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The Journal of Real Estate Finance and Economics

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24-11-2020

Pricing Moral Hazard in Residential Properties: The Impact of Sinkhole Claims on House Prices

Authors: Randy E. Dumm, Charles Nyce, G. Stacy Sirmans, Greg T. Smersh

Published in: The Journal of Real Estate Finance and Economics | Issue 1/2022

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Abstract

Previous research shows that sinkhole presence, proximity, and density create negative externalities and all have a significant negative effect on house prices. This study extends sinkhole research by examining opportunistic fraud and moral hazard associated with the relationship between sinkhole insurance claims and house prices. This is done by evaluating the relationship between house prices and the payment or denial of sinkhole insurance claims for both affected properties and neighboring properties. Applying a spatial error regression model to single-family detached home sales and sinkhole insurance claims data for Hillsborough County, Florida for the period 2008 to 2016, we find that not only do sinkhole insurance claims have a negative impact on the property associated with the claim, but also have a negative impact on surrounding properties regardless of the source of classification. This result holds for both paid and unpaid insurance claims. The results also show a price discount even after the sinkhole has been remediated.

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For example, Dumm et al. (2018) use Florida Geological Survey (FGS) data on all known sinkholes (regardless of property type) to determine the impact of both proximity (the distance to the nearest sinkhole) and sinkhole density (the number of sinkholes within explicit radial areas) on residential property prices. While Fleury (2007) finds no significant effect of sinkhole presence on house prices, Dumm et al. (2018) find a significant negative effect of sinkholes on house prices in terms of presence, proximity, and density.

As noted in the 2010 Florida Senate Committee on Banking and Insurance report, insurers were reluctant to deny claims due to their legal exposure under Florida statues following an adverse court judgement where they would not only be responsible for the plaintiff’s legal fees but also open themselves up to large financial judgements via the potential for a bad faith claim judgement. Additional complications may arise if the sinkhole property is insured by Citizens, the state-run insurer. Citizens is not a for-profit insurer with capital market incentives (i.e. investors) and, as a result, may be less likely to deny claims to improve their financial performance.

The 2010 Florida Senate Committee on Banking and Insurance reported that the Florida Insurance Commissioner had publicly identified sinkhole claims as a “major cost driver that had could threaten insurer solvency and further weaken the Florida residential property insurance market. The report also states that the insurance regulator and insurers had expressed concern “that many policyholders are incentivized to file such claims because they can keep the cash proceeds from the claim instead of effectuating repairs to their home or remediating the land.”

For a more complete discussion on sinkholes and sinkhole formation, see Dumm et al. (2018).

The term “karst” is derived from the Slovenian word kras which refers to the Kras region in Slovenia. The land areas of both Slovenia and Croatia (formerly Yugoslavia) are major sinkhole areas.

These counties collectively are known as sinkhole alley. Of these counties, Hillsborough County has one of the highest levels of sinkhole activity.

The costs associated with investigating and testing (engineering) for sinkhole activity are non-trivial. This is further evidenced by a 2010 report by the Florida Senate Committee on Insurance and Banking that average total costs associated with investigation and engineering ranged from $8004 to $9301 during the period of 2006 to 2009.

The FGS reports 579 sinkhole properties in Hillsborough County. At the end of our sample period there were more than 340,000 owner-occupied homes in the county.

The peak-to-trough decline in Florida of 50% was one of the highest in the U.S (Corelogic 2018).

The Hillsborough County Property Appraisers office reported nearly 2100 sinkholes in Hillsborough County at the end of our sample period. Of those sinkholes, 1240 had been remediated while 846 remained unremediated.

While the Citizens data does not contain claims filed with other insurers, this proxy would bias against finding any results for properties with claims, since properties with claims with other insurers are included in the non-claim properties.

Unless SB408 was perfectly timed with a change in climate or ground water use that reduced the number of sinkholes (which does not appear to be the case), it seems that a significant number of sinkhole claims may be related to opportunistic fraud.

For example, see e.g., Dumm et al. 2016; Farber 1998; Seo and Simons 2009, Simons et al. (1997), Simons et al. (1999), Zabel and Guignet (2012), Skantz and Strickland (1987), Harrison et al. (2001), Bin and Polasky (2004), Bin and Kruse (2006), Murdoch et al. (1993)

Sirmans et al. (2005) provide a comprehensive review of studies that have used hedonic pricing models. They review 125 studies and examine over 150 variables that may affect house prices.

While he suggests these results could occur because homebuyers may not be aware of sinkhole locations or do not distinguish between man-made lakes and sinkholes, his method of evaluating median home value by aggregating it at the census block level may obscure true price variation across properties. For that reason, the Dumm et al. (2018) study and this study use individual property transaction price data.

