The Company leases office space in its Winston-Salem headquarters and its thirteen underwriting offices located throughout the country under leases expiring between 2004 and 2012 and which require annual lease
payments of approximately $1.3 million in 2004. With respect to all facilities, the Company either has renewal options or believes it will be able to obtain lease renewals on satisfactory terms. The Company believes its existing properties are well utilized and are suitable and adequate for its present circumstances.
The Company maintains mid-range and micro-computer systems from its corporate data center located in its headquarters building to support its data processing requirements for accounting, claims, marketing, risk management, and underwriting. The Company has in place back-up procedures in the event of emergency situations.
Based on statutory accounting practices and derived from consolidated statutory financial statements of Triad.
Our reserving process is based upon the assumption that past experience, taking into consideration the above factors, adjusted for anticipated economic conditions and projected future economic trends, provides a reasonable basis for estimating severity and frequency. We consider severity and frequency to be the most significant assumptions in the establishment of our loss reserves. Inherently, there are risks and uncertainties involved in making these assumptions.
The timely identification and valuation of potentially impaired securities involves many judgments. Inherently, there are risks and uncertainties involved in making these judgments. Changes in circumstances and critical assumptions such as unforeseen events which affect our investments in one or more companies, political subdivisions, or industries could result in additional write downs in future periods for impairments that are deemed to be other-than-temporary.
The costs of acquiring new business, principally commissions and certain policy underwriting and issue costs which vary with and are primarily related to the production of new business, are capitalized as deferred policy acquisition costs (DAC). Amortization of such policy acquisition costs is charged to expense in proportion to premium recognized over the estimated policy life. We make judgments in the identification of deferrable acquisition costs and the determination of estimated policy life utilized in the amortization assumptions. See further discussion of deferred policy acquisition costs under the Financial Position section of Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Through our subsidiaries, we provide mortgage guaranty insurance coverage to residential mortgage lenders and investors as a credit-enhancement vehicle, typically when individual borrowers have less than 20% equity in the property. Business originated by lenders and submitted to us on an individual basis is referred to as flow business. Mortgage guaranty insurance facilitates the sale of individual low down payment loans in the secondary market and provides protection to lenders who choose to keep the loans. Additionally, we provide mortgage insurance to lenders and investors who seek additional default protection, capital relief, and credit-enhancement on groups of loans that are sold in the secondary market. This business is referred to as structured bulk business.
We derive our revenues principally from a) initial and renewal earned premiums from flow business (net of reinsurance premiums ceded as part of our risk management strategies), b) initial and renewal earned premiums from structured bulk transactions, and c) investment income on invested assets. We also realize investment gains periodically as a source of revenue when the opportunity presents itself within the confines of our overall investment strategy.
Our profitability depends largely on a) the adequacy of our product pricing and underwriting discipline relative to the risks insured, b) persistency levels, c) operating efficiencies, and d) the level of investment yield, including realized gains and losses, on our investment portfolio.
Two other important drivers of our results have been the increase in bulk production and our continued commitment to risk-sharing arrangements with our lender partners. We address these primary drivers and the impact each had in the detailed year-by-year comparisons that follow this discussion. The information is presented in three categories: Production and In Force, Revenues, and Losses and Expenses.
Net income for 2003 increased 13.3% to $51.1 million from $45.1 million in 2002. Net income per share on a diluted basis increased 11.9% to $3.52 for 2003 from $3.15 per share for 2002. This improvement in net income was driven by a 14.0% increase in earned premiums and a 6.1% increase in net investment income. Net income for 2003 includes net realized investment gains, net of income taxes, of $2.0 million, while net income for 2002 included net after-tax realized investment losses of $1.6 million.
Total insurance written in 2003 was $20.5 billion compared to $13.4 billion in 2002, an increase of 52.5%. Total insurance written includes insurance written from flow production and structured bulk transactions.
Insurance written in 2003 attributable to structured bulk transactions totaled $3.9 billion compared to $1.2 billion in 2002. The jump in structured bulk transactions written was driven by a robust growth in the
overall bulk marketplace in 2003 coupled with our renewed strategic commitment to that market. Our investments in technology and personnel enabled us to participate successfully in this arena in 2003. Structured bulk transactions are generally initiated by secondary mortgage market participants who wish to use mortgage insurance as a credit enhancement. We compete against other mortgage insurers as well as other forms of credit enhancement provided by capital markets for these transactions. Insurance written attributed to structured bulk transactions is likely to vary significantly from period to period, as opposed to insurance written from flow originations, due to a) the limited number of transactions (but with larger size) occurring in this market, b) competition from other mortgage insurers, c) the attractiveness in the marketplace of mortgage insurance versus other forms of credit enhancement, and d) the changing loan composition and underwriting criteria of the market.
