The Role of Mortgage Insurance as a Credit Risk Management Tool

Globally, mortgage lenders (originators and/or underwriters) are increasingly being encouraged to lend down-market and develop products that cater for low income households or households with irregular incomes. However, mortgage lenders face the risk of borrowers defaulting on loan repayments.

The growing trend of countries worldwide is to adopt the mortgage insurance model which provides lenders with a reliable means of transferring credit risk to the insurance sector and enhance access to homeownership to borrowers viewed as being riskier to lend to. Research undertaken on mortgage insurance (MI) by academics and practitioners argues that MI has a pivotal role in fostering mortgage finance systems in developed, emerging and transition economies.

Financial institutions and other lenders use Loan-to-Value (LTV) ratios before approving a mortgage application. It is generally argued that LTV ratios are used in mortgage lending to evaluate the down payment required by a borrower and to assess whether the lender will grant a mortgage loan. Higher LTV ratios are a higher credit risk for lenders as borrowers have less “skin in the game.”  Lenders and financial institutions in Africa on average require down payments that range from 10 percent to 30 percent. Across the African continent unlike in the developed countries, many first-time homebuyers enter the market without savings. As a result, borrowers cannot afford the down payment required, contributing to credit ineligibility.

Along with other impediments to developing mortgage markets in emerging economies are weak legal systems which fail to adequately protect the interests of lenders in collateral recovery and foreclosure proceedings.

What is Mortgage Insurance?

Mortgage Insurance offers credit protection to mortgage lenders against a portion of the costs related to homeowner mortgage defaults or foreclosures. MI provides lenders with a reliable means of transferring credit risk from high LTV loans to the insurance sector and is a credit risk management tool.

MI is known as mortgage credit insurance, mortgage indemnity insurance and lenders’ mortgage insurance. The premium is typically paid for by the borrower and where the lender pays for the premium it is known as lender’s mortgage insurance. Mortgage Insurance is not a guarantee which covers the entire portfolio of the mortgage lender but is underwritten for a defined, specific risk that insures the top part of the loan. MI does not cover risks associated with the lender failing to recover property after default or establishing clear property title.

Potential Benefits of MI

A successfully implemented mortgage insurance programme has benefits for the borrower, lender, capital markets and the housing finance system. MI reduces the borrower equity required for paying a down payment towards a mortgage and protects the lender from credit risk. MI deepens capital markets and enhances access to affordable housing for the underserved market segments. Blood (2009, p. 326) notes that MI programmes worldwide have been adopted to:

• Enhance access to homeownership for low income, low equity, or higher risk borrowers by inducing lenders to accept incremental credit risks and lower down payment financing; and/or
• Expand the primary market by facilitating access to mortgage finance through risk transfer, while promoting the secondary market as a credit enhancer for securitised mortgage pools.

In Sub-Saharan Africa and most emerging economies worldwide, lowering the down payment financing would improve affordability where borrowers have struggled to save deposits.

How do we assess whether a country is ready for MI?

An analysis of the available MI literature shows countries must meet the prerequisite conditions for establishing MI. Preconditions include:

• Macroeconomic and monetary stability;
• The legal and administrative framework for mortgage finance must support mortgage lending and collateral acquisition in case of default; and
• Availability of accurate and reliable information on housing and mortgage markets. MI needs three basic types of data: housing market and home price data, borrower income and credit data, and home mortgage performance data.

Developing countries have small, undeveloped mortgage markets and market impediments such as poor property regulatory systems will dissuade private sector MI firms entering the market as a primary provider. This means that governments should step in as initial MI sponsors to attract private risk capital and facilitate the introduction of MI.

Designing a Mortgage Insurance Product

MI programmes are typically government-sponsored (public), privately sponsored or public-private partnerships. Blood (2009) notes that over two thirds of MI programmes are public sponsored and privately sponsored MI providers have tended to operate in developed economies. Developing economies such as Algeria, Morocco, Kazakhstan, Latvia and Lithuania, Peru and the Philippines have government-sponsored MI programmes. Privately sponsored MI programmes include those in Australia, Canada, Spain and Portugal.

A growing trend is public-private partnership arrangements that seek to incorporate the advantages of both public and private schemes. Notable examples include South Africa’s Home Loan Guarantee Company (HLGC), which was initially capitalised by the South African government and privately reinsured by a UK firm. In Canada and the Netherlands, the government backed up the private MI provider.

The designing of an MI Product involves:

• Setting the maximum LTV ratio to insure the top layer of the loan. It is argued that the product should be designed in such a way that the borrower has “skin in the game”;
• Risk sharing between the MI provider and originating lender;
• Establishing a premium rate structure that is actuarially based to cover future losses. A key consideration is how the premiums for the credit risk insurance are determined for the different income types and occupations. To increase affordability in developing markets, a single upfront premium payment method is suggested.

MI developments in Africa’s mortgage markets – Home Finance Guarantors Africa Reinsurance Collateral Replacement Indemnity Programme

The Home Finance Guarantors Africa Reinsurance Limited (HFGARe) was established in Mauritius and builds on the experience of South Africa’s Home Loan Guarantee Company . HFGARe facilitates and provides access to housing finance for lower and middle income families in Africa. It does this through reinsurance or retrocession arrangements with insurers in African countries, through the introduction and implementation of a collateral replacement indemnity. This section reflects on some of the learnings shared at the African Union for Housing Finance (AUHF) workshop on ‘Managing Credit Default Risk’.

How does the CRI work?

