Data from the German Weather Service (Deutscher Wetterdienst – DWD) clearly demonstrate that the Earth's atmosphere is warming at an accelerating pace. The ten hottest years since 1881 have all occurred in the past 25 years. In 2023 and 2024, the average annual temperature in Germany set all-time records. According to the DWD, average annual temperatures that were considered extremely high between 1881 and 1990 have now become the norm. This means that natural disasters are likely to occur more frequently and the potential damage from them will be greater. In short, the physical risks posed by climate change are increasing.

This is also having economic consequences. A study by the German Federal Government estimates that the future costs of climate change will likely add up to between €280 billion and €900 billion by 2050, depending on the rate of global warming. The physical risks from climate change are therefore expected to have an increasing impact on banks’ loan portfolios and insurers’ loss amounts.

BaFin focusing on certain business models

Over the last few months, BaFin has intensively analysed the potential impact of these risks on the financial sector. BaFin conducted a study surveying a number of less significant institutions (LSIs) and insurers whose business model could be strongly affected by natural disasters. BaFin therefore selected companies exhibiting one of the following three characteristics:

1. Geographical concentration – for example, regional banks in flood-prone regions;
2. Strong dependency on the smooth functioning of supply chains – for example, industrial insurers whose customers could be adversely affected by low water levels that hinder river transportation;
3. High level of concentration on specific product or client groups – for example, credit institutions that focus on agriculture and forestry.

The survey was not based on a representative sample. The study merely aimed to gain an initial impression of how supervised companies are managing physical risks.

Companies face a variety of physical risks

There was some good news among the insights gained by BaFin: the companies surveyed are, in general, addressing ESG risks. Almost all of the companies surveyed assume that extreme weather events will occur more frequently and become more intense in future. Insurers view storms, surface water floods and heavy rain as particularly relevant to their business models. In contrast to this, banks are more concerned with river floods, surface water floods, high temperatures and storms (see Figure 1).

Figure 1: Extreme weather events deemed relevant by companies

BaFin

The survey also showed that most insurers and all credit institutions queried take physical risks into account in their risk inventories and materiality analyses. However, only 10% of the credit institutions surveyed believe that physical risks are having a substantial (i.e. relevant) influence on the risk types that are of material significance for them. Contrasting this, half of the insurers surveyed believe that physical risks are having a substantial influence on their material risk types.

Figure 2: Consideration in risk inventory and substantial influence on material risk types

BaFin

These responses naturally raise the question of why companies often do not view physical risks as having have a substantial influence on their material risk types, although extreme weather events are on the rise.

Many companies view data availability as a challenge

One possible answer is that the companies are not substantially affected by the higher physical risks. Another possible explanation is the limited availability of reliable data on physical risks. 70% of the banks and 60% of the insurers stated that they view data availability as a problem.

Banks often noted that they lacked the location details needed to conduct address-specific risk analyses. In many cases, they do not have the exact addresses of all of the relevant locations of their customers. Furthermore, they often lack information about which specific types of natural disasters are most likely to affect these locations.

Insurers stated that they lack models for certain weather events, such as droughts and forest fires. They also believe that databases are needed, for example, on flood defences in vulnerable regions.

Companies must comprehensively address physical risks

It is BaFin’s view that the supervised entities should draw on the data that are available on their specific physical risks and, if necessary, gather such information in a risk-oriented manner. For example, they need to know the locations of their borrowers’ and policyholders’ production facilities, arable land and residential properties. They also need to know which physical risks are relevant at these locations. If they do not have this data, they can use public sources or make estimates.

Due to their business model, insurers already often deal with physical risks. Although they have far-reaching experience in this area, they should nevertheless continuously check that their models accurately reflect the current pace of climate change. Historical data may no longer accurately reflect the current situation.

It is also important for supervised companies to quantify the physical risks posed by climate change and integrate them into all aspects of risk management. In most cases, qualitative descriptions are no longer sufficient. Ultimately, companies must be able to estimate the potential costs of their specific risks.

Companies in the financial sector should also incorporate biodiversity risks into their risk management systems and take a holistic approach to the topics of climate, environment and biodiversity, as these are closely interlinked.

In order to manage risks effectively, it is necessary to adapt to climate change and take preventive measures. For example, supervised entities should consider whether financed and insured properties can withstand the types of natural disasters that are most relevant at each respective location.

Ultimately, supervised companies cannot rely on the state to step in after extreme weather events.

Supervisory efforts will continue to focus on physical risks

BaFin will continue to discuss the management of the physical risks posed by climate change when communicating with supervised entities. The questions asked here will be more in-depth in future. This is because BaFin expects the supervised companies to thoroughly analyse the physical risks that are relevant to them specifically. In particular, they should assess how these risks will affect them and whether they will have a material impact on their risk profile.

Examining these questions may, of course, reveal that such physical risks are not relevant to a company. Not every supervised entity will be affected to the same degree. Nevertheless, it is vital that any such conclusion is firmly based on a cogent assessment of the topic.