Wildfires, hurricanes, and floods are some of the many perils exacerbated by climate change. High-risk regions face events with multi-billion dollars’ worth of damage. Over the next months, we’ll devote a number of episodes to the financial cost of climate change and how we can move forward in an effort to protect ourselves and our investments. We’re starting off the conversation with Karen Clark, a leading expert in catastrophe modeling. Karen joins Tony to explain how modeling possible catastrophic events helps insurers, financial institutions, corporations, and public agencies estimate and prepare for future losses from climate-related natural disasters.
Catastrophe Modeling and the Perils of Climate Change
Tony Roth, Chief Investment Officer, Wilmington Trust Investment Advisors
Karen Clark, CEO Karen Clark & Co.
Tony Roth: This is Tony Roth, and you are listening to Wilmington Trust’s Capital Considerations. We have a really interesting episode today, the first episode of a series of episodes that all fit under the same arch the economic impact of climate change, and we're going to start today on that topic with what we think of as catastrophe modeling and the implications for climate change on things like real estate, personal real estate, commercial real estate, et cetera.
We're here today with Karen Clark from Karen Clark and Company, she's a co-founder of the company and really the first, what we call catastrophe modeling firm in the industry. She created the first model for catastrophe modeling back in 1987, and she's been a well-recognized leading expert in the space since that time, so many years now.
And she's been recognized for her contributions to the space, including, and very importantly, winning an award called the Nobel Peace Prize Certificate in 2007 for her contributions to the Intergovernmental Panel on Climate Change. And this had a lot to do with really establishing that climate change is real.
It's something that we accept, I think now pretty broadly, but there was a long time when folks didn't really accept that climate change was a phenomenon and that it was manmade and so on and so forth. This is I think really a privilege to be able to have Karen here with that kind of gravitas and background to talk to us about what is an increasingly prevalent set of phenomenon across our country and the world with catastrophic events assuming as a result of climate change.
So, Karen, thank you so much for joining us today.
Karen Clark: Well, thank you for having me, Tony.
Tony Roth: Maybe you could talk to us about that forefront of modeling of climate change and your work many years ago with the intergovernmental panel on climate change and how that has been a watershed event, if you will, for the world and understanding the significance of climate change.
Karen Clark: Sure. And perhaps a few words of background on the IPCC. IPCC was formed in 1988 as a collaboration between the United Nations and the World Meteorological Organization and the mission was to provide government policy makers with the current state of knowledge, with respect to climate change and to make, you know, potential recommendations for policy actions.
How they have implemented their mission is by producing reports. So, about every five or six years, starting in 1990, they'll produce a new set of reports with the most current science. To produce those reports, from early on, they had to reach out to the global scientific community to get volunteers, who would participate in the writing of those reports. So, I volunteered, and I was a lead author on some of the early chapters on the financial impacts of climate change.
So, I provided some modeling and also materials for those chapters discussing even way back then what could be the potential financial impacts. And many people may know that in 2007, the IPCC, along with Al Gore, received the Nobel Peace. And it was very kind of them, but what they did is they made replicas of the Nobel Peace Prize certificate that were personalized with people's names on it. I was one, some of the early contributors to those reports. So, that's how I personally was honored for my contributions to those early activities of the IPCC.
Tony Roth: Well, that's exciting, albeit you probably didn't get the call from Stockholm at 2:00 AM famously to wake you up and let you know about that. But it's still, I'm sure you have that very prominently displayed someplace. I certainly would. So that's really cool.
Your specialty is, when we think about the economic impacts of climate change, which is the broad rubric for the series that we're starting here, you focus on primarily a subset of that which is catastrophe. So, for example, you wouldn't focus on the gradual warming of the globe and the economic impact on for example, water resource utilization because the water's evaporating or so on and so forth. You’d rather would focus on the fact that climate change creates a higher incidence of fire or hurricanes or floods or those types of things. Do I have that that right?