Periodically we enter into structured bulk transactions involving loans that have insurance effective dates within the current reporting period but for which detailed loan information regarding the insured loans is not provided by the issuer of the transaction until later. When this situation occurs, we accrue premiums that are due but not yet paid based upon the estimated commitment amount of the transaction in the reporting period with respect to each loan’s insurance effective date. However, the policies are not reflected in our in force, insurance written, or related industry data totals until the loan level detail is reported to us. At December 31, 2003, we had approximately $1.3 billion of structured transactions with effective dates within the fourth quarter for which loan level detail had not been received and, therefore, are not included in our own data or industry totals. These amounts will be reported as new production and insurance in force totals in 2004 when the issuer of the transactions provides loan level detail to us. We have properly included in premium written and premium earned the respective amounts due and earned during the fourth quarter of 2003 related to this insurance.
Refinance activity was 52.1% of insurance written (42.1% in the fourth quarter) in 2003 compared to 40.1% (47.0% in the fourth quarter) in 2002. Persistency was 50.7% at December 31, 2003, compared to 60.9% at December 31, 2002. The high level of refinance activity and the resulting decrease in persistency is reflective of the low interest rate environment that has been in place during the past year. The annualized
We define persistency as the percentage of insurance in force remaining from twelve months prior. Cancellations of policies originated during the past twelve months are not considered in our calculation of persistency. This method of calculating persistency may vary from that of other mortgage insurers. We believe that our calculation presents an accurate measure of the percentage of insurance in force remaining from twelve months prior. Cancellations result primarily from the borrower refinancing or selling mortgaged residential properties and, to a lesser degree, from the borrower achieving prescribed equity levels at which the lender no longer requires mortgage guaranty insurance. The primary driver of our reduced persistency over the past two years has been the record low interest rates on mortgage loans.
Total direct premiums written were $154.0 million for 2003, an increase of 24.0% compared to $124.2 million for 2002. Net premiums written increased by 19.7% to $126.7 million in 2003 from $105.9 million for 2002. Contributing to the increase in premiums written for 2003 were significant writings under our annual premium payment plan. The annual premium payment plan requires a first-year premium paid at mortgage loan closing, with the entire amount reported as premium written. The annual premium payment plan contrasts with our monthly premium payment plan which involves, in general, the payment of one or two months’ premium at mortgage loan closing and monthly renewal payments thereafter, with the associated amounts reported as premium written. During 2003, 34% of total insurance written was under the annual premium payment plan compared to 18% of total insurance written during 2002.
Net incurred losses and loss adjustment expenses (net of reinsurance recoveries) increased by 69.5% in 2003 to $23.8 million from $14.1 million in 2002. The increase in losses and loss adjustment expenses was anticipated based upon the growth in the number of delinquencies and is reflective of our overall growth of insurance in force, relative growth of our participation in the bulk market, and the seasoning of our in force business. Net paid losses, excluding loss adjustment expenses, increased to $17.5 million during 2003 from $10.3 million during 2002, an increase of 70.3%. The increase in net paid losses approximates the increase in incurred losses and was within our expected range. Average severity (direct paid losses divided by number of
claims paid) was approximately $24,100 for 2003 compared to $21,400 for 2002. The following table provides detail on direct paid losses from flow business and structured bulk business (in thousands of dollars).
Our loss ratio (the ratio of incurred losses to earned premiums) was 19.9% for 2003 compared to 13.4% for 2002. The loss ratio was 21.6% for the fourth quarter of 2003 and 15.4% for the fourth quarter of 2002. As mentioned earlier, the increase in the loss ratio is consistent with our expectations given the overall growth of insurance in force, relative growth of our participation in the bulk market, and the seasoning of our in force business.
