Don't Let Your Bank Pick Your Homeowner's Insurance

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If you're thinking about letting your home's property or flood insurance lapse because you think you don't need it or money's tight, here's a word of advice — don't. (See also: 9 Costly Things New Homeowners Don't Prepare For)

Your bank can make you pay for home insurance in what's called lender-placed or forced-placed insurance. And the worst part about it is that it could cost much more than insurance you can find on your own, about 5 to 10 times as much.

The problem is because of what's called "reverse competition." Instead of seeking cheaper policies, lenders may be motivated to collect commissions and other fees.

"In this case, the lender, who is not the ultimate payer, has an incentive to seek higher cost insurers that offer bigger kickbacks and benefits, rather than the lowest cost option," J. Robert Hunter, director of insurance for the Consumer Federation of America, told the New York Department of Financial Services.

Besides being more expensive, lender-placed insurance policy may have limited coverage. For example, the policies typically do not cover personal items or owner liability.

If you're thinking that doesn't sound right, you're not the only one. Regulators in New York, California, Texas, and Florida, as well as the federal Consumer Financial Protection Bureau, are cracking down on the practice and considering new regulations.

Watch the Paperwork

Sometimes homeowners have to pay forced-placed insurance because they mistakenly let their policy lapse in a paperwork oversight. Other times homeowners who never dropped their insurance get forced-placed insurance because their lenders or insurance companies fouled up.

Even if they never let their policy lapse, homeowners can still go through a nightmare as they pay high insurance costs while trying to prove to their mortgage servicer that they always had their own policy.

Ask Kevin McCarty, who went through over a year of wrangling to get his money back and fix the problem after a paperwork snafu prompted his lender to force-place insurance on his Florida condominium. His insurance agent accidentally sent the wrong policy to his lender, according to the banking magazine American Banker. The agent kept trying to fax the right policy and confirm receipt, while the lender billed McCarty for its more expensive insurance.

"It was a very, very frustrating — from a consumer perspective, enormously frustrating — experience," McCarty told American Banker.

Unfortunately for banks, McCarty is the insurance commissioner of Florida.

The state insurance agency recently started investigating bank and insurance links over forced-placed insurance. Banks maintain they receive the same commissions that agents selling directly to homeowners get, but the insurance commissioner doesn't seem to be buying that argument. You might wonder if McCarty holds a grudge or why Florida didn't start the investigation earlier, considering the state accounts for 40% of the forced-placed insurance market.

Hazard and Flood Insurance

Lenders naturally insist that borrowers carry property insurance, also known as hazard insurance, to protect their loans. If a house burns down, the homeowner probably won't keep paying the mortgage. Homes located in a National Flood Insurance Program Special Flood Hazard Area are required to carry flood insurance.

When you buy a home, you sign documents spelling out what must be covered and how proof of coverage will be submitted to the lender or its loan servicer. Mortgage contracts typically allow lenders to buy property insurance dating back to the last date when they think the homeowner had insurance. They'll send you the bill — and it could be a large one. And if you don't pay it, you could be at risk of foreclosure.

Tips for Avoiding Forced-Placed Insurance

To avoid a forced-placed insurance headache...

• Be sure to pay the bills on time.
   
• Review all paperwork you get from your lender and insurance company.
   
• If you pay insurance through a mortgage escrow, watch for a jump in the total monthly payment — it's a red flag for an insurance issue.
   
• Make sure you don't send insurance verification to the wrong address, a common mistake when lenders often use third-party loan administrators.
   
• If you change insurance companies, make sure there's no lapse between policies.
   
• Consider notifying your lender of any change and provide proof of coverage directly, instead of waiting for a copy to be mailed from the new insurance company.

If you're stuck in a quandary, you can contact your state insurance department.