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Flood Insurance Regulatory Changes Chart New Course for Lenders

Written by: Brian M. Shea, CRCM, CAMS
According to the National Oceanic and Atmospheric Administration, flood damages in 2013 totaled more than $2.2 billion. By 2014, damages reached more than $2.8 billion. In fact, damages totaled greater than $1 billion every year since 2000 except one, 2012 – when the amount was a paltry $522 million.

That’s a lot of affected homeowners and businesses, not to mention insurance claims, property damage and paperwork. It's no wonder that flood insurance, rules and regulations are an extremely important consideration for all those connected to floods, especially financial institutions. There is a close link between lenders and flood insurance regulations.

Current areas of key focus for financial institutions include the following:

  • Flood insurance mandatory escrow rules.
  • Flood insurance exemption for detached residential structures.
  • Flood insurance force placement rules.

The bottom line is that lenders need to understand current flood insurance regulations, so proper planning can take place regarding implementation and future business strategies.

RECENT CHANGES HAVE HAD AN IMPACT
It’s a turbulent time for financial institutions. New rules and regulations are coming in from all sides, some of which pertain directly to flood insurance.

In recent memory, there has been the:

The effective dates for the final rule were October 1, 2015 for the exemption for detached structures on residential properties and provisions relating to force placed flood insurance, and January 1, 2016 for the mandatory escrow of flood insurance premiums. Based on guidance previously issued by federal regulatory agencies, lenders have been permitted to utilize the exemption for detached structures and the force placement changes prior to this effective date.

Essentially, the last few years have seen a series of changes, followed by changes to the changes. It's not surprising that this can be confusing. Here is what lenders should know about three of the biggest tweaks out of these laws and regulations:

# 1 – MANDATORY ESCROW REQUIREMENT
For this new rule, the change relates to escrowing of the flood insurance premium. Escrow is now mandatory for all loans secured by residential real estate either made, increased, extended or renewed on or after January 1, 2016. Such escrow accounts must be consistent with the practices utilized for taxes, insurance and other premiums, and must be in compliance with the Real Estate Settlement Procedures Act and Regulation X.

There are also exemptions to this rule for certain products and circumstances. Those include the following:

  • Extensions of credit primarily for business, commercial or agricultural purposes.
  • Home equity lines of credit and subordinate liens if adequate flood insurance is already in place.
  • Loans with terms shorter than 12 months.
  • Non-performing loans.
  • Loans secured by condo units assuming the condo association policy provides adequate coverage (supplemental borrower purchased policies are not exempt).

There are also exemptions specifically for small lenders assuming the following conditions are all met:

  • The lender had total assets of less than $1 billion by December 31st of the past two calendar years.
  • The lender was not legally required to escrow taxes or insurance for the loan on or before July 6, 2012.
  • The lender did not have a policy of consistently and uniformly requiring escrow of taxes, insurance premiums/fees for any loans secured by residential real estate on or before July 6, 2012.

Lenders who lose the small lender exemption status have until July 1st of the first calendar year where they lose the exemption in order to comply.

Additionally, part of the changes related to the mandatory escrow requirement is the obligation to provide a written notice informing the borrower of the mandatory escrow requirement. If the lender is considered a small lender, and loses that status, it has to notify affected borrowers by September 30th of the calendar year it becomes subject to the rule.

It is also important to note that this rule only applies to loans originated on or after January 1, 2016; any prior loans only need to have the option to escrow flood insurance premiums, which must be offered no later than June 30, 2016, via formal written notice. Lenders must make this offer even if the borrower has previously declined escrow.

# 2 – DETACHED RESIDENTIAL STRUCTURES
The second major alteration to flood insurance is related to detached residential structures. Flood insurance is not mandatory for any structure that is detached from the residence and does not serve as a residence in its own right. Lenders are permitted to apply this exception to both consumer and commercial purpose loans assuming that the collateral is a residential property. Lenders can choose to require flood insurance for these structures, but it is no longer a requirement.

So then, what counts as a detached structure that is not a residence? A good place to start is to determine if it has a kitchen, sleeping and bathroom facilities. However, this isn't a cut-and-dry determination. More steps may need to be taken to decide if it is - or is not - a residence based on the specific circumstances, and that falls on the lender. This determination is only required when the loan is made, increased, renewed or extended.

# 3 – FORCE PLACEMENT
The third change is when lenders are required to force place flood insurance coverage on borrowers. Based on the new rules, it is now permitted to force place coverage and charge borrowers for the cost commencing on the date that coverage lapsed or became insufficient.

The key language here is "permitted." Lenders can choose to force place immediately, but they don't have to. It only becomes a requirement once 45 days have passed since the policy lapsed or became insufficient and the borrower was notified. Once the borrower purchases his or her own coverage, the lender must notify their provider to terminate the force placed insurance. The borrower must also be reimbursed if there was coverage overlap.

