Key Takeaways
- The ability of insurance to offset financial risks from catastrophic events, including climate-related events, is relevant to the creditworthiness of issuers and debt instruments outside of the insurance sector.
- Not all coverage is equal, and protection will depend on the policy terms and conditions governing the timeliness and size of insurance payments, particularly in relation to entities' debt-service commitments.
- Insurance coverage could become less affordable if the frequency and cost of claims increases significantly, as insurance companies have to manage their own risk too.
There are few businesses more aware, or more wary, than insurers of the financial risks stemming from catastrophic events, including climate-related events. The threat of larger and more frequent extreme weather events carries with it the potential for greater financial damage and increased payouts.
Yet insurers don't bear the brunt of extreme weather alone. Insured parties face the prospect of increased premiums, reduced coverage, and, for those in some industries and regions, difficulties securing insurance--especially after a previous claim. That should make insured parties more aware of their risks, but could also affect the credit quality of both debt issuers and debt instruments.
S&P Global Ratings' assessment of credit risk includes a consideration of the potential for insurance to "partially or fully offset" rated entities' environmental, social, and governance risks (see "General Criteria: Environmental, Social, And Governance Principles In Credit Ratings," published Oct. 10, 2021).
Insurers' evolving ability and willingness to offset the financial impact of catastrophic events demands the attention of both policyholders and those seeking to accurately assess their creditworthiness. Notable trends are emerging within industry sectors and are evident from specific cases that illuminate how insurance is being used to protect credit quality, and where it is falling short (see Appendix 1: Sector-Specific Case Studies below).
Insurers' Risk Management Drives Policy Changes
Insurance companies are in the business of assuming and managing risk for entities that wish to offload at least some of that risk, yet they also expect to generate a profit and proactively manage their capital. That compels them to manage risk on their own balance sheets with various levers. The three main ones that directly affect policyholders are:
- Insurance premiums;
- Risk retention and limits; and
- Other terms and conditions such as policy coverage and exclusions.
Insurers have scope to make changes to those terms and conditions as policies renew, and the majority of property and casualty insurance policy contracts, including those providing protection against climate-related physical risks, have one-year terms.
The insurance sector's profitability, especially in the U.S., has been affected by unusually frequent and severe natural catastrophes, including convective storms, floods, and wildfires (see "Record Weather-Related Losses Hit U.S. Homeowners Insurers And Pose Challenges In Estimating Catastrophe Risk Charges," Sept. 3. 2024). The number of insured weather losses over 2024 is on pace to pass the record set in 2023. According to the Natural Catastrophe and Climate Report produced by Gallagher Re, a reinsurance broker, global insured losses amount to $108 billion in the first nine months of 2024. That sum excludes the losses from Hurricane Milton, which made landfall in the U.S. in the fourth quarter. Economic and population growth, as well as claims inflation, will be the main growth drivers of insured losses over the long term, while climate change will contribute to the volatility of both the frequency and severity of natural catastrophes.
An increase in insured losses could increase reinsurance costs and reduce underwriting margins in the primary insurance industry. This, in turn, encourages insurers to increase the price of insurance protection and/or reduce their risk exposure.
It is important that policyholders understand how the year-on-year evolution of their insurance coverage can affect the level of risk mitigation provided by insurance. That involves monitoring a set of key considerations.
Key Insurance Policy Considerations
Insurance's effectiveness as a risk mitigant depends on the timing of payments if a valid claim is made, the amount an insurer is expected to pay out, and how the occurrence of an insured event could affect the entity involved. Depending on the relevance and materiality of insurance as a risk mitigation, we may consider the following insurance policy aspects:
Coverage And Exclusions
This notably includes the perils covered by a given insurance policy, which could include business interruption, cyberattacks, earthquakes, and hurricanes, for example.
Key elements for policyholders to consider include:
Who is covered by the policy?
Which parties have an insurable interest?
Which perils are covered by the insurance policy?
Just as importantly, which perils are not covered?
How does the maximum payout size compare to the entity's financial commitments?
Considerations include coverage of short- and medium-term interest and principal payments, and the expected recovery on the related collateral.
Could the policy terms create uncertainty regarding risk mitigation?
