For Your Consideration

Look, before we begin understand that a homeowner’s policy is a complex document. Remember, an insurance policy is a legally binding contract, so of course, it’s complex and not easy to read. It’s designed that way.

And just so we’re clear, I’m not your agent and I have no idea your particular coverage or circumstance. But writing the post just prior to this one got me thinking: Many people who bought their homeowners coverage in the last 48 months are in all likelihood paying for coverage they’ll never get to use - but think they will. Here’s the skinny, but a point of clarification first:

One of the coverages included in your homeowners policy covers the “dwelling”. In fact, in all probability, your policy declarations page will show just that: “Dwelling” and then a dollar amount indicating the limit of coverage purchased/provided. Assuming you bought replacement cost coverage (you *did* buy replacement cost coverage, didn’t you?), this limit is there (in the best cases) to accurately and adequately reflect the cost to replace the “dwelling” (or “structure”) of the home in the event of a total loss.

In many cases over the last four years, however, people had been forced by their lender(s) to purchase a dwelling limit in an amount that equaled the purchase price of the home. This amount has no bearing to the amount of coverage available under the policy. You see, the “fine print” of most homeowners policies states that the insurance company will pay the dwelling limit amount shown on the policy, but only up to the actual loss sustained! Let’s look at a brief example to help illustrate:

A hypothetical NY/NJ metro single family home, 2000 sf, owner-occupied, would currently have a dwelling replacement value of about $250,000 to $350,000 (anywhere between $125 - $175 per square foot depending on age and build quality). Let’s split the difference and go with $300,000 replacement value. The market value (pre-August 2007) of this home is: $650,000.

Here’s where the lenders missed a turn in the road and their borrowers are paying for it: The policy dwelling limit should reflect $300,000 and not $650,000, even though the mortgage amount is greater than $300,000! (It’s probably around $585,000, assuming a 10% down payment). Because the premium on a homeowners policy is based in large part on the dwelling limit, the homeowner is paying about TWICE what he should because he/she was forced into buying a $650,000 dwelling limit instead of $300,000.

AN IMPORTANT POINT: a homeowners insurance policy does not pay off the mortgage in the event of a loss- it pays the replacement value of the home ONLY, irrespective of your mortgage amount! So, don’t bother torching the home, it won’t pay off your mortgage unless the mortgage amount is LESS than the replacement value of the home - then you’ll get what’s left over after the mortgage is paid.

If you think about it (and who does, unless you’ve got much too much time on your hands), this all makes sense. You don’t want the value of the land to be included in the dwelling limit, that’s just silly. Remember, the land will still be there, even if the home isn’t. It’s doubly silly when I tell you of another “fine point” you’ll find in most homeowners policies… “Land” is EXCLUDED from coverage! Ah, those insurance company types.

In my years as a retail insurance agent, I can’t tell you how many times a lender strong-armed the borrower to insure the property to the purchase price (or at the very least, the mortgage amount). They simply would not fund the loan unless this was done. Well, times are a little tougher for the lenders these days and you just might be able to get them to see it “your way” now.

Talk to your agent and see if you can reduce your cost of insurance today.

This is great quote. Read it and just let it sink in for a moment….

“The entire real estate debacle is the fault of everybody that was involved. And it was all about greed and speed,” said Rachel Dollar, a Santa Rosa attorney who represents lenders in fraud and other cases. “The brokers wanted their commission. The lenders wanted their premiums. The borrowers wanted their homes.”

(Emphasis added by me). The direct source of the quote.

I love the way Ms. Dollar (sometimes this stuff just writes itself!) uses the word “everybody”…. Let me add some more people who need to be included in the “everybody” category…

• Real estate attorneys received payment for their closings;
• Newspapers received increased real estate advertising revenue;
• Home appraisers received payment for their (ahem) valuation reports;
• Home inspectors received payment for their services;
• Homeowners insurance companies received premiums (and still continue to get paid) based on inflated real estate values (which were required by the lender to fund the loan);
• We can add insurance agents/brokers to the line above as commissions in large part are based on the gross premium paid by the homeowner;
• Many local and state governments benefited (and continue to benefit) from inflated real estate values;

I could go on, but you get the point. In short, it’s turned out to be a big turd sandwich in which we will all now have to take a bite.

Almost every investor has a money market account (MMA) or a bond fund. Almost everyone knows these accounts are not ordinary bank accounts and thus are not insured by the FDIC. Of course, FDIC “insurance” is a bit of a canard, as there is nowhere near enough money in reserves to pay everyone who has an FDIC insured account in the event of a sufficiently large enough U.S. banking crisis.

