Our principal executive offices are located at 101 South Stratford Road, Winston-Salem, NC 27104. This five-story office building totals 79,254 square feet and we currently lease approximately 61,324 square feet under a lease that will expire in November 2012. We currently occupy two entire floors and have additional space on two other floors. All staff functions are located within this office complex. During 2010, we negotiated with the lessor to terminate a portion of the original lease representing 7,608 square feet so that the lessor could enter into a new long-term lease with another tenant. We currently sublease space on two floors of this facility to Essent, totaling approximately 20,937 square feet, under a sublease that will expire concurrently with our existing lease in 2012. We have negotiated with both Essent and the lessor to allow Essent to take over as the primary tenant on a reduced amount of space at the end of the existing term and Triad will sublet from Essent a single floor and limited space on another floor. Under the terms of the two year sublease, Triad will sublease approximately 17,728 square feet from Essent. We believe this property is suitable and adequate for our present circumstances.
The following discussion is intended to provide information that the Company believes is relevant to an assessment and understanding of the Company’s consolidated financial position, results of operations and cash flows and should be read in conjunction with the Consolidated Financial Statements and Notes contained herein. The current depressed market conditions in residential housing markets coupled with elevated unemployment rates have subjected our business, financial condition and results of operations to substantial risks, many of which are summarized under Item 1A., “Risk Factors,” which should be read in conjunction with the following discussion.
TGIC is an Illinois-domiciled mortgage guaranty insurance company and TGAC is an Illinois-domiciled mortgage guaranty reinsurance company. The Illinois Department of Insurance (the “Insurance Department”) is the primary regulator of both TGIC and TGAC. The Illinois Insurance Code grants broad powers to the Insurance Department and its director (collectively, the “Department”) to enforce rules or exercise discretion over almost all significant aspects of our insurance business. We ceased issuing new commitments for mortgage guaranty insurance coverage in 2008 and are operating our business in run-off under two Corrective Orders issued by the Department. As noted above and throughout this report, the term "run-off" means continuing to service existing policies but writing no new mortgage guaranty insurance policies. Servicing existing policies during run-off includes:
working with borrowers in default to remedy the default and/or mitigate losses;
Our insurance remains effective until one of the following events occurs: the policy is cancelled at the insured’s request; we terminate the policy for non-payment of premium; the policy defaults and we satisfy our obligations under the insurance contract; or we rescind or deny coverage under the policy for violations of provisions of a master policy. Additionally, coverage may be cancelled on certain Modified Pool transactions if pre-determined aggregate stop loss limits are met, or if coverage is reduced to a de minimus amount of the initial amount insured or, for some contracts, ten years from the date of the contract.
Our results of operations in run-off could also be impacted significantly by Federal government and private initiatives to limit foreclosures through loan modifications. See the discussion below for further details on these initiatives. Lastly, our results of operations in run-off could be materially affected by our ability to recognize benefits from our NOL carryforwards.
As an insurance company, Triad is required to file financial statements prepared in accordance with SAP with the insurance departments of the states in which it conducts business. The financial statements for Triad that are provided to the Department and that form the basis for our corrective plan required by the Corrective Orders are prepared in accordance with SAP as set forth in the Illinois Insurance Code or prescribed by the Department. However, the Company prepares its financial statements presented in this annual report on Form 10-K and in our other SEC filings in conformity with GAAP. The primary difference between GAAP and SAP for Triad at December 31, 2011 was the reporting requirements relating to the establishment of the DPO stipulated in the second Corrective Order, which is described below.
A deficit in assets occurs when recorded liabilities exceed recorded assets in financial statements prepared under GAAP. A deficiency in policyholders’ surplus occurs when recorded liabilities exceed recorded assets in financial statements prepared under SAP. A deficit in assets at any particular point in time under GAAP is not necessarily a measure of insolvency. However, we believe that if Triad were to report a deficiency in policyholders’ surplus under SAP for an extended period of time, Illinois law may require the Department to seek receivership of Triad, which could compel TGI to institute a proceeding seeking relief from creditors under U.S. bankruptcy laws, or otherwise consider dissolution of the Company. The second Corrective Order was designed in part to help Triad maintain its policyholders’ surplus.
