Climate risk creating physical protection gap warns Fitch

There is growing concern that the long-term effects of climate change are not being accurately factored into many risk calculations.

Fitch ratings have issued a new report which examines what it sees as the growing protection gap for physical climate risks.

It said there is increasing evidence that longer-term climatic risks to key residential and commercial mortgaged-backed securities markets are rarely priced in to bonds or their underlying property insurance.

“The gap between insured and uninsured (or underinsured) climate related losses on real estate assets continues to grow, with implications for the pace of recovery from increasingly severe and frequent natural disasters as a result of uninsured assets,” it explained. “Across countries and within key real estate markets such as the United States, a patchwork of coverage across different hazards and locations means that exposure to risks can vary substantially.”

“Insurance and risk transfer in relation to extreme weather and natural disasters are geared towards protection against individual events. By contrast, the physical impacts of climate change tend to be chronic, long-term and cumulative in nature; there is growing evidence that these effects may not be fully priced into existing risk frameworks” said David McNeil, Associate Director, Sustainable Finance at Fitch Ratings.

The report added diversification of risk, whether in the form of geographical distribution of assets, or in insurance-linked instruments or country risk pools, looks set to grow in importance as physical climate risks take hold.

“Fitch assesses the impact of physical climate risks when it assigns credit ratings to issuers and transactions across all asset classes,”  explained the report. “In structured finance real estate mortgage backed securities (RMBS) transactions, for example, the credit risk of a mortgage pool with strong loan characteristics may require a major negative adjustment to reflect geographical concentration if the pool is heavily concentrated in areas which are historically prone to multiple natural hazards that are typically underinsured.”

Fitch said while insurers’ risk models are increasingly sophisticated, their products cater towards compensation for individual events. The firm added it believes that the longer-term climate risks to key real estate markets are rarely priced in bonds or their underlying property insurance costs. “Much of this risk stems from the slow, incremental damage that many chronic climate risks can create, particularly when coupled with more frequent and more severe acute risk events (as expected by climate scientists) and their implication for asset values and the real economy. Urbanisation in particular has led to high concentrations of human and physical asset exposure.”

Therefore, the protection gap between insured and uninsured climate-related losses on real-estate assets continues to grow, with losses from uninsured assets negatively affecting the pace and level of recovery from increasingly severe and frequent natural disasters. Blended finance and insurance-linked securities instruments will be used increasingly to address the protection gap, although these instruments are much smaller than the protection gap.

The report said there are concerns that unless issues are addressed a situation maty well arise where capacity becomes impossible to access.

“Globally, there will inevitably be some degree of assets that are difficult to insure due to climate considerations, leading to growing pockets of uninsured assets,” it added. “Fitch’s ESG RS for the insurance and reinsurance sector point to the particular credit relevance of natural disasters and environmental hazards for issuers in APAC, with Chinese and Japanese non-life insurers having an average score of ‘4’ for the category Exposure to Environmental Impacts – this is similar to most reinsurers, suggesting that this issue is having a material influence on insurers’ credit ratings.”