Heatwaves, droughts, hurricanes, floods... in a year of commodity shortages and supply chain disruptions, a host of extreme weather events have added stress to the system. So how do companies address the financial risks associated with these events? Catastrophe bonds and reinsurance markets have existed for a long time, but the more extreme the disruptions, the more these industries change. On this episode of the podcast, we speak to Steve Evans, owner and editor-in-chief of Artemis.BM, about recent developments, new types of insurance products and how financial markets are incorporating the effects of climate change. This transcript has been lightly edited for clarity.
Key insights from the pod:
Is extreme weather becoming more of an issue for insurers? — 4:10
The importance of modeling in the insurance industry— 7:08
Are cat bonds actually uncorrelated with markets? — 11:12
How cat bonds are priced — 14:05
What is parametric insurance? — 23:00
How are triggers on parametric insurance calculated? — 25:58
Insurance for non-damage business interruption — 29:58
Should insurers insure climate change-related risk at all? — 32:46
Impact of higher interest rates and inflation on insurance — 38:30
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Tracy: (00:10)
Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway.
Joe: (00:14)
And I'm Joe Weisenthal.
Tracy: (00:16)
Joe, do you know what day it is? It's a very special day.
Joe: (00:20)
Like, literally the day? Why don't you just tell me?
Tracy: (00:22)
It's November 30th. Do you know what November 30th is?
Joe: (00:26)
Go on.
Tracy: (00:28)
By the time this episode comes out, it will not be November 30th, but we are recording it at the end of the month and it is the end of hurricane season.
Joe: (00:38)
I didn’t realize. So this is officially when the season comes to an end? I didn’t know that.
Tracy: (00:42)
Right. It starts on June 1st and it ends at the end of November and it has been an unusual season for hurricanes. I think it was really quiet right through August. And I actually tweeted something about this, so maybe I jinxed it, but then in September we had a whole bunch of hurricanes, I think four major ones including Hurricane Ian, which was the deadliest hurricane to hit the US in two decades.
Joe: (01:08)
Yeah. This is always kind of, I mean, it's kind of random. It's interesting because I think of Florida as being like in Hurricane Alley or right in there, but it hadn't actually been hit by a hurricane in a long time. But this was a really big one. I'm seeing something that at least over $50 billion in damage. And then beyond hurricanes -- and we'll talk about them obviously -- weather and extreme weather events seem to come up a lot for us in terms of things we talk about -- climate risk, drought, the heat of rivers and lakes. Weather seems to be popping up a lot, but we haven't actually like really talked about that as a consistent thing.
Tracy: (01:47)
No. So we had this erratic hurricane season, but we also had major droughts around the world. As you mentioned, there was a drought even in, in the Northeast in places like Connecticut, which is kind of unusual. Major extreme weather events seem to be happening more often. And this kind of begs the question of how the financial industry is thinking about this because of course there is a lot of money that is related to things like the weather.
Joe: (02:15)
Right. And so we think of, you know, obviously when there is a major hurricane with people’s homes and infrastructure being destroyed, there's sort of a straightforward insurance/reinsurance cost associated with that. And then of course all these other things that create business disruptions of various sorts. Again, going back to the drought, we recently talked about [how it’s] affecting the corn market on the Mississippi River. And so yes, financial implications abound from unpredictable variations in the weather.
Tracy: (02:47)
Absolutely. And today I am very pleased to say we are going to be discussing something that we've been meaning to for a long time, which is how the insurance industry is basically handling extreme weather, and what the implications of extreme weather events are for the vast ecosystem of insurance-linked securities and products and reinsurance. There's this whole massive pool of money that is basically set up for these events, but it feels like we don't talk about it often and enough. So we're going to rectify that today with someone who talks about it all the time. We're going to be speaking with Steve Evans. He is of course the owner of Artemis, which is a publication covering the insurance-linked securities market. And he is also the owner of Reinsurance News. So really the perfect person, the perfect guest. All right. Steve, thank you so much for coming on Odd Lots.
Steve: (03:42)
Thank you, Tracy. Thank you, Joe. It's a pleasure to be here and I've been looking forward to being one of the perfect guests as an avid listener.
