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Prioritizing financial protection in the face of extreme weather

It’s the start of hurricane season, and we’ve identified significant opportunities to better prepare for the risk of a disaster.

Leads McKinsey’s Sustainability Practice globally, where he helps transform companies' product, service, and asset portfolios to capture the opportunities and mitigate the risks posed by climate change and other sustainability issues

As a partner specializing in McKinsey's insurance work, helps leaders in insurance and governments on issues of strategy and how to measurably improve resilience

Hauke Engel

Partner in McKinsey's Sustainability Practice. Leads work on climate change globally and supports businesses across sectors with challenges involving strategy and sustainability

The three consecutive, major hurricanes in 2017, Harvey, Irma and Maria, devastated parts of Texas, Florida, and most of Puerto Rico. Each was among the ten most costly insured natural catastrophes globally, with total economic costs surpassing $270 billion. And while the 2018 hurricane season costs didn’t match that of the previous record year, hurricanes Florence and Michael swept across Florida and the Carolinas and became two of the most destructive storms in recent years, as well. Michael was the first Category 5 hurricane to strike the contiguous US since Hurricane Andrew in 1992. Then in November 2018, large-scale wildfires erupted throughout California, leading to the costliest and deadliest wildfire season in the state’s history.

The Fourth National Climate Assessment, released late last year, stated that climate change was already having noticeable effects in the US and predicted “more frequent and intense extreme weather and climate-related events,” such as floods and hurricanes. Consider the number of US weather events that have caused at least $1 billion in damage. Between 1980 and 2015, there was an average of five events a year. Since 2016, that average has grown to 15 major weather events. A year or two of quiet weather should not mute this directional change.

June marks the start of the Atlantic hurricane season, and prompts us to ask: If this is indeed the new norm, how ready are we to sustain such repetitive disasters? How can we innovate?

With the World Economic Forum naming extreme weather events as “the risk of greatest concern” earlier this year, it is essential that those affected by disasters can finance a successful recovery. And yet building a culture of preparedness, establishing robust financial protection and putting it in place at scale before a disaster hits remains a challenge.

Managing insurance strength, operations and assets for resilience

The insurance industry has become more financially resilient. In fact, the capital available to pay claims in the property and casualty industry in the US alone doubled in the past 20 years—a remarkable achievement.

In our 2017 analysis “Insuring Hurricanes,” we referred to operational gaps as the frequency and severity of hurricanes challenged many insurers’ claim operations. We asked whether claim operations were modern enough to cope with these types of events in the most efficient way. Insurers that had not made investments in digital tools could likely find their operations severely challenged, leading to longer time to closure, and possibly reputation issues. These extreme weather events call for a boost in technological innovation across the industry, and the use of automation, advanced analytics, and artificial intelligence to deal with claim adjustment demand surge and deliver better customer experience when big weather catastrophes occur.

The insurance gap paradox

The US insurance market is the largest in the world, yet most economic losses from hurricanes and floods are not insured, raising market opportunity questions. Take floods, which are typically excluded from homeowners’ insurance in the US. Nearly nine out of 10 people in the US lack flood insurance, according the Insurance Information Institute, despite half the population living near the water. This financial protection gap is even more worrisome because more than 40 percent of Americans cannot, according to the Federal Reserve board, pay for an unexpected $400 emergency expense.

Taking 2017 as a test case, our analysis of flood insurance penetration in counties most affected by hurricane-driven floods revealed that as many as 80 percent of Texas homeowners, 60 percent of Florida homeowners, and 99 percent of Puerto Rican homeowners did not have flood insurance. This means, in practice, that recovering from such shocks will probably be much harder than many people think, often requiring reliance on uncertain and limited government relief programs and/or having to take an additional loan, when eligible.

Many people underestimate their risk and don’t believe disaster will happen to them. Purchasing disaster insurance is probably not a common topic of discussion at the family dinner table. While there is no silver bullet, cultural changes can be nudged by choice architecture. For instance, many OECD countries that have included all hazards into homeowners’ insurance enjoy much higher flood insurance penetration. One can also adopt an opt-out approach (as a property owner or renter you are insured unless you deny the coverage, rather than having to opt-in). Default options matter a great deal, as we know from behavioral science evidence. Piloting this opt-out approach could expand the number of individuals and small businesses protected.

This would take coordination between decision makers in the federal and state governments, who would have to work closely with the private sector. They could do this by allocating more capital to protect against flood risks, establishing risk-based prices (combined with a means-based subsidy program, if needed), and developing new, simpler products. The private market can be a force of change, complementing the current products offered by the federally run National Flood Insurance Program, which is currently undergoing important changes.

Insurers as game changers

Most insurers issue one-year policies and can adapt to changing weather patterns. Yet a lesser-known strength of the insurance industry lays not in underwriting the risks, but in its long-term investment decisions. Indeed, insurers globally are the second-largest institutional asset managers, after pension funds, according to the OECD, with more than $25 trillion in assets. Where and how insurers decide to invest those funds can be a true game changer in mitigating disaster risk and launching a transformative resiliency movement.

For instance, the sheer scale of the industry means that its investment decisions could go a long way toward supporting global decarbonization efforts. Commitments to invest in renewable energy assets and reducing exposure to fossil fuels are some of the ways leading global insurance companies, several of which with Europe-based headquarters, have already modified their investment strategy. Yet, in a recent report on the top ten US insurance companies, only two said they had altered their investment strategy, considering its possible impact on a changing climate. Such investment avenues need to be made commercially viable of course. But we also see more boards of insurance companies now discuss the environmental, social, and governance (ESG) impacts of their investments and be eager to understand best practices.

Insurers around the world could also partner with governments and other private sector actors to creatively invest a more substantial part of their portfolio into new financial assets that support resiliency improving programs (e.g. flood protection, new building elevation; alert systems improvements, and lifeline infrastructure operations), and do this in a way that is aligned with prudential regulatory requirements. These new assets could attract different types of long-term investors who consider the long-term impact of their decisions.

In so doing, the industry can fundamentally redefine what we would call the “Insurability Frontier”– weather risks that are not seen as insurable at an affordable price today might become insurable again if actions are taken to reduce local exposure and improve resilience. Millions more families will be protected, less federal money will have to be spent on uninsured losses, and investors will enjoy attractive returns over time. A win-win-win opportunity.

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