Will Climate Change’s Rising Seas Drown Real Estate, Insurance?

Art by Lior Hizgilov

When Noah divined that floodwaters would rampage over the land, he took the one prudent course. He got out of harm’s way.  

But nowadays, people are doing the opposite: heading toward rising seas, building along the coasts with abandon. Without the help of an ark, what will this mean for the real estate and insurance industries, which sit squarely in the path of climate-change-induced inundation? How will those businesses fare as investments?

For the near future, both industries likely can weather those storms, albeit with some financial pain. Long-term, however, the picture grows darker. This menace will tax the resourcefulness of environmental, social, and governance (ESG) strategists.

Among pension plans and other institutional investors, concern is growing. The California Public Employees’ Retirement System (CalPERS) says that climate change will pose an increased financial risk on 20% of its $180 billion-plus stock portfolio. Take the materials and building sector, which is 6% of the equity holdings. CalPERS warned that its buildings might be vulnerable to extreme weather, including “chronic level sea rise.”

To Ash Williams, CIO of the Florida State Board of Administration (SBA), a sound response is to diversify his portfolio’s real estate holdings to “gateway cities” around the US—midsize urban centers that anchor local economies.  Also to overseas locales, pooled with other investors. Of the SBA’s $165 billion in pension assets under management, 10% is in properties. “The vast majority of our real estate,” he said, “is not in Florida.”

Good thinking. The peninsula, sitting between the Atlantic Ocean and the Gulf of Mexico, is the most hurricane-battered state: 41% of the 292 hurricanes that have made landfall in the US since 1851 have slammed into Florida.

For commercial borrowers, access to capital and its cost will increasingly hinge on climate change risk, of which flooding is a major part. Banks are starting to look at weather damage in their assessments of potential borrowers’ creditworthiness. Ditto regulators, although much of that action is overseas. In 2016, the European Union mandated that pension funds factor climate change into their investment strategies.

Due to melting glaciers and ice sheets, plus heat expansion of water, the oceans are rising. The worldwide sea level has risen an average 3.2 inches since 1993, by the measure of the National Oceanic and Atmospheric Administration (NOAA). The present level is up nine inches from 1880, when records first were kept.

More trapped heat simmering the extra water has spawned a growing hazard of hurricanes and other fierce storms. Using temperature data from satellites, NASA last year found that, for every added Celsius degree in ocean surface temperature, the probability of severe storms climbs by 20%. That’s bad news for the 230 million people on earth who live near coasts. But it also affects those who dwell near any body of water, from lakes to rivers.

These new storms can be almost biblical in their power. Hurricane Harvey doused Texas and Louisiana with 60 inches of rain in August 2017, which inflicted $125 billion in damages. “No one had ever heard before of five to 10 inches of rain in Houston,” marveled John Quealy, CIO of Trillium Asset Management, a sustainable investing firm.

As Karen Clark, CEO of her eponymous environmental consulting firm, pointed out, “flooding is becoming worse faster.” What’s more, flooding isn’t confined to downpours. Tidal inundations are an increasing problem in places such as Miami and Charleston, South Carolina.

No doubt preventing flooding and other ESG concerns are top of mind for many institutional investors lately. This winter, for instance, the California State Teachers’ Retirement System (CalSTRS) adopted a new investing principle that requires the pension program’s staff to consider investment risks associated with climate change.

There is some progress on overcoming investment inertia on preventing future environmental catastrophes. But the US is a laggard. Only 53%, of American insurance companies consider climate risk during their investment process, versus 73% of European peers and 72% of Asian ones, Goldman Sachs Asset Management found in a survey released earlier this month. 

Insurance: Will It Be Overwhelmed?

As time goes by, the burden of paying for flood damage will increase for insurance companies and the federal government, which covers numerous coastal properties. Whether that’s sustainable, either economically or politically, remains to be seen.

Climate change is likely to have a high or extremely high impact on insurance coverage availability and underwriting assumptions, in the opinion of 52% of state insurance regulators in a recent Deloitte survey. Flood damage last year totaled $98 billion globally, the Insurance Information Institute calculated. That was slightly below the 2018 figure, owing to more storm activity then.

The toll of the flooding threat is mounting gradually. Carriers are busily crunching numbers to project what their risks will be. Some don’t like what they see and get out. Allianz, one of the world’s largest insurers, sold the retail business of US subsidiary, Fireman’s Fund Insurance, in 2015 partly out of concern over the escalating risk of insuring coastal homes in California and Florida.

Insurers are in solid financial shape, at the moment, although they face some tough challenges ahead from deluges. One of the largest carriers, Swiss Re, did see its business property-casualty and reinsurance (a program that insures other insurers against risk, thus lightening the system’s burden) sectors post a loss last year. This was mainly as the result of natural disasters, most of them flooding. But the company’s life and health lines did well, so Swiss Re was in the black overall. Plus, it has substantial reserves.

Will things always be as nice, though? In 2017, Swiss Re believed it would run $1.18 billion in natural disaster losses, but ended up doling out a much larger sum, $3.65 billion. In 2018, it expected a $1.15 billion claims payout, and the tab was $1.9 billion.

In his recent message to shareholders, CEO Christian Mumenthaler emphasized that the company was well-positioned for the future, as it weighs what risks to shed and which ones to take on. Swiss Re has “adopted more conservative loss assumptions” than before, he added.

