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This article originally appeared in the May 2009 edition of ISO Review.
Feature Story:
Mortgage Fraud: Hidden Dangers for Property/Casualty Insurers
by Ann Fulmer, Vice President, Interthinx, and Cecil Rhodes, Principal Consultant, NIA Consulting
As residential foreclosures have risen over the past few years to unprecedented levels, the financial fallout has been staggering. The federal government has had to spend trillions of dollars to stabilize the economy, and hundreds of mortgage banks have folded along with storied Wall Street brokerages. FNMA and FHLMC are under federal conservatorship, private mortgage insurers’ ability to pay claims has been impaired, and some insurers have quit writing new business altogether. In addition, public and private retirement systems have lost billions of dollars with devastating consequences to individuals whose lifelong investments have virtually evaporated.
According to the FBI, fraudulent mortgage transactions are at epidemic levels. Fraud is the fuel of the foreclosure crisis because fraudulent mortgages almost always end in foreclosure. While the direct financial loss is sustained by the lender or the investor and its mortgage and title insurers, mortgage fraud can adversely affect property/casualty insurers in unforeseen ways, leaving them exposed to unexpectedly high claims levels and mispriced risk.
Types of Mortgage Fraud
You can generally divide mortgage fraud into two categories: fraud for profit and fraud for property. In fraud-for-profit schemes, the goal is to obtain excess financing, which the perpetrator then skims from the transaction. A fraudulent or negligently prepared appraisal that inflates the property value is critical to the success of the transaction. Fraud for profit involves multiple properties — sometimes hundreds — and a small group of participants whose common goal is to extract as much money from each transaction as possible. Since the offenders do not intend to repay the loan or to occupy the property, houses generally remain vacant — sometimes for years — until foreclosure.
In fraud-for-property schemes, the borrowers, or someone acting on the borrowers’ behalf, misrepresent their income or credit-worthiness to obtain a loan they intend to repay on a property they intend to occupy. Dishonest real estate and mortgage professionals frequently instigate the schemes and profit from fees and commissions on the transactions and/or by skimming the excess loan proceeds. The transactions frequently end in vacancies and foreclosures because the borrower does not really have the means to repay, especially if the interest rate adjusts or a serious illness, job loss, divorce, or death occurs.
Mortgage Fraud Leads to Increased Property/Casualty Claims
Foreclosure, whether caused by economic circumstance or fraud, inevitably leads to vacant properties, increased incidences of property crimes, insurance claims, and corresponding losses to property/casualty insurance companies. When a foreclosure is pending, the property owners or their tenants may inflict heavy damage as a means of extracting revenge on the lender. This may include filing false burglary reports or committing arson in an attempt to generate cash from an insurance policy. Once the foreclosure is complete and the property is vacant, it is vulnerable to the “midnight recyclers” who strip the property of anything saleable, including appliances, fixtures, doors, windows, plumbing, and electrical wiring. In one extreme case, criminals removed the entire house, never to be seen again. Vacant, unsecured properties can also suffer water and weather damage from open or missing windows and doors and/or lack of heat, and they are at greater risk for fire loss because they may be occupied by squatters or vagrants.
Mortgage fraud tends to occur in clusters. Concentrations of fraud in co-ops, condominiums, and townhouse developments lead to vacancies and reduced revenue for co-op or homeowner associations who cannot afford to maintain the buildings and common areas properly. This often results in an increased number of personal injury, vandalism, theft, and property damage claims. Concentrations of foreclosures and vacancies in detached residential properties also increase personal and property crimes, even in previously stable neighborhoods. Police agencies around the country report that buildings abandoned after foreclosure are contributing to higher property crime rates. Since those properties are often subject to vandalism for any items of value, inhabited by squatters, or used for the manufacture of drugs, the slum-like conditions spark a downward spiral that radiates throughout the community, even in the most upscale areas.
Mortgage Fraud Impacts Local Government Services
High concentrations of foreclosed and vacant properties increase demand for public health, safety, and welfare services. Since fraud and foreclosure adversely affect property values and tax collections, cashed-strapped local governments are hard-pressed to meet the increased need. This is especially true where there have been cuts in police and fire services and personnel to balance the budget.
Indirect Effects on Property Insurers
Mortgage fraud elevates the risk for all insurers in the vicinity — residential and commercial — because fraud’s negative effects spread geographically. During good times, property values within a quarter mile increase because inflated values are fundamental to creating excess financing and “profit.” Since policy limits frequently match the mortgage amount, property/casualty insurers may have difficulty in adequately assessing the true risk of potential claims before binding coverage on properties near those acquired through fraud. Loss severities in the area may increase because personal property and loss-of-use coverage limits are often a function of the dwelling coverage limits. This is especially problematic in states that require the payment of policy limits in the event of a total loss. Even if insurers ultimately deny the claims because of excluded hazards or breach of conditions, they must still expend significant resources to investigate, adjust, and process the claims. Finally, the persistence of policies in force declines because of high levels of foreclosure and the resultant owner turnover in those neighborhoods.
Benefits of Tracking Foreclosures for P/C Insurers
In a related article, Rising Foreclosure Rates Produce Greater Risks for Insurers, Jim Levendusky reviews the benefits to property/casualty carriers who track foreclosures within their books of business and within geographic areas disposed to mortgage fraud schemes. He recommends insurers become more proactive by, among other things, reviewing claims histories, conducting property inspections, and using other available indicators and services to forecast and mitigate losses.
Impact of Mortgage Fraud Will Continue
It is unlikely that circumstances will improve anytime soon. Millions of adjustable rate mortgages are due to reset between now and 2012. There is no end in sight to the foreclosure crisis or the decline in property values. And the incidence of fraudulent mortgage originations continues to increase. As the economy struggles to recover, unethical builders, developers, property investors, and borrowers will be increasingly tempted to commit mortgage and insurance fraud to escape their financial difficulties or to increase their net worth. Insurers must be alert to the dangers and adjust their underwriting and loss control policies accordingly.
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