The Company leases office space in its Winston-Salem headquarters and its nine underwriting offices located throughout the country under leases expiring between 2006 and 2012 and which require annual lease payments of approximately $1.3 million in 2006. With respect to all facilities, the Company either has renewal options or believes it will be able to obtain lease renewals on satisfactory terms. The Company believes its existing properties are well utilized and are suitable and adequate for its present circumstances.
Accounting estimates and assumptions discussed in this section are those that we consider to be the most critical to an understanding of our financial statements because they inherently involve significant judgments and uncertainties. In developing these estimates, we make subjective and complex judgments that are inherently uncertain and subject to material change as facts and circumstances develop. Although variability is inherent in these estimates, we believe the amounts provided are appropriate based on the facts available upon compilation of the financial statements. Also, see Note 1 to the Consolidated Financial Statements, Summary of Significant Accounting Policies for a complete discussion of our significant accounting policies.
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 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.
The costs of acquiring new business, principally commissions and certain policy underwriting and issue costs which are primarily related to the production of new business, are capitalized as deferred policy acquisition costs (DAC). Amortization of such policy acquisition costs is charged to expense in proportion to premium recognized over the estimated policy life. We make judgments in the determination of estimated policy life utilized in the amortization assumptions. The most significant judgment that we make is the estimated life of the DAC. See further discussion of DAC under the Financial Position section below.
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.
Our profitability depends largely on a) the adequacy of our product pricing and underwriting discipline relative to the risks insured, b) persistency levels, c) operating efficiencies, and d) the level of investment yield, including realized gains and losses, on our investment portfolio. We define persistency as the percentage of insurance in force remaining from twelve months prior. Cancellations of policies originated during the past twelve months are not considered in our calculation of persistency. This method of calculating persistency may vary from that of other mortgage insurers. We believe that our calculation presents an accurate measure of the percentage of insurance in force remaining from twelve months prior. Cancellations result primarily from the borrower refinancing or selling mortgaged residential properties and, to a lesser degree, from the borrower achieving prescribed equity levels at which the lender no longer requires mortgage guaranty insurance.
Following is selected financial information for the last three years and the percentage change from year-to-year:
Net income for 2005 declined from 2004, as losses and loss adjustment expenses grew faster than earned premium during 2005. The growth in net losses and loss adjustment expenses in 2005 is principally a result of the ongoing seasoning of our insurance portfolio. In 2005, we experienced an increase in the number of paid claims, the number of reported defaults, and the severity of paid claims causing us to significantly increase our reserve for losses to reflect these trends. We experienced growth in earned premiums in 2005, driven by moderate growth of our risk in force combined with an increase in premium basis points related to specific lender programs and a change in the mix of business.
Comparing 2004 to 2003, losses and loss adjustment expenses grew at a rate exceeding the growth in earned premium, but at a much more moderate rate than occurred in 2005. This increase in losses and loss adjustment expenses reflected the seasoning of our insurance portfolio as over 80% of the insurance in force was less than two years old at December 31, 2003. A substantial increase in persistency in 2004 contributed to both the increase in earned premiums and a reduction in expenses through lower DAC amortization when compared to 2003.
The overall mortgage loan origination market was relatively flat in 2005 compared to 2004. Additionally, the percentage of loan originations for which mortgage insurance was provided declined in 2005. The decline was due primarily to the continued expansion of alternative credit enhancements such as 80-10-10 structures. In spite of the relatively flat overall loan origination market in 2005, we were able to show an increase in production reflected in a net gain in market share. Refinances were a large part of the overall mortgage loan origination market in 2003 when borrowers took advantage of historically low rates during that period, resulting in a record amount of originations in
2003. Refinances comprised 52% of our Primary insurance written in 2003 compared to 31% in 2005 and 30% in 2004. These factors caused our Primary insurance written to decline in 2005 and 2004 from levels achieved in 2003.
