Could Climate Change Cause the Buy-In Market To Collapse?

We’ve been researching the environmental, social and governance (ESG) approaches of bulk annuity providers since 2019. Each time we update our research, we find that insurers’ approaches have improved. 

In 2019, we heard a lot about how insurers were considering ESG risks and opportunities within their assets. 

In 2021, we heard more from the insurers on how they consider ESG risk within their liabilities. 

In 2023, we focused more on how insurers are considering climate change as a systemic risk – one that is not just at risk of impacting their assets and liabilities, but at risk of damaging the solvency of the whole insurance regime. 

In 2024, we continued with our focus on systemic risks and also heard from some new entrants to the market. 

This focus on systemic risks may seem surprising and you may wonder why we did this, so I set out our reasons below. It starts with how climate change could impact pension schemes, the insurance regime and financial markets as a whole. In this blog, I look at what the insurers are doing to tackle climate change and also provide thoughts on what LCP, trustees and regulators can do to make these outcomes less likely. 

What does three degrees of warming look like? 

When we talk about climate change, we often use numbers to describe the average level of temperature warming of the world compared to pre-industrial levels. You’ll hear the terms ‘1.5 degrees’ or ‘well below two degrees’ come up a lot – this is what the global target is. 

It’s not what we are currently on track to achieve though – in fact, based on current policies, we are on track for around a three degree temperature rise. So, what does that actually look like? 

To take one example, we could see around 74% of the world’s population living in uninhabitable areas, because there would be more than 20 days a year of deadly heat. 

74% of the population’s current homes becoming uninhabitable could result in mass migration, a climate refugee crisis, social unrest and even war. 

There may be additional pressure on food and water resources, which will already be under pressure due to crop failures, water scarcity, drought, transport and infrastructure challenges. 

All of this does not make for a good stable financial environment either – we are likely to see the stability of markets being completely undermined, economies collapsing and GDP plummeting. 

This may sound like an extreme outcome, but it’s not – this report from the UN Environmental Programme indicates this is where we are currently heading – and given that this is likely to manifest over the next few decades, it is extremely relevant to the payment of members’ benefits. The latest climate change conference, COP29, did not materially change this global climate outlook in our view. 

How could climate change impact the insurance regime? 

Buying out a pension scheme is often seen as the safest way to ensure that members will get the benefits they are promised. As part of the solvency regime, insurers are required to hold plenty of assets to help cover high-risk events. 

But what if these high-risk events posed by climate change become more and more frequent, and have wider-reaching and more devastating impacts? 

An insurer has to make assumptions to model what the likelihood and potential impacts of these high-risk scenarios could be. 

Are the insurers’ assumptions fully taking into account the risks of unmitigated climate change? 

The answer is likely no – not least because these physical risks are very hard to model and capture. They tend to work in feedback loops, where if one planetary boundary is crossed, others are too, resulting in a compounding effect which comes back to seriously damage the economy and financial markets as whole. Some of the standard assumptions about how markets behave are likely to stop being true in these scenarios – so relying on modelling alone is a difficult way to fully capture the potential impacts of climate change. 

So what happens in this scenario – what happens if the insurer’s assets fall by more than the protection levels they had in place, and it therefore does not have enough capital to pay its beneficiaries? 

Well, this is where the next stage of protection comes in – the Financial Services Compensation Scheme (FSCS). In short, if an insurer goes bust, the idea is that the FSCS will still provide its beneficiaries with the full compensation they have been promised – so pension scheme members will still get paid what they are owed. 

This sounds great! There’s no downside – so why should we care about climate change at all? 

Let’s dig a bit deeper into this. 

The regime is broadly untested – we haven’t seen any buy-in insurers fall into the position where they need to use this. However, if we are in a position where an insurer has gone bust, because it has underestimated the potential financial impacts of climate change, is this going to be a one-off case, that only affects one insurance firm? 

I think that’s unlikely. If one insurer is impacted in this way, it’s very likely that other insurers will be in a similar position. 

If several insurers go bust at the same time, against a backdrop of broader financial market crashes – how is the FSCS going to hold up? Is it really going to be able to pay the full benefits to all the policyholders and beneficiaries of all the insurance companies? If climate change goes unmitigated, are the protections provided by the insurance regime going to be enough – or could we see even these protections collapse? 

I think these are the questions we need to be asking, as the realities of unmitigated climate change come to reality. 

So what’s the solution? 

Do insurers need to be working more on their models to reflect the potential impacts and probabilities of unmitigated climate change scenarios? 

My answer is no – or not just that. Yes, models can be improved, but there will always be limitations. 

And the thing is, even if we do have models that capture the full likelihood of these downside scenarios – what do we do with them? 

To put it bluntly, in a set of scenarios that reflect a world with unmitigated climate change, the outcomes are going to look really bad. Can insurers actually hold enough capital to cover this? And what would this world mean for members’ quality of life? Unmitigated climate change is likely to come with all sorts of knock-on impacts – financial markets crashing, mass migration, geopolitical conflict and more – I don’t think any members really want to be living in this outcome set. 

So I think the solution is not about modelling a terrible world. It’s about changing the world itself, so we don’t end up with these outcomes. 

It’s about insurers, and indeed everyone in the investment chain, using their influence to try and stop the world from getting to that dire position that scenario modelling may or may not be capturing. 

We need to collectively change the global direction of travel so we don’t end up in this dire situation where an insurance regime can’t hold up, and our lives are in peril. 

How do we do this – how can we use systemic stewardship to mitigate climate change? 

Climate change risks are really big picture – they are systemic in nature and long term, which means they can’t simply be diversified away from. Instead, action needs to be taken on a systems level, for example by changing the laws and regulations that govern how businesses operate, both within the financial sector and beyond. 

Insurers are in a really good position to influence what happens, by engaging with regulators and policymakers about climate change, and we are seeing them take action already. 

The nine insurers active in the UK buy-in market hold c £350bn of assets to back individual and bulk annuities, and this is only projected to grow. This means the insurers have a huge amount of influence between them to drive forward positive change. Insurers also generally have good relationships with policymakers and regulators, so can use their influence to drive forward positive change on a broader systemic level via these avenues too. 

Indeed, our research found that the buy-in insurers are already starting to do this: 

Most insurers are regularly responding to relevant consultations and publishing their responses 

Some insurers are having bilateral discussions with policymakers and taking part in roundtables 

Most insurers are in regular contact with regulatory bodies 

Some insurers are proactively taking part and even leading regulatory working groups, such as those within the PRA’s and FCA’s Climate Financial Risk Forum. 

It’s not just about insurers though. 

Trustees of pension schemes can also influence these outcomes, via the insurers they choose to work with. When trustees consider which insurer to transact with through a selection exercise, they are unlikely to pick an insurer that they think is at risk of going insolvent, or contributing to financial market instability – after all, this would undermine their duty to protect their members’ benefits. Given the importance of systemic risks like climate change in determining the long-term stability of the insurance regime, insurers’ climate change approach should be considered as part of this selection process. In doing so, trustees can encourage insurers to strengthen their approach in ways that will help to reduce climate risks to the system as a whole (so avoiding the dire scenario outlined above) as well as to the insurer itself (so providing greater protection to members’ benefits in less extreme scenarios). 

Claire Jones is Partner and Head of Responsible Investment at Lane, Clark & Peacock