What Are the Economic Effects of a Heat Wave?

When hurricanes and wildfires occur, the economic consequences are stark: roofs ripped away and burned homes flanking the streets. However, heat waves also inflict financial harm, albeit in a more subtle way: crops may fail, construction can halt, and data centers might falter, leaving customers disconnected.

Climate risk models, widely utilized in the insurance industry, can project the chances of fires or floods impacting specific areas in the US, even pinpointing individual addresses and estimating potential damages. Currently, these models typically lack comprehensive forecasts for extreme heat, as heat presents less of a direct threat to real estate compared to its effects on health, energy systems, and food supplies.

Nonetheless, cities, businesses, and insurers need clearer risk assessments. Some experts suggest that a new market for heat insurance, partly driven 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 providing heat-hazard modeling on its widely-used risk-analysis platform. Additionally, Mercer, a division of Marsh & McLennan Cos Inc, rolled out a climate health cost forecaster tool in May to analyze how extreme heat and other climate hazards could impact health insurance expenses for companies. This tool employs historical data, medical claim codes linked to climate incidents, and published studies.

“The health costs are just one part of the equation,” remarked Tracy Watts, Mercer’s US leader for healthcare policy. “There are also heightened workers’ compensation costs, disability issues, implications for life insurance, and concerns about absenteeism.”

These new tools complement the emergence of hedging instruments like weather derivatives, forward contracts, and parametric insurance. For example, a forward contract might allow a utility to secure additional electricity from a supplier at a fixed price for summer. If temperatures remain mild, they incur losses; if they spike, they benefit. Conversely, parametric insurance only delivers payouts when certain predetermined criteria are met—such as temperatures exceeding 95°F for five consecutive days.

“As we delve into extreme heat more thoroughly,” noted Garrett Bradford, a principal at Milliman Inc., an actuarial and management consulting firm, “it will become evident that risks are often inadequately considered” in insurance, “and that the consequences of a significant heat event can be quite serious.”

Last year witnessed record-high temperatures, with the US enduring deadly heat waves this decade, including the 2021 heat dome in the Pacific Northwest that resulted in hundreds of fatalities. According to the US Environmental Protection Agency, heat waves have become more frequent in urban settings, 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 grapple with the uptick in hazardous health consequences, initial efforts are being made to quantify the financial ramifications of heat. A study released last year revealed that seven extreme events in California from 2013 to 2022 resulted in $7.7 billion in economic losses, including $44 million in missing milk production from a single heat wave in 2017 in the Central Valley (as cows produce less milk in extremely hot conditions).

‘Bespoke’ predictions

One challenge in forecasting the effects of a heat wave, according to Anand Srinivasan, an executive at Cotality focused on climate change products, is that heat damage is complicated to model. Multiple factors influence its impact, including duration, humidity, and nighttime cooling. Risks can vary widely by industry; for example, businesses with outdoor workers face far greater risks than those with air-conditioned staff.

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

“What we can deliver 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 might require.”

Srinivasan foresees that more granular modeling of heat waves’ financial effects will eventually be available, broken down by sector.

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

While models for wildfires and hurricanes have become somewhat “commoditized,” he observed, heat prediction remains “bespoke” as it is tailored to both specific industries and geographical locations.

Historically, insurance companies have often recognized shifts in climate risk too late, leading to substantial payouts after extreme events. Hurricane Andrew in Florida in 1992 and Northern California’s Camp Fire in 2018 are two instances where insurers faced losses far exceeding expectations; both disasters prompted investments in more precise modeling for hurricanes and wildfires, which subsequently led to increased premiums for policyholders.

The technology for conducting comprehensive hazard analyses on heat across various industries or cities exists, explained Cole Mayer, who oversees parametric products for Aon Plc, a risk management firm. However, clients’ willingness to invest in additional insurance remains low. “A shift in risk perception is crucial,” Mayer remarked.

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

Dave Bigelow, a climate risk advisor for Aon, believes that time will reveal the necessary adaptations. “We’ve amassed hundreds of years’ worth of records on floods and hurricanes and acute perils,” he noted. “However, for heat, we are only beginning to see this information come to light.”

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