This article first appeared in The Edge Malaysia Weekly on August 12, 2024 - August 18, 2024

Malaysia, situated just north of the equator, is free from many forms of natural disasters. However, it is prone to seasonal flooding that is increasing in frequency on the back of global warming.

When floods occur, families are displaced, lives are lost and wealth destroyed. It is pertinent that all parties, including the financial sector, come together to address the risks and challenges of climate change.

Recall the large-scale floods in December 2021 in Malaysia that resulted in over 50 deaths and the displacement of around 40,000 people. The nation suffered losses from damage of an estimated RM6.1 billion, or 0.4% of its gross domestic product (GDP), according to Bank Negara Malaysia.

Recently, long-duration and heavy rainfall had led to many cars being damaged, as open-air parking lots turned into yellow ponds and trees planted along the roadside in Kuala Lumpur fell. One such incident claimed the life of a 47-year-old man in May.

The good news, however, is that regulators, banks and insurers in the country have been proactively working on various climate change policies to better prepare the industry for the future.

During the interviews with some local banks and insurers, it was found that they are highly concerned about flood risks.

Mok Fan Wai, head of sustainability at Alliance Bank, says the floods in 2021 resulted in the largest documented claims payout for the local insurance and takaful industry of up to RM2.2 billion. Such an occurrence is expected to increase in both frequency and intensity, according to a report conducted by Bank Negara and the World Bank.

Teresa Wong, chief risk officer and head of sustainability risks at Zurich Malaysia, concurs. She says floods are occurring more frequently, while many homeowners are not insuring their houses against such risks.

In 2021, when Malaysia was hit by severe floods, there were 222 flood disasters recorded around the world. It was the second-highest figure reported since 1990. The number was lower in the following year, but still high at 176 cases.

“Seven of the top countries facing flood risks are in Asia, especially in the south and east. Factors such as low-lying lands, tropical storms, heavy rainfall, long monsoons and poor flood defences make Southeast Asia very vulnerable to floods,” says Wong.

She points out that the risk of floods increases in tandem with the rise in severity of global warming. When the global temperature goes up by 2°C, the number of people at risk from flooding could increase by 30%.

“Seasonal flooding is becoming more frequent, occurring not just during the northeast and southwest monsoon seasons. And they have a significant impact on the local insurance and takaful sectors,” says Wong.

Citing a survey conducted by Zurich in 2021, Wong says only half of the homes in Malaysia are covered by insurance or takaful for potential damages. Moreover, 74% of homeowners do not have coverage against flood damage, even though they live in flood-risk areas.

“Many homeowners do not know or are not sure what their home insurance or takaful covers, especially for home content, including valuable items and appliances. Only one in three insured homeowners has some content protection, and 13% bought separate plans for it,” she says.

Wong makes a simple comparison using data provided by Bank Negara on the December 2021 floods to show that in general, Malaysians are underinsured when it comes to flood risks.

According to Bank Negara, the floods had caused total economic damage of RM6.1 billion, while insurance and takaful operators (ITOs) had paid out more than RM2.2 billion for flood claims. “This means that only 36% of the losses incurred were covered by insurance or takaful,” she says.

She adds that those in the low-income group are often underinsured, despite a variety of products available in the market, which could be due to a lack of awareness. Overall, less than 25% of homes owned by this group have flood insurance, and only about 5% of vehicles are insured for floods, she continues.

Without a doubt, floods impact insurers and banks as well — the former have had to pay out more claims than in the past, while the latter have seen their clients’ properties, purchased using loans, suffer damage and decline in value.

“Seasonal monsoon floods, typically occurring at the end of the year and sometimes extending into the new year, markedly impact the underwriting profitability of the ITOs. This effect is especially apparent in the financial results of the first and final quarters [of the ITOs],” says Wong.

To protect themselves, ITOs purchase “catastrophe excess of loss” cover for their insurance/ takaful portfolios, she explains. Catastrophe excess of loss is a form of reinsurance, where a reinsurer agrees to reimburse the amount of a very large loss in excess of a particular sum to the insurers.

A reinsurer is a company that provides financial protection to insurance companies. In other words, ITOs tend to spread their risk with reinsurers, and do not bear the full brunt of the loss in some situations.

However, more frequent floods that lead to large losses for insurers would eventually increase the reinsurance and retakaful cover cost.

Besides losses and damage to physical assets, there are other forces at play that are pushing businesses to be more aware of climate change developments around the world, and to adopt sustainability practices.

