Insurance. QBE Lenders Mortgage Insurance Limited. Australia Credit Analysis. Rating Rationale. Key Rating Drivers. Recent Events. Ratings.

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1 Australia Credit Analysis Ratings QBE Lenders Mortgage Insurance Limited Insurer Financial Strength AA Affiliate Ratings QBE Insurance Group Limited Long Term Issuer Default Rating A Outlooks QBE Lenders Mortgage Insurance Limited Insurer Financial Strength QBE Insurance Group Limited Foreign Currency Long Term IDR Analysts John Miles john.miles@fitchratings.com John Birch john.birch@fitchratings.com Stable Stable QBE Lenders Mortgage Insurance Limited Rating Rationale (QBE LMI) is ultimately owned by QBE Insurance Group Limited (QBE: IDR A /Stable); it was formerly PMI Mortgage Insurance Limited (PMI). QBE LMI s ratings reflect sound capitalisation and a robust risk management framework, which is underpinned by prudent underwriting policies. The company has sufficient capital to withstand a AA stress as defined by Fitch Ratings Australian depression scenario, which involves a property market several times more severely distressed than anything experienced in the past 25 years. Furthermore, QBE LMI maintains a reasonable level of capital resources to support future business growth. Also an important consideration for QBE LMI s rating is the support available now that it is part of a large and diverse insurance group. QBE appears both willing and capable of providing financial support over and above reinsurance and various forms of operational support. While QBE LMI s rating is enhanced by its new ownership arrangements, economic conditions have deteriorated in Australia and the company faces a challenging operating environment. A significant number of Australian households are highly leveraged and unemployment has risen to 5.8% in July While the impact is evident in rising defaults and mortgage insurance claims, house prices have remained remarkably stable and significant credit losses have not transpired. A prudent risk management framework has underpinned consistent profitable performance over many years. When acquisition adjustments are excluded, QBE LMI s net profit after tax dropped by around 11.0% to AUD72.3m for Consistent with other Australian mortgage insurers, QBE LMI s gross written premium dipped, reflecting a slowdown in credit growth, while claims have risen in line with a weaker operating environment. Key Rating Drivers A very severe housing downturn, most likely due to a sharp rise in unemployment looms as the most serious threat to QBE LMI s rating. Mindful of this, QBE LMI maintains a conservative investment mix and significant capacity within its reserves, capital and reinsurance to meet claims in the event of severe stress. Furthermore, losses on the acquired business (see Recent Events below) are protected through a contingent note. From a regulatory perspective, QBE LMI must observe high minimum capital requirements, as well a strict corporate governance regime. Access to group support is a key rating driver; in Fitch s view, QBE LMI could rely on its parent as a source support for growth or recapitalisation. Recent Events On 23 October 2008, PMI was acquired by QBE Holdings (AAP) Pty Limited, a wholly owned subsidiary of QBE, and the name was changed to QBE LMI. PMI s ultimate parent entity was The PMI Group, Inc., which was US based. On 17 December 2008, QBE also acquired QBE Mortgage Insurance (Asia) Limited (formerly PMI Mortgage Insurance Asia Limited), which operates as a wholly owned subsidiary of QBE LMI. 17

2 Key Rating Issues Rapid rises in unemployment leading to higher claims and loss ratios Capital management and flexibility Investment performance Peer Analysis QBE LMI is one of only two major external mortgage insurers operating in the Australian market, the other being Genworth Financial Mortgage Insurance Pty Limited. There are also several bank owned captive mortgage insurers, although these do not compete for business outside of their captive arrangements. Table 1: Peer Comparison (AUD 000) GWP NPAT Equity Assets MCR (x) IFS rating QBE LMI , AA Genworth , , St.George Insurance Australia AA Note: MCR is a ratio of insurers regulatory capital base to its minimum regulatory capital requirement Source: Respective statutory accounts Company Profile Originally known as MGICA Ltd, QBE LMI was established in 1965 in Sydney and some 25 years later in New Zealand. The business was acquired by The PMI Group in 1999 and