Effective March 2007, the Company has entered into a lease to rent office space in Toronto, Canada for its Canadian operations under a lease expiring in 2009. Annual lease payments would be approximately $135,000 in 2007.
Management’s Discussion and Analysis of Financial Condition and Results of Operations analyzes the consolidated financial condition, changes in financial position, and results of operations for the three years ended December 31, 2006, of the Company. The discussion should be read in conjunction with the Consolidated Financial Statements and Notes contained herein.
The estimation of loss reserves requires assumptions as to future events, and there are inherent risks and uncertainties involved in making these assumptions. Economic conditions that have affected the development of loss reserves in the past may not necessarily affect development patterns in the future in either a similar manner or degree. To provide a measure of the sensitivity on pretax income and loss reserves carried on the balance sheet, we have provided the following table that quantifies the impact of percentage increases and decreases in both the average frequency and severity as of December 31, 2006:
Valuing our investment portfolio involves a variety of assumptions and estimates, particularly for investments that are not actively traded. We rely on external pricing sources for highly liquid, publicly traded securities and use an internal pricing matrix developed by our outside investment advisors for privately placed securities. This matrix relies on our judgment concerning a) the discount rate we use in calculating expected future cash flows, b) credit quality and c) expected maturity.
We regularly monitor our investment portfolio to ensure that investments that may be other-than-temporarily impaired are identified in a timely fashion, properly valued, and any other-than-temporary impairments are charged against earnings in the proper period. The timely identification and valuation of potentially impaired securities involves many judgments. The most significant judgments that we make relate to the estimated future cash flows on potentially impaired securities and our intent and ability to hold a security to anticipated recovery of value. Inherently, there are risks and uncertainties involved in making these judgments. See further discussion of the valuation of our investment portfolio and the methodology to identify potential impairments under the “Investment Portfolio” section below.
The costs of acquiring new business, principally commissions and certain policy underwriting and issue costs which are primarily related to the production of new business, are capitalized as deferred policy acquisition costs (“DAC”). Amortization of DAC is charged to expense in proportion to premium recognized over the estimated policy life. We make judgments in the determination of estimated policy life utilized in the amortization assumptions. The most significant judgment that we make is the estimated life of the DAC. See further discussion of DAC under the “Financial Position” section below.
Through our subsidiaries, we provide Primary and Modified Pool mortgage guaranty insurance coverage to residential mortgage lenders and investors as a credit-enhancement vehicle. We classify insurance as Primary when we are in the first loss position and the LTV is 80% or greater when the loan is first insured. We classify all other insurance as Modified Pool. The majority of our Primary insurance is delivered through the flow channel, which is defined as loans originated by lenders and submitted to us on a loan-by-loan basis. We also provide mortgage insurance to lenders and investors who seek additional default protection (typically secondary coverage or on loans for which the individual borrower has greater than 20% equity), capital relief, and credit-enhancement on groups of loans that are sold in the secondary market. These transactions are referred to as our structured bulk channel business. Those individual loans in the structured bulk channel in which we are in the first loss position and the LTV ratio is greater than 80% are classified as Primary. All of our Modified Pool insurance is delivered through the structured bulk channel.
Our profitability depends largely on a) the volume of business insured combined with the adequacy of our product pricing and underwriting discipline relative to the risks insured, b) persistency levels, c) operating efficiencies, and d) the level of investment yield, including realized gains and losses, on our investment portfolio. We define persistency as the percentage of insurance in force remaining from twelve months prior. Cancellations of policies originated during the past twelve months are not considered in our calculation of persistency. This method of calculating persistency may vary from that of other mortgage insurers. We believe that our calculation presents an accurate measure of the percentage of insurance in force remaining from twelve months prior. Cancellations result primarily from the borrower refinancing or selling insured mortgaged residential properties and, to a lesser degree, from the borrower achieving prescribed equity levels at which the lender no longer requires mortgage guaranty insurance.
