PhD Seminar with Koen van den Bosch

Title: Financial Stability and Natural Disasters under Endogenous Adaptation

Abstract: We examine the effect of natural disasters (ND) on financial stability in insurance and mortgage markets when household adaptation is endogenous to changing financial conditions. We first empirically establish that ND reduce insurers’ and banks’ solvency and profitability metrics, although the effects for banks are small. Using a novel instrument based on reinsurance market shocks, we show that the sensitivity of bank financials to ND rises with the size of the insurance gap, revealing interaction effects. Using a structural model with heterogeneous households, we then analyze how the responses of banks and insurers following ND dynamically shape moral hazard and credit constraints, affecting investment in physical resilience against ND and therefore long-run financial stability. Consistent with the empirical results, disaster-driven default rates increase when insurance gaps grow. Yet, endogenous adaptation substantially lowers the long-run financial consequences of ND relative to the counterfactual of no adaptation. We further illustrate the implications of moral hazard and credit constraints for the optimal mix between insurance- and adaptation subsidies when the aim is to reduce defaults. Our micro-founded model highlights how the interplay between regulation, frictions, and household behavior shapes the long-run financial consequences of ND.