When a forward-looking statement includes an underlying assumption, we caution that, while we believe the assumption to be reasonable and make it in good faith, assumed facts almost always vary from actual results, and the difference between assumed facts and actual results can be material. Where, in any forward-looking statement, we express an expectation or belief as to future results, there can be no assurance that the expectation or belief will result. Our actual results may differ materially from those expressed in any forward-looking statement made by us. Forward-looking statements involve a number of risks of uncertainties including, but not limited to, the risks described under the heading “Risk Factors.” All forward-looking statements are qualified by and should be read in conjunction with those risk factors. Except as may be required by applicable law, we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.
U.S. Mortgage Insurance Operations. We offer mortgage insurance products in the U.S. that enable borrowers to buy homes with low down-payment mortgages. Net income from U.S. Mortgage Insurance Operations was $254.5 million in 2004 and $245.5 million in 2003, and includes PMI Mortgage Insurance Co. and its affiliated U.S. mortgage insurance and reinsurance companies (collectively, “PMI”), and equity in earnings from PMI’s joint venture, CMG Mortgage Insurance Company.
Our goal is to become a global provider of credit enhancement products across multiple asset and risk classes and to continue to diversify our product offerings beyond mortgage insurance, while at the same time expanding our mortgage insurance product offerings. The percentage of our consolidated revenues generated by our International Operations and Financial Guaranty segments increased to 25.0% in 2004, from 16.0% in 2003 and 10.1% in 2002.
Our revenues in 2004 were reduced by a realized capital loss on our equity investment held for sale.
Our consolidated net income was $399.3 million in 2004 compared to $299.4 million in 2003. Our consolidated net income from continuing operations in 2004 was $366.5 million and increased by 33.6% compared to 2003. (See Results of Operations table below.) The 2004 increase in consolidated income from continuing operations after taxes was primarily due to increases in 2004 in our equity in earnings from FGIC, premiums earned and net investment income, particularly from our International Operations, and the slight profitability of SPS in 2004 compared to its losses in 2003. The increases were partially offset by higher losses and loss adjustment expenses, or LAE, and other underwriting and operating expenses, primarily from U.S. Mortgage Insurance Operations, a $20.4 million (pre-tax) realized capital loss on our equity investment in SPS, and an increase in our interest expense as a result of long-term debt that we issued in the fourth quarter of 2003.
New Insurance Written (NIW). PMI’s NIW decreased by 28.1% in 2004 compared to 2003. PMI’s ability to write new mortgage insurance is directly affected by, among other factors, the sizes of the U.S. mortgage origination, purchase money mortgage, and private mortgage insurance markets. The sizes of the U.S. mortgage origination and private mortgage insurance markets decreased in 2004 compared to 2003 as a result of a decline in refinancing activity in 2004. We expect mortgage originations and refinance activity to decline and the percentage of purchase money mortgage transactions to increase in 2005 if U.S. mortgage interest rates remain stable or increase. Increased use of alternatives to private mortgage insurance, such as “piggyback,” “80/10/10” or “80/20” loans, also negatively affected the size of the private mortgage insurance market and PMI’s NIW in 2004. We believe that the use of such loans, which include a first mortgage lien with an LTV of 80% and a second mortgage lien of between 10% and 20%, has increased in the last three years and may continue to do so in 2005.
Credit and Portfolio Characteristics. PMI’s NIW and insurance in force in 2004 consisted of higher percentages of adjustable rate mortgages, or ARMs, Alt-A loans and high loan to value, or LTV, loans. We consider a loan Alt-A if it has a credit, or FICO, score of 620 or greater and has certain characteristics such as reduced documentation verifying the borrower’s income, deposit information or employment. We believe that PMI’s increases reflect the higher concentrations of ARMs, Alt-A and high LTV loans in the 2004 mortgage origination and private mortgage insurance markets. We believe that these market trends will continue in 2005, particularly if mortgage interest rates increase. We expect higher default and claim rates for ARMs, Alt-A and high LTV loans and incorporate these assumptions into our pricing and loss and claim estimates.
PMI’s Losses and Claims. PMI’s claims paid including LAE increased by 8.6% in 2004 compared to 2003 primarily as a result of the aging of PMI’s insurance portfolio and higher claim rates associated with the portion of PMI’s portfolio that contains less-than-A quality (loans with FICO scores less than 620) and Alt-A loans. We expect a significant majority of PMI’s mortgage insurance claims with respect to its current portfolio to occur between the second and fourth years after loan origination. Approximately 85% of PMI’s insurance in force at December 31, 2004 was written after January 1, 2002. We expect PMI’s total losses and LAE to increase in 2005 compared to 2004 due to the seasoning of PMI’s insurance portfolio, particularly the 2003 book year which represents 36.1% of PMI’s primary insurance in force, the higher average loan size of PMI’s portfolio and higher claim rates associated with ARMs, Alt-A, high LTV and less-than-A quality loans. We expect that the impact of the seasoning of
the 2003 and earlier book years on total losses and LAE will be greatest in 2005, with some continued impact in 2006. However, changes in economic conditions, including mortgage interest rates, U.S. unemployment and job creation, could significantly impact our total losses and LAE and our estimates. In addition, changes in economic conditions may not necessarily be reflected in PMI’s loss development in the quarter or year in which such changes occur.
Underwriting and Operating Expenses. The profitability of our business depends in part on our ability to control our underwriting and operating expenses. Our expense ratio, the ratio of underwriting expenses to net premiums written, in our U.S. Mortgage Insurance Operations segment has been adversely affected by lower persistency from historical levels, which has reduced PMI’s premiums written, and by the increased use of captive reinsurance, which decreases premiums written without fully offsetting decreases in underwriting expenses.
Regulatory and Legislative Environment. At any point in time, there are multiple proposals and initiatives for statutory and regulatory changes that may significantly affect the mortgage insurance industry as well as PMI’s business. We may also be impacted by changes in statutes and regulations affecting the GSEs, including changes to the risk-based capital rules and as a result of changes in the GSEs eligibility guidelines.