The following table provides estimates of our national market share of net new insurance written, using MICA definitions, through our flow and structured bulk channels based on information available from MICA and other public sources for the years ended December 31, 2006, 2005 and 2004:
A significant trend over the last three years in our Primary production has been our increased participation in the Alt-A marketplace. We have defined Alt-A loans as individual loans having FICO scores greater than 619 and that have been underwritten with reduced or no documentation. The following table summarizes the credit quality characteristics of our Primary new insurance written over the past three years and reflects the growth in our Alt-A production. We have defined A Minus loans as those loans having FICO credit scores greater than 574, but less than 620. We have defined Sub Prime loans as those loans with credit scores less than 575.
Risk characteristics that we consider in our underwriting discipline also include, among other factors, the LTV of the loan. The following table summarizes the percentage of our Primary production by LTV over the past three years:
LTVs on policies originated in the structured bulk channel are generally lower than those on policies we receive via the flow channel. Those policies generally also have other Primary coverage in front of our risk.
Periodically we enter into structured bulk transactions involving loans that have insurance effective dates within the current reporting period but for which detailed loan information regarding the insured loans is not provided by the issuer of the transaction until later. When this situation occurs, we accrue premiums that are due but not yet paid based upon the estimated commitment amount of the transaction in the reporting period with respect to each loan’s insurance effective date. However, these policies are not reflected in our insurance in force, new insurance written, or related industry data totals until we verify the loan level detail. At December 31, 2006, we had approximately $119 million of structured transactions with effective dates within 2006 for which loan level detail had not been received and, therefore, are not included in our own data or industry totals. These amounts will be reported as new production and insurance in force totals in 2007, when the issuer of the transactions provides accurate loan level detail to us. We have included in premium written and premium earned the respective estimated amounts due and earned during 2006 related to this insurance. At December 31, 2005, we had approximately $979 million of structured transactions with effective dates within 2005 for which loan level detail had not been received.
Our Modified Pool insurance in force grew significantly in 2006 and in 2005 due to our strong production in the structured bulk channel as well as an improving persistency rate. Approximately 34%, 39% and 81% of our insurance written attributable to our structured bulk channel during 2006, 2005, and 2004, respectively, was structured with deductibles that put us in the second loss position. The declines in Modified Pool insurance written with deductibles in 2006 and 2005 were the result of increased business with entities that do not utilize deductibles in their structures, although the use of deductibles remains an effective part of our Modified Pool risk management strategy.
This increase in risk embedded in our portfolio increased the basis points that we charged for mortgage insurance in 2006 and 2005.
Our book of business is relatively unseasoned, having a weighted average life of 2.3 years at December 31, 2006 compared to 2.4 years at December 31, 2005 and 2.2 years at December 31, 2004. The following table shows direct risk in force as of December 31, 2006, 2005 and 2004 by year of loan origination.
We experienced strong growth in earned premiums in both 2006 and 2005 due to increases in net premium written in both years. Direct premium written is comprised of premium written for both Primary and Modified Pool business. Our growth in total direct premiums written in 2006 and 2005 was the result of the growth of our insurance in force through the strong production of Primary insurance products with risk-based pricing as noted previously in the “Production and In Force” section as well as growth in our Modified Pool business. Because of the increased production of products with risk-based pricing, the premium rate expressed in terms of basis points on our average Primary insurance in force for 2006 has risen approximately 7% over 2005. Additionally, favorable persistency levels increased renewal premium in both years, which is included in direct premium written. Annual persistency was at 76.8% at December 31, 2006 compared to 68.7% at December 31, 2005 and 67.6% at December 31, 2004.
The percentage of Primary flow insurance written subject to captive reinsurance declined in 2006 from 2005 due to increased production of certain lender-paid programs that were not subject to captive reinsurance arrangements. The percentage of Primary flow insurance written subject to captive reinsurance was relatively flat in 2005 compared to 2004. The declines in the percentage of total insurance written subject to captive reinsurance in 2006 and in 2005 is again reflective of the fact that Modified Pool insurance written comprised a greater portion of our total insurance written in both of these years.
