This insurance works well in good times. Only a small proportion of borrowers default, due to their personal circumstances such as loss of employment or severe illness. It can be covered by the premiums paid by the other borrowers.

During an economic downturn, when many people loss their jobs  at the same time and property values drop severely, it can cause a big problem for the mortgage insurers.

This happened in Europe in the early 1990s. Many insurance companies that provided this type of insurance faced large losses. They had to be re-capitalised or sold to other owners.

In more recent times, we have the problems caused by the sub-prime mortgages in America. The mortgages were issued to sub-prime borrowers to generate a high return to the lender. Funds were raised through the credit market in the form of asset backed securities, with the credit risks being guaranteed by the lending institution. Several of the lenders were not sufficiently capitalised to take the losses caused by the downturn in the housing market.

Considering the risks, is it a good practice to encourage mortgage insurance as a way to transfer or spread the risks?

Here is a surprise. I think that it is a good idea. But it has to come with certain caveats.

1. The mortgage insurer must have expertise in the assessment of the risks. They should be familiar with the property market, economic conditions and lending practices in Singapore. In particular, they have to know the rules regarding the use of Central Provident Fund savings to pay the installments under the mortgages.
   

2. The mortgage insurer should be required to retain the major share of the risk, and not be allowed to transfer the risk to the credit market through securitisation or other means. This is to avoid the moral hazard.
   

3. The mortgage insurer should have sufficient capital to allow them to ride over several years of an economic downturn.
   

4. The mortgage insurer should be required to use sufficient actuarial expertise to measure the potential losses and to charge an adequate premium to cover the risk. They should avoid excessive competition leading to inadequate pricing.

There is a significant advantage of the in the mortgage insurance scheme, especially for the handling of the more risky loans.

Lenders, who are hungry for business, may be tempted to lower their credit assessment standards to win a large market share.   If they are required to buy mortgage insurance, the assessment is transferred to a professional mortgage insurer, which can assess the risk independently of the lending. This may impose some discipline on the lending institution.