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A risky new strategy for the future

One of the most significant developments about to hit the mortgage market is &#39pricing for risk&#39. This concept is one that the mainstream mortgage market seems to have missed, whereas in the general insurance market, the profile of the customer is targeted and priced for. Take car insurance, for example. An insurer might offer you the best deal in the market but next time around, it doesn&#39t seem interested in your business. This is because they define the risk element of segmented customer groups and price accordingly. Buildings and contents insurers have been pricing for risk for years. When assessing the cost, the postcode and past claims record are taken into account.

In the mortgage market, the main pricing variants are based on LTV bands and a traditional banking view that the more personal investment the customer has made, the greater the commitment to the repayments. Although you could argue that the 75% LTV borrower who has given you a £20,000 deposit is less likely to hand the keys in if things go wrong compared with the £2,000 invested by the 95% LTV borrower, this belief is diminishing fast. It could be argued that this is a case of &#39pricing for safety&#39 rather than &#39pricing for risk&#39, but there is little doubt that this type of structure is becoming less feasible. It seems crazy that a high street lender would rather lend money to an 18-year-old firsttime buyer at 95% with no payment history, than a 35-year-old self-employed businessman wanting a 75% LTV, yet this has historically been the case.

One of the flaws being exposed with this LTV band pricing is the realisation that decisions should not be based on the profile of the property but of the customer. The same house could require a 95% loan for one purchaser but only a 70% loan for another. The property itself does not influence the propensity for payment. Lenders are beginning to accept that investigation into affordability is an important consideration. This is one area where specialist lenders have stolen a march on their high street counterparts. Whereas in the past, the sub-prime market has been shunned by the high street, it was not because the security of the property was any different, but perhaps a fear of exactly what level of risk was being taken. However, margins have fallen and the overall mainstream market is diminishing due to increasing numbers of borrowers requiring non-conforming loans or having to approach lenders with credit blips. As a result, more and more high street names are trying to challenge this market.

The strength of the sub-prime underwriting strategy comes with increased confidence in the predisposition to pay by reference to past and current performance. If you have ever bought an investment product you will be familiar with the statement &#39past performance is no indication of the future&#39. Investment product providers are committed to publicising this fact, yet in mortgages the customer acquisition and criteria strategy seems exactly the reverse. Past performance is in fact an excellent and valid indicator of the future.

Through detailed affordability studies, lenders can identify those who can pay, but this is certainly no guarantee that they will pay. You have to look no further than the current raft of people looking for sub-prime loans and realise that each one was at some point a &#39prime&#39 borrower who proved their lender wrong. Although &#39past performance…&#39 still holds true, the indication of intent to pay is far greater. This development in what is called &#39predictive modelling&#39 in the sub-prime market is likely to get more sophisticated as there is now more robust data on customer behaviour and payment profiles. This is a direct result of the market maturing and the raw data available to credit and risk departments.

Aside from the emergence of pricing for risk in the insurance industry, we can also see examples in the US mortgage market. The US adopted pricing for risk in the late 1980s driven in part by the size and fragmentation of the market. Also, the almost obsessive capture of customer data and analysis of regional and cultural profiles provides the basis for excellent customer relationship models. This use of CRM systems is perhaps the greatest deficiency among UK lenders.

Over the next five years, we will see every UK lender pricing for risk across their entire book. So what will this future look like? If we think about the other markets where pricing for risk is a standard practice, e.g. car insurance, it is interesting to consider lenders using similar tactics. Could we target customers with product prices defined by age, postcode or a &#39no-claim&#39 discount? If this were to happen, lenders could operate different strategies throughout the year to ensure an overall balance in the mortgage book. With a greater frequency of products, brokers would have the task of finding out which lender at any given time is actively seeking their client. Because this would be such a movable feast there would be an even greater reliance on the intermediary market.

The next step would be to introduce ancillary pricing models depending on customer behaviour; a &#39no-claim&#39 bonus if you will. Could annual account reviews now mean that, if the client has achieved certain attributes e.g. 12 regular payments, they could be rewarded with a lower rate? Then, of course, any faults or claims would cause the rate to rise. Customers would be encouraged to maintain payments to reap rewards. You could also introduce a fixed price for borrowers to protect their no-claim bonus. One of the benefits for lenders may be that it would help retain customers. The benefit for the borrower is a longer term service-led relationship with the product provider.

So how will this affect intermediaries? In the current market, it is appropriate for intermediaries to shop around for the best deal for their clients. But is this an opportunity to create more long-term relationships with lenders? Perhaps moving away from up-front commissions for a single sale to the model adopted in other countries, that pays intermediaries on an annual renewal basis.

What is needed now is for the market to be educated that pricing for risk is, indeed, a business tool for the lender – but it is one that could benefit the customers as well, in the longer term.

Pricing for risk could make inroads in the growing &#39non-standard&#39 sector

Source: Datamonitor, ONS, Registry Trust, CML, IMPACT 2001, Gallup 1998, DETR English Housing Survey

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