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. Forward-looking statements in this document include: (i) our expectations that expenditures on new strategic investments will decline in the near term, that a significant portion of net income derived from our Financial Guaranty segment will be generated by our investment in FGIC Corporation, and that we will realize a gain on the sale of APTIC; and (ii) our expectations with respect to PMI’s persistency rate and incurred losses in 2004, the size of the U.S. mortgage origination market in 2004, and potential expense savings relating to PMI’s consolidation of certain field underwriting offices.
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 $245.5 million in 2003, primarily derived from PMI.
International Operations. We offer mortgage insurance and other credit enhancement products in Europe, Australia, New Zealand and Hong Kong. In October 2003, we entered into a definitive agreement to acquire the U.K. lenders’ mortgage insurance portfolio from Royal & Sun Alliance, or R&SA. The portfolio consists of U.K. residential mortgage loans originated in 1993 and subsequent years and covers approximately $15 billion of original insured principal value and approximately $2.3 billion of remaining exposure. The acquisition is subject to U.K. and Irish regulatory approval and U.K. court approval, which is anticipated to take approximately six to nine months, and other customary closing conditions. Net income from our International Operations segment was $78.6 million in 2003, primarily derived from our Australian and New Zealand operations.
Other. Our Other segment consists of holding company and contract underwriting revenue and expenses, equity in earnings (losses) primarily from our unconsolidated strategic investment Fairbanks and the discontinued operations of our title insurance subsidiary, APTIC. On October 27, 2003, we announced that we had reached a definitive agreement to sell APTIC for $115 million in cash, subject to
post-closing adjustments. The transaction is subject to regulatory approvals and other customary closing conditions and is expected to close in the first half of 2004. Our Other segment generated a net loss of $35.1 million in 2003, primarily due to losses at Fairbanks and contract underwriting operations.
Approximately 17% of our consolidated total revenues in 2003 was interest and dividend income associated with our investment portfolio of approximately $2.8 billion. Accordingly, the performance of corporate and municipal bond and securities markets in the U.S., Australia and Europe can significantly affect our consolidated
U.S. Mortgage Insurance Operations. The financial performance of our U.S. Mortgage Insurance Operations segment is affected by a number of factors, including:
Policy Cancellations (Persistency). Lower interest rates in 2002 and 2003 resulted in heavy mortgage refinance activity and caused PMI’s policy cancellations to increase. PMI’s persistency rate, the percentage of insurance policies at the beginning of a 12-month period that remain in force at the end of that period, was 44.6% at December 31, 2003 compared to 56.2% at December 31, 2002. Low persistency caused PMI’s revenues, cash available for investment and insurance in force to decline in 2003. We do not expect PMI’s persistency rate to increase significantly during 2004 unless mortgage interest rates significantly increase and refinance activity significantly declines from 2003 levels.
Captive Reinsurance. Captive reinsurance is a reinsurance product in which PMI shares portions of its risk written on loans originated by certain lenders. In return, a portion of PMI’s gross premiums written is ceded to the captive reinsurers. At December 31, 2003, approximately 50% of PMI’s insurance in force was subject to captive reinsurance agreements, compared to approximately 43% at December 31, 2002. The increase was driven by refinance activity resulting in heavy cancellations of policies not subject to captive reinsurance and a higher percentage of NIW being generated by lenders with captive reinsurance arrangements. We expect that the percentage of our insurance in force that involves captive reinsurance will further increase in 2004, thereby negatively impacting PMI’s net premiums written and earned.
decrease in underwriting expenses, and by increased acquisition costs associated with higher levels of NIW.
Regulatory and Legislative Environment. At any point in time, there are multiple proposals and initiatives for statutory and regulatory changes that may significantly affect the mortgage insurance industry as well as PMI’s business. We may also be impacted by changes in regulations affecting the GSEs, including changes to the risk-based capital rules, and as a result of changes in the GSEs’ eligibility guidelines.
PMI Australia. PMI Australia’s mortgage insurance coverage is typically purchased with a single, lump-sum premium. Accordingly, policy cancellations do not negatively impact PMI Australia’s revenue but rather decrease its overall claim risk and increase net premiums earned. PMI Australia’s losses and loss adjustment expenses decreased significantly in 2003 partly as a result of a strong housing market. We expect the rate of Australian home price appreciation to moderate in 2004. The Australian and New Zealand economies performed well in 2003 and PMI Australia’s results are closely tied to developments in those economies.
Currency Exchange Fluctuations. The performance of our International Operations is subject to currency exchange fluctuations, particularly by fluctuations in the exchange rates between the U.S. dollar, the Australian dollar, pounds sterling and Euro. Based on the exchange ratio at December 31, 2002, 2003 net income for our International Operations segment benefited by $8.7 million from changes in foreign exchange rates in 2003.
Fairbanks. Our equity in losses from Fairbanks for 2003 totaled $17.7 million. Fairbanks’ losses in 2003 were primarily attributable to expenses relating to its settlement of certain regulatory actions and civil class action lawsuits, associated restructuring expenses and operating losses. Fairbanks still faces significant regulatory issues and pending class action litigation. In 2003, the rating agencies downgraded Fairbanks Capital’s servicer ratings. As a result of these downgrades, Fairbanks Capital is no longer qualified to be named as a primary servicer on future residential mortgage-backed securities, or RMBS, transactions rated by Moody’s or S&P. Fairbanks Capital may serve as a subservicer on these rated transactions under certain circumstances. Fairbanks is attempting to obtain upgrades of its servicer ratings in 2004 so that it may
regain its qualification to be named as primary servicer on future RMBS transactions rated by Moody’s and S&P. Even if it is successful in its efforts, Fairbanks may not regain profitability this year. We regularly evaluate our investment balance in Fairbanks for impairment in accordance with GAAP. Through December 31, 2003, we reported our equity in Fairbanks’ results on a one-month lag basis.
Contract Underwriting Services. New policies processed by contract underwriters represented 25% of PMI’s NIW in 2003, compared to 30% in 2002. We anticipate that loans underwritten by us will continue to make up a significant percentage of PMI’s NIW. As a part of contract underwriting services, we provide monetary, indemnification and other remedies to customers in the event of a failure to properly underwrite a mortgage loan. Contract underwriting remedies paid in 2003 totaled $13.1 million.
The following table presents our consolidated financial results for the years ended December 31, 2003, 2002 and 2001.
Consolidated net income for 2003 decreased by 14% over 2002, due primarily to increases in losses and loss adjustment expenses and other underwriting and operating expenses in our U.S. Mortgage Insurance Operations. Total revenues in 2003 were impacted by increases in premiums earned in our International Operations and an increase in net investment income, offset by a decrease in equity in earnings from unconsolidated strategic
investments, principally from Fairbanks, and the decrease in persistency in U.S. Mortgage Insurance Operations. Consolidated net income for 2002 increased by 13% over 2001, largely attributable to the increases in premiums earned and equity in earnings from our consolidated strategic investments, partially offset by higher losses and underwriting and operating expenses.
Premiums earned represent the amount of premiums recognized as revenue for accounting purposes. The increase in premiums earned in 2003 over 2002 was attributable primarily to increased premiums earned by PMI Australia, offset by cumulative adjustments for ceded premiums of $8.4 million recorded in the fourth quarter of 2003 (see U.S. Mortgage Insurance Operations-Premiums written and earned below). The increase in premiums earned in 2002 over 2001 was due primarily to the growth of the primary mortgage insurance portfolio and an increase in the volume of modified pool insurance written in our U.S. Mortgage Insurance Operations.
The increase in net investment income in 2003 over 2002 was due to growth in our investment portfolio combined with adjustments to increase interest income related to accretion of discounts and call premiums. Our investment portfolio grew primarily as a result of excess cash flows from operations. During the fourth quarter of 2003, we made adjustments to reflect the appropriate accounting treatment related to the accretion of discounts and call premiums on bonds that have been called for early redemption. The adjustment related to the periods 2000 through 2003 and included a reclassification of $5.2 million of net realized gains to interest income as well as a positive yield adjustment of $5.1 million to reflect the accretion of purchase discounts and call premiums. The net effects of these adjustments were an increase in net investment income of $10.3 million and a decrease in net realized investment gains of $5.2 million. The decrease in net investment income in 2002 over 2001 was primarily the result of the deployment of capital with respect to PMI Plaza, and a decline in the portfolio yield.
We account for our unconsolidated strategic investments and limited partnerships using the equity method of accounting. The decrease in equity earnings from our unconsolidated strategic investments and limited partnerships in 2003 over 2002 was due primarily to losses at Fairbanks, our proportionate share of which was $17.7 million in 2003 compared to $22.4 million of net income in 2002. The increase in equity earnings from our unconsolidated strategic investments in 2002 over 2001 was primarily attributable to the increase in our ownership of Fairbanks to 57% in 2002 and the growth in Fairbanks’ servicing portfolio.
Included in net realized investment gains and losses are impairment losses recognized for financial reporting purposes on certain impaired securities in our investment portfolio and other investments. Impairment losses were $0.5 million in 2003, compared to $6.9 million in 2002 and $3.2 million in 2001. In September 2003, we sold our ownership interests in Truman Capital Founders, LLC and Truman Capital Advisors, LLC, or Truman, and incurred a $3.6 million loss, which was included in net realized investment gains and losses.
The increase in other underwriting and operating expenses in 2003 over 2002 was due largely to the increases in underwriting and operating expenses in our U.S. and Australian operations and an increase in remedy expenses in our contract underwriting services. The increase in other underwriting and operating expenses in 2002 over 2001 was the result of increased contract underwriting expenses associated with higher contract underwriting activity.
In October 2003, we reached a definitive agreement to sell our title insurance operations, American Pioneer Title Insurance Company, or APTIC, for $115 million in cash subject to post-closing adjustments. The transaction is subject to regulatory approvals and other customary closing conditions and is expected to close in the first half of 2004. In accordance with Statement on Financial Accounting Standards, or SFAS, No. 144, Accounting for Impairment or Disposal of Long-Live Assets, the results of APTIC are classified as discontinued operations with prior periods adjusted for comparability. We expect to realize a gain on the transaction upon receiving regulatory approval.
We recognized an extraordinary (after-tax) gain of $5.4 million, which was our share of negative goodwill recognized by FGIC Corporation resulting from the application of purchase accounting adjustments. Due to subsequent refinements of FGIC Corporation’s purchase accounting adjustments, this extraordinary (after-tax) gain was $3.0 million larger than estimated in our January 27, 2004 earnings press release.
