Analysts at Fitch Ratings have warned that the UK’s latest supervisory climate stress test for insurers is “the world’s toughest yet,” with many firms expected to fall below the minimum standards imposed.
The BoE’s 2021 Climate Biennial Exploratory Scenario test explores the resilience of the UK financial system to the physical and transition risks in both short- and long-term timeframes.
Testing both insurers and reinsurers, the BoE will measure the full climatic effects of each scenario as an instantaneous shock, which makes it likely that some insurers will breach their solvency ratios, Fitch says.
The rating agency notes that non-life insurers and reinsurers are exposed to physical risk through property and catastrophe losses, which are becoming more frequent and severe due to climate change.
Additionally, life insurers are more exposed to the transition risk that affects the assets in their investment portfolios, due to their high investment leverage.
And the BoE test makes no allowance for how insurers could adjust premium rates, asset allocation or reinsurance programmes over the 30-year projection period.
In practice, Fitch expects insurers to reprice their business and to steer their investment portfolios towards lower-risk sectors to reflect changing circumstances, meaning they would be fairly resilient to the BoE scenarios if such management actions were taken into account.
Comparing the BoE test with last year’s French climate test, Fitch argues that the new standards are much tougher due to their assumption of higher peak carbon prices and greater global warming, and their limited credit for the management actions that firms could take to mitigate the effect of the scenarios on their business models.
“In practice, we would expect companies to adjust their asset and liability profiles significantly over time to reduce their exposure to transition and physical risks,” analysts said. “Consequently, regulatory capital breaches under the BoE scenarios do not signal that breaches in reality are likely.”
As a result, Fitch does not believe the test results should cause investor concern, but should instead help re/insurers to assess vulnerabilities to climate risks, understand the challenges to their business models, and enhance their risk management of climate-related financial risks.
