Consumer Compliance Outlook > 2022 > Second Issue 2022

Consumer Compliance Outlook: Second Issue 2022

Commercial Flood Insurance Compliance — Washing Away Common Pitfalls

By Danielle Martinage, Senior Examiner, Federal Reserve Bank of Boston

Flooding is the most common and costly natural disaster in the United States. Ninety-eight percent of counties across our country have experienced a flooding event, and flood waters continue to pose a greater potential for damage than any other natural disaster. Moreover, in the last decade, floods alone have caused over $155 billion in property damages and they continue to account for the majority of federally declared disasters.

• Michael Grimm, FEMA Assistant Administrator for Risk Management¹

Congress created the National Flood Insurance Program (NFIP) “to provide access to flood insurance for properties with significant flood risk and to reduce flood risk through the adoption of floodplain management standards.”² The NFIP provides flood insurance to property owners and businesses to safeguard against the risk of loss in the event of a flood. In 1973, Congress enacted the Flood Disaster Protection Act of 1973 (FDPA)³ to ensure that loans secured by property in a special flood hazard area originated by a regulated lending institution or certain federal agency lenders, or loans sold to the government sponsored enterprises, are covered by flood insurance for the life of the loan.⁴ Loans subject to flood insurance purchase requirements are defined as “designated loans” in the agencies’ implementing regulations.⁵

Although compliance staff often focus on flood insurance purchase requirements for designated loans for residential properties, the FDPA also applies to commercial properties. According to the Flood Emergency Management Agency (FEMA), approximately 40 percent of businesses close after a disaster, while another 25 percent close within one year of reopening.⁶ FEMA also indicates that over 90 percent of natural disasters involve floods and that “high-risk flood areas are not the only ones at risk: about 25% of flood insurance claims come from moderate- to low-risk areas.”⁷

To facilitate compliance, this article discusses some common pitfalls for commercial flood insurance compliance, provides examples to assist in ensuring appropriate flood insurance coverage is in place, and reviews FEMA’s recent Risk Rating 2.0 initiative and its effect on premiums for commercial properties. FEMA does not use the terminology commercial property but instead uses the broader term nonresidential property, which it defines as a “building where the primary use is commercial or non-habitational.”⁸ To align with FEMA’s terminology, this article uses the term nonresidential to discuss the requirements for commercial loans.

Key Flood Insurance Requirements

The FDPA requires the borrower of a designated loan to obtain flood insurance for the entire term of the loan when:

• lenders make, increase, extend, or renew a loan (nonresidential or residential) secured by improved real estate or a mobile home that is affixed to a permanent foundation;
• the loan is secured by property located or will be located in a Special Flood Hazard Area (SFHA)⁹ as identified by FEMA; and
• the community in which the property is located participates in the NFIP.¹⁰

Table 1 lists the maximum amount of coverage available under the NFIP for residential and nonresidential structures and their contents.

In addition, the revised Interagency Questions and Answers regarding flood Insurance (Flood Q&As)¹¹ specify that “if a lender, or a servicer acting on its behalf, determines at any time during the term of a designated loan that a building or mobile home and any personal property securing the loan is not covered by flood insurance or is covered by flood insurance in an amount less than the amount required under the Regulation, the lender or its servicer must notify the borrower to obtain flood insurance, at the borrower’s expense, in an amount at least equal to the minimum amount required under the Regulation.”¹²

Table 1 — Distinguishing Between Residential and Nonresidential Loans

To provide additional clarity, the revised Flood Q&As defines nonresidential loans and provides examples of both. Table 2 provides examples in the “Interagency Questions and Answers Regarding Flood Insurance” and the NFIP Flood Insurance Manual.¹³

Table 2: Examples of Residential and Nonresidential Flood Insurance Coverage

How to Determine Proper Flood Insurance Amounts

Once a property has been properly classified as residential or nonresidential, the lender or servicer must determine the proper amount of flood insurance coverage. The required amount is: 1) the outstanding principal balance of the loan(s), or 2) the maximum amount of insurance available under the NFIP.¹⁷ It is important to note that the latter actually has two tests; the lesser of the maximum amount available for the type of structure or the insurable value of the property.¹⁸

To demonstrate how this works, let’s review an example:

How to Calculate Insurable Value

Insurable value is defined as the overall value of the property securing the designated loan minus the value of the land on which the property is located.¹⁹ It is important to calculate the correct insurable value of the property; otherwise, the lender might inadvertently require the borrower to purchase too much or too little flood insurance.²⁰

According to the Flood Q&As, the insurable value of a building is generally 100 percent of its replacement cost value (RCV), which is the cost to replace the building with the same kind of material and construction without deducting depreciation.²¹ In calculating the amount of insurance to require, the lender and borrower may choose from a variety of ways to establish the insurable value, including:

• an appraisal based on a cost-value (not market-value) approach
• a construction-cost calculation
• the insurable value used in a hazard insurance policy (recognizing that adjustments may be necessary as this value does not include the value of the foundation), or
• any other reasonable approach, so long as it can be supported.²²

Nonetheless, the RCV may not always be practical in determining insurable value. For nonresidential properties, the insurable value might be based on actual cash value (ACV), which is RCV minus the value of its physical depreciation.²³ In these situations, using RCV rather than ACV could cause the borrower to be insured for more coverage than they would be recovered in the event of a loss.

