Property insurance: A direct link between climate risk and municipal bond creditworthiness

In September 2015, then Bank of England Governor Mark Carney gave a speech in which he famously referred to the “Tragedy of the Horizon.” He was referring to the fact that financial markets tend to mis-price climate risk because the perceived timing for such risk lies far into the future, beyond the normal investment horizon for most investors.

Nowhere is this phenomenon more evident than in the municipal market, where climate risk continues to be largely ignored, even though state and local governments clearly stand on the front line for climate change impact and mitigation.

We explain the historical reasons for the market’s apparent lack of concern and explore how the current property insurance crisis in several states may dramatically shorten the climate risk horizon for municipal investors.

Traditional View of Climate Risk
Many industry observers have been puzzled by the absence of a demonstrable “climate premium” in current tax-exempt yield and price levels. There is actually a good reason for the municipal market’s apparent lack of concern about climate risk. 

Historically, the cost of natural disasters at the state and local level have been “federalized” through federal disaster relief and the impact on local economies have turned out to be more stimulative than negative. 

To illustrate, let’s take a look at the historical data for New Jersey counties, courtesy of Spatial Risk Systems (SRS). According to SRS, “under normal conditions, federal transfers constitute a minor share of NJ total county revenues. The average is only 2%. Florida and Louisiana show similar distributions. The federal transfers in these states contribute only 5% and 3%, respectively.”

However, during and after a disaster, the extent of federal assistance can spike up to between 30% and 70% of NJ counties’ GDP covering, as an example, the period from 2009 to 2015 when major storms such as Superstorm Sandy, amid other severe weather, hit the state. 

The past may not be a prologue to the future in this case. First, disaster relief takes time to work itself through the FEMA bureaucracy, leading to serious short-term financial stress on homeowners affected by natural disaster. Secondly, by focusing only on the acute weather events which dominate the evening news, investors may be overlooking the rising costs of chronic climate events which may not qualify for federal relief. Flood risk is one such example.

Flood Risk and Limitations of the National Flood Insurance Program
The Federal Emergency Management Agency (FEMA) administers the National Flood Insurance Program (NFIP), which provides flood insurance to property owners in participating communities. While the NFIP plays a crucial role in flood risk management, it has several limitations:

• Coverage Limits and Exclusions: The NFIP offers limited coverage compared to private insurance. For residential properties, the coverage limit is $250,000 for the building and $100,000 for contents. For businesses, the limit is $500,000 for the building and $500,000 for contents. These limits may not fully cover the cost of rebuilding or replacement, especially in high-cost areas. The NFIP policy also has numerous specific exclusions. 
• Lack of Business Interruption Coverage: For businesses, the NFIP does not offer business interruption insurance, which is crucial for covering lost income and operating expenses after a flood.
• Mapping Issues: FEMA’s flood maps, which determine the areas and properties required to have flood insurance, can be outdated or inaccurate. This leads to some properties being improperly classified, either overestimating or underestimating their flood risk.
• Mandatory Purchase Requirement: In areas designated by FEMA as high-risk flood zones, homeowners with mortgages from federally regulated or insured lenders are required to purchase flood insurance. However, this mandatory purchase requirement does not always capture all properties at risk, and some homeowners may remain uninsured or underinsured.
• Rate Structure and Subsidies: The NFIP’s rate structure, historically subsidized for certain properties, has faced criticism for not accurately reflecting the true risk of flooding. 
• Debt and Financial Stability: The NFIP has accumulated a $20 billion debt to the U.S. Treasury, largely due to payouts from major hurricanes and flood events. This debt challenges the program’s financial sustainability.
• Limited Private Market Competition: The existence of the NFIP has historically limited the development of a robust private flood insurance market, although recent years have seen more private insurers entering the market.
• Lack of Incentives for Mitigation: Critics argue that the NFIP does not provide enough incentives for flood mitigation and resilience. While there are some discounts for mitigation efforts, they may not be sufficient to encourage widespread adoption of flood-proofing measures.
• Community Participation Requirement: Flood insurance through the NFIP is only available in communities that have joined the program and agreed to enforce certain floodplain management regulations. Residents in non-participating communities cannot access NFIP insurance.

With all its flaws, the NFIP has increasingly become the flood insurer of last resort for many homeowners, at least for those that are forced by mortgage lenders to take out such insurance coverage. Given its precarious financial condition, there is little doubt that flood insurance premiums will be rising sharply in the years to come.
The Property Insurance Crisis
In early December 2023, the U.S. Senate Budget Committee launched an investigation into the solvency of the state of Florida’s state-backed home and property insurer of last resort, the Citizens Property Insurance Corporation. The Committee expressed concern about the “potential economic consequences of an eventual wide-scale decline in property values,” not only in Florida but also across the nation, should the Sunshine State turn to the Federal government for a bailout.

