Is climate change a threat to insurance-linked bonds?

Savvy investors are constantly looking for new ways to diversify their portfolios, and the ongoing search has led many to look at insurance-linked securities (ILS). We look at one of the key questions surrounding the asset class.

13 August 2015

Executive summary

A question often asked by clients considering an investment in ILS is whether climate change will have a negative impact on the asset class. The answer is not straightforward.

Climate change will not necessarily have a negative impact on an ILS portfolio or on the ILS market as a whole, nor does it make these instruments more attractive. However, there may be some positive side effects.

Although climate change has undeniably had an influence on the frequency and severity of certain natural catastrophes, its impact on insurance-linked instruments is more limited than one would expect at first glance.

ILS performance is primarily driven by the occurrence, or absence, of natural catastrophes. It seems logical that the risk level of these instruments would be significantly changed by a global warming trend.

However, the key here is the word ‘trend’. Climate change is a gradual and long-term phenomenon, whereas ILS are typically short-term instruments.

The market will change, but don't lose sleep over it

Individual insurance-linked instruments will only be marginally impacted by climate change.

These securities have certain features which mitigate the impact that climate change could have on their risk level or overall attractiveness. Over the longer term, climate change is one of many elements that shape the overall ILS market.

Other factors that play an important role are:

  • Building standards
  • Demographic changes
  • The pricing
  • Attachment levels of insurance-linked instruments

These other medium to long-term weather patterns can have a more pronounced effect on an insurance-linked instrument over its relatively short tenure than climate change itself.

In the long run, the impact of climate change may lead to higher (re)insurance demand, both in regions which are already exposed and in new geographical areas.

This could result in a broader and deeper ILS market due to new investible risks becoming available.

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