Flood Insurance: Compliance Tips for Avoiding Costly Penalties

Flood insurance comes across as a simple regulation, yet every year it continues to be a significant source of civil money penalties—and those penalties can be expensive.  

Just look at the past six month of flood insurance civil money penalties:  

Related: What Is A Compliance Management System And Why Your FI Needs One

Why are flood insurance violations so expensive? 

The National Flood Insurance Act requires agencies to assess up to $2,000 (adjusted annually for inflation) per violation per loan against a pattern or practice that fails to properly ensure a consumer in the event of a flood.  

That means a single loan file can be the source of numerous violations and penalties. If there is a systemic problem impacting a whole portfolio, each individual loan can add to the penalty.   

It is very likely that if your examiner finds one violation, they’ll find another. 

What makes complying with flood insurance regulation so difficult?  

For some reason, flood insurance continues to be one of those regulations that financial institutions have trouble getting right. The Flood Act requires a borrower buy and maintain flood insurance for the life of a loan when the property securing the loan is in a specially designated flood hazard area. If the borrower fails to buy or renew flood insurance on the property, the lender must purchase the flood insurance on behalf of the borrower (forced placement).  

While the rules do not seem that complicated, ensuring compliance requires a lot of dual controls that do not consistently happen. 

The biggest flood insurance problems FIs have are: 

• Failing to ensure flood insurance is in place prior to loan closing.   
• Not following rules for forced place insurance. 

Here are some of the common issues that cause problems: 

Only getting an estimate. Sometimes the borrower obtains and turns in an estimate for flood insurance but does not actually buy a policy. The lender does not follow up and collect proof of insurance (the binder), which causes the loan to close without proper coverage. 

Not setting a deadline for proof of insurance. Loan officers care about closing loans quickly and figure there is no harm in backfilling paperwork. They might tell the borrower they can provide proof of insurance anytime. That is a potentially expensive mistake if it leads to a loan closing without flood insurance in place.   

Missing key dates. The rules require that borrowers receive their flood insurance binder in a reasonable timeframe before closing. A reasonable amount of time is not the day of closing. Three days is more appropriate and industry best practice. 

Borrowers let flood insurance lapse. Borrowers often let flood insurance lapse after the first year, hoping the lender will not notice. If the lender does not have proper processes in place to follow up with the borrower, there will not be a way to verify ongoing coverage and then notify the borrower of the need for force place coverage (if existing coverage has lapsed).  This in most cases leads to a violation.  

Not insuring outbuildings. Every dwelling on a property needs flood insurance if it is part of the land being used for collateral—even if it is old and rundown and regardless of whether the owner intends to use it. When someone buys a property with an old structure, the lender needs to make it clear to the owner that it will require coverage at replacement cost value if it is still on the property at loan closing.  In some cases, the owner may choose to tear it down, donate it to a local fire department, or otherwise remove the structure before the loan is closed. The easiest way to think about it is: If it’s got a roof and four poles, it’s required to be insured.  

Not enough coverage. There are tables to determine how much flood insurance is necessary, but lenders can make mistakes. Other times, they do not want to lose the deal, so the lender will see $250,000 is required but will tell the borrower that they only need $200,000 because coverage is expensive. That is a violation.  Loan officers should not have the authority to waive or reduce coverage. There are no allowable exceptions.      

Third-party failures. One recent civil money penalty came about when a bank hired a third-party to notify borrowers of the need for forced place insurance. The third-party servicer’s policies and procedures extended beyond the 45-day notification period. As a result, the forced place insurance was not put in place in a timely manner. 

Forgetting to require flood insurance when a loan is renewed. Whether a loan is refinanced or extended, or a new loan number is issued, that loan still needs flood insurance. A change in terms does not change that requirement. 

How to avoid flood insurance compliance issues 

The best protection against flood insurance violations—and most compliance issues—is a strong three-lines of defense model. That includes first line process with strong dual controls, a compliance management system (CMS), and of course audit processes that show corrective action.  All three of these working together ensure the FI has: 

Policies and procedures that DO NOT allow for exceptions. Flood insurance compliance needs to be clear, understood, and have procedures for ensuring requirements are met. For example, there should be a process to verify insurance is in place before the loan closes and practices (i.e., checklists) for determining the proper coverage amount (it is often simplest to require maximum coverage for the size of the loan).   

Compliance training. Lenders and all employees involved in the process must receive timely and periodic flood insurance training that is both general and role specific in nature. They need to be aware of flood insurance policies and procedures and the consequences for failing to follow them.  

The key message: Flood insurance must be in place before loan paperwork is signed. This requirement cannot be waived. No exceptions.  

Testing & monitoring. Flood insurance should be part of your first and second line of defense testing and monitoring. This allows for proactive change! Testing and monitoring frequency needs to be commensurate with the number of errors testers continue to find. In some cases, monthly testing may be necessary. 

You should test and monitor: 

• New loans. Make sure they have sufficient, verified in flood insurance in place prior to loan closing. 
• Closed loans. Verify they continue to have sufficient flood insurance in place—whether it is through the borrower or forced place for lapse of coverage.  Test dates to make sure they align with both FI policy and regulation. 

If you do not have enough resources for monitoring, that could be viewed as a deficiency in your loan operations. 

Flood Audits.  Does your internal or external audits review flood requirements as part of testing commensurate with the number of errors found? Or is flood reviewed on an 18 -24-month cycle with the view that the fines are immaterial? It is important that audits are conducted to make sure the first and second line have made corrections to the processes as needed to limit errors and potential regulatory fines.   

My colleagues Paul Viancourt and Katie Ferrell will talk about how the three-lines of defense work together to help in situations like flood insurance in our upcoming webinar, Success with the three lines of defense: How to build a compliance and risk management dream team. Register now so you don't miss it!