Premiums written and earned-PMI’s net premiums written refers to the amount of premiums recognized based on effective coverage during a given period, net of refunds, and net of premiums ceded primarily, but not
The increase in premiums written for 2003 over 2002 was largely due to a single transaction in which PMI restructured certain existing primary insurance policies, relating primarily to less-than-A quality loans, with an aggregate unpaid principal balance of $2.9 billion. PMI and the customer canceled the existing contract and PMI returned unearned premiums under the initial contract to the customer of approximately $6 million. PMI issued a new policy which provides primary insurance coverage for the life of each affected loan in exchange for a single premium of approximately $114 million. Approximately $5 million of this premium was earned in the fourth quarter of 2003, with the balance to be earned over the next ten years. The increase in premiums written in 2002 over 2001 was due to an increase in modified pool insurance written and growth in the primary insurance portfolio.
In 2003, 54% of primary NIW was subject to captive reinsurance agreements compared to 56% in 2002 and 45% in 2001. This decrease was due primarily to an increase in the amount of NIW PMI received through its bulk channel in 2003 compared to 2002. NIW received through the bulk channel generally is not subject to captive reinsurance agreements; accordingly, the level of bulk activity impacts the percentage of primary new insurance subject to captive reinsurance agreements. As of December 31, 2003, approximately 50% of primary insurance and risk in force were subject to captive reinsurance agreements, compared to approximately 43% at December 31, 2002 and approximately 33% at December 31, 2001. We anticipate that captive reinsurance cessions will continue to reduce PMI’s net premiums written and earned, and that PMI’s primary risk in force subject to captive reinsurance agreements will continue to increase as a percentage of total risk in force.
Upon cancellation of certain insurance coverage, PMI refunds the portion of premiums that is unearned to the borrowers or servicers. The increases in refunded premiums in 2003 over 2002 and 2002 over 2001 were due primarily to the refund associated with the single transaction discussed above, and to an increase in policy cancellations resulting from refinance activities (see Primary insurance and risk in force below).
PMI’s premiums earned decreased in 2003 over 2002, reflecting the impact of lower persistency, an increase in ceded premiums under captive reinsurance agreements, the cumulative adjustments to ceded premiums, and a reduction in PMI’s unearned premium reserve. During the first quarter of 2003, we completed a review of PMI’s unearned premium reserve and loss reserves for its pool insurance business and determined that the actual loss development was lower than underwriting expectations. Accordingly, we reduced the unearned premium reserve to match actual loss experience, which resulted in $7.1 million of additional premiums earned in the first quarter of 2003. The increase in premiums earned in 2002 over 2001 was attributable to an increase in modified pool written and growth in primary insurance portfolio.
The increase in claims paid and total losses and LAE in 2003 over 2002 was due to increases in the average primary claim size, the percentage of delinquent loans going to claim, and the total number of primary loans in default. The increase in the average primary claim size was the result of increases in the average principal balance of loans and deeper coverage amounts, principally on bulk loans which represented a larger percentage of all claims in 2003 than in 2002. PMI’s delinquent primary bulk loans that result in claims generally reach claims status more quickly than primary flow loans. This faster rate to claim allows less time for equity appreciation or loss mitigation by PMI and, accordingly, generally leads to higher claims paid. The increases in the percentage of delinquent loans going to claim and the number of primary loans in default were caused by higher levels of unemployment in the economy and the seasoning of PMI’s primary portfolio. Claims paid and LAE include amounts paid on pool claims. Pool claims paid was $17.3 million in 2003, compared to $10.6 million in 2002. The increase was primarily due to seasoning of PMI’s modified pool portfolio and the economic factors described above. The increases in 2002 over 2001 claims paid and total losses and LAE were due to higher default and claim rates associated with the maturation of PMI’s primary insurance business and PMI’s GSE Pool insurance portfolio, the increases in less-than-A quality loans and non-traditional loans in PMI’s 2000 insurance portfolio, and generally weaker economic conditions and higher unemployment rates throughout the U.S.
During the second quarter of 2003, we assessed the reasonableness of our estimate of reserves for LAE. As a result of this assessment, we decreased PMI’s LAE reserves by approximately $14 million and reduced the allocation of claim related expenses from operating expenses to LAE. PMI’s case and incurred but not reported reserves were increased by approximately the same amount of the reduction to LAE reserves according to our best estimate for loss reserves as of June 30, 2003. For a discussion of changes in net loss reserves, see Critical Accounting Policies and Estimates, Reserves for Losses and LAE, below.
The increase in PMI’s primary loans in default as of December 31, 2003 over December 31, 2002 was primarily the result of the seasoning of PMI’s portfolio, particularly its bulk portfolio acquired in and after 2000, and weaker economic conditions. The increase in 2002 over 2001 was primarily the result of the weaker economy in the U.S. and the seasoning of PMI’s portfolio. The increases in PMI’s primary default rates in 2003 and 2002 were driven by increases in primary loans in default and declines in the number of policies in force. The default rates for bulk transactions at December 31, 2003 and 2002 were higher than the overall primary default rates due primarily to the higher concentration of less-than-A quality and non-traditional loans (see Credit characteristics below) in PMI’s bulk portfolio.
Other underwriting and operating expenses consist of all other costs that are not attributable to the acquisition of new business and that are recorded as expenses when incurred. The increase in other underwriting and operating expenses in 2003 over 2002 was due to payroll and related expenses, depreciation and premium taxes. The decrease in 2002 over 2001 was due in part to higher ceding commissions related to captive reinsurance agreements and contract underwriting expense allocations. PMI incurs underwriting expenses related to contract underwriting services for mortgage loans without mortgage insurance coverage. These costs are allocated to MSC, which is reported in the Other segment, thereby reducing U.S. Mortgage Insurance Operation’s underwriting and operating expenses. Contract underwriting expenses allocated to MSC were $44.3 million in 2003, $46.1 million in 2002 and $38.8 million in 2001. The increase in allocations in 2002 over 2001 reflects higher contract underwriting activity.
As previously discussed, we completed an analysis of LAE during the second quarter of 2003 which resulted in a decrease of reserves for LAE and a corresponding decrease to LAE allocation from operating expenses. The effect of this adjustment on operating results was a reduction to the allocation of operating expenses to LAE by approximately $1 million per quarter, thereby increasing other underwriting and operating expenses beginning in the second quarter of 2003.
PMI will consolidate certain field underwriting offices and reduce the number of field personnel in 2004. This consolidation is expected to result in expense savings beginning in 2005. We expect aggregate charges for the present value of the remaining lease obligations and payroll related expenses to total between $3 million and $4 million.
Traditional pool insurance-Prior to 2002, PMI offered certain pool insurance products to lenders and the GSEs, or GSE Pool, and to the capital markets, or Old Pool. GSE Pool and Old Pool products insure all losses on individual loans held within a pool of insured loans up to the stop loss limit for the entire pool. GSE Pool risk in force was $0.5 billion at December 31, 2003, $0.8 billion at December 31, 2002 and $0.8 billion at December 31, 2001. Old Pool risk in force was $0.7 billion as of December 31, 2003, $0.9 billion as of December 31, 2002 and $1.1 billion as of December 31, 2001.
Modified pool insurance-In 2003, PMI wrote $358.9 million of modified pool risk, compared to $807.9 million in 2002 and $398.8 million in 2001. The decrease in 2003 was due to a reduction in demand by our principal customer for this product. Modified pool risk in force was $1,390.9 million at December 31, 2003, $1,159.6 million at December 31, 2002 and $414.5 million at December 31, 2001.
Primary insurance and risk in force-Primary insurance in force and risk in force for PMI are shown in the table below.
Persistency rate, as of any date, is the percentage of insurance policies 12 months prior to that date which remain in force on that date.
Credit characteristics-PMI insures less-than-A quality loans and non-traditional loans through all of its acquisition channels. PMI defines less-than-A quality loans to include loans with FICO scores generally less than 620. PMI considers a loan non-traditional if it does not conform to GSE requirements, including loan size limits, or if it includes certain characteristics such as reduced documentation verifying the borrower’s income, deposit information and/or employment. A small number of loans insured by PMI include both less-than-A quality and non-traditional characteristics. Less-than-A quality and non-traditional loans that resulted in claims in 2003 and 2002 generally had deeper coverage and, in the case of bulk loans, reached claims status more quickly than A quality and traditional loans, contributing to higher average claim amounts in PMI’s less-than-A quality and non-traditional portfolio. PMI generally expects higher default and delinquency rates and faster prepayment speeds for less-than-A quality loans and non-traditional loans than for PMI’s A quality and traditional loans. However, in 2003 and 2002, PMI’s less-than-A quality and non-traditional loans exhibited slower prepayment speeds than PMI’s A quality and traditional loans.
The percentage of PMI’s primary risk in force comprised of loans with LTV’s above 97% has increased from 0.7% as of December 31, 2001, to 2.8% as of December 31, 2002, to 8.6% as of December 31, 2003. LTV is the ratio of the original loan amount to the value of the property. This increase is due, in part, to changes in a number of state statutes and regulations to permit the issuance of mortgage insurance on such loans, and to the expansion of underwriting guidelines by lenders and PMI as a result of market out-reach efforts. We believe that loans with LTVs greater than 97% have higher risk characteristics than loans below 97% LTV and we incorporate this assumption into our pricing.
International Operations include the results of our Australian holding company, PMI Mortgage Insurance Australia (Holdings) Pty Limited, and operating subsidiaries, PMI Mortgage Insurance Ltd and PMI Indemnity Limited, collectively referred to as PMI Australia; our Irish subsidiaries, PMI Mortgage Insurance Company Limited and TPG Reinsurance Company Limited, collectively referred to as PMI Europe; and PMI’s Hong Kong reinsurance revenues. Reporting of financial and statistical information for International Operations is subject to currency rate fluctuations in translation to U.S. dollar reporting. International Operations’ results are summarized as follows:
The change in foreign exchange rates from December 31, 2002 to December 31, 2003 favorably impacted our International Operations’ net income by $8.7 million for 2003. The foreign currency translation impact for 2003 is calculated using average monthly exchange rates compared to ending period spot rates as of December 31, 2002. The favorable impact in 2003 was primarily driven by exchange rate growth in the Australian dollar and, to a lesser extent, exchange rate growth in the Euro, relative to the U.S. dollar.
