We currently own approximately 200,000 square feet of office space in Walnut Creek, California for our home office. PMI leases offices throughout the United States. We conduct our international operations in leased facilities in Ireland, the United Kingdom, Italy, Spain, Germany, Belgium, Canada, Mexico, Australia, New Zealand, Hong Kong, and Japan.
For the year ended December 31, 2007, we recorded a consolidated net loss of $915.3 million compared to consolidated net income of $419.7 million for 2006. Our net loss in 2007 was primarily due to our equity in losses of FGIC of $763.3 million and our U.S. Mortgage Insurance Operations’ net loss of $190.8 million. FGIC’s loss in 2007 was driven by $1.9 billion of unrealized mark-to-market losses and $1.2 billion of losses and loss adjustment expenses (which includes claims paid, loss adjustment expenses and changes in loss reserves during the period). U.S. Mortgage Insurance Operations’ loss in 2007 was driven by $1.1 billion of losses and loss adjustment expenses compared to $263.0 million in 2006. Our consolidated 2007 financial results were positively impacted by higher premiums earned in the U.S. and Australia.
International Operations. We offer mortgage insurance and other credit enhancement products in Australia, New Zealand, Europe, Asia, and Canada. Net income from our International Operations segment was $55.0 million in 2007 and $103.5 million in 2006.
Financial Guaranty. Our Financial Guaranty segment includes equity in (losses) earnings from FGIC Corporation and RAM Re and the results of PMI Guaranty. Our Financial Guaranty segment generated a net loss of $731.7 million in 2007 compared to net income of $97.3 million in 2006.
Losses and LAE. The significant weakening of the U.S. residential mortgage, housing, credit, and capital markets negatively affected our U.S. Mortgage Insurance Operations’ financial condition and results of operations in 2007 and will continue to do so in 2008. PMI’s losses and loss adjustment expenses (“LAE”) increased to $1.1 billion in 2007 from $263.0 million in 2006. We increased PMI’s net loss reserves in 2007 by $733.8 million as a result of the increase in PMI’s default inventory (discussed under Defaults below), higher claim rates and higher average claim sizes. Higher claim rates have been driven by home price declines and diminished availability of certain loan products, both of which constrain refinancing opportunities, and result in a decrease in the percentage of the default inventory that is returning to current status. The increase in PMI’s average claim sizes has been driven by, among other things, higher loan sizes and coverage levels in PMI’s portfolio, and declining home prices which limit PMI’s loss mitigation opportunities. We expect PMI’s losses and LAE to be higher in 2008 than 2007.
We expect claim rates and average claim sizes to continue to increase and our 2007 loss reserve increases reflect this expectation. Future increases in these factors beyond our current expectations will negatively impact losses and LAE. Changes in economic conditions, including mortgage interest rates, job creation, unemployment rates and home prices could significantly impact our reserve estimates, and therefore, PMI’s losses and LAE. In addition, changes in economic conditions may not necessarily be reflected in PMI’s loss development in the period in which such changes occur, potentially leading to continued increases in losses and LAE even as economic conditions improve.
Defaults. PMI’s primary default inventory increased to 63,197 as of December 31, 2007 from 39,997 as of December 31, 2006. PMI’s primary default rate increased to 7.9% as of December 31, 2007 from 5.6% as of December 31, 2006. The increases in PMI’s primary default inventory and default rate in 2007 have been driven by a number of factors including:
Decline in cure rate-As discussed above, the significant decline in the percentage of defaults that cure has also negatively affected PMI’s default inventory and default rate. The declines in the percentage of defaults that cure have resulted from, among other things, a slowdown in the time to resolution of defaults (either through cure or claim payment), some of which is attributable to significant backlogs in workout activity by loan servicers attempting to resolve delinquencies and prevent foreclosures.
Geographic factors-Declining home prices, particularly in California and Florida, and weak economic conditions in Michigan, Indiana, Ohio, and Illinois (the “Auto States”) have negatively affected the development of PMI’s 2005, 2006 and 2007 portfolios. PMI’s default rates in California and Florida increased steeply in 2007 from below PMI’s average default rate as of December 31, 2006 to well above it as of December 31, 2007. The default rate from California as of December 31, 2007 was 10.9% compared to 3.6% and 2.3% as of December 31, 2006 and 2005, respectively. The default rate from Florida as of December 31, 2007 was 10.6% compared to 3.4% and 3.9% as of December 31, 2006 and 2005, respectively. As of December 31, 2007, risk in force from California and Florida insured loans represented 8.1% and 10.8% of PMI’s primary risk in force, respectively. The average default rate of the Auto States as of December 31, 2007 was 10.6% compared to 8.1% and 7.2% as of December 31, 2006 and 2005, respectively. As of December 31, 2007, risk in force from the Auto States represented 13.6% of PMI’s primary risk in force.
As the 2005, 2006 and 2007 books continue to age under stressed market conditions, we expect PMI’s default inventory and default rate to be higher in 2008 than in 2007.
the percentage of NIW comprised of Above-97s loans declined in the fourth quarter of 2007. Effective March 1, 2008, we will no longer insure Above-97s through our primary flow channel. (See Item 1(B)(6) - Business-Risk Management, 2007 Underwriting Guidelines and Pricing Changes, above.)
Captive Reinsurance. Under captive reinsurance agreements, PMI transfers portions of its risk written on loans originated by certain lender-customers to captive reinsurance companies affiliated with such lender-customers. In return, PMI cedes a share of its gross premiums written to these captive reinsurance companies. As of December 31, 2007, 52.2% of PMI’s primary insurance in force was subject to captive reinsurance agreements compared to 52.9% as of December 31, 2006. We received $1.2 million in claim payments from captive trusts in 2007. Based on current trends, we expect that claim payments from captive trusts assets will increase in 2008 and substantially increase in 2009, reducing PMI’s losses in those years.
Rating Agency and Capital Constraints. Like PMI, the ability of our international insurance subsidiaries to attract new business and to compete has been highly dependent on their perceived value and strength as a counterparty as reflected in part by the insurer financial strength ratings assigned to them by the rating agencies. The ratings of PMI Australia, PMI Europe, PMI Canada, and PMI Guaranty are dependent in part upon the capital support of PMI. A downgrade of PMI’s ratings, therefore, would likely cause a downgrade of the ratings of our other insurance subsidiaries. Continued adverse loss development in our U.S. Mortgage Insurance Operations could further weaken the perceived counterparty strength of our international insurance subsidiaries and limit new business opportunities. In addition to rating agency actions, capital constraints at both The PMI Group and PMI, as well as at our international subsidiaries, may limit our international subsidiaries’ abilities to engage in new business transactions in 2008 and thereafter.
Foreign Currency Exchange Fluctuations and Foreign Currency Put Options. The performance of our International Operations is subject to fluctuations in exchange rates between the reporting currency of the U.S. dollar and our other functional foreign currencies. The changes in the average foreign currency exchange rates from 2006 to 2007 positively affected International Operations’ net income by $5.3 million. Foreign currency translation impact is calculated using the period over period change in the average exchange rates to the current period ending net income in the functional currency.
RAM Re. Equity in earnings from RAM Re was $4.5 million in 2007 compared to $8.7 million in 2006. This decrease was due primarily to unrealized mark-to-market losses of $28.4 million on its credit derivative portfolio as a result of widening credit spreads partially offset by higher premiums earned and net investment income. As we report our equity in earnings/losses from RAM Re on a one quarter lag, our 23.7% share of RAM Re’s fourth quarter 2007 results will be reflected in our consolidated financial results in the first quarter of 2008. Due to, among other things, the continuing deterioration of the credit market, rating agency actions and the decline in RAM Re’s share price, in the fourth quarter of 2007 we realized an other-than-temporary impairment of our investment in RAM Re of $38.5 million. This impairment charge was based on the difference between our investment balance in RAM Re as of December 31, 2007 (before the impairment) and our share of RAM Re’s market value as of September 30, 2007 (due to our one quarter accounting lag). After impairment, the carrying value of our investment in RAM Re as of December 31, 2007 was $60.0 million. We do not expect RAM Re’s fourth quarter of 2007 to be profitable. We expect the carrying value of our investment in RAM Re to be further reduced in the first quarter of 2008 as a result of RAM Re’s losses and/or further impairment by us of our investment, and such reduction could be significant. We will continue to evaluate this investment for possible future impairment. (See Item 1A. Risk Factors - Recent downgrades relating to FGIC and the placing of RAM Re on negative credit watch have adversely affected our financial condition and results of operations. Additional adverse rating agency actions with respect to FGIC or RAM Re could further harm our financial condition and results of operations, and The performance of our financial guaranty equity investees could harm our consolidated financial results.)
