The Bank of England (BoE) has officially launched its Climate Biennial Exploratory Scenario (CBES), which is designed to explore the financial risks posed by climate change for the largest UK banks and insurers.
While the BoE runs regular stress tests to help assess the resilience of the UK financial system and individual institutions, this represents the first time that re/insurers have been included its climate assessments.
The CBES, which will return results in May 2022, uses three scenarios of early, late and no additional action to explore transition risk (arising from the structural changes to the economy needed to achieve net zero emissions) and physical risks (from higher global temperatures).
By testing both banks and insurers for the first time, the BoE says it will be able to capture interactions between these two industries and better understand the risks presented by climate change across the financial system.
The chief objectives of the exercise include measuring the financial exposures of individual firms and the financial system to their end-2020 balance sheets, as well as gaining insight into business model challenges and likely responses to these risks.
Additionally, it’s thought the tests will improve individual insurers’ risk management and prompt strategic views towards climate change, while also encouraging participants to engage their largest counterparties to understand their vulnerabilities.
UK general insurers participating in the CBES include AIG, Allianz, Aviva, AXA, Direct Line and RSA, which collectively represent around 60% of the national market based on gross written premium.
Ten Lloyd’s syndicates will also participate, representing 40% of the Society of Lloyd’s property and liability insurance market by premium, and participating life insurers include Aviva, Legal & General, M&G, Phoenix and Scottish Widows, which together represent 65% of the UK life insurance market by asset size.
The BoE assured that the CBES will not be used to set capital requirements, but may inform the Financial Policy Committee’s future approach to system-wide policy issues, and the Prudential Regulation Authority’s (PRA) future supervisory approach.
“Today’s exercise will help us size the risks from climate change for both the largest banks and insurers as well as the financial system as a whole,” said Andrew Bailey, Governor of the Bank of England.
“It’s a novel exercise as firms will have to engage closely with their counterparties in order to get detailed data on those counterparties’ exposures to these risks,” he explained. “It will stretch the time horizon over which the banks and insurers assess these risks and it will require them to build up their own scenario analysis capabilities, helping them to understand better how they are exposed under different potential climate pathways. The end result will be more robust management of climate related financial risks across the sector.”
The key features of the CBES are three scenarios of early, late and no policy action built on a subset of the Network for Greening the Financial System (NGFS) scenarios, which are applied over a span of 30 years to reflect the longer-term nature of climate-related risks.
For insurers, the CBES will focus on changes in invested assets (and reinsurance recoverables), and insurance iabilities (including accepted Reinsurance) assuming an instantaneous shock. This aims to brings forward the future climatic environment to today’s balance sheet, with no allowance for changes in future premiums, asset allocation, expenses, reinsurance programs and other future changes in participants’ business models.
Other features of the stress test include a questionnaire to capture participants’ own views on their risks, as well as detailed counterparty-level analysis for the largest counterparties.
“We are excited to launch today’s climate scenarios, which build upon the second iteration of NGFS scenarios released yesterday,” said Sarah Breeden, the Bank of England Executive Sponsor for climate change. They provide central banks and supervisors around the globe with a common starting point for analysing climate risks under different future pathways.”
“Though fiendishly complicated, climate scenario analysis is a critical part of our toolkit to address future uncertainty about what might happen to our planet, our economy and our financial system,” Breeden went on. “Some scenarios show the most efficient pathway to net zero, while others highlight the risks of late or insufficient action. By highlighting the risks of tomorrow, they can help guide actions today. I encourage all firms, not just those participating, to engage in and learn from this exercise.”
