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, Australia, New Zealand and Hong Kong.
Forward-looking statements in this document include discussions relating to the U.S. mortgage origination market in 2005, PMI’s persistency rate, the seasoning of PMI’s current insurance portfolio and its impact on losses and claims, PMI’s captive reinsurance agreements, PMI’s modified pool products and delegated underwriting program, contract underwriting services, our loss reserve assumptions and estimates, The PMI Group’s liquidity, the new Basel Capital Accord (Basel II), and regulatory developments in the U.S. and Australia and their possible impact on us.
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 $99.9 million in 2004 and $78.6 million in 2003.
Financial Guaranty. We are the lead investor in FGIC Corporation, whose subsidiary, Financial Guaranty Insurance Company, or FGIC, provides primary financial guaranty insurance. We also have a significant interest in RAM Reinsurance Company, Ltd., or RAM Re, a financial guaranty reinsurance company based in Bermuda. Net income from our Financial Guaranty segment was $60.7 million in 2004 and $10.4 million in 2003.
Other. Our Other segment consists of our holding company and contract underwriting operations, equity in earnings (losses) from SPS Holding Corp., or SPS, and certain limited partnerships, and the discontinued operations of our former title insurance subsidiary, American Pioneer Title Insurance Company, or APTIC. On March 19, 2004, we completed the sale of APTIC, which generated
$115.1 million in cash proceeds and an after tax gain of $29.0 million. Accordingly, there were no results of operations related to APTIC in the last three quarters of 2004. Our Other segment generated a net loss of $15.8 million in 2004 and $35.1 million in 2003.
Approximately 16% of our consolidated total revenues in 2004 consisted of interest and dividend income associated with our consolidated investment portfolio of $3.3 billion. 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.
Policy Cancellations and Persistency. Low interest rates in 2003 and 2004 resulted in heavy mortgage refinance activity and caused PMI’s policy cancellations to increase, which in turn negatively affected PMI’s insurance in force. While policy cancellations negatively affect PMI’s insurance in force, cancellations due to borrower prepayments positively affect premiums earned on PMI’s single premium policies in the year in which the cancellations occur. Upon notification of cancellation of a loan under a non-refundable single premium policy, any unearned premium with respect to that loan is recognized as earned premium. PMI’s persistency rate, the percentage of insurance in force at the beginning of a 12-month period that remains in force at the end of that period, was 60.9% at December 31, 2004 compared to 44.6% at December 31, 2003. While interest rates remain at affordable levels, the improvement in PMI’s persistency rate at December 31, 2004 compared to December 31, 2003 resulted from a stabilization of mortgage interest rates and corresponding decline in refinance activity in 2004. If these trends continue in 2005, and particularly if mortgage interest rates increase, we believe that PMI’s persistency rate will continue to improve.
Captive Reinsurance. Captive reinsurance is a reinsurance product in which PMI shares some of its risk written on loans originated by certain lender-customers. In return, a portion of PMI’s gross premiums written is ceded to the captive reinsurance companies of those lender-customers. At December 31, 2004, 53.7% of PMI’s insurance in force was subject to captive reinsurance agreements, compared to 50.0% at December 31, 2003. The captive reinsurance activity was due to refinance activity in 2003 and 2004 resulting in heavy cancellations of policies not subject to captive reinsurance and a higher percentage of NIW being generated by lenders with captive reinsurance agreements. We expect that the percentage of our insurance in force that involves captive reinsurance will increase in 2005.
PMI Australia. PMI Australia’s NIW and insurance in force increased during 2004 compared to 2003, positively affecting consolidated premiums earned and net investment income. The increases in NIW and insurance in force were also positively affected by exchange rate fluctuations and favorable economic conditions in the Australian and New Zealand economies. PMI Australia’s mortgage insurance coverage is typically purchased with a single, lump-sum premium. Accordingly, policy cancellations do not negatively impact PMI Australia’s revenues, but rather decrease its overall claim risk and increase its net premiums earned. PMI Australia’s net income also continued to be positively impacted by the low level of reported defaults and decreases in its losses and LAE due to a strong housing market, low interest rates and low unemployment. We expect the rate of Australian home price appreciation to moderate in 2005. The Australian and New Zealand economies performed well in 2004 and PMI Australia’s results are closely tied to economic developments in those countries.
Contract Underwriting Services. Due to a decline in refinancing activity and mortgage originations in 2004, our contract underwriting activities declined and associated revenue decreased to $26.1 million from $40.3 million in 2003. Allocated contract underwriting expenses to our Other segment also decreased to $26.1 million in 2004 from $44.3 million in 2003. Total contract underwriting expenses include monetary remedies provided to customers in the event we failed to properly underwrite a loan. Expenses associated with contract underwriting remedies, and accruals thereof, were $10.0 million in 2004 and $13.1 million in 2003.
As of December 31, 2004, our consolidated pre-tax book yield was 5.07% compared to 5.38% as of December 31, 2003. This decline reflects the reinvestment of maturing, higher yielding securities into lower yielding securities in our U.S. investment portfolio. During the fourth quarter of 2003, we made adjustments to reflect the appropriate accounting treatment related to the accretion of discounts and call premiums on U.S. municipal bonds that had been refunded. The adjustment related to the periods 2000 through 2003 and included a reclassification of $5.2 million of net realized gains to interest income as well as a positive yield adjustment of $5.1 million to reflect the accretion of purchase discounts and call premiums. The net effects of these adjustments recorded in 2003 were an increase in net investment income of $10.3 million and a decrease in net realized investment gains of $5.2 million.
Included in net realized investment gains and losses are impairment losses recognized for financial reporting purposes on certain securities that meet the definition of other-than-temporary impairment in our investment portfolio and other investments. Impairment losses were $0.2 million in 2004 compared to $0.5 million in 2003
In January 2005, we signed a Summary of Terms with CSFB, pursuant to which CSFB received an option to acquire 100% of our outstanding stock of SPS. Based upon the transaction, for the fourth quarter of 2004 we recorded a pre-tax realized capital loss on our equity investment held for sale (SPS) of $20.4 million and $13.3 million after tax.
The increase in our losses and LAE in 2004 over 2003 was due primarily to higher claims paid in U.S. Mortgage Insurance Operations and a reserve reversal in the third quarter of 2003 in International Operations. The increase in losses and LAE in 2003 over 2002 was the result of an increase in claims paid in our U.S. Mortgage Insurance Operations and an increase in loss reserves for PMI Europe, partially offset by a reduction of loss reserves for PMI Australia.
The increase in other underwriting and operating expenses in 2004 over 2003 was due primarily to higher operating expenses in our U.S. Mortgage Insurance Operations, including recognition of expenses previously deferred as acquisition costs, higher compensation and related expenses and expenses related to PMI’s field operations restructuring. Increases in PMI Australia’s payroll and payroll-related expenses, primarily due to increased employee head-count, and profit and exchange commissions related to PMI Australia’s captive reinsurance arrangements also contributed to the increase in our consolidated other underwriting and operating expenses in 2004 compared to 2003. The increase in other underwriting and operating expenses in 2003 over 2002 was due largely to the increases in underwriting and operating expenses in our U.S. Mortgage Insurance Operations and PMI Australia and an increase in remedy expenses in our contract underwriting operations.
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 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.
The results of our U.S. Mortgage Insurance Operations include the operating results of PMI Mortgage Insurance Co. and other U.S. mortgage insurance and reinsurance companies, collectively referred to as PMI. CMG Mortgage Insurance Company, CMG Mortgage Assurance Company and CMG Mortgage Reinsurance Company, collectively referred to as CMG, are accounted for under the equity method of accounting and their results are recorded as equity in earnings from unconsolidated strategic investments. U.S. Mortgage Insurance Operations’ results are summarized in the table below.
During the fourth quarter of 2003, we made cumulative adjustments to ceded premiums of $8.4 million pre-tax, which decreased premiums earned. The adjustments were made to reflect a more appropriate accounting treatment of captive reinsurance premium cessions related to the periods from 1998 through 2003.
Upon cancellation of certain insurance coverage, PMI refunds the portion of premiums that is unearned to the borrowers or servicers. The decrease in refunded premiums in 2004 compared to 2003 and the increase in 2003 compared to 2002 were due primarily to high levels of policy cancellations in 2003 resulting from refinance activities (see Insurance and risk in force below).
PMI’s premiums earned increased in 2004 compared to 2003 due primarily to an increase in PMI’s average premium rate in 2004 and the release of $14.5 million of unearned premiums to earned premiums in the second half of 2004. The release of unearned premiums to earned premiums was caused by reported loan cancellations relating to a non-refundable, single premium policy executed in 2003. To a lesser extent, the increase in premiums earned was due to higher levels of risk in force in 2004 compared to 2003. The increase in premiums earned in 2004 compared to 2003 was partially offset by an adjustment to PMI’s unearned premiums in the first
quarter of 2003 that resulted in the recognition of $7.1 million of premiums earned. The decrease in premiums earned in 2003 compared to 2002 reflects higher levels of policy cancellations in 2003 as well as an increase in ceded premiums under captive reinsurance agreements.
