Bruce Cran spends most of his working days complaining about insurance. As president of the Ottawa-based Consumer's Association of Canada, he knows all about the shortcomings of the Canadian insurance industry–auto, property, business, life–you name it. “We respond to public complaints, and insurance is an industry that has been plagued with complaints,” he says. According to Cran, the auto insurance industry, in particular, is guilty of unfairly raising premiums and being overly stingy on claims. But not every form of insurance earns a scolding. Asked about mortgage insurance–which almost one out of every two homebuyers in Canada must buy and which can add thousands of dollars to the price of a house–Cran draws a blank. “Not been one of our subjects–haven't dealt with it at all,” he says. “Is it government-run?”
Canada's mortgage insurance industry is not entirely government-run. But it is certainly government-controlled. Canada Mortgage and Housing Corp., a federal Crown corporation, commands more than two-thirds of the mortgage insurance business in this country. The remainder goes to a lone private-sector competitor–Genworth Financial Canada, which is part of the GE empire. And business for this cozy duopoly is very good. According to the federal Bank Act, every mortgage from a federally regulated institution with a down payment of less than 25% is required to carry mortgage insurance. Last year, 45% of all homebuyers, or 500,000 Canadian families, were required to buy a total of $1.6 billion worth of mortgage insurance.
Considering the outrage the auto insurance industry generates, the following seems rather interesting: In 2003, auto insurers took in $15.8 billion in premiums and paid out $12 billion in claims–a payout rate of 76%. Life and health insurance firms paid out at approximately the same level. And CMHC? According to its annual report, last year it earned $1.1 billion in premiums from homebuyers and paid out $51 million in claims–a payout rate of less than 5%. While 2004 was an exceptional year for mortgage insurance, over the past 10 years CMHC has paid out at an average rate of 45%, far lower than most other forms of insurance. In fact, there is probably no more lucrative line of insurance in Canada than mortgage insurance. “CMHC is making an absolute fortune right now, and I don't think it is fair,” says James Sears, co-owner of Toronto-based mortgage broker Trillium Mortgage, which has been in business since 1989. “But no one complains,” he notes, somewhat puzzled.
Because insurance is typically rolled into the principal of a mortgage, Sears figures people don't even notice they are paying it. And since it is required by law, perhaps no one sees the point in complaining. Sears adds that many of his clients, who hire him to find the best mortgage rates available, are under the false impression that CMHC insurance actually protects them against default. It does not. Given the confusion, and the vast profits being made, it seems clear that CMHC's mortgage insurance business deserves much more scrutiny that it is currently getting.
Mortgage insurance was conceived in the 1930s by the U.S. government's Federal Housing Administration to promote home ownership during the Great Depression. It proved to be a significant innovation and a major factor behind the North American housing boom of the postwar era. Because banks and other lenders shy away from borrowers with less than a 25% down payment as higher-risk clients, mortgage insurance gives people with smaller down payments a better risk profile. If the homeowner defaults on his or her payments and the lender faces a loss following foreclosure, mortgage insurance covers the difference and turns a high-risk customer into a zero-risk customer. In this way, potential homebuyers with a steady income but little in the way of savings can own a house much earlier.
The concept came to Canada in 1954 when its exclusive provider was the precursor to CMHC. The Crown corporation had the mortgage insurance business to itself until the 1970s, when several private-sector firms tried and failed, over the next 20 years, to establish themselves. In 1995, Genworth entered the Canadian market, and it has since proven an able competitor. Even so, CMHC still commands a 70% market share.
Today, CMHC embraces a broad range of private- and public-sector objectives. In addition to mortgage insurance, it also issues mortgage-backed securities and pursues a variety of social policy agendas at the behest of Ottawa, such as disseminating information on regional housing markets, improving access to affordable housing and encouraging energy efficiency in new homes. Some of these activities are covered by an annual appropriation from Ottawa. But mortgage insurance has proven to be its most important and lucrative line of business. Over the past 10 years, CMHC has reaped $3.2 billion in profits from mortgage insurance–representing more than 90% of its retained earnings. (Genworth doesn't release financial statements, but, according to government filings, in 2004 it took in $504 million in premiums and paid out $26 million in claims. That's about the same payout ratio as CMHC.) So is mandatory mortgage insurance a good deal for consumers?
Like most successful businesses, CMHC prefers to focus on the benefits its product provides, rather than on how much it costs. “Mortgage insurance allows Canadians across the country, in rural areas and big cities, to have the same opportunities to access home ownership and at the same interest rates as people who can afford to put down a 25% down payment,” says Pierre Serré, chief financial officer of CMHC. “Our one objective is to make housing more affordable and accessible to all Canadians.”
