This interview with a lecturer in finance at Harvard business school talks about the impact of climate change on the financial system, a linkage not often made – so far, at least. Specifically, the lecturer posits that insurers don’t yet accurately price the risk of extreme weather events due to climate change. Therefore, many properties are being built today in the USA in high-climate-risk zones that are under-insured for these climate events. That low insurance encourages property buying, causing property prices in these high risk areas to rise. People paying more for houses in such areas are at risk of financial ruin should they lose those houses without adequate insurance coverage.
What’s also notable is the parallels the lecturer draws to the financial instruments that causes the 2008 financial crisis, which was also linked to housing in the USA:
Homeowners buy their property/casualty and fire/flood insurance policies through brand-name companies, such as Allstate or Progressive. But these companies often don’t retain all of the exposure to pay for loss events. In particular, they don’t mind being exposed if say one house burns down – the other premiums collected cover that cost.
But if an entire county or part of a state gets hit hard by a hurricane, they can’t cover losses to all of those homes on their own. They often contract, in bulk, with another tier of insurers called reinsurance companies. These firms include giant but lesser-known companies like Swiss Re, Munich Re, and General Re. Those international firms attempt to spread their exposure across the globe and across many categories of peril like tornado, hurricane, earthquake, wind, and flood.
In addition to diversifying the risks, the reinsurers also can slice off some of the risk into insurance-linked securities — including weather derivatives sometimes known as “catastrophe bonds.” The probability of an event happening and the likely cost of the event are rated by several specialty companies then bought and sold by financial investors — who have zero knowledge of or interest in your particular home or city — who can be paid to accept financial exposure of a defined nature for a fixed period of time in the event that one of the named events occurs.
This means we have a situation where whoever is buying or selling the risk is multiple steps away from the actual property.