IAIS Reports Shows 35% Of Insurer Investments Are ‘Climate-Relevant’ (3)
Climate Change And Financial Stability Risks
Insurers are exposed to climate change both as underwriters and investors and could be affected by a variety of climate risks. The transmission channels represent how adverse climate-risk events could spread beyond the insurance sector and impact the wider financial system.
Initial impacts on the financial system could also trigger reactions with other players within the financial system (including insurers) trying to mitigate the impact of the events on their balance sheet. These reactions could generate feedback loops within the financial system and, ultimately, through macroeconomic and social effects, the real economy. Not all climate risk-related events generate a significant impact or turn into systemic risks if they materialise but, through the channels described above, insurers could contribute to the generation or amplification of systemic risk induced by climate risk events.
Though the potential financial stability impact of climate-related risks can be considered from different perspectives, the figure above focuses on the effect of both physical and transition risks, emphasising the latter, ie extensive policy, technology and market changes in favour of a low carbon economy on the asset side of the insurers’ balance sheet.
Much of this section is based on the work of the FSB report (2020), which provides more information.
Financial Impact Of Climate Change On Insurers’ Assets
Existing literature already investigates channels by which climate-related shocks might be transmitted through and amplified by the financial system (see FSB (2020)). The manifestation both of physical risks and of a disorderly transition towards a low-carbon economy could affect insurers’ asset portfolios, although the timing of such impacts is uncertain and may differ. Transition risks affecting financial stability could appear in the near term, particularly if policies towards a net-zero emissions economy are accelerated. By contrast, physical risks are unlikely to lead to financial stability concerns in the short or medium term. Focusing on insurers’ assets, financial risks may materialise in different risk dimensions with potential financial stability consequences. There are also important second-round and spillover effects within the financial system that may amplify the effect of climate-related risks.
Examples of a possible split along four risk dimensions and related spillover effects are provided below. Credit risk: Sectors exposed to climate-related risks may suffer losses when they are unable to effectively manage transition risk. Climate-related risks can thus induce, through direct or indirect exposure, a deterioration in borrowers’ capacity to generate sufficient income, as it might lead to higher probabilities of default in: * carbon intensive industries (stranded assets); *investments in technologies that turn out to be less promising than expected or superseded by new technologies.
This would affect the creditworthiness of these borrowers, and ultimately affect bond prices or cause yield shocks. Moreover, the potential depreciation of assets used for collateral (eg lower value of real estate due to policy changes) can also contribute to higher credit risk.
In terms of physical risk, an example would be if the destruction of a production site due to an extreme weather-related event increases the probability of default of the company operating the site.
Market risk: Under a disorderly transition scenario, financial assets concentrated in certain sectors of the real economy and/or certain regions could be subject to a change in investors’ perception of profitability, leading to a propensity for reducing the value of these assets. As outlined by the FSB (2020), such changes need not, in themselves, pose risks to financial stability.
However, such movements may be amplified by an unanticipated and sudden disorderly transition, which could have a destabilising effect on the financial system through a sharp fall in asset prices (eg stranded assets, significant decrease in the value of real estate, carbon intensive and/ or GHG intensive sectors). Following a regulatory shock aimed at sectors whose technology relies on carbon emissions, large-scale sales may ensue through several channels of transmission.
First, investors may have trouble gauging the fundamental value of such assets, which itself depends on future regulatory actions that are not yet known. In a world of increasing physical risk events and lagging technology within those sectors, many investors may deem such assets as undesirable to hold. Further, coupled with more stringent disclosure standards with respect to a portfolio’s carbon footprint, investors may fear a reputational cost associated with holding such instruments. These are two examples of how market risk can intensify and lead to a significant drop in the value of climate-relevant assets beyond what has already been priced in.
Liquidity risk: A lack of reliable and comparable information on climate-sensitive exposures could create uncertainty and cause procyclical market dynamics, including large-scale sales of carbonintensive assets, and hence reduce liquidity in these markets. As such, assets could become less liquid due to, for instance, climate-related increased credit or market risk, thereby triggering potential procyclical investment behaviour by insurers and negatively affecting insurers’ ability to liquidate the assets when needed. Reputational risk: Negative publicity may be triggered by an insurer’s underwriting, or investing in, sectors perceived as contributing to climate change, or that do not take into account climatechange consequences and do not take mitigation or adaptation measures. This is exemplified by social movements calling for divestment from fossil fuels and the cessation of the underwriting of coal-fired power infrastructure.
When looking at an insurer’s investment mix, each type of asset class may in theory be affected by transition and/or physical risks. The following table provides an overview and examples of the materialisation of these risks for five main asset classes on an insurer’s balance sheet.
Financial Stability Transmission Channels And Amplification Mechanisms Of Climate Change
As noted by the FSB (2020), a gradual and well anticipated transition to a low-carbon economy has a relatively contained impact on asset prices and is less likely to have material implications for financial stability. A rapid or disorderly transition could occur, however, due to sudden unanticipated changes in public policy, technology developments or the preferences of investors or consumers. This may affect the balance sheet or generate a decline in financial earnings – with potential implications for the solvency position – of companies whose business models are not based on low carbon emissions or in favour of climate adaptation or mitigation. In this case, a direct consequence may be the write-down of assets held by insurers investing in such companies, potentially leading to large-scale sales of assets.
Under these circumstances, the financial system as a whole (including insurers, banks, investment funds and hedge funds) may demonstrate procyclical behaviour. This would enhance market imperfections and could have a destabilising effect on the financial system.