Net investment income-In addition to currency exchange rate appreciation, the increase in net investment income in 2003 over 2002 was attributable to growth of the investment portfolio. The decrease in 2002 over 2001 was primarily the result of the cumulative adjustments discussed above. PMI Australia’s investment portfolio, including cash and cash equivalents, was $642.1 million at December 31, 2003 compared to $401.5 million at December 31, 2002 and $300.9 million at December 31, 2001. The growth was driven by positive cash flows from operations. The pre-tax book yield under U.S. GAAP was 5.21% at December 31, 2003, 6.06% at December 31, 2002 and 6.60% at December 31, 2001. The decrease in the pre-tax book yield in 2003 compared to 2002 was primarily due to the lower interest rate environment in 2003 and to adjustments made to conform to U.S. GAAP.
Underwriting and operating expenses-The increase in underwriting and operating expenses in 2003 over 2002 was due primarily to increases in payroll and related expenses, profit commissions and special project related expenses. The increase in 2002 over 2001 was due to the acquisition of PMI Indemnity in 2002 and a $4.5 million reduction in underwriting and operating expenses in 2001 as a result of the amortization of negative goodwill.
In addition to the appreciation of the Australian dollar, the increase in primary NIW in 2003 over 2002 was driven by a reduction in the number of market participants that underwrite mortgage insurance, and strong market activity in Australia. The increase in 2002 over 2001 was driven by the inclusion of PMI Indemnity’s business and the strong Australian economy. The increases in primary insurance in force and risk in force at December 31, 2003 compared to December 31, 2002 were driven primarily by the volume of NIW during the past 12 months. The increases in primary insurance in force and risk in force at December 31, 2002 compared to December 31, 2001 were largely driven by the acquisition of PMI Indemnity’s business and the increase in NIW.
The following table sets forth the results of PMI Europe for the years ended December 31, 2003, 2002 and 2001.
In addition to currency exchange rate appreciation, the increases in total revenues in 2003 and 2002 were attributable to increases in premiums earned driven by continued growth of PMI Europe’s portfolio, particularly the acquisition of the U.K. lenders’ mortgage insurance portfolio from R&SA. Net income for 2001 consisted primarily of net investment income, including currency re-measurement gains.
billion of original insured principal value and $2.3 billion of remaining exposure. R&SA transferred all loss reserves and unearned premium reserves associated with the portfolio to PMI Europe totaling $55 million, of which $47 million were unearned premium reserves. R&SA has also agreed to provide excess-of-loss reinsurance to PMI Europe with respect to the portfolio under certain conditions. Under the terms of the agreement, R&SA and PMI Europe will share certain economic benefits if loss performance is better than expected. The acquisition is subject to U.K. and Irish regulatory approval, followed by U.K. court approval, which is anticipated to take approximately six to nine months, and other customary closing conditions. TPG Reinsurance Company Limited, or TPG Re, the parent of PMI Mortgage Insurance Company Limited, has agreed to reinsure the R&SA portfolio to be acquired on a 100% quota share basis prior to regulatory and court approval.
PMI Europe’s net investment income includes interest and dividend income from its investment portfolio, gains and losses on currency re-measurement, realized investment gains and losses from investment activity, and currency exchange gains and losses when investments are sold. Gains and losses on currency re-measurement represent the revaluation of monetary assets and liabilities held by PMI Europe that are denominated in non-functional currencies into the functional currency, the Euro. PMI Europe incurred re-measurement losses of $34,000 in 2003 compared to re-measurement losses of $0.9 million in 2002. PMI Europe reduced its exposure to foreign exchange re-measurement fluctuations in early 2003 by reducing the amount of investments held in currencies other than the Euro. In October 2003, PMI Europe’s investments in Pounds Sterling increased by approximately 39 million Pounds Sterling in connection with its pending acquisition of the U.K. lenders’ mortgage insurance portfolio from R&SA. However, as these investments are available-for-sale debt securities, changes in market value due to currency re-measurement are recognized in other comprehensive income.
Losses and LAE increased in 2003 over 2002 due to increases in reserves for losses and claims. PMI Europe increased its loss reserves in 2003 primarily as a result of the additional risk acquired in the R&SA and other 2003 transactions. Claims paid totaled $0.8 million in 2003; no claims were paid in 2002 or 2001.
Our equity in earnings (pre-tax) from RAM Re totaled $4.2 million for 2003, $4.2 million for 2002 and $3.6 million for 2001. The equity in earnings from RAM Re for 2003 were unchanged compared to 2002 as a result of RAM Re’s $6.0 million increase to its provisions for losses and $1.9 million of other-than-temporary impairment to its investment portfolio, offset by an increase in RAM Re’s premiums earned in 2003. In 2003, we invested $24.4 million of a total of $92 million of additional capital raised by RAM Re. Our ownership interest percentage as a result of this capital investment remained the same.
The decrease in equity in earnings in 2003 over 2002 was due primarily to Fairbanks’ losses, our proportionate share of which was $17.7 million pre-tax in 2003. The growth in equity earnings in 2002 over 2001 was attributable to the increase in our ownership percentage of Fairbanks to 57% in 2002. In 2003, we sold our ownership interests in Truman for $6.5 million, resulting in a $3.6 million pre-tax realized loss, which was included in net realized investment gains and losses. We contributed an aggregate of $13.6 million in capital to Truman including our initial investment and received $8.3 million in capital distributions and $6.0 million of distributed earnings prior to the sale of this investment.
The PMI Group’s principal sources of funds are (i) dividends from certain of its insurance subsidiaries, (ii) investment income from its investment portfolio and (iii) funds that may be raised in the capital markets. 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.
The laws of Florida limit the payment of dividends by APTIC to The PMI Group without the approval of the Florida Department of Insurance to, subject to certain conditions, the greater of (i) 10% of policyholders’ surplus derived from realized net operating profits and net realized capital gains, or (ii) APTIC’s entire net operating
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 Corporation, which is the parent corporation of FGIC. FGIC’s ability to pay dividends is subject to restrictions contained in the insurance laws and related regulations of New York and other states where FGIC is licensed to do insurance business. Under New York insurance law, FGIC may pay dividends out of statutory earned surplus, provided that statutory surplus after any dividend may not be less than the minimum required paid-in capital and provided that together with all dividends declared or distributed by FGIC during the preceding 12 months, the dividends do not exceed the lesser of (i) 10% of policyholders’ surplus as of its last statement filed with the New York superintendent or (ii) adjusted net investment income during this period. In addition, in accordance with the normal practice of the New York Insurance Department in connection with change in control applications, FGIC Corporation is subject to commitments to the department that it will prevent FGIC from paying any dividends for a period of two years from the date of the acquisition, or December 18, 2005, without the prior written consent of the department.
FGIC Corporation is further restricted in the payment of dividends by the terms of its 6% senior notes, due 2034. Except as described in the following sentence, FGIC Corporation may not pay dividends unless the amount of the dividends, together with other similar payments, or restricted payments, during any fiscal year does not exceed the greater of (i) 30% of FGIC Corporation and its subsidiaries’ consolidated net income for the previous fiscal year and (ii) 2.5% of FGIC Corporation’s stockholders’ equity on its and its subsidiaries’ consolidated balance sheet as of the end of the previous fiscal year. FGIC Corporation may make restricted payments regardless of amount so long as the payments would not reasonably be expected to cause an adverse change to either (i) the then current insurance financial strength rating and outlook of FGIC or (ii) FGIC Corporation’s then current senior unsecured debt rating and outlook.
Our consolidated investment portfolio consists primarily of publicly traded municipal bonds, U.S. and foreign government bonds and corporate bonds. In accordance with SFAS No. 115, our entire investment portfolio is designated as available-for-sale and reported at fair value, and the change in fair value is recorded in accumulated other comprehensive income.
The following table summarizes the rating distributions of our consolidated investment portfolio.
Net realized gains decreased $0.8 million after-tax in 2003 compared with 2002. The decrease was due mainly to a reduction in fixed income sales activity in 2003, partially offset by an $11.2 million increase in net gains pre-tax in our equities portfolio due to favorable market conditions during 2003. In addition, other-than-temporary impairment of our equity portfolio was $0.3 million in 2003 compared to $6.9 million in 2002. During 2003 we sold our ownership interest in Truman, an unconsolidated subsidiary, and recognized a realized loss of $3.6 million.
$360.0 million in principal amount of 2.50% Senior Convertible Debentures due July 15, 2021 issued by The PMI Group;
$62.9 million in principal amount of 6.75% Notes due November 15, 2006 issued by The PMI Group;
$51.5 million 8.309% subordinated debentures due February 1, 2027 issued to an unconsolidated subsidiary trust of The PMI Group; and
The senior notes described above relate to our issuance in November 2003 of 13.8 million 5.875% equity units with a stated value of $25 per unit. The units include the senior notes and stock purchase contracts to purchase, no later than November 15, 2006, up to 9,032,100 shares of common stock for an aggregate purchase price of $345 million. Contract adjustment payments will be made on the stated value of the equity units at a rate of 2.875% per annum. Also in November 2003, we issued 5,750,000 shares of our common stock for an aggregate purchase price of approximately $220 million. As a result of the increase in our aggregate indebtedness upon completion of these recent transactions, our ability to issue significant amounts of additional indebtedness, while maintaining The PMI Group’s senior debt ratings and outlook and PMI’s financial strength ratings and outlook, is more limited. Accordingly, we do not anticipate effecting significant additional debt financings in the near term except the proposed credit facility described above.
The terms of the 2.50% Senior Convertible Debentures due July 15, 2021 provide that the holders of the debentures may require The PMI Group to repurchase outstanding debentures on July 15, 2004, 2006, 2008, 2011 and 2016 at a purchase price equal to the principal amount of the debentures to be repurchased plus accrued and unpaid interest. Instead of paying the purchase price in cash, we may pay all or a portion of the purchase price in common stock, valued at 97.5% of the average sale price of the common stock over a specified period, provided that the shares of common stock to be issued are registered under the Securities Act, if required. If the holders were to require us to repurchase the debentures on July 15, 2004, we presently have sufficient cash resources to fund such a repurchase.
We currently do not expect to engage in significant additional strategic investments in the near future. However, if we wish to provide additional capital to our existing operations or want to increase our equity investment in FGIC Corporation as opportunities become available, 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 be dependent 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 the risk-to-capital limitations described above. The stockholders agreement entered into in connection with our investment in FGIC Corporation restricts our ability to increase our equity interest in FGIC Corporation and, accordingly, we cannot be sure that, if we desire to do so, we will have opportunities to increase our ownership of FGIC Corporation in the near term or at all.