In their study the coefficient for sinkhole presence on a property is negative but not statistically significant. This result is likely a function of too-few sinkhole property observations.

Impact here is both on the insured location as well as on properties in the neighborhood.

Central Florida provides an ideal setting to test the effects of sinkhole claims on house prices. Three central Florida counties (Hernando, Hillsborough, and Pasco) are collectively known as “sinkhole alley”. Per the above-cited 2011 report from the Florida Office of Insurance Regulation, over the period 2006 to 2010, two-thirds of the reported sinkhole damage insurance claims came from these three counties.

If the year built is more recent than the sale year, we assume that the original house was torn down. In that case, the observation is deleted as structural data is only available for houses that are currently standing.

All results reported in this paper use the ¼ mile radius. Results using larger radii were similar to those for the ¼ mile radius.

As a reviewer pointed out, in an ideal setting we would have a control group and a treatment group of repeat-sale properties. We could then look at the differences in sales prices across those properties both before and after the treatment. Doing this, however, would require a significant number of repeat sales on properties in multiple groups such as those that did not have a sinkhole on the property, those that had a sinkhole on the property, and then both of those groups being treated with sinkholes near the property. The nature of our data, unfortunately, does not allow us to perform a repeat sales analysis.

As Flood HazardV includes wave action, it and the 140 mile per hour windzone are both proxies for how close to the coast these properties are (even if they are not directly on the water OnWater).

Later in the paper we use the variables PreCitSinkDen and PostCitSinkDen to denote claims denied before and after passage of SB408. Ideally a more direct test of effect of opportunistic fraud reduction may be testing whether these variables are statistically different. Unfortunately, the coefficient for PostCitSinkDen, although negative, is not significant. Thus, the two coefficients are not statistically different from each another and do not provide direct proof that SB408 reduced the effects of fraud on neighboring properties. Our evidence is more anecdotal, i.e., the number claims made. SB408 significantly reduced the number of sinkhole claims being filed, which logically would lead to fewer fraudulent claims.

This seems to imply that the Hillsborough County Property Appraiser is not updating their database with insurance claim data being reported to the Clerk of the Court. It could be that they do not necessarily believe that a paid claim is a legitimate sinkhole.

Remember that CitSinkClm simply reflects whether or not a sinkhole claim was filed with Citizens and would reflect the information known at the time of sale. For example, suppose a property was sold in 2008 and a sinkhole claim was filed in 2012. In this case CitSinkClm would have a value of zero and, if the property sold for a lower price, it would be for other reasons and not because of a sinkhole claim.

It should be noted that CitSinkClm is not meant to imply a negative effect of a sinkhole claim only and not the sinkhole itself. We further divide the CitSinkClm variable into pre and post SB 408 and paid and unpaid claims in order to differentiate between an actual sinkhole (claim is paid) and a filed claim which is settled for zero dollars. Likewise, we make the same distinction across sinkhole properties and those that are in close proximity.

Two possible scenarios come to mind for this result: the property has residual damage that is not covered by the sinkhole settlement or a stigma is now attached to the property due to its history. For more on stigma effects in house prices, see Kiel and McClain (1995), Jackson (2001), Clauretie and Daneshvary (2009), and Turnbull and Zahirovic-Herbert (2011).

Although the insurer has denied the sinkhole claim, it is possible that the property shows signs of damage that affects the selling price (e.g. cracked walls or tile) or there may, again, be a stigma effect.

These two variables are not statistically different from one another. Thus, we cannot conclude that the effect is weaker post SB408. The biggest difference is in the number claims made. SB408 significantly reduced the number of sinkhole claims being filed, which led to fewer fraudulent claims. The effect of fraudulent claims may remain the same, however the claims themselves are a lot less prevalent.

That is why the regression models do not include a post SB408 claim paid variable, it only identifies one property.

Per the reviewer’s suggestion, we replicated Tables 11 and 12 using the following winsorized variables: citposclaimdens25, citzeroclaimdens25, precitposclaimdens25, and precitzeroclaimdens25. The results are similar, with a slightly less significant effect on the subject property and a slightly greater significant effect on surrounding properties (what happens around you per the density variables becomes more economically significant). This produces a nice robustness check to ensure that our results are not driven by a few outliers. These results are available from the authors upon request.

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Title: Pricing Moral Hazard in Residential Properties: The Impact of Sinkhole Claims on House Prices
Authors: Randy E. Dumm
Charles Nyce
G. Stacy Sirmans
Greg T. Smersh
Publication date: 24-11-2020
Publisher: Springer US
Published in: The Journal of Real Estate Finance and Economics / Issue 1/2022
Print ISSN: 0895-5638
Electronic ISSN: 1573-045X
DOI: https://doi.org/10.1007/s11146-020-09804-2

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