Managing physical climate risk: Part 1 & 2

Part 1

Mark Maroon:

Hey everybody, welcome to Climate Check. This is Mark Maroon, VP at American Modern, a Munich Re Company, and today I'm joined by Chris Gottardo, head of business development, global banks, and asset managers for climate change solutions at Munich Re. Thank you, Chris, for joining me today.

Chris Gottardo:

Thank you, Mark, it's my pleasure.

Mark Maroon:

So, just to start, can you tell us a little bit about your role at Munich Re?

Chris Gottardo:

It's a new role. So, the new role that I've taken on is in a new department within Munich Re, so climate change solutions. And we're using the knowledge that Munich RE uses itself in its own decision making processes to offer that to other financial institutions in the market. So, my role is to develop the business we have for new business, away from our traditional primary insurance clients, to work with the banking sector, asset management sector, and other financial institutions that are looking at addressing physical climate risk issues in their business.

Mark Maroon:

Obviously, we are here to talk a little bit about climate change, and it's pretty interesting because particularly in Australia, catastrophic weather, tropical cyclones, floods, sea level rise, hail, coastal erosion, et cetera, et cetera, et cetera, it seems like it's going to be hitting harder and faster in more populous areas than in the past. So, can you maybe tell us why that's going to be a problem for financial institutions?

Chris Gottardo:

Sure. Yeah. So, the Australian market, we do have just about every natural catastrophe except for the snow related ones, and we've seen that, in the last couple of years, these bushfires and tropical cyclones have become more regular. And this is coupled with timing where our local regulator has looked at what's happening in the rest of the world as far as encouraging financial institutions to start to identify climate risk in their businesses, and measure it, and then think about what actions they might take to help mitigate these risks. So, for financial institutions, I'll separate them from the primary insurers because they've been on this topic for some time, which is our traditional client base. But when I talk more broadly about financial institutions, it's more about the banking sector, the asset management sector, and well, we call it the superannuation funds here, so the pension funds. And this is a risk that they have been taking in a passive way, up until now, and they're having to, once they're identified, take some action and think about what steps they might take to mitigate these risks.

Mark Maroon:

So, to follow up on that then, can you maybe talk about how some of these institutions are taking active steps to address this, instead of just passively, like you said, just accepting it and taking it as it comes?

Chris Gottardo:

So, it's a bit of a new journey for financial institutions, and we've been lucky enough to work with both the regulator and the five largest banks on this topic, and helping them educate the senior management teams, but also bring it into seeing climate risk as a business risk. And that's the step we're at at the moment, is bringing that knowledge into those that are looking at stress testing the portfolio, or understanding how physical climate risk impacts credit losses, when you're talking about the banking sector. For the asset management sector, there is probably a couple of steps away. So, if you think about all the different underlying asset classes that asset managers manage, the first one that they're looking at is the real asset portfolio, so commercial real estate, but it gets a bit more challenging when you start to look at other asset classes, such as government bonds, corporate bonds, and asset backed securitized assets in the fixed income space.

There is a bit of a data gap there, which we can touch on a little bit further. Then it gets even a little bit harder when you start thinking about equities and private equity. So, I think, for us, it's helping those that do have the risk there already, and I can expand on that a little bit if you like, is really just being able to identify that risk, and understand how that might change in time. So, there's currently a natural catastrophe risk in most of these businesses, what is it today, but then what happens depending upon which particular pathway we take in the future, what does climate change look like on top of that?

Mark Maroon:

No, that makes sense. And it's pretty interesting too, because if I'm thinking about just your standard bank with a bunch of mortgages that you're holding, in the US at least it's pretty standard to have 15, 20, or 30 year mortgages. So, obviously you're looking at a longer time horizon when we're dealing with things like climate change and everything that goes along with that. So, if you're a bank, what would you do to be more proactive to address some of those risks, knowing that you could be on some of these properties for 30 years?

Chris Gottardo:

Yep, that's a very good question. On the flip side of that, the primary insurance business is repriced every year. And so, while primary insurers are better at understanding the effects of climate change, they have the ability to reprice, or to write new business or don't write business, or change their premium. So, we often talk about an insurance market, that it's not that an asset will be uninsurable, it will just be unaffordable at some point in time, as climate change takes its effects. But coming back to the banking sector, the first step to do really is understand your existing risk. So, roughly, if you look at the Australian market, across, say the 15 million different locations, there's probably about 20% of the portfolio that has exposure to some form of natural catastrophe risk. So, wind and flood today. And the change actually is probably about another five or 10% depending upon where your portfolio lies.

So, it really is getting to understand where are your areas of concentration, right now? So, which geographical locations have the highest exposure to the various perils? Understanding the effect of those perils. So firstly, identifying and assessing that risk, secondly, measuring the financial impact, should a tropical cyclone come through or a particularly low-lying area of flood. And there's really two areas here that the banks are concerned about, and if I was a banker in that position, then I'd be concerned about. The first is what's the exposure to your own organization?

So, your back book, and how you might write new business in the future with new information about physical climate risk. But the second area of concern that the banks are showing is that, what about their borrower? They don't want to be in a position where they need to exclude anyone in the market, most of the Australian banks, the big four, in any case, have a nationwide mandate, and they just want to be able to fund borrowers in every location. So, what sort of product innovation can the insurance markets bring to help protect the borrower in some of these high risk areas, is some of the areas that we are focusing on with the sector.

