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The new lender placed insurance rules.

S ince the modernization of the banking system in the 1960s, mortgage servicers have required borrowers (under the terms of the mortgage) to insure the collateral against any unintended damage by carrying the proper amount of hazard insurance. This is a well-defined obligation of a homebuyer, and as such, is disclosed in the lending documents signed by the borrower.

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When a borrower's hazard insurance is canceled or there is a lapse in coverage, servicers will place insurance on the property until the borrower provides evidence of insurance. The practice is called lender-placed insurance (LPI), and it has taken on a vital role in protecting homeowners, mortgage servicers, and the primary and secondary market investors in the mort2aa industry. However, in the wake of the housing crisis, recent discovery of some questionable practices and policy abuse has brought LPI under public scrutiny. Some consider LPI costs to be excessive--in some cases as much as 10 times the premium of typical insurance for less coverage, and often leaving the borrower's interest unprotected. Due to the substantial policy premiums charged, LPI premium underwriting dollar volumes have quadrupled, exceeding $6 billion, in the last 10 years.

The argument for higher premiums is that any homeowner allowing his or her policy to lapse is considered to be a high risk. However, according to the National Association of Insurance Commissioners (NAIC), Kansas City, Missouri, the average loss ratios on LPI are about 22 percent. This compares with loss ratios of 65 percent on traditional homeowners insurance.

In addition, servicers have been accused in class-action lawsuits and regulatory probes of receiving commissions that inflate premiums, creating a phenomenon known as reverse competition--where the consumer is forced to pay the premium on a policy selected by the lender. Under this practice, the lender may not necessarily be motivated to select the lowest price for coverage, driving up prices for the borrower that is then passed on to the investor in cases of default.

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Policy tracking has also come under the eyes of regulators, where false placements of LPI--also known as instances where insurance has been lender-placed and coverage is already in place--have been noted to be as high as 10 percent to 20 percent, according to a May 2013 comment letter from the Austin, Texas-based Center for Economic Justice to the Federal Housing Finance Agency (FHFA).

This has caused overlapping coverage and erroneous costs to the borrowers. It has been found that LPI providers are not always timely in their correction and reimbursement of an error. The Dodd-Frank Wall Street Reform and Consumer Protection Act sought to address this issue by including a requirement that the servicer terminate LPI within 15 days of receipt of evidence of a borrower's existing insurance coverage and refund the pro-rated portion to the borrower's escrow account. This requirement was further supported as a metric in the National Mortgage Settlement.

This has proved challenging for servicers to monitor for compliance because account maintenance, including billing and refund processing, are also often outsourced to the insurer.

With the issuance of new rules by the Consumer Financial Protection Bureau (CFPB) on LPI, which took effect on Jan. 10, the entire lender-placed insurance industry has attracted new attention, with much speculation surrounding the impact of the rules.

What the new rules say

The CFPB rules under Regulation X will implement Dodd-Frank sections that address servicers' obligations to provide protections to homeowners in connection with LPI.

Key provisions of Dodd-Frank with regard to lender-placed insurance include the following:

* Servicers would not be permitted to charge a borrower for LPI coverage unless the servicer has a reasonable basis to believe the borrower has failed to maintain hazard insurance and has provided required notices.

* One notice to the borrower would be required at least 45 days before charging for LPI coverage and a second notice would be required no earlier than 30 days after the first notice. The proposal contains model forms that servicers could use.

* If a borrower provides proof of hazard insurance coverage, the servicer would be required to cancel any LPI policy and refund any premiums paid for periods in which the borrower's policy was in place.

* If the servicer makes payments for hazard insurance from a borrower's escrow account, the servicer would be required to continue those payments rather than force-placing a separate policy, even if there is insufficient money in the escrow account.

* Charges related to LPI (other than those subject to state regulation as the business of insurance or authorized by federal law for flood insurance) must relate to a service that was actually performed. Additionally, such charges would have to bear a reasonable relationship to the servicer's cost of providing the service.

LPI rules have been established to protect the consumer from overly aggressive policies. However, groups such as the Washington, D.C.-based American Bankers Association (ABA), Alexandria, Virginia-based Consumer Mortgage Coalition and the Mortgage Bankers Association (MBA) have voiced concerns that unintended consequences of the rules will increase costs to all borrowers as servicers shoulder more of the accountability and risk.

