Flood Insurance: A Compliance Contingency Plan

Congress didn't carry out all of its responsibilities before adjourning in 2002. Among the tasks not completed was renewal of the [National Flood Insurance Program.] While Congress saved itself a little time by omitting this piece of work, it has caused major expenses in the form of contingency plans on the part of federal agencies and lenders - to say nothing of the anxiety it has caused compliance managers.

This article has two purposes. One is to discuss the response to the specific set of problems created by the lapse of the flood insurance program. The other is to outline how an institution can or should respond to this sort of compliance crisis. The flood insurance program lapse is an excellent model for a compliance contingency program.

The Questions
In considering contingency plans, it is important to distinguish between the availability of flood insurance through FEMA and the requirements of the law. The legal requirements to make flood hazard determinations and notify customers of flood hazards are fully in place. They are not dependent on the existence of a federal flood hazard insurance program.

The definition of a designated loan for which you must require insurance depends on the availability of federal flood insurance. Thus, while the program remains unauthorized, there is a technical loophole.

This is a situation that will tempt lenders to conclude that all flood hazard requirements are temporarily lifted. However, the requirements themselves are not canceled or suspended in any way. The failure to authorize the FHIP simply makes compliance more complicated but no less necessary. As a practical matter, it makes compliance more important than ever.

Choices
Contingency plans are all about choices and options. What choices are left when the main path is barred? This is much more complex than a yes or no decision. The core of contingency planning is what to do instead? How do we keep going?

Obviously, one choice here is not to make loans secured by property located in a flood hazard zone. For some institutions, this may not be a significant decision. If very little property in the market area is actually located in a flood hazard zone, this particular decision may seem like a no-brainer.

Things are much more complicated if your market area includes a flood hazard zone.

The institution can continue to make loans but require the borrower to produce private flood hazard insurance. This approach is clearly safe and sound. It has the advantage of fully complying with the laws on the books and covering risk for both lender and borrower. It has the drawback of being the most expensive option for the borrower.

The institution can choose to follow the advice of FEMA and the regulatory agencies. This involves some willingness to take risk - the risk that Congress won't get around to renewing the flood insurance program any time soon. Absurd as this may sound, it is a very real possibility. There are likely to be a lot of battles about federal budgets between now and the next presidential election. It is an element of risk that must be weighed.

FEMA and the regulatory agencies have offered a solution that is not without risk. The risks are that the program might not be renewed or - more likely - might not be renewed for a substantial period of time. From the uninsured lender's perspective whether a period of time is substantial depends on whether any flooding occurs. And that is the risk.

During the non-renewal period, the coverage for any flood damage that occurs to not-yet-insured properties is undetermined. It would take an act of Congress - the same Congress that failed to renew the program - to provide for the situation. The only guarantee the agencies have given is that the institution will not be cited for non-compliance if it chooses to take this risk.

FEMA's Guidance
After putting considerable effort into encouraging and supporting lender compliance, this period of non-insurance is a practical set-back for FEMA. The agency is doing everything possible to maintain the status quo - without the key piece.

FEMA is advising lenders to take all compliance steps beginning with flood hazard determinations and continuing through applications for insurance. FEMA advises lenders that when Congress re-authorizes the program, it expects that Congress will make the authorization retroactive to January 1, 2003. However, FEMA can offer no guarantees.

FEMA plans to hold policy applications received after January 1, 2003 until the insurance program is re-authorized. However, if this takes an extended period of time, FEMA may cancel the applications and refund the pre-paid premiums.

Based on FEMA's advice and a reading of the Flood Hazard Protection Act as it applies to them, Freddie Mac and Fannie Mae have issued their own advice. First, all loans submitted to Freddie or Fannie must contain flood hazard determinations. If the property is located in a flood hazard zone, borrowers must produce proof of purchase of flood insurance by closing.

Proof of purchase of insurance may be established by a completed NFIP Flood Insurance Application plus proof of payment. The proof of payment may be reflected on the HUD-1 showing that the premium was collected at settlement.

Flood insurance proof may also be established by an agent-executed certification of purchase or by an endorsement form transferring flood insurance from the seller to the purchaser of the insured property.

FFIEC's Guidance
The financial institution regulatory agencies have issued their own guidance. This begins with a warning to lenders that there are no guarantees that the NFIP will be re-authorized or that the renewal will be retroactive. There is risk involved in almost any approach an institution decides to take.

First, the agencies remind lenders that they must continue to make flood hazard determinations on all loan applications supported by improved real property. In addition, institutions must continue to comply with all other requirements of the flood hazard rules. In the context of compliance, the FFIEC agencies advise institutions that they must "evaluate safety and soundness risks and prudently manage those risks" during the lapse period. While the agencies note that institutions may make loans in flood hazard areas during this period, the risk lies with the institution. In short, each institution must measure risk and have a policy for managing that risk. The agencies remind institutions that they are responsible for protecting collateral from risk in a manner appropriate to the circumstances.

One option is to refrain from making loans secured by property in a flood hazard area. Such a policy should be based on an evaluation of risk, including the institution's ability to track the status of the NFIP, and responsiveness to customer needs.Another option is to require borrowers to purchase private flood insurance. This has the advantage of certainty and the disadvantage of higher cost to the customer.

Finally, you may choose to rely on force-placement if and when the flood insurance program is re-authorized. However, this approach has several negatives. First, the loan is not salable to the secondary market without evidence of flood insurance purchase. Second, when insurance is purchased, there would be a thirty-day effective delay.

Perhaps one of the most important pieces of compliance will be the notice sent to applicants whose property is located in a flood hazard zone. This notice will need to advise customers of the need for flood insurance and of the lender's requirements for insurance while the NFIP is unfunded. It would be a good idea (to protect your institution as well as to inform the customer) to advise borrowers about the interim procedures until the program is re-authorized.

The agencies also expect lenders to maintain systems to track policies that are applied for during this period. Lenders have the responsibility of determining that insurance is in fact obtained as soon as possible. If the insurance is not placed or FEMA suspends applications, the lender will have to force-place insurance.

Placement of requested policies may not be automatic. It will be the responsibility of the lender to see that policies go into place. Furthermore, FEMA may decide to refund premiums and not issue policies if Congress does not act within a "reasonable" time. Lenders will need to be aware if this happens and take alternative steps for insurance.

Thirty Days?
Loans made without required flood hazard insurance face a problem beyond the issues discussed in the official guidance. If a lender chooses to make the loan secured by property in a flood hazard zone but does not require insurance or proof of purchase of insurance, there are two consequences. First, the property is not insured during the lapse period of NFIP.

Second, once the program is re-authorized, any attempt to purchase flood hazard insurance will not be in connection with making, increasing, renewing, or extending the loan. As a consequence, there will be a thirty day waiting period for insurance to take effect. This adds thirty days of risk.

ACTION STEPS

Do not let your lenders interpret this lapse as an indication that flood hazard insurance isn't important. Use it instead to highlight the risks of not having insurance.
Work with your lenders to determine how your institution will treat applications for mortgages on property located in flood hazard areas.
Communicate your temporary policy throughout the lending department. It may be a good idea to also inform branch staff as they my face questions from customers.
Check with several private insurance agents to find out the cost of private flood hazard insurance. Cost to the customer may be a factor in your decisions.
If you decide to make loans pending re-authorization of the flood program, be sure you have a reliable system for tracking those loans and making sure insurance is provided.
Stay tuned!