Servicing Management, May 2006.
Hurricane season begins next month, with predictions of another strong season ahead of us. Now – before the next storms hit – is the time to take steps to lessen their financial impact.
Last year, Hurricane Katrina devastated some 90,000 square miles along the Gulf Coast, creating immense losses for property owners, lenders and loan servicing professionals. For the fortunate property owners with flood insurance, the National Flood Insurance Program (NFIP) has received approximately 211,500 claims as of April; the average claims payment has been nearly $95,000.
However, the sad fact is that many property owners did not have flood insurance, even in the high-risk special flood hazard areas (SFHAs), where flood insurance is required by law for borrowers with loans from federally regulated lenders. Fewer than 40% of the properties in Katrina's path were covered by flood insurance, and the ripple effect is still being felt throughout the mortgage lending and servicing industry.
The risk of being uninsured or under-insured for flood is by no means limited to the Gulf Coast. Nationwide, on average, only about half of those eligible to buy flood insurance in high-risk flood areas do so. Outside the SFHAs, where the risk of flooding is reduced but still present, the percentage of covered properties drops considerably. The owners of these properties are putting their own financial well-being – and their servicers' and lenders' investments – at risk of delinquency and foreclosure.
The lending and loan servicing industry can play a key role in compelling property owners to adequately protect their financial investments through flood insurance. For this reason, lenders and loan servicing professionals need to prepare themselves and their customers to address the threat of flooding through aggressive customer education.
Notification requirements
The purchase of flood insurance is mandatory for all federal or federally-backed financial assistance for the acquisition or construction of buildings in SFHAs. It is the lender's fundamental responsibility to require flood insurance coverage for all borrowers in high-risk flood areas. Lenders who don't comply are at risk when a property is damaged.
They also risk being assessed fines known as civil monetary penalties (CMPs) of $385 per violation, up to $125,000 per year, by their federal regulatory entity. For CMPs assessed in 2005, the NFIP received a total of $618,930 from 21 institutions, a 253% increase from the previous year, when the NFIP received $175,150 from 11 lending institutions.
Under federal regulations, lenders need to notify borrowers in writing of the requirement to buy flood insurance for new and existing loans. For new loans, if it's determined that a home or business is in a SFHA before loan closing, the borrower must be notified within a reasonable time (defined by federal regulations as within at least 10 days) prior to the loan closing. If it's determined that an existing loan for a home or business is in a SFHA, lenders are also required to notify the borrower once they become aware.
The law also provides for lender placement of flood insurance 45 days after the borrower is notified of deficient flood insurance coverage. As you may know, after closing, if flood insurance servicing responsibilities are outsourced, lenders still need to be sure providers are keeping portfolios in compliance. In addition, if flood zone determinations are outsourced, lenders need to ensure that agreements have proper guarantees in case of an error (per the National Flood Insurance Reform Act of 1994).
Some property owners allow their insurance to lapse, and others fail to insure adequately. Lenders can take steps to ensure that property owners maintain adequate levels of flood insurance during the life of the loan. A simple reminder, included with or as part of the monthly statement, has been shown to make a real difference.
Beyond SFHAs
Since flooding can also occur in low- to moderate-risk areas, consider taking other steps to protect your portfolios and the communities you serve. The 2005 hurricane season reminded everyone that coverage in lower-risk flood areas is important. Water doesn't always stop at the lines on a map, and many properties in low- to moderate-risk areas are flooded each year. Too many of those affected didn't consider the option of purchasing flood insurance. You can educate and stress options to customers, such as highlighting the importance of flood insurance coverage in these lower-risk areas.
If a property is in a low- to moderate-risk area, federal law does not require flood insurance. However, lenders may choose to require flood insurance no matter what flood zone the property is in. For example, one savings and loan company has had a steadfast rule for mortgage lending in the New Orleans area – some borrowers are required to have flood insurance, no matter what flood zone they live in. Last year, the company's borrowers outside of SFHAs were pleased about this requirement when their homes were flooded. Companies like these recommend flood insurance in non-SFHA areas because, historically, about 20% to 25% of all flood claims in the U.S. come from such low- to moderate-risk areas.
The responsibility of keeping customers informed about flood areas and insurance doesn't end when the loan closes. The challenge for servicers is to make sure that properties that need to be protected by flood insurance continue to be covered. Therefore, it also makes sense for lenders and servicers to keep current on flood map changes.
Flood maps are in the process of being updated as part of the nationwide flood map modernization effort. Many of the maps need to be updated because of changes over time to urban growth, changes to river flows and coastlines, and flood mitigation efforts such as drainage systems and levees. Clearly, updated and accurate information is essential in order to understand emerging flood risks, and to determine appropriate rates for flood insurance coverage.
If, during the life of a loan, the maps are revised and the property is mapped into a high-risk area, lenders are required to notify borrowers that they must purchase flood insurance when they learn of these changes. If a borrower does not purchase flood insurance, it can be lender-placed. Alternately, if a borrower's property status changes from a SFHA area to a lower-risk area, the flood insurance requirement is removed. However, you may still wish to promote coverage, as the risk has been reduced, but not eliminated.
Replacement cost coverage
Almost as devastating as being uninsured is being under-insured. So, another way to safeguard your portfolio and borrowers is to encourage adequate coverage. Lenders and servicers can recommend that borrowers have flood insurance coverage above the minimum that is required by law – not simply for the amount of the loan. The NFIP's coverage limits can help insure property for replacement cost coverage: $250,000 for residential building coverage and $100,000 for contents; $500,000 for nonresidential building coverage and $500,000 for contents.
Lenders and servicers can also take steps to ensure that myths are dispelled. For instance, many people mistakenly believe that homeowners insurance covers flooding. Please remind customers that most homeowners insurance policies do not cover losses due to flooding, so a separate flood insurance policy is needed.
Lenders and loan servicing professionals play a unique role in local communities and can help significantly in preparing home and business owners for the threat of flooding. The NFIP urges you to reach out to customers about flood insurance – not only during loan origination, but also during the life of the loan to ensure that flood insurance is renewed and maintained.
For additional information, you can visit FloodSmart: www.floodsmart.gov; the National Flood Insurance Program: www.fema.gov/fima/nfip.shtm; or the National Lenders' Insurance Council: www.nlic.org.