By Kathryn Morris, CRCMThe enforcing regulation behind the Flood Disaster Protection Act doesn’t take long to read from start to finish. Perhaps 12 minutes at a moderate pace. Newer compliance officers may mistake the simplicity of the regulation for minimal risk and calm waters, while seasoned compliance officers know that it only takes minutes for a thunderstorm to gather and rain down a flash flood of violations and civil money penalties. The text of the regulation alone is not enough to understand the full scope of our responsibilities for flood compliance. Shifting supervisory expectations and an uncertain legislative environment only complicate these already turbulent waters, so let’s dive below the surface of the regulation and explore deeper.
Which way are the NFIP currents flowing?
While funding for the National Flood Insurance Program itself is not generally a subject of debate, times of pervasive political polarity often have a largely unintended effect on the stability of the program. The authorization congress must provide in order for the program to function, has historically become attached to more contentious legislation, and this can result in lapses in the availability of flood insurance. In 2010, predicting whether or not the NFIP was going to be funded on any given day (and preparing for the case that it wouldn’t be), became a central focus for compliance officers. As of mid-May, 2018 has seen two short lapses in the program, and current political waves seem to indicate continuing choppy waters.
The regulation itself does not anticipate a lapse in the program and provides no framework for how a bank should manage the mandatory purchase requirements during such a period. Guidance issued by the FDIC to bridge frequent lapses in 2010, clarifies that consummating a loan secured by property in a Special Flood Hazard Area during a lapse without flood insurance in place, is permissible. It further indicates that banks should continue to comply with determination, notification and other requirements of the regulation, and that insurance should be obtained for all covered upon reauthorization of the NFIP. Cross-referencing this with the Federal Reserve Board’s Consumer Affairs letter on the topic issued the same year, reveals additional permissive, direction for compliant handling of new loans during a lapse:
- Lenders may request that the borrower complete an application and submit payment for an NFIP policy, which will be processed upon reauthorization. The FRB points out here that borrowers should be informed that they cannot legally be required to remit payment for the policy until the program is reauthorized, and that doing so is voluntary.
- Lenders may delay closing of a loan secured by property in an SFHA in the event it is determined that closing the loan without flood insurance in place would present too great a risk of loss.
- Lenders may require that a borrower obtain privately issued flood insurance. It should be noted that privately issued policies of this nature may need to conform to NFIP standards (more on this in the next section).
- Lenders may close the loan in the absence of flood insurance, provided that insurance is obtained by the borrower directly upon reauthorization of the program or force-placed as necessary.
To frame the treatment of a lapse within the terms of the regulation, it may be helpful to think of the requirements for policies in communities that do not participate in the NFIP. The mandatory purchase section of the regulation is titled “Requirement to Purchase Flood Insurance where Available” which means that banks are not required by federal law to treat flood insurance as compulsory if the property securing the loan is in an SFHA in a non-participating community, though all other sections of the regulation continue to apply. When the NFIP lapses, the whole country essentially becomes a non-participating community for purposes of compliance.
Biggert-Waters and private flood insurance
The last major legislation that affected flood compliance was the passage of the Biggert-Waters Act in 2012 and subsequent amendments (is it a coincidence it was co-sponsored by Maxine Waters?). This law implemented new, stiffer penalties for non-compliance, and called for other reforms in the NFIP.
However, the provision of the Biggert-Waters Act that has the most sweeping implications for our industry, is the requirement for banks to accept privately issued flood insurance policies— those issued outside the scope of the NFIP. While we have seen two separate final rules implementing other portions of the Act, and two separate proposed rules for implementing the private policy requirements, no final rule has yet been issued to implement this section. Unless addressed in pending NFIP reform in Congress, ABA expects to see a final rule in late fall 2018.While the industry remains hopeful that certain updates will be included in the final rule that may alleviate some of the anticipated burden, the substance of the requirements are not expected to change significantly. Banks will be required to accept private flood policies, as long as the policy:
- Is issued by an insurance company that is licensed, admitted or otherwise approved (such as approval as a surplus lines insurer) to engage in the business of insurance in the state or jurisdiction in which the insured building is located by the insurance regulator of the State or jurisdiction;
- Provides flood coverage at least as broad as the coverage provided by a standard flood insurance policy (SFIP) under the NFIP;
- Includes a requirement of the insurer to give 45 days’ written notice of cancellation or non-renewal of flood insurance coverage to the insured and the regulated lending institution;
- Includes a mortgage interest clause similar to the clause contained in an SFIP;
- Includes a provision requiring an insured to file suit not later than one year after the date of a written denial for all or part of a claim under a policy; and
- Contains cancellation provisions as restrictive as the provisions included in an SFIP (42 US 4012a (7)).
