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Opinion: Ratings agencies could play a key role in policing climate change pricing

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With COP26 on the horizon, one of the major issues facing the (re)insurance industry right now is how to get a handle on modelling and pricing for the impacts of climate change on catastrophe risk.

But as a recent S&P report highlighted, technical understanding is only half the battle here – the other existential question is how to encourage a highly price-sensitive industry to be able to build in additional costs over the longer-term, recognising the competitive disadvantage this could put them at.

The report cited research from French regulator the ACPR that suggested annual average rate increases of 2.8%-3.7% might be required to cover the additional expected costs of higher cat activity in that country.

This seems on the face of it a fairly reasonable additional sum – but could easily be the difference between either an insurance or reinsurance buyer taking more of their business to another carrier.

At any rate, S&P suggested that an “abrupt rethinking” was a more likely outcome than gradual pricing increases due to competitive pressures.

Alternatively, it suggested that there could be a kind of slow-burn Darwinian winnowing out of (re)insurers that have had better internal models because they will be better positioned to ride out near-term loss activity.

Despite its highly pragmatic tone, the report was careful to imply that this was not the first step in changing the firm’s base-case assumptions for ratings analysis, saying that it was merely intended to “facilitate dialogue with issuers about their management of climate risk”.

But surely behind closed doors, this report must be the first step towards that ultimate scenario of changing base-case assumptions. S&P and other ratings agencies must be debating the role that they will play in policing assumptions around climate change risk.

Only they, or another regulator, can essentially set the baseline assumptions that would enable carriers to confidently add in those additional charges without fearing that they will be left off signings or drop to the end of a pricing comparison portal listing.

S&P and other ratings agencies must be debating the role that they will play in policing assumptions around climate change risk

There is a huge amount of noise amongst cat (re)insurers right now about studying climate change research and applying those factors to their underwriting processes.

But our industry faces inherent challenges in quantifying current baseline risk levels and adequate pricing, due to the inherent volatility of long-term cat risk. It is understandable that getting the current price right is the immediate focus – not trying to figure out how to start adding in a loading for the future price in 2040.

Thus, while individual company boards could push change to some extent, it is really only when costs start getting real – i.e. they are built into capital charges and ratings agency scoring – that carriers will be effectively forced to measure future risks into their pricing.

Moreover, if the industry was to try to find some kind of steady-state path to adopting those loadings, to avoid a sudden shift, then it would need an external party to define the acceptable glidepath.

Beyond the importance to the industry, forcing change is also a self-protecting measure for ratings agencies to take as well. The last financial market crisis in 2008 led to hugely costly settlements for some agencies over downgrades to structured finance deals, and it is not hard to imagine a scenario that leads climate finance activists to take action against the agencies again if a major disaster prompted insurer devaluations.

As previously reported, the stress test scenario run by S&P suggested that (re)insurers would need to hold another $21.7bn in capital against a one-in-250-year catastrophe risk scenario, and $7.4bn for a one-in-10-year event.

The additional capital loading could drain 91% of the sector’s estimated $32.1bn capital buffer above AA requirements following a one-in-10-year loss.

The agency said this was based on its assumption that a $150bn insured industry loss represented a one-in-10-year return period whereas the industry was modelling this size of loss to be much less likely at return periods of between one-in-20 and one-in-30 years.

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Halfway house

This final point reinforced another finding of the survey, which again reiterates the importance of external benchmarking and forced stress testing.

This was that while a high number of (re)insurers are actively considering climate change in their pricing assumptions, delving a bit further into the responses found an uneven application and much lower levels of loading being applied.

It highlighted the fact that 71% of reinsurers were considering climate change in their pricing assumptions, but only 35% included a specific component of the price allocated to climate change.

Further, a lower 59% majority of reinsurers included in the firm's analysis reflected climate change in annual aggregation PMLs, while a surprising 41% do not.

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The amount of explicit loading can vary by region and peril, but S&P said it believed the average load was in the low-single-digit percentage range of overall pricing, adding that it “does not play a dominant role in premium rates charged by the market for natural catastrophe risk”.

In gathering this data, S&P is taking the first steps towards quantifying how the industry is managing these issues.

How fast it moves beyond these steps to start applying more use of climate change capital loadings is an issue it will be grappling with in negotiations with (re)insurers over the coming years.

But that these kind of de facto regulators will have to play an important role in that transition seems inevitable.

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