The Company’s principal executive offices are located at 101 South Stratford Road, Winston-Salem, NC 27104. This five-story office building totals 79,254 square feet and the Company currently leases approximately 66,200 square feet under a lease that will expire in 2012. A majority of staff functions are located within this office complex.
With respect to all remaining facilities, the Company either has renewal options or believes it will be able to obtain lease renewals on satisfactory terms. The Company believes its remaining existing properties are well utilized and are suitable and adequate for its present circumstances.
The Company maintains mid-range and micro-computer systems from its corporate data center located in its headquarters building to support its data processing requirements for accounting, policy administration, claims, marketing, risk management, and underwriting. The Company has in place back-up procedures in the event of emergency situations.
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 negative market conditions in the home mortgage and residential housing markets are unprecedented from an historical standpoint and have subjected our business, financial condition and results of operations to substantial risks, many of which are summarized under “Risk Factors” above, which should be read in conjunction with the following discussion.
Certain of the statements contained herein, other than statements of historical fact, are forward-looking statements. These statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and include estimates and assumptions related to economic, competitive and legislative developments. These forward-looking statements are subject to change and uncertainty, which are, in many instances, beyond our control and have been made based upon our expectations and beliefs concerning future developments and their potential effect on us. Actual developments and their results could differ materially from those expected by us, depending on the outcome of certain factors, including the possibility of general economic and business conditions that are different than anticipated, legislative developments, changes in interest rates or the stock markets, stronger than anticipated competitive activity, as well as the factors described in the “Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995” section below with respect to forward-looking statements contained herein.
Through our U.S. subsidiaries, we provide Primary and Modified Pool mortgage guaranty insurance coverage to residential mortgage lenders and investors as a credit-enhancement vehicle. We classify insurance as Primary when we are in the first loss position and the LTV is 80% or greater when the loan is first insured. We classify all other insurance as Modified Pool. The majority of our Primary insurance is delivered through the flow channel, which is defined as loans originated by lenders and submitted to us on a loan-by-loan basis. We have also historically provided mortgage insurance to lenders and investors who seek additional default protection (typically secondary coverage or on loans for which the individual borrower has greater than 20% equity), capital relief, and credit-enhancement on groups of loans that are sold in the secondary market. These transactions are referred to as our structured bulk channel business. Those individual loans in the structured bulk channel in which we are in the first loss position and the LTV ratio is greater than 80% are classified as Primary. All of our Modified Pool insurance is delivered through the structured bulk channel. We do not expect any significant production of Modified Pool or Primary bulk business from the structured bulk channel in 2008. Our Canadian subsidiary was formed in 2007 for the express purpose of exploring the opportunities of providing mortgage insurance in Canada, but did not write any business and only had start up expenses in 2007. We suspended our Canadian expansion efforts in the fourth quarter of 2007 and we do not expect to write any business through our Canadian subsidiary.
Our profitability depends largely on (a) the volume of business insured combined with the adequacy of our product pricing and underwriting discipline relative to the risks insured, (b) the conditions of the housing, mortgage and capital markets that have a direct impact on mitigation efforts, cure rates and ultimately the amount of claims paid, (c) the overall general state of the economy and job market, (d) persistency levels, (e) operating efficiencies, and (f) the level of investment yield, including realized gains and losses, on our investment portfolio.
Persistency is an important metric in understanding our premium revenue. The longer a policy remains on our books, or “persists”, the greater the amount of revenue that we will derive from the policy from renewal premiums. We define persistency as the amount of insurance in force at the 12-month end of a financial reporting period as a percentage of the amount of insurance in force at the beginning of the period. 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 at the end of the 12-month measurement period. Cancellations result primarily from the borrower refinancing or selling insured mortgaged residential properties and, to a lesser degree, from the borrower achieving prescribed equity levels, at which point the lender no longer requires mortgage guaranty insurance.
