Global Insurance Market Report PDF

SEPT '21 GLOBAL INSURANCE MARKET REPORT GIMAR SPECIAL TOPIC EDITION THE IMPACT OF CLIMATE CHANGE ON THE FINANCIAL STABILITY OF THE INSURANCE SECTOR ABOUT THE IAIS The International Association of Insurance Supervisors (IAIS) is a voluntary membership organisation of insu...

SEPT '21 GLOBAL INSURANCE MARKET REPORT GIMAR SPECIAL TOPIC EDITION THE IMPACT OF CLIMATE CHANGE ON THE FINANCIAL STABILITY OF THE INSURANCE SECTOR ABOUT THE IAIS The International Association of Insurance Supervisors (IAIS) is a voluntary membership organisation of insurance supervisors and regulators from more than 200 jurisdictions. The mission of the IAIS is to promote effective and globally consistent supervision of the insurance industry in order to develop and maintain fair, safe and stable insurance markets for the benefit and protection of policyholders and to contribute to global financial stability. Established in 1994, the IAIS is the international standard setting body responsible for developing principles, standards and other supporting material for the supervision of the insurance sector and assisting in their implementation. The IAIS also provides a forum for Members to share their experiences and understanding of insurance supervision and insurance markets. The IAIS coordinates its work with other international financial policymakers and associations of supervisors or regulators, and assists in shaping financial systems globally. In particular, the IAIS is a member of the Financial Stability Board (FSB), member of the Standards Advisory Council of the International Accounting Standards Board (IASB), and partner in the Access to Insurance Initiative (A2ii). In recognition of its collective expertise, the IAIS is also routinely called upon by the G20 leaders and other international standard setting bodies for input on insurance issues as well as on issues related to the regulation and supervision of the global financial sector. CONTENTS ACRONYMS AND ABBREVIATIONS BIS Bank of International Settlements COP26 26th United Nations Climate Change Conference of the Parties CDS Credit default swap CPRS Climate policy relevant sectors EIOPA European Insurance and Occupational Pensions Authority ESG Environmental, social and governance FSB Financial Stability Board GA General account GHG Greenhouse gas GIMAR Global Insurance Market Report GME Global Monitoring Exercise IAIS International Association of Insurance Supervisors IPCC Intergovernmental Panel on Climate Change NACE Statistical classification of economic activities in the European Community ND-GAIN Notre Dame Global Adaptation Initiative NGFS Network of Central Banks and Supervisors for Greening the Financial System SIF Sustainable Insurance Forum TCDC Targeted climate data collection TCFD Task Force on Climate-related Financial Disclosures WRI World Risk Index EXECUTIVE SUMMARY T his International Association of Insurance (including equities and corporate debt, loans and Supervisors (IAIS) Global Insurance Market mortgages, sovereign bonds and real estate) could Report (GIMAR) special topic edition be considered “climate-relevant”, ie exposed to provides the first quantitative global study on the climate risks. Within the equities, corporate debt, impact of climate change on the insurance sector. and loans and mortgages asset classes, the The report focuses exclusively on insurers’ assets, majority of climate-relevant exposures relate to although insurers are exposed to the consequences counterparties in the housing and energy-intensive of climate change on both sides of their balance sectors. However, the report also highlights sheets as they underwrite risks that could be significant regional differences in terms of balance affected by climate change as well as invest in sheet asset composition and exposures to assets that could be affected by climate change. climate-relevant sectors. Drawing on unique quantitative and qualitative data gathered from 32 IAIS Members covering DRAWING ON UNIQUE 75% of the global insurance market, analysis was carried out to better understand insurers’ asset- QUANTITATIVE AND side exposures to, as well as supervisors’ views QUALITATIVE DATA on, climate-related risks. In addition, scenarios GATHERED FROM 32 IAIS were developed to assess climate change impact MEMBERS COVERING 75% on a forward-looking basis. The data was gathered through the arrangements put in place as part of OF THE GLOBAL INSURANCE the IAIS Holistic Framework for the Assessment MARKET, ANALYSIS WAS and Mitigation of Systemic Risk in the Insurance CARRIED OUT TO BETTER Sector, in particular the Global Monitoring Exercise. UNDERSTAND INSURERS’ ASSET SIDE EXPOSURES TO, The analysis of climate-related risks poses conceptual and methodological challenges, AS WELL AS SUPERVISORS’ including a lack of understanding about the VIEWS ON, CLIMATE- uncertain process of climate change and its non- RELATED RISKS. linear effects, the forces influencing it and how these relate to financial sectors, and the lack of a globally consistent framework for measuring Scenario analysis was carried out using the climate risk-related financial information. The representative scenarios developed by the Network report engages with these debates, highlighting of Central Banks and Supervisors for Greening the the challenges encountered, the paths followed to Financial System (NGFS) to explore the potential address them and the resulting limitations emerging impact on the insurance sector of alternative from the choices made. policy approaches to climate change. A scenario with climate change policies pursuing an orderly Our quantitative data analysis on insurers’ asset- transition towards internationally agreed climate side exposures to climate risks shows that targets appears to have only limited impacts more than 35% of insurers’ investment assets on insurers’ solvency positions. A scenario  potential financial impact of climate change on SCENARIO ANALYSIS WAS their businesses, strategies and financial planning CARRIED OUT USING remains low (TCFD, 2020). THE REPRESENTATIVE With specific reference to the insurance sector, in SCENARIOS DEVELOPED May 2021 the IAIS and the Sustainable Insurance BY THE NETWORK OF Forum (SIF) published Application Paper on CENTRAL BANKS AND the Supervision of Climate-related Risks in the SUPERVISORS FOR Insurance Sector, which provides guidance for supervisors in integrating climate-related risks into GREENING THE FINANCIAL their supervision. SYSTEM (NGFS) TO EXPLORE THE POTENTIAL IMPACT ON THE INSURANCE AS A NEXT STEP, AND SECTOR OF ALTERNATIVE BUILDING ON THE LESSONS POLICY APPROACHES TO LEARNED FROM THIS CLIMATE CHANGE. ANALYSIS, THE IAIS WILL CONTINUE TO IMPROVE with policies that reflect a disorderly transition DATA AVAILABILITY AND towards meeting targets or that do not meet the ANALYTICAL TOOLS FOR climate targets has more significant effects on the MONITORING FINANCIAL insurance sector. For example, under an orderly transition scenario, results show a drop in insurers’ STABILITY RISKS AS available capital of around 7% to 8% of their WELL AS TO SUPPORT required capital; that drop increases to over 14% THE DEVELOPMENT AND under a disorderly transition scenario, and to almost SHARING OF GOOD 50% under a “too little, too late” scenario. Despite the significant losses shown in the four scenarios SUPERVISORY PRACTICES analysed, the insurance sector as a whole appears AMONG IAIS MEMBERS. to be able to absorb these investments losses, in light of the high pre-stress capital levels. However, As a next step, and building on the lessons learned these outcomes also partly depend on the scope from this analysis, the IAIS will continue to improve of the data collected, which cover 53% of the data availability and analytical tools for monitoring targeted climate data collection (TCDC) sample financial stability risks as well as to support the total assets (general account only). For instance, development and sharing of good supervisory for the analysis of both climate-relevant exposures practices among IAIS Members. and stress scenarios, assets out of scope are not taken into account although they may contain some climate-relevant assets; therefore, the results may not fully reflect the actual impact of the different scenarios. Over the past few years, a number of private and public initiatives aimed primarily at expanding and strengthening consistent cross-border and cross-sectoral reporting of climate-related risks disclosures have been developed or implemented. At a global level, the