Risk transfer, insurance, cat bonds highlighted in climate change report

by Artemis on March 31, 2014

The latest Intergovernmental Panel on Climate Change (IPCC) report, published today, highlights the important role that risk transfer, insurance and reinsurance, instruments like catastrophe bonds and weather index insurance have to play in resilience efforts.

The report, titled Climate Change 2014: Impacts, Adaptation, and Vulnerability, from Working Group II of the IPCC, is perhaps the strongest warning to date that the effects of climate change are already occurring on all continents and across the oceans.

The report shows that the world is not, in many cases, prepared for the resulting risks and impacts of a changing climate, but says that there are opportunities to respond to such risks, though the risks will be difficult to manage with high levels of warming.

The report details the impacts of climate change to date, the future risks from a changing climate, and the opportunities for effective action to reduce risks and increase resilience. As you’d expect risk transfer is highlighted in a number of sections of the report as a mechanism for increasing resilience and financing recovery from climate change induced disaster.

The report concludes that in responding to the impact and threat of climate change the world needs to make choices about risks. It identifies people, industries and ecosystems around the world which are most at threat from climate change and discusses vulnerability, exposure and hazards, three terms the re/insurance sector is very familiar with.

The greatest risks and impacts can be seen where vulnerability (lack of preparedness) and exposure (people or asset’s in harm’s way) overlap with hazards (triggering climate events or trends). Each of these three components can be targeted by actions to reduce risk, says the report.

“We live in an era of man-made climate change,” said Vicente Barros, Co-Chair of Working Group II. “In many cases, we are not prepared for the climate-related risks that we already face. Investments in better preparation can pay dividends both for the present and for the future.”

“Climate-change adaptation is not an exotic agenda that has never been tried. Governments, firms, and communities around the world are building experience with adaptation,” Field said. “This experience forms a starting point for bolder, more ambitious adaptations that will be important as climate and society continue to change.”

The report suggests that climate change will result in increased severe weather and greater losses to economies around the world, one key area that risk transfer and reinsurance can help to create greater resilience:

More severe and/or frequent extreme weather events and/or hazard types are projected to increase losses and loss variability in various regions and challenge insurance systems to offer affordable coverage while raising more risk-based capital, particularly in developing countries. Large-scale public-private risk reduction initiatives and economic diversification are examples of adaptation actions.

However the actual economic impact of climate change is difficult to estimate and even harder to reach agreement on:

Economic impact estimates completed over the past 20 years vary in their coverage of subsets of economic sectors and depend on a large number of assumptions, many of which are disputable, and many estimates do not account for catastrophic changes, tipping points, and many other factors. With these recognized limitations, the incomplete estimates of global annual economic losses for additional temperature increases of ~2°C are between 0.2 and 2.0% of income (±1 standard deviation around the mean) (medium evidence, medium agreement). Losses are more likely than not to be greater, rather than smaller, than this range (limited evidence, high agreement). Additionally, there are large differences between and within countries. Losses accelerate with greater warming (limited evidence, high agreement), but few quantitative estimates have been completed for additional warming around 3°C or above. Estimates of the incremental economic impact of emitting carbon dioxide lie between a few dollars and several hundreds of dollars per tonne of carbon (robust evidence, medium agreement). Estimates vary strongly with the assumed damage function and discount rate

Insurance and reinsurance has a role to play in enhancing the resilience of developing economies and poorer communities:

Insurance programs, social protection measures, and disaster risk management may enhance long-term livelihood resilience among poor and marginalized people, if policies address poverty and multidimensional inequalities.

However, the solutions implemented to date in risk transfer have perhaps not always been successful, lacking the ability to foster local market creation and often resulting in pilot scheme which do not follow through to fruition. It’s encouraging to see the report address product design here, as implementing risk transfer facilities in developing economies requires a different mind-set to providing re/insurance in the developed world.

Instruments include public-private finance partnerships, loans, payments for environmental services, improved resource pricing, charges and subsidies, norms and regulations, and risk sharing and transfer mechanisms. Risk financing mechanisms in the public and private sector, such as insurance and risk pools, can contribute to increasing resilience, but without attention to major design challenges, they can also provide disincentives, cause market failure, and decrease equity. Governments often play key roles as regulators, providers, or insurers of last resort.

The report highlights some products and systems which can help countries to respond to changes in weather risk, with insurance, reinsurance and risk transfer tools such as catastrophe bonds all highlighted as suitable tools. It also highlights the disaster gap between economic and insured losses and the inequality in developing nations which do not have developed insurance systems.

In the years following weather-related disasters countries with high insurance penetration show almost no impact on sovereign deficit and increasing economic output (GDP), whereas low penetration countries experience substantially rising government deficit and missing positive change in output. The absence of developed insurance systems, as is the case in many middle- and low-income countries, translates into greater macroeconomic vulnerability than with developed insurance systems.

Catastrophe bonds and the securitisation of risks is highlighted as a useful tool which could help to diversify the risk of major disasters across the worlds capital markets. Also highlighted are weather derivatives, the use of parametric triggers and hybrid products with dual catastrophe and economic loss triggers (a very good option for many developing nations).

Following the hurricane disasters of 2004 and 2005, securitisation instruments, e.g. catastrophe bonds, industry loss warranties and sidecars, acquired greater prominence, and have been recovering again from the market break in 2008. Investors in insurance linked securities are attracted by the lack of correlation to typical financial market risks (e.g., currency risks), and the well defined loss-per-index structure. The higher transparency relative to other asset-backed securities, such as mortgage-backed securities, contributed to the better performance of catastrophe bonds following the financial crisis of 2007/2008. As bonds typically cover large losses, the basis risk, i.e. suffering damage without parametric triggering, is reduced; further reduction may be feasible by optimizing index measurements. Weather derivatives are further instruments used to transfer risks to the capital markets. Also multiple-trigger “hybrid” products are available, combining a parametric trigger-based catastrophe bond with a trigger-based protection against a simultaneous drop in stock market prices, thereby hedging against a double hit from direct disaster loss and losses incurred by the asset management side.

The report also highlights weather index insurance products as a key tool for enabling poorer nations to recover and maintain livelihoods post-disaster, but also notes that improvements to these products are required to reduce basis risk and enable them to support local insurance markets.

There is a theme running through the report which suggests that perhaps efforts by the insurance and reinsurance industry have not always been successful to date. That some microinsurance and weather index insurance schemes have not resulted in a sustained market-based solution to weather and disaster insurance, meaning that product design needs to be reconsidered in some cases. Also highlighted are sovereign risk pooling efforts, of which the report suggests more could be created.

The capital markets ability to provide financial backing for climate change risk transfer efforts are only really referred to in the small piece on catastrophe bonds and securitisation of catastrophe risks. It would perhaps be beneficial for the reinsurance and insurance linked securities market to begin to think about how fully-collateralized structures, backed by capital markets investors, other than cat bonds could be utilised within climate change response.

The report is lengthy, based on over 12,000 peer-reviewed scientific reports and contains the input of many scientists, academics, economists and disaster risk specialists. As such it is an important document which hopes to educate policymakers as to the risks, threat and opportunities to mitigate climate change.

The fact risk transfer, insurance, reinsurance and catastrophe bonds feature heavily is no surprise, but the report also shows that the insurance and reinsurance market could do more to better design and adapt products for use in developing nations and specifically for climate resilience efforts.

You can access the full report via the IPCC website here.

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