The change in diluted (loss) earnings per share for 2007 from 2006 was consistent with the change in our operating results. The denominator used in calculating diluted loss per share for 2007 shown above excludes exercise of options and unvested restricted stock, which is required when a loss from operations is being reported or the result would otherwise be antidilutive. Realized investment gains (losses), net of taxes, decreased diluted loss per share in 2007 by $0.13, increased diluted earnings per share in 2006 by $0.07 and had no impact on diluted earnings per share in 2005. Diluted realized gains and losses per share is a non-GAAP measure. We believe this is relevant and useful information to investors because, except for write-downs on other-than-temporarily impaired securities, it shows the effect that our discretionary sales of investments had on results of operations.
We describe our results of operations in greater detail in the discussion that follows. The information is presented in four categories: Production; Insurance and Risk In Force; Revenues; and Losses and Expenses.
Total NIW decreased slightly during 2007, however, 69% of total NIW that was written in 2007 was written in the first two quarters, with 19% and 12%, respectively, coming in the third and fourth quarters of 2007. Primary flow NIW increased $4.9 billion for 2007 compared to 2006, however 60% of the increase for 2007 was written in the first half of the year and, similar to total NIW, declined in the third and fourth quarters of 2007. We believe it is likely that Primary flow NIW will continue to decline into 2008 for a variety of reasons including those described below:
Bulk insurance is a term that describes Primary and Modified Pool mortgage insurance written for a group of loans that is generally securitized in the secondary market. Mortgage insurance provides loss protection to the issuer and thus increases the credit rating and pricing of the securitization. In the Primary bulk channel, we recorded $3.7 billion of NIW in 2007, much of which was attributable to a forward commitment created in the fourth quarter of 2006. A large percentage of the loans contained in this single transaction had loan amounts in excess of $500,000 with LTVs greater than 95%. We do not expect any further production in the Primary bulk channel for the foreseeable future.
Structured bulk transactions, which include both Primary and Modified Pool, are likely to vary significantly from period to period due to (a) the limited number of transactions occurring in this market, (b) the larger size of such transactions compared with Primary insurance, (c) the level of competition from other mortgage insurers, (d) the relative attractiveness in the marketplace of mortgage insurance versus other forms of credit enhancement, and (e) the changing loan composition and underwriting criteria of the market. During the second half of 2007, we viewed the structured bulk market as unsettled, with a wide variety of products that did not meet our criteria and a lack of clear direction in spreads and pricing. In this environment, we chose to decrease our participation in structured bulk transactions and we do not expect any further production of Modified Pool NIW in 2008.
Many lenders have significantly reduced their emphasis on simultaneous seconds or “piggyback” mortgage products, which has created an opportunity for increased penetration of mortgage insurance in loan originations. However, these piggyback mortgage products have been replaced by products with greater than 95% LTV, which contains a higher amount of risk. These products present a higher level of risk as home values have declined, especially in the soft market areas where home values have declined at a more rapid pace. Evidence exists that important positive changes in the market are emerging, including the development of a more stringent and pragmatic underwriting environment.
amount of reduced documentation loans that we are willing to underwrite. We are also reducing our dependence on certain significant customers and are expanding existing relationships with customers that we believe share our focus on quality. Our enhanced quality standards will cause us to forgo some volume opportunities.
As part of our overall risk management, we monitor various risk characteristics in both our Primary and Modified Pool NIW. The following three tables detail certain risk characteristics - credit quality, loan type and LTV - of our Primary NIW during the respective periods.
The following table summarizes the loan type characteristics of our Primary NIW production for the past three years. The increase in loans with fixed rates in 2007 reflects the conversion of ARM products to more predictable fixed-rate loan products. Most of the potentially negative amortization loan types were the result of production in the first two quarters of 2007. Production from this type of product had declined to less than 3% by the fourth quarter of 2007.
Another risk characteristic that we consider in our underwriting guidelines is the LTV of the loan. The following table summarizes the percentage of our Primary production by LTV for 2007, 2006 and 2005:
The above table indicates a significant increase in the Primary production of NIW on loans with LTV greater than 95%. These loans are coming from both the flow and bulk channels. We believe many of the greater than 95% loans are
the result of lenders turning away from “piggyback” or simultaneous second mortgages in favor of a loan product that has a higher LTV ratio. The majority of Primary bulk transactions that were included in 2007 NIW consisted of loans that were greater than 95% LTV, which impacted the overall Primary stratifications by LTV as shown above.
