A presentation on the overview of loss reserving for lender captive mortgage reinsurance as presented at the Casualty Actuarial Society\'s 2008 Casualty Loss Reserving Seminar in Washington DC

1. Private Mortgage Insurance
Beyond Carriers and Actuarial Opinions
Prepared for: 2008 CLRS
Prepared by: Kyle Mrotek, FCAS, MAAA
Consulting Actuary
Milliman, Inc.

2. Outline
 Mortgage Insurance (MI) Background
 Lender Captive Mortgage Reinsurance
 Unique Reserving Issues
 Impact of Economics on RMAD
 Closing Thoughts
2

3. MI Background
 Types of MI
– Government
• FHA
– Provides insurance to lenders on loans for one- to four-family houses
– 100% coverage
• VA
– Guarantees loans made to eligible veterans
– Limited coverage
• Dept of Agriculture
– Private
• Provides insurance to mortgage originators and investors on conventional
first-lien high LTV loans
• Limited coverage
Source: Residential Mortgage Lending, Fourth Edition and Mortgage Insurance Companies of America (MICA)
3

4. MI Background
Primary Mortgage Insurance Activity
Market Share %
90%
80%
70%
60%
Market Share %
50% PMI
FHA
40% VA
30%
20%
10%
0%
2002 2003 2004 2005 2006 2007 2008 H1
Calendar Period
Source: Inside Mortgage Finance, August 15, 2008
4

5. MI Background
LENDER
PM
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EC
PM
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IP
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RE
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BORROWER INSURER
5

6. MI Background
– Private MIs
• CMG Mortgage Insurance Company (CMG)
• Genworth Mortgage Insurance Corp. (Genworth)
• Mortgage Guaranty Insurance Corp. (MGIC)
• PMI Mortgage Insurance Company (PMI)
• Radian Guaranty, Inc. (Radian)
• Republic Mortgage Insurance Company (RMIC)
• Triad Guaranty Insurance Corp. (Triad)
• United Guaranty Residential Insurance Company (UGC)
6

7. MI Background
Private MI Industry Market Share
1H2008 Direct Premiums Earned
TGIC CMG
RMIC MGIC
MGIC
PMI
Radian
UGC Genworth
UGC
RMIC
TGIC
CMG
PMI
Genworth
Radian
Source: Annual Statements
7

8. MI Background
– Relevance of MI Ratings
• MI rating accompanies credit risk of loan to investor/lender
• GSE policy
– According to Freddie Mac Private Mortgage Insurer Eligibility Requirements,
January 2008:
» “Freddie Mac may purchase mortgages guaranteed or insured by a qualified approved insurer.”
» Approved insurers are further classified into Type I Insurers or Type II Insurers:
» * Type I Insurer: An approved insurer that is rated by at least two of the following
three rating agencies – S&P, Moody’s, and Fitch – and no rating is less than
AA-/Aa3 by any listed rating agency
» * Type II Insurer: An approved insurer that is 1) unrated or 2) rated by less than
two of the following rating agencies – Fitch, S&P, or Moody’s or 3) rated lower
than AA-/Aa3 by any listed rating agency
» Additional requirements for Type II Insurers:
» * Liquidity of assets (90% of admitted assets)
» * Risk-to-capital (15:1)
» * Combined ratio (85% for consecutive calendar years)
» * Captive reinsurance (“The ceding approved insurer must at all times be a Type I insurer.”)
8

9. MI Background
Ratings as of
March 2006 September 4, 2008
Rating Agency Rating Agency
MI Fitch Moody's S&P MI Fitch Moody's S&P
CMG AA Not rated AA- CMG AA< Not rated AA-<
Genworth AA Aa2 AA- Genworth AA< Aa3< AA<
MGIC AA+ Aa2 AA- MGIC A+< A1< A<
PMI AA+ Aa2 AA- PMI A+< A3< A-<
Radian AA Aa3 AA- Radian Not rated A2< BBB+<
RMIC AA Aa3 AA- RMIC AA-< A1< A+<
Triad AA Aa3 AA- Triad Not rated Not rated Not rated
UGC AA+< Aa2 AA+< UGC AA+< Aa3< AA+<
> Outlook positive > Outlook positive
< Outlook negative < Outlook negative
Source: Fitch, Moody’s, S&P
9

10. MI Background
– Coverage
• Accumulated interest during delinquent period
• Legal fees
About 15% of UPB
• Home maintenance and repair expenses
• Real estate broker’s fees and closing costs
• Property resold for less than original sales price
• Limited to about 20% to 30% of original loan amount
• Coverage depends on many factors, but primarily LTV
Source: MICA
10

