Being held captive by HUD.

Captive reinsurance subsidiaries present a unique opportunity for mortgage companies to increase their revenue with minimum effort. In a new interpretive letter, HUD clarified the RESPA provisions applicable to captive reinsurance subsidiaries and, in the process, created a money-making opportunity for mortgage companies.

So you want to increase your earnings and presence in the mortgage industry without the bricks and mortar, time, employees and regulatory hoops traditionally associated with a joint venture. Thanks to an August 6, 1997, informal advisory letter from HUD, mortgage companies may be able to help their bottom lines without all the formalities typically involved in an affiliated business arrangement (AfBA). The letter clarifies HUD's position on "captive reinsurance companies" - entities that are subsidiaries of mortgage companies that provide their parents with reinsurance coverage.

Since 1992, when a change in the Real Estate Settlement Procedures Act (RESPA) regulations created substantial advantages to entering affiliated business arrangements, builders, Realtors and others have formed joint ventures with experienced settlement service providers, such as mortgage companies and title insurance agencies. These AfBA rules provide a vehicle through which a referrer of settlement business may earn dividends for a referral to an affiliated business.

However, the AfBA rules are complicated and require time, money and manpower that many mortgage companies are not willing to invest, despite the potential earnings involved. Now there is an alternative way to funnel business and revenue to an affiliated entity - the captive reinsurance subsidiary.

How captives work

Generally speaking, captive insurance companies provide insurance coverage for their parent companies and affiliates. In other industries, captive insurance companies have been profitably used for a variety of reasons. A company that creates its own insurance provider and products can tailor coverage to meet its specific needs, gain control over policy claims and reduce operating costs by eliminating the insurance middleman.

Captive reinsurance companies reap similar benefits by providing reinsurance coverage and a stream of insurance premium payments that is directed back to the parent mortgage company, not lost to an unaffiliated insurance provider. Captive reinsurance subsidiaries carry another benefit - reinsurance companies are generally more profitable than primary insurers.

In the mortgage lending industry, these captive reinsurance arrangements generally involve three participants:

* A referring entity such as a mortgage company, builder or real estate broker.

* A primary insurance company that is unaffiliated with the referring entity (the "primary insurer").

* A "captured" reinsurance company that is an affiliated subsidiary of the referring entity.

In a typical example, a mortgage company enters an agreement with a primary mortgage insurer to refer its borrowers to the primary insurer for policies. The primary mortgage insurer will in turn "lay off" a portion of the insurance coverage that results from these referrals to the captured reinsurance subsidiary. Captured reinsurance subsidiaries might be established to provide either mortgage or title insurance coverage. The arrangements allow mortgage companies to increase their profits and diversify in a familiar field. That represents a welcome development at a time when increased competition and low interest rates are diminishing lenders' profit margins.

The relationship between the primary insurer and the captive reinsurance subsidiary may be structured in different ways. In each case, the primary insurer will pay the captive subsidiary a portion of the insurance premiums it receives from referred borrowers. In return, the captive reinsurance subsidiary will assume a portion of the risk the insurer faces on these policies.

How the captive subsidiary assumes this risk may vary in each situation. For example, in an "excess loss" arrangement, a primary insurer is solely responsible for all claims arising from a group of policies up to a certain dollar limit or percentage of loan amount. After that ceiling is reached, the captive reinsurance subsidiary is then liable for all remaining claims or may be liable only for claim amounts up to a second ceiling of another predetermined figure or percentage. If a second ceiling is in place in the arrangement, the primary insurer would then be liable for the remainder of any claims beyond that ceiling. In contrast, in a "quota share" arrangement, the captive reinsurance subsidiary is liable simply for a fixed percentage of all insured losses.

Vermont: "Captivating country"

No other state has as aggressively sought participants in the captive insurance industry as Vermont. According to data provided on Vermont's Internet Web page devoted to luring these businesses, 72 percent of the captive insurance companies currently active in the United States are located in Vermont. The assets of these companies total more than $15 billion.

While relatively few mortgage industry participants have delved into the world of captive insurance, it is obvious from these figures that other sectors have embraced the idea. Those industries with active captive insurance providers in Vermont include ski areas, accounting and actuarial firms, airports, financial institutions and chemical industries.

Currently, four captive mortgage insurance subsidiaries are located in Vermont, the first of which was licensed in 1995, with the remaining three being formed in 1996. The Vermont Captive Insurance Association predicts, based on inquiries that it has received, that 10 to 15 new mortgage insurance captives could be added soon.

The popularity of Vermont as a home for captive insurers is driven by a number of factors. The Special Insurer Act, passed by the Vermont legislature in 1981, provides a flexible framework for forming captive insurance subsidiaries. The Vermont Department of Economic Development notes several advantages to the state's statutory scheme, including:

* No required approval of rates or forms.

