Is Climate Risk Insurable?

As climate-related disasters become more severe and frequent, insurers and governments face an economic black hole.

The insurance industry specializes in understanding the nature of risk, and in estimating the likelihood, and cost, of future damages that can result.

A major challenge for the insurance industry is to understand how climate change alters the likelihood of future natural disasters, from floods to wildfires, and how to accurately reflect these risks in the premiums it charges to consumers and businesses.

Carolyn Kousky, executive director of the Wharton Risk Center, takes a look at insurers’ struggle to manage natural disasters of unprecedented scale, the challenge of communicating climate risk, and how climate risk is being felt in the energy industry.

Andy Stone:  Welcome to the Energy Policy Now podcast from the Kleinman Center for Energy Policy at the University of Pennsylvania. I’m Andy Stone. This podcast normally focuses on issues directly related to energy, and on the policies that govern and in many cases drive the evolution of our energy system.

Today’s podcast, however, looks at an industry that is neither a producer nor a major consumer of energy. The insurance industry specializes in understanding the nature of risk, and in estimating the likelihood and cost of future damages that can result. One of the insurance industry’s major challenges today is to understand how climate change alters the likelihood of future natural disasters, from floods to wildfires, and how to accurately reflect these risks in premiums it charges to consumers and businesses.

The challenge of understanding climate risk is complicated by our use of energy, and by uncertainty over the extent to which fossil fuels will continue to play a central role in our energy system, and impact our climate in the future. Here to talk about climate risk is Carolyn Kousky, Executive Director of the Wharton Risk Center at the University of Pennsylvania. Carolyn’s work focuses on disaster insurance markets and policy responses to changes in extreme events arising from climate change. Carolyn, welcome to the podcast.

Carolyn Kousky:  Thanks so much. Thanks for having me.

Stone:  So, I wonder if we could start by having you tell us a little bit about your work at the Wharton Risk Center on climate risk.

Kousky:  Sure. The Wharton Risk Center is a research center associated with the business school here at Penn. It’s been around for over three decades, doing research and policy analysis on risk management, risk financing, and risk communication topics. But more recently, I’d say over the last several years, we’ve been involved in several areas of work on managing climate risk. This could be transition risk for businesses and governments as we move to a low-carbon economy. But much of it is on the physical impact risks associated with changing extreme events, and what those changes mean for households, for communities, for businesses. And we have projects looking at how we reduce those risks, how we better manage them, how we communicate about them, and of course how we finance them.

Stone:  So what does climate risk look like to the insurance industry? What types of events and disasters are more frequently behind insurance claims?

Kousky:  So, when it comes to climate change, the insurance sector is really concerned about impacts on weather-related extreme events. And climate scientists tell us that weather-related disasters are likely to change in frequency and severity, in timing and duration and spatial extent, as the planet warms. Among these weather-related events, flooding is the most costly of the natural disasters. And that’s true in the United States and also worldwide.

That includes a number of types of flooding, though. So that includes river flooding, where rivers overflow their banks. It includes stormwater flooding from heavy precipitation events. And lots of communities in the US right now are seeing more and more of their rain come as these heavy precipitation events that overwhelm local drainage and cause flooding almost anywhere. It also includes coastal tidal flooding, and storm surge from hurricanes. In fact, hurricanes are a big source of loss for the insurance industry in the US. And hurricanes are projected to get potentially more intense as the planet warms. But also, as the sea surface temperature rises, to start tracking further north, so that there might be places up the Atlantic Coast that rarely saw hurricanes historically, that are now going to have to deal with that risk going forward. And indeed, if you look at insured losses — so for example, with the flood insurance program, the six costliest years for the flood insurance program over the last five decades have all occurred since 2005. And a lot of that is flooding related to hurricane events.

But it’s not just flooding. We should probably also say that climate change is going to impact wildfires as well. And California has seen some of the most destructive fires, as you’ve probably seen in the news the last few years. So, the Camp Fire in 2018 was the deadliest and most destructive wildfire on record for the state. Another fire that year, the Mendocino Complex, was the largest in state history. So California’s grappling with this new reality when it comes to wildfire. And indeed, their Department of Insurance estimated that insured losses from the 2018 fires have exceeded $12 billion.

Stone:  So we’re seeing greater losses in recent years, essentially.