On the surface, this change will necessitate a more detailed review of the text of policies issued by private insurance companies. Looking deeper, while it may be relatively simple to review a policy for inclusion of a 45-day cancellation clause, the provision that may make the most waves here is the one that appears most simple; “Coverage at least as broad as” a policy issued under the NFIP. Understanding how to apply this in practice requires comprehension of an insurance policy and its coverage at a level not previously required of financial institutions. The most common points of conflict between an NFIP policy and a privately issued policy are:
- Deductible Amount: An SFIP requires a deductible not to exceed $10,000 for residential policies and $50,000 for non-residential policies. Private policies sometimes include a deductible higher than the SFIP requirement, or may even state the deductible as a percentage of the building’s insurable value. If stated as a percentage of the value, this may be acceptable so long as the calculation results in a deductible equal to or lower than the maximum SFIP deductible. However, beware if the deductible is stated as a percentage of the building’s value “at time of loss.” The bank cannot predict what the value at the time of loss might be, since it could depreciate, or significant improvements could increase the value over time. Accepting a policy with this deductible provision may not meet the requirements of the regulation.
- Aggregated vs. Per Occurrence Coverage: SFIPs are written with “Per Occurrence” coverage, which means that the limit of coverage will be applied to each loss event even if there are multiple loss events in a single year. Many private policies instead employ “Annually Aggregated” coverage, meaning that the limit of coverage is applied annually, regardless of the potential for multiple loss events in the course of one year. While multiple flooding events on the same property may be an infrequent occurrence, the SFIP standards afford the greater protection for the borrower and the bank. Consequently, private policies issued with aggregated coverage do not meet the “at least as broad as” standard.
- Certifications of Compliance with the NFIP: As more institutions impose the Biggert-Waters standards in their acceptance of private policies in anticipation of the pending regulatory change, a trend has emerged among companies that issue private flood insurance policies. Such policies may now be accompanied by a certification or endorsement from the insurance company indicating that the policy meets the requirements of the NFIP. Commenters on both proposed versions of the private policy rule have requested a provision in the final rule allowing banks to rely on this type of assertion from the insurance provider, but it is unclear if we will see that inclusion in the final rule. In the absence of a regulatory safe harbor of this nature, responsibility for verifying that the policy meets all NFIP requirements will remain with banks. There are two versions of this endorsement that may necessitate different treatment:
- A certification affirmatively stating compliance—this will be a sentence, sometimes on the declarations page, sometimes within the text of a policy, that states “this policy meets the standards of the NFIP,” or similar verbiage. While this sounds good, it may not accurately reflect the terms of the policy. This should prompt additional review to ensure the policy meets each of the six guidelines.
- An endorsement or certification amending the policy—this will be a sentence that states that where the policy text does not comply with the NFIP, the policy is hereby amended such that those provisions conform to NFIP standards. This would mean that, for instance, a policy showing aggregated coverage on the declarations page would function with per occurrence coverage under the certification. This can be an acceptable policy.
There is a lot of hazardous debris in this private policy stream, and it’s best to keep a sharp eye out for those bits of danger that lurk beneath the surface.
Walled and roofed structures
The flood regulation will tell you that a covered building “means 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 339.3(a)). What won’t the regulation tell you about covered buildings? Everything else. Let’s wade in a bit further.
The NFIP Flood Insurance Manual provides a more specific definition of “building,” which includes the clarification that a structure need only have “two or more outside rigid walls” to be considered “walled and roofed.” This widens the pool of structures requiring flood insurance to include pass-through structures having only two walls, open-sided lean-to style structures, and small structures. The only things not insurable under this definition are structures lacking rigid walls, such as greenhouses covered in sheet plastic; buildings located primarily below ground and buildings not affixed to a permanent site.
Just as some areas are known to flood each and every year, a particular, if somewhat familiar challenge in complying with the flood insurance regulation lies in obtaining proper insurance when the property collateralizing a loan comprises more than a single structure. With a definition of “structure” that is so broad, this is a frequent occurrence. The bank may be interested from a value perspective in only the primary buildings on a property, but even the pump houses, prefabricated sheds, small storage buildings and neglected barns require insurance from a regulatory perspective. Undoubtedly, a universal experience of compliance officers with flood responsibility is explaining to personnel that even though such a structure does not add to the collateral value it does still require insurance. Yes, even that shed.
