Epistula #10: Risk Mispriced, Risk Realized
We’ve been underpricing climate risk for too long – the consequences are arriving faster than expected.
We started the year with Los Angeles on fire. Tens of thousands of structures reduced to ash. Fifty thousand more at risk. Unsurprisingly, the news was filled with stories of profound hardship, tremendous heroism, and the incredible resilience of people and communities during their darkest hours.
These fires will likely go down as one of the worst natural disasters ever recorded – and the most expensive in U.S. history. We all likely know someone who was impacted. Among the victims are at least one Deciens LP who lost everything and a portfolio CEO whose business was devastated. Colleagues, collaborators, and co-investors have suffered similar fates. In the coming weeks, we will undoubtedly learn of more losses.
But the tragedy that has befallen Los Angeles is not an isolated event. This is part of a broader crisis.
Climate Disasters: The New Normal
A cursory reading of the news shows that climate-related calamities – many of them downright biblical – are increasingly the norm rather than the exception.
In recent weeks, the country had one of the worst cold spells in recent memory. The Houston area, for example, received its second-largest snowfall on record, enough to close Houston International Airport and likely functionally shut down the city, the third-largest in the US, for several days. Harris County didn’t have snow plows and instead followed a “wait for it to melt” strategy.
Every week someone, somewhere, is facing or recovering from some sort of weather-related disaster, with attendant social, political, and economic costs.
In 2024, the United States experienced 27 separate weather or climate disasters that each resulted in at least $1 billion in damages. NOAA map by NCEI.
Incentives Rule the World
Ultimately, the incentives people and institutions operate under must change for there to be scaled mitigation of climate impacts. We can no longer treat real costs as mere externalities.
We have simply been operating under a tragedy of the commons for far too long, which has gotten us into the expensive, painful, and unsustainable position we find ourselves in. It has also led to material underinvestment in capabilities. But change will be very expensive, painful, and, to many, scary.
Given that both doing nothing and doing something create the potential for pyrrhic victories, we believe that not doing anything will be at least as painful and scary as taking a proactive approach.
The Role of Financial Services in Climate Change Mitigation
In a world where natural disasters are getting much more severe and frequent, financial services can help enable scaled, effective climate-change mitigation. The sector has been one of the defining enabling technologies of the past two centuries, and we see no reason it will not remain so going forward, certainly in our professional lifetimes.
When considering the role of financial services in relation to climate change, we typically think about risk and risk management, mostly via insurance or related financial services tools (futures, forwards, options, swaps, etc.). In this regard, at its best, financial services can help an individual, family, or organization understand their true risk and price it appropriately so they can make well-informed decisions. Well-priced risk (i.e., a price that properly accounts for the actual, probability-weighted economic costs borne by the risk holder) is the most powerful incentive inducement tool we can think of.
Conversely, poorly priced risk produces false signals that markets internalize. And we believe that much of the risk in the marketplace today is dramatically underpriced. This has acted as an unintended (or, for some policymakers, intended) subsidy from insurers and reinsurers to policyholders. Going from mispriced to accurately priced risk (i.e., removing the subsidy) often angers policyholders. Just look at the frequent headlines lamenting insurers leaving the marketplace or premiums becoming unaffordable. Not appropriately pricing risk, however, creates existential peril for insurers.
There are real costs to taking one's head out of the sand, but in Deciens’ view, not doing so is the most costly option.
Why Has Climate Risk Been Underestimated?
Two major forces have driven the chronic underestimation of climate risk:
1. Outdated Risk Models
Most actuarial and statistical views of peril use retrospective data analysis techniques, such as linear and multivariate regression. These analytical tools look at historical patterns and extrapolate potential futures, within given degrees of variance.
Believing that the past can help provide insight into the future is the fundamental assumption underpinning the risk-pricing methodology used by most insurers. But climate change breaks down the correlation between the past and the future. Since correlation generally drives the predictive value of these analytical techniques, approaches built on top of them are increasingly failing.
2. Distorted Public Policy
A series of policy decisions has artificially suppressed the cost of climate risk:
California’s Proposition 103 (1988) effectively banned certain types of rate increases, forced policy renewals, required insurers to either take on all risks or none, and other highly distortionary behavior
The California FAIR Plan serves as a “last resort” insurance pool, requiring all property insurers in the state to subsidize coverage in high-risk areas.
Florida's Citizens Property Insurance Corporation socializes risk through a taxpayer-funded "insurer of last resort,” asking all Americans to pay for it via the National Flood Insurance Program (NFIP) – effectively meaning taxpayers in Idaho are subsidizing expensive homes in Miami that are hit by "once-in-a-century" Category 5 hurricanes every other year.
