We currently own approximately 200,000 square feet of office space in Walnut Creek, California for our home office. PMI leases offices throughout the United States. We conduct our international operations in leased facilities in Ireland and Italy.
Our management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. Our internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of our consolidated financial statements for external purposes in accordance with U.S. generally accepted accounting principles. Our internal control over financial reporting includes policies and procedures that:
Provide reasonable assurance that transactions are recorded as necessary to permit preparation of consolidated financial statements in accordance with U.S. generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of our management and directors; and
Based on management’s assessment and those criteria, management has concluded that we maintained effective internal control over financial reporting as of December 31, 2009.
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, 2009 and 2008, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2009, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), The PMI Group, Inc. and subsidiaries’ internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 5, 2010 expressed an unqualified opinion thereon.
In our opinion, The PMI Group, Inc. and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2009, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the 2009 consolidated financial statements of The PMI Group, Inc. and subsidiaries and our report dated March 5, 2010 expressed an unqualified opinion thereon.
The accompanying consolidated financial statements include the accounts of The PMI Group, Inc. (“The PMI Group”, “TPG” or the “Company”), a Delaware corporation and its direct and indirect wholly-owned subsidiaries, including: PMI Mortgage Insurance Co. (“MIC”), an Arizona corporation, and its affiliated U.S. mortgage insurance and reinsurance companies (collectively “PMI”); PMI Mortgage Insurance Company Limited and its holding company, PMI Europe Holdings Limited, the Irish insurance companies (collectively “PMI Europe”); PMI Mortgage Insurance Company Canada and its holding company, PMI Mortgage Insurance Holdings Canada Inc. (collectively “PMI Canada”); and other insurance, reinsurance and non-insurance subsidiaries. Also included in the accompanying financial statements and reported as discontinued operations for all periods presented are the accounts of PMI Mortgage Insurance Ltd. and its holding company, PMI Mortgage Insurance Australia (Holdings) Pty Limited (collectively “PMI Australia”) and PMI Mortgage Insurance Asia Ltd. (“PMI Asia”) which were sold as of December 31, 2008; and the accounts of PMI Guaranty Co. (“PMI Guaranty”) which was considered disposed of other than by sale as of December 31, 2008. As of December 31, 2008, upon receiving regulatory approval, PMI Guaranty’s remaining assets and liabilities were merged into PMI. The PMI Group and its subsidiaries are collectively referred to as the “Company.” All material inter-company transactions and balances have been eliminated in the consolidated financial statements.
The Company has equity ownership interests in CMG Mortgage Insurance Company and CMG Mortgage Assurance Company (collectively “CMG MI”), which conduct residential mortgage insurance business for credit unions. In addition in the third quarter of 2009, MIC and CUNA Mutual Insurance Society contributed the stock of CMG Mortgage Reinsurance Company, which provides reinsurance to residential mortgage insurers, to CMG Mortgage Assurance Company. The Company also has an approximately 42.0% equity ownership interest in FGIC Corporation, the holding company of Financial Guaranty Insurance Company (collectively “FGIC”), a New York-domiciled financial guaranty insurance company. The Company also has ownership interests in several limited partnerships. In addition, the Company owns 100% of PMI Capital I (“Issuer Trust”), an unconsolidated wholly-owned trust that privately issued debt in 1997. In the fourth quarter of 2009, the Company sold its equity ownership interest in RAM Holdings Ltd., the holding company of RAM Reinsurance Company, Ltd. (collectively “RAM Re”), a financial guaranty reinsurance company based in Bermuda.
During the first quarter of 2008, the Company impaired its investment in FGIC and reduced the carrying value of its investment in FGIC from $103.6 million to zero. To the extent that the carrying value of the Company’s investment in FGIC remains zero, the Company will not recognize in future periods its proportionate share of FGIC’s losses, if any. The Company is under no obligation to provide additional capital to FGIC.
The ongoing weakness in the U.S. residential mortgage, housing, credit, and capital markets continues to negatively affect the Company’s results of operations and overall financial condition. The Company’s consolidated net loss was $659.3 million, $928.5 million and $915.3 million for the years ended December 31, 2009, 2008 and 2007, respectively.
The Company continues to focus on its core U.S mortgage insurance business under difficult market conditions. Unless the Company raises substantial additional capital to support PMI or achieves significant additional statutory capital relief in the first quarter of 2010, MIC’s excess minimum policyholders’ position will decline and its risk-to-capital ratio will increase beyond levels necessary to meet regulatory capital adequacy requirements.
mortgage insurance market conditions, PMI’s underwriting guidelines which limit the type of new business that PMI is willing to write and continuation of certain customer management strategies adopted in 2009. The Company believes there is currently sufficient liquidity at the holding company to pay holding company expenses (including interest expense on its outstanding debt) in 2010 and there are sufficient assets at the insurance company level for PMI to meet its obligations in 2010.
The Company’s consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) and the requirements of Form 10-K and Article 7 of Regulation S-X. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements, as well as the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates. In the opinion of management, all adjustments, consisting of only normal recurring adjustments, considered necessary for a fair presentation for the period presented have been included.
The Company is affected by economic downturns, natural disasters and other events in specific regions of the United States where a large portion of its U.S. business is concentrated. As of December 31, 2009, 10.1% of PMI’s primary risk in force was located in Florida, and 7.7% was located in California. The Company has experienced accelerated delinquency and loss development in those states. In addition, it has experienced higher default and claim rates for high LTV loans, ARMs, 2/28 Hybrid ARMs, Alt-A loans, interest only loans, payment option ARMS and less-than-A quality loans. The Company also insures loans that have more than one of the above risk characteristics. This “layering” of risk has further increased the risk of borrower default. Although the Company attempts to incorporate the higher default and claim rates associated with these loans into its underwriting and pricing models, there can be no assurance that the premiums earned and the associated investment income will be adequate to compensate for future losses from these loans or that future adverse loss development will not emerge.
reserves may not be adequate to cover ultimate loss development on incurred defaults. The Company’s consolidated financial condition, results of operations and cash flows could be harmed if the Company’s reserve estimates are insufficient to cover the actual related claims paid and loss-related expenses incurred.
