Climate Risk Update: The Intersection of Physical Risk and Insurance Industry Developments

Banks and insurance companies are now recognizing that catastrophic weather events are becoming a major and inescapable risk factor—one that corporate risk managers worldwide must contend with as the exposure to and cost of climate change swells. 

Risk managers from banking and insurance are examining how physical risks stemming from climate change could shape credit portfolios and other concerns.  

Matt Kramer, climate risk executive at U.S. Bank, said that when it comes to performing scenario analysis for climate change, credit risk is the primary focus—but it is not the only one. “We're trying to take a holistic approach that also encompasses operational losses, including insurance coverage, so we can paint a complete picture of what our risk exposure could be,” he said at an RMA Annual Risk Management Virtual Conference session. That includes working with the bank’s real estate teams to decide which risks make sense to track for each geographical area. Wildfire risk on the West Coast, for instance, is one type of risk his bank examines. 

Emily Westendorf, director of the climate risk program for Fifth Third Bank, pointed out that because her bank has a retail footprint largely in the Midwest and the Southeast, flooding is a focus. For the bank’s Florida operations, hurricanes are a consideration. “We’re focusing on wildfire risk in the western states where we lend, as well,” she said. 

As the climate risk senior manager at Popular Inc. (which includes Banco Popular in Puerto Rico and Popular Bank the mainland U.S.), Adfred de la Rosa Berrios highlighted Puerto Rico’s particular vulnerability to climate change as an island. “In the long term, we see rising sea levels and coastal erosion posing a risk to our current assets and future lending,” he said. Currently the bank includes an environmental questionnaire for commercial clients as part of its credit underwriting that focuses on understanding the potential environmental impact of their business or project. In the future, the bank could incorporate other questions that may include an analysis of a client’s additional capital available for losses that insurance might not cover. 

Kramer noted the different risks commercial and consumer banking clients face as climate-related risks evolve over time. On the consumer side, customers are heavily invested in their homes, which are vulnerable to natural disasters. When asked about the high percentage of low-to-moderate income residents living in U.S. floodplains, Westendorf said the Fifth Third team has been discussing the topic and considering the role of education and opportunity in managing the risk. 

On the commercial side, large institutional clients may be more resilient to a natural disaster in a certain area—not only because they tend to be more geographically diverse but also because bigger buildings tend to be stronger in the face of extreme weather, Kramer said. 

The insurance perspective 

From the insurers’ perspective, encouraging banks to identify physical exposure and the geographic concentration of assets is key to helping them proactively manage climate risk in their portfolios, said Daniel Raizman, managing director and global head of client engagement and climate risk advisory at (re)insurance broker Aon. It is important to flag particularly exposed assets, identify insurance gaps and areas and assets that are susceptible to uninsured losses, and leverage analytics to model potential hazard risk and loss potential both today and in the future. 

Raizman pointed out that insurers price risk based on modeled outputs and actuarial best practices to estimate future losses and are often unable to effectively recover reinsurance costs in ratemaking due to regulatory requirements and market dynamics. In California for example, where wildfires are a constant threat, insurers were, until recently, required by law to file rates they set using their 20-year loss experience, not by modeling future potential losses. As a result, insurers try to play catch up or drop out, rendering insurance harder to access and less affordable for home and business owners. 

That’s not to say insurers can’t adapt. “The reality is this current inflection point is a cycle, not a cliff. While losses have notably increased over the past few decades, adverse loss experience has historically been a catalyst for change in the industry,” Raizman said. 

He cited Hurricane Andrew’s 1992 devastation of South Florida, which, by triggering the insolvency of 11 insurance companies in Florida, spurred use of catastrophe models to understand what risk could look like in any given year. Later catastrophes brought other issues to light. September 11 notably exposed gaps in workers’ compensation and triggered the terrorism risk insurance program as a backstop to help fortify the industry and incentivize underwriting. And hurricanes in 2004 and 2005 showed the threat of consecutive large-loss years. In 2017, Hurricanes Harvey, Irma, and Maria were notably significant destructive events as well. 

“While I have no doubt that losses will continue to rise, whether from changing climate or increases in population growth in areas like Texas, Colorado, and Florida, my hope is that the creation and adoption of new tools will help to insure both emerging risks and growing risks,” Raizman said. “I think that the market is in a place to respond to this.” He also pointed to increasing demand for catastrophe bonds to transfer catastrophic risk to the capital markets as a tool leveraged by insurance companies and sovereign governments. Innovative parametric products are gaining prevalence as well. 

For banks and insurers, making informed decisions starts with reliable data. A 2023 report from the U.S. Federal Reserve Bank of New York outlined the difficulties in obtaining data to assess risk, especially since future climate scenarios are inherently uncertain. One suggestion: Use historical data to proxy for such future risks. “Historical data on climate-related disasters may be limited, especially for long-tail events with low frequency but high severity,” the report noted. “Second, climate risks are dynamic and can evolve over time. Insurers’ exposure to climate risks may change as new hazards emerge or existing risks intensify.” 

U.S. Bank’s Kramer recommended FEMA’s National Risk Index as one initial source for available data that is a nice starting point, while other panelists suggested consulting physical risk vendors and other third-party data vendors for help estimating current and future risk.