For the year ended December 31, 2008, we recorded a consolidated net loss of $928.5 million compared to a consolidated net loss of $915.3 million for 2007. Our consolidated net loss for 2008 includes the financial results of our discontinued operations related to PMI Australia, PMI Asia and PMI Guaranty. Our consolidated net loss in 2008 was primarily driven by losses in our U.S. Mortgage Insurance Operations, Financial Guaranty and International Operations segments. U.S. Mortgage Insurance Operations’ net loss in 2008 was primarily driven by an increase in losses and loss adjustment expenses (“LAE”), higher impairment losses in our U.S. investment portfolio and a decrease in earned premiums from 2007. Our Financial Guaranty segment’s loss in 2008 was the result of our impairment of our investment in FGIC in the first quarter of 2008, impairment of our investment in RAM Re in the third quarter of 2008 and equity in losses from RAM Re. International Operations’ net loss in 2008 was primarily driven by increases in losses and LAE in PMI Europe as compared to 2007 and losses on the sales of PMI Australia and PMI Asia. Our consolidated 2008 financial results were positively impacted by $123.6 million in gains related to the change in fair value of certain of our senior debt instruments in our Corporate and Other segment. Our consolidated net loss in 2007 was primarily due to our equity in losses from FGIC and higher losses and LAE in our U.S. Mortgage Insurance Operations.
We provide residential mortgage insurance products designed to promote homeownership and strengthen communities. Mortgage insurance protects lenders and investors from credit losses, helping to ensure that mortgages are available to prospective homebuyers. In 2008, we divided our business into four segments:
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. The results of U.S. Mortgage Insurance Operations include PMI Mortgage Insurance Co. and its affiliated U.S. mortgage insurance and reinsurance companies (collectively, “PMI”), and equity in earnings from PMI’s joint venture, CMG Mortgage Insurance Company and its affiliated companies (collectively, “CMG MI”). U.S. Mortgage Insurance Operations recorded a net loss of $709.5 million in 2008 and $190.8 million in 2007.
premiums earned on our U.S. and international mortgage insurance policies and other credit enhancement products;
Market Conditions and Capital Constraints. The significant weakening of employment in the United States and the U.S. credit, capital, residential mortgage, and housing markets continues to negatively affect our U.S. Mortgage Insurance Operations segment. As discussed below under Losses and LAE, PMI is experiencing higher losses. These losses, which we expect to continue in 2009, have reduced and will continue to reduce, PMI’s net assets. Partially in response to PMI’s increased losses and reduced capital, as of March 15, 2009, Standard &Poor’s, Moody’s and Fitch had each lowered their insurer financial strength rating on PMI from “AA” or equivalent to “A-”, “Ba3” and “BBB+”, respectively. Because of rating agency actions in 2008, we submitted written remediation plans to Fannie Mae and Freddie Mac (collectively, the “GSEs”) outlining, among other things, the steps we are taking or plan to take to bolster PMI’s financial strength. To date, each of the GSEs has continued to treat PMI as an eligible mortgage insurer. There, however, can be no assurance that the GSEs will continue to treat PMI as an eligible mortgage insurer.
acceptable terms and in a timely manner, or at all. See Item 1A. Risk Factors-Capital and Liquidity Constraints. In addition, our reduction of new insurance written will correspondingly reduce our premiums earned.
Losses and LAE. PMI’s losses and LAE increased to $1.8 billion in 2008 from $1.1 billion in 2007. We increased PMI’s net loss reserves in 2008 by $1.0 billion as a result of increases in PMI’s default inventory (discussed under Defaults below), higher claim rates (the rate at which delinquent insured loans result in claims), higher average claim sizes and worsened severity. The increase in claim rates was driven by home price declines and diminished availability of certain loan products, both of which constrain refinancing opportunities and result in a decrease in the cure rate (the percentage of the default inventory that is returning to current status). The increases in PMI’s average claim size have been driven by, among other things, higher loan sizes and coverage levels and declining home prices which limit PMI’s loss mitigation opportunities. During 2008, the increase in loss reserves was partially offset by a decrease in our estimated claim rate due to the impact of loss mitigation efforts and increased rescissions of insurance written in prior periods. PMI’s losses and LAE will be negatively affected if future estimated claim rates and/or claim sizes increase. Changes, or lack of improvement, in economic conditions including, the U.S. credit and capital markets, mortgage interest rates, job creation, unemployment rates, and home prices, could significantly impact our reserve estimates and, therefore, PMI’s losses and LAE. Claims paid including LAE in 2008 increased to $814.0 million from $362.3 million in 2007.
progressively tightening our underwriting guidelines related to Alt-A loans and effective June 1, 2008, we eliminated Alt-A loan eligibility. 5.3% of new insurance written in 2008 consisted of Alt-A loans compared to 27.4% in 2007. Risk in force from Alt-A loans represented 18.8% of PMI’s primary risk in force as of December 31, 2008 compared to 22.8% as of December 31, 2007. The default rate for Alt-A loans was 30.6% as of December 31, 2008 compared to 13.9% as of December 31, 2007.
Interest Only Loans-Interest only loans, also known as deferred amortization loans, have more exposure to declining home prices than traditional loans, in part because principal is not reduced during an initial deferral period. In 2008, PMI primarily insured interest only loans through our flow channel and most of such loans were sold by the originating lenders to the GSEs. Due to the tightening of underwriting guidelines in late 2007 and early 2008, 5.2% of new insurance written in 2008 was comprised of interest only loans, compared to 20.2% in 2007. Risk in force from interest only loans represented 11.8% of PMI’s primary risk in force as of December 31, 2008 compared to 14.2% as of December 31, 2007. The default rate for interest only loans was 28.6% as of December 31, 2008 compared to 11.0% as of December 31, 2007.
None of the above categories (or risk characteristics) are mutually exclusive, and PMI’s portfolio may contain loans with one or more of such characteristics. We expect the percentage of the above categories of loans in our portfolio to continue to decline as a result of our underwriting guideline changes in 2007 and 2008.
New Insurance Written (NIW). PMI’s primary NIW decreased by 50.9% in 2008 compared to 2007. This decrease was principally due to changes to PMI’s pricing and underwriting guidelines implemented in 2007 and 2008 that reduce the types of loans that PMI will insure. Due to capital constraints, PMI will continue to limit NIW in 2009. See Item 1A. Risk Factors-Capital and Liquidity Constraints.
As discussed above in Item 1(B)(9). Business-U.S. Mortgage Insurance Operations-Reinsurance-Captive Reinsurance, PMI no longer seeks reinsurance under excess-of-loss (“XOL”) captive reinsurance agreements on new business. PMI will continue to cede premiums to the captive trust accounts related to the captives in runoff, but these cessions are expected to decrease over time as the number of loans in our portfolio subject to captive reinsurance agreements decrease. Due to the run-off of these XOL agreements and commutation of certain captive reinsurance agreements in 2008, as well as expected future claim payments from captive trust accounts in 2009, we do not anticipate that the aggregate amount of assets held for the benefit of PMI in captive trust accounts will significantly increase in 2009 and will likely decrease once claim payments begin to exceed premium cessions to the trusts. In addition, we expect that the percentage of PMI’s primary insurance in force that is subject to captive reinsurance agreements will decrease over time.
Policy Cancellations and Persistency. PMI’s persistency rate, which is based upon the percentage of primary insurance in force at the beginning of a 12-month period that remains in force at the end of that period, was 82.2% as of December 31, 2008 and 75.5% as of December 31, 2007. The increase in PMI’s persistency rate reflects home price declines and lower levels of residential mortgage refinance activity. To the extent that home prices continue to decline and residential mortgage refinance activity remains relatively low, we expect that PMI’s persistency rate will likely remain high and therefore limit the rate at which PMI’s existing risk in force runs off. Because PMI must maintain sufficient capital to satisfy regulatory risk-to-capital metrics, higher persistency rates further constrain PMI’s capital position and limit its ability to write new business.
Other-than-Temporary Impairment of Investments. During 2008, we recorded a realized loss of $96.5 million related to preferred securities held in our U.S. investment portfolio due to continuing stress in the capital markets. We may have additional impairments for preferred or other securities if they meet the criteria for other-than-temporary impairment, which would negatively affect our capital and have an adverse effect on our results of operations and financial condition. See Item 1A. Risk Factors-As a result of significant volatility and uncertainty in the market, we impaired the value of certain securities held in our investment portfolio and there is a risk that additional impairments may occur in the future.
