How municipal bond insurers underwrite for decades of extreme weather risk

Larry: How can natural hazard risk translate to losses for municipal bond investors or insurers?

Jamie: We think about everything that can disrupt an issuer's economy and its cash flows. That might mean long-term damage to property - including residences, commercial or industrial buildings, or government facilities - that could disrupt economic activity and tax collections or impose large, unforeseen rebuilding costs. But we're also watching for very short-term impacts, like damage to communications infrastructure that could physically prevent local officials from making on-time payments to investors, even if they have the cash in their accounts.

It's important to remember that many municipal bond investors rely on the semi-annual cash flow from their holdings to make their own essential payments, like rent or the grocery bill, and so we take our obligation to make timely payments very seriously: we make sure the investor gets their cash on schedule, and then work with the issuer to cure any defaults.

Larry: On a practical level, how does BAM evaluate natural hazard risk?

Jamie: We use a variety of tools to assess natural hazard risk, including the ICE Climate Analytics Platform, FEMA's National Risk Index, and other risk-specific tools primarily for earthquake. Every credit we underwrite gets prescreened for natural hazard risk through ICE Climate Analytics. Based upon the platform's output, we may decide to continue our credit review, consult with other natural hazard risk assessment resources, or suspend our credit review (reject the credit) if the natural hazard risk exceeds our risk acceptance parameters.

If the ICE Climate Analytics Platform flags an issuer for elevated natural hazard risk, we consider the probability of such an event occurring and the projected loss or impact of such an event on both the repayment source and overall credit. There are more than 50,000 individual borrowers in the municipal bond market and nearly as many discrete credit pledges, so you really have to understand both the hazard risk, and how it interacts with the legal structure and security pledge of a specific bond issue.

For example, sales tax receipts often increase following a natural hazard as residents replace lost items and rebuilding activity begins, while lower property values associated with a natural hazard can have a negative impact on property tax receipts, special assessments, and tax increment revenues. In an abatement lease, an issuer is not required to make annual lease payments if it does not have use and occupancy of the encumbered asset - often a specific property, like a school building.

In addition to probability and loss magnitude, we also look at the possibility that an issuer could be found to have a legal liability associated with the natural hazard - this is particularly relevant in California with respect to wildfires.