March 9, 1999, Reviewed November 29, 2007

Competition in the market for mortgage insurance is perverse, in that it is not directed at the borrowers who buy the insurance. Rather, it is directed at the lenders who select the insurer, which has the effect of raising costs to the insurer and premiums to the borrower.

"I realize that since I don't have the cash to make a 20% down payment, I must purchase mortgage insurance, but I was flabbergasted to discover that I couldn't shop for it. The loan officer said that the lender selected the insurer, and it didn't matter anyway because all the mortgage insurance companies charged the same insurance premiums. Is that right? Is there no competition in this market?"

The loan officer is largely right on the futility of shopping for mortgage insurance. While you could insist on selecting the insurer, there isn't much point to it because the premiums charged by different companies are either identical or so close that the difference wouldn't pay you for the trouble.

Competition in the Mortgage insurance Market Is Perverse

There is competition in the mortgage insurance market, but it is the kind that raises prices rather than reducing them. Some economists call this "perverse competition".

Perverse competition arises in markets where the consumer purchasing a big-ticket item from A must also purchase a smaller item from B, C or D, and A is in a position to direct or refer the buyer to one of them. Since B, C and D can get access to the consumer only through A, they compete among themselves for A's favor in ways that raise their costs, and hence prices to the consumer.

This is exactly how the mortgage insurance industry works. (It also describes the title insurance industry, see Is Title Insurance Overpriced?). The consumer pays for the insurance, but ordinarily has no direct contact with the insurer. All merchandising by the insurers is directed toward lenders. So long as they can't be accused of steering their customers to an insurer that charges more than another insurer, lenders are largely indifferent to the price charged the consumer. Their goal is to profit from their strategic position as a referral source. Competition by the insurers for referrals of business generates benefits for lenders, not consumers.

Referrals to Mortgage Insurers

Lenders are not paid directly for referrals of mortgage insurance business. Under The Real Estate Settlement Procedures Act of 1974 ("RESPA"), referral fees are illegal. But there is more than one way to skin a cat. Mortgage insurers have always provided services of one sort or another to lender-customers, free or at bargain prices. In recent years, an increasing number of lenders have established captive mortgage reinsurance affiliates which have no other purpose but legitimizing referral fees. "Performance notes" sold by insurers to lenders that carry very attractive yields (15% or higher) serve the same purpose.

The Department of Housing and Urban Development (HUD), which must administer RESPA, has set up elaborate rules regarding both of these devices that lenders must follow to avoid violating the law. These rules don't help the consumer. On the contrary, they legitimize the practice of concealing referral fees, while raising the cost of receiving them. So long as consumers are the ones paying for mortgage insurance, they probably would be better served if referral fees were legal and open for all the world to see, and lenders were not forced to incur significant expense to collect them. For elaboration of this argument, see Questions About Mortgage Referral Fees.

Reducing Mortgage Insurance Premiums

But the best remedy by far is to eliminate perverse competition by requiring that mortgage insurance be paid for by the lender. This rule would immediately drive down mortgage insurance premiums, since insurers would then be obliged to compete in terms of premiums rather than referral fees. It would eliminate the costly charade of converting referral fees into something that doesn't look like a referral fee. And it would end the contentious issue of when, and under what circumstances, consumers can cancel their mortgage insurance. If lenders buy the insurance, cancellation becomes an issue between the lender and the insurer, which is where it belongs.

To be sure, if lenders buy the mortgage insurance, they will pass on the cost to consumers in the rate, but that's OK. The premiums added to the rate will be lower, and borrowers can shop for rates. Furthermore, the rate increase that the lender tacks on to cover the cost of insurance is deductible to the borrower, where a mortgage insurance premium paid by the borrower is not. In contrast to most "pro-consumer" rules in the home loan market, which raise costs to lenders but accomplish little else, this rule would confer immediate and measurable benefits.