Perspectives on Mortgage Default Insurance

Abstract

Mortgage default insurance differs from most of the other types of insurance underwritten by insurance companies. In particular, the risk units covered by a mortgage insurer are often highly correlated since some of the determinants of default are related to either economy-wide or regional factors. In such situations, the risk cannot be diversified away by underwriting more risk units. It is argued in the present paper that traditional actuarial approaches to the pricing and risk management of this type of business are inadequate. Some new paradigms from the field of financial economics are used to provide alternative approaches to these problems. The paper starts with a brief description of mortgage loan default insurance and describes some aspects of the current situation in Canada and the United States. Next, there is a discussion of informational asymmetry in the context of the mortgage default insurance market. This provides a useful framework for discussing the relationships between risk sharing and incentives. This is followed by a discussion of the determinants of default risk. One approach to the pricing of this insurance is to use an option pricing analysis. Some numerical illustrations are given to illustrate the application of this type of approach.