Consumer Compliance Outlook: Second Quarter 2008

Complex Issues in Flood Insurance Compliance

by Alex Kunigenas, Consumer Compliance Analyst
Federal Reserve Bank of San Francisco

Compliance with federal flood insurance regulations has become an increasingly important issue for financial institutions and consumers.¹ Incorrect amounts of flood insurance can negatively affect property owners and increase lenders' legal and financial risks. Some areas of recent concern that examiners have observed include using blanket insurance policies (also known as gap or master policies),² calculating replacement cost value (RCV), determining when to obtain insurance for buildings under construction, and determining the insurance requirements for condominiums. This article reviews the compliance requirements for these four problematic areas in light of recent guidance contained in the Interagency Questions and Answers Regarding Flood Insurance (Flood Q&A), which were proposed by the banking agencies³ on March 21, 2008, and guidance from the September 2007 "Mandatory Purchase of Flood Insurance Guidelines" (FEMA guidelines) issued by the Federal Emergency Management Agency (FEMA).⁴ The Flood Q&A is a proposed amendment currently in the 60-day public comment period of the rulemaking process. The agencies could make further changes in response to public comments. The deadline to submit comments is May 20, 2008. The discussion here is intended to serve as general guidance and not to address all possible scenarios.

Blanket Insurance Policies

Compliance examinations occasionally reveal instances of banks' relying on blanket insurance policies to satisfy the requirements of the flood insurance provisions of Regulation H. Typically, the lender obtains a blanket policy to protect its collateral in one or more locations. While these policies may protect the lender, they typically do not protect a borrower's interests and, therefore, in most instances, are not considered a suitable substitute for individual National Flood Insurance Program (NFIP) policies. However, in the limited circumstances discussed below, a blanket policy can be appropriate provided that its coverage is at least as broad as the coverage under the NFIP standard flood insurance policy, including deductibles, exclusions, and conditions.⁵

A blanket policy can be used when NFIP and private insurance are unavailable or when a policy has expired and the borrower has failed to renew coverage.⁶ For example, when a designated loan has a policy with insufficient coverage but the borrower refuses to increase coverage, a blanket policy may be appropriate when the lender is unable to force-place private insurance for some reason. When a policy has expired and the borrower has failed to renew coverage, a blanket policy can be adequate protection for the bank during the 15-day gap in coverage between the end of the 30-day grace period after the policy has expired and the end of the 45-day force-placement notice period. However, the lender must force-place insurance in a timely manner and may not rely on the blanket policy as a permanent solution.

With the exception of these limited circumstances, a blanket insurance policy obtained by the lender for its protection is not an acceptable substitute for flood insurance obtained by the borrower for his or her protection and does not comply with the requirements of section 208.25(c)(1) of the Board's Regulation H or §4012a(b) of the Reform Act.

Blanket insurance should not be confused with private flood insurance obtained by the borrower. The NFIP allows a borrower to obtain private flood insurance as a substitute for an NFIP policy as long as it is comparable to an NFIP policy in coverage, deductibles, exclusions, and conditions. The critical difference between a blanket policy and private flood insurance is that a lender obtains a blanket policy for its protection, while a borrower can obtain private insurance for his or her protection.⁷

Replacement Cost Value

The new reference in the FEMA guidelines to 100 percent RCV has raised a number of questions from lenders about how to determine RCV when calculating the amount of insurance that must be obtained and how examiners will determine minimum coverage amounts in the future.

To comply with the guidelines, banks must ensure that the amount of flood insurance borrowers obtain is at least an amount equal to the lesser of:

The outstanding principal balance of the loan(s); or
The maximum amount of coverage available under the NFIP for the particular type of building; or
The full insurable value of the building and/or its contents, which is the same as 100 percent RCV.⁸

Generally speaking, the traditional method employed by many banks (and referenced in the old FEMA guidelines) of calculating the full insurable value of the building and/or its contents based on total appraised value minus the value of the land is still appropriate. FEMA's new guidelines do not require lenders to change this methodology. However, banks now have the option of using RCV to determine insurable value. If a lender uses RCV, examiners will typically review the method used to calculate the RCV to verify that it is reasonable. In addition, examiners will likely compare any RCV to the amount that would be required under the traditional calculation method. If the RCV determination were substantially lower, examiners would review the calculation methodology for the RCV in greater detail.

Buildings Under Construction

Another problematic flood insurance issue involves buildings under construction. Bankers frequently raise questions about the point at which a flood policy must be in place for such buildings. It is a prudent practice to have insurance coverage during the construction period for buildings that will be located in a special flood hazard area. This coverage can be purchased when the loan is made, even though construction has not yet begun.

