There is a need for insurers and banks to reflect climate risks in their decisions, said The Reserve Bank of New Zealand in its six-monthly Financial Stability Report issued last week.
Property insurance penetration is high in New Zealand, so these risks may crystallise in the insurance sector. However, most property insurance contracts are negotiated annually, allowing insurers to reassess risk and adjust policy terms each year, noted the central bank.
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,” said the RBNZ.
It indicated that it will engage further with banks and insurers to understand how they are incorporating these and other climate-related risks within their businesses.
Multi-party effort for sound financial system
The RBNZ noted that ‘a broader response will be required’ and 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 central 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.
Agricultural sector the linchpin to manage climate risks
New Zealand’s financial system is primarily exposed to climate risks through the sectors that it lends to and insures. The financial system will be affected by both the physical and transitional impacts of climate change, noted the central bank.
While the physical impacts of climate change will pose risks through damage to property, changing property values, and disruptions to supply chains, the transitional impacts, which reflect the shift of New Zealand and other countries to lower-carbon economies, may pose risks through the impact of regulatory changes, technological advances and changes in consumer and investor preferences. There is also potential for significant liability risks to emerge.
The central bank said in the report that managing exposures to assets linked to agriculture and property, in particular the former, would be the focal point for New Zealand as agriculture accounts for half of the country’s emissions.