If your home or small business was destroyed in a disaster, would you have the resources to rebuild it completely? Very few do. That is why insurance exists. By paying an annual premium, policyholders transfer the risk of financial devastation to an insurance company.
But climate change is shattering the foundations of this model. We are now in a game of hot potato when it comes to the risk of increasing climate extremes. And unfortunately, those left holding the risk are often those least able to deal with it.
Insurance, especially for catastrophes, is based on a chain of risk transfer. Households buy insurance from an insurance company. That insurer then passes on the risk through reinsurance, which spreads the risk around the world. For example, while everyone in a community in Florida will suffer if a hurricane hits, hopefully that hurricane won’t hit at the same time as a bushfire in Australia or an earthquake in Japan. Reinsurance helps insurers reduce the volatility of losses and allows them to write more policies.
Recently, however, we have seen catastrophe risk being pushed back onto insurers. Reinsurers have reduced the amount of catastrophe risk they accept and raised their prices. This has shifted more risk to the insurers themselves, as they are not able to transfer as much as in previous years.
As insurers take on more catastrophe risk, they respond by shifting more risk back to policyholders. This can happen in a number of ways. Insurers can exit markets altogether, as some have done in Florida and California, where the combination of climate catastrophe risk and higher rebuilding costs make it difficult to continue operating.
Insurers may also shift more risk to consumers by adjusting policy terms. This could include higher deductibles, such as the common hurricane deductible, exclusions for certain types of losses (such as flood exclusions), or sub-limits on payouts for certain types of catastrophe losses (such as burst pipes or roof damage). If allowed by regulators, insurers will try to raise prices to reflect the higher risks they are taking, but this may make policies too expensive for many households.
As private insurers shed risk, it also falls to public programmes, because when households cannot find affordable policies in the private market, they turn to the government. Florida Citizens, Louisiana Citizens and California’s FAIR plan – public sector programmes offering either hurricane wind or wildfire coverage (or full homeowners policies) – are growing. Florida Citizens is now the largest insurer in the state.
Public programmes are caught between a rock and a hard place. Increasing climate risk and a growing policyholder base require them to raise rates to ensure solvency in the face of a major catastrophe. But doing so puts a burden on cash-strapped residents and is, unsurprisingly, very unpopular. But if they are priced below risk levels, these programmes increase the likelihood of serious fiscal stress in the aftermath of a disaster.
The households left holding the hot potato of climate risk are low- and middle-income households – those least able to afford higher prices and most in need of financial protection. We know from research that lack of insurance can increase fiscal stress, slow recovery and increase inequality after a disaster.
Three things can help end this game of hot potato.
First, we can invest massively in reducing our risk. We have more federal money than ever before, and we know how to build stronger to withstand disasters like hurricanes and wildfires. What we lack is the will to relocate to safer areas, the institutional framework to help us rebuild stronger and safer, and the policies to guide future development out of harm’s way and into the future.
Insurance can play a greater role here, starting with political support for stronger building codes. We also need property policies that cover the extra costs of building to climate-resilient standards (this should include energy efficiency and rooftop solar in rebuilding, as reducing emissions is the ultimate climate risk reduction). Insurance also needs to help policyholders get the technical expertise and support they need to make these changes.
Second, we need to rethink the role of government. Risk is migrating to the public sector. If we do not think strategically about when and how this happens, we will miss important opportunities, such as linking this socialisation of risk to investment in risk reduction and raising the importance of universal access to insurance as a necessary social good. We also risk stretching public programmes to the breaking point. This could have even deeper implications for housing markets, local economies and people’s well-being.
We could draw on the experience of other countries, such as France and Spain, and consider a model where the public sector provides a layer of reinsurance in exchange for companies providing all-hazards insurance to residents. This could help ensure that everyone has the coverage they need against escalating catastrophes, maintain a stronger private market and protect businesses from catastrophe-related insolvencies. Such public reinsurance could be linked to risk reduction requirements and include risk-based pricing, but also means-tested support for the most vulnerable.
Third, we cannot let this game of hot potato leave climate risk on the shoulders of the most vulnerable. The Biden administration’s nascent efforts to reform disaster programs to help those most in need must be expanded to include insurance. Congress should pass a means-tested flood insurance assistance program, and states should support broader access to risk transfer for vulnerable populations through regulatory reforms and new product offerings.
As climate risks continue to grow, our households and communities should not be left holding the bag.
