Consumer Compliance Outlook > 2015 > Third-Fourth Quarter 2015

Consumer Compliance Outlook: Third-Fourth Quarter 2015

Flood Insurance Compliance Requirements

By Kenneth Benton, Consumer Regulations Specialist, and Michael Schiraldi, Former Research Assistant, Federal Reserve Bank of Philadelphia

This article provides an overview of federal flood insurance requirements for federally regulated financial institutions, including a brief history of the federal flood insurance statutes and regulations, a review of general flood insurance requirements, a discussion of specific flood insurance compliance issues, and an examination of enforcement provisions. As noted in the introduction to this issue, this article was originally published in 2011.1 Because several significant changes to the federal flood insurance laws and regulations have occurred since then, we are republishing this article with updates to reflect these changes.

STATUTORY BACKGROUND: THE NATIONAL FLOOD INSURANCE ACT OF 1968 AND ITS SUBSEQUENT AMENDMENTS

In response to increased flood damage, the escalating costs of disaster relief for taxpayers, and the lack of affordable flood insurance, Congress enacted the National Flood Insurance Act (NFIA) in 1968.2 The NFIA established the National Flood Insurance Program (NFIP) to address the economic burdens of floods, encourage protective and preventative measures, and reduce the cost of flood insurance.3 Property located in a flood area where the community participates in the NFIP is subject to the NFIA’s requirements. According to the Federal Emergency Management Agency (FEMA), “[a]lmost all of the nation’s communities with serious flooding potential have joined the NFIP.”4

Flood insurance compliance requirements for federally regulated financial institutions began in 1973, when Congress enacted the Flood Disaster Protection Act of 1973 (FDPA).5 Section 102(b) of the FDPA amended the NFIA to require the Board of Governors of the Federal Reserve System (Board), the Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency (OCC), and the National Credit Union Administration (NCUA) to issue regulations directing lending institutions under their supervision not to make, increase, extend, or renew any loan secured by improved real estate or mobile homes located, or to be located, in a special flood hazard area (SFHA) where flood insurance is available under the NFIP unless the building or mobile home and any personal property securing the loan are covered by flood insurance for the term of the loan.

Congress subsequently enacted the National Flood Insurance Reform Act of 1994 (Reform Act),6 which made comprehensive changes to the NFIA and FDPA. The changes include obligating lenders to escrow all premiums and fees for flood insurance required under the NFIA and its implementing regulations if they require escrows for other loans secured by residential real estate or a mobile home7 and applying flood insurance requirements to loans purchased by the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation.8 The Reform Act also brought lenders regulated by the Farm Credit Administration (FCA) within the mandatory flood insurance purchase requirement and directed the Board, FDIC, OCC, NCUA, and FCA (collectively, the agencies) to issue implementing regulations for the institutions they supervise.9 In response to the last requirement, the agencies published substantially similar flood insurance regulations to implement the statutory requirements of the federal flood insurance statutes for the institutions they supervise.10

In part because the NFIP incurred large deficits from paying claims for major floods, Congress enacted the Biggert-Waters Flood Insurance Reform Act of 2012 (BWA)11 to ensure the NFIP’s fiscal stability and for other purposes. To make the program self-sustaining, the BWA phases out both subsidized rates, which apply to approximately 20 percent of policyholders,12 and grandfathering properties (the practice of providing preferential rates to certain property owners when rates are raised or when a property is newly mapped into an SFHA). In addition, because some of the flood insurance rate maps on which FEMA relies in setting premiums did not fully reflect the actuarial risk of floods, the BWA directs FEMA to implement full-risk pricing for all policies, with some limits on yearly rate increases for certain properties until full-risk pricing is implemented.

The BWA also:

As FEMA began to phase in full actuarial rates, some policyholders in high-risk areas expressed concerns that the full rates were unaffordable. In addition, real estate sales in some high-risk areas were negatively impacted because the BWA required full-risk pricing for new policies issued on or after July 6, 2012, and some potential property buyers could not afford the full-risk premiums. In March 2014, Congress passed the Homeowners Flood Insurance Affordability Act (HFIAA)13 to address these concerns and implement other changes to the NFIP.