The following table provides detail on our direct insurance in force at December 31, 2007, 2006, and 2005:
The following tables provide information on selected risk characteristics of our business based on risk in force at December 31, 2007, 2006 and 2005. Risk in force is the total amount of coverage for which we are at risk under our certificates of insurance. The following is a list of what we believe are important indicators of increased risk that are present in our risk in force as of December 31, 2007:
Percentages represent distribution of direct risk in force on a per policy basis and do not account for applicable stop-loss amounts or deductibles on Modified Pool.
The above table reflects that certain indicators of increased risk continue to grow as a percentage of our risk in force, consistent with a general shift to these products and risk characteristics in the overall mortgage industry. While we have limited our exposure to certain sectors in the marketplace such as sub prime and second mortgages, our portfolio contains an increased exposure to Alt-A loans as well as PNAMs. As discussed earlier in this report, PNAMs contain an additional future risk when scheduled positive amortization is required in later years. As a group, the Alt-A loans and the PNAM loans have performed worse than the remaining prime fixed rate loans through December 31, 2007. We also have experienced a significant increase in the size of the mortgages for which we are providing coverage. As noted above, loans greater than $250,000 make up an increasing percentage of our risk in force. Loans greater than $250,000 totaled 37.4% of total Primary risk in force at December 31, 2007 compared to 28.5% at December 31, 2006 and 19.4% at December 31, 2005. Loans greater than $250,000 also totaled 48.5% of total Modified Pool risk in force at December 31, 2007 compared to 46.0% at December 31, 2006 and 36.2% at December 31, 2005. In addition, the increase in loans with LTVs greater than 95%, which historically produced higher default rates, has increased our risk.
Due to the recent significant growth in our production and the amount of refinancing that took place in 2002 through 2005, our insurance portfolio is relatively unseasoned, having a weighted average life of 2.5 years at December 31, 2007 compared to 2.3 years at December 31, 2006 and 2.4 years at December 31, 2005. The following table shows direct risk in force as of December 31, 2007, 2006, and 2005 by year of loan origination.
As noted above, approximately 62% of the Primary and 35% of the Modified Pool risk in force at December 31, 2007 has been generated in 2006 and 2007. This is the result of increased production in the number of certificates and an increase in the size of the loans during these periods. The 2006 and 2007 vintage years have so far exhibited higher default rates at this stage of development than we have historically experienced from preceding vintage years. For additional information regarding these vintage years, see “Losses and Expenses,” below.
We also offer mortgage insurance structures designed to allow lenders to share in the risks of such insurance. One such structure is our captive reinsurance program under which reinsurance companies that are affiliates of the lenders assume a portion of the risk associated with the lender’s insured book of business in exchange for a percentage of the premium. Under the captive reinsurance program, the risk held by the captive is supported by assets held in trust with Triad as the beneficiary. At December 31, 2007, we had $202 million in captive reinsurance trust balances supporting the risk transferred to captives, helping to limit our loss exposure. Approximately 59% of our Primary flow insurance in force at December 31, 2007 was subject to these captive arrangements compared to approximately 61% at December 31, 2006 and 59% at December 31, 2005. The decline of the Primary flow insurance in force that was subject to captive reinsurance arrangements at December 31, 2007 compared to December 31, 2006 resulted from two of our larger lender customers moving to a lender-paid product that does not qualify for captive participation.
During 2007, 19.7% of our NIW subject to captive reinsurance had a premium cede rate greater than 25%. In February 2008, Freddie Mac and Fannie Mae each separately announced that it was temporarily changing its private
The difference between net written premiums and earned premiums is the change in the unearned premium reserve, which is established primarily on premiums received on annual and single payment plans. Our unearned premium liability increased $4.3 million during 2007 compared to declines of $0.3 million and $2.4 million, respectively, in 2006 and 2005 primarily due to the introduction of a single premium product in 2007.
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. We wrote down other-than-temporarily impaired investments by approximately $5.3 million in 2007 compared to $0.4 million in 2006 and $0.2 million in 2005. See “Realized Losses and Impairments” below.