* Capitalization requirements that may be met with a letter of credit.

* Favorable tax rates.

* A variety of permissible affiliate relationships.

Other popular homes for captive insurance companies are Colorado, Tennessee, Illinois and Hawaii, as well as offshore locations like Bermuda and Grand Cayman. In the U.S. jurisdictions, including Vermont, the captive is charged various application fees, annual fees and taxes. Factors such as required filings, permitted coverage, investment restrictions and scope of permitted reinsurance activities vary from state to state.

Forming your own captured reinsurance subsidiary can begin as easily as placing a phone call. A separate industry has developed for the sole purpose of organizing these subsidiaries on behalf of parent corporations. Depending on the home jurisdiction, a captive insurance subsidiary can be formed in as little as 30 days. Legal and other experts experienced in these matters will be able to help you get started.

But what about RESPA anti-kickback provisions?

As enacted by Congress in 2974, RESPA generally prohibits the payment of any referral fee for settlement service business in connection with federally related mortgage loans. RESPA provides that no person may give a "thing of value" in return for the referral of real estate settlement service business involving a federally related mortgage loan. Mortgage and title insurance are explicitly included in the definition of "settlement service."

Although captive reinsurance arrangements involve post-settlement transactions between an unaffiliated primary insurer and a captive reinsurance subsidiary, the relationships still must be examined for potential RESPA violations. After all, if the terms of the reinsurance arrangement are preferential, the arrangement could be viewed as a thing of value given by a primary insurer in return for the referral of settlement service business by a mortgage company.

But RESPA does list certain exemptions from the settlement service payment prohibitions. RESPA does not forbid the payment of any amount that is a bona fide salary or compensation or a payment for services actually performed. Therefore, even though payments to a reinsurance subsidiary are things of value, those payments still might pass muster under RESPA. So long as these payments are "for goods or facilities actually furnished or for services actually performed" by the subsidiary - and not merely a kickback to the mortgage company for the referral of settlement service business - there is no RESPA violation.

HUD tests captive reinsurance subsidiaries against RESPA

In a letter dated August 6 to Countrywide Funding Corporation, HUD considered the application of these RESPA provisions to captive reinsurance arrangements. HUD confirmed that such arrangements do not necessarily violate the anti-kickback provisions of RESPA, and it established a two-part test to determine whether such arrangements are lawful. Payments to reinsurance subsidiaries are permitted despite RESPA's anti-kickback prohibition if the payments qualify for the "goods and services actually furnished" exception.

When do these arrangements appear suspect? HUD identified eight factors that will lead it to scrutinize a captive reinsurance arrangement for the possibility of a disguised kickback:

* The amount charged directly or indirectly to the consumer for the mortgage insurance in a captive program is greater than the amount charged to the consumer for mortgage insurance not involving reinsurance for a similar risk.

* The costs paid to the captive reinsurer are greater than the cost for comparable noncaptive reinsurance available in the market.

* The lender restricts its mortgage insurance business in whole or to a large extent to a primary mortgage insurer that has a reinsurance agreement with the lender's captive reinsurer.

* Any major secondary-market institution refuses to purchase mortgages insured under a particular captive reinsurance agreement or places special conditions on such purchases.

* Any credit-rating agency reduces the rating of the primary mortgage insurer in whole or in part because of agreements with captive reinsurers.

* Any state regulatory body questions the adequacy of the reserves maintained by the primary mortgage insurer or the captive reinsurer.

* The primary insurer's agreement to reinsure is conditioned on the affiliated lender's agreement to refer all or a predetermined volume of its mortgage insurance business to the primary insurer, or the terms of the agreement fluctuate depending on the volume of business referred by the lender to the primary insurer.

* Adequate consumer disclosure is not provided.

While the presence or absence of any one of these items is not fatal, HUD stresses the importance of the last of these factors - adequate consumer disclosure. HUD noted, "consumers would be well served by a meaningful disclosure and a meaningful choice for consumers about having their loans included in a captive reinsurance program."

HUD defines a meaningful disclosure as one that "would reveal that the captive reinsurance arrangement exists, that the lender stands to gain financially under the arrangement, and that the consumer may choose not to have his or her insurance provided by an insurer in such an arrangement."

HUD's suggested captive reinsurance arrangement disclosure is similar to that required under the AfBA rules covering joint ventures. RESPA regulations provide that an affiliated business arrangement is not a violation of RESPA if:

* A written disclosure is provided by the person making a referral to an affiliated business.

* The use of the affiliated business is not required.

* The only thing of value received from the arrangement is a return on an ownership interest.

