Climate-related events in the U.S., such as floods and fires, appear to be occurring more frequently. Because some projections indicate that such events could become more extreme in the future, insurance premiums in certain regions are rising, and this trend is expected to continue. S&P Global Ratings analyzes the impact of rising premiums on U.S. home values and consumer affordability more broadly.

Why it matters:  The U.S. housing market is widely believed to be on solid footing, due primarily to strong demand that exceeds the limited supply of both existing and newly built homes. The resulting upward price momentum has led to an affordability squeeze (complemented by the rise in mortgage rates to near 20-year highs), notwithstanding many capable and potential buyers without an actual house to buy due to low inventory levels. However, interest rates, taxes, and home price appreciation (HPA) aren't the only factors affecting affordability. Insurance premiums have also been increasing, in part due to climate-related events, and some market participants have been discussing the extent to which these recurring costs (in the form of dwelling protection from climate-related perils) are starting to play a material role in the decision to buy a home and in home values themselves.

Economics Of Buying A Home

The cost-benefit analysis of buying a home (when financing it) usually starts with finding the best available mortgage rate. Borrowers with mortgaged residential property in the U.S. generally enjoy an interest rate that is fixed for the term of the loan. This portion of the monthly payment obligation is immune to the effects of inflation, and when wages are increasing (as they are now), monthly mortgage payments effectively become a smaller portion of earnings over time.

The bulk of a homeowner's monthly housing payment traditionally comes from the level repayment amount of mortgage principal and interest (in proportions that vary over time). For example, the monthly payment for a $300,000 house, with a 75% loan-to-value (LTV) ratio and a 30-year fixed-rate mortgage of 5%, leads to annual payments of approximately $14,500--about 5% of the initial home value. Other monthly costs, such as taxes and insurance, have historically been secondary to the principal and interest, and in the case of single-family homes, these may amount to only a percent or two of the home value on an annual basis.

Rising real estate taxes typically correlate with increases in home values. In this sense, the increase in homeowner equity could be viewed as an acceptable tradeoff, with the additional taxes representing the municipality's share of the homeowner's gain (i.e., it's a type of equity tax). Property insurance, however, is a different story--especially considering such a cost doesn't have the same potential tax benefit that interest and/or real estate taxes may provide depending on a homeowner's tax situation and state. While rising insurance premiums do correspond to higher home prices (to cover the appreciating value of the home), the relationship is also dependent on extraneous risk factors not directly related to the value of the home. Because climate-related events in the U.S. appear to be occurring more frequently and could become more extreme, insurance premiums in certain areas are rising--a trend that could continue.

Rising Insurance Premiums Across The Country

Home prices have experienced dramatic growth over the past 10 years. Because the cost of repairing or replacing a dwelling has generally gone up over time, insurance costs have followed suit. However, the increasing frequency of natural disasters and related events (ranging from wildfires in California to storms in Florida) over the past several years has also been a major driver of rising homeowner insurance premiums. For example, hurricane activity in Florida has led to increased risk of housing damage in the state, and insurance for some homeowners is either prohibitively expensive or impossible to obtain in the private market. According to the Insurance Information Institute Inc., as of 2022, over 5% of Florida's population uses state-run Fair Access to Insurance Requirements (FAIR)--Citizens Property Insurance Corp.--as an insurer of last resort. In contrast, the population share in most other states that use FAIR is less than 1%. At the national level, premiums for owner-occupied properties increased 18.2% during 2022-2023 and 33.8% during 2018-2023 (see "US homeowners insurance rates jump by double digits in 2023," Market Intelligence, published Jan. 25, 2024).

Regional variability in home insurance costs

Things are more nuanced at the state level, however. Chart 1 below shows the 2023 and 2019-2023 (average) numbers of loss events exceeding $1 billion (sorted in descending order by the 2019-2023 averages) using data provided by the National Oceanic and Atmospheric Administration (as of March 22, 2024). Chart 1 also depicts a 2023 snapshot of annual insurance premiums (normalized to reflect local dwelling costs) for all 50 states as a percentage of median home price. Typically, the number of events for 2023 exceeds the five-year average. While certain states stand out as having particularly high counts of expensive losses (e.g., Texas, Georgia, and Pennsylvania), the trend suggests that these counts correlate with the relative cost of insurance (as depicted by the downward sloping trend line for dollar premium as a percent of median home value in the state). It's worth noting that the number of $1 billion-plus events may be more frequent for states that are more populous and/or have greater land mass (e.g., Texas had 16 events last year, but also ranks as the second-most populous state in the U.S.). California is an interesting case because its 2023 event count is lower than its five-year average. However, it may be that single events were disproportionately catastrophic, as a wildfire that spreads throughout other parts of the state may be counted as a single event. Losses in California have indeed been significant as we depict in chart 4 below, where we present the five-year average dollar value of California losses over time. It could also be that there were numerous events, most of which individually totaled less than $1 billion in damages.

