Best Practices: Flood Insurance Requirements under 50 10 5 (K)

It seems like every time we turn on the television, we see communities across the United States devastated by storms and resulting floods. These floods destroy homes and businesses alike. When businesses financed with SBA loans are hit with flooding issues, losses can extend to the lenders that advanced the loans as well as the SBA. Therefore, it is crucial for SBA lenders to understand flood insurance and when it needs to be obtained under the guidelines of SOP 50 10 5 (K).

Under SOP 50 10 5 (K), flood insurance must be obtained when any collateral is located in a special flood hazard area, or flood zone. SBA flood insurance requirements are based on determinations made by FEMA on the FEMA Form 086-0-32, Standard Flood Hazard Determination Form. In order to determine whether the collateral is in a flood zone, a search must be performed on the address or land parcel number where the collateral is located. The FEMA form will indicate whether or not the address or parcel number is in a flood zone. The National Flood Insurance Program (NFIP), a FEMA initiative, determines the requirements of when flood insurance is required by the federal government, and for our purposes, by the SBA.

When requiring real property to be pledged as collateral for a loan, lenders must always determine if flood insurance is required. Under the NFIP, if any part of a building that is being used as collateral to secure the loan is located in a flood zone (zone “A” or “V”), the lender must require flood insurance for the building. It is worth noting that no exceptions are made for condominiums and cooperative units. In the case of a condominium or cooperative unit, lenders must require (i) the individual owner of the particular unit to obtain flood insurance for the unit, and (ii) the condominium or cooperative association to obtain insurance for the exterior of the entire building. Further, these regulations apply to collateral pledged by either a borrower or guarantor. Regardless of the type of real estate collateral or party pledging the real estate collateral, lenders must perform appropriate due diligence to determine if flood insurance is required.

Flood insurance requirements do not only apply to real estate collateral. If any tangible non-real estate collateral, such as equipment, fixtures or inventory (“Personal Property Collateral”) is located within a building that is in a flood zone, the lender must require the borrower to obtain flood insurance for the Personal Property Collateral. The SBA does provide lenders with some flexibility to make a business decision regarding flood insurance when the Personal Property Collateral is located in a building that is not collateral for the loan. The lender may waive this requirement when the building is not collateral if the lender (i) uses prudent lending standards to determine that flood insurance was not economically feasible or not available, and (ii) includes a written justification explaining why the insurance was not economically feasible, or the steps they took to determine that it was not available. Lenders must be careful to properly document their file when choosing to waive this requirement, as failure to properly document or justify the determination to waive could jeopardize the guaranty.

Lenders must also consider the amount of flood insurance that is needed. The SBA requires the amount of insurance obtained by the borrower to be the lesser of the outstanding principal balance of the loan or the maximum limit of available coverage ($500,000, per NFIP guidelines). The insurance coverage must also contain either a Mortgagee clause, or Lender’s Loss Payee clause, in favor of the Lender. These clauses must contain language that protects the Lender from any action or failure to act by the debtor or owner of the insured property that would invalidate the interest of the Lender.

In the event a borrower defaults on a loan as a result of a flood, failure to obtain required flood insurance would almost certainly result in a repair or denial of the guaranty. Similarly, even if a default is unrelated to a flood event, if a lender suffers a loss due to flood damage that should have been covered by flood insurance, SBA is likely to recommend a repair of the guaranty. Losses may also result from a failure to obtain proper endorsements to the insurance coverage or failure to require the proper amount of insurance coverage.

It is important for lenders to know what the SBA requires in order to protect the guaranty. An important part of protecting the guaranty is obtaining required insurance coverage. This includes knowing when flood insurance is needed. Flood insurance is not just about protecting your collateral, it’s also about protecting your guaranty. For more information regarding flood insurance and other SBA related due diligence matters, contact the attorneys at Starfield & Smith, PC at 215-542-7070.