REQUIRED READING: With the continued depreciation of residential home values, elevated construction costs and seemingly greater frequency of devastating natural disasters, lender-placed insurance has become an increasingly important component of the mortgage servicing business.
Very few lenders can claim that all of their borrowers are adequately insured, and although traditional insurance coverage has always been a top priority for servicers, today's lack of availability in some markets has created pressure on the industry to rely more heavily on lender-placed insurance to insulate against risk.
Deciding whether to leverage lender-placed insurance can be daunting for those who have not used it before, and there are multiple factors that servicers should carefully consider when evaluating it as a business strategy.
Depreciating home values. For organizations that service mortgage loans across multiple states, the difference between housing prices (the appraised value) and the actual cost to construct properties can greatly vary. For example, Nevada has a very high incidence of foreclosures, and according to recent CoreLogic data, has had the biggest drop in home prices – down 12.4% in September – compared to any other state.
When homes are foreclosed on and sold in today's market, many – although not all – are sold at auction. Others are sold at greatly reduced prices by the lenders to recover as much of their losses as possible and reduce their liability of owning the properties.
Historically, it has been a common belief that a house would gain value over time, and mortgage loans originated over the past several decades have been structured in anticipation of the increased value of the property over time.
A typical 30-year mortgage compounds interest in such a way that over 70% of the original loan amount is still owed after 20 years. But in today's economy, many homes have depleted in value by 50% or more in some regions.
As a result, when a house is bought, sold or refinanced, the economy where the property is located strongly affects the price or loan amount. In the case of Nevada, as well as other areas that have been greatly impacted by the downturn in the economy, a property may sell for a fraction of its original value simply based on comparisons by the appraisal industry, comparing it to other properties recently sold. Increasingly, the comparable homes are foreclosed properties that have been sold in a distressed environment, significantly lowering the value.
Despite depreciating home values, there are several contributing factors to insurance coverage and rates, including construction costs, natural disasters, overexposure in some regions and investor expectations. While the appraised value of a home may have plummeted over recent years, the insurance rate may not be reflective of that because of these factors.
Construction costs. In a February 2011 Los Angeles Times article titled "Rising Construction Costs Could Boost New-Home Prices Soon," Bernard Markstein, vice president of forecasting and analysis for the National Association of Home Builders (NAHB) indicated that the overall price for building materials has been rising year-over-year since summer 2010. Despite construction costs' having fallen since the start of the housing recession, today they account for nearly three-fifths of the price of a home as compared to just one-half nine years ago, according to an NAHB survey.
In addition, new state and federal regulations have impacted construction costs. For example, at the local level, "jurisdictions may charge permit, hookup and impact fees, and establish development and construction standards that either directly or indirectly increase costs to builders and developers, or cause delays that translate to higher costs," according to Paul Emrath of the NAHB's Economics and Housing Policy Group, in a July 2011 study. Emrath also reported that some states have adopted statewide building codes. The federal government can also impact costs – requiring, for example, stormwater discharge on construction sites.
An April 2011 survey conducted by NAHB shows that regionally, the impact of code changes on construction costs is higher in the Northeast and West than in the Midwest and South. Construction fees paid by builders are highest in the West, affecting states like Nevada.
Duncan Associates found in a 2010 survey that the state average impact fee for a standard single-family home in California was nearly $32,000 – more than twice the average fee for the next highest Western state.
Consequently, the insurance industry finds itself in a quandary in respect to the different types of construction with varying and consistently high costs for materials and labor to repair or replace the damage to the property. Even if home values are at their lowest, the cost to rebuild or repair can impact the rates simply because construction costs remain so high.
Natural disasters. Adding to construction costs are the natural and repetitive types of loss that are more likely to occur in areas prone to tornados; coastal areas prone to hurricanes or typhoons; other areas prone to flash flooding, wind or hail damage; or drought areas where wildfires rage.
Estimates of the damage caused by Hurricane Irene in August are projected to earn it a place as one of the 10 costliest catastrophes in our nation's history. Having wreaked havoc up the East Coast, the storm is estimated to have cost as much as $10 billion in damage, according to analysts' estimates.
In Northeastern states, where construction costs are higher (as noted above), the impact of Hurricane Irene greatly affects all properties – whether in good standing by the borrower or in foreclosure. And because states like New York and New Jersey are not typically susceptible to Hurricanes and mass flooding, insurance carriers may not cover the costs to repair or rebuild, and if they do, claims may be delayed due to bandwidth. For mortgage lenders, this presents a serious issue.
Overexposure in regions. It is also likely that some insurance companies are more exposed in certain geographic areas. This ultimately affects both the availability of insurance and pricing for mortgage servicers.
A real-world example is Florida, which in 2009 sought to increase insurance rates by 7.5% for its riskiest policies – some 300,000 homes on exposed beaches, which are more prone to damage from passing hurricanes and tropical storms.
This is where outsourcing can make business sense for a servicer, as independent agents and brokers often have the ability to introduce additional insurance companies to new areas, providing better coverage and better rates because the companies are not already heavily exposed to the specific risks that normally occur.
Understanding investors. In the secondary market, different investors require different levels of insurance coverage on properties. Investors for some mortgages may feel that a property should be insured for repair or replacement in a loss, while other investors may choose to only require that the loan balance be covered to protect the lender/investor.
This becomes complicated as mortgages are bought and sold, and ultimately serviced, by several different mortgage loan servicers over the life of the mortgage. In response, servicing companies are tasked with confirming that the insurance coverage on a property meets the specific demands of the current investor.
The net impact is that servicers must be positioned to clearly understand the different risk factors that impact each property and, using that information, address and meet the insurance needs of multiple stakeholders. Whether lender-placed or specific coverage for real estate owned properties, great care must be exercised to satisfy the mortgagor, the mortgagee and the investor.
Larry Cason is president of Gulf Shores, Ala.-based The IL Group, a provider of customized insurance solutions for lending institutions nationwide. He can be contacted at (251) 968-9888.