Consumer Compliance Outlook > 2024 > First Issue 2024

Consumer Compliance Outlook: First Issue 2024

Overview of Private Flood Insurance Compliance Requirements

By Kenneth J. Benton, Principal Consumer Regulations Specialist, Federal Reserve Bank of Philadelphia

The great Mississippi River flood of 1927 caused more destruction than any flood in American history, covering over 27,000 square miles across several states and producing $427 million dollars in damage (in 1927 dollars).¹ In response to this flood, many private flood insurers retreated from the market out of concern that “insurance against the peril of flood cannot successfully be written.”² Eighty-five years later, Congress tried to revive the private flood insurance market by enacting the Biggert–Waters Flood Insurance Reform Act of 2012 (BWA),³ with the goal of improving the financial stability of the National Flood Insurance Program (NFIP) by increasing the role of private insurers in managing the nation’s flood risks.⁴

Among other changes, the BWA directed the Federal Emergency Management Agency (FEMA) to implement risk-based pricing of premiums⁵ and amended the Flood Disaster Protection Act of 1973 (FDPA) to require regulated lending institutions, federal agency lenders, and the government-sponsored enterprises (GSEs) to accept a private flood insurance policy meeting the BWA’s definition of “private flood insurance” to satisfy the FDPA’s mandatory flood insurance purchase requirements.⁶ This provision was designed to decrease the cost to the federal government of providing flood insurance through the NFIP by encouraging private flood insurance carriers to enter the market. Previously, lenders had the discretion to accept private policies under certain conditions pursuant to questions and answers (Q&As) 63 and 64 of the 2009 notice “Interagency Questions and Answers Regarding Flood Insurance” but were not required to accept them.⁷

In 2019, the Board of Governors of the Federal Reserve System (Board), the Farm Credit Administration, the Federal Deposit Insurance Corporation (FDIC), the National Credit Union Administration (NCUA), and the Office of the Comptroller of the Currency (OCC) (agencies) jointly issued a final rule to implement the BWA’s private flood insurance provision.⁸ The agencies had previously implemented the other provisions of the BWA in a final rule published in 2015.⁹ This article provides an overview of the private flood insurance final rule, which includes 1) mandatory acceptance of private flood insurance, 2) discretionary acceptance of private flood insurance, and 3) flood insurance coverage provided by mutual aid societies. The agencies also conducted an Outlook Live webinar on the final rule on June 18, 2019.¹⁰ The first part of the article reviews the regulation’s requirements for these three sections of the final rule, while the second part summarizes the agencies’ clarifications of these requirements in the 2022 updates to the flood insurance Q&As.¹¹

FDPA’S FLOOD INSURANCE PURCHASE REQUIREMENTS

The National Flood Insurance Act, as amended by the FDPA, requires a regulated lending institution or federal agency lender that makes, increases, extends, or renews a 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 to ensure the loan is covered by flood insurance for the term of the loan for the lesser of the loan balance or the maximum amount of insurance available under the NFIP.¹² The agencies’ implementing regulations refer to a loan for which flood insurance is required as a designated loan.¹³ Loans sold to the GSEs are also subject to the flood insurance purchase requirements.¹⁴

BWA’S REQUIREMENTS

Mandatory Acceptance of Private Flood Insurance

The final rule requires regulated lenders to accept a flood insurance policy meeting the regulation’s definition of private flood insurance to satisfy the purchase requirements for designated loans.¹⁵ The rule defines private flood insurance as an insurance policy that:

