Certain of the statements contained herein, other than statements of historical fact, are forward-looking statements. These statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and include estimates and assumptions related to economic, competitive, and legislative developments. These forward-looking statements are subject to change and uncertainty, which are, in many instances, beyond our control and have been made based upon our expectations and beliefs concerning future developments and their potential effect on us. Actual developments and their results could differ materially from those expected by us, depending on the outcome of certain factors, including the possibility of general economic and business conditions that are different than anticipated, legislative developments, changes in interest rates or the stock markets, stronger than anticipated competitive activity, as well as the factors described in the Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995 with respect to forward-looking statements contained herein.
The estimation of loss reserves is an inexact process 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. Due to the inherent uncertainty in estimating reserves for losses and loss adjustment expenses, there can be no assurance that reserves will be adequate to cover ultimate loss developments on loans in default, currently or in the future. The Company’s profitability and financial condition could be adversely affected to the extent that the Company’s estimated reserves are insufficient to cover losses on loans in default.
Because the estimate for loss reserves is sensitive to the estimates of claims frequency and severity, we perform analyses to test the reasonableness of the best estimate generated by the loss reserve process. The loss reserve estimation process and the analyses support the reasonableness of the best estimate of loss reserves recorded in our financial statements. See Losses and Expenses under Consolidated Results of operations for a more detailed discussion of the reserves for losses and loss adjustment expenses.
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. Our methodology to identify potential impairments is further described in the Investment Portfolio section below. 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 under the Investment Portfolio 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, typically when individual borrowers have less than 20% equity in the property. Business originated by lenders and submitted to us on a loan-by-loan basis is referred to as our flow channel business. Mortgage guaranty insurance facilitates the sale of individual low down payment loans in the secondary market and provides protection to lenders who choose to keep the loans in their own portfolios. Additionally, we provide mortgage insurance to lenders and investors who seek additional default protection, capital relief, and credit-enhancement on groups of loans that are sold in the secondary market. These transactions are referred to as our structured bulk channel business.
The changes in diluted earnings per share in 2005 and 2004 were consistent with the changes in net income for those years. Diluted realized investment gains, net of taxes, had no impact on diluted earnings per share in 2005 compared to an increase of $0.02 in 2004 and $0.13 in 2003. Diluted realized gains and losses per share is a non-GAAP measure. We believe this is relevant and useful information to investors because, except for write-downs on other-than-temporarily impaired securities, it shows the effect that our discretionary sales of investments had on earnings.
A summary of new production broken out between Primary and Modified Pool and the year-to-year percentage changes follows:
Although terms vary, the structured bulk market can be broadly categorized into three different segments, or tiers, depending on the risk characteristics of the loans comprising a transaction. The loan characteristics of the three segments are a) predominantly high credit quality, low loan to value (LTV), fully underwritten loans that may have niche characteristics such as non-conforming loan balances and risk concentrations related to geography, transaction purpose, or occupancy type; b) loans that generally have high credit quality and low to moderate LTVs that have been underwritten with reduced, streamlined, or no documentation; and c) generally fully underwritten loans with credit impaired borrowers (FICO credit score less than 575). In general, we believe that structured bulk business originated in segments b) and c) will report a higher default rate than our Primary business. However, we also believe that the lower LTVs associated with the structured bulk business originated in segments a) and b) will ultimately generate lower claim rates as a proportion of the reported defaults and lower levels of severity than Primary business. We have entered into structured bulk transactions primarily in the first two segments mentioned above. At December 31, 2005 and 2004, only approximately 1% of our insurance in force attributable to structured bulk transactions was categorized in segment c) above.
The following table provides estimates of our national market share of net new insurance written, using industry definitions, through our flow and structured bulk channels based on information available from the industry association and other public sources for the years ended December 31, 2005, 2004 and 2003:
Our market share of flow business increased in 2005 due to increased writings with our targeted lenders, specifically with special lender-paid programs that applied primarily to non-prime loans. These special lender-paid programs are competitively priced among mortgage insurers and the production can vary from period to period, depending upon our willingness to accept the specific risk characteristics of these products. As mentioned earlier, our structured bulk market share will vary from period to period since this market can have significantly larger transactions and our share of this market is dependent on the availability of transactions that meet our credit quality and pricing benchmarks and on our ability to bid successfully for these transactions.
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, 2005, we had approximately $979 million of structured transactions with effective dates within the fourth quarter for which loan level detail had not been received and, therefore, are not included in our own data or industry totals. These amounts will be reported as new production and insurance in force totals in 2006, 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 2005 related to this insurance. At December 31, 2004 we had $685 million of structured transactions with effective dates within 2004 for which loan level detail had not been received.
The following table provides detail on our direct insurance in force at December 31, 2005, 2004 and 2003 (in millions, except percentages):
Our Modified Pool insurance in force grew significantly in 2005 and in 2004 due to our strong production in that market. Approximately 39%, 81% and 60% of our insurance written attributable to our structured bulk channel during 2005, 2004, and 2003, respectively, was structured with deductibles that put us in the second loss position. The decline in Modified Pool insurance written with deductibles in 2005 was 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.