A strong control environment will give heavy consideration to:
- Identifying all structures located on a property proactively, such as by providing the appraiser with specific instructions or having the loan officer perform a site visit.
- Retaining appropriate documentation when a building is determined not to require insurance. Regulators will expect the financial institution to have considered each structure and provide proof that it does not meet the definition of a structure or is otherwise uninsurable. Is that manufactured home sitting on cinderblocks, not permanently affixed to the site? A photograph of those cinderblocks or a description of them from the appraiser will go a long way toward answering questions posed by an examiner. Is that vacation home situated primarily over water? Somewhat ironically, that fact makes it ineligible for flood insurance and even that ineligibility must be documented (NFIP Flood Insurance Manual, Section IV(C), GR 7).
- Calculating and documenting the amount of adequate insurance. In the event the lender is relying on the amount of the loan to establish the minimum amount of insurance, coverage will be considered adequate so long as all structures have some insurance and the aggregate of the policies exceeds the loan amount. If the lender is relying on the maximum amount of insurance available or the building value, each structure will require a policy insuring it either to its full value or the maximum allowed under the NFIP (whichever is lower). A worksheet or other job aid showing the calculation and the basis on which it was completed will help to support the determination of adequate insurance, especially in the case of multiple structures.
An SFIP can generally only cover a single structure, requiring a property with multiple structures to be covered by multiple policies. A private policy may cover more than one structure, but lenders should ensure the policy includes a schedule of all covered buildings and individual limits of coverage for each (and that such a policy meets Biggert-Waters standards).
Establishing insurable value
Establishing the insurable value of covered structures securing a loan is integral to being able to document compliance with the regulation. The lack of direct guidance for this within the regulation allows flexibility in determining the standards a financial institution will use to document value, but care must be taken to ensure a consistent approach.
The amount of insurance available under the NFIP is generally the lesser of the full insurable value of the building, or the maximum allowable under the program ($250,000 for 1 to 4 family residential structures and $500,000 for non-residential structures and multifamily residential structures). However, the type of value to be utilized depends on the type of structure being covered. SFIPs covering a dwelling can cover a loss up to the full replacement cost value, whereas those covering a structure other than a dwelling will only cover a loss up to the actual cash value, or the RCV less the cost of physical depreciation. These values are not connected to (and therefore should not be sourced from) the tax assessment value or the market value. Best practices for documenting valuation should include:
- Consistent references to the Standard Uniform Appraisal. For dwellings, the standard uniform appraisal includes a section that breaks out the replacement cost value of the structure. Consistent reference to this documentation adequately supports insurable value for dwellings.
- A request that commercial appraisers provide a cost approach as part of their investigation. While not generally included in commercial appraisals as a matter of course, specific instructions provided to the appraiser can allow for identification and documentation of a depreciated replacement cost value, or ACV, for all structures on the property.
- Consistent basis for and documentation of insurable value. As stated on a Hazard Insurance policy, this may be referenced to support the insurable value for flood insurance purposes, but this approach should be undertaken with care. Hazard Insurance policies generally do not cover or consider the value of the foundation of a structure and values used for this purpose may differ in other ways from the requirements of a flood insurance policy. As a result, Hazard Insurance policies relied upon to inform insurable value for flood insurance purposes should undergo a full review to ensure that adjustments for discrepancies in the calculation of value are accounted for. In the absence of such a review, which may fall outside the expertise of bank personnel, it is best to utilize the hazard insurance value only for the purpose of identifying changes in the value over the life of the loan. For instance, receipt of a renewed hazard policy showing a significant increase in value may prompt a review of the property to determine if reevaluation of the amount of flood insurance is necessary.
- Utilization of third party tools, such as cost valuation models like Marshall & Swift. When performed internally by bank personnel, valuations arrived at through such a model may offer a cost effective alternative to enhanced appraisals.
Despite the fact that the regulation does not mention insurable value, successful compliance with its requirements hinges on appropriate understanding of this term and the methods by which it can be calculated and documented. These waters can get murky; be careful and conscious in your approach.
Pursuing a water-tight flood compliance program can feel like bailing water out of sinking ship with a storm fast approaching. By understanding how compliance with the regulation is inextricably linked to the programs and supporting guidance, we can be ready for any flash flood that comes our way.
Kathryn Morris, CRCM, VP and compliance manager at Tacoma, Wash.-based Columbia Bank. She specializes in lending regulation with primary responsibility for compliance in the areas of residential lending, commercial Banking, credit administration, loss mitigation and international banking.