11. MI Background
– Cancellation
• Private MI policies non-cancellable by MI
– Exceptions include non-payment of premium or fraud
• Borrower-initiated cancellation possible, in general, if:
– LTV < 80%, and
– No other loans on house, and
– Borrower current on payments
• Automatic termination occurs, in general, if:
– LTV < 78%, and
– Borrower current on payments
• Automatic termination occurs at the mid-point of the loan
Source: MICA
11

12. MI Background
– Profitability
Mortgage Insurance Industry Loss Ratios
200%
175%
150%
CY Incurred Loss Ratio
125%
100%
75%
50%
25%
0%
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
Source: MICA Calendar Year
12

13. Lender Captive Mortgage Reinsurance
MI Industry Participants
The Applies for Loan The Selects MI The
Borrower Lender MI
Makes the Sells
g
Loan icin The
Payment S erv Reinsures
The Loan
including Sells O
w
MI fee ims ns
iu m e Cla
Pr em s th
the Pay
Pay
s Lender
The
Captive
Servicer
Forwards Pac
Interest Yield
Fannie / kag
es l
and MI Claim Checks Freddie oan
s as
MB
S
Investors
13

14. Lender Captive Mortgage Reinsurance
Primary Company
Premium Ceding Comm. Losses
Unearned Premium
TRUST FUND
Loss Reserves
Admin. Expenses (Beneficiary = Contingency Reserves
Premium Tax Primary Co.) Capital
Capital Dividends
Lender Captive Reinsurer
14

15. Lender Captive Mortgage Reinsurance
Number of Lender Reinsurer Trusts w ith Ceded Premium
Industry (Excluding PMI)
1998-2007
300
250
Total
Number of Captives
200 Trusts
Lender
150 Reinsurers
100
50
0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Calendar Year Source: Annual St at ement s
15

16. Lender Captive Mortgage Reinsurance
Average Number of Lender Reinsurer Trusts
Industry (Excluding PMI)
1998-2007
2.5
2.0
1.5
1.0
0.5
0.0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Calendar Year Source: Annual St at ement s
16

17. Lender Captive Mortgage Reinsurance
Dollars of MI Premium Ceded to Lender Reinsurers
Industry (Excluding PMI 1998-1999)
1998-2007
($000's)
1,100,000
1,000,000
900,000
800,000
700,000
600,000
500,000
400,000
300,000
200,000
100,000
0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Calendar Year Source: Annual St at ement s
17

18. Lender Captive Mortgage Reinsurance
Percentage of MI Premium Ceded to Lender Reinsurers
Industry (Excluding PMI 1998-1999)
1998-2007
20%
15%
10%
5%
0%
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Sour ce: Annual St at ement s
Calendar Year
18

19. Lender Captive Mortgage Reinsurance
Market Share Of CY 2006 Assumed Premium
By Top Ten Lender Captive Reinsurers In Descending Order
100%
90%
80%
Market Share Of CY 2006 Assumed Premium
70%
60%
50%
40%
30%
20%
10%
0%
1 2 3 4 5 6 7 8 9 10
Lender Captive Reinsurer Count In Descending Order
Source: Annual Statements
19

20. Lender Captive Mortgage Reinsurance
Distribution of Lender Reinsurers by Domicile
Weighted by CY 2007 Earned Premium
0% Vermont
0% 0%
1% Arizona
0%
3% Haw aii
0%
3% South Carolina
0%
New York
5%
Turks & Caicos
11% Bermuda
Michigan
Texas
11% Other On Shore
65% Other Off Shore
Rhode Island
Florida
Source: Annual St at ement s
20

21. Lender Captive Mortgage Reinsurance
Distribution of Lender Reinsurers by Domicile
Weighted by CY 2007 Counts
1% 1% Turks & Caicos
1%
2% Vermont
1% Haw aii
5%
1% Bermuda
South Carolina
6%
New York
40% Michigan
7%
Arizona
Texas
Rhode Island
Florida
36%
Source: Annual St at ement s
21

22. Lender Captive Mortgage Reinsurance
– Loss Reserving
• Option 1: Reserve for delinquent loans only
– Advantages:
» Reserve for payments in near term
» NAIC authorized reserving method
– Disadvantages:
» Mismatch between incurred loss and earned premium
» Reserve not adequate for future paid claims
Illustrative Distribution of Accruals for Mortgage Reinsurer
Reserve only for delinquencies
30%
Incurred Loss
25% Earned Premium
20%
Percentage
15%
10%
5%
0%
1 2 3 4 5 6 7 8 9 10 11
Source: Milliman, Inc. Years since origination
22

