Insurers and banks need to reflect climate risks in their decisions, says the Reserve Bank of New Zealand in its latest six-monthly Financial Stability Report released last week.
Property insurance penetration is high in New Zealand, so climate risks may crystallise in the insurance sector, the report says. However, most property insurance contracts are negotiated annually, allowing insurers to reassess risk and adjust policy terms each year.
Some insurers in New Zealand appear to have begun adjusting their products and pricing to reflect emerging climate risks, and some existing properties could ultimately become uninsurable. Whilst this supports the efficiency and stability of the insurance sector, it poses challenges for property owners and lenders.
An increase in the cost of insurance or a reduction in its availability may reduce the value of affected assets. In the first instance, this represents a cost to the owners of the assets. But these costs will also translate into higher risks for lenders if the value of loan collateral falls or underinsured borrowers suffer losses. More generally, lenders protect against the risk of losses on loans by assessing the value of property security, assessing the capacity of borrowers to service their loans, and requiring ongoing insurance coverage in loan contracts.
To work effectively it is essential that these processes are calibrated to longer-term risks, including climate change. This may mean placing less reliance on backward-looking valuation models, strengthening serviceability tests to incorporate the potential future variations in insurance costs, and investing in systems to monitor ongoing insurance coverage and exposure to physical risks.
The Reserve Bank says that it will engage further with insurers and banks to understand how they are incorporating these and other climate-related risks within their businesses.
The report says that within New Zealand, action will be required from a range of parties to ensure that the financial system remains sound and efficient in the long term:
- Financial sector participants have a critical role in assessing their own current and future exposures, ensuring the appropriate allocation of financial resources through robust lending standards and insurance underwriting policies, and providing the necessary finance for mitigation actions.
- The Reserve Bank has an important role in monitoring climate risks across the system and incorporating them within regulatory frameworks, driving appropriate disclosure to help market participants assess climate-related exposures, and addressing any barriers to the development of green finance.
- Government has a vital role in driving the transition to a low-carbon economy and in alleviating uncertainty by developing robust and durable frameworks that can be analysed and priced by market participants.
Whilst it is not possible to predict future climatic developments with certainty, it is essential that all sectors of the economy work within a coherent national strategy on climate change, the report says. Decisions about future investment and development should factor in long-term climate risks. Decision-makers should take responsibility for the risks that they are building today, such as by avoiding building infrastructure in vulnerable locations where not essential.
Meanwhile, the Reserve Bank is developing its own climate change strategy. The strategy focuses on ensuring that climate risks are appropriately incorporated within the Reserve Bank’s mandate.