Cash and Cash Equivalents-The Company considers all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents.
The Company reports the equity in earnings from CMG MI and FGIC on a current month basis and the Company’s interest in limited partnerships are reported on a one-quarter lag basis. Due to the impairment of the Company’s investment in FGIC in 2008, the carrying value of the Company’s investments in FGIC was reduced to and has remained at zero. To the extent that the carrying value remains zero, the Company will not recognize in future periods its proportionate share of FGIC losses, if any. In the fourth quarter of 2009, the Company sold its equity ownership interest in RAM Re.
The Company capitalizes costs incurred during the application development stage related to software developed for internal use and for which it has no substantive plan to market externally in accordance with FASB ASC Topic 350 Intangibles-Goodwill and Other, previously SOP No. 98-1. Capitalized costs are amortized at such time as the software is ready for its intended use on a straight-line basis over the estimated useful life of the asset, which is generally three to seven years.
Derivatives-Certain credit default swap contracts entered into by PMI Europe are considered credit derivative contracts under FASB ASC Topic 815 Derivatives and Hedging (“Topic 815”), previously SFAS No. 133 and SFAS No. 149. These credit default swap derivatives are recorded at their fair value on the consolidated balance sheet with subsequent changes in fair value recorded in consolidated net income or loss. The Company determines the fair values of its credit default swaps on a quarterly basis and uses internally developed models since observable market quotes are not regularly available. These models include future estimated claim payments and market input assumptions, including discount rates and market spreads to calculate a fair value and reflect management’s best judgment about current market conditions. Due to the illiquid nature of the credit default swap market, the use of available market data and assumptions used by management to estimate fair value could differ materially from amounts that would be realized in the market if the derivatives were traded. Due to the volatile nature of the credit market as well as the imprecision inherent in the Company’s fair value estimate, future valuations could differ materially from those reflected in the current period.
The Company establishes loss reserves on a gross basis for losses and LAE for its deductible pool policies, which contain aggregate deductible and stop-loss limits, on a pool by pool basis. The gross reserves for each pool are based on reported delinquencies, claim rate and claim size assumptions which are determined based on the loan characteristics of the pool, delinquency trends and historical performance as well as expected economic conditions. After determining the gross loss reserve, deductible and stop-loss limits are applied to determine the net loss reserve.
The Company establishes reserves for losses and LAE for financial guaranty contracts on a case-by-case basis when specific insured obligations are in payment default or are likely to be in payment default. Financial guaranty contracts are recorded in accordance with the accounting guidance provided in Topic 944. These reserves represent an estimate of the present value of the anticipated shortfall between payments on insured obligations plus anticipated loss adjustment expenses and anticipated cash flows from, and proceeds to be received on sales of any collateral supporting the obligation and/or other anticipated recoveries. The discount rate used in calculating the net present value of estimated losses is based upon the risk-free rate for the duration of the anticipated shortfall. The Company currently reinsures six financial guaranty contracts in PMI Europe.
Revenue Recognition-Mortgage guaranty insurance policies are contracts that are generally non-cancelable by the insurer, are renewable at a fixed price, and provide for payment of premiums on a monthly, annual or single basis. Upon renewal, the Company is not able to re-underwrite or re-price its policies. Consistent with industry accounting practices, premiums written on a monthly basis are earned as coverage is provided. Monthly premiums accounted for 88.5%, 84.7% and 81.0% of gross premiums written from the Company’s mortgage insurance operations in 2009, 2008 and 2007, respectively. Premiums written on an annual basis are amortized on a monthly pro rata basis over the year of coverage. Primary mortgage insurance premiums written on policies covering more than one year are referred to as single premiums. A portion of the revenue from single premiums is recognized in premiums earned in the current period, and the remaining portion is
Income Taxes-The Company accounts for income taxes using the liability method in accordance with FASB ASC Topic 740 Income Taxes (“Topic 740”), previously SFAS No. 109. 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 consolidated financial statements that will result in future increases or decreases in taxes owed on a cash basis compared to amounts already recognized as tax expense in the consolidated statement of operations. The Company’s effective tax rates from continuing operations were 38.4% and 32.8% for the years ended December 31, 2009 and 2008, respectively, compared to the federal statutory rate of 35.0%. As the Company reported a net loss for 2009, municipal bond investment income and income from certain international operations, which have lower effective tax rates, increased the Company’s effective tax rate in comparison to the federal statutory rate. PMI has historically provided for U.S. federal income tax on the undistributed earnings from its foreign subsidiaries, except to the extent such earnings are reinvested indefinitely. During the quarter ended June 30, 2009, the Company determined that earnings from foreign subsidiaries were no longer deemed “permanently reinvested” resulting in a tax expense. In addition, the Company refined certain estimates as a result of preparing its 2008 income tax return which resulted in additional tax benefits for 2009. The refinements primarily related to foreign tax credits, foreign basis adjustments and other tax adjustments and thereby further increased the Company’s effective tax rate for the year ended December 31, 2009. The effective tax rate of 32.8% for 2008 was lower than the federal statutory rate due to income derived from certain international operations, which have lower effective tax rates, combined with the Company’s municipal bond investment income.
