April 13, 2024

Physical Climate Risk and Insurance Companies

As the frequency and severity of natural disasters increases with climate change, insurance – the main tool for families and businesses to cover the risks of natural disasters – becomes increasingly important. Can the insurance sector withstand the stress of climate change? To answer this question, it is first necessary to understand insurers’ exposure to physical climate risk, that is, risks arising from physical manifestations of climate change, such as natural disasters. In this post, based on our recent staff report, we construct a new factor to measure aggregate physical climate risk in the financial market and discuss its applications, including assessing insurers’ exposure to climate risk and insurers’ expected capital shortfall under climate stress scenarios.

Physical Climate Risk Factor

The main challenge in studying insurers’ exposure to climate risk lies in accurately measuring this risk, particularly physical climate risk, as future climate scenarios and impact projections are inherently uncertain and depend on various modeling assumptions. While historical data can serve as a proxy for physical risk, perceptions of such risks can evolve as new hazards emerge and existing risks intensify. Even if we can measure physical risks accurately, another challenge is measuring insurers’ exposure to these risks, as it can also fluctuate due to operational changes, such as changes in policies, sales locations and reinsurance coverage.

In our recent staff report, we used an innovative approach to address the challenges of assessing insurers’ exposure to climate risk. By using a market-based approach and relying only on publicly available data, including stock market data, we overcome the lack of adequate data. Specifically, we have constructed several portfolios designed to lose value as physical risk increases. One of these portfolios comprises shares of public property and casualty (P&C) insurers, with the weight of each insurer determined by its premium exposure to states with a history of significant damage from natural catastrophes. We refer to the return on this portfolio as a physical risk factor. This factor can serve as a forward-looking measure, capturing changes in financial market expectations about the future risk of physical climate change.

Why would this factor decrease as physical risk increases? As future physical risks increase, states more susceptible to natural catastrophes are likely to experience a greater incidence of such events. Consequently, insurers with greater exposure to these states through their operations are likely to record lower stock returns. However, there may be counterarguments. First, one could argue that insurers could increase premiums to compensate for increased risks in these states. However, regulatory restrictions often prevent insurers from fully adjusting premiums to reflect these risks, especially in high-risk states (see, for example, Oh, Sen, and Tenekedjieva 2022). Furthermore, higher premiums can impede policy adoption, thus reducing insurers’ overall profits, even if they are able to maintain profitability per policy.

Second, it could be suggested that insurers could withdraw from risky states as physical climate risks intensify. However, while some insurers may choose to exit unprofitable markets, increased physical climate risk could still erode the overall profits of exposed insurers.

Does the factor work as intended? If the constructed factor works as intended, it should decrease following unexpected spikes in physical climate risk. However, this is difficult to observe. A viable validation exercise is to test whether the factor decreases after the occurrence of severe climate-related natural disasters. The chart below illustrates that the factor typically decreases after major natural catastrophes, indicating that insurers with substantial exposure in high-risk states experience a decrease in stock returns following major natural catastrophes. Therefore, when stock market investors anticipate more frequent and/or severe disasters due to climate change, we expect the factor value to decline, as intended.

Physical Risk Factor Response Around Natural Disaster Events

line graph with 95% confidence interval following the cumulative coefficient of the shock from day 0 to day 20 after the event start date;  the largest downward response begins 5 days after the event

The graph above also shows that the physical risk factor takes more than five days to respond, likely due to the delay in clarity regarding the impact of disasters, such as their severity and duration. For example, during Hurricane Katrina, early media reports suggested little damage in South Florida. It was only six days later that the financial market’s reaction was mentioned. Furthermore, our analysis suggests that attention to natural disasters typically peaks between ten and fifteen days after the event begins. By tracking the frequency of event mentions in New York Times articles that focus on major hurricanes, we document a gradual increase in the number of articles mentioning hurricanes after the event start date, with a sharp increase after twelve days, as illustrated in the chart below. These findings clarify why the factor does not decrease immediately after disasters.

