Insurance, Risk Financing, and Development
Mark Carney is an economist and banker. He holds Canadian, British and Irish citizenship and is the current Governor of the Bank of England.
Mark Carney, the outgoing governor of the Bank of England, has accepted the role to be Boris Johnson’s finance advisor for this year’s COP26 climate change conference which will be held in Glasgow in November 2020. The conference will discuss “ambitious ways in which the world can lower emissions to keep global temperatures below 1.5 degrees of warming.” Recently, Carney spoke at event in New York on the subject of ‘Insurance, Risk Financing and Development’. Modern Insurance reports on the key points.
Mirroring the theme to be discussed at COP26, Mark Carney spoke about the role of insurance in smoothing the transition to a 1.5-degree world. “This sector brings three things: expertise, money and perspective and those are all crucial in helping society adjust to the reality of that transition.” He continued, “And my message is, whether it’s reducing the protection gap, financing resilient infrastructure or improving reporting, risk management and return optimisation across the financial sector, the insurance industry has a unique contribution of over $30 trillion of large capital, deep risk management expertise and long-term perspective.”
Carney said that insurers are well aware that the physical risks of climate change are being felt across the globe with a plague of extreme weather events. “The human costs are immeasurable,” he said. “The financial losses, however, can be measured and they are significant. Insured losses in 2018 were $80 billion, double the inflation-adjusted average for the past 30 years.”
Protection gaps in low and middle-income countries meant that even greater costs were being borne by the uninsured, Carney said, and in 2017 the record $140 billion of insured losses were eclipsed by an additional $200 billion of uninsured ones. In some of the countries most exposed to climate change – Bangladesh, India, Vietnam, Philippines, Indonesia, Egypt, and Nigeria – insurance penetration is under 1%.
Carney emphasised that the potential economic benefits of closing the insurance gap are striking. He said: “Lloyd’s of London estimates that a 1% rise in insurance penetration can translate to a 13% reduction in uninsured losses and over 20% reduction in disaster recover burden on taxpayers. Substantial macroeconomic benefits include increased investment, higher output, potentially up to 2% of GDP, and greater climate resilience.”
Despite this prize, progress is proving stubbornly slow, Carney said, and over the past 30 years, the gap has narrowed by only from 78% to 70% globally, underscoring the importance of the Insurance Development Forum’s (IDF’s) work.
“Insurers are well aware that the physical risks of climate change are being felt across the globe with a plague of extreme weather events”
The role of insurance for adaptation and resilience
When asked what should be done, Carney said both sides of insurers’ balance sheets needed to respond. He stressed that on the liability side, the focus must be reducing the protection gap and supporting the resilience of households and companies to growing climate risks. He said: “Better understanding of past losses can obviously help. Projects like the open-source Oasis Loss Modelling Framework of the IDF are leveraging the expertise of the private sector, the public sector, and academia, to improve the data available for risk analysis in low and middle-income countries.”
He emphasised that new products, such as insurance-linked securities based on parametric triggers, are vital to helping reduce macro protection gaps and increase resilience. These are generally cheaper to structure and administer and more efficient to blend with commercial finance if required, he said. “Of course, increasingly climate-related tail risks could prove uneconomic for private-sector insurers to cover. That is where development agencies and Multilateral Development Banks can step in. Disaster reinsurance could be one of the most effective uses of development financing.”
On the asset side, infrastructure investments will be essential. And to transition to net zero, all countries need to step up their investments in sustainable energy. “The reality of climate change also means that all countries, but particularly developing and emerging economies, will need to invest in new climate-resilient infrastructure in order to adapt to the new realities of a hotter and more volatile climate.”
There are various estimates, all enormous, ranging between US$70-90 trillion over the next decade, three-quarters of which are in emerging and developing economies, so it’s imperative to act now, Carney said, to create practical tools and frameworks to support climate-resilient infrastructure investments, ranging from broader use of catastrophe bonds to greater risk pooling for the most vulnerable countries.
“Climate-resilient infrastructure assets are well suited to life insurers that need reliable returns over long-term investment horizons. This is even more compelling in a low-for-long interest rate world. However, as the IDF infrastructure has flagged, at present only 2.5% of insurance assets managed are allocated to infrastructure.”
The world needs much more investment in infrastructure, and greater risk-sharing of climate risks, said Carney. “Insurers have a unique ability to meet both needs. In this context, the impact of regulation on the provision and cost of infrastructure finance must be carefully considered. As World Bank studies have shown, there is evidence that infrastructure debt can be a lower risk as it has more predictable and stable long-term cash flows and has a low correlation to other assets.” He added that the historical default experience of infrastructure debt suggests a ‘hump-shaped’ credit risk profile, which converges to investment grade quality within a few years after financing has closed.
However, such robustness is not reflected in the standardised approaches for credit risk in most regulatory frameworks, according to Carney, and the World Bank study suggests that capital charges could decline significantly for a differentiated regulatory treatment of infrastructure debt as a separate asset class. He said: “Now, the International Association of Insurance Supervisors (IAIS) is reviewing the data sources and gaps and considering the risk case for a differentiated capital treatment for infrastructure under the global Insurance Capital Standard – ICS 2.0.”