As of December 31, 2003, approximately 92% of our insurance in force was originated in the last 36 months compared to 83% at December 31, 2002. We believe, based upon our experience and industry data, that claims incidence for flow business is generally highest in the third through sixth years after loan origination. We believe that the period of highest claims incidence for structured bulk transactions is earlier than that for flow business. We expect our incurred losses to increase as a greater amount of our insurance in force reaches its anticipated highest claim frequency years. Changes in the economic environment could accelerate paid and incurred loss development. Due to the inherent uncertainty of future premium levels, losses, economic conditions, and other factors that affect earnings, it is difficult to predict with any degree of certainty the impact of such higher claim frequencies on future earnings.
Other operating expenses decreased 0.5% to $22.8 million for 2003 from $22.9 million for 2002. The decline in other operating expenses is primarily the result of operational efficiencies achieved through the use of technology. We have made substantial investments in technology that allow for significant increases in volume without a proportional increase in operating expenses. As a result, the substantial majority of our business now enters into our administrative systems through electronic interfaces at a lower cost than those requiring manual intervention. The expense ratio (ratio of the amortization of deferred policy acquisition costs and other operating expenses to net premiums written) for 2003 was 32.3% compared to 34.6% for 2002. The expense ratio for 2003 improved because other operating expenses decreased and net written premium increased, offset somewhat by the accelerated amortization of DAC.
Total insurance written in 2002 was $13.4 billion compared to $13.3 billion in 2001, an increase of 1.3%. Flow insurance written for 2002 increased 42.8% to $12.2 billion from $8.5 billion in 2001. The increase in insurance written from flow production was primarily the result of expanding relationships with national lenders, strong demand for risk-sharing arrangements, and an expanding marketplace as the result of lower interest rates. Insurance written in 2002 attributable to structured bulk transactions totaled $1.2 billion compared to $4.7 billion in 2001.
According to industry data, Triad’s national market share of net new primary insurance written was 3.7% for 2002 compared to 3.6% for 2001. Triad’s national market share of net new primary insurance written on a flow basis was 4.3% for 2002 compared to 3.4% for 2001.
Total direct insurance in force reached $25.4 billion at December 31, 2002, compared to $21.7 billion at December 31, 2001, an increase of 16.8%. Increased refinance activity in 2002 drove a high level of policy cancellations that partially offset the impact that the high level of insurance written had on in force growth.
Total direct premiums written were $124.2 million for 2002, an increase of 30.0% compared to $95.6 million for 2001. Net premiums written increased by 24.6% to $105.9 million in 2002 from $85.0 million for 2001.
Driven primarily by increases in captive arrangements and also by excess of loss reinsurance, ceded premiums written increased 73.8% to $18.3 million in 2002 from $10.6 million in 2001. Our premium cede rate was 14.8% for 2002 compared to 11.0% for 2001. Our premium cede rate for captive reinsurance was 12.7% for 2002 compared to 6.6% for 2001. Approximately 51% of flow insurance written (46% of total insurance written including structured bulk transactions) during 2002 was subject to captive mortgage reinsurance compared to 58% of flow insurance written (37% of total insurance written including structured bulk transactions) in 2001. Approximately 45.7% of direct insurance in force was subject to captive arrangements at December 31, 2002, compared to 34.6% at December 31, 2001. The increase in insurance in force subject to captive arrangements was due primarily to the increased market penetration of our captive arrangements and the increased level of refinance activity during 2002.
Earned premiums increased 24.6% to $105.1 million for 2002 from $84.4 million for 2001. The growth in written and earned premium resulted from record levels of insurance written offset by the impact of a declining persistency rate due to a high level of refinance activity.
Net investment income for 2002 was $16.1 million, a 9.0% increase over $14.8 million in 2001. This increase was the result of growth in the average balance of invested assets by $49 million to $301 million for the year ended December 31, 2002, from $252 million for 2001. The growth in invested assets was attributable
to normal operating cash flow. The percentage increase in net investment income was lower than the percentage increase in invested assets primarily due to a decrease in investment yields that were a result of the low interest rates in 2002 for new investments and the disposal of a number of higher yielding corporate bonds with lower credit quality during 2002 to enhance the overall quality of the portfolio.
Other operating expenses increased 26.3% to $22.9 million for 2002 from $18.1 million for 2001. This increase in expenses was primarily attributable to personnel, technology amortization, and equipment and software costs required to support our increased levels of production, product development, system enhancements, and geographic expansion. The expense ratio for 2002 was 34.6% compared to 35.1% for 2001.
