Obligation to accept Private Flood Insurance

QUESTION

We are a community bank financing the construction of a mixed use property consisting of retail/business use on the first floor and four residential units on the second floor. The property, which will be the collateral for the loan, is located in a flood zone. The loan amount is $550,000, with a replacement cost value of $980,000 (as is)/$1,110,000 (completed). The borrower is asking that we accept a private flood insurance policy that contains an 80% coinsurance clause which also has a 20% coinsurance deductible. Do we have any obligation to accept such a policy? And, if not, are we permitted to accept such a policy?  Lastly, given that this is a mixed use property, how do we determine the maximum amount of coverage available under the NFIP?

ANSWER

Let’s take the last question first. Nonresidential buildings include mixed use buildings with less than 75% residential square footage. If you are stating the first floor is commercial space and the second floor is residential space, I am assuming the square footage is 50-50, which would make it a nonresidential building for the purpose of flood insurance under the NFIP. The maximum coverage available for Other Non-Residential is $500,000. 

Now onto the private flood insurance policy issue! In light of the current regulations as well as those effective July 1, 2019, the bank is under no obligation to accept a private flood insurance policy containing a coinsurance clause. However, the bank may use its discretion and accept same, provided the policy meets certain criteria which include the provision of sufficient protection of the loan, consistent with general safety and soundness considerations.

Under current law, with respect to properties located in a flood zone, the bank must require flood insurance in an amount at least equal to the lesser of the outstanding principal balance of the loan or the maximum coverage available for the particular type of property under the Act.  [12 CFR §339.3 (effective 10/01/15)] Under the National Flood Insurance Program (NFIP) policy, insurance will cover up to whatever the stated amount is (less any deductible).  

The current regulation is silent as to whether the bank must accept private flood insurance in lieu of that provided under the NFIP.

Effective July 1, 2019 (although earlier adoption is permissible), the regulations have been revised such that the bank must accept private flood insurance in satisfaction of the requirement for flood insurance if the policy meets certain requirements. 

The bank is mandated to accept a private flood insurance policy that, among other items 

“provides flood insurance coverage that is at least as broad as the coverage provided under an SFIP for the same type of property, including when considering deductibles, exclusions, and conditions offered by the insurer. To be at least as broad as the coverage provided under an SFIP, the policy must, at a minimum: . . .  (ii)  Contain the coverage specified in an SFIP, including that relating to building property coverage; personal property coverage, if purchased by the insured mortgagor(s); other coverages; and increased cost of compliance coverage; (iii) 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; . . . and (v)  Not contain conditions that narrow the coverage provided in an SFIP.”  [12 CFR §339.2 (effective 7/01/19)] 

A private flood insurance policy which contains a coinsurance clause does not equate to a policy issued under the NFIP. The coinsurance clause narrows the coverage otherwise provided under an SFIP, and effectively is a clause not applicable in an SFIP policy. Under an NFIP General Property – Standard Flood Insurance Policy, which is what issues with respect to Other Non-Residential Building such as the property you describe, the insurance covers up to whatever the stated amount is (in this case $500,000) less any deductible. However, the amount covered under a private policy with a coinsurance clause vastly differs.

Under a policy with a coinsurance clause, the insured must carry insurance equal to at least a certain percentage of the property’s actual cash value. This is done to ensure that the property is not underinsured when the replacement cost loss settlement option is purchased.

Your scenario is as follows: 

• Loan amount: $550,000
• RCV: $980,000 (as is)/$1,110,000 (as complete)
• Insurance: $500,000
• Coinsurance Clause: 80% 

Let’s assume the loss to the property is $600,000 and the actual cash value at time of loss is $980,000. 

