From Drought to Deluge

(Chapter 6 of 6) When too much water is the problem.

Jonathan Malawer, CFA

Jonathan Malawer, CFAHead of insurance linked securities, commodities and environmental strategies K2 Advisors

On August 25, 2017, Hurricane Harvey made landfall on the US coast just south of Houston, Texas. After pushing inland, the storm ran against a ridge of high pressure, blocking its forward movement. As most tropical cyclones do, the storm carried with it a prodigious amount of moisture. In the case of Harvey, the precipitation was made worse by its stalled location. With counter-clockwise circulation hovering partially over the Gulf of Mexico, the storm operated as a sort of planet-sized shop-vac, sucking up water from the Gulf and pouring it onto Texas. For three long days and nights Harvey tormented the Houston area, dumping biblical volumes of rain. The result was catastrophic flooding, massive property loss and, sadly, many deaths. A common misconception is that the primary threat from hurricanes is damaging winds. In reality, water causes most of the destruction.

Beyond the obvious and devastating humanitarian threat the risk of increased flooding presents to the world, there is a less recognized financial threat as well. In general, flood risk is an under-insured peril, in the United States and other countries globally. Even in places where insurance coverage is in-force, it is often found to be insufficient. For Hurricane Harvey, for example, total economic losses were around US$85 billion. Insured losses, however, were roughly US$30 billion–US$35 billion, revealing a significant protection gap. Around 80% of the homes inundated by floods in the Houston area were uninsured.53

The good news is private financial markets are beginning to provide a solution to the flood insurance problem facing the world today. In addition to traditional reinsurance, new forms of “alternative” risk transfer have also developed. For example, insurance linked securities (ILS)—financial products whose values are driven by insurance loss events, and which transfer major natural disaster risks to capital market investors—are being employed. The most common form is catastrophe bonds (or cat bonds), which operate somewhat like other bonds, but whose payout is dependent on the occurrence of a catastrophe. We’re seeing a growing market for these instruments in the United States and globally. As these events become more common and destructive with climate change and sea level rise, we expect the market to grow.

Future forecast: more flooding

Flooding catastrophes such as Harvey are happening more frequently in recent years, and not just in the United States. This is a global phenomenon. In 2018, floods impacted over 35 million people worldwide, making them the most widespread natural disaster in terms of human impact.54 In 2019, tropical cyclone Idai left in its wake devastating floods in Mozambique, Zimbabwe and Malawi. The cyclone made landfall over the city of Beira, Mozambique, a rapidly growing low-lying community on the coastline vulnerable to storm surges and rising sea levels. Ninety percent of the city was destroyed, with flood waters reaching depths of 20 feet in some areas, according to the International Federation of Red Cross and Red Crescent Societies.55

Indeed, slow moving Hurricane Sally (2020) recently dropped 20–30 inches of rain in parts of the Florida Panhandle and coastal Alabama in the United States. Along with storm surges exceeding six feet, the deluge triggered catastrophic flooding.56

Although estimates for future sea levels vary substantially, some of the more dire predictions suggest a potential rise of three feet by the year 2100...this will have a major impact on flood severity and frequency.

By all reasonable scientific measures, the reality of climate change cannot be denied. According to the World Meteorological Organization (WMO), record greenhouse gas concentrations are pushing global temperatures toward increasingly disruptive levels. A 2018 WMO report showed carbon dioxide levels rising from 357.0 parts per million in 1994 to 405.5 parts per million in 2017, and scientists expect these greenhouse gas concentrations will continue to trend upward.57 As shown in Exhibit 18, the 10 warmest years on record have all occurred since 1998, and the last four years have been the warmest four on record.

LAST FOUR YEARS ARE THE WARMEST ON RECORD Exhibit 18. History of global surface temperature anomalies since 1880 (As of August 2020)

Source: NOAA

With rising temperatures comes rising sea levels, as sea ice melts and glaciers retreat. Although estimates for future sea levels vary substantially, some of the more dire predictions suggest a potential rise of three feet by the year 2100.58 Implicitly, this will have a major impact on flood severity and frequency. As seen in Exhibit 19, planners in New York City are projecting significant portions of the city to be impacted by rising sea levels. To put this into context, many of the areas projected to be underwater in 2080 roughly correspond to where we saw inundation from the 14-foot storm surge during Hurricane Sandy in 2012.

