Should P&C Insurers Be Afraid of Climate Change?
The situation is complex, but ultimately we think investors shouldn't be overly concerned.
While climate change is a major social issue, in this article we will focus strictly on assessing the potential implications for the property-casualty insurance industry. The negative impact of climate change on P&C insurers seems obvious at first glance, as much of their business revolves around protecting against property damage arising from extreme weather events. But while we believe climate change is a material issue for the industry, it should not deter long-term investors from holding P&C insurance stocks. In our view, the most likely long-term outcome is the exit of the most affected lines, which include homeowners insurance.
The combination of the potential for increased catastrophe losses and the increasing value of coastal property does paint a potential alarming picture: $1.5 trillion in home value in the United States is exposed to coastal storms, with more than $400 billion exposed to even a Category 1 storm. While this issue is localized, and only about 5% of U.S. homes are exposed to coastal storms, the trend toward higher coastal populations could increase the exposed property value over time. Over the past four decades, coastal shore counties have added 125 people per square mile, compared with 36 people per square mile for the U.S. as a whole.
But it is not completely clear that the risk of extreme weather events has been increasing. While climate change has been occurring, and there have been a number of high-profile weather incidents in recent years, we've no seen no material upward trend in global catastrophe losses as a percentage of economic activity. Insured losses due to catastrophes as a percentage of GDP have increased modestly over time, but this is due to greater insurance penetration. Economic losses as a percentage of GDP (which includes both insured and uninsured losses) have not shown any material upward trend over the past 20 years. While losses could increase going forward, there is not clear evidence that climate change has had an impact on catastrophe losses so far.
Climate change outcomes such as warmer temperatures and higher sea levels are relatively certain, but the impact of climate change on catastrophes is less certain, and historical data is difficult to interpret given the extreme volatility. For instance, in the Intergovernmental Panel on Climate Change's latest climate change report, it ascribes only "low confidence" to its prediction that climate change has had or will have an effect on tropical cyclone activity. There does not appear to be scientific consensus on whether climate change will increase the number of hurricanes, but there is widespread agreement that hurricanes will cause more damage, if only due to higher sea levels.
These assessments are on a global basis, and there is some speculation that the U.S. could be more prone to the impacts of climate change. The number of U.S. weather events leading to sizable economic losses does appear to have increased over time.
While the evidence is not completely clear, in our view, it is reasonable to conclude that the probability of extreme weather events and/or the magnitude of these events could increase over the long term, and climate change could have some unanticipated effects. Conceptually, one could think of weather as a normal distribution, with climate change increasing the mean temperature over time. As a result, the number of tail weather events related to warm weather presumably will increase, and could increase significantly. At the very least, climate change introduces an additional point of uncertainty for the industry.
Given the inherent volatility of catastrophes and the tail nature of these events, the impact will be difficult to estimate for the foreseeable future. In our view, the extreme year-to-year volatility of catastrophe losses will remain a meaningful swing factor in industry profitability.
Exiting Lines Most Heavily Exposed to Climate Change Is Likely
In general, we believe management teams are fully aware of the potential implications of climate change and the possibility of increases in weather-related losses. But given the complicated nature of the actuarial models insurers use to assess weather-related risk, it is hard to determine whether this awareness has translated into appropriate action. In our view, it may be difficult for insurers to be proactive in adjusting pricing to account for the future effects of climate change, even if they are aware of the risks. For personal lines, about half of the states require insurers to request pricing changes and receive approval before they go into effect. As a result, in our view, even if insurers thought that climate change was leading to a material change in risk, they would have little evidence to convince regulators that rates were no longer adequate until losses accelerated. We believe it would take large loss events to spur a material change in pricing, and insurers would then have to pass through a period of subpar profitability before this occurred.
