Stormy Future for Insurers: The Growing Costs and Risks of Extreme Weather Events

This Ceres report examines how extreme weather trends may be a harbinger of significant challenges ahead for a sector in which many companies are already confronting profitability and growth challenges. This analysis is based on a careful review of U.S. property/casualty insurance industry financial results as reported by A. M. Best Company in early 2012.

Today, rising losses related to extreme weather events are significantly impacting the insurance industry and will increasingly challenge the sector’s risk models and underwriting capabilities. In coastal and non-coastal areas alike, U.S. insured losses triggered by volatile weather events are steeply rising. 1 Extreme weather events cost U.S. property/casualty insurers more than $32 billion in losses in 2011. 2 While 2012 insured property losses to date are lower, the pattern of extreme weather and associated economic costs are continuing.

These rising payouts come as insurers are simultaneously confronting historically low investment returns and a sluggish overall economy. Even before the recent spate of underwriting losses, the insurance industry’s overall financial performance, as measured by average return-on-equity (ROE), lagged significantly behind other industries. 3 The threat of rising catastrophic losses triggered by increasing concentrations of insured assets, along with a changing global climate, present very real and significant challenges to the sector’s financial future.

The implications of these rising loss trends are obvious for insurance companies and their shareholders. Beyond just declining profitability and returns, these increasingly visible trends could undermine some insurer’s ability to manage and, in some cases, even survive, future catastrophic, weather-related loss events.

Investors in insurance companies are not the only ones affected by these issues. Extreme weather is already causing more businesses and properties to be uninsurable in the private insurance markets, leaving the higher risks and costs to governments, taxpayers and individuals. In fact, since 1990, total government exposure to losses in hurricane-exposed states has risen more than 15-fold to $885 billion in 2011. 4

Insurance sector losses and lackluster financial results have even broader implications. Taken to their logical conclusions, these trends could ultimately undermine our state, regional and national ability to rebound from the shocks of natural disasters. The state of Florida’s huge exposure as the “insurer of last resort” for more than one million homeowners— a situation triggered by insurers withdrawing from the state after several devastating hurricanes—is living testament to this. 5

Against this backdrop, this Ceres report, “Stormy Future for U.S. Property and Casualty Insurers,” examines how extreme weather trends may be a harbinger of significant challenges ahead for a sector in which many companies are already confronting profitability and growth challenges. This analysis is based on a careful review of U.S. property/casualty insurance industry financial results as reported by A. M. Best Company in early 2012.

The report’s key findings and recommendations are as follows:

EXTREME WEATHER RISKS TO THE PROPERTY/CASUALTY INSURANCE SECTOR ARE GROWING 

More frequent and severe extreme weather events, along with increasing populations in coastal areas and other exposed regions, are having profound impacts on the property/casualty insurance sector. The value of insured losses due to weather perils has been trending upward over the past 30 years, with 2011 exacting an especially heavy toll. 6 Overall, the estimated $44 billion of insured catastrophe and extreme weather losses in 2011 was second only to 2005 when Hurricanes Katrina, Rita and Wilma hit the Gulf Coast (with insured losses totaling approximately $60 billion). 7]

In early 2011, insurers watched as severe weather including tornadoes in Missouri, wildfires in Texas, hailstorms in Arizona and flooding along the Mississippi River drained their capital reserves. For many insurers, these spring storm events substantially eroded or exceeded their 2011 budgets for catastrophe losses, making last year’s relatively quiet hurricane season a blessing. It is notable that while the property/casualty industry remains strongly capitalized, shock events can push more vulnerable companies into the red and even insolvency.

By year-end, the industry’s net underwriting loss was $34 billion and the industry had suffered the most credit downgrades in a single year since 2005. 8 2011 was also marked by a record 99 disaster declarations by the federal government, significantly exceeding the prior record of 81 set in 2010. 9

While 2012 insured losses (so far) are significantly lower, total economic losses due to extreme weather have been no less troubling in 2012. Extreme drought conditions across much of the country have already devastated corn, soy, wheat and other crops. While almost all commercial crops in the U.S. have some form of weather insurance, the federal government heavily subsidizes both the initial cost of protection and the resulting claims. As a result, taxpayers are going to pay tens of billions of dollars indirectly—in addition to the direct cost of higher food prices. 10

Given that weather peril losses have been trending upward for years, due to a combination of higher concentrations of property in vulnerable areas and increasingly more severe and frequent extreme weather events, there is strong reason to believe that 2011 and 2012 are not anomalies. Consider these trends: 11

➜ Losses from excessive precipitation during 2008-2011 were the highest on record.