Tracy: (03:51)
Thank you. So maybe just to begin with, can you talk about from your perspective, from the insurance industry's perspective, does it seem like extreme weather is becoming more of an issue? Is this a topic that is cropping up more for you?
Steve: (04:10)
Absolutely. It's an area that's cropping up even more these days. I mean, extreme weather has been something that the insurance industry has provided capital to support for hundreds of years now. I mean, it's one of the major risks that the marine insurance market covered when you were heading off across the Atlantic to go and gather your commodities from overseas, you'd want to make sure that your boat was going to make it back on in one piece and storms were one of the things that you wanted financial protection against. So the insurance industry's been in this space for forever, really since the industry began.
But I guess over the last sort of two decades, it's become an increasingly important focus point, obviously with the climate change discussion alongside that as well. Now, I guess insurers and reinsures are hedging weather within many of their product sets, but then you have the specific area of the market that really interests me, which is around catastrophe, severe weather, and all of the areas you mentioned in your opener there.
And this is an area that's just become much more sophisticated, I guess. It’s probably three decades now since the first major catastrophe models came along, which were software designed to really help people not predict when weather's going to happen, but understand the magnitude of the potential impact it could have and how that would affect portfolios, whether that's portfolios of insurance risk or portfolios of property.
And I guess the advent of the cat model, which really they pretty much came out of places like universities in the States and even Silicon Valley, one of the main cat modeling firms came out of that's really helped the industry to get a better handle on catastrophe risk and help to develop the whole catastrophe reinsurance market into something that's a really meaningful piece of overall insurance capital today. And alongside that, we also have everything from weather derivatives to swaps between companies and what's called parametric insurance, which is another area of the market that's particularly interesting right now and moving forwards very rapidly, particularly with what we sort of always refer to as the InsureTech trend where tech advancements are coming into insurance carriers finally. It's taken a while, but now companies are increasingly looking at new ways to construct products to help their customers hedge risk as well.
Tracy: (06:39)
Just on the modeling point, so my impression of the insurance linked securities industry is that one of the reasons it became so big was because of improvements in weather modeling and it gave investors maybe some reassurance that they were gauging and pricing weather related risks more accurately. Has that been a major factor in the growth and development of this market?
Steve: (07:08)
Absolutely. I mean, I guess there's two types of technology that really helped the insurance-linked securities market come about. There's the advent of the cat mode,l then the sort of advancement of the cat model into the two main peak perils, which are really predominantly US hurricane risk. That's really the, the peak exposure in the whole world. But then other cyclone and storm risks around the world and then earthquake risk being the other one.
When the cat models came around, it helped companies to really understand what exposure they were taking on. So I'm thinking about the insurance and reinsurance companies of the world there and they realized that really that the capacity within the insurance market itself was probably not sufficient for the really peak events. If you think about a Cat Five hurricane barreling into Miami one day or San Francisco having a really serious earthquake event, or Tokyo, or any of the other big cities of the world, and there was a sort of a recognition that tapping into the deepest most liquid pool of capital available would be a beneficial thing for the insurance and reinsurance market.
It's already funded by institutional investors, obviously on the shareholder side, but this was seeing whether there could be the development of almost a companion source of risk capital that the companies in the insurance space could tap into. And so really the next bit of technology alongside the cat models was actually financial technology. So the plumbing of the financial world and predominantly the fund structure and securitization as well, that helped very bright people in the early days and very small companies that sometimes spun out of existing reinsurers or sometimes set up as like individual hedge fund type managers.
And they started to construct financial instruments that would allow catastrophe risk to be contained within them modeling to be put against that, to develop the understanding for that risk and to enable a price to be put on it as well. And then that was issued out in a form that was investible. And so these sort of niche little hedge funds that set themselves up and started to target the space could build portfolios for their third party investor base. So I think without the cat models it would've been very hard to see the ILS market, as we call it, developing.
Joe: (09:47)
So I have a short question first, but how big are these markets that we're talking about?
