October 4, 2022

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Why Climate Change Should Take More Real Estate in Industry Conversations

A Conversation with Kent David

As a provider of data-driven insurance solutions, CoreLogic knows that damages from extreme weather events are stressful and expensive for everyone involved.

While repairing catastrophic property damage has never been simple, it is no secret that the magnitude — and the costs — of these events is expanding due to climate change. To ensure that owners can recover from these devastating natural catastrophes, the insurance industry requires the participation of insurers, reinsurers and sovereign governments. However, there is another segment of people who are invested in the outcomes of climate change: those who are involved with the insurance-linked securities (ILS) market. 

To learn more about how the ILS market is intended to support the compensation of economic losses that result from extreme weather events, host Maiclaire Bolton Smith sits down with Kent David, a senior leader in analytics consulting at CoreLogic to answer some questions such as what are these securities? How do catastrophe bonds work? And how are investors hedging their bets against climate change by investing in this market?

Maiclaire Bolton Smith:

Welcome back to Core Conversations: A CoreLogic Podcast, where we dive into the heart of what makes the property market tick. I’m Maiclaire Bolton Smith, your host and curious observer of all things related to property — from affordable housing to market trends and the impacts of natural disasters to climate change — and I want to converse about it all.

Today, we’re going to dive a bit deeper into one of the hottest topics around right now, climate change. Climate change brings extreme weather patterns that are demanding more attention across the property industry, from floods, hail, and tornadoes to winter storms and wildfire, our changing climate is a force to be reckoned with due to its ability to damage structures and uproot lives. While severe weather has widespread consequences, one segment of the industry that’s particularly focused on these events includes the insurers and governmental entities that are concerned with insurance-linked securities or the ILS market. In part, the ILS market is intended to compensate for economic losses arriving from extreme weather events and is, therefore, inherently subject to the impacts that our changing climate has on that covered risk. To explore this topic more thoroughly, we have Kent David, a senior leader in analytics consulting at CoreLogic with us here today. Kent, welcome to Core Conversations.

Kent David

Thank you, Maiclaire. It’s a pleasure speaking with you. I’ve greatly enjoyed following your podcast to date and look forward to contributing to it.

MBS:

Well, I’m excited to chat with you about this today. Before we dive into today’s topic, can you tell our listeners a little bit about your background and your role here at CoreLogic?

KD:

Sure. By training, by education, I’m a civil engineer in the structural field. I’ve pursued a long and varied career starting with looking at extreme earthquake events and their impact on the built environment. That led me to some post-earthquake assessments. Well, I lived through Loma Prieta in San Francisco, traveled to Northridge in 1994 to assist in the recovery, tagging buildings and really understanding the impact of earthquakes on the built environment.

MBS:

Wow.

KD:

Then in terms of traveling to earthquakes, there was obviously at the time a number of earthquakes in relatively short succession. I went to Kobe following the Great Hanshin earthquake in 1995. All of that really drove home to me the importance of being able to have capital adequacy to recover from disasters. That led me into the field of catastrophe risk management, which is where I work today and the main focus of my team is in looking at quantifying risk and assisting in the transfer of that risk to various agencies, including the capital markets.

MBS:

Well, we’ve talked a lot about catastrophes and different aspects of catastrophe risk management on this podcast over the years, but we’ve not talked about risk transfer and the ILS market. So, I’m excited to jump into this with you, Kent, but we’re now talking about something a little bit different. Let’s start with some of the basics today because I think you’ve likely introduced some new terminology that many of our listeners are not familiar with. What are insurance-linked securities? How do these investments support the property market at large? We talked about risk transfer — can you get into some of these definitions of things before we jump into this?

KD:

Sure, so a real brief primer on risk transfer in the insurance industry. Almost everybody’s familiar with their primary insurer, and primary insurers write policies covering property and pay you for your claims when you experience a disaster of some sort, be it a house fire, whatnot. When catastrophes strike, those primary insurers can have very, very large losses based on their portfolios of exposure subject to that disaster. To mitigate the risk to primary insurers, to make sure they have adequate capital to pay claims following a large catastrophe, reinsures exist. Essentially, reinsures provide insurance policies called “treaties” for primary insurers. A reinsurer looks at the world through… They typically are worldwide agencies, so they spread their risk worldwide and get paid their fees based on these large books, global books of exposure, and look at the high levels of loss. A primary insurer typically pay the first tier of risk following a catastrophe where a lot of their policies are impacted, and then the reinsure steps in and provides them capital to make sure — so yeah, insurers for the insurers: reinsurers.

