No need to be a rocket scientist to understand current climate situation. The recent IPCC report is a great reminder of where we are and the possible paths we might take. Clearly achieving the Paris agreement targets of 1.5c of temperature rise by the end of the century will be a challenge – we’re already outperforming at over 1c! One of the big implications is not only temperature rises but extreme weather events – natural catastrophes (hurricanes, extreme flooding, bushfires etc.). The evidence points to an increase in severity and frequency. If the past five years are only a warning sign, the future doesn’t look like rainbows and unicorns.

So, you didn’t need a financials credit analyst to tell you that. But one area where this is particularly relevant in the financials sector is reinsurance. The sector is directly exposed to physical risk – typically natural catastrophe reinsurance. The business has been historically very profitable with many years of limited events and only a few years of large weather claims. But over the past five years, extreme events have been more severe and frequent – and have seriously dented the sectors’ profitability. Using Swiss Re, the world’s largest reinsurer, as a proxy for the sector, the group generated a 2.6% average RoE over the past five years compared to 9.8% in the previous decade – ouch. This is not solely because of natural catastrophes, but these have definitely weighed on profitability of the sector.

Luckily the reinsurance sector starts from a position of extreme strength – market leading solvency ratios and conservative balance sheets – reflected in AA-category ratings. So far so good, but the current trend in extreme weather events will most likely continue, lowering profitability and pressuring fundamentals and ratings. I’m not talking about the death of the sector, but a gradual de-rating of once the safe haven of the insurance sector.

When the top reinsurers trade at the tightest spreads in the European insurance space driven by high ratings and positive perception – this raises the question of the investment case of the sector. Don’t get me wrong reinsurers are not 100% geared to natural catastrophes and typically diversified in reinsurance lines and primary insurance. But for those most exposed and some of the smaller players (be it reinsurers or specialty insurers) it does raise the question of long-term prospects. Again, reading the IPCC report, trend is… not your friend.

Published by Romain Miginiac on LinkedIn

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