Rethinking insurance for floods, wildfires and other catastrophes

When Hurricane Katrina hit Louisiana on August 29, 2005, surges of seawater more than 20 feet higher than normal tide levels crested over the levees surrounding New Orleans. Within hours, the levees started to fail, flooding 80 percent of the city. More than 1,800 people across several states died in the storm or its aftermath, and thousands of homes and businesses were destroyed. The economic losses totaled more than $100 billion in 2020 dollars, and experts estimate that private insurance covered just $40 billion to $55 billion of the damage.

Carolyn Kousky, then a PhD student in public policy at Harvard University, was alarmed by the slow and uneven recovery from Katrina. Failures in both public disaster programs and insurance had contributed not only to a human tragedy, but to the most expensive natural disaster in history. Kousky decided to study how people recover from floods and other extreme weather events — and how poor insurance coverage can exacerbate existing inequalities.

In the 17 years since Hurricane Katrina, climate change has made extreme weather events more frequent and  expensive, as recent record-breaking floods, heat waves and  wildfires show. Kousky, now associate vice president for economics and policy at the Environmental Defense Fund, is carefully tracking how communities and insurers are responding to the onslaught. The author of the forthcoming book  Understanding Disaster Insurance: New Tools for a More Resilient Future, Kousky wrote in the 2019  Annual Review of Resource Economics about how insurance can be crucial for recovery from natural disasters, and how new models of insurance could make communities and ecosystems more resilient.

This conversation has been edited for length and clarity.

How is disaster insurance different from other types of insurance, like car insurance? Why is it so expensive?

The original concept of insurance was risk pooling. A group of people all put money in a pot. Every year, something bad might happen to a few people. Then they get to take the money and contribute again when they’re fine. This is formalized through insurance companies, where the contribution is the premium and the claim is what people get when they suffer a loss.

This type of insurance works really well when risks happen to individuals in a random way. When you get into a car accident, for example, it doesn’t mean that all your neighbors got into a car accident. The number of accidents every year is more or less stable when you look at it in aggregate around the country. This means insurers have a very good idea what their losses are going to be in the coming year, and they can charge premiums to match that.

For a big disaster, though, like a hurricane, wildfire or an extreme flood, entire communities get hit at the same time, and hit hard. This means that the losses that a disaster insurance company faces are not stable year to year like auto insurance — they’re very spiky. They’ve got years where there are no losses at all, and then there’s a huge loss.

In order to cover those huge losses, insurers have reserves, the equivalent of a savings account for a household. They also buy their own kind of insurance, called reinsurance, and use other financial tools to avoid bankruptcy. But none of those things are free. That means that the premium — the price — of disaster insurance is higher than for more idiosyncratic risks. Sometimes the cost is so high that it can’t be offered at a price that’s profitable for the company and that households can afford. Then there’s a breakdown in the market.

What happens when the private insurance market breaks down?

The availability of insurance dries up — it gets harder to get insurance in some areas. In fact, a lot of disasters aren’t covered by private insurance companies any more. Instead, the government has set up programs to sell disaster insurance to consumers who can no longer buy it privately. In the US, the federal government has been providing flood insurance for over 50 years because early on, major riverine flooding made the private sector pull out of providing flood coverage. We have state-level insurance programs for hurricanes along the Gulf of Mexico and in the Southeast, and a state program that’s increasingly taking on wildfires in California. We also have a state program for earthquakes in California.

How do these public sector insurance options measure up to private insurance? 

It varies. Often the public insurance options are more expensive or more limited. For a household, it means having to pay more for not having as good or as broad coverage as you might have been able to buy through a private company. But they are all run a bit differently and vary in how they price policies.

Take a look at the National Flood Insurance Program. In this program, pricing had not been modernized in decades. Some people have been paying too little and others too much. But recently, the federal flood insurance program has started to let the price of insurance more accurately reflect a household’s risk. So now, if your prices are higher than someone else’s, it’s almost certainly because your risk of flooding is higher. This has meant lower rates for some people, but others are seeing costs go up.

For some, like those in areas at high risk of rainfall-related flooding, this can be a surprise, since the government’s flood maps typically don’t include flooding from extreme rain. People don’t like buying disaster insurance anyway, and if it is expensive, they often won’t do it.

Are we in a disaster insurance crisis? 

There are clear signs of stress. We’re at a point where we need to be carefully thinking about both our private and public sector insurance. This gets into some difficult questions about how much risk and cost we want taxpayers to be taking on through lower-cost insurance programs or disaster aid, versus putting those costs on the people who choose to live in risky locations. Some people, though, are trapped in risky areas and unable to afford a safer area. Right now, we don’t have any extra assistance with the costs of disaster insurance for people with low incomes.

Some countries, like Spain, France and New Zealand, have taken an approach where they mandate that property insurance, like your homeowners insurance, cover all natural disasters. Then the government provides either reinsurance or a backstop to make sure that requirement doesn’t bankrupt a company. The thing I like about that model is that it takes a lot of the burden off households. Right now, in the US, private insurance companies are choosing to exclude a whole bunch of risks. So you buy an insurance policy, and you think you’re protecting your house against bad things that might happen to it. But then you find out that your policy doesn’t cover what you thought it did.

