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What do the Bank of England’s CBES results mean for insurers?

We live in a different world to early 2020 when the Climate Biennial Exploratory Scenario (CBES) exercise was first developed, but despite this, climate change remains the biggest existential threat to civilisation. Two years and one pandemic later, the big day is here – yesterday marked the much anticipated publication (in insurance and banking circles, at any rate) of the CBES results. The Bank of England has published the aggregated results of this flagship exercise, which is designed to size the financial exposures of participants and the financial system more broadly to climate-related risks. The results will help firms understand the climate-related challenges to their business models, by testing large insurers’ and banks’ portfolios against three climate pathways [1]:

  • early action scenario (EA) – an orderly transition to net-zero between 2021 and 2050;
  • late action scenario (LA) – a more abrupt and disorderly transition beginning in 2031;
  • no additional action scenario (NAA)– no new climate policies are implemented and the transition to net-zero doesn’t take place

Nine ABI members participated, conducting pioneering climate scenario analysis – a risk management tool that is still in relative infancy in a climate change context. It’s also important to note what the exercise was not – an industry-wide test of individual insurers’ solvency. This is an exploratory exercise over a very long-time horizon and so is not intended to inform the regulator’s approach to required capital. Whilst some of the conclusions may appear on the face of it to be alarming, they must be read in the context of the scenarios – the most extreme of which assumes that no additional government or insurer actions are taken in response to climate risks.  As the PRA highlights in the executive summary of the released CBES results, the exercise is not a forecast and should not be considered as such.

climate changeAs with all scenario analysis exercises there are inherent limitations, particularly with regards to assumptions made within the design of the various climate scenarios, as well as the ‘fixed balance sheet’ design which assumes that insurers do not take any management actions to change the structure of their portfolios in response to the risks which they identify. Although this helps ensure consistency across insurers’ and banks’ submissions, this also means that the projections to 2050 are not realistic; these are plausible scenarios, rather than ‘predictions’. Another challenge is the dependency on counterparty and third-party data upon which much of the analysis relies – and for which there are still significant gaps.

Notwithstanding these challenges, insurers have invested significantly in the CBES exercise, including each participant dedicating Board time and resource to analysing and approving submissions. As outlined in a speech by Sam Woods this morning, ‘overall, this is a good news story: [the Bank was] encouraged by the progress firms have made’ with respect to climate risk management capabilities. Firms are committed to learning from the exercise and taking actions based on what has been learned. Insurers are  also fully committed to meeting regulatory expectations on scenario analysis usage, including as set out in the PRA’s 2019 Supervisory Statement SS3/19 on climate risk management, and to advancing capabilities in this emerging practice through initiatives such as the PRA / FCA Climate Financial Risk Forum.

As general insurers (property, casualty and health insurers) and long-term savings providers, ABI members are on the front line of climate change. From climate-related physical risks – e.g. flooding, wind, storm surges, wildfires – for which general insurers pick up the tab, to the transition risks impacting long-term savings provers’ investments as we move towards a net-zero economy, to the liability risks which could be on the horizon [2], the CBES results make it clearer than ever that financial institutions must double down their efforts to manage their climate-related financial risks – not only for their own solvency, but for the stability of wider society.

The headline findings of the results show that the climate risks captured in the scenarios are likely to create a drag on participants’ profitability (varying across firms and scenarios, but equivalent to an average drag on annual profits of around 10-15%) but these ‘should be bearable without substantial impacts on firms’ solvency positions’. In the NAA scenario, insurers’ asset values fall by 15%, compared with 8% and 11% in the early and late action scenarios respectively. On the liability side, insurers projected a rise in average annualised losses of around 50% on UK exposures, and 70% on US exposures, by the end of the NAA scenario. Within the UK the projected general insurance losses in the NAA scenario were highly geographically concentrated, with just 10% of four-digit postcode districts accounting for two thirds of this. For the 5% of postcodes most affected, the increase in average annual losses is 548%. When combined with other (non-climate sensitive) risks, this could equate to a doubling of insurance premiums.

The CBES results underscore the need for regulators, the government, and financial services to work together with all sectors of the real economy to ensure that credible, realistic and governable transition plans are set out to underpin a UK-wide transition to a net-zero economy. While this exercise was designed and championed by the Bank, it is vital that the lessons from this exercise are used to inform public policy making and that the Bank works closely with Government and other public bodies. Ultimately, we must decide where in society the risks from climate change sit across customers, shareholders and taxpayers, and this must be a conversation in which all stakeholders participate.