Financial Stability Board's (FSB's) Task Force on Climate-related Financial Disclosures (TCFD) Framework continues to gather support. However, companies’ disclosure of the 1. INTRODUCTION these exposures. Finally, the report also includes a T his is the 2021 special topic edition of the GIMAR. While the regular GIMAR reports on qualitative description of possible risks to financial the outcomes of the IAIS’ Global Monitoring stability as well as an overview of mitigating steps Exercise (GME),1 this special topic edition delves taken by the insurance industry and supervisors. more deeply into the potential impact of climate change on the financial stability of the insurance The analysis provided in this report should be sector, focusing on the insurer’s investments. viewed as a step in the IAIS’ work on assessing and responding to climate-related risks in the This report contributes to the IAIS’ strategic work insurance sector. It is a first attempt to gauge on climate risk, which is a key theme of the IAIS the climate-related risks of the insurance Strategic Plan 2020–2024. Scientists are already sector’s investment portfolio, to be refined as observing changes in the Earth’s climate in every methodologies develop and more data become region and across the whole climate system, available. Undertaking this analysis has been according to the latest Intergovernmental Panel an important learning experience for the IAIS on Climate Change (IPCC) Report, released in and its Members, and also helps inform the August 2021. Climate change will lead to more need for further work. The conclusions in this extreme and frequent weather-related events, report provide a partial and indicative insight increasing the physical risks to which insurers into the climate-related risks of the insurance are exposed and affecting insurers' assets and sector. It is partial as it focuses on investments investments, and the insurability of policyholder only and does not examine the impact on property and operations. Insurers’ assets and liabilities (underwriting) – which is expected to be investments are also impacted by the necessary significant, especially for the non-life insurance transition to a net-zero emissions economy,2 sector. It is indicative given the limitations on data especially if the transition is disorderly. availability, the top-down nature of the analysis and the relative infancy of available analytical This report is the first global attempt to provide tools. Finally, the report does not provide a full insight into the possible impact of climate global picture on the assessment of risks, but change on the insurance sector’s investment instead provides insights across different regions. portfolio across regions and jurisdictions. The By publishing this report, the IAIS hopes to effects of climate change on the investment encourage further work on this area. portfolio vary substantially and may depend on the locations and economic environments of 1.1 CLIMATE CHANGE AS A FINANCIAL RISK entities, sectors and economies. Based on a Climate change is an overarching global threat. It unique data collection among 32 IAIS Members affects human, societal, environmental and economic systems through rising temperatures, rising sea (representing around 75% of the global insurance levels, and an increasing frequency and severity of market), this report analyses the size of the natural catastrophes and extreme weather-related insurance sector’s investment exposures to events. Climate change, as well as the global economic sectors and jurisdictions that are response to the threats posed by climate change (eg more likely to be negatively impacted by climate the reduction of greenhouse gas (GHG) emissions change. The analysis is complemented by an and adaptation programmes), may have wide-ranging exploratory scenario analysis exercise assessing impacts on the structure and functioning of the global the possible magnitude of risks stemming from economy and financial system. As such, climate change is a source of financial Paper providing guidance to supervisors on risk.3 It may have an impact on the resilience of embedding climate-related risks into the day-to- individual financial institutions, including insurers, day supervision. See also section 5. This GIMAR as well as on financial stability through physical special edition complements existing IAIS work risks and transition risks.4 Physical risk refers by presenting a quantitative analysis based on to increased damage and losses from physical unique supervisory information provided by IAIS phenomena associated with climate-related Members, including quantitative information and trends (eg changing weather patterns or rising sea supervisory assessments of the risks.5 levels) and events (eg natural disasters or extreme weather). Transition risk refers to disruptions and The report draws on, and complements, existing shifts associated with the transition to a low- work by other international organisations as well carbon economy, which may affect the value of as by IAIS Members. In recent years, several assets or the costs of doing business. international organisations have highlighted the importance of climate change for central banks Important interdependencies may exist between and supervisors, including the need for coordinated physical and transition risks. For instance, if the action to better assess and respond to climate- transition is slow at first, this may increase the related risks. This includes publications by the Bank probability that physical risks will materialise. In for International Settlements (BIS, 2020), the FSB turn, sharp increases in economic losses from and the Network of Central Banks and Supervisors weather-related events may trigger more abrupt for Greening the Financial System (NGFS). In policy responses, leading to higher transition addition, several IAIS Members have undertaken, risks. In the least favourable scenario, extreme or are undertaking, analyses similar to this report. climate-induced damage as a result of long However, these analyses focus largely on assessing delays in the transition will eventually force a risks within their own jurisdictions. The IAIS’ sudden and radical change in the economy. analysis leverages the experience from Members’ existing efforts and complements it by providing a 1.2 SCOPE AND CONTEXT cross-jurisdictional picture for the first time. The scope of the analysis is how insurers’ investments may be negatively affected by 1.3 STRUCTURE The remainder of this report is structured as physical and/or transition risks. It thereby focuses follows: on the insurers’ assets. The analysis does not assess the potential impact of climate change ◗ Section 2 describes how the insurance sector on insurer liabilities (underwriting), although their may be affected by climate-related risks and relevance is briefly described in a qualitative provides insight into the potential financial manner in Section 2. It also does not assess stability transmission channels insurers’ exposures to assets that are deemed to ◗ Section 3 discusses the approach taken in contribute to a sustainable transition (sometimes assessing the insurance sector’s investment called “green” investments). exposures to climate-related risks and presents the outcome of the data collection The report builds on existing IAIS work on ◗ Section 4 presents an exploratory scenario climate risk. In early 2017, the IAIS published analysis as a forward-looking perspective on a qualitative analysis of the impact of climate the risks change on insurance as part of its 2016 GIMAR. ◗ Section 5 discusses initiatives and measures In mid-2018, the IAIS and the Sustainable taken by the private and public sectors in Insurance Forum (SIF) published Issues Paper on addressing climate-related risks in the insurance Climate Change Risks to the Insurance Sector. sector (with a focus on risks to insurers’ assets) As the first analysis of climate change risk by an ◗ Section 6 presents the conclusions and work international standard setting body, this paper planned for the future. provided an overview of how climate change affects the insurance sector and its relevance for insurance supervision. Since then, the IAIS and SIF also published an Issues Paper on disclosures and, most recently, an Application 2. CLIMATE CHANGE AND FINANCIAL STABILITY RISKS F igure 1 illustrates a generic chain The framework shows how a potential systemic of events.6 It presents a conceptual impact could be created, without expressing the framework from the perspective