For example, uncertainty could be created if there are policy deductibles (in value or time), or first-loss provisions that have to be borne and funded by the insured entity.
Are there coverage (sub)limits and exclusions?
Under which circumstances could they be applied?
Is the sum insured equal to the replacement value of the insured asset and has inflation changed that calculation?
If the sum insured is below the value of the insured assets at the time a claim is made, an insurer is often only liable to pay for a percentage of the value of the asset lost, leaving the insured entity to pay the remaining cost, which is determined by the percentage to which the asset is underinsured. In the worst case, underinsurance can lead to policy cancellation.
Is there a risk that insurance protection could be voided?
For example, this could be due to missed premiums, misrepresentation, or nondisclosure.
In the event that insurance is absent, what is the reason?
Renewals
Policy renewal is the point at which an insurance contract could change most. This and other factors, including the timing of a renewal, and the possibility that a renewal will be refused, are risk factors.
Key elements to consider include:
Does a mismatch between the term of the insurance and the term of the rated debt create renewal risk?
What is the insurance policy renewal cycle?
Many insurance policies are provided on an annual basis, and so there will often be an inherent timing mismatch between the minimum duration of the policy coverage, the non-time-bound entity creditworthiness and long-term issuer credit rating (ICR), and the life of the covered asset. Policy renewal risk may therefore be important.
Will cover likely be available on an ongoing basis?
This is especially pertinent on the policy renewal date. Are there implications for the ICR on the rated entity or the issue rating on the rated debt if the policy is not renewed?
The premium may change at renewal.
What are the credit risk implications of a much higher premium? This is especially pertinent for issuers where insurance is an important credit risk mitigant and liquidity is limited.
Terms and conditions could change at renewal.
Changes could include a decrease in the sum insured and limits, an increase in deductibles, and the exclusion of certain perils.
Claims And Payment
Claims against an insurance policy can be subject to adjustments that lead to reduced payments, while delays in the payment of a claim could expose a policyholder to liquidity risks.
Key elements for policyholders to consider include:
The likely delay to a payment following a claim.
Considerations may include whether payment is likely to be received prior to an interest or principal payment falling due.
Commitments that the insurance provider has made regarding payment timing and timeliness.
Insurance policies often have terms and conditions, supplemented by legal precedent that preserves the insurer's ability to withhold payments while it explores the validity of an insurance claim. Our insurer financial strength ratings address the ability of an insurer to pay under its insurance policies, in accordance with their terms, but do not address the timeliness of payment, which may be a relevant credit risk driver for the insured entity. On the other hand, our insurer financial enhancement rating is a forward-looking opinion about the creditworthiness of an insurer with respect to particular insurance policies or other financial obligations that are predominantly used as credit enhancement and/or financial guarantees where we consider such a policy or obligation creates a commitment to make payments in a timely manner (see Appendix 2: Types Of Insurance Ratings).
Sources of liquidity of the rated entity.
The existence of alternative sources of liquidity to cover any delay in an insurance payment would likely be relevant for credit quality.
The scope for a claim to be subject to loss adjustments.
The method of calculation for such adjustments and the extent of the possible reduction in payment.
Contract stipulations regarding prompt claim notification.
Delays in lodging a claim can constitute a breach of the insurance contract and lead to a claim being denied.
Risk Management Is An Ongoing Process
Managing and overseeing the risk mitigation that insurance provides can be complex.
That complexity was highlighted by recent research by Gallagher Re, which found that claims managers in the U.K. consider about 46% of the country's commercial properties are underinsured--with the average deficit on those underinsured assets at about 40% (i.e., the sum insured is 40% less than the replacement value of the asset). The main contributing factors to that underinsurance were the rising cost of materials and labor prices.
If climate change causes catastrophic events, or increases the frequency of severe events, it could exacerbate the complexity of risk management. That could, in turn, affect insurers' risk calculations and thus lead them to change the insurance policy's terms and conditions at renewal. It is the policyholders that have to bear the consequences of a mismatch between their insurance coverage and any losses stemming from damaging events.
Priced-Out Or Excluded: Access Could Prove More Of A Challenge
Beyond the issues around insurance's ability to mitigate credit risk, changes in the frequency and extent of catastrophic events, including those related to climate change, could increasingly force entities to grapple with more fundamental questions of access to insurance.