Steve: (09:53)
So it’s very difficult to give an accurate number, it's changing all the time with events and things like that and with inflows and outflows, but it's been estimated that global sort of reinsurance capital has been somewhere around the $600 billion-ish mark for a few years. The ILS capital within that is anywhere between$ 80 to $100 billion depending on which type of structures and funds and things like that you include within it.
Joe: (10:22)
So a thing that I maybe heard once or that my understanding is that part of the appeal of investments that essentially lose money when there's a big catastrophe is that, you know, people are always seeking uncorrelated returns and so much of the economy is correlated because when there's a recession and everything is hit all at once and the physical catastrophes, whether they be hurricanes or earthquakes or other storms, are a type of risk that is not going to be cyclica,l related to the economy because hurricanes can happen in recessions or booms. And so does it work out like that in practice? In theory, I get that. That makes total sense. In practice, do securities that are linked to extreme events properly exhibit these sort of uncorrelated payout structures?
Steve: (11:12)
It's a very good question. Definitely the lack of correlation is an important aspect that attracts investors to the space. Now I say lack of correlation because I don't think any anything is ever fully uncorrelated when you're talking about potentially world changing events. So a good example actually is the Tohoku earthquake and tsunami in Japan. Now that was a very major insurance market event. It had some impact to the ILS market including to a number of catastrophe bonds, mostly in mark to market losses for the cat bond market, but there were some drawdowns of principle as well.
And when that event occurred, there was a decline in Japanese equities. There was a decline in the Japanese economy and things like that, but that all bounced back quite quickly. So I think predominantly natural catastrophe and weather risk are diversifying. I would never say totally uncorrelated because I think when the biggest sort of market moving events occur in the nat cat space, they're still going to move some indices, but the recovery from the event should be far, far quicker. And so it's really a very, very far tail risk correlation. I would say a lot of people talk about ILS as being lightly correlated or loosely correlated rather than being completely uncorrelated. And I think investors should really be educated to the degree that a correlation could occur, but it's probably not going to be something that you really need to worry about in the overall scheme of your portfolio.
Tracy: (12:47)
I remember this was something that came up when I was writing about the World Bank’s pandemic bonds, which failed to trigger [in early 2020], and you know, one of the selling points for those was, well buy pandemic exposure -- it's going to be uncorrelated, but then you have this massive global pandemic and the markets absolutely dropped and it turns out that, you know, it was rather correlated.
But okay, Steve, a related question. Can you talk a little bit about the pricing of cat bonds or other insurance-linked securities and products? Because this is also kind of a sensitive point, which is you want it priced enough that investors are going to come in and buy these things because they feel they're being accurately compensated for the risk that the bonds are potentially going to get written down to zero or something like that if there is a major catastrophe. But at the same time you don't want the payout to be so rich that it becomes uneconomical for the insurers or the governments who are actually issuing these things. So how are people thinking about that pricing aspect, especially as we get more extreme weather events? Are investors demanding more of a return for taking on this risk?
Steve: (14:05)
Sure. A very timely question because right at this point in time, certainly investors are demanding more return. There's been a particularly difficult number of years for the global reinsurance market as a whole. And whenever the reinsurance market has significant losses from severe weather or catastrophes, then the ILS market will take share because it is providing a significant proportion of the capital these days. So since 2017, obviously we had a severe hurricane season that year. We've had wildfires, floods, more hurricanes, some earthquakes, a number of other events, and there have been losses and now the losses haven't been enough to significantly dampen investor demand until you start to get repeat years. And actually we have seen a decline in investor demand through this year, but that's also happened at exactly the same time as we've had some financial market pressures. Obviously there's the war, Russia's war in Ukraine going on, and then you've got inflation as well.
And all of this has kind of come home to roost in one single year for the insurance market. And as a result we see reinsurance rates and pricing going up and in tandem rates for insurance-linked securities are going up as well, because insurance-linked securities are essentially largely providing capital either to an insurance or reinsurance arrangement. And so the pricing kind of follows the pricing of the traditional insurance and reinsurance market to a degree. Now there are some capital efficiencies in terms of being able to tap diversifying sources, being able to distribute risk into an enormous markets such as the capital markets as well, which can give some sort of capital efficiencies as well. But then there are additional costs sometimes with issuing insurance-linked securities because they are financial securitization structures and so they do have additional costs attached to them sometimes as well.
