Mortgage Meltdown

Desperate Homeowners May Be Turning To Arson And Insurance Fraud

As more and more Americans fall behind in payments on their mortgages or auto loans, the insurance industry has noted a "dramatic increase" in the number of suspicious home and auto fires, according to a report in the L.A. Times (here). Right now most of the indicators of the increase in arson are anectdotal -- whether a particular fire was arson is difficult and expensive to prove. However, the insurance industry is sufficiently alarmed that it is meeting with California insurance fraud investigators about the problem. The insurers believe there may have been as many as 2,000 homes burned intentionally by homeowners during last fall's wildfires.

In a previous post (here), we highlighted a recent Tennessee Appellate Court opinion where the court held that the insurance company was not required to pay an insurance claim on a house that burned down because the mortgage lender failed to give the insurer notice that it had initiated foreclosure proceedings against the homeowners. The court stated that foreclosure generally increases the risk that the homeowner will intentionally destroy the property for the insurance money; therefore, the foreclosure proceedings trigged the increase of hazard notice requirement in the insurance policy. Although we have not been able to locate other cases adopting the Tennessee court's reasoning (which broke new ground in this area of the law), it seems that the issue could be the subject of additional litigation between mortgage lenders and insurers of homes destroyed by fire while in foreclosure or the threat of foreclosure.

TN Court Requires Bank to Give Insurer Notice of Increased Risk of Arson

In Tennessee, a home in foreclosure burnt down under questionable circumstances (allegedly from an illegal methamphetamine lab operated within the home).  When the bank sought to collect the insurance proceeds, the Tennessee appeals court denied the bank's claim – not because of the suspicious nature of the fire, but because the bank failed to notify the insurance company about the "increased risk" that the homeowner would damage or destroy the home after it initiated foreclosure.

Tennessee, like many jurisdictions, has statutes providing that a homeowner's insurance policy is not cancelled when foreclosure proceedings are initiated.  Instead, the policy will continue and the mortgagee need only give notice to the insurer when there is a change in ownership or occupancy or increase of hazard to the property (emphasis added).  As such, it was generally thought that there is no requirement that the bank or mortgagee give the insurer notice of the foreclosure proceedings. 

This changed in U.S. Bank N.A. v. Tennessee Farmers Mut. Ins. Co., No. W2006-02536-COA-R3-CV, 2007 WL 4463959 (Tenn. Ct. App. Dec. 21, 2007), when the Tennessee court of appeals, going against well-established precedent, found that the initiation of foreclosure proceedings constituted an increase of hazard.  The court noted that:  "Experience has taught insurance companies that, when property owners become financially unable to take care of their secured obligations, or are so neglectful of them that … foreclosure must be resorted to, the likelihood of fire becomes greater." The court reasoned that because foreclosure generally increases the risk that the homeowner will intentionally destroy the property for the insurance money, that the foreclosure proceedings trigged the increase of hazard notice requirement.  Because neither the bank nor the mortgagee notified the insurer of the foreclosure proceedings, the insurer was not required to pay out, even though the fire was not attributed to homeowner arson. 

This decision is a sharp blow to banks whose foreclosure procedures often do not include notice to the mortgagee's insurer, and is a significant departure from established precedent. By creating a broad and nebulous concept of increase of hazard, the Tennessee court has increased the potential financial exposure of many mortgage holders who currently believe they have insurance coverage to protect them against such losses.

Banks and other mortgage holders can reduce the risk of losing coverage by taking such steps as notifying insurance carriers of foreclosure proceedings (easier said than done given that the homeowner may have changed insurers or failed to provide the correct information) and also by pushing the insurers to include an express definition of "increase in hazard" that clarifies the disclosure obligations.  At the very least, banks and other mortgage lenders should educate themselves about these potential problems and look to develop policies that protect their financial interests.

The insurance industry and the subprime crisis

Typical assessments of financial losses from the subprime mortgage crisis focus on Wall Street, banks and other lenders, and the real estate industry.   Another industry which is tallying its potential losses is the insurance industry.  Many different types of insurance can be involved.

Liability insurers

As we have noted previously, errors and omissions (E&O) and directors and officers (D&O) claims arising out of the subprime mortgage litigation crisis could be significant.  A recent study from reinsurance broker firm Guy Carpenter  attempts to estimate the impact and finds that insured claims on D&O policies could be in the range of $1 to $3 billion, with the likely number towards the upper end of that range.  The study finds E&O losses more difficult to estimate, but there exists the possibility that claims against mortgage brokers and real estate agents alone could be in the "hundreds of millions" of dollars.

Mortgage insurers

Mortgage insurance enhances the credit of borrowers by stepping in to make mortgage payments in the event of a default.   As defaults increase, so do the underwriting losses for the mortgage insurers.  Milliman, Inc. actuary Mike Schmitz described the impact of increasing mortgage default rates and declining real estate values on the reserve situations of mortgage insurers:

More specifically, mortgage insurers are on the front lines directly
underwriting the risk of borrowers defaulting on their mortgage loans,
especially on high loan-to-value ratio loans where there are smaller
equity slices for the borrower. This is a big issue when it comes to
mortgage insurers’ liabilities, since these insurers reserve for loans
that are currently delinquent. In other words, their reserves cover
their forecasted costs for defaults on loans that are currently behind
on payments. Because delinquency rates have been rising, insurers have
more loans in their portfolio that require reserves. Decreasing home
prices and the corresponding erosion of home equity will have a
significant impact on the insurers’ losses for current delinquencies.In
the past, insurers could set aside a much smaller portion for reserves
on current delinquencies because many of those delinquencies would
resolve themselves thanks to rising home prices and refinance
opportunities; even if a loan was foreclosed upon, there was enough
equity that the lender was less likely to experience a financial loss
from that default. With home prices coming down, and with the futures
markets forecasting further declines, there is likely to be a
significant change in both the frequencies and severities for loans
covered by mortgage insurers’ reserves. The impact on reserves and loss
payments will negatively impact the profitability of these insurers and
will have important ramifications for their claim settlement practices.
This will be a big issue for insurers during the next couple of years.

