The information required by this Item 6 is not required to be provided by issuers that satisfy the definition of “smaller reporting company” under SEC rules.
The following discussion is intended to provide information that the Company believes is relevant to an assessment and understanding of the Company’s consolidated financial position, results of operations and cash flows and should be read in conjunction with the Consolidated Financial Statements and Notes contained herein. In addition, the current depressed market conditions in residential housing markets coupled with elevated unemployment rates have subjected our business, financial condition and results of operations to substantial risks, many of which are summarized under Item 1A. “Risk Factors,” above, which should be read in conjunction with the following discussion.
Triad Guaranty Inc. (“TGI”) is a holding company that historically provided private mortgage insurance coverage in the United States through its wholly-owned subsidiary, Triad Guaranty Insurance Corporation (“TGIC”). Unless the context requires otherwise, references to “Triad” in this annual report on Form 10-K refer to the operations of TGIC and its wholly-owned subsidiary, Triad Guaranty Assurance Corporation (“TGAC”). References to “we,” “us,” “our,” and the “Company” refer collectively to the operations of TGI and Triad. TGIC is an Illinois-domiciled insurance company and TGAC is an Illinois-domiciled reinsurance company. The Illinois Department of Insurance (the “Insurance Department”) is the primary regulator of both TGIC and TGAC. The Illinois Insurance Code grants broad powers to the Insurance Department and its director (collectively, the “Department”) to enforce rules or exercise discretion over almost all significant aspects of our insurance business. Triad ceased issuing new commitments for mortgage guaranty insurance coverage on July 15, 2008 and is operating its remaining business in run-off. As used in this annual report on Form 10-K, the term “run-off” means writing no new mortgage insurance policies and continuing to service existing policies. Servicing includes: receiving premiums on policies that remain in force; cancelling coverage at the insured’s request; terminating policies for non-payment of premium; working with borrowers in default to remedy the default and/or mitigate our loss; reviewing policies for the existence of misrepresentation, fraud or non-compliance with stated programs; and
settling all legitimate filed claims per the provisions of the two Corrective Orders issued by the Department. The first Corrective Order was issued in August 2008. The second Corrective Order was issued in March 2009 and subsequently amended in May 2009. These Corrective Orders, among other things, include restrictions on the distribution of dividends or interest on notes payable to TGI by Triad, allow management to continue to operate Triad under close supervision, and include restrictions on the payment of claims. Failure to comply with the provisions of the Corrective Orders may result in the imposition of fines or penalties or subject Triad to further legal proceedings, including receivership proceedings for the conservation, rehabilitation or liquidation of Triad.
refunds paid or accrued resulting from the cancellation of insurance in force or for coverage rescinded or anticipated to be rescinded due to violations of certain provisions of a master policy;
changes in reserves for estimated future claim payments on loans that are currently in default net of any reserves ceded to captive reinsurers;
the conditions of the housing, mortgage and capital markets that have a direct impact on default rates, mitigation efforts, cure rates and ultimately the amount of claims settled;
Our results of operations in run-off could also be impacted significantly by recent federal government and private initiatives to stabilize the housing and financial markets. See Item I, “Business” and the discussion below for further details on these initiatives.
Persistency is an important metric in understanding our premium revenue, especially in run-off as no new business is being written and our overall premium base declines over time. Generally, the longer a policy remains on our books, or “persists”, the greater the amount of premium revenue we will earn from the policy. Cancellations result primarily from the borrower refinancing or selling insured mortgaged residential properties, from policies being rescinded due to fraud, misrepresentation or other underwriting violations, from a servicer choosing to cancel the insurance, from the payment of a claim, and, to a lesser degree, from the borrower achieving prescribed equity levels, at which point the lender no longer requires mortgage guaranty insurance.
Triad has entered into two Corrective Orders with the Department. The first Corrective Order was entered into on August 5, 2008 and remains in effect. This Corrective Order was implemented as a result of our decision to cease writing new mortgage guaranty insurance and to commence a run-off of our existing insurance in force as of July 15, 2008. Among other things, that Corrective Order:
Prohibits interest and principal payments on Triad’s surplus note to TGI without the prior approval of the Department;
Requires Triad to furnish to the Department certain reports, agreements, actuarial opinions and information on an ongoing basis at specified times.
