By Rick Pitts, Arlington/Roe
Anyone who spends much time in personal lines insurance becomes at least somewhat familiar with the difficulties and intricacies of flood insurance. Flood insurance is also a political issue, too. The national flood insurance marketplace and federal government’s involvement continues to make headlines in our national news as we reexamine the National Flood Insurance Program in light of the costs of events such as Hurricane Katrina and Superstorm Sandy.
According to a widely-publicized report from the Government Accounting Office, the NFIP owes approximately $24 billion to the United States Treasury. In 2012, the Biggert-Waters Flood Insurance Reform Act of 2012 (known as “BW-12”) was enacted in an attempt to put the National Flood Insurance Program on surer footing financially. The Federal Emergency Management Agency says that BW-12 will adjust “premium rates to more accurately reflect flood risk,” and will also trigger coverage and claims handling changes.
One of the more controversial ways in which BW-12 will generate more revenue is through phasing out grandfathered premium subsidies and through redrawing flood maps. FEMA says that only, “about 20 percent of all NFIP policies pay subsidized rates [and] only a portion of those policies that are currently paying subsidized premiums will see larger premium increases of 25% annually [until reaching full-risk premium status].” This has generated some substantial political consternation and legislative efforts are underway to slow the impact of BW-12.
Taken by themselves, these regulatory developments present significant challenges for insurance producers who handle flood insurance. Simply put, the coverage is changing and there is significant upward pressure on premiums (even for those insureds not subsidized). Layered on top of the challenge of explaining the coverage itself and the expense of flood insurance is one more challenge: what can be a difficult and perhaps contentious relationship between the homeowner and the lender over flood insurance issues.
A recent case from the First Circuit federal Court of Appeals, Kolbe v. BAC Home Loans Servicing, LP, d/b/a Bank of America, illustrates how these sorts of disputes on flood insurance placement can play out.
Stanley Kolbe bought a house in Atlantic City, New Jersey. He obtained a mortgage in October, 2008 for nearly $200,000 from a mortgage company, Taylor Bean & Whitaker. Mr. Kolbe’s loan was an FHA loan; the mortgage contained the following clause:
Fire, Flood and Other Hazard Insurance. Borrower shall insure all improvements on the property, whether now in existence or subsequently erected, against any hazards, casualties, and contingencies, including fire, for which Lender requires insurance. This insurance shall be maintained in the amounts and for the periods that Lender requires. Borrower shall also insure all improvements on the Property, whether now in existence or subsequently corrected, against loss by floods to the extent required by the Secretary [of Housing and Urban Development].
Kolbe’s house is located in what had been designated as a “special flood hazard zone” under the National Flood Insurance Act. The special flood hazard zones are those prone to flooding; according to FEMA, they are areas that have a one-in-four chance of a flood during a thirty year mortgage. So, with his house in a special flood hazard zone, Mr. Kolbe was required, under the regulations, to maintain a minimum coverage of the lesser of two amounts: his outstanding loan balance or the amount that could be obtained (which, in his case, was $250,000).
Taylor Bean & Whitaker never required Mr. Kolbe to get higher flood limits. However, Taylor Bean & Whitaker went bankrupt. Shortly thereafter, BAC Home Loans Servicing, a part of Bank of America, became the servicing entity for the Kolbe loan.
Shortly after it began servicing the loan, BAC wrote Kolbe a letter and told him that he was required to purchase $46,000 more in flood insurance. BAC said that this was necessary to increase the flood coverage level to the replacement cost for Kolbe’s home. BAC also informed Kolbe that if he did not purchase the insurance as required by the letter, BAC would lender-place or force-place the insurance for him. (Kolbe would later allege that BAC had a financial interest in all of this through its affiliated insurer, Balboa.)
Kolbe purchased the insurance, but also pursued a lawsuit in federal court. He filed a class action on behalf of all borrowers who had similar mortgages who were required to purchase flood insurance above the amount of the outstanding balance of the loan (or available limits).
Two major theories were launched against the BAC practice: the first was that the Lender was breaching the actual terms and conditions of the mortgage by upping the limits; the second was that BAC had violated the implied covenant of good faith and fair dealing.
The suit did not go well for Kolbe in the trial court. The federal district court judge ruled that BAC had the right to choose the amount of flood insurance that it would require.