• is issued by an insurance company that is licensed, admitted, or otherwise approved by the state insurance regulator where the insured property is located or that is recognized (or not disapproved) as a surplus lines insurer for a policy of difference in conditions, multiple peril, all risk, or other blanket coverage insuring nonresidential commercial property.
• provides flood insurance coverage at least as broad as a standard flood insurance policy (SFIP) issued under the NFIP for the same type of property, including with respect to deductibles, exclusions, and other conditions. To be at least as broad as the coverage provided under an SFIP, the policy must satisfy these requirements:
  • define flood to include the flood events defined in an SFIP;
  • contain coverage as broad as the SFIP’s, including building property coverage; personal property coverage, if purchased by the insured mortgagor(s); other coverages; and increased cost of compliance coverage;
  • contain deductibles no higher than the specified maximum and include similar non-applicability provisions, as under an SFIP, for any total policy coverage amount up to the maximum available under the NFIP at the time the policy is provided to the lender;
  • cover direct physical loss that a flood causes and not include exclusions other than those in SFIPs unless they are for coverage in addition to the amount and type of coverage that could be provided by an SFIP or provide broader coverage to the policyholder; and
  • does not narrow the coverage provided in an SFIP.
• includes all of the following:
  • a requirement that the insurer provide a written notice 45 days before cancellation or nonrenewal of flood insurance coverage to the insured and the lender or loan servicer,
  • information about the availability of flood insurance coverage under the NFIP,
  • a mortgage interest clause similar to the clause in an SFIP, and
  • a provision requiring the insured to file suit not later than one year after the date of a written denial of all or part of a claim under the policy.
• contains cancellation provisions that are as restrictive as the provisions contained in an SFIP.

To facilitate lenders’ compliance, the agencies included a compliance aid statement in the private flood insurance final rule, which provides that a lender may determine whether a policy qualifies as private flood insurance, without further review of the policy, if the policy or endorsement contains this verbatim language: “This policy meets the definition of private flood insurance contained in 42 U.S.C. 4012a(b)(7) and the corresponding regulation.”¹⁶

Discretionary Acceptance of Private Flood Insurance

The private flood insurance final rule permits a lender to accept a policy that does not meet the regulation’s definition of a private flood insurance policy if it meets the regulation’s discretionary acceptance standard. To qualify, a policy must:

• provide coverage in the required amount;
• be issued by an insurer licensed, admitted, or otherwise approved by the state insurance regulator to provide insurance in the jurisdiction in which the property to be insured is located; or, in the case of a policy of difference in conditions, multiple peril, all risk, or other blanket coverage insuring nonresidential commercial property, be issued by a surplus lines insurer recognized (or not disapproved) by the insurance regulator of the state or jurisdiction where the property to be insured is located;
• cover both the lender(s) and borrower(s) as loss payees, except in the case of a policy that is provided by a condominium association, cooperative, homeowners association, or other applicable group and for which the premium is paid by the condominium association, cooperative, homeowners association, or other applicable group as a common expense; and
• provide sufficient protection of the designated loan, consistent with general safety and soundness principles, and the lender must document its conclusion regarding sufficiency of the protection of the loan in writing.

Mutual Aid Societies

Under the private flood insurance final rule, a regulated lender may accept a plan offered by a mutual aid society to cover flood damages to a member’s property to satisfy the mandatory purchase requirements if the plan meets the regulation’s requirements. The regulation defines mutual aid society as an organization:

• whose members share a common religious, charitable, educational, or fraternal bond;
• that covers losses caused by damage to members’ property pursuant to an agreement, including damage caused by flooding, in accordance with this common bond; and
• that has a demonstrated history of fulfilling the terms of agreements to cover losses to members’ property caused by flooding.

The regulation requires that the mutual aid society’s plan must:

• qualify as flood insurance by the lender’s federal regulator;
• provide coverage in the amount required by the regulation;
• cover both the mortgagor(s) and the mortgagee(s) as loss payees; and
• provide sufficient protection of the designated loan, consistent with general safety and soundness principles, and the lender must document its conclusion of the plan’s protection of the loan in writing.

Since the regulation requires a lender’s primary regulator to approve a mutual aid society plan, a lender should contact its regulator if it is considering allowing a borrower to use a mutual aid society plan.

Q&A CLARIFICATIONS OF THE PRIVATE FLOOD INSURANCE REQUIREMENTS

When the agencies updated the 2022 revised flood insurance Q&As, they added several clarifying Q&As on the requirements for private flood insurance policies and mutual aid society plans, which we highlight here.

Q&As on Mandatory Acceptance

• Mandatory 1: A lender may decide to accept only flood insurance policies issued by a private insurer under the mandatory provision that meet the definition of private flood insurance and provide the proper amount of insurance.
• Mandatory 2: A lender whose policy is to not originate loans in nonparticipating communities or other regions where the NFIP is not available is not required to change this policy because of the private flood insurance requirements.

