Rising Tides, Increasing Risk

The insurance industry has taken the lead in researching the risks associated with climate change. Analysis conducted by the industry suggests that the effects of climate change, including increasingly unpredictable weather events and increasingly damaging storm surge, could threaten its ability to provide affordable flood insurance in many coastal areas around the world.

Sea level rise is expected to greatly increase damages resulting from flooding in low-lying coastal areas. Analysis by Risk Management Solutions and Lloyd’s of London indicates that sea level rise could drive a doubling of average annual losses from storm surge for properties in the world’s most exposed coastal areas by the 2030s. Moreover, climate change adds irreducible uncertainty to calculations of the probability of future extreme weather events.

According to research by the Geneva Association, a think-tank focused on insurance economics, climate change limits the precision with which existing risk estimation methods can predict the frequency and magnitude of future weather hazards. As these losses and uncertainty combine with the increased demand for insurance arising from development in coastal areas, insurance companies could come to see the risk of flooding in high-risk coastal areas as ninsurable.

In principle, the loss of coverage for flood damage could have a considerable and detrimental impact on investors who own commercial properties in coastal areas. Not only would they find themselves exposed to uninsurable flood risk, but they might find themselves in violation of insurance requirements specified by their lenders. Previously performing loans could be deemed non-performing. Potential buyers might find it difficult to secure financing for properties in high-risk areas, reducing demand and undermining property values.

In practice, however, the risks to commercial property owners might not be so great. To get an idea of how the insurance industry’s response to climate change could affect property owners in the future, it is useful to consider the current experiences of real estate investors in coastal areas of South Florida (i.e., Miami-Dade, Broward and Palm Beach counties). This case is instructive because the region is densely populated, rapidly growing, low-lying, castal and vulnerable to extreme weather events. It is therefore currently encountering challenges related to climate change and sea level rise that other parts of the country will likely confront in the future. Much of the most densely occupied areas of the Miami CBD, and virtually all of the nearby community of Miami Beach, are located in Special Flood Hazard Areas (SFHAs) identified by the Federal Emergency Management Agency (FEMA) and designated in its official Flood Insurance Rate Maps. The SFHA designation indicates these areas are at the highest risk for flooding.

Any party seeking to finance the purchase of property in an SFHA will be required by their lender, in accordance with federal regulations, to purchase flood insurance through the National Flood Insurance Program (NFIP). The program, which is administered by FEMA in partnership with nearly 90 private companies, is responsible for the vast majority of flood insurance policies in the U.S. NFIP coverage is available to all property owners in communities that agree to participate in the NFIP’s flood zone management program. To date, more than 21,000 communities, or about 90% of at-risk communities, participate in the NFIP, including Miami and Miami Beach. No flood risk, including storm surge, is considered uninsurable by the NFIP, nor can the program drop policies after multiple claims. However, NFIP coverage is subject to limits. Flood coverage under NFIP is capped at $250,000 for single-family homes and $500,000 for commercial structures. Coverage limits also apply to building contents. Moreover, NFIP insurance does not cover lost business income or loss of rents.

In some cases, for properties located in SFHAs, lenders may require borrowers to purchase insurance coverage in excess of these limits. In such cases, the borrower needs to seek additional or replacement coverage in the private insurance market. In the U.S., private insurers have largely refused to offer flood insurance policies since the 1920s, after having recognized the risks of large correlated losses from events along major waterways. This was a major motivation for the federal government to create the NFIP in 1968. As a result, virtually all excess flood policies purchased in the private market are ultimately backed by a single insurer: Lloyd’s of London. The high risk of correlated losses and lack of competition in this market make private flood insurance policies expensive relative to coverage available from the NFIP.

