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The Asian tsunami last year; recent flash flooding due to springtime rains; and hurricanes Dennis, Emily, and Katrina have greatly raised our awareness of the destructive power of flooding. In light of this heightened awareness, this flood insurance recap should help banks ensure that their portfolios remain above water.
This article is the first of a two-part series summarizing the Mandatory Purchase of Flood Insurance Guidelines, published by the Federal Emergency Management Association (FEMA Guidelines). Part II of the series will appear in the Fourth Quarter 2005 issue of Compliance Corner and will focus on some of the more problematic areas encountered by bankers and regulators.
Overview of the National Flood Insurance Program
The National Flood Insurance Program (NFIP) was created by the National Flood Insurance Act of 1968. The NFIP provides an incentive for communities to adopt floodplain management ordinances (participating communities) to mitigate the effects of flooding on new or existing construction. The program also allows property owners in participating communities to purchase flood insurance for structures and contents.
From 1968 until the adoption of the Flood Disaster Protection Act of 1973 (1973 Act), the purchase of flood insurance was voluntary. However, the 1973 Act mandated flood insurance coverage for all properties located in special flood hazard areas (SFHA). In 1994, Congress revisited the mandatory purchase requirements and enacted the National Flood Insurance Reform Act of 1994 (Reform Act). The intent of the Reform Act was to improve compliance with the mandatory purchase requirements of the NFIP and to increase participation nationwide by those borrowers who own mortgaged homes or businesses in SFHAs and have not purchased or maintained flood insurance coverage.
While the mandatory purchase requirements apply only to buildings located in SFHAs in participating communities, NFIP flood insurance is available for all properties located in participating communities. This fact is especially significant because, historically, approximately 25 percent of the NFIP claims paid have actually been for properties located outside of an SFHA.
A mortgage lender may require a borrower to carry flood insurance, even if the building serving as security for a loan is located outside an SFHA. Lenders and property owners may wish to exercise additional caution in areas subject to flooding due to storm water, where the NFIP has used approximate methods to map SFHAs, or in remote locations, where no SFHAs have been designated by FEMA. In January 1989, the NFIP began offering a low-cost preferred risk policy for buildings located outside of SFHAs.
Mandatory Purchase Requirements
Lenders cannot make, increase, extend, or renew any loan secured by improved real estate located in an SFHA in a participating community (a designated loan) unless the property securing the loan is covered for the life of the loan by flood insurance. There is no waiting period for flood insurance to go into effect when it is in connection with a loan origination or the renewal or extension of an existing loan. In most other instances, there is a 30-day waiting period before the insurance goes into effect.
Whether a designated loan is for consumer or commercial purposes is irrelevant, and the extension of credit may take several forms, including origination, refinancing, consolidation, or renewal. The mandatory purchase requirement applies to any designated loan, including fixed rate, variable rate, or balloon loans.
The requirement to obtain flood insurance also applies regardless of the type of security interest taken, including a mortgage indenture, judgment note, cognovit note, or any other type of security or trust agreement. The mandatory purchase provisions even apply to those loans where real estate is secured out of an abundance of caution, typically found in commercial transactions. The Reform Act mandates flood insurance coverage even if the SFHA designation is first identified after settlement but during the term of the loan, because of remapping or other reasons.
Flood insurance is also required on designated home equity or second mortgage loans regardless of the lien priority. The location of the secured property, not the use of funds received on a home equity or second mortgage, governs whether flood insurance is required.
The flood insurance requirement does not apply to (i) any state-owned property covered under a policy of self-insurance satisfactory to the director of FEMA, which publishes and periodically revises the list of states falling within this exemption, or (ii) property securing any loan with an original principal balance of $5,000 or less and a repayment term of one year or less.
If a borrower will not voluntarily obtain flood insurance and a lender is unable to force-place coverage, the lender must deny the loan. A lender cannot accept a borrower’s assurance that he or she will obtain flood insurance coverage in the future. Closing a designated loan without flood insurance in place constitutes a violation of Regulation H.
The Reform Act requires lenders to escrow flood insurance premiums for homes in SFHAs only when taxes, other forms of insurance, or any other payments are also required to be escrowed. Lenders must ensure that the building and any applicable personal property securing a designated loan are covered by flood insurance for the term of the loan.
Finally, the duties of a lender with respect to flood insurance requirements for a particular loan cease upon the sale of the loan, unless the seller agrees to retain responsibility for complying with the Reform Act’s requirements under a loan servicing agreement with the transferee.
Flood Hazard Determinations
Lenders must use FEMA’s standard flood hazard determination form (SFHDF) when determining whether the building or mobile home offered as security for a loan is or will be located in an SFHA in which flood insurance is available. The completed SFHDF should be retained in either paper copy or electronic form for the period of time the bank owns the loan. The SFHDF is available on FEMA’s website at www.fema.gov/pdf/nfip/sfhdf.pdf.
Reliance on Third Parties in Determining a Building’s Location
The Reform Act places the ultimate responsibility to require flood insurance on the lender, yet it allows for limited reliance on third parties to the extent that the information they provide is guaranteed. Lenders may reasonably seek assistance from third parties that have demonstrated their knowledge concerning flood map information. For regulatory purposes, reasonable reliance upon such services in the making of a lender's determination is regarded as acceptable only to the extent that such person guarantees the accuracy of the information as provided under the statute. A financial institution cannot rely on the assurances or statements of a borrower that the structure in question is or is not in an SFHA.
