Natural disasters have cost the United States more than $600 billion over the past five years. With climate change, those costs are expected to continue increasing. Moving forward, managing and distributing these harms will become increasingly important. Insurance is one tool to do so. Unfortunately, the insurance system is also at risk from climate change.
By changing the underlying risk profile of certain insurance products, climate change threatens insurers’ business model. At the same time, insurers also face risk as investors, as insurers’ assets may be overvalued due to unassigned climate risk. Improved data, research and resilience planning can contribute to a more robust and more equitable insurance system, while improving financial disclosure requirements can limit investment risk. Just last month, the New York State Department of Financial Services took major strides toward solving these problems by issuing guidance on how insurers are expected to integrate climate risk assessment into their operations and investments. Further action is needed.
Insurance works by pooling risk across a population. Essentially, policyholders pay into a pot. When a policyholder suffers a harm, they collect from the value in the pot. Because only a small number of policyholders are likely to suffer an insured harm in a given period, the money from the lucky policyholders covers the claims of the unlucky.
However, this system breaks down when large portions of the population suffer harms at the same time, as is the case with many climate-related events. Consider a wildfire, which can affect an entire region. In response, insurers may either raise premiums beyond what most Americans can afford or pull out of a high-risk market altogether, leaving gaps in coverage and reducing accessibility (an alarmingly common trend for homeowners in wildfire-prone areas of California).
Underwriters and policyholders need better access to climate data in order to make informed decisions with regards to climate risk. Where private insurance is uneconomical, however, policymakers should consider how public insurance programs can play a role, with an eye toward designing those programs to distribute risk equitably. Alongside this research, policymakers should investigate how resilience measures can reduce damages from disasters, limiting overall risk in the first place. Federal resilience grants have been found to save the public $6 for every $1 spent.
However, underwriting risk is only a piece of the puzzle. Insurers are also large institutional investors, holding about $7.5 trillion (about one-third of the United States gross domestic product) in cash and invested assets. As investors, insurers face and create climate risk by making investing decisions without fully accounting for the underassessed financial risks created by climate change.
For example, sea-level rise might mean coastal homes are worth less than they appear, and movement away from fossil fuel dependence could indicate that long-term oil assets have little value. Just as mortgages were overvalued in 2008, experts fear investors are ignoring climate risk and consequently overvaluing assets across our economy, creating a climate bubble. This climate bubble means that insurance companies, their policyholders and their investors may be on far less stable financial ground than they think.
Policymakers should take action to unearth hidden risk in insurers’ portfolios. Requiring insurers to identify and disclose the climate risk in their portfolios is a necessary step. Disclosure would create a foundation from which policymakers could consider how climate risk threatens insurer solvency and, from there, regulate the risk. This is important not only to insurers and policymakers, but to all Americans who rely upon a well-functioning financial system.
Change is coming. On the investment side, a recent survey by BlackRock found that 95 percent of insurers expect climate change to affect how they build their investment portfolios. Regulators are also taking action, as evidenced by New York’s recent guidance, setting the expectation that insurers analyze their climate risk as both underwriters and investors and report that risk to stakeholders.
These efforts are encouraging, but more are urgently needed.
These solutions need to be incorporated across all 50 states. While insurance is state-regulated, the Federal Insurance Office, established by the Dodd-Frank Wall Street Reform and Consumer Protection Act, is charged with monitoring the insurance industry and can play a critical role in giving states the tools they need to do the job. Working with a coalition of advocacy groups, we encouraged the agency to use its unique position to set and socialize best practices in this area, provide the insurance industry, policyholders and state regulators with better climate data, as well as develop research on resilience efforts and the role of public insurance in spreading risk.
Climate risk can be redistributed only to a point; ultimately, the best tools in the fight against climate change are decarbonizing the economy and investing in climate resilience measures. But, as climate risks grow steeper and the climate bubble expands, it is necessary to align incentives in the insurance industry to prevent widespread defaults that would leave policyholders unprotected. Where insurers are absent from the market, policymakers must also examine who is bearing risk in society and how that burden can be shared. Other states should follow New York and take concrete steps to protect consumers and investors.
Bridget Pals is a legal fellow at the Institute for Policy Integrity at New York University School of Law.
Michael Panfil is lead counsel and director of Climate Risk Strategies at the Environmental Defense Fund