It feels like an apocalyptic moment in history as areas are deemed uninsurable. Wildfires? Severe floods? There will be no insurance coverage when the shock occurs.
It is hard to blame the insurers, which have been haemorrhaging financially. But whose obligation is it to fill the void? The government? If so, it must be done proactively and comprehensively to manage liabilities.
California is the most populous US state, and by extension the largest insurance market. In June, major US insurer State Farm announced that it would no longer accept new applications from homeowners in the state due to “rapidly growing catastrophe exposure” to extreme weather events such as wildfires. This is undoubtedly a harbinger of what is to come globally.
This situation arises from a 2022 order by California commissioner Ricardo Lara, an elected official, imposing a one-year moratorium that protected insurance coverage for residents of areas hit by wildfires. Insurers were required to keep coverage and were prohibited from imposing steep premium increases. It couldn’t last forever though.
The insurance sector has been bearing the financial risk associated with climate change. Due to worsening climate shocks many countries, particularly developing ones, aim to procure insurance to transfer risk from their fiscal liabilities to private insurers and reinsurers. This includes sectoral coverage such as agriculture insurance, with broader sovereign insurance that would trigger payouts for severe climate shocks.
But successive years of significant financial losses — sometimes resulting in insolvency — have forced insurers to withdraw from the most vulnerable markets. The question now is whether there is an alternative way to manage climate risk.
Even in advanced economies governments lack the financial capacity to manage risk. Several Republican governors in the US, including Florida’s Ron DeSantis and Texas’s Greg Abbott, who have historically shunned federal intervention and advocated for state independence, have turned to the national government for financial support after a major hurricane and large-scale freeze.
The following are key areas for intervention to manage the risk more effectively:
- Derisking insurers through financial support. The sector will inevitably need to price in risk — but households and small businesses can’t absorb the increased cost. Governments will thus need to subsidise insurance premiums and function as reinsurers to absorb the cost of shocks that cross a specified threshold, to cap losses for insurers. Insurance companies are not offering a social good; they are providing a commercial financial product and need to operate profitably.
- Making critical investments. Governments will need to finance climate-resilient roads and bridges that don’t wash out every time there is a flood, and subsidise new development in areas that are removed from the risk of wildfires, for example. This will reduce liabilities for insurers and governments. These are critically time sensitive. If large US insurance companies are pulling out of large markets it is a matter of a short time before firms begin to pull out of emerging economies, where risk pools are significantly smaller due to lower insurance penetration. In the US, 61% of residents have home insurance and 66% have private health insurance. In 2021 life and nonlife insurance penetration in SA reached just more than 12%.
- Creating policies to discourage long-term investments in high-risk areas. These investments will undermine broader financial stability given that there will be high risk of default in vulnerable areas. Research by the European Central Bank shows that the average default probability of the credit portfolios of the 10% of euro area banks that are most vulnerable to climate change could rise 30% by 2050.
While an oceanfront property in Durban sounds nice, and commercially lucrative in the short term, it is an ill-advised investment given long-term risk. Three of the past seven years have included catastrophic flooding. When insurers pull out homeowners will default when the next storm occurs. Property developers should be required to cover these costs rather than profiting and leaving government with fiscal liabilities.
Responding is expensive. The US government paid out $120bn after Hurricane Katrina. The US department of housing & urban development distributed nearly $20bn for the Community Development Block Grant-Disaster Recovery Programme after the hurricanes in the 2010s. SA simply couldn’t cover such losses.
A suite of complementary risk management efforts is required in developed and emerging economies. Proactive financial and nonfinancial measures are critical to prevent undermining millions of livelihoods and opening up billions of dollar in fiscal liabilities as insurers scale back their risk exposure.
• Baskaran, a development economist, is a non-resident fellow at the Brookings Institution in Washington DC.
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