Climate change risk perception contributes to ILS slowdown: Fitch

Among all the reasons for inflows of alternative reinsurance capital into insurance-linked securities (ILS) slowing down over recent months, Fitch Ratings believes that climate change is a factor.

The rating agency said today that the recent slowdown in ILS market inflows is expected to continue for a little longer, while the ILS market and investors in alternative reinsurance capital structures continue to deal with the hangover of losses and paying claims.

That process can take some years, as losses are confirmed and claims paid, while other collateral that had been held gets unwound and released. Hence, the market may appear slightly dented for a while longer as the recovery continues.

But Fitch believes that, as well as the impacts of catastrophe losses, payment of those losses and some redemptions from investors as a result, the ILS market is also suffering from investor reluctance to allocate more funds as there is increasing nervousness regarding climate risks.

“Investors appear to be more hesitant about investing and are seeking higher returns given concerns over climate change and loss reporting,” Fitch explained in a report today.

Of course, there are other issues than climate change itself, such as confidence in the models and analytics used to inform underwriting and pricing decisions, as well as the portfolio diversification strategies employed.

But climate risk and climate change has definitely climbed the agenda in the last two years, particularly after the hurricanes and two years of California wildfire losses.

We (at Artemis) have been having increasing numbers of conversations with investors that end up being a discussion about climate risk in the last year, as the topic moves higher and higher up agendas.

Fitch explains how it sees the ILS inflow slowdown and why it believes it has occurred, saying that, “While there have been continued inflows of new capital in the insurance linked securities (ILS) market, the rate of growth in the sector has slowed significantly.

“This reflects reduced investor demand, which is driven by various concerns including the effects of climate change, loss development on recent catastrophe losses, and the accuracy of existing catastrophe models, which pricing relies on.”

The rating agency cites “growing evidence” that climate change is affecting claims activity across insurance and reinsurance, which naturally would also impact ILS capacity as well.

“Climate change appears to be increasing wildfire risk, with two successive years of record losses, and it also appears to be affecting insured losses from hurricanes as well, with warmer temperatures leading to more moisture and greater precipitation and hence increased flood losses,” Fitch explained.

As a result of this the rating agency warns that a slowdown in ILS inflows could be more prolonged than had perhaps been expected.

“Fitch expects investors to be more discerning in ILS investments with investors likely to be searching for higher returns to offset the perceived increase in risk,” they explained.

Should this result in a prolonged slowing of ILS investor inflows, Fitch warns that, “This could slow the development of the ILS market and reduce its pricing advantage relative to the traditional reinsurance business model.”

However, it’s important to note that this issue faces all in insurance, reinsurance and insurance-linked securities (ILS), as climate change and adequately factoring its risks into decision making is an urgent need for all sides of the market.

Yes, pressure from investors to ensure climate change is factored in may be more acutely felt by ILS fund managers, given they directly manage money for large institutional investors with who they have direct relationships.

But insurance and reinsurance company executives are also going to feel the same pressure from their shareholders and analysts, just perhaps with a bit of a lag.

Being an industry that actively creates and manages portfolios of catastrophe and weather linked risks puts ILS at the front-line of discussions on climate change, hence this is an important issue Fitch has raised today.

So, adequately explaining how climate change is accounted for within insurance and reinsurance underwriting and pricing decisions is a challenge that faces the entire sector, both traditional and ILS or alternative.

In addition, the risk model providers need to support the market, as it seeks to explain how climate related risks are accounted for within their portfolio decisions, as so much of this hinges on the output of models and other analytical decision-support tools.

As well, greater support and flow of information, to both existing investors in the ILS sector and new investors looking at ILS or reinsurance and considering it as an asset class, is required. Nothing beats openness and having an ongoing conversation about issues such as this that can affect investor confidence.

It is only through better education and increased transparency that investors will gain renewed confidence in the ability of both reinsurance markets and ILS managers to correctly factor climate risk into their decision making.

Providing transparency and educating investors to understand steps taken to factor in climate risk now, can only help ILS fund managers to become the recipients of a greater share of the market’s inflows in years to come.

Climate change and the risks it poses to the re/insurance and ILS business model are set to be hot topics for years to come.

The sector’s ability to reprice contracts at renewals, largely on an annual basis, helps of course. But only if the baseline pricing is really correct.

As the world’s understanding of climate risk continues to evolve, while the effects are said to accelerate by some, this challenge is likely persist.

But, at the same time, this will only serve to further underscore the importance that there is efficient risk capital available to support the world’s adaptation to a changing climate. Which of course is where the capital market and ILS sector is perfectly aligned to support the globes adaptation, risk transfer and reduction needs.

Also read:

– Climate risk data needs linking to insurance & risk-transfer process.

– Climate risk transfer an opportunity for product design innovation: Greg Lowe, Aon.

– Risk transfer a key tool in climate change adaptation: Nephila report.

– Capital + tech + data can help address climate risks: Schauble, Nephila.

– ILS at forefront of monitoring for climate change impacts: John Seo.