But the pricing does sort of tend to follow traditional reinsurance. And I guess the one thing that everybody in the insurance industry will always point to, particularly when it comes to climate sort of variability and climate change and how the risk might be changing over time, is that typically these are transactions on the traditional reinsurance side, they might be one-year to three-year. On the insurance-linked-security side, they might be sort of two to five years in tenure. So you are getting a chance to reprice that risk. Now within an insurance-linked securities transaction, there's also what's called an annual reset as well, where a sponsor can adjust the profile of risk that's covered in the transaction. But at the same time, the metrics that are used to calculate the coupon payment for the investors also get adjusted as well. So as the risk changes, you get a chance to reprice the risk when you either renew a contract or you reset a contract.
And so the idea is in an ideal world, the pricing would keep up with the changes. Now when the whole industry feels like perhaps it's been sort of underpricing for a little while, which I think is something that most of the industry would recognize that we had some particularly big sort of inflows of capital. We also had some particularly benign years in terms of catastrophes through the sort of 2010s, right up to sort of 2017 when suddenly the hurricane season exploded and we had three major storms all in a row. And I think now it's taken a few years for it to sort of sink in that there really is a need for higher pricing. Alongside that, without a doubt there appears to be changes in sort of frequency of events and potentially severity as well. But also some climate scientists would say that the overall sort of the way a hurricane exhibits its damage might have changed or might be set to change with climate change as well in terms of potentially carrying more water, potentially storms getting bigger, that sort of thing.
So there's a lot of money spent on both the traditional catastrophe models that the industry's used now for about 30 years or so, but also increasingly on climate models and climate simulations as well where people are trying to look ahead 20 to 40 years, to try and see how the impact of storms such as hurricanes might change over a broader period of time. And really there's just a lot more research nowadays with better technology being available as well to try and help people to price risk better, but also to perhaps ensure that the pricing is more sustainable over a longer period of time as well.
Joe: (18:55)
Yeah, I want to just talk further about that because I guess, you know, part of the appeal of investing in this space is that there's just going to be some randomness, we talked about this sort of lightly correlated market and you might have a year or two of very extreme hurricanes and then you might have years and years where Florida and other major property areas really don't get hit much at all. But I would imagine that if there is a sort of significant climate change element to this, that perhaps some of this randomness could go away or that, you know, could get worse and worse in some sort of maybe predictable trajectory. Can you talk a little bit more about the sort of intersection of extreme weather risk with the climate modeling that you're talking about, and how it changes the industry if there's a perception that some of these things aren't random and that there are trends that are going to sustain themselves for years to come?
Steve: (19:51)
That's actually quite a difficult question to answer to be honest with you. Without talking to the people with the money or the underwriters on the ground. But I guess my response to that would be that the industry is certainly looking far ahead now in terms of the research and analysis that they're doing and they're really trying to understand where the trajectory of events is going. But it can be very difficult to pinpoint that in any exact way. And Tracy began this by saying that this year's hurricane season was a little strange. Now some of the forecasts in advance of the hurricane season from the main meteorological agencies were predicting huge numbers of storms and we just didn't see that. So you really can't go out and buy your protection based on a forecast. You've got to look at sort of recent history plus factor in your forward looking climate science and try and come up with something reasonable for the next season or two seasons or three seasons.
Now I'm sure at the at the CFO level of the big insurance companies, they're thinking much further ahead and wondering how they're going to adjust their pricing to accommodate the potential climate of the future. But I think on the sort of underwriting side, the people who are sort of analyzing, underwriting and then pricing these risks, they're thinking about the duration of the contract and what could happen within that period of time. And there's other factors out there that have really been as damaging in some ways in terms of losses as the events themselves in some cases. And I'm thinking here about elements like social inflation, litigation alongside inflated prices and how that that is affecting property sort of rebuild costs and things like that. There's a lot been going on over the last five years, which has all sort of coincided with a particularly challenging period of catastrophe activity as well. And when hurricanes have hit Florida and the industry's been hit by what we tend to call loss creep a lot of that loss creep has ended up to be down to litigation. There's a lot of people who would call some of that litigation at least to be driven by fraud and that really has inflated some of the claims payments that insurers make, which results in insurers claiming more back from their reinsurers and would even result in some insurance-linked securities potentially paying out in return for inflated loss costs that come through.
