Rising Home Equity Increases Demand For Flood Insurance, Research Finds

Large disasters like floods can be financially devastating for many Americans, as these disasters increase the rate of missed mortgage payments and mortgage default, as well as the likelihood of home foreclosure. Still, millions of flood-prone properties remain uninsured for flood damage, exacerbating the mortgage system's vulnerability to natural disasters.

A new working paper by scholars at Resources for the Future (RFF) and the Wharton Risk Management and Decision Processes Center at the University of Pennsylvania analyzes one critical cause of this flood insurance demand gap: home equity. The authors find that as home equity increases, so too does the demand for flood insurance.

The authors isolate the impact of home equity on flood insurance demand by focusing on the housing boom-and-bust cycle of the 2000s. During this cycle, changing land values spurred variation in housing markets independent of changes in flood risk or economic fundamentals, like productivity or demographics.

"The first thing we see is that flood insurance take-up indeed increases more in high boom markets when compared to low boom markets," RFF Fellow and paper co-author Yanjun (Penny) Liao said. "But more importantly, we're able to estimate how flood insurance take-up changes over time in response to that shock."

The researchers find that flood insurance adoption follows home prices closely, with a 1 percent increase in housing prices leading to a 0.3 percent increase in flood insurance demand. They note that the magnitude of home equity's effect is comparable to other factors, such as insurance premiums and flood events in shifting flood insurance demand.

As disaster risk is predicted to increase over the coming decades, homeowners must decide between purchasing insurance or risking mortgage default following a flood. The study's findings indicate that many households vulnerable to floods will not choose to insure due to the expense, meaning that some of their losses will be assumed by the larger housing finance system, the government-sponsored enterprises (GSE) that securitize mortgages, and the taxpayers that support them.

The authors suggest two policy interventions that follow from these implications:

* Mortgage purchase requirements could be expanded to include high-risk locations that are not classified as Special Flood Hazard Areas by the Federal Emergency Management Agency (FEMA), for homeowners and lenders to better internalize their flood risk.

* GSEs could themselves start pricing the risk of disaster-induced default, improving lenders' incentive to require borrowers to maintain flood insurance.

"Recently, we have seen promising steps taken by federal agencies such as FEMA and the Federal Housing Finance Agency to assess climate and disaster risk, which reflects their attention to this issue," Liao said. "I think it would be very interesting to see where these efforts take us eventually."

To learn more about the findings, read the working paper, "What's at Stake? Understanding the Role of Home Equity in Flood Insurance Demand," (https://www.rff.org/publications/working-papers/whats-at-stake-understanding-the-role-of-home-equity-in-flood-insurance-demand/) by RFF Fellow Yanjun (Penny) Liao and Wharton Applied Economics PhD student Philip Mulder.