Q&As on Compliance Aid Statement

• Mandatory 3: The compliance aid statement is not a conformity clause. Such a clause would have the legal effect of making the private policy conform to the regulation’s definition of private flood insurance. Instead, the statement “is intended to leverage the expertise of insurers to assist lenders in satisfying the ‘private flood insurance’ definition of the regulation.”
• Mandatory 4: A lender is not required to rely on a compliance aid statement. A lender “may choose to make its own determination about whether the policy meets the definition of ‘private flood insurance’ or whether the policy is acceptable under the discretionary acceptance or mutual aid criteria.”
• Mandatory 5: A lender may rely on a compliance aid statement without reviewing the policy to determine that it meets the definition of “private flood insurance” if the statement contains the verbatim language in the regulation. But a statement does not have to be rejected because it contains stylistic differences such as formatting, font, or punctuation that do not change the substantive meaning of the clause.
• Mandatory 6: A lender relying on a compliance statement must still ensure the loan has the proper amount of insurance. The FDPA requires that “the amount of insurance is 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 [FDPA].”
• Mandatory 7: A lender may review a policy with no compliance aid statement under the discretionary acceptance standard without first checking if it meets the mandatory acceptance requirements. But if the policy does not meet the discretionary acceptance standard, the lender has to determine if it must accept the policy because it meets the definition of a private flood insurance policy.
• Mandatory 8: If the compliance aid statement appears on the declaration page using the verbatim language in the regulation, further review is not required. But as noted in Q&A Mandatory 6, the lender must still confirm the borrower obtained the required amount of insurance.
• Mandatory 9: A lender may rely on a compliance aid statement containing the regulation’s verbatim language even if the policy contains the disclaimer “insurer is not licensed in the State or jurisdiction in which the property is located” (suggesting a surplus lines insurer), provided the policy complies with the regulation and applicable state law.

Q&As on Discretionary Acceptance and Mutual Aid Societies

• Discretionary 1: A lender is not required to accept a policy or mutual aid society plan that meets the discretionary acceptance standard.
• Discretionary 2: A lender may include any information reasonably supporting its conclusion that a discretionary policy provides sufficient protection of the loan to fulfill the requirement that the lender document its conclusion in writing. Specific documentation is not required.
• Discretionary 3: A lender may obtain information from the insurance regulator of the state in which the property securing the loan is located to evaluate the insurer’s financial strength. A lender can rely on the licensing or other processes used by the state insurance regulator for such an evaluation.
• Discretionary 4: Both the discretionary acceptance standard and the mutual aid society standard require coverage that sufficiently protects the loan, which the lender must document. This Q&A discusses the factors a lender may consider to support its conclusion:
  • whether the policy’s deductibles are reasonable based on the borrower’s financial condition;
  • whether the insurer provides adequate cancellation notice to the borrower and lender to ensure the borrower has time to obtain replacement insurance or the lender can provide timely force placement of flood insurance, if necessary;
  • whether the terms and conditions of the policy for payment per occurrence or per loss and aggregate limits adequately protect the lender’s interest in the collateral;
  • whether the policy complies with applicable state insurance laws; and
  • whether the private insurance company has the financial solvency, strength, and ability to satisfy claims. See also Q&A Discretionary 3 (lender may look to information from the state regulator to evaluate a flood insurer’s financial condition).
• Private Flood Compliance 1: A lender may accept a discretionary policy with a deductible greater than the maximum one under the NFIP. However, the lender must still determine whether the policy sufficiently protects the loan, consistent with safety and soundness principles, and cannot select a deductible that equals or exceeds the insurable value of the property.

Q&As on Requirements for All Private Policies and Plans

• Private Flood Compliance 7: Lenders selling designated loans in the secondary markets to the GSEs must ensure they comply with the agencies’ requirements and should ensure the GSEs’ requirements for private flood insurance policies are also met. After the agencies issued their regulations, Fannie Mae discussed this issue in a June 5, 2019, selling notice, and Freddie Mac discussed it in a June 12, 2019, bulletin.
• Private Flood Compliance 11: At renewal, a lender may rely on its previous review provided changes were not made to the policy or plan that would affect its acceptance. For example, if a policy were unchanged, a lender would not be required to conduct another review to determine whether the policy complies with private flood insurance requirements. But a lender is still required to verify the policy or plan provides the required amount of coverage.