These policies, while politically expedient, have delayed the inevitable reckoning. The true cost of climate risk remains hidden – until insurers collapse, markets freeze, or governments are forced into costly bailouts.
The Looming Insurance Crisis
The chart below shows the combined ratio of US homeowners insurers. The lower the number, the better; when the ratio is above 100, the insurer loses money. Insurers that consistently have ratios above 100 are not viable long-term. Eventually, they will run out of equity and collapse. Damningly, this chart excludes Citizens Property Insurance Corporation, Florida’s public, tax-payer-funded insurer of last resort. Though the data is not yet out, we expect that 2024 will be above 100, and with very expensive parts of metro Los Angeles ablaze in its first two weeks, 2025 is not looking good.
In the past few years, insurers have, to some degree, woken from their torpor and slashed risk by canceling policies and raising rates. Obviously, they have been on the receiving end of much derision for doing so. But if consumers were actually paying for the real cost of the risk, many wouldn't be able to afford their current lifestyles. Case in point, as I’m writing this, State Farm requested emergency approval from California regulators to raise premiums by 22% – a timely reminder of the mounting pressures on the system.
A System in Distress
The core issue remains: poorly designed incentive structures and materially improperly priced risk introduced substantive distortions into the marketplace. But let’s be clear – anyone who believes they have a well-founded grasp of the risks we face in the coming years is peddling snake oil, and even if they were not, there is simply not enough insurance capital in the marketplace to properly price all the risks today, let alone tomorrow. Capital partners will need to be paid more for holding risk than premiums can support.
In the future, many families will either need to be uninsured or move because of the price of insurance related to climate risk. This creates two potential death spirals:
For insurers, as fewer people buy insurance, premium pools shrink, and there is less diversification, requiring higher premiums from those who remain, driving fewer policies to be bought, and so on.
For property owners, as premiums become harder to come by or more expensive, the value of their real estate goes down. There is a strong incentive to sell first because the longer a seller waits, the less value they can recapture until, ultimately, their home is worthless. The game theory is clear, and no one wants to be left holding the proverbial bag.
The Mortgage Market Problem
Of course, all of this is complicated by the fact that over 60% of American households have mortgages, and mortgages require homeowners insurance to protect the debt holders.
Government-guaranteed insurance programs are no panacea, as their bankruptcy seems inevitable, and the desire of one state’s citizens to bankroll the unsustainable lifestyles of another state’s citizens seems limited at best. Perhaps the government guarantees debt holders instead of insurers. But, again, this is simply a transfer and socialization of risks that seem like political non-starters.
This is where the post-war rubber is meeting the climate-change road, with many second and third-order consequences. Or, to summarize, a mess.
Rethinking an Entire Financial Value Chain
We have been pitched by many insurance and insurtech businesses looking at closing these gaps, but we are not sure they can be closed. Properly priced risk, while essential, is not economically viable. And risk that can be sold cost effectively seems underwater. Neither makes for a happy equity investor, bondholder, customer, regulator, or employee.
To the best of our knowledge, society has never had to rethink an entire financial value chain in the way we likely need to do in response to climate change. And because of the intersection of homeowners insurance and mortgages (and associated mortgage-backed securities) in the US, it will probably cause substantial social, economic, and political change on a scale not seen since Reconstruction or the Great Depression.
Scaled internal migration may become a reality, albeit further hamstrung by tighter building codes that make it harder to build or rebuild the housing stock where it is needed, with large portions of the country rendered functionally or actually uninhabitable.
Socialized Risk & Mitigation Strategies: A Partial Solution
The only real alternative is for the government to internalize the risk and pass it on to taxpayers and buyers of treasury bonds. Given the current view of bailing out the banks during the 2008 global financial crisis and already high debt-to-GDP levels, this massive risk transfer seems unlikely. And, of course, it doesn’t fix the underlying problem of where risk is and how to price it. It merely kicks the can down the road – a specialty of politicians in the US and elsewhere.
Increased spending on mitigation reduces the potential severity and frequency of the worst climate calamities (i.e., there will be fewer injured and killed people and destroyed properties). In this regard, solar, nuclear, desalination, and related technologies offer some hope within a portfolio of mitigation strategies. But financing these very capital-intensive projects, which require relatively rare, highly skilled labor, is in itself a challenge. And these worthy activities won't stop the calamities in the first place. They are, as their name suggests, merely mitigants. That genie is out of the bottle and won’t be returning any time soon.
A Final Thought
The financial industry must grapple with an uncomfortable truth: Climate risk is here. It’s not theoretical. It’s not distant. It’s unfolding in real time, with real economic consequences. Markets can ignore risk, but they cannot escape it. The only question is how painful the reckoning will be.
The choices ahead will be painful, but they must be made. Because the cost of inaction is far greater.