International Operations. Factors affecting the financial performance of our International Operations segment include:
PMI Europe. In 2008, we restructured PMI Europe to conserve capital and reduce expenses. PMI Europe is not assuming any new risk and has reduced staff and facilities accordingly. The aggregate cost associated with PMI Europe’s reconfiguration is estimated to be approximately $7.6 million (pretax) of which $7.1 million was recognized in 2008. PMI Europe had a net loss of $80.3 million in 2008 compared to a net loss of $33.4 million in 2007. The increase in net loss in 2008 compared to 2007 was primarily due to an increase in loss reserves of $48.8 million in 2008. The increase in loss reserves was due primarily to the deteriorating performance of certain U.S. subprime exposures on which PMI Europe provided reinsurance coverage in 2005 and, to a lesser extent, increased defaults on the Italian primary flow business. As of December 31, 2008, PMI Europe’s total exposure from its reinsurance of U.S. subprime risk is approximately $188.6 million. Total reserves associated with this portfolio were $64.5 million as of December 31, 2008. PMI Europe has posted collateral related to these reinsurance transactions, and as of March 15, 2009, the posted collateral balance was $53.7 million. PMI Europe’s losses in 2008 were also due to changes in the fair value of PMI Europe’s credit default swap (“CDS”) derivative contracts resulting from the widening of European residential mortgage-backed securities (“RMBS”) credit spreads during the period.
PMI Canada. We are in the process of closing our operations in Canada, and estimate that the total costs to exit Canada will be between $8 million and $10 million, pre-tax, of which $2.6 million was recognized in 2008. We repatriated to PMI $41.5 million of capital in the fourth quarter of 2008. To fully close our operations in Canada, we must facilitate the removal of PMI Canada’s risk in force and obtain regulatory approvals.
Discontinued Operations of PMI Australia and PMI Asia. On October 22, 2008, we sold PMI Australia for an aggregate purchase price of approximately $920 million (approximately 100% of the net tangible asset value of PMI Australia under GAAP as of June 30, 2008). As discussed in Item 1(C) Business-International Operations-Discontinued Operations in PMI Australia and PMI Asia, PMI received approximately $746 million in cash and $187 million in contingent consideration paid in the form of a note (the “Note”), subject to reductions in certain events. In connection with recording PMI Australia as discontinued operations, we recognized an after tax loss with respect to the write-down of the carrying amount of PMI Australia to its fair value less cost to sell. The loss on sale was approximately $64.6 million for the year ended December 31, 2008 primarily due to no value being assigned to the Note due to contingent elements with respect to repayment. On December 17, 2008, we completed the sale of PMI Asia and received approximately $51.6 million in cash. In connection with recording PMI Asia as discontinued operations, we recognized an after tax loss with respect to the write-down of the carrying amount of PMI Asia to its fair value less cost to sell. The loss on sale was approximately $14.2 million for the year ended December 31, 2008.
RAM Re. Equity in losses from RAM Re in 2008 was $57.7 million compared to equity in earnings of $4.5 million in 2007. As of June 30, 2008, the carrying value of our investment in RAM Re had been reduced to zero due to equity in losses in RAM Re. During the third quarter of 2008, we recognized equity in earnings from RAM Re of $9.4 million and realized an other-than-temporary impairment charge of $2.9 million. During the fourth quarter of 2008, we recognized equity in losses from RAM Re of $6.5 million. The carrying value of our investment was zero at December 31, 2008.
FGIC. We impaired our investment in FGIC in the first quarter of 2008, and reduced the carrying value of the investment from $103.6 million to zero. To the extent that our carrying value remains zero, no equity in losses relating to FGIC will be recorded. Equity in earnings from FGIC could be recognized in the future to the extent those earnings are deemed recoverable. We are under no obligation, nor do we intend, to provide additional capital to FGIC.
Fair Value Measurement of Financial Instruments. Effective January 1, 2008, we adopted SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, Including an amendment of FASB Statement No. 115, which 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. We elected to adopt the fair value option for certain corporate debt. In 2008, the decrease in fair value (representing increase in revenue) of $123.6 million was related to the subsequent measurement of fair value for these debt instruments. The changes in the fair value of liabilities for which the fair value was elected were primarily due to widening of credit spreads and interest rate fluctuations. (See Item 8, Note 10. Fair Value Disclosures, for further discussion.)
Share-Based Compensation. During 2008, we incurred pre-tax share-based compensation expense of $8.8 million compared to $16.1 million in 2007. The decrease in share-based compensation expense was due primarily to a decrease in the fair value of the share-based compensation granted in 2008.
Holding Company Liquidity. Our holding company’s principal sources of liquidity include dividends from its insurance subsidiaries, expected tax receivables from PMI, income from its investment portfolio and funds drawn from our revolving credit facility and cash and investments held at the holding company. PMI did not pay dividends to The PMI Group in 2008 and we do not expect that PMI will be able to pay dividends in 2009 or 2010. Our holding company’s available funds, consisting of cash and cash equivalents and investments, were $235.9 million at December 31, 2008 and included $200 million outstanding under our revolving credit facility. We are engaged in discussions with the lenders under our credit facility to amend the financial covenants and certain events of default under the credit facility. We currently have sufficient liquidity at our holding company to repay the credit facility in the event we no longer comply with its terms or in the event of a potential cross-default under our senior notes. See Item 1A. Risk Factors-Our credit facility contains restrictive and financial covenants and, if we are unable to comply with these covenants, we may trigger an event of default under the facility and Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources.
For the year ended December 31, 2008, we recorded a consolidated net loss of $928.5 million compared to a consolidated net loss of $915.3 million for 2007. Our consolidated net loss for 2008 includes the financial results of our discontinued operations related to PMI Australia, PMI Asia and PMI Guaranty. Our consolidated net loss in 2008 was primarily driven by losses in our U.S. Mortgage Insurance Operations, Financial Guaranty and International Operations segments. U.S. Mortgage Insurance Operations’ net loss in 2008 was primarily driven by an increase in losses and loss adjustment expenses (“LAE”), higher impairment losses in our U.S. investment portfolio and a decrease in earned premiums from 2007. Our Financial Guaranty segment’s loss in 2008 was the result of our impairment of our investment in FGIC in the first quarter of 2008, impairment of our investment in RAM Re in the third quarter of 2008 and equity in losses from RAM Re. International Operations’ net loss in 2008 was primarily driven by increases in losses and LAE in PMI Europe as compared to 2007 and losses on the
sales of PMI Australia and PMI Asia. Our consolidated 2008 financial results were positively impacted by $123.6 million in gains related to the change in fair value of certain of our senior debt instruments in our Corporate and Other segment. Our consolidated net loss in 2007 was primarily due to our equity in losses from FGIC and higher losses and LAE in our U.S. Mortgage Insurance Operations.
The change in fair value of certain debt instruments in 2008 resulted from our adoption of SFAS No. 159 effective January 1, 2008. The changes in fair value of $123.6 million in 2008 were primarily due to changes in interest rates and widening of credit spreads associated with our senior debt.
The increase in our losses and LAE in 2008 compared to 2007 was primarily driven by U.S. Mortgage Insurance Operations’ increased loss reserves and claim payments during the period, as well as loss reserve increases by PMI Europe. The increases in U.S. Mortgage Insurance Operations reflect the significant weakening of the U.S. employment, credit, capital, residential mortgage, and housing markets which drove higher default inventories, claim rates, average claim sizes and claim severity. The significant increase in our losses and LAE in 2007 compared to 2006 was primarily due to loss reserve increases in the U.S. Mortgage Insurance Operations and, to a lesser extent, PMI Europe. The 2007 increase in U.S. Mortgage Insurance Operations’ losses and LAE was due to an increase in net loss reserves and an increase in claims paid compared to 2006 due to declines in credit and housing markets.
The increase in other underwriting and operating expenses in 2008 compared to 2007 was primarily due to severance costs associated with our Voluntary Early Retirement Program and involuntary terminations and disposal costs in our U.S. Mortgage Insurance Operations and International Operations segments, as well as certain software impairment charges in the Corporate and Other Segment. The decrease in other underwriting and operating expenses in 2007 compared to 2006 was primarily a result of lower employee compensation expenses in 2007.
We recorded income tax benefits from continuing operations of $434.0 million in 2008, compared to income tax benefits of $246.5 million in 2007. The effective tax rates for the continuing operations were 32.8% for 2008, 19.6% for 2007 and 23.7% for 2006. The change in our effective tax rate in 2008 was primarily due to losses in our U.S. Mortgage Insurance Operations and Financial Guaranty segments and the effects of tax exempt income as a proportion of net losses. The change in our effective tax rate in 2007 compared to 2006 was primarily due to the losses in our U.S. Mortgage Insurance Operations and Financial Guaranty segments. In 2007, a valuation allowance of approximately $168 million was established against deferred tax assets resulting from losses attributable to FGIC and RAM Re, decreasing the effective tax rate. In 2008, the valuation allowance increased by $6.5 million to $174.6 million due primarily to unrealized losses primarily related to FGIC, RAM Re and preferred investments.