What most people are blissfully unaware of is that a MMA is essentially a very short term bond fund. A bond is essentially a “promise to pay” a certain sum tomorrow (over time) for a certain sum today. There are many websites that explain bond funds in hyper detail (go here for a great primer) - this is the most stripped down explanation I could think of! Bonds can be offered by many entities (corporations/governments, etc.) and are used for many purposes (capital expenditures/cash flow/reserves, etc). “Short term” refers to what is essentially a bond’s duration (which is essentially it’s “repayment period”). The duration of a MMA is usually less than 1 year. Short term bond fund duration as of this writing is about 2 years. Intermediate term bond fund duration is about 5-7 years and long term bond fund duration is 7+ to 3o years.

Let’s consider ABC Company, which needs money to manufacture a new plant. It decides to sell bonds (backed by its ability to repay) to meet its needs. It becomes the bond’s “issuer”. It will pay the bond owner interest for the use of the bond owner’s money today over the duration of the bond. But consider that ABC Company is not in the best of financial shape and would have to pay an interest rate much higher to attract an investor (who is concerned with ABC Co’s ability repay its debt, which is commonly referred to as “default risk”).

So ABC Company decides to pay to have its bonds insured with a monoline bond insurer for a fee, essentially “lending” its own credit rating to ABC Company’s bonds. Without the bond insurance, ABC would (in this hypothetical example) have to pay 8% interest on its bonds, but now that the bonds are “insured”, an investor might only be able to get 5% interest from ABC Co. since the risk of default is (allegedly) far less. ABC Company “pockets” the 3% difference, less the cost of the fee to the bond insurer.

So far, everybody’s happy, right?

• ABC Company is happy, it’s paying 5% interest instead of 8%;
• The investor is happy because the bond is “guaranteed” by a triple AAA rated bond insurer; and
• The bond insurer is happy because it charged and collected the bond insurance premium.

So what happens when the bond insurer goes belly-up? It’s a reasonable question these days and while it hasn’t happened (yet) don’t mistake the improbable for the impossible.

You see, the bond insurers have taken a bite of the sub-prime mortgage mess and the losses in this market segment may cause these insurers to lose their AAA rated credit status and even worse, may bankrupt them.

So in answer to my own question, very bad things would happen. Existing bonds would lose their insured status. New bonds would not be able to become insured, increasing borrowing costs for issuers.  Investors would, in many cases, lose money (principal)  on existing bonds that go into default. The shockwaves are so vast that it’s difficult to get your head around it. Our economy relies so heavily on credit that almost every industry will be effected by this in one way shape or form. Of course, as businesses are negatively impacted, employment will be as well.

The best primer I’ve found to help explain this potential meltdown can be found here. You can’t put your head in the sand on this one.

From wikipedia, “The yield spread premium (YSP) is the cash rebate paid to a mortgage broker based on selling an interest rate above the wholesale par rate that the borrower qualifies for”. What that means in plain language: YSP is a mark-up on the interest rate charged to you over and above the rate a lender would be willing to receive.

Lenders provide rate sheets to mortgage originators (including mortgage brokers). If the originator closes your loan at a rate higher than shown on lender’s rate sheet, the lender pays a percentage of that amount (overage) back to the originator. This is over and above any other fees the originator may charge such as appraisal fees, underwriting fees, etc.

In a prepared statement to Congress in 2002, Professor Howell E. Jackson of Harvard Law School noted in relevant part that the “study indicates that the vast majority of borrowers pay yield spread premiums - on the order of 85 to 90 percent of all transactions” and that “the average amount of yield spread premiums is quite substantial, on the order of $1,850 per transaction, making these payments the most important single source of revenue for mortgage brokers.”

It’s reasonable to suspect the “substantial” YSP amount of $1,850 in the Professor’s study is woefully antiquated. Since this testimony was prepared before the housing bubble, let me give you an updated example for your review, using some reasonable NY/NJ real estate values.

• Hypothetical loan amount: $400,000
• Lender’s par rate per their rate sheet (the rate the lender would accept): 5.50%
• The rate you closed at: 6.25%
• YSP paid to originator: $12,000
• Difference in the total amount of interest paid by borrower on 30 year loan: $69,016.61.

The rule of thumb is for every 25 basis points (0.25) paid by the borrower over the par rate, 1% of YSP is created. So in the example above, about 3% YSP is created. Following the math, $400,000 X .03 = $12,000 would be paid to the loan originator.

As I understand it, there currently is no legal obligation to disclose the loan YSP to borrowers except on the final settlement statement at closing, when it is often too late to do anything about. I believe it is a moral and ethical duty to disclose prior to closing, but since greed trumps morality almost every time, I would urge you request this information before the closing date on your next mortgage.

