We learned this week that July 4’s global average temperature of 62.92 degrees Fahrenheit was the world’s hottest day since at least 1
979, when the US National Centers for Environmental Prediction began keeping records, and potentially the warmest in about 125,000 years.And yet, in a world where even ExxonMobil acknowledges the reality of climate change and claims it is “playing a leading role in the transition to a lower-emissions future,” it seems that insurance “consumer advocates” are the group most adamant in its the refusal to come to grips with what adaptation to a warmer planet inevitably entails.
For the insurance industry itself, there is no doubt that the effects of climate change are already here and that, as the world’s richest and most insured nation, the economic impact (but not the human toll) has been felt most acutely in the United States. According to the UN’s World Meteorological Organization, US disasters accounted for $1.7 trillion of the $4.3 trillion in economic damage from extreme weather, climate and water-related events around the world between 1970 and 2021.
Brokerage Aon PLC finds that the United States accounted for 75% of last year’s $132 billion in global insured losses from natural disasters, led by the $50 billion to $55 billion in insured losses stemming from Hurricane Ian. Swiss Re, which found similar estimates, also notes that 2022 totals were 45% higher than the 10-year average of $91 billion in insured losses, continuing a three-decade trend of insured losses increasing 5% to 7 % annually.
These trends have clearly been reflected in market pricing, with Guy Carpenter recently reporting that mid-year 2023 reinsurance renewals for US property catastrophe accounts were the highest in 17 years. They have also been reflected in reduced availability of property insurance in some disaster-prone markets, as seen in the ongoing collapse of the Florida homeownership market and high-profile decisions by State Farm and Allstate to stop writing new coverage in wildfire-ravaged California.
And also unsurprisingly, insurance regulators around the world are seeking, as the International Association of Insurance Supervisors put it earlier this year when they announced the launch of an 18-month consultation on the topic, “a globally consistent regulatory response to climate change in the insurance sector.”
For its part, in response to President Joe Biden’s executive order on climate-related financial risks, the U.S. Treasury Department’s Federal Insurance Office recently published a report with 20 policy recommendations to improve insurance regulators’ oversight of climate-related risks. These include potentially creating charges in risk-based capital (RBC) formulas for floods, convective storms and other climate-related risks; enhance the NAIC Catastrophe Modeling Center’s capacity to help regulators better assess insurers’ climate-related risks; and move towards a single “materiality” standard for climate-related risks to be used in insurers’ own risk and solvency assessment (ORSA) summary reports.
The FIO also proposes various information gathering measures which, depending on their cost levels or intrusiveness, are likely to cause some pushback from the industry. But by and large, the proposals to improve how regulators incorporate climate risk are reasonable and almost certainly necessary, in some form or another.
But in response to the FIO report, the group United Policyholders issued a statement with its own set of recommendations, almost all of which seek ways to suppress, delay or ignore the price signals that guide consumers in how and where to build as we adapt to a changed climate. As United Policyholders explains:
We oppose allowing insurers to pass on reinsurance costs to policyholders. Reinsurance rates are not regulated and fluctuate frequently. We also oppose allowing insurers to have unrestricted use of predictive CAT models to set rates. Unlike rating tools that are based on historical facts and actual weather and damage events, CAT models are developed by for-profit companies to sell to for-profit insurance companies. They apply forward-looking algorithms to project future losses. Their advocates are persuasive, but they have a track record of reducing accessibility and affordability.
It seems clear that disaster models that project, as climate science itself does, that future losses will be worse than past losses must be reflected in coverage that is more expensive and less available for the properties most at risk of loss. It seems equally clear that, given such trends, rates based solely on “historical facts and actual weather and claim events” will be inadequate. Sticking your head in the sand to pretend that these were not facts about the world is tantamount to denying climate change itself.
This stance extends to several of United Policyholders’ other proposals. The group suggests that California “develop a public high-dollar disaster coverage facility” to provide reinsurance to the California Earthquake Authority and the California FAIR plan, and that Congress “begin drafting a national disaster insurance model to provide a basic amount of needed housing, building code upgrades and temporary coverage for living expenses.”
Clearly, the animating principle here seems to be a widespread mistrust of business itself, as seen in the shade thrown at cat models for being “developed by for-profit companies to sell to for-profit insurance companies.” But more fundamentally, the only reason to propose public insurance and reinsurance facilities is to allow them to charge less than private companies would. And it’s certainly true that governments can offer not-for-profit insurance products because they can rely on taxpayers to make up the difference between the cost of coverage and the claims that will eventually roll in. We need look no further than the National Flood Insurance Program, which remains tens of billions of dollars in debt to American taxpayers.
But is it a good idea? Providing coverage at prices lower than actuarially justified means subsidizing choices to live in harm’s way, rather than allowing these price signals to encourage people to harden their homes or, ultimately, to move to places with less exposure to the kinds of disasters that climate change will inevitably become more expensive. Instead, we’ve seen the reverse trend, with Americans moving to places with greater exposure to disaster risk. As researchers from the University of Vermont put it:
We find that, considering socio-economic and environmental factors, people have moved towards areas with the highest risk of forest fires and towards metropolitan areas with relatively warm summers. As climate change progresses, we can expect to see warmer summer temperatures and increased risk of wildfires, meaning that if these migration trends continue, more and more people will be at risk from heat and fire. We hope that our findings will contribute to greater awareness of these growing hazards, while providing empirical evidence to guide planners and policy makers as they design climate resilience and risk preparedness strategies.
Of course, price signals from insurance and reinsurance can play an appropriate role in countering or reversing these settlement patterns, but for regulatory schemes like California’s Prop 103 that seek to suppress them. Indeed, California embodies United Policyholders’ preferences by denying insurers the ability to reflect reinsurance costs and limiting their ability to use potential catastrophe models. That’s why, even after the state’s extreme wildfires in 2018 and 2019, and despite trailing only Hawaii in median home prices, in 2020 Californians paid an annual average of $1,285 in homeowner’s insurance premiums for all types of insurance — less than the national average of 1 319 USD.
Such regulations not only disrupt price mechanisms that might otherwise facilitate climate adaptation in the states that implement them, but researchers Sangmin Oh, Ishita Sen, and Ana-Maria Tenekedjieva find that they create counterproductive cross-subsidies across the country:
Using two distinct identification strategies and new data on regulatory filings and ZIP code-level rates, we find that insurers in more regulated states adjust rates less frequently and to a lesser extent after experiencing losses. Importantly, they overcome these rate-setting frictions by adjusting rates in less regulated states, consistent with insurers’ cross-subsidization between states. In the long run, these behaviors lead to a decoupling of interest rates from risks, which implies distortions of risk sharing between states.
Adapting to climate change will be a difficult, cumbersome process with no shortage of political pain points. There will undoubtedly be a role for governments to play in helping citizens with containment, relocation and potentially even subsidies to fund crushing insurance costs. But it serves neither these policyholders nor society at large to ignore the information provided by insurance markets, let alone the climate science that drives today’s catastrophe models.
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