As one of the largest re-insurers in the world with circa 43,000 employees across the globe and over EUR 50bn premium income in 2015[i], Munich Re has felt the repercussions of climate change on its business model. The company has managed built a solid basis for future business success by diversifying its business across property/casualty (P/C) vs. life/health (L/H) insurance markets, and several geographies (US, Europe, Asia). More importantly, however, Munich Re has become a thought leader in innovative risk modeling for natural catastrophes and product offerings on the P/C side of the business.
Re-insurance companies are affected by climate change, because of the increased probability of high impact natural catastrophes and thus increasing direct costs via higher damages. Pricing for re-insurance is heavily reliant on knowledge of these exact probabilities. Research suggests that climate change is shifting the probability distributions of natural catastrophes, such as hurricanes, blizzards, etc. to the right[ii], increasing the cost for re-insurers. However, data implies that probability distributions of disasters occurring are also getting more skewed[iii], i.e. showing fat tails, please see below[iv].
These developments make underwriting increasingly difficult for re-insurance companies. An easy example of the egregious impact of even the slightest change in weather patterns for hurricanes highlights the challenges climate change imposes on this industry: a change of 5-10% in wind speed during hurricane season will lead to damages amounting to roughly 0.13% of total US GDP[v]. Similarly, in a worst case scenario assuming a change in average temperature by 3-4 degrees Celsius, damages caused by natural catastrophes (e.g. flooding) would quadruple in the UK[vi]. Munich Re outlines its expectations for the average damage caused by several natural catastrophes[vii]:
Rising Value at Risk numbers have a direct impact on Solvency ratios imposed by regulators and thus on profit margins of the entire industry. For instance, a single Atlantic Hurricane disaster, as outlined above, would wipe out 20 % off the solvency ratio which as of 2015 stood at a comfortable 302%, please see exhibit below[viii]. This impact is more powerful than a 30% drop in equity capital markets and a negative FX effect of 20% combined which illustrates the dramatic impact of climate change on the re-insurance business model, as well as the need to innovation.
There are several levers to address this challenge:
- First of all, re-insurance companies need to find superior investment solutions to add investment income as a buffer in high loss years. This has been particularly difficult during the recent low yield environment. Munich Re with its in-house asset management company MEAG has increasingly switched its investment exposure to alternative investments, such as renewable energy and infrastructure which offer attractive characteristics, such as long durations, stable (often government regulated) cash flows matching their long-dated liabilities, and relatively high yields. However, the low yield environment has impacted several other industries, especially pension and sovereign wealth funds in similar ways, such that the competition for alternative investments has most recently driven up valuations, thus providing increasingly limited yield upside for Munich Re.
- In addition to that, Munich Re has outsourced parts of its tail risks to the capital market via so called ‘cat bonds’ (catastrophe bonds). These bonds allow Munich Re to better manage specific risks. Once a niche market, cat bonds have become increasingly popular for a whole range of risks. However, cat bonds introduce a certain risk for cannibalization in the re-insurance industry. Munich Re is slightly mitigating this risk by positioning itself on both sides of the Cat Bond market, issuing bonds for both clients and its own book, which further diversifies its revenues[ix]:
- Most importantly, however, Munich Re has been at the forefront of climate change research, building a climate change research center, a world class NatCat Service database for its clients, and started offering insurance solutions for renewable energy insurance coverage, crop failure insurance[x], etc.
NGOs, such as Ceres, have ranked Munich Re among the top 3 re-insurance companies[xi] in 2014regarding adherence to ESG criteria and it has received substantial external recognition for its continued efforts as a responsible investor and thought leader on climate change solutions.
In my opinion, Munich Re’s message to shareholders and customers alike would profit from an additional commitment on the product side: phasing out underwriting for carbon intensive industries. However, this sector continues to be profitable and Munich Re Syndicate Limited is actually one of the market leaders in the overall energy underwriting business[xii]. In my opinion, this conflicts with the overall message to shareholders. In its mission statement to customers and capital market participants alike, Munich Re puts carbon neutrality front and center in its business model[xiii].
In my opinion, the company will be truly able to claim this when phasing out oil and gas underwriting in addition to its other very successful climate change initiatives. (880 words)
[i] See https://www.munichre.com/us/property-casualty/about-us/mr/portrait/index.html
[ii] Heck et al. (2006), as cited in Stern, Nicholas (2007), The Economics of Climate Change: The Stern Review, p. 15; available from: http://webarchive.nationalarchives.gov.uk/20100407010852/http://www.hm-treasury.gov.uk/d/Chapter_5_Costs_Of_Climate_Change_In_Developed_Countries.pdf
[iii] See Association of British Insurers (2005a): ‘Financial risks of climate change’, London: Association of British Insurers, available from http://www.abi.org.uk/flooding; as cited in Stern, Nicholas (2007), The Economics of Climate Change: The Stern Review, p. 15; available from http://webarchive.nationalarchives.gov.uk/20100407010852/http://www.hm-treasury.gov.uk/d/Chapter_5_Costs_Of_Climate_Change_In_Developed_Countries.pdf
[v] See Stern, Nicholas (2007), The Economics of Climate Change: The Stern Review, p. 1; available from http://webarchive.nationalarchives.gov.uk/20100407010852/http://www.hm-treasury.gov.uk/d/Chapter_5_Costs_Of_Climate_Change_In_Developed_Countries.pdf
[vii] See Munich Re, 2016, p. 126: https://www.munichre.com/site/corporate/get/documents_E-90938998/mr/assetpool.shared/Documents/0_Corporate%20Website/_Financial%20Reports/2016/Annual%20Report%202015/302-08843_en.pdf
[viii] See Munich Re, 2016, p. 35: https://www.munichre.com/site/corporate/get/documents_E1513219753/mr/assetpool.shared/Documents/0_Corporate%20Website/5_Investor%20Relations/Publications/Presentations/Presentation-Investor-Relations-MunichRe-en.pdf
[ix] See Munich Re, 2016, p. 42: https://www.munichre.com/site/corporate/get/documents_E1513219753/mr/assetpool.shared/Documents/0_Corporate%20Website/5_Investor%20Relations/Publications/Presentations/Presentation-Investor-Relations-MunichRe-en.pdf
[xi] See https://www.ceres.org/press/press-releases/first-of-its-kind-report-ranks-u.s.-insurance-companies-on-climate-change-responses
[xii] See https://www.munichre.com/syndicate457/business-solutions/underwriting/energy/index.html
[xiii] See https://www.munichre.com/en/group/focus/climate-change/mission-and-vision/mission/index.html