Valuation Allowance. We established a valuation allowance of approximately $168.1 million against a $214.3 million deferred tax asset associated with our investments in FGIC and RAM Re. The deferred tax asset was created upon the recognition of losses from FGIC and RAM Re in excess of our tax basis with respect to our investments in FGIC and RAM Re. We did not record a full valuation against the deferred tax asset, as it is management’s expectation that some portion of the tax benefit will be realized. Additional tax benefits could be recognized in the future if we determine that additional
Corporate and Other. Factors affecting the financial performance of our Corporate and Other segment include:
Contract Underwriting Services. As a result of lower levels of mortgage originations and a decline in customers’ requests for contract underwriting services, our contract underwriting activities and revenues have declined, and will likely continue to decline in the future. Total contract underwriting expenses include allocated expenses and monetary remedies provided to customers in the event we failed to properly underwrite a loan. Contract underwriting remedies, and accruals thereof, were $7.1 million in 2007 compared to $12.4 million in 2006.
Share-Based Compensation. During 2007, we incurred pre-tax share-based compensation expense of $16.1 million compared to $12.2 million in 2006. Our share-based compensation expense was higher in 2007 compared to 2006 as a result of our acceleration of out-of-the-money stock options in 2005. We expect share-based compensation expenses to be higher in 2008.
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 compensation expense not included in our other operating segments, and interest expense.
The increase in premiums earned in 2007 compared to 2006 was driven by higher levels of insurance in force caused by increased level of NIW, higher persistency and higher insured loan sizes. The strengthening Australian dollar relative to the U.S. dollar and continued insurance in force growth in Australia also drove the increase in premiums earned. The increase in premiums earned in 2006 compared to 2005 was also primarily due to higher premiums earned in Australia and the U.S. The increase in PMI Australia’s premiums earned in 2006 was primarily due to the scheduled release of unearned premiums to premiums earned associated with PMI Australia’s NIW and insurance in force growth, and premiums earned as a result of higher levels of policy
cancellations in 2006. The increase in U.S. Mortgage Insurance Operations’ premiums earned in 2006 was due primarily to PMI’s higher average premium rates and average insured loan sizes, as well as higher levels of modified pool premiums.
The increases in net investment income in 2007 and 2006 compared to prior years were due to the growth of PMI Australia’s investment portfolio and a stronger Australian dollar relative to the U.S. dollar. Our consolidated pre-tax book yield was 5.45%, 5.45 % and 5.18 % as of December 31, 2007, 2006, and 2005 respectively.
The increase in amortization of deferred policy acquisition costs in 2007 compared to 2006 was primarily due to an impairment of $33.6 million as a result of our evaluation of the recoverability of the U.S. Mortgage Insurance Operations’ deferred policy acquisition asset. The decrease in amortization of deferred policy acquisition costs in 2006 compared to 2005 was primarily due to cost savings realized from our U.S. field office restructurings in 2004 and 2006.
We account for our unconsolidated subsidiaries and limited partnerships using the equity method of accounting. Equity in losses from FGIC was $763.3 million in 2007 compared to equity in earnings of $98.5 and $74.9 million in 2006 and 2005, respectively. FGIC’s financial results for 2007 were negatively impacted by net unrealized mark-to-market losses of $1.9 billion, predominantly related to CDS derivative contracts, and loss reserve increases of $1.2 billion in 2007 as a result of credit deterioration of insured collateralized debt obligations comprised primarily of tranches of sub-prime RMBS and other CDOs, as well as direct exposure to RMBS. FGIC’s 2007 mark-to market losses and additions to loss reserves reflect the significant weakening of the U.S. residential mortgage, housing, credit and capital markets. The increase in equity in earnings from FGIC in 2006 compared to 2005 was primarily due to an increase in premiums earned, the partial release of loss reserves related to Hurricane Katrina, and higher investment income.
We recorded income tax benefits of $212.1 million in 2007, compared to income tax expenses of $140.0 million in 2006. The effective tax rates were 18.8% for 2007 and 25.0% for 2006 and 24.3% for 2005. The change in 2007 effective tax rates compared to 2006 was primarily due to the losses in our U.S. Mortgage Insurance Operations and Financial Guaranty segments. In 2007, a valuation allowance of approximately $168 million was established against deferred tax assets resulting from losses attributable to FGIC and RAM Re, decreasing the effective tax rate. The change in our effective tax rate in 2006 compared to 2005 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 following table presents consolidated net income (loss) and net income (loss) for each of our segments for the years ended:
The decreases in gross and net premiums written in 2006 compared to 2005 were primarily due to two single premium transactions totaling $47.3 million in premiums written in the fourth quarter of 2005, partially offset by higher levels of modified pool premiums and increases in PMI’s average premium rates and average insured loan balances in 2006. PMI’s premiums earned increased in 2006 compared to 2005 as a result of higher average premium rates in 2006, partially offset by lower levels of earned premiums associated with loan cancellations of single premium policies and lower levels of NIW.
Net investment income-The increase in net investment income in 2007 compared to 2006 was primarily due to an increase in municipal bond refundings in 2007. The pre-tax book yield was 5.22% at December 31, 2007, 5.34% at December 31, 2006, and 5.21% at December 31, 2005.
Losses and LAE-PMI’s losses and LAE represent claims paid, certain expenses related to default notification and claim processing and changes to loss reserves during the applicable period. Because losses and
Continuing deterioration of the U.S. housing and mortgage markets caused PMI’s losses and LAE and default inventory to increase significantly in 2007. We increased PMI’s net loss reserves in 2007 by $733.8 million as a result of the increase in PMI’s default inventory (discussed under Defaults below), higher claim rates and higher average claim sizes. Higher claim rates have been driven by, among other things, home price declines and diminished availability of certain loan products, both of which constrain refinancing opportunities, and result in a decrease in the percentage of the default inventory that is returning to current status. The increase in PMI’s average claim sizes has been driven by higher loan sizes and coverage levels in PMI’s portfolio, and declining home prices which limit PMI’s loss mitigation opportunities.
The increase in claims paid including LAE in 2007 compared to 2006 was primarily due to higher claim rates and higher average claim sizes discussed above. Because we expect these factors to continue to increase, we also expect PMI’s claims paid to be higher in 2008 than in 2007. Primary claims paid were $329.6 million in 2007, $214.0 million in 2006, and $214.9 million in 2005. Pool insurance claims paid were $21.0 million in 2007, $18.3 million in 2006, and $21.6 million in 2005.
Defaults-PMI’s primary mortgage insurance master policies define “default” as the borrower’s failure to pay when due an amount equal to the scheduled monthly mortgage payment under the terms of the mortgage. Generally, the master policies require an insured to notify PMI of a default no later than the last business day of the month following the month in which the borrower becomes three monthly payments in default. For reporting and internal tracking purposes, we do not consider a loan to be in default until the borrower has missed two consecutive payments. Depending upon its scheduled payment date, a loan delinquent for two consecutive monthly payments could be reported to PMI between the 31st and the 60th day after the first missed payment.
Geographic factors-Declining home prices, particularly in California and Florida, and weak economic conditions in Michigan, Indiana, Ohio, and Illinois (the “Auto States”) have negatively affected the development
PMI’s policy acquisition costs are those costs that vary with, and are related to, our acquisition, underwriting and processing of new mortgage insurance policies, including contract underwriting and sales related activities. To the extent that we are compensated by customers for contract underwriting, those underwriting costs are not deferred. We defer policy acquisition costs when incurred and amortize these costs in proportion to estimated gross profits for each policy year by type of insurance contract (i.e. monthly, annual and single premium). Policy acquisition costs incurred and deferred are variable and fluctuate with the volume of new insurance applications processed and NIW. The increase in amortization of deferred policy acquisition costs in 2007 compared to 2006 was primarily due to a $33.6 million impairment of PMI’s deferred acquisition costs based on our recoverability analysis of deferred costs relating to new mortgage insurance policies acquired in 2007. The impairment of all remaining costs associated with the 2007 book year as of December 31, 2007 was driven by our expected loss development under various scenarios and our determination that the remaining costs were not recoverable. The decrease in amortization of deferred policy acquisition costs in 2006 compared to 2005 was primarily due to expense savings realized from field office restructurings in 2006. PMI’s deferred policy acquisition cost asset was $10.5 million, $43.5 million and $48.3 million as of December 31, 2007, 2006 and 2005, respectively.
PMI’s expense ratio is the ratio of total underwriting and operating expenses to net premiums written. The decrease in PMI’s expense ratio in 2007 compared to 2006 was primarily due to an increase in net premiums written and a decrease in employee compensation expenses, partially offset by an increase in amortization of deferred acquisition costs. The decrease in PMI’s expense ratio in 2006 compared to 2005 was primarily due to the decrease in amortization of deferred policy acquisition costs and the re-allocation of costs to our Corporate and Other segment, partially offset by a decrease in net premiums written. The combined ratio is the sum of the loss ratio and the expense ratio.
The increase in PMI’s flow channel NIW in 2007 was driven by a larger private mortgage insurance market. We believe that the private mortgage insurance market grew in 2007 primarily as a result of a decline in the origination of alternative loan products, particularly 80/20 piggyback loans, that do not require mortgage insurance. We believe that the decline in the use of alternative products was due to both diminished demand in the capital markets for these products and increased concern on the part of portfolio lenders with respect to rising credit losses in an environment of declining home prices. We also believe that the private mortgage insurance market increased as a result of tax deductibility for eligible borrowers of borrower-paid mortgage insurance premiums relating to loans closed in 2007. We expect PMI’s NIW generated through both its flow and structured finance channels to be lower in 2008 than in 2007. Our expectations are based upon the continuing slowdown in the mortgage origination and secondary mortgage markets and the previously described changes to PMI’s pricing and underwriting guidelines that have decreased the types of loans that PMI will insure.