HFGARe works with local registered and licensed insurance and reinsurance companies in participating countries who enter into agreements with local banks to provide collateral replacement indemnity for low to moderate income earners who do not have the deposit required by mortgage lenders.

• An insurance product replaces the down payment required for mortgage loans with a guarantee;
• The insurer indemnifies the lender against a portion of the loss suffered by the lender at a legal sale of the property (auction or voluntary sale) due to default;
• CRI covers loans for purchase of new or existing homes and construction loans;
• CRI enables the lender to offer a 100% mortgage loan to qualifying borrowers (maximum LTV ratio of 100%);
• CRI covers/insures the lender who pays the premium to the insurer;
• HFGARe provides technical assistance to lender staff who will be working with the CRI product; and
• The borrower, lender, insurer, reinsurer, and retrocessionaire share risk in the agreement and the borrower loses their home should they default.

Table 1: HFGARE agreements with local insurers in nine African countries (Source: HFGARe Presentation at the AUHF Managing Credit Default Risk Workshop in Zambia, 26-27 September 2019)

Lessons learnt from the CRI product in Zambia were shared at the African Union for Housing Finance (AUHF) capacity building training workshop on Managing Credit Default Risk. Under the Collateral Replacement Indemnity structure, Madison General Insurance Ltd is the cedent and retains 10% while Home Loan Guarantee Company is the reinsurer with 90% share. The product is targeted at financial Institutions engaged in financing would-be homeowners, real estate and property developers. Madison representatives noted the premiums are thin as the facility is not a profit-making one and its main objective is home empowerment for those in low income brackets.

Blood (2009, p.360) notes that the newly implemented MI programmes of most emerging economies can only be judged after those programmes have survived a major economic downturn. The MI programme in the United States began in 1934 and Canada’s MI Programme in 1954. Recently, the Federal Government of Nigeria through the Central Bank of Nigeria has set up a mortgage guarantee company (Nigeria Mortgage Guarantee Company) in collaboration with World Bank and other stakeholder partners under the Nigeria Housing Finance Programme (NHFP). More research is needed on the implementation and roll-out of the CRI programmes in African countries to identify challenges and opportunities for enhancing access to mortgage finance for low income households.

Conclusion

Mortgage Insurance is becoming a popular credit risk management intervention in the mortgage markets of the emerging economies. Both public and private sector stakeholders need to make a concerted effort to work together to solve challenges across the housing value chain. This involves reviewing the applicability of land titling and registration laws, which in many African countries have not been updated since colonial times. Policymakers have an opportunity to support innovative approaches to titling such as blockchain technology. Governments in African countries have a significant role to play in establishing and supporting a financially sound regulatory environment that oversees the banking and insurance sectors. Basel III advocates more robust underwriting processes for mortgage insurers, which means that mortgage lenders and policymakers need to understand and segment housing markets to deliver the right product for each market segment of the population.

References

AUHF. (2019). Managing Credit Default Risk Training Workshop, 26-27 September 2019. Lusaka, Zambia

Bank for International Settlements. (2013). Mortgage insurance: market structure, underwriting cycle and policy implications. http://www.hofinet.org/upload_docs/BIS%20Mortgage%20Insurance%20-%20Mkt%20Structure%20Underwriting%20Cycle%20&%20Policy%20Implcations%202015.pdf (Accessed 20 September 2019) {Available Online)

Blood, R. (2009). Mortgage Insurance. In L.Chiquier and M.Lea (ed.), Housing Finance Policy in Emerging Markets . Washington, United States of America, The World Bank. Pg 325 -361 Available Online – http://www.hofinet.org/upload_docs/Blood_Mortgage%20Insurance_Housing%20Finance%20for%20Emerging%20Markets.pdf

Blood, R. (2009). Regulation of Mortgage Default Insurance: Principles and Issues. http://www.hofinet.org/upload_docs/A-Blood%20-%20Regulation%20of%20Mortgage%20Default%20Insurance.pdf (Accessed 23 September 2019)

Email correspondence with Nkole Kasase, 14 October 2019.

Federal Financial Analytics, Inc. (2012). The Future of Credit Risk Insurance: A Business Model at a Regulatory Precipice. http://www.hofinet.org/upload_docs/UPLOADED_%20FFA%20-%20The%20Future%20of%20Credit-Risk%20Insurance.pdf (Accessed 20 September 2019)

Home Finance Guarantors Africa Reinsurance Limited. (2019). Presentation at AUHF Managing Credit Default Risk Training Workshop. Lusaka, Zambia.

Home Loan Guarantee Company. (2019). http://www.hlgc.co.za/. (Accessed 17 November 2019)

Housing Finance Course for Sub-Saharan Africa, 29 September – 5 October 2019. Cape Town, South Africa

Merril, S and Whiteley, D. (2003) Establishing Mortgage Guarantee Insurance in Transition and Emerging Markets: A Case Study of Kazakhstan. http://www.housingfinance.org/uploads/Publicationsmanager/0309_Kaz.pdf  (Accessed 18 November 2019).

Raphadu, C.M. (2015). Risk sharing for mortgage finance through default insurance for low-income households in South Africa (Doctoral dissertation, University of Pretoria). https://repository.up.ac.za/handle/2263/50766 (Accessed 18 November 2019).

Rust, K. (2019). Housing Finance in Africa: Building the Investment Argument. https://housingfinanceafrica.org/documents/housing-finance-in-africa-building-the-investment-argument/ (Accessed 18 November 2019)