As of January 1, 2007, the Company adopted FASB ASC Topic 740 Income Taxes Recognition (“Topic 740”), previously FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes-An Interpretation of FASB Statement No. 109 (“FIN 48”).
previously SFAS No. 158, for its treatment of U.S. employees’ pension benefits. This topic requires the Company to recognize the funded status (i.e., the difference between the fair value of plan assets and the projected benefit obligations) of its defined benefit postretirement plans, with a corresponding adjustment to accumulated other comprehensive income or loss.
On May 17, 2007, The PMI Group’s Board of Directors approved an amendment to the Retirement Plan. The amendment changed the Plan’s benefit formula from a “final pay” pension formula to a cash balance formula. Under the new cash balance formula, the Company contributes 8% of qualified employees’ compensation to cash balance accounts and credit interest at a rate equal to the 30-year Treasury bond rate. The cash balance formula took effect immediately for employees hired or rehired on or after September 1, 2007. For employees hired before and were continuously employed on September 1, 2007, the cash balance formula will take effect on January 1, 2011.
Business Segments-The Company’s reportable operating segments are U.S. Mortgage Insurance Operations, International Operations and Corporate and Other. U.S. Mortgage Insurance Operations includes the results of operations of PMI Mortgage Insurance Co., affiliated U.S. insurance and reinsurance companies and the equity in earnings from CMG MI. International Operations includes the results from continuing operations of PMI Europe and PMI Canada, and the results from discontinued operations of PMI Australia and PMI Asia. Effective December 31, 2009 the Company combined its former “Corporate and Other” and “Financial Guaranty” segments into a “Corporate and Other” segment for all periods presented. The Corporate and Other segment includes other income and related operating expenses of PMI Mortgage Services Co.’s change in fair value of certain debt instruments, interest expense, intercompany eliminations and corporate expenses of the Company; the results of PMI Mortgage Assurance Company, formerly Commercial Loan Insurance Co., WMAC Credit Insurance Corporation, equity in earnings (losses) from certain limited partnerships and its equity investment in FGIC Corporation and its former investment in RAM Re. The Company merged the assets and liabilities of PMI Guaranty into its U.S. Mortgage Insurance Operations during the fourth quarter of 2008.
during the period. The weighted-average dilutive common shares reflect the potential increase of common shares if contracts to issue common shares, including stock options issued by the Company that have a dilutive impact, were exercised, or if outstanding securities were converted into common shares. As a result of the Company’s net losses for the years ended December 31, 2009, 2008 and 2007, 7.3 million, 9.0 million and 7.4 million share equivalents issued under the Company’s share-based compensation plans in the respective periods were excluded from the calculation of diluted earnings per share as their inclusion would have been anti-dilutive.
Share-Based Compensation-The Company applies FASB ASC Topic 718 Compensation-Stock Compensation (“Topic 718”), previously SFAS No. 123R, in accounting for share-based payments. This topic requires share based payments such as stock options, restricted stock units and employee stock purchase plan shares to be accounted for using a fair value-based method and recognized as compensation expense in the consolidated results of operations. Share-based compensation expense was $4.1 million (pre-tax), $10.1 million (pre-tax) and $18.2 million (pre-tax), respectively, for the years ended December 31, 2009, 2008 and 2007.
Fair Value of Financial Instruments-Effective January 1, 2008, the Company adopted FASB ASC Topic 820 Fair Value Measurements and Disclosures (“Topic 820”), previously SFAS No. 157. This topic describes three levels of inputs that may be used to measure fair value, of which “Level 3” inputs include fair value determinations using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation. Due to the lack of available market values for the Company’s credit default swap contracts, the Company’s methodology for determining the fair value of its credit default swap contracts is based on “Level 3” inputs. (See Note 3. New Accounting Standards and Note 10. Fair Value Disclosures, for further discussion.) Effective January 1, 2008, the Company adopted Topic 820 and the fair value option outlined in FASB ASC Topic 825 Financial Instruments (“Topic 825”), previously SFAS No. 159. Topic 820 provides a framework for measuring fair value under GAAP. The fair value option allows an entity the irrevocable option to elect fair value for the initial and subsequent measurement of certain financial assets and liabilities on a contract-by-contract basis. The Company elected to adopt the fair value option for certain corporate debt on the adoption date. The fair value option requires that the difference between the carrying value before election of the fair value option and the fair value of these instruments be recorded as an adjustment to beginning retained earnings in the period of adoption. The Company recognized a net of tax gain of $31.8 million in retained earnings as of January 1, 2008 related to the initial adoption of the fair value option for certain debt instruments held by the Company. For the year ended December 31, 2009, the Company’s net loss included a $16.5 million gain related to the subsequent measurement of fair value for these debt instruments compared to a $123.6 million gain for the year ended December 31, 2008.
Reclassifications-Certain items in the prior years’ consolidated financial statements have been reclassified to conform to the current years’ consolidated financial statement presentation. The Company reclassified the results of operations of PMI Australia, PMI Asia and PMI Guaranty as discontinued operations for all periods presented.
In June 2009, the FASB updated FASB ASC Topic 860 Transfers and Servicing-Derecognition (“Topic 860”), previously SFAS No. 166, to eliminate the concept of a qualifying special-purpose entity and modify the derecognition provision in Topic 860. Topic 860 requires additional disclosures to enhance information reported to users of financial statements by providing greater transparency about transfers of financial assets, including securitization transactions, and an entity’s continuing involvement in and exposure to the risks related to transferred financial assets. Topic 860 is effective as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009. Topic 860 is not currently expected to significantly impact the Company’s consolidated financial statements.
In April 2009, the FASB updated guidance in Topic 825 to require disclosures about fair value of financial instruments for interim reporting periods of publicly traded companies as well as in annual financial statements. Topic 825 requires those disclosures in summarized financial information at interim reporting periods. Topic 825 is effective for interim and annual reporting periods ending after June 15, 2009. Topic 825 has not significantly impacted the Company’s consolidated financial statements.
