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Insuring future climate catastrophes

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Abstract

The combined influences of a change in climate patterns and the increased concentration of property and economic activity in hazard-prone areas has the potential of restricting the availability and affordability of insurance. This paper evaluates the premiums that private insurers are likely to charge and their ability to cover residential losses against hurricane risk in Florida as a function of (a) recent projections on future hurricane activity in 2020 and 2040; (b) insurance market conditions (i.e., soft or hard market); (c) the availability of reinsurance; and (d) the adoption of adaptation measures (i.e., implementation of physical risk reduction measures to reduce wind damage to the structure and buildings). We find that uncertainties in climate projections translate into a divergent picture for insurance in Florida. Under dynamic climate models, the total price of insurance for Florida (assuming constant exposure) could increase significantly by 2040, from $12.9 billion (in 1990) to $14.2 billion, under hard market conditions. Under lower bound projections, premiums could decline to $9.4 billion by 2040. Taking a broader range of climate change scenarios, including several statistical ones, prices could be between $4.7 and $32.1 billion by 2040. The upper end of this range suggests that insurance could be unaffordable for many people in Florida. The adoption of most recent building codes for all residences in the state could reduce by nearly half the expected price of insurance so that even under high climate change scenarios, insurance premiums would be lower than under the 1990 baseline climate scenario. Under a full adaptation scenario, if insurers can obtain reinsurance, they will be able to cover 100 % of the loss if they allocated 10 % of their surplus to cover a 100-year return hurricane, and 63 % and 55 % of losses from a 250-year hurricane in 2020 and 2040. Property-level adaptation and the maintenance of strong and competitive reinsurance markets will thus be essential to maintain the affordability and availability of insurance in the new era of catastrophe risk.

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Notes

  1. All dollar figures used in this paper are in U.S. dollars.

  2. By surplus we mean the difference between an insurer's assets and liabilities, i.e., its net worth.

  3. The climate model names are typically the names of the institutions that built them. GFDL-CM2.1 was built by the U.S. National Oceanic and Atmospheric Administration (NOAA)’s Geophysical Fluid Dynamics Laboratory. The UKMO model HadCM3 was built by the United Kingdom Met Office.

  4. One could think of the portfolio of the Florida Hurricane Catastrophe Fund (FHCF) that has been providing subsidized reinsurance to all insurers in Florida since the aftermath of Hurricane Andrew in 1992. Note also that it would be a complex exercise to model the dynamics of any insurance market involving hundreds of companies of different sizes, natures (e.g., public, private, publicly traded, mutual), operations (e.g., Florida only, national, international), risk concentrations (e.g., homeowner coverage only or multi-risk lines). It would also require access to proprietary data that is beyond the scope of this paper. We thus assume that a representative insurer covering the whole state can reflect the market equilibrium in Florida.

  5. Storm surge losses are not included here.

  6. See Gron (1994) and Doherty and Garven (1995) for detailed discussion of the origins and implications of soft/hard market conditions on insurance underwriting cycles.

  7. It is also possible to compute the ratio c·σ Δ/(E(L Δ ) to measure the effect of volatility on reinsurance prices but this is outside the scope of this paper.

  8. We assume that only one insurer provides coverage for the more than 5 million residences in the portfolio. Hence we cannot compare these results with what each insurer doing business in Florida in 1990 was actually charging for its individual portfolio.

  9. For instance, homes can be retrofitted by reinforcing gabled roofs, applying additional adhesives to roof shingles, installing hurricane straps and clips to ensure the roof stays in place despite high winds. Hurricane resistant shutters, as well as impact resistant glass, may help keep windows closed from driving rain, despite flying debris. One can also reinforce garage doors and entry doors.

  10. In reality, of course, the determination by each insurer as to how much surplus it is willing to assign to a specific risk (e.g., wind damage) in Florida depends on its financial characteristics (assets, credit rating), the distribution of its portfolio for that risk and other risks in Florida as well as other states and other countries, its risk appetite, and how much state insurance regulators allow it to charge to cover the risk.

  11. The current analysis reflects only the benefits of adaptation measures. Some of these measures may not be cost-effective on existing structures but worthwhile undertaking when they are integrated into the design of new construction as shown by Aerts and Botzen (2011a) and Jones et al. (2006) for the design of buildings with respect to the flood risk.

  12. See Aerts and Botzen (2011b) for an application of this concept to flood in the Netherlands.

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Acknowledgments

This research is part of an ongoing collaboration between the Risk Management and Decision Processes Center at the Wharton School of the University of Pennsylvania, the Centre for Climate Change Economics and Policy (CCCEP) at the LSE and Risk Management Solutions (RMS). The paper has benefited from excellent research assistance by Peter Eschenbrenner and Chieh Ou-Yang, editorial assistance by Carol Heller, and comments on an earlier version by Jeroen Aerts, Wouter Botzen, Simon Dietz and two referees. We would like to thank Risk Management Solutions for providing some of the data on hurricane risks in Florida which made our analysis possible. We acknowledge partial support from the Wharton Risk Center’s Extreme Events project, the National Science Foundation (SES-1062039 and 1048716), the Travelers Foundation, the Center for Climate and Energy Decision Making (NSF Cooperative Agreement SES-0949710 with Carnegie Mellon University), the Center for Research on Environmental Decisions (CRED; NSF Cooperative Agreement SES-0345840 to Columbia University) and CREATE at University of Southern California. Dr. Ranger acknowledges the support of the UK Economic and Social Research Council (ESRC) and Munich Re.

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Authors and Affiliations

  1. Center for Risk Management and Decision Processes, The Wharton School, University of Pennsylvania, Philadelphia, PA, USA

    Howard Kunreuther & Erwann Michel-Kerjan

  2. Centre for Climate Change Economics and Policy, London School of Economics and Political Science, London, UK

    Nicola Ranger

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  1. Howard Kunreuther
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  2. Erwann Michel-Kerjan
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Correspondence to Erwann Michel-Kerjan.

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Kunreuther, H., Michel-Kerjan, E. & Ranger, N. Insuring future climate catastrophes. Climatic Change 118, 339–354 (2013). https://doi.org/10.1007/s10584-012-0625-z

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