Additional Items Affecting this Segment. Our Corporate and Other segment also includes net investment income from our holding company, expenses related to corporate overhead, including employee compensation expense not included in our other operating segments, and interest expense. Effective January 1, 2006, we refined our method of operating cost allocation between our U.S. Mortgage Insurance Operations segment and our Corporate and Other segment. As a result of this refinement, we allocated approximately $7.5 million (pre-tax) in 2006 to our Corporate and Other segment which previously would have been allocated to our U.S. Mortgage Insurance Operations segment. We incurred a $5.5 million (pre-tax) settlement accounting charge in 2006 related to a lump-sum distribution from our Supplemental Employee Retirement Plan. The lump-sum distribution triggered settlement accounting under SFAS No. 88, to revalue our pension-related liabilities in 2006.
Our consolidated net income was $409.2 million in 2005 compared to $399.3 million in 2004. Consolidated net income in 2004 included a $29.0 million after tax gain on the sale of discontinued operations, partially offset
Our income tax expense from continuing operations in 2006 increased compared to 2005 primarily as a result of the increase in our pre-tax income. Our effective tax rates were 25.0% for 2006 and 24.3% for 2005. This change in our effective rates was primarily due to increases in our U.S. Mortgage Insurance Operations’ and International Operations’ net income, excluding net investment income and equity in earnings, which are taxed at effective tax rates between 30% and 35%. The increase in income tax expenses for 2005 compared to 2004 was primarily due to the increase in pre-tax income from continuing operations, and an increase in the effective tax rate to 24.3% for 2005 from 23.5% for 2004. The increase in our effective tax rate in 2005 was due primarily to an increase in our U.S. Mortgage Insurance Operations’ net income, and also due to reduced proportionate contributions to our consolidated financial results of municipal bond interest income, which has a lower effective tax rate.
Our increase of net loss reserves by $20.2 million in 2006 reflects our belief that PMI’s average claim sizes and claim rates will continue to increase in the future. PMI experienced higher claim rates in 2006 due in part to changes in the business mix of its mortgage insurance portfolio (discussed in Credit and portfolio characteristics, below) and the seasoning of NIW acquired through PMI’s structured finance channel. Net loss reserves increased in 2005 from 2004 due to an increase in 2005 in PMI’s expected claim rates associated with the portion of PMI’s portfolio that contains ARMs, high LTV and less-than-A quality loans. (See Critical Accounting Estimates-Reserves for Losses and LAE.)
PMI’s total modified pool default rate decreased in 2006 due to an increase in the number of modified pool policies in force and a decrease in modified pool loans in default. Modified pool loans in default decreased in 2006 primarily due to a higher number of delinquencies in the fourth quarter of 2005 from hurricane impacted areas and higher cure rates in 2006 in those areas. PMI believes that its modified pool insurance products’ risk reduction features, including a stated stop loss limit, exposure limits on each individual loan in the pool and, in some cases, deductibles, reduce PMI’s potential for loss exposure on loans insured by those products. The increase in the 2005 modified pool default rates compared with 2004 was primarily due to defaults relating to Hurricane Katrina, customer default reporting enhancements begun in the third quarter of 2005, and increases in modified pool loans in default in 2005 due to the seasoning of the modified pool portfolio.
Credit and portfolio characteristics-PMI insures less-than-A quality loans and Alt-A loans through all of its acquisition channels. We define less-than-A quality loans to include loans with credit scores generally less than 620. We consider a loan Alt-A if it has a credit score of 620 or greater and has certain characteristics such as reduced documentation verifying the borrower’s income, assets, deposit information, and/or employment. The following table presents PMI’s less-than-A quality loans and Alt-A loans as percentages of its flow channel and structured finance channel primary NIW for the years ended:
The following table presents PMI’s less-than-A quality loans, Alt-A loans, ARMs, high LTV, interest only and payment option ARMs loans as percentages of primary risk in force as of December 31 of the years presented:
The table below sets forth the results of PMI Australia for the years ended:
Underwriting and operating expenses-The slight decrease in underwriting and operating expenses in 2006 compared to 2005 was primarily due to a reduction in provisions for profit sharing obligations on the R&SA portfolio, partially offset by a growth in headcount. In the second quarter of 2006, PMI Europe and R&SA terminated the future sharing of economic benefits with respect to the portfolio’s loss performance. As a result, PMI Europe will not be required to pay R&SA profit sharing commissions in the future.