The following table presents consolidated (loss) income and (loss) income for each of our segments:
Premiums written and earned-PMI’s net premiums written refers to the amount of premiums recorded based on effective coverage during a given period, net of refunds and premiums ceded primarily under captive reinsurance agreements. Under captive reinsurance agreements, PMI transfers portions of its risk written on loans originated by certain lender-customers to captive reinsurance companies affiliated with such lender-customers. In return, portions of PMI’s gross premiums written are ceded to those captive reinsurance companies.
PMI’s premiums earned refers to the amount of premiums recognized as earned, net of changes in unearned premiums. The components of PMI’s net premiums written and premiums earned are as follows:
Net realized investment (losses) gains-The net realized investment loss in 2008 was due to other-than-temporary impairments of PMI’s preferred securities as a result of declines in the market values of the securities. The effect of the impairments in 2008 was partially offset by realized gains on the sale of certain equity investments in PMI’s portfolio in the first half of 2008. The net realized investment gain in 2007 was primarily due to gains from sale of common stock offset by losses from impairment of common stock and losses from the sale of preferred securities.
The calculation of the average primary claim size for 2008 excluded $34.0 million received from certain captive trust accounts as a result of commutations completed during the year ended December 31, 2008.
claim sizes in 2008 and 2007 have been driven by higher loan sizes and coverage levels in PMI’s portfolio and declining home prices, which limit PMI’s loss mitigation opportunities. Higher claim rates have been driven by, among other things, home price declines and diminished availability of certain loan products, both of which constrain refinancing opportunities, and result in a decrease in the percentage of the default inventory that is returning to current status. Primary claims paid were $743.0 million in 2008, $329.6 million in 2007, and $214.0 million in 2006. Pool insurance claims paid were $55.2 million in 2008, $21.0 million in 2007, and $18.3 million in 2006.
Defaults-PMI’s primary mortgage insurance master policies define “default” as the borrower’s failure to pay when due an amount equal to the scheduled monthly mortgage payment under the terms of the mortgage. Generally, the master policies require an insured to notify PMI of a default no later than the last business day of the month following the month in which the borrower becomes three monthly payments in default. For reporting and internal tracking purposes, we do not consider a loan to be in default until the borrower has missed two consecutive payments. Depending upon its scheduled payment date, a loan in default for two consecutive monthly payments could be reported to PMI between the 31st and the 60th day after the first missed payment due date.
Total pool loans in default (which includes modified and other pool products) as of December 31, 2008, 2007, and 2006 were 50,772, 29,143, and 15,898, respectively. The default rates for total pool loans as of December 31, 2008, 2007, and 2006 were 15.5%, 7.76% and 4.24%, respectively.
insurance, associated underwriting costs were not deferred. We defer policy acquisition costs when incurred and amortize these costs in proportion to estimated gross profits for each policy year by type of insurance contract (i.e. monthly, annual and single premium). Policy acquisition costs incurred and deferred are variable and fluctuate with the volume of new insurance applications processed and NIW. The decrease in amortization of deferred policy acquisition costs in 2008 and the increase in 2007 were primarily due to our $33.6 million impairment in 2007 of PMI’s deferred policy acquisition costs associated with PMI’s 2007 book year. PMI’s deferred policy acquisition cost asset was $32.3 million, $10.5 million, and $43.5 million as of December 31, 2008, 2007 and 2006, respectively.
Other underwriting and operating expenses generally consist of all costs that are not attributable to the acquisition of new business and are recorded as expenses when incurred. Other underwriting and operating expenses increased in 2008 compared to 2007 primarily as a result of severance costs associated with our Voluntary Early Retirement Program and involuntary terminations.
Equity in earnings from unconsolidated subsidiaries-U.S. Mortgage Insurance Operations’ equity in earnings is derived entirely from the results of operations of CMG MI. Equity in earnings from CMG MI in 2008 was $6.5 million compared to equity in earnings of $17.1 million in 2007 and $20.3 million in 2006, primarily as a result of higher losses.
PMI’s loss ratio is the ratio of losses and LAE to premiums earned. The loss ratio increased in 2008 compared to 2007 as a result of higher losses and LAE and lower premiums earned. The loss ratio increased in 2007 compared to 2006 as a result of higher losses and LAE, partially offset by higher premiums earned.
PMI’s expense ratio is the ratio of total underwriting and operating expenses to net premiums written. The decrease in PMI’s expense ratio in 2008 compared to 2007 was primarily due to decreases in amortization of deferred policy acquisition costs and employee compensation expenses. The decrease in PMI’s expense ratio in 2007 compared to 2006 was primarily due to an increase in net premiums written and a decrease in employee compensation expenses, partially offset by an increase in amortization of deferred policy acquisition costs.
The decrease in PMI’s primary flow NIW for 2008 compared to 2007 was principally due to changes to PMI’s pricing and underwriting guidelines that were implemented during 2007 and 2008 that have decreased the types of loans that PMI would insure and, to a lesser extent, the continuing slowdown in the mortgage origination and non-agency mortgage capital markets, as well as increased competition from the Federal Housing Administration’s mortgage insurance programs. The increase in PMI’s flow channel NIW in 2007 compared to 2006 was driven by a larger private mortgage insurance market. Structured finance NIW was lower in 2008 compared to 2007 as a result of the deterioration in the housing, mortgage, credit, and capital markets and the near elimination of the non-agency MBS market.
The decreases in 2008 in the percentages of PMI’s NIW consisting of ARM and Above-97 loans were driven primarily by changes in PMI’s pricing and underwriting guidelines adopted in 2007 and 2008. We no
longer insure Above-97s. The increase in 2007 in the percentage of PMI’s NIW consisting of Above-97 loans was primarily due to the reduced availability of alternative mortgage products, including piggyback loans, and increased activity by the GSEs.
In 2008, interest only loans were insured primarily through PMI’s flow channel and such loans were primarily sold to the GSEs. The majority of interest only loans insured in 2008 have ten year terms and are subject to additional underwriting criteria to limit the potential for layered risk. With a payment option ARM, a borrower generally has the option every month to make a payment consisting of principal and interest, interest only, or an amount established by the lender that may be less than the interest owed in which case the interest shortfall is added to the principal amount of the loan. The following table presents PMI’s interest only loans as percentages of its flow channel and structured finance channel primary NIW and payment option ARMs as percentages of its flow channel primary NIW:
The decrease in 2008 in the percentage of PMI’s NIW consisting of interest only loans and the decreases in 2008 and 2007 in the percentage of PMI’s NIW consisting of payment option ARM loans were driven primarily by changes in PMI’s pricing and underwriting guidelines adopted in 2007 and 2008. The increase in 2007 in the percentage of PMI’s NIW consisting of interest only loans was primarily the result of an increase in the percentage of interest only loans originated by mortgage lenders in 2007.
The average USD/Euro currency exchange rate was 1.4712 in 2008, 1.3709 in 2007, and 1.2566 in 2006. The changes in the average USD/Euro currency exchange rates from 2007 to 2008 negatively impacted PMI Europe’s financial results by $5.5 million in 2008. Changes in the average USD/Euro currency exchange rates from 2006 to 2007 negatively impacted PMI Europe’s financial results by $2.8 million in 2007.
Underwriting and operating expenses-The increase in underwriting and operating expenses in 2008 compared to 2007 was primarily due to severance costs related to the restructuring of PMI Europe and the strengthening of the Euro relative to the U.S. dollar. The increase in underwriting and operating expenses in 2007 compared to 2006 was primarily due to expenses related to our continuing expansion in Europe and also due to a strengthening of the Euro against the U.S. dollar.
During the third quarter of 2008, we reported PMI Australia and PMI Asia as discontinued operations. As a result, we classify the assets and liabilities of PMI Australia and PMI Asia as discontinued operations for all periods presented. In addition, 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:
The following table represents PMI Australia’s results of operations, recorded as discontinued operations, and loss on sale of PMI Australia:
Loss on sale of PMI Australia was principally due to receiving a portion of the purchase price in the form of a note issued by the purchaser in the principal amount of $187 million, the payment of which is contingent on certain performance criteria. Due to the contingent nature of the note, we did not record it as an asset in the consolidated financial statements. Loss on sale of PMI Australia was also due in part to selling and other costs associated with the sale transaction, including a $46.5 million reinsurance premium, partially offset by gains on realization of accumulated other comprehensive income relating to foreign currency translation adjustment. The income tax expense related to the sale reflects the recognition of a U.S. taxable gain, reduced by the benefits of certain foreign tax credits generated by the sale.
