Of all the US states, hurricane-prone Florida faces some of the greatest climate-related challenges, a situation that has led to the exit or collapse of many of the state’s homeowners insurers.
A new study digs into what’s wrong with Florida’s insurance market — and how taxpayers end up footing the bill for it.
Key Takeaways:
- In Florida and other markets where climate change is a major risk, many home insurers are at high risk of insolvency, despite having a financial stability A rating from rating agencies.
- Households exposed to fragile insurers are more likely to default on their mortgage after natural disasters, particularly for government mortgages.
- The mispricing of risk by niche insurers and the mortgage market ends up offering a de facto subsidy for living in high-risk areas.
- Current institutional design creates perverse incentives for insurers and rating agencies; much of the resulting risk falls on taxpayers.
The insurance industry operates on the assumption that most policyholders will not face disaster in the course of a given year. But climate change and its associated risks have begun changing industry math, leaving the markets in high-risk areas, like the state of Florida, in trouble.
The problem originates in the interplay of several parties, including homebuyers, insurance companies, credit rating agencies, the government, and lenders.
Homes are most households’ largest asset, but the majority of them are bought with a mortgage, with the house serving as security. Mortgage lenders require homeowners to carry insurance to protect this security interest, making insurance carriers vital to a functional real estate market.
Although banks and other providers originate mortgages, they do not always hold them long term. As too many Americans learned in the 2008 financial crisis, mortgages are bundled, securitized, and sold to government-sponsored entities (GSEs) like Fannie Mae and Freddie Mac. However, only mortgages protected by an insurer with a high stability rating are eligible for the GSE program.
To get rated, insurance carriers pay a rating agency. During the study’s time frame, there were three such agencies: Standard & Poor's, AM Best, and relative newcomer Demotech.
An Insurance Flashpoint and a Call to Research
In the wake of catastrophic hurricane losses, major insurers, including State Farm and Farmers, exited the Florida homeowners market, leaving smaller, more local insurers to fill the gap. These smaller insurers often went to Demotech for their ratings — and virtually every one received an A.
Parinitha Sastry, assistant professor of business in Columbia Business School’s Finance Division, has devoted much of her research career to studying the impacts of climate change on financial markets. Florida, she says, has the misfortune to be the perfect laboratory for understanding climate change’s influence on markets.
In 2022, Sastry closely followed an unfolding insurance crisis in Florida. Demotech threatened to downgrade the A ratings of two dozen insurance companies to grades unacceptable to mortgage giants Fannie and Freddie Mac. This would have left the market with only Citizens, the state-run insurer of last resort. In response, the state of Florida took the unprecedented step of providing reinsurance for the at-risk companies, which allowed them to avoid downgrades and remain eligible in the mortgage market.
“There was this extraordinary government intervention where the state of Florida essentially backed these 20 or so risky property insurers, so disaster was avoided,” Sastry says. After watching this drama unfold, Sastry and her colleagues began looking at historical data. What did these ratings mean, and how important were they really for the mortgage market?
The Research and Its Results
To examine the effects of insurer exit, climate change, and rating agencies on Florida’s climate-stressed market, the authors assembled granular county-level underwriting data for the state, then cross-referenced it with insurers’ financial and operational statements. Information on ratings from Demotech and other ratings agencies, underwriting data, and financial reports were then combined with mortgage originations and securitization data made available through the Home Mortgage Disclosure Act. Although the data conclude in 2018, it allowed Sastry and her co-authors to examine some of the trends that culminated in 2022’s crisis.
The authors’ findings were significant and concerning. First, insurers rated by Demotech were substantially more likely to fail. They tended to be underdiversified, often operating in just one state, meaning a single statewide event like 2017’s Hurricane Irma could wipe out their loss reserves. These insurers were more highly leveraged, faced greater reinsurance counterparty risk, and were undercapitalized for the risks they faced. And such risk wasn’t merely theoretical: 19 percent of the insurers in the study that were rated A by Demotech entered bankruptcy.
The growing market share of these riskier insurers was also surprising in that it was supported by the state. Many insurance policies in Florida were on the balance sheet of Citizens, Florida’s insurer of last resort. The state initiated a program that incentivized private insurers to take over these policies from Citizens; Demotech-rated firms were happy to oblige, with sometimes disastrous results.
Sastry is blunt about ratings failure: “We show that almost all insurance companies rated by Demotech receive an A rating, even though many of them become insolvent a month or two after their latest A rating. We found, using an empirical model that is standard in the literature, that a lot of them would have had a lower rating if they were rated by AM Best.”
Taxpayers on the Hook
The study’s findings show that mortgage lenders are more likely to offload mortgages backed by riskier insurers by selling them to GSEs. It also shows that private lenders are less likely to originate mortgages backed by weaker insurers if the mortgage cannot be sold to the GSEs. However, had these riskier insurers been rated by AM Best, it is likely that they would not have been eligible for GSE acquisition.
For Sastry and her colleagues, this offloading shows that the private mortgage lenders understand the real underlying risk. As she summarizes it, “If all of that risk is borne by the government, it’s the taxpayers facing risk, not the private sector. What we’re finding is that there’s this offloading of risk from the banking system to the government because the banks are aware that these insurance companies are really high risk but the government treats them as if they are safe.”
Sastry hopes her work will draw attention to real issues that will only spread as climate change continues. To that end, she and her co-authors have suggested possible remedies, including updating GSE rules to incorporate insurer risk. Another possibility is changing risk-based capital regulations for insurers, as these existing requirements may not accurately reflect underlying risks. They’re working to get these issues in front of essential decision-makers. Sastry’s co-author, Ishita Sen of Harvard Business School, addressed the USSenate in June to explain the problem and propose possible solutions.
While Florida faces unique difficulties, market distortions brought on by climate change are already happening elsewhere. Sastry expects more problems down the line: “We started with Florida because that’s where the Demotech presence is largest. Florida is a bellwether for other states. Florida’s been dealing with this issue since 1992, but now we’re seeing similar things in Iowa, California, Louisiana, Texas — the wildfire states, the windstorm states, and the Gulf states.”
Adapted from When Insurers Exit: Climate Losses, Fragile Insurers, and Mortgage Markets by Parinitha Sastry of Columbia Business School, Ishita Sen of Harvard Business School, and Ana-Maria Tenekedjieva of the Board of Governors of the Federal Reserve System.
