Three steps to mitigate hurricane risks in lending portfolios: Lessons from Hurricane Milton

Hurricanes and other climate-related events can cause direct damage to people and properties while also causing widespread disruption to economies and communities.

The associated implications for a bank’s lending portfolio are complicated, driven by a range of factors including damage from the storm, loan characteristics, and insurance coverage, among others. In this paper, we outline three steps lenders can take to address hurricane risk: anticipate, measure, and manage. Focusing on commercial real estate (CRE) portfolios, we use Hurricane Milton as an example and frame its impacts in the context of the broader landscape of climate events that the Gulf Coast, the broader US, and other regions globally have been experiencing for years and will continue to experience.
 

Anticipate:

Before Hurricane Milton, Moody’s estimated that over 235,000 commercial real estate (CRE) properties, valued at around $1.1 trillion, were exposed to high winds. This information can help portfolio managers to take preemptive actions, such as communicating with borrowers to mitigate risks, informing internal stakeholders, and monitoring insurance underwriting moratoriums.
 

Measure:

Post-event analysis revealed that approximately 100,000 properties with an estimated total building value of $400 billion in a hypothetical portfolio based on Moody’s CRE database, were modeled to experienced structural damage from Hurricane Milton. Less than 1% of this value was modeled to be damaged, indicating that overall portfolio level impacts from Milton are expected to be minor. However, there were pockets of notable damage, with the most affected properties expected to have damage ratios in the double digits. Credit analysis for a property in the portfolio demonstrates that loan quality and insurance coverage significantly influence the change in baseline credit risk stemming from hurricane damage. For example, analyzing a property with a hypothetical damage of 40% showed that the expected default frequency (EDF) of a healthy loan could increase by almost 7% if no insurance coverage was in place. For unhealthy loans with a higher loan-to-value (LTV) ratio and lower debt-service coverage ratio (DSCR), credit impacts would be much worse.
 

Manage:

The paper emphasizes the importance of insurance coverage in mitigating financial stress and potential defaults. However, it also highlights the challenges posed by the evolving insurance landscape, including high costs and low capacity. Lenders have an opportunity to use detailed catastrophe models and post-event analytics to inform their insurance negotiations and portfolio strategies.