Although we currently have no plans to make significant additional capital contributions to our consolidated subsidiaries or strategic investments, business opportunities or unanticipated developments could require capital contributions. For example, as discussed under “-Ratings”, FGIC’s ability to conduct its business successfully depends in part on the triple-A financial strength ratings assigned to it by Moody’s, S&P and Fitch. We believe that FGIC has adequate capital to meet its current and anticipated needs. However, if there was a significant deterioration in FGIC’s operating results or rating agency concerns with respect to FGIC’s business, we could find it necessary to contribute substantial additional capital to maintain FGIC’s ratings in the future.
Consolidated cash flows generated by operating activities, including premiums, investment income, underwriting and operating expenses and losses, was $559 million in 2003 compared to $400 million in 2002. The increase in 2003 over 2002 was primarily due to premiums written of $114 million associated with the restructuring of certain existing U.S. primary insurance policies, and PMI Australia’s increased business activities, which primarily consist of single premium products.
Our contractual obligations include long-term debt, capital lease obligations, operating lease obligations and purchase obligations. Most of our capital expenditure commitments will be used for technology improvements. We have lease obligations under certain non-cancelable operating leases. Minimum rental payments under these operating leases as well as the obligation recorded under capital leases are provided in the table below.
Capitalized costs associated with software developed for internal use was $22.5 million in 2003 and $25.2 million in 2002. We expect to continue to invest in internally developed software.
Moody’s Investors Service, or Moody’s, has assigned an “A1” senior unsecured debt rating, stable outlook, with respect to The PMI Group’s 2.50% Senior Convertible Debentures and the 5.875% equity units; has assigned PMI an “Aa2” (stable outlook) insurance financial strength rating; has assigned PMI Australia an “Aa3” (positive outlook) insurance financial strength rating; and has assigned PMI Europe an “Aa3” (stable outlook) insurance financial strength rating.
In connection with our December 18, 2003 investment in FGIC Corporation, S&P, Fitch and Moody’s each affirmed their ratings of The PMI Group and PMI.
Determinations of ratings by the rating agencies are affected by a variety of factors, including macroeconomic conditions, economic conditions affecting the mortgage insurance industry, changes in regulatory conditions that may affect demand for mortgage insurance, competition, the need for us to make capital contributions to our subsidiaries and underwriting and investment losses.
We establish reserves for losses and LAE to recognize the liability of unpaid losses related to insured mortgages that are in default. We do not rely on a single estimate to determine our loss reserves. To ensure the reasonableness of the best estimates, we develop scenarios using generally recognized actuarial projection methodologies that result in a range of possible losses and LAE. Each scenario in the loss reserve model is assigned different weightings based upon actual claims experience in prior years to project the current liability. Our best estimate was slightly above the midpoint of our actuarially determined range of losses for 2003, primarily due to reserves for PMI Australia. Changes in loss reserves can materially affect our consolidated net income. The process of reserving losses requires us to forecast the interest rate and the housing market environments, which are highly uncertain and requires significant management judgment. In addition, different estimates could have been used in the current period, and changes in the accounting estimates are reasonably likely to occur from period to period based on the economic conditions. We review the judgments made in our prior period estimation process and adjust our current assumptions as appropriate. While our assumptions are based in part upon historical data, the loss provisioning process is complex and subjective and, therefore, the ultimate liability may vary significantly from our estimates.
International Operations includes PMI Australia and PMI Europe. Loss reserves for PMI Europe were $11.5 million at December 31, 2003, the majority of which were reserves acquired in connection with the R&SA mortgage insurance portfolio acquisition. An actuarial range for PMI Europe’s reserves has not been established.
U.S. Mortgage Insurance Operations-We establish PMI’s reserves for losses and LAE based upon our estimate of unpaid losses and LAE on (i) reported mortgage loans in default and (ii) estimated defaults incurred but not reported to PMI by its customers. As of December 31, 2003, our actuaries determined that PMI’s reasonable range of loss and LAE reserves was $285.3 million to $362.9 million. As of December 31, 2003, PMI’s reserves for losses and LAE were $325.3 million (gross of reinsurance recoverable), which represented our best estimate and approximately the midpoint of the actuarial range of loss. We believe the amount recorded represents the most likely outcome within the actuarial range.
Our current recorded loss reserve balance represents an increase of $9.6 million from PMI’s reserve balance at December 31, 2002. Our increase to the reserve balance at December 31, 2002 was due primarily to increases in reported delinquency inventory, expected higher proportions of those delinquencies developing into claims and higher mortgage insurance coverage levels on pending delinquencies leading to higher average claim sizes.
The table below provides a reconciliation of our U.S. Mortgage Insurance segment’s beginning and ending reserves for losses and LAE for each the periods indicated:
The above loss reserve reconciliation is presented to display the components of our loss reserve and LAE changes for the periods presented. Losses and LAE payments of $204.6 million, $121.2 million and $88.7 million for the periods ended 2003, 2002 and 2001, respectively, reflect amounts paid during the period presented and are not subject to estimation because they are derived solely from the actual timing of payments made. Losses and LAE incurred, net of changes to prior years, of $214.7 million, $149.8 million and $99.5 million for the periods ended 2003, 2002 and 2001, respectively, are management’s best estimates of ultimate losses and LAE and, therefore, are subject to estimation. Within the total losses and LAE incurred line item are reductions to incurred related to prior periods of $3.6 million, $85.2 million and $143.1 million for the periods ended 2003, 2002 and 2001, respectively. By setting out losses and LAE incurred by accident year, the table below breaks down the 2003, 2002 and 2002 reductions in reserves by particular accident years.
compared to PMI’s historic loss experience, evidenced by lower claim amounts, a robust real estate market and strong home price appreciation.
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, claims handling expenses and net expected future claim recoveries. These assumptions are evaluated in light of the same factors used by PMI. As of December 31, 2003, the actuarial range for PMI Australia’s reserves for losses and LAE ranged from $7.8 million to $10.5 million. As of December 31, 2003, PMI Australia’s reserves for losses and LAE were $10.2 million, which represented our best estimate and a decrease of $7.1 million from PMI Australia’s reserve balance of $17.3 million at December 31, 2002. The $7.1 million reduction in PMI Australia’s reserves for losses and LAE since December 31, 2002 was due primarily to a decline in the rate of defaults developing into claims as well as a reduction in default rates, both attributable to strong economic conditions in Australia. The reserves released were established primarily in the years 2002 through 2003. We recorded reserves in Australia of $10.2 million, at the high end of the actuarial range of loss, in light of the factors described above and were also influenced by Australian insurance regulations requiring higher confidence levels for reserve balances and our belief that the recent low loss rates experienced by PMI Australia may be unsustainable in the future.
PMI Europe’s loss reserves at December 31, 2003 were $11.5 million compared to $0.5 million at December 31, 2002. This increase was due primarily to the fourth quarter 2003 acquisition of the R&SA portfolio, which included reserves of $8 million. The remaining increase was due to additional risk written by PMI Europe during 2003. Currently we do not determine an actuarial range of loss for PMI Europe loss reserves. As we accumulate additional loss data related to the acquired portfolio, we anticipate determining an actuarial range of loss. We establish PMI Europe’s loss reserves for credit default swap transactions consummated before July 1, 2003, primary insurance and excess-of-loss reinsurance. Revenue, losses and other expenses associated with credit default swaps executed on or after July 1, 2003 are recognized through a derivative accounting treatment in accordance with SFAS No. 149. PMI Europe’s loss reserving methodology contains three components: case reserves, IBNR reserves, and reserves on risk-remote positions. Case and IBNR reserves are based upon PMI Europe’s estimation of incurred loss. Reserves on risk-remote positions are based on the assumption that even in transactions where the likelihood of loss to PMI Europe is remote, a series of such transactions represent an increased likelihood that some small percentage of these transactions may experience losses. Therefore, PMI Europe has calculated reserves on risk-remote positions based upon historical bond default rates at the corresponding rating levels.
Other-Than-Temporary Impairment-We have a formal review process for all securities in our investment portfolio, including a review for impairment losses. Factors considered when assessing impairment include:
The following table shows our investments’ gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2003.
We have determined that there was no other than temporary impairment in our consolidated investment portfolio as of December 31, 2003. Unrealized losses in the fixed income portfolio are primarily due to interest rate fluctuations during the year and as such do not qualify for other than temporary impairment as we have the ability to hold until maturity. The remaining unrealized losses do not meet the criteria established in our policy and as such are not considered impaired.
Our policy acquisition costs are related to the issuance of primary mortgage insurance policies, including acquiring, underwriting and processing new business, as well as sales related activities. We defer policy acquisition costs when incurred and amortize these costs in proportion to estimated gross profits for each policy year. The estimates for each policy year are monitored regularly to reflect actual experience and any changes to persistency or loss development. We review our estimation process on a regular basis and any adjustments made to the estimates are reflected in the current period’s operating results. Deferred policy acquisition costs are reviewed periodically to determine that they do not exceed recoverable amounts, after considering investment income.
Economic factors have adversely affected and may continue to adversely affect PMI’s loss experience and demand for mortgage insurance.
PMI’s loss experience has materially increased over the past year and could continue to increase as a result of: national or regional economic recessions; declining values of homes; higher unemployment rates; higher levels of consumer credit; deteriorating borrower credit; interest rate volatility; war or terrorist activity; or other economic factors. These factors could also materially reduce demand for housing and, consequently, demand for mortgage insurance.
We could be affected by economic downturns in specific regions of the United States where a large portion of PMI’s business is concentrated. As of December 31, 2003, 9.3% of PMI’s primary risk in force was located in California, 9.2% was located in Florida and 7.0% was located in Texas. In addition, refinancing of mortgage loans can have the effect of concentrating PMI’s insurance in force in economically weaker areas of the U.S.
PMI’s insurance written includes less-than-A quality loans and non-traditional loans. The credit quality, loss development and persistency on these loans can vary significantly from PMI’s traditional A quality loan business. For example, PMI’s primary bulk portfolio is experiencing higher delinquency and claims rates, and higher average claims paid amounts, than PMI’s primary flow portfolios due, in part, to the higher concentration of less-than-A quality and non-traditional loans in the bulk portfolio. We expect that PMI will continue to experience higher default rates for less-than-A quality and non-traditional loans than for its A quality loans. We cannot be sure that the premiums that PMI charges on less-than-A quality loans and non-traditional loans will adequately offset the associated risk.
PMI’s loss experience may increase as PMI’s policies continue to age.
