On Monday 13th March, the Bank of England (BoE) published a report setting out its latest update following up on the call for papers issued ahead of the October Climate and Capital conference, the conference itself, and additional internal work from the PRA. This report does not set out any policy changes but rather describes the Bank’s latest thinking on climate-related risks and regulatory capital frameworks and areas of future work. The report notes that although some insurers and banks have made significant progress in embedding climate risks within risk frameworks, the level of progress varies, and all firms need to make further progress. The Bank also noted that better, more effective risk management controls within firms are likely to reduce the amount of capital required for future resilience.
On specific capability gaps, this report provides limited additional information on capability gaps when compared to the PRA’s October 2022 Dear CEO letter, but rather calls for more research / analysis from the academic and corporate communities, as few submitted papers ahead of the October Climate and Capital conference tackled the challenges of incorporating climate risks into capital frameworks. The BoE notes in its paper that “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”.
On regime gaps, based on all the analysis / thinking to date, the BoE’s current thinking is that the modelling of climate risks requires more reliance on forward-looking approaches to capital setting than other risks, which will include more use of stress and scenario testing. However, one of this report key conclusions is that, based on evidence provided to date, the time horizons currently used in capital setting are appropriate for climate risks, therefore a change to this component of the capital regime is presently unlikely.
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Firms should expect continued engagement from the PRA on climate risks and may find that the bar to meet continues to raise as engagement progresses. Firms should continue to work on their capabilities for the identification, measurement, and management of climate risks, and be ready to demonstrate how this work is being embedded within their risk framework. Senior managers and board members should therefore continue to both dedicating meetings on this topic, as well as preparing to answer climate-related questions in regular supervisory meetings.
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Any future change to the regulatory capital regime is more likely to be an evolution rather than a revolution. The report noted that the use of stress and scenario testing will be key in managing climate-related risks, more particularly in informing their calibration. Stress and scenario testing is already a prominent risk management tool within the Own Risk and Solvency Assessment (ORSA). The latest confirmation from the PRA that current capital regime’s time horizons (e.g. one year SCR) are appropriate will be welcomed news for firms.
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As a consequence of the above, firms should continue to invest in their stress and scenario testing capabilities to improve their understanding, managing and modelling of climate risks, which may lead to a reduction in capital requirements in the future.
We expect firms that invest in understanding their exposure to climate risks, and in adequate capability to model that exposure under a range of scenarios, will experience better outcomes in the capital regime as well as easier conversations with the regulator. Developing and improving these tools will also result in a more holistic understanding of risks taken which in turn could lead to a better offering to policyholders, and improved financial results.
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With the Bank’s focus on firms making progress to address ‘capability gaps’ to improve identification, measurement, and management of climate risks, it is imperative that insurers continue to adapt and enhance Exposure Management methods for risk assessment and management purposes.
David Singh, Head of WTW’s Exposure Management and Climate Risk states that “similar to ESG (Environmental, Social and Governance), insurers need to embed Exposure Management in many aspects of their vision and strategy to support underwriters.
This ensures that risk assessment methods and inhouse expertise is continually assessed for appropriateness based on current and forward-looking views of risk”. Linking longer term time climate considerations in risk management frameworks can provide a step change to managing climate risks. Singh further states that “only reverse engineering out longer term assessments of capital and portfolio targets inc. the transition to net zero, can help address the challenges of climate risks today.
WTW can support firms in building, implementing, and embedding climate risk management within firms’ wider risk management frameworks. WTW has worked with a wide range of insurers across the industry to develop climate risk management approaches which capture the uniqueness of this risk, and how it impacts other traditional risk categories.
The WTW approach ensures consistency with the wider risk management framework, rather than being an isolated ‘bolt-on’. WTW also ensures that the approaches are embedded across the business, leveraging existing resources and specialisms across the 3 lines of defence to deliver forward-looking and efficient risk management.
WTW has worked with a range of insurers to develop, implement, and embed climate risk management approaches. WTW can leverage this experience to assist insurers in understanding how their current approaches compare with the wider market and provide actionable, practical recommendations to reach best practice.
WTW is a strong contributor to research and regulatory consultations in this area, and we are continuously developing our offering to clients to ensure they remain at the forefront of strong risk management.
As approaches to modelling climate risks develop, and as noted in the BoE report, stress and scenario testing is likely to be a key component of the capital setting process for climate risks. We expect firms’ management teams and Boards will want to understand how climate risks may impact the firm’s capital requirements in the near future and the longer term.
As an industry leader in capital modelling and having worked with a wide range of insurers in developing robust capital models, WTW can support firms in incorporating climate stress and scenario testing into capital models to understand how the capital position may be impacted based on a range of transition scenarios and emissions paths. We will work with clients in selecting and refining appropriate scenarios which are plausible and relevant to their risk profile (which would include leveraging climate scenario analysis performed in other parts of the business), and use the results from this scenario analysis to inform management and the Board on the likely impact of climate risks on their capital requirements and capital setting processes, as well as provide practical recommendations for further refinements with the view of, where appropriate, reduce capital requirements held in respect of climate risks.
WTW can support firms in developing appropriate climate scenarios, which reflect their risk profiles, and leverages WTW’s industry expertise and academic research to ensure plausibility, timeliness and usability.
WTW has a team of climate experts whose combined expertise covers all business and risk areas, and has access to the right, latest data and technology to support both the parameterisation of climate scenarios and the implementation of those in a way that minimise internal changes by adapting to the firm’s business structure and risk management processes, and provides meaningful value-add to clients.