Tracy: (22:39)
Maybe this is a good time to ask you about parametric insurance as well because this is something, you know, I've written a little bit about cat bonds in the past and the World Bank’s pandemic bonds, but parametric insurance is something that I've seen come up increasingly in recent years, but I don't actually have any idea what it means. So what is that exactly?
Steve: (23:00)
Sure. So essentially insurance is usually what we call an indemnity-based product where it's a promise to make somebody whole again when something happens that meets the terms of the contract, and the making whole is subject to certain exclusions and things like that as with any insurance contract might be. That works really well obviously for your average insurance consumer. It also works well for insurers buying reinsurance as well and they will do that on an indemnity basis as well. Parametrics really came into the industry, it’s well over two decades ago when we first saw them come into the marketplace and they're basically an insurance contract that will trigger based on the parameter of an event. So it's some kind of data input -- be that wind speed, earthquake intensity, ground movement from an earthquake flood depth temperature there.
There's so many different triggers out there now in the parametric world, these are much more applicable in developing economies because there's often a lack of insurable interest on the ground. So there may not be very much insurance in force, but a sovereign government, for example, could buy direct protection that pays out based on a parametric index of how much moisture has fallen in that year, in that country and that that's now quite a popular product in places like Africa. But there's people in Florida on the coast who will buy parametric protection to cover their condos or their hotels or golf courses or whatever, they may be against a hurricane of a certain wind speed moving through a specific area of the coastline that's going to be close to where they're based.
For me parametrics are something that I'd love to see continue to develop at the pace they're now beginning to, because it's really accelerated over the last few years. There's some really good technology companies come into the space trying to build better parametric triggers, trying to build software for it, trying to automate claims payments to some degree as well because that's the other beauty of a parametric trigger that there's no need for a lengthy claims assessment. You don't have to send an adjuster out to look at a property, for example, to assess how much damage has been done. You can just see from the data input that it's above the level that is required to trigger the contract and trigger a payout. And then there's usually a third party who'll validate that in some way. So claims payments can be as quick as, I mean they're usually in the sort of two- to four-week range, but I've seen them made in in 24 hours for certain parametric contracts, which is really fantastic because it means you can make somebody -- not whole because they're buying a certain amount of protection -- but you can certainly deliver the capital they may need to help them recover far, far more quickly.
Tracy: (25:58)
It does seem like the triggers for the payouts on parametric insurance products… So I understand you're trying to make specific parameters or data points that get hit by an event so that you have these automatic payouts, but it does seem like getting the triggers right would still be an issue, right? Because the investors would want to see something that they think isn't likely to happen and then the people who are actually selling those products would want to have them set so that there is a realistic chance that if something happens they would get that additional money. I don't know, it just seems like it would be slightly complicated to figure those out.
Steve: (26:44)
It's certainly complicated and I think this is an area that the industry struggled with, for a while when parametrics first came around, they tended to be quite simplistic in the way the triggers were structured. One of my favorites was Tokyo Disneyland, the theme park…
Tracy: (27:02)
I love Tokyo Disneyland, it's the best Disneyland.
Steve: (27:06)
Don’t we all. They actually bought a catastrophe bond back in the late nineties, I can't remember the exact year, but it was called Concentric Limited. And the reason it was called Concentric was that the people who structured the deal drew three circles around the center of Tokyo Disneyland. And if an earthquake occurred within those three concentric circles that worked out from Disneyland, you'd get a different payout depending on which circle it fell in. Now of course, if the earthquake epicenter was outside the furthest circle there could still be some damage. They may not get any payout at all of course, but that's really something that the buyer of the protection I guess has to reconcile with themselves and really they're buying this as kind of, a form of just in time capital that's going to come in when the worst thing possible happens. There's some really sophisticated insurance buyers out there now who buy parametric cover as well and they'll buy their traditional property insurance tower, all of their other liability and commercial coverages and then they'll buy some elements of parametric cover just really to provide them with capital inflows should the really bad events that they don't want to see happen occur.
