Changing climate could result in greater risk capital requirement: S&P

by Artemis on November 17, 2015

The uncertain, potential impact climate change could have on the insurance and reinsurance industry has seen it fast become a top emerging risk and the possibility of increased weather-related event severity or frequency could result in greater demand for risk capital and ILS.

The climate change debate is an ongoing, uncertain, and complex global issue that affects industries and markets in all corners of the world, often drawing differing opinions and conclusions to its severity, timeframe and potential impact.

And now, in a new report, insurance, reinsurance and financial services ratings agency Standard & Poor’s (S&P), has brought to light the possibility that climate change “may present a wider range of threats for insurers,” threats that could result in an increased demand for reinsurance and ILS capacity and solutions.

“Insurers’ capital positions could be affected by lower investment income and higher capital requirements, as well as by the anticipated increase in weather-related claims,” explains S&P.

If the impact of climate change is not anticipated within an insurers risk management framework, notes S&P, this could lead to reduced earnings and drive a need for higher levels of required capital, which, while meaning adaption measures for the primary players, also creates an opportunity for reinsurance and insurance-linked securities (ILS) providers to supply this new, required risk transfer capacity.

Despite remaining uncertain, there is an expectation across the re/insurance space, and wider risk transfer and disaster resilience world, that climate change could mean a rise in the severity and frequency of adverse weather-related events, including extreme weather events.

Linking climate change to specific increases in disaster or changes in weather pattern severity and frequency is an imprecise science still, but generally, if the scenarios of rapid warming, melting sea ice and resulting sea level rises all occur, there is an expectation that impacts will grow.

S&P highlights this point; “Although such events could happen with or without the impact of climate change, it could be argued that climate change may increase their likelihood. We do not consider that any such extreme event would be solely attributable to climate change.”

Regardless of the potential impact climate change could have on the insurance industry, S&P notes several benefits that could arise from continued debate within the risk transfer markets, including the possibility of improving risk awareness in developed and emerging regions of the globe, “which could lead to governments, corporates, and individuals taking better risk mitigation efforts.”

Risk mitigation goes hand in hand with risk transfer and if the world wants to become more resilient it needs to access the capacity to help it to do so. However risk transfer also needs to be closely tied to risk mitigation, as simply pouring more money into buying protection is not the answer to the task of creating a more resilient world.

Furthermore, explains S&P; “This could, for example, reduce weather-related losses at insured properties. Increased risk awareness may also increase demand for insurance, even in less-developed insurance markets.

“As a result, insurers’ geographical diversification would widen. Better diversification could lead to more stable insurance portfolios that required lower levels of capital.”

The final point raised by the ratings agency here is an interesting one, and we’d hasten to add that this will likely also result in an increased demand for reinsurance and third-party, or ILS capital.

Should the threat of more severe, more frequent weather-related events and resulting insurance industry losses, as a result of climate change, prove to be accurate, it will impact developed markets such as U.S. wind and flood, or European windstorm, and also have a significantly adverse affect on the already challenging sustainability and vulnerability of emerging markets, like Asia and Latin America.

However, as S&P notes, increased awareness and understanding could lead governments and other public/private sector entities to increase their disaster risk management capabilities, utilising the hugely beneficial structures, and efficient capital of the global reinsurance and alternative risk transfer or ILS landscape.

Based on their analysis, which used a study by the Mercer Group, and analysis from catastrophe risk modelling firm, RMS, S&P concludes “insurers’ capital management will be sufficient to manage additional strain of a reduction of about 0.5% in capital adequacy per year,” as a result of climate change impacts on the investment and loss side.

However, the industry will be tested should climate change signal an abrupt, unexpected change, something that can be mitigated on a regional and international level through the establishment of advanced disaster risk management and financing pools, utilising the expertise, capacity and knowledge of the insurance, reinsurance and ILS space, to protect against extreme weather events.

As is so often with debates and reports concerning climate change and its potential impacts, the future remains unclear and complex. But in order to prepare for a potential rise in the severity and frequency of extreme weather events, climate change-related or as a consequence of global weather cycles and variability, the willingness and availability of reinsurance and third-party capital would be put to good work supporting global resilience efforts.

“We consider that the industry has processes in place to implement the necessary risk mitigation actions, provided that it is affected gradually and with sufficient warning. That said, we see a small risk that climate change may hit without giving any clear signals to guide decision makers,” concludes S&P.

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