Capturing the cost of physical climate risk

While much of the regulatory attention to climate-related financial risks focuses on the costs of the transition to a low-carbon economy, a new paper from researchers at the Bank of Canada examines physical risks — namely how natural disasters can impact household finances.

The paper, co-authored by central bank researchers and academics from Toronto Metropolitan University and Emery University, focuses on the financial fallout from the Fort McMurray wildfire in 2016 — finding that, in areas that were severely damaged by the fire, the disaster caused a spike in households falling behind on their mortgages.

According to the paper, the Fort McMurray wildfire — the costliest wildfire in Canadian history, inflicting an estimated $9.9 billion in damages, and about $3.7 billion in insured losses — provides a prime opportunity to study how the severity of physical damage echoes through the financial system, given that the fire destroyed certain areas, while sparing others.

The researchers focus on financial distress in insured mortgages measured by loan delinquency, which has implications for households and the financial industry — including lenders, mortgage insurers, and policymakers.

“We find that wildfires have a substantial impact on mortgage delinquencies,” it said, with delinquencies doubling in areas that were hit hard by the fire.

The increase in mortgage arrears in the hard hit areas was on par with the effect of the global financial crisis in 2008, the paper noted.

“In terms of severity, our estimates show that the financial distress of affected individuals devastated by wildfires is comparable to that of the Great Recession, although the events are of different scales,” it said.

The paper indicated that while most of the damaged residential properties were insured, these policies generally don’t cover mortgage payments on damaged properties.

“The required mortgage payments and additional living expenses for dislocated individuals can be a potential source of financial stress,” it said, adding that these burdens can be “further aggravated by the prolonged period of time required for insurance settlements due to the sheer number of claims.”

However, the paper also noted that the effect on mortgage arrears was temporary, and that it had largely dissipated within 12 to 18 months.

However, given the possibility of spillover effects from natural disasters throughout the financial industry, the paper suggested that climate risks need to be incorporated into financial stability analyses.

“The financial impact of natural disasters, which are more frequent and severe due to climate change, may propagate through financial linkages between stakeholders,” it said.

“For instance, the risk management and practices of property and casualty insurers can affect insurance settlements, which, in turn, may induce financial stress that impairs consumers’ ability to repay their loans extended by other financial institutions,” the paper said.

Additionally, an increase in mortgage delinquency and defaults due to climate-related events “can potentially increase the risk of mortgage insurers and investors of mortgage-backed securities if the risk of these events is not fully accounted for,” it noted.

James Langton

James is a senior reporter for Advisor.ca and its sister publication, Investment Executive. He has been reporting on regulation, securities law, industry news and more since 1994.