Low Home Equity Depresses Flood Insurance Take-up

Views and opinions expressed are those of the authors and do not necessarily represent official positions or policy of the OFR or Treasury.

New OFR Working Paper Shows Low Home Equity Depresses Flood Insurance Take-up

University of Wisconsin – Madison professor and affiliated OFR researcher Philip Mulder sought to understand why millions of U.S. homeowners with flood-prone properties don’t have flood insurance. In “What’s at Stake? Understanding the Role of Home Equity in Flood Insurance Demand,” Mr. Mulder and co-author Yanjun Liao explain how they arrive at one reason—low home equity depresses flood insurance take-up. Understanding why so few homeowners insure their flood risk is important for understanding how increasing flood risk could affect financial markets, particularly by exposing the mortgage system to risks from upticks in delinquencies and defaults.

The Pattern of Insurance Take-up Closely Follows That of House Prices

The authors find a direct relationship between home prices and flood insurance take-up. To isolate the causal effect of home equity on flood insurance demand, they exploit price changes over the housing boom and bust of the 2000s and early 2010s. They find that the dynamic pattern of insurance take-up closely follows variation in home prices. Insurance take-up and home prices peak around the same time—three years after the start of the boom—before declining.

The authors find a large, positive relationship between home prices and flood insurance take-up during the boom cycle of 2003-05. For example, a one-standard-deviation increase in the initial boom size was associated with 5 percent higher flood insurance take-up at the peak. Insurance take-up during the housing bust declined the most for homes built at the peak of the boom, a group that was highly leveraged with little home equity at the market’s low.

Mortgage Default Can Insure Households Against Climate Shocks, Albeit at the Social Cost of Reducing Incentives to Buy Insurance or Otherwise Lower Risk

Leveraged homeowners have less incentive to purchase flood insurance policies because mortgage default provides a form of implicit insurance that shifts some of their losses to lenders and investors. A natural disaster is a classic example of the sort of double-trigger events—simultaneous income and equity shocks—that are the main drivers of mortgage default. For highly leveraged households, the option of mortgage default or bankruptcy after a disaster can act as a high-deductible substitute for formal insurance.

The relationship between home prices and flood insurance demand is strongest in states with stronger mortgage borrower protections and in high-risk areas outside the floodplain where lenders do not require leveraged homeowners to carry flood insurance. As a result, disaster losses in such areas can spread to the investors who ultimately hold uninsured borrowers’ mortgage debt.

As disaster risk increases over time, more homeowners will face the choice between purchasing insurance or risking default after a flood. This working paper (link to WP) provides the first evidence of a causal relationship between home equity and flood insurance demand, with the key factor being that leveraged households with little home equity are less likely to insure. This means that the broader housing finance system, the GSEs that securitize mortgages, and the taxpayers who support GSEs will all ultimately bear some of such households’ losses. These results have important implications for understanding the likely impact of climate change on housing and mortgage markets.