Aon  |  Financial Institutions Practice
How The Insurance Industry Can Inform And Assist Bank Climate Risk Management

Richard Webley, Head of Global Data Insights at Citi, describes current climate risk management efforts at banks—regarding data and other respects—as “the start of a long journey.”

As they try to get a handle on incorporating climate risk into their risk management frameworks, a source that could be instructive is the insurance industry.

“The insurance industry has had a long history of managing climate risk,” said Derrick Oracki, Financial Industry Risk Consulting Leader at Aon. “As early as the 1970s, the big reinsurers started to observe climate change. Munich Re, one of the largest reinsurers, first warned the world about climate change in 1973 when they started seeing increased losses from flooding.”

“Perhaps more than any other industry, insurance can’t hide from climate change,” Oracki said.

At a recent industry panel, Oracki, Webley, and Natalia Moudrak, Managing Director and Climate Resiliency Leader at Aon’s Public Sector Partnership, discussed how the insurance industry can help banks in climate risk management and the transition to a low-carbon economy. The session, “The Role of the Insurance Industry in Climate Risk Management,” was part of the Risk Management Association’s virtual Governance, Compliance, and Operational Resiliency (GCOR) conference.

The panel discussed how the insurance industry can provide models, data, and insights to help banks measure the climate risk to their portfolios, as well as offer solutions that can optimize green financing deals.

“Whether it’s hurricanes, tornadoes, or wildfires, the insurance industry has been in place, transferring and managing the risk of climate perils or climate events for hundreds of years,” Oracki said. “When a huge proportion of properties within economies are insured against climate risks, this gives the industry an inside view into how those risks are changing.”

Insurers have experience applying climate models “to a granular level of exposures, and rolling them back up into a systematic view,” he said. The models show “where events are becoming more frequent, where they are becoming more severe, and where they are shifting and causing more economic and social impacts,” he said.

The traditional method of assessing climate-related risk for reinsurers is through what are known as catastrophe models, he said. “They simulate hundreds of thousands of events, against massively large portfolios, and provide the entire distribution of potential loss outcomes,” Oracki said.

Catastrophe models, he said, do a “really good job of predicting acute physical risk”—think hurricanes and tornadoes—but not “chronic impacts or losses from things like precipitation increases or heat stress, and the knock-on effects on the resilience of individual infrastructure assets, homes, and buildings.”

That’s because such models “rely almost exclusively on historical data to predict losses,” he said. “But the very idea of climate change is that something dynamic is happening. There are changes in long-term trends and relationships and these need to be incorporated. We are working to layer on climate change analytics and more of that forward-looking view to help companies create that quantification for the physical risk assessment.”

For example, he said, Aon and Columbia University are “modeling out how U.S. hurricanes may change under the various climate scenarios. That new view will give us a scientific researchbased view of how climate change will impact the behaviors of hurricanes, and not just how frequently they'll make landfall. Research shows the path that hurricanes typically take will shift and move more northward, maybe driving an increased frequency of landfall and more extreme events in the Northeast United States. Also, research shows that we'll see more rapid intensification, whereas hurricanes traditionally weaken as they approach land.”

Webley said Citi is working with Aon and The Climate Service (recently acquired by S&P) to assess a baseline climate exposure and to forecast, for periods up to 30 years, the effect of varying climate scenarios on the performance of U.S. mortgages it holds. Citi is also performing a climate stress test on residential mortgages it holds and commercial real-estate lending to physical assets in Singapore, at the request of the Monetary Authority of Singapore. “If we are lending money against a physical asset, we need to understand the physical climate risk of that asset,” he said.

Ultimately, Oracki said, banks want “to capture the incremental risk of defaults and/or losses given default due to acute and chronic climate risks.” And then respond through measures such as reducing credit exposure.

When it comes to corporate borrowers, Webley said, Citi must consider how the physical risk of climate change could impact a borrower’s headquarters, data centers, international locations, and other physical assets. Citi is beginning to explore how to model the assets of corporate clients and how they would be affected by various climate scenarios.

The first step, he said, is to know the location of a corporate borrower’s assets—which is not as straightforward as it may sound. When banks onboard or perform know-your-customer due diligence on a corporate client, Webley said, they are not in the habit of asking, “where are your 500 locations?” “We lend money at a corporate parent or subsidiary level. We don’t know where all their locations are around their world.” Now that they want to, he said, “we are exploring the use of geolocation modeling companies. We can use data providers to give us addresses and then use mapping software to map different physical places.”

