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, 2004, of Triad Guaranty Inc. and its consolidated subsidiaries, collectively the Company. The discussion should be read in conjunction with the Consolidated Financial Statements and Notes.
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 the Financial Position section below for a more detailed discussion of the reserves for losses and loss adjustment expenses.
The timely identification and valuation of potentially impaired securities involves many judgments. Inherently, there are risks and uncertainties involved in making these judgments. Changes in circumstances and critical assumptions such as unforeseen events which affect our investments in one or more companies, political subdivisions, or industries could result in additional write-downs in future periods for impairments that are deemed to be other-than-temporary. See further discussion of the valuation of our investment portfolio under the Investment section below.
Following is a summary of our results for the last three years (in thousands except per share information):
Two other important drivers of our results have been an increase in bulk production and the development of losses and loss adjustment expenses. We describe our results in greater detail in the discussions that follow. The information is presented in three categories in each of the year-to-year comparisons that follow: Production and In Force, Revenues, and Losses and Expenses.
Total insurance written in 2004 was $17.2 billion compared to $20.5 billion in 2003, a decrease of 16.1%. Total insurance written includes insurance written from flow production and structured bulk transactions.
Flow insurance written for 2004 decreased 36.7% to $10.5 billion from $16.6 billion in 2003. We experienced record levels of production in 2003 due to the lower interest rate environment in that year that contributed to a very strong refinance market. Refinances comprised 29.9% of our flow insurance written in 2004 compared to 51.5% in 2003. Loan originations for the entire industry declined approximately 27% in 2004, primarily due to this drop in refinancing activity. The Mortgage Bankers Association anticipates an even smaller loan origination market for 2005 compared to 2004. This is due in part to the continued decline in refinancing activity, as borrowers have previously locked in lower rates and terms than are expected to be available in 2005. Further, the continued expansion of alternative credit enhancements such as 80/10/10 structures (a combination of an 80% first mortgage loan, a 10% second mortgage loan usually issued by the same lender, and a 10% down payment) continues to erode the mortgage insurance industry’s overall penetration into the mortgage marketplace. We believe that the increasing use of these alternative credit enhancements will moderate new flow business in 2005. However, should interest rates rise, these types of arrangements will become less attractive to borrowers.
Insurance written in 2004 attributable to structured bulk transactions totaled $6.7 billion compared to $3.9 billion in 2003 as we continued our strategic commitment to that market. Insurance written attributed to structured bulk transactions is likely to vary significantly from period to period due to: a) the limited number of transactions (but with larger size) occurring in this market, b) the level of competition from other mortgage insurers, c) the relative attractiveness in the marketplace of mortgage insurance versus other forms of credit enhancement, and d) the changing loan composition and underwriting criteria of the market.
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 flow 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 flow business. We have entered into structured bulk transactions primarily in the first two segments mentioned above. At December 31, 2004, only approximately 1% of our insurance in force attributable to structured bulk transactions is categorized in segment c) above.
Our market share of flow business declined slightly in 2004 from 2003 due to the decline in production of a product driven primarily by the refinance segment. The increase in our structured bulk transactions market share shown above was the result of the greater availability of transactions that met our credit quality and pricing benchmarks on which we were able to successfully bid.
Periodically we enter into structured bulk transactions involving loans that have insurance effective dates within the current reporting period but for which detailed loan information regarding the insured loans is not provided by the issuer of the transaction until later. When this situation occurs, we accrue premiums that are due but not yet paid based upon the estimated commitment amount of the transaction in the reporting period with respect to each loan’s insurance effective date. However, the policies are not reflected in our in force, insurance written, or related industry data totals until the loan level detail is reported to us. At December 31, 2004, we had approximately $0.7 billion of structured transactions with effective dates within the fourth quarter for which loan level detail had not been received and, therefore, are not included in our own data or industry totals. These amounts will be reported as new production and insurance in force totals in 2005 when the issuer of the transactions provides loan level detail to us. We have properly included in premium written and premium earned the respective estimated amounts due and earned during 2004 related to this insurance.
