Jack M. Guttentag The Mortgage Professor

A reader writes: "The title insurance industry has been in the news recently for a variety of alleged abuses of consumers. Is there something fundamentally wrong with this industry?"

I think there is, but the abuses reported by the media aren’t the problem. The abuses are the consequences of a dysfunctional market. Competition by sellers of title insurance does not benefit consumers the way it is supposed to. When title companies compete, you lose.

Industry Structure

The title insurance industry is structured much like the wholesale/broker segment of the mortgage market. Mortgage brokers find the customers, and do most of the work involved in originating loans. When the work is done, the loan is funded by a wholesale lender at a price that lender had posted with the broker earlier.

Title agencies are the counterpart of the mortgage broker. They operate locally or state-wide, and there are many thousands of them. They find the customers and do all the work involved in creating title policies, including searching title records. When their work is done, the policy is issued by the agent on behalf of one of the title insurance companies.

About two-thirds of all title policies are issued by independent agents, which is about the same market share that mortgage brokers have. The balance is accounted for by branches of insurers or by agencies wholly owned by them.

But there are some important differences between the two markets. Where there are hundreds of wholesale mortgage lenders, five title insurers account for about 90% of the policies. While wholesale mortgage lenders reset mortgage prices every day, title premiums change only occasionally. In most states, title insurance premiums must be posted with the state in accordance with procedures established by state law.

Borrower Innocence and Competition

Few borrowers shop for title insurance, which is a minor part of a larger transaction that commands their attention. In most cases, they wouldn’t know where to shop even if they wanted to. The great majority, therefore, accept the title agency recommended by their Realtor, builder, or lender, who often assure them that all agencies charge the same price.

Competition for clients by title agencies is thus directed not at borrowers but at the Realtors, lenders, and builders who have referral power. If the referrers are independent of the title companies and act in the best interest of their clients, they'll select agencies that offer the best price and service. Sometimes this happens, but all too often referrers use their power to benefit themselves rather than their clients.

Competition directed at referrers who expect to be compensated tends to drive up prices. It is sometimes referred to as "reverse" or "perverse" competition. Compensation paid to referrers is called a referral fee -- but it's really just a kickback.

Kickbacks

Kickbacks in the title insurance market can be illegal, legal -- or shams which purport to be legal but aren’t.

Under the Real Estate Settlement Procedures Act (RESPA), a party who is compensated for referring a customer to a title agency has received an illegal kickback. Illegal kickbacks occur, because it is extremely difficult to police all the ways that one party can provide something of value to another.

A legal kickback is called an "affiliated business arrangement," or ABA. The referring party (a Realtor, for example) and the title agency can form a new title agency owned jointly. The Realtor can make referrals to this new entity, and can profit in proportion to its ownership share. ABAs are costly to create and operate.

A sham is an attempt to legalize kickbacks without incurring all the costs of an ABA. It may have only the façade of an ABA, for example, with the work actually done by another agency. Reinsurance schemes where the referrer receives a portion of the title insurance premium in exchange for assuming some of the insurance risk, have also been deemed shams by regulators.

Government and Kickbacks

At this time, government is doing nothing that would reduce the cost of title insurance. The current policy of HUD (which administers RESPA), and those state regulators who have gotten themselves involved, is to eliminate shams. While the law should be enforced, requiring those with referral power to incur heavy costs in order to legalize their kickbacks won't drive down the price of title insurance.

The high price of title insurance, and the prevalence of kickbacks in the industry, both stem from the fact that mortgage borrowers pay the insurance premiums while others select the title agency. To reduce prices, you have to change that.

Proposal for Lender-Paid Title Insurance

The way to reduce the cost of title insurance (and also mortgage insurance and credit insurance) is to have the federal government mandate a general policy that any insurance that protects only lenders must be paid for by lenders. On any real estate transaction that involves a mortgage, lenders should pay the policy premium on the lender policy, plus related title costs.

If lenders had to pay for title insurance, prices would drop. Instead of millions of buyers a year taking one policy each, there would be thousands, each one purchasing many policies. The buyers would be knowledgeable rather than ignorant; they'd be in the market continuously rather than once or twice; they'd shop alternative sources rather than accept recommendations from interested parties; and they'd have the clout associated with their purchase volume.