PMI Europe. PMI Europe’s net income and premiums earned increased in 2004 compared to 2003 primarily as a result of its fourth quarter 2003 acquisition of a portion of the U.K. lenders’ mortgage insurance portfolio of Royal & Sun Alliance, or R&SA and the positive performance associated with PMI Europe’s various credit default swaps. Under the terms of the agreement, PMI Europe and R&SA share certain economic benefits if loss performance performs to certain target levels. Due to better than expected loss experience on the R&SA portfolio, we anticipate increased profit commission accruals in 2005. PMI Europe’s ability to expand its business in the U.K. and elsewhere in Europe depends on several factors. These factors include lender expectations of future mortgage losses and the degree to which PMI Europe’s products are accepted in Europe’s secondary mortgage market and recognized as a method to reduce capital requirements with respect to the New Basel Capital Accord (Basel II), which is expected to become applicable to European banks starting in 2007.
Foreign Currency Exchange Fluctuations. The performance of International Operations is subject to fluctuations in the exchange rates between the reporting currency of the U.S. dollar and the functional currencies of the Australian dollar and the Euro. The change in the average foreign currency exchange rates from 2003 favorably impacted our 2004 International Operations net income by $10.2 million, primarily due to appreciation of the Australian dollar. This foreign currency translation impact is calculated using the year over year change in the average monthly exchange rates to the current period ending net income in the local currencies. In the second quarter of 2004, we purchased foreign exchange put options at a cost of $1.1 million to mitigate the negative effects of a potential strengthening U.S. dollar relative to either the Australian dollar or the Euro in 2004. We entered into a similar foreign exchange put program in January 2005 at a pre-tax cost of $1.8 million.
FGIC Corporation. The significant portion of our 2004 net income derived from our Financial Guaranty segment was generated by equity in earnings from FGIC Corporation. Factors affecting FGIC Corporation’s financial performance include interest rate movements, which may generate refundings, the level of public financings, and FGIC’s ability to expand into new markets.
RAM Re. RAM Re’s net income increased in 2004 in comparison to 2003 primarily due to increases in premiums earned and investment income, offset by increases in underwriting and operating expenses and amortization of policy acquisition costs.
SPS (formerly Fairbanks Capital Holding Corp.). We recorded $0.4 million in equity in earnings relating to SPS in 2004 compared to a $17.7 million loss in 2003. In September 2003, SPS recorded $55.0 million (pre-tax) in charges in connection with its settlement of potential civil charges by the FTC and HUD, settlement of certain putative class action litigation, and estimated costs relating to certain state regulatory actions. In January 2005, we signed a Summary of Terms with Credit Suisse First Boston (USA), Inc., or CSFB, pursuant to which CSFB received an option to acquire 100% of our outstanding stock of SPS. Based upon the transaction, for the fourth quarter of 2004 we recorded an after tax $13.3 million realized capital loss on our equity investment in SPS, and classified our remaining carrying value in SPS as equity investment held for sale on our consolidated balance sheet. We will record future equity in earnings or losses from SPS in Other income.
U.S. Mortgage Insurance Operations, and a realized capital loss on our equity investment in SPS in 2004. Consolidated net income for 2003 decreased by 13.5% compared to 2002, due primarily to a reduction in earnings from unconsolidated strategic investments, increases in losses and LAE and other underwriting and operating expenses primarily from U.S. Mortgage Insurance Operations.
Premiums earned represents the amount of premiums recognized as revenue for accounting purposes. The increase in premiums earned in 2004 over 2003 was attributable primarily to increases in premiums earned by our International Operations and U.S. Mortgage Insurance Operations. PMI Australia’s premiums earned increased as a result of growth in its business and the continued weakening of the U.S. dollar relative to the Australian dollar. U.S. Mortgage Insurance Operations’ premiums earned increased primarily as a result of higher average premium rates in 2004 and the release of $14.5 million of unearned premiums to earned premiums in the second half of 2004. This release of unearned premiums was caused by loan cancellations reported in the third and fourth quarters of 2004 relating to a non-refundable, single premium policy executed in 2003. PMI Europe’s premiums earned increased in 2004 by approximately $7 million compared to 2003 primarily as a result of its acquisition of the R&SA mortgage insurance portfolio in the fourth quarter of 2003. The increase in consolidated premiums earned in 2003 over 2002 was attributable primarily to increases in PMI Australia’s premiums earned, offset by cumulative adjustments for ceded premiums of $8.4 million recorded in the fourth quarter of 2003 in our U.S. Mortgage Insurance Operations.
The increase in net investment income in 2004 over 2003 was due primarily to growth in our investment portfolio, partially offset by a decrease in our book yield related to our U.S. investment portfolio. Our investment portfolio grew primarily as a result of excess cash flows from operations and the sale of APTIC. The increase in net investment income in 2003 over 2002 was due to growth in our investment portfolio combined with adjustments to interest income related to accretion of discounts and call premiums. In 2003, our investment portfolio grew primarily as a result of excess cash flows from operations, partially offset by our investment in FGIC in December 2003.
We account for our unconsolidated strategic investments and limited partnerships using the equity method of accounting. The increase in equity in earnings from our unconsolidated strategic investments in 2004 over 2003 was due primarily to our investment in FGIC Corporation in December 2003 and our resulting equity in earnings from FGIC Corporation of $61.6 million in 2004. The increase in equity in earnings from unconsolidated strategic investments in 2004 was also due to a small profit at SPS in 2004 compared to losses in 2003. Equity in earnings from SPS was $0.4 million in 2004, a change of $18.1 million from 2003. The losses in 2003 were largely a result of SPS charges of $55.0 million (pre-tax) in connection with its settlement of potential civil charges by the Federal Trade Commission, or FTC, and U.S. Department of Housing and Urban Development, or HUD, settlement of certain putative class action litigation, and estimated costs relating to certain state regulatory actions. Our proportionate share of the SPS charges was $19.1 million pre-tax and $17.8 million after tax.
and $6.9 million in 2002. In September 2003, we sold our ownership interests in Truman Capital Founders, LLC and Truman Capital Advisors, LLC, collectively referred to as Truman, and incurred a $3.6 million loss which was included in net realized investment gains and losses.
The decrease in other income in 2004 compared to 2003 and 2002 was largely attributable to a decline in fees generated by our contract underwriting operations. Contract underwriting activity decreased during 2004 due to a decline in the refinance market. The results of our contract underwriting operations are included in our Other segment.
