|Don't let flood rule enforcement soak you (April 2007)|
An expert’s examination of flood insurance regulation penalties—and their broader application—will help you wring yourself dry.
Feel like you’re drowning in flood insurance regulation penalties? It’s more than a feeling. Flood insurance penalties are continuing at a strong pace—or a rising tide, if you prefer. The banking regulatory agencies continue to keep pressure on banks to maintain a high standard of compliance with the regulations implementing the National Flood Insurance Program.
Regulators bear down
In 2005 and 2006 the Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency (OCC) and the Federal Reserve assessed a total of more than $1 million in civil money penalties against banks that they supervise for flood insurance violations. By contrast, in 2004, the total penalty amount assessed by the three agencies was only $116,000.
Yet it is FDIC that has been the most aggressive of the three banking regulators in the penalty assessment business. In 2005, the FDIC assessed civil money penalties against 13 state nonmember banks for flood insurance regulation violations. In 2006, that number jumped to 34 state nonmember banks. FDIC’s total of flood insurance fines is larger than the OCC and FRB. It is difficult to say whether the reason for that statistic is that FDIC supervises more banks than the other agencies, or that the agency is more diligent in its examinations and enforcement of the regulation, or even that the FDIC-supervised banks are not doing as good a job complying with flood insurance regulatory requirements as other banks.
Whatever the reason, banks all over the country under every type of banking regulator are expending a significant amount of time and money to comply with the flood insurance regulations.
The regulators do not have much of a choice. They are under a legal mandate to assess penalties whenever they find a pattern or practice of committing a violation of the flood insurance regulations. A pattern or practice involves a repeated, intentional, regular, usual, deliberate, or institutionalized practice. However, just because a violation is unintentional does not necessarily get the bank off the hook. An isolated error, on the other hand, is not a pattern or practice.
The regulators will consider a variety of factors in making a determination of pattern or practice, including:
• Conduct that is grounded in written policy or unwritten policy and established practice;
• Relationship of instances of violation to the total lending activity;
• Common source or cause of the problem (such as computer systems or training provided);
• Evidence of similar conduct toward multiple borrowers/applicants.
(These points were made in a Federal Reserve Bank of San Francisco flood insurance seminar a few years ago.)
The most important consideration in the assessment of penalties is whether the violation is a repeat violation. If a violation has been previously identified in a regulatory examination and is identified again in the current examination, the regulators are very likely to throw the book at the bank.
A bank that ignores regulatory findings and does nothing to correct the problems found would certainly find itself facing penalties. What is more likely to occur, however, and still subject a bank to potential civil money penalties, is a recurrence of a problem that was thought to be corrected. Since there is usually one or two years between compliance examinations of a bank, a flood insurance violation that was corrected immediately following one examination could resurface by the time the next examination occurs, unless the bank continues to diligently control and enforce compliance.
Banks could also face civil money penalties for “repeat violations” of flood insurance regulations when a violation of a different provision of the regulation is identified. If a bank was previously found to have failed to provide adequate notice to borrowers of the requirement to purchase flood insurance, and now has violated the provision requiring sufficient amount of insurance coverage for properties, the bank has a repeat violation of the regulation and enters the arena of a “pattern or practice.”
Hitting your pocketbook
Civil money penalties for flood insurance violations are currently $385 per violation, with a maximum annual cap of $125,000. The amounts are indexed to inflation, and can be adjusted every four years.
Assessed penalties are paid by the institutions into the National Flood Mitigation Fund and used to help offset flood losses. There have been plenty of flood losses that need offsetting. The back-to-back 2004 and 2005 hurricane seasons have dramatically impacted the National Flood Insurance Program.
Up until 2005, NFIP had been self-supporting. Now, the fund has to borrow from the U.S. Treasury to pay claims and has had to obtain increased borrowing authority from Congress. More money is needed to cover the catastrophic losses from Hurricanes Rita, Katrina, and Wilma. In its January 2006 study of the Federal Emergency Management Agency, the Government Accountability Office (GAO) reported that some in Congress are considering legislative changes that would require lenders to require borrowers to obtain flood insurance in 500-year flood zones in addition to the 100-year flood zones. That move would generate additional funds to help cover actual losses.
However, the civil money penalties are only a portion of the expense to a bank that has violated the flood insurance regulations. There is also the considerable cost of employee time to research and identify impacted loans and borrowers that would need corrective action.
Common violations by banks
The types of flood insurance violations and deficiencies that are being identified are somewhat different from those of a few years ago.
Adequate coverage. When a determination is made that flood insurance is required for a loan, the amount of coverage obtained by the borrower must be equal to the amount of the outstanding principal balance of the loan, or the maximum coverage available for the property under the flood program, whichever is less (see table, top of next column). One of the more frequent recent violations has been a finding of inadequate insurance coverage on the collateral property.
Maximum available coverage
Single family residence $250,000
Commercial building $500,000
Often, inadequate coverage involves a borrower that has both a first and second lien on a property. Adequate flood insurance coverage is required for both lien positions. Just because there is a first lien on the property and flood insurance is in place, doesn’t mean the property is sufficiently insured as to the second lienholder.
Construction loans. Many lenders have a hard time being convinced that flood insurance would be necessary for a construction loan when there is no structure at the time the loan is made. But if the property is located in a special flood hazard area, flood insurance must be purchased to provide coverage during the construction period. Flood insurance requirements are not deferred to the permanent loan phase.
Condominiums. A condominium, whether in a highrise building or ground-level cluster, is an insurable single-family dwelling for flood-insurance purposes. When making (and increasing, renewing, or extending) a loan secured by a condominium, a bank must follow the same rules as it does for a single-family house. Condominiums, however, often come under the umbrella insurance obtained by the condominium association.
Banks often mistakenly believe that they can rely on the condominium association to take care of any insurance requirements for the entire building. In reality, banks should determine whether or not the amount of coverage purchased by the association under the Residential Condominium Building Association Policy is adequate to protect the bank’s loan and the borrower’s property. The FEMA website carries detailed information about flood insurance provisions for condominiums and other common ownership entities.
Internal controls. Many banks are being criticized for inadequate flood insurance compliance controls and processes. It does not matter that a bank is not located in an area that has a high risk of flood losses, and has only a handful of loans that are required to have flood insurance in place. In spite of this, the bank must demonstrate good mechanisms for making flood determinations; providing notice to borrowers; escrowing flood insurance premiums; obtaining adequate insurance coverage, etc., for the eventual covered loans. A bank may have no loans in its portfolio that require flood insurance, but it must still have procedures and controls in place to ensure that a flood determination on the Standard Flood Hazard Determination Form is obtained for every loan secured by improved real property.
Examinations for flood insurance compliance are not drifting off with the outgoing tide. Flood insurance is a fixture in bank compliance examinations. Congress may complete work on several legislative initiatives continued from 2006 that would further strengthen the NFIP and could add new requirements, such as a notice about flood insurance in the Good Faith Estimate disclosure and increased civil money penalty amounts. Even without that, flood insurance remains an area of significant compliance risk to banks. BJ
What to watch for before examiners (or floods) arrive
Before the examiners come to the bank to conduct a compliance exam, do some internal flood insurance mopping up.
10. Last, but definitely not least, has the bank corrected all of its previous problems concerning flood insurance compliance? Any previous criticisms must be addressed before the examiners come again. — Nancy Derr-Castiglione
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