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

1 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

2 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

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

4 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

5 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

6 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

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

8 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

9 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

10 Amount of New Loans Insured ($ in billions) Source: Mortgage Insurance Companies of America

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

12 Industry Income $ in Millions Net WP$2,323$2,650 $2,832 $3,009 Net EP2,4042,738 2,909 3,039 Net U/W Income7191,021 1,241 1,668 Net Operating Income1,2281,596 1,905 2,331 Source: Mortgage Insurance Companies of America

13 Industry Capital $ in Millions Risk In Force $117,471$127,538 $133,738 $146,054 Contingency Reserve 4,0505,152 6,510 7,950 Policyholders Surplus 2,2562,378 2,854 2,857 Total Capital 6,3067,530 9,365 10,807 Risk-to-Capital Premium-to-Surplus.37 to 1.35 to 1.30 to 1.28 to 1 Source: Mortgage Insurance Companies of America

14 Total Industry Assets and Reserves Admitted Assets$12,083,431$13,800,478 Unearned Reserve Premium $492,025$479,979 Loss Reserve$3,884,484$1,985,822 Contingency Reserve $6,510,450$7,949,831 $ in thousands Source: Mortgage Insurance Companies of America

15 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

16 Factors that Influence Ultimate Losses Housing Values Unemployment Interest Rates Claim Settlement Practices

17 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

18 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

19 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

20 Industry Loss Reserving Approach Identification of claims by status – for example: 1.Delinquent 2.Pending Foreclosure 3.Foreclosure 4.Claim Filed Severity Factor – Percentage of exposure to be paid – greater than 100% for filed claim

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

22 Recent Runoff History (in $ millions) Year Original Loss Reserve Developed Reserves Thru ’99 Developed to Original (32%) (30%) 19961,000714(29%) 19971,151757(34%) 19981,261805(36%)

23 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

24 Loss Reserving Approach Projection 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

25 Loss Reserving Approach Projections 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

26 Loss Reserve Approach Determining 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

27

28 Loss Reserve Approach Determination 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

29 Loss Reserving Approach Reserve 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

30 Loss Reserve Approach Determination 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

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

32