Tag Archives: climate change

A Riskier World?

This year’s Davos gathering is likely to be dominated by Donald Trump’s presence. I look forward to seeing him barge past other political and industry leaders to get his prime photo opportunity. As US equity markets continue to make all time highs in an unrelentingly fashion, it is scary to see the melt-up market been cheered on by the vivacious talking heads.

Ahead of Davos, the latest World Economic Forum report on global risks was released today. 59% of the contributors to the annual global risks survey point to an increase in risks in 2018, with environmental and cybersecurity risks continuing their trend of growing prominence, as can be seen below.

click to enlarge

Undoubtedly, environmental risks are the biggest generational challenge we face and it is hard to argue with the statement that “we have been pushing our planet to the brink and the damage is becoming increasingly clear“. That said, what is also striking about these assessments (and its important to remember that they are not predictions) is how the economic risks (light blue squares) have, in the opinion of the contributors, receded as top risks in recent years. The report does state that although the “headline economic indicators suggest the world is finally getting back on track after the global crisis that erupted 10 years ago” there is “continuing underlying concerns”.  Amongst these concerns, the report highlights “potentially unsustainable asset prices, with the world now eight years into a bull run; elevated indebtedness, particularly in China; and continuing strains in the global financial system”.

A short article in the report entitled “Cognitive Bias and Risk Management” by Michele Wucker caught my attention. The article included the following:

Risk management starts with identifying and estimating the probability and impact of a given threat. We can then decide whether a risk falls within our tolerance limits and how to react to reduce the risk or at least our exposure to it. Time and again, however, individuals and organizations stumble during this process—for example, failing to respond to obvious but neglected high-impact “grey rhino” risks while scrambling to identify “black swan” events that, by definition, are not predictable.

and

One of the most pervasive cognitive blinders is the availability bias, which leads decision-makers to rely on examples and evidence that come immediately to mind. This draws people’s attention to emotionally salient events ahead of objectively more likely and impactful events.

I do wonder about cognitive blinders and grey rhinos for the year ahead.

Ignorance in action

The last time I posted on the climate change debate was here in November 2014 on the release of the synthesis reports on the IPCC’s 5th assessment. The post asked whether the debate would now move on, away from the climate change deniers, given the weight of scientific opinion. Well, that was before Mr Trump. In his inane rationale for withdrawing from the (nonbinding) Paris climate agreement, Trump has provided a classic illustration of Johann Wolfgang von Goethe’s quote that “there is nothing more frightful than ignorance in action”.

The Paris agreement is far from perfect. It does not however contain hard emissions targets but rather gives a framework for voluntary reductions. Admittingly previous voluntary reductions promised by many countries have been missed but even a flawed agreement is better than nothing. Recent declines in the growth in coal use in China and India were positive initial signs.

Maybe Mr Trump’s delusional thinking is that his masterful negotiations skills mean he can negotiate a global agreement with hard emission targets! More likely, he is acting politically to shore up his mid America coal loving support given the danger that some of his core support may just be realising that his healthcare and fiscal policies are not that favourable to those at lower incomes.

I recently came across this statement from January 1954 by the Tobacco Industry Research Committee, a tobacco firm group representatives, in reaction to some of the initial medical research showing that smoking was linked to lung cancer. The group stated that “we believe the products we make are not injurious to health”. My favorite bit is the arguments cited by “distinguished authorities” below countering the emerging scientific evidence:

  1. That medical research of recent years indicates many possible causes of lung cancer.
  2. That there is no agreement among the authorities regarding what the cause is.
  3. That there is no proof that cigarette smoking is one of the causes.
  4. That statistics purporting to link cigarette smoking with the disease could apply with equal force to any one of many other aspects of modern life. Indeed the validity of the statistics themselves is questioned by numerous scientists.

Don’t these arguments sound familiar?