The increase in interest expense and distributions on mandatorily redeemable preferred securities in 2004 compared to 2003 was due to the inclusion of a full year’s interest expense on the equity units we issued in November 2003. The increase in interest expense in 2003 compared to 2002 was also due to the equity units.
Our income tax expense from continuing operations in 2004 decreased by 0.5% compared to 2003 primarily as a result of a decrease in the effective tax rate to 23.5% from 29.8%, offset by an increase in pre-tax income from continuing operations. The decrease in our effective tax rate was due primarily to an increase in equity in earnings from FGIC Corporation which is tax effected at a rate lower than the statutory federal income tax rate of 35.0% and our reversal of a $4.7 million tax contingency reserve established as a result of assessments received from the California Franchise Tax Board (“FTB”) for the years 1997 through 2000. The $4.7 million reversal is reflected as a reduction in the tax expense for 2004. The effective tax rate for 2004, excluding the reversal of the $4.7 million reserve, would have been 24.5%.
We recognized an extraordinary after-tax gain of $5.4 million in 2003, which was our share of negative goodwill recognized by FGIC Corporation resulting from the application of purchase accounting adjustments. In 2002, we realized a $7.2 million gain relating to the remaining balance of negative goodwill originally recorded upon our acquisition of PMI Ltd in 1999.
Premiums written and earned-PMI’s net premiums written refers to the amount of premiums recorded based on effective coverage during a given period, net of refunds and premiums ceded primarily under captive reinsurance agreements. Under captive reinsurance agreements, PMI transfers portions of its risk written on loans originated by certain lender-customers to captive reinsurance companies affiliated with such lender-customers. In return, a proportionate amount of PMI’s gross premiums written is ceded to these captive reinsurance companies. PMI’s premiums earned refers to the amount of premiums recognized as earned, net of changes in unearned premiums. The components of PMI’s net premiums written and premiums earned are as follows:
The decreases in gross and net premiums written in 2004 compared to 2003, and the increases in 2003 compared to 2002, were largely due to a non-refundable, $114 million single premium policy executed in 2003 pursuant to which PMI restructured the insurance coverage of certain loans under then-existing primary insurance policies. The decreases in gross and net premiums written in 2004 were offset by an increase in PMI’s average premium rate caused by higher percentages of polices with deeper coverage and policies on ARMs and high LTV loans, in 2004 than in 2003.
Losses and LAE-PMI’s total losses and LAE represent claims paid, certain expenses related to default notification and claim processing, and changes in loss reserves during the applicable period. Claims paid including LAE includes amounts paid on primary insurance claims, pool insurance claims and LAE. PMI’s total losses and LAE and related claims data are shown in the following table.
Claims paid including LAE increased in 2004 compared to 2003 primarily as a result of increases in 2004 in the number of primary claims paid, partially offset by a decrease in the average primary claim size. The increase in the number of primary claims paid in 2004 was due to a number of factors, including the seasoning of our primary insurance portfolio and higher claim rates associated with the portion of PMI’s portfolio that contains less-than-A quality and Alt-A loans. (See Credit and portfolio characteristics, below.) The decrease in the average primary claim size in 2004 compared to 2003 was primarily the result of continued home price appreciation and PMI’s loss mitigation efforts. Primary claims paid increased to $193.2 million in 2004 compared to $176.9 million in 2003 and $101.3 million in 2002. Pool insurance claims paid increased to $19.4 million in 2004 from $18.0 million in 2003. Changes in net loss reserves increased in 2004 compared to 2003 due to an increase in PMI’s primary loans in default inventory.
Total losses and LAE represent management’s best estimate of our future claim payments and costs to process those claims relative to our current inventory of loans in default. As discussed above, the increase in total losses and LAE in 2004 compared to 2003 was a function of the seasoning of our primary insurance portfolio and higher claim rates associated with the less-than-A quality and Alt-A loans. We expect a significant majority of claims on insured loans in PMI’s current portfolio to occur between the second and fourth years after loan origination, and 85.0% of PMI’s insurance in force at December 31, 2004 was written after January 1, 2002. Accordingly, we expect PMI’s total losses and LAE in 2005 to be higher than 2004 as a result of the seasoning of the U.S. portfolio, particularly the 2003 book year which represents 36.1% of PMI’s primary insurance in force. In addition, to the extent we continue to have high levels of our insurance in force that are in or approaching their peak loss development years, total incurred losses may continue to increase from prior periods. However, estimates of total losses and LAE are derived primarily by notices of default which are impacted by economic conditions such as U.S. unemployment and job creation rates. Changes in economic conditions could significantly impact our total losses and LAE and our estimates. In addition, changes in economic conditions may not necessarily be reflected in PMI’s loss development in the quarter or year in which such changes occur.
The increases in claims paid including LAE and total losses and LAE in 2003 compared to 2002 were due to increases in the average primary claim size, the percentage of delinquent loans going to claim, the total number of primary loans in default and the seasoning of our modified pool and bulk loans acquired in 2002 and 2003. The increase in the average primary claim size was the result of increases in the average principal balance of loans and deeper coverage amounts, principally on bulk loans which represented a larger percentage of all claims in 2003 than in 2002. Pool claims paid were $18.0 million in 2003 compared to $11.4 million in 2002. This increase was primarily due to the seasoning of PMI’s modified pool portfolio.
PMI’s primary mortgage insurance master policies define “default” as the borrower’s failure to pay when due an amount equal to the scheduled monthly mortgage payment under the terms of the mortgage. Generally, the master policies require an insured to notify PMI of a default no later than the last business day of the month following the month in which the borrower becomes three monthly payments in default. For reporting and internal tracking purposes, we do not consider a loan to be in default until the borrower has missed two consecutive payments. PMI’s primary default data are presented in the table below.
The increases to primary loans in default as of December 31, 2004 compared to 2003 and 2002 were primarily the result of the seasoning of PMI’s primary flow portfolio and weak economic conditions in 2003. The increase in PMI’s primary default rate from December 31, 2003 to December 31, 2004 was due to a decline in the number of primary insurance policies in force and an increase in primary flow loans in default. Bulk loans in default and the bulk default rate decreased in 2004 as a result of certain bulk loan transactions having experienced their peak loss development in prior periods. The default rates for bulk transactions at December 31, 2004, 2003 and 2002 remained higher than the overall primary default rates due primarily to the higher concentration of less-than-A quality and Alt-A loans in PMI’s bulk portfolio.
