When Arch Capital Group acquired United Guaranty Corp. last year from American International Group, one of the attractions was an innovative form of reinsurance modeled on risk-sharing programs developed by Fannie Mae and Freddie Mac.
Over the past four years, the two government-sponsored agencies have transferred the credit risk on hundreds of billions of dollars of mortgages they insure by selling bonds whose performance is linked to that of a pool of residential mortgages. If losses in these pools reach certain levels, the GSEs can hold on to the principal of the bonds. The risk-sharing programs serve as a kind of capital, because they reduce the likelihood of another taxpayer bailout.
Arch’s new insurance-linked securities serve a similar purpose, according to James Bennison, senior vice president, alternative markets.
Fannie and Freddie’s flagship programs, Connecticut Avenue Securities and Structured Agency Credit Risk, look a lot like bonds that AIG and others use to transfer the risk of catastrophic insurance losses from natural disasters such as hurricanes and earthquakes. So when CAS and STACR were launched in 2013 and subsequently developed a strong investor following, AIG saw an opportunity to do something similar with private mortgage insurance. Under the insurance giant, United Guaranty completed two private transactions transferring risk on its own portfolio.
The first deal, for$298.9 million in 2015, was used to reinsure a portfolio of mortgage insurance policies issued from 2009 through the first quarter of 2013.
The second deal, for $298.6 million in 2016, was used to reinsure a portfolio of mortgage insurance policies issued in 2008 and prior years.
Arch is picking up where AIG left off. Last month it completed a third transaction under the same program, dubbed Bellemeade Re. But this one has the benefit of a credit rating, from Morningstar Credit Ratings, which broadened the investor base. It transferred the risk from three of Arch’s private mortgage subsidiaries, and not just United Guaranty. And the policies benefiting from this reinsurance were all underwritten in the first half of 2017.
Going forward, Arch plans to be a programmatic issuer, coming to market twice a year. It expects to complete another transaction in the first quarter of 2018 that will reinsure its production for the second half of 2017.
Bellemeade is more than just a way for Arch to diversify its sources of reinsurance, however. Bennison explains that the securities help it to meet capital required to do business with Fannie and Freddie — private mortgage insurance protects lenders from losses on mortgages with low down payments.
Just as important, according to Bennison, capital markets investors have a broad perspective on mortgage risk that is valuable in pricing insurance policies. “The feedback loop that’s created will help [us to] appropriately manage a long-tailed risk,” he said in a recent interview with Asset Securitization Report.
No small thing, considering the losses sustained by the mortgage insurance industry following the credit crisis.
What follows is an edited transcript.
ASR: The first two Bellemeade transactions were unrated; was the credit rating for the third transaction designed to broaden the investor base?
Bennison: The rating helped broaden the investor base. For example, it’s the first Bellemeade transaction with any insurance company participation, which is a key investor class. Insurance companies run the gamut, but in this case, only one credit rating was sufficient. It just depends on the company’s internal guidelines.
How does the transaction help Arch with capital requirements?
One of the key considerations goes to the credit we get for the assets raised. They are placed into a trust, and the trust’s assets are used to repay bonds or pay claims, in the event our first loss position is exhausted. We get credit in a couple of different ways: from state regulators, from the GSEs (under the PMIERs eligible assets test) and from the rating agencies that provide Arch’s corporate ratings. When factoring all of these together, from a purely capital perspective, there’s a strong incentive for us to continue to do this as it’s an effective way for us to raise capital.
What else does the transaction accomplish?
We view the ability to go into the capital markets and price a portion of our risk to be a key element in proactively managing the business. It provides feedback about how investors view the risk in our portfolio, which is a key observation we can use in determining how we price and adjust guidelines in taking mortgage risk on a go forward basis. This information feedback loop helps us to appropriately manage the long-tailed risk of mortgage insurance.
Given strong investor interest in the Bellemeade ILS, we believe that there is enough demand for us to issue these securities a couple times a year.
Can’t investors become complacent about risk?
History suggests that mortgage insurers can be complacent, too. For this reason, it’s best to have as many eyes as possible looking at what you do. Fixed-income investors are looking at a much broader swathe of the mortgage market than mortgage insurers. While we are in the conventional above-80-LTV space, investors like money managers, hedge funds and insurance companies invest in a broader range of mortgage credit and develop a perspective that we might miss.
Would it benefit Arch if other insurers developed similar programs; would a broader market benefit everyone?
Certainly. Fannie and Freddie’s CAS and STACR programs influenced our thinking about what we could accomplish. Additionally, our transactions are truly insurance-linked securities not general obligation bonds, like CAS and STACR. We were also influenced by what had been done in the cat bond market. By being a regular issuer, we’re in the best position to manage risk, and we hope to reduce volatility in the business.
What percentage of Arch’s total mortgage reinsurance will the program provide?
That’s not how we think about it. The goal isn’t to achieve a particular mix of capital sources. Rather, we evaluate the total capital need for the business and consider the options available. Though this is one tool, it’s one with a particular benefit because of the pricing and risk information we are getting from the institutional market. We can certainly go to the traditional reinsurance market; most of our peers are more active there. However, we find our approach to be more efficient and it provides us with specific information that we view as critical to managing the business effectively.
Can’t Arch’s peers get the same information?
It takes a bit of an investment. It was expensive to get the Bellemeade program off the ground. We’ve already been through that and now we’re benefiting. I suspect that other mortgage insurers haven’t pursued this strategy because of the relative ease with which they’re able to attract reinsurance versus the cost of starting an issuance program in the capital markets.
Is it meaningful to compare pricing to CAS and STACR?
The liquidity premium we pay is real. Liquidity absolutely matters because we want to see good support in the second market. We have a fairly robust banking group on the deal; that’s intended to help support the secondary market. More frequent issuance should help, but it’s unlikely to ever trade on top of CAS or STACR.
But is it the same risk?
It’s a different risk. We have the first-loss position on above-80-LTV loans, which puts Fannie and Freddie in secondary position if they do high-LTV loans. The GSEs’ investors benefit from our mortgage insurance. In our deal, investors accept a little higher risk and [sit] lower in the credit structure for an individual loan. But the structure we’re using offsets some of the additional risk they take. For example, credit enhancement on our transaction is 225 basis points for the B1 tranche, versus about 50 basis points for CAS or STACR. This reflects the fact that investors are taking deeper risk on the underlying loans, but have more protection via the structure.
Are Bellemeade investors getting exposure to the same loans as in CAS and STACR?
Arch MI is the largest mortgage insurer in the country. When investors take part in future CAS or STACR exposed to this vintage in January through June 2017, they will almost certainly have exposure to some of the same loans. They’ll just be accepting a slightly different risk.