Is Title Insurance Over-Priced?
March 21, 2005, Revised December 18, 2007
Title companies must compete for the favor of the builders, brokers and lenders who can refer clients to them, which leads to heavy referral costs. The solution is not trying to enforce RESPA rules against payment of referral fees, but elimination of referral power by requiring the referrer to purchase the policy.
"I recently read that some of the large title insurance companies in Colorado 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, is just the tip of the iceberg. Referral fees are pervasive in this industry.
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 of it.
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. See Questions About Referral Fees.
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.
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, as they did in 2007. 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.
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 the policy.
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 prevent it.
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 insurance. See Why Do Borrowers Pay For Mortgage Insurance?
Title companies must compete for the favor of the builders, brokers and lenders who can refer clients to them, which leads to heavy referral costs. The solution is not trying to enforce RESPA rules against payment of referral fees, but elimination of referral power by requiring the referrer to purchase the policy.
Title Insurance Fees Paid by Borrowers Include Referral Costs
"I recently read that some of the large title insurance companies in Colorado 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, is just the tip of the iceberg. Referral fees are pervasive in this industry.
Why Title 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 of it.
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. See Questions About Referral Fees.
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.
Reinsurance 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, as they did in 2007. 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.
RESPA Enforcement Is Uneven
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.
A Market-Based Solution
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 the policy.
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 prevent it.
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 insurance. See Why Do Borrowers Pay For Mortgage Insurance?