Policy acquisition costs consist of direct costs related to PMI’s acquisition, underwriting and processing of new insurance including contract underwriting and sales-related activities. These costs are initially deferred and amortized against related premium revenue for each policy year book of business. Policy acquisition costs incurred and deferred are variable and fluctuate with the volume of new insurance applications processed and NIW and can also be reduced by increased use of PMI’s electronic origination and delivery methods. Customer use of PMI’s electronic delivery options accounted for approximately 85% of PMI’s insurance commitments issued in its primary flow channel in 2004, compared to approximately 81% in 2003 and 74% in 2002.
The decrease in policy acquisition costs incurred and deferred in 2004 compared to 2003 was primarily the result of the decline in NIW in 2004 and the increase in electronic delivery in 2004. From December 31, 2003 to December 31, 2004, PMI’s deferred policy acquisition cost asset decreased by $15.7 million due primarily to the decline in NIW compared to prior periods and the increase in electronic delivery. Continued declines in the deferred policy acquisition cost asset would reduce future amortization of deferred policy acquisition costs.
Other underwriting and operating expenses generally consist of all other costs that are not attributable to the acquisition of new business and that are recorded as expenses when incurred. The increase in other underwriting and operating expenses in 2004 compared to 2003 was due primarily to recognition of expenses previously deferred as acquisition costs, higher compensation and related expenses and expenses related to PMI’s field operations restructuring. The increase in 2003 compared to 2002 was due to increases in payroll and related expenses, depreciation and premium taxes.
Traditional pool insurance-Prior to 2002, PMI offered certain pool insurance products to lenders and the GSEs, or GSE Pool, and to the capital markets, or Old Pool. GSE Pool and Old Pool products insure all losses on individual loans held within a pool of insured loans up to the stop loss limit for the entire pool. GSE Pool risk in force was $0.1 billion at December 31, 2004, $0.5 billion at December 31, 2003 and $0.8 billion at December 31, 2002. Old Pool risk in force was $0.5 billion at December 31, 2004, $0.7 billion at December 31, 2003 and $0.9 billion at December 31, 2002.
Modified pool insurance-PMI currently offers modified pool insurance products that may be attractive to investors and lenders seeking a reduction of default risk beyond the protection provided by existing primary insurance or with respect to loans that do not require primary insurance, or for capital relief purposes. In 2004, PMI wrote $0.2 billion of modified pool risk, compared to $0.4 billion in 2003 and $0.8 billion in 2002. The decrease in 2003 from 2002 was due to a reduction in demand by our principal customer for this product. Modified pool risk in force was $1.5 billion at December 31, 2004, $1.4 billion at December 31, 2003 and $1.2 billion at December 31, 2002.
Insurance and risk in force-PMI’s primary insurance in force and primary and pool risk in force are shown in the table below.
The following table presents PMI’s ARMs (mortgage loans with interest rates that may adjust prior to their fifth anniversary) and high LTV loans (loans exceeding 97% LTV) as percentages of its flow channel and bulk channel primary NIW for the years ended:
As shown in the tables above, PMI insured greater percentages of Alt-A loans, ARMs and high LTV loans in 2004 than in 2003. The percentage of PMI’s primary risk in force comprised of loans with LTV’s above 97% has increased from 2.8% as of December 31, 2002, to 8.6% as of December 31, 2003, and to 11.6% as of December 31, 2004. The percentage of ARMs included in PMI’s primary risk in force was 9.2% as of December 31, 2002, 9.6% as of December 31, 2003, and 14.5% as of December 31, 2004. We believe that these increases reflect higher concentrations of high LTV loans, ARMs and Alt-A loans in the 2004 mortgage origination private mortgage insurance markets. The higher concentration of high LTV loans is also, to a lesser extent, the result of changes in a number of state statutes and regulations to permit the issuance of mortgage insurance on such loans, and to the expansion of underwriting guidelines by lenders, the GSEs and PMI as a result of market outreach efforts. We believe that these market trends could continue in 2005.
International Operations includes the results of our Australian holding company, PMI Mortgage Insurance Australia (Holdings) Pty Limited, and operating subsidiaries, PMI Mortgage Insurance Ltd and PMI Indemnity Limited, collectively referred to as PMI Australia; our Irish subsidiaries, PMI Mortgage Insurance Company Limited and TPG Reinsurance Company Limited, collectively referred to as PMI Europe; and PMI’s Hong Kong reinsurance revenues. Reporting of financial and statistical information for International Operations is subject to foreign currency rate fluctuations in translation to U.S. dollar reporting. International Operations’ results are summarized as follows:
The change in the average foreign currency exchange rates from December 31, 2003 to December 31, 2004 favorably impacted our International Operations’ net income by $10.2 million, primarily due to the appreciation of the Australian dollar. This foreign currency translation impact is calculated using the year over year change in the average monthly exchange rate to the current year ending net income in the local currency. The change in the average foreign currency exchange rates from December 31, 2002 to December 31, 2003 favorably impacted our International Operations’ net income by $12.7 million, primarily due to the appreciation of the Australian dollar.
Premiums written and earned-In addition to currency exchange rate appreciation, the increases in PMI Australia’s net premiums written and premiums earned in 2004 compared to 2003, and 2003 compared to 2002, were due to increases in NIW and insurance in force. These increases were attributable primarily to the strong overall mortgage origination market in Australia and New Zealand, as well as a reduction in the number of market participants underwriting mortgage insurance.