MBS:

Okay. No, that’s a good start to help us right there. The next one you were going to talk about was insurance-linked securities.

KD:

Right. Insurance-linked securities are an alternative form of reinsurance. Now, insurance-linked securities writ large don’t necessarily need to be reinsurance. It’s essentially the difference between insurance-link securities and other of securities are that insurance-linked securities cover insured risk and they differ from standard insurance in that the provider of the coverage is, instead of insurance company or reinsurance company, it’s an investor. If you look at the investment world writ large, investors sometimes invest in stocks, sometimes in bonds. In this case, outside of the standard financial sector investment opportunities, an investor can also invest through various means that we’ll discuss later in this conversation. They can invest kind of acting as an insurer or a reinsurer. Essentially, an investor in insurance-linked securities is getting an uncorrelated investment, so the investment risk to them is not related the standard financial markets. If there’s a market crash, a downturn, the investments in these sorts of insurance-linked securities aren’t impacted, but they are impacted if there’s a catastrophe that is related to their insurance-linked security investment.

MBS:

You mentioned bonds. I think many people are probably familiar with savings bonds, but you are referring to catastrophe bonds or CAT bonds. CAT bonds are relatively common now, but that wasn’t always the case. Can you talk a little bit about their origin and why these — I mean, inherently risky bonds — have become so popular?

KD:

Sure. As I mentioned before, if you are an investor with capital to deploy, you can deploy it in the standard financial markets. In doing so, you run the risk that all of your investments may track up or down to together should the financial markets rise or fall. That’s typically the economic cycles have booms and busts, they can be mitigated, but essentially, an investor in stocks and bonds will see their stocks or their bonds rise and fall with the rest of the market.

What a catastrophe bond allows an investor to do is to invest in a product, an investment vehicle that pays them significant returns, but it is the losses to a catastrophe bond are conditional only upon the occurrence of well-defined catastrophe, so a natural catastrophe. That is beneficial to the investor because it’s not correlated to the rest of their investments and allows them to have a leveling, essentially get good returns that don’t follow the rise and follow their other investments. So it’s a nice diversifying investment opportunity. From the insurance side, the people who sponsor catastrophe bonds, there’s benefits to having an alternative source of capital as opposed to just reinsures. Catastrophe bonds complement the reinsurance industry by providing this alternative source of capital for reinsurance and also the catastrophe is fully collateralized. In other words, the money is stored away that forms the basis, the invested money. So should there be a catastrophe, the sponsor of a catastrophe bond does not have to worry about the counterparty risk of, for example, a reinsurer going bust due to the nature of a catastrophe.

MBS:

Okay, that’s great. That’s really interesting. Okay, but when we started today, we said we were going to talk about climate change, and we have not talked about climate change yet. So I do want us to deviate over to that direction because climate change doesn’t happen overnight, we all know that, but there are both long-term and short-term effects that scientists are predicting that will happen over the foreseeable future. How is the ILS marketplace responding to these issues?

KD:

It’s a really interesting question and phenomena because as we know… Well, let me take a real quick step to the side, most investments that exist in the insurance-linked securities market have a term of maybe three years. Some can be longer, some can be one year. If you’re an investor or a sponsor of a catastrophe bond, for example, or other insurance-linked security offering, the timeframe for that investment for that vehicle is still relatively short compared to the lifespan or the time horizons of significant climate change.

That being said, we believe that we’re seeing the impacts of climate change today. In recent years, we’ve seen a change in the frequency and the nature of hurricanes and the flooding resultant from them. We’ve seen wildfires in the western United States, which have deviated significantly from years past. We know that’s due to drought and interesting weather, bad fire weather. That seems highly correlated or likely to be the derivative of climate change. These sorts of impacts, we’re seeing really across the weather insurance industry right now, so climate change is certainly a driving force or an impactful issue that investors and insurers need to look at today.

How does it impact the market? Essentially, one of the things that makes catastrophe bonds in particular interesting and different from other offerings that are out in the market that investor might participate in is that the risk in a catastrophe bond is expertized. It means that when the bond is offered, an expert in the field will characterize and quantify what that risk is. For example, if there’s a California earthquake catastrophe bond, an agency will be hired that will calculate the risk to the notes and expertize that in the offering circular.

What that means is that investors have a good way of looking at what that risk is and they may disagree with that opinion of the risk, but at least there’s a starting point for the basis of the investment returns on those notes relative to the insurance risk. When we’re talking about climate change, what that means is if you’ve got a catastrophe bond that includes risks that are potentially correlated to climate change, the investor can look at that and say, “Well, I actually believe that the risk for California wildfire is higher than what the modeler presumed,” or that the risk from hurricane flooding is higher or from hurricanes or severe convective storms, so the nature of the offering allows for a difference of opinion on what that risk is.

