De-risking Risky Business: Climate and Insurance Markets

On June 5, 2024, the U.S. Senate Budget Committee, chaired by Sen. Sheldon Whitehouse (D-R.I.), held a hearing titled “Riskier Business: How Climate is Already Challenging Insurance Markets.” That hearing was a sequel to the committee’s March 2023 hearing, “Risky Business: How Climate Change is Changing Insurance Markets.” Recent articles by The New York Times and CNN exemplify this keen interest in the intersection of climate and insurance. In May, The Daily podcast discussed “The Possible Collapse of the U.S. Home Insurance System,” while CNN described the homeowners’ insurance market as “crumbling.”

This strain on the property insurance market stems from increased risk. Insurers are in the business of pricing policies in accordance with the magnitude of the risk they bear: When risk increases, rates and prices rise; when risk levels fall, rates are reduced. At R Street, we recognize that insurance markets are now “riskier,” as suggested by the title of the June hearing. We argue that the appropriate response to this elevated risk environment is to de-risk via risk management. This is desirable both for insurance buyers, who pay less for insurance, and for insurance providers, who experience lower losses. If we can successfully decrease risk, then insurers can reduce their rates. We disagree with those who pessimistically maintain that rising insurance prices are unavoidable.

This article will analyze the relationship between climate and insurance by exploring four topics:

1. 1. Changes to insurance markets that challenge both companies and buyers
   2. Drivers of these changes and challenges
   3. Insurers’ responses to these changes and challenges
   4. A crystal-ball view of what the future should hold

Changes and Challenges to Insurers

How have insurance markets changed or been challenged in the past year? One challenge has been the sudden failure of numerous property and casualty (P&C) insurance companies. In a typical year, the number of insurance company failures can be counted on one hand. There were, perhaps not surprisingly, failures at several Florida-based insurance companies as the result of excessive litigation and the fact that many insurers were undercapitalized, over-leveraged, under-reserved, or had expanded too fast in unfamiliar markets. These are traditional causes of insurance company failure.

In 2023, the number of insurers entering liquidation or receivership was nearly double the 2022 level. The failures of 2023 and 2024 differed from those of the past. Many of the recently failed insurers were midwestern mutual insurance companies whose financial strength was critically wounded by exceptionally destructive severe weather events, such as powerful convective storms like derechos and strong hailstorms. Some of the recent failures included insurers that had been in business for well over a century:

• Missouri-based Cameron Mutual, founded in 1892, was driven into liquidation in December 2023 after feeling the effects of excessively severe weather events that year.
• Also formed in 1892, Wisconsin Re—a reinsurer of several dozen town and county mutuals in Arkansas, Illinois, Iowa, Missouri, South Dakota, and Wisconsin—entered rehabilitation in June 2023. Its failure led to many of its cedants scrambling to find reinsurance protection.
• Arkansas-based United Home Insurance, founded in 1868, was liquidated in November 2023.
• Kansas-based MutualAid eXchange (MAX) received a liquidation order in August 2023. Organized as a reciprocal and focused on mutual aid ministries and faith-based risks, MAX was buffeted by severe weather.

These insurers (and several others downgraded by rating agencies) were conservatively managed, well-capitalized mutual or reciprocal insurers prior to their failure. Farm Bureau Mutual Insurance Company of Arkansas, reeling financially from the impact of hail, windstorms, and tornadoes, is the most recently downgraded insurer. In 2023, the severity of extreme weather events in the Midwest was unprecedented. Heartland states like Iowa experienced a string of catastrophes. The new year began in the Hawkeye State with an ice storm, soon followed by over 10 inches of snow and a tornado season that kicked in earlier than ever in 74 years of records. Summer brought numerous powerful storms, including derechos and hailstorms raining down baseball-sized hailstones, followed by a drought and record-setting heat. Many insurers withdrew from states with unprofitable results. Some stopped writing new homeowners’ insurance business; others chose not to renew existing policies.

The main measure of insurance company profitability, the combined ratio, compares net premium to expenses. The lower the combined ratio, the more profitable the business. In 2023, the combined ratio for homeowners’ insurance was 110.5 percent—the highest since 2011—indicating an unprofitable result.

