Part 2 in the Series
This is the second part of a three part series on title insurance, the possibility of blockchain technology being used for land records and what effect that would have on title insurance. This part discusses the business of title insurance in order to answer the question why it is expensive. This is a very timely topic. As we put this article together we had no idea Bitcoin Magazine was going to drop the following article today:
Democratizing Real Estate Investing with Blockchain Technology
Bitcoin Magazine, March 31, 2017
The article discusses REIDAO's efforts to apply blockchain technology to real estate investing. The potential implications are massive and complex. While their efforts are currently focussed in Asia, the model will be interesting to watch from the U.S. perspective. Conceptually this type of blockchain application could provide for fractionalization of real estate asset ownership, totally dis-intermediate traditional title insurance and alter the real estate taxation mechanism. All before breakfast, so to speak.
Let's have a look at the current pricing structure and economics of real estate title insurance.
According to this article, the ratio on pay out of claims for title insurance is about 7%, so for every $100 of title premium collected, $7 is paid in claims. Fidelity National Title, the largest title insurance underwriter, reported in its 10-K for 2016 (p.41) loss provision rates (the statutory accounting estimate for what claims will prove to be expressed as a ratio of title insurance premiums received) of 6.2% and 5.7% for 2014 and 2015, respectively, and, after adjustment, 3.3%(!) for 2016. As noted last week, title insurance works by risk elimination (and a 7% claims payout demonstrates the effectiveness of this strategy) through title searches, which is typically covered by a fee separate from premium, so why must the premium be so high?
It’s not perfectly clear, other than to say that premium is often split with third parties. Continuing to pick on Fidelity, its 10-K (p.48) reported $2.6 billion in title insurance premiums from its third party agents, to whom Fidelity was able to pay $2 billion, or nearly 80% of total insurance premiums for agent-issued policies (to be fair to Fidelity, First American also pays nearly 80% of agent-generated policy premiums to the agents - First American's 10-K (see p.38)). Fidelity also goes directly to market, and generated $2.1 billion in premiums and another $2.1 billion in “escrow, title-related and other revenue,” from its direct activities. Fidelity doesn’t clearly break out its expense associated with its direct operation even though premiums are broken out between agency and direct. Fidelity need only keep the ratio below the agency commission (almost 80%) for its direct operations to perform better than its agency business. If that is so, why would Fidelity bother with agents?
It’s instructive that, while property buyers are the beneficiaries of title insurance policies, the industry does not see its insureds as their customers. Pointing again to Fidelity’s 10-K (p.7), its sales personnel target other real estate related service providers, including real estate brokers, financial institutions, independent escrow companies, developers and mortgage brokers. Of course, entertainment is part of any sales budget, including title insurance. But sharing can be more direct.
To understand this, consider the federal anti-kickback statute in the Real Estate Settlement Procedures Act (RESPA), making payment of referral fees for business related to real estate services illegal. While RESPA’s restriction is limited to residential properties, it does sanction affiliated business arrangements (joint ventures, or JVs) between different parties to a real estate transaction. A title insurer can therefore establish a JV with, for instance, a real estate or mortgage broker, where the JV acts as a title insurance agent. The JV partner uses its influence to direct title insurance business to the JV.
Generally, as long as the property buyer is not required to use the JV and the JV does actual work, the JV won’t run afoul of RESPA’s anti-kickback provision, and the JV partners share in the profits of the JV. In other words, it’s a way to share the action with business influencers. And since RESPA is limited to residential property, there is no similar federal restraint on commercial business (though one should be wary of state laws, as this article points out). In other words, title insurers need to share their revenue with others to generate that revenue, and given the low claims ratio to premiums, title insurers apparently have the revenue to share.
Title insurance is an expensive proposition. An owner buys a policy to protect the lender’s loan, and then a policy to protect the owner’s investment. As explained in part 1, title insurance is about risk elimination, work which is separately paid for than the premium for title insurance. As noted above, payouts average about 7% (and Fidelity is closer to half of that). Is there any reason to hope that title insurance could be eliminated, or at least priced more reasonably?
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