Climate change is creating conditions for more devastating and more widespread disasters, and many households nationwide now find themselves without adequate home insurance. Households with mortgages through Fannie Mae and Freddie Mac (the government-sponsored enterprises, or GSEs) are required to maintain home insurance based on replacement cost, but they are not required to have flood insurance unless they live in a dedicated flood zone. As a result, the GSEs’ insurance requirements create a system of distorted incentives.

On one hand, the requirement that homeowners carry insurance at replacement cost means many homeowners are overinsured and have higher-than-necessary monthly payments. On the other hand, the GSEs do not do enough to ensure insurance coverage for locations starting to be affected by climate change, especially areas experiencing increasing flood risk and areas where insurers are leaving the market entirely. 

These problems are substantial. Although we need more data and analysis to fully understand their scope, we take a preliminary step here toward describing potential solutions, such as allowing actual cash value (ACV) insurance, negotiating multiyear insurance terms, and requiring flood insurance coverage everywhere. We focus on the GSEs and their regulator, the Federal Housing Finance Agency (FHFA), because they have the resources to implement changes faster, but the same issues plague the Federal Housing Administration and the US Department of Veterans Affairs. 

The GSEs currently require overinsurance, leading to higher costs and bad incentives

The GSEs currently require replacement cost value (RCV) home insurance, which can lead to overinsurance for borrowers and can provide incentives for inefficient insurance claims and outright fraud, further increasing insurance costs.  

Consider a borrower buying a home with an older roof. RCV insurance incorporates the full cost of a new roof (say, $30,000). Even though the borrower paid less for the house because of an older roof, the GSEs require insurance that covers the new roof cost, resulting in overinsurance from the guarantor’s point of view. 

The RCV requirement also perpetuates inefficient insurance claims, giving borrowers the incentive to have an insurer pay for a full replacement for minimal damage. Anecdotally, the RCV policy perpetuates schemes that escalate already-high insurance costs, where contractors replace every roof in a neighborhood after a hurricane or other disaster and then sue insurers who are not willing to pay for the repairs. Consumers ultimately pay these costs through higher insurance rates.

Alternatively, the GSEs could allow homeowners who own their home outright to take out ACV insurance, which can be 20 to 25 percent cheaper than RCV policies, with the average premium around $2,000 a year. In our previous roof example, an ACV policy would insure the roof at its current value—say, $10,000 because the roof is older instead of the $30,000 cost of a new roof. Some borrowers might still choose an RCV policy voluntarily, especially in risky areas, because they value the protection, but they shouldn’t be required to. Insurance is meant to protect against unexpected risk realizations, not be a substitute for ongoing home maintenance or for a mortgage reserve account.

More stability in insurance could help borrowers better prepare for climate change 

Climate change is one of the biggest reasons home insurance costs are rising in many parts of the country, such as California, Florida, and Louisiana. The GSEs acknowledge that climate change is making insurance more expensive, but they do not explicitly acknowledge the risk to their own book. The GSEs have some built-in protection because servicers are required to ensure that borrowers maintain their coverage and to obtain forced place insurance if necessary.

We believe the real concern for the GSEs should be the one-year duration of insurance contracts—considerably shorter than the average mortgage duration. While mortgages carry a 30-year term, the standard home insurance policy lasts only a year, increasing the risk of policy nonrenewals. Requirements on borrowers and servicers mean little when insurers pull out of an area or when the remaining insurers charge higher rates that homeowners struggle to pay. The Congressional Budget Office projected that the total expected flood damage (not including wildfires or other risks) to federally backed properties over the next 30 years is around $200 billion and rising. The same report notes that about 30 percent of losses attributable to disasters are already uninsured.

To solve this mismatch, the GSEs could explore negotiating multiyear insurance policy contracts with insurers and reinsurers. Such multiyear contracts are not unheard of in commercial coverage, and the GSEs’ size—$7 trillion of mortgages—would allow them to start a negotiation of at least two-year policies with prespecified rate increases. 

These multiyear contracts could be more expensive but would allow for better underwriting decisions by the GSEs and clearly signal to borrowers the long-term risk. With a longer-term contract, the borrowers’ monthly expenses would be calculated based on the long-term insurance rate, and the GSEs could use their projections of home values over time in their underwriting decisions. These home values could be lower in areas most at risk of climate change’s effects. The GSEs can decide whether to require borrowers to sign the multiyear terms or to allow them as an option while using these terms for underwriting.

It is possible that no insurer or reinsurer is willing to write a longer contract in a particular area of the country. That admission should lead to a fundamental rethinking of underwriting from the GSEs. If insurers are not willing to even quote a two-year rate for a particular area, why are the GSEs underwriting a 30-year loan? Getting these data could also inform other federal or local government interventions, if required.

Flood insurance requirements need to be updated in light of new risks

Currently, the GSEs require flood insurance coverage only in special flood hazard areas (SFHAs) as defined by the Federal Emergency Management Agency (FEMA), which are outdated and mean only about 4 percent of homeowners have flood insurance. This issue will be exacerbated by increased flooding attributable to climate change. We already saw that most homeowners affected by Hurricanes Helene and Milton were not insured against flood risk. For the GSEs, this lack of coverage could result in potential mortgage payment difficulties when borrowers are unexpectedly hit with massive repair costs.

FEMA could overhaul its coverage maps to include tens of millions of additional homeowners. But the FEMA 2.0 update took years to roll out and is still highly controversial. Homeowners and communities in the newly designated flood zones often push back, causing the maps to take on a political shape. Given the reliance on FEMA, the GSEs’ current risk management is indirectly undermined by the congressional politics that keep true actuarial risks from being incorporated. Similarly, state-level restrictions on risk-based insurance pricing, which often forbid incorporating future climate forecasts, indirectly undermine the GSEs’ current risk management.

To address these dynamics, the GSEs could work with insurers and reinsurers to include weather-related flood coverage in the standard home insurance policy in areas FEMA 2.0 does not cover. This change would allow homeowners in areas that are currently underdiagnosed by FEMA 2.0 to receive much-needed coverage while most other homeowners have minimal flood risk, so their premiums should not increase much. This solution also ensures that taxpayers are not on the hook for losses through the GSEs. Other alternatives include the GSEs starting their own risk management system or incorporating a broader flood risk definition than FEMA’s special flood hazard areas.

More work is needed to ensure the home insurance industry’s climate resiliency

As climate change and its resulting weather disasters accelerate, this conversation about insurance will continue to evolve. In the meantime, we need to experiment with potential solutions, such as those discussed here, and analyze their effects on costs and coverage. Given the GSEs’ resources and flexibility, we believe they can lead in this space. Pilot programs in specific areas would be a good first step.