Risky World

The latest World Economic Forum report on global risks is out today and, as usual, it reflects current concerns rather than offering any predictions for 2017. To be fair to WEF, the top risk for 2012 to 2014 inclusive in their survey was income disparity which is commonly viewed as one of the factors behind the rise in populism.

click to enlargewef-global-risks-2017

The report states the obvious about the impact on global risks following 2016, specifically that “societal polarization, income inequality and the inward orientation of countries are spilling over into real-world politics” and that “decision-making is increasingly influenced by emotions” due to the increase in nationalism. Where this year’s report is spot on, in my view, is in relation to the top 5 global trends that will determine global developments over the next 10 years, as below.

click to enlargewef-top-5-global-trends-2017

The report also states that “although anti-establishment politics tends to blame globalization for deteriorating domestic job prospects, evidence suggests that managing technological change is a more important challenge for labour markets” and that “we are in a highly disruptive phase of technological development, at a time of rising challenges to social cohesion and policy-makers’ legitimacy”.

Among the many risks highlighted in the report is a reduction in geopolitical co-operation which is likely to be detrimental to global growth, action on global indebtedness, and climate change.  It’s particularly depressing to think that even if the commitments under the Paris agreement were delivered, which now looks doomed after the election of Trump, the United Nations Environment Programme (UNEP) estimates the world will still warm by 3.0°C to 3.2°C, still far above the 2°C limit where scary and irreversible stuff happens.

Another worrying risk is the possibility of a new arms race in an era of rapid advancements in a technology which also has a retrograde feel, especially “while risks intersect and technologies develop quickly, too often our institutions for governing international security remain reactive and slow-moving”.

All pretty cheery stuff! And on it goes.

As I write this, I’m watching reports on Mr Trump’s press conference today, and although there is no doubt that our world is riskier as we enter 2017, it will be entertaining to see this guy as the leader of the free world. Hopefully good entertaining, not depressing entertaining!

How low is CAT pricing?

So, the February dip in the equity market is but a memory with the S&P500 now in positive territory for the year. With the forward PE at 16.4 and the Shiller CAPE at 25.75, it looks like the lack of alternatives has, once again, brought investors back to the equity market. As Buttonwood puts it – “investors are reluctant bulls; there seems no alternative.”  A December report from Bank of England staffers Rachel and Smith (as per previous post) has an excellent analysis of the secular drivers on the downward path of real interest rates. I reproduced a sample of some of the interesting graphs from the report below.

click to enlargeReal interest & growth & ROC rates

In the course of a recent conversation with a friend on the lack of attractive investment opportunities the subject of insurance linked securities (ILS) arose. My friend was unfamiliar with the topic so I tried to give him the run down on the issues. I have posted my views on ILS many times previously (here, here and here are just a recent few). During our conversation, the question was asked how low is current pricing in the catastrophe market relative to the “technically correct” level.

So this post is my attempt at answering that question. On a back of the envelop basis (I am sure professionals in this sector will be appalled at my crude methodology!). Market commentary currently asserts that non-US risks are the more under-priced of the peak catastrophe risks. Guy Carpenter’s recent rate on line (ROL) regional index, which is a commonly used industry metric for premium as a percentage of limit, shows that US, Asian, European and UK risks are off 30%, 28%, 32% and 35% respectively off their 2012 levels.

Using the US as a proxy for the overall market, I superimposed the Guy Carpenter US ROL index over historical annual US insured losses (CPI inflation adjusted to 2015) as per Munich Re estimates in the graph below. The average insured loss and ROL index since 1990 is $25 billion and 168 respectively. On the graph below I show the 15 year average for both which is $32 billion and 178 respectively. The current ROL pricing level is 18% and 23% below the average ROL since 1990 and the 15 year average respectively.

click to enlargeUS CAT Losses & ROL Index

However, inflation adjusted insured losses are not exposure adjusted. Exposure adjusted losses are losses today which take into account today’s building stock and topology. To further illustrate the point, the graph in this 2014 post from Karen Clark shows exposure adjusted historical catastrophe losses above $10 billion. One of the vendor catastrophe modelling firms, AIR Worldwide, publishes its exposure adjusted annual average insured loss each year and its 2015 estimate for the US was $47 billion (using its medium timescale forecasts). That estimate is obviously some way off the 15 year average of $32 billion (which has been influenced by the recent run of low losses).

