The United States is being battered by Hurricanes along the Gulf Coast and by wildfires in Northern California. These events are harbingers of climate change. Accelerated warming is making hurricanes more destructive and storm surges higher. As homeowners grapple with these disasters, while social distancing in a pandemic, insurance companies are weighing their financial exposure to higher payouts as more frequent and severe localized events cause damage.

Two concerns regarding the convergence of rising climate change impacts and the insurance industry are addressed below: 1) Has the industry has assessed their vulnerability to mounting climate impacts; and, 2) how are vulnerable communities covering the cost of weather-related natural disasters?

“Fat Tail” Risk

In environmental economics, a “fat tail” of risk refers to the extremes of a critical probability distribution. The probabilities in a normal distribution produce a bell curve. However, because global warming presents economists with possible events outside the realm of ordinary experience, the distribution produces extreme tails between the speed of probability declining and how fast damages are increasing. There is a fat tailed uncertainty over global temperature change from increasing greenhouse gas emissions, which affects the gain or loss of utility from preventing the increase.

The climatologist and a lead author of the third assessment report by the Intergovernmental Panel on Climate Change (IPCC), Michael E., Mann, says we should hedge our bets against uncertainty and purchase a “planetary insurance policy”; invest in mitigation now to avoid the worst later. And even if a catastrophic climate-related event is unlikely to happen, we still need to insure against it due to the possible severity of the end result. As Dr. Mann notes, we don’t buy fire insurance thinking the house will certainly go up in flames. We do the possibility of it happening.

The global average surface temperature has risen nearly an entire degree Celsius and sea-level rise rose 20 centimeters over the last century. Since we have historically underestimated the rate of climate change impacts, uncertainty should engender us to plan for uncertainty.

The insurance industry and its customers are both on the front lines of fat tail risk and the house fire has started. One worries about payouts and the other about the cost of rebuilding. But both worry about their livelihood.

They say insurance is a business of risk. Rather, it’s a risky business.

As the frequency and severity of climate change impacts — from floods and wildfires, to storm surges and sea-level rise — increases, the insurance industry may not be able to manage several concurrent events. The U.S. is projected to see $16 billion in average flood damages to urban property annually by 2030.

The flood levels of Hurricane Sandy, which submerged New York City subway stations, left millions stranded, and resulted in over $60 billion in damages for the U.S. are nearly twice as likely to occur today than in 1950.

New models are being developed by insurers and risk managers to price climate change impacts. It comes on the heels of ballooning natural disasters that are reshaping the financial world, as rising levels of CO2 emissions put the planet on a course to an average temperature rise of 3.2°C by the end of this century.

But factoring all potential risks to the insurance industry is a tall task.

There are those incidences we are certainly aware of, which includes catastrophic hurricanes and sea-level rise. Changing weather patterns that bring about increasingly more intense rain, faster snowmelt, and heat-related respiratory issues and mosquito-borne diseases have to be factored in too. Business and homeowner claims increase due to floods or loss of business from a shorter ski season. Health insurance firms have to account for greater numbers of respiratory illnesses, and vehicle insurers will see more claims for damages due to more severe and frequent storms.

The destabilizing of financial markets of increasing claims is a test to the insurance industry. The loss in value of coastal and wildfire-prone homes could trigger drastic capital reallocation and repricing of assets. The largest insurance loss in 2018 was the Camp Fire in California, costing a whopping $12 billion. Homes at risk of flooding across the U.S. are said to be overvalued by over $30 billion, which could prompt a potential real estate bubble.

Insurers are being forced into holding enough capital to cover outstanding losses as climate impacts become increasingly more frequent and severe. Higher and more recurring losses lead to private insurers charging higher premiums. In turn, homeowners and businesses are made to front the bill.

The global average commercial insurance pricing increased by 14% in the first quarter of this year, the largest rise since records began. Moreover, property risk rates have increased since 2018, forcing insurers to demand owners improve their resilience to growing risk.

For policymakers to better evaluate risk and prevent higher premiums for assets in hazardous areas, climate models have to improve and be heeded.

Model projections of global sea-level rise are in doubt as the melting of the ice sheets and glaciers was found to be occurring far faster than initially predicted. And the level of damage that rising seas will have on the property has been “substantially underestimated” due to modeling expectations focusing only on direct sea-level rise and accounting for considerations like tides, storms and storm surges, and land erosion. But various analyses point firmly to drastic climate risks — from loss of mortgage value to rising default rates to soaring insurance payouts requiring bailouts.

The unaccounted risk could lead insurance firms to financial ruin. And the uncertainty and lack of proactive accounting for risk could have rippling effects through the economy. A possible consequence of improperly pricing insurance risk in climate risky assets — namely coastal properties — is that available credit in the market might dry up. Banks could even become unwilling to take on additional risk, in turn, tightening its lending.

