We currently own approximately 140,000 square feet of office space in Walnut Creek, California for our home office. PMI leases offices throughout the United States. We conduct our international operations in leased facilities in Ireland, the United Kingdom, Italy, Belgium, Australia, New Zealand and Hong Kong.
We are an international provider of credit enhancement as well as other products that promote homeownership and facilitate mortgage transactions in the capital markets. We divide 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. Net income from U.S. Mortgage Insurance Operations was $275.4 million in 2005 and $254.5 million in 2004, and includes PMI Mortgage Insurance Co. and its affiliated U.S. mortgage insurance and reinsurance companies (collectively, “PMI”), and equity in earnings from PMI’s joint venture, CMG Mortgage Insurance Company and its affiliated companies (collectively, “CMG”).
International Operations. We offer mortgage insurance and other credit enhancement products in Australia, New Zealand, Europe, and Hong Kong. Net income from our International Operations segment was $105.5 million in 2005 and $99.9 million in 2004.
Approximately 16% of our consolidated total revenues in 2005 consisted of interest and dividend income associated with our $3.2 billion consolidated investment portfolio. Accordingly, the performance of corporate and municipal bond and securities markets in the U.S., Australia and Europe can significantly affect our consolidated financial results. Our primary goal in managing our investment portfolios is to achieve a predictable level of income while maintaining adequate levels of liquidity and the preservation of capital. Growth of the portfolio and minimizing the realization of taxable gains are secondary considerations. A substantial portion of our consolidated investment portfolio consists of investment grade fixed income securities.
Losses and Claims. PMI’s claims paid including LAE increased by 12.5% in 2005 compared to 2004 primarily as a result of the aging of PMI’s insurance portfolio, an increased number of claims paid in 2005 that were previously delayed by bankruptcy protection, and, to a lesser extent, higher claim rates associated with the portion of PMI’s portfolio that contains less-than-A quality (loans with credit scores less than 620) and Alt-A loans. Net loss reserves increased by $7.0 million in 2005 primarily due to increases in PMI’s expected claim rates as a result of changes in the business mix of PMI’s portfolio, and increases in the number of loans in PMI’s default inventory. The increase in PMI’s default inventory in 2005 was primarily due to the effects of the 2005 hurricanes.
Captive Reinsurance. 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, PMI cedes a proportionate amount of its gross premiums written to these captive reinsurance companies. At December 31, 2005, 53.4% of PMI’s primary insurance in force was subject to captive reinsurance agreements, compared to 52.0% at December 31, 2004. This increase was due to refinance activity resulting in heavy cancellations of policies not subject to captive reinsurance and a higher percentage of NIW from PMI’s flow channel being generated by customers with captive reinsurance agreements. We expect that the percentage of PMI’s primary flow insurance in force, primary flow risk in force and primary flow NIW subject to captive reinsurance will continue to increase. NIW generated through PMI’s structured channel are generally not subject to captive reinsurance agreements.
PMI Australia. While PMI Australia’s insurance in force increased 5.5% from December 31, 2004 to December 31, 2005, PMI Australia’s NIW decreased by 15.3% in 2005 compared to 2004. This NIW decrease in 2005 was primarily due to slowing Australian mortgage origination and residential mortgage backed securities markets, increasingly competitive pricing and the restructuring of a major captive reinsurance arrangement causing the customer’s affiliated captive reinsurer to retain higher levels of mortgage default risk. The restructuring of this captive reinsurance arrangement will negatively impact PMI Australia’s premiums written in 2006. PMI Australia’s primary regulator, the Australian Prudential Regulation Authority, issued mortgage insurer capital requirements in 2006 and intends to implement Basel II capital requirements for financial institutions effective January 1, 2008. These requirements, as well as other regulatory proposals, have had and/or will have an impact on both the mortgage insurance industry and the market for mortgage insurance in Australia.
FGIC. The significant portion of our 2005 net income derived from our Financial Guaranty segment was generated by equity in earnings from FGIC. Equity in earnings from FGIC was $74.9 million for 2005 compared to $61.6 million for 2004. This increase was primarily due to increases in premiums, reflecting growth in scheduled premiums earned and increased refundings as well as higher investment income due to growth in FGIC’s investment portfolio. These increases were partially offset by a $20.8 million increase in reserves primarily related to insured obligations impacted by Hurricane Katrina. FGIC’s financial performance is also affected by, among other things, interest rate movements, which may generate refundings, the volume of issuance in the public and structured finance markets and FGIC’s ability to penetrate these markets.
Other. Factors affecting the financial performance of our Other segment include:
Consolidated net income for 2005 increased by 2.5% over 2004 primarily due to higher premiums earned in U.S Mortgage Insurance Operations and PMI Australia in 2005 and increases in our equity in earnings from FGIC in 2005. The increase in net income in 2005 was partially offset by higher losses and LAE, primarily from U.S. Mortgage Insurance Operations in 2005, and a reduction in other income from our Other segment in 2005. Consolidated net income in 2004 included a $29.0 million after tax realized gain on the sale of our former title insurance company, APTIC, partially offset by a $20.4 million (pre-tax) realized capital loss on our former equity investment in SPS. Consolidated net income for 2004 increased compared to 2003 primarily due to increases in 2004 in premiums earned in U.S. Mortgage Insurance Operations and International Operations,
equity in earnings from FGIC, and the gain on the sale of APTIC. These increases in 2004 and the realized gain on sale were partially offset by higher losses and LAE and other underwriting and operating expenses in 2004, primarily from U.S. Mortgage Insurance Operations, and the realized capital loss on our equity investment in SPS in 2004.
The increases in consolidated premiums earned in 2005 over 2004, and 2004 over 2003, were due to increases in premiums earned by U.S. Mortgage Insurance Operations and International Operations. U.S. Mortgage Insurance Operations’ premiums earned increased primarily as a result of higher average premium rates and the recognition of premiums associated with loan cancellations under non-refundable, single and annual premium policies. PMI Australia’s premiums earned increased as a result of growth in its business and the continued weakening of the U.S. dollar relative to the Australian dollar. In 2004, PMI Europe’s premiums earned increased by approximately $7 million compared to 2003 primarily as a result of its acquisition of the R&SA mortgage insurance portfolio in the fourth quarter of 2003.
In September 2005, we recognized a $2.1 million pre-tax realized capital loss on our equity investment in a private equity limited partnership investment that met the criteria for other-than-temporary impairment. In September 2003, we sold our ownership interests in Truman Capital Founders, LLC and Truman Capital Advisors, LLC, collectively referred to as Truman, and incurred a $3.6 million capital loss which was included in net realized investment gains and losses.
The decreases in other income in 2005 compared to 2004, and 2004 compared to 2003, were largely attributable to lower fees generated by our contract underwriting operations. Contract underwriting fees decreased in 2004 and 2005 primarily due to declines in customer requests for our contract underwriting services and lower levels of mortgage refinance activity in 2005. The results of our contract underwriting operations are included in our Other segment.
Our income tax expense from continuing operations in 2005 increased by 17% compared to 2004 primarily as a result of an increase in pre-tax income from continuing operations, and an increase in the effective tax rate to 24.3% from 23.5%. The increase in our effective tax rate was due primarily to an increase in our U.S. Mortgage Insurance Operations’ net income, excluding net investment income and equity in earnings, which is taxed at an effective tax rate of 35.0%. The increase was also due to reduced proportionate contributions to our consolidated financial results of municipal bond interest income, which has a lower effective tax rate. The decrease in our income tax expense from continuing operations in 2004 compared to 2003 was primarily driven by the increased proportion of our consolidated net income from FGIC which has a lower tax rate and the reversal in 2004 of a previously established tax contingency related to a state tax legislation matter.
In October 2003, we entered into an agreement to sell our title insurance operations, APTIC, for $115 million in cash. In accordance with accounting guidance, the results of operations for APTIC were classified as discontinued operations beginning in the fourth quarter of 2003. In 2004, we recognized an after-tax realized gain of $29.0 million relating to the sale of APTIC on March 19, 2004. No results related to APTIC have been recorded in the consolidated statements of operations for the last three quarters of 2004.
PMI’s premiums earned increased in 2005 compared to 2004 due primarily to an increase in PMI’s average premium rate in 2005 and the release of unearned premiums to earned from the cancellation of annual and single premium policies. The increase in premiums earned in 2004 compared to 2003 was primarily due to an increase in PMI’s average premium rate in 2004 and the release of unearned premiums to earned premiums in 2004. The release of unearned premiums to earned was caused by reported loan cancellations relating to a non-refundable single premium policy executed in 2003.
