KEY POINTS:
• In our view, climate change represents an acknowledged, yet still underappreciated, risk in the municipal (muni) bond market, but also presents investment opportunities for active managers.
• We believe this risk should become part of the “mosaic” for how institutional investors approach the asset class — ideally sooner rather than later.
• For insurers, we believe having a diversified asset/liability mix, while very important, may not sufficiently mitigate potential portfolio losses related to climate risk.
• Given the risk of material climate impacts on certain municipalities, insurers may want to rethink their long-term assumptions on the asset class, particularly for credits in vulnerable areas.
• Insurers might consider making substitution trades for inefficiently priced municipal issues and diversifying their climate risk exposure (while maintaining favorable legacy book yields).
Insurance companies are keenly aware of how to assess, price, and diversify risks associated with their liabilities. But forward-looking issues like climate change, with little or no historical precedent, may pose a vexing challenge for their traditional methods of underwriting risk. And the same climate risk issues could also negatively impact the asset side of insurers’ balance sheets. For example, municipalities in climate-sensitive regions are particularly vulnerable if/when their tax revenues decline as their citizens and businesses emigrate to lower-risk climates. We think these risks will play out, and perhaps intensify, over a number of years as the adverse impacts of climate change increase in frequency and severity.
As the threat of climate change grows and losses mount, insurance companies may face the potential “double whammy” of also incurring losses on their municipal (muni) bond portfolios at the same time as their insured losses increase. (While climate change is clearly a global matter, this paper focuses exclusively on US projections and the potential impact on the muni bond market.)
Highway to the danger zone?Figure 1: Varying Levels of Climate Risk by Insurance IndustryNot all munis are a “safe haven”“Skepticism over the muni market’s perceived “safe-haven” status may begin to mount as the impacts of climate change become more apparent.”Figure 2: US “Heat Map” Additional days per year in NWS danger zone throughout the 2020 – 2029 decade US: based on 1951 – 1980 reference periodInternal US migration risk due to climate changeClimate risk may not be fully reflected in muni bond pricesFigure 3: Texas vs Michigan Municipal Bondsre cities and towns prepared?“We expect there to be times when investors will be more than adequately compensated for climate risk, or when the payment for other risks associated with a credit more than makes up for the inherent climate risk.”“As investors, we look at each municipal subsector through a different lens and are careful to weigh climate risk against a variety of other risk factors, as well as municipal bond pricing.”High-level summary of our processResults: Linking location to valuationWhy it mattersLearn more