Our objective is to continually grow market share through controlled, profitable growth in both the flow and bulk arenas while adhering to our risk management strategies. Our strategy is to continue our focus on national lenders while maintaining the productive relationships that we have built with regional lenders. However, consolidation within the mortgage origination industry has resulted in a greater percentage of production volume being concentrated among a smaller customer base. Our ten largest customers were responsible for 74%, 73%, and 64% of flow insurance written during 2003, 2002, and 2001, respectively. Our two largest customers were responsible for 58%, 53%, and 42% of flow insurance written during 2003, 2002, and 2001, respectively. Measured by risk in force, our ten largest customers were responsible for 67%, 59%, and 42% of flow risk in force at December 31, 2003, 2002, and 2001, respectively. Additionally, our two largest customers were responsible for 49%, 40%, and 25% of flow risk in force at December 31, 2003, 2002, and 2001, respectively. The loss of one or more of these significant customers could have an adverse effect on our business.
Total assets increased to $576 million at December 31, 2003, a 19% growth over the same date in 2002. Total liabilities increased to $206 million at December 31, 2003, from $173 million in 2002. This section identifies several items on our balance sheet that are important in the overall understanding of our financial position. These items include deferred policy acquisition costs, prepaid federal income tax and related deferred income taxes, and loss and loss adjustment expense reserves. Our mortgage insurance operations and reserves are primarily supported by our investment portfolio. The majority of our assets are contained in the investment
Costs expended to acquire new business are capitalized as deferred policy acquisition costs (DAC) and recognized as expense over the anticipated premium paying life of the policy. We employ dynamic models that calculate amortization of DAC separately for each book year. The models rely on assumptions that we make based upon historical industry experience and our own unique experience regarding the annual persistency development of each book year. Persistency is the most important assumption utilized in determining the timing of reported amortization expense reflected in the income statement and the carrying value of DAC on the balance sheet. A change in the assumed persistency can impact the current and future amortization expense as well as the carrying value on the balance sheet. However, our models are dynamic and adjust when actual book year persistency is lower than the assumptions employed in the models. When this happens, the DAC amortization is accelerated through a dynamic adjustment in order to match the amortization expense with the life of the policies on which the acquisition costs were originally deferred. The following table shows the DAC asset for the previous three years and the effect of persistency on amortization(amounts in thousands):
We establish reserves using estimated claim rates (frequency) and claim amounts (severity) to estimate ultimate losses. Our reserving process incorporates numerous factors in a formula that gives effect to current economic conditions and profiles delinquencies by such factors as policy year, geography, chronic late payment characteristics, and the number of months the policy has been in default. Because the estimate for loss reserves is sensitive to the estimates of claims frequency and severity, we perform sensitivity analyses to test
Our loss and loss adjustment expense reserves increased to $27.2 million at December 31, 2003, compared to $21.4 million at December 31, 2002. Note 4 in the Notes to the Consolidated Financial Statements contains a roll forward of these amounts for the last two years showing the incurred losses and the actual payments for the current and prior years. Loss and loss adjustment expense reserves are established when notices of default on insured mortgage loans are received. Reserves also are established for estimated losses incurred on notices of default not yet reported by the lender. Consistent with industry practices, we do not establish loss reserves for future claims on insured loans that are not currently in default. The growth in loss reserves is primarily the result of the increase in reported defaults. Over 81% of our insurance in force was written within the last two years. Experience indicates that years three through six have the highest incidence of defaults. Because of this fact, we expect loss reserves to continue to grow, reflecting the growth and aging of our insurance in force.
The following table shows default statistics as of December 31, 2003, and 2002.
Our strategy for managing our investment portfolio is to meet or exceed regulatory and rating agency requirements while appropriately managing credit risk. We invest for the long term, and most of our investments are held until they mature. Our investment portfolio includes primarily fixed income securities, and the majority of these are tax-sheltered state and municipal bonds. We have established a formal investment policy that describes our overall quality and diversification objectives and limits. Our investment policies and strategies are subject to change depending upon regulatory, economic, and market conditions and the existing or anticipated financial condition and operating requirements, including the tax position, of our company. During 2003, we strengthened our investment portfolio by increasing the overall credit quality. At the end of 2003, 95.4% of the portfolio was rated “A” or higher as compared to 90.1% at the end of 2002. Additionally, we focused our new purchases on state and municipal tax-preferred securities in 2003. Our investment portfolio consists entirely of available-for-sale securities; therefore, all values are carried on our balance sheet at fair value.
