Climate risk protection gaps need capital market (ILS) solutions

The physical climate risk protection gap, so the gulf between climate related losses covered by insurance, reinsurance or risk transfer and those going uncovered, is widening, but instruments such as insurance-linked securities (ILS), catastrophe bonds and other blended financing solutions can help to narrow this gap.

In real estate the climate risk protection gap is particularly stark and financing tools are needed urgently to help absorbing some of the climate exposure that is uncovered at the moment, Fitch Ratings explained in a recent report.

The rating agency looked at the need for risk transfer and risk financing instruments that can help in the global response to longer-term climate related exposures, explaining that there are a patchwork of insurance and reinsurance related solutions, but that in insurance-linked securities (ILS) we perhaps get a glimpse of emerging financial products that could, in future, make a significant difference.

We’ve regularly discussed the ambitions in ILS, reinsurance and related capital market circles to create longer-term instruments, better-suited to transferring climate change trend related risks to the capital markets for some years now.

It’s long been a target for the sector, to offer longer-term hedges against weather variability and climate change linked trends, but as yet this market remains nascent and while interest is high, activity sadly remains relatively low.

But the ILS market and in particular the full securitization model of the catastrophe bond, does offer a mechanism through which climate related exposures can be transferred to the deepest source of capacity possible, the global capital markets.

It is finding and putting together the right structures and trigger inputs that really matters here, work that is ongoing in some corners of the ILS market. As experts look to create the kind of widely applicable climate risk hedges that could really make a difference in narrowing the climate risk protection gap.

Call these insurance, reinsurance, ILS, derivatives or some other kind of hedging instrument, what’s clear is that climate risk is deeply embedded inside economic activity and needs to be transferred out where it can be.

Of course, that’s not a replacement for reducing climate risk and risk mitigation, reduction and resilience initiatives are the ultimate answer to lowering climate risk in our world.

But as this risk is not going away anytime soon, the world would be advised to take advantage of the financial tools that can make climate risk more economically bearable, while at the same time increasing its resilience and mitigation efforts.

Importantly, this is about getting risk out of its concentrations, diversifying it into global capital markets, and so freeing those directly impacted by it to more rapidly enhance their resilience.

The insurance, reinsurance, ILS and catastrophe bond markets, as well as whatever longer-term climate risk transfer solutions emerge over the next few years, are going to play key roles in helping reduce the climate burden on society and fostering uptake of resilience and mitigation efforts and tools.

Fitch Ratings explained, “Diversification of risk, whether in the form of geographical distribution of assets, or in insurance-linked instruments or country risk pools, looks set to grow in importance as physical climate risks take hold. ”

Fitch, as a rating agency for a broad range of companies, financial assets and securities, acknowledges that climate risks are going to drive potentially major negative adjustments to some ratings, where the rated entity or asset holds a concentration type of exposure to climate related risks.

Making insurance type coverage all the more important, but at such a scale and with such diversification that will need the capital markets full support.

Risk models used by the insurance, reinsurance and insurance-linked securities (ILS) community tend to cater towards coverage and compensation for specific loss events.

But they are in most cases not doing a sufficiently robust job in helping measure climate related exposures, which can be slower in their onset and impacts.

Fitch Ratings explained, using the real estate market as an obvious example, “Longer-term climate risks to key real-estate markets are rarely priced in bonds or their underlying property insurance costs. Much of this risk stems from the slow, incremental damage that many chronic climate risks can create, particularly when coupled with more frequent and more severe acute risk events (as expected by climate scientists) and their implication for asset values and the real economy. Urbanisation in particular has led to high concentrations of human and physical asset exposure.”

All of which is driving the expansion of the climate risk protection gap and heightening the need for sophisticated blended financing tools, which take elements of catastrophes bonds and other risk linked securitization techniques and transfer longer-term risks to capital markets.

However, and back to models, Fitch notes that, “The accuracy with which exposure to long-term climate risks can be measured and modelled using existing tools and methodologies is unknown.”

Measurement is absolutely vital of course, if any market in longer-term, climate related weather and catastrophe risk exposure is to be created.

The ILS market is seen as an area able to respond to the rising physical risk from climate exposures, as well as being a potential home for certain risks to be carved out and transferred to.

Fitch cites the embedded and uninsured risks in real-estate securities transactions as an example of a location that climate risk is underinsured and the protection gap growing.

But of course this year we’ve seen an investment fund focused on mortgage investments, so real estate related assets, utilise a catastrophe bond to transfer earthquake exposure that was embedded in its strategy to capital market investors. It’s easy to consider similar being done for investment funds exposed to other climate linked disasters, including weather variables, storm activity, sea levels, rainfall, flooding and more.

If longer-term, climate linked ILS and cat bond instruments can be created, these could enable those bearing significant climate related exposure to offload some of that, or at least hedge their assets or portfolios against rising climate risks, potentially lowering the burden and freeing them to do more on the mitigation and resilience side.

Finance can’t provide any solutions to climate exposure, being physical in nature. But clever use of financial risk markets can make it more viable to operate and continue working towards risk reduction.

There’s a lot to do in this area and it’s a huge opportunity for technology, science and capital market’s financing to come together to provide solutions that enable society to work through the rising climate related risks we all face.

It’s going to become an area of focus for many of us and as a result we intend to spend a lot of time in 2021 thinking about what the insurance, reinsurance and ILS market’s can do to assist society by reducing climate risk protection gaps.