In a joint effort, the European Central Bank (ECB) and the European Systemic Risk Board (ESRB) have highlighted the indispensable role of insurance and reinsurance in managing climate-related financial stability risks throughout the European Union (EU).
The recently released comprehensive report delves into the vulnerabilities of financial institutions, emphasizing the need for proactive measures to effectively confront the challenges presented by climate change.
According to the report, banks find themselves significantly exposed to high-emitting firms and households, with the share of high-emitting sectors in bank lending exceeding economic activity by 75%.
Moreover, a substantial portion, ranging from 60% to 80%, of mortgage lending in the euro area is directed towards households associated with high-emission activities.
The report underscores that climate change not only poses an evident threat to financial stability through increased climate hazards but also due to the underpricing and underinsurance of potential climate risks.
To address these risks, the report advocates for a robust macroprudential strategy that extends beyond the banking sector to encompass borrowers and non-bank financial intermediation.
Recognizing the importance of existing EU macroprudential tools, such as systemic risk buffers and risk concentration limits, the report emphasizes their necessity in addressing climate-related financial stability risks in a focused and scalable manner.
The degradation of nature is highlighted as an additional risk factor for financial stability in the report. It stresses that a significant proportion of bank loans and insurer investments in corporate bonds and equity, 75% and over 30% respectively, are in sectors heavily reliant on ecosystem services.
Additionally, the report points out a substantial insurance protection gap across euro area countries, with only 25% of average climate losses currently being insured.
While reinsurance is acknowledged as a pivotal player in managing risks from low-frequency, high-impact events, the report notes potential challenges for reinsurers in adequately pricing risks given the increased frequency and severity of climate-related events.
To complement traditional reinsurance and private insurance schemes, the report suggests the use of capital market instruments, including catastrophe bonds (CAT bonds). These instruments can provide diversification and potentially combine impact underwriting with impact investing.
In proposing solutions at the EU level, the report recommends the establishment of a public scheme for natural disaster insurance covering a broad spectrum of hazards. This initiative aims not only to reduce economic costs and expedite recovery efforts but also to incentivize risk reduction through mitigation and adaptation measures. Importantly, the suggested EU-wide fund is positioned as additional to existing climate change funding, incorporating safeguards against moral hazard.