Karen Clark: Yes, that's exactly correct. And the models are very sophisticated scientific tools, but they're designed to estimate the financial impacts from extreme events. And most of those extreme events that we deal with are weather related, hurricanes, tornadoes, winter storms, but also earthquakes and some other perils that are not weather related. It's interesting talking about the IPCC because as you know, in the early days of the study of climate change, it was very focused on the science and what's happening with sea surface temperatures, global air temperatures, these slow moving, phenomenon, how greenhouse gas emissions are influencing that. And it's only been relatively recently. Actually, I would say in the latest IPCC report, which was released in 2021 AR6, where the scientific consensus gave high confidence to climate change impacts on extreme events such as hurricanes, wildfires, and floods. And I think talking about the confidence level is very important because the science does have a lot of uncertainty around it. So, as I said, today we do have high confidence around climate change impacts on certain extreme events.
Tony Roth: When we had that series of hurricanes specifically probably around 10 years ago, we had Sandy and Irene all come up the East Coast, New York City. Of course, New York City became flooded in the lower part of the city, which hadn't happened in a century. I think it was at that time when people started to take stock of the reality that climate change was not only responsible for the broad warming of the planet, but also there might be a connection between climate change and the incidents of these more extreme events. And now of course you also have the prevalence of forest fires that you're seeing where we also believe there may be a connection. Does that all sound correct?
Karen Clark: Yes, absolutely. And early on there was a lot of confusion between weather and the climate, and I think we've gone beyond that now, so people understand that just because it's warmer you know, this February than it was, than average, or if it was colder, for example, doesn't mean there's no climate change and the impacts of climate change we know are not uniform around the globe. Some places are experiencing, for example, can experience more extreme floods, some less. But it is true as we discussed that more recently, there has been, a growing scientific consensus on the impacts of climate change on these extreme events.
Tony Roth: Let's start with the catastrophe modeling itself. What is it? How do you do it? what value does it have and to whom? Sounds like maybe insurance companies.
Karen Clark: Yes. Well, it is true that the primary users to date of catastrophe models are insurance companies. Because when you think about these multi-billion-dollar events, you mentioned Sandy and Irene, and we just had Hurricane Ian, that's likely to cause 50 to 60 billion dollars in insured losses.
So, when you think about these extreme events, a lot of the tab is picked up by insurance. So obviously they need to know what to expect, with respect to these events. I already mentioned that the models are, you know, scientific tools are based on science. They're based on engineering, and they're designed to estimate the financial impacts of these extreme events.
And more specifically, they focus on property damage. So, damage and loss to homes, to businesses, to other types of physical structures. So, we're really talking about the property damage, the physical loss from these events, and what was really unique about the models, the really powerful aspect of the catastrophe models is that they not only provide information on, say if a category five hurricane hits Miami, the loss would be, you know, certainly over a hundred billion dollars, the more important information provided by the models are the probabilities of those loss amounts. The models can estimate by geography, you know, how likely are we to have a hundred-billion-dollar hurricane in the Northeast versus Florida versus Texas? How likely are we to have a $20 billion loss, 30 billion, 40 billion all along the coastline?
And the models are very high resolution. So, you can actually take that all the way down to an individual location. So, the models actually produce expected loss estimates down to the individual property level.
Tony Roth: Essentially, what those companies are doing is they're summing all of those possible losses on a probabilistic basis, and then they're spreading their exposure over multiple years across their customer base.
Karen Clark: And also, geographically diversifying the risk. When you think about it, you know, insurance is very important. I mean, societies could not really develop and grow without insurance because you had hit it on the head: insurance spreads the risk. So, you pay a small premium every year for your homeowner's insurance, so you don't have to pay, you know, 500,000 dollars in one shot or a million dollars if your home is destroyed by a fire or by a hurricane. So, why they need the models is because they need to do a couple things. One, they need to make sure they're not overly exposed to one event.
So, you wouldn't want to write all your policies in Miami and then if that 500-billion-dollar event happens, you may end up having 50 billion dollars of that loss, which would make you insolvent. So, we want to make sure that insurance companies can stay solvent after these events. So, they need to spread the risks they need to make sure they're not overly concentrated.
