Impact of climate change and inflation trends on the Cat Bond market
Looking at rising insurance losses worldwide, investors are increasingly concerned about the potential impact of climate change on the Cat Bond market. Indeed, looking at historical data of insured losses, there is a clear trend towards higher insured losses. However, most of the increase in losses is not due to climate change, but to demographic trends, namely steep increases in population density, insurance density, inflation, wealth, and building quality in exposed areas (e.g., coastal regions of the U.S.). Catastrophe risk models - used to value Cat Bonds - reflect these developments by continuously adjusting the underlying risk assumptions.
With regard to climate-related trends, we conducted a detailed analysis in 2021 based on the latest IPCC report, with the aim of quantifying climate trend risks and the corresponding loss inflation per year and risk category (where relevant for Cat Bonds). Based on this, we conducted various stress tests to understand the extent to which risk models already take climate-related loss inflation into account, and we have taken various measures to minimize climate-related inflationary trends*.
Looking at non-climate-related inflation trends, notably current increases in construction or repair costs can have a significant impact on the amount of insurance claims in the event of a natural catastrophe. Therefore, it is critical to adequately consider these trends and trend forecasts in the risk assessment process.
Consequently, in order to properly assess the risks, it is critical to closely analyze and understand the features and weaknesses of the risk models. Where appropriate, Cat Bonds should be remodeled to incorporate specific factors (both climate and non-climate inflation trends) to obtain a realistic, risk-adjusted valuation to better assess the attractiveness of cat bonds.