Triad has entered into two Corrective Orders with the Department. Among other things, the Corrective Orders:
Prohibit stockholder dividends from Triad to TGI without the prior approval of the Department;
Prohibit the accrual of interest and the payment of interest and principal on Triad’s surplus note to TGI without the prior approval of the Department;
Restrict Triad from making any payments or entering into any transaction that involves the transfer of assets to, or liabilities from, any affiliated parties without the prior approval of the Department;
Require that loss reserves in financial statements prepared in accordance with SAP be established to reflect the cash portion of the estimated claim settlement but not the DPO.
The second Corrective Order provides financial thresholds, specifically regarding our statutory risk-to-capital ratio and our level of statutory policyholders’ surplus that, if met, may indicate that the Department should reduce the DPO percentage and/or require distributions to DPO holders. In January 2012, the Department notified Triad that as of December 31, 2011, based upon Triad’s surplus position, risk-to-capital ratio and the continued economic uncertainty, the Department had determined that no change to the DPO percentage was in order nor would it be appropriate for Triad to make a distribution to the DPO holders.
Our financial statements have been prepared on a going concern basis under GAAP, which contemplates the realization of assets and the satisfaction of liabilities and commitments in the normal course of business. However, there is substantial doubt as to our ability to continue as a going concern. This uncertainty is based on, among other things, the possible failure of Triad to comply with the provisions of the Corrective Orders and our ability to generate enough income over the term of the remaining run-off to overcome a $703.6 million deficit in assets.
The positive impact on statutory surplus resulting from the second Corrective Order has resulted in Triad reporting a policyholders’ surplus in its SAP financial statements of $234.7 million at December 31, 2011, as opposed to a deficiency in policyholders’ surplus of $732.8 million on the same date had the second Corrective Order not been implemented. While the implementation of the second Corrective Order has deferred the institution of an involuntary receivership proceeding, no assurance can be given that the Department will not seek receivership of Triad in the future and there continues to be substantial doubt about our ability to continue as a going concern. The Department may seek receivership of Triad based on its determination that Triad will ultimately become insolvent, if Triad fails to comply with provisions of the Corrective Orders, or for other reasons. If the Department was to seek receivership of Triad, TGI could be compelled to institute a proceeding seeking relief from creditors under U.S. bankruptcy laws, or otherwise consider dissolution of the Company. The consolidated financial statements that are presented in this report do not include any accounting adjustments that reflect the financial risks of Triad entering receivership proceedings or otherwise not continuing as a going concern. See Item 1A, “Risk Factors” for more information about our financial solvency and going concern risks and uncertainties.
During the first quarter of 2010, we determined that our two largest captive reinsurers had not maintained the required capitalization in their trusts. As a result, and with the mutual agreement of each of the captive reinsurers, we commuted both of these captive reinsurance agreements during the first quarter and received approximately $188.7 million of aggregate trust assets from the two captive reinsurers. These commutations resulted in an increase in our invested assets and a corresponding decrease in reinsurance recoverable. The commutations had minimal impact on our results of operations or financial condition because the net amounts received were previously recorded as reinsurance recoverable on our balance sheet. The commutations and receipt of the trust assets, however, positively impacted our cash flows for the year ended December 31, 2010. Commutation activity for the year ended December 31, 2011 has not been material to the Company’s results of operations, financial condition, or cash flow.
Several programs have been initiated by the federal government, the GSEs, and certain lenders that are, in general, designed to prevent foreclosures and provide relief to homeowners. These programs may involve modifications to the original terms of existing mortgages or their complete refinancing. These programs seek to provide borrowers a more affordable mortgage by modifying the interest rate, extending the term of the mortgage, or, in limited cases, principal forgiveness. We are active participants in many of these programs including government-initiated programs such as the Home Affordable Modification Program (“HAMP”) and the Home Affordable Refinance Program (“HARP”).
