«by MICHAEL GUDGER FAO AGRICULTURAL SERVICES BULLETIN 129 The designations employed and the presentation of material in this publication do not imply ...»
• The guaranteed lenders would not have made the mortgage without the guarantee. The borrower, who could not present adequate collateral in the form of a 20% down payment, would not have been able to buy the house without the guarantee. Clearly these borrowers are collateral constrained and the insurance guarantee obviated that collateral constraint.
• This is clear cut case of additionality. In the absence of adequate collateral required by the lender these mortgages would not have been made without the insurance company’s guarantee of payment.
The counter argument would be that the borrower in the absence of the insurance guarantee simply would have found a less expensive house to buy so that the insurance was not necessary. Alternatively, he would have sought out a lender prepared to extend him a loan to value (LTV) mortgage requiring only a 5-10% down payment and charged him a higher rate.23 Both almost certainly occur, but a large and growing number of less than prime borrowers opt for the larger house, the lower mortgage payment and the PMI premium. In part this is so because the mortgagee can in effect cancel the insurance when his equity reaches 20% by refinancing and using a mortgage product for which he now has adequate collateral to satisfy the lender - or more accurately can be sold to a secondary mortgage market.24 To be more precise, most borrowers would not have been able to buy the house for which he cannot produce a 20 % loan to value (LTV) down payment without the guarantee. Some borrowers would have been able to find a lender prepared to make a “non-conforming” loan that would be retained on the lender’s books. Relatively few lenders still make “non-conforming” loans that cannot be sold into the secondary market.
In this case, the lender would still have required the guarantee. This company does not write a significant 90-97%LTV guarantees but there are other companies that do.
This “right” has been more theoretical than real until recently. Mortgagees are seldom told and seldom know that that they have a right to suspend the PMI when the equity reaches 20% and the LTV of the mortgage declines to 80%. There are currently several bills before the U.S. Congress that will require annual statements from the PMI company advising borrowers of this right.
As Triad only has less than 2% of the market, how are they able to compete?
The company does this through a series of measures to manage risk and keep down costs:
• Experience Rating. The company manages risk in a variety of ways. Triad has segmented the market and underwrites to a higher credit standard than the industry. In return, their customers get a lower rate. Triad increases or decreases the premiums paid by borrowers according to the loss ratios of the lending banks. If a bank is successful in producing loans with very few defaults, Triad gives that bank’s customers a lower rate, and thus provides the bank with a competitive advantage vis-a-vis other banks.
• Limited Delegation. Second, and probably more importantly Triad uses very little “delegated”25 underwriting. Only very high quality banks are allowed to underwrite for the company. All other underwriting is done in house.
• Credit Management. Triad uses frequent lender audits, strict surveillance of losses on delegated underwriting, and sophisticated credit-scoring techniques to prevent opportunistic behavior on the part of lenders.
The financial condition of the Triad Guaranty Company is shown in the following table, which covers the last 5 years for which consolidated financial and statistical data are available. Instead of presenting the traditional balance sheets and income statements, the following table extracts the relevant elements from both.
From the table, we can see that the net volume of premium has grown about four fold while total revenues and stockholder equity increased by about 5 fold in 5 years. The statutory and GAAP (Generally Accepted Accounting Principles) ratios indicate that the company pays away about 16% of its premium income for losses and spends around 40-50% (depending on how the accounts are done) on meeting the running costs of the company. These including the underwriting of risks, credit surveillance, and the other corporate expenses. This is a very high overhead is largely a function of the small size of the company. A risk to capital ratio of about 25 to 1 generally is considered acceptable. This company has produced very good results without over leveraging their capital. In fact, for the five years it has remained under 15 to 1, considerably below the permitted 25 to 1. If one subtracts the insurance in force in “ Delegated underwriting” is the delivery of the underwriting pen by a guarantee company to a lender. The guarantee company and the lender agree upon the characteristics and credit scoring of loans that the bank can guarantee on behalf of the guarantee company. The lender can then provide both the loan and the guarantee. The Guarantee Company has a contractual right to review the guarantees issued on its account by the lender. The opposite of this transaction is “contract underwriting” where the guarantee company in effect prepares the loan for the bank. A client will have both the loan and the guarantee applications approved by the Guarantee Company. The bank then funds a client it often has never met and subsequently sells the “conforming” loan into the secondary market.
1995 from the insurance in force in 1996 to determine the additional amount of risk written and then divides this into the direct premium written in 1996, the approximate premium cost of 1.77% is derived. Thus, with this charge, the company meets its losses, expenses, and reserve requirements.
TRIAD GUARANTY INCORPORATED
SELECTED CONSOLIDATED FINANCIAL AND STATISTICAL DATA(DOLLARS IN THOUSANDS ON DEC. 31)
General Electric Mortgage Insurance Company General Electric Mortgage Insurance Corporation (GEMICO), a part of the General Electric Financial Services group, is the giant of the industry. It has a market share of 19.8% of the total new business written. The data presentation above is not available for GEMICO but several important comparisons can be drawn.