The decrease in PMI’s primary NIW in 2006 compared to 2005 was primarily driven by increasingly competitive flow pricing and a reduction in the size of the flow private mortgage insurance market.
Credit and portfolio characteristics-PMI insures less-than-A quality loans and Alt-A loans through all of its acquisition channels. Less-than-A quality loans generally include loans with credit scores less than 620. We consider a loan Alt-A if it has a credit score of 620 or greater, and the borrower requests and is given the option of providing reduced documentation verifying income, assets, deposit information, and/or employment. PMI’s 2007 NIW consisted of a higher percentage of less-than-A quality loans. We believe the higher percentage of these loans was driven by the growth of GSE market outreach programs. However, because of our recent guideline changes, we do not expect this trend to continue in 2008. 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:
PMI expects higher default and claim rates on Above-97s, 2/28 hybrid ARMs and Alt-A loans. While we incorporate these assumptions into our underwriting approach, portfolio limits, pricing and loss and claim estimates, in 2007 we experienced higher delinquencies than expected for each of these loan types.
International Operations’ results include our Australian subsidiaries, collectively referred to as PMI Australia; our Irish subsidiaries, collectively referred to as PMI Europe; PMI Asia; and PMI Canada. PMI Canada, our Canadian mortgage insurer, began offering residential mortgage insurance products in 2007.
The decrease in International Operations’ net income in 2007 compared to 2006 was primarily due to higher losses and LAE in Australia and Europe, and unrealized mark-to-market losses on PMI Europe’s CDS contracts accounted for as derivatives, partially offset by higher premiums earned and net investment income in Australia. The decrease in International Operations’ net income in 2006 compared to 2005 was primarily due to higher losses and LAE in PMI Australia, partially offset by increased premiums earned and net investment income in Australia and an increase in income from changes in the fair value of PMI Europe’s credit default swaps in 2006.
The changes in the average foreign currency exchange rates from 2006 to 2007 positively impacted International Operations’ net income by $5.3 million primarily due to the strengthening of the Australian dollar relative to the U.S. dollar. The change in the average foreign currency exchange rates from December 31, 2005 to December 31, 2006 negatively impacted our International Operations’ net income by $0.9 million primarily due to the weakening of the Australian dollar relative to the U.S. dollar. The average exchange rates between U.S. dollars and Hong Kong dollars did not fluctuate significantly in 2007 and 2006. The foreign currency translation impact is calculated using the period over period change in the average exchange rate to the current period ending net income in the local currency.
In 2007, we purchased Australian dollar and Euro foreign currency put options designed to partially mitigate the negative financial impact of a potential strengthening of the U.S. dollar relative to the Australian dollar or the Euro. The options had an aggregate pre-tax cost of $1.3 million. International Operations’ net income for 2007 was reduced by $1.3 million pre-tax, related to these put options. In early 2008, we purchased Australian dollar foreign currency put options with an aggregate pre-tax cost of $1.1 million.
Losses and LAE-PMI Australia’s losses and LAE and related claims data are shown in the following table:
Underwriting and operating expenses-Underwriting and operating expenses increased in 2007 compared to 2006 primarily due to a stronger Australian dollar relative to the U.S. dollar and growth in the business. A decrease in profit sharing commissions due to increased loss ratios and a decrease in exchange commissions due to changes to PMI Australia’s reinsurance arrangements partially offset the expense increase. Underwriting and operating expenses in 2006 increased slightly compared to 2005 primarily due to higher compensation expenses.
Total NIW for 2007 decreased compared to 2006 primarily due to the successful execution of major RMBS transactions in 2006, partially offset by an increase in flow channel NIW and a strengthening of the Australian dollar relative to the U.S. dollar. We expect RMBS NIW to decrease in 2008 as a result of expected RMBS market declines and recent rating agency actions affecting PMI and PMI Australia. The increases in insurance in force and risk in force as of December 31, 2007 compared to December 31, 2006 were driven by continued business writings in excess of policy terminations and a stronger Australian dollar against the U.S. dollar. The increase in NIW generated by PMI Australia’s flow channel and RMBS channel in 2006 compared to 2005 was primarily due to higher demand for flow and RMBS-related insurance and to streamlined flow product offerings and new marketing initiatives in 2006.
Net investment income-PMI Europe’s net investment income consists primarily of interest income from its investment portfolio including cash deposits, and gains and losses on foreign currency re-measurement. The pre-tax book yield was 4.5%, 4.3% and 4.5% for December 31 2007, 2006 and 2005, respectively. The decrease in net investment income in 2007 compared to 2006 was primarily due to foreign currency re-measurement, partially offset by an increase in PMI Europe’s investment portfolio, including cash and cash equivalents. Net investment income decreased in 2006 compared to 2005 primarily due to a decline in the average investment portfolio balance in 2006 caused by the payment of profit sharing obligations.
PMI Europe’s investment portfolio, including cash and cash equivalents, was $254.2 million as of December 31, 2007, $215.3 million as of December 31, 2006, and $216.3 million as of December 31, 2005. The increase in the investment portfolio, including cash and cash equivalents, in 2007 was primarily due to the strengthening of the Euro relative to the U.S. dollar, and the capital contribution from PMI of $8 million. The decrease in PMI Europe’s investment portfolio in 2006 was primarily driven by the payment of an accrued profit commission relating to the termination of future profit sharing obligations on the R&SA portfolio.
portfolio. Losses and LAE increased in 2006 and 2005 primarily due to lower than expected cure rates and higher loss severities, offset in part by decreases in reserves associated with R&SA.
The following table sets forth the financial results of PMI Asia:
Income taxes-The transfer of PMI’s Hong Kong mortgage reinsurance portfolio to PMI Asia resulted in a $1.1 million tax charge in the second quarter of 2006. PMI Asia’s statutory tax rate has been 17.5% since the
The following table sets forth the financial results of our Financial Guaranty segment. Other than equity in earnings/losses from unconsolidated subsidiaries, the results reflect the performance of PMI Guaranty for the years ended:
The decrease in equity in earnings from RAM Re was due primarily to unrealized mark-to-market losses of $28.4 million on its credit derivative portfolio as a result of widening credit spreads partially offset by higher premiums earned and net investment income. As we report our equity in earnings/losses from RAM Re on a one quarter lag, our 23.7% share of RAM Re’s fourth quarter results will be reflected in our consolidated financial results in the first quarter of 2008.
In connection with the preparation of the consolidated financial statements for the year ended December 31, 2007, we realized a $38.5 million other-than-temporary impairment charge related to RAM Re due to continuing deterioration of the credit market, rating agency actions and declines in RAM Re’s share price. We expect the carrying value of our investment in RAM Re to be further reduced in the first quarter of 2008 as a result of RAM Re’s losses and/or further impairment. We will continue to evaluate the investment for possible additional impairment in future periods.
The segment income tax benefit of $64.2 million reflects the reversal of previously accrued deferred tax liabilities and the establishment of a deferred tax asset attributable to our investment in FGIC and RAM Re. We established a valuation allowance of approximately $168.1 million against a $214.3 million deferred tax asset associated with our investment in FGIC and RAM Re. The deferred tax asset was created upon the recognition of losses from FGIC and RAM Re in excess of our tax basis with respect to FGIC and Ram Re. We did not record a full valuation against the deferred tax asset, as it is our expectation that some portion of the tax benefit may be realized. Additional tax benefits could be recognized in the future if we determine that additional realization of such tax benefits is more likely than not to occur. To the extent our current estimate of future tax benefits to be realized changes, our tax expenses could be affected positively or negatively.
Premiums written and earned-Net premiums written decreased in 2007 compared to 2006 primarily due to the business mix in FGIC’s public finance sector and limited activity in structured finance, along with a decrease in business assumed from other insurers and an increase in business ceded to other insurers. Net premiums written decreased in 2006 compared to 2005 primarily due to a decrease in FGIC’s U.S. public finance premiums written and an increase in business ceded to other insurers, partially offset by growth in international finance and structured finance transactions. Net premiums earned increased in 2007 compared to 2006 due to installment revenues. Net premiums earned increased in 2006 compared to 2005 due primarily to growth in FGIC’s U.S. structured finance and international finance portfolios, offset by a decrease in premiums earned on refundings. FGIC recorded earned premiums from refundings of $43.7 million in 2007, compared to $41.8 million in 2006 and $54.8 million in 2005. A refunding occurs when an insured credit is called or legally defeased by the issuer prior to the stated maturity. When a credit insured by FGIC has been refunded prior to the end of the expected policy coverage period, any remaining unearned premium is recognized at that time.
