An important risk management tool
The United States appears to be emerging from a severe recession that was caused, in part, by a dramatic collapse of the U.S. housing market. While there are signs of improvement in the overall economy and the housing market specifically, there are still many obstacles to a full-fledged economic recovery. Among these obstacles is the sustained high level of U.S. mortgage loan delinquencies that continues to adversely impact lending institutions across the country. An important risk mitigation tool that lending institutions should consider in this time of uncertainty is Mortgage Impairment / Mortgagee’s Errors & Omissions insurance (“MIP”).
Financial institutions that can benefit from MIP insurance include commercial banks, community banks, credit unions, mortgage banks, insurance companies, and any other financial institution that originates, services, or invests in mortgage loans.
Essential Components of Coverage
MIP provides two basic components of insurance coverage within one policy form: Mortgage Impairment and Mortgagee’s Errors & Omissions.
- Mortgage Impairment
Mortgage Impairment provides insurance coverage to a financial institution for a loss to its “Mortgage Interest” (defined as interest in real property as security for a loan). The core element of Mortgage Impairment provides coverage to a financial institution for loss to its Mortgage Interest caused by the lack, inadequacy, or uncollectibility of direct insurance against physical loss or damage to the collateral property caused by “Required Perils” (i.e., the perils of fire, extended coverage, flood in the amount necessary to comply with the federal Flood Disaster Protection Act of 1973 (“Flood Act”), or other similar direct physical damage perils against which the lender requires the borrower to obtain insurance on the collateral property). These Required Perils are typically covered by homeowner’s insurance, fire and extended coverage insurance, and flood insurance policies. Mortgage Interest can even be expanded to cover foreclosed properties after a financial institution takes ownership.
As a supplement to the Mortgage Impairment component of the policy, MIP insurance may also provide coverage to a financial institution for loss to its Mortgage Interest caused by the lack, inadequacy, or uncollectibility of direct insurance against physical loss or damage to the collateral property caused by a “Non-Required Perils” (i.e., perils against which the lender has not required the borrower to obtain insurance on the collateral property). Examples of Non-Required Perils include:
- Earthquake where the borrower was not required to purchase earthquake insurance;
- Flood when the collateral property located outside of a designated flood zone, and the borrower is therefore not required to carry flood insurance under the Flood Act.
- Flood in excess of the limits required by the Flood Act.
Available supplements to the Mortgage Impairment component of the policy may include coverage against loss to the Mortgage Interest caused by (a) the seizure and sale of real property by a governmental agency as a result of the borrower’s failure to pay real estate taxes, local municipal taxes, or assessments, or (b) loss of V.A., F.H.A., S.B.A., or private mortgage guarantee insurance.
The Mortgage Impairment component of MIP is written on an occurrence basis (i.e., coverage is limited to losses to the Mortgage Interest that occur during the policy period).
- Mortgagee’s Errors & Omissions
Mortgagee’s Errors & Omissions provides liability insurance coverage to a financial institution for claims made against it arising from alleged negligent acts, errors, or omissions regarding property upon which it has a Mortgage Interest. The core element of Mortgagee’s Errors & Omissions provides coverage to a financial institution against claims alleging negligent acts, errors, and omissions in procuring and/or failing to maintain insurance for Required Perils (as detailed above). Of particular importance in today’s housing market, this liability insurance also covers claims alleging a failure to procure or maintain F.H.A., V.A., or private mortgage insurance on mortgaged property.
Available supplements to Mortgagee’s Errors & Omissions may include coverage for claims made against a financial institution alleging negligent acts, errors, or omissions in (a) the payment of real estate taxes or local or municipal taxes or assessments, (b) procuring or maintaining life or disability insurance on the life or health of the borrower, or (c) determining whether the mortgaged property should be covered by flood insurance as required by the Flood Act.
The Mortgagee’s Errors & Omissions component of MIP is written on a “claims made” basis – i.e., coverage is limited to (a) claims that are made against the financial institution for losses during the policy period, or (b) potential claims that are reported during the policy period.
We have seen two recent claims that clearly demonstrate how MIP insurance can contribute to a financial institution’s overall risk management strategy. Both of these claims have their genesis in the current U.S. housing crisis.
