Climate change catastrophes to hit sovereign ratings, risk transfer key: S&P

The impact of climate change is set to exacerbate the negative effect on sovereign ratings from major natural catastrophe events by 20%, according to Standard & Poor’s, as the loss and damage caused by these events increases due to warmer temperatures.

Ratings agency Standard & Poor’s (S&P) has for the first time tried to quantify what impact our changing climate will have on major natural catastrophes effect on sovereign or country ratings and finds that the impact of more severe tropical storms and associated storm surge or floods could be dramatic.

The need for risk transfer at the sovereign level to help to offset the impact to ratings of these major catastrophe events is clear. An S&P report finds that catastrophe insurance, risk pooling, reinsurance and risk transfer, including through instruments such as catastrophe bonds, can mitigate the rating impact of climate change disasters to a degree.

“Our simulations indicate that climate change-related natural hazards can harm sovereign ratings,” commented Standard & Poor’s credit analyst Marko Mrsnik.

S&P found that climate change will worsen the negative sovereign rating effect of a 1-in-250 year natural catastrophe by an average of 20%, according to the simulations it ran. For tropical cyclones and floods this means an average expected sovereign rating downgrade of one notch could become 1.2 notches with the anticipated effect of climate change.

It’s the first time S&P has analysed and quantified the potential severity of the economic and ratings impact of climate change. The work focused on tropical storms and cyclones, as well as associated storm surge and flooding events.

For the report Standard & Poor’s used direct damage data provided by Swiss Re to construct a simplified sovereign rating tool, looking at the impact of 1-in-1250 year events and then adding a climate change, or warmer climate, loading to them to see how that exacerbates the rating effect.

“In terms of average impact of climate change by peril, our simulations show that tropical cyclones and associated storm surges will be more damaging than floods as the earth’s temperature rises. Geographically, ratings of sovereigns in the Caribbean and Southeast Asia appear to be most at risk,”
Mrsnik explained.

Climate change related risk from tropical storms and cyclones came out as highest in the Bahamas, Barbados, Dominican Republic, Jamaica, and Vietnam, and floods in Thailand, S&P’s analysis found.

In contrast, the climate change risks to sovereign ratings for advanced economies appear to be much smaller, S&P said, however the rating agency said that it does “expect advanced sovereigns to also see significantly raised potential direct damage from climate change.”

Interestingly, S&P’s analysis found that direct damage could be from tropical cyclones in the U.S., New
Zealand, or Japan could be higher by 45%, 50%, and 64%, respectively. Meanwhile the impact of floods in Europe appears quite small according to S&P’s simulations.

Mrsnik continued; “The additional climate change damage caused in richer countries is on average more moderate. Their higher level of preparedness, including insurance coverage, further reduces the economic and rating impacts for that prosperous group.”

S&P looked at the expected economic shock to sovereigns from these natural catastrophe events, finding that it would “expect government finances to deteriorate due to the necessary public spending on reconstruction following the disaster, as well as the negative cyclical effect of the resulting economic downturn.”

If that’s not a clear example of the reason that having a responsive source of risk transfer in place, to provide immediate post-catastrophe liquidity and reconstruction finance is a good thing, we don’t know what is. It again makes clear the use-case for the parametric trigger and catastrophe bonds for sovereign disaster risk transfer.

S&P explained the expected impact in some scenarios; “Climate change alone would increase government debt in the affected sovereigns by between slightly more than 4% of GDP in Vietnam and 42% of GDP in Bahamas, compared to a no-climate-change scenario.”

While the average negative impact from climate change on sovereign ratings after these natural catastrophe events is anticipated to be 20%, the impact to some sovereigns will be much greater than to others.

For the most affected sovereigns the impact to their ratings could be 50% greater, while for Thailand it could be almost twice the impact and a near two notch rating downgrade could be expected with the impact of climate change factored into S&P’s simulations.

S&P expects that some countries will be able to adapt to the challenges associated with climate change. However, the ratings agency says that the speed of change has the potential to be so rapid as to make adaptation “all but impossible for the most vulnerable nations in Asia, Africa, the Caribbean, and elsewhere in the developing world.”

