How lenders can mitigate flood risk in their portfolios

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Around 400 properties were flooded in February after storms Dudley, Eunice and Franklyn crashed into the UK.

It’s the first time since storm naming began that three named storms landed on our shores in just one month, highlighting the reality of climate change risk.

Severe flood warnings were issued for several major rivers, yet despite the hazards of living close to water – the risk of flooding does little to damage the appeal of homes situated in such locations.

Clustered around rivers or in coastal towns, these homes are some of the most desirable in the country. The occasional flood, it seems, is not too high a price to pay to live somewhere steeped in history with a scenic view.

Developing effective climate-related risk management strategies

Financial institutions have been told by the Prudential Regulation Authority that they must develop an effective climate-related financial risk management strategy.

We’ve seen there is no shortage of demand for homes under threat from flooding and their value is currently unmarred.

So what are the risks caused by flooding that lenders must plan for and manage in the future? This is where the collection and analysis of climate change risk data is key.

Insurance risk doesn’t deter buyers from floodplains

A small rise in insurance premiums isn’t enough to deter homebuyers from buying on or near a floodplain. But as this year has already shown us, instances of extreme weather are increasing the frequency and severity of flooding. This will eventually lead to a steep rise in the cost of insurance.

This causes lenders two problems.

Firstly, if premiums rocket, borrowers’ ability to pay their mortgage is put under stress. Right now, stress testing at 7% instead of the actual mortgage pay rate, means borrowers can cope with interest rate rises and have a buffer built into their household budget that allows for increasing premiums.

But proposals to do away with the stress test are out for consultation which heightens the risk that an exponential rise in premiums could lead to more borrowers defaulting on their mortgages. This puts pressure on lenders to increase their provisions for bad loans.

Property risk and flooding for lenders

At some point, if a property’s risk of flooding becomes too frequent and significant insurers will stop hiking premiums and refuse to insure the home altogether – problem number two.

Being left holding assets that are uninsurable could give rise to serious losses if a repossession takes place.

But it also creates potential conduct and reputation issues if the borrower believes the lender is to blame for lending money on a property where the value would be severely impacted by climate change.

If the borrower becomes a mortgage prisoner, unable to sell or remortgage because a new lender will not secure funds on an uninsurable property, the TCF risk isn’t the lender’s only issue. Forced to pay a higher rate of interest, there is a greater chance the borrower could default on their mortgage.

How lenders can mitigate flooding concentration risk

Lenders have policies to mitigate their concentration risk in a block of flats, for example, but not on individual houses. This exposes them to the danger that they hold mortgages on every property situated on street at risk of flooding.

Climate change risk data can be used to inform lenders of the threats they have lurking in their back books.

That means they’ll know today the quantity and location of properties they have secured funds on that will be exposed to severe climate change risks in the future.

Such data can also be used to inform decision making at origination by alerting lenders to the level of concentration risk they are currently exposed to on a particular street when they receive a new application for mortgage finance. Applications can be declined to keep their exposure at an acceptable level.

Climate change risk management

By assessing their current exposure to concentration risk and identifying the proportion of assets that could become uninsurable in the future, mortgage lenders can devise a climate change risk management strategy.

Understanding the risks means lenders can adjust their appetite to new lending, work out how to self-insure if they have a heightened level of exposure to flood risk properties and critically examine how well they are covered by their provisions and capital.

It’s new territory for everyone. The emerging threats of climate change risk have yet to be quantified and the increased risk of future flooding hasn’t begun to play a big role in how properties are valued nor does it feature. highly in homebuyers’ decision making.

But, if swathes of properties are going to be damaged or destroyed by extreme weather over the next 50 years, lenders must know how much of this risk they carry, how it will affect borrowers’ ability to maintain payments and the detriment caused to the value of those assets.

Collecting and harnessing climate change risk data now is vital to remaining resilient in the future.

Find out more about our climate change risk products.

Samantha Partington 24 March 2022
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