The majority of claims with respect to primary insurance written through PMI’s flow channel have historically occurred during the third through the sixth years after issuance of the policies. PMI’s primary bulk loans that result in claims generally reach claims status more quickly than primary flow loans. As of December 31, 2003, approximately 92% of PMI’s primary risk in force was written after December 31, 1998 and 73% was written after December 31, 2001. Accordingly, a significant majority of PMI’s primary portfolio is in, or approaching, its peak claim years. We believe PMI’s loss experience may increase as PMI’s policies age. If the claim frequency on PMI’s risk in force significantly exceeds the claim frequency that was assumed in setting PMI’s premium rates, our consolidated financial condition and results of operations would be harmed.
We establish loss reserves to recognize the liability for unpaid losses related to insurance in force on mortgages that are in default. These loss reserves are regularly reviewed and are based upon our estimates of the claim rate and average claim amounts, as well as the estimated costs, including legal and other fees, of settling claims. Any adjustments, which may be material, resulting from these reviews are reflected in our consolidated results of operations. Our consolidated financial condition and results of operations could be harmed if our reserve estimates are insufficient to cover the actual related claims paid and loss-related expenses incurred.
A significant percentage of PMI’s new insurance written is underwritten pursuant to a delegated underwriting program under which certain mortgage lenders may determine whether mortgage loans meet PMI’s program guidelines and commit us to issue mortgage insurance. We may expand the availability of delegated
underwriting to additional customers. If an approved lender commits us to insure a mortgage loan, PMI may not refuse, except in limited circumstances, to insure, or rescind coverage on, that loan even if it reevaluates that loan’s risk profile and determines the risk profile to be unacceptable or the lender fails to follow PMI’s delegated underwriting guidelines.
Our subsidiary MSC provides contract underwriting services for a fee. As a part of the contract underwriting services, MSC provides monetary and other remedies to its customers in the event that it fails to properly underwrite a mortgage loan. As a result, we assume credit and interest rate risk in connection with our contract underwriting services. Generally, the scope of the remedies provided by MSC is in addition to those contained in PMI’s master policies. Contract underwriting services apply to a significant percentage of PMI’s insurance in force and the costs relating to the investigation and/or provision of remedies could have a material adverse effect on our consolidated financial condition and results of operations. Worsening economic conditions or other factors that could increase PMI’s default rate could also cause the number and severity of remedies to increase.
years, the volume of 80/10/10 loans as an alternative to loans requiring mortgage insurance has increased significantly and may continue to do so for the foreseeable future.
The principal sources of PMI’s competition include: other private mortgage insurers, some of which are subsidiaries of well-capitalized, diversified public companies with direct or indirect capital reserves that provide them with potentially greater resources than we have; and alternatives to private mortgage insurance discussed above.
Through their various origination channels, PMI’s top ten customers accounted for approximately 42% of PMI’s premiums earned in 2003. A single customer represented 13% of PMI’s earned premiums in 2003. Mortgage insurers, including PMI, may acquire significant percentages of their business through negotiated transactions (including bulk primary and modified pool insurance) with a limited number of customers. The loss of a significant customer could reduce our revenue, and if not replaced, harm our consolidated financial condition and results of operations.
The GSEs are the beneficiaries on a substantial majority of the insurance policies we issue as a result of their purchases of home loans from lenders or investors. The GSEs offer programs that require less mortgage insurance coverage on mortgages approved by their automated underwriting systems. In the past Freddie Mac and, more recently, Fannie Mae, have indicated their intent to reduce their use or required level of mortgage insurance. If the reduction in required levels of mortgage insurance becomes widely accepted by mortgage lenders, or if the GSEs further reduce mortgage insurance coverage requirements for loans they purchase, PMI’s premium revenue would decline and our consolidated financial condition and results of operations could suffer.
The GSEs, mortgage lenders and PMI jointly develop and make available various products and programs. These arrangements involve the purchase of PMI’s mortgage insurance products and frequently feature cooperative arrangements between the parties. FM Policy Focus, a lobbying organization representing financial services and housing-related trade associations, including the Mortgage Insurance Companies of America and several large mortgage lenders, supports increased federal oversight of the GSEs. The GSEs have criticized the activities of FM Policy Focus. FM Policy Focus, the GSEs and other groups are engaged in extensive lobbying activities with respect to proposed legislation which would change the way GSEs are regulated. These activities could polarize Fannie Mae, Freddie Mac, members of FM Policy Focus, PMI’s customers and us. Any such polarization could limit PMI’s opportunities to do business with the GSEs as well as with some mortgage lenders. Either of these outcomes could harm our consolidated financial condition and results of operations.
An increasing percentage of PMI’s new insurance written is being generated by customers with captive reinsurance companies, and we expect that this trend will continue. See “Business-U.S. Mortgage Operations-Products-Captive Reinsurance”. If PMI does not provide its customers with acceptable risk-sharing structured transactions, including potentially increasing levels of premium cessions in captive reinsurance agreements, PMI’s competitive position may suffer. An increase in captive reinsurance agreements will negatively impact PMI’s net premiums written, which may negatively impact the yield that we obtain on net premiums earned for customers with captive reinsurance agreements.
A downgrade of PMI’s claims-paying ability could materially harm our financial performance.
To control its risk-to-capital ratio, PMI may seek capital contributions from The PMI Group or third party credit enhancements, or may be required to reduce the amount of new business written. The PMI Group may not be able to raise additional funds, or do so on a timely basis, in order to make a capital contribution to PMI. In addition, third party credit enhancements may not be available to PMI or, if available, may not be available on satisfactory terms. A material reduction in PMI’s statutory capital, whether resulting from underwriting or investment losses or otherwise, or a disproportionate increase in risk in force, could increase its risk-to-capital ratio, which in turn could limit its ability to write new business, impair PMI’s ability to pay dividends to The PMI Group and seriously harm our consolidated financial condition and results of operations.
Our ongoing ability to pay dividends to our shareholders and meet our obligations primarily depends upon the receipt of dividends and returns of capital from our insurance subsidiaries and our investment income.
In addition, a protracted economic downturn, or other factors, could cause issuers of the fixed-income securities that we and FGIC and RAM Re own to default on principal and interest payments, which could cause
If we are unable to keep pace with the technological demands of our customers or with the technology-related products and services offered by our competitors, our business and financial performance could be significantly harmed.
Participants in the mortgage lending and mortgage insurance industries rely on e-commerce and other technology to provide and expand their products and services. Our customers generally require that we provide our products and services electronically via the Internet or electronic data transmission, and the percentage of our new insurance written and claims processing which is delivered electronically has increased. We expect this trend to continue, and accordingly, we believe that it is essential that we continue to invest substantial resources in maintaining electronic connectivity with our customers and, more generally, in e-commerce and technology. Our business may suffer if we do not keep pace with the technological demands of our customers and the technological capabilities of our competitors.
We received notices of assessment from the California Franchise Tax Board, or FTB, for 1997 through 2000 in amounts totaling $13.9 million, not including the federal tax benefits from the payment of such assessment or interest that might be included on amounts, if any, ultimately paid to the FTB. As of December 31, 2003, we had $4.7 million of reserve relating to the assessments for the years 1997 through 2000. We could be subject to additional assessments relating to years after 2000. We have not reserved amounts for years after 2000. While we are protesting the assessments we have received, we cannot provide assurance as to the ultimate outcome of this matter.
Our international insurance subsidiaries subject us to numerous risks associated with international operations.
We have subsidiaries in Australia and Europe. We have committed and may in the future commit additional significant resources to expand our international operations. Accordingly, in addition to the general economic and insurance business-related factors discussed above, we are subject to a number of risks associated with our international business activities. These risks include: the need for regulatory and third party approvals; challenges in attracting and retaining key foreign-based employees, customers and business partners in international markets; economic downturns in targeted foreign mortgage origination markets; interest rate volatility in a
variety of countries; unexpected changes in foreign regulations and laws; the burdens of complying with a wide variety of foreign laws; potentially adverse tax consequences; restrictions on the repatriation of earnings; foreign currency exchange rate fluctuations; potential increases in the level of defaults and claims on policies insured by foreign-based subsidiaries; the need to successfully develop and market products appropriate to the foreign market, including the development and marketing of credit enhancement products to European lenders and for mortgage securitizations; and natural disasters and other events (e.g., toxic contamination) that would damage properties and that could precipitate borrower default.
PMI Australia’s five largest customers provided 58% of PMI Australia’s 2003 gross premiums written. PMI Australia’s loss of a significant customer, if not replaced, could harm PMI Australia’s and our consolidated financial condition and results of operations.
We have devoted resources to expand our European operations, PMI Europe, and we plan to continue these efforts. The success of our efforts will depend partly upon legislative and regulatory policies in Europe that support homeownership and provide capital relief for institutions that obtain credit enhancement with respect to their mortgage loan portfolios. If European legislative and regulatory agencies do not adopt such policies, our European operations may be adversely affected.
PMI Europe is currently rated “AA” by S&P and Fitch and “Aa3” by Moody’s. These ratings are based in part upon a capital support agreement between PMI and PMI Europe and a guarantee of that agreement by The PMI Group. Termination or amendment of this support structure could negatively impact PMI Europe’s ratings. PMI Europe’s business is dependent on maintaining its ratings. Any negative impact on its ratings will negatively affect its financial results.
The performance of our unconsolidated strategic investments could harm our consolidated financial results.
We have made significant investments in the equity securities of several privately-held companies, including FGIC Corporation, the parent of Financial Guaranty Insurance Company, or FGIC, a financial guaranty insurer, Fairbanks, the parent of Fairbanks Capital, a third-party servicer of single-family residential mortgages, and RAM Holdings Ltd. and RAM Holdings II Ltd., which are the holding companies for RAM Re, a financial guaranty reinsurance company based in Bermuda.
Our investments in FGIC Corporation, Fairbanks and RAM Re are accounted for on the equity method of accounting in our consolidated financial statements. Our investments in our unconsolidated strategic investments together with CMG Mortgage Insurance Company totaled $937.8 million as of December 31, 2003, compared to $289.8 million as of December 31, 2002. The nature of the businesses conducted by these companies differs significantly from our core business of providing residential mortgage insurance. These companies are subject to a number of significant risks that arise from the nature of their businesses. Some of the various risks affecting Fairbanks and FGIC Corporation are discussed below. Because we do not control these companies, we are dependent upon the management of these companies to independently operate their businesses and, accordingly, we may be unable to take actions unilaterally to avoid or mitigate those risks.
