Flood Insurance Exam Preparation

QUESTION

We have been told that you provide flood insurance audits. Your firm was referred to us by a company that you assisted in getting ready for their flood insurance policies review prior to their examination. We have received notice that our company's forthcoming examination is going to include a flood insurance audit. What should we do to get ready for the flood examination? Also, can you tell us about the Biggert-Waters Act?

ANSWER

Yes, we provide compliance audits, examination readiness, and policies for flood insurance.

Contact us at Compliance@LendersCompliance Group for more information or click the Contact button.

The first thing to do is review your policies, both written and informal, and internal controls concerning flood insurance, particularly the method you use to make the flood hazard determination. Make sure you interview the appropriate personnel to ascertain that these policies are implemented in the prescribed manner.

With respect to preparation, obtain and review copies of the following: 

• If you use a third-party provider, ensure that the contract requires the third party to use the most recent Community Status Book on the Federal Emergency Management Agency’s (FEMA’s) website.
• Written notices (and forms) that inform borrowers that the property securing a loan is in a standard flood hazard area (SFHA) and whether federal disaster relief assistance will be available if the property is damaged by flooding.
• Written acknowledgments from borrowers indicating their understanding that the property securing the loan is or will be located in an SFHA and that they have received the notice regarding the availability of federal disaster relief assistance.
• A sample of loans secured by real estate in all lending areas, including commercial lending.
• A list from your company’s third-party flood determination company of loans with properties in a flood hazard area that require insurance. Choose a sample of those loans to review.

Importantly, determine whether you have taken steps to correct violations regarding flood insurance that may have been exceptions in previous audits.

With regards to the Biggert-Waters Flood Insurance Reform Act (“Biggert-Waters”), the banking agencies and the National Credit Union Administration (NCUA) issued a joint final rule to implement provisions of the Biggert-Waters, requiring regulated institutions to accept certain private flood insurance policies in addition to National Flood Insurance Program (NFIP) policies.

An overview of the rule, which took effect July 1, 2019, would include these features: 

• Implements the Biggert-Waters requirement that regulated lending institutions accept private flood insurance policies that satisfy the criteria specified in the Act;
• Allows institutions to rely on an insurer’s written assurances in a private flood insurance policy stating that the criteria are met;
• Clarifies that institutions may, under certain conditions, accept private flood insurance policies that do not meet the Biggert-Waters criteria; and
• Allows institutions to accept certain flood coverage plans provided by mutual aid societies, subject to agency approval.

Jonathan Foxx, Ph.D., MBA
Chairman & Managing Director
Lenders Compliance Group

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. 

Force-Placed Flood Insurance

QUESTION

We are a lender that must occasionally force-place flood insurance. Could you please let us know what the timeline is for notification to the borrower? Also, how do we charge for retroactivity? And what is the required information on the insurance declarations page to show coverage?

ANSWER

If a lender or a servicer acting on behalf of the lender determines at any time during the term of a designated loan, that a building or a mobile home and any personal property securing the designated loan is not covered by flood insurance or is covered by flood insurance in an amount less than the amount required, then the lender or servicer acting on its behalf, must notify the borrower that the borrower should obtain flood insurance, at the borrower’s expense, in an amount at least equal to the amount required, for the remaining term of the loan.

With respect to notification, if the borrower fails to obtain flood insurance within 45 days after notification, then the lender or its servicer must purchase insurance on the borrower’s behalf. The lender or its servicer may charge the borrower for the cost of premiums and fees incurred in purchasing the insurance, including premiums or fees incurred for coverage beginning on the date on which flood insurance coverage lapsed or did not provide a sufficient coverage amount.

Under Regulation X, the implementing regulation of the Real Estate Settlement Procedures Act, the Consumer Financial Protection Bureau requires a servicer to send two written notices before a servicer can assess a force placement charge on a borrower: (1) a notice at least 45 days before assessment of a charge, and (2) a notice at least 30 days after the initial notice and at least 15 days before assessment of a force placement charge. [12 CFR 1024.37(c)-(d)] However, the lender or its servicer still would be required to send the mandated 45-day notice following the lapse of the borrower’s policy.

Regarding retroactivity, the plain language of the applicable statute provides that the lender or servicer may charge for premiums and fees incurred for coverage beginning on the date on which flood insurance coverage lapsed or did not provide a sufficient coverage amount. Further, when the lender determines there is a coverage lapse or insufficient coverage, the Flood Disaster Protection Act (FDPA) requires the institution to send a notice to the borrower.