“Once you understand where the asset is,” Webley said, “you need to know what type of asset: Is it a wooden building? Concrete? How many floors? You do get some of that information provided to you, particularly in the mortgage business. It’s part of our underwriting process. But we don’t get that for everything. When we don’t, we have to pull it from different data sources. Satellite imagery and geolocation are very available. You can see 25 square meters on any part of the earth right now whether it’s in the Amazon or New York.”

Continuing advances in the ability to access climate risk data will be necessary for banks and other companies to meet reporting requirements like those proposed by the U.S. Securities and Exchange Commission to enhance and standardize climate-related disclosures.

“The landscape of data sources available to quantify climate change risk is very extensive and meaningful, especially when you look at the physical risk component of climate change,” Oracki said. “The insurance industry has used a wide array of tools to assess natural catastrophe risk, and has a strong understanding of using this type of information to understand risk selection. That expertise is becoming available to a broader set of stakeholders, and giving more people access to that type of rich analytics to understand the baseline catastrophe risk from climate change.”

Another use case for climate models, Webley said, is a bank’s desire to reduce its own carbon footprint. Citigroup, he said, operates in many countries around the world and has over 500 principal sites. Citi has committed to being net zero for its operations by 2030, and that will require changes to existing buildings and perhaps moves to new ones. As it moves toward net zero, he said, it must also consider whether the geographical location of a site puts it at risk of being affected by climate-related hazards like floods and wildfires.

Webley advised financial institutions to “think about the footprint of your buildings as you develop a net zero plan.” While one goal is “about getting to net zero emissions,” he said, another is to ensure the safety and security of company locations.

In addition to achieving net zero regarding their own operations, of course, banks will also be a primary source of funding for companies that will drive entire economies to net zero. Moudrak said that many banks have made sustainable finance commitments that will propel renewable energy projects such as wind and solargreen mobility solutions, sustainable agriculture and forestry initiatives, and clean technologies—such as direct air carbon capture and storage, sustainable aviation fuels, waste-toenergy projects, energy storage, and green hydrogen.

But the risks of financing such projects are many, she said, including project exposures to natural disasters, equipment breakdown, cyber exposures, supply chain issues, geopolitical risk, construction and infrastructure failures, and technology performance downfalls.

For example, “supply chain bottlenecks,” she said, could “affect potential downtimes and cause delays in completing projects on time, with a potential for financially consequential losses.”

Leveraging insights from the insurance industry can help make some of the projects more “bankable,” Moudrak said. An example she shared was working with an infrastructure client to increase the credit rating on publicly issued debt for a major infrastructure project. The use of certain insurance and performance security products provided the client with additional contingent liquidity should the risk of prime or subcontractor default on the project be realized. The credit ratings upgrade achieved by the client allowed for a lower cost of project financing, thereby improving the financial performance of the project—i.e., making the project more “bankable.”

Aon also sees the opportunity to help scale finance towards net zero by helping companies better manage, protect, and value their intellectual property, such as patents, copyrights, trademarks, designs, and trade secrets.

“Some companies in the clean tech space may be IP-rich but physical-assetpoor,” Moudrak said. “So, assessing the value of the intangible property to raise money and/or to obtain IP-backed debt capital becomes important.”

She said Aon helped secure a $125 million loan for Indigo Ag, a highgrowth agritech business that needed funding for a key phase of its corporate journey. The company develops biological and digital technologies that improve farmer profitability, environmental sustainability, and consumer health.

While IP-rich, Indigo Ag had limited physical assets on which to secure traditional debt. The company wanted to avoid dilution from third-party equity investment and was prepared to offer its IP as collateral for a loan. Moudrak said Aon reviewed Indigo’s IP portfolio and identified a range of values—from a going concern to liquidation basis—to enable a lender to assess the value of the IP that was being offered as collateral for the loan.

“We then structured an insurance solution to protect the lender with respect to that IP collateral and agreed to support the lender by performing periodic IP monitoring services,” Moudrak said. “The outcome for Indigo was access to the less-dilutive debt funding that it sought, and for the lender, it was the IP portfolio valuation, the IP protection, and the ongoing IP monitoring support.”

As the insurance and banking sectors continue on their climate risk journeys, “there will be a process of learning and adapting,” Oracki said. Different institutions will have different risk appetites and strategies. No matter their approach, though, “banks need to engage now,” he said. “They need to actively manage the immediate and potential impacts to their balance sheets, their customers, and their people.”