November 28, 2016 by Canadian Underwriter
Extreme weather events can be modelled as “independent” by global reinsurers when assessing many of their key aggregate risks around the world, confirmed a new report from Lloyd’s, the world’s only specialist insurance and reinsurance market, and the Met Office, the United Kingdom’s national meteorological service.
Released late last week, the report, titled The risk of global weather teleconnections, analyzed the links between extreme weather events occurring in separate regions of the world that can take place over a range of timescales from days to years (known as teleconnections).
Lloyd’s said in a statement on Thursday that Met Office research found that the majority of perils are not significantly correlated, but identified nine noteworthy “peril-to-peril” teleconnections, most of which are negatively correlated. In this context, peril-to-peril means the interconnection between risks, for example, the potential for a hurricane in the United States and a flood in China to occur as the result of one another, the statement explained.
The Met Office research analyzed the impact of nine (out of a pool of 22) “earth-system drivers,” such as El Niño, on 16 priority region-perils. The region-perils include, among others, flooding, windstorms and wildfire in Australia; tropical cyclones in the northeastern part of the United States and the east coast of Canada; and tornadoes in the U.S.
Lloyds’ modelling found that the studied correlations were not substantial enough to warrant changes to the amount of capital it holds to cover extreme weather claims. “An assumption of independence for capital-holding purposes is therefore appropriate for the key risks the Lloyd’s market currently insures,” the statement said. “Even when there is some correlation between weather patterns, it does not necessarily follow that there will be large insurance losses. Extreme weather events may still occur simultaneously even if there is no link between them.”
Trevor Maynard, head of exposure management and reinsurance at Lloyd’s, said in the statement that the report’s findings “go a long way to answering the challenge that capital for local risks should be held in their own jurisdictions. Lloyd’s believes this approach reduces the capital efficiency of the (re)insurance market by overlooking the heart of insurance and the diversification benefits provided by writing different risks in different locations, and in doing so, needlessly increase costs to the ultimate detriment of policyholders.”
The report concluded that “the assumption of independence between weather events in models used by the insurance industry remains appropriate. Only nine of the 120 peril correlations analyzed in this study showed any significant links, and the links can be both positive and negative.” For example, the study confirmed the study confirmed that while the El Niño-Southern Oscillation influences the majority (14 of 16) of regional weather perils, it also reduces the impact of 10 of the 14 perils for three months of the year.”
The results of the modelling demonstrate that an assumption of region-peril independence is currently appropriate for use in modelling extreme natural catastrophe risks. “This important finding supports the broader argument that the global reinsurance industry’s practice of pooling risks in multiple regions is capital efficient and that modelling appropriate region perils as independent is reasonable.”