The DPO requires that we accrue a carrying charge based on the investment yield earned by Triad’s investment portfolio;
Triad will establish an escrow account at least equal to the DPO balance and any associated carrying charges;
Triad will require that any risk or obligation of any captive reinsurer must be paid in full, and will deposit any excess reinsurance recovery above the 60% cash payment into an escrow account;
Payment of the DPO and the carrying charge is subject to Triad’s future financial performance and requires the approval of the Department;
Procedures to account for the impact of the second Corrective Order in the financial statements prepared in accordance with SAP;
Upon payment of a claim under these provisions, Triad is deemed to have fully satisfied its obligations under the respective insurance policy;
Other restrictions and requirements affecting the payment and transferability of the DPOs and associated carrying charge; and
The DPO recording requirements of the second Corrective Order became effective on June 1, 2009. At December 31, 2009, the recorded DPO, including a carrying charge of $2.1 million, amounted to $168.4 million. The recording of a DPO does not impact reported settled losses as we continue to report the entire amount of a claim in our statement of operations. The accounting for the DPO on a SAP basis is similar to a surplus note which is reported as a component of statutory surplus; accordingly, any repayment of the DPO or the associated carrying charge requires approval of the Department. However, in our financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) included in this report, the DPO is reported as a liability.
Failure to comply with the provisions of the Corrective Orders or any other violation of the Illinois Insurance Code may result in the imposition of fines or penalties or subject Triad to further legal proceedings, including the institution by the Department of receivership proceedings for the conservation, rehabilitation or liquidation of Triad. See Item 1A, “Risk Factors” for more information.
Our operating results and financial condition continue to be negatively impacted by the adverse conditions present in the housing and mortgage markets, including, but not limited to, declines in home prices and a restrictive credit environment, combined with high levels of unemployment and the recessionary economic environment in general. We believe these conditions will persist for an extended period of time and will continue to have an adverse impact on our financial results.
Prior to the second Corrective Order, our recurring losses from operations and resulting decline in policyholders’ surplus as calculated in accordance with SAP increased the likelihood that Triad would be placed into receivership and raised substantial doubt about our ability to continue as a going concern. The positive impact on surplus resulting from the second Corrective Order has resulted in Triad reporting a policyholders’ surplus in its SAP financial statements of $122.8 million at December 31, 2009, as opposed to a deficiency in policyholders’ surplus of $597.8 million on the same date had the second Corrective Order not been implemented. While implementation of the second Corrective Order has deferred the institution of an involuntary receivership proceeding, no assurance can be given that the Department will not seek receivership of Triad in the future
and there continues to be substantial doubt about our ability to continue as a going concern. The Department may seek receivership of Triad based on its determination that Triad will ultimately become insolvent or for other reasons stated above. If the Department were to seek receivership of Triad, TGI could be compelled to institute a proceeding seeking relief from creditors under U.S. bankruptcy laws. Our consolidated financial statements that are presented in this report do not include any adjustments that reflect the financial risks of Triad entering receivership proceedings and assume that we will continue as a going concern. We expect losses from operations to continue and our ability to continue as a going concern is dependent on the successful implementation of the revised corrective plan. See Item 1A, “Risk Factors” for more information about our financial solvency and going concern risks and uncertainties.