During the second quarter of 2003, we assessed the reasonableness of our estimate of reserves for LAE. As a result of this assessment, we decreased PMI’s LAE reserves by approximately $14 million and reduced the allocation of claim related expenses from operating expenses to LAE. PMI’s case and incurred but not reported reserves were increased by approximately the same amount of the reduction to LAE reserves according to our best estimate for loss reserves as of June 30, 2003. (For a discussion of changes in net loss reserves, see Critical Accounting Policies and Estimates, Reserves for Losses and LAE, below.)
PMI’s loss ratio is the ratio of total losses and LAE to premiums earned. The increases in the loss ratio in 2004 and 2003 were primarily driven by increases in total losses and LAE. PMI’s expense ratio is the ratio of underwriting and operating expenses to net premiums written. The increase in PMI’s total underwriting and operating expenses, discussed above, primarily drove the increase in PMI’s expense ratios in 2004. The decline in PMI’s expense ratio in 2003 was attributable partly to the increase in net premiums written specific to a large single premium policy written in the fourth quarter of 2003. The expense ratio in 2002 included $9.3 million of expenses related to the relocation of our headquarters and a $12.2 million charge related to a litigation settlement. The combined ratio is the sum of the loss ratio and the expense ratio.
The decrease in PMI’s primary NIW in 2004 was driven primarily by lower volumes in the residential mortgage origination and mortgage insurance markets and, to a lesser extent, to reduced opportunities for bulk insurance writings. The mortgage insurance market and PMI’s NIW in 2004 were negatively impacted by the use of alternative mortgage products not requiring mortgage insurance by lenders. The increase in primary NIW in 2003 was driven by higher volumes of residential mortgage originations and refinance activities due to the historically low interest rate environment.
Primary insurance at the end of force in 2004 remained generally flat compared to 2003 although persistency did increase. The increase in persistency in 2004 was a result of the stabilization of interest rates during 2004. The increase in primary risk in force at December 31, 2004 compared to December 31, 2003 was the result of a higher percentage of policies with deeper coverage and higher persistency. The decreases in primary insurance in force and risk in force at December 31, 2003 compared to December 31, 2002 were primarily driven by higher policy cancellations. Low mortgage interest rates in 2003 and 2002 resulted in heavy mortgage refinancing activity, which caused PMI’s policy cancellations to increase and PMI’s policy persistency rate to decline.
Credit and portfolio characteristics-PMI insures less-than-A quality loans and Alt-A loans through all of its acquisition channels. PMI defines less-than-A quality loans to include loans with FICO scores generally less than 620. PMI considers a loan Alt-A if it has a FICO score of 620 or greater and has certain characteristics such as reduced documentation verifying the borrower’s income, assets, deposit information and/or employment. The following table presents PMI’s less-than-A quality loans and Alt-A loans as percentages of its flow channel and bulk channel primary NIW for the years ended:
We expect higher default rates and claim payment rates for high LTV loans, ARMs, less-than-A quality loans and Alt-A loans and incorporate these assumptions into our pricing. In 2004, PMI’s average premium rate increased primarily as a result of PMI’s primary portfolio containing higher percentages of ARMs and high LTV loans. PMI offers pre- and post-purchase borrower counseling to borrowers with high LTV loans in an effort to reduce the risk of default on those loans. PMI also believes that the structure of its modified pool products mitigates the risk of loss to PMI from the less-than-A quality loans and Alt-A loans insured by those products.
International Operations’ net income increased in 2004 compared to 2003 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 increase in net income in 2003 compared to 2002 was primarily due to increases in PMI Australia’s and PMI Europe’s premiums earned, an $8 million reduction in loss reserves by PMI Australia in 2003, and favorable currency exchange rate appreciation in both the Australian dollar and Euro versus the U.S. dollar.
The increase in PMI Australia’s net income in 2004 compared to 2003 was due primarily to increased premiums written and earned, higher investment income and the appreciation of the Australian dollar in 2004, offset by increased underwriting and operating expenses and the reserve reversal in 2003. The increase in PMI Australia’s net income in 2003 compared to 2002 was attributable to a decrease in losses and LAE and an increase in premiums written and earned. The average annual AUD/USD currency exchange rate was 0.7370 in 2004 compared to 0.6529 in 2003 and 0.5440 in 2002. The change in the average AUD/USD currency exchange
rates from 2003 to 2004 and 2002 to 2003 favorably impacted PMI Australia’s net income by $8.7 million and $10.6 million, respectively. This foreign currency translation impact is calculated using the 2004 change in the average monthly exchange rate to the current year ending net income in the local currency.
In April 2004, PMI Australia purchased foreign currency put options for the purpose of hedging 2004 net income against a potential strengthening of the U.S. dollar relative to the Australian dollar. These options, with a total pre-tax cost of $1.0 million, expired at the end of 2004. PMI Australia recognized net losses of $0.6 million related to these purchased options in 2004. In January 2005, PMI Australia purchased foreign currency put options at a total pre-tax cost of $1.6 million for the purpose of hedging 2005 net income against a strengthening U.S. dollar.
Primary NIW and risk in force-PMI Australia’s primary NIW includes flow channel insurance and insurance on residential mortgage-backed securities, or RMBS. In Australia, an active securitization market exists due in part to the relative absence of government sponsorship of the mortgage market. RMBS transactions include insurance on seasoned portfolios comprised of prime credit quality loans that have LTVs often below 80%. The following table presents the components of PMI Australia’s primary NIW, insurance in force and risk in force for the years ended:
The significant increase in RMBS insurance written in 2004 compared to 2003 reflects increased securitization activity in the Australian market and the fact that there are only two market participants providing mortgage insurance for RMBS in the Australian market. Levels of activity in the Australian RMBS market can vary from quarter to quarter. Flow insurance written in 2004 increased slightly from 2003 due primarily to currency appreciation. The strong level of residential mortgage origination activity in 2003 moderated in 2004 primarily due to interest rate increases in late 2003 and home price appreciation, both of which have affected housing affordability.
The increases in PMI Europe’s net income in 2004 compared to 2003 and 2002 were primarily due to PMI Europe’s fourth quarter 2003 acquisition of a portion of the U.K. lenders’ mortgage insurance portfolio of R&SA and the positive performance associated with PMI Europe’s various credit default swaps.
The reported results of PMI Europe were favorably affected by the appreciation of the Euro in 2004. The average Euro/USD currency exchange rate was 1.2443 compared to 1.1329 in 2003 and 0.9461 in 2002. The changes in the average Euro/USD currency exchange rates from 2003 to 2004 and 2002 to 2003 favorably impacted PMI Europe’s net income by $1.5 million and $2.1 million, respectively. This foreign currency translation impact is calculated using the year over year change in the average monthly exchange rate to the current period ending net income in the local currency. In June 2004, PMI Europe purchased foreign currency put options for the purpose of hedging 2004 net income against a strengthening U.S. dollar relative to the Euro. These options, with a total cost of $0.1 million, expired at the end of 2004. PMI Europe recognized net losses of $0.1 million related to these purchased options. In January 2005, PMI Europe purchased foreign currency put options at a total pre-tax cost of $0.2 million for the purpose of hedging 2005 net income against a strengthening U.S. dollar.
Premiums earned-The increases in premiums earned in 2004 and 2003 were due primarily to the acquisition of a portion of the U.K. lenders’ mortgage insurance portfolio of R&SA in the fourth quarter of 2003. The portfolio covers approximately $15 billion of original insured principal balance. R&SA transferred all loss reserves and unearned premium reserves associated with the portfolio to PMI Europe totaling $55 million, of which $47 million was unearned premium reserves. R&SA has also agreed to provide excess-of-loss reinsurance to PMI Europe with respect to the portfolio under certain conditions.
Net investment income-PMI Europe’s net investment income consists primarily of interest income from its investment portfolio, and to a lesser extent, gains and losses on foreign currency re-measurement, realized investment gains and losses from investment activity and foreign currency exchange gains and losses when investments are sold. Net investment income increased in 2004 and 2003 due primarily to the growth of the investment portfolio. PMI Europe’s investment portfolio, including cash and cash equivalents, as of December 31, 2004 was $229.3 million, compared to $194.4 million as of December 31, 2003 and $94.2 million as of December 31, 2002. The growth of the investment portfolio from the previous year was primarily driven by cash received in connection with the R&SA portfolio acquisition, positive cash flows from operations and the appreciation of the Euro relative to the U.S. dollar. The pre-tax book yield remained constant at 4.5% at December 31, 2004 and 2003, and was 4.7% at December 31, 2002. PMI Europe incurred net realized investment gains of $0.5 million in 2004 compared with $0.5 million net realized investment gains in 2003, and $1.6 million net realized investment losses in 2002.