Peter Vukanovich, president and CEO of Genworth, also stresses the benefits of mortgage insurance, and argues that it is unfair to focus on what appear to be outrageous profits over the past few years. “Mortgage insurance is a long-tail insurance risk,” he explains. “When we write a policy, it will be in effect for the 25-year life of the mortgage.” He adds that while current payout ratios might look unbalanced, that's only because of a buoyant housing market. When housing prices are rising, even the homes of owners who have defaulted on their mortgage payments are likely to have appreciated in value, eliminating the risk of a loss to an insurer. And default rates are at 15-year lows. “These are very good times,” says Vukanovich, “but when things return to normal–think higher interest rates, think more unemployment–then there will be more payouts. We are kind of socking money away for a rainy day.”
It is true that in the 1990s, CMHC and Genworth combined to pay out $2 billion in losses to mortgage lenders. And in 1997 CMHC lost money on its mortgage insurance business when claims outweighed premiums by $50 million due to a weak housing and employment market. Since a housing bust has the potential to cause a large run on the mortgage insurers' accounts, the Office of the Superintendent of Financial Institutions sets minimum capital reserve requirements to ensure insurers can meet payout requirements during downturns. Genworth already meets its required capital reserve. CMHC, as a Crown corporation, is not directly regulated by OSFI. Still, it plans to voluntarily meet its $3.8-billion requirement by 2007.
By their recent actions, however, both firms seem to be tacitly admitting that they suffer from an embarrassment of riches. In 2003, CMHC and Genworth lowered premiums across the board by 15%. And earlier this year they both cut their highest premiums–for buyers with 5% down–by another 15%. CMHC also created a zero-down category in 2004 by permitting homebuyers to borrow their required 5% down payment. But the booming profits at CMHC have been funding a variety of other programs as well.
A few months before lowering its 5% down payment rate, CMHC announced even greater reductions for owners of energy-efficient homes and for those borrowing for energy-saving renovations. And it has waived premiums altogether for certain types of rental housing aimed at lower-income Canadians. All told, over a third of CMHC's total mortgage insurance business, according to its corporate plan, “directly supports the corporation's public policy objectives.” And as the profits continue to roll in, it intends to increase its public policy expenditures in step. That means, in effect, that homebuyers have become something of a new source of tax revenue for Ottawa. CMHC is funding federal government objectives using its mortgage insurance profits.
Like the employment insurance fund, another mandatory insurance program with a public policy goal, CMHC's mortgage insurance business could soon become a healthy source of real money for the federal government. According to five-year projections by CMHC, in 2009 the organization will be sitting on cumulative retained earnings of $8.3 billion. This is far in excess of the $3.8 billion required by OSFI as capital reserves. So what will become of that extra $4.5 billion? As a Crown corporation, that money technically belongs to the federal government. And just as Ottawa earns dividends from other profitable Crown corporations, such as Canada Post, it is entirely possible that premiums from homeowners paying for government-mandated insurance will eventually find their way into Ottawa's general ledger. Serré notes that under federal legislation, any surplus must either be paid to Ottawa, retained by CMHC or spent on housing in Canada.
Mortgage broker Sears argues that the decent thing to do with the surplus would be to refund that money to homeowners who have presumably paid too much for their mortgage insurance. “After five years, very few people default on their mortgages,” he observes. “So why not give everyone in good standing after five years a rebate? It would be fairer than dropping premiums for new customers. And better than the [federal] Liberals keeping it.”
Perhaps aware of the inequities presented by an ever-increasing surplus at CMHC, the Department of Finance has begun a review of the industry. In an annex to the 2005 budget, it asked for public input on the concept of mandatory mortgage insurance, which, it says, “may have increased the cost of home ownership to some Canadians.”
Genworth's Vukanovich argues against shaking up the status quo by altering mandatory mortgage insurance. He claims any changes could weaken the underpinnings of the current robust Canadian housing market. “The beauty of the Canadian mortgage insurance market is its simplicity,” says Vukanovich. “People who have an income but not a large down payment can buy a house, and the cost of mortgage insurance is very transparent. We think it's the most efficient market there is.” Vukanovich figures removing mandatory insurance or altering other aspects of the business could cause the real estate market to suffer by forcing some Canadians to pay more for a house.
But there are many characteristics of the “simple” Canadian system that appear stacked against consumers. Few would argue that the concept of mandatory mortgage insurance should be eliminated entirely. But if the Department of Finance wants to find ways to save Canadians money on mortgage insurance, it need look no further than the 49th parallel. While Americans also have mandatory mortgage insurance, they pay much less for it than Canadians do. There are four reasons why.
First, all Canadians pay the same premium, based on the size of their down payment. That means good-risk clients are charged the same as poor-risk clients. American consumers, on the other hand, are rewarded for better creditworthiness with lower rates. Higher-risk homebuyers naturally face higher mortgage insurance premiums. U.S. mortgage insurance is thus based on the actual risk characteristics of the individual borrower rather than pooled across all citizens, as is the case in Canada. Changing to an American-style system would mean some Canadian homebuyers would pay more, some would pay less. Vukanovich has supplied figures to the Department of Finance arguing that more Canadians would pay higher rates than would save money if pooling was eliminated, although this is speculative.
