The Office of the Superintendent of Financial Institutions Canada ("OSFI") released Draft Guideline B-21 Residential Mortgage Insurance Underwriting Practices and Procedures (the "Draft Guideline") on April 14th, 2014. Once the final version of the Draft Guideline is implemented it will apply to federally-regulated insurers governed by the Insurance Companies Act that either provide residential mortgage loans in Canada or reinsure such loans. The Draft Guideline sets out six fundamental principles relating to mortgage insurance underwriting and insurer disclosure obligations. This bulletin explains how the Draft Guideline will impact mortgage originators and acquirers of residential mortgage loan assets.1 For an in-depth analysis on the impact of the Draft Guideline on insurers and reinsurers, please refer to the bulletin found here.
The Draft Guideline:
The Draft Guideline sets out six fundamental principles for sound residential mortgage insurance underwriting. These six principles are as follows:
- Residential Mortgage Insurance Underwriting Plan – Residential mortgage insurers are required to have a Residential Mortgage Insurance Underwriting Plan ("RMIUP") that consolidates the insurer's key mortgage underwriting policies including its business objectives, risk appetite and risk-management policies. The Draft Guideline also stipulates that senior management of an insurer should be responsible for the development and implementation of the RMIUP.
- Establishing Standards for the Initial Assessment and Qualification of Mortgage Lenders – the Draft Guideline requires insurers to establish standards for the assessment and qualification of mortgage lenders that apply for mortgage insurance coverage.
- Mortgage Insurance Criteria and Insurance Coverage
Requirements for Lenders –
insurers should establish prudent underwriting practices that
specify the characteristics and parameters of insurable mortgage
loans for lenders. At a minimum, an insurer is expected to set out
criteria for managing risk and include at least the following
components for each mortgage insurance product and insurance
- mortgage loan parameters (which includes allowable loan purpose, allowable loan security position, allowable loan term and amortization length and maximum loan to value ratio);
- borrower's background and willingness and capacity to service debt (such as verifying the borrower's income and employment, and ensuring there is an adequate down-payment);
- a proper assessment of the value of the underlying mortgage property; and
- actuarially-sound premium rates are established which reflect the insurer's risk assessment.
- Insurer's Periodic Assessment of Lenders' Underwriting Practices – insurers are expected to exercise "reasonable due diligence" through periodic assessments of lenders' underwriting practices to ensure compliance with the requirements contained in Master Policy Agreements. Such reviews can include automated reviews, desk-reviews, or on-site inspections by a team of reviewers.
- Assessment and Validation of Underwriting Systems, Models, and Underwriters' Processes – Insurers are expected to assess and validate their respective insurance underwriting systems, models and underwriters' processes to assess consistency with the insurer's RMIUP.
- Effective Portfolio Risk Management and other Risk Mitigation – insurers are expected to undertake appropriate risk management such as through stress testing or reinsurance, where necessary.
Insurers are also required to abide by disclosure requirements to allow market participants to evaluate the soundness and condition of their insured residential mortgage portfolio.
The Impact on Mortgage Lenders
The Draft Guideline is meant to complement the previously implemented Guideline B-20 Residential Mortgage Underwriting Practices and Procedures ("Guideline B-20") released in June 2012. Guideline B-20 applies to mortgage originators and acquirers of residential mortgage loan assets, rather than insurers. The Draft Guideline stipulates that insurers must monitor and supervise lender mortgage underwriting practices for those loans for which mortgage insurance is provided such that lenders and insurance companies abide by proper and complementary risk-management techniques. Many of the requirements for insurers found in the Draft Guideline follow the requirements for mortgage lenders set out in Guideline B-20.
For example, the Draft Guideline provides that insurers should ensure that lenders abide by certain loan parameters and verify lenders' borrower loan-verification criteria, whereas Guideline B-20 already requires these lenders to abide by similar loan parameters and be satisfied with borrowers' ability to service debt obligations. On this basis, it is expected that the Draft Guideline will not substantially impact lenders' day to day mortgage origination processes or the acquisition of residential mortgage assets, as many of these requirements reflect what is already done in the market.
However, the Draft Guideline effectively mandates another level of oversight for lender compliance. In fact, OSFI expects insurers to undertake remedial action and set out an escalation process for non-compliant mortgage lenders that in many ways resembles OSFI's own remediation and escalation policy to handle non-compliant federally regulated financial institutions. This additional, contractually-imposed oversight of mortgage lenders will likely add to the cost of mortgage lending as many of OSFI's expectations in the Draft Guideline will require mortgage lenders to cooperate and work closely with their mortgage insurers through onerous disclosure requirements and other compliance obligations.
Furthermore, mortgage insurers and mortgage lenders will now be mandated to work together to develop adequate risk-management policies and implement such policies in Master Policy Agreements. To the extent that lenders and insurers are not already developing such policies in concert, such negotiation will add to the complexity, time and cost of obtaining mortgage insurance. Lenders will want to ensure ongoing compliance with the risk-management policies and expectations of insurers so as to avoid any disputes or exclusions of coverage.
Rebate and Incentive Programs
OSFI has also reiterated in the Draft Guideline that incentive and rebate payments (so called "cash back" programs) should not form part of a borrower's down-payment. Guideline B-20 requires mortgage lenders to use reasonable efforts to determine whether borrowers are sourcing down-payments from their own savings or the lender's sources, and also discourages lenders from including cash back arrangements as part of the down-payment calculation. The Draft Guideline now imposes a parallel obligation on insurers by stipulating that insurers should mandate in their Master Policy Agreements with mortgage lenders that the lender should not consider cash back arrangements to be part of the down-payment.
The focus of the Draft Guideline is for insurers to promote and oversee sound mortgage underwriting and lending practices, including through the imposition of risk-management policies in Master Policy Agreements with lenders. While mortgage lenders will be familiar with many of the expectations set out in the Draft Guideline due to the previously released Guideline B-20, the Draft Guideline will add another level of oversight for lenders and increase the cost of originating and processing mortgages with mortgage insurance. Comments on the Draft Guideline are due by May 23rd, 2014 and OSFI is expected to release the final guideline later in 2014.
1 Referred to collectively as "mortgage lenders" in this bulletin.
The foregoing provides only an overview and does not constitute legal advice. Readers are cautioned against making any decisions based on this material alone. Rather, specific legal advice should be obtained.
© McMillan LLP 2014