Alt-A continues to grow as a percentage of our Primary insurance in force, and the majority of our Modified Pool insurance is classified as Alt-A. The following table shows the percentage of our insurance in force broken out by product and in total that we have classified as Alt-A at December 31, 2005, 2004 and 2003:
A summary of the individual components of our revenue for the past three years and the year-to-year percentage changes follows:
Ceded premium written is comprised of premiums written under excess of loss reinsurance treaties with captive as well as non-captive reinsurance companies. Ceded premiums written increased in 2005 and 2004 due to an increase in the amount of premium subject to captive reinsurance arrangements. The following table provides further data on ceded premiums for the years ended December 31, 2005, 2004 and 2003:
Assuming no significant decline in interest rates, we anticipate our persistency will remain at current levels with a bias toward improvement in 2006. This should continue to have a positive effect on renewal earned premiums and total earned premiums in 2006. Overall, based upon the above production and persistency assumptions, we expect that earned premiums will continue to increase in 2006, but at a lower level of growth than was achieved in 2005.
Net investment income grew in 2005 and in 2004 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 17.6% in 2005 and 20.6% in 2004 as a result of the investment of cash flows from operations throughout those years. Our investment portfolio tax-equivalent yield was 6.77%, 6.99%, and 7.13% at December 31, 2005, 2004 and 2003, respectively. We expect to see a growth in invested assets in 2006; however, we anticipate a continuing decline in the overall portfolio tax-equivalent yield as current interest rates are still below our average portfolio rate. See further discussion of the Investment Portfolio later in this document.
Paid claims increased in 2005 and in 2004 due to the overall growth of the insurance portfolio and the seasoning of our portfolio as a larger percentage of our insurance in force reaches its anticipated highest claim frequency period of years two to five from loan origination. To assist in the understanding of the seasoning process and the impact on paid claims, we have provided the following table that presents the percentage of Primary risk in
The increase in average severity also contributed to the growth in paid losses. The increase is reflective of the larger loan sizes and, as mentioned earlier, also reflects the growth of Alt-A loans that generally have a larger average loan balance than the rest of our portfolio.
The following table shows default statistics as of December 31, 2005, 2004 and 2003:
As shown in the above table, the number of Modified Pool defaults subject to deductibles continued to increase while the number of Modified Pool defaults without deductibles declined in 2005 and was relatively flat in 2004. At December 31, 2005, no individual structured bulk transaction with deductibles as part of the structure had incurred total losses that approach these individual deductible amounts. We do not provide reserves on Modified Pool defaults with deductibles until the incurred losses for that specific structured bulk transaction reach a pre-established threshold.
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 and a new chief financial officer in 2005. 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 2005 was 26.7% compared to 28.8% for 2004 and 32.3% for 2003. The improvement in the expense ratio for 2004 was due primarily to the decrease in DAC amortization expense mentioned above.
Total assets increased to $768 million at December 31, 2005, a 14% growth over the same date in 2004, primarily the result of growth in invested assets. Total liabilities increased to $268 million at December 31, 2005, from $235 million in 2004, primarily driven by an increase in reserves for losses and loss adjustment expenses coupled with an increase in deferred tax liabilities. This section identifies several items on our balance sheet that are important in the overall understanding of our financial position. These items include deferred policy acquisition costs, prepaid federal income tax and related deferred income taxes. The majority of our assets are contained in our investment portfolio. A separate Investment Portfolio section follows the Financial Position section and reviews our investment portfolio, key portfolio management strategies, and methodologies by which we manage credit risk.
Costs expended to acquire new business are capitalized as DAC and recognized as expense over the anticipated premium paying life of the policy in a manner that approximates the estimated gross profits. We employ a dynamic model that calculates amortization of DAC separately for each year of policy origination. The model relies on assumptions that we make based upon historical industry experience and our own unique experience regarding the annual persistency development of each year of policy origination. Persistency is the most important assumption utilized in determining the timing of reported amortization expense reflected in the income statement and the carrying value of DAC on the balance sheet. A change in the assumed persistency can impact the current and future amortization expense as well as the carrying value on the balance sheet. Our model accelerates DAC amortization through a dynamic adjustment when actual persistency for a particular year of policy origination is lower than the estimated persistency originally utilized in the model. This dynamic adjustment is capped at the levels assumed in the models, and we do not decrease DAC amortization below the levels assumed in the model when persistency increases above those levels. When actual persistency is lower than that assumed in our models, the dynamic adjustment effectively adjusts the estimated policy life utilized in the model to a policy life based upon the current actual persistency.
Assuming no significant declines in interest rates, we expect persistency to remain at current levels or to moderately improve in 2006. Based on this assumption, we anticipate DAC amortization to increase at a rate similar to growth in the DAC asset. See further information on the accounting for DAC in Note 1 in the Notes to Consolidated Financial Statements.
