Extreme weatherWhen catastrophe strikes, who foots the bill?
One consequence of climate change is that extreme weather events are occurring more often with the potential to cause catastrophic damage more frequently. According to the 2016 Global Risks Report of the World Economic Forum, extreme weather events rank second as the most likely threat to global stability going forward. And my research on the safety and soundness of financial institutions suggests this trend may also threaten the stability of the insurance industry. Extreme weather is expensive for insurance companies and their reinsurers, communities, taxpayers, and also, potentially, capital market investors. And it’s only getting more expensive as climate change increases the frequency of storms and their severity. While more can be done to improve risk pricing and risk management, climate change mitigation is critical for our ability to continue to survive and recover from the catastrophes that lie ahead.
Hurricane Matthew has slammed into the Florida coast after hammering Haiti. Close to two million people were asked to evacuate to escape its winds and rain.
While any loss of life will be the biggest concern, the hurricane is expected to cause extensive damage to buildings and infrastructure, leaving Floridians saddled with heavy losses – some insured and some not.
For a category 4 storm in this area – as it was deemed at one point – the economic disruption is expected to cost anywhere from $5 billion to $15 billion, according to Bloomberg. The storm was later downgraded to category 3.
Real estate analytics firm CoreLogic estimates that more than 954,000 homes in Florida are at risk of surge damage from a Category 4 storm, with another million at risk in South Carolina, North Carolina and Georgia.
So who’s going to pay for it?
First lines of defense
One consequence of climate change is that extreme weather events are occurring more often with the potential to cause catastrophic damage more frequently. According to the 2016 Global Risks Report of the World Economic Forum, extreme weather events rank second as the most likely threat to global stability going forward. And my research on the safety and soundness of financial institutions suggests this trend may also threaten the stability of the insurance industry.
The first line of defense to deal with the costs are the insurance companies operating in Florida, which will be busy in coming weeks and months assessing and paying the insurance policy claims of the insured home and business owners.
But most of Florida’s property insurers are relatively new because the market went through a fundamental restructuring after Hurricane Wilma in 2005, transitioning from large national insurers to smaller ones focused almost exclusively on the state. Wilma caused $12.3 billion in insured losses (in 2015 dollars), ranking it fifth among the most costly U.S. hurricanes.
This has made the next line of defense, reinsurers, much more important.
Insurance companies buy backup policies with reinsurers to reduce their exposure to insurance claims that require potentially large payouts in extreme weather events. This allows firms to reduce their liability on individual claims and achieve a reduced overall risk exposure from greater diversification.
The costs of all these policies are rising, though, as the historical and mathematical models used to price the policies factor in the more recent and more severe storms.
