What is Mortgage Impairment Insurance
Make sure you’re protecting the balance sheet against mortgage origination and servicing oversights (for all real property secured notes). HUB Financial Services answers the most frequently asked questions about loan portfolio risk, origination / operational risk and secondary market compliance.
We are often asked “What is mortgage impairment insurance and why do we need it?” In this article, we’ll explain the what and why of this specific type of insurance along with answering some common FAQs.
Mortgage Impairment Insurance (MI) is a hybrid (first party property and third party liability) coverage that protects financial institutions from losses emanating from mortgage origination, ownership and servicing operations.
Mortgage impairment insurance coverage is also referred to as Mortgagee Protection Policy, Mortgageholders Errors and Omissions Coverage and Mortgage Protection Insurance.
To minimize the risk associated with originating, selling, and servicing Mortgage Impairment insurance stands behind financial institutions to protect the lender’s or servicer’s interest should certain situations occur. Knowing which type to secure and what’s best for the portfolio of mortgages your institution holds or services is where it gets tricky.
FAQ #1: Which type of Mortgage Impairment insurance do you need? Narrow Form vs. Broad Form – What’s the difference?
Mortgage Impairment insurance, or mortgagee errors and omissions (E&O) coverage, generally comes in two forms. Narrow Form coverage is mortgagee E&O in its most basic form. It’s what financial institutions are required to have in order to comply with secondary markets regulations (and certain safety and soundness issues) and will cover a limited set of situations.
Broad Form is significantly enhanced mortgagee E&O coverage. The Broad Form coverage is effectively two types of insurance married together:
1. Extra E&O. Covers lenders for certain servicing-related operation failures resulting in demands from third parties.
2. Balance of perils. Covers lender’s loss from perils NOT required of a borrower that are not excluded by the mortgage impairment insurance policy. For example, a house destroyed by an earthquake when the borrower was not required to carry earthquake insurance.
Secondary Market mortgage impairment insurance requirements are based on a sliding scale that directly correlates to the size of a financial institution’s portfolio of owned and serviced mortgages. Keep in mind these requirements are a bare minimum and may not provide adequate coverage for a big claim or multiple claims in one calendar year. These calculations can be found in the agency guides.
Community banks and credit unions will sometimes carry Narrow Form coverage, but limits are often inadequate when it comes to backing the complete scope of a financial institution’s properties. For financial institutions concerned about risk management, a Broad Form policy with one or both endorsements will provide the most complete coverage possible.
FAQ #2: How should you buy your Mortgage Impairment insurance coverage? Should you choose stand-alone vs. packaged – What’s the difference?
Stand-alone Mortgage Impairment insurance coverage, in Narrow or Broad Form, can be independently negotiated to meet the needs of any financial institution, including desired premiums, limits and endorsements.
Lenders might also consider packaged Mortgage E&O insurance coverage, which will come in one of two forms: a Financial Institution Bond (FIB) that bundles mortgagee E&O as well as bond coverage. A packaged policy will feature mortgagee E&O coverage attached to the master property policy, which in of itself has benefits and drawbacks.
FAQ #3: What is First Party Property Coverage – Mortgagee Interest – Section A.1. under Lloyds forms?
The primary purpose of the first party mortgage impairment insurance coverage is to protect the owner of the mortgage, in the event the collateral is damaged and there is no insurance to repair or replace the building.
In the event of a significant uninsured loss, the borrower is likely to discontinue making their monthly mortgage payments. If the mortgage goes into default, the owner of the mortgage has the right to foreclose on the property and sell it to recover their outstanding mortgage balance.
If however, there is damage to the property, the value of the collateral may not be adequate to pay off the mortgage balance. In this case, the MI policy would compensate the owner of the mortgage for the difference between the outstanding mortgage balance and the proceeds of the sale of the property.
This first party section of the MI policy protects the insured’s interest in mortgaged properties provided:
- there is direct physical damage to a mortgaged property, caused by a required peril;
- the required insurance is not if force; and
- the borrower does not make the mortgage payment on the due date.
The insured’s mortgagee interest consists primarily of the outstanding mortgage balance as of the date of the physical damage to the mortgaged property.
Most MI policies include the following conditions:
- The insured must require that the borrower obtain, and maintain for the duration of the mortgage, hazard insurance on the mortgaged property.
- The insured must verify the existence of the insurance at origination and also verify that they are listed as mortgagee on the borrower’s hazard insurance policy.
- If the insured becomes aware that the required insurance has been, or is about to be cancelled, they are required to obtain replacement coverage within 90 days.
The insured usually becomes aware that the borrower’s insurance has been cancelled, because of the mortgage clause on the borrower’s insurance policy.
This clause requires the insurer of the mortgaged property to notify the mortgagee in the event coverage is canceled or non-renewed by the insurer.
Once the insured (lender) becomes aware that the required coverage has been or is about to be cancelled, they are required to contact the borrower to obtain evidence that the coverage has been placed with another insurer.
If the borrower does not provide information that the coverage has been replaced, the terms of the mortgage document allow the lender to obtain force placed coverage (which typically protects only the interest of the lender) and charge the premium for the coverage back to the borrower.
FAQ #4: What is Third Party Liability Coverage – Mortgagee’s Error and Omissions or Mortgagee Liability – Section A.2. and B.1., 3. and 4. under Lloyds forms?
