The Company leases approximately 59,000 square feet for its corporate headquarters in Philadelphia under leases which expire in 2003. In addition, CMAC leases space for its Divisional, Service Center and On-Site offices throughout the United States comprising approximately 57,000 square feet with leases expiring
between 1999 and 2001. With respect to all facilities, the Company believes it will be able to obtain satisfactory lease renewal terms.
The Company maintains a mini-computer network from its corporate data center located in its headquarters building to support its data processing requirements for accounting, claims, marketing, risk management, underwriting and non-insurance operations. In 1997, the Company centralized all computer operations. All the service centers are linked to the home office in Philadelphia via a high speed frame-relay network. The centralized environment is based on the Business Recovery Server ("BRS") architecture. The BRS consists of two geographically dispersed, identical data centers. Each data center is currently running at 30% of capacity. Either data center is capable of supporting the entire company. The data centers are linked via a fibre-optic link allowing simultaneous data updates through disk shadowing. Each center is part of a separate power grid. This redundant configuration provides disaster tolerance and automatic back-up, resource sharing and fail-over.
- --------------- (1) Diluted net income per share and share information per Statement of Financial Accounting Standards No. 128, "Earnings Per Share." See note 1 of Notes to Consolidated Financial Statements set forth on page herein.
(2) All share and per-share data for prior periods have been restated to reflect the stock split. See note 1 of Notes to Consolidated Financial Statements set forth on page herein.
CMAC's volume in 1998 was positively impacted by low interest rates which affected the entire mortgage industry. The trend toward lower interest rates, which began in the third quarter of 1997, caused refinancing activity during 1998 to continue at a higher rate than normal and strong housing prices have caused a large percentage of the refinanced loans to be closed without private mortgage insurance at an LTV of 80% or below. Therefore, the rate of growth in the private mortgage industry has not been as high as that of the entire mortgage market. CMAC's refinancing activity as a percentage of primary new insurance written was 32.0% for 1998 as compared to 17.0% in 1997. However, for the fourth quarter of 1998, refinanced loans represented 38.0% of new primary insurance written as compared to only 24.0% for the third quarter of 1998 as a result of the slight decline in interest rates during the fourth quarter. The persistency rate, which is defined as the percentage of policies in force that are renewed in any given year, was 68.0% for 1998 as compared to 84.2% for 1997. This large decline was consistent with the increase in the level of refinancing activity during 1998. The persistency rate for the beginning of 1999 should continue at a level similar to 1998 although if the current refinance boom slows, the persistency rate could improve.
product is captive reinsurance, in which a mortgage lender sets up a mortgage reinsurance company that assumes part of the risk associated with that lender's insured book of business. In most cases, the risk assumed by the reinsurance company is an excess layer of aggregate losses that would be penetrated only in a situation of adverse loss development. For 1998, premiums ceded under captive reinsurance arrangements were $1.5 million or less than 1% of total premiums earned during 1998 and new primary insurance written under captive reinsurance arrangements was $2.6 billion, or 12.1% of total new primary insurance written. CMAC expects to enter into several new agreements in 1999, although the aggregate amount of captive reinsurance is not expected to have a material financial impact on CMAC's balance sheet or financial results in 1999.
Net investment income for 1998 was $38.6 million, a 14.1% increase compared to $33.8 million in 1997. This increase was a result of continued growth in invested assets primarily due to positive operating cash flows of $132.3 million during 1998. The Company has continued to invest new operating cash flow in tax- advantaged securities, primarily municipal bonds, although the Company did modify its investment policy to allow the purchase of various other asset classes, including common stock and convertible securities, beginning in the second quarter of 1998. The Company's intent is to target the common equity exposure at a maximum of 5% of the investment portfolio's market value while the convertible securities and mortgage-backed securities exposures are targeted not to exceed 10% each. During 1998, the Company purchased a total of $26.0 million of common equities which led to a slight decrease in the growth in investment income during 1998. Although there will be a short-term decline in investment income from this change in investment policy, the Company expects no material long-term impact on total investment returns as a result of this investment diversification.
reported an increased number of defaults on the Alternative A and A minus business insured beginning in 1997. Although the default rate for this business is higher than on CMAC's normal books, it is not currently higher than was expected for this type of business and the higher premium rates charged are expected to compensate for the increased level of risk. Direct losses paid in 1998 were $83.8 million as compared to direct losses paid during 1997 of $82.1 million, an increase of only 2.1%.