We anticipate that the overall mortgage loan origination market will be smaller in 2006 than in 2005, which could further moderate our Primary new insurance written. Assuming mortgage interest rates remain constant or continue to slowly increase, we expect to see production of Primary new insurance written in 2006 to be at levels slightly lower than that achieved in 2005. Further, we believe that the 80-10-10 loan penetration will soften in 2006. If short-term interest rates continue to rise, this type of financing should become less attractive to borrowers, which could partially mitigate the overall reduction of Primary insurance written.
Our Modified Pool insurance written grew significantly in 2005 and 2004 due to strong production in that market. We write Modified Pool insurance only through our structured bulk channel. We believe there will continue to be additional opportunities in the structured bulk market in 2006, and we will pursue those transactions that meet our loan quality and pricing objectives. Modified Pool insurance written 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.
The risk characteristics applicable to our Primary production have changed somewhat over the past three years. The most significant trend over the last three years has been our increased participation in the Alt-A marketplace. We have defined Alt-A as individual loans having FICO scores greater than 619 and that have been underwritten
with reduced or no documentation. The following table summarizes the credit quality characteristics of our Primary new insurance written over the past three years and reflects the growth in our Alt-A production:
Other risk characteristics that we consider in our underwriting discipline include the percentage of adjustable rate mortgages (ARMs) and the percentage of loans with LTV greater than 95%. The following table summarizes the percentage of our Primary production in ARMs and higher LTV loans over the past three years:
The majority of our Modified Pool production has been in the Alt-A marketplace over the last three years. As mentioned earlier, the LTVs on policies originated in the structured bulk channels are generally lower than those on policies we receive via the flow channel. Those policies may also have other Primary coverage in front of our risk. The percentages of ARMs included in our Modified Pool production approximate those included in our Primary production during the last three years.
Our Primary insurance in force grew in 2005 and in 2004 as a result of continued production and improvements in persistency. Primary insurance persistency improved to 70.0% at December 31, 2005 compared to 68.5% at December 31, 2004 and 52.2% at December 31, 2003. The average mortgage coupon rates in our existing portfolio have declined over the past three years as a result of relatively heavy refinancings and lower rates on mortgages for home purchases than our existing average rate. Additionally, mortgage rates in the market have recently remained flat or increased slightly which will deter those borrowers seeking lower coupon rates. These conditions have caused a reduction in cancellations from refinancing and, therefore, an increase in persistency. We anticipate that persistency rates will continue near current levels or increase moderately for 2006. However, persistency may be adversely affected if market interest rates decline significantly from the levels experienced during 2005.
We offer mortgage insurance structures designed to allow lenders to share in the risks of mortgage insurance. One such structure is our captive reinsurance program under which a reinsurance company, generally an affiliate of the lender, assumes a portion of the risk associated with the lender’s insured book of business in exchange for a percentage of the premium. The following table shows the percentage of our direct insurance in force that was subject to captive reinsurance arrangements at December 31, 2005, 2004 and 2003.
The growth of the percentage of Primary direct insurance in force that was subject to captive reinsurance arrangements in 2005 and in 2004 was the result of increased production from lenders that participate in captive reinsurance arrangements. The declines in the percentage of total direct insurance in force subject to captive reinsurance in 2005 and in 2004 reflect the fact that a greater portion of our insurance in force consists of Modified Pool insurance in force. None of our Modified Pool insurance in force is subject to captive reinsurance arrangements.
We experienced strong growth in earned premiums in both 2005 and 2004, primarily due to an increase in net premium written. Direct premium written is comprised of premium written for both Primary and Modified Pool business. Our growth in total direct premiums written in 2005 over 2004 was the result of the growth of our insurance in force, offset somewhat by a decline in average basis points as Modified Pool business comprised a greater percentage of our insurance in force. The premium rate for Modified Pool business, when calculated on insurance in force, is generally lower than that of Primary business due to the structures of the bulk transactions (which may include a stop loss limit and/or a deductible) that serve to reduce the overall risk assumed in the transaction. Renewal premiums increased $33.8 million or 21.2% in 2005 over 2004 as a result of growth in overall production and improved persistency. Initial, or new, premiums declined $3.2 million or 18.2% due to net lower premium basis points on Modified Pool transactions, especially those that are subject to deductibles, and a higher percentage of our production from Modified Pool business. Our growth in total direct premiums written in 2004 over 2003 was primarily due to a $31.3 million growth in renewal premiums partially offset by an $8.6 million decline in direct initial premiums. The growth of risk in force in 2004, resulting from improved persistency, drove the increase in renewal premiums over 2003. The declines in refinancing activity combined with increased popularity of alternative credit enhancements were the primary drivers of the decline in initial premiums in 2004 from 2003.