On September 4, 2009, we filed a complaint against American Home Mortgage (“AHM”) in the United States Bankruptcy Court for the District of Delaware seeking rescission of multiple master mortgage guaranty insurance policies (“master policies”) and declaratory relief. The complaint seeks relief from AHM as well as all owners of loans insured under the master policies by way of a defendant class action. We alleged that AHM failed to follow the delegated insurance underwriting guidelines approved by Triad, that this failure breached the master policies as well as the implied covenants of good faith and fair dealing, and that these breaches were so substantial and fundamental that the intent of the master policies could not be fulfilled and Triad should be excused from its obligations under the master policies. The total amount of risk originated under the AHM master policies, accounting for any applicable stop loss limits associated with modified pool contracts, was $1.6 billion, of which $1.1 billion remains in force at December 31, 2009. We continue to accept premiums and process claims under the master policies but, as a result of this action, we ceased remitting claim payments to companies servicing loans originated by AHM. Both premiums and claim payments subsequent to the filing of the complaint have been segregated pending resolution of this action. We have not recognized any benefit in our financial statements pending the outcome of the litigation. See Item 3, “Legal Proceedings” for more information.
At December 31, 2009, we reported a deficit in assets under GAAP of $706.4 million compared to a deficit in assets of $136.7 million at December 31, 2008. A deficit in assets occurs when recorded liabilities exceed recorded assets in financial statements prepared under GAAP and is not necessarily a measure of insolvency. The growth in the deficit in assets is the result of the substantial increase in loss reserves and settled claims over the past two years, reflecting the continued decline in housing and mortgage loan conditions. We will have to earn in excess of $706.4 million on a GAAP basis during the remaining run-off period and continue to meet our debt obligations in order to become financially solvent and continue as a going concern. We expect to continue to report a deficit in assets for the foreseeable future. See Item 1A, “Risk Factors” for more information about our financial solvency and going concern risks and uncertainties.
We have identified a substantial number of underwriting or program violations and borrower’s misrepresentations in the defaults reported to us. As a result, we have subsequently rescinded or cancelled coverage on these
There have been numerous news reports on the elevated level of rescission and denial activity by the private mortgage insurance industry and the effect on lenders and legal action has been initiated against certain mortgage insurers. On December 11, 2009, American Home Mortgage Servicing filed a complaint against Triad for damages, declaratory relief, and injunction in the United States District Court, Northern District of Texas. The complaint alleges that Triad denied payment on legitimate claims on 15 mortgage insurance loans and seeks damages, a declaration that our mortgage insurance policies prohibit denial of claim without evidence of harm, and an injunction against future like denials. See Item 3, “Legal Proceedings,” for more information.
Certain segments of our insured portfolio continue to perform more adversely when compared to the rest of the portfolio. These segments include:
Policies originated in 2006 and 2007 - At December 31, 2009, the default rate for these policy years was 27.1% and 26.6%, respectively, compared to 14.4% for the other policy years combined. Defaults in these policy years comprised 70.2% of our gross risk in default while only comprising 55.7% of our total risk in force. All policy years, however, experienced a large increase in default rates in 2009.
On July 15, 2008, we ceased issuing commitments for mortgage insurance. Our future production, if any, will consist of certificates issued from commitments for mortgage insurance that were entered into prior to July 15, 2008 and will be immaterial to our results of operations. In 2009, we wrote $42.9 million of new insurance compared to $3.5 billion in 2008. All production in 2009 and 2008 was from our Primary flow channel.
Historically, cancellation of insurance coverage has been primarily due to refinance or sales activity and has an inverse correlation to the movement in mortgage rates. Although mortgage rates remain at historically low levels, refinance activity has been minimal for the past two years. We believe this is primarily due to the general inability of borrowers to refinance or sell their homes as a result of stricter underwriting guidelines by lenders as well as the decline in home prices since 2007.
This decline in insurance in force was moderated by very strong persistency over recent periods. Primary insurance persistency was 82.9% at December 31, 2009 compared to 86.6% at December 31, 2008. Modified pool insurance persistency was 75.5% at December 31, 2009 compared to 88.3% at December 31, 2008 and was impacted by the cancellation of the Modified Pool transactions. While interest rates available currently in the marketplace are lower than those on our existing portfolio, we do not believe that factor will have a significant impact on persistency in the immediate future as many borrowers are unable to meet more stringent underwriting guidelines regarding equity or debt-to-income levels to facilitate a refinancing or sell an existing property.
