I live two short blocks from Rock Creek National Park, one of D.C.’s hidden wonders. As befits a national park, Rock Creek is very large and densely wooded, but no one has thought much about fire hazard until last summer’s drought led to some significant brush fires. I thus asked a forestry professor next to whom I happened to be seated waiting for a plane if those of us living near Rock Creek Park should worry. Instantly and unequivocally, his answer was emphatically, “Yes.” I’m still not sure what I or any of us now at risks we never contemplated can do, but I’m even less sure that what can clearly be done to reduce financial-system risk due to natural disasters will be done until after it’s too late.
Is risk really this frightening? A report last week from the Financial Stability Board lays out what it believes to be plausible, yet-severe scenarios demonstrating that the extent to which property insurers and reinsurers are able to absorb natural-disaster risk determines whether a disaster leads to systemic financial risk. In the U.S., this is a thin reed.
We know that the National Flood Insurance Program is woefully unable to address the scale of recent hurricanes and inundations. A treasury study last Friday shows that private insurance is in at least as much disarray. Homeowners in the highest climate-risk zip codes pay premiums about eighty percent higher than those in the lowest-risk codes and have far, far higher non-renewal rates. Fifteen of the nineteen largest California P&C insurers reduced or terminated California homeowners insurance as of 2023, with this number likely a good deal worse a year later when the January 2025 fires hit. Not so coincidentally, my home insurance costs went way up last summer.
The FSB’s severe scenario is thus all too plausible. Burned-out homes mean many mortgages that won’t or can’t be repaid. In the U.S., the most immediate and worrisome cost is not just to homeowners without a home, but also to Fannie and Freddie. As of the most recent data, the unpaid principal balance (UPB) of GSE single- and multi-family mortgages in Los Angeles County equals $39.2 billion. This is only three percent of the GSEs’ total UPBs of $1.29 trillion and thus may seem negligible. However, Fannie and Freddie are far less capitalized than banks. L.A. UPBs account for a whopping 31 percent of the GSEs’ thin $125 billion capital cushion.
Under ordinary circumstances, so much capital at risk would put a financial company in grave danger of illiquidity or insolvency. However, the GSEs are still swathed in conservatorship with an “effective” federal guarantee staving off any form of market discipline. The real risk of likely GSE losses is thus not to financial stability, but to any hope for privatization anytime soon, no matter all the happy talk from private shareholders.
The other major U.S. mortgage guarantor is Ginnie Mae, but its losses are full-faith-and-credit obligations of the federal government. There is thus even less doubt about Ginnie’s capacity to absorb L.A. defaults. Nonbank mortgage companies are also at risk if loan payments fall behind their obligations to the GSEs and Ginnie, but this systemic risk will take time to materialize and may never do so given likely forbearance from the GSEs and Ginnie to prevent it if things start to get out of hand.
Still, conventional mortgages are just part of the U.S. systemic-risk profile. Many of the most expensive houses had private mortgages and much, much else that’s gone was also insured. If P&C insurers and their reinsurers can save themselves without need of federal backstop thanks to policy hikes and cancellations, then near-term systemic risk to the broader financial system will be staved off. However, there is simply no public data of which I am aware to size the odds that insurers are in fact able to save themselves nor are there data on how interconnected these companies are to the rest of the financial system if they can’t. Fannie, Freddie, and Ginnie can handle huge losses should these come to pass; other financial institutions aren’t likely to be so lucky.
One reason for skepticism about P&C resilience is that regulatory capital for U.S. insurers is not shareholder equity at risk as it is for the GSEs and for banks. Instead, regulatory capital for insurance companies is based on holdings of assets such as Treasuries and corporate bonds which state regulators believe are of sufficient quality to allow insurers to liquidate enough holdings to handle claims in an orderly, long-term way. This is not a model for crisis resilience — the last time sudden risk hit the insurance sector, private mortgage insurance (MI) companies imploded when borrowers couldn’t repay, leaving the GSEs and banks with systemic-scale losses they absorbed only due to the GSEs’ conservatorships and the 2008 rescue packages backing the banking system. If the property sector is as vulnerable to sudden losses and counterparty demands as the MIs, then financial risk could quickly escalate due not only to other financial exposures to those harmed by the fires, but also to systemic inter-connections between these huge insurance companies across an array of lending, derivatives, and other channels. Inter-connections could prove to be strangleholds.
So far, it seems likely that L.A.’s disaster will be devastating to its citizenry, its erstwhile leaders, and years of productivity and, for its elite, prosperity. However, P&C and flood-insurance crises critical to broader resilience are likely to be slow-moving train wrecks, not systemic explosions because it takes time to assess damage, determine coverage, and seek redress. However, MIs blew up even though it also took time after the 2008 crisis before borrowers became delinquent and then defaulted into a market which had experienced an almost instantaneous drop in home-equity valuations. Time is thus helpful, but not necessarily all it takes to prevent systemic risk, which can also be slow-moving until it isn’t.
Even if P&C stands firm through the L.A. crisis, the only way P&C insurers can pull out of the underlying earnings debacle is to continue to pull back from high-risk markets. The more of them there are, the more under- and un-insurance will threaten financial stability and macroeconomic growth. Wise policy-makers could see this risk and avert it, but wise policy-makers seem these days to be in even shorter supply than affordable homeowners’ insurance.