The increase in persistency rates over the 2003 levels was primarily due to the decline in refinance activity described above. If current interest rate levels persist or increase further, we anticipate continuing, although slowing, improvements in persistency in 2005. However, persistency will be adversely affected if rates decline significantly from current levels.
Total direct premiums written were $176.7 million for 2004, an increase of 14.7% compared to $154.0 million for 2003. This increase was driven by a $31.3 million increase in direct renewal premiums written, partially offset by a $8.6 million decline in direct initial premiums. As mentioned earlier, increased persistency was the primary factor that caused the increase in renewal premiums in 2004. Lower mortgage
originations for the industry caused by lower levels of refinancings and the increased popularity of the alternative credit enhancements described earlier caused the decline in direct initial premiums.
Net premiums written increased 11.5% to $141.3 million in 2004 over $126.7 million in 2003. The difference between direct premiums written and net premiums written is ceded premium. Ceded premium is comprised of premiums written under excess of loss reinsurance treaties with captive as well as non-captive reinsurance companies. Driven by an increase in the amount of premium subject to captive reinsurance arrangements, ceded premiums written increased 29.5% to $35.4 million in 2004 from $27.3 million in 2003. The following table provides further data on ceded premiums for the years ended December 31, 2004 and 2003:
At December 31, 2004, 56.6% of direct flow insurance in force and 43.3% of total direct insurance in force was subject to captive reinsurance arrangements, compared to 51.5% and 43.6% of total insurance in force at December 31, 2003. None of our insurance in force under structured bulk transactions is subject to captive reinsurance arrangements.
We believe captive reinsurance arrangements are an effective risk management tool as selected lenders share in the risk under such arrangements. Additionally, captive reinsurance arrangements are structured so that Triad receives capital relief in certain risk-based capital models utilized by rating agencies. We remain committed to the concept of captive reinsurance arrangements, including deep ceded arrangements where the net premium cede rate is greater than 25%, on a lender-by-lender basis as we deem it to be prudent. We will continue to be an active participant with our lender partners in structures utilizing alternative attachment points, risk bands, cede rates, and ceding commissions.
Net investment income for 2004 grew 15.6% over 2003 primarily due to the growth in average invested assets, partially offset by a decline in portfolio yields. Average invested assets at cost or amortized cost grew by 17.7% in 2004 over 2003 as a result of the investment of cash flows from operations throughout the year. Our
Net realized investment gains/(losses), except for write-downs on other-than-temporarily impaired securities, are the result of our discretionary dispositions of investment securities in the context of our overall portfolio management strategies and are likely to vary significantly from period to period. Write-downs on other-than-temporarily securities were approximately $0.5 million in 2004 compared to $0.8 million in 2003. See further discussion of impairment write-downs in the Realized Gains, Losses and Impairments section below.
The increase in paid losses is consistent with our expectations as a greater amount of our insurance in force reaches its anticipated highest claim frequency years. Due to the growth of our inforce business, we believe direct paid losses for both flow and structured bulk business will continue to increase in 2005, although somewhat less than the 2004 growth rate.
Net losses and loss adjustment expenses also includes the change in reserves for losses and loss adjustment expenses. The following table shows further detail about the Company’s loss reserves at December 31, 2004 and 2003 broken out by flow business and structured bulk business (in thousands):
In 2004 and 2003, 81% and 60%, respectively, of our structured bulk production was structured with deductibles that put us in the second loss position, which we expect to moderate the loss development in the bulk portfolio. Prior to the fourth quarter of 2004, there was only a small amount of reported defaults on the
As of December 31, 2004 and 2003, approximately 91% and 92% of our insurance in force was originated in the previous 36 months. Based upon our experience and industry data, we believe that claims incidence for flow business is generally highest in the third through sixth years after loan origination. We believe that the period of highest claims incidence for structured bulk transactions is generally highest in the second through fourth years after loan origination. Changes in the economic environment could accelerate paid and incurred loss development. Due to the inherent uncertainty of future premium levels, losses, economic conditions, and other factors that affect earnings, it is difficult to predict with any degree of certainty the impact of such higher claim frequencies on future earnings. The factors most significant to our loss development will continue to be the level of new delinquent loans and their subsequent cure performance. Because of the growth of our inforce business, we believe the number of loans in default for both flow and structured bulk business will increase, although moderating from the 2004 growth level. The following table indicates the growth of the number of loans in default at December 31:
Our effective tax rate was 28.7% for 2004 and 29.4% for 2003. The decrease in the effective tax rate is due primarily to an increase in tax-exempt interest resulting from a higher percentage of assets being invested in tax-preferred municipal securities. We expect our effective tax rate to remain near current levels or increase slightly as we expect earned premium to grow faster than tax-preferred income.
