In/Ensuring Financial Disaster

The mathematical soothsayers are issuing their prognostications

Good Afternoon,

I have a morbid fascination with insurance. Basically it’s a bet that something bad won’t happen, or at least a bet that something bad won’t happen too many times, which sounds optimistic until you consider that insurers have to consider all the times a bad thing did happen and have a strong grip on the conditions that allowed that bad thing to happen. As a result, insurers become the closest thing to mathematical soothsayers we have on this planet.

So, if you want to know if a thing is likely to happen, ask an insurer. Lately, it seems like insurers are thinking that climate change is not only likely, but actually happening. The implications are big. Today, I take a close look at that idea.


Trees burn within eyesight of a California National Guard hand crew with Joint Task Force 578 during the Dixie Fire, Aug. 16, 2021, in Northern California. (U.S. Army National Guard/1st Sgt. Harley Ramirez)

In/Ensuring Financial Disaster

You can build a house, start a business, or purchase a car. But as soon as you do that, the first thing you need to do – if you want to keep those things – is buy insurance. Therefore, in modern society, ownership of practically anything has a direct connection to whether or not you can obtain insurance. In fact, the value of many things, like buildings or businesses, is also connected to insured value. If you can’t insure a house that cost $1 million to build, how much is it worth to a potential buyer? Probably not $1 million.

Since insurance has been around for a long time – part of Hammurabi’s code in the 1700’s B.C. included rules for shipping insurance – we’ve gotten used to the idea that we can use insurance to cover every kind of risk imaginable. And insurance companies have gotten used to the idea of large pools of insured people allowing them to spread out the risk of unusual events, providing insurers with a chance to make money.

But now climate change is turning risk evaluations upside down, because large pools of risk, actually the entire globe, is encountering the same set of problems: Increased likelihood and size of natural disasters.

How big a change is it?

After the 2019-20 bushfires and repeated cyclones, about 4%, or over 500,000 Australian homes have been deemed “uninsurable” by private companies. Following massive hurricane flooding in Florida, about 12% of homes there are uninsured, because insurance companies refuse to insure them. Drought and unprecedented hail storms in France last year led to €10.6 billion of insurance losses. In the 1980’s, the average annual French disaster payout was €1 billion.

Insurance companies seeking to spread out their risk, actually get insured themselves by reinsurance companies, like SwissRe and Aon, who make massive multi-billion dollar bets. If re-insurers, who usually renew their bets on insurance companies every June and July, don’t like the odds, they force insurance companies to rejigger their offerings, by limiting total coverage, raising fees, or in some worst case scenarios, by halting all insurance offerings.

As a result, in high risk parts of Australia, the average homeowner is paying A$3,000 a year for coverage, a pretty big nut when the average household makes A$65,000 a year. In Florida, average homeowner insurance is hitting $4,200 a year, three times the national average.

It’s not just homeowners. The average Florida car insurance is now $3,121 a year. Businesses that need to insure their buildings in Florida, Louisiana, and California are being forced to cobble together policies from multiple companies because individual companies are afraid to take on too much risk in one location. Universities in particular are having problems finding coverage, reports the Wall Street Journal, because they can’t move locations, and have many buildings that need coverage.

But it’s turning out that just getting insurance coverage at all is turning into something of a luxury. Earlier this year California experienced a wave of companies halting coverage, while Florida is also losing major insurers. This week Farmers Insurance was the latest to bolt for the door in Florida. Wineries in California, which are particularly sensitive to climatic conditions, are now beginning to lose private vineyard insurance coverage.

Sometimes, businesses who can’t obtain regular property insurance are turning to “parametric” policies (think “parimutuel” here) where policies are linked directly to specific wind speeds or water levels. So, if for instance the winds reached 80 miles per hour outside the office building I own, an insurance company would pay me $500,000, an amount I’ve calculated to cover costs I expect to incur when the winds get that high. The metric is much clearer than, say, a wind damage estimate, so actuarial tables are clearer and insurers can determine their risk more easily. Payouts tend to be faster too.

For those unable to go parametric, Australia and U.S. states are setting up state-sponsored insurance funds where governments assume the primary risk and cover the payouts with a mixture of insurance fees and taxes. Increasingly government insurers of last resort are becoming the primary option. In Louisiana, the state plan saw a 300% increase in policyholders between 2021 and 2022, leading to a 63% rate increase. Last year Florida’s state plan became the largest, covering 15% of homeowners in the state.

But these state plans often have sharp coverage caps. For instance, a new state-sponsored plan launched in Colorado this year, to counteract insurers pulling out of wildfire-prone areas, is limited to $750,000 of coverage. If a $1 million house covered by the state plan in Boulder was burned down, the owners would have to eat the difference.

What do you suppose that house is now worth?

Recognizing the growing problem of uninsurable areas, last month the U.S. Treasury Department released a study that amounted to asking states to reassess their disaster cost models. In other words, “Why don’t your state regulators lower your expectations of how much damage a wildfire or hurricane might do, so insurers can plug those numbers into their models?”

Changing the numbers in a spreadsheet seems like a kind of actuarial rearranging of the deck chairs on the Titanic, if you ask me. Fires are going to rage longer, drought is going to get hotter, hurricanes are going to flood more. We’re now asking governments to prop up insurance markets under attack from climate change.

The real questions are, when will the real estate market accurately reflect the value of living in disaster-prone areas? And when that happens, how financially devastating will it be for the rest of us who have been paying to prop up that market?

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