In the U.S., pricing survey data suggests that rates on homeowners' insurance rose nearly 23% cumulatively, between 2019-2023, while reported loss severity rose by 31% (see "Record Weather-Related Losses Hit U.S. Homeowners Insurers And Pose Challenges In Estimating Catastrophe Risk Charges," Sept. 3, 2024). These premium increases are testing the economic viability of coverage for some policyholders and, in some cases, have resulted in insurers withdrawing coverage altogether.
An April 2024 report by S&P Global Ratings discussed the effect of premium increases on home prices (see "The Impact Of Rising Insurance Premiums On U.S. Housing," April 22, 2024). Under certain scenarios, home prices could start to see pressure in anticipation of a sustained period of significant insurance premium increases.
The evolution of insurance coverage and availability could also lead some governments to take a more active role in supporting access to insurance, in the form of financial support or legislation, or even as insurers of last resort. Recovering from a disaster, or replenishing reserves for insurance programs of last resort, means governments' priorities for resources and funds could change (see "Rising Insurance Costs And Mounting Affordability Challenges Could Weigh On Some U.S. Governments' Creditworthiness," Oct. 31, 2024).
The wider trend of price increases could accelerate and spread if extreme weather events become more frequent and severe. That could add uncertainty to insurance costs and further complicate risk-mitigation calculations for issuers seeking protection.
Appendix 1: Sector-Specific Case Studies
1. Corporations: Insurance Coverage And Diversification Matter
From a credit perspective, the overwhelming majority of corporate entities we rate have successfully managed their climate risks so far. From April 2020 to December 2023, we took only 20 rating actions relating to physical climate-related risks (see "ESG In Credit Ratings Deep Dive: ESG Factors Drove 13% Of Corporate And Infrastructure Rating Actions Since 2020," March 13, 2024). All but one of those rating actions were in the energy and utility sectors, with the exception being in the real estate sector.
Our recent study of close to 7,000 corporations found that only about one-fifth had disclosed a climate change adaptation plan, and less than half planned to implement an adaptation plan within 10 years. That suggests adaptation to climate change could lag worsening climate hazards (see "Risky Business: Companies' Progress On Adapting To Climate Change," April 3, 2024). The limited financial effects of climate change, to-date, may further contribute to this lag.
The case study
Wildfires and mudslides that hit California in 2017 and 2018 resulted in multiple lawsuits against U.S. utility Southern California Edison Co. (BBB/Stable/A-2), the primary subsidiary of Edison International.
We lowered the rating on Southern California Edison (SCE) by one notch in 2019, reflecting weaker-than-expected regulatory protection that increased the risk that further wildfires posed, and the significant losses that SCE incurred as a result of the event, which, despite insurance cover, surpassed the utility's own asset base.
Those losses largely stemmed from California's common law application of the legal doctrine of inverse condemnation, which can hold a utility financially responsible for a wildfire if its facilities were a contributing cause, regardless of questions of negligence.
SCE's accrued estimated losses from the wildfires and mudslides were $9.4 billion as of Dec. 31, 2023. Recoveries from insurance were about $2.0 billion, all of which SCE has collected. Recoveries through the Federal Energy Regulatory Commission electric rates are set to be $413 million, of which SCE has collected $376 million.
Total after-tax net charges to earnings from claims were $5.1 billion, as of Dec. 31, 2023, while insurance will not cover SCE's billions of dollars of capital expenditure needed to improve infrastructure resilience.
Our view
Insurance coverage can be a key mitigant of a corporation's climate risk, particularly with regards to loss recovery and related litigation risks. It is thus a consideration in assessing credit quality. As well as strengthening their asset base physically, corporations can also reduce climate-event risk through strategic initiatives, and notably diversification of their physical assets, products and services, and supply chains.
The ability to divert production or supply chains to areas that are unaffected, or are less likely to be affected, by floods or storms, for example, could reduce disruption and thus financial risk. Insurance could be a greater factor in creditworthiness if a company does not put in place such safeguards, or where liabilities from an event could be material.
2. Infrastructure: Insurance Is Standard And Key To Risk Management
Typically, public-private partnerships have well-defined minimum insurance requirements that are maintained throughout a concession's life.