If a loan is modified or refinanced as part of one of these programs, the previously reported default is cured, but we would maintain insurance on the loan and would be subject to the same ongoing risk if the policy were to re-default. Policies that re-default under these programs may ultimately result in losses that are greater than the loss that would have occurred if the policy was never modified. However, we do not provide loss reserves to account for the potential for re-default. These programs could adversely affect us to if borrowers who otherwise could make their mortgage payment choose to default in an attempt to become eligible for modification. For more information on the risks and uncertainties related to HAMP and other such programs, see Item 1A, “Risk Factors”.
HARP was developed in 2009 but revised in the third quarter of 2011. This program is designed to provide a borrower, who is current on all mortgage payments, the opportunity to take advantage of existing lower interest rates through a refinancing that would make the loan more affordable. The original HARP program limited eligible fixed-rate loans to those with a maximum current loan-to-value (“LTV”) ratio of 125%. The revised program has removed the LTV limitation for fixed-rate loans. The LTV limit for ARMs continues to be 105% of the current value. We do not expect the revised HARP program to have a significant impact on our results because: (i) these loans must not be in default to qualify; and (ii) we would continue to provide mortgage insurance on the refinanced loan.
The financial results for 2011 as compared to those of 2010 were affected by the following.
A decline in earned premium in 2011 primarily due to a 23% reduction in insurance in force. Actual and projected premium refunds related to rescissions reduced premium earned by $49.0 million, or 24%, in 2011 compared to $39.1 million, or 16%, in 2010.
An extraordinary gain on the repurchase and retirement of our long-term debt which contributed $29.6 million to 2010 results.
The decline in Primary insurance in force at December 31, 2011 from December 31, 2010 is due to the cancellation of insurance coverage on policies that were mainly either rescinded or had a claim for loss settled. The decline in Modified Pool insurance in force for the same period is also due to claim settlement and rescission activity, as well as the termination of a number of Modified Pool transactions where pre-determined aggregate stop loss limits in the contracts were met on a settled basis. Cancellation of insurance coverage resulting from refinance activity or actual non-forced sales continues to be minimal despite record low mortgage rates. Cancellation activity has benefited from the temporary delays in foreclosure as well as foreclosure prevention programs such as HAMP and HARP.
Primary insurance persistency increased slightly to 83.1% at December 31, 2011 compared to 82.4% at December 31, 2010. Modified Pool insurance persistency declined to 59.2% at December 31, 2011 compared to 66.0% at December 31, 2010, primarily due to the large number of terminated transactions due to reaching stop loss limits on a settled basis.
A portion of our Modified Pool contracts contain provisions that terminate both the coverage and the contract when cumulative settled losses reach the stop loss limit. No future premium is received following the termination of these Modified Pool contracts. Approximately $747.9 million of Modified Pool insurance in force under this type of contract was terminated in 2011 compared to $1.2 billion in 2010. At December 31, 2011, 9% of our Modified Pool insurance in force was subject to this type of contract.
Approximately 68% of our Modified Pool insurance in force at December 31, 2011 was originated from 2005 through 2007. Given the adverse development of our Modified Pool insurance originated in these years, the majority of these transactions have already reached the stop loss limit on an incurred basis and, as the following table indicates, we have limited loss exposure for future defaults, or changes in loss reserves on existing defaults, on Modified Pool policies originated during these years. The majority of our Modified Pool loss exposure is on policies originated prior to 2005. Given the performance to date for policies originated prior to 2005, the limited exposure for policies originated from 2005 through 2007, and our belief about the expected future performance, we expect losses from Modified Pool contracts to have significantly less bearing on our future results compared to our Primary business. The following table quantifies the remaining aggregate exposure for our Modified Pool business:
The following table shows risk in force and default statistics for our Primary business by policy year and breaks out the impact of the distressed markets at December 31, 2011 and December 31, 2010:
The number of loans in default includes all reported delinquencies that are in excess of two payments in arrears at the reporting date and all reported delinquencies that were previously in excess of two payments in arrears and have not been brought current.
