Loss Reserving Approaches for

Mortgage Guaranty Insurance

2001 Casualty Loss Reserve SeminarThe Fairmont, New Orleans

John F. Gibson, FCAS, MAAAPrincipal

PricewaterhouseCoopers, LLP

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Outline of Presentation

• Overview of the Transaction and the Industry• Loss Reserving Distinctives• Factors that Influence Ultimate Losses• Data to Analyze• Contingency Reserves• Industry Loss Reserving Approach• Problems with Traditional Loss Development Methods• Loss Reserving Approaches• Current and Future Trends

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Basics of Mortgage Guaranty Insurance (MI)

• Covers lender for financial loss if borrower defaults

• Required if (loan > 80% x property value)• Lender selects MI carrier, pays the premium,

receives the claim benefit• Lender pays MI via escrow payment • MI carrier prohibited from paying the lender a

commission, policyholder dividend or rebate

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MI and Mortgage Transactions

The Borrower

Fannie / Freddie

The Servicer

The Originator

The MI

The MI Captive

Applies for Loan Selects MI

Sells T

he Serv

icing

Sells TheLoan

Pays the Premium

Makes the LoanPaymentincludingMI fee

Pays the Claims

ForwardsInterest Yieldand MI Claim Checks

Ow

ns

Reinsures

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MI Premium & Rates

• Rate fixed for life of loan• Average rate = 0.60% x original loan amount

($150,000 loan = $900 annual premium)• Rarely in the interest rate (lender-pay)• Rate varies by loan type, term, LTV, but not by

state or loan amount• Premium vulnerable to prepayments &

cancellation

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Why MI Rates Uniform

• Cyclical: The better the past, the more likely the future will be bad

• High capital: Big U/W profits high ROE• Catastrophe risk: Must price for long run• Computers: Hard to change lender loan

origination systems that quote the rate• Price insensitivity: He who chooses MI carrier

does not pay the premium

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Prepayment and Cancellation

• Only the lender can cancel the cover

• 1998 legislation:– Lender must annually notify and allow

borrower-initiated cancellations if loan is 80% of the lesser of appraisal or purchase price

– Requires cancellation at sooner of (a) amortization to 78% or (b) midpoint of loan term

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Cover & Claim

PR

OP

ER

TY

V

AL

UE

10%EQUITY

LOAN( 90%LTV=LOAN

TOVALUE)

25%MI

COVER

EXPO-SURE

=90% X (1-25%)=68.5%

THEORETICAL COVER

AMORT-IZEDLOAN

BACKINTER-

EST

25%MI

COVER

CL

AIM

A

MO

UN

T

NET PRO-

CEEDSFROMSALE

SALECOSTS

LENDER LOSS

DIS

TR

ES

SE

D

PR

ICE

ACTUAL CLAIM

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Coverage Exclusions

• Earthquake/Flood – property must be restored before a claim can be filed (Indirect EQ risk due to drop in values)

• Fraud by lender

• Fraud by borrower unless borrower makes 12 payments

• Environmental impairment/title/etc

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Restrictive Statutory Rules

Original MI Industry failed during 1930s; losses

impaired multi-line insurers -- Hence rebirth in 1959 was under restrictive statutory rules:

Monoline: Cannot endanger P&C co.s w/ MI risk

Capital: Conservative 25-to-1 risk-to-capital ratio

Exposure: Insure < 25% of any 1 loan

Concentration: Less than 10% of risk w/ 1 lender

Contingency reserve: Restricts dividends

Reinsurance: Only with another MI or a P&C insurer backed by a trust account/LOC

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Amount of New Loans Insured($ in billions)

FHA VA MI Co.s

1996 1997 1998 1999

140

120

100

80

60

40

20

0

Source: Mortgage Insurance Companies of America

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MI Industry Loss & Combined Ratios

0%

50%

100%

150%

200%

250%

80 82 84 86 88 90 92 94 96 98

Source: Mortgage Insurance Companies of America

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Industry Income 1996 - 1999$ in Millions

1996 1997 1998 1999

Net WP $2,323 $2,650 $2,832 $3,009

Net EP 2,404 2,738 2,909 3,039

Net U/W Income 719 1,021 1,241 1,668

Net Operating Income 1,228 1,596 1,905 2,331

Source: Mortgage Insurance Companies of America

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Industry Capital 1996 - 1999$ in Millions