together with Genworth it has for many years been one of the two large providers of mortgage insurance to the Australian and New Zealand markets. This status quo has been upset by the global financial crisis, which adversely affected PMI s US parent, ultimately leading to the sale of the Australian subsidiary to QBE. QBE s founding company was established in Queensland, Australia in 1886, and since that time the group has expanded its reach into 45 countries, writing a wide range of personal and commercial lines both in the primary and reinsurance markets. At end 2008 the group had total assets of AUD48.4bn and shareholders funds of AUD11.3bn, while by premium it was the largest insurer domiciled in Australia and in the top 25 general insurers and reinsurers globally. With the head office based in Sydney, Australia, operationally the group is divided into five divisions, four geographic regions (Australia, Asia Pacific, the Americas and Europe) and a captive reinsurer based in Bermuda. In December 2008, QBE LMI acquired 100% of the issued capital of QBE Mortgage Insurance (Asia) Limited (formerly PMI Mortgage Insurance Asia Limited) from PMI Mortgage Insurance Co. This small mortgage insurance company is one of three authorised reinsurers in the Hong Kong Mortgage Corporation s reinsurance programme and has operated in Asia since Historically, claims rates have been very low (since inception, 42 claims totalling AUD1.7m), although QBE LMI has given a capital maintenance undertaking totalling USD50m and a commitment to ensuring the Asian company has sufficient liquid assets at all time to meet maturing obligations. QBE LMI also holds a 50.1% interest in small joint venture captive mortgage insurance company. Its JV partner is Heritage Building Society and QBE LMI provides reinsurance to the captive. 2

3 Ownership Structure Our Shareholder Structure QBE Holdings (AAP) Limited QBE Lenders Mortgage Insurance Holdings Pty Limited QBE Lenders Mortgage Insurance Limited 100% QBE LMI 50.1% QBE LMI 49.9% Heritage Building Society QBE Mortgage Insurance (Asia) Limited Permanent Pty Limited (Joint Venture Captive LMI) Source: Transaction document Key Events Acquisition of QBE LMI in October 2008 Global financial crisis and its impact on unemployment in Australia Australian government guarantee of regulated financial institutions Products QBE LMI s portfolio is weighted towards fully documented, prime borrowers (see Table 2). Low documentation (low doc) loans accounted for around 9% of risks in force as at 31 December 2008, which is a similar ratio to previous years. The portfolio is also heavily weighted towards owner occupied borrowers, which accounted for around 83% of the portfolio; investors accounted for the remaining 17%. By loan/value ratio (LTV), 57% of the book had an LTV below 80%, although this ratio includes not only full documentation loans, but also most low doc loans, which QBE LMI only writes to 80% LTV. Geographically, the book remains similar to previous years: there is a higher weighting towards New South Wales (NSW), consistent with higher house prices in that state, and Victoria and New Zealand are relatively under represented in the portfolio, reflecting QBE LMI s relative position among mortgage originators in those regions. New South Wales accounts for around one third of total GSP, including New Zealand, which has about the same sized economy as that of Western Australia. Table 2: Portfolio Mix Underwriting year Risk in force (%) LTV (%) Risks in force (%) Geographic split Risks in force (%) < <= NSW Queensland Victoria Western Aust Other > Total Source: QBE LMI 3

4 Target Markets QBE LMI s main customers are the larger banks, building societies and credit unions. Lenders mortgage insurance has historically had two key market segments: home buyers and the residential mortgage backed securities (RMBS) market. However, the RMBS market has been effectively shut to new issues since the onset of the subprime crisis in H207. Home buyers are typically required by the lender to take out lender s mortgage insurance if they apply for a loan with an LTV above 80%, and this has virtually guaranteed a solid underlying quasi regulated market for the lenders mortgage insurers. With the introduction of Basel II, demand for mortgage insurance cover may alter. Australia s smaller regulated financial institutions will be adopting the standardised approach and will most likely continue to use mortgage insurance to reduce riskweightings. However, the