Mortgage Insurance Deductibles: An Idea Whose Time Hasn't Come

Abstract

The rise in house prices – especially in Toronto and Vancouver – has coincided with an increase in the number of homeowners taking on high debt-to-income ratios. This has intensified debate on whether further reforms to mortgage insurance are needed to limit the build-up of risk in housing markets. The focus on mortgage insurance is not surprising, as federally regulated financial intermediaries cannot offer high loan-to-value (80 percent or higher) mortgages without mortgage insurance. A Department of Finance consultation paper (Canada 2016a) is the most recent proposal to reform the mortgage insurance system so as to limit risk build-up in the housing sector. It proposes to introduce a deductible on lenders for insured mortgage losses that would shift a significant amount of potential losses back to mortgage lenders from the insurers. The deductible is intended to address moral-hazard concerns, whereby lenders have an incentive to extend credit to high-risk borrowers if they can shift all of the default risk to mortgage insurers. In this Commentary, we argue that the proposed deductible is a blunt and ineffective tool to address these concerns. Deductibles need to be capped at relatively modest levels in order to maintain the effectiveness of the mortgage insurance system as a macroprudential tool that insulates the Canadian financial system from the large losses that follow a housing crash. Once passed on to borrowers, such modest values for the deductible imply small increases in mortgage rates for riskier borrowers. This in turn implies that a deductible would have little impact on the problem that mortgage insurance might facilitate lending to some borrowers who are at relatively high risk of defaulting on their mortgages. A better way of dealing with excessive mortgage lending to high-risk borrowers is to combine a change in the pricing regime for mortgage insurance with continued refinement of the regulation of the mortgage insurance system. Currently, mortgage insurance premiums do not take into account how default risk differs across mortgages beyond the loan-to-value ratio. Charging the lender an insurance premium that takes into account risks associated with idiosyncratic characteristics of the borrower would directly address moral-hazard concerns. This shift to risk-based pricing should be complemented with a continued refinement of regulations for mortgage insurance underwriting to limit further build-up of risks in the housing sector.