Chart 1

Part of the regional variability in home insurance costs is driven by the extent to which land itself contributes to the overall value of the property, given the total insured value is predominately related to the physical dwelling. Areas where land values are high relative to the dwelling value may indeed require less coverage as a percentage of total property value. Furthermore, greater acreage can reduce the overall impact of damage to the property (which includes land and dwelling) because the land itself should be largely immune to long-term harm, whereas the dwelling structure may be at risk of complete destruction. For example, chart 1 indicates that Hawaii had only one large-scale loss event in 2023 (the Maui wildfire). However, Hawaii has one of the highest land-to-price ratios (i.e., property value comes mostly from the land, not the dwelling); therefore, the ratio of insurance coverage/premium to median home value is comparatively low (although this could change in the future as insurance premiums adjust to reflect revised views on risk). For all 50 states, we determined the dwelling value by subtracting average construction cost (see "How Much Does It Cost to Build a House?" Forbes, Dec. 22, 2023) from median home value (see chart 2). In cases for which the construction cost exceeded 90% of the median home price for a state, we floored the land value to be 10% of median home value.

As there are many different sources of insurance costs, methods of calculating it, and timing discrepancies (insurance policies tend to be updated annually, at which time the new premiums are put in place), we note that the values we cite may be subject to variation (as noted above in the case of Hawaii). As a result, premiums depicted herein may not reflect the actual cost of insurance if one were entering or renewing a policy now. However, because we use data at the state level (all subject to similar variability), the comparative analysis remains informative. Also, when natural disasters strike densely populated areas, the increased likelihood of multiple claims suggests that subsequent demand for materials and labor could increase rebuilding costs, potentially exerting upward pressure on insurance premiums.

Chart 2

A closer look at California and Florida

The two states that garnered outsized visibility in recent years regarding climate-related events are California and Florida. These states, which make up roughly 12% and 7% of the U.S. population, respectively, saw insurance costs grow approximately 43% during 2018-2023 (see "US homeowners insurance rates jump by double digits in 2023," Market Intelligence, published Jan. 25, 2024). The degree to which insurance premiums are expected to increase over the short-to-medium term will depend on various factors, including state-level limits on premium increases coupled with rising risks and commensurate expected losses.

Florida 

Florida's long south Atlantic coastline makes it particularly vulnerable to hurricanes. While there are various ways to estimate the average insurance premium for a Florida home, a reasonable assumption is that the annual premium is about 1% of the home value. While premiums have been on the rise in recent years, Florida's population continues to grow (1.5% in 2023 according to the Census Bureau) and is outpacing the national average (0.5% in 2023), with part of its growth coming from immigration. Moreover, factors such as warm weather and favorable tax treatment remain selling points for the state. For now, it appears as though rising premiums are not deterring people from moving to the state, thus driving housing demand and putting upward pressure on prices. Chart 3 depicts 2023 annual population changes by U.S. metropolitan statistical areas (MSAs).

Chart 3

Home price appreciation in Florida has generally been in line with that of the broader U.S. over the last year (for a detailed depiction of MSA level fourth-quarter home price changes, see "U.S. Home Price Overvaluation Softens As Wage Growth Outpaces Home Price Gains," published April 15, 2024). However, relatively high mortgage rates have made housing less affordable, and the situation may worsen as insurance premiums rise. The question is: At what point are buyers deterred such that demand in the state subsides? On one hand, Florida's geography makes it difficult to implement physical measures to limit storm damage (because of its large area and long coastline), which means the liabilities will likely increase from an insurance perspective; but on the other hand, high (and growing) population density and limited new lots for construction curtail available supply, which supports home prices.

California 

An interesting point of comparison is the state of California, which has been subject to severe wildfires. Unlike Florida, California's population has declined in recent years. However, this seems to do less with rising insurance premiums and more to do with pandemic effects, industry relocation, high home prices and associated home affordability issues, and a tax regime that is less favorable than that of a state like Florida. Nevertheless, as with Florida, rising insurance costs may become a deterrent to residing in California.

Unlike Florida, which may have limited options to reduce its flood risk, California may be able to prevent or limit fire damage through periodic utility company inspections, dry vegetation management, and requiring fire retardant roofing materials (see "North American Wildfire Risks Could Spark Rating Pressure For Governments And Power Utilities, Absent Planning And Preparation," published Nov. 29, 2023).

Consistent increases in insurance costs in both states 

For now, however, both states have seen consistent increases in insurance costs since 2017 (see chart 4). Interestingly, Florida's premiums had declined for the three straight years prior to 2017, consistent with the relatively low dollar costs of losses at the time. However, the notable increases in subsequent years are correlated with significant increases in dollar losses.