Net investment income grew in 2006 and in 2005 primarily due to the growth in average invested assets in both years, partially offset by declines in portfolio yields. Average invested assets at cost or amortized cost grew by 13.4% in 2006 and 17.6% in 2005 as a result of the investment of positive cash flows from operations. Our investment portfolio tax-equivalent yield was 6.71%, 6.77%, and 6.99% at December 31, 2006, 2005 and 2004, respectively. We expect to see a growth in invested assets in 2007; however, we anticipate a continuing decline in the overall portfolio tax-equivalent yield as current interest rates remain below our average portfolio rate. See further discussion in the “Investment Portfolio” section of this document.
Net losses and loss adjustment expenses (“LAE”) for 2006 increased over 2005 due to growth and seasoning of our insurance in force combined with refinements in the frequency and severity factors utilized in our calculation of our reserves. These refinements, most of which occurred in the fourth quarter of 2006, were made primarily to reflect a weakening housing market. The increases in the amortization of deferred policy acquisition costs in 2006 and 2005 are consistent with the growth in that asset balance. Other operating expenses increased in 2006 over 2005, reflecting the growth of our insurance in force as well as several key initiatives that have taken place in 2006. The discussion below provides more detail on both losses and expenses.
During the first three quarters of 2006, the average severity dropped compared to 2005. This was partially the result of the loss mitigation processes implemented during 2005. During the fourth quarter of 2006, we experienced a significant change in our ability to reduce claims through our traditional mitigation processes, which we believe was related to weakness in the housing market. In many cases, properties on which loans have defaulted are sold during the foreclosure process, which generally reduces our loss. When the property does not sell prior to foreclosure, we often pay the full amount of our coverage, which we call a full option settlement. In the fourth
As shown in the “Production and In Force” section above, we are insuring a larger percentage of mortgages in excess of $200,000. Claim payments on defaults of these larger mortgages are greater even if coverage percentages remain constant. Claim payments on these larger mortgages also increased severity in the fourth quarter of 2006. We expect the average severity will continue to trend upward as the average loan amounts in our portfolio continue to rise and as the housing market continues to experience a general deterioration, which reduces our loss mitigation opportunities. However, our average severity on paid losses can fluctuate from quarter to quarter as a result of the relatively small number of claims paid in a given period, especially in regards to our Modified Pool insurance. The increase in severity and the further seasoning of the insurance portfolio indicate that paid losses will continue to trend upward in 2007.
The table above reflects relatively higher cumulative ratios of losses paid to premium received for the 2000 through 2002 policy years at this stage of development. This is due, in part, to a large portion of this business refinancing in subsequent years and the resulting lower aggregate level of premium received for these policy years.
In the fourth quarter of 2006, we experienced a significant increase in our paid loss severity due to the deteriorating developments in the housing market as well as changes in our insured portfolio. After careful evaluation of these items, we determined that it was prudent to significantly increase the severity factors utilized in our reserving methodology to reflect trends in the housing markets that will reduce our opportunity for loss mitigation.
Increases in frequency factors also contributed to the increase in reserves during 2005, although the primary factor was an increase in the number of reported defaults at December 31, 2005 from December 31, 2004. A significant portion of this increase in defaults occurred in FEMA-designated areas as a result of hurricanes Katrina and Rita. At December 31, 2005, the number of defaults without deductibles in these areas represented approximately 11% of our total number of defaults without deductibles. Given the unique circumstances surrounding that situation and absent any evidence that these would develop differently, we reserved for these defaults at our normal level. As a result, we increased reserves approximately $3.4 million for the hurricane related defaults during the fourth quarter of 2005.
Primary and Modified Pool insurance defaults without deductibles from these FEMA-designated areas totaled 421 at December 31, 2006 compared to 693 at December 31, 2005. The terms of our coverage exclude any cost or expense related to the repair or remedy of any physical damage to the property collateralizing an insured mortgage loan. We have not obtained detailed property assessments for the defaults in the FEMA-designated areas. Our exposure could be limited if such assessments demonstrate that there is significant un-repaired physical damage to properties securing loans for which we have provided mortgage insurance. Additionally, we believe that many borrowers living in these areas did not make scheduled mortgage payments due to forbearance granted by Fannie Mae, Freddie Mac and lenders, even though the individual borrower’s financial condition was not significantly impacted. We continued to reserve for these defaults at our normal level through December 31, 2006. At December 31, 2006 there were reserves of $3.7 million for defaults in the FEMA-designated areas compared to $4.5 million at December 31, 2005. The reserve for these defaults has not declined as greatly as the decline in the number of defaults primarily due to the increase in the frequency and severity factors discussed above. We will continue to monitor this situation as the longer-term impacts develop.