Further, with many borrowers who bought homes in the bubble years 2003 - late 2007 looking for someone to blame, I wonder what would happen if they looked at the mortgage originator and lender as a prospective target? Perhaps an argument could be made that the lender/originator was “unjustly enriched” for failing to disclose YSP prior to closing. I have to believe that insurers writing mortgage brokers and lenders professional liability (malpractice) coverage are concerned with this. It wouldn’t take many of these actions to start an avalanche of litigation, especially for those in the most “bubbly” real estate markets of California, Nevada, Florida and New York. I’m certain there are litigators who wouldn’t mind trying.

Of course, where the YSP was disclosed and agreed to by the borrower prior to closing, I have no issue. I wonder just “how many” disclosures occurred prior to closing…

I do have one final question, but it is admittedly rhetorical: How can we objectively review borrowers’ legal counsel’s role here? While the closing documents are in preparation, this information is available. What action(s) did borrower’s counsel undertake to explain YSP to their clients? Yes, I know. This line of questioning is a slippery slope with no answer.

Think this post is over the top?  Check out this link.

I’m not going to try to talk you into it. I’ve heard all the objections and reasons for not buying private disability insurance. None of them any good. If you don’t mind NOT having an income when you’re not able to work, you’re right, you don’t need disability coverage.

If however, having a ready income stream when you can’t work is important to you (heck, maybe it’s even a necessity with that mortgage you have and car payment and let’s not forget the insurance and …), you’d be wise to consider it. Premiums are about 3% of gross income per year.

But this post isn’t about buying disability coverage. It’s about buying it BEFORE you start your own business.

You see, no one thinks about disability insurance before they start their new business. Truth is, it’s next to impossible to get it once you begin self-employment. This is due to the financial underwriting process the company will undertake, where you will have to prove the financial “need” for the coverage by providing copies of your W-2 (or similar documentation) for review.

See the problem already? You won’t be able to prove financial “need” because you probably will not have a salary at opening day- OR you will have a greatly reduced salary at start-up, which will severely limit the amount of coverage you will be able to qualify for.

There’s also the bit about employment history. Disability underwriters want to see 2+ years at a job (or at least job function). You won’t have that at start-up either. It’s not difficult to understand why. Offering a policy to someone in a new business has the very real increased potential for claim written all over it. Not doing well in your new venture? No problem! You’ve got a disability policy that’ll pay!

So, before you leave that cushy job (with group long term disability coverage), budget for a disability policy on yourself while you can qualify for it!

My good friend Phil has always said that a very smart insurer could make a killing by offering “End of the World” coverage. The idea is that people would buy insurance to cover themselves from the peril of Armageddon and the “End of the World”. In case you weren’t aware, insurance policies as a general rule specifically exclude the peril of war (there are some exceptions).  In the event of a claim, people could send in their proofs of loss to a mailbox or post office box for review (and prompt payment, ostensibly).

If any underwriter at Lloyds of London thinks this is a good idea for a new product and can get 100% subscription, call me.

Some subjects just lend themselves to exciting writing: politics, religion and of course, the current media-created sensation du jour, Britney Spears. Let’s face it: writing about insurance is kind of like trying to make paint drying exciting and inspires as much enthusiasm as the thought of watching grass grow.

Well, no argument here. In fact, after spending close to 20 years in my chosen profession, it’s absolutely true that people want to know about their coverage exactly on two occasions: when their premium is due and when it comes time to file a claim. This should not exactly surprise anyone.

The industry is vast and complex and it’s not surprising to get (at least) 2 different answers to any one question asked. Even alleged “experts” disagree on fine points of coverage (ask a victim of Hurricane Katrina if their loss was a result of a flood or wind damage) and in many occasions, the court system is relied upon to tell us what the definition of is is. And so goes the insurance industry’s delicate dance with the legal system. It’s sometimes impossible to imagine one without the other.

Personal financial risk management is not for the timid or weak of heart. The best insurance people find reasonable solutions to the very real risks faced by their clients. When things go well, the work goes mostly unnoticed, due to the intelligent risk management design of an insurance professional.

There is a subtle, yet real difference between the terms customer and client – they are not interchangeable. Essentially, a customer is a Wal-Mart shopper: the active party in a transaction. A client is generally defined as one who is “under the protection of another”. Usage of the term “client” conveys an active professional standard and duty of care, which may be why the term has fallen out of favor.

Over the past decade, insurers have come under increasing pressure to become more a “financial services firm that happens to do insurance” than what most people think of as the traditional financial risk transfer role of insurers. With this subtle transition, and much to my dismay, insurers have been quietly exiting the “client” business.

Of course, the insurers are not solely to blame, as they will stress that they are only reacting to consumer demand. There’s truth to it: One cannot get through an evening without seeing at least one TV commercial with an animated character espousing the ability to quote, bind and print auto insurance policies online within minutes.

The subtext is clear: The burden of being “correct” has shifted to you from the insurer (or its representative) . Regrettably, the choices made will not be known to be adequate until AFTER an incident. Let’s be careful out there!