Valuing Climate Risk in the Real Estate Sector

Insurance remains the primary tool for managing climate-related risk. But for how long?

Despite indications that real estate asset managers and investors have begun taking steps to manage climate uncertainties more proactively, as reported in the Climate Risk and Real Estate Investment Decision-Making report from ULI and Heitman, interviews conducted with leading industry figures over the past four years reveal that the sector continues to rely primarily on property insurance policies to manage its climate-related risk from year to year.

In addition to the risk of physical damage to properties, the ULI/Heitman report noted that risks of rising capital and operational costs as well as asset devaluation are among several climate-related drivers of the real estate sector’s future performance. To manage such risks, managers and investors alike are leveraging new forms of asset- and portfolio-level risk mapping, developing new reporting standards in line with emerging climate-related disclosure frameworks, and considering ways to invest in new and existing holdings in ways that mitigate their financial exposure to disaster losses.

“It’s understandable that reinsurers are leading the conversation, but maybe the real estate sector needs to be driving the conversation a little more,” says Daniel Stander, who leads the resilience practice at Silicon Valley–based Risk Management Solutions (RMS), a firm that pioneered catastrophe risk modeling in the late 1980s.

One reason for greater involvement by real estate experts is that in the future, property insurance may not be economical—or even available—in high-hazard real estate markets. Will South Florida property be insurable in 20 years’ time, for example? If insurance is unaffordable or, worse, unavailable, what would happen to the fundamentals of a market?

Stander sees another reason for the real estate sector to act: opportunity. By better quantifying and managing their climate-related risk, asset managers and investors ultimately will improve their performance.

Seek First to Understand

Reinsurers have long used third-party catastrophe models from vendors like RMS to price environmental uncertainties. These models provide probabilistic estimates of expected catastrophic losses for a given portfolio of assets against a wide range of potential events.

The results generated by these models, judiciously adjusted for model and data uncertainty, support a wide range of financial decisions. Reinsurers use these analytics to incorporate climate and engineering science into their underwriting practices, to manage their solvency, and to cede risk to other capital providers. Ultimately, the models are used to refine how and where policies are sold and the premiums charged.

It is no exaggeration to say that these models have become essential to how and where reinsurers underwrite risk today. Three decades ago, however, catastrophe models were scarcely used in the insurance industry. That changed after a series of unexpectedly high losses.

Before Hurricane Andrew—a Category 5 storm that struck the Bahamas, Florida, and Louisiana in 1992—and the 4.0 magnitude Northridge earthquake near Los Angeles in 1994, reinsurers relied almost exclusively on historical claims experience to underwrite risk. The likes of RMS, though, warned the industry that, when it comes to extremes, history is an imperfect predictor of the future. They raised the possibility of Andrew- and Northridge-like losses and suggested that some insurers had miscalculated their potential exposure, undervaluing it substantially.

This miscalculation had profound consequences. Several insurers were declared insolvent after Hurricane Andrew, leaving the taxpayers to pay hundreds of millions of dollars in claims. Global reinsurance rates spiked, bringing consumer rates up with them: one year after Andrew, insurance premiums in coastal South Florida communities had doubled. Not unlike today, questions were posed about the affordability and availability of residential insurance—and the stability of disaster-prone real estate markets more broadly.

The advent of catastrophe models shifted the paradigm for valuing risk. They transformed how the reinsurance sector quantified risk and underwrote policies. They also changed the way regulators set capital requirements and influenced how rating agencies quantified financial strength.

Moreover, models made it easier for nontraditional investors, who lack decades of claims experience, to enter the business of financing physical risks of extreme weather. Insurance-linked securities, which today transform almost $100 billion of capital from institutional investors into reinsurance coverage for regions like Florida, were born. Catastrophe-prone property insurance markets stabilized, to the benefit of the real estate sector.

Such transformations have facilitated a climate change “business as usual” attitude within the real estate sector. But mounting losses from disasters, greater ESG (environmental, social, and corporate governance) scrutiny, and increasing demands from institutional investors are driving the real estate industry to develop its own view of climate risk.

Calculating Risk Like a Pro

The questions property reinsurers faced in the 1990s are remarkably similar to those being posed by the real estate sector today. Have we fully understood the climate-related financial risk we face? And how can we manage that risk if we cannot measure it?

Just as reinsurers woke up to catastrophe modeling after Andrew, asset managers and investors are beginning to embrace probabilistic risk analytics to gain a deeper understanding of their risk.

