The $5 trillion insurance industry faces a reckoning. Blame climate change.

The water has receded and the embers have died down from many of the disasters in the United States this year — leaving insurance companies that cover floods, fires, hail, and extreme cold on the hook for staggering losses. If current trends continue, they could suffer one of the costliest years in recent memory.

In the first half of 2021, disasters inflicted a staggering $42 billion in losses covered by insurance, a 10-year high. Then in September, Hurricane Ida cut a path of destruction through the Gulf Coast and flooded neighborhoods from Louisiana to New Jersey, causing between $31 billion and $44 billion in insured losses. Ida now ranks among the top five costliest storms in US history.

The Atlantic hurricane season still isn’t over, and California’s autumn fire season has yet to enter its peak, so the total damages are poised to rise even higher. Insurers are still tallying damage totals from wildfires in the US West this year, but last year’s fires cost insurers $13 billion.

The human costs of these disasters in terms of lost lives and livelihoods are the most profound, but dollar-value losses have a huge impact on the economy that can linger for years. They reveal where risks are growing and could shape transformative policy decisions, such as where to rebuild, where to erect defenses, and where the costs of staying might be too high to bear. Here, the insurance industry plays a critical role, not just in the recovery from disasters but in shaping preparations for the next one.

Climate change is altering these risks. Rising average temperatures are driving weather events to greater extremes, making floods, fires, and heat waves more destructive when they occur. Populations in high-risk areas are also growing, putting more people and property in harm’s way.

These trends are perilous for the insurance business. “Climate change is the No. 1 long-term risk out there,” said Jerome Haegeli who is group chief economist for Swiss Re, an international firm that sells reinsurance (a type of insurance that protects insurance companies from being overwhelmed by losses during disasters). “The insurance sector is part of solving the existential threat, the No. 1 long-term risk. There’s a lot we can do as an industry.”

But many experts told Vox that even as a sector focused on anticipating risk, insurance isn’t yet ready for the full consequences of climate change that lie ahead, which could harm both insurers and their customers. “In fact, these threats are already playing out in some local insurance markets within regions of the United States affected by hurricanes and wildfires,” says a climate change and economy roadmap released by the White House on October 15.

Some insurers are caught in a bind between balancing their books and satisfying regulations that require them to keep people covered. As the climate changes and more people and property become vulnerable, a massive question remains unanswered: Who will ultimately pay the growing costs of protecting, relocating, and rebuilding communities after a calamity?

Climate change is shaking the foundations of a massive global industry

Insurance is big business, and it’s one of the most powerful industries shaping action on climate change. The global insurance sector topped $5 trillion in 2021, according to Research and Markets, which is in the same ballpark as the entire US federal budget. The most relevant form of climate-related insurance is property and casualty, which covers homes, cars, and personal belongings. In 2020, this segment scooped up $1.6 trillion in premiums, or payments from the policyholders who buy insurance.

The point of insurance is to distribute risk so that no individual has to bear the full brunt of a loss on their own. That’s why lenders like banks often require their customers to buy coverage when they take out loans for homes and other property. The business model for an insurer is to charge more for premiums than they are paying out in claims. It sounds simple enough, but the industry depends on a whole field of actuarial science that conducts complicated risk assessments so that insurers can stay in the black.

Prices then shape human behavior. If an insurance company charges a high premium on a flood-prone coast or in a neighborhood in a fire zone, that might dissuade a potential buyer from ever moving in.

This model works well when a lot of people buy insurance and only a handful suffer the kind of damage that requires big payouts. To spread out their risks, insurance companies tend to sell a diverse set of policies across a variety of markets — homes in rural areas, businesses in coastal regions, cars in a given state, and so on.

However, major disasters like hurricanes and catastrophic fires can wipe out whole towns and lead to correlated losses, or large claims that have to be paid out at the same time across a wide range of insurance products. Climate change connects many disasters and worsens them in ways many insurers haven’t yet recognized.

“What the industry has not come to grips with is how related are all these events,” said Kia Javanmardian, a partner at McKinsey & Company who studies insurance. “In the past, they weren’t as related — the flood in Florida might not be related to the fire in California — but if there’s an underlying driver called climate change that’s driving both, then they do become related.”

The combination of more frequent and more extreme disasters can create situations where insurance policies become too expensive for most customers, or make it impractical for companies to provide coverage.