Fairbanks and Fairbanks Capital’s servicing practices have been the subject of investigations by the FTC, HUD and the Department of Justice. On November 12, 2003 the FTC and HUD announced that they had reached a settlement of their ongoing investigations of Fairbanks. The settlement requires changes in Fairbanks’ operations and the creation of a $40 million redress fund for the benefit of consumers to remedy the violations of law alleged by the FTC and HUD. We have guaranteed approximately two-thirds of the funds that may become due to Fairbanks’ lenders under a $30.7 million letter of credit, which may be drawn upon by the FTC as security for a portion of a $40 million redress fund as part of the settlement. The settlement is contingent upon the final order of the federal district court in Massachusetts becoming effective, which will occur upon the related settlement of certain class action litigation (see below). The FTC staff has indicated that the FTC will file an enforcement action against Fairbanks if the settlement order does not become effective. Fairbanks’ financial condition and results of operations could be adversely impacted if the settlement does not become effective and the FTC commences an enforcement action against it.
Regulatory agencies in five states in which Fairbanks Capital does a significant amount of business have indicated that, notwithstanding the settlement by Fairbanks with the FTC and HUD, they intend to require Fairbanks Capital to refund to consumers in their respective states amounts that they allege Fairbanks Capital had improperly collected and to enter into consent decrees regulating various aspects of Fairbanks Capital’s business. In addition, Fairbanks has entered into a consent order with the State of Maryland under which it has agreed to change certain of its practices under Maryland law and refund certain amounts to Maryland borrowers. Other states could also seek to require such refunds or consent orders. If Fairbanks is unable to resolve the issues with the state regulatory agencies, those regulatory agencies may bring administrative or other actions against Fairbanks or Fairbanks Capital seeking to change its business practices, require refunds and, potentially, monetary penalties or revocation of Fairbanks Capital’s license to conduct its business in such states.
and a stipulation regarding its future operations. There can be no assurance that the Court will approve the settlement. Fairbanks’ financial condition and results of operations could be negatively impacted if such settlement is not finalized. In addition, PMI has been named as a defendant in several actions relating to the practices of Fairbanks. With the exception of two actions in California, both of which have been stayed, the actions in which PMI has been named as a defendant have been dismissed without prejudice or settled by Fairbanks Capital. If the Fairbanks Capital settlement of the class action litigation described above is effected, that settlement will also include a release of PMI. PMI could be named as a defendant in additional actions with respect to Fairbanks in the future.
As of December 31, 2003, our total investment balance in Fairbanks was approximately $142 million, consisting of approximately $116 million book value of equity investment and approximately $26 million in subordinated participation interests and advances to Fairbanks. In addition, we have guaranteed an aggregate of $7 million of Fairbanks’ indebtedness as well as approximately two-thirds of Fairbanks’ obligations under a $30.7 million letter of credit related to the pending settlement with the FTC and HUD. Our total investment could become impaired or uncollectible as a result of the risks involving Fairbanks, which would harm our consolidated financial condition and results of operations. We have evaluated our total investment in Fairbanks as of December 31, 2003 and have not recognized an impairment charge with respect to our investment. Developments with respect to regulatory and litigation matters involving Fairbanks, Fairbanks Capital’s ratings, Fairbanks Capital’s credit facilities and Fairbanks’ business prospects generally could require us to recognize an impairment charge with respect to our investment in Fairbanks in the future.
The settlement by the FTC and HUD of proposed civil charges against Fairbanks includes a release by the FTC and HUD in favor of us and our employees who served as directors of Fairbanks relating to the claims and conduct alleged or that could have been alleged in the FTC and HUD actions with respect to Fairbanks’ loan servicing practices. If the settlement is not implemented by the Court, or if the settlement is implemented and is subsequently overturned on appeal, the FTC may choose to bring an action against us. The filing of an FTC action against us could lead to regulatory actions by other regulatory agencies or private litigation against us, could impact our ability to obtain regulatory approvals necessary to carry out our present or future plans and operations, and could result in negative publicity that might adversely affect our business. Any such action brought against us by the FTC could seriously harm our consolidated financial position and results of operations.
recent developments discussed above, Fairbanks Capital’s ability to continue to service its existing servicing portfolios and to acquire new portfolios in the future is uncertain. Fairbanks has a limited number of customers and losses in Fairbanks’ customer base due to rating agency actions or otherwise could have an adverse effect on Fairbanks and our investment in Fairbanks.
Fairbanks Capital is highly leveraged and, if it were to lose access to, or default on, its debt facilities, Fairbanks might be unable to fund its operations or pay its debts as they come due.
Our ability to borrow money is constrained by a number of factors, including the impact of borrowings on our ratings. In November, 2003, we offered and sold equity units which consist in part of $345 million aggregate principal amount of our 3.0% senior notes due November 15, 2008. As a result of the equity units offering, we have used a significant portion of our borrowing capacity and have significantly increased our leverage. As a result, among other things, we may be limited in our ability to raise significant amounts of capital, in the event that we need to do so, without the use of equity. Future issuances of our common stock may adversely affect our stock price. In addition, the degree to which we are leveraged will limit our ability to obtain financing for working capital, acquisitions or other purposes.
We expect that a significant portion of our net income will be derived from FGIC and its financial guaranty business. Accordingly, we will be subject to all the risks and uncertainties associated with that business. In addition, FGIC has historically operated its financial guaranty business principally in one market segment-municipal finance. We currently expect that FGIC will expand its business lines and products into other markets and asset classes that historically have experienced higher default rates than municipal finance. The risks and uncertainties to which we will be exposed as a result of the FGIC acquisition include the following, among others:
The financial guaranty business is subject to extensive regulation. Future legislative, regulatory or judicial changes affecting the financial guaranty industry or municipal or asset-backed obligations or markets, including changes in tax laws, could adversely affect FGIC’s business.
FGIC establishes specific reserves for the net present value of estimated losses on particular insured obligations when, in management’s opinion, the likelihood of a future loss is probable and the amount of the ultimate loss that FGIC expects to incur can be reasonably estimated. FGIC also establishes reserves to cover those impaired credits on its credit watch list. These latter reserves are designed to recognize the potential for claims on credits that have migrated to an impaired level where there is an increased probability of payment default, but that are not presently or imminently in payment default. Although FGIC’s loss reserves are regularly reviewed and updated, they are necessarily based on estimates and subjective judgments about the outcome of future events. We cannot be sure that losses in FGIC’s insured portfolio will not exceed by a material amount the loss reserves previously established by FGIC or that additional significant reserves will not need to be established.
FGIC’s insurance portfolio contains concentrations of sellers, servicers and obligors, some of which are significant. An adverse event with respect to one or more of these concentrations could result in disproportionate and significant losses to FGIC.
The accompanying consolidated financial statements include the accounts of The PMI Group, Inc. (“The PMI Group”), a Delaware corporation; its direct and indirect wholly-owned subsidiaries, PMI Mortgage Insurance Co. (“PMI”), an Arizona corporation; American Pioneer Title Insurance Company (“APTIC”), a Florida corporation reported as discontinued operations; PMI Mortgage Insurance Ltd and PMI Indemnity Limited, Australian mortgage insurance companies, and their holding company, PMI Mortgage Insurance Australia (Holdings) Pty Limited (collectively, “PMI Australia”); PMI Mortgage Insurance Company Limited and its holding company TPG Reinsurance Co. Ltd, Irish insurance corporations (collectively, “PMI Europe”); and other insurance, reinsurance and non-insurance subsidiaries. The PMI Group and its subsidiaries are collectively referred to as the “Company.” All material intercompany transactions and balances have been eliminated in consolidation.
In addition to FGIC, the Company has equity ownership interests in Fairbanks Capital Holding Corp. (“Fairbanks”), a servicer of single-family residential mortgages; CMG Mortgage Insurance Company (“CMG”), which conducts residential mortgage insurance business; and through the holding companies, RAM Holdings Ltd. and RAM Holdings II Ltd., RAM Reinsurance Company, Ltd. (“RAM Re”), a financial guaranty reinsurance company based in Bermuda.
The Company’s various U.S. insurance subsidiaries are subject to comprehensive federal and state regulation. The Company’s Australian and Irish insurance subsidiaries are subject to similarly comprehensive regulation. These regulations are generally intended to protect policyholders, rather than to benefit investors. Although their scope varies, applicable laws and regulations grant broad powers to supervisory agencies or officials to examine companies and to enforce rules or exercise discretion touching almost every significant aspect of the insurance business. The licensing of the Company’s insurance subsidiaries, their premium rates,
their forms and policies offered to customers, their financial statements and periodic financial reporting, and their permissible investments and adherence to financial standards relating to statutory surplus, dividends to the Company and other criteria of solvency are all subjects of detailed regulation.
The Company expects that a significant portion of its consolidated net income will be derived from FGIC and its financial guaranty business. Accordingly, we are subject to all the risks and uncertainties associated with that business. The financial guaranty business is subject to extensive regulation. Future legislative, regulatory or judicial changes may affect the financial guaranty industry or municipal or asset-backed obligations or markets. Any expansion by FGIC into other markets and other asset classes will entail risks and uncertainties associated with its ability to maintain a triple-A rating and to compete with other monoline financial guaranty insurance companies.
The Company’s short-term investments have maturities of greater than three and less than 12 months when purchased and are carried at fair value. Realized gains and losses on sales of investments are determined on a specific-identification basis. Investment income consists primarily of interest and dividends. Interest income and preferred stock dividends are recognized on an accrual basis. Dividend income on common stock is recognized on the date of declaration. Net investment income represents interest and dividend income, net of expenses.
Although the Company’s ownership percentage of Fairbanks exceeds 50%, the Company reports its investment in Fairbanks using the equity method of accounting due to an agreement among the shareholders of Fairbanks limiting the Company’s ability to control the operations of Fairbanks. This treatment is in accordance with guidance provided by Emerging Issues Task Force Issue (“EITF”) No. 96-16, Investor’s Accounting for an Investee When the Investor Has a Majority of the Voting Interest but the Minority Shareholder or Shareholders Have Certain Approval or Veto Rights.
Periodically, or as events dictate, the Company evaluates potential impairment of its investments in unconsolidated subsidiaries. APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock, 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 gains or losses resulting from the sale of the Company’s ownership interests of unconsolidated subsidiaries are recognized in net realized investment gains or losses in the consolidated statement of operations.
