Building climate-aware stress tests

Channels: Sustainability

Assessing the Bank of England stress test framework and potential impact on insurance solvency ratios.

Climate change is perhaps the biggest challenge of the age. Tackling man-made global warming and preventing catastrophic temperature increases will touch every sector of the economy. As investors, we all need to be prepared to adapt and make changes to our portfolios to ensure we're positioned as economies are progressively de-carbonised. Insurance companies are no different, with climate change creating three main risks for insurance balance sheets:

  • Underwriting risk
  • Market risk
  • Credit risk

Many insurers now include climate risks in their investment process, and there is a move across the industry to commit to "net zero" carbon emissions in the coming years. Furthermore, insurers are also facing increasing pressures from regulators to include environmental, social and governance (ESG) issues as part of their balance sheet management.

The UK's Prudential Regulation Authority (PRA) and the Dutch central bank were the first in Europe to request a formal assessment of risks from climate change in 2019 and 2018 respectively. In 2021, the European Insurance and Occupational Pensions Authority (EIOPA) set out its own expectations on the integration of climate change risk scenarios as part of insurers' own risk solvency assessments (ORSAs).

There are several areas where insurers can incorporate ESG factors and account for climate risk on the asset side of their balance sheets. ESG criteria could be filtered in the strategic asset allocation stage of the asset liability management function. Insurers could integrate ESG analysis into their portfolio management by excluding certain sectors, implementing positive tilts towards sustainable companies and by monitoring investments for carbon emissions. Finally, insurers can also look to regularly stress test their portfolios based on a range of climate risk scenarios.

In this paper we focus on the last of these areas: stress testing portfolios for climate risk. First, we consider a methodology that insurers can use to measure the sensitivity of their balance sheets to climate change based on the Bank of England's stress testing framework. We then look at the limitations of the stress test framework and how it could be applied to insurance balance sheets. Finally, we apply the Bank of England climate risk scenarios to estimate the potential impact on asset class valuations and insurance solvency ratios by country.

 

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