We experienced a significant increase in the amount of paid claims during 2007 as both the number of claims and the average severity of the paid claims increased. The increases in the amortization of deferred policy acquisition costs in 2007 and 2006 are consistent with the growth in that asset balance. Other operating expenses increased in 2007 over 2006, reflecting the growth of our insurance in force as well as several key initiatives that have taken place in 2007. The discussion below provides more detail on both losses and expenses.
The following table shows the average loan size and risk in force per policy by vintage year. As each of the more recent vintage years season and enter the period of peak defaults, the amount of risk per default and, ultimately, the amount of paid claims as well as the average paid claim is expected to increase.
The table below shows the average severity of paid claims during the past three years. Average severity on paid claims was relatively flat between 2006 and 2005, but increased significantly in 2007, primarily due to growth in the average amount of risk in force on paid claims.
Beginning in late 2006, we experienced a significant reduction in our ability to mitigate claims through our traditional processes, which we believe was related to weakness in the housing market. In some cases, properties for which loans have defaulted are sold during the foreclosure process, which generally reduces our loss. When the property does not sell prior to foreclosure, or sells after foreclosure but prior to when the claim is paid, we often pay the full amount of our coverage, which we call a full option settlement. Full option settlements as a percentage of our paid claims have generally increased since the fourth quarter of 2006. During the second half of 2007, the rapid decline in home prices in certain markets coupled with the overall uncertainty in the housing markets on a national basis had a significant negative impact on our ability to mitigate claims and negatively impacted the average severity.
As shown under “Insurance and Risk in Force,” we are insuring a larger percentage of mortgages in excess of $250,000. Claim payments on larger mortgages are greater even if coverage percentages remain constant. Claim payments on these larger mortgages are reflected by the increase in average severity during 2007. We expect severity will continue to trend upward as the average loan amounts in our portfolio continue to rise. Continued deterioration in the housing market could further reduce our loss mitigation opportunities and also contribute to increased severity in 2008.
The table above reflects relatively higher cumulative ratios of losses paid to premium received for the 2000 through 2002 policy years at this stage of development. This is due, in part, to a large portion of this business being refinanced in subsequent years and the resulting lower aggregate level of premiums received for these policy years. As discussed in “Business - Claims,” we anticipate making higher claim payments in the second through the fifth years after the loan is originated.
Net losses and LAE also include the change in reserves for losses and LAE. The following table provides further information about our loss reserves at December 31, 2007, 2006, and 2005 and the related changes for the years then ended:
The following table shows the change in reserves for losses and LAE:
Average loan size and vintage year of the loans entering the default pool in 2007 are notably different compared to one year earlier. Although defaults increased across the board geographically, defaults in the distressed market states - California, Florida, Arizona and Nevada - increased 380.2% in 2007, compared to a 63.9% increase in defaults for the remaining states during 2007. Additionally, the higher average loan balance in these distressed market states has resulted in significantly higher reserve per default, all else being equal, compared to the rest of the portfolio. As of December 31, 2007, the reserve per default for distressed market states was $33,769, compared to the reserve per default of $18,680 for the remaining states. As of December 31, 2006, the reserve per default was $14,977 and $11,128, respectively, for distressed market states and all remaining states.
We do not provide reserves on Modified Pool defaults with deductibles until the incurred losses for that transaction reach the deductible threshold. At December 31, 2007, three structured bulk transactions with deductibles as part of the structure had incurred losses that had exceeded these individual deductible amounts.
As part of our overall risk management strategy, we have entered into excess of loss captive reinsurance agreements with several of our lender customers. As detailed under “Business - Risk Sharing Products” in Part I, Item 1 of this report, we retain the first loss position on the first aggregate layer of risk and reinsure the second finite layer with the captive reinsurer with each separate policy year standing on its own. During 2007, for the first time since the establishment of these captives, certain captives exceeded their first loss layer in incurred losses, which resulted in the ceding of reserves of $7.3 million as of December 31, 2007 related to specific book years. However, we deemed $383,000 of this as potentially uncollectible as the reserves ceded to one reinsurer exceeded the current amount in the captive’s trust balance. At December 31, 2007, actual paid losses have not exceeded the first layer of any captive reinsurer. If the current default and paid claim trends continue, we expect other vintage year layers and other captives to reach the attachment points on both incurred losses and paid claims, especially the 2006 and 2007 vintage years that have experienced a higher default rate at a faster pace than we have seen historically.
