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, Germany, Belgium, Canada, Australia, New Zealand, and Hong Kong.
Statements made or incorporated by reference from time to time in this document, other documents filed with the Securities and Exchange Commission, press releases, conferences or otherwise that are not historical facts, or are preceded by, followed by or that include the words “believes,” “expects,” “anticipates,” “estimates” or similar expressions, and that relate to future plans, events or performance are “forward-looking” statements within the meaning of the federal securities laws.
U.S. Mortgage Insurance Operations. We offer mortgage insurance products in the U.S. that enable borrowers to buy homes with low down payment mortgages. Net income from U.S. Mortgage Insurance Operations was $290.3 million in 2006 and $275.4 million in 2005, and includes PMI Mortgage Insurance Co. and its affiliated U.S. mortgage insurance and reinsurance companies (collectively, “PMI”), and equity in earnings from PMI’s joint venture, CMG Mortgage Insurance Company and its affiliated companies (collectively, “CMG MI”).
International Operations. We offer mortgage insurance and other credit enhancement products in Australia, New Zealand, Europe, and Asia. Net income from our International Operations segment was $103.5 million in 2006 and $105.5 million in 2005.
Financial Guaranty. We are the lead investor in FGIC Corporation, whose wholly-owned subsidiary, Financial Guaranty Insurance Company (“FGIC”), provides financial guaranty insurance. We also have a significant interest in RAM Reinsurance Company, Ltd., or RAM Re, a financial guaranty reinsurance company based in Bermuda, and its holding company, RAM Holdings Ltd. Our Financial Guaranty segment also includes PMI Guaranty Co., a wholly-owned surety company based in New Jersey. PMI Guaranty was formed in 2006 to provide financial guaranty insurance, financial guaranty reinsurance and related credit enhancement products and services. Net income from our Financial Guaranty segment was $97.3 million in 2006 and $72.2 million in 2005.
New Insurance Written (NIW). PMI’s NIW decreased by 10.3% in 2006 compared to 2005. The decrease reflects a 17.5% decrease in NIW generated by PMI’s flow channel. We believe that the decrease in PMI’s flow channel NIW was primarily driven by increasingly competitive pricing, higher concentrations of loans in the 2006 private mortgage insurance market of a type or credit quality that PMI has traditionally not insured through our flow channel to a great extent, and a reduction in the size of the flow private mortgage insurance market. We believe the size of the flow private mortgage insurance market has been negatively impacted by lenders’ use of alternative mortgage products which do not require mortgage insurance and higher levels of loans originated and sold to non-agency investors which do not generally require mortgage insurance at the point of loan origination. In late 2006, Congress enacted legislation that provides for the tax deductibility, under certain circumstances, of borrower-paid mortgage insurance premiums relating to loans closed on or after January 1, 2007. We believe this legislation may positively impact flow NIW in 2007. NIW from PMI’s structured finance channel increased 15.8% in 2006 compared to 2005 due to increased customer opportunities as a result of the favorable mortgage-backed securities (“MBS”) market.
Investment Income. In 2006, PMI obtained authorization to dividend $500 million to its parent, The PMI Group. PMI paid $350 million in dividends to The PMI Group in 2006. Due to the dividends paid in 2006 and expected dividends to be paid in 2007, the size of PMI’s investment portfolio, and corresponding investment income for U.S. Mortgage Insurance Operations, will be reduced in 2007.
Regulatory and Legislative Environment. At any point in time, there are multiple regulatory proposals and initiatives that could significantly affect the mortgage insurance industry as well as PMI’s business. We may also be impacted by changes in statutes and regulations affecting the GSEs, financial institutions and capital market participants.
PMI Europe. PMI Europe’s net income was $11.9 million in 2006 compared to $9.8 million in 2005. This increase in PMI Europe’s net income in 2006 was due in part to an increase in other income arising from changes in the fair value of its credit default swap derivative contracts. The increase in income from changes in the fair value of credit default swap derivative contracts was primarily due to mark-to-market gains, including accretion from deferred gains on existing contracts and five new contracts entered into during 2006. The increase in net income in 2006 was partially offset by a reduction in premiums earned associated with the acquired Royal & Sun Alliance (“R&SA”) portfolio and increases in losses and LAE. In accordance with our established earnings pattern, which is based upon management’s estimation of the expiration of the R&SA portfolio’s risk, we expect that premiums earned and risk in force associated with the portfolio to continue to decline in 2007 and through the remaining life of the portfolio. However, we expect the decline in premiums earned on this portfolio will be offset, at least in part, by premiums earned on new primary flow business written throughout Europe. In the second quarter of 2006, PMI Europe and R&SA terminated the sharing of future economic benefits with respect to the portfolio’s loss performance.
PMI Canada. We are forming a wholly-owned Canadian subsidiary, PMI Canada, with headquarters in Toronto, Ontario. We expect PMI Canada to begin offering residential mortgage insurance products to Canadian lenders and mortgage originators in the first half of 2007.
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 the functional currencies of the Australian dollar, Euro and Hong Kong dollar. The change in the average foreign currency exchange rates (primarily the weakening of the Australian dollar against the U.S. dollar) from 2005 to 2006 reduced our International Operations’ 2006 net income by (i) $1.2 million and (ii) a $1.3 million pre-tax decrease in the fair value of our foreign currency put options.
reserves recorded in 2005, and higher investment income. FGIC’s financial performance is affected by, among other things, interest rate movements, which may generate refundings, the volume of issuance in the public and structured finance markets and FGIC’s ability to penetrate these markets. FGIC’s refunding premiums were $41.8 million in 2006 compared to $54.8 million for 2005.
RAM Re. Equity in earnings from RAM Re was $8.7 million in 2006 compared to $4.8 million in 2005. This increase was due primarily to higher premiums earned, release of loss reserves in 2006 and an increase in net investment income.
PMI Guaranty. PMI Guaranty began operations in the fourth quarter of 2006. PMI Guaranty’s net income (pre-tax) for the year ended December 31, 2006 was $0.8 million.
Hurricane Katrina. As of December 31, 2006, FGIC had Katrina-related net reserves of $8.7 million, representing a $11.4 million decrease from December 31, 2005 in net reserves related to credits affected by Hurricane Katrina. FGIC’s loss reserve will likely be adjusted in the future as additional information concerning such credits becomes available. Any such adjustments may have a material impact on the results of operations of and our equity in earnings from FGIC Corporation. As of December 31, 2006, RAM Re had $26.6 million of par amount of exposure on its watch list related to exposures affected by Hurricane Katrina. We cannot predict whether FGIC or RAM Re will ultimately incur losses or will record additional reserves in the future as a result of Hurricane Katrina.
Share-Based Compensation. In 2006, we adopted SFAS No. 123R, which requires us to record the fair value of share-based awards, including stock options and our Employee Stock Purchase Plan (“ESPP”) shares to employees, in our consolidated statements of operations effective January 1, 2006. During 2006, our Corporate and Other segment incurred $12.2 million (pre-tax) in compensation expense relating to unvested and outstanding stock options and the ESPP. The after tax charge related to this item was $9.4 million in 2006. Due to our acceleration of out-of-the-money stock options in 2005, our expenses in 2006 were reduced and our expenses in 2007 will be higher by approximately $3 million to $5 million (after tax).
The increase in premiums earned in 2006 compared to 2005 was primarily due to increases in premiums earned from PMI Australia and our U.S. Mortgage Insurance Operations segment. 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 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 increase in premiums earned in 2005 compared to 2004 was due to increases in premiums earned from U.S. Mortgage Insurance Operations, primarily as a result of higher average premiums rates and the recognition of premiums associated with loan cancellations under non-refundable single and annual premium policies, and from PMI Australia, as a result of insurance in force growth.
Our income related to credit default swaps was generated by gains related to changes in the fair value of PMI Europe’s credit default swap transactions. Currently, PMI Europe is party to eleven transactions classified as derivatives. PMI Europe’s income increased from these transactions in 2006 in comparison to 2005 primarily due to risk written through new swaps in 2006 and increases in mark-to-market gains on existing derivatives.
The decreases in other income in 2006 compared to 2005, and 2005 compared to 2004, were largely attributable to lower fees generated by our contract underwriting revenues in our Corporate and Other segment. Contract underwriting fees decreased in 2006 and 2005 primarily due to declines in customer requests for our contract underwriting services and lower levels of mortgage refinance activity in 2006.
