EXTREME WEATHER EXTREME COSTS Building Malawi’s Financial Resilience in a Changing Climate A roadmap for assessing and managing climate risks for banks and insurers © 2024 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW Washington DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org This work is a product of the staff of The World Bank with external contributions. The findings, interpretations, and conclusions expressed by World Bank staff or external contributors in this work do not necessarily reflect the views of The World Bank, its Board of Executive Directors, or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. 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Cover Photos: alamy.com / istockphoto.com Graphic Design: Kane Chong EXTREME WEATHER EXTREME COSTS Building Malawi’s Financial Resilience in a Changing Climate A roadmap for assessing and managing climate risks for banks and insurers DECEMBER 2024 © wilpunt / istockphoto.com Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 03 Table of Contents List of Figures, Tables, and Boxes 04 Abbreviations and Acronyms 06 Acknowledgements 07 Executive summary 08 1. Introduction 12 2. Financial sector context 16 3. Climate change context 20 3.1 Vulnerability to the physical impacts of climate change 21 3.2 Transition towards a low carbon, environmentally sustainable economy 24 3.3 Policy priorities for climate mitigation and adaptation 27 4. The insurance sector’s vulnerability to climate risks 28 4.1 The insurance sector’s exposure to climate risks 29 4.2 Overview of the insurance sector response to climate risks 35 5. The banking sector’s vulnerability to climate risks 38 5.1 The banking sector’s exposure to climate risks 39 5.1.1 Banks’ exposure to climate physical risks 39 5.1.2 Banks’ exposure to climate transition risks 46 5.1.3 A deeper dive on bank-by-bank exposures 46 5.1.4 Operational risk: Mapping the banking sector’s branch network 50 5.2 Overview of the banking sector’s response to climate risk 52 6. Policy roadmap for managing climate risks for banks and insurers 54 6.1 Governance, strategy, and capacity building 57 6.2 Regulatory and supervisory response to climate risks for the insurance sector 58 6.2.1 RBM supervisory and supportive role to help insurers manage climate-related financial risks 58 6.2.2 Developing structures for climate risk insurance programs 60 6.2.3 Engagement with the government on policy to enhance the role of climate risk insurance 62 6.3 Regulatory and supervisory response to climate risks for the banking sector 65 6.3.1 Risk identification, assessment, and monitoring 65 6.3.2 Supervisory framework for climate risk management 67 04 Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate List of Figures Figure 1 Examples of African countries that have established their own supervisory and regulatory 13 frameworks on sustainable finance and climate risk Figure 2 Global mapping of NGFS and SBFN members 14 Figure 3 Global mapping of NGFS and SBFN members 14 Figure 4 Climate risk assessment approach 15 Figure 5 Key natural disaster hazard statistics for Malawi 1980–2020 and number of people affected 21 Figure 6 Mean temperature (left) and precipitation trends (right) and projections to 2100 across 125 22 climate models Figure 7 Per capita annual GHG emissions in Malawi, surrounding countries, and the world 24 Figure 8 GHG emissions by sector 25 Figure 9 Potential impact of CBAM regulations on African economies 26 Figure 10 Exports of goods by destination, 2022 (US$ millions) 26 Figure 11 Key insurance statistics for non-life products 30 Figure 12 Sectoral distribution of Malawian banking credit as of January 2024 (percentage of total 40 gross loans) Figure 13 Agricultural credit as a percent of total credit for Malawi and other African countries 40 Figure 14 Sectoral distribution of NPLs as of January 2024 (percentage of total NPLs by value) 41 Figure 15 Sectoral credit exposure of Malawian banking sector’s largest borrowers as of January 2024 41 Figure 16 Malawian sectoral credit exposure (2012–2022) 44 Figure 17 Malawian banking sector’s credit exposure by counterparty as of January 2024 (percentage 45 of total credit) Figure 18 Loan exposure to transition-sensitive sectors as of January 2024 (percentage of total gross 46 loans) Figure 19 Percentage of loans per bank in agriculture and associated sectors as of January 2024 47 Figure 20 Average credit exposure masks wide variations within banks as of January 2024 (range of 47 the percentage of gross loans in Malawian banks) Figure 21 Sectoral breakdown of total credit of the top 10 borrowers of eight banks in Malawi (as of 48 June 2024) Figure 22 Distribution of agricultural credit to the top borrowers, by crop (as of June 2024) 49 Figure 23 There is a significant presence of banks in urban centers 50 Figure 24 Malawi experiences recurring droughts and floods, especially in the south 50 Figure 25 Financial products matched to household segmentation 63 Figure 26 Roadmap for implementation of the Ghana Climate-Related Risk Directive–2024 68 Figure 27 Case study: CBK implementation roadmap of climate risk management for banks 69 Figure 28 Commercial farming households, presumably with the higher access to formal credit, are 71 concentrated in north and central regions Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 05 List of Tables Table 1 Description of potential direct and indirect impacts of physical climate shocks by sectors (floods 42 and droughts) Table 2 Summary of the climate risk policy roadmap for the banking and insurance sectors 55 Table 3 Overview of data requirements for monitoring climate risks for banks 66 List of Boxes Box 1 Case study of the impact of climate risks on insurance sector in South Africa 31 Box 2 Insurance products can be designed on an indemnity or index basis, depending on the purpose 32 Box 3 The rise in protection gap as a result of climate change 33 Box 4 Capacity building needs for Malawi’s insurance sector 36 Box 5 Preliminary analysis of the climate risk exposure of top 10 borrowers of eight Malawian banks 48 Box 6 Preliminary analysis of climate-related market risks for banks 51 Box 7 Banks in Malawi are in various stages of integrating climate financial risks into their business 53 models and operations Box 8 Examples of a regulatory approach to index insurance 59 Box 9 Examples of climate risk being treated as a separate line of business 60 Box 10 Examples of co-insurance pools 61 Box 11 Examples of countries implementing tax incentives 62 Box 12 Case study examples of supervisory guidelines developed by African countries 68 Box 13 Managing unintended consequences of climate risk management on financial exclusion 70 06 Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate Abbreviations and Acronyms AYII Area yield index insurance BAM Bank-Al-Maghrib BAU Business as usual BCBS Basel Committee on Banking Supervision CBAM Carbon Border Adjustment Mechanism CBK Central Bank of Kenya CCDR Country Climate and Development Report DFI Development Finance Institution DRM Disaster risk management GDP Gross domestic product GHG Greenhouse gas IAIS International Association of Insurance Supervisors ICAAP Internal Capital Adequacy Assessment Process IMF International Monetary Fund LUCF Land use change and forestry MPCI Multi-peril crop indemnity MSE Malawi Stock Exchange MSME Micro, small, and medium enterprise NBM National Bank of Malawi NCCMP National Climate Change Management Policy NDC Nationally Determined Contribution NDRMP National Disaster Risk Management Policy ND-GAIN Notre Dame Global Adaptation Initiative NGFS Network for Greening the Financial System NPL Nonperforming loan RBM Reserve Bank of Malawi SBFN Sustainable Banking and Finance Network WII Weather index insurance VAT Value added tax Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 07 Acknowledgements The report was developed jointly by the Reserve Bank of Malawi and the World Bank. The Reserve Bank of Malawi team included Martin Magomero (Principal Examiner, General Insurance and Intermediaries), Paul Nyirenda (Director, Pension and Insurance Supervision) and Titus Chima (Chief Examiner, Banks). The World Bank team included Rachel Mok (Financial Sector Specialist), Evie Calcutt (Senior Financial Sector Specialist), Mansi Panchamia (Consultant), and Agrotosh Mookerjee (Consultant). The World Bank team was supervised by Alwaleed Fareed Alatabani (Practice Manager, Finance, Competitiveness, and Innovation, Southern and Eastern Africa) and received strategic guidance and support from Randa Akeel (Senior Financial Sector Specialist), Innocent Njati Banda (Financial Sector Specialist), and Isfandyar Khan (Lead Financial Sector Specialist). The report was designed by Kane Chong. The initiative is supported by the World Bank’s Climate Support Facility (CSF). The mission of the CSF is to support developing countries in accelerating their transition to low-carbon and climate-resilient development and elevate the national decarbonization agenda. The team would like to thank the following World Bank staff for their invaluable feedback as peer reviewers: Fiona Stewart (Lead Financial Sector Specialist) and Oliver Masetti (Senior Financial Sector Specialist). 08 Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate Executive summary Climate change is already having a devastating impact on Malawi. In the last 36 years, Malawi has experienced eight major droughts, affecting over 24 million people. These disasters have led to widespread crop failure and have left over 6.7 million people food insecure, including 3.5 million children.1 As this report is being drafted, the country is still reeling from the impacts of Cyclone Freddy, which has displaced over half a million people and resulted in more than 1,400 fatalities, making it one of the deadliest cyclones to strike Africa,2 alongside a declaration of disaster in March 2024 in response to the El Niño induced drought. These events highlight Malawi’s acute vulnerability to climate-related hazards, including floods and droughts. Unfortunately, the outlook is even more concerning—rising temperatures, changes in precipitation patterns, and more frequent and intense extreme events are projected to exacerbate the impacts of climate change in Malawi. This will further threaten key sectors such as agriculture and infrastructure and will have wide-reaching impacts on the overall well-being of the population, leading to increased poverty and food insecurity. Climate change could lead to material risks for insurers and banks in Malawi. Recognizing the impact that climate change is already having on the economy, the Reserve Bank of Malawi (RBM), with the support of the World Bank, conducted this assessment to better understand the impacts of climate change on the insurance and banking sectors in Malawi. This report’s analysis In the last 36 is the first of its kind for Malawi, and one of the first climate-related financial risk years, Malawi analyses of any country in the Africa region that looks at the impact of climate change on the insurance sector in addition to the banking sector. The ultimate has experienced objective of this report is to build a roadmap for RBM to better assess and eight major manage climate-related financial risks. droughts, affecting over In the insurance sector, climate-related events have led to major 24 million losses for some of the largest insurers in Malawi in recent years, but people. These the overall sector’s exposure to climate risks is relatively low due to underinsurance. There are eight non-life (general) insurance companies disasters registered in Malawi, with a total gross written premium of MWK 71 billion as have led to of 2022. Most of the premium is for motor insurance (52 percent), followed by widespread fire and allied perils business3 (22 percent) and miscellaneous, which includes crop failure agriculture (18 percent). Surveyed insurance companies estimate that climate and have risks, such as cyclones, flooding, droughts, and agricultural production risks left over 6.7 represent 10 to 25 percent of the fire and allied perils and miscellaneous million people business lines. Overall, this means around 5 to 10 percent of the gross written premium relates to climate risk, which is low given the significance of climate food insecure, risks. Nonetheless, the recent cyclone events led to high claims, reaching MWK including 3.5 28.8 billion (US$25 million) across all insurers in 2022, with a significant portion million children. of claims in relation to Cyclone Ana. Multiple insurers indicated large losses with loss ratios for property business lines over 90 percent before expenses and up to a maximum of 200 percent. This has created liquidity challenges for some insurers because multiple claims are due simultaneously. 1 World Bank. Malawi drought recovery and resilience project. 2 Vox (2023). In Malawi, a blueprint for recovery from climate disaster. 3 This includes insurance against loss of or damage to property arising from fire as well as from allied perils such as earthquakes, explosions, riots and strikes, malicious damage, and special perils that could include natural disaster events.  Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 09 Executive summary © Science Photo Library / alamy.com Increasing claim frequency and costs have also hardened the reinsurance and retrocession markets, pushing the cost up further, reducing the customers’ ability to purchase. Reinsurance renewals have become difficult for insurers to secure, and loadings have increased significantly, alongside deductibles increasing significantly to around US$500,000. The cost increases are largely passed to the consumer or result in the insurer adding exclusions to standard policies.  In addition, the impact of climate risks on disposable incomes has lowered consumers’ willingness to renew insurance contracts and pay premiums for insurance products, further widening the protection gap. Some insurance companies have started to take actions to manage climate-related financial risks, but urgently need capacity building support to adequately respond to climate shocks. To protect the business, insurers have started to introduce stricter product design features (e.g., higher deductibles) to mitigate the impacts of climate risks. For example, indemnity-based agriculture insurers apply very strict exclusions, such as excluding overflowing, droughts, and floods. These mitigation measures do, however, lead to an increase in the protection gap. The insurance companies consulted highlighted the urgent need to scale capacity building, including the need to share best practices on climate risk-related product design, underwriting, and claims processing, among others. There is also a keen interest in exploring index-based insurance to ease the risk transfer to international reinsurance markets. Capacity building for financial institutions as well as businesses is important to help these stakeholders understand the benefits and limitations of the application of climate risk insurance linked to broader access to finance. Climate change could also lead to risks for the banking sector in Malawi, although the impact is sectorally concentrated and varies across banks. The banking system could be highly vulnerable to climate physical risks due to its substantial credit exposure to the agriculture sector, which represents 17 percent of total loans in Malawi as of January 2024. This exposure is notably higher than in other regional countries and is concentrated among large private corporations. Banks also have significant exposure to other sectors such as trade and manufacturing, which could be affected by climate disasters. Preliminary analysis suggests that 63 percent of gross loans could be exposed to sectors that are vulnerable to climate physical risks.4 Lending 4 Sectors that could be directly or indirectly affected by climate change include agriculture, forestry, and hunting; mining and quarrying; manufacturing; electricity, gas, water, and energy; construction; wholesale and retail trade; restaurants and hotels; transport, storage, and communications; and real estate. 10 Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate Executive summary to individuals and households, which represents a significant share of credit exposure, could also increase vulnerability to climate risks, if the physical location of the asset is in high-risk areas. Banks’ overall exposure to climate transition risks is likely low, given the country’s small greenhouse gas (GHG) emission profile. However, transition risks could still be high for some banks that have high exposure to sectors dependent on carbon- intensive and environmentally harmful technologies and practices. Conservative estimates based on sectors’ GHG emission profile suggest that as of January 2024, 24 percent of gross loans are in highly transition- sensitive sectors, and 18 percent of loans are in sectors that are moderately transition-sensitive. Some banks have highly concentrated credit portfolios, which means they could feel the impacts of climate physical and transition risks more acutely than other banks that have more diversified portfolios. For example, two of the largest banks in Malawi have over 20 percent of their total credit exposure in agriculture and related sectors; credit exposure to wholesale and retail trade also ranges from only 9 percent in one bank to as high as 57 percent for another bank. Banks are at a nascent stage of assessing and managing climate risks, which further increases their vulnerability to climate risks. Even though all banks surveyed for the analysis believe that climate change will have a material impact on their businesses and operations, limited actions have been taken to respond to climate risks. For example, only 14 percent of surveyed banks have integrated climate risk management into their internal governance structures. Less than half of banks include climate risks in their risk Even though frameworks and only a few are conducting scenario analyses. Key challenges all banks that hinder banks’ ability to manage climate risks include data scarcity, surveyed for the lack of standardized methodologies, and the need for more resources and analysis believe specialized knowledge. that climate change will Data limitations significantly limited the granularity of this assessment for the banking and insurance sector. For example, uncertainties around have a material climate scenarios limited our understanding of the regional and sectoral impact on their impacts of climate physical and transition risks. Several data challenges businesses and limited the granularity of the banking sector analysis, including the lack of operations, data on the physical location of banking sector assets, lack of granular data limited actions on the breakdown of credit at the subsector level, and limited understanding have been taken of sectors’ supply chains, as well as limited data on risk mitigation measures to respond to taken by banks (e.g., via insurance). For the insurance sector, while some information is reported annually to the RBM by the insurers, it is often not climate risks. sufficiently granular to identify which policies are exposed to climate risk and the extent of this exposure. Similarly, for most insurers we cannot assess which claims are because of climate risk as they are aggregated into broader business lines. The exception for this was from one of the larger insurers who provided data on specific claims from Tropical Cyclone Freddy. A range of policy recommendations has been identified to further assess and manage climate-related risks for the banking and insurance sector. Sequencing and proportionality are critical to prioritize the main policy actions and ensure that banks and insurers can build their expertise over time. The key policy recommendations are as follows: • Governance, strategy, and capacity building: One important immediate priority is to ensure there is sufficient climate risk expertise within RBM, supported by international knowledge exchange and dedicated technical assistance programs. As RBM builds capacity and expertise on climate risks, RBM could develop an institutional strategy to prioritize policy actions, coordinate their implementation, and signal its commitment to the climate risk agenda. Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 11 Executive summary • Managing climate risks for insurers: In general, as an insurance regulator, RBM can play an active role in creating the awareness of insurance as a tool for managing climate risks but also support the insurers to build or access the expertise they need to deliver commercially and financially sustainable solutions. A fundamental starting point is to build the capacity of the regulator and the insurance sector. For example, external experts could be brought in to provide training on product design (including actuarial pricing and index insurance) to support the quality of products on offer. Due to the limited expertise within the country, it is advised that Malawi’s insurance sector establish partnerships with experienced regional insurers and reinsurers, including those located in South Africa, to leverage their expertise and regional experience. Another immediate priority is for the RBM to engage closely with the government of Malawi (through the Ministry of Finance and Economic Affairs) to better understand the government’s policy objectives and interventions and contribute to the upcoming review of their disaster risk financing strategy. As part of this, there can be discussions on the use of targeted tax waivers, premium subsidies, and use of the domestic market to support these and learn from regional and international initiatives. For the regulator, some guidance is available from the International Association of Insurance Supervisors (IAIS), with a guidance note on climate risk scenario analysis due in the coming months. It will take time for this global guidance to be translated into country specific supervisory guidance, and currently only the most developed insurance markets have developed guidance. In Malawi, the data available from insurance companies makes it difficult to identify the exposure of business lines to climate risk. As a starting point, the RBM could request some initial evidence on the suitability of design and pricing, using standardized data definitions, to ensure the insurers have appropriately considered the risk. Any reporting requests should be carefully considered and proportionate. In the medium to longer term, the RBM should look to establish expectations through national guidelines on insurers’ governance, processes, and controls on climate-related data and disclosure requirements in line with IAIS guidance. • Managing climate risks for banks: A key starting point is to build RBM staff and banks’ expertise on climate risk management through dedicated training programs. Over time, RBM should improve the availability and granularity of climate and financial data that is critical for climate risk assessments, including data on the regional and sub-sectoral breakdown of credit exposure, as well as forward-looking metrics on the socioeconomic impacts of climate physical and transition risks. As data availability improves, RBM could conduct more sophisticated climate risk scenario analyses to better understand and quantify climate risks under future scenarios. Given the resource and data intensity of such analytical work, RBM could start with more simplistic exposure analysis and focus on areas that are considered high-risk (e.g., assessing the country’s largest borrowers’ vulnerability to climate risks, focusing on assessing banks that have high exposure to the agriculture sector or have less diversified portfolios, and/or analyzing the vulnerability of real estate loans such as mortgages to climate risks). RBM will also continue to develop supervisory expectations, in line with the Basel Committee on Banking Supervision’s (BCBS) principles for the effective management and supervision of climate-related financial risks, to help banks integrate climate risks into their corporate governance structure and risk management framework. As a next step, RBM could develop an implementation roadmap to ensure that banks have the needed resources and expertise to comply with the supervisory expectations. In the long run, RBM could consider developing more detailed supervisory guidelines on key topics, such as scenario analysis and disclosure, and could consider integrating climate risks into supervisory tools and actions, such as Internal Capital Adequacy and Assessment Process (ICAAP). The impact of climate risk management on financial exclusion also needs to be carefully managed. For example, the Ministry of Finance could explore risk mitigation mechanisms for micro, small, and medium enterprises (MSMEs) that are vulnerable to climate risks (e.g., loan guarantees, digital finance services). Capacity building should also be offered to help MSMEs develop monitoring and due diligence capability for climate risk management. 12 Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 1 Introduction Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 13 1 Introduction The agenda to green the financial sector is gaining rapid momentum globally. There is growing concern among central banks and financial regulators that climate change could lead to material risks for the financial sector. At the same time, the financial sector, representing about US$400 trillion in assets globally, could play a critical role in closing the significant funding gap needed to reach countries’ climate goals. Many global initiatives have already been established to help financial institutions recognize both the risks and the opportunities that climate change presents. For example, the Network for Greening the Financial System (NGFS) brings together 138 central banks and supervisors to support its agenda.5 The G20 also established a working group on sustainable finance to align policies and financing with the goals of the Paris Agreement and Agenda 2030. Global standard setting bodies, such as BCBS, IAIS, and the International Organization of Securities Commissions, have similarly issued guidance and/or principles on related topics. Notably, in 2022, the BCBS issued the principles for the effective management and supervision of climate-related financial risks, marking a key milestone and guidance tool for central banks globally. IAIS also developed draft climate risk supervisory guidance for the insurance sector. Africa’s green agenda is nascent compared to that of other regions, but it is growing. Several institutions in African countries, such as the Central There is growing Bank of Kenya, the Bank of Tanzania, and Bank-Al-Maghrib (BAM), have already concern among issued guidelines and directives to help banks manage climate-related financial central banks risk (Figure 1).6 In 2024, with the support of the World Bank and the Agence and financial Française de Développement, BAM also published a climate risk scenario analysis for Morocco in 2024, marking the first comprehensive analyses regulators that of climate-related financial risks in Africa and among the few conducted in climate change emerging markets globally. Despite these positive developments, most could lead to African central banks and financial institutions are relatively inactive in the material risks global forums such as NGFS and the Sustainable Banking and Finance Network for the financial (SBFN), and environmental, social, and governance–related regulations remain sector. limited in the region (Figures 2 and 3). FIGURE 1 Examples of African countries that have established their own supervisory and regulatory frameworks on sustainable finance and climate risk Directive n°5/W/2021 on the Guiding Principles for management of climate related Sustainable Finance (2021) and environmental risks (2021) Guidelines on Climate-related Sustainable banking principles Financial Risks Management (2021) (2022) Guidance on climate-related risk management (2021) Prudential Communication 10 of Climate–related risks (2022) Guidance on climate-related and environmental financial risk management (2021) Source: Authors 5 As of May 2024. 6 Central Bank of Kenya, ”Guidance on Climate-related Risk Management”, 2021; Bank of Tanzania, “Guidelines on Climate-related Financial Risks Management”, 2022; For more information, see Green Finance Platform, “Bank Al -Maghrib (BAM) “Directive relative au dispositif de gestion des risques financiers liés au changement climatique et à l’environnement”,” 2021. 14 Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 1 Introduction FIGURE 2 Global mapping of NGFS and SBFN members NGFS members SBFN members Member of both NGFS and SBFN Source: Climate Bonds Initiative 2021 FIGURE 3 Global mapping of NGFS and SBFN members 450 Cumulative number of policy interventions 400 350 300 250 200 150 100 50 0 1985 1990 1995 2000 2005 2010 2015 2020 2025 Africa Asia Europe Middle East North America Oceania South America Source: Principles for Responsible Investment, 2021 This note is dedicated to building a policy roadmap for RBM to assess and manage climate risks for Malawi’s banking and insurance sectors. Although it is challenged by data limitations,7 the assessment aims to act as a first explorative analysis of the banking and insurance sectors’ vulnerability to climate physical and transition risks. In this way, the analysis is designed to identify short, medium, and long-term policy priorities for assessing and managing climate risks for Malawi’s financial sector. The analysis, insights, and policy recommendations presented in this assessment should be seen as a starting point, laying the foundation for future enhancement and refinement. 7 The assessment employs the latest accessible public data when feasible. In certain cases, it also utilizes nonpublic data provided by the Reserve Bank of Malawi (RBM). Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 15 1 Introduction The assessment has four key components: • As shown in Figure 4, the first step of the assessment is to provide context of the macro and sectoral impacts of climate change, largely building on the World Bank’s Country Climate and Development Report (CCDR) for Malawi. • The second step is to analyze how climate change could lead to financial risks for banks and insurers. Given data limitations, the analysis focuses on a high-level exposure analysis and a qualitative analysis of transmission channels for climate-related financial risks. • The third step is to review banks’ and insurers’ current practices around climate risk management and potential challenges that need to be addressed by policymakers. This step is informed by a series of stakeholder consultations with banks and insurers. Surveys were sent to 11 banks and development finance institutions as well as 15 insurance companies to gauge their perspectives and practices around climate risk management.8 • The fourth and final step is to develop a roadmap for RBM and other policymakers to identify key policy actions required to manage climate risks for the financial sector. The policy roadmap builds on the consultation and analysis of this report as well as various global guidance and good practices, including the World Bank’s Toolkits for Policymakers to Green the Financial System, as well as publications from the NGFS and other standard setting bodies. The recommendation from the analysis is intended to be a starting point for further discussion with authorities and should be deepened and refined over time through future technical assistance, data availability, and advisory support. FIGURE 4 Climate risk assessment approach Step 1 is built off Climate risk assessment approach the World Bank’s Country Climate 1 How is climate change impacting Malawi's developmental goals? and Development What are Malawi's priorities for climate mitigation and adaptation? Report for Malawi to understand the macro and sectoral impacts of climate change and is only Climate-related risks for the financial sector briefly touched upon in this 2 What are the key transmission channels through Are banks and insurance companies exposed assessment. which climate impacts could translate into risks to sectors and regions that are vulnerable to for the banking and insurance sectors? climate physical and transition risks? Climate risk management practices 3 How are banks managing the impact of climate How are insurers managing the impact of climate change on their business model and portfolio? change on their business model and portfolio? Next steps for climate risk supervision and regulation 4 How can the Reserve Bank of Malawi and other policymakers improve banks' and insurers' climate risk management? Source: Authors 8 Responses from the following banks and development finance institutions (DFIs) are included in the assessment: Standard Bank, National Bank of Malawi, Centenary Bank Limited, FDH Bank, First Capital Bank, CDH Investment Bank, Malawi Agricultural and Industrial Investment Corporation. Responses from the following insurance companies are included in the assessment: NICO General Insurance, Britam Insurance, UGI, Reunion Insurance, General Alliance Insurance, Emeritus Re. Insurers/others the team had interviews with are the following: NICO General Insurance, NICO Life Insurance, Britam Insurance, Emeritus Re (the only Malawi-based reinsurance company, formerly known as Malawi Re), Microinsurance Services Ltd, Old Mutual. 16 Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 2 Financial sector context Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 17 2 Financial sector context Malawi’s financial system is small even by African standards. At the end of 2020, total financial sector assets stood at 47 percent of gross domestic product (GDP). Malawi’s financial system is dominated by banks, with assets equivalent to 25.5 percent of GDP; the pension system accounts for 12.4 percent while insurance accounts for 10 percent. The banking system is shallow, and credit is highly concentrated, both in terms of the types of firms and sectors receiving credit. The RBM notes that in 2019, 31 percent of all loans was lent to the top 10 borrowers in the market; furthermore, a World Bank analysis notes that in the same year, the largest single borrower in the market had an outstanding loan of 67 percent of core capital of its lender (compared to the RBM’s limit of 25 percent).9 As of January 2024, most of the banking sector credit was concentrated in four sectors and accounted for 78 percent of the credit portfolio: community, social, and personal services10 at 35 percent; wholesale and retail trade at 15 percent; agriculture, forestry, fishing, and hunting at 17 percent; and manufacturing at 10 percent.11 The banking sector is dominated by two banks and exhibits a sizeable presence of foreign owned institutions and domestic The sector privately owned banks.12 The sector comprised eight banks, of which comprised eight four are domestically owned and constituted 56.2 percent of total net banks, of which four banking assets in 2022. The remaining four banks were foreign owned are domestically and constituted 43.8 percent of total net assets, an increase from 40.5 percent in 2021. The banking sector is concentrated, with two banks owned and accounting for about 46 percent of total banking sector assets and 47 constituted 56.2 percent of total deposits as of December 2021.13 percent of total net banking assets in Banks follow a traditional business model typically seen in 2022. The remaining African economies—based on government investments and four banks were lending and a high reliance on deposit funding. In 2022, the asset foreign owned and side of banks’ balance sheets is dominated by investments, primarily in Treasury bills and government bonds, accounting for 46 percent of constituted 43.8 system wide bank assets, followed by credit which accounted for about percent of total net 28 percent of total assets. The liability side of banks’ balance sheets assets, an increase consists of over 80 percent of deposits and is historically heavily skewed from 40.5 percent towards deposits on the short end, which are potentially unsuitable for in 2021. long-term investments.14 Banks are facing a challenging environment characterized by high risk aversion. The banking sector has maintained high profits and a strong overall financial performance, shown by buffers in both 2022 and 2021. The core capital ratio stood at 19 percent in 2022 compared to 17.5 percent in 2021. The liquidity ratio remained high at 53.6 percent in 2022, well above the 25 percent regulatory requirement. Risk aversion has increased, and banks are lending mainly to low-risk customers (large companies and the government).15 Capital markets are underdeveloped, constraining the ability of investors to buy long-term products. The total number of companies listed on the Malawi Stock Exchange is 16, comprising 14 domestic counters and two foreign counters in 2022; six of these are banks or bank holding companies and two are telecom companies. 9 World Bank, “Malawi: Mobilizing Long-term Finance for Infrastructure,” 2021. 10 According to the RBM, loans to community, social, and personal services include “all loans and advances granted to enterprises engaged in community, social, and personal services, e.g. schools, churches, NGOs etc.” 11 Based on data provided by the RBM. 12 RBM, “Financial Institutions Annual Report 2022,” 2022. 13 International Trade Administration, “Malawi -Trade Financing,” 2024. 14 World Bank, “Malawi: Mobilizing Long-term Finance for Infrastructure,” 2021. 15 Making Finance Work for Africa, “Malawi". 18 Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 2 Financial sector context In terms of market share, these eight companies account for 78 percent of total market capitalization. Malawi capital markets are in their nascent stage and not well configured to provide adequate and suitable long-term finance that can ably meet the financing requirements of the economy. That said, the total market capitalization almost doubled from MK2.7 trillion (US$2.6 billion) at the end of June 2022 to MK5.9 trillion (US$5.6 billion) at end of June 2023, exceeding banking sector total assets (MK4.1 trillion). The increase was mostly driven by share price gains.16 The government debt market is also limited in depth with mostly short-term instruments offered. In June 2020, the stock of outstanding Treasury securities, dominated by Treasury notes and securities, was MK2.4 trillion, representing 29 percent of GDP and 99.3 percent of total public debt securities. Eight Treasury notes were listed on the Malawi Stock Exchange for secondary market trading as of end of June 2020, and 16 more were listed in September 2020 but hardly any trading had been observed as of the end of November 2020.17 The barriers to entry remain high for the average person, resulting in negligible participation of retail investors in the financial markets. Out of the total outstanding Treasury securities portfolio holdings by the public by June 2020, commercial banks held the majority at 46.2 percent.18 Foreign institutional investors held 32.5 percent while insurance companies, pension funds, and other financial institutions held 12.2 percent, 5.3 percent, and 1.9 percent, respectively. The nonfinancial sector in the form of corporates and households (retail investors) retained a very low share of 1.9 percent and 0.1 percent, respectively. These retail investors were constrained by low financial literacy, low per capita income, and lack of innovative, trustworthy, user-friendly, and cost-effective means of accessing the capital markets. The low liquidity of capital markets instruments also means investors have unaddressed needs prohibiting them from actively participating in long-term financial investments. © Ashley Cooper pics / alamy.com 16 International Monetary Fund, “Malawi: Second Review Under the Staff-Monitored Program with Executive Board Involvement and Request for an Arrangement Under the Extended Credit Facility-Press Release; Staff Report,” 2023. 17 Malawi Stock Exchange, “Malawi Capital Markets Development Plan 2021–2025.” 18 Malawi Stock Exchange, “Malawi Capital Markets Development Plan 2021–2025.” Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 19 2 Financial sector context Malawi’s insurance sector is in the early stages of development, with limited exposure in property and agriculture. Malawi has a small but Malawi has dynamic insurance market, composed of eight non-life companies and six life companies. At the end of 2020, total assets of life insurance companies a small but stood at 9.3 percent of GDP, while the non-life sector had total assets of dynamic less than 1 percent of GDP. Malawi has gained a wealth of experience on insurance market, agricultural insurance in the past 14 years, but so far has failed to scale up. composed of The agricultural production that is insured is equivalent to less than 1 percent eight non-life of the agricultural GDP. All eight general insurers are actively engaged in the companies agricultural market, and six insurance schemes aimed at small-scale farmers are currently being operated, covering different crops (maize, tobacco, soya, and six life and oilseeds). The key challenge in Malawi is to design agricultural insurance companies. schemes that can reach the majority of the farming population. As the formal financial sector continues to be small, access to financial services remains a problem. According to the World Bank’s Global Findex database, 43 percent of adults, including 38 percent of women and 48 percent of men have an account in 2021.19 However, only 39 percent of adults living in rural areas have access to an account (compared to 51 percent of adults in urban areas), reflecting the high incidence of poverty, high degree of informality, and a higher proportion of the population living in rural areas. MSMEs face growth challenges due to limited access to resources and expensive informal credit. 20 The 2019 Malawi FinScope MSME Survey found that there are approximately 1.6 million MSMEs in Malawi, employing around 1.8 million people. The majority of these are micro enterprises (74 percent), with small enterprises at 23 percent and medium enterprises at 3 percent. MSMEs contribute significantly to the economy, accounting for about 40 percent of GDP and 24 percent of employment, with 21 percent of adults in the country relying on the sector for their livelihood. However, MSMEs face challenges in expanding due to limited access to knowledge, networks, and financing. They often struggle with business planning, management, bookkeeping, financial management, marketing, and employee management. The high level of informal firms not meeting formal banking requirements drives them to rely on informal and often expensive credit sources, such as loan sharks. The government launched the Financial Inclusion and Entrepreneurship Scaling project in 2020 with a US$86 million credit from the International Development Association to improve MSME financial inclusion. Through this project, the RBM is partnering with commercial banks, microfinance institutions, and development finance institutions to provide low-cost loans to innovative enterprises including those hit by COVID-19, support innovative start-ups, and establish capable and well supervised investments while enabling them to adopt digital financial services. As of early 2024, out of US$47 million allocated to a line of credit, US$44.8 million was disbursed, of which US$38 million has been lent to more than 36,000 MSMEs and most of the remaining balance is committed to a pipeline of MSMEs who have submitted applications.21 RBM is the sole regulator of the financial sector. The RBM, through the Registrar of Financial Institutions, is the regulatory and supervisory authority that sets minimum prudential requirements for banks to ensure that the banking sector is sound and stable.22 The RBM also regulates non-bank financial institutions—including capital markets—under the Financial Services Act, 2010. In addition to the passing of the Pensions Act, 2011 and Insurance Act, 2011, the RBM issued several directives for the supervision of the pension and insurance sectors. The Pensions and Insurance Supervision Department supervises the pensions and insurance sectors while the Microfinance and Capital Markets Supervision Department covers the capital markets.23 19 World Bank, “Global Findex Database 2021,” 2022. The 2021 data reflects the latest available data because the Global Findex Database is published every three years. 20 World Bank, “Supporting Malawi’s Small Enterprises to Spur Economic Growth and Create More Job Opportunities,” 2022. 21 World Bank, “Financial Inclusion and Entrepreneurship Scaling Project (P168577): Implementation Status & Results Report,” 2024. 22 African Economic Research Consortium, “Regulatory Capital Requirements and Risk Taking Behavior: Evidence from the Malawi Banking System,” 2021. 23 World Bank, “Financial Sector Assessment—Development Module: Malawi,” 2018. 