Climate insurance-linked securities (ILS) opportunity seen for London

A forum co-chaired by UK regulator the Financial Conduct Authority (FCA) and the Bank of England’s Prudential Regulation Authority (PRA) calls for the development of a market for climate-related insurance-linked securities (ILS) in London.

London and the United Kingdom has been seeking to create a greater role for itself in insurance-linked securities (ILS) for a number of years now, having enacted its own ILS legislation and played host to a number of catastrophe bond and other collateralised reinsurance transactions.

The ILS regulatory and legislative regime in the UK saw activity halt under the shadow of Brexit, with further potential amendments to the policy related to insurance-linked securities (ILS) and insurance special purpose vehicles (iSPV’s) to be assessed once that process has completed.

But the UK continues to see opportunity in ILS and wants to bring more capital markets supported reinsurance business to its shores, with the growing awareness of climate related risks and the need for risk transfer to mitigate that seen as a potential area of opportunity.

Enter the Climate Financial Risk Forum (CFRF), a group co-chaired by the UK’s FCA and PRA that aims to build-out capacity and share best practice across financial regulators and industry parties, featuring members from banks, insurers, and asset managers, with the goal of advancing the UK’s responses to the financial risks from climate change.

The CFRF has published a guide to climate-related financial risk management and it’s no surprise to find insurance, reinsurance and also insurance-linked securities (ILS) featuring.

With climate related risks, the cost and availability of insurance and reinsurance capacity, as well as the efficiency of risk transfer structures, are all seen as key and discussed in the CFRF’s guide.

Climate change and climate risks are expected to affect asset values and also raise insurance costs, as the perception and understanding of the risks grow and impacts increase, which the guide warns “may alter the distribution of risk across the system over time.”

Insurance and reinsurance claims are expected to rise, along with the frequency and severity of weather and climate disasters, all driving the need for more capacity and product solutions to provide effective protection and risk transfer.

But it is the effective sourcing of the capacity required to help the world deal with growing climate related exposures where ILS and instruments such as catastrophe bonds could come to the fore, as alternative and complementary sources of reinsurance capacity to support the insurance industry’s goals in offering protection, as well as in providing direct capacity to those seeking to transfer climate related exposure.

The CFRF recognises this opportunity, saying that, “Building on London’s leading role as an insurance and reinsurance centre, the development of a market for climate-related insurance-linked securities (ILS) – securitised reinsurance transactions including, but not limited to catastrophe bonds – should be promoted.”

The capital markets is without doubt the deepest and most liquid pool of capital available that can absorb climate risk exposures and provide financial protection to those needing to offload some of this risk.

Not just as a source of reinsurance capacity though.

The ILS market through catastrophe bonds can also help large asset holders and owners to transfer climate-related risks that are embedded in their portfolios, so providing direct risk capacity and mitigation for the rising exposure some portfolios are carrying.

The cat bond market has demonstrated its effectiveness as a source of risk capital and its ability to help asset owners, be they investors, funds, corporates, or other entities, to carve out the climate, weather and natural disaster exposure that is embedded in their portfolios of assets (physical or financial).

The most recent evidence of this was the innovative Sierra Ltd. catastrophe bond, that saw a mortgage investment fund transferring earthquake risk embedded in its portfolio to the capital markets using a parametric trigger.

This transaction highlights the potential for asset holders and owners to follow-suit and transfer risks such as rising sea level related storm surge exposure, storm exposures, flood risks and even temperature to the capital markets in catastrophe bond form.

All of these risks have been transferred to the capital markets by ILS structures before and there is every reason to think these examples provide a glimpse for how climate-related exposure reduction can be assisted by the ILS market.

There are plenty of use-cases and examples that show how ILS can assist on climate risks, it’s really down to those selling the protection to make this clear to the clients carrying this climate exposure.

From the investor-side, it’s going to be key to be able to demonstrate that climate risk is priced in before ILS investors will want to support such issuance, so the availability of robust models and risk data will also be vital for climate-related ILS to really take off.

The CFRF noted that London has an exchange ready to list such instruments, saying, “London Stock Exchange’s International Securities Market (ISM) is ready to list these instruments, in line with the Risk Transformation Regulation 2017, which established a regulatory framework for ILS issuers to be domiciled in the UK.

The London Stock Exchange (LSE) has been ready to support ILS issuance with listings and said it can also make these instruments tradable, but of course we need to see more issuance in the UK before we’re likely to see this occur.

The UK is ambitious when it comes to insurance-linked securities (ILS) and this CFRF report reflects the ambitions of many at the regulator’s that want London to become a home for ILS business.

Targeting climate-related ILS is a potential avenue for gaining more traction and this is likely to become a particularly competitive area of thought and endeavour across global insurance, reinsurance and capital markets in the years to come.