The Company leases office space for its eight underwriting offices located throughout the country under leases expiring between 2008 and 2009, as well as office space in Toronto, Canada for its Canadian operations under a lease expiring in 2009. In the fourth quarter of 2007, the Company suspended its expansion efforts in Canada and in the first quarter of 2008, the Company took steps to close four of its underwriting offices, with corresponding reductions to its sales staff. The Company is seeking a purchaser for its Canadian operations and is pursuing subleases for all underwriting offices that were closed.
Based on statutory accounting practices and derived from combined statutory financial statements of Triad.
Our revenues principally consist of (a) initial and renewal earned premiums from flow business (net of reinsurance premiums ceded as part of our risk management strategies), (b) initial and renewal earned premiums from structured bulk transactions, and c) investment income on invested assets. We also realize investment gains, net of investment losses, periodically as a source of revenue when the opportunity presents itself within the context of our overall investment strategy.
A substantial increase in the reserve for losses and LAE in 2007 was primarily responsible for our net loss for 2007. The increase in the reserves was directly related to the growth in the number of reported loans in default as well as an increase in the frequency and severity factors utilized in the reserve model. Additionally, the changing characteristics of the loans entering the default pool, with new defaults having substantially higher average risk per loan than a year ago, has contributed to the increase in reserves. These factors have been especially evident in (i) distressed markets (California, Florida, Arizona and Nevada), (ii) the development of the 2006 and 2007 books of business, (iii) our Primary bulk business written in 2007, which is showing a significant amount of early payment defaults and has a significant amount of high LTV loans, and (iv) our recent Modified Pool business, which also has exhibited a significant amount of early payment defaults. At December 31, 2007 distressed markets accounted for 32% of the total risk in force but represented 47% of both the risk in default and reserves. At December 31, 2006, distressed markets accounted for 31% of the total risk in force, but represented only 18% of the risk in default and 14% of reserves. These distressed markets contributed $156 million, or 57%, of the total reserve increase experienced in 2007, compared to $8 million, or 24%, of the total reserve increase experienced in 2006.
Net losses and LAE for the year ended December 31, 2007 increased $278.7 million compared to the year ended December 31, 2006. Loss and LAE reserves increased by $276 million during the year, driven by a 91% increase in the number of loans in default for which we provide a reserve and a 48% increase in the average risk in default on those loans. In addition to the substantial increase in reserves, there was also strong growth of paid losses in both total dollars and the average paid loss severity. Paid losses of $100.6 million for 2007 were up $41.6 million, or 70%, as compared to 2006. Average paid loss severity was $44,800 as of December 31, 2007, compared to $27,900 as of December 31, 2006. The increase in average paid severity is primarily the result of a higher percentage of claims from the more recent vintage years, which reflect larger loan balances, and a decline in our ability to mitigate losses.
Earned premiums for 2007 grew significantly when compared to 2006, principally due to growth in Primary insurance in force. Total insurance in force grew by $11.4 billion, or 20.1%, as a result of total NIW of $2.7 billion and a total annual persistency rate of 81.9%.
Other operating expenses for 2007 increased over 2006 due to organizational changes and staff additions to support our growth and strategic initiatives, including expenses associated with entering the Canadian market. We incurred approximately $3.3 million of expenses in 2007 relating to our start-up operations in Canada.
American Home Mortgage Corp. (“AHM”) was our second largest customer for 2007, contributing $3.2 billion, or 21% of our total Primary flow NIW. AHM filed for protection under Chapter 11 of the U.S. Bankruptcy Code during the third quarter of 2007 and, as a result, provided extremely limited production during the second half of 2007. We do not anticipate any further production from AHM. The AHM bankruptcy, coupled with contractions in personnel and a reduction in production by two of our other large lender customers due to the unsettled nature of the mortgage marketplace, negatively impacted production for the second half of 2007. We expect that we will see further reductions in production in 2008.
