flood insurance policy

When the Tide is Against You

Over the past several months, the banking industry has experienced tremendous loan origination volume. While increased loan production is a good thing, it is important for Compliance Managers to stay cognizant of rising risks. Pressure, whether from peers or self-imposed, to push loans through leads to a breakdown in controls that are caused from procedural deviations, incomplete or carelessly completed checklists, or uncompleted preclosing reviews. The consequence of these breakdowns is increased regulatory violations.

As a Department/Process Manager, being not only aware, but communicating with staff Management’s expectation regarding adherence to established controls, specifically those designed to prevent high-risk violations, is critical. This is especially important when you consider the volume of messages being sent to your production staff on a daily basis (via text, email, phone, memos, or just talk at the water cooler). Messages like “We’ve got to get that loan closed!” or “When is that file going to be ready for closing?” or “We’ve got to hit our number!” People begin to respond to message with “I’m on it!” or “It will be done” because it results in positive reinforcement (“great job!”, “you’re the best!”, etc.). When you are under pressure already, no one wants to be the bearer of bad news and the recipient of its corresponding negative responses.

Is it any wonder why people, consciously or unconsciously, start cutting corners? As a Manager, it is your responsibility to anticipate the flow of communication and counter it with your own positive reinforcement. Acknowledging control adherence publicly (which admittedly is part of the job and should happen without question) will help counter those influences that lead to control breakdowns. All production team leaders/managers should make a point in each staff meeting of mentioning the importance of the controls and communication of task overload.

Not All Violations are Equal

As Managers, we need to look at what risks are being mitigated by the process control and given limited resources, what controls we are willing to back off on until such time as additional resources can be brought online or production declines.

In making this decision – which should always be done in coordination with Compliance/Risk Management – we need to use some reasonable methodology to quantify the risk to the bank. In loan production, we often look to which violations pose the greatest risk with reputation, financial, and regulatory emphasis leading the way. One that always seems to be at the top of the list is flood regulations. This particular regulation has a well-developed methodology for determining when Civil Money Penalties (CMPs) must be issued.

Who’s Afraid of a Little Flood?

Because of the mandatory nature behind the issues of Flood CMPs, and that you can pretty much count on the flood rules being included in the scope of your examination; weaknesses in your flood controls can turn a regulatory examination into a trip though Dante’s Inferno. Given that one file could contain multiple findings and if the findings are determined to meet your regulators definition of “Pattern or Practice” … get ready to write a check.

For example, if you have a couple loan files where flood was completely ignored (I know, it is a stretch), you could easily be looking at a CMP for each file of over $8,000, (i.e., $2,000 per violation) – no determination, no notice, no coverage, no escrow, etc. Granted the CMPs per violation are “up to $2,000” and your regulator does have some discretion in that amount, but any CMP will hurt. Worst of all, the effectiveness of your Compliance Management System (CMS) will take a serious hit in the eyes of your regulator.

Since flood violations pose a significant risk to the bank’s bottom line and to the credibility of the CMS, it is important to understand what might constitute a “Pattern or Practice.”

The interagency flood FAQs noted that the presence of one or more of the following factors may support a finding that a pattern or practice exists:

  • Conduct has some common source or cause within the bank’s control;
  • Conduct appears to be grounded in a written or unwritten policy or established practice;
  • Non-compliance occurred over an extended period of time;
  • Relationship of the instances of non-compliance to one another (e.g., whether they all occurred in the same area of the bank’s operations);
  • Number of instances of violations is significant relative to the total number of applicable transactions. Depending on the circumstances, however, violations that involve only a small percentage of an institution’s total activity could constitute a pattern or practice;
  • The bank was cited for violations of the Flood Act during prior examinations and no steps have been taken by the bank to correct the identified deficiencies;
  • The bank’s internal and/or external audit program had not identified and addressed deficiencies in its Flood Act compliance; or
  • The bank lacks generally effective flood insurance policies and procedures and/or a training program for its employees.

Your examiner will take the individual facts and circumstance of each case into account when determining whether a pattern or practice exists. If they determine the findings are repeats from prior examinations, intentional, regular, deliberate, or the result of bank practices, they will most likely be considered a pattern or practice.

A note on repeat violations: The violation does not have to be the same citation or of the same severity. The severity of the findings, the number repeat findings, and/or the asset size of the bank may impact the ultimate amount of the CMP.

Controls are the Key

You can see that easing up on controls to ensure compliance with flood regulations is likely to put your bank at significant risk. So, to ensure we do not inadvertently diminish to controls, let’s quickly recap flood rules as they relate to loan production.

