March 21, 2005
Title Insurance Fees
Paid by Borrowers Include Referral Costs
"I recently read that some of
the large title insurance companies have been kicking back to home builders 50%
of the premiums collected from the people who buy houses from the builders.
Doesn�t that mean that title insurance is seriously over-priced�?"
The price of title insurance must include the
heavy referral costs incurred by the title companies, so in this sense it is
overpriced. The referral costs that have come to light recently in Colorado,
where companies funneled 50% of the premiums from builder customers to
reinsurance affiliates owned by the builders, may be just the tip of the
iceberg. Investigations have recently started in both Florida and California.
In Michigan, title companies pay referral
fees to builders directly. House sellers in Michigan are required by state law
to purchase an owner�s title policy for the buyer. If the seller is a builder,
however, the premium is a flat $25, provided the builder arranges for the buyer
to purchase the loan policy required by the lender from the same title company.
The premium on the loan policy is not discounted by 60%, as it is when the house
seller is not a builder. This situation has stimulated a class action lawsuit
against the 4 largest title companies in Michigan.
Insurance Generates Substantial Referral Fees
Borrowers typically know little or nothing
about title insurance, which is part of much larger transactions that they
encounter very infrequently. In most cases, therefore, a borrower purchases
policies from the title company recommended by the industry professional most
closely involved in their transaction. On the purchase of a new house, this will
be the builder. On the purchase of an existing house, it will probably be the
Realtor. On a refinance, most likely it will be the lender.
Because the referrers select the title
company, the companies must market to them rather than to the consumers who pay
the premiums. For this reason, the price charged the consumer plays little role
in the marketing of title insurance. Many referrers do not care how much the
consumer pays. Indeed, their interest is best served by large profit margins
which enable the title companies to pay hefty referral fees.
Title companies don't want to pay referral
fees, but they must compete for the favor of the builders, brokers and lenders
who can refer clients to them. Referrals have value and they want a piece
Referral Fees are
Illegal Under RESPA
Under the Real Estate Settlements and
Procedures Act (RESPA), referral fees are illegal unless they constitute payment
for services rendered, and the payments must not exceed the value of the
services. However, the Department of Housing and Urban Development (HUD), which
has responsibility for enforcing RESPA, does not have the army of examiners it
would need to do the job effectively.
Violations of the anti-kickback provision of
RESPA are widespread. Small players do it with many different varieties of
under-the-table payments. Large players generally search for legal ways to
comply with the letter of the law while violating its spirit. Title companies in
Colorado viewed the reinsurance affiliate as such a device.
Affiliates as a Method of Complying With RESPA
Some large lenders have used this device to
extract referral fees legally from mortgage insurance companies. The lenders
have reinsurance affiliates that receive part of the mortgage insurance premiums
paid by borrowers who have been referred to the mortgage insurers by the
lenders. In exchange for the premiums, the affiliate shares the risk with the
insurer. This is the legal cover for RESPA compliance.
The title companies in Colorado used the same
device, reinsurance affiliates owned by builders, to pay off the builders. It
boomeranged, however, because of the major difference between mortgage insurance
risk and title insurance risk.
Losses from defaults are a major part of the
costs of mortgage insurers. And while they can go for many years with no
problems, losses will balloon when real estate prices collapse. Since one can
never be sure when this will happen, nor how large the losses will be when it
does, it would be very difficult for HUD or anyone else to establish beyond
reasonable doubt that the reinsurance affiliates are being overpaid for the
risks they assume.
Most title insurance costs, in contrast, stem
from their risk prevention functions rather than from insurance losses. Title
insurance losses account for a small part of the premium dollar, and are much
less vulnerable to conditions in real estate markets than mortgage insurance
losses. The finding in Colorado, that the builders� reinsurance affiliates have
had zero losses, is thus powerful evidence that the premiums paid to them were
only thinly-disguised referral fees.
Why do the title companies get all the heat
for paying referral fees? RESPA states very clearly that those who receive
kickbacks are as guilty as those who pay them. Indeed, their demands drive the
referral process. But the title industry has some large players, who make the
best targets for district attorneys and class action lawyers.
The failure of the title companies has been
their inability to resist the pressures to pay. It is difficult because they
must compete for the patronage of builders and others in a position to refer
customers to them, who can play one title company off against another. It would
be easier for them to say no if the recipients of referral fees had as much to
lose from exposure as the payers.
Is a Crack-Down
the Best Response?
When news emerges of widespread
payoffs, as it did recently in Colorado, the knee-jerk reaction is to demand a
step-up in enforcement actions. In my view, this is the wrong response.
Terminating referral fees by regulation would require an army of examiners, and
even then it wouldn�t work. The financial incentives are too strong, there are
too many ways that payoffs can be made, and there are too many people involved
for regulation to be effective.
Another option which is being considered in
some quarters is to socialize the title insurance industry. In Iowa, only a
state agency is allowed to sell title insurance, although residents are
permitted to buy policies from out-of-state firms. Some view Iowa as a possible
model for a complete overhaul of the industry.
I favor a market-based solution, the goal of
which would be to eliminate referral power and with it, referral fees and any
need for RESPA examiners.
A market solution must be based on the
following principal: whoever
selects the title company from whom title insurance is purchased must pay for
Implementation of the principal requires
three rules. The first would mandate that title loan policies, if required by
mortgage lenders, had to be paid for by mortgage lenders. The second would
mandate that on purchase transactions in which Realtors were involved, the
owners� policies had to be paid for by the Realtors.
These rules would eliminate "perverse
competition" by insurers for the favor of referrers, which raises the
price of title insurance. Instead, title companies would compete to sell to
lenders and Realtors, which would reduce the price of title insurance.
Of course, lenders and Realtors would embed
the title insurance premiums in their own prices to consumers, but they would
cost borrowers far less in that form than they pay now. Lenders and Realtors
would be price-sensitive buyers because they are paying the premiums, and they
would be knowledgeable buyers because they are in the market continually. Prices
should drop sharply, provided that state regulation of title premiums doesn�t
The third rule that is needed is one that
eliminates state regulation of title insurance premiums. If lenders and Realtors
purchase title insurance, regulation of premiums is not needed and can only
impede the decline of title costs to consumers.
The most radical part of this proposal is the
one involving Realtors. Unlike lenders, Realtors don�t need title insurance for
themselves but would be pressed into service as purchase agents of home buyers.
This makes all kinds of sense, although important details such as how the
responsibility would be allocated when there is a buyer�s agent as well as a
seller�s agent, have to be worked out.
The title insurance industry is under the gun
and it will be interesting to see how it responds. The market-based solution
described above would be painful in the short-term, but the industry would
survive and ultimately become stronger. If the industry hunkers down and resists
all meaningful change, it might or might not outlast its critics, for many of
whom the socialization model ala Iowa has a strong appeal.
The market for mortgage insurance works very
much like the market for title insurance, but it is simpler. Mortgage insurance
protects only the lender, there is no analogue to a buyer title policy. Further,
the lender has all the referral power; no other entity involved in the
settlement process has any say in the matter. The remedy is equally
straightforward: lenders should be required to pay for their own mortgage
Copyright Jack Guttentag 2005