How climate change may affect insurance-linked investments
An opportunity for long-term investors. Climate change is set to be one of the defining drivers of the global economy in the years and decades ahead. Whether action to reduce emissions intensifies or temperatures continue to rise, the challenge has profound implications for all investors.
During the Schroders Sustainability & Climate Change Seminar 2018, several experts presented their views on the importance of considering environmental, social and governmental (ESG) factors when making investment decisions.
Zeba Ahmad, Alternatives Director at Schroders, touched upon investment opportunities within the insurance-linked securities market and how they relate to the topic of sustainability and climate change.
Insurance-linked securities (ILS) are an alternative source of capital for insurance and re-insurance companies. To protect themselves from very large natural catastrophes, such as hurricanes, typhoons, earthquakes, tsunamis, thunderstorms, wildfire and flood, players in the insurance industry may use the ILS market to balance risk. The creation of this asset class, which allows for a direct transfer of reinsurance risk to the capital markets, was a result of the devastating Hurricane Andrew that caused $26.5 billion of damage on the south-eastern coastline of the US in 1992.
Ahmad points out that this asset class will provide a natural diversification of risk across different regions and different threats. “You need a combination of accumulated wealth and perils in a region to have large insurance exposures. Not surprisingly therefore, much of ILS will be exposed to North America and to a lesser extent Japan, Europe and Australia.”
Furthermore, she points out that wind risks are seasonal; the hurricane seasons of June to November is when the bulk of returns from ILS are made. “Over the last few decades, the occurrence of truly catastrophic events has not been as frequent as investors might think” Ahmad said. “From 2002 to 2017, catastrophe bonds (a sub part of the ILS market) have, for instance, been able to generate an annualised return of 7.6%, similar to the S&P500 Total Return Index, with a much more limited volatility of 3.2%”.
Even during the largest catastrophic events since the creation of the Swiss Re Cat Bond Index in 2002, drawdown losses have been limited with, for instance, a short-lived 6.5% correction in September 2017 when Irma and Maria caused substantial damage to Florida and the Caribbean. “Overall, positive months have occurred 92% of the time. As long as there is not a big negative event, there is a good chance that you will get an attractive premium over the money market with almost no interest rate duration risk. In addition to this, the ILS market has shown good decorrelation with major asset classes.”
Even if the reality of climate change is well accepted, it is unknown how this will influence the occurrence of natural catastrophes, Ahmad points out. “We do not know yet to what extent the different regions will be exposed. For instance, it is currently not certain that hurricanes will become more dangerous or prevalent in the years to come. Furthermore, new zones of perils will likely be created. “All in all, the biggest driver of economic loss going forward will be related to demographic changes and the migration of people towards the riskier zones on the planet, which results in the growth of wealth and insured values in exposed areas.”
Finally, many homeowners in the US remain under-insured. “For instance, in California, at least half of residential houses are still not insured against earthquake risk, so there is quite some potential for the market to grow in the future”, concludes Ahmad.
“ILS provide a nice diversification from traditional asset classes with good compensation per unit of risk, and climate change does not seem to threaten these instruments going forward.”
ESG at Schroders
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Insurance-Linked Securities at Schroders
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The views and opinions contained herein are those of Zeba Ahmad and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds.
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