For financial institutions, climate risks are categorised into two broad types, namely physical risk and transition risk, says Luanne Sieh, group chief sustainability officer at CIMB Group.

Physical risk refers to risk arising from the exposure of a group and its clients’ assets to the acute or chronic physical effects of climate change.

Transition risk refers to that arising from the world transitioning into a low-carbon economy, leading to technological shifts as well as changes in regulations, investor expectation and consumer preferences.

An example of transition risk is the shift in car production and consumer preferences for automobiles to electric vehicles. EV sales increased to 13% of total sales in 2023 from 4% in 2020. Such growth has also sparked a parallel demand for critical minerals, such as lithium and nickel, to support EV battery production.

Another example would be the implementation of the Carbon Border Adjustment Mechanism (CBAM) by the European Union (EU), which is a tariff on carbon-intensive products imported to the region. At the moment, it covers steel, cement, fertiliser, electricity and hydrogen products, which increases business costs for many companies.

Climate risk, if not well assessed and evaluated, could have a bearing on financial institutions. For instance, a bank may experience heightened credit risk — the possibility of loss due to borrowers defaulting on loans — when its clients are affected by the EU’s CBAM, says Sieh.

A bank could also face mortgage defaults due to extreme weather events, such as severe floods, which lead to continuous business disruption and damage to property. These events could have a negative impact on the creditworthiness of a bank’s client, or the value of their assets held as collateral.

“We are approaching a series of tipping points in the economy — how we do business and how society functions — all shifting towards various attempts to reduce carbon emissions and to avert the worst effects of climate change. But we are not moving fast enough,” says Sieh.

However, that does not mean that the global financial industry is not moving at all, and in the right direction. Local banks are guided by several Bank Negara policies in assessing and mitigating climate risks.

For one, Sieh says CIMB is guided by Bank Negara’s policy document on Climate Risk Management and Scenario Analysis and the Climate Risk Stress Testing (CRST) Methodology Paper in developing its internal capabilities for climate scenario analysis (CSA) and CRST. These are used to evaluate the potential impact of climate-related physical and transition risks on businesses.

In 2023, CIMB conducted a CSA proof-of-concept exercise on its non-retail financing and investment portfolios across key operating countries, including Malaysia, Indonesia, Singapore and Thailand.

Sieh says the initiative focused on investigating the credit impact of transition risk on the bank’s main sector portfolios, such as agriculture, power generation, and oil and gas.

How does it work? Sieh says the bank begins with the selection of representative companies with differing risk and business profiles for each sector. Subsequently, these representative companies in each sector are categorised based on their business and risk attributes, and assigned an appropriate archetype that would allow for extrapolation at a later stage.

These representative companies’ financials are then individually stressed under each climate scenario across a set of key financial risk drivers, allowing the bank to observe the impact of transition or physical risk on their probability of default.

Lastly, the results of these representative companies are extrapolated to other companies in the same sector and archetype, and applied to the rest of the companies in the bank’s non-retail book, explains Sieh.

CIMB’s first attempt at CSA provided it with some insights into the complexities of climate risk analysis, she adds.

Key challenges include data availability and quality, as the CSA requires a large amount of financial and non-financial data, but not all information is readily accessible in the public domain. The bank had to rely on a research team to comb through reports and websites to obtain necessary data points to fill the gaps. Due to the lack of data, CIMB had to make assumptions and used proxies for its analysis. However, proxies are indicative in nature and may not fully reflect a company’s performance or market conditions.

Granularity is another issue, as climate risk is based heavily on sector or location. The climate risk profile of a renewable energy company in Malaysia could differ widely from that of a coal-based power generation company in Indonesia. It means the bank’s models and methodologies for analysis have to be flexible to cater for the various context and risk drivers of each sector and companies assessed.

Sieh says the CSA concept is in its infancy. The bank sees the main intent of its impending CRST exercise as: to facilitate financial institutions’ learning and capacity building in addressing climate risk, without direct capital requirements.

“Results at this stage are directional and indicative due to challenges highlighted earlier. However, we do anticipate that as disclosures, methodologies and scenarios improve, the CSA results could be used by banks to price in climate risk in the future,” says Sieh.

Meanwhile, Alliance’s Mok says the bank is also embarking on its climate stress testing following Bank Negara’s latest publication on the CRST Methodology Paper on Feb 29. At the moment, she says climate-related risks are “incorporated into the risk evaluation process as transmission of climate-related risk into common risk types, such as credit, market and operational risk”.