Net income for 2003 increased 13.3% over 2002 to $51.1 million. Net income per share on a diluted basis increased 11.9% to $3.52 for 2003 from $3.15 per share for 2002. This improvement in net income was driven by a 14.0% increase in earned premiums and a 6.1% increase in net investment income. Net income for 2003 included after-tax net realized investment gains of $2.0 million, while net income for 2002 included after tax net realized investment losses of $1.6 million.
Total insurance written in 2003 was $20.5 billion compared to $13.4 billion in 2002, an increase of 52.5%. Flow insurance written for 2003 increased 36.0% to $16.6 billion from $12.2 billion in 2002. This increase was primarily the result of expanding relationships with national lenders, strong demand for risk-sharing arrangements and other product offerings, and a lower interest rate environment that contributed to a very strong refinance market. Insurance written in 2003 attributable to structured bulk transactions totaled $3.9 billion compared to $1.2 billion in 2002. The jump in structured bulk transactions written was driven by a robust growth in the overall bulk marketplace in 2003 coupled with our renewed strategic commitment to that market. As described above, insurance written attributed to structured bulk transactions is likely to vary significantly from period to period.
Refinance activity was 52.1% of insurance written in 2003 compared to 40.1% in 2002. The high level of refinance activity and the resulting decrease in persistency was reflective of the low interest rate environment that was in place during 2003.
Driven by an increase in the amount of premium subject to captive reinsurance arrangements, ceded premiums written increased 48.9% to $27.3 million in 2003 from $18.3 million in 2002. The following table provides further data on ceded premiums for the years ended December 31, 2003 and 2002:
During 2003, 46.1% of flow insurance written and 37% of total insurance written was subject to captive reinsurance arrangements compared to 51% of flow insurance written and 46% of total insurance written in 2002. The decline in the percentage of flow insurance written subject to captive reinsurance arrangements from 2002 to 2003 was primarily a result of increased production in our lender-paid mortgage insurance program that was not subject to captive reinsurance arrangements.
Earned premiums increased 14.0% to $119.7 million for 2003 from $105.1 million for 2002. The difference between net written premiums and earned premiums in 2003 was due to the significant writings of our annual premium product and the related increase in the unearned premium reserve. Our unearned premium liability increased to $15.6 million at December 31, 2003, from $8.5 million at December 31, 2002. Direct written premium from the annual premium product represented 15.5% of direct premium written in 2003 compared to 7.0% of direct premium written in 2002. The growth in written and earned premiums resulted from strong levels of new insurance written offset by the impact of a low level of persistency and by the increase in ceded premiums.
to the investment of funds derived from cash flows from operations in 2003. The percentage increase in net investment income was much lower than the percentage increase in invested assets primarily due to a decrease in investment yields.
The following table showing further detail about the Company’s loss reserves at December 31, 2003 and 2002 broken out by flow business and structured bulk business (in thousands):
Amortization of DAC increased by 31.8% to $18.1 million in 2003 from $13.7 million for 2002. The increase reflects growth in DAC related to the expansion of our insurance in force and accelerated amortization due to higher cancellations from refinance activity in 2003. Low persistency levels during 2003 and 2002 resulted in additional amortization of deferred policy acquisition costs through dynamic adjustments totaling $5.5 million in 2003 and $2.6 million in 2002.
Our effective tax rate was 29.4% for 2003 and 30.9% for 2002. The decrease in the effective tax rate was due primarily to an increase in tax-exempt interest resulting from a higher percentage of assets being invested in tax-preferred municipal securities.
