Analysis from S&P Global Ratings suggests that reinsurance firms may be underestimating their natural catastrophe exposures by anywhere from 33% to as much as 50%, as they grapple with incorporating climate change into their decision-making process.
After running a stress test on reinsurance firms designed to illuminate the potential exposure to climate risk at an industry level, S&P said that only 35% of reinsurers surveyed include a specific component of the price allocated to climate change.
The stress tests looked at reinsurers’ estimates of their exposure to natural catastrophe risk, therefore physical climate risk, finding that they could be underestimated by 33%-50%.
S&P noted that this is 91% of the sector’s buffer above the ‘AA’ capital requirement and while not the rating agency’s base case, it said the scenario illustrates the significant potential for volatility in earnings and capital.
“Unmodelled risks and the inherent difficulties in attributing extreme events to climate change create the risk that climate change may not be fully reflected in reinsurers’ catastrophe modelling, particularly in the short term,” explained Dennis P. Sugrue, S&P Global Ratings credit analyst. “We believe that those companies that take a more proactive approach to understanding and adapting their exposure to climate risk will be better protected against future capital and earning volatility linked to climate-related losses.”
Those reinsurance firms that do take climate change specifically into account when pricing only factor in 0%-10% of the rate charged on average, S&P also said, which it believes “does not appear to be a significant determinant of market pricing.”
“Re/insurers may consider that the effects of climate change will not be felt for some time, and that at present, the ability to annually reprice most property policies provides them with some insulation. However, there is clear scientific consensus that climate change is already influencing the frequency and intensity of extreme weather–and therefore (where not suitably mitigated), insured losses–today,” the rating agency said.
Adding that, “A comparison between the historical premium rate movements for global catastrophe insurance versus the amount of estimated rate increases required to account for future climate-driven losses demonstrates why annual repricing is not a solution on which reinsurers should rely too heavily.”
S&P also believes that unmodelled risks and the challenge of attributing extreme events to climate change heightens the risk that “climate change may not be fully reflected in catastrophe modelling,” particularly in the short term.
All of which means that, “If re/insurers are not properly accounting for the impact of climate change in their catastrophe modelling and pricing today, it could lead to significant unexpected volatility in their earnings and capital, resulting in pricing corrections that could have implications for the cost of reinsurance purchased by primary writers, thereby hitting their profitability and risk profiles as well.”
The stress test scenario used by S&P indicates that the reinsurance industry may need to materially increase the amount of capital they hold for their catastrophe exposures (the one-in-250 catastrophe charge in S&P’s risk-based capital model), which could amount to as much as $21.7 billion in aggregate for the industry.
On top of this, the modelled exposure to a one-in-10-year event for the reinsurance industry could increase by at least $7.4 billion in aggregate, S&P added.
To offset the potential additional capital burden, S&P said price hikes may be required in reinsurance, to cover the added costs.
Importantly though, S&P notes this could be a challenge in itself, as “The industry’s ability to reprice for the risk of climate change may not be sufficient or responsive enough, particularly in a largely commoditized market with differing viewpoints on the adequacy of pricing for physical climate risks.”
Of course, this isn’t news to reinsurance firms, which are increasingly aware that frequency and severity changes are exposing the industry’s capital base to climate related risks, particularly those that can be considered physical risks of climate change itself.
This will apply across insurance-linked securities (ILS) as well, where pricing largely aligns with reinsurance, although accounting for different costs-of-capital in some cases.
What does this mean?
It could suggest that in future reinsurers’ cost-of-capital is going to rise, making efficiency and lower-cost options to bring in capital to attach to catastrophe and climate risks will be increasingly important, perhaps also putting an increasing emphasis on the need for efficient retrocession and risk transfer tools such as the catastrophe bond.
But those risk transfer tools also need to be priced commensurately with the risk and to account for physical climate risks and any changes to them.
All of which suggests that while firming is slower this time around, than in previous hard reinsurance markets, it may be sustained for a longer period if reinsurers continue to exhaust catastrophe budgets and find their capital threatened.
Of course, this also all reads across to primary P&C insurers, which will need to ensure pricing at the front of the market chain is accounting for these risks as well.
It is quite damning for the industry if analysts believe reinsurers are not yet adjusting their pricing sufficiently for climate change, especially as the industry makes so much noise about climate change and the way certain risks are escalating.
The industry has often made a big deal of its ability to change pricing on an annual basis, as a way to ensure climate risk is incorporated. But if this isn’t moving fast enough, then things may need to accelerate on that front.
With clear implications for the cost of reinsurance capital and ultimately for the cost of insurance.
Investors in reinsurers will also be displeased with this, as they are keen to know their reinsurance investments are being properly priced for the climate we live in at any one point in time.