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Mortgage Banking and Loan Servicing Industry Standard Practices and Procedures for Force Placed Insurance

Expert Witness: Don Coker
A look at what happens when a collateral property is not covered by insurance and a lender has to force place insurance.

Before I explain the forced placed insurance aspects of lending and mortgage banking that will be covered later on in this article, first let me present some basics to make sure that all readers are up to speed on the foundational issues.

Some Basics of How Mortgage Loans are Originated and Serviced

1. Financial professionals universally agree that a first mortgage lien on an owner-occupied home is considered one of the highest quality loan investments. This is due to the dual facts that a homeowner will place the highest financial priority on preserving the ownership of their home, and – notwithstanding
the obvious downward trend in home values that we are presently experiencing (here in mid-2009) – the general long-term upward trend in home values.

2. The mortgage origination and investment process involves several parties. A borrower may go directly to a lender, or to a mortgage broker who takes the loan to a lender. That part of the process is not important to this discussion.

3. The lender that originally makes the loan may then sell the loan to another lender, sometimes referred to as an “investor.”

4. When a lender sells a loan to an investor, the lender may sell the loan and continue to service the loan (i.e., collect the payments, handle the escrows, handle payoffs, etc.), or the lender may sell the loan “servicing released” which means that the investor that purchases the loan simply adds the loan to their existing portfolio and services it along with their other loans.

5. There are further nuances where a financial institution may sell loans to Fannie Mae or Freddie Mac, or pool loans together into a pooling and servicing agreement wherein various entities serve as Depositor, Seller, Servicer, Credit Risk Manager, and Trustee. We do not need to scrutinize these structures in order to understand the forced placed insurance issue.

6. And finally, it is important to note that the vast majority of home loans are “conforming” loans, i.e., loans that conform to Fannie Mae and Freddie Mac lending criteria. The reason for this is to “commoditize” the loans so that they easily can be bought and sold among institutions in a somewhat fungible manner. And this brings us to a couple of important points: (a) Conforming loans are originated on standard Fannie Mae or Freddie Mac forms, and (b) They are serviced according to the requirements cited in the Fannie Mae and Freddie Mac servicing guidelines. Later on, we will discuss these two points in more depth.

Importance of Property Insurance

The underlying factor that makes a mortgage loan a prime investment is the value of the collateral. All of the parties that guarantee the timely repayment of mortgage loans and portfolios of mortgage loans require that the value of the underlying collateral is protected by adequate property insurance. Furthermore, even if other entities - such as Fannie Mae, Freddie Mac, FHA, and VA – did not require adequate property insurance, mortgage lenders would still require the insurance to protect their interests in the collateral. Maintaining proper insurance to protect the value of the collateral securing mortgage loans is considered in the banking, mortgage banking, and lending industries to be a logical requirement for operating in a safe and sound manner.

Proper insurance coverage is one of the many items that governmental financial institution regulators check when they perform an examination of a financial institution. If any loans are found not to have proper insurance coverage, then the examiner writes up the situation as one that has to be corrected immediately.

Therefore, it is easy to see why investors in the mortgage market hold mortgage originators and servicers responsible for maintaining proper insurance coverage that is in accordance with the investor’s written and stated guidelines. The loan servicing guidelines of Fannie Mae and Freddie Mac include requirements that the collateral property be covered by adequate insurance. Failure of a mortgage company to conform to an investor’s servicing guidelines can result in the investor terminating the relationship with the mortgage company.

It is important to note that once a mortgage loan is sold to an investor in the secondary mortgage market, the originating mortgage lender no longer owns the mortgage but rather - if servicing the mortgage - is being paid to provide a service for the owner of the mortgage – i.e., servicing the mortgage loan - and must abide by the investor/owner’s servicing terms. In the case of conforming loans, this normally includes the requirement that the servicer comply with Fannie Mae and Freddie Mac servicing standards.

What Happens When There is No Insurance Coverage?

There are occasions when the insurance coverage for improved real estate collateral lapses, perhaps for accidental or intentional non-payment on the part of the property owner, a change in the insurance company’s underwriting requirements or business strategies, a change in the character of the property, etc. When the insurance coverage ceases, the owner of the mortgage loan is exposed to loss in the amount of the difference between what it is owed on the loan and the net amount for which the property could be sold.