The following table represents PMI Asia’s results of operations, recorded as discontinued operations, and loss on sale of PMI Asia:
We sold PMI Asia for a cash purchase price equal to 92.5% of its book value as of June 30, 2008. The loss on sale of PMI Asia was primarily due to selling PMI Asia for less than its book value and selling and other costs associated with the sale, which was partially offset by gains on realization of accumulated other comprehensive income related to foreign currency translation adjustment. The income tax expense related to the sale reflects the recognition of a U.S. taxable gain, reduced by the benefits of certain foreign tax credits generated by the sale.
Financial Guaranty includes the equity in earnings (losses) from FGIC and RAM Re. The financial results of PMI Guaranty are reported as discontinued operations.
Net investment income-Net investment income decreased in 2008 compared to 2007 due primarily to a decrease in book yield on our fixed income securities as well as lower rates on cash and cash equivalents. Net investment income decreased in 2007 compared to 2006 due primarily to a decrease in the size of the investment portfolio as a result of repurchases of common shares and capital contributions to certain wholly-owned subsidiaries in 2007, and a decrease in book yield for the Corporate and Other segment.
Net realized investment losses-The net realized investment losses in 2008 are due primarily to losses from actual or anticipated investment sales. The increase in net realized investment gains in 2007 compared to net realized investment losses in 2006 was primarily due to the settlement gain of $12.7 million on the sale of an unconsolidated subsidiary.
Other operating expenses-The decrease in other operating expenses in 2008 compared to 2007 was due primarily to our receipt in 2008 of settlement proceeds of approximately $10.9 million related to insurance coverage litigation concerning PMI’s defense and settlement of the litigation captioned Baynham et al. v. PMI Mortgage Insurance Co., and a decrease in contract underwriting remedies paid in 2008. Other operating expenses decreased in 2007 compared to 2006 due to decreases in employee compensation costs and contract underwriting remedies.
We are actively engaged in discussions with the lenders under our credit facility to amend the financial covenants and certain events of default under our revolving credit facility. Pending negotiation and execution of an amendment to the credit facility, the lenders under the credit facility have agreed to suspend the financial strength ratings event of default, reduce the minimum Adjusted Consolidated Net Worth requirement from $1.5 billion to $1.2 billion, and increase the maximum PMI risk-to-capital ratio requirement to 24.0 to 1, through April 15, 2009. As part of this agreement, we have agreed not to borrow additional amounts under the facility or contribute additional capital to our subsidiaries unless and until we are in compliance with the rating, Adjusted Consolidated Net Worth and risk-to-capital ratio provisions as they were set forth in the credit facility prior to their suspension. We cannot be sure that we will complete an amendment to the credit agreement on terms acceptable to us prior to the expiration of this temporary suspension or at all. We believe that unless we raise capital, or the credit facility is successfully amended, we will be unable to comply with all credit facility covenants and terms on or after April 16, 2009. See Item 1A. Risk Factors-We may face liquidity issues at our holding company, The PMI Group. We currently have sufficient liquidity at our holding company to repay the credit facility in the event we no longer comply with its terms or in the event of a potential cross-default under our senior notes.
The credit facility includes a number of conditions to our being able to borrow additional amounts under the facility. Among other things, we will not be able to borrow additional amounts if either (1) PMI fails to meet the GSE eligibility requirements for mortgage insurers or (2) there exist any limitations that were not in effect on March 16, 2008 with respect to the eligibility of mortgages insured by MIC for purchase by the GSEs that would adversely affect (other than in a manner that is insubstantial) the ability of PMI to conduct its business as it was conducted prior to that date. There can be no assurance that we will be able to meet the conditions required to borrow additional amounts under the facility.
The facility contains restrictions on asset dispositions and investments. While we are generally permitted (subject to the terms of the temporary suspension described above) to make additional investments in PMI and its subsidiaries, our ability to invest in our reinsurance subsidiaries is subject under the credit facility to dollar limitations (other than with regard to four of TPG’s subsidiaries whose capital stock is pledged to the lenders). The credit facility does not permit us to make additional investments in FGIC or RAM Re.
the facility) being subject to certain regulatory actions or restrictions by their respective primary insurance regulators that are not cured within specified periods of time. Upon an event of default, we would likely be required to repay all outstanding indebtedness under the credit facility and would be unable to draw on the facility, and the lenders under the credit facility would have the right to terminate their loan commitments under the facility. In addition, an event of default under the facility, if not cured within 30 days, would cause an event of default under our outstanding senior notes and could require us to repay all our outstanding senior notes. As described above, the financial strength ratings event of default has been suspended through April 15, 2009 by the lenders under the facility.
PMI’s ability to pay dividends is also subject to restriction under the terms of a runoff support agreement with Allstate Insurance Company. Under the terms of such runoff support agreement, PMI is subject to restrictions that may apply if its risk-to-capital ratio exceeds 23 to 1. Under the runoff support agreement, among other things, PMI may not declare or pay dividends at any time that its risk-to-capital ratio equals or exceeds 23 to 1 or if such a dividend would cause its risk-to-capital ratio to equal or exceed 23 to 1. In addition, if PMI’s risk-to-capital ratio equals or exceeds 23 to 1 at three consecutive monthly measurement dates, PMI may not enter into new insurance or reinsurance contracts without the consent of Allstate Insurance Company. If following such time as PMI’s risk-to-capital ratio were to exceed 24.5 to 1, the runoff support agreement requires PMI to transfer substantially all of its liquid assets to a trust account for the payment of PMI’s obligations to policyholders, therefore negatively affecting PMI’s and The PMI Group’s liquidity position. As of December 31, 2008, PMI’s risk-to-capital ratio was 18.5 to 1 compared to 10.8 to 1 at December 31, 2007 and 8.1 to 1 at December 31, 2006.
International Operations and Financial Guaranty Liquidity-The principal uses of these segments’ liquidity are the payment of operating expenses, claim payments, taxes, and growth of their investment portfolios. The principal sources of these segments’ liquidity are written premiums, investment maturities and net investment income.
the performance of our U.S. mortgage insurance operations, which is affected by, among other things, the economy, default and cure rates and losses and LAE;
financial and other covenants and event of default triggers in our credit facility;
We are significantly limiting PMI’s new business writings to conserve capital and are exploring other alternatives, including potentially obtaining capital or other relief under the U.S. Treasury’s Financial Stability Plan (including TARP), obtaining reinsurance for our insurance subsidiaries’ existing or future books of business, other capital relief initiatives at PMI, and/or debt or equity offerings. Given current market conditions generally and in our industry, as well as the possibility that we may need to raise additional capital with little notice, there can be no assurance that we will be able to consummate any capital raising transactions on favorable terms, in a timely manner or at all, or that we will successfully obtain assistance under the Financial Stability Plan or other government program. Unless we raise capital, PMI’s policyholders position will likely decline and risk-to-capital ratio increase beyond levels necessary to meet capital adequacy requirements and, if we are unsuccessful in renegotiating our credit facility, certain credit facility covenants. We could exceed regulatory capital adequacy requirements in 2009 and, if we did, PMI would likely cease writing new business.
Under certain circumstances, when we make an underwriting error in the course of providing contract underwriting services to a customer, we issue to the customer a loan indemnification. Such an indemnification is in lieu of paying a monetary remedy to the customer at the time the underwriting error is discovered and is usually issued on a loan by loan basis. While the terms of the indemnifications vary, each indemnification generally requires us to reimburse the customer for certain costs (excess of insurance recoverables) it incurs as a result of the borrower’s default on the loan in question. If the indemnified loan remains current, or is repaid or refinanced, we have no actual liability under the indemnification. As of December 31, 2008, we estimate that the total principal balance of indemnified loans was between approximately $30 million and $35 million. We believe a number of factors will cause our contingent liability with respect to these indemnifications to be significantly lower than this amount. These factors include the following: (i) we generally only indemnify performing loans; (ii) we expect only a portion of the indemnified loans to default; (iii) loans in default may not necessarily cause our customers to incur losses; and (iv) we expect a portion of these loans to be refinanced, or their indemnification coverage to expire. On March 12, 2009, we announced that we will discontinue offering contract underwriting services; however, we may still have liabilities under the existing loan indemnifications. In 2008, we paid customers $0.2 million pursuant to loan indemnifications compared to $0.2 million in 2007. These amounts are included in our expenses associated with contract underwriting remedies.
