U.S. banks are increasingly using insurance as a key mitigant against growing climate-related risks and potential losses in their commercial and residential real estate loan portfolios by limiting exposure to volatile, deteriorating weather environments, Fitch Ratings says.
Banks’ climate risk governance is increasingly important as losses related to weather events occur with more regularity and as regulators scrutinize climate-related vulnerabilities and local, state and federal authorities implement policies that influence economic incentives.
The Federal Reserve’s recent “Pilot Climate Scenario Analysis Exercise” underscores the importance of hazard insurance in reducing potential losses for banks. It advises banks to regularly review and update their insurance coverage and underwriting practices to keep pace with industry changes and protect their credit profiles.
This exercise, involving the six largest U.S. bank holding companies, examined potential credit effects of a hurricane in the Northeast and severe disasters like hurricanes, floods, or wildfires in the Southeast or Southwest.
The report indicates that relatively low property damages can be managed through insured customer deductibles or out-of-pocket expenses by uninsured customers, with minimal impact on bank credit profiles.
In more severe scenarios in the Southeast or Southwest, a “no insurance” assumption significantly increased the estimated probability of default, leading to higher losses for banks.
However, this “no insurance” scenario is considered extreme, requiring drastic changes in the insurance landscape.
US Bank Real Estate Loan Probability of Default to Climate-Related Shock
Banks lacking insurance face higher loan defaults and meaningfully higher losses CRE – Commercial real estate. RRE – Residential real estate.
| Idiosyncratic Shock | 200-Year Event (Insurance) | 200-Year Event (No Insurance) |
|---|---|---|
| % CRE Loans with >500 bp change in Probability of Default | 4.80% | 9.20% |
| % RRE Loans with >500 bp change in Probability of Default | 2.40% | 4.30% |
Banks set property insurance requirements at loan origination, mandating borrowers to purchase and maintain specific types and amounts of insurance with maximum deductibles to limit exposure to worsening operating environments.
If policy costs, adjustments, or availability fail to meet underwriting standards, banks are expected to halt loan originations. This business adjustment could affect bank operations but would reduce the likelihood of large uninsured loan portfolios.
Standard property insurance policies renew annually, posing risks of significant premium increases that could reduce borrowers’ debt service coverage, impair property values, or lead borrowers to drop policies.
Insurers have notably reduced exposure in California and Florida due to regulations, litigation, and rising losses, prompting both states to seek legislative solutions.
However, when borrowers lapse on their policies, lenders can “force place” coverage on the borrower’s behalf. If the borrower does not pay the premium or replace the force-placed coverage with an acceptable policy, the property could be put into foreclosure.
Banks also face risk from the changing landscape of inland flooding, as lenders could incur significant losses in areas historically not considered at high risk.
In 2022 numerous catastrophic inland floods occurred in Kentucky and elsewhere that were largely uncovered.
Homeowners most commonly purchase flood insurance through the National Flood Insurance Program.
Future unusual flooding events could drive higher lender losses, particularly at smaller, geographically concentrated banks.
Flood coverage is not included in traditional homeowner’s insurance, and it is typically not required by lenders outside of FEMA designated flood zones, with less than 10% of homeowners in the U.S. covered for flood risk.
by Yana Keller