We purchase ten-year non-interest bearing United States Mortgage Guaranty Tax and Loss Bonds (“Tax and Loss Bonds”) in lieu of paying current federal income taxes to take advantage of a special contingency reserve deduction specific to mortgage guaranty companies. We record these bonds on our balance sheet as prepaid federal income taxes. Purchases of Tax and Loss Bonds are essentially a prepayment of federal income taxes that will become due in ten years when the contingency reserve is released, and the Tax and Loss Bonds mature. Prepaid income taxes were $139.5 million and $119.1 million at December 31, 2005 and 2004, respectively. The change from year to year approximates the change in the deferred income tax liability for the year.
Deferred income taxes are provided for the differences in reporting taxable income in the financial statements and on the tax return. These cumulative differences are enumerated in Note 6 in the Notes to Consolidated Financial Statements. The largest cumulative difference is the special contingency reserve deduction for mortgage insurers mentioned above. The remainder of the deferred tax liability has primarily arisen from book and tax reporting differences related to DAC and unrealized investment gains.
The following table summarizes by category our unrealized gains and losses in our securities portfolio at December 31, 2005 (in thousands):
We also owned bonds of a financing company related to this same U.S. car manufacturer at the time of our assessment of this impairment. Although the bonds had a fair value above 90% of amortized cost, we determined the impairment was other-than-temporary due to the circumstances surrounding the related car manufacturer and wrote down the bonds by approximately $60,000. We still hold this security at December 31, 2005, and its fair value approximated its amortized cost at that time. No other securities were impacted by the circumstances surrounding these impairments.
During 2004 we wrote down six securities by a total of approximately $480,000. Further details on the two most significant write-downs in 2004 are as follows:
Approximately $192,000 was a write-down on preferred stock in an international airline for which the value had fluctuated below 80% of amortized cost for over a year. The write-down resulted from our assessment that the security was other-than-temporarily impaired because of a reduction in credit quality by rating agencies. We sold this security in 2004 following the write-down and realized a small gain. The circumstances surrounding this impairment did not impact other securities in our portfolio.
Approximately $176,000 was a write-down in the third quarter on common stock of a pharmaceutical company for which the value had fluctuated below 80% of amortized cost after the company was required to
During 2003, we wrote down five securities by a total of approximately $779,000. Further details on the four most significant write-downs in 2003 are as follows:
Approximately $175,000 was a write-down on a bond issue collateralized by high-yield securities that continued to experience excessive defaults on its underlying securities. The circumstances surrounding this impairment did not impact other securities in our portfolio.
Approximately $165,000 was a write-down on common stock of a pharmaceutical company for which patents on various products were expiring. The market value of the equity had fluctuated below 55% of its cost. We subsequently sold these securities at an amount that approximated its carrying value after the write-down. The circumstances surrounding this impairment did not impact other securities in our portfolio.
We cede business to captive reinsurance affiliates of certain mortgage lenders (“captives”), primarily under excess of loss reinsurance agreements. Generally, reinsurance recoverables on loss reserves and unearned premiums ceded to these captives are backed by trust funds or letters of credit.
Triad’s ability to write insurance depends on the maintenance of its financial strength ratings and the adequacy of its capital in relation to risk in force. A significant reduction of capital or a significant increase in risk may impair Triad’s ability to write additional insurance. A number of states also generally limit Triad’s risk-to-capital ratio to 25-to-1. As of December 31, 2005, Triad’s risk-to-capital ratio was 12.6-to-1 as compared to 14.0-to-1 at December 31, 2004. The risk-to-capital ratio is calculated using net risk in force as the numerator and statutory capital as the denominator. Net risk in force accounts for risk ceded under reinsurance arrangements, including captive risk-sharing arrangements as well as any applicable stop-loss limits and deductible amounts.
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 through 2005 or that these rules will have a significant adverse impact on our financial condition in the future. However, if the risk-based capital rules result in future changes to the preferences of Fannie Mae and Freddie Mac regarding their use of the
Our long-term debt has a single maturity date of 2028. The following table represents our aggregate contractual obligations as of December 31, 2005 (in thousands).
The other long-term liabilities reflected on the Registrant’s balance sheet under GAAP category above is comprised of our reserve for losses and loss adjustment expenses. The establishment of loss reserves is subject to inherent uncertainty and requires significant judgment by management. The future loss payment periods are estimated based upon historical experience.
Fixed maturity securities represented approximately 98% of our invested assets at December 31, 2005. 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 generally 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.
Management’s Discussion and Analysis and this Report contain forward-looking statements relating to future plans, expectations, and performance, which involve various risks and uncertainties, including, but not limited to, the following:
the amount of insurance written could be adversely affected by changes in federal housing legislation, including changes in the Federal Housing Administration loan limits and coverage requirements of Freddie Mac and Fannie Mae (Government Sponsored Enterprises);
proposed regulation by the Department of Housing and Urban Development to exclude packages of real estate settlement services, which may include any required mortgage insurance premium paid at closing, from the anti-referral provisions of the Real Estate Settlement Procedures Act could adversely affect our earnings;