PRESS

Volume 6 | Issue 85 | Wednesday, May 02, 2007

Top National News

MBA (5/2/2007) San Nicolas, Silvia

(Silvia San Nicolas is a senior corporate strategist for The Bluebook International, a cost-data services company, where she is responsible for strategic initiatives, marketing, and channel distribution management within the Mortgage and Secondary Markets. Previously, she was with an Olympia Washington Law firm where she was a partner. She has more than 15 years experience in law, insurance, real estate and mortgage banking and lending. She is a graduate of UC Berkeley and Seattle University School of Law, a member of both the California and Washington State Bar, is a licensed broker, and holds the insurance designation of a Senior Claims Law Associate.)

An ounce of prevention could be worth a pound of cure. With most residential loans requiring replacement cost hazard insurance in an amount sufficient to rebuild the improvements in the event of a loss, the question: how much insurance is sufficient is critical to the sufficient transfer of risk to a third-party insurer pursuant to the loan underwriting guidelines? Failure by the lender to ensure sufficiency of coverage directly impacts whether or not the seller has made valid reps and warranties to loan purchasers that underwriting guidelines were met, impedes proper quantification of portfolio exposure for uninsured losses and fails to mitigate weather related risk of loss to collateral through proper insurance.    

Since the early 1990s insurers have shifted the risk of loss to the homeowner and the mortgagee by eliminating the Guaranteed Replacement Cost (GRC) policy and replacing it with its watered down sibling, the Replacement Cost (RC) policy. The RC policy places all risk of insurance sufficiency onto the homeowner and mortgagee (secondary insured) and further penalizes both if coverage is less than 80 percent of what it actually costs to rebuild the home, by triggering a clause in the policy that only requires the insurer to pay actual cast value (the depreciated value of the insurable improvements). This risk shifting has created a national underinsurance problem that remains unresolved and has serious impacts for mortgagees on any residential loans and loan pools.

Industry estimates indicate that more than 58 percent of residential homes remain underinsured by at least 22 percent. Insurers have successfully litigated the industrywide position that the consumer is ultimately responsible for determining how much insurance is necessary to rebuild their home, leaving the insurers free from liability.  Historically, originators have relied on two methods of hazard insurance validation in meeting underwriting guidelines: sole reliance on the insurance binder from the borrower and his agent, or the cost approach in the Uniform Residential

Appraisal Report 1004 or 2055. 
Lenders who defer to the insurer, who in turn offers replacement cost suggestions but relegates liability onto the borrower for the amount of coverage are in effect accepting the borrower’s determination as to the sufficiency of the replacement cost amount of the insurable improvements. This is problematic because the majority of homeowners do not know what it would take to replace their home if a loss occurred.

Studies on consumer awareness and insurance reveal that 85 percent of homeowners do not understand their policy, only 3 percent know if they have replacement cost insurance or not, and 59 percent mistakenly believe the insurance company is responsible for coverage sufficiency. Very concerning is that the majority of consumers still mistakenly believe that their home will be replaced if they have replacement cost coverage. Additionally, homeowners are driven to price-shop and some insurers are motivated to provide lower coverage amounts so they can offer lower premiums to get the business, leaving the homeowner and the mortgagee with insufficient coverage to replace the home in accordance with loan requirements. Lenders who rely on the cost approach cost to replace new field in the URAR are typically no better off. Since the inception of the new forms by Fannie Mae and Freddie Mac, USPAP instructors and Appraiser E & O companies have been diligent about instructing their appraisers to include disclaimers in their reports expressly prohibiting the lender from relying on the cost approach calculations for insurance purposes because doing so increased appraiser exposure to liability. 

The liability issue in part rests not only on ‘scope of work’ issues, but according to an independent survey conducted by Strategic Development Worldwide in September 2006, the majority of appraisers admitted that they either “wing” the calculations in the cost approach or “back into the numbers” so they are consistent with the market value approach indication of value. The survey revealed that the assumed inaccuracy creates risk for appraisers, lenders, investors and borrowers when the cost approach is utilized for hazard insurance purposes.

More than $900 billion of financial risks from catastrophic loss due to weather-related events were set forth in a report by the Government Accountability Office (GAO-07-285) on March 17. The report revealed that the estimated economic losses did not take into account unquantifiable losses from underinsurance or non covered losses. In the report, assessments form the National Academy of Sciences (NAS) and the Intergovernmental Panel and Climate Change (IPCC) reported that the effects of climate change on weather-related events, and by extension, weather-related losses, could be substantial, with climate model projections revealing a likely increase in the frequency and severity of damaging extreme weather related events. 

IPCC reported that it is very likely that hot extremes, heat waves and heavy-precipitation events will become more frequent, noting that typhoons and hurricanes will become more intense, with larger peak wind speeds and heavy precipitation associated with ongoing increases in tropical sea surface temperatures. The report also noted that since 1980, 40 percent of all insured losses were associated with hurricane activity. AIR Worldwide, a leading catastrophe modeling firm, recently reported that insured losses should be expected to double roughly every 10 years because of increases in construction costs, increases in the number of structures and changes in their characteristics due to exposure growth in catastrophe loss.

With the onset of the decline in real estate values, juxtaposed with predicted default levels and solid forecasts of more frequent and severe Katrina-like scenarios, the White Elephant Risk of physical loss to collateral due to non-existent, ineffective or negligent methods of validating or determining and maintaining hazard insurance sufficiency in accordance with loan underwriting guidelines at origination and throughout the life of the loan presents a very real, yet unnecessary exposure that is easily mitigated through sophisticated yet accurate and cost-effective replacement cost web applications such as that offered by Bluebook International (www.bluebook.net). SecureBASE, Bluebook’s web based replacement cost tool for the mortgage industry, enables users to obtain accurate replacement cost values one property at a time, or in thousands at a time in minutes. (A White Paper on the subject is available from Bluebook International.)

How many red flags does it take to justify an ounce of prevention?  Basel II, Reg AB, Sarbanes-Oxley, crazy weather, a declining market and the subprime shakeout collectively mean that ignoring loan requirements designed to transfer the risk of physical loss (White Elephant Risk) to a third-party insurer is not longer an option. It may be the borrower’s loan, but it remains the investor’s collateral. In the case of hazard insurance sufficiency, it is the lender’s fiduciary duty to perform a reasonable level of due diligence in making sure that the risk of loss is sufficiently transferred to a third-party insurer as required by the loan.    

(The views expressed do not necessarily reflect the views or policies of the Mortgage Bankers Association, nor does it connote and endorsement of any product or service. MBA NewsLink welcomes your articles and opinion pieces. Articles or inquiries should be sent to Mike Sorohan, editor, at msorohan@mortgagebankers.org.)