Climate change influence on ILS returns uneven: SIGLO

The influence of climate change on returns in the insurance-linked securities (ILS) market is uneven and ILS investment managers have access to the tools necessary to adapt to advancing climate risks, making it important that investors take a balanced-view, according to alternative asset advisors SIGLO Capital Advisors AG.

While climate change’s influence is accepted in relation to some perils that ILS funds underwrite, it is not applicable to all.

SIGLO believes investors should not lay the blame for the recent poor historical performance of some ILS strategies at the door of climate risk, rather it is important to take a view on where and how climate impacts are affecting the specific perils ILS and investable reinsurance strategies are allocating, while ILS investment managers must ensure they are taking a robust approach to modelling and understanding climate related risks.

ILS returns have fallen short of expectation in recent years, SIGLO explains, and this has led to some end-investors pointing to climate change as the main cause.

An intuitively understandable reaction, but SIGLO advises that it’s important to also consider factors that played into the performance of the ILS market through recent years, such as the specific claims history and the type of peril events that drove underperformance.

SIGLO says it wants to help address concerns and scepticism of investors interested in ILS, while also questioning them from a scientific point of view.

This involves looking at the risk factors inherent in a diversified ILS fund portfolio and assessing how they are or could be affected by the impact of climate change.

Investors first intuitive reaction to the possible connection between ILS and climate change tends to be critical, which is understandable given the focus on climate within investment circles and the climate related perils an ILS portfolio covers.

But it’s important to consider how ILS industry participants are incorporating an understanding of climate risk into their decision-making, as well as to understand that not every asset in an ILS portfolio will hold climate change exposure.

SIGLO puts ILS peril categories into three buckets, one where there is no known influence from climate change (such as earthquake risk), another where there is possible climate influence but the science remains uncertain to a degree (into which it puts tropical storms and hurricanes) and one where climate change influence is likely (into which severe weather and wildfires are allocated).

Tropical storms and hurricanes is likely to be the most contentious here, with some believing there is a strong climate link to the impact potential of these storms, others that while there is a link to climate at this stage how it will affect storm impacts is less certain.

Importantly though, SIGLO notes that ILS managers are not at the mercy of any climate-related changes to storm activity, as they are equipped with scientific information and risk models and keep abreast of the developing understanding of climate risks.

As a result, ILS managers can project the risk-return profile of their ILS portfolios into the future, under a range of climate change scenarios and so should be able to make investment decisions to mitigate any increase in risk, SIGLO’s report implies.

In addition, the typical 12 month reinsurance renewal cycle means that programs and contracts should be repriced to account for developing understanding of climate change related risks, which is the really key point here.

ILS managers have all the tools available to help them understand climate exposure, but it is down to them (and the market) to price risks accordingly.

There is perhaps greater uncertainty and volatility in the more strongly climate change linked perils of weather, floods and wildfires, SIGLO believes, but this just means yields should be higher, to compensate for uncertainty.

Again, this comes down to the ILS manager to price adequately and develop their own underwriting strategy around certain climate change linked perils, to ensure the contracts they add to investment portfolios are robustly underwritten and understood, while efforts have been taken to mitigate the inherent uncertainty and potential volatility.

Climate change represents an added layer of uncertainty, when it comes to ILS manager decision making and investing, and SIGLO rightly says, “Only disciplined investment approaches will lead to long-term success.”

Which is really what this comes down to, as risk analysis, modelling, selection, underwriting, structuring, terms and conditions are all tools at the ILS fund managers disposal that, when applied with discipline, should mean ILS portfolios can either avoid climate change related exposures (if they choose) or mitigate the uncertainty and volatility, in as much as they can.

The ILS market is not powerless in the face of climate change, but it does call for greater discipline and scientific rigour.

As a result, we expect there will be climate-related winners and losers in the ILS market, as there will in almost all markets and areas of the economy.

Those demonstrating an understanding, appreciation and ability to best construct portfolios around climate exposures, while importantly keeping the climate risk transfer product useful to clients, may stand to provide the best opportunities to investors.