The Pricing of Mortgage Insurance Premiums under Systematic and Idiosyncratic Shocks

Abstract

The recent financial crisis has posed new challenges to the pricing issue of mortgage insurance premiums. By extending an option-based approach to this pricing issue, we attempt to tackle several key challenges including the clustering of mortgage defaults, the diversification effect of underlying property pools and mortgage insurers’ information advantages. Our model partitions the volatility of collateralized property prices into idiosyncratic volatility and systematic volatility so that we can conduct an in-depth investigation on the effects of these two categories of shocks. Our results demonstrate that although the rising number of pooled mortgage loans can reduce the volatility of average default losses, the increasing correlation between the collateralized properties can lead to the volatility clustering of these losses.

Keywords: mortgage insurance, default loss, default clustering, systematic shocks, portfolio diversification

JEL Classification: G21, G22