Will private flood insurance keep mortgages from going underwater?

Then, Congress mandated that federally regulated lenders accept private flood insurance (in certain situations) to satisfy the mandatory flood insurance requirements that apply to their loans and private insurers began offering private policies more broadly.

 Meanwhile, the Federal Emergency Management Agency has been working to update its risk rating system to align premiums with flood risk and to modernize its flood maps to ensure accurate identification of flood risks. These reforms may substantially increase premiums and the number of homes that require flood insurance, which, in turn, threatens property values. Indeed, the U.S. Department of Housing and Urban Development published a study in 2019 that found “robust evidence of large price reductions for properties that were drawn into the flood zone of the new FEMA flood maps.” Further, a 2015 study found that each $500 increase in flood insurance premiums resulted in a $10,000 decrease in home values.

Some believe that expanding private flood insurance may mitigate these effects on property values. It’s not clear whether this will be the case. 

Historically, many federally regulated lenders feared that examiners would find private flood insurance policies unsatisfactory. But the changes that the federal banking regulators (Office of the Comptroller of the Currency, Federal Reserve Board, Federal Deposit Insurance Corporation, Farm Credit Administration and National Credit Union Administration) put in place last year address these issues by encouraging and, in some cases, requiring lenders to accept private flood insurance policies. 

Proponents of the new rules believe private policies will offer additional choice that may be less expensive than NFIP coverage, particularly after FEMA has updated the NFIP ratings. 

Opponents of the rules believe expansion of private flood insurance is unlikely to benefit property owners and could be disastrous for the NFIP, which may end up insuring the riskiest properties while private insurers opt to cover only the less risky ones. Regardless of the pros and cons, lenders must adjust their policies and procedures to align with the changes.

The new private flood insurance rule 

Since July 1, 2019, the federal banking agencies have required regulated lenders (generally banks and credit unions) to accept flood insurance policies that meet a specific definition and have permitted acceptance of some other policies. These new regulations have turned out to be more complicated to implement than expected. And investors have imposed their own requirements that expand on and occasionally conflict with the new regulations, which has only exacerbated the challenges. The result is potential long-term risks for lenders, notwithstanding care in implementing the new rules. Lenders who have not done so should carefully review their practices for full compliance with the new rule and all investor requirements.

Mandatory acceptance

Under the federal banking regulators’ new regulations, a lender must accept a private flood insurance policy if it satisfies the statutory definition by meeting the following requirements:

• Issued by a licensed or approved insurance company
  
• Provides coverage that is “at least as broad as” the coverage provided under a  standard flood insurance policy issued under the NFIP
  
• Includes:
  
  • A requirement for the insurer to give 45 days’ notice to the borrower and the regulated lending institution prior to cancellation or nonrenewal
    
  • Information regarding the availability of coverage under the NFIP
    
  • A mortgagee interest clause similar to the clause in an SFIP
    
  • A limitation provision that the insured must file suit not later than one year after the date of a written denial of a claim under the policy
    
  • Contains cancellation provision that are as restrictive as an SFIP

Because evaluating whether a particular private flood insurance policy meets those requirements can be cumbersome and imprecise, the federal banking regulators’ regulations allow regulated lending institutions to rely on “compliance aids” to determine whether a policy meets the statutory definition. Specifically, a regulated lending institution may assume that a policy containing the following language is sufficient: 

“This policy meets the definition of private flood insurance contained in 42 U.S.C. 4012a(b)(7) and the corresponding regulation.” 

In theory, this should be a useful shortcut, but private flood insurance policies rarely, if ever, include this precise language. 

Discretionary acceptance

Regulated lending institutions have discretion to accept private flood insurance policies that do not meet the statutory definition if the policies:

• Provide the minimum amount of required coverage
  
• Are issued by a licensed or approved insurance company
  
• Cover both the mortgagor and the mortgagee as loss payees
  
• Provide adequate protection of the designated loan, consistent with general safety and soundness principles. The lender must document its conclusion regarding sufficiency of the protection of the loan in writing.

Some regulated lending institutions rely on these criteria to avoid the complex analysis required under the mandatory acceptance requirements. 

In doing so, lenders must be mindful to always accept a policy that satisfies the mandatory acceptance requirements, regardless of whether the policy includes the compliance-aid language.

Unresolved challenges

The new private flood insurance rules have created a unique set of challenges that lenders have yet to fully resolve, which include, among others:

• Fannie Mae and Freddie Mac rules do not appear to permit lenders to rely on the compliance-aid provision, and generally require that a private policy mirror an NFIP policy. This limits a regulated lending institution’s ability to invoke the discretionary acceptance criteria for loans sold to the GSEs. In addition, the GSEs’ rules require that private policy carriers meet certain ratings requirements that the federal banking regulators have not imposed. Because regulated lending institutions must accept policies that meet the definition of “private flood insurance” regardless of the GSEs’ ratings requirements, policies that lenders are required to accept under the banking agencies’ rules may not be sellable to the GSEs.
  
• Despite ongoing discussions indicating that FHA will issue rules allowing private policies, it has not done so to date, and FHA programs currently prohibit acceptance of private flood insurance policies.
  
• While it would seem reasonable to conclude that a private policy meets the definition of private flood insurance if the policy contains language similar to the compliance-aid provision, this may not always be the case. Indeed, some key coverage distinctions may exist between private policies and NFIP policies, even when the private policies assert that they are at least as broad as an NFIP policy. For example, some private policies define coverage limits differently than NFIP policies, or exclude mold damage (which NFIP policies cover) from their coverage. Existing federal banking regulator guidance does not address when these differences cause private policies to provide inadequate coverage. 

The bottom line is this: Whether private flood insurance will have a meaningful impact on home values is yet to be determined. 

But the new rules around private flood insurance are certainly presenting challenges for lenders.