Total assets increased to $672 million at December 31, 2004, a 17% growth over the same date in 2003, primarily the result of growth in invested assets. Total liabilities increased to $235 million at December 31, 2004, from $206 million in 2003, primarily driven by 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, and loss and loss adjustment expense reserves. Our mortgage insurance operations and reserves are primarily supported by our investment portfolio. The majority of our assets are contained in the investment portfolio. A separate Investments section follows the Financial Position section and reviews our investment portfolio, key portfolio management strategies, and methodologies by which we manage credit risk.
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 for 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 $119.1 million and $98.1 million at December 31, 2004 and 2003. The change from year to year approximates the change in deferred income tax liability for the year.
Our reserving methodology focuses on the determination of a loss severity factor and a projected claim rate (frequency factor) for each reported delinquent loan category at the valuation date.
Our loss and loss adjustment expense reserves increased to $34.0 million at December 31, 2004 from $27.2 million at December 31, 2003. Note 4 in the Notes to the Consolidated Financial Statements contains a roll forward of these amounts for the last three years showing the incurred losses and the actual payments for the current and prior years. During the fourth quarter of 2003, claim severity had increased, particularly on paid claims related to structured bulk transactions from the 2001 and 2002 book years. At that time, we concluded that these extremely limited amount of actual claim payments related to the 2001 and 2002 bulk book years did not constitute a long-term trend and we did not adjust the severity factors during 2003. During of the first half of 2004, we continued to experience adverse severity trends on claims paid, particularly on the 2001 and 2002 structured bulk book years. Additionally, during the first half of 2004, we settled some flow claims with extended delinquency periods at amounts that exceeded our expectations based upon the factors in place at the end of 2003.. As a result of these two factors reflecting both prior structured bulk and flow books, we increased our severity factors utilized in our reserve calculations in 2004. This action also contributed to the recognized deficiency in 2004. A redundancy in reserves is shown for 2003 and 2002. These redundancies resulted principally from settling case-basis reserves on default notices occurring in prior years for amounts less than expected. Over 81% of our insurance in force was written within the last two years.
The following table shows default statistics as of December 31, 2004, and 2003.
We manage our investment portfolio to meet or exceed 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 policies 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. While we invest for the long term and most of our investments are held until they mature, we classify our entire investment portfolio as available for sale. This classification allows us the flexibility to dispose of securities in order to meet our investment strategies and operating requirements. All investments are carried on our balance sheet at fair value.
As shown above, no investment in the securities of any single issuer exceeded 2% of our investment portfolio at December 31, 2004.
The drop in the effective pre-tax yield shown above reflects the decrease in new money rates available for investment coupled with our strategies to increase the overall credit quality of the portfolio and increase our investment in state and municipal bonds.
The following table summarizes by category our unrealized gains and losses in our securities portfolio at December 31, 2004 (in thousands):
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
Further, we regularly review our investment portfolio to identify securities that may have suffered impairments in value that will not be recovered, termed potentially distressed securities. In identifying potentially distressed securities, we first screen for all securities that have a fair value to cost or amortized cost ratio of less than 80%. Additionally, as part of this identification process, we utilize the following information:
Information about unrealized gains and losses is subject to changing conditions. Securities with unrealized gains and losses will fluctuate, as will those securities that we identify as potentially distressed. Our current evaluation of other-than-temporary impairments reflects our intent to hold certain securities for a reasonable period of time sufficient for a forecasted recovery of fair value. However, we may subsequently decide to sell certain of these securities in future periods as a result of facts and circumstances impacting a specific security. If we make the decision to dispose of a security with an unrealized loss, we will write down the security to its fair value if we have not sold it by the end of the reporting period.
Realized losses include both write-downs of securities with other-than-temporary impairments and losses from the sales of securities. During 2004, we wrote down six securities by a total of approximately $480,000. Further details on the 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 later sold this security in 2004 and realized a small gain. The circumstances surrounding this impairment did not impact other securities in our portfolio.
