Homes washed away, seaside resort towns decimated—awful tragedies we’ve seen before.

But tidal surges transforming subway and traffic tunnels into aquariums, Wall Street underwater, power stations inundated with saltwater exploding sections of the country’s largest city into darkness?

When the Atlantic Ocean breached the banks of Manhattan Island and the lights went out south of Broadway, turning Lower Manhattan black, it was likely the first time many in the Northeast realized their environment is seriously changing.

Call it “global warming” or something more palatable like “climate change,” many people’s assessment of physical risk was seismically altered on that late October evening. But this was only the latest chapter in severe weather that the rest of the country has already been experiencing. Whether it is the California and Florida coasts or Cape Cod and the Hamptons, affluent clients of financial advisors are likely to own properties in these areas.

From unprecedented drought, multistate wildfires, to violent tornados and hailstorms, virtually every industry has been affected by what’s been happening to the climate, perhaps none more than insurance. And the effects on insurance directly impact decisions about where we live and do business, as well as public finances, observes Sharlene Leurig, senior manager of insurance and water programs at Ceres, a coalition of investors, environmental organizations and public interest groups with a focus on climate and insurance.

As private insurers increasingly move out of disaster-prone regions, she sees “risk of catastrophic loss being shifted to public insurance pools and to individual and business policyholders who have to bear more risk through more restricted coverage while premiums continue to rise.”

The Underlying Issue

Though politicians are still debating whether man is influencing the earth’s environment, most climate scientists think it’s a done deal, making the impact on insurance so decisive. Jean-Pascal van Ypersele, the vice chairman of the U.N.
Intergovernmental Panel on Climate Change, said at a recent conference in Qatar that the degree of scientific community belief in man-made climate change is now comparable to the consensus backing the principles of gravity.

In its 2012 study, Severe Weather in North America, Munich Re, one of the world’s largest reinsurance firms, reports, “Nowhere in the world is the rising number of natural catastrophes more evident than in North America.” It found the number of weather-related loss events quintupled over just the last three decades.

These realizations have led the Securities and Exchange Commission to formerly request that all companies address material impacts that damaging weather may have on their businesses. This puts the impact of climate change visibly right up there with financing and sales in the discussion of forces affecting corporate profitability.

In a recent 10-K filing, southern utility Entergy wrote that it and its subsidiaries own “assets in and serve communities that are at risk from sea-level rise, changes in weather conditions, storms and loss of the protection offered by coastal wetlands. A significant portion of the nation’s oil and gas infrastructure is located in these areas and susceptible to storm damage that could be aggravated by wetland and barrier island erosion, which could give rise to fuel supply interruptions and price spikes.”

Allstate, the largest publicly traded U.S. insurer, is reducing its exposure in hurricane-prone areas. “You see a lot more severe weather,” says CEO Thomas Wilson, “and we are acting and running our homeowners business as if that is a permanent change as opposed to an anomaly.”

Whether increasing capitalization, altering underwriting procedures and pricing, or requiring greater backstopping from reinsurers that insurers themselves pay to be certain they are adequately protected from disaster, climate change is impacting the industry.

Challenges

Jim Ryan, senior insurance analyst at Morningstar, evaluates insurers in terms of revenues and payouts. Presently, he doesn’t view climate change as an exogenous factor in equity analysis, believing insurers are capable of factoring it into their forecasts.

The problem, however, is that there is no clear consensus about how to model future climate events. The process involves a large degree of catch-up by insurers as they respond to increasing risk, and investors can be very unforgiving as such adjustments are being made.

For example, shares of a leading global property insurer, Australia-based QBE Insurance, dropped in value by more than 15% in just two days after the company announced in early November that its exposure to Hurricane Sandy was nearly twice the initial forecasts. The company now expects a liability of up to $450 million with major claims for fiscal 2012.

Coupled with payouts for U.S. crop losses due to a protracted drought, losses for the year are now set to exceed $1.8 billion. As a result, QBE’s profit margins are projected to fall from more than 12% to around 8%, which has led to a slew of analyst downgrades.

More disconcerting, according to Kieren Chidgey, a Deutsche Bank equity analyst, is the payout trend. Expressed as large catastrophic claims as a percentage of net earned premium, QBE’s ratio has climbed from 6.3% in the second half of 2007 to around 15% for three out of the last four quarters through the end of 2012.

The large German insurer Allianz reports 40% of industrial insurance claims it’s now paying are related to natural catastrophes, making climate change a threat to its business.

Tapping into the capital markets, reducing potential liability and increasing premiums will help raise reserves across the industry. Higher rates will mean either the reduced profitability of business policyholders or the passing along of such costs across the economy at a time when growth is already sluggish.

