UK BoE climate stress test is toughest yet

The UK’s latest supervisory climate stress test for banks and insurers is the world’s toughest yet, Fitch Ratings says, with some institutions’ capital ratios under the 30-year scenarios likely to fall close to, or even below, regulatory minimums.

However, the results, published by the Bank of England (BoE) on 24 May, should not trigger undue investor concern because they will not be used to set capital requirements.

Instead, the BoE and the participants will use the results to assess vulnerabilities to climate risks, understand the challenges to their business models, and enhance their risk management of climate-related financial risks.

According to Clyde & Co legal director Wynne Lawrence: “The Bank of England’s assessment is that insurers still need to do much more to understand and manage their exposure to climate risks. The findings will help the UK’s financial regulators shape future regulation.

“Other jurisdictions are looking to the UK’s leadership in this space, so the results should also be of interest internationally to corporates and their advisors working on climate risk management.

“The CBES exercise has highlighted how important it is for insurers and banks to move in lockstep with their counterparties across the economy in transitioning to net zero.

“That is going to require concerted and predictable policy action that is clearly communicated and disclosure of clear metrics and standards of green and climate-resilient products and investments.”

Nigel Brook, partner, Clyde & Co added: “The Bank is actively considering the use of capital requirements to address climate-related financial risk faced by insurers and banks. Particularly in light of the Bank’s feedback on the results of this first CBES, assessing climate risk is now a priority for UK insurers.

Firms expected to transition

The BoE test is tougher than last year’s French climate test. It assumes higher peak carbon prices and greater global warming, and it limits credit for the management actions that firms could take to mitigate the effect of the scenarios on their business models.

In practice, firms are likely to adjust their asset and liability profiles significantly over time to reduce their exposure to transition and physical risks.

Consequently, regulatory capital breaches under the BoE scenarios do not signal that breaches in reality are likely.

Non-life insurers and reinsurers are exposed to physical risk through property and catastrophe losses, which are becoming more frequent and severe due to climate change.

The severe design of the BoE test brings forward the full climatic effects of each scenario as an instantaneous shock, which makes it likely that some insurers will breach their solvency ratios.

”In practice, we expect insurers to reprice their business and to steer their investment portfolios towards lower-risk sectors to reflect changing circumstances, and we believe they would be fairly resilient to the BoE scenarios if such management actions were taken into account,” notes the rating agency.

Climate stress tests are becoming more mainstream for banks and insurers around the world as supervisors become increasingly aware of the urgency in gauging the risks from climate change.  

The UK Prudential Regulation Authority will report by end-2022 on whether changes to the UK’s regulatory capital regimes may be required to explicitly capture climate risks.