Having published the results of its Climate Biennial Exploratory Scenario (CBES), examining the financial risks posed by climate change for the largest banks and insurers operating in the UK, the Bank of England estimates that over the Over time, climate risks could become a persistent problem. drag on gains.
Although climate loss projections are uncertain, notable data gaps exist, analysis and modeling are still in their infancy and UK banks and insurers still have a long way to go to understand their exposure to climate risks, results suggest that, without action, climate risk will lead to a significant decline in profits and ultimately the economy if left unchecked.
“At an aggregate level, UK banks and insurers are likely to be able to absorb the transition costs that fall on them,” the Bank of England said.
“Overall costs will be lowest with early and well-managed actions to reduce greenhouse gas emissions and thereby limit climate change,” the Bank continued, but added that “Certain costs that initially fall on banks and insurers will ultimately be passed on to their customers.”
Climate policy will be a key determinant of the impact of climate risks on the insurance and reinsurance industry, the Bank of England believes.
Noting that “banks and insurers have a collective interest in managing climate-related financial risks in a way that supports this transition over time.”
Sam Woods, Deputy Governor for Prudential Regulation and Managing Director of the Prudential Regulation Authority, said: “Recent events such as the war in Ukraine and rising energy prices illustrate the challenges facing banks and insurers may be faced with due to changes in their operating environment. Today’s exercise explores how well they are equipped to manage the longer-term challenges of climate change, in the context of our goal of financial stability.
“We see that they are likely to be able to absorb the climate costs that fall on them without material risks to their solvency, but they will face significant headwinds and will therefore need to continue to invest in their ability to sustain the climate. transition of the economy to net zero”.
But in a speech this morning, PRA CEO Woods elaborated further on the scale of the impacts of climate risk on the UK insurance and reinsurance industry, saying that “the first key lesson of this exercise is that over time, climate risks become a permanent drag on the profitability of banks and insurers, especially if they do not manage them effectively.
“While they vary by company and scenario, the overall loss rates equate to an average annual earnings slowdown of around 10-15%.”
This is significant and a 15% decline in climate risk earnings, which could also imply that higher attrition would also be felt due to extreme weather and high disaster losses outside of climate scenarios, could be enough to make some insurance or reinsurance companies much less profitable, or even unprofitable.
Furthermore, Woods admitted that “the limitations of the exercise mean that the actual impact may well be greater due to some important exclusions”.
However, and encouragingly, Woods also stated that “based on this exercise, the costs of a transition to net zero appear absorbable for banks and insurers, with no worrying direct impact on their solvency. By themselves, these are not the kinds of losses that would make me doubt the stability of the system, and they suggest that the financial sector has the capacity to support the economy through the transition.
Also warning that “any positive message should be taken with a big pinch of salt: both because there is a lot of uncertainty in these projections and because this drag on profitability will make the sector more vulnerable to other future shocks. A world with climate change is more risky for the financial system to navigate.
Woods also warned that as climate scenarios become more severe, with less climate action, the impacts on insurance consumers will be far greater, due to increased levels of risk and losses due. climate-related effects.
“The ‘no action’ scenario is particularly unpleasant for life and P&C insurers – even sticking to the 30-year window, their losses in this scenario were worse than in the transition. For example, UK and international P&C insurers, respectively, expected average annualized losses to increase by around 50% and 70% by the end of the NAA scenario. It should be emphasized that these costs would primarily be passed on to consumers through higher premiums,” Woods said.
Adding: “Ultimately, in a ‘no action’ scenario, we would see reduced access to credit and insurance for so-called ‘climate vulnerable’ sectors and households. To give an example of what this means, homes at risk of flooding would likely become prohibitively expensive to insure or borrow. Like so many other impacts of climate change, this cost would be borne unevenly: 45% of mortgage writedowns in the scenario affect only 10% of the country. And there is evidence that in areas particularly prone to flooding, many homes could become uninsurable.
Overall, the scenario exercise and its results show that “climate risk is a top-notch strategic issue for the companies we regulate,” Woods said. “But in my view, it is not yet clear that the magnitude of the transition costs requires a fundamental recalibration of capital requirements for the system.”
“A persistent decline in profitability would be very damaging to companies, but as long as they are able to continue to earn sufficient profits to maintain their capital reserves, its impact on safety and soundness may be less significant. If the results of this exercise had suggested a fundamental threat to the solvency of these companies, our response would of course have been quite different,” he continued.
It will be critical to look at capital adequacy, not just in aggregate or in isolation, but to identify where capital gaps may appear in the banking and insurance or reinsurance industry, Woods noted. , because “some of these risks are highly concentrated in particular sectors. ”
As the insurance and reinsurance market transitions and climate risks evolve, the need to access venture capital as well as functional risk markets, where risks can be transferred and traded from more strategic way, can increase.
As well as the need to access new forms of capital and effective risk transfer structures, even if we still believe that the development of a new generation of products and covers focusing on the transfer of climate risks could be an opportunity, to provide products that are effective solutions to climate risks, while offering attractive returns to investors and financial partners.
There is going to be a wave of demand for new climate risk transfer and hedging solutions, which, fueled by the data provided by regulated disclosure, will likely be designed to be increasingly responsive and responsive to the needs of their users. .