Other income-PMI Europe is currently a party to four transactions that are classified as derivatives. As of December 31, 2004, $6.6 million of deferred gains related to initial fair value were included in other liabilities and $1.3 million of accretion from deferred gains were included in other income in 2004. Subsequent changes in the value from prior periods, exclusive of accretion, of such derivative contracts resulted in $5.6 million of gains in 2004, which were included in PMI Europe’s other income. The primary driver related to these subsequent changes in derivative values was fewer claim payments than had been previously projected. We believe claim payments will increase in the future for certain of PMI Europe’s larger derivative contracts and have incorporated this assumption into cash flow models that are used to determine the fair value of these derivatives. PMI Europe’s German risk portfolio has exhibited more defaults than originally anticipated; however, ultimate losses on this portfolio to date have been lower than expected.
Losses and LAE-Losses and LAE performance in 2004 continued to be favorable. PMI Europe increased its loss reserves by $1.0 million in 2004 primarily as a result of additional reserves posted for non-derivative accounted credit default swap transactions. Claims paid totaled $1.0 million in 2004, $0.8 million in 2003, and no claims were paid in 2002.
Underwriting and operating expenses-The increase in underwriting and operating expenses in 2004 compared to 2003 and 2002 was due primarily to profit commission accruals due to better than expected claims experience on the R&SA portfolio and to increases in staff and costs associated with expansion efforts. Under the terms of PMI Europe’s agreement with R&SA with respect to the acquired mortgage insurance portfolio, PMI Europe and R&SA share certain economic benefits if the portfolio’s loss performance performs to certain target levels. Due to better than expected loss experience on the R&SA portfolio, we anticipate increased profit commission accruals in 2005.
Risk in force-As of December 31, 2004, PMI Europe had assumed $2.4 billion of risk on $25.1 billion of mortgages on properties in the United Kingdom, and $0.4 billion of risk on $9.3 billion of mortgages on properties in Germany and the Netherlands. As of December 31, 2004, $2.1 billion of PMI Europe’s $2.8 billion of assumed risk was first loss default.
We completed our acquisition of a 42.1% equity ownership interest in FGIC Corporation on December 18, 2003. Accordingly, our consolidated results of operations do not reflect any results of FGIC Corporation prior to
As a result of the sale of FGIC Corporation on December 18, 2003, purchase accounting adjustments were made to FGIC Corporation’s consolidated balance sheet as of December 18, 2003 and are reflected in its consolidated results of operations subsequent to that date. As a result of the effect of these adjustments being included in FGIC’s results, net income and other line items (as discussed below) may not be comparable period over period. All 2003 results discussed below refer to FGIC’s full-year, combined results.
FGIC Corporation recorded interest expense of $14.9 million in 2004 related to $325.0 million in senior notes issued in 2004. The senior notes are due January 15, 2034, accrue interest at 6% per annum and are paid semiannually.
The increase in equity in earnings from RAM Re in 2004 compared to 2003 was largely due to increases in premiums earned and investment income in 2004. The equity in earnings from RAM Re for 2003 were unchanged compared to 2002 as a result of RAM Re’s $6.0 million increase to its provisions for losses and $1.9 million of other-than-temporary impairment to its investment portfolio, offset by an increase in RAM Re’s premiums earned in 2003. In 2003, we invested $24.4 million of a total of $92 million of additional capital raised by RAM Re. Our ownership interest percentage as a result of this capital investment remained unchanged.
The change in our Other segment’s net loss in 2004 compared to 2003 was primarily due to the gain on our sale of APTIC and equity in earnings from SPS in 2004, offset by a realized capital loss on SPS in 2004, reductions in income from APTIC in 2004, and reduced fee income from contract underwriting in 2004. The net loss of $35.1 million in 2003 compared to net income of $14.3 million in 2002 was primarily the result of losses at SPS and increases in contract underwriting remedy expenses, partially offset by increased net income from APTIC which was classified as discontinued operations due to its pending sale.
Equity in earnings from SPS was $0.4 million in 2004 compared to a $17.7 million loss and $22.4 million in earnings in 2003 and 2002, respectively. 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, discussed below. Our proportionate share of such aggregate expenses was $19.1 million pre-tax and $17.8 million after tax. The decrease in equity in earnings in 2003 compared to 2002 was due primarily to SPS’ losses, our proportionate share of which was $17.7 million pre-tax in 2003.
As a result of rating agency downgrades in 2003, Select Portfolio Servicing was unable to be named as a primary servicer on newly issued RMBS transactions rated by Moody’s Investors Service, or Moody’s, and Standard & Poor’s Rating Service, or S&P. On April 28, 2004, Moody’s raised Select Portfolio Servicing’s servicer ratings from SQ4 (“below average”) to SQ3 (“average”). On May 7, 2004, S&P raised Select Portfolio Servicing’s servicer ratings from “below average” to “average.” While Select Portfolio Servicing is now able to be named as primary servicer on newly issued RMBS transactions rated by S&P and/or Moody’s, several of its competitors maintain servicer ratings that are higher than “average.” On March 4, 2005, Fitch upgraded Select
Our ability to raise additional funds for these purposes will be dependent on our ability to access the debt or equity markets and/or cause our insurance subsidiaries to pay dividends, subject to rating agency and insurance regulatory considerations and risk-to-capital limitations.
U.S. Mortgage Insurance Operations Liquidity-The principal uses of the U.S. Mortgage Insurance Operations’ liquidity are the payment of operating expenses, claim payments, taxes, dividends to The PMI Group and the growth of its investment portfolio. We believe that the U.S. Mortgage Insurance Operations’ operating liquidity needs can be funded exclusively from its operating cash flows. The principal sources of U.S. Mortgage Insurance Operations’ liquidity are written premiums and net investment income.
In December 2004, the PMI Group entered into a five-year $175 million revolving credit facility that can be utilized for working capital, capital expenditures and other business purposes. The facility may be increased to $200 million at the Company’s request subject to approval by the lenders. The credit facility contains certain financial covenants and restrictions, including a debt-to-capital ratio threshold and a risk-to-capital ratio threshold of 23 to 1. The PMI Group was in compliance with all debt covenants for the year ended December 31, 2004. There are no amounts outstanding related to this facility.
PMI’s ability to pay dividends to The PMI Group is affected by state insurance laws, credit agreements, credit rating agencies and the discretion of insurance regulatory authorities. The laws of Arizona, PMI’s state of domicile for insurance regulatory purposes, provide that PMI may pay out of any available surplus account, without prior approval of the Director of the Arizona Department of Insurance, during any 12-month period in an amount not to exceed the lesser of 10% of policyholders’ surplus as of the preceding year end or the last calendar year’s investment income. A dividend that exceeds the foregoing threshold is deemed an “extraordinary dividend” and requires the prior approval of the Director of the Arizona Department of Insurance. On June 23, 2004, the Director of the Arizona Department of Insurance approved PMI’s extraordinary dividend request of $150 million, and this dividend was paid to The PMI Group in July 2004. No further dividends may be paid by PMI prior to July 15, 2005 without the prior approval of the Director of the Arizona Department of Insurance. In addition, APTIC paid $13.0 million in dividends to The PMI Group in the first quarter of 2004 prior to our sale of APTIC.
reserves for losses and LAE as of December 31, 2004 shown below are estimates and may ultimately be greater or less than the amounts shown. They 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, $292.2 million of scheduled interest and $19.0 million of contract adjustment payments related to our equity units.
Net investment income increased in 2004 compared to 2003 primarily due to growth in our investment portfolio. Net investment income increased in 2003 compared to 2002 primarily due to growth in our investment portfolio and $10.3 million in pre-tax adjustments in 2003 to reflect the appropriate accounting treatment related to the accretion of discounts and call premiums on bonds that have been called for early redemption. Our pre-tax book yield was 5.07% at December 31, 2004, down from 5.38% at December 31, 2003, and 5.56% at December 31, 2002. The decreases reflect the lower interest rate environment. The decrease in the book yield for 2003 also reflects our higher cash positions in anticipation of our liquidity needs related to the FGIC acquisition.
The components of net realized investment gains and losses are presented in the following table.
The following table presents the components of accumulated other comprehensive income:
The terms of the 2.50% Senior Convertible Debentures due July 15, 2021 provide that the holders of the debentures may require The PMI Group to repurchase outstanding debentures on July 15, 2006, 2008, 2011 and 2016 at a purchase price equal to the principal amount of the debentures to be repurchased plus accrued and unpaid interest. Instead of paying the purchase price in cash, we may pay all or a portion of the purchase price in common stock, valued at 97.5% of the average sale price of the common stock over a specified period, provided that the shares of common stock to be issued are registered under the Securities Act, if required. On July 15, 2004, certain debenture holders required us to repurchase a nominal amount of the debentures. We have the option to 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. In addition, the debentures may be converted into common stock at the debenture holder’s option, prior to stated maturity, if specified requirements are met (See Item 8. Financial Statements and Supplementary Data-Note 11. Long-Term Debt and Line of Credit). Due to the common stock 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. In 2004, we included the dilutive effect of CoCo’s 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 used in investing activities, including purchases and sales of investments, investments in unconsolidated subsidiaries, and capital expenditures, was $411.8 million in 2004 and $1,010.7 million in 2003. This decrease was due primarily to our investment in 2003 in FGIC of approximately $611 million.