Calculating Coverage for Multiple Buildings

Another challenging issue is the required amount of insurance for a loan secured by multiple properties, when at least one of them is in an SFHA. To clarify, the lender must first determine whether the community in which the buildings securing the loan are located participates in the NFIP.²⁴ For those buildings, the lender must calculate the required amount of insurance required on each building and add them together.²⁵ Similar to the prior example, the total amount of required flood insurance is the lesser of 1) the outstanding principal balance of the loan(s), or the maximum amount of insurance available under the NFIP, which is the lesser of (a) the maximum limit available for the type of structures, or the insurable value of the structures. All buildings in the SFHA must be covered, though the amount of total required flood insurance can be allocated among the secured buildings in varying amounts.²⁶

Mixed-Use Properties

A property can be used for both residential and nonresidential purposes. Here is an example of a property qualifying as a mixed-use building.

Contents Coverage

When a loan is secured by a building and its contents, and the building is in a SFHA in a participating community, flood insurance coverage is required for both the building and the contents.²⁷ As noted previously, the maximum amount of coverage available through the NFIP is $100,000 for residential contents and $500,000 for nonresidential contents.

Here are some examples in which the building and its contents are taken as collateral.

It is important to note that lenders can review loan agreements²⁹ and security instruments to verify whether a security interest is taken in the building and contents. Examiners frequently see situations in which a lender obtains flood insurance for the building but not its contents, often because the lender did not intend to take the contents as collateral. The Interagency Flood Q&As clarify the lender cannot exempt the contents from required coverage because the lender took a security interest inadvertently or out of an abundance of caution. Where the loan agreements and security instruments create a security interest in the contents, regardless of whether the security interest is perfected under applicable law, flood insurance must be purchased to cover the contents.³⁰

EFFECT OF RISK RATING 2.0 ON PREMIUMS FOR NONRESIDENTIAL PROPERTIES

Outlook recently reviewed FEMA’s Risk Rating 2.0 initiative to revise its methodology for pricing flood insurance to more accurately capture the actuarial risk of a flood based on a property’s individual risk factors, rather than the flood insurance zone in which it is located.³¹ Some policyholders will see decreases in premiums, while others will see increases. As discussed in the article, the Homeowner Flood Insurance Affordability Act generally limits annual increases in food insurance premiums to no more than 18 percent for individual policies. However, the annual limit for business properties and certain other properties is 25 percent.³² While the annual limit prevents immediate implementation of full risk pricing for policies whose premiums are increasing, premiums will eventually rise to full-risk pricing.

Conclusion

Congress enacted the NFIP and FDPA to mitigate flood risk and provide access to flood insurance for properties at high risk of flooding. It is important for lenders to ensure borrowers maintain the required amount of flood insurance through the life of a designated loan to protect their collateral and to protect their borrowers against flooding. This is achieved through strong flood insurance compliance management programs for all applicable business lines, including residential and nonresidential. Specific issues and questions about consumer compliance matters should be raised with your primary regulator.

ENDNOTES

¹ See Testimony of Michael Grimm, FEMA assistant administrator for Risk Management, before the Committee on Science, Space, and Technology of the House of Representatives, February 27, 2020.

² See “Introduction to the National Flood Insurance Program (NFIP),” Congressional Research Service Updated on December 9, 2021.

³ See Pub. L. 93-234, 87 Stat. 975 (December 31, 1973). Codified, as amended, at 42 U.S.C. §4012a. The full text of the FDPA is available here.

⁴ See 12 C.F.R. §208.25(c)(1) for the requirements for federally regulated lenders.The agencies’ implementing regulations for the FDPA are found at12 C.F.R. §208.25(Regulation H) for institutions supervised by the Board,12 C.F.R. part 22for institutions supervised by the Office of the Comptroller of the Currency,12 C.F.R. part 339for institutions supervised by the Federal Deposit Insurance Corporation,12 C.F.R. part 614for institutions supervised by the Farm Credit Administration, and12 C.F.R. part 760for institutions supervised by the National Credit Union Administration. This article refers to the flood insurance requirements of the Board’s Regulation H, but the other agencies’ regulations, which are issued on an interagency basis, are substantially similar.

⁵ See 12 C.F.R. §208.25(b)(5).

⁶ See Stay in Business After a Disaster by Planning Ahead.

⁷ See FEMA Fact Sheet Flooding: Our Nation’s Most Frequent and Costly Natural Disaster (2010).

⁸ See Sections_1‒6_October 2021 RR 2.0 NFIP Flood Insurance Manual at 3.11.

