Recall the spring
of 1997. If you lived or worked in the Midwest, you undoubtedly will remember
the floods that ravaged many Ninth District communities. As lenders and real estate
owners recall the vast flooding, their thoughts eventually return to the property
loss. Rightly so, according to Lesli A. Rucker, federal coordinating officer for
the Federal Emergency Management Agency (FEMA). Rucker reminds us that "year in
and year out, flooding is the leading cause of property loss from natural disasters
in this country." 1/ As demonstrated last spring, while flooding
presents various unknown risks to lenders and real estate owners, flood insurance
offers one means of managing the potential risk of financial loss.
U.S. Congress authorized the National Flood Insurance Program (NFIP) through the
National Flood Insurance Act of 1968. At its inception, NFIP provided an opportunity
for property owners to purchase voluntary, federal government-subsidized flood
insurance protection for their structures and contents at or below actuarial rates.
Because this voluntary flood insurance program lacked sufficient participation,
Congress enacted the Flood Disaster Protection Act of 1973 (FDPA of 1973) to mandate
flood insurance coverage for many types of properties. FDPA of 1973 was a direct
response to findings that few people whose properties sustained damage during
major flooding disasters had purchased flood insurance.
Despite the mandatory
purchase requirement set forth in FDPA of 1973, program participation remained
low. According to FEMA, statistics show that the new, weak-sanctioned mandatory
program yielded still too few subscribers. This situation changed in the middle
1990s. Congress responded to the widespread flooding in the Midwest in 1993 by
enacting the National Flood Insurance Reform Act of 1994 (NFIRA of 1994). NFIRA
of 1994 not only continued the mandatory flood insurance program but established
severe sanctions for those who fail to comply with the mandatory insurance purchase
provisions, among others.
According to FEMA, NFIRA of 1994 has a provision
that limits the future availability of disaster relief for some flood victims.
FEMA says that as a condition of NFIRA of 1994, residents who live in a floodplain
and have received disaster assistance must purchase and maintain flood insurance
to be eligible for similar help in the future. 2/ Despite the
mandatory purchase requirement and the disaster-relief limitation, participation
in NFIP apparently remains low: only one in five homeowners with properties in
flood-zone areas currently participates. 3/
NFIP is more
than just a flood insurance program, however. It is also a hazard-mitigation program
that awards communities that adopt plans to mitigate potential flood damage. These
communities, known as participating communities, become eligible to participate
in the NFIP by:
- adopting and enforcing floodplain management measures
to regulate new construction; and
- ensuring that substantial improvements to
existing structures within its special flood hazard areas (SFHA) are designed
to eliminate or minimize future flood damage.
What is improved real property?
Improved real property is simply real estate upon which a building is located.
Anyone who has tried to apply this definition, however, knows it is not quite
so simple. FEMA provides more guidance by defining the term "building." For purposes
of the National Flood Insurance Program, a building is separated from other buildings
by intervening clear space or solid, vertical, load-bearing division walls; is
walled and roofed; is principally above ground and affixed to a permanent site.
The definition of building includes buildings in the course of construction, alteration
or repair as well as manufactured (mobile) homes on foundations. The federal regulators
have adopted the following definition of building: it means a walled and roofed
structure, other than a gas or liquid storage tank, that is principally above
ground and a permanent site, and a walled and roofed structure while in the course
of construction, alteration or repair. Informal discussions with FEMA revealed
that a structure must have at least two stiff walls to be considered a walled
SFHAs are areas within a floodplain that have
a 1 percent or greater chance of flood occurrence within a given year. FEMA defines
SFHAs and issues maps showing the location of such areas. Most owners of improved
real property located within a participating community's SFHA are eligible to
purchase NFIP flood insurance.
Different rules apply to people and businesses
in nonparticipating communities. For them, NFIP insurance is not available at
all. At one time, lenders were not permitted to extend conventional loans secured
by improved real property in a nonparticipating community's SFHAs. Pursuant to
a 1977 amendment to the law, lenders are now allowed to do so; however, some government
loans are still not available in these communities. When extending loans in SFHAs
in nonparticipating communities, lenders must give special consideration to the
additional collateral risk presented by these loans. This potential flood loss
risk occasionally results in the lender requiring the borrower to acquire flood
insurance through a private provider.