Under certain circumstances, when we make an underwriting error in the course of providing contract underwriting services to a customer, we issue to the customer a loan indemnification. Such an indemnification is in lieu of paying a monetary remedy to the customer at the time the underwriting error is discovered and is usually issued on a loan by loan basis. While the terms of the indemnifications vary, each indemnification generally requires us to reimburse the customer for any costs (excess of insurance recoverables) it incurs as a result of the borrower’s default on the loan in question. If the indemnified loan remains current, or is repaid or refinanced, we have no actual liability under the indemnification. As of December 31, 2004, we estimate that the total principal balance of indemnified loans was between approximately $70 million and $90 million. We believe a number of factors will cause our contingent liability with respect to these indemnifications to be significantly lower than this amount. These factors include the following: (i) we generally only indemnify performing loans; (ii) we expect only a small portion of the indemnified loans to default; (iii) loans in default may not cause our customers to incur losses due to home appreciation; and (iv) we expect a portion of these loans to be refinanced, or their indemnification coverage to expire. In 2004, we paid customers $1.4 million pursuant to loan indemnifications compared to approximately $2.5 million in 2003. These amounts are included in our expenses associated with contract underwriting remedies.
The rating agencies have assigned the following ratings to The PMI Group and certain of its wholly-owned subsidiaries:
Determinations of ratings by the rating agencies are affected by a variety of factors, including macroeconomic conditions, economic conditions affecting the mortgage insurance industry, changes in regulatory conditions that may affect demand for mortgage insurance, competition, and the need for us to make capital contributions to our subsidiaries and underwriting and investment losses.
“Management’s Discussion and Analysis of Financial Condition and Results of Operation,” as well as disclosures included elsewhere in this Annual Report on Form 10-K, are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosure of contingencies. Actual results may differ significantly from these estimates. We believe that the following critical accounting policies involved significant judgments and estimates used in the preparation of our consolidated financial statements.
We establish reserves for losses and LAE to recognize the liability of unpaid losses related to insured mortgages that are in default. We do not rely on a single estimate to determine our loss reserves. To ensure the reasonableness of our ultimate estimates, we develop scenarios using generally recognized actuarial projection methodologies that result in various possible outcomes of losses and LAE. Based on these scenarios and other considerations, our actuaries determine a reasonable range which assists in determining a best estimate. Our best estimate with respect to our consolidated loss and LAE reserves was approximately the midpoint of our actuarially determined range at December 31, 2004.
Changes in loss reserves can materially affect our consolidated net income. The process of reserving losses requires us to forecast the interest rate, employment and housing market environments, which are highly uncertain. Therefore, the process requires significant management judgment. 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.
U.S. Mortgage Insurance Operations-We establish PMI’s reserves for losses and LAE based upon our estimate of unpaid losses and LAE on (i) reported mortgage loans in default and (ii) estimated defaults incurred but not reported to PMI by its customers. As of December 31, 2004, our actuaries determined that PMI’s reasonable range of loss and LAE reserves was $300.0 million to $379.8 million compared to $285.3 million to $362.9 million as of December 31, 2003. As of December 31, 2004 and 2003, PMI’s reserves for losses and LAE (gross of reinsurance recoverables) were $338.6 million and $325.3 million, respectively, which represented our best estimates and approximately the midpoints of the actuarial ranges of loss. We believe the amounts recorded represent the most likely outcome within the actuarial ranges.
The table below provides a reconciliation of our U.S. Mortgage Insurance segment’s beginning and ending reserves for losses and LAE for each of the last three years:
The following table shows a breakdown of loss reserves by primary and pool insurance for the years ended:
These sensitivities are hypothetical and should be viewed in that light. For example, the relationship of a change in assumption relating to future average claim size, claim rate or cost of claims settlement to the change in value may not be linear. Also, the effect of a variation in a particular assumption on the value of the loss and LAE reserves is calculated without changing any other assumption. Changes in one factor may result in changes in another which might magnify or counteract the sensitivities. Changes in factors such as persistency or cure rates can also affect the actual losses incurred. To the extent persistency increases and assuming all other variables remain constant, the absolute dollars of claims paid will increase as insurance in force will remain in place longer, thereby generating a higher potential for future incidences of loss. Conversely, if persistency were to decline, absolute claim payments would decline. In addition, changes in cure rates would positively or negatively affect total losses if rates increases or decreased, respectively.
The following table shows our investments’ gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2004.
Our policy acquisition costs are those costs that vary with, and are primarily related to, our acquisition, underwriting and processing of new mortgage insurance policies, including contract underwriting and sales related activities. To the extent that we are compensated by customers for contract underwriting, those underwriting costs are not deferred. We defer policy acquisition costs when incurred and amortize these costs in proportion to estimated gross profits for each policy year by type of insurance contract (i.e. monthly, annual and single premium). The amortization estimates for each underwriting year are monitored regularly to reflect actual experience and any changes to persistency or loss development by type of insurance contract. The rate of amortization is not adjusted for monthly and annual policy cancellations unless it is determined that the policy cancellations are of such magnitude that the recoverability of the deferred costs is not probable. Generally, in order for policy cancellations to create an impairment of policy acquisition costs related to our monthly and annual products, we estimate that, due principally to scheduled amortization, our annual cancellation rate would need to exceed 60% before it would become probable that deferred policy costs associated with PMI’s monthly and annual premium policies would not be recoverable. Since 1993, PMI’s highest annual cancellation rate was 56% which occurred in 2003. No impairment for monthly or annual policies was recognized for that year. The deferred costs related to single premium policies are adjusted as appropriate for policy cancellations to be consistent with our revenue recognition policy. We review our estimation process, specifically related to single premium policies, on a regular basis and any adjustments made to the estimates are reflected in the current period’s consolidated net income. Deferred policy acquisition costs are reviewed periodically to determine that they do not exceed recoverable amounts, after considering investment income.
As of December 31, 2004, our total investment in SPS was $126.2 million and consisted of $109.5 million book value of our equity investment and $16.7 million of related party receivables which are presently current. Included in the $109.5 million carrying value of SPS is a $6.5 million component of goodwill which represents the excess of our cost basis over our ownership percentage of SPS’s net book value as of December 31, 2004. Pursuant to the Summary of Terms with CSFB described above, the remaining balance of our $16.7 million related party receivable will be payable in full at closing if CSFB exercises its option to purchase our shares in SPS. In the event CSFB exercises its option, we expect, based on December 31, 2004 book values, to receive $69.7 million in cash at closing exclusive of our related party receivable. The remaining carrying value of SPS of $39.8 million would be received over time through 2007 with cash flows generated from certain mortgage servicing assets held by SPS. To the extent the net book value of SPS changes prior to CSFB exercising its option or the carrying value of SPS changes post-closing, the above cash flows could increase or decrease.
The GSEs are the principal beneficiaries of PMI’s mortgage insurance policies and a decline in the number of low down payment mortgage loans originated that are purchased or securitized by the GSEs could adversely affect PMI’s revenues. The GSEs’ loss of market share in 2004 was due in part to a higher percentage of ARMs, loans with interest only payments and less-than-A quality loans originated in 2004 compared to 2003. Such loans are generally either retained by loan originators and not sold to the GSEs or are placed in mortgage-backed securities that are privately issued and not guaranteed by the GSEs.
A significant percentage of the premiums PMI earns each year is generated from insurance policies written in previous years. As a result, a decrease in the length of time that PMI’s policies remain in force could cause our revenues to decline. Factors that lead to borrowers canceling their mortgage insurance include: current mortgage interest rates falling below the rates on the mortgages underlying PMI’s insurance in force, which frequently results in borrowers refinancing their mortgages; and appreciation in the values of the homes underlying the mortgages PMI insures.
If mortgage lenders and investors select alternatives to private mortgage insurance, such as piggyback loans, the amount of insurance that PMI writes could decline, which could reduce our revenues and profits.
member institutions providing credit enhancement on loans sold to a Federal Home Loan Bank, or FHLB;
Although the FHLBs are not required to purchase insurance for mortgage loans, they currently use mortgage insurance on substantially all mortgage loans with a loan-to-value ratio above 80%. If the FHLBs were to purchase uninsured mortgage loans or increase the loan-to-value ratio threshold above which they require mortgage insurance, the market for mortgage insurance could decrease, and we could be adversely affected.
The risk-based capital rule applicable to the GSEs may allow large financial entities such as banks, financial guarantors, insurance companies and brokerage firms to provide or arrange for products that may efficiently substitute for some of the capital relief provided to the GSEs by private mortgage insurance. Our consolidated financial condition and results of operations could be harmed if the GSEs were to use these products in lieu of mortgage insurance. See also “Legislation and regulatory changes, including changes impacting the GSEs, could significantly affect PMI’s business and could reduce demand for private mortgage insurance” and “The implementation of new eligibility guidelines adopted by Fannie Mae could harm our profitability and reduce our operational flexibility,” below.