By way of answering the question posed, I have assumed (using nothing more than an educated guess) a base of an average annual insured loss level of $40 billion, being within an approximate inflation adjusted and exposure adjusted range of $35-45 billion, would imply a “technically correct” ROL level around 185. I guesstimated this level based upon the 10 year average settling at 195 for 4 years before the 2016 decline and applying a discount to 185 due to the lower cost of capital that ILS investors require. The former assumes that the market is an efficient means of price discovery for volatile risks and the latter is another way of saying that these ILS investors accept lower returns than professional insurers due to the magic which market wisdom bestows on the uncorrelated nature of catastrophic risk. 185 would put current US catastrophe premium at a 25% discount to the supposed “technical correct” level.

Some in the market say rates have bottomed out but, without any significant losses, rates will likely continue to drop. Kevin O’Donnell of RenRe recently said the following:

“We believe that a playbook relying on the old cycle is dead. The future will not see multi-region, multi-line hardening post-event. There’s too much capital interested in this risk and it can enter our business more quickly and with less friction. There will be cycles, but they will be more targeted and shorter and we have worked hard to make sure that we can attract the best capital, underwrite better, and deploy first when the market presents an opportunity.”

I cannot but help think that the capital markets are not fully appreciating the nuances of the underlying risks and simply treating catastrophe risks like other BB asset classes as the graph below illustrates.

click to enlargeBB Corporate vrs ILS Spreads

There is an alternate explanation. The factors impacting weather systems are incredibly complex. Sea surface temperatures (SSTs) and wind shear conditions are key variables in determining hurricane formation and characteristics. Elements which may come into play on these variables include the North Atlantic Oscillation (NAO) which is a fluctuation in pressure differences between the Icelandic and Azores regions, the Atlantic Multi-Decadal Oscillation (AMO) which measures the natural variability in sea surface temperature (and salinity) of the North Atlantic, and the El Niño Southern Oscillation (ENSO) which measures cyclical temperature anomalies in the Pacific Ocean off South America. Climate change is impacting each of these variables and it may be possible that US hurricanes will become less frequent (but likely more severe).

An article from late last year in the Nature Geoscience Journal from Klotzbach, Gray and Fogarty called “Active Atlantic hurricane era at its end?” suggests the active hurricane phase in the Atlantic could be entering a new quieter cycle of storm activity. The graph below is from their analysis.

click to enlargeAtlantic hurricane frequency

Could it be that the capital markets are so efficient that they have already factored in such theories with a 25% discount on risk premia? Yep, right.

Rating Risks

The latest World Economic Forum report on global risks reflects the common concerns of its almost 750 global contributors across multiple disciplines. Such reports are often poor predictors of issues (e.g. the emergence of the migrant issue in Europe) but do reflect current thinking as the graphic below on the changing risks by likelihood and impact illustrates.

click to enlargeWEF Global Risks 2007 to 2016

It’s interesting that China hasn’t made it onto either list since 2010. The report has the following to say about a slowing Chinese economy:

The government faces a dilemma. If it tightens credit conditions, it could reduce investment more quickly than consumption can increase to compensate, and cause massive defaults among struggling and heavily leveraged companies. This could mean a much more severe economic slowdown, potentially causing a surge in unemployment and social unrest. However, if the government lets more credit flow to avoid these destabilizing defaults, it risks further increasing the indebtedness of underperforming industries and creating bigger problems down the line.

Unsurprisingly, different regions in the world have different concerns and it’s interesting to compare and contrast each.

click to enlargeWEF Regional Perspective Top 3 Risks 2016

Climate change, extreme weather and water issues are ever present risks. At least it’s reassuring to see that the 5th IPCC assessment report (as per this post) does seem to have moved the debate on from whether we humans are impacted climate to the speed of implementing the mitigation and adaption actions required. As the WEF report states, the Paris Agreement reached last December is a positive step although “to date, nearly 190 governments have submitted their climate action plans, covering over 95% of total global emissions” and “these efforts alone will not suffice as even the most optimistic estimates suggest that these pledges taken together would contain warming only to 2.7°C above pre-industrial levels.” Over 2.0°C is commonly believed to be the point where things could get extremely unpredictable. The Paris Agreement is however better than previous efforts and therefore represent progress.