(To see a PDF version of the above table, click here.)

While testifying at congressional hearings, R Street scholars witnessed some ambivalence about changes in the frequency and severity of natural catastrophes. This observation inspired an independent data-based study on catastrophe frequency, severity, and attribution, which includes a compilation of published findings from 18 prominent meteorologists and data scientists. The vast majority concluded that natural catastrophe frequency and severity have increased—due, in some extent, to human action and climate change. (Higher values at risk of loss also contribute to the increase in severity.)

Insurer Responses to Challenges

The unprofitability of the homeowners’ insurance market and the selective withdrawal from some states has led some to adopt alarmist views about the insurance industry. Whereas homeowners’ insurance is in the red, the overall P&C insurance industry reported profits over the past five years. Whereas the combined ratio has hovered around 100 percent since 2019, the impact of investment income contributed to a favorable operating ratio. To wit, while the 2023 industry combined ratio (for all lines of business) was 101.8 percent, the contribution of investment income drove the operating ratio to 93.5 percent. This equates to a 6.5 percent profit margin in the year, which—while not wildly lucrative—does not justify characterizing the insurance industry as “collapsing” or “crumbling.”

(To see a PDF version of the above table, click here.)

The business line getting the most media attention is homeowners’ property insurance. One reason homeowners’ insurance has gotten more expensive in recent years is the impact of higher reinsurance cost. Reinsurance is like a shock absorber for the insurance industry in that insurers craft their reinsurance purchases to keep losses within their risk tolerance and protect their balance sheet. Buffeted by losses, reinsurers have raised their rates in recent years. In the June 1 reinsurance treaty renewals, which apply mainly to Florida risk, reinsurance rates declined by approximately 5 percent after several years of increases.

Another indication of the overall health of the P&C insurance industry is improved results in Florida, the most problematic state for property insurance. In recent months, several new insurers have entered the market for Florida property insurance. These include:

• Sypher
• Slide Insurance
• Orange Insurance Exchange
• Condo Owners Reciprocal Exchange
• Tailrow Insurance
• Mainsail Insurance

Further demonstrating the health of the insurance industry are the inflow of significant amounts of fresh capital into the insurance-linked securities (catastrophe bond) market and the success of some recent initial public offerings (IPOs) of insurance companies. In May 2024, catastrophe bond issuance was 38 percent above the same period in 2023 and on track for a record-breaking year. Investor confidence is evidenced by capital flows into the industry, as well as IPOs at values above the initial offering price at insurers like Skyward Specialty and Bowhead Specialty.

Risk Reduction
The most practical solution to keep insurance costs reasonable is to reduce risk. Properties located in wildfire-prone areas or at risk of damage from other severe weather events should follow commonsense guidelines like those promulgated by the Insurance Institute for Business and Home Safety. These include securing roofs, shutters, impact-resistant doors, garage doors, and windows. To the extent property owners take such measures, insurers in a competitive environment will prefer to insure such risks, thereby incentivizing risk-reduction measures. Insurers may also provide credits to communities that incorporate natural barriers between homes and bodies of water. R Street has found that “natural infrastructure can also do a better job weathering the effects of storms and flooding than engineered structures.” Natural barriers include environmental features that reduce severe weather events risk, such as mangroves, coral reefs and marshes. Just 15 feet of marshland can absorb 50 percent of the destructive power of storm surge, while 330 feet of mangrove trees can reduce wave height by 66 percent.

Insurers in some states offer premium discounts to homeowners and businessowners who make their properties safer from wildfires with upgrades like sprinkler systems and fire-resistant building materials.

Conclusion

The insurance industry is not in crisis. Although several insurers have responded to increased losses with more restrictive policy wordings and higher premiums, higher prices are far from inexorable. When risk magnitude goes down, so do premiums. The workers’ compensation market is a strong example of this. Thanks to increased safety measures in the workplace, accident frequency has declined significantly—along with insurance rates and prices. The same can happen for property insurance.