Consumer Compliance Outlook: Third Issue 2024

Top Federal Reserve System Compliance Violations in 2023 Under the Flood Disaster Protection Act of 1973

By Consumer Compliance Outlook Staff

Congress enacted the Flood Disaster Protection Act of 1973 (FDPA)¹ to identify flood-prone areas and to condition the eligibility of state and local communities to receive disaster assistance by requiring them to participate in the National Flood Insurance Program (NFIP) and adopt flood plain ordinances to reduce future flood losses. The FDPA also prohibits regulated lending institutions from making, increasing, extending, or renewing a loan secured by improved real estate or a mobile home that is in, or that will be in, a special flood hazard area (SFHA) in a participating community, unless the property securing the loan is covered by flood insurance.² Loans for which flood insurance is required are defined as “designated loans” in the FDPA’s implementing regulations.³

FLOOD INSURANCE COMPLIANCE VIOLATIONS

Although the FDPA was enacted more than 50 years ago, violations of its requirements regularly appear in the Federal Reserve’s list of top-cited compliance violations. The other federal regulatory agencies that enforce the FDPA also frequently cite these violations.⁴ A review of 2023 examination data of state member banks, for which the Federal Reserve is the primary federal regulator, reveals the following top-cited violations of Regulation H, the Federal Reserve’s FDPA implementing regulation:⁵

Originating designated loans without flood insurance or with an insufficient amount of insurance
Failing to ensure designated loans maintain insurance for the life of the loan and in the proper amount
Failing to provide the required notice to borrowers when they apply for a designated loan

The format for the common violations articles is to first list the regulatory requirements (either by quoting the verbatim text or by summarizing it) and then discuss the violations, root causes, and sound practices.

REGULATORY REQUIREMENTS

In general: 12 C.F.R. §208.25(c)(1)

“A member bank shall not make, increase, extend, or renew any designated loan unless the building or mobile home and any personal property securing the loan is covered by flood insurance for the term of the loan. The amount of insurance must be 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. Flood insurance coverage under the Act is limited to the building or mobile home and any personal property that secures a loan and not the land itself.”

Force placement of flood insurance: 12 C.F.R. §208.25(g)

A member bank, upon learning a designated loan is uninsured or underinsured, must direct the borrower to purchase insurance or increase the amount within 45 days. If the borrower fails to purchase insurance, the bank must purchase the insurance on the borrower’s behalf.

Notice of special flood hazards and availability of federal disaster relief assistance: 12 C.F.R. §208.25(i)

During origination of a designated loan, a bank must mail or deliver a written notice to the borrower or servicer explaining that, if the property securing the loan is in an SFHA, flood insurance must be purchased. The notice also notifies the borrower that the premiums may be required to be escrowed and that private flood insurance may be available. A model form is available in Appendix A to Regulation H.

Notices must be provided to the borrower “within a reasonable time before the completion of the transaction,” and to the servicer “as promptly as practicable” after notice to the borrower.

Failing to Require Flood Insurance at Origination

For the Property Securing the Loan

Examiners observed several banks making designated loans to borrowers without requiring flood insurance coverage. Root causes included:

staff failing to understand the requirement of the FDPA and its implementing regulations that designated loans must be covered by flood insurance;
inadequate internal controls, audit, monitoring, and oversight; and
relying on vendors to determine if insurance is required.

Flood insurance compliance, like other areas of consumer compliance, involves multiple lines of defense. The first line is ensuring lending staff understand the FDPA’s requirements for designated loans so they are able to comply. The second line is utilizing controls, tracking, monitoring, testing, and other oversight procedures to ensure insurance is obtained when required. The third line is implementing a strong compliance management system that ensures its components are working as intended to identify and mitigate compliance risk.

For the Property Contents

Examiners observed lenders failing to include contents coverage when it was required. A bright-line rule applies for contents coverage, as explained in the 2022 Interagency Questions and Answers Regarding Flood Insurance (Flood Q&As):⁶

OTHER SECURITY INTERESTS 9. Does the Regulation apply when the lender takes a security interest in improved real estate and contents located in an SFHA only as an ‘‘abundance of caution’’?

Yes. The Act and Regulation look to the collateral securing the loan. If the lender takes a security interest in improved real estate and contents located in an SFHA, then flood insurance is required. The language in the loan agreement or security instrument determines whether the improved real estate and contents are taken as security for the loan. (emphasis added) ...

OTHER SECURITY INTERESTS 10. Is flood insurance required if the lender takes a security interest in contents located in a building in an SFHA securing the loan but does not perfect the security interest?

Yes, flood insurance is required. The language in the loan agreement or security instrument determines whether the contents are taken as security for the loan. If the lender takes a security interest in contents located in a building in an SFHA securing the loan, flood insurance is required for the contents, regardless of whether that security interest is perfected (emphasis added).

Incorrect Amount of Insurance

Under the FDPA, flood insurance must be purchased for the lesser of the outstanding principal balance of the loan or the maximum amount of insurance available under the NFIP. The maximum amount of flood insurance under the NFIP is $250,000 for residential buildings and $500,000 for nonresidential buildings. Contents coverage is available for up to $100,000 for residential structures and $500,000 for nonresidential structures. The maximum amount of coverage available under the NFIP is based on the property’s insurable value.