Since PMI generally cannot cancel mortgage insurance policies or adjust renewal premiums, unanticipated claims could cause our financial performance to suffer.
PMI’s primary risk in force includes mortgage loans with high loan-to-value ratios and adjustable rate mortgages, which generally result in more claims than mortgage loans with lower loan-to-value ratios and fixed rate mortgages.
A significant percentage of PMI’s new insurance written is underwritten pursuant to a delegated underwriting program under which certain mortgage lenders may determine whether mortgage loans meet PMI’s program guidelines and commit us to issue mortgage insurance. We may expand the availability of delegated underwriting to additional customers. If an approved lender commits us to insure a mortgage loan, PMI generally
If we fail to properly underwrite mortgage loans when we provide contract underwriting services, we may be required to provide monetary and other remedies to the customer. In addition, we may not be able to recruit a sufficient number of qualified underwriting personnel.
Our subsidiary MSC provides contract underwriting services for a fee. As a part of the contract underwriting services, MSC provides monetary and other remedies to its customers in the event that it fails to properly underwrite a mortgage loan. As a result, we assume credit and, to a lesser extent, interest rate risk in connection with our contract underwriting services. Generally, the scope of the remedies provided by MSC is in addition to those contained in PMI’s master policies. Contract underwriting services apply to a significant percentage of PMI’s insurance in force and the costs relating to the investigation and/or provision of remedies could have a material adverse effect on our consolidated financial condition and results of operations. Worsening economic conditions or other factors that could increase PMI’s default rate could also cause the number and severity of remedies to increase.
The Office of Federal Housing Enterprise Oversight, or OFHEO, has issued a risk-based capital rule that treats credit enhancements issued by private mortgage insurance companies with claims-paying ability ratings of “AAA” more favorably than those issued by private mortgage insurance companies with “AA” ratings. PMI Mortgage Insurance Co. has been assigned financial strength ratings of “AA” by S&P, “AA+” by Fitch and “Aa2” by Moody’s. The rule also provides capital guidelines for Fannie Mae and Freddie Mac, or the GSEs, in connection with their use of other types of credit protection counterparties in addition to mortgage insurers. Although it has not occurred to date, if the rule resulted in the GSEs increasing their use of either “AAA” rated mortgage insurers instead of “AA” rated entities or credit protection counterparties other than mortgage insurers, our consolidated financial condition and results of operations could be adversely affected.
Mortgage origination transactions are subject to compliance with various federal and state consumer protection laws, including the Real Estate Settlement Procedures Act of 1974, or RESPA, the Equal Credit
Lobbying activities by large mortgage lenders calling for expanded federal oversight and legislation relating to the role of the GSEs in the secondary mortgage market could damage PMI’s relationships with those mortgage lenders and the GSEs.
The GSEs, mortgage lenders and PMI jointly develop and make available various products and programs. These arrangements involve the purchase of PMI’s mortgage insurance products and frequently feature cooperative arrangements between the parties. FM Policy Focus, a lobbying organization representing financial services and housing-related trade associations, including the Mortgage Insurance Companies of America, supports increased federal oversight of the GSEs. The GSEs have criticized the activities of FM Policy Focus. FM Policy Focus, the GSEs and other groups are engaged in extensive lobbying activities with respect to the legislation pending in Congress that would change the way GSEs are regulated. These activities could polarize Fannie Mae, Freddie Mac, members of FM Policy Focus, PMI’s customers and us. Any such polarization could limit PMI’s opportunities to do business with the GSEs as well as with some mortgage lenders. Either of these outcomes could harm our consolidated financial condition and results of operations.
Fannie Mae has revised its approval requirements for mortgage insurers, including PMI, with new guidelines for borrower-paid and lender-paid mortgage insurance. These requirements became effective for PMI on January 1, 2005. The guidelines cover substantially all areas of PMI’s mortgage insurance operations, require the disclosure of certain activities and new products, give Fannie Mae the right to purchase mortgage insurance from other than existing approved mortgage insurers, including insurers that are either rated below “AA” or are unrated, and provide Fannie Mae with increased rights to revise the eligibility standards of insurers. We do not know how Fannie Mae will enforce the terms of the guidelines, especially in those areas in which it has retained significant discretion, such as the right to approve mortgage insurers with lesser qualifications, and to purchase mortgage insurance or other credit enhancements directly from entities not subject to the guidelines. Depending on how the guidelines are implemented, our operational flexibility as well as our profitability could suffer.
Our business and financial performance could suffer if PMI were to lose the business of a major customer.
Through their various origination channels, PMI’s top ten customers accounted for 42.0% of PMI’s premiums earned in 2004. A single customer represented 8.3% of PMI’s earned premiums in 2004. Mortgage insurers, including PMI, may acquire significant percentages of their business through negotiated transactions (including bulk primary insurance, modified pool insurance and captive reinsurance) with a limited number of customers. The loss of a significant customer could reduce our revenue, and if not replaced, harm our consolidated financial condition and results of operations.
The mortgage insurance industry and PMI face litigation and regulatory risk in the ordinary course of operations, including the risk of class action lawsuits. Consumers are bringing a growing number of lawsuits against home mortgage lenders and settlement service providers and in recent years mortgage insurers, including PMI, have been involved in litigation alleging violations of the Real Estate Settlement Procedures Act, or RESPA, and the Fair Credit Reporting Act. In the future, PMI could become subject to class actions and individual suits and plaintiffs in such lawsuits could seek large or indeterminate amounts, including punitive damages, which may remain unknown for substantial periods of time.
supervisory agencies and officials to examine and investigate insurance companies and to enforce rules or exercise discretion touching almost every aspect of PMI’s business. Recently, the insurance industry has become the focus of increased scrutiny by regulatory and law enforcement authorities concerning certain practices. Increased federal or state regulatory scrutiny could lead to new legal precedents, new regulations or new practices, or regulatory actions or investigations, that could adversely affect PMI’s business and its financial condition and results of operation.
RESPA precludes PMI from providing services or products to mortgage lenders free of charge, charging fees for services that are lower than their reasonable or fair market value, and paying fees for services that others provide that are higher than their reasonable or fair market value, in exchange for the referral of settlement services. A number of lawsuits have challenged the actions of private mortgage insurers, including PMI, under RESPA, alleging that the insurers have provided products or services at improperly reduced prices in return for the referral of mortgage insurance. We cannot predict whether civil, regulatory or criminal actions might be brought against us or other mortgage insurers. Any such proceedings could have an adverse effect on our consolidated financial condition and results of operations.
We are a holding company and conduct all of our business operations through our subsidiaries. Our principal sources of funds are dividends from our subsidiaries and funds that may be raised from time to time in the capital markets. Factors that may affect our ability to maintain and meet our capital and liquidity needs as well as to pay dividends to our shareholders include: the level and severity of claims experienced by our insurance subsidiaries; the performance of the financial markets; standards and factors used by various credit rating agencies; financial covenants in our credit agreements; and standards imposed by state insurance regulators relating to the payment of dividends by insurance companies.
Like PMI, the financial results of our Australian and New Zealand mortgage insurance operations, or PMI Australia, are affected by domestic and regional economic conditions, including movements in interest and unemployment rates, and property value fluctuations. These economic factors could impact PMI Australia’s loss experience or the demand for mortgage insurance in the markets PMI Australia serves. PMI Australia is also subject to significant regulation. Future legislative or regulatory changes could adversely affect PMI Australia. PMI Australia’s primary regulator, the Australian Prudential Regulation Authority, or APRA, is considering, and has sought comment on proposals to, among other things, increase the capital requirements for mortgage insurance companies, eliminate the requirement that mortgage insurers be mono-line insurers, and change the requirements for acceptable mortgage insurers. APRA’s latest proposals indicate that the capital requirements for mortgage insurers will be increased. If APRA ultimately determines to increase the amount of capital required for mortgage insurers, we may, depending on the amount of such increase, be required to increase the capital in PMI Australia. In addition, APRA’s latest proposals indicate that the monoline requirement will be retained, and that acceptable mortgage insurers for purposes of capital and risk relief for Australian regulated lenders is a mortgage insurer that is authorized by APRA or domiciled in a country considered by APRA to have comparable prudential regulations. APRA has indicated that it will implement the final regulations on October 1, 2005. We are not able to predict the impact of future regulations on PMI Australia’s competitive position, although the issuance of final regulations may make it easier for new competitors to enter the Australian market.
We may not be able to execute our strategy to expand our European operations.
We have made significant investments in the equity securities of several privately-held companies, including FGIC Corporation, the parent of FGIC, a financial guaranty insurer; SPS, the parent of Select Portfolio
Investigations by regulatory agencies into Select Portfolio Servicing’s activities and private litigation involving Select Portfolio Servicing could harm its business and adversely affect our investment in SPS.
