Climate Risk Is Growing. Is Your Company Prepared?

Climate Risk Is Growing. Is Your Company Prepared?

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The recent images of damage in Florida following Hurricane Ian are heartbreaking and terrifying. What’s scarier still is that at the societal level we don’t have a strategy for how to handle the worsening perils of flooding, wildfires, and extreme heat. Governments don’t have the funds to invest in resilience at a meaningful scale to avert calamity in advance, or to rebuild indefinitely after disasters; regulators and permitting authorities are unlikely to have the political support to say “don’t build there” or, more controversially, to say “move away and don’t come back”; and it’s clear from the inadequacies of payouts that “we will just get insurance” is a highly naïve response to the potential exposures going forward.

So what is to be done? Individuals, businesses, and investors have to make tough decisions — starting today. In this article, we’ll lay out a four-step framework for these decisions — and the choices for action. These steps can be used by homeowners, organizations with extensive real property assets (such as businesses, universities or even local governments), and financial providers (such as mortgage lenders as well as equity investors and REITs).

Step 1: Prioritize how big a deal this is compared to everything else in your business, home, or other jurisdiction.

For individuals, this means evaluating the degree to which your home is truly exposed to flood or wildfire and how badly you would be wiped out if the house were lost. For businesses, this means assessing what else is going on around revenue, cost of doing business, capital structure, hiring, and all the other issues that a C-suite executive also has to consider. In many places in the world, just surviving until tomorrow takes precedent over abstract concerns around natural catastrophes.

Step 2: Transfer risk by financial means.

Historically for both homeowners and businesses, this has meant just buying property/casualty, fire, and flood insurance — but not changing the underlying physical risk at all. You pay a fee so that if something happens, someone else makes you financially whole. The challenges now arising, though, are that the exposures seem to be increasing. Insurance premiums get super expensive; or you can’t get coverage at any price.

Step 3: Avoid the exposure altogether.

Taken literally, if you are really worried, move your home or business. One now hears stories of homeowners who have had enough of Napa fires or Naples floods and thus relocate elsewhere. For corporates (for example, a large owner/operator of dozens of shopping malls) it means selling the most exposed properties before they get wrecked — and beefing up the ones that have better geographic, hydrologic, and structural attributes.

Step 4: Prepare to minimize the damage if there is an incident.

There will be some investments where the risk is a primary concern, you can’t transfer it financially, and you are unwilling or unable to avoid the exposure altogether — for example by moving away from West Palm or Sonoma, or abandoning a large institutional facility. In these instances, you see and accept the danger — and damage minimization can still be undertaken, in several time frames depending on cost and concern.

For example, in advance of an event, a property owner can invest up front in “hardening” such as waterproofing or even raising of foundations, expanding storm drainage capability in case of river flooding, replacing flammable roof material with non-flammable, or cutting back vegetation that can fuel fires.

During an event, reactions might include lowering flood gates, activating fire suppression sprinklers, having a “go bag” at the door, stocking water and batteries, or for large entities: designing and building refuge areas in the complex. Often these steps are less expensive than hardening.

Finally, property owners can even prepare for the event’s aftermath by, for instance, having prior arrangements with remediation companies and builders, stocking the space with disposable furniture, or keeping cleanup equipment available. Insurers and mortgage lenders can participate in all phases, too. They can demand certain investments in preparation, in response, or in recovery; or they can use their expertise to advise property owners on cost/benefit analysis for risk transfer, avoidance, or mitigation.

The Four Steps At Work

Let’s use the example of how one large insurance company uses the four-step framework in its own operations. As part of the company’s planning process, the CEO and executive team decide the level of priority they give climate risk within their portfolio. In so doing, they realize that their biggest business worry is that their IT system might get compromised. The second concern is that there is some problem that leads to huge reputational risk. Property casualty losses due to natural catastrophe events are thus third tier — and that informs how much they spend on addressing each risk.

With that priority in mind, the natural next step is risk transfer: when they are worried about a big natural catastrophe event like flood or wildfire destroying hundreds or thousands of covered properties — well beyond what usual insurance diversification could handle — they can enter into risk transfer contracts with reinsurance companies like Swiss Re or General Re who get paid a fee in good times to absorb economic losses in bad times.

Then, they can avoid, by refusing to renew coverage on certain policies. This firm purchases weather risk forecasting from a private company with proprietary algorithms which they believe gives them better information than other insurers have: so they can walk away from clients. But this has the business danger of losing market share and sacrificing short-term revenue. (Turning down some clients also increases the financial exposure of their former client, if that person buys coverage from a less well capitalized insurer who is using an inferior risk model, and who then goes broke in the face of a bad event and can’t pay claims — which is happening right now following Hurricane Ian).

Finally, for the risks they are unwilling to totally avoid, they prepare to minimize damage. For instance, they invest in better early warning. This company operates in a region where hail is a frequent problem. They now work with a startup that uses ground based antennae and advanced analytics to parse electrical activity and lightning strikes, to provide warnings of hail and other weather events in a much smaller time window, over a much smaller geographic area, which a much higher correlation between “warning” and “actual” than is available from traditional radar. Insureds are thus less likely to write off notices as false alarms and much more likely to get their assets — in this case largely cars and cattle — out of the way before a hailstorm hits and causes greater damage.

In this way this company has prioritized the natural catastrophe risk in comparison to all of its business exposures, it has made financial arrangements for some risk transfer without changing anything else, it has carefully considered how climate change impacts who and what they cover, and they have invested in tools that minimize damage.

This all sounds both easy and obvious. But in practice, these choices are really hard for everyday asset owners. Almost all of the steps above involve saying “no” to something or walking away from something else. That’s not in our nature; we want to resist all threats, we want to “build back better” when something bad does happen, and we sure don’t want to deal with these headaches when it’s nice and sunny and cool and dry outside. Unfortunately, the financial risk transfer dodge of “more insurance” or the big government “FEMA will bail me out” bet are looking like worse and worse strategies. Families, organizations, and businesses need to assess how big these exposures really are for them — and act now to prioritize, transfer, avoid, or minimize before the next “big one” hits.