To make flood insurance premiums more affordable, the HFIAA limits the extent to which rates can increase in one year. While the HFIAA limits annual rate increases, it does not affect Congress’ eventual goal of implementing full-risk pricing for all policies. Other provisions of the HFIAA also attempt to make rates more affordable, such as permitting lenders to not require flood insurance on structures that are part of a residential property but detached from it and that do not serve as a residence. The agencies issued a final rule in July 2015 to implement the changes under the BWA and the HFIAA for which they have jurisdiction, except for the private insurance requirement, which will be addressed in a separate final rule. This article reviews the July 2015 final rule.

The agencies have provided additional guidance about flood insurance compliance requirements for the institutions they supervise through the Interagency Questions and Answers Regarding Flood Insurance (Interagency Flood Q&As). In July 2009, the agencies updated this guidance and included five new proposed Q&As.14 In October 2011, the agencies made two of the questions final, withdrew one, and sought additional comments on some of the force-placement questions.15 On March 29, 2013, the agencies issued the Interagency Statement on the Impact of the BWA, which updated the status of the 2011 proposed questions.16

GENERAL COMPLIANCE REQUIREMENTS

Flood Hazard Area Determination

Before making a loan secured by a residential or nonresidential building or mobile home, a federally regulated lending institution must determine whether the structure is located, or will be located, in an SFHA for which flood insurance is available under the NFIP.17 This requirement applies even if a creditor takes a security interest simply out of an “abundance of caution.” Interagency Flood Q&A 41 makes it clear that “if the lender takes a security interest in improved real estate located in a[n] SFHA, flood insurance is required.” Therefore, lenders must consider these requirements when determining if they will take a security interest in a property located in an SFHA.

Lenders must document the flood hazard determination using FEMA’s Standard Flood Hazard Determination Form (SFHDF) and retain a hard or electronic copy of the form throughout the term of the loan.18 Making a flood determination as early as possible in the loan underwriting process is a good practice because it allows time for the borrower to obtain insurance if it is required and for the lender to meet all other obligations that such a determination may trigger.

Lenders often inquire whether they may rely on a prior flood hazard determination for the same property. Under Interagency Flood Q&A 68, a lender may rely on its own prior determination when it is increasing, extending, or renewing a loan secured by the property if three conditions are satisfied: 1) the prior determination was made within seven years of the date of the transaction, 2) the SFHDF reflects the basis of the determination, and 3) FEMA has not revised or updated the map affecting the property since the original determination was made.19 Lenders can determine when the last update was made to a flood map for a particular address from FEMA’s website.20 A lender may not rely on a determination made by a different lender.21

Required Flood Hazard and Insurance Availability Notice

If a lender determines that property securing the loan is or will be located in an SFHA, the lender must provide a notice to the borrower.22 This borrower notification requirement applies regardless of whether the community participates in the NFIP. The notice must contain a warning that the property is or will be located in an SFHA; a description of the NFIA’s flood purchase requirements; a statement, when applicable, that flood insurance is available under the NFIP and from private insurers; and a statement on the availability of federal disaster relief assistance. Use of the sample notice form provided in Appendix A of Regulation H is not mandatory but provides lenders with a safe harbor if used.23 As discussed in the accompanying article on the new final flood insurance rule, the agencies revised the model form in Appendix A of their implementing regulations to add language notifying the borrower that the lender or servicer may be required to escrow premiums and fees for flood insurance on a residential building or mobile home that lenders may use when the escrow requirements apply and that flood insurance providing the same level of coverage as a standard flood insurance policy under the NFIP may also be available from a private insurance company.

If a lender chooses, it may use its own customized notice, but the notice must contain at least the minimum information required by the NFIA and its implementing regulations.24 The lender must provide the notice to the borrower within a reasonable time before the transaction is completed.25 A record (such as a signed copy of the notice or a certified mail receipt) of the borrower’s receipt of the notice must be retained for the term of the loan.26 In a loan transaction involving multiple borrowers, the lender need only provide notice to one of the borrowers in the transaction.27 If a mortgage servicer is used, the lender must provide notice to the servicer “as promptly as practicable” after the notice is furnished to the borrower and no later than when the lender transmits other loan data (such as information concerning hazard insurance and taxes) to the servicer.28

