In 2008, many homeowners were stunned by the sharp drop in housing prices. Built-up home equity vanished. In a rising housing market, protecting against a loss in home equity seemed unnecessary. And while homeowners can’t turn back the hands of time, they could mount a defense against a drop in home equity with insurance that makes it possible for individuals and families to more comfortably take on the risk of buying or owning a home.
Home ownership has largely defined the American Dream. For more and more individuals and families, the purchase of a home was becoming a reality during the early part of the past decade. By 2004, when home ownership peaked, slightly more than 69% of families had homes. And as home ownership rose, so did the wealth of families.
The dream began to dim, however, in the middle of the decade when home prices slipped. The hint of trouble materialized in 2007 when the median price fell more than 8%, according to the S&P/Case-Shiller U.S. National Home Price Index (HPI). The following year, median prices tumbled more than 18%, a rate that accelerated during the first few months of 2009 before easing. Over the past few years, home prices have started to rebound. But if a family bought a home in the summer of 2006 and sold it at the end of 2011, it would have been deeply out-of-the-money if its price followed the median price of a home, which sank in value by more than 34% (or $83,600) over that time.
Unlike the supply-and-demand principle that governs buying behavior of many other assets, falling home prices tend to scare off home buyers, which in turn sets off a downward spiral of events. The initial drop in prices shocks the market, and risk-averse home buyers shy away because of the volatility. This leads to even deeper declines in prices, which only exacerbates buyers’ hesitations to purchase a home.
Falling home values are also significant because most families rely on a mortgage to purchase their homes. Typically accounting for approximately 75% of the family’s total debt, a mortgage makes the purchase of a home a highly leveraged proposition that is extremely sensitive to changes in the value of the housing market. A small drop in home prices can translate into a large loss in the family’s net worth years after the purchase. This is precisely what has happened to many families.
From 2007 through 2010, median family net worth plunged nearly 39%. While declines in financial or business assets contributed to the drop, the collapse of home prices had a far more devastating impact on family net worth. This situation was especially true for families living in the West, whose median net worth took a nosedive of more than 55%, largely because of the crash in home prices.
Also hard-hit were families whose homes accounted for a greater share of their assets. For example, the median net worth for a family headed by an individual between the ages of 35 and 44 fell more than 54% from 2007 through 2010, according to the Federal Reserve.
If the recent drop in home prices had been an anomaly, the risk in home equity could perhaps be managed as other rare misfortunes are. Families could pick up the pieces and move on. But volatility in home prices seems to be part and parcel of home ownership. During the mid-1980s, the oil-patch crisis in Texas drove down home prices. Decreases in defense spending in the late 1980s and early 1990s led to a downturn in the economy of Southern California, which eventually rippled into the housing market. The early and mid-1990s also saw drops in home prices in New England. Across the U.S., more than 50% of home buyers in the early 1990s found themselves in markets that experienced a decline in home prices over the five years following purchase, according to Ian Ayres, Townsend professor at Yale Law School, and Barry Nalebuff, Steinbach professor at Yale School of Management.
Deteriorating housing prices can transform what seems like a rosy picture of financial health into a torn remnant of security, as unrealized wealth a family thinks it possesses vanishes into thin air. Retirement, a child’s education or other long-planned activities may need to be postponed, because there is often little or no time to readjust savings and spending to compensate for the loss in wealth.
But what if a homeowner could be protected from a drop in a home’s equity?
Families insure their homes against fire, their cars against collision, their personal property against theft. In a day and age when forecasting home prices has become as fickle as predicting the weather, home equity insurance would be a way to reduce some of the risk in a loss of value for a family’s largest investment.
A home equity insurance product could pay a homeowner if a drop in the housing market were to occur when a house is sold. The payout might be based on a housing price index that is tied to local home pricing trends. For example, an individual who buys a home for $250,000 and decides to sell it five years later when market prices have declined 4% would receive $10,000 based on the change in the index at the time of sale. For a nominal monthly premium, homeowners could insure against a possible decline in home equity for years after purchasing a house.
While an index-based approach does not track the changes in the price of an individual home, it is granular enough to compensate homeowners for price changes within a reasonable local area.