Premium refunds, primarily related to rescission activity, include cash premium refunded as well as the change in the accrual for expected premium refunds. Cash premiums refunded is dependent on the number of policies rescinded and the amount previously collected while the accrual for expected premium refunds is dependent on our future expectations for these items. Cash refunds declined significantly during 2011 which is consistent with the decline in rescission activity. However, during 2011, the accrual we have established for expected premium refunds, which is reported in “Accrued expenses and other liabilities” on our Consolidated Balance Sheet, increased by 11% to $32.6 million at December 31, 2011 compared to a decline of 38% in 2010. The increase in the accrual in 2011 was the result of an agreement reached with a lender that confirmed Triad’s ability to rescind for certain program violations indefinitely, which impacted the population of potential rescindable defaults. The impact of premium refunds on our financial statements going forward will be determined primarily by our expectations for future cash premium refunds, which may alter our premium refund accrual. We expect actual rescissions and cash premium refunds to decline in 2012 compared to the volume we experienced in 2011.
Ceded premium written is comprised of premiums written under excess of loss reinsurance treaties with captive reinsurers. The decline in ceded premium in 2011 compared to 2010 reflects the commutation of a number of captive reinsurance agreements and the resulting decline in insurance in force subject to captive reinsurance.
Net investment income declined in 2011, primarily due to a decline in invested assets and a decline in the realized investment yield. Invested assets have been used as a source of cash to fund operating cash shortfalls. We expect invested assets to decline further in 2012 as we anticipate a continued deficit in operating cash flow. As a result of lower market yields, we sold securities with a market value of $233.4 million during 2011 and realized gains of $18.6 million. The majority of the discretionary sale activity occurred in the fourth quarter. These gains were offset somewhat by realized losses of $3.4 million that were primarily due to write-downs. The realized gains reported in 2010 were primarily due to a partial portfolio repositioning designed to extend the average life of our investment portfolio. For further discussion, see “Investment Portfolio.”
Net losses and LAE are comprised of settled claims, LAE and the change in the loss and LAE reserve during the period. The increase in net losses and LAE in 2011 compared to 2010 is primarily due to the positive impact during 2010 from the development of loss reserve carried at December 31, 2009. During 2010, actual rescissions and cures were higher than incorporated in our factors used to established reserves at December 31, 2009. The impact of the higher actual cures and rescissions, along with the changes in our reserve factors for expected future cure and rescission rates, significantly reduced our incurred losses in 2010. During 2011, however, both rescission activity and cure development were generally consistent with our expectations and the net effect of the change in reserve factors had only a minimal impact on the level of loss reserves at December 31 and losses incurred during 2011. The following table indicates the amount of incurred losses attributable to new defaults and the benefit received from favorable reserve development in 2011 and 2010.
Also contributing to the increase in net losses and LAE incurred in 2011 compared to 2010 was a moderation in the decline of Primary risk in default. Primary risk in default declined by 23% in 2011 and 31% in 2010. The following table presents a roll-forward of our Primary risk in default for 2011 and 2010. The vast majority of amounts included in “Rescinded/Denied risk in default” is comprised of risk on policies that were rescinded.
After increasing from prior year levels in 2010, the cure rate (cured risk in default as a percentage of beginning risk in default) for Primary risk in default declined to 29% in 2011 compared to 37% in 2010. In general, our expectation for a cure decreases significantly as the underlying mortgage becomes further delinquent. Given the delays in foreclosures and other factors slowing settled claim activity, the average age of our total default inventory has increased considerably over the past year which, all else being equal, is expected to produce a lower overall future cure rate. At December 31, 2011, 55% of Primary risk in default has missed more than 12 payments compared to 47% at December 31, 2010. The following table presents the distribution of primary risk in default by the number of payments for which the borrower is in default.
HAMP and other lender loan modification programs have contributed to cure activity, including cures on policies that have been in default for an extended period of time. However, the benefit we have received from these programs declined in 2011 from 2010. The Federal government announced changes to HAMP in January 2012 and has extended the program until 2013. We cannot estimate the impact these changes will have on our loss development in 2012. Individual lenders are still actively seeking loan modifications as an alternative to foreclosure outside of the HAMP guidelines and we continue to see the positive results of those efforts, although these cures are primarily coming from more recently reported defaults.