➜ Average annual winter storm losses have nearly doubled since the 1980s.

➜ Since 1980, wildfires burned the highest amount of acreage in 2005, 2006 and 2007; and in 2010, wildfires caused over $1 billion in damage (and in 2012 record setting wildfires occurred in Colorado and other parts of the West.); and

➜ Losses from low precipitation (drought) during 2012 will be the highest since 1988.

CLIMATE CHANGE WILL LIKELY WORSEN FUTURE LOSSES

The worldwide impacts of climate change are already discernible. Global average as well as land and ocean temperatures have increased. 13 Worldwide, the hottest days are now hotter, 14 and extremely hot summers are now 40 times more frequent. 15 There have also been regional increases in more pronounced heat waves and heavy precipitation events, all of which exceed the levels expected from standard climate variability. 16

Within the United States, average temperatures have risen over the past half-century, while extreme weather events, including heat waves, droughts and floods, have become more frequent and intense. More than 25,000 new record highs have been set in 2012 alone across the US. 17 These changes are already causing deepening economic damages in the form of crop losses, wildfire losses, supply chain disruptions and critical infrastructure outages.

Looking ahead, insurers will need to better understand and anticipate changes in the climate and weather extremes so they can adapt their pricing accordingly and promote effective risk management strategies to customers. However, recent loss data suggests that many property/casualty insurers may not currently be well equipped to address the uncertainty of increasingly unpredictable and severe extreme weather events. Connecting the linkages and impacts between rising temperatures and extreme events remains a highly technical exercise fraught with uncertainty. As a result, many insurers now and increasingly in the future will be underwriting business without fully comprehending the probability and severity of the losses they may sustain.

COMPANY AND SHAREHOLDER IMPACTS

Other factors are contributing to the industry’s overall vulnerability. Low interest rates and weak capital market performance have squeezed insurer investment returns, a linchpin of industry profitability. In addition slow overall economic growth is tempering new premium production, further diminishing earnings.

As a result of these trends and their impacts on underwriting losses, overall profitability of the property/casualty insurance sector significantly lags behind other industries’. In fact, the return on equity (ROE) for all Fortune 500 companies has substantially exceeded the property/casualty sector ROE in every year since 1994. 18

2011 was an especially tough year. Relatively weak investment returns from the industry’s $1.3 trillion of invested assets combined with the large underwriting losses, resulted in a 61 percent decline in pre-tax operating income compared to 2010. 19 Another troubling sign: A.M. Best has indicated that the sector’s reserve cushion is nearing exhaustion. Without this benefit, there is added pressure for insurers to maintain profitability from core underwriting results. 20

It is important to note that the industry, as of late summer 2012, has demonstrated its resiliency to increased weather related claims, despite the increasing number of negative rating actions. Still, a growing number of industry stakeholders believe that these conditions have the potential to undermine the industry’s ability to thrive in the face of future potentially larger extreme weather calamities. Industry reports confirm this outlook.

“Looking ahead, we believe higher catastrophe losses, a relatively weak macroeconomic environment, lower investment yields and the tapering off of the benefit of reserve releases are likely to weigh on profitability for the overall P/C industry,” concluded Standard & Poor’s, in its 2012 Industry Outlook. 21

“The P/C industry will face increasing headwinds that will pressure operating performance and capital levels for many insurers,” stated global reinsurance broker Guy Carpenter & Co. in a 2012 report. 22

“Catastrophe activity remains the wild card every year, but expectations are for continued aboveaverage storm activity, including increased frequency of non-hurricane storms,” warned A.M Best, in a February 2012 special report. 23

INSURANCE AFFORDABILITY

Property insurance affordability and availability is already coming under increasing pressure due to increasing extreme weather losses. For example, Risk Management Solutions, the market leader in catastrophe risk modeling, recognizes that its 100-year database of historical Atlantic hurricane activity is no longer a valid predictor of future risk. 24 As a result, in May 2011 RMS released a new catastrophe model for Atlantic storms with significant implications for property insurance underwriting and pricing. Among its key projections for the coming five years: 25

➜ The likelihood of a Cat 3 storm making landfall on the U.S. coast will be about 20 percent higher than previously modeled;

➜ Modeled losses will increase by 40 percent on average for the Gulf Coast, Florida and Southeast;

➜ Modeled losses will increase by 25 to 30 percent on average for mid-Atlantic and Northeast coastal regions.