The Citizens inquiry is the latest sign of a growing property insurance crisis in various parts of the United States. ChatGPT actually does a good job of summarizing the key elements of this ongoing crisis, as follows:

• Rising Premiums: Homeowners in many areas, especially those prone to natural disasters, are facing steep increases in insurance premiums. As the risk of damage from disasters grows, insurance companies are raising rates to cover potential losses.
• Insurer Insolvency and Market Exit: Some insurance companies have become insolvent or have chosen to exit markets in high-risk areas due to the financial strain of covering catastrophic losses. This reduces competition and availability of coverage, leaving homeowners with fewer options.
• Non-Renewals and Coverage Reductions: Insurance providers are increasingly non-renewing policies in areas they deem too risky, often leaving homeowners to seek coverage from state-sponsored insurance pools, which can be more expensive and offer less coverage.
• Increased Deductibles and Policy Exclusions: To mitigate their risk, insurers are increasing deductibles and introducing policy exclusions, especially for high-risk events like hurricanes and floods. This shifts more financial burden onto homeowners.
• Affordability and Availability Issues: In high-risk areas, the combination of rising premiums, higher deductibles, and reduced coverage options is making property insurance unaffordable or unavailable for some homeowners.
• Regulatory Challenges: Insurance is regulated at the state level, leading to a patchwork of regulations. Some states have struggled to balance consumer protection with maintaining a solvent and competitive insurance market.
• Increased Demand for State-Backed Insurance: As private insurers pull back from high-risk markets, more homeowners rely on state-backed insurance programs like the California FAIR Plan or Florida’s Citizens Property Insurance. However, these programs have their own limitations and financial challenges.
• Impact of Reinsurance Costs: Insurers rely on reinsurance to cover large losses, but as the risk of catastrophic events increases, so does the cost of reinsurance. These higher costs are often passed on to consumers.
• Adverse Selection and Market Segmentation: The insurance market is experiencing a segmentation, where only lower-risk properties can afford or qualify for private insurance, while higher-risk properties are pushed into state-backed plans or left uninsured.

The Cases of Florida, Alabama, Louisiana and California
As the poster child for climate risk, Florida’s exposure to hurricanes and tropical storms has led to frequent and costly claims, forcing many insurers to either leave the state or go bankrupt, reducing competition and availability of coverage. Homeowners in the state face soaring insurance premiums as insurers try to cover their risks. Florida also has a high rate of insurance litigation and claims fraud, which certainly adds fuel to its property insurance crisis.

Similar to Florida, Alabama’s Gulf Coast is prone to hurricanes, leading to high insurance costs. There are fewer insurers operating in Alabama’s coastal areas, leading to less competition and higher premiums. For many homeowners, especially in high-risk coastal areas, insurance is becoming increasingly unaffordable.

Louisiana, for its part, frequently faces hurricanes and flooding, most notably Hurricane Katrina and more recently, Hurricane Ida. Several insurers in Louisiana have become insolvent following major storms, straining the state’s insurance market and, here also, homeowners face not only high premiums but also high deductibles, particularly for wind and hail damage.

The primary concern in California is quite different from the southern states: it is the increased frequency and severity of wildfires. Insurers have been non-renewing policies in high-risk areas and increasing premiums, partly due to the high cost of reinsurance. Homeowners in high-risk areas often resort to the California FAIR Plan, a state-sponsored insurance pool, which is typically more expensive and offers less coverage.

You can’t talk about the Golden State without mentioning earthquake risk, and here also, the state had to intervene to ensure the availability of earthquake insurance. In the aftermath of the 1994 Northridge quake, the California Earthquake Authority (“CEA”) was created to provide residential earthquake coverage of last resort.

Critically, the insurance risk transfer and pricing mechanism in many states has been distorted by local politicians’ desire to cap insurance premiums at an “affordable” level for their constituents, creating an untenable situation in the long run.

Property Insurance Availability and Local Property Values
So how would the property insurance crisis, which forces many homeowners into the arms of federal and state-backed insurers of last resort, affect local property values? The First Street Foundation, a nonprofit group, has attempted to quantify the potential impact of higher insurance costs on home values in its recent report: “The 9th National Risk Assessment: The Insurance Issue.” According to the report, “areas with higher insurance costs may experience decreased property values as buyers factor in these added financial burdens.” 

How much of a hit to property values, you ask? Using a Net Operating Income formula typically used by real estate investors (please consult First Street’s full report for details), First Street estimates that the average home in West Palm Beach, FL could experience an 18.9% drop in value when Citizens’ recently announced rate increase takes effect. Should the implicit cap rate also rise as buyers start to require an additional risk premium, First Street estimates the property value could decline by as much as 40.6%!

These are just illustrative examples, of course. Regardless of what the actual value decline may turn out to be, even a highly rated city like West Palm Beach would have difficulty absorbing a double-digit percentage decline for some or all of its tax base. At a minimum, there would be a significant impact on the city’s credit profile.

Conclusion
The municipal market’s relaxed attitude toward climate risk may be seriously challenged in the years ahead. Unlimited post-disaster federal transfers may no longer be taken for granted, given the ballooning federal deficit. Importantly, the market may be mistaken in focusing solely on acute climate events such as hurricanes and tornadoes. The economic costs associated with chronic climate events, such as riverine flooding and drought, may prove to have a longer-lasting negative impact on state and local governments’ fiscal condition. In this context, property insurance “rationing” and its potentially negative impact on local property values may well turn out to be the direct link between climate risk and municipal credit risk we’ve all been watching out for. And for many states, the impact is here and now, not 30 years hence.