Increasing flood damage is correlated to reduced asset valuations and therefore increases the probability of default to lenders. Regulators including the Prudential Regulation Authority (PRA) are increasingly concerned about increasing credit risk i.e. counterparty risk to banks and building societies specifically for residential properties mortgages due to increasing flood damage caused by future climate risks.

This is set out in the PRA’s Supervisory Statement in which there is an expectation for firms to address the financial risks from climate change through their existing risk management frameworks, in line with their board-approved risk appetite, and whilst recognising that the nature of the risks requires a strategic approach.

As outlined in the newly published Ambiental whitepaper there are now some good methodologies for modelling risks using both qualitative and quantitative approaches using scenario analysis. Scenario analysis helps to evaluates a range of hypothetical outcomes by considering a variety of alternative plausible future states (scenarios) under a given set of assumptions and constraints.

Flood risk can be modelled using discrete scenarios at probabilities associated with Low, medium and high emissions, over different future horizons across different layers of flooding. Both the Task Force on Climate-related Financial Disclosures (TCFD) and regulators have made clear that that scenario analysis should be conducted to understand the strategic implications of climate-related risks and opportunities

The main benefits of undertaking more detailed risk assessments using climate flood model to project losses for various climate scenarios outlined include:

• Improved understanding of physical risks from increased frequency and severity of flooding over extended time horizons
• Enhanced risk management of credit risk and concentration exposures of mortgage default risk due to reduction in value of assets correlated to impacts from climate change
• Increased regulatory compliance, aligning with the requirements of the with Prudential Regulatory Authorities (PRA) supervisory statement SS3/19 on managing financial risks from climate change.

In respect to risk mitigation techniques and use of insurance there is increasing demand to provide specialist insurance coverage to provide balance sheet protection to lenders for defaulting of their mortgage loans which is seen as a systemic risk. The current coverage is quite limited and does not meet the demands of most lenders. Lenders are seeking more bespoke and cost-effective solutions such as tailored parametric insurance that provide coverage for the most vulnerable exposures within legacy mortgage portfolios that typically will be high concentration zones in future flood zones. The insurance industry is already seeking to innovate and has been developing parametric insurance solutions through the use of platforms that draw on remote sensing and weather and climate data from national agencies.

By conducting feasibility studies in this area lenders will gain increased knowledge and understanding, and potential competitive advantage by both reducing their risk on their legacy portfolios, but also supporting improved processes for taking on new business and developing new products by either reducing their future exposure to future climate risks from flood damage or pricing in the risk differentials, which is analogous to the financial crisis.

Improving risk assessment processes and developing frameworks to assess future risk transfer solutions will provide the basis of a number of strategic and operational benefits that include the following:

• Enhanced insurance protection - that reduces volatility in earnings and optimise current insurance spend for mortgage impairment
• Improved risk selection – by being able to identify those high credit risk which are also most at risk from climate change (i.e. the key risks)
• Better long-term business planning - supporting other internal processes such as improved scenario analysis that in turn will support the ICAAP and impairment provisioning processes by exploring sensitivities for long-term business planning.

Risk leaders in organisations can and should play an increasing important role in supporting organisations integrate climate risk within existing Enterprise Risk Management (ERM) frameworks and internal processes, and act as a coordinator for change. Developing and embedding a formal Emerging Risk Management Framework together with a Swiss Solvency Test (SST) framework will be critical for assessing climate change risk and opportunities and meeting regulatory requirements. The processes should be subject to a documented governance approach, supported by policies and procedures, and subject to independent review. Outputs should be communicated effectively to encourage discussion and debate and crucially identify management actions.

The future is full of uncertainty and the potential impacts of climate change are nuanced and complex. This leads to a challenge for insurers in attempting to interpret huge quantities of highly dimensional data. Ambiental Climate Suite is a data cube solution which allows easy selection of the specific metrics of relevance to financial institutions and which instantly unlock answers to the questions which matter.

Climate Suite features high dimensionality and includes multiple emissions scenarios and future time epochs, combined with probability-driven hazard data and loss-based risk information.

¹ - https://www.theirm.org/join-our-community/special-interest-groups/climate-change/
² - https://uk.milliman.com/en-gb/