There's some good examples of this in Japan again where around earthquake risk retailers and things like that will be buying an element of earthquake parametric insurance protection so that if there's a bad earthquake anywhere in the country, they know it's probably going to mean that they either can't get their stock in, they can't open, they lose power, all these bad things could happen to them, but the parametric insurance might pay them $20, $50, $100 million in a very quick period of time to help them recover. It's also very good in areas such as the developing world where aid inflows can actually be much slower than we might think. I mean, when you look at how fast aid flows into an area that has drought or famine, it can take months before there's any real buildup of capital. If their government can afford to buy or can get donors to pay the premiums for parametric protection, that can actually flow into the country much more quickly.
Joe: (29:17)
You mentioned drought in Africa and we started talking about this conversation that some of the things we've talked about drought in the US particularly with the Mississippi River and then also elevated water levels due to heat waves, which are a really big story in Europe over the past summer and we had some episodes where we talked about the effect that that is having on nuclear plants that need the cool water from the river so that they cannot dump the hot water safely. Are those types of things also insured against in some way? Like are their products structured around all of these risks or would something like that be too niche really to have a, you know, financial infrastructure around it?
Steve: (29:58)
Sure, the river level one is a very good example because there actually have been some parametric insurance products covering the riverine for, specifically, the ability of shipping companies to continue moving up and down the river easily and delivering their their goods. I don’t know whether they triggered or not, but I know that the river levels did get very close to where I understand the triggers to be last year. I don't imagine there's a huge amount of capacity deployed into those sorts of risks. They are quite niche but certainly they can now be protected against something, can be structured to do exactly that.
On the nuclear power plant issue, again, if it's based on river levels then there certainly are people out there providing insurance on that basis already today. I think where parametrics get really interesting for the future for me are around what we call non-damage business interruption. So this is where something happens that impacts businesses and it's not a physical damage incident, but there's something that has a knock on effect. If you can start to put some understanding around those potential events that could cause those effects, then you can possibly start to put parametric triggers around them as well. And there are some people looking at this quite seriously right now, both around sort of financial effects that could affect businesses, but also the knock on effects of other events in the world that could hurt businesses. So things that cause shipping delays for example. There are certainly companies out there looking at those sorts of risks as well.
Tracy: (31:35)
I want to ask a sort of existential question about this entire space, which is, you know, obviously as we get more extreme weather related events, more natural catastrophes, you could see why people would want to have this kind of insurance in place. But on the other hand, one of the criticisms I've seen of catastrophe bonds, and I guess this would extend to parametric insurance as well, one of the criticisms is that if you are offering more protection against extreme weather, then maybe that will disincentivize people from planning effectively for climate change or maybe changing their own behavior. The classic example of this is whether or not we should be providing insurance for people to build beach houses on the coast of Florida, right? Or whether we should not offer insurance for that risk because we know that climate change is going to happen and those houses are going to get swept away at some point. Is that a valid criticism in in your opinion?
Steve: (32:46)
Is it a valid criticism? I mean the insurance industry's provided protection to industries that perhaps some of us would certainly think nowadays maybe shouldn't have ever had that protection because it's enabled their businesses, to some degree I suppose. And that's really been the way of the insurance industry, that they will sell protection to people for the right price. But it actually now speaks to a couple of things that are happening in the industry which I’m particularly passionate about. One is around resilience. So there are a number of initiatives around the world. Again, these are largely in developing economies at the moment, but I think we'll start to see this, and actually we are seeing this increasingly in developed world as well, but in a slightly different way. And this is around the terms of your insurance coverage also requiring you to do something that's going to increase your resilience to those events as well.
So whether that's, you need to have a resilience plan in place, you need to have a plan for how you are going to deploy that money should the insurance pay out. And you need to demonstrate that that's going to go to the right people, particularly in the case of sovereign risk transfer where a government or country is buying it. But alongside that there's also sort of examples where people are being encouraged to put in place things that will help them to keep flood waters out of their property for example. And that can be tied into an insurance sale. Cyber risk is another interesting area because the cyber insurance market is growing very fast. It has capacity issues because obviously it's an enormous risk that's actually quite hard to model in a lot of ways. So there's only a certain number of people who really want to put capital down for that.