RISING SEA LEVELS INCREASE FLOOD RISK IN DENSELY POPULATED AREAS Exhibit 19: The New York panel on climate change future 100-year flood zones (2015)

Source: New York City Panel on Climate Change 2015 Report. There is no assurance that any estimate, forecast or projection will be realized.

There is high confidence among scientists that rising sea levels are playing a part in the increase in flood catastrophe risk. Rising sea levels increases risk of cyclone-related inundation to coastal properties from storm surge, as well as inland riverine flooding. In the United States, for example, almost 40% of the population lives in relatively high population-density coastal areas.59 Globally, eight of the world’s 10 largest cities are near a coast, according to the UN Atlas of the Oceans. Again, looking at Sandy’s 14 feet of storm surge, it is easy to imagine a significant portion of Manhattan swamped if 2080’s New York City were to experience a similar surge and no upgrades were made to sea barriers.

Beyond rising sea levels, the connection between climate change and increased flood risk is not as obvious as it may seem. Intuitively, the assumption is that—since hurricanes and cyclones feed on warm air and water—the increase in global temperatures is creating more and larger storms, and hence more flooding damage. There is mixed evidence to suggest this may be a factor, but there is no scientific consensus.

A more concrete (no pun intended) factor contributing to flood risk, in addition to higher sea levels, is physical changes to topography associated with human development—things like increased pavement, less natural drainage, and less foliage and green space to absorb and retain water.

Hurricanes are slowing down

Lastly, and perhaps most interestingly, recent research shows that storms are slowing down. And because they are slowing down, they are concentrating larger volumes of rain in certain areas—hence more flooding.

As Earth’s atmosphere warms, the atmospheric circulation changes. These changes vary by region and time of year, but there is evidence that warming causes a general weakening of summertime tropical circulation. Because tropical cyclones are carried along environmental winds, the speed of tropical cyclones appears to have slowed with global warming. Over the period 1949–2016, tropical-cyclone translation speed has decreased globally by 10%.60 The unprecedented rainfall totals associated with the “stall” of Hurricane Harvey over Texas in 2017, for example, provide a notable example of the relationship between regional rainfall amounts and tropical cyclone translation speed. This may indeed be the greatest risk to flooding created by climate change.

The financial risk

For many property owners, the problem is two-fold: first, many are simply unaware of their flood risk. Second, for those who do have coverage, it is generally inadequate. In the United States, for example, most flood policies are covered by the federal government through the Federal Emergency Management Agency (FEMA) and the National Flood Insurance Program (NFIP), which already is severely underfunded.61

A recent study from flood risk analytics specialist KatRisk LLC and actuarial consultancy Milliman Inc. shows that 69% of metropolitan areas in the United States have 90% or more of their expected flood losses uninsured. As sea levels rise, total storm surge losses in these areas may increase 21% by 2050.62

In terms of cost, flood losses to single-family residences could be upwards of US$7 billion annually, with more than 87% of those costs uninsured by the NFIP.63 If private flood insurance data were included, this estimate would only marginally decrease due to the small size of the residential private flood market relative to the NFIP.

Transferring risk to capital markets

As alluded to in this chapter’s introduction, ILS and cat bonds are gaining traction globally as potential solutions to the financial risk posed by increased flooding. In the United States, the Homeowner Flood Insurance Affordability Act of 2014 (P.L. 113-89) revised the authority of the NFIP to look to the capital markets for financing. In this way, risk transfer to the private market is helping alleviate the financial burden on FEMA and the US Treasury.

In August 2018, FEMA entered its first transfer of NFIP risk through an ILS transaction, transferring US$500 million of the NFIP’s risk to capital markets by sponsoring issuance of an indemnity-triggered cat bond.64 More recently, after witnessing the significant impact of Hurricane Sandy in 2012 on its subway system, the NYC Metropolitan Transportation Authority (MTA) issued a cat bond.

