Your paper examines the intersection of climate risk, insurance, and mortgage markets. What motivated you to study this, and why is it becoming increasingly important?
I have actually been interested in this nexus since graduate school (my dissertation was also on this topic). After many major natural disasters, households discover that their insurance may not be as reliable as they thought. Rebuilding can be extremely challenging when an insurer goes insolvent, as losses spill over to the mortgage market. Furthermore, insurer insolvency can destroy trust in the insurance industry altogether. All of these patterns are likely only to become more important as rising losses from climate events puts more pressure on insurer balance sheets.
Your findings suggest that climate risk is being mispriced in both property insurance and mortgages. What does that mean in practice, and why do these mispricings pose risk for homeowners and lenders?
What this means in practice is that the rate you get on your mortgage, or the premium you pay in your insurance, may not reflect your actual risk. This is important because one important role of financial markets is that they provide signals about underlying risk. With mispricing, the signal gets jammed, meaning that households and lenders become more exposed to climate risk than they may realize.
A key part of your paper focuses on the role of fragile insurers. What makes an insurer fragile, and how do they affect mortgage outcomes after natural disasters?
Insurance fragility refers to the fact that some insurers are likely to become insolvent, especially after a major catastrophic event. In our paper, we identify a class of insurers that are smaller, have less capital, less diversification, worse quality reinsurance, and extremely high insolvency rates (20%). We show that when insurers become insolvent after natural disasters, households are more likely to default on their mortgages. Households rely on insurance payments to repair and rebuild after natural disasters; when there is an insolvency, insurance claims become heavily delayed or limited in size, leaving households to rebuild largely on their own. Some households have the financial resources to smooth these shocks, but many do not.
What should policymakers be paying attention to in light of your findings?
The government-sponsored enterprises Fannie Mae and Freddie Mac play an extremely important role in setting the de-facto standards for insurance markets and mortgage markets. Not only should they have better calibrated screening of insurers to protect against their own exposures, in my view there is also a consumer protection imperative to help households. All of this becomes even more important against the backdrop of rising climate risk.
How can future research build upon your paper?
We hope our paper can help advance the literature to think more about the role that insurance plays in housing and real estate markets. There are a number of open questions in this space.