Mortgage Insurance

 

Definition and Purpose

Mortgage default insurance (MI) is a specialized form of credit insurance or guarantee that protects mortgage lenders and investors, as beneficiaries, against loss by reason of borrower default on individual mortgage loans—most often loans secured by individual housing units. MI is not to be confused with mortgage life insurance, mortgage disability insurance, and mortgage payment protection insurance, which protect borrowers, as beneficiaries, by repaying some or all of their mortgage obligations in the event of borrower death, disability, or other defined loss of income such as unemployment. MI is also distinct from, though closely related to, “financial guaranty insurance,” which protects investors against losses from defaults on mortgage-backed securities (MBS) and bonds whose underlying collateral typically includes individual mortgage loans.

The benefits of MI, depending on an individual country’s needs and circumstances, can include:

  • Increasing access to homeownership financing for borrowers of limited means
  • Expanding lenders’ housing finance opportunity by reducing credit risks
  • Helping to grow mortgage secondary and capital markets by attracting risk-averse investors
  • Stimulating economic activity through increased housing construction
  • Strengthening mortgage lending standards, standardization, and housing finance sector stability
Beyond advancing homeownership or other primary housing policy goals such as improving the quality of the housing stock, the main underlying objective of MI is to protect and stabilize a country’s banking and housing finance sector in the event of economic catastrophe, i.e., severe recession or depression. MI risk is unusual in terms of its long-term cyclical exposure and its dependence upon government economic policies.

 

 

Background and Evolution

Mortgage insurance and guarantee programs exist in more than 30 countries on all continents. Nearly two-thirds of all MI programs globally are government-sponsored, although program sponsorship and structure vary greatly and include privately capitalized firms, non-profit/NGOs, and a growing variety of public-private partnership arrangements. Most programs today are relatively small, with limited operating experience that has yet to include survival through a period of significant economic stress and falling home values.

Mortgage insurance began over 100 years ago in the United States as an adjunct to title insurance and was used to stimulate private investor interest in purchasing “guaranteed mortgages” from mortgage companies. All such guarantee programs failed with the advent of the Great Depression in the early 1930s due to inadequate reserves, ineffective regulation, conflicts of interest, and bad property appraisal practices.

Government-sponsored MI began in the United States in 1934 with the creation of the Federal Housing Administration and the Mutual Mortgage Insurance Fund. The primary purpose was economic and financial stimulus, via new housing construction. This unsubsidized FHA program has operated successfully for over 75 years.

The 1950s and 1960s saw government-sponsored MI programs initiated internationally, including in Canada, Australia, the Netherlands, the Philippines, the Dominican Republic and Guatemala. During these two decades, private-sector MI providers also began operating in the United States, Canada, Australia, and the UK.

In the late 1980s, established MI programs in some developed markets—both public and private—encountered severe economic stress, resulting in risk and financial management and regulatory reforms. Beginning in the late 1990s many new public and private MI programs were established in Europe, Africa, the Mideast, Latin America and Asia, in support of both primary lending and emerging securitization markets. The recent credit crisis is testing the staying-power of some countries’ MI programs.

Conditions and Coverage
 
Key success factors for a country-based MI program include:

  • Functional legal and regulatory system for title registration, contract enforcement, financial institutions.
  • Functional primary mortgage market, including loan underwriting, loan administration, transaction costs, property valuation
  • Available information and data, including property sales prices, borrower credit, mortgage performance
  • Government economic policies conducive to economic and financial sector stability, personal savings
The most frequent use of MI is in situations in which borrowers have not accumulated a sufficient cash deposit (down payment) to meet minimum lender requirements; where lenders are reluctant to lend to informal sector borrowers; and where capital market investors seek a cost-effective credit enhancement, including for investment rating purposes. Many countries offer lenders a regulatory inducement to secure MI coverage—particularly on high LTV ratio loans—either in the form of a substantial reduction in bank risk-based capital requirements, or via an outright regulatory mandate. Such regulatory inducements are also considered to be a useful deterrent to “adverse selection of risk” by insured lenders.

MI typically entails a contract between the lender and the MI provider that defines the terms of coverage, its cost, and provisions for claims recovery. Premiums charged to the lender are typically passed through to the borrower. Premium rates may vary according clearly identifiable risk classes, such as loan-to-value ratio (LTV), type of mortgage instrument, terms of coverage, and other significant factors affecting risk of borrower default. Experience based premium pricing models are driven by projections of both the frequency and the severity of claims losses. MI premiums may be charged through from lender to borrower as part of the interest rate, as an annual or monthly add-on, or as an up-front lump sum that may or may not be added to the initial principal balance of the loan.

Coverage may include either 100 percent of the loan balance or some designated partial (usually first loss) percent coverage. Likewise, MI coverage may extend for the life of the insured loan or for some predetermined or lender-discretionary shorter period. Some type of risk-sharing between insurer and lender is often viewed as a useful deterrent to “moral hazard.” Coverage typically excludes fraud.

MI programs underwrite credit risks originated by lenders in several different ways, including:
  • individual loan document review
  • electronic document or data transfer, with automated approval based upon predetermined criteria
  • underwriting approval authority delegated to the lender by contract, with periodic reporting and audit
Public Role in MI

Public MI programs, even without direct subsidies, typically include a social purpose, including some form of socioeconomic targeting. Such program targeting often includes some combination of income, home price or insured loan limits. Certain types of public subsidy programs, such as down payment assistance, can be productively combined with public MI; however, the public MI program itself should not provide subsidies that undermine its capital reserves and increase exposure to the national treasury.