Trends like this, according to Mike Kreidler, Washington State Insurance Commissioner, are threatening the insurance industry’s stability. “This could ultimately lead to a crisis of affordability and availability of essential insurance for consumers and businesses,” Kreidler says, “as well as solvency problems for insurers themselves.” A reduction in private sector coverage shifts the burden of insurance to state governments and Washington, D.C., at a time when public finances can ill afford to take them on.

Public Option

In flood zones, the National Flood Insurance Program is the primary means in which residential and commercial property owners can protect themselves. Federal law requires such insurance for mortgage property in high-risk areas. But when the initial term, typically one year, expires, some homeowners decide not to maintain coverage, which substantially increases their liability and often proves to be a very costly choice.

Even when owners keep their national flood insurance, they are often surprised to find that while coverage includes basic systems like boilers and hot water heaters and contents, many physical improvements may not be covered and total compensation is hard capped.

Enhanced coverage can be secured through private surplus insurance. Ceres’ Sharlene Leurig explains that such policies are designed for wealthier homeowners. But with premiums that are typically so high, she thinks policyholders could make out better over the long run by being self-insured.

States also offer insurance against wind damage where private coverage isn’t available. Leurig explains that these so-called “FAIR” plans—government-backed risk pools of insurance—are supported by special taxing powers to make up for policy rates priced below actual risk. After an event, insurance companies operating in a given state may be required to pay a one-time tax. Additional support can also be raised by one-time taxes on homeowners and businesses.

Knowing that shortfalls will likely continue, states have been lobbying the federal government to gain a further backstop through special U.S. Treasury-issued debt.

States have also periodically issued “catastrophe bonds” to raise capital that doesn’t get paid back in full in case of a qualified event. This arcane security appeals to certain institutional investors looking for market-uncorrelated assets and high yields, but is not considered a major source of reserves.

Leurig is concerned that states are taking on increasing liability without attempting to mitigate basic risks, such as restricting the development of lands in storm-prone areas. Just this past summer, North Carolina actually prohibited local development boards from considering rising sea levels as they affect tidal risk when the boards assess the viability of waterfront development.

“Myopic focus on increasing property tax receipts could prove very expensive,” she posits, “not necessarily unlike what we saw with how subprime mortgage underwriters got us into the financial crisis by chasing immediate gains and ignoring the real costs to the system and taxpayers of writing suspect loans.”

Another unexpected consequence of the rising number of climate events is the decision by some insurers to avoid investing their capital in municipalities that are being affected by climate change. The property and casualty insurer Hanover Insurance Group, based in the Northeast, recently reported that it’s avoiding coastal areas in determining municipal bonds in which to invest.

Response

Insurers, consultants, investors and policyholders are moving to proactively mitigate risk.

Rebecca Henson, senior sustainability analyst at Calvert Investments, the country’s largest socially responsible asset manager with more than $12 billion, is seeing businesses encouraged to review supply chains and devise backup plans that fill in gaps when certain portions of the chain fail. She notes that after Hurricane Katrina, utilities are moving to the forefront in calling for greater coastal restoration to better protect customers from devastating storm surges.

Henson also reports that a growing number of state insurance commissioners are requiring insurers to clearly disclose their approach to climate change risk. But she feels “insurers still need a greater level of sophistication in how they model and adapt to risk along with greater transparency in explaining their approaches.”

Swiss Re and Munich Re have been leading voices in the discussion, echoing Europe’s more progressive response to climate change.

In addressing all players involved, Munich Re recommends heightened focus on loss prevention, maintenance of up-to-date flood maps, a push for more robust construction, a strengthening of infrastructure and a movement toward more accurately priced government insurance premiums that clearly articulate risks to disincentivize building and activities in vulnerable regions.

The Investor Network on Climate Risk (INCR)—a group of some of the world’s largest investors, including BlackRock, Deutsche Asset Management and TIAA-CREF, along with public pension funds in California, Florida and New York, with assets exceeding $11 trillion—is pushing the issue globally.

Just ahead of the international climate negotiations in Doha, Qatar, last November, the INCR called for decisive government action committed to low-carbon investment; to the sharing of knowledge and clean energy technologies; and to the passage of strong, clear international agreements that emphasize the importance of climate policy and a reduction in greenhouse gas emissions.

While these are encouraging signs, the European Union’s recent decision to delay enforcement of its long-awaited civil aviation emissions law, bending to global business and government pressures, shows just how far leaders are from jointly taking meaningful steps to mitigate a warming planet.