MBS:

Oh, that’s interesting.

KD:

Yeah, and so essentially the price that’s paid for these devices, these notes or offerings is really a negotiated rate that both sides can agree on. It’s a reasonable premium for the sponsor of the bond to pay, and the investor believes they’re being adequately compensated for the risk, again, possibly considering climate change.

MBS:

Wow. No, you said a lot of really interesting things there, so I want to kind of flesh out a couple of things and dive in that. You’ve mentioned that it’s no secret that wildfire season is getting longer. The Environmental Protection Agency has also has recently done a study saying that it is, in fact, wildfire season is getting longer each year. Similarly, the Intergovernmental Panel on Climate Change, the IPCC, has acknowledged that the frequency of hurricanes will continue to increase as time continues. We’ve seen events are more severe, more frequent, and that is expected to continue because of climate change. You’ve talked a little bit about how these types of events are impacting ILS risk, but I guess the kind deeper question is, how is climate change influencing the longer-term impact from the ILS market?

KD:

As I mentioned before, the issuance of a catastrophe bond and presumably other insurance and securities opportunities or investments, involves a discussion, a conversation between the cedent, the sponsor, and the investor, and because of the relatively short term, typically up to three years of these devices, both parties can decide on what the actual premium, what the real risk is that exists in the offering. That forms a basis for the negotiation on what the premium should be.

The other thing that really impacts the pricing is this current market condition’s availability of capital, which makes teasing out whether there’s trends in the pricing of weather-related catastrophe bonds, whether those trends are related to climate change or whether just related to scarcity of capital in the markets. But we can see that weather perils have been behind some potential payouts in the market. Whether the bonds actually payout or not is not public information. There have been bonds that have been reported have been impacted by wildfire and severe convective storm. What that means in terms of the market as a whole investors are expecting some losses. This is just like investing in the bond market. There are going to be bad days or bad years and so it really becomes a negotiation on how much they need to be paid to accept the risk. Then they may change their appetites for different types of weather peril risks.

MBS:

Right. Because they have such a short term of usually three years, then it is almost more like short-term impacts that they’re looking at versus the long-term strategies.

KD:

Yeah, I think that’s fair. Yeah, what we don’t know is how quickly these impacts will occur. There’s also just typical changes or trends in the weather that happened before we had climate change. We can look at it kind of looking at it, like in oscilloscope or some way of looking at waves, you’ve got normal oscillations, and then you’ve got trends. Probably where we sit right now is that both are really important, both the season to season oscillations that are normal changes from year to year, but I think we’re seeing also the fact that climate change is changing those trends, and the signal seems to be growing that that is indeed the case.

MBS:

Right. Okay, so as we look at these trends, one thing we’ve talked about on this podcast before is disaster gaps. If we have big events — and over the last few years, there’s been some really extreme events like Hurricane Harvey in 2017, the Camp Fire, which destroyed Paradise, California in 2018 — they’ve really highlighted this significant need for external capital to support traditional reinsurance, really. So when we think of these disaster gaps, how can ILS help bridge the gap between the capital base of insurance industry and potential losses that these catastrophe events are bringing?

KD:

It’s a really interesting question because as much as the ILS community, the investor community, brings additional capital to bear and solves these sorts of gaps in the traditional insurance market. In the insurance market, as any investor or investment strategy would have, there’s limits to how much risk any particular investor might want to have. You only have so much perhaps appetite for North Atlantic hurricane risk or Central United States, tornado/hail risk. Every investor has an investment strategy and that may limit their appetite for certain types of risk regardless of how they’re portrayed, or even at whatever price, so they may just have a very high price standard in order to accept more California wildfire risk, for example. The community, the market does supplement the traditional reinsurance market, and we’ve seen that, absolutely, that there’s areas where it was very, very hard to impossible to get insurance from the traditional markets where it has been possible from the capital markets, but there are limits to what that is as well.

MBS:

Okay. One other thing that we mentioned off the top was the government entities. I want to talk a little bit about how the government’s growing investment in ILS….We have to thank our producer here at Core Conversations who did some research into this and she discovered that it was the Mexican government that became the first sovereign government to issue catastrophe bonds and the U.S. followed quite quickly after. What currently is the state of the government’s growing in investment in the ILS space?

