The risk of hurricanes and its impact on stock prices

19 January 2022. The economic repercussions of natural disasters have become increasingly severe. Ongoing population growth, urban sprawl into hazard-prone areas (such as coastlines, flood plains, or tectonic faults) and, most recently, anthropogenic climate change have led to a clear upward trend in disaster losses throughout the last three decades and the risk has reached alarming magnitudes: in the three years 2017, 2018, and 2019, natural catastrophes caused combined economic damages of about USD 600 billion around the world, more than the annual GDP of Sweden.

Weather-related perils, such as cyclones, and floods have increased threefold since the 1980s and are responsible for the lion’s share of global disaster losses. The most violent type of natural hazards faced by households and businesses in the U.S. are Atlantic hurricanes, which account for eight of the ten costliest disasters in the history of the country.

Hurricanes threaten households and firms in the U.S.

Households and firms can suffer direct or indirect losses from hurricanes. Direct impacts are damages to physical property. Storm surge and extreme precipitation pose a major problem in this regard, as they overburden sewage systems and result in widespread flooding of urban agglomerations. Despite the availability of subsidized coverage from the National Flood Insurance Program (NFIP), only five percent of U.S. homeowners are insured against such flood losses.

Indirect impacts refer to all changes in economic activities caused by the disaster, such as supply chain interruptions, shortages of upstream inputs, and plunges in sales due to reduced consumer spending in disaster-struck areas. Hurricane-induced flooding events in particular are known to inflict serious business interruption losses on the economy. In many cases, production facilities, suppliers and customers are not geographically co-located with the firm’s headquarters. Nevertheless, there are strong economic links and shocks from natural disasters have been shown to propagate through production networks. Hence, hurricanes can affect firms far away from their actual landfall location.

Increased hurricane risk since the mid-1990s

Hurricane risk is highly dynamic, because hurricane activity exhibits seasonality and varies with the North Atlantic sea surface temperature (SST) on interannual and decadal time scales. The last three decades were the hottest ever measured. Thus, unsurprisingly, these periods also set new records with regard to extreme hurricane events and their economic impacts. A major increase in hurricane risk can be traced back to the mid-1990s. Around that time, the Atlantic Multidecadal Oscillation (AMO) Index, a measure for the sea surface temperature variability in the North Atlantic, switched into a warm phase. Scientific research shows that the same time period is characterized by a clear upward trend in key measures of hurricane intensity, such as the Accumulated Cyclone Energy (ACE) and the Power Dissipation Index (PDI). 

Moreover, the geographic region in which cyclones can form has expanded and the storms themselves are able to travel greater distances away from the topics, reaching previously unharmed locations. In line with these observations, average normalized hurricane losses in the U.S. more than doubled from USD 10.5 billion for the period from 1977 to 1994 to USD 23.5 billion between 1995 and 2017.

Hurricane risk premium

Prof. Dr. Alexander Braun (I.VW-HSG), together with Julia Braun (also I.VW-HSG, not related) and Prof. Dr. Florian Weigert of the University of Neuchâtel examined whether hurricane risk affects stock prices. They developed a theory for a hurricane risk premium on stocks and tested its implications empirically.

Their evidence shows that, in the period from 1995 to 2020, stocks that react negatively to economy-wide hurricane losses bear a risk premium of more than 9 percent per annum relative to stocks that react positively. This hurricane risk premium is neither explained by traditional risk factors nor by firm characteristics, such as market beta, size, book-to-market, and momentum.

The hurricane risk premium is particularly high for larger firms, firms located in states that were economically exposed to hurricanes in the past, and firms that belong to the construction, manufacturing, services, as well as finance, insurance, and real estate industries.

Climate change and the cost of capital of exposed firms

The results of the study indicate that firms threatened by hurricane risk have a higher cost of equity than their unexposed peers. This is a particularly important implication in the face of climate change. Specifically, the increase in hurricane activity since the mid-1990s may already be attributable to anthropogenic forcing beyond the usual cyclical patterns. The onset of climate change will therefore further add to the significance of hurricane risk and other atmospheric perils. Firms should prepare for the consequences by integrating exposure to extreme weather events in their decisions about risk transfer, the location of company property and the diversification of supply chains.

Image: Adobe Stock / Mike Mareen