Net investment income-Net investment income in 2005 was $104.3 million compared to $102.2 million in 2004. This increase was due to growth in PMI’s investment portfolio as a result of increased cash flows from operations, partially offset by a reduction in the portfolio’s average pre-tax book yield. The pre-tax book yield reduction reflects increased liquidity during 2005 in order to fund an extraordinary dividend from PMI to its parent, The PMI Group. Although our average pre-tax book yield declined during 2005, the pre-tax book yield of the investment portfolio was 5.21% as of December 31, 2005 compared to 5.14% as of December 31, 2004.
The increases in claims paid including LAE and the number of primary claims paid in 2005 compared to 2004 were due to a number of factors, including the seasoning of PMI’s primary insurance portfolio’s largest book years, an increased number of claims paid that were previously delayed by bankruptcy protection and higher claim rates associated with the portion of PMI’s portfolio that contains ARMs, high LTV, Alt-A, and less-than-A quality loans. (See Credit and portfolio characteristics, below.) Primary claims paid increased to $214.9 million in 2005 compared to $193.2 million in 2004 and $176.9 million in 2003. Pool insurance claims paid
The increases in the 2005 modified pool default rates shown above were primarily due to customer default reporting enhancements begun in the third quarter of 2005, and, to a lesser extent, to increases in modified pool loans in default due to the seasoning of the modified pool portfolio, partially offset by an increase in the number of modified pool policies in force. We do not believe the reporting enhancement will affect ultimate losses incurred related to our modified pool loans in default and, accordingly, the reporting enhancement did not affect our estimation of total losses and LAE. The increases in 2004 modified pool default rates were driven by the seasoning of the modified pool portfolio and decreases in the number of modified pool policies in force. PMI believes that its modified pool insurance products’ risk reduction features, including a stated stop loss limit, exposure limits on each individual loan in the pool, and in some cases, deductibles, reduce PMI’s potential for loss exposure on loans insured by those products. Total pool loans in default (which includes modified and other pool products described below) as of December 31, 2005, 2004 and 2003 were 20,379, 17,186 and 16,763, respectively. The increase in total pool loans in default was primarily a result of improved delinquency reporting enhancement mentioned above. The default rates for total pool loans at December 31, 2005, 2004 and 2003 were 6.84%, 5.50% and 4.36%, 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. The increase in other underwriting and operating expenses in 2005 compared to 2004 was due primarily to higher compensation, insurance and depreciation related expenses. The 2005 increase was partially offset by expenses incurred in 2004 related to 2003 compensation and $2.9 million of field restructuring expenses in 2004. The increase in expenses in 2004 compared to 2003 was due primarily to recognition of expenses previously deferred as acquisition costs, additional compensation expenses and expenses related to PMI’s field operations restructuring.
PMI’s loss ratio is the ratio of total losses and LAE to premiums earned. The increases in the loss ratio in 2005 and 2004 were primarily driven by increases in total losses and LAE. 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 2005 compared to 2004 was due to the increase in PMI’s net premiums written, primarily as a result of the two single premium structured transactions in 2005, a decline in the amortization of deferred policy acquisition costs, and higher average premium rates in 2005. The increase in PMI’s expense ratio in 2004 was attributable to a large single premium policy written in 2003, which reduced the 2003 expense ratio, and an increase in other underwriting and operating expenses in 2004. The combined ratio is the sum of the loss ratio and the expense ratio.
The decrease in PMI’s primary NIW in 2005 was driven by a decrease in the size of the flow private mortgage insurance market, partially offset by increased opportunities for structured transactions. We believe the size of the flow private mortgage insurance market was negatively impacted in 2003 through 2005 by lenders’ continued use of alternative mortgage products which do not require mortgage insurance and an increase in the level of loans originated and sold to non-agency investors as a percentage of the total origination market. PMI’s NIW has also been negatively affected by higher concentrations of loans in the market of a type or credit quality that PMI has traditionally not insured to a great extent.
The decrease in primary insurance in force in 2005 was due to continued high levels of policy cancellations and lower NIW. Primary risk in force at December 31, 2005 remained flat compared to December 31, 2004 due to a greater number of high LTV loans with deeper coverage and higher average loan balances in 2005 compared to 2004. Continued low mortgage interest rates and high levels of home price appreciation have driven high levels of policy cancellations and low persistency in 2005, 2004 and 2003. The primary persistency rate is based on 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. The increase in the persistency rate in 2004 was primarily the result of the stabilization of interest rates during 2004 and a corresponding decrease in refinancing activities.
The following table presents PMI’s ARMs (mortgage loans with interest rates that may adjust prior to their fifth anniversary) and high LTV loans (loans exceeding 97% LTV) as percentages of its flow channel and structured channel primary NIW for the years ended:
The following table presents PMI’s less-than-A quality loans, Alt-A loans, ARMs and high LTV loans as percentages of primary risk in force as of December 31 of the years presented:
As shown by the above tables, PMI’s 2005 NIW and primary risk in force at December 31, 2005 contained higher percentages of Alt-A loans, ARMs, and high LTV loans. PMI’s 2005 NIW and primary risk in force also contained higher percentages of interest only loans and payment option ARMs. We believe that these increases reflect the higher concentrations of these types of loans in the mortgage origination and private mortgage insurance markets. The higher concentration of high LTV loans is, to a lesser extent, also the result of the expansion of underwriting guidelines by lenders, the GSEs and PMI pursuant to market outreach efforts and changes in a number of state statutes and regulations to permit the issuance of mortgage insurance on such loans. We believe that these market trends may continue in 2006.
We expect higher default rates and claim payment rates for less-than-A quality loans, Alt-A loans, ARMs, high LTV loans, interest only loans, and payment option ARMs than our traditional primary portfolio and incorporate these assumptions into our underwriting approach, portfolio limits, pricing and loss and claim estimates. In 2005, PMI’s average premium rate generally increased principally as a result of PMI’s primary portfolio consisting of higher percentages of these types of loans. PMI also insures less-than-A quality loans, Alt-A loans, ARMs, interest only loans, payment option ARMs, and high LTV loans through its modified pool products. We believe that the structure of PMI’s modified pool products mitigates the risk of loss to PMI from the loans insured by those products.
International Operations’ net income increased in 2005 compared to 2004 due to increases in PMI Australia’s premiums earned and net investment income and the currency exchange rate appreciation in the Australian dollar versus the U.S. dollar, offset by a decline in PMI Europe’s net income. The increase in net income in 2004 compared to 2003 was primarily due to increases in PMI Australia’s and PMI Europe’s premiums earned and favorable currency exchange rate appreciation in both the Australian dollar and Euro versus the U.S. dollar.
The change in the average foreign currency exchange rates from December 31, 2004 to December 31, 2005 favorably impacted our International Operations’ net income by $2.9 million, as a result of the appreciation of the Australian dollar. This foreign currency translation impact is calculated using the year over year change in the average monthly exchange rate to the current year ending net income in the local currency. The change in the average foreign currency exchange rates from December 31, 2003 to December 31, 2004 favorably impacted our International Operations’ net income by $10.2 million, primarily due to the appreciation of the Australian dollar.
The increase in PMI Australia’s net income in 2005 compared to 2004 was due primarily to increased premiums earned, increased investment income and the strengthening of the Australian dollar, offset by increased underwriting and operating expenses. The increase in PMI Australia’s net income in 2004 compared to 2003 was also attributable to increased premiums earned, higher investment income and the favorable currency exchange rate appreciation in the Australian dollar versus the U.S. dollar, offset by increased underwriting and operating expenses and a reserve reduction in 2003. The average annual AUD/USD currency exchange rate was 0.7621 in 2005 compared to 0.7370 in 2004 and 0.6529 in 2003. The change in the average AUD/USD currency exchange rates from 2004 to 2005, and 2003 to 2004, favorably impacted PMI Australia’s net income by $2.8 million in 2005 and $8.7 million in 2004. Net income from PMI Australia in 2005 and 2004 includes pre-tax foreign currency put option costs of $1.6 million and $1.5 million, respectively.
Premiums written and earned-The increase in PMI Australia’s net premiums earned in 2005 compared to 2004 was due to increased insurance in force and the continued strengthening of the Australian dollar relative to the US dollar. The increases in PMI Australia’s net premiums earned and written in 2004 compared to 2003 were due to increased NIW primarily attributable to the strong mortgage origination market in 2004 and a reduction in the number of market participants underwriting mortgage insurance in 2004.
Net investment income-The increase in net investment income in 2005 compared to 2004 was due primarily to the growth of PMI Australia’s investment portfolio. PMI Australia’s investment portfolio, including cash and cash equivalents, was $877.2 million at December 31, 2005 compared to $801.5 million at December 31, 2004 and $642.1 million at December 31, 2003. This growth was driven by positive cash flows from operations. The pre-tax book yield was 5.87% at December 31, 2005 and 2004 and 5.21% at December 31, 2003. The increase in the pre-tax book yield in 2004 was primarily due to the higher interest rate environment. The increase in net investment income in 2004 compared to 2003 was attributable to the growth of the investment portfolio and the higher pre-tax book yield.
