Climate change could present more threat than anticipated to insurance industry: Standard & Poor’s

Insurers’ capital positions could be affected by lower investment income and higher capital requirements, as well as by an anticipated increase in weather-related claims due to climate change, Standard and Poor’s Rating Services said in an analyst article earlier this week.

The insurance industry recognizes climate change as one of its top emerging risks and many insurers consider the potential consequences of the latest scientific findings for their operations, said the analyst article on S&P Capital IQ’s Global Credit Portal website. However, the article said, insurers do not typically view climate change as a major threat to their day-to-day activities as they anticipate that their ability to reprice and renew non-life policies annually offers them protection against increases in weather-related claims attributed to climate change.

“In Standard & Poor’s Ratings Services’ view, climate change may present a wider range of threats for insurers,” the article said. “Taking into account those effects that we currently consider to be quantifiable, our analysis indicates that insurers’ capital management will be sufficient to manage the additional strain of a reduction of about 0.5% in capital adequacy per year, possibly at the expense of dividends being 5%-10% lower.”

The effect of a sudden climate change shock, however, could test the industry, the article said. For example, if market values are adjusted to incorporate the expected lower returns under climate change, it could reduce insurers’ capital adequacy by up to 10%, S&P said.

S&P’s analysis used a recent study by consultancy The Mercer Group, which indicates that climate change has implications for investment returns, and thus for earnings. The ratings firm also used analysis from Risk Management Solutions Inc. (RMS), a catastrophe risk modelling company. RMS has reviewed likely changes to common perils, and considers that there is strong evidence that climate change will worsen the effect of tropical storms, which could increase capital requirements.

“In our view, climate change could affect insurers’ prospective capital adequacy through reducing earnings and by increasing the level of required capital, if its impact is not anticipated,” the article said. “Earnings will be affected, not only by the potential for higher weather-related claims, but also through lower investment returns. We have also allowed for a possible increase in required capital as a result of increased volatility in weather-related claims.”

Overall, if the impact of climate change is gradual, it will erode insurers’ capital adequacy by about 0.5% per year. Still, insurers’ capital management tools should be effective in handling the additional strain of climate change, the article said. However, managing the repercussions of climate change may require insurers to balance maintaining capital adequacy against meeting the profit expectations of their shareholders.

“We anticipate that insurers could reduce their dividends moderately, slow growth rates, or increase their use of risk mitigation techniques such as reinsurance. Taking these actions may have consequences for insurers’ risk/return profile, reducing their expected shareholders’ total return and dividend income by about 5%-10%.”

The investment impact appears to be more material than the weather-related impact across all four types of insurers analyzed – one offering insurance and reinsurance and operating in the London market (the reinsurer), a multiline insurer, a life insurer and a non-life insurer. The estimated climate change impact on the life and multiline insurers, which are more exposed to investment risk, is slightly higher than that on the other two (an average annual capital impact of 0.5%, versus 0.3%-0.4%). Even for the non-life insurer and the reinsurer, the investment impact is bigger than the weather-related, representing 70% of the total impact and 60%, respectively.

Although there are negative impacts of climate change, there could also be benefits for the insurance industry, the article said. For example, the climate change debate may improve risk awareness, which could lead to governments, corporates and individuals taking better risk mitigation measures.

“This could, for example, reduce weather-related losses at insured properties,” the article said. “Increased risk awareness may also increase demand for insurance, even in less-developed insurance markets. As a result, insurers’ geographical diversification would widen. Better diversification could lead to more stable insurance portfolios that required lower levels of capital,” article concluded.