The Flood Rules and Loan Participations

Issue/Inquiry

The Bank has purchased a participation interest in a loan secured by a property in a special flood hazard area. The flood policy for such loan does not show a flood zone. Will the examiners find that the policy is sufficient proof of flood insurance coverage for the loan participation?

Response Summary

A discrepancy between the flood zone under which the flood insurance policy was written and the flood determination may mean that the lender has not fulfilled the requirement of the Flood Rules for obtaining adequate flood insurance coverage, since claim payments under the flood insurance policy will be based on the actual flood hazard zone and not the one that was erroneously designated in the coverage. A bank that has purchased a participation interest in the loan after the loan was made is not responsible for such errors under the Flood Rules, but it should have such corrected for safety and soundness purposes.

Response Detail

Introduction

In this scenario, the Bank is trying to determine whether the flood insurance coverage must indicate the flood zone applicable to the property and, if so, the extent to which a participant is responsible if such designation is not made.

Flood Zone Designation

Under the Flood Rules, it is stated that “an FDIC-supervised institution shall not make, increase, extend, or renew any designated loan unless the building or mobile home and any personal property securing the loan is covered by flood insurance for the term of the loan.” A designated loan is a loan secured by a building or mobile home located in a special flood hazard area for which flood insurance is available. The amount of insurance must be at least equal to the outstanding principal of the designated loan or the maximum limit of coverage available under the NFIP (whichever is less). Insurance coverage is limited by the insurable value of the property, which is the value of the property with improvements minus the value of the land. Interagency Questions and Answers Regarding Flood Insurance (“Interagency Flood Q&A”), Q. 8.

All claim payments are based on the coverage limitations provided in accordance with the correct flood zone for the building location, rather than the zone that was shown for the flood insurance coverage in error. The flood zone for the coverage will be designated on the Flood Insurance Policy Declarations Page (the “Declarations Page”), which is part of the flood insurance contract, along with the policy and any endorsements. The Declarations Page will show the following:

• Current Flood Zone
• Grandfathered (i.e., previous flood zone designation that is carried over)
• Restated Flood Zone

For example, if a policy is written for a property located in a non-special flood hazard area (e.g., Zone X), but, at the time of the loss, the property is determined to be located in a special flood hazard area (e.g., Zone AE), then the claim is paid in accordance with the coverage limitations applicable to the designated special flood hazard area.

A discrepancy between the flood zone indicated on the Standard Flood Hazard Determination Form (“SFHDF”) and that which is indicated on the flood insurance policy is only a matter of concern if the discrepancy is between a high-risk zone (i.e., Zone A or V) and a low or moderate-risk zone (i.e., Zone B, C, D, or X).  If the difference concerns a subcategory (e.g., between A1 and AE), this is not considered to be a discrepancy and a lender is not required to do anything further.

What this means is that if a flood insurance policy is issued for an incorrect flood zone, the insured will not have been paying the proper premium for the risk involved. If the payment is not sufficient for the actual risk and such is discovered after a loss has been suffered, the policy is then required to only provide the amount of insurance coverage that could have been purchased for the entire term of the policy for the premium received. Since the reduced coverage will not cover the loss suffered, a claim would be rejected.

In this case, if the flood insurance policy, as indicated by the Declarations Page, does not show the flood zone that the policy was written for, there is no proof that the policy was written for the correct zone and, thus, that the insurance coverage is adequate. As such, the proof of flood insurance coverage would not satisfy the requirements of the Flood Rules.

Federal law places the ultimate responsibility for obtaining adequate flood insurance coverage on the lender. Interagency Flood Q&A, Q. 71, 72.  If the flood insurance coverage is not adequate due to a discrepancy, the Bank will be guilty of the following two violations of the Flood Rules:

• Closing the loan with insufficient flood insurance coverage
• Not having required the proper coverage in place during the term of the loan after it was closed

Such a discrepancy must be resolved by determining the flood zone for which the flood insurance coverage was written, ensuring that that flood zone coincided with the flood zone indicated in the SFHD, and then having the Declarations Page revised to reflect the correct flood zone.

Loan Participation

As with purchased loans, the acquisition by a bank of a participation interest in a loan after the loan has been made does not trigger the requirements of the Flood Rules, such as making a new flood determination or requiring the borrower to purchase flood insurance, since the loan is not being made, increased, renewed, or extended. The funds are being disbursed to the lead bank and not the borrower. Depending on the circumstances, however, safety and soundness considerations sometimes necessitate that a bank undertake due diligence to protect itself against flood loss.

If the Bank contributed funds that would be simultaneously advanced to the borrower, however, it would be responsible for compliance with all requirements of the Flood Rules. Even if the contract with the lead bank made the lead bank responsible for compliance, the examiners would expect the participant to have performed upfront due diligence prior to closing to be sure that the lead bank has undertaken all activities necessary to comply with the requirements of the Flood Rules and that it has adequate controls to monitor compliance with the Flood Rules on an ongoing basis. Interagency Q&A, Q.4.

In this case, if the Bank purchased a participation interest after the loan had been made, it did nothing that would trigger compliance with the Flood Rules. The funds it disbursed would go to the bank which made the loan, rather than the borrower.

From a risk management standpoint, however, its collateral may be at risk. For that reason, the Bank should bring the discrepancy in the flood zone between the SFHD and the flood insurance policy to the attention of the lead bank and require it to take the appropriate steps for resolving the matter. This should be documented on file.

While the failure of the lead bank to provide proof of adequate flood insurance coverage would not necessarily be criticized in a flood compliance examination of the Bank, it could certainly be the focus of examiner criticism in a safety and soundness examination because it affects the soundness of the underlying loan.

With respect to the purchase of loan participations in the future, the Bank will want to make sure that the lead bank has a proper flood compliance program in place, and that it has made the flood determination within the proper timeframe, recorded it on the SFHD form, and required the borrower to obtain insurance in the correct amount for the full term of the loan if the property did turn out to be in a flood hazard zone. The participation agreement should have a provision that would require the lead bank to buy back the participation in the event it was subsequently determined that the lead bank failed to properly discharge its flood compliance duties.

This response is for informational purposes only and is not intended for legal guidance.

This entry was posted on Tuesday, February 18th, 2020 at 6:00 am.