Fair Values and Gross Unrealized Gains and Losses on Investments-The cost or amortized cost, estimated fair value and gross unrealized gains and losses on investments as of December 31, 2009 and December 31, 2008 are shown in the tables below:
At December 31, 2009, the Company had gross unrealized losses of $23.6 million on investment securities, including fixed maturity and equity securities that had a fair value of $2.6 billion. The unrealized losses on foreign governments and corporate bonds as of December 31, 2009 were primarily due to foreign currency
translation on securities denominated in a currency other than the functional currency as well as continuing credit issues in that sector. The unrealized losses in the preferred stock portfolio as of December 31, 2009 decreased from December 31, 2008 as a result of an overall improvement in the preferred sector as well as a change in the composition of the Company’s holdings as a result of preferred stock exchanges and dispositions throughout 2009. The change in unrealized losses on the fixed income portfolio from December 31, 2008 to December 31, 2009 was primarily due to contracting municipal bonds credit spreads. At December 31, 2009, the total preferred portfolio had a fair value of $186.0 million, with $35.5 million invested in public utility companies and the remaining $150.5 million invested in the financial services sector. As of December 31, 2009, the total fair value of the mortgage backed securities portfolio was $5.8 million, with $2.6 million invested in residential mortgage backed securities and the remaining $3.2 million invested in commercial mortgage backed securities.
The Company reviews on a quarterly basis, or as needed in the event of specific credit events, unrealized losses on all investments with declines in fair value. These investments are then tracked to establish whether they meet the Company’s established other than temporary impairment criteria. This process involves monitoring market events and other items that could impact issuers. The Company considers relevant facts and circumstances in evaluating whether the impairment of a security is other-than-temporary.
Relevant facts and circumstances considered include but are not limited to:
whether it is more likely than not the Company will hold the security for a sufficient period of time to allow for anticipated recoveries in fair value.
The Company assesses equity securities using the criteria outlined above and also considers whether, in addition to these factors, it has the ability and intent to hold the equity securities for a period of time sufficient for recovery to cost or amortized cost. Where the Company lacks that ability or intent, the equity security’s decline in fair value is deemed to be other than temporary, and the Company records the full difference between fair value and cost or amortized cost in earnings.
During the second quarter of 2009, the Company reviewed all previously recorded other-than-temporary impairments of securities to develop an estimate of the portion of such impairments that were not due to credit. This resulted in an opening balance adjustment to reclassify from retained earnings into AOCI an amount of $2.5 million, which related to non-credit related impairment charges taken prior to adoption of Topic 320 on debt securities held principally at PMI Europe.
In the Consolidated Statements of Operations, the Company had other-than-temporary impairments of $8.3 million for the year ended December 31, 2009 on securities considered to be impaired. The credit component of the impairments for the year ended December 31, 2009 was $7.0 million.
The total impairment for any debt security that is deemed to have an other-than-temporary impairment is recorded in the statement of operations as a net realized loss from investments. The portion of such impairment that is determined to be non-credit-related is deducted from net realized losses in the statement of operations and reflected in other comprehensive income (loss) and accumulated other comprehensive income (loss), the latter of which is a component of stockholders’ equity in the balance sheets.
Other-than-temporary Impairment-During the year ended December 31, 2009, the Company recorded other-than-temporary impairment losses as follows:
Scheduled Maturities-The following table sets forth the amortized cost and fair value of fixed income securities by contractual maturity at December 31, 2009:
Net Realized Investment Gains (Losses)-Net realized investment gains (losses) consist of the following:
Net realized investment gains (losses) for 2009 resulted primarily from sales of municipal bonds in addition to impairments and exchanges of preferred equity securities. Net realized investment gains for 2009 includes other-than-temporary impairments recorded during the first quarter of 2009; upon adoption of Topic 320 on April 1, 2009, the Company recognized a cumulative effect adjustment to retained earnings and accumulated other comprehensive income for the non-credit portion of previously recorded impairments of debt securities in the amount of $2.5 million; $1.1 million of these losses were recorded in the first quarter of 2009 and $1.4 million of the losses were recorded in previous years. The net investment losses in 2008 include a $96.5 million loss related
to the Company’s other-than-temporary impairment of certain preferred securities in its U.S. investment portfolio. Also included in the net investment losses for 2008 is the Company’s impairment of its investment in its unconsolidated subsidiaries, which includes an $88.0 million loss related to the impairment of the Company’s investment in FGIC in the first quarter of 2008 and a $2.9 million loss related to the Company’s impairment of its investment in RAM Re. The net investment losses in 2007 were due primarily to an other-than-temporary impairment of the Company’s investment in RAM Re of $38.5 million, partially offset by a $12.7 million settlement gain related to the sale of an unconsolidated subsidiary. The Company sold its investment in RAM Re in the fourth quarter of 2009 for $3.2 million.
As of December 31, 2009, the Company’s investment portfolio included 129 securities in an unrealized loss position compared to 284 securities as of December 31, 2008.
Investment Concentrations and Other Items-The Company maintains an investment portfolio principally of U.S. municipal bonds. The following states and the District of Columbia represent the largest concentrations in the U.S. municipal bond portfolio, expressed as a percentage of the fair value of all U.S. municipal bond holdings. Holdings in states and the District of Columbia that exceed 5% of the U.S. municipal bond portfolio at the respective dates are presented below:
At December 31, 2009, fixed income securities and short-term investments with an aggregate fair value of $15.6 million were on deposit with regulatory authorities as required by law.
