Climate’s Big Short: Florida Insurance and a Financial Apocalypse

Trillions in real estate increasingly exposed to existential climate risk.
More and more experts as worried, for near term, about things like infrastructure and insurance as they are about ice and corals.

Andrew Dessler in The Climate Brink:

I’ve become convinced that insurance is one of the places where climate change will manifest itself most clearly in our everyday lives and I’ve written about it before on TCB (https://www.theclimatebrink.com/p/climate-change-and-insurance-the). Because of that, I wanted to bring to your attention this great post from the Moving Day Substack. It describes the details of how the insurance market, in collusion with State government, is using smoke and mirrors to push climate risk onto the general public — i.e., you and me. Insurance companies are among the most sophisticated evaluators of risk, so when climate risk gets too hot for them to handle, we should be worried. 

Harvard Business School Faculty and Research:

This paper studies how homeowners insurance markets respond to growing climate losses and how this impacts mortgage market dynamics. Using Florida as a case study, we show that traditional insurers are exiting high risk areas, and new lower quality insurers are entering and filling the gap. These new insurers service the riskiest areas, are less diversified, hold less capital, and 20 percent of them become insolvent. We trace their growth to a lax insurance regulatory environment.
Yet, despite their low quality, these insurers secure high financial stability ratings, not from traditional rating agencies, but from emerging rating agencies. Importantly, these ratings are high enough to meet the minimum rating requirements set by government-sponsored enterprises (GSEs). We find that these new insurers would not meet GSE eligibility thresholds if subjected to traditional rating agencies’ methodologies. We then examine the implications of these dynamics for mortgage markets.
We show that lenders respond to the decline in insurance quality by selling a large portion of exposed loans to the GSEs. We quantify the counterparty risk by examining the surge in serious delinquencies and foreclosure around the landfall of Hurricane Irma. Our results show that the GSEs bear a large share of insurance counterparty risk, which is driven by their mis-calibrated insurer eligibility requirements and lax insurance regulation.

Susan Crawford in Moving Day:

Insurance makes the mortgage market work. You can’t get a mortgage from a bank (these days, likely a nonbank) without insurance, because the lender needs some kind of guarantee that you’ll pay them back. Your pledge to the bank that it can have your house if you don’t repay the loan has to be accompanied by property insurance that will preserve the collateral value of the property that secures the mortgage. 

But what if the insurer is unreliable and isn’t able to pay claims following a major storm? Then everything happens at once: properties are damaged at the same time that the insurer becomes insolvent, borrowers default on their loans, and lenders have losses on their books. Multiply those losses, and you get tremendous economic pain to entire financial systems as credit freezes and markets plunge. 

The 2008 financial crisis was triggered by the insolvency of nonbanks heavily involved in dodgy mortgages. You probably remember that credit rating agencies were at the heart of the problem: they gave high ratings to mortgage-backed securities that were bought by nonbanks (and investors around the globe). Those MBSs became worthless and the whole house of cards tumbled.

Today, a similar story appears to be playing out in Florida, where 10 percent of the nation’s homeowners live: a dubious credit rating agency is giving high “financial stability” ratings to flimsy insurers. A whole series of players is going along with those ratings, using them to check boxes and issue mortgages. And then those actors are swiftly shifting the resulting mass of risk to Fannie Mae and Freddie Mac. The GSEs are accepting these inflated financial stability rankings and buying these smelly mortgages. The strategy is, must be, to have the feds bail out the situation when storms strike and the casino suddenly closes its doors. 

US citizens have paid nearly a billion dollars since 2018 simply to replenish the sand lost to storms and "erosion" (aka sea level rise) in Florida — quite aside from the billions in Federal disaster relief they've also given the state.#resilience 💸💸💸 https://t.co/vc5QxQUPQn

— Dr. Genevieve Guenther (@DoctorVive) April 16, 2024

The consequences of this credit-rating box-checking will be felt far beyond Florida. In the subprime mortgage crisis, the problem was that the borrowers weren’t credit-worthy. Now the problem is that the properties aren’t credit-worthy, but it is in no one’s interest to blow the whistle.

This alarming story is spelled out in an elegant recent paper by Pari Sastry, Ishita Sen, and Ana-Maria Tenekedjieva called “When Insurers Exit: Climate Losses, Fragile Insurers, and Mortgage Markets.” The authors look carefully at public data up through 2018 and conclude that although large, well-capitalized insurers have steadily pulled out, smaller, riskier insurers kept issuing policies in risky Florida areas. 

These shakier insurers were incentivized in part by payments Florida made to them to take on policies the state’s insurer-of-last-resort, Citizens Property insurance Corporation, issued. And most of them were the beneficiaries of grade inflation by a rapidly-growing rating agency called Demotech. Both the mortgage originators and the GSEs accept Demotech’s financial stability rankings for these insurers, and the GSEs are now stuck with a steaming pile of risk.

I think we can assume that this situation has only gotten worse since 2018. But the authors had to stop there because the insurers convinced a court that their data was all a trade secret and shouldn’t be released to the public. This is a common move; picture the industry as ATMs with lawyers layered on top. Avoiding disclosure is easy.

Back to the narrative. You may have heard of the big three credit rating agencies: AM Best, Moody’s, and S&P. Demotech is probably new to you. It entered the market in the 1990s and specializes in evaluating the financial stability of regional and specialty insurers, mostly in Florida. It now issues most of the insurer credit ratings in Florida. 

Following Hurricane Andrew in 1992, and the huge numbers of insurer exits and insolvencies that storm caused, Florida set up its public insurance option, Citizens. Floridians swarmed toward Citizens, which ballooned. Florida then began paying insurers to take policies off Citizens’ books. 

Meanwhile, however, the big insurers like State Farm had quietly been leaving high climate-risk counties in Florida. That didn’t mean that the wheel stopped spinning. New, substantially lower-quality insurers with financial stability ratings from Demotech rapidly gained market share in Florida, growing in large part by absorbing those Citizens’ policies. That was superficially great news for Florida, because if Citizens goes under Florida bears all the liability—meaning the state’s residents will have to bail it out.

According to the study’s authors, the Demotech-rated insurers are lower quality in many ways: they have far less capital, focus on lower-value homes, aren’t geographically- or product-diversified, and tend to enter rehabilitation (restructuring) at higher rates. But Demotech gives them grades that are higher than the ratings traditional credit ratings agencies would give for insurers comparable characteristics. Grade inflation is rampant at Demotech: “The vast majority of these insurers would likely be rated ‘junk’ if they received their ratings from a traditional rating agency rather than Demotech,” say the study authors.

New York Times:

A key area of the Atlantic Ocean where hurricanes form is already abnormally warm, much warmer than an ideal swimming pool temperature of about 80 degrees and on the cusp of feeling more like warm bathtub water.

These conditions were described by Benjamin Kirtman, a professor of atmospheric sciences at the University of Miami, as “unprecedented,” “alarming” and an “out-of-bounds anomaly.” Combined with the rapidly subsiding El Niño weather pattern, it is leading to mounting confidence among forecasting experts that there will be an exceptionally high number of storms this hurricane season.