Reinsurance costs for Australia’s three leading insurers are set to rise at July renewals, Morgan Stanley has warned, and the upward trend is likely to persist, reflecting the increased business risk they face from climate change.

A report from the US investment bank and financial services company says reinsurers’ risk appetite has hardened considerably after two years of underwriting losses as earnings at Suncorp, IAG and QBE took a hit from bushfires, floods and other severe weather events.

Various climate studies have concluded there is a strong correlation between global warming and the increasing numbers and severity of natural catastrophes.

Since 2010, reinsurance recoveries have averaged 74% of reinsurance expenses and in the past 24 months, it has increased to 87%. Reinsurers domiciled in Australia operate with expense ratios of 27-28%, which means they are probably not making any profits here.

“We think reinsurance pricing will rise for Australian general insurers after a decade of severe catastrophe losses,” the report says. “Reinsurance pricing momentum was already building earlier in the year, on the back of elevated catastrophe losses, as global reinsurers were reconsidering Australia's changing catastrophe risk profile.

“While all Australian general insurers are starting to address climate change risk, it is not yet clear how much they can control an issue of this magnitude.”

Suncorp and IAG are believed to be more vulnerable than QBE because they have a significantly larger presence in Australia and also in New Zealand, where the risk of earthquake is among the highest globally.

According to the report, Suncorp and IAG hold relatively concentrated insurance portfolios with risks that are centred around the capital cities of Sydney, Melbourne and Brisbane.

“This means a single event can trigger outsized losses or in an extreme case, a weather event could hit multiple cities,” the report says. “The capital framework that they operate under explicitly looks at maximum possible loss from a single event, as well as accumulation of losses from several medium sized events.

“In both cases, losses are taken post-reinsurance recoveries, so reinsurance matters for capital planning.”

IAG has a multi-year quota share reinsurance cover, which will reduce the pricing fluctuations from annual renewals, the report says, but the same can’t be said for Suncorp, which means the business is most exposed during the July renewals.

A 10% increase in group reinsurance cost in the 2020/21 financial year could lead to a 1.2 percentage point fall in Suncorp’s insurance margin and 11% drop in insurance profit, the report says. In contrast, IAG’s insurance margin will only decline by 0.7 percentage points and insurance profit by 5% under the same scenario.