The following table shows default statistics as of December 31, 2006, 2005 and 2004. Prior to 2006, information that came in late in the quarter from lenders was considered in our incurred but not reported reserve, but the default counts were not reflected in our default statistics. During 2006, we included the default information in our statistics and restated the 2005 and 2004 statistical information below. The number of loans in default restatement did not have a significant impact on the delinquency ratio. The table below includes these default counts in the default statistics for all years presented.
Our Modified Pool insurance continues to season, and the default rate increased accordingly at December 31, 2006 from December 31, 2005. As shown in the table above, this business is growing rapidly, which will cause fluctuations in the default rate from period to period.
Other operating expenses increased in 2005 due to growth in our insurance in force and due to expenses incurred in connection with the organizational changes following the hiring of a new chief executive officer in 2005 and a new chief financial officer in 2006. Because the growth in net premiums written was greater than the growth in expenses, the expense ratio (ratio of the amortization of deferred policy acquisition costs and other operating expenses to net premiums written) for 2006 improved to 24.6% from 26.7% for 2005 and 28.8% for 2004.
Our effective tax rate was 27.3% for 2006 compared to 27.1% for 2005 and 28.7% for 2004. The variance in the effective tax rates between years was due primarily to the change in tax-preferred interest income on investments as a percentage of pre-tax income. We expect our effective tax rate to remain near current levels, or increase slightly if total pre-tax income grows faster than tax-preferred income.
The growth in the normal DAC amortization is driven by growth in the DAC assets. Improvements in persistency during 2006 and 2005 decreased DAC amortization resulting from the dynamic adjustment. Assuming no significant increases in persistency, we anticipate DAC amortization to increase at a rate similar to the growth in the DAC asset during 2007. See further information on the accounting for DAC in Note 1 in the Notes to Consolidated Financial Statements.
Our strategy for managing our investment portfolio is to optimize investment returns while preserving capital and liquidity and adhering to regulatory and rating agency requirements. We invest for the long term, and most of our investments are held until they mature. Our investment portfolio includes primarily fixed income securities, and the majority of these are tax-preferred state and municipal bonds. We have established a formal investment policy that describes our overall quality and diversification objectives and limits. Our investment policy and strategies are subject to change depending upon regulatory, economic, and market conditions as well as our existing financial condition and operating requirements, including our tax position. Although we invest for the long term, we classify our debt and equity securities with readily determinable market values as available for sale. This classification allows us the flexibility to dispose of securities in order to pursue our investment strategy and meet our operating requirements. Investments classified as available for sale are carried on our balance sheet at fair value. Investments without readily determinable market values are classified as other investments and are also carried at fair value.
As shown above, no investment in the securities of any single issuer exceeded 2% of our investment portfolio at December 31, 2006.
These unrealized gains and losses do not necessarily represent future gains or losses that we will realize. Changing conditions related to specific securities, overall market interest rates, or credit spreads, as well as our decisions concerning the timing of a sale, may impact values we ultimately realize. We monitor unrealized losses through further analysis according to maturity date, credit quality, individual creditor exposure and the length of time the individual security has continuously been in an unrealized loss position. Of the gross unrealized losses on fixed maturity securities shown above, approximately $440,000 related to bonds with a maturity date in excess of ten years. The largest individual unrealized loss on any one security at December 31, 2006 was approximately $100,000 on a bond issued by a Government-Sponsored Enterprise with an amortized cost of $5.0 million. Gross unrealized gains and losses at December 31, 2005 were $18.5 million and $(1.4) million, respectively.
Past due interest or principal payments or other violation of covenants
In analyzing our potentially distressed securities list for other-than-temporary impairments, we pay special attention to securities that have been on the list continually for a period greater than six months. Our ability and intent to retain the investment for a sufficient time to recover its value is also considered. We assume that, absent reliable contradictory evidence, a security that is potentially distressed for a continuous period greater than nine months has incurred an other-than-temporary impairment. Such reliable contradictory evidence might include, among other factors, a liquidation analysis performed by our investment advisors, improving financial performance of the issuer, or valuation of underlying assets specifically pledged to support the credit.
