State Farm’s actions, and those of other insurers in California reflect a cold reality that neither private insurers nor state governments are prepared for the exponential rise in climate-related losses.
The recent decision by State Farm Insurance to stop issuing new home insurance policies in California because of climate-related wildfire risk is a wake-up call for those who think climate change is not a systemic financial and economic risk.
The move highlights the growing exposure to catastrophic risks and insurance market challenges that come with escalating climate-related property damage. It is also a little-known but important economic indicator.
The significance of insurance on the American economy cannot be overstated. Policymakers need to craft regulations that address climate issues proactively to ensure the smooth functioning of the insurance market and economy. Any significant disruption of insurance coverage poses an economic risk because property insurance plays a pivotal role in ensuring business continuity, stimulating construction, supporting mortgage lending, and, most importantly, consumer confidence.
The threat is getting worse by the day. Wildfires have burned nearly 10 million acres of forest and destroyed 39,000 homes in California over the last five years, providing a glimpse at just how dire the state’s climate crisis has become.
The good news is that the sleepy insurance industry is finally adopting and crafting innovative products and solutions to ensure that property insurance coverage stays in place.
The threat is getting worse by the day. Wildfires have burned nearly 10 million acres of forest and destroyed 39,000 homes in California over the last five years, providing a glimpse at just how dire the state’s climate crisis has become.
The State Farm bombshell
State Farm’s announcement is reverberating across America because of its marketplace clout as the largest property insurer in California by premiums written, accounting for approximately 20% of the market, announced. California’s economy is the equivalent of the world’s fourth-largest economy. California boasts a massive $3 trillion gross domestic product (GDP), surpassing Germany. And any action taken by companies in California rarely stays in California, given its disproportionate impact on the U.S. economy.
Like America, California’s economy heavily depends on consumer spending, which accounts for 68% of the nation’s GDP. Consumer spending, in turn, depends on consumer confidence, which in turn, depends on the wealth of the consumer. And much of that wealth is often concentrated in the homes they live in. The average single-family home value in California is $728,121, and the average single-family net worth in California is $884,003. That means the average single-family residing in America’s largest and wealthiest state economy has 82% of their net worth in their home. Any threat to the family home, or business, is a threat to the broader economy.
But the consequences of a property insurance crisis extend beyond financial numbers and touch the psychological aspect of consumer spending. Property owners and renters rely on insurance coverage to protect their assets and belongings, providing them with peace of mind. This sense of security contributes to overall financial stability by reducing the financial burden and potential debt resulting from property damage or loss. Without long-term property insurance options, consumer spending in California will undoubtedly suffer.
Unprepared for climate losses
State Farm’s actions, and those of other insurers in the state, reflect a cold reality that neither private insurers nor state governments are prepared for the exponential rise in climate-related losses. This is, in part, because laws and policies limit the ability to properly calculate the risk of the exponential rise in climate-related damage when seeking to price insurance.
The industry argues that California’s 2017 and 2018 fires wiped out decades of industry profits, making it all but impossible to do business in California. That means that the number of Californians whose insurers told them that their policy wouldn’t be renewed jumped up by 42% to almost 235,000 households. That, in turn, triggered the advocacy group, Consumer Watchdog, to call on California Insurance Commissioner Ricardo Lara to utilize the state’s Proposition 103 to prevent State Farm’s retreat. Such an unprecedented intervention into the free market could severely damage confidence in the California market.
“The current situation in California highlights some key dynamics in play within the insurance industry that go beyond the politics and forestry management practices of the state. The industry is in the early stages of trying to solve both the weather and non-weather climate insurance needs of businesses and individuals while facing a $100 billion capacity crunch (funds that enable insurers to underwrite policies) and an expertise gap relating to climate-related industries and risks,” says my colleague, Benjamin Banwart, Co-Founder & Chief Risk Officer of specialty climate insurance platform Climate Risk Partners.
The sector is grappling with a shortfall of over $100 billion in capacity, indicating a severe lack of funds needed to meet policy demand.