CMG MI’s condensed balance sheets as of December 31, 2009 and 2008, and condensed statements of operations for the years ended December 31, 2009, 2008 and 2007 are as follows:
The following table summarizes deferred policy acquisition cost activity as of and for the periods set forth below:
Deferred policy acquisition costs are affected by qualifying costs that are deferred in the period and amortization of previously deferred costs in such periods. Deferred policy acquisition costs are reviewed periodically to determine whether they exceed recoverable amounts, after considering investment income. In the second quarter of 2008, PMI Guaranty impaired its remaining deferred policy acquisition cost asset by $3.6 million, reducing its value to zero. The Company also impaired $1.2 million of deferred policy acquisition cost assets relating to PMI Europe during both 2009 and 2008. Due to higher persistency levels experienced in the Company’s U.S. Mortgage Insurance portfolio, in 2008 the Company increased the period over which it amortizes deferred policy acquisition costs in its U.S. Mortgage Insurance Operations.
Deferred policy acquisition costs are reviewed periodically to determine that they do not exceed recoverable amounts, after considering investment income. For the year ended December 31, 2007, as a result of a recoverability analysis of deferred costs relating to new mortgage insurance policies acquired in 2007, the Company impaired its deferred policy acquisition cost asset related to its U.S. Mortgage Insurance Operations by $33.6 million relating to the 2007 book year. The deferred policy acquisition cost asset at December 31, 2008 includes only costs associated with the 2008 book of business and book years prior to 2007.
The $196.8 million, $192.9 million and $208.6 million increases in prior years’ reserves in 2009, 2008 and 2007, respectively, were due to re-estimations of ultimate loss rates from the prior period estimates. The $196.8 million increase in prior years’ reserves during 2009 reflected the significant weakening of the housing and mortgage markets and was driven primarily by adverse claim size and claim rate development in the modified pool insurance portfolio partially offset by reductions in claim size on the Company’s primary insurance portfolio. The $192.9 million and $208.6 million increases in prior years’ reserves during 2008 and 2007 reflected significant weakening of the housing and mortgage markets and were driven by lower cure rates, higher claim rates and higher claim sizes on the Company’s primary insurance portfolio. These re-estimations of ultimate loss rates are the result of management’s periodic review of estimated claim amounts in light of actual claim amounts, loss development data and ultimate claim rates.
The fair value and carrying value of the Company’s 6.000% Senior Notes and 6.625% Senior Notes at December 31, 2009 include accrued interest.
6.000% and 6.625% Senior Notes-In September 2006, the Company issued $250 million in principal amount of 6.000% Senior Notes, due September 15, 2016 and $150 million in principal amount of 6.625% Senior Notes, due September 15, 2036. The 6.000% Senior Notes and the 6.625% Senior Notes bear interest at a rate of 6.000% and 6.625% per annum, payable semi-annually in arrears on March 15 and September 15 of each year, beginning on March 15, 2007. The PMI Group may redeem the 6.000% and 6.625% Senior Notes in whole or in part at any time at the “make-whole redemption price”. The “make-whole redemption price” will be equal to the greater of (a) 100% of the principal amount of the 6.000% and 6.625% Senior Notes to be redeemed and (b) the sum of the present values of the remaining scheduled payments thereon discounted to the date of redemption, on a semi-annual basis (assuming a 360-day year consisting of twelve 30-day months), at a rate equal to the applicable treasury rate plus 25 basis points for the 6.000% Senior Notes and 35 basis points for the 6.625% Senior Notes, plus in the case of either (a) or (b), any interest accrued but not paid to but excluding the date of redemption. In connection with the issuance of these Senior Notes, the Company entered into two interest rate lock agreements which were designated as cash flow hedges. The fair value of the cash flow hedges was settled for $9.0 million and is amortized into interest expense over the terms of the new senior debt that was issued. As of December 31, 2009, the unamortized balance in the other comprehensive income related to these fair value hedges was approximately $7.0 million (pre-tax).
Effective January 1, 2008, the Company elected to adopt the fair value option presented by ASC Topic 825 for the Company’s 6.000% Senior Notes and 6.625% Senior Notes. ASC Topic 825 requires that the difference between the carrying value before election of the fair value option and the fair value of these instruments be recorded as an adjustment to beginning retained earnings in the period of adoption. (See Note 10. Fair Value Disclosures, for further discussion.)
In considering the initial adoption of the ASC Topic 825, the Company determined that the change in fair value of the 8.309% Junior Subordinated Debentures would not have a significant impact on the Company’s consolidated financial results. Therefore, the Company did not elect to adopt the fair value option for the 8.309% Junior Subordinated Debentures.
Prior to the effectiveness of the amended facility, on May 29, 2009, the Shared Collateral Pledge Agreement, dated as of April 24, 2008, between the Company and U.S. Bank National Association as collateral agent (the “Collateral Agent”), pursuant to which the Company granted a security interest in the stock of MIC in favor of the Collateral Agent for the equal and ratable benefit of the lenders under the credit facility and the noteholders under certain of the Company’s senior notes, was terminated and the security interest in the stock of MIC was released.
Thereafter, MIC and the Company entered into a Note Purchase Agreement, dated as of May 29, 2009 (the “Note Purchase Agreement”), pursuant to which the Parent Company purchased the contingent note (the “QBE Note”) that MIC received in connection with the sale of PMI Australia to QBE Holdings (AAP) Pty Limited. Pursuant to the Note Purchase Agreement, the Company made an initial payment to MIC of $75 million and agreed to make an additional contingent payment of up to $25 million; the amount of the contingent payment will be determined based on the value of the QBE Note at redemption or on the net proceeds received by the Company upon a sale of the QBE Note prior to redemption. (See Item 7, Liquidity and Capital Constraints, for further discussion on the QBE Note.)