At December 31, 2007, our risk to capital ratio was 20.5-to-1 compared to 12.5-to-1 at December 31, 2006. The maximum risk to capital ratio permitted by most states is generally 25.0-to-1. In addition, we are subject to a maximum risk to capital ratio of 22.1-to-1 under our $80 million credit facility. Our risk to capital ratio has been increasing over the last several quarters, partially as the result of operating losses during the third and fourth quarters of 2007. In order to manage our risk to capital ratio in this environment, we are carefully monitoring the writing of new business and allocating our capital against what we believe to be the most promising opportunities. This allocation of capital is expected to further limit the amount of future production.
For the twelve months ended December 31, 2007, our exposure to loans with LTVs of greater than 95% represented 32.6% of Primary NIW. As noted above, we are reducing the risk in our portfolio through tightened underwriting guidelines and are limiting our exposure to loans with LTVs of greater than 95%. Our focus on quality through tightened underwriting guidelines has resulted, and we expect will continue to result, in the elimination of certain mortgage lenders with which we had historically done business and a reduction in volume from other lenders with which we continue to do business.
The following table provides estimates of our national market share of NIW, 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, 2007, 2006, and 2005:
Our total market share declined in 2007 due primarily to our decision to exit the structured bulk market during the second quarter. In addition, our flow market share declined in 2007 primarily due to the termination of two lender paid programs and the termination of production from AHM in the third quarter of 2007.
According to estimates published by Fannie Mae, the overall mortgage loan origination market for 2007 declined approximately 14%, and is estimated to decline another 21% in 2008. The housing market continued to slow throughout 2007, as evidenced by reduced sales of new and existing homes, near record high levels of unsold inventories in many markets and a general decline in home prices. Fannie Mae predicts total home sales to decline by 15% in 2007, and another 13% in 2008. A significant contributor to the decline in mortgage originations in the second half of 2007 was the liquidity crisis that developed in the secondary markets, which prevented many mortgage originators from selling their loans in the secondary markets. This development contributed to the failure of a number of large national lenders and has negatively altered the outlook for mortgage originations for the foreseeable future.
In addition, we have further tightened our underwriting guidelines to help limit our exposure to high LTV loans, especially in the distressed markets that have experienced the greatest decline in home prices. We have limited the
One of the risk characteristics that we pay particular attention to is credit quality. We have defined Alt-A as individual loans having FICO scores greater than 619 and that have been underwritten with reduced or no documentation. A-Minus is defined as loans having FICO scores greater than 574, but less than 620. We have defined sub prime loans as those with credit scores less than 575. The following table summarizes the credit quality characteristics of our Primary NIW production during each of the last three years:
Adjustable rate mortgages that include a feature allowing for a potential negative amortization (“PNAMs”) declined significantly in 2007. An inherent risk in a PNAM loan is the scheduled milestone in which the borrower must begin making amortizing payments. These payments can be substantially greater than the minimum payments required before the milestone is met. While most of these PNAMs have interest rates that will reset on an annual basis, these loans do not have scheduled payment increases until later years, so the borrower has not been required to make an increased payment or to refinance, adding uncertainty and potential risk to this product. We limited our exposure to PNAMs by reducing the number of PNAMs for which we provide insurance in the third quarter of 2007. We also announced guideline changes to eliminate mortgage insurance eligibility on PNAMs in the fourth quarter of 2007. PNAM loans have experienced a higher delinquency rate than that of the remaining portfolio.
Almost all of the Modified Pool NIW over the last three years has been in the Alt-A credit quality classification. The risk associated with our Modified Pool NIW certificates differs from Primary NIW in that Modified Pool structures in which we participate generally include either loans that have Primary coverage by other insurers in front of our risk or loans that are originally written with an LTV lower than 80%, some of which may have a simultaneous second mortgage precipitating the lower LTV. The 2006 and 2007 structured bulk transactions that are classified as Modified Pool, while similar in many risk characteristics when compared to earlier years, have exhibited an earlier and greater default pattern in the early stages of development.