Insurable Value

Examiners observed banks failing to understand how to properly calculate insurable value, a factor in determining the amount of required insurance. 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.⁷ It is important to calculate this properly; “otherwise, the lender might inadvertently require the borrower to purchase too much or too little flood insurance.”⁸ For example, assume the replacement cost value for a property securing a nonresidential loan is $475,000, and the loan amount is $550,000. The lender incorrectly requires $500,000 in insurance, believing this amount is the lesser of the maximum amount available under the NFIP for a nonresidential property or the loan amount. But because the insurable value is $475,000, and the NFIP will not pay a claim in excess of the insurable value, the lender should have required $475,000 (the lesser of the loan amount or the maximum amount available under the NFIP).

According to the 2022 Flood Q&As, the insurable value of a building may generally be the same as 100 percent of its replacement cost value, defined as the cost of replacing the building with similar material and construction without deducting depreciation. To calculate the amount of required insurance, the lender and borrower (by themselves or in consultation with the flood insurance provider or another appropriate professional) may choose from a variety of ways to establish the insurable value, including:

an appraisal based on the cost value, not the market value;
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 that is supportable.⁹

Multiple Properties

Examiners observed lenders choosing the incorrect amount of insurance for commercial loans when multiple properties secured the loan. Consumer Compliance Outlook (CCO) published an article in 2022 that included examples of how to calculate the proper amount of insurance when a designated loan is secured by multiple properties. See Danielle Martinage, “Commercial Flood Insurance Compliance — Washing Away Common Pitfalls” (CCO, Second Issue 2022).

Notice to Borrowers

Failing to Provide the Notice

Banks were cited for failing to provide the required flood insurance notice under 12 C.F.R. §208.25(i) to the borrower when loans were made, increased, renewed, or extended for real property or a mobile home in an SFHA.

Failing to Provide the Notice in a Timely Manner

Lenders were cited for failing to provide the required notice in a reasonable time. The interagency flood insurance examination procedures clarify the timing requirement:¹⁰

“[A] borrower should receive notice timely enough to ensure that:

The borrower has the opportunity to become aware of the borrower’s responsibilities under the NFIP; and
Where applicable, the borrower can purchase flood insurance before completion of the loan transaction.”

The adequate time interval for delivery of the notice can vary based on the circumstances of the transaction, but 10 days is generally considered reasonable.

The root causes for notice violations included:

staff having an inadequate understanding of flood insurance requirements;
staff failing to adhere to the institutions’ written flood procedures;
a lack of strong internal controls;
insufficient sample sizes in insurance monitoring and audits;
improper documentation; and
lack of compliance oversight.

SOUND PRACTICES TO MITIGATE COMPLIANCE RISKS

Most of the violations discussed occurred because of inadequate training of employees and poor oversight by management. Additionally, examiners found weaknesses in internal controls and a lack of audits. The table lists compliance practices that examiners have observed and recommend, and the figure provides a flood insurance flowchart with an overview of the compliance process.

Table: Sound Compliance Practices

Board and Senior Management Oversight	Provide prompt responses to employee questions Ensure that any third-party service providers understand and effectively perform their compliance responsibilities
Internal Controls	Conduct a secondary review of all loan approvals in SFHAs Enhance preventative and detective controls
Training	Conduct regular training on the FDPA, including notice and insurance requirements Include training when regulatory changes occur or when procedural weaknesses are noted Provide flowcharts and worksheets for staff
Monitoring and Audit	Conduct frequent audits of loans in high-risk areas to ensure loans are neither uninsured nor underinsured Validate that all policies and procedures implemented are applied correctly Utilize weekly system reports to identify expiring policies and verify renewal
Policies and Procedures	Implement detailed policies and procedures to ensure a consistent and repeatable process Ensure that policies and procedures are updated when regulatory requirements change Develop comprehensive flood checklists to provide guidance for bank staff

CONCLUDING REMARKS

It is important for financial institutions that originate or purchase loans subject to the FDPA to have a strong flood insurance compliance management system in place. This article discusses common violations among Federal Reserve–regulated institutions and sound practices to mitigate the compliance risks. Lenders should raise specific issues and questions about FDPA requirements with their primary regulator.

ENDNOTES

¹ Public Law 93–234, 87 Stat. 975 (December 31, 1973). Codified, as amended, at 42 U.S.C. 4002 et seq.

² 42 U.S.C. §§4002(b); 4012a(b).

³ 12 C.F.R. §208.25(b)(5) The FDPA implementing regulations are issued on an interagency basis but are separately codified in each agency’s regulations: Federal Reserve: Regulation H, 12 C.F.R. §208.25; Farm Credit Administration: 12 C.F.R. Part 614, sub-part S; Federal Deposit Insurance Corporation: 12 C.F.R. Part 339; National Credit Union Administration: 12 C.F.R. Part 760; and Office of the Comptroller of the Currency: 12 C.F.R. Part 22. For convenience, this article cites the Board’s regulations, but the other agencies’ regulations are substantially similar.

⁴ Government Accountability Office Report 21-578, “National Flood Insurance Program: Congress Should Consider Updating the Mandatory Purchase Requirement” (July 2021) at p. 24.

⁵ “Recent Supervisory Data for Institutions the Federal Reserve Supervises” (CCO, First Issue 2024).

⁶ Interagency Questions and Answers Regarding Flood Insurance, 87 FR 32826 (May 31, 2022).

⁷ Flood Q&As, Q&A Amount 1.

⁸ Flood Q&As, Q&A Amount 1.

⁹ Flood Q&As, Q&A Amount 2.

¹⁰ “Revised Interagency Examination Procedures for the Flood Disaster Protection Act” (July 2019) at p. 18.