And of course, everyone's favorite topic is they have to price the risk. Okay? So, they have to tell homeowners in Miami what they need to pay each year relative to someone, as you said, in Albany or on Long Island. And I know it may be hard to believe for some people, but really the job of the insurance industry is to make sure prices are fair, fair, and reasonable. So, if you live in a higher risk area, I think we would all agree, if you live on the coast of Miami, you probably should pay more than the person in Albany for hurricane insurance. So that's another important use of the catastrophe bottles is to distinguish, and actually put a number on that.
Tony Roth: One, one of the things that I find to be really counterintuitive, but very true and I get this from our financial analysts that I've spoken to, is that you might think that climate change is a disaster for insurance companies because they're going to be involved with a higher incidence of perils that come to fruition. But in fact, these folks are pretty smart that are running these insurance companies and they learned, and they realize that there's going to be a higher, uh, incidence of perils and a higher cost and they charge for it. And it actually creates more business for them as long as they manage the risk effectively. And it makes their enterprises more valuable to invest in. But in order to do this, they have to have the kind of information that you're able to furnish them. And they need to be able to have enough time to spread things over a long enough period of time so that when you do have three events in a short period of time, it doesn’t cause them to be insolvent.
But having that high fidelity information, which you guys are providing is really critical. What is the probability of these events today compared to what they used to be whether it be hurricanes or fires or floods? How has that changed and how frequently are you finding that you need to update these models because you're getting new scientific information that's really having a big change that needs to go to the insurance companies. And I'll just say anecdotally, I have a house on Cape Cod. It's actually a condominium, but I'm on the board. So, I see our insurance rates and they go up every year, even if we have five years in a row without having a hurricane, they just keep on going up. There's obviously a lot going on that the insurance companies are realizing that circumstances continue to change.
Karen Clark: Yes, since you brought up your premiums going up, I would like to explain that your premium goes up for two reasons. One could be the risk is going up, but the other dominant impact is the cost to replace your house goes up. So, a premium is really a rate times of value. You know, the cost to replace the same house today, you know, as it was even three years ago, it’s about 25% higher according to our studies. So, I think it's important for everyone to know that the premium is really a multiplication of a rate times the value of your home and not the market value, not the sales value, but the cost to replace it. And our studies have shown the cost the construction costs generally rise at about double the rate of inflation. So, insurance companies have to keep that current because you wouldn't want, let's say you, built a house for $500,000, but you know, a decade later it would cost you $750,000 to rebuild it. You would want to make sure your insurance covers that.
Tony Roth: Can I just ask you about one thing you just said? Cause it's very counterintuitive, which is that construction costs increase at double the rate of inflation. And I could see that being the case over a short period of time for example, lumber costs were up a hundred percent one year recently as a result of the pandemic and such. But I would think over a longer period of time, wouldn't you expect sort of reconstruction to keep place pace with inflation or is there something structural going on there that I'm not appreciating?
Karen Clark: What we built today is very different from what we built even 10 years ago if you think about the materials being used. We’re also hopefully making homes more resistant, you know, to these natural hazards. So, I think it's a combination of what we're building today, how we're building them, and how much that costs.
Tony Roth: Got it. So, for example, I build a house today I put a heat pump instead of an air conditioning and compressor and a heat pump costs twice as much and that's this new technology, things cost more. Okay. Thank you for clarifying that. I apologize for interrupting, but I just had to understand that. So, let's go to the climate change point around the probability and the incidents of these events.
Karen Clark: So, I will just point out again that the rising construction cost is really outpacing the influence of climate change to date, but let's talk about what, how much climate change is impacting your premiums. So, as I mentioned earlier, the scientific consensus is we have high confidence, hurricanes, floods, wildfires, what's happening with each. Hurricanes, we believe that they are not, it sounds counterintuitive again, but not so much increasing in frequency, but in severity. So, what's happening is we're seeing more major hurricanes, category three, fours, and fives. So, the proportion of major hurricanes is increasing over time.
The impact that has, I think is very interesting. We talk about extreme events and extreme losses, you know, up to a, say over a hundred billion we could have for a major hurricane, but what that increase in severity is really doing, it's increasing the frequency of major storms all along the coastline that may not be a Miami or a Galveston, Houston. So, it's really increasing the probabilities of 20, 30, 40, 50-billion-dollar losses. So we're seeing that with Ida, with Laura. You know, with many of the recent hurricanes we've seen. They're not, you know, the really extreme events because they're not hitting populated areas, and I think that's, oh, you mentioned real estate.
