Climate change: insurers' exposure to physical and transitional risks

The Bank of England's (BoE) first Climate Biennial Exploratory Scenario 2021 (CBES) explored climate change driven financial risks posed to the largest insurers and banks operating in the UK.

This article focuses on the CBES's findings in respect of the physical risks (ie risks related to physical damage resulting from climate change) and transition risks (ie risks related to changes to the economy in response to climate change) to which insurers are exposed. The CBES report outlined the risks that had been identified, made recommendations for improvements and suggested some areas that needed to be examined further. While it is not surprising, given this is the first CBES, the lack of appropriate data to enable sophisticated modelling was highlighted as an area that needed particular attention.

Impact of insurers' exposures to climate risks

Scenarios

The CBES exercise considered three scenarios:

• An 'Early Action' scenario, which assumed ambitious climate policy is implemented quickly.
• A 'Late Action' scenario, which assumed the transition to a net-zero economy is delayed by a decade.
• A 'No Additional Action' scenario, which explored the physical risks that would materialise if governments failed to enact policy responses to global warming.

The CBES concluded that while insurers will suffer drags on their profitability across all scenarios, the impact will be more pronounced in the No Additional Action and Late Action scenarios than in the Early Action scenario.

Impacts on assets and liabilities

The BoE concluded that insurers would, on average, be affected by the equivalent of an annual drag of 10-15%, with the extent of the drag varying considerably in the different scenarios.

As expected, the greatest losses would be incurred in the No Additional Action scenario, with notable risks including a build-up in physical risks which would increase claims for perils such as damage by extreme weather events. General insurers in the UK projected a rise in average annualised losses of around 50% by the end of the No Additional Action scenario, while international insurers in the UK market projected around 70%.

Insurers reported that the impact of these increased domestic and international insurance claims would fall, ultimately, on households and businesses through higher insurance premiums or through lower availability of insurance cover.

The BoE projected that the value of insurers' assets would fall by 15% in the No Additional Action scenario, as compared with 11% in the Late Action scenario and 8% in the Early Action scenario.

The above predictions were caveated in a number of ways, including the following:

• The CBES's focus was restricted to change in the value of invested assets and the impact on insurance claims. The full impact on insurers' income and capital positions was not analysed.
• Loss projections were based on insurers' fixed balance sheets as at 31 December 2020. This increased projected losses as, in practice, insurers will adjust their business models in response to climate risks.
• The No Additional Action scenario did not capture other potential geopolitical impacts of severe climate change like conflict and increases in migration, which would cause further financial losses.

Conclusions

The CBES reached a number of conclusions with respect to insurers' risk calculation and quantitative findings. The following are among the most notable:

• The CBES report found that, across insurers, there was a material data gap with respect to their emissions across geographical locations and supply chains. Addressing this data gap was highlighted as a priority because, without improvements in that area, the veracity of models will always be open to question.
• General insurers’ ability to model expected losses from insurance claims is also limited by challenges arising from the use of third-party models, which suffer from a lack of flexibility. The firms that were able to utilise their own models arrived at much higher loss estimates. Life insurers also rely heavily on third-party modelling but are now investing in developing their capacity to do so internally.
• Among participating insurers, life insurer portfolios accounted for the majority of total projected investment losses. This is because their investments tend more towards long duration assets, the value of which fluctuates heavily.
• Macro-economic policy considerations were identified. In particular, the BoE identified that banks and insurers could, through initiatives to reduce their own exposure to carbon emissions, negatively impact the wider economy. For example, if there was widespread reduction in financing and insurance for carbon-intensive energy sources before those energy sources could be replaced by sustainable sources of energy, that could result in energy shortages and price increases that impact all sectors of the economy, including both businesses and households.

Looking ahead

The CBES report also made some observations on the future of the insurance industry:

• While insurers have had some success in protecting their investments from climate change risk, most general insurers have not yet set risk appetites for underwriting activities.
• Insurers were beginning to avoid providing insurance cover to certain businesses in carbon-intensive sectors.
• Insurers envisaged far fewer new opportunities in the No Additional Action scenario, which suggests the challenges to their business models and profitability would be more significant.
• If insurers monitor exposure to perils and track them against territories where physical risk could become more material in the future due to climate change, these insights could provide them with a significant competitive advantage over those who do not to do that exercise.

The CBES also included a range of recommendations for insurers to protect investment portfolios and mitigate future liabilities, many of which were unsurprisingly focussed on improving modelling capabilities for climate-related risks:

• Co-ordination of initiatives to address the data gaps that currently exist are encouraged. The data needs to be improved if these exercises are to achieve their objectives.
• Insurers need to identify the limitations of the third-party models that they use and make the necessary adjustments in response to those limitation.
• Academic research should be used to inform the modelling of physical risk and to develop internal risk modelling approaches. A high level of sophistication will be required.
• Insurers should use bespoke models for sectors with specific climate vulnerabilities, such as non-renewables and transport. These models should incorporate the combined effect of public policy changes, capital expenditure to fund transition and demand elasticity.
• Insurers should review results by comparing the results reached via different models and develop a clear plan on how to address variations and discrepancies.
• Pricing models should be adapted to account for near-term market price changes arising from expected future changes in physical and transitional risks.