But most of the sort of the big large commercial cyber insurance agreements of the world will have an element of cyber risk protection into them as well. There'll be cyber software, there'll be cyber security reviews, there'll be penetration testing, all sorts of things that go on as you buy your cyber insurance policy. And some of them may be conditional on whether you can actually buy that policy or not. If you are not willing to demonstrate that you are making some efforts to prevent cyber sort of exploits occur within your business, you may find it harder or you may pay more for your cyber insurance protection.
Joe: (35:07)
So I just have one more question and it relates to climate change and it also sort of relates to ESG and government regulations because you know, I feel like okay if I'm thinking about insuring against hurricanes or flood risk in Florida, then I might be concerned about climate risk and whether that's going to amplify the number of highly destructive hurricanes in the future and I have to model that out. But then the other thing I feel like that is always changing is not just the hurricanes itself, but how are the laws going to change and how are regulations going to change? And so essentially the risk of a different legal framework or, you know, we just had the latest climate conference in Egypt and some new rule that comes out of that. And so, not necessarily the extreme weather itself, but that governments say to some industry, you can't do this or you can do that, or you have to price this higher, you have to pay this tax or something like that. How much of the thinking is related to the straightforward risk of extreme weather as opposed to sort of like various mandates that may change the nature of business going forward as a result of governments trying to take action on climate change?
Steve: (36:23)
That's a very interesting question. Obviously there's a lot going on in the climate sort of legislative arena at the moment and insurers are kind of exposed to that to a degree, I suppose. I guess it's another input that really needs to – and [it might] be difficult to model for -- but needs to be considered when they model and price their business. And the other thing is that the insurance and reinsurance industry are incredibly engaged in most of those discussions where they can be as well, and certainly there's some areas that the insurance and reinsurance industry might actually see potential future opportunity coming from, such as climate disclosure. So if the, say for example the Fortune 500 companies and the largest businesses in the world, all have to start to disclose their weather exposure on their balance sheets or something because that comes out of a COP conference. Obviously if you start to disclose that kind of thing and your shareholders are seeing these potential big negative numbers on your balance sheet, even if they don't manifest it's still something that really any sensible business owner should be taking steps to protect against. So there's also potentially going to be more demand that comes out of climate legislation as well. I mean demand for risk transfer and insurance itself.
Tracy: (37:43)
So we've been focused on, on the weather and climate change for obvious reasons, but there's another thing happening which has an impact on the insurance industry as a whole and that is just higher benchmark interest rates in general. Can you maybe talk a little bit about what that means for the insurance and the reinsurance market and, I guess the other big question would be, given the combination of we have this expectation that there will be more extreme natural disasters in the future, plus interest rates seem to be trending higher for the foreseeable future, does that just inevitably mean that insurance rates are going to have to go up? Like is that our inevitable future?
Steve: (38:30)
I mean while inflation remains at 10% then just the cost of everything that potentially gets damaged is going up significantly from property to everything that you own. And as a result, insurance costs will go up to cover those items that we all love and want to want to keep. But I guess going back to the start of your question there, the interest rate aspect, there's certainly a negative initial effect on the insurance and reinsurance industry in terms of how it affects some of their portfolios of assets on the bond side. That has caused some sort of decline in in industry capital due to some of the volatility we've seen in financial markets, so through this year so far. But most of that will would be expected to be recovered as obviously the instruments all move towards maturity and yields increase on them again in the insurance-linked security space.
Interest rates are very relevant there as well because, say a catastrophe bond, the return that investor gets is based on the coupon, which is the risk spread. So how much they're getting paid for the risk they're taking on. But then there's also the return from the collateral because these are fully collateralized instruments. So a hundred percent of the collateral is usually invested in something like a Treasury money market bond or something like that. So it's a very safe asset. Now all of those assets are floating up with rising interest rates, which means that the returns from catastrophe bonds rise on top of it. And so that's a maybe a positive for the investors there and also something that keeps the insurance and securities market still appealing even while other asset classes around the world are obviously inflating their returns as well.