of an probability that this chain of events will occur insurer’s balance sheet and outlines the sources, and abstracting from regulatory mechanisms transmission channels, potential spillovers and and interventions that could dampen or interrupt feedback loops for climate risks to materialise. the chain of events. Transition risks Policy and Regulation Technological development Consumer’s/ investors preferences Physical risks Exreme weather Long-term changes in climate patterns Economic impact and transmission channels Individual businesses/households eg residential, corporate loans, credit insurance Macroeconomic effects Capital depreciation, productivity changes 09 Social effects Labour market issues, socioeconomic conflicts, governments impacts Insurers are exposed to climate change both as the effect of climate-related risks.8 Examples of underwriters and investors and could be affected a possible split along four risk dimensions and by a variety of climate risks. The transmission related spillover effects are provided below.9 channels represent how adverse climate-risk events could spread beyond the insurance Credit risk: Sectors exposed to climate-related sector and impact the wider financial system. risks may suffer losses when they are unable to Initial impacts on the financial system could also effectively manage transition risk. Climate-related trigger reactions with other players within the risks can thus induce, through direct or indirect financial system (including insurers) trying to exposure, a deterioration in borrowers’ capacity mitigate the impact of the events on their balance to generate sufficient income, as it might lead to sheet. These reactions could generate feedback higher probabilities of default in: loops within the financial system and, ultimately, ◗ carbon intensive industries (stranded assets); through macroeconomic and social effects, the ◗ investments in technologies that turn out to be real economy. Not all climate risk-related events less promising than expected or superseded generate a significant impact or turn into systemic by new technologies. risks if they materialise but, through the channels described above, insurers could contribute to This would affect the creditworthiness of these the generation or amplification of systemic risk borrowers, and ultimately affect bond prices induced by climate risk events. or cause yield shocks. Moreover, the potential depreciation of assets used for collateral (eg lower Though the potential financial stability impact value of real estate due to policy changes) can of climate-related risks can be considered from also contribute to higher credit risk. different perspectives, the figure above focuses on the effect of both physical and transition In terms of physical risk, an example would be if the risks, emphasising the latter, ie extensive policy, destruction of a production site due to an extreme technology and market changes in favour of a low- weather-related event increases the probability of carbon economy on the asset side of the insurers’ default of the company operating the site. balance sheet. Market risk: Under a disorderly transition Much of this section is based on the work of scenario, financial assets concentrated in certain the FSB report (2020),7 which provides more sectors of the real economy and/or certain information. regions could be subject to a change in investors’ perception of profitability, leading to a propensity 2.1 FINANCIAL IMPACT OF CLIMATE for reducing the value of these assets. As outlined CHANGE ON INSURERS’ ASSETS by the FSB (2020), such changes need not, Existing literature already investigates channels by in themselves, pose risks to financial stability. which climate-related shocks might be transmitted However, such movements may be amplified by through and amplified by the financial system (see an unanticipated and sudden disorderly transition, FSB (2020)). The manifestation both of physical which could have a destabilising effect on the risks and of a disorderly transition towards a financial system through a sharp fall in asset low-carbon economy could affect insurers’ asset prices (eg stranded assets, significant decrease portfolios, although the timing of such impacts is in the value of real estate, carbon intensive and/ uncertain and may differ. Transition risks affecting or GHG intensive sectors). Following a regulatory financial stability could appear in the near term, shock aimed at sectors whose technology relies particularly if policies towards a net-zero emissions on carbon emissions, large-scale sales may economy are accelerated. By contrast, physical ensue through several channels of transmission. risks are unlikely to lead to financial stability First, investors may have trouble gauging the concerns in the short or medium term. fundamental value of such assets, which itself depends on future regulatory actions that are Focusing on insurers’ assets, financial risks not yet known. In a world of increasing physical may materialise in different risk dimensions with risk events and lagging technology within those potential financial stability consequences. There sectors, many investors may deem such assets are also important second-round and spillover as undesirable to hold. Further, coupled with more effects within the financial system that may amplify Table 1: Climate-related risks and insurance investment portfolio Relevance of climate-related risk Asset class Physical risk Transition risk Sovereign bond Depends on the intrinsic exposure of a Through the need for additional fiscal jurisdiction to physical risk events (for spending on adaptation programmes, or via instance, the debt of jurisdictions most impacts on governments where the economy exposed to a rise in sea levels may suffer is heavily reliant on fossil fuels. in case of a global warming quicker than anticipated). Corporate bond Depends on the location or sector, eg Borrowers, bonds and/or counterparties exposure to agriculture may suffer from that fail to properly address transition risk decreasing yields, for instance when may suffer losses due to deteriorating extreme weather-related events become creditworthiness. more common and damage crops. Equity Depends on the location or sector, An impairment of financial asset values due eg exposures to corporates that have to the low-carbon transition, for instance facilities in flood areas may suffer from stranded assets, may decrease the value of equity price shocks after major flooding. carbon/GHG intensive sectors. Loans/ Depends on the location. For example, Loans to debtors may be impaired if the mortgages lien assets located in areas more prone to debtors fail to address climate change issues. flood risk or other weather-related events. Real estate Depends on the location. For example, Buildings with low energy efficiency may be buildings located in areas more prone to prone to transition risks, for instance if new flood risks may experience suspension of regulation forced all properties to meet certain business activities and increased credit higher sustainability standards, leading either losses, eg of corresponding mortgages to stranded assets or significant investments and lower market values.10 to meet the higher standard. stringent disclosure standards with respect to a change, or that do not take into account climate- portfolio’s carbon footprint, investors may fear a change consequences and do not take mitigation reputational cost associated with holding such or adaptation measures. This is exemplified by instruments. These are two examples of how social movements calling for divestment from market risk can intensify and lead to a significant fossil fuels and the cessation of the underwriting of drop in the value of climate-relevant assets coal-fired power infrastructure. beyond what has already been priced in. When looking at an insurer’s investment mix, each Liquidity risk: A lack of reliable and comparable type of asset class may in theory be affected by information on climate-sensitive exposures could transition and/or physical risks. The following create uncertainty and cause procyclical market table provides an overview and examples of the dynamics, including large-scale sales of carbon- materialisation of these risks for five main asset intensive assets, and hence reduce liquidity in classes on an insurer’s balance sheet. these markets. As such, assets could become less liquid due to, for instance, climate-related 2.2 FINANCIAL STABILITY TRANSMISSION increased credit or market risk, thereby