Net investment income-Net investment income increased to $158.0 million in 2007 from $139.7 million in 2006 and $118.8 million in 2005 primarily due to the growth of FGIC’s investment portfolio. FGIC’s investment portfolio is comprised primarily of U.S. municipal bonds with an average rating of AA. The book yield of FGIC’s investment portfolio was 4.0% in 2007, 3.9% in 2006, and 3.8% in 2005.
Net unrealized losses-FGIC incurred net unrealized mark-to-market losses on derivative contracts of $1.9 billion in 2007 compared to $1.3 million in 2006. The 2007 unrealized mark-to-market losses were related to derivative contracts issued by FGIC in CDS form on CDOs, a portion of which are collateralized by asset-backed securities, including mortgage-backed securities. FGIC’s unrealized mark-to-market losses for the fourth quarter of 2007 of $1.7 billion consisted of approximately $750 million related to estimated credit impairments and $960 million related to the widening of credit spreads in the structured credit markets. The estimated credit impairment of $750 million represents FGIC management’s estimate of future claim payments on certain CDOs. FGIC did not pay claims related to asset-backed securities CDOs in 2007.
Losses and LAE-FGIC’s loss and loss adjustment expenses was $1.2 billion in 2007 compared to a benefit of $8.7 million for 2006. The increase in losses and LAE in 2007 was primarily related to the guarantees FGIC provided during 2006 and 2007 on CDOs of ABS (comprised to a large extent of tranches of RMBS as well as other CDOs) and RMBS transactions. The adverse results in both of these areas was due primarily to negative developments in the U.S. housing and mortgage markets, particularly with regard to sub-prime mortgages and second liens. Total reserves, net of reinsurance recoverables, were $1.3 billion at December 31, 2007 compared to $38.8 million as of December 31, 2006.
Income tax (benefit) expense-Equity in 2007 losses of FGIC include previously unrecognized tax benefits of FGIC of $12.2 million. The tax benefits were recognized in connection with the completion of an IRS examination of FGIC tax returns for 2003 and 2004.
Settlement gain on sale of unconsolidated subsidiary-The settlement gain of $12.7 million was related to the favorable resolution of certain indemnifications associated with the sale of SPS in 2005. Net realized investment losses increased in 2006 compared to 2005 due primarily to the other-than-temporary impairment of investments that we no longer had the intent to hold until recovery in value.
Other income-Other income primarily includes contract underwriting revenue. In 2007, contract underwriting revenue was $13.1 million compared to $12.7 million in 2006. Other income decreased in 2006 compared to 2005 as a result of a decline in contract underwriting activity.
Other operating expenses-Other operating expenses decreased in 2007 compared to 2006 due to decreases in employee compensation costs and contract underwriting remedies. Operating expenses increased in 2006 compared to 2005 primarily due to increases in contract underwriting remedies as well as costs related to debt extinguishment.
The PMI Group Liquidity-The PMI Group’s liquidity is primarily dependent upon: (i) The PMI Group’s subsidiaries’ ability to pay dividends to The PMI Group; (ii) financing activities in the capital markets; and (iii) maturing or refunded investments and investment income from The PMI Group’s stand-alone investment portfolio. The PMI Group’s ability to access these sources depends on, among other things, the financial performance of The PMI Group’s subsidiaries, regulatory restrictions on the ability of The PMI Group’s insurance subsidiaries to pay dividends, The PMI Group’s and its subsidiaries’ ratings by the rating agencies, and restrictions and agreements to which The PMI Group or its subsidiaries are subject to that restrict their ability to pay dividends, incur debt or issue equity securities.
The PMI Group’s available funds, consisting of cash and cash equivalents and investments, were $78.4 million at December 31, 2007 compared to $182.1 million at December 31, 2006. It is our present intention to maintain at least $75 million of liquidity at our holding company in connection with rating agency considerations.
As a result of higher losses and LAE in 2007, higher projected losses in 2008 and growth in insurance in force, we will likely need to raise significant amounts of additional capital in 2008 to maintain The PMI Group’s and our insurance subsidiaries’ ratings. Although we do not yet know what form these capital raising activities will take, we expect to seek to raise additional capital through a variety of types of transactions, including, but not limited to, one or more debt or equity offerings. On an ongoing basis, we intend to explore other available alternatives to enhance our liquidity, including obtaining reinsurance for our insurance subsidiaries’ existing or future books of business, limiting the new insurance written by our insurance subsidiaries and/or the disposition of equity investments (which could include certain wholly-owned subsidiaries) or portions thereof. Given current market conditions generally and in our industry, there can be no assurance that we will be able to consummate any capital raising transactions on favorable terms or at all.
investment income. To the extent PMI experiences a downgrade in ratings, we expect that the ratings of our international mortgage insurance subsidiaries (PMI Australia, PMI Europe and PMI Canada), as well as PMI Guaranty, could be negatively affected, largely as a result of capital support agreements between PMI and those subsidiaries, as well as guarantees of those agreements by The PMI Group. If this were to occur, those subsidiaries’ ability to compete and their financial condition, including liquidity position, could be negatively affected. In addition, we have in the past dedicated increasing amounts of capital resources to expand our International Operations. Capital constraints described above may prevent us from continuing to expend such resources, which in turn may limit our international subsidiaries’ abilities to engage in capital intensive transactions in 2008 and thereafter. In addition, in the case of PMI Australia, higher losses, declines in its investment portfolio and/or adjustments by APRA to PMI Australia’s minimum capital requirements could cause PMI Australia to fall below APRA capital requirements.
financial strength rating of at least BBB from Standard & Poor’s, or our material insurance subsidiaries (as defined in the facility) being subject to certain regulatory actions or restrictions by their respective primary insurance regulators that are not cured within specified periods of time. Upon an event of default, we could have to repay all outstanding indebtedness and would be unable to draw on the facility, and the lenders would have the right to terminate their loan commitments under the facility.
PMI’s ability to pay dividends to The PMI Group is affected by state insurance laws, credit agreements, rating agencies, and the discretion of insurance regulatory authorities. The laws of Arizona, PMI’s state of domicile for insurance regulatory purposes, provide that PMI may pay dividends out of any available surplus account, without prior approval of the Director of the Arizona Department of Insurance, during any 12-month period in an amount not to exceed the lesser of 10% of policyholders’ surplus as of the preceding year end or the prior calendar year’s net investment income. A dividend that exceeds the foregoing threshold is deemed an “extraordinary dividend” and requires the prior approval of the Director of the Arizona Department of Insurance. In December 2006, the Director of the Arizona Department of Insurance approved an extraordinary dividend request of $250 million and a $100 million installment was paid to The PMI Group in the form of a return of capital. In April 2007, an additional $200 million extraordinary dividend was approved by the Director of the Arizona Department of Insurance. In 2007, PMI paid $165 million in dividends to The PMI Group. As of December 31, 2007, there was $185 million of remaining approved dividends.
Cash payments related to our reserves for losses and LAE as of December 31, 2007 shown below are based upon management’s best estimate from historical experience as well as current economic conditions. These estimates could vary significantly based on, among other things, changes to claim rates and claim sizes. Minimum rental payments under non-cancelable capital and operating leases are provided in the table below.
The following table summarizes the estimated fair value of the consolidated investment portfolio as of December 31, 2007 and 2006. Amounts shown under “Corporate and Other” consist of the investment portfolio of The PMI Group, and amounts shown under “Financial Guaranty” consist of the investment portfolio of PMI Guaranty:
Our consolidated investment portfolio holds primarily investment grade securities comprised of readily marketable fixed income and equity securities. At December 31, 2007, the fair value of these securities in our consolidated investment portfolio increased to $3.7 billion as of December 31, 2007 from $3.2 billion as of December 31, 2006. The increase was due primarily to growth in PMI Australia’s investment portfolio and increases in foreign currency translation rates.
In 2007, PMI obtained authorization to pay a dividend of $200 million to its parent, The PMI Group. This was in addition to a remaining unpaid but authorized dividend of $150 million. PMI paid $165 million of the dividends to The PMI Group in 2007, and has $185 million remaining of unpaid but approved dividends. Due to the dividends paid in 2006 and 2007, the average size of PMI’s investment portfolio and corresponding investment income for U.S. Mortgage Insurance Operations may be reduced in 2008 to the extent capital is not contributed to PMI.
The following table summarizes the rating distributions of our consolidated investment portfolio (including cash and cash equivalents, excluding common stocks) as of December 31, 2007.
The following table summarizes the pre-tax book yield of our consolidated investment portfolio by segment as of December 31, 2007, 2006 and 2005.
The decrease in the pre-tax book yield of U.S. Mortgage Insurance Operations, Financial Guaranty and Corporate and Other in 2007 was due to interest rate decreases during the year. The increase in pre-tax book yield of International Operations in 2007 was primarily due to the rising interest rates in Australia.