position is less clear for the banks adopting the internal ratings based (IRB) approach, which will likely comprise the four major Australian banks; these four institutions account for more than 80% of housing loans written by regulated banks, credit unions and building societies. Under Basel I, LMI cover halved the risk weighting for standard loans with an LTV greater than 80% and low doc loans with an LTV greater than 60% LTV. Under Basel II, banks using the standardised approach will follow a prescribed formula based on LTV, and the type of loan (standard or non standard) to gain lower risk weightings for mortgage insured loans. For example, a standard loan with an LTV of 95% will be risk weighted at 50% with mortgage insurance or 75% without. Banks adopting the advanced IRB will use their own internal estimates of probability of default and loss given default to determine risk weighting. However, the Australian Prudential Regulation Authority (APRA) has imposed minimum loss given default for mortgages, irrespective of whether the loan has LMI or not. How LMI will be used by advanced IRB banks is at this stage uncertain, but demand may arise for new products that better suit the changed regulatory requirements. Furthermore, the major banks also derive risk management benefit from mortgage insurance protection in addition to capital management benefits. Distribution Channels QBE LMI uses a business to business model. Underwriting delivery channels include e business, direct underwriting, delegated underwriting authority/open policy and tranche RMBS. Financial Analysis Profitability Table 3: Financial Performance 31 December (AUD 000) Gross written premium 165, , , , ,382 Net earned premium 24, , , , ,686 Underwriting result 288,543 57, , , ,390 Net investment income 89,976 51,898 46,961 56,424 56,027 Profit before tax 197, , , , ,117 Net profit after tax 137,221 81,477 81, ,954 92,074 Ratios Loss ratio Expense ratio Combined ratio 1, Source: QBE LMI statutory accounts Financial results for 2008 include a number of acquisition adjustments which affect reported profit but reflect a strengthening of reserves (see Reserve Adequacy and 4

5 Development below). Table 3 presents the statutory income statement, while Table 4 excludes the acquisition adjustments. Adjusted numbers imply a loss ratio of around 67% for 2008, which represents a significant increase on prior years. Losses continue to emerge from parts of western Sydney, which went into downturn in 2003, but the financial crisis is also starting to have an impact. In response, QBE LMI has tightened underwriting policies (e.g. no business with an LTV > 95%). Table 4: Adjusted Profit & Loss 31 December (AUD 000) 2008 Premium revenue 220,720 Other 95,796 Total revenue 316,516 Reinsurance expense 12,508 Gross claims incurred 138,644 Other 62,119 Profit before tax 103,245 Income tax 30,915 Net profit after tax 72,330 Source: QBE LMI statutory accounts Investment earnings remained solid, with interest and dividend income of AUD91.9m not materially affected by net realised and unrealised gains and losses of (AUD187,000). This performance was underpinned by the quality of QBE LMI s investment portfolio. Given the relatively high levels of household debt in Australia, the factor most likely to affect QBE LMI s financial performance in 2009 is unemployment, and in particular the speed at which it rises. Currently hovering at around 5.8%, unemployment has risen quickly from levels of around 4.0% a year ago. Nonetheless, compared with the UK and US housing markets there are a number of features that could help to buffer the financial impact of a housing downturn in Australia: there is full recourse to borrowers; subprime lending is only around 1% of total housing loans and is not insured by mortgage insurers; most loans are on variable interest rates, enabling households to benefit from the reduction in official interest rates; and mortgage insurance companies and banks are governed by a common regulator. APRA, by having oversight of both banks and mortgage insurance companies, is in a good position to determine and set an appropriate level of capitalisation across the system. In 2003, APRA began stress testing on the banks and mortgage insurers, imposing parameters that reflect a severe housing market downturn. Based on the initial findings minimum capital requirements for the mortgage insurers were raised. These minimum requirements are accompanied by a stringent corporate governance regime and