The United Kingdom’s Prudential Regulatory Authority (PRA), part of the Bank of England, has published its second climate change adaptation report and featuring heavily in it is the subject of whether new or additional capital requirement charges may be needed as a result of climate change.
The PRA is becoming increasingly focused on the way insurance and reinsurance companies are managing their climate-related financial risks and its about to become far more proactive on this.
CEO of the PRA and Deputy Governor for Prudential Regulation at the Bank of England Sam Woods stated that the PRA is, “embedding climate change into its supervisory approach from the end of this year.”
He further explained that, “This means that firms will need to demonstrate their ability to understand and manage climate-related financial risks on an ongoing basis, making further improvements with time. As we enter 2022, where firms have not kept pace with our expectations we will stand ready to respond with our supervisory and regulatory toolkit.”
So what’s in the regulators toolkit when it comes to climate related risks?
Woods continues, “A key part of our normal regulatory toolkit is capital requirements. We set these requirements to ensure firms have sufficient resources to help absorb financial losses over time. This supports their safety and soundness and contributes to protecting depositors and insurance policyholders. The report explores the links between climate change and the regulatory capital framework, with the aim of accelerating research to inform our future approach.”
While regulatory capital requirements are not thought a way to address the causes of climate change, the PRA does believe capital requirements are a valid tool for dealing with its consequences, the financial risks associated with climate change, Woods said.
“Further work is required to identify whether changes in the design, use or calibration of the regulatory capital framework are needed to ensure resilience against those consequences,” Woods explained.
The PRA intends to produce more guidance for the UK insurance and reinsurance industry on how it intends to approach capital requirements and capital charges related to climate risk by the end of the year.
The paper published suggest that, “Under the existing regulatory capital framework, there is scope to use capital requirements to address certain aspects of climate-related financial risks.”
“We expect firms to incorporate judgements of their exposure to climate-related financial risks in the way they assess their own capital requirements, as they do for other drivers of financial risks,” the PRA explains.
Adding that, “In addition, under our existing policies, where firms have significant climate-related financial risk management and governance weaknesses, we will also be prepared to impose an additional capital charge or scalar where appropriate.”
But there is a lot of work to do in addressing this, it seems, as, “Determining whether changes to the design, use or calibration of the existing capital framework are needed to address climate-related financial risks beyond what is currently in place is complicated and needs to be supported by further work and research.”
As we explained in a recent article, we understand that practically all of the major rating agencies are having internal discussions about how they handle catastrophe risk within their evaluations of capital adequacy and the necessary capital charges, driven by climate and frequency trends, with changes to rating methodologies seen as increasingly likely over the coming year or so.
Catastrophe risk charges and catastrophe capital requirements may be updated to include climate risk related factors it seems, which to a degree could account for some of the necessary buffering to ensure the insurance and reinsurance industry is protected and is protecting its customers against climate-related financial risk.
But where these diverge is around the duration of climate risk and how it may manifest, over short, medium and longer-term timescales, plus how transition, policy, intervention and possible tipping points play into this as well.
Which makes setting any new capital requirements or charges particularly challenging when it is focused on climate-related financial risks, perhaps more so than on catastrophe charges and ensuring trends in severe weather, secondary perils and also importantly inflation trends, are accounted for within them.
These ideas, of adjusting the way capital requirements are formulated so that they account for climate-related financial risks and changes in catastrophe losses, frequency, severity and exposure, are going to make the setting of capital charges considerably more complex and challenging over time.
There are so many variables involved in this and the challenge is going to be as big for regulators like the PRA, as it is for rating agencies.
Adding complexity, on the regulator side especially, is the fact that nobody wants to make their financial services industry less competitive, so punitive climate capital charges are unlikely to begin with and regulators are expected to look internationally for support and guidance in these efforts and to align the way climate related risks are dealt with on a supervisory level.
But dealt with they must be, as many in the insurance and reinsurance industry believes catastrophe losses from severe weather perils are already increasing on the back of climate related trends, which is driving a need for some to reduce exposure, others to buy more reinsurance protection and could also result in a need for more capital markets based risk transfer.
Does the insurance and reinsurance market need access to a liquid marketplace for hedging specific climate-linked perils, which could provide a financial tool and lever to adjust exposure and alongside capital requirements enable companies to ensure the robustness of their strategies going forwards? Something the ILS and capital markets would be only too delighted to facilitate.
Quite possibly. It does seem sensible for there to be an increasing array of hedging tools in the box that insurers and reinsurers can use defensively against climate capital requirements and charges, more than just pure reinsurance and retro anyway.
Would the industry embrace this? Less likely it seems, for now. At least until capital requirements became so onerous that it was a case of downsize the business or hedge against the risk, which under certain climate assumptions and scenarios could be where we’re all headed.
There is a lot for the insurance and reinsurance industry to do on climate, with regulatory and rating oversight and climate-related rules set to drive much of the response.
It’s all about keeping coverage affordable and the industry robust or at least stable, which to us suggests a clear role for advanced capital modelling and analytics, the capital markets, plus modern hedging or risk transfer tools, as the construct of a traditional reinsurance tower just may not cut it in the future.
So, being more responsive to climate and responding strategically might mean having to change (or upgrade) the way you manage risk, capital and protection.