Stander cites a current collaboration between RMS and a large asset manager as an example. The asset manager is using RMS models to characterize its risk from coastal flooding, hurricane-force winds, and earthquakes across its entire U.S. portfolio. The asset manager plans to use the modeled output not just to prepare for its annual insurance negotiations, but also to help meet the due diligence requirements of new and existing investors.

“The asset manager now has a much more granular understanding of [its] nationwide exposure across a wide range of scenarios, right down to the property level,” Stander says. “By demonstrating this level of understanding, the asset manager is able to better satisfy increasing investor concerns.”

The adoption by the real estate industry of catastrophe risk modeling techniques has not been limited to the purchase of insurance and investor relations. The approaches pioneered in reinsurance are now being used by institutions to anticipate and manage emergencies in real time.

The asset-level hazard mapping and emergency response systems of larger property managers can be informed by catastrophe modeling. One major property manager is using models to shift its exposure assessment and emergency response procedures away from individual assessments of risk and toward strategies driven by science-based modeling and real-time hazard and impact data.

If the evolution of catastrophe model use in the reinsurance sector is any indication, these applications in real estate are just the beginning.

Consider, for example, the fact that insurers are constantly optimizing their property portfolios, increasing or reducing their exposure to a given place or peril to improve the likelihood that they will meet their targeted returns. Just as the insurance sector leverages catastrophe risk models to decide where to underwrite, so asset managers and investors might analyze their portfolios to improve the risk/return profile of their investments.

Indeed, the ULI climate risk report states that asset managers are actively exploring ways to manage and optimize their climate exposure. Speaking in confidence, a senior executive at a large international asset manager confirmed that his firm is revisiting its property acquisition, divestment, and retrofitting strategies with climate risks in mind.

In this context, catastrophe models can enable firms to develop a more refined and risk-adjusted view of their business opportunities.

“There’s no reason why a property manager can’t do the same as an insurer,” contends Stander. “In fact, asset managers have more opportunities to influence how risk is managed because they control where they invest and the adaptive features of a property in a way than an insurer doesn’t.”

Valuing Adaptation

Investing in and managing a property are very different from having the skills to prioritize and cost-justify investments in adaptation. Assigning financial value to specific adaptive measures is essential to taking strategic action, but it remains a significant challenge across the real estate value chain.

In a recent discussion, one pioneering developer expressed frustration that resilient building measures remain undervalued by its investors, dampening the firm’s capacity for innovation. The issue of systematically and quantitatively assigning value to adaptation is equally pervasive among the most forward-looking asset managers.

Yet significant progress has been made in recent years to quantify the risk reduction benefits of physical investments in adaptation, from elevated seawalls to preserved coastal marshes. In these cases, the adoption of catastrophe modeling has been catalytic. Indeed, according to Lloyds of London, quantifying avoided damages—and by extension reduced insurance costs—is one way in which risk models can help asset owners identify “resilience dividends,” the return on investment from taking action to reduce risk.

Despite recent progress, the importance of the real estate sector investing in climate risk valuation capabilities cannot be overemphasized. It is naive to expect reinsurers to manage the risk alone and indefinitely. While reinsurers are generally content to finance risk, there are thresholds at which the costs of risk transfer outweigh the economic benefits—a point reinforced by the Economics of Climate Adaptation Working Group’s 2009 research into adaptation finance, Shaping Climate-Resilient Development: A Framework for Decision-Making.

As recurring market signals from places like Florida remind us, high insurance costs can lead to housing affordability challenges. Even if an asset owner is not directly exposed to higher insurance costs, entire markets might feel negative consequences from perceptions of insurance unaffordability—or, worse, potential long-term uninsurability.

Other dynamics, like property tax increases to finance community adaptation projects or asset devaluation triggered by perceptions of market riskiness, are also emerging factors with which asset managers and investors must contend. Layering in these considerations and deciding how to act on them bring additional demands to those shaping the sector’s use of climate risk analytics.

Consensus about how to measure, disclose, and manage climate risk is yet to fully form inside the sector. Nevertheless, a clear imperative exists to develop more refined and forward-looking risk intelligence through tools like catastrophe modeling. These emerging approaches are likely to redefine how the real estate industry understands and acts on climate risk, and in doing so directly shape patterns of risk and resilience in our communities. 

Source: urbanland.uli.org