A recent study completed by the Met Office that was commissioned by the Lloyd’s of London specialist insurance and reinsurance marketplace, supports the notion that independence in re/insurers’ internal models for weather events across the globe is appropriate, suggesting no need to hike required capital levels.
The collaborative research and analysis from the Met Office and Lloyd’s is in response to some in the regulatory community arguing that extreme weather events across the globe might be more interconnected than previously believed, questioning how appropriate the assumption of independence of events is.
As insurers and reinsurers are required to hold a certain amount of capital to cover their exposures, the belief that extreme weather events are heavily interconnected could result in regulators increasing required capital levels for market players.
“This requirement would tie up funds that could otherwise be allocated to new business development, such as developing products for new threats e.g. cyber risks,” explains the report.
Key findings from the report, titled ‘The Risk of Global Weather Teleconnections,’ are that most perils are not significantly correlated, and that Lloyd’s modelling concludes that nine peril-to-peril teleconnections (correlation between meteorological or other environmental phenomena that occur a long distance apart) were not sufficient enough to warrant changes to capital levels.
Furthermore, even where there is some correlation between weather patterns, this doesn’t necessarily mean that high insurance losses will follow and, extreme weather events may still take place at the same time, regardless of any link between them.
“An assumption of independence for capital-holding purposes is therefore appropriate for the key risks the Lloyd’s market currently insurers; and the methodology released in the report enables scenario modelling across global portfolios for appropriate region-perils,” explains the report.
Head of Exposure Management & Reinsurance at Lloyd’s, Trevor Maynard commented on the report; “The report’s findings go a long way to answering the challenge that capital for local risks should be held in their own jurisdictions.
“Lloyd’s believes this approach reduces the capital efficiency of the re/insurance market by overlooking the heart of insurance and the diversification benefits provided by writing different risks in different locations, and in doing so, needlessly increase costs to the ultimate detriment of policyholders. Insisting on the fragmentation of capital is not in the best interest of policyholders.”
Lloyd’s and the Met Office collaborated to develop the innovative methodology for assessing the interconnectedness of extreme weather events globally. To develop the methodology, 16 peril regions were selected in relation to their relevance to the Lloyd’s marketplace, and the Met Office identified 22 ‘Earth System Drivers,’ such as El Nino & La Nina, that may be connected to these peril regions.
“The Met Office selected nine of these based on characteristics of influence and seasonality that related most closely to answering the question of independence posed by Lloyd’s. The next stage involved analysing the various interactions between perils and climate drivers, which showed the extent of the potential connections between weather events,” explains the report.
So according to the analysis and research efforts of the Met Office and the Lloyd’s marketplace, an assumption of peril region independence is currently appropriate for reinsurers when modelling extreme catastrophe risks around the globe, suggesting that no additional capital level requirements are necessary.
“This important finding supports the broader argument that the global reinsurance industry’s practice of pooling risks in multiple regions is capital efficient and that modelling appropriate region perils as independent is reasonable,” concludes the report.
Commenting on the report, Professor Dame Julia Slingo, Chief Scientist at the Met Office said; “This report demonstrates the continuous improvement our understanding of connections between climate drivers and regional perils across the globe.
“When we add this to our cutting-edge capabilities in simulating the global climate to the local weather and in deploying these for more skilful long-range predictions, we can help re/insurers model multiple, and possibly teleconnected, scenarios and more effectively manage their portfolio of risk.”
Of course, while the study suggests that weather peril interconnections are not sufficient to cause a reassessment of reinsurance capital levels, or indeed reinsurance usage for insurers, there are weather patterns which are clearly connected, due to jet stream patterns and the like.
So it’s important that insurers, reinsurers and ILS fund managers are aware of the meteorological science surrounding connections between differing weather phenomena, even if not sufficient to result in changes to how their capital models are assessed.