Kousky:  Yes, yeah. And if you look at disaster loss data bases, whether you’re looking at particular weather-related events or particular regions of the world, almost all of them show an upward trend the last several decades.

Stone:  So, normally risk is reflected in the premiums that insurers charge to their customers. In the case of natural disasters, that’s not always the case. Can you explain?

Kousky:  Yeah. So I think we need to step back for a second and understand what makes insuring disasters trickier than other risks. So, insuring disasters can be more expensive, or in the extreme can often be impossible or very difficult to do. And why is that? It’s because disasters are correlated. So if you think about auto insurance, when you get into a car accident, it doesn’t mean all your neighbors did too. But when there’s a big flood or a hurricane or wildfire, it often means your entire community is suffering damages at the same time.

And natural disasters also have what we call “fat tail loss distributions,” which just means that the damages from these events can be very, very extreme. Right? And what all this means is that disaster losses, if you look over time, are what I tend to think of as spiky. So you’ll have a few good years where there’s very low losses, and then all of a sudden you’ll have an extreme loss year.

And the challenge with insurance is that in order for an insurance company to not go bankrupt, they have to have access to capital to cover that really extreme loss year. And so how do they do that? Well, they’ll build up reserves. They’ll have essentially savings. They’ll purchase reinsurance, which is insurance for the insurance companies. They might use financial instruments to put some of that risk into the financial markets. But any of these methods — and they’ll probably use all of them to have access to that capital — are expensive. And that price gets passed on to the insured. And so that means that disaster insurance tends to cost more than non-disaster lines.

And what can happen then is that it’s possible that there’s not a price at which disaster insurance can be profitably offered by the private sector, and that households or businesses are willing or able to pay. And then you get this breakdown in disaster insurance markets. When you get this breakdown, governments step in. And indeed, governments have intervened in every disaster insurance market in the United States, and in fact, around the world. So you can look in the US. For flood, we have a federal flood insurance program. For hurricane wind, when there are challenges in that market, there are state wind pools in every state along the Gulf and East Coast. And we’re not going to be talking about them today because they’re not related to climate change, but there’s also quasi-governmental programs in the State of California for earthquake. We have a federal program for terrorism. So, any disaster line creates these challenges.

Stone:  So the National Flood Insurance Program is the federal program that actually covers flood insurance, and it’s in pretty bad shape. It’s $20 billion in debt, and that’s after Congress cancelled $16 billion of its debt about two years ago. Shows how heavy these losses can be.

Kousky:  Yes. The federal flood program is deeply in debt, and they provide about 95 percent of residential flood insurance in the United States.

Stone:  So one result of this, I guess, subsidization of the insurance market, if that’s the correct terminology to use — has been kind of a self-perpetuating cycle of development and growing risk in coastal areas. And there’s a recent book — and I know you’ve spoken with the author, Gilbert Gall. He’s a Pulitzer Prize-winning author who wrote, this year, The Geography of Risk. And he really focuses on how development on the Jersey Shore has been enabled by the National Flood Insurance Program. Can you tell us a little bit more about what happens in these circumstances?

Kousky:  Yeah, sure. And that’s a great book. As you noted, we hosted him at an event at Wharton this past fall, to talk about these issues. The role of the federal flood insurance program in influencing development, I should say, has been a matter of debate for decades. And it’s become even more important as we face escalating flood risk from climate change, but has been an ongoing concern. And clearly from sort of first principles argument, economic principles — if you suppress the cost of something — so, you make it cheaper to live somewhere — like, somewhere really risky, by lowering the cost of insurance, or — and I should say, often more importantly, by using public dollars to pay for the necessary infrastructure and everything else that enables development in these areas — then you would expect, inefficiently — inefficiently from an economic perspective–high levels of development in areas that are risky.

And there’s some evidence that the flood insurance program might have led to development sort of clustering right outside the 100-year flood plain, which is the area that’s regulated by the program. And there’s also some anecdotal evidence that it might have changed the way we build in risky areas. So I’ve heard stories, for example, that — you know, there used to be maybe river vacation homes that were really just like shacks, because people knew they were going to flood repeatedly, and so they didn’t invest a lot of money in them. Sort of simple cabins, that would be easy to rebuild.

Stone:  Disposable homes.