Closing the Gap Between Total and Insured Losses

The “protection gap” is a term the reinsurance firm, Swiss Re, uses to explain total global losses versus insured losses resulting from weather-related catastrophes. In other words, communities with high rates of insured households recover much more quickly than those relying heavily on the government for recovery. There’s a protection gap that has widened drastically over the past three decades: economic losses are nearly three times that of insured losses.

California’s property insurance premiums have skyrocketed these past few years, reaching as high as a 500% increase. More frequent wildfires have caused insurers to opt-out of renewing coverage, even canceling policies outright to prone households. The rate of insurers avoiding liabilities in climate impact hotspots has been so high that the California government set a one-year moratorium preventing insurers from dropping customers.

Homes are often the primary asset for American households, representing over 60% of the median homeowner’s total assets and over 40% of total wealth. It makes the risk of climate-borne disasters all that more dangerous to financial livelihoods.

In Florida, flooding is expected to devalue homes by the coast by up to $80 billion by 2050. A 15-35% loss in value on a property could in turn reduce property tax revenue, impacting state and local revenue sources. Moreover, the protection of U.S. coastal communities from rising sea-levels has been projected to cost as much as $400 billion over the next two decades. These compounding issues are leading to a new wave of foreclosures that the U.S. is all too familiar with.

There is a correlation between property delinquencies and catastrophes. The intense California wildfires and Hurricane Harvey making landfall in 2017 did not only leave a trail of financial and human ruin. Long after that costly summer, homeowners were faced with a new set of problems: how to pay their mortgage while also repaying to reconstruct their homes. What’s more, their employment may have also been swept away with the damage. After Hurricane Harvey, there was a sharp increase in 90+ day mortgage delinquency when compared to six months prior.

Vulnerable communities to more extreme weather are having to prepare for a future in which coastal storms, flooding, and wildfires are increasingly the norm. Cities like Houston that felt the brunt of Hurricane Harvey, with no zoning code and buildings scattered throughout floodplains lacking insurance, will continue to bear the costs.

Lower-income and minority homeowners are at the highest risk of mortgage defaults. They will often have fewer options to emigrate when a crisis strikes and hold less insurable value in a county. As the higher-income households in vulnerable flood plains become more aware of the climate-driven hazard, they will emigrate inland to higher ground. The move has implications in terms of lowering the property value of lower-income, at-risk areas and changes the rating plans for insurance firms since the insurable value of at-risk areas decreases. Socioeconomic disparities aggravate an already-difficult situation, making insurance costlier and prices of goods and property more difficult to afford.

But Were They Covered?

Households and businesses are on the frontline, bound to an insurance structure that can leave them out in the soggy debris.

If uninsured by a private policy, U.S. flood insurance underwritten by the federal government serves as a very common safeguard. The National Flood Insurance Program (NFIP) provides homeowners with government-backed insurance for losses from flooding, with a statutory limit of $250,000. If they do not have NFIP, they are eligible for FEMA funding. However, these grants or loans for post-disaster repairs have averaged a mere $4,000, as it did during Hurricane Harvey. In comparison, the average NFIP claim payment following that hurricane was $110,000.

Earlier this year, a study by the Association of State Floodplain Managers and another by the R Street Institute warned about increasing flood damage from climate change. The former notes that current federal flood maps cover only one-third of the country’s 3.5 million miles of streams and only about 50% of shoreline. The latter warns of a failure in preparations for the degree to which climate change and sea-level rise will heighten flood risks and expand flood zones. These are maps used by the NFIP to classify coverage. Only the risk premium zones applicable to participating communities of the federal flood insurance program are depicted in these maps. Hence, they seek to discourage people from living in these areas.

However, if flood insurance is provided by taxpayer-backed federal policies, it creates an incentive for real estate developers to ignore flood maps since the burden of insurance is not on them, nor is it on private insurers.

Buying Fire Insurance Means Heeding Risk

The knock-on effects from a lack of consideration or appropriate pricing of climate risks by insurance firms and related government agencies are far and large. Rising climate impacts are causing a devaluation of homes, increasing insurance premiums, raising financing costs, and disrupting the demand and supply for housing markets along coastlines and wildfire-prone areas. Pricing those risks into assets must come from the top-down: in serving its people, governments have an obligation to price in the impacts of a warming climate with at least an average, even if uncertainties exist. And the possibility of property losses causing a shortfall in federal and state budgets should give them ample motivation.

Without adequate protocols, discounting of climate impacts, and regulatory oversight backed by science on zoning ordinances and land use plans, housing and commercial real estate are at significant risk. Defaults by property owners and liability of financial institutions over the next few decades will be tested. The insurance industry can play a pivotal role in global climate action by creating a snowball effect in the markets and regulatory fields they operate in. (If the money moves, others will follow). Mitigating flood risk and reducing losses to all players involved will depend on smart pricing and risk assessment today.

This article first appeared in The Global Current

Andrew Pickens tweets @pickensa

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