The private mortgage insurance (PMI) industry can trace its origin to the early years of this century and the activities of title insurance companies in New York State.(1) The state legislature authorized the issuance of mortgage guarantee insurance in 1904, but the law permitted insurers to guarantee the payments only on mortgages owned by the institution that originated the loan. In 1911, New York amended the law to permit mortgage insurers to purchase and resell mortgages. To enhance their ability to sell mortgages to investors, insurers guaranteed the property title as well as the loan.(2)
Until the Depression, rising real estate values made it possible for most mortgaged properties that were in default to be sold without a loss. This experience reinforced a widely held perception that insuring mortgages was a low-risk business. But the sharp decline in real estate values in the early years of the Depression–together with the low capitalization, questionable business practices, and weak regulation of the PMI industry–resulted in the collapse of the industry.
Government efforts to revive the housing industry during the Depression led to the establishment by the Federal Housing Administration (FHA) of the Mutual Mortgage Insurance Fund to provide mortgage insurance on FHA loans.(3) After World War II, the federal government’s role in providing insurance on mortgages expanded with the creation in the Veterans Administration (VA) of a mortgage insurance program for veterans.(4)
FHA and VA home loan insurance programs apply to a wide range of prospective homebuyers, but both programs have significant limitations. The FHA, for example, limits the size of the mortgages it will insure. The VA programs guarantee only a portion of the loan amount up to a congressionally established ceiling and are available only to veterans. In addition, the property and credit underwriting standards of both the FHA and VA exclude some prospective borrowers.
Among the steps lenders can take to mitigate credit risk is the requirement that borrowers whose mortgages have high loan-to-value ratios obtain private mortgage insurance.(8) PMI reduces credit risk by insuring against losses associated with default up to a contractually established percentage of the claim amount (see box, “Claims under Private Mortgage Insurance”). Defaults on these loans may result in a loss to the insurer; therefore PMI companies address credit risk in many ways in pursuing their business strategies:
* First, a PMI company may simply not insure a particular type of mortgage contract or a mortgage secured by a specific type of property, ceding that business to competitors.
* Second, in determining whether to insure a particular loan in a chosen line of business, PMI companies act as a review underwriter, evaluating both the creditworthiness of the prospective borrower and the adequacy of the collateral offered as security on the loan. They will deny insurance to prospective borrowers judged to impose undue credit risk on the insurer and lender; lenders, of course, are free to extend credit to such borrowers, but they must do so without the protection of PMI.
* Third, insurers may underwrite some mortgages more strictly than others and thus limit their exposure to losses.
* Fourth, they may charge a higher premium to insure riskier mortgages, although state regulation can limit or set the premiums charged for different types of mortgage insurance.
* Fifth, the PMI companies can limit the extent of their coverage of losses, either directly (by limiting the proportion of the mortgage insured) or by using reinsurance or pooling arrangements.
* Sixth, PMI companies can mitigate credit risk through credit counseling and early intervention once a borrower falls behind on payments.
In assessing the risk of the borrower, PMI companies evaluate both the ability and the willingness of the borrower to repay the mortgage loan. In determining the borrower’s ability to repay, insurers examine sources of income, debt-to-income ratios, asset holdings, employment history, and prospects for income growth. Insurers gauge willingness to repay primarily by reviewing the borrower’s credit history, including rent and utility payment records in some cases.
PMI companies also evaluate the characteristics of the property securing the mortgage. For example, because insurers generally perceive condominiums, manufactured homes, and properties with two, three, or four units as riskier sources of collateral than single-family detached dwellings, they usually treat them more stringently.
In addition, insurers consider the use of the property securing the mortgage. Dwellings to be used as vacation homes, second homes, or investment properties are generally underwritten to standards that are more strict than those for owner-occupied, primary residences. For example, the maximum loan-to-value ratio allowed for second homes is often lower than that for primary residences. In the extreme, some PMI companies have chosen not to offer insurance for particular uses of property, such as investment.
Furthermore, insurers examine the characteristics of the mortgage itself and adjust the price of insurance coverage accordingly. The loan-to-value ratio on the mortgage is a primary indicator of default risk; hence, the higher the ratio, the higher the premium.(9) Insurers also generally assess higher premiums on adjustable rate mortgages because these mortgages can potentially impose larger payment burdens on borrowers and because they have historically exhibited an inferior payment record.(10) Finally, insurers assess lower premiums on shorter-term mortgages because such mortgages result in a more rapid accumulation of equity by the borrower and therefore impose less risk of loss.
The PMI companies often use the credit underwriting guidelines of the two large government-sponsored mortgage agencies, the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), when deciding whether to approve an application. Many lenders desire to sell their mortgages to these agencies, and both Fannie Mae and Freddie Mac require PMI before they will consider purchasing a low-down-payment mortgage. Thus, PMI companies have a strong motivation to assure lenders that mortgages insured by PMI companies conform to the standards set by these organizations.
When examining the risks described above, many PMI companies rely heavily on automated underwriting systems to identify and quickly approve applications that are acceptable for insurance. PMI employees further evaluate applications that fail the automated review. Computer automation of underwriting thus allows PMI companies to focus their efforts on applicants with marginal or unusual credit histories and other special circumstances and is generally perceived to have widened the availability of PMI.
A fundamental strategy of insurance underwriting is to diversify risk.(11) In the case of PMI companies, risk diversification means limiting geographic concentrations of insurance, dealing with numerous lenders, and restricting the insurance written for any one particular project. The importance of these tactics is illustrated by the large losses in the 1980s of PMI companies that had significant concentrations of insurance in “oil patch” states.
An integral part of the PMI business is the management of problem mortgages. Foreclosing on properties is both time-consuming and costly, and insurers attempt to avoid it. Insurers try to work with delinquent borrowers, mostly through lenders, but sometimes directly with borrowers. Insurers often stress counseling as a way of helping borrowers overcome payment difficulties. Insurers will try to determine the prospects for bringing the mortgage back to scheduled payments and may work out a plan with the borrower to do so. In some cases, however, encouraging borrowers to sell their properties may be the least costly method, for both insurer and borrower, of resolving problems.