The decreases in amortization of deferred policy acquisition costs in 2006 and 2005 compared to their prior years were due to lower levels of amortization in our U.S. Mortgage Insurance Operations. U.S. Mortgage Insurance Operations’ deferred policy acquisition cost asset was $43.5 million, $48.3 million and $54.0 million as of December 31, 2006, 2005 and 2004, respectively. These decreases were due primarily to cost savings realized from our U.S. field office restructurings in 2004 and 2006, and declines in NIW in 2005 and 2006.
The increase in other underwriting and operating expenses in 2006 compared to 2005 was primarily due to $12.2 million (pre-tax) of compensation expenses relating to our adoption of SFAS No. 123R in 2006, a $6.2 million (pre-tax) settlement accounting charge required due to a lump-sum distribution from our Supplemental Employee Retirement Plan, partially offset by cost savings from our field office restructurings. The increase in other underwriting and operating expenses in 2005 compared to 2004 was due primarily to higher operating expenses in our International Operations as a result of higher R&SA profit sharing commission accruals by PMI Europe and an increase in PMI Australia’s expenses related to payroll and regulatory compliance.
The increase in interest expense in 2006 compared to 2005 was primarily due to debt and equity financing activities during 2006. The decrease in interest expense in 2005 compared to 2004 was primarily due to the capitalization of interest expenses related to internally developed software.
Premiums written and earned-PMI’s net premiums written refers to the amount of premiums recorded based on effective coverage during a given period, net of refunds and premiums ceded primarily under captive reinsurance agreements. 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, portions of PMI’s gross premiums written are ceded to those captive reinsurance companies. PMI’s premiums earned refers to the amount of premiums recognized as earned, net of changes in unearned premiums. The components of PMI’s net premiums written and premiums earned are as follows:
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 average premium rate increased in 2006 as a result of changes in the business mix of PMI’s portfolio. PMI’s average insured loan balances increased primarily due to home price appreciation. The increases in gross and net premiums written in 2005 compared to 2004 were primarily due to the two single premium transactions written in the fourth quarter of 2005.
As of December 31, 2006, 63.5% of primary flow insurance in force and 64.4% of primary flow risk in force were subject to captive reinsurance agreements compared to 61.7% and 63.1% as of December 31, 2005. These increases are the result of a higher portion of new flow insurance written with customers with whom we have captive reinsurance agreements. NIW generated through PMI’s structured finance channel is generally not subject to captive reinsurance agreements.
PMI’s premiums earned increased in 2006 compared to 2005 as a result of higher average premium rates in 2006. This increase was partially offset by lower levels of earned premiums associated with loan cancellations of single premium policies and lower levels of NIW. PMI’s premiums earned increase in 2005 compared to 2004 primarily as a result of higher average premium rates in 2005 and the release in 2005 of unearned premiums to earned from the cancellation of annual and single premium policies.
Net investment income-Net investment income remained relatively flat in 2006 compared to 2005. U.S. Mortgage Insurance Operations’ investment portfolio, including cash and cash equivalents was $2.0 billion at December 31, 2006 compared to $2.1 billion at December 31, 2005 and 2004. The decrease in 2006 was primarily due to dividends paid by PMI to its parent. The pre-tax book yield for U.S. Mortgage Insurance Operations was 5.34% at December 31, 2006, 5.21% at December 31, 2005 and 5.14% at December 31, 2004. The increases in the pre-tax book yield in 2006 compared to 2005, and 2005 compared to 2004, were primarily due to higher interest rates.
Equity in earnings from unconsolidated subsidiaries-U.S. Mortgage Insurance Operations’ equity in earnings are derived entirely from the results of operations of CMG MI. Equity in earnings from CMG MI increased in 2006 and 2005 compared to their respective prior years primarily as a result of higher premiums earned due to insurance in force and risk in force growth.
The decrease in claims paid including LAE in 2006 compared to 2005 was primarily due to the decrease in the number of primary claims paid in 2006, offset by higher claim sizes in 2006. The decrease in the number of primary claims paid in 2006 was due in part to additional claims paid in 2005 that were previously delayed by bankruptcy protection. The higher average primary claim size in 2006 was a result of higher average loan sizes and coverage levels in PMI’s insurance in force. The increase in claims paid including LAE in 2005 compared to 2004 was due to a number of factors, including the seasoning of PMI’s primary insurance portfolio’s largest book years, an increased number of claims paid that were previously delayed by bankruptcy protection and higher claim rates associated with the portion of PMI’s portfolio that contains ARMs, high LTV, Alt-A, and less-than-A quality loans. (See Credit and Portfolio Characteristics).
The decrease in PMI’s primary default rate as of December 31, 2006 compared to December 31, 2005 was primarily due to a decline in the number of primary loans in default, offset by a decrease in the number of primary insurance policies in force. The decrease in flow loans in default was primarily due to high cure rates associated with approximately 3,500 loans in default from hurricane impacted areas in 2005. Higher concentrations of Alt-A and high LTV loans contributed to the increase in structured loans in default as of December 31, 2006 compared to December 31, 2005.
Total pool loans in default (which includes modified and other pool products) as of December 31, 2006, 2005 and 2004 were 15,898, 20,379 and 17,186, respectively. The default rates for total pool loans as of December 31, 2006, 2005 and 2004 were 4.24%, 6.84% and 5.50%, respectively.
PMI incurs underwriting expenses related to contract underwriting services for mortgage loans without mortgage insurance coverage. These costs are allocated to PMI Mortgage Services Co., or MSC, which is reported in our Corporate and Other segment, thereby reducing PMI’s underwriting and operating expenses. Contract underwriting expenses allocated to MSC were $12.7 million in 2006, $18.7 million in 2005 and $26.1 million in 2004. The declines in allocated expenses were due to decreases in contract underwriting activity.
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 2006 compared to 2005 was primarily due to the decrease in total underwriting and operating expenses described above, partially offset by a decrease in net premiums written in 2006 compared to 2005. The decrease in PMI’s expense ratio in 2005 compared to 2004 was due to the increase in PMI’s net premium written and a decline in the amortization of deferred policy acquisition costs. Excluding the re-allocation of costs to our Corporate and Other segment described above, PMI’s expense ratio would have been approximately 24.3% for 2006. The combined ratio is the sum of the loss ratio and the expense ratio.
The decrease in PMI’s primary NIW in 2006 compared to 2005 was primarily driven by increasingly competitive flow pricing, higher concentrations of loans in the 2006 private mortgage insurance market of a type or credit quality that PMI has traditionally not insured through our flow channel to a great extent, and a reduction in the size of the flow private mortgage insurance market. The decrease in PMI’s primary NIW in 2005 compared to 2004 was driven by a decrease in the size of the flow private mortgage insurance market, partially offset by increased opportunities for structured transactions. We believe the size of the flow private mortgage insurance market was negatively impacted by lenders’ use of alternative mortgage products that do not require mortgage insurance and an increase in the level of loans originated and sold to non-agency investors as a percentage of the total origination market.
Modified pool insurance-PMI currently offers modified pool insurance products that may be attractive to investors and lenders seeking a reduction in the severity of the impact of borrower default beyond the protection provided by existing primary insurance or with respect to loans that do not require primary insurance, or for capital relief purposes. In 2006, PMI wrote $0.7 billion of modified pool risk, compared to $0.3 billion in 2005 and $0.2 billion in 2004. Modified pool risk in force was $2.5 billion at December 31, 2006, $1.8 billion at December 31, 2005 and $1.5 billion at December 31, 2004.
As shown by the above table, PMI’s primary risk in force at December 31, 2006 contained higher percentages of Alt-A loans, high LTV loans, interest only loans and payment option ARMs. We believe that these increases reflect the higher concentrations of these types of loans in the mortgage origination and private mortgage insurance markets.
International Operations’ results include our Australian subsidiaries, collectively referred to as PMI Australia; our Irish subsidiaries, collectively referred to as PMI Europe; and PMI Asia.
The decrease in International Operations’ net income in 2006 compared to 2005 was primarily due to higher losses and LAE in PMI Australia. The decrease in International Operations’ net income in 2006 was 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. International Operations’ net income increased in 2005 compared to 2004 primarily due to increases in PMI Australia’s premiums earned and net investment income.