triggering CHANNELS AND AMPLIFICATION potential procyclical investment behaviour by MECHANISMS OF CLIMATE CHANGE insurers and negatively affecting insurers’ ability to As noted by the FSB (2020), a gradual and well- liquidate the assets when needed. anticipated transition to a low-carbon economy has a relatively contained impact on asset prices Reputational risk: Negative publicity may be and is less likely to have material implications for triggered by an insurer’s underwriting, or investing financial stability. A rapid or disorderly transition in, sectors perceived as contributing to climate could occur, however, due to sudden and unanticipated changes in public policy, technology interconnectedness of lending activities between developments or the preferences of investors or insurers and other financial institutions. Insurers consumers. This may affect the balance sheet are exposed to the banking and investment or generate a decline in financial earnings – with funds sectors through several exposed classes potential implications for the solvency position – of (mainly investments in bonds and equity). When companies whose business models are not based financial institutions are hit by a shock, they can on low carbon emissions or in favour of climate easily transmit it to the insurance sector through a adaptation or mitigation. In this case, a direct sharp decline in the institutions’ creditworthiness. consequence may be the write-down of assets A reduction in (re)financing within the financial held by insurers investing in such companies, system could in time amplify climate-related potentially leading to large-scale sales of assets.11 shocks to the real economy. Under these circumstances, the financial system Various insurers are also part of financial as a whole (including insurers, banks, investment conglomerates (including credit institutions, funds and hedge funds) may demonstrate investments funds, hedge funds and payment procyclical behaviour. This would enhance market institutions), where a decline in the financial imperfections and could have a destabilising effect soundness and solvency position of one institution on the financial system. may affect the whole conglomerate. Further, the failure of a systemic financial group or the failure Climate-related risks may have an impact on of several non-systemic financial institutions may insurers’ investments portfolio via three main lead to contagion in the broader financial system identified transmission channels: exposure through interlinkages. As seen in previous financial channel, asset liquidation channel and legal crises, such as in 2008, such disruption of the liability risk channel. The analysis focuses on the whole financial market can trigger a market crash first two. It thereby explains the channels through and a domino effect that impacts the global which climate-related risks might impact the real economy. financial system, without including any conclusive statements on the likelihood that these risks Market and credit risks can also be concentrated will materialise. in certain geographies and sectors of the real economy. Among insurers’ investments portfolios, 2.2.1 Exposure channel mortgage loans and real estate portfolios are, The exposure channel is related to direct and in some geographies, particularly exposed to indirect interlinkages between insurers and climate-related risks, increasing their default risk. other parts of the financial system, and the Credit insurers will also need to monitor increasing real economy. risk of default on trade-credit insurance portfolios, in light of climate-related risks. Transition risk Investment exposure emerging from a large systemic default of As the value of insurers’ assets (cf table 1) runs corporates12 may mean trade-credit insurers are the risk of a sharp downward shock, expected unable to honour their insurance liabilities (increase returns on investments become hazardous for in market risks and credit risks). investors (including insurers) who may face potential financial (market) losses. As noted by 2.2.2 Asset liquidation channel the FSB (2020), the breadth of climate-related Asset liquidation refers to the sudden sale of risks might reduce the degree to which market assets on a large scale by one large insurer or a participants are able to properly price and sufficient number of smaller insurers, which could manage their investments, which is likely to lead trigger a decrease in asset prices and significantly to increases in risk premia across a wide range of disrupt trading or funding in key financial markets assets. An unanticipated shift in asset prices may or cause significant losses or funding problems for challenge market participants’ ability to diversify other firms with similar holdings. Such behaviour their exposure to climate-related risks. may have a more significant impact on smaller, less liquid markets or in a stressed environment. Counterparty exposure This phenomenon may be enhanced by the Climate-related shocks have the potential to lead 2.3 FINAL CONSIDERATIONS the insurance industry to large-scale shifts in its Insurers are dually exposed to the consequences of portfolios. Market movements from investors’ climate change, as they underwrite risks and invest procyclical behaviour (including insurers and other in assets that could be affected by climate change. financial institutions) may amplify changes in asset While climate risk analysis related to insurers’ prices. As noted by the FSB (2020), this effect investments often focuses on transition risks only, may be particularly widespread where there are potential physical risks should not be neglected. substantial commonalities between investors’ The manifestation of physical risks – particularly portfolios or concentrations of exposures through prompted by a self-reinforcing acceleration in certain financial products (such as derivatives). It climate change and its economic effects – could could also be amplified by changes in collateral also lead to a sharp fall in asset prices and increase values. Liquidity mismatches can also be seen in uncertainty (see FSB (2020)). in securities lending activities when collateral is invested by the insurers in less liquid assets. A variety of mechanisms within the financial Furthermore, policyholders in need of cash (eg system could amplify the effects of credit, liquidity following damages resulting from a weather- and counterparty risks arising from climate-related related event) may be triggered to surrender their shocks. Interactions within the financial system life savings in insurance. If such behaviour were and with the real economy may also increase risks to occur, insurers may be forced into procyclical to financial stability. behaviour to obtain the necessary liquidity to meet policyholders’ payouts. As noted by the FSB (2020), a widespread reappraisal of the creditworthiness of large portions A procyclical phenomenon,13 pushing the market of the real economy might reduce the willingness to simultaneous and large-scale sales of assets, of firms to provide financial services, reducing may trigger increased market volatility and raise access to (or raising the cost of) bank lending, the likelihood of further losses and failures of corporate finance and insurance. By depressing actors within the financial system. As a result, macroeconomic prospects, this could result in liquidity risks may emerge if insurers are not able further losses for the financial system, which in turn to sell the stranded assets quickly enough to could lead to another reduction in finance. prevent or minimise losses. Ultimately, as the financial sector provides financial 2.2.3 Legal liability risk channel support to the real economy and taking into In addition to a reputational risk (through financial account the strong interconnectedness of the support for carbon-intensive sectors), insurers financial system, physical and transition risks may may also be exposed to counterparty risk from generate ‘feedback effects’ within the financial their business relations with companies subject to system and between the financial system and climate-related legal liabilities. This might also have the real economy14. In particular, and directly in implications for the financial system. connection with insurers’ activities, these effects may be expected at a macroeconomic level and at This risk is not further developed as it is less the level of individual businesses and households relevant to the analysis in this report. (ie loan mortgages and homeowner’s insurance). 