Three US senators opened an inquiry into insurance ratings firm Demotech and whether its assessments may be exposing Fannie Mae and Freddie Mac — and ultimately taxpayers — to growing risks tied to climate-driven insurer failures.

In a letter sent Tuesday to Fannie Mae acting Chief Executive Officer Peter Akwaboah and Freddie Mac CEO Kenny Smith, the three Democratic lawmakers questioned why the government-backed mortgage giants continue to accept Demotech ratings as sufficient proof of insurer financial strength, despite evidence that insurers carrying those ratings have failed at unusually high rates. In a separate letter, they pressed Demotech on its own finances and why, in 2022, it suddenly threatened to downgrade the ratings of up to 27 insurance companies.

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"Demotech's deep involvement in the Florida insurance market — and its repeated methodological shortcomings — raise profound governance and reliability concerns," the lawmakers, Senators Sheldon Whitehouse,  Elizabeth Warren and Ron Wyden, wrote the mortgage managers in the letter viewed by Bloomberg News. They further urged the companies to reassess their insurer counterparty risk controls. 

Fannie Mae and Freddie Mac were not immediately reachable for comment.

"As Americans struggle with rising insurance costs related to housing, Demotech-rated insurers provide needed capacity throughout the US," Demotech President Joseph Petrelli said in an email. He added, "We have a strong track record comparable to other rating agencies from our four decades of serving the marketplace."

The inquiry comes as climate change intensifies hurricanes, wildfires and other disasters, straining the property insurance market nationwide.  

Combined, the two government-backed financial giants purchase more than half of all US mortgages on the secondary market. The government sets standards for quality of insurance on each of the properties to protect its investment. 

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Florida, in particular, historically struggled to keep insurers in the market. Demotech, based in Columbus, Ohio, was founded in 1985 with the express purpose of rating smaller insurance companies that have trouble meeting the standards to get an A from big ratings companies like AM Best and Standard & Poor's, which require steady capitalization and geographic diversification, among other things. Demotech gave these smaller firms more credit for buying generous reinsurance — that is insurance on the insurance — and thus a better shot at an A.

Fannie Mae first accepted Demotech's "A" rating for mortgage eligibility in 1989, with Freddie Mac following a year later. 

Florida quickly began to rely heavily on Demotech-rated insurers. A 2023 study found that more than 60% of Florida insurers had a Demotech rating.  But the study, which was conducted by researchers at Columbia Business School, Harvard Business School and the Federal Reserve Board, also found that nearly 20% of Demotech-rated Florida insurers became insolvent even while holding an A rating between 2009 and 2022.  

The senators warned that continued reliance on Demotech could allow private lenders to offload riskier mortgages onto the federally backed enterprises, which could pose systemic risks to the mortgage market.

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The trio of lawmakers are seeking detailed disclosures on how many mortgages rely solely on Demotech-rated insurers; the geographic concentration of those loans; and whether Fannie and Freddie have contingency plans for widespread insurer failures in hurricane- or wildfire-exposed regions, they said. They are seeking similarly detailed insight into Demotech's ratings process.

The letter warns that a climate change-fueled insurance collapse in a major housing market could ripple through mortgage-backed securities and revive risks reminiscent of the 2008 financial crisis.

"The homeowners' insurance market is a time bomb waiting to detonate," said Sen. Wyden.