Are we dealing with a property that is located in a flood zone? From a regulatory viewpoint, we know that any loan secured by a building or mobile home cannot be closed unless adequate flood insurance is in place on the securing property.

While determining real estate loan production collateral is usually straightforward, this can become a little bit complicated when there are multiple sources of collateral is involved. This usually brings up these questions: “What properties do I need a determination on?” or “Do I need to send a notice of Special Flood Hazard on all properties?” or “When do I have to send the notice?”

From a control standpoint, we must ensure we are able to identify the subject property or properties, pull determination on all and, if required, send the notice and document receipt of the notice all prior to closing. Of course, the determination(s) should be reviewed for accuracy and other anomalies (e.g., property partially in a flood zone, multiple structures on the property, etc.). Many banks perform this process early in the loan production function and document the validation process via checklists, while others choose to delay this process and thus increasing their risk.

The timing of the notice is one of great debate. The regulation does not give a specific number of days before closing for delivery of the notice; it does state the notice must be provided a “reasonable time before completion of the transaction.” From the Flood FAQs, we know the Agencies generally continue to regard ten days as a ‘‘reasonable’’ time interval. This puts the onus on the bank to prove that any notice given less than ten days prior to closing was “reasonable.” If the bank is willing to define “reasonable” as something less than ten days, it is recommended that be memorialized in the bank’s Flood procedures.

If we determine the property lies within a flood zone that requires coverage, the next step in the process is to determine how much. This is where you hope you are dealing with a large loan amount, as you then default to maximum insurable amounts for the required coverage.

However, assuming we are dealing with a more modest loan and structure, our next key process is to determine the property’s “insurable value.” Someone from the loan production team should be responsible for documenting this calculation. The documentation retained should include the source documents (i.e., cost approach in an appraisal, hazard insurance plus some justified amount for the foundation, or sometimes a replacement cost value given by an insurance agent) and any calculation worksheet used.

This documentation is critical when we are justifying coverage amounts that are less than the loan amount and less than the maximum available coverage under the NFIP. This calculation could become exponentially more complex when we are dealing with loans that have cross-collateralization clauses, multiple buildings securing the loan, and/or subordinate financing. The amount of coverage we will discuss here is property coverage and does not include situations where the contents of the property are taken as collateral for the loan.

Knowing as early as possible how much coverage is necessary, what property or properties need a policy, and whether we will be dealing with a pre-existing policy is critical to ensuring loans close on time – not to mention avoiding the aggravation of loan officers when closing dates get postponed due to flood insurance problems. At the same time, someone in the production team should be stipulating the requirement of an escrow account when the transaction is a consumer first lien loan; unless the loan is otherwise exempted from the escrow requirement, such as a condo where the Association maintains a RCBAP with sufficient coverage.

As we proceed deeper into the loan production process, redundancies for flood controls are vital. Is the existence of flood documents verified as the loan proceeds toward closing? Typically, at this point we are reviewing the policy. Generally, this is a simple process of verifying effective dates, property address, flood zone designation, coverage amounts, etc. That said, any process rushed through can lead to errors.

Here is where the review of a completed, detailed flood checklist will greatly increase the probability that any issues with the flood policy will be identified. I say “greatly increase” as anything done carelessly cannot guarantee errors will be caught, nor is following the checklist to the letter a guarantee there will be no mistakes.

We have reached the last stage and are ready to close the loan. Our closing team is often our last chance to avoid errors. By this point, all flood documentation should have been gathered, verified, and archived. If required, escrow documentation (i.e., the Initial Escrow Account Disclosure, Closing Disclosure, etc.) will disclose the inclusion of flood insurance and should be verified one last time, preferably on a checklist.

And this brings us back to the beginning scenario, the pressure to close the loan. As I mentioned, staff will sometimes go in search of shortcuts when under pressure. It is human nature. Managers should remind those performing redundant checks down the production line to treat the file as if the check has not been performed. It is so easy to convince oneself that the documentation is fine just because it was checked off by someone else.

This is where the Manager/Team Leader earns their pay – by motivating the production team to perform their control-related task with attention to detail, no matter what! Relentlessly reminding staff of the importance of controls, celebrating adherence to those controls, and keeping communication open is critical to the success of your flood compliance.

In this time of incredible production volume, understanding inherent risk, how increase risk is manifested, and how to react to mitigate that risk, may be the difference between a relatively low-stress compliance examination or a head full of gray hairs.

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