A lender or its servicer can force-place flood insurance beginning on the day the borrower’s policy lapsed or did not provide sufficient coverage, and also, as of that day, the institution can charge the borrower for the force-placed insurance. [12 CFR 1024.37(c)-(d)]

If a lender, despite its monitoring efforts, discovers a policy with insufficient coverage, the lender may charge back to the date of insufficient coverage provided it has purchased a policy that covers the property for flood loss and that policy was effective as of the date of insufficient coverage. However, if purchasing a new policy is necessary to force-place insurance upon discovery of insufficient coverage, a lender may not charge back to the date of lapse or insufficient coverage because the policy did not provide coverage for the borrower prior to purchase.

Under the FDPA, as amended by the Biggert-Waters Act, a lender or its servicer must accept from the borrower an insurance policy declarations page that includes the existing flood insurance policy number and the identity of, and contact information for, the insurance company or its agent. This is known as “sufficient demonstration,” meaning that the foregoing information and documentation are all that is required under Biggert-Waters for an insurance policy declarations page to be considered sufficient evidence of a borrower’s flood insurance coverage.

This minimum sufficient demonstration can cause concern at times, since the required information does not have to include the policy term effective dates, the current flood coverage amount, limitations and exclusions, the mortgagee’s identity, and, if the coverage is provided by a private flood policy, some documentation that the policy satisfies either the Biggert-Waters definition of private flood insurance or the mandatory purchase requirement.

Indeed, with respect to private flood insurance, the requirement to accept the declarations page as sufficient demonstration may cause lenders to accept a private flood insurance policy based on the declarations page, only to later determine that the policy is unacceptable.

Nevertheless, a lender is responsible for making all necessary inquiries into the adequacy of the borrower’s insurance policy to ensure that the policy complies with the mandatory purchase requirement. If the lender determines the coverage amount or any terms and conditions fail to meet applicable requirements, the lender should notify the borrower and request that the borrower obtain an adequate flood insurance policy.

Jonathan Foxx

Managing Director 

Lenders Compliance Group

Flood Insurance: Two Residential Structures under One Policy

QUESTION

We have a loan which is secured by a single family residential property with a guest house located on the property. The guest house is connected to the main residence via an elevated deck. In the past, we have required separate flood insurance policies for the main residence and the guest house. Our borrower would like to have both buildings covered under the same policy. Is this permissible?

ANSWER

If a building securing a loan is in a special flood hazard area, the lender must require flood insurance in an amount at least equal to the lesser of the outstanding principal balance of the loan or the maximum limit of coverage limit of coverage available under the National Flood Insurance Program (NFIP).  [12 CFR § 339.3] 

“Building” is defined as a “walled and roofed structure, other than a gas or liquid storage tank, that is principally above ground and affixed to a permanent site, and a walled and roofed structure while in the course of construction, alteration, or repair”.  [12 CFR § 339.2]   

The flood insurance requirement does not apply with respect to “any structure that is a part of any residential property but is detached from the primary residential structure of such property and does not serve as a residence”. A structure is "detached" from the primary residential structure if it is not joined by any structural connection to that structure and it “serves as a residence” if it is “intended for use or actually used as a residence, which generally includes sleeping, bathroom, or kitchen facilities”.  [12 CFR §339.4] 

As the guest house serves as a residence and is attached to the main house by a structure (i.e. the deck), it does not qualify for the exemption from the flood insurance requirement, which brings us back to the initial question: can the main residence and guest house be covered under one flood insurance policy? Nothing in the regulation prohibits the structures from being covered by one policy.

In accordance with the NFIP Flood Insurance Manual, the NFIP “insures additions and extensions attached to and in contact with the building by means of a rigid exterior wall, a solid load-bearing interior wall, a stairway, an elevated walkway, or a roof.” Thus, the guest house can be considered an addition or extension of the guest house and both the main residence and guest house can be covered under one policy. Alternatively, the homeowner can cause the guest house to be separately insured. However, in permitting the structures to be covered by one policy, the lender as well as the homeowner must be mindful of the fact that limiting coverage to one policy could have a substantial effect on the ability of the homeowner to rebuild in the event of a flood.

Joyce Wilkins Pollison

Director/Legal & Regulatory Compliance

Lenders Compliance Group