The opinions expressed here are those of the authors. They do not necessarily reflect the views or positions of UK Finance or its members.

This blog is co-written by Michael Lutterodt, Banking & Markets Senior Partner, Silvia Amoros, Banking & Markets Senior Partner and David McNamara, Insurance Partner, Robert Brack Insurance Partner at Davies.

According to the World Meteorological Organization, the January-September 2024 global temperature was 1.55^oC above the 1850-1900 average and 2015-2024 were the warmest ten years on record.

As well as their impact on the individuals affected, significant weather events related to global warming bring substantial financial impact too. The Southern Californian Wildfires earlier this year, for example, resulted in over 16,000 structures being destroyed. Insurers estimated insured losses of between $28bn and $75bn, with total economic damage potentially reaching $275 billion, making it the most costly disaster in US history.

The impact of these disasters is far-reaching, and the financial sector is certainly not immune. Financial organisations can suffer direct impacts, such as when weather events damage assets. They can also suffer more indirect impact, for example, moving to a low-carbon economy can cause risks such as policy changes (for instance, a reduction of subsidies for green investments could result in stranded green assets). 

Since financial organisations touch so many aspects of life, there is a wide-reaching ripple effect to the impact of climate change as the sector is impacted by the organisations it interacts with.

The Financial Stability Board (FSB) recently published its Climate Vulnerability Framework which offers a framework and analytical toolkit to assess the build-up of climate-related vulnerabilities and examines how climate risks could impact the global financial system.

Climate shocks

A climate shock is a sudden climate-related event that causes a significant impact. As well as natural disasters such as floods, droughts or windstorms (physical risks), they can also come from abrupt changes in policies, technological innovation and/or consumer preferences (transition risks).

Climate shocks impact the financial system through transition risks, physical risks, or both, and the severity of that impact depends on whether they are anticipated, where the risks occur and how they are managed. Whilst it’s difficult to assess the impact of climate shocks – because nothing like climate change has happened before and there’s nothing similar to base it on – we know that the effect of poorly managed risks will likely reverberate throughout the financial system.

Considering the impact of climate shocks on the insurance market, AIG’s Group CEO recently noted a continued trend of high attachment points and primary insurers’ absorption of a large majority of natural catastrophe losses. He reflected that higher reinsurance retentions and increased losses have led to more risk retained by primary insurers and predicted that 2025 could be the year for $200 billion in insured catastrophe losses. 

Broadly speaking, as climate-related risks become more pronounced, insurers may face higher costs to ensure solvency against potential claims arising from climate events – and these costs could be passed onto customers. 

With these trends in mind, insurers are likely to recalibrate premiums, especially in high-risk areas, to reflect the true cost of coverage and may even withdraw from certain exposed locations, leading to protection gaps. 

If we take the property insurance market in particular, the market is already undercapitalised, and a large climate shock will likely drive further market destabilisation and systemic economic effects, both within and outside of the market. CAT (catastrophe) exposed property is the key emerging risk in property insurance, with the compounding impact of climate change and more of the population shifting to exposed areas. This impacts both personal and commercial property carriers, primary and residual lines markets.

The framework

The FSB’s Climate Vulnerability Framework traces how physical and transitional climate risks could be transmitted to and amplified by the global financial system. It also includes some metrics that can be used to monitor climate-related vulnerabilities.

Risks that the framework explores include: credit risk, market risk, liquidity risk, and underwriting risk. Let’s look at two of those types of risks in more detail, to show how the framework captures cross-sectoral impact among FS firms:

• Credit risk transmission:
  • Banks: Banks may experience increased credit risk as borrowers in climate-sensitive sectors face financial difficulties due to climate-related events or regulatory changes.
  • Insurers: Insurers could encounter higher underwriting risks if they insure entities in these sectors, leading to increased claims and potential solvency concerns.
  • Investment Funds: Investment funds holding assets in these sectors may see asset devaluations, affecting their portfolios and potentially leading to liquidity challenges.
• Liquidity risk transmission:
  • Banks: Banks may experience liquidity challenges if climate-related events lead to a surge in loan defaults or if they hold significant assets in affected sectors.
  • Insurers: Insurers might face liquidity issues if they must pay out large claims following climate events, especially if they lack sufficient reserves.
  • Investment Funds: Investment funds could encounter liquidity problems if they need to sell assets in a depressed market to meet redemption requests, potentially realising losses.

Within the framework, the FSB has developed an analytical toolkit containing three high-level categories of metrics: proxies, exposure metrics and risk metrics, to assess and monitor climate-related vulnerabilities. It includes indicators on vulnerabilities in the financial system that could interact with climate shocks; metrics that trace their transmission, and their potential amplification within the financial system and economy.

Why it’s important

As the fight to slow down climate change continues, climate vulnerability is an important topic that needs more attention. With the world continuing to warm up, greater impact will be felt by the world’s financial institutions.

The FSB’s work is valuable in trying to anticipate how climate change will impact the financial world and ensure we are as prepared as possible and that we can minimise the consequences. For example, data gaps identified as part of the FSB’s vulnerabilities work could provide input to international initiatives to quantify the impacts of climate change. For the insurance sector, by evaluating direct and indirect exposures to climate risks, insurers can better understand their potential liabilities and adjust premiums accordingly.

It is more important than ever that financial institutions are aware of the potential risks and ensure they are planning as effectively as possible. After all, by understanding the scale of challenge, we can surely be far better prepared to meet it.