The following is from the April edition of our newsletter. I think you'll find the answers to your questions in this.Flood Insurance & Construction Loans
When it comes to construction loans, there are two options concerning the purchase of flood insurance:
1. Require flood insurance before closing the loan; or,
2. Delay the purchase of flood insurance until a slab is poured or an elevation certificate is issued.
This article will explain the complications and risks of the second approach.
We often hear that lenders want to delay the purchase of flood insurance for the “benefit” of the borrower. While this approach creates some extra complications, you can do this and remain in compliance. Before doing so; however, it’s important to realize the potential effects.
First, lenders often think they’re saving the borrowers some money. But it is important to remember that a lender’s job is to act in the best interest of the bank and its collateral. Additionally, this may result in anything but a convenience to your borrowers.
As you probably already realize, there is generally a 30-day waiting period before a flood insurance policy goes into effect. However, there is no waiting period for flood insurance that is purchased in connection with making, increasing, extending, or renewing a loan (i.e., a MIRE event). This allows a borrower the potential to apply and pay for the flood insurance premium so that you can have proof of the required flood insurance to close the loan.
There used to be an exception to the 30-day waiting period in scenarios where the lender determined that flood insurance was required but not in place. However, effective October 1, 2013, the NFIP changed their rules and a 30-day waiting period now applies anytime a lender is requiring flood insurance outside of a MIRE event. Therefore, a 30-day waiting period will apply if you allow the borrower to delay the purchase of flood insurance in connection with a construction loan. This seems to be contradicted by Interagency Flood Insurance Q&A #23, which states:Does the 30-day waiting period apply when the purchase of the flood insurance policy is deferred in connection with a construction loan?
Answer: No. The NFIP will rely on an insurance agent’s representation on the application for flood insurance that the purchase of insurance has been properly deferred unless there is a loss during the first 30 days of the policy period. In that case, the NFIP will require documentation of the loan transaction, such as settlement papers, before adjusting the loss.
We’ve never seen anything that officially rescinded this Q&A, so one would expect it to still hold true. However, the Q&A simply wasn’t updated with the change in the NFIP’s policy in October 2013. This is just one of many things that complicate attempts to get flood insurance right. FEMA makes changes that directly impact creditors, but there’s no direct line of communication to those creditors. FEMA communicates with insurance agents, and you likely already know there is some risk in taking flood insurance advice from an agent.
If you’re not going to require flood insurance at the time of closing a construction loan you will have a 30-day wait (after the borrower applies for and provides payment for a flood insurance policy and the agent submits the information and payment to the NFIP) before the policy goes into effect. This means you may be faced with explaining to your borrower that you cannot disburse any more loan proceeds until the flood insurance policy goes into effect. Construction will likely need to be delayed during this waiting period, since funds can’t be advanced if you wish to remain in compliance. At the very least, you will absolutely want to make sure your borrowers understand this potential effect of not having the flood insurance in place at closing. Any “goodwill” you may have built up with the borrower by allowing them to delay the purchase of flood insurance may quickly be spent if you are unable to disburse funds down the road because there is a 30-day wait before their flood insurance becomes effective.
We’ve never been fans of allowing borrowers to delay purchasing flood insurance because of the additional monitoring burden that comes with it. Flood insurance is hard enough and takes enough manpower that we don’t understand taking on the additional, unnecessary responsibility of monitoring construction just to see when you have to require flood insurance. We know that some agents like to say they can’t write flood insurance prior to construction, but they CAN write it based on estimated elevation and the anticipated value. Don’t let them tell you differently.
If you’re allowing borrowers to delay the purchase of flood insurance on a construction loan, we feel you should reconsider that practice. It could make sense if construction won’t start right away. Otherwise, your intent may be good, but the effects may not be, for the bank or the borrower. We understand that you want to make your borrower happy; however, remember that you’re balancing the interests of the borrower(s) with those of the bank and you’re undoubtedly in the best position to enforce loan requirements before you make the loan.
Just to recap, if you delay the purchase of flood insurance, you should consider the following:
1. You will need to monitor the construction progress. This is an expense to you, the creditor. Once a slab is poured or an elevation certificate is issued, you cannot allow any more advances on the loan until adequate flood insurance is in place.
2. Understand there will be a 30-day wait after the borrower pays for the insurance and the agent completes the insurance application and submits it to the NFIP.
3. Realize that borrowers are normally cooperative prior to closing a loan. But typically, once the loan is closed, borrower cooperation can deteriorate. Asking them to bring you evidence of adequate flood insurance can be a tougher challenge and you’ve lost your “leverage”.
4. Understand the lender is taking on a risk of not having evidence of adequate insurance. Examiners will also review this process very closely.
It’s important to weigh these costs and risks to the bank with the possibly small savings to the borrower. Often times, they won’t pay very much in premiums before the slab is poured or the elevation certificate is issued.