By Jason Pratt
Residential whole loans present insurance investors with a unique opportunity in terms of SCR charge and credit quality.
With yields in more attractive territory, insurance portfolios are benefitting from improved income profiles from higher-quality asset classes. Within Europe and the U.K., that typically means a greater focus on credit markets given how Solvency 2 treats structured assets including asset-backed securities and similar, relatively complex sectors.
Residential whole loans, however, are a unique opportunity specifically because this asset class can be exempt from spread risk Solvency Capital Requirement (SCR) charges,1 keeping in mind that spread risk SCR is effectively most impactful for European insurers as defined by European Insurance Occupational Pensions Authority criteria.
Residential whole loans are high-credit-quality, senior, private mortgage loans secured by U.S. residential properties and sponsored by prime borrowers, as measured by the FICO credit scoring system. The loans provide term and transitional residential real estate financing, and offer a yield premium due to their complexity, with the underwriting process generally requiring additional documentation and borrower diligence and verification.
These loan types have loan-to-value ratios in the range of 70%, which ties into the Solvency 2 calculation of required capital1—a resulting capital impact that is commensurate with A rated bonds. Loan types, corresponding yields and tenors vary with traditional term loans yielding 6.5 – 7.5% in U.S. dollars at durations of 4 – 6 years. Development, renovation and bridge loans have yields ranging 8.5% to 9.5% for two years of duration.
Housing fundamentals remain robust given thin supply trends for single-family residential. Borrower profiles tend to be high-quality self-employed professionals, high-net-worth individuals, professional real estate investors and developers. Therefore, the underwriting process is more robust compared to traditional conventional mortgage lending.
The opportunity to gain diversified yield with no spread SCR impact to capital is unique. This segment of the mortgage market is growing and non-U.S. insurers can benefit accordingly. It is effectively a “private” asset class with loans sourced from private originators, but there is a secondary market as well. In light of its attractive characteristics, we believe the segment is well worth investigating.
1Pending compliance with Article 191 of the Solvency II Delegated Acts, mortgage loans contribute to the counterparty default risk, with a charge of 0% if the loan-to-value (LTV) is less than 60%, and a charge of 6% for a 100% LTV. If not, mortgage loans are accounted under the spread risk SCR, with the possibility to use Article 176.5 of the Delegated Acts to lower the capital charge (which can be halved if the LTV is less than 75%).
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