Hyeyoon Jung, Robert Engle, Shan Ge, and Xuran Zeng

Because the frequency and severity of pure disasters enhance with local weather change, insurance coverage—the primary device for households and companies to hedge pure catastrophe dangers—turns into more and more essential. Can the insurance coverage sector face up to the stress of local weather change? To reply this query, it’s essential to first perceive insurers’ publicity to bodily local weather threat, that’s, dangers coming from bodily manifestations of local weather change, reminiscent of pure disasters. On this submit, primarily based on our current workers report, we assemble a novel issue to measure the mixture bodily local weather threat within the monetary market and focus on its functions, together with the evaluation of insurers’ publicity to local weather threat and the anticipated capital shortfall of insurers below local weather stress eventualities.

Bodily Local weather Threat Issue

The first problem in finding out insurers’ publicity to local weather threat lies in precisely measuring this threat, significantly bodily local weather threat since future local weather eventualities and influence projections are inherently unsure and depend on numerous modeling assumptions. Though historic knowledge can function a proxy for bodily threat, perceptions of such dangers can evolve with new hazards rising and current dangers intensifying. Even when we are able to measure bodily dangers exactly, one other problem is to measure insurers’ publicity to such dangers, as it will possibly additionally fluctuate as a result of operational adjustments, reminiscent of shifts in coverage, gross sales places and reinsurance protection.

In our current workers report, we use a novel strategy to deal with the challenges of assessing insurers’ publicity to local weather threat. Through the use of a market-based strategy, and relying solely on publicly accessible knowledge, together with inventory market knowledge, we circumvent the shortage of ample knowledge. Particularly, we assemble a number of portfolios which might be designed to fall in worth as bodily threat escalates. One such portfolio includes the shares of public property and casualty (P&C) insurers, with every insurer’s weight decided by its premium publicity to states with a historical past of serious pure catastrophe damages. We consult with the return on this portfolio as a bodily threat issue. This issue can function a forward-looking measure by capturing adjustments in monetary market’s expectations on future bodily local weather change threat.

Why would this issue fall as bodily threat escalates? As future bodily dangers escalate, states which might be extra inclined to pure disasters are prone to expertise larger incidence of such occasions. Consequently, insurers with higher publicity to those states by their operations are prone to expertise decrease inventory returns. Nevertheless, there might be counterarguments. First, one may argue that insurers might increase premiums to compensate for the elevated dangers in these states. Nevertheless, regulatory constraints typically hinder insurers from totally adjusting premiums to replicate such dangers, significantly in high-risk states (see, for instance, Oh, Sen, and Tenekedjieva 2022). Furthermore, larger premiums might deter coverage uptake, thereby lowering insurers’ total income even when insurers can keep per-policy profitability.

Second, one may counsel that insurers might withdraw from dangerous states as bodily local weather dangers intensify. However, whereas some insurers might choose to exit unprofitable markets, heightened bodily local weather threat can nonetheless erode the entire income of uncovered insurers.

Does the issue work as meant?  If the constructed issue works as meant, it ought to decline following sudden spikes in bodily local weather threat. Nevertheless, that is tough to look at. A possible validation train is to check whether or not the issue drops after extreme climate-related pure disasters happen. The chart beneath illustrates that the issue usually declines following giant pure disasters, indicating that insurers with substantial publicity in high-risk states expertise a lower in inventory returns after giant pure disasters. Due to this fact, when inventory market buyers anticipate extra frequent and/or extreme disasters as a result of local weather change, we count on the issue to say no in worth, as meant.

Bodily Threat Issue Response round Pure Catastrophe Occasions

The above chart additionally reveals that the bodily threat issue takes greater than 5 days to reply, seemingly because of the delayed readability relating to the disasters’ influence, reminiscent of its severity and period. For example, throughout hurricane Katrina, preliminary media experiences instructed little harm in South Florida. It wasn’t till six days later that the monetary market’s response was talked about. Moreover, our evaluation means that the eye to pure catastrophe occasions usually peaks between ten and fifteen days after the occasion’s onset. By monitoring the frequency of occasion mentions in New York Occasions articles that concentrate on main hurricanes, we doc a gradual enhance within the variety of articles mentioning hurricanes after the occasion’s begin date, with a pointy rise after twelve days, as illustrated within the chart beneath. These findings make clear why the issue doesn’t decline instantly after disasters.

The Common Variety of New York Occasions Articles round Pure Disasters

The Bodily Local weather Beta

Our issue has a variety of functions. For example, by estimating monetary establishments’ inventory return sensitivity to the bodily threat issue, one can estimate the anticipated extent of capital shortfall skilled by establishments throughout extreme declines within the bodily threat issue. We current ends in the paper demonstrating this utility, specializing in insurance coverage corporations. Particularly, we calculate insurers’ time-varying inventory return sensitivity to the bodily threat issue whereas controlling for market components, that we name the “bodily local weather beta”.

To validate that this “beta” is reflective of dangers in insurers’ operations, we examine this “bodily local weather beta” (which relies on insurers’ inventory returns) with insurers’ “coverage portfolio local weather beta.” We estimate the latter because the weighted common riskiness of states in insurers’ coverage portfolios utilizing detailed knowledge on the place insurers underwrite insurance coverage insurance policies. Every state’s threat degree is assessed by analyzing municipal bond returns, since prior analysis reveals that these returns replicate bodily threat. We calculate how delicate county-level municipal bond returns are to bodily threat components and mixture the sensitivity measure to the state degree.

The chart beneath means that the stock-based measure (denoted “bodily local weather beta”) aligns with the “riskiness” of insurers’ coverage portfolios, as measured by their “coverage portfolio local weather beta.” Within the cross part, smaller insurers have bigger bodily local weather threat exposures. The alignment between the 2 betas can function a foundation for assessing the bodily threat publicity of unlisted insurance coverage corporations that wouldn’t have publicly listed shares however disclose operational publicity throughout states.

Correlation between Bodily Local weather Beta and Coverage Portfolio Beta

Ultimate Phrases

Because the frequency and severity of pure disasters escalate, households and companies flip to insurance coverage to mitigate local weather threat. Can the insurance coverage sector climate the challenges posed by local weather change? To deal with this essential query, we introduce a novel bodily local weather threat issue that has all kinds of functions such because the quantification of particular person insurance coverage firm’s publicity to bodily dangers and assessing the vulnerability of economic system to local weather change threat. Along with bodily threat, the paper additionally assesses insurers’ publicity to transition local weather dangers, the dangers coming from regulatory adjustments, utilizing the framework developed by Jung, Engle, and Berner (2021).

Hyeyoon Jung is a monetary analysis economist in Local weather Threat Research within the Federal Reserve Financial institution of New York’s Analysis and Statistics Group.  

Robert Engle is a professor emeritus of finance on the New York College Stern College of Enterprise.

Shan Ge is an assistant professor of finance on the New York College Stern College of Enterprise.

Xuran Zeng is a Ph.D. scholar in finance on the New York College Stern College of Enterprise.

Methods to cite this submit:
Hyeyoon Jung, Robert Engle, Shan Ge, and Xuran Zeng, “Bodily Local weather Threat and Insurers,” Federal Reserve Financial institution of New York Liberty Road Economics, April 3, 2024, https://libertystreeteconomics.newyorkfed.org/2024/04/physical-climate-risk-and-insurers/.