substantially ring fence Australian general insurance companies. These requirements are also consistent with relatively high credit ratings. Investments and Liquidity Investment management has been moved to QBE s in house manager, Minster Court Asset Management Pty Limited. Various controls are in place around practices and types of permissible securities. Within the fixed interest portfolio only highly rated securities the equivalent of A and above, while 75% must be the equivalent of AA or better. The quality of fixed interest investments at end 2008 is presented in Table 5, and consists mainly of government and bank issued securities. During 2008, QBE LMI completely divested itself of listed equities its only equity exposure is to controlled entities, the main one being QBE Mortgage Insurance (Asia) Limited. 5

6 Table 5: Fixed Income Investments Rating AUD 000 % AUD 000 % AAA 295, , AA to AA+ 1,104, , A to A+ 36, , BBB to BBB+ 49, Unrated 5, Total 1,437, ,350, Source: QBE LMI statutory accounts Reinsurance Protection and Credit Quality PMI s reinsurance arrangements were in place with the Arizona domiciled PMI Mortgage Insurance Company, the group s main operating entity in the US. This was a rolling five year agreement, but from 23 October 2008 reinsurance arrangements were restructured and an excess of loss arrangement put in place with Equator Reinsurances Limited (Equator Re), a controlled entity of QBE. This cover provides significant protection on losses on the current year and provides for three years of run off should it fail to be renewed. Additionally, on the acquired book, in force risks are protected through a fully funded contingent promissory note. Beyond this, QBE LMI has cover placed with Equator Re, which is partially funded by PMI Mortgage Insurance Co in the US. Reserve Adequacy and Development In 2008, QBE LMI increased the risk margin on gross claims by AUD101m and as a result the probability of adequacy (POA) increased to 98%. Fitch believes this provides greater surety around how ultimate losses are expected to perform and should result in reserve redundancies rather than deficiencies on prior years. Table 6: Reserve Adequacy Central estimate 122,617 Risk 75% POA 24,348 Risk 98% POA 101,000 Net outstanding claims 246,965 Maturity profile (AUD 000) 1 year or less 1 to 2 years 2 to 3 years 3 to 4 years 4 to 5 years > 5 years Total 31 Dec ,161 73,498 19,328 4,592 1, , Dec 07 55,224 21,430 4, ,560 78,557 Source: QBE LMI and statutory accounts Capitalisation Fitch s Australian Depression Model for LMI simulates an Australian economic slowdown, determining the level of capital required by QBE LMI to meet projected claims payments. Fitch s approach assumes that QBE LMI s risk book is effectively placed in run off, with unexpired risk recognised over the run off period, with investment income and reinsurance capital the only cash inflows. The theoretical level of capital calculated by the model is dependent on the following: the specific nature of QBE LMI s risk book (an LMI company writing business at an average LTV of 90% would require more capital than a company writing an average LTV of 80%, due to the higher expected loss arising from a claim); and the extent to which QBE LMI s portfolio is stressed. (For example, the capital required by a company to withstand the most severe Australian economic downturn, or an AAA stress, is higher than that required under an AA stress. A company s portfolio is modelled under a range of stress scenarios to determine the impact on its capital resources.) 6

7 Applying AA stress on projected claims payments and related expenses, QBE LMI s internal capital resources are more than sufficient to withstand a very severe stress, although it may need additional capital to observe regulatory minimum requirements and keep expanding its business. To meet its regulatory capital ratio, referred to as its minimum capital requirement (MCR), QBE LMI must hold sufficient capital to cover the risks in its business. In a two step process, the regulator defines what constitutes capital and then explains how the insurance company should quantify its risks. In defining what constitutes capital, the Australian regulator APRA allows an insurer to hold a combination of Tier 1 and Tier 2 capital instruments. With regard to risks, there are three categories that determine the required capital: insurance risk: outstanding claims plus premiums liability; investment risk: incorporating market and credit risk; and concentration risk: equal to QBE LMI s maximum event retention. At end 2008 QBE LMI s regulatory capital ratio was 1.52x (2007: 1.30x), which exceeds (by around AUD236m) the requirement for the company to maintain an MCR ratio of 1.20x. Financial Leverage and Balance Sheet Quality QBE LMI has no borrowings. Debt Servicing Capabilities QBE LMI has no borrowings. 7