Losses and LAE-The increase in losses and LAE in 2005 compared to 2004 was attributable to increased claims paid during 2005 slightly offset by a $1.1 million reserve reduction in the third quarter of 2005. The increase in losses and LAE in 2004 compared to 2003 was largely due to an $8.0 million reduction in loss
reserves in 2003 resulting from our 2003 review of PMI Australia’s loss provisioning. See Critical Accounting Policies and Estimates below. PMI Australia’s default rate at December 31, 2005 was 0.13%, 0.08% at December 31, 2004, and 0.12% at December 31, 2003.
Premiums earned-The decrease in premiums earned in 2005 compared to 2004 was due primarily to the expected decline in premiums earned associated with the U.K. lenders’ mortgage insurance portfolio acquired by PMI Europe in 2003. The increase in premiums earned in 2004 compared to 2003 was due primarily to an increase in premiums earned associated with this portfolio. We recognize premiums associated with this acquired portfolio in accordance with established earnings patterns that are based upon management’s estimation of the expiration of the portfolio’s risk. As this portfolio continues to age, we expect premiums earned and risk in force associated with the portfolio to continue to decline.
Other income-PMI Europe is currently a party to five transactions that are classified as derivatives. PMI Europe’s other income decreased in 2005 compared to 2004 as a result of the reduction in gains related to the change in the derivatives’ fair value to $0.8 million in 2005 from $5.6 million in 2004. As of December 31, 2005 and 2004, $6.8 million and $6.6 million, respectively, of deferred gains related to the initial fair value of these transactions were included in other liabilities. For the years ended December 31, 2005 and 2004, $1.6 million and
$1.3 million, respectively, of accretion from deferred gains were included in other income. While changes in the fair value of PMI Europe’s derivatives may occur as a result of a number of factors, the primary drivers are actual and projected claim payments.
Losses and LAE-PMI Europe’s losses and LAE performance continued to be favorable in 2005 and decreased from 2004. This reduction was offset by increases in a profit sharing obligation, discussed below. PMI Europe increased its loss reserves by $0.9 million and $1.0 million as of December 31, 2005 and 2004, respectively, primarily as a result of additional reserves posted for non-derivative accounted credit default swap transactions. (See Critical Accounting Policies and Estimates, below.) Claims paid, including claim payments from credit default swaps accounted for as derivatives, totaled $2.8 million in 2005, $1.0 million in 2004, and $0.8 million in 2003.
Risk in force-As of December 31, 2005, PMI Europe had assumed $2.0 billion of risk on $25.3 billion of mortgages on properties in the United Kingdom, and $0.8 billion of risk on $13.1 billion of mortgages on properties in Germany, Italy, the United States and the Netherlands. As of December 31, 2005, $1.7 billion of PMI Europe’s $2.8 billion of assumed risk was first loss default.
We completed our acquisition of an approximate 42% common equity ownership interest in FGIC on December 18, 2003. Accordingly, our consolidated results of operations do not reflect any results of FGIC prior to December 18, 2003. Our equity in earnings from FGIC for the period December 18 through December 31, 2003 was $2.4 million (pre-tax), excluding an extraordinary gain of $5.4 million after tax related to our share of negative goodwill written off by FGIC in connection with the purchase accounting adjustments. FGIC’s financial results for the years ended December 31, 2003, 2004 and 2005 are discussed below.
Premiums written and earned-Net premiums written and earned increased in 2005 and 2004 primarily due to growth in FGIC’s U.S. Public Finance and U.S. Structured Finance transactions and, to a lesser extent, International Finance transactions in those years. Additionally, FGIC recorded earned premiums from refundings of $54.8 million in 2005, compared to $42.7 million in 2004 and $44.9 million in 2003. The increase in earned premiums in 2005 and 2004 compared to 2003 was also partially due to a purchase accounting adjustment of unearned premiums as of December 18, 2003 to reflect the fair value of the unearned premium reserve at
acquisition. When an obligation insured by FGIC has been refunded prior to the end of the expected policy coverage period, any remaining unearned premium is recognized at that time. A refunding occurs when an insured obligation is repaid or legally defeased prior to the stated maturity.
Net investment income-Net investment income increased to $118.8 million in 2005 from $98.0 million in 2004 and $116.9 million in 2003 primarily due to the growth of the investment portfolio. The decrease in net investment income in 2004 was primarily due to purchase accounting adjustments, which increased the investment portfolio to fair value as of the acquisition date. This adjustment to FGIC’s investment portfolio resulted in a reduction of FGIC’s book yield to reflect current market rates as of the acquisition date. The decrease in net investment income in 2004 was also due to lower average invested assets as a result of a $284.3 million dividend paid by FGIC to GE Capital in 2003. There was also a significant reduction in net realized gains in 2004 versus 2003. FGIC’s investment portfolio is comprised primarily of U.S. municipal bonds with an average rating of double-A. The book yield of FGIC’s investment portfolio was 3.8% as of December 31, 2005 and 3.5% as of December 31, 2004.
Underwriting expenses-Underwriting expenses increased in 2005 and 2004 compared to 2003 primarily due to increases in headcount, partially offset by ceding commissions.
Deferred policy acquisition costs-The deferred policy acquisition cost (“DAC”) asset was $63.3 million at December 31, 2005 compared to $33.8 million at December 31, 2004. As a result of purchase accounting, the DAC asset prior to the December 2003 acquisition was written off. Therefore, the net increase resulted from new business. The amortization of deferred policy acquisition costs increased in 2005 to $8.3 million from $2.0 million in 2004 due to an increase in the DAC asset since the acquisition. Amortization of deferred policy acquisition costs was lower in 2004 compared to 2003, when the pre-acquisition DAC balance was amortized.
Goodwill write-off-In 2003, FGIC recognized a $19.2 million impairment of its historical goodwill related to the goodwill established when FGIC was acquired by GE Capital. The impairment charge occurred prior to the acquisition date but was a direct result of GE Capital pursuing the sale of FGIC.
included in this segment in other income. The Other segment also includes the results from, and realized gain on sale of, the discontinued operations of APTIC. Our Other segment results are summarized as follows:
The change in our Other segment’s net loss in 2005 compared to 2004 was primarily due to the 2004 realized gain on our sale of APTIC, partially offset by the realized capital loss on SPS in 2004, and the reduced fee income from contract underwriting in 2005. The net loss of $15.8 million in 2004 compared to $35.1 million in 2003 was primarily due to the gain on our sale of APTIC and equity in earnings from SPS in 2004, offset by the realized capital loss on SPS in 2004, reductions in income from APTIC in 2004 and reduced fee income from contract underwriting in 2004.
Net investment income-The decrease in net investment income in 2005 compared to 2004 was due primarily to declining market yields on the investment portfolio and a decrease in the size of our investment portfolio due to repurchases of our common shares. The increase in net investment income in 2004 compared to 2003 was due primarily to higher investment portfolio balances at The PMI Group and higher book yields in 2004.
Equity in earnings (losses)-For 2004 and 2003, our Other segment’s equity in earnings from unconsolidated subsidiaries includes equity in earnings (losses) from SPS of $0.4 million and ($17.7) million, respectively, and equity earnings from investments in certain limited partnerships. As a result of the reclassification of our interest in SPS to held for sale as of December 31, 2004, we reclassified equity in (losses) earnings from SPS to other income for 2005. Accordingly, equity losses from unconsolidated subsidiaries for 2005 include only equity losses from our limited partnership investments. In September 2003, SPS recorded $55.0 million of charges in connection with the FTC and HUD settlement, settlement of certain putative class action litigation, and estimated costs relating to certain state regulatory actions. Our proportionate share of such aggregate expenses was $19.1 million pre-tax and $17.8 million after tax.
Net realized investment losses-Net realized investment losses increased in 2005 compared to 2004 due primarily to a $2.1 million pre-tax realized capital loss on our equity investment in a private equity limited partnership investment that met the criteria for other-than-temporary impairment. In September 2003, we sold our ownership interest in Truman Capital Founders, LLC and Truman Capital Advisors, LLC, collectively referred to as Truman, and incurred a $3.6 million capital loss which was included in net realized investment losses.