“For instance, potential damage of a borrower’s business or collateral by floods is evaluated and priced as part of credit risk assessment,” she adds.

Mok concurs with Sieh’s view that climate-related risk-based pricing is still at its nascent stage, and it is complex and challenging for the banks due to limited data. These challenges are compounded as small and medium enterprises face limitations in providing the banks with the necessary data.

Mike Ng, group chief sustainability officer at OCBC, says credit and reputational implications from climate risks are likely to be more material than other traditional risks, based on the bank’s assessment.

As one of the largest banks in Singapore and with a huge presence in Malaysia, OCBC has proactively tightened its lending policies to shift away from fossil fuel consumption, including enforcing enhanced coal-related prohibition, says Ng.

In fact, as early as in 2021, the bank committed to growing its sustainable portfolio to S$50 billion by 2025. “We have surpassed the target ahead of schedule with total sustainable loan commitments of S$60.5 billion as at end-March 2024,” he says.

Ng adds that the Joint Committee on Climate Change, co-chaired by Bank Negara Malaysia and Securities Commission Malaysia, advocates the importance of “just transition”. It reminds financial institutions of the importance of encouraging and/or enabling banks’ corporate clients and individual customers to transition towards more sustainable business models or lifestyles.

“Bank Negara has been actively rolling out new guidelines and regulations. All these ensure that the financial industry actively monitors and mitigates potential climate-related risks to safeguard the long-term sustainability of our financial system, while protecting the interests of our stakeholders,” he adds.

Other well-known foreign banks with local operations, including United Overseas Bank (Malaysia) Bhd (UOB Malaysia) and HSBC Bank Malaysia Bhd (HSBC Malaysia), are also doubling down on their sustainability efforts to tackle climate change risks and challenges.

In its financial year 2023, UOB Malaysia posted a net profit of RM1.9 billion, up 44.5% from the previous year. Its sustainable financing portfolio has grown in tandem, partly reflected in its green financing loans of RM6.2 billion as at May 10, according to a news report by the Malaysian National News Agency.

In its Sustainability Report 2023, UOB also mentioned that the firm has extended a total of S$44.5 billion in sustainable financing to corporates, and channelled a total of S$10.4 billion in total assets under management to environmental, social and governance-focused investments.

The bank aims to reduce carbon emissions for various sectors, including energy, automotive, oil and gas, real estate, construction and steel.

According to the report, UOB targets to reduce the carbon emissions intensity of the power sector by 64% by 2030 and 98% by 2050. It also wants to reduce the emissions intensity of the automotive sector by 58% by 2030 and achieve net zero by 2050.

UOB also stopped financing new projects for upstream oil and gas projects after 2022.

HSBC as a group has set various sustainability targets, including phasing out the financing of coal-fired power and thermal coal mining by 2030 in markets in the European Union and Organisation for Economic Co-operation and Development, and by 2040 in other markets.

Among others, it has also set reduction targets for additional carbon intensive sectors, namely cement, iron, steel and aluminium, and the transport sectors of automotive and aviation.

Locally, HSBC Malaysia has collaborated with public-listed companies, such as cocoa manufacturer Guan Chong Bhd (KL:GCB), on their sustainability journey to achieve 100% traceable and sustainable cocoa by 2023, creating a more responsible supply chain.

Teresa Wong, chief risk officer and head of sustainability risks at Zurich Malaysia, says climate risk-based pricing is possible. She adds that changes are already underway in general insurance, as the Phased Liberalisation of Motor and Fire Tariffs (Phase 2) aims to allow the industry to move towards a market-based pricing system that reflects a customer’s risk profile and the claims experience.

However, such a shift could also make basic protection for climate-related events, such as floods, less accessible and affordable for some segments of the country’s population.

“Insurance and takaful operators (ITOs) would need to balance the need for risk-based pricing with the need for social responsibility and customer protection,” she says.

Wong believes that local ITOs are taking proactive steps to ensure their strategies include climate change risk in support of Malaysia’s economy and businesses.

The main challenge for climate risk-based pricing is similar to those faced by banks, which is the availability and quality of necessary data. There is also the harmonisation and standardisation of definitions and methodologies, the alignment and coordination of policies and regulations, and the awareness and education of stakeholders.

“Therefore, we welcome and appreciate the efforts of regulators, industry associations, academia and civil society to foster a collaborative and conducive ecosystem for climate action in the Malaysian insurance and takaful sector,” says Wong.

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