Academic journal article Journal of Risk and Insurance

Flood Hazard Pricing and Insurance Premium Differentials: Evidence from the Housing Market

Academic journal article Journal of Risk and Insurance

Flood Hazard Pricing and Insurance Premium Differentials: Evidence from the Housing Market

Article excerpt

Flood Hazard Pricing and Insurance Premium Differentials: Evidence From the Housing Market

In an efficient market, property value differentials reflect the perceived probability of hazards. Sales price differentials on homes located in and out of a hazard zone should reflect the expected loss associated with the hazard occurring, as well as any market determined risk premium (assuming all other factors influencing price are held constant). If all costs associated with the hazard are insurable, the efficiency of market hazard pricing can be tested using insurance premium differentials associated with the hazard.

In this article, a model characterizing the consumer's location decision is specified and estimated using data on individual housing transactions. (1) Specifically, a methodology is developed for estimating consumer willingness to pay for a reduction in the probability of flooding hazard in an urban area. The price that consumers are willing to pay is extracted by examining the prices of like homes in and out of the flood hazard zone. The estimated price (willingness to pay) to avoid the flood hazard from housing market data is then compared to flood insurance premiums to test market efficiency. If any differences in the market price of the flood hazard and the expected loss represented by the difference in insurance premiums exists, then either (1) costs which are not insurable exist or (2) the market for housing is not efficient.

Theoretical Issues

In an efficient market, the prices of houses in and out of a flood hazard zone, holding other characteristics constant, should reflect the expected loss from flooding. The risk neutral or risk averse consumer should be willing to pay an amount at least equal to the expected loss from flooding to locate outside the flood hazard zone. In the absence of a risk premium, the house price differential will equal the expected loos from flooding. Since insurance premiums on like houses in and out of the flood hazard zone should also reflect the expected loss from flooding, the difference in these premiums should also provide an estimate of the expected loss from the flood hazard. In the absence of noninsurable costs, and given market efficiency, the estimated differential in house prices (holding all other factors constant) should equal the expected loss from flooding reflected in the discounted value of the difference in flood insurance premiums for like housing located in and out of the flood hazard zone. (2)

The house price differentials can be estimated using an hedonic model (Rosen, 1974) with flood hazard entered as an argument. The predicted sales price differential from housing market data can then be compared to the insurance premium differentials to gain some insight into the market's pricing of the hazard. If the house price differential is less than the insurance premium differential, it indicates the market is not fully pricidng the expected loss, perhaps because of information or perception problems. If the house price differential is greater than the insurance premium differential, it indicates that the perceived loss from flooding by market participants exceeds that predicted by the actuaries, perhaps because of noninsurable costs associated with the hazard.

Data

The data used were obtained from Monroe, Louisiana a well defined urban area with a population of almost 120,000 that has experienced flooding in the past and participates in the National Flood Insurance Program (NFIP). (3) The flooding hazard exists because of the low elevation of the entire urban area. Water generally drains from the bayous and canals into the Ouachita River. However, when the river rises (springtime) or the drainage passages become blocked (anytime there are heavy rains, and especially in the winter) the water must be diverted with stationary or portable pumps. The flooding damage to residential housing occurs when the pumps fail or the water backs up too quickly or both. …

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