In 2006 and 2005, 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 and the Euro in those years. The options had an aggregate pre-tax cost of $1.4 million and $1.8 million in 2006 and 2005, respectively. International Operations’ net income in 2006 and 2005 was reduced by $1.3 million pre-tax and $1.1 million pre-tax, respectively, related to the cost, net of realized gains, of our foreign currency put options. We have entered into a similar foreign exchange put option program in 2007 at a pre-tax cost of $1.3 million.
The average annual AUD/USD currency exchange rate was 0.7535 in 2006, 0.7621 in 2005 and 0.7370 in 2004. The change in the average AUD/USD currency exchange rates from 2005 to 2006 negatively impacted PMI Australia’s net income by $1.3 million in 2006, and the change in the average AUD/USD currency exchange rates from 2004 to 2005 favorably impacted PMI Australia’s net income by $2.8 million in 2005.
Net income from PMI Australia in 2006, 2005 and 2004 includes pre-tax foreign currency put option costs of $1.2 million, $1.6 million and $1.5 million, respectively.
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. The decrease in NIW in 2005 compared to 2004 was primarily due to slowing Australian mortgage origination and residential mortgage backed securities markets, competitive pricing, and the restructuring of a captive reinsurance arrangement causing a customer’s affiliated captive reinsurer to retain
more mortgage default risk. The increases in insurance in force and risk in force at December 31, 2006 compared to December 31, 2005, and December 31, 2004, were driven by NIW. Low Doc loans represented 7.9%, 7.8% and 5.0% of PMI Australia’s risk in force as of December 31, 2006, 2005 and 2004, respectively.
The following table sets forth the results of PMI Europe for the years ended:
Losses and LAE-PMI Europe’s losses and LAE increased in 2006 compared to 2005. PMI Europe’s losses and LAE over the periods presented were driven primarily by reserves posted for non-derivative accounted credit default swap transactions. PMI Europe increased its loss reserves by $1.4 million and $0.9 million as of December 31, 2006 and 2005, respectively, primarily due to lower than expected cure rates and higher loss severities, offset in part by decreases in reserves associated with the favorable claims performance of the R&SA portfolio. Claims, excluding claim payments from credit default swaps accounted for as derivatives, totaled $1.9 million in 2006, $1.0 million in 2005, and $0.6 million in 2004.
Premiums written and earned-Effective June 30, 2006, PMI Asia assumed all mortgage risk previously ceded to PMI. The decrease in gross reinsurance premiums written in 2006 compared to 2005 was due primarily to a decrease in mortgage origination activity in Hong Kong and the increased retention of risk by a leading customer. In 2005 and 2006, this customer increased, and will increase further in 2007, the percentage of mortgage insurance risk and associated premiums that it retains, thereby negatively impacting PMI Asia’s reinsurance premiums written.
Net investment income-Net investment income increased in 2006 as compared to 2005 due primarily to growth in PMI Asia’s investment portfolio and higher book yields in connection with the transfer of our Hong Kong branch’s mortgage reinsurance portfolio to PMI Asia. As of December 31, 2006, PMI Asia has total cash and investments of $62.4 million.
The increase in equity in earnings from FGIC Corporation in 2006 compared to 2005 was primarily due to increases in premiums earned, release of loss reserves associated with Hurricane Katrina, and higher investment income, offset by higher interest expenses. The increase in equity in earnings from FGIC Corporation in 2005 compared to 2004 was primarily due to increases in premiums earned and net investment income, partially offset by increases in underwriting expense and losses and LAE due to Hurricane Katrina reserves recorded in 2005.
The increase in equity in earnings from RAM Re in 2006 compared to 2005 was due primarily to increases in premiums earned and net investment income, and a decrease in losses and LAE. The decrease in equity in earnings from RAM Re in 2005 compared to 2004 was due primarily to unrealized losses associated with certain credit derivatives and increases in operating expenses.
The table below shows the main components of FGIC’s 2006, 2005, and 2004 results.
Premiums written and earned-Net premiums written decreased in 2006 compared to 2005 primarily due to a decrease in FGIC’s U.S. public finance premiums written, partially offset by growth in international finance and structured finance transactions. 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 $41.8 million in 2006, $54.8 million in 2005, and $42.7 million in 2004. 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 premiums written and earned increased in 2005 compared to 2004 primarily due to growth in FGIC’s U.S. public finance and structured finance portfolios and, to a lesser extent, growth in its international finance portfolio.
Net investment income-Net investment income increased to $139.7 million in 2006 from $118.8 million in 2005 and $98.0 million in 2004, 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 3.9% as of December 31, 2006, 3.8% as of December 31, 2005, and 3.5% as of December 31, 2004.
The results of our Corporate and Other segment include income and operating expenses related to contract underwriting, and net investment income, interest expense and corporate overhead of The PMI Group, our holding company. Equity in earnings from SPS in 2004 was included in this segment in equity in (losses) earnings from unconsolidated subsidiaries. As a result of the sale of our interest in SPS in October 2005, equity in earnings or losses from our investment in SPS in 2005 was included in this segment in other income. The Corporate and Other segment in 2004 also included the results from, and realized gain on sale of, the discontinued operations of APTIC. Our Corporate and Other segment results are summarized as follows:
Total other operating expenses-Total other operating expenses for the segment increased in 2006 compared to 2005 primarily due to $12.2 million (pre-tax) of additional compensation expenses in 2006 related to our adoption of SFAS No. 123R, $7.5 million of reallocated expenses from U.S. Mortgage Insurance Operations to our Corporate and Other segment, and a $5.5 million (pre-tax) settlement accounting charge related to a lump-sum distribution from our Supplemental Employee Retirement Plan. SFAS No. 123R requires the measurement of all share-based compensation to employees, including grants of employee stock options, using a fair-value-based method, and the recording of such expense in our consolidated statements of operations. We were required to adopt SFAS No. 123R effective January 1, 2006. The reallocation increase relates to a 2006 refinement in our allocation of operating expenses between our business segments. The lump-sum distribution triggered settlement accounting under SFAS No. 88, to revalue our pension-related liabilities in 2006. The decrease in other operating expenses in 2005 compared to 2004 was due primarily to reductions in contract underwriting expenses due to lower levels of contract underwriting, partially offset by an increase in contract underwriting remedies from $10.0 million in 2004 to $14.5 million in 2005. Contract underwriting remedies in 2006 totaled $12.4 million.
Interest expense-Interest expense increased in 2006 compared to 2005 due primarily to higher average debt levels related to our capital initiatives in 2006, including interest on our $345 million bridge loan which was repaid in the fourth quarter of 2006, and lower interest expense in 2005 due to capitalized interest for internally developed software costs. (See Liquidity and Capital Resources - Debt and Equity Financing, below.)
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 that restrict their ability to pay dividends, incur debt or issue equity securities.
In the normal course of business, we evaluate The PMI Group’s capital and liquidity needs in light of its debt-related costs, holding company expenses, our dividend policy, and rating agency considerations. If we wish to provide additional capital to our existing operations, make new equity investments or increase our existing equity investments, we may need to increase the cash and investment securities held by The PMI Group. Our ability to raise additional funds for these purposes will depend on our ability to access the debt or equity markets and/or cause our insurance subsidiaries to pay dividends, subject to rating agency and insurance regulatory considerations and risk-to-capital limitations.
U.S. Mortgage Insurance Operations Liquidity-The principal uses of U.S. Mortgage Insurance Operations’ liquidity are the payment of operating expenses, claim payments, taxes, dividends to The PMI Group and the growth of its investment portfolio. The principal sources of U.S. Mortgage Insurance Operations’ liquidity are written premiums and net investment income. During the second quarter of 2006, CMG MI paid a dividend of approximately $35 million to its two stockholders, of which $17.5 million was paid to PMI. We have reached an agreement with CUNA Mutual Group, CMG MI’s other equity owner, to cause CMG MI to dividend to its parents approximately $37 million of dividends in 2007, subject to regulatory and rating agency approval. PMI will receive 50% of any dividend from CMG MI.