Other operating expenses-Other operating expenses, which were incurred by MSC and The PMI Group, decreased in 2005 compared to 2004 due primarily to reductions in contract underwriting expenses due to lower levels of contract underwriting, partially offset by an increase in contract underwriting remedies from $10.0 million in 2004 to $14.5 million in 2005. As a result of expected lump-sum distributions, primarily from our Supplemental Employee Retirement Plan, in amounts sufficient to trigger settlement accounting under Statement of Financial Accounting Standard (“SFAS”) No. 88, we expect to revalue our pension-related liabilities in the second quarter of 2006. In connection with this revaluation, we expect to incur an expense of approximately $6 million to $7 million pre-tax in that quarter.
The PMI Group Liquidity-The PMI Group’s liquidity is primarily dependent upon: (i) The PMI Group’s subsidiaries’ ability to pay dividends to The PMI Group; (ii) financing activities in the capital markets; and (iii) maturing or refunded investments and investment income from The PMI Group’s stand-alone investment portfolio. The PMI Group’s ability to access these sources depends on, among other things, the financial performance of The PMI Group’s subsidiaries, regulatory restrictions on the ability of The PMI Group’s insurance subsidiaries to pay dividends, The PMI Group’s and its subsidiaries’ ratings by the rating agencies, and restrictions and agreements to which The PMI Group or its subsidiaries are subject that restrict their ability to pay dividends, incur debt or issue equity securities.
The PMI Group’s available funds, consisting of cash and cash equivalents and investments, was $570.1 million at December 31, 2005, compared to $441.2 million at December 31, 2004. In 2005, we repurchased approximately $250 million of our common shares, completing the $100 million and $150 million common shares repurchase programs authorized in February 2005 and July 2005, respectively. In February 2006, our Board of Directors authorized an additional $150 million common shares repurchase program. It is our present intention to maintain a minimum of $100 million to $150 million of liquidity at our holding company in
connection with various rating agency considerations. We believe that we have sufficient liquidity to meet all of our short- and medium-term obligations, and that we maintain excess liquidity to support our operations as needed.
PMI’s ability to pay dividends is also subject to restriction under the terms of a runoff support agreement with Allstate. Under the Allstate agreement, PMI may not pay a dividend if, after the payment of that dividend, PMI’s risk-to-capital ratio would equal or exceed 23 to 1. As of December 31, 2005, PMI’s risk-to-capital ratio was 8.2 to 1 compared to 8.2 to 1 at December 31, 2004 and 9.1 to 1 at December 31, 2003.
In addition to its consolidated subsidiaries, The PMI Group may in the future derive funds from its unconsolidated equity investments, including its investment in FGIC Corporation, which is the parent corporation of Financial Guaranty Insurance Company. As described below, FGIC Corporation’s ability to pay dividends is subject to restrictions contained in applicable state insurance laws and regulations, FGIC’s
The stockholders agreement between The PMI Group and the other investors in FGIC also restricts the payment of dividends by FGIC. The stockholders agreement provides that FGIC will not declare or pay cash dividends to holders of its common stock prior to the earlier of the fifth anniversary of the closing of the investment and the completion of the first underwritten public offering of FGIC Corporation’s common stock, and, in any event, that such dividends will not be paid prior to the redemption of FGIC Corporation’s senior preferred stock and class B common stock. FGIC Corporation is further restricted in the payment of dividends by the terms of its 6% senior notes, due 2034.
Our consolidated contractual obligations include reserves for losses and LAE, long-term debt obligations, capital lease obligations, operating lease obligations, and purchase obligations. Cash payments related to our reserves for losses and LAE as of December 31, 2005 shown below are based upon management’s best estimate from historical experience as well as current economic conditions. These estimates could vary significantly based on, among other things, changes to claim rates and claim sizes. Most of our purchase obligations are capital expenditure commitments that will be used for technology improvements. Minimum rental payments under non-cancelable operating leases as well as the obligation recorded under capital leases are provided in the table below.
Includes $819.5 million of principal debt, $271.5 million of scheduled interest and $9.9 million of contract adjustment payments related to our equity units.
We have invested in certain limited partnerships with ownership interests greater than 3% but less than 50%. As of December 31, 2005, we had committed to fund, if called upon to do so, $6.1 million of additional equity in certain limited partnership investments. This commitment to fund is excluded from the above table. Capitalized costs associated with software developed for internal use were $24.9 million in 2005 and $29.5 million in 2004. We expect to continue to invest in internally and externally developed software.
realized capital loss of $3.6 million pre-tax. The $20.4 million pre-tax realized capital loss on equity investment held for sale (SPS) recognized in 2004 was separately classified in our consolidated statement of operations and was therefore not included in the above table.
The change in net unrealized gains and losses net of deferred taxes consists of:
The following table summarizes the estimated fair value of the consolidated investment portfolio as of December 31, 2005 and 2004. Amounts shown under “Other” include the investment portfolio of The PMI Group:
The following table summarizes the rating distributions of our consolidated investment portfolio as of December 31, 2005.
Our other comprehensive income consists of changes in unrealized net gains and losses on investments, less realized gains and losses in the current period earnings and currency translation gains and losses, net of deferred taxes.
As of December 31, 2005, our consolidated shareholders’ equity was $3.2 billion. The carrying value of our long-term debt outstanding issued by The PMI Group at December 31 was as follows:
The 3.00% Senior Notes described above relate to our issuance in November 2003 of 13.8 million 5.875% equity units with a stated value of $25 per unit. The units include the senior notes and purchase contracts to purchase, no later than November 15, 2006, up to 9,044,520 shares of PMI common stock for an aggregate purchase price of $345.0 million. The senior notes are scheduled to be remarketed in August 2006. Assuming that the remarketing is successful, a portion of the proceeds from the remarketing will be applied to satisfy the equity unit holders’ obligations under the purchase contracts to purchase up to 9,044,520 shares of common shares under the purchase contracts and we will receive approximately $345 million in the fourth quarter of 2006. If the senior notes are not successfully remarketed, the holders of the senior notes will have a right to put the senior notes to us on November 15, 2006, the purchase contract settlement date. Contract adjustment payments are made on the stated value of the equity units at a rate of 2.875% per annum. Additionally in November 2003, we issued 5,750,000 shares of our common shares for an aggregate purchase price of approximately $220 million.
Item 8. Financial Statements and Supplementary Data-Note 10. Long-Term Debt and Line of Credit). In the event we choose to redeem or are required to repurchase some or all of the debentures, it may be necessary for us to access the capital markets. Due to the common shares conversion feature of these debentures, they satisfy the criteria for contingently convertible debt, or CoCo’s, according to EITF Issue No. 04-08, The Effect of Contingently Convertible Instruments on Diluted Earnings per Share. The dilutive effect of CoCo’s is included in our consolidated dilutive earnings per share for all periods presented, which had no impact on our short- or long-term liquidity or capital resources.
Consolidated cash flows generated by operating activities, including premiums, investment income, underwriting and operating expenses and losses, was $385.8 million in 2005 compared to $390.5 million in 2004. Cash flows from operations declined slightly as the increase in claim payments and underwriting expense were principally offset by increases in premiums earned and in investment income in 2005 compared to 2004.
Consolidated cash flows used in financing activities, including purchases of common shares, proceeds from issuance of long-term debt and equity, repayment of long-term debt, and dividends paid to shareholders, was $237.9 million in 2005 compared to $79.4 million cash flows in 2004. The difference was due primarily to $250.0 million of repurchases of common shares in 2005 compared to $100 million in 2004.
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
As part of the sale of our interest in SPS on October 4, 2005, we and SPS’s other prior shareholders indemnified CSFB for certain liabilities relating to SPS’s operations, including litigation and regulatory actions. This indemnification obligation could potentially reduce the monthly proceeds that we expect to receive from CSFB in 2006 through 2008. The maximum indemnification obligation for SPS’s operations will not exceed approximately $34 million. Our portion of this obligation is 61.4% or $20.7 million. As of December 31, 2005, we have a $6.4 million liability related to this indemnification.
In connection with structured transactions in the U.S., Europe and Australia, we are often required to provide narrative and/or financial information relating to us and our subsidiaries to mortgage-backed securities issuers for inclusion in the relevant offering documents and the issuers’ ongoing SEC filings. In connection with the provision of such information, we or our subsidiaries may be required to indemnify the issuer of the mortgage-backed securities with respect to the information’s accuracy and completeness and its compliance with applicable U.S. securities laws and regulations.
In January 2006, the rating agencies withdrew the ratings of PMI Indemnity following the transfer of its portfolio and policyholders’ obligations to PMI Ltd.