International Operations and Financial Guaranty Liquidity-The principal uses of these segments’ liquidity are the payment of operating expenses, claim payments, taxes, and growth of its investment portfolio. The principal sources of these segments’ liquidity are written premiums, investment maturities and net investment income.
In 2006, PMI obtained authorization to dividend $500 million to its parent, The PMI Group. PMI paid $350 million of the dividends to The PMI Group in 2006. Due to the dividends paid in 2006 and expected to be paid in 2007, the size of PMI’s investment portfolio and corresponding investment income for U.S. Mortgage Insurance Operations will be reduced in 2007.
The 5.568% Senior Notes relate to our issuance in November 2003 of 13.8 million 5.875% equity units (“Equity Units”) with a stated value of $25 per unit. The Equity Units included the senior notes and purchase contracts to purchase, no later than November 15, 2006, up to 9,050,040 shares of The PMI Group’s common stock for an aggregate purchase price of $345 million. In August 2006, pursuant to the terms of the Equity Units, we completed the remarketing of approximately $345 million in principal amount of senior notes maturing in November 2008, which we refer to as the 5.568% Senior Notes. As a result of the remarketing, the annual interest rate on the Senior Notes was reset from 3.00% per annum to 5.568% per annum, paid quarterly, effective from and including August 15, 2006. In connection with the remarketing, we purchased and cancelled $300 million in principal amount of the 5.568% Senior Notes, leaving $45 million in principal amount of the 5.568% Senior Notes outstanding after completion of the remarketing. Pursuant to the terms of the Equity Units, a significant portion of the proceeds of the remarketing was applied to satisfy the Equity Unit holders’ obligations under the purchase contracts to purchase shares of our common stock upon settlement of the purchase contracts. We issued approximately 8 million common shares on November 15, 2006 in exchange for approximately $345 million, which we used to repay the bridge loan described below.
U.S. Mortgage Insurance Operations-We establish PMI’s reserves for losses and LAE based upon our estimate of unpaid losses and LAE on (i) reported mortgage loans in default and (ii) estimated defaults incurred but not reported to PMI by its customers. We believe the amounts recorded represent the most likely outcome within the actuarial ranges.
These sensitivities are hypothetical and should be viewed in that light. For example, the relationship of a change in assumption relating to future average claim size, claim rate or cost of claims settlement to the change in value may not be linear. Also, the effect of a variation in a particular assumption on the value of the loss and LAE reserves is calculated without changing any other assumption. Changes in one factor may result in changes in another which might magnify or counteract the sensitivities. Changes in factors such as persistency or cure rates can also affect the actual losses incurred. To the extent persistency increases and assuming all other variables remain constant, the absolute dollars of claims paid will increase as insurance in force will remain in place longer, thereby generating a higher potential for future incidences of loss. Conversely, if persistency were to decline, absolute claim payments would decline. In addition, changes in cure rates would positively or negatively affect total losses if cure rates increased or decreased, respectively.
Other-Than-Temporary Impairment-We have a formal committee review process for all securities in our investment portfolio, including a review for impairment losses. Factors considered when assessing impairment include:
Property, Equipment and Software-Property and equipment, including software, are carried at cost and are depreciated using the straight-line method over the estimated useful lives of the assets, ranging from three to thirty nine years. Leasehold improvements are recorded at cost and amortized over the lesser of the useful life of the assets or the remaining term of the related lease.