Rescission activity continues to mitigate our level of loss reserves and settled losses although the impact is down considerably compared to 2010. During 2011, we rescinded coverage on Primary policies with $321.0 million of risk in default compared to $597.3 million in 2010. While we expect rescission activity to continue to have a material impact on settled claim activity and our results of operations, we expect rescission activity to generally decline going forward. Rescission activity remains concentrated on policies originated by certain originators and on those originated in 2006 and 2007. We believe the majority of the rescinded risk in default would have ultimately resulted in settled claims. See Item 1A, “Risk Factors” for risks and uncertainties associated with rescission activity.
The following table details the amount of Primary risk in default and the Primary reserve balance as a percentage of Primary risk in default at December 31, 2011 and 2010. The table also provides the impact of the rescission factor, which is a component of the frequency factor utilized in the reserve model, on gross case reserves at the respective period end. Due to the changes in the assumptions utilized in our reserve methodology and the change in the mix of defaults, the gross case reserves, net of expected rescissions, expressed as a percentage of gross risk in default has increased to 59% at December 31, 2011 compared to 52% one year prior.
Settled claim activity continues to be slowed due to delays in foreclosure proceedings although the impact, which was most evident in the first quarter of 2011, has declined over the year. Settled claim activity has also been affected by other factors including our investigation of policies for underwriting violations and fewer Modified Pool settlements as we reached the stop loss limit on a settled basis on a number of these transactions.
Average severity on settled claims is influenced by our ability to mitigate claims. Historically, the sale of properties by the borrower either before or during the foreclosure process was effective in reducing average severity However, the decline in home prices since 2007 across almost all markets, with significant declines in the distressed markets, combined with reduced mortgage credit availability has continued to negatively impact our ability to mitigate losses from sales of properties. Policies originated in 2006 and 2007 have been particularly impacted by the decline in home prices because the properties were acquired by the borrowers at the peak of the market. We expect our ability to mitigate losses will continue to be adversely affected by these factors. A greater concentration of settled claims in distressed markets or more recent policy years will exacerbate this effect. Furthermore, issues with foreclosure proceedings may further negatively impact home sales.
The Primary claim rate, defined as the number of Primary claims paid over the previous twelve months as a percentage of the number of Primary policies in force at the beginning of the period, for the distressed markets was 9% and 8% at December 31, 2011 and 2010, respectively, compared to 3% at both periods for the non-distressed markets.
These policy years accounted for 66% of our Primary risk in default at December 31, 2011 while only comprising 59% of the Primary risk in force.
(1) Percentages are not mutually exclusive and there are many borrowers that qualified under both segments.
Prior to 2007, the policies that we insured defaulted for a variety of reasons, but primarily due to loss of employment, divorce, or illness of a mortgage holder. Historically, based on these primary determinants of default, we expected the gross cumulative incurred loss incidence rate for a specific book year to increase over time as the incidence of default is relatively low in the first few years of development, typically reaches its peak in the second through the fifth year after loan origination, and will moderately increase over time as a small number of policies continue to default. However, in addition to the above factors, the incidence of default in the current economic environment has been and continues to be adversely impacted by the prolonged elevated levels of unemployment throughout the United States and the steep decline in home prices. Because of the decline in home prices, many borrowers are now in the position where they owe more on the mortgage than the home is worth, causing some borrowers to strategically default, or stop paying the mortgage even though they are financially able to do so. Prior to 2007, strategic defaults were believed to be a minimal cause of reported defaults. As the above table indicates, the 2005, 2006 and 2007 book years are exhibiting significantly worse performance compared to the more developed earlier book years. We do not expect this adverse performance to subside and expect the gross cumulative incurred loss incidence rate of these book years to remain significantly higher than our previous books of business. As the above table indicates, although not material to the overall results of operations, the 2002 - 2004 book years are also seeing increases to the gross cumulative incurred loss incidence rate where historically we would not have expected to see such a large increase given the age of the underlying policies.