Any significant decreases in our ratings may adversely affect the ratings of FGIC. FGIC’s ability to attract new business and to compete with other triple-A rated financial guarantors is largely dependent on its triple-A financial strength ratings. Also, the stockholders agreement entered into in connection with the acquisition of FGIC provides that The PMI Group will not acquire a majority of the voting stock of FGIC Corporation or cause its designees to constitute a majority of FGIC Corporation’s Board of Directors unless, at the time of such action, S&P, Fitch and Moody’s, as applicable, reaffirm FGIC’s then current financial strength rating and outlook and FGIC Corporation’s then current senior unsecured debt rating and outlook. The value of our investment in FGIC, and our ability to increase our ownership interest in FGIC in the future, to the extent opportunities arise to do so, depend in part on The PMI Group’s and PMI’s ratings and on the views of the rating agencies with respect to any
such transaction. Any decrease in our ratings could also negatively impact PMI Australia’s and PMI Europe’s ratings, which could place them at a competitive disadvantage.
Changes in loss reserves can materially affect our consolidated net income. The process of reserving losses involves significant management judgment and requires us to forecast the interest rate, employment and housing market environments, which are highly uncertain. In addition, different estimates could have been used in the current period, and changes in the accounting estimates are reasonably likely to occur from period to period based on the economic conditions. We review the judgments made in our prior period estimation process and adjust our current assumptions as appropriate. While our assumptions are based in part upon historical data, the loss provisioning process is complex and subjective and, therefore, the ultimate liability may vary significantly from our estimates.
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 payment, 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, including trends in housing prices, unemployment and interest rates. Our estimation process uses generally recognized actuarial projection methodologies. As part of our estimation process, we also evaluate various scenarios representing possible losses and LAE under different economic assumptions. We established PMI’s reserves at December 31, 2005 and 2004 at the approximate mid-point of the actuarial range based on, among other reasons, our evaluation of PMI’s number of delinquencies, average claim rate and average claim size.
The following table shows a breakdown of reserves for losses and LAE by loans in default, incurred but not reported or (“IBNR”), and the cost to settle claims, or LAE for the years ended:
of incurred but not reported loans in default as of December 31, 2005, the effect on pre-tax income would be approximately $2 million; and (iii) for every 5% change in our estimate of the future cost of claims settlement as of the December 31, 2005, the effect on pre-tax income would be approximately $1 million.
The reductions in losses and LAE incurred relating to prior years of $9.1 million, $5.2 million and $15.4 million in 2005, 2004 and 2003, respectively, were primarily due to favorable development of actual claim amounts and adjustments to ultimate claim rates due to the strong housing appreciation and overall economic conditions experienced in Australia over the last three years. PMI Europe contributed to the release in prior years reserves due to certain reductions in reserves related to the R&SA portfolio.
The following table provides the composition of our fixed income securities with an unrealized loss at December 31, 2005 in relation to the total of all our fixed income securities with an unrealized loss by contractual maturities.
During 2004, the SEC staff reviewed the accounting practices for loss reserves of publicly held financial guaranty industry companies and upon noting various differences in accounting practices requested the Financial Accounting Standards Board (“FASB”) staff to review and potentially clarify the applicable existing accounting guidance. As noted in the minutes of its June 8, 2005 meeting, the FASB agreed to consider whether additional accounting guidance is necessary for the financial guaranty industry as well as other insurance products with similar characteristics, such as mortgage guarantee contracts and credit insurance. Due to the FASB’s decision to include mortgage guarantee insurance within the scope of this project, PMI, CMG, FGIC and RAM Re, along with other companies in the mortgage insurance and financial guaranty industries, may be required to change certain aspects of their accounting for loss reserves, premium income and deferred acquisition costs. It is not possible to predict the impact, if any, its or the SEC’s review may have on our consolidated results of operations, financial condition or cash flows or those of our unconsolidated subsidiaries.
Consolidated Statements of Shareholders’ Equity for the years ended December 31, 2005, 2004 and 2003
Our management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. Our internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of our consolidated financial statements for external purposes in accordance with generally accepted accounting principles in the United States. Our internal control over financial reporting includes policies and procedures that:
Provide reasonable assurance that transactions are recorded as necessary to permit preparation of consolidated financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of our management and directors; and
Based on management’s assessment and those criteria, management has concluded that we maintained effective internal control over financial reporting as of December 31, 2005.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005, 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 8, 2006, expressed an unqualified opinion thereon.
In our opinion, management’s assessment that The PMI Group, Inc. maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, The PMI Group, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on the COSO criteria.
The Company has a 42.0% common 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 equity ownership interests in CMG Mortgage Insurance Company, CMG Mortgage Reinsurance Company and CMG Mortgage Assurance Company (collectively “CMG”), which conduct residential mortgage insurance business for credit unions; and in the holding companies RAM Holdings Ltd. and RAM Holdings II Ltd. and RAM Reinsurance Company, Ltd. (collectively “RAM Re”), a financial guaranty reinsurance company based in Bermuda. The Company also has ownership interests as a limited partner 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. As of December 31, 2003, the Company deconsolidated PMI Capital I upon adoption of Financial Accounting Standards Board (“FASB”) Interpretation (“FIN”) No. 46, Consolidation of Variable Interest Entities, which provides guidance on identifying and assessing interests in variable interest entities to determine if consolidation or deconsolidation of that entity is required. See Note 10. Long-Term Debt and Line of Credit for further discussion of the Issuer Trust.
On October 4, 2005, the Company sold to Credit Suisse First Boston (USA), Inc. (“CSFB”) its equity ownership interest in SPS Holding Corp. (“SPS”), whose subsidiary, Select Portfolio Servicing, Inc. (“Select Portfolio Servicing”), is a servicer of single-family residential mortgages. The Company received cash payments of $98.8 million for its holdings in SPS and expects to receive additional monthly cash payments through the first quarter of 2008 from a residual interest in mortgage servicing assets with an estimated fair value at closing of approximately $20.7 million. As of December 31, 2005, the carrying value of the residual interest was $16.4 million. The Company and SPS’s other former shareholders agreed to indemnify CSFB for certain liabilities relating to SPS’s operations. As of December 31, 2005, the Company recorded a liability of $6.4 million with respect to this indemnification. Simultaneously with the sale, the Company received repayment of the outstanding balance on its related party receivable from SPS in the amount of $5.1 million. See Note 5. Investments in Unconsolidated Subsidiaries for further details on the closing of the sale of SPS on October 4, 2005.
revenues and expenses during the reporting period. Actual results could differ from these estimates. In the opinion of management, all adjustments, consisting only of normal recurring adjustments, considered necessary for a fair presentation, have been included.
The Company has made significant investments in the equity securities of several privately-held companies, including FGIC. The business conducted by FGIC differs significantly from the Company’s core business of providing residential mortgage insurance. FGIC is subject to a number of significant risks that arise from the nature of its business. Accordingly, the Company is subject to the risks and uncertainties associated with that business. In addition, the Company has limited ability to control FGIC and, accordingly, may be unable to take actions unilaterally to avoid or mitigate those risks. A significant portion of the Company’s consolidated net income is derived from FGIC and its financial guaranty business. The financial guaranty business is subject to extensive regulation. Future legislative, regulatory, accounting or judicial changes may affect the financial guaranty industry or municipal or asset-backed obligations or markets. Any expansion by FGIC into other markets and other asset classes will entail risks and uncertainties associated with its ability to maintain a triple-A rating and to compete with other monoline financial guaranty insurance companies.
Investments in Unconsolidated Subsidiaries-Investments in the Company’s unconsolidated subsidiaries include both equity investees and unconsolidated majority-owned subsidiaries. Investments in equity investees with ownership interests of 20-50% are generally accounted for on the equity method of accounting, and investments of less than 20% ownership interest are generally accounted for on 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 Company reports the equity in earnings from FGIC and CMG on a current month basis, and RAM Re and the Company’s interest in limited partnerships on a one-quarter lag basis. Equity in earnings or losses of RAM Re and certain limited partnership investments are included in the Company’s consolidated financial results on a one quarter lag to facilitate timely reporting of financial results. Effective January 1, 2004, the Company recorded a reduction of $4.8 million, net of tax, to retained earnings due to a change in reporting of SPS from a one-month lag to a current month basis. This reduction represented the Company’s proportion of SPS’s results for the month of December 2003. 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.
As of December 31, 2004, the Company reclassified its equity investment in SPS to equity investment held for sale as a result of a Summary of Terms entered into with CSFB, whereby CSFB received an option to acquire 100% of the Company’s outstanding investment in SPS. The Company recorded an impairment of its equity investment in SPS of $20.4 million pre-tax as of December 31, 2004. The impairment was recorded as a realized capital loss on equity investment held for sale due to the Company’s decision to dispose of SPS. Equity in earnings or losses from SPS is included in equity in earnings from unconsolidated subsidiaries for 2004 and 2003. Due to the expected sale of SPS, beginning January 1, 2005, equity in losses from SPS of $1.7 million is included in other income. SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, (“SFAS No. 144”), does not allow discontinued operations treatment of an equity investment, and accordingly, the realized capital loss related to the SPS write-down is included in income from continuing operations.