Index-based payments also would discourage homeowners from slacking off on the maintenance of their properties because payment of a claim would be limited to the decline in the housing index for the areas of their residence. If a home is allowed to deteriorate and then sold in a rising market or even a mild slump, the homeowner would probably receive little or no compensation. Nor could they simply take a low-ball offer just to move the sale, then try to collect the difference from the insurer.
But for homeowners who look at the purchase of a home as a path to economic security, home equity insurance provides a means to that end. Homeowners can’t reverse the losses they sustained in the housing market during the crisis, but with home equity insurance they would have a viable way of protecting themselves against a future decline in the values on what is likely their largest investment: their homes.
Behind the scenes of home equity insurance
In purchasing the coverage, a consumer would be, in fact, buying a put on home prices. In this sense, home equity products would straddle the lines between insurance and security markets, but the techniques used to manage home equity risk are effectively the same as for many other insurance products.
Making home equity insurance affordable for consumers involves understanding the real estate cycle, which is characterized by prolonged periods of stable or rising prices that are often followed by severe downturns, when home equity claims would spike. The challenge for insurers is to funnel the experience of this wide spectrum of events into a premium that consumers will find reasonable—a process that is somewhat similar to rate-making for other lines. But there are some important differences.
Because of the line’s volatility, insurers would need to consider the full range of losses over the product’s entire cycle rather than a typical year’s losses in developing a rate. This is because a normal loss year does not fully reflect the risk inherent in a deep downturn in the real estate market or, for that matter, the potentially high profitability during a booming market. For this reason, as with similarly volatile catastrophic coverage, losses need to be more carefully incorporated in rate-making for home equity insurance than they are for other lines with more stable risk profiles. Balancing the extremes to arrive at a reasonable rate can be a tricky process without a considerable amount of experience in estimating volatility.
Because of the small sample size of historical losses in home equity, as well as the immense uncertainty underlying house prices (which would be the primary driver of claims frequency for this coverage), pricing this type of coverage would need to rely on predictive forecasts of future home prices, rather than allowing past experience alone to dictate prices. This is true with most catastrophic coverage, of which home equity insurance would be no exception. This potentially introduces even more uncertainty, in the form of model risk, which would need to be managed and incorporated into the price.
And like other insurance coverages, product features can be designed to control for moral hazard. An index-based approach that uses trends in metropolitan statistical areas (MSAs) to determine claims payments can control for the variability of individual home prices that might occur because of poor maintenance or speculation.
Aside from specific product features, home equity insurance could subject insurers to steep losses during a severe downturn in the housing market. But insurers are no strangers to the possibility of catastrophic loss.
In home equity insurance, as with most other insurance lines, diversification is key. Despite reports of unprecedented price drops in certain markets, even the recent downturn in housing was muted in some areas of the country. While housing markets in California, Florida, Nevada, New York and the District of Columbia, among other locations, tumbled from the end of 2006 through the beginning of 2008, nearly two dozen other markets continued to see a rise in housing prices, according to Eli Beracha, assistant professor of finance, East Carolina University, and Mark Hirschey, Anderson W. Chandler professor of business at the University of Kansas. In nearly a dozen other states, the decline was modest or negligible.
And, as with other lines of business, insurers can reinsure a portion of their risk. Contracts, however, will have to demonstrate that the risk assumed by the reinsurer is commensurate with the premium ceded by the insurer.
With the launch of housing futures and options trading by the Chicago Mercantile Exchange (CME) in May 2006, the use of options and futures has also become a more feasible technique for managing home equity risk.
Using standardized contracts, insurers can hedge their home equity risks by selling housing futures or buying puts on housing future contracts. Trading gains can be used to offset claims payments.
The CME housing futures contracts are based on tradable S&P/Case-Shiller HPIs that are updated monthly rather than quarterly, as are the Case-Shiller standard indexes. Futures and options are offered for Boston, Chicago, Denver, Las Vegas, Los Angeles, Miami, New York, San Diego, San Francisco, Washington, D.C., and a 10-city composite.
Because options aren’t sold for every MSA, an insurer would need to model its investments based on its mix of business throughout the country to achieve a good match between its risk and its hedging strategy. But it would be possible to reasonably hedge an insurer’s risk, while providing a product that offers homeowners a new way to protect their investments.
Public awareness of the risk of home ownership has rarely been greater than it is now, and all the pieces are in place to design and offer a product to meet consumers’ needs. Insurers only need to take the next step.