Capital Markets Gear Up For Climate Change
It might prove to be the earth's "saving grace". On the other hand, this month's Copenhagen climate change summit currently looks like being a major emission of hot air, rather than an occasion to act decisively to reduce global warming.
Since the second World Summit on Sustainable Development, Johannesburg 2002, insurance and re-insurance companies have led the commercial world in warning of the fiscal dangers attached to global greenhouse gas emissions.
This is hardly surprising, considering they're the first port of call for businesses and private citizens when floods and typhoons wreak their appalling damage.
Over the past five years, such damage has become so frequent, pervasive, and on such a scale, that insurance companies have warned they may not be able to cover resultant losses.
Some insurers have dropped out of this part of the business altogether. In 2005, the world's fourth largest re-insurer, Hanover Re, saw all its profits wiped out, thanks to claims following that year's European floods.
However, this doesn't mean that continued promotion of the root causes of adverse climate change - specifically the burning of fossil fuels - will deprive projects of future insurance cover.
Instead, capital markets (capitalists to the rest of us) are planning to increase issuance of derivative instruments (hedging), whereby bets for and against future disastrous weather events are "spread" between a larger group of speculators.
These instruments, generically known as "CAT bonds" (see Background below), have been around for a decade and a half.
But their usage has increased significantly since the dawn of the new millennium. Not surprisingly, hedge funds have adopted them, as well as mainstream investors and some insurance companies themselves.
Whether employing CATs and their kin actually results in more compensation being paid to the growing numbers of victims of climate change follies, is moot. In fact they may actually reduce access to monetary relief, should speculators engage in lengthy arguments over the nature and causes of specific catastrophes.
And many will find repugnant the idea that essentially "unnatural", human-created, disasters could be subject to rich men's betting - as if they were horses in a race.
Capital Markets Gear Up For Climate Change
30 November 2009
LONDON - As the world wrangles over how to fight climate change, with national leaders to meet in Copenhagen early next month, capital markets are gearing up to handle the consequences if the effort fails.
The insurance industry, including reinsurers, who distribute risk around the sector, has traditionally been the main way to hedge against hurricanes, floods and other natural disasters.
But climate change could increase the scale and frequency of these disasters so drastically in coming years that traditional insurance might become unable to handle the burden.
Much of the risk would have to be shifted into the capital markets, where financial instruments such as catastrophe bonds and hurricane futures may boom, and increasingly exotic instruments are being developed to spread the burden further.
"In a more volatile risk landscape, as might be produced by climate change, the need for risk transfer instruments quickly increases," said John Seo, managing principal at Fermat Capital Management.
"If we look 10 years ahead, we will see an acceleration of the need for newer, or at least more evolved, forms of insurance-linked securities (ILS) to manage reinsurer risks."
Nobody can predict with certainty the costs of climate change, but a consensus is building in financial markets that the insurance burden is likely to rise substantially. Even a successful meeting in Copenhagen might only slow global warming and an increase in violent weather patterns over coming decades.
Climate change could cut gross domestic product in countries at risk by up to a fifth by 2030, a study by the U.N.-backed Economics of Climate Adaption Working Group found this year. The hurricane-prone U.S. state of Florida could see weather-related costs knock 10 percent off its GDP each year.
A report by catastrophe modeling company AIR Worldwide, in partnership with the Association of British Insurers, said the general insurance industry might not be able to cope with the increased frequency and severity of floods and typhoons brought about by climate change.
Ten years ago, a natural disaster that could be expected to occur once in a hundred years would have cost insurers $55 billion, Seo said. Ten years from now, it might cost $220 billion, he estimated.
One result may be rapid growth in issuance of catastrophe bonds. These are ILS which insurers use to pass on potential losses from natural disasters to investors; the bonds pay interest, but if a disaster occurs and results in a specified amount of damage, the investors have to pay part of the cost.
An estimated $27 billion of cat bonds have been issued since the first such instrument was launched in 1994 -- a tiny part of the burden carried by traditional insurance. Issuance almost ground to a halt after last year's collapse of Lehman Brothers, which played a counterparty role in several cat bonds.