Deferred Policy Acquisition Costs-The Company defers certain costs in its mortgage insurance operations relating to the acquisition of new insurance and amortizes these costs against related premium revenue in order to match costs and revenues. These costs are primarily associated with the acquisition, underwriting and processing of new business, including contract underwriting and sales related activities. To the extent the Company is compensated by customers for contract underwriting, those underwriting costs are not deferred. Costs related to the issuance of mortgage insurance are initially deferred and reported as deferred policy acquisition costs. SFAS No. 60, Accounting and Reporting by Insurance Enterprises, (“SFAS No. 60”), specifically excludes mortgage guaranty insurance from its guidance relating to the amortization of deferred policy acquisition costs. Consistent with industry accounting practice, amortization of these costs for each underwriting year book of business is charged against revenue in proportion to estimated gross profits. Estimated gross profits are composed of earned premiums, interest income, losses and loss adjustment expenses as well as the amortization of deferred policy acquisition costs. The rate of amortization is not adjusted for monthly and annual policy cancellations unless it is
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.
Under the provisions of Statement of Position (“SOP”) No. 98-1, Accounting for the Cost of Computer Software Developed or Obtained for Internal Use, the Company capitalizes costs incurred during the application development stage related to software developed for internal-use purposes and for which it has no substantive plan to market externally. Capitalized costs are amortized at such time as the software is ready for its intended use on a straight-line basis over the estimated useful life of the asset, which is generally three to seven years.
During 2003, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 149, Amendment of SFAS No. 133 on Derivative Instruments and Hedging Activities (“SFAS No. 149”). SFAS No. 149 requires certain credit default swaps similar to those entered into by PMI Europe after July 1, 2004 to be accounted for as derivatives and reported on the consolidated balance sheet at fair value, and subsequent changes in fair value are recorded in consolidated net income. In addition, as required by EITF Issue No. 02-3, Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities (“EITF No. 02-3”), for certain credit default swaps entered into by PMI Europe where the fair value cannot be determined by reference to quoted market prices, current market transactions for similar contracts, or based on a valuation technique incorporating observable market data or inputs, initial fair value related to the credit default swaps are deferred and recognized in consolidated net income in proportion to the expiration of the associated insured risk. Gains or losses are recognized in consolidated net income at inception for all other derivative contracts where the fair value can be readily determined from market sources.
Reserve for Losses and Loss Adjustment Expenses-The reserve for mortgage insurance losses and loss adjustment expenses (“LAE”) is 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. The Company’s U.S. mortgage insurance primary 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, however, 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, the Company does not consider a loan to be in default until it has been delinquent for two consecutive monthly payments. SFAS No. 60, Accounting and Reporting by Insurance Enterprises, specifically excludes mortgage guaranty insurance from its guidance relating to reserves for losses and LAE. Consistent with industry accounting practices, the Company considers its mortgage insurance policies as short-duration contracts and, accordingly, does not establish loss reserves for future claims on insured loans that are not currently in default. The Company establishes loss reserves on a case-by-case basis when insured loans are identified as currently in default using estimated claim rates and average claim amounts for each report year, net of salvage recoverable. The Company also establishes loss reserves for defaults that have been incurred but have not been reported to the Company prior to the close of an accounting period, using estimated claim rates and claim amounts applied to the estimated number of defaults not reported. The reserve levels as of the consolidated balance sheet date represent management’s best estimate of existing losses and LAE incurred. The estimates are continually reviewed and adjusted as necessary as experience develops or new information becomes known to the Company. Such adjustments, to the extent of increasing or decreasing loss reserves, are recognized in the current period’s consolidated results of operations.
Reinsurance-The Company uses reinsurance to reduce net risk in force, optimize capital allocation, and comply with a statutory provision adopted by several states that limits the maximum mortgage insurance coverage to 25% for any single risk. The Company’s reinsurance agreements typically provide for a recovery of a proportionate level of claim expenses from reinsurers, and a reinsurance recoverable is recorded as an asset for such recoveries. The Company remains liable to its policyholders if the reinsurers are unable to satisfy their obligations under the agreements as with all reinsurance contracts. Reinsurance recoverable on paid losses and loss estimates are based on the Company’s actuarial analysis of the applicable business. Amounts the Company will ultimately recover could differ materially from amounts recorded as reinsurance recoverable. Reinsurance transactions are recorded in accordance with the provisions of the reinsurance agreements and the accounting guidance provided in SFAS No. 113, Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts. Accordingly, management assesses, among other factors, risk transfer criteria for all reinsurance arrangements.
premiums. Premiums written on a monthly basis are earned as coverage is provided. Monthly premiums accounted for 71.5% of gross premiums written from the Company’s mortgage insurance operations in 2005 and 72.1% in 2004 and 61.7% in 2003. Premiums written on an annual basis are amortized on a monthly pro rata basis over the year of coverage. Primary mortgage insurance premiums written on policies covering more than one year are referred to as single premiums. A portion of the revenue from single premiums is recognized in premiums earned in the current period, and the remaining portion is deferred as unearned premiums and earned over the expected life of the policy, a range of seven to 15 years. If single premium policies related to insured loans are cancelled due to repayment by the borrower, and the premium is non-refundable, then the remaining unearned premium related to each cancelled policy is recognized as earned premiums upon notification of the cancellation. Unearned premiums represent the portion of premiums written that is applicable to the estimated unexpired risk of insured loans. Rates used to determine the earning of single premiums are estimates based on actuarial analysis of the expiration of risk. The earnings pattern calculation is an estimation process and, accordingly, the Company reviews its premium earnings pattern for each policy acquisition year (“Book Year”) annually and any adjustments to these estimates are reflected for each Book Year as appropriate.
Business Segments-The Company’s reportable operating segments are U.S. Mortgage Insurance Operations, International Operations, Financial Guaranty and Other. U.S. Mortgage Insurance Operations includes the results of operations of PMI Mortgage Insurance Co., affiliated U.S. reinsurance companies and the equity in earnings from CMG. International Operations include the results of operations of PMI Australia, PMI Europe and the results of operations of the Company’s Hong Kong branch operations. Financial Guaranty includes the equity in earnings from FGIC and RAM Re. The Company’s Other segment consists of our holding company and contract underwriting operations, a realized capital loss on equity investment held for sale, our equity in earnings or losses from SPS and limited partnerships, and the discontinued operations of the Company’s former title insurance subsidiary, APTIC.
Earnings Per Share-Basic earnings per share (“EPS”) excludes dilution and is based on consolidated net income available to common stockholders and the actual weighted-average of the common stock shares that are outstanding during the period. Diluted EPS is based on consolidated net income available to common stockholders adjusted for the effects of dilutive securities and the weighted-average of dilutive common stock shares outstanding during the period. The weighted-average dilutive common stock shares reflect the potential increase of common stock shares if outstanding securities were converted into common shares, or if contracts to issue common shares, including stock options issued by the Company that have a dilutive impact, were exercised. The mandatorily redeemable preferred capital securities and equity units outstanding have not been included in the calculation of diluted shares outstanding as they are anti-dilutive for the periods presented.
Stock-Based Compensation-The Company accounts for stock-based compensation to employees and directors using the intrinsic value method prescribed in APB Opinion No. 25, Accounting for Stock Issued to Employees, (“APB No. 25”), and its related interpretations. Under APB No. 25, compensation cost for stock-based awards is measured as the excess, if any, of the market price of the underlying stock on the grant date over the employees’ exercise price for the stock options. As all options have been granted with an exercise price equal to the fair value at the date of the grants, no compensation expense has been recognized for the Company’s stock option program. SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS No. 123”), requires the pro forma disclosure of net consolidated income and earnings per share using the fair value method, and provides that the employers may continue to account for the stock-based compensation under APB No. 25. SFAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure, amends SFAS No. 123 and requires prominent disclosures in both annual and interim consolidated financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results.
On May 19, 2005, the Company approved the acceleration of the vesting of certain unvested out-of-the-money stock options awarded under the Company’s Equity Incentive Plan to all officers and employees. The affected options were those unvested options outstanding with exercise prices greater than $37.00 per share, which was the closing price of the Company’s common stock on May 19, 2005. As a result of this acceleration, unvested options granted in 2005 and 2004 to acquire approximately 2.3 million shares of the Company’s common stock, which otherwise would have vested on an annual basis through March 14, 2008, became immediately vested. The accelerated stock options represented approximately 32% of the Company’s total outstanding stock options.
The purpose of the accelerated vesting was to enable the Company to reduce compensation expense associated with these options in future periods, beginning with the first quarter of 2006, in its consolidated financial statements as a result of the adoption of SFAS No. 123R and the SEC related requirements.
