The fourth of five essays compiled in SCI's inaugural SRT Journal examines the growth of unfunded mortgage SRT

Mortgage insurance is as old as the hills, but the provision of financial guarantees or insurance policies on pools of home loans to secure capital relief as a tool of the significant risk transfer (SRT) market is of much more recent vintage. SCI looks at the growth and structural developments in the unfunded mortgage SRT market, but also the reasons as to why unfunded insurance provided to private banks in the US is still subdued.

Arch wrote an unfunded mortgage SRT transaction with ING in 2018, and this is generally thought of as the starting point of the market. Supranationals like the European Investment Fund had provided guarantees before this date, but Arch started the ball rolling for private insurance and reinsurance companies.

Arch Capital Group Ltd writes insurance, reinsurance and mortgage insurance on a worldwide basis with a focus on specialty lines. The business is Nasdaq-listed and a member of the S&P 500 index.

Since the first unfunded trade in 2018, other names such as Munich Re, Fidelis and Renaissance Re have entered the space as well, but Arch remains a leader with a circa 35% market share in 2023, based on data from the International Association of Credit Portfolio Managers (IACPM). The same body also says that protection provided by insurance companies on tranches in 2023 totaled about US$1bn.

Although these firms provide guarantees or policies on a variety of portfolios, including, for example, high quality corporate and SME loans, mortgage remains very much a core asset class for SRT transactions. All of the trades written by Arch to date in 2024 have provided protection on mortgages for issuers across Europe.  

This is an asset class Arch understands intimately; it’s in its DNA. It makes sense that this is where it is most comfortable playing.

“Mortgage is a key tenet of Arch’s overall strategy,” says Ruairi Neville, head of European origination for Arch International Mortgage. “We’re the largest and only globally diversified mortgage insurer in the world. Along with our European SRT business, our global presence includes primary mortgage insurance operations in the US and Australia along with our GSE Credit Risk Transfer business in Bermuda.”

Since its first transaction in 2018, Arch has completed almost 30 unfunded SRT transactions and has now about US$1bn of limit out in the market. Arch has the flexibility to write SRT as either a Financial Guarantee or an Insurance Policy and has concluded trades using both formats, says Neville. It is at the banks’ discretion as to how they wish to classify the trade. In some regulatory jurisdictions, guarantees work better, and in others insurance policies are preferred.

Mortgage SRT is typically transacted on an unfunded basis. Insurers make use of their generally robust credit rating to execute these deals and keep liquid assets on the balance sheet. Arch and Renaissance Re are both rated A+ by S&P and Munich Re has an AA S&P rating.

Asset management firms are not usually as well rated as this. Ares is rated BBB, for example. They are obliged to do funded SRT deals, but generally also have disposable capital at hand and run bespoke SRT funds.

Insurers also have a greater appetite for longer-dated assets than asset managers.

“Arch is very comfortable covering long-dated risk,” Neville says. “Many of the SRT trades Arch has written have maturities in excess of 10 years.” 

The average asset manager which likes SRT investment would have wanted to invest and reinvest this capital several times in this passage of time.

Insurers also tend to have a lower cost of capital than traditional funded buyers, so they achieve more efficient funding at lower coupons. This, clearly, is a large advantage to a lender seeking to attain capital relief on a portfolio of mortgages.

Arch usually works directly with the bank owning the assets. Many of the SRT trades the insurer wrote in the last 24 months have been repeat trades with existing clients.

“Building a strong network of trusted partners is critical to our success in the SRT arena,” says Neville. 

Although it participates across all levels of the capital stack, Arch typically tends to cover lower or upper mezzanine risk, or a combination of the two. “The structures of transactions are very much deal-specific and depend on the banks’ individual motivations. We are agile in the cover we can provide. Our bank partners very much value this flexibility. The vast majority of our trades involve the bank retaining a thin First Loss layer and/or excess spread. We can attach from ground up and do this occasionally for trades which necessitate this type of structure, but this is very much trade-specific,” states Neville.

However, like many insurers in this market, they are conservative and favor granular pools of lower risk assets. “The scope where (re)insurers are interested is much narrower. Their risk appetite tends to be lower. They generally prefer low risk pools like mortgages or vanilla corporates, often with a focus on granularity and consistency. They’re also generally more interested in the more risk-remote pieces of risk like senior mezz and not first loss, while noting their ability to transact the most junior tranches is steadily increasing as familiarity grows,” says Robert Bradbury, head of structured credit execution and advisory at London-based Alvarez and Marsal.

Arch’s SRT trades are written from both Dublin and Bermuda. Arch has invested significantly in its European SRT operations over the last few years with key hires in the underwriting, legal and actuarial teams, while also having the benefit of being able to leverage the expertise in mortgage credit that exists across the broader Arch Group.

Insurers also claim that pricing can be very competitive compared to funded investors. They say they have less volatile premium requirements and can offer more consistent pricing on an ongoing basis. This is especially pertinent in an era when a new raft of relatively untried investors has entered the SRT market, sowing discord among the more established, and perhaps more trusted, buyers. These newcomers will perhaps fade away into the distance when SRT investment loses its lustre in comparison to the alternatives, say the critics.

The reach of the unfunded insurance guarantee is extending into further reaches of the SRT market as well. In 2022, Arch secured a mortgage SRT transaction with a large Spanish bank and since then has done several trades with Iberian counterparties. It is now the largest provider of unfunded mortgage protection in the region.

In the same year, it wrote two unfunded mortgage deals with counterparties in central Europe and this year did the first mortgage trade with a Nordic bank. Italy has been a core market for the firm since it began providing cover for Mortgage SRT.  

