Flood Insurance and Keeping Pace with a Construction Loan

Issue/Inquiry

The Bank recently closed a construction loan for $2.9 million, for which it advanced $200,000 at closing. The customer is now requesting an additional $648,000. The property consists of two lots, both of which are in a flood zone “AO”. The foundation has been built and the customer has indicated that the insurance agent stated that the customer can only get $25,000 in flood insurance at this time. Additionally, the customer raised the building 3.5 feet and will be applying for an elevation certificate. How much insurance should the Bank be requiring of the customer at this time?

Response Summary

For construction loans, flood insurance does not have to be in the full amount of the finished project, but can be purchased to keep pace with new construction. What the Bank must determine at each stage of construction will be the replacement cost of the structure already completed. The cost of materials will not be included, since these are not insurable against flood hazard. If insurance is obtained sufficient to cover the value of the structure at each phase of construction, it will satisfy the flood insurance requirements.

Response Detail

Whether the Bank must require the borrower to have flood insurance for a construction loan before making disbursements and the amount of the coverage that must be in place when such coverage is required will depend on the stage of construction.

Under the Flood Rules, a lender may allow a borrower to defer the purchase of flood insurance until either a foundation slab has been poured and/or an elevation certificate has been issued; or, if the building to be constructed will have its lowest floor below the Base Flood Elevation, when the building is walled and roofed.

The lender, however, must require the borrower to have flood insurance in place before the lender disburses funds to pay for building construction (except as necessary to pour the slab or perform preliminary site work, such as laying utilities, clearing brush, or the purchase and/or delivery of building materials). It must also have adequate internal controls in place at origination to ensure that the borrower obtains flood insurance no later than when the foundation slab has been poured and/or an elevation certificate has been issued. Interagency Questions and Answers Regarding Flood Insurance, Q. 22.

In this case, if the initial disbursement of $200,000 was for preliminary work prior to pouring the foundation slab, the purchase of materials, or for the pouring of the slab, then it was properly made even though the borrower had not yet provided proof of flood insurance coverage.

Now that the foundation is in place, however, it will be necessary for the borrower to provide proof of flood insurance coverage before the Bank can make further disbursements.

The general rule is that the amount of flood insurance required is the lesser of:

• The outstanding principal balance of the loan
• The maximum amount of insurance available under the NFIP, which is the lesser of:
  • The maximum amount available for the type of structures
  • The “insurable value” of the structures. Loans in Areas Having Special Flood Hazards: Interagency Questions and Answers Regarding Flood Insurance (“Interagency Q&A”), Q.14; FDIC Compliance Manual, V-6.4

With respect to construction loans, flood insurance does not have to be in the full amount of the finished project, since an NFIP policy will pay no more than the insurable value, but can be purchased to keep pace with new construction. FDIC Compliance Examination Manual, V – 6.2; Interagency Q&A, Q. 14. This means that the amount of flood insurance coverage will be incrementally increased from time to time to cover the increasing value of the structure as it is constructed.

In determining this value, the Interagency Q&A once noted in Question 9:

In calculating the amount of insurance to require, the lender and borrower (either by themselves or in consultation with the flood insurance provider or other appropriate professional) may 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.

While this answer has been removed from the current Interagency Q&A, it remains valuable guidance. In making the determination, however, two particular factors should be kept in mind:

• The materials or supplies used in construction or repair are not insurable against flood hazard unless they are in an enclosed building located on or adjacent to the premises. Federal Reserve Bank of Philadelphia, Consumer Compliance Outlook, Fourth Quarter, 2011. These materials should be covered under a Builder’s Risk insurance policy, but unless they are in an enclosed building, their value would not be considered for flood insurance purposes at any particular phase of construction.

• The amount of available flood insurance would not be affected by whether a survey and/or elevation certificate has been obtained, as the NFIP allows a policy to be issued based on estimated elevation from the builder’s plans. Upon renewal, the policy will be issued based on actual elevation and value. FEMA, NFIP Flood Insurance Manual (GR 4, APP 6, and PRP 16).

What the Bank will determine at each stage of construction will be the replacement cost of the structure already completed. It should document the basis for its determination of this value. If insurance is obtained sufficient to cover this amount, it will satisfy flood insurance requirements, even if the better part of any disbursement is for the purchase of materials, which cannot be covered by flood insurance. The amount of insurance will be increased as the value of the structure increases.

This entry was posted on Monday, October 26th, 2015 at 2:00 pm.