The average number of New York Times articles about natural disasters

line graph tracking the number of New York Times articles that mention the word “hurricane” from the day of the natural disaster until 20 days later;  a sharp increase occurred after 12 days
Sources: New York Times articles; Natural disaster events from the Billion Dollar Weather and Climate Disaster Database; authors’ calculations.
Notes: This chart shows the frequency of mentions of “hurricane” in NYT articles following a hurricane. The event start date is represented as t=0. The average number of mentions is calculated for the most significant hurricanes (95th percentile of all hurricanes generated losses). We focus on these major hurricanes due to greater public attention and supposed greater market impact.

The Beta Physical Climate

Our factor has a wide range of applications. For example, by estimating the sensitivity of financial institutions’ stock returns to the physical risk factor, one can estimate the expected extent of the capital shortfall suffered by institutions during severe declines in the physical risk factor. We present results in the article that demonstrates this application, focusing on insurance companies. Specifically, we calculate the variable sensitivity of insurer stock returns to the physical risk factor, while controlling for market factors, which we call “physical climate beta”.

To validate that this “beta” reflects the risks in the insurers’ operations, we compare this “physical climate beta” (which is based on the insurers’ stock returns) with the insurers’ “policy portfolio climate beta”. We estimate the latter as the weighted average risk of states in insurers’ policy portfolios, using detailed data on where insurers write insurance policies. Each state’s level of risk is assessed by analyzing municipal bond returns, as previous research shows that these returns reflect physical risk. We calculate how sensitive county-level municipal bond returns are to physical risk factors and aggregate the sensitivity measure to the state level.

The chart below suggests that the equity-based measure (called “physical climate beta”) aligns with the “risk” of insurers’ policy portfolios, as measured by their “policy portfolio climate beta.” Cross-sectionally, smaller insurers have greater exposures to physical climate risk. The alignment between the two betas can serve as a basis for assessing the physical risk exposure of unlisted insurance companies that do not have publicly listed shares, but disclose operational exposure across states.

Correlation between Beta Physical Climate and Beta Policy Portfolio

scatterplot comparing the physical climate beta of equity-based insurers (based on the insurers' stock returns) with the beta of the insurers' policy portfolio
Sources: Economic losses from natural hazard events from the United States Space Hazard Loss and Event Database (SHELDUS); Direct insurance premiums received from the National Association of Insurance Commissioners (NAIC) and SNL Financial; SPY ETF return, US P&C insurer stock return, and market capitalization from CRSP-Compustat merged dataset; municipal bond transaction and issuance information from the Municipal Securities Regulatory Board’s (MSRB) municipal bond transaction database and merger municipal bond database; authors’ calculations.
Notes: This chart demonstrates the pooled scatterplot of insurer physical climate beta and policy portfolio climate beta, based on annual data from 2005 to 2019 for U.S.-listed P&C insurers

Final Words

As the frequency and severity of natural disasters increase, families and businesses are turning to insurance to mitigate climate risks. Can the insurance sector face the challenges posed by climate change? To address this important issue, we introduce a new physical climate risk factor that has a wide variety of applications, such as quantifying individual insurance companies’ exposure to physical risks and assessing the financial system’s vulnerability to climate change risk. In addition to physical risk, the article also assesses insurers’ exposure to climate transition risks, the risks arising from regulatory changes, using the framework developed by Jung, Engle and Berner (2021).

Photo: portrait of Hyeyoon Jung

Hyeyoon Jung is a financial research economist in Climate Risk Studies at the Research and Statistics Group at the Federal Reserve Bank of New York.

Robert Engle is professor emeritus of finance at New York University’s Stern School of Business.

Shan Ge is an assistant professor of finance at New York University’s Stern School of Business.

Xuran Zeng is a Ph.D. finance student at New York University’s Stern School of Business.

How to cite this post:
Hyeyoon Jung, Robert Engle, Shan Ge, and Xuran Zeng, “Physical Climate Risk and Insurance Companies,” Federal Reserve Bank of New York Economy of Rua da LiberdadeApril 3, 2024, https://libertystreeteconomics.newyorkfed.org/2024/04/physical-climate-risk-and-insurers/.

The views expressed in this post are those of the author(s) and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the author(s).

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