KD:

Yeah, no, the development there has been a long-running process. It’s interesting. It’s hard to say where we’re going to end up. Sovereign risk has long been transferred in the Caribbean. There’s been a series of disaster-relief-type catastrophe bonds meant to support the governments throughout the Caribbean from that risk. As you mentioned, Mexico has sponsored CAT bonds. It’s not uncommon for countries to sponsor bonds to supply them with immediate capital following a disaster. As you mentioned, the NFIP has sponsored some bonds in recent years supporting their risk that would result from flooding in the U.S. and payout for those flood policies. I think that those offerings have been well-accepted by the market.

It’s an interesting question, more a government policy question I think than anything. Does the NFIP look to really gather more reinsurance from the capital markets? How does that fit in with their strategy of updating their flood policies, et cetera? The National Flood Insurance Program is designed fundamentally to protect investments in the real-estate sector, so to support homeowners who buy properties that might be in flood-prone areas to make sure that those loans are viable following a flooding event. Not just the loans, but obviously, the homeowners can recover from that.

That conglomeration of flood risk has grown over the years. The NFIP has been highly beneficial in protecting the financial services sector as well as homeowners, related to flooding risk. They’re currently involved in updating their flood insurance policies and programs to better reflect the changing risk in the area. Do I see the ILS sector as being fundamental to being able to do their job? I think the bigger question there is really, how does the NFIP, how are they going to update their policies and their underwriting processes? It’s probably more important to their long-term success as opposed to just the way that they receive reinsurance protection.

MBS:

Sure. That was really helpful. I love that you brought up the NFIP in what you’re talking about because that really ties back to our first episode of season two, Episode 31, where we had Scott Giberson talk about Risk Rating 2.0 and really what FEMA is doing to help with the evolution of flood insurance in this country, so I’m glad you brought that up as well, too.

Okay, one thing just to close with, Kent. Data. Obviously, insurance-linked securities rely on data, and that’s something we do very well here at CoreLogic. Can you explain why it’s so crucial for entities to have the ability to determine the peril and concentration of risks from various other weather threats and adjust their portfolios accordingly?

KD:

What we’re seeing, I mean, the development of losses in the insurance industry, and that certainly impacts the ILS industry, is that the developing risks, the risks that are really becoming more and more prevalent, really are what I term or what we typically call “high-definition perils.” Following Hurricane Harvey, for example, we did a number of studies for clients in the financial services sector where there was a great concern that there would be tremendous losses, a lot of defaults on loans due to the flooding that was well-publicized and quite rampant in the area.

MBS:

Right. Oh, it was awful, yeah.

KD:

But what we learned is that there was actually… Most of our clients who were concerned about the issue found that the actual risk to their loan portfolios and the homeowners was much lower than they were expecting simply because the risk to a certain house from flooding varies greatly up and down a street. At one end of the street, it may be very high. At the other end of the street, it might be quite low due to slight changes in elevation, different terrain features on a given lot. And so based on the very nature of how loans are packaged and sold, and the fact that a flood does not impact the whole region uniformly, the losses tend to be, again, high-definition. So highly variable from location to location, block to block, zip code to zip code.

The ability to capture that risk to the ability to analyze and understand it and to transfer it really depends on having high-definition models, high-definition data to capture that risk to differentiate a house that’s at one foot below the flood level versus one foot above the flood level. High-definition perils, such as severe convective storm, flooding, wildfire all have highly variable risk and highly variable resilience to that risk or vulnerability to that risk.

Working at CoreLogic, it’s been very empowering to have the data assets that are needed to capture high-definition risk, and be able to differentiate from high risk to low risk in a way that’s otherwise impossible. We have parcel data. We have digital elevation data. We have models that capture risk down to a very refined area. This empowers us to capably differentiate and quantify those risks.

MBS:

That’s a great place to end, Kent. One thing I say quite often on this podcast that one of our tag phrases here at CoreLogic is “Know your risk to help accelerate your recovery,” and that understanding your risk through many of the things that you’ve just talked about really do define that. Kent, I learned a lot today. You and I talk almost every day, and there are so many things I did not know, so this was a really great conversation. Thank you so much for joining me today on Core Conversations, a CoreLogic podcast.

KD:

It’s been my great pleasure as well. Thank you for having me.

MBS:

All right. Thank you for listening. I hope you’ve enjoyed our latest episode. Please remember to leave us a review and let us know your thoughts and subscribe wherever you get your podcast to be notified when new episodes are released. Thanks to the team for helping bring this podcast to life, producer Jessi Devenyns, editor and sound engineer, Romie Aromin, and our social media duo of Sarah Buck and Makaila Brooks. Tune in next time for another Core Conversation.

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