Our portfolio contains significant exposure to Alt-A loans, loans with the potential for negative amortization (“pay option ARM”), as well as interest only loans. An inherent risk in both a pay option ARM loan and an interest only loan is the impact of 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. An additional risk to a pay option ARM loan is that the payment being made may be less than the amount of interest accruing, creating negative amortization on the outstanding principal of the loan. We define Alt-A loans as loans that have been underwritten with reduced or no documentation verifying the borrower’s income, assets, or employment and where the borrower has a FICO score greater than 619. We have found a substantial amount of misrepresentation and fraud on the Alt-A loans in our portfolio. Due in part to recent conditions in the housing markets, the Alt-A loans, pay option ARM loans, and interest only loans have, as a group, performed significantly worse than the remaining prime fixed rate loans through December 31, 2009.
Gross risk in force is on a per policy basis and does not account for risk ceded to captive reinsurers or applicable stop-loss amounts and deductibles on Modified Pool structured bulk transactions.
During 2009, we terminated three captive reinsurance arrangements and received approximately $18.9 million of trust assets. We also commuted one captive reinsurance arrangement and the majority of the trust assets were remitted to the reinsurer. The terminations and commutation resulted in an increase in cash and invested assets and a corresponding decrease in reinsurance recoverable. The terminations and commutation had no material impact on our results of operations or financial condition.
The decrease in direct premium written in 2009 is the result of the impact of premium refunds from rescissions and a 19.3% decline in insurance in force over the one-year prior period. Rescission activity increased substantially during 2009 compared to 2008. When we rescind coverage on a policy, the entire previously paid premium is refunded. Cash premium refunded during 2009, primarily due to rescission activity, was 15.7% of direct premium written before the impact of refunds compared to 3.3% for 2008. We also establish an accrual for expected premium refunds on policies that are currently under investigation for rescission. During 2009, the rescission factors used in our reserve methodology were incrementally increased, which also caused corresponding increases in the accrual for anticipated premium refunds. The increases in rescission factors were based upon actual substantially increased rescission activity than what we had previously utilized in our reserve methodology. At December 31, 2009 we accrued $47.5 million of premium refunds on our balance sheet compared to $17.1 million at December 31, 2008.
Ceded premium written is comprised primarily of premiums written under excess of loss reinsurance treaties with captives. Ceded premium during 2009 decreased over 2008 due to: (1) a decrease in insurance in force subject to captive reinsurance as a result of policy cancellations and the termination or commutation of certain reinsurance arrangements; and (2) the establishment of an accrual to account for the rescission of coverage on policies subject to captive reinsurance and the expected refunds of premiums previously ceded. The premium cede rate decreased slightly to 18.8% for 2009 compared to 19.2% for 2008.
increased by the accretion of the revised discount amount of the impairment over the remaining expected life of the security. For a further discussion, see “Investment Portfolio.”
The number of claims settled during 2009 increased over 2008 primarily as a result of the aging of the default inventory. Another contributing factor to the increase in settled claims was the end of certain lender and GSE foreclosure moratoriums that had previously delayed the completion of the foreclosure process, which is generally necessary before a claim can be filed. Average severity, which is calculated by dividing total direct settled claims by the number of claims settled, increased to $61,900 in 2009 from $53,800 in 2008 reflecting a larger percentage of our paid claims from the more recent vintage years, specifically the 2006 and 2007 vintage years, and the distressed markets, both of which reflect larger loan balances (see tables below for more detail).
The following table shows the average loan size and average risk per policy by vintage year. Policies originated during 2006 and 2007 comprised approximately 67.3% of our 2009 settled claims compared to 38.4% in 2008.
The following table shows the average loan size and average risk per policy for the distressed markets compared to the remainder of the portfolio. Policies from the distressed markets comprised 54.5% of our 2009 settled claims compared to 31.1% in 2008.
