The Bank of England (the Bank) has published its findings following the Climate Biennial Exploratory Scenario (CBES) it set for seven banks, five life insurers, six general insurers and ten Lloyd’s syndicates (UK entities only) over the past year.
The Bank’s main findings were as follows:
- Firms are making progress but there is much more work to do in managing their own exposure to climate risks.
- Climate risks will affect profitability but the transition to net zero is not likely to result in firms’ insolvency – though a financial assessment of the impacts of climate risks on firms were not carried out by the Bank.
- Firms had, however, underestimated the physical risks of climate change – though the Bank recognised the lack of available data, particularly around emissions and transition plans.
- The best submissions came from insurers that had brought together individuals from their claims, underwriting and actuarial teams to work through the scenarios and where there was an assessment of future, rather than just current, perils.
- Unsurprisingly, there are greater opportunities and fewer transition risks where the decarbonisation of the economy takes place in a slow and managed way.
- The removal of capital/coverage for carbon-intensive sectors may result in macroeconomic shocks if the renewable energy sector/alternative technologies are unable to keep pace to fill the gap.
- The D&O market was most exposed to litigation risks with a reinsurance pool being a potential solution to ensure the availability and affordability of cover – though this risk may diminish with time in any event.
- The scenarios did not involve an assessment of the human costs or geopolitical impacts of climate change, such as climate migration/conflict.
- Regular scenario testing of policy wordings should be carried out to assess whether the cover both the policyholder intended to procure, and the (re)insurer intended to provide, align with the policy wording.
The Bank asked firms to consider their exposure to physical risks (arising from higher global temperatures) and transition risks (arising from the move from a carbon-intensive economy to net zero emissions) in three scenarios:
- An Early Action scenario in which the world achieves net zero carbon dioxide emissions by 2050, capping the global temperature rise at 1.8ºC above pre-industrial levels and falling to 1.5ºC by 2100, having decarbonised in a managed and ordered way.
- A Late Action scenario where the same 2050 net zero goal and temperature cap is achieved, though there is no further temperature reduction by 2100 as a result of action being delayed by ten years therefore requiring more drastic measures within a shorter time period.
- A No Additional Action scenario in which no further action, other than that already announced by governments, is taken resulting in a temperature rise of 3.3ºC with the resulting increase in severity and frequency of natural catastrophes.
As is often stated with respect to anything ESG (environmental, social and governance) related, the lack of data (e.g. supply chain emissions) was a real hindrance to insurers’ ability to thoroughly assess climate risks. However, the Bank encourages firms to do the best they can with the information they have – a sentiment with which we would certainly agree – as there simply isn’t the time to wait for a perfect data set. This meant that there were wide variations in the projected estimated financial costs to firms as a result of climate risks – the highest estimate being around ten times greater than the lowest.
Nevertheless, the Bank considers these losses within an acceptable range and would not result in firms’ insolvency, particularly in light of the fact that, in real life, firms would be able to adapt their models as needed over time.
The No Additional Action scenario would, as expected, have the most significant impact with insurers predicting a 50% to 70% rise in annualised losses by the end of the 30-year period – a figure that the Bank considered could be four times higher than insurers had predicted. Interestingly, the Bank noted that those insurers that had more sophisticated models, and were able to adjust these models to the requirements of the scenarios, typically arrived at significantly higher losses.
Insurers stated that the increased claims would lead to higher premiums for consumers and businesses or an inability to offer cover. In this worst case scenario (in which the Flood Re scheme will have ended), the Bank considers that around 7% of households/businesses would have no access to insurance or insurance that is affordable, and the figure may well be higher than this, were this scenario to materialise.
The Bank highlights the rise in climate-related litigation and, as result, ran an exercise asking insurers to consider a range of potential claims to assess whether these would fall within the scope of cover.
It found that D&O policies were the most likely to be triggered by climate-related claims providing cover for allegations of greenwashing, breach of fiduciary duties and the indirect financing of carbon emissions. Over 8,500 D&O policies had been underwritten by the insurers involved in the CBES exercise, typically through a syndicated market arrangement, with each insurer having an exposure of between £2 million to £7.5 million and often with legal costs in addition. While these are generally annual polices, the fact that this is a rapidly developing area may mean that the risks have not been accurately priced. If/when a re-pricing does occur, this may then make the cover unaffordable with the potential need for a reinsurance pool to help the market. However, the Bank notes that as climate risk assessments, disclosures and transition plans become more standardised and embedded, policyholders’ (and therefore insurers’) exposure to these claims may reduce.
It remains our view that awareness of climate litigation risk has lagged well behind considerations of the physical and transition risks. It had often been reasoned that it would be very difficult for the courts to join the dots between the changing climate and the activities of one particular organisation.
However, there are a number of claims currently before the courts in the US and also in Germany aiming to do precisely this. In addition, the landmark case by Milieudefensie (Friends of the Earth in the Netherlands) against Shell focused not on what Shell had done in the past but on the fact that its plan to transition to net zero wasn’t worth the paper it was written on. Milieudefensie have been very open about the fact that they intend to use this case as a blueprint for many others and has written an open letter to 30 Dutch organisations putting them on notice of this. Added to this, climate NGOs are ready to hold companies to account if their deeds do not match their words.
It is also foreseeable that claimants will direct claims against banks and insurers as enablers of carbon-intensive activities. These activities depend on access to credit and insurance. These claims may not succeed but defending them will inevitably result in high legal costs and significant management time.
Given these risks, it is rather surprising that the Bank expresses caution regarding the speed of divestment/refusal to cover these activities for fear of a macroeconomic shock if the move away from carbon-intensive activities cannot keep pace with the advances in green technology/growth of the renewable energy sector. The Bank states that: "insurers may resort to actions that do not appropriately reflect climate risks" and that "[u]nless this transition is managed carefully, this could have significant impacts on businesses and consumers, and through them the financial sector...".
It is certainly preferable for insurers to work with policyholders to put in place robust transition plans and decarbonise their activities - though where a policyholder is clearly unwilling to do this, it ought to be open to insurers to decline to offer cover. Indeed, a failure to do so may cause insurers to fall foul of their own net zero plans and expose their directors and officers to precisely the litigation risks detailed above.
Added to this, the Bank stated that “[t]he responsibility for addressing the causes of climate change ultimately lies with governments, businesses and households”, which also strikes us as rather odd given that the financial system is estimated to be approximately 20% to 25% of the world economy.
Surely, it is not tenable for the financial sector to separate itself from the real economy? Given the really progressive actions taken by a number of insurers, they don’t seem to see themselves this way either and are keen to be at the heart of the transition to a net zero economy.
In summary, the conclusions the Bank has drawn from the scenarios certainly indicates that banks and insurers will be able to navigate the challenges arising from a range of climate risks, which will be welcomed by many in the sector. However, it is also a warning that a number of risks have been underestimated and that, in order for insurers to remain solvent, vast numbers of consumers and business may need to be declined cover.
The Bank makes it clear that it has not included the likely human impacts within the three scenarios and so we query whether such a protection gap will be acceptable to the public, and therefore the government in 30 years’ time. If not, the financial impact on insurers will undoubtedly be much greater.
Read other items in Professions and Financial Lines Brief - July 2022