Rebecca Walzak
Rebecca Walzak

Mortgage lenders and servicers will have to be more careful than ever about force-placing insurance this year.

A 2012 law designed to stabilize the National Flood Insurance Program's finances could have the unintended consequence of dramatically increasing the price of coverage for borrowers in flood zones. This in turn could result in more borrowers failing to pay or renew flood coverage, requiring lenders to force-place coverage, says Tom Elder, the program manager for financial institutions at the wholesale insurance brokerage All Risks.

A jump in lender-paid policies would come at an inopportune time for the industry, which faces new regulatory requirements for such insurance, underscoring the need to educate borrowers why it is necessary.

In recent years regulators cracked down on improper fees paid to banks for lender-placed insurance hazard insurance referrals. The fees raised questions about whether mortgage companies got the best deal they could when they force-placed.

Hence, lender-placed insurance has acquired a stigma akin to subprime mortgage lending. Many consumers may have a hard time understanding why it is used at all. But they need to understand that unlike subprime, lender-placed coverage is not something companies can simply drop. Regulatory and risk management requirements compel them to use it.

Mortgage companies "are to some extent are caught between a rock and a hard place," says Rebecca Walzak, president and CEO of Walzak Consulting in Deerfield Beach, Fla. They have to balance the need to make sure there is not a gap in coverage with the possibility that force-placing insurance will draw regulatory scrutiny, she says.

"They are responsible for ensuring that the property is insured, so that if the property is damaged there is the ability to recoup. If you are getting cancellation notices [for a borrower-paid policy], you have to force-place," Walzak says.

The NFIP is under financial stress due to an unexpectedly high number of claims from natural disasters in recent years. Biggert-Waters has sought to cover the costs by raising rates, potentially over time. It shrinks federal subsidies on loans in flood zones, implementing 25% annual increases on subsidized properties until market rates are reached, according to the Federal Emergency Management Agency. About 20% of NFIP policies receive subsidies, FEMA data show.

Since the law was passed two years ago, legislators have become concerned that the effect of the increases is too severe and introduced legislation to mitigate Biggert-Waters' effect. Meanwhile, insurers have begun to warn of increases in some consumer flood zone insurance rates where private insurers fail to offer alternatives to NFIP coverage.

Borrowers need to understand that lenders can't operate without the coverage. They are legally responsible for covering flood insurance risk when the borrower fails to do so, and banks would be exposed to high risks that would severely constrain lending if they tried to manage their inventory of foreclosed properties without lender-placed hazard insurance.

In other words, consumers need to know that keeping up with these payments is part of what they agree to when they get a loan. They also need to understand why lenders have to pay more to manage hazard-insurance risk than borrowers do in the lender-placed situation.

The difference in lender- and consumer- placed costs on the hazard insurance side can be substantial. Insurance pricing varies widely depending on the individual circumstance of the property and the region it is in. But in a normal market, lender-placed hazard insurance can be two to four times the cost of borrower-placed insurance, says Elder, who is also the manager of All Risks' REO program.

Consumers might well wonder why lenders and insurers, who generally have more financial resources and economies of scale than most borrowers, may charge more for force-placed hazard policies than they would pay if they got individual policies on their own. The cost difference may seem especially unfair when it comes to hazard insurance on loans in foreclosure, as these, by definition, generally involve borrower distress.

Borrowers need to understand that the answer lies in the fact that mortgage companies can't afford to cover the risk themselves, Walzak says, and that the risk grows when the insured party has more limited access to the collateral.

Homeowners have access and control over their property; lenders, not so much, according to Elder. Because insurer data show that this lack of control results in a higher level of property damage risk, insurers generally charge a lender more than they do a borrower, he says.

"Having care, custody and control of the property is going to be determining factor as to whether the rate is going to be higher or not," says Elder.

The backlog of properties seized during the downturn has decreased over time. But because of long foreclosure timelines in some areas and the degree of the risk, involved the need for the insurance remains significant, he says.

Borrowers need to understand that the risk to the collateral is so integral to their loans' value to lenders that if the risk is not covered, "they will not lend money," he says.

While lender-placed insurance premiums may be as challenging as any other payment to collect from a distressed borrower, borrowers need to understand they can't be written off.

"If the borrower has the chance to work through this, you still have to have it," Walzak says, noting that servicers may use tools like loan modifications and forbearance to help borrowers with the payments.

Borrowers should also know that if they stop paying for flood coverage based on vagaries in flood zone maps, such as a property that straddles a flood zone line, they are still responsible for the payments during the review process and may face LPI charges as a result, she says.

Costs are important to explain not only because of the disparity between consumer and forced-placed hazard insurance prices, but because they are a source of lender-placed coverage's stigma.

Hazard lender-placed charges in instances regulators have identified were clearly too high—far higher than even the usual huge premium charged for lender-placed insurance hazard coverage over borrower-paid coverage, Elder says.

These circumstances involved "unnecessary lender-placed insurance being placed, and much-too-close relationships between the lender-placed insurance carriers and the large banks that were setting up these programs and these commission structures," he says.

Banks largely say they have discontinued referral fees so they are no longer a concern.

Citigroup, for example, stopped accepting lender-placed hazard insurance commissions last year, and never accepted commissions for lender-placed flood insurance, according to a spokesman. (Lender-placed hazard insurance on repossessed properties was the type of insurance generally targeted by the regulatory crackdown in this area. There have been questions raised in other legal actions about whether some flood insurance force-placement was necessary and fair as well.)

Aside from cost, servicers sometimes attempt to force-place insurance when it isn't even necessary due to miscommunication and operational concerns. Walzak has witnessed this firsthand. She says she once had to fax proof of her borrower insurance coverage five times to different fax numbers until the servicer acknowledged receipt and stopped trying to lender-place coverage on her property.

"My thought is they really didn't know to update the system," she says, when asked why she thought the servicer messed up. This was a long time ago, and since then, industry reform–including new borrower notification requirements—has helped, Walzak says.

But even with reform, the problem is "not entirely gone," she says. Reform and regulation, such as the Consumer Financial Protection Bureau's new servicing guidelines, will "help focus servicers on strengthening the policies," says Walzak. But she "can't stress enough" the need for lenders and servicers to keep proactively measuring the processes associated with handling borrower lender-placed notifications to make sure they are effective.

"If you can automate it, that's even better," Walzak says, noting that standardized handling of lender-placed insurance can help defend a company in regulatory reviews. In this way, mortgage companies can ensure they have a demonstrable and consistent way to inform borrowers about the potential need to forcibly place insurance in situations where consumer policies lapse. It also allows them to show they have a regular process in place that results in the purchase of competitive lender-placed policies when borrowers are unable to rectify the situation themselves.

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