Forced-Placed Kerfuffle

A little over four months ago, I linked to an article by Jeff Horwitz in the American Banker that discussed the "scandal-in-the-making" over force-placed insurance by loan servicers. At that time, I expected that we'd be hearing a lot more about it. Since then, it hasn't become exactly front-page news (which is understandable, given the more pressing issues of Charlie Sheen and Lindsay Lohan). On the other hand, Jeff is still on the case and, it's evident, so are the attorneys general of the states.

In an article in Friday's American Banker, Jeff referred to the 27-page proposed settlement that we discussed in our last post and stated that few restrictions in that document "are as absolute as the prohibition of profiting from force-placed insurance."

Under the settlement's terms, banks and other mortgage servicers are forbidden from placing policies with an affiliate or accepting "commissions," "referral fees," "kickbacks" or "anything of value" in relation to force-placed policies. Moreover, it would require servicers to attempt to maintain delinquent borrowers' existing policies, rather than replacing them with more expensive ones.

Servicers are not speaking to the press (yet) on this aspect of the settlement. Maybe they're hoping that no one will notice and, if they just ignore it, it will go away. However, other interested observers, including consumer advocates, think that the large loan servicers will eventually come out swinging and will keep on swinging until this aspect of the proposed settlement is knocked down for the count. I think that those observers are correct. As Jeff reveals with a little digging and the application of logic, there are a lot of dollars at stake.

Even the scant data available on the sector's finances is sufficient to show how much banks and other servicers may have at stake.

Last year, a leading force-placed insurer, Assurant Inc., collected roughly $2.7 billion of premiums through its specialty insurance division, which is overwhelmingly devoted to force-placed insurance. Of that it paid out claims equaling 36% of its take — though in the company's other lines of business, a 70% claims-to-premiums ratio is the norm. (The company has said that low recent hurricane losses explain the difference, though even in bad years claims have remained far below the levels seen in other businesses.)

But while high premiums and low losses consistently make force-placed insurance the company's most profitable segment, the company doesn't get to keep all of the extra money. According to the company's SEC filings, 40% of the division's revenue is eaten up by "general expenses," a category that includes commissions to the banks. In other lines of insurance, overhead and expenses are usually a fraction of policyholder claims.

Assurant does not provide a breakdown of its expenses, but analysts say that referral fees, commissions and other payments to bank affiliates explain why the overhead is higher — implying paydays for servicers amounting to hundreds of millions of dollars a year. Other insurers operate similarly, borrower advocates and analysts say; they just disclose less than Assurant in their financial statements. While servicers that partner with force-placed insurers customarily perform little of the work in monitoring their portfolios for lapses and writing policies, payments to them are simply a cost of doing force-placed business.

For those who are unfamiliar with the concept of force-placed insurance (for example, those who escrow for insurance as part of their monthly mortgage payment or otherwise actually honor their obligation to keep hazard insurance in place on their home), Jeff gives a brief explanation of what it is and why it has become controversial.

Banks purchase force-placed policies when mortgage borrowers don't live up to their obligation to maintain insurance on their property. Homeowners then must pay back the servicer for the premiums it advanced the insurer, often at multiples of what a voluntarily purchased policy would run.

Though part of the extra expense can be explained by the higher risks associated with insuring the homes of delinquent borrowers, force-placed policies generate profit margins unheard of elsewhere in the insurance industry — even after accounting for the generous commissions and other payments that servicers demand. Force-placed policies are reviled by consumer advocates for pushing already-struggling borrowers toward foreclosure, and their costs have also drawn criticism from mortgage investors who end up paying for them when borrowers default.

Defenders of the loan servicers claim that there's nothing wrong with the payment of these commissions and fees by the insurers to the financial institutions. The attorneys general of all fifty states disagree. They think that the large loan servicers and insurers are in cahoots in a scheme that incentivizes servicers to implement forced-place insurance at the first available opportunity because of the huge fees that will be generated by the sky-high premiums, rather than working with borrowers to reinstate existing policies or find much cheaper alternatives. As Jeff discusses, the proposed settlement would impose not only a requirement of a "commercially reasonable price" for force placed insurance premiums, but a requirement that the servicer attempt to pay the premiums on the borrowers' existing insurance (at a much lower cost to the borrowers) before resorting to much more expensive force-placed insurance. Some analysts state that the latter requirement could cause an administrative nightmare for servicers and insurers.

As I've indicated in other posts, I'm no fan of many of the practices of the loan servicers. However, as is the case with loan modifications, the root cause of this particular problem becoming a problem in the first place is the fact that borrowers don't comply with the loan terms they've negotiated. They are in default of the covenant in their mortgages to keep in place homeowners insurance that protects not only themselves, but the lender. The failure to keep such insurance in place gives the lender the contractual right to obtain the force-placed insurance or, for that matter, to declare the loan in default and foreclose. You don't want the servicer ordering expensive force-placed insurance? Pay your insurance premiums.

As far as investors are concerned, I think they may have a right to balk, since the cost comes out of their pockets. On the other hand, force-palced insurance has been around for years (decades, in fact), although it has only been with the default tsunami of recent years that the exhorbitant cost impact has been felt to a degree that investors have started howling. I question, though, whether this issue might be better handled by changes to pooling and servicing agreements than by a settlement agreement administered in part by the attorneys general of fifty states. Personally, I wouldn't trust many of those politically posturing Spitzer wanna-be's to tote up my bar bill, much less determine what's a "commercially reasonable" premium for a force-placed insurance policy. Perhaps that task is delegated to the CFPB and the fair and balanced judgment of people like Elizabeth Warren.

I admit that micro-managing loan servicing processes and procedures is a lot less dangerous than fighting organized crime or gangs like Los Zetas, but when most citizens think about the primary purpose they elect a state attorney general to fulfill, stopping force-placed insurance "abuse" is not what leaps first to mind.