Climate change presents both P&C threat & opportunity: Moody’s

by Artemis on March 22, 2018

Climate change will create challenges and also opportunities for the property & casualty insurance and reinsurance industry, according to rating agency Moody’s. However the threats presented by a changing climate are likely greater and Moody’s says this has a “net negative credit impact on the industry.”

Weather image from DreamaticoMoody’s highlights a number of reasons that it sees climate risk as increasing in insurance and reinsurance, which of course suggests it’s also increasing in the insurance-linked securities (ILS) or catastrophe bond sector as well, in the rating agencies view.

While catastrophe risks have always been a key exposure for P&C re/insurers, Moody’s believes that the continued rise in insured property values along the coastline and the increasing volatility of weather-related catastrophe loss events, both will serve to “magnify” the volatility within insurer and reinsurer results over time.

“The effects of climate change on the frequency and severity of catastrophic events are difficult to predict, and the correlation of climate-exposed risks that span P&C (re)insurers’ balance sheets increases the magnitude of potential losses arising from the physical and transition risks associated with climate change,” commented James Eck, Moody’s Vice President.

Any increased volatility within insurance and reinsurance company results, due to climate change, will also affect the insurance-linked investments market and ILS funds.

Climate risks are priced in, as well as they can be, with transactions modelled both on the current views of risk and also under warm sea surface temperature scenarios, or stressed for other climate related variables.

But the volatility within weather related catastrophe patterns are considerably harder to analyse, understand and forecast, leaving investments linked to weather and catastrophe risks potentially exposed.

Of course the majority of transactions are just one to three-years in duration, so priced for that short term or reset with new exposure factors each year, and as a result are not exposed to climate changes over a longer multi-decadal horizon.

But record-setting events (such as hurricane Harvey’s rainfall) and the general uncertainty and the unpredictability associated with the weather, mean there is always an element of climate volatility risk being taken.

Moody’s believes that as the volatility of climate risk becomes more evident in the results of the insurance and reinsurance industry, companies are going to face a number of risk management challenges related to the assessment, measurement and mitigation of catastrophic risks.

“We expect P&C (re)insurers to continue to adapt to the economic and regulatory challenges that result from climate change, as these firms can reprice risk on an annual basis, and further diversify their underwriting exposures and investment portfolios,” Eck explains.

However, Moody’s notes that smaller, more geographically concentrated re/insurers could struggle to adequately adapt to these challenges.

Moody’s forecasts that the industry’s risk modelling and pricing methodologies will face an additional level of uncertainty, given climate change can produce an unpredictable environment which makes the assessment and pricing of risk more testing.

Moody’s notes that the result could be that pricing lags behind the loss trends the industry faces due to climate change, which it says, “may force the industry to play “catch up” in raising premiums to match increasing losses.”

Re/insurers have been playing pricing catch-up forever though, as they can only price risks based on what they know about the exposure and the science is constantly moving, evolving and learning from events, with data augmented every year and new findings from meteorological or geological science emerging that need to be factored in.

Risk model update and development lag times could become an increasing risk factor for re/insurers and also the ILS or catastrophe bond market. As risk models often only undergo major updates every few years, so increasing the need for underwriters and ILS portfolio managers to layer on top their own view of climate risk.

Having their own view of this risk is going to become increasingly important and will be a significant differentiator for some firms in years to come, as those who can better analyse and price risks based on their understanding of the science and meteorology, could have an edge, as their results may prove to be less volatile than others.

The majority of ILS funds, insurers and reinsurers all layer their own views of risk on top of the main vendor models already, which will help to reduce some of the uncertainty and the impact of model update lag time.

But with more volatile weather anticipated, due to the variability or changes in our climate, it’s going to become increasingly important to manage this view of risk proactively to ensure it’s always priced in.

One area that most ILS funds do not have to worry so much is in the potential for correlation of risks.

Insurers and reinsurers face climate related risks on the underwriting side of their book, both in property exposures and liability or casualty risks as well. Additionally, re/insurers face risks from climate to their investment portfolios as well, so both sides of the balance-sheet are potentially exposed.

ILS investors of course likely have numerous sources of climate related risks within their overall portfolios, so for them it is key to understand how ILS funds look to manage and address any exposures.

On the other side of the risks posed by climate and also of particular relevance to the ILS market, Moody’s believes that as the understanding and acceptance of climate related risk changes increase among corporations and governments, there will be opportunities to provide more protection and to develop new products, to help those looking to hedge their climate volatility.

“As governments, businesses and individuals become more aware of the financial and economic risks arising from climate change, P&C (re)insurers could generate business growth by providing broader risk management solutions and products that help close the “protection gap”,” Moody’s explains.

In fact, this is not just in covering the protection gap, but also in creating products that have not existed before, to cover risks that have previously gone uninsured.

A number of ILS funds have been working on initiatives in this area, looking to cover corporate climate volatility as an insurance product and working to identify what elements of catastrophe reinsurance, capital markets structures and risk transfer trigger design can provide coverage that will smooth earnings volatility caused by climate-linked weather risks.

But overall, climate related risks are likely to outweigh any opportunities, Moody’s believes, which will make hedging an increasingly vital piece of the ILS fund toolkit, as well as for re/insurers.

For if climate and weather related risks is to be an area of expansion for the sector, it will need to identify the best ways to hedge the volatility that will be assumed and that will manifest in its results.

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