We seek to provide liquidity in our investment portfolio through cash equivalent investments and through diversification and investment in publicly traded securities. We attempt to maintain a level of liquidity and duration in our investment portfolio consistent with our business outlook and the expected timing, direction, and degree of changes in interest rates. See Note 2 in Notes to Consolidated Financial Statements that describes the scheduled maturity of our fixed maturity investments. Another way that we manage risk and liquidity is to limit our exposure on individual securities. As of December 31, 2003, no investment in the securities of any single issuer exceeded 2% of our investment portfolio.
The growth in net investment income has moderated recently in spite of an increase in our overall investment portfolio. The drop in the effective pre-tax yield reflects the decrease in new money rates available for investment coupled with our strategies to increase the overall credit quality of the portfolio and increase our investment in state and municipal bonds. The portfolio’s yield was also affected by a higher percentage of the fixed income portfolio invested in short-term investments at low yielding money market rates.
We manage credit risk in our investment portfolio by managing to internal investment quality guidelines and diversification. We improved the overall credit quality of our fixed maturity portfolio during 2003. The following table describes our investment portfolio by credit ratings (dollars in thousands).
When we conclude that the decline is other than temporary based on management’s judgment, the security is written down to fair value through a charge to realized investment gains and losses. We adjust the amortized cost for securities that have experienced other-than-temporary impairments to reflect fair value at the time of the impairment. We consider factors that lead to an other-than-temporary impairment of a particular security in order to determine whether these conditions have impacted other similar securities.
Of the $769,000 gross unrealized losses at December 31, 2003, none was included in our potentially distressed securities list mentioned above.
Our sources of operating funds consist primarily of premiums written and investment income. Operating cash flow is applied primarily to the payment of claims, interest, expenses, and prepaid federal income taxes in the form of Tax and Loss Bonds.
The insurance laws of the State of Illinois impose certain restrictions on dividends that an insurance subsidiary can pay the parent company. These restrictions, based on statutory accounting practices, include requirements that dividends may be paid only out of statutory earned surplus and that limit the amount of dividends that may be paid without prior approval of the Illinois Insurance Department. There have been no dividends paid by the insurance subsidiaries to the parent company.
Triad’s ability to write insurance depends on the maintenance of its financial strength ratings and the adequacy of its capital in relation to risk in force. A significant reduction of capital or a significant increase in risk may impair Triad’s ability to write additional insurance. A number of states also generally limit Triad’s risk-to-capital ratio to 25-to-1. As of December 31, 2003, Triad’s risk-to-capital ratio was 15.3-to-1 as compared to 15.5-to-1 at December 31, 2002, and 11.0-to-1 for the industry as a whole at December 31, 2002, the latest industry data available. The risk-to-capital ratio is calculated using net risk in force, which takes into account risk ceded under reinsurance arrangements, including captive risk-sharing arrangements as well as any applicable stop-loss limits, as the numerator, and statutory capital as the denominator.
Triad is rated “AA” by both Standard & Poor’s Ratings Services and Fitch Ratings and “Aa3” by Moody’s Investors Service. In July of 2003, S&P revised its rating outlook for the U.S. private mortgage insurance industry to “Negative” from “Stable.” According to S&P, industry outlooks are primarily determined by the expected course of rating actions during the next one to two years. S&P stated that they see little chance that there will be any outlook or rating improvements among the mortgage insurers in the next one to two years, but they do see a considerable possibility that there will be some negative revisions in outlooks and ratings. In January 2003, Fitch revised its rating outlook for the U.S. private mortgage insurance industry to “Negative” from “Stable”. Currently, Fitch, S&P, and Moody’s all report a “Stable” ratings outlook for Triad. A reduction in Triad’s rating or outlook could adversely affect our operations.
The Office of Federal Housing Enterprise Oversight (OFHEO) issued its risk-based capital rules for Fannie Mae and Freddie Mac in the first quarter of 2002. The regulation provides capital guidelines for Fannie Mae and Freddie Mac in connection with their use of various types of credit protection counterparties including a more preferential capital credit for insurance from a “AAA” rated private mortgage insurer than for insurance from a “AA” rated private mortgage insurer. The phase-in period for OFHEO’s risk-based capital rules is ten years. We do not believe the new risk-based capital rules had an adverse impact on our financial condition for 2003 nor that these rules will have a significant adverse impact on our financial condition in the future. However, if the risk-based capital rules result in future changes to the preferences of Fannie Mae and Freddie Mac regarding their use of the various types of credit enhancements or their choice of mortgage insurers based on their credit rating, our financial condition could be significantly harmed.
