BoE raises questions over insurers’ climate capitalisation shortfalls

The Bank of England has cast doubts on the ability of insurers and banks to weather the storm of major climate risks.

The Bank issued its report on climate-related risks and the regulatory capital frameworks, which warned that there were concerns that existing capability and regime gaps created uncertainty over whether banks and insurers are sufficiently capitalised for future climate-related losses.

As such the uncertainty represents a risk appetite challenge for micro and macroprudential regulators.

“Regulators, including the Bank, need to form judgements on whether quantified and unquantified risks are within risk appetite – and act accordingly,” the BoE warned. “Effective risk-management controls within PRA-regulated firms can reduce the quantum of capital required in the future for resilience, but the absence of controls might suggest a greater quantum of capital will be required. “As a short-term priority, the Bank is focused on ensuring firms make progress to address ‘capability gaps’ to improve their identification, measurement, and management of climate risks.”

In October 2021, the Bank published  its Climate Change Adaptation Report (CCAR), which set out the Bank’s initial thinking on climate-related risks and the regulatory capital framework. The purpose of the CCAR was to deepen understanding of the links between climate change and the regulatory capital frameworks.

The CCAR set out that capital frameworks should be a core tool within the broader regulatory frameworks to ensure that PRA-regulated firms are resilient to climate risks, the Bank added. This includes risks that might arise through two key channels – physical risks and transition risks. The CCAR noted that the regulatory capital framework already captures climate risks to some extent, for example through capital models and credit ratings. However, this risk capture is potentially incomplete due to capability gaps and regime gaps.

Capability gaps refer to the difficulties inherent in identifying and measuring climate risks.

“These challenges might arise due to lack of relevant granular data from firms on their own climate risks, or limitations in modelling techniques to fully incorporate and estimate the impact of climate factors on their counterparties,” added the Bank. “These gaps encompass broader challenges related to firms’ climate risk management in areas such as scenario analysis, accounting, and regulatory valuations.”

Regime gaps refer to challenges in capturing climate risks due to the design or use of methodologies in the capital frameworks. For example, in microprudential capital frameworks, methodologies are typically calibrated using historical data to capture risks that crystallise over a relatively short-term horizon. This is often around a year ahead.

The bank warned while this ensures that capital is set in a standardised and quantifiable way, it might underestimate future climate risks that could emerge over longer horizons.

“Another example is that there is currently no explicit consideration of climate risks in the macroprudential framework,” it added.

The Bank said it has explored conceptual issues to better understand the nature and materiality of ‘regime gaps’ in the capital framework.

“The unique characteristics of climate risks mean that their capture by capital frameworks requires a more forward-looking approach than used for many other risks,” the report explained. “Scenario analysis and stress testing will play a key role in this. Regulators, including the Bank, need to focus on the development of these frameworks and how they can inform capital requirements. Firms will be expected to make further progress in this regard.”

It added current evidence suggests that the existing time horizons over which risks are capitalised by banks and insurers are appropriate for climate risks. Therefore, there does not appear to be sufficient justification for regulators, including the Bank, to make a policy change to these time horizons.

“Further work is needed to assess whether there may be a regime gap in the macroprudential framework,” the Bank added. “Any use of macroprudential tools would need to be assessed carefully against how well they mitigate climate risks, their behavioural impacts, and the potential for unintended consequences.

“Calibration of macroprudential tools would also be challenging given uncertainties around climate risks and the need for them to help facilitate an orderly transition to net zero. The Bank will explore the nature and materiality of such regime gaps as part of its ongoing policy work and consider whether action to address them would be appropriate.”

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