Net investment income-In addition to currency exchange rate appreciation, the increase in net investment income in 2004 compared to 2003 was due to the growth of PMI Australia’s investment portfolio and a higher pre-tax book yield. The increase in net investment income in 2003 compared to 2002 was attributable to the growth of the investment portfolio, offset by a decrease in the pre-tax book yield. PMI Australia’s investment portfolio, including cash and cash equivalents, was $801.5 million at December 31, 2004 compared to $642.1 million at December 31, 2003 and $401.5 million at December 31, 2002. The growth was driven by positive cash flows from operations. The pre-tax book yield was 5.87% at December 31, 2004, 5.21% at December 31, 2003 and 6.06% at December 31, 2002. The increase in the pre-tax book yield in 2004 compared to 2003 was primarily due to the higher interest rate environment in 2004. The decrease in the pre-tax book yield in 2003 compared to 2002 was primarily due to the lower interest rate environment in 2003.
Losses and LAE-The increase in losses and LAE in 2004 compared to 2003 and the decrease in losses and LAE in 2003 compared to 2002 were largely due to an $8.0 million reduction in loss reserves in 2003, which resulted from our third quarter 2003 review of PMI Australia’s loss provisioning. See Critical Accounting Policies and Estimates below. PMI Australia has continued to experience low levels of claim payments and default rates attributable primarily to the current low interest rate environment, low unemployment levels and home value appreciation in Australia and New Zealand. PMI Australia’s default rate at December 31, 2004 was 0.11%, compared with 0.17% at December 31, 2003 and 0.30% at December 31, 2002.
Underwriting and operating expenses-The increase in underwriting and operating expenses in 2004 compared to 2003 was due primarily to higher levels of insurance in force and exchange rate fluctuations. The increase in 2003 compared to 2002 was due primarily to increases in payroll and related expenses, primarily due to increased employee head-count and profit and exchange commissions related to captive reinsurance agreements. Underwriting and operating expenses were also negatively affected by foreign currency exchange rate appreciation between 2002 and 2003.
The increase in primary NIW in 2004 compared to 2003 was driven primarily by RMBS insurance written and the appreciation of the Australian dollar relative to the U.S. dollar. The increase in primary NIW in 2003 compared to 2002 was driven by a reduction in the number of market participants that underwrite mortgage insurance from four to two, strong market activity in Australia and the appreciation of the Australian dollar. The increases in primary insurance in force and risk in force at December 31, 2004 compared to December 31, 2003 and December 31, 2002 were driven primarily by the volume of NIW during the past 24 months.
PMI’s Hong Kong branch reinsures mortgage risk primarily for the Hong Kong Mortgage Corporation, or HKMC. The increases in gross reinsurance premiums written and reinsurance premiums earned in 2004 and 2003 were due primarily to an increase in mortgage origination activity in Hong Kong. In July 2004, the HKMC began insuring, and PMI began reinsuring, residential mortgages with LTVs up to 95%. This product expansion has contributed to the growth in PMI’s gross reinsurance premiums written and earned in Hong Kong in 2004.
The following table sets forth the results of our Financial Guaranty segment for the years ended:
December 18, 2003. Our equity in earnings from FGIC Corporation for the period December 18 through 31, 2003 was $2.4 million (pre-tax), excluding an extraordinary gain of $5.4 million after tax related to our share of negative goodwill written off by FGIC in connection with purchase accounting adjustments. The increase in our net income from Financial Guaranty in 2003 compared to 2002 was attributable to our investment in FGIC Corporation and this extraordinary gain.
The table below shows the main components of FGIC Corporation’s 2004 results and 2003 results prior to, and after, our investment in FGIC Corporation on December 18, 2003.
Net investment income decreased to $98.0 million in 2004 from $116.9 million in 2003 primarily due to purchase accounting adjustments which increased the investment portfolio to fair value as of the acquisition date. This adjustment to FGIC’s investment portfolio resulted in a reduction of FGIC’s book yield to reflect current market rates as of the acquisition date. As of December 31, 2004, the book yield of FGIC’s investment portfolio was 3.5% and was comprised primarily of U.S. municipal bonds. The decrease in net investment income in 2004 was to a lesser extent also due to investment income lost as a result of a $284 million dividend paid by FGIC to GE Capital in 2003. There was also a significant reduction in net realized gains in 2004 versus 2003.
Loss and loss adjustment expenses increased in 2004 compared to 2003 due primarily to a reduction in reserves related to reserves taken prior to December 18, 2003.
In 2003, FGIC Corporation recognized a $19.2 million impairment of its historical goodwill related to the goodwill established when FGIC Corporation was acquired by GE Capital. The impairment charge occurred prior to the acquisition date but was a direct result of GE Capital entering into an agreement to sell FGIC Corporation.
FGIC Corporation recorded a $13.9 million extraordinary gain as of December 18, 2003 related to negative goodwill. We recognized our proportionate share of FGIC Corporation’s extraordinary gain ($5.4 million net of tax) separately from equity in earnings from unconsolidated strategic investments.
The results of our Other segment include: other income and related operating expenses of MSC; investment income, interest expense and corporate overhead of The PMI Group; a realized capital loss on equity investment held for sale; equity in earnings (losses) primarily from SPS; and the results from and realized gain on sale of the discontinued operations of APTIC. Our Other segment results are summarized as follows:
In January 2005, we signed a Summary of Terms with CSFB, pursuant to which CSFB has an option to acquire 100% of our outstanding stock of SPS. Based upon the transaction, we recorded an impairment write-down of $20.4 million as a realized capital loss on equity investment held for sale for the fourth quarter of 2004. As of December 31, 2004, our total investment in SPS was $126.2 million, consisting of $109.5 million carrying value of equity investment held for sale and $16.7 million of related party receivables which are current.
Portfolio Servicing’s servicer rating for Alt-A product to “RPS2-” from “RPS3,” its servicer rating for subprime and home equity products to “RPS2-” from “RPS3-” and its special servicing rating to “RSS2-” from “RSS3.” As of December 31, 2004, Select Portfolio Servicing serviced approximately $22 billion in mortgages, compared to approximately $41 billion as of December 31, 2003. This significant decline in servicing was caused by heavy borrower prepayment of loans serviced by Select Portfolio Servicing, and loss of business to competitors due to the ratings downgrades, combined with its inability to acquire new servicing business because of ratings downgrades.