Other financial guarantors

Bond insurers are another type of insurance company which faces losses arising out of the current credit crunch.   These insurers offer "credit enhancement" on bonds and other credit products, guaranteeing the payment of principal and interest in the event of a default.   A December 4, 2007 report on  MarketWatch.com describes the efforts of various financial guarantors to address their capital needs in the face of billions of dollars of payments required on outstanding guarantees on structured credit products like collateralized debt obligations.

Title insurers

Bush Nielsen, editor of The Title Insurance Law Newsletter, described the risk to title insurance companies from the subprime mortgage crisis this way:

Title insurers have incurred increases in claim payments, and face an as-yet-incalculable future loss risk, from securitized loan defaults.  Title insurers have loss exposure in certain cases of loan fraud, although typically the lien of the mortgage is valid despite the fraud.  Loan fraud losses have arisen from forged flipping deeds and the duty to defend a lender against claims that the insured mortgage is invalid due to the acts of a loan originator.  Title insurers have also suffered significant losses in bankruptcy court, when the trustee seeks to avoid (void) the insured mortgage as a preference.  A necessary element of such an avoidance claim is that the borrower files the bankruptcy petition within 90 days of the recording of the mortgage.  In that sense, all such actions involve subprime borrowers.  The emerging concern for the land title industry is new theories by borrowers or classes of borrowers that the "securitization" of a mortgage loan is somehow illegal or contrary to the loan terms, and thus the trustee for the bondholders does not have the power to foreclose.  Some courts have entertained such theories very recently.

Property insurers

When homeowners are financially distressed and cannot make mortgage payments and cannot sell a house to get out from under a mortgage, they may turn to desperate means.   An upsurge in arson may be related to the subprime mortgage crisis.  From an article on the website of Insurance Journal:

Insurance fraud investigators are girding for an expected rash of
arsons by cash-strapped homeowners trying to avoid foreclosures and
ballooning monthly payments as the subprime mortgage crisis deepens.

"Home arsons for insurance money by mortgage-burdened owners are
hardly new. The question is whether a new and virulent spike looms,"
says the Coalition Against Insurance Fraud....

Only a few suspected home torchings have surfaced so far. Samuel
White allegedly burned down his Houston home for insurance money to
dodge a scheduled foreclosure. An African-American, he allegedly
spray-painted racial slurs around the interior to make the suspected
crime appear to be a hate crime.

Suspected mortgage-related home arsons already have jumped 50
percent above the 2006 rate in California, though the numbers are still
relatively small, the insurance department says.

Perhaps the proposed federal freeze on ARM adjustments for 5 years will prevent some houses from burning down.

All insurers' potential portfolio losses.   

The financial costs described above all appear on the liability side of insurers' balance sheets.   On the asset side, insurers may also see financial losses from the subprime crisis, depending on the exposure of their portfolio to securities backed by real estate mortgages.  Once again, according to actuary Mike Schmitz:

For general insurers, the decline in [housing prices] affects the
risks on the asset side of their balance sheet. A lot of insurers hold
mortgage-backed securities, which are collateralized by home values;
thus, decreasing home prices put certain strains on the collateral
that's backing those assets, which can lead to market value declines in
such securities.

In all of these sectors of the insurance industry, attempts to "reallocate" the costs to other parties can and will lead to litigation.

Subprime Lending Impacts Insurance Industry

     Insurance companies may soon count themselves among the ever increasing number of parties embroiled in litigation related to subprime lending. While insurers face the risk of loss through subprime backed investments, experts say the greater industry wide risk may lie in large directors' and officers' (D&O) and errors and omissions (E&O) claims on policies.

     Marsh, one of the world's largest insurance brokers, has been warning that financial services companies, including insurers, face an increase in D&O and E&O claims growing out of subprime lending.  Insurance insider, and former AIG head Maurice "Hank" Greenberg, thinks that the industry's greatest exposure may lie in the D&O and E&O claims that will accompany this type of financial crisis. When lenders and hedge funds can't pay on subprime loans and related litigation, they will turn to their E&O and D&O carriers for relief.  This in turn will require that coverage related issues be litigated. Certain coverage related issues are likely to arise.

     On the most basic level, D&O and E&O policies are designed to cover different people and claims. While often lumped together for discussion purposes, an up front analysis of whether coverage is sought under the right policy is essential. For instance, D&O policies often exclude coverage for "rendering of professional services," while E&O policies may not.

     Both D&O and E&O policies are written on a "claims made" basis, meaning that they only cover "claims" made within the policy period itself. The question of when a "claim" is made,  hinges on the definition of "claim" within the policy though. It is important to note that a "claim" is always defined broadly, and often requires little more than notice that a claimant is unhappy. Careful evaluation of that policy term and the surrounding facts of a claim are essential, given that these policies also require timely notice of claims. If a subprime related "claim," has been made against an insured, and timely notice of the claim was not given to the insurer, coverage may be denied.

     Given that subprime related lawsuits against insureds will likely involve accusations of misrepresentation, fraud, and other intentional acts, policy exclusions for that type of behavior will also need to be closely examined. Fraud related exclusions can vary from policy to policy, with some excluding for "actual fraud," others for "fraud in fact," and still others for a "determination of fraud." Having a full understanding of the meaning of these terms within the jurisdiction where coverage is being sought will be crucial in litigation of subprime related coverage issues.