Mitigating property risk in portfolios requires understanding how the climate and catastrophe risk is changing
Climate change doesn’t just affect the properties and the people facing natural catastrophes. There can also be significant ramifications for banks and financial institutions — albeit not immediately.
Just look at the city of Miami. Month over month, Miami has seen the largest gains in home price growth in the U.S. However, the Florida city is also exposed to hurricanes, which bring damage from wind gusts and flooding — and as climate change increases the frequency and severity of storms, physical property risk is only getting worse.
Research shows that homes in Miami flood zones sell for less and appreciate slower over time. And insurance prices for these homes are on the rise. In a recent webinar with CoreLogic, Lonnie Hendry, Senior Vice President, Head of Commercial Real Estate and Trepp Advisory Services said, “If you look at the actual increases at the line-item level, Miami took the top spot at a 28% increase in their insurance expense on a year-over-year comparison.” And yet, in spite of all this, the city “has the highest flood risk in the U.S., but it hasn’t to this point truly stopped development in that market.” Human behavior can be hard to change.
Visualizing Property Risk to Protect Future Investments
How financial institutions identify, measure, and control the risks associated with a changing climate can affect a financial institution’s safety and soundness. That is why in October 2023, the Federal Reserve Board of Governors (FRB), Federal Deposit Insurance Corporation (FDIC), and Office of the Comptroller of the Currency (OCC) jointly issued a set of interagency principles for large financial institutions about climate-related financial risk management.
“Banks need to understand, and appropriately manage, their material risks, including the financial risks of climate change,” said Federal Reserve Chair Jerome Powell in a statement issued alongside these principles. “Both we and the banks themselves are in the early stages of understanding and measuring the financial risks posed by climate change and how best to manage them. Accordingly, our work in this area must continue to remain grounded in data, measured in its approach, and tightly linked to our responsibilities.”
Mitigating property risk and working to grow portfolios in a resilient manner requires a profound understanding both of how the climate is developing and how catastrophe risk is changing. However, current climate modeling and risk modeling options rarely equip banks to easily see what their financial futures hold amid this changing climate.
Climate-Coupled Catastrophe™ Models Can Forecast Physical Risk in Banking Portfolios
Providing a holistic perspective on financial futures requires successfully integrating two separate models (climate and catastrophe) and the downscaling of underlying climate model data to a resolution that is compatible with a catastrophe risk model.
Climate risk models typically run at a horizontal and vertical resolution that is 50 million times larger than a catastrophe model. That makes risk modeling comparisons complex.
While it may be tempting to simply overlay these projected scenarios on top of historical climate data, this will not present the full range of risks. The data on past climate events is limited and does not define the potential range of future events.
Instead, when building climate models, a separate stochastic event set should be created for each projected climate pathway. Stochastic event sets have long been used by catastrophe risk modelers to simulate thousands of years of potential events, allowing us to gain insights that cannot be gleaned from the observed range of historical events alone. This is done by creating simulated events based on the underlying data points from the observed record and the parameters of the specific climate model pathway.
Climate modeling produces outputs representing a range of potential climatic outcomes, all depending on the degree to which climate change impacts our environment. This future uncertainty is represented in the graph below depicting projections for five different future climate scenarios identified by the Intergovernmental Panel on Climate Change (IPCC).
Consider All the Inputs to Model a Holistic View of Risk
One common criticism of climate modeling stems from the fact that the models do not incorporate property-level data – such as building characteristics, insurance features, and mitigation efforts – that affect structures and their financial vulnerability to hazards.
This criticism can be addressed by:
- Integrating data from each of the climate model’s projected climate pathways — created using the separate stochastic event sets mentioned above — with the vulnerability module of a catastrophe model. The vulnerability module reflects the susceptibility of an asset to damage or business interruption and ensures accurate property-level damage predictions.
- Constructing a reliable vulnerability module. This requires comprehensive property data, extensive loss data, detailed structural engineering analyses, and a deep understanding of how various assets perform under diverse levels of hazard intensity. All these considerations must then be used in tandem to reliably predict property-level damage.
- Calculating potential financial losses using an estimation of damage produced by the vulnerability module. Using Climate Risk Analytics, the financial impacts can be calculated both at an individual property level as well as a portfolio level. These loss distributions can then be inserted into the previously created stochastic event sets to calculate annual loss metrics.
As our climate continues to change, climate risk assessments will become increasingly critical to the financial stability of banks and financial institutions. Governmental agencies are already encouraging lending institutions to identify and understand their risk, so why not get ahead of the curve? Prepare for future regulation changes now, while building a more resilient portfolio.
CoreLogic’s climate-coupled catastrophe (C3) models are changing the forecast for the future of catastrophe modeling. These models offer highly detailed property risk assessments combined with future climate risk probabilities, enabling stakeholders to make informed decisions based on enriched datasets.
For further insights into this process, CoreLogic will be releasing a white paper focused on constructing climate-coupled catastrophe models.