In October 2006, we entered into a $400 million revolving credit facility and terminated our then-existing $175 million revolving credit facility. Our $400 million revolving credit facility can be utilized for working capital, capital expenditures and other business purposes. The facility may be increased to $500 million at our request subject to approval by the lenders. The facility includes a $50 million letter of credit sub-limit. The 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 $1.7 million outstanding under the revolving credit facility as of December 31, 2006.
PMI’s ability to pay dividends to The PMI Group is affected by state insurance laws, credit agreements, credit 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. On June 7, 2006, the Director of the Arizona Department of Insurance approved an extraordinary dividend request of $250 million. This dividend was paid to The PMI Group in two installments of $150 million in August of 2006 and $100 million in September of 2006, respectively. On December 14, 2006, the Director of the Arizona Department of Insurance approved an additional extraordinary dividend request of $250 million. In December 2006, a $100 million installment was paid to The PMI Group in the form of a return of capital. The second installment of the approved $250 million dividend is expected to be paid in the first half of 2007.
PMI’s ability to pay dividends is also subject to restriction under the terms of a runoff support agreement with Allstate. Under the Allstate agreement, PMI may not pay a dividend if, after the payment of that dividend,
PMI’s risk-to-capital ratio would equal or exceed 23 to 1. As of December 31, 2006, PMI’s risk-to-capital ratio was 8.1 to 1 compared to 8.2 to 1 at December 31, 2005 and 8.2 to 1 at December 31, 2004.
In addition, so long as any senior preferred stock or class B common stock issued upon conversion of that preferred stock is outstanding, FGIC Corporation’s certificate of incorporation generally prohibits the payment of dividends or other payments on any of FGIC Corporation’s capital stock, except the senior preferred stock, without the consent of the holder of two-thirds of the outstanding shares of that preferred stock (or the class B common stock issued upon conversion of that preferred stock). This restriction does not apply to cash dividends declared and paid on the class A common stock after the ninth anniversary of the closing of the FGIC Corporation investment provided that those dividends are paid from retained earnings in excess of the amount of FGIC Corporation’s retained earnings on the closing date of such investment, the amount of the dividends in any fiscal year does not exceed one-third of one percent of FGIC Corporation’s stockholders’ equity and equivalent dividends are paid on the class B common stock.
Under certain circumstances, when we make an underwriting error in the course of providing contract underwriting services to a customer, we issue to the customer a loan indemnification. Such an indemnification is in lieu of paying a monetary remedy to the customer at the time the underwriting error is discovered and is usually issued on a loan by loan basis. While the terms of the indemnifications vary, each indemnification generally requires us to reimburse the customer for certain costs (excess of insurance recoverables) it incurs as a result of the borrower’s default on the loan in question. If the indemnified loan remains current, or is repaid or refinanced, we have no actual liability under the indemnification. As of December 31, 2006, we estimate that the total principal balance of indemnified loans was between approximately $44 million and $48 million. We believe a number of factors will cause our contingent liability with respect to these indemnifications to be significantly lower than this amount. These factors include the following: (i) we generally only indemnify performing loans; (ii) we expect only a small portion of the indemnified loans to default; (iii) loans in default may not cause our customers to incur losses due to home appreciation; and (iv) we expect a portion of these loans to be refinanced, or their indemnification coverage to expire. In 2006, we paid customers $0.6 million pursuant to loan indemnifications compared to approximately $1.1 million in 2005. These amounts are included in our expenses associated with contract underwriting remedies.
As part of the sale of our interest in SPS in October 2005, we and SPS’s other prior shareholders indemnified CSFB for specified liabilities relating to SPS's operations, including certain litigation and regulatory actions. This indemnification obligation could potentially reduce the monthly proceeds that we expect to receive from CSFB in 2006 through 2008. The maximum indemnification obligation for SPS's operations is approximately $34 million. Our portion of this maximum obligation is 61.4% or $20.7 million. As of December 31, 2006, we have a $6.4 million liability related to this indemnification obligation.
The changes in unrealized gains in 2006 and 2005 were due primarily to increases in interest rates that caused market value declines relative to our consolidated fixed income portfolio. The change in unrealized gains in 2004 was due to declines in interest rates. As interest rates, market and other economic conditions change, we expect the market value of the securities in our consolidated investment portfolio and of our unconsolidated equity investments to be affected.
The following table summarizes the estimated fair value of the consolidated investment portfolio as of December 31, 2006 and 2005. Amounts shown under “Corporate and Other” include the investment portfolio of The PMI Group, and amounts shown under “Financial Guaranty” include 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, 2006, the fair value of these securities in our consolidated investment portfolio increased to $3.3 billion from $3.2 billion at December 31, 2005. The increase was due primarily to positive cash flows from consolidated operations and increases in foreign currency translation rates.
The following table summarizes the rating distributions of our consolidated investment portfolio as of December 31, 2006.
The following table summarizes the pre-tax book yield of our consolidated investment portfolio by segment as of December 31, 2006, 2005 and 2004.
As of December 31, 2006, our consolidated shareholders’ equity was $3.6 billion. The carrying value of our long-term debt outstanding issued by The PMI Group at December 31 was as follows:
Prior to August 10, 2006, the interest rate on these Senior Notes was 3.0%. Pursuant to the remarketing that occurred on August 10, 2006, the interest rate was increased to 5.568%.
In September 2006, we delivered a notice of redemption to the holders of the old debentures and the new debentures. Holders of $3,000 principal amount of the old debentures and $339,000 principal amount of the new debentures converted their debentures in connection with the call for redemption. On October 27, 2006, we
On August 23, 2006, The PMI Group entered into a bridge loan credit agreement with an affiliate of the financial institution pursuant to which we borrowed $345 million to fund the purchase of the common shares pursuant to any common share repurchase program we entered into with the financial institution or any of its affiliates, including, without limitation the common share repurchase programs described above. Amounts borrowed under the bridge loan credit agreement were repaid in November 2006.
The 6.75% Senior Notes described above relate to our issuance in November 1996 of $100.0 million in principal amount of 6.75% senior notes. We repaid the Senior Notes at maturity in November 2006. The 8.309% Junior Subordinated Debentures described above are redeemable at our option beginning in the first quarter of 2007.
On a consolidated basis, our principal sources of funds are cash flows generated by our insurance subsidiaries, investment income derived from our investment portfolios and debt and equity financings by The PMI Group as described above. It is one of the goals of our cash management policy 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.
Consolidated cash flows used in investing activities, including purchases and sales of investments, investments in unconsolidated subsidiaries and capital expenditures, were $92.5 million due primarily to increased purchases of fixed-income and equity securities, partially offset by the change in short term investments, and distributions net of investments from unconsolidated subsidiaries. Cash flows provided by investing activities in 2005 were $174.2 million due to the reduction in investing activity in 2005 to achieve a higher level of liquidity to fund common share repurchases and extraordinary dividends to The PMI Group from PMI.
Consolidated cash flows used in financing activities, including purchases of common shares, proceeds from issuance of long-term debt and equity, repayment of long-term debt, and dividends paid to shareholders, were $503.1 million in 2006 compared to $237.9 million of cash flows in 2005. The difference was due primarily to repurchase of common shares and repayment of long-term capital instruments in 2006.
The rating agencies have assigned the following ratings and outlooks to The PMI Group and certain of its subsidiaries:
Any significant downgrades in our ratings may adversely affect FGIC’s ratings. FGIC’s ability to attract new business and to compete with other triple-A rated financial guarantors is largely dependent on its triple-A financial strength ratings. Also, the shareholders agreement entered into in connection with the acquisition of FGIC Corporation provides that The PMI Group will not acquire a majority of the voting stock of FGIC Corporation or cause its designees to constitute a majority of FGIC Corporation’s Board of Directors unless, at the time of such action, S&P, Fitch and Moody’s, as applicable, reaffirm FGIC’s then current financial strength rating and outlook and FGIC Corporation’s then current senior unsecured debt rating and outlook. The value of our investment in FGIC Corporation, and our ability to increase our ownership interest in FGIC Corporation in the future, to the extent opportunities arise to do so, depend in part on The PMI Group’s and PMI’s ratings and on the views of the rating agencies with respect to any such transactions. Any downgrade in our ratings could also negatively impact the ratings of PMI Australia, PMI Europe, PMI Guaranty, and CMG MI, which could place them at a competitive disadvantage.
“Management’s Discussion and Analysis of Financial Condition and Results of Operation,” as well as disclosures included elsewhere in this Annual Report on Form 10-K, 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.
