Flood Insurance for Properties with Little or No Value
Question. Bank asks for guidance for obtaining flood insurance in proper coverage amounts, especially for properties with little or no value.
Summary. Any reasonable approach can be used in calculating the value of the property for flood purposes. The flood rules do not specifically exempt properties from flood insurance coverage because they have little or no value, but the federal regulators generally will not require flood insurance for purchase money loans for properties with nominal value or which will be torn down shortly afterwards. If a flood insurance provider will not assign an insurable value, or where the insurable value is less than the deductible, the bank should document this.
Analysis.
The NFIP provides caps on the maximum amount of insurance available, depending on the type of property. For residential property, the maximum amount available is $250,000 or $500,000 for multi-family properties, plus $100,000 for contents. For commercial property, it is $500,000 plus $500,000 for contents.
Flood insurance coverage is limited to the overall value of the property securing the loan minus the value of the land on which the property is located. The appraised value of a property for flood insurance purposes is different than the market value. Market value is what someone may be willing to pay for the property. The bank will also look to it as the basis of the collateral value for a loan. Insurable value is a cost approach which looks to the cost to rebuild a property.
If the flood hazard determination indicates that the property is located in a special flood hazard area, the bank can obtain the information it needs for the insurable value of the property by requesting the appraiser to provide a cost approach, otherwise known as replacement cost valuation, in addition to the market value.
Under the Interagency Guidelines, the insurable value of residential property is generally the replacement cost value or “RCV,” while for nonresidential property, it is generally the actual cost value or “ACV.” RCV is the cost to replace the property with the same quality of material and construction, while ACV is RCV less present day physical depreciation. ACV may be appropriate if the residential property is not the principal residence of the owner or RCV would exceed the amount the NFIP would pay in the event of loss.
In calculating the amount of insurance to require, the Interagency Guidelines permit the lender and borrower (either by themselves or in consultation with the flood insurance provider or other appropriate professional) to choose from a variety of approaches or methods to establish the insurable value. They may use an appraisal based on a cost-value (not market-value) approach, a construction-cost calculation, the insurable value used in a hazard insurance policy (recognizing that the insurable value for flood insurance purposes may differ from the coverage provided by the hazard insurance and that adjustments may be necessary; for example, most hazard policies do not cover foundations), or any other reasonable approach, so long as it can be supported.
There are only two exemptions from the purchase requirements. The first applies to state-owned property covered by a policy of self-insurance which is satisfactory to FEMA. The second applies if the original balance of the loan is $5,000 or less and the original repayment term is one year or less.
While there is no specific exemption from coverage because a property has little or no value, the federal regulators generally do not require flood insurance in the case of a purchase money mortgage transaction, where the improvements have nominal value, or where the improvements are going to be torn down. In the first instance, the mortgage should specifically exclude the improvements from the transaction. In the second, there should be a plan of demolition.
Where the flood insurance provider has assigned no insurable value to a property and will not issue a policy covering it, or where the value of the property is less than the deductible of the policy, the bank should document this for its loan file. As indicated, any reasonable approach may be chosen to calculate insurable value, so long as it can be supported. A number of compliance commentators are favorable to this particular approach, but there remains a question as to whether the federal regulators will accept it.