Average severity in 2009 continued to be influenced by our reduced ability to mitigate claims. The decline in home prices since 2007 across almost all markets, with significant declines in the distressed markets, combined with reduced mortgage credit availability have continued to negatively impact our ability to mitigate losses through the sale of properties. Policies originated in 2006 and 2007 have been particularly impacted by the decline in home prices as these borrowers have had less time to build up equity before the decline in prices. We expect our ability to mitigate losses will continue to be adversely affected by the continued pressure on home prices combined with the limited availability of credit in the U.S. financial markets. A greater concentration of settled claims in distressed markets or more recent policy years will exacerbate this effect.
We expect that, in general, the number and amount of settled claims will increase in 2010. Longer-term future claim settlement activity, however, remains uncertain due to rescission activity as well as government and other efforts to stem the level of foreclosures. During 2009, we rescinded coverage on loans with $683 million of risk in default compared to $244 million of risk in default during 2008. We believe the majority of the rescinded risk in default would have ultimately proceeded to foreclosure and resulted in settled claims. At December 31, 2009, approximately 30% of the policies in our default inventory were under review for fraud or misrepresentation and we currently expect a significant percentage of these to be rescinded. The degree to which policies are rescinded could have a substantial impact on settled claim activity and our results of operations in 2010.
information on all of the loans participating in these programs nor the current status of the participating loans and we do not have the necessary information to determine the number of our policies in force that would be eligible for such modification programs. This affects our ability to evaluate the ultimate success rate of HAMP and other such programs and, therefore, the impact on our results of operations and financial condition. If HAMP and/or similar programs prove to be effective in preventing ultimate foreclosure, future settled claim activity could be reduced.
The table below provides a trend analysis of the gross cumulative incurred loss incidence rate by book year (calculated as cumulative gross losses settled plus loss reserves, excluding the impact of modified pool and captive structures, divided by policy risk originated, in each case for a particular book year) as it has developed for each three-month period beginning September 30, 2008.
Approximately 14.6% of our insurance in force at December 31, 2009 is comprised of pay-option ARM loans, the majority of which were originated in 2005, 2006 and 2007. The performance of these loans has been, in general, worse than that of our other insured loans. As described above, the structure of a pay-option ARM loan poses certain inherent risks, including the potential for payment shock and negative amortization. Historically, the performance of pay-option ARM loans has benefitted from, and the risk has been mitigated by, home price appreciation and the ability to refinance before amortizing payments are required. We do not believe these historical mitigating factors are present to any meaningful degree in the current environment.
We are not provided with information on whether a borrower is required to make amortizing payments but we are provided information on the accumulation of negative amortization. The majority of our pay-option ARM loan portfolio has accumulated negative amortization and we believe the majority of this portfolio is approaching the milestone where amortizing payments will be required. As a result, our pay-option ARM loans may face a significant payment shock in the current and future periods which increases our risk of loss.
The increase in net loss and LAE reserves was mitigated substantially by stop loss levels in Modified Pool transactions and, to a lesser degree, by captive reinsurance structures. We do not provide reserves on Modified Pool defaults where the cumulative incurred losses to date for the related transaction have exceeded the stop loss limit. The benefit received from Modified Pool stop loss levels accounted for 56.1% of the change in gross reserves and LAE in 2009 compared to 4.4% in 2008. The table below reports on the performance and remaining risk exposure of vintage year modified pool transactions. A significant portion of the Modified Pool transactions from the 2005, 2006 and 2007 policy years have reached the transactions’ stop loss limit on an incurred basis given the adverse development of this business. As a result, additional new defaults on this Modified Pool business will have a limited net impact on future results.
Ceded reserves to captive reinsurers served to reduce the change in gross reserves and LAE by $76.3 million during 2009 compared to $149.7 million during 2008. At December 31, 2009, the majority of our captive reinsurance arrangements had total ceded reserves, combined with any unpaid ceded claims, that exceeded the respective trust balance. In those cases, the net reserve credit that we recognize in our financial statements is limited to the trust balance. Given this limitation, we do not expect any material benefit from these arrangements in future periods.
