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.