On Force-Placed Homeowners Insurance and the Effect on Investors

I had a number of people ask me today, so tonight I am writing about the American Banker article on Force-placed homeowners insurance, and its impact on Assurant (AIZ), which was down 11% on the 10th.  To give an example, one fellow asked:

David, care to comment on the Assurant (AIZ) news? American Banker magazine is alleging “kickbacks” to banks that agree to place “expensive” creditor-placed property insurance on homes. Would you be a buyer here?

Yes, I would be a buyer here, but my rules prevent me from buying here, because the price did not hit my lower rebalance point, even at the lows of the day.

A word about Assurant, from my point of view: Assurant is one of the few insurance firms that if they asked me to come work for them, I would make adjustments that I would not make for other companies.  They are one of the few insurance firms that I think treats their employees right, and does risk control right.  They also choose their markets carefully, and understands what their “sweet spot” is with respect to what businesses their corporate culture will do well at.

After I read the two articles at American Banker, I wrote the following as a letter to the editor:

Your articles on forced-place homeowners insurance left out several significant bits of information:

• Most forced-place homeowners policies are only in effect for several months.  Why?
• Because people have an incentive to go and get a regular policy after that.  And most do.
• These policies also only come into force because a homeowner is neglectful in maintaining the insurance that is required to have as a stipulation of his loan.
• Typically, the insured gets warned in advance that the policy will be force placed.  He has time to make other arrangements.

Any homeowner can avoid forced-place insurance.  All they have to do is keep current on their insurance policy, which they have to do as a term of their loan.

As for any sort of long backdating, that’s an abuse that needs to be corrected.  But as for the other competitive dynamics of this industry, it would be impossible for a forced-place insurer to do business without compensating the mortgage servicer, whether through commissions, which should be disclosed, or via reinsurance treaties.  Similar practices exist in other areas of insurance, including warranties and private mortgage insurance, both of which do not disclose the commissions.

In the interests of full disclosure, I am a shareholder of Assurant.

Sincerely,

David J Merkel

The author wrote me back, reminding me that he had met me at the Fordham University Too Big To Fail bank conference.  I hit myself on the head, remembering that I had really liked his approach to the markets.  He said:

Your note came closer to addressing a key issue than any insurer or bank ever did – and I spent a week asking them. So I figured I’d ask if you wanted to address this question:

— are commissions regular in other fields where the entity receiving it is buying the insurance on behalf of a third party who has not requested it? (It sounded from your e-mail like your answer is “yes,” but a bit more detail would be helpful.

— Next, what would you say to the allegation that servicers have no incentive to pick the cheapest insurance – and in fact are incentivized to send business to insurers that pad their rates to account for commissions? This was the key element of the story, and I never found a bank or insurer or trade group that would address it.

So I wrote back the following:

I agree that it gets murky when you have undisclosed commissions.  When I worked for Provident Mutual, in their pension division, we had a rule for pension consultants – you can have undisclosed commissions, so long as you disclose that you are getting a commission, or disclosed commissions, but not both.  Some of our competitors would allow for both.  Legal, but shady, definitely.

Private mortgage insurance has the same practice of reinsurers owned by the banks, which get the majority of the profits, because they control the communications of the transaction.  The insurer is the “back office,” for lack of a better term.  The insureds have no idea that the lender is benefitting from the PMI, I’m pretty certain.

With warranties, buyers are not told that the retailer is getting a large amount of the premium.  The typical breakdown is something like an even split between retailer, loss costs, insurer expense, and insurer profit.

Insurance brokerage was another area where undisclosed commissions to brokers led to a scandal 6-7 years ago.  The big guys discontinued the practice, the little guys didn’t, and the laws were never changed.  It’s still legal, and at least one of the big brokers has returned to the practice — can’t remember which one.

This highlights how these deals come to be, in any complex (multiparty) insurance arrangement.  The one who controls communications gets the lions share of the value of the transaction.  Even though forced-place is an oligopoly, the servicers have the advantage, and they take little to none of the risk, typically.

