We're playing hot potato with insurance risk, and everybody is losing

If your home or small business were destroyed in a disaster, would you have the resources to fully rebuild? Very few do. That is why insurance exists. By paying an annual premium, policyholders shift the risk of financial devastation to an insurance company.

Climate change, however, is breaking the foundations of this model. We are now in a game of hot potato when it comes to the risk of ever-growing climate extremes. And unfortunately, those left holding the risk are often the ones least able to handle it.

Insurance, especially for disasters, is built on a chain of risk transfer. Households buy insurance from an insurance company. That insurer then passes on the risk through reinsurance, which spreads risk globally. For example, while everyone in a Florida community is going to suffer when a hurricane hits, hopefully that hurricane won’t happen at the same time as a wildfire in Australia or an earthquake in Japan. Reinsurance helps insurers reduce volatility in losses and enables them to write more policies.

Recently, however, we have seen disaster risk pushed back onto insurers. Reinsurers have reduced the amount of catastrophe risk they will assume and raised their prices. This has put more of the risk on insurance companies themselves, as they have been unable to transfer as much as in prior years.

When insurers get hit with more of the disaster risk, they respond by pushing more risk back onto policyholders. This can be done in several ways. Insurers may exit markets completely, as some have done in Florida and California, where the combination of climate disaster risk and higher rebuilding costs are making it challenging to continue operating.  

Insurers may also push more risk onto consumers by adjusting policy terms. This could entail higher deductibles, such as prevalent hurricane deductibles, excluding coverage for certain types of losses (such as flood exclusions), or sub-limits on payouts related to certain types of disaster damage (for example, burst pipes or roof damage). If regulators allow it, insurers will try to raise prices to cope with the higher risks they are taking, but this can make policies too expensive for many households.

As private insurers shed risk, it also falls upon public-sector programs, for as households fail to find affordable policies in the private market, they turn to the state. Florida Citizens, Louisiana Citizens, and the California FAIR plan—public sector programs offering either hurricane wind or wildfire coverage (or full homeowners policies) — are growing. Florida Citizens is now the largest insurer in that state.

Public programs are caught between a rock and a hard place. Growing climate risk and a growing policyholder base require them to raise rates to help ensure solvency in the face of a major disaster. Doing so, however, will burden fiscally-stressed residents and, unsurprisingly, is very unpopular. But if they price below risk levels, these programs increase the possibility of serious post-disaster fiscal stress.

Households left with the hot potato of climate risk are low- and moderate-income households — those least able to afford higher rates and most in need of financial protection. We know from research that lack of insurance can increase fiscal stress, slow recovery, and widen inequality after a disaster.

Three things can help end this game of hot potato.

First, we can massively invest in reducing our risk. There are more federal funds than ever before, and we know how to build stronger in order to withstand disasters like hurricanes and wildfires. We lack, however, the will to relocate to safer areas, the institutional frameworks to support building back stronger and safer, and policies to guide future development out of harm’s way and in accommodation of future risk.

Insurance can play a larger role here, starting with political support for stronger building codes. We also need property policies that cover the extra costs of building to standards that can withstand climate perils. (This should incorporate energy efficiency and rooftop solar during rebuilding, as reducing emissions is the ultimate climate risk reduction.) Insurance must also help policyholders obtain the necessary technical expertise and assistance to adopt these changes.

Second, we need to rethink the role of government. Risk is migrating to the public sector. Without strategic thinking as to when and how this occurs, we will miss important opportunities, like tying such socialization of risk to investments in risk reduction and in elevating the importance of inclusive access to insurance as a necessary social good. We also risk straining public-sector programs to the fiscal breaking point. That could have even deeper ramifications for housing markets, local economies, and people’s wellbeing.

We could draw from other countries’ experiences, such as France and Spain, and consider a model where the public sector provides a layer of reinsurance in exchange for firms providing all-hazard insurance to residents. This could help guarantee that everyone has needed coverage against escalating catastrophes, maintain a stronger private market, and protect firms against disaster-related insolvencies. Such public reinsurance could be tied to risk reduction requirements, and include risk-based pricing, but also provide means-tested assistance to the most vulnerable.

Third, we cannot let this game of hot potato leave climate risk falling on the shoulders of the most vulnerable. The Biden administration's incipient efforts to reform disaster programs to help those most in need must be expanded and move to insurance as well. Congress should adopt a means-tested assistance program for flood insurance, and states should support wider access to risk transfer for vulnerable populations through regulatory reforms and new product offerings.

As climate risks continue to mount, our households and communities should not be left holding the hot potato.

Carolyn Kousky, associate vice president for economics and policy at the Environmental Defense Fund, serves on the Federal Insurance Advisory Committee of the U.S. Department of Treasury and is vice chair of the California Climate insurance Working Group.