October 18, 2021 by Jason Contant
Global reinsurers could be underestimating climate change exposure by up to 50%, according to a recent analysis by S&P Global Ratings.
“Our scenario analysis suggests that reinsurers’ estimates of their exposure to natural catastrophe risk — and therefore physical climate risk — could be underestimated by 33%-50%, which is 91% of the sector’s buffer above the ‘AA’ capital requirement,” S&P said in a report released in late September. “While not our base case, this scenario illustrates significant potential for volatility in earnings and capital.”
Unmodelled risks and the inherent difficulties in attributing extreme events to climate change create the risk that climate change may not be fully reflected in catastrophe modelling, particularly in the short-term, S&P noted.
An S&P survey of 17 rated insurers found that 71% of responding insurers consider climate change in their pricing assumptions, but only 35% include a specific component of the price allocated to climate change. This ranges from 0%-10% of the rate charged on average, and “does not appear to be a significant determinant of market pricing,” the ratings firm said.
To understand the possible effects of climate change on reinsurers’ financial strength, S&P applied a simple stress scenario based on 30 years of insured loss experience from catastrophes (1990-2020).
S&P’s research found that the reinsurance industry could be underestimating its exposure by about 33%-50%. “This is because our empirical scenario suggests a $150 billion insured industry loss at a one-in-10-year return period while, based on the exposure from the top 21 global reinsurers, we assess that the industry is modelling this size of loss to be much less likely at return periods of between one-in-20 and one-in-30 years.
“This is less frequent than under our empirical scenario,” S&P said. “The 33%-50% uplift would bring the industry’s one-in-10-year view in line with our empirical scenario.”
For more recurrent events (typically below the one-in-50-year return period), there is a risk that exposure might be underestimated, the ratings firm said. “For return periods beyond this point, where there is actually no data point in recent history, we think it is difficult to quantify potential underestimation. Nonetheless, we believe that under our scenario, very extreme losses — such as a one-in-200 or one-in-250-year event — would likely be underestimated, and we have assumed a shift of the risk of a similar magnitude.”
This means there is a material increase in the amount of capital (re)insurers will need to hold for their catastrophe exposures (that is, the one-in-250 catastrophe charge), to the tune of $21.7 billion in aggregate for the industry.
In addition, the modelled exposure to a one-in-10-year event for the industry would increase by at least $7.4 billion in aggregate. These additional capital considerations would deplete 91% of the sector’s estimated $32.1 billion excess capital buffer above the ‘AA’ capital requirement after a one-in-10-year loss.
S&P said that while it recognizes the limitation of a simple scenario with a relatively short 30-year period against a stochastic model, “we believe it is possible that the risk of extreme events may be underestimated when using data that comes from a period when climate change had less of an effect on the underlying weather risk. Therefore, the outcomes from the scenario provide us with a starting point for a dialogue with re/insurers about their modelling assumptions.”
Feature image by iStock.com/piyaset