⁹ The Special Flood Hazard Area (SFHA) is a high-risk area defined as any land with at least a 1 percent chance of flooding within a given year. On flood maps, SFHA are labeled as zones starting with A or V. Answers to Questions About the National Flood Insurance Program.

¹⁰ See Federal Reserve Supervision Manual for Flood Insurance at p. 2.

¹¹ The agencies recently revised the Q&As. See 2022 Interagency Questions and Answers Regarding Flood Insurance at 87 Federal Register 32826 (May 31, 2022).

¹² See Force Placement Q&A 1 of the 2022 Q&As. In the new Q&As, the agencies also revised the numbering methodology from consecutive numbering of all of the Q&As to subcategories, with consecutive numbering for each of the questions within the subcategory, such as Construction 2.

¹³ This list is not exhaustive. See NFIP Flood Insurance Manual Sections_1-6 Oct 2021 RR 2.0 NFIP Flood Insurance Manual at p. 75.

¹⁴ The Flood Q&As add language to clarify that the description of a nonresidential building is based on language in the NFIP Flood Insurance Manual and revised the answer to more clearly indicate that the building does not have to be one in which the named insured is a commercial enterprise.

¹⁵ For more information on condominiums, see “Flood Insurance Compliance Requirements,” Consumer Compliance Outlook (Third/Fourth Quarter 2015).

¹⁶ For loans secured by individual commercial condominium units, the regulation does not have mandatory purchase requirement since the NFIP does not provide coverage for such units other than contents coverage. See Condo and Co-Op 9 87 Federal Register at 32883.

¹⁷ See 12 C.F.R. §208.25(c)(1).

¹⁸ We discuss the amount of insurance required by the FDPA, but lenders may require flood insurance coverage in excess of that amount. For example, for a commercial property, the maximum coverage available under the NFIP is $500,000. If the loan amount exceeds $500,000, the lender may want supplemental coverage through a private flood insurance policy to protect its collateral. See Answers to Questions About the National Flood Insurance Program.

¹⁹ See Q&A Amount 7. The implementing regulations also provides that “flood insurance under the Act is limited to the building or mobile home and any personal property that secures a loan and not the land itself.” See 12 C.F.R. §208.25(c)(1).

²⁰ See Flood Q&A Amount 1 (87 Federal Register at 32878).

²¹ See Flood Q&A Amount 2 (87 Federal Register at 32878): “In calculating the amount of flood insurance to require, the lender and borrower may choose from a variety of approaches or methods to establish the insurable value. They may use an appraisal based on cost-value (not market-value) approach, a construction-cost calculation, the insurable value based on a hazard insurance policy, or any other reasonable approach so long as it can be supported.” See also FEMA’s discussion of Replacement Cost Value (RCV).

²² See Flood Q&A Amount 2.

²³ FEMA pays Replacement Cost Value for primary residences and Actual Cash Value for all other structures (National Flood Insurance Program April 2021 Flood Insurance Manual). The NFIP used the term principal residence, as defined in the Standard Flood Insurance Policy (SFIP), to determine the amount of the loss settlement. The SFIP defines this term as a single-family dwelling in which, at the time of loss, the named insured (or the named insured’s spouse) has lived for either 80 percent of the 365 days immediately preceding the loss, or 80 percent of the period of ownership, if the dwelling was owned less than 365 days. If the dwelling does not meet this definition, the NFIP will settle the claim using actual cash value, under the terms of the SFIP.

²⁴ See 12 C.F.R. §208.25(f)(1) (Board). For safety and soundness reasons, lenders may require the purchase of private flood insurance on buildings located in an SFHA but not in a participating community. See Q&As Applicability 3. (See 87 Federal Register at 32867.) Further, depending on the risk factors of the building, a lender may elect to require flood insurance even if the building is not in an SFHA.

²⁵ The flood regulations require insurance of “at least equal to the lesser of the outstanding principal balance of the designated loan or the maximum limit of coverage available for the particular type of property under the Act.” FEMA, the agency under the National Flood Insurance Act charged with implementing the NFIP, states in its manual: “The aggregate limits for building coverage are the maximum coverage amounts allowed by statute for each building included in the relevant occupancy category.” See NFIP Flood Insurance Manual at 3-3.

²⁶ See Flood Q&A Amount 6 (87 Federal Register at 32879).

²⁷ See 12 C.F.R. §208.25(c)(1).

²⁸ See Flood Q&A Other Security Interests 7 (87 Federal Register at 32885).

²⁹ Flood Q&A Other Security Interests 9 specifies that the loan agreement or security instrument determine whether the contents are taken as security for the loan. See 87 Federal Register at 32885.

³⁰ See Flood Q&A Other Security Interests 9. For additional information on contents coverage for commercial loans, see “Vendor Management Considerations for Flood Insurance Requirements,” Consumer Compliance Outlook (Second Issue 2019).

³¹ See “FEMA Begins Risk Rating 2.0 Flood Insurance Initiative 2021,” Consumer Compliance Outlook (Issue 4 2021).

³² See 42 U.S.C. §4015(e)(4).