20 Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 3 Climate change context Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 21 3 Climate change context 3.1 Vulnerability to the physical impacts of climate change Malawi is prone to adverse climate hazards including dry spells, seasonal droughts, intense rainfall, riverine floods, and urban floods. Droughts and floods, the most severe of these hazards, have increased in frequency, intensity, and magnitude over the past 20 years, with dire consequences for food and water security, water quality, energy resources, and sustainable livelihoods of rural communities (Figure 5). In fact, Malawi has the world’s highest incidence of extreme dry events since 1980.24 In the last 36 years, Malawi has experienced eight major droughts, affecting over 24 million people. These disasters have led to widespread crop failure and have left over 6.7 million people food insecure, including 3.5 million children.25 Hydropower production was also sharply reduced due to droughts. Severe droughts also affect water levels in Lake Malawi, with implications for fisheries. In addition, since 2010 alone, Malawi has experienced 16 major flooding events, which have led to widespread impacts on properties, crop production, electricity generation, and public infrastructure such as roads and bridges. FIGURE 5 Key natural disaster hazard statistics for Malawi 1980–2020 and number of people affected 100M 1M 10k 100 1 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Flood Drought Earthquake Epidemic Storm Landslide Source: EM-DAT via World Bank Climate Change Knowledge Portal Malawi is already experiencing severe negative impacts from climate-related natural disasters. As this report is being drafted, the country is still reeling from the impacts of Cyclone Freddy, which has displaced over half a million people and resulted in more than 1,400 fatalities, making it one of the deadliest cyclones to strike Africa.26 Concurrently, persistent droughts have diminished food production, endangering the biodiversity of and the livelihoods that depend on Malawi’s aquatic ecosystems.27 Recently, President Lazarus Chakwera launched a US$446.74 million appeal to address the challenges faced by 9 million people due to the prolonged dry spell and flooding caused by El Niño weather conditions across the country. President Chakwera, who recently declared a state of disaster in 23 out of the country’s 28 districts, said only US$21.6 million of the total 24 World Bank, “Malawi Economic Monitor,” 2024. 25 World Bank, “Malawi Drought Recovery and Resilience Project.” 26 Vox, “In Malawi, a Blueprint for Recovery from Climate Disaster,” 2023. 27 US AID, “Malawi Climate Change Country Profile,” 2023. 22 Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 3 Climate change context required sum has been mobilized, leaving a huge funding gap. The required funds are aimed at mobilizing resources to boost food production and improve national food stocks as well as addressing the lifesaving needs of the affected population from April 2024 to March 2025. The impacts of natural hazards will worsen with climate change. Malawi is highly vulnerable to climate change, as recognized by the Notre Dame Global Adaptation Initiative (ND-GAIN) Index, 28 the Climate Risk Index,29 and the Inform Risk Index.30 Climate models show average annual temperatures increasing in almost all scenarios, but the pace and scale of the increases varies significantly due to modeling uncertainties. The average projected increase across the model runs is 1.03°C by 2040 (from 22.34°C to 23.37°C), and 1.34°C by 2050 (to 23.68°C) (Figure 6). Future precipitation projections are also uncertain (Figure 6), but the latest Intergovernmental Panel on Climate Change (IPCC) assessment indicates that globally and in Southeastern Africa, extreme precipitation events are expected to intensify and become more frequent. There is also high confidence that warming will intensify very wet and very dry weather, with implications for flooding and drought. FIGURE 6 Mean temperature (left) and precipitation trends (right) and projections to 2100 across 125 climate models Average monthly temperature (ºC) Average monthly precipitation (mm) 30 150 28 100 26 24 50 22 2000 2020 2040 2060 2080 2100 2000 2020 2040 2060 2080 2100 Historical SSP 1-1.9 Historical SSP 1-1.9 SSP 1-2.6 SSP 2-4.5 SSP 1-2.6 SSP 2-4.5 SSP 3-7.0 SSP 5-8.5 SSP 3-7.0 SSP 5-8.5 Source: World Bank (2022) Climate change, coupled with other shocks such as biodiversity loss and the pandemic, could have compounding negative effects on the economy. Modeling under the CCDR suggests that climate change impacts could result in very large annual GDP losses, as high as 20 percent under a business-as-usual (BAU) scenario. The largest impacts from climate change are projected to come from damage to roads and bridges. Heat impacts on labor productivity are also significant and point to compounding shocks on already poor and vulnerable households. The analysis finds that over the next 10 years, climate shocks on the economy could push another 2 million people into poverty (an 8 percentage point increase in the poverty rate), increasing to 4 million additional poor by 2040. 28 The Notre Dame Global Adaptation Initiative Country Index summarizes a country’s vulnerability to climate change in combination with its readiness to improve resilience. Countries are ranked from 1 (lower risk) to 185 (higher risk). Malawi ranks 161st. 29 The 2019 Climate Risk Index score is based on the impacts of extreme weather events and the associated socioeconomic data. Countries are ranked from 1 (higher risk) to 182 (lower risk). Malawi ranks 57th with a score of 60.5. 30 The INFORM Risk Index is a global risk assessment tool that uses three dimensions: hazard and exposure, vulnerability, and need for coping capacity. Countries are ranked from 1 (higher risk) to 191 (lower risk). Malawi ranks 54th. Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 23 3 Climate change context © Cavan Images / alamy.com Key segments of the economy will be especially affected by climate change. For example, as noted in the CCDR:31 • More frequent and intense rainfall events and flooding will increase damage to public infrastructure and private property. This is a particular concern for informal settlements, where most urban residents in Malawi are concentrated. Malawi’s energy sector and its infrastructure are highly susceptible to climate variability. This impact is especially significant on its existing hydropower stations, most of which are on the Shire River. Transport infrastructure is already highly susceptible to climate- related shocks. Repairing roads damaged by Tropical Storm Ana, for instance, is expected to cost at least US$6.1 million. • The agriculture sector is highly vulnerable to climate shocks, particularly for smallholder farmers. Since most of Malawi’s crop production is rainfed, reliant on a single rainy season, changes in precipitation pose significant threats. Already, increased dry spells have reduced maize yields and production, resulting in recurrent food insecurity. Cyclone Idai, which hit Malawi in March 2019, caused devastating floods that affected an estimated 975,600 people and submerged or washed away mature crops as well as destroying irrigation infrastructure. • Extreme heat can impact the Malawian economy through shocks to labor productivity. Heat stress from climate change can reduce the performance of outdoor laborers, and many of these impacts are already being felt. The largest impacts are in agriculture, because activity in the sector involves mostly outdoor labor, followed by industry and then services. World Bank’s CCDR estimates that climate change impacts on labor productivity could reduce GDP by as much as 4.6 percent by 2050. • Malawi’s natural assets (land, forest, water, biodiversity) form an essential part of the Malawian economy and could be exposed to impacts of climate change. The National Tourism Investment Master Plan 2022–2042 identifies Malawi’s lakes, nature, and wildlife as its top tourist attractions. Climate change could undermine those assets and exacerbate biodiversity loss and land degradation. More frequent and more intense extreme events could also damage tourism infrastructure; as noted, both transport and communications infrastructure, which are important for tourism, are at risk. • Climate change will also increase a variety of health risks throughout Malawi. For example, cholera has been a recurring problem in Malawi, most recently in the aftermath of Tropical Storm Ana. Climate change also poses risks due to extreme heat and could affect many people’s productivity and mental health. The most widely felt impacts of climate change are hunger and malnutrition, as food insecurity is a chronic problem in Malawi. 31 World Bank, “Malawi Country Climate and Development Report,” 2022. 24 Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 3 Climate change context 3.2 Transition towards a low carbon, environmentally sustainable economy Malawi has one of the smallest GHG footprints in the world. In 2019, its total GHG emissions were only 19.34 million tons (metric tons) of carbon dioxide equivalent (MtCO2e) if land use change and forestry (LUCF) is included, or 10.95 MtCO2e without LUCF, about 0.02 percent of global emissions. The latter translates to just 0.59 tCO2e per capita—the lowest in the world. Including LUCF, Malawi’s 2019 per capita emissions are just 1.04 tCO2e, 11th lowest in the world and still one of the lowest in Sub-Saharan Africa. Figure 7 shows how Malawi’s emissions footprint compares with its neighbors’ and with the world average. The top-emitting sectors in Malawi are agriculture, land use change, and forestry (Figure 8). Additionally, in 2019, the energy sector emitted an estimated 1.61 MtCO2e, including 1.18 MtCO2e from transport; most of the rest was from biomass combustion for household energy. The agriculture sector (not including land conversion) emitted 7.86 MtCO2e, while industrial processes produced 1.02 MtCO2e and the waste sector produced 0.45 MtCO2e. As noted, LUCF contributed 8.39 MtCO2e. According to the updated Nationally Determined Contribution (NDC) 2021 submitted by Malawi, in 2017, emissions from livestock, predominantly methane from enteric fermentation in cattle (2.14 MtCO2e), represented the largest emissions source category. Another notable mention includes direct N2O emissions from managed soil in crop productions (1.12 MtCO2e).32 The CCDR estimates that emissions will increase over the coming decades, in line with population growth, but Malawi will likely still maintain a small carbon footprint. The majority of the predicted increase is emissions from the energy and transport sectors. FIGURE 7 Per capita annual GHG emissions in Malawi, surrounding countries, and the world 6.5 World 6.0 5.5 Greenhouse gas emissions per capita (MtC0₂e) 5.0 4.5 4.0 3.5 3.0 2.5 2.0 Sub-Saharan Africa Burkina Faso 1.5 Tanzania Mozambique 1.0 Uganda Malawi 0.5 Rwanda 0 1990 1995 2000 2005 2010 2015 2020 Source: Climate Watch via World Bank’s Climate Country and Development Report 32 Republic of Malawi, “Updated Nationally Determined Contributions,” 2021. Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 25 3 Climate change context FIGURE 8 GHG emissions by sector Agriculture Land-use change and forestry 8 million t 6 million t 4 million t Transport Industry Waste 2 million t Manufacturing and construction Fugitive emissions Other fuel combustion Electricity and heat 0t Buildings 1990 1995 2000 2005 2010 2015 2021 Aviation and shipping Source: Our World in Data Malawi’s population relies on biomass for energy generation. 33 In 2019, the energy sector emitted an estimated 1.61 MtCO2e, including 1.18 MtCO2e from transport; most of the rest was from biomass combustion for household energy. Transitioning away from biomass, while essential, needs to be done in a cautious way to mitigate adverse impacts of moving rural households away from their only source of energy, especially when they are not connected to the national grid34 and the solar photovoltaic grid rollout is still nascent.35 Finally, through its integration in international value chains, Malawi may be exposed to transition risk stemming from international trade mechanisms designed to reduce carbon leakage and potential private sector preference for green investments. Malawi may face increased costs as countries might impose tariffs at the border, if products are deemed to have a higher carbon footprint or contribute to environmental degradation. For example, in 2022, the European Council agreed to the Carbon Border Adjustment Mechanism (CBAM), which puts a carbon price on selected carbon-intensive imports. This could increase the costs for Malawi’s exports which currently enter the EU duty-free. The Euro area imported goods worth US$328 million in 2022 from Malawi, which made it the country’s largest partner for exports (Figure 10). Thus, the CBAM could have profound impact on Malawi’s GDP. Nonetheless, preliminary analysis suggests that in its current state, given the scope of EU’s CBAM and the nature of Malawian exports to the EU, the regulation will likely have minimal impact on the country’s GDP (Figure 9).36 Similarly, in 2023, the EU proposed the Regulation 33 In 2021, biofuels and waste accounted for nearly 87 percent of Malawi’s total energy supply, followed by coal (9 percent) and hydropower, solar, and wind cumulatively accounting for about 4 percent. See Ministry of Energy, “Malawi Energy Statistics Overview.” 34 According to the 2020 Doing Business Report, getting electricity in Malawi is more difficult than elsewhere in the region, on average. Connecting to the grid took an average of 127 days, according to respondents, and cost more than 12 times the average citizen’s annual income. 35 Most installed solar photovoltaic installations in Malawi are no longer operational due to poor installation, lack of proper maintenance, or inability to acquire new batteries. Equipment costs are a major problem. Solar-powered mini grids in Malawi are nearly twice as expensive as similar projects in the region. 36 The Africa Climate Foundation, LSE, “Implications for African Countries of a Carbon Border Adjustment Mechanism in the EU,” 2023. 26 Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 3 Climate change context on Deforestation-Free Products. Under the regulation, any operator or trader who places commodities (e.g., cattle, wood, cocoa, soy, palm oil) on the EU market must prove that the products do not originate from recently deforested land or have not contributed to forest degradation. Nonetheless, the regulation in its current state is expected to have a modest impact on Malawian exports: Per World Bank calculations, only 0.21 percent of total exports of Malawi (primarily coffee) will likely be subject to EU’s deforestation regulation.37 Lastly, given Malawi’s significant private sector investment potential, more climate-aware European investors might also require additional standards in Malawi in the future, potentially posing transition risk for firms.38 FIGURE 9 FIGURE 10 Potential impact of CBAM regulations on Exports of goods by destination, 2022 African economies39 (US$ millions) 350 300 250 200 150 100 50 Real GDP (change in %) –0.17 – –0.05 s 0 –0.05 – –0.02 Euro Area Kenya United Arab Emirates Zambia South Africa India United Kingdom Rwanda United States Zimbabwe –0.02 – –0.01 –0.10 – –0.00 0.00 – 0.02 0.20 – 0.30 0.30 – 0.05 0.05 – 0.32 Not available Source: African Climate Foundation and the Firoz Lalji Institute for Source: International Monetary Fund Direction of Trade Statistics Africa, 2023 37 World Bank, “Trade and Development Chart: Impact of the EU Deforestation Regulation,” 2023. 38 International Finance Corporation, “Country Private Sector Diagnostic: Creating Markets in Malawi,” 2021. 39 Change in real GDP, limited coverage covering only a few goods (aluminum, steel and iron, fertilizers, electricity, and cement). Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 27 3 Climate change context 3.3 Policy priorities for climate mitigation and adaptation Malawi’s updated NDC makes an unconditional economy-wide GHG emission reduction commitment, as well as a much more ambitious pledge conditional on the provision of external support. The unconditional commitment to be achieved using domestic resources is to reduce GHG emissions by 6 percent by 2030 relative to a BAU pathway, and to keep emissions at 6 percent below BAU up to 2040. The conditional pledge is to reduce GHG emissions by another 45 percent by 2040. Both targets exclude emissions from LUCF, the second highest emitting industry. To achieve these mitigation targets, Malawi’s NDC has identified more than 30 mitigation actions across various sectors. These actions cover energy, industrial processes and product use, waste management, and agriculture. The country aims to increase the share of renewables in its electricity production, with plans to replace high-cost The National diesel generation with solar power from independent power producers. Climate Change Malawi also aims to promote modal shift in passenger and freight Management transport to rail, increase the use of biofuels, and invest in nonmotorized Policy (2016) is transport to reduce GHG emissions in the transport sector. Furthermore, the main strategy Malawi is working on improving energy sector building standards to guiding the ensure infrastructure can withstand climate change impacts. The country government’s is also exploring public-private partnerships to enhance private sector participation in the energy sector and establish a regulatory regime for actions on climate passenger transport. change adaptation, mitigation, The adaptation actions, like the mitigation pledge, include research, activities to be funded with domestic resources and a much more technology ambitious agenda with international support. This includes climate development services, strengthening governance for effective NDC implementation, and measures to build resilience in the water sector; biodiversity and and transfer, and ecosystems; agriculture, livestock and fisheries; infrastructure; and capacity building. human well-being. Notably, although the NDC provides extensive details of all the proposed actions, it does not set specific targets for the individual actions. As noted in the CCDR, several policies and funds have been established to support climate action. The National Climate Change Management Policy (2016) is the main strategy guiding the government’s actions on climate change adaptation, mitigation, research, technology development and transfer, and capacity building. The National Disaster Risk Management Policy (2015) does the same for disaster risk management (DRM). The National Resilience Strategy 2018–2030 aims to promote more coherent, coordinated, and efficient approaches to food security, support climate change and disaster response, and humanitarian interventions. In addition, several dedicated funds have been established to support climate action and DRM at both the national and local levels. For example, under the Forest Act, a development trust fund was established to finance investments in forest landscape restoration across the country. The Environmental Affairs Department is also setting up a National Climate Change Fund to support adaptation, mitigation, research, and capacity development activities. Even though Malawi has a relatively strong climate policy framework, the CCDR notes that there are overlaps and undefined functional mandates which could hinder effective implementation. Gaps in legal frameworks also disempower institutions from taking full responsibility for climate and disaster risk management. 28 Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 4 The insurance sector’s vulnerability to climate risks Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 29 4 The insurance sector's vulnerability to climate risks 4.1 The insurance sector’s exposure to climate risks Insurance markets globally are seeing an increase in claim frequencies and severities due to climate risks, leading to higher insurance premiums, a more complex claims process, and stricter terms and conditions on products. An increase in climate-related claims is leading to worsening claims ratios, reduced profitability for insurers, and increased reinsurance costs. In response, the insurers are putting stricter terms in place and increasing the premium for multiple product categories to protect the insurance business against losses. This is leading to reduced renewals of insurance policies due to the impact of climate risks on customers’ available resources for paying premiums and a reduced perception of value for money. The overall impact implies a growing protection gap at the micro (household-level), meso (business or organization level), or macro (government or public-body level) levels. Typically, households and businesses, vulnerable to climate change and located in the highest risk regions, struggle the most to access affordable insurance. Managing this market failure may require public support or cross-subsidization from less risky regions to enable the availability of affordable products which meet their needs. The increasing exposure to climate risk is putting considerable strain on the cost allocation needs and procedures of insurers. Costs need to be absorbed into the company’s overall cost structure, and so insurers are looking to allocate resources more efficiently to respond quickly and effectively to climate events. This requires insurers to adapt their risk management protocols by adjusting their underwriting, policy, and claims management strategies. This could include reevaluating catastrophe modeling techniques to better understand the risk or consider shifting consumer demands in response to changing environmental conditions. The insurance sector in Malawi is generally vulnerable to the impact of climate change because climate risks lead to higher frequency and severity of losses, particularly for property damage, including losses to agriculture and buildings due to fire, flood, or wind damage. Climate risks can impact various business lines and products, such as property through fire and allied perils, goods in transit, and agriculture through miscellaneous business. For example, climate events such as fires, floods, droughts, and cyclones affect these business lines through damage to buildings, crops, critical infrastructure, power shortages, and business interruption. For motor insurance, exposure to climate risks is limited since most people in Malawi buy third party liability motor insurance only and not insurance for property damage to the vehicle itself. © Ashley Cooper pics / alamy.com 30 Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 4 The insurance sector's vulnerability to climate risks Based on estimates provided by surveyed insurers, less than 10 percent of the gross written non-life insurance premium in Malawi is related to climate risk, and the exposure of insurers is limited due to the low overall insurance penetration. Fire and allied perils (typically for properties) and miscellaneous business (which includes agriculture insurance40) constitute approximately 40 percent of the total non-life insurance premiums (Figure 11). Inconsistent data reporting across the insurance market prevents precise estimates of exposure of this premium to climate risks, but feedback from a subset of insurers indicates that around 10 to 25 percent of the fire and allied perils and miscellaneous insurance premiums are related to climate risks. This corresponds to around 5 to 10 percent of the total non-life gross written premium relating to climate risks, which is very low given the significance of climate risks in the country. Of the total risk, 70 percent of the fire business and over 50 percent of miscellaneous business is ceded to reinsurers. Whilst personal accidents and the need for medical services are expected to increase in Malawi as a result of climate change (as noted in Section 3), the impact on the insurance sector is currently relatively small among those with coverage. The limited impact of climate risks on the insurance market is evidenced by an increased number of climate risk events in recent years, but there was a steady increase in profits from MWK 3.4 billion in 2018 to 5.4 billion in 2022. FIGURE 11 Key insurance statistics for non-life products Gross Written Premium, 2022 Gross Written Premium, 2022 (split by retention and ceded) 40,000 35,000 22% 18% 30,000 MWK millions Fire 25,000 Motor 20,000 7% Personal Accident 15,000 Miscellaneous 10,000 (incl. Agriculture) 5,000 52% 0 Fire Motor Personal Miscellaneous Accident (incl. Agriculture) Retained risk Risk ceded to reinsurers Net Claims Incurred by General Insurers by Class of Business 35,000 30,000 MWK millions 25,000 20,000 15,000 10,000 5,000 0 2018 2019 2020 2021 2022 Fire Motor Personal Accident Miscellaneous Source: Authors based on Malawi Financial Institutions Annual Report 2022 40 With the data available it was not possible to break down the miscellaneous claims further. Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 31 4 The insurance sector's vulnerability to climate risks Despite the relatively low exposure of insurance business to climate risks, the unprecedented insurance losses from Cyclone Idai (2019), Cyclone Ana (2022), and Cyclone Freddy (2023) did result in some severe claims experiences for the policies in place. Prior to 2019, cyclone risk was not a material risk for insurers in Malawi, but the recent cyclones have led to increased claims due to loss of lives, property damage, and business interruption related losses. In 2022 alone, the total claims across all lines of business were around MWK 28.8 billion (US$25 million) for all insurers, with significant claims in the fire and allied perils business in relation to property damage from Cyclone Ana. Despite aggregate excess of loss reinsurance in place, cyclone-related losses have also caused some challenges with the liquidity for insurers, due to many claims being payable due to the same risk event at the same time. These losses related to cyclones led to high claims ratios41 for the property business of some insurers, including some lines of business being loss making for two largest insurers. One insurer had total claims paid of MKW 40 billion (US$22 million) cumulatively from the three large cyclones, which was 90–100 percent of the total gross claims for the fire business. Another large insurer had cyclone-related claim payouts of around MWK 1.3 billion (US$0.8 million) for Tropical Cyclone Ana. For this insurer, it is estimated that 25–30 percent of all non-life claims experienced was due to this catastrophic event which resulted in loss ratios of 80–90 percent for fire business (this business line was therefore loss making after accounting for all other costs). Claims ratios did however vary by insurer; in an extreme case, one insurer had a loss ratio of around 200 percent for their property business line, the losses driven by the cyclone event (with the claim payments being met in installments), whereas others made a profit. This difference is potentially due to differences in underwriting, product design, and distribution strategies. Increasing claims costs have led to the reinsurance and retrocession markets hardening and reinsurance and retrocession renewals becoming very difficult to secure. Some of the highly rated reinsurers have shut down their fire and allied perils and agricultural insurance product lines due to their poor underwriting experience in recent years. The reinsurers left available in the market have a lower rating in general, which can also be a challenge, in terms of ability to pay valid claims on a speedy and consistent basis. A further consequence of the high claims ratios is that reinsurance loadings have increased significantly recently, and the deductible for new placements has increased to around US$500,000, resulting in higher liquidity challenges. Box 1 provides a case study of the impact of climate risks on the insurance sector in South Africa. BOX 1 Case study of the impact of climate risks on insurance sector in South Africa South Africa is highly vulnerable to climate change and is ranked 96 out of 182 countries assessed under the Notre Dame Global Adaptation Initiative index. Climate change poses the most significant threat for South African insurance companies and risks raising premiums and the cost of reinsurance. After staying almost flat in the decade up to 2020, the cost for reinsuring against catastrophic events for Old Mutual Ltd. has climbed as much as 30 percent, according to Garth Napier, managing director at Old Mutual Insure Ltd., the group’s non-life unit. Reinsurance costs have jumped, in part, due to the worst flooding in almost three decades that drowned more than 400 people in landslides and washed away houses in 2022. Reinsurers paid out more than 30 billion rand (US$1.6 billion) for that catastrophe. “The biggest concern for the industry is climate change driving a significant increase in the number of events that are happening,” Napier said. Customers could see a 10 percent increase in premiums across the board in 2024. 41 The percentage of claims costs incurred in relation to the premiums earned. 32 Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 4 The insurance sector's vulnerability to climate risks Given the contribution of agriculture to the country’s GDP and food security, agriculture insurance products have been tested but constitute a relatively small proportion of overall premium in Malawi. Most insurers are currently not providing agriculture insurance and for those who do, agriculture constitutes a relatively small proportion of their portfolio. There are indemnity and index based agricultural insurance products, for example multi-peril crop indemnity insurance (MPCI), area yield index insurance (AYII), and weather index insurance (WII). Indemnity products rely on a loss assessment to determine the size of any claim, where index insurance is based on an underlying index, whereby insurance compensation is made as per the specified index and claims do not have to be reported or verified for every insured asset (see Box 2 for details). Some AYII and WII products, supported by development partners, have had relatively significant exposure and premium volumes. For example, an AYII product supported by the World Food Program R4 program, has been in the market since 2018, with a total sum insured of approximately US$17 million and a total premium received of US$456,000. Average premium rate for this product has been 2.7 percent of the sum insured. The product was underwritten by a local insurer, with loss ratios exceeding 100 percent in aggregate over the last three years. Despite the large volumes, the high claims ratios for some of the AYII products as a result of climate events has made them unattractive for insurers and reinsurers in recent years. BOX 2 Insurance products can be designed on an indemnity or index basis, depending on the purpose Product can be on an indemnity basis, where claims must be reported and assessed for the affected insured assets, e.g., indemnity-based property insurance insuring cyclone risk. They can also be based on an underlying index, whereby insurance compensation is made as per the specified index and claims do not have to be reported or verified for every insured asset, e.g., for climate risks. Such indices might include weather index and area yield index for smallholder crop farming. Both indemnity-based and index-based products could be potentially applied at the micro (household) level, although for smallholder farming and microinsurance customers, typically index-based products are seen as being more potentially feasible, as per global practices. For the meso (business) and macro (government) levels, index-based approaches are usually most relevant for addressing climate risks, although indemnity-based products could also be potentially implemented. Hybrid approaches of combining indemnity and index-based products can also be considered. In Malawi, most of the market’s experience is with indemnity products. Typically, indemnity products take longer to settle due to the claims assessment process, whereas under index insurance the size of claim is determined by the index value with no subjectivity or assessment required. For example, some claims from Cyclone Freddy, which occurred in the first quarter of 2023, took over 12 months to settle due to being determined purely on an indemnity basis. Due to the simplification in product design and claims processes, insurers are more interested in underwriting WII than AYII. The interest in WII is due to better data availability, lower claims ratios experienced in the past, and ease of monitoring and verifying claim events, based on satellite-based weather data. Hence, there is an interest among some insurers to return to focusing more on WII going forward. However, potential downsides to implementing WII, such as potentially high basis risk; not insuring non-weather risks; high concentration risk for major weather disasters; complexity of products, etc. remain. The regulator, insurers, and aggregators need to be aware of these downsides and take necessary steps in both product design and implementation to mitigate these risks associated with WII. Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 33 4 The insurance sector's vulnerability to climate risks BOX 3 The rise in protection gap as a result of climate change Even though enhancing insurance companies’ awareness and management of climate risks is crucial for ensuring the financial health of the insurance sector, doing so could increase the protection gap, particularly for underserved segments of the economy that are already vulnerable to the impacts of climate change. The occurrence of climate risks has led to a reduction in both supply and demand for associated insurance products. On the supply side, regional concentration in high-risk areas and limited product design and pricing expertise are pushing up the price and the loss ratios, resulting in insurers withdrawing from the market. On the demand side, the severe effect of climate risks on reducing customers’ income levels or income certainty and simultaneously increasing insurance premiums and product exclusions have resulted in the demand for such products to reduce, resulting in a significant protection gap. This is particularly the case for business in the agricultural value chains, such as processors and traders. Climate risks also lead to indirect effects on other lines of insurance, such as customers reducing their expenditures (e.g., buying a car) if they have suffered damage to their properties and businesses, which in turn leads to reduced expenditure on associated insurance products (e.g., motor insurance). © Agencja Fotograficzna Caro / alamy.com 34 Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate © Ashley Cooper pics / alamy.com Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 35 4 The insurance sector's vulnerability to climate risks 4.2 Overview of the insurance sector response to climate risks To manage climate risks, insurers need to ensure their product design, underwriting, pricing, and reinsurance arrangements account for the risk appropriately. Globally, general insurers typically use surveyors, including engineers, to assess risks and conduct loss adjustments for environmental risks for fire and allied perils and engineering policies. Surveyors can also provide recommendations on mitigating risk, which can also help with ex-ante risk management of climate risks, e.g., improved drainage recommended for warehouses to deal with risk of flash flooding. Insurers need to actuarially price products and to review this pricing on a regular (e.g., annual) basis. Claims frequencies and severities must be analyzed for each product category as well as for different covers within the same product, to identify the specific perils leading to such high claims experience. This can also improve the underwriting experience for the insurers and consequently lead to better access to reinsurance markets and terms. Insurers in Malawi have started to use stricter product design features in order to mitigate the impact of climate risks on their business. For example, there is use of higher deductibles, so that the customer retains more of their risk; the use of lower limits and sub-limits on the sum insured; maximum payouts per peril to reduce the insurer’s exposure to climate risks. Hours clauses are also used, whereby defined climate risk events would Insurers in be limited to certain number of hours, e.g. coverage for a cyclone event is defined as occurring over 72 hours or less as a way of limiting liability for Malawi have the insurer and reinsurer. There has been a demand from clients to increase started to use this definition of cyclones to 120 hours, but reinsurers are reluctant to make stricter product this change, which would increase their liability from a single cyclonic event. design features Product design modifications are also used to reduce insurance premiums. in order to mitigate the For indemnity-based agriculture insurance (such as multi-peril crop indemnity insurance), most Malawian insurers tend to apply very impact of climate strict exclusions to mitigate against climate risks. MPCI products are risks on their provided to medium-large scale farmers for crops, such as tobacco. Such business. MPCI products are focused on risks with a localized impact, such as hail, fire, and wind related losses. To mitigate against climate risks they often exclude flooding, cyclone, and drought impacts for agriculture insurance policies. However, these exclusions reduce the relevance of such agriculture insurance products from the farmers’ perspective. Suitable reinsurance coverage is a crucial risk management method used by insurers to manage climate risks. Insurers can use reinsurance to limit their exposure to certain risks. In Malawi, insurers are reducing their risk concentration through reinsurance arrangements on a surplus quota-share and aggregate excess of loss basis for product lines such as fire and agriculture insurance. Surplus treaties are used for insuring individual properties and aggregate excess of loss treaties are used for insuring the entire property portfolio. Facultative reinsurance arrangements42 are now allowing for environmental risks such as the vulnerability of a region to cyclones and flash flooding, when pricing the reinsurance coverage, which is making the policies more costly. This is a contributing factor to insurers withdrawing products or terms exposed to climate risk. 42 Reinsurance that is outside of the existing reinsurance treaty and tailor-made for a specific risk. 36 Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 4 The insurance sector's vulnerability to climate risks There are examples where insurance regulators have imposed minimum pricing for certain insurance products to ensure that they are not underpriced. RBM is considering a provision in the new insurance act on minimum pricing starting with motor third-party liability insurance. For example, the Insurance Regulatory and Development Authority of India sets minimum premium rates for motor third-party liability insurance to prevent underpricing, such that insurers can cover the costs associated with all claims. By regulating the minimum premiums, the regulatory authority helps maintain the solvency of insurers and ensures that victims of road accidents receive adequate compensation. The regulatory authority has also issued guidelines to prevent the underpricing of health insurance products. In South Africa, the Financial Sector Conduct Authority monitors the pricing of short-term insurance products to prevent underpricing. This includes ensuring that premiums for products like motor and property insurance are adequate to cover potential claims. BOX 4 Capacity building needs for Malawi’s insurance sector There is a significant need for capacity building to be conducted for public and private sector insurance industry stakeholders. Topics of interest to the industry include relevance of climate risks for Malawi and the insurance sector, climate-risk insurance products, data requirements, product design, underwriting, policy wording, actuarial pricing, distribution, claims processing, roles of government and private sector, regulatory and policy recommendations, etc. Insurers are also keen to learn about international best practices on other products, which also cover climate risks, such as engineering (contractor’s all risk) and fire and allied perils and marine insurance. RBM and insurers raised the following specific areas of interest: 1. Deeper knowledge of index and parametric insurance. The lack of actuarial and risk modeling expertise and experience is a huge issue for the market and regulator. Currently there are only one or two qualified actuaries working within Malawi, and no specific initiatives underway to improve catastrophe risk models, as far as the market is aware. This presents a challenge when trying to bring more nascent products to the market for a risk that is changing quickly. The result is a risk of mispricing and lack of appetite from the market to sell such products. Specific index insurance products of interest include: i. Agricultural insurance. Considering the poor underwriting experience on AYII in the last three years, there is interest in understanding how agricultural insurance can be implemented on a sustainable and profitable basis. There is also an interest in developing suitable products for the livestock sector, which has been relatively neglected, compared to crops. ii. Tropical cyclone insurance. There is some experience in other countries that cover this risk on an index basis to make it easier to transfer to the international reinsurance markets. Cyclone-index insurance can be based on indices related to high windspeed and/or excessive rainfall. This typically requires over 20 years of historical data, which is available (often for free) from multiple satellite sources, as well as weather stations in Malawi. This makes it possible to model the frequency and severity of extreme climate events, and thus makes it easier to design, price, and settle claims and find good quality reinsurance for index-based cyclone insurance. In comparison, there is very limited historical data on cyclone impacts on property etc. to model the payouts in extreme events for indemnity-based cyclone insurance. Some insurers also expressed a strong Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 37 4 The insurance sector's vulnerability to climate risks interest in using an indexed or hybrid of index and indemnity approach for cyclone insurance as a way of better managing cyclone claims, which are currently very difficult to settle quickly. An example of such a catastrophe index-insurance product is a flood- index insurance product developed in Kenya in 2023, which was implemented in Tana River County and insured by Britam Kenya and reinsured by Swiss Re. iii. Online tools. Some good resources are available online for regulators to review the best practices with respect to index insurance. For example, the access to insurance initiative (A2ii) has free online trainings and reports.43 2. Partnerships with regional experts. Where skills are lacking within the country, partnerships with regional insurers and reinsurers present an opportunity for training and to leverage expertise. For example, local insurers from Malawi could partner with regional reinsurers and risk pools like Africa Re, African Risk Capacity, and ZEP-RE, or a large financial services group like Old Mutual, which has much experience from South Africa and across the region. With this support, Malawian insurers could offer the types of products which have been successfully building resilience, particularly for farmers, in Africa. 3. Capacity building for financial institutions as well as businesses on the application of climate risk insurance for de-risking lending is important. Some banks, such as the National Bank of Malawi, have been bundling insurance with loans and providing financial incentives, such as better interest rates and lower collateral requirements for those who take out insurance. This can increase the access to finance for those who would otherwise have been deemed too risky. Given the relatively high proportion of agricultural financing in Malawi (approximately 17 percent of total credit compared to less than 4 percent in Kenya), there is a need for the capacity building of various key banks and microfinance institutions as well as the banking regulator to train stakeholders on the benefits and limitations of bundling agricultural insurance with agricultural financing at the micro and/or meso levels, in order to improve access to finance and reduce credit risk for the banking sector in Malawi. Such products could also benefit other sectors where climate risks pose a business interruption or supply chain risk. 43 Free online course available for regulators and supervisors: Impact Capital for Development, “Access to Insurance Initiative (A2ii) and United Nations Capital Development Fund (UNCDF) Launch Training on Index Insurance,” November 29, 2023; Access to Insurance Initiative, “Index Insurance Best Practices for Insurance Regulators and Practitioners in the Pacific Island Countries,” 2023. 