This understanding of NFIP's evolution
often prompts several questions about NFIRA of 1994's technical requirements.
Although this article does not address all the nuances of NFIP, it does describe
some of the more basic aspects of the program.
Who is subject to the mandatory
flood insurance provisions of NFIRA of 1994?
Surprisingly, the answer is
not the owner of an improved real property located within an SFHA. The law is
directed at lenders. More specifically, it is directed at three classes of lenders:
federally regulated lenders, government-sponsored enterprises (GSE) and federal
Federally regulated lenders are financial institutions
regulated by 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, the National Credit Union Administration and
the Farm Credit Administration. Since the enactment of NFIRA of 1994, the definition
of federally regulated lender has been interpreted to include subsidiary service
corporations of mortgage lenders.
GSEs are privately owned, federally chartered
corporations. The most familiar GSEs are the Federal National Mortgage Association
(Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac) and the
Government National Mortgage Association (Ginnie Mae). These organizations support
residential housing ownership by creating a secondary market for residential real
estate loans. Any lender that sells loans to a GSE will be subject to the mandatory
flood insurance requirements because these enterprises are required by law to
implement procedures designed to ensure that borrowers using improved real property
in an SFHA for loan collateral have flood insurance.
Federal agency lenders
are public agencies. These agencies are familiar to most people involved in residential
real estate or small business lending and include the Federal Housing Administration,
the Small Business Administration, and the Department of Veterans Affairs. Although
there are some exceptions, these agencies generally require flood insurance for
loans secured by improved real property located in SFHAs. None of these agencies
can subsidize, insure or guarantee any loan if the property securing the loans
is in an SFHA of a community not participating in NFIP.
What is insurable
under NFIRA of 1994?
The mandatory flood provisions apply to most improved
real property that secures a loan. Generally speaking, the law applies to buildings
and mobile homes, not raw land. It requires the lenders described above to ensure
that any loan secured by improved real property in a participating community's
SFHA has flood insurance covering buildings, mobile homes and personal property.
More specifically, if a lender takes a security interest in an improved real property
and the the contents of that property, both elements must be covered by flood
insurance. Conversely, if a lender takes a security interest only in contents
(which will be located in an SFHA) but does not take a security interest in the
improved real property, no flood insurance is required. The latter situation raises
questions about the soundness of such a loan, and FEMA encourages lenders to advise
borrowers to include contents coverage for personal and business items when it
is prudent to do so.
Note that it is the structures, not merely the land,
that must be within the SFHA. Additionally, when securing a loan with a mobile
home, the lender must require flood insurance regardless of whether the collateral
includes the underlying real property. To qualify for flood insurance, however,
the mobile home must be attached to a permanent foundation. In other words, if
an improvement can float away, it is not insurable. (Finally, when taking a security
interest in improved real property where the value of the land, excluding the
value of the improvements, is sufficient collateral for the debt, the lender must
nonetheless require flood insurance if the structure is located in a participating
Where must an improved real property be located to be insurable
The improved real property must be in a participating community
to be insurable. FEMA issues maps through its Map Service Center, which can be
reached at (800) 358-9619. The law now requires a lender to document its conclusions
about whether improved real property securing a loan is located in an SFHA. FEMA
has developed the Special Flood Hazard Determination Form for this purpose.
How do you calculate the amount of required flood insurance?
NFIRA of 1994 applies to structures, not land. Flood insurance is available only
for potential losses to buildings and mobile homes. The law sets the maximum limits
for buildings at $250,000 for residential structures and $500,000 for nonresidential
structures. It sets the limits for contents of residential and nonresidential
structures at $100,000 and $500,000, respectively.
To calculate the insurable
value of improved real property located in an SFHA, a lender must determine the
overall value of the property less the value of the land. FEMA recommends that
lenders follow the same practice for determining coverage for flood insurance
as they follow for establishing hazard insurance coverage. It is very important
to calculate the insurable value of the property, otherwise the lender might inadvertently
require the borrower to pay for too much or too little flood insurance coverage.
