Climate Risk Puts Insurance Companies Under Fire — How to Turn Down the Heat

In previous posts in this series, we focused on the need for financial institutions to manage climate risk, considering potential regulations to standardize that process. In this article, we will focus on the insurance industry, a segment of the financial system that is particularly vulnerable to climate change, putting the government, private insurers, and homeowners at serious risk.

Roadmap to Addressing Insurance Risk from Climate Change

The federal government, as the major provider of flood insurance through the National Flood Insurance Program (NFIP), bears significant financial risk from climate change. Currently, the government is responsible for covering flood insurance claims and subsidizes premiums for many policyholders in high flood risk zones. As climate change results in a higher frequency and intensity of storms and sustained sea level rises, the federal government’s insurance risk exposure through NFIP also increases. While the federal government has tried to hedge against this risk through reinsurance purchases and catastrophe bonds, the impact of these measures is limited. The Biden administration has therefore made it a priority for the federal government to assess its climate-related financial risk and take action.
In early October, President Biden released a Roadmap to Build a Climate-Resilient Economy, which set forth a whole-of-government approach to protecting the US economy from the financial impact of climate change.  The roadmap built on President Biden’s March 2021 executive order, providing additional detail regarding steps the government will take to address the insurance risk from climate change. Some of the actions outlined included:
  • Updating NFIP’s risk rating methodology. The Federal Emergency Management Agency (FEMA) is implementing a new pricing methodology, called Risk Rating 2.0. The updated methodology “leverages industry best practices and cutting-edge technology to enable FEMA to deliver rates that are actuarially sound, equitable, easier to understand, and better reflect a property’s flood risk.”
  • Encourage communities to Build Resilient to protect assets. FEMA recently issued a request for information (RFI) on revising the NFIP’s floodplain management standards for “land management and use regulations to better align with the current understanding of flood risk and flood risk reduction approaches.”
  • Address climate-related financial risk within the insurance section. In August, the Federal Insurance Office (FIO) issued an RFI to solicit public input on three priorities:

Assess climate-related risks or gaps in the supervision and regulation of insurers, including impacts on US financial stability
Assess potential for climate-related impacts to private insurance coverage, as well as facilitating mitigation and resilience efforts for disasters
Increase FIO’s regular engagement with insurers on climate-related matters and leverage the insurance sector’s ability to help address climate-related insurance risks

FSOC Report Addresses Climate Risk

Shortly after the release of the roadmap, the Financial Stability Oversight Council (FSOC) released its long-awaited report in which it charged various federal agencies with tasks and responsibilities to better understand and prepare for climate-related challenges, including insurance risk. Specifically, the report noted:

  • The need for Government-Sponsored Entities (GSEs) to conduct additional studies and gather additional data to assess climate-related physical risks. The studies should assess insurance risk for the underlying collateral throughout the lifetime of the loan, as well as risks for GSE counterparties and other market participants.
  • Recent increased frequency of severe weather events has made it challenging, but necessary, to re-assess exposure. Predicting future climate trends is complicated and changing climate patterns create additional uncertainty around insurers’ exposures. Insurers should use both proprietary and third-party data and models to calibrate such risks, set premiums, and manage exposures.
  • Increased frequency and severity of storms can result in outsized and sustained losses to insurers and the insured. Specifically, physical risks can be seen in the increased frequency of floods, wildfires, and storms, and from longer-term events such as sea-level rise and chronic heat waves.

The risks outlined above are not limited to the federal government. Financial institutions should be undertaking similar measures, including using the latest data and risk models when determining coverage needs, to identify climate risks posed to their business. As noted, current insurance policies may not be able to fully account for the elevated risk from increased storm frequency or sustained flooding. As climate trends continue to evolve, financial institutions should assess their risk and develop a plan to ensure better coverage and avoid outsized losses.

 
Special thanks to Henry Darmstadter for contributing to this article.

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