• Required coinsurance = $784,000 (ACV x .80 coinsurance)
• 63.75% = $500,000 (amount of insurance carried) / $784,000 (amount of insurance should have carried)
• 63.75% x $600,000 (amount of loss) = $382,500 (amount covered by insurance less any deductible) 

For the purpose of this analysis, I will assume that the deductible under both the NFIP and private policy is $0. So, at the end of the day, under the NFIP policy, $500,000 will be covered by insurance whereas under the private policy, only $382,000 will be covered by insurance. Thus, as the coverage provided under the private policy is not meeting the maximum coverage available under the Act, the bank is under no obligation to accept it. 

That being said, commencing July 1, 2019, the bank may, but is not required to accept private flood insurance even though it may not meet the statutory definition described above provided that it:

• Provides coverage in an amount at least equal to the lesser of the outstanding principal balance of the loan or the maximum amount of insurance coverage available for the particular property under the Act;
• Is issued by an insurer that is approved to engage in the insurance business in the state in which the property is located, or recognized or not disapproved as a surplus lines insurer by the state insurance regulator;
• Covers both the mortgagor and mortgagee, except in the case of a condominium or similar group, and for which the premium is paid as a common expense; and
• Provides sufficient protection of the loan, consistent with general safety and soundness considerations, and the lending institution documents this determination. 

Notably, the requirement that the private policy – “(iii) 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; . . . and (v)  Not contain conditions that narrow the coverage provided in an SFIP” – are not conditions to the bank’s acceptance of a private flood insurance policy.

The Agencies noted that factors the institution can take into account in determining whether the policy provides sufficient protection of the loan include the policy’s deductibles, whether the policy provides adequate notice of cancellation, whether the policy’s limits of amounts to be paid per loss as well as the aggregate limits are adequate, whether the policy complies with state law, and whether the insurer has the financial solvency and strength to satisfy claims.

Relevant sections of the regulation and the NFIP Flood Insurance Manual are set forth below.

12 CFR Part 339

§339.3: Requirement to purchase flood insurance where available (10/01/15)

(a)  In general. An FDIC-supervised institution 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.

§339.3: Requirement to purchase flood insurance where available (7/1/19)

(c) Private flood insurance—

(1) Mandatory acceptance. An FDIC-supervised institution must accept private flood insurance, as defined in §339.2, in satisfaction of the flood insurance purchase requirement in paragraph (a) of this section if the policy meets the requirements for coverage in paragraph (a) of this section.

(2) Compliance aid for mandatory acceptance. An FDIC-supervised institution may determine that a policy meets the definition of private flood insurance in §339.2, without further review of the policy, if the following statement is included within the policy or as an endorsement to the policy: “This policy meets the definition of private flood insurance contained in 42 U.S.C. 4012a(b)(7) and the corresponding regulation.”

(3) Discretionary acceptance. An FDIC-supervised institution may accept a flood insurance policy issued by a private insurer that is not issued under the NFIP and that does not meet the definition of private flood insurance in §339.2 in satisfaction of the flood insurance purchase requirement in paragraph (a) of this section if the policy: 

(i) Provides coverage in the amount required by paragraph (a) of this section; (ii) Is issued by an insurer that is licensed, admitted, or otherwise approved to engage in the business of insurance by the insurance regulator of the State or 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, is 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; (iii) Covers both the mortgagor(s) and the mortgagee(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 (iv) Provides sufficient protection of the designated loan, consistent with general safety and soundness principles, and the FDIC-supervised institution documents its conclusion regarding sufficiency of the protection of the loan in writing.

Relevant Definitions from the April 2019 NFIP Flood Insurance Manual:

Mixed-Use Building: A building that has both residential and non-residential uses.

Non-Residential Building: A commercial or mixed-use building where the primary use is commercial or nonhabitational.

Non-Residential Property: Either a non-residential building, the contents within a non-residential building, or both.

Other Residential Building: A residential building that is designed for use as a residential space for five or more families or a mixed-use building in which the total floor area devoted to non-residential uses is less than 25% of the total floor area within the building.

Joyce Wilkins Pollison, Esq.

Director/Legal & Regulatory Compliance

Executive Director/Lenders Compliance Group