After a decade of existence, lender captive entities, which are mortgage lenders established to reinsure a portion of the insurance they direct to mortgage insurers (MI), have become an integral component of the mortgage insurance industry. According to MIs’ statistics, much of the new insurance written (NIW) in 2006 was subject to lender captive arrangements, and the amount reinsured ranged from 24% to 54% of that year’s business. Standard & Poor’s Ratings Services considers the claims lender captives would pay during adverse economic conditions to be the primary benefit to MIs. Our 2005 report on the mortgage insurance industry expressed concern that a 40% level of ceded premium could be too high for the amount of risk assumed (see “After Tough Times, U.S. Mortgage Insurance Outlook Stabilizes,” published Feb. 22, 2005, on Ratings Direct). An earlier commentary also questioned the ability of lender captives to cover all of the risks that MIs cede to them. (See ” U.S. Mortgage Insurance Industry To Remain Strong Despite Negative Outlook,” published Sept. 11, 2003, on Ratings Direct.) Today, we believe it’s safe to say that we no longer have such concerns. Several years of low lender losses have enhanced lender captive profitability, which in turn has improved their ability to satisfy obligations. Also, a publicly available 2005 study by the actuarial consulting firm of Milliman Inc. for a mortgage insurer detailed the economics of certain lender captives and concluded that they met the requirements for risk transfer.

The study also concluded that the price the insurer paid was reasonable in relation to the risk ceded and that the use of reinsurance from lender captives improved the risk-reward trade-off. Typically, a lender captive’s initial capitalization is equal to 10% of the risk it assumes. However, a lender captive cannot pay dividends to its owner unless its capitalization equals the greater of 20% of original risk in force or 102% of the lender captive’s combined contingency reserves, unearned premiums, and loss reserves. The reinsurance coverage they provide is similar to certain forms of property-catastrophe reinsurance. The contracts are generally excess-of-loss arrangements, which reinsure a layer of aggregate excess-of-loss coverage from loans their parent lenders make. These loans are commonly prime-quality paper (FICO scores above 620 and full documentation) and, sometimes, better-quality Alt-A paper (FICO score usually above 620 with low or no documentation) and fully documented A-paper with FICO scores usually between 580 and 620.