The ghost of the 2008 financial collapse still haunts the liability insurance market for real estate professionals and some are worried the business may be headed for a replay of that crisis.
While it is still recovering from the crash of more than seven years ago, the real estate errors and omissions (E&O) market is also contending with new exposures related to cyber, energy, regulation, drones and the trend of Realtors morphing into developers and property managers.
Mike W. Smith, president of Axis Insurance Services, remembers the period before the 2008 crash well.
“Real estate was something where you just couldn’t lose money. Every person wanted to be in it. People jumped in it that had no business being in it, from the mortgage brokers to title agents, and real estate agents,” the Franklin Lakes, N.J., insurance broker told a Professional Liability Underwriting Society (PLUS) audience. “Real estate prices were high; interest rates were low. What it set up was an environment that was just really doomed to fail.”
After the housing market collapsed, claims and lawsuits against all types of real estate professionals – and pretenders who got into the business – commenced.
Most claims from the crash had a four or five-year statute of limitations, although some came in as late as 2014 and are still in litigation, according to Jonathan Kanov, a real estate defense lawyer with the Fort Lauderdale firm of Marshall Dennehy Warner Coleman & Goggin.
The bulk of claims had to do with residential transactions. “That makes sense because for the commercial deals you generally had lawyers on either side, buyer and seller. You had a lengthier due diligence period that people actually availed themselves of, and the level of all of the real estate professionals was higher,” Kanov said.
Mortgage brokers were among those hardest hit by claims after the crash.
According to Kanov, too many mortgage brokers were nothing more than forgers processing loans that did not require documentation of income.
“They had no experience in the industry. They took a test and they got into it,” Kanov said, citing a case where $175,000 was the reported income for a nail technician who made $39,000 a year. She would face monthly payments of more than $4,000 a month after two years on a 40-year adjustable mortgage.
“You saw that all the time, and that of course was a recipe for disaster,” Kanov said. “Of course, it opened up the mortgage brokers for claims, and lots of underwriters got out of writing mortgage brokers completely after the crash.”
Title agents also faced claims. These came from loan originators looking for any possible errors to hold the title agent responsible for the bad deal. “If there was cash to close that should have been brought by the buyer and they didn’t bring it; if there were suspicious-looking credits; if there were credits that were not approved by the lender to a marketing assistant, or something that looked suspicious, they were easy targets to go after the title agent,” the Florida attorney said.
The crisis drove title companies to begin holding title agents strictly accountable for defects, according to Gary Shendell, an attorney with Shendell & Pollock in Boca Raton, even when the title insurer does the title search. “Their theory is that the title agent had the last chance to find the error. It’s really a very difficult environment out there for title agents at the moment,” he said.
Real Estate Brokers
The third group hit hard by claims after the 2008 crash was real estate agents and brokers.
Kanov said he realized the Florida market was overheated when his landscaper quit to get his real estate license. “It was just the thing to do,” he recalled. “Everybody was flipping houses – their own and their investment properties.”
Real estate agents became easy targets for people losing their homes and their investments. Claims trumpeted the agent’s “duty of loyalty” and “duty of candor” and complained about a failure to disclose nearby construction or failure to advise a homebuyer to hire a termite specialist.
Axis’ Smith said that appraisers also became targets as lenders pressured them to inflate values. If the appraiser’s estimate did not reach what the lender wanted, the appraiser either gave the lender the value it wanted or never got another assignment from that lender. “That’s the position they were in. Then when the crash came, of course they were on the front lines of getting sued for these inflated values,” said Smith.
Research by Shendell’s firm found that at least 50 percent of the real estate professionals subject to claims were in the business less than two years. “Everyone and their mother and father wanted to be a weekend realtor so they could have a realtor license to share in the commission,” he said.
“One of the revelations was the tremendous risk that insurance companies were taking when they underwrote them for professional liability policies,” he said.
Parade of Exclusions
After the claims started pouring in, insurers reacted in ways that are still being felt in the marketplace, according to the speakers at PLUS. Insurers pulled out of some real estate E&O markets including the biggest, California, and elsewhere they pulled back on what they would cover.