This is still, however, a relatively small corner of the European SRT market. The entire unfunded market, which includes guarantees of other assets in addition to mortgages, constitutes, perhaps, between 5% and 7% of the whole.

“It’s only a small proportion of the overall deal flow. Insurer appetite for risk is lower and there are fewer broadly relevant deals as a result,” says Bradbury.

The relatively small size of the mortgage SRT market is also relevant because there are some disadvantages to unfunded protection provided by insurers. Firstly, EU regulation currently disallows these deals from STS qualification. The framework for “simple, transparent and standardized” securitization was introduced in early 2019, and it set out the process by which certain institutional investors could benefit potentially from more favorable regulatory capital treatment for STS securitization exposure.

Certain investors, including insurers, were excluded from these provisions. As law firm Norton Rose Fulbright has written in its guide to STS securitisation, “The SPR (Securitization Preferential Treatment), which focuses on CRR (Capital Requirements Regulation) regulated credit institutions and investment firms, does not afford the same STS capital relief to other institutional investors such as pension funds, insurance and reinsurance undertakings.”

In the same guide, it also notes that while the European Commission (EC) has made “encouraging noises” about extending STS capital relief to insurers, the effect of the new STS framework “may be muted if insurers are effectively excluded from benefitting from preferential capital treatment.”

Some six years after this piece was written, the adumbrated encouraging noises have not yet been transfigured into action. Things happen slowly in EC regulation.

The lack of STS categorisation also makes tranching and structuring less efficient as it changes the risk weighting floor adversely and removes more favourable regulatory inputs, notes Robert Bradbury.

Neville is aware that this is a problem.

“The fact that insurers are not currently considered eligible protection providers for the purposes of the STS framework is a disadvantage,” Neville says. “Insurers represent highly regulated and well-capitalized counterparties who can bring significant diversity to the total investor base. The exclusion of insurers from STS trades is not conducive to furthering securitization in Europe, and we hope this will change in the near future.”

In addition, issuers must hold counterparty risk weight against unfunded guarantors, further reducing the efficiency of the transaction. However, argues Neville, this is a relatively minor burden for issuers.

“The protected tranche may only be about 5% and the bank will need to hold capital against our A+ rating, so it’s not a huge number,” he says.

Despite the caveats, the provision of guarantees or insurance by insurers is a growth market. Once banks have done one deal, they are likely to do more. Putting all the pieces in place before an unfunded SRT deal can go ahead is a considerable internal labour, and it doesn’t make a lot of sense to do one and then retreat from the sector.

“Each year, we onboard new counterparties. All the banks we deal with have done multiple deals or are looking to do multiple deals,” Neville says.

In the US, as is not uncommon, things are very different. Insurers and reinsurers, including Arch have worked with GSEs to provide credit risk transfer of exposure to mortgage assets since 2013 through the agency credit insurance structure (ACIS) programme at Freddie Mac and the credit insurance risk transfer (CIRT) programme at Fannie Mae.

In August 2024, Freddie Mac concluded its 100^th ACIS transaction, and in the last 11 years has protected more than US$2.5 trillion of unpaid principal balance of mortgage loans via UD$35 billion of ACIS coverage with more than 60 (re)insurers. Each deal normally has about 25 insurers and reinsurers.

Fannie Mae has executed five CIRT deals so far in 2024, the fifth deal in late June transferring US$337 million to 27 insurers and reinsurers. Since the inception of CIRT, the GSE has acquired approximately US$27.6 billion of insurance coverage.

But unfunded insurance provided to private banks a la the European model hasn’t got to first base.

According to section 12 CFR 172.2, the portion of Regulation Q that deals with capital adequacy, insurance companies are not permitted to act as “eligible guarantors”. These rules were devised in the wake of the financial crisis of 2008/2009, in which several firms that provided mortgage insurance failed.

Insurers could participate in the mortgage CRT market in the US by providing cash collateralized positions in the CLN market, but for the bulk of insurers it doesn’t make sense to lock up capital for the duration of a deal.

One possible way around this is for a European subsidiary of a US insurer to write the protection as they are not required to comply with US law.

“If a London branch of a US bank bought a guarantee from an eligible insurance company in London, this would tick the boxes for reg cap treatment in the US,” explains Matt Bisanz, a partner in Mayer Brown’s banking and finance practice.

However, Bisanz says, there is currently little inclination among bank issuers to devote the time and resources to explore this particular avenue.

So, for the time being, this leaves the mortgage CRT market in the U.S. high and dry. A potentially vast pool of capital is locked out of the space. As Michael Shemi, North America structured credit leader at Guy Carpenter in the US notes, “I think reinsurance companies are a huge source of steady capital for CRT as buy-and-hold counterparties. If the GSE CRT market plateaus, or even declines over the next year, then reinsurers would be looking to deploy their capital elsewhere, and bank CRT would be a great place to do it.  Some feel that the market would benefit from further clarity about the treatment of reinsurers as eligible guarantors in the US regulatory framework.”

But for the time being, the mortgage CRT market outside that written for the GSEs is high and dry, and it will be until there is regulatory change. Not unlike their European counterparts, however, US regulators tend to move slowly and unpredictably.

While it would be a mistake to describe the European mortgage CRT market as yawning, it is growing and offers a new and different outlet for lenders seeking to achieve capital relief of mortgage assets. In 2023, Arch provided guarantees and insurance for lenders in northern Europe, southern Europe and the DACH region (Germany, Austria and Switzerland). In all, it has clients for unfunded capital relief transactions in 11 different EU and non-EU geographies.

These lenders will prove to be repeat customers, so the pool is set to expand. Not dramatically, perhaps, but inexorably.

Simon Boughey

SCI’s SRT Journal is sponsored by Arch MI and Mayer Brown. All five essays can be downloaded, for free, here.