Two Steps Forward

Burning questions about insurance and climate

My state is burning — again. As I write this, millions of its citizens are living in the dark. But that’s not necessarily the worst of it.

In what seems to have become a rite of fall, scores of wildfires are roaring through California, stoked by seasonal winds and delayed rainfall. Meanwhile, the electric utility that services 16 million people in the northern half of the state has been systematically shutting down power to reduce the risk of spark-ignited fires from downed power lines and malfunctioning electrical equipment.

My neighborhood in Oakland was spared PG&E’s latest Public Safety Power Shutoff, as it’s officially known, although we spent much of the past weekend wondering if we might soon find ourselves scrambling to salvage the food in our freezer and fridge, among other inconveniences borne by a sustained loss of power. Still, compared to the tens of thousands of Californians who’ve had to flee their homes to escape fire and smoke — some to return only to smoldering ash — we consider ourselves fortunate.

It’s all part of the "new normal." And, of course, it’s hardly limited to the Golden State. In recent weeks, fires have raged from Indonesia to Bolivia to Siberia. The European Forest Fire Information System reported in August that wildfires in Europe this year are occurring at a rate three times higher than the average over the past decade. Things aren’t likely to cool down anytime soon.

If you’re in the business of property insurance, that’s a frightening thought. If you own a home or business and are expecting to receive compensation for your losses, you may find yourself out of luck. Absent aggressive leadership from the financial sector, the global economy could find itself swooning in response.

And we’re only in the early days of a changing climate.

We’ve been covering the implications of the climate crisis to the financial sector for well over a decade, although our coverage has ramped up over the past year or so. With good reason: As fires, floods, storms, heatwaves and droughts increase around the globe, the fortitude and viability of insurers, banks and others likely will be tested again and again.

There are at least three key hotspots:

  • Insurance affordability — the rising cost of premiums for homes and businesses deemed to be in harm’s way, in many cases making coverage simply unaffordable.
  • Property values — the potential for trillions of dollars of real estate assets to be devalued due to the increased climate risks they are facing, in some cases giving new meaning to property "being underwater."
  • Financial stability — the wherewithal of banks and insurers, and the government entities that backstop them, as losses mount.

We’re already seeing the leading edge of these challenges and hearing the concerns of those in the industry. In March, for example, Ernst Rauch, chief climatologist at Munich Re, the world’s largest reinsurer, told the Guardian that climate change could make insurance coverage unaffordable for many people. Munich Re’s premiums in hurricane-prone regions such as Florida are already higher than in northern Europe by an order of magnitude.

Premiums also are being adjusted in regions facing an increased threat from severe convective storms, primed by the climate crisis to hold high levels of energy and severity, including in parts of Austria, France, Germany, Italy and the U.S. Midwest.

In California, property insurance premiums have skyrocketed over the past few years — as much as 500 percent. In high-risk parts of the state, insurers are increasingly opting not to renew coverage. Over the past four years, more than 340,000 Californians have been told they are no longer insurable.

Loan arrangers

The financial sector, for its part, is handing off some of these risks to taxpayers. Mortgage lenders — mostly large banks — are selling loans for homes in vulnerable coastal areas to Fannie Mae and Freddie Mac, according to a working paper released last month by the National Bureau of Economic Research. This represents "a potential threat to the stability of financial institutions," the authors write.

Those asset sales allow "commercial lenders to transfer their worst flood risk" to Fannie and Freddie with "no negative market signals," according to the study. The fallout from climate-induced disasters could be on par with that of the 2008 financial crisis, they warn.

A handful of investors are starting to pay attention. Savvy ones see profit amid the peril.

Consider David Burt, who made vast sums a dozen years ago betting against the U.S. mortgage market — "the big short," as it came to be known. Today, Burt’s firm, DeltaTerra Capital, is helping investors take advantage of ways the market hasn't yet priced in the risk of climate change. He’s targeting residential mortgage-backed securities with exposure to climate hot spots, such as in Texas and Florida. 

Burt is betting that rising insurance costs will lead to home price declines and mortgage losses, which would increase volatility in the price of residential mortgage-backed securities. And where there's volatility, there's an opportunity to invest in specific outcomes, much like the credit default swaps that allowed investors to short the housing market a dozen years ago. Burt expects a correction beginning in the next six to 18 months.

"The market’s failure to integrate climate science with investment analysis has created a mispricing phenomenon that is possibly larger than the mortgage credit bubble of the mid-2000s," Burt wrote in a presentation to prospective clients, according to Reuters.

Assuming risk

The insurance industry has a positive role to play, should it choose to step up. Besides providing financial relief following a disaster, the industry could create incentives and pricing structures that reduce risk and foster resilience before disasters strike. The industry already has the collective tools and expertise to identify, assess and price risk — that’s essentially what insurers do — in order to allow the markets to assume climate risk for a price.

But there remains a lot of uncertainty. "Insurability is likely to become a key challenge for the sector, as there is a dearth of data and modeling solutions for many of these new exposures," writes Robert Bentley, CEO of Guy Carpenter’s Global Strategic Advisory. "There are even questions around the insurability of some established risks like extreme weather events, given that the long-term trends associated with climate change remain difficult to measure, predict and, ultimately, model."

Perhaps insurers will be moved to act by the next generation of professionals, like Schuyler Holder, a risk, insurance and financial services major at the University of North Texas. She recently penned an essay for Teen Vogue magazine excoriating insurers for failing to adequately address the climate crisis. She wrote:

The insurance industry is aging right now. It’s expected to have 400,000 job openings by next year, and it’s counting on an influx of young talent, including me and my peers, to bring it out of the baby boomer retirement hole. But new graduates want to work with companies that care about and contribute to sustainability, and this matters to us far more than it did to previous generations.

We, myself and the other students that stand with me, are fighting for something so much bigger than a desk job after graduation. We want climate change policies that will bring an end to the use of coal and other fossil fuels; we want investments in sustainable sources of energy.

Holder didn’t focus explicitly on the insurability of vulnerable homes and communities, or on the financial instability that could result from getting it wrong, but her message was loud and clear: The insurance sector has a key role to play here, and its future talent pool is watching. It fails to step up at its peril. 

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