Reinsurers (and ILS) may underestimate climate change exposure: S&P

by Artemis on September 3, 2014

Ratings agency Standard & Poor’s performed some analysis on the global reinsurance sectors exposure to climate change and found that, under a scenario it tested for, reinsurers may be underestimating their exposure to catastrophe losses by around 50%.

This is the latest in a series of reports on the global reinsurance sector in challenging times published by S&P in advance of the Monte Carlo Rendezvous event in September.

In the report S&P says that despite uncertainty the possibility that climate change is already affecting the frequency and severity of catastrophe loss events impacting the reinsurance sector cannot be ruled out. Scientific consensus is still lacking, with respect to how climate change is affecting extreme weather now and how much it will affect it into the future. However the reinsurance industry has a keen appreciation of the need to factor climate variations into its modelling and outcomes, so is perhaps better prepared than many business sectors.

Reinsurers typically expect climate change will have a negative effect on their catastrophe loss exposures, with an expectation that events will become more severe or frequent. As a result reinsurers already run model scenarios to take into account a warming climate, rising sea levels and other climate change related factors. Reinsurers also apply adjustments to the vendor risk models to account for their specific views of event frequency and severity.

S&P notes that many reinsurers are actively engaged in scientific efforts to better understand the impacts of climate change. They also rely on their regular contract renewals to allow them to adjust premium prices to account for any gradual increase in weather related claims over time.

Despite this, S&P says, most reinsurers do not believe that climate change is having a material, quantifiable impact to their current risk exposure, nor do they expect it to in the near future.

So, S&P set out to test a scenario that would make the assumption that the catastrophe loss experience of the last 10 years is the probabilistic norm. S&P believes that it is unwise to rule out the chance that climate change has already begun to impact reinsurers loss experience, especially given the number of extreme weather events contributing to insurers and reinsurers losses in recent years.

In an effort to understand the impact that climate change could have on reinsurers financial strength, S&P looked at a scenario that made an assumption that reinsurers catastrophe loss experience over the last 10 years indicates the current probabilistic distribution of extreme events. So an assumption that recent catastrophic loss experience is the new normal under climate change and that the last decade is now typical, including an expectation that the very high cat loss years of 2005 and 2011 would be repeated more regularly.

S&P said that under this simple scenario it estimates that, on a gross basis, reinsurers may be understating both their one-in-10 and one-in-250-year loss totals by around 50%. That is a huge difference in the current assumption versus where catastrophe loss exposure could actually be, if the climate change related scenario’s assumption that recent experience is the new catastrophe loss normal was accepted as true.

S&P says that under a 50% increase in losses for these return periods some of the key metrics it uses to assess reinsurance firms capital adequacy and catastrophe exposures are materially affected. It’s highly likely that such a dramatic increase in catastrophe loss exposure would result in downgrades for some reinsurance firms.

The scenario is a simplistic one, says S&P, but it should serve to highlight that reinsurers catastrophe loss exposure could be dramatically higher than they currently estimate, with climate change being a likely factor.

For the insurance-linked securities (ILS) market and instruments such as catastrophe bonds and collateralized reinsurance the same implications are possible. Given that collateralized reinsurance is essentially traditional reinsurance with full collateral and perhaps some structural differences in terms of transformation and transacting the deals, ILS managers writing this kind of business could also be underestimating their catastrophe loss exposure if S&P’s scenario were true.

For catastrophe bonds the same could be true, that catastrophe exposure could be underestimated if S&P’s climate change scenario were the truth. Cat bonds are modelled under various stress test scenarios, including using warm sea surface temperature scenarios for hurricane cat bonds, but still the modelling may not take full account of climate change.

S&P’s report is only based on reinsurers’ own estimates of their catastrophe loss exposure, which includes factoring in reinsurers adjustments to catastrophe models. The ILS market, investors and managers, will apply their own adjustments to cat models based on their own beliefs of how loss frequency and severity has changed and so any underestimation would likely differ to a reinsurers. However the basic premise, that under a scenario like S&P has run catastrophe exposure would be higher, is true for ILS and cat bonds as well.

Of course the issue here is a lack of firm scientific evidence about the impact of climate change on catastrophe and extreme weather losses. Once there is a firm link between the two, providing accepted evidence of the impact climate change has on insurer and reinsurer losses, then the catastrophe risk models will likely factor this in, adjustments to models will be brought into line, and the end result would no doubt be an increase in premiums.

Reinsurers and ILS managers or investors would charge more for providing capacity and coverage if a scenario such as S&P’s were the accepted truth, something that in the current soft market, which many are referring to as the worst reinsurance market ever, would most likely be actioned very quickly to narrow any gap between the previous view of return period losses and the new one.

However until such a scenario is the accepted truth, in the insurance and reinsurance sector, it’s hard to see how reinsurers can fully factor climate change into pricing in any way other than via a gradual response to loss trends in recent history in tandem with factoring in any new and accepted scientific view. The question is how reinsurers might react if a new view of weather extreme frequency and severity, like S&P’s scenario, did become accepted. Would they increase their rates by 50% to compensate?

If catastrophe loss years like 2005 and 2011 become the ‘new normal’ the impact to reinsurers would be huge, both in terms of exposure and impact to ratings. As a result the industry would have to react to ensure it could maintain its ratings, remain financially viable and either reduce exposure or ensure it was compensated for taking it on.

Getting better protected through the purchase of retrocession might be one response you would think, but S&P explains that retro would be no panacea under its climate change impacted catastrophe loss scenario:

Even though we did not explicitly quantify it, the impact after retrocession recoveries may be somewhat higher. This is because the average benefit of retro protection reduces at this increased level of estimated losses. The benefit of retrocession protection may be further reduced if extreme losses are accompanied by an increase in frequency because most reinsurers have very limited protection after a second catastrophe event occurring within a contract year. Purchasing new retrocession protection may be prohibitively expensive after a second major catastrophe event.

Under its scenario capital adequacy of the reinsurers S&P rates would fall, with average capital adequacy dropping from extremely strong to the high-end of very strong, the rating agency explains. In the event of a one-in-250-year loss under the new scenario, S&P said that capital at risk would be as much as 54% of risk adjusted capital, up from the 36% it sees today under current expectations.

Earnings volatility would also be higher, with more frequent events taking a toll on reinsurers’ earnings more regularly. S&P questions whether under such a scenario investors would continue to support insurers and reinsurers that have high levels of catastrophe exposure when the probability of increased annual losses is higher.

This exercise by S&P, while simplistic as it admits, provides a useful look at what may be ahead for reinsurers if a higher frequency and severity of weather and catastrophe losses is in the industry’s future due to climate change.

With such a large deviation in exposure and return period losses it should drive home the need for reinsurers, ILS managers and investors in the sector (both in equity or ILS instruments like catastrophe bonds) to champion and push forward climate and weather research to help us to better understand the potential exposures that will be faced in years to come.

You can access a copy of the report via the S&P website here (login may be required). A video of S&P analysts discussing the report is below.

Read our other articles on S&P’s recent notes on the reinsurance sector:

Reinsurers appetite for catastrophe risk remains, despite lower profit: S&P.

Asia-Pacific regional reinsurers better positioned to withstand pressure: S&P.

Reinsurance opportunity in sovereign catastrophe risk financing: S&P.

Competition, earnings pressure, threatens global reinsurer ratings: S&P.

S&P questions viability of hedge fund reinsurer business model.

To remain credible ILS growth shouldn’t be at expense of discipline: S&P.

Competition would be fierce even without third-party capital surge: S&P.

With few places to hide from soft market, reinsurers need to adapt: S&P.

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