Arch’s Freddie Mac mortgage risk deal. A glimpse of the future?

by Artemis on March 16, 2018

Bermudian insurance and reinsurance firm Arch Capital announced an interesting arrangement with the U.S. mortgage insurer Freddie Mac this week, which will position the re/insurer as an intermediary of sorts, channeling mortgage credit and insurance related risks back to a panel of reinsurance capital providers.

Mortgage riskArch Capital has established Arch MRT (Mortgage Risk Transfer we assume) as a new subsidiary in the United States, to participate in the Freddie Mac sponsored mortgage credit risk transfer program “IMAGIN” (Integrated Mortgage Insurance).

Arch explained that the arrangement will attract “a diversified and robust capital base to the U.S. housing market, in a highly efficient structure, that will support market stability through economic cycles.”

What that means is that Arch will accept mortgage related risks from Freddie Mac and arrange their transfer to a panel of reinsurance capital providers, through Arch MRT.

It’s interesting to us, as it positions Arch in a unique position of being a gatekeeper to Freddie Mac’s mortgage risk, sitting between the government-sponsored enterprise (GSE) and the reinsurance capital providers, which in this case won’t just be reinsurers, they will also be investors from the debt capital markets.

Arch explained at the time of launch that Arch MRT will, “Insure Freddie Mac and transfer 100% of the risk assumed to a panel of diversified, well-capitalized, and highly rated (re)insurers that provide high quality collateral assets in trust.”

It turns out that this is more than just rated reinsurers, the plan is to diversify capital sources to debt capital market investors, as well as the equity investors that will we presume allocate to the Arch MRT vehicle as well.

This piece of the puzzle will reduce counterparty risk for Freddie Mac, providing a much broader pool of capital for the mortgage risks to be ceded through to.

“This arrangement encourages additional participants and capital to support first-loss exposure in mortgages,” Arch said.

The re/insurer also highlighted that re/insurers behind the facility, presumably the investors too in future, will “competitively bid, through a transparent process” to access the mortgage risks.

This will involve a process facilitated by Arch MRT, which will interact with Freddie Mac to facilitate the transfer of risk, arranging the data and passing that to the re/insurers through its own digital platform and then running an auction process to identify demand and pricing indications for the risks.

The bids will be delivered back to the GSE and if accepted the GSE will determine the allocations to each successful participant, after which the re/insurers or investors will post collateral to trust to back their share of the mortgage risks, while for the lifetime of the transaction the Arch will liaise with the GSE and provide reporting both ways.

The goal? “To provide, over the long term, lower cost mortgage insurance for borrowers,” Arch explained.

By acting as the intermediary, between the GSE (perhaps GSE’s in future if Fannie gets involved) and the risk capital, but without bearing the risk itself, Arch Capital provides a glimpse of one future for the re/insurers of the world.

With this arrangement, Arch is utilising its intellectual capital, origination, structuring and underwriting expertise, along with its access to capital, in order to facilitate risk transfer without actually holding all of the risk on its balance-sheet.

Yes, Arch may participate as one of the reinsurers backing the arrangement, but it will have to enter the auction process like anyone else and may not be the bidder with the most-efficient cost-of-capital all of the time.

But that doesn’t matter, as Arch is putting its expertise to good use and getting paid for it anyway, all while leveraging the most efficient access to risk capital that it can.

So the GSE’s get what they want, another channel to diversify their counterparty risks while tapping a broad range of risk capital providers, using it to control their risks while offering lower-cost products to end-consumers.

The risk capital providers get what they want, in access to a new source of risk, with a bidding process that could be relatively transparent (we can’t be sure, of course), all originated through a recognised sector leader in mortgage risk.

While Arch gets a new source of income, in a market where it cannot just continue to soak up more and more risk, but it can now get paid for the mortgage risk and underwriting expertise it is developing.

The model, of acting as go-between, intermediary, or perhaps even “real-time warehouser and distributor of risk”, between large sources of exposures and a broader swathe of the reinsurance and risk capital markets, allows Arch to earn income where it previously hasn’t. Even from competitors in some cases.

Arch can put its intellectual capital to work and get paid, without taking additional risk on its balance-sheet and also position itself as a leading source of risk for a much broader capital base than it has before.

So why a glimpse of the future?

Well, we’ve said for years that the future of reinsurance will be about working out the best way to get paid for the value you bring to the risk-to-capital chain. Monetising your expertise and intellectual capital, aware of the fact you’re not always the most effective or efficient ultimate risk bearer.

Arch demonstrates exactly this with the MRT arrangement.

It’s the kind of model we will likely see others adopt, acting as a conduit for risk and becoming the one that gets to match it with the right capital.

Re/insurers have to work out how to monetise the significant expertise they have developed over the years, while recognising that they aren’t always the most appropriate underwriting capital anymore and that there are risks out there too large for them to manage alone.

Arch Capital shows one way of achieving this with the MRT mortgage risk pilot with Freddie Mac.

We’re convinced we’ll see many more examples over the coming years and this model could work especially well for reinsurers to channel risks back to capital market or ILS investors, making themselves an invaluable facilitator while still earning their cut.

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