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

In this article, a model is developed of the rational consumer's willingness to pay for a marginal reduction in the probability of an undesirable state (flooding) occurring in the residential location decision. The model incorporates a hedonic price gradient for low-probability, high-loss flood hazards. Individuals can self-insure against flooding hazards by locating in residential areas where the probability of flooding hazard is relatively low and, all other things equal, consumers should pay more for houses located in relatively less hazardous areas. A relationship between housing price differentials and insurance premiums for housing located inside and outside of a hazard zone is developed, as well as tests for noninsurable costs. 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.' Specifically, a methodology is developed for estimating consumer willingness to pay for a reduction in the probability of flooding hazard in an urban area.