Specialty Insurers on the Ropes
Mortgage and bond insurance industries are a wreck, but title insurance offers some opportunities.
While most attention in the insurance industry centers on life, property-casualty, and reinsurance stocks, Morningstar also covers a smaller subset that we refer to as specialty insurance. Within this category the major industries are title, mortgage, and bond insurance. All three have fallen on hard times these days, suffering from the ill effects of the housing crisis. Still, out of the ashes opportunity may sometimes arise, causing us to revisit our assumptions now that it appears the worst of the recession has passed.
Mortgage insurers continue to report rising delinquencies, with the contagion spreading to prime mortgages. An average of two industry leaders ( MGIC (MTG) and Radian Group (RDN)) shows that the subprime delinquency rate increased by 44% from last year's third quarter, while the prime delinquency rate doubled to 11.5%. Add PMI Group to the averages and the average delinquency rate of all insured mortgages for the three leading mortgage insurers ended the third quarter at a startling 15.8%.
In our view, two factors will determine the fate of the mortgage insurers. First is the "cure rate," which is the percentage of delinquencies that are saved from foreclosure either through borrowers resuming mortgage payments due to improved economic conditions or through lender modifications of the mortgage. In normal times, the cure rate is quite high, approaching 80%, but today it is much lower--somewhere in the 50% range. This drop is driven mainly by the massive decline in housing prices, as homeowners with no or negative equity in their houses have less incentive to continue making payments. The continuing malaise in the economy is an additional stress, as it creates few opportunities for out-of-work homeowners to get back on track. But a second factor that could lift the burden from mortgage insurers is the "rescission rate," the number of coverage denials the insurers can invoke based on fraud or misrepresentations. It's ironic that the sloppy mortgage underwriting that caused the housing crisis might provide an offset to the mortgage insurers' woes, but we're skeptical this will provide enough relief to offset the sharp drop in cure rates.
Due to the spike in delinquencies and the drop in cure rates, insurers whose sole line of business is mortgage insurance will come up short on capital sooner or later, in our opinion. To reach that conclusion we assume a cure rate that is a bit higher than current and a rescission rate of 20%. We also allow for reinsurance recoverables from captive lender reinsurance as disclosed by the companies. Unfortunately, given the depressed stock prices of MGIC, PMI, and Radian, a capital raise through an equity offering is highly unlikely. What's more, all three companies are rapidly approaching the 25:1 risk/capital ratio that many states impose to allow them to write additional insurance. Bottom line, unless the cure rate significantly improves, or unless the companies can increase the rescission rate, we expect all three companies to enter run-off, which means they would be unable to write new business, and any equity value would depend on existing reserves being sufficient to settle claims. Our uncertainty rating is extreme on all three companies.
There is, however, one other company writing mortgage insurance that is partially shielded from these dire consequences as a result of having other insurance lines of business. Old Republic International (ORI) has a large general P&C insurance operation and a title insurer that does quite well these days. We still have a very high uncertainty rating for Old Republic, and an investment in this stock would still carry substantial risk. But if an investor wanted to take a chance on a turnaround in mortgage insurance, we think this would be a more reasonable place to look.
The former bond insurance leaders MBIA (MBI) and Ambac are in even worse shape than the mortgage insurers. Not only are they in peril of having greater claims than reserves, but they've also seen their highly valued AAA insurance financial strength ratings dropped to junk status, restricting new insurance issuance. Worse yet, Ambac recently warned that it may have to consider seeking bankruptcy protection if it fails to implement new strategies to address liquidity needs. Needless to say, we rate both MBIA and Ambac as having extreme uncertainty and we wouldn't recommend the stocks at any price.
One bond insurer, however, has navigated the difficult environment over the past couple of years and emerged as a viable heir to the throne. Assured Guaranty (AGO) now stands alone as the only bond insurer that has written appreciable new business in 2009 and will likely hold that position for the foreseeable future. Assured avoided writing the worst of the structured finance mortgage-backed securities that have brought others to their knees. But even though Assured has fared far better than its competitors, we still think it faces elevated risk. Assured recently stated that it expects higher losses on insured first lien Alt-A and option-ARM RMBS as well as increased delinquencies in home equity loans, which could increase claim payments. Overall, we think this remains a high-risk investment and caution that the worst may still lie ahead.
Unlike mortgage and bond insurers, the title industry's woes have not arisen from claims exposure but from lack of business. Claims expense at title insurers have historically averaged in the range of 7%-8% of premium, and it's not any different today. The larger insurers did under-reserve a bit in the housing boom that began in 2003, reducing their estimates of loss to the 4%-5% range as they thought the business mix at that time merited lower claim provisioning. However, industry participants have since realized the error in this judgment and increased reserves. At this time we think the title insurers are adequately reserved on past policies issued and have realistic provisioning in relation to written premium.
The real problem with the title insurers has been the top line, as revenue has fallen off the cliff due to a lack of real estate transactions in both residential and commercial markets. Title insurance premiums are transaction driven, and premium growth exploded in the early to mid-2000s, matching the jump in real estate sales and refinances. Title insurance industry premiums averaged over $16 billion per year in the peak years of 2003-07, more than triple the average in the 1990s. To accommodate the increased servicing demands, title insurers staffed up, increasing fixed costs, which became a problem when real estate markets came down to earth. We estimate that industry written premium in 2009 will be roughly half the average of the peak years.
Beginning in 2008, title companies have slashed costs through layoffs, branch office closures, and consolidation. Most notable was the purchase of the title operations of LandAmerica by Fidelity National Financial (FNF), a move that increased Fidelity's market share to about 45%. That, combined with First American's (FAF) share, creates an industry where the top two companies control about 75% of the market. The combination of cost control and consolidation allowed both Fidelity and First American to report 2009 year-to-date profits from title operations, even in the face of a still deeply depressed real estate market. We think the industry's top line will ultimately bounce back once the real estate market has healed, and we expect improved profitability not only from releveraging of the cost structure, but also due to the reduced competition in the space. These two stocks are not quite cheap enough for us to recommend right now, but we think they're worth keeping on the radar, as we believe both companies are positioned to not only survive the crisis, but to exploit the inevitable recovery. Investors considering the stocks should be aware, however, that the timing of this recovery remains uncertain, and patience may be required.
Jim Ryan does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.