Property owners are starting to see the ugly repercussions of climate change on a warming planet. Destructive weather events like hurricanes, rainstorms, and large forest fires are becoming more common. From 1980 to 2021 there was an average of 7.7 events that caused $1 billion dollars or more in damage (CPI-adjusted of course). In the last 5 years, on the other hand, the average was $17.8 billion.
This alarming acceleration of losses from natural disasters has so far been paid for by a combination of property insurance, governmental relief agencies, and the individuals whose losses are uninsured. If disaster occurrences keep growing exponentially and we don’t find ways to relocate people out of risky areas we might face an insurance calamity that could put a huge burden on homeowners and taxpayers, leave billions of dollars of property uninsured, and even lead to a mortgage industry crisis.
Property insurance exists to help fund repair and rebuilding after large natural catastrophe disasters, but it has a limit to what it can cover. The industry is massive and growing. In 2021 it took in $715 billion in premiums, an almost 10 percent jump since the year prior. But it is not consistently as high margin as one might think. On average, the insurance industry makes around $54 billion annually in net income after losses, expenses, taxes, and shareholder payouts.
As profitable as the insurance industry may seem, many years of those profits could easily be wiped out by one large disaster. The most damaging natural disaster in terms of property loss was Hurricane Katrina, which caused $90 billion dollars in insured damages (and a comparable amount in uninsured losses). Hurricanes Irma, Ida, Sandy, Harvey, and Maria each cost insurers over $30 billion. To help protect insurers from possible default and inability to pay claims, they are required, depending on the state, to keep around 8 to 12 percent of their premiums received as reserves. But those can be depleted quickly if multiple large disasters happen at the same time.
Large insurance carriers like State Farm, Berkshire Hathaway, and Progressive are the big issuers of property insurance policies in the United States, but they are not the ones at risk long term. Much of their financial exposure to loss is transferred by contracts with re-insurance companies like Munich RE, Swiss RE, or Canada Life RE. Re-insurers are publicly traded and also are often funded by sovereign wealth or pension funds. Large global funds like these have hundreds of billions of dollars of assets under management and spread out their risk with a large, diversified risk portfolio across many geographies and categories (like earthquakes, wind, or wildfires). They clearly understand the risky situation they are in when it comes to large disasters. Munich RE’s own website says “It is expected that major storms (categories 4 and 5 on the Saffir-Simpson scale) will occur more frequently in most regions.”
Even if insurance companies are able to stay solvent after a large disaster, they never pay for all of the damage that is done. “In any disaster, a big portion of the damages are uninsured losses,” said Professor John Macomber, Senior Lecturer in Finance at Harvard Business School. “If those uninsured losses become too big, the government might step in to help homeowners but those homeowners almost never recover all the value that was lost.”
If the prediction of more large storms proves to be correct, we could see a lot more damage from flooding, something that is not covered by most homeowner property/casualty policies. Munich RE’s website explained it as such: “Only a relatively small proportion of material assets is covered for flood damage, and this means that the insurance gap is considerable.”
Despite the risk that property owners take, even if they are insured, it has not appeared to deter people from moving to some of the most exposed places. Florida has topped the list of states that have the most new residents for five years running. From April 2020 to April 2021 almost 330,000 people moved to Florida, roughly 903 each day.
If insurers refuse to cover properties that are in disaster prone areas, both the citizens and local governments are in a tight spot. We are seeing this playing out right now in Florida. The average home insurance premium in the state is $4,231, nearly triple the U.S. average of $1,544. Laws and regulations prohibiting how much private insurers can raise rates has caused many carriers to pull out or go bankrupt. To help property owners that now find themselves with little to no ability to buy property insurance, the state’s legislation that limits how much private insurers can raise rates also created a not-for-profit state funded “insurer of last resort” called Citizens Property Insurance Company.
What started as a way to help the few with special circumstances that couldn’t get insurance has ballooned into the biggest insurer in the state. Two years ago, Citizens insured just over 510,000 Florida properties. That number has recently passed 1 million and could reach nearly 2 million by the end of 2023 according to projections. A government funded not-for-profit like Citizens can help, but they are not immune to the costs of actual losses, either. Citizens was recently granted the ability to raise rates 6.4 percent next June, less than the 10.7 percent the organization had requested. There is also a special clause written into the legislation that allows Citizens to “assess its own policyholders a charge equal to 45 percent of their premium” according to the Citizens website. “One major hurricane event or a series of hurricane events like Louisiana had in the past few years could easily wipe out Citizens’ reserves to pay claims,” Insurance Information Institute spokesman Mark Friedlander said in an interview.
So what can be done about the possibility of disasters causing a systemic failure to our financial system? One place to start might be the financing of these risky buildings. “Property insurance is required to get a mortgage, but once the loan is obtained there is often nothing keeping the owners from letting the coverage expire,” Professor Macomber explained. Requiring mortgage companies to verify property coverage would be a lot more than just a clerical burden. “If mortgage companies start to enforce proof of insurance on an annual basis, we might see a big problem with either foreclosures or a decline in home values as the market considers the ballooning cost of insurance,” said Macomber.
As hard as it would be to for homeowners and the housing market to adjust to an increase in premiums, decline in home prices, and exodus from super risky areas, a gradual realignment would be less messy than pushing off the day of reckoning by continuing to paper over the true financial exposure to these perils. A slow reset is much less chaotic than waiting for a series of disasters that forces everyone to abandon places completely. Professor Macomber thinks that this could be a great opportunity to create development opportunities and jobs in targeted new locations, rather than a reaction to a disaster in historic locations. “If we can help people to move out of these at-risk places now, even slowly, with compensation for value, this could all turn out OK,” he said. “If not, then more rapid and very large displacements down the road will be a total free-for-all that leads to a worse outcome and destroys value.”