8 Summary Financial Statements 31 December (AUD 000) Profit and loss Gross premiums written 165, , , , ,382 Gross earned premium 36, , , , ,323 Net earned premium 24, , , , ,686 Underwriting profit 288,543 57, , , ,390 Net investment income 89,976 51,898 46,961 56,424 56,027 Other income 1,165 3,378 Profit before tax 197, , , , ,117 Tax expense 60,181 31,298 35,724 43,522 40,043 Net profit after tax 137,221 81,477 81, ,954 92,074 Balance sheet Cash 21,246 61, ,518 95,767 70,537 Receivables 86,230 28,626 43,433 23,471 21,357 Deferred acquisition costs 61,254 69,022 49,720 50,545 46,294 Investments 1,437,324 1,399,654 1,163, , ,450 Intangibles 2, Other 142,435 24,485 14,501 6,289 23,556 Total assets 1,748,489 1,585,753 1,463,783 1,079, ,194 Trade/other creditors 37,998 24,212 21,302 19,319 19,342 Outstanding claims 254,447 84,639 59,173 15,227 10,384 Unearned premium 654, , , , ,935 Tax liability ,588 9,424 15,995 15,866 Provisions 1,353 1,169 2,930 2,571 2,360 Total liabilities 948, , , , ,876 Net assets 799, , , , ,318 Share capital 364, , , , ,520 Reserves 6,329 6,206 4,756 2,553 Retained profits 429, , , , ,818 Minority interests 20,477 12,589 7,980 Total equity 799, , , , ,318 Source: QBE LMI statutory accounts Copyright 2009 by Fitch, Inc., Fitch Ratings Ltd. and its subsidiaries. One State Street Plaza, NY, NY Telephone: , (212) Fax: (212) Fitch Australia Pty Ltd does not hold an Australian financial services licence under the Corporations Act This rating information has been prepared without taking into account your objectives, financial situation or needs and before acting on the information, you should consider the appropriateness of this information having regard to your own objectives, financial situation and needs. Reproduction or retransmission in whole or in part is prohibited except by permission. All rights reserved. All of the information contained herein is based on information obtained from issuers, other obligors, underwriters, and other sources which Fitch believes to be reliable. Fitch does not audit or verify the truth or accuracy of any such information. As a result, the information in this report is provided as is without any representation or warranty of any kind. A Fitch rating is an opinion as to the creditworthiness of a security. The rating does not address the risk of loss due to risks other than credit risk, unless such risk is specifically mentioned. Fitch is not engaged in the offer or sale of any security. A report providing a Fitch rating is neither a prospectus nor a substitute for the information assembled, verified and presented to investors by the issuer and its agents in connection with the sale of the securities. Ratings may be changed, suspended, or withdrawn at anytime for any reason in the sole discretion of Fitch. Fitch does not provide investment advice of any sort. Ratings are not a recommendation to buy, sell, or hold any security. Ratings do not comment on the adequacy of market price, the suitability of any security for a particular investor, or the tax exempt nature or taxability of payments made in respect to any security. Fitch receives fees from issuers, insurers, guarantors, other obligors, and underwriters for rating securities. Such fees generally vary from US$1,000 to US$750,000 (or the applicable currency equivalent) per issue. In certain cases, Fitch will rate all or a number of issues issued by a particular issuer, or insured or guaranteed by a particular insurer or guarantor, for a single annual fee. Such fees are expected to vary from US$10,000 to US$1,500,000 (or the applicable currency equivalent). The assignment, publication, or dissemination of a rating by Fitch shall not constitute a consent by Fitch to use its name as an expert in connection with any registration statement filed under the United States securities laws, the Financial Services and Markets Act of 2000 of Great Britain, or the securities laws of any particular jurisdiction. Due to the relative efficiency of electronic publishing and distribution, Fitch research may be available to electronic subscribers up to three days earlier than to print subscribers. 8