Flood Regs Come In Waves

As July came to a close, the financial institution regulatory agencies promulgated final regulations to implement the National Flood Insurance Reform Act of 1994 ("Reform Act"). Although each agency must issue its own regulation, the final version is substantially uniform because it was developed by an interagency task force. That's what took so long.

In developing this regulation, the agencies had several priorities that will have a significant and positive impact on your compliance program. First, they placed a high priority on uniformity throughout the flood regulation system. That means that not only are the financial institution regulatory agencies' regulations consistent with each other, they are also consistent with regulations issued by FEMA. In the process of strengthening the act, Congress established divided regulatory responsibilities that could have resulted in a complex tangles of regulations with no clear compliance solution. The agencies took steps to prevent this.

Second, the agencies placed top priority on minimizing regulatory burden. They took into account how something would get done, and what an institution would have to do to "know" or find out about something. The result is a regulation which is reasonable and workable. Moreover, (and this is especially nice in August) it contains no real surprises.

Forced Placement
The act gives institutions the authority to force place flood insurance when the borrower fails to obtain or renew required insurance. The regulations help to clarify when and how the lender should exercise this authority. Consistent with the Act, the regulation provides that if the customer fails to purchase insurance within 45 days after notification, the lender shall purchase the insurance on the borrower's behalf. The regulation's language is mandatory. It does not give the lender the option of purchasing insurance, it requires the lender to purchase insurance. This language is intended to leave no room for doubt about the lender's authority- and legal obligation-to place the insurance.

Some commenters suggested that the agencies clarify that if a borrower refuses to purchase insurance, the lender may force place insurance before or immediately after closing. The agencies rejected this suggestion. The agencies concluded that there is no need to have clear authority to force place insurance at closing or at origination because the act makes it illegal to make a loan secured by real estate located in a flood hazard zone without having insurance in place. In other words, no insurance, no loan. As a practical matter, it doesn't make good sense to enter into a loan transaction when the lender knows the borrower will refuse to purchase needed flood insurance.

Escrowing Insurance Premiums
Under the act, lenders that require borrowers to maintain an escrow account for loans secured by residential real property in a flood hazard zone must also escrow flood insurance. There are several issues worth noting here. First, the act's requirement to escrow is limited to residential properties. This requirement therefore does not apply to loans on improved non-residential real estate, i.e., commercial properties.

However, dealing with the requirement for residential properties will not be easy. The act has a different definition of residential real property than the definition in RESPA. The agencies studied the possibility of adopting coverage that is identical to that of RESPA's escrow rules, but concluded that the specific but different language in the two acts did not permit them the necessary latitude. As a result (with apologies from the agencies) the flood rule coverage is different from RESPA.

First, the flood insurance escrow requirement is triggered by the creditor requiring an escrow account for the payment of taxes, insurance premiums and similar charges. It is not triggered by a determination that the loan is covered by RESPA. As a result, loans exempt from RESPA may be subject to the flood insurance escrow requirement. This will typically be loans on residential buildings of 5 or more units, loans to a commercial borrower secured by residential real property, construction loans, and loans secured by properties of 25 acres or more (agricultural loans).

Second, when the lender requires escrowing for loans that are subject to RESPA, the lender must comply with section 3500.17 for all payments into and disbursements from the account, including those for flood insurance. If the loan is not subject to RESPA, the lender does not need to maintain the escrow account in a manner which complies with RESPA. (We think it was nice of the agencies to give you this room, but we strongly recommend that you maintain all your escrow accounts in compliance with RESPA. That should minimize compliance problems.) Loans secured by a condominium are exempt from the flood regulation's escrow requirement because the condominium association, not the individual borrower, handles flood insurance payments.

Exempt Transactions
The act provides very limited exemptions. Only two types of situations can be exempted. First, loans having a principal balance of no more than $5,000 and a repayment term of one year or less are exempt. Second, a loan secured by state-owned property that is covered by a self-insurance policy is exempt if the self-insurance is satisfactory to the Director of FEMA.

Not Exempt
Commenters also asked for several exemption categories that the agencies did not adopt in the final rule. One request was to exempt loans when real estate located in a flood hazard zone was taken only in "an abundance of caution" to secure the loan. The agencies concluded that the statute did not permit this exemption. The statute requires insurance on "any loan secured by improved real property" that is located in a flood hazard area. This position is consistent with the Congressional purpose of using the financing process to maximize flood insurance coverage.

