Monday October 13, 2008

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Title Insurance and Homebuilders - An Unholy Alliance?

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The end user is the homeowner who is usually required to purchase lender's title insurance when buying a home or refinancing it and who may or may not choose to buy owner's insurance at the time of initial purchase or subsequent refinancing. In either case, once is enough. Title insurance isn't cornflakes, and, as a consumer product, has a darn poor business strategy.

Instead, title insurers market to the middlemen who are in the position to give them business time after time. There is big money to be made if a title insurance company can secure the repeat business of a major bank, mortgage company or escrow agent.

Rarely is a home buyer asked to pick his title insurance company. Certainly he could demand that right, but most homebuyers are unaware of or forget about this item on the settlement statement and are as content with the fait accompli - a policy ordered by the lender - as they can be expected, considering it may have cost them $500 or more at closing.

Thus the competition for title insurance business takes place at a very sophisticated level, business to business, and has, over the last ten years or so come under serious investigation for several illegal or unethical schemes to give title companies an unfair advantage and/or to reward lenders for their patronage.

The most recent allegations are ongoing. At present ten states are investigating alleged title insurance fraud. These investigations involve not only a number of America's top title insurance companies but two super-size lenders, a national real estate company, and, most notable in this investigation, a large number of large homebuilding corporations.

The current scheme, at least the one under scrutiny in California, Washington State, and Colorado, is very complicated and involves not only the title company and the middleman (lender/homebuilder/real estate company), but a reinsurance company, usually a subsidiary of the middleman.

In case you wonder how we went from lender to homebuilder in a single paragraph, a note about how homebuilders sometimes operate is in order. A huge nationwide developer of golf course communities (real story) once it options a tract of land in virgin territory, makes its second item of business picking a local lender for end financing of its development. Being selected to handle the financing for a 200 or 800 lot development, even if only for a short term mortgage on the land, is a tremendous opportunity for a local, even a regional lender. The builder cannot guarantee that its buyers will use that bank or mortgage company, but in the case of our example, the marketing strategies and the timelines that are stringently enforced certainly encourage the buyer to go with the program. It is up to the chosen lender to convert that opportunity into a construction loan or eventual, long-term, take-out financing, but selection is a tremendous leg-up.

In return for it alliance with the lender, which also carries a lot of positive public and media exposure in addition to the actual lending business, the builder calls the shots. Our profiled builder calls itself a selling machine. No argument here. It trains the lender in the builder's methods and insists on strict adherence to its policies. It negotiates favorable rates for buyers, sets deadlines for closings that impact the lender as well as the buyer, and is in a position, if it desires, to pick closing attorney's, escrow agents, and title companies. (These are not necessarily the same in every state.) Remember, many of the large homebuilders in this country are listed on the New York Stock Exchange and are much larger than either the local banks or the title companies they are dealing with.

Some homebuilders are now accused of collaborating or conspiring with title insurance companies to profit from providing them with nearly guaranteed business.

The current scheme, at least as alleged in Colorado and California, is pretty sophisticated stuff.

Enter the third player - a reinsurance company. Reinsurance is in common use in the industry (not just title insurance but also hazard and other types) as a way to share risk. No single insurance company can take on insuring a huge development such as the Empire State Building against fire, hurricane, liability, or terrorism, so they sell off pieces of the policy they wrote to other companies, sharing the premiums and sharing the risk.

In the case of title insurance, there is not much danger of the company suffering a crippling loss from writing a title policy on a $200,000 house in Toledo. According to Erin Toll, Colorado deputy director of the state's Department of Insurance, "Over 99 percent of the transactions involving title insurance don't require reinsurance." This is typically for "hugely expensive commercial properties or tiny title insurance companies." The California Department of Insurance estimates the loss ratio for the typical single family title policy at three to five percent.

Now here comes the kicker. Guess who controls the reinsurance companies? Yes, the homebuilder. The reinsurance companies, which are to a stunning extent incorporated in Vermont, collect premiums from the title insurance companies for assuming part of the risk of a policy and then return a large portion of the premiums - shall we say "kick back" - to the homebuilder for the original referral. These reinsurance companies are not necessarily owned by the homebuilders but are what investigators call "captive" to them.

Deputy Director Toll has stated that these reinsurance premiums were often grossly out of line with the risk, in some case half of the total insurance premiums they got from the builders (as originally collected from the home buyers). This may (ya think?) have forced up the title insurance premiums required from the insured, yes, those same homebuyers.

That so many states, so many home builders, and so many title companies are potentially involved in this mess makes a concise report on its current status almost impossible. To date, however, First American Title has agreed to repay $24 million to consumers nationwide. Fidelity National Financial has stopped issuing reinsurance policies and is negotiating settlements in some states. Commissioner Garamendi issued subpoenas to ten companies in February and March and has scheduled an April 4 hearing to take testimony from executives of LandAmerica and Fidelity National Title, two of California's largest companies; and more than a dozen builders in have been named in a suit filed by regulators in Colorado for guaranteeing First American further business in exchange for kickbacks.