US coastal homeowners have the security of a government backstop, up to a point. Residential homeowners in flood plains can buy federal insurance from the National Flood Insurance Program (NFIP). The NFIP furnishes the bulk of American home flood coverage, with 5 million policies furnishing a total of $1.3 trillion in protection against water damage. 

Trouble is, only 15% of the nation’s households have this coverage, as rampaging storms don’t only restrict their destruction to federally designated flood-prone districts. Hence, of the massive damage from 2017’s Hurricane Harvey, a daunting 70% of properties were uninsured.

NFIP policies are mandatory for any mortgages that Washington backs that lie in a flood zone, defined as running a risk of a deluge once in every 100 years. And some three-quarters of all mortgages carry federal support, directly or indirectly, through the likes of the Federal Housing Authority, Fannie Mae, etc.

Alas, because huge flooding now takes place more often than a century, the program’s expenses have expanded seven-fold, now about $3.5 billion yearly. Insurance premiums have not kept pace with the replacement costs of flood-wrecked housing. So the NFIP has been getting bailed out by the US Treasury (which in 2017 forgave $16 billion in debt, and still is owed $20 billion). The upshot is that luxury beach houses get subsidized, paying below-market rates.

What’s more, since the NFIP is forbidden to yank coverage once granted, it often foots the bill for recurrent repairs and reconstructions. As of 2016, the Pew Charitable Trust estimated that these “severe repetitive loss” properties had costed the program $12.5 billion. How long will this keep going on, especially if the storm tempo increases?

For private insurers, which focus on commercial real estate and residences outside the flood plains, Wall Street has invented a supplemental source of capital, which taps institutional and other large investors. The most widely used are catastrophe bonds, aka cat bonds, which are short-term (usually two years in length) and pay decent mid-single-digit yields. Further, “they’re uncorrelated to capital markets and offer good diversification,” said Pete Keliuotis, Callan’s head of alternative consulting.

The risk for investors is that, if floods or other natural disasters are heavy, their principal would get reduced or even wiped out. The bonds’ principal is channeled to insurers after the carriers have paid out a given level of claims. Recently, cat bonds have performed well, helped by a paucity of disasters. At year-end 2019, they paid 6.1% coupons. These vehicles were created in the wake of 1992’s Hurricane Andrew, which creamed Florida.

What could go wrong? That the sheer volume of climate-related claims overwhelms cat bonds, and makes them unattractive to investors. In 2017, the onslaught of hurricanes whittled their average total return (price appreciation plus coupon) to 0.54%, down one-twelfth from the year before. They bounced back, yet who knows what the weather situation will be like in a decade or two, and whether cat bond investors will stick with them?

Another cautionary note: A 2019 study by the Federal Reserve Bank of St. Louis’ research arm found significant undervaluation of global warming risk in the cat bonds market. This finding casts shade upon their long-term viability as support for insurers.

Real Estate: Here Come the Lemmings

The yen for people to buy seaside housing and the appeal of ocean views for office buildings and other commercial ventures hasn’t waned. It’s all reminiscent of the myth of the lemmings, small hamster-like creatures that follow each other over the cliff to drown in the ocean. In truth, lemmings aren’t that gullible. But people …

In 2017, high-tide flood days in Atlantic City hit a record 22. By 2050, the celebrated seaside resort is projected to suffer between 65 and 155 days of high-tide floods annually. Some 2,600 coastal New Jersey homes, designated as risky owing to their flimsy structures or exposure to the ocean, have been built or rebuilt after Superstorm Sandy drenched the Garden State in 2012.

But coastal homes that are hardened—usually by sitting on sturdy stanchions that raise them six feet or so above the ground—fetch a premium over more vulnerable properties the same distance from the beach. These less-protected houses sell for 7% less on average, a study by University of Colorado and Penn State researchers concluded.  

While waterfront property is hardly seeing price slides, a trend is underway to award loftier values to houses at higher elevations. A Harvard study discovered that these high-ground residences are appreciating at a faster rate. Another study, from the First Street Foundation, declared that similar houses in Boston were worth twice as much as those in the flood-prone areas.

Commercial real estate stands a better risk of bolstering itself for storms and tides. Consider the three-year-old Vert Global Sustainable Real Estate fund, which specializes in real estate investment trusts (REITs) that own buildings girded against the ravages of climate change, particularly flooding.

Before investing, the mutual fund asks REITs if they “are awake to the threat,” said Sam Adams, CEO of parent Vert Asset Management. “Sandy will come again.” Trusts making the grade include those from Boston Properties (offices), Avalon Bay (apartments), and Prologis (warehouses).

One encouraging flood defense, Adams said, is used by Boston Properties-owned Atlantic Wharf, a swanky-residential-retail-entertainment complex. It opened in 2011 next to Boston’s harbor, which is susceptible to overflows. The answer to the water problem: portable barriers the landlord erects when the water spills over the harbor’s edge.  

Such ingenuity may allow human habitations along the coasts to endure, safe and dry, when the seas surge onto the land. But writ large across thousands of miles of shoreline, attempts to thwart Mother Nature and her relentless waters will be expensive and difficult.

Related Stories:

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One-Fifth of CalPERS Equity Portfolio Faces Climate Change Risk