Earthquake Risk Analysis
Threat or Opportunity? Credit Union Mortgage Portfolios and Earthquake Risk
If a major earthquake struck somewhere in British Columbia, how will your mortgage portfolio be affected?
Which properties will be damaged and to what extent?
Which borrowers have insured their homes and businesses against earthquake?
Which borrowers will have funds readily available to pay for damage which is:
- under their insurance policy’s hefty deductible?
- in excess of their insurance policy limits?
- unrecoverable due to the insolvency of their insurance company?
What will be the impact to your real estate market due to:
- reduced demand for residential and commercial properties?
- a greater number of properties for sale (voluntary and from foreclosures)?
How will your risk measurements be affected, including:
- delinquency rates due to job losses among members whose employers cannot cope with the disaster?
- higher loan-to-value ratios as real estate values are depressed?
What is the risk?
British Columbia is a very active earthquake zone. The majority of earthquakes occur along fault lines in the Pacific Ocean and most are not felt by B.C. residents. While the major oceanic faults west of Vancouver Island are the likely source of a huge earthquake, many smaller earthquakes occur directly under the B.C. land mass and in every region of the province. The largest earthquake in Canadian territory was a 9.0 event in the year 1700 which originated in the Cascadia fault located off the west coast of Vancouver Island. Vancouver Island itself was the location of Canada’s largest onshore earthquake, a 7.3 shaker in 1946.
Natural Resources Canada maintains an informative website that illustrates the earthquake activity in all of Canada at www.earthquakescanada.nrcan.gc.ca.
How can the risk be measured?
The first step in measuring your mortgage portfolio exposure is to determine the probable damage that an individual property may incur during an earthquake. The dominant factors in this evaluation are location and construction. Earthquake modeling software can provide damage estimates for each property. To be able to use earthquake modeling software, you will need to provide for each property in your mortgage portfolio:
- the exact location of a mortgaged property (for example: street address)
- the primary construction material of the buildings (for example: wood frame)
- the age, square footage, and number of storeys of the buildings
- the estimated replacement cost of the buildings
The second step is to determine the amount of loss your borrower is likely to incur after any insurance recovery. While many of the mortgaged properties are protected by insurance, often as required by the mortgage contract, the risk exists that coverage will not have been placed, will be insufficient, or may even be uncollectible. Furthermore, for those who did purchase insurance, deductibles of 5% to 20% of insured values (buildings plus contents) may cause tremendous financial strain on borrowers who do not have sufficient liquid assets or income to finance this retained loss.
Example: A house insured for $200,000 (replacement cost of building) is also insured for at least $140,000 (70%) of personal property. A 5% deductible equates to the first $17,000 ($200,000 + $140,000 x 5%) of damage being the responsibility of the homeowner – a potentially unachievable amount of money for someone already at the maximum of their debt-financing capacity.
The analysis may reveal that a substantial portion of likely damage from an earthquake is actually directly retained by the property owner and that the benefit of insurance is less than anticipated.
The third step is a calculation to determine your borrower’s new equity position on each mortgage and the potential loss position of the credit union after foreclosure, if the loan goes into default. Owner’s equity is the difference between the outstanding mortgage balance and the revised market value. The negative equity position that results for some borrowers is aggregated and this represents the credit union’s total exposure on its mortgage portfolio.
For the most accurate exposure determination, it is recommended that credit unions have their entire mortgage portfolio analyzed initially. Thereafter, a complete analysis can be run as necessary, depending on the credit union’s opinion of how much the geographic distribution of mortgaged properties has changed and/or potential impact of enhancements in the modeling software, or changes in assumptions and variables used to refine the impact on owner equity positions. Between complete analyses, figures can be intuitively adjusted for factors such as changes in building replacement costs, loan-to-value ratios, and insurance protection purchased by borrowers.
How can the risk be managed?
In recent years, low interest rates and sustained increases in property market values have attracted more people to home buying. Additionally, mortgage portfolios have been influenced by:
- increasing use of adjustable rate mortgages
- growing acceptance of high-ratio mortgages
- longer amortization periods
- interest-only payment terms
Lenders may not fully appreciate that these developments are also increasing mortgage impairment risk exposure from natural hazards such as earthquakes. As these trends in mortgage terms continue, credit unions are increasingly at risk to widespread defaults should a major earthquake strike a region where the portfolio is concentrated. A credit union can protect itself against unforeseen losses due to earthquake by learning about the risk, evaluating it, and managing it. Steps may include:
- performing an in-depth analysis on the entire portfolio as described above
- determining high-risk areas and requiring borrowers in these areas, or all borrowers, to purchase insurance against earthquake
- monitoring and occasionally re-balancing portfolios to maintain acceptable average loan-to-value ratios
- monitoring and maintaining geographic diversification within the portfolio to avoid or reduce concentrations of locations and at-risk mortgage balances subject to the same catastrophic event
- purchasing sufficient mortgage impairment insurance
What is the opportunity?
Following a major earthquake, a lender that has managed its risk appropriately can be relied upon to have the financial resources readily available to provide additional or new funding to qualified borrowers without greatly sacrificing loan quality, thereby securing and enhancing its position in the community.
Carefully analyzing the exposure will not only determine the potential losses following an earthquake, but will also identify the appropriate risk management strategies to follow to optimize return on investment while minimizing risk to the portfolio.
A lender that understands and appreciates the exposure can also:
- help its borrowers help themselves by:
- ensuring that borrowers know the value of earthquake insurance to protect their equity
- ensuring that borrowers know the amount of the deductible on their earthquake insurance and consider how they might afford it
- refer borrowers to an insurance broker which may generate additional business for a related broker and/or referral fees
How can your credit union perform an analysis?
CUPP Services can assist credit unions in:
- arranging access to earthquake modeling software
- identifying the mortgage and property detail to be gathered from the credit union’s banking system
- obtaining property detail and assessment authority information
- coordinating all information and performing calculations
- evaluating mortgage impairment insurance options and alternatives
Risk Management Department
Central 1 Credit Union