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With unprecedented increases in floods combined with homeowners' low flood insurance enrollment rates, mortgage lenders need to anticipate and mitigate the consequences.
Why do mortgage lenders require flood insurance from homeowners?
Homeowners are required to buy flood insurance if they take out a mortgage from a lender that is federally regulated or insured and purchase a home in a high-risk flood zone. The underlying reason for such a requirement from mortgage lenders is that when a property is financed, the lender has a greater financial stake in the property than the borrower. Indeed, if one of the lender's assets is damaged by floodwaters and the borrower leaves the home (and stops making the relevant mortgage payments), the lender finds himself in a losing position. Ultimately, to mitigate the risk, lenders require the homeowner to purchase flood insurance.
When is a mortgage lender required to get a new determination on a property?
Regulators require that each time a bank makes, increases, or renews a loan it must determine whether the improved property is in a special flood hazard area. However, there are very particular circumstance in which an existing flood determination can be relied upon. Firstly, the flood determination must be less than seven years old. Secondly, the flood map, which is used by mortgage lenders to determine if a property is in a special flood hazard area, and its status must not have changed. Lastly, the determination must have been prepared on the standard flood hazard determination form.
How does a mortgage lender calculate the appropriate amount of insurance?
To properly evaluate the amount of insurance to be paid by a future homeowner, the relevant mortgage lender compares three values. To determine the first value, the lender looks at the maximum amount of insurance available under the NFIP (The National Flood Insurance Program), which provides flood insurance to property owners, renters, and businesses. For example, for a multi-family, residence the maximum amount under the NFIP is $500,000, whereas for a non-multi-family residence the amount decreases to $250,000. To determine the second value, the mortgage lender estimates the insurable value of the property. The third value is the principal loan amount outstanding. The lesser of the three values, analyzed by the mortgage lender, is the minimum required amount of coverage.
Limited flood insurance coverage from homeowners poses a risk management challenge for mortgage lenders
There is an important flood insurance gap in the United States, where many people who are exposed to flood risk are not covered by flood insurance. Indeed, it is estimated that only 5% of single-family homeowners in the US have flood insurance. More troubling, in some of the Midwestern states, the rate of coverage among homeowners is as low as 1% to 2%. In addition, recent floods inflicted by storms such as Hurricane Harvey have brought about the issue of high uninsured rates. According to data from the Insurance Information Institute, in August 2016, just 15% of the 1.6 million homes in Harris County, Texas, had flood insurance and only 28% of the homes in high-risk areas for flooding. Consequently, limited coverage from homeowners poses longstanding consequences for mortgage lenders, particularly from a risk management perspective.
Mortgage lenders calculate the amount of insurance to be paid by future homeowners based on a contentious rating methodology used by the NFIP
The NFIP, the primary provider of residential flood insurance, has over the years been criticized by industry experts and consumer protection groups regarding its rating methodology. According to private flood insurer Poulton Associates and geospatial scientists at Hazard HubIndeed, the lowest third of the per-capita income group paid proportionately higher premiums than the upper two per-capita income groups, over the last nine years. Furthermore, the methodology used by the NFIP has not only been criticized with regards to premiums but also concerning approved claims. Indeed, according to the NFIP own data, 48% of total claims arising from the top three income groups (with household income over $106,000) were approved, whereas only 15.5% of claims were approved, for the three lowest income categories.
Mortgage lenders need to review their risk assessment process when evaluating their loans portfolio
With unprecedented increases in floods and other natural disasters over the last decade in both coastal and inland communities, mortgage providers have failed to fully incorporate these new variables in the risk assessment process of their mortgage portfolio. Indeed, according to the Task Force on Climate Related Financial Disclosure (TCFD) created by the Financial Stability Board, climate risk has become a financial risk for banks with long standing consequences to its assets, if not incorporated in their risk modeling. According to a recent study from Fannie Mae, in the two years following Hurricane Harvey, the probability of mortgage borrowers needing a loan modification increased significantly, as did the odds of a loan being 180 days or more delinquent or in default. Ultimately, mortgage lenders must urgently address the growing correlation between increased floods and a higher probability of their mortgage loans defaulting.
Mortgage lenders need to prepare for increased regulatory oversight
Financial institutions are under growing regulatory pressure to protect themselves from the consequences of climate change, including natural disasters (floods). Indeed, regulators around the world, including the SEC, are now crafting new laws for climate-risk management and intend to introduce challenging stress tests for lending institutions. Even though some lending institutions have made a start, many must still provide strategies, build their capabilities, and create coherent risk-management frameworks. Ultimately, the consequences of climate change, including the multiplication of floods, will produce more thorough supervision of risk modeling from regulators, posing longstanding consequences on lending institutions.
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