Flood insurance helps manage risk of financial loss

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.

The 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.

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 agency lenders.

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 community's SFHA.)

Where must an improved real property be located to be insurable under NFIP?

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?

As noted, 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 insurance?

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 community's SFHA.

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 borrower.

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.

What are 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; and
• force place insurance.

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.

1/ FEMA News Desk: FEMA-North Dakota Flood 1997

2/ Ibid.

3/ FRB Boston Regional Review, Summer 1997