The Office of Inspector General for the Federal Housing Finance Agency (OIG-FHFA) has completed an evaluation of how well FHFA oversees Freddie Mac and Fannie Mae's management of lender-placed insurance (LPI). FHFA has been conservator of the two government sponsored entities (GSEs) Freddie Mac and Fannie Mae since August 2008.
LPI, commonly called "force-placed" insurance, is ordered by a lender when it identifies a lapse in the hazard insurance a borrower is required to carry on a mortgaged property. As one result of the evaluation OIG concluded that the GSEs have suffered considerable financial harm in the LPI market, perhaps as much as $158 million in 2012 alone from excessively priced insurance coverage.
The GSEs rely on their servicers to ensure that borrowers maintain hazard insurance and servicers outsource that task to specialty insurance companies that track the status of insurance coverage and force place policies when necessary. Two LPI providers and their subsidiaries do most of this work for the GSEs' servicers, Assurant, Inc. and QBE Holdings, Inc. Collectively the company's subsidiaries write more than 90% of the nation's LPI coverage, according to industry observers.
Servicers advance payment for the insurance premium to the provider then bills the borrower who is responsible for paying the premium but does not always do so. When a home is foreclosed the unpaid premiums become the responsibility of the GSE that owns or guarantees the mortgage. In 2012 the GSEs paid about $360 million for this coverage and $327 million in 2013.
In 2012 and 2013 insurance regulators ns in three large states, New York, California, and Florida, determined that premiums paid for LPI in their states were excessive and that those rates may have been driven up by profit-sharing arrangements between the servicers and LPI providers to whom they steered business. These arrangements were often in the form of commissions or reinsurance deals. The regulators have employed a variety of enforcement techniques to reduce LPI rates and prevent future abuses within their jurisdictions. Forty-eight percent of earned LPI premiums nationwide in 2012 were attributed to homes in those three states.
Last November, after receiving comments from the public and industry stakeholders, FHFA directed the GSEs to prohibit their servicers from receiving such LPI related commissions or entering into reinsurance arrangements with providers. Both GSEs subsequently issued new servicing guidelines that took effect on June 1, 2014. However FHFA has yet to complete an assessment of whether there should be litigation to recover financial damages to the GSEs from past abuses.
LPI is often sold as a group insurance master policy covering a predetermined group of homes rather than a single home and is priced as a fixed dollar amount per $100 of coverage. On average LPI premiums are 1.9 to 2.3 times more expensive than insurance bought by borrowers on the open market. Providers have given reasons for this discrepancy such as that they must insure properties sight unseen. Some experts maintain that this risk is offset by other factors - it is not as comprehensive as regular insurance, does not cover personal property, and has lower overhead as there is no individual underwriting.
The loss ratio is the percentage of the premium that an insurer pays out in claims. A high loss ratio indicates a high payout relative to collections, a low ratio indicates the insurer has retained a large portion of the premiums collected. The review by New York's insurance regulator (NYDFS) found that Assurant's insurance subsidiary had an expected loss ratio on file for the years 2006 to 2012 of 58.1 percent while its actual loss ratio in those years varied between 17.3 percent and 42.8 percent. In only one year, 2012, did it rise above 25 percent. A similar scenario was found for QBE's subsidiary where the expected ratio was 55.0 percent and it topped 20 percent only in 2006 (20.7 percent) 2008 (29.0 percent) and 2012 (44.3 percent). OIG noted that 2012 was the year Superstorm Sandy hit the state.
Additionally NYDFS found that providers employed several mechanisms through which to share profits with the servicers who gave them business. Commissions were paid to the servicers' insurance agency affiliates of 10 to 20 percent of the premium but these affiliates "do little or no work for the commissions." The second mechanism, used by the Assurant subsidiary was a reinsurance arrangement where the LPI provider shared a set percentage of its earned premiums and claims paid with servicer affiliates. The New York study concluded that both commissions and reinsurance arrangements tend to incentivize servicers to purchase higher priced LPI.
Similar actual loss ratios and premium sharing arrangements were identified in the other two states. In New York the two providers entered into consent orders requiring them to pay $24 million in civil penalties and provide restitution to borrowers. They were also prohibited from remitting commissions to or entering into reinsurance arrangements with servicers and to set new rates that would support an expected loss ratio of 62 percent or more. Providers in the other two states agreed to rate reductions.
Mortgage borrowers have also begun filing class action lawsuits against their servicers and LPI providers alleging some of the abuses above. Thus far several have been settled out of court for a total of at least $674 million to date.
The new guidelines from FHFA that went into effect on June 1 generally prohibit servicers and their affiliates from receiving any commission or incentive-based compensation from providers and explicitly restrict any type of reinsurance arrangement. Finally, they give the GSEs the right to inspect any contractual documents between servicers and LPI providers to ensure compliance.
OIG found that FHFA has taken some steps to prevent the GSEs from being harmed further by their servicers and LPI providers but has not determined whether the GSEs should pursue litigation to recover damages. In response to OIG questioning, FHFA's Office of General Counsel said it had not yet conducted such an assessment, citing competing priorities, such as finalizing pending legal claims. OIG said its analysis indicates that such litigation could result in significant financial recoveries for Fannie Mae and Freddie Mac.
OIG recommends that FHFA assess the merits of litigation by the GSEs against their servicers and LPI providers to remedy potential damages caused by past abuses in the LPI market and take appropriate action in this regard. The GSE's could build their case based on the information collected by state insurance regulators in their investigations and the GSEs may have been harmed in the same manner as the borrowers who settled the class action lawsuits described above.
The report from OIG acknowledges that the servicers and LPI providers would raise defenses to any such claims asserted by the GSEs, claiming for example that they never expressly breached a contract; that the coverage at issue was purchased in compliance with servicing guidelines. However similar defenses advanced in the borrower class action suits calling for dismissing the cases were denied by the courts.
FHFA accepted OIG's recommendation. The Agency will complete its litigation assessment within 12 months.