23. Lender Captive Mortgage Reinsurance
– Loss Reserving (continued)
• Option 2: Reserve for all loans insured
– Advantages:
» Attempts to match incurred loss and earned premium
» Requires more actuarial involvement
– Disadvantages:
» Requires auditor and regulator approval
» Requires more actuarial involvement
23

24. Lender Captive Mortgage Reinsurance
– Option 1: Reserve for delinquent loans only
• Date of default = Incurred loss date (SSAP No. 58):
– Known delinquencies (case reserve)
– Incurred but not reported (IBNR reserve)
– * Reserve for pipeline delinquencies
• Frequency-Severity Method:
– Frequency = Probability of claim
– Severity = Loss given claim
• Reserve = Reinsurer incurred loss less Reinsurer paid loss
– Calculation performed for each book year in each trust
– Reinsurer incurred loss equals cumulative ground-up paid loss plus calculated reserve
(both case and IBNR) in excess of reinsurer attachment point
24

25. Lender Captive Mortgage Reinsurance
– Option 1: Reserve for delinquent loans only
Illustration of Calculating Reinsurer Reserve
5% Limit xs 5% Attachment Point
% of Original Coverage
10%
5%
Book Year 2000 Book Year 2001
MI Gross Paid Loss Rate
MI Gross Reserve
Reinsurer Reserve
25

26. Lender Captive Mortgage Reinsurance
– Option 2: Reserve for all loans insured
• Ultimate Loss Ratio Method - Reinsurer incurred loss equals ultimate loss ratio times
cumulative earned premium, where ultimate loss ratio equals ultimate loss divided by
ultimate premium
Illustrative Calculation of Reinsurer Reserve
A B C= D E= F G=
A/B C*D E-F
Reinsurer Reinsurer
Reinsurer Reinsurer Ultimate Cumulative Reinsurer Reinsurer
Book Ultimate Ultimate Loss Earned Incurred Paid Reinsurer
Year Loss Premium Ratio Premium Loss Loss Reserve
2000 50.0 120.0 41.7% 100.0 41.7 0.0 41.7
2001 70.0 125.0 56.0% 80.0 44.8 10.0 34.8
Total 120.0 245.0 49.0% 180.0 86.5 10.0 76.5
26
A and B estimated using projection methods

27. Lender Captive Mortgage Reinsurance
– Premium/risk assumption limits
• GSE 2008 guidance
• “…Freddie Mac’s express written approval must be obtained for any risk
sharing transaction which involves ceding over 25% of the gross aggregate
risk or premium with respect to a loan or pool of loans and which is entered
into with a mortgage enterprise, or an affiliate of a mortgage enterprise,
other than a qualified reinsurer that is not a captive reinsurer.”
Source: Freddie Mac’s “Private Mortgage Insurer Eligibility Requirements”, January 2008
27

28. Lender Captive Mortgage Reinsurance
– Revised Underwriting Guidelines
Simplified Example of the Effect of a Change In Underwriting
Distribution
1
Property Type Before After Risk Weight
Single Family 85% 100% 1.00
2-4 Family 5% 0% 1.10
Condo 10% 0% 1.50
Total 100% 100%
Indicated Risk Relativity 1.06 1.00
Indicated Change -5%
1
Moody's Approach to Rating Residential Mortgage Pass-Throughs
28

29. Lender Captive Mortgage Reinsurance
– RESPA (Real Estate Settlement Procedures Act)
• HUD’s 1997 letter to Countrywide
• Two tests must be met:
– Transfer of risk
– Price commensurate with risk
29

30. Lender Captive Mortgage Reinsurance
– Restricted Markets
• More stringent eligibility
– Varies by MI, evolving with time
– Lower maximum LTV
» (5% lower or 90%-95%)
» Lower for condos
– Higher credit score (680)
30

31. Lender Captive Mortgage Reinsurance
Illustration of restricted markets
31

32. Unique Reserving Issues
– Contingency Reserve
• SSAP No. 58 – “The purpose of this reserve is to protect policyholders against
loss during periods of extreme contraction”
• Statutory only, not GAAP
• Liability
• 50% of earned premium
• Held ten years
• Early withdrawals allowed
– Insurance Commissioner approval
– CY incurred loss ratio > 35%
– FIFO
• Not explicitly in scope of actuary’s SAO
32

33. Unique Reserving Issues
– Contingency Reserve
Early/Extraordinary Releases of Contingency Reserve
($ Millions)
MI CY 2007 1H 2008
CMG $0 $0
Genworth $470 $245
MGIC $1,536 $657
PMI $503 $879
Radian N/A N/A
RMIC $312 $0
Triad N/A N/A
UGC $876 $317
Total $3,697 $2,098
Source: Annual Statements
33

