What Are the Economic Consequences of a Heat Wave?

When hurricanes or wildfires occur, the economic fallout is often glaring: roofs stripped away and scorched homes lining the streets. Yet, heat waves also inflict financial harm, albeit in a more widespread fashion: crops may wilt, construction can halt, and data centers may falter, leaving customers disconnected.

Climate risk models, widely utilized in the insurance field, can forecast the probability of fires or floods affecting particular areas in the US, right down to the address level, along with estimating potential damage. At present, these models typically do not provide comprehensive forecasts for extreme heat, as heat represents less of an immediate threat to real estate compared to its effects on health, energy infrastructure, and food supplies.

Nonetheless, cities, businesses, and insurers need clearer insights into financial risks. Some experts argue that a new heat insurance market, driven in part by artificial intelligence and the cooling requirements of data centers, is on the horizon.

Hedging against heat

The property information company Cotality, formerly known as CoreLogic, has started to provide heat-hazard modeling on its well-known risk-analysis platform. In addition, Mercer, a division of Marsh & McLennan Cos Inc, unveiled a climate health cost forecasting tool in May to assess how extreme heat and other climate risks may impact health insurance expenses for companies. This tool leverages historical incident data, medical claim codes related to climate occurrences, and published research.

“Health costs are just one facet,” noted Tracy Watts, Mercer’s US leader for healthcare policy. “There are also heightened workers’ compensation costs, disability issues, life insurance ramifications, and absenteeism concerns.”

These new tools follow the creation of hedging instruments like weather derivatives, forward contracts, and parametric insurance. For example, a forward contract might permit a utility to purchase additional electricity from a producer at a predetermined price for the summer. If temperatures remain low, they incur losses; if they rise, they profit. Conversely, parametric insurance only pays out when specific set criteria are met—such as temperatures surpassing 95°F for five consecutive days.

“I believe that as we scrutinize extreme heat more closely,” commented Garrett Bradford, a principal at Milliman Inc., an actuarial and management consulting firm, “we’ll find that risks are often inadequately considered” in insurance, “and that the implications of a severe heat event can be quite substantial.”

Last year recorded the highest temperatures ever, with the US facing lethal heat waves in this decade, including the 2021 heat dome in the Pacific Northwest that claimed hundreds of lives. According to the US Environmental Protection Agency, heat waves have become more common in urban areas, and the duration of heat seasons has lengthened.

Read/listen: SA extreme weather and insurance: What policyholders must know

As healthcare professionals and public officials address the growing hazardous health effects, initial efforts are being made to quantify the financial impact of heat. A study published last year found that seven extreme events in California from 2013 to 2022 led to $7.7 billion in economic losses, including $44 million in lost milk production from a single heat wave in 2017 in the Central Valley (where cows yield less milk under extreme heat conditions).

‘Bespoke’ predictions

One hurdle in forecasting a heat wave’s effects, according to Anand Srinivasan, a Cotality executive focused on climate change products, is that heat damage is intricate to model. Numerous factors influence its impact, such as duration, humidity, and nighttime cooling. The risks can vary dramatically by industry; for instance, businesses with outdoor workers face far greater risks than those with air-conditioned employees.

Last year, Cotality not only modeled “acute” hazards like wildfires and floods but also began exploring “chronic” threats: extreme heat, drought, cold spells, and heavy rainfall. Its first tool for chronic hazard modeling provides risk indices for heat at the address level, although it does not predict the financial repercussions of heat events.

“What we can offer is the data and analytics for decision-makers,” stated Srinivasan. “This way, a typical risk manager can decide whether to keep their office open during a heat wave and identify what additional support their personnel may require.”

Srinivasan believes that eventually, there will be more detailed modeling of heat waves’ financial impacts on a sector-by-sector basis.

Skyline Partners, a data firm with offices in Colorado and the UK, has developed metrics for a parametric insurance policy tailored for dairy cows stressed by heat. Laurent Sabatié, Skyline’s co-founder and executive director, emphasized that this demanded extensive analysis.

While models for wildfires and hurricanes have become somewhat “commoditized,” he noted, heat prediction remains “bespoke” as it is customized to specific industries and geographical areas.

Historically, insurance companies have sometimes acknowledged shifts in climate risk too late, resulting in significant payouts following extreme events. Hurricane Andrew in Florida in 1992 and Northern California’s Camp Fire in 2018 are two instances where insurers faced losses exceeding expectations; both disasters triggered investments in more accurate modeling for hurricanes and wildfires, respectively, which subsequently led to increased premiums for policyholders.

The technology for conducting extensive hazard analyses on heat for various industries or cities exists, explained Cole Mayer, who manages parametric products for Aon Plc, a risk management firm. However, clients’ readiness to invest in extra insurance remains limited. “A change in risk perception is essential,” Mayer stressed.

AI and cryptocurrency, both dependent on heat-sensitive data centers, may accelerate the growth of this market, he added: “These exposure concerns weren’t as significant a decade ago.”

Dave Bigelow, a climate risk advisor for Aon, believes that time will reveal the necessary adjustments. “We’ve assembled hundreds of years of records on floods and hurricanes and acute dangers,” he pointed out. “However, for heat, we are just beginning to see this information come to light.”

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