Climate change will drive ILS market growth
The heatwaves and the wildfires in the Northern Hemisphere in the summer of 2018 have put climate change at top of the agenda of media and politics. As we already see the adverse effects of rising temperatures, it is important to assess the impact on insurance-linked securities (ILS). In summary, the typical cat bond term of 3 – 5 years provides for continuous adjustments of pricing to encompass both climate effects and a globally increasing need for insurance. As ILS are an important mean to mitigate climate risks, we are likely to see more ILS solutions in the future.
1. The time span concerned
Typically, ILS instruments have a life-span of three to five years, which allows for adaption to ongoing climate change. The pricing at every issuance will reflect current risk based on observation natural scientific models, and insurance data. Hence, the current pricing also reflects the state of a changing climate as of today.
An increasing frequency of certain insurance events (see below) will inevitably lead to increasing insurance premiums. This could lead to primary insurers accepting higher frequency natural catastrophe events and using ILS for more remote risks. Or, it could lead to direct insurers transferring more natural catastrophe risk to the capital markets.
Either way, Entropics holds that the market and the transparency of ILS instruments is such that every transaction must be economically viable for investors itself. Investors would not buy a bond where the expected loss is not exceeded by the coupon by an acceptable multiple. This is different from traditional insurance operations, where an insurer could accept an insurance line with an otherwise unacceptable ratio between premiums and expected loss for business strategic reasons.
2. The complex relationship between climate and catastrophe events
There is widespread consensus that climate change will lead to more extreme weather events globally and that we can expect more severe catastrophes. However, this is not to say that all types of catastrophes, locations or societies will be affected in the same way.
That the climate is changing and the direction of change is an established fact. To quantify to which extent, when and where, scenarios and probability calculations are applied. It is possible calculate the risk with fairly good precision, as it fundamentally is about natural science. While some believe that this is much more difficult than calculating equity or interest rate risk, the situation is really quite the opposite.
The dominant risks on the cat bond market today are US East Coast hurricanes and California earthquakes. Of these, primarily hurricanes are affected by a changing climate.
The number of hurricanes does not necessarily have to increase, but since there is more heat energy trapped in oceans, the frequency of strong hurricanes (categories four and five on the Saffir Simpson scale) is likely to increase, and to have longer duration at maximum intensity and to cover a larger area in the future.
The assessment is based on modelling and simulation, as the relatively low frequency of the events entail a small dataset. Also, natural annual variation is a far larger than the short-term impact of climate change.
Climate change is already seen in an increased likelihood of warm weather. At Entropics, we adjust for this likelihood by annually analyzing the probability of warm surface temperatures in the Atlantic.
In combination with urbanization and increasing housing values in vulnerable areas (as many people prefer to live near the coastline), climate change could lead to more infrequent, but more costly hurricane events. Basically, this is a scenario for which ILS solutions are well adapted. We have described a a blog with an animation of this situation..
Reconstruction following hurricane Sandy in Lavallette, New Jersey. Photo: Rosanna Arias/FEMA
Concerning earthquakes, reports to IPCC link increasing seismic activity to climate change, as glaciers melt and the pressure on the earth’s crust decreases. Changes in ground water reservoirs as well as so called oil fracking also affect motions in the earth’s crust. Effects of a magnitude that would changed the probability of events covered by ILS, however, are not likely to be seen for several decades.
Events such as the frequency and the extent of wildfires are affected by climate change. This follows as the paths of low and high pressures and of precipitation change with new weather patterns. The previous and the current California wildfire seasons, in combination with many wildfires in Europe, has contributed to an increasing awareness of the threat from wildfires. Available studies indicate increasing risk of wildfires in many areas of the Northern Hemisphere, including western United States, northern Africa and northeast Russia.
Wildfire perils currently make up a small portion of the total risk on the market and are all remote. Not even the 2017 season, the costliest season on record with losses exceeding $10 billion, would have been sufficient to trigger bonds in the liquid cat bond segment by itself. The bonds that triggered in 2017 due to wildfire was multi-peril bonds following a severe hurricane season in combination with an extreme wildfire season.
As wildfire risks increase, Entropics finds it reasonable to expect that more of this risk will be transferred to the capital markets and contribute to overall growth of the ILS market volume.
Both the frequency and the severity of heavy precipitation causing inland flooding and coastal flooding are clearly increasing according to observations. Concerning rain-induced flooding, effects are not, however, uniformly distributed. Many regions already see more frequent and more severe flooding following precipitation, while others experience prolonged periods of drought.
The sea level is expected to increase following ocean warming (thermal expansion) and melting land glaciers.
Currently only a few cat bonds cover flooding. Particularly, bonds covering hurricane risks typically do not include flooding following the event. This summer, the Federal Emergency Management Agency (FEMA) issued its first cat bond covering flood events to strengthen its flood insurance program.
With the large values at stake, where most of the losses from recent hurricanes were induced by flooding, we can reasonably expect an increasing number of bonds to cover flooding and contributing to ILS market growth.
Increasing demand for insurance
Insurance penetration in most developed countries is fairly high with some notable exceptions concerning risks such as flooding insurance. In developing countries, though, there is an increasing gap between economical losses and insured losses. As incomes grow, the economic activity as well as property values increase and with that there is more need for insurance protection
This is important, not least as climate change is expected to have severe impact in developing economies. Lack of proper insurance coverage also hampers economic activity.
The failure to provide insurance can probably be ascribed to several factors, including insufficient capacity to assume large new risks, lack of modelling data for the affected regions and a lack of purchasing power.
We have already seen responses to these challenges, such as the African Risk Capacity, which offers weather insurance based on parametric triggers to the member states of the African Union. The insurance covers both extreme precipitation and extreme drought. Although not currently backed with cat bonds, it is an interesting development paving the way for further innovative solutions to expand insurance coverage to new regions.
This summer it also was evident to everyone that even developed countries are vulnerable to climate change and can be affected by “new” natural catastrophes. The consequences and insights for society regarding the need for adaption and improved preparedness is being investigated within government agencies and organisations.
While climate change and weather risk is a substantial threat to society, on many levels, the short-term impact on ILS is limited. The maturity-time of an ILS is typically between three and five years. In this time span, annual variations, for example ocean heat content and ocean currents, are the major risk factors. The liquidity of cat bonds and many ILS instruments entail that new knowledge and changing risks will be reflected by pricing mechanisms.
As risks are continuously reassessed, prices of bonds are adjusted accordingly. In fact, ILS solutions bring a market valuation of climate/weather related risks, which can also facilitate a discussion on climate investments in mitigation efforts.
Climate change, along with increasing wealth in many countries and urbanization in vulnerable areas, will likely be important drivers for increasing demand for insurance, both for existing perils and for new ones. In the longer term, increasing risks will inevitably entail increasing insurance premiums, and even higher if mitigation investments are not in place to compensate for climate change.
On a growing market it is very likely that we will see an increased use of alternative capital, both to ensure access to capital and to decrease capital costs. If anything, the ILS market is set to grow following climate change.
4. Further reading
Entropics cooperates with AIR Worldwide for catastrophe risk modelling and analysis. For further information on the science backing up the description, please visit AIR’s site on climate change.