The following table shows the reasonable range of loss and LAE reserves, as determined by our actuaries, and recorded reserves for losses and LAE (gross of reinsurance recoverables) as of December 31, 2006 and December 31, 2005 on a segment and consolidated basis:
The $2.2 million and $6.3 million increases, and $5.9 million reduction in 2006, 2005 and 2004 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. 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 or ultimate claim rates. The $2.2 million increase in prior years’ reserves during 2006 was due primarily to 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. The $5.9 million reduction in prior years’ reserves during 2004 was due primarily to a reduction in the incurred but not reported estimate and to a lesser extent our reallocation of reserves between 2003 and 2002.
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 annual report, our actuaries determined an actuarial range for PMI Australia’s reserves for losses and LAE, at December 31, 2006, of $26.5 million to $35.9 million. As of December 31, 2006, PMI Australia’s recorded reserves for losses and LAE were $30.4 million, which represented our best estimate. In arriving at this estimate, we reviewed the key assumptions described above and the work performed by our actuaries. Our estimate of $30.4 million represents an increase of $21.9 million from PMI Australia’s reserve balance of $8.5 million at December 31, 2005. This increase was due to, among other factors, an increase in PMI Australia’s default inventory in 2006 and increases in expected average claim sizes and claim rates.
PMI Asia’s loss reserves at December 31, 2006 were $0.2 million. Our actuaries calculated a range for PMI Asia’s loss reserves at December 31, 2006 of $0.2 to $0.3 million.
The following table shows a breakdown of International Operations’ loss and LAE reserves for the years ended:
The following table provides a reconciliation of our International Operations segment’s beginning and ending reserves for losses and LAE for each of the last three years:
The increase in total incurred of $10.0 million in 2006 relating to prior years was primarily due to our re-estimate of expected claim sizes and claim rates for PMI Australia as a result of interest rate increases in 2006 and moderating or declining home price appreciation in 2005 and 2006. The reductions in losses and LAE incurred relating to prior years of $9.1 million and $5.2 million in 2005 and 2004, respectively, were 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.
management’s current assessment of the factors noted above. If that assessment changes in the future, we may ultimately record a loss after having originally concluded that the decline in value was temporary.
premiums. A portion of revenue on single premiums is recognized in premiums earned in the current period, and the remaining portion is deferred as unearned premiums and earned over the expected life of the policy. If single premium policies related to insured loans are cancelled due to repayment by the borrower, and the premium is non-refundable, then the remaining unearned premium related to each cancelled policy is recognized to earned premiums upon notification of the cancellation. The earnings pattern for single premium products is based on a range of seven to fifteen years, and the rates used to determine the earnings of single premiums are estimates based on actuarial analysis of the expiration of risk. Single premiums written accounted for 20.7%, 21.5% and 19.0% of gross premiums written in 2006, 2005 and 2004, respectively, and came predominantly from PMI Australia in our International Operations segment. The premium earnings process generally begins upon receipt of the initial premium payment. The premiums earnings pattern methodology is an estimation process and, accordingly, we review the 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.
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. Generally, in order for policy cancellations to create an impairment of policy acquisition costs related to our monthly and annual products, we estimate that, due principally to scheduled amortization, our annual cancellation rate would need to exceed 60% before it would become probable that deferred policy costs associated with PMI’s monthly and annual premium policies would not be recoverable. Since 1993, PMI’s highest annual cancellation rate was 56%, which occurred in 2003. No impairment for monthly or annual policies was recognized for that year. 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. Deferred policy acquisition costs are reviewed periodically to determine that they do not exceed recoverable amounts, after considering investment income.
We currently use the Black-Scholes option pricing model to determine the fair value of stock options and employee stock purchase plan shares. The determination of the fair value of share-based payment awards on the date of the grant using an option-pricing model is affected by our share price as well as assumptions regarding a number of complex and subjective variables. These variables include our expected share price volatility over the expected term of the awards, actual and projected employee stock option exercise behaviors, the risk-free interest rate and expected dividends.
If factors change and we employ different assumptions for estimating stock-based compensation expense in future periods or if we decide to use a different valuation model, the future periods may differ significantly from what we have recorded in the current period and could affect our consolidated net income and net income per share.
On January 2, 2007, the FASB issued a project summary and stated that a proposed interpretation on the Financial Guarantee Insurance Project is expected to be issued in the first quarter of 2007. In addition, the FASB Board decided to exclude mortgage guarantee insurance and credit insurance from the scope of the proposed interpretation. It is possible that, due to the proposed interpretation, 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, FASB’s or the SEC’s review may have on our consolidated results of operations, financial condition or cash flows or those of our unconsolidated subsidiaries.
Management assessed the effectiveness of our internal control over financial reporting as of December 31, 2006. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework.
Based on management’s assessment and those criteria, management has concluded that we maintained effective internal control over financial reporting as of December 31, 2006.
Our independent registered public accounting firm has issued an audit report on management’s assessment of our internal control over financial reporting. That report appears below in this Item 8.
As of December 31, 2006, the Company adopted FASB Statement No. 123(R), Share-Based Payment, and FASB Statement No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106 and 132(R). These matters are further described in Notes 15 and 16 to the consolidated financial statements.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 26, 2007 expressed an unqualified opinion thereon.
In our opinion, management’s assessment that The PMI Group, Inc. maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, The PMI Group, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the 2006 consolidated financial statements of The PMI Group, Inc. and our report, dated February 26, 2007, expressed an unqualified opinion thereon.
In 2006, the Company formed PMI Guaranty, a wholly-owned surety company based in New Jersey. PMI Guaranty received its certificate of authority from the New Jersey Department of Banking and Insurance in July 2006 and began operations in the fourth quarter of 2006. PMI Guaranty’s financial strength is rated AA+ by Fitch Ratings, AA by Standard & Poor’s and Aa3 by Moody’s Investors Service. PMI Guaranty competes in the markets for AA-rated financial guaranty insurance, financial guaranty reinsurance and related credit enhancement products and services.
On October 4, 2005, the Company sold to Credit Suisse First Boston (USA), Inc. (“CSFB”) its equity ownership interest in SPS Holding Corp. (“SPS”), whose subsidiary, Select Portfolio Servicing, Inc., is a servicer of single-family residential mortgages. The Company received cash payments of $98.8 million for its holdings in SPS at the initial closing and will receive additional monthly cash payments through the first quarter of 2008 from a residual interest in mortgage servicing assets with an estimated fair value at closing of $20.7 million. The Company has received cash payments of approximately $14.2 million during the year ended December 31, 2006 from the residual interest in SPS mortgage servicing assets. As of December 31, 2006, the remaining carrying value of this residual interest was $2.2 million. The Company and SPS’s other former shareholders agreed to indemnify CSFB for certain liabilities relating to SPS’s operations. As of December 31, 2006, the Company has recorded a liability of $6.4 million with respect to this indemnification.
preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements, as well as the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates. In the opinion of management, all adjustments, consisting only of normal recurring adjustments, considered necessary for a fair presentation, have been included.
The Company has made significant investments in the equity securities of several privately-held companies, including FGIC. FGIC is subject to a number of significant risks that arise from the nature of its business. Accordingly, the Company is subject to the risks and uncertainties associated with that business. In addition, the Company has limited ability to control FGIC and, accordingly, may be unable to take actions unilaterally to avoid or mitigate those risks. A significant portion of the Company’s consolidated net income is derived from FGIC and its financial guaranty business. The financial guaranty business is subject to extensive regulation. Future legislative, regulatory, accounting or judicial changes may affect the financial guaranty industry or municipal or asset-backed obligations or markets.
Investments-The Company has designated its entire portfolio of fixed income and equity securities as available-for-sale. These securities are recorded at fair value based on quoted market prices with unrealized gains and losses, net of deferred income taxes, accounted for as a component of accumulated other comprehensive income in shareholders’ equity. The Company evaluates its investments regularly to determine whether there are declines in value and whether such declines meet the definition of other-than-temporary impairment in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 115, Accounting for Certain Investments in Debt and Equity Securities and Securities and Exchange Commission (“SEC”) Staff Accounting
Bulletin (“SAB”) No. 59, Accounting for Noncurrent Marketable Equity Securities. The fair value of a security below cost or amortized cost for consecutive quarters is a potential indicator of an other-than-temporary impairment. When the Company determines a security has suffered an other-than-temporary impairment, the impairment loss is recognized, to the extent of the decline, as a realized investment loss in the current period’s net income.