38 Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 5 The banking sector’s vulnerability to climate risks Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 39 5 The banking sector's vulnerability to climate risks 5.1 The banking sector’s exposure to climate risks This section evaluates the banking sector’s exposure to climate physical and transition risk. There is growing recognition, including from global bodies such as BCBS and the Financial Stability Board, that climate physical and transition risks could lead to material impacts on banks and other financial institutions. Physical risks stem from both the chronic and acute impacts of climate change and natural disasters such as sea level rise, droughts, floods, and hurricanes on the value of real assets and their underlying financial instruments. Transition risks originate from efforts to mitigate climate change and improve environmental conditions by greening the economy, which may create economic adjustment costs in a broad range of sectors. These costs can create financial risks for banks that did not anticipate the transition and can ultimately jeopardize the functioning and stability of the financial system. The analysis presented here provides initial insights that may help improve banks’ climate-related financial risk management practices. The assessment draws upon academic and policy reports, publicly available climate and sector-specific data from global and domestic sources, as well as unpublished data on banks’ lending (as of January 2024) and unpublished data on the top borrowers of eight banks (as of June 2024) provided by the RBM. Due to data limitations, this note focuses on analyzing credit exposure to climate physical risks through two interconnected lenses: by sector and by counterparty, recognizing that these perspectives are not mutually exclusive but rather complementary in nature, to identify potential impacts from climate-related risks. Banks’ exposure to transition risk is analyzed at a high level based on unpublished data on the sectoral breakdown of bank credit. In addition, the section also (partially) considers operational risk by mapping banks’ branch network’s vulnerability to climate physical risks. For a comprehensive assessment of physical and transition risks in Malawi, however, more detailed data modeling and analysis of critical transmission channels and indirect impacts would be necessary. Key data gaps need to be addressed to obtain precise estimates of the effects of climate-related physical risks in the financial sector. For example, while some literature exists, there are no regular modeling assessments that map the socioeconomic impacts of climate physical risk at the subnational and national level. Other data that limit banks’ ability to assess climate risks include the physical location of asset (not just the head office), more granular sub-sectorial mapping of credit exposure, regional mapping of credit exposure, further information on banks’ use of risk mitigation measures (e.g., insurance), and supply chain data. Over time, these data gaps could be addressed to further refine the analysis of climate risks for the banking sector. 5.1.1 Banks’ exposure to climate physical risks Climate change could pose risks for the Malawi banking system due to the impact of climate-related shocks on the agriculture sector. As shown in Figure 12, agriculture, forestry, fishing, and hunting industries represent 17 percent of bank credit as of January 2024, and the demand for agricultural loans is expected to grow, as reported in the RBM Bank Lending Survey of 2023. The concentration in agriculture credit in Malawi is high, surpassing that of regional counterparts such as Ethiopia, Kenya, Tanzania, and South Africa by at least twofold in most cases (Figure 13). Furthermore, banks primarily lend to large private corporates, while smallholder farmers’ access to lending remains very limited. Nearly a third of private corporations’ loans are for agriculture (Figure 15). As noted in Section 3, climate change could increase the frequency and severity of natural hazards, especially floods and droughts. These climate impacts will directly affect the agricultural sector because most agricultural production in Malawi is vulnerable to temperature increases and changes 40 Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 5 The banking sector's vulnerability to climate risks in precipitation. The agriculture sector is also indirectly affected by climate change, such as through pest infestations and soil erosion. These impacts on the agriculture sector could translate into credit risks for banks, for example, if floods and droughts destroy borrowers’ collateral assets or reduce the borrowers’ ability to repay loans by disrupting supply chains. Banks’ vulnerability to climate physical risks could be even more significant when considering sectors that are interconnected with agriculture (e.g., restaurants and hotels, which already represent 38 percent of nonperforming loans [NPLs] as of January 2024, see Figure 14). Beyond the agriculture sector, banks’ high exposure to forestry loans could also create credit risks due to the forestry sector’s vulnerability to climate-related impacts such as wildfire.44 FIGURE 12 Sectoral distribution of Malawian banking credit as of January 2024 (percentage of total gross loans) Mining and quarrying (0.7%) Real estate (0.9%) Financial services (2.1%) Restaurants and hotels (3.9%) Construction (4%) Electricity, gas, water and energy (4.4%) Transport, storage and communications (6%) Community, social and personal services (35%) Manufacturing (15%) Agriculture, forestry, fishing Wholesale and retail trade (15%) and hunting (17%) Source: Authors based on Rerserve Bank of Malawi data FIGURE 13 Agricultural credit as a percent of total credit for Malawi and other African countries Ethiopia Kenya Malawi South Africa Tanzania 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% Source: Authors based on central bank data across selected countries 44 The risk level for wildfires is rated as “high” in Malawi under ThinkHazard!. Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 41 5 The banking sector's vulnerability to climate risks FIGURE 14 Sectoral distribution of NPLs as of January 2024 (percentage of total NPLs by value) Electricity, gas, water and energy (1%) Real estate (1%) Mining and quarrying (3%) Financial services (4%) Construction (5%) Transport, storage and communications (5%) Restaurants and hotels (38%) Agriculture, forestry, fishing and hunting (6%) Manufacturing (6%) Wholesale and retail trade (16%) Community, social and personal services (16%) Source: Authors based on Reserve Bank of Malawi data FIGURE 15 Sectoral credit exposure of Malawian banking sector’s largest borrowers as of January 2024 6% Agriculture, forestry, fishing and hunting 5% 4% 6% Wholesale and retail trade 29% Manufacturing 7% Transport, storage and communications Private Individuals and 9% corporations households Restaurants and hotels Construction 22% Community, social and personal services 17% 91% Other Source: Authors based on Reserve Bank of Malawi data Sixty-three percent of banking sector credit goes to sectors which could be particularly vulnerable to climate physical risks.45 Beyond agriculture, other sectors that banks are exposed to, such as trade and manufacturing, could also be vulnerable to climate physical risks. For example, beyond agriculture, banks also supply substantial credit to trade and manufacturing sectors (nearly one in four credit are either to trade or manufacturing sectors as of January 2024), which, based on their locations, could be exposed to climate disasters. For instance, manufacturing firms could be clustered in Special Economic Zones and industrial parks in Dunduzu in Mzuzu, Area 55 in Lilongwe, Matindi, and Chigumala in Blantyre46 —localities are vulnerable to various climate disasters, such as floods and cyclones. Depending on the share of banks’ credit located in these regions, banks could be very vulnerable to climate change. Other sectors could also be affected by climate change due to various indirect and direct transmission channels, as summarized in Table 1. However, more granular data on asset location, sub-sectorial mapping, and climate-related damages are needed to better understand the precise impacts on banks’ credit. 45 Sectors that could be directly or indirectly affected by climate change include agriculture, forestry, and hunting; mining and quarrying; manufacturing; electricity, gas, water, and energy; construction; wholesale and retail trade; restaurants and hotels; transport, storage, and communications; and real estate. 46 Malawi Investment and Trade Centre, “Special Economic Zones.” 42 Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 5 The banking sector's vulnerability to climate risks TABLE 1 Description of potential direct and indirect impacts of physical climate shocks by sectors (floods and droughts) Sector Definition: % of gross % of total Potential impact Potential impact of climate- The sectoral credit includes loans (as NPL (as of of climate-related related floods loans and advances for of January January droughts 2024) 2024) Agriculture, Financing agricultural 17% 6% Direct and indirect. Direct and indirect. Floods forestry, production, including the Droughts directly can destroy crops and cause fishing, and growing and storing of crops, impact crop livestock losses. hunting the marketing or carrying production and of agricultural products by deplete livestock In Malawi, Cyclone Idai, growers, and the breeding, herds. which hit the country raising, fattening, or in March 2019, caused marketing of livestock; devastating floods that Purchase of farm machinery, affected an estimated equipment, and implements; 975,600 people and Financing fisheries and submerged or washed forestry, including loans to away mature crops and commercial fishermen, and destroyed irrigation for hunting; infrastructure. All other purposes associated with the maintenance or operations of the farm. Mining and Mining, oil, and gas producing 0.7% 3% Direct, particularly Direct. Floods can disrupt quarrying and quarrying. for mining operations the production and flow of with high water goods by directly affecting consumption. production sites and infrastructures. Manufacturing Manufacturing companies 10% 6% Indirect, particularly Direct and indirect. Floods of all kinds, including those for agroindustry can disrupt production and which process agricultural (via impacts on the flow of goods by directly commodities. agriculture sector) affecting production sites and and industries infrastructures, as well as by with high water affecting workers’ capability consumption such to work or to reach the site of as textile and leather work. (via impacts on the water sector). Electricity, Public utilities and energy 4.4% 1% Direct and indirect. Direct and indirect. Floods gas, water, and production. Drought can disrupt the production energy can reduce the and distribution of energy and availability and damage water treatment and quality of water distribution infrastructure. supplies and increase demand. Drought can In January 2022, the cause disruptions in country lost 129.60 the energy supply megawatts of base and increase energy power due to damage demand. caused to the Kapichira Hydropower Plant by Tropical Storm Ana. Construction Construction companies. 4% 5% Direct. Drought can Direct and indirect. Floods generate damage to can generate physical damage buildings due to soil and affect workers’ capability desiccation. to work or to reach the site of work. Positive impacts may also appear in the medium term with the increase in demand for the reconstruction of destroyed buildings and infrastructures. Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 43 5 The banking sector's vulnerability to climate risks Sector Definition: % of gross % of total Potential impact Potential impact of climate- The sectoral credit includes loans (as NPL (as of of climate-related related floods loans and advances for of January January droughts 2024) 2024) Wholesale and Wholesale and retail trade 15% 16% Indirect, particularly Direct and indirect. Floods retail trade enterprises and other dealers for food trade. More can disrupt the flow of goods in commodities, e.g., shops, broadly, firms could and impact storage facilities supermarkets, wholesalers, be affected by and commercial spaces. etc. climate damage on road and bridges. Restaurants and Service enterprises such as 3.9% 38% Indirect. Drought can Direct and indirect. Flood hotels hotels, motels, lodges, inns, disrupt the flow of can damage infrastructure rest houses, and restaurants services, particularly of hotels and restaurants. operated for profit or tourism connected to the Floods can disrupt the flow of in general. food industry; lower services. water levels can affect the availability of recreational activities and associated tourism. Reduced agriculture production caused by droughts could also indirectly reduce food availability. Transport, Operating transportation, 6% 5% Indirect, Direct and indirect. storage, and storage, and communication particularly for Transportation networks communications businesses. food transportation and infrastructures can be (via impacts on the impacted by floods, directly agriculture sector). (by damage to infrastructures and vehicles) and indirectly (e.g., by rerouting traffic). In Malawi, 5 percent of the transport network is exposed to floods; repairing roads damaged by Tropical Storm Ana, for instance, is expected to cost US$6.1 million. Real estate All loans and advances 0.9% 1% Direct. Drought can Direct. Floods can damage or granted for purposes of real generate damage to destroy buildings. estate, e.g. finance land buildings due to soil development (i.e. the process desiccation. of improving land—laying of sewers, water pipes, etc.); preparatory to erecting new structures or the on-site construction of industrial, commercial, residential, or farm buildings. For this item “construction” includes not only construction of new structures, but also additions or alterations to existing structures and the demolition of existing structures to make way for new structures. Source: Authors adapted from World Bank (2024)47 47 World Bank, “Double Trouble? Assessing Climate Physical and Transition Risks for the Moroccan Banking Sector,” 2024. 44 Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 5 The banking sector's vulnerability to climate risks Lending to individuals and households could increase vulnerability to climate physical risks, but more granular data (including on geographical location of these loans) is needed to refine the assessment. Lending for community, social, and personal services48 has increased significantly over the past decade, although this is partially driven by the change in classification (Figure 16). Depending on where these loans are located, this increase could heighten vulnerability to physical risks. For example, schools or churches could be situated in areas highly exposed to flood risks, leading to bank loss if customers default and the value of collaterals are reduced. FIGURE 16 Malawian sectoral credit exposure (2012–2022) Community, social and personal services 30 Loans by sector (in percentage) 20 Wholesale and retail trade Agriculture, forestry, fishing and hunting Manufacturing 10 Transport, storage and communications Electricity, gas, water and energy Construction Restaurants and hotels Financial services Real estate Mining and quarrying 0 Other sectors 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 Source: Authors based on publicly available Reserve Bank of Malawi data In extreme cases, lending to sovereign and subnational borrowers could also be affected by climate physical risks. The direct credit exposure from sovereigns and subnational borrowers in Malawi, primarily the para-statals, the central government, local government, and statutory bodies, is relatively small (Figure 17), cumulatively comprising 7.74 percent of total credit as of January 2024. Nonetheless, indirect and interconnected exposure may make the credit risk material and cascading. For instance, climate disasters could result in (i) higher government spending to address the ramifications of the disasters; (ii) lower tax revenues due to reduced household income and impaired corporates; and (iii) an overall decline in output. For these reasons, the government could face higher fiscal constraints and a higher risk of default as a result of climate impacts, which in turn could heighten credit risk within banks’ sovereign and local government credit exposures. Moreover, the government’s ownership stake in some private corporations could exacerbate this vicious cycle. 48 According to the RBM, loans to community, social, and personal services include “all loans and advances granted to enterprises engaged in community, social, and personal services, e.g. schools, churches, NGOs etc.” See Table 1 for RBM’s sector classification definitions. Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 45 5 The banking sector's vulnerability to climate risks As further elaborated in Box 5, 27 percent of total credit to top 10 borrowers goes to companies where the government is either a majority or minority shareholder. These companies could be more vulnerable to climate risks if they rely on government revenue that could be impacted by climate risks. FIGURE 17 Malawian banking sector’s credit exposure by counterparty as of January 2024 (percentage of total credit) Private corporations 56.33% Individuals and households 34.16% Para-statals 3.67% Central government 3.03% Non-residents 1.35% Statutory bodies 0.97% Affiliated companies 0.15% NBFIs 0.13% Credit/Debit cards 0.12% Local government 0.07% Non-profit organizations 0.01% Other banking institutions 0.00% Source: Authors based on Reserve Bank of Malawi data © Ashley Cooper pics / alamy.com 46 Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 5 The banking sector's vulnerability to climate risks 5.1.2 Banks’ exposure to climate transition risks Banks’ exposure to climate transition risks is likely low, given the small GHG emission profile of the country (as noted in Section 3B). However, transition risks could increase over time if GHG emissions continue to grow. Transition risks could be particularly high for sectors dependent on carbon-intensive technologies or requiring substantial energy efficiency improvements. Based on conservative analysis—without second round effects—in Malawi, as of January 2024, 24 percent of loans are provided to sectors which are highly transition sensitive49; and 18 percent of the loans are provided to sectors which are moderately transition sensitive50 (Figure 18). Exposure is highest for agriculture (along with forestry, fishing, and hunting), recording 17 percent of total loans, and for transport, storage, and communications, with 6 percent of total credit. Beyond considering the carbon intensity of sectors, industries could also be affected by transition risks related to other regulatory, consumer, and environmental advocacy pressures. For example, as noted in Section 3B, some industries (e.g., coffee) which export to the EU could be affected by the Regulation on Deforestation-Free Products. FIGURE 18 Loan exposure to transition-sensitive sectors as of January 2024 (percentage of total gross loans) 24% Highly transition sensitive Other sectors 58% 18% Moderately transition sensitive Source: Authors based on Reserve Bank of Malawi data 5.1.3 A deeper dive on bank-by-bank exposures Some banks have highly concentrated credit portfolios, which means they could feel the impacts of climate physical and transition risks more acutely than banks that have more diversified portfolios. Relying solely on the average concentration of credit portfolios across the banking sector can obscure the substantial differences that exist between individual banks. For example, many of the commercial banks in Malawi have significant credit exposures in agriculture and associated sectors (such as forestry, fishing, and hunting). Based on the latest data from RBM, as of January 2024, two of the largest banks in Malawi have over 20 percent of their total credit exposure in agriculture and associated sectors (Figure 19). In addition, as of January 2024, the range of credit exposure to wholesale and retail trade among banks ranges from only 9 percent in one bank to as high as 57 percent for another bank—a difference of 48 percentage points (Figure 20). One of the largest commercial banks in terms of asset size exhibited a highly concentrated portfolio—nearly 30 percent of its loans are to community, social, and personal services, and agriculture, along with forestry, livestock, and fishing, accounts for 23 percent of the loan distribution. The bank has notably increased its lending to tobacco 49 Based on the greenhouse gas emission profile of sectors and per capita emissions per sector, highly transition-sensitive sectors identified could include agriculture, forestry, fishing, and hunting; and transport, storage, and communications. 50 Based on the greenhouse gas emission profile of sectors and per capita emissions per sector, moderately transition sensitive could include construction, manufacturing and electricity, gas, water, and energy. Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 47 5 The banking sector's vulnerability to climate risks farmers by 40 percent and to other crops by 30 percent in the 2021–2022 period.51 Some of the areas where tobacco is most likely to be produced, including Mangochi and Balaka, are highly susceptible to floods and droughts, posing additional risks to the bank’s agricultural credit exposure. Depending on the share of banking sector assets per bank and whether a bank requires climate risk insurance (which based on consultations, most banks do not), such concentration risks in climate vulnerable sectors could become even more material. FIGURE 19 Percentage of loans per bank in agriculture and associated sectors as of January 2024 26% 23% 19% 16% 13% 3% 2% 0% Bank 1 Bank 2 Bank 3 Bank 4 Bank 5 Bank 6 Bank 7 Bank 8 Source: Authors based on Rerserve Bank of Malawi data FIGURE 20 Average credit exposure masks wide variations within banks as of January 2024 (range of the percentage of gross loans in Malawian banks) Lowest Highest Highly transition sensitive Transport, storage and communications 13% Agriculture, forestry, fishing and hunting 26% 0% 20% 40% 60% 80% 100% Moderately transition sensitive Electricity, gas, water and energy 18% Manufacturing 31% Construction 12% 0% 20% 40% 60% 80% 100% Other sectors Mining and quarrying 11% Wholesale and retail trade 57% Restaurants and hotels 11% Financial services 5% Community, social and personal services 69% Real estate 3% 0% 20% 40% 60% 80% 100% Source: Authors based on Reserve Bank of Malawi data 51 National Bank of Malawi, “Annual Report 2022,” 2023. 