CBES delivers a stark warning to Insurers on climate risk inaction

The Bank of England (BoE’s) Climate Biennial Exploratory Scenario (CBES) analysis has provided a stark insight into the risks faced by the insurance industry in the face of climate change.

The analysis, where participants provided loss projections plus responses to a qualitative questionnaire, provided insight into estimated losses that banks and insurers face depending on the following levels of climate policy:

• Early Action (EA) – Ambitious climate policy from the outset, with a gradual intensification of carbon taxes and other policies over time.
• Late Action (LA) – Policy implementation, both sudden and disorderly, is delayed by a decade.
• No Additional Action (NAA) – A deliberately severe scenario. Primarily explores physical risks from climate change under the assumption that no additional action is taken to address them.

Key Takeaways

Though CBES was a first of its kind study, climate risk management is well underway in the insurance market. Participants are making good progress with elements of climate risk management, such as the governance pillar of TCFD.

However, the BoE’s assessment is that insurers still have significant room for improvement for managing and enhancing their understanding of climate risk.

Considering individual firms, the study found there to be serious data gaps on key driving factors needed to effectively manage climate risk. For example, there was a noticeable lack of standardised information surrounding the value chain in emissions relating to corporate counter-parties.

Furthermore, there was an array of approaches taken by insurers to assess and model climate risks. This resulted in inconsistent outcomes for comparable firms. For example, estimated losses on the same corporate clients differed substantially, by a factor of 10 in some instances. We anticipate that the BoE and PRA will provide clarity on best practice for climate risk modelling to help ensure greater consistency in future exercises.

However, it is in aggregate that the results of the CBES were truly stark.

Across all scenarios and participants, CBES shows a reduction in annual profits of between 10-15%. Unsurprisingly, these impacts were felt most acutely in the NAA scenario.

Furthermore, insurers’ investment asset values were projected to drop by 15% in the NAA, compared to 8% and 11% in the EA and LA scenarios.

These deepening investment losses (see fig 1.) – primarily affecting life insurers – were driven by reduced equity values, increasing credit downgrades and anticipated defaults in bond portfolios. However, BoE analysis of submissions found some participants to be seriously underestimating their UK insurance losses, in some instances by a factor of four, implying that these outcomes may substantially underestimate the real worst-case outcome.

Fig 1:

General insurers’ losses, whilst also impacted by reduced investment asset values, materialised primarily through increasing numbers of claimants due to buildup in physical risks, such as flood and wind damage. This led to a projected rise in average annualised losses for UK general insurers of 50%, rising to 70% for international general insurers.

BCS Insights – What actions should firms look to take?

So, in response to such a stark outlook for the industry, what actions should insurers take? We recommend firms take immediate action across five key elements of their climate risk management framework:

Modelling and Data Capabilities: A common theme in the submissions was the existence of data gaps and weak modelling capabilities. This can lead to an incomplete understanding of climate risk exposures in the balance sheet. Insurers should look to better understand what data they need, and how they can capture and model it, to help manage their full climate risk exposure. BCS helps design and implement data management solutions to help drive performance through analytics.

Business Models: Insurers should assess how they regularly update climate policy and integrate it into their business models. BCS helps insurers embed climate risk management strategy into their business models to ensure they meet their goals in working towards a net-zero economy.

Improved TCFD Disclosures and Risk Frameworks: The underlying theme in the study is that the insurers are still yet to fully understand the full extent of climate risks they face; material risks outside of the scope of CBES are just as significant as those considered. BCS helps firms develop more robust processes to identify, disclose and manage their climate risk exposure.

Capital Requirements: Though not directly addressed in CBES, firms should not ignore how the results could affect their solvency. Firms need to assess how climate change may impact expected losses on their books of business, particularly on books of business that are exposed to the impacts of the environment, such as home and flood insurance. BCS helps firms to develop more effective forward-looking capital and financial planning systems and processes

Senior Management ESG Training and Awareness: Enables adequate preparation for senior management oversight and strategic planning, highlighting industry trends and taking into consideration the business model of the organisation. BCS develops and delivers ESG executive training programs.

The CBES highlights the magnitude of the risk facing the insurance sector from climate change.  However, it also offers some hope. If insurers act now to help drive a more timely transition to a net zero economy, they can perhaps insulate their sector from the most devastating impacts of the LA and NAA scenarios.

As the differing environmental outcomes between the three CBES scenarios show, this would support a brighter future not just for the insurance industry, but the whole world.