See Note 3. New Accounting Standards for further discussion of SFAS No. 123R and SFAS No. 123.
Income Taxes-The Company accounts for income taxes using the liability method in accordance with SFAS No. 109, Accounting for Income Taxes (“SFAS No. 109”). The liability method measures the expected future tax effects of temporary differences at the enacted tax rates applicable for the period in which the deferred asset or liability is expected to be realized or settled. Temporary differences are differences between the tax basis of an asset or liability and its reported amount in the consolidated financial statements that will result in future
increases or decreases in taxes owed on a cash basis compared to amounts already recognized as tax expense in the consolidated statements of operations. The Company’s effective tax rate was 24.3% for 2005 compared to the federal statutory rate of 35.0%. The difference in the tax rates was due primarily to equity in earnings from unconsolidated subsidiaries and income derived from PMI Australia, which have lower effective tax rates, combined with the Company’s municipal bond investment income.
Benefit Plans-The Company provides pension benefits to all employees under The PMI Group, Inc. Retirement Plan, and to certain employees of the Company under The PMI Group, Inc. Supplemental Employee Retirement Plan. In addition, the Company provides certain health care and life insurance benefits for retired employees under another post-employment benefit plan. 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. Contract underwriters are covered under The PMI Group, Inc. Alternate 401(k) Plan, under which there are no matching Company contributions. In addition to the 401(k) Plan, the Company has an officers’ deferred compensation plan (“ODCP”) available to certain employees, and an Employee Stock Purchase Plan (“ESPP”). The ODCP is available to certain of the Company’s officers, and permits each participant to elect to defer receipt of part or all of his or her eligible compensation on a pre-tax basis. Under the ODCP, the Company makes a matching contribution of its common shares for each participant equal to 25% of the initial contribution to the extent the participant elects to select the Company’s common shares from the investment choices available under the ODCP. These matching contributions are subject to a three year vesting period. The ESPP allows eligible employees to purchase shares of the Company’s stock at a 15% discount to fair market value as determined by the plan. The ESPP offers participants the 15% discount to current fair market value or fair market value with a look-back provision of the lesser of the duration an employee has participated in the ESPP or two years.
Foreign Currency Translation-The financial statements of our foreign subsidiaries have been translated into U.S. dollars in accordance with SFAS No. 52, Foreign Currency Translation. Assets and liabilities denominated in non-U.S. dollar functional currencies are translated using the year-end spot exchange rates. Revenues and expenses are translated at monthly-average exchange rates. The effects of translating operations with a functional currency other than the reporting currency are reported as a component of accumulated other comprehensive income included in consolidated shareholders’ equity. Gains and losses on foreign currency re-measurement incurred by PMI Australia and PMI Europe represent the revaluation of assets and liabilities denominated in non-functional currencies into the functional currency, the Australian dollar and Euro, respectively.
In December 2004, the FASB issued SFAS No. 123R which replaces SFAS No. 123 and supersedes APB No. 25. As a result of SFAS No. 123R and the SEC’s related requirements, the Company will be required to recognize the cost of certain stock options as compensation expense in the consolidated statements of operations beginning in the first quarter of 2006.
In relation to stock options and the ESPP common shares outstanding as of December 31, 2005, combined with stock options granted in February 2006, the estimated impact to consolidated net income of the Company from the adoption of SFAS No. 123R using the modified prospective method for the year ended December 31, 2006 ranges from approximately $8 million to $9 million, net of taxes. Had the Company adopted SFAS No. 123R in prior periods, the impact of the standard would have approximated the impact of SFAS No. 123 as described in the disclosure of pro forma consolidated net income and earnings per share. In addition, the estimated impact to consolidated net income for 2006 has been significantly reduced due to the acceleration of certain stock options previously discussed in Note 2. Summary of Significant Accounting Policies.
In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections (“SFAS No. 154”), which replaces APB No. 20, Accounting Changes, and SFAS No. 3, Reporting Accounting Changes in Interim Financial Statements. SFAS No. 154 applies to all voluntary changes in accounting principle and changes the accounting for and reporting of a change in accounting principle. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. As a result, the Company will implement the requirements of SFAS No. 154 after its effective date, as applicable.
Actual maturities may differ from those scheduled as a result of calls or prepayments by the issuers prior to maturity.
Unrealized Investment Gains and Losses-The change in unrealized gains and losses net of deferred taxes consists of the following:
Unrealized losses were primarily due to interest rate fluctuations during the year and are not considered to be other-than-temporarily impaired as the Company has the intent and ability to hold these investments until they recover in value or mature. The remaining unrealized losses do not meet the criteria established in the Company’s policy for determining other-than-temporary impairment and as such are not considered impaired. The Company determined that the decline in the market value of certain equity and fixed income securities in its investment portfolio met the definition of other-than-temporary impairment and recognized realized pre-tax losses of $0.6 million, $0.2 million, and $0.3 million in 2005, 2004 and 2003, respectively.
Investment Concentrations and Other Items-The Company maintains a diversified portfolio principally of U.S. municipal bonds. The following states and the District of Columbia represent the largest concentrations in the U.S. municipal bond portfolio, expressed as a percentage of the fair value of all U.S.
As of December 31, 2005, the Company’s investment in FGIC was $751.8 million, which included $617.0 million of cash and capitalized acquisition costs, with the balance representing undistributed equity in earnings and the Company’s proportionate share of net unrealized gains in FGIC’s investment portfolio.
Equity in earnings (losses) from unconsolidated subsidiaries and equity investment held for sale consisted of the following for the years ended December 31, 2005, 2004 and 2003:
Condensed financial statements of FGIC as of and for the periods presented were as follows:
In 2005, the Company recognized a $2.1 million pre-tax realized capital loss on a private equity limited partnership investment. The Company determined that this investment met the criteria for other-than-temporary impairment in accordance with APB No. 18.
In connection with the settlement reached between SPS and the Fair Trade Commission, (“FTC”) and the Department of Housing and Urban Development, (“HUD”), SPS recognized aggregate charges of approximately $55 million pre-tax in September 2003 related to the costs of settlement, settlement of certain putative class actions pending against SPS, and estimated costs relating to certain pending state regulatory actions. The Company’s proportionate share of such charges was $19.1 million pre-tax, which was recognized in equity in earnings from unconsolidated subsidiaries in September 2003.
The unaudited pro forma condensed combined statements of operations of the Company give effect to the investment in FGIC and the issuance of securities from common shares and equity units offerings on a pro forma basis. The unaudited pro forma condensed combined statements of operations for the year ended December 31, 2003 was prepared assuming the Company completed its acquisition of a 42.1% ownership interest in FGIC as of January 1, 2003.
The pro forma adjustments are based on estimates which are derived from available information and contain assumptions. The pro forma financial statements do not purport to represent what the consolidated results of operations actually would have been if these transactions had occurred on the dates indicated or what such results will be for any future date or future periods. The pro forma consolidated statements of operations are based on historical consolidated financial statements of The PMI Group and FGIC, primarily giving effect to the Company’s common shares and equity unit offerings, reduction of interest income due to investment and the Company’s 42.1% ownership share of FGIC’s historical income adjusted for the application of purchase accounting adjustments.
The Company establishes reserves for losses and LAE to recognize the estimated liability for potential losses and related loss adjustment expenses in connection with borrower default on their mortgage payments. The establishment of loss reserves is subject to inherent uncertainty and requires significant judgment by management. The following table provides a reconciliation of the beginning and ending reserves for losses and loss adjustment expenses for each of the three years:
Equity Units-In November 2003 and in connection with the Company’s investment in FGIC, the Company sold 13.8 million of 5.875% Equity Units and raised $345.0 million of gross proceeds. Each unit has a $25 principal amount with two components: a senior note component and a purchase contract component. The senior note has a 3.0% annual interest rate paid quarterly and maturing on November 15, 2008. The purchase contract component pays a 2.875% annual contract payment quarterly and obligates the holders to purchase $25 ($345 million in total) of newly issued shares of the Company’s common stock, no later than November 15, 2006. Further details are provided in Note 15. Dividends and Shareholders’ Equity. In addition, the senior notes have a remarketing feature and will be remarketed in or about August, 2006. The senior notes rank equally with all other senior unsecured debt securities of The PMI Group. If the senior notes are not successfully remarketed, the holders of the senior notes will have the right to put the senior notes to the Company on the purchase contract settlement date which is November 15, 2006.