Another factor contributing to the decline in other operating expenses is lower expenses for indemnifications related to contract underwriting performed prior to going into run-off. During 2011, expenses related to contract underwriting amounted to $2.9 million compared to $6.9 million in 2010. We did not change the reserve for estimated contract underwriting remedies in 2011 compared to an increase of $4.1 million in 2010. However, we remain exposed to potential liability for our previous underwriting activities for up to seven years from the date the services were provided and contract underwriting expenses may increase in the future. Interest expense increased 55% in 2011 compared to 2010 primarily due to the increase in accrued interest related to the DPO liability. Interest expense on the DPO, the only component of interest expense in 2011, increased by 77% in 2011 compared to 2010. The payment of interest related to the DPO is dependent on Triad attaining certain risk to capital and other operating ratios and is subject to approval by the Department. No interest has been paid on the DPO since it was established in June 2008. Interest expense on the long-term debt, which was repurchased and retired in July 2010, contributed $1.5 million to 2010 interest expense.
Total liabilities were $1.6 billion at both December 31, 2011 and December 31, 2010 as a $205.8 million decrease in loss and LAE reserves was offset by a $214.0 million increase in the DPO liability and related accrued interest. Terms of the second Corrective Order require that Triad establish a separate custody account with investments at least equal to the unpaid DPO. The DPO liability, including accrued interest, comprises approximately 81% of our total invested assets December 31, 2011, compared to 49% at December 31, 2010. We are currently in discussions with the Department regarding the increasing percentage of assets supporting the DPO liability and the amount of interest credited to the DPO holders.
If the Department determines that the DPO percentage should be reduced and/or distributions should be made to DPO holders, it would most likely result in a large cash payment by Triad, which would be funded by these assets held in escrow. While we have structured the maturities of our invested assets to provide flexibility to accommodate any such possible payments, when and if they occur, the estimation of the timing of these payments requires assumptions as to future events and there are inherent risks and uncertainties involved in making these assumptions. If the maturity of investments fails to provide sufficient cash flow to fund any such possible payments to DPO holders, we could be forced to liquidate securities prior to maturity, which may result in unanticipated realized investment losses. See Item 1A, “Risk Factors” for more information.
The majority of our assets are included in our investment portfolio. Our goal for managing our investment portfolio is to preserve capital, provide liquidity as necessary for the payment of claims, optimize investment returns, and adhere to regulatory requirements. We have established a formal investment policy that describes our overall quality and diversification objectives and limits although this policy is subject to change depending on market conditions, the economic and regulatory environment, as well as our financial condition. We classify our entire investment portfolio as available-for-sale. All investments are carried on our balance sheet at fair value.
We utilize a third-party investment manager that specializes in the management of fixed income portfolios for insurance companies, for investment advice, portfolio management, and investment accounting and reporting services. We utilize independent pricing services in determining the fair value of the majority of our investments and the investment manager assists in verifying the accuracy of these values. For more information on the pricing of our securities, see “Critical Accounting Policies and Estimates” below and Note 11 to the Consolidated Financial Statements.
Our portfolio is primarily composed of taxable publicly-traded fixed income securities as well as tax-preferred state and municipal securities. Our taxable publicly-traded fixed income securities primarily include corporate debt obligations, asset-backed securities, commercial mortgage-backed securities, and residential mortgage-backed securities.
The decline in our invested assets from December 31, 2010 is due to the use of cash proceeds to fund our negative cash flow from operations, although a general decrease in market interest rates partially mitigated the decline. We anticipate continued negative cash flow from operations in 2012 due to the expected level of claims settled and declining net premium collections. We expect the proceeds from the maturity and sale of securities will be used to fund these anticipated shortfalls.
The following table summarizes by category our unrealized gains and losses in our securities portfolio at December 31, 2011:
We evaluate the credit risk of a security by analyzing the underlying credit qualities of the security. For corporate securities, we attempt to mitigate credit risk by managing exposure to different market sectors as well as individual issuers. We also seek value in enhancements provided by financial guaranty insurers to our tax-preferred state and municipal fixed income securities which may benefit the credit rating. If a security has an enhancement provided by a financial guaranty insurer, the security would carry the rating of the financial guaranty insurer if it is higher than the security’s underlying rating.
