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Insurance Capital Games and PMI Reinsurance Kickbacks

posted by Adam Levitin

The New York Times carried an important story about the risky investment moves of life insurance companies. There's a lot of good stuff in the story, but it missed an important angle, namely the consumer harm that has already resulted from bank affiliation with captive reinsurers in the private mortgage insurance space, namely inflated and unecessary private mortgage insurance premiums because of illegal kickback arrangements. 

Here's what happened. Federal law forbids Fannie Mae and Freddie Mac from purchasing mortgages with a loan to value ratio of over 80% absent private mortgage insurance (PMI). Some lenders will also require PMI irrespective of whether the loan is sold to Fannie/Freddie (without PMI, the loan isn't saleable, so PMI preserves the loan's liquidity). PMI is paid by borrowers, but it is the lender that is insured. There are roughly seven major PMI companies around, and they all price virtually identically, so the consumer doesn't care which company it uses. Instead, the consumer is likely to use whatever company the lender recommends.  So how does the lender pick? Is it based on things like speed of payment and likelihood of contestation? Nope. It's about kickbacks. The PMI firms reinsure parts of their insurance books. Among the reinsurance firms they use are the captive reinsurance affiliates of the lenders. Thus, a PMI firm gets business steered to it by a lender in exchange for agreeing to cede a certain percentage of its reinsurance business to that lender's captive reinsurer. 

What's the problem with this? First, as a legal matter, it violates the Real Estate Settlement Procedures Act (RESPA), which contains an anti-kickback provision. Second, it potentially results in consumers purchasing unnecessary insurance:  PMI is supposed to shift/spread risk away from the lender, but because of the captive reinsurance it circles right back to the lender via its affiliate. Third, this sort of kickback creates safety and soundness risks for the lender. 

In the past fews of years, there have been a number of settlements about the PMI kickbacks:  the NY and Florida Departments of Insurance, CFPB, and private class action litigation. (Full disclosure: I have served as an expert in some of this litigation.) But the risks of this arrangement have been well-known since the get-go. Bank affiliation with captive mortgage reinsurers was approved by the OCC via private letter ruling in the mid-1990s, prior to the Gramm-Leach-Bliley Act, over objections from the NY Dept. of Insurance which expressed concerns about kickbacks. Not surprisingly, the OTS, not wanting to fall behind in the regulatory competition, approved a subsequent private letter ruling from a federal thrift almost immediately afterwards. 

Why did the OCC approve? Because captive reinsurers enabled banks to assume greater risk on mortgages with less regulatory capital, thereby goosing returns on equity. The captive reinsurers were generally Vermont reinsurers. My reading of the Vermont reinsurance statute at the time is that a captive reinsurer's capital is not meaningfully regulated by the state's department of insurance, but instead is set by the reinsurer's private auditor. (Since when are auditors in this business?) Whatever the precise details, the point is that instead of facing the Basel I rules that would require 4¢ of capital for ever $1 of first-lien mortgages, the bank holding company could hold more like 0¢ or 1¢ of capital for ever $1 of first-lien mortgages by having the mortgage insured and then reinsured by its captive affiliate that was not subject to Basel I, but to Vermont rules. In short, the captive mortgage reinsurance business was all a massive regulatory capital dodge. 

What is the most astonishing about the OCC's approval of a regulatory capital dodge involving insurance is that just a few years before, a major life insurer, First Executive (also d/b/a/Executive Life Insurance Company) failed with a regulatory capital dodge in the background.  First Executive was deeply in cahoots with Michael Milken's junk bond daisy chain scheme (and was the largest holder of junk bonds around). It even engaged in one of the world's first collaterlized debt obligation transactions in order to arbitrage insurance regulatory capital rules. First Executive basically swapped with itself in order to change a bunch of medium capital requirements bonds into a collection of low capital requirement bonds and few high capital requirement bonds. This was possible under the NAIC rules at the time.  (Bill Bratton and I detail this history here.) 

All of which is to say that the financial conglomeration story goes back to before Gramm-Leach-Bliley, was spearheaded by captive bank regulators, was driven by regulatory capital arbitrage, and the risks to safety-and-soundness and consumers were apparent at the time (and subsequently borne out).  But I doubt we'll learn a lesson now. 



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