Title insurance is an important—and sometimes misunderstood—aspect of real estate transactions. Even if the parties to a deed do not plan to purchase title insurance, it is important that the deed meet title insurance requirements.
Many people assume that if a deed is valid under state law and meets all recording requirements, there is nothing to worry about. This is not always the case. There are two different sets of requirements that apply to real estate transfers. First, there are legal requirements. Legal requirements can differ from state to state, but generally include things the correct format and language to include in the deed.
The second group of requirements is practical requirements. Title insurance fits in this category. As discussed below, sometimes title insurance requirements are more important than legal requirements.
What is Title Insurance?
Title insurance is a special type of insurance that protects the insured from financial loss relating to problems with title to real estate. These title problems include:
- The transferor did not own the property that he or she conveyed to the new owner;
- The transferor owned the property at one time, but has already conveyed some or all of the property to another new owner;
- There are unpaid mortgages or other liens against the property that give creditors a right to seize the property in a foreclosure proceeding;
- There are unpaid property tax liens or other tax-related encumbrances that give taxing authorities or tax lien purchasers the right to foreclose against the property; or
- There are gaps in the prior chain of title, such as deceased owners whose estates have not been admitted to probate.
If a lawsuit arises due to any of these issues, the title insurance company will defend the lawsuit and, if the title insurance company loses the lawsuit, pay any claims relating to the lawsuit.
Without title insurance, the parties to a real estate transaction could only look to each other to resolve any legal liabilities. If the seller conveys property with a deed form that includes a warranty of title, the buyer could sue the seller for any title issues. But if the seller is insolvent or cannot be located, this may not be an effective remedy for the buyer. From the seller’s perspective, the possibility of future lawsuits over property that was sold years ago is not attractive.
Title insurance allows both buyer and seller to shift the risk of loss to the insurance company. The insurance company is a professional organization designed to identify any title issues before they arise. If the title company fails to identify the issue and a title defect is later discovered, the title insurance company is responsible. The buyer need not rely solely on the financial status of the seller and, unless the seller gave a warranty of title, the seller need not worry about future legal liability.
Because both buyer and seller would usually prefer to shift risk to a title insurance company, title insurance supplements and even replaces the protection provided by warranty deeds in many residential real estate closings.
Why Title Insurance Matters
People who transfer property to friends or family members often mistakenly assume that it doesn’t matter whether title is insurable. This is a mistake. Title insurance matters because it effects the value of the property.
If title is not insurable, it cannot be sold for full market value. Any buyer would need to bring a legal action to remove any title issues (a process called clearing title). Because of this built-in legal liability, no reasonable buyer would pay full price for property that does not have insurable title.
The lack of insurable title may not have short-term effects. The person who receives the property can use it immediately. But the property will be worth less because of the title issues. Sooner or later, the property will be sold or mortgaged. The lack of ability to obtain title insurance will prevent the buyer or borrower from getting full value for the property.
To protect against the risk of de-valuing the property, real estate transfers should be structured in a way that meets title insurance requirements. This helps ensure that the full value of the property passes to the new owner.
Title Insurance Requirements
Each title insurance company has underwriting guidelines. These guidelines can differ from state to state and from title company to title company. The title company will only issue policies on transactions that meet these underwriting guidelines.
Because it is important that title be insurable, the title insurance companies’ underwriting guidelines can be almost as important as the legal requirements of state law. If a title insurance company will not issue a policy on a specific type of deed, for example, it may not matter whether the deed is otherwise valid under state law.
How Title Insurance Works
Before issuing a title policy, title insurance companies will search the public records to verify that all prior conveyances of the property are in order. An abstractor is often used for this purpose. The abstractor will look at each document to be sure that it is clearly connected to the prior document.
Title examination is about connecting each document to the prior document. For example, if John Amos Doe was received the property by deed at some point, the abstractor will look for a deed from John Amos Doe at a later point. When the abstractor finds that deed, she will verify that the same name was used and that the property was validly conveyed. This process is known as verifying the chain of title.
The abstractor will also review the legal descriptions used in each conveyance. This lets the abstractor verify that the correct property is being transferred. Improper legal descriptions can raise questions about property ownership.
The abstractor will also look for evidence of any recorded encumbrances on real estate. If the current owner mortgaged the property or allowed some other form of lien to attach to the property, the abstractor will look for evidence that the mortgage was paid off or the lien was otherwise satisfied. This ensures that there are no liens against the property that affect property value.
After examining the chain of title, the abstractor reports his or her findings to the title company. A title agent—required to be a licensed attorney in some states—will then review the findings and write a title policy on the property. There are two main types of title policies:
- Owner’s Policy – Insures that the owner has title to the property and that the title is free from any liens or encumbrances other than those listed in the title policy.
- Lender’s Policy – Insures the lender against any title issues that would affect the lender’s collateral in the property.
For each type, the policy will insure title as to anything other than the exceptions to title listed in the insurance contract. The exceptions to title usually involve things that the abstractor could not have located in the public records, as well as items that the abstractor located but could not be resolved prior to closing.
Role of Title Insurance in Warranty Deeds
There are two forms of warranty deeds, which differ in the scope of warranty they provide:
- Full Warranty – Deeds that provide a full or unlimited warranty are called warranty deeds. They may also be called general warranty deeds to distinguish them from deeds that provide a limited warranty. This type of deed provides warranties for all title problems, including those that arose before the previous owner owned the property.
- Limited Warranty – Deeds that provide a limited warranty are called special warranty deeds, grant deeds, or covenant deeds, depending on the state. These deeds only provide a warranty for title problems that arose while the previous owner owned the property.
Each of these types of deeds use the warranties to allocate risk. If it turns out that there is a problem with title, the transferor is legally responsible to the transferee. Stated differently, the transferee can bring a lawsuit or other legal action against the transferor to force the transferor to fix any problem with the property.
The role of warranty deeds has changed with the widespread availability of title insurance. Title insurance shifts risks from the transferor and transferee to the title insurance company. If there is a problem with title, the transferee can file a claim against the title insurance company instead of suing the former owner. This can present a win/win situation for both the transferee and the transferor:
- The transferee often prefers title insurance over having to rely solely on the former property owner. Title insurance is backed by a reputable company, making the transferee less dependent on the financial status of the former owner if there is a claim against the property.
- Transferors like title insurance because it shifts risk from the transferor to the title insurance company.
Although a title insurance policy may be issued in connection with a warranty deed, a title insurance policy can also be issued in a transaction that uses a quit claim deed or other form of deed that does not provide a warranty of title.