48 Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 5 The banking sector's vulnerability to climate risks BOX 5 Preliminary analysis of the climate risk exposure of top 10 borrowers of eight Malawian banks52 Data from the RBM highlights that Malawi’s banking sector exhibits a high concentration of credit among a limited number of borrowers. Specifically, the top 10 borrowers received 31 percent of the total credit issued by eight banks in Malawi. Therefore, evaluating the climate risk exposure of these borrowers is critical due to their significant share of credit access. This box uses data sourced from the RBM to conduct a preliminary climate risk assessment of the top 10 borrowers. Such analysis should be refined over time, if other key datasets become available, such as the physical location of the asset and collateral, supply- chain data, further information on banks’ use of risk mitigation measures (e.g., insurance), and supply chain data. Banks are exposed to many of the same borrowers which are sectorally and geographically concentrated. For instance, an oil company borrowed from four different banks with cumulative amount across all banks equal to 7 percent of total banking sector credit as of January 2024. Going a step further, 27 percent of total credit to top 10 borrowers for each of the eight banks goes to companies where the government is either a majority or minority shareholder. These borrowers are also sectorally concentrated—60 percent of the credit to the top 10 borrowers in each bank is either to companies in agriculture, trade, or public utilities and energy production (Figure 21). The two largest borrowers in the country (by amount borrowed) belong to the wholesale and retail trade sector. Geographically, a majority of these borrowers are headquartered in Blantyre or Lilongwe, which could expose banks to climate physical risks vis-à-vis potentially damaging borrowers’ collateral assets. FIGURE 21 Sectoral breakdown of total credit of the top 10 borrowers of eight banks in Malawi (as of June 2024) Restaurants and hotels (3%) Mining and quarrying (1%) Transport, storage and communications (6%) Construction (8%) Wholesale and retail trade (27%) Manufacturing (10%) Financial services (11%) Electricity, gas, water and energy (18%) Agriculture, forestry, fishing and hunting (15%) Source: Authors based on unpublished data from Reserve Bank of Malawi Note: ‘Wholesale and Retail, Accommodation and Food Services’ sector from one bank was equally divided into sectors ‘Wholesale and retail trade’ and ‘Restaurants and Hotels’. 52 The banks included in this assessment include Centenary Bank Limited, CDH Investment Bank, Ecobank, FDH Bank, First Capital Bank, Standard Bank, NBS, and National Bank of Malawi. Credit data was provided as of June 2024. Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 49 5 The banking sector's vulnerability to climate risks The top borrowers in the agriculture sector are producing crops that may be less vulnerable to climate change, given their reliance on irrigation water. However, these companies could still be exposed to climate risks because of the location of the assets. In agriculture and its associated sectors, 12 companies were among the top borrowers across eight banks. The largest of these borrowers is a tobacco company, which constituted a fifth of this agricultural credit (Figure 22). The other top borrowers were involved in the production of coffee, tea, macadamia, tobacco, sugarcane, and poultry, among others (Figure 22). This breakdown is not surprising as largescale producers in the country are almost exclusively involved in production of tobacco, tea, sugar, and macadamia nuts for export. 53 Previous analysis conducted in the CCDR suggests that climate change is not expected to significantly impact production of commonly irrigated crops, such as fruits, stimulants (coffee and tea), and sugarcane, as the availability of irrigation water is not affected even if rainfall declines or becomes less predictable. Furthermore, the use of insurance could further reduce these crops’ vulnerability to climate risks. Nonetheless, these companies could still be vulnerable to climate physical risks because they are headquartered or have physical assets in Lilongwe, Limbe, Mzuzu, Nkhata Bay, Thyolo and Blantyre—all locations vulnerable to climate physical hazards such as floods to varying degrees (see Figure 24). FIGURE 22 Distribution of agricultural credit to the top borrowers, by crop (as of June 2024) Poultry (7%) Other (2%) Sunflower, soya, palm, cotton and groundnut seeds (10%) Coffee, tea or macadamia Sugarcane (10%) or a combination of the three (41%) Tobacco (30%) Source: Authors based on unpublished data from Reserve Bank of Malawi Credit to companies in the public utilities and energy production sector could face an increase in vulnerability from climate physical and transition risks. About 23 percent of the total credit to this sector among the top 10 borrowers goes to a public utilities project which finances the treatment of water from Lake Malawi at Lifuwu in Salima and transportation of the treated water through a 112-kilometer transmission pipeline to Lilongwe City. This dependency on Lake Malawi could be a concern to the project as severe droughts have previously affected water levels in Lake Malawi; since 2015, a multi-year dry period (including the 2015/16 El Niño event) has led to prolonged low lake levels and reduced outflows. 54 Furthermore, the two dominant fuel companies in the country constitute 41 percent of the total credit to the sector among the top 10 borrowers. As Malawi moves towards renewable energy sources and if the country introduces more stringent regulations to decarbonize (e.g., through carbon pricing), such companies (and by association, the banking sector) could face climate transition risks, although this seems unlikely in the short term. 53 World Bank, “Climate-smart Agriculture in Malawi,” 2019. 54 Ajay G. Bhave et al., “Lake Malawi’s Threshold Behaviour: A Stakeholder-informed Model to Simulate Sensitivity to Climate Change,” Journal of Hydrology 584 (May 2020): 124671. 50 Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 5 The banking sector's vulnerability to climate risks 5.1.4 Operational risk: Mapping the banking sector’s branch network Operational risk is defined in the Basel Capital Framework as the “risk of loss from inadequate or failed internal processes, people, and systems, or from external events”.55 Climate-related hazards could lead to operational risks for banks in several ways. For example, climate-related hazards such as floods could disrupt transportation facilities and telecommunication infrastructure, thereby indirectly affecting banks’ operational ability. Corporates and banks may also be exposed to legal and regulatory compliance risks associated with climate-sensitive investments and businesses. Overall, there are limited studies around banks’ climate-related operational risk since publicly available information on the topic is scarce. Bank branch locations in Malawi could be susceptible to climate physical risks such as floods, storms, and temperature rise. For example, flooding and storms can damage the physical infrastructure of bank branches and cause liquidity shock through extensive withdrawals and repayment delinquencies, asset quality deterioration, and managerial problems. Additionally, the overall increase in temperatures can lead to higher operational costs, for example, due to the need for additional cooling. Bank branches are concentrated in urban areas that are vulnerable to flood risks. Cross comparing the map of distribution of branch locations against a map of flood and drought hotspots suggests that 5 percent of bank branches are in areas which are at “very high” risk of floods and drought; 33 percent of bank branches are in areas which are at “high” risk of flood and droughts. Additionally, bank branches are highly concentrated in urban centers that are vulnerable to climate-induced disasters such as floods and droughts (Figure 23 and Figure 24). FIGURE 23 FIGURE 24 There is a significant presence of banks in Malawi experiences recurring droughts and urban centers floods, especially in the south Number of branches Degree of risk <4 Very low 4–8 Low 8–32 Moderate ≥ 32 High Very high Source: World Bank calculations based on data provided by the Source: World Food Program, 2014 Rerserve Bank of Malawi 55 Basel Committee on Banking Supervision, “Climate-related Risk Drivers and Their Transmission Channels,” 2021. Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 51 5 The banking sector's vulnerability to climate risks Lilongwe has the highest percentage of total branches in Malawi at nearly 22 percent, followed by Blantyre with about 16 percent and Mzimba with nearly 8 percent. In terms of managing operational risks, banks may be further disincentivized to establish branches in rural or remote locations—which already have a limited number of branches—due to elevated climate shocks. For instance, in Nsanje, the southernmost district in Malawi—one of its poorest and primarily agrarian—had a 20-kilometer-long vein of cropland on the east bank of the Shire River overwhelmed by the 2015 floods, destroying resources needed to sustain the population for a year.56 It also has less than four bank branches in the entire district. If these branches were to close due to the impacts of a future climate induced disaster, it would leave rural and poor consumers without access to financial services. This would further compound the challenges faced by these communities, as they would need to travel long distances to access financial services given that only 32 percent of adults in rural areas in Malawi have a mobile money account. This is especially concerning considering a recent study which found that local branches play a critical role in bridging the time gap between the disaster and governmental aid by immediately increasing their lending for months following the flood.57 BOX 6 Preliminary analysis of climate-related market risks for banks According to BCBS, climate physical and transition risks could increase market risks for banks by reducing the value of financial assets, leading to downward price shocks and an increase in market volatility in traded assets. For physical risks, uncertainty around future climate-related shocks and impacts could lead to higher volatility in financial markets (e.g., due to shocks in currencies, stocks, and commodity prices). Transition risks (e.g., technological advances and investor sensitivities) could similarly lead to abrupt repricing of financial assets (e.g., by reducing the value of carbon-intensive companies as a result of a low carbon transition).58 This report’s preliminary analysis suggests that market risk is likely not as material as credit and operational risks, at least in the short run. Securities and investments constitute 46 percent of banking sector assets in Malawi—the highest asset class; of this, 41 percent—nearly 20 percent of total banking assets—is invested in Treasury bills. While research on the impact of climate change on sovereigns is still emerging, preliminary analysis suggests that climate change could lead to volatility in government-related assets if climate risks are not adequately priced in (e.g., due to unanticipated increase in fiscal burden and public debt levels in the aftermath of a climate disaster and/or sudden, large reduction in tax revenues due to climate-induced business losses). Having said that, given the short-term nature of Treasury bills (maturing in less than one year), these impacts are unlikely to lead to material market risks for banks. In addition, banks’ investment in local bonds makes up about 5 percent of total assets. The sector and geographical location breakdown of these local bond investments is unknown, so it is difficult to analyze the impact of climate risks on these bonds. Nonetheless, since local bonds represent a very small share of banks’ overall investments, it is unlikely that climate impacts on these local bond valuations will create significant market risks for banks, at least in the short run. 58 Basel Committee on Banking Supervision, “Climate-related Risk Drivers and Their Transmission Channels,” 2021. 56 Richard Nield, “Devastation and Disease after Deadly Malawi Floods,” Aljazeera, February 25, 2015. 57 Pejman Abedifar, Seyed Javad Kashizadeh, and Steven Ongena, “Flood, Farms and Credit: The Role of Branch Banking in the Era of Climate Change,” Journal of Corporate Finance 85 (April 2024): 102544. 52 Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 5 The banking sector's vulnerability to climate risks 5.2 Overview of the banking sector’s response to climate risk Stakeholder consultations and surveys were carried out to better understand Malawian banks’ climate risk management practices. This section summarizes the main findings on the banking sector’s approach to climate risk management across the following areas: strategy and governance, risk management, and challenges faced by the banks while trying to incorporate climate-related financial risks. Box 7 summarizes progress made by Malawian banks across various metrics. It should however be noted that the results should be interpreted with caution because the survey responses are based on self-reported data from banks and have not been verified. Strategy and governance Respondents at all seven banks that returned the questionnaire believe that climate change will affect its business in the future. However, in general, banks are at an early stage of integrating climate risks into business models, corporate strategies, and governance practices. While 71 percent of the sampled banks are aware of BCBS principles for effective management and supervision of climate-related financial risks, only 14 percent have integrated climate risk management into their internal governance structures. This indicates a gap between recognizing the importance of climate risks and fully incorporating them into governance practices. The situation in Malawi reflects varying levels of maturity among banking institutions in considering climate risk, which could be due to differences in market demands and institutional capacities. While most banks are still in the early stages of evaluating the impact of climate risks, steps have been taken to integrate climate risks into banks’ broader governance frameworks. Fifty-seven percent of banks have long term strategies that incorporate climate financial considerations, and 29 percent of banks have climate requirements in loan considerations and decline to finance non-climate friendly projects. This indicates a positive trend in the banking sector towards recognizing and managing climate-related risks, and a commitment at the highest level of governance. The variation in risk management structures likely reflects the different stages of maturity in climate risk management across banks. Banks are calling for more guidance, data, and capacity building to help them manage climate risks. In response to climate risks, surveyed banks are asking for more guidance and support (e.g., for scenario analysis/stress testing, governance, risk management, and disclosure); availability of data, proxies, tools, or case studies that could be leveraged for the banks’ climate risk analyses. These responses indicate that banks would find it easier to develop climate risk capacity if there were clear signals that such oversight will become a regulatory requirement. Risk management Less than half of the sampled banks have integrated climate change into their risk management framework. Forty-three percent of sampled banks have included climate-related financial risks in their risk management framework. Few banks have introduced specific targets, tools, or metrics to assess climate risks. The full integration of climate considerations into risk management practices is hindered by several challenges: the absence of uniform tools, data, and metrics to evaluate climate risk; the unpredictable and potentially severe long-term effects of climate change; a shortage of specialized knowledge in this area; and the overarching need for additional resources to support these initiatives. Only 29 percent of the sampled banks have conducted a scenario analysis/vulnerability assessment to analyze climate risks. Data limitation was identified as one of the key challenges, especially in terms of granularity. Other challenges include the need for standardized and approved methodologies to assess and manage climate risks. Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 53 5 The banking sector's vulnerability to climate risks BOX 7 Banks in Malawi are in various stages of integrating climate financial risks into their business models and operations Integrated climate risks into the governance and organizational structure Yes Yes Yes 14% 14% 71% Has integrated climate risks Has a system to Has awareness of BCBS into its internal governance administer and manage climate principles arrangements risks created by its portfolio Integrated climate risks into the risk management process Yes Yes Yes 29% 43% 29% Has climate requirements in Has integrated climate-related Has excluded financing of loan origination financial risk in risk non-climate friendly management frameworks projects Conducted climate risk scenario analysis Yes Yes Yes 43% 29% 57% Has assessed the impact of Has conducted scenario Has long-term strategy that climate risks on its portfolio analysis or stress testing to incorporates climate assess climate risk financial risk considerations Key challenges that limit banks’ climate risk management Lack of data/forward-looking climate scenarios 43% Difficulty assessing/incorporating climate risks 43% in financial risk modelling Unclear or absent disclosure regulations 43% Monitoring and reporting challenges 14% Other 14% Source: Authors based on data from Reserve Bank of Malawi 54 Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 6 Policy roadmap for managing climate risks for banks and insurers Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 55 6 Policy roadmap for managing climate risks for banks and insurers RBM is committed to creating a policy enabling environment for greening the financial sector. The preliminary analysis of this report suggests that climate change (especially in the context of physical risks) could pose risks to Malawi’s financial system. Against this backdrop, this section outlines a roadmap which identifies short, medium, and long-term policy actions that could be taken to help banks and insurers better assess and manage these risks. Equally important is to ensure that Malawi’s financial system continues to develop in line with a vision of a low carbon, sustainable economy, although policy recommendations related to the development of green financial markets are out of this assessment’s scope. The policy recommendations are divided into three broad categories (a) governance, strategy, and capacity building; (b) supervisory and regulatory framework for the insurance sector; and (c) supervisory and regulatory framework for banks. The recommendations under each category are summarized below. TABLE 2 Summary of the climate risk policy roadmap for the banking and insurance sectors Policy area Policy action Timeline Governance, Capacity building strategy, and • Raising internal awareness and building staff capacity. capacity building SHORT TERM • Raising awareness and building expertise among banks and insurers in collaboration with industry associations. Institutional strategy • Developing and publishing a supervisory strategy/roadmap for SHORT TERM climate risk management (endorsed by board/governors). • Publicly reporting on governance approach and strategy. Data collection • Identifying key metrics for monitoring climate risks. MEDIUM TERM • Ensuring adequate data availability and reporting by financial institutions (e.g., granular regional and sectoral breakdowns of exposures). Climate risk Climate risk monitoring supervisory • Monitoring supervised banks’ risk exposure. MEDIUM TERM and regulatory framework for banks Climate risk assessment for banks • Engaging in exposure analysis targeting high-risk areas (e.g., vulnerability of top borrowers to climate risks, climate SHORT TERM vulnerability of the agriculture sector, climate vulnerability of personal loans). Climate risk scenario analysis • Developing (macro and micro prudential) climate risk scenario MEDIUM TERM analysis capabilities and exercises. 