Breaking down the Bank of England Prudential Regulation Authority’s guidance on the management of climate-related risks for UK insurers

What does PRA’s guidance mean for UK insurers’ investment, risk, and sustainability teams?

The PRA has stated that while climate risks are uncertain in both scale and timing, they are foreseeable to some extent. It notes all firms, no matter the size, may be significantly exposed to these risks, with the magnitude of the impact being particularly influenced by an institution’s business model and the geographical concentration of its balance sheet.

From a UK insurer’s total balance sheet perspective, it is important for investment, risk and sustainability teams to understand how the geographical distribution of assets within the investment portfolio shapes the insurer’s exposure to climate-related risks, as well as how physical climate risks could increase policy payouts, challenge insurability, and affect solvency ratios.

Assessing and managing climate risk exposure in line with PRA expectations

While an assessment should be undertaken irrespective of the size of the insurance company, the PRA expects insurers that are materially exposed to climate-related risks to make a greater investment in monitoring and managing those risks than firms that are less exposed. As climate risk is systemic, all insurance companies are expected to fall into this category, requiring them to place greater focus on establishing effective climate risk management frameworks to assess the resilience and vulnerabilities of their business model, including investment strategies.

For insurance companies with material exposure, the PRA states that climate scenario analysis is a key tool for identifying, quantifying and managing climate risks, and for conducting internal assessments for capital adequacy – Own Risk and Solvency Assessment (ORSA). This reflects the fact that the characteristics of climate-related risks make it impossible to rely solely on historical data and experience, which is generally the approach used to evaluate traditional risks such as inflation and interest rate risks.

The PRA further advises that assessments should be proportionate to the scale of the risks and their proximity, considering both time horizon and likelihood. For risks expected to emerge over a longer time horizon, narrative-based scenarios should be employed.

Additional guidance on climate scenario analysis

The PRA also emphasized a number of key focus areas for insurers.

PRA guidance on managing physical, transition, and market-related risks

The PRA has also elaborated further on how insurers should specifically approach physical, transition, and market-related risks.

• Physical risks: Assessments should be geographically granular enough to capture changes in the frequency and intensity of (acute physical risk) extreme weather events as well as long-term shifts in precipitation and average temperatures.
• Transition risks: Insurers should assess exposures with sufficient sectoral detail to capture risk dynamics and severe impacts, and account for concentrations in transition-sensitive sectors, such as fossil fuels.
• Market risks: Insurers should recognize that future returns may be more volatile than historical experience due to climate risks, with variations across sectors, subsectors, or regions. They should also understand how traditional financial models, such as Economic Scenario Generators, account for climate-related risks.

How can Ortec Finance’s climate scenario analysis and asset liability management capabilities support UK insurers in adhering to the PRA’s guidance?

Ortec Finance has developed proprietary climate scenarios specifically for investment decision-making, helping insurance companies to measure, monitor, and manage portfolio climate risk, with results that can be integrated into traditional risk analysis and asset-liability management (ALM) platforms.

Looking ahead: Harnessing available tools and scenarios to align with the Bank of England’s expectations

Selecting the right climate scenarios, which allow quantified assessments of climate risks and can be integrated with traditional risk assessments, is essential for insurers to incorporate the Bank of England’s climate expectations into their risk management frameworks and to address their implications across the entire balance sheet.

Ortec Finance offers insurers an integrated economic and climate risk management tool through its proprietary GLASS asset-liability management software and ClimateMAPS – a climate scenario analysis solution. GLASS utilizes economic scenarios that incorporate climate change and works in combination with ClimateMAPS’ narrative-based climate scenarios to explore a wide variety of potential climate-related economic and financial market impacts. Together, they provide one of the most comprehensive risk management tools available to institutional investors globally.