The appeal began in promising fashion for Mr. Kolbe. Initially, a three judge panel of the court ruled that Kolbe’s lawsuit could go forward and reversed the lower court’s order of dismissal. In September, 2013, though, all of the judges of the First Circuit reheard the appeal. The judges then reinstated the District Court dismissal, but did so in a most unusual fashion, splintering into multiple opinions. The result was a tie: three judges voting in favor of letting the lawsuit go forward; three against. By court rule, the original dismissal stood.
Flood Insurance and Mortgages
With the First Circuit unable to come to a consensus on either rationale or result, it seems fairly evident that this is a complicated question. Other courts have struggled with the question of force-place in the context of flood insurance and the Kolbe court uses the term “sharply conflicting” to describe the various opinions.
The question does revolve around the terms of the mortgage and the federal statutory and regulatory scheme for flood insurance and federally-backed, FHA mortgages. As the Kolbe court notes, this particular clause is a standard term in what are known as FHA mortgages, and one of many different mortgage clause HUD/FHA requires.
To paraphrase the clause for insurance purposes, there are three sentences and three basic requirements:
- The Borrower has to obtain insurance for hazards or casualties as the Lender requires.
- The Borrower has to maintain the insurance for the time and at the limits the Lender requires.
- The Borrower must obtain flood insurance if required by the Secretary of HUD.
One of Kolbe’s main arguments was that the first two requirements of this clause apply to insurance other than flood insurance. In essence, these two sentences address a lender’s ability to require something along the lines of the Insurance Services Office’s HO or DP insurance policy forms (along with any other ancillary coverages that might be necessary). To Kolbe, the only sentence that applied to flood insurance was the third sentence or requirement. It addresses flood insurance specifically.
Even though a lender could dictate amounts of coverage for property and casualty insurance, Kolbe argued, it could not dictate amounts of coverage for flood insurance. The mortgage only specifies insurance in the amount required by HUD.
BAC, in contrast, argued that the first and second sentences or requirements were also applicable to flood insurance. These two sentences gave it the authority to demand higher limits. With this reading in mind, BAC said, the regulations on the required amount of flood insurance should be seen as a floor rather than a ceiling. This gave the bank the authority to demand the higher amount of insurance, probably closer to true replacement cost, even though that amount was not mandated by regulations or specified in the mortgage.
True Insurance Implications
BAC’s argument or explanation obviously did not garner support from all of the judges; as noted, three voted one way and three the other. In fact, half the judges said that, even though this mortgage section is required by federal law for FHA loans, the mortgage document itself is still part of a private contract between Kolbe and his original lender.
But this actually leads to a point where the case becomes particularly instructive and helpful to producers who have to break the bad news of the cost of flood insurance to the personal lines customers. The Kolbe court discussed the nature of FHA loans and why the clause is required. In FHA loans, if the lender eventually forecloses on the property, the lender assigns the property to the Department of Housing and Urban Development. HUD pays the lender the proceeds of the mortgage insurance so that the lender does not suffer a loss on the loan. Now the owner of the house, HUD then sells the property to recoup some of its money for the program.
But what if there has been a casualty loss, such as a fire or a flood? According to HUD regulations, the lender cannot collect on the mortgage insurance until the physical damage has been repaired (or, the costs of the repair are deducted from the amount paid to the lender). Therefore, the risk of an uninsured fire or flood loss rests with the private lender, and not HUD / FHA.
Because the private bank or mortgage lender bears the risk of loss for a casualty loss, the mortgage clause gives that bank or lender the authority to dictate the length, type and term of the insurance. This is why the court finds that BAC had the power to dictate flood insurance at replacement cost, rather than at the lower amount proscribed by regulation.
The ages-old axiom is that knowledge is power. In personal lines insurance, the old axiom may be most apt when it comes to flood insurance. Disappointed, or financially strapped, insureds may not want to hear of the complexities of flood insurance rate calculations, the intricacies of BW-12, or the authority that the lender has to dictate limits. Yet having those discussions with insureds will educate the insured about where the coverage and limits decisions are made, where the cost pressures are created and directed, and may ultimately ameliorate some of the shock of flood insurance rates on a going-forward basis.