Surging opportunities in bricks and mortar

The reinsurance industry has been facing hard times for some years, as rates soften, investment returns dwindle and opportunities dry up. But there are still some places where profits can be found—and mortgage reinsurance is one such place, as many Bermuda players have discovered.

Mortgage reinsurance has come a long way since the financial crisis of 2008/09. Back then the mortgage industry was a very different place and took substantial losses from defaulting sub-prime lenders. In the wake of that, the housing market took a long hard look at what had gone wrong and changed the way it approached the concept of defaulting borrowers. Mortgage reinsurance was one such change as the market realised its attractions.

In US Mortgage Reinsurance Continues To Shine, Though Pricing Is Tightening issued in August this year S&P Global Ratings(S&P) points out that opportunities in the US mortgage business have provided reinsurers with some respite from deteriorating business conditions in traditional property/casualty (P/C) reinsurance lines (especially property-catastrophe).

According to S&P, this has forced many to look for growth avenues to help support their earnings. As the returns in the mortgage reinsurance business have been fairly healthy, this has attracted an increasing number of players who hope to benefit from still-decent margins helped by favourable macroeconomic conditions, and thereby diversify their business profile.

Hardeep Manku, primary credit analyst at S&P, says it is important to bear in mind that the mortgage market in 2017 is radically different from that of a decade ago.

“It’s pretty public knowledge how the US mortgage market performed through the financial crisis of 2008. When you look at mortgages the main cut-off year was 2008; there’s a marked difference in the quality and performance of the mortgages originated in 2009 or later, compared to those originated prior to the crisis years,” he says.

“We all know what happened in 2007/08. Post-2009 mortgages have performed quite strongly, much better than many had expectations for them. Usually what happens in a cycle is that credit quality improves because the underwriting standard tightens.

“You need to think of it as a pendulum—it moves in one direction and then over a period of time it starts moving back to the centre. While the underwriting guidelines tightened in response to the mortgage crisis we haven’t really seen much loosening of the credit box over that period.”

Margins loosen

Manku says there has been some loosening at the margins, however, as can be seen with the US government-sponsored housing enterprises (GSEs)—aka Freddie Mac and Fannie Mae. They have seen the maximum loan-to-value ratio (LTV) increase from 95 percent to 97.5 percent a few years ago.

The market is also seeing a higher proportion of lower borrower credit scores, but this is nowhere close to the level during the financial crisis. As a result the credit risk profile of the underlying portfolio hasn’t expanded much and, according to Manku, that’s a big reason for these mortgages to have performed so well.

The attractions of this part of the market have caught the eye of a number of companies, including Capsicum Re, which has specifically targeted it.

“Capsicum Re is coming up for its fourth anniversary and we’ve been successful in building niche business units,” says Rupert Swallow, CEO and co-founder of Capsicum Re.

“Our mortgage reinsurance unit will be our ninth business unit. We have focused over the past four years on areas of the industry where there’s either an opportunity or a requirement for the types of services that Capsicum Re delivers to the marketplace, ie, highly intermediated, relationship-driven, on both the buy side and the sell side,” he says.

“The mortgage reinsurance business is therefore absolutely in our sweet spot, in that it’s a very specialist area of the industry with what seems to be an interesting market opportunity. Reinsurers perceive the risk of mortgage reinsurance to be non-correlated to their basic property portfolios, which of course are principally threatened by catastrophe risk.”

Swallow says that the reinsurance of mortgages appears to have potentially higher returns than the traditional property market, where there is a long-term soft market. According to Swallow, the mortgage reinsurance asset class has picked up substantially since Arch became the first company to deal with the GSEs in 2013, to the point where there is what he describes as a ‘vibrant’ reinsurance market of perhaps 35 carriers on the sell side; on the buy side are the monolithic organisations—the GSEs—which have a demand, or a requirement, for traditional reinsurance capacity.

“You have all the ingredients for a positive business opportunity from a broker perspective and that’s principally the reason for us to launch into this marketplace,” says Swallow.

“The interesting part of the decision-making process was the realisation that the mortgage reinsurance market is going be a long, slow burn for us. We are expecting to build up our expertise, our know-how, our modelling capability, and then build all those relationships that will be required on the buy and the sell sides.

“This is not a short-term opportunity for us, it’s a long-term one.”

S&P’s Manku agrees that the market is attractive at the moment. He says mortgage performance has been fairly strong and robust, so if there is a stress event then mortgage performance is expected to be more resilient than was observed during the financial crisis of a decade ago. As a consequence, he says, market participants are taking “a fair bit of comfort” from that fact.

“The second thing that’s coming into play is the demand for mortgage reinsurance,” Manku adds. “The primary driver of demand is Fannie Mae and Freddie Mac. The GSEs are holding most of the mortgages that have been originated post-crisis.

“After the crisis their capital was depleted because of all the losses. They were put into conservatorship and one of the mandates from their supervisor was that they needed to involve private capital to a greater degree.

“They created credit risk transfer (CRT) structures to involve various forms of private capital including capital markets and reinsurance.”

Just more capital

Manku points out that private mortgage insurance (PMI) is another form of private capital that the GSEs have used both post and pre-crisis. It’s not new—it’s just one of the ways GSE have chosen to diversify their sources of capital. There is demand from private mortgage insurers as well. Reinsurance provides capital relief, which enables the mortgage insurers to write more business.

While S&P believes that returns will remain decent for the next few years in view of economic growth and a robust housing market, the margins enjoyed by re/insurers that participated at the inception of the GSEs’ CRT programmes and built up a good portfolio won’t be available, considering the expectation for pricing and increase in the programmes’ risk profile.

Therefore, re/insurers that understand the risk well and can allocate limits by various layers and programmes based on risk-reward analysis will stand to benefit despite some tightening. For others, the prospect of adequate returns may be tempting enough to load up on this business.

However, S&P also points out, it’s important to consider the long-tail nature of this business, and if things were to go south, it is not as easy to get this risk off the books. As a result, S&P says it will continue to focus on the re/insurers’ risk management framework—their understanding of the risk and its relationships with other exposures, strength of risk controls, and alignment of internal limits with their risk appetite.

S&P concludes by stating that a robust framework can enable re/insurers to take advantage of this business line and manage their business profile to offset some of the pressures from weak business conditions within the traditional P/C reinsurance sector without, in its opinion, exposing them to outsize risks.