Home insurance is collapsing in several housing markets as climate change makes old assumptions obsolete

The end of climate stability signals the end of the insurance market as we know it. Will it also signal the beginning of a broader understanding of physical risks by equity and debt holders, regulators and citizens? The answer to that question will determine whether climate risk changes capital markets forever. Put succinctly: 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 is not protection against perils such as flood, wind, fire, or hail. It is a financial contract to reimburse property owners for the cost of repairing structures only after events that are, unsurprisingly, rare. If perils cease to be rare, cease to be predictable, and/or produce damage that is not easily repairable (or suggest that a building should not be rebuilt at that location), the existing market structures for both property insurance and property in general will not work.

Climate stability underpins a multitude of assumptions. Farmers could plant the same crops decade after decade. Architects, builders, engineers, and city planners could follow building codes and engineering standards based on past temperature and precipitation ranges without learning about local climates. Real estate became an asset class valued in spreadsheets and two-dimensional databases. The weather behaved so well that only a few specialists cared about it.

Past weather patterns and variations that repeated over time enabled a huge and reliable property insurance market that relieved asset owners and lenders from estimating and preparing for low probability events. Not only could specialists assess which events had a 1% chance in a given year (“1-in-100-year events”), but they could also anticipate the damage those 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’s a graph of average atmospheric temperature going back 100 million years. The green band shows the narrow strip that allowed civilization.

Courtesy of probable futures

Today’s insurance markets are full of peculiarities that derive from supposed stability:

  • Virtually all property insurance is annual. There is no term structure.
  • After a loss, the insured is expected to rebuild the same building in the same location.
  • 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-aware catastrophe models.
  • Regulators also periodically limit the amount by which insurance rates can increase from year to year.

Climate change undermines all of these assumptions.

Investors largely (and logically) assume that insurance markets are pricing in physical risks, so pension funds, investment managers, banks and even real estate companies have historically not investigated climate risk. For example, mortgage loans often require borrowers to have insurance, but a 30-year loan does not need to be accompanied by a 30-year insurance policy: a one-year policy is considered a sufficient sign that the insurance will be in place. available at approximately the same cost for the duration of the loan.

A few years ago, sophisticated users of weather and climate models—notably reinsurers and insurance-linked mutual funds—began to pull out of some markets. Their withdrawal left insurers unable to unwind tail risks just as the tails were getting longer. In turn, insurers—most of whom are prohibited by regulators from rapidly raising rates—have begun to pull out of the markets, especially in Florida and California. In response, governments have stepped in to provide coverage.

Government insurance plans were created decades ago in nearly all coastal states to bolster housing markets during periods of market dislocation. These interventions were intended to be temporary, as risks would – naturally – return to their historical levels and market dislocations would end. Unfortunately, insurance markets are unlikely to view the current dislocation as temporary and will not “come back” to bail out governments that are implicitly assuring their residents that they have the right to affordable insurance no matter what. Without saying it explicitly – and without citizens voting – governments are turning property insurance from a financial product whose price depends on the markets into an implicit right. This silent transfer of risk should worry everyone.

Reevaluating the assumptions on which we build society will be a challenge, but climate science can help us figure out how to live well in a warmer world. The same models that accurately anticipated increased heat and humidity, increased droughts and floods, rising oceans, larger tropical storms, elevated wildfire risk, and weakening jet streams. They warned sophisticated investors not to buy fattening tails. The same research and data can help decision makers of all types integrate this information into processes as diverse as urban planning, building codes, mortgage underwriting (including by FNME and FMCC), and REIT valuation. . Free educational, mapping, and risk tools, such as those offered by Probable Futures, Climate Central, and FirstStreet, are good places to start.

Almost 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, specialized civilization we have today. If we continue to assume that risk is solely the responsibility of insurance markets, the stresses of increased heat, droughts, storms, etc. will be aggravated by increasingly dysfunctional markets and increasingly inflated 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. By becoming climate literate, society can begin to assess current and future risks and figure out how to ensure financial markets reflect them.

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