In June 2003, Fannie Mae found certain business practices at Select Portfolio Servicing to be out of compliance with a servicing agreement between the parties. Select Portfolio Servicing and Fannie Mae have agreed that Select Portfolio Servicing will not service any new Fannie Mae-owned loans without the approval of Fannie Mae. However, since June 2003, Fannie Mae has continually renewed Select Portfolio Servicing’s right to service new Fannie Mae-owned loans, initially on a month to month basis and, more recently, in two-month intervals.
Pursuant to the Summary of Terms, the parties are currently negotiating a definitive option agreement with respect to CSFB’s option to acquire the outstanding SPS common stock. While we expect this definitive agreement to be executed by all parties, we cannot estimate the impact to our financial condition of a failure to consummate such agreement.
Select Portfolio Servicing has undergone ratings downgrades that have adversely affected its business and any future downgrade could seriously harm SPS and the value of our investment in SPS.
SPS is highly leveraged and, if it were to lose access to, or default on, its debt facilities, SPS might be unable to fund its operations or pay its debts as they come due.
SPS is highly leveraged and dependent upon debt facilities with lenders to make servicing and delinquency advances in the regular course of its business, and for other business purposes. If SPS were to lose access to debt facilities for any reason, SPS would be unable to continue funding its operations or pay its debts as they become due. In addition, an event of default under one or more of SPS’s significant debt facilities could accelerate SPS’s obligation to repay amounts outstanding under its debt facilities and could cause SPS to lose access to funding, either of which could prevent SPS from continuing to operate. If SPS were to cease operations, the value of our investment in SPS would be seriously harmed and we might be required to write off our entire investment in SPS.
As a significant portion of our net income is derived from FGIC and its financial guaranty business, we are subject to various risks and uncertainties associated with the financial guaranty business.
FGIC is subject to extensive competition from other monoline financial guaranty insurance companies, other providers of third party credit enhancement and providers of alternative transaction structures and executions that do not use financial guaranty insurance. We cannot be sure that FGIC will be able to continue to compete effectively in its current markets or in any markets or asset classes into which it expands.
Demand for financial guaranty insurance is constantly changing and is dependent upon a number of factors, including changes in interest rates, regulatory changes and supply of bond issues. A general reduction in demand for financial guaranty insurance could harm FGIC Corporation’s consolidated results of operations and business prospects.
The financial guaranty business is subject to extensive regulation. Future legislative, regulatory or judicial changes affecting the financial guaranty industry or public finance or structured finance markets, including changes in tax laws, could adversely affect FGIC’s business.
As of December 31, 2004, 8.3% of our U.S. investment portfolio consists of FGIC-insured non-refunded bonds. As a result of our investment in FGIC, we have amended our investment policy to provide that no more than 15% of our U.S. investment portfolio consists of FGIC-insured non-refunded bonds.
We have audited the accompanying consolidated balance sheets of The PMI Group, Inc. and subsidiaries, (the Company) as of December 31, 2004 and 2003, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2004. 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.
As of December 31, 2004, the Company adopted Emerging Issues Task Force Issue No. 04-8, The Effect of Contingently Convertible Instruments on Diluted Earnings per Share. This change in accounting principle was applied retroactively and required restatement of dilutive earnings per share for all periods presented. As of December 31, 2003, the Company adopted FASB Interpretation No. 46, Consolidation of Variable Interest Entities, as revised. Also, during the year ended December 31, 2002, the Company adopted Statement of Financial Accounting Standards No. 141, Business Combinations and No. 142, Goodwill and Other Intangible Assets. These matters are further discussed in Note 3 to the consolidated financial statements.
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, 2004, 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 3, 2005, expressed an unqualified opinion thereon.
We have audited management’s assessment, included in the accompanying report from management, that The PMI Group, Inc. maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). The PMI Group, Inc’s management is responsible for maintaining effective internal control over financial reporting and for its assessment about the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.
In our opinion, management’s assessment that The PMI Group, Inc. maintained effective internal control over financial reporting as of December 31, 2004, 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, 2004, based on the COSO criteria.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements of The PMI Group, Inc. and subsidiaries and our report, dated March 3, 2005, expressed an unqualified opinion thereon.
Risks and Uncertainties-The Company is dependent upon mortgage originators to provide mortgage loans to insure. In the event any of its largest customers choose to stop providing the Company with mortgage loans to insure, the Company’s ability to generate new insurance business could be adversely affected. The Company’s U.S. Mortgage Insurance Operations’ ten largest customers generated 42.0% and 42.1% of its premiums earned in 2004 and 2003, respectively.
The Company establishes loss reserves to recognize the liability of unpaid losses related to insured mortgages that are in default. These loss reserves are based upon the Company’s estimates of the claim rate and average claim amounts, as well as the estimated costs of settling claims. These estimates are regularly reviewed and updated using currently available information. Any adjustments due to positive or adverse developments, which may be material, resulting from these reviews would impact current reserve requirements. The Company’s reserves may not be adequate to cover ultimate loss development on incurred defaults. The Company’s consolidated financial condition, results of operations or cash flows could be seriously harmed if the Company’s reserve estimates are insufficient to cover the actual related claims paid and loss-related expenses incurred.
Investments-The Company has designated its entire portfolio of fixed income and equity securities as available-for-sale. These securities are recorded at fair value based on quoted market prices with unrealized gains and losses, net of deferred income taxes, accounted for as a component of accumulated other comprehensive income in shareholders’ equity. The Company evaluates its investments regularly to determine whether there are declines in value and whether such declines meet the definition of other-than-temporary impairment in accordance with SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities and SEC Staff Accounting Bulletin No. 59, Accounting for Noncurrent Marketable Equity Securities. The fair value of a security below cost or amortized cost for consecutive quarters is a potential indicator of an other-than-temporary impairment. When the Company determines a security has suffered an other-than-temporary impairment, the impairment loss is recognized, to the extent of the decline, as a realized investment loss in the current period’s earnings.
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 Corporation, SPS and CMG on a current month basis, and RAM Re and the Company’s interest in limited partnerships on a one-quarter lag basis. 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 represents 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 portfolio.
In 2004, the Company reclassified its equity investment in SPS to equity investment held for sale as a result of the Summary of Terms entered into with CSFB. Equity in earnings or losses from SPS is included in equity in earnings from unconsolidated subsidiaries for all periods presented. Although the Company’s ownership percentage of SPS exceeds 50%, the Company reports its investment in SPS using the equity method of accounting due to an agreement among the shareholders of SPS (the Shareholder Agreement) limiting the Company’s ability to control the operations of SPS. This treatment is in accordance with guidance provided by Emerging Issues Task Force Issue (“EITF”) No. 96-16, Investor’s Accounting for an Investee When the Investor Has a Majority of the Voting Interest but the Minority Shareholder or Shareholders Have Certain Approval or Veto Rights, (“EITF No. 96-16”). By operation of the Shareholder Agreement, the Company may designate three of the six SPS directors. The other non-management SPS shareholder may designate the other three directors. Further, the Shareholder Agreement requires that more than two-thirds of the SPS board of directors approve, among other things, the distribution of dividends by SPS, any SPS capital expenditure exceeding $250,000, and the adoption of SPS business plans or budgets. These and other supermajority provisions contained in the Shareholder Agreement constitute substantive participating rights as defined in EITF No. 96-16. These rights effectively prevent the Company from causing SPS to take actions that are significant in the ordinary course of its business without the prior approval of the minority shareholder and assure the minority shareholder of effectively participating in the significant decisions that must be taken by SPS in its ordinary course of business.
which would justify the carrying amount of the investment. Realized capital gains or losses resulting from the sale of the Company’s ownership interests of unconsolidated subsidiaries are recognized as net realized investment gains or losses in the consolidated statement of operations.
During the second quarter of 2004, the Company provided SPS with $19.7 million of a $40.0 million redress fund established pursuant to SPS’s settlement with the U.S. Federal Trade Commission (“FTC”) and the Department of Housing and Urban Development (“HUD”). In exchange for providing SPS with $19.7 million, the Company received from SPS a note in the amount of $19.7 million. In September 2004, the $19.7 million note along with accrued interest thereon, were exchanged by the Company for additional shares of common stock of SPS.
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 business 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 determined that the policy cancellations are of such magnitude that impairment of the deferred costs is probable. The deferred costs related to single premium policies are adjusted as appropriate for policy cancellations to be consistent with the Company’s revenue recognition policy. The amortization estimates for each underwriting year are monitored regularly to reflect actual experience and any changes to persistency or loss development. Deferred policy acquisition costs are reviewed periodically to determine that they do not exceed recoverable amounts, after considering investment income.
As of December 31, 2004, PMI Europe had entered into four credit default swaps that were classified as derivatives in accordance with SFAS No. 149. Accordingly, initial fair value gains were deferred in accordance with EITF No. 02-3. As of December 31, 2004, $6.6 million of deferred gains related to the initial fair value of these derivatives were included in other liabilities compared to $3.8 million as of December 31, 2003. Included in other income were $1.3 million (pre-tax) and $0.1 million (pre-tax) of accretion from the deferred gains in 2004 and 2003, respectively. Subsequent changes in the value, exclusive of accretion, of such derivatives resulted in $5.6 million of gains (pre-tax) in 2004 and $0.6 million of losses (pre-tax) in 2003 which were included in other income.
