After Superstorm Sandy, Gov. Chris Christie said, “I’m never gonna use the phrase ‘hundred-year storm’ again because we’ve had three of those, three hundred-year storms, in the past three years.” Considering the recent flooding our state has endured, many New Jerseyans would agree with Gov. Christie’s sentiments. One effect of the recent storms is a heightened awareness of the importance of flood insurance by owners of property on or near areas prone to flooding and by financial institutions whose loans are secured by those properties.
Given our state’s topography, transactions involving properties located in flood zones are inevitable for most New Jersey real estate attorneys. Flood searches are a routine part of most loan transactions involving real estate, and flood insurance coverage is a standard closing requirement when the mortgaged property is in a flood zone. This is because most lenders are required by federal law to both determine whether a building offered as security is in a high-risk flood zone and, if so, to require the borrower to secure at least a minimum amount of flood insurance.
This article provides an introduction into the basic concepts of the federally run flood insurance program, the National Flood Insurance Program (NFIP), and the underlying statutory and regulatory requirements that govern the flood determination and insurance process.
Seeking to alleviate the economic burden of disaster relief on the country after flooding, the NFIP was created in 1968 to provide federally subsidized flood insurance to the public. See 42 U.S.C. § 4001-4129. Property owners are eligible to obtain flood insurance coverage under the NFIP if their community adopts regulatory standards set forth by the Federal Emergency Management Agency (FEMA) designed to minimize future flood damage. In New Jersey, only five communities do not participate in the NFIP: Audubon Park, Fieldsboro, Hi-Nella, Newfield and South Harrison. As a result, federal flood insurance is not available in those communities.
In 1973, the law was expanded, making it mandatory that properties located in high-risk flood areas be covered by flood insurance before federally regulated lenders could take security interests in those properties. Accordingly, federally regulated lending institutions are effectively prohibited from making, increasing, extending or renewing any loan, whether consumer or commercial, secured by improved real estate located in a flood zone in a participating community, unless the building and any personal property securing the loan is covered for the life of the loan by a flood insurance policy. See 42 U.S.C § 4012a.
The law was expanded again by the National Flood Insurance Reform Act of 1994, Pub. L. 103-325, Title V, 108 Stat. 2160, 2255-87 (Sept. 23, 1994), which allowed lenders to charge reasonable fees for making flood zone determinations, granted lenders the authority to “force place” coverage on uninsured or underinsured buildings, imposed an escrow requirement for flood insurance premiums on residential properties, and enhanced the flood notice requirements. See 42 U.S.C. § 4012a.
The Biggert-Waters Flood Insurance Reform Act of 2012 (BW-12), which was passed in July 2012, reauthorizes the NFIP through Sept. 30, 2017. There has been significant unrest among flood zone residents because the act may also result in rate increases under the NFIP.
The NFIP is administered by FEMA. FEMA conducts studies to determine the location of high-risk flood areas, called Special Flood Hazard Areas (SFHA), and issues maps based on those studies. SFHAs are those areas that have a one percent chance or greater of being flooded in any given year. See 44 C.F.R. § 59.1. FEMA is currently in the process of updating flood maps for the New Jersey coast; however, preliminary working maps for Hudson, Monmouth, Ocean and Atlantic counties were released in June. While referred to as “preliminary working,” these maps reflect current conditions, replace older maps and must be utilized with respect to the NFIP.
While the intent of the law is to encourage property owners to purchase flood insurance, the law does not actually compel property owners to do anything. Rather, the law directs the federal agencies that oversee federally regulated lending institutions to adopt regulations mandating that lenders require flood insurance coverage over any “improved real estate or mobile home” located in a SFHA, if the building, mobile home or any personal property is to be security for the loan. See 42 U.S.C. 4012a(b)(1)(A). The agencies that supervise federally regulated lenders issued a joint final rule in 1996 setting forth new regulations. See 61 F.R. 45684-01. All references in this article are to the FDIC regulations, which are very similar to the regulations of the other agencies.
