Capital charges on Fannie and Freddie deals
As part of its strategic plan for conservatorship of the government-sponsored enterprises (GSEs) Freddie Mac and Fannie Mae, the Federal Housing Finance Agency (FHFA) requires that GSEs de-risk their balance sheets and expand the role of private capital in the mortgage market.
Around 2013, Fannie Mae and Freddie Mac began transferring mortgage credit risk to the reinsurance market through their credit risk transfer (CRT) programmes: Freddie Mac through the Agency Credit Insurance Structure (ACIS) and Fannie Mae through Credit Insurance Risk Transfer (CIRT).
ACIS and CIRT transactions transfer mortgage credit risk to the reinsurance market through excess of loss reinsurance agreements (see Charts 1 and 2 for simplified examples of risk towers from ACIS and CIRT transactions).
Each ACIS transaction transfers multiple layers of risk, while each CIRT transaction transfers only one layer of risk. As Chart 3 shows, reinsurers have significantly expanded their participation in these programmes since their inception. As of June 2019, the GSEs had transferred $22.2 billion of initial limits to the reinsurance market.
CRT Net Capital Charge and its impact
The overall Net Capital Charge is defined as the amount of net capital charged in Best’s Capital Adequacy Ratio (BCAR) model as a percentage of original exposure. It is based on unexpected losses and premiums associated with the GSE CRT programmes and takes into account each reinsurer’s portfolio of ACIS and CIRT transactions.
AM Best’s factor-based approach, as described in the criteria procedure, Evaluating Mortgage Insurance, is used in the calculation of the Net Capital Charge for each reinsurer.
For ACIS transactions, the Net Capital Charge associated with each risk layer depends on its position in the transaction’s risk tower. According to the transaction structure, the rate at which the limits of the top layers of ACIS transactions shrink is relatively high, given that scheduled amortisation and prepayments in the loan portfolio are allocated sequentially from the top to the bottom layer to reduce those limits.
Charges in the layers
In a number of cases, Net Capital Charges are less than zero for specific layers of ACIS transactions because (i) losses do not penetrate those layers (given AM Best’s Value-at-Risk [VaR] analyses); or
(ii) those layers may have been very small to begin with and have paid down completely (according to our assumption of the amortisation of the underlying loans) before the losses could pierce such layers.
Once the Net Capital Charges for each layer are calculated, they are aggregated at the transaction level (floored at 5 percent of current exposures) and ultimately at the portfolio level for each reinsurer, before they are captured in the BCAR model.
Chart 4 uses exposures in the ACIS 2015-9 transaction to show how the Net Capital Charges are aggregated from the layer level to the transaction level while incorporating the Net Capital Charge floor of 5 percent of total current exposures. The chart shows the exposure information and Net Capital Charges for layers M1, M2, M3, and B of ACIS 2015-9.
The last row in Chart 4 is the consolidation of the layer-by-layer exposures and Net Capital Charges. Note that in this example, the exposure associated with the M2 layer is relatively large. Thus, the transaction-level Net Capital Charge (before applying the 5 percent floor) is approximately $1.75 million, or 2.79 percent of the current exposure (2.79 percent = $1.75 million/$62.83 million). When the 5 percent floor is applied, the resulting Net Capital Charge is $3.14 million ($3.14 million = 5 percent of $62.83 million).
Although the transaction as a whole benefits from the negative Net Capital Charge contributed by the M2 layer, the aggregate Net Capital Charge is still floored by 5 percent of the prevailing exposure at the time of the analysis.
Chart 5 shows the average Net Capital Charges at the VaR 99.6 level associated with each layer for a sample group of ACIS and CIRT transactions that were originated in 2017 and 2018, with similar characteristics. The chart assumes equal dollar exposures in all layers. The ACIS transactions (the first three bars in the chart) confirm the escalating risk charges from the top layer (ACIS M1) to the bottom layer (ACIS B1).
Reinsurance impact
The impact of the total Net Capital Charge on a reinsurer due to its portfolio of GSE CRT transactions varies depending on the diversification of the reinsurer’s business lines as well as the magnitude of its investment risk.
AM Best’s Net Required Capital (NRC) formula incorporates a number of risks, B1 through B8, as Chart 6 shows. Note that in Chart 6, Net Capital Charge is represented by B5m, the mortgage-related net loss and LAE reserves risk. (For a more complete description of the mortgage-related NRC calculation, see AM Best’s criteria procedure, Evaluating Mortgage Insurance.)
The effect of GSE CRT risk on NRC can be illustrated using three hypothetical reinsurers with the following characteristics:
- Hypothetical reinsurer 1: Large, well-diversified business lines; low-risk investment portfolio
- Hypothetical reinsurer 2: Moderately diversified business lines; high-risk investment portfolio
- Hypothetical reinsurer 3: Covers only mortgage risk; low-risk investment portfolio
The assumptions underlying the mortgage risk that these hypothetical reinsurers undertake follow:
- Calculations are performed at the VaR 99.6 level.
- The GSE mortgage exposure limit is 20 percent of reported surplus for each reinsurer.
- The Net Capital Charge of 55.4 percent is based on a portfolio of selected ACIS/CIRT transactions the GSEs offered for which the reinsurers cover the same limit amount for each layer in each transaction.
To better understand the effect of GSE CRT-related Net Capital Charge on each of the three hypothetical reinsurers we define the additional term: Incremental NRC = NRC including GSE risk minus NRC excluding GSE risk.
Chart 7 shows the Incremental NRC for each increase in limit by the three hypothetical reinsurers. Incorporating the additional GSE CRT exposure has the least effect on Hypothetical reinsurer 1, which experiences an increase of only $16 in NRC for every additional $100 of limit.
Hypothetical reinsurer 2 is more acutely impacted, as it experiences an increase of $29 in NRC for every marginal $100 of limit.
The most severe impact is experienced by Hypothetical reinsurer 3, which covers only mortgage risk and experiences an increase of $56 in NRC for each additional $100 of limit—3.5 times the increase in NRC compared to the NRC increase for Hypothetical reinsurer 1 (the large, well-diversified reinsurer).
The various types of reinsurers illustrate the effect that business line diversification and the risk of their investment portfolios have on incremental NRC. Adding mortgage exposure has a far more muted effect on the incremental NRC (due to the assumed 10 percent correlation between mortgage reserves risk and non-mortgage reserves risk) for a well-diversified reinsurer than for a reinsurer covering only mortgage risks.
Furthermore, due to the assumed 50 percent correlation between mortgage reserves risk and investment risk, the riskier the investment portfolio, the greater the impact of the additional mortgage risk on the NRC.
Wai Tang is a quantitative director, Insurance-Linked Securities Group, AM Best. He can be contacted at: wai.tang@ambest.com
David Mautone is a quantitative specialist, Insurance-Linked Securities Group, AM Best. He can be contacted at: david.mautone@ambest.com