In the second quarter of 2004, the Company purchased foreign currency put options to mitigate the negative financial impact of a strengthening U.S. dollar relative to both the Australian dollar and the Euro. These Australian dollar and Euro put options expired ratably over the calendar year 2004 and had a combined cost of $1.1 million. In 2004, the Company recorded a net loss of $0.7 million (pre-tax) in other income related to amortization of option costs, partially offset by realized gains of $0.4 million.
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 current period’s consolidated results of operations.
Revenue Recognition-Mortgage guarantee insurance policies are contracts that are generally non-cancelable by the insurer, are renewable at a fixed price, and provide payment of premiums on a monthly, annual or single basis. Upon renewal, the Company is not able to re-underwrite or re-price its policies. SFAS No. 60 specifically excludes mortgage guaranty insurance from its guidance relating to the earning of insurance premiums. Premiums written on a monthly basis are earned as coverage is provided. Monthly premiums accounted for 72.1% of gross premiums written from the Company’s mortgage insurance operations in 2004 and
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 PMI Mortgage Insurance Co., affiliated U.S. reinsurance companies and equity in earnings from CMG. International Operations include the results of PMI Australia, PMI Europe and the results of operations for Hong Kong. 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, 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 stock, or if contracts to issue common stock, 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.
Income Taxes-The Company accounts for income taxes using the liability method in accordance with SFAS No. 109, Accounting for Income Taxes. 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 statement of operations. The Company’s effective tax rate was 23.5% for 2004 compared to the federal statutory rate of 35.0%, due to equity in earnings from FGIC Corporation and income derived from PMI Australia, which have lower effective tax rates, combined with the Company’s municipal bond investment income. The effective tax rate for 2004 also reflects the reversal of a $4.7 million tax contingency reserve established by the Company in connection with assessments received from the California Franchise Tax Board that have been resolved favorably. Without this reversal, the effective tax rate for 2004 would have been 24.5%.
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 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 available to certain employees, and an Employee Stock Purchase Plan (“ESPP”) which 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 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 currencies are translated into functional currencies using either the year-end spot exchange rates or historical rates. Revenues and expenses are translated at monthly-average exchange rates. Gains and losses on 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. 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.
On September 30, 2004, the EITF issued FASB Staff Position EITF Issue No. 03-1-1, Effective Date of Paragraphs 10-20 of EITF Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, (“EITF No. 03-1-1”), which delayed the effective date of paragraphs 10 through 20 of EITF Issue No. 03-1 that provides guidance on how to evaluate and recognize an other-than-temporary impairment loss. The application of those paragraphs is deferred until additional implementation guidance is provided. EITF No. 03-1-1 is not currently expected to significantly impact the Company’s consolidated results of operations or consolidated financial condition.
On December 16, 2004, the FASB issued SFAS No. 123 (Revised 2004), Share-Based Payment, (“SFAS No. 123(R)”), which is a revision of SFAS No. 123. SFAS No. 123(R) supersedes APB No. 25 and amends SFAS No. 95, Statement of Cash Flows. Generally, the approach in SFAS No. 123(R) is similar to the approach described in SFAS No. 123. However, SFAS No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer allowed. SFAS No. 123(R) must be adopted for public companies at the beginning of the first interim or annual period beginning after June 15, 2005, or July 1, 2005 for the Company. Non-public companies will be required to adopt SFAS No. 123(R) at the beginning of the first annual period beginning after December 31, 2005. Early adoption will be permitted in periods in which financial statements have not yet been issued. The Company expects to adopt SFAS No. 123(R) on July 1, 2005. As permitted by
SFAS No. 123, the Company currently accounts for share-based payments to employees using APB No. 25’s intrinsic value method and, as such, generally recognizes no compensation cost for employee stock options. Accordingly, the adoption of SFAS No. 123(R)’s fair value method will have a significant impact on the Company’s consolidated results of operations, although it will have no impact on the Company’s overall consolidated financial position.
Scheduled Maturities-The following table sets forth the amortized cost and fair value of fixed income securities by contractual maturity at December 31, 2004:
Aging of Unrealized Losses-The following table shows the gross unrealized losses and fair value of the Company’s investments, aggregated by investment category and the length of time that individual securities have been in a continuous unrealized loss position as of December 31, 2004.
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 until such investments 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 securities in its investment portfolio met the definition of other-than-temporary impairment and recognized realized losses of $0.2 million, $0.3 million, and $6.9 million in 2004, 2003 and 2002, respectively.
At December 31, 2004, fixed income securities and short-term investments with a fair value of $15.9 million were on deposit with regulatory authorities as required by law. In addition, $19.4 million in cash was held in a bank in Hong Kong for statutory purposes.
As of December 31, 2004, the Company’s total investment in SPS was $126.2 million and consisted of $109.5 million carrying value of the Company’s equity investment and $16.7 million of related party receivables which are presently current. Included in the $109.5 million carrying value of SPS is a $6.5 million component of goodwill which represents the excess of the Company’s carrying value over the Company’s ownership
During 2004, the Company’s ownership percentage of SPS increased to 64.9% from 56.8%, primarily due to SPS’s repurchase of its common stock from three minority shareholders. The Company’s ownership percentage also increased in 2002 to 56.8% from 45.7%.
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 stock and equity units offering. The unaudited pro forma condensed combined statements of operations for the years ended December 31, 2003 and 2002 were prepared assuming these transactions were completed as of the first day of the periods presented.
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 debt and equity offering, 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 following table summarizes deferred policy acquisition cost activity as of and for the years ended:
Depreciation and amortization expense related to property, equipment and software totaled $27.5 million in 2004, $25.5 million in 2003 and $17.8 million in 2002. Capitalized costs associated with software developed for internal use were $29.5 million in 2004, $22.5 million in 2003 and $25.2 million in 2002.
In connection with relocating its corporate headquarters, the Company performed an evaluation of the estimated costs with respect to the relocation and recognized a $12.2 million pre-tax charge related to lease abandonment and relocation costs in 2002. The charge consisted of $8.3 million for the estimated loss on the abandonment of the lease obligations for the previous home office space, $1.7 million for the write-off of abandoned fixed assets, and $2.2 million for other relocation and employee retention expenses. As of December 31, 2004, the lease related to the abandoned property has expired.
The increase in loss reserves in 2004 over 2003 was due primarily to increases in the reserve balances in U.S. Mortgage Insurance Operations and in PMI Europe offset by a decrease in the reserve balance in PMI Australia. The reserve increase in U.S. Mortgage Insurance Operations was the result of expected higher proportions of delinquencies developing into claims as well as higher mortgage insurance coverage levels on pending delinquencies. This has led to higher expected average claim amounts. U.S. Mortgage Insurance Operations primary insurance default inventory was 39,054 at December 31, 2004, 37,445 at December 31, 2003 and 36,537 at December 31, 2002. The default rate was 4.86% at year end 2004, 4.53% at year end 2003, and 4.18% at year end 2002. Generally, it takes approximately 12 to 36 months from the receipt of a default notice to result in a claim payment. Accordingly, most losses paid relate to default notices received in prior years.
Mandatorily Redeemable Preferred Capital Securities and Junior Subordinated Deferrable Interest Debentures-In February 1997, The PMI Group, through a wholly-owned trust, privately issued $100.0 million of 8.309% mandatorily redeemable preferred Capital Securities, Series A (the “Capital Securities”). The Capital Securities were issued by PMI Capital I (“Issuer Trust”). The sole asset of the Issuer Trust consists of $103.1 million principal amount of Junior Subordinated Deferrable Interest Debentures, Series A (the “Junior Subordinated Debentures”) issued by The PMI Group to the Issuer Trust. The Junior Subordinated Debentures bear interest at the rate of 8.309% per annum paid semiannually and mature on February 1, 2027. In 2001, the Company repurchased $51.5 million of the Capital Securities. The Capital Securities are subject to mandatory redemption upon repayment of the Junior Subordinated Debentures by the Company. The Junior Debentures are redeemable at the option of the Company on or after February 1, 2007 at a premium or upon occurrence of certain tax events and mature on February 1, 2027. The Junior Subordinated Debentures are subordinated to all senior indebtedness of The PMI Group.
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.
Senior Notes-In November 1996, the Company issued $100.0 million in face amount of 6.75% senior notes (the “Notes”). As of December 31, 2004 and 2003, $63.0 million of face amount remained outstanding. The Notes bear interest at the rate of 6.75% per annum paid semiannually and mature on November 15, 2006. No sinking fund is required or provided for the Notes and are not redeemable prior to maturity. The Notes rank equally with all other senior unsecured debt securities of The PMI Group.