Most Mortgage Impairment policies also contain a third party liability component that pays on behalf of the insured, those sums they are legally obligated to pay resulting from:
- the failure of the insured to purchase or maintain insurance for the benefit of the borrower;
- the failure to pay real estate taxes on behalf of the borrower; and
- the failure to accurately determine whether or not a mortgaged property is located in a Special Flood Hazard Area.
- the failure to maintain FHA, VA or private mortgage insurance on the mortgaged property.
The first two items above, usually result from the insured’s escrow operations. While escrowing for insurance and real estate taxes increases the likelihood that these payments will be made, this activity also increases the insured’s obligations and exposure to a claim from one of its borrowers.
Many MI policies also include optional third party liability coverages such as:
- Mortgage life and disability errors and omissions ;
- Title insurance errors and omissions; and
- Custodial errors and omissions.
Consistent with most other third party liability coverages, MI policies also include defense costs.
Some policies include these costs within the policy limits and others provide defense costs in addition to the limit of insurance.
FAQ #5: What is Physical Loss or Damage from “Balance of Perils” – Section C under Lloyds forms?
This section of the policy is another First Party coverage. It protects the insured’s mortgagee interest from damage to mortgaged property from perils not required in the mortgage document.
For example, the standard residential mortgage document requires the borrower to maintain fire and extended coverage on the mortgaged property.
(If the mortgaged property is located in a Special Flood Hazard Area, the borrower will also be required to maintain flood insurance on the policy.)
If the mortgaged property is damaged by an earthquake, flood (if the property is not located in a SFHA) or other “non-required” peril that results in a default by the borrower, then this section of the MI policy will compensate the insured for its loss of mortgagee interest.
FAQ #6: What is Foreclosed Property Coverage?
One of the most valuable extensions of most mortgage impairment insurance policies is the Newly Acquired Property coverage.
This coverage extension, provides primary property coverage, for up to 90 days, on properties that the insured acquires through foreclosure.
The intent of this coverage is to temporarily protect the insured’s insurable interest in these properties until they can be sold or insured separately.
FAQ #7: What is Mortgage Servicing – Secondary Mortgage Markets?
A large percentage of all residential mortgages are sold, by the originating financial institution (FI), to secondary mortgage markets.
The largest secondary markets are Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac).
These entities were established by the government to make financing of residential properties easier to obtain and to make housing more affordable to Americans.
Many FI’s originate mortgages with the intention of selling the mortgages to the above markets, but retain the responsibility (and corresponding fee income) for servicing of the mortgage.
Mortgage servicing typically involves:
- accepting and disbursing the monthly mortgage payments;
- escrowing and disbursing funds for insurance premiums and real estate taxes;
- verifying the maintenance of the required insurance coverages; and
- foreclosing on properties on which payments become delinquent.
Also, many of the FHA and VA mortgages are guaranteed by the General National Mortgage Association (Ginnie Mae).
To assure that the interest of the mortgage owners (secondary markets) is protected; Ginnie Mae, Fannie Mae and Freddie Mac all have mortgage servicing guidelines that require the FI to purchase the above stated Mortgage Errors and Omissions coverage and for the policy to include the following coverage extensions:
- Coverage is extended to include the owner of the mortgage as well as the mortgage servicer;
- loss payments are to be made payable jointly to the insured and the owner of the mortgage;
- the owner of the mortgage has a right to file a claim under the MI policy if the insured chooses not to; and
- the owner of the mortgage is to receive at least 30 days advance notice if the mortgage impairment insurance coverage is canceled, non-renewed or substantially restricted.
Some of the secondary market requirements place a significant burden on the MI insurer or broker.
Coverage for these requirements, dealing primarily with notification provisions, is not readily available from many of the MI insurers.
As a result, total compliance with all the secondary market’s requirements has become an issue of much debate within the mortgage industry.
FAQ #8: How does a financial institution choose the right mortgage impairment insurance?
Base your decision as to which Mortgage Impairment insurance coverage is best for your business on a thorough analysis of your portfolio, systemic risk, origination/servicing operations and risk tolerance. Working with a broker to analyze these key data points will both get you to the right policy and will provide your risk manager with a road map of how the decision was made and why.
This analysis will serve you beyond your institution’s initial purchase, as a backup should the risk manager be called upon to support the financial institution’s decision.
FAQ #9: Who can help us find the right coverage we need?
Contact your HUB Financial Institutions specialist for more information about safeguarding your institution and assessing your options for mortgage impairment insurance.
Conclusion
How do you ensure that the value of the loan is protected when your customer doesn’t secure the appropriate coverage? Or, that your borrower insurance tracking operations are protected against mistakes? For example:
A homeowner cancels their insurance policy days before their home burns to the ground in a fire. A commercial borrower on the coast inadvertently fails to secure flood or wind coverage before a major hurricane hits. You fail to properly advance borrower insurance escrow payments resulting in a borrower’s policy being cancelled right before they suffer a physical damage loss. And the worst of it…. your financial institution holds the mortgages and servicing rights.
Inevitably, borrower oversights and internal servicing errors or omissions can lead to lender risk, some which might not be covered by lender placed automatic coverage provisions.
For these missteps and more mortgage lender risks, there is Mortgage Impairment insurance (MI).