The Bank has highlighted (unsurprisingly) that for the UK one of the most significant perils from climate change is an increase in the severity and frequency of flooding – whilst the order of magnitude by which floods become more frequent and more severe will depend upon which climate pathway the world takes, it is not disputed that we are due to see such an increase.  And that is certainly not good news: not for insurers who will see increasingly large claims to restore flooded properties; nor for customers, who will not only see their homes flooded more frequently; and finally, not for the economy either, since there is a risk that policymakers will need to divert greater resources to repairing damage rather than productively investing in new green assets.

Consequently, the CBES results reaffirm ABI members’ commitment to the net-zero transition. Insurers have proactively demonstrated this through launching the ABI roadmap last year – the first national industry roadmap of its kind – as well as initiatives such as the Race to Zero (including the recently launched Net Zero Insurance Alliance) and the Build Back Better Scheme as part of Flood Re. Currently, 94% of the UK home insurance market provide access to policies backed by Flood Re and since being launched in 2016, 350,000 flood risk households have benefited from access to affordable cover.

However, Flood Re is intended to be a temporary scheme and as the severity and frequency of weather events increase due to climate change, the nature of the insurance business model increasingly comes under threat. Insurers offer peace of mind to consumers by pooling risks that cannot be managed individually, but this is only possible where known perils are localised. In a world where climate change makes perils systemic, the insurance business model could break down with a risk of a more dramatic market failure.

Consequently, it is imperative that government action is taken now to mitigate the worst impacts of climate change – particularly as we seek to level up the UK, as articulated by my colleague Chris Rumsey in his recent blog. Insurers have long called for Government to continue to invest in building and maintaining flood defences, including sewers and drainage, and reform the planning system to ensure homes are not built on flood plains. The Flood Re initiative was purposefully designed to allow the sector to return to risk-reflective pricing in the future to ensure inappropriate building in high flood risk areas was not incentivised. Amending the scope of the Government’s agreement with the industry risks sending the wrong signal about the importance of reducing exposure to flood risk.

While government and policymakers are in a unique and pivotal position to drive this transition, insurers also recognise their role to play: the best mitigator of climate risk is to deliver on the Net Zero commitments, in order to avoid the worst impacts of climate change. Insurers also have a significant role to play in investing in both adaptation and mitigation against climate risks, given that the insurance and long-term savings industry manages significant investments of over £2trillion. BCG research shows that, with the right frameworks in place, ABI members could finance as much as one third of the UK Government’s Net Zero pathway.

Unlocking the full investment capacity will require an ambitious approach from the Government. This must include meaningful reform of the Solvency II regime and action to tailor the structure of investment demand to meet the investment priorities of our sector. Insurers and banks, acting as stewards of the economy, will have a pivotal role to ensure that the transition is a responsible, just and orderly one. The ‘old’ economy cannot be simply abandoned, but will need to be engaged with, invested in and supported as we turn to the ‘new’ net-zero economy. The required investment will be unprecedented, and will need to be underpinned by insurance if we are to ensure that this is paid for fairly across society. Regulators must also be agile and engage with industry with flexibility to support this.

So, whilst the CBES exercise hasn’t provided us with any shocking new conclusions, it has given valuable insights and learnings for the financial services sector responding to climate risks, and by extension for the Bank in its mission to support economic stability in the face of the biggest existential threat to society.

In a speech last year Mark Carney pointed out that climate change risks human mortality equivalent to a coronavirus pandemic every year from the middle of this century. As we emerge from covid we should keep in mind that we are at the beginning of an ever worsening crisis, unless swift action is taken. Whilst insurers will continue to diversify against the risks they face, humanity as a whole cannot diversify away from the planet on which we live.

Join us for free at our climate summit on the 8th June, where we will hear more about insurers’ role in the net-zero transition from industry experts, including the Bank of England’s own Anna Sweeney.

[1] https://www.bankofengland.co.uk/stress-testing/2021/key-elements-2021-biennial-exploratory-scenario-financial-risks-climate-change

[2] https://www.bankofengland.co.uk/climate-change#:~:text=Physical%20risks,financial%20system%20and%20the%20economy.

Last updated 25/05/2022