As regulators in the U.K., Europe, and U.S. have proposed additional disclosure requirements on sustainability and climate-related activities, more and more companies have paid greater attention to understand and measure their climate-related exposures or even incorporate climate risk drivers into their stress testing and underwriting models for capital management and decision-making purposes.
Specifically, capturing credit exposures of mortgage portfolio to physical risk,1 such as cyclones, hurricanes, or floods, and mitigating those risks subsequently, pose significant importance to GSEs (Government-Sponsored Enterprise), banks, and mortgage lenders. In this article, we will discuss why it is important to leverage flood insurance data in physical risk modeling and the key challenges to quantify the impact of flood risks on mortgage loan behaviors (i.e., default, prepay, and losses).
What is a flood insurance program?
In the U.S., flood risk is covered through a policy from FEMA's National Flood Insurance Program (NFIP), created by Congress in 1968. Flood insurance is mandatory for buildings located in a Special Flood Hazard Area (SFHA2), but optional otherwise. Historically, the highest NFIP payouts belong to Hurricane Katrina in 2005 at $16.3 billion, followed by Hurricane Harvey in 2017, at $8.9 billion.
How can a flood event affect your mortgage book behavior?
In the area damaged by flood events, one would expect to see an instant spike in delinquency rates. That is because homeowners will have to repair significant damages or even rebuild their properties while paying rent for short-term housing. Figure 1 demonstrates the instant hike in delinquency rates in Texas after Hurricane Harvey in August 2017.