56 Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 6 Policy roadmap for managing climate risks for banks and insurers Policy area Policy action Timeline Climate risk Supervisory guidance for banks supervisory • Developing and publishing supervisory guidance including on and regulatory governance, strategy, risk management, and disclosure and framework for SHORT TERM reporting. banks (continued) • Developing an implementation roadmap for the supervisory guidance. Banking supervisory practices Embedding the consideration of climate risks into the following: • Supervisory tools & methods (e.g., integrating climate risks into ICAAP). LONG TERM • Internal capacity building. • Supervisory review and monitoring processes of banks’ climate risk management process. Engagement with government on policy priorities • Engaging on an ongoing basis with the Ministry of Finance and Economic Affairs to better understand the government’s policy LONG TERM objectives and interventions. • Contributing to the upcoming review of their disaster risk financing strategy. Climate risk Climate risk assessment for insurers supervisory • Updating reporting requirements to capture additional and regulatory information on climate risk to fully assess the exposure of the framework for market. SHORT TERM insurers • Reviewing guidance issued by the IAIS and consider implementing scenario analysis once data reporting is improved. Source: Authors, adapted from World Bank (2021) Note: Short term = within 1 year; medium term = 1-3 years; long term = 3-5 years Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 57 6 Policy roadmap for managing climate risks for banks and insurers 6.1 Governance, strategy, and capacity building One of the first priorities is to deepen RBM staff’s climate expertise. RBM has already set up an internal governance framework for climate risk management. Climate risk-related issues are primarily managed by two departments. The development of climate risk supervisory guidelines for banks is managed by the Banking Supervision Department, which reports to the deputy governor for economics and regulations and the governor. Other aspects of climate risk management (e.g., in relation to climate risk analyses) are managed by the Financial Markets Department. An internal climate risk taskforce within RBM has also been established and is managed by the Financial Markets Department. The taskforce brings together relevant departments such as the Capital Markets and Microfinance Supervision, Pensions and Insurance Supervision, Banking Supervision, and Economic Policy and Research Departments to discuss policy issues related to climate risk management. The Financial Markets Department is also responsible for coordinating with other ministries (e.g., Ministry of Finance and Ministry of Natural Resources and Climate Change) on climate-related issues. Moving forward, with the support of development partners such as the World Bank, targeted climate risk training could be provided to members of the RBM’s climate risk taskforce. RBM could also consider joining international and regional forums such as the NGFS to keep track of the latest policy developments and promote knowledge sharing. In addition to building the expertise of RBM staff, RBM could also consider collaborating with industry associations to develop outreach programs for banks and insurers to solicit sufficient feedback on key challenges and policy needs for climate risk management. As RBM builds capacity on climate risks, RBM could develop and publish an institutional strategy for climate risk management, endorsed by the senior management and board, to prioritize key actions and signal its commitment to the agenda. Building on the policy recommendations outlined in this report, a strategy could provide more detail on (a) how climate risks would be integrated into supervisory frameworks, risk assessments, reporting, and disclosure and capacity building for the banking and insurance sectors; (b) the internal organization and governance structure for managing climate risks; and (c) expected resources to be allocated to address climate risks. It may also be relevant to include a set of actions related to mobilizing green finance (which is not covered by this report). Given the limited resources and capacity, the strategy should emphasize the need for gradual implementation and proportionality. The roadmap should also identify short- term priorities, including, for example, addressing data gaps and building insurers and banks’ capacity. © mtcurado / istockphoto.com 58 Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 6 Policy roadmap for managing climate risks for banks and insurers 6.2 Regulatory and supervisory response to climate risks for the insurance sector The policy priorities discussed in this section cover two key aspects. On one hand, it outlines policies that RBM could support to help insurers better respond to the financial impacts that climate change could have on insurers’ business and operations. On the other hand, it identifies policies that RBM and other authorities could support to help insurers develop climate risk products to help businesses and households in the real economy better respond and adapt to the impacts of climate change. For the latter, insurance supervisors are an important part of the dialogue when it comes to managing climate risk through risk transfer solutions. They play four key roles: (i) deepening understanding of protection gaps; (ii) improving risk literacy; (iii) encouraging and incentivizing prevention, mitigation, and adaptation; and (iv) creating an enabling environment and advising policymakers. 6.2.1 RBM supervisory and supportive role to help insurers manage climate-related financial risks The International Association of Insurance Supervisors (IAIS) highlights the urgent need for insurance supervisors worldwide to play a proactive role to address the protection gap related to climate- related disasters. As part of this initiative, the IAIS plans to publish an application paper on climate risk scenario analysis in 2024. This paper will set out how climate risks impact the financial system, and the increased protection gap due to decreasing insurance coverage and increasing cost of insurance premiums. It will do this by assessing risks to underwriting (several large events compounding), asset risks, liquidity risks, physical/ operational risks, transition risks, macroprudential risks, and risks to protection gaps. The IAIS identifies several types of “traditional” non-life insurance products which have a role to play in reducing the financial impact of climate risks; such as property and household contents insurance, insurance coverage for businesses, including MSMEs, business interruption coverage; and agricultural insurance products. The IAIS concludes that insurance supervisors should have a direct interest in climate risk adaptation as this directly impacts insurers’ risk exposures as well as the availability and affordability of insurance coverage for customers. There are limited examples of best practice for developing climate risk supervisory guidelines for insurers, with the progress made focused on developed countries with advanced insurance markets. RBM should take a proportional approach to managing the impact of climate financial risk on the insurance market. They will need to consider data availability, capacity, and information technology capabilities and prepare a strategy for improving this in a phased and realistic way. Where possible, RBM should promote simplicity and consistency by using common definitions, such as those proposed by standard-setting bodies and international bodies, of different classes of risks to integrate into insurance functions (risk management, audit, actuarial etc.). A fundamental starting point for RBM is to build the capacity of the regulator and the insurance sector on all areas of risk management and product design. For example, external experts could be brought in to provide training on product design (including actuarial pricing and index insurance). Given the lack of expertise in the country, it is recommended that that the insurance sector in Malawi form collaborations with experienced regional insurers and reinsurers, including those based in South Africa, who can bring the missing expertise and regional experience. Given the interest in index insurance, RBM should consider benchmarking the approach used by insurance regulators in other countries for adequate and proportionate regulations of index insurance products (Box 8). Specific regulations will encourage supply and improve consumer protection and prudential supervision. Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 59 6 Policy roadmap for managing climate risks for banks and insurers BOX 8 Examples of a regulatory approach to index insurance In both Kenya and Uganda , the insurance regulator has specific regulations in place to support consumer protection for policyholders and beneficiaries of index insurance products. The regulations in both countries define the insurable interest, which must be clear, and basis risk, specifying that insurers should adopt specific measures for reducing basis risk. There are also specifications for permissible indices; cancellation after starting coverage is not allowed; there is a requirement for having a backup trigger; and there are requirements related to specific communications regarding the index insurance product. Index insurance products need to be explicitly approved by the regulator in both countries. In the Philippines, the insurance regulator has fewer specific requirements for index insurance, although many of the similar requirements apply. In addition, in the Philippines, index insurance is regulated as part of a “microinsurance” product and there are specifications about the calculation agency for index insurance. Based on these and other case studies of index insurance regulations and published studies on index insurance regulatory guidelines, the RBM can develop a suitable regulatory framework for Malawi, which would allow for innovation and enable many insurers to provide index insurance as a tool for mitigating climate risk, while also improving customer protection and prudential supervision. The current level of data aggregation makes it difficult to identify the exposure of insurance policies to climate risk, which means RBM and others rely on anecdotal perspectives on risk. To have a more robust assessment of the impact of climate risk requires more specific data to be collected and shared systematically by the market. Insurers should be encouraged to collect consistent data that can easily be reported, understood, and aggregated. To start, RBM needs to take stock of the data that they receive currently and prepare guidelines and reporting requirements to capture the current gaps. The data received to date could be strengthened with summary statistics on policy location and an indication of whether claims are related to climate risk and how. One option is for RBM’s regulatory reporting returns to include the request for more granular information on the current exposure of capital to climate risks and reporting on forward-looking information, such as the results from climate stress testing. They can also review the financial institutions’ internal audit function alongside delivering capacity building to strengthen data reliability. Insurers can also be requested to provide evidence of the suitability of product design and pricing, for example on data, frequency of payouts, correlation between events, payout amounts, and payout functions to ensure the risk is well understood.59 In more developed markets, there are examples of distinct regulatory frameworks for climate-related risks to give them due attention. Currently, in Malawi, climate risks predominately fall under fire and allied 59 Data that could be interesting for the regulator to understand the strength of the market may include (1) time taken from the occurrence of, reporting of, and settlement of climate-related claims. This will give an indication of how quickly climate-related claims are being settled as there are some complaints/experiences in the market on claim payment delays for climate risks; (2) details of the reinsurance placement of climate risks. There are some concerns in the region on the agriculture risk not being fully placed with reinsurers, leading to severe delays with claims payments. The regulator should be aware of what proportions are being retained and reinsured and also the quality of the reinsurers used; (3) correlation between occurrence of major losses (and/or major bad years, such as El Niño years) and simulated payouts triggered in those years. Some insurance regulators (e.g., in the Philippines) used to ask for such correlation analysis; (4) data on claims experienced due to new/emerging climate risks, e.g., flooding of Lake Malawi is apparently causing lots of tourism- related business interruption losses in 2024. As and when these new risks emerge, the regulator could ask for data on the impact of these events on the insurance sector; (5) claims severity in terms of claims as a percentage of sum insured for climate-related losses. This can give an idea of the relative severity of the climate-related losses. Also, the insurance claims for climate risks should be compared to other data on climate-related losses and on government disaster relief expenditure to give an idea about the protection gap. 60 Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 6 Policy roadmap for managing climate risks for banks and insurers perils and miscellaneous business, which means the trends and results are diluted by other risks. Separating out climate risk allows for closer assessment (see Box 9 for examples of climate risk being treated as a separate line of business) and can help mitigate scenarios where climate risks may even be excluded, such as in the practice for some commercial crop indemnity insurance products and cyclone risks, although these risks are extremely relevant for both households and businesses. However, this does require more processes and training in the market, and it may not be worth the effort for such small levels of business. BOX 9 Examples of climate risk being treated as a separate line of business France has a system in place where climate-related risks such as floods, earthquakes, and landslides are treated under a specific regulatory framework called the Natural Disaster Compensation Scheme (Cat-Nat). This is managed separately from traditional insurance lines. Insurers are required to include coverage for natural disasters in their property insurance policies. The state acts as a reinsurer, providing additional financial backing. This approach ensures that there is dedicated focus and financial capacity to handle climate-related claims, promoting resilience and faster recovery from natural disasters. The United Kingdom has a reinsurance scheme in the UK, Flood Re, specifically designed to make flood cover more affordable and available to homeowners in flood-prone areas. Insurers cede the flood risk portion of household policies to Flood Re in exchange for a premium. Flood Re then covers the flood risk, providing reinsurance to the insurers. This separate treatment of flood risk helps to stabilize the market, ensuring that high-risk properties can still access affordable insurance coverage. Some international regulators have allowed insurance companies to pay claims in installments to help manage large-scale losses from climate-related financial risks. This approach is sometimes used to manage the liquidity challenges of large-scale losses or when the insured parties may benefit from receiving payments over time rather than in a lump sum. This approach has been granted for Malawian insurers in specific cases. An international example is the Caribbean Catastrophe Risk Insurance Facility,60 a risk-pooling facility that provides parametric insurance coverage to Caribbean governments for hurricanes, earthquakes, and excessive rainfall. The insurance facility allows for the payment of claims in installments rather than a single lump sum. This flexibility helps governments manage cash flow and budgetary constraints in the aftermath of a disaster. By providing installment payments, the facility supports timely recovery and reconstruction efforts in member countries affected by climate-related disasters. 6.2.2 Developing structures for climate risk insurance programs Through training and outreach activities, RBM could encourage co-insurance pools to reduce the exposure of individual insurers and incentivize them to put their capital at risk. Co-insurance is  an arrangement where the risk covered by one insurance policy is shared between several insurers, typically with a lead insurer designing and potentially distributing the product. Each insurer accepts a percentage of the risk 60 Caribbean Catastrophe Risk Insurance Facility. Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 61 6 Policy roadmap for managing climate risks for banks and insurers and receives a corresponding percentage of the premium. Given the limited expertise on climate risk products in Malawi (including expertise on product design, pricing, and underwriting), there are few insurers who can take the lead and provide comfort to the others to follow. Box 10 summarizes co-insurance pool schemes in other countries. Experience in Africa and beyond highlights the following key success factors for co-insurance pools, especially for agriculture insurance schemes that build the resilience and financial inclusion of vulnerable households and firms. • Parametric or index insurance: Many successful programs use parametric insurance models where payouts are triggered by predefined indices such as rainfall levels or livestock mortality rates. This approach simplifies the claims process and ensures timely payouts using standardized procedures, reducing the need for loss adjustors. • Public-private partnerships: Effective agricultural insurance pools often involve partnerships between governments, private insurers, and sometimes development partners and international technical experts. The private sector can offer access to financial services and support risk sharing and the government can deliver direct financial interventions or provide incentives through policy interventions to increase take up, support market development, and enhance capacity. • Focus on smallholder farmers: Many of these programs specifically target smallholder farmers, who are most vulnerable to agricultural risks but often missed by insurance companies in marketing efforts due to the difficulty of reaching remote and rural areas and their ability to pay. Technology such as mobile platforms has been crucial in facilitating distribution, awareness creation, and payouts. BOX 10 Examples of co-insurance pools In Malawi, there have been some attempts to set up a co-insurance pool for agricultural insurance products but to date they have not been successful due to a lack of market experience with these products and an insurer comfortable to take the lead. The Uganda Agriculture Insurance Scheme is an initiative designed to protect farmers in Uganda from the financial risks associated with agricultural production. Insurance products provided by the scheme include crop insurance, which provides coverage for losses due to adverse weather conditions, pests, and diseases affecting crops and livestock insurance, which covers losses due to diseases, accidents, and disasters affecting livestock. Products include indemnity- based products and parametric insurance. Both smallholders and commercial farmers are eligible to participate in the scheme. The scheme is implemented by the Ugandan government in partnership with private insurance companies, who form a consortium to pool the risk, and development partners. The insurers underwrite the policies and handle product distribution and claims. Working as a consortium, the insurance products, terms, and conditions are standardized, as are the procedures for approval and settlement of subsidy and farmer claims. The government provides a subsidy to make insurance premiums more affordable for smallholder farmers and encourage uptake (up to 50 percent of the premium cost). Development partners often collaborate to provide technical assistance and capacity building. The Turkish Catastrophe Insurance Pool is a notable example of an insurance pool aimed at addressing earthquake risk. It provides mandatory earthquake insurance for residential buildings, offering affordable premiums and ensuring wide coverage. It has increased earthquake insurance penetration rates significantly in Turkey, enhancing financial protection for homeowners against seismic risks. 62 Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 6 Policy roadmap for managing climate risks for banks and insurers 6.2.3 Engagement with the government on policy to enhance the role of climate risk insurance RBM should engage closely with government of Malawi (through the Ministry of Finance and Economic Affairs) to better understand the government’s policy objectives and interventions and contribute to the upcoming review of their disaster risk financing strategy. Government should consider policy interventions that help stimulate insurance market development and reduce the cost of policies to increase take up. For example, the government could provide tax waivers (value added tax (VAT) and reinsurance withholding tax) on insurance premiums and potentially subsidize insurance premiums for climate risk policies. Tax waivers for climate risk related insurance are strategic measures employed by various governments to enhance the affordability and accessibility of these financial protection tools (see Box 11 for country examples). These initiatives can specifically help in promoting the uptake of insurance among farmers and low-income individuals, thereby increasing their resilience to risks and contributing to overall economic stability and growth. Some insurers in Malawi are concerned by the lack of consistent tax treatment for all stakeholders, as entities like African Risk Capacity receive a tax advantage under their African Union Treaty, which the local insurers currently do not have. Taxes, such as VAT and reinsurance withholding tax, have been waived in some countries for agriculture insurance products. BOX 11 Examples of countries implementing tax incentives In the Philippines, the insurance commission has waived certain taxes and fees for micro- insurance products to make them more accessible to low-income populations. Uganda has implemented tax waivers on premiums for agricultural insurance to support the agricultural sector. The government subsidizes a significant portion of the insurance premiums and waives taxes to reduce the financial burden on farmers. These measures have made agricultural insurance more affordable for Ugandan farmers, increasing their uptake of insurance products and enhancing their ability to manage risks associated with farming. Similarly in Fiji, Rwanda , and Zambia, VAT is no longer applicable for agriculture insurance products, which has resulted in reduction of the final premium for smallholder farmers. Currently climate risks pose a significant contingent liability to the government, and the Ministry of Finance and Economic Affairs may also consider conducting value for money analyses of insurance and whether it should be made mandatory or be subsidized to reduce this liability. Based on the results of such analysis, policy decisions can be made on whether products, such as cyclone, flood, and drought insurance should be made mandatory for certain households (e.g., certain categories of farmers or those accessing agricultural loans) and certain businesses as a way of improving financial inclusion and reducing uninsured losses. Importantly, no single instrument will provide adequate protection for all risks; households and firms require integrated financial services based on their risk profiles. For example, financial inclusion and resilience can be achieved through the design of a comprehensive package of well-designed, pre-arranged financial services offering savings, credit, and insurance (Figure 25). Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 63 6 Policy roadmap for managing climate risks for banks and insurers FIGURE 25 Financial products matched to household segmentation Risk finance instruments Target segmentation More productive households with stable incomes Credit Indemnity Index (long-term insurance insurance finance and guarantees) Households with productive capacity Savings and payments Social safety-net programs: Government invests in DRF instruments Micro-credit Poorest households on behalf of pre-identified households Source: World Bank, Disaster Risk Financing and Insurance Program 64 Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate © Ashley Cooper pics / alamy.com Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 65 6 Policy roadmap for managing climate risks for banks and insurers 6.3 Regulatory and supervisory response to climate risks for the banking sector The policy roadmap identifies two key policy areas that should be developed in a phased manner. The two policy areas are (i) risk identification, assessment, and monitoring; and (ii) a supervisory framework for banks’ climate risk management. The policy actions should be developed in a phased manner to ensure that banks have sufficient time to familiarize themselves with the regulatory requirements and are able to build sufficient capacity to comply. Proportionality should also be a key principle for implementation, to reduce unnecessary regulatory burden and compliance costs. 6.3.1 Risk identification, assessment, and monitoring A short-term priority is for RBM to build internal expertise to assess and monitor climate risks for banks. Estimating climate risks is a complex task, given the uncertainties and interlinkages of climate and its macroeconomic and financial impacts. Staff with specialized climate expertise are needed to ensure that climate risk assessments are holistic and reflect the latest understanding on climate science and policy. RBM should therefore, through training programs, build in-house expertise on climate science and climate risk stress testing, which is needed to assess climate impacts on financial stability on a structural basis. To address data gaps, RBM should start collecting qualitative and quantitative information required to monitor and track climate financial risk exposure for the banking sector. As noted in Table 3 Estimating climate below, a wide range of data is needed to monitor climate risks for banks. risks is a complex However, given the limited resources and capacity of RBM and banks, RBM could prioritize its data collection, targeting entities and areas that are task, given the particularly vulnerable to climate change. For example, RBM could focus uncertainties and on collecting more granular data on the sectoral and regional breakdown interlinkages of of loans from banks that have less diversified portfolios. Another priority climate and its could be to collect data from nonfinancial entities that banks have high macroeconomic exposure to and are considered more high-risk, such as those in the and financial agriculture sector. For example, banks could collect more information on impacts. Staff the location of agricultural loans and assess whether these regions are particularly vulnerable to climate shocks such as floods and droughts. with specialized Banks could also collect more information on whether risk transfer and climate expertise mitigation measures have been taken by these agriculture firms to reduce are needed to climate shocks (e.g., penetration of insurance, government guarantees, ensure that climate and adaptation measures such as drought-resilient crops). RBM could risk assessments also collect more granular climate risk data from the top 10 borrowers are holistic and that dominate the bank loan market (e.g., information on adaptation and resilience measures taken by these borrowers to reduce their climate risks reflect the latest or supply chain data from these top borrowers to assess their exposure understanding on to indirect climate risks). Finally, given banks’ high exposure to personal climate science loans, RBM could prioritize collecting more information on whether and policy. personal loans are in regions that are highly vulnerable to climate shocks such as floods. 66 Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 6 Policy roadmap for managing climate risks for banks and insurers TABLE 3 Overview of data requirements for monitoring climate risks for banks Feature of climate risks Implications for data needed Challenges in collecting the data Impact of climate change • Need data on the impact of climate • Lack of disclosure of climate depends on the location change on supply chains and risks across firms and banks’ and production patterns macroeconomic environment • Lack of data on firms’ supply of entities, sectors, and • Need data to capture the chains economies concentrations of risks within • Lack of data and modeling on banks’ exposures, including more macro impacts of climate change granular data on regional and sectoral breakdown of bank loans • Lack of granular exposure data Climate risks rely on data • Need information and tools to • Limited historical data on the beyond those normally translate climate outcomes into impact of climate risks on banks collected by RBM. Climate economic variables and changes in • Lack of forward-looking metrics risks are also subject to cashflows and the value of assets and climate models that can uncertainty and tail risk and liabilities adequately capture uncertainties • Need climate risk metrics and scenarios that account for uncertainty and tail risks The widespread nature of • Need data on the future availability • Lack of data on the degree climate risks could lead of climate risk transfer instruments to which banks’ climate risk to sharp increases in the (e.g., insurance) exposure can be transferred via correlation of risk premia on insurance and financial securities • Need to use scenario analysis to different assets. Past data explore impacts under different • Lack of data to assess factors is not a good indication of scenarios that amplify or mitigate climate future climate impacts risks and feedback loops within the economy Source: Authors, adapted from Financial Stability Board (2021)61 Over time, as more data becomes available, and building on this report’s climate risk exposure analysis, RBM could consider integrating climate-related scenarios in its macroprudential stress testing framework. Given the severe impacts of natural disasters and climate change, RBM may consider developing more specific stress tests, with a focus on climate physical risk scenarios, to identify relevant risk factors and assess the adequacy of banks’ risk management approaches. However, since scenario analyses are relatively complex and data intensive, as a starting point, RBM could conduct exposure analyses (similar to the one conducted in this report) to analyze the economy, banks, and financial markets’ exposure to key climate physical risks such as floods, droughts, and storms. As noted in Section 2, given the high concentration of individual borrowers (with the top 10 borrowers representing 31 percent of all loans), the exposure analysis could initially focus on assessing the resilience of these large borrowers to climate-related risks. Over time, RBM could conduct a more in-depth scenario analysis, focusing on scenarios that may be most relevant to the banking sector in Malawi. For example, the scenario analysis could analyze the impact of more frequent flooding on mortgage loans. It could also analyze the impact of climate shocks on bank loans to the agriculture sector. To the extent possible, the analysis should consider the compounding effects of multiple shocks (floods, droughts, and biodiversity loss) occurring at the same time. 61 Financial Stability Board, “The Availability of Data with Which to Monitor and Assess Climate-related Risks to Financial Stability,” 2021. Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 67 6 Policy roadmap for managing climate risks for banks and insurers 6.3.2 Supervisory framework for climate risk management Climate risk supervisory guidelines are an important component of the supervisory response to climate risks. Supervisory guidelines aim to clarify authorities’ expectations on climate risk management and play a key role in driving regulated financial institutions to action. Many jurisdictions have issued supervisory guidance, and central banks in Africa in many jurisdictions are working to make such issuances (e.g., Morocco, Kenya, Ghana and Tanzania). This guidance tends to focus on (a combination of) several key areas: governance, strategy, risk management, scenario and stress testing, and disclosure. Box 12 provides examples of guidelines in Ghana and Kenya. RBM is already drafting climate risk supervisory guidelines for the banking sector. There are two sets of guidelines that are being Supervisory developed, one for supervisors and the other for banks. This marks an important first step in signaling the importance of the climate risk guidelines aim to agenda to banks. As RBM continues to develop the guidelines, it clarify authorities’ should ensure that the guidelines are in line with existing and emerging expectations international guidance and principles to the extent possible, including on climate risk BCBS’s Principles for the Effective Management and Supervision of management and Climate-Related Financial Risks (2023), Basel Consultative Document– play a key role in Disclosure of Climate-Related Financial Risk (2023) as well as the driving regulated International Financial Reporting Standards on Climate-Related Disclosures (IFRSS2) (2023), while ensuring that the guidelines are financial institutions implemented proportionately based on the nature, scale, and to action. complexity of banks’ activities. Several activities are planned to build banks’ readiness to implement the climate risk supervisory guidelines. The climate risk supervisory guidelines will be issued and enforced in 2025. RBM plans to track banks’ progress in implementing the guidelines through three means. First, climate risk management will be integrated into RBM’s on-site supervision in 2025. Second, banks are expected to provide quarterly reporting to their board to explain how climate risk is being managed within the bank. Third, RBM will assess how climate risks are integrated into banks’ public disclosures, including annual reports. To ensure that banks have the needed capacity to implement climate risk management, the Bankers Association of Malawi could offer training programs. Standardized reporting tools and templates could also be used by banks to ease RBM’s ability to track banks’ progress. Over time, RBM plans to develop more detailed guidelines, tools, and templates to help banks comply with areas that are particularly complex (e.g., scenario analysis). 68 Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 6 Policy roadmap for managing climate risks for banks and insurers BOX 12 Case study examples of supervisory guidelines developed by African countries Ghana: In May 2024, the Bank of Ghana published an exposure draft climate-related financial risk directive for banks.62 The guidance builds on the Ghana Sustainable Banking Principles and Sector Guidance Notes published in 2019,63 and takes into consideration the expectations set out in the BCBS Principles on the Effective Management and Supervision of Climate-Related Financial Risks (published in June 2022), Basel Consultative Document-Disclosure of Climate- Related Financial Risks (published in November 2023) as well as the International Financial Reporting Standards on Climate-Related Disclosures (IFRSS2) (published in June 2023). The bank’s directive sets out the supervisory expectations for regulated financial institutions in relation to the approach to management and disclosure of climate-related financial risks with a focus on corporate governance, internal control framework, assessment of adequacy of capital and liquidity, risk management process, monitoring and reporting, comprehensive management of specific financial risks, scenario analysis, and disclosures. An interesting, newer, aspect that is covered in Ghana’s draft guidance is climate-related transition plans, which comprise of board-approved strategies and policies towards net-zero transition and integrating climate- related financial risks into financial institutions’ governance and risk management frameworks. A roadmap is included in the draft guidance for the implementation of the directive (Figure 26). As part of this roadmap, financial institutions are expected to submit a time-bound plan approved by their board on how they plan to implement the directive by the end of December 2024. Financial institutions are also expected to submit a quarterly report to the Bank of Ghana on the progress of its implementation of the plans. FIGURE 26 Roadmap for implementation of the Ghana Climate-Related Risk Directive–2024 Activity Period/Dates Sensitization of banks Boards, Chief Executive Officers and Senior 1 Quarter 2 2024 Management Banks Key Management Personnel (KMP) sensitization on climate- 2 Quarter 2 2024 related financial risk management 3 Submission of board approved implementation Plan by RFls September 2024 4 Quarterly updates on implementation of board approved plans From March 2025 Disclosures of climate-related information to enhance transparency 5 as per the expectation of the ISSB Standards on Climate-related December 2025 disclosures (IFRS S2) 6 First submission of credible climate-related transition plans December 2025 Source: Bank of Ghana (2024) 62 Bank of Ghana, “Climate-related Financial Risk Directive,” 2024. 63 Bank of Ghana, “Sustainable Banking Principles and Sector Guidance Notes,” 2024. Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 69 6 Policy roadmap for managing climate risks for banks and insurers Central Bank of Kenya’s (CBK’s) climate risk supervisory guidelines for banks marked an important milestone. In October 2021, CBK released the Guidance on Climate-Related Risks Management for Banks.64 The guidance applies to all commercial banks and mortgage finance companies operating in Kenya. The guidance covers three main components: i) governance arrangements to effectively identify, manage, monitor, and report climate risks; ii) oversight over the institution’s exposure and responses to climate issues; iii) strategy to identify an action plan; and iv) risk management to integrate climate risks into banks’ risk management framework; and v) reporting to ensure that there is a process for periodic internal reporting to the board and senior management on climate risks. A phased approach is taken to adopt the guidance (Figure 27), starting with capacity building and outreach in 2021/2022. Banks are then asked to develop and submit a time-bound plan to CBK. The plan should be approved by the banks’ board and should describe how the guidance will be implemented. Banks should subsequently submit a quarterly report to CBK to assess their implementation of the plan. Furthermore, through the ICAAP, which was adopted in 2013, banks are expected to include climate risk among risks they are exposed to and set aside capital if climate risks are considered material. CBK, with the support of the European Investment Bank, is currently in the process of updating the disclosure requirements to align with International Sustainability Standards Board (ISSB) and is also developing a green taxonomy.65 FIGURE 27 Case study: CBK implementation roadmap of climate risk management for banks 2021 2022 2023 2024 • CBK publishes • Sensitizing bank • Disclosure data • Update diclosure guidance staff on climate to be used requirements to on climate- risks to enhance align with ISSB related risk transparency management for • Submission of benchmarked to • Develop a green banks Board-approved TCFD framework taxonomy implementation • CBK sensitizes plan bank CEOs • Quarterly updates on implementation (effective September) Source: Authors adapted from United Nations Education Programme, 202166 64 Central Bank of Kenya, “Guidance on Climate-related Risk Management,” 2021. 65 Central Bank of Kenya, “Draft Kenya Green Finance Taxonomy,” 2024. 66 United Nations Environment Programme, African Development Bank, Global Center on Adaptation, “Climate Risk Regulation in Africa’s Financial sector and Related Private Sector Initiatives,” 2021. 70 Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 6 Policy roadmap for managing climate risks for banks and insurers BOX 13 Managing unintended consequences of climate risk management on financial exclusion Marginalized segments of the economy, including low-income households, rural households and MSMEs, are typically more vulnerable to climate physical and transition risks than other segments. Many MSMEs work in sectors (e.g., agriculture) and geographical areas that are highly exposed to the effects of climate change and have less resources and capacity to respond to these climate shocks. MSMEs could also be vulnerable to transition risks because, compared to larger firms, MSMEs have less capacity to mobilize the required financing for investments in low-carbon and environmentally sustainable technologies and practices. Enhancing banks’ climate risk management, while well intentioned and important for managing banking sector stability, could have unintended consequences on financial exclusion. For example: • In terms of managing operational risks, banks already have a limited number of branch locations in rural or remote areas in Malawi. Banks may be further disincentivized to establish branches in these locations due to elevated climate shocks. For instance, in Nsanje, the southernmost district in Malawi—one of its poorest and primarily agrarian— had a 20-kilometer-long vein of cropland on the east bank of the Shire River overwhelmed by the 2015 floods, destroying resources needed to sustain the population for a year.67 It also has less than four bank branches in the entire district. If these branches were to close due to the impacts of a future climate induced disaster, it would leave rural and poor consumers without access to financial services. This would further compound the challenges faced by these communities, as they would need to travel long distances to access financial services given that only 32 percent of adults in rural areas in Malawi have a mobile money account. This is especially concerning considering a recent study68 which found that local branches play a critical role in bridging the time gap between the disaster and governmental aid by immediately increasing their lending for months following the flood.  • Managing climate-related credit risks could also further reduce smallholder farmers’ access to formal credit. For instance, in Malawi, the geographic distribution of commercial farmers, who are typically the most likely to secure formal credit, is uneven, with a concentration in the northern and central regions. These areas are relatively less affected by climate-related risks, such as droughts, compared to the southern region of the country. The southern region not only contends with more severe climate threats but also has a higher concentration of rural households, productive and nonproductive (Figure 28). This creates a vicious cycle, whereby the lack of access to formal credit could exacerbate smallholders’ vulnerability to climate shocks, and these farmers’ increased vulnerability to climate shocks could further deter banks from providing credit to them. The impact of policy measures to improve climate financial risk management on financial exclusion therefore needs to be carefully assessed and managed. For example, climate risk disclosure and reporting requirements could be overly burdensome for MSMEs. Enhanced climate risk management by banks could also steer bank lending away from MSMEs, which are typically more exposed to climate physical and transition risks than larger enterprises. Several policy measures could be considered to respond to these potential challenges. For example, if 67 Nield, “Devastation and Disease after Deadly Malawi Floods,” 2015. 68 Pejman Abedifar, Seyed Javad Kashizadeh, and Steven Ongena, “Flood, Farms and Credit: The Role of Branch Banking in the Era of Climate Change,” Journal of Corporate Finance 85 (April 2024): 102544. Extreme Weather, Extreme Costs: Building Malawi's Financial Resilience in a Changing Climate 71 6 Policy roadmap for managing climate risks for banks and insurers appropriate, authorities could also enhance access to risk mitigation mechanisms for MSMEs that are vulnerable to climate risks (e.g., loan guarantees and digital financial services). Capacity building could also be offered (e.g., by public financial institutions) to help MSMEs develop monitoring and due diligence capabilities for climate risk management.69 FIGURE 28 Commercial farming households, presumably with the higher access to formal credit, are concentrated in north and central regions70 a. Commercially oriented farming households b. Other productive rural households c. Not economically productive households Percent Percent Percent less than 5 less than 50 less than 5 5–10 50–70 5–10 10–15 70–80 10–20 more than 15 more than 80 more than 20 7 percent 63.6 percent 13.4 percent of households of households of households nationally fall nationally fall nationally fall in this category in this category in this category Source: World Bank (2022) 69 World Bank, “Climate Risk and Financial Inclusion: A Regulatory Perspective on Risks and Opportunities,” 2023. 70 World Bank, “Planning beyond the Next Harvest: Advancing Economic Stability and Agricultural Commercialization,” 2022. In the long run, RBM could further explore opportunities to embed climate risks into day-to-day supervisory tools and actions. At this stage, RBM has not yet made use of its existing supervisory toolbox to assess and mitigate climate and environmental risks. However, in line with emerging global practices,71 RBM could explore different ways of integrating climate risks into its supervisory tools and practice. For example, RBM could access opportunities to integrate climate risk in the assessment criteria of the ICAAP72 process. Integrating climate risks into ICAAP may involve various components. This may involve issuing guidance on what material exposures relating to climate change should be covered by banks; an assessment of how banks have determined the materiality of climate risk exposures in the context of their business; and of sensitivities to longer term business plans. 71 For further details, refer to Toolkit 7, “Incorporate Climate-Related and Environmental Risks into Supervisory Practice” of World Bank, “Toolkits for Policymakers to Green the Financial System,” 2021. 72 The purpose of the Internal Capital Adequacy and Assessment Process is to ensure that a bank has internal procedures and processes in place to ensure that it has adequate capital resources to cover all material risks.