Effective January 1, 2008, the Company adopted Topic 820 and the fair value option outlined in Topic 825. In particular, the Company elected to adopt the fair value option outlined in Topic 825 for certain corporate debt liabilities on the adoption date. The fair value option outlined in Topic 825 requires that the difference between the carrying value before election of the fair value option and the fair value of these instruments at the time of election of the fair value option be recorded as an adjustment to the opening balance of retained earnings in the period of adoption.
The following tables present the difference between fair values as of December 31, 2009 and December 31, 2008 and the aggregate contractual principal amounts of the long-term debt for which the fair value option has been elected. Had the Company not adopted the fair value option, the Company’s diluted loss per share for the year ended December 31, 2009 would have been $(8.14) per share compared to $(12.39) per share for the year ended December 31, 2008.
Level 2 Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by
observable market data for substantially the full term of the assets or liabilities. Level 2 assets and liabilities include debt securities with quoted prices that are traded less frequently than exchange-traded instruments and derivative contracts whose value is determined using a pricing model with inputs that are observable in the market or can be derived principally from or corroborated by observable market data.
Assets and liabilities measured at fair value on a recurring basis, including financial instruments for which the Company has elected the fair value option, are summarized below:
The values of the Company’s CDS contracts are affected by estimated changes in credit spreads of the underlying obligations and/or the cost of the Company’s capital. As credit spreads change, the values of these CDS contracts will change and the resulting gains and losses will be recorded in the Company’s operating results. In addition, with the adoption of Topic 820, the Company has incorporated its non-performance risk into the market value of its derivative assets and liabilities. The fair value of these CDS liabilities was $17.3 million as of December 31, 2009. Excluding the Company’s non-performance risk, the fair value of these CDS liabilities would have been $19.3 million as of December 31, 2009.
creditworthiness. If a CDS contract is extended beyond its expected call date, PMI Europe will be required to adjust its internal valuation model assumptions. To the extent that credit spreads are higher than at the time of inception of the transaction, extending the expected life from the call date to the maturity date could result in PMI Europe recognizing further significant mark-to-market losses. If counterparties elect to extend PMI Europe’s CDS contracts and spreads remain at their current levels, mark-to-market losses could be material and there will be a greater likelihood of incurring higher than currently expected realized losses in the form of paid claims on the contracts. To date, all of PMI Europe’s CDS contracts have either been called at the Company’s expected call date or have deviated from the Company’s expected call date in lengths of time that are not significant.
Similar third party information is not available for non-investment grade contracts, and, accordingly, for those contracts, fair value is estimated using the present value of expected future contractual payments and incorporating a market-based estimated cost of capital that would be required by a third party with similar credit standing as PMI to assume an identical contract. Expected future contractual payments are determined through the analysis of recent performance of the relevant transaction and similar transactions. Cash flows are discounted using a risk-free rate. The market-based cost of capital is based on an estimate of PMI’s cost of capital as of the period in which the value is being determined.
The combined losses on equity and fixed income securities of $0.8 million and $1.5 million for the years ended December 31, 2009 and 2008, respectively, are included in net investment income in the Company’s consolidated statement of operations. The gain on credit default swaps of $31.6 million and the loss of $11.3 million for the years ended December 31, 2009 and 2008, respectively, is included in other income in the Company’s consolidated statement of operations.
The loss on credit default swaps of $0.4 million and the gain on credit default swaps of $0.9 million for the years ended December 31, 2009 and 2008, respectively is a result of the translation from the Euro to the U.S. dollar and is included in other comprehensive income.
The components of income tax benefit from continuing operations for the years ended December 31, 2009, 2008 and 2007 are as follows:
§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 did not purchase any tax and loss bonds in 2009, 2008 and 2007. The Company redeemed tax and loss bonds of $274.8 million in 2009, $396.3 million in 2008 and $62.7 million in 2007. The purchase and redemption of tax and loss bonds are included as a deferred component of income tax expense.
The components of the deferred income tax assets and liabilities for the year ended are as follows:
The Company evaluates the need for a valuation allowance quarterly taking into consideration the ability to carryback and carryforward tax credits and losses, available tax planning strategies and future income, including the reversal of temporary differences. In addition, the Company has benefits from the use of tax and loss bonds which have allowed the Company to deduct statutory contingency reserves on its federal tax return. Once redeemed, the tax and loss bonds result in taxable income which have offset the Company’s operating losses. As of December 31, 2009, the Company evaluated whether it was “more likely than not” that the deferred tax assets would be utilized in the future and determined that a valuation allowance of $248.3 million was required. Any future changes in management’s assessment on the need for a valuation allowance will be recognized as a change in estimate in future periods.
When incurred, the Company recognizes interest and penalties related to unrecognized tax benefits in tax expense. The Company incurred net interest and penalties of $0.4 million in 2009. A contingent liability of $0.2 million was reversed during the third quarter of 2009 based on the closing of the statute of limitations and the conclusion of certain audits. The Company remains subject to examination in the following major tax jurisdictions:
As of December 31, 2009, there were no positions for which management believes it is reasonably possible that the total amounts of tax contingencies will significantly increase or decrease within 12 months of the reporting date.
PMI has historically provided for U.S. federal income tax on the undistributed earnings from its foreign subsidiaries, except to the extent such earnings are reinvested indefinitely. During the quarter ended June 30, 2009, the Company determined that earnings from foreign subsidiaries, principally PMI Europe, were no longer deemed “permanently reinvested”. As such, related income tax amounts have subsequently been recorded as components in the consolidated statement of operations and accumulated other comprehensive income (loss).
The Company has foreign net operating loss carryforwards of approximately $79.1 million primarily related to our PMI Europe and Canada operations that will expire in 2012-2027.
