26 July 2022

Insurers in the frontline for climate risk shocks

By Ronan McCaughey

Unforeseen climate shocks could abruptly impact market prices and initially hit the portfolios of insurers, investment funds and pension funds, the European Central Bank (ECB) and the European Systemic Risk Board (ESRB) have warned.

The ECB and ESRB today published a report detailing how such shocks could hit the European financial system.

The report’s scenario analysis suggests climate risks might take shape in the financial system in a specific order. For example, sudden repricing from climate risk shocks could cause companies to default, resulting in losses for exposed banks.

“In a disorderly transition scenario, marked by an immediate and substantial increase in carbon prices, respective market losses of insurers and investment funds could potentially amount to 3% and 25% on stress-tested assets in the near term,” warned the report.

It noted an orderly transition towards net zero by 2050 could soften such shocks and alleviate the fallout for companies reducing the probability of corporate defaults by around 13-20% in 2050 compared with today’s policies.

Market dynamics can magnify the financial impact of physical risks, said the study. It explained a climate shock could lead to a sudden reassessment of climate risk pricing, thereby causing fire sales, where financial institutions – especially those with overlapping portfolios – quickly sell a large number of exposed assets at the same time at distressed prices.

The report also assesses the scope for macroprudential policies as part of a broader policy response to address the financial impact of climate change. It presents the case for adapting existing instruments, notably systemic risk buffers or concentration thresholds.

“Such measures could complement efforts at the microprudential level, such as the ECB’s supervisory climate agenda including the ongoing thematic review of climate risks and the 2022 climate risk stress test,” said the ECB and ESRB.

The Association of British Insurers (ABI) has previously called on the UK government to fulfil five actions needed for the insurance sector to further tackle climate change.

In May, the Bank of England’s (BoE) climate stress test results revealed UK insurers and banks “still need to do much more to understand and manage their exposure to climate risks”.

The full ECB and ESRB report can be read here.