Second, the Canadian market lacks dependable competition since the government is the price setter. Note that both price reductions in the past two years were initiated by CMHC, which is the dominant player. Genworth simply matched the changes the next business day. This creates a potential incentive problem, since the federal government creates the regulatory environment that provides CMHC with a near-captive market. And, as we have seen, Ottawa stands to benefit from CMHC's spectacular success through its various public policy mandates and its surplus.
In the United States, there are seven private providers of mortgage insurance competing against the federal government. The private sector controls about two-thirds of the market and the government's share has been falling in recent years. As opposed to a single rate sheet in Canada, there appears to be genuine competition in rates and service south of the border. Genworth's U.S. division, for instance, offers homebuyers a $500 rebate on their mortgage insurance if they arrange their mortgage through preferred lenders on its website. Genworth Canada does not offer any such rebates.
Third, the entire mortgage premium in Canada is due upfront and typically rolled into the principal of the mortgage, meaning homeowners must pay interest on their premiums. In the United States, most homebuyers pay monthly. An average homeowner pays between US$50 and US$100 per month for mortgage insurance, according to the Mortgage Insurance Companies of America trade association. The savings on interest alone due to the monthly schedule can be substantial.
Finally, and most significantly, Canadians are forced to buy far more coverage than they actually need. There are two aspects to this. Mandatory insurance in Canada kicks in for anyone putting down less than 25%. In the United States, homebuyers are not required to buy mortgage insurance until the 20% down payment level. This means many more homebuyers are exempt from mortgage insurance in the U.S. Further, Canadian homebuyers must purchase 100% coverage for their mortgage. In other words, the entire mortgage value is covered by the insurance policy. But this is wholly unnecessary, since it means a property would have to fall to nearly zero value for the full insurance policy to be paid out. Even Vukanovich admits the chance that a house and the land it's on could not be sold for any price is an “extremely unlikely event.”
American homebuyers typically purchase only 25% coverage for their mortgage. That means the insurance firm covers the first 25% of losses on a property and lenders are responsible for anything over that amount. Such a scenario recognizes that even in a housing bust, property still has substantial value. The most precipitous real estate crashes in Canada in the past 30 years–Calgary during the 1980s oil bust and Toronto in the early 1990s recession–resulted in losses of 25% to 28% in the average price of a house. They were large drops, to be sure, but most properties still retained the bulk of their value.
Even more favourable for American homeowners is the fact that the mandatory aspect of mortgage insurance is eliminated once homeowners' equity reaches 22% of the value of their property. This is enshrined in a federal law. Thus, after four or five years, most Americans stop their monthly mortgage insurance premiums altogether. If homeowners choose to pay down their mortgage quicker, or if a rising housing market boosts the equity in their house, those payments can end even earlier. In this way, Americans are not paying for insurance they will never use.
Put all these differences together and what does it mean for Canadians? Higher costs and less flexibility. Converting a typical U.S. monthly rate to a lump-sum premium using the rate schedule of PMI Group, the second-largest mortgage insurance firm in the U.S., an American customer with a fixed-rate 25-year mortgage can expect to pay 1.15% of the loan value to insure a mortgage with 10% down. The rate in Canada is 2%. At an average home price in Canada of $251,000, the Canadian homebuyer faces $1,924 in additional insurance premiums. Add on the interest costs of amortizing this over 25 years at 5%, and the cross-border difference is more like $3,400. That is not an insignificant sum for anyone familiar with the assorted costs of moving into a new house.
CMHC officials claim any price difference between Canadian and U.S. mortgage insurance is irrelevant. “A direct comparison isn't appropriate in our view,” says Steve Mennill, director of products and strategic direction for mortgage insurance at CMHC, citing differences between the two countries' banking and housing systems. He adds that CMHC has no plans to allow Canadians to decide for themselves whether they would prefer to pay monthly, reduce the level of their coverage or take advantage of any of the other innovations on display in the private-sector-dominated U.S. market. “Our product, for the moment, is appropriate,” Mennill says.
The Department of Finance's upcoming review provides Canadians with an opportunity to educate themselves about the overlooked issue of mortgage insurance and to speak out about it. While mortgage insurance has been a useful addition to the Canadian housing market, whether people are getting good value for the billions in premiums they pay each year has yet to be determined. Is it proper that a federal Crown corporation is reaping record profits selling a product that federal law requires Canadians to buy? And if it is, how should that surplus be used?
Given the U.S. experience, it appears there is ample room for significant consumer-friendly modifications to mortgage insurance, such as lowering the down payment requirement from 25% to 20%, reducing the amount of mandatory coverage, offering a monthly payment option and encouraging greater competition through the private sector. The fact that U.S. home ownership rates exceed those in Canada puts to rest any argument that these sorts of changes will undermine the domestic housing market. And claims that the two countries are so different that the benefits of lower rates can't be transferred to Canada seem rather specious.
The Canadian mortgage insurance system is certainly simple. The question is whether Canadians are happy paying more than they need to for the privilege of simplicity.