My favorite saying, I will say Tony is, hurricanes are like real estate. It's location, location, location. Hurricane Michael hit the Florida panhandle in 2018, it cost about 15 billion. That same storm would've hit Miami. It would've been 150 billion. So, it, it's really about location. What we're seeing is we're seeing more intense storms hitting not our most populated areas along the coast, but our more moderately populated areas and that's pushing up the 20 30, 40 billion.
Tony Roth: but there's nothing about the science if you will. I mean, we had Katrina hit New Orleans, of course. Right? So, any of these storms could hit the big, populated areas. It's just a, it's just a matter of time, right?
Karen Clark: Oh, yeah. Absolutely. It's just a matter of time. But the, so the probability of that a hundred billion is going up, but the probability of 20, 30, 40 billion events is going up more. It’s going up faster because more places along the coastline where we can have those size losses from major storms.
Tony Roth: Overall, how more frequent do your models tell us these storms are, these perils, the incidents of these perils?
Karen Clark: Well, it’s a little shocking for hurricanes, I would say. It even shocks me when I look at the numbers because they just grow so fast. Because people are moving to the coastlines, you know, we're building bigger homes, right in harm's way. They cost more to build. Rough rule of thumb were like doubling the lost potential every 10 years. It use to be, you know, a hundred-billion-dollar losses were about a one in a hundred, but now that's down to about one in 50. Okay, so we should expect about one in 50 hurricane loss over a hundred billion. That's about a 2% probability. And we're seeing, these 20 billion losses are more like every five years. It goes up faster than you would think.
Tony Roth: Okay. So, Fair to say then that if I live in Miami, there's a 50% greater chance that there's going to be a hurricane five storm than there was 50 years ago. Can you conclude something like that?
Karen Clark: The dramatic change is really in the losses, again, which is a combination of the science and more dominated by the increase in property values. So, what you could say is that, not necessarily a cat five, but the probability of a major hurricane three, four or five, it's not 50% higher, but it’s a much smaller percentage higher all along the coastline than it was, and I wouldn't say 10 years ago, I would say in the last century. You know, our hurricane data goes back to 1900. And we normally extrapolate from all that data. But now what we have to do, not to go too much into the weeds, but we, to build our models, we have to go back and take all that historical data and adjust it to say, okay, if those events happened in the current climate, what would our probabilities look like?
It's kind of like, if you had a hundred dollars in 1950, what would that be worth today? So, it's kind of the same type of methodology. So that's not going up by 50%. In fact, it may be surprising after this conversation, but we estimate that on average, the average loss is from hurricanes, from the change from climate change is about 1% per year. But again, it's multiples of that for the increase in property values that are being built in harm's way. So, with hurricanes, we've quantified it as about 1% increase every year that were seen from these impacts of more severe. Now for wildfire, wildfires are being more significantly impacted by climate change.
Tony Roth: So, if the current rate of increase remained from today to 50 years from now, roughly speaking and ignoring compounding, the chance of having a big event 50 years from now would be 50% higher than it would be today?
Karen Clark: I mean big event is too vague. The expected loss from hurricanes grows by 1% a year just due to climate change.
Tony Roth: Not including the fact that size of the loss is greater because construction's growing at twice the rate of inflation.
Karen Clark: Exactly and the probability change by event. Now that varies along the coastline.
Tony Roth: Okay, so now if you bring fire into the equation and we are all aware that the fires in California have been much more prevalent than we're ever used to previously. That is something that is happening much more frequently as a result of climate change just in the last decade. Is that correct in your estimation?
Karen Clark: Yes, that is correct. Of all, of all the perils that we model, wildfire is the most sensitive to climate change, and we're already seeing the most increase in both the frequency and the severity, i.e., the size of wildfires is increasing much faster than for example, the increase in hurricane intensity. Here we see the, the increases are much more significant. If we're going out your time period, you know, we would see more like a hundred percent increase in losses, not the 50%.