Of course, borrowers would pay for the lender policy in the price of the mortgage. The incremental price, however, would be a fraction of what they pay now.

Lender Insurance vs. Borrower Insurance

On mortgage refinance transactions, lenders would pay for lender policies, and borrowers would have the option to buy or not buy title policies that protect them. On home purchases in areas where home buyers purchase their own title insurance, they would have the same option. In both cases, borrowers would have to be persuaded that the incremental protection provided by owners policies are worth the price. This is as it should be.

In some areas, by law or custom, home sellers are obliged to purchase homeowner policies for the buyer. Lender policies are a "simultaneous issue," often priced at a discount. Since home sellers, in selecting a title agency, will continue to be influenced by Realtors, instituting a lender-pay requirement on lender policies may not have much immediate impact on title costs. Hopefully, over time, the evidence of price declines elsewhere will generate pressures to eliminate the practice of having home sellers purchase title policies for buyers.

State Regulation a Partial Barrier

A potential impediment to price declines would be state regulation of title insurance premiums. Such regulation is supposed to protect consumers, which it doesn’t. In some states, it may provide the major title insurers with a convenient way to collude on premiums.

In Texas, New Mexico, and Florida, the state actually sets the premiums. In some others, insurers are allowed to band together to propose premium rates that the state will then approve for all of them. In a third group, each company posts its own premium rates with the state; in some, the state must approve, in others no approval is needed. In all cases, the information is public and available to other insurers.

Resistance to declines in posted insurance premiums will be strong. The title insurance industry is highly concentrated at the insurer level, with the five largest companies writing about 90% of the policies. These companies also have a demonstrated ability to influence state legislatures.

Prices will drop nonetheless. Large lenders probably will negotiate package deals with the major insurers, who will be obliged to reduce their posted prices. Smaller lenders probably will negotiate deals with local agencies, which have cost structures swollen by high marketing expenses, including legal and illegal kickbacks. (On average, agencies retain more than 70% of all title insurance premiums.) Large lenders could also deal with the agencies if the large insurers refuse to drop their posted prices.

Vested Interests in Existing Arrangements

The prospects for legislation that would require lenders to pay for their own title protection depend on the attitudes of the major groups that would be affected by it. In April 2006, the House Committee on Financial Services, chaired by Rep. Michael Oxley (R-Ohio), held hearings on title insurance. The papers prepared for the hearings reveal the attitudes of the various groups with an interest in title insurance.

Mortgage lending groups did not participate in the hearings. However, the likelihood that they would support a legal requirement that they pay for their own title protection is low.

A Voice in the Wilderness

The most interesting testimony at the hearing came from Douglas R. Miller, CEO of one of the few title agencies remaining in Minnesota that is not part of an ABA. His prices are well below those charged by the affiliated companies, but, he stated:

"Service excellence and price are now meaningless in my market. Instead, we have a system that rewards real estate professionals for manipulating their clients into selecting the highest priced title companies. We are stopped at the door at most real estate brokerage houses in town. They have their own "affiliated" title company and don’t want to hear about us ... Consumers are carefully guarded from information about competing title companies, and agents are chastised if they recommend a title company other than their in-house company."

Minnesota may be an outlier in the extent to which ABAs have come to dominate the market. It is the direction toward which other markets are trending, however, with increasing support from HUD.

HUD, a Public Guardian?

HUD is responsible for enforcing RESPA, which means it has the unenviable task of shutting down sham kickback arrangements. But it also has a broader if less well-defined mandate to reduce settlement costs, a goal that is not furthered by the pursuit of sham kickbacks. Most of Mr. Miller’s problems, after all, are caused by ABAs, which generate legal kickbacks.

In the paper submitted for the hearings, HUD referred to a 1980 study that concluded that title insurance was not provided to consumers "at a price which approximates the cost of efficiently providing these services..." And it went on to say that nothing has changed since then. But the major part of the paper is directed to its enforcement efforts directed against sham kickbacks.

HUD simply ignores the lack of congruence between its enforcement obligations, and the policy objective that that enforcement is supposed to further -- but doesn’t. At the conclusion of the paper, instead of informing Congress that the current rules will never reduce settlement costs, it asks for more power to enforce those rules.