The table below provides data on insurance written that was subject to captive reinsurance arrangements for the years ended December 31, 2005, 2004 and 2003:
The percentage of Primary insurance written subject to captive reinsurance arrangements was relatively flat in 2005 compared to 2004. The increase in the percentage of Primary insurance written subject to captive reinsurance arrangements in 2004 from 2003 was due to the decline of production of certain lender-paid programs that were not subject to captive reinsurance arrangements in 2003. The declines in the percentage of total insurance written subject to captive reinsurance in 2005 and in 2004 were a result of Modified Pool insurance written comprising a greater portion of our total insurance written in both of these years. None of our Modified Pool insurance written in 2005, 2004 and 2003 was subject to captive reinsurance arrangements.
The difference between net written premiums and earned premiums is the change in the unearned premium reserve. Our unearned premium liability declined $2.4 million from December 31, 2004 to December 31, 2005 compared to an increase of $0.3 million from December 31, 2003 to December 31, 2004. An unearned premium reserve is established primarily on premiums received on annual products, which prior to 2005 was largely attributed to Modified Pool transactions. During 2005, many of the new transactions required the remittance of premium on a quarterly or monthly basis as opposed to annually, which will further decrease the unearned premium liability going forward. Direct written premiums from the annual premium product represented 11.8% of direct premium written in 2005 compared to 15.5% of direct premium written in both 2004 and 2003, respectively.
Net realized investment gains, 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. We wrote down other-than-temporarily impaired
securities by approximately $0.2 million in 2005 compared to $0.5 million in 2004 and $0.8 million in 2003. See further discussion of impairment write-downs in the Realized Losses and Impairments section below.
A summary of the individual components of losses and expenses and the year-to-year percentage change follows:
Net losses and loss adjustment expenses (LAE) are comprised of both paid losses and the change in loss and LAE reserves during the period. Net losses and LAE increased significantly in 2005 over 2004 due to increases in both paid claims and reserves as a result of the continued seasoning of our portfolio. We will focus separately on both paid claims and the increase in defaults.
The following table provides detail on paid claims and the average severity for our Primary and Modified Pool insurance for the years ended December 31, 2005, 2004 and 2003:
At December 31, 2003, 80.3% of the insurance in force was originated in the prior two years and would not have generated a significant amount of paid claims in 2003. The percentage of insurance in force less than two years old decreased to 75.3% at December 31, 2004 and 57.9% at December 31, 2005 and thus, more of our insurance in force is currently in its peak claim paying period.
We expect the average severity will continue to trend upward as the newer policy years develop and the average loan amounts rise with the increase in housing prices. However, our average severity on paid losses can fluctuate from year to year as a result of the relatively small number of claims paid in a given period. The anticipated increase in severity and the further seasoning of the insurance portfolio indicate that paid losses will trend upward in 2006.
A significant portion of the 2005 increase in defaults occurred in FEMA-designated areas as a result of hurricanes Katrina and Rita. Primary and Modified Pool insurance defaults from these FEMA-designated areas totaled 891 at December 31, 2005. At December 31, 2005, the number of defaults without deductibles in these FEMA-designated areas was 693, which represented approximately 11% of our total number of defaults without deductibles. The terms of our coverage exclude any cost or expense related to the repair or remedy of any physical damage to the property collateralizing an insured mortgage loan. We have not obtained detailed property assessments that could limit our exposure where there was significant unrepaired physical damage. Additionally, we believe that many borrowers living in certain FEMA-designated areas did not make scheduled mortgage payments due to forbearance granted by Fannie Mae, Freddie Mac and lenders, even though the individual borrower was not significantly harmed. Given the unique circumstances surrounding that situation and absent any evidence that these would develop differently, we reserved for these defaults at our normal level. As a result, we increased reserves approximately $3.4 million for the hurricane related defaults during the fourth quarter of 2005. We will continue to monitor this situation throughout 2006 as the longer-term impacts develop.