Lender’s Responsibilities Under the NFIP
Lenders are charged with several responsibilities when a building or mobile home is taken as security for a loan. First, the lender must determine whether the building or mobile home is located in a SFHA, and that determination must be documented on FEMA’s Standard Flood Hazard Determination Form. See 44 C.F.R. § 65.16.
If the building or mobile home is located in a SFHA, the lender is responsible for providing written notice to the borrower, indicating that the property is in a flood zone, within a “reasonable time” prior to closing. See12 C.F.R. § 339.9(c). In the preamble to the joint final rule, the federal agencies state that 10 days is considered “reasonable.” See 61 F.R. 45684-01.
Once a building or mobile home is determined to be in a SFHA of a participating community, lenders must require that the borrower purchase flood insurance that is at least the lower of: 1) the outstanding principal balance of the loan; or 2) the maximum amount of coverage available under the NFIP for the particular type of building. See 42 U.S.C. 4012a(b)(1)(A). The maximum amount of coverage available under the NFIP is defined as the lesser of: (a) the full insurable value of the building and/or its contents; and (b) the maximum limit of flood insurance available for the structure type. See12 C.F.R. § 339.3(a). Under the NFIP, the maximum limit of flood insurance available for residential properties is $250,000 for buildings and $100,000 for contents. Nonresidential properties have higher limits: $500,000 for buildings and $500,000 for contents. The flood insurance requirements under the regulations are minimums. Lenders may determine that additional flood insurance is necessary, but any amount over these minimums is discretionary and not mandated by federal law.
A lender may simply choose to require flood insurance coverage equaling the full replacement value of the building. Another approach is for the lender to require coverage in the amount of the loan. The circumstances surrounding the loan transaction should dictate the prudent course. For example, consider a relatively small loan secured by a very valuable building in a SFHA. In this case, requiring flood insurance for the replacement value of the building could be seen as excessive. In the situation of a significant loan secured by a high-value piece of land containing a very modest building in a SFHA, requiring flood insurance equaling the amount of the loan could be seen as excessive. Once the minimum requirements of the law are met, the question of additional flood insurance is an area for negotiation between the lender and the borrower.
Regardless of the value of the building, lenders must require flood insurance on a building located in a SFHA in a participating community if that building is serving as security for a loan. Borrowers may balk at this requirement when the building adds little or no monetary value to the secured property. Consider a valuable piece of land located in a SFHA that also contains a dilapidated garage. Even if the land alone has sufficient value to secure the loan, flood insurance is required by law if the lender is taking a security interest in the garage. Interestingly, lenders are technically permitted to omit a structure located in a SFHA from the security of the loan, thereby making the mandatory flood insurance purchase provisions inapplicable; however, the complications that could arise if the lender is forced to foreclose on the property warn against this approach. See FDIC Compliance Manual — December 2012, V-6.22.
The solution could be the lender agreeing to modify its general policy with respect to the amount of flood insurance required and accepting the minimum amount of flood insurance required by law. In the case of the dilapidated garage, the minimum amount of flood insurance required is the maximum amount of coverage available under the NFIP for the particular type of building, which in this case is the full insurable value of the building. See 42 U.S.C. 4012a(b)(1)(A). Given recent storms, however, borrowers cannot be surprised if lenders show a more conservative approach and require more than the minimums required by law.
To every rule there are exceptions, and this is certainly the case with respect to the mandatory flood insurance purchase provisions. State-owned property and loans in the amount of $5,000 or less with a repayment term of one year or less are exempt from the mandatory purchase provisions. See42 U.S.C. § 4012c. Further, the mandates do not apply to lenders who are not federally regulated and do not sell loans to Fannie Mae and Freddie Mac or other government-sponsored enterprises.
Flood insurance not only provides protection to property owners and lending institutions, but in many instances it is also mandated by federal law. Attorneys should be aware of the NFIP and the underlying statutory and regulatory provisions in order to protect their clients’ interests. •