The end of climate stability means the end of the insurance market as we know it. Will this also mark the start of a broader understanding of physical risks by equity and debt holders, regulators and citizens? The answer to this question will determine whether climate risk will forever change financial markets. Bottom line: the first time a property floods it’s an insurance issue, and maybe the second time, but after that it’s an equity and debt issue.
It is important to understand that insurance does not protect against hazards such as flood, wind, fire or hail. It is a financial contract to reimburse owners for the cost of repairing structures only after predictable and rare events. If hazards cease to be rare, cease to be predictable and/or produce damage that is difficult to repair (or suggest that a building should not be rebuilt in that location), existing market structures, both for insurance of goods than for goods in general, will prevail. It does not work.
Climate stability underlies a myriad of assumptions. Farmers could plant the same crops decade after decade. Architects, builders, engineers and urban planners could follow building codes and engineering standards based on past temperature and precipitation ranges without learning about local climates. Real estate has become an asset class valued on spreadsheets and two-dimensional databases. The weather was so good that only a few specialists were concerned about it.
Past patterns and weather ranges that have repeated over time have enabled the creation of a huge and reliable property insurance market, which has relieved asset owners and lenders of having to estimate and prepare for low probability events. Not only could specialists assess which events had a 1% probability in a given year (“events occurring every 100 years”), but they could also anticipate the damage these events would cause.
Unfortunately, historical weather data is no longer a good guide, even for our present, let alone the future. The atmosphere is warmer than it has been since the dawn of civilization and continues to warm. Here is a graph of average atmospheric temperature going back 100 million years. The green band shows the narrow span that allowed civilization.
Today’s insurance markets are full of quirks that arise from assumed stability:
- Virtually all property insurance is annual. There is no term structure.
- After a disaster, the insured is supposed to rebuild the same building in the same place.
- Insurance is only available for damage to a structure, not the value of the land.
- Regulators often insist on the use of retrospective data, prohibiting the use of climate models and climate-informed catastrophe models.
- Regulators also routinely limit the amount insurance rates can increase from year to year.
Climate change challenges all of these assumptions.
Investors largely (and understandably) assume that insurance markets price physical risks, so pension funds, investment managers, banks, and even real estate companies have historically not studied climate risk. For example, mortgages often require borrowers to buy insurance, but a 30-year loan does not need to come with a 30-year insurance policy: a one-year policy is considered a sufficient signal that insurance will be available at roughly the same cost over the life of the loan.
A few years ago, sophisticated users of climate and weather models (including reinsurers and insurance-related investment funds) began to withdraw from certain markets. Their withdrawal left insurers unable to offload tail risks even as they grew bigger and bigger. In turn, insurers – most of whom are barred from rapidly increasing their rates by regulators – have begun to withdraw from the markets, notably in Florida and California. In response, governments have stepped in to provide coverage.
Government insurance schemes were established decades ago in almost all coastal states to support real estate markets during periods of market disruption. Such interventions were intended to be temporary, as risks would – naturally – return to historical levels and market disruptions would end. Unfortunately, insurance markets are unlikely to view the current disruption as temporary and will not “come back” to bail out governments that implicitly assure their residents that they are entitled to affordable insurance no matter what. Without saying it explicitly – and without the vote of citizens – governments are making property insurance a financial product evaluated by markets, an implicit right. This discreet transfer of risk should worry everyone.
It will be difficult to reevaluate the assumptions on which we have built society, but climate science can help us understand how to live well in a warmer world. The same models that accurately predicted increased heat and humidity, increased droughts and floods, rising oceans, larger tropical storms, increased risk of wildfires and Weakening jet streams have warned savvy investors not to insure the growing tails. The same research and data can help decision-makers of all types integrate this information into processes as diverse as city planning, building codes, mortgage underwriting (including by FNME and FMCC), and appraisal REITs. Free education, mapping, and risk management tools like those offered by Probable Futures, Climate Central, and FirstStreet are good places to start.
Nearly 12,000 years ago, our hunter-gatherer ancestors noticed that the climate had stopped changing. In response, they stopped wandering, settled into communities, and began to develop the complex and specialized civilization we know today. If we continue to assume that risk is solely the responsibility of insurance markets, the stresses of increased heat, drought, storms, etc. will increase. will be aggravated by increasingly dysfunctional markets and an explosion in government balance sheets.
Fortunately, unlike our ancestors, we not only know why the climate is changing, but we can also anticipate where and to what extent. If we gain climate knowledge, society can begin to assess current and future risks and figure out how to ensure that financial markets reflect them.
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