DBRS Morningstar Confirms Sagen Mortgage Insurance Company Canada’s Financial Strength at AA, and Sagen MI Canada Inc.’s Issuer Rating at A (high); All Trends Are Stable

DBRS Limited (DBRS Morningstar) confirmed the Financial Strength rating of Sagen Mortgage Insurance Company Canada at AA with a Stable trend. In addition, DBRS Morningstar confirmed the Issuer Rating and Senior Unsubordinated Debt rating of Sagen MI Canada Inc. (Sagen or the Company) at A (high), the Preferred Shares rating at Pfd-2 (high), and the Fixed-to-Fixed Rate Subordinated Notes rating at A (low). All trends are Stable.

KEY RATING CONSIDERATIONS
The rating confirmations and Stable trends reflect the Company’s position as the largest residential mortgage insurer in the Canadian market as well as its strong earnings and capitalization levels. The ratings also reflect a higher proportion of lower-rated securities in its investment portfolio, as Sagen strives to increase investment yields. Sagen’s robust risk management framework allows it to closely monitor and manage its mortgage risk exposures under increasingly challenging market conditions that are expected to result in higher defaults compared to 2022 levels.

Rapid rate increases over the last year have resulted in the benchmark overnight rate increasing to 4.25% presently from 0.25% prior to March 2022, which has had an adverse impact on housing market activity. As a result, there has been a steady decline in housing prices of about 16% relative to year-ago levels as well as a lower volume of units sold. While the slowdown in housing market activity has resulted in lower written premiums, profitability metrics show continued strength and resilience with a combined ratio of 20% and record return on equity (ROE) of 21%. Earned premiums continue to show healthy growth based on prior years’ high volumes because it takes about five years for the majority of written premiums to be earned into income.

Macroeconomic fundamentals in Canada, including the unemployment rate and the GDP growth, remain resilient, which is reflected in strong borrower quality (high credit scores and low loan utilizations). Past home price appreciation has also allowed the borrowers to achieve significant equity gains. An economic slowdown or a recession resulting in high unemployment levels, combined with a housing market decline, presents risks to the mortgage insurance sector and Sagen. For most mortgages due for renewal in 2023, the payment shock arising from significantly higher interest rates is mitigated by income growth and strong housing market appreciation since the time of purchase, about five years ago. These mortgages are predominantly on a fixed-rate payment schedule. Mortgages originated in the last two years are subject to heightened risk as many have a variable rate and equity build up that is small or negative. Depending on the lenders’ policies, some of these borrowers are required to increase the size of their mortgage payments with each interest rate increase, while others keep a fixed payment, but the proportion of payment that goes toward mortgage balance repayment is reduced, in some cases resulting in negative amortizations. In order to address those concerns, lenders are offering longer amortization periods and other loan modifications to the most vulnerable borrowers.

Positively, delinquency rates as of Q4 2022 are approximately the same as in 2021 and below pre-pandemic levels, and historical long-term rates. Additionally, the Canadian mortgage market is regulated with very robust underwriting standards, ensuring that borrowers can withstand much higher rates than those prevailing at origination, which should limit potential losses. Notwithstanding these mitigating factors, DBRS Morningstar expects delinquency rates to increase modestly along with higher insured losses throughout the year. However, the Company is well equipped to deal with more adverse macroeconomic conditions given its strong financials and capitalization levels, in addition to homeowner assistance programs.

RATING DRIVERS
A ratings upgrade is unlikely given the current high rating level. Conversely, a material deterioration in capitalization levels and profitability or a significant weakening of its investment risk profile would result in a ratings downgrade.

RATING RATIONALE
Sagen remains the largest mortgage insurer in Canada (with transactional insurance market share of 37%), although the market is trending toward becoming more evenly divided among the three players than was the case in 2021. The Company has maintained strong financial results while continuing with its disciplined underwriting practices. Sagen also has a well-established distribution network and a conservative insurance portfolio that is well diversified across geographic regions and mortgage origination years. Its operational technology and data capabilities benefit from a long operating history and are viewed as strong by DBRS Morningstar. However, being a monoline insurer, the Company lacks diversification at the insurance product level.

Sagen has a comprehensive risk management framework and capabilities that allow it to effectively monitor and manage its mortgage insurance risk exposures. The Company has increased its investment risk appetite as it aims to achieve portfolio yield improvements relative to historical results. Sagen does not invest in common shares. Bonds comprise the majority of its investment portfolio; however, a growing proportion is rated BBB and lower or unrated, which contributes negatively to its credit and market risk profile.

The Company has demonstrated strong underwriting results, including a low combined ratio and a record-high ROE in 2022, exceeding 20%. Borrower credit quality remains good despite the significantly higher interest rates, elevated inflation, and the slowdown in the housing market. Mitigating any potentially severe deterioration in the insurance portfolio is the large home equity build- up for many borrowers and low unemployment rate.

Sagen holds sufficient liquid assets to meet the liquidity needs arising from its liabilities. While profitability levels are expected to stay resilient, revenue generation has slowed down. DBRS Morningstar expects delinquency rates to increase along with higher insured losses throughout the year because mortgage default claims are correlated with macroeconomic fundamentals, which have deteriorated over the past 12 months. However, claims are fairly predictable with approximately 12–18 months of lead time, which increases the importance of effective monitoring and homeowner assistance programs.

Although Sagen’s leverage ratio increased at the time of its privatization in April 2021 when Brookfield Business Partners L.P. together with certain of its affiliates and institutional partners acquired it, Sagen’s cash flow generation capabilities are solid, and capital flexibility remains good. However, capital ratio is expected to decline somewhat to be closer to the Company’s target operating range of 160%–165%, following the adoption of IFRS 17 in Q1 2023 and as the housing market adjusts in light of higher interest rates.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS
There were no Environmental/Social/Governance factors that had a significant or relevant effect on the credit analysis.

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/396929 (May 17, 2022).

The Grid Summary Grades for Sagen are as follows: Franchise Strength – Strong/Good; Risk Profile – Strong/Good; Earnings Ability – Very Strong/Strong; Liquidity – Strong/Good; Capitalization – Strong/Good.

Notes:
All figures are in Canadian dollars unless otherwise noted.

The principal methodology is the Global Methodology for Rating Insurance Companies and Insurance Organizations (August 31, 2022; https://www.dbrsmorningstar.com/research/402220). In addition, DBRS Morningstar uses the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (May 17, 2022; https://www.dbrsmorningstar.com/research/396929) in its consideration of ESG factors.

The credit rating methodologies used in the analysis of this transaction can be found at: https://www.dbrsmorningstar.com/about/methodologies.

The related regulatory disclosures pursuant to the National Instrument 25-101 Designated Rating Organizations are hereby incorporated by reference and can be found on the issuer page at www.dbrsmorningstar.com.

The rating was initiated at the request of the rated entity.

The rated entity or its related entities did participate in the rating process for this rating action.

DBRS Morningstar had access to the accounts, management, and other relevant internal documents of the rated entity or its related entities in connection with this rating action.

This is a solicited credit rating.

The conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. DBRS Morningstar’s outlooks and ratings are under regular surveillance.

For more information on this credit or on this industry, visit www.dbrsmorningstar.com.

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