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Pressure growing on mortgage re returns: S&P

Robust risk management frameworks will be vital for reinsurers writing mortgage risk transferred by Freddie Mac and Fannie Mae, as returns on the business come under pressure in the coming years, according to S&P Global.

In a report published last week, the firm said it believed returns would remain adequate for the next few years because of economic growth and a strong housing market.

But it cautioned that the margins enjoyed by reinsurers that were able to build up good portfolios by entering the space early wouldn't be available to latecomers.

Mortgage GSE transfer

That is partly because of mounting pressure on pricing and an increase in the risk profile of the business being transferred by the two US government-sponsored entities (GSEs) Fannie Mae and Freddie Mac.

It added that as the market matures the number of reinsurers in the space will continue to increase, and that as the credit risk profile expands, risk-adjusted returns will be pressured.

"Therefore, reinsurers that understand the risk well and can allocate limits by various layers and programmes based on risk-reward analysis will stand to benefit despite some tightening.

"But for others, the prospect of adequate returns may be tempting enough to load up on this business. However, considering its long-tail nature, if things were to go south, it is not as easy to get this risk off the books," S&P Global warned.

That means reinsurers need to increase their focus on risk management frameworks, including their understanding of the risk and its relationship with other exposures, strength or risk controls, and align internal limits with their risk appetite.

"A robust framework can enable reinsurers to take advantage of this business line and manage their business profile to offset some of the pressures from weak business conditions within the traditional P&C reinsurance sector, without exposing them to outsized risks, in our opinion," said the firm.

In the report, S&P Global noted that demand for mortgage reinsurance remained strong, largely because of GSEs' ongoing appetite for offloading risk after they were mandated to bring in private capital to reduce taxpayers' exposure.

The volume of risk transferred has steadily increased over the last four years, from $400mn in 2013 to $4.0bn last year.

In the first quarter of 2017 $1.2bn of risk was transferred to reinsurers, suggesting that this year is on course to beat last year's record (see chart).

Meanwhile, as the credit exposure for private mortgage insurers continues to grow, they are expected to increase their own use of reinsurance to manage risk and seek capital relief, said S&P Global.

"Considering the long-tail nature of the liabilities, we expect there will be a need for additional capacity as existing reinsurers come close to their internal limits for mortgage exposure," the report continued.

S&P Global noted that although the market had been expanding and the number of reinsurers interested in the GSE credit risk transfer programmes had increased, the participants are largely domiciled in Bermuda or in the US.

"The large European reinsurers have not participated at all, or to a limited extent, perhaps due to their experience through the financial crisis of 2008.

"However, that might not be the case indefinitely; hence, this market segment can potentially provide additional capacity," the firm observed.

S&P Global suggested that participants appeared to be employing rational pricing in the mortgage reinsurance market.

But it also suggested that risk-adjusted returns on Freddie Mac's Agency Credit Insurance Structure (ACIS) transactions were coming under pressure, because of changes made by the GSE.

It noted that last year the deals were structured with a move from three mezzanine layers to two and lower attachment points.

"All things being equal, a lower attachment point increases the probability of losses attaching to a layer for a given stress scenario and hence affects the risk-adjusted price," the firm commented.

This year, Freddie Mac introduced a five-year call option, which could reduce the amount of premiums reinsurers can collect over the lifetime of the tranche on which the risk is transferred.

And the GSE also offered an ACIS deal to the market where loans with high credit scores were carved out, increasing the overall risk profile of the underlying mortgage portfolio.

"We believe this differentiated approach to tailoring the underlying mortgage portfolio exposure is another development that, if continued, may result in further reduction in risk-adjusted returns," said S&P Global.

US mortgage guaranty performance


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