Few had expected the Bank of England´s warning that long-run investors in fossil fuels should worry about climate change because they could take a huge hit from limits on carbon emissions. Investors are regularly surprised by the changes and action of politicians, by natural disasters and by unexpected moves in the economy.
Tomorrow’s world inevitably brings change.
Some changes can be forecast, or guessed by extrapolating from what we know today. But there are, inevitably, the unknown unknowns which will help shape the future. In particular, the risk of cyber-attack is a great concern. These questions have potentially large financial stability implications, and financial stability has become a much more prominent aspect of central bank work.
The insurance industry has been founded upon taking the long term view. Without making any implied comment about monetary policy, just looking at today’s yield curve, it is not plausible for insurers to expect high nominal or real rates of return in the near future from low-risk assets.
A number of challenging developments in society and the real economy could ultimately trigger monetary and financial stability problems. A topical environmental change that is quickly moving up the agenda is that of climate change. One live risk right now is of insurers investing in assets that could be left ‘stranded’ by policy changes which limit the use of fossil fuels.
Uncertainty generates challenges but also represents opportunity:
How global warning will affect market and specific regions is one of the thorniest questions in climate science. As we have learned at this years Economist’s Insurance Summit Climate change impacts insurers on both sides of their balance sheets. It appears that the asset side may also give rise to unexpected risks. But insurers,as long term investors, are also exposed to changes in public policy as this affects the investment side. “As the world increasingly limits carbon emissions, and moves to alternative energy sources, investments in fossil fuels and related technologies – a growing financial market in recent decades – may take a huge hit”.
There are already a few specific examples of this having happened. Firms relying on high income streams from their assets may find themselves taking ever greater risks to their balance sheets. As stated by Paul Fisher, Deputy Head of the PRA, at Economist´s Summit March 3, 2015 2. “In the use of risk models Solvency II will play a huge role for the larger, more complicated firms”.
In a deepened EU market integration: Through the harmonisation of supervisory regimes, the “Supervisory Review Process” will shift supervisors’ focus from compliance monitoring and capital to evaluating insurers’ risk profiles and the quality of their risk management and governance systems. In particular, firms will have to hold a risk margin to ensure that the insurance liabilities reflect the value for which they could be transferred to a third party.
The Bank of England has been carrying out analysis to better understand these risks. Insurance cuts across all aspects of society. As with the other risks, insurers are affected for both good and ill: with ever more frequent and increasingly sophisticated cyber-attacks on businesses and individuals, -reason insurers are being relied upon more and more for protection. A new business opportunity for sure. But, unlike most other insured risks, insurance firms could themselves be significant victims.
While the Bank of England strives to be an international intellectual leader in the areas of its policy responsibilities, making progress on such a broad agenda requires input from the wider community of academics, policymakers and experts. It therefore makes sense to broaden the research agenda of central banks in order to address these questions.
This (pdf) paper gives more details on these themes. Trying to plan ahead makes sense, and the climate must be on the list.
- One Bank Research Agenda
- Speech given by Paul Fisher, Deputy Head of the PRA, at Economist’s Insurance Summit 2015, March 3 in London