Chart 4

Affordability Depends On Premium Growth

To appreciate the behavioral aspects of how increasing insurance costs may deter or dampen home price growth, it is important to also understand the trade-off between renting and buying as it presents itself in the current housing and interest rate environment. Multifamily housing and the broader commercial real estate markets are not immune to rising insurance costs, because they too have exposure to the environmental events described above. However, the initial impact of rising insurance costs is probably felt more acutely by the owner rather than the renter. Of course, the renter will eventually pay for the owner's increase in insurance costs through rent hikes (assuming they are permissible for a given property). It is important to note that states employ regulatory frameworks regarding annual insurance premium increases for residential properties. This means that, depending on the framework of a given state, the magnitude of premium increases may be subject to periodic caps. Commercial real estate may not have the same degree of pricing regulation, which means that premium shocks could be more sudden for those properties.

Because most mortgagors in the U.S. enjoy a low fixed rate of financing, they are hedged against inflation, especially with the strong wage gains in recent years and historically low locked-in financing rates for many. Rising insurance premiums, however, remain unhedged and can be viewed as a sort of climate cost. To understand the potential impact this cost will have on the borrower with a 30-year mortgage of $320,000 (a property value of $400,000 and an LTV ratio of 80%), we present various monthly payment scenarios in table 1. The impact of rising insurance premiums for existing homeowners with low costs of financing can be viewed as though the fixed-rate mortgage were in fact an adjustable-rate mortgage (ARM). Table 1 shows that a doubling of the annual insurance premium results in approximately a 1.5% growth in implied mortgage rate, which is not an exceptional payment shock relative to the shock experienced by a typical ARM holder in a rising rate environment. Note that an immediate doubling of insurance premiums may not always be a realistic applied assumption due to the presence of caps that may constrain the extent to which insurers can raise premiums. Table 1 depicts scenarios based on various hypothetical shocks to premiums.

Table 1

If premiums don't rise rapidly, table 1 suggests that the impact of rising premiums should have a limited effect on existing homeowners in the near-term. Of greater concern is the impact that rising premiums might have on buyers entering the market now, with mortgage rates at near 20-year highs. However, because rates could fall several percentage points over the next few years to an average of 4.9% in 2027 (see "Economic Outlook U.S. Q2 2024: Heading For An Encore," published March 26, 2024), a buyer entering today at a mortgage rate of 7% may have opportunities to refinance into a cheaper fixed-rate mortgage in the future. In the near term, however, the situation is different. Table 1 shows that a mortgagor paying 7% on their loan would see almost 30% of their monthly payments going to insurance if their insurance premium tripled.

The scenarios show that increasing housing costs in the form of higher premiums affect a homeowner's ability to service monthly debt (as calculated using a debt-to-income [DTI] ratio assuming no other debts other than the housing-related obligations) to varying degrees. According to our mortgage pool credit analysis for U.S. RMBS issued 2009 and later, the DTI ratio impacts our default projections under different rating scenarios (as depicted in the DTI factor column of the chart). In the case of a loan for which the mortgagor has a 4% interest rate and experiences a tripling of the insurance premium to 3% from 1%, table 1 shows the default projection would increase roughly 6.5% (0.92 DTI factor to a 0.98 DTI factor). To exemplify this, suppose the 1% premium resulted in a default projection under a 'AAA' scenario of 15% in our credit model. In this case, the tripling to a 3% premium would equate to a 16% default projection. Because these default projections are multiplied by a loss-given-default assumption, the overall impact is minimized. However, what is demonstrated is that the degree of credit impact can vary depending on the significance of the associated change in DTI ratio.

Another interesting situation not directly tied to the evaluation of credit in a mortgage pool concerns the homeowner that has paid down the mortgage entirely. Such homeowners are often seniors on a fixed income. Therefore, the effect of rising premiums may be particularly difficult to address financially. Florida and certain other states allow for a real estate tax exemption at the state level (although the application depends on the municipality) if any homeowner occupying the property is aged 65 years or over. In addition to the absence of state income tax, this feature may partially offset the impact of rising insurance premiums in Florida and perhaps explain some of the population gains depicted in chart 3.

How Much Downward Pressure Could Rising Premiums Put On Home Prices?

The Federal Housing Finance Agency (FHFA) all-transactions home-price index shows that the U.S. has experienced roughly an average 4.5% annual rate of growth over the past 40 years. In the case of Florida, the 40-year average is roughly 5.2%. When interest rates increased rapidly in 2022, the FHFA index saw a rare instance of contraction. In the same way rising interest rates can put downward pressure on home prices, it is reasonable to think that increasing insurance premiums could do the same.