Like banks, insurance companies don’t always have all the cash on hand they need to pay out lots of big claims at the same time. To cushion the blow of disasters, insurance companies often buy coverage from their own insurance companies, known as reinsurers.

But when disasters like major hurricanes or torrential rainfall strike, even reinsurance companies can face a crunch. In recent years, the cost of reinsurance policies has risen. Swiss Re expects that climate change will expand the pool of at-risk properties by 33 to 41 percent by 2040, generating $149 billion to $183 billion in new premiums but also increasing the potential payouts.

The biggest fear is that a massive climate-linked disaster, or multiple disasters back to back, could create compounding losses that don’t scale up in a neat straight line. “It doesn’t get gradually worse; it gets exponentially worse over time,” Javanmardian said.

The delicate balance between insurance and policy often breaks

In 2012, North Carolina’s Coastal Resources Commission studied the risk of sea-level rise over the next century and reported that water levels along the coast could rise by as much as 39 inches. After coastal property developers realized that their holdings could lose value and become uninsurable in such a scenario, they pressured the state government, which outlawed policies that incorporated the agency’s forecast. The move inspired widespread mockery.

“If your science gives you a result you don’t like, pass a law saying the result is illegal,” joked comedian Stephen Colbert at the time on The Colbert Report. “Problem solved.”

The commission in 2015 came back with another forecast, this one looking only 30 years ahead and finding that waters could rise 6 to 8 inches. The result seemed far more palatable to North Carolinians.

The episode illustrates just how thorny it can be to factor climate change into risk forecasts. In years since, public interest in climate change has surged. Activists have been pushing governments and businesses to do more to curb emissions and deal with the consequences of warming. Yet insurers and policymakers have continued to struggle to make insurance products reflect what’s really at stake.

The difference between US approaches to flood insurance and fire insurance is a case study in how climate change and the public interest can squeeze insurance providers, or create strange incentives for their customers.

There are few companies willing to insure homes against floods because widespread flooding runs the risk of damaging entire neighborhoods and causing correlated losses. To fill the void, the federal government created the National Flood Insurance Program (NFIP) as a backstop. In high flood-risk areas, homes and businesses that have government-backed loans are legally required to be insured against floods, and the NFIP has to provide coverage.

That leads to situations where even the highest-risk homes — which may flood again and again and incur huge damages — are covered. There are also limits on how high premiums can go. So the program ends up losing vast sums of money while subsidizing the rebuilding of homes in dangerous areas.

The NPR podcast Planet Money highlighted the case of a Houston home that received payouts from NFIP five times, noting that 1 percent of homes account for 25 percent of claims since the program’s inception in 1968. The NFIP is now more than $20 billion in debt, in addition to $16 billion in debt that was canceled by Congress in 2017.

There are also many at-risk homes and businesses with government financing that haven’t purchased flood insurance. That’s because the Federal Emergency Management Agency (FEMA), which administers the NFIP, is using outdated maps of flood zones that don’t account for recent and future changes in the climate, the Government Accountability Office (GAO) reported this summer.

“Especially with climate change, people outside the flood hazard area are also at risk of flooding, and they have much less awareness of what their risk is,” Alicia Puente Cackley, director of financial markets and community investment at GAO, told Vox. The bright lines that delineate outdated flood zones, Puente Cackley said, “give people the false sense they are not at risk.”

Changing this requires new federal laws, which means Congress would have to act. The NFIP is now in the process of raising flood insurance rates to account for climate change, but that is creating a new problem: Coverage may become too expensive for some households, and many residents can’t afford to move.

Fire insurance, on the other hand, has no federal coverage mandate. Insurers can raise rates and even allow policies to lapse if they decide the fire risks are too high for a given property. But these companies are still regulated: Every state has an insurance commissioner whose job is to keep tabs on insurance companies, and many limit how much insurers can charge and prescribe who they have to cover.

As with flooding, insurers may still be underestimating the risk from wildfires. Estimates show that one in 12 homes in California is at high risk of burning, and risk assessment maps haven’t been updated since 2007, according to a study published this summer from the think tank Next 10 and the University of California Berkeley.

Yet people are still building in areas at high risk of climate-related disasters. About 40 percent of the US population lives in a coastal county, and populations in many of these regions are growing even while sea levels rise. One estimate showed that by 2050, 645,000 homes in California will be built in “very high” wildfire severity zones. The value of these properties is likely to rise as well, which in turn raises the bill when a catastrophe strikes.