In our view, a more likely outcome is insurers exiting business that is not adequately priced. The evolution of the homeowners insurance market in Florida potentially provides an example of how insurers exit areas when risks increase and regulators don't allow adequate pricing. In the wake of Hurricane Andrew in 1992 (the third most costly hurricane in inflation-adjusted insurance losses in history), Florida regulators made a number of changes designed to support a healthy insurance market and maintain affordable rates. In practice, however, these changes achieved the latter goal at the expense of the former. As a result of the constraints on pricing, national carriers exited the state, and the market became dependent on small local insurers and government-backed entities such as Citizens Property Insurance Corporation. Regulatory changes in 2007, which froze Citizens' rates and allowed consumers to purchase Citizens policies without being rejected by private carriers, led to further concentration, with Citizens writing about as many new policies as the next nine carriers combined in 2012.
National carriers and their subsidiaries now write only about a third of Florida's homeowners policies, whereas they almost completely dominated the market before these changes. In retrospect, exiting the market was the best decision. The loss ratio (claims losses divided by premiums) in the state has been the highest in the region and at a level that doesn't allow for adequate profitability. While the loss ratio in Louisiana and Mississippi has been almost as bad, that is primarily the result of Hurricane Katrina in 2005, which was the costliest hurricane in history and resulted in insured losses about 3 times as high as Hurricane Andrew, adjusted for inflation.
Flood insurance provides another example of the government taking over when risk grew too great for private carriers. Hurricane Sandy in 2012 caused considerable insurance losses, but the bulk of these losses were borne by the government, as most of the damage related to flooding. Given that much of the risk from climate change is related to higher sea levels, private insurers in the U.S. are already shielded from a material portion of these risks.
Downside Limited by Market Valuations; Stewardship Is Key
While potentially having to exit some lines would be a long-term negative for the industry, it would be preferable to underwriting inadequately priced business, as deficient reserves and inadequate pricing is by far the most common problem insurers can face, accounting for about 40% of insurer impairments. If pricing is inadequate, the most value-creative move, in our opinion, is to reject the business.
Given our view that pricing is unlikely to fully account for any change in risk due to climate change before the fact, we think stewardship is a key consideration, as insurers must develop the internal capacity to appropriately project these new risks and maintain the discipline to walk away from value-destructive business. We award exemplary stewardship ratings to three companies: Chubb (CB), Progressive (PGR), and W.R. Berkley (WRB). Of these three, only Chubb has a material exposure to catastrophes. Chubb's management has shown that it prioritizes profitability over growth. During CEO John Finnegan's decade-long tenure, premiums have grown at only a 2% compound annual rate, while return on equity has averaged 15%, and he has shown his willingness to walk away from inadequately priced business. Among the companies we cover, we believe Chubb would best handle any long-term climate change impacts.
The valuation impact of any disintermediation is limited by the fact that many insurers trade at only a modest premium to book value. These valuation levels are justified, in our opinion, as in general, property-casualty insurers do not benefit from favorable competitive positions. Industry competition is fierce and the products are essentially commodities. Furthermore, participants do not know their cost of goods sold, sometimes for a number of years, causing them to underprice policies without knowing it. Firms have a large incentive to chase growth without regard for profitability, a cycle that repeats itself as competitors are forced to match artificially low prices or risk losing business. While we believe that some companies have been able to establish narrow moats, in most cases, they are able to earn only modest excess returns, which keeps multiples constrained for even relatively high-quality names.
If insurers were forced to exit some lines as a result of increased climate change risks, it would release the capital used to support these lines. As such, we think book value is a reasonable rough estimate of the valuation floor for lines that might be exited, provided that insurers are reasonably timely in their exits and do not suffer dramatic losses before making this decision. As result, we believe climate change could have a slight negative affect on multiples over time, but the impact is likely to be minor, given the modest size of existing premiums and that fact that only a small part of the industry will be affected.
