Clifford Chance

On 24 May 2022, the Bank of England (BoE) published the results of its first Climate Biennial Exploratory Scenario (CBES), the BoE's first climate stress test and serves to boost the central bank's climate credentials.

The report assessed the preparations of participating UK banks and insurers for climate-related risks associated with the move to a net-zero economy under three scenarios:

• 'Early action' (EA) by governments to cut carbon emissions;
• 'Late action' (LA); and
• 'No additional action' (NAA).

The three scenarios were assumed to take place over the period from 2021 to 2050 and were applied to two main risks:

• Physical risks from the impact of fires, floods and more caused by climate change; and
• Transition risks from the move to more climate-friendly businesses that could bring sudden changes in asset values and the price of carbon. For insurers, the CBES focused on the impact on both underwriting and investment results.

Overall, the CBES results are encouraging. UK insurers are making good progress in aspects of their climate risk management, although there is still more to do to improve data and modelling abilities to ensure climate risk is captured in practice. Notably, climate risks are likely to create a drag on the profitability of insurers (with an annual drag on profits of around 10-15% on average quoted), albeit with a caveat on the figures given the substantial uncertainty around the true magnitude of climate risks. Whilst some responses (to the NAA scenario in particular) implied a material reduction in access to insurance for sectors and households, the BoE noted that this possibility would be reduced if insurers continue to advance their capabilities to identify, measure and manage climate risks. Helpfully, the BoE noted that the uncertainty around managing climate-related financial risks could be reduced if the UK's climate policy is clearer and better communicated. The BoE is now giving firm-specific feedback to participants and will use the results to help target the BoE's future efforts in this area.

Key findings

Insurance losses

The aggregate CBES results show that, for life and general insurers, the NAA scenario would unsurprisingly to have a more significant impact than either of the other two scenarios, with the losses explained as follows:

• For life insurers, this was primarily due to investment losses with an overall impact of just over 15% of total market value. This compares to 8% and 11% in the EA and LA scenario respectively. Losses of this magnitude could make individual firms, and the financial system overall, more vulnerable to other future shocks.
• For general insurers, losses materialised via a build-up in physical risks, which resulted in higher claims for perils such as flood and wind-related damage. UK and international general insurers, respectively, projected a rise in average annualised losses of around 50% and 70% by the end of the NAA scenario.
  

The BoE's analysis of UK insurance losses was gloomier, with suggestions that the loss increases could be as much as four times higher than those submitted by the participant firms. A note of concern for UK regulators was feedback from insurers that the impact of these increased domestic and international insurance claims would fall, ultimately, on households and businesses through higher insurance premiums or lower availability of insurance cover.

Climate Risk Management

Although good progress is being made, the CBES results indicate that UK insurers need to do more to understand and manage their exposure to climate risks. To produce better estimates of climate risks in their portfolios, the BoE expects insurers to prioritise investment in their assessment capabilities, including:

• Internal modelling, for example, by incorporating possible future carbon prices into pricing, lending, and investment decisions; and
• Data capabilities, by doing more to scrutinise data and projections supplied by third parties (upon which participants relied heavily to compile CBES submissions).

 The above 'capability gaps' were also recently cited by Stefan Claus, head of the BoE's insurance division, when speaking at the Association of British Insurers’ Climate Change Summit about the CBES results. Claus said that insurers need to continue to develop more advanced capabilities to identify, measure and manage climate risks, including by incorporating climate risks in scenario analysis and investing in the development and scrutiny of models. Claus also noted that insurers might need to invest in better processes to improve data capture across their operations, customers, and investments, but that regulators also had their part to play in setting standards.

Challenges to business models and participants' responses to scenarios

The BoE noted that the sophistication of participant firms’ strategic thinking was mixed, and in general, firms did not tailor their responses to the specific CBES scenarios. Instead, UK insurers typically responded to all three scenarios in the CBES exercise by following their existing plans around the transition to net-zero emissions.

It was further noted that a common mitigation approach to the scenarios was for participants to reduce their exposure (i.e., limit supply of insurance) to carbon-intensive sectors such as fossil fuel producers. However, without a carefully managed transition, the BoE observed that a reduction in investment in these sectors could outpace investment in sustainable energy alternatives and improvements to energy efficiency, ultimately leading to knock-on impacts on businesses and consumers as these sectors struggle to access finance. This also underscores the need for regulatory reform to the Solvency II regime to unlock the insurance industry’s full green investment capacity.

Next steps

The BoE is now giving firm-specific feedback to participants. The CBES results will be shared with the UK government and international counterparts to drive forward the transition to net-zero and decarbonise the economy.

Whilst the CBES and its results were not intended to inform capital requirements, UK insurers should expect climate-related risks to impact capital requirement assessments in the medium term. The BoE is expected to hold a research conference to discuss capital requirements later this year and has already published a 'Call for Papers' on the relationship between climate change and capital.

The findings will also be shared with the PRA and will inform where more intensive action is needed by firms (both individually and collectively) to address the issues identified in the PRA's supervisory statement on enhancing firms' approach to managing climate risks (SS3/19). Firms should therefore expect a continued regulatory focus on climate change risk.