In light of the expense it imposes on borrowers, and in an effort to attract customers in a competitive marketplace, most lenders in South Florida do not require excess flood insurance, even for properties in SFHAs. Lenders that plan to hold loans on their balance sheets rather than selling them in the secondary market, such as local banks and many life insurance companies, have flexibility to negotiate their insurance requirements (except for requiring borrowers to purchase NFIP insurance, which is mandated by the FDIC). Such lenders typically agree to waive the requirement for excess flood coverage in favor of alternative means of reducing their exposure to flood risk. These alternative means usually take the form of recourse to the borrower, either through recourse debt or carve-outs in non-recourse loans that hold borrowers responsible for damage and loss of business due to flooding. Life companies have also been known to require borrowers to invest a specified amount in a CD they issue, so they know that funds are available to cover damages and loss of business in case of flooding.

Lenders that intend to sell their loans in the secondary market are subject to the insurance requirements specified by issuers of mortgage-backed securities, and therefore typically have less flexibility to negotiate with borrowers. For instance, lenders who plan to securitize mortgage debt on single-family and multifamily residential properties will require borrowers to purchase flood insurance coverage that meets requirements set by Freddie Mac and Fannie Mae. For properties in SFHAs, these requirements may exceed NFIP coverage caps.

Freddie Mac will not purchase a mortgage on a property in an SFHA unless the borrower has flood insurance coverage equal to the estimated replacement cost for all areas below grade as well as the bottom two stories above grade, plus coverage of business and rental income. Similarly, Fannie Mae requires flood insurance coverage for properties equal to 100% of replacement costs for the entire property and coverage of business income and rental value.

Lenders seeking to securitize debt for commercial properties may also require borrowers to purchase flood insurance coverage in excess of NFIP caps when financing properties in SFHAs. However, unlike Freddie Mac and Fannie Mae loans, there are no standard requirements for these CMBS loans. Some CMBS issuers have similar requirements to Fannie Mae and Freddie Mac. Others, rather than using uniform requirements for all properties, base their requirements on the elevation of the particular property in relation to the Base Flood Level indicated on the official FEMA flood map for the area in which the property is located. Base Flood Levels are calculated by the Army Corps of Engineers and represent the level to which flood water would have to rise before inundating an area.

Ultimately, excess flood policies on commercial properties are rare in South Florida, as property owners do not wish to buy them due to their cost, and most lenders choose not to push the issue. As a result, owners of most types of commercial real estate make only limited use of the private market for flood insurance, and are therefore insulated from the risk that the private insurance industry will reduce coverage.

Risks do remain, however. For instance, significant reductions to the availability and affordability of NFIP flood insurance could have serious repercussions for property owners. Such reductions are unlikely in the current political environment, as major changes to NFIP coverage require an act of Congress, and property owners have considerable leverage over the political process. Property owners’ influence over the terms of NFIP flood insurance was exhibited in early 2014, when public outcry prompted Congress to partially reverse a 2012 law that increased the annual cap on NFIP premium hikes.

Of course, the political calculus could change dramatically if a major hurricane were to devastate South Florida or another coastal metropolitan area. FEMA borrows from the U.S. Treasury to pay claims exceeding reserves. Claims filed with the NFIP following Hurricanes Katrina, Rita and Wilma in 2005, and Sandy in 2012, resulted in a debt of nearly $24 billion as of December 2013. If increasingly frequent and damaging storms cause FEMA’s debts to proliferate further, Congress may act to transfer more cost to policy holders through higher premiums and deductibles, or by reducing coverage caps.

Even with their current $500,000 coverage limits, NFIP policies could fall far short of covering the costs associated with flood damage from a severe weather event, particularly as sea level rise multiplies expected losses due to storm surge. As most commercial property owners have chosen not to purchase supplemental coverage, they are effectively choosing to insure themselves for any damages in excess of $500,000. As such, they are exposed to the risk that the insurance industry itself is backing away from: the risk of increasingly unpredictable and damaging floods from extreme weather events. While current property owners are willing to accept this risk, there may come a day in the future when potential buyers will not be willing to do the same.