As of December 31, 2007, our consolidated shareholders’ equity was $2.5 billion. The carrying value of our long-term debt outstanding issued by The PMI Group at December 31 was as follows:
On a consolidated basis, our principal sources of funds are cash flows generated by our insurance subsidiaries and investment income derived from our investment portfolios. One of the primary goals of our cash management policy is to ensure that we have sufficient funds on hand to pay obligations when they are due. We believe that we have sufficient cash to meet these and other of our short- and medium-term obligations. However, as described above, we expect that we will need to raise significant additional capital in 2008 as the result of rating agency capital requirements to maintain our and our insurance subsidiaries’ ratings.
Consolidated cash flows generated by operating activities, including premiums, investment income, underwriting and operating expenses and losses, were $558.6 million in 2007 compared to $359.6 million in 2006 and $428.0 in 2005. Cash flows from operations increased primarily due to increases in premiums written. The significant losses at FGIC were recorded as equity in losses from an unconsolidated subsidiary which represent non-cash losses. Further the losses experienced at PMI were principally due to increases in loss reserves versus the payment of claims. Accordingly, the cash flows from operations were not negatively affected by losses at FGIC and PMI. We expect cash flows from operating activities to be negatively affected in 2008 due to payment of claims from losses recorded by PMI in 2007.
Consolidated cash flows used in investing activities in 2007, including purchases and sales of investments and capital expenditures, were $461.8 million compared to consolidated cash flow provided by investing activities of $10.8 million in 2006 and $95.5 million in 2005. The increase in cash flows used in investing activities in 2007 compared to 2006 was due primarily to decreased proceeds from sales and maturities of fixed income securities and increased purchases of fixed income securities. The decrease in cash flows provided by investing activities in 2006 compared to 2005 was due primarily to increased purchases of fixed income and equity securities offset by increased proceeds from the sale of fixed income securities.
In November 2007, Standard & Poor’s removed from CreditWatch with negative implications its “A” counterparty credit rating on PMI Group Inc., its “AA” counterparty credit and financial strength ratings on PMI Mortgage Insurance Co., PMI Guaranty, PMI Europe and PMI Australia, and its “AA” financial strength rating on PMI Insurance Co. At the same time, Standard & Poor’s affirmed its ratings on all the companies with a negative outlook.
On January 31, 2008, Moody’s placed its “Aa2” insurer financial strength ratings on PMI Mortgage Insurance Co., and PMI Australia and its “Aa3” insurer financial strength ratings on PMI Europe and PMI Guaranty on review for possible downgrades. Moody’s noted that these actions reflected its view that increased losses are likely to have a meaningful impact on PMI’s US mortgage insurance portfolio and that, because the international franchises and PMI Guaranty benefit from capital support provided by PMI U.S. and The PMI Group, a downgrade of PMI’s U.S. operations would have negative implications for the ratings of our international subsidiaries.
A ratings downgrade, or the announcement of a potential downgrade or other concern relating to the financial strength of our wholly-owned insurance subsidiaries could have a material adverse effect on our business prospects, our ability to compete, our holding company debt ratings, the ratings or performance of our other insurance subsidiaries (who may receive capital support from the downgraded subsidiary), or the ratings of CMG MI. Any of these events would harm our consolidated financial condition, results of operations and cash flows. See Item 1A. Risk Factors-A downgrade of the financial strength ratings of our wholly-owned insurance subsidiaries would adversely affect our business and prospects and, consequently, our results of operations and financial condition.
On January 30, 2008, Fitch downgraded its rating on FGIC from “AAA” to “AA” and placed FGIC on CreditWatch Negative. In announcing its downgrade of FGIC, Fitch stated that it believed that FGIC’s capital deficiency totaled approximately $1.3 billion and that the downgrade was based on FGIC having not yet raised new capital, or having executed other risk mitigation measures, to meet capital guidelines within a timeframe consistent with Fitch’s expectations. Fitch also stated that the downgrade and continuation of the Negative Rating Watch reflected the significant uncertainty with respect to the company’s franchise, business model and strategic direction; uncertain capital markets; the company’s future capital strategy; ultimate loss levels in its insured portfolio; and the challenges in the financial guaranty market overall.
On January 31, 2008, Standard & Poor’s downgraded its insurer financial strength rating on FGIC from “AAA” to “AA”. Standard & Poor’s also placed its rating of FGIC on CreditWatch with developing implications. In announcing the downgrade, Standard & Poor’s stated that the downgrade reflected execution and timing risk with respect to FGIC’s capital plan and the fact that the capital plan did “not fully address projected losses.”
On February 25, 2008, Standard & Poor’s downgraded its insurer financial strength rating on FGIC from “AA” to “A”. Standard & Poor’s also placed its rating of FGIC on CreditWatch with developing implications. In announcing the downgrade, Standard & Poor’s stated that the downgrade reflect its current assessment of potential losses, which is now higher than previous estimates.
On February 14, 2008, Standard & Poor’s placed its “AAA” financial strength ratings on RAM Re, on CreditWatch Negative. Standard & Poor’s indicated that this action reflected their view of a shortfall in RAM Re’s capital position relative to projected sub-prime-related losses and the need for the company to demonstrate improved financial metrics.
In response to the rating agencies’ actions, RAM Re has stated that it is pursuing a number of alternatives to improve its capital position, including obtaining reinsurance for selected policies and slowing its growth. RAM Re stated that it did not intend to raise new capital at the present time due to current market conditions. RAM Re further stated that its strategy remains subject to change, and there can be no assurance that RAM Re will be successful in improving its capital position or in restoring its ratings in the event of a downgrade. See Item 1A. Risk Factors-Recent downgrades relating to FGIC and the placing of RAM Re on negative credit watch have adversely affected our financial condition and results of operations. Additional adverse rating agency actions with respect to FGIC or RAM Re could further harm our financial condition and results of operations.
“Management’s Discussion and Analysis of Financial Condition and Results of Operation,” as well as disclosures included elsewhere in this report, are based upon our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosure of contingencies. Actual results may differ significantly from these estimates. We believe that the following critical accounting estimates involved significant judgments used in the preparation of our consolidated financial statements.
Changes in loss reserves can materially affect our consolidated net income. The process of estimating loss reserves requires us to forecast the interest rate, employment and housing market environments, which are highly uncertain. Therefore, the process requires significant management judgment and estimates. The use of different estimates would have resulted in the establishment of different reserves. In addition, changes in the accounting estimates are reasonably likely to occur from period to period based on the economic conditions. We review the judgments made in our prior period estimation process and adjust our current assumptions as appropriate. While our assumptions are based in part upon historical data, the loss provisioning process is complex and subjective and, therefore, the ultimate liability may vary significantly from our estimates.
Our best estimate of PMI’s reserves for losses and LAE is derived primarily from our analysis of PMI’s default and loss experience. The key assumptions used in the estimation process are expected claim rates, average claim sizes and costs to settle claims. We evaluate our assumptions in light of PMI’s historical patterns of claim payments, loss experience in past and current economic environments, the seasoning of PMI’s various books of business, PMI’s coverage levels, the credit quality profile of PMI’s portfolios, and the geographic mix
of PMI’s business. Our assumptions are influenced by historical loss patterns and are adjusted to reflect recent loss trends. Our assumptions are also influenced by our assessment of current and future economic conditions, including trends in housing prices, unemployment and interest rates. Our estimation process uses generally recognized actuarial projection methodologies. As part of our estimation process, we also evaluate various scenarios representing possible losses and LAE under different economic assumptions. We established PMI’s reserves at December 31, 2007 at a level approximately the midpoint of the actuarial range based on, among other reasons, our evaluation of PMI’s estimated future claim rates and average claim sizes.
Our increases to the reserve balance in 2007 were primarily due to PMI’s higher default inventory, and higher expected claim rates and claim sizes on reported delinquencies. Continuing deterioration of the U.S. housing and mortgage markets caused PMI’s Loss and LAE and default inventory to increase significantly in 2007. Higher claim rates have been driven by, among other things, home price declines and diminished availability of certain loan products, both of which constrain refinancing opportunities, and result in a decrease in the percentage of the default inventory that is returning to current status. The increase in PMI’s average claim sizes has been driven by high loan sizes and coverage levels in PMI’s portfolio, and declining home prices which limit PMI’s loss mitigation opportunities. The table below provides a reconciliation of our U.S. Mortgage Insurance segment’s beginning and ending reserves for losses and LAE for the years ended December 31, 2007, 2006 and 2005:
The $201.7 million, $2.2 million and $6.3 million increases, in 2007, 2006 and 2005 related to prior years, respectively, were due to re-estimations of ultimate loss rates from those established at the original notice of default, updated through the periods presented. The $201.7 million increase in prior years’ reserves during 2007 reflected the significant weakening of the housing and mortgage markets and was driven by lower cure rates, higher claim rates and higher claim sizes. The $2.2 million increase in prior years’ reserves during 2006 was driven by higher than estimated claim sizes on pending delinquencies, partially offset by a reduction in the incurred but not reported estimate. The $6.3 million increase in prior years’ reserves during 2005 was due primarily to an increase in the primary and pool claim rates, partially offset by a reduction in the incurred but not reported estimate. These re-estimations of ultimate loss rates are the result of management’s periodic review of estimated claim amounts in light of actual claim amounts, loss development data and ultimate claim rates. Future declines in PMI’s cure rate, or higher default and claim rates or claim sizes could lead to further increases in losses and LAE.
