(This is Part 1 of a three-part series. See Part 2 and Part 3.)
“The title insurance industry has been much in the news recently for a variety of alleged abuses of consumers. Is there something fundamentally wrong with this industry?”
I think there is, but the abuses reported by the media aren’t the problem. The abuses are the consequences of a dysfunctional market. Competition by sellers of title insurance does not benefit consumers the way it is supposed to. When title companies compete, you lose.
Industry Structure
The title insurance industry is structured much like the wholesale/broker segment of the mortgage market. Mortgage brokers find the customers, and do most of the work involved in originating loans. When the work is done, the loan is funded by a wholesale lender, at a price that lender had posted with the broker earlier.
Title agencies are the counterpart of the mortgage broker. They operate locally or statewide, and there are many thousands of them. They find the customers and do all the work involved in creating title policies, including searching title records. When their work is done, the policy is issued by the agent on behalf of one of the title insurance companies.
About two-thirds of all title policies are issued by independent agents, which is about the same market share that mortgage brokers have. The balance is accounted for by branches of insurers or by agencies wholly owned by them.
But there are some important differences between the two markets. Where there are hundreds of wholesale mortgage lenders, five title insurers account for about 90 percent of the policies. While wholesale mortgage lenders reset mortgage prices every day, furthermore, title premiums change only occasionally. In most states, title insurance premiums must be posted with the state in accordance with procedures established by state law.
Borrower Innocence and Competition
Few borrowers shop for title insurance, which is a minor part of a larger transaction that commands their attention. In most cases, they wouldn’t know where to shop even if they wanted to. The great majority, therefore, accept the title agency recommended by their Realtor, builder or lender, who often assure them that all agencies charge the same price.
Competition for clients by title agencies is thus directed not at borrowers but at the Realtors, lenders and builders who have referral power. If the referrers are independent of the title companies and act in the best interest of their clients, they will select agencies that offer the best price and service. Sometimes this happens, but all too often referrers use their power to benefit themselves rather than their clients.
Competition directed at referrers who expect to be compensated tends to drive up prices. It is sometimes referred to as “reverse” or “perverse” competition. Compensation paid to referrers is called “referral fees” or “kickbacks.”
Kickbacks
Kickbacks in the title insurance market can be illegal, legal or shams that purport to be legal but aren’t.
Under the Real Estate Settlement Procedures Act (RESPA), a party who is compensated for referring a customer to a title agency has received an illegal kickback. Illegal kickbacks occur, because it is extremely difficult to police all the ways that one party can provide something of value to another.
A legal kickback is called an “affiliated business arrangement,” or ABA. The referring party (a Realtor, for example) and the title agency can form a new title agency owned jointly. The Realtor can make referrals to this new entity, and can profit in proportion to its ownership share. ABAs are costly to create and operate.
A sham is an attempt to legalize kickbacks without incurring all the costs of an ABA. It may have only the facade of an ABA, for example, with the work actually done by another agency. Reinsurance schemes where the referrer receives a portion of the insurance premium in exchange for assuming some of the insurance risk, have also been deemed shams by regulators.
Government and Kickbacks
At this time, government is doing nothing that would reduce the cost of title insurance. The current policy of the Department of Housing and Urban Development, which administers RESPA, and those state regulators who have gotten themselves involved, is to eliminate shams. While the law should be enforced, requiring those with referral power to incur heavy costs in order to legalize their kickbacks will not drive down the price of title insurance.
The high price of title insurance, and the prevalence of kickbacks in the industry, both stem from the fact that mortgage borrowers pay the insurance premiums while others select the title agency. To reduce prices, you have to change that. Stay tuned.
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.
