How Lenders Are Providing Natural-Disaster Insurance

With the chaos of cleanup and insurance claims, the aftermath of a natural disaster often triggers a financial shock for households. This was strikingly evident in the United States in 2020, which saw not only COVID-19 but also a record 22 officially declared weather and climate disasters. Each caused at least $1 billion of damage.

Since 9/11, US financial institutions have taken to voluntarily applying disaster flags to consumers’ credit files in regions affected by disasters. The idea is to give consumers a break by temporarily overlooking any missed payments. In the pandemic, flags popped up everywhere for the first time.

For all that, little is known about how widely these designations have been applied or what the effects are, according to Chicago Booth PhD student Benedict Guttman-Kenney, who argues that these flags have helped consumers and lenders alike.

A disaster flag on a consumer’s account masks any missed payments, giving the impression in a credit score that payments are up to date. “This is like natural-disaster insurance for your credit file,” Guttman-Kenney says. “When you’re in that position, there’s something to help you.”

But unlike health and unemployment insurance, and other types of systems in place, disaster flags are assigned ad hoc. Currently the onus is on lenders to decide whether to flag accounts and for how long, as well as which types of financial products to apply the designation to.

To find out how the flags were being used, Guttman-Kenney examined the TransUnion Consumer Credit Panel, a representative sample of credit files, housed at Chicago Booth’s Kilts Center for Marketing, covering 2000 to the end of 2021. He then combined this with Federal Emergency Management Agency public data to track where and on which dates disasters struck over the past 20 years.

From January 2010 to December 2020, a period when the use of disaster flags expanded dramatically, 59 million people had such a tag on at least one open account on their credit file for at least one month, he finds. Lenders’ use of disaster flags accelerated with climate change and more-frequent extreme weather crises, rising particularly after Hurricanes Irma and Harvey in 2017.

The data show the prevalence of the flags, including a change in the use of the designation over time, the characteristics of affected consumers, and the types of products involved, such as mortgages and credit cards.

People at higher risk of defaulting—those with lower credit scores, higher debt, and more credit products a year before a disaster—were more likely to have flags on their accounts, Guttman-Kenney finds. They also got a much bigger boost to credit scores when their accounts were flagged—10 to 15 percentage points—than people with better credit, who saw little change, according to the study.

However, disaster flags typically only stay on a credit file for a few months and, as a result, their beneficial effects on credit scores were temporary, and didn’t translate into consumers’ credit access increasing.

In his analysis of the FEMA disaster records, Guttman-Kenney wanted to know how costly it would be for lenders if there were a standardized requirement in place to permanently mask disaster defaults in credit files, rather than the current ad-hoc version that only provides temporary relief. To find out, he essentially created his own disaster flags and applied them in disaster zones, which affected 6 percent of defaults that occurred during and shortly after a disaster, as well as 18 percent of defaults that occurred more than a few months later.

“A disaster default may be adding noise to your credit scoring model, so if you mask it, it actually improves your model,” he notes.

Guttman-Kenney finds that removing missed-payment information didn’t hamper lenders’ ability to assess risk and build effective credit-scoring models. “It’s almost like we are removing something that is randomly occurring,” he says. “If we remove disaster defaults, it might help consumers without hurting lenders.”

With weather-related catastrophes expected to continue to rise, the findings provide some rationale for creating a standardized system of applying such credit flags to replace the present practices, Guttman-Kenney says. A formal policy could make sense for both lenders, which would have a clearer picture of true customer credit risk, and consumers, who don’t want to be penalized for the bad luck of being hit by a disaster.