To provide a measure of sensitivity on pre-tax income to changes in loss reserve estimates, we estimate that: (i) for every 5% change in our estimate of the future average claim sizes or every 5% change in our estimate of the future claim rates with respect to the December 31, 2007 reserves for losses and LAE, the effect on pre-tax income would be an increase or decrease of approximately $53.1 million; (ii) for every 5% change in our estimate of incurred but not reported loans in default as of December 31, 2007, the effect on pre-tax income would be approximately $2.3 million; and (iii) for every 5% change in our estimate of the future cost of claims settlement expenses as of December 31, 2007, the effect on pre-tax income would be approximately $1.3 million.
International Operations-PMI Australia’s reserves for losses and LAE are based upon estimated unpaid losses and LAE on reported defaults and estimated defaults incurred but not reported. The key assumptions we use to derive PMI Australia’s loss and LAE reserves include estimates of PMI Australia’s expected claim rates, average claim sizes, LAE, and net expected future claim recoveries. These assumptions are evaluated in light of similar factors used by PMI. In connection with the preparation and filing of this report, our actuaries determined an actuarial range for PMI Australia’s reserves for losses and LAE, at December 31, 2007, of $56.3 million to $76.3 million. As of December 31, 2007, PMI Australia’s recorded reserves for losses and LAE were $65.1 million, which approximated the actuarial mid-point, and represented our best estimate. In arriving at this estimate, we reviewed the key assumptions described above, the analysis performed by our actuaries and current economic and real estate market condition in Australia. Our estimate of $65.1 million is a 114% increase from PMI Australia’s reserve balance of $30.4 million at December 31, 2006. This increase was primarily due to the increase in PMI Australia’s default inventory in 2007 and higher claim rates and average claim sizes. PMI Australia’s default inventory increased to 2,666 loans as of December 31, 2007 from 2,281 loans as of December 31, 2006.
PMI Europe establishes loss reserves for all of its insurance and reinsurance business and for credit default swap transactions consummated before July 1, 2003. Revenue, losses and other expenses associated with credit default swaps executed on or after July 1, 2003 are recognized through derivative accounting treatment. PMI Europe’s loss reserving methodology contains two components: case reserves and IBNR reserves. Case and IBNR reserves are based upon factors which include, but are not limited to, our analysis of arrears and loss payment reports, loss assumptions derived from pricing analyses, our view of current and future economic conditions and industry information. Our actuaries calculated a range for PMI Europe’s loss reserves at December 31, 2007 of $18.1 million to $76.2 million. PMI Europe’s recorded loss reserves at December 31, 2007 were $41.6 million, which represented our best estimate and an increase of $23.7 million from PMI Europe’s loss reserve balance of $17.9 million at December 31, 2006. The increase to PMI Europe’s loss reserves in 2007 was primarily due to reserves established on certain U.S. reinsurance transactions on remote loss layers combined with the seasoning of credit default swap transactions accounted for as insurance and flow business.
The following table shows a breakdown of International Operations’ loss and LAE reserves:
decline in certain areas and interest rate increases in 2006 and 2007. The reduction of losses and LAE incurred relating to prior years of $9.1 million in 2005 was primarily due to favorable development of actual claim amounts and adjustments to ultimate claim rates due to the strong housing appreciation and overall economic conditions experienced in Australia over the last several years.
The following table shows our investments’ gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, as of December 31, 2007 and 2006:
Unrealized losses on fixed income securities were primarily due to an increase in interest rates in 2006 and 2007 and are not considered to be other-than-temporarily impaired as we have the intent and ability to hold such investments until they recover in value or mature. We determined that the decline in the market value of certain investments met the definition of other-than-temporary impairment and recognized realized losses of $6.1 million, $6.2 million and $0.6 million in 2007, 2006 and 2005, respectively.
The following table provides the composition of fixed income securities with an unrealized loss at December 31, 2007 in relation to the total of all fixed income securities with an unrealized loss by contractual maturities:
Our policy acquisition costs are those costs that vary with, and are primarily related to, our acquisition, underwriting and processing of new mortgage insurance policies, including contract underwriting and sales related activities. To the extent that we are compensated by customers for contract underwriting, those underwriting costs are not deferred. We defer policy acquisition costs when incurred and amortize these costs in proportion to estimated gross profits for each policy year by type of insurance contract (i.e. monthly, annual and single premium). The amortization estimates for each underwriting year are monitored regularly to reflect actual experience and any changes to persistency or loss development by type of insurance contract. The rate of amortization is not adjusted for monthly and annual policy cancellations unless it is determined that the policy cancellations are of such magnitude that the recoverability of the deferred costs is not probable. The deferred costs related to single premium policies are adjusted as appropriate for policy cancellations to be consistent with our revenue recognition policy. We review our estimation process, specifically related to single premium policies, on a regular basis and any adjustments made to the estimates are reflected in the current period’s consolidated net income.
a decline in the carrying value due to significant equity losses;
unrealized mark-to-market losses principally reflective of widening spreads and viewed as largely uneconomic losses to the extent these losses don’t develop into realized expected losses;
net book value of FGIC reduced by significant unearned premiums from the municipal bond portfolio which contains very low expected future loss development; and
We perform premium deficiency analyses quarterly on a single book basis for each of our operating segments. A premium deficiency analysis was performed as of December 31, 2007. We determined there was no premium deficiency in our U.S. Mortgage Insurance Operations segment despite significant losses in 2007. To the extent premium levels and actual loss experience differ from our assumptions, our results could be negatively affected in future periods.
In 2004, the SEC staff reviewed the accounting practices for loss reserves of publicly held financial guaranty industry companies and upon noting various differences in the accounting practices requested the Financial Accounting Standards Board (“FASB”) Staff to review and potentially clarify the applicable existing accounting guidance. An exposure draft, Accounting for Financial Guarantee Insurance Contracts, An Interpretation of SFAS No. 60 was issued in April 2007. The draft excludes mortgage guarantee insurance and credit insurance from the scope of the proposed interpretation. The final pronouncement is expected to be issued in the first quarter of 2008 with an effective date of January 1, 2009. It is possible that, upon issuance of the final pronouncement, FGIC, RAM Re and PMI Guaranty may be required to change certain aspects of their accounting for loss reserves, premium income and deferred acquisition costs. It is not possible to predict the impact, if any, that the FASB’s review may have on our consolidated results of operations, financial condition or cash flows or those of our unconsolidated subsidiaries.
Consolidated Statements of Operations for the years ended December 31, 2007, 2006 and 2005
Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on our consolidated financial statements.
Based on management’s assessment and those criteria, management has concluded that we maintained effective internal control over financial reporting as of December 31, 2007.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of The PMI Group, Inc. and subsidiaries at December 31, 2007 and 2006, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2007, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
We have audited The PMI Group, Inc.’s internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). The PMI Group Inc.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the 2007 consolidated financial statements of The PMI Group, Inc. and our report dated March 16, 2008 expressed an unqualified opinion thereon.
The accompanying consolidated financial statements include the accounts of The PMI Group, Inc. (“The PMI Group” or “TPG”), a Delaware corporation and its direct and indirect wholly-owned subsidiaries, including: PMI Mortgage Insurance Co., an Arizona corporation, and its affiliated U.S. mortgage insurance and reinsurance companies (collectively “PMI”); PMI Mortgage Insurance Ltd and its holding company, PMI Mortgage Insurance Australia (Holdings) Pty Limited (collectively “PMI Australia”); PMI Mortgage Insurance Company Limited and its holding company, PMI Europe Holdings Limited, the Irish insurance companies (collectively “PMI Europe”); PMI Mortgage Insurance Asia Ltd. (“PMI Asia”); PMI Mortgage Insurance Company Canada and its holding company, PMI Mortgage Insurance Holdings Canada Inc. (collectively “PMI Canada”); PMI Guaranty Co. (“PMI Guaranty”); and other insurance, reinsurance and non-insurance subsidiaries. The PMI Group and its subsidiaries are collectively referred to as the “Company.” All material inter-company transactions and balances have been eliminated in the consolidated financial statements.
On October 4, 2005, the Company sold to Credit Suisse First Boston (USA), Inc. (“CSFB”) its equity ownership interest in SPS Holding Corp. (“SPS”). The Company has received cash payments of $5.4 million during 2007 from the residual interest in SPS mortgage servicing assets. Based on the settlement agreement dated January 25, 2008, the Company recorded a $12.7 million settlement gain in connection with the favorable resolution of certain indemnifications associated with SPS.
Risks and Uncertainties-The Company is dependent upon mortgage originators to provide mortgage loans to insure. In the event any of its largest customers choose to stop providing the Company with mortgage loans to insure, the Company’s ability to generate new insurance business could be adversely affected. The Company’s U.S. Mortgage Insurance Operations’ ten largest customers generated 52.0%, 43.9% and 42.8% of its premiums earned in 2007, 2006 and 2005, respectively.
