Industry Issues | ERM & Emerging Risks

Bank of England Warns of Climate Change Risk, Potential Mandatory Disclosures

Climate Change - News

The Prudential Regulation Authority, the arm of the Bank of England that supervises the activity of regulated companies in the U.K., has published a consultation paper urging banks, insurers and asset managers to take a "strategic approach" to gauging their financial exposure to climate change.

The PRA warns that the "window for action" to deal with potential losses from assets exposed to climate risks "is finite and closing." The time has come for companies to designate a board-level senior manager to take responsibility for assessing climate-related risks, envisioning a broad variety of scenarios, adds the agency.

The consultation paper advises companies, including Lloyd's syndicates and managing agents, to use scenario analysis and stress testing to inform the risk identification process and understand the short- and long-term financial risks to their business model from climate change. The PRA is considering the introduction of mandatory disclosure of climate change exposures, potentially two to three years after the final version of the paper is published, subject to the consent of other regulators such as the Treasury and the Financial Conduct Authority.

"We will look to issue further guidance on best practice 12 to 18 months after the supervisory statement has been finalized," a spokeswoman for the PRA said. "On disclosure, this is part of a broader authorities' response and we seek to determine our approach in the context of that wider debate."

The PRA's press release states "Climate change and society's response to it presents financial risks that are relevant to the PRA's objectives of safety and soundness. Whilst these risks may crystallise in full over longer-time horizons, they are becoming apparent now. Firms are enhancing their approaches to managing these risks, but more need to take a forward-looking, strategic approach if financial risks are to be minimised."

The regulatory agency requests comments from affected companies - all UK insurance and reinsurance firms and groups, i.e. those within the scope of Solvency II including the Society of Lloyd's and managing agents ('Solvency II firms') and non-Solvency II firms, banks, building societies, and PRA-designated investment firms. The consultation ends Jan. 15, 2019.

The two main areas of risk, the PRA said, could be divided into 1) physical risks - such as extreme weather  destroying assets that serve as collateral for bank loans or are subject to insurance policies, and 2) transition risks - the risk of assets, such as buildings that have low energy efficiency, losing their value due to increasingly stringent norms imposed by the state as society becomes less reliant on carbon-generating industries.

The PRA's report on the impact of climate change on the UK insurance sector identified a third risk factor - liability risks - arising from parties who have suffered loss or damage from physical or transition risk factors seeking to recover losses from those they hold responsible. The legal risks from climate-related liabilities can be of particular importance to insurance firms given these risks can be transferred through liability protection, such as directors' and officers' and professional indemnity insurance.

A draft supervisory statement sets out expectations regarding firms' approaches to managing the financial risks from climate change. These center around how managing the far-reaching and foreseeable risks from climate change requires a strategic approach which considers how actions today affect future financial risks. The PRA identifies numerous key risk areas that will be embedded into its existing supervisory framework and expects firms' responses to be proportionate to the nature, scale and complexity of their respective businesses: 

  • Governance: There should be clear board-level engagement and responsibility for managing the financial risks from climate change. This includes identifying the relevant Senior Management Function holder(s);
  • Risk Management: Risks should be addressed through firms' existing risk management frameworks, in line with their board-approved risk appetite, while recognizing that the nature of financial risks from climate change requires a strategic approach;
  • Scenario analysis: This should be conducted (where proportionate) to inform a firm's strategic planning and determine the impact of the financial risks from climate change on its overall business strategy;
  • Disclosure: Firms should consider the relevance of disclosing information on how financial risks from climate change are integrated into governance and risk management processes. This includes firms engaging with the wider initiatives on climate related financial disclosures, such as the Task Force on Climate-related Financial Disclosures (TCFD). 

RELATED NEWS

The IPCC Approves Climate Change Report on the Impacts of Global Warming of 1.5 °C

A recently approved Special Report of the IPCC addresses the impacts of global warming of 1.5°C above pre-industrial levels and related global greenhouse gas emission pathways, in the context of strengthening the global response to the threat of climate change, sustainable development, and efforts to eradicate poverty. The report is being leveraged by California Insurance Commissioner Dave Jones to reassert the potential risks that insurers and investors face in regard to their investments in the carbon economy. The commissioner stresses that markets and governments will move aggressively to decarbonize the economy, in which case the value of those assets could drop significantly. Jones has required insurers with more than $100 million in annual premium to disclose publicly their investments in fossil fuels, and last year established the Carbon Risk Initiative that includes information on the amount of oil, gas, coal, and utilities investments held by insurance companies. (See Insurance Journal)

UN: Losses from Natural Disasters Surge Over Last 20 Years
Associated Press (10/10/18)

The United Nations Office for Disaster Risk Reduction says worldwide reported economic losses from earthquakes, volcanic eruptions, floods, hurricanes, and other climate-related disasters surged to nearly $2.9 trillion over the past 20 years. The loss of resources and assets, such as homes and farms, due to more frequent and widespread climate-related disasters rose 51 percent compared to the previous 20-year period. Climate-related disasters, such as impacts from floods, droughts, and heat waves, accounted for $2.25 trillion of the total, up from $895 billion between 1978 and 1997. The remainder of the total stems from tsunamis and earthquakes.

Footing the Bill for Climate Change: 'By the End of the Day, Someone Has to Pay'
National Public Radio (09/20/18) Dwyer, Colin

As the risks of natural disasters increase, regulators, consumer advocates, and insurance researchers are concerned that the bulk of those bills will increasingly fall on the shoulders of low-income homeowners. California Insurance Commissioner Dave Jones observes, "The climate scientists tell us that we're going to continue to see temperatures rise, and that will contribute to more catastrophic weather-related events. In California, what this has meant is loss of life, loss of property, business interruption, and community devastation associated with wildfires." Jones' office found that in areas that insurers consider risky for wildfires, such as Mendocino County, complaints about price increases increased from 2010 to 2016, the last year for which data is available. More homeowners have also turned to California's state-created insurer of last resort, the FAIR Plan, which can be more expensive.