The Securities and Exchange Commission (“SEC”) requires public companies to disclose condensed financial statement information in the footnotes for significant equity investees and unconsolidated majority owned subsidiaries, individually or in the aggregate, if (i) the Company’s investments in and advances to the subsidiaries are in excess of 10% of the total consolidated assets of the Company, (ii) the Company’s proportionate share of unconsolidated majority owned subsidiaries’ total assets is in excess of 10% of total consolidated assets of the Company, or (iii) income from continuing operations before income taxes, extraordinary items and the cumulative effect of a change in accounting principle of the unconsolidated subsidiaries is in excess of 10% of such income of the Company. Furthermore, if certain of the above tests exceed 20% by any unconsolidated subsidiary; separate financial statements of that unconsolidated subsidiary are required to be included in SEC filings. As of December 31, 2003, the Company’s equity investees and unconsolidated majority owned subsidiary exceeded the 10% test in the aggregate and, accordingly, condensed financial statements on a combined basis are provided in Note 23.
Deferred Policy Acquisition Costs-The Company defers certain costs in its mortgage insurance operations relating to the acquisition of new insurance and amortizes these costs against related premium revenue in order to match costs and revenues. These costs are primarily associated with the acquisition, underwriting and processing of new business, including contract underwriting and sales related activities. To the extent the Company is compensated by customers for contract underwriting, those underwriting costs are not deferred. Costs related to
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 on a straight-line basis over the estimated useful life of the asset at such time as the software is ready for its intended use, which is generally three to seven years.
Related Party Receivables-These receivables include non-trade receivables from unconsolidated subsidiaries. The balance is comprised of approximately $23 million of subordinated participation interests in Fairbanks debt, which was part of a debt restructuring completed in the second quarter of 2003. The participation bears interest at LIBOR plus 2.5% and is payable monthly. The balance may begin to be repaid as early as June 2004, with the balance due and payable in September 2004. In addition, the Company has approximately $3 million of advances to Fairbanks related to other matters.
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 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 as with all reinsurance contracts. 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.
Stock-Based Compensation-The Company accounts for stock-based compensation to employees and directors using the intrinsic value method prescribed in APB Opinion No. 25, Accounting for Stock Issued to Employees, and its related interpretations. Under APB Opinion No. 25, compensation cost for stock-based awards is measured as the excess, if any, of the market price of the underlying stock on the grant date over the employees’ exercise price for the stock options. As all options have been granted with an exercise price equal to the fair value at the date of the grants, no compensation expense has been recognized for the Company’s stock option program. SFAS No. 123, Accounting for Stock-Based Compensation, requires the pro forma disclosure of net income and earnings per share using the fair value method, and provides that the employers may continue to account for the stock-based compensation under APB Opinion No. 25. SFAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure, amends SFAS No. 123 and requires prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results.
Income Taxes-The Company accounts for income taxes using the liability method in accordance with SFAS No. 109, Accounting for Income Taxes. The liability method measures the expected future tax effects of 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 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.
outstanding during the period. Diluted EPS is based on consolidated net income available to common stockholders and the weighted-average of dilutive common stock shares outstanding during the period. The weighted-average dilutive common stock shares reflect the potential increase of common stock shares if outstanding securities were converted into common stock, or if contracts to issue common stock, including stock options issued by the Company that have a dilutive impact, were exercised. Consolidated net income available to common stockholders is the same for computing basic and diluted EPS. The convertible debt and equity units outstanding have not been included in the calculation of diluted shares outstanding as they are antidilutive for the periods presented.
The following is a reconciliation of the weighted-average of the common stock shares used to calculate basic EPS to the weighted-average common stock shares used to calculate diluted EPS for the years ended December 31, 2003, 2002 and 2001:
Reclassifications-Certain items in the prior year’s consolidated financial statements have been reclassified to conform to the current year’s presentation.
In August 2002, the FASB issued FIN No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Other, prescribing the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The initial recognition and initial measurement provisions of this guidance are applicable on a prospective basis to guarantees issued or modified after December 31, 2002. The disclosure requirements in this Interpretation are effective for financial statements of interim or annual periods ending after December 15, 2002. The additional disclosure requirements of FIN No. 45 are included in Commitments and Contingencies footnote. The Company has determined that the effect of the adoption of this pronouncement was not material as of December 31, 2003.
In December 2003, the FASB issued SFAS No. 132 (revised 2003), Employers’ Disclosures about Pensions and Other Postretirement Benefits. This revision carries forward the disclosures previously required by SFAS No. 132, and requires additional disclosure of the measurement date used for the majority of the plans, the accumulated benefit obligation, and information about the plans assets and cash flows. It also requires that cost and contribution information be presented in interim period reports. The new disclosure requirements are generally effective for annual financial statements for fiscal years ending after December 15, 2003 or interim periods beginning after December 15, 2003. The required disclosures are provided in Benefit Plans footnote.
Effective January 1, 2002, the Company adopted SFAS No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets. Under SFAS No. 142, any unamortized negative goodwill related to an excess of fair value over cost arising from business combinations completed before July 1, 2001 must be written off and recognized as a cumulative effect of a change in accounting principle upon the adoption of SFAS No. 142. Accordingly, the Company realized a $7.2 million gain for the remaining balance of negative goodwill in the first quarter of 2002, which was originally recorded in connection with the acquisition of PMI Ltd in 1999.
The Company determined that the decline in market value of certain equity securities in its investment portfolio met the definition of other-than-temporary impairment, and recognized realized losses of $0.3 million, $6.9 million and $3.2 million in 2003, 2002 and 2001, respectively.
Scheduled Maturities-The following table sets forth the amortized cost and fair value of fixed income securities by contractual maturity at December 31, 2003:
The following table shows our investments gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position as of December 31, 2003.
The Company determined that there was no other than temporary impairment in its consolidated investment portfolio as of December 31, 2003. Unrealized losses in the fixed income portfolio are primarily due to interest rate fluctuations during the year and as such do not qualify for other than temporary impairment as the Company has the ability to hold until maturity. The remaining unrealized losses do not meet the criteria established in our policy and as such are not considered impaired.
Investment Concentrations and Other Items-The Company maintains a diversified portfolio of municipal bonds. The following states represent the largest concentrations in the municipal bond portfolio, expressed as a percentage of the carrying value of all municipal bond holdings. Holdings in states that exceed 5% of the municipal bond portfolio at December 31, for the respective years are presented below:
At December 31, 2003, fixed income securities and short-term investments with a fair value of $15.3 million were on deposit with regulatory authorities as required by law. In addition, $15.4 million cash were held in a bank in Hong Kong for Statutory purposes.
In connection with the settlement reached between Fairbanks and the FTC and HUD, Fairbanks recognized aggregate charges of approximately $55 million pre-tax in September 2003 related to the costs of settlement, estimated costs of potential settlements of certain putative class actions pending against Fairbanks, and estimated costs relating to certain pending state regulatory actions. The Company’s proportionate share of such charges was $19.1 million pre-tax, which was recognized in equity in earnings from unconsolidated subsidiaries in September 2003.
In 2003, the Company sold its ownership interest in Truman Capital Founders, LLC and Truman Capital Advisors, LLC, for $6.5 million resulting in a $3.6 million loss pre-tax, which was recognized in net realized investment gains and losses in the consolidated statements of operations.
The following table sets forth the cost basis and accumulated depreciation of property and equipment as of December 31, 2003 and December 31, 2002:
Depreciation and amortization expense related to property and equipment totaled $22.7 million in 2003, $17.8 million in 2002 and $10.6 million in 2001. Capitalized costs associated with software developed for internal use was $22.5 million in 2003, $25.2 million in 2002 and $16.1 million in 2001.
In connection with relocating its corporate headquarters, the Company performed an evaluation of the estimated costs with respect to the relocation and recognized a $12.2 million pre-tax charge related to lease abandonment and relocation costs in 2002. The charge consists of $8.3 million for the estimated loss on the abandonment of the lease obligations for the previous home office space, $1.7 million for the write-off of abandoned fixed assets, and $2.2 million for other relocation and employee retention expenses.
The increase in loss reserves in 2003 over 2002 was due primarily to increases in the reserve balances in U.S. mortgage operations and in PMI Europe offset by a decrease in the reserve balance in PMI Australia. The reserve increase in U.S. operations were the result of expected higher proportions of delinquencies developing into claims as well as higher mortgage insurance coverage levels on pending delinquencies. This has led to higher average claim amounts. U.S. Operations primary insurance default inventory was 37,445 at December 31, 2003, 36,537 at December 31, 2002 and 25,228 at December 31, 2001. The default rate was 4.53% at year-end 2003, 4.18% at year-end 2002 and 2.86% at year-end 2001. 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.
The $19.1 million, $88.6 million and $143.2 million reductions in total incurred related to prior years were due to re-estimations of ultimate loss rates from those established at the original notice of default, updated through the period 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 $19.1 million reduction in prior years’ reserves during 2003 was due primarily to (i) a reduction in PMI Australia’s loss reserves; and (ii) favorable PMI pool portfolio loss development trends. The $88.6 million and $143.2 million total reductions in prior years’ reserves during 2002 and 2001, respectively, were due primarily to more favorable loss trends than expected compared to PMI’s historic loss experience, evidenced by lower claim amounts, a robust real estate market and strong home price appreciation.
Equity Units-In November 2003 and in connection with the Company’s investment in FGIC, the Company sold 13.8 million 5.785% equity units and raised $345.0 million of gross proceeds. Each unit has two components: a senior note component and a purchase contract component. The senior note has a $25 principal amount with a 3.0% annual interest rate paid quarterly and maturing on November 11, 2008. The purchase contract component pays a 2.875% annual contract payment quarterly and obligates the holders to purchase $345 million of newly issued shares of the Company’s common stock, no later than November 15, 2006. Further details are provided in Dividends and Shareholders’ Equity footnote. In addition, the senior notes have a remarketing feature and will be remarketed in August 2006.
