How reinsurers are grappling with climate change
Whether from primary or secondary perils, losses from natural disasters have now exceeded cat budgets for some years in a row. The frequency and severity of events have exceeded our expectations, usually based on internal and vendor cat models. Efforts have been made using multiple granular economic and risk data to better understand what and where the insured values are (including density, inflation and business interruption), but we are forced to recognize the changing nature of events we face.
Even if what we are seeing is the consequence of previous decades of unmatched access to resources, global warming is an ongoing process, and we’re trying to contain it within a very different time horizon than the one used to calculate budgets.
Regulators, investors and rating agencies are all inviting reinsurers and insurers to try and quantify the effect of climate change in their portfolios, over different time horizons and scenarios. Market exercises have already been carried out in some countries to quantify the effect of future climate path scenarios, and the associated expected loss ratio and probably maximum losses (PMLs). This requires a significant amount of work, from selecting and collecting appropriate data, and weighting it correctly to derive the most probable climate outcomes by 2050. A deep understanding of the physics in climate change is also needed.
But currently, do we sufficiently reflect the effect of climate change in our rates online or related nat cat charges today? For many reasons, I think we do not.
Precise geolocalized data are not used in every market. There are still a lot of markets dealing with aggregated data, that are then redistributed from land use maps. This provides a greater amount of uncertainty for those perils like flood, for which granularity of geolocalized data is so important. There is also a need to have regularly updated data, especially in some fast-growing areas where new residential, commercial and industrial properties are springing up all the time. This is particularly important when it comes to coastal flooding and sea level rise.
Reinsurers often used to assume that climate change had been implicitly taken into account with confidence in the versioning, from either agencies or internal climate expertise, mainly due to the yearly duration of contracts. But the versioning is not annually updated, so techniques changing the frequency of events in the existing catalogues have been developed in order to measure changes in average annual loss, occurrence exceedance probability, and aggregate exceedance probability; climate change attribution science (medicanes -- also called Mediterranean cyclones -- or extreme droughts followed by extreme floods) has been developed and is sometimes delivered with post-event responses, but there is still a part for the unmodelled. There is a clear need for the industry to get an ‘easy to use’ climate change tool from modelling specialists.
We used to balance our portfolio considering mutualization in space and in time, counting on a diversification effect with a continuity approach. Regulations validate that approach through capital requirements. But we are now in a situation where we have observed, for several years in a row, places experiencing either wildfires or floods. Temperatures and rainfall records are regularly broken. This is impacting some regions where reinsurability (and insurability) is becoming a question mark (even with public-private parternships). Furthermore, this is impacting not only property risks, but clearly also agriculture and health, and for some regions, political risk and liability as well. There are domino effects with positive correlation between lines of business, probably after reaching some unknown thresholds, that our chief risk officers are looking at.
The different reactions of the industry are wide-ranging: from decreasing property and agricultural exposure substantially, to reinforcing their PMLs, taking the capacity crunch as an opportunity. All in all, there is a true hardening in the cat portfolio driven by supply and demand.
This move has even greater impact on the market when demand is increasing, for different reasons such as inflation, financial losses in 2022 reducing the size of balance sheets of buyers or obviously, because of global warming issues.
What is true on the retro and primary market side is also becoming true on the reinsurance side. This is fair, considering retrocession is clearly challenging since the last 1/1 renewal, and will be the same for the coming one. But what is new is the fact that reinsurance is definitely going to experience the same trend for 2023 and years after.
With some exceptions, capital is not flowing any more and property cat capacity is becoming scarce at each and every level. This impact pricings, but also wordings. One very relevant example is the willingness of reinsurers/retrocessionnaires to ask for named perils in the contracts or to extend the list of exclusions.
This is, in a way, what we have seen in the ILS market, with a shift of investor strategy going back to cat bonds and ILW instead of the likes of collateralized quota shares bringing its share of attritional losses. This makes it simple for risk takers to understand the kind of losses to anticipate, and level of capital trapped, because global warming is not that easy to deal with.
Reinsurers are also involved as investors in order to facilitate the transition to a low carbon economy. To be able to do that, they need to measure regularly the sustainability of their investment portfolios, commit with goals clearly stated, and follow the pathway taken to adapt. They are helped by regulations with extra-financial reporting, as in Europe, the sustainability-related disclosures in the financial services and EU taxonomy. We are all trying to avoid stranded assets as we also try continuing to be relevant, reinsuring, avoiding stranded risks.
Last but not least, reinsurers invest a lot in people, in science, and in research and development, in order to better understand and price the risks they reinsure, but also to mitigate them, investing with public authorities in prevention. On a broader view, they try to understand how the societies (objects, people, nature) will evolve in different climate scenarios, with a preference for the ones that avoid water wars!