Force-Placed Insurance Is a Necessary Good

NEW YORK ( TheStreet) -- Since the housing bubble burst in 2008, there have been many headlines bashing banks for forcing mortgage borrowers to have insurance on their homes, but it's a good thing they do.

The Wall Street Journal on Tuesday reported that the Federal Housing Finance Agency -- which took Fannie Mae ( FNMA) and Freddie Mac ( FMCC) under government conservatorship in September 2008 -- was preparing to "to ban lucrative fees and commissions paid by insurers to banks on so-called force-placed insurance."

The FHFA is clearly doing something good, but it's important to take a balanced look at force-placed, or lender-placed, insurance, to understand why it is actually a good thing for borrowers, as well as lenders.

When taking out a mortgage loan or a home equity loan, the borrower agrees to make sure that the home's potential replacement cost is covered by a homeowner's insurance policy. For borrowers in special flood-hazard zones, as determined by maps prepared by the Federal Emergency Management Agency, borrowers will also be required to have flood insurance.

In some states, certain perils, such as hurricane wind damage, aren't covered by regular homeowner insurance policies. Mortgage borrowers in coastal areas in Florida, for example, may need to purchase separate windstorm insurance policies.

Borrowers are required to have insurance covering the replacement cost of their structures to protect banks' interest in the collateral. For flood insurance, banks are required by law to make sure customers in special flood hazard zones are covered from the damage caused by rising water. Bank examiners -- especially in areas prone to hurricanes, tornadoes, floods and earthquakes -- carefully scrutinize banks' loan servicing operations, not only make sure the lenders are complying with the law, but to make sure the banks are adhering to their own risk management policies.

Most borrowers with a first-lien mortgage loan have escrow accounts set up from the start, through which the bank or loan servicer pays annual insurance premiums. Borrowers who are not escrowed for insurance, as well as borrowers with home equity loans, are required to provide annual proof of homeowner's insurance, as well as flood or other types of insurance if applicable.

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