For example, if the lender fails to deduct the value of the land when determining
the insurable value of the improved real property, the borrower will incur unnecessary
charges by paying for coverage that exceeds the amount NFIP will pay in the event
of a loss. After calculating the insurable value of the improved real estate,
the lender must compare that value with the outstanding principal balance of the
loan and require flood insurance for that amount or the maximum amount of flood
insurance allowable under NFIP, whichever is less.
In addition to the maximum
insurable values, NFIP set additional recovery limits. For residential properties,
NFIP pays losses on the basis of replacement value for primary residences where
the insured has purchased insurance of up to at least 80% of the replacement cost
of the structure. This policy is intended to include the full cost of repair or
replacement without deduction for depreciation. For a nonresidential property,
the recovery limit is the actual cash value, which is intended to include repair
and replacement costs less depreciation.
When must lenders require flood
The general rule is lenders must require borrowers to obtain
flood insurance when making, increasing, extending or renewing any loans secured
by improved real property located in an SFHA. A refinancing of an existing loan
is the equivalent of making a new loan for purposes of the mandatory flood insurance
purchase requirements. The mandatory flood insurance requirement continues for
as long as the loan is secured by improved real property located in a participating
Some lenders might be presented with a situation where borrowers
fail to maintain sufficient insurance during the life of the loan. In the case
of an uninsured or underinsured property, the NFIRA of 1994 obligates the lender
to force place the insurance once specific conditions are fulfilled. First, the
lender must issue a notice that the borrower should purchase sufficient flood
insurance at his or her own expense. The borrower is allowed 45 days to acquire
sufficient flood insurance. If the borrower fails to comply within 45 days, the
lender must purchase the flood insurance. If the improved real property is located
in an SFHA, the law allows the lender to assess the cost of the insurance to the
Many lenders have third-party service providers conduct flood zone
determinations during the underwriting process. Many of these service providers
also monitor the status of their determination throughout the life of a loan.
Although the life-of-loan monitoring is not required by law, it provides lenders
with information about changes to the flood-hazard status of these types of loans
secured by improved real property located in an SFHA.
NFIRA of 1994 provides
two exceptions to the general rule that flood insurance is required whenever a
lender makes, increases, extends or renews any loan secured by improved real property
located in an SFHA. The first exception is for small loans and provides that the
mandatory flood insurance requirement does not apply to any loan made with an
original outstanding principal balance of $5,000 or less and with a repayment
term of one year or less. The other exception applies to certain state-owned property.
What notice must the lender provide to borrowers who secure loans with improved
real property located in an SFHA?
Lenders must provide a Notice of Special
Flood Hazard and Availability of Federal Disaster Relief Assistance to loan applicants
who propose to secure the loan with improved real property located in an SFHA,
regardless of whether it is in a participating community. Lenders must provide
this notice within a reasonable time, interpreted as 10 days, before closing a
loan transaction. FEMA has issued a model form for lenders.
the penalties for failing to comply with NFIRA of 1994?
With NFIRA of
1994, regulators can now assess civil money penalties if a lender engages in a
pattern or practice of committing violations. Four types of violations are subject
to civil money penalties. The violations include failure to:
- place insurance;
- escrow flood insurance premiums when required by law;
- provide notices;
- force place insurance.
The statutory civil money penalties limit
is $350 per individual violation; the aggregate penalty amount is $100,000 per
The flood insurance rules are complicated, but it is critical for people
in the housing industry to have a sound understanding of these rules. To increase
awareness of the flood insurance program, FEMA has published a pamphlet entitled
"Mandatory Purchase of Flood Insurance Guidelines." It describes how
NFIRA of 1994 extends the waiting period before NFIP insurance policies can become
effective from five days to 30 days. Given the extended waiting period, people
have less opportunity to purchase flood insurance when faced with imminent flooding.
Perhaps now more than ever before, it is important for lenders to establish sound
policies and procedures for requiring flood insurance.
Lisa DeClark is an attorney and Consumer
Affairs examiner for the Federal Reserve Bank of Minneapolis.