Our Primary insurance in force grew in 2007 and in 2006 as a result of significant production during those years and improved persistency rates. Primary insurance annual persistency improved to 81.4% at December 31, 2007 compared to 76.6% at December 31, 2006 and 70.0% at December 31, 2005. We anticipate that persistency rates will be maintained near current levels for 2008 based upon the slowdown of the existing housing and mortgage markets. However, persistency could be adversely affected if interest rates decline significantly and the housing and mortgage markets begin to improve. Furthermore, if persistency were to decline, the decline may be concentrated in areas experiencing economic expansion and home price appreciation but may not decrease or may not decrease to the same degree in areas experiencing economic contraction and declining home prices. As a result, our remaining insurance in force would be more heavily concentrated in higher risk areas, areas experiencing economic contraction and declining home prices.
For Modified Pool, the Direct Risk in Force is calculated utilizing the particular stop-loss limits and deductibles within each specific structure.
mortgage insurer eligibility requirements so that approved mortgage insurers may not cede new risk if the premium ceded to captive reinsurers is greater than 25%. This temporary change is effective on or after June 1, 2008. This change may affect the percentage of flow NIW in 2008 subject to captive reinsurance and may affect the total amount of flow NIW in 2008 if lenders choose other forms of credit enhancement over mortgage insurance. We remain committed to structuring captive reinsurance arrangements on a lender-by-lender basis depending on a number of considerations, including competition, market share and lender quality.
A summary of the individual components of our revenue for the past three years follows:
Net investment income grew in 2007 and in 2006 primarily due to the growth in average invested assets in both years, partially offset by declines in portfolio yields. In 2007, the increase in investment income was also enhanced by the investment of the entire $80 million that we drew down from our credit facility during the third quarter of 2007. Average invested assets at cost or amortized cost grew by 21.4% in 2007 and 13.4% in 2006 as a result of the investment of positive cash flows from operations. Our investment portfolio tax-equivalent yield was 6.45%, 6.71%, and 6.77% at December 31, 2007, 2006, and 2005, respectively. We anticipate a continuing decline in the overall portfolio tax-equivalent yield as current interest rates remain below our average portfolio rate. For a further discussion, see “Investment Portfolio”.
Net losses and LAE are comprised of both paid losses and the increase in the loss and LAE reserve during the period. Net losses and LAE for 2007 increased over both 2006 and 2005 primarily due to significant increases in the reserve. The reserve increase reflects both an increase in the number of loans in default and an increase in the average risk per loan on the loans that were in default at December 31, 2007. We increased the frequency and severity factors utilized in the calculation of the reserve during 2007, which also impacted the size of the reserve increase. During the third and fourth quarters of 2007, we identified four specific states (California, Florida, Arizona and Nevada) that were experiencing declining home prices and increasing default rates at a faster pace than other states. We collectively refer to these four states as distressed markets. These distressed markets contributed $156 million, or 57%, of our total reserve increase in 2007.
The following table provides details on both the amount and the number of paid claims of both Primary and Modified Pool insurance for the years ended December 31, 2007, 2006, and 2005:
The amount of paid claims increased 70.5% in 2007 compared to 2006 while the number of claims paid increased 20.3% over the same time period. The difference in the growth rates is due to a 42% increase in the average severity on claims paid from $25,900 in 2006 to $36,700 in 2007. The increase in the average severity is reflective of: the development of the more recent vintage years, specifically the 2005 and 2006 vintage years, which have significantly higher average loan sizes; increase in paid claims relating to loans originated in the distressed markets, which have significantly higher average loan sizes; and a reduced ability to mitigate claims. For 2006, both
the amount of paid losses and the actual number of paid losses increased by approximately 21%, which resulted in average severity remaining constant for 2006 as compared to 2005.
The table below provides the cumulative paid loss ratios by certificate year (calculated as direct losses paid divided by direct premiums received, in each case for a particular policy year) that have developed through December 31, 2007, 2006, and 2005. The data below excludes the effects of reinsurance.
Reacting to the rapidly changing housing markets and the shifting mix in the composition of our defaults, such as the changes in geographic location, size and policy year, we substantially increased reserves in 2007. The increase in reserves reflects a growing number of loans in default and an increase in the average risk in default, as well as increases in the frequency and severity factors utilized in our determination of the reserves. Our reserving model incorporates management’s judgments and assumptions regarding the impact of the current housing and economic environment on the estimate of the ultimate claims we will pay on loans currently in default. In addition, we noted a continued decline in our cure rates on reported defaults during the fourth quarter of 2007. Accordingly, we increased the frequency factor utilized in our model by approximately 44% in 2007 to reflect these most recent changes. However, future economic conditions surrounding the housing or mortgage markets could significantly impact the ultimate amount of claims paid.
