The emergence of US mortgage exposure in reinsurance
Historically, US mortgage risks ceded to the reinsurance market were generally concentrated among reinsurance affiliates of primary monoline mortgage insurance companies, captive mortgage reinsurance entities affiliated with mortgage lending institutions, and a handful of mainstream reinsurers. US mortgage insurance exposures, which generally have been an obscure product line for reinsurance companies, have now become very pronounced in reinsurers’ lines of business.
Two key factors are driving this phenomenon: (i) the mandate by the Federal Housing Finance Agency (FHFA) requiring the two government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, to cede as much credit risk of their pooled loans as possible to the private sector; and (ii) soft market conditions in the property/casualty reinsurance sector, driven by falling rate-on-line on property catastrophe exposures and competition from the alternative capital sector.
Insurance-reinsurance transactions
The re/insurance transactions in the GSEs’ mortgage credit risk transfer programmes mimic a traditional reinsurance programme, whereby an insurance policy for the credit risk on a reference pool of the GSEs’ mortgage loans portfolio is issued by a primary insurer or a protected cell insurance vehicle and transferred to one or more reinsurance companies. The reinsurance programmes are structured as aggregate excess of loss covers with GSEs retaining a portion of credit losses underlying the loan portfolio.
The reinsurers generally follow the fortunes of the GSEs. The majority of the reference pool on the reinsurance programme is generally composed of 30-year loans on single family homes. The reinsurance cover is in effect for approximately 10 to 12 years from the transaction date, with a cancellation option by the GSEs. The reinsurance transactions are partially collateralised, with the amount of collateral provided depending on the credit rating of the reinsurer and other factors.
As of September 20, 2017, the GSEs have transferred approximately $12.3 billion in limits through two programmes associated with losses on about $932.7 billion of mostly 30-year mortgages in well-defined reference pools. Fannie Mae’s and Freddie Mac’s reinsurance programmes are called Credit Risk Insurance Transfer (CIRT) and Agency Credit Insurance Structure (ACIS), respectively.
Net required capital
Net required capital (NRC) is an important component in AM Best’s risk-based capital approach in the rating of insurance and reinsurance companies. The NRC formula is calculated to support the three broad risk categories: investment risk, credit risk, and underwriting risk. The NRC formula also includes a covariance adjustment to reflect the relative statistical independence of the individual components. Figure 1 shows the NRC formula.
AM Best’s determination of a reinsurer’s NRC to account for net unexpected losses associated with the GSEs’ sponsored credit risk-sharing reinsurance programmes depends on stressed loss projections associated with the reference pool of mortgages, as well as on the premiums earned by the insurers for providing protection on the risk-sharing programmes. Ultimately, losses and premiums determine the capital charges associated with the reinsurance programmes which are placed into the underwriting risk bucket of the NRC.
Calculating capital charges
AM Best’s recently released draft criteria procedure, Evaluating Mortgage Insurance, describes in detail how to incorporate the exposures associated with the GSE reinsurance programmes into the NRC calculation for reinsurers.
To calculate the capital charges associated with the GSE reinsurance transactions, AM Best generally:
- Calculates the projected stressed losses associated with mortgage reference pools;
- Determines how the projected losses may breach each reinsured layer under the reinsurance agreement;
- Calculates the amount of ceded premiums accruing to the reinsured layers;
- Estimates the capital charge for the reinsured layers as the projected discounted losses, minus the projected discounted premiums of the corresponding reinsured layers; and
- Establishes a capital charge floor of 5% of a reinsurer’s total outstanding limits.
Unless reinsurers are covering extreme ends of the risk spectrum in the GSE-related transactions, the initial risk charges as a percentage of limits can generally range from 40% to 60% and the risk charges can diminish quickly over time. Nevertheless, the effect of the risk charges on NRC is attenuated by diversification.
Benefits of underwriting diversification and covariance adjustment
It is important to emphasise the role diversification plays in the calculation of the NRC. In the NRC, the correlation of mortgage underwriting risks to the underwriting risks of other property/casualty lines of business is assumed to be only 10%; therefore, the underwriting diversification benefit is significant when the underwriting risks associated with mortgages are weakly correlated with the underwriting risks associated with other lines of business covered by the reinsurer.
In addition to the underwriting diversification benefits, the covariance adjustment in the NRC formula (as represented by the square root in the equation) further attenuates the capital charge on the losses associated with the GSEs’ mortgage-related reinsurance transactions.
Figure 2 shows the NRC components for a well-diversified reinsurer that has GSE-related mortgage exposures through the ACIS/CIRT transactions. In this example, the underwriting risks associated with only mortgage exposures are represented by B5m and B6m—the risks associated with loss and loss adjustment expense (LAE) and net premiums written, respectively. B5before_mortgage_risk and B6before_mortgage_risk are non-mortgage related reserve and premiums risks undertaken by the reinsurer.
Figure 2 also shows the results of correlating the mortgage and non-mortgage underwriting risks to produce B5 and B6 risks which are ultimately inserted into the NRC formula. The covariance term, (B1n + B2n)*(B5m + B6m), simply reflects 50% correlations between investment assets and underwriting risk—normally a small component of risk in the NRC formula for most reinsurers.
It’s important to note that if we simply added B5before_mortgage_risk and B5m together (implying a 100% correlation of the two risks and resulting in a B5 total of $1,566,124), this risk would have been about 9.8% higher than B5 result of $1,426,223 achieved by correlating the two risks by 10%. Furthermore, after inserting the NRC components in the NRC formula, the NRCs before and after adding mortgage risk were 1,844,636 and 1,895,433, respectively—about a 2.8% increase in NRC.
In the future, AM Best expects to see more of the GSEs’ mortgage risks finding their way to the reinsurance market, as the FHFA expects the GSEs to reduce taxpayers’ risk by expanding the role of private capital in the mortgage market. The GSEs would continue to cede the credit risks associated with single-family and multifamily loans in the foreseeable future. In addition, AM Best also expects an increase in demand in GSEs’ mortgage credit risk from reinsurers and other alternative capital providers in reinsurance.
AM Best will continue to monitor and assess the effects of the GSEs’ risk-sharing programme on the reinsurance market and provide periodic updates on this programme.
Emmanuel Modu is a managing director at AM Best and heads its insurance-linked securities group. He can be contacted at:
emmanuel.modu@ambest.com