The MTA chose a parametric mechanism65 that triggers payments when storm surge reaches a particular water depth at select measurement stations around New York Bay. It is designed to provide a cash influx to the MTA of US$100 million—in the latest 2020 issuance—if those conditions materialize, allowing the city to deploy funds as required to repair infrastructure or respond to emergencies.

Going forward, we anticipate the increasing frequency of flood events, like Harvey in the United States, Hagibis in Japan, or Idai in Africa, will accelerate the development of the private flood market.

Globally the ILS market is showing appetite for flood risk as well—including inland flood risk—with several catastrophe bonds completed during 2017 for European flood risk (Generali’s Lion II), and Japanese flood risk (MSI and ADI’s Akibare Series 2018-1 Notes).

Going forward, we anticipate the increasing frequency of flood events, like Harvey in the United States, Hagibis in Japan, or Idai in Africa, will accelerate the development of the private flood market. More efficient risk pooling and risk sharing mechanisms will help to alleviate financial flood risk exposure. Clearly there exists a meaningful gap between potential economic loss and insured loss, and this gap will likely widen with climate change and rising sea levels. This will be a catalyst for the ILS market, as consumers seek efficiently priced coverage for their risk exposures.

With trillions of dollars in capital in the world, there is clearly enough liquidity to absorb event risk. The challenge is accessing the capital base in an efficient way. Moving flood perils from government pools to private insurers will be a slow evolution. It will take time, particularly if existing coverage is subsidized.

While we discussed prior the potential longer-term implications for New York City flood risk into the latter half of the century, a traditional reinsurance risk period is typically one year. Cat bonds can have a four-year maturity profile, but like traditional reinsurance, the risk period is usually annual and typically resets at the beginning of each year. This is an important characteristic to highlight, as the private market has the flexibility to reprice risk frequently to incorporate the latest scientific research and claims data. This will be important as we continue to see years with multiple events hitting a region consecutively, as well as periods of severe hurricane and typhoon seasons happening over consecutive years.

For private insurers, the solution is not just about flood risk modeling to ensure risk adequate pricing, but also about navigating government legislation. Furthermore, as ESG considerations are more widely adopted by the industry, we expect to see new investors enter this market, attracted to a diversifying income stream that provides an environmental market-based solution.



All investments involve risks, including possible loss of principal. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Investments in lower-rated bonds include higher risk of default and loss of principal. Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer or guarantor, may affect the bond’s value. Municipal bonds are debt securities issued by state and local governments and are generally exempt from federal income tax and also from state and local taxes for residents in the state where the bond was issued. They typically offer income, rather than capital appreciation potential. Corporate bonds are issued by corporations. Bonds with lower ratings and higher credit risk (risk of default) typically offer higher interest rates to compensate investors for the higher risk associated with the investment. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Treasuries, if held to maturity, offer a fixed rate of return and fixed principal value; their interest payments and principal are guaranteed. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments. Investments in emerging market countries involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Such investments could experience significant price volatility in any given year. Investing in the natural resources sector involves special risks, including increased susceptibility to adverse economic and regulatory developments affecting the sector—prices of such securities can be volatile, particularly over the short term. Some strategies, such as hedge fund and private equity strategies, are available only to pre-qualified investors, may be speculative and involve a high degree of risk. An investor could lose all or a substantial amount of his or her investment in such strategies. Real estate securities involve special risks, such as declines in the value of real estate and increased susceptibility to adverse economic or regulatory developments affecting the sector. The companies and case studies shown herein are used solely for illustrative purposes; any investment may or may not be currently held by any portfolio advised by Franklin Templeton Investments. The opinions are intended solely to provide insight into how securities are analyzed. The information provided is not a recommendation or individual investment advice for any particular security, strategy, or investment product and is not an indication of the trading intent of any Franklin Templeton managed portfolio. This is not a complete analysis of every material fact regarding any industry, security or investment and should not be viewed as an investment recommendation. This is intended to provide insight into the portfolio selection and research process. Factual statements are taken from sources considered reliable but have not been independently verified for completeness or accuracy. These opinions may not be relied upon as investment advice or as an offer for any particular security. Past performance does not guarantee future results.