The question of does insurance have to keep rising? I mean I think that's the inflationary factor really there and it's certainly something that, right now, that's one of the key drivers for rates and we're expecting next year, well the January renewals, which is the time of year when sort of 60% to 70% of global reinsurance gets renewed, they're going to see a what we would call a hard market. So steep increasing rates, people are projecting sort of anything up to 20%, 30% increases, particularly for property catastrophe risks. More broadly in areas like liability, there will still be increases it seems like even though there hasn't been the severe loss experience there. But then inflation obviously affects things like court judgment payouts and litigation costs. And so I would imagine that the more inflation is entrenched. the more costs for the insurance industry rise and therefore the more customers would have to pay for it as a result.
Tracy: (41:19)
All right, Steve Evans, thank you so much for coming on Odd Lots, I'm glad we could finally have this conversation. You know, we've covered weather from a real economy perspective, but we haven't actually done it from a sort of financial industry perspective. So thank you so much.
Steve: (41:34)
Sure. It was my pleasure. Really great to talk to you both and I hope that was interesting!
Joe: (41:38)
Yeah, very much so. Thank you so much.
Steve: (41:40)
Thanks Joe. Thanks Tracy.
Tracy: (41:56)
So Joe, I found that conversation to be fascinating. I do think, I guess I come out of it with more questions because it does seem like, you know, there is really this -- there's always this tension in insurance between paying enough that investors want to take on this risk without making it sort of prohibitively expensive. But then also when it comes to a lot of the catastrophe bonds and weather-related insurance, it seems like there is this added factor of should we be insuring some of these risks at all?
Joe: (42:28)
You know, I say if people want to pay for the insurance, like people build on the Florida coast, you know. I don't think it should be like subsidized or it should be free, but you know, if people want to pay for it…
Tracy: (42:42)
Well there's also the question, and we didn't get into this with Steve, but you have seen a lot of governments and states issuing catastrophe bonds selling those to private investors and it does, this is something that I vaguely remember came up with the World Bank pandemic bonds as well, but it does beg the question of should the government be paying investors [to take on these risks], you know? Well, it's not that impressive anymore, but three or four years ago it was impressive, a 6% yield on a bond instead of just borrowing themselves directly in the market.
Joe: (43:14)
Yeah, we need to do a whole thing on municipal finance because once you start getting the question of like, well why is there like these specific bonds or why they, then, yes, maybe we could do a sort of state and local government financing episode because I have a million questions about that.
But you know, there were all kinds of, you know, in terms of things that Steve talked about, I want to do more on like software and just modeling software and the software comes up in a lot of our conversations. There's that, it also it comes up in the semiconductor conversations that we have. So I feel like I want to learn more about the software side of all this.
Tracy: (43:53)
We should talk to AIR, which are the big modeling guys for a lot of cat bonds. And then we should also talk to, on a related note, we should talk to the third party pricing services for bonds. No one ever talks about them. Okay. So this is an episode in which like we've come away with what? Three more episodes that we need to do?
Joe: (44:13)
At least three more. And you know, just on the one thing that I keep coming back to is like, okay, if you have insurance on some level, you sort of expect it to be mean reverting, you sort of expect things to be random. These sort of like un diversifiable risks that you need these big pools of capital out there to protect you against. But I do wonder, you know, if there are certain areas particularly related to climate change in which the expectation is that there is some sort of extreme weather event that is going to march steadily worse and worse over time, that there is no natural mean reversion, that there is less chaos and randomness. It does make me wonder like the degree to which some of these industries will be upended.
Tracy: (44:53)
Totally. And there are all sorts of philosophical questions thrown up by this as well, which is of course insurance can be a really effective way of actually altering behavior – like maybe you shouldn't build houses on a beach in Florida, and whether or not they're going to be partnering maybe with
Joe: (45:19)
Yeah. I'm glad we finally had it.
Tracy: (45:20)
Shall we leave it there?
Joe: (45:21)
Let's leave it there.
You can follow Steve Evans on Twitter at @steve_e.