The end of insurance: Climate change is destroying homeowners and insurers

MW The end of insurance: Climate change is destroying homeowners and insurers

By Anna Scherbina and Joel Lander

Traditional insurance models aren't able to handle escalating natural disaster risks

A major hurricane striking Miami or Manhattan could make the hurricane Helene and the Palisades Fire look like trivial events.

The Los Angeles wildfires have caused economic losses currently estimated in the range of $250 to $275 billion. Meanwhile, insurance is disappearing. Many homeowners now choose to go skip insurance altogether, owing to the difficulty of obtaining coverage at all or even at a reasonable price. Insurance coverage has been diminishing in many respects, with rising deductibles and exclusions that effectively mean there is less true coverage.

Hurricane Helene struck the southeastern United States in September 2024, resulting in total personal property damages between $31 and $48 billion, of which $20-$30 billion were uninsured flood losses. The averages of these ranges indicate that insured losses covered about two-thirds of the total damages - leaving property owners responsible for the remainder. In North Carolina's Buncombe County, where flooding from Hurricane Helene resulted in over 57 fatalities, federal flood insurance covered less than 1% of homes.

The 2018 Camp Fire in California, personal property losses accounted for approximately 86% of the total losses, and if this fraction applies to the current Los Angeles fires, households stand to lose between $215 and $237 billion. That might be an overestimate if business losses are a higher share, but is indicative. With insurers expected to cover about $30 billion, these numbers imply that just 13% of such damages will be covered by insurance, and mostly property owners and the government will shoulder the remaining 87%.

Risk is difficult to estimate and to price reasonably - which could lead to oscillating enormous profits and losses for insurance companies.

Both Florida and California are trying to stem the loss of insurers. Just before the L.A. fires, California regulators announced they would allow climate risk assessments to justify higher insurance premiums. But this is far from a perfect fix. Part of the problem is that the risk of extreme losses has increased well in excess of historical events. This risk is difficult to estimate and to price reasonably - which could lead to oscillating enormous profits and losses for insurance companies.

For instance, a major hurricane striking Miami or Manhattan could make the hurricane Helene and the Palisades Fire look like trivial events. Would insurers have accumulated sufficient reserves from prior potentially extremely profitable years to cover those kinds of losses? Politically and otherwise, such an uncertain insurance scheme is challenging to make workable.

The traditional insurance model is no longer viable in the face of escalating climate risks that also create systemic financial pressures. The future of insurance must address these challenges by shifting toward models that manage risk and align incentives in better ways. By adopting innovative solutions such as bundled mortgage-insurance models, fairer pricing, and more efficient risk management through financial innovation, the industry can reinvent itself to meet the challenges of a changing world.

Insuring the uninsurable

Mortgage originators require homeowners to purchase insurance, but leave the search costs to the borrowers, who are likely less informed than lenders about the quality and prices of various insurance providers. A better model could help insulate banks from mortgage losses due to climate risks, and thereby reduce systemic risks posed by natural disasters.

Integrate insurance directly into mortgage payments.

One approach would be to integrate insurance directly into mortgage payments. Mortgages would include interest and principal payments as they do now, but also with a high-deductible insurance component that protects the bank's principal. This insurance component would be dynamically priced according to changing conditions related to risk and repair and replacement costs. Consumers able and wanting more insurance could buy supplemental policies.

Combining the bundled and supplemental insurance would approximate traditional coverage. However, the high costs suggest many would opt only for the bundled insurance. Homeowners could mitigate the impacts from natural disasters by choosing more resilient structures, or, conversely, opt for low-cost structures that could be rebuilt quickly without large financial burdens.

Further financial innovation, of which catastrophe bonds is one example, would allow insurance companies to offload some climate risks to well-diversified and geographically dispersed investors. This mechanism would distribute risk more fairly and effectively than the current regulatory processes that often shift risks to taxpayers, or ongoing insurance pricing practices that offload risks to other policy holders.

Bad actions from insurance companies deserve some of the vitriol against them. Yet insurance companies can serve beneficial roles and can be reinvented in a way that preserves what is valuable, such as facilitating risk sharing and acting as information intermediaries. By helping policyholders understand risks and reduce informational disadvantages, insurers can regain public trust and better serve their role in society. As disasters worsen, such reinvention is not merely desirable - it is essential for the survival of both insurers and those they serve.

Anna Scherbina is a nonresident senior fellow at the American Enterprise Institute $(AEI)$ and a professor of finance at Brandeis University's International Business School. At AEI, her research is focused on behavioral finance, cybersecurity, investment management, asset pricing, and real estate as an asset class.

Joel Lander is a consultant and cofounder of Tatari Inc. He earned his PhD in economics at UCLA and worked at the Federal Reserve Board of Governors as an economist.

More: Who gets to rebuild? Los Angeles fires expose the weakness of U.S. home insurance.

Plus: More homeowners are being denied insurance. The L.A. fires can be a turning point.

-Anna Scherbina -Joel Lander

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February 08, 2025 16:32 ET (21:32 GMT)

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