Our long-term debt has a single maturity date of 2028. The following schedule represents our aggregate contractual obligations as of December 31, 2003 (in thousands of dollars).
economic downturns in regions where our risk is more concentrated could have a particularly adverse effect on our financial condition and loss development;
OFHEO risk-based capital rules could severely limit our ability to compete against various types of credit protection counterparties, including “AAA” rated private mortgage insurers;
changes in the eligibility guidelines of Fannie Mae or Freddie Mac could have an adverse effect on the Company;
proposed regulation by the Department of Housing and Urban Development to exclude packages of real estate settlement services, which may include any required mortgage insurance premium paid at closing, from the anti-referral provisions of the Real Estate Settlement Procedures Act could adversely affect our earnings.
See information in this report under the heading “Market Risk Exposures” in Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Information regarding our directors and nominees for directors is included in our Proxy Statement for the 2004 Annual Meeting of Stockholders, and is hereby incorporated by reference.
This information is included in our Proxy Statement for the 2004 Annual Meeting of Stockholders, and is hereby incorporated by reference.
(a) (3) Listing of Exhibits - The response to this portion of Item 15 is submitted as a separate section of this report.
(b) Reports on Form 8-K filed or furnished during the fourth quarter of 2003 and through the date of this Form 10-K filing.
October 29, 2003 - Triad Guaranty Inc. issued a news release announcing its financial results for the three-month and nine-month periods ended September 30, 2003.
January 30, 2004 - Triad Guaranty Inc. issued a news release announcing its financial results for the fourth quarter and the fiscal year ended December 31, 2003.
Indenture Between Triad Guaranty Inc. and Banker’s Trust Co.(6) (Exhibit 4.2)
Investment Advisory Agreement between Triad Guaranty Insurance Corporation and Collateral Mortgage, Ltd.(2) (Exhibit 10(d))
Amendment to Employment Agreement between the Registrant and Darryl W. Thompson(3)(4) (Exhibit 10.17)
Amendment to Employment Agreement between the Registrant and Henry B. Freeman)(3)(4) (Exhibit 10.19)
Amendment to Employment Agreement between the Registrant and Ron D. Kessinger(3)(4) (Exhibit 10.20)
Employment Agreement between the Registrant and Michael R. Oswalt(3)(9) (Exhibit 10.24)
Employment Agreement between the Registrant and Kenneth N. Lard(3) (Exhibit 10.25)
Chief Executive Officer Sarbanes-Oxley Act Section 302 Certification dated March 12, 2004, 2004 for the Triad Guaranty Inc.’s Annual report on Form 10-K for the year ended December 31, 2003.
Chief Executive Officer Sarbanes-Oxley Act Section 906 Certification dated March 12, 2004, 2004 for the Triad Guaranty Inc.’s Annual report on Form 10-K for the year ended December 31, 2003.
Chief Financial Officer Sarbanes-Oxley Act Section 906 Certification dated March 12, 2004, 2004 for the Triad Guaranty Inc.’s Annual report on Form 10-K for the year ended December 31, 2003.
Incorporated by reference to the exhibit identified in parentheses, filed as an exhibit in the June 30, 2002 Form 10-Q.
We have audited the accompanying consolidated balance sheets of Triad Guaranty Inc. as of December 31, 2003 and 2002, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2003. Our audits also included the financial statement schedules listed in the Index at item 15(a). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.
The costs of acquiring new business, principally commissions and certain policy underwriting and issue costs, which vary with and are primarily related to the production of new business, are deferred. Amortization of such policy acquisition costs is charged to expense in proportion to premium revenue recognized over the estimated policy life. The Company reviews the persistency of policies in force and makes appropriate adjustments to reflect policy cancellations.
Reserves are provided for the estimated costs of settling claims in respect of loans reported to be in default and estimates of loans in default which have not been reported to the Company. Consistent with industry accounting practices, the Company does not establish loss reserves for future claims on insured loans that are not currently in default. Loss reserves are established by management using historical experience and by making various assumptions and judgments about claim rates (frequency) and claim amounts (severity) to estimate ultimate losses to be paid on loans in default. The Company’s reserving methodology gives effect to current economic conditions and profiles delinquencies by such factors as age, policy year, geography, and chronic late payment characteristics. The estimates are continually reviewed and, as adjustments to these liabilities become necessary, such adjustments are reflected in current operations.