The following table indicates the growth in both the risk in default in these four distressed market states and reserves attributable to these states at December 31, 2007, 2006 and 2005. The reserves related to the distressed market states were 46.5% of total reserves at December 31, 2007, compared to 13.6% at December 31, 2006 and 6.7% at December 31, 2005 despite the fact that risk in force in distressed market states as a percentage of the total risk in force has increased only moderately over those same periods. At December 31, 2007, all of these states except Arizona had default rates in excess of the total portfolio rate of 4.44%. As recently as June 30, 2007, none of these four states had default rates that were in excess of the total of 2.65% at June 30, 2007, indicating the rapid increase in default rates in these states during the third and fourth quarters of 2007. Additionally, at December 31, 2007, these four states had average loan balances of $249,000 compared to $160,000 for the remainder of the portfolio, which increases the potential negative impact that further defaults in these distressed markets may have on future growth in risk in default and reserves.
The reserves recognized in the fourth quarter for these three contracts added $5.5 million to reserves at December 31, 2007. Based upon rapid growth in the reported defaults during 2007 and the significant amount of early payment defaults in some of our 2006 vintage year structured bulk transactions, we believe that we will be providing additional reserves on certain structured bulk transactions with deductibles in 2008.
Given the growth of our insurance in force and the current state of the mortgage and housing market, we anticipate that our number of loans in default for both Primary and Modified Pool insurance will continue to increase as the largest percentage of our insurance in force reaches its peak claim paying period. We experienced an increase in the number of defaults as of December 31, 2007 of approximately 96% as compared to December 31, 2006. Accordingly, we expect reserves to continue to increase as our business continues to age. We also expect default rates to increase for business that has increased risk characteristics such as Alt-A loans, higher LTV loans and PNAM ARMs. We expect the overall default rate to increase as the business with increased risk characteristics becomes a larger percentage of our insurance in force and as the recent vintage years reach their peak default period. The default rate is also affected by the number of policies in force, which is the denominator in the default rate calculation. The anticipated lower production in 2008 is also expected to result in an increase in the default rate compared to the rate that would result if our 2008 production were consistent with 2007 levels.
As discussed earlier in this report, we have experienced a faster and more severe increase in both defaults and claims on our 2006 and early 2007 vintage years. As discussed under “Business - Defaults and Claims,” generally our master policies provide that we are not liable to pay a claim for loss if the application for insurance regarding the loan in question contains fraudulent information, material omissions or misrepresentations that would increase the risk characteristics of the loan. We are currently reviewing the majority of the claims for losses and early defaults occurring soon after origination, especially with respect to the 2006 and early 2007 vintage years, to determine whether the limitations on our liability contained in our master policies are applicable. Our ability to rescind or deny coverage as described above with respect to certain loans originated by American Home Mortgage, formerly one of our largest customers, is limited, and is the subject of a lawsuit that American Home Mortgage filed against us on November 5, 2007. See Item 3, “Legal Proceedings” in Part I of this report. We expect rescissions or denials of coverage for additional loans originated by American Home Mortgage for similar reasons, which may be the subject of further litigation. Management currently does not expect the American Home Mortgage rescission or denial of coverage litigation to have a material adverse impact on our results of operations or financial condition.
Amortization of DAC for 2007 increased moderately over 2006, reflecting growth in the asset balance and, in some part, a reduction in our persistency assumption for policy years 2006 and thereafter from seven to five years. A more complete discussion of the impact of persistency on DAC amortization is included under “Deferred Policy Acquisition Costs” below.
the Company’s Quality Assurance group were reclassified to LAE because the function of that department changed to matters of loss mitigation. Because the growth in net premiums written was greater than the growth in expenses, the expense ratio (ratio of the amortization of DAC and other operating expenses to net premiums written) for 2007 improved to 21.9%, compared to 24.6% and 26.7%, respectively, for 2006 and 2005.