Carney stated: “We also need to develop the conditions to make infrastructure assets more readily investable and more easily tradable. Under the Argentine G20 presidency last year, with support from the World Bank and OECD, the G20 designed a roadmap to make infrastructure a more coherent asset class. The foundation is greater standardisation through greater commonality in terms, conditions and financial frameworks. This allows the assets to become easier to invest in, easier to insure, and project risks to be better managed.”
In Carney’s opinion, data on the input and impact of infrastructure projects can also be improved. “For instance, data on project phases would allow comparisons across construction phases of infrastructure versus non-infrastructure assets”, he said. “And information on the types of concessions and licenses offered in different regions are important as they determine the kinds of revenue arrangements for infrastructure projects, which ultimately influence cash flow stability, critical information for investors. The IAIS is developing a workplan to examine these data gaps in the coming year.”
Reporting, risk management and return
Turning to mainstream investing, Carney said that changes in climate policies, technologies and physical risks in the transition to a net zero world will prompt reassessments of the value of virtually every asset. The financial system will reward companies that adjust and punish those who don’t, he said, and insurers can be highly influential in bringing the realities of climate change into mainstream financial decision-making.
To do so, he said, there needs to be a step change in three areas: reporting, risk management and return.
Carney said that better corporate disclosure of climate-related financial risks is essential and the next few years will be decisive. On the demand side, current supporters of the Task Force on Climate-related Financial Disclosures (TCFD) are responsible for assets totalling $120 trillion and include the world’s globally systemic banks, top 10 global asset managers, leading pension funds, and insurers.
“Not surprisingly, supply is responding,” Carney said. Users of capital are providing increasingly sophisticated decision-useful information. Four-fifths of the top 1,100 G20 companies surveyed in a recent TCFD report are now disclosing climate-related financial risks in line with the recommendations.”
Carney suggested that now is the time to get involved. The IAIS and UN Sustainable Insurance Forum are monitoring developments in disclosures closely: with a systematic survey of TCFD adoption by insurance firms and they will be publishing a paper on this early next year, including recommendations for any changes. The Climate Change Research Initiative (CCRI) will do the same.
The next step, according to Carney, is to make these disclosures mandatory. “The UK and EU have already signalled their intents. But it’s time for every country to get involved because the world won’t get to net zero if the financial sector doesn’t know how our companies are responding. To watch we must be able to see. And over the next two years, the current process of disclosure by the users of capital, reaction by the suppliers of capital, and adjustment of these standards, will be critical to ensure that the TCFD standards are as comparable, efficient and as decision-useful as possible.”
“Insurers have responded by developing their modelling and forecasting capabilities, improving exposure management, and adapting coverage and pricing”
Carney went on to say that with better information, the frontier will be to upgrade risk management and optimise returns. “As the supervisor of the world’s fourth largest insurance industry, the Bank of England knows that general insurers and reinsurers are on the front line of managing the physical risks from climate change.” He added that insurers have responded by developing their modelling and forecasting capabilities, improving exposure management, and adapting coverage and pricing. “In the process, insurers have learned that yesterday’s tail risk is closer to today’s central scenario.”
He continued: “And leading insurers also understand that the breadth, magnitude, and foreseeable nature of climate risks, mean the biggest challenge will be to assess the resilience of firms’ strategies to transition risks. That’s why, the Bank of England set out our supervisory expectations for banks and insurers regarding their governance, risk management, strategic resilience and disclosure of climate-related financial risks. And in June 2019, the Bank announced that we will be the first supervisor to stress test our financial system for resilience against different climate transition pathways, ranging from early and orderly to late and disruptive.” The test, Carney insisted, will motivate banks, insurers and asset managers to address data gaps and to develop cutting-edge risk management approaches consistent with a range of possible climate pathways.
“The Bank will develop the approach in consultation with industry, including best practice insurers, and other informed stakeholders including experts from the Network for Greening the Financial System and the PRA’s Climate Financial Risk Forum.”
Carney next addressed the increasing evidence that sustainable investment can generate excess returns, particularly for investors, like insurers, with longer term horizons. One of the biggest hurdles to channelling mainstream finance to sustainable investment, he said, is the inconsistent definition and measurement of environmental, social and governance (ESG) criteria. “An agreed taxonomy would allow markets to understand better where there is real outperformance and direct investments accordingly.”
He said: “The EU’s Green Taxonomy and the Green Bond Standard are good starts but they are binary, dark green or brown, and don’t account for progress from brown to green – progress that could make a significant contribution to our climate goals. However, one possible solution, as recommended by the UN’s Climate Financial Leaders Initiative, could be the development of transition indices which track companies in high-carbon sectors that adopt low-carbon strategies. Such approaches are essential for our citizens to make sure their money is being invested in line with their values.”
Ultimately, the speed with which the new sustainable finance develops will be decided by the coherence and credibility of countries’ climate policies, Carney said. “Finance will complement, and potentially amplify these initiatives, but it will never substitute for climate policy action. The 20 countries, including the UK, that have plans to legislate for net zero show what can be done. And if countries build their track records, their credibility will grow, and the market will allocate capital to deliver the necessary innovation and growth and pull forward the adjustment to a low carbon future.”
Carney concluded: “The more prolific the reporting, the more robust the risk management and the more widespread the return optimisation, the more rapidly the insurance sector can build resilience while promoting the transition that our citizens demand.”
“The financial system will reward companies that adjust and punish those who don’t, he said, and insurers can be highly influential in bringing the realities of climate change into mainstream financial decision-making”