When that day comes, property values will suffer. as local banks and many life insurance companies, have flexibility to negotiate their insurance requirements (except for requiring borrowers to purchase NFIP insurance, which is mandated by the FDIC). Such lenders typically agree to waive the requirement for excess flood coverage in favor of alternative means of reducing their exposure to flood risk. These alternative means usually take the form of recourse to the borrower, either through recourse debt or carve-outs in non-recourse loans that hold borrowers responsible for damage and loss of business due to flooding. Life companies have also been known to require borrowers to invest a specified amount in a CD they issue, so they know that funds are available to cover damages and loss of business in case of flooding.

Lenders that intend to sell their loans in the secondary market are subject to the insurance requirements specified by issuers of mortgage-backed securities, and therefore typically have less flexibility to negotiate with borrowers. For instance, lenders who plan to securitize mortgage debt on single-family and multifamily residential properties will require borrowers to purchase flood insurance coverage that meets requirements set by Freddie Mac and Fannie Mae. For properties in SFHAs, these requirements may exceed NFIP coverage caps.

Freddie Mac will not purchase a mortgage on a property in an SFHA unless the borrower has flood insurance coverage equal to the estimated replacement cost for all areas below grade as well as the bottom two stories above grade, plus coverage of business and rental income. Similarly, Fannie Mae requires flood insurance coverage for properties equal to 100% of replacement costs for the entire property and coverage of business income and rental value.

Lenders seeking to securitize debt for commercial properties may also require borrowers to purchase flood insurance coverage in excess of NFIP caps when financing properties in SFHAs. However, unlike Freddie Mac and Fannie Mae loans, there are no standard requirements for these CMBS loans. Some CMBS issuers have similar requirements to Fannie Mae and Freddie Mac. Others, rather than using uniform requirements for all properties, base their requirements on the elevation of the particular property in relation to the Base Flood Level indicated on the official FEMA flood map for the area in which the property is located. Base Flood Levels are calculated by the Army Corps of Engineers and represent the level to which flood water would have to rise before inundating an area.

Ultimately, excess flood policies on commercial properties are rare in South Florida, as property owners do not wish to buy them due to their cost, and most lenders choose not to push the issue. As a result, owners of most types of commercial real estate make only limited use of the private market for flood insurance, and are therefore insulated from the risk that the private insurance industry will reduce coverage.

Risks do remain, however. For instance, significant reductions to the availability and affordability of NFIP flood insurance could have serious repercussions for property owners. Such reductions are unlikely in the current political environment, as major changes to NFIP coverage require an act of Congress, and property owners have considerable leverage over the political process. Property owners’ influence over the terms of NFIP flood insurance was exhibited in early 2014, when public outcry prompted Congress to partially reverse a 2012 law that increased the annual cap on NFIP premium hikes.

Of course, the political calculus could change dramatically if a major hurricane were to devastate South Florida or another coastal metropolitan area. FEMA borrows from the U.S. Treasury to pay claims exceeding reserves. Claims filed with the NFIP following Hurricanes Katrina, Rita and Wilma in 2005, and Sandy in 2012, resulted in a debt of nearly $24 billion as of December 2013. If increasingly frequent and damaging storms cause FEMA’s debts to proliferate further, Congress may act to transfer more cost to policy holders through higher premiums and deductibles, or by reducing coverage caps.

Even with their current $500,000 coverage limits, NFIP policies could fall far short of covering the costs associated with flood damage from a severe weather event, particularly as sea level rise multiplies expected losses due to storm surge. As most commercial property owners have chosen not to purchase supplemental coverage, they are effectively choosing to insure themselves for any damages in excess of $500,000. As such, they are exposed to the risk that the insurance industry itself is backing away from: the risk of increasingly unpredictable and damaging floods from extreme weather events. While current property owners are willing to accept this risk, there may come a day in the future when potential buyers will not be willing to do the same.

When that day comes, property values will suffer.

By Quinn W. Eddins, Director of Research and Analysis, Americas Research, CBRE.