An October 2012 comment letter by MBA sent to the CFPB stated that when making changes to the current model, we need to be mindful of unforeseen and unintended consequences that could result ultimately in higher costs for consumers and fewer benefits or options for borrowers. The comment letter also states that change imposes significant pressure on servicer costs, resources and capacity. The costs are becoming prohibitive for many smaller, and even larger, companies. And these costs will eventually be passed on to consumers.

Anticipated impacts on various parties

This article examines the LPI rule's impact on investors, servicers, homeowners and insurance providers. Based on the author's analysis, these are some of the anticipated implications of the CFPB's new rules on LPI:

* LPI vendors will be required to increase transparency around fees and operations--specifically on false placements, evidence of insurance reviews, LPI termination, timely notices and reimbursements, and loss ratios.

* Servicers that are not part of the National Mortgage Settlement may face increased scrutiny and costly fines by the CFPB if they were not prepared to comply with the rule by Jan. 10, 2014.

* Investors and homeowners will generally be better protected through the rule from irresponsible and questionable activities concerning LPI.

Regulatory and economic perspective

With the passing of the Dodd-Frank Act, LPI will be examined by the CFPB for any role it has played in causing homeowner foreclosures through excessive fees and cases of unwarranted policy enforcements. Many of the rules concerning LPI have already been addressed in the recent National Mortgage Settlement, the $25 billion settlement with the nation's five largest mortgage servicers.

The CFPB's rules will now extend the LPI requirements contained in the National Mortgage Settlement to all industry participants. With the addition of the new rules effective in January, the CFPB has clarified the provisions it will follow to monitor and police financial institutions in the foreseeable future.

Investors

LPI is designed to protect collateral security when homeowners have blatantly failed to do so. With LPI in place to "continuously cover" a property, the assumed risk from various hazard events is marginalized. The conceptual intent of LPI to preserve asset value plays an essential role in securing the underlying collateral of an investment.

LPI monitoring is often outsourced by the servicer to an LPI vendor that then communicates the tracking results back to the servicer. In the event of coverage breaches by the borrower, the servicer will direct the LPI provider to issue its coverage at the expense of the borrower.

In my view, this presents an inherent risk to the quality of insurance monitoring. The insurance providers, which are paid premiums on coverage of policy gaps, are also the same entities monitoring for coverage gaps.

Performance-driven theorists may argue that insurance providers would be best positioned to monitor the continuous-coverage requirement due to their discernible financial incentive. On the other hand, the argument can be made that when all you have is a hammer, everything looks like a nail.

Furthermore, with the financial crisis creating challenges for many homeowners to stay current on their obligations, the Boston-based National Consumer Law Center stated in a May 2012 white paper, The Consumer Financial Protection Bureau Should Rein in Mortgage Seruicers' Use of Force-Placed Insurance, that the high cost of this type of insurance can drive a borrower into default or prevent a borrower who is already in arrears from catching up on missed payments. In the event of a borrower default/foreclosure, the costs of these excessive premiums may be passed through to the investor.

It must be noted that debate continues regarding the correlation that LPI has on foreclosures; however, any material impact would be counterproductive to LPI's intent to protect, rather than destroy, the underlying collateral value of a security.

As an outcome of the CFPB's new LPI rules, investors may realize fewer losses as the amount of defaults and LPI costs passed on to investors decline. This theoretically should align LPI with its original intent as a value-preservation control rather than an additional revenue stream opportunity.

Servicers

Servicers are probably the most highly impacted stakeholders by the new rules. They are certainly the most accountable to ensure implementation and compliance.

In an October 2012 comment letter from the American Bankers Association submitted to the CFPB, arguments were provided concerning the challenge servicers will face in protecting their interests and those of their investors, as well as satisfying the CFPB's proposed rules.

Specifically, the ABA articulated that the rule fails to consider that mortgage servicers may not have the information necessary to determine why a voluntary policy was canceled.

In the Mortgage Bankers Association's October 2012 comment letter to the CFPB, similar arguments were made that the borrower in some cases is the only link to critical pieces of information necessary to verify if the appropriate amount of borrower-purchased insurance is in place. The MBA letter goes on to state that this is especially true with insurance on condominiums, where the borrower may be the only means by which the servicer can determine the condominium project-level insurance and the number of units (which allows the servicer to determine sufficiency of insurance for the particular unit). The condominium association need not respond to the servicer, but has a responsibility to respond to the borrower, as the unit owner.

