Fair Valuation of Mortgage Insurance with Current Loan-to-Value and Debt Service Ratios

This study advances the mortgage insurance pricing literature by providing theory and methods for incorporating both equity and ability to-pay theories (Jackson and Kasserman, 1980). We develop a new option-based model by adding the current loan-to-value and debt service ratios to the pricing process of Mortgage Insurance (MI). Specifically, the MI is regarded as a portfolio of a series of put options to obtain the analytical pricing formulas. Under the consistent pricing framework, we also derive three types of MI contracts designed for different purposes: full MI can compensate mortgage lenders for default loss; maximum claim policies provide insurers with a limit loss; and partial indemnity policies can be adjusted to different insurance coverage for borrowers' default losses. Finally, we conduct numerical and empirical analyses to evaluate how different designs of MI relate to insurance premiums, and to examine how housing price dynamics and income flow affect insurance premiums