34. Unique Reserving Issues
– Premium Deficiency Reserve
• SSAP No. 58 – “When the anticipated losses, loss adjustment expenses,
commissions and other acquisition costs, and maintenance costs exceed the
recorded unearned premium reserve, contingency reserve, and the estimated
future renewal premium on existing policies, a premium deficiency reserve shall
be recognized by recording an additional liability for the deficiency with a
corresponding charge to operations.”
• SSAP No. 53 – “For purposes of determining if a premium deficiency exists,
insurance contracts shall be grouped in a manner consistent with how policies
are marketed, serviced and measured. A liability shall be recognized for each
grouping where a premium deficiency is indicated. Deficiencies shall not be
offset by anticipated profits in other policy groupings.”
• Not explicitly in scope of actuary’s SAO
34

35. Unique Reserving Issues
– Example Calculation of Lender Captive Reinsurer Statutory
Premium Deficiency
MI1 MI2 MI3 MI4 Total
A PV Future Paid Loss $50 $100 $75 $25 $250
B PV Future Admin Expense $10
C = A+B Uses $260
D PV Future Written Premium $40 $70 $60 $20 $190
E Loss Reserve $10
F Unearned Premium Reserve $5
G Contingency Reserve $75
H = Sum (D:G) Sources $280
I = Max (0, C-H) Premium Deficiency $280
– GAAP Premium Deficiency Reserve
• No contingency reserve
Examples of MI GAAP PDR
($ Millions)
MI @12/07 @ 6/08 LOB
MGIC $1,211 $788 Bulk
Radian $196 $584 Second-Lien
Source: Company SEC Filings
35

36. Impact of Economics on RMAD
– Home Price Appreciation (HPA)
– Interest Rates
– Unemployment
– Affordability
– Others
36

37. Impact of Economics on RMAD
Comparison of Delinquency Rate and HPA
7.0% 16%
14%
6.0%
12%
5.0%
10%
8%
Delinquency Rate
4.0%
Delq
HPA
6%
HPA
3.0%
4%
2%
2.0%
0%
1.0%
-2%
0.0% -4%
1979-1 1981-1 1983-1 1985-1 1987-1 1989-1 1991-1 1993-1 1995-1 1997-1 1999-1 2001-1 2003-1 2005-1 2007-1
Yr-Qtr
Source: OFHEO, MBA
37

38. Impact of Economics on RMAD
Illustration of Frequency of Foreclosure Versus Cumulative Home Price Appreciation
FICO 620-LTV 95
FICO 660-LTV 90
Frequency of Foreclosure
FICO 700-LTV 85
-35% -30% -25% -20% -15% -11% -6% -1% 4% 8% 13%
Cumulative Home Price Appreciation
Source: Milliman, Fitch
38

39. Impact of Economics on RMAD
Year Over Year HPA By CBSA
40%
30%
20%
Year Over Year HPA%
Las Vegas
Milwaukee
10% Riverside, CA
Springfield, IL
Washington, DC
0%
1985-2
1986-2
1987-2
1988-2
1989-2
1990-2
1991-2
1992-2
1993-2
1994-2
1995-2
1996-2
1997-2
1998-2
1999-2
2000-2
2001-2
2002-2
2003-2
2004-2
2005-2
2006-2
2007-2
2008-2
2009-2 f
2010-2 f
2011-2 f
-10%
-20%
Source: Historical OFHEO, Forecast Moody's Economy.com Yr-Qtr
39

40. Impact of Economics on RMAD
Case Shiller Historical HPI and CME Futures @ Sept 13, 2008
300
250
200
Wash DC
Miami
HPI
150
Las Vegas
Composite 10
100
50
0
00
01
02
03
04
06
07
08
09
10
05
11
12
0
1
2
3
4
5
6
7
8
9
0
1
2
l-0
l-0
l-0
l-0
l-0
l-0
l-0
l-0
l-0
l-0
l-1
l-1
l-1
n-
n-
n-
n-
n-
n-
n-
n-
n-
n-
n-
n-
n-
Ju
Ju
Ju
Ju
Ju
Ju
Ju
Ju
Ju
Ju
Ju
Ju
Ju
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Year-Month
Source: Standard & Poor's, CME Group
40

41. Impact of Economics on RMAD
Geographic Distribution of Market Risk IndexSM @ Summer 2008
Probability That House Prices will be Lower in Two Years
0% - 10%
10% - 20%
20% - 40%
40% - 60%
60% - 100%
Source: PMI Group
41

42. Closing Thoughts
– Inflection point for MIs
• Survival
• Pricing
• Underwriting
• Accounting?
– Inflection point for lender captive mortgage reinsurers
• Survival
• Structures
• Volatile
• Interests aligned
– Correlated risks tied to economics
42