Kousky:  Yeah. Easy to rebuild. But if you know you can actually insure them and get the full value back, then you can build a much more expensive home. And so, you know, to circle back to what we were talking about earlier, when you look at these increasing losses from flooding and other weather-related events, part of that is climate. And the signal from climate’s going to get worse as we go forward, right? But a lot of it has to do with where and how we’ve built. And we’ve built in risky places, in ways that are not that safe. And when you put stuff in the path of harm’s way, it gets damaged.

Stone:  So where risk is born by private insurers, we’ve seen insurance companies try to raise premiums, notably following recent California wildfires. But insurers have faced pushback. What’s been happening?

Kousky:  Yeah. So, there’s a couple things going on, and it’s going to be interesting to see how the market evolves in California. So first, as we discussed earlier, insuring disasters is inherently more expensive. And if firms suffer huge losses from an event like the 2018 wildfires in California, they have to rebuild their capital so that they’re in a sound financial position to keep offering insurance going forward. So Milliman, for example, estimated that the 2017 fires wiped out ten years of profits for insurance companies in the state in one season. And if you look at the two bad years of 2017 and 2018, it wiped out twice their underwriting profits for the past 26 years. So, two fire seasons erased a quarter decade of profits for the industry. And in that kind of environment, a private company can’t continue to profitably offer wildfire insurance at low rates, if we think that years like 2017 and 2018 are not an anomaly but are going to be the new normal with climate change.

Stone:  So the insurers are understandably trying to get out of that, I would imagine.

Kousky:  They’re figuring out what to do, right? And when risk is clearly changing, then we’re learning as we go. And it’s unclear whether what we’re seeing now are just some market adjustments. So, after any big disaster, there’s adjustments in the insurance industry. Or if we’re in for sort of really a totally different state of affairs in the state of California. And then the question is, how do we handle that?

Stone:  You know, I wanted to ask about the international part of this. You mentioned a few minutes ago that this whole — the subsidization of insurance and these problems are also global. Do we see these same types of policies going back to the National Flood Insurance program as a model in other countries around the world?

Kousky:  Yeah. So, globally, like in the US, there’s almost nowhere — a few minor exceptions — where there are healthy private markets for disaster insurance with large take-up rates. To get people insured against disasters generally requires some sort of government program. And these take a wide variety of forms across the world. Some of them are designed quite differently from how we do it here in the US.

So for example, if you look at countries like France or Spain, they require that your standard homeowner’s policy — so, that everyone takes out when they have to take out a mortgage — cover disaster risks. Which is really different than in the US. Because when you get your standard homeowner’s policy — and this can often be a point of confusion for people — it excludes flood. It excludes earthquake. There’s concern about whether it would start excluding wildfire in the high-risk parts of California. And so you have to buy additional coverages to cover those perils.

So in these other countries, they require that all those disaster perils be included in your policy. But because that creates these real bankruptcy risks for the insurance industry, the government comes in as a backstop. And so if losses get really severe, the insurance company knows they’ll be protected by the government stepping in.

Stone:  Obviously not everyone who lives in the disaster-prone areas is well-to-do, and there are many lower-income people for whom insurance just isn’t really an option. What recourse is available to lower-income people?

Kousky:  That’s a really good question. And I think how we make insurance available and affordable for low-income families is a really big challenge that I think should be a top-of-mind policy issue in the very near term. And let me just first say why I think that’s so important of an issue. And that’s because there’s really no substitute in the United States for insurance as a source of funds for recovery.

So you might think, “Well, people get aid from the federal government.” You see these billions of dollars in disaster supplementals. Well, actually, very little of that goes directly into the pockets of victims to reimburse them. So you can get grants from FEMA. That’s what people think of as sort of the free governmental money after a disaster. But they’re capped, and they’re usually only a few thousand dollars on average, because they’re designed not to bring you back to pre-disaster conditions, but only to make your home safe and habitable again after a disaster. So it’s not going to give you the money you need to rebuild. And we know that 44 percent of Americans don’t have $400 in liquid funds for an emergency. And so if you don’t have $400 for an emergency, you certainly do not have enough money to rebuild your home after a disaster.