TGI is the public company whose stock is traded on the OTC Bulletin Board (“OTCBB”) and the OTC Markets Group’s OTCQB tier (“Pink Sheets") under the symbol “TGIC”. TGI owns TGIC, which is its only operating subsidiary. Aside from its ownership of Triad, TGI’s assets amount to approximately $1.3 million, which consists primarily of cash holdings (refer to Schedule II - Condensed Financial Information of the Registrant filed as part of this Form 10-K). The remainder of the $896.2 million of assets reported on the consolidated balance sheet presented in this Form 10-K are the assets of Triad. Triad is prohibited from paying dividends or distributing assets to TGI without the approval of the Department. We believe that, absent significant positive changes in the economy and the residential real estate market, the existing assets combined with the future premiums of Triad likely will not be sufficient to meet Triad’s current and future policyholder obligations and, therefore, none of Triad’s assets would be available to TGI and its stockholders other than to reimburse certain TGI expenses incurred on behalf of TGIC. Therefore, the ultimate value of TGI will be determined by its cash holdings less any future expenses not reimbursed by Triad. TGI is exploring strategies to acquire profitable, growing businesses and leverage its insurance industry knowledge, management expertise, and Net Operating Loss (“NOL”) carryforwards that were generated on a consolidated basis with Triad in order to increase its value for the benefit of its stockholders. No assurance can be given that TGI will be able to successfully implement such a strategy, or, if implemented, to increase its stockholder value.
Generally, our sources of operating funds consist of renewal premiums received and investment income. Operating cash flow is applied to the payment of claims and other expenses. We reported a deficit in operating cash flow from operations of $76.6 million in 2011 compared to positive cash flow from operations of $57.9 million in 2010, which included $188.7 million from the commutation of our two largest captive reinsurance agreements. Absent those commutations and excluding any additional amounts that would have been ceded under those agreements, we would have reported negative operating cash flow from operations of $130.8 million for 2010. Operating cash flow in 2011 benefited from delays in foreclosure proceedings and from one-time tax refunds amounting to $11.7 million related to NOL carrybacks that were filed in 2010. The operating cash flows in both 2011 and 2010 have benefited from the DPO requirements of the second Corrective Order. Operating cash flow shortfalls were funded through sales and maturities of short-term investments and other longer-term investment securities. See “Investment Portfolio” for more information.
During 2011, net cash outflows for settled claims were $269.9 million compared to a $154.1 million during 2010, which accounts for the receipt of $188.7 million related to the previously mentioned captive commutations. Cash outflows on settled claims were reduced by $214.0 million and $247.3 million in 2011 and 2010, respectively, as a result of the DPO requirement.
We expect to report negative cash flows from operations in 2012 as we continue to believe that claims and expenses will exceed our net premium and investment income. We do not anticipate any other significant cash receipts in future periods from captive commutations, income tax refunds, or from other means. We anticipate that the funds necessary to meet the operating shortfall will come from the scheduled maturities of invested assets and, if needed, sales of other assets in our investment portfolio.
The statutory risk-to-capital ratio has historically been used as a measure by many states and regulators of an insurer’s capital adequacy and ability to underwrite new business. The risk-to-capital ratio is no longer relevant for Triad for that purpose because we are operating in run-off. The risk-to-capital ratio is one of the financial measures that the Department uses to determine if the DPO percentage should be reduced and/or if a distribution to DPO holders should be made. In January 2012, the Department notified Triad that as of December 31, 2011, based upon Triad’s surplus position, risk-to-capital ratio and the continued economic uncertainty, the Department had determined that no change to the DPO percentage was in order nor would it be appropriate for Triad to make a distribution to the DPO holders.