The changes in net unrealized gains (losses), net of deferred taxes, consist of:
The changes in unrealized gains in 2008, 2007 and 2006 were due primarily to changes in interest rates that caused market value fluctuations relative to our consolidated fixed income portfolio. In 2008, changes in interest rates and widening credit spreads contributed to the changes in unrealized (losses) on our preferred stock in our equity portfolio. As interest rates, market and other economic conditions change, we expect the market value of the securities in our consolidated investment portfolio and of our unconsolidated equity investments to be affected.
The following table summarizes the estimated fair value of the consolidated investment portfolio as of December 31, 2008 and 2007. Amounts shown under “International Operations” consist of the investment portfolios of PMI Europe and PMI Canada. Amounts shown under “Corporate and Other” consist of the investment portfolio of The PMI Group, and amounts shown under “Financial Guaranty” consist of the investment portfolio of PMI Guaranty as of December 31, 2007. As of December 31, 2008. PMI Guaranty’s assets and liabilities were merged into our U.S. Mortgage Insurance Operations.
Our consolidated investment portfolio holds primarily investment grade securities comprised of readily marketable fixed income and equity securities. The fair value of these securities in our consolidated investment portfolio decreased to $2.2 billion as of December 31, 2008 from $2.4 billion as of December 31, 2007.
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, Accounting for Certain Investments in Debt and Equity Securities, our entire investment portfolio is designated as available-for-sale and reported at fair value with changes in fair value recorded in accumulated other comprehensive income.
As of December 31, 2008, approximately $850.5 million, or 24.8% of our consolidated investment portfolio (including cash and cash equivalents, excluding common stocks) was insured by monoline financial guarantors. The financial guarantors include MBIA, FGIC, FSA, AMBAC and others. The table below presents the fair value of securities and the percentage of our consolidated investment portfolio that are insured by these financial guarantors as of December 31, 2008.
The decrease in the pre-tax book yield of U.S. Mortgage Insurance Operations, Financial Guaranty and Corporate and Other in 2008 was due to interest rate decreases during the year.
As of December 31, 2008, our consolidated shareholders’ equity was $1.3 billion. The fair value and carrying value of our long-term debt outstanding issued by The PMI Group at December 31 was as follows:
In considering the initial adoption of the SFAS No. 159, we determined that the change in fair value of the 8.309% Junior Subordinated Debentures would not have 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. Since the 5.568% Senior Notes matured in 2008, the Company did not elect to adopt the fair value option for the 5.568% Senior Notes.
For a discussion of our revolving credit facility, see Liquidity and Capital Resources-Credit Facility, above.
PMI also has a capital support agreement with PMI Canada. Because we terminated our Canadian operations in PMI Canada, we believe it is unlikely there is any remaining material support obligation under the PMI Canada capital support agreement.
Consolidated cash flows provided by investing activities in 2008, including purchases and sales of investments and capital expenditures, were $686.0 million compared to consolidated cash flows used in investing activities of $102.0 million in 2007 and cash provided by investing activities of $284.0 million in 2006. The increase in cash flows provided by investing activities in 2008 compared to 2007 was due primarily to proceeds from the sales of PMI Australia and PMI Asia. The increase in cash flows used in investing activities in 2007 compared to 2006 was due primarily to decreased proceeds from sales and maturities of fixed income securities and increased purchases of fixed income securities.
The rating agencies have assigned the following ratings to The PMI Group and certain of its affiliates and its equity investee subsidiaries as of March 15, 2009:
On April 8, 2008, Standard & Poor’s downgraded its counterparty credit and insurer financial strength ratings on PMI Mortgage Insurance Co., PMI Insurance Co. and PMI Europe from “AA” (CreditWatch with Negative Implications) to “A+” (Negative Outlook). Standard & Poor’s also downgraded its counterparty credit rating on The PMI Group from “A” (CreditWatch with Negative Implications) to “BBB+” (Negative Outlook). In taking these actions, Standard & Poor’s noted that the downgrades reflected, among other things, “weaker-than-expected results for the fourth quarter of 2007 and the continued deterioration in key variables that influence claims for mortgage insurance.” Also on April 8, 2008, Standard & Poor’s placed its “AA-” counterparty credit and insurer financial strength ratings on CMG MI on CreditWatch with Negative Implications. Standard & Poor’s indicated that it had taken this action in order to review the impact that the downgrade of PMI Mortgage Insurance Co. would have on CMG MI.
On April 15, 2008, Standard & Poor’s removed CMG MI from CreditWatch with Negative Implications, affirmed its “AA” counterparty credit and insurer financial strength ratings and revised the outlook to Negative. In taking these actions, Standard & Poor’s indicated that it viewed the April 8, 2008 downgrade of PMI Mortgage Insurance Co. as not having a material impact on CMG MI’s financial strength.
On June 5, 2008, Fitch lowered its insurer financial strength rating on PMI and PMI Europe from “AA” (Rating Watch Negative) to “A+” (Rating Watch Negative) and its long-term issuer rating of The PMI Group from “A” (Rating Watch Negative) to “BBB+” (Rating Watch Negative).
2008, Standard & Poor’s concluded that the increase in their loss cost estimates for PMI Mortgage Insurance Co. was not large enough to necessitate a downgrade. Ratings remain on CreditWatch.
On March 6, 2009 Fitch Ratings placed CMG MI’s ‘AA’ insurer financial strength rating on Rating Watch Negative. The rating action was a result of Fitch’s downgrade of CUNA Mutual’s insurer financial strength rating to ‘A’ from ‘AA-’, which was covered under a separate rating commentary on March 6. Fitch expects to resolve the Rating Watch Negative on CMG MI’s rating within one month.
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 and LAE reserves. To ensure the reasonableness of our ultimate estimates, we develop scenarios using generally recognized actuarial projection methodologies that result in various possible losses and LAE.
The following table shows the reasonable range of loss and LAE reserves, as determined by our actuaries, and recorded reserves for losses and LAE (gross of recoverables) as of December 31, 2008 and December 31, 2007 on a segment and consolidated basis:
Our best estimate of PMI’s reserves for losses and LAE is derived primarily from our analysis of PMI’s default and loss experience. The key assumptions used in the estimation process are expected claim rates, average claim sizes and costs to settle claims. We evaluate our assumptions in light of PMI’s historical patterns of claim payments, loss experience in past and current economic environments, the seasoning of PMI’s various books of business, PMI’s coverage levels, the credit quality profile of PMI’s portfolios, and the geographic mix of PMI’s business. Our assumptions are influenced by historical loss patterns and are adjusted to reflect recent loss trends. Our assumptions are also influenced by our assessment of current and future economic conditions,
We established PMI’s reserves at December 31, 2008 based on, among other factors, our evaluation of PMI’s estimated future claim rates and average claim sizes. Management’s best estimate of reserves for losses at December 31, 2008 was approximately the mid-point of the actuarial range.
Our increases to the reserve balance in 2008 were primarily due to PMI’s higher default inventory, higher expected claim rates and claim sizes on reported defaults driven by increases in the average loan size and coverage level within PMI’s default inventory. Continuing deterioration of the U.S. housing and mortgage markets caused PMI’s default inventory, claim rates and claim sizes to increase in 2008. Higher claim rates have been driven by home price declines and diminished availability of certain loan products, both of which constrain refinancing opportunities and result in a decrease in the percentage of the default inventory that is returning to current status (cure rate). The increases in PMI’s average claim size have been driven by, among other things, an increase in defaults from loans with higher loan sizes and coverage levels, and declining home prices which limit PMI’s loss mitigation opportunities. The table below provides a reconciliation of our U.S. Mortgage Insurance segment’s beginning and ending reserves for losses and LAE for the years ended December 31, 2008, 2007, 2006:
The following table shows a breakdown of reserves for losses and LAE by primary and pool insurance:
To provide a measure of sensitivity of pre-tax income to changes in loss reserve estimates, we estimate that: (i) for every 5% change in our estimate of the future average claim sizes or every 5% change in our estimate of the future claim rates with respect to the December 31, 2008 reserves for losses and LAE, the effect on pre-tax income would be an increase or decrease of approximately $122.6 million; (ii) for every 5% change in our estimate of incurred but not reported loans in default as of December 31, 2008, the effect on pre-tax income would be approximately $4.6 million; and (iii) for every 5% change in our estimate of the future cost of claims settlement expenses as of December 31, 2008, the effect on pre-tax income would be approximately $2.9 million.