So if you don’t have savings and you don’t get money from the government, then what? Well, the first line of defense is actually a loan. And the government, through the Small Business Administration, offers loans, actually, to households, to help them repair. And that can be a really important source of recovery, but it’s best for sort of middle-income families, right? Because lower-income families often can’t even get the loan because they might not have qualifying credit scores, or taking on additional debt might be really burdensome to those families, and not actually the help that it would be to a family that has the income in order to repay that debt.

So that’s just to say that there’s not really other options. And so to prevent really serious financial hardship post-disaster, you really need insurance. And yet the people who need that insurance the most, because the loans aren’t going to help them and they can’t afford — you know, they don’t have savings — are the ones that can’t afford the insurance. And so that’s, really, I think, the issue at the heart of your question.

So now to, what do we do about it? There are a number of policy solutions that many groups have explored as a useful path forward. And one that seems to have a lot of consensus to it is the idea of a federal means-tested assistance program for the cost of insurance. So the idea is that the federal government would pay to subsidize the cost of insurance specifically for low-income families, because we know how important it is to their recovery. But everyone else would face risk-based rates, in order to send that signal to the market. But frustratingly, while many researchers think that that could be a helpful policy, and Democrats in Congress agree with it, and this administration’s OMB think it’s a good idea, Congress has yet to implement it.

Stone:  You know, Warren Buffet, the famous investor, has said that if insurance contracts were written for 30 years, then climate change would certainly be factored into premiums. In fact, they’re written for just one year in most cases. So are we really seeing long-term climate risk reflected in insurance pricing?

Kousky:  That’s a great quote, and I completely agree. Most insurance contracts are only for a year. And that means they’re pricing the risk for this year only. So no, insurers are not going to be pricing impacts that are going to materialize in the next ten years, the next 20 years, the next 50 years. And so I think that’s an important point, which is that insurance alone isn’t going to solve climate adaptation for us, right? And we’re going to need other policy tools to communicate to people, and to communities and investors, when they’re making longer-lived decisions, about how that risk will be changing. Because the price they see on their insurance today is not going to be communicating that.

So if you’re buying a home, or allowing development, or citing infrastructure, we have to have ways to talk about how the cost of ownership and the risk itself is going to be changing going forward. And we don’t have any good policy models of how to make sure that that happens consistently and routinely, so that that risk can be factored into these decisions. Now, there’s lots of groups working on trying to get this information to people. And I feel like we’re close. But we’re not there yet.

Stone:  You know, I often think about — or I’ve heard the insurance industry talked about, as if it’s the canary in the coal mine when it comes to insuring these coastal areas or other areas that are at risk. So basically what we’re saying here, though, is that, “Don’t count on the insurance industry to moved first and pull back?”

Kousky:  That’s a good question. And I think, don’t count on the insurance industry to be sending the full financial signal to markets. But, you know, you’re right, in the sense that insurers probably understand these risks better than anyone, and are doing a lot of very sophisticated modeling to get their hands around it. And so they do have a sense of what’s coming, and their findings and tools can be really useful beyond just the pricing of insurance. And when we see things like the sort of disruption we’ve seen in the insurance market in California after the wildfires, we should take that as a signal and try to get ahead of things.

But I think that at the same time, we need to recognize that to really adjust to the changes that are coming our way from climate change, you need an entire culture of risk management– I think that’s a term that Robert Muir-Wood of RMS used — that involves risk communication, risk reduction, and the risk financing– the kind of risk transfer piece. And you really need all of these. And they are strongest when they work together.

Stone:  And when you’re talking about risk communication, that is so people understand the risk themselves?

Kousky:  Yeah. So they understand. Yeah.

Stone:  So let me ask if you can clarify this. You know, we often hear talk about the 100-year flood, the 100-year hurricane, the 100-year fire risk. It’s often spoken about in the media. Is this a reliable guide to the likelihood of a disaster happening in any given year?

Kousky:  No. And this speaks to some of the problems that we face right now in how we communicate, particularly about flood risk but also about some of these other hazards. When it comes to flooding and this 100-year term, it really comes from the National Flood Insurance Program, this federal program we’ve been talking about. And it has regulatory requirements that were set around the 100-year flood plain. And that’s made it this de facto standard when we talk about flooding, and it’s even spilling over into other areas.