We generated positive cash flow from operating activities of $68.9 million in 2004 compared to $59.3 million for 2003 and $47.0 million for 2002. The increase in cash flow from operating activities in 2004 reflects the growth in premiums and investment income partially offset by an increase in losses and other operating expenses paid. Our business does not routinely require significant capital expenditures other than for enhancements to our computer systems and technological capabilities. Positive cash flows are invested pending future payments of claims and expenses. 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.
The insurance laws of the State of Illinois impose certain restrictions on dividends that an insurance subsidiary can pay the parent company. These restrictions, based on statutory accounting practices, include requirements that dividends may be paid only out of statutory earned surplus and that limit the amount of dividends that may be paid without prior approval of the Illinois Insurance Department. There have been no dividends paid by the insurance subsidiaries to the parent company. Further, there are no restrictions or requirements for capital support arrangements between the parent company and Triad or its subsidiaries.
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 2004 nor that these rules will have a significant adverse impact on our financial condition in the future. However, if the risk-based capital rules result in future changes to the preferences of Fannie Mae and Freddie Mac regarding their use of the various types of credit enhancements or their choice of mortgage insurers based on their credit rating, our financial condition could be significantly harmed.
Our long-term debt has a single maturity date of 2028. The following schedule represents our aggregate contractual obligations as of December 31, 2004 (in thousands).
our market share may change as a result of changes in underwriting criteria or competitive products or rates;
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 may have an adverse effect on our earnings;
our performance may be impacted by changes in the performance of the financial markets and general economic conditions;
revisions in risk-based capital rules by the Office of Federal Housing Enterprise Oversight 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;
Triad Guaranty Inc. maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in its periodic reports to the Securities and Exchange Commission (SEC) is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to Triad Guaranty Inc.’s management, including its Chief Executive Officer and acting Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure based upon the definition of “disclosure controls and procedures” as defined under Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment to the cost-benefit relationship of possible controls and procedures.
As of December 31, 2004, an evaluation was performed under the supervision and with the participation of management, including the Chief Executive Officer and acting Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. Based upon that evaluation, management has concluded that disclosure controls and procedures as of December 31, 2004 were effective in ensuring that material information required to be disclosed in this Form 10-K was recorded, processed, summarized, and reported on a timely basis. Additionally, there were no changes in the Company’s internal controls over financial reporting that occurred during the quarter ended December 31, 2004 that have materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting.
provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America. Internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of Triad Guaranty Inc.; (2) provide reasonable assurance that the transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America; (3) provide reasonable assurance that receipts and expenditures of Triad Guaranty Inc. are being made in accordance with authorization of management and directors of Triad Guaranty Inc; and (4) provide reasonable assurance regarding the prevention of or timely detection of unauthorized acquisition, use or disposition of assets that could have a material effect on the consolidated financial statements. Internal control over financial reporting includes the controls themselves, monitoring (including internal auditing practices) and actions taken to correct deficiencies as identified.
Management assessed the effectiveness of Triad Guaranty Inc.’s internal control over financial reporting as of December 31, 2004. Management based this assessment on criteria for effective internal control over financial reporting described in “Internal Control - Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based upon this assessment, management determined that, as of December 31, 2004, Triad Guaranty Inc. maintained effective internal control over financial reporting.
The Board of Directors has adopted a Code of Ethics for the Company’s principal executive and senior financial officers. This Code supplements the Company’s Code of Conduct applicable to all employees and directors and is intended to promote honest and ethical conduct, full and accurate reporting, and compliance with laws as well as other matters. Both of these documents can be found on the Company’s website at http://www.triadguaranty.com under the Corporate Governance page.
(b) Reports on Form 8-K filed or furnished during the fourth quarter of 2004 and through the date of this Form 10-K filing.
December 14, 2004 - Triad Guaranty Inc. terminated its investment advisory agreement (formerly Exhibit 10.4) and entered into a new consulting agreement for advice and counsel during the transition to Conning Asset Management Company.
(d) Financial Statement Schedules - The response to this portion of Item 15 is submitted as a separate section of this report.
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on the 11th day of March 2005.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on the 11th day of March, 2005 by the following persons on behalf of the Registrant in the capacities indicated.