The following table provides a reconciliation of International Operations’ beginning and ending reserves for losses and LAE for each of the last three years:
The increases in losses and LAE incurred relating to prior years of $45.1 million and $6.9 million in 2008 and 2007, respectively, were primarily due to a loss provision related to deteriorating performance of several U.S. exposures on which PMI Europe provided reinsurance coverage. The $2.8 million increase in 2006 was primarily the result of moderating home price appreciation and home price decline in certain areas and interest rate increases in 2006.
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, 2008 and 2007:
We perform an analysis for premium deficiency using assumptions based on our best estimate when the analysis is performed. The calculation for premium deficiency requires significant judgment and includes estimates of future expected premiums, expected claims, loss adjustment expenses and maintenance costs as of the date of the test. The calculation of future expected premiums uses assumptions for persistency and termination levels on policies currently in force. Assumptions for future expected losses include future expected average claim sizes and claim rates which are based on the current default rate and expected future defaults. Investment income is also considered in the premium deficiency calculation. For the calculation of investment income we use our pre-tax investment yield.
Based on management’s assessment and those criteria, management has concluded that we maintained effective internal control over financial reporting as of December 31, 2008.
Our independent registered public accounting firm has issued an audit report on our internal control over financial reporting. That report appears below in this Item 8.
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, 2008, 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 15, 2009 expressed an unqualified opinion thereon.
We have audited The PMI Group, Inc.’s internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). The PMI Group, Inc.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the 2008 consolidated financial statements of The PMI Group, Inc. and our report dated March 15, 2009 expressed an unqualified opinion thereon.
On October 22, 2008, the Company completed the sale of PMI Australia and on December 17, 2008 the Company completed the sale of PMI Asia. In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets,” the Company has classified the results of its PMI Australia, PMI Asia and PMI Guaranty operations as discontinued operations for all periods presented. The Company reports the assets and liabilities of PMI Australia and PMI Asia in the consolidated balance sheets for all periods presented as “Assets/Liabilities - discontinued operations - held for sale”. The assets and liabilities of PMI Guaranty which were disposed of other than by sale, are classified in the consolidated balance sheet according to their nature. The results of discontinued operations, which include both disposed of by sale and disposed of other than by sale, are reported as “Loss/income from discontinued operations, net of taxes” in the consolidated statements of operations for all periods presented.
The Company has equity ownership interests in CMG Mortgage Insurance Company, CMG Mortgage Reinsurance Company and CMG Mortgage Assurance Company (collectively “CMG MI”), which conduct residential mortgage insurance business for credit unions. The Company also has equity ownership interests in RAM Holdings Ltd., the holding company of RAM Reinsurance Company, Ltd. (collectively “RAM Re”), a financial guaranty reinsurance company based in Bermuda. The Company also has a 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.
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. During 2008, the Company realized an other-than-temporary impairment charge of $2.9 million and recognized equity in losses from RAM Re of $57.7 million, which decreased the value of the Company’s investment in RAM Re to zero. To the extent that their carrying values remain zero, the Company will not recognize in future periods its proportionate share of FGIC’s and RAM Re’s losses, if any. Equity in earnings from FGIC and RAM Re could be recognized in the future to the extent those earnings are deemed recoverable. The Company is under no obligation to provide additional capital to FGIC or RAM Re.
The significant and continuing weakening of the U.S. residential mortgage, housing, credit, and capital markets has negatively affected the Company’s results of operations and overall financial condition. The Company’s consolidated net loss was $928.5 million and $915.3 million for the years ended December 31, 2008 and 2007, respectively. As part of the Company’s response to difficult market conditions, it has adopted a number of initiatives that affect the composition of its business. In particular, the Company is focusing on its core business, U.S. mortgage insurance.
In the current environment, the Company continues to face significant challenges and risks. Unless the Company raises new capital to support PMI, its policyholders position will likely continue to decline and its risk-to-capital ratio will likely increase beyond levels necessary to meet regulatory capital adequacy requirements and credit facility financial covenants. In response to the Company’s capital constraints, it is exploring alternatives to enhance its liquidity and capital at TPG and PMI including potentially obtaining capital or other relief under U.S. Treasury’s Financial Stability Plan (including the Troubled Asset Relief Program, or TARP), obtaining reinsurance for PMI’s future book of business and/or debt or equity offerings. PMI wrote significantly less business in 2008 and, in response to capital constraints, will continue to reduce new insurance written, or NIW, in 2009.
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 only of normal recurring adjustments, considered necessary for a fair presentation for the periods presented have been included.
no assurance that the premiums earned and the associated investment income will prove adequate to compensate for future losses from these loans or that future adverse loss development will not emerge.
Unless we raise new capital, PMI’s policyholders’ position will likely decline and its risk-to-capital ratio increase beyond the levels necessary to meet capital adequacy requirements imposed by regulators as well as under our credit facility. (See Note 25. Subsequent Events, for further discussion.)
Investments-The Company has designated its entire portfolio of fixed income and equity securities as available-for-sale. These securities are predominantly recorded at fair value based on quoted market prices with unrealized gains and losses, net of deferred income taxes, accounted for as a component of accumulated other comprehensive income in shareholders’ equity. The Company evaluates its investments regularly to determine whether there are declines in value and whether such declines meet the definition of other-than-temporary impairment in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 115, Accounting for Certain Investments in Debt and Equity Securities and Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin (“SAB”) No. 59, Accounting for Noncurrent Marketable Equity Securities. The fair value of a security below cost or amortized cost for consecutive quarters is a potential indicator of an other-than-temporary impairment. When the Company determines a security has suffered an other-than-temporary impairment, the impairment loss is recognized, to the extent of the decline, as a realized investment loss in the consolidated statement of operations. The Company’s short-term investments have maturities of greater than three and less than 12 months when purchased and are carried at fair value.
Realized gains and losses on sales of investments are determined on a specific-identification basis. Investment income consists primarily of interest and dividends. Interest income and preferred stock dividends are recognized on an accrual basis. Dividend income on common stocks is recognized on the date of declaration. Net investment income represents interest and dividend income, net of investment expenses.
Investments in Unconsolidated Subsidiaries-Investments in the Company’s unconsolidated subsidiaries include both equity investees and other unconsolidated subsidiaries. Investments in equity investees with ownership interests of 20-50% are generally accounted for using the equity method of accounting, and investments of less than 20% ownership interest are generally accounted for using the cost method of accounting if the Company does not have significant influence over the entity. Limited partnerships with ownership interests greater than 3% but less than 50% are primarily accounted for using the equity method of accounting. The carrying value of the investments in the Company’s unconsolidated subsidiaries also includes the Company’s share of net unrealized gains and losses in the unconsolidated subsidiaries’ investment portfolios.
The Company reports the equity in earnings from CMG MI on a current month basis and the Company’s interest in limited partnerships are on a one-quarter lag basis. Equity in earnings (losses) from RAM Re are reported on a one-quarter lag basis. Due to the impairment of the Company’s investments in FGIC and RAM Re in 2008, the carrying value of the Company’s investments in FGIC and RAM Re were reduced to zero. To the extent that the carrying value remains zero, the Company will not recognize in future periods its proportionate share of FGIC and RAM Re’s losses, if any. Equity in earnings from FGIC and RAM Re could be recognized in the future to the extent those earnings are deemed recoverable.
Related Party Receivables and Payables-As of December 31, 2008, related party receivables were $1.5 million and related party payables were $1.9 million compared to $1.4 million and $1.9 million as of December 31, 2007, respectively, which were comprised of non-trade receivables and payables from unconsolidated subsidiaries.
Property, Equipment and Software-Property and equipment, including software, are carried at cost and are depreciated using the straight-line method over the estimated useful lives of the assets, ranging from three to thirty nine years. Leasehold improvements are recorded at cost and amortized over the lesser of the useful life of the assets or the remaining term of the related lease. The Company’s accumulated depreciation and amortization from continuing operations was $206.4 million and $179.0 million as of December 31, 2008 and December 31, 2007, respectively.
Under the provisions of Statement of Position 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 and for which it has no substantive plan to market externally. Capitalized costs are amortized at such time as the software is ready for its intended use on a straight-line basis over the estimated useful life of the asset, which is generally three to seven years. In 2008, the Company recorded an impairment charge of $7.2 million related to capitalized software.
Effective January 1, 2008, the Company adopted SFAS No. 157, Fair Value Measurements (“SFAS No. 157”). The standard 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 10. Fair Value Disclosures, for further discussion.)