Mark Maroon:

Thank you, Chris. I do have a few more questions for you on addressing physical climate risk. So folks, please join us for part two of our conversation with Chris Gottardo, up next. And head over to munichre.com/climate for more information.

Part 2

Mark Maroon:

Hey everyone. This is Mark Maroon, vice president at American Modern, a Munich Re Company. Continuing my interview with Chris Gottardo, head of business development global banks and asset managers for climate change solutions at Munich Re about addressing physical climate risk. So Chris, what are some of the solutions that reinsurers like Munich Re and others can offer to support financial institutions in managing that physical climate risk we previously discussed?

Chris Gottardo:

Well, if we've gone through the process of assessing the areas of concentration, understanding the potential financial impact both to the bank and or to the borrower, we have what's necessary to work out is some of the protection that the reinsurance market might be able to offer because we have a location, we understand which perils or risks we're talking about, and we understand the size of a potential loss. So there are existing types of solutions that are used in other examples, and we tend to talk about parametric covers where there's quite simply a point or a circle or a square on the map. If the wind gets to a certain speed or flood gets to a certain height at a particular point in time, there's a payout and there's a premium attached to that. I guess part of the challenges that we have at the moment is that for the banking sector, these are not being used regularly.

And where we will see, I think more uptake in these types of instruments is where there is at some point in the future, additional regulatory capital requirements around holding additional capital for climate risk. And when that happens, you'll see banks saying, well, do we need to raise additional capital to meet these additional capital requirements or is it better to have to trade out of this risk, so to speak, such that it is part of the insurance and reinsurance markets using their capital base and paying for someone to take that risk away. So it's early days yet, but I think the economic incentives, once people have gone through the process of understanding what financial impact may have on their business and their borrowers, we are more likely to see these sorts of risk transfer ideas come into play.

Mark Maroon:

That's an interesting concept, and it's interesting to me at least having gone through the '08 housing bubble in the US. It was a similar situation where there are a lot of folks trying to de-risk their portfolio for different reasons, obviously, but obviously a lot of the finance folks got a little too clever for their own good. The subprime stuff started happening and then all of a sudden the house of cards collapsed in on itself. So I guess I would ask, are there certain things that Australia can learn from the rest of the global markets and or vice versa that can potentially help financial institutions manage this risk a little bit more intelligently so we don't see another economic collapse?

Chris Gottardo:

Sure. Well, when we talk to the Australian banks, they're always very interested to know what's happening in other parts of the world and vice versa. So I think what we need to see really is, and what we are encouraging as part of my new role is to help cross-fertilize ideas around the world to say, and to have banks that are not competing in the same market, to have a dialogue to say, what should the industry response be to these issues? And they get a little bit bigger than just managing a risk in a business. It is about equality across treating people fairly in various locations so that if you choose to live on the coast in a high wind area, you insurance premium doesn't get up to being 25% of your house value.

How is it that the industries and I talk about insurers, reinsurers and the broader financial service industry, how can we make sure that we are sustainable in the future as the climate changes? One of our efforts will be when we see ideas in one markets bring it to another. So as I say, we're still early days in these discussions, but as we find some of the braver banks in whichever part of the world, which decides to take some steps to look at a new idea, a new concept, and working with us to originate new ideas, we'll definitely be sharing that in other parts of the world.

Mark Maroon:

That's pretty interesting. So I guess I'll get you out of here on this. It sounds like there's going to be a lot more cooperation between the industry and the financial sector in trying to de-risk this, but do you think there's an opportunity to work with governments as well to try to come to a better solution across the board?

Chris Gottardo:

Yeah, I'll be selective as to way I might answer this one, because sometimes we have seen with government intervention that there's some unintended consequences that follow. So there is a place at the end for the last hold of the risk is the state at some point in time. And you'll see that when there are significant events that are way beyond expectations, and they may not be climate related, it might be, say, earthquake risk for example, where a particular economy is completely destroyed past anyone's expectation. So there's obviously some room to negotiate with governments. I guess where the areas that we have been trying to influence is looking at say, building code standards, for example.

So in Australia, tropical cyclones are moving further south down the coast. Some larger regional areas such as Brisbane and the Gold Coast are not built to the same standard that you might have in further higher up the coast. So just thinking about the adaptation or trying to mitigate risk, the building regulations can play a part in that. So they're definitely part of the picture. I'll use that one example just to say they're part of the picture, but I don't necessarily think that we should rely too heavily on that. They're just one piece of this really big jigsaw puzzle.

Mark Maroon:

That's a good point. I think really as we move forward, resilience is going to become such an important topic. If we know that we're going to be seeing more of these events, potentially more frequent, potentially more severe, is there a way that we can build up our infrastructure to be able to withstand a lot of the additional hazard that we're going to be seeing? So maybe it is worth the investment ahead of time to get out in front of it as opposed to constantly trying to rebuild and reinvest in everything that goes along with that. So Chris, I just wanted to say thank you so much for joining us today. It was a pleasure having you on.

Chris Gottardo:

You're welcome, Mark. Thanks for your time.

Mark Maroon:

Absolutely. And so folks, if you liked this episode, please subscribe to our podcast and for more information go to munichre.com/climate and we will see you next time.