The Company has tax credit carryforwards of approximately $192.8 million, primarily related to the payment of alternative minimum tax of $113.3 million and foreign taxes of $78.9 million. The foreign tax credits will expire if not utilized in 2018 and the alternative minimum tax credits do not expire.
Effective June 2008, PMI Guaranty, FGIC and Assured Guaranty Re Ltd (“AG Re”) executed an agreement pursuant to which all of the direct FGIC business reinsured by PMI Guaranty was recaptured by FGIC and ceded by FGIC to AG Re. Pursuant to the Agreement, with respect to two of the exposures ceded to AG Re, PMI Guaranty agreed to reimburse AG Re for any losses it pays, subject to an aggregate limit of $22.9 million. PMI Guaranty has secured its obligation by depositing $22.9 million into a trust account for the benefit of AG Re and, to the extent AG Re’s obligations are less than $22.9 million, the remaining funds will be returned to the Company. As of December 31, 2009, the $20.8 million remaining deposit is included in cash and cash equivalents with a corresponding liability in losses and LAE reserves on the Company’s consolidated balance sheet.
Certain of PMI Europe’s CDS and reinsurance transactions contain collateral support provisions which, upon certain circumstances, require PMI Europe to post collateral for the benefit of the counterparty. As of December 31, 2009, PMI Europe posted collateral of $14.7 million on credit default swap transactions accounted for as derivatives and $19.1 million related to insurance and certain U.S. sub-prime related reinsurance transactions. The collateral of $33.8 million is included in investments and cash and cash equivalents on the Company’s consolidated balance sheet at December 31, 2009.
Preferred Stock-The PMI Group’s certificate of incorporation authorizes the Board of Directors to issue up to 5,000,000 shares of preferred stock of The PMI Group in classes or series and to set the designations, preferences, qualifications, limitations or restrictions of any class or series with respect to the rate and nature of
Defined Benefits Plan-Effective January 1, 2003, certain U.S. employees of the Company are eligible to participate in The PMI Group, Inc. Retirement Plan (the “Plan”), a noncontributory defined benefit plan. In addition, certain employees whose annual earnings exceed $220,000 under Internal Revenue Code (“IRC”) Section 401(a)(17) and limits established under IRC Section 415, participate in The PMI Group, Inc. Supplemental Employee Retirement Plan (“The SERP Plan”), a noncontributory defined benefit plan. Benefits under both pension plans are based upon the employees’ length of service and average annual compensation.
Included in the underfunded status of the pension benefits is the underfunded status of The SERP Plan of $6.6 million and the underfunded status of the Plan of $13.5 million resulting in a net underfunded status of $20.1 million.
In 2009, the Company contributed $15.7 million to its pension plans. The Company intends to contribute $5.5 million to the Plan in 2010. The benefit costs decreased in 2009 compared to 2008 primarily due to pension settlement costs associated with the VERP initiated in the third quarter of 2008 (discussed above).
PMI’s overall investment strategy is to match its plan asset duration with that of the plan liabilities, through appropriate allocations to equity, fixed income, and cash investments, that provides long-term growth and near-term benefit payments. The target allocation for plan assets are 40 to 60 percent U.S. stocks, 0 to 30 percent International stocks, 20 to 50 percent U.S fixed income securities, and 0 to 10 percent U.S cash and cash equivalents.
Defined Contribution Plan-Certain regular U.S. employees of the Company are eligible to participate in The PMI Group, Inc. Savings and Profit-Sharing Plan (“Savings Plan”). Eligible employees who participate in the Savings Plan may receive, within certain limits, matching Company contributions. The Company contributions recognized as expense were $1.6 million for 2009, $0.9 million for 2008 and $2.1 million for 2007.
Equity Incentive Plan-The PMI Group Inc. Amended and Restated Equity Incentive Plan (the “Equity Incentive Plan”) provides for awards of both non-qualified stock options and incentive stock options, restricted shares, restricted stock units and stock appreciation rights subject to forfeiture and restrictions on transfer, and performance awards entitling the recipient to receive cash or common shares in the future following the attainment of performance goals determined by the Board of Directors. Stock options are granted with an exercise price equal to the market value on the date of grant, and generally expire ten years from the grant date and have a three-year vesting period. The Equity Incentive Plan provides for the granting of restricted shares to officers and key employees. Restricted shares issued under the Equity Incentive Plan to date have had vesting periods ranging from two to four years from the grant date. Holders of restricted stock were entitled to dividends and voting rights, while holders of performance shares accrued dividend equivalents to the same extent that dividends, if any, were paid on the Company’s common stock. Under the Equity Incentive Plan, non-employee directors receive quarterly, non-discretionary grants of stock units. Pursuant to a November 2008 plan amendment, the units have had an initial value of $4,000, subject to a limit of 2,500 units per quarter. The number of units granted depends on the fair market value of the Company’s common shares on the grant date. Each stock unit has an initial value equal to the fair market value of one common share on the grant date. Non-employee director grants of stock units vest on the earlier of the fifth anniversary of the applicable grant date or termination of Board service. Dividend equivalents accrue on directors’ stock units to the same extent that dividends, if any, are paid on the Company’s common stock. The total number of non-employee director stock units outstanding is 405,483 and 436,364 on December 31, 2009 and 2008, respectively.