Senior Convertible Debentures-In July 2001, the Company issued $360 million of 2.50% Senior Convertible Debentures (“the Debentures”) in a private offering to qualified institutional buyers, and subsequently filed a shelf registration statement for the resale of the Debentures and the common stock of The PMI Group issuable upon conversion of the Debentures. The Company used a portion of the net proceeds for the repayment or retirement of existing indebtedness and the remainder for general corporate purposes. The Debentures are due on July 15, 2021 and bear interest at a rate of 2.50% per annum, payable semiannually. The Debentures are convertible at the registered holders’ option, prior to stated maturity, into shares of the Company’s common stock at an initial conversion price of $44.16 per share if specified requirements are met, subject to adjustments in specified circumstances. The most significant requirement for such conversion is that the trading price of the Company’s common stock must exceed 120% of the initial conversion price for 20 consecutive trading days within a 30-day trading period. The Company may redeem some or all of the Debentures on or after July 15, 2006 for a price equal to the principal amount of the Debentures plus any accrued and unpaid interest. The holders may put the Debentures to the Company on July 15, 2004, 2006, 2008, 2111 and 2116. Upon a change of control of the Company, holders may also require the Company, subject to certain conditions, to repurchase all or a portion of the Debentures. The Company may repurchase the Debentures with cash, common stock, or a combination of cash and shares of common stock. If the Company elects to pay all or a portion of the purchase price in common stock, the shares of common stock will be valued at 97.5% of the average sale price for twenty trading days ending on the third day prior to the repurchase date.
Considerable judgment is required in interpreting market data to develop the estimates of fair value and, therefore, changes in the assumptions may have a material effect on the fair valuation estimates. A number of the Company’s significant assets and liabilities, including deferred policy acquisition costs, real estate owned, property and equipment, loss reserves, unearned premiums and deferred income taxes are not considered financial instruments.
The effects of reinsurance on premiums written, premiums earned and losses and loss adjustment expenses of the Company’s operations for the years ended December 31, 2003, 2002 and 2001 are as follows:
The majority of the Company’s existing reinsurance contracts are captive reinsurance agreements in U.S. Mortgage Insurance Operations. Under captive reinsurance agreements, a portion of the risk insured by PMI is reinsured with the mortgage originator or investor through a reinsurer that is affiliated with the mortgage originator or investor. Ceded premiums for U.S. captive reinsurance accounted for 82% of total ceded premiums written in 2003 compared to 77% in 2002 and 80% in 2001. Reinsurance recoverable on losses incurred was $3.3 million at December 31, 2003, $3.8 million at December 31, 2002 and $6.1 million at December 31, 2001.
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 $67.8 million in 2003, $106.1 million in 2002 and $99.0 million in 2001. The purchase and redemption of tax and loss bonds are included as a deferred component of income tax expense.
The components of the income tax expense for 2003 included a foreign provision for current tax expense of approximately $27 million and a deferred tax expense of approximately $5 million primarily related to PMI Australia and PMI Europe.
PMI has provided for U.S. federal income tax on the undistributed earnings of its foreign subsidiaries and foreign corporate joint ventures, except to the extent that such earnings are reinvested indefinitely. It is not practicable to determine the amount of U.S. tax that would result if such earnings were not reinvested indefinitely.
The components of the deferred income tax assets and liabilities as of December 31, 2003 and 2002 are as follows:
Common Stock-In November 2003 and in connection with the Company’s investment in FGIC, the Company issued 5.75 million shares of common stock and raised $219.7 million of gross proceeds in addition to Equity Units, disclosed in long-term debt footnote. Each Equity Units consist of a senior note and a purchase contract. The purchase contract will obligate the holders to purchase, no later than November 15, 2006, shares of the Company’s common stock subject to anti-dilution adjustments. The number of shares of common stock which will be purchased depends upon the 20-trading day average closing price at the date of purchase. If the average closing price is greater than $38.20 per share but less than $47.37 per share, the settlement rate per unit is equal to $25 divided by the applicable market price of the Company common stock. If the market price of our common stock is greater than or equal to $47.37, the settlement rate will be .5278 shares of common stock. If the market price of the Company common stock is less than or equal to $38.20 per share, the settlement rate will be .6545 shares of common stock.
Dividends-Under Arizona insurance law, PMI may pay during any twelve-month period, without prior approval of the Arizona Director of Insurance (the “Director”), an amount not to exceed the lesser of (i) 10% of policyholders’ surplus as of the preceding year-end, and (ii) the previous calendar year’s investment income. Dividends that exceed this amount are extraordinary dividends and require the prior approval of the Director. While Arizona permits dividends, whether ordinary or extraordinary, to be paid out of any capital and surplus account (other than paid-in capital), other state insurance laws require the payment of dividends to be made from the unassigned funds surplus account only. In 2003, following approval from the Director, PMI declared and paid an extraordinary dividend of $100.0 million to The PMI Group holding company. In addition, Residential Guaranty Co., one of our Arizona domiciled insurance subsidiaries, paid dividends to TPG in the amount of $8.4 million, which it was able to pay in dividends without prior permission from the Arizona Department of Insurance. In 2002, following receipt of approval from the Director, PMI declared and paid an extraordinary
dividend of $100 million to the PMI Group holding company. The dividend was paid in cash of $66 million and stock of Fairbanks, as well as its limited partnership interest in Truman. The combined value of the stock of Fairbanks and Truman at time of dividend was approximately $34 million.
Preferred Stock-The PMI Group’s restated 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 stock, voting rights and other terms. The Company may issue, without the approval of the holders of common stock, 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.
Pursuant to the support agreement described in the Capital Support Agreements footnote, the Company has agreed that, in the event that Allstate, the Company’s former parent, makes a payment contemplated by the Allstate Support Agreements or the runoff support agreement, Allstate will have the right to receive preferred stock of The PMI Group or PMI with a liquidation preference equal to the amount of such payment. Such preferred stock will rank senior in right of payment to the issuer’s common stock and, so long as such preferred stock is outstanding, the issuer thereof will be prohibited from paying any dividends or making any other distributions on its common stock.
Effective January 1, 2003, all full-time and part-time employees of the Company are eligible to participate in The PMI Group, Inc. Retirement Plan (the “Plan”), a noncontributory defined benefit plan. Prior to January 1, 2003, one year of service was required for eligibility. The Plan has been funded by the Company to the fullest extent permitted by federal income tax rules and regulations. In addition, certain employees whose annual earnings exceed $200,000 participate in The PMI Group, Inc. Supplemental Employee Retirement Plan, a noncontributory defined benefit plan. Benefits under both pension plans are based upon the employees’ length of service, average annual compensation and estimated social security retirement benefits.
The Company provides certain health care and life insurance benefits for retired employees under another post-employment benefit plan (the “OPEB Plan”). Generally, qualified employees may become eligible for these benefits if they retire in accordance with the Company’s established retirement policy and are continuously insured under the Company’s group plans or other approved plans for ten or more years prior to retirement. The Company shares the cost of the retiree medical benefits with retirees based on years of service. The Company has the right to modify or terminate these plans. The Company has not included any estimates of the Medical Prescription Drug, Improvement and Modernization Act of 2003 in the following table.
The Company’s accumulated benefit obligation for its pension plans at December 31, 2003 was $39.8 million and $3.7 million. Health care cost trend on covered charges for other postretirement benefits was 11% in 2003, which will be reduced by 2% per year to 5% in 2006. The Company has funded $10 million anticipated contributions in 2004.
The primary objective of the Plan is to provide retirement income for Plan participants and their beneficiaries in accordance with the terms of the Plan. As such, the key objective in the Plan’s financial management is to promote stability and, to the extent appropriate, growth in funded status. A secondary financial objective is to reduce reliance on contributions as a source of benefit payments. As such, Plan assets are invested to maximize the Plan’s funded ratios over the long-term while managing the downside risk. The strategic asset allocation ranges represent a long-term perspective. Rapid unanticipated market shifts or changes in economic conditions may cause the asset mix to fall outside the policy range. These divergences should be of a relatively short-term nature, unless the circumstances warrant a longer term divergence from the permissible ranges. The Company evaluates and rebalances asset allocations as appropriate and reviews the Plan to make sure that the Plan remains properly funded to protect the benefit security of the participants. As of December 31, 2003, cash and cash equivalents were higher than the target range due to the timing of the contribution and fund allocation at year-end 2003, and to the expected payout in the following year at December 31, 2002.
Sensitivity of Retiree Welfare Results-Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plans. A one percentage point change in assumed health care cost trend rates would have the following effects:
The Company’s domestic insurance subsidiaries prepare statutory-basis financial statements in accordance with the accounting practices prescribed or permitted by their respective state’s department of insurance, which is a comprehensive basis of accounting other than GAAP.
Accounting changes adopted to conform to the provisions of the NAIC Accounting Practices and Procedures Manual are reported as changes in accounting principles. The cumulative effect of changes in accounting principles is reported as an adjustment to unassigned funds, or surplus, at the end of the period in which the change in accounting principle occurs. The cumulative effect is the difference between the amount of capital and surplus at the beginning of the period and the amount of capital and surplus that would have been reported at that date if the new accounting principles had been applied retroactively for all prior periods. As a result of these changes, the Company reported an increase in statutory-basis unassigned funds of $6.2 million in January 2001.
Under the insurance laws of the State of Arizona and several other states, mortgage insurers are required to establish a special contingency reserve from unassigned funds, with annual additions equal to 50% of premiums earned for that year. 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 2003, $132 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 claims-paying ratings from certain national 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, which possibility 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.
The Runoff Support Agreement contains certain covenants, including covenants that (i) PMI will write no new business after its risk-to-capital ratio equals or exceeds 23 to 1; (ii) PMI will pay no dividends if, after the payment of any such dividend, PMI’s risk-to-capital ratio would equal or exceed 23 to 1; and (iii) on the date that any of the following events occur: (a) PMI’s risk-to-capital ratio exceeds 24.5 to 1, (b) Allstate shall have paid any claims relating to PMI policies directly to a policyholder or by paying an amount equal to such claims to
PMI, or to The PMI Group for contribution to PMI, pursuant to the Runoff Support Agreement, or (c) any regulatory order is issued restricting or prohibiting PMI from making full or timely payments under policies, PMI will transfer substantially all of its assets in excess of $50.0 million to a trust account established for the payment of claims.
As of December 31, 2003, included in the Company’s retained earnings were approximately $51 million of undistributed equity earnings of existing equity investees with ownership interests of 50% or less.
We have audited the accompanying consolidated balance sheets of The PMI Group, Inc. and subsidiaries (the Company) as of December 31, 2003 and 2002, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2003. Our audits also included the financial statement schedules listed in the Index at Item 15(a). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of The PMI Group, Inc. and subsidiaries at December 31, 2003 and 2002, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
As of December 31, 2003, the Company adopted FASB Interpretation Number (FIN) No. 46, Consolidation of Variable Interest Entities, as revised, which required the deconsolidation of its trust subsidiary that issued mandatorily redeemable preferred securities. Also, during the year ended December 31, 2002 the Company changed its method of accounting for goodwill and intangible assets. These matters are further described in Note 3 to the consolidated financial statements.