Insurers Struggle to Address Climate Risk

Helicopter flies over a forest on fire
February 5, 2020
This piece was first published in Forbes on January 30, 2020. It is reprinted with their permission.

The wildfires that ripped through California in 2017 and 2018, the state’s worst two years for fire on record, cost insurers $24 billion in claims and erased a quarter century of insurance industry profits in the state.

In response, insurers have sought to minimize their exposure to wildfire risk by refusing to renew home policies.  Over the past five years California insurers declined 350,000 renewals and would continue to do so today but for California’s one-year moratorium on the practice, which the state put into effect for at-risk areas in December.

While the moratorium gives homeowners short-term security, it leaves open the question of how anyone will be able to afford insurance as the severity and frequency of natural disasters increases due to climate change.  The insurance industry was built to handle discreet incidents of damage.  A fire here and a home razed there, but not widespread blazes that wipe out whole neighborhoods, in succession, as did the Kincade Fire in Sonoma County last fall.  As climate change-related damages become more widespread the industry’s traditional calculus, which has allowed for affordable coverage of manageable risks, becomes obsolete.

In California this reality has become evident in just a few short years.  In 2016 the average annual home insurance premium in the state was around $1000, making California one of the cheapest places to insure a home.  Recently, however, some annual policies in fire-prone areas have recently risen to $19,000 on the open insurance market, while even California’s backstop wildfire insurance program, the FAIR Plan, quotes a fire-specific policy on a similar home at $6000 per year.

As fire increasingly becomes a neighborhood-wide event, its scope begins to mimic that of flooding along the nation’s coasts and rivers, where damage can be indiscriminate and widespread.  Private insurers abandoned the flood insurance market long ago, handing off the costly burden to the federal government and the National Flood Insurance Program.

We all know how that has gone.  The NFIP, which has paid out claims in post-Katrina New Orleans, post-Harvey Houston, and following many more non-headline inundations, is over $20 billion in debt.  NFIP’s financial black hole would be deeper if not for the beneficence of Congress, which wrote off $16 billion in additional obligations two years ago, passing the bill to taxpayers.

While many will point out that it’s impossible to pin any particular flood, hurricane, drought or fire on climate change, the insurance industry isn’t shy about making the connection.  Recently, global risk advisory Willis Towers Watson and the Society of Actuaries both named climate change the biggest risk to the industry.  Reinsurer Munich Re said that 2017-2018 was the worst two-year period for natural disasters on record, with insured losses totaling $225 billion.

“Insuring disasters is trickier than insuring other risks,” says Carolyn Kousky of the Wharton Risk Management Center at the University of Pennsylvania.  “Insuring disasters can be more expensive and in the extreme can be very difficult or impossible to do.”

Tomorrow’s natural disasters won’t look like those from the past in terms of frequency, severity or location.  Yet the insurance industry’s modeling of risk is based on historic disaster data, the value of which is inversely related to the rising concentration of carbon dioxide in Earth’s atmosphere.

As long as this dynamic holds, premiums will continue to rise where they accurately reflect disaster risk, putting existing homeowners in a bind.  In Australia, where ravaging wildfires have drawn sustained international attention, estimates are that by the end of the century five percent of homes will simply be uninsurable.

Where the premiums fail to reflect true risk, as has been the case with the NFIP, homeowners will continue to build in disaster-prone areas, such as along the New Jersey shore and other desirable coastal areas.  Here the size and value of properties have grown with each successive post-flood rebuilding, as owners of vacation homes and supportive mayors have acted in apparent disregard of flood peril and stood aside as their risk burden has been spread among their land-locked brethren.

Yet concern over the unsustainability of building in disaster-prone areas is rising, as is action to address the problem.  In late January, New Jersey announced new rules that will require developers to account for rising sea levels when proposing new projects and gain state approval before building. New Jersey’s rules are the most specific in the country on the issue of rising seas.

In hurricane-prone Florida insurers implemented a new generation of catastrophe models that predict the future likelihood of hurricanes and the damage they might inflict.  Use of such models is politically tricky because they rely on complex modeling of the future rather than historic experience, leaving open the possibility that insurers could overstate risk to justify excessive premiums.  In Florida, all models must be approved by regulators.  California, where the need for new wildfire models is so apparent, has thus far balked at letting insurers use catastrophe models to set premiums.

Ultimately, however, as the experience of California’s wildfires shows, the cost of insuring against some disasters is simply going to be more than the market can bear.  In neighborhoods nestled within dry forests, on former coastal wetlands now paved over with cement, and along midwestern rivers where 100-year floods are increasingly likely to happen in a given year, a reckoning is beginning to take place.  Rising insurance costs will make living in some of these areas unaffordable.  If the government subsidizes policies, the cost of insuring against disasters will be passed onto homeowners elsewhere, until spiraling costs generate political pressure against such shifting of risk.

Then what?  Climate change isn’t a problem that actuaries will be able to model their way around indefinitely.  The solution, as unsatisfying as it will be to those facing immediate threat from flooding and fires, lies in a broader recognition of the danger of climate change.  What must follow is a move to discourage building in risky areas, combined with aggressive action to mitigate greenhouse emissions and limit the number of neighborhoods destined to find themselves at high risk in the future.

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