All posts tagged 'models'

Opening Day: CAT Bonds, Climate Change and the 2012 Hurricane Season

May 31, 2012 20:54
by J. Wylie Donald
Tomorrow is June 1,  the official start of the Atlantic Hurricane Season, which is predicted by NOAA to be near normal. It comes almost as an afterthought this year because already we have had two named storms.  In mid-May Tropical Storm Alberto appeared and quickly disappeared.  It was followed shortly after by Tropical Storm Beryl, which made landfall at Jacksonville, Florida with record winds for a May storm.   Some undoubtedly have the view that the season's early arrival is further evidence of climate change.  That conclusion may be premature.  According to a report by the Miami Herald,  single named storms in the pre-season are not that unusual, but to have two, that has happened only thrice in the 150 years of official recordkeeping.  The science too does not support increased frequency of tropical storms as a result of climate change.  In a 2010 article, Tropical cyclones and climate change, Dr. Thomas Knutson with many others set forth what they perceived as the state of the science: Frequency. It is likely that the global frequency of tropical cyclones will either decrease or remain essentially unchanged owing to greenhouse warming. .... Current models project changes ranging from −6 to −34% globally, and up to ±50% or more in individual basins by the late twenty-first century.Intensity. Some increase in the mean maximum wind speed of tropical cyclones is likely (+2 to +11% globally) with projected twenty-first-century warming, although increases may not occur in all tropical regions. The frequency of the most intense (rare/high-impact) storms will more likely than not increase by a substantially larger percentage in some basins.Rainfall. Rainfall rates are likely to increase. The projected magnitude is on the order of +20% within 100 km of the tropical cyclone centre. This may not be nearly as dire as some have suggested, but we point out that ignoring a substantial increase in the frequency of storms like Hurricanes Katrina and Andrew is done at some peril.  People in harm's way are paying attention and using this kind of analysis to make decisions on how to insure the billions of dollars of at-risk property in Florida.  We have written before of the "life on the edge" of Florida's insurer of last resort, Citizens' Property Insurance Corporation.  In trying to get off the edge and get closer to financial stability, Citizens this spring made the insurance record books when it became the ceding insurer on the largest reinsurance catastrophe bond1 ever placed:  $750 million.  So where does climate change fit in?  The CAT bond's offering document doesn't mention climate change at all.  But one should not be fooled.  The modeler for the bond is AIR Worldwide.  AIR is all over climate change risks.  In fact, just this March AIR published a literature review regarding extratropical cyclones (aka North Atlantic winter storms).   • The frequency of ETCs may diminish with increasing global temperatures• The intensity of the more extreme ETCs may rise• ETC tracks are expected to shift poleward in both hemispheres One can see parallels with the conclusions reached by Dr. Knutson et al. regarding tropical cyclones.  Accordingly, we think it would be naive to conclude that AIR did not model for climate change.  We also expect that the negotiators for Citizens wanted to insure that climate change risk was applied. As did the investors. So climate change matters to the people with real skin in the game - like three-quarters of a billion dollars.  As such, one can bet all involved are paying close attention to the official opening of the Atlantic Hurricane Season, and also to what occurs before and what occurs after. 1This is not the financial instruments blog but for those who want a quick explanation try this from BusinessWeek:  "An insurance company issues bonds to financial investors, such as hedge and pension funds, that are willing to place a bet on the probability of a disaster occurring at a particular location and during a specific time frame. During the life of the bond, the insurer pays investors a coupon interest rate. If nothing happens, the insurer returns the money when the bond matures. If the fates are cruel, cat bond investors kiss off all or part of the principal."  What investors especially like is that there is no correlation between cat bond risk and stock market or corporate bond risk.

Climate Change | Insurance | Regulation | Weather

Ceres and a Series of Serious Thoughts About the NAIC Climate Disclosures - Part II

September 16, 2011 05:09
by J. Wylie Donald
We wrote yesterday to introduce Ceres’ report on the disclosure of climate risks by insurers and considered its first Recommendation to Regulators concerning mandatory and public disclosures.  We address today the second recommendation in Climate Risk Disclosures by Insurers:  Evaluating Insurer Responses to the NAIC Climate Disclosure Survey.    Ceres’ second recommendation is to "[c]reate shared resources around the implications of climate trends on enterprise risk management."  Id. at 51.  In other words, more research should be made available concerning investment risks and opportunities, correlated risks, loss modeling, the potential for loss of health and life, and customer resilience (ability to resist extreme events).  Id.  Taking modeling by way of example, Ceres discusses modeling thoroughly in Part 2 and the discussion is thought-provoking.  Several insurers are conducting climate change modeling internally.  For the rest, they rely on third-party vendors, which invokes much criticism from Ceres.  "The majority of insurers that report using catastrophe models describe them in terms that suggest their company does not have a clear understanding of how the models can or cannot be used to anticipate changing risk.  Most of the industry relies on third-party catastrophe risk models that only marginally integrate changing extreme weather."  Id. at 6.  "[I]nsurers relying entirely on third-party models may be severely unequipped to adjust pricing to incorporate emerging climate risks." Id. at 31.  "Insurers' disclosures suggest that the majority of insurers may be setting pricing based on flawed assumptions of how the industry's loss models incorporate changing climate trends."  Id. at 32. Ceres lauds those companies that can do it in-house.  But specialization and economies of scale are fundamental drivers of the market.  Were every insurer to bring modeling inside, undoubtedly there would be some new insights not presently uncovered.  But there would also be insurers who got the models grievously wrong and, in most cases, the resources spent on modeling would be more cost-effectively spent on other items necessary to delivering products or services. To be sure, reliance on EQECAT, AIR Worldwide and RMS as the sources for all climate change modeling has its flaws.  One need only think back a few years to where another triumvirate dispensing financial ratings (allegedly) misled sophisticated investors around the globe.  But in a world of constrained resources, or even an unconstrained one, third-party modelers are necessary and beneficial.  Further, a disadvantage to society from in-house modeling is that the insights developed from proprietary work may remain just that:  proprietary.  Ceres acknowledges "it is ... possible that asymmetrical information can be used by individual companies to secure a competitive edge against their peers."  Id. at 38.  Indeed, "larger insurers more readily recognize the inherent limitations of current catastrophe models in light of changing climate than do their smaller competitors or clients.  These players have a clear competitive advantage in deploying resources to build the latest climate science into their pricing models."  Id. at 37.  Third-party vendors, on the other hand, spread their best products across many insurers, in effect sharing their best research (but only to those willing to pay for it).  We wrote yesterday of the need to recognize that intellectual capital is a business asset and criticizing a goal of making climate change disclosures public available.  We think those comments apply likewise to the sharing of resources. Nevertheless, Ceres does great work in raising the bar for third-party vendors.  By pointing out to insurer-users that they may not be getting what they really need from the modeling firms, we expect the modelers will have to go out and address Ceres’ criticisms.  For example, insurers are exposed if (as Ceres asserts) "few insured perils are modeled by insurers, leaving the possibility for climate-affected perils to be underpriced."  Id. at 35.  More specifically, "recent years have demonstrated that climate change may be driving up aggregated losses from smaller events, including perils such as floods, snowstorms and hailstorms, in ways that erode insurer profitability."  Id. Tomorrow we conclude our review with a look at Ceres’ third recommendation as well as sharing some concerns about research.

Climate Change | Insurance | Regulation

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