But first of all, it’s misleading. So the term “100-year flood plain” really means the area that has a 1 percent chance annually of having a flood. You could also say that as saying there’s greater than a quarter chance of a flood over a 30-year mortgage. And all these terms are saying the same probability, but you can see how they — people would respond to them quite differently, right? It also creates this in-out mentality, because a lot of the regulations around flood insurance in this country — for example, if you live in this 100-year flood plain and you have a mortgage from a federally-backed or regulated lender, you’re required to buy flood insurance. And it’s a requirement on lenders. And so lenders will tell you, “You’re in this flood area.” But then people think that means if they’re out of it, they’re safe. But really, flood risk varies across the landscape. And it’s not the same within it, and it goes beyond it. There’s much more extreme events that can and do occur.

And we’re still not done with the problems, because I also have to tell you that these flood maps are inherently backward-looking. And flood risk in many places around the US, as we’ve been talking about with climate change, particularly on the coast, is escalating. And often escalating rapidly. And the 100-year flood of a decade ago is no longer the 100-year flood of today. And so when you have these FEMA flood maps that have not been updated frequently enough, and are really looking at historical data and they don’t include these heavy precipitation events or they don’t include rainfall risk — all this is to say that, no, that’s not really the best way to be thinking about who’s at risk.

Stone:  Well, that sounds like you’re going to the larger issue here, that many of the risk models and the weather patterns that insurance companies rely upon to predict the future are no longer really relevant at this point.

Kousky:  Yes. Yeah. And that speaks to sort of a broader trend in risk management, which has been the rise of catastrophe models. And really, much more sophisticated ways to model our exposure to these risks. And so insurers, for example, will use these catastrophe models that are offered by firms that specialize in these. And it’s not actually that new. They kind of really took off after Hurricane Andrew back in 1992, and they combine sort of a physical model of the hazard that will simulate events. So they’re not based on historical data. They’re kind of simulating what we’re seeing today, and could be used to simulate what we’re seeing in the future with climate change. And then they couple that to a data base of exposure. So, what buildings or people are in the way? And then how does that hazard, like rising flood waters or storm surge or heavy winds interact with those buildings and people to create damage?

The concern that we see in the insurance sector around these is that, you know, they’re essentially black box models. They’re also really complicated. You have to really be a specialist to really understand how they work. And that kind of is uncomfortable for some consumers and regulators. And so for example, California won’t let insurers use them in rate setting for homeowner’s insurance. You can only use historical losses. But that’s really problematic, when we’re talking about how inadequate historical data is for these risks that we’re now facing.

Stone:  And California’s not allowing them specifically because —

Kousky:  I think they’re concerned about not being able to unpack them, and that they could be used to justify rates that are really too high. So I think they think that this is a consumer protection measure, but really there’s not another way. This is sort of the state of the art way to be understanding these risks. And so Florida, which — you know, another incredibly catastrophe-prone state — has solved this by creating a commission– and they did this back in 1995 — that reviewed all the cat models. So, looked under the hood of these models, and approved the ones that they felt were, you know, state of the art. Best science, factual. And so then insurers could use them. I think they also built out a public one as well. And so many observers have suggested that really, California could either build on what Florida’s done, or — you know, do something similar for wildfire.

Stone:  I’d like to ask about some of the more direct connections between energy and insurance. And California’s electric utilities now have extensive liability for fire damage. To what extent are insurers backing up that liability?

Kousky:  Yeah, that raises a complicated issue in the state of California. So, let’s maybe start by unpacking what’s going on a little bit. In California, they have this relatively unique, strict liability regime when it comes to their investor-owned utilities, and third-party wildfire damages. So what this means is that their electric utilities, if a wildfire is started by their equipment, have to pay for any property damage that results. And we saw in 2017 and 2018 that that can create massive liabilities that can essentially bankrupt the utilities. Because it makes them act like an insurer, when they’re not. Because they have to cover all the property damage.

So for example in Florida, if a hurricane happens, their utilities don’t have to pay for all the damaged homes. They only have to pay to fix their lines. And in California, the utilities are being asked to pay for all the damaged homes. Now, the reason for that is concern that the utility equipment can start fires. And so they want to incentivize safety, right? And make sure that utilities are doing everything they can to prevent the start of wildfires.

