Loss Reserving Approaches for Mortgage Guaranty Insurance

1. Loss Reserving Approaches for Mortgage Guaranty Insurance 2001 Casualty Loss Reserve Seminar The Fairmont, New Orleans John F. Gibson, FCAS, MAAA Principal PricewaterhouseCoopers, LLP

2. Outline of Presentation • Overview of the Transaction and the Industry • Loss Reserving Distinctives • Factors that Influence Ultimate Losses • Data to Analyze • Contingency Reserves • Industry Loss Reserving Approach • Problems with Traditional Loss Development Methods • Loss Reserving Approaches • Current and Future Trends

3. Basics of Mortgage Guaranty Insurance (MI) • Covers lender for financial loss if borrower defaults • Required if (loan > 80% x property value) • Lender selects MI carrier, pays the premium, receives the claim benefit • Lender pays MI via escrow payment • MI carrier prohibited from paying the lender a commission, policyholder dividend or rebate

4. MI and Mortgage Transactions The Borrower The Originator The MI Applies for Loan Selects MI Makes the Loan Payment including MI fee Sells The Loan Sells The Servicing Reinsures Owns Pays the Claims Pays the Premium The Servicer The MI Captive Forwards Interest Yield and MI Claim Checks Fannie / Freddie

5. MI Premium & Rates • Rate fixed for life of loan • Average rate = 0.60% x original loan amount ($150,000 loan = $900 annual premium) • Rarely in the interest rate (lender-pay) • Rate varies by loan type, term, LTV, but not by state or loan amount • Premium vulnerable to prepayments & cancellation

6. Why MI Rates Uniform • Cyclical: The better the past, the more likely the future will be bad • High capital: Big U/W profits  high ROE • Catastrophe risk: Must price for long run • Computers: Hard to change lender loan origination systems that quote the rate • Price insensitivity: He who chooses MI carrier does not pay the premium

7. Prepayment and Cancellation • Only the lender can cancel the cover • 1998 legislation: • Lender must annually notify and allow borrower-initiated cancellations if loan is 80% of the lesser of appraisal or purchase price • Requires cancellation at sooner of (a) amortization to 78% or (b) midpoint of loan term

8. Cover & Claim BACK INTER-EST 25% MI COVER 10% EQUITY CLAIM AMOUNT PROPERTY VALUE LOAN ( 90% LTV= LOAN TO VALUE) 25% MI COVER AMORT-IZED LOAN LENDERLOSS SALE COSTS DISTRESSED PRICE EXPO-SURE =90% X (1-25%) =68.5% NET PRO-CEEDS FROM SALE THEORETICAL COVER ACTUAL CLAIM

9. Coverage Exclusions • Earthquake/Flood – property must be restored before a claim can be filed (Indirect EQ risk due to drop in values) • Fraud by lender • Fraud by borrower unless borrower makes 12 payments • Environmental impairment/title/etc

10. Restrictive Statutory Rules Original MI Industry failed during 1930s; losses impaired multi-line insurers -- Hence rebirth in 1959 was under restrictive statutory rules: Monoline: Cannot endanger P&C co.s w/ MI risk Capital: Conservative 25-to-1 risk-to-capital ratio Exposure: Insure < 25% of any 1 loan Concentration: Less than 10% of risk w/ 1 lender Contingency reserve: Restricts dividends Reinsurance: Only with another MI or a P&C insurer backed by a trust account/LOC

11. Amount of New Loans Insured($ in billions) 140 120 100 80 60 40 20 0 Source: Mortgage Insurance Companies of America

12. MI Industry Loss & Combined Ratios Source: Mortgage Insurance Companies of America

13. Industry Income 1996 - 1999$ in Millions 199619971998 1999 Net WP $2,323 $2,650 $2,832 $3,009 Net EP 2,404 2,738 2,909 3,039 Net U/W Income 719 1,021 1,241 1,668 Net Operating Income 1,228 1,5961,9052,331 Source: Mortgage Insurance Companies of America

14. Industry Capital 1996 - 1999$ in Millions 19961997 19981999 Risk In Force $117,471 $127,538 $133,738 $146,054 Contingency Reserve 4,050 5,152 6,510 7,950 Policyholders Surplus 2,256 2,378 2,854 2,857 Total Capital 6,306 7,530 9,365 10,807 Risk-to-Capital 18.6 16.9 14.2 13.5 Premium-to-Surplus .37 to 1 .35 to 1 .30 to 1 .28 to 1 Source: Mortgage Insurance Companies of America

15. Total Industry Assets and Reserves $ in thousands Source: Mortgage Insurance Companies of America

16. Loss Reserving Distinctives • Claim = Loan that has defaulted as of the statement date • Not a reserve for the life of the loan • Type and amount of coverage • Amounts paid can exceed theoretical coverage

17. Factors that Influence Ultimate Losses • Housing Values • Unemployment • Interest Rates • Claim Settlement Practices

18. Data to Analyze • Analysis by region or state • Analysis by type of loan – LTV • Analysis by size of loan • Analysis by age of loan • Analysis of Pool Insurance and other higher risk segments

19. Contingency Reserves – Need • Premiums and losses have mismatched timing • Losses realized when loans become delinquent • But economic catastrophes can drive 100+% loss ratios for a number of consecutive years • Mortgage insurers are monoline

20. Contingency Reserves - Determination 50% of premium each year is set aside into a contingency reserve and held for 10 years Losses in excess of a 35% loss ratio in a calendar year can be removed on a FIFO basis After 10 years, remaining funds, if any, can be moved to free surplus

21. Industry Loss Reserving Approach • Identification of claims by status – for example: • Delinquent • Pending Foreclosure • Foreclosure • Claim Filed • Severity Factor – Percentage of exposure to be paid – greater than 100% for filed claim

22. Industry Loss Reserving Approach • IBNR Provision = % of reported • Regional analysis • Pool business analysis • Recent runoff history very favorable

23. Recent Runoff History(in $ millions)

24. Problems with Traditional Loss Development Methods • Leverage effect of economic cycle on number of defaults, cure rates and amounts paid can produce significant volatility • Economic cycle operates on a calendar year, not an accident year

25. Loss Reserving ApproachProjection of Ultimate Reported Delinquincies • Delinquencies are reported quickly – 85% at 12 months, more that 99% at 24 months • Check for reasonability against loan balances • Eliminates need for separate IBNR provision

26. Loss Reserving ApproachProjections of Ultimate Claims Paid - Approaches • Project directly – very volatile • Project Closed Without Payment (Cured) claims and subtract from ultimate reported • Bornhuetter – Ferguson method using a priori ratio of closed with payment (CWP) to loan balances

27. Loss Reserve ApproachDetermining Paid Claims by Payment Year • Subtract cumulative CWP claims from ultimate CWP claim to derive remaining CWP claims by accident year • Using CWP pattern, determine distribution of remaining CWP claim for each accident year to each payment year • Sum for each payment year

29. Loss Reserve ApproachDetermination of Severity • Review calendar year severity – has been declining since 1996 • Determine selected average loss payment for future calendar years • Trend of prior years • Relate to average coverage amounts • Balance recent favorable results with leveraged effect of economic change

30. Loss Reserving ApproachReserve Estimates • Loss reserve by payment year is projected claims to be closed by payment year times projected loss payment by payment year • Supplement with traditional loss development methods

31. Loss Reserve ApproachDetermination of Reserve Range • Based on conservative and optimistic assumptions for defaults, cure rates and severity • Reserve range is much wider than most P&C lines of business

32. Current & Future Trends • Impact of the Economic Cycle • Refinance Cycle • House Price Appreciation • Deterioration of Credit Quality