By-Laws of the Registrant as amended March 21, 2003 (Exhibit 3.2(c)) (10)
Administrative Services Agreement between the Registrant, Triad Guaranty Insurance Corporation, Collateral Mortgage, Ltd., Collat, Inc., and New South Federal Savings Bank (Exhibit 10.28)
Chief Executive Officer Sarbanes-Oxley Act Section 906 Certification dated March 11, 2005, for the Triad Guaranty Inc.’s Annual report on Form 10-K for the year ended December 31, 2004
Incorporated by reference to the exhibit identified in parentheses, filed as an exhibit in the 1993 Form 10-K.
Incorporated by reference to the exhibit identified in parentheses, filed as an exhibit in the 1996 Form 10-K.
Incorporated by reference to the exhibit identified in parentheses, filed as an exhibit in the 1997 Form 10-K.
Incorporated by reference to the exhibit identified in parentheses, filed as an exhibit in the 2000 Form 10-K.
Incorporated by reference to the exhibit identified in parentheses, filed as an exhibit in the 2002 Form 10-K.
We have audited the accompanying consolidated balance sheets of Triad Guaranty Inc. as of December 31, 2004 and 2003, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2004. Our audits also included the financial statement schedules listed in the Index at item 15(a). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Triad Guaranty Inc. at December 31, 2004 and 2003, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2004 in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
The accompanying consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America, which vary in some respects from statutory accounting practices which are prescribed or permitted by the various state insurance departments.
Fair value generally represents quoted market value prices for securities traded in the public market or prices analytically determined using bid or closing prices for securities not traded in the public marketplace. Realized investment gains or losses are determined on a specific identification basis. The Company evaluates its investments regularly to determine whether there are declines in value that are other-than-temporary. When the Company determines that a security has experienced an other-than-temporary impairment, the impairment loss is recognized as a realized investment loss. Short-term investments are defined as short-term, highly liquid investments both readily convertible to known amounts of cash and having maturities of twelve months or less upon acquisition by the Company.
The Company reviews the persistency of policies in force and makes appropriate adjustments to the amortization of deferred policy acquisition costs to reflect policy cancellations. In addition, the recoverability
Reserves are provided for the estimated costs of settling claims in respect of loans reported to be in default and estimates of loans in default which have not been reported to the Company. Consistent with industry accounting practices, the Company does not establish loss reserves for future claims on insured loans that are not currently in default. Amounts for salvage recoverable are considered in the determination of the reserve estimates. Loss reserves are established by management using historical experience and by making various assumptions and judgments about claim rates (frequency) and claim amounts (severity) to estimate ultimate losses to be paid on loans in default. The Company’s reserving methodology gives effect to current economic conditions and profiles delinquencies by such factors as age, policy year, geography, and chronic late payment characteristics. The estimates are continually reviewed and, as adjustments to these liabilities become necessary, such adjustments are reflected in current operations.
Certain premiums and losses are assumed from and ceded to other insurance companies under various reinsurance agreements. Reinsurance premiums, loss reimbursement, and reserves related to reinsurance business are accounted for on a basis consistent with that used in accounting for the original policies issued and the terms of the reinsurance contracts. The Company may receive a ceding commission in connection with ceded reinsurance. If so, the ceding commission is earned on a monthly pro rata basis in the same manner as the premium and is recorded as a reduction of other operating expenses.
The only element of other comprehensive income applicable to the Company is changes in unrealized gains and losses on securities classified as available-for-sale, which is displayed in the following table, along with related tax effects (in thousands):
The amortized cost and estimated fair value of investments in fixed maturity securities, at December 31, 2004, are summarized by stated maturity as follows (in thousands):
An analysis of deferred policy acquisition costs is as follows (in thousands):
Activity for the reserve for losses and loss adjustment expenses for 2004, 2003, and 2002 is summarized as follows (in thousands):
The classification of current and prior year amounts in the above reconciliation is prepared based upon the date the notice of default is received, consistent with industry practice, rather than based upon the actual date of default as in prior years. Prior year incurred and paid loss and loss adjustment expense amounts have been reclassified to conform to the current year presentation.
