Climate Change and Credit Risk

The insurance industry has for a long time sought to identify the best practical methods for selecting investments to maximise their overall returns within an acceptable level of risk. Since Markowitz’s concept of diversification introduced in the 1950s, the selection of appropriate investments typically now involves complex models to quantify credit risk for investment portfolios.
Structural models are amongst the most popular credit risk models. They use the evolution of a firm’s ‘structural’ variables, such as asset and debt values, to determine probabilities of (economic) conditions under which borrowers are expected to default. Merton’s model (1974) assumes a firm’s asset value evolves over time, e.g. through a simple diffusion process. Vasicek (1987) has adapted Merton’s model to a portfolio of loans. The Vasicek model assumes that firms’ asset returns are a linear combination of the asset portfolio systematic risk and idiosyncratic risks, and that firms’ assets are correlated, a concept at the heart of Markowitz’s and modern portfolio theories.
In more recent years, insurance firms have increasingly focused on risks from climate change – physical and transition risks – and the impact these can have on the valuation of their investment and the quantification of risk. As such, risks from climate change now need to be factored into credit risk modelling. Climate change brings new paradigms and risks in credit risk. In this paper, we will consider the Vasicek framework used to model credit risk of an asset portfolio, and how risks from climate change can be associated with the variables and parameters in the framework.
Several key areas within risks from climate change which are pertinent to credit risk include:

• physical and transition risk
• increased volatility in asset valuation and credit and other risks
• relationship with liabilities – particularly relevant for life insurers whose liability valuation depends on their matching investment portfolio.

In this paper, we will investigate how risks from climate change can be factored in Vasicek’s framework. We will investigate the relationship between risks from climate change and variables and parameters in Vasicek’s framework, and methods for quantifying risks from climate change within an asset portfolio credit risk.
 
Find the Q&A here: Q&A on 'Macro Issues Affecting Financial Markets'