We have seen record flooding in recent years, and 2018 is no exception. With increased flooding, it is very likely flood maps will be changing. Flood map changes can increase the risk of financial institutions being assessed civil money penalties (CMP) for flood violations. Financial institutions should take the time to examine their flood procedures to ensure they have sufficient policies and procedures in place to help mitigate their risk of flood violations. If your financial institution has designated loans, you need to be aware of flood requirements and the most common violations. A designated loan is a loan secured by a building or mobile home located in a flood zone.
The first step in reviewing your financial institution’s flood process is to be aware of the most common violations noted by examiners that result in CMPs:
- Failure to obtain adequate flood insurance before a designated loan is consummated
- Failure to maintain adequate flood insurance throughout the life of the loan
- Failure to perform appropriate force-placement procedures for flood insurance
- Failure to require escrow for flood insurance, when applicable
- Failure to provide borrowers with a Notice of Special Flood Hazard and Availability of Federal Disaster Relief Assistance within a reasonable time before loan consummation, renewal, extension, or any increase in loan amount
Lack of Flood Insurance
Financial institutions are prohibited from consummating a designated loan without flood insurance. That means you’re required to ensure there is sufficient flood insurance in place before closing a designated loan. For new policies, sufficient evidence of flood insurance is a copy of the flood insurance application and proof the premium has been paid, or a copy of the declarations page. If your financial institution relies on a copy of the flood application and proof of payment, you should get a copy of the declarations page after the loan has closed and retain that in the file. Binders are not acceptable proof of insurance. For renewal policies, a copy of the declarations page or Certificates of Insurance are acceptable proof of insurance. Generally, there is a 30-day waiting period before flood insurance policies will be effective; however, this waiting period is waived if the flood insurance purchase is lender required.
Don’t forget about contents taken as collateral. If a designated loan is secured by a building and the assets of the borrower and those assets are kept in the building located in a flood zone, you will need proof of insurance as well. For example, if a loan is secured by an office building located in a flood zone and the equipment located inside the office building, the equipment will need to have flood insurance in addition to the building.
Insufficient Flood Insurance
In addition to obtaining proof of flood insurance, financial institutions are required to ensure the amount of flood insurance is sufficient. This is probably the most commonly cited violation. The principal balance of all designated loans must be included when you calculate the amount of required insurance. This means if there are multiple loans secured by a property in a flood zone, the balance of all of those loans must be included in the calculation of insurance coverage. If your notes include cross-collateralization language, the balance of those loans will need to be included in the flood insurance calculation as well.
The amount of flood insurance required is the lesser of the:
- Outstanding principal balance of the loan (or loans)
- Maximum amount of insurance available under the NFIP
- Insurable value of the structure
The insurable value is replacement cost (not market value) for residential loans. For commercial property, the insurable value is actual cash value, which is calculated as the replacement cost value less depreciation. A good practice is to review the amount of flood insurance whenever you receive a copy of the declarations page to ensure there is adequate flood insurance coverage.
Financial institutions are required to ensure borrowers have sufficient flood insurance in place for the life of the loan. This means your financial institution needs to obtain and retain evidence of flood insurance the entire time you have the loan on your books. To avoid potential CMPs, you should have a process to track flood insurance for your designated loans and perform force-placement procedures in the event flood insurance lapses or coverage is insufficient. Your institution also needs to have procedures on what to do when you become aware an existing loan becomes a designated loan due to flood zone remapping.
Once your financial institution becomes aware flood insurance has lapsed, is insufficient, or is newly required due to remapping, you are required to notify the borrower of the borrower’s requirement to obtain flood insurance. The flood notification must be written and inform the borrower of the requirement to obtain flood insurance at their expense and in an amount equal to the lesser of insurable value, combined loan amount, or maximum amount available. If the borrower does not provide documentation of sufficient flood insurance within 45 days, your financial institution is required to purchase flood insurance on behalf of the borrower.
Under the Biggert-Waters Act, lenders can force-place insurance immediately when they determine flood insurance has lapsed. However, they cannot pass on the costs to the borrower until the end of the 45-day period. If the borrower obtains flood insurance, the lender must terminate the force-placed insurance and refund any premiums and fees incurred while both policies were in place.
Escrowing for Flood
Another common violation is failure to escrow for flood insurance when required. Financial institutions with total assets of $1 billion or more became required to implement mandatory flood escrows, and those with total assets less than $1 billion are required to escrow flood insurance premiums if on or before July 6, 2012, the institutions were either required by state or federal law to escrow for property costs or had a policy of consistently or uniformly requiring an escrow account.
If the financial institution sold loans to the secondary market on or before July 6, 2012, and the secondary market required the escrow account, this is considered having a policy requiring an escrow account, if the financial institution retained servicing rights after the sale of the loan to the secondary market. Financial institutions that are not exempt are also required to offer and make available the option for borrowers to escrow flood insurance premiums and fees for any designated loan secured by residential improved real estate or a mobile home that is outstanding on January 1, 2016, or July 1 of the year following the lender’s exemption status change. This holds true unless the loan or lender qualifies for a statutory exception or the borrower is already escrowing for flood premiums and fees.
Flood Notice Not Provided
Financial institutions are required to provide borrowers a Notice of Special Flood Hazard and Availability of Federal Disaster Relief Assistance within a reasonable time before the loan is originated. This notice is required to be provided whenever a loan is made, increased, renewed, or extended. This notice is also required to be provided regardless of whether the property is in a participating community.
Often this violation occurs when a loan is increased, renewed, or extended. Even though notice was provided at the time the loan was originally consummated, your financial institution is required to provide a new notice if the loan is increased, renewed, or extended. This could result in multiple identical notices being provided to the same borrower. It may seem redundant; however, it is a requirement and must be done.
Be particularly cautious if there is more than one loan secured by the same property located in a flood zone or there are loans that are cross-collateralized by a property located in a flood zone. Whenever any of these loans are increased, renewed, or extended, your financial institution needs to provide a new notice. Borrowers are not allowed to “opt-out” of receiving these notices. In addition to providing the notices, you must also get acknowledgment from the borrowers or documented receipt that the notice was provided. Typically, we see borrowers signing the notice; however, some financial institutions use certified mail as documentation the notice was provided.
Being aware of the common flood violations is a crucial step in mitigating your financial institution’s risk related to flood violations. Monitoring for flood compliance begins before the designated loan is originated and must continue throughout the life of the loan until the loan is paid off. Be sure you have sufficient policies and procedures to avoid these common errors.