Covering Your Climate Risk Bases

It has never been more important for banks to understand the risks posed by a changing climate, and a recent article in The RMA Journal digs into why. Last year, 421 climate disasters resulted in $313 billion in losses—only $132 billion (42%) was insured.

How serious is the situation? Earlier this year, two of America’s largest insurers stopped issuing new homeowners policies in California owing to climate risk. And the Federal Reserve is conducting a pilot Climate Scenario Analysis (CSA) exercise for six major banks to learn about their climate risk management practices.

How can banks quantify physical climate risk? Dan Raizman, senior director for climate risk advisory at Aon, said there are two main categories of models to consider: catastrophe and climate. Catastrophe models “are the primary tools the insurance industry has leveraged to price and manage risk over the past 35 years.” Climate modeling typically starts with downscaling global climate models, and is best at understanding chronic impacts such as droughts; wildfires; and extreme precipitation, heat, and freeze.

Bank analysts can use these models to predict how future events could play out in terms of credit losses or operational risk events. They can also use them to factor the potential of future climate-related losses into appraisals and credit rating calculations.

Covering your bases. Banks also need to model potential insurance recoveries, or lack thereof: It’s crucial to have reliable data concerning the borrower’s insurance. Are hurricanes, wind, tornadoes, and flooding covered? What are the terms of the insurance? What are the deductibles and the limits that apply?

“Unprecedented physical events pose a notable risk to bank portfolios,” Raizman said. “It’s important for banks to commit time to understand risk quantification and establish a process for that understanding.”

For the complete article, click here.