3. ASSESSMENT OF CLIMATE-RELATED RISKS TO INSURERS’ INVESTMENTS ◗ I n this report, the analysis of risks stemming The availability of data, ie the extent to which from insurers’ investment exposures to it is possible to distinguish between climate- climate change follows a two-step approach. relevant and other assets within these asset The first step, in this section, consists of classes (existence of a taxonomy). assessing the size and nature of the climate- relevant exposures and their materiality on On aggregate, insurers’ investment assets are insurers’ balance sheets. This analysis aims to typically composed as follows (from most to provide an initial indication of the relevance of least material):15 climate-related risks to the insurance sector’s ◗ Sovereign debt investment portfolio. The second step is to ◗ Corporate debt analyse the potential losses for the insurance ◗ Equity sector stemming from different forward-looking ◗ Loans and mortgages scenarios (see section 4). ◗ Real estate 3.1 METHODOLOGY FOR DERIVING CLIMATE ◗ Other: cash, securitisations and more. RISK EXPOSURES The analysis starts by identifying insurers’ Table 1 in section 2 shows relevance for climate- exposures to climate-relevant assets: this means related risks analysis. classifying sectors and jurisdictions into different categories depending on their sensitivity to To consider data availability and taxonomy climate-related risks. Insurers’ investments are issues, existing initiatives on classifying climate- then mapped to those categories. relevant investments, notably from the academic literature and supervisory authorities,16 were The analysis covers the asset classes most reviewed. Different approaches were taken relevant for insurers, namely equity, sovereign for equity, corporate debt, and loans and bond, corporate bond, real estate, and loans mortgages, compared to sovereign bonds and and mortgages. To select those assets, the IAIS real estate, as explained further in sections considered: 3.1.1 and 3.1.2. The first set is based on a ◗ The materiality of those asset classes in the categorisation of economic sectors, whereas the insurers’ balance sheets second set is based on a geographic approach. ◗ Their relevance for climate risk, ie the extent to which physical and/or transition risks can impact the performance of those assets  classification in its 2019 Financial Stability 3.1.1 Equity, corporate bonds, and loans and Review to assess the exposure of euro area mortgages investors to economic activities that are The choice of climate-relevant sectors is based considered climate policy relevant. on climate policy relevant sectors (CPRS), a classification of economic activities to assess ◗ The European Commission’s Joint Research transition risk, which was developed in Battiston Centre used it to assess the transition risk et al. (2017)17 and refined over the years. exposure of the sectors included in the European Commission’s green taxonomy CPRS follow the statistical classification of (Alessi et al., 2019). economic activities in the European Community ◗ The Austrian National Bank analysed (NACE Rev2, 4-digit level)18. As described on banks’ exposure to transition risk using this the CPRS project webpage of the University of classification in its Financial Stability Report Zürich,19 the CPRS “…provide a standardised 2020. and actionable classification of activities where revenues could be affected positively or negatively CPRS considers the economic and financial risk in a disorderly transition to a low carbon economy, stemming from the (mis)alignment of firms' and based on their energy technology (eg based on sectors' climate and decarbonisation targets. fossil fuel or renewable energy)”. As noted in CPRS includes six economic sectors: fossil fuels, FSB (2021), this approach has the advantage utilities (electricity), energy-intensive activities, of usability and compatibility with existing buildings, transportation and agriculture, which are economic and financial datasets (many of which identified by considering: are also at sector level). For this reason, “the ◗ their direct and indirect contribution to GHG CPRS classification is regarded as a reference emissions (see Graph 1) for climate-related financial risk assessment and ◗ their relevance for climate policy has been used by several international financial implementation (ie their cost sensitivity to institutions to assess investors’ exposure to climate policy change, such as the European climate transition risk”. For example: Union carbon leakage directive 2003/87/EC20) ◗ The classification was used by the European ◗ their role in the energy value chain. Insurance and Occupation Pension Authority (EIOPA) in its 2018 Financial Stability Report Table 2 provides more detail on the mapping of to assess the climate risk exposure of the those 6 sectors with NACE codes, as well as European insurance sector. the main reasons why these sectors have been ◗ The European Central Bank used this identified as climate-relevant. Graph 1: Greenhouse gas emissions by economic sectors Forest, grass and cropland Crop Burning Transport Agricultural Soils Rice Cultivation Livestock & Manure Wastewater Energy 57% Landfills Chemical & Transport 16% petrochemical (industrial) Industrial processes 5% Cement Energy in buildings Waste 3% Agriculture, Fugitive emissions from forestry and land 18% energy use Fishing Energy in Unallocated fuel Agri combustion & Energy in industry Source: Climate Watch, World Resources Institute Table 2: Description of CPRS CPRS: definition and classification CPRS Role in GHG emissions Transition risk NACE (4-digit codes) Fossil fuels Production of primary Revenues primarily from Exraction of coal, gas and energy based on fossil fuel; fossil fuels (eg extraction, oil (eg 05.20), manufacturing indirectly responsible for refinement); diversification/ related to the refinement of GHG emissions from fossil use of different resources coal, gas and oil (eg 19.10) fuels not possible electricity and gas (eg 35.21), retail sales of automotive fuels (eg 47.30) Utilities Production of secondary Revenues from generation, Electricity production (eg energy, responsible for GHG transmission or distribution 35.11) emissions relative to type of of electricity; diversification fuel used possible (eg solar, wind) Energy- Activities with intensive Affected by price changes Mining and quarrying (eg intensive energy use as input of energy restrictions on 07.10), various manufacturing use of GHG-intensive secors (eg 11.01, 13.10, 23.51) sources based on the European Union carbon leakage list Transportation Provision of and support for Fossil-fuel intensive, but no Manufacturing of motor transportation services strict dependence on GHG vehicles, ships and trains emissions, diversification (eg 29.10), construction possible of roadways (eg 42.11), sale of vehicles (eg 45.32), transportation (eg 49.10) Buildings Provision of building services Energy-intensive, but Residential and commercial from construcion to renting diversification possible construction (eg 41.10), accommodation (eg 55.10), real estate (eg 68.20) Agriculture Agriculture, forestry and Energy-intensive, but Agriculture, forestry and related services diversification possible fishery (eg 1.10) Source: Austrian banks’ exposure to climate-related transition risk (2020) 3.1.2 Sovereign bonds and real estate a widely referenced source in other studies and As noted above, with respect to sovereign bonds has also been used by rating agencies.23 The ND- and real estate exposures, this analysis focuses GAIN index is based on 45 underlying indicators, on the geographic location of the asset. For the of which 36 variables contribute to the vulnerability purpose of this global study, analysis is performed score and nine variables constitute the readiness at the country level.21 score. Vulnerability refers to “a country’s exposure, sensitivity and capacity to adapt to the impacts of Sovereign bonds climate change” and include indicators of six life- To assess climate-related risks in sovereign bond supporting sectors (food, water, health, ecosystem exposures, the ranking system developed by the services, human habitat and infrastructure). University of Notre Dame, Notre Dame Global Readiness assesses “a country’s capacity to Adaptation Initiative (ND-GAIN), was used. ND- apply economic investments and convert them GAIN is based on a jurisdiction’s vulnerability to to adaptation actions” and covers three areas climate change in combination with its readiness to (economic, governance and social readiness). improve resilience.22 It aims to help governments, The ND-GAIN index uses a score between 0 and businesses and communities better prioritise 100, where 0 corresponds to “most vulnerable, investments for a more efficient response to the least ready” and 100 corresponds to the “least immediate global challenges ahead. ND-GAIN is vulnerable, most ready”.  