UK insurers’ climate change losses manageable but rates likely to rise, finds BoE

UK insurers and banks are set to lose 10%-15% of annual profit to climate change and are likely to pass on some of this to customers through price rises, according to the Bank of England’s (BoE) latest climate stress test. The test also concluded that insurers and banks are making good progress on climate change risk management, but more needs to be done. Sam Woods, head of the BoE’s Prudential Regulation Authority, said the 2021 Climate Biennial Exploratory Scenario (CBES) stress test showed that “over time climate risks will become a persistent drag on banks’ and insurers’ profitability – particularly if they don’t manage them effectively”. “While they vary across firms and scenarios, overall loss rates are equivalent to an average drag on annual profits of around 10%-15%,” said Woods. Collectively, banks and insurers face £200bn to £340bn of climate-related impairment and investment losses across the 30-year stress test horizon, which the BoE suggests can be absorbed by participants through earnings without threatening their regulatory solvency ratios or capitalisation. Woods said that although these are “big numbers”, the impact could well be bigger given some limitations on the stress-test exercise. But he explained that the transition to net zero looks “absorbable” for banks and insurers, without a “worrying direct” impact on their solvency. “By themselves, these are not the kinds of losses that would make me question the stability of the system, and they suggest that the financial sector has the capacity to support the economy through the transition. But any positive message needs to be taken with a major pinch of salt – both because there is a lot of uncertainty in these projections and because this drag on profitability will leave the sector more vulnerable to other, future shocks. A world with climate change is a riskier one for the financial system to navigate,” he said. Woods added that the exercise will not be used to set higher capital requirements. The CBES test asked the largest UK insurers and banks to analyse climate change risks they face by 2050 and their strategic responses under three separate scenarios. The first scenario would see early action on climate change that limits global warming to 1.8°C by 2050, falling to about 1.5°C by the end of century. The second, late-action, scenario limits global warming to 1.8°C by 2050 but it remains at this level by 2100. The third scenario sees no additional action on climate change, with global warming at 3.3°C higher by 2050. The overall stress test found that UK banks and insurers are likely to be able to bear the costs of the transition. But this is in part because a “significant” proportion of these costs may ultimately be passed on to their customers, the BoE said. Businesses and households vulnerable to physical risks would be “particularly hard hit” in the scenario, with no additional climate change action, it continued. “General insurers would pass on the cost of higher claims into premiums, or otherwise refuse to renew insurance for some customers,” said Woods. He added that how and when the transition to net zero takes places will make a big difference to the impact on insurers and banks. Costs to the financial sector will be substantially lower if early, orderly action is taken, he said. “For example, projected climate-related bank credit losses were 30% higher in the late-action scenario than the early-action scenario… So, early action is important to lower the cost of the transition,” said Woods. “If we are ever to reach net zero, a number of sectors are going to have to adapt their business models on a fundamental level. As the report sets out, it will be in the collective interests of financial institutions to support counterparties that have credible plans to adapt – and ultimately reduce their exposures to those sectors of the economy that are inconsistent with a net-zero policy,” said the regulator. The stress test also measured the progress insurers and banks are making to manage climate change risk. And overall, this is a “good news story”, said Woods. “We were encouraged by the progress firms have made. But there is still much more to do,” he said. Woods said there are three key risk management areas that need improving. Firstly there is the need for more data on, and understanding of, customers’ current emissions and transition plans. This can include looking through complex chains of financial relationships between clients and counterparties to see the underlying emissions. Secondly, there is a need to invest in modelling capabilities and better scrutinise data and projections supplied by third parties. And then there is the need for some firms to consider more deeply how they would respond strategically to different scenarios, including thinking through the implications of different paths for climate policy. Wynne Lawrence, legal director at Clyde & Co, said the BoE assessment concluded that insurers still need to do much more to understand and manage their exposure to climate risks. “The findings will help the UK’s financial regulators shape future regulation. Other jurisdictions are looking to the UK’s leadership in this space, so the results should also be of interest internationally to corporates and their advisers working on climate risk management,” Lawrence said. Meanwhile, Moody’s Investors Service analyst Brandan Holmes said: “The outcome of the CBES exercise is in line with our view that large UK banks and insurers will be able to absorb the financial costs associated with their moderately negative exposure to carbon transition. However, a lack of data and underdeveloped modelling capabilities significantly hampers their ability to measure and manage these risks.”

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