STATE OF THE PRIVATE FLOOD INSURANCE MARKET

Recent data suggest the BWA and other changes in the flood insurance market are increasing the use of private flood insurance policies. According to the Insurance Information Institute (III), an industry trade group, “between 2016 and 2022, the total flood market grew 24 percent — from $3.29 billion in direct premiums written [DPW] to $4.09 billion — with 77 private companies writing 32.1 percent of the business” (see Figure 1). FEMA’s introduction of Risk Rating 2.0 (RR2), which changed FEMA’s pricing methodology to more accurately reflect a property’s actuarial flood risk by analyzing multiple data points,¹⁷ contributed to this large increase, according to the III. As RR2 increased premiums for many policyholders, the pricing of private policies became more competitive.¹⁸ The III report also noted that communities participating in FEMA’s Community Rating System (CRS), which encourages floodplain standards that exceed FEMA’s minimum standard, can reduce premiums. For example, premiums in Folly Beach, SC, dropped 30 percent after it became a CRS Class-4 community.¹⁹

CONCLUSION

Floods are the most common and expensive natural disaster in the United States.²⁰ Congress enacted the BWA to help mitigate this risk. The agencies’ private flood insurance final rule and the updated flood insurance Q&As have clarified the BWA’s requirements to help lenders comply. Specific issues and questions by lenders should be raised with the lender’s primary regulator.

ENDNOTES

¹ “Flood History of Mississippi,” National Weather Service.

² Phyllis Cuttino, “How 20th-Century Events Shaped the National Flood Insurance Program,” Pew Charitable Trusts (June 7, 2016). See also Affordability of National Flood Insurance Program Premiums: Report 1 (The National Academies of Science, 2015), p. 23, and Scott Gabriel Knowles and Howard Kunreuther, “Troubled Waters: The National Flood Insurance Program in Historical Perspective,” Journal of Policy History 26(3): 327.

³ Pub. L. 112–141; 126 Stat. 957, Div. F, Tit. II, Subtit. A (July 6, 2012), codified as amended at 42 U.S.C. §4014(a)(2) and (g), 42 U.S.C. §4017a.

⁴ H. Rep. No. 112–102 (Committee on Financial Services, June 9, 2011) at 1.

⁵ Section 100207 of the BWA (codified at 42 U.S.C. §4015). Congress later enacted the Homeowner Flood Insurance Affordability Act (HFIAA), which amended the BWA to impose limits on rate increases so risk-based pricing could be phased in over time to avoid price shocks to insureds. CCO reviewed the HFIAA in a Compliance Spotlight (Second Quarter 2014).

⁶ Section 100239 of the BWA (codified at 42 U.S.C. §4012a(b)).

⁷ 74 FR 35914, 35944 (July 21, 2009).

⁸ 84 FR 4953 (Feb. 20, 2019). Each agency codified the regulatory text of the final rule into its implementing regulations. Board: 12 C.F.R. §205.25; Farm Credit: 12 C.F.R. Part 614, sub-part S; FDIC 12 C.F.R. Part 339; NCUA: 12 C.F.R. Part 760; and OCC: 12 C.F.R. Part 22. For convenience, this article uses the Board’s citations. The BWA also requires the federal agency lenders and the GSEs to accept private flood insurance meeting the BWA’s definition. See §4012a(b)(2) and (b)(3). In response, the Department of Housing and Urban Development issued a rule allowing acceptance of private flood insurance for Federal Housing Administration–insured loans, using the BWA’s definition. 87 FR 70733 (Nov. 21, 2022). The GSEs updated their selling guides to address private flood insurance requirements.

⁹ 80 FR 43126 (July 21, 2015).

¹⁰ The webinar and the presentation slides are available in the Outlook Live archives. Free registration is required in order to view the webinar.

¹¹ 87 FR 32826 (May 31, 2022).

¹² 42 U.S.C. §4012a(b)(1).

¹³ 12 C.F.R. §208.25(b)(5).

¹⁴ 42 U.S.C. §4012a(b)(3).

¹⁵ 12 C.F.R. §208.25(c)(3).

¹⁶ 12 C.F.R. §208.25(c)(3)(ii).

¹⁷ CCO summarized RR2 in the Fourth Issue 2021.

¹⁸ Flood: State of the Risk (Insurance Information Institute, August 16, 2023).

¹⁹ Flood: State of the Risk at p. 2.

²⁰ Flood Insurance and the NFIP (FEMA, June 14, 2021).