This article was produced by Moody’s

The insurance industry is suffering under increased payouts and bankruptcies.

Insurance coverage is traditionally real estate owners’ and lenders’ line of first defense against extreme climate events, but the increase in recording-setting floods, storms and wildfires in the past few decades is threatening the insurance industry, raising the cost and decreasing the availability of the financial safeguards they provide to real estate stakeholders.

Insurance providers rely on complex catastrophe models to estimate assets’ exposure to extreme events, but until recently, these models were based entirely on historical data, which means they did not account for the impact climate change has on the rate and severity of acute hazards. In some states like California, insurance companies were even prevented by law from using forward-looking data to set their premiums. This has created a reactive industry, which adjusts premiums after extreme events and is now facing severe financial hardship.

In California, insurers had $20.1 billion in underwriting losses from the 2017-2018 fires, which erased 26 years worth of profit, by some estimates. Meanwhile, in Florida, the insurance market is composed of small, not diversified companies, which rely heavily on reinsurance essentially insurance for insurers. When reinsurers increase their rates or effectively withdraw coverage due to the growing number of costly storms and floods, these small insurers struggle. Since April 2022, five Florida property insurers have gone insolvent.

Dropping Coverage and Raising Premiums in Exposed Areas

As insurers face real costs of increasing climate hazards they are passing them on to their clients, with broad implications for real estate developers, investors, lenders, and taxpayers. Figure 1 shows the change in U.S. and global commercial property insurance composite pricing from Q1 2015 through Q2 2022. Insurance costs are growing substantially each year, with U.S. insurance premiums increasing by more than 10 percent year-over-year for the last 11 quarters through Q2 2022.

Figure 1. Increase (yellow) or decrease (blue) in insurance composite pricing by quarter

While rising premiums present financial hardship, some insurers are dropping coverage altogether, presenting additional challenges. To mitigate these impacts, California passed a law allowing the state’s insurance commissioner to keep insurers from canceling or not renewing residential coverage in or near a fire perimeter for a year after a declaration of a state of emergency. While this provides temporary protection, it is less meaningful when considering the long-term life span of real estate assets.

In Florida, a growing number of property owners are relying on the state’s public option, Citizens Property Insurance Corporation (Citizens). Public insurance options are colloquially known as “insurers-of-last-resort” (IoLRs), and exist in most states under the management of each state’s insurance legislators. Florida Citizens had 883,000 policies in May 2020, over double its number three years ago. Figure 2 shows the increase in condo association Citizens Insurance policies. Clients are only eligible for this insurance if no private insurer will provide coverage or if premiums from private insurance would be over 20 percent higher than premiums from the Citizens Insurance. However, this option transfers risk to the public because by law Citizens can issue assessments resulting in additional bills on all its policy holders (and also those using private insurance) if it hits a deficit (such as from a particularly severe storm).

Figure 2: The increasing share of Miami condo association policies that are from Citizens Insurance

Louisiana Citizens Property Insurance Corporation, that state’s insurance of last resort, is mandated to have premiums that are 10 percent higher the private insurance. It is also required to create plans in such a way that encourage depopulation, or the transfer of clients back to private insurance. However, it’s now absorbing an increasing number of policies. In early Summer 2022 insurers ended over 80,000 policies in the state, just ahead of hurricane season and over 13,000 new policies have moved to Louisiana Citizens between 2020 and spring 2022.

In California, the public option, the FAIR plan, is based on a shared market in which private insurance companies together share the risk of highly exposed properties. Similar to the Louisiana option, FAIR Plan rates are typically much higher than private insurance. From 2015-2018, voluntary market policies in California counties highly exposed to wildfire decreased by 4.5 percent while FAIR plan policies in those areas rose by 177 percent, with the increase driven by increasing commercial policies.  While many states have recently moved plans back to the private insurance market, the trend is reversed in states like California, Louisiana and Florida due to high value real estate overlapping with high risk exposure.

Long-term Risks for Development and Mortgage Markets

Insurance penetration plays a large role in whether a community and its real estate market will rebound after a hazard. For example, Santa Rosa, California, had relatively high insurance coverage when 5 percent of housing stock was destroyed by the 2017 Tubbs Fire. However, there was a mini-economic boom during reconstruction in which property prices and rents increased and overall rebuilding proceeded more quickly than expected. Paradise, California, on the other hand, went from 26,000 residents to 2,000 after the 2018 Camp Fire. Over a year later only a fraction had moved back and rebuilt. Paradise had much lower insurance penetration than Santa Rosa, as well as more low-income households. As insurers continue to remove coverage or raise premiums to prohibitive levels, this will be a factor in more markets hit by disasters. In fact, research finds that over two thirds of U.S. metropolitan statistical areas are uninsured for at least 90 percent of their flood losses, underscoring the scale of this challenge.

The CRE market is particularly vulnerable to increasing premiums, as CRE lenders set high minimum coverage thresholds and unlike private homeowners there is not the option to forego coverage. On the other hand, this vulnerability varies by asset class. For example, retail, office and industrial landlords and property owners usually pass insurance coverage through to the tenants. However, for multifamily, hotel and condos it’s much harder to pass on rising insurance costs to tenants. Rising insurance costs can reduce property values, which has implication for investors’ returns and mortgage values. Likewise, the mortgage industry faces a greater risk of default as property owners face growing financial strain from the damage of extreme events and the growing insurance challenges.

Looking Forward: Building Resilience into Markets

Multistakeholder conversations are underway in California, Florida, and elsewhere, examining the best way to address the growing questions around the viability of continued development in areas repeatedly hit by extremes. They strive to find a balance between ensuring property owners can receive coverage and limiting the tax-payer burden of funding insurance for properties in highly exposed areas.

One established and increasingly important effort is to identify hazard-specific resilience measures and discount insurance premiums if they are implemented. FEMA research estimates that the average annualized loss avoided by switching to International Codes focused on floods, earthquakes and hurricanes/wind was $1.6 billion in post 2000 construction, demonstrating the value of integrating hazard resilience measures. Factoring resilience into insurance decision-making and development will only continue to grow in importance as the frequency and severity of climate hazards continue to increase.