Our ten largest customers were responsible for approximately 73%, 80%, and 77% of insurance written through the flow channel during 2007, 2006, and 2005, respectively. In 2007, we had three customers that individually were each responsible for more than 10% of insurance written through the flow channel. In the aggregate, these customers were responsible for approximately 55% of insurance written through the flow channel. In 2006, these same three customers were responsible for approximately 65% of insurance written through the flow channel. In 2005, we had two customers that individually were each responsible for more than 10% of insurance written through the flow channel. In the aggregate, these two customers were responsible for approximately 58% of insurance written through the flow channel in 2005.
In recent years, a significant portion of our business has been concentrated in our top two or three lender customers. One of these customers, AHM, stopped accepting new business and ultimately filed for bankruptcy during the third quarter of 2007. For the first six months of 2007, AHM was our single largest customer, contributing 26% of Primary NIW and 15% of Modified Pool NIW. Another of our top customers, Countrywide Credit Industries, Inc., agreed in January 2008 to be acquired by Bank of America. Bank of America is also a customer of the Company, and it is unclear how this acquisition will affect our NIW or competitive position going forward. Other lenders have announced contractions in personnel and have lowered their estimated production due to the unsettled nature of the mortgage marketplace. These actions impacted production for the second half of 2007, and we expect that we will see further reductions in production into 2008. We plan to closely monitor the AHM bankruptcy process in order to assess whether it will adversely affect other aspects of our business, although we currently cannot predict the nature or materiality of any such effects.
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 premium. 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. The base persistency assumption is the most important factor 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 base persistency will impact the current and future amortization expense as well as the carrying value on the balance sheet. During 2006, based upon a study performed on the entire mortgage industry and specifically on our own experience, we altered our base persistency assumption on that origination year and for all future years going forward to recognize a shorter expected life due to the amount of refinancing over the past several years. Our model accelerates DAC amortization through a dynamic adjustment when actual persistency for a particular year of policy origination is lower than the estimated base persistency 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. Due to the increase in actual persistency over the past two years, the dynamic adjustment has not been as significant a factor in the quarterly DAC amortization as it was during periods of high refinancing and low persistency.
The following table shows our DAC asset for the previous three years and the effect of persistency on amortization:
The growth in the normal DAC amortization is due to the growth in the DAC asset and a decrease in the base assumption of the expected life of the flow and bulk portfolios. Assuming no significant declines in interest rates, we expect persistency to remain at the current rates or improve slightly in 2008. For further information on the accounting for DAC, see “Critical Accounting Policies and Estimates” under Item 7 and in Note 1 in the Notes to Consolidated Financial Statements.
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. During 2007, the deferred income taxes declined by $53 million, primarily the result of the reversal of the contingency reserve 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 (losses).
investments at December 31, 2007 primarily reflects the initial investment of funds associated with the capitalization of our Canada affiliate as well as proceeds of the draw down of the credit facility in August, 2007.
The following table summarizes by category our unrealized gains and losses in our securities portfolio at December 31, 2007:
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, overall market conditions 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 $1,380,000 related to bonds with a maturity date in excess of ten years. The largest individual unrealized loss on any one security at December 31, 2007 was approximately $190,000 on a bond issued by a Government-Sponsored Enterprise with an amortized cost of $935,000. Gross unrealized gains and losses at December 31, 2006 were $19.4 million and $(0.9) million, respectively. Unrealized losses are not considered to be other-than-temporarily impaired, as we believe we have the ability to hold investments until they recover in value or maturity.
Credit risk is inherent in an investment portfolio. We manage this risk through a structured approach to internal investment quality guidelines and diversification while assessing the effects of the changing economic landscape. One way we attempt to limit the inherent credit risk in our portfolio is to maintain investments with high ratings. The following table shows our investment portfolio by credit ratings.
Most of the fixed maturity bonds that have credit ratings of “AAA” above are the result of credit enhancements from financial guaranty insurers. At December 31, 2007, many of the financial guarantors had experienced substantially weaker financial results and, as a result, their own “AAA” ratings are under significant pressure which, if lowered, could impact the credit rating of our portfolio.