Periodically, or as events dictate, the Company evaluates potential impairment of its investments in unconsolidated subsidiaries. Accounting Principles Board (“APB”) Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock, (“APB No. 18”), provides criteria for determining potential impairment. In the event a loss in value of an investment is determined to be an other-than-temporary decline, an impairment charge would be recognized in the consolidated statement of operations. Evidence of a loss in value that could indicate impairment might include, but would not necessarily be limited to, the absence of an ability to recover the carrying amount of the investment or the inability of the investee to sustain an earnings capacity which would justify the carrying amount of the investment. Realized capital gains or losses resulting from the sale of the Company’s ownership interests of unconsolidated subsidiaries are recognized as net realized investment gains or losses in the consolidated statement of operations.
The SEC requires public companies to disclose condensed financial statement information in the footnotes for significant equity investees and unconsolidated majority owned subsidiaries, individually or in the aggregate, if (i) the Company’s investments in and advances to the subsidiaries are in excess of 10% of the total consolidated assets of the Company, (ii) the Company’s proportionate share of unconsolidated majority owned subsidiaries’ total assets is in excess of 10% of total consolidated assets of the Company, or (iii) equity in income from continuing operations before income taxes, extraordinary items and the cumulative effect of a change in accounting principle of the unconsolidated subsidiaries is in excess of 10% of such income of the Company. Furthermore, if certain of the above tests exceed 20% with respect to any unconsolidated subsidiary, separate audited financial statements of that unconsolidated subsidiary are required to be included in the registrant’s Form 10-K. For the year ended December 31, 2006, the Company’s equity in income before tax as described in item (iii) above of FGIC exceeded 20% of such income of the Company, and accordingly, separate audited financial
Related Party Receivables-As of December 31, 2006 and 2005, related party receivables were $0.7 million and $2.9 million, respectively, which were comprised of non-trade receivables from unconsolidated subsidiaries.
Under the provisions of Statement of Position (“SOP”) No. 98-1, Accounting for the Cost of Computer Software Developed or Obtained for Internal Use, the Company capitalizes costs incurred during the application development stage related to software developed for internal use purposes and for which it has no substantive plan to market externally. Capitalized costs are amortized at such time as the software is ready for its intended use on a straight-line basis over the estimated useful life of the asset, which is generally three to seven years.
SFAS No. 149, Amendment of SFAS No. 133 on Derivative Instruments and Hedging Activities (“SFAS No. 149”) requires certain credit default swaps similar to those entered into by PMI Europe after July 1, 2003 to be accounted for as derivatives and reported on the consolidated balance sheet at fair value, and subsequent changes in fair value are recorded in consolidated net income. In addition, as required by EITF Issue No. 02-3, Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities (“EITF No. 02-3”), for certain credit default swaps entered into
by PMI Europe where the fair value cannot be determined by reference to quoted market prices, current market transactions for similar contracts, or based on a valuation technique incorporating observable market data or inputs, initial fair value related to the credit default swaps are deferred and recognized in consolidated net income in proportion to the expiration of the associated insured risk. Gains or losses are recognized in consolidated net income at inception for all other derivative contracts where the fair value can be readily determined from market sources.
As of December 31, 2006, PMI Europe had entered into eleven credit default swaps that were classified as derivatives in accordance with SFAS No. 149. Accordingly, initial fair value gains on these derivatives were deferred in accordance with EITF No. 02-3. As of December 31, 2006, $13.3 million of deferred gains related to the initial fair value of these derivatives were included in other liabilities compared to $6.8 million as of December 31, 2005. Included in other income was $2.2 million (pre-tax) and $1.6 million (pre-tax) of accretion from the deferred gains in 2006 and 2005, respectively. Subsequent changes in the value, exclusive of accretion, of such derivatives resulted in $5.2 million of gains (pre-tax) in 2006 and $0.8 million of gains (pre-tax) in 2005 which were included in other income.
During the second quarter of 2006, the Company entered into two transactions that were designated as cash flow hedges for accounting purposes under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (“SFAS No. 133”), to hedge interest rate risk on the forecasted payment of interest resulting from the issuance of fixed rate debt obligations in the third quarter of 2006. When designating a derivative as an accounting hedge, the Company formally documents the hedging relationship, risk management objective and strategy. The documentation identifies the hedging instrument, the hedged item, the nature of the risk being hedged, and the assumptions used to assess how effective the hedging instrument is in offsetting the exposure to changes in the hedged item’s fair value attributable to the hedged risk. For cash flow hedges of this type, changes in fair value are included in other comprehensive income. Upon issuance of the fixed rate debt, the fair value of the cash flow hedges was settled for $9.0 million and is being amortized into interest expense over the terms of the new senior debt that was issued. As of December 31, 2006, the unamortized balance in other comprehensive income related to these fair value hedges was approximately $8.8 million (pre-tax).
Special Purpose Entities-Certain insurance transactions entered into by PMI and PMI Europe require the use of foreign special purpose wholly-owned subsidiaries principally for regulatory purposes. These special purpose entities are consolidated in the Company’s consolidated financial statements.
last business day of the month following the month in which the borrower becomes three monthly payments in default. SFAS No. 60 specifically excludes mortgage guaranty insurance from its guidance relating to reserves for losses and LAE. Consistent with industry accounting practices, the Company considers its mortgage insurance policies as short-duration contracts and, accordingly, does not establish loss reserves for future claims on insured loans that are not currently in default. The Company establishes loss reserves on a case-by-case basis when insured loans are identified as currently in default using estimated claim rates and average claim amounts for each report year, net of salvage recoverable. The Company also establishes loss reserves for defaults that have been incurred but have not been reported to the Company prior to the close of an accounting period using estimated claim rates and claim amounts applied to the estimated number of defaults not reported. The reserve levels as of the consolidated balance sheet date represent management’s best estimate of existing losses and LAE incurred. The estimates are continually reviewed and adjusted as necessary as experience develops or new information becomes known to the Company. Such adjustments, to the extent of increasing or decreasing loss reserves, are recognized in the current period’s consolidated results of operations.
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 coverage to 25% for any single risk. The Company’s reinsurance agreements typically provide for a recovery of a proportionate level of claim expenses from reinsurers, and a reinsurance recoverable is recorded as an asset. The Company remains liable to its policyholders if the reinsurers are unable to satisfy their obligations under the agreements. Reinsurance recoverable on paid losses and loss estimates are based on the Company’s actuarial analysis of the applicable business. Amounts the Company will ultimately recover could differ materially from amounts recorded as reinsurance recoverable. Reinsurance transactions are recorded in accordance with the provisions of the reinsurance agreements and the accounting guidance provided in SFAS No. 113, Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts. Accordingly, management assesses, among other factors, risk transfer criteria for all reinsurance arrangements.
temporary differences at the enacted tax rates applicable for the period in which the deferred asset or liability is expected to be realized or settled. Temporary differences are differences between the tax basis of an asset or liability and its reported amount in the consolidated financial statements that will result in future increases or decreases in taxes owed on a cash basis compared to amounts already recognized as tax expense in the consolidated statement of operations. The Company’s effective tax rate was 25.0% and 24.3% for the years ended December 31, 2006 and 2005, respectively, compared to the federal statutory rate of 35.0% due to equity in earnings from FGIC and income derived from PMI Australia, which have lower effective tax rates, combined with the Company’s municipal bond investment income. The Company’s effective tax rate for the year ended December 31, 2006 was adversely affected by a U.S. tax charge of $1.1 million that resulted from the transfer of PMI’s Hong Kong mortgage reinsurance portfolio to PMI Asia in the second quarter of 2006. The Company records a federal tax expense relating to its proportionate share of net income available to FGIC’s common shareholders at a rate of 7% based on its assessment that it will ultimately receive those earnings in the form of dividends from FGIC.
Comprehensive Income-Comprehensive income includes net income, the change in foreign currency translation gains or losses, changes in unrealized gains and losses on investments and from derivatives designated as cash flow hedges, and reclassification of realized gains and losses previously reported in comprehensive income, net of related tax effects. The Company reports the components of comprehensive income in its consolidated statements of shareholders’ equity.