Now, through the tort system, if the utilities were negligent and engaged in poor behavior, they could always be held liable for these. But in California — and this is the concern, really — is that this law has become more problematic under climate change. Or this interpretation of the law has become more difficult under climate change. Because now you’re at the point where even if a utility cleared all the vegetation, and upgraded its infrastructure, and maintained it really well, you could have a drought and really high temperature and crazy winds that blows a stick from a half mile, and it knocks a line down and starts a fire that burns down a whole town. And they’d still have to pay for it, even though they’d done everything right.

So now the state’s trying to figure out how to do that. How to kind of solve this problem. They’ve put in place new wildfire mitigation requirements for utilities — so, really defined, what is the safety measures that we need to require on our utilities to minimize the risk of wildfire? And they’ve created a pool to help the investor and utilities pay for any liabilities they may face.

Because to return to your very first question, no, the insurance sector and investors — because they’ve also looked at trying to do this through catastrophe bonds — are not interested in touching third-party wildfire liabilities for California’s utilities, because they can be so extreme. And so it’s been very hard for them to have that risk covered outside the state-created pool.

Stone:  What happens when and if risk catches up to the market? And I guess another way to say this is, you know, what happens if and when risk is accurately reflected in insurance premiums, in all the markets that we’re talking about here?

Kousky:  That’s a really good question. I think we need to face the fact that extreme events are escalating, and are going to continue to do so. And while what we really need is action on climate abatement, right? We just heard that greenhouse gas emissions are continuing to increase this year. And so fact, though, is that even if countries get it together to aggressively reduce their emissions — which they desperately need to do — we’re still going to be facing these impacts from extreme events from extreme events in our lifetime and beyond, from all the prior emissions in our atmosphere. And scientists are also more recently warning that we might have passed tipping points that we can’t put back. So we might have already committed ourselves to massive sea level rise, for example. And we can’t insure our way out of this.

Now, as these impacts begin to materialize, insurance can send those signals to the market. But they’re not going to be long-term signals, but they will eventually start to happen. You’ll see more insurers unwilling to write on the coast, for example. But you need to really have some aggressive commitment to risk reduction. Which means building differently, in different places, since we know these impacts are going to be coming.

Stone:  What is your prescription? I think you probably hit on part of it. But, what’s your prescription to address the problem of growing climate-related risk?

Kousky:  So, I think if you couple sort of risk-reduction measures with insurance, we can help handle a lot of the impacts we’re gonna see. So this means more resilient building. And we know how to build safer. So you can look at, like, the Institute for Business and Home Safety. They have some designations for homes. We can build homes that are less likely to be damaged in a hurricane, and that can withstand fire. And yet those building codes have not been adopted in a widespread way in places that are at risk. So, we need to adopt these better building codes, so that we’re building to face our new realities.

We also need to face the fact that there are places where we shouldn’t be putting capital for the next 50 years. Because in 50 years, it’s going to be too risky and cause too many damages. And so that means we need to actually regulate development in some places, which is very hard to do but I think really needs to be done. And so to get to that place, it’s critical that people understand how risk is changing. So this brings us back to the risk information piece.

And I think that’s starting to happen. It’s starting to happen through better data and models that are being more widely communicated to people. But people can also see the changes in a way that I don’t think they could even a decade ago.  You know, I think about being around here in Philly. And we get a lot of intense precipitation events. And I can talk to my neighbors who say, “This road’s been flooding out, and basements are getting wet in a way that they didn’t used to.” So people are starting to see these events. And now that they’re starting to see them and understand them, we have to give them the tools to address them.

Stone:  Carolyn, thanks for talking.

Kousky:  Thanks so much for having me.

Stone:  Today’s guest has been Carolyn Kousky, Executive Director of the Wharton Risk Center at the University of Pennsylvania. For more energy policy insights, visit the Kleinman Center for Energy Policy’s website, where you’ll find a wealth of research, policy digests, and blog posts. Our web address is Kleinmanenergy.upenn.edu. And get updates from the Center by subscribing to our Twitter feed, @KleinmanEnergy. Thanks for listening to this episode of Energy Policy Now, and have a great day.


Carolyn Kousky

Executive Director, Wharton Risk Center
Carolyn Kousky is the executive director of the Wharton Risk Center at the University of Pennsylvania.

Andy Stone

Energy Policy Now Host and Producer
Andy Stone is producer and host of Energy Policy Now, the Kleinman Center’s podcast series. He previously worked in business planning with PJM Interconnection and was a senior energy reporter at Forbes Magazine.