Senior Convertible Debentures-In July 2001, the Company issued $360.0 million of 2.50% Senior Convertible Debentures (“the Debentures”) in a private offering to qualified institutional buyers, and subsequently filed a shelf registration statement for the resale of the Debentures and the common shares of The PMI Group issuable upon conversion of the Debentures. The Company used a portion of the net proceeds for the repayment or retirement of existing indebtedness and the remainder for general corporate purposes. The Debentures are due on July 15, 2021 and bear interest at a rate of 2.50% per annum, payable semiannually. The Debentures are convertible at the registered holders’ option, prior to stated maturity, into shares of the Company’s common stock at an initial conversion price of $44.16 per share if specified requirements are met, subject to adjustments in specified circumstances. The most significant requirement for such conversion is that the trading price of the Company’s common stock must exceed 120% of the initial conversion price for 20 consecutive trading days within a 30-day trading period. The Company may redeem some or all of the Debentures on or after July 15, 2006 for a price equal to the principal amount of the Debentures plus any accrued and unpaid interest. The holders may put the Debentures to the Company on July 15, 2006, 2008, 2011 and 2016. On July 15, 2004, certain debenture holders required us to repurchase a nominal amount of the debentures. Upon a change of control of the Company, holders may also require the Company, subject to certain conditions, to repurchase all or a portion of the Debentures. The Company may repurchase the Debentures with cash, common shares, or a combination of cash and shares of common stock. If the Company elects to pay all or a portion of the purchase price in common stock, the shares of common shares will be valued at 97.5% of the average sale price for twenty trading days ending on the third day prior to the repurchase date. The Debentures are senior unsecured debt securities and rank equally with all other senior unsecured debt of The PMI Group.
Upon the adoption of FIN No. 46 as of December 31, 2003, the Company deconsolidated the Issuer Trust subsidiary that issued $48.5 million of the Capital Securities. The underlying securities of $48.5 million issued by the Issuer Trust are backed by the Junior Subordinated Debentures issued by the Company to the Issuer Trust in the amount of $51.6 million. The Capital Securities are no longer recognized in the consolidated balance sheets. As the Junior Subordinated Debentures issued by the Company to the Issuer Trust were previously eliminated in consolidation, the amount of $51.6 million was not previously reflected in the Company’s consolidated financial statements. Upon deconsolidation of the Issuer Trust, the Junior Subordinated Debentures due to the Issuer Trust are no longer eliminated and have been classified as long-term debt.
The following table shows the effects of reinsurance on premiums written, premiums earned and losses and loss adjustment expenses of the Company’s operations for the years ended are as follows:
The majority of the Company’s existing reinsurance contracts are captive reinsurance agreements in U.S. Mortgage Insurance Operations. Under captive reinsurance agreements, a portion of the risk insured by PMI is reinsured with the mortgage originator or investor through a reinsurer that is affiliated with the mortgage originator or investor. Ceded premiums for U.S. captive reinsurance accounted for 89% of total ceded premiums written in 2005 compared to 87% in 2004 and 82% in 2003. Reinsurance recoverables on losses incurred were $2.5 million at December 31, 2005, $2.4 million at December 31, 2004 and $3.3 million at December 31, 2003.
The components of the income tax expense for 2005 included a foreign provision for current tax expense of $42.7 million and a deferred tax benefit of $1.4 million primarily related to PMI Australia and PMI Europe.
Income Taxes-In March 2005, the Internal Revenue Service commenced its regular audit examination of the Company’s taxable years 2001 to 2003. As of December 31, 2005, no tax issues have been presented, that 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.
Indemnification-As part of the sale of the Company’s interest in SPS on October 4, 2005, the Company and SPS’s other prior shareholders have indemnified CSFB for certain liabilities relating to SPS’s operations, including litigation and regulatory actions, and this indemnification obligation may potentially reduce the monthly proceeds that the Company receives post sale. The maximum indemnification obligation for SPS’s operations is $33.7 million. The Company’s portion of this obligation is 61.4% or $20.7 million. As of December 31, 2005, the Company had recorded a liability of $6.4 million with respect to this indemnification.
In August 2005, the Company’s Board of Directors approved a $0.03 per share annual dividend increase to $0.21 per share annually beginning in the third quarter of 2005 and the establishment of a dividend reinvestment plan.
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.
Pursuant to the support agreement described in Note 21. Capital Support Agreements, the Company has agreed that, in the event that Allstate, the Company’s former parent, makes a payment contemplated by the Allstate Support Agreements or the runoff support agreement, Allstate will have the right to receive preferred stock of The PMI Group or PMI with a liquidation preference equal to the amount of such payment. Such preferred stock will rank senior in right of payment to the issuer’s common stock and, so long as such preferred stock is outstanding, the issuer thereof will be prohibited from paying any dividends or making any other distributions on its common stock.
Effective January 1, 2003, all full-time and part-time employees of the Company are eligible to participate in The PMI Group, Inc. Retirement Plan (the “Plan”), a noncontributory defined benefit plan. The Plan generally has been funded by the Company to the fullest extent permitted by federal income tax rules and regulations. In addition, certain employees whose annual earnings exceed $210,000 under Internal Revenue Code (“IRC”)
Section 401(a)(17) and limits established under IRC Section 415, participate in The PMI Group, Inc. Supplemental Employee Retirement Plan (“The SERP Plan”), a noncontributory defined benefit plan. Benefits under both pension plans are based upon the employees’ length of service, average annual compensation and estimated social security retirement benefits.
The primary objective of the Plan is to provide retirement income for Plan participants and their beneficiaries in accordance with the terms of the Plan. As such, the key objective in the Plan’s financial management is to promote stability and, to the extent appropriate, growth in funded status. A secondary financial objective is to reduce reliance on contributions as a source of benefit payments. As such, Plan assets are invested to maximize the Plan’s funded ratios over the long-term while managing the downside risk. The strategic asset allocation ranges represent a long-term perspective. Rapid unanticipated market shifts or changes in economic conditions may cause the asset mix to fall outside the policy range. These divergences should be of a relatively short-term nature, unless the circumstances warrant a longer term divergence from the permissible ranges. The Company evaluates and rebalances asset allocations as appropriate and reviews the Plan to make sure that the Plan remains properly funded to protect the benefit security of the participants. The Company makes contributions that are sufficient to fully fund its actuarially determined costs, generally exceeding the minimum amounts required by the Employee Retirement Income Security Act. The Company expects to contribute between $8 million and $12 million to the Plan in 2006.
Savings and Profit Sharing Plans-All U.S. full-time, part-time and certain temporary employees of the Company are eligible to participate in The PMI Group, Inc. Savings and Profit-Sharing Plan (“401(k) Plan”). Eligible employees who participate in the 401(k) Plan may receive, within certain limits, matching Company contributions. The Company contributions recognized as expense were $3.2 million for 2005, $2.4 million for 2004 and $3.1 million for 2003. Contract underwriters are covered under The PMI Group, Inc. Alternate 401(k) Plan, under which there are no matching Company contributions. In addition to the 401(k) Plan, the Company has an officers’ deferred compensation plan available to certain employees. The obligation related to the deferred compensation plan was $19.2 million and $14.0 million as of December 31, 2005 and 2004, respectively, and is included in other liabilities and accrued expenses.
Equity Incentive Plan-The PMI Group, Inc. Equity Incentive Plan provides for awards of both non-qualified stock options and incentive stock options, stock appreciation rights, restricted stock subject to forfeiture and restrictions on transfer, and performance awards entitling the recipient to receive cash or common shares in the future following the attainment of performance goals determined by the Board of Directors. As amended and restated in 2004 under the Equity Incentive Plan, non-employee directors receive quarterly, non-discretionary grants of stock units with an initial value of $21,250. The number of units granted depends on the fair market value of the Company’s common shares on the grant date but each stock unit has an initial value equal to the fair market value of one common share on the grant date. Non-employee director grants of stock units vest on the earlier of the fifth anniversary of the applicable grant date or upon termination of board service. Generally, options are granted with an exercise price equal to the market value on the date of grant, expire ten years from the grant date and have a three-year vesting period.
Under the insurance laws of the State of Arizona and several other states, mortgage insurers are required to establish a special contingency reserve included in total liabilities, with annual additions equal to 50% of premiums earned for that year. During 2005, PMI contributed $337.9 million to the reserve. This reserve is required to be maintained for a period of 120 months to protect against the effects of adverse economic cycles. After 120 months, the reserve is released to unassigned funds. During 2005, $150.1 million was released to unassigned funds. In the event an insurer’s loss ratio in any calendar year exceeds 35%, however, the insurer may withdraw from its contingency reserves an amount equal to the excess portion of such losses.
In 2001, PMI executed a capital support agreement whereby it agreed to contribute funds, under specified conditions, to maintain CMG’s risk-to-capital at or below 18.0 to 1. PMI’s obligation under the agreement is limited to an aggregate amount of $37.7 million, exclusive of capital contributions made prior to April 10, 2001.
As of December 31, 2005, the Company was in compliance with all covenants included in its capital support agreements.