One way to estimate this effect is to assume that expected excess insurance premium growth has an immediate impact on home prices. Consider a 20-year time frame during which home prices are expected to appreciate 4.5% year over year on average. Given the correlation between home prices and insurance premiums described above, it is reasonable to assume that 4.5% growth of insurance premiums would also be an acceptable annual increase that exerts no downward pressure on HPA. Any anticipated premium growth above that rate should be incorporated into the current market value of the home. To understand the potential price impact, we assumed a $400,000 home with $2,000 in annual premiums (0.5% of the home value) as of today. We then contemplated three scenarios of annual premium growth: 10%, 15%, and 20%--all well above the baseline scenario of 4.5%. After discounting the annual future premium payments by either 4%, 5%, or 6% (reasonable figures in the range of the risk-free rate), we subtracted the sum of annual excess costs from the current home price to determine the price discounts that result from the expected excess premiums paid over 20 years. The results, shown in table 2, show that 10% growth in premiums discounted at 6% would reduce the current home price only by about $4,000 (or about 1%). In the most extreme scenario, we observe that 20% expected premium growth discounted at 4% leads to a price reduction of roughly $40,000 (or about 10%).

Table 2

Home prices derive predominantly from a (sales-based) market comparable approach, which is the typical residential home valuation method that would underlie a price index. As an alternative, one can employ an income and capitalization rate approach to examine price movements. When doing so, increased insurance premiums have a direct impact on valuation. Such an approach is not incompatible with the quasi-commercial style valuation approach (focusing on the debt service coverage ratio [DSCR]) that has been used in recent years for residential real estate underwriting when the property is used for investment purposes.

Consider the sensitivity of home value under the assumption of an average unadjusted expense ratio of 37.5%. Assume further that the gross rental yield is 8% and that insurance premiums start at 0.5% of the home value. Increasing the insurance premium (by either 25%, 50%, or 100%) results in the corresponding changes in value shown in table 3. The table also depicts the change in a gross DSCR ratio commonly used in residential investor property underwriting. As depicted above in table 1, as it relates to DTI ratio changes from various premium assumptions, table 3 shows varying DSCR factors used in assessing default projections for such DSCR ratio loans. When looking at the control (DSCR ratio of 1.00) compared to scenario 3, the adjustment factor increases by roughly 6.5% (i.e., to 4.26 from 4.00).

Table 3

Rising Insurance Premiums May Feature More Prominently In The Home Buying Decision As The Frequency Of Climate-Related Events Increases

Indeed, the homeowner and the broader market would benefit from improved prediction of events that result in property damages, as well as practices/measures that can prevent or protect against these events and related damages. Property insurance coverage can vary, and ultimately, the homeowner chooses suitable options when considering how to manage premium costs. Possibilities include higher deductibles, lower dwelling coverages, or even self-insurance (although this would likely work only for unmortgaged properties).

Traditionally, the typical home buyer has prioritized the purchase decision as follows: (1) locate a suitable dwelling, (2) calculate the required down payment, (3) shop for the best interest rate, and finally (4) add in the monthly tax, insurance, and other payment obligations (e.g., homeowner association fees). In other words, the annual insurance premiums were among the bottom of the list of financial obligations prioritized, and generally, the arrangement would be consummated near closing with communication to the insurance company to effectuate the policy. This may be changing, however, as the frequency in climate-related events appears to have been (and could still be) on the rise. In some cases, a homeowner's insurance company may not offer coverage for the home. As such, the homeowner may be forced to turn to a limited number of other companies or even a state-run company of last resort. These alternatives could lead to higher-than-average premiums, in which case, the prioritization of monthly costs might need to be reconsidered.

While we have not explored the regulatory implications of rising insurance premiums, it is worth noting that in some instances, local governments have modified urban planning or development codes in areas exposed to climate events, particularly floods. There has even been implementation of "managed retreat," such that existing homes have been moved away from vulnerable regions. However, there currently does not appear to be a consistent regulatory approach in the U.S. In terms of home valuation, regulations to limit development in areas considered overly exposed to environmental hazards could lead to additional supply constraints, which would put upward pressure on home prices.

It's not surprising that rising insurance premiums have recently garnered so much attention; however, the impact on consumer affordability is likely obscured by the housing supply-demand mismatch that has dominated home price gains for the past decade. While the housing market (both purchase and rental) seems unlikely to soften in the near term, it's likely that the supply and demand will eventually reach a stable and sustainable equilibrium. When that comes about, the true impact of increasing insurance costs could become more apparent.

Related Research

• US homeowners insurance rates jump by double digits in 2023, Market Intelligence, Jan. 25, 2024
• U.S. Home Price Overvaluation Softens As Wage Growth Outpaces Home Price Gains, April 15, 2024
• Economic Outlook U.S. Q2 2024: Heading For An Encore," March 26, 2024
• North American Wildfire Risks Could Spark Rating Pressure For Governments And Power Utilities, Absent Planning And Preparation, Nov. 29, 2023