So while climate change is worsening disasters, people are also putting more valuable houses, offices, and infrastructure in threatened regions, increasing the toll when a major disruptive event does occur. “Climate change is part of it, but it’s not the whole story,” said Haegeli. “It’s also economic development.”

Regulators can try to protect homeowners by passing local insurance mandates or preventing customers from losing their coverage. In California, the state insurance commissioner placed a one-year moratorium on dropping fire insurance coverage for 325,000 homeowners and renters in 22 counties in the wake of major fires this year. But these kinds of policies are stop-gaps, which can create situations where insurers aren’t collecting enough in premiums to cover their losses — or when moratoriums expire, property holders are left on their own when a blaze ignites.

While insurance prices could nudge people, property developers, and policymakers toward less-risky practices, many don’t have the resources to respond to these signals. Therein lies the dilemma: Providing insurance for properties facing climate disasters can create what economists call moral hazard, a situation where people are less inclined to adequately prepare for a disaster because they are insulated from the consequences. Yet dropping coverage or pricing people out of policies leaves them in the lurch when disaster strikes.

An unregulated insurance market can also worsen existing inequities: Wealthy property owners may end up protected with insurance while less-affluent people are unable to find affordable coverage. “I think that that dynamic is going to be a really difficult one,” said Sean Hecht, co-executive director of the Emmett Institute on Climate Change and the Environment at the UCLA School of Law. “Nobody’s really come up with a good answer to those questions.”

And while insurance can be a valuable instrument in coping with disasters, there are limits to how much it can protect society at large from climate change. “If we’re talking about the total amount of losses growing, insurance can’t fix that problem,” Hecht went on. “It can just redistribute and rearrange capital so that it’s easier to address the problem.”

Truly curbing the economic impacts of climate change would require a more comprehensive approach across the economy. That can mean reexamining zoning laws, buying up uninsurable properties, paying for people to relocate, or building public infrastructure projects like sea walls to mitigate climate risks.

Legislators are also considering proposals to make companies disclose the climate change risks they face and to make banks and insurers incorporate climate forecasts into their work. These tactics also have to account for the existing imbalances in wealth and risk across society. Otherwise, “further declines in available and affordable insurance could exacerbate the inequities that these communities currently face,” warned the White House’s roadmap for a climate-resilient economy.

None of these are simple tasks, and many of these measures will take years to implement. But without steps toward reducing the economic harm of climate change, the problem will grow and the people least equipped to deal with it will likely suffer the most.

Insurance companies aren’t just preparing for climate disasters — they hope to prevent them

The insurance industry, especially reinsurers, is spending a lot of time and energy studying climate change and trying to do something about it.

“The biggest global insurers also see themselves as having a stake in reducing climate change itself,” said Hecht. “They’re well aware that the worse climate change is, the more average warming we have around the globe, [and] over time, the more extreme events are likely to happen.”

An honest assessment of where the risks lie is a key step in making sure they don’t get overwhelmed when the next major wildfire ignites or when a tropical storm makes landfall. Insurers also have an incentive to prevent and mitigate losses, which is why they have pushed for policies like fire safety standards and building codes that can reduce flood risk.

Some companies are even developing new financial tools to deal with major calamities, like catastrophe bonds for insurance companies. These are high-yield bonds that only pay out if a specified disaster occurs.

Where insurance companies aren’t willing or able to offer policies, governments are also stepping in to try to move people out of danger. California, for example, is working on a program that would buy up properties at risk of coastal flooding and rent them out until they are no longer habitable.

The insurance industry is also starting to flex its power with another, often unappreciated tool in its kit: trillions of dollars in assets.

Insurance and reinsurance companies are responsible for nearly a fifth of global capital investments, and some are thinking closely about where they are placing their bets. Several insurers, for example, are phasing out their stocks in coal companies. They are also declining to offer insurance protection to fossil fuel projects.

Insurers hope these moves could influence other investors to follow suit and make polluting sectors a riskier and less attractive prospect.

Some companies are advocating for more aggressive action on climate change, for example through policies like carbon prices that better account for the potential harms from rising temperatures. They’re calling for more aggressive international action to curb warming. The countries that signed the 2015 Paris climate agreement set a goal of limiting warming this century to 2 degrees Celsius, with a high ambition target of staying below 1.5°C of warming.

“It’s now in our interest to reach 1.5°C,” said Swiss Re’s Haegeli. “There is no other sector, I think, that can provide so much positive impact in tackling climate change.”