Flood Insurance Changes: What Mortgage Investors Need to Know

Major changes are coming to FEMA’s National Flood Insurance Program on April 1st, 2021, the impacts of which will reverberate throughout real estate, mortgage, and structured finance markets in a variety of ways. 

For years, the way the NFIP has managed flood insurance in the United States has been the subject of intense scrutiny and debate. Compounding the underlying moral hazard issues raised by the fact that taxpayers are subsidizing homeowners who knowingly move into flood-prone areas is the reality that the insurance premiums paid by these homeowners collectively are nowhere near sufficient to cover the actual risks faced by properties in existing flood zones. 

Climate change is only exacerbating the gap between risk and premiums. According to research released this week by First Street Foundation, the true economic risk is 3.7 times higher than the level at which the NFIP is currently pricing flood insurance. And premiums would need to increase by 7 times to cover the expected economic risk in 2051. 

A New York Times article this week addresses some of the challenges (political and otherwise) a sudden increase in flood insurance premiums would create. These include existing homeowners no longer being able to afford the higher monthly payments as well as a potential drop in property values in high-risk areas as the cost of appropriately priced flood insurance is priced in. These risks are also of concern to mortgage investors who obviously have little interest in seeing sudden declines in the value of properties that secure the mortgages they own. 

Notwithstanding these risks, the NFIP recognizes that the disparity between true risk and actual premiums cannot continue to go unaddressed. The resulting adjustment to the way in which the NFIP will calculate premiums – called Risk Rating 2.0 – will reflect a policy of phasing out subsidies (wherein lower-risk dwellings absorb the cost of those in the highest-risk areas) and tying premiums to the actual flood risk of a given structure. 

Phase-In 

The specific changes to be announced on April 1st will go into effect on October 1st, 2021. But the resulting premium increases will not happen all at once. Annual limits currently restrict how fast premiums can increase for primary residences, ranging from 5%-18% per year. (Non-primary residences have a cap of 25%). FEMA has not provided much guidance on how these caps will apply under Risk Rating 2.0 other than to say that “all properties will be on a glide path to actuarial rates.” The caps, however, are statutory and would require an act of Congress to change. And Members of Congress have shown reluctance in the past to saddle their constituents with premium spikes. 

Phasing in premium increases helps address the issue of affordability for current homeowners. This is equally important to investors who hold these existing homeowners’ mortgages. It does not however, address the specter of significant property value declines because the sale of the home has historically caused the new, fully priced premium to take effect for the next homeowner. It has been suggested that FEMA could blunt this problem by tying insurance premiums to properties rather than to homeowners. This would enable the annual limits on price increases to remain in effect even if the house is sold. 

Flood Zones & Premiums 

Despite a widely held belief that flood zone maps are out of date and that climate change is hastening the need to redraw them, Risk Rating 2.0 will reportedly apply only to homes located in floodplains as currently defined. Premium calculations, however, will focus on the geographical and structural features of a particular home, including foundation type and replacement cost, rather than on a property’s location within a flood zone.  

The Congressional Research Service’s paper detailing Risk Rating 2.0 acknowledges that premiums are likely to go up for many properties that are currently benefiting from subsidies. The paper emphasizes that it is not in FEMA’s authority to provide affordability programs and that this is a job for Congress as they consider changes to the NFIP. 

“FEMA does not currently have the authority to implement an affordability program, nor does FEMA’s current rate structure provide the funding required to support an affordability program. However, affordability provisions were included in the three bills which were introduced in the 116th Congress for long-term reauthorization of the NFIP: the National Flood Insurance Program Reauthorization Act of 2019 (H.R. 3167), and the National Flood Insurance Program Reauthorization and Reform Act of 2019 (S. 2187) and its companion bill in the House, H.R. 3872. As Congress considers a long-term reauthorization of the NFIP, a central question may be who should bear the costs of floodplain occupancy in the future and how to address the concerns of constituents facing increases in flood insurance premiums.” 

Implications for Homeowners and Mortgage Investors 

FEMA is clearly signaling that NFIP premium increases are coming. Any increases to insurance premiums will impact the value of affected homes in much the same way as rising interest rates. Both drive prices down by increasing monthly payments and thus reducing the purchasing power of would-be buyers. The difference, however, is that while interest rates affect the entire housing market, this change will be felt most acutely by owners of properties in FEMA’s Special Flood Hazard Areas that require insurance. The severity of these impacts will clearly be related to the magnitude of the premium increases, whether increase caps will be applied to properties as well as owners, and the manner in which these premiums get baked into sales prices. 

Mortgage risk holders need to be ready to assess their exposure to these flood zone properties and the areas that see the biggest rate jumps. The simplest way to do this is through HPI scenarios based on a consistent view of the ‘affordability’ of the house — i.e., by adjusting the maximum mortgage payment for a property downward to compensate for the premium increase and then solving for the drag on home price.