Climate change won’t impact ILS investments uniformly: Twelve Capital

Climate change is not expected to impact all forms of investment in insurance-linked securities (ILS) uniformly, according to Twelve Capital, which means for ILS investors and managers, analysing climate exposure, as well as establishing and updating a house view on risk is key.

In an update on hurricane activity yesterday, Twelve Capital explained that, “Analysing and assessing the impact of climate change on natural catastrophes is key for benchmarking risk-adjusted pricing of Insurance-Linked Securities.”

The ILS investment manager asks whether the recent particularly active hurricane seasons are “the new normal in a climate change impacted world?”

NOAA updated its baseline view of a normal hurricane season this year, which as we explained at the time now means that the benchmark average year contains two more named tropical storms and one more hurricane than before.

“NOAA likely attributed the increase in activity to the improvement in observing platforms as well as highlighting the warmer ocean and atmosphere and the possible influence of climate change,” Twelve Capital said.

But is this recent activity really the future normal, Twelve Capital asks.

Analysing and understanding recent hurricane season activity is “critical in assessing potential risk levels associated with any potential future climate change,” Twelve Capital believes.

“Mean observed basin wide activity from 2011-2020 is above the baseline from 1991-2020 with the last ten years having exhibited both the most active hurricane season on record in terms of named storms (2020) and most costly in terms on insured losses arising from US Hurricane damage (2017). The mean forecast for this year is in line with the expected value from 2011-2020,” the investment manager explained.

The graphic below shows a comparison of numbers of named storms per year between 2011-2020, the forecast for 2021 and the Twelve Capital / reask climate projection for 2020-2060. The baseline mean 1991-2020 and the recent 2011-2020 average are also shown. CESM: Community Earth System Model (developed by the University Corporation for Atmospheric Research (UCAR) out of the National Centre for Atmospheric Research (NCAR)).

Twelve Capital and reask extended out the forecast to include the possible impacts of continued greenhouse emissions, using simulations of possible future climates from the Community Earth System Model (CESM) and the image above shows the expected value of named storms based on simulation years from 2020-2060 under the RCP8.5 scenario, the companies explained.

“Under the RCP8.5 scenario hurricane frequencies are expected to rise modestly by about 12%. The model simulations also suggest that the heightened activity of the last 10 to 20 years was in fact “unlucky” relative to other simulated scenarios and that the future expected value, albeit clearly trending up, might not be as extreme as the value observed in recent history,” Twelve Capital summarised their findings.

Because of its research and the variability seen in natural catastrophe risk distributions, Twelve Capital said that it has “proactively taken a view to weight the most recent history in its assessment of risk and risk selection process.”

This gives a little insight into how an ILS fund manager is using research and technology, with reask models being powered by artificial intelligence, to help it make better risk selection and portfolio decisions.

Looking beyond just hurricane risk, Twelve Capital said that it believes that “climate change will manifest itself in a variety of ways and with different impacts across peril regions.”

Adding, “Further Twelve does not believe all forms of investment within ILS will be impacted uniformly.”

Which is a really good point, as ILS structures and also portfolios of ILS or reinsurance investments could show a wide dispersion in their results as climate related impacts are expected to intensify.

Highlighting the importance of considering climate change related factors in modelling of ILS instruments and portfolios, to ensure that potential exposure is being managed and mitigated where possible.

Of course, the shorter tenure of the majority of ILS, being under five years and more likely between one and three years in terms of coverage length, does mean that the ability to reprice persists for the ILS market.

But without insights into how future climate scenarios could affect the pricing of ILS and catastrophe bonds, or other collateralised reinsurance investments, managers may not be able to make the decisions necessary to protect their portfolios against the effects of climate change on frequency and severity as well as those putting in the time to understand the risk better.