And one of the things we do to look into the future, I didn't mention this earlier, is the IPCC in their reports, they do project out things like temperatures, you know, but not only that, but this variable I call vapor pressure deficit, which they can project out to 20 25, 20 30, and 2050. They can go beyond, but the uncertainty becomes too large, we believe to go beyond to 2050.
But we can use our models and the science collected by the IPCC to project what wildfire losses will look like in 2050. And as I said, there, we see a much faster increase in the loss potential than we see for hurricanes.
Tony Roth: I've certainly read in the LA times that there are numerous situations of regions where property owners can no longer obtain fire protection insurance. Why is that? I remember when I was a kid, you know, Lloyds of London would insure anything as long as you wanted to pay the premium. What's going on there?
Karen Clark: Yeah, well, what a lot of people don't understand is insurance is highly regulated. Okay? It's regulated by the states and particularly homeowners’ insurance. So, insurers cannot do whatever they want to do. They can't charge whatever they want to charge. They have to get rate increases approved. And they have make sure they comply with the regulations of different states. California, believe it or not, has decided for one thing, that they will not allow the catastrophe models for wildfire, which is interesting because they are used there for earthquakes. And I won't opine on the reason for that, as I mentioned, insurance companies need the catastrophe models, not just to price the risk, but to spread the risk. No homeowner would like it if their insurance company wrote all their policies in an area that were all going to be destroyed from a wildfire. The company goes bankrupt, the homeowner doesn't get paid.
Tony Roth: These are commercial businesses, right? They can look at whatever they want. I mean, it'd be sort of like saying to me that I'm not allowed to look at the, you know, private research services forecast on inflation in order to invest. Can an insurance company not reach out to Karen and purchase a catastrophe, you know, probability model on having, you know, the hills of Los Angeles burn to the ground. I mean, how is that not allowed?
Karen Clark: Okay, so if you want to, if I want to say I want to use the KCC model, to determine, you know, how much I need to charge homeowners to make sure I remain solvent and I'm being fair and reasonable, I have to file my rates with California and I have to tell them that I've used a catastrophe model. And to date, they will say, well, no, you can't use a catastrophe model. So, you have to develop your rates some other way. And I know it sounds like a long time ago, but in the world of insurance, the catastrophe models came to be in the late 1980s.
But actuaries have been traditionally for, you know, over a hundred years, been estimating rates based on historical experience. So, the actuarial approach will be, let's look at the last 10 years of experience, or 20 years, whatever they have, but you can't look at historical experience, especially when you have climate change, you have other things changing in the environment and you need to use a model. So, the regulators in any state can say, no, you can't base your rates on a model, and that's what they've done in California so far. Now, of course, we're meeting with the regulators. We're trying to change that, and I think we will over time because again, the models are very sophisticated. They help the states make sure that the companies remain solvent, that they're being fair, you know, and equitable among policy holders. I mean, again, I think policy holders do want, you know, that people who have higher risks should pay more. Now, if you want to subsidize, you can, but you should start with the, with the true, uh, risk-based premium.
Tony Roth: So, so Karen, what is the situation as you understand it today in California, we have lots of listeners that are in California, that might own homes, in wooded or forested areas, particularly around some of these big cities. I would imagine their ability to get a mortgage is going to be contingent on their ability to get property and casualty insurance that covers all the major perils, which clearly includes fire. So, does this mean that today in certain areas of California people can't get mortgages probably because they can't get the, the underlying P&C insurance that the borrower would require. Is that sort of what's happening?
Karen Clark: Well, I wouldn't say it's happening across the board, but obviously there are some very high-risk areas where I'm sure that is the case, but there are things we should talk about, Tony, that homeowners can do. One of the things that the state of California is promoting are what they call mitigation credits. Okay. So, if a homeowner undertakes some mitigation efforts, they can get credit for that, and hopefully, you know, have a better opportunity at getting the insurance. So, what are things homeowners could do for wildfire? Well, probably the biggest thing is defensible space. Okay. You don't want like dried up trees and you know, things that are combustible near your house. You need to clear all that vegetation. You make what's called a defensible space. Making sure, embers can't get into your eaves, more fireproofing materials, so there are, mitigation efforts that homeowners can take that will hopefully help them. And again, California is supporting that and making sure that they do get credits in their premiums for these activities.