“The industry did a pretty significant knee-jerk reaction as to what was happening in the claims,” said Smith. “We had the insurance companies that were just throwing up their hands, and there was pretty much a mass exodus in this market. California real estate E&O was the first to go, and after that, other companies might not have left the market but they certainly increased their prices and then they started putting new exclusions to the policy.”
Some insureds discovered they were not covered for certain exposures. Mortgage brokers, for example, had contracts with repurchase agreements. “When the banks came back and said, ‘You have to repurchase the loan,’ they were really surprised that they weren’t covered for that type of exposure,” Smith said.
Insurers began piling new exclusions onto E&O policies. Among them was an exclusion for the thousands of real estate-owned (REO) properties the banks ended up with after foreclosing. Banks wanted to get them off their books so they farmed them out to real estate agents but did not include much information at all. “There were a lot of allegations on the sale that the agent should have known about the property. The agent had a duty to inspect the property, and know the conditions of the property,” said Eric E. Myers. “That just wasn’t possible for a lot of these agents taking on these sales.”
Myers, manager of one of the country’s largest real estate E&O programs for Victor O. Schinnerer, said the result was a slew of claims against real estate agents for failure to disclose. “That scared a lot of carriers. A lot of carriers just said, ‘If you’re selling REOs, we’re not covering you.’ It was just such a shock, the sheer number of REO property sales,” he said.
Real estate agents doing property maintenance as part of receivership responsibilities faced a similar E&O fate. Insurers decided that this was not a covered professional real estate service. Smith noted that courts appoint individual agents, not their companies, as receivers and they can be held personally liable for the property taxes or other matters related to the property in foreclosure.
Insurers also began excluding the activities of agents who were “flipping” properties they owned themselves or jointly with others. Myers said agents would buy a property for $300,000, do some cosmetic repairs, quickly put it back on the market, and sell it for $800,000. Buyers who felt taken advantage of filed claims alleging failure to disclose. “If you own the property because you bought it, you should know about it. Even if you own 10 percent of it, you should know about the conditions of the property, the history of the property,” said Myers of the attitude of these claimants.
The good E&O news is that many of the bad actors behind the 2008 real estate crash are gone. Also, claims are down in part because there have been fewer transactions. Insurers have come back, and brokers are having some success, albeit limited, getting insurers to cover some of the exposures they dropped a few years ago.
But it isn’t easy ridding policies of all of the exclusions. “I spend my whole life fighting with the carriers to try to get all of that stuff back in,” said Smith.
As Myers sees it, the “E&O policy is evolving” as the soft market offers some leverage to get insurers to relax exclusions. But the admitted market is not looking to add coverages so the excess and surplus lines (E&S) market is important to providing coverage for new exposures.
Smith said it’s been a “hard battle” in California in particular. But now carriers are coming back. “It was a three, four, five-year period where California was really a tough market,” he said. He agrees the market is being helped by E&S players.
Even as they maneuver to restore some of the lost protections, insurance brokers are having to locate coverages for a menu of newer exposures.
For example, more Realtors are getting into the property flipping that gives underwriters heartburn. They are partnering with contractors, raising money from investors, buying and fixing up dilapidated properties, and sometimes acting as general contractors in the process. When things sour, these Realtors can face complaints by both investors and buyers, according to Shendell.
Cyber and privacy exposures are also growing as real estate professionals, like most businesses, become more dependent on the Internet. According to Melanie Wyne, a technology expert with the National Association of Realtors (NAR), data breaches pose a series of risks to real estate brokerages. There is financial harm from the expenses resulting from the breach; legal risks from lawsuits; and reputational risks from having to publicly disclose the hack.
Real estate brokers can be liable for something as simple as using the wrong photos of a property or vulnerable when transferring funds electronically.
Jessica Edgerton, NAR associate counsel, cites an upswing in a particular wire scam where a hacker breaks into an agent’s email account and obtains information about upcoming real estate transactions. After monitoring the account, the hacker sends an email to the buyer as the closing nears, posing as the agent or someone from the title company and requesting that the buyer wire funds.
The E&O problem with these technology exposures is that while real estate professionals are very vulnerable, many do not take them seriously, according to Smith. “They don’t think they maintain any information. That exposure is there for the real estate agent more so than other folks,” the insurance broker said.
