Your Property Insurance vs. Current Appraisal

A reader asked about a post I had written a long time ago about property insurance. Her question relates to the realities of today’s marketplace.

First, she wants to get her premium down because the home is not worth the amount of the policy limits. So she wants to go to her insurance agent and ask for a site survey and a “re-do” on the insurance. Her premise is that the insurance company will decide that the home, once purchased for $700,000 is now worth around $400,000. The value of the land is, by her estimate, not worth more than $75,000. So, she says she wants to lower her premium on what had been a $700,000 policy and would now be a $325,000 policy, since the land would still be there even after an insurable event. It makes sense but there are many wrinkles in this plot. The first one is what will the insurer say?

So, her second premise is that the insurance company will notify her “lender” about the reduction in insurance, if indeed the insurer agrees with her in Part I. Of course the contract for insurance might speak of replacement value, and that might include factors like what it would cost to rebuild the house and she knows that it might cost a little more to rebuild the house than the fair market value or it might cost a little less. Here are her questions and my suggested answers:

1. Who does the insurer notify? In fact, with whom is the insurer communicating now?
2. Has the insurance company taken into consideration the fact that while they must pay in an insurable event, there is a question of whom they must pay if the loan was securitized.
3. What will the receiver of this information (servicer etc.) do with it. The property has a $600,000 mortgage on it. The property is worth $400,000 and the insurer is not going to insure it for more than it is worth. So if there is an insurable event, like the house burns down, the proceeds of insurance will only be $400,000 leaving a $600,000 mortgage on a burned down house where the insurance proceeds at only $400,000.
4. Will the “lender” demand that the homeowner rebuild? What if the homeowner won’t or can’t?
5. Will the “lender” demand the entire proceeds of the insurance policy?
6. What will the “lender” do about the balance?
7. If the homeowner stops making mortgage payments what are the remedies available to the lender? In this scenario it is highly unlikely that the homeowner would continue to make payments, and even if they did, the amount of the principal at least would need to be adjusted and perhaps the rest of the “mortgage” would need modification, assuming the homeowner is willing to keep paying.
8. If the “lender” forecloses, what do they get?

These questions and more lie at the heart of the mortgage mess. The core of the entire scheme was appraisal fraud at both ends of the transaction — lying to the investor-lender and the borrower about the value of the property. Everyone made money except the investor-lender and the borrower for that reason — the appraisal was intentionally inflated in order to satisfy demand for mortgage backed bonds. That demand was based upon AAA ratings (appraisal) which in turn were based upon “honest” appraisals of the value of the property and the credit worthiness of the borrower.

The reality of the insurance company stating that it won’t insure the property for $700,000 when it is only worth $400,000 forces another issue: the borrower is technically in default of the mortgage terms (or Deed of Trust). The terms of that security instrument require that the insurance equal the balance due on the mortgage. That was an easy thing to do before the era of securitization and appraisal fraud.

So going through this exercise of getting the insurance premiums down, a valid thing to do as viewed by the homeowner and the insurer, forces an issue. It might be that a declaratory action stating the conflict between the requirements of the Deed of Trust (or Mortgage) and the reality of the marketplace create an obvious controversy in which the instrument declares that the borrower is in default but the borrower has no available way to comply with the insurance requirements under the mortgage. The declaratory action would need to declare the rights of the parties and whether the borrower is now in default — through no fault of the borrower. It is probable that even if the insurance policy is not changed, that it would not pay more than $400,000 anyway.

The devil is in the details. Whom do you sue in the declaratory action? We again come face to face with the realities of securitization as it was done in practice. The suit would need to be against the lender of record. The servicer does not appear to be a proper party to such a suit, just as they are not a proper party in a quiet title action. Assuming the Court takes jurisdiction and makes a decision, that judgment would need to identify the name of the lender and the name of the borrower.

This is a round about way of flushing out the real creditor, if there is or ever was one.

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