AS HOVNANIAN ENTERPRISES, the Red Bank, N.J.-based builder, expanded nationally over the past few years, executives there discovered that one or more of the home building companies it acquired along the way had business arrangements with title insurers that played fast and loose with compliance laws.

“They were nothing more than fee-for-referral setups,” says Michael Kehoe, president of Hovnanian's insurance subsidiary Eastern Title, which meant they operated outside the legal bounds intended to corral these business practices. “It seems like a lot of builders have no idea about RESPA [the Real Estate Settlement Procedures Act, a consumer protection statute outlawing such quid pro quos], and are relying on attorneys or underwriters who own title companies and are urging these arrangements.”

Up to now, builders might have been cavalier about the fine print on these arrangements, because title insurance hasn't gotten much scrutiny among home buyers nor regulators. Then came the wake-up call: The housing industry got sideswiped earlier this year, as prominent builders got caught in hostile crossfire between regulators in several states and insurers. At issue were business structures through which title companies allegedly agree to share about half of their premiums with entities known as captive reinsurance companies that builders, developers, or realtors create. In exchange, insurers transferred a portion of their risk to these captives, and in the process gained access to more referrals.

To date, the reaction and response among the nation's leading home builders would seem to indicate more a public relations hassle and less a legal snarl. But the legality of these and other longstanding complex interactions and alliances with title companies and financial partners is now inevitably under a microscope among regulators—some with suspect agendas and oppositional interests alike. What's more, these incidents could open a Pandora's Box of mistrust among home buyers and investors if company executives fail to admit error if it has occurred, and wholeheartedly and decisively set matters straight.

THE DEVIL IN THE DETAILS Reinsurance is legal, as long as one partner isn't remunerated solely for referrals, the risk and reward are equitable, and everyone discloses the arrangement to buyers. Most health insurance is reinsured, and mortgage companies prefer such structures. But captive title reinsurance turned out to be a low-cost solution that was too good to be true, as builders and insurers split up to 70 percent of the premiums collected with minimal risk of paying out claims. Regulators howled “kickbacks,” and derided these arrangements as “scams” and “a form of commercial bribery.” With watchdogs breathing down their necks, insurers and builders suspended their captive reinsurance ventures. In February, First American, one of the country's three largest title companies, agreed to refund $24 million to home buyers in eight states to settle a dispute with Colorado's Department of Insurance. That settlement identified 16 builders as partners in these captive schemes, and ignited a firestorm of investigations into captive insurance arrangements in states across the country. Regulators in California, Hawaii, Washington, and Arizona called builders to account for their involvement in these entities. As of late June, investigations were ongoing, with most states seeking settlement remedies from insurers but some also hinting at possible legal action against other partners.

“What builders essentially were saying is that they wanted a discount on title insurance,” which is what captive arrangements provided them, says Erin Toll, Colorado's deputy insurance commissioner, who also is co-chairman of the National Association of Insurance Commissioners' title insurance working group, which is coordinating investigations in several states. “What I want is an end to these secret deals, and competition in the truest sense of the word, which would bring down the cost of title insurance.” And now she's gunning for bigger game: affiliated business arrangements (ABAs), a broader classification of partnerships that, in the housing industry, might encompass some agreements between builders and mortgage lenders. Toll petitioned her state's attorney general and the U.S. Department of Housing and Urban Development to take a closer look at ABAs for kickbacks. And legislatures in at least two states have flirted with bills that would impose tighter rules on these arrangements.

Builders take exception to being called crooks. They continue to insist that the captive title reinsurance their companies entered into complied with state and federal statutes. But without admitting guilt or complicity, some builders and insurance experts concede, albeit usually off the record, that rigorous due diligence may have been missing when some captive title reinsurance entities were created. “Builders can make a lot of money, improve their deliveries, and simplify their lives by having close relationships with a title company, but they better be sure these deals comply with [federal and state] laws, and that their partners are paying as much attention to this as they should,” says Bill Cotter, CEO of Title Alliance, a Media, Pa.-based company that creates and manages joint ventures between builders, banks, realtors, and mortgage lenders.

That message probably resonates loudest among builders who partner with mortgage companies, which exist primarily to help builders maintain control of their closings. Even though Congress established the legal status of ABAs years ago, mortgage brokers still carp that these arrangements—as well as builders owning mortgage subsidiaries outright—are unfair. So builders don't want to give regulators any reasons to introduce new laws that would dilute the effectiveness of these arrangements.

LOW RISK, BIG REWARD Underwriting title insurance seems to lend itself to competitive practices that make regulators earn their pay every day (see “Complicated Titles,” page 42). But it's not clear why state officials homed in on captive title reinsurance. Nationwide over the past six years, only about $45 million in title insurance premiums, out of a total of $65 billion, flowed through captives.

Regulators might have initiated their investigations after being egged on by disgruntled title agents who complained, perhaps, that captives cut them out of the process. What's more, California's insurance commissioner, John Garamendi, plans to run for lieutenant governor in 2006, and could be flogging insurance reform as a campaign issue. “Garamendi grandstands every time he opens his mouth,” says Leonard Crouse, deputy commissioner of Captives for Vermont's Department of Banking, Insurance, and Securities. Vermont is one of a handful of states whose laws are receptive to captive reinsurance entities, and Crouse's department was criticized for sanctioning arrangements that regulators now view as illegal.

Learn more about markets featured in this article: Los Angeles, CA.