Recent natural disasters, such as the catastrophic and tragic flooding in Germany and neighbouring countries are making it increasingly difficult to ignore the new reality of multi-billion-dollar loss events occurring with increased frequency and severity.
Climate risk has been on the insurance industry’s agenda for some time now, however, the ferocity of recent catastrophes serves as a stark warning bell for the industry – capacity will need to increase further and significantly. The mechanisms through which capacity is created will likely need to change also.
The industry has created innovative solutions in response to capacity issues in the past – the insurance-linked securities (ILS) market and catastrophe (CAT) bonds, in particular, were developed as a means of creating capacity following unprecedented natural disasters, such as Hurricane Andrew, in the mid-1990s.
For investors, CAT bonds have been an attractive financial instrument due to their lack of correlation with the returns of other financial market investments, such as Treasury bonds. CAT bonds have therefore proven to be a very popular alternative to Treasury bonds throughout the enduring low interest rate environment.
However, with the U.S. Fed signalling an acceleration of interest rate hikes to combat inflation and an environmental outlook that points to a new norm of record-breaking catastrophe losses, capital market investors’ appetite for assuming insurance risk through CAT bond purchases may well start to wane dramatically. A perfect storm could be brewing for the industry.
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