Reserve for Losses and Loss Adjustment Expenses-The consolidated reserves for losses and loss adjustment expenses (“LAE”) for the Company’s U.S. Mortgage Insurance and International Operations are the estimated claim settlement costs on notices of default that have been received by the Company, as well as loan defaults that have been incurred but have not been reported by the lenders. For reporting and internal tracking purposes, we do not consider a loan to be in default until the borrower has missed two payments. Depending upon its scheduled payment date, a loan delinquent for two consecutive monthly payments could be reported to PMI between the 31st and the 60th day after the first missed payment due date. The Company’s U.S. mortgage insurance primary master policy defines “default” as the borrower’s failure to pay when due an amount equal to the scheduled monthly mortgage payment under the terms of the mortgage. Generally, however, the master
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. 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.
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 that can be provided by a single company to 25% for any single risk. The Company’s reinsurance agreements typically provide for a recovery of a proportionate level of claim expenses from reinsurers, and a reinsurance receivable is recorded as an asset based on the type of reinsurance coverage. The Company remains liable to its policyholders if the reinsurers are unable to satisfy their obligations under the agreements. Reinsurance recoverables on 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 recoverables. Reinsurance transactions are recorded in accordance with the accounting guidance provided in SFAS No. 113, Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts. Accordingly, management assesses, among other factors, risk transfer criteria for all reinsurance arrangements.
Comprehensive Income (Loss)-Comprehensive income (loss) includes net income (loss), the change in foreign currency translation gains or losses, derivatives designated as cash flow hedges, pension adjustments, changes in unrealized gains and losses on investments, accretion of cash flow hedges and reclassification of realized gains and losses previously reported in comprehensive income (loss), net of related tax effects.
Earnings (Loss) Per Share-Basic earnings (loss) per share (“EPS”) excludes dilution and is based on consolidated net income (loss) available to common shareholders giving effect to discontinued operations and the actual weighted-average common shares that are outstanding during the period. Diluted EPS is based on consolidated net income (loss) available to common shareholders giving effect to discontinued operations, adjusted for the effects of dilutive securities, and the weighted-average dilutive common shares outstanding 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. Due to the net loss in 2008 and 2007, normally dilutive components of shares outstanding such as stock options were not included in fully diluted shares outstanding as their inclusion would have been anti-dilutive.
The following table presents for the periods indicated a reconciliation of the weighted average common shares used to calculate basic EPS to the weighted-average common shares used to calculate diluted EPS from continuing and discontinued operations:
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, assets and liabilities of PMI Australia and PMI Asia and the results of operations of PMI Guaranty as discontinued operations for all periods presented.
In December 2008, the Financial Accounting Standards Board (“FASB”) issued FASB staff position (“FSP”) No. FAS 132(R)-1, Employers’ Disclosures about Postretirement Benefit Plan Assets. This FSP amends FASB Statement No. 132, Employers’ Disclosures about Pensions and Other Postretirement Benefits, to provide guidance on an employer’s disclosures about plan assets of a defined benefit pension or other postretirement plan. It requires companies to provide users of financial statements with an understanding of how investment decisions are made, the major categories of plan assets, inputs and valuation techniques used to measure fair value of plan assets, the effect of fair value measurements when using unobservable inputs and significant concentrations of risk within plan assets. FSP No. FAS 132(R)-1 is effective for fiscal years ending after December 15, 2009. FSP No. FAS 132(R)-1 is not currently expected to significantly impact the Company’s consolidated financial statements.
In May 2008, the FASB issued SFAS No. 163, Accounting for Financial Guaranty Insurance Contracts, an Interpretation of FASB Statement No. 60 (“SFAS No. 163”), which specifically clarifies the accounting guidance for financial guaranty contracts under SFAS No. 60. SFAS No. 163 requires that an insurance enterprise recognize a claim liability prior to an event of default when there is evidence that credit deterioration has occurred in an insured financial obligation. The statement also clarifies how SFAS No. 60 applies to financial guarantee insurance contracts, including the recognition and measurement to be used to account for premium revenue and claim liabilities. SFAS No. 163 is effective for fiscal years and interim periods beginning after December 15, 2008. SFAS No. 163 is not currently expected to significantly impact the Company’s consolidated financial statements.
In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities-an amendment of FASB Statement No. 133 (“SFAS No. 161”), which amends and expands the disclosure requirements of Statement 133. SFAS No. 161 requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative agreements. SFAS No. 161 is effective for fiscal years and interim periods beginning after November 15, 2008. SFAS No. 161 is not currently expected to significantly impact the Company’s consolidated financial statements.
Realized investment (losses) gains for 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 realized investment (losses) gains 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 to fair value of its investment in RAM Re. The net realized investment losses in 2007 were due primarily to an other-than-temporary impairment of the investment in RAM Re of $38.5 million, partially offset by a $12.7 million settlement gain related to a sale of an unconsolidated subsidiary.
Aging of Unrealized Losses-The following table shows the gross unrealized losses and fair value of the Company’s investments, aggregated by investment category and the length of time the individual securities have been in a continuous unrealized loss position as of December 31, 2008 and 2007:
Unrealized losses in 2008 on fixed income securities were primarily due to the widening of credit spreads which have also increased market interest rates on most fixed income securities. Unrealized losses in 2008 on preferred securities were primarily due to the widening of credit and sector spreads. The unrealized losses are not considered to be other-than-temporarily impaired as the Company has the intent and ability to hold such investments until they recover in value or mature. The Company determined that the decline in the fair value of certain investments in 2008 met the definition of other-than-temporary impairment and recognized realized losses of $104.2 million.
At December 31, 2008, fixed income securities and short-term investments with a fair value of $16.0 million were on deposit with regulatory authorities as required by law.
Equity in (losses) earnings from unconsolidated subsidiaries consisted of the following for the years presented below:
CMG MI’s condensed balance sheets as of December 31, 2008 and 2007, and condensed statements of operations for the years ended December 31, 2008, 2007, and 2006 are as follows:
amount of acquisition costs being deferred. Conversely, in periods where there is significant growth in new business, the asset will generally increase because the amount of acquisition costs being deferred exceeds the amortization of previously deferred policy acquisition costs.
Depreciation and amortization expense related to property, equipment including capital lease, and software totaled $29.3 million in 2008, $30.6 million in 2007 and $31.0 million in 2006. Capitalized costs associated with software developed for internal use were $8.1 million in 2008, $15.8 million in 2007 and $15.6 million in 2006.
The Company establishes reserves for losses and LAE to recognize the estimated liability for potential losses and LAE related to insured mortgages that are in default. The establishment of a loss reserve is subject to inherent uncertainty and requires significant judgment by management. The following table provides a reconciliation of the beginning and ending consolidated reserves for losses and LAE between January 1 and December 31 for each of the three years:
The increase in total consolidated loss reserves at December 31, 2008 compared to December 31, 2007 was primarily due to increases in the reserve balances for U.S. Mortgage Insurance Operations as a result of an increase in the default inventory, higher claim rates and higher average claim sizes. Upon receipt of default notices, future claim payments are estimated relating to those delinquent loans and a reserve is recorded. 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.
Effective January 1, 2008, the Company elected to adopt the fair value option presented by SFAS No. 159 for the Company’s 6.000% Senior Notes and 6.625% Senior Notes. SFAS No. 159 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 SFAS No. 159, 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.
5.568% Senior Notes-In August 2006, the Company completed the remarketing of approximately $345 million in principal amount of senior notes which matured in November 2008 and are referred to as the 5.568% Senior Notes. As a result of the remarketing, the annual interest rate on these notes was reset from 3.00% per annum to 5.568% per annum, paid quarterly, effective from and including August 15, 2006. In connection with the remarketing, the Company purchased and cancelled $300.0 million in principal amount of the 5.568% Senior Notes, leaving $45.0 million in principal amount of these notes outstanding after completion of the remarketing. Since the 5.568% Senior Notes were scheduled to mature in 2008, the Company did not elect to adopt the fair value option for the 5.568% Senior Notes. The 5.568% Senior Notes matured and were paid in November 2008.
The carrying value of the Company’s 6.000% Senior Notes and 6.625% Senior Notes before adoption include accrued interest and unamortized deferred costs. The fair value and carrying value after adoption of these notes include accrued interest.
The following table presents the difference between fair values as of 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 SFAS No. 159, the Company’s diluted loss per share for the year ended December 31, 2008 would have been $(12.39) per share.
The change in fair value of certain of the Company’s corporate debt for which the fair value option was elected was principally due to the widening of credit spreads. SFAS No. 157 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. SFAS No. 157 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value.