While Triad’s net premium has increased over the last five years from $6.8million to almost $24 million, GEMICO has seen its net premium increase from about $430 million to $466 million. Triad has stockholder equity of just under $100 million while GEMICO has capital of over $1.3 billion and assets of well over $2 billion. The much smaller Triad expended about 40-50% of annual premium income on overhead while GEMICO’s expense ratio was in the range of 22-23% of premium income. Triad paid away only 16% of income in losses while GEMICO’s losses have ranged from 60 to 87% of premium income over the last five years. While Triad has managed a combined ratio under 60%, GEMICO has been over 80% in four of five years between 1992 and 1996 and in one year producing a significant loss of 108%. Triad has managed to keep the risk to capital ratio under 16 while GEMICO has been over 20 for four of the last five years.
The two companies are strikingly different both in size and in results. GEMICO is an older company with a more mature book of business. More loans have gone sour than is the case with the relatively young portfolio of Triad. More importantly, GEMICO confronts competitive discounting, risk based pricing (by Triad, among others) which removes some of the subsidy by stronger borrowers of weaker borrowers, and a growing use of “off shore captives27 for a lenders’ best mortgage insurance business. While Triad delegates little underwriting to lenders GEMICO produces 43% of its new business by way of delegated underwriting. To offset this delivery of the corporate pen to a lender, the parent company, General Electric, has developed a sophisticated programme for mortgage credit scoring which, through its electronic interface, reduces paper documentation significantly. GEMICO “Combined ratio” is the method used by insurers to measure their underwriting profit and loss. It is the losses and the operating expenses divided by the premium income. A number of less than 1.0 means that the insurer is underwriting profitably while a combined ratio excess of 1.0 means the company pays away more than it take receives in premiums. This ratio does not include investment income which is usually the principle source of profit for most U.S. insurers, as the market is so competitive that underwriting profits are elusive at best.
“Offshore captives” are insurance or reinsurance companies set up in jurisdictions such as Bermuda.
These companies are owned by a large buyer of insurance products and in effect allow large buyers to form their own “captive” insurer and recapture the profit margin that would have been enjoyed by a commercial insurer for the captive owners.
in the face of a largely saturated market is also moving to expand its market share in the 95LTV mortgage guarantee market..
There are several “best practice” lessons to be learned from GEMICO.
• General Electric at the corporate level has a commitment to a significant market share in all its businesses. The corporation is prepared to commit the capital necessary to support insurance activities at a level compatible with reduced overheads and economies of scale. In fact, GEMICO has the lowest overhead in the industry at about 19% (compared to nearly 50% for Triad). We will see later in the review of the bond insurers that economies of scale in financial services are quite large indeed, but not all guarantee insurers have a rich parent to supply capital.
• GEMICO has maintained a consistent focus on customer service, product innovation and process efficiencies. Despite the high quality of customer service, increasing competition has eroded its market share from about 27% in 1994 to 20% in 1996.
• Innovation and new products, not all of which are successful or profitable, has been a characteristic of GEMICO management’s response to growing competition. Backed by the financial strength of the largest non-bank bank in the world, GEMICO can experiment with new products such as guarantees of 3-5% down payments. GEMICO is currently trying to recapture market share by increasing its high LTV (loan-to-value) guarantees portfolio. In 1995, high LTV’s were 21% of the portfolio; last year, they were 43% of the portfolio. GEMICO also has sharply increased its “delegated book” from 21% of new insurance in 1995 to 43% in 1996. This delegation in effect turns the lenders into franchisees of GEMICO.
Home mortgage guarantees and financial market development
The home mortgage guarantee industry relevant to many of the issues confronted by development finance community because the experience of this industry speaks directly to the issues of viability of the guarantee fund, collateral constraints, sources of SME finance, and additionality. With the creation of very low down payment programmes, the guarantee product has facilitated affordable home ownership by low-income groups.
• Viability The home mortgage guarantee industry is “viable” in the commercial sense. It can acquire the capital it requires from shareholders in the capital markets and produce an acceptable return on that capital. It requires no external support and continues to expand by creating new markets for its products.
• Collateral Constraints The home mortgage guarantee industry’s private mortage insurance (PMI) obviates the need for at least 20% down payment in order to buy a house.
Clearly collateral constrained borrowers are able to buy a house that they could not buy without the guarantee.
• Source Of SME Finance Equity built up in a home can be mobilized for business purposes (or any other purpose) through the use of the PMI product that allow the mortgagee to take cash out of his home equity.
• Savings Development While not an intentional purpose of the home mortgage guarantee, its creation promoted savings. The home is the American family’s single largest asset. Putting cash into a private home is an attractive option for most families especially as this cash can be utilized via the mortgage to access the some of the home equity for other purposes.
• Additionality It is clearly the case that borrowers who were formerly excluded from mortgage markets gain entry through the PMI guarantee. These companies entered the 95-97% LTV market with a profit motivation and to sustain their own premium growth.
In the process, they have opened home ownership to a large number of lower income families. While the terms of the mortgage and PMI may not be as favourable as a noncollateral constrained borrower, they are superior to exclusion from the mortgage market, at least in the view of millions of American families.
• Financial Market Development The development of home mortgage guarantees and the creation of a secondary market for the mortgage products was a major element in creating a vast new market in which lenders could originate loans and then sell them into the market. Investors could buy these products to meet their specific needs either for a steady cash yield or in a discounted zero form to provide a specific amount of cash on a given date. In either case, the products were often more attractive than deposit accounts and the interest rates were usually considerably higher. With the guarantee, the default risk was removed at a relatively small cost to the ultimate holder of the paper.
BOND INSURERS: THREE CASE STUDIES