Climate-related risks may have an impact on insurers’ investments portfolio via three main identified transmission channels: exposure channel, asset liquidation channel and legal liability risk channel. The analysis focuses on the first two. It thereby explains the channels through which climate-related risks might impact the financial system, without including any conclusive statements on the likelihood that these risks will materialise.
Exposure channel
The exposure channel is related to direct and indirect interlinkages between insurers and other parts of the financial system, and the real economy.
Investment exposure
As the value of insurers’ assets runs the risk of a sharp downward shock, expected returns on investments become hazardous for investors (including insurers) who may face potential financial (market) losses. As noted by the FSB (2020), the breadth of climate-related risks might reduce the degree to which market participants are able to properly price and manage their investments, which is likely to lead to increases in risk premia across a wide range of assets. An unanticipated shift in asset prices may challenge market participants’ ability to diversify their exposure to climate-related risks.
Counterparty exposure
This phenomenon may be enhanced by the interconnectedness of lending activities between insurers and other financial institutions. Insurers are exposed to the banking and investment funds sectors through several exposed classes (mainly investments in bonds and equity). When financial institutions are hit by a shock, they can easily transmit it to the insurance sector through a sharp decline in the institutions’ creditworthiness.
A reduction in (re)financing within the financial system could in time amplify climate-related shocks to the real economy. Various insurers are also part of financial conglomerates (including credit institutions, investments funds, hedge funds and payment institutions), where a decline in the financial soundness and solvency position of one institution may affect the whole conglomerate. Further, the failure of a systemic financial group or the failure of several non-systemic financial institutions may lead to contagion in the broader financial system through interlinkages. As seen in previous financial crises, such as in 2008, such disruption of the whole financial market can trigger a market crash and a domino effect that impacts the global real economy.
Market and credit risks can also be concentrated in certain geographies and sectors of the real economy. Among insurers’ investments portfolios, mortgage loans and real estate portfolios are, in some geographies, particularly exposed to climate-related risks, increasing their default risk.
Credit insurers will also need to monitor increasing risk of default on trade-credit insurance portfolios, in light of climate-related risks. Transition risk emerging from a large systemic default of corporates12 may mean trade-credit insurers are unable to honour their insurance liabilities (increase in market risks and credit risks).
Asset liquidation channel
Asset liquidation refers to the sudden sale of assets on a large scale by one large insurer or a sufficient number of smaller insurers, which could trigger a decrease in asset prices and significantly disrupt trading or funding in key financial markets or cause significant losses or funding problems for other firms with similar holdings. Such behavior may have a more significant impact on smaller, less liquid markets or in a stressed environment.
Climate-related shocks have the potential to lead the insurance industry to large-scale shifts in its portfolios. Market movements from investors’ procyclical behaviour (including insurers and other financial institutions) may amplify changes in asset prices. As noted by the FSB (2020), this effect may be particularly widespread where there are substantial commonalities between investors’ portfolios or concentrations of exposures through certain financial products (such as derivatives). It could also be amplified by changes in collateral values. Liquidity mismatches can also be seen in securities lending activities when collateral is invested by the insurers in less liquid assets.
Furthermore, policyholders in need of cash (eg following damages resulting from a weatherrelated event) may be triggered to surrender their life savings in insurance. If such behaviour were to occur, insurers may be forced into procyclical behaviour to obtain the necessary liquidity to meet policyholders’ payouts.
A procyclical phenomenon,13 pushing the market to simultaneous and large-scale sales of assets, may trigger increased market volatility and raise the likelihood of further losses and failures of actors within the financial system. As a result, liquidity risks may emerge if insurers are not able to sell the stranded assets quickly enough to prevent or minimise losses.
Legal liability risk channel
In addition to a reputational risk (through financial support for carbon-intensive sectors), insurers may also be exposed to counterparty risk from their business relations with companies subject to climate-related legal liabilities. This might also have implications for the financial system.
This risk is not further developed as it is less relevant to the analysis in this report.
Final Considerations
Insurers are dually exposed to the consequences of climate change, as they underwrite risks and invest in assets that could be affected by climate change.
While climate risk analysis related to insurers’ investments often focuses on transition risks only, potential physical risks should not be neglected.
The manifestation of physical risks – particularly prompted by a self-reinforcing acceleration in climate change and its economic effects – could also lead to a sharp fall in asset prices and increase in uncertainty (see FSB (2020)).
A variety of mechanisms within the financial system could amplify the effects of credit, liquidity and counterparty risks arising from climate-related shocks. Interactions within the financial system and with the real economy may also increase risks to financial stability.
As noted by the FSB (2020), a widespread reappraisal of the creditworthiness of large portions of the real economy might reduce the willingness of firms to provide financial services, reducing access to (or raising the cost of) bank lending, corporate finance and insurance. By depressing macroeconomic prospects, this could result in further losses for the financial system, which in turn could lead to another reduction in finance.
Ultimately, as the financial sector provides financial support to the real economy and taking into account the strong interconnectedness of the financial system, physical and transition risks may generate ‘feedback effects’ within the financial system and between the financial system and the real economy14. In particular, and directly in connection with insurers’ activities, these effects may be expected at a macroeconomic level and at the level of individual businesses and households (ie loan mortgages and homeowner’s insurance).
To be continued
Source: Africa Ahead
Below is link to Part (2)
https://therevealerng.com/iais-reports-shows-35-of-insurer-investments-are-climate-relevant-2/
