Catastrophic norms of the future are in tail risks of today: Mark Carney

by Artemis on September 26, 2016

The insurance and reinsurance industry has organised itself to address existential issues related to climate change risk and the industry has shown “genius” by recognising that catastrophes and weather disasters could become increasingly severe in the future, according to Mark Carney.

The Governor of the Bank of England and Chair of the Financial Stability Board, Mark Carney holds significant sway in the discussion of climate risk and the threat it could pose to financial stability, markets and the economic prosperity of the world.

Insurance and reinsurance markets are “on the front line” when it comes to the physical risks related to climate change, Carney said while giving the Arthur Burns Memorial Lecture in Berlin, Germany on 22nd September 2016.

Physical risks due to climate are the primary concern and likely where the insurance and reinsurance industry can assist in the short to medium term.

Carney warned that physical climate risks translate to “increased frequency and severity of climate- and weather-related events that damage property and disrupt trade.”

This is where re/insurers and ILS players are already “on the front line”, as Carney terms it.

But, Carney notes; “A combination of sophisticated forecasting, a forward-looking European insurance capital regime and business models built around short-term coverage has left insurers relatively well-placed to manage physical risks.”

This is why Warren Buffett famously said that he did not believe that climate risk was a threat to the Berkshire Hathaway insurance and reinsurance business, although it is of course a risk to the investments that he makes with the re/insurance float.

The short-term nature of insurance and reinsurance contracts means that re/insurers and ILS fund managers are able to update assumptions based on the latest models, data, meteorological and climate science when underwriting fresh contracts or renewing programs and accounts.

However, Carney warns that this does come with its own risks for society, that “growing swathes of our economies could become uninsurable absent public backstops.”

Re/insurers and ILS managers have been pushing for these public backstops to become smaller and to shift risk into the private markets, something we’ve seen most dramatically in Florida in recent years and ost recently with FEMA’s flood reinsurance purchase last week.

However, as models become updated to factor in increasing sea-level rise, the expectation of more severe storms, rainfall, flooding and other weather events, as well as temperature increases which tend to exacerbate the other meteorological perils, the fear would be that the private re/insurance market prices itself out and public backstops are the only way for coverage to be maintained.

“If coverage is not maintained, the broader financial system would become increasingly exposed to large and variable physical risks,” Carney warned.

As climate-related risks rise it becomes increasingly important that the cost of risk capital in the insurance and reinsurance industry is as efficient and low as possible, as this will enable the sector to maintain coverage for as long as possible.

Hence the use of insurance-linked securities (ILS) to cover the tail risks that become increasingly frequent will and the increasing transfer of peak catastrophe and weather risks to the capital markets could help society to remain better protected against a changing climate and the risks that poses.

“Insurers have some of the greatest incentives to understand and tackle climate change in the short term,” Carney continued.

He explained that at Lloyd’s of London insurance and reinsurance underwriters are required to factor climate change into their business plans and models.

“Their genius has been to recognise that past is not prologue and that the catastrophic norms of the future are in the tail risks of today,” Carney said.

Insurance-linked securities (ILS) markets already specialise in taking on the tail risks of today, as do global reinsurance firms. The capital markets has the depth necessary to bear rising weather and catastrophic risk, and could have the liquidity as well if the industry would only embrace electronic trading.

As those tail risks move up the frequency curve, as many expect them to, the expertise to structure and underwrite weather and catastrophe related risks will become more vital to society and ILS capacity likely increasingly in demand.

It’s not just the physical risks from climate change that need insurance and reinsurance capital support. The liability risks associated with compensation claims from those they hold responsible made by parties suffering financial loss due to the effects of climate change are also potentially huge.

Tied to this is Carney’s work with the FSB to form the Task Force on Climate-related Financial Disclosures (TCFD), which it is hoped results in a proportionate standard for climate risk disclosure, which could see large corporations disclosing their climate-tied disaster risks, as well as climate change linked.

This could result in a need for greater insurance protection, it is hoped that through disclosure the shareholders will pressure board’s of international businesses to better protect themselves against the disclosed risks.

Catastrophe and weather related insurance coverage will clearly be one way a company can offset the negative side of its disclosure, resulting in greater need for reinsurance and ILS capital to support these risks.

Green finance is the final area Carney discussed in his speech, an area where trends in insurance-linked securities (ILS) could be leveraged to create investment opportunities with low-correlation that help to finance de-carbonisation of economies, or fund resilience, while also offsetting climate-related risks as well.

The world does not just need financing to help it to become greener and more resilient, it also needs capital that is willing to take and bear risk while that process (which is an ongoing one over many, many decades) occurs.

The resilience bond initiative, which would create a financial instrument that both promoted resilience and also transferred the particular risk in question as well, is a prime example of this. Somewhere innovation can take learnings from the ILS and catastrophe bond market to help increase climate security and resilience.

The green bond market has not grown significantly, but Carney foresees a huge opportunity for investors in financing green projects and authorities are working on standardised term sheets for this asset class.

Perhaps, as these green bonds often finance climate-linked projects in terms of renewable energies or resilient infrastructure, there is a case for factoring in climate and weather related risks, akin to the resilience bond approach, in order to allow for insurance offsets for projects and municipalities benefiting from them.

The ILS market can assist in helping markets understand the importance of weather and catastrophe risk transfer. While tail risks become the norm and frequency of events impacting ILS markets grows, it can only result in a greater need for diversification within the sector and linking risk with resilience is one way that could add a new dimension to the asset class.

While the insurance, reinsurance and ILS industry has shown “genius” (as Carney says) in preparing itself and maintaining a pro-active view of our changing climate, it is also the source of expert capital that can best help to shift some of these risks away from governments and the population and into the global capital markets.

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