When Insurers Exit: Climate Losses, Fragile Insurers, and Mortgage Markets

Abstract

Despite growing climate losses, Americans continue to move into high risk areas. This paper uses a range of natural experiments to show how mispricing of climate risk in mortgages and property insurance creates large taxpayer exposures and leads to excess credit flows to risky areas. Our central finding is that the government-sponsored enterprises' (GSEs) policies for evaluating property insurers are a crucial source of this mispricing. We assemble a comprehensive new dataset on both mortgages and insurance to analyze these dynamics in Florida from 2009-2018. We begin by documenting a breakdown in the quality of insurance provision, with new under-capitalized and under-diversified insurers dominating insurance markets. These fragile insurers have high rates of insolvency, which we show causally increases mortgage defaults after natural disasters. We find that the GSEs' reliance on third-party ratings of insurers leads them to accept insurance from companies at high risk of insolvency without pricing for it. This creates large taxpayer exposures, with an estimated 31% of the GSEs' expected losses in Florida coming from insurance fragility. Most starkly, we show that private lenders strategically respond to the GSE mispricing. Mortgage denial rates are sensitive to insurance quality in the jumbo segment where loans are retained, but not in conforming segment where loans are offloaded to the GSEs. Our estimates imply that 1 in 5 GSE-eligible conforming mortgages would not have been originated by private lenders if they internalized insurance fragility risk at origination.

Keywords: Climate Risk, Insurance, GSEs, Lenders, Mortgages, Rating Agencies, Housing

JEL Classification: G22, G21, G28, Q54, L32, G24, R11, R31