Graph 2: ND-GAIN Country index ND-GAIN Index (World Bank segmentation) Lower middle income Source: ND-GAIN (2021); World Bank Income segmentation. As such, for the combined ND-GAIN index, a higher countries’ probability of natural disasters. The score reflects lower climate risk. monitored natural disasters include earthquakes, volcanic eruptions, storms, floods, droughts and The index is available for more than 180 countries sea level rise for 173 countries worldwide. The and spans almost 25 years. The most recent WRI is annually calculated by the United Nations index uses data up until 2019 and was published University – Institute for Environment and Human in July 2021. Over time, the ND-GAIN index has Security and disclosed in its annual World Risk remained relatively stable, although there were Reports. However, this indicator is not a perfect slight improvements particularly in the European proxy for physical risk, as it mostly provides a and Asian regions. The range of global scores retrospective view on the frequency of natural shows a correlation between the ND-GAIN index disasters, and it includes non-climate-relevant and income levels, with low-income countries being disasters such as volcano eruptions. most vulnerable, and least adapted, to climate- related risks (see Graph 2). The energy efficiency labels of buildings would be another relevant indicator to assess transition risks Real estate for real estate.24 It is plausible that the transition ND-GAIN was also used as a proxy for climate- to net-zero emissions could include a policy related real estate risks in the geographic location, measure imposing a minimum energy efficiency focusing only on the vulnerability element. The ND- requirement for existing housing stock.25 If the GAIN readiness element focuses on the readiness necessary structural adjustments are not made of the sovereign (ie the government), which is an to meet the new standards, due to a lack of imperfect indicator for the risk associated with real resources for the additional investment, inability estate within each country. In contrast with the to find a construction firm or because people combined index used for sovereign bonds, the ND- are not willing to make the investment, the value GAIN vulnerability sub-index is constructed such of energy-inefficient buildings could be severely that a higher score implies a higher risk. affected. This could have a significant impact on real estate markets and collateral values. However, For the scenario analysis, the analysis is due to limited data availability, this indicator is not augmented with the World Risk Index (WRI), included in this report. a proxy for physical risk. The WRI measures  Map 1: World Risk Index Source: WRI (2021) 3.2 LIMITATIONS effective market pricing is hampered by a lack of As the IAIS’ first global, quantitative exercise on consistent methodologies, standardised metrics this topic, this study has some limitations and the and comparable disclosures around climate risk. results in this report should be interpreted with See Basel Committee on Banking Supervision due care. This report should be seen as a first (2021a) for a summary of existing empirical work attempt to gauge the climate-related risks of the on this issue. insurance sector investment portfolio, to be refined as methodologies develop and higher-quality data Also, the classification of assets based on become available. economic sectors and geographic locations relies on a rather high aggregation level. This is When interpreting the outcomes of the exposure important because: analysis, it is important to remember that a ◗ Climate-relevant sectors, and firms within these fundamental assumption of the report is that sectors, will not all be equally affected in the climate risk is not yet fully accounted for in transition. Within each sector, and between asset prices. This is important as markets that sectors, some assets may be negatively already price in climate risk may be less sensitive affected while others may experience a limited to abrupt price shifts in the future, for instance (or even positive) impact. The sectoral approach following severe weather-related events or a also abstracts differences in the intensity of sudden transition to a less carbon-intensive emissions between firms within a given sector. economy. Although there is some evidence Another challenge is that a firm may operate in that prices in some corporate debt and equity different sectors, such that any asset issued by markets have begun to reflect transition risk, that firm could potentially be classified both as  climate-policy relevant by some investors and The data collection outcomes in this report should not relevant by other investors26 be interpreted with some caution, since this is the first time data was collected at the global ◗ Within a country, physical risk impacts may level to assess climate-related risks in insurance vary greatly between regions, municipalities investment portfolios and given the best effort or even between different postal codes, nature of the data collection. At the same time, a depending on for instance the proximity to specific data dictionary was developed to ensure the coast or the level of elevation. This is the consistency of data as much as possible, particularly relevant to the real estate analysis, including across regions. as the ND-GAIN and WRI methods rely on country-wide rankings rather than the climate A total of 32 IAIS Members, representing around quality of a single building. 75% of the global insurance market in terms of gross written premiums, provided data. They are Specific limitations and assumptions relating to the highlighted in green on the following world map. 27 classification of equity, corporate bonds, and loans A few jurisdictions shared qualitative information and mortgages in climate-relevant sectors are only. While the quantitative information was directly described in subsection 3.4.1.1. available in some jurisdictions, other Members had difficulties in collecting this information if relying 3.3 DATA COLLECTION AND COVERAGE solely on existing supervisory reporting. As such, a To support this report, the IAIS collected few Members relied on an ad-hoc data collection quantitative and qualitative information from IAIS among a subset within their insurance sector to Members. This TCDC is similar to the sector-wide provide the requested information. monitoring data collection of the regular GME, as it covers data at a sector-wide level (aggregated There is also good coverage in terms of the data from legal entities within a jurisdiction) insurance sector’s asset mix (see Graph 3). For and has both a quantitative and a qualitative most jurisdictions, the total insurance sector was component. The quantitative information is based covered – with some exceptions as denoted with on year-end 2019; the qualitative information the striped grey bars in the graph. On average, the represents the situation as of March 2021. The five asset classes under analysis account for more analysis focuses solely on the insurance sector than half of reported total assets, with relatively investments in the general account (GA); unit- better coverage in Europe, South Africa and Latin linked or separate accounts are excluded. America. Assets not covered include items such Map 2: Jurisdictions that participated in the data collection 4. SCENARIO ANALYSIS T he future path of climate change and In addition, it may include modelling second- related financial risks is highly uncertain order effects in response to public and/or private and scenario analysis can help clarify these sector management actions. Therefore, various inherent uncertainties.33 Climate change scenario scenario analysis or stress testing exercises analysis is an important tool for central banks, use simplified assumptions by translating the supervisors and financial institutions. It provides scenarios into instantaneous shocks. a framework for exploring how (tail) risks may The scenario analysis in this report aims to evolve in the future and how climate factors may complement the exposure statistics in section drive changes in