In the past year a number of banks and other mortgage lenders have set up captive reinsurance companies. Eight have been set up in Vermont, the leading US captive domicile. Several other lenders are currently evaluating the feasibility of establishing mortgage insurance captives.

Why the recent activity? Mortgage insurance has been profitable for the past several years. Lenders, who essentially produce the business for the mortgage insurers, have been seeking ways to share in these profits. Mortgage insurers are prohibited from making payments (such as sales commissions) to lenders by the Real Estate Settlement Procedures Act ("RESPA"). Also, lenders are generally prohibited from underwriting the insurance directly in house. However, in October, 1996, the Office of the Comptroller of the Currency ("OCC") cleared the way for banks to assume risk, via captive reinsurance subsidiaries, on mortgage loans originated or purchased by the bank.

Banks and other mortgage lenders generally require mortgage insurance on loans where the borrower's down payment is less than 20% of the property value. Traditionally, lenders purchase the mortgage insurance from a third-party insurer and charge the premium back to the borrower. Now, a lender can set up a captive reinsurance subsidiary to assume a portion of the premium (and a portion of the risk) on loans it originates.

In general, a mortgage captive program works as follows:

• The lender forms a subsidiary company licensed to reinsure mortgage insurance. The subsidiary, called a captive, reinsures the lender's mortgage insurer.
• The captive must meet the capital requirements of the licensing domicile and the primary mortgage insurer. Generally, the mortgage insurer also requires the captive to maintain a trust account where funds are held to pay for future claims. Capital and trust fund requirements are commensurate with the risk assumed by the captive.
• The lender originates loans, which are insured as usual by the primary mortgage insurer.
• The captive assumes a portion of the premium via a reinsurance contract with the primary mortgage insurer (common captive premium levels are 15% to 20% of the total premium). The captive is then responsible for certain losses as defined by the contract. Typically, an aggregate excess approach is used, where the captive is responsible for losses within a certain tier.
  
  For example, on a $1 billion block of loans, the expected (average) losses might be $10 million. The captive might cover losses in the tier from $15 million to $22.5 million (i.e., maximum losses of $7.5 million). Over the ten-year term of a reinsurance contract covering this block of loans, the captive might collect $5 million in premium.
  
  As in this example, the captive's coverage tier is usually set above the level of expected losses. However, the captive is usually exposed to some risk of loss in order for the program to qualify as reinsurance under financial accounting standards.
• In the example above, the captive's exposure on one loan origination year is capped at $7.5 million. Generally, the captive's total exposure across all loan origination years also is capped by an aggregate limit (e.g., based on funds available in the trust account).

If actual losses develop to the expected level, the above arrangement, from the lender's perspective, is financially equivalent to receiving a commission or profit sharing equal to a percentage of premium, less any administrative expenses incurred to set up and operate the captive. However, there is risk involved as actual long-term results are uncertain.

It typically takes from two to four months for a captive program to be licensed and begin operations. Certain domiciles are conducive to forming a captive, due to their regulatory environment and service provider infrastructure. Formation costs can vary from $25,000 to $50,000 or more. Annual operating costs typically are in the $25,000 to $50,000 range.

We expect that there will more of these captive mortgage reinsurance companies formed in the future.

By: Timothy J. Cremin
Milliman, Inc.
289 Edgewater Drive
Wakefield, MA 01880
Telephone: (781) 213 - 6200
Fax: (781) 213-6201
E-mail: tim.cremin@milliman.com