Insurance Coverage
The amount of insurance must be at least equal to the lesser of the outstanding principal balance or the maximum limit of coverage available. In addition to this statutorily prescribed limit, the new regulation provides that flood insurance coverage under the NFIP is limited to the overall value of the property less the value of the land. This has the effect of insuring only the improvements, not the land.

Recordkeeping
Records may be kept electronically or on paper. Records must be retrievable and sufficient to demonstrate that the borrower received and acknowledged the notices. If the property is located in a flood hazard zone, the lender must retain these records for as long as it holds the loan.

Forms
The final regulation makes some changes to the notice to the borrower that the property is in a flood hazard form. These changes are primarily stylistic, but do include a reference to the lender's obligation to force place insurance if the borrower fails to obtain or maintain required insurance. Unlike FEMA's certification notice, the language in the notice of special flood hazard is a model only although lenders will be in compliance with the act if they use the model language. Lenders may change the format or add language. Any form that a lender develops must include at least the minimum information included in the model form.

Table Funding
The new regulation gives guidance on the distinctions between loan originations, loan purchases, and "table fundings." The underlying philosophy in drafting regulation was to ensure that the type of loan transactions that the act intends to reach cannot be structured to avoid the coverage of the regulation. In this respect, the agency concluded that the purpose of the flood hazard regulation is similar to the goals of RESPA. As HUD did with RESPA, the agencies determined that the substance of the transaction should control. Thus, a table funded transaction is treated as an origination, just as it is in RESPA.

Loan Servicing
The act did not make clear the responsibilities of loan servicers when the servicer is different from the loan originator or loan purchaser. The new regulation provides that the contract between the loan servicer and the lender should provide for the obligations with respect to flood insurance. This means that banks can, through their contracts, make servicers responsible for maintaining required escrow accounts, force placing insurance as needed, and collecting fees. However, this must be clearly provided for in the servicing contract. Although this is a duty that can be transferred to the servicer by contract, the lender remains ultimately liable. The lender should therefore have procedures to ensure that the servicer is performing as agreed.

Fees
The new regulation clarifies that it is appropriate to charge reasonable fee for flood certification both for loan closing and for the life of the loan. However, this permission does not affect the existing rules in Regulation Z (Truth in Lending) and Regulation X (RESPA) which deal with how to treat the fee in calculations and disclosures. This is an area that you need to implement and monitor carefully.

Mobile or Manufactured?
The terms mean the same thing. For purposes of flood insurance, it doesn't matter what you call it. Either mobile or manufactured will do, as long as it is build on a permanent chassis. Recreational vehicles are excluded. The more important issue is whether or not the home is secured to a permanent foundation. The new regulation defers to FEMA to determine what is a "properly secured" mobile home. Identifying the need for insurance may be more difficult than deciding whether or not the structure is a mobile home. Fortunately, the agencies have recognized that you can't determine whether the property is located in a flood hazard zone until the borrower determines where the mobile home will be secured to a permanent foundation. The timing rules require that the lender make the flood hazard determination as soon as the location is known.

ACTION STEPS

Determine how your institution is complying with the requirement to determine whether a property is in a flood hazard zone and what fees are being charged.
Review a sample of closing documents to determine whether the fees were properly treated and disclosed.
Review your procedures for escrow accounts. Make sure that the necessary instructions are in place for escrowing flood insurance premiums. In particular, make sure the procedures are clear as to the types of loans that are covered by the escrow requirements.
Meet with your commercial loan department and any other department (Trust, private banking) that rarely makes loans that are subject to RESPA. Talk with them about the new rules and work out any appropriate changes to procedures. Also, schedule training for this staff.
Review your servicing contracts (for sales and purchases). Check to see that the contracts do clarify responsibilities for flood insurance monitoring and customer notices.
Review your process (or establish one) for making sure that servicers perform their contractual obligations, including flood insurance.
Sit down with loan operations and work out procedures for monitoring flood insurance accounts and for force placement. Be sure that the procedures include periodic reports to Compliance.
Remind all lenders and loan underwriters of the insurance coverage amounts.