We are often asked “What is mortgage impairment insurance and why do we need it?” In this article, we’ll explain the what and why of this specific type of insurance.
Mortgage Impairment (MI) is a hybrid (first party property and third party liability) coverage that protects financial institutions from losses emanating from mortgage origination, ownership and servicing operations.
This coverage is also referred to as Mortgagee Protection Policy, Mortgageholders Errors and Omissions Coverage and Mortgage Protection Insurance.
First Party Property Coverage - Mortgagee Interest – Section A.1. under Lloyds forms
The primary purpose of the first party MI coverage is to protect the owner of the mortgage, in the event the collateral is damaged and there is no insurance to repair or replace the building.
In the event of a significant uninsured loss, the borrower is likely to discontinue making their monthly mortgage payments. If the mortgage goes into default, the owner of the mortgage has the right to foreclose on the property and sell it to recover their outstanding mortgage balance.
If however, there is damage to the property, the value of the collateral may not be adequate to pay off the mortgage balance. In this case, the MI policy would compensate the owner of the mortgage for the difference between the outstanding mortgage balance and the proceeds of the sale of the property.
This first party section of the MI policy protects the insured’s interest in mortgaged properties provided:
- there is direct physical damage to a mortgaged property, caused by a required peril;
- the required insurance is not if force; and
- the borrower does not make the mortgage payment on the due date.
The insured’s mortgagee interest consists primarily of the outstanding mortgage balance as of the date of the physical damage to the mortgaged property.
Most MI policies include the following conditions:
- The insured must require that the borrower obtain, and maintain for the duration of the mortgage, hazard insurance on the mortgaged property.
- The insured must verify the existence of the insurance at origination and also verify that they are listed as mortgagee on the borrower’s hazard insurance policy.
- If the insured becomes aware that the required insurance has been, or is about to be cancelled, they are required to obtain replacement coverage within 90 days.
The insured usually becomes aware that the borrower’s insurance has been cancelled, because of the mortgage clause on the borrower’s insurance policy.
This clause requires the insurer of the mortgaged property to notify the mortgagee in the event coverage is canceled or non-renewed by the insurer.
Once the insured (lender) becomes aware that the required coverage has been or is about to be cancelled, they are required to contact the borrower to obtain evidence that the coverage has been placed with another insurer.
If the borrower does not provide information that the coverage has been replaced, the terms of the mortgage document allow the lender to obtain force placed coverage (which typically protects only the interest of the lender) and charge the premium for the coverage back to the borrower.
Third Party Liability Coverage – Mortgagee’s Error and Omissions or Mortgagee Liability – Section A.2. and B.1., 3. and 4. under Lloyds forms
Most Mortgage Impairment policies also contain a third party liability component that pays on behalf of the insured, those sums they are legally obligated to pay resulting from:
- the failure of the insured to purchase or maintain insurance for the benefit of the borrower;
- the failure to pay real estate taxes on behalf of the borrower; and
- the failure to accurately determine whether or not a mortgaged property is located in a Special Flood Hazard Area.
- the failure to maintain FHA, VA or private mortgage insurance on the mortgaged property.
The first two items above, usually result from the insured’s escrow operations. While escrowing for insurance and real estate taxes increases the likelihood that these payments will be made, this activity also increases the insured’s obligations and exposure to a claim from one of its borrowers.
Many MI policies also include optional third party liability coverages such as:
- Mortgage life and disability errors and omissions ;
- Title insurance errors and omissions; and
- Custodial errors and omissions.
Consistent with most other third party liability coverages, MI policies also include defense costs.
Some policies include these costs within the policy limits and others provide defense costs in addition to the limit of insurance.
Physical Loss or Damage from “Balance of Perils” – Section C under Lloyds forms
This section of the policy is another First Party coverage. It protects the insured’s mortgagee interest from damage to mortgaged property from perils not required in the mortgage document.
For example, the standard residential mortgage document requires the borrower to maintain fire and extended coverage on the mortgaged property.
(If the mortgaged property is located in a Special Flood Hazard Area, the borrower will also be required to maintain flood insurance on the policy.)
If the mortgaged property is damaged by an earthquake, flood (if the property is not located in a SFHA) or other “non-required” peril that results in a default by the borrower, then this section of the MI policy will compensate the insured for its loss of mortgagee interest.
Foreclosed Property Coverage
One of the most valuable extensions of most MI policies is the Newly Acquired Property coverage.
This coverage extension, provides primary property coverage, for up to 90 days, on properties that the insured acquires through foreclosure.
The intent of this coverage is to temporarily protect the insured’s insurable interest in these properties until they can be sold or insured separately.
Mortgage Servicing – Secondary Mortgage Markets
A large percentage of all residential mortgages are sold, by the originating financial institution (FI), to secondary mortgage markets.
The largest secondary markets are Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac).
These entities were established by the government to make financing of residential properties easier to obtain and to make housing more affordable to Americans.
Many FI’s originate mortgages with the intention of selling the mortgages to the above markets, but retain the responsibility (and corresponding fee income) for servicing of the mortgage.
Mortgage servicing typically involves:
- accepting and disbursing the monthly mortgage payments;
- escrowing and disbursing funds for insurance premiums and real estate taxes;
- verifying the maintenance of the required insurance coverages; and
- foreclosing on properties on which payments become delinquent.
Also, many of the FHA and VA mortgages are guaranteed by the General National Mortgage Association (Ginnie Mae).
To assure that the interest of the mortgage owners (secondary markets) is protected; Ginnie Mae, Fannie Mae and Freddie Mac all have mortgage servicing guidelines that require the FI to purchase the above stated Mortgage Errors and Omissions coverage and for the policy to include the following coverage extensions:
- Coverage is extended to include the owner of the mortgage as well as the mortgage servicer;
- loss payments are to be made payable jointly to the insured and the owner of the mortgage;
- the owner of the mortgage has a right to file a claim under the MI policy if the insured chooses not to; and
- the owner of the mortgage is to receive at least 30 days advance notice if the MI coverage is canceled, non-renewed or substantially restricted.
Some of the secondary market requirements place a significant burden on the MI insurer or broker.
Coverage for these requirements, dealing primarily with notification provisions, is not readily available from many of the MI insurers.
As a result, total compliance with all the secondary market’s requirements has become an issue of much debate within the mortgage industry.
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