Climate Resilience & the Insurance Industry
Proactive risk management has a high ROI, if you can incentivize it.
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The frequency and severity of extreme weather events are getting worse. This trend has become increasingly apparent to stakeholders who stand to lose from property damages, as well as to the tens of millions of people impacted by storms, fires, and heat. We write this post in the midst of a severe heat wave that continues to linger over much of the US, and just days after Hurricane Beryl, the earliest Category 5 storm in history, incurred billions in damage across the Caribbean and the Gulf Coast. For insurers, businesses, local governments, and the federal entities that ultimately foot the bill on tail risk events, the situation has already become impossible to ignore.
This trend has clear implications for the insurance industry. More accurate forecasting and risk modeling is table stakes, though still underutilized and poorly implemented. According to a recent Insurance CRO Roundtable conducted by McKinsey, 80% of carriers self-report climate analytics capabilities that are inadequate. But addressing the impact of climate change is not only a function of underwriting risks more effectively. As we’ve written about in prior posts, this moment calls for a new paradigm in risk management, mitigation, and resiliency. Forecasting risks is not sufficient; insurers (and broader society) must also do a better job of anticipating and preparing for outsized weather events. We must implement more proactive, vs. reactive, risk management strategies.
Resting on first principles alone, one reasonably would expect there to be benefits to proactive resilience strategies. If investments in mitigation and resilience reduce the total magnitude of losses, this helps carriers decrease underwriting ratios and improve profitability. Reducing the impact of massive (but increasingly common) tail natural catastrophe events also helps to smooth the volatility in rates and availability for property owners. A recently-published study conducted by Allstate and the US Chamber of Commerce attempts to quantify the ROI on resiliency, and suggests that the benefits are more than just theoretical. For each $1 spent on climate resilience, the study found impacted communities saved a staggering $13 in loss.
The alleged benefits from resilience were split across first-order and downstream effects. The study estimates $6 (of the total $13) in payback from direct reduced loss from natural disasters, and the balance ($7) in broader economic benefits including reduced impact to employment, GDP activity, and migration from the impacted area. While the resilience payback was generally higher for larger population centers (vs. remote areas) and for larger magnitude disasters (vs. more moderate events), investments in natural catastrophe preparedness showed a highly positive payback across the board. Whether the true economic benefit per dollar invested is in fact $13 or $23 or $3, the study makes a compelling case that it is very much a positive return, and that there ought to be more proactive resilience taking place.
Resilience can take many forms. This can include infrastructural investments (like a floodwall, or clearing flammable areas at risk of fires), or natural climate solutions, in which government stakeholders and re/insurers collaborate on bespoke solutions for at-risk ecosystems. For example: a healthy coral reef absorbs an estimated 97% of a wave's energy, so proactive investment to keep vulnerable reefs robust can have positive impacts not just on the reef habitat, but on the broader community and property. Alternatively, resilience might rely more on individually-financed initiatives, like home-hardening or brush clearing, in which insurers compel property owners to pursue mitigation (in return for lower premiums or to avoid non-renewal).Â
In whatever form resilience is pursued, insurers, regulators and local communities should be incentivizing more of it. The still-limited uptake across the insurance ecosystem calls for the question of why the industry is not moving faster to adopt mitigation practices. Below, we outline what we believe are the principal challenges standing in the way of broader investment in resiliency:
Incomplete data obscures ROI:Â
Climate and nat-cat models are shifting quickly, and faster than most underwriters can adapt. This in turn can make it difficult for traditional insurers to establish a clear-cut ROI for mitigation activities. We’ve talked to property managers who believe they do not get adequate credit for common-sense resilience efforts (like hardening the roof in a hail-prone area, or installing sprinklers). Conversations with carriers to better understand why this happens point to pricing uncertainty. Even if underwriters are bought into mitigation in theory (and many are not), in practice this requires having a concrete expectation of the value of the specific mitigation effort. Estimating the value of a specific intervention on a given property requires precise, hyper-local risk models, which most underwriters do not have.Â
Regulation skews incentives:Â
State-by-stage regulation further complicates insurers’ ability to compel insureds to take proactive measures. Though Excess and Surplus lines are growing fast, in admitted lines (which still comprise a vast majority of policies), some underwriters fear that offering credits based on property-specific mitigations can be considered a form of prohibited bias. While some of the most egregious states, like CA, are finally beginning to incorporate mitigation into their regulatory guidelines, historically they have prohibited or disincentivized carriers from resilience-oriented pricing.
Rates don’t necessarily reflect real risks:
A byproduct of complex and inconsistent state regulations is that carriers tend to take rate where they can, but not necessarily where they should. The result is what the NYT recently referred to as wildly distorted pricing that fails to adequately reflect actual risks. Carriers are effectively subsidizing high combined ratios in regulated high-risk regions with higher rates in less-regulated, lower-risk areas. The incentive structure that should push property owners toward regions with lower risk and toward mitigation activities is inverted when rates don’t reflect the actual level of risk.
Limited financing mechanisms:Â
Unlike other high-priority transition categories that benefit from government subsidies and robust financing availability (like, say, tax incentives and loan programs for resi solar, batteries, and energy equipment) there is very limited if any financing available for homeowners to pursue property interventions. This ties back to the aforementioned lack of clarity about mitigation ROI. Since carrier and government strategy remains a moving target (e.g., insurers continue to exit the most distressed regions), it becomes challenging for them to underwrite mitigation investments. Imagine a situation where there is a clear payback for the insurer after X years, but where the carrier may need to non-renew the policy before X years have elapsed. If there is limited confidence in the duration of the insurance relationship, it inhibits incentivizing or financing resilience.Â
Emerging product solutions are imperfect:
A wide range of new, often parametric, products are being developed to tackle emerging risks more effectively. Targeting new categories like extreme heat, or developing products for underserved stakeholders (like microinsurance policies in EM) is a positive, and we’d like to see more of it. But it remains the case that parametric coverage inherently has basis risk. In the days following widespread destruction in Jamaica from Hurricane Beryl, reports suggest that a large cat bond is unlikely to pay out because the parametric trigger (based on pressure level) was a near miss and not breached. Without making any comment about how this particular trigger was structured, it is clear that basis risk in any parametric product can make resiliency efforts more challenging.
Community action > individual action:
Individual actions, like hardening a home, are smaller swings and easier to implement compared to multi-stakeholder infrastructure investments. But community resilience projects may generally have greater impact compared to individual projects. Imagine you live in an area susceptible to flooding or hurricanes; fortifying your property to withstand a storm surge of a few additional inches will have less impact compared to localized infrastructure that prevents the region from flooding in the first place. In this respect, there is a bit of a collective action problem at work: benefit is maximized when community projects are taken on, and individual actors are disincentivized from pursuing actions on their own. That said, even if community projects are optimal, we recognize that at-scale, the individual mitigation projects can still move the needle for both property owners and their insurers. Because property resilience has been overlooked for so long, we believe there is significant low-hanging fruit for carriers to incentivize property owners to take on mitigation (especially given record-high rates and increasingly limited supply of policies).
We are excited about the massive potential impact of resilience and mitigation for the insurance industry. The high ROI demonstrated in the Allstate & Chamber of Commerce study is hugely compelling, and should make resilience a priority for insurers, local governments, and property owners. If you’re building at the intersection of insurance and resilience, or have strong opinions about the opportunity area – we’d love to hear from you.