In focus - Markets
What will climate change mean for insurance-linked securities?
ILS has close ties to natural disasters but we believe climate change will have a limited impact on the asset class.
A question often asked by investors considering investing in insurance-linked securities (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.
The climate change debate
The last two years have been a period of intense natural catastrophe, or “nat cat”, activity. In the Atlantic, 2017’s hurricanes Harvey, Irma and Maria and 2018’s hurricanes Florence and Michael led to considerable damage in high insurance penetration areas. Over the Pacific, major typhoons such as Hato, Jebi and Mangkhut struck China and Japan. Apart from cyclones, destructive wildfires caused significant damage in California, burning a record amount of structures.
The contribution from climate change to the severity of these events is under continuous discussion. Its potential impact on the rapid intensification of cyclones1 - and extreme precipitation associated with cyclones (e.g. Harvey or Florence2) – are debated. Wildfire risk studies point out the expansion of wildland-urban interface (WUI), where homes are increasingly built in hazard-prone areas3.
The two recent active hurricane seasons in the Atlantic have followed a record-long hurricane drought of almost 12 years. No major hurricane had made landfall in the continental US since the record-breaking 2004 and 2005 seasons. These different pictures of seasonal activity highlight the challenge to define what “normal” looks like for Atlantic hurricane activity.
Information on the overall warming of the earth’s atmosphere since the 1950s, as well as the human influence – via the use of fossil fuels – and the effects on oceans and the arctic ice caps, has been well publicised.
Tremendous efforts have been put into researching the effects climate change may have on the frequency, severity and tracks of extreme weather events around the globe. In its special report in 20124, the Intergovernmental Panel on Climate Change (IPCC) – the leading international body for the assessment of climate change – provided an overview of the current findings on climate change effects on extreme events.
The report highlighted the uncertainty around the observations, citing agreements and disagreements across the findings of various research centres. Some findings seem to agree on a possible increase in the number of hurricanes in the Atlantic basin, but others indicate that climate change could also lead to a decrease in the number of hurricanes making landfall5.
Climate change effect: the time scale mismatch
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, we believe the impact is more muted than one would expect at first glance.
The key here is the word ”trend”. Climate change is a gradual and long-term phenomenon, whereas ILS are typically short-term instruments. Most catastrophe bonds have a term of three years, and private transactions linked to natural catastrophe risk typically provide cover for 12 months. Over such periods, climate change should not have a discernible influence on the risk level of an insurance-linked security as modelled at the inception of the instrument.
The graph below, from a 2013 World Bank report, shows that climate change is at the long end of the spectrum of possible weather-related financial events. It will impact the ILS market and its composition in the long term, but not individual ILS instruments or portfolios on an ongoing basis. The effects of climate change on the ILS market over multi-year or multi-decade periods needs to be assessed in combination with its secondary effects: supply-demand dynamics, (re)pricing or upward moving trigger levels and shifts in insured exposures.
The climate change timeframe
Source: World Bank
Climate change impact: market exposure and risk pricing
Climate change only impacts a part of the ILS market. Only ILS covering natural catastrophe risk are potentially impacted. Within this category, only weather-related insurance risks are affected. Other natural catastrophe risks such as earthquakes – a key driver of “tail risk” for the overall ILS market – are not really affected. The same is true for tsunamis caused by earthquakes below the seabed or volcanic eruptions.
Catastrophe risk models are designed to help assess the economic impact of natural disasters on a given instrument or portfolio. This is achieved by calculating the probability of losses for all types of natural events such as cyclones or earthquakes, including those of magnitudes that have not been observed in the past. These models rely on a range of potential natural catastrophes listed in a so-called 'event catalogue' which are simulated based on historical observations.
To account for possible climate change effects on the frequency or severity of natural events, catastrophe models can apply an alternate view of the risk. Users can put more emphasis on risk as modelled using current or most recent climate conditions. Modelling for tropical cyclones could thus emphasise warmer, contemporary sea-surface temperature patterns, rather than considering the complete sea-surface temperature records from the last 150 years. This would provide a more up-to-date representation of the potential risk from tropical cyclones.
In cases where the effects of climate change would lead to increased frequency or severity of weather-related events in covered areas, the affected instruments will not necessarily become more risky. If risk levels rise over time, ILS investors with modelling expertise would be able to model accordingly and could command a higher risk premium to compensate.
New research findings are embedded into modelling software constantly. The software used by the issuers of insurance-linked instruments is, in the case of catastrophe bonds, provided to prospective investors. If issuers are unwilling to accept higher premiums described above, climate change could instead translate into higher attachment levels (the loss level where investors start to incur losses), or other risk-mitigation measures.
Finally, the insured values protected by the ILS market are typically property. Assumptions of greater damage from climate change also assumes that the durability of the property does not change. Buildings in areas prone to natural catastrophes could be built or retrofitted to higher engineering standards over time, and therefore better able to withstand these events.
In the past 20 to 30 years insured losses related to natural perils have certainly increased. Researchers agree that the main driver of this increase in losses is the shift of overall exposure and demographic growth. There are simply more people with insurance living in areas prone to natural catastrophes such as coastal areas or cities close to earthquake fault lines. Urbanisation and a higher concentration of values in these areas leads to higher potential losses from natural catastrophes. This is a key driver for the ILS market: a higher insurance density leading to higher exposure.
Global warming may lead to higher frequency and/or severity of certain extreme weather events in some regions. If these are densely populated areas – either already exposed or newly exposed – this could lead to an increased demand for (re)insurance over the medium-term which is beneficial for ILS markets. It should either lead to higher premiums paid or to a wider market with an increased opportunity set.
Given the short-term nature of the natural catastrophe ILS market and the short spread duration, premium increases will not directly impact ILS portfolios. However, as these will take place gradually, investors will benefit from reinvestment at higher yield levels over time.
1. Bhatia et al., 2019: Recent increases in tropical cyclone intensification rates. Nature Communications.↩
2. Hall and Kossin, 2019: Hurricane stalling along the North American coast and implications for rainfall. npj Climate and Atmospheric Science.↩
3. Radeloff et al., 2018: Rapid growth of the US wildland-urban interface raises wildfire risk. Proceedings of the National Academy of Sciences, National Academy of Sciences.↩
4. IPCC, 2012: Managing the Risks of Extreme Events and Disasters to Advance Climate Change Adaptation↩
5. Wang, Liu, Lee, and Atlas, 2011: Impact of the Atlantic warm pool on US landfalling hurricanes. Geophysical Research Letters↩