Other operating expenses increased in 2007 due to expenses incurred in connection with organizational changes, growth of the operations and costs associated with our proposed expansion into Canada. Direct expenses relating to the Canadian expansion amounted to approximately $3.3 million for 2007, including $1.4 million in the fourth quarter, compared to none in 2006. In the first quarter of 2008, we made the decision to suspend expansion efforts in Canada and repatriate capital previously committed to Canada back to the U.S. market. Although we are currently exploring options for the Canadian subsidiary, we expect our expenses related to the Canadian operations to diminish in 2008. During the fourth quarter of 2007, operating expenses in the amount of $2.0 million related to
Our effective tax rate was 40.7% for 2007 compared to 27.3% and 27.1%, respectively, for 2006 and 2005. The change in the effective tax rate was due primarily to reporting an operating loss in 2007 versus operating income in 2006 and 2005, as well as an increase in tax-exempt interest resulting from growth of investments in tax-preferred municipal securities.
Our objective is controlled, profitable growth in both Primary and Modified Pool business while adhering to our risk management strategies. Our strategy is to continue our focus on national lenders while maintaining the productive relationships that we have built with regional lenders. Competition within the mortgage insurance industry remains intense as many large mortgage lenders have limited the number of mortgage insurers with which they do business. In addition, consolidation among national lenders has increased the share of the mortgage origination market controlled by the largest lenders, and that has led to further concentration of business with a relatively small number of lenders. Many of the national lenders allocate Primary business to several different mortgage insurers or accept competitive bids on certain lender-paid products. These lender allocations and our success in the bidding process for lender-paid products can vary over time, even quarter to quarter.
During the fourth quarter of 2007 and first quarter of 2008, we announced adjustments to our underwriting guidelines. These adjustments place limitations on maximum LTVs, minimum FICO scores, acceptable documentation and various other factors. These limitations are more restrictive in certain geographic markets. We expect that these adjustments will result in a reduced level of NIW in 2008 and the reduction in the number of lenders with which we have historically done business.
Total assets increased 26% to $1.1 billion at December 31, 2007 over December 31, 2006, primarily due to positive cash flows from operations and growth in invested assets. The increase in invested assets was due in part to the investment of the $80 million that we drew down from our credit facility during the second half of 2007. Total liabilities increased to $634 million at December 31, 2007, from $325 million at December 31, 2006, due to an increase of $276 million in reserves for losses and the $80 million short-term borrowings on our revolving line of
credit, offset by a decrease in deferred income taxes. This section identifies several items on our balance sheet that are important to the overall understanding of our financial position. These items include DAC, prepaid federal income tax and related deferred income taxes. The majority of our assets are contained in our investment portfolio. A separate “Investment Portfolio” section follows this “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”) to take advantage of a special contingency reserve deduction that mortgage guaranty companies are allowed for tax purposes. 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 are scheduled to become current in ten years, when the contingency reserve is scheduled to be released, and the Tax and Loss Bonds are scheduled to mature. The scheduled proceeds from the maturity of the Tax and Loss Bonds are used to fund the income tax payments that would be due in the same year as a result of the scheduled reversal of the contingency reserve for tax purposes.
In years when the taxable income of a mortgage insurer shows a loss before the application of the special contingency reserve, the prior contingency reserve that was established can be reversed earlier than originally scheduled to offset the loss. When the special contingency reserve for tax purposes is reversed earlier than the scheduled years to offset a current year operating loss, the Tax and Loss Bonds purchased when the contingency reserve was established are redeemed earlier than originally scheduled. During 2007, we reversed $113 million of contingency reserves for tax purposes earlier than originally scheduled and redeemed $51 million of Tax and Loss Bonds related to that reversal.