Because the Reform Act does not explicitly address this issue, the new FEMA guidelines state that the federal banking agencies and lenders must determine at what point in the construction process insurance coverage is required. FEMA's guidelines highlight two options: requiring the purchase of insurance at the time the development loan is made or when a specified drawdown of the loan for actual construction is made.⁹ The latter option is more complicated and requires close monitoring of the loan to determine when construction actually begins. Accordingly, it may be more practical to require insurance at the time the loan is made.

Under the proposed amendments to the Flood Q&A,¹⁰ lenders must ensure that borrowers have adequate insurance in place at the time of loan origination. As an alternative, proposed question 19 of the Flood Q&A states that insurance must be in place once a foundation slab has been poured or an elevation certificate has been issued, provided that the lender requires flood insurance prior to the disbursement of funds to pay for building construction. In the latter case, the lender must have adequate controls in place to ensure that insurance is obtained no later than when the foundation slab has been poured and/or an elevation certificate has been issued.

Condominiums

Questions often arise regarding the flood policy requirement for condominium units, especially in multi-story complexes. Flood insurance requirements do apply to loans secured by individual residential condominium units, including multi-story condominium complexes. The amount of flood insurance coverage required on a particular condominium unit must, at a minimum, equal the lesser of the outstanding balance of the loan, the insurable value of the unit, or the maximum amount available under the NFIP.¹¹ One way to meet the insurance requirements is through a residential condominium building association policy (RCBAP), purchased by the condominium association, which would cover both the common areas and the individually owned units in the building. To be considered sufficient from a regulatory perspective, under the proposed amendments to the Flood Q&A, if the outstanding balance of the loan exceeds the maximum amount available under the NFIP, the RCBAP should cover either 100 percent of the replacement cost of the building or the total number of units in the building times $250,000, whichever is less. If there is no RCBAP or if the RCBAP is insufficient, lenders must require unit owners to purchase individual dwelling policies for the amount of the shortfall.¹² The NFIP offers individual coverage to borrowers under a dwelling form policy.¹³ In either case, the mortgage lender is responsible for obtaining copies of any policies, RCBAP or otherwise, showing sufficient coverage for individual units.

Conclusion

Regulators are likely to continue to focus on flood insurance. The potential impact on consumers and the associated risks to lenders make the correct application and monitoring of flood insurance requirements particularly important. While clearly not exhausting all of the possible complexities of the flood insurance rules, this article discussed some aspects of the requirements of the Reform Act, the Federal Reserve's flood regulation, FEMA's guidance, and the proposed amendments to the Flood Q&A. Specific issues, questions, or unique fact patterns should be raised with the consumer compliance contact at your supervising Reserve Bank or with your primary regulator.

¹ The National Flood Insurance Reform Act of 1994 (the Reform Act) (Title V of the Riegle Community Development and Regulatory Improvement Act of 1994) comprehensively revised the two federal flood insurance statutes: the National Flood Insurance Act of 1968 and the Flood Disaster Protection Act of 1973. The Reform Act required the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision, and the National Credit Union Administration to revise their flood insurance regulations and required the Farm Credit Administration to promulgate flood insurance regulations for the first time. Each agency has adopted its own regulation to implement the Reform Act for the institutions it supervises. The Board's implementing regulation for the Reform Act is section 208.25 of Regulation H.
² The terms blanket, gap, and master are used interchangeably to refer to various types of insurance obtained by institutions to cover their entire portfolio of loans for insurance shortfalls or expired policies.
³ Board of Governors of the Federal Reserve System, Farm Credit Administration, Federal Deposit Insurance Corporation, National Credit Union Administration, Office of the Comptroller of the Currency, and Office of Thrift Supervision.
⁴ National Flood Insurance Program, "Mandatory Purchase of Flood Insurance Guidelines," FEMA (September 2007), Federal Emergency Management Agency (FEMA).
⁵ The requirements are discussed on page 58 of the FEMA guidelines.
⁶ The agencies recently addressed this issue in question 57 of the Flood Q&A.
⁷ Private insurance is discussed on page 57 of the FEMA guidelines.
⁸ RCV is discussed on page 27 of the FEMA guidelines.
⁹ FEMA guidelines, p. 30.
¹⁰ Flood Q&A, 73 FR 15269 (March 21, 2008).
¹¹ FEMA guidelines, p. 46.
¹²Flood Q&A, 73 FR 15270 (March 21, 2008).
¹³ FEMA guidelines, p. 48.