Defending Force-Placed Insurance – Part II: How FPI is Supposed to Work

Originally Published - Jun 28, 2012

In the first part of this series we introduced the concept of collateral risk using my Bluefin fishing example.  In this Part, we are going to get into the history of force-placed insurance which will lead up to the mess our industry is in today.

First, let’s finish the Bluefin fishing story to help us understand the way force-placed insurance is supposed to work.  If you recall from Part I, I had forgotten to renew the insurance on my boat.  The boat was destroyed by a whale and sank while I was uninsured.  

What happened behind the scenes was that my insurance company had sent me a renewal notice 20 days prior to my expiration that I never read.  They also sent my bank a similar lienholder renewal notice since they were listed as lienholder on my insurance policy.  When I failed to renew my insurance, my insurance company sent both my bank and I cancellation notices.
  
Although I didn’t open my mail, my bank did, and they promptly issued force-placed insurance to protect the collateral.  When they did this, I was sent the first of 3 notifications of the force-placed insurance….that letter never got read, just like the other insurance notices I received.

On the day after my boat sinking, once I realized that I didn’t have insurance, I made a call to my bank to inform them of the bad news.  I was still on the fence as to whether I would continue to pay the loan…..I knew very well that I still owed the money….

My bank informed me that they had force placed a limited dual interest policy on my boat and that the loan balance on my boat loan would be paid by the insurance.  I was thrilled.  What a pleasant surprise that my loan balance was paid off.  I lost a little bit of equity in the boat, but all in all I was still alive and didn’t have to keep paying the bank.

This is how force-placed insurance is supposed to work.  The lender is insured for the outstanding loan balance.  Because the insurance claim paid the bank, my outstanding loan balance was paid and I didn’t owe them any money.  We’ll get into more detail about the mechanics of forced placed insurance in the next section.

Force-placed insurance is not something new.  This collateral risk transfer technique has been around for some time protecting collateral in mortgage and auto portfolios.  It was widely used with consumer auto portfolios in the late 80’s and early 90’s and was known as collateral protection insurance (CPI).

The way CPI works is as follows:

1. The borrower agrees to maintain insurance as part of the promissory note at loan    origination.
2. The lender is listed as lienholder on the borrower's auto policy
3. The lender tracks the borrower insurance notices to make sure the collateral has insurance
4. If the borrower’s insurance lapses:
a. The lender force places insurance to protect their interest in the collateral
b. There is no liability coverage for the lender or the borrower, since the borrower, not the bank, has title to the collateral
c. The force-placed policy may be single interest or limited dual interest
i. Single Interest:  Coverage only applies to the lender if the loan is impaired after repossession
ii. Limited Dual Interest:  Coverage extends to the borrower while the collateral is in their possession.
d. Any claim will be settled as the lesser of:
i. Outstanding loan balance
ii. Actual cash value of the vehicle if totaled
iii. Damage amount on the vehicle
 

When the lender force places insurance on collateral, they are obligated to pay the premium to the insurance company regardless of how they collect this same premium from the borrower.  It became common practice in the late 80’s to bill the borrowers for the premium by placing a balloon note at the end of the loan term, or by simply extending the term of the loan to pay for the force-placed premium.

This all came to an end in Alabama in 1991.  A borrower who had paid their loan as agreed went to the bank to get the title to their car.  When they asked for the title, the bank clerk responded that they were unable to release the title because there was still a balance of over $4,000 for force-placed insurance.  The borrower had no idea that force-placed insurance was in effect.   The borrower went across the street to their lawyer and this started a series of class action law suits resulting in dozens of settlements totaling over $100 million during the next 4 years.

During the height of these lawsuits, the National Association of Insurance Commissioners convened to create the Creditor-Placed Insurance Model Act which was published on July 8, 1996.  This model act created the first guidance document for forced placed insurance.  The guidance centered around 7 topics:
 

1. Created separation between the creditors and the insurers
2. Forbid balloon payments or extending loan terms to pay insurance premium
3. Created a borrower notification process
4. Limited the force-placed policy term to 1 year
5. Premium refunds had to be processed in 60 days
6. Set underwriting targets designed to a 60% loss ratio
7. Rebates to creditors were not allowed.
 

The force-placed industry adopted this act on auto portfolios and began to rebuild the CPI product over the next 5 years, but this guidance was never widely adopted on mortgage portfolios.

With guidance available from the NAIC Model Act, where did the industry veer off track?  That answer begins in 1996, coincidentally the same year that the Model Act was adopted.  In that year, banks began to get involved in the insurance business.  The Supreme Court decision Barnett Bank v. Nelson concluded that state regulation could not unreasonably interfere with the insurance activities of banks.  Banks getting involved with insurance activities were further strengthened 5 years later with the passage of the Gramm-Leach-Bliley Financial Services Modernization Act which further expanded the bank’s ability to provide insurance.

So the table was set.  Force-placed insurance for mortgage portfolios could have adopted guidance from the NAIC Model Act, but the industry as a whole chose to ignore this guidance.
  

• Separation between creditors and insurers was blurred with passage of the G-L-B Act.
• Borrower notification cycles were at times implemented, but not in a consistent basis.
• Premium refunds to borrowers were not completed on a timely basis.
• The 60% targeted loss ratio was not implemented.
 

Each of these issues by themselves may have been regulated successfully by industry competition, but the straw that broke the camel’s back was that the industry did not follow the guidance regarding prohibiting rebates to creditors.

In the next part, we will attempt to understand why forced placed insurance transformed from a tried and true collateral risk management tool to a fee income product that spread like cancer through the largest banks in our industry.

Jim Gilpin is a principal and EVP of Miniter Group, who is a provider of collateral risk management solutions to the lending industry.  In 2007, Miniter introduced borrower-centric insurance tracking for forced placed insurance.  To learn more about Borrower-Centric Insurance Tracking, visit Miniter’s informative website at www.miniter.com and follow Jim on twitter at @JimGilpin