Positive cash flows are invested pending future payments of claims and expenses. Our business does not routinely require significant capital expenditures other than for enhancements to our computer systems and technological capabilities. Cash flow shortfalls, if any, could be funded through sales of short-term investments and other investment portfolio securities. We have no existing lines of credit due to the sufficiency of the operating funds from the sources described above.
Total stockholders’ equity increased to $570.2 million at December 31, 2006, from $499.2 million at December 31, 2005. This increase resulted primarily from 2006 net income of $65.6 million and additional
Triad is rated “AA” by both Standard & Poor’s Ratings Services and Fitch Ratings and “Aa3” by Moody’s Investors Service. S&P has not changed its “Stable” rating outlook for the U.S. private mortgage insurance industry that was issued in February of 2005. In December 2006, Fitch maintained its “Negative” rating outlook for the U.S. private mortgage insurance industry. Currently, Fitch, S&P, and Moody’s all report a “Stable” ratings outlook for Triad. A reduction in Triad’s rating or outlook could adversely affect our operations.
Fannie Mae has approval requirements for mortgage insurers. The rules require prior approval by Fannie Mae for many of Triad’s activities and new products, allow for other approved types of mortgage insurers rated less than “AA”, and give Fannie Mae increased rights to revise the eligibility standards of mortgage insurers. We have not seen any material impact on our operations and do not see any material impact on our current or future operations as a result of these rules. However, a material impact could still occur if Fannie Mae were to begin to utilize mortgage insurers rated below “AA” or revise eligibility standards of mortgage insurers in a way that would be adverse to Triad.
The Office of Federal Housing Enterprise Oversight (“OFHEO”) issued its risk-based capital rules for Fannie Mae and Freddie Mac in the first quarter of 2002. The regulation provides capital guidelines for Fannie Mae and Freddie Mac in connection with their use of various types of credit protection counterparties including a more preferential capital credit for insurance from a “AAA” rated private mortgage insurer than for insurance from a “AA” rated private mortgage insurer. The phase-in period for OFHEO’s risk-based capital rules is ten years. We do not believe the new risk-based capital rules had an adverse impact on our financial condition or operations through 2006 or that these rules will have a significant adverse impact on our financial condition or operations in the future. However, if the risk-based capital rules result in future changes to the preferences of Fannie Mae and Freddie Mac regarding their use of the various types of credit enhancements or their choice of mortgage insurers based on their credit rating, our operations and financial condition could be significantly impacted.
We lease office facilities, automobiles, and office equipment under operating leases with minimum lease commitments that range from one to ten years. We had no capitalized leases or material purchase commitments at December 31, 2006.
Our long-term debt has a single maturity date of 2028. The following table represents our aggregate contractual obligations as of December 31, 2006:
Fixed maturity securities represented approximately 97% of our invested assets at December 31, 2006. While the fair value of these fixed rate securities generally bears an inverse relationship to changes in prevailing market interest rates, a change in market interest rates would not immediately impact earnings because we have the ability and intent to hold these securities until maturity. However, a decrease in market interest rates generally will have the effect of initiating an early call provision of those securities possessing such provisions. The proceeds relating to the early called securities in a decreasing interest rate environment generally are invested in lower yielding investments that would ultimately decrease earnings. Our long-term debt matures in 2028 with no early call or put provisions and bears interest at a fixed rate of 7.9% per annum. The fair value of this debt is sensitive to changes in prevailing interest rates; however, a change in rates would not impact earnings. We believe that a 20% increase or decrease in market interest rates is reasonable for the upcoming year. A 20% relative increase or decrease in market interest rates that affect our financial instruments would not have a material impact on earnings during the next fiscal year.
revisions in risk-based capital rules by the OFHEO for Fannie Mae and Freddie Mac could severely limit our ability to compete against various types of credit protection counterparties, including “AAA” rated private mortgage insurers;