Way too often, consumers go to rebuild and they’re like, “Wait, I don’t have enough to rebuild, and I thought that I took care of that.” That’s not right. But asking them to read lots of legal fine print is unrealistic. We should make it easier on households.

How does climate change alter the picture?

Climate change has really stressed the system. Risks that the private sector used to cover because they weren’t that bad have gotten much worse. Wildfire is a good example. For a very long time, wildfire was part of your homeowners policy, covered in the private market. But the rapidly increasing risk of wildfires means that the private sector has started to pull back in high-risk areas. They saw incredibly steep losses from the 2017 and 2018 wildfires and it really woke up the industry. We’ve seen similar dynamics play out over time along the Gulf Coast and the Southeast because of hurricanes. Very large homeowners insurance companies have largely left the state of Florida, and you see insurers leaving the Gulf Coast all the time. Several just went bankrupt with Hurricane Ida in Louisiana.

Public sector programs aren’t immune from climate stress either. So they’re going to have to increase prices or limit coverage to maintain their own solvency. Or, we’re going to have to decide as a society that we’re going to subsidize that risk — or radically invest in risk reduction. There’s no way around the fundamental problem that the risk is going up.

Radical investment in risk reduction — what do you mean by that?

What really needs to be done is to stop emitting carbon. But putting that aside, we know the things we need to do in terms of adaptation. We know how to build better. We know how to have better zoning that doesn’t put people and capital at such risk. For instance, researchers at the Insurance Institute for Business and Home Safety have drafted building standards for wildfires and hurricanes that could save buildings. And yet we often lack the will to build stronger or to limit development.

We also need to do a better job of telling people that the risk and cost of living in some places is going to go up. A lot of that communication should focus on the home-buying process, because that’s a decision point where it really matters that you understand the risks you’re facing when you make a long-term financial commitment to a place. That can be done through better state disclosure laws about risk, but it also requires better free and public data on those risks.

For instance, I’m on the advisory board of the First Street Foundation and it is working to provide information on weather-related disasters for every house in the country, and how those risks are changing with climate change. They are now integrated into some real estate websites to help potential buyers better understand the risk of where they might move.

You’ve written about the potential for using insurance to protect and restore ecosystems. Can you share some examples of how that could work?

There are a few ways insurance can help. First, insurers are very large holders of capital. They have to hold all these funds in order to pay claims, and there’s been a push for them, as with other large investors, to screen their investments and not put them into fossil fuels or other carbon-intensive sectors. And some insurance companies have started to do that. But they could also screen their investments for other environmental impacts and even actively invest to promote greater conservation and restoration.

They also can choose not to offer insurance at all to companies that are contributing to biodiversity loss or other harmful environmental impacts. Or to offer the insurance only if they improve their practices. Then there are other new tools and types of insurance that can help restoration companies or land trusts or other players with their specific needs. Finally, there is also one case of insuring a natural asset — a coral reef — like you would insure property. So after a hurricane damaged it, the insurance paid out for divers to go and help repair the reef.

We can also use insurance to prevent disasters, rather than just responding after they happen. What does that look like?

Insurance has always been about paying people for things they lost. But recently there have been some programs that turn that thinking on its head and say, what if we can use it to pay people to make sure they don’t suffer a loss?

An example of this is the Kenya Livestock Insurance Program, which actually aims to prevent losses in the first place. Severe droughts in Kenya can lead to the death of livestock for pastoralists, which puts them into much deeper poverty. Insurance would typically pay them for the dead livestock after the fact. But this program instead says, let’s pay people ahead of time when the drought is starting, to buy additional feed so that their cattle don’t die. The premium for some people is paid by the government, because these are very poor populations. And the program is coupled to another public sector program that makes feed available. That’s nice, because the financing mechanism is directly tied to a plan to make sure that disaster doesn’t cause as much harm.

The Kenya program is an example of what’s called parametric insurance, which pays out a predetermined amount when a hazard hits a certain threshold. In Kenya, that threshold is drought. In hurricane-prone regions it could be wind speed, and in flood-prone areas it could be when water reaches a certain height. This model of insurance doesn’t require an adjuster to go to your house and assess the damage in person, which saves time and lowers the cost to the insurance company. It can also avoid drawn-out disputes over what’s covered and what’s not. In some cases, the money gets deposited automatically into your bank account.

Parametric insurance can open up all sorts of new models, like that program in Kenya. Another good example is microinsurance, which has been offered around the globe and is now starting to be offered in Puerto Rico. Many people can’t afford disaster insurance that will reimburse all their losses after a disaster, but they might be able afford a policy that automatically dispenses a certain amount — say $6,000 — to cover immediate needs. Parametric insurance is not a replacement for homeowner’s insurance. But it could help more people plan ahead for disasters and recover more quickly after they happen.

Planning ahead — what a concept! 

It’s surprising how bad we are as individuals and a society at planning ahead. But planning ahead can make so much difference, and insurance can help give people the extra push to do it.