Other Items Affecting this Segment. Our Other segment also includes net investment income, net income from discontinued operations, expenses related to corporate overhead including salaries, bonuses, interest expense and distributions on our mandatorily redeemable preferred securities, and the 2004 gain on sale of APTIC.
The increases in ceded premiums in 2003 and 2004 were driven primarily by increases in gross premiums written (excluding the $114 million single premium policy received in 2003), higher average premium rates and increasing percentages of primary insurance in force subject to captive reinsurance agreements. Primary insurance in force refers to the current principal balance of all primary insured mortgage loans as of a given date. As of December 31, 2004, 53.7% of primary insurance in force and 55.0% of risk in force were subject to captive reinsurance agreements, compared to 50.0% and 50.6% at December 31, 2003 and 43.1% and 43.4% at December 31, 2002, respectively. These increases are the result of a higher portion of new insurance written with customers with whom we have captive reinsurance agreements. We anticipate that higher levels of captive reinsurance cessions will continue to reduce PMI’s net premiums written and earned, and that PMI’s primary risk in force subject to captive reinsurance agreements will continue to increase as a percentage of total risk in force.
The increase in the total modified pool default rate was driven by both an increase in modified pool loans in default due to the seasoning of the modified pool portfolio and a decrease in the number of modified pool policies in force. 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. PMI’s default rate for GSE Pool (see Traditional pool insurance below) at December 31, 2004 was 5.12% with 3,484 GSE Pool loans in default compared to a default rate of 3.60% with 3,870 loans in default as of December 31, 2003. Although GSE Pool loans in default declined slightly, the GSE Pool default rate increased due to a larger decline in the total number of loans insured.
The following table presents PMI’s less-than-A quality loans and Alt-A loans as percentages of primary risk in force for the years ended:
Net premiums written and earned increased to $313.9 million and $174.9 million in 2004 compared to $266.0 million and $150.3 million in 2003, respectively. These increases were due primarily to FGIC’s increased public financing and, to a lesser extent, structured financing transactions in 2004. The increase in earned premiums in 2004 also was partially due to a purchase accounting adjustment of unearned premiums as of December 18, 2003 to reflect the fair value of the unearned premium reserve at acquisition, partially offset by a $9.4 million decrease in earned premiums in 2004 related to municipal bond refundings, calls and other accelerations.
International Operations Liquidity-The principal uses of the International Operations liquidity are the payment of operating expenses, claim payments, profit commission payments, taxes, and growth of its investment portfolio. We believe that the International Operations’ operating liquidity needs can be funded exclusively from its operating cash flows. The principal sources of International Operations’ liquidity are written premiums, investment maturities and net investment income.
The 3.00% Senior Notes described above relate to our issuance in November 2003 of 13.8 million 5.875% equity units with a stated value of $25 per unit. The units include the senior notes and purchase contracts to purchase, no later than November 15, 2006, up to 9,034,860 shares of common stock for an aggregate purchase price of $345.0 million. Contract adjustment payments are made on the stated value of the equity units at a rate of 2.875% per annum. Also in November 2003, we issued 5,750,000 shares of our common stock for an aggregate purchase price of approximately $220 million.
Any significant decreases in our ratings may adversely affect the ratings of FGIC Corporation and FGIC. FGIC’s ability to attract new business and to compete with other triple-A rated financial guarantors is largely dependent on its triple-A financial strength ratings. Also, the stockholders agreement entered into in connection with the acquisition of FGIC Corporation provides that The PMI Group will not acquire a majority of the voting stock of FGIC Corporation or cause its designees to constitute a majority of FGIC Corporation’s Board of Directors unless, at the time of such action, S&P, Fitch and Moody’s, as applicable, reaffirm FGIC’s then current financial strength rating and outlook and FGIC Corporation’s then current senior unsecured debt rating and outlook. The value of our investment in FGIC Corporation, and our ability to increase our ownership interest in FGIC Corporation in the future, to the extent opportunities arise to do so, depend in part on The PMI Group’s and PMI’s ratings and on the views of the rating agencies with respect to any such transaction. Any decrease in our ratings could also negatively impact PMI Australia’s and PMI Europe’s ratings, which could place them at a competitive disadvantage.
If we believe a decline in the value of a particular investment is temporary and we have the ability and intent to hold to recovery, we record the decline as an unrealized loss on our consolidated balance sheet under “accumulated other comprehensive income” in shareholder’s equity. If we believe the decline is other-than-temporary, we write-down the carrying value of the investment and record a realized loss in our consolidated statement of operations under “net realized investment gains”. Our assessment of a decline in value includes management’s current assessment of the factors noted above. If that assessment changes in the future, we may ultimately record a loss after having originally concluded that the decline in value was temporary. Other-than-temporary declines in the fair value of the investment portfolio were $0.2 million in 2004 and $0.3 million in 2003.
unconsolidated subsidiaries are recognized in net realized investment gains or losses in the consolidated statement of operations.
Opportunity Act, the Fair Housing Act, the Homeowners Protection Act, the Fair Credit Reporting Act, the Fair Debt Collection Practices Act and others. Among other things, these laws prohibit payments for referrals of settlement service business, require fairness and non-discrimination in granting or facilitating the granting of credit, require cancellation of insurance and refunding of unearned premiums under certain circumstances, govern the circumstances under which companies may obtain and use consumer credit information, and define the manner in which companies may pursue collection activities. Changes in these laws or regulations could adversely affect the operations and profitability of our mortgage insurance business. (See “The U.S. mortgage insurance industry and PMI are subject to litigation and regulatory risk” below.)
