Climate change is a hot topic for many companies, none more so than the insurers.
Insurance Australia Group (ASX: IAG), Suncorp (ASX: SUN) and QBE Insurance (ASX: QBE) write policies that protect individuals and businesses against losses that arise from bad weather.
Particularly violent storms can be costly: IAG, for example, expects to receive around $850m in natural disaster claims this year – up from earlier estimates for $680m – thanks to February’s hailstorm in Sydney and April’s tropical cyclone Debbie.
If, as the earth warms, natural disasters become more frequent, could it not catch insurers off-guard and lead to a rising tide of losses? Warren Buffett doesn’t think so.
In last year’s annual letter, he wrote ‘It seems highly likely to me that climate change poses a major problem for the planet’ … ‘But insurance policies are customarily written for one year and repriced annually to reflect changing exposures. Increased possibilities of loss translate promptly into increased premiums.’
In other words, even if cyclones and severe weather events become more frequent, insurers have little to worry about because they reprice policies year-to-year, rather than write contracts that span decades at a fixed price. IAG doesn't need to predict the climate 30 years from now.
What’s more, the insurance industry tends to be reactionary in its pricing: in times of mild weather, insurers aggressively lower prices to remain competitive and often under-price policies. These then come back to bite when bad weather picks up and losses mount. However, after a major storm, policy prices – and profit margins – tend to rise as the insurers try to claw back previous losses. This boom and bust of profitability is known as the ‘insurance cycle’.
Buffett went on to say that climate change may in fact be a tailwind for insurers: ‘If [super catastrophes] become costlier and more frequent, the likely – though far from certain – effect on Berkshire’s insurance business would be to make it larger and more profitable.’
The reason, again, comes down to pricing. Insurers tend to price policies based on expected losses plus a target profit margin. If the average loss per policy is rising due to bad weather, the increased costs will be passed on to customers by increasing premiums. If insurers continue to target a fixed margin, the rising revenue should translate into profit growth, making the insurers more valuable.
But what if, rather than a gradual increase in storm frequency, one mega-storm came along causing a huge rise in claims?
In this case, insurers are often still protected by a process known as ‘reinsurance’, whereby the insurer takes out its own insurance policy with larger firms to reduce risk. IAG, for example, retains the first $250m of losses from a particular event, but the next $6.75bn is covered by its reinsurers. IAG estimates that a disaster that size would only occur once every 250 years.
As far as climate change is concerned, Australian insurers are largely shielded from catastrophic losses through regular policy repricing and reinsurance. Counterintuitively, more frequent and severe storms may even be a windfall for insurers – though we hope the theory is never truly tested.
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