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.

With each passing year, it is becoming increasingly clear to mortgage credit investors that climate change is emerging as a non-trivial risk factor that must be accounted for. Questions around how precisely to account for this risk, however, and who should ultimately bear it, remain unanswered. 

Current market dynamics further complicate these questions. Late last year, Politico published this special report laying out the issues surrounding climate risk as it relates to mortgage finance. Even though almost everyone agrees that underinsured natural disaster risk is a problem, the Politico report outlines several forces that make it difficult for anyone to do anything about it. The massive undertaking of bringing old flood zone maps up to date is just one example. As Politico puts it: 

The result, many current and former federal housing officials acknowledge, is a peculiar kind of stasis — a crisis that everyone sees coming but no one feels empowered to prevent, even as banks and investors grow far savvier about assessing climate risk. 

At some point, however, we will reach a tipping point – perhaps a particularly devastating event (or series of events) triggering significant losses. As homeowners, the GSEs, and other mortgage credit investors point fingers at one another (and inevitably at the federal government) a major policy update will become necessary to identify who ultimately bears the brunt of mispriced climate risk in the market. Once quantified and properly assigned, the GSEs will price in climate risk in the same way they bake in other contributors to credit risk — via higher guarantee fees. For non-GSE (and CRT) loans, losses will continue to be borne by whoever holds the credit risk.  

Recognizing that such an event may not be far off, the GSEs, their regulator, and everyone else with credit exposure are beginning to appreciate the importance of understanding the impact of climate events on mortgage performance. This is not easily inferred from the historical data record, however. And those assessing risk need to make informed assumptions about how historically observed impacts will change in the future. 

The first step in constructing these assumptions is to compile a robust historical dataset. To this end, RIskSpan began exploring the impact of certain hurricanes a few years ago. This initial analysis revealed a significant impact on short-term mortgage delinquency rates (not surprisingly), but less of an impact on default rates. In other words, affected borrowers encountered hardship but ultimately recovered. 

This research is preliminary, however, and more data will be necessary to build scenario assumptions as climate events become more severe and widespread. As more data covering more events—including wildfires—becomes available, RiskSpan is engaged in ongoing research to tease out the impact each of these events has on mortgage performance.  

It goes without saying that climate scenario assumptions need to be grounded in reality to be useful to credit investors. Because time-series data relationships are not always detectable using conventional means, especially when data is sparse, we are beginning to see promise in leveraging various machine learning techniques to this end. We believe this historical, machine-learning-based research will provide the backbone for an approach that merges historical effects of events with inputs about the increasing frequency and severity of these events as they become better understood and more quantifiable. 

Precise forecasting of severe climate events by zip code in any given year is not here yet. But an increasingly reliable framework for gauging the likely impact of these events on mortgage performance is on the horizon.