Opportunity knocks in US mortgage credit

As traditional lines remain challenging for re/insurers, diversifying into US mortgage credit business can offer lucrative growth opportunities, Joe Monaghan, executive managing director, Aon Benfield tells PCI Today.

A lucrative new market, which has opened its doors to re/insurers only in the past three years, is providing much-needed growth and diversification for those brave enough to invest.

The US mortgage credit business has a very different risk profile compared with what re/insurers are used to writing. But the reasons for its opening up are unique and present a compelling proposition for re/insurers, according to Joe Monaghan, executive managing director at Aon Benfield.

Monaghan explains that in addition to several private mortgage insurers who purchase reinsurance, much of the new business is generated in the US by Fannie Mae and Freddie Mac, the two US government-backed financial institutions that provide liquidity to the US mortgage markets by buying mortgages from lenders.

Traditionally Fannie and Freddie held these assets on their own balance sheets, but the 2008 financial crisis—which was triggered by a sudden rise in defaults in the US residential mortgage market—meant they suffered big losses and needed to be bailed out by the US government.

Since then and over the last three years in particular, they have been encouraged by the government to transfer more risk into the private sector. They now do this in two forms: around 75 percent of risks are transferred into the bond markets, and about 25 percent into the re/insurance sector.

“They are experimenting with other solutions, but these two methods are now the main source of credit risk transfer in addition to private mortgage insurance,” says Monaghan.

He estimates that some $40 billion of public risk exposure has been transferred into the private sector so far—20 percent of that into the re/insurance sector: “so this represents a significant growth opportunity for re/insurers,” he said.

“The process of mortgage approval has been tightened since the financial crisis, and the result is pristine quality credit with very high underwriting standards and detailed documentation. Many of the current underwriting standards are driven not just by a reaction to inadequate mortgage underwriting pre-crisis but also as a result to changes in regulation and law following the crisis. The quality of the business and the availability of data are exceptional and that means it can be very profitable business for re/insurers.

“They can generally choose which part of the credit spectrum they want to play in and get rewarded appropriately, so it is a very good type of business in that sense as well,” says Monaghan.
Fannie Mae and Freddie Mac are seeking multiline re/insurers as counterparties because they have a diversified portfolio or risks that aren’t correlated to mortgage default, Monaghan adds.

“Re/insurers are not overly exposed to the US housing market so it offers them a diversified source of premium,” he says.

The deals are relatively straightforward. The majority of the loans are 30-year fixed rate mortgages, for which historic default rates can be easily assessed and the business can therefore be layered appropriately.

Despite the many benefits of this line of business, re/insurers usually have to do a lot of work upfront so they understand and can effectively manage these risks. According to Monaghan, re/insurers are approaching the opportunity prudently, with many taking anywhere from 12 to 18 months from first looking at the class to actually writing the business.

“They are prudent and cautious—there is systemic risk inherent in these deals and re/insurers want to develop an analytical framework to understand how it correlates to their other liabilities as well as the asset side of their balance sheet,” Monaghan says.

“A lot of education is required to build this market and build confidence. Re/insurers will need either to invest in internal analytics or to have the third party tools at hand to effectively manage the risk accumulations. We also believe that we have a responsibility to help educate re/insurers about this opportunity and grow the market.”

One unusual aspect of this market is that all re/insurers are required to post partial collateral against the risks, something many are unfamiliar with. “There are a number of atypical elements they need to get comfortable with before entering this space,” he says.

Aon Benfield, the dominant broker in this market responsible for placing over 90 percent of the risks, is working with around 30 re/insurers at the moment and Monaghan expects another 10 to enter this market in the next 12 months.

This is a big step up from 2014 when the first deals were done and just three reinsurers were participating.

“We see a lot of room for growth,” Monaghan says. “We are working as an advocate of this market and we expect solid growth for the next few years as more mortgage business is transferred in this way and more re/insurers want to participate.”

Signoff

Aon Benfield will be hosting two, 30-minute sessions on opportunities for re/insurers in US mortgage credit business at the Aon Benfield Client Center, on the East Atrium Lobby Level of the Hilton Anatole. Attendees have the chance to win one of 50 Amazon Echo Dots each day in a prize draw.

Presentation with Freddie Mac senior executives:
Monday, October 24 at 1:00pm

Presentation with Fannie Mae senior executives:
Tuesday, October 25 at 12:30pm

For more details contact anita.white@aonbenfield.com or Client Center.