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How Climate Change Poses Risks for Banks and Insurers

In 2010 the Securities and Exchange Commission passed a rule requiring publicly traded companies to report their corporate risks from climate change. CERES, a non-profit organization that tracks this disclosure prepared a report cited in a 2014 Wall Street Journal article that concluded that climate-related disclosures by S&P 500 companies are terse, provide little discussion of “material” issues and fail to quantify impacts or risks. As a result, the report urges the SEC to strengthen the implementation of its guidance.

So what do climate change and these disclosure requirements mean for banks and insurance companies? Will they affect the lending and investment approaches and the risk management procedures of these institutions?

How Climate Change Concerns Affect Bank and Insurance Company Operations

For banks and insurance companies, corporate risk from climate change is different from the risk posed by owned or leased properties.  Many of the physical risks, such as storms, droughts, cold, flash flooding, wildfires and landslides, are the same for both institutions.  To banks, these pose a threat both to their borrowers and investments.  To the insurance companies they are both a claims risk and an investment risk. The risks apply not only to the direct borrower, insurance or investment, but also to their supply chains, further increasing the potential damage it may cause to these organizations’ success and profitability.

A great article that covers much of the risks for banks and insurers is Investing in Extreme Times , which states that “the world is hurtling toward a climate change crisis and any serious global effort to prevent it will render a good chunk of recoverable oil reserves essentially unburnable.”  It further argues that other climate-related risks investors must consider include the fact that “increasing frequency of severe droughts and 100-year storms are indeed correlated with—and most likely caused by—rising temperatures. (…) Everyone will feel the impact, particularly the poor, as weather extremes become more common and risks to food, water, and energy security increase”.

The Vulnerability of Banks

Boston Commons Asset Management has published a report titled Financing Climate Change: Carbon Risk in the Banking Sector”, which notes that: “Banks are connected to every market sector, making them uniquely vulnerable to the economic and political uncertainty caused by climate change. There is no specific requirement for banks to disclose climate risks, although as public companies they do fall under the SEC 2010 rule mentioned above.  To date, investors have little public data to help them see potential risks buried in their portfolios and to accurately assess a bank’s climate change management strategy.

For banks, potential risks in their portfolios caused by climate change include business interruption, legal and reputational implications of investment and loan pricing.  The EPA has issued new emission criteria which could have a financial impact on the fossil fuel and electrical generation sectors.  Both industries are fighting this, and along with politicians joining in the debate, this is creating uncertain costs which mean banks need to be cautious about lending to and investing in major emitters of greenhouse gases.

To address these risks, banks should consider establishing an advocacy within their corporate hierarchy (both at board and management levels) for social and environmental issues.  A number of major banks, including Wells Fargo and Deutsche Bank, have committed to this in their corporate policy statements.

The Risk to Insurance Companies

What makes climate change risk different for insurance companies is their premiums, which are traditionally calculated on actuarial tables of prior events. For climate change risk, this evaluation must look at future future events to have appropriate premiums. The Bank of England has begun calling on insurance companies to report the impact of climate change on their claims history.

It’s important to note that the property and liability insurers in the US rely on Federal Emergency Management Agency (FEMA) Flood Zone maps for determining flood insurance premiums in their policies.  While FEMA is in the process of creating Coastal Flood Hazard Maps, these seem to use the data from recent storms. It’s not clear that an effort is being made to incorporate forward thinking about sea rise.

In an article “Responding to Climate Change, the Insurance Industry Perspective” Dr. Evan Mills of Lawrence Berkeley National Laboratory writes “With core competencies in risk management and finance, the insurance industry is uniquely positioned to further society’s understanding of climate change and advance creative solutions to minimize its impacts. Insurers have now begun to embrace this huge opportunity, which will enable them to prosper while reducing the claims from climate change.”

Ceres published a report which discusses activities commonly used by insurers to address climate change risk. ‘Promoting loss prevention’ was a tactic used by 27% of the companies surveyed. ‘Innovative insurance products’, ‘building awareness and participating in public policy’, ‘leading by example’ and ‘carbon risk disclosure’ were used by between 35% and 39% of insurers.  As stated in a report by the Geneva Association, the most important take-away for the insurance industry is that “the old approach of analyzing historic data to predict future risk is inadequate.”

An assessment of greenhouse gas emissions and energy consumption (such as a building energy audit and benchmarking) can help quantify and understand the impact of these issues on your property, portfolio or operations. Banks and insurance companies should seek advice from a climate change consultant on how to best manage the broader aspects of climate change risks, such as droughts, storms, food supply and related impacts.