As the housing bubble burst in 2008 and mortgage-backed securities dominated the headlines, few observers considered the role of captive reinsurance in subprime lending. Plaintiffs’ lawyers, however, have detected a litigation opportunity in the fact that large institutional lenders frequently created captives to reinsure the mortgages they issued in the run-up to the financial crisis. As a result, and in light of recent far-reaching court decisions, it now appears that lenders may have exposed themselves to liability by forming mortgage reinsurance captives.
These types of cases generally settle at an early stage, so the claims against lenders relating to captive mortgage reinsurance structures rarely get decided on their merits. Nevertheless, plaintiffs’ lawyers smell blood in the water and the lesson is clear: creating captives to reinsure subprime mortgages has become risky business.
The issue in most instances arises in connection with consumers who put down less than 20% on a home loan. Homebuyers in such instances are generally required to purchase private mortgage insurance (PMI) to protect against the risk of default. The lender usually selects the PMI insurer, which remains unknown to the consumer, and the premiums are tacked on to the borrower’s monthly mortgage payment. The homeowner has the option of refinancing into a loan that does not require PMI after reaching a predefined equity position.
As the volume of mortgages increased in the 2000s, lenders developed the practice of forming captive reinsurers to further spread the exposure relating to PMI. The PMI insurer would typically transfer, or cede, a portion of its premiums to the captive in exchange for transferring a portion of the risk.
The mortgage reinsurance captive is a variation on the traditional captive structure. In its simplest form, captives essentially operate as private in-house insurers that are wholly owned by a parent company. The parent pays the captive premiums, just as it would to a conventional insurance company, and the captive assumes the risk for certain defined losses. This construct is known as the “single parent captive.”
Unlike traditional insurance, the parent company keeps its capital if claims fall short of premiums. The parent also bears the risk of loss if the opposite happens.
Mortgage reinsurance captives, by contrast, are not funded by premiums paid by the parent company. Just like a standard reinsurer, they operate by collecting premiums from the PMI provider and sharing in the payment of losses. They are “captives” by virtue of their relationship to the parent institutional lender. In that way, they appear to the outside world just like any other wholly owned subsidiary of the lender.
Once commonplace, this arrangement may create legal exposure to lenders that outweighs the benefits of reinsuring through a captive. Courts are increasingly frowning on the captive mortgage reinsurer model, allowing class actions to proceed against lenders that allege the premiums generated constitute improper referral fees or even “kickbacks.”
The legal theory underpinning the actions is that the parent lenders, in setting up the captives and allegedly requiring the PMI insurers to utilize them, violated the federal Real Estate Settlement Procedures Act of 1974 (RESPA), which prevents fees and kickbacks in connection with “a real estate settlement service involving a federally related mortgage loan.”
In 2009, the Third Circuit Court of Appeals got the ball rolling in Alston v. Countrywide Financial Corp., a class action brought by Pennsylvania mortgage holders challenging Countrywide’s reinsurance practice. The case is significant because the court held that the provision of mortgage insurance is a “settlement service” within the meaning of the RESPA. This holding provided a legal foundation for the case, and others like it, to go forward.
Moreover, the court flatly rejected Countrywide’s primary defense that the rates it charged were proper because they were approved by the Pennsylvania Insurance Department. This is commonly known as the “filed rate doctrine.”
The doctrine first arose as a defense in connection with public utility rates. In essence, courts have historically immunized utilities from suits claiming that their rates are unreasonably high where those utilities are required by law to have their rates approved by a governmental regulatory authority. Several courts transferred that concept to the insurance context in the late 1990s, protecting insurers from claims challenging certain business practices on the grounds that their rates had been authorized by state regulators. The current trend, however, is for courts to reject the link between insurance and rate regulation for the purposes of the doctrine.
An example from 2012 is Ellsworth v. U.S. Bank, N.A., a California federal court case. There, a lender required a mortgage holder to maintain flood insurance on his property because the Federal Emergency Management Agency (FEMA) declared that the property was in a flood zone. The property owner declined to purchase the coverage and the lender force-placed a policy. The property then owner sued the lender and insurer, alleging that the forced placement constituted an improper kickback scheme.
The insurer countered that the plaintiff had suffered no cognizable injury because its rates had been approved by the Department of Insurance. The court declined to apply the filed rate doctrine, holding that the case fundamentally involved a challenge to a business practice, not rates.
Accordingly, courts have removed an important defensive weapon from lenders’ legal arsenal in cases challenging captive reinsurance arrangements. With this procedural impediment removed, plaintiffs have gained leverage to push for favorable settlements.
Another California federal court in 2013 struck a blow against mortgage reinsurance captives in Munoz v. PHH Corp., a putative class action involving lender PHH Corp. and its captive reinsurer, Atrium. Plaintiffs there alleged that premiums paid to Atrium constituted improper kickbacks to PHH because Atrium never assumed real insurance risk. The risk was absent, plaintiffs argued, because (1) Atrium was funded almost exclusively by reinsurance premiums and not its own capital, and (2) Atrium’s agreements with the PMI insurers contained significant liability limiting provisions.
As in Alston, the court rejected the lender’s “filed rate doctrine” defense. The court held that the doctrine did not preclude a reinsurance-related RESPA claim, the court stated: “Fundamentally, plaintiffs are not challenging the PMI premium rates but an alleged unfair business practice.”
In May of 2013, the Munoz court handed plaintiffs another significant victory, formally giving the green light for the case to proceed as a class action. Even though the plaintiffs alleged varying degrees of damages arising from distinct transactions, the court held, those damages were susceptible to common proof that rendered the case appropriate for class treatment. It remains to be seen whether PPH Corp. will settle Munoz or allow the case to go forward on the merits. Either option will likely be an expensive proposition.
The Alston and Munoz cases illustrate the possible pitfalls to lenders who utilize a reinsurance captive for mortgage insurance. The lesson is that the liability risks for these arrangements are increasing exponentially in light of the double whammy that appears to be evolving as the judicial norm. First, courts have effectively eviscerated the “filed rate doctrine” defense, significantly increasing the likelihood that cases will proceed past the pleading stage. Second, courts are certifying such cases for class treatment, meaning that the sky’s the limit in terms of damages.
Whether or not to establish and/or maintain a reinsurance captive remains an important business decision for lenders and their risk management teams. The cost/benefit analysis should certainly consider the realities of the current judicial climate.