The following table shows the growth and diversification of our investment portfolio:
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 and cash needs for claim payments. See Note 2 in Notes to Consolidated Financial Statements for a description of the scheduled maturity of our fixed maturity investments. The increase of short-term
We also manage risk and liquidity by limiting our exposure on individual securities. As shown below, no investment in the securities of any single issuer exceeded 1% of our investment portfolio at December 31, 2007. The following table shows the ten largest exposures to an individual creditor, or issuer in the case of equity securities, in our investment portfolio as of December 31, 2007:
The following table shows the results of our investment portfolio for the last three years:
The drop in the tax-equivalent yield-to-maturity shown above reflects the investment of our cash flows from operations and reinvestment of proceeds from the maturity or call of higher yielding investments at new money rates, which were and are projected to continue to be lower than that of our overall portfolio yield.
Of the approximate $2.0 million of gross unrealized losses at December 31, 2007, securities with a fair value to cost or amortized cost ratio of less than 90% had a combined unrealized loss of approximately $257,950.
Realized losses include both write-downs of securities with other-than-temporary impairments and losses from the sales of securities. We wrote down securities, including other investments, by a total of approximately $5.3 million, $375,000 and $170,000 during 2007, 2006, and 2005, respectively, due to other-than-temporary declines in fair value. During 2007, we wrote down the entire carrying value of Structured Credit Holdings, a $5.0 million equity investment that was previously carried as other investments.
Generally, our sources of operating funds consist of premiums written and investment income. Operating cash flow is generally applied to the payment of claims, interest, expenses and prepaid federal income taxes in the form of Tax and Loss Bond purchases. During 2007, the early redemption of Tax and Loss Bonds due to the significant increase in loss reserves provided a source of funds (See “Prepaid Federal Income Taxes and Deferred Income Taxes” for information on the Tax and Loss Bonds).
We generated positive cash flow from operating activities of $191.1 million in 2007 compared to $88.4 million for 2006 and $70.8 million for 2005. The increase in cash flow from operating activities reflects the strong growth in
Positive operating cash flows are invested pending future payments of claims and expenses. We attempt to match the maturities of our invested assets to the anticipated timing of the payments of claims and expenses. Maturities within our fixed income investment portfolio have been structured to provide options to reinvest those funds or have such funds available to meet operating cash needs, such as the payment of claims. At December 31, 2007, maturities scheduled within the next twelve months within our fixed income portfolio amount to $91.4 million. An operating cash flow shortfall, if any, could be funded through sales of short-term investments and other investment portfolio securities. Our business does not routinely require significant capital expenditures other than for enhancements to our computer systems and technological capabilities.
Our risk-to-capital ratio has risen dramatically over the past year, driven primarily by significant increases in our risk-in-force during the past 12 months and operating losses we incurred in the last two quarters of 2007. We believe the housing and mortgage markets in 2008 will continue to be adversely affected by a number of factors, including declining home prices, an oversupply of homes offered for sale and increased foreclosures, particularly in certain distressed markets. We expect we will incur additional operating losses as new defaults are reported. Based on our internal projections, we must significantly augment our capital resources in the second quarter of 2008 in order to preserve our ability to continue to write new insurance. Since the fourth quarter of 2007, we have been working with a prominent financial advisory firm to pursue alternatives for enhancing our capital. We have not yet succeeded in obtaining any commitments for an investment in our company, and there can be no assurance that we will be able to obtain any such commitments in the future.
involve a direct investment in Triad. Completing any such transaction would be subject to numerous conditions, including obtaining necessary consents and approvals from our stockholders, the Illinois Department of Insurance and other state insurance regulatory authorities, the GSEs, rating agencies and other third parties. No assurance can be given that such consents and approvals could be obtained or that we can complete any such transaction. In addition, no assurance can be given that we would have any ownership interest in any new mortgage insurer formed to acquire assets of Triad or have any opportunity to share in the potential financial returns available from insurance written by such an insurer.
The insurance laws of the State of Illinois impose certain restrictions on dividends that an insurance subsidiary can pay its 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 Department of Insurance. In addition to these statutory limitations on dividends, Illinois regulations provide that a mortgage guaranty insurer may not declare any dividends except from undivided profits remaining on hand over and above the amount of its policyholder reserve. In the second quarter of 2007, Triad declared and paid a dividend of $30 million to its parent company to partially fund the initial capital required to commence business in Canada. In the fourth quarter of 2007, the parent company made an additional capital contribution of $50 million to Triad that was recorded as additional paid in capital on the books of Triad.