A downgrade of PMI’s insurer financial strength ratings could materially harm our financial performance.
The Basel Committee on Banking Supervision (BCBS) has published a final proposal for the implementation of a new international capital accord known as Basel II. The Basel II provisions related to residential mortgages and mortgage insurance could alter the competitive positions and financial performance of mortgage insurance providers. It is expected that that Basel II Capital Accords will be adopted in final form within the next 12 months and that implementation will begin initially in 2007 with full implementation in 2008.
PMI Australia, our Australian and New Zealand mortgage insurance operations, is subject to many of the same risks facing PMI.
FGIC’s exposure to insuring public finance issuers in the transportation industry has experienced increased stress as a result of terrorism and general global unrest, including a downgrading of the ratings of some of those issuers. Other sectors currently insured by FGIC or into which FGIC may expand could also see direct increased stress as a result of terrorism and general global unrest. FGIC may incur material losses due to such exposures if the economic stress caused by such events is more severe than FGIC currently foresees or has assumed or will assume in the future in underwriting its exposures.
The Securities and Exchange Commission (“SEC”) requires public companies to disclose condensed financial statement information in the footnotes for significant equity investees and unconsolidated majority owned subsidiaries, individually or in the aggregate, if (i) the Company’s investments in and advances to the subsidiaries are in excess of 10% of the total consolidated assets of the Company, (ii) the Company’s proportionate share of unconsolidated majority owned subsidiaries’ total assets is in excess of 10% of total consolidated assets of the Company, or (iii) income from continuing operations before income taxes, extraordinary items and the cumulative effect of a change in accounting principle of the unconsolidated subsidiaries is in excess of 10% of such income of the Company. Furthermore, if certain of the above tests exceed 20% with respect to any unconsolidated subsidiary, separate audited financial statements of that unconsolidated subsidiary are required to be included in the registrant’s Form 10-K. Equity investees are not subject to the 20% threshold for the proportionate share of unconsolidated subsidiaries total asset test, and accordingly, separate financial statements of FGIC are not included in this Form 10-K. As of December 31, 2004, the Company’s equity investees and unconsolidated majority owned subsidiaries on a combined basis exceeded certain of the 10% tests in the aggregate and, accordingly, condensed financial statement information is provided in Note 23. Condensed Financial Statements of Significant Unconsolidated Subsidiaries.
61.7% in 2003 and 74.6% in 2002. Premiums written on an annual basis are amortized on a monthly pro rata basis over the year of coverage. Primary mortgage insurance premiums written on policies covering more than one year are referred to as single premiums. A portion of revenue on single premiums is recognized in premiums earned in the current period, and the remaining portion is deferred as unearned premiums and earned over the expected life of the policy, a range of seven to 15 years. If single premium policies related to insured loans are cancelled due to repayment by the borrower, and the premium is non-refundable, then the remaining unearned premium related to each cancelled policy is recognized to earned premiums upon notification of the cancellation. Unearned premiums represent the portion of premiums written that is applicable to the estimated unexpired risk of insured loans. Rates used to determine the earning of single premiums are estimates based on actuarial analysis of the expiration of risk. The earnings pattern calculation is an estimation process and, accordingly, the Company reviews its premium earnings cycle for each policy acquisition year (“Book Year”) annually and any adjustments to the estimates are reflected to each Book Year as appropriate.
The following is a reconciliation of consolidated net income to net income for purposes of calculating diluted EPS for the years ended:
The estimated impact to consolidated net income of the Company from the adoption of SFAS No. 123(R) using the modified prospective method for 2005 ranges from approximately $5 million to $6 million. Had the Company adopted SFAS No. 123(R) in prior periods, the impact of the standard would have approximated the impact of SFAS No. 123 as described in the disclosure of pro forma consolidated net income and earnings per share in Note 2. Summary of Significant Accounting Policies to the Company’s consolidated financial statements. SFAS No. 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow. While the Company cannot estimate what those amounts will be in the future (because they depend on, among other things, when employees exercise stock options), the amount of cash flows recognized for such excess tax deductions were $8.2 million, $3.8 million, and $5.7 million in 2004, 2003 and 2002, respectively.
Considerable judgment is required in interpreting market data to develop the estimates of fair value and, therefore, changes in the assumptions may have a material effect on the fair valuation estimates. A number of the
Company’s other significant assets and liabilities, including deferred policy acquisition costs, real estate owned, property, equipment and software, loss and LAE reserves, unearned premiums and deferred income taxes are not considered financial instruments.
Although realization is not assured, management believes it is more likely than not that the deferred tax assets will be realized.
The primary objective of the Plan is to provide retirement income for Plan participants and their beneficiaries in accordance with the terms of the Plan. As such, the key objective in the Plan’s financial management is to promote stability and, to the extent appropriate, growth in funded status. A secondary financial objective is to reduce reliance on contributions as a source of benefit payments. As such, Plan assets are invested to maximize the Plan’s funded ratios over the long-term while managing the downside risk. The strategic asset allocation ranges represent a long-term perspective. Rapid unanticipated market shifts or changes in economic conditions may cause the asset mix to fall outside the policy range. These divergences should be of a relatively short-term nature, unless the circumstances warrant a longer term divergence from the permissible ranges. The Company evaluates and rebalances asset allocations as appropriate and reviews the Plan to make sure that the Plan remains properly funded to protect the benefit security of the participants. As of December 31, 2003, cash and cash equivalents were higher than the target range due to the timing of the contribution and fund allocation at year end 2003, and to the expected payout in the following year at December 31, 2002.