The following table provides further information about our loss reserves, absent the impact of reserves ceded to the lender sponsored captive reinsurers, carried on our balance sheet at December 31, 2009, and December 31, 2008:
Certificates originated during 2007 and 2006 comprise 61.4% of the number of loans in default, but 70.2% of the risk in default at December 31, 2009. Both measures are down slightly from 2008 year-end levels due primarily to a large amount of claim activity attributable to the 2006 policy year and rescission activity attributable to both the 2006 and 2007 policy years. The difference in percentages of loans in default and risk in default primarily reflects the higher loan amounts associated with these policy years.
To illustrate the impact of the changes in the frequency and severity factors utilized in the reserve model, the following table details the amount of risk in default and the reserve balance as a percentage of risk in default at December 31, 2009 and December 31, 2008. The table also provides the impact of the rescission factor, which is a component of the frequency factor utilized in the reserve model, on gross case reserves at the respective periods.
Reflects gross case reserves, which excludes IBNR, ceded reserves and the benefit from Modified Pool structures, as a percentage of risk in default for total delinquent loans.
The following table shows default statistics as of December 31, 2009 and 2008:
The percentage of total loans in default, or default rate, increased to 20.1% as of December 31, 2009 from 11.7% at December 31, 2008, an overall increase of 71.8% during 2009. The number of loans in default includes all reported delinquencies that are in excess of two payments in arrears at the reporting date and all reported delinquencies that were previously in excess of two payments in arrears and have not been brought current. The default rate is affected by the number of policies in default as well as the number of policies in force. Because we are
no longer issuing commitments for mortgage insurance, we expect the number of policies in force to continue to decrease, which can lead to an increase in our default rate.
At the end of the first quarter of 2008, we wrote off the remaining deferred policy acquisition costs (“DAC”) asset balance of $34.8 million because the estimated gross loss in the remaining portfolio no longer supported the asset value. Subsequently, we have not capitalized any cost to acquire new business.
Interest expense increased by $2.5 million or 69.6% in 2009 compared to 2008. Interest expense in 2009 included the accrual of $2.1 million related to the DPO liability and $1.2 million related to an accrual for interest on an IRS assessment. We have paid the tax portion of the IRS assessment in order to stop the accrual of interest and have appealed the IRS assessment.
Total liabilities increased substantially to $1.8 billion at December 31, 2009 from $1.3 billion at December 31, 2008. The increase in total liabilities was primarily due to the $349.2 million increase in loss and LAE reserves and the establishment of the DPO which totaled $168.4 million, including a carrying charge of $2.1 million, at December 31, 2009.
by moving into taxable publicly-traded securities, primarily corporate debt obligations, asset-backed securities, and mortgage-backed securities. Because we anticipate negative cash flow from operations in 2010 due to the expected increase in claims paid, we expect the proceeds from the maturity and sale of securities during 2010 will be used to fund the shortfall. In connection with the restructuring of our investment portfolio, we shortened the portfolio duration to better match the maturities with our anticipated cash needs. We have completed the majority of the restructuring and at December 31, 2009, we had $95.7 million of tax-preferred state and municipal fixed income securities remaining in our portfolio. Risks are involved in attempting to restructure our remaining tax-preferred portfolio, including execution risk in the selling and buying of securities, additional credit risk in moving from primarily insured, highly rated municipal bonds to lower rated corporate bonds, and uncertainty surrounding mortgage-backed and asset-backed securities.
The following table shows the makeup of our investment portfolio and the transition since one year ago:
The following table shows the operating results of our investment portfolio for the last two years:
The unrealized gains are partly due to the recovery in value of previously impaired fixed income securities. These unrealized gains do not necessarily represent future gains that we will realize. Changing conditions related to specific securities, overall market interest rates, or credit spreads, as well as our decisions concerning the timing of a sale, may impact values we ultimately realize. Taxable securities typically exhibit greater volatility in value than tax-preferred securities; accordingly, we expect greater volatility in unrealized gains and realized losses in future periods. Volatility also may increase in periods of uncertain market or economic conditions.