Underwriting and other operating expenses were $75.1 million for 1998, an increase of 30.3% compared to $57.7 million for 1997. These expenses consisted of policy acquisition expenses, which relate directly to the acquisition of new business, and other operating expenses, which primarily represent contract underwriting expenses, overhead and administrative costs.
The effective tax rate for 1998 was 27.6% as compared to 26.9% for 1997. Operating income accounted for 68.1% of net income in 1998 as compared to 66.2% in 1997 thus resulting in the increase in effective tax rate for 1998.
Net income for 1997 was $75.0 million, a 20.5% increase compared to $62.2 million for 1996. This improvement was a result of significant growth in premiums earned and net investment income, partially offset by a higher provision for losses, policy acquisition costs and other operating expenses.
Mac transactions) is the most that can be paid out in losses before the insurer's exposure terminates. The Company expects its pool insurance activity to continue at this same level in 1998 due its demand in the marketplace. Premium rates on such pool insurance are significantly lower than on primary insurance loans due to the low stop-loss levels, which limit the overall risk exposure to CMAC, and the focus of such product on high quality primary insurance customers. Nonetheless, this pool insurance has contributed to the increase in earned premiums during 1997. Standard & Poor's has recently determined that the capital requirements to support such pool insurance will be significantly more stringent than on primary insurance due to the low premium rates and CMAC has reviewed its capital levels to ensure compliance with these requirements. The average stop-loss on pool insurance written during 1997 was 1.5%.
Refinanced loans represented 17.0% of new primary insurance written during 1997 as compared to 16.5% in 1996. However, for the fourth quarter of 1997, refinanced loans represented 21.8% of new primary insurance written as compared to only 13.4% for the fourth quarter of 1996 as lower interest rates in the third quarter of 1997 caused refinance activity to increase significantly in the fourth quarter. The persistency rate was 84.2% for 1997 as compared to 83.9% for 1996. This increase was consistent with the slight decline in the level of refinancing activity during 1997.
The provision for losses was $117.1 million in 1997, an increase of 27.5% compared to $91.9 million in 1996. This increase reflected the significant growth and maturation of CMAC's book of business over the past several years, the continued adverse experience of California loans, and the relatively poor experience of certain "affordable housing" program loans insured starting in 1994. Although the ultimate performance of the books of business that originated since 1994 cannot yet be determined, it appears that the ultimate loss levels will be higher than average, due in part to the presence of these "affordable housing" loans. CMAC's overall default rate at December 31, 1997 was 1.8% as compared to 2.1% at December 31, 1996. The number of defaults rose from 10,127 at December 31, 1996 to 12,359 at December 31, 1997 and the average loss reserve
per default rose from $10,685 at the end of 1996 to $12,026 at December 31, 1997. This increase in average loss reserve per default reflected the Company's continued implementation of a more conservative reserve calculation for certain loans in default perceived as having a higher risk of claim incidence. In addition, an increase in the coverage percentage on loans originated beginning in 1995 has necessitated a higher reserve balance on loans in a default status due to the increased ultimate exposure on these loans. The default rate in California was 3.6% (including pool) at December 31, 1997 as compared to 4.0% at December 31, 1996 and claims paid in California during 1997 were $48.2 million, representing approximately 57.0% of total claims as compared to 61.9% in 1996. The "affordable housing" early default experience is a result of insuring certain loans in which the borrowers' principal and interest reserves and other credit factors were not as strong as on prior years' books of business. Certain underwriting changes were implemented near the end of 1996 to compensate for the factors that contributed to the early default experience on these "affordable housing" loans; however, it is too early to determine the impact of such changes. The Company believes that many loan servicers have changed the timing of reporting loans in default, which has continued to result in an incremental increase in the number of loans in default. This change allows for earlier intervention with borrowers in default, which might lead to a higher cure rate for such loans.
Underwriting and other operating expenses were $57.7 million for 1997, an increase of 19.8% compared to $48.1 million for 1996. These expenses consisted of policy acquisition expenses, which relate directly to the acquisition of new business, and other operating expenses, which primarily represent overhead and administrative costs.