W.R. Berkley Offers Relative Value, Limited Exposure
Exposure to climate change differs widely across different lines, with the exposure obviously concentrated in property lines. Among the major property lines, homeowners has the most exposure to climate change issues, while auto lines have relatively little exposure. Catastrophes can lead to damage to cars, but unlike homes, cars can be moved out of the path of catastrophes, and individual claim amounts for autos are relatively low. Commercial is a mixed bag, given that many commercial policies are comprehensive and cover a variety of risks.
With its sizable homeowners business representing 24% of premiums, Allstate (ALL) is the most exposed company we cover. On the other side, Progressive and W.R. Berkley have relatively little exposure to catastrophes. W.R. Berkley's business centers on casualty lines, and CEO Bill Berkley has long been clear in his preference to avoid catastrophe exposure as much as possible, given the volatility it introduces into results.
In our view, the potential exit of lines affected by climate change could hurt moats in the space, as insurers might have to walk away from what is now profitable business. Among the companies we cover, we believe Allstate's moat is the most exposed, due to both its relatively high catastrophe exposure and its strategy. Allstate has set itself apart in personal lines insurance through its use of captive agents and its bundling strategy. As customers add policies, they are more likely to rely on an agent who can help them customize their policies and save them money through bundling. Each additional policy will allow the customer to save money, and each incremental policy creates stickier customers. As these customers have multiple policies for a car (or two), a home, and possibly a boat, price shopping becomes more burdensome, making them less likely to switch companies in order to save a small amount on an individual policy. Whereas many competitors use independent agents to source sales, Allstate's captive agents sell only company policies. This allows Allstate to benefit from the stickiness of the customer relationship, rather than an independent agent, and lowers its customer acquisition costs. If Allstate were forced to move away from homeowners policies on a meaningful scale, it would weaken the effectiveness of its bundling strategy.
In assessing an individual company's risks, our framework would consistent of three factors: (1) the degree of catastrophe exposure the company faces across its lines, (2) our assessment of the quality of the company's stewardship (reflecting our confidence that management will reject inadequately priced business as risks change), and (3) the scope for multiple compression if the company was forced to exit affected lines (with a higher book multiple being a negative in this regard). This last consideration implicitly takes moats into account, as moaty insurers should trade at higher multiples. Looking through this lens, among the companies we cover, we believe Allstate faces the highest level of exposure to climate change risk, while Progressive and W.R. Berkley are the least exposed. Of these last two, we believe W.R. Berkley is the most attractive given its modest multiple. Among the companies with average overall exposure, we have confidence that Chubb will best navigate any industry changes related to climate change, as our positive view of its stewardship is a key factor.
Cat Bonds, Weak Reinsurance Pricing Are Offsets for Now
Industry participants are largely in agreement that reinsurance pricing is weak and potentially inadequate for the risks being assumed. Periods of weak pricing in reinsurance are not uncommon historically. But, in our view, the rise in the catastrophe bond market raises questions about whether the industry is moving through a soft period in the cycle, or if a structural shift is taking place as a new type of capital now occupies a meaningful position in the industry. For primary carriers, weak reinsurance pricing could be a meaningful offset to any increase in climate change risks, as they could cede portions of this risk at attractive rates. Reinsurers have typically covered 20%-45% of losses from major hurricanes.
Catastrophe bond activity has accelerated in recent years, and it has been estimated that catastrophe bonds now represent 16% of global property catastrophe limit purchased annually. While some speculate that the recent increase in catastrophe bond issuance is a result of the low interest rate environment and investors stretching for yield, we think there is an equally compelling case to be made for ongoing growth in this market, regardless of interest rates. In our view, catastrophe bonds offer a potentially attractive vehicle for many investors, as they offer returns uncorrelated with more typical investment options. With roughly $18 billion outstanding, the catastrophe bond market is minuscule in the context of overall capital markets, which would seemingly leave a large growth runway. Hedge funds' increasing interest in reinsurance is a similar phenomenon that could draw more capital to the industry as well. Either way, for primary insurers, this situation is a positive and a potential offset to higher catastrophe risk, with the length of the tailwind the only uncertainty.
Brett Horn does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.