The case study
Aberdeen Roads (Finance) PLC, a Scotland-based limited-purpose entity, issued senior secured debt (A/Stable/--) to finance the design, construction, and operation of the Aberdeen Western Peripheral Route in Northern Scotland. The project fell several months behind schedule after it was flooded in 2015 and 2016, raising the then possibility that the contracting authority might not approve a revised construction schedule.
In February 2016, we revised our outlook on the senior secured debt issued by Aberdeen Roads to negative to capture the financial risks associated with the delay in construction works that resulted from the flooding episodes and also a lack of progress on the diversion of adjacent supply pipelines. Timely compensation from insurance limited liquidity risk at Aberdeen Roads, yet construction delays continued, and the schedule slipped further in 2016, prompting us to lower the rating to 'BBB+' from 'A-' in February 2017.
Our view
Our "General Project Finance Rating Methodology," published Dec. 14, 2022, details how we could revise down an issuer's preliminary stand-alone credit profile (SACP) if we determine that the insurance package is weak (though this was not an issue with regards to Aberdeen Roads). We typically view an insurance package as weak if it lacks coverage for business interruption or casualties, or if deductibles are unusually high.
3. U.S. Public Finance: Defined Economic Boundaries Can Heighten Risks
Because U.S. governments and not-for-profit entities operate in defined economic areas, their ability to manage exposure to climate-related hazards by diversifying revenues and operations is curtailed. That makes liquidity, reserves, and insurance coverage important factors in the successful preparation, response, and recovery from events such as hurricanes, floods, and wildfires.
The case study
Californian investor-owned and publicly owned utilities are held to a high level of regulatory accountability due to the state's interpretation of the inverse condemnation doctrine--whereby a Californian utility can be financially responsible if its facilities were a contributing cause of a wildfire, regardless of negligence.
We rate Trinity Public Utilities District Financing Authority (TPUD's) electric revenue bonds (BB+/Stable/--). After TPUD was found liable for sparking the Helena fire in 2017, it was unable to secure wildfire insurance, partly because the California Public Utilities Commission designated the district a Tier 2 elevated risk zone. At the same time, TPUD demonstrated reluctance to rebuild its liquidity and reserves due to the possibility that it would have to use the cash to pay a $10 million liability due to the fire.
We lowered the long-term rating and underlying rating (SPUR) on TPUD to speculative grade, 'BB+', from 'BBB+', in August 2022 because of the district's inability to manage its wildfire exposure due to its lack of insurance coverage, liquidity, and insufficient reserves. In our view, the lack of these financial resources meant that an investment-grade rating was no longer appropriate.
Our view
Utilities are particularly exposed to climate hazards, given the fixed location and maintenance of a sizable number of assets. Insurance coverage can provide a financial mitigant to physical risks, particularly as costly improvements following an acute event can be expensive and drag on the entity's operations and budget. Therefore, insurance coverage is a consideration in assessing credit quality. Furthermore, other adaptive planning for wildfires is considered in our operational management assessment for utilities, including burying electric lines, more frequent vegetation management to remove combustible material, and replacing wood poles with steel and concrete ones.
4. Structured Finance: Underlying Asset Insurance Could Be Protective
In a structured finance transaction backed by a pool of assets, concentrations by obligor, industry, or geography may increase an issuer's exposure to potential natural disasters or other physical climate-related events, such as hurricanes and floods. Insurance coverage may be available to protect issuers against losses and secure the lenders' security in the collateral, or to mitigate a temporary disruption in collections if an insured peril occurs.
Structured finance transactions may also contain structural features, such as servicer advances, cash reserves, liquidity facilities, or the possibility of borrowing principal. These can support the issuer's ability to make timely interest payments if an extreme weather event results in the temporary disruption in payments.
The case study
In August 2017, Hurricane Irma struck Miami, causing significant damage to a luxury beachfront resort that was the sole mortgaged property backing CCRESG Commercial Mortgage Trust 2016-HEAT (already repaid in full), a commercial mortgage-backed security (CMBS) transaction that closed in 2016. The issuer had all-risk insurance covering the property's full replacement cost, as well as business interruption insurance, with suitable rated insurers in accordance with our criteria.
