The best protection for flood risk is an educated borrower

Mortgage lenders can take some proactive steps to mitigate risk when lending in areas that have a high chance of hurricane-related flooding. But climate change has affected areas not previously seen as being prone to water damage, for example, the recent deadly flooding in Kentucky.

Also, borrowers still want to live in these high risk locales.

The 50 counties with the largest percentage of homes facing high flood risk reported an average population increase of 1.9% from 2016 through 2020, a recent Redfin report found.

“When people decide where to live, they consider a whole host of things ahead of climate change, which has potential implications on their safety, home stability, and finances,” Redfin Chief Economist Daryl Fairweather said in a press release.

The median sale price of homes with high flood risk was $402,010 in the first quarter, compared with $353,783 for homes with low flood risk, Redfin said.

Analytics firm dv01, which tracks non-qualified mortgages (among other types of private label securities) issued its first-ever report on the non-QM market’s exposure to environmental, social and governance risks. This study looked at 58,575 active non-QM loans, with a total balance of $24 billion outstanding. Out of these figures, 30,993 loans and $13 billion outstanding provided the necessary criteria for ESG assessment.

Using the Federal Emergency Management Agency’s National Risk Index, dv01 determined that 72% of the non-QM loans they assessed are in areas defined as high to very high for environmental risk of any type.

Riverine flooding, when rivers and creeks overflow their banks, is the biggest environmental risk with $6.8 billion or 54% of assessed outstanding balance exposed. Hurricane risk is high-to-very high in 14%, coastal flooding in 15% and wind in 18%. A property can have more than one type of risk.

Lenders haven’t gotten to the point “where the decisions around ESG and climate are front of mind,” said Vadim Verkhoglyad, co-head of research and publication at dv01. “And I do think that will become a little bit more salient, especially after this current market volatility.”

The environmental part of ESG is not just risk, he noted, but also positive items like homes that use renewable energy.

“The markets are very, very new in the way they address ESG frameworks, and we’re trying to anchor the idea that there’s a data driven process that is there for opportunities as well as risks,” said Verkhoglyad.

A lot of market participants found it was hard to gauge what their portfolios look like when it comes to this subject, added Sam Hillier, dv01’s director of ESG.

“So, hopefully, this piece will give that framework and that reference point for the market in terms of what the ESG profile looks like for everybody,” Hillier explained.

Federal housing policy makes it clear that lenders cannot simply redline these areas when making mortgage loans.

The primary way for lenders to mitigate underwriting risk for these properties is to strongly encourage consumers to obtain flood insurance policies. Many areas that might have been seen as obvious for inclusion in a flood zone had not been mapped as such, and that will change with FEMA’s Risk Rating 2.0. Critics of the flood insurance program note it has significantly undercharged for the risk it assumes. The remapping is designed to make the program more actuarially sound.

In the case of hurricanes, two particular risks that have different implications are in play: flood and wind, said Howard Botts, chief scientist at CoreLogic. While external water damage is not covered by homeowners’ policies, in most areas wind damage is.

Increasingly CoreLogic is finding that homes are underinsured relative to what the replacement costs are. This is because insurers turn to the homeowner to get an estimate of value.

“And in the absence of knowing that, often a very low number is used,” said Botts. “I think what is critical for the lender is to really understand beyond the automated valuation model or some other metric of the property, to really understand the structure itself and what it would cost to replace it.”

The borrower determines the amount of coverage, and the lender has no say, which is a problem, said Pat Howard, a licensed property and casualty insurance expert at insurtech Policygenius.

Climate change is on the minds of younger homeowners, with 72% between the ages of 18 and 34 expecting their homes to be damaged by extreme weather in the next 30 years, a recent Policygenius survey found. This is compared with nearly half (45%) of all adult homeowners.

Nearly two in three (64%) young homeowners believe it likely they will choose or be forced to move due to climate change-related extreme weather in the next 30 years, compared to 27% of all homeowners.

So lenders need to “on a just simple basic level, communicate with the borrower before they extend these loans to them, is to just make sure that the home is insured up to its full rebuild cost, or its replacement costs,” Howard said.

The survey found that 33% of homeowners realize that they do not have enough coverage. Only 21% have a flood policy.

“You’re seeing these unforeseen ways that climate change has reared its head and I think people are finally noticing it all over the country,” Howard said. “And I guess if there’s one positive that I took away from this survey is that a lot of younger homeowners understand the risks and they seem to be doing a better job of protecting their home.”

At the same time, homeowners are trying to keep costs down and they might not purchase enough coverage, or get a policy with a high deductible. The problem with that is if they do need to make a claim, they lack the funds to pay that deductible.

And that could be bad news for the lender and servicer.

“If somebody has very low equity in the home and is uninsured or underinsured from it, often people make the calculation ‘I’m better to walk away than I am to try to repair the property’ and they just don’t have the assets,” CoreLogic’s Botts said.

Delinquency rates increase in these areas following a hurricane between property damage and job loss, with Botts pointing to recent events in Houma and Lake Charles, Louisiana.

“Mortgage companies, banks and others that are issuing mortgages need to understand the risk, and then make sure that homeowners are aware of that risk and insured to that risk,” Botts declared.

In his opinion, with climate change putting a lot of stress on the financial system, the government is going to create requirements for not only looking at financial risks, but also looking at natural hazard risk as part of a loan assessment.

Tackling the issue of climate change head on for investor properties, Incenter Insurance Solutions has just rolled out a new unit, Lender Insurance Services.

It has two functions: looking at real estate investment portfolio reviews of existing insurance, and providing specialty insurance products for short-term opportunities, such as fix and flips.

“The whole point of our product offering is to bring some insurance experience into the lender-insurance process,” said Royce Yeager, the director of Lender Insurance Services. “The mortgage loan officers, mortgage professionals, they are great at what they do on the mortgage side, but they don’t have in depth expertise on the insurance side.”

While the lender is initially the client, if the borrower needs to obtain insurance, they then become the customer. Insurance agents have a fiduciary duty to their clients if they need to obtain a policy, Yeager pointed out

“But we still have that open line of communication between us and the lender involved in the process,” Yeager said. “And it’s basically just an extra awareness and extra capability to do things from the lender’s perspective.”

Investment properties have different needs than those that are owner-occupied. Renters, while doing their utmost to protect themselves in the event of a natural disaster, do not have the same emotional ties to a property.

“We do engage with the borrower as much as the lender would like us to and we can have those discussions about well, you know, you may not be in a flood zone, but you’re not far from this body of water or are you familiar with the geography of the area?” Yeager said.

And it is cheaper to obtain flood insurance if a property is not considered to be in a flood zone. But Risk Rating 2.0 will significantly shift the maps with some properties currently in an “X” category — where flood coverage is not required — shifted into high risk zones.

“As a longtime insurance broker and consultant, I always encourage people to think about practical measures to prevent loss,” Yeager said. “The reality is if you’re making an insurance claim, it’s your last resort, the worst thing that could possibly happen has happened.”