Amount of Coverage

The required amount of flood insurance for a loan secured by property located in a flood hazard area is the lesser of 1) the loan’s outstanding principal balance or 2) the maximum amount of coverage available under the NFIA for the particular type of property serving as collateral.29 The maximum coverage available under the NFIA is the lesser of 1) the maximum amount of coverage available under the NFIP for the property type securing the loan (i.e., residential, nonresidential) or 2) the overall property value securing the loan minus the value of the land on which it is located (i.e., the property’s “insurable value”).30 The maximum coverage caps in an NFIP participating community are $250,000 for a residential building and $500,000 for a nonresidential building.31 The BWA increased the maximum amount of coverage for a noncondominium residential building designed for use for five or more families from $250,000 to $500,000. This change was effective for new policies, renewals, or change endorsements made on or after June 1, 2014.32

Insurable Value

Because an NFIP policy will not pay a claim in excess of a property’s insurable value, it is important that this value be determined correctly. A miscalculation of the property’s insurance value could cause the lender to inadvertently require the borrower to purchase too much or too little flood insurance coverage, resulting in a violation. For example, if the value of the land is not excluded when determining the insurable value of a home or building, the borrower will purchase coverage exceeding the amount the NFIP will pay for a covered loss.33

To provide greater clarity about insurable value, the agencies issued Interagency Flood Q&A 9 in October 2011. Interagency Flood Q&A 9 explains that while equating the insurable value to replacement cost value (RCV) is appropriate in some cases, RCV should not be used as a proxy for insurable value for properties whose insurance loss payout would ordinarily be based on actual cash value:

Strictly linking insurable value to RCV is not practical in all cases. In cases involving certain residential or condominium properties, insurance policies should be written to, and the insurance loss payout usually would be the equivalent of, RCV. However, in cases involving nonresidential properties, and even some residential properties, where the insurance loss payout would normally be based on actual cash value, which is RCV less physical depreciation, insurance policies written at RCV may require an insured to pay for coverage that exceeds the amount the NFIP would pay in the event of a loss. Therefore, it is reasonable for lenders, in determining the amount of flood insurance required, to consider the extent of recovery allowed under the NFIP policy for the type of property being insured.34

The guidance further states that when this occurs, lenders may choose from any reasonable approach to calculate insurable value as long as it can be supported. The guidance provides examples of permissible methods, including appraisal based on a cost-value (not market-value) approach, a construction-cost calculation, and the insurable value used in a hazard insurance policy with appropriate adjustments.35

Escrowing Flood Insurance Premiums and Fees

In the Interagency Flood Q&As, the agencies encourage lenders and servicers to escrow flood insurance premiums. Following this recommendation could result in less force placement of flood insurance. If a creditor requires escrow accounts for loans secured by residential real estate or mobile homes, the creditor must also require the escrow of all premiums and fees for flood insurance required under the NFIA and its implementing regulations.36 The agencies’ regulations authorize regulated lenders, or servicers acting as their agents, to deposit the funds earmarked for flood insurance premiums and fees into the escrow fund on the borrower’s behalf. The lender or its servicer is then required to make payments for the borrower’s flood insurance premiums from the escrow account as they become due.37

The BWA amended these escrow requirements by requiring lenders or servicers to escrow flood insurance premiums and fees for all loans secured by residential property unless an exception applies, including an exception for small lenders meeting certain requirements. The article on the final rule reviews the escrow requirement and its exceptions.

Force Placement of Flood Insurance

The agencies’ flood regulations address the requirements for force placement of flood insurance. If at any time during the term of the loan a lender or its servicer determines that the collateral has less flood coverage than is required by the agencies’ implementing regulations, it must notify the borrower to obtain the required insurance.38 If the borrower has not purchased the necessary flood insurance within 45 days after the notice was sent, the lender must purchase insurance on the borrower’s behalf.39 A lender may comply with the force-placement requirement by purchasing an NFIP Standard Flood Insurance Policy or an appropriate private flood insurance policy in the amount required by the implementing regulations.40

The agencies provide guidance on when force-placement insurance must become effective in Interagency Flood Q&A 61, which states that if a borrower fails to obtain insurance within 45 days after notification, the agencies expect the lender to have insurance in effect on the 46th day. If there is a brief delay, for example, because of batch processing, the agencies expect the lender to provide a reasonable explanation for the delay.41

The BWA made changes to the force-placement flood insurance requirements. In particular, the BWA requires that if a lender force places flood insurance and the borrower already had coverage and notifies the lender and produces the declaration page, the lender must refund the premiums and charges incurred during the period of duplicate coverage. The BWA also authorizes lenders to purchase force-placement flood insurance when they learn that a property has no coverage or insufficient coverage and to pass the cost along to the borrower. These changes are discussed in the final rule article.