We would be affected by economic downturns, natural disasters and other events in specific regions of the United States where a large portion of our U.S. business is concentrated. As of December 31, 2007, 10.8% of PMI’s primary risk in force was located in Florida, and 8.1% was located in California. We are currently
The Company establishes loss reserves to recognize the liability of unpaid losses related to insured mortgages that are in default. These loss reserves are based upon the Company’s estimates of the claim rate and average claim size, as well as the estimated costs of settling claims. These estimates are regularly reviewed and updated using currently available information. Any adjustments due to positive or adverse developments, which may be material, resulting from these reviews would impact current reserve requirements. The Company’s reserves may not be adequate to cover ultimate loss development on incurred defaults. The Company’s consolidated financial condition, results of operations or cash flows could be harmed if the Company’s reserve estimates are insufficient to cover the actual related claims paid and loss-related expenses incurred.
The Company’s short-term investments have maturities of greater than three and less than 12 months when purchased and are carried at fair value. Realized gains and losses on sales of investments are determined on a specific-identification basis. Investment income consists primarily of interest and dividends. Interest income and preferred stock dividends are recognized on an accrual basis. Dividend income on common stocks is recognized on the date of declaration. Net investment income represents interest and dividend income, net of investment expenses.
The SEC requires public companies to disclose condensed financial statement information for significant equity investees and other unconsolidated 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
Deferred Policy Acquisition Costs-The Company defers certain costs in its mortgage insurance operations relating to the acquisition of new insurance and amortizes these costs against related premium revenue in order to match costs and revenues. To the extent the Company is compensated by customers for contract underwriting, those underwriting costs are not deferred. Costs related to the acquisition of mortgage insurance business are initially deferred and reported as deferred policy acquisition costs. SFAS No. 60, Accounting and Reporting by Insurance Enterprises (“SFAS No. 60”) specifically excludes mortgage guaranty insurance from its guidance relating to the amortization of deferred policy acquisition costs. Consistent with industry accounting practice, amortization of these costs for each underwriting year book of business is charged against revenue in proportion to estimated gross profits. Estimated gross profits are composed of earned premiums, interest income, losses and loss adjustment expenses as well as the amortization of deferred policy acquisition costs. The rate of amortization is not adjusted for monthly and annual policy cancellations unless it is determined that the policy cancellations or losses are of such magnitude that impairment of the deferred costs is probable. The deferred costs related to single premium policies are adjusted as appropriate for policy cancellations to be consistent with the Company’s revenue recognition policy. The amortization estimates for each underwriting year are monitored regularly to reflect actual experience and any changes to persistency or loss development. Deferred policy acquisition costs are reviewed periodically to determine that they do not exceed recoverable amounts, after considering investment income. For the year ended December 31, 2007, the Company impaired its deferred policy acquisition cost asset in an amount equal to $35.8 million relating to PMI and PMI Europe. Refer to Note 7. Deferred Policy Acquisition Costs, for more details.
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. The Company’s accumulated depreciation and amortization was $181.6 million and $156.9 million as of December 31, 2007 and December 31, 2006, respectively.
Reinsurance-The Company uses reinsurance to reduce net risk in force, optimize capital allocation and comply with a statutory provision adopted by several states that limits the maximum mortgage insurance
Revenue Recognition-Mortgage guaranty insurance policies are contracts that are generally non-cancelable by the insurer, are renewable at a fixed price, and provide payment of premiums on a monthly, annual or single basis. Upon renewal, the Company is not able to re-underwrite or re-price its policies. SFAS No. 60 specifically excludes mortgage guaranty insurance from its guidance relating to the earning of insurance premiums. Consistent with industry accounting practices, premiums written on a monthly basis are earned as coverage is provided. Monthly premiums accounted for 66.7%, 70.1%, and 70.8% of gross premiums written from the Company’s mortgage insurance operations in 2007, 2006 and 2005, respectively. 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 the revenue from 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 fifteen 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 as 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 premiums earnings pattern calculation methodology 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 these estimates are reflected for each Book Year as appropriate.
Benefit Plans-The Company provides pension benefits to all eligible U.S. employees under The PMI Group, Inc. Retirement Plan (the “Retirement Plan”) and to certain employees of the Company under The PMI Group, Inc. Supplemental Employee Retirement Plan. In addition, the Company provides certain health care and life insurance benefits for retired employees under another post-employment benefit plan. On December 31, 2006, the Company adopted the recognition and disclosure provisions of SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106 and 132(R) (“SFAS No. 158”). SFAS No. 158 requires the Company to recognize the funded status (i.e., the difference between the fair value of plan assets and the projected benefit obligations) of its defined benefit postretirement plans, with a corresponding adjustment to accumulated other comprehensive income.
On May 17, 2007, The PMI Group’s Board of Directors approved an amendment to the Retirement Plan. The amendment changed the Plan’s benefit formula from a “final pay” pension formula to a cash balance formula. The amendment takes effect immediately for employees hired or rehired on or after September 1, 2007. For employees hired before and continuously employed on September 1, 2007, the amendment will take effect on January 1, 2011. Under the new cash balance plan formula, the Company will contribute 8% of qualified employees’ compensation to cash balance accounts and credit interest at a rate equal to the 30-year Treasury bond rate.
All U.S. full-time, part-time and certain temporary employees of the Company are eligible to participate in The PMI Group, Inc. Savings and Profit-Sharing Plan (“401(k) Plan”). Eligible employees who participate in the 401(k) Plan may receive, within certain limits, matching Company contributions. Contract underwriters are covered under The PMI Group, Inc. Alternate 401(k) Plan, under which there are no matching Company contributions. In addition to the 401(k) Plan, the Company has an officers’ deferred compensation plan (“ODCP”) available to certain employees, and an Employee Stock Purchase Plan (“ESPP”). The ODCP is available to certain of the Company’s officers, and permits each participant to elect to defer receipt of part or all of his or her eligible compensation on a pre-tax basis. Under the ODCP, the Company makes a matching contribution of its common shares for each participant equal to 25% of the initial contribution to the extent the participant selects the Company’s common shares from the investment choices available under the ODCP. These matching contributions are subject to a three year vesting period. The ESPP allows eligible employees to purchase shares of the Company’s stock at a 15% discount to fair market value as determined by the plan. The ESPP offers participants the 15% discount to current fair market value or fair market value with a look-back provision of the lesser of the duration an employee has participated in the ESPP or two years.
Business Segments-The Company’s reportable operating segments are U.S. Mortgage Insurance Operations, International Operations, Financial Guaranty, and Corporate and Other. U.S. Mortgage Insurance Operations includes the results of operations of PMI Mortgage Insurance Co., affiliated U.S. insurance and reinsurance companies and the equity in earnings from CMG MI. International Operations includes the results of operations of PMI Australia, PMI Europe, PMI Asia, and PMI Canada. Financial Guaranty includes the equity in earnings (losses) from FGIC and RAM Re, and the financial results of PMI Guaranty. The Company’s Corporate and Other segment mainly consists of our holding company and contract underwriting operations.
Scheduled Maturities-The following table sets forth the amortized cost and fair value of fixed income securities by contractual maturity at December 31, 2007:
At December 31, 2007, fixed income securities and short-term investments with a fair value of $15.3 million were on deposit with regulatory authorities as required by law.
Investments in the Company’s unconsolidated subsidiaries include both equity investees and other unconsolidated subsidiaries. The carrying values of the Company’s investments in unconsolidated subsidiaries consisted of the following as of December 31, 2007 and 2006:
CMG MI’s condensed balance sheets as of December 31, 2007 and 2006, and condensed statements of operations for the years ended December 31, 2007, 2006, and 2005 are as follows:
Depreciation and amortization expense related to property, equipment including capital lease, and software totaled $31.7 million in 2007, $31.7 million in 2006 and $28.9 million in 2005. Capitalized costs associated with software developed for internal use were $15.7 million in 2007, $15.6 million in 2006 and $24.9 million in 2005.
The $238.3 million and $12.2 million increases and the $2.6 million reduction in total losses and LAE incurred in 2007, 2006 and 2005, respectively, were due to re-estimates of ultimate loss rates and amounts from those established at the original notice of default, updated through the periods presented. These re-estimates of ultimate loss rates and amounts are the result of management’s periodic review of estimated claim amounts in light of actual claim amounts, loss development data or ultimate claim rates. The increases in prior years’ reserves in 2007 and 2006 were primarily due to the significant weakening of the U.S. housing and mortgage markets and was driven by lower cure rates, higher claim rates and claim sizes.
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 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, 2007, the unamortized balance in the other comprehensive income related to these fair value hedges was approximately $8.2 million (pre-tax).
Senior Notes. As a result of the remarketing, the annual interest rate on these 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, the Company purchased and cancelled $300.0 million in principal amount of the 5.568% Senior Notes, leaving $45.0 million in principal amount of these notes outstanding after completion of the remarketing.
Revolving Credit Facility-The Company has a $400 million revolving credit facility for working capital, capital expenditures and other business purposes. The facility includes a $50 million letter of credit sub-limit. The revolving credit facility contains certain financial covenants and restrictions, including an adjusted consolidated net worth threshold and a risk-to-capital ratio threshold of 23 to 1. There are no amounts outstanding related to the facility. There were three letters of credit for approximately $1.9 million outstanding under the revolving credit facility as of December 31, 2007.
