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ECONOMY| 17.11.2022

How climate risk impacts the financial system

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The United Nation’s annual climate summit, known as COP27, looks set to end on a grim note: global greenhouse gas emissions must be cut by 43% before the end of 2030 if we are to avoid environmental disaster.

This threat affects everyone, and the finance sector is no exception, and its impact can be seen at credit, reputational, operational and market levels. As far as insurance companies are concerned, extreme climate events could cause a drop in insurance coverage. For banking, this results in a higher probability of default by both families and businesses, as well as less collateral to secure loans. It also affects asset prices and volatility, in addition to reducing borrowers’ capacity to pay.

Both insurance companies and banks have a lot to lose. The International Association of Insurance Supervisors’ last global report, published in 2021, shows that more than 35% of insurance companies’ investment assets (including shares and corporate debt, loans and mortgages, sovereign bonds, and real estate) could be considered to have “climate relevance”, meaning they are exposed to climate-related risks, the majority of them related to their counterparts in the housing and energy-intensive industries. The report also pointed out that insurance companies are doubly exposed because they underwrite risks and invest in assets that could be affected by climate change.

Ricardo González García, director of Analysis, Sectorial Research and Regulation at MAPFRE Economics, explains that the effects of climate change are causing natural disasters to become more frequent and severe. Estimates generally indicate that these secondary risks make up over half of insured losses from natural disasters, and in 2021 they notably represented over 70% of all the insured losses from these types of events. According to data from Swiss RE, global economic losses attributable to natural disasters were estimated to be approximately 270 billion dollars in 2021, 53 billion more than the previous year. Total insured losses rose to 119 billion dollars, the fourth-highest amount for a single year, as per the data available.

In addition, the European Central Bank (ECB) recently warned banks that if they don’t address financial risks stemming from climate change, they’ll face greater capital requirements and fines, which would lead to heightened pressure on the system. In July of this year, the ECB, led by Christine Lagarde, calculated that banks could face a negative impact of 70 billion euros due to the increasing frequency of extreme weather events. In addition, according to the European regulator, nearly two-thirds of the revenue that the sector generates through non-financial corporate customers stems from greenhouse gas-intensive industries, which will likely make the transition towards a low-carbon economy more scattered.

Among the challenges that the finance sector is facing is the war in Ukraine, which has affected investment in ESG funds. The latest report published by the Joint Committee of the European Supervisory Authorities (EBA, ESMA, and EIOPA) indicates that ESG bond issuance fell 29% from the beginning of the year to June, in comparison with the same period in 2021. On the bright side, issuance by European companies remained steady, which was mainly thanks to growth in the sustainability-linked bond market.

How can we combat climate risk?

To fulfill its climate change mandates, the European Union designed the Regulation on sustainability-related disclosure in the financial services sector (SFDR), with the aim of improving the transparency and standardization of financial products in the environmental area. The taxonomy Regulation was also created, establishing a list of economic activities that can be considered environmentally sustainable based on six environmental objectives. Though a very important measure, it has also become the most controversial one this year, as Brussels moved to label nuclear energy and gas as green activities.

Meanwhile, the European Council reached an agreement on amendments to the Solvency II directive in June, underlining the insurance and reinsurance industry’s role in contributing to the achievement of the Capital Markets Union and to the financing of the green and digital transitions. As regards the role of the European Insurance and Occupational Pensions Authority (EIOPA), the Council assigned the body the task of preparing a risk assessment report related to biodiversity loss by insurance companies, along with natural disasters and climate-related risks, in line with the European Green Deal, as well as asking it to define consistent guidelines for the national standards followed by insurance companies assessing their macroprudential risks, i.e., risks affecting an entire sector or the economy as a whole.

Furthermore, in 2021 the Institute of International Finance proposed that prudential authorities should consider both the microprudential objective of resilience and the macroprudential objective of examining the alignment of the financial system with future climate pathways. The Institute recommended using standardized metrics to quantify the impacts of different risk scenarios in July of this year.

At corporate level, within the framework of its Strategic Sustainability Plan 2022-2024, and under the concept of #PlayingOurPart, MAPFRE has committed to contributing to decarbonizing the economy, aiming to achieve carbon neutrality by 2050, i.e., zero net emissions in its insurance and reinsurance underwriting portfolios. To achieve this goal, MAPFRE promotes agreements, products, and services to reduce energy consumption and its carbon footprint, and it has made public commitments in relation to not insuring or investing in coal, gas, or oil companies that do not have an energy transition plan in place.

MAPFRE is also committed to developing a range of socially responsible investment (SRI) products that in addition to generating attractive returns for the customer, have a positive impact on society. For its part, MAPFRE Asset Management, the insurer’s asset manager, has several funds on the market that specifically conform to the new regulation on sustainability-related financial disclosure (SFDR), as well as other sustainable investment products, such as the infrastructure fund that was launched with Abante, or investments made in renewable energy alongside Iberdrola.

From 2019 to 2021, MAPFRE reduced its emissions by 20%, and also cut more than a million tons of investment-related emissions. According to Javier Miralles, Equity Portfolio Manager at MAPFRE AM, this figure “is likely to improve in the future and demonstrates the company’s commitment to combatting climate risk.”

New challenges for the insurance industry

According to González García, insurers already have models in place for calculating insurance prices, but if significant variations occur due to changes in the behavioral patterns and severities of these events, there may come a time when coverage will be so costly that it will disappear from the market, or turn into non-insurable risks due to a lack of reliable pricing information.

In any case, there is a considerable protection gap against certain specific events, as in the case of flooding. It’s estimated that over the past 20 years, insurance has only covered 7% of total economic losses resulting from flooding in emerging markets and 31% in advanced economies. In cases that cannot be covered by insurance, there are normally other types of mechanisms available based on government assistance or public-private partnerships that try to alleviate damage suffered by the population to some extent. Against this backdrop, González García recognizes that “there is still much to do, and insurers have a lot of knowledge and infrastructure they can contribute to help make these types of formulas accessible and combat the challenges ahead.”