SPECIFIC COMPLIANCE ISSUES

Flood Insurance Requirements for Residential Condominiums

Flood insurance is required for loans secured by an individual residential condominium unit, including a unit in a multistory condominium complex, if the condominium is located in an SFHA where flood insurance is available under the NFIP. Loans secured by other condominium property are also covered, such as loans to condominium associations or to condominium developers.42

The NFIP offers a specific insurance policy for a residential condominium complex — defined as a building having 75 percent or more of its floor area in residential use — known as the Residential Condominium Building Association Policy (RCBAP).43 This policy, which can only be purchased by condominium owners’ associations, covers all individual units (including improvements) and common property. Content in the units can also be covered if content coverage is purchased.

The minimum amount of flood insurance for a loan secured by a condominium unit is the lesser of the outstanding principal balance of the loan or the maximum amount available under the NFIP, which is the lesser of:

To facilitate compliance, the Interagency Flood Q&As include a condominium loan example in which a lender makes a $300,000 loan secured by a residential condominium unit in a 50-unit condominium building that is located in an SFHA within a participating community, with a replacement cost of $15 million and that is insured by an RCBAP with $12.5 million of coverage.44

In this example, additional flood insurance is not required because the RCBAP’s $250,000 per unit coverage ($12.5 million ÷ 50 = $250,000) satisfies the mandatory flood insurance requirement, which is the lesser of 1) the outstanding principal balance ($300,000), 2) the maximum coverage available under the NFIP ($250,000), or 3) 100 percent of the insurable value ($15 million ÷ 50 = $300,000). Lenders may rely on the RCV and number of units on the RCBAP declaration page when verifying compliance.

If a lender determines that a borrower’s unit is not covered by an RCBAP or that the coverage under an RCBAP is below the minimum amount required by the NFIA, the lender must ensure that the borrower obtains sufficient coverage.45 The lender should first request that the borrower ask the condominium association to obtain coverage or obtain additional coverage sufficient to meet the regulation’s requirements. If the association fails to comply, the lender must require the borrower to purchase a FEMA dwelling policy for supplemental coverage or force place the policy if necessary.46 When both the RCBAP and a dwelling policy cover the same unit, the RCBAP is considered primary insurance. The maximum amount of coverage for a residential condominium unit is $250,000; therefore, when both an RCBAP and dwelling policy are in place, the policies are coordinated such that the maximum payout is capped at $250,000.

Nonresidential Condominium Associations

For a nonresidential building (a building with less than 75 percent residential square footage) that includes condominiums, the condominium association must purchase FEMA’s general property policy. Both building and contents coverage are available separately, in amounts up to $500,000 per nonresidential building.

Home Equity Loans or Lines of Credit

A home equity loan (closed-end credit) or home equity line of credit (open-end credit) secured by a building or mobile home located in an SFHA community that participates in the NFIP is subject to the flood insurance requirements, regardless of lien priority.47 Therefore, when a lender makes, increases, extends, or renews a designated home equity loan or line of credit, it must ensure adequate flood insurance is in place, taking into account the liens of other creditors on the property.

For home equity loans with multiple lienholders, the required minimum coverage is determined by the same formula used for single-lien designated loans, except that the outstanding principal balance of the designated home equity loan is calculated by adding together the principal balances of each existing loan. Therefore, when the outstanding principal balance of all loans is less than the property’s insurable value, a lender making a home equity loan on a property with multiple liens cannot comply with the minimum coverage requirement by simply ensuring that flood coverage for the collateral is at least equal to the outstanding principal balance of its loan to the borrower.