But issuance has rebounded dramatically in the past several months and is on track to total about $3-4 billion this year. It is expected easily to reach $5 billion in 2010, closing in on its record annual peak of $7 billion, hit in 2007.
The Lehman crisis may in fact have helped prepare the cat bond sector for growth by encouraging issuers to experiment with new collateral provisions aimed at reassuring investors.
This could eventually help cat bonds become mainstream investments, expanding the pool of active buyers beyond adventurous ones such as hedge funds to include diversified asset managers.
Another way to spread the risks of climate change is hurricane futures, which pay out to investors if the size of insurance losses exceeds a trigger level.
The Chicago Mercantile Exchange and U.S.-British insurance futures exchange IFEX have been trading hurricane futures since 2007; IFEX had its busiest-ever month for the futures in April this year, with $41.1 million in notional trades.
In June this year, Eurex became the first continental European exchange to offer the futures. They have not yet traded because of a quiet U.S. hurricane season, but Eurex is launching new contracts for 2010, aiming to attract investors who want to diversify beyond traditional asset classes such as equities.
Demand for more exotic insurance-linked instruments may also rise in coming years. They include industry loss warranties, which are derivatives triggered by the size of losses caused by an event to the entire insurance industry, and "sidecars," which capture the risk of a sub-portfolio of an insurance or reinsurance company's business.
Other exotic products being developed include temperature futures, and catastrophe-linked instruments that bear a resemblance to equities.
Some governments and international organizations, looking ahead to the burden of climate change, are encouraging development of new financial instruments to cope with it.
One example is the Caribbean Catastrophe Risk Insurance Facility, which the World Bank helped to set up in 2005. It is owned and operated in the Caribbean for Caribbean governments, selling windstorm and earthquake cover to them.
The facility said in October that it was developing an excess rainfall weather derivative that might eventually be repackaged into a cat bond to spread the risk through the international capital markets.
The World Bank estimates only 3 percent of potential losses from natural disasters in developing countries are insured, against 45 percent in developed countries, and says the capital markets are important to changing this.
"Societies are becoming more vulnerable as the risks they face become more interconnected," said Martin Bisping, head of non-life risk transformation at Swiss Re.
"The transfer of catastrophic risk should be a key element in the financial strategy of every disaster-prone country."
© Thomson Reuters 2009 All rights reserved
BACKGROUND: CATS ON A HOT TIN ROOF
By Roger Moody
International Books website
The huge losses sustained by insurers in the aftermath of hurricanes, earthquakes and tropical storms during the early 1990s, rocked the reinsurance market.
But Big Business is - if nothing else - resourceful at re-dressing old financial 'products' in order to raise new money. Hence the invention of "Cat Bonds" in the middle of that decade.
This wasn't a device to compensate one's four footed friend, stranded on the top of a battered hut in the Caribbean, or marooned in a California condo. "Catastrophe" bonds were aimed solidly at investors in capital markets: those who have enough money to buy not just the pet food, but the factory too.
The concept is really quite simple, though (one might think) only those with a certain type of intelligence could devise it.
The investor pays in capital for the bond, for which it receives interest as well as a premium issued and financed by the reinsurer. If the reinsurer can't pay out for a loss sustained above an agreed threshold, some of the investor's capital is used. But if no pay-outs are triggered, the investor walks away some time later with a generous bagful of interest, on top of the principal.
By the end of 2000, according to Goldman Sachs, the investment bank, some US$2.3 billion of these bonds were outstanding: not a negligible amount, but hardly earth-shattering.
Less than a year later - September 11 2001 to be precise - suddenly insurers' risks got notched up several levels. At stake wasn't just the ability of the big reinsurance companies to pay out on claims; there was also the parlous liquidity of their co-insuring counter-parties.
Soon, claims Michael Milette, head of "financial institutions structured finance" at Goldman Sachs, Cat Bonds were clawing their way back into favour.
By the end of 2003 the bonds were worth US$5 billion and are expected to exceed US$6 billion by the end of this year.
