In response to the subprime mortgage crisis, Congress passed the Home Ownership and Equity Protection Act (HOEPA). To protect consumers from unfair, deceptive or abusive acts and practices in mortgage lending and to restrict certain mortgage practices, HOEPA legislation requires lenders to establish escrow accounts for property taxes and homeowner's insurance for first-lien “higher-priced mortgage loans.” These are defined as first-lien mortgages with an annual percentage rate of 1.5 percentage points or more above the Federal Reserve Board “average prime offer rate,” or 3.5 percentage points if it is a subordinate-lien mortgage. Many mortgage lenders have not previously escrowed for their borrowers taxes and insurance and do not have the appropriate mortgage impairment insurance in place to address the unique mortgage E&O exposures associated with escrow operations.

Mortgage impairment insurance

The mortgage impairment policy was designed to address the unique exposures associated with lending and escrow operations. Almost any combination of the following coverage sections is available:

Section A(1): Physical loss or damage from required perils covers loss to the insured's interest through the uncollectability or non-existence of insurance against perils that are required by the borrower–including mandatory flood insurance–in the insured's loan closing procedures.

Section A(2): Liability covers E&O on a claims-made basis relating to the insured's handling of physical damage insurance and homeowner's insurance covering the real property of borrowers. The insured's defence costs also are provided for within the limits.

Section B(1): Real estate tax liability covers the insured against errors and omissions relating to non-payment of real estate tax by the insured on behalf of a borrower.

Section B(3): Life and disability insurance covers the insured against errors and omissions arising out of the insured's procurement and maintenance of life or disability insurance on behalf of a borrower.

Section B(4): Flood Disaster Act 1973 liability covers the insured against errors and omissions claims arising out of the insured's duty to determine whether or not a particular property is in a flood zone.

Section B(5): Government National Mortgage Association (GNMA) procedures covers the insured, as mortgage servicer, against errors and omissions should the insured fail to comply with GNMA procedures which result in a loan guarantee being lost.

Section B(6): Title E&O liability covers errors and omissions arising out of the insured's failure to obtain the correct title insurance, title abstract or legal opinion as to a title depending on custom and practice.

Section B(7): Recordation E&O covers errors and omissions arising out of the insured's recordation of a loan as a servicer of a loan sold to GNMA/Federal National Mortgage Assn. (FNMA)/ Federal Home Loan Mortgage Corporation (FHLMC).

Section B(8): Satisfaction of mortgage liability covers errors and omissions arising out of the insured's connection with the satisfaction of a mortgage on property in which the insured holds an insurable interest.

Section C: Physical loss or damage from balance of perils provides insurance should the security for the loan suffer a physical loss from any other cause other than those outlined in A(1), and the insured is unable to recover the loan from the borrower.

Section D: Loss of Federal Housing Administration, Veterans Administration, Small Business Administration and private mortgage guarantee coverage covers loss to the insured's interest should it fail to provide to a “mortgage guarantee” agency or insurance company its property notice of loans in arrears.

Section E: Loss of security interest due to defective title.

Section F: Custodial errors and omissions covers errors and omissions losses incurred due to the verification, certification, maintenance and custody of documents concerning loans sold to GNMA, FNMA or FHLMC.

Agents should take care when comparing the various mortgage impairment policies available in the market. Not all policies are created equal and significant coverage differences exist. Mortgage impairment coverage is available in both the admitted and surplus lines markets.

In addition to providing protection against escrow operations E&O, the mortgage impairment policy also provides limited protection on the lender's mortgage portfolio (A1) should the borrower's insurance be cancelled or non-renewed. The lender typically is afforded hazard coverage for 90 days before coverage must be force-placed. Coverage is limited to the actual mortgage impairment net of salvage and is subject to subrogation against any loan guarantor.

Mortgage impairment can be written on a “checking” or “ex-checking” basis. Checking means the insured has a system to check for borrowers insurance at loan origination and renewal. Ex-checking is verification of insurance at loan origination only, but still requires a response to cancellations. Some carriers offer broader coverage under the mortgage impairment policy by adding a blanket endorsement. This removes certain policy coverage restrictions relieving the lender of the need to track its borrowers' hazard insurance or react to insurance cancellations. Typically, blanket coverage is only used by lenders not using loan guarantee companies, many of whom require insurance tracking.

Tracking outsourced coverage

If the hazard insurance tracking functions become overwhelming or the potential for an uninsured loss becomes unacceptable, lenders can outsource these functions to third-party vendors. Vendors will be required to sign confidentiality agreements and demonstrate their ability to maintain the confidentiality of the lender's sensitive information. SAS70 certification is the standard method of evidencing the effectiveness of the vendor's internal controls as required by the Sarbanes-Oxley Act of 2002.

Once the outsourcing agreement has been signed, the lender and the third-party vendor establish a schedule of data interface. The lender provides loan information to the vendor and all related insurance correspondence is forwarded to the vendor for processing. In return, the vendor provides detailed reports indicating the insurance status of the loan portfolio. If an adequate evidence of insurance has not been provided by the borrower, the vendor will initiate a letter cycle advising the borrower of his/her insurance responsibilities under the loan agreement. If necessary, the vendor will force place the required coverage on behalf of the lender.

