The S-Curve

Why Financial Firms Need a New Climate Change Risk Strategy Starting Now

Eknath Belbase

According to a report by the Research Institute for Housing America, climate change risk is rapidly increasing in the housing industry and will continue to demand more attention and regulation in the near future.

Climate change will impact risk factors in the housing industry in nearly every corner of the globe. Wildfires are becoming more common and the area they ravage more extensive. Hurricanes and severe storms are happening with more frequency and severity. Potential damage from excess heat and droughts elevates risk to properties every day.

However, flooding is currently one of the highest risk factors posed to the housing industry. Many housing areas are used to the idea of flood risk and are adequately prepared and protected, but many properties that were never at risk before are now in the danger zone. The housing market is currently in a vulnerable position.

When Floods Outpace Insurance Policies

Depending on geography, more properties without previous flood risk are increasingly likely to experience flood damage. Homes and communities that were erected in floodplains are used to the protocols: Safety procedures such as evacuating or securing the area, working with insurance to cover damage, or receiving aid to rebuild when possible.

Under the National Flood Insurance Program, homes that are federally backed by programs such as Freddie Mac and Fannie Mae in certain areas require the owners to carry flood insurance. Those homes are located in floodplains that are defined based on a 100-year flood probability.

The problem is that floodplain boundaries are rapidly changing. One hundred years' worth of flooding data is not as relevant as it used to be when flooding zones are becoming more and more volatile. Even as the area of potential flooding damage overflows into neighboring regions, the floodplain boundaries have not been redrawn recently enough to impact flood policy uptake.

That means many homes that are at risk of future flooding are not likely or required to carry flood insurance. Experts are predicting that the National Flood Insurance Program will be stretched to its limits very soon, and that banking and insurance regulation will need to act quickly to spread and manage climate-related risk. It's possible that soon, the total cost of owning homes will outpace the value of the home.

This becomes very concerning when we consider the likelihood of mortgages going unpaid; a lack of flood insurance then quickly becomes not just a housing risk but a credit risk for the owners and an economic risk for the country if housing prices plummet and people’s debts begin to far outvalue their assets.

Updating Risk Calculations on Climate Change Analysis

Firms currently vary in their preparedness to face climate change insurance risk. As data becomes more advanced, some firms have begun to license property-level climate risk data, and specialist analytics firms are appearing with expertise in climate models.

The Fed and the SEC are also trying to adapt regulations to fit the new (and ever-changing) reality of climate change risk. There are new committees dedicated to assessing climate change analysis and determining systemic risk to the entire financial world, including the Supervision Climate Committee. These regulators will need updated methods to quantify risk and mandate disclosure, but for now, changes are nascent and firms will have to add their own experience to the bank of loss exposure research.

Financial firms are facing — or are about to face — considerable pressure from investors, governing and regulatory bodies, and insurance and banking regulators concerning the way they calculate risk. They will probably also feel some pressure from employees and workers in the financial sector, who are becoming increasingly alarmed about the impending disruption of climate change.

Firms will need to manage climate risk alongside their broader risk management strategy. For that to work, they’ll need to understand climate change data and the set of exposure scenarios that are relevant to them. For example, McKinsey predicts that about one-third of the planet's land will be affected by climate change. In addition, flooding exacerbated by climate change is expected to double the damage to capital stock by 2030.

Financial institutions urgently need to understand how to calculate and explain the risks posed by climate change, both for their own risk management strategies and for stakeholders. Quantifying climate change risk will be an evolving science. Property portfolios will require new risk scores based on the potential hazards that climate change will bring. Those scores will then need translating into commonly used financial measures, such as credit risk, market risk and prepayment risk.

As financial firms wait for regulatory approaches to become clear, they will need to continue to educate themselves and to remember that climate change models will shift rapidly — the best climate change risk strategy will be the one that is most able to change.