A New Twist On Paying For Real Estate Title Insurance
Jack Guttentag
(This is Part 2 of a two-part series. See Part 1: Is real estate title insurance overpriced?)
Last week I discussed the pressures on title insurance companies to pay referral fees to builders and others who send clients to them. Referral fees are a cost of doing business, and therefore passed along to consumers in the prices they pay for title insurance.
Borrowers typically know little or nothing about title insurance, which is part of much larger transactions that they encounter very infrequently. In most cases, therefore, a borrower purchases policies from the title company recommended by the industry professional most closely involved in their transaction. On the purchase of a new house, this will be the builder. On the purchase of an existing house, it will probably be the Realtor. On a refinance, most likely it will be the lender.
Because the referrers select the title company, the companies must market to them rather than to the consumers who pay the premiums. For this reason, the price charged the consumer plays little role in the marketing of title insurance. Many referrers do not care how much the consumer pays. Indeed, their interest is best served by large profit margins, which enable the title companies to pay hefty referral fees.
Referral fees paid by title companies to referrers, when the referrers have not performed services of equivalent value for the companies, violate the Real Estate Settlements and Procedures Act (RESPA). Both the companies and the referrers are guilty. Enforcement of RESPA, however, is spotty, intermittent and limited to actions against payers. When news emerges of widespread payoffs, as it did recently in Colorado, the knee-jerk reaction is to demand a step-up in enforcement actions.
In my view, this is the wrong response. Terminating referral fees by regulation would require an army of examiners, and even then it wouldn't work. The financial incentives are too strong, there are too many ways that payoffs can be made, and there are too many people involved for regulation to be effective.
Another option that is being considered in some quarters is to socialize the title insurance industry. In Iowa, only a state agency is allowed to sell title insurance, although residents are permitted to buy policies from out-of-state firms. Some view Iowa as a possible model for a complete overhaul of the industry.
I favor a market-based solution, the goal of which would be to eliminate referral power and with it, referral fees and any need for RESPA examiners.
A market solution must be based on the following principal: whoever selects the title company from whom title insurance is purchased must pay for the policy.
Implementation of the principal requires three rules. The first would mandate that title loan policies, if required by mortgage lenders, had to be paid for by mortgage lenders. The second would mandate that on purchase transactions in which Realtors were involved, the owners' policies had to be paid for by the Realtors.
These rules would eliminate "perverse competition" by insurers for the favor of referrers, which raises the price of title insurance. Instead, title companies would compete to sell to lenders and Realtors, which would reduce the price of title insurance.
Of course, lenders and Realtors would embed the title insurance premiums in their own prices to consumers, but they would cost borrowers far less in that form than they pay now. Lenders and Realtors would be price-sensitive buyers because they are paying the premiums, and they would be knowledgeable buyers because they are in the market continually. Prices should drop sharply, provided that state regulation of title premiums doesn't prevent it.
The third rule that is needed is one that eliminates state regulation of title insurance premiums. If lenders and Realtors purchase title insurance, regulation of premiums is not needed and can only impede the decline of title costs to consumers.
The most radical part of this proposal is the one involving Realtors. Unlike lenders, Realtors don't need title insurance for themselves but would be pressed into service as purchase agents of home buyers. This makes all kinds of sense, although important details such as how the responsibility would be allocated when there is a buyer's agent as well as a seller's agent, have to be worked out.
The title insurance industry is under the gun and it will be interesting to see how it responds. The market-based solution described above would be painful in the short-term, but the industry would survive and ultimately become stronger. If the industry hunkers down and resists all meaningful change, it might or might not outlast its critics, for many of whom the socialization model ala Iowa has a strong appeal.
The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.
Copyright 2005 Jack Guttentag
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