Our expectations for future claim amounts (severity) increased during 2005. This was primarily the result of the higher loan amounts included in the recent production. In addition to the increase in reserves due to the impact of the hurricanes, we increased our reserves in 2005 to reflect the increase in average severity that we believe will impact the long-term loss development of our insurance in force. We anticipate that our number of loans in default for both Primary and Modified Pool insurance will continue to increase as a larger percentage of our insurance in force reaches its peak claim paying period and as a result of overall growth of our insurance in force. We expect reserves will increase as our business continues to grow and season.
We are cautious about housing market conditions in certain regions that have recently experienced rapid house price appreciation. Changes in the economic environment could accelerate paid and incurred loss development. Our reserving model incorporates management’s judgments and assumptions regarding these factors; however, due to the uncertainty of future premium levels, losses, economic conditions, and other factors that affect earnings, it is difficult to predict the impact of such higher claim frequencies on future earnings.
Amortization of DAC increased moderately in 2005, primarily due to growth in the asset balance. The significant decline in DAC amortization in 2004 from 2003 was due to improved persistency in 2004. A full discussion of the impact of persistency on DAC amortization is included in the Deferred Policy Acquisition Costs section below.
We anticipate DAC amortization to be up slightly in 2006, primarily due to an increase in the DAC asset if persistency levels remain at current levels or improve slightly. We expect the growth in other operating expenses to moderate in 2006 when compared to 2005. However, given our expectations for premium growth, we anticipate continued improvements in our expense ratio.
Our effective tax rate was 27.1% for 2005 compared to 28.7% for 2004 and 29.4% for 2003. The declines in the effective tax rates for both 2005 and 2004 were due primarily to an increase in tax-exempt interest resulting from a higher percentage of assets 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.
Our DAC models separate the costs capitalized and the amortization streams between transactions arising from structured bulk and flow delivery channels. Generally, structured bulk transactions have significantly lower acquisition costs associated with the production of the business and they also have a shorter original estimated policy life. We apply the dynamic adjustment to the structured bulk DAC models utilizing the same methodology. At December 31, 2005 and 2004, net unamortized DAC relating to structured bulk transactions amounted to 6.8% and 5.4% of the total DAC on the balance sheet.
Low persistency levels during 2003 caused accelerated DAC amortization as can be seen by the large dynamic adjustment in that year. As persistency improved during 2004 and 2005, DAC amortization resulting from the dynamic adjustment leveled off. Differences in persistency in the flow and structured bulk delivery channels will not have the same impact on their respective DAC amortization because of the lower balance and the shorter estimated policy life of loans included in the typical structured bulk transactions.
The following table shows the growth and diversification of our investment portfolio (dollars in thousands).
We seek to provide liquidity in our investment portfolio through cash equivalent investments and through diversification and investment in publicly traded securities. We attempt to maintain a level of liquidity and duration
in our investment portfolio consistent with our business outlook and the expected timing, direction, and degree of changes in interest rates. See Note 2 in Notes to Consolidated Financial Statements that describes the scheduled maturity of our fixed maturity investments. The effective duration of the fixed maturity portfolio was 7.16 years at December 31, 2005 compared to 7.59 years at December 31, 2004 as we invested on a shorter time horizon during a period of unsettled long-term interest rates of 2005.
We also manage risk and liquidity by limiting our exposure on individual securities. The following table shows the ten largest exposures to an individual creditor in our investment portfolio as of December 31, 2005 (dollars in thousands):
As shown above, no investment in the securities of any single issuer exceeded 2% of our investment portfolio at December 31, 2005.
The following table shows the results of our investment portfolio for the last three years (dollars in thousands):
The drop in the tax-equivalent yield-to-maturity shown above reflects the impact of the maturity or call of higher yielding investments and the subsequent investment purchases at new money rates available, which were lower than that of our overall portfolio. We anticipate this trend to continue into 2006.