Smith said these claims aren’t covered under the E&O policy but getting a small firm or an appraiser to buy a cyber policy is “almost impossible.”
Real estate firms that are using drones to showcase or inspect properties are courting additional exposure. “This technology is an incredible tool for real estate professionals, but can be dangerous if the wrong person is in control,” said Kolleen Kelley, vice chair of NAR’s risk management committee, at a recent conference where panelists advised that following the rules on drones is important to mitigate potential risks even while acknowledging that the rules are still evolving.
Smith believes E&O policies need to recognize that the profession has changed. “If we’re looking at a box of how a real estate agent, title agent, mortgage broker does their business, they’re not doing it the same way that they did it five years ago. We have to evolve to be able to address that,” Smith said.
Fair Housing and Fracking
Looking ahead, Myers thinks there could be claims activity related to the government’s desire to protect citizens’ civil rights in housing. He sees a possible uptick in fair housing claims as a result of the Obama administration’s decision to fund Housing and Urban Development (HUD) testers whose job is to find out if real estate agents, property managers or mortgage brokers are violating anyone’s civil rights. One provision of HUD’s Fair Housing Initiatives Program meant to assist people who believe they have been discriminated against calls for deploying “minorities and whites with the same financial qualifications who evaluate whether housing providers treat equally-qualified people differently.”
Liability linked to fracking and energy rights is another emerging issue. A 2015 Reuters report on 25 states found that builders in some areas are retaining the rights to oil, gas, water and natural resources under the homes they erect and sellers are not required to disclose it.
Another emerging risk involves what Myers calls “horrors in the house.” These cases arise, for example, when there’s a death in a house or a sexual predator next door. “Should the agent disclose those claims to the public, to their protected buyers?” is the question, according to Myers. He cited a case where there had been a series of random phone calls and letters threatening to kill a child who lived in the home being sold. “The whole neighborhood knew about it, but the out-of-town buyers didn’t know. The agent got sued for not disclosing that,” said Myers.
Smith warned about potential claims arising out of changes in settlement forms for real estate closings. Last October, new disclosure documents required by the government went into effect.
The government has replaced the Good Faith Estimate and Truth in Lending disclosures with a single document that must be given to consumers within three business days of applying for a loan. Also, a new Closing Disclosure form has replaced the HUD-1 settlement statement and the final Truth in Lending disclosure. This form must be given to consumers at least three business days before closing.
Fortunately, early reports indicate that the changes do not seem to be presenting major problems, according to NAR President Chris Polychron. “We are pleased that closing delays and other harmful effects resulting from the new rules have been reportedly few in number so far,” he said at a conference about six weeks after the new rules went into effect. “Nonetheless, as the new rules continue to take hold, we anticipate there could be bumps in the road.”
Last year was the real estate sector’s best year in a decade, with existing homes sales and the median price both up more than six percent, according to NAR’s Chief Economist Lawrence Yun. But those numbers are well below the highs achieved in the years leading up to the 2008 crash. Looking ahead to 2016, Yun sees sales actually slowing.
Mortgage bankers are more optimistic and believe the home buying market will be even better in 2016. But whether sales are up or down in 2016, the median home price is likely to keep rising due to pent-up demand and fewer new houses being built.
Real estate pros reassure that the housing market is not about to go into crisis mode again because, for one, more people are employed. Also, adjustable rate mortgages are no longer as popular as they were in the years before 2008. Also, while bank repossessions are up as banks continue to work through their old business, only 2.1 percent of loans are in foreclosure, the lowest level since 2007, according to the Mortgage Bankers Association.
Insurance broker Smith isn’t totally convinced that 2008 couldn’t happen again and he wonders if the lessons of the crash have been learned.
“I want to say we learned some lessons. I want to say the lenders learned some lessons. I want to say the regulators learned some lessons. But the real answer is, we’re getting pretty close to that again,” he said.
Myers is also leery about what lies ahead.
“In Florida specifically, there’s another era of this irrational exuberance,” he said. “There is so much construction going on, there are so many cranes in every major city in Florida, there are so many units available that at some point it’s going to give rise to that bubble that just a little pinprick will explode.”