Insurance Insights into the Bank of England’s Climate Biennial Exploratory Scenario

• United Kingdom

• ESG
• Insurance and reinsurance

18-08-2022

Introduction

At the Association of British Insurers’ recent Climate Summit 2022, the technical head of the Bank of England’s (the “Bank”) General Insurance Division, Stefan Claus, detailed the conclusions of the Bank’s Climate Biennial Exploratory Scenario (“CBES”) exercise.

CBES considered the challenges faced by the insurance industry over the next 30 years as a result of climate risk, and provided useful insights for general insurers in relation to:

• climate risk management;
• the financial implications of climate risk;
• litigation risk; and
• longer-term implications for business models.

Climate risk management

CBES identified good progress made by the largest insurers concerning certain aspects of climate risk management, including senior accountability, risk appetite and the inclusion of climate scenarios within their own risk and solvency assessments.

However, attention was drawn to the need to address data gaps for the purpose of climate analysis, with specific reference to:

• information on corporate emissions across value chains; and
• geographical corporate asset location data.

The reliance of insurers upon third-party models was also noted, and in particular a failure to effectively adapt such models, or to understand and challenge their outputs. Best practice was determined to incorporate physical perils beyond those used by the most readily available catastrophe models.

Financial implications of climate risk

Significantly, CBES concluded that a ‘No Additional Action’ scenario, whereby climate change remains unaddressed, would result in a more significant impact on insurers when compared to either ‘Early Action’ or ‘Late Action’ scenarios, where net-zero is reached by 2050.

For general insurers, CBES focused on property classes and the losses stemming from the direct impact of physical climate risk. Specific risks naturally reflect the existing climate, with tropical cyclones dominating average annual loss in the US, versus inland and coastal flooding for the UK. In year 30 of a No Additional Action scenario, these losses were predicted to increase by 70% and 50%, respectively.

CBES determined that climate risk had the potential to cause a persistent and material drag on profitability, amounting to around £1.2bn in the No Additional Action scenario. Losses of this size would make individual insurers, and the financial system overall, more vulnerable to other future shocks.

Overall, CBES indicated that the costs to insurers from the transition to net-zero should be absorbable.

Climate litigation

Climate-related litigation is increasing globally, as a result of both climate activists initiating claims against businesses and their directors with the aim of changing corporate behaviour, and by those seeking compensation for consumer or investment losses.

CBES identified that claims were most likely to be paid out under Directors’ and Officers’ policies, being particularly vulnerable to claims concerning:

• greenwashing;
• breaches of fiduciary duties, and
• claims based on the indirect financing of carbon emissions.

In participating in CBES, firms faced difficulty in identifying and aggregating policy exposures, given the variety of contract wordings and industry sector classifications used. Accordingly, the Bank encouraged all London Market insurers to develop their data extraction and modelling techniques to enable regular scenario testing, in order to examine whether coverage intent is aligned with contract wording.

Longer term implications for business models

CBES went on to consider the resilience and adaptability of firms’ business models in response to climate risk.

General insurers had two main strategies for responding to increased physical risk:

• repricing in response to increased risk; and
• purchasing more reinsurance in the No Additional Action scenario to mitigate increased tail risk.

While the physical risks foreseen by CBES evolve smoothly, in its conclusions, the Bank highlighted that a more sudden change in physical conditions, or a rapid shift in the legislative environment, could bring an increased risk of mis-pricing and under-reserving. Moreover, few insurers considered the implications on longer-term profitability from increased reinsurance premiums and commissions, and the increased risk to reinsurers under this scenario.

Beyond their own business models, insurers’ responses indicated that future insurance cover could become prohibitively expensive for households or businesses, or potentially unavailable, particularly if insurers felt that they could no longer accurately assess the risk.

Conclusions

CBES indicated that losses to insurers appear manageable under ‘No Additional Action’, ‘Early Action’ or ‘Late Action’ scenarios, while insurers’ resilience should mean that they are able to fully play their role in financing the transition to net zero, and driving improvements in resilience to physical risks.

However, CBES did identify two key gaps in the soundness of firms with respect to climate risk:

• ‘regime gaps’, where the design, methodology or scope of the capital framework does not adequately cover risks from climate; and
• ‘capability gaps’, where firms and regulators do not have the data and modelling abilities to ensure climate risk is captured in practice.

In its conclusions, the Bank pledged to work with both insurers and international partners to address these issues, while highlighting the need for insurers to continue to develop more advanced capabilities to identify, measure and manage climate risk.

With the PRA committed to incorporating the lessons learnt from CBES into its supervisory approach, general insurers can expect more focus on their plans to meet the challenges posed by climate risk in the future.