Is flood insurance required on a building that has practically no value? If so, how much? We often get this question on the Compliance Hub Hotline, so we want to take the time to dive into it a little deeper today.
The federal flood rules generally require a bank to ensure any “buildings” (that is, any structures that meet the definition of a building) securing the loan that are located within a Special Flood Hazard Area (SFHA) are covered by flood insurance – even those with little or no value – unless some other exemption applies (such as the so-called “detached structure” exemption), or if that specific building has been otherwise “carved out” of the security agreement (for reference on this option, and this risks it presents, please see: “Applicability 2” in the Loans in Areas Having Special Flood Hazards; Interagency Questions and Answers Regarding Flood Insurance, .pdf pg. 156).
As far as the amount of insurance in these cases – coverage must generally be at least the lesser of the loan amount or the maximum limit of coverage for the type of property pursuant to NFIP. 12 CFR 208.25(c)(1). The amount of coverage available under NFIP is the lesser of the maximum limit for the type of property (see NFIP Manual, Table 4 at .pdf pgs. 69-71 and Table 24 at .pdf pg. 104) or the insurable value (and again, in these scenarios, the insurable value will likely be far below the maximum amount of insurance available under NFIP).
For purposes of identifying the insurable value of a particular building type, the Interagency Q&As offer this guidance:
“The insurable value of the building may generally be the same as 100 percent Replacement Cost Value (RCV), which is the cost to replace the building with the same kind of material and construction without deduction for depreciation. In calculating the amount of insurance to require, the lender and borrower (either by themselves or in consultation with the flood insurance provider or other appropriate professional) may choose from a variety of approaches or methods to establish the insurable value. They may use an appraisal based on a cost-value (not market-value) approach, a construction-cost calculation, the insurable value used on a hazard insurance policy (recognizing that the insurable value for flood insurance purposes may differ from the coverage provided by the hazard insurance and that adjustments may be necessary), the replacement cost value listed on the flood insurance policy declarations page, or any other reasonable approach, so long as it can be supported.” Amount 2, .pdf pg. 198.
Unfortunately, the guidance related to this undertaking is relatively limited, though ultimately, there is a fair amount of flexibility here and it may generally come down to the bank’s historic practices and risk-based decision making (looking at their own policies, procedures, and the facts specific to the case in question.)
The NFIP Manual discusses this further (to a degree, that is) on.pdf pgs. 93-94, though essentially refers to ‘common industry practices’ (i.e., the same as the Q&A referenced above). The borrower’s insurance provider may be able to provide a quote that includes an acceptable valuation of the insurable structure(s). Further, the bank’s procedures and any third-party guidelines may include requirements relating to the permissible methods for these types of valuations.
As always, we recommend consistent treatment of similarly situated customers to mitigate fair lending and UDAAP/UDAP risks. If you have any other questions or concerns, feel free to reach out to us on the Compliance Hub Hotline.