Flood Insurance: Where to Go Wrong

Flood hazard insurance has been with us for a long time. Unfortunately, we still don't seem to be getting it right. Civil money penalties are assessed all too often. The 2005 hurricane season is only going to bring more attention to this area. This is a good time to take a close look at where and how mistakes happen.

Land or Improvement
Which matters more when calculating the amount of flood insurance? The amount of the loan or the value of what will be left after the flood - the land? Or should you consider the loan amount? Or perhaps the value of the improvements?

Loan officers, eager to accommodate their customer's interest in not paying for anything extra, are inclined to approach the flood insurance requirement with the wrong priorities in mind. When you are looking for a way to save your customer money (at settlement) you may be making an unsafe and unsound decision for the long term - when the flood happens.

There are several factors to consider when determining the amount of flood insurance that is needed. First, there is the amount of the loan. Then there is the value of the improvements, and finally, there is the value of the land without the improvements.

It can be tempting to look to the value of the land to determine whether that will support the loan in the event that a flood destroys the improvements. If this is the case, it would mean that there is adequate value to support the loan after the flood. Nice theory, but wrong. If you want to persuade your lenders that this approach is wrong, ask them to consider the sales value of a lot in New Orleans in the wake of Hurricane Katrina.

The purpose of flood insurance is to anticipate the possibility of loss and to protect against it. Relying on what will be left falls seriously short of this goal. It also fails to consider the amount of loss. Consider, for example, your customer's priorities after the flood destroys his home. How eager will your customer be to make payments on the sodden patch of dirt that is left?

The correct calculation is to use the value of the improvements. Ignore the value of the land. Flood insurance insures the improvements and therefore looks only to the improvements to assess the amount needed.

Next, compare the amount of the loan to the value of the improvements. The lesser amount is the amount of insurance that must be purchased - up to a limit of $250,000 for residential properties.

Valuing Improvements
The value of the improvements relative to the value of the land is not always clear. Much of the advice on how to determine the value of the improvements is inconsistent - and either wrong or unwise. When setting the value, there are several approaches. Some are fairly scientific and some should only be used when better evidence is not available.

The best source to determine the value is a full appraisal. The appraisal should determine the value of the land and the value of the improvements and present both values. Reminder: use the appraised value for the improvements, not the appraised value for the land.

Without a full appraisal, there may be several other methods to determine property value but these methods are less reliable for separating the value of the land from the value of the improvements. Property tax assessments usually provide values for land and improvements. However, these numbers are not as current as an appraisal would be. They are generally developed in response to the previous year's market. In some jurisdictions, they may be older. Because they are less reliable than a full appraisal, the numbers could be challenged - after the flood. The biggest risk in using out-of-date numbers is that they might be used to reduce or limit the amount of insurance. If this is the case, there won't be adequate insurance to support the real value.

But be prudent
When property improvements are located in a high risk flood hazard zone, it is in everyone's interest to determine the value with a full appraisal. And that appraisal may come in handy later when your borrower needs to file the insurance claim.

Changing Amounts
There is a reason that purchasing a home is the best investment most people ever make. Property values show a consistent increase. While desirable in most respects, this also means that your insurance policy may become inadequate over time. When property values change, the policy should change with it.

The biggest problem with insurance policies over time is that the borrower sometimes reduces the amount of coverage and doesn't tell you. When monitoring the status of flood insurance policies, you need to know more than whether the policy was renewed. You need to know the amount of insurance purchased.

One of the common - and expensive - flood insurance violations that examiners find is that customers have renewed their insurance policy but for a lesser amount. The status of the insurance policy is usually tracked by flood hazard determination firms, but they don't all track the amount of insurance. Because this information is as important as the existence of the policy, you should know what information your vendor is tracking and providing.

Is later OK?
One of the most common questions we get is "can we close now and force place the insurance later?" Tempting, especially when the borrower is arguing about the need to purchase the insurance. But not only does this show poor judgment, it is a serious violation.

Force placement is intended to be a remedy of last resort. It applies when the customer fails to renew an existing policy. Force placement replaces an existing policy. But this isn't all. Any policy placed that is not in conjunction with the making, increasing, renewal, or extension of a loan cannot take effect for 30 days.

As a practical matter, since the borrower didn't want the insurance in the first place, it is reasonable to presume that the borrower won't renew the insurance. This means going through the force placement drill every year, with risk exposure periods.

But there is an even more significant reason to avoid this temptation. It is in direct violation of the law. It is illegal to close that loan without flood hazard insurance in place. The force placement technique is not a legal option.

Another concern is that force placed insurance protects the lender but not the borrower. After the flood, your borrower will not be happy with this solution because it leaves the borrower out-of-pocket.

Construction Projects
A disturbing number of insurance agents try to tell their customers that flood insurance is not available on new construction until the walls and roof are in place. There are several problems with this advice. First, it is not correct. Just ask FEMA. They'd be more than happy to tell you that insurance should be purchased before everything begins - including the loan.

Insurance on construction doesn't take full effect immediately. The insurance binder should be in place, but the amount of insurance available rises along with the structure.

Purchasing insurance after the construction has begun has two problems. First, there is a mandatory 30-day delay because the insurance was not purchased in connection with the loan. Second, making the loan without insurance was illegal.

ACTION STEPS

Review your flood insurance training materials to be sure all the issues in this article are covered. When you train, include some insurance calculation problems for lenders to solve.
Audit some loan application files to evaluate the flood hazard determination procedures.
Select some loans that are subject to flood insurance requirements. Review the insurance tracking that is in place and determine whether it is effective.
Contact your flood hazard determination vendor to confirm the type and detail of information they provide when they track life-of-loan insurance coverage. Make sure they verify insurance policy amounts.
Review how insurance amounts are determined when insurance is renewed if you don't get this information from your vendor. If you don't have this information, put a process in place to get accurate information.
Review your procedures for force placement of flood insurance. If you don't have procedures, get cracking!