Key inputs used in the Company’s valuation of CDS contracts include the transaction notional amount, expected term, premium rates on risk layer, changes in market spreads, estimated loss rates and loss timing, and risk free interest rates. As none of the instruments that we are holding are traded, in order to obtain representative current CDS premium rates or spreads that represent an exit price for the CDS contracts, we develop an internal exit price estimate based on informal market data obtained through market surveys with investment banks, counterparty banks, and other relevant market sources in Europe. The assumed market credit spread is a significant assumption that, if changed, could result in materially different fair values. Accordingly, market perceptions of credit deterioration would result in the increase in the expected exit value (the amount required to be paid to exit the transaction due to wider credit spreads).
The purchase, issuance and settlements of $17.2 million for 2008 represent net cash received on credit default swaps.
A reconciliation of the statutory federal income tax rate to the effective tax rate reported on (loss) income from operations before income taxes is shown in the following table:
The Company has tax credit carryforwards of approximately $64.9 million, primarily related to the payment of alternative minimum tax and foreign taxes.
Income Taxes-As of December 31, 2008, no tax issues from the recently closed IRS audit would, in the opinion of management, give rise to a material assessment or have a material effect on the consolidated financial condition, results of operations or cash flows of the Company.
Funding Obligations-The Company has invested in certain limited partnerships with ownership interests greater than 3% but less than 50%. As of December 31, 2008, the Company had committed to fund, if called upon to do so, $3.0 million of additional equity in certain limited partnership investments. In addition, the Company is under no obligation to fund FGIC or RAM Re, two unconsolidated equity investees.
and, to the extent AG Re’s obligations are less than $22.9 million, the remaining funds will be returned to the Company. The $22.9 million deposit is included in cash and cash equivalents on the Company’s consolidated balance sheet at December 31, 2008.
Dividends-PMI’s ability to pay dividends to The PMI Group is affected by state insurance laws, credit agreements, rating agencies, and the discretion of insurance regulatory authorities. The laws of Arizona, PMI’s state of domicile for insurance regulatory purposes, provide that PMI may pay dividends out of any available surplus account, without prior approval of the Director of the Arizona Department of Insurance (“Arizona Director”), during any 12-month period in an amount not to exceed the lesser of 10% of policyholders’ surplus as of the preceding year end or the prior calendar year’s net investment income. A dividend that exceeds the foregoing threshold is deemed an “extraordinary dividend” and requires the prior approval of the Arizona Director. In 2006 and 2007, the Arizona Director approved two extraordinary dividend requests totaling $450 million. PMI paid $265 million of the $450 million of approved extraordinary dividends to The PMI Group in 2006 and 2007. We do not anticipate that PMI will pay any dividends to The PMI Group in 2009 and 2010. Any payment of the remaining $185 million of approved dividends by PMI to The PMI Group requires prior written notice to the Director of the Arizona Department of Insurance, who could withdraw approval of such dividends.
Preferred Stock-The PMI Group’s certificate of incorporation authorizes the Board of Directors to issue up to 5,000,000 shares of preferred stock of The PMI Group in classes or series and to set the designations, preferences, qualifications, limitations or restrictions of any class or series with respect to the rate and nature of dividends, the price and terms and conditions on which shares may be redeemed, the amount payable in the event of voluntary or involuntary liquidation, the terms and conditions for conversion or exchange into any other class
or series of the shares, voting rights, and other terms. The Company may issue, without the approval of the holders of common shares, preferred stock that has voting, dividend or liquidation rights superior to the common stock, which may adversely affect the rights of holders of common stock.
On May 17, 2007, The PMI Group’s Board of Directors approved an amendment to the Retirement Plan. The amendment changed the Plan’s benefit formula from a “final pay” pension formula to a cash balance formula. The amendment took effect immediately for employees hired or rehired on or after September 1, 2007. For employees hired before and continuously employed on September 1, 2007, the amendment will take effect on January 1, 2011. Under the new cash balance plan formula, the Company will contribute 8% of qualified employees’ compensation to cash balance accounts and credit interest at a rate equal to the 30-year Treasury Bond rate.
The Company provides certain health care and life insurance benefits for retired employees under another post-employment benefit 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 contributes a fixed dollar subsidy towards the cost of coverage. Retirees are expected to pay all amounts in excess of the Company’s fixed dollar subsidy.
The 2008 contribution is reflected net of the $24 million refund that was nondeductible for tax purposes.
Prior to the plan amendment in May 2007, the discount rate used to determine the net periodic cost was 5.95%.
Savings and Profit Sharing Plans-All U.S. full-time, part-time and certain temporary employees of the Company are eligible to participate in The PMI Group, Inc. Savings and Profit-Sharing Plan (“401(k) Plan”). Eligible employees who participate in the 401(k) Plan may receive, within certain limits, matching Company contributions. The Company contributions recognized as expense were $0.9 million for 2008, $2.1 million for 2007 and $3.3 million for 2006. Contract underwriters are covered under The PMI Group, Inc. Alternate 401(k)
SFAS No. 123R requires cash flows resulting from gross excess tax benefits to be classified as a part of cash flows from financing activities. Excess tax benefits are realized tax benefits from tax deductions for exercised
options in excess of the deferred tax asset attributable to share compensation costs for such options. Cash received from option exercises and the ESPP for the years ended December 31, 2008, 2007 and 2006, was $1.6 million, $27.3 million and $41.6 million, respectively. The actual tax benefit realized for the tax deductions from option exercise of the share-based payment arrangements totaled $0.0 million, $7.0 million and $6.2 million, respectively.
The weighted-average remaining contractual life of restricted stock units outstanding as of December 31, 2008 and vested and exercisable as of December 31, 2008 was 2.4 years, respectively. The aggregate intrinsic value for the restricted stock units outstanding as of December 31, 2008 was $2.1 million.
The following is a summary as of December 31, 2007 of the assets and liabilities of PMI Australia held for sale and included under the captions “Assets - discontinued operations” and “Liabilities - discontinued operations” on the Company’s consolidated balance sheet:
The following is a summary as of December 31, 2007 of the assets and liabilities of PMI Asia held for sale and included under the captions “Assets - discontinued operations” and “Liabilities - discontinued operations” on the Company’s consolidated balance sheet:
PMI has a capital support agreement with PMI Europe, with a corresponding guarantee from The PMI Group, under which PMI may be required to make additional capital contributions from time-to-time as necessary to maintain PMI Europe’s minimum capital requirements. PMI also has a capital support agreement, whereby it agreed to contribute funds, under specified conditions, to maintain CMG MI’s risk-to-capital ratio at or below 19.0 to 1. PMI’s obligation under the CMG MI capital support agreement is limited to an aggregate of $37.7 million. As of December 31, 2008, CMG MI’s risk-to-capital ratio was 16.2 to 1.
PMI also has a capital support agreement with PMI Canada. Because the Company terminated its Canadian operations in PMI Canada, we believe it is unlikely that there is any remaining material support obligation under the PMI Canada capital support agreement.
On October 27, 1994, Allstate Support Agreements were terminated with respect to policies issued after October 27, 1994, but continue in modified form (as so modified, the “Runoff Support Agreement”) for policies written prior to such termination. Under the terms of the Runoff Support Agreement, Allstate may, at its option, either directly pay or cause to be paid, claims relating to policies written during the terms of the respective Allstate Support Agreements if PMI fails to pay such claims or, in lieu thereof, make contributions directly to PMI or The PMI Group. In the event any amounts are paid or contributed, the likelihood of which management believes is remote, Allstate would receive subordinated debt or preferred stock of PMI or The PMI Group in return. No payment obligations have arisen under the Runoff Support Agreement. As of December 31, 2008, less than $235 million of risk in force was subject to the Runoff Support Agreement.
Revenues from continuing operations include interest income on a surplus note with PMI Guaranty which is classified as discontinued operations.
The changes in unrealized gains/losses in 2008 were primarily due to widening market spreads principally in the U.S. The changes in foreign currency translation adjustments for 2008 were due primarily to the recognition of approximately $124.4 million of accumulated currency translation gains in connection with the sale of PMI Australia and PMI Asia.
The expenses in the U.S. Mortgage Insurance Operations segment are primarily payroll and related expenses from a reduction in force due to both involuntary terminations and the Voluntary Early Retirement Program (the “Program”) in the fourth quarter of 2008. 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.
PMI Europe is required to post collateral for the benefit of the counterparty under the terms of certain credit default swap and reinsurance transactions it has concluded. As of March 15, 2009, PMI Europe posted collateral of $64.2 million on credit default swap transactions and $53.7 million related to U.S. sub-prime related reinsurance transactions.