Select Portfolio Servicing’s servicing practices have been the subject of investigations by the FTC, HUD, and the Department of Justice, as well as putative state and national class actions. In October 2003, the United States District Court for the District of Massachusetts approved a settlement that resolves the investigations by the FTC and HUD. In May 2004, the District Court approved a nationwide settlement that resolves claims raised in approximately 40 putative class action lawsuits. The FTC and HUD settlement provided for the implementation of a $40.0 million redress fund and certain changes to Select Portfolio Servicing’s servicing practices. In the second quarter of 2004, in exchange for a promissory note from SPS, and pursuant to our guarantee of approximately two-thirds of Select Portfolio Servicing’s obligations under a $30.7 million letter of credit, we provided to Select Portfolio Servicing $19.7 million of the $40.0 million redress fund established pursuant to the FTC and HUD settlement. In the third quarter of 2004, we exchanged the $19.7 million promissory note and accrued interest thereon for additional shares of SPS’s common stock. In the third quarter of 2004, we also received a subordinated promissory note with an original principal balance amount of $23.0 million in exchange for $23.0 million of subordinated participation interests in SPS held by us. As of December 31, 2004, this note had an outstanding balance of $16.6 million.
Other income, which was generated by MSC, decreased in 2004 compared to 2003 primarily due to a decline in contract underwriting activity related to lower mortgage origination and refinance volume. Other income increased in 2003 and 2002 due primarily to increased contract underwriting activity in connection with heavy mortgage originations and refinance volume.
Other operating expenses, which were incurred by MSC and The PMI Group, Inc., decreased in 2004 compared to 2003 primarily as a result of a decrease in contract underwriting expense allocation, offset by an increase in interest expense relating to monthly interest on the 13.8 million 5.875% equity units we issued in November 2003. Other operating expenses increased in 2003 compared to 2002 due to increased salary expense and other corporate overhead and contract underwriting remedies expenses.
The PMI Group Liquidity-The PMI Group’s liquidity is primarily dependent upon: (i) The PMI’s Group’s subsidiaries’ ability to pay dividends to The PMI Group; (ii) financing activities in the capital markets; and (iii) maturing or refunded investments and investment income from The PMI Group’s stand-alone investment portfolio. The PMI Group’s ability to access these sources depends on, among other things, the financial performance of The PMI Group’s subsidiaries, regulatory restrictions on the ability of The PMI Group’s insurance subsidiaries to pay dividends, The PMI Group’s and its subsidiaries’ ratings by the rating agencies and restrictions and agreements to which The PMI Group or its subsidiaries are subject that restrict their ability to pay dividends, incur debt or issue equity securities.
The PMI Group’s principal uses of liquidity are the payment of operating costs, income taxes (which are predominantly reimbursed by its subsidiaries), principal and interest on its debt, payments of dividends to shareholders, repurchases of its common stock, purchases of investments and capital investments in and for its subsidiaries. In the normal course of business, we evaluate The PMI Group’s capital and liquidity needs in light of its debt-related costs, holding company expenses, our dividend policy, and rating agency considerations. If we wish to provide additional capital to our existing operations, make new equity investments or increase our existing equity investments, we may need to increase the cash and investment securities held by The PMI Group.
The PMI Group’s available funds, consisting of cash and cash equivalents and investments, were $441.2 million at December 31, 2004, compared to $307.9 million at December 31, 2003. In December of 2004, The PMI Group entered into a five-year $175 million revolving credit facility agreement that is expandable to $200 million at The PMI Group’s request subject to approval by the lenders. Also during 2004, we repurchased approximately $100 million of our common stock, completing the $100 million stock repurchase program authorized in 2003. In February 2005, our Board of Directors authorized an additional $100 million stock repurchase program. It is our present intention to maintain between $100 million to $150 million of liquidity at our holding company in connection with rating agency considerations. We believe that we have sufficient liquidity to meet all of our short- and medium-term obligations, and that we maintain excess liquidity to support our operations.
Other states may also limit or restrict PMI’s ability to pay shareholder dividends. For example, California, New York and Illinois prohibit mortgage insurers from declaring dividends except from the surplus of undivided profits over the aggregate of their paid-in capital, paid-in surplus and contingency reserves.
PMI’s ability to pay dividends is also subject to restriction under the terms of a runoff support agreement with Allstate. Under the Allstate agreement, PMI may not pay a dividend if, after the payment of that dividend, PMI’s risk-to-capital ratio would equal or exceed 23 to 1. As of December 31, 2004, PMI’s risk-to-capital ratio was 8.2 compared to 9.1 at December 31, 2003 and 11.3 at December 31, 2002.
In addition to its consolidated subsidiaries, The PMI Group may in the future derive funds from its unconsolidated equity investments, including its investment in FGIC Corporation, which is the parent corporation of FGIC. As described below, FGIC’s ability to pay dividends is subject to restrictions contained in applicable state insurance laws and regulations, FGIC’s Corporation’s certificate of incorporation, a stockholder agreement between The PMI Group and other investors in FGIC Corporation, and its 6.0% senior notes. Under New York insurance law, FGIC may pay dividends out of statutory earned surplus, provided that statutory surplus after any dividend may not be less than the minimum required paid-in capital and provided that together with all dividends declared or distributed by FGIC during the preceding 12 months, the dividends do not exceed the lesser of (i) 10% of policyholders’ surplus as of its last statement filed with the New York superintendent or (ii) adjusted net investment income during this period. In addition, in accordance with the normal practice of the New York Insurance Department in connection with change in control applications, FGIC Corporation is subject to commitments to the department that it will prevent FGIC from paying any dividends on its common stock for a period of two years from the date of the acquisition, or December 18, 2005, without the prior written consent of the department.
In addition, so long as any senior preferred stock or class B common stock issued upon conversion of that preferred stock is outstanding, FGIC Corporation’s certificate of incorporation generally prohibits the payment of dividends or other payments on any of FGIC Corporation’s capital stock, except the senior preferred stock, without the consent of the holder of two-thirds of the outstanding shares of that preferred stock (or the class B common stock issued upon conversion of that preferred stock). This restriction does not apply to cash dividends declared and paid on the class A common stock after the ninth anniversary of the closing of the FGIC Corporation investment provided that those dividends are paid from retained earnings in excess of the amount of FGIC Corporation’s retained earnings on the closing date of such investment, the amount of the dividends in any fiscal year does not exceed one-third of one percent of FGIC Corporation’s stockholders’ equity, and equivalent dividends are paid on the class B common stock.