1. Mortgage Impairment
Our Insured was a medium-sized financial institution holding a mortgage loan on a large residential property. The loan was non-performing when the property was destroyed due to a fire, which the authorities have attributed to an act of arson. While there were no charges filed in connection with the arson, the homeowner’s insurer refused to make any payment under its policy.
As a general rule, if the fire is proved to be arson by the borrower, the homeowner’s insurer can refuse to pay any insurance proceeds under the policy to the borrower. However, the lender should always be named as the Mortgagee (the creditor or lender in a mortgage agreement) under the homeowner’s policy. As Mortgagee, our Insured would have a separate right of action to collect under the policy for the fire damage, assuming there is no complicity in the crime.
In this claim, however, our Assured was not listed as Mortgagee in the homeowner’s policy, and the claim (and separate right of action) was denied by the homeowner’s insurer. Thus, the following criteria existed for a covered claim under the Mortgage Impairment section of the MIP policy:
- Physical damage to property as the result of a Required Peril (i.e., fire);
- The lack, insufficiency, or uncollectibility of direct (homeowner’s) insurance; and
- A loss to the Insured’s “mortgage interest” (i.e., the security for repayment of their loan that the collateral provided), resulting from the physical damage to the collateral.
This claim may be emblematic of the dire circumstances the economic downturn has created for some borrowers. The circumstances suggest that the borrower may have been so desperate to get out “from under” the mortgage loan that he committed arson in order to try to obtain the homeowners insurance policy proceeds and effectively terminate his mortgage obligation. While, as described above, most often a borrower’s actions will not prejudice a lender’s rights under a direct insurance policy, in this case it may very well turn out to be the case that our Insured has no viable recourse against the homeowner’s insurer. In such a case, Mortgage Impairment insurance may provide the Insured with a second level of protection against loss to its Mortgage Interest.
2. Mortgagee’s Errors & Omissions
Due to the negligence of an employee in the loan servicing unit, our Insured failed to pay the premium for Private Mortgage Insurance (“PMI”) on several dozen loans.
While the Insured had collected funds from its borrowers to make the premium payments, the employee charged with the responsibility of remitting the payments to the PMI insurers failed to do so. This resulted in the cancellation of the PMI policies. Although upon discovering these failures the Insured remitted the funds to the PMI insurers and requested that coverage be reinstated, in certain cases the PMI insurers refused to do so.
Due to the dramatic decline in property values, and the sustained elevated levels of unemployment, half of these loans have since gone into default. Each of the defaulted loans without proper PMI had been sold to a secondary market investor. The amount recovered on each property through foreclosure and sale has been, or is likely to be, insufficient to cover the outstanding mortgage loan balance. The investors looked to our Insured for recovery of the loss sustained as a result of its failure to procure PMI, and to date the Insured has agreed to reimburse the investors for their losses, which amount in total to hundreds of thousands of dollars.
This claim is a glaring example of the increased exposure for financial institutions due to the housing market crisis. In a healthy housing market, many of these loans would be current, and the ultimate loss to the insured would have been substantially mitigated. Additionally, if housing prices had not declined so precipitously, many of these loans would not be “underwater,” and the borrowers would have been able to refinance.
In addition, in a healthy U.S. housing market, the investor might very well have recovered most, if not all, of the loan balance through the foreclosure process. Given the sheer number of foreclosed loans, any negligent act, error, or omission can now lead to a catastrophic loss to a financial institution. Having Mortgagee’s Errors & Omissions insurance in place can insulate a financial institution from bearing the full impact of such a loss.
These claims examples demonstrate why MIP insurance is a coverage that lending institutions and servicing institutions can ill afford to forgo. In an environment of high levels of delinquency and looming foreclosures, a financial institution’s exposure to Mortgage Impairment losses increases dramatically.
With housing prices bottoming out, many borrowers are “underwater” on their mortgage loans and foreclosure levels are at an all-time high. Lending institutions need to do everything they can to manage their risk. MIP insurance can be your ally in this time of economic uncertainty.
Tom Delaney is Managing Director of Bankers Insurance Service in Chicago, Illinois, a managing general underwriter that provides insurance coverage for residential and commercial lenders’ and servicers’ mortgagee or owner interest in mortgaged properties. Bankers Insurance Service has been the endorsed insurance provider of the national Mortgage Bankers Association since 1952. He can be reached at 312.381.3722 or firstname.lastname@example.org.