Earnings Per Share-Basic earnings per share (“EPS”) excludes dilution and is based on consolidated net income available to common shareholders and the actual weighted-average of the common shares that are outstanding during the period. Diluted EPS is based on consolidated net income available to common shareholders, which includes consideration of share-based compensation required by SFAS No. 123 (revised 2004), Share-Based Payment (“SFAS No. 123R”), adjusted for the effects of dilutive securities and the weighted-average of dilutive common stock shares outstanding during the period. The weighted-average dilutive common shares reflect the potential increase of common shares if outstanding securities were converted into common shares, or if contracts to issue common shares, including stock options issued by the Company that have a dilutive impact, were exercised.
EITF Issue No. 04-8, The Effect of Contingently Convertible Instruments on Diluted Earnings per Share, (“EITF No. 04-8”), states that the dilutive effect of contingently convertible debt and other instruments (“CoCos”) must be included in dilutive earnings per share. Prior to completion of the exchange offer and redemption described above, the Company’s approximately $360 million in principal amount of its 2.50% Senior Convertible Debentures were considered CoCos under EITF No. 04-8. For purposes of determining dilutive earnings per share, the interest expense, net of tax, was added back to consolidated net income and additional weighted common shares were added to diluted shares outstanding for the years ended 2006, 2005 and 2004. Inclusion of the CoCos in diluted shares outstanding resulted in a decrease to diluted earnings per share of $0.22, $0.28 and $0.24 for the years ended December 31, 2006, 2005 and 2004, respectively.
Reclassifications-Certain items in the prior corresponding period’s consolidated financial statements have been reclassified to conform to the current period’s consolidated financial statement presentation.
In September 2006, the SEC released Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (“SAB No. 108”). This release provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. SAB No. 108 is effective for annual financial statements covering the first fiscal year ending after November 15, 2006 with early application encouraged. The adoption of SAB 108 is not expected to have a material effect on the Company’s consolidated financial statements.
In June 2006, the FASB issued FIN 48, Accounting for Uncertainty in Income Taxes-An Interpretation of FASB Statement No. 109, (“FIN 48”) which prescribes a recognition threshold and measurement process for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. Additionally, FIN 48 provides guidance on derecognition, classification, interim reporting, and disclosure requirements for uncertain tax positions. FIN 48 is effective for fiscal years beginning after December 15, 2006. FIN 48 is not currently expected to materially impact the Company’s consolidated financial condition.
Unrealized losses are primarily due to interest rate fluctuations during the year and are not considered to be other-than-temporarily impaired as the Company has the intent and ability to hold these investments until they recover in value or mature. The Company determined that the decline in the market value of certain equity and fixed income securities in its investment portfolio met the definition of other-than-temporary impairment and recognized realized pre-tax losses of $6.2 million, $0.6 million and $0.2 million in 2006, 2005 and 2004, respectively.
Investment Concentrations and Other Items-The Company maintains a diversified portfolio principally of U.S. municipal bonds. The following states and the District of Columbia represent the largest concentrations in the U.S. municipal bond portfolio, expressed as a percentage of the fair value of all U.S. municipal bond holdings. Holdings in states and the District of Columbia that exceed 5% of the U.S. municipal bond portfolio at December 31, for the respective years are presented below:
At December 31, 2006, fixed income securities and short-term investments with a fair value of $17.1 million were on deposit with regulatory authorities as required by law.
As of December 31, 2006, the Company’s investment in FGIC was $856.5 million, which included $617.0 million of cash and capitalized acquisition costs, with the remaining balance representing equity in earnings and the Company’s proportionate share of net unrealized gains in FGIC’s investment portfolio.
The following table sets forth the cost basis of, and accumulated depreciation and amortization for, property, equipment and software for the years ended:
Deferred policy acquisition costs are affected by qualifying costs that are deferred in the year and amortization of previously deferred costs in such years. In years where new business activity is declining, the asset will generally decrease because the amortization of previously deferred policy acquisition costs exceeds the amount of acquisition costs being deferred. Conversely, in years where there is significant growth in new business, the asset will generally increase because the amount of acquisition costs being deferred exceeds the amortization of previously deferred policy acquisition costs.
U.S. Mortgage Insurance Operations primary insurance default inventory was 39,997 at December 31, 2006, 42,702 at December 31, 2005 and 39,054 at December 31, 2004. The default rate was 5.55% at year end 2006, 5.74% at year end 2005, and 4.86% at year end 2004. Generally, it takes approximately 12 to 36 months from the receipt of a default notice to result in a claim payment. Accordingly, most losses paid relate to default notices received in prior years.
As of December 31, 2006 and 2005, the carrying value of long-term debt outstanding issued by The PMI Group, was as follows:
6.75% Senior Notes-In November 1996, the Company issued $100 million in face amount of 6.75% Senior Notes. As of December 31, 2005 and 2004, $63.0 million of face amount remained outstanding. These notes bore interest at the rate of 6.75% per annum paid semiannually and matured on November 15, 2006. On November 15, 2006, the Company repaid the aggregate principal amount of its 6.75% Senior Notes.
5.568% Senior Notes-The 5.568% Senior Notes related to the issuance in November 2003 of 13.8 million 5.875% equity units (“Equity Units”) with a stated value of $25 per unit. The Equity Units include the senior notes and purchase contracts to purchase, no later than November 15, 2006, up to 9,050,040 shares of The PMI Group’s common stock for an aggregate purchase price of $345 million. In August 2006, pursuant to the terms of the Equity Units, the Company completed the remarketing of approximately $345 million in principal amount of senior notes maturing in November 2008, which are referred to as the 5.568% 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. Pursuant to the terms of the Equity Units, a significant portion of the proceeds of the remarketing was applied to satisfy the Equity Unit holders’ obligations under the purchase contracts to purchase between 7.3 million and 9.1 million shares of common stock, depending on the market price of the common stock, upon settlement of the purchase contracts, which occurred on November 15, 2006. Upon settlement of the purchase contracts, the Company issued approximately 8 million shares of common stock on November 15, 2006 in exchange for approximately $345 million.
2.5% Senior Convertible Debentures-In July 2006, the Company commenced an exchange offer pursuant to which it offered to exchange a new series of our 2.50% senior convertible debentures due 2021 (referred to as the “new debentures”) and an exchange fee of $3.50 per $1,000 principal amount of debentures for all of our existing 2.50% senior convertible debentures due 2021 (referred to as the “old debentures”). The purpose of the exchange offer was to change certain terms of the old debentures, including the addition of a net share settlement feature. This feature allowed the Company to satisfy a portion of its obligation due upon conversion of the debentures in cash, thereby reducing the dilution associated with the conversion of the new debentures. This feature also limits the dilutive impact of the new debentures on diluted earnings per share. Following completion of the exchange offer in August 2006, the Company had approximately $341.5 million in principal amount of new debentures outstanding and approximately $18.4 million in principal amount of old debentures outstanding. In September 2006, the Company delivered a notice of redemption to the holders of the old debentures and the new debentures. Pursuant to the terms of the old debentures and the new debentures, the debentures were convertible by the holders until the close of business on October 25, 2006. Holders of $3,000 principal amount of the old debentures and $339,000 principal amount of the new debentures converted their debentures prior to the close of business on October 25, 2006. Upon conversion of the old debentures, the Company issued 67 shares of its common stock. No shares were issued for conversion of new debentures. On October 27, 2006, the Company redeemed the $359.6 million aggregate principal amount of debentures that were not converted for a price equal to principal amount of the debentures plus accrued and unpaid interest.
Revolving Credit Facility-In October 2006, the Company entered into a $400 million revolving credit facility and terminated its then-existing $175 million revolving credit facility. The $400 million revolving credit facility can be utilized for working capital, capital expenditures and other business purposes. The facility may be increased to $500 million at the Company’s request subject to approval by the lenders. 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 $1.7 million outstanding under the revolving credit facility as of December 31, 2006.
In the normal course of business, the Company invests in various financial assets and incurs various financial liabilities. The estimated fair value of the financial instruments indicated in the table below has been determined by available market information and appropriate valuation methodology. The carrying values of cash and cash equivalents and accrued investment income approximate their fair values primarily due to their liquidity and short-term nature. The estimated fair value of the outstanding debt has been determined by quoted market price.
