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Borrowers' insurance -- coverage on the bank's collateral -- is not a popular subject with most lenders. The policies are hard to understand and they jam the bank's loan files. More importantly, managing borrowers' policies exhausts the time and energy of the bank's loan department staff.

Banks would tolerate these expenditures if they felt comfortable with the results. Unfortunately, in spite of the expenditures on borrowers' insurance, most banks are uncomfortable with the results. Most feel that the time spent on receiving, evaluating, filing, and retrieving these policies could be better spent on the bank's core business -- banking.

The problem is worse because of a number of myths and misunderstandings that have grown up around borrowers' insurance. The following are five common ones:

Myth #1: Prudent home and business owners know enough to carry adequate insurance. We don't need to second guess them.
Prudent people certainly will carry proper insurance, but even prudent people make mistakes. Besides, it is not always possible to know which of your borrowers will prove to be less than prudent. It is those borrowers (who might have been prudent whe nthe loan started) who cause the majority of the bank's problems.

Myth #2: Insurance can't be a very serious problem. We've never had a problem with any of our borrowers.
Although the number of insurance problems is small compared to the total number of loans, it still represents a serious threat. Insurance lawsuits involving borrowers and lenders would fill a small reference book every year. The amount disputes may not threaten a bank's solvency, but each of these cases represents a significant investment in legal expenses and management time.

Myth #3: The borrower's agent is responsible to provide adequate coverage. If anything goes wrong with the borrower's insurance, the agent will handle it.
A number of serious insurance problems can crop up without the agent's knowledge. Suppose the borrower paid a year's premium at the time he took out a loan with your bank. Six months later he finds himself in financial trouble and vacates the building on which you hold a mortgage. Your loan officer is aware of the shut-down, but forgets to notify the insurance agent (who has no reason to know of it). If the mortgaged building is destroyed by fire, the bank's claim could be denied because the bank failed to inform the insurer of a significant change in occupancy.

Myth #4: We do a good job on insurance when the loan is granted. After that things pretty much take care of themselves.
A lot can happen to a borrower's insurance after the loan is granted. Some of the most serious -- failure to pay premiums, arson, and insurance fraud -- often coincide with deliquency and other credit problems.

Myth #5: If all else fails, we've got E&O insurance.
Mortgage Errors and Omissions (E&O) provides protection, but it doesn't cover everything. For example, some policies only cover errors or omissions in your usual program of checking for insurance. If you don't have a program, you may not have any protection. Coverage under some E&O policies ends immediately when you receive notice that a borrower's coverage has lapsed. Finally, some E&O policies do not cover personal property, watercraft, vehicles, or aircraft.

Banks can overcome these hurdles by adopting a uniform procedure for managing borrowers' insurance. Steps in this process should include (1) establishing a threshold of concern, a loan amount below which the bank willl not actively pursue the borrowers' insurance; (2) assigning a person or organization to be responsible for borrowers' insurance; and requiring documented follow-up on the entire process.