Past due interest or principal payments or other violation of covenants; and
premiums and investment income received, partially offset by increases in paid losses and operating expenses. A significant factor impacting the 2007 increase was the early redemption of $50.9 million of previously purchased Tax and Loss Bonds, which served as a source of cash in the current year. During 2006 and 2005, we purchased Tax and Loss Bonds which had the effect of reducing operating cash flow by $27.4 million and $20.3 million, respectively. We anticipate the early redemption of Tax and Loss Bonds to continue to be a source of cash in 2008 and 2009.
In 2007, we experienced significant operating losses, primarily the result of an increase in loss reserves of $275.6 million, which did not immediately impact our cash flow. Generally, there is about a 12 to 18 month delay from when reserves are initially established on a default to when a claim is ultimately paid. In 2007, paid losses amounted to $100.6 million; however, we expect paid losses to increase significantly in 2008. We anticipate that the majority of this cash outflow requirement related to the payment of claims in 2008 will be met by premiums and investment income; however, the liquidation of some short-term investments may be required to meet the expected paid loss requirements.
On June 28, 2007, the Company entered into a three-year, $80.0 million unsecured revolving credit facility with three domestic banks to provide short-term liquidity for insurance operations and general corporate purposes. On August 22, 2007, we drew down $80 million under the credit facility and it continued to remain outstanding through year end. In December 2007, we utilized a portion of the funds provided through the credit facility to provide a $50 million capital contribution to Triad in anticipation of funds being repatriated from our Canadian subsidiary. In January 2008, we repatriated $39 million of the original $45 million originally invested in our Canadian subsidiary.
Under the credit agreement, the Company must maintain a minimum adjusted consolidated net worth level of $409.9 million at December 31, 2007, and must not exceed a statutory risk-to-capital ratio threshold of 22-to-1. The agreement also contains covenants restricting the Company’s ability to incur liens, merge or consolidate with another entity and dispose of all or substantially all of its assets. In addition, the parent company is restricted from the payment of dividends if the Company is in default or if the payment of dividends places the Company in default. At December 31, 2007, the Company was in compliance with all such covenants. If the Company were to violate any of the covenants requiring the repayment of the $80 million drawn down under the credit facility, there remains adequate funds (including the $39 million repatriated from our Canadian subsidiary in January 2008) at the parent level to repay the debt.
The proposals that have been considered involve structures under which Triad would implement a “run-off” plan and a newly formed mortgage insurer would acquire certain of Triad’s employees, infrastructure, sales force and insurance underwriting operations. In addition, we would cease writing new business. These proposals do not
As of December 31, 2007 there are no specific restrictions or requirements for capital support arrangements between the parent company and Triad or its subsidiaries. An agreement between the parent company and Triad, which was approved by our primary regulator, exists that allows for the reimbursement of expenses by Triad to the parent company for expenses.
Total stockholders’ equity declined to $498.9 million at December 31, 2007, from $570.2 million at December 31, 2006. This decrease resulted primarily from our 2007 net loss of $77.5 million, offset by an increase in additional paid-in-capital of $4.7 million resulting from activity related to share-based compensation and the associated tax benefit.
Triad’s ability to write insurance depends on the maintenance of its financial strength ratings. Generally, states limit Triad’s statutory risk-to-capital ratio to 25-to-1. As of December 31, 2007, Triad’s risk-to-capital ratio was 20.5-to-1 as compared to 12.5-to-1 at December 31, 2006. The growth in the risk-to-capital ratio in 2007 was the result of significant increases in production in the first half of the year and operating losses in the last two quarters. 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 on structured transactions. Several states, including Triad’s domiciliary state, Illinois, require detailed calculations of risk-to-capital that differentiate risk between LTVs, coverage percentage, and type of product. As of December 31, 2007, Triad’s statutory capital was approximately 101% of the minimum capital required by the Illinois Department of Insurance and TGAC’s statutory capital was approximately 258% of the minimum required capital.