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 tax and loss bonds of $51.0 million in 2006, $90.0 million
The components of the income tax expense for 2006 included a foreign provision for current tax expense of $39.6 million and a deferred tax expense of $1.2 million primarily related to PMI Australia and PMI Europe.
Rent expense for all leases was $7.8 million for 2006, $5.3 million for 2005 and $7.0 million for 2004.
Indemnification-mortgage-backed securities-In connection with structured transactions in the U.S., Europe and Australia, the Company is often required to provide narrative and/or financial information relating to the Company and its subsidiaries to mortgage-backed securities issuers for inclusion in the relevant offering documents and the issuers’ ongoing SEC filings. In connection with the provision of such information, the Company and its subsidiaries may be required to indemnify the issuer of the mortgage-backed securities and the underwriters of the offering with respect to the information’s accuracy and completeness and its compliance with applicable U.S. securities laws and regulations.
Funding Obligations-The Company has invested in certain limited partnerships with ownership interests greater than 3% but less than 50%. As of December 31, 2006, the Company had committed to fund, if called upon to do so, $5.2 million of additional equity in certain limited partnership investments.
Legal Proceedings-Various legal actions and regulatory reviews are currently pending that involve the Company and specific aspects of its conduct of business. In the opinion of management, the ultimate liability in one or more of these actions is not expected to have a material effect on the consolidated financial condition, results of operations or cash flows of the Company.
Common Stock-As disclosed in Note 9, Long-term Debt and Revolving Credit Facility, the Company issued 13.8 million 5.875% equity units (“Equity Units”) in November 2003 with a stated value of $25 per unit. Each equity unit consists of a senior note and a purchase contract. The Equity Units include the senior notes and purchase contracts to purchase, no later than November 15, 2006, up to 9,050,040 shares of The PMI Group’s common stock for an aggregate purchase price of $345 million. On November 15, 2006, the Company issued 7,975,822 shares of common stock in exchange for $345 million.
Arizona Department of Insurance approved an extraordinary dividend request for another $250 million. The first installment of the dividend of $100 million was paid to The PMI Group in December 2006.
In addition to its consolidated subsidiaries, The PMI Group may in the future derive funds from its unconsolidated equity investments, including its investment in FGIC. FGIC’s ability to pay dividends is subject to restrictions contained in applicable state insurance laws and regulations, FGIC Corporation’s certificate of incorporation, a stockholders agreement between The PMI Group and other investors in FGIC Corporation, and covenants included in its 6.0% senior notes.
Preferred Stock-The PMI Group’s certificate of incorporation authorizes the Board of Directors to issue up to 5,000,000 shares of preferred stock of The PMI Group in classes or series and to set the designations, preferences, qualifications, limitations or restrictions of any class or series with respect to the rate and nature of dividends, the price and terms and conditions on which shares may be redeemed, the amount payable in the event of voluntary or involuntary liquidation, the terms and conditions for conversion or exchange into any other class or series of the shares, voting rights, and other terms. The Company may issue, without the approval of the holders of common shares, preferred stock that has voting, dividend or liquidation rights superior to the common stock, which may adversely affect the rights of holders of common stock.
Included in accumulated other comprehensive income at December 31, 2006 are the following amounts that have not yet been recognized in net periodic benefit cost: unrecognized prior service credit of $9.4 million ($6.1 million, net of tax) and unrecognized actuarial loss of $11.2 million ($7.3 million, net of tax). The prior service credit and actuarial loss included in accumulated other comprehensive income and expected to be recognized in net periodic benefit cost during the fiscal year-ended December 31, 2007 is $0.9 million ($0.6 million, net of tax) and $0.6 million ($0.4 million, net of tax), respectively.
The underfunded status of the defined benefit postretirement plans of $18.6 million is recognized in the accompanying consolidated balance sheet as accrued pension liability. No plan assets are expected to be returned to the Company during the year ended December 31, 2007.
The Company’s accumulated benefit obligation for its pension plans at December 31, 2006 was $61.3 million and $4.1 million, the combination of which equals the $65.4 million accumulated benefit obligation. As of December 31, 2006, the combined fair value of plan assets is approximately $12.2 million higher than our combined accumulated benefit obligation. The health care cost trend on covered charges for other postretirement benefits was 9% in 2006, which will be reduced by 1% per year to 5% in 2010. In 2006, the Company contributed $12.1 million to its qualified pension plan.
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. The Company expects to contribute approximately $10 million to the Plan in 2007.
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 $3.3 million for 2006, $3.2 million for 2005 and $2.4 million for 2004. 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 $22.5 million and $19.2 million as of December 31, 2006 and 2005, respectively, and is included in other liabilities and accrued expenses.
Equity Incentive Plan-The PMI Group’s Amended and Restated Equity Incentive Plan (the “Equity Incentive Plan”) provides for awards of both non-qualified stock options and incentive stock options, nonvested shares, stock appreciation rights subject to forfeiture and restrictions on transfer, and performance awards entitling the recipient to receive cash or common shares in the future following the attainment of performance goals determined by the Board of Directors. Stock options are granted with an exercise price equal to the market
The Company has recognized compensation expense for all awards granted based on the estimated grant date fair value method using the Black-Scholes option pricing model to determine the fair value of stock options and ESPP shares. For stock options, compensation expense is recognized using the accelerated amortization method. The determination of the fair value of stock-based payment awards on the date of grant using an option-pricing model is affected by the Company’s share price as well as assumptions regarding a number of complex and subjective variables. These variables include the Company’s expected share price volatility over the expected term of the awards, actual and projected employee stock option exercise behaviors, risk-free interest rates, and expected dividends.
The total intrinsic value of options exercised during the years ended December 31, 2006, 2005 and 2004, was $18.7 million, $11.4 million and $24.8 million, respectively. The weighted-average remaining contractual life of options outstanding as of December 31, 2006 and vested and exercisable as of December 31, 2006 was 5.7 and 4.9 years, respectively. Aggregate intrinsic value for the options outstanding as of December 31, 2006 and vested and exercisable as of December 31, 2006 was $75.3 million and $70.2 million, respectively.
Pro Forma Information for Periods Prior to the Adoption of SFAS No. 123R-Prior to the adoption of SFAS No. 123R, the Company accounted for share-based compensation transactions using the intrinsic value method as prescribed by APB No. 25 and provided the disclosures required under SFAS No. 123, as amended by SFAS No. 148. Employee share-based compensation expense recognized under SFAS No. 123R was not reflected in the consolidated results of operations for the year ended December 31, 2005 for employee stock option awards as all options were granted with an exercise price equal to the market value of the underlying common stock on the date of grant. The ESPP was deemed non-compensatory under the provisions of APB No. 25. Forfeitures of awards were recognized as they occurred. In accordance with the modified prospective method, previously reported amounts have not been restated to reflect, and do not include, the impact of SFAS No. 123R.
The following table presents PMI’s statutory net income, statutory surplus and contingency reserve liability as of and for the years ended as follows:
Under the insurance laws of the State of Arizona and several other states, mortgage insurers are required to establish a special contingency reserve included in total liabilities, with annual additions equal to 50% of premiums earned for that year. During 2006, PMI contributed $346.7 million to the reserve. This reserve is required to be maintained for a period of 120 months to protect against the effects of adverse economic cycles. After 120 months, the reserve is released to unassigned funds. During 2006, $197.6 million was released to unassigned funds. In the event an insurer’s loss ratio in any calendar year exceeds 35%, however, the insurer may withdraw from its contingency reserves an amount equal to the excess portion of such losses.
PMI’s financial strength ratings from certain rating agencies have been based on various capital support commitments from Allstate (“Allstate Support Agreements”). On October 27, 1994, the 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. The Runoff Support Agreement provides PMI with additional capital support for rating agency purposes.
In 2001, PMI executed a capital support agreement whereby it agreed to contribute funds, under specified conditions, to maintain CMG MI’s risk-to-capital at or below 18.0 to 1. PMI’s obligation under the agreement is limited to an aggregate amount of $37.7 million, exclusive of capital contributions made prior to April 10, 2001. As of December 31, 2006, CMG MI’s risk-to-capital ratio was 12.6 to 1 compared to 12.2 to 1 as of December 31, 2005.