We evaluate the credit risk of a security by analyzing the underlying credit qualities of the security. We also seek value in enhancements provided by financial guaranty insurers to our tax-preferred state and municipal fixed income securities which may benefit the credit rating. However, given the decline in our holdings of tax-preferred securities, the value of enhancements provided by financial guaranty insurers compared to the total portfolio has reduced considerably. Taxable securities generally do not have such credit enhancements and the credit rating reflects only the securities’ underlying credit qualities.
The accompanying consolidated financial statements have been prepared in accordance with GAAP and assume that we will continue as a going concern, which contemplates the realization of assets and the satisfaction of liabilities and commitments in the normal course of business. However, our ability to continue as a going concern will be dependent on our ability to comply with terms of the Corrective Orders. If we are unable to comply with the terms of the Corrective Orders, the Department may institute legal proceedings to place Triad in receivership. If Triad were placed into receivership, all of the assets and future cash flows of Triad would be allocated to Triad’s policyholders to pay insurance claims and the administrative expenses of the receivership, and none of such assets or cash flows would be available to TGI and its stockholders. As Triad is the Company’s primary source of current and potential future cash flow, if Triad were placed in receivership proceedings by the Department, TGI would likely be forced to institute a proceeding seeking relief from creditors under U.S. bankruptcy laws and it is likely that no funds would ever be available for distribution to our stockholders. The report of our independent registered public accounting firm with respect to our December 31, 2009 and 2008 financial statements included a statement that they believe there is substantial doubt about our ability to continue as a going concern.
During 2009, we had a deficit in operating cash flow of $134.9 million compared to positive operating cash flow of $147.1 million in 2008, which was aided significantly by the redemption of the Tax and Loss Bonds. The decline in operating cash flow in 2009 would have been $303.3 million had the second Corrective Order not stipulated the payment in cash of 60% of each settled claim and the establishment of a DPO for the remainder of each claim. The decline in operating cash flow in 2009 compared to 2008 reflects the lack of any material redemption of Tax and Loss Bonds, a substantial increase in settled claims, and a decline in net premiums received. The operating cash flow shortfall in 2009 was funded through sales and maturities of short-term investments and other longer term investment securities. See “Investment Portfolio” for more information.
Net cash paid for claims and LAE, after accounting for the impact of the DPO, increased to $373.2 million during 2009 from $241.9 million during 2008. Net cash paid for claims and LAE in 2009 benefited from $51.2 million of reimbursed paid claims primarily from captive reinsurers. Cash outflows on settled claims in 2009 were reduced by $166.3 million, the amount of the DPO. While the DPO requirement will mitigate the actual cash paid on claims in any period in the short run, we expect that the amount of settled claims and the related cash paid will continue to increase in subsequent quarters, and the increase may be substantial.
The insurance laws of the State of Illinois impose certain restrictions on dividends that an insurance subsidiary, such as Triad, can pay its parent company. As discussed above, the Corrective Orders prohibit the payment of dividends by Triad to TGI without prior approval from the Department, which is highly unlikely for the foreseeable future.
Triad cedes business to captive reinsurance affiliates of certain mortgage lenders, primarily under excess of loss reinsurance agreements. Generally, reinsurance recoverables on loss reserves and unearned premiums ceded to these captives are backed by trust accounts where Triad is the sole beneficiary. When we terminate or commute a captive reinsurance agreement, all reinsurance coverage terminates, Triad ceases to cede premium to the reinsurer, and the supporting trust agreement is terminated and the assets are distributed per terms of the agreement resulting in an increase in cash and invested assets and a corresponding decrease in reinsurance recoverable. During 2009, we terminated three captive reinsurance treaties and received approximately $18.9 million of trust assets. We also commuted one captive reinsurance treaty where the majority of the trust assets were remitted to the reinsurer. Additionally, in March 2010 we entered into a commutation agreement with our largest captive reinsurance partner. Under terms of the commutation agreement, we will assume all liability for the existing and future claims covered by the reinsurance and trust agreement in exchange for the entire trust balance of approximately $142.0 million. We do not expect the transaction will have any impact on the statement of operations for the first quarter of 2010. We are currently in discussion with other captive reinsurers regarding the termination or commutation of their treaties.
