Climate change inflates losses up to 2.50% & premiums don’t cover it: Credit Suisse ILS

After the publication of the latest Intergovernmental Panel on Climate Change (IPCC) report earlier this year in August, the Credit Suisse Insurance Linked Strategies team has analysed its findings on climate trends related to severe weather catastrophes and tried to quantify their impacts on the global insurance, reinsurance and insurance-linked securities (ILS).

climate-change-tipping-point-ilsThe Credit Suisse ILS team believe this is the first time anyone has tried to quantify the annual inflation of insurance losses due to climate change for the reinsurance and ILS markets.

Their analysis also sought to quantify the possible effects of a warmer climate that further increases extreme weather events on the re/insurance industry over the next 20 years.

Niklaus Hilti, Head of Credit Suisse Insurance Linked Strategies, and Georges Bolli, Risk Aggregation & Management at Credit Suisse Insurance Linked Strategies, explained the findings of their study, which make for interesting reading for anyone writing climate-linked catastrophe risks, which of course is the majority of the insurance-linked securities (ILS) market.

The research suggests that the annual inflation of losses to property insurance lines because of climate change is around 1.35% to 2.50%, dependent on the exposure, region, type of natural peril covered, as well as the seniority of the reinsurance transaction itself.

With this in mind, the soft market phase between 2013 and 2017 resulted in a “heavy burden for margin adequacy” for insurance, reinsurance and ILS interests writing climate-exposed catastrophe contracts, the Credit Suisse ILS team believe.

Leading them to conclude that the insurance and reinsurance industry, including the ILS market, has not increased premiums sufficiently over the last two decades.

Their study looked at:

  • What are the most important extreme weather events for (re)insurance and ILS and what are the climate change trends observed for these risks?
  • Do the risk models used in the (re)insurance and ILS industry correctly reflect those trends?
  • Are market participants pricing climate change into their products?
  • Are (re)insurers and ILS investors adequately compensated for climate trend risks?
  • Are there ways to manage climate trends in (re)insurance and ILS?
  • What is the outlook for the industry and how will the already inevitable further temperature increases impact the profitability of the global (re)insurance and ILS industry?

Positive rate momentum experienced since 2017 was much-needed and continues to be, with the Credit Suisse ILS team stating that, “The reinsurance market (including ILS) cannot afford to have lower risk-adjusted premiums going forward,” with climate change related loss inflation likely to keep driving impacts higher for the sector.

“Considering the inflation of insurance losses, risk-adjusted premiums will have to increase on average by at least 2% every year just to remain risk neutral (from a climate change perspective) in the future,” the Credit Suisse ILS research suggests.

But more positively, their study found that, “The inflation of insurance losses due to climate change is captured by the vendor model we included in our assessment,” which is key, as least the industry is using models capable of accurately factoring this in.

The Credit Suisse ILS team conclude, “Ultimately, we are convinced that it will be essential to apply strict measures and take decisive steps in managing the risks within ILS portfolios to make them resilient to inflation of insured losses caused by climate change.”

Adding that, “We believe that a combination of de-risking and higher premium levels is key for the reinsurance and ILS markets.”

Interestingly, the research undertaken by the Credit Suisse ILS team also looked at how climate related inflation could affect the trigger probability of instruments such as industry loss warranties (ILW’s), finding that suggested increases in hurricane intensity would increase the default probabilities for ILW’s, especially in the tail of more severe events.

Also, combining the climate trend related inflation estimate, of up to 2.5%, with other inflationary factors such as exposure growth, means that the industry could actually need a 4.75% to 6.40% increase in their risk-adjusted premiums each year in order to remain risk neutral, Credit Suisse’s research suggests.

Studying historic trends in ILS instrument pricing, for catastrophe bonds and ILW’s, the Credit Suisse ILS team found that rates have not been keeping up with increasing risks, from climate change and non-climate related inflationary factors.

What’s absolutely key, going forwards, is to ensure that the pricing, of insurance, reinsurance and ILS contracts, covers loss costs, cost-of-capital, expenses and a margin, as we’ve often said.

Here, loss costs should include pricing adequately to cover inflation caused by climate change and the industry needs to ensure that this is caught up with, as pricing may currently be running behind climate trends for some perils.

Credit Suisse ILS team state, “The reinsurance and ILS markets have to react decisively now and demand annual increases in risk-adjusted premium levels in order to at least remain risk neutral with regard to climate change.”

The study suggests that catastrophe bonds have been doing the best job of keeping this inflationary pressure in-check, as rising attachment points and deductibles have helped to reduce the risks covered, even though margins have been under the same pressures as the wider reinsurance industry has seen.

However, risk-adjusted premiums of cat bonds need to increase by roughly 2% per-annum to keep pace with inflationary loss trends, the Credit Suisse ILS team say.

“We believe that over the coming decades, premium increases and/or de-risking will be pivotal in keeping up with climate- and non-climate-related inflation,” the Credit Suisse team insist.

The team provide a number of recommendations:

  1. Reinsurance transactions with low attachments could become a “no-go area”, while “even transactions attaching at higher levels have to be monitored carefully for adequate rate increases to stay risk neutral.”
  2. Cleaner structures, named perils and clearly defined coverage are key in managing exposure.
  3. Occurrence transactions are likely to be more attractive than aggregate.

“As overall risk assumptions in the natural catastrophe (re)insurance business are expected to change, and with nonstationary climate risks evolving and adding more complexity, the importance of maintaining a sophisticated understanding of these trends and translating those into progressive underwriting capabilities is becoming more and more important. In our capacity as an ILS investment manager, we believe that we are in a good position to take proactive measures to respond to these trends and sustainably manage ILS portfolios for the challenges ahead,” Credit Suisse ILS’ research concludes.

You can view the full research, including some of the data behind it here.

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