Changes introduced by the new RMS model, combined with last year’s record losses, are already creating cost ripples for commercial insurance buyers. The Willis Group and Marsh & McLennan have both seen property insurance rates for catastrophe-exposed risks increase in the range of 10 to 20 percent during first-quarter 2012. 26

Consumers are also paying more. Homeowners in wind exposed areas are seeing rate increases in the range of 5 to 12 percent, and many insurers are restricting capacity, increasing deductibles and requiring wind mitigation construction. 27

A CRITICAL ROLE FOR INSURERS

There is evidence from all around the world that society is increasingly vulnerable to the impacts of weather related natural catastrophes. In even the best-case scenarios, this will increase due to climate change. Building resiliency, while reducing future greenhouse gas emissions, are necessary and complementary strategies for dealing with climate change.

Insurers have historically been influential in motivating society to reduce risks, whether by advocating for smoke detectors in buildings or safety restraints in vehicles. Insurers have much to offer, and much at stake, in helping governments and private markets to further understand and develop solutions to better predict and prevent losses from extreme weather events. For instance, stronger resiliency to extreme weather is of great importance to the insurance sector as it reduces property risks, and promotes future insurability.

We have seen excellent examples of insurer sector leadership in addressing climate risks, but industry-wide engagement and action in this regard is nowhere near its potential.

 RECOMMENDATIONS

(Re) Insurance Companies

➜ Evaluate and price the increased risk exposure of insured property in the context of climate change and new/emerging extreme weather patterns. Insurance companies—and the companies (and individuals) they insure—need to look at their risk exposure and evaluate losses to insured property based on new and emerging weather patterns, not on past experience.

• Support/undertake research on national and regional forecasting of future weather and catastrophe patterns. While there is strong scientific consensus around climate change, there is a particular need to advance our understanding of the likely impacts of warming temperatures on the frequency and severity of thunderstorms, hailstorms and tornadoes, of which little is known.

• Develop and use catastrophe models that anticipate the probable effects of climate change on extreme weather events. Insurers with deep scientific resources should partner directly with climate scientists to develop new modeling capabilities. For many carriers, with little scientific expertise, it is equally important that the impact of climate change on extreme inland and coastal weather events be a routine part of the conversation with catastrophe model vendors and reinsurance brokers.

• Update insurance pricing and underwriting of risks to reflect changes in extreme weather impacts/changes on property damage loss trends. Insurers need to ensure that rates and loss reserves adequately cover damages from higher frequency and severity of catastrophic events. Insurers will also need to increase their ability to offer preferential pricing to property owners who have increased the resiliency of their structures.

➜ Inform land use planning, infrastructure design and building codes to ensure continued insurability in critically exposed markets and markets expected to face future insurability challenges. The potential for damages from extreme weather events is a major threat to all aspects of society, including our critical infrastructure (including roads, bridges, airports, water treatment facilities and dams). Insurers can lend their expertise directly to planners and work collaboratively with nongovernmental organizations with on-the-ground capacity in critical population centers.

➜ Promote reduction of carbon emissions. By reducing green house gas (GHG) emissions we can still limit the severity of climate change impacts. Insurers must also help enable transition to a low-carbon economy by offering new products and services that promote scaling clean and efficient uses of energy.

Insurance Sector Investors/Rating Agencies

➜ Encourage insurance companies to improve disclosure of climate change risks/opportunities and response strategies. Disclosure expectations should be consistent with disclosure mandates now being required by state insurance regulators in New York, Washington and California.

➜ Conduct their own analysis of insurance company exposure and management responses to extreme weather risks and other climate-related impacts.

➜ Build climate change management practices into regular dialogues with insurance companies and other companies being impacted by climate change.

Insurance Regulators

➜ Strengthen mandatory climate risk disclosure by expanding the number of states participating, and by clarifying disclosure expectations.

➜ Build climate risk considerations into the financial oversight process through the addition of climate change related questions to the Financial Condition Examiners Handbook.

➜ Create more shared resources to help insurers analyze and respond to climate-related risks and opportunities, including investment risks and opportunities, correlated risks and loss modeling.

➜ Engage with insurers, and consumers to better understand the nature of climate change risks, how they will impact rates, and what steps insurers and regulators needs to take to better incentivize consumers to increase the resiliency of their homes and businesses.