The Company uses the asset and liability method of accounting for income taxes. Under the asset and liability method, deferred tax assets, net of a valuation allowance, and deferred tax liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
The Company grants stock options to employees and directors for a fixed number of shares with an exercise price equal to or greater than the fair value of the shares at the date of grant. The Company accounts for stock option grants using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and accordingly, recognizes no compensation expense for the stock option grants.
The cost or amortized cost and the fair value of investments are as follows (in thousands):
Realized gains and losses on sales of investments are as follows (in thousands):
Net unrealized appreciation (depreciation) on fixed maturity securities changed by $1,479,000, $13,410,000, and ($1,821,000) in 2003, 2002, and 2001, respectively; the corresponding amounts for equity securities were $2,460,000, ($1,626,000), and ($290,000).
At December 31, 2003 and 2002, investments with an amortized cost of $6,556,000 and $6,634,000, respectively, were on deposit with state insurance departments to satisfy regulatory requirements.
Activity for the reserve for losses and loss adjustment expenses for 2003, 2002, and 2001 is summarized as follows (in thousands):
The foregoing reconciliation indicates a deficiency in 2003. The deficiency is a result of the increase in reserves from prior years due to increased severity assumptions, and not from paid claims. Years 2002 and 2001 show a redundancy in reserves. These redundancies in prior years resulted principally from settling case-basis reserves on default notices occurring in prior years for amounts less than expected or reducing incurred but not reported reserves.
The Company leases certain office facilities, autos, and equipment under operating leases. Rental expense for all leases was $1,950,000, $1,792,000, and $1,657,000 for 2003, 2002, and 2001, respectively. Future minimum payments under noncancellable operating leases at December 31, 2003, are as follows (in thousands):
The Company leases facilities for its corporate headquarters under an operating lease that is to expire in 2012. The Company has options to renew this lease for up to ten additional years at the fair market rental rate at the time of the renewal.
The tax effects of temporary differences that give rise to significant portions of deferred tax assets and deferred tax liabilities at December 31, 2003 and 2002, are presented below (in thousands):
At December 31, 2003, approximately 55% of Triad’s direct risk in force was concentrated in 10 states, with 12% in California, 8% each in Florida and Texas, 5% in Georgia and North Carolina, 4% each in Illinois and Arizona, and 3% each in New York, New Jersey, and Colorado. While Triad continues to diversify its risk in force geographically, a prolonged recession in its high concentration areas could result in higher incurred losses and loss adjustment expenses.
Insurance regulations limit the writing of mortgage guaranty insurance to an aggregate amount of insured risk no greater than twenty-five times the total of statutory capital and surplus and the statutory contingency reserve. The amount of net risk for insurance in force at December 31, 2003 and 2002, as presented below, was computed by applying the various percentage settlement options to the insurance in force amounts, adjusted by risk ceded under reinsurance agreements and by any applicable aggregate stop-loss limits. Triad’s ratio is as follows (in thousands except ratio):
In August 1993, the Company adopted the 1993 Long-Term Stock Incentive Plan (the “Plan”). Under the Plan, certain directors, officers, and key employees are eligible to be granted various stock-based awards. The number of shares of common stock which may be issued or sold or for which options or stock appreciation rights may be granted under the Plan is 2,600,000 shares.
Information concerning stock options outstanding and exercisable at December 31, 2003, is summarized below:
The carrying values and fair values of financial instruments as of December 31, 2003 and 2002 are summarized below (in thousands):
The fair value of the Company’s long-term debt is estimated using discounted cash flow analysis based on the Company’s current incremental borrowing rates for similar types of borrowing arrangements.
Lawsuits have been filed against the Company in the ordinary course of the Company’s business. In the opinion of management, the ultimate resolution of the pending litigation will not have a material adverse effect on the financial position or results of operations of the Company.
The following is a summary of the unaudited quarterly results of operations for the years ended December 31, 2003 and 2002. (The sum of the quarterly basic earnings per share does not equal the amount for the year as the basis for calculating average outstanding number of shares differs.) (in thousands):