Structural prepayment risk behavior of the underlying mortgages for residential mortgage life insurance in a developing market

Since 1998 all residential mortgages in China have been adjustable rate mortgages (ARMs). However, the borrower's motivation for prepayment is different from that in the US or other developed mortgage markets. In the US, mortgage insurance plays an imperative role in covering some of the risk typically faced by housing finance institutions. However, China's residential mortgage life insurance (RMLI) market is in its infancy. It offers the insured mortgagor a life-insurance death benefit, arising from only illness or accident, settling the insured's outstanding residential mortgage balance. Prepayments of some RMLIs' underlying mortgages are observed, leading to a premature termination of both the residential mortgage and the insurance commitment to settle the outstanding mortgage balance even though the insured has not yet passed away. Because such prepayments significantly influence the pricing of the RMLI, it is imperative to know more about the prepayment rate of occurrence and the prepayment characteristics of the underlying residential mortgages in terms of observable macro economic factors, loan specific factors and borrower specific characteristics. Hence, this study investigates the prepayment risk behavior of the underlying mortgages for RMLIs, utilizing a pilot study of 1000 Shanghai residential mortgagors who took up RMLIs between January 1999 and December 2003. This study uses the Cox proportional hazard model to investigate RMLI-mortgage prepayment risk behavior. The resultant hazard rate is dependent on four primary factors: combined monthly income of the co-borrowers, growth in the gross domestic product, number of co-borrowers and initial loan-to-value ratio.