Climate change presents many challenges for financial institutions. It poses risks that are dynamic in nature, systemic in impact, and testing on the interdependencies across the financial system. A case in point is the impact of climate change on extreme weather events.
Traditionally, insurance has provided protection against losses arising from extreme weather events and banks have relied on it to mitigate the financial impact of those events on their finance activities. However, this ‘safety net’ may break as climate change increases the frequency and severity of extreme weather events: risks associated with extreme weather events may become too expensive to insure or even uninsurable, harming both insurers and banks, as well as the society as a whole.
In the past, insurers have been be able to handle the financial implications of climate change on their business, given their expertise in pricing and managing natural catastrophe risks. Insurers typically have the right to reprice their contracts on an annual basis, which allows them to incorporate any increased risk in the pricing. To date, negative financial impact attributed to the impact of climate change on extreme weather events has been limited and for many insurers natural catastrophe represents a small part of their business.
This could be set to change – recent events shed light on how this could unfold. Extreme weather events could make more properties uninsurable, undermining insurers’ top line. There could be reputational damages if insurers increase premiums or withdraw coverage for those living in the most vulnerable areas. At the same time, social and consumer pressures will likely grow on insurers to offer insurance on unprofitable terms to ensure that coverage is available for all. Indeed, insurers in California which tried to increase insurance premium following the wildfires in 2017 experienced all of these.
As extreme weather events create headwinds for insurance businesses, they also create powerful knock-on impact on other parts of the financial system. Banks need to recognise that they cannot take the availability of insurance as a risk mitigation tool for granted in the future. They should improve their understanding of how extreme weather risk may increase and what the potential implications on the cost and availability of insurance may be and adjust their risk management practices accordingly. When the impacts of the increase in insurance cost or unavailability of insurance are material for banks, they will need to be incorporated in the tools producing the key metrics driving investment and lending decisions, such as expected credit losses. When the increase in the extreme weather risk is severe, the best option for banks may even be to withdraw financing in such areas.
The interdependency between insurance and banking sectors aside, firms should also be aware of other channels where extreme weather events could manifest into challenges to financial resilience. In particular, extreme weather events could affect financial markets if they disrupt long and geographically concentrated supply chains. The impact could in turn lead to disruptions and financial losses of the counterparties of banks and insurers.
Furthermore, how societies respond matters. For example, building flood defences to protect a major city may increase flood risk in neighbouring towns. As a result, adaptation actions can reduce some while increase other exposures to the impact of extreme weather event.
Financial institutions have the option to limit their exposure to those risks by withdrawing insurance and financing from the most affected areas but this could have a very damaging impact on local communities. The increased risk of natural catastrophe and lack of insurability is likely to dampen economic activity in the high-risk areas with the inevitable negative social impact for the people and reputation impact on the firms.
The onus is on both private and public sectors to ensure that the increased extreme weather risk due to climate change doesn’t create new economically deprived areas. Primarily, governments need to ensure that adequate adaptation is in place to counteract, at least to some extent, the negative impact of climate change.
Insurers and banks should also work together to develop solutions which can provide more certainty with regards to financial protection against extreme weather events. For example, multi-year insurance contracts can provide more certain revenue for insurers and more certain coverage for banks. There may also be opportunities to design new insurance and financing products which encourage and reward resilience to extreme weather events properties through preferential pricing. In addition, insurers could offer ‘build back better’ cover ensuring that any damaged properties are better prepared for the future. As with the understanding of climate change risks, harnessing the opportunities also require firms to develop the necessary expertise to identify and quantify the benefit to balance against the potential higher risk and capital loading of such contracts.
Incorporating the impact of climate change in decision-making will likely be a challenging and lengthy process. Defining priorities and development path is key. For many financial institutions, the likely best path forward is to incorporate climate change risks into the existing risk management framework and prioritise investment to improve data granularity and availability.