What's attractive about them is their high yield and the fact that they are increasingly traded by specialist cat bond investment firms, hedge funds, mainstream fund managers and insurance companies: in other words, by many of those institutions which supposedly care for our personal savings and workers' pension funds.
The buying and selling is particularly active during the hurricane season. However, none of last year's storms were severe enough to trigger payments.
Cat bonds still comprise only 5% of the total catastrophe reinsurance market, though the proportion could rise. Millette predicts that they will soon be used to cover not just climate-related disasters but third party claims associated with major industrial disasters, such as explosions at oil refineries. (Or, indeed, chemical plants and mines).
It's the same old story - albeit with a contemporary gloss.
Those who have the money speculate it and hope to reap the rewards while sitting on their arses. Even if the gamble fails, the results won't be catastrophic. It's not bond holders who are in danger of losing members of their families or their homes. The real risks are run by those too poor to secure insurance in the first place. (Ample examples can be found in "The Risks We Run", Moody, International Books, 2005)
And it's their fundamental protection which continues to be severely compromised as investors pass their money between each other's pockets, rather than towards sustainable livelihoods.
[The key source for this article is "Betting on Mother Nature's Wrath" by Richard Beales in the Financial Times July 20 2005]
[This article originally appeared on the website of International Books, publishers of "The Risks We Run: Mining, Communities and Political Risk Insurance", by Roger Moody, 2005: http://www.antenna.nl/i-books/ib/pages/006risk/006.html]
Insurance Sector Can't Cope With Climate Change: Trade Group
5 November 2009
LONDON - The general insurance industry may not be able to cope with the increased frequency and severity of floods and typhoons brought about by climate change, the Association of British Insurers (ABI) said on Wednesday.
ABI research, commissioned from Britain's Met Office and catastrophe risk modeling firm AIR Worldwide, examined the implications of 2 Celsius, 4C and 6C increases in global mean temperature on inland flooding and windstorms in Great Britain, and typhoons in China.
The ABI says a 2C is rise inevitable and this will increase average annual insured losses in Britain from inland flooding by eight percent, or by 47 million pounds ($77 million), to 600 million pounds. This would indicate a 16 percent theoretical impact on insurance pricing (with an annual GDP growth of 2.25 percent assumed).
Nick Starling, the ABI's Director of General Insurance and Health, told the Climate Change conference in London that the continued widespread availability of property insurance in the future depends on taking action now to manage the threats of climate change.
"The clear message to world leaders meeting at the UN's Copenhagen Climate Change Summit in December is that they must reach agreement on ambitious emission reduction targets.
"And, closer to home, the UK Government needs to push ahead with the Flood and Water Management Bill, and ensure long-term investment in flood management as a priority, so that the long-term flood risk is better managed," he said.
The impact of losses from weather hazards can also mean increases in insurance capital requirements, to ensure that insurers hold sufficient capital to cover the additional risks. With a 2C temperature increase, the ABI reckons additional insurance capital of 1.65 billion pounds would be required for a 200-year flood.
If insurers do not hold sufficient capital, this is likely to result in reduced availability of insurance, the ABI said.
Cyclone tracks are excepted to shift as a result of an increase in global temperatures and this could increase the frequency of storm passage over the UK.
The ABI said that even a modest systematic change in storm tracks could increase average annual insured losses from windstorms by 25 percent.
The impact of temperature change on typhoons in China was shown to be greatest in terms of associated rain. Rain associated with a typhoon is likely to increase by 13 percent, 26 percent and 30 percent under the 2C, 4C and 6C temperature increases respectively.
Professor Julia Slingo, Chief Scientist at the Met Office warned that a further temperature rise to 4C would make some parts of the world uninhabitable.
"We have committed to a different world than the one we are used to," she said at the ABI's Climate Change conference today.
"A compelling case to reduce commissions is because a 2 C increase in temperatures may be livable, but any higher would be life changing for certain parts of the world -- that is why the negotiations at Copenhagen in December are vital."
The ABI called on global governments to ensure they prepare now for "the inevitable consequences of climate change" and invest wisely in mitigation and adaptation measures.
(Editing by Andy Bruce)
© Thomson Reuters 2009 All rights reserved