the severity factors. During of the first half of 2004, the Company continued to experience adverse severity trends on claims paid, particularly on the 2001 and 2002 bulk book years. Additionally, during the first half of 2004, the Company settled some flow claims with extended delinquency periods from the 2000 and 2001 flow book years at amounts that exceeded expectations. As a result of these two factors reflecting prior structured bulk and flow books, the Company increased its severity factors utilized in its reserve calculations in 2004. This action also contributed to the recognized deficiency in 2004. A redundancy in reserves is shown for 2003 and 2002. These redundancies resulted principally from settling case-basis reserves on default notices occurring in prior years for amounts less than expected.
The Company leases certain office facilities, autos, and equipment under operating leases. Rental expense for all leases was $2,061,000, $1,950,000, and $1,792,000 for 2004, 2003, and 2002, respectively. Future minimum payments under noncancellable operating leases at December 31, 2004, are as follows (in thousands):
The tax effects of temporary differences that give rise to significant portions of deferred tax assets and deferred tax liabilities at December 31, 2004 and 2003, are presented below (in thousands):
Insurance regulations limit the writing of mortgage guaranty insurance to an aggregate amount of insured risk no greater than twenty-five times the total of statutory capital and surplus and the statutory contingency reserve. The amount of net risk for insurance in force at December 31, 2004 and 2003 as presented below, was computed by applying the various percentage settlement options to the insurance in force amounts, adjusted by risk ceded under reinsurance agreements and by any applicable aggregate stop-loss limits. Triad’s ratio is as follows (in thousands, except ratio):
The Code permits dividends to be paid only out of earned surplus and also requires prior approval of extraordinary dividends. An extraordinary dividend is any dividend or distribution of cash or other property, the fair market value of which, together with that of other dividends or distributions made within a period of twelve consecutive months, exceeds the greater of (a) ten percent of statutory surplus as regards policyholders or (b) statutory net income for the calendar year preceding the date of the dividend. Consolidated net income as determined in accordance with statutory accounting practices was $78,202,000, $69,848,000, and $61,787,000 for the years ended December 31, 2004, 2003, and 2002, respectively. At December 31, 2004, the amount of the Company’s equity that can be paid out in dividends to the stockholders is $51,946,000, which is the earned surplus of Triad on a statutory basis.
Approximately 72% of eligible employees participate in the Company’s 401(k) Profit Sharing Plan. Under the plan, employees elect to defer a portion of their wages, with the Company matching deferrals at the rate of 50% of the first 8% of the employee’s salary deferred. The Company’s expense associated with the plan totaled $463,000, $462,000, and $374,000 for the years ended December 31, 2004, 2003, and 2002, respectively.
Reinsurance activity for the years ended December 31, 2004, 2003, and 2002, respectively, is as follows (in thousands):
Pro forma information required by Financial Accounting Standards Board Statement No. 123, Accounting for Stock-Based Compensation, has been estimated as if the Company had accounted for stock-based awards under the fair value method of that Statement. The fair value of options granted in 2004, 2003, and 2002 was estimated at the date of the grant using a Black-Scholes option pricing model with the following weighted-average input assumptions: risk-free interest rate of 3.62% for 2004, 3.34% for 2003 and 3.63% for 2002; dividend yield of 0.0%; expected volatility of 0.40 for 2004, 0.38 for 2003, and 0.39 for 2002; and a weighted-average expected life of the option of seven years.
In 1998, the Company completed a $35,000,000 private offering of notes due January 15, 2028. Proceeds from the offering, net of debt issue costs, totaled $34,453,000. The notes, which represent unsecured obligations of the Company, bear interest at a rate of 7.9% per annum and are non-callable.
The carrying values and fair values of financial instruments as of December 31, 2004 and 2003 are summarized below (in thousands):
A lawsuit has been filed against the Company in the ordinary course of the Company’s business. In the opinion of management, the ultimate resolution of the pending litigation will not have a material adverse effect on the financial position or results of operations of the Company.
The cost or amortized cost and the fair value of investments held by the parent company are as follows (in thousands):