This process requires the use of file transfer protocol (ftp) sites or similar secure file transfer methods. The advantage of using a vendor for this process is the elimination of internal overhead by the lender and the security of transferring the insurance tracking liability to a third party, eliminating the possibility of an uninsured loss to the collateral supporting a loan.

Blanket mortgage hazard insurance

If outsourcing is not a viable option and the financial institution does not wish to track hazard insurance, another coverage option is the blanket mortgage hazard policy. This policy relieves the lender of its tracking responsibility but does not afford any E&O protection. It does, however, provide enhanced physical damage protection to the collateral supporting the loan, as the trigger to loss is not subject to loan impairment (foreclosure). The trigger to loss is simply an otherwise uninsured loss. The lender is the named insured under a blanket mortgage hazard policy, and only its interest in the collateral is protected.

Coverage is available in the admitted market and typically written as a Dwelling Fire (DP-3) for residential occupancies and ISO forms for the commercial risks. Caution should be exercised to ensure that high risk or unusual occupancies are eligible for coverage under these programs. A high rate of known uninsured properties in the mortgage portfolio or a concentration of high valued or coastal properties will significantly impact the price of a blanket mortgage hazard policy.

Real estate owned properties

Another issue nagging at mortgage lenders is dealing with real estate owned (REO) properties. Even lenders who historically maintained conservative loan underwriting guidelines are now finding themselves dealing with REO properties.

Before a property becomes an REO, the loan advanced on the property will have been thoroughly reviewed to determine the best outcome for the lender. Only as a last resort will a lender want to become a property owner.

Once the property is foreclosed, the lender must address both the physical damage and liability exposures associated with the new property. Adding the property to a schedule based upon a reporting form is optimal.

Along with placing the appropriate insurance coverage, steps should be taken to adequately manage the new property. Mortgage loan servicing companies recommend the following:

o Secure and change locks on property within 24 hours

o Provide a full photo report on vacant property within 24 hours to your asset manager or loan servicing representative

o Perform ongoing property inspections and take photos every 2 to 3 weeks

o Winterize vacant properties

o Shut off water source at curb

o Drain all plumbing and heating systems

o Shut off gas and electric service

o Confirm that the sump pump is working properly.

Flood insurance

One last area of strife for lenders is the determination and administration of flood insurance. Federal regulations require the purchase of flood insurance when a loan is extended on improved real property that is located in a special flood hazard area (SFHA) in a participating community. The requirement is satisfied by completing the Standard Flood Hazard Determination Form. It is the lender's responsibility to make the flood determination, either internally or from a third party. Changes in flood mapping must also be monitored to ensure continued compliance.

The usual National Flood Insurance Program (NFIP) underwriting rules apply to financial institutions. In fact, a large portion of the NFIP Mandatory Purchase of Flood Insurance guidelines address the special responsibilities of lenders. These scenarios include:

o Land and land values

o Calculation of coverage

o Lack of coverage if land loan only

o Low-value building on high-value land

o Buildings in the course of construction

o Manufactured (mobile) homes/travel trailers

o Underinsured buildings

o Home equity and second mortgages.

An exception to the standard 30-day waiting period applies when flood coverage is placed in conjunction with loan activity or in connection with the remapping of a community.

The 1994 Reform Act placed the responsibility of tracking and force placing flood insurance on the lender if it is determined that the building securing the loan is not adequately insured. The amount of flood insurance coverage must be at least the lowest of the principal balance or the maximum available under the NFIP.

If the borrower fails to purchase adequate flood insurance within 45 days of coverage termination, the lender is required to purchase this insurance on behalf of the borrower and may charge the borrower for the cost of the premiums and fees incurred.

Lender-placed flood coverage is available through the following channels:

o Mortgage Portfolio Protection Program (MPPP)

o WYO insurer or NFIP servicing agent

o Non-NFIP flood coverage from a private insurer.

Mortgage Portfolio Protection Program (MPPP) is designed for lenders to force place flood insurance coverage under the NFIP with minimal underwriting data. Accordingly, the rates are considerably higher than those of voluntary policies.

Non-NFIP flood coverage from a private insurer is available in both the admitted and non-admitted markets. Policy and insurer acceptance by FEMA is established in the published guidelines.

Policies offered by private insurers can include coverage to protect against loss during the 45-day notification window as required by regulation. Additional coverage is available through endorsement to address partial insurance scenarios. With the addition of the concurrent coverage endorsement, the policy will pay the proportion of the loss that the limit of liability applies to the total amount of insurance covering the loss. This endorsement is particularly beneficial in a partial loss.

As the nation undergoes its economic recovery, considerable regulatory changes continue to march through the halls of Congress. Such changes will drastically impact financial institution operations. It is the agent's role to be cognizant not only of these changes, but of how they will impact the operations and exposures of insureds. Failure to do so will result in missed opportunities to expand coverage and additional exposure to an uninsured loss to the collateral supporting a loan for the already stressed financial institution.