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Last quarter’s Compliance Corner contained the first of two articles on the mandatory flood insurance requirements of the 1994 National Flood Insurance Reform Act (Reform Act) and its application to lenders under Regulation H, the Board’s implementing regulation for the Reform Act. The first installment provided a general overview of the Mandatory Purchase of Flood Insurance Guidelines published by the Federal Emergency Management Association (FEMA guidelines). This second installment reviews the more problematic areas encountered by lenders and regulators.1
Land Value Versus Property Value
Lenders sometimes write loans on buildings situated on land located in a special flood hazard area (SFHA) whose value alone provides sufficient security for the loan, without regard to the building’s value. The question often arises in these circumstances whether the lender must still require the borrower to obtain flood insurance. The answer is unequivocal because the Reform Act and Regulation H specify that when a lender has a security interest in a building in an SFHA, regardless of its value, the lender cannot close the loan until it has verified that the borrower obtained flood insurance for the property.
The question of flood insurance coverage for high-value land with relatively low-value buildings is often an issue in agricultural lending. Regulators have made it clear that Congress, in enacting the Reform Act, did not differentiate agriculture from other types of lending, and therefore agriculture borrowers also must comply. The value of the land should be deducted from the overall value of the secured property when calculating the required amount of flood insurance.
Buildings in the Course of Construction
For new construction, lenders are often uncertain when flood coverage is required: is it before, during, or after construction is completed? For a structure being built in an SFHA that will be a walled and roofed building eligible for coverage, flood insurance must be purchased to provide coverage during the construction period. Thus, when a development or interim loan is made to construct insurable improvements on land, flood insurance coverage must be purchased.
The only practical way to implement this is to require the borrower to purchase the policy when the development loan is made, with coverage becoming effective when construction commences and existing in an amount that satisfies the mandatory purchase requirement.
When a structure is yet to be walled and roofed, the material to be used during construction is eligible for flood insurance, but it is subject to certain underwriting restrictions. The National Flood Insurance Program (NFIP) conforms its practices, to the extent possible, to those of fire insurers by providing insurance coverage on materials, which begins when construction takes place. For more detailed information, refer to FEMA guidelines at www.fema.gov/nfip/mpurfi.shtm.
Residential Condominium Associations
The NFIP offers a specific policy for residential condominium associations called the Residential Condominium Building Association Policy (RCBAP). The RCBAP allows condominium associations to purchase up to $250,000 in coverage for each unit in the building or the replacement cost of the building, whichever is less. For instance, in a 10-unit condominium building, the maximum amount of coverage is $2,500,000 ($250,000 x 10). However, if the replacement value of the building is $2,000,000, the maximum coverage is $2,000,000. A condominium association may opt to purchase flood coverage under the RCBAP, even though individual owners do not have mortgages on their units.
This area can be problematic because the RCBAP is for all of the units, and the lender must determine how coverage applies to a specific borrower’s unit. When making a loan on a condominium unit located in an SFHA, lenders should verify whether the association has an RCBAP in place that provides adequate flood insurance coverage at the time the loan is made and also that it will continue for the term of the loan.
A unit owner’s mortgage lender has no direct interest in an RCBAP and is not an additional named insured. Because of this, lenders should take steps to protect their interest in the proceeds of a policy in the event of a claim. In the loan documents, lenders should require borrowers to fully assign all future claims under any insurance purchased or in which the borrower is named as an insured, such as an RCBAP. The lender should also notify the flood insurance carrier of the assignment. Otherwise, the carrier will send the proceeds of a claim to the borrower.
If a lender determines that the unit owner’s coverage under the RCBAP is insufficient to meet the mandatory requirements, the lender can ask the borrower to purchase a dwelling policy to bridge the gap. However, the maximum benefit payable under the NFIP for a single condominium unit under the combination of the RCBAP and the dwelling policy is $250,000. When both the RCBAP and a dwelling policy cover the same unit, the RCBAP is considered primary insurance.
If the RCBAP lapses during the term of the loan, the lender must notify the borrower that there is a 45-day limit to obtain a policy for the amount of the loan or the maximum amount of coverage available, whichever is less, and that the lender will obtain a policy if the borrower fails to do so within the 45 days.2 It is important to note that while cooperatives are similar to condominiums, they are not covered by the RCBAP. The NFIP requires that cooperatives be insured through the general property policy, instead of the RCBAP.
Coinsurance penalty. If a flood insurance policy is for the lesser of 80 percent of the replacement value of the property or the maximum amount of coverage available under the NFIP, a coinsurance penalty applies. This penalty reduces the amount paid on a claim by the ratio of the value of the replacement policy divided by the value of the property. For example, assume a $5 million condominium is insured for only $3 million. Since $4 million is required for replacement coverage (80 percent of $5 million), the coinsurance penalty applies. Only 75 percent ($3 million divided by $4 million) of any loss would be recovered. Therefore, the NFIP encourages an association to purchase coverage equal to at least 80 percent of the replacement cost of the building to avoid the penalty. If the 80 percent threshold is met, the NFIP pays 100 percent of all covered losses up to the limits of the policy minus any deductible.
Dwelling policy. When the condominium association fails to obtain full replacement cost coverage, the unit owner can acquire supplemental building coverage by purchasing a dwelling policy in excess of the association policy. The policies are coordinated such that a unit owner’s policy responds to shortfalls in the association’s building coverage pertaining either to improvements owned by the insured or to assessments by the condominium association. Assessment coverage is available under the unit dwelling policy, which covers the risk of a special assessment against the unit owner from a condominium association because of damage to common areas due to flooding. Residents are advised to purchase contents coverage separately because contents are not covered under the dwelling policy or the RCBAP.
Nonresidential Condominium Associations
To purchase coverage under the NFIP on a nonresidential condominium building, a condominium association must use the general property policy. Both building and contents coverage are available separately, in amounts up to $500,000 per nonresidential building.
NFIP’s coverage of timeshares depends on the property law of the state where the property is located. If state law treats the timeshare as real property (fee simple), then the timeshare is treated like a condominium and must be covered by an RCBAP. Also, the timeshare unit owner must have an ownership in the unit similar to that of a condominium unit owner. In nonfee jurisdictions, where the title remains with the building owner who has the full insurable interest in the property, a general property policy must be used.
The Secondary Market
Lenders participating in the secondary market through government sponsored enterprises (GSE), including Freddie Mac and Fannie Mae, should consult the GSE’s guidelines for flood insurance requirements. Fannie Mae’s guidelines are available at www.allregs.com/efnma/index.asp under “Selling Guide.” Freddie Mac’s guidelines are available at www.allregs.com/fhlmc/index.asp.
Recent events in the gulf states vividly demonstrate that flood insurance is critical for the financial stability of individuals living in and financial institutions operating in SFHAs. Between 2002 and 2004, the Board of Governors of the Federal Reserve System imposed penalties on 16 state member banks for violating the flood insurance rules. The penalties ranged from $1,750 to $34,100 and were imposed when a pattern or practice was noted, not for isolated incidents.
Lenders should be particularly careful to ensure compliance with the most frequently violated sections of Regulation H, namely Section 208.25(f)(1)’s requirement that lenders use the standard flood hazard determination form when writing loans and Section 208.25(c)’s requirement that lenders ensure that borrowers living in an SFHA obtain flood insurance. This is an appropriate time for lenders to ensure that their loan portfolios are adequately protected and that lending procedures are in compliance with the Reform Act and Regulation H.
The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.