In order to deal with this potential problem, the mortgage lending and property insurance industries developed a blanket insurance policy product that automatically covers a lender’s exposure for the length of time that the property is not insured by the borrower. This coverage is sometimes referred to in the industry as a Blanket Policy, Lender Placed Policy (“LPP”) or simply Lender Placed Insurance (“LPI”). (Note: The requirement that the borrower must maintain insurance, and the lender’s option to obtain Lender Placed Insurance if the borrower does not maintain adequate coverage, is contained in paragraph 5 of the standard Fannie Mae and Freddie Mac deed-of-trust form.)

The lender’s insurance coverage under the blanket insurance policy begins automatically when the previous insurance coverage ended. Therefore, this coverage includes claims for damage that may have occurred even before the lender or the insurance company was aware that the previous coverage had ended. That is one reason that premiums on this blanket insurance coverage are higher than normal homeowner’s insurance premiums.

The normal coverage provided through a blanket insurance policy covers only the lender’s interest. For example, if the property is completely destroyed while being covered by the blanket policy, then the lender would be paid off in full and the borrower would receive nothing.

Nothing found in any loan documents I have ever seen requires a lender to maintain insurance that covers a borrower’s interest in collateral property.

A mortgage company normally would have, or attempt to have, some communication with the borrower / property owner regarding the lapse of their insurance coverage which would include information that the blanket insurance coverage would be more expensive than the homeowner’s previous coverage, and that the borrower’s interests would not be insured. However, mortgage companies do not send a certificate of insurance or an insurance policy copy or an insurance binder for the blanket coverage to the borrower since the coverage is for the lender and not for the borrower. Borrowers do not receive anything evidencing the lender’s insurance coverage, but typically receive a notice that LPI has been added to their loan account balance. Sending a certificate of insurance or a copy of the blanket insurance policy to a borrower could be misleading to a borrower and lead them to think that they have coverage when, in fact, they do not.

When a lapse of insurance coverage is detected, by either the lender itself or by a captive or independent insurance tracking company that has been engaged by the lender to monitor the insurance status of the properties securing a lender’s loans, the blanket insurer is notified that coverage is needed for the particular property. Then the coverage begins retroactively to when the previous insurance coverage ended.

All standard loan documents, including those of Fannie Mae and Freddie Mac, require borrowers to provide insurance coverage for the property that is the collateral for the mortgage loan; and standard loan documents also allow the lender or loan servicer to provide insurance coverage for the collateral property if the borrower does not.

Of course, the reason for LPP or LPI is that the owner of a mortgage loan must be continuously covered by insurance. Insurance coverage that protects the value of the collateral securing the loan is, in effect, alternative collateral. Just as no lender would make a mortgage loan without collateral, no lender would make a mortgage loan without sufficient insurance covering the collateral.

Likewise, mortgage investors require this same coverage and require mortgage banking companies that service their loans to maintain a blanket insurance policy that provides the lender with insurance coverage in the case of lapsed insurance policies.

There have been few if any changes in this insurance coverage system and in the mortgage servicing policies and procedures pertinent to this issue in recent decades.

Borrowers should pay attention to their property insurance coverage and make sure that their policy provides them with continuous coverage in amounts that will adequately compensate them for any losses.

If a coverage problem does develop, for whatever reason, and LPI is force placed on the borrower’s property, the borrower can stop the clock running on the higher-priced forced placed policy by simply paying their delinquent homeowner’s insurance premium or by obtaining a new homeowner’s policy, depending on the circumstances. The minute that the new homeowner’s policy that meets all of the lender’s requirements is presented to the lender, the lender will cancel the LPI and resume their reliance on the borrower’s insurance coverage.

Over 400 cases for plaintiffs and defendants nationwide, over 100 testimonies in all areas of banking and finance. Listed in the databases of recommended expert witness consultants of both the DRI and the AAJ.

Clients have included individuals, 60 banks, and governmental clients such as the IRS, FDIC.

Employment experience includes Citicorp, Ford Credit, and entities that are now JPMorgan Chase Bank, BofA, Regions Financial, Guaranty Bank, and a two-year stint as a high-level governmental financial institution regulator.

B.A. degree from the University of Alabama. Postgraduate and executive education work at Alabama, the University of Houston, SMU, Spring Hill College, and the Harvard Business School.

Called on by clients in 27 countries for work involving 56 countries.

Widely published, often called on by the media.

Copyright Don Coker

Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.

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