The majority of the Company’s existing reinsurance contracts are captive reinsurance agreements in U.S. Mortgage Insurance Operations. Under captive reinsurance agreements, a portion of the risk insured by PMI is reinsured with the mortgage originator or investor through a reinsurer that is affiliated with the mortgage originator or investor. Ceded premiums for U.S. captive reinsurance accounted for 90.6% of total ceded premiums written in each of 2007 and 2006 compared to 89% in 2005. Reinsurance recoverables on losses incurred in U.S. Mortgage Insurance Operations were $35.9 million as of December 31, 2007, $2.9 million as of December 31, 2006 and $2.5 million as of December 31, 2005.
Section 832(e) of the Internal Revenue Code permits mortgage guaranty insurers to deduct, within certain limitations, additions to statutory contingency reserves. This provision allows mortgage guaranty insurers to increase statutory unassigned surplus through the purchase of non-interest bearing “tax and loss bonds” from the federal government. The tax and loss bonds purchased are limited to the tax benefit of the deduction for additions
to the contingency reserves. The Company purchased $51.0 million and $90.0 million of tax and loss bonds in 2006 and 2005, respectively, and did not purchase any tax and loss bonds in 2007. The Company redeemed tax and loss bonds of $62.7 million in 2007 and $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. The decrease in current and deferred income tax expense in 2007 as compared to 2006 is primarily attributable to the reversal of contingency reserve deductions related to tax and loss bonds.
The components of the deferred income tax assets and liabilities for the years ended are as follows:
The Company established a valuation allowance of approximately $168.1 million against a $214.3 million deferred tax asset, upon the recognition of losses from FGIC and RAM Re, in excess of tax basis. The Company did not record a full valuation against the deferred tax asset, as it is management’s expectation that some portion of the tax benefit may be realized. Additional tax benefits could be recognized in the future if management determines that realization is more likely than not to occur.
The Company adopted the provisions of FIN 48 on January 1, 2007. As a result of the implementation of FIN 48, the Company recognized an approximately $15.6 million increase in deferred tax liabilities, which was accounted for as a reduction to the January 1, 2007 balance of consolidated retained earnings. This liability was accrued upon adoption of FIN 48 and after consideration of certain 2004 California legislation relating to the taxation of insurance companies that could impact the Company’s future tax payments. Additionally, the Company has unrecognized tax benefits of approximately $2.6 million as of December 31, 2007, which if recognized, would affect the Company’s future effective tax rate. Of this total, approximately $2.5 million had been accrued as of December 31, 2006.
As of December 31, 2007, while the Company is subject to federal examination in the U.S. from 2001 through the present, the IRS has recently closed its audit for taxable years 2001 through 2003.
Rent expense for all leases was $6.4 million for 2007, $6.4 million for 2006 and $5.3 million for 2005.
Income Taxes-As of December 31, 2007, no tax issues from the recently closed audit have been presented that would, in the opinion of management, give rise to a material assessment or have a material effect on the consolidated financial condition, results of operations or cash flows of the Company.
Indemnification-SPS-As part of the sale of the Company’s interest in SPS in 2005, the Company and SPS’s other prior shareholders have indemnified CSFB for certain liabilities relating to SPS’s operations. Based
Guarantees-The PMI Group has guaranteed certain payments to the holders of the privately issued debt securities (“Capital Securities”) issued by PMI Capital I. Payments with respect to any accrued and unpaid distributions payable, the redemption amount of any Capital Securities that are called and amounts due upon an involuntary or voluntary termination, winding up or liquidation of the Issuer Trust are subject to the guarantee. In addition, the guarantee is irrevocable, is an unsecured obligation of the Company and is subordinate and junior in right of payment to all senior debt of the Company.
Funding Obligations-The Company has invested in certain limited partnerships with ownership interests greater than 3% but less than 50%. As of December 31, 2007, the Company had committed to fund, if called upon to do so, $6.7 million of additional equity in certain limited partnership investments. In addition, the Company is under no obligation to fund FGIC or RAM Re, two unconsolidated equity investees.
deemed an “extraordinary dividend” and requires the prior approval of the Director of the Arizona Department of Insurance. In December 2006, the Director of the Arizona Department of Insurance approved an extraordinary dividend request of $250 million and a $100 million installment was paid to The PMI Group in the form of a return of capital. In April 2007, an additional $200 million extraordinary dividend was approved by the Director of the Arizona Department of Insurance. In 2007, PMI paid $165 million in dividends to The PMI Group. As of December 31, 2007, there was $185 million of remaining approved dividends.
Pursuant to the support agreement described in Note 19, Capital Support Agreements, the Company has agreed that, in the event that Allstate, the Company’s former parent, makes a payment contemplated by the Allstate Support Agreements or the runoff support agreement, Allstate will have the right to receive preferred stock of The PMI Group or PMI with a liquidation preference equal to the amount of such payment. Such preferred stock will rank senior in right of payment to the issuer’s common stock and, so long as such preferred stock is outstanding, the issuer thereof will be prohibited from paying any dividends or making any other distributions on its common stock.
Prior to the plan amendment in May 2007, the discount rate used to determine the net periodic cost was 5.95%
The Company’s accumulated benefit obligation for its Retirement Plan and SERP Plan at December 31, 2007 was $72.5 million and $5.1 million, the combination of which equals the $77.6 million accumulated benefit obligation. As of December 31, 2007, the combined fair value of plan assets is approximately $13.5 million higher than our combined accumulated benefit obligation. The health care cost trend on covered charges for other postretirement benefits was 9.0% in 2007, which will be reduced to 5% in 2013.
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. The Company makes contributions that are sufficient to fully fund its actuarially determined costs, generally exceeding the minimum amounts required by the Employee Retirement Income Security Act. In January 2008, the Company contributed $10 million to the Plan.
Savings and Profit Sharing Plans-All U.S. full-time, part-time and certain temporary employees of the Company are eligible to participate in The PMI Group, Inc. Savings and Profit-Sharing Plan (“401(k) Plan”). Eligible employees who participate in the 401(k) Plan may receive, within certain limits, matching Company contributions. The Company contributions recognized as expense were $2.1 million for 2007, $3.3 million for 2006, $3.2 million for 2005. Contract underwriters are covered under The PMI Group, Inc. Alternate 401(k) Plan, under which there are no matching Company contributions. In addition to the 401(k) Plan, the Company has an officers’ deferred compensation plan available to certain employees. The obligation related to the deferred compensation plan was $17.7 million and $22.5 million as of December 31, 2007 and 2006, respectively, and is included in other liabilities and accrued expenses.
As SFAS No. 123R requires that share-based compensation expense be based on awards that are ultimately expected to vest, share-based compensation for the year ended December 31, 2007 has been reduced for estimated forfeitures. The Company is required to estimate forfeitures at the time of grant and revise those estimates in subsequent periods if actual forfeitures differ from those estimates. The Company uses historical data to estimate pre-vesting option forfeitures and record share-based compensation expense only for those awards that are expected to vest.
SFAS No. 123R requires cash flows resulting from gross excess tax benefits to be classified as a part of cash flows from financing activities. Excess tax benefits are realized tax benefits from tax deductions for exercised options in excess of the deferred tax asset attributable to share compensation costs for such options. Cash received from option exercises and the ESPP for the years ended December 31, 2007, 2006 and 2005, was $27.3 million, $41.6 million and $20.7 million, respectively. The actual tax benefit realized for the tax deductions from option exercise of the share-based payment arrangements totaled $7.0 million, $6.2 million and $3.8 million, respectively.
A summary of the share-based compensation activity under the Equity Incentive Plan as of December 31, 2007, 2006 and 2005 and changes during the three years then ended is presented below:
The total intrinsic value of options exercised during 2007, 2006 and 2005, was $19.8 million, $18.7 million, $11.4 million, respectively. The weighted-average remaining contractual life of options outstanding as of December 31, 2007 and vested and exercisable as of December 31, 2007 was 6.1 and 4.6 years, respectively. There was no aggregate intrinsic value for the options outstanding as of December 31, 2007 or for the options vested and exercisable as of December 31, 2007.
On October 27, 1994, Allstate Support Agreements were terminated with respect to policies issued after October 27, 1994, but continue in modified form (as so modified, the “Runoff Support Agreement”) for policies written prior to such termination. Under the terms of the Runoff Support Agreement, Allstate may, at its option, either directly pay or cause to be paid, claims relating to policies written during the terms of the respective Allstate Support Agreements if PMI fails to pay such claims or, in lieu thereof, make contributions directly to PMI or The PMI Group. In the event any amounts are paid or contributed, the likelihood of which management believes is remote, Allstate would receive subordinated debt or preferred stock of PMI or The PMI Group in return. No payment obligations have arisen under the Runoff Support Agreement. As of December 31, 2007, less than $372 million of risk in force was subject to the Runoff Support Agreement.