Some third party flood vendors also provide life-of-loan services that monitor the flood hazard status of the building for the term of the loan. Third party life-of-loan services are designed to discover a change in flood hazard status, thereby minimizing administrative burden for the lender or servicer. The law does not require a lender to subscribe to life-of-loan monitoring; however, the lender is required to ensure that appropriate flood insurance is maintained during the term of the loan.
Lenders must notify the borrower in writing of the requirement to purchase flood insurance for new and existing loans. For new loans, lenders are required to notify the borrower that the building is in an SFHA within a reasonable time, defined by federal regulation as at least 10 days prior to the loan closing.
If, during the term of the loan, it is determined that the building securing the loan is in a SFHA, the lender is required to notify the borrower within a reasonable time. The law provides for the force placement of flood insurance 45 days after the borrower is notified of deficient flood insurance coverage.
Additionally, if a loan is sold or if there is a change of servicer, lenders must notify the insurance company or agent that wrote the flood insurance policy of a change of lender or servicer within 60 days after the effective date of the change.
The Reform Act establishes required coverage as the lesser of the following:
The current maximum coverage limits for residential property are $250,000 for buildings and $100,000 for contents and, for nonresidential property, $500,000 for buildings and $500,000 for contents.
The Reform Act applies to real estate improvements, such as buildings and mobile homes, but not to land. Since the NFIP does not provide insurance coverage for land, the location of the building in relation to the SFHA determines the applicability of the mandatory purchase provisions. Some portion of the building itself, and not just a portion or portions of the land, must be located in an SFHA for the mandatory purchase provisions to apply.
As specified in the Reform Act, contents coverage is not required unless personal property, in addition to a building, secures the loan. Since residential mortgages rarely include personal possessions as part of the loan security, lenders are not required to compel borrowers to purchase contents coverage. However, when a commercial loan on a building includes inventory and other trade or business movable property as security for the loan, that property must be covered by flood insurance under contents coverage. Lenders are encouraged to advise borrowers to include contents coverage for personal property and inventory when it is prudent to do so.
Force Placement of Flood Insurance
The Reform Act places responsibility on both lenders and servicers to force place flood insurance if it is determined that the building securing the loan is not adequately insured. The law also grants statutory authority to a lender (or servicer) to purchase flood insurance for the building if it is in an SFHA and to charge a premium to the borrower.
If at any time during the term of a designated loan the lender or servicer determines that the building securing the loan is not covered by flood insurance or is covered by insurance in an amount less than that required by law, the lender or servicer must first notify the borrower of the need to carry adequate flood insurance. The law does not specify the precise wording of the notice; however, the notice must state that the borrower should, at the borrower’s expense, obtain flood insurance that is not less than the amount required under the law.
If the borrower fails to purchase flood insurance within 45 days after notification, the lender or servicer must purchase the insurance on behalf of the borrower and charge the borrower for the cost of premiums and fees incurred. The 30-day waiting period does not apply to force-placed policies.
The force-place provisions also apply to home equity and second mortgage loans. A secondary lien holder that force places coverage only to the extent of its loan will not protect its interest if a first mortgagee claims priority to any insurance proceeds. Force placement of insurance by a second mortgagee requires coordination with the first mortgagee, as well as with the insurance provider and insurer on the first mortgage, if one exists.
Regulatory Penalties for Violations of Regulation H
The Reform Act requires the Federal Reserve Board and other regulatory agencies to impose civil money penalties when they find a pattern or practice of violations. The law provides penalties related to designated loans for which a lender fails to do the following:
The individual penalty amount is $350 per violation, with a ceiling of $100,000 per institution during any calendar year. Penalties assessed will be deposited in the National Flood Mitigation Fund created by the Reform Act. Other remedial sanctions consist of unsatisfactory bank ratings, supervisory actions, and ultimately, cease and desist orders being issued against lending institutions.
Compliance examiners will continue to review the flood insurance practices of Third District state member banks to ensure compliance with the applicable provisions of the law. A sample of loan files will be reviewed to verify that (i) determinations are made in a timely manner and documented on the SFHDF, (ii) notifications are provided in a timely manner, and (iii) adequate flood insurance is maintained during the term of the loan.
Each review will be tailored to the activities of the institution. For example, if an institution purchases servicing rights, the review probably will include a review of the contractual obligations placed on the institution by the owner of the loans. Similarly, if the institution uses a third party to service loans, the contract with the third party may be reviewed to ascertain that the flood insurance requirements are identified and that compliance responsibilities are adequately addressed.
If the institution transfers the servicing of loans to another entity, it must show it provided notice of the new servicer’s identity to the FEMA designee within the prescribed timeframe. Additionally, if the institution uses a third party to perform flood zone determinations, it can expect a review of its contractual provisions to verify that compliance requirements are identified and covered, including the extent of the third party’s guarantee of work.
Institutions should review the guidance carefully to ensure that their loan portfolios are adequately protected. The FEMA guidelines are available in PDF format on FEMA’s website at www.fema.gov/nfip/mpurfi.shtm.
If you have any questions regarding flood insurance guidelines, please contact Senior Examiner Carletta M. Longo or Supervising Examiner John D. Fields through the Regulations Assistance Line at (215) 574-6568.
The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.