Cat bond & ILS coupons should compensate as climate increases hurricane risk: Twelve Capital

Climate change, variability and the expected increases in Atlantic hurricane risk that these factors will drive, is still likely to be compensated for in catastrophe bond and private insurance-linked securities (ILS) coupons, as pricing should rise and consequently returns, in line with the risk, according to ILS manager Twelve Capital.

Twelve Capital, the Zurich headquartered insurance sector specialist fund manager, works with machine learning focused climate technology company, reask on hurricane risk analysis. The pair have looked at how climate change and climate variability will influence the market and impact portfolios of ILS or cat bonds.

They expect we will see a “modest increase in Atlantic hurricane risk over the forthcoming decades as a consequence of climate change.”

Modelling analysis of climate and hurricane activity data “suggest that a “worst-case” style climate scenario of a continued rise in greenhouse gas concentration over the next century will likely increase North Atlantic hurricane activity over the period 2020-2060. Key patterns point to more dominant La Niña-type SST (Sea Surface Temperature) signals and a warmer tropical Atlantic.”

As well as heightened and potentially increasing hurricane activity linked to climate change, Twelve Capital and reask’s analysis also suggests that “Landfall risk is expected to increase by approximately 12% across the basin, with landfalls emanating from the Main Development and Gulf regions up by approximately 10%. Landfalls from the East Coast region are expected to increase by approximately 20%.”

While activity over the 2000 to 2019 period is considered “extreme compared to the mean of alternative simulated realities.”

The research suggests that, “The expected risk over the period 2020-2060 is likely to trend to a risk level similar to that observed between 2000-2019; the high activity observed over the last 20 years is predicted to be the future normal.”

However, this is an environment in which insurance-linked securities (ILS) have actually performed quite well, Twelve Capital notes.

It is a true that even through recent severe hurricane seasons, many of the ILS market losses have come as a result of aggregation of catastrophe losses across other perils as well. While direct losses solely from hurricane landfall events have actually been quite manageable by the ILS sector, both in the catastrophe bond and broader private ILS or collateralised reinsurance space.

Twelve Capital and reask believe that as climate influences on hurricane activity increase and so hurricane risk, “Cat Bonds and Private ILS coupons should however, compensate the investor, even after accounting for the increases in potential risk levels.”

The reason for this is that, “Climate variability will likely continue to drive US hurricane risk premia with increased demand for ILS capital to help the (re)insurance industry manage capital-intensive peak peril US Hurricane exposure.”

As cat bond and ILS pricing is based on the risk levels assumed, as the hurricane risk level increases and this is incorporated into catastrophe models, the ILS instruments pricing should be increased in-line with this, so ensuring investors are compensated over the long-term.

“For that reason, the risk metrics used to price ILS instruments at the time of issuance reflect these gradual increases in the expected loss. ILS investors are therefore able to price in the current state of the climate into their investment decisions,” Twelve Capital explained.

However, the ILS fund manager adds that, “Whilst Twelve Capital believes that ILS pricing is sufficient from an asset class perspective, even under an adverse climate change scenario, a more in-depth analysis is needed on individual regions, cedents, trigger structures and with regards to portfolio construction.

“Incorporating continuous climate change research and development into Twelve Capital’s investment process facilitates improved risk assessment over the medium term. Understanding both the uncertainty in the observed climate and the possible variability associated with potential future climates allows Twelve Capital to evaluate the risk levels associated with current and expected future trends. Twelve Capital’s research and development forms a key part of its ESG framework and is a cornerstone of its approach to responsible insurance investing in a changing climate.”

Twelve Capital also explained how it positions itself for an expected hyperactive hurricane season, like 2020 is proving to be.

“The portfolio measures implemented for this year’s hurricane season are some examples of the many possibilities in Twelve Capital’s dynamic portfolio construction process, which supports the construction of attractive ILS portfolios even in a world affected by climate change and other volatility-increasing topics,” the investment manager said.

Adding that, “Ultimately, Twelve Capital is convinced that ILS portfolios provide investors with access to a diversifying asset class that is well-positioned and robust enough to generate attractive returns, even after accounting for potential changes in climatological conditions.”