Policy acquisition costs were $31.3 million in 1997, an increase of 16.5% compared to $26.9 million in 1996. This reflects the increase in sales-and underwriting-related expenses relating to the Company's continued market share expansion and the development of the Company's marketing infrastructure needed to support a focus on larger, national mortgage lenders in order to take advantage of the widespread consolidation occurring in the mortgage lending industry. Other operating expenses for 1997 were $26.4 million, an increase of 24.0% compared to $21.3 million for 1996. Much of the increase continued to result from an expansion of the Company's technology efforts and an increase in expenses associated with the company's ancillary services, specifically contract underwriting. Some of these additional contract underwriting expenses were correspondingly offset by increases to other income, which rose 31.9% from $3.8 million in 1996 to $5.0 million in 1997, although the main purpose of the contract underwriting effort is to support the sales effort by generating incremental mortgage insurance business. During 1997, loans underwritten via contract underwriting accounted for 29% of applications, 25% of insurance commitments, and 22% of certificates issued by CMAC as compared to 35% of applications, 21% of commitments and 18% of certificates in 1996. Changing market conditions caused the cost of contract underwriting to increase during 1997 due to the shortage of available resources.
The effective tax rate for 1997 was 26.9% as compared to 24.6% for 1996. Operating income was 66.2% of pretax income in 1997 as compared to 62.6% in 1996, thus resulting in the increase in effective tax rate for 1997.
Total investments were $736.3 million at December 31, 1998, including $18.6 million of short-term investments with maturities of 90 days or less and $45.5 million of U.S. Treasury equivalents and government agency securities. At December 31, 1998, approximately 96.3% of the Company's investments consisted of money market and investment-grade, readily marketable, fixed-income securities, concentrated in maturities
of greater than five years. In addition, at December 31, 1998, the Company's investment portfolio included $27.4 million of equity securities, which includes convertible debt and convertible preferred stock.
Stockholders' equity plus redeemable preferred stock increased to $563.0 million at December 31, 1998, an increase of 19.8% from $469.9 million at December 31, 1997. This increase resulted primarily from net income for 1998 of $91.1 million, a $2.6 million increase (net of tax) in the market value of securities available for sale and proceeds from the issuance of common stock of $5.4 million, offset by $6.0 million of dividends.
As part of its Year 2000 remediation effort, the Company will upgrade all desktop and laptop personal computers and vendor software programs that are not currently Year 2000 compliant (see Year 2000 Issue below) during 1999. The cost of this upgrade is currently estimated at $814,000. In addition, the Company plans to implement system and network monitoring software during 1999 at a cost of approximately $200,000 that will enhance the efficiency of the Company's operating systems.
The Company believes that CMAC will have sufficient funds to satisfy its claims payments and operating expenses and to pay dividends to the Company for at least the next 12 months. The Company also believes that it will be able to satisfy its long-term (more than 12 months) liquidity needs with cash flow from CMAC. As a holding company, the Company conducts its principal operations through CMAC. The company's ability to pay dividends on the $4.125 Preferred Stock is dependent upon CMAC's ability to pay dividends or make other distributions to the Company. Based on the company's current intention to pay quarterly common stock dividends of approximately $0.03 per share, the Company will require distributions from CMAC of $6.0 million annually to pay the dividends on the outstanding shares of $4.125 Preferred Stock and common stock. There are regulatory and contractual limitations on the payment of dividends or other distributions (See note 7 to the Consolidated Financial Statements.) The Company does not believe that these restrictions will prevent the payment by CMAC or the Company of these anticipated dividends or distributions in the foreseeable future.
The Company has completed the necessary program modifications to make them Year 2000 compliant and all date sensitive files have been appropriately modified and updated. The Company has built a stand-alone testing environment that allowed simulation of different year-end scenarios and testing of the Year 2000 programming changes and file modifications was completed in October 1998. In addition, the Company has undertaken a review of all of its hardware systems to assess Year 2000 compliance. The Company's servers are currently Year 2000 compliant and any desktop or laptop systems not currently Year 2000 compliant are scheduled for replacement in 1999.
Although the Company will be Year 2000 compliant, in the event that third parties with whom the Company transacts business are not Year 2000 compliant, potential for an adverse effect on the Company's operations may remain. The Company has taken precautions to minimize this risk by contacting each of its mission critical business partners to ascertain their Year 2000 compliance status. Currently, the Company believes its most reasonably likely Year 2000 worst case scenario would involve the failure of its business partners' loan origination, renewal processing or default reporting systems. The Company is an active participant in the mortgage industry's Year 2000 testing project and has developed contingency plans to minimize the risks of business disruptions resulting from its business partners' Year 2000 issues.
The Company did not incur any significant incremental expense related to Year 2000 issues during 1998 and does not expect that its Year 2000 compliance program will result in any material costs or have a material impact on its financial condition or results of operations. The Company has not used any independent verification and/or validation processes to assure the reliability of its risk and cost estimates.
The condensed consolidated financial statements and supplementary data are indexed in the Index to Consolidated Financial Statements and Financial Statement Schedules which appears on page 41 and are incorporated in this item by reference.