Assurant may have some advantage here, because they are the biggest, and their systems do actively troll for policies going out of force.  I have talked with management several times about the business, and how they warn potential insureds that their existing policy has gone out of force, etc.  They claim to follow all existing laws and regulations, but in a big firm, when many things are automated, who can tell for sure.

So, when I read your piece, I agree with a lot of it.  The trouble is that the average person in such a crisis does not think straight because he is in a crisis that he can’t get out of, and everyone is pinging him for money that he doesn’t have.  Most could mitigate the forced place, and get a cheaper policy in force, but they don’t even have the money for that.

Everything goes against people who are on the brink of bankruptcy, and I feel sorry for them.  Trouble is, as a nation, we encouraged people to take on too much mortgage debt, and now we are dealing with the aftermath.

Please pass the above onto your editor, so that he knows that I am not one-sided on this issue.  If he wants, I could reformulate a longer letter that embeds more of the complexity of multiparty insurance deals.  Most financial scandals require three or more parties to be effective.

I did not comment on the lack of incentive to choose the cheapest insurance, because I missed it.  That is one of the perversities of multiple party arrangements.  When you sign an agreement that allows someone to make choices for you if you fail in your obligations, and bill it back to you, or bill it back to the one that will pay if you default, you have essentially said, “If I default, you are free to harm me in some limited way.”

The author responded to me:

Thanks. This is well thought out. I sent your e-mail to our web folks, and expect they’ll follow up. For what it’s worth, I thought your original letter was solid.

The only quibble I’d have is that I guess when it comes down to it, the borrower isn’t actually the entity that I think is usually getting harmed. The investor/GSE is.

That’s sort of the point I wanted to make with the lead of the sidebar (Don’t know if you saw that one: http://www.americanbanker.com/issues/175_216/losses-from-forced-place-insurance-1028475-1.html)

While the borrowers do get a notice of the commission sometimes, the investors have no say in any of this – but are paying for the commission at the time of foreclosure. When it comes down to it, most force-placed policies aren’t a choice – they’re bought on homes owned by people who can’t/won’t pay their mortgage, making the information about force-placed costs and commissions useless.

So it seems to me that no amount of disclosure to the borrower could fix that problem. Even if the commissions are being disclosed, they’re being disclosed to a party who is no longer in the game.

The author is entirely correct here, and I hit myself on the head and go “duh” as a result.  There is a hole in the securitization agreements, because if the borrowers go into foreclosure and won’t pay, it comes out of the hide of the junior certificateholders of the securitization.  With GSE loans, that means the taxpayer takes a hit.

From one of the articles:

“It is clear that [the Real Estate Settlement Procedures Act] prohibits fee splitting and unearned fees for services that are not performed,” said Brian Sullivan, spokesman for the Department of Housing and Urban Development. Foreclosure defense and legal aid attorneys say force-placed insurance is found on most of the severely delinquent loans in this country. If so, the cost to investors may well be in the billions of dollars.

“This is clearly not in the investors’ interest,” said Amherst Securities analyst Laurie Goodman, who in May noted the potential for misconduct with Bank of America’s force-placed-insurer subsidiary, Balboa Insurance Group. “Servicers are getting a huge chunk of money from force-placed insurance, and investors pay for it by higher loss severity at the liquidation of the loan.”

This will be hard to enforce in a court of law, but the insurers are doing the work and bearing the risk; those receiving riskless profits are the servicers.  From my view, banks and servicers will be on the hook for bad decisions here.  The insurers have no discretion.

Now, my perception of Assurant is that they are on the more ethical side of their industry here.  But, this is only a belief, and not a fact.  I am willing to accept contrary data, and I welcome the thoughts of those who know things that I don’t.

Down another 7% percent, I will buy more shares of Assurant, but for those that don’t own it, this is a good entry point.  Assurant is a very diversified insurance company, more than any other that I know of.  Their P&C division will not die, and the other divisions are not affected.

PS — It is really difficult to lose money on stocks where the P/E is below 10, and the P/B is below 1.

Full disclosure: long AIZ (it is a double-weight in my portfolio)