We have invested in certain limited partnerships with ownership interests greater than 3% but less than 50%. As of December 31, 2004, the Company had committed to fund, if called upon to do so, $5.6 million of additional equity in certain limited partnership investments. This commitment to fund is excluded from the above table. Capitalized costs associated with software developed for internal use were $29.5 million in 2004 and $22.5 million in 2003. We expect to continue to invest in internally developed software.
Net realized gains increased by $1.6 million after-tax in 2004 compared with 2003 and decreased $0.8 million after-tax in 2003 compared with 2002. The decrease of 2003 compared to 2002 was due mainly to a reduction in fixed income sales activity in 2003, partially offset by an $11.2 million increase in net gains pre-tax in our equities portfolio due to favorable market conditions during 2003. In addition, other-than-temporary impairment of our equity portfolio was $0.2 million in 2004 and $0.3 million in 2003, compared to $6.9 million in 2002. During 2003, we sold our ownership interest in Truman, an unconsolidated subsidiary, and recognized a realized capital loss of $3.6 million pre-tax. The $20.4 million pre-tax realized capital loss on equity investment held for sale (SPS) recognized in 2004 was separately classified in our consolidated statement of operations and was therefore not included in the above table.
The change in net unrealized gains and losses net of deferred taxes are presented in the following table.
The following table summarizes the estimated fair value of the consolidated investment portfolio as of December 31, 2004 and 2003. Amounts shown under “Other” include the investment portfolio of The PMI Group.
Our consolidated investment portfolio holds primarily investment grade securities comprised of readily marketable fixed income and equity securities. At December 31, 2004, the fair value of these securities in our consolidated investment portfolio increased to $3.3 billion from $2.8 billion at December 31, 2003. The increase was primarily the result of positive cash flows from consolidated operations, a $41.3 million increase related to increases in foreign currency translation rates in our international operations from December 31, 2003 to December 31, 2004, our common stock and equity units’ offerings in the fourth quarter of 2003, and the proceeds from the sale of APTIC in the first quarter of 2004, partially offset by a decrease in unrealized gains in our portfolio. As interest rates, market and other economic conditions change, we expect the market value of the securities in our investment portfolio to be affected.
The following table summarizes the rating distributions of our consolidated investment portfolio as of December 31, 2004.
Our accumulated other comprehensive income consists of changes in unrealized net gains and losses on investments, less realized gains and losses in the current period earnings and currency translation gains and losses, net of deferred taxes.
As of December 31, 2004, our consolidated shareholders’ equity was $3.1 billion. The carrying value of our long-term debt outstanding issued by The PMI Group at December 31 was as follows:
PMI has entered into various capital support agreements with its Australian and European subsidiaries that could require PMI to make additional capital contributions to those subsidiaries for rating agency purposes. With respect to the Australian and European subsidiaries, The PMI Group guarantees the performance of PMI’s capital support obligations. In 2001, PMI executed a capital support agreement whereby it agreed to contribute funds, under specified conditions, to maintain CMG’s risk-to-capital ratio at or below 18.0 to 1. PMI’s obligation under the agreement is limited to an aggregate of $37.7 million, exclusive of capital contributions that PMI made prior to April 10, 2001. On December 31, 2004, CMG’s risk-to-capital ratio was 13.0 to 1 compared to 13.4 to 1 as of December 31, 2003.
Consolidated cash flows generated by operating activities, including premiums, investment income, underwriting and operating expenses and losses, was $390.5 million in 2004 compared to $558.7 million in 2003. The decrease was primarily due to a significant increase in unearned premiums in 2003, specifically related to premiums written of approximately $114 million in the fourth quarter of 2003 associated with the restructuring of certain existing U.S. primary insurance policies. The decrease in operating cash flows was also attributable to an increase in equity in earnings from unconsolidated subsidiaries. We expect future claim payments in 2005 to be higher than 2004 levels due to the continued seasoning of our insurance portfolio, specifically the 2003 book year.
Consolidated cash flows used by financing activities, including purchases and sales of investments, proceeds from issuance of long-term debt and equity, repayment of long-term debt, purchase of treasury stock and dividends paid to shareholders, was $79.4 million in 2004 compared to $528.7 million cash flows generated by financing activities in 2003. The decrease was due primarily to $100.0 million of repurchases of common stock in 2004 and proceeds in 2003 of $334.7 million from the issuance of long-term debt and $207.9 million from the issuance of common stock.
PMI Indemnity Limited is rated AA- (stable) by S&P, AA (stable) by Fitch, and Aa3 (stable) by Moody’s.
The following table shows the reasonable range of loss and LAE reserves, as determined by our actuaries, and recorded reserves for losses and LAE (gross of reinsurance recoverables) as of December 31, 2004 and 2003 on a segment and consolidated basis:
International Operations includes loss and loss reserves for PMI Australia and PMI Europe. As of December 31, 2003, we had not established a range of loss reserves for PMI Europe, rather, we included the actual recorded reserve of $12.1 million in both the low and high range.
Our best estimate of PMI’s loss and LAE reserves is derived primarily from our analysis of PMI’s default and loss experience. The key assumptions used in the estimation process are expected claim rates, average claim sizes, and costs to settle claims. We evaluate our assumptions in light of PMI’s historical patterns of claim payment, loss experience in past and current economic environments, the seasoning of PMI’s various books of business, PMI’s coverage levels, the credit quality profile of PMI’s portfolios, and the geographic mix of PMI’s business. Our assumptions are influenced by historical loss patterns and are adjusted to reflect recent loss trends. Our assumptions are also influenced by our assessment of current and future economic conditions, including trends in housing prices, unemployment and interest rates. Our estimation process uses generally recognized actuarial projection methodologies. As part of our estimation process, we also evaluate various scenarios representing possible losses and LAE under different economic assumptions. We established PMI’s reserves at December 31, 2004 and 2003 at the approximate mid-point of the actuarial range due to, among other reasons, our belief that PMI’s number of delinquencies, average claim rate and average claim size are currently less volatile relative to periods prior to 2003. We believe the midpoint of the range represents the most likely outcome related to future claim payments on loans currently in our default inventory.