Insurance proceeds funded the repairs at the beachfront property, which reopened in January 2020, while business interruption proceeds exceeded loan repayments during the closure period. The benefit of the insurance coverage meant that we did not take a negative rating action at that time, as the issuer maintained timely payments and the repairs did not materially affect our view of the property value.
Our view
Insurance coverage for assets that collateralize structured finance instruments can protect issuers from the financial repercussions of specified perils, including physical climate-related perils. In our CMBS analysis, we consider whether issuers maintain comprehensive, all-risk insurance for the mortgaged property for an amount that at least equals the property's full replacement cost, especially where there is a greater reliance on a single property or small group of properties. We also consider whether issuers have business interruption insurance that would cover the lack of property income while repairs are underway.
Furthermore, for properties located in areas with additional environmental risks, such as the risks of floods or earthquakes, we consider whether additional insurance is in place to mitigate those risks. Also, servicing advances can provide temporary liquidity to support timely interest payments, including cases where insurance may not cover events. Other structural features, such as credit enhancement, can mitigate losses if assets are underinsured or if there are reductions in payouts.
Appendix 2: Types Of Insurance Rating
In addition to ICRs, which look at an obligor's capacity and willingness to meet its financial commitments, we also have two specific ratings that we can assign to insurance companies--the financial strength rating (FSR) and the financial enhancement rating (FER). These ratings measure different factors (see table 1).
In some sectors, we may consider the ICR to be a good proxy for the FSR and FER. For more on this subject, see sections D and E of "S&P Global Ratings Definitions, " published Oct. 15, 2024.
Table 1
| Comparison: Financial strength rating and financial enhancement rating | ||||
|---|---|---|---|---|
| Financial strength rating | Financial enhancement rating | |||
| Assesses an insurer's ability to make payments under its insurance policies and contracts in accordance with their terms, but is not specific to any particular policy. | Assesses the creditworthiness of an insurer with respect to particular insurance policies or other financial obligations used as credit enhancements and/or financial guarantees that oblige it to make payments in a timely manner. | |||
| Doesn't account for any specific terms and conditions of a policy, such as deductibles or cancellation penalties. | Accounts for the capacity and willingness of an insurer to meet the obligations in accordance with the terms of the policy. | |||
| Doesn't consider the timeliness of payments or the potential to deny a claim. | Considers the timeliness of payments based on individual policy terms. | |||
| Source: S&P Global Ratings. | ||||
Writer: Paul Whitfield
Related Criteria
- General Project Finance Rating Methodology, Dec. 14, 2022
- General Criteria: Environmental, Social, And Governance Principles In Credit Ratings, Oct. 10, 2021
Related Research
- Rising Insurance Costs And Mounting Affordability Challenges Could Weigh On Some U.S. Governments' Creditworthiness, Oct. 31, 2024
- S&P Global Ratings Definitions, Oct. 15, 2024
- Sustainability Insights: Insurers Focus On Underwriting To Tackle Climate Risk, Sept. 10, 2024
- Record Weather-Related Losses Hit U.S. Homeowners Insurers And Pose Challenges In Estimating Catastrophe Risk Charges, Sept. 3, 2024
- The Impact Of Rising Insurance Premiums On U.S. Housing, April 22, 2024
- Risky Business: Companies' Progress On Adapting To Climate Change, April 3, 2024
- ESG In Credit Ratings Deep Dive: ESG Factors Drove 13% Of Corporate And Infrastructure Rating Actions Since 2020, March 13, 2024
This report does not constitute a rating action.
| Primary Credit Analysts: | Kapil Jain, CFA, New York + 1 (212) 438 2340; kapil.jain@spglobal.com |
| Maren Josefs, London + 44 20 7176 7050; maren.josefs@spglobal.com | |
| Terry Sham, CFA, FRM, London + 44 20 71760432; terry.sham@spglobal.com | |
| Secondary Contacts: | Benedetta Avesani, Milan + 39 02 72 111 258; benedetta.avesani@spglobal.com |
| Pierre Georges, Paris + 33 14 420 6735; pierre.georges@spglobal.com | |
| Elisa Suarez, Madrid +34 914233223; elisa.suarez@spglobal.com | |
| Nora G Wittstruck, New York + (212) 438-8589; nora.wittstruck@spglobal.com |
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