Revolving Credit Facility-In December 2004, the Company entered into a five-year $175.0 million revolving credit facility agreement with Bank of America, N.A. and a consortium of lenders. The interest rate is LIBOR plus a margin. The agreement provides the availability of additional liquidity and capital, which PMI can utilize for working capital, capital expenditures and other business purposes. The facility may be increased by $25.0 million to $200.0 million at the Company’s discretion subject to approval by the lenders. The credit facility contains certain financial covenants and restrictions, the most restrictive being debt-to-capital and risk-to-capital ratio thresholds. The Company was in compliance with all debt covenants for the year ended December 31, 2004. There were no amounts related to this facility outstanding as of December 31, 2004.
Section 832(e) of the Internal Revenue Code permits mortgage guaranty insurers to deduct, within certain limitations, additions to statutory contingency reserves. This provision allows mortgage guaranty insurers to increase statutory unassigned surplus through the purchase of non-interest bearing “tax and loss bonds” from the
federal government. The tax and loss bonds purchased are limited to the tax benefit of the deduction for additions to the contingency reserves. The Company purchased tax and loss bonds of $87.6 million in 2004, $67.8 million in 2003 and $106.1 million in 2002. The Company redeemed tax and loss bonds of $21.5 million in 2004. The purchase and redemption of tax and loss bonds are included as a deferred component of income tax expense.
The components of the income tax expense for 2004 included a foreign provision for current tax expense of $35.5 million and a deferred tax expense of $2.5 million primarily related to PMI Australia and PMI Europe.
Leases-The Company leases certain office space and office equipment. Minimum rental payments under non-cancelable operating leases in the aggregate for the five years subsequent to 2004 are as follows:
Rent expense for all leases was $7.0 million for 2004, $7.0 million for 2003 and $10.0 million for 2002.
Income Taxes-During 2002 and 2003, the Company received notices of assessment from the California Franchise Tax Board (“FTB”) for 1997 through 2000 in amounts totaling $13.9 million. The assessments were the result of a memorandum issued by the FTB in April 2002, which was based partly on the California Court of Appeals decision in Ceridian v. Franchise Tax Board. The memorandum issued by the FTB provided for the disallowance of the deduction for dividends received by holding companies from their insurance company
On September 29, 2004, the State of California enacted legislation that allows the deductibility of “qualifying dividends received” from a wholly-owned insurance company regardless of its domicile or the source of the insurance company’s income. This legislation permits an irrevocable election to take a deduction of 80% of “qualifying dividends received” for 1997 through 2003. The Company has made this election and, accordingly, has reversed the $4.7 million reserve established in connection with the FTB assessments. This reversal is reflected as a reduction in the Company’s consolidated income tax expense for the year ended 2004.
Guarantee-The PMI Group has guaranteed certain payments to the holders of the Capital Securities issued by PMI Capital I. Payments with respect to any accrued and unpaid distributions payable, the redemption amount of any Capital Securities that are called and amounts due upon an involuntary or voluntary termination, winding up or liquidation of the Issuer Trust are subject to the guarantee. In addition, the guarantee is irrevocable, is an unsecured obligation of the Company and is subordinate and junior in right of payment to all senior debt of the Company.
Common Stock-In November 2003 and in connection with the Company’s investment in FGIC, the Company issued 5.75 million shares of common stock and raised $219.7 million of gross proceeds in addition to 13.8 million equity units, disclosed in Note 11. Long-Term Debt and Line of Credit. Each equity unit consists of a senior note and a purchase contract. The purchase contract will obligate the holders to purchase, no later than November 15, 2006, shares of the Company’s common stock subject to anti-dilution adjustments. The number of shares of common stock which will be purchased depends upon the 20-trading day average closing price at the date of purchase adjusted by changes in the Company’s common stock dividend rate. As of December 31, 2004, the maximum and minimum settlement rates of the Company’s common stock that can be purchased were 0.6547 and 0.5280 shares per purchase contract, respectively. The settlement rate per unit changed in comparison to prior periods as a result of an increase in the Company’s common stock dividend rate in 2004. The equity units contain a dividend protection provision whereby the settlement rate increases if the Company increases the common stock dividend rate relative to when the equity units were issued.
Dividends-PMI’s ability to pay dividends to The PMI Group is affected by state insurance laws, credit agreements, credit rating agencies and the discretion of insurance regulatory authorities. The laws of Arizona, PMI’s state of domicile for insurance regulatory purposes, provide that PMI may pay dividends out of any available surplus account, without prior approval of the Director of the Arizona Department of Insurance, during any 12-month period in an amount not to exceed the lesser of 10% of policyholders’ surplus as of the preceding year end or the prior calendar year’s net investment income. A dividend that exceeds the foregoing threshold is deemed an “extraordinary dividend” and requires the prior approval of the Director of the Arizona Department of Insurance.
On June 23, 2004, the Director of the Arizona Department of Insurance approved PMI’s extraordinary dividend request of $150 million, and this dividend was paid to The PMI Group in July 2004. No further dividends may be paid prior to July 2005 without the prior approval of the Director of the Arizona Department of Insurance. APTIC paid $13.0 million in dividends to The PMI Group in the first quarter of 2004 prior to the Company’s sale of APTIC. In 2003, following approval from the Director of the Arizona Department of Insurance, PMI declared and paid an extraordinary dividend of $100 million to The PMI Group. In addition, Residential Guaranty Co., one of the Company’s Arizona domiciled insurance subsidiaries, paid dividends to The PMI Group in the amount of $8.4 million, which it was able to pay as an ordinary dividend without prior permission from the Arizona Department of Insurance. In 2002, following receipt of approval from the Director, PMI declared and paid an extraordinary dividend of $100 million to The PMI Group. The dividend was paid in cash of $66 million and stock of SPS, as well as its limited partnership interest in Truman. The combined value of the stock of SPS and Truman at the time of the dividend was approximately $34 million. No dividends have been paid to PMI by our international subsidiaries in 2004, 2003 or 2002.
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
The Company provides certain health care and life insurance benefits for retired employees under another post-employment benefit plan (the “OPEB Plan”). Generally, qualified employees may become eligible for these benefits if they retire in accordance with the Company’s established retirement policy and are continuously insured under the Company’s group plans or other approved plans for ten or more years prior to retirement. The Company contributes a fixed dollar subsidy towards the cost of coverage. Retirees are expected to pay all amounts in excess of the Company’s fixed dollar subsidy. The Company assessed the impact on liabilities due to the Medical Prescription Drug, Improvement and Modernization Act of 2003 and determined that it is not material to our liability.
Savings and Profit Sharing Plans-All 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 $2.4 million for 2004, $3.1 million for 2003 and $2.8 million for 2002. 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 is $14.0 million as of December 31, 2004 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 stock 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, automatic, 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 stock on the grant date but each stock unit has an initial value equal to the fair market value of one share of common stock 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. During 2004, an additional 2,000,000 shares were authorized by the Board of Directors for future option grants. 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.
In October 2003, the Company announced that it had reached a definitive agreement to sell APTIC for $115.1 million in cash. In accordance with SFAS No. 144, the results of operations for APTIC were classified as discontinued operations for the fourth quarter of 2003 with prior periods adjusted for comparability. The Company recognized an after-tax gain of $30.1 million upon completion of the sale of APTIC on March 19, 2004. In December 2004, the Company reduced its gain on sale of APTIC by $1.1 million after tax related to the true-up of the Company’s pension liability due to settlement accounting triggered by the sale of APTIC as previously discussed in Note 17. Benefit Plans.
The assets and liabilities of APTIC as of December 31, 2003 were as follows:
Transactions between segments are not deemed significant. The following tables present information for reported segment income or loss and segment assets as of and for the periods indicated:
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 2004, PMI contributed $319.7 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 2004, $135.7 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.
PMI’s claims-paying ratings from certain national rating agencies have been based on various capital support commitments from Allstate (“Allstate Support Agreements”). On October 27, 1994, the Allstate Support Agreements were terminated with respect to policies issued after October 27, 1994, but continue in modified form (as so modified, the “Runoff Support Agreement”) for policies written prior to such termination. Under the terms of the Runoff Support Agreement, Allstate may, at its option, either directly pay or cause to be paid, claims relating to policies written during the terms of the respective Allstate Support Agreements if PMI fails to pay such claims or, in lieu thereof, make contributions directly to PMI or The PMI Group. In the event any amounts are paid or contributed, which possibility management believes is remote, Allstate would receive subordinated debt or preferred stock of PMI or The PMI Group in return. No payment obligations have arisen under the Runoff Support Agreement. The Runoff Support Agreement provides PMI with additional capital support for rating agency purposes.
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. A 1999 CMG capital support agreement was superseded by execution of the new agreement. On December 31, 2004, CMG’s risk-to capital ratio was 13.0 to 1.
EITF No. 04-8 requires the dilutive effect of CoCo’s be included in dilutive earnings per share regardless of whether the triggering contingency based on the market price of the issuer’s shares has been satisfied. This change in accounting principle was applied on a retroactive basis for all periods presented. Therefore, the Company restated all prior period dilutive earnings per share. The quarter and year ended December 31, 2004 diluted EPS excluding the effect of CoCo’s is presented for comparative purposes only. Refer to Note 3. New Accounting Standards for further discussion.