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Mortgage Insurance and Lender Captives

2002 Casualty Loss Reserve Seminar (CLRS)

September 24, 2002

Presented by:Michael C. Schmitz, F.C.A.S., M.A.A.A.Principal and Consulting ActuaryMilliman USA, Brookfield, Wisconsin

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Overview of Presentation

Background on Milliman’s typical role for lender reinsurers

Types of Reinsurance companies and structures/features

Regulatory issues Accounting issues

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Milliman Role-Mortgage Reinsurance Front-End Role

Request lender’s historical MI data from the primary insurers

Conduct a portfolio risk analysis Determine benchmark risk assumptions Evaluate alternative structures Conduct feasibility study – assist in set-up Regulatory assistance Risk transfer/pricing opinions

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Milliman Role-Lender Reinsurers - Ongoing Role

If Milliman not involved in up-front, consider: Request lender’s historical MI data from the primary

insurers Conduct a portfolio risk analysis Determine benchmark risk assumptions

Loss reserve analysis/opinion Reinsurance Performance Metrics (RPM) services

Loan Reconciliation Reinsured Risk Analysis/Segmentation Economic Analysis Benchmarking of experience Forecasting of premium and losses

Miscellaneous assistance Sounding board – ad hoc requests Mortgage Reinsurance Conference (MRC)

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Types of Reinsurance Companies

Single parent captives

Sponsored Captives

Licensed Insurers

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Sponsored Captives The sponsored captive allows lenders, through a

participation agreement, to assume risk on loss performance of the mortgage loans the participant has insured with the sponsored captive’s parent company.

Sponsored captives are capitalized by mortgage insurers (parent) for participation by several lenders.

Lenders must contribute capital to support losses on their loans

Parent provides mortgage insurance to specific lenders who enter into participation agreements with the sponsored captive.

The lender receives a percentage of the mortgage insurance premium as a participation fee in return for assumption of part of the insured risk.

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Sponsored Captives

Each lender has a protected cell which separates the risks assumed by an individual lender from the risks of other participants (lenders).

Structure is different, but sponsored captives operate essentially the same as wholly-owned subsidiaries of lenders.

Sponsored captive enters into a reinsurance agreement with its parent, and assumes business written by its parent for the mortgage lender.

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Reinsurance Structures

Quota-share: pro-rata sharing of premium and losses

Excess of Loss: Reinsurer covers a layer of losses once the primary carrier's direct losses exceed an attachment point for a book year

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Reinsured LayerIn Relation to Gross Risk

100%

Limit

Attachment

100%

Quota-Share Excess of Loss

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Risk Characteristics-Claims

Lifetime Claim Rate Probability Distributions

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

1.2%

1.4%

1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.0% 11.0% 12.0% 13.0% 14.0% 15.0% 16.0% 17.0% 18.0% 19.0%

Claim Rate

% P

rob

ab

ility

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MI Reinsurance Regulations

Due to potential size of ceded reserves, it is important for MIs to be able to obtain reinsurance credit.

Contingency Reserve is currently largest issue

Security - Licensed or trust accounts or LOC’s with unaffiliated financial institutions.

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Trust Accounts

Reinsurer establishes a separate trust account for each mortgage insurer

Essentially all capital infusions, premiums, losses and expense cash flows go through the trust account.

Reinsurers typically maintain reinsurance arrangements with several different mortgage insurers

Separate trust for each

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Trust Accounts

Assets restricted for the sole use and benefit of the ceding mortgage insurer.

Cannot be drawn down to cover losses reinsured on behalf of other mortgage insurers.

If trust account depleted by losses, certain important remedies apply.

Excess funds in the trust account are eligible for release (and dividended to parent) subject to various restrictions.

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TRUST FUND

(Beneficiary = Primary Co.)

Primary Company

Captive Reinsurer

Admin. Expenses

Premium Tax

Capital Dividends

Unearned Premium

Loss Reserves

Contingency Reserve

Capital

Premium Ceding Comm. Losses

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Complex Regulatory Environment

OCC/OTS/Federal Reserve regulate the ability of banks & thrifts to form captives

HUD regulates mortgage transactions and administers RESPA and TILA

The NYID regulates MI companies licensed in NY and most are

The captive’s state of domicile (e.g. Vermont) Normal FASB & Tax rules - not unique to

MI captives Fannie Mae and Freddie Mac through

eligibility guidelines

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RESPA (HUD) The Real Estate Settlement Procedures Act is enforced by HUD and,

more effectively, by the threat of specified civil remedies that include treble damages.

RESPA is broadly written: “no person shall give and no person shall accept any fee, kickback or thing of value [that is] incident to or part of a real estate settlement service…”

Exempts secondary market transactions which might include reinsurance. However, both the captive owner and the ceding MI are parties to the home purchase transaction itself.

August 6, 1997 letter from Nicolas Retsinas to Countrywide Funding (no legal standing but suggests how HUD may analyze captives under RESPA).

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HUD – August 6, 1997Letter from Nicolas Retsinas to

Countrywide Funding Two tiered approach to determining if specific

reinsurance deals permissible Red Flags - features that may cause HUD to

scrutinize a deal more closely, e.g.,: Consumer pays higher premium? Lack of consumer disclosure? Reinsurance conditioned on agreement to refer

business Two Part Test - for those deals where HUD

determines more scrutiny is required: I. Reinsurance actually provided - Risk Transfer II. Compensation (net premium) commensurate

with risk

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Risk Transfer FASB 113: Reasonable possibility of

substantial loss AICPA task force\

Attempted to develop a standard through Accounting Standards Executive Committee (AcSEC)

Informal sub-group

Reserving and Matching

Accounting Issues

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Primary loss incurred when loan defaults (delinquent)

Primary company reserves only for current delinquencies Known delinquencies (case reserves) Unreported current delinquencies

(IBNR) Statutory contingency reserve

Reserving Practices for Mortgage Insurance

Financials For Primary Company

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Reserving Practices for Mortgage Insurance - Reinsurance

Excess of loss coverage on a book year basis

Reinsurers generally follow primary modelReinsurer accrues when Primary (ground-

up) incurred losses exceed attachment point

Cumulative paid losses + reserve for current delinquencies = cumulative incurred losses

Likely no losses for first 3-5 years for each aggregate excess of loss book year

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Deferred losses for excess of loss structures

However, premium is front loaded Reflects declining insurance in-force for

book year Poor matching Contingency reserve mitigates this on a

statutory basis Premium Deficiency Reserve if extreme on

a cumulative run-off basis

Reserving Practices for Mortgage Insurance - Matching

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Illustrative Premium Earnings Pattern vs. Incurred Loss PatternIncremental

One Book Year

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

1 2 3 4 5 6 7 8 9 10

Run-off Year

Per

cen

t o

f U

ltim

ate

Premium Earnings Pattern Incurred Loss Pattern

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One way to better match would be to defer some of the premium in an UEPR Has generally been rejected

Some reinsurers have considered booking an IBNR reserve for book year pooled projected losses to better match premium and losses (particularly on GAAP Statements)

Example: Loss ratio approach Set aside a % of earned premium based on

actuarial ultimate loss and premium expectations for each book year

Adjust based on revised projections Mixed responses as to appropriateness of this

approach Must seek auditors feedback

Reserving Practices for Mortgage Insurance