MI, including both private and public programs, needs effective regulation, the most important element of which is a requirement to build and hold segregated capital reserves that are adequate to pay all claims in the event of economic catastrophe. In order to avoid the need for government“bailouts” of public MI or insolvency of private providers, MI programs should be required to operate under sound business principles, including actuarially based pricing and independent financial audits. Financial regulators that grant risk-based capital relief to banks that use public or private MI protection need to know that those insurance and guarantee programs will be amply capitalized to pay claims over time and under stress.

Various forms of public-private MI partnerships have emerged with some success over recent decades, including:
  • government-sponsored programs reinsured by private MI providers (e.g., Hong Kong, United States)
  • private MI programs reinsured by a public MI provider (e.g., Canada)
  • public sponsorship with joint public-private governance structure (e.g., the Netherlands)
  • public and private financial support for special purpose NGO (e.g., South Africa) 
Related Products

Insurance and guaranty products that are variants or closely related to MI, as discussed above, include:
  • “timely payment” or “cash flow” guarantees on loans in default, payable to MBS holders (e.g., the United States’ “Ginnie Mae” program)
  • “mortgage payment protection” (MPP) insurance covers borrower’s monthly mortgage payments in the event of loss of income/employment (e.g., in Mexico, the UK, other European countries)
  • “gap insurance” protects lenders against default-related losses during the interim period between loan closing and proper title and mortgage registration (e.g., in Poland)
  • “mortgage life insurance” pays off the mortgage debt in the event of death of primary breadwinner. Such coverage is required by lenders in many developing markets.

 

 

Key Cases to Watch

Canada
The Canadian MI system has been increasingly recognized for its “best practices,” which include:

  • statutory requirement for banks to use MI coverage on all high LTV loans
  • government backing of private MI providers in the event of insolvency
  • bank regulator use of MI underwriting limits to help prevent irresponsible lending
While some smaller countries’ mortgage markets may not generate sufficient lending volume to support multiple (i.e., both public and private) MI providers, the Canadian system bears watching—including how well it manages to maintain a “level playing field” for public and private MI programs.

United States

The dominant public MI program—the FHA—has had severe losses since 2007, which has precipitously eroded its statutory capital from three times the required minimum to about one quarter of the amount required. While premium rates have been substantially increased and underwriting standards tightened, a weak, post-subprime national market is looking to the FHA to assume an enormous volume of new underwriting risk. Interested observers are closely watching to see whether in 2010 FHA’s capital begins to recover or falls further below required minimums.

The private MI industry, also fulfilling the role of “economic shock absorber,” incurred over US$20 billion in losses during 2008-09, versus only $2.7 billion in 2005-06. Paying out such massive claims has put the companies close to their regulatory capital limits and constricted new-business-writing capacity. Some new private capital has been raised, and recovery appears likely.

Of special note has been the successful introduction, by both a state-based public guaranty fund and some private providers, of an ancillary MI benefit directly for borrowers in the form of limited “mortgage payment protection” (MPP) insurance in the event of involuntary loss of employment. For no added premium, the standard MI coverage carried by lenders will now advance up to (typically) six monthly payments to help the borrower avoid foreclosure while he or she seeks another job or relocates.

Peru
Peru’s Fondo MiVivienda guarantee fund demonstrated its ability to induce private lenders to move “down-market” from serving only “A”-level borrowers to also serve profitably “B” and “C+”-level borrowers. Can this MI success story be further replicated in Peru or other national markets?

The Netherlands
Operational since 1995, the Netherlands’ Waarborgfonds Eigen Woningen (WEW) MI program has succeeded in reducing lender risk-based capital by over 90 percent and lowering borrowers’ mortgage interest rates by about 0.5 percent or more. Of special note is this program’s premium rate—recently increased to a current one-time charge of only 0.55 percent. This premium charge remains far lower than other country-based MI programs, both public and private. To date, WEW has managed to pay its claims and maintain reasonable reserves under its uniquely low rate structure. Will the Netherlands’ financial and housing market stability, good credit risk management, and remarkably strong borrower credit culture enable such low MI charges to be sustained over the long run?

Lithuania
Established in 1998, the Lithuanian Mortgage Insurance Company (“UAB”) is 100 percent government-owned, but does not enjoy a sovereign guaranty of claims payments. UAB operated successfully and grew until the credit crisis of 2007-08, when volume fell sharply and defaults and claims multiplied. Although the government recently tripled UAB’s capital reserves to 25 million Euros, without a backup sovereign guarantee private lenders remain wary of UAB’s claims-paying capacity and are reluctant to purchase MI coverage on newly originated loans. Will the program continue to fulfill its mission, with ample capital and/or a backup government guarantee sufficient to restore banking sector confidence?

The Philippines

The government-sponsored and -backed Home Guaranty Corporation insured home loans in the Philippines since the 1950s. However, in the 1980s it also began insuring large-scale housing development loans whose risks ripened into massive claims losses, exceeding the Fund’s capital and resulting in a call on the government to make good on its backup guarantee. The national legislature delayed action, and it took many years to clear the backlog of unpaid claims. Will HGC’s program reforms provide the long-term sustainability and private-sector confidence essential to its housing policy mission?

India, Singapore, Thailand and Brazil

These four countries are at various stages of developing or seriously exploring new country-based MI programs. India has progressed furthest, with a program launch imminent; Singapore has adopted a special MI regulation; the Government Housing Bank of Thailand is in the advanced planning stages of developing an MI program; and Brazil is at an earlier research/reconnaissance stage.

 

 

Links to Publications

European Mortgage Federation, Study of the Efficiency of Mortgage Collateral in the European Union, Brussels 2008

 

Related Documents
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