Non-Employee Director Phantom Stock Plan. Non employee directors also receive quarterly shares of phantom stock under The PMI Group Inc. Non-Employee Director Phantom Stock Plan, which became effective January 15, 2009. The phantom share grants are initially valued at $8,500, with the number of phantom shares being determined based on the fair market value of the Company’s common shares at the grant date. In addition to these grants, if under the Equity Incentive Plan’s 2,500-unit cap on the amount of stock units they can receive on a quarterly basis, the directors receive stock units with a grant date fair value of less than $4,000, the directors
will receive phantom stock in an amount that represents the difference between $4,000 and the 2,500-unit cap, if any. The phantom stock vests on the earlier of the fifth anniversary of the applicable grant date or termination of Board service, and upon vesting, is settled in cash. Dividend equivalents accrue on directors’ phantom shares to the same extent that dividends, if any, are paid on the Company’s common stock. Total expense accrued under the Non-Employee Director Phantom Stock Plan was $0.6 million and $0.0 million for the year ended December 31, 2009 and 2008, respectively. The total number of phantom stock shares outstanding under the plan is 218,475 and 0 on December 31, 2009 and 2008, respectively.
Employee Stock Purchase Plan-The PMI Group, Inc. Employee Stock Purchase Plan (“ESPP”) allows eligible employees to purchase shares of the Company’s stock at a 15% discount to fair market value as determined by the plan. The ESPP offers participants the 15% discount to current fair market value or fair market value with a look-back provision of the lesser of the duration an employee has participated in the ESPP or two years. Based on the features of the ESPP, it is considered compensatory according to the provisions of Topic 718. Under the ESPP, the Company issued 381,333 treasury shares in 2009, 470,671 treasury shares in 2008, and 98,038 treasury shares in 2007. Topic 718 requires expense recognition of the amount of the discount to current fair value of ESPP shares purchased by employees.
The Company recognized employee share-based compensation expense of $4.1 million (pre-tax), $10.1 million (pre-tax) and $18.2 million (pre-tax) for the years ended December 31, 2009, 2008 and 2007, respectively. As of December 31, 2009, there was approximately $1.1 million of unrecognized compensation cost, adjusted for estimated forfeitures, related to non-vested share-based payments granted to employees. This unrecognized expense is expected to be recognized over a weighted average period of 1.1 years. Total unrecognized compensation cost will be adjusted for future changes in estimated forfeitures.
Since the Company’s employee restricted stock units do not participate in dividends during their vesting period, their fair value is determined using the closing price of the Company’s stock on the date of grant less the present value of anticipated dividends (which is zero for the 2009 grant) over the vesting period. The discount rate used is the risk-free rate as of the date of grant of 1.5%.
A summary of the employee stock option activity under the Equity Incentive Plan as of December 31, 2009, 2008 and 2007 and changes during the three years then ended is presented below:
As phantom shares are cash settled, the shares are valued at the closing price of the Company’s stock. The weighted average fair value of outstanding and granted shares is the closing price of the Company’s stock as of December 31, 2009. The weighted average fair value of vested shares is based on the closing price of the Company’s stock when a participant vested the shares and was paid.
Reporting segments are based upon the Company’s internal organizational structure, the manner in which the Company’s operations are managed, the criteria used by the Company’s management to evaluate segment performance, the availability of separate financial information and overall materiality considerations.
The following tables present segment income or loss and balance sheets as of and for the periods indicated:
During the third quarter of 2008, PMI Australia, PMI Asia and PMI Guaranty were reported as discontinued operations. Where applicable, the notes to the consolidated financial statements have been restated to reflect these discontinued operations for all periods presented. A summary of the composition of operating results included in discontinued operations is as follows:
In 2009, the Company recorded certain reconciliation adjustments related to the sale of PMI Australia and PMI Asia. The adjustments were to reconcile certain estimates that were made during the closing of the transaction.
Sale of PMI Australia-On October 22, 2008, the Company completed the sale of PMI Australia and received approximately $746 million in cash (including certain adjustments for pre-completion interest and changes in the value of PMI Australia’s investment portfolio) and a note receivable (“QBE Note”) in the principal amount of approximately $187 million. The actual amount owed under the QBE Note is subject to reductions to the extent (i) performance of PMI Australia’s existing insurance portfolio as of September 30, 2008 does not achieve specified targets and (ii) PMI is required to satisfy certain warranty claims. The Company currently does not record any statutory or GAAP value with respect to the QBE Note due to the contingencies discussed above.
Sale of PMI Asia-On December 17, 2008, the Company completed the sale of PMI Asia and received approximately $51.6 million in cash equal to 92.5% of PMI Asia’s book value as of June 30, 2008. The following table represents PMI Asia’s results of operations, which were recorded as discontinued operations:
In the third quarter of 2009, the Company recorded a tax benefit of $1.3 million due to a refinement of the tax estimate associated with the sale of PMI Asia.
The results of operations of PMI Guaranty are as follows for the periods indicated:
The following table presents PMI’s statutory net loss, statutory surplus and contingency reserve liability as of and for the years ended as follows:
Under the insurance laws of the State of Arizona and several other states, mortgage insurers are required to establish a special contingency reserve included in total liabilities, with annual additions equal to 50% of premiums earned for that year. During 2009, MIC contributed $356 million to the reserve. This reserve is required to be maintained for a period of 120 months to protect against the effects of adverse economic cycles. After 120 months, the reserve is released to unassigned funds. 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. The Company withdrew $1.4 billion from its contingency reserves predominately due to actual losses exceeding 35% of the corresponding earned premiums.
The expenses in the U.S. Mortgage Insurance Operations segment are primarily payroll and related expenses from a reduction in force due to the Voluntary Early Retirement Program in the fourth quarter of 2008 and involuntary terminations in 2008 and 2009. The expenses in the International Operations segment are primarily due to reductions in force from the closure of PMI Canada’s office in Toronto and reconfiguration of PMI Europe. The additions in 2009 are related to the termination of contract underwriting services announced in the first quarter of 2009 and effective April 2009 and fixed asset dispositions. Exit costs incurred to date were $21.8 million which consisted primarily of severance and related costs.