by Robert Smith
Originally Published - June 06,2016
Our company was recently approached with questions from our clients regarding the proper procedures for handling flood insurance if a community where they have properties securing existing loans is suspended from the NFIP. It should be noted that none of the communities in question are suspended as of yet. Though FEMA issues notices of pending suspensions rather frequently, actual suspensions appear to be a rare event, or at least short-lived. Should it occur, however, it is not something that should create panic for a lender, but it should absolutely be given close and careful attention.
The first thing to keep in mind is that your borrowers' current, active NFIP policies do not cancel on suspension, but they cannot be renewed. Your interests should be relatively safe in the short-term but, the longer a suspension goes, the more exposure your institution will likely face. You may want to consider reaching out to the local government or the floodplain managers responsible for the suspended community. They should be able to provide insight or help you get at least some idea of a time frame on getting the community back into compliance.
So what happens if you are or could be faced with a substantial exposure? You are effectively free to decide what is best for your institution. Lenders are urged by regulators to consider their risks carefully. You are permitted, but not mandated, to require your borrowers obtain sufficient coverage under private flood insurance policies. On new loans, you must still inform the borrower if the property is in a high-risk flood zone and the ability to at least buy private flood insurance. Existing borrowers, though, should already be aware if they are in a high-risk flood zone.
Having fewer mandates may sound like it could make things easier, but it places a very serious responsibility in your lap. There are two major questions from somewhat opposing views to ask yourself in this scenario: "Is it safe and sound to forgo or wait on requiring private flood insurance?" and "How will this impact our relationship with borrowers in that community?"
For the first question, consider how large of an exposure you are facing and for how long. Though there is nothing directly requiring flood insurance on properties in a non-participating community, the principle of risk management remains. Flood ratings exist since the community was participating, you know the risk exists, and you know depositor funds are on the line. We see it as very conceivable an institution could be slapped with allegations of unsafe and unsound practices for leaving too much exposed. Even if it did not happen now, it could only take one lender getting hit hard enough with collateral losses in a flood to compel regulators to pursue that avenue. Additionally, it is hard to say what kind of reaction legislators could have to a number of borrowers losing their homes and being left unable to replace them.
For the second question, consider how much of a burden requiring private flood insurance could place on your borrowers. Suspensions from the NFIP are not your fault, of course, but your borrowers may not care whose fault it is when they see how much it will cost them. Force-placed insurance is more expensive as well, and could easily create resentment, not to mention complaints you may have to report to the CFPB. Perhaps worse, it could even result in defaults. Consider a borrower whose financial situation has become just manageable under normal conditions. After the placement occurs at a non-participating rate, the borrower may be unable to keep up with the cost of insurance on top of their mortgage payments.
So what's the best option? We think that will vary for each institution, as each will have to balance those two perspectives. There may not be an ideal solution even in the best of cases, as either will likely come with challenges. Getting more details on the communities themselves and any timelines for coming back into compliance may be key to developing the best solution. It may be beneficial to get information on non-participating flood insurance rates as well. In short, the best approach is to be proactive, gather all the information you can, and approach the risk assessment with the caution and diligence.