Dr Olaf Novak, Allianz SE Rückversicherung Wien, 5. November Hedging climate change Risk and opportunities for the insurance industry Dr Olaf Novak, Allianz SE Rückversicherung Wien, 5. November

Natural catastrophes on the march The number of natural catastrophes is already clearly trending upwards. The vast majority of these are weather related. This suggests there is a connection with the slow but constant increase in global temperatures resulting from climate change Allianz sees a connection between climate change and frequency of extreme weather, with significant implications for insurers. © Copyright Allianz

Climate Change will continue to hit insurers There has been a fifteen-fold increase in weather-related insurance claims over last 30 years. In Allianz’s global industrial insurance business, 40% of damages are due to storms and floods. Between 2010-2019, Allianz estimates average losses for the insurance industry could grow to US$41 billion per annum. Trends like urbanization and coastal/ floodplain development increase the risk of such losses. Average Insured Losses1 (Billion USD) 1 Allianz / Dresdner Economic Research © Copyright Allianz

Path to the Future Once, insurers relied on their past experience to determine projected loss levels. That changed with Hurricane Andrew, which caused levels of damage that, at the time, were not considered possible. Since then, work on catastrophe models has intensified, which can be used to simulate the damage that could be caused by potential catastrophes. While catastrophe models can reduce uncertainty, diversification is still required. However, there are questions about whether traditional reinsurance can provide adequate levels of intertemporal diversification to cover the major risks caused by natural forces, particularly in the context of climate change. © Copyright Allianz

Capital markets can assist with diversification Capital markets have a role to play in the diversification of natural catastrophe risks. Because the potential damage in relation to market capitalisation is relatively small. For example, the value of the average fluctuation of all the net assets traded daily in the US alone amounts to $US133 billion. Thus, larger insurers (and investment bankers) have developed a number of capital market instruments, in particular, catastrophe bonds. © Copyright Allianz

How catastrophe bonds work The insurer sets up a Special Purpose Vehicle to issue the bond. The investment vehicle insures the insurer against a defined catastrophe for which an annual premium is paid. The vehicle makes coupon payments to investors via a variable interest rate based on money market rates plus an interest loading. The investment vehicle finances these interest payments with earnings from safe bonds (risk- free interest) and the insurer’s premiums. If the event occurs, the bond expires, the vehicle sells the safe bonds and pays the insurer the agreed coverage. If the event does not occur, the investor gets back the nominal value of the bonds. Cat bonds have very advantageous correlation properties so investors can diversify their portfolio. They also have attractive yields eg, between 2003 and 2006 the spreads of various cat bonds was between 200 and 900 basis points. Thus, cat bond yields are among the largest. © Copyright Allianz

Catastrophe bonds The number and volume of Cat Bond issuances has increased in recent years. Issuances in the first half of 2007 have already surpassed to total for 2006. In early 2007, Allianz launched a $US157m bond with a maturity period of six years to hedge against floods in the UK and earthquakes in Canada and the US (except California). These risks were chosen because they are high risks that are insufficiently covered by existing reinsurance. The market response was positive and the bond was several times oversubscribed. Allianz will continue to explore the potential of the capital market to absorb natural catastrophe risks © Copyright Allianz

Private and Public Risk Partnerships A risk partnership between private insurers and governments can exert considerable influence over the effects of natural catastrophes. Examples of such partnerships include: - flood risk in the UK - state reinsurance The UK case is one example, but a large range of cooperation possibilities exist, in areas such as: - safety standards - land-use planning - construction regulations - public infrastructure - catastrophe protection measures - taxation arrangements © Copyright Allianz

Government reinsurance When reinsurance cover is limited and capital market instruments under-developed, the insurability of natural catastrophes can be improved through government reinsurance. Since 9/11, government reinsurance arrangements for terrorism cover have been introduced in a number of countries, including Australia. Such programs should be based on the following principles: - only be available for major damage above a certain level, which would depend on market conditions, out of which would emerge a system of multi- layered liability, as is typical in insurance markets. - private insurance should always remain involved to retain flexibility eg, a proportional division of coverage – above a certain level – between insurers and the government. - premiums should be set at levels appropriate to the risk. Premiums that are too low will crowd private insurers/reinsurers out of the market and increase moral hazard behaviour. © Copyright Allianz

Key findings and conclusions The frequency and intensity of natural catastrophes is increasing as a result of climate change. Average insured losses have been increasing and are expected to rise to $US41 billion per annum over the period 2010 – 2019. Catastrophe risk markets exhibit underinsurance, sub-optimal diversification and efficiency, and high premiums in some markets. Catastrophe risks - difficult to predict occurrence and loss levels, require high levels of capital and have limitations on reinsurance coverage. Capital markets can assist with diversification eg, Catastrophe Bonds However, private – public partnerships will also be required to ensure future natural catastrophe risks can be covered, particularly in light of the predicted effects of climate change. © Copyright Allianz

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Total damage bills also projected to rise Using relatively conservative total loss to insured loss ratios of 2:1 and 3:1, the projected average annual total damages in the period 2010 to 2019 will be in the region of $US80 – US$120 bn. However, annual losses can vary considerably above and below the average. For example, in 2005, insured losses were more than three times trend average, and have reached nearly four times trend on another occasion. On this basis, annual total losses of up to US$400 billion are not merely possible but probable. © Copyright Allianz

Allianz & WWF Global Partnership on Climate Change Credible Leadership Comprehensive, integrated approach to reducing carbon footprint, from operations to investments Climate-conscious decision making from management to employees Amidst ever clearer climate risks and opportunities… One of the world’s largest financial services providers, with more than 60 million customers in over 70 countries and a comprehensive range of services in the areas of insurance, banking and asset management. has partnered with … One of the world’s largest and most experienced independent conservation organizations, with a global network working with politics, businesses, consumers, and conservationists, to find solutions to climate change. … to demonstrate a leadership financial sector response. Over the three years the two partner will cooperate in the following areas: Research for Solutions Going where the green growth is - from renewable energy and energy efficiency, to eco-friendly investments and to carbon trading For more information contact Michael.Anthony@allianz.com © Copyright Allianz