The lender must calculate both the total principal balance of all of the outstanding liens on the property and the total amount of flood insurance on the other senior and junior lien(s) securing the property.48 Interagency Flood Q&A 36 provides several examples to facilitate compliance. Lenders may obtain a borrower’s current credit report to determine the current amounts owed to other lienholders.49

For home equity lines of credit, a flood determination must be made before the consummation of the loan, but draws against an approved line of credit do not require additional determinations.50 However, a borrower’s request to increase the credit limit on the line of credit may trigger a new flood insurance determination depending on whether the requirements in Interagency Flood Q&A 68 for relying on a previous flood insurance determination are satisfied.

Construction Loans

The Interagency Flood Q&As 19 through 23 provide detailed guidance on the flood insurance requirements for construction loans. If a loan is secured only by land that will later be developed into a buildable lot, flood insurance is not required because the insurance requirements apply only to a loan secured by a building or mobile home.51 On the other hand, a loan secured by a building in the course of construction is subject to flood insurance requirements, even if the building is not yet walled and roofed, as long as the construction has not been halted for 90 days or longer or the lowest floor used for rating purposes is not below the base flood elevation (BFE).52 When insurance is obtained for a building in the course of construction, materials or supplies used in construction or repair are not insurable unless they are in an enclosed building located on or adjacent to the premises.

The Interagency Flood Q&As offer two compliance options for a lender making a loan secured by a building to be constructed. A lender may require the borrower to acquire a flood insurance policy at the time of origination. Alternatively, a lender may allow a borrower to defer the purchase of flood insurance until either 1) a foundation slab has been poured or an elevation certificate has been issued or 2) the building is walled and roofed, provided the building to be constructed will have its lowest floor below the BFE.53 But before the lender disburses funds for construction (except for pouring the slab or preliminary site work), it must require the borrower to have flood insurance in place.

A lender that elects to allow the borrower to defer the purchase of flood insurance until after origination must have adequate internal controls in place to detect whether either of the above two mandatory purchase triggers has occurred. When either of these triggering conditions occurs, the lender must require the borrower to purchase flood insurance or, if necessary, prepare to force place the insurance.54

Regulated Lender Responsibility for Designated Loans Serviced by Third Parties

When a regulated lender originates a designated loan and later transfers or sells the servicing rights to a nonregulated party but retains ownership of the loan, the regulated lender remains ultimately responsible for fulfilling the flood insurance compliance requirements. The regulated lender must take adequate steps to ensure that the loan servicer will comply with all flood insurance requirements. Such steps include notifying FEMA or its designee of the identity of the new servicer.55

ENFORCEMENT: CIVIL MONETARY PENALTIES

Under the NFIA, a regulated lender demonstrating a “pattern or practice” of violating any of the following statutory requirements is subject to civil monetary penalties (CMPs): 1) purchasing flood insurance where available, 2) escrowing flood insurance premiums when required, 3) force placing flood insurance after providing the requisite notice to the borrower, 4) providing notice of special flood hazards and the availability of federal disaster relief assistance, and 5) providing notice of the identity of the loan’s servicer and any change of that servicer to the regulatory entity.56

The NFIA does not define “pattern or practice.” In determining whether a lender has engaged in a pattern or practice of flood insurance violations, Interagency FloodQ&A 82 states that the following factors may be considered whether:

While “[i]solated, unrelated, or accidental occurrences” will not be deemed a pattern or practice, “repeated, intentional, regular, usual, deliberate, or institutionalized practices will almost always constitute a pattern or practice.”57

The BWA increased the maximum amount of CMPs for a “pattern or practice” of violating certain flood insurance requirements from $385 to $2,000 for each violation and removed the $135,000 statutory cap on the amount of CMPs that may be assessed against an individual financial institution in a single calendar year.58

The agencies assess CMPs for violations when required by the statute. In addition to imposing a substantial financial penalty, CMPs can cause reputational damage to financial institutions because the CMP orders are often reported by local media outlets and are tracked on websites.59

CONCLUSION

Congress enacted the NFIA to reduce the costly burden of floods. In recent years, major flooding has caused devastating property losses, making the NFIA and its amendments even more crucial. It is important that financial institutions have strong flood insurance compliance programs. Specific issues and questions about consumer compliance matters should be raised with your primary regulator.