Loan Buyback Loss Control
Liquidity is the lubricant of the financial markets. Without proper loss control, financial institutions are unable to provide capital to the markets. Banks raise the funds necessary to provide mortgages through various kinds of investors. For example, mortgage-backed securities are one way in which a financial institution raises money to lend to homeowners. In exchange, investors in the mortgage-backed securities receive a claim for their investment plus interest. The bank pays back this obligation through mortgage payments it receives from homeowners. Theoretically, a bank has internal procedures in place designed to preclude offering a mortgage to a fraudulent borrower.
Occasionally, even the best procedures fail. Mortgage buyback requests are actions by investors which demand the bank to immediately pay back the value of the investment. Improper or non-existent practices resulted in a glut of toxic mortgages which led to the 2008 financial crisis. Toxic mortgages have largely worked their way out of the market, but future forced buybacks could lead to the insolvency or non-compliance of lenders if these procedures fail en masse as they did in 2008. As such, loss control with regard to loan buybacks is paramount both for banks as well as borrowers and investors.
Loan repurchase demands are generally limited to instances of fraud or gross negligence. Loss control for this exposure is critical. However, some investors delay filing a repurchase demand until the extinguishment of the underlying collateral, which makes it easier for them to challenge the pre-funding appraisal. Sometimes an investor may demand that the lender provide an insurance policy to protect the investor in the event of a loan default. Smaller organizations’ policies may simply choose to pay for an indemnification in lieu of repurchasing the loan from the investor. Regardless, traditional policies do not provide the lender with autonomy or control over lawsuits and claims.
The Benefits of a Captive Insurance Company
Setting up a captive insurance company provides ultimate loss control due to fraud by applicants or brokers. A common example is as follows: A bank issues a mortgage to a loan applicant who knowingly provided false information, such as a false Social Security Number or a falsified appraisal of the underlying property, and slips through the bank’s system. The aggrieved party requests a buyback and the lender then relies upon its insurance carrier either to settle the request or indemnify the investor. Any settlement may result in higher annual premiums for the lender regardless of whether the lender was actually at fault. Inadequate policies create a large liability for a bank or lender which manifests as a buyback.
Captive insurance provides an opportunity to set up an insurance reserve through which to fund defense costs and in-house loss control policies. Every lender’s risk profile is unique and traditional insurers are often unable to properly price premium or are unwilling to take the risk at all. Using captive insurance to resolve buyback demands provides the lender with autonomous control and authority over defense costs.
In addition, captive insurance empowers the lender to set up loss control policies with the flexibility to cover other risks not typically insured by traditional carriers. For example, the lender’s policy can pay premium into a “risk of default insurance coverage policy” to provide funds to the lender in the event of default by one or more borrowers, or, the policy can direct the captive insurance company to provide professional liability coverage narrowly tailored to the needs of the lender without overpaying for unnecessary coverage through a traditional lender.
Finally, the greatest advantage to a lender lies in the ability to turn loss control from a cost center into a profit center. Proper policies should result in fewer claims and lower premiums over time. Rather than handing profit to a third party insurance carrier, a captive insurance company allows the bank to internalize the profits generated through smart policies. Loss control becomes a profitable enterprise which not only reduces the total number of claims but also allows the captive insurance company to earn a health profit. Profits from the captive are generally invested and realized later at a tax preferred rate.
In summary, these procedures for banks are necessary to ensure that investors receive the value of their investment as well as to keep the capital markets healthy. Banks and lending institutions are at the front lines of loss control and owe a duty to their investors to keep their policies tight. However, no procedure could eliminate 100% of fraud and negligence, which means that even the best lenders will face aggrieved investors demanding a loan buyback. Banks and lenders need to considering incorporating captive insurance companies into their program in order to keep down claims costs, reduce premiums, and retain the profits otherwise forfeited to traditional insurance carriers.