Impact of climate change on ILS market expected to be marginal: Schroders

Underscoring the potential impacts of climate change on the insurance-linked securities (ILS) market, analysts at global asset management group Schroders have suggested the effects “should be marginal” given climate change is gradual and long-term in nature, while ILS instruments typically have a term of one to three years.

In a recent report on the matter, co-authors Dr Christophe Etienne, Senior Nat Cat Specialist, ILS, and Beat Holliger, Senior Products and Solutions Executive, ILS, noted it is key to consider that climate change directly impacts just a portion of the ILS market.

The analysts added, “Only ILS instruments covering natural catastrophe risks are (potentially) impacted, and within this category, just weather-related insurance risks are affected.

“Other natural catastrophe risks such as earthquakes are not exposed to climate change. The same is true for tsunamis caused by earthquakes below the seabed or volcanic eruptions.”

The analysts observed that the risk level of ILS instruments is certainly exposed to any global warming trend, however, they highlighted the significance of the word “trend”, stating that climate change is a gradual and long-term phenomenon, while typical ILS instruments are short-term.

They continued, “Most catastrophe bonds have a term of three years, during which they are tradable in the secondary market, while private ILS instruments typically have a 12-month risk period.”

The co-authors also said that while there is some evidence that climate change is contributing to the frequency and severity of weather-related natural catastrophes, there are a number of other factors driving insurance losses “which need to be incorporated into any risk assessment of ILS instruments such as catastrophe bonds.”

“While climate-related hazard events are an essential component of risk, so is exposure,” the analysts explained.

They went on, “Along with urbanisation, people continue to settle in hazard-prone areas, not only in major cities but, for example, along coastlines. This growing accumulation of asset values obviously increases the odds of a major loss from an event which hits these regions.”

Elsewhere, the pair noted that the inflationary environment most of the world has been facing since early 2020 has had a notable impact on the prices of goods, including on construction and replacement costs.

“Insurance companies have taken measures to incorporate these inflation effects in order to adequately value their physical exposures. From an ILS perspective, properly understanding how these underlying inflation assumptions are factored in is key to avoiding an underestimation of both the exposures and the associated modelled financial losses from potential natural catastrophes,” the analysts said.

In closing, Schroders’ analysts reiterated, “Insofar as climate change impacts ILS instruments, the effect should be marginal given climate change is gradual and long-term in nature, while ILS instruments typically have a term of one to three years.”