NEW RULES SPECIFIC TO MASSACHUSETTS
All of these developments affect lenders across the country. However, there are a few changes that are specific to Massachusetts. The Bay State has its own flood rules which have taken effect and have had regulations recently issued. Lenders are no longer allowed to require flood insurance on residential properties in an amount that is greater than the principal balance. The lender also cannot mandate that the insurance include contents coverage or have a deductible of less than $5,000. While lenders are prohibited from mandating such a coverage amount or conditions, borrowers have the option to obtain these if they desire.

These rules are part of Massachusetts General Law Chapter 183, Section 69, which took effect on November 20, 2014. The new regulation was issued as 209 CMR 57. The effective date for the regulation was September 11, 2015, with certain notice provisions coming into place on November 10, 2015.

In particular, the regulation provides critical clarification and instructions for lenders with respect to the law. The prohibitions apply to mortgage loans secured wholly or in part by a mortgage on residential property located in a specially designated flood hazard area. This includes residential first mortgages, subordinate liens such as home equity lines of credit and home equity loans, and reverse mortgages. The rules apply to any residential property located in Massachusetts that is occupied or to be occupied in whole or in part by the obligor. However, properties with five or more units and commercial purpose loans are exempt.

The regulation also provides guidelines over when the lender needs to make a determination as to whether it is requiring flood insurance coverage in excess of the principal balance. Lenders only need to consider the principal balance when the loan is initially made, increased, extended or renewed and at the start of the flood insurance policy year. At the time of policy renewal the borrower has the option to request that the coverage amount be lowered to match the principal balance, although the lender only needs to take action if requested by the borrower.

Finally, the regulation provides a specific format for a notice that lenders are required to provide to the borrower informing them of the prohibitions. For loans that are made, increased, renewed or extended, this notice must be provided at the same time and in the same method as the notice required by federal rules. Existing loans only require the notice in specific circumstances, in particular when new coverage is added, when there is an increase in the coverage amount in excess of the amount in effect for the expiring policy period and when notifying the borrower of the need to obtain insurance when the insurance coverage becomes delinquent. The regulation provides a model format that lenders are required to follow. While the notice requirement has been effective since the law took effect in 2014, lenders have until November 10, 2015 to change their systems and processes to provide the form in the required format.

WHAT SHOULD LENDERS DO?
What steps should lenders take if they have not yet implemented processes to comply with these rules? The lender will want to consider the following practices to ensure compliance:

  • Become familiar with any key effective dates so as to plan implementation around them. Where possible lenders should work backward from the effective dates to establish key deadlines by which critical tasks must be performed.
  • Determine applicability of escrow rules to the lender. There will be certain lenders and certain products for which the rules will not apply. By making this initial determination the lender will save time spent when compliance is not mandatory.
  • Consider the risks and benefits over any of the rules that are optional (detached structures, certain force placement rules) and decide on the lender’s policy. Where the lender is not formally required to apply a certain exemption or rule, immediate changes are not as critical, but still may have key benefits to the lender.
  • Update written policy and procedure documents. Formal policies and procedures are critical guidelines for staff and management to follow and the lender will want to ensure that they accurately reflect both the regulatory requirements and the lender’s actual practices.
  • Provide training and assistance for key lending and other impacted staff. It will be critical to ensure that employees impacted day to day by these rules have the appropriate knowledge of the requirements and the lenders’ policies and procedures so as to be able to implement them effectively.
  • Review notices, worksheets, checklists and other documents for updates. While only notices have formal content and timing rules, many lenders utilize other material to assist in compliance and will want to be sure that they are fully up to date to ensure they meet their purpose in assisting the lender in complying.
  • Work with systems, vendors and other service providers. It is rare when a regulatory change takes place and the lender is able to implement it without these being impacted in some way. The lender should reach out to its third parties where applicable to ensure they will have the proper processes and technology in place in a timely manner.
  • Ensure monitoring procedures are in place to ensure correct processes have been implemented. The lender may want to consider secondary checks at key times if such controls are not already in place until there is a comfort level that the lender is in compliance. The lender will also want to ensure that the compliance audit plan is updated to include coverage of the new rules.
  • Be aware of applicability rules and conditions. For those lenders not subject to the escrow rules, they will still want to know all the applicability rules and conditions so as to be ready if their lender becomes subject to them. While they will not require as much in depth knowledge as those lenders who must immediately comply, having at least a general knowledge of the rules will assist if the lender anticipates that within the next few years it will no longer qualify for an exemption.

In some cases, the changes are minimal. But in others, they are quite significant, and the overall impact on financial institutions is anything but minor.

If you have any questions, contact Brian M. Shea, CRCM, CAMS, Regulatory Compliance Senior Manager, at 617-261-8133 or bshea@wolfandco.com.   

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