In addition, servicers are now required to advance insurance policy payments through a borrower's escrow in the event the borrower's policy expires. This will require servicers to identify when a policy was expired due to a missed payment and not an intended expiration.

High LPI prices would historically act as a deterrent for letting voluntary insurance policies expire. In paragraph five of the standard Fannie Mae and Freddie Mac Deed of Trust form, it states the requirement that the borrower must maintain insurance, and the lender has the option to obtain lender-placed insurance at a significant premium to other options if the borrower does not maintain adequate coverage.

The new rules do appear to leave little in the form of incentives for the borrower to be concerned about upholding a responsibility outlined in his or her Deed of Trust. The new rules fundamentally shift almost all accountability to maintain an insurance policy from the borrower over to the servicer.

Servicers will likely be impacted in the following ways:

* The end-to-end LPI operation will be impacted. Change will need to occur across people, processes and technology--rais-ing costs and increasing risk.

* Processes will need to be re-engineered to ensure compliance with the CFPB's requirements. Timely notifications and reimbursements may prove challenging considering historical issues. Controls and quality assurance, capacity models and time studies are some activities that may need to be implemented.

* Technology capabilities need to be enhanced for LPI tracking. Some LPI vendors have been running on outdated--and in some cases, manual--processes. Additional reporting with key performance indicators that observe compliance with notifications and reimbursements may need to be developed.

* Servicers will need to enhance their vendor-management capabilities. They may be able to outsource the activity, but they cannot outsource the compliance accountability. This will require executive focus, as the National Mortgage Settlement has illustrated that LPI vendors have faced challenges in compliance.

* Change-management plans will need to be assessed to properly train staff, update procedures and communicate transition dates.

LPI provider

Significant scrutiny from regulators and the public will create downward price pressure on the $6 billion LPI industry. It will be likely that servicers will attempt to share accountability for compliance with regulatory requirements.

This will increase operating costs, as LPI providers will need to modernize their infrastructure and operations to meet the new business requirements. In addition, LPI and servicer compensation structures will be highly scrutinized; including regulatory oversight and continued public attention of corn-mission incentives.

Homeowner

Homeowners with an escrow account have the most to gain from the new proposed rules. CFPB has not yet formed clear expectations for scenarios where there are no escrow accounts.

Previously, if a borrower was behind on payments and did not have sufficient funds in his or her insurance escrow, a mortgage servicer was able to purchase LPI. The CFPB rules now mandate that the current insurance policy be advanced regardless of the homeowner's current state unless a servicer is unable to disburse funds from the borrower's escrow account to ensure that the borrower's hazard insurance premium charges are paid in a timely manner.

Homeowners should experience more frequent communication from servicers to make sure they are aware of any lapse in coverage, and better understand their options for protecting their home.

They should experience a more responsive and timely remediation of any false placements or coverage overlaps, and in the event a homeowner's policy does lapse, they should have the ability to get back on to a plan that satisfies their agreement and any fees for force-placed insurance will be "bona fide and reasonable."

The future of lender-placed insurance

The scope and depth of impact from the CFPB's LPI rules cannot yet be certain. Early analysis appears to trend costly for the mortgage industry with significant compliance challenges, but to the long-term benefit of homeowners and investors.

Institutions have been bracing for the rules and made efforts to prepare, respond and remediate any noncompliant practices in place. There is significant noise that the CFPB is overreaching the Dodd-Frank rules with its interpretation--but don't look for changes to come anytime in the near future.

After considering the original intent of LPI, the destruction of value caused by the housing crisis and the customer-centric strategy taken by the CFPB, the potential long-term value created at a market level will most likely compensate for the adversities experienced in the near term.

Jonathan Shiery is an associate director in the Financial Services practice, based in Washington. D.C., with Chicago-based Navigant Consulting, a specialized global consulting firm that helps clients address their most critical business needs. His expertise covers regulatory risk, compliance, and control strategy and execution. He can be reached at jonathan.shiery@navigant.com.
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Title Annotation:COMPLIANCE
Author:Shiery, Jonathan
Publication:Mortgage Banking
Date:Feb 1, 2014
Words:2511
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