Tony Roth: When one buys a home and they finance the home and they take out a mortgage, that mortgage could be for 30 years. And I wonder whether or not the lenders are taking into account today. You think the lenders would need to have catastrophe models in order to protect themselves because it may well be the case that at some point in the life of that loan, the insurance companies will stop writing the insurance on the property like, what's happening in California with respect to fires. I imagine the same thing could happen in Florida with respect to hurricanes if the incidents were to increase, and that would essentially mean that the lender was unprotected. Have you thought about selling your catastrophe models to banks because, you know, people that, essentially people that are extending capital and securing it with property?
Karen Clark: Well, we do actually, we do have some major banks as our clients. The in main interest so far has been earthquake and flood. And why is that the case? Well, the interesting thing is for hurricane and wind, you have to buy insurance. Okay? So, everybody like the bank, you're going to have insurance. So, if the home you have a mortgage on goes back, you're going to have an insurance policy to cover it. But the interesting thing, and this is true about California, most of the major perils are either uninsured or underinsured. So, earthquake, there's not a lot of private insurance for earthquake. Um, and the policies you can get through the fair plan are very limited, you know, in terms of cover. So, there's a lot of interest in earthquake and also flood, flooding losses. So, there hasn't been as much interest yet in wildfire, but I assume it will come. And again, because banks are coming to realize that they also have exposure, to many of these perils.
Tony Roth: to ask one last question for, for our, our clients that either own or are considering purchasing property in the hurricane areas are there considerations around insurability in your mind going forward or are there rules that require if you're going to do business in the state, you have to be able to offer, you're required to offer p and c to homeowners for, um, the things that banks require, such as hurricane and flood and such.
Karen Clark: Well, the interesting thing on hurricane in the coastal area is that what, most states have done, this includes Florida, Louisiana, is that they've created a state-owned insurance company. So, in Florida it's called Citizens. If you can't get insurance in the private market, you can buy a policy through Citizens. Which may be okay. The coverage is probably, I'm sure is not as good as a private market. I will say high valued homeowners they normally can get insurance in the private market. You know, even though you have insurance, Tony, nobody wants their house to be destroyed by hurricanes. So, I think the advice I would give to homeowners is if you're buying a new house or certainly, if you're building a house, make sure you build it to even above the current building codes.
But building codes have improved. There's an organization called the Institute for Business and Home Safety, sponsored by the insurance industry, and they have something called a fortified home. So, they can tell you how to make your home fortified and how you can build it. Now, it's going to cost you a little bit more to build, you know, a less vulnerable home but it'll pay off on the long run with, you know, reduced premiums, but also, you know, I mean the hardship, the pain and suffering, if you have significant damage to your home or your community, basically, obviously outweighs, outweighs all of that. So, I would just encourage people to make sure that you know, the home is built to, I would say, even above standard, you know, above the minimum standard.
Tony Roth: I think that the takeaway really is just to have to be very cognizant of the risks and the perils and the financial costs of carrying that property, properly, if you will, in light of those in light of those risks over a long period of time, really need to be thought through at the outset. Because the incidents, whether it's growing at 1% a year or the overall reconstruction costs, you know, double inflation, which is at this 7% or 8% a year at least they really are going to add up over time.
Unfortunately, climate change seems to be accelerating, not becoming, invisible. For individuals and homeowners that really want to live in those areas, just have to be very thoughtful and have a long-term perspective, I think and make sure you're prepared for those long-term costs to carry that. That's probably the best advice that we could give. Would you agree with that?
Karen Clark: I definitely believe in looking at the long run and thinking about rising risk and yes making sure you're prepared for it, for sure.
Tony Roth: Well, thank you so much. Karen. It’s been a great episode.
Tony Roth: I want to remind all of our listeners that this is the first of a number of episodes that we're going to have on the economic impacts of climate change. We'll have mixed other episodes in there, but we'll identify the episodes when they do fall under thisparticular umbrella. And lastly please go to Wilmington Trust.com for a full roundup of our latest thoughts on the economy in the markets.
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