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 the portfolio is to maintain investments with high ratings. The following table shows our investment portfolio by credit ratings (dollars in thousands).
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 screen all securities held with a particular emphasis on those 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:
In analyzing our potentially distressed securities list for other-than-temporary impairments, we pay special attention to securities that have been on the list continually for a period greater than six months. Our ability and intent to retain the investment for a sufficient time to recover its value is also considered. We assume that, absent reliable contradictory evidence, a security that is potentially distressed for a continuous period greater than nine months has incurred an other-than-temporary impairment. Such reliable contradictory evidence might include, among other factors, a liquidation analysis performed by our investment advisors or outside consultants, improving financial performance of the issuer, or valuation of underlying assets specifically pledged to support the credit.
When we conclude that a decline is other than temporary, the security is written down to fair value through a charge to realized investment gains and losses. We adjust the amortized cost for securities that have experienced other-than-temporary impairments to reflect fair value at the time of the impairment. We consider factors that lead to an other-than-temporary impairment of a particular security in order to determine whether these conditions have impacted other similar securities.
Of the approximate $1.4 million of gross unrealized losses at December 31, 2005, no securities had a fair value to cost or amortized cost ratio of less than 90%.
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 securities for a reasonable period of time sufficient for a forecasted recovery of fair value. However, our intent to hold certain of these securities may change in future periods as a result of facts and circumstances impacting a specific security. If our intent to hold a security with an unrealized loss changes, and we do not expect the security to fully recover prior to the expected time of disposition, we will write down the security to its fair value in the period that our intent to hold the security changes.
Realized losses include both write-downs of securities with other-than-temporary impairments and losses from the sales of securities. During 2005, we wrote down three securities by a total of approximately $170,000. Further details on the two most significant write-downs in 2005 are as follows:
cease sales of one of its major products due to alleged health risks. Rating agencies then reduced the credit ratings for this company. We sold this security in the next quarter following the write-down 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.
Approximately $216,000 was a write-down on common stock of an automobile manufacturer for which the value had fluctuated below 85% of amortized cost for more than six months. Our assessment deemed that the security would not significantly recover in value over our anticipated holding period. This security was later sold 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.
Approximately $173,000 was a write-down on common stock of an energy provider for which the value had fluctuated below 85% of amortized cost for more than six months. Our assessment deemed that the security would not significantly recover in value over our anticipated holding period. The circumstances surrounding this impairment did not impact other securities in our portfolio.
We generated positive cash flow from operating activities of $70.8 million in 2005 compared to $68.9 million for 2004 and $59.3 million for 2003. The slight increase in cash flow from operating activities in 2004 reflects the growth in premiums and investment income received, largely offset by an increase in paid losses. 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.
In January of 2006, the Board of Directors authorized the repurchase of up to 1,000,000 shares of common stock. We view this authorization as another capital management option available when we believe it is prudent to be purchasing our stock. While we believe that the best opportunities available to Triad for the deployment of capital are for future growth and expansion, this authorization will enable the Company to purchase shares opportunistically depending on market conditions. Currently, our plans would be to liquidate some of the short-term and other investments at the holding company level to fund future stock purchases, if any. Our current intention would be to immediately retire any shares repurchased.
Statutory capital, for the purpose of computing the net risk in force to statutory capital ratio, includes both policyholders’ surplus and the contingency reserve. The following table provides information regarding our statutory capital position at December 31, 2005 and 2004:
Fannie Mae has revised its approval requirements for mortgage insurers. The new rules require prior approval by Fannie Mae for many of Triad’s activities and new products, allow for other approved types of mortgage insurers rated less than “AA,” and give Fannie Mae increased rights to revise the eligibility standards of mortgage insurers. We do not see any material impact on our current or future operations as a result of the new rules, although a material impact could still occur if Fannie Mae were to begin to utilize mortgage insurers rated below “AA” or revise eligibility standards of mortgage insurers in a way that would be adverse to Triad.
various types of credit enhancements or their choice of mortgage insurers based on their credit rating, our financial condition could be significantly harmed.
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 earnings;