In January 2006, the Company adopted SFAS No. 123R which requires the fair value of share-based payments, including grants of employee stock options and employee stock purchase plan shares, to be recognized in the income statement based on their fair values unless a fair value is not reasonably estimable. Prior to the Company’s adoption of SFAS No. 123R, the Company followed the intrinsic value method prescribed in APB No. 25, and its related interpretations, as permitted by SFAS No. 123. Accordingly, no share-based employee compensation cost was recognized in the consolidated statement of operations for the year ended December 31, 2005. The Company elected to adopt the modified prospective method, under which prior periods are not revised for comparative purposes. The valuation provisions of SFAS No. 123R apply to new grants and to grants that were outstanding as of the effective date and are subsequently modified. Estimated compensation for grants that were outstanding as of the effective date will be recognized over the remaining service period using the compensation cost estimated for the SFAS No. 123 pro forma disclosures.
6.000% and 6.625% Senior Notes-In September 2006, the Company issued $250 million in principal amount of 6.000% Senior Notes, due September 15, 2016 and $150 million in principal amount of 6.625% Senior Notes, due September 15, 2036. The Company utilized most of the proceeds from the issuance of the 6.000% and 6.625% Senior Notes to redeem the 2.50% Senior Convertible Debentures due 2021, as discussed further below. The 6.000% Senior Notes and the 6.625% Senior Notes bear interest at a rate of 6.000% and 6.625% per annum, payable semi-annually in arrears on March 15 and September 15 of each year, beginning on March 15, 2007. The PMI Group may redeem the 6.000% and 6.625% Senior Notes in whole or in part at any time at the “make-whole redemption price”. The “make-whole redemption price” will be equal to the greater of (a) 100% of the principal amount of the 6.000% and 6.625% Senior Notes to be redeemed and (b) the sum of the present values of the remaining scheduled payments thereon discounted to the date of redemption, on a semi-annual basis (assuming a 360-day year consisting of twelve 30-day months), at a rate equal to the applicable treasury rate plus 25 basis points for the 6.000% Senior Notes and 35 basis points for the 6.625% Senior Notes, plus in the case of either (a) or (b), any interest accrued but not paid to but excluding the date of redemption. In connection with the issuance of these Senior Notes, the Company entered into two interest rate lock agreements which were designated as cash flow hedges. The fair value of the cash flow hedges was settled for $9.0 million and is amortized into interest expense over the terms of the new senior debt that was issued. As of December 31, 2006, the unamortized balance in the other comprehensive income related to these fair value hedges was approximately $8.8 million (pre-tax). The 6.000% and 6.625% Senior Notes are unsecured and will rank equally in right of payment with all of The PMI Group’s other existing and future senior unsecured indebtedness.
in 2005 and $87.6 million in 2004. The Company redeemed tax and loss bonds of $48.6 million in 2006. The purchase and redemption of tax and loss bonds are included as a deferred component of income tax expense. The increase in current and decrease in deferred income tax expense in 2006 as compared to 2005 is primarily attributable to reduced purchases of tax and loss bonds offset by an increase in utilization of alternative minimum tax credits.
A reconciliation of the statutory federal income tax rate to the effective tax rate reported on income from continuing operation before income taxes is shown in the following table:
value on the date of grant, and generally expire ten years from the grant date and have a three-year vesting period. The Equity Incentive Plan provides for the granting of nonvested shares to officers and key employees. Nonvested shares issued under the Equity Incentive Plan to date generally vest annually between two to four years and holders are entitled to dividends and voting rights. Under the Equity Incentive Plan, non-employee directors receive quarterly, non-discretionary grants of stock units with an initial value of $25,000. The number of units granted depends on the fair market value of the Company’s common shares on the grant date but each stock unit has an initial value equal to the fair market value of one common share on the grant date. Non-employee director grants of stock units vest on the earlier of the fifth anniversary of the applicable grant date and termination of board service.