Two primary challenges confront insurers: a capacity shortage and an expertise gap relating to climate-related industries and risks. The sector is grappling with a shortfall of over $100 billion in capacity, indicating a severe lack of funds needed to meet policy demand. Compounding this situation, the overall insurance industry lacks the internal expertise and data necessary to appropriately analyze and underwrite the novel risks associated with the emerging climate economy. Some examples of these challenging coverage areas include providing technology performance policies for clean energy or critical minerals processing facilities and credit risk policies supporting vital offtake or feedstock contracts. Weather-related perils, such as hurricanes, floods, and wildfires, are subject to these same challenges as non-weather risks”
The insurer of last resort
As private insurer restrictions increase, the state of California is increasingly becoming the “insurer of last resort.” In the past five years, California property owners have turned to the California FAIR (Fair Access to Insurance Requirements) plan in record numbers.
But the program, designed to provide bridge coverage when traditional insurance options are not available, currently covers only around 3% of the California population and lacks the capacity to absorb systemic risks from significant severe weather events. In the event of plan failure, extensive litigation is likely to arise, delaying payouts and further burdening California property owners while exposing the insurance community to residual liabilities.
“As climate claims grow, free market failures are inevitable, and California will require a dramatic expansion in FAIR and other programs to ensure citizens have coverage. Otherwise, the Government of California must work with insurers to provide balance sheet support such as first loss provisioning as reinsurance markets fail to offset risks adequately,” says Paul Krake, Co-Founder of Climate Transformed, a climate intelligence platform, and View From the Peak, a multi-asset class research platform.
New solutions
Innovative solutions are being applied to existing insurance product areas to address the challenges of insuring property risks from climate-related damage.
These product areas experiencing rapid change include parametric insurance, catastrophe bonds, advanced risk modeling, resilience investments, collaborative initiatives, and climate risk pools all address the challenges associated with climate-related risks and provide comprehensive coverage to property owners.
“As climate claims grow, free market failures are inevitable, and California will require a dramatic expansion in FAIR and other programs to ensure citizens have coverage.”
Parametric insurance pays out only upon the occurrence of specified events, unlike traditional indemnity insurance, which pays out a claim based on the value of the loss suffered.
Catastrophe Bonds, also known as cat bonds, are financial instruments that transfer the risk of catastrophic events to investors. These bonds are typically issued by insurance or reinsurance companies and pay investors a high coupon rate. If a predefined catastrophic event occurs, such as a major hurricane or earthquake, the principal of the bond may be used to cover the insurer’s losses. Catastrophe bonds provide insurers with additional capital to manage their exposure to climate risks while enabling investors to diversify their portfolios.
Advanced risk modeling techniques and predictive analytics are becoming increasingly sophisticated in assessing climate-related risks. By leveraging historical weather data, climate models, and other relevant information, insurers can better estimate the potential impact of climate events on specific locations. This enables them to price policies more accurately and tailor coverage to meet the specific needs of policyholders in high-risk areas.
Insurers are exploring the concept of resilience investments, where they partner with property owners to implement risk reduction measures that mitigate the impact of climate-related damage. This can include funding and incentivizing the adoption of resilient building materials, retrofitting structures to withstand extreme weather events, or supporting the installation of smart technologies for early warning systems. By investing in resilience, insurers reduce their potential losses, and policyholders benefit from lower premiums and enhanced protection.
Climate risk pools are collective risk-sharing mechanisms that allow insurers to pool resources and spread the exposure to climate-related risks. By combining the risks across multiple insurers, these pools can enhance capacity and provide coverage to properties that would otherwise be uninsurable due to high climate risk. This approach helps to stabilize premiums and ensure the availability of coverage in high-risk areas.
The ultimate solution will require not only innovative tools that apply to existing and newly created insurance products but also robust public-private partnerships. The risk is too great for a traditional private market, but too much of a burden for governments. No economy will be able to withstand uninsured or underinsured against climate-related perils. The only way to promote continued economic well-being is by joining efforts to improve risk assessment, develop affordable coverage options, and enhance resilience in vulnerable communities.