1996 1997 1998 1999

Risk In Force $117,471 $127,538 $133,738 $146,054

Contingency Reserve 4,050 5,152 6,510 7,950

Policyholders Surplus 2,256 2,378 2,854 2,857

Total Capital 6,306 7,530 9,365 10,807

Risk-to-Capital 18.6 16.9 14.2 13.5

Premium-to-Surplus .37 to 1 .35 to 1 .30 to 1 .28 to 1

Source: Mortgage Insurance Companies of America

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Total Industry Assets and Reserves

1998 1999

Admitted Assets $12,083,431 $13,800,478

Unearned Reserve Premium

$492,025 $479,979

Loss Reserve $3,884,484 $1,985,822

Contingency

Reserve$6,510,450 $7,949,831

$ in thousands

Source: Mortgage Insurance Companies of America

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Loss Reserving Distinctives

• Claim = Loan that has defaulted as of the statement date

• Not a reserve for the life of the loan

• Type and amount of coverage

• Amounts paid can exceed theoretical coverage

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Factors that Influence Ultimate Losses

• Housing Values

• Unemployment

• Interest Rates

• Claim Settlement Practices

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Data to Analyze

• Analysis by region or state

• Analysis by type of loan – LTV

• Analysis by size of loan

• Analysis by age of loan

• Analysis of Pool Insurance and other higher risk segments

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Contingency Reserves – Need

•Premiums and losses have mismatched timing

•Losses realized when loans become delinquent

•But economic catastrophes can drive 100+% loss ratios for a number of consecutive years

•Mortgage insurers are monoline

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Contingency Reserves - Determination

50% of premium each year is set aside into a contingency reserve and held for 10 years

Losses in excess of a 35% loss ratio in a calendar year can be removed on a FIFO basis

After 10 years, remaining funds, if any, can be moved to free surplus

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Industry Loss Reserving Approach

• Identification of claims by status – for example:

1. Delinquent

2. Pending Foreclosure

3. Foreclosure

4. Claim Filed

• Severity Factor – Percentage of exposure to be paid – greater than 100% for filed claim

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Industry Loss Reserving Approach

• IBNR Provision = % of reported

• Regional analysis

• Pool business analysis

• Recent runoff history very favorable

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Recent Runoff History(in $ millions)

YearOriginal

Loss Reserve

Developed Reserves Thru ’99

Developed to Original

1994 548 371 (32%)

1995 731 515 (30%)

1996 1,000 714 (29%)

1997 1,151 757 (34%)

1998 1,261 805 (36%)

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Problems with Traditional Loss Development Methods

• Leverage effect of economic cycle on number of defaults, cure rates and amounts paid can produce significant volatility

• Economic cycle operates on a calendar year, not an accident year

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Loss Reserving ApproachProjection of Ultimate Reported Delinquincies

• Delinquencies are reported quickly – 85% at 12 months, more that 99% at 24 months

• Check for reasonability against loan balances

• Eliminates need for separate IBNR provision

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Loss Reserving ApproachProjections of Ultimate Claims Paid - Approaches

• Project directly – very volatile

• Project Closed Without Payment (Cured) claims and subtract from ultimate reported

• Bornhuetter – Ferguson method using a priori ratio of closed with payment (CWP) to loan balances

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Loss Reserve ApproachDetermining Paid Claims by Payment Year

• Subtract cumulative CWP claims from ultimate CWP claim to derive remaining CWP claims by accident year

• Using CWP pattern, determine distribution of remaining CWP claim for each accident year to each payment year

• Sum for each payment year

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Loss Reserve ApproachDetermination of Severity

• Review calendar year severity – has been declining since 1996

• Determine selected average loss payment for future calendar years

– Trend of prior years– Relate to average coverage amounts – Balance recent favorable results with

leveraged effect of economic change

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Loss Reserving ApproachReserve Estimates

• Loss reserve by payment year is projected claims to be closed by payment year times projected loss payment by payment year

• Supplement with traditional loss development methods

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Loss Reserve ApproachDetermination of Reserve Range

• Based on conservative and optimistic assumptions for defaults, cure rates and severity

• Reserve range is much wider than most P&C lines of business

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Current & Future Trends

• Impact of the Economic Cycle

• Refinance Cycle

• House Price Appreciation

• Deterioration of Credit Quality

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