock could expose large, publicly traded companies to regulatory penalties and to stock price declines, which in turn could lead to shareholder lawsuits alleging climate risk mismanagement or inadequate disclosures that warrant compensation. Such "stock-drop suits" are currently the most plausible pathway to severe, systemic monetary damages for this scenario, because they are already a major driver of corporate risk management-related liability losses in the US and are on the rise in the UK and EU.

Industries

The team then identified and ranked various industries' exposure to this event.

• Virtually allindustries face some climate risks, and many new climate disclosure regulations apply to all industries. However, the Ariumteamidentifiedcertain industries as more exposed to climate risk-related stock price drops and regulator penalties than others, based on their transition risks, historical patterns of shareholder and regulatory scrutiny, and other key factors.
• Dozens of industries were found to be exposed to this scenario, including oil and gas, financial services, energy utilities, and auto manufacturing.

Three stochastic scenario models

To quantify the potential losses and represent a range of possible severities and industry loss shares, the Arium team built separate stochastic models for the US, UK, and EU. Each jurisdiction's model generates 10,000 simulated loss and industry loss share outputs to represent the uncertainty in how such a scenario might develop. The model achieves this by allowing key inputs to randomly vary across specified ranges (i.e., probability distributions) to capture the potential interactions between the various sources of uncertainty in this event. These sources of uncertainty may include the pace of changes to climate-related regulations, the steps companies have taken to mitigate their climate risks, and litigation dynamics.

• The stochastic modeling also supports a variety of views of which industries could be hardest hit during this shock event, translating to specific breakdowns of loss shares by industry. This variety is useful, given high uncertainty relative levels of preparation in each industry for rapid regulatory change, rapid market transitions, or high demand for accurate climate disclosures.
  • For example, in some model simulations, oil and gas companies pay out the majority of the total event losses, while in others, those companies are able to mitigate their risk while auto manufacturers experience worse stock price declines and shareholder lawsuits.
• Plausible ranges for the frequency and severity of stock price declines, shareholder lawsuits, and regulatory penalties vary across the US, UK, and EU versions of the model, based on historical precedents and current trends in each region.

Losses

The median simulated ground-up losses (before liability insurance terms and conditions are applied) for this "what-if" scenario are roughly $11 billion in the US, $2 billion in the UK, and $3.5 billion in the EU-all of which are large potential losses for a liability event implicating management and professional lines in these respective regions.

Clients can run their portfolios through a variety of simulation outcomes in the Arium Liability Analytics Platform, with varying loss sizes and industry loss shares, to see how multiple versions of this hypothetical climate management "shock" would impact their books.

Learn more about Arium Liability Models

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