Included in policyholders’ surplus of the U.S. insurance subsidiary, Triad, is a “surplus note” of $25 million payable to the registrant, its parent. The surplus note is included as statutory capital for the purpose of the calculation of all regulatory ratio analyses. The accrual of and payment of the interest on the surplus note must be approved by the Illinois Department of Insurance. Additionally, specific covenants of Triad’s surplus note prohibit the accrual of or payment of interest on the note if the most recently reported policyholders’ surplus is below the level at the time the note was originated. At year end, based upon the most recent statutory filings with the Illinois Department of Insurance (September 30, 2007), reported total policyholders’ surplus was below the level at the time the note was originated. Therefore, Triad did not request approval to accrue the interest on the surplus note at year end nor did we request approval to pay the interest on the scheduled due date of January 10, 2008. The statutory filings at December 31, 2007 included a release of the contingency reserve that resulted in policyholders’ surplus at a level greater than that when the surplus note was originated. We have requested the approval from the Illinois Department of Insurance to accrue and pay the interest on the $25 million surplus note, but as of this date, we have not received its approval.
Debt service on the $35 million long-term debt amounts to $2.8 million per year. The primary source of the cash flow for the debt service comes from the interest on the $25 million surplus note at Triad, which provides $2.2 million on an annual basis. If Triad is unable to pay the scheduled debt service on the $25 million surplus note to its parent for an extended period of time, the holding company may be unable to continue to meet its debt service obligations on the $35 million long-term debt.
We cede 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 we are the sole beneficiary. When ceded loss reserves exceed the trust balances, we address the counter-party credit risk of the reinsurance recoverable on a case-by-case basis and provide for a provision for uncollectible accounts where appropriate.
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, 2007 and 2006:
The primary differences between statutory policyholders’ surplus and equity computed under generally accepted accounting principles are the statutory contingency reserve, DAC and deferred income taxes. Generally, mortgage insurance companies are required to add to the statutory contingency reserve through a charge to surplus an amount equal to 50% of calendar year earned premiums and retain the contingency reserve in the statutory statements for a period of ten years. The contingency reserve can be released earlier than the scheduled ten years if the loss ratio exceeds 35%. The loss ratio substantially exceeded 35% in 2007 and marginally exceeded 35% in 2006. Accordingly, we released approximately $275.0 million and $19.7 million of contingency reserve surplus in 2007 and 2006, respectively.
At December 31, 2007, Triad was rated “AA-” by both Standard & Poor’s Ratings Services and Fitch Ratings and “Aa3” by Moody’s Investors Service. On February 13, 2008, S&P placed its ratings of Triad on “credit watch” with negative outlook or implications indicating that ratings on Triad could be lowered multiple notches or affirmed with a negative outlook. On January 31, 2008, Moody’s placed its ratings of Triad on review for possible downgrade. On October 25, 2007, Fitch placed Triad on “Rating Watch Negative” as it addresses the revisions implemented in its proprietary capital model for U.S. mortgage insurers and related performance of the more recent vintage years. All three rating agencies are in the process of reviewing their ratings outlook for the U.S. private mortgage insurance industry. A further reduction in Triad’s ratings or a significant deterioration in the ratings outlook could impact our ability to write new business and jeopardize our GSE rating as a Type 1 or Type I mortgage insurer. See Part I, Item 1A, “Risk Factors” in this report for further discussion relating to potential ratings downgrades.
“Financial Strength Rating” and Part I, Item 1A, “Risk Factors” in this report for further discussion on the qualification standards of Fannie Mae and Freddie Mac.
We lease office facilities, automobiles, and office equipment under operating leases with minimum lease commitments that range from one to ten years. We had no capitalized leases or material purchase commitments at December 31, 2007.
