ILS and broader securitisation key to absorbing nat cat risk: Schroders Capital

The increasing need for capital to manage and mitigate natural hazard risk is creating strong opportunities for investors, according to Schroders Capital, who emphasises that by allocating to catastrophe risk through insurance-linked securities, broader securitisation, and other risk-transfer markets, investors can secure attractive returns by absorbing catastrophe risk when pricing reflects expected losses and required margin.

A new report from the firm has outlined that as insured losses from natural catastrophe events continue to rise and insurance capacity becomes more constrained, risk is being redistributed across households, lenders, capital markets, institutional investors and governments, which is ultimately creating a wave of new transmission channels and investment considerations.

“Economic exposure has increased: there are more assets and individuals in coastal regions and other exposed areas, and higher construction costs driven by labour and material inflation. As a result, the financial impact of individual events is simply greater today than it was some decades ago. Climate-induced hazard changes amplify that trend,” Schroders Capital explained.

Nevertheless, the firm outlines that aligning how risks are quantified and interpreted is a key step towards implementing more robust physical climate risk management across various sectors.

“Given the insurance industry’s enabling role for other economic activities, that approach should be closer to the way insurance has assessed risk: probabilistically, distribution-based, and with explicit acknowledgement of uncertainty,” Schroders Capital said.

Adding: “For investors, this means that one never invests only in an insurance product or a real asset, but also in a model, and in the manager’s ability to apply that model as one of a number of decision inputs – and to analyse, understand and consistently manage tail risk.”

Moreover, the firm acknowledges that changes within public-sector data provision, combined with growing complexities and prevalence of physical risks, is creating a stronger case for innovation in catastrophe modelling.

According to Schroders Capital, one clear opportunity lies in the expansion of private data ecosystem and alternative proprietary data, such as through satellite imaging, sensor networks, geospatial datasets.

All in all, there are numerous areas of innovation that are growing, across the likes of machine learning, hybrid and scenario-based modelling.

As natural hazard risk continues to intensify, Schroders Capital notes that the capital markets are increasingly being recognised as not only being a mechanism for absorbing financial losses, but also as a key source of financing for adaptation and resiliency.

The capital markets offer a variety of risk transfer and dissemination opportunities, focusing on redistributing the materialisation of natural hazards rather than a reduction in the underlying risk; spreading losses across a broader pool of investors and improving the capacity of the overall system to absorb shocks. Key examples of which include insurance-linked securities and catastrophe bonds.

Highlighting the effectiveness of ILS towards nat cat risk, Schroders Capital said: “ILS are a clearly defined mechanism for transferring natural catastrophe risk into capital markets, providing reinsurance capacity in a fully collateralised and structurally transparent manner. Triggers and payout conditions are contractually defined, and the maximum loss is limited by the collateral posted. Expected loss, tail risk and diversification effects determine the spread required by investors.”

At the same time, Schroders Capital’s report outlined that ILS can also play a “stabilising role” given its ability to provide additional capacity when the price is right, whilst also emphasising that the capital is sufficiently opportunistic to withdraw when risk-return relationships no longer fit.

“By providing capital for peak risk and supporting efficient price discovery, ILS improves the resilience of the reinsurance risk transfer chain,” the report reads.

Adding: “For institutional investors, ILS offer access to an attractive risk premium, typically with low correlation to traditional financial markets and business cycles. They are not, however, a risk-free haven. Investors assume natural catastrophe risk – including model limitations, parameter risk and tail exposure. That is precisely why the quality of models, data and risk management is central to this asset class.”

Schroders Capital continued: “From our perspective, a significant share of value is created where a robust own view of risk is genuinely applied and used to inform portfolio construction: through consistent interpretation of models, including sensitivities and tail analysis, selecting optimal investment structures, and ongoing monitoring of the key parameters. That is essential if the risk-return profile is to be managed transparently in an environment of evolving models and changing climate signals.”

Whilst the global protection gap continues to grow, Schroders Capital also points towards how private equity can complement insurance mechanisms by mobilising capital in order to help close the gap.

The report outlines that private equity has the potential to tackle structural market failures in climate insurance, such as underdeveloped insurance ecosystems in emerging markets, where they face notable challenges such as insufficient data, inadequate modeling and distribution, as well as issues related to affordability and accessibility.

“The opportunity sets can be both earlier stage/growth investments in climate adaptation technologies and data platforms, as well as scaling established platforms in insurance, insurtech and financial intermediaries. Whilst private equity focuses on risk origination, distribution and technology, it can complement the likes of insurance-linked securities, which acts more as a risk transfer capacity enablement,” Schroders Capital added.

As natural hazard risk continues to shape capital allocation across financial markets, and insurance capacity becomes more selective and physical risks become more financially material, investors are likely to encounter these exposures across a growing range of asset classes.

“The increasing need for capital to absorb, finance and reduce natural hazard risk also creates compelling investment opportunities. From providing catastrophe risk capacity through insurance-linked securities and broader securitisation, to financing more resilient buildings and infrastructure, or investing into businesses developing adaptation solutions and services, investors can access structural sources of return while contributing to a more resilient financial system. Those best positioned to capture these opportunities are likely to be managers with deep expertise in natural hazard risk and sustainability, understanding of local market dynamics and needs, and a demonstrable ability to apply models thoughtfully, rather than simply rely on them,” Schroders Capital concludes.