Our current recorded loss reserve balance represents an increase of $13.3 million from PMI’s reserve balance of $325.3 million at December 31, 2003. Our increase to the reserve balance at December 31, 2004 was due primarily to our increase in primary loans in default and, to a lesser extent, the higher proportion of delinquencies developing into claims.
The above loss reserve reconciliation shows the components of our loss reserve and LAE changes for the periods presented. Losses and LAE payments of $219.0 million, $204.6 million and $121.2 million for the periods ended 2004, 2003 and 2002, respectively, reflect amounts paid during the period presented and are not subject to estimation. Losses and LAE incurred, net of changes to prior years, of $233.2 million, $214.7 million and $149.8 million for the periods ended 2004, 2003 and 2002, respectively, are management’s best estimates of ultimate losses and LAE and, therefore, are subject to change. Within the total losses and LAE incurred line item are reductions to incurred related to prior periods of $5.9 million, $3.6 million and $85.2 million for the periods ended 2004, 2003 and 2002, respectively. The table below breaks down the 2004, 2003 and 2002 reductions in reserves by particular accident years.
The $5.9 million, $3.6 million and $85.2 million reductions in 2004, 2003 and 2002 over prior years, respectively, were due to re-estimations of ultimate loss rates from those established at the original notice of default, updated through the period presented. These re-estimations of ultimate loss rates are the result of management’s periodic review of estimated claim amounts in light of actual claim amounts, loss development data or ultimate claim rates. The $5.9 million reduction in prior years’ reserves during 2004 was due primarily to a reduction in the incurred but not reported estimate and to a lesser extent our reallocation of reserves between 2003 and 2002. The $3.6 million reduction in prior years’ reserves during 2003, respectively were due primarily to our reallocation of reserves between accident years combined with more favorable claim size and certain pool portfolio loss development trends. The $85.2 million reductions in prior years’ reserves during 2002 was due primarily to more favorable loss trends than expected compared to PMI’s historical loss experience, evidenced by lower claim amounts, a robust real estate market and strong home price appreciation.
The following table shows a breakdown of loss reserves by loans in default, incurred but not reported, and cost to settle claims (LAE) for the years ended:
To provide a measure of sensitivity on pre-tax income to changes in loss reserve estimates, we estimate that: (i) for every 5% change in our estimate of the future average claim size or every 5% change in our estimate of the future claim rate with respect to the December 31, 2004 reserve for losses and LAE, the effect on pre-tax income would be an increase or decrease of approximately $17 million; (ii) for every 5% change in our estimate of the future cost of claims settlement as of the December 31, 2004, the effect on pre-tax income would be approximately $1 million.
International Operations-PMI Australia’s reserves for losses and LAE are based upon estimated unpaid losses and LAE on reported defaults and estimated defaults incurred but not reported. The key assumptions we use to derive PMI Australia’s loss and LAE reserves include estimates of PMI Australia’s expected claim rates, average claim sizes, claims handling expenses and net expected future claim recoveries. These assumptions are evaluated in light of the same factors used by PMI. As of December 31, 2004, the actuarial range for PMI Australia’s reserves for losses and LAE ranged from $6.7 million to $9.3 million. As of December 31, 2004, PMI Australia’s reserves for losses and LAE were $9.8 million, which represented our best estimate and a decrease of $0.4 million from PMI Australia’s reserve balance of $10.2 million at December 31, 2003. The $0.4 million reduction in PMI Australia’s reserves for losses and LAE since December 31, 2003 was due primarily to the release of reserves as a result of favorable economic conditions and claims experience. In recording reserves in Australia slightly above the high end of the actuarial range of loss, we were influenced in part by our belief that the recent extremely low loss rates experienced by PMI Australia are not sustainable in the future as its current loans in default ultimately go to claim. We also place significant emphasis on interest rate forecasts which indicate future rate increases. Additionally, we expect on an on-going basis to record reserves above the actuarial midpoint due to Australian insurance regulations requiring higher confidence levels for reserve balances.
Our actuaries calculated a range for PMI Europe’s loss reserves at December 31, 2004 of $8.2 million to $29.3 million. PMI Europe’s loss reserves at December 31, 2004 were $16.4 million, which represented management’s best estimate and an increase of $4.3 million from December 31, 2003. The increase in reserves over 2003 was due primarily to credit default swaps accounted for under insurance accounting. PMI Europe establishes loss reserves for all of its insurance and reinsurance business and for credit default swap transactions consummated before July 1, 2003. Revenue, losses and other expenses associated with credit default swaps executed on or after July 1, 2003 are recognized through a derivative accounting treatment. PMI Europe’s loss reserving methodology contains two components: case reserves and IBNR reserves. Case and IBNR reserves are based upon factors which include, but are not limited to, our analysis of arrears and loss payment reports, loss assumptions derived from pricing analyses, our view of current and future economic conditions and industry information.
The reductions in losses and LAE incurred relating to prior years of $5.2 million, $15.4 million and $3.5 million in 2004, 2003 and 2002, respectively, were primarily due to favorable development of actual claim amounts and adjustments to ultimate claim rates due to the strong housing appreciation and overall economic conditions experienced in Australia over the last three years.
Unrealized losses related to fixed income securities were primarily due to an increase in interest rates during 2004. They are not considered to be other-than-temporarily impaired as we have the intent and ability to hold the investments until they recover in value or mature. The remaining unrealized losses do not meet the criteria established in our policy and as such are not considered impaired.
The following table provides the composition of fixed income securities with an unrealized loss at December 31, 2004 in relation to the total of all fixed income securities with an unrealized loss by contractual maturities.
We generate a significant portion of our revenues from mortgage insurance premiums on either a monthly, annual or single payment basis. Premiums written on a monthly basis are earned as coverage is provided. Premiums written on an annual basis are earned on a monthly pro-rata basis over the year of coverage. Primary mortgage insurance premiums written on policies covering more than one year are referred to as single premiums. A portion of revenue on single premiums is recognized in premiums earned in the current period, and the remaining portion is deferred as unearned premiums and earned over the expected life of the policy. If single premium policies related to insured loans are cancelled due to repayment by the borrower, and the premium is non-refundable, then the remaining unearned premium related to each cancelled policy is recognized to earned