Fixed maturity securities represented approximately 92% of our invested assets at December 31, 2007 based on amortized cost. While the fair value of these fixed rate securities generally bears an inverse relationship to changes in prevailing market interest rates, a change in market interest rates would not immediately impact results of operations because we have the ability and intent to hold these securities until maturity. However, a decrease in market interest rates generally will have the effect of initiating an early call provision of those securities possessing such provisions. The proceeds relating to the early called securities in a decreasing interest rate environment generally are invested in lower yielding investments that would ultimately decrease results of operations. Our long-term debt matures in 2028 with no early call or put provisions and bears interest at a fixed rate of 7.9% per annum. The fair value of this debt is sensitive to changes in prevailing interest rates; however, a change in rates would not impact results of operations. We believe that a 20% increase or decrease in market interest rates is reasonable for the upcoming year. A 20% relative increase or decrease in market interest rates that affect our financial instruments would not have a material impact on results of operations during 2008.
We calculate our best estimate of the reserve for losses to provide for the estimated costs of settling claims on loans reported in default, as of the date of our financial statements. Additionally, we provide a reserve for loans in default that are in the process of being reported to us (incurred but not reported) using an estimate based on the percentage of actual reported defaults. Our reserving process incorporates various components in a model that gives effect to current economic conditions and segments defaults by a variety of criteria. The criteria include, among others, policy year, lender, geography and the number of months and number of times the policy has been in default, as well as whether the defaults were underwritten as flow business or as part of a structured bulk transaction.
The impact on loss reserves on the balance sheet would be to decrease reserves for favorable developments and to increase reserves for unfavorable developments. There would be no impact on liquidity resulting from the change in reserves. However, there would be a change in cash or invested assets equal to the increase or decrease in the
ultimate paid claims related to the change in reserves. We believe that a 20% increase or decrease in frequency or severity is reasonably likely based on potential changes in future economic conditions and past experience, although we believe there is a greater propensity during 2008 for an increase in the frequency and severity factors given the current conditions of the housing market. Economic conditions that could give rise to an increase in the frequency rate could be a sudden increase or a prolonged period of increase in the unemployment rate or a continued downward trend in home prices while, conversely, an improved housing market, a sudden drop in interest rates or a sustained period of economic and job growth could decrease the frequency rate. Any factor that would affect our ability to sell a home of a borrower in default prior to foreclosure would affect our severity. The most prominent of these would be the value of the underlying home.
Much of our fixed maturity municipal bond portfolio contains credit enhancements that guarantee the payments of principal and interest. This guarantee is generally provided by “AAA” rated financial guaranty companies and has resulted in most of these securities being at the highest credit rating. Many of the financial guaranty companies that provide the credit enhancement on our municipal bond portfolio are currently in jeopardy of being downgraded below “AAA” by the rating agencies or already have been downgraded below “AAA”. As a result, the ratings of the bonds they insure will generally be downgraded as well. As a result, we have examined the underlying credit on the individual securities to determine if an other-than-temporary impairment has taken place.
The costs of acquiring new business, principally sales compensation and certain policy underwriting and issue costs that are primarily related to the production of new business, are capitalized as deferred policy acquisition costs (“DAC”). Amortization of DAC is charged to expense in proportion to premiums 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 related to DAC is the estimated life of the asset.
sensitive to future economic events, these estimates may change in the future. For a further discussion of DAC, see “Financial Position” above.
if we implement a run-off plan and our business is limited to servicing our remaining book of in-force insurance, we face additional regulatory and operating risks that could reduce or eliminate the market value of our common stock;
housing transactions requiring mortgage insurance may decrease for many reasons, including changes in interest rates or economic conditions or alternative credit enhancement products;
the amount of insurance written and the growth in insurance in force or risk in force, as well as our performance, may be adversely impacted by the competitive environment in the private mortgage insurance industry, including the type, structure, mix and pricing of our products and services and our competitors;
if we fail to properly underwrite mortgage loans under contract underwriting service agreements, we may be required to assume the costs of repurchasing those loans;
economic downturns in regions where our risk is more concentrated, such as the distressed markets, could have a particularly adverse effect on our financial condition and loss development;
further changes in the eligibility guidelines of the GSEs could have an adverse effect on results of operations and our ability to conduct our business;
our financial and competitive position could be affected by regulatory activity requiring changes to mortgage industry business practices, such as captive reinsurance.
The Financial Statements and Supplementary Data are presented in a separate section of this report and are incorporated herein by reference.