So with the impacts of climate change and warming on natural catastrophe events potentially going to increase the economic and fiscal impact of such events or hazards on sovereigns and governments, the case for increased use of risk transfer, insurance or reinsurance seems clear.

S&P found that there is a case for risk transfer and insurance or reinsurance capital to provide disaster financing post-event and that this can help with reducing the economic impact. However the ratings impact cannot be saved by risk transfer alone it seems.

“Our results confirm that a larger insurance coverage against natural hazards is on average associated with more likely mitigation of adverse economic implications of any climate change impact,” Mrsnik explained. “The extent to which this can be effective, however, depends to a large degree on the strength of the fundamentals that support the rating, especially when the damage caused by the disaster is large.”

So having in place some type of responsive sovereign level risk transfer, such as parametric insurance or catastrophe bonds, would likely help to reduce the economic impact, mitigate the risk to the country and enhance recovery, the amount of mitigation will depend on the strength of the country itself.

But the essential financial liquidity that post-disaster risk capital can provide to assist with recovery and reconstruction cannot be denied, and that is the clear use-case that risk transfer, insurance, reinsurance and instruments such as parametric structures and catastrophe bonds can meet.

“Catastrophe insurance can partly mitigate the rating impact of climate change disasters,” S&P explains in the report, but the type of protection has a bearing on the level of mitigation that a risk transfer or insurance coverage can provide.

One of the reasons that S&P found that wealthier sovereigns and more advanced economies are more resilient to the increasing impact of catastrophes due to climate change is their more developed insurance markets.

Insurance protection, or risk transfer, increases the resilience of the sovereign through multi-layered provision of capital post-disaster event to the population, the local industry, commercial businesses and the government itself. Having this in place is key to enhancing resilience and enabling a quicker recovery after catastrophes.

S&P explains; “Insurance coverage cushions the negative effect on the private sector, and insurance payouts help accelerate the restoration of damaged productive assets of the private sector. This boosts economic growth and raises the tax base. As a result, higher insurance coverage will also mitigate the ratings impact of natural catastrophes. This holds true if we account for changes in magnitude of disasters due to climate change.”

S&P looked to answer the question of: “What incremental insurance coverage would an economy need to fully offset the ratings impact due to climate change?”

However, insurance is no panacea and cannot offset all of the economic and potential ratings impact of a disaster or catastrophe, even when insurance penetration is at 100%. So S&P looked at what increase in insurance would be needed to offset the climate change effect on catastrophes.

So, for Thailand, where climate change could double the impact of a catastrophe under S&P’s scenarios, it found that an additional 74% of insurance coverage would be required to offset that climate effect, a huge leap.

Average impact of climate change, by peril type

S&P highlights the work of risk-pooling initiatives and sovereign risk transfer pools such as the CCRIF SPC in the Caribbean, the Pacific Catastrophe Risk Assessment and Financing Initiative (PCRAFI) and the African Risk Capacity (ARC). These provide valuable protection, but alone are not sufficient to prevent sovereign rating impacts.

The key though is in making risk transfer and risk capital as available as possible to sovereigns that lack insurance penetration, helping to provide immediate liquidity after catastrophic events (again think parametric triggers and catastrophe bonds), while at the same time fostering the development of local insurance markets.

Without a multi-layered approach to bringing risk capital into economies and sovereigns at risk of major catastrophe events and the impact of climate change, the ability of these nations to become more resilient and to lower the risk of sovereign rating impact is diminished.

Without the sovereign level risk transfer to protect local markets it is hard to see a sustainable insurance market developing sometimes, but without the lower level insurance products the ability of a nation to bounce back after disaster is reduced as well.

Hence a multi-layered, or pronged, approach to building risk transfer, insurance markets and resilience is required, in order to enable sovereigns to be better prepared and able to recover from disaster. Hand in hand with resilience, preparation and development, the insurance, reinsurance, insurance-linked securities (ILS), capital and risk transfer markets have a key role to play going forwards.

Read our series of articles focused on the insurance protection gap – under-insurance in emerging and developing economies, the gap between economic and insurance losses, and transferring risk from public sector to private – the opportunity that is on every reinsurance CEO’s lips and which presents the largest opportunity to put excess risk transfer capital to use, requiring both traditional and capital markets support.