Frequency and severity are the two most significant assumptions in the establishment of our loss reserves. Frequency is used to estimate the ultimate number of paid claims associated with the current inventory of loans in default. The frequency estimate assumes that long-term historical experience, taking into consideration criteria such as those described in the preceding paragraph, and adjusted for current economic conditions that we believe will significantly impact the long-term loss development, provides a reasonable basis for forecasting the number of claims that will ultimately be paid. Our expectations regarding future rescissions of the loans currently in default have been incorporated into the overall frequency factor. Severity is the estimate of the dollar amount per claim that will be paid based upon the amount of risk in default on each particular loan. The severity factors used are based on an analysis of the severity rates of recently paid claims, applied to the risk in force of the loans currently in default. The frequency and severity factors are updated quarterly. Economic conditions and other data upon which these factors are based may change more frequently than once a quarter and the impact of the change may not be perceived immediately. Therefore, significant changes in reserve requirements may become evident three or more months following the underlying events that would necessitate the change.
The estimation of loss reserves requires assumptions as to future events, and there are inherent risks and uncertainties involved in making these assumptions. Economic conditions that have affected the development of loss reserves in the past may not necessarily affect development patterns in the future in either a similar manner or degree. Furthermore, the current conditions of the economy and the mortgage market are substantially different from those we have witnessed before and, as such, we believe our estimates are susceptible to a large degree of variation.
The impact on loss reserves on the balance sheet would be to decrease reserves for favorable developments and to increase reserves for unfavorable developments. There would be no impact on liquidity resulting from the change in reserves. However, there would be an ultimate change in cash or invested assets equal to the increase or decrease in the actual claims ultimately paid related to the change in reserves. Based upon the last three years of both favorable and unfavorable loss development in our reserves during a depressed and uncertain housing market coupled with extended periods of high unemployment, we continue to believe a 20% increase or decrease in the overall frequency factor is reasonably possible. We believe there is a greater propensity during 2012 for an increase rather than a decrease in the overall frequency factor given the current conditions and the uncertainty surrounding home prices and the mortgage markets. Economic conditions that could give rise to an increase in the frequency rate could be a prolonged period of elevated unemployment rates, further deterioration in home prices especially in geographical areas that had previously been resistant to such downward trends, or failure of Federal government sponsored or other programs to prevent foreclosures. Conversely, an improved housing market with rising home prices, additional loan modification or forgiveness programs by the Federal government or individual lenders, or a sustained period of economic and job growth could potentially decrease the frequency rate.
Notwithstanding a considerable decline in rescission activity in 2011 compared to 2010, we expect rescission activity will continue to decline in 2012. Furthermore, our ability to rescind a policy may be adversely impacted by legal challenges from policyholders of our right to rescind policies. The level of rescission and claims denial activity by mortgage insurers has caused certain policyholders and loan servicers to institute legal actions to challenge the validity of rescissions and claim denials, and we are currently a defendant in one such proceeding. See Item 3, “Legal Proceedings,” for further information. We believe it is likely that other lenders and mortgage servicers will challenge the ability of mortgage insurers to rescind and deny coverage, including filing of additional lawsuits. An adverse court decision against us or another mortgage insurer could set a precedent that has the effect of significantly restricting or limiting our ability to rescind policies or deny coverage of claims and require a corresponding decrease in our rescission factor.
Invested assets comprise 87% of total assets and the determination of the fair value of these invested assets is a critical accounting policy. We utilize the provisions of ASC 820-10 as amended by ASU 2010-06 in the estimation and disclosures about the fair value of our invested assets. ASC 820-10 establishes a fair value hierarchy that prioritizes the inputs to valuation methods used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy under ASC 820-10 are as follows:
Quoted prices for similar assets in active markets or for identical or similar assets in inactive markets. Alternatively, quoted prices may be based on models where the significant inputs are observable or can be supported by observable market data. The majority of our fixed income investments, including corporate bonds, municipal securities, and asset-backed and mortgage-backed securities, utilize Level 2 inputs. Approximately 99.3% of our invested assets are Level 2.
An asset’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement. An asset’s or a liability’s level within the fair value hierarchy as well as transfers in and out of Level 3 are determined at the end of the reporting period.
if Triad is not permitted or is otherwise unable to provide funds to TGI, the available resources of TGI will be insufficient to satisfy future operating expenses;
if we have failed to properly underwrite mortgage loans under contract underwriting service agreements, we may be required to reimburse lenders for the losses incurred on those loans that we underwrote or provide other remedies;