This AfBA disclosure must explain that the borrower is not required to use the recommended business, provide a description of the affiliated business arrangement that might benefit the referring party and list the range of rates that may be charged for the referred service.

However, a captive reinsurance arrangement like those discussed earlier does not trigger the affiliated business rules. While a mortgage company makes a referral of settlement service business, the entity to which it is referring business - the primary insurer - is not affiliated with the mortgage company. The borrower does not pay an insurance premium to an affiliate, but to an unaffiliated mortgage insurance provider.

Nonetheless, HUD takes the position that the consumer should be given a "meaningful disclosure and a meaningful choice" whether to participate in a captive reinsurance arrangement. The HUD letter goes so far as to suggest that the referring entity should "provide the consumer an easy, nonburdensome opportunity to opt out by, for example, indicating a preference one way or another on a form." HUD concludes that a "demonstrated willingness to provide such a disclosure may indicate that the arrangement is designed to provide real reinsurance."

In short, lenders owning captive reinsurance companies should provide consumers with an "AfBA-like" disclosure that informs consumers of the affiliated arrangement and makes clear that the use of the captive reinsurance company is not required.

Two-part test for RESPA compliance

If further scrutiny of a captive reinsurance arrangement is warranted by the foregoing eight factors, or for other reasons determined by HUD, the department has formulated a two-part test to evaluate whether such arrangements comply with the RESPA kickback prohibitions. A payment of premiums to a captive reinsurance subsidiary by an unaffiliated primary insurer is not a RESPA violation if those payments are for reinsurance services actually furnished or for services performed and are bona fide compensation that does not exceed the value of such service.

Are services actually being performed? The first step in determining whether the payment of premiums to a reinsurance subsidiary is an illegal kickback under RESPA is to examine whether the subsidiary is actually providing reinsurance services to the primary insurer. A subsidiary must meet all three of the following requirements to be providing reinsurance services.

* There must be a legally binding contract for reinsurance with terms and conditions conforming to industry standards.

* The reinsurer must post capital and reserves satisfying the laws of the state in which it is chartered, and the reinsurance contract between the primary insurer and the reinsurer must provide for the establishment of adequate reserves to ensure that, when a claim against the reinsurer is made, funds will exist to satisfy the claim.

* There must be a real transfer of risk.

The last of these requirements is the most difficult to establish. For example, consider the risk a reinsurance subsidiary would bear if most claims on title insurance policies result in awards to the insured policy holders in amounts less than $10,000. In an excess-loss captive reinsurance arrangement which provided that the reinsurance subsidiary was liable to the primary insurer only for that portion of claims over $10,000, there would be little chance the subsidiary would ever have to pay on a policy. In that case, the payment of premiums to the reinsurance subsidiary would likely be seen as a disguised kickback to the mortgage company for the referral of business. The reinsurance subsidiary, and its parent, would be receiving a stream of insurance premium payments while effectively bearing no risk.

In contrast, the risk transfer requirement would clearly be satisfied in a "quota share" arrangement under which the reinsurer is liable for a fixed percentage of all insured losses.

Is the compensation paid bona fide? If the subsidiary is actually performing reinsurance services, the second part of the test examines whether the compensation paid for those services accurately reflects their value. If the compensation is too great, considering the risk that the subsidiary bears, the excess payment may be considered an illegal kickback. Again, HUD's letter lists factors that it will use to judge the amount of compensation paid. But generally speaking, HUD will evaluate whether the compensation is commensurate with the risk and, where warranted, administrative costs.

Outlook for the future

Given the ever-increasing diversification of participants in the industry, it is likely that mortgage companies will consider expanding through the establishment of a captured reinsurance subsidiary. Certainly, HUD's August 6 letter demonstrates that the department has clearly focused on these entities and is aware that they may present issues under RESPA.

HUD has now established standards that must be met for captured reinsurance company arrangements to pass muster under RESPA's anti-kickback provisions.

Obviously, HUD's recent interpretation of captured reinsurance subsidiaries places several hurdles before mortgage companies anxious to establish this new source of income. Most important, captive arrangements must be carefully examined to ensure that the subsidiary is actually performing reinsurance services for a fair price. Though not officially required, a substantive disclosure of the captured insurance subsidiary relationship provided to consumers might go a long way toward convincing HUD that the insurance premium payments are legitimate.

Indeed, these few hurdles seem modest compared with the stringent AfBA regulations applicable to traditional joint ventures. Captive reinsurance companies offer a unique opportunity for mortgage lenders to increase revenues. Check it out.

Phillip L. Schulman is a partner in the Washington, D.C., office of Kirkpatrick & Lockhart, LLP, where he specializes in regulatory compliance and enforcement proceedings affecting the mortgage industry.