At December 31, 2009, we had approximately $257 million in captive reinsurance trust balances. We received approximately $41.0 million in reimbursed settled losses from captive reinsurance during 2009, which includes the assets received from the termination of the captive agreements, and expect further reimbursement in 2010. Due to
TGI has very limited sources of cash flow. TGI’s $35 million outstanding long-term debt is the obligation of TGI and not of Triad. Debt service amounts to $2.8 million per year and is paid by TGI. The primary source of funds for TGI debt service has historically been the interest paid by Triad to TGI on the $25 million surplus note, which has provided $2.2 million on an annual basis. We do not expect this source of cash to be available for the foreseeable future. In 2009, TGI wrote off the $25 million surplus note and reversed accrued interest of $4.4 million on its financial statements as an other-than-temporary impairment. This other-than-temporary impairment did not affect TGI’s consolidated results of operations. Excluding the surplus note receivable from Triad, total cash and invested assets at TGI totaled $8.7 million at December 31, 2009. While we currently believe that the cash resources on hand at TGI will be sufficient to cover the required debt service for 2010 and 2011 on the $35 million long-term debt, we cannot provide any assurance that these or any future debt service payments will be made and the ultimate ability of TGI to repay the entire $35 million is subject to substantial risks and cannot be assured unless a source of funds is secured. The ability of TGI to pay the debt service with funds obtained from Triad, whether in the form of dividends, payments on the surplus note or otherwise, will require the approval of the Department, and it is unlikely that such approval will be sought or obtained in the foreseeable future.
As part of the sale of the information technology and operating platform to Essent, TGI also sold the software related to the establishment of Canadian operations and received approximately $0.4 million and accrued an additional $0.2 million for software owned exclusively by TGI. Additionally, under the terms of the agreement, TGI may receive an additional $0.6 million in contingent payments through 2014.
We had no material off-balance sheet arrangements at December 31, 2009.
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 inventory of loans in default. 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. Our expectations regarding future rescissions have been incorporated into the frequency factor. Severity is the estimate of the dollar amount per claim that will be paid based upon the amount of risk in default on each particular loan. 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 and the impact of the change may not be perceived immediately. 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. Furthermore, the current conditions of the economy and the mortgage market are substantially different than those we have witnessed before and, as such, we believe our estimates are susceptible to a larger degree of variation than those established in previous financial statements.
During 2009, we raised the severity factor for all loan categories above 100% (we can pay greater than 100% of the covered risk due to interest and certain foreclosure costs that we are required to pay under terms of our policies). 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 reasonable percentage increases and decreases in the average frequency and severity factors as of December 31, 2009:
During 2009, we experienced a much higher level of rescission activity than in previous years. This activity has been concentrated in policies originated in 2006 and 2007. We have also identified concentrations with specific lenders and by delivery channel. We incorporate a factor in our computation of loss reserves to account for expected rescissions, based upon the status of our investigation of defaults in progress and our actual experience. The effect of the factor is to reduce the loss reserve by reflecting the probability that we may rescind coverage on a certificate. The rescission factor is a significant component of the frequency factor utilized in the calculation of our loss reserves and resulted in a reduction to our gross reserves of approximately $540 million at December 31, 2009 compared to $239 million at December 31, 2008.
the possibility that the Department may take various actions regarding Triad if it does not operate its business in accordance with its revised financial and operating plan and the Corrective Orders, including instituting receivership proceedings, which would likely eliminate all remaining stockholder value;
the ability of TGI to pay its debt service with funds obtained from Triad, whether in the form of dividends, payments on the surplus note or otherwise, will require the approval of the Department, and it is unlikely that such approval will be sought or, if sought, will be obtained in the foreseeable future;
if house prices continue to fall, particularly in non-distressed markets, or remain depressed, additional borrowers may default and claims could be higher than anticipated;
the impact of programs and legislation affecting modifications and refinancings of mortgages could materially impact our financial performance in run-off;
if the GSEs or our lender customers choose to cancel the insurance on policies that we insure, our financial performance in run-off could be adversely affected;