Fannie Mae and Freddie Mac both have approval requirements for mortgage insurers and differentiate between services and the amount of insurance allowed depending upon the tier the mortgage insurer qualifies for under their requirements. If our ratings fall below the equivalent of “AA-” and if either Fannie Mae or Freddie Mac or both determine that we would not qualify as a Type 1 or Type I mortgage insurer, respectively, lenders may limit the amount of mortgage insurance that they would place with us, which would significantly impair our competitive position in the MI industry and adversely affect our business and financial condition. Additionally, both Fannie Mae and Freddie Mac as well as other investors have the ability to redirect renewal premiums to other mortgage insurers that meet the Type 1 or Type I requirements, respectively, if they determine a lower tier mortgage insurer is a risk for the payment of claims. If Triad were to fail to meet the requirements to qualify as a Type 1 or Type I mortgage insurer, respectively, and Fannie Mae or Freddie Mac or both redirected renewal premiums to higher rated mortgage insurers, then it would have a significant negative impact on future results of operations. See Part I, Item 1,
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. At present, no private mortgage insurer is rated higher than “AA” and based upon the overall negative outlook for mortgage insurers presently, we do not believe 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 had no material off-balance sheet arrangements at December 31, 2007.
The other long-term liabilities reflected on our balance sheet under the GAAP category above is comprised of our reserve for losses and LAE. For the purpose of this table, we estimated that 75% of the existing reserves will result in claim payments in the next year and the remaining 25% will be paid in the following two years in equal amounts based upon historical claim payment trends. The establishment of loss reserves is subject to inherent uncertainty and requires significant judgment by management.
Frequency and severity are the two most significant assumptions in the establishment of our loss reserves. Frequency is used to estimate the ultimate number of paid claims associated with the current defaulted loans. The frequency estimate assumes that long-term historical experience, taking into consideration criteria such as those described in the preceding paragraph, and adjusted for current economic conditions that we believe will significantly impact the long-term loss development, provides a reasonable basis for forecasting the number of claims that will be paid. Severity is the estimate of the dollar amount per claim that will be paid. The severity factors are estimates of the percentage of the risk in force that will be paid. The severity factors used are based on an analysis of the severity rates of recently paid claims, applied to the risk in force of the loans currently in default. The frequency and severity factors are updated quarterly. Economic conditions and other data upon which these factors are based may change more frequently than once a quarter. Therefore, significant changes in reserve requirements may become evident three or more months following the underlying events that would necessitate the change.
The estimation of loss reserves requires assumptions as to future events, and there are inherent risks and uncertainties involved in making these assumptions. Economic conditions that have affected the development of loss reserves in the past may not necessarily affect development patterns in the future in either a similar manner or degree. 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, 2007:
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 our loss reserve process. Our loss reserve estimation process and our analyses support the reasonableness of the best estimate of loss reserves recorded in our financial statements. See “Losses and Expenses” above for a more detailed discussion of the reserves for losses and LAE.
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 results of operations 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. For a further discussion of the valuation of our investment portfolio and the methodology we use to identify potential impairments, see “Investment Portfolio” above.
if our current ratings are downgraded or we violate regulatory requirements, absent the receipt of waivers from the GSEs and insurance regulators, we would not be able to write new insurance and would be limited to servicing our remaining book of business;
ongoing credit problems in the mortgage marketplace may continue and cause an increased number of defaults and paid claims;
our financial condition and competitive position could be affected by legislation or regulation impacting the mortgage guaranty industry or the GSEs, specifically, and the financial services industry in general;
rating agencies may revise methodologies for determining our financial strength ratings and may further revise, downgrade or withdraw the assigned ratings at any time;
with consolidation occurring among mortgage lenders and our concentration of insurance in force generated through relationships with significant lender customers, our margins may be compressed and the loss of a significant customer or a change in their business practices affecting mortgage insurance may have an adverse effect on our results of operations;
revisions in risk-based capital rules by the Office of Federal Housing Enterprise Oversight for the GSEs could severely limit our ability to compete against various types of credit and our risk-to-capital ratio may continue to grow, which could cause us to face adverse regulatory action, rating agency action or both;
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 results of operations; and
Accordingly, actual results may differ from those set forth in the forward-looking statements. Attention also is directed to other risk factors set forth in documents that we file from time to time with the SEC.