the real economy and financial 3 with a more forward-looking perspective. system.34 Scenario analysis can also help inform The aim is neither to evaluate the risks from strategic decisions and thereby ex ante help climate change conclusively nor to provide a prevent the materialization of these risks. deterministic sequence of climate variables, but to gain further indicative insights on the risks At the same time, climate change scenario and uncertainties around different scenarios. It analysis is still in its infancy and methodologies also gives a direction for future work by the IAIS. are developing and evolving. Furthermore, insufficient standardized and granular data, 4.1 SCENARIO DESIGN alongside methodological limitations, may The exploratory scenario analysis employed in hinder scenario analyses that are consistent and this report was conducted as follows: comparable. These limitations also apply to the ◗ The starting point is the scenarios developed analysis underpinning this scenario analysis, as by the NGFS. These scenarios describe in noted in section 3. a qualitative manner how insurers’ asset classes may be impacted by physical and/or In this scenario analysis, the impact of different transition risks. “climate states of the world” is assessed, ◗ As a second step, the scenarios are often in comparison to the Paris Agreement. translated into numerical stress factors, Scenarios typically include two dimensions: the which are differentiated by sector and asset climate outcome and the transition path towards class. To determine the risk factors, externals that state. The analysis requires a framework sources were used.35 which selects scenario-relevant variables, ◗ The final step includes an indicative projects them in accordance with a specific quantitative assessment of the potential scenario (pathway) as defined by the IPCC and impact of the scenarios on the market value links these variables to the prices of financial of insurers’ investments. The investment assets. It can be relatively complex, as it implies exposures (see section 3) are multiplied by defining and modelling a large set of climate, the risk factors. technological, socio- and macroeconomic, and financial variables over many years.  scenario featuring less stringent policy action 4.1.1 NGFS scenarios would yield a 67% chance of limiting global The NGFS distinguishes four main scenarios with warming to below 2°C. Physical and transition escalating severity: risks are both relatively low in such scenarios ◗ An orderly (early, ambitious) transition, and transition risks are illustrated by a gradual consistent with a temperature increase of 2°C shift from fossil fuels to renewable energy and a by 2100. This is the mildest scenario. gradual increase in carbon prices. ◗ A disorderly (late, disruptive action) transition, ◗ A disorderly scenario assumes that climate consistent with the same temperature increase but amplifying transition risk. policies are not introduced quickly enough to minimise macroeconomic disruptions. As ◗ A “hot house world” scenario consistent with a a result of late action, emissions reductions temperature increase of close to 4°C by 2100 need to be sharper and more sudden or, and little or no transition policy, which focuses alternatively, exhibit costly heterogeneity on physical risk. across sectors increasing the overall costs ◗ A “too little, too late” scenario which can be associated with the transition. The difference considered a worst-case scenario that exhibits relative to an orderly scenario is clearly visible both transition and physical risk. in Graph 10, which shows a sudden reduction in the total energy supply and a more sudden Figure 2 represents these scenarios and Graph shift to renewables. Carbon prices also 10: illustrates examples of key variables under increase significantly. In this type of scenario, each scenario.36 transition risks for carbon-intensive sectors, ie climate-relevant sectors in this study, are high. Figure 2: NGFS scenarios ◗ A hot house world scenario assumes that policies currently implemented or pledged at a national level are preserved, which will High not be sufficient to meet the targets under the Paris Agreement. Emissions continue to grow, leading to warming of more than 3°C and significant physical risks. This includes irreversible changes like higher sea level rise. Transition risks The scenarios above differentiate between physical and transition risks. Actions taken in the disorderly scenario effectively reduce carbon emissions to levels below those in the orderly transition. By 2100, therefore, the manifestation of physical risk is minimal compared to the scenarios where the 2016 Paris Agreement targets are not met. Conversely, a “hot house” scenario is one in which transition risk is minimal, as no (or only limited) actions are taken Low to mitigate GHG emissions. Low Physical risks High The NGFS illustrates an additional, “too little, Source: NGFS (2021) too late” scenario framework that would contain elements of both risks, although it has not yet been quantified in detail. In this scenario, a critical The NGFS has developed detailed quantitative volume of emissions become concentrated information for three of its scenarios:37 in the atmosphere before a disorderly or futile ◗ An orderly scenario assumes that climate transition takes place. This “too little, too late” policies are introduced early and become scenario would therefore exhibit both transition more stringent gradually. In one such scenario, and physical risk. It contains pessimistic net-zero emissions are achieved before 2050, meteorological assumptions and significant limiting temperature rises to 1.5°C. A separate economic disturbances.  Graph 10: NGFS scenarios – illustration on key variables Energy mix (hot house) Energy mix (below 2 degrees) 900 900 800 800 700 700 600 600 500 500 400 400 300 300 200 200 100 100 0 0 2015 2020 2025 2030 2035 2040 2045 2050 2015 2020 2025 2030 2035 2040 2045 2050 Coal Oil Non-biomass renewables|Solar Non-biomass renewables|Hydro Gas Nuclear Non-biomass renewables|Wind Biomass Carbon price Carbon dioxide emissions 800 50000 700 45000 USD2010 per tCO2 40000 Mt CO2 per year 600 35000 500 30000 400 25000 300 20000 15000 200 10000 100 5000 0 0 2015 2020 2025 2030 2035 2040 2045 2050 2015 2020 2025 2030 2035 2040 2045 2050 Below 2°C Delayed transition Current policies Source: NGFS (2021)38 market value of insurers’ assets are assumed to The scenario analysis in this report estimates the exhibit sectoral heterogeneity. For sector-level value of insurers’ current asset portfolios under analysis, this report relies on scenario-consistent an orderly transition, a disorderly transition and a “too little, too late” world. As the report focuses on transition risks, there is no separate analysis of a “hot house” or purely physical risk scenario. Instead, physical risk factors consistent with a hot house scenario are embedded in the “too little, too late” scenario. 4.1.2 Stress factors design for equity, corporate bonds, and loans and mortgages As noted earlier, the data assessed for this report indicates that about 35% of insurers’ assets on average are held in equities (including in investment funds), corporate bonds, and loans and mortgages. The effects of these adverse scenarios on the stress factors derived and applied in both the academic sphere and among supervisoryauthorities.39 The stress factors consist of an arithmetic mean for each asset class and each climate-relevant sector, from those used in publiclyavailable methodologies. 4.1.2.1 Orderly and disorderly transition scenarios Equities The range of the stress factors varies with respectto the asset class and sectoral segmentation. Graph 11 shows that most sectors exhibit moderate variance across the methodologies, although utilities shows greater uncertainty. By using information from a wide range of methodologies, less weight is given to any singlestress factor — some of which may contain intentionally severe assumptions that are difficult to compare with those made in other studies.  Graph 11: Stress factors from supervisory studies and academic literature (equities) 10% 0% -10% -20% -30% -40% -50% -60% -70% -80% -90% -100% Agriculture Energy intensive Fossil fuel Housing Transport Utilities Source: 2Degrees Investing, BdF, BoE, DNB, EIOPA, IMF and own IAIS calculations Existing methodologies do not standardise the assumptions that derive the shock for assets features distinguishing an orderly from a disorderly such as corporate bonds as a fixed proportion of transition scenario. A disorderly scenario could equity shocks in the same sector. Work is under consist of either late or abrupt policy action, way to derive a widely accepted and harmonised with various degrees of macroeconomic spillover methodology for use within the industry and by and disruption to the real economy. In contrast, supervisory authorities. In the interim, this report an orderly transition may involve more moderate uses the same approach as taken by the BoE sectoral impacts and limited second-round and EIOPA for the corporate bonds and loans and effects on the real economy. To help differentiate mortgages asset classes, with a fixed multiplier of between the two scenarios, this report assumes 0.15 compared to the assumed impact on equities that an orderly transition involves half the market (for both orderly and disorderly transitions). risk found in the disorderly scenario. Therefore the disorderly stress factors implemented in the 4.1.2.2 “Too little, too late” scenario existing literature have been multiplied by 0.5 For the “too little, too late” scenario, the assumed to derive the stress factors used in the orderly stress factors are calculated as the sum of the transition scenario. following three components: ◗ A transition risk component: the sector-specific Corporate bonds, and loans and mortgages stress factors used in the disorderly transition In a number of studies, distinguishing stress scenario as described above. factors across asset classes has been more ◗ A physical risk component: sector-specific stress challenging than across sectors. For instance, factors as used by BoE40, ranging between 10% abundant historical market data for equities and 30% for equities, and 1.5% and 4.5% for make it easier to econometrically estimate the corporate bonds, and loans and mortgages. co-movement of equities with macroeconomic ◗ A general market stress component: given the variables affected by a carbon tax. It can be more wide-ranging impacts of both physical and difficult to apply similar quantitative methods for transition risks on the real economy in this non-traded assets such as loans and mortgages. scenario, it is assumed that all assets – not Certain studies, including that of the Bank of only those held in climate-relevant sectors – are England (BoE) and EIOPA, have simplified the affected. A constant stress factor of 10% was  applied to all other equities and 1.5% to all other As the depth and frequency of the underlying corporate bonds, and loans and mortgages. time series used can vary, this study integrates additional market-based data, credit default 4.1.3 Stress factors design for sovereign swap (CDS) spreads, to incorporate more current bonds and real estate information on a country’s creditworthiness. First, For the sovereign bond and real estate asset a statistical model, which predicts the (composite) classes, a geographic (rather than sectoral) ND-GAIN Index of 108 countries as a function of approach is taken.41 their respective five-year CDS spread data from the Bloomberg Default Risk model, is fitted. 4.1.3.1 Sovereign bonds Graph 12 represents this visually. Transitioning towards carbon neutrality can affect a country’s ability to issue debt in financial markets Intuitively, this model yields an approximate (or influence the market value of existing debt), measure for the share of cross-country variation due to the possibility of disturbances that may in the ND-GAIN Index that can be explained, spillover into the real economy. Furthermore, high or determined, using CDS data. The remaining exposure to increasingly severe physical risks may variation, unexplained by the model, reflects any affect vital infrastructure. Therefore, sovereign variables unrelated to CDS spreads that influence bonds are considered a climate-relevant asset developments in the ND-GAIN Index. To recognise class in this study, and a methodology relying their impact, this residual component (≈ 1.3), on several data sources has been developed to resulting from the statistical model, is added to the produce jurisdiction-specific stress factors to CDS spreads. The factors are therefore derived in apply to government bonds. the following way: Several distinct data sources have been considered 𝑓𝑓 𝑆𝑜𝑣 = 5𝑌 𝐶𝐷𝑆 𝑌𝐸19 ∗ 𝑟𝑒𝑠𝑖𝑖𝑑𝑢𝑎𝑙 𝑐𝑜𝑚𝑝𝑜𝑛𝑒𝑛𝑡 𝑐𝑜𝑢𝑛𝑡𝑟𝑦 𝑖𝑖 𝑐𝑜𝑢𝑛𝑡𝑟𝑦 𝑖𝑖 to develop this methodology. In order to provide a measure of a country’s readiness as well as related shocks. its vulnerability to the effects of climate change, the combined ND-GAIN Index was used to help demonstrate how a country’s exposure to climate- related risks could ultimately impact its sovereign risk (see section 3). By considering readiness and vulnerability, this index reflects a country’s exposure to both transition and physical risks. The vulnerability component of this index specifically measures a country’s susceptibility to physical risk (“exposure”), degree of sectoral dependence on at-risk sectors (“sensitivity”) and current capacity to implement solutions (“adaptive capacity”). These factors are naturally difficult to quantify and often exhibit considerable inertia; indeed, “exposure” indicators are assumed to not vary over time in the ND-GAIN database. Nonetheless, the measures are based on 36 different variables and are rooted in a wide array of available datasets and scientific studies, providing important insight into the vulnerability of each country to climate change. The readiness component is composed of nine variables (grouped into “social”, “economic” and “governance” categories), which aim to measure a country’s ability to cope financially with climate- In sum, this approach magnifies the market- basedCDS spreads data that is proportionate to the partof the ND-GAIN Index unrelated to a country’s creditworthiness. Financial and macroeconomic impacts are assumed to materialise with differing degrees of severity according to the orderliness of thetransition. A higher degree of disturbance in a country’s real economy will imply a higher degreeof credit risk posed by a given sovereign debt instrument. At present, there is no widely used methodology for applying climate-related financialshocks to sovereign debt. The above method was thus implemented to retain the majority of information embedded in the ND-GAIN dataset, supplemented with more current market data. Thisapproach may be imprecise and is not assumed to project highly certain impacts. Rather, it is a rough method for combining information from different datasets to form a single stress factor that is based on available data and reflects currentmarket expectations. Graph 13 shows the range of factors resulting from the model for all 108 jurisdictions where ND-GAIN and Bloomberg data are available. Formost jurisdictions within the scope of this report,  Graph 12: ND-GAIN index versus five-year CDS spreads 80 NOR 75 NZL FIN SD CHEWNEK DESAU U GIS PL T LUXGBR 70 AUKSOR JDP NLF RNAAN C USA IRL 65 SVN EST CZE BELPRT ESPPOL AL RTEU ISR CHL 60 ITA LVA GRCRUS ND-GAIN index MLT SVK CYP BRN MYS MKD HUN MU S KAZ BSGARH URV URY QAT 55 MNE CHN OMN CRI THA SRB MR AR OU MNG TUN UAKN R JOR P 50 KWT AZ E MDA PER JAC MOMEX ARG TTO L BWABRA ZPAR FY VNM DOM IDN 45 NAM DZA SG E LV Y LKA LBNGHA ECU PHGLTM RWA GAB IND NIC 40 HND BOL MRT SEN ZMB CMR TZA PNG PAK KEN AGO MOZ 35 BGD MWI NGA UGA 30 - 100 200 300 400 500 600 700 5year CDS (in basis points) Source: ND-GAIN, Bloomberg and WorldGovernmentBonds however, the factors are more modest, eg for 4.1.3.2 Real estate the “too little, too late” scenario, factors range Factors for real estate exposures were derived between 0.3% and 7.3%. This is because many similarly to the methods described above. of these jurisdictions either have relatively low Exposures to climate-related risks differ among CDS spreads and/or relatively high (favourable) countries in line with their vulnerability to physical ND-GAIN Index scores. and transition risks. Graph 13: Stress factors for sovereign bonds 0% -2% -4% -6% -8% -10% -12% -14% -16% -18% The real estate factors in this report contain: orderly scenario for the transition component and in the hot house scenario for the physical risk ◗ A transition risk-related component calculated component; and the 99.5th percentile is applied using the Readiness ND-GAIN Index and five- year country CDS spread in a statistical model: for the disorderly scenario and the “too little, too late” scenario. Graph 14 shows the range of factors 𝑇𝑟𝑎𝑛𝑠𝑖𝑖𝑡𝑖𝑖𝑜𝑛 𝑐𝑜𝑚𝑝𝑜𝑛𝑒𝑛𝑡 𝑅𝐸 = 5𝑌 𝐶𝐷𝑆𝑌𝐸19 ∗ 𝑟𝑒𝑠𝑖𝑖𝑑𝑢𝑎𝑙 𝑐𝑜𝑚𝑝𝑜𝑛𝑒𝑛𝑡 resulting from the model for all 108 countries where 𝑐𝑜𝑢𝑛𝑡𝑟𝑦 𝑖𝑖