A different world
How does mortgage indemnity reinsurance work?
This class of business is dominated by the US, the largest global mortgage market, where the government-sponsored enterprises (GSEs)—Freddie Mac and Fannie Mae—are mandated by law to have one of three credit enhancements to be in place at the time the GSEs purchase a high loan-to-value (LTV) mortgage. A mortgage insurance policy from a qualified insurer, as determined by the GSEs, insures the portion of the unpaid principal balance (UPB) of the mortgage in excess of 80 percent of the property’s value.
Mortgage indemnity reinsurance is the reinsurance of these underlying policies. Since 2014, under mandate from the Federal Housing Finance Agency (FHFA) to reduce US taxpayer risk, the GSEs have been consistently transferring credit risk to the capital markets and reinsurance market via their credit risk transfer (CRT) programmes.
The typical CRT deal structure is mezzanine, excess of loss coverage, in which the GSEs sell in the range of 250bps to 300bps of the risk, as measured by UPB.
Historically this coverage was provided by monoline mortgage insurers and there was no change to the one-way counterparty risk exposure post the financial crisis. Arch Mortgage Risk Transfer (MRT), was an innovative step within CRT, whereby the GSE was able to mitigate its one-way risk exposure by bringing in more highly rated, diversified sources of capital.
MRT’s main distinction within existing forms of CRT has been procuring reinsurance coverage from global, diversified reinsurers on >80 percent LTV mortgages in the first loss position.
In March 2018, Arch Capital Group worked with the GSEs to structure a new mortgage CRT programme. Freddie Mac launched the first Arch MRT product, IMAGIN 2018-01, which placed a highly diversified panel of reinsurers behind Freddie Mac in the first transaction of its kind.
Fannie Mae’s programme is known as an EPMI (Enterprise Paid Mortgage Insurance); both programmes aim to bring robust and diverse capital to the low down-payment housing market (>80 percent LTV).
How is it safer than the earlier iteration of mortgage risk transfer that led to the financial crisis of a decade ago?
Understanding the answer to this question is key for markets interested in writing mortgage risk, as it is a completely different world now compared to pre-2008. Since the financial crisis I would say there have been three key changes.
First is the introduction of a ‘qualified mortgage’ standard in the underwriting process which has led to a contraction in the credit box leading to a very high standard of underwriting via this strict lending criteria.
Second, Freddie Mac and Fannie Mae have made all their mortgage data publicly available. This performance data goes back years, over several cycles, meaning that reinsurers can model specific mortgage types and portfolios for a range of economic scenarios making mortgage reinsurance a data-rich class of business.
Third, these GSEs started CRTs which now have up to 50 reinsurances participating across multiple transactions. The GSEs have a group of underwriters who conduct detailed analysis on the underlying mortgage portfolios and are, in effect, another set of eyes watching the credit mix.
Does this market offer strong growth potential for reinsurers?
Unquestionably. The expansion of mortgage reinsurance since 2013 has delivered attractive margins and low loss ratios so it remains one of the few classes demonstrating growth for reinsurers. We see this trend continuing as mortgage risk is set to grow, and the underlying economic metrics from the US, the world’s largest mortgage insurance market, remain strong.
This will help underpin the growth for potential reinsurers. There are very few other lines of business in the reinsurance world which offer these combined attributes.
Recent innovations within the mortgage insurance world, such as Arch’s MRT transactions, are only increasing the need for more capacity from diverse reinsurers.
Is specific expertise to write this business needed?
We have an ‘identify, educate and recruit’ philosophy for new capacity which is a tried and tested roadmap for reinsurers interested in this class of business. Our experience is that a market doesn’t need any prior experience within the area, rather a willingness to understand the fundamentals.
This is where Arch’s experience as the world’s largest mortgage insurer is invaluable for market education as we can help markets understand the underlying data, the story it tells, and how differing scenarios would play out.
How can Bermuda benefit from this market?
Bermuda is a well-positioned geographically, agile and adaptable market which means it can respond to changing dynamics in the reinsurance market. Mortgage indemnity is one of the few classes that’s growing and as reinsurers look to diversify their portfolios, they can take advantage of the growth opportunities offered by the structure of the Bermudian market.
Bermuda is at the centre of reinsurance excellence and home to Arch Capital Group, which this year completed the largest mortgage insurance-linked securities (ILS) transaction to date. Mortgage risk reportedly now makes up 18.9 percent of all ILS risk capital.
What do you foresee for the medium and long-term future of this market?
In the US, the future of the market is the MRT programme. Not only is it an excellent example of utilising the emerging interest from reinsurers in a sector and adapting it to meet stakeholder demands, but it fundamentally helps to de-risk the US housing finance system. We see the programme growing in the future—the market is around $260 billion and MRT currently covers a fraction of it.
Looking at the US, the current supply and demand dynamic will continue to shape the market. The persistent supply shortage in the US housing market continues to underpin the steady growth in house prices seen over the last few years. What this persistent housing supply shortage means is that the risk of a national house price decline is extremely limited, as the shortage should help cushion home price declines.
Furthermore, demographic changes in the US population will increase the demand side of the real estate market dynamic. The increasing rates of home ownership by millennials is also expected to accelerate the demand for housing as this generation reaches prime home-buying age. All of this leads to the conclusion that this lack of supply and increasing demand will continue to underpin the housing market.
There are also opportunities outside the US and Bermuda markets, namely in Asia where we are working with a number of insurers, lenders and government bodies who are interested in the role that reinsurance could play in extending lending and developing home ownership and home building.