UK insurers must better understand climate risk: PRA

UK insurers need to do “much more work” to understand and manage their exposure to climate risks, the Prudential Regulation Authority (PRA) has warned.

The PRA today published the results of its latest climate stress test – the Climate Biennial Exploratory Scenario (CBES) – which is seen as a key exercise to help the regulator better understand the resilience of the sector.

The exercise found insurers will be able to absorb the climate costs that fall on them “without material risks to solvency”.

But companies will still face “significant headwinds and therefore need to continue to invest in their ability to support the economy’s transition to net zero”, the regulator said.

In addition, climate risks are likely to create a “drag” on the profitability of insurers, particularly if they are unable to manage these risks effectively.

There is also “substantial uncertainty” regarding the true magnitude of these risks. The PRA warned projections of climate losses are uncertain. “Scenario analysis in this area is still in its infancy and there are several notable data gaps,” it said.

The regulator also warned a transition to net zero would “materially impact” a number of sectors insurers are exposed to, which would force companies “to adapt their business models or potentially risk becoming unviable over time”.

Analysts said the results highlighted the need to improve climate risk modelling capabilities.

“The outcome of the CBES exercise is in line with our view that large UK banks and insurers will be able to absorb the financial costs associated with their moderately negative exposure to carbon transition,” Moody’s Investors Service analyst Brandan Holmes said.

“However, a lack of data and underdeveloped modelling capabilities significantly hampers their ability to measure and manage these risks,” Holmes added.

The CBES test explored the resilience of the UK financial system to the physical and transition risks under three climate scenarios.

The “early action” scenario sees a transition to a net zero emissions economy over 2021 to 2050, while a “late action” scenario models a delayed but then more intense transition over 2031 to 2050. Finally, a “no additional action” pathway assumes no new climate policies implemented.

The participating firms – banks and insurers - modelled how their businesses could be affected in each scenario.

The three key objectives of the exercise were to: improve firms’ climate risk management, to size the risks participants in the exercise face and to better understand the potential responses firms to climate-related risks and their broader implications.

At an aggregate level UK banks and insurers are likely to be able to absorb the costs of transition that fall on them, the PRA found.

And while governments set public climate policy, banks and insurers have a collective interest in managing correlated financial risks in a way that supports that transition over time, the regulator added.

PRA chief executive, Sam Woods, said: “Today’s exercise explores how well they are equipped to manage the longer-term challenges from climate change, in the context of our financial stability objective.

“We find they are likely to be able to absorb the climate costs that fall on them without material risks to solvency, but will face significant headwinds and therefore need to continue to invest in their ability to support the economy’s transition to net zero.”