Even with a safe harbor, private flood insurance rules may prove vexing

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Seven years after Congress mandated that the federal banking agencies issue rules to facilitate growth of the private flood insurance market, the rules are here, and mortgage lenders and servicers should take notice.

Starting on July 1, the Federal Deposit Insurance Corp., Office of the Comptroller of the Currency, Federal Reserve, Farm Credit Administration and National Credit Union Association will require the entities they supervise ("lending institutions") to accept certain types of private flood insurance policies and permit acceptance of others. The new rule is technical and nuanced. Some of the most important considerations follow:

When a private policy must be accepted

Lending institutions must accept private flood insurance policies that meet a highly technical definition that includes a requirement that the policy be "at least as broad as" a standard flood insurance policy under the National Flood Insurance Program. Determining the breadth of a private policy involves five elements, including confirming that the policy does "not contain conditions that narrow the coverage provided in an SFIP." Assessing whether a private flood insurance policy meets the definition of "private flood insurance" has the potential to be a time-consuming, confusing, imprecise and costly exercise for lending institutions.

There is a safe harbor. Lending institutions may determine, without further review, that a policy meets the definition if the policy (or an endorsement to it) contains the following language: "This policy meets the definition of private flood insurance contained in 42 U.S.C. 4012a(b)(7) and the corresponding regulation." This language is referred to as the "streamlined compliance aid provision."

If a policy (or an endorsement) does not contain the streamlined compliance aid provision, a lending institution must nevertheless accept the policy if it meets the definition of "private flood insurance." Thus, lending institutions must be prepared to perform the complex analysis of evaluating whether the definition of "private flood insurance" is met, requiring advance thought and planning if the process is to work efficiently. Lending institutions found to have a pattern or practice of incorrectly rejecting private policies could be subject to civil money penalties.

When a private policy may be accepted

Lending institutions may accept private policies that do not meet the statutory criteria as long as the policies offer "sufficient protection for a designated loan, consistent with general safety and soundness principles," and the policies meet other criteria.

In addition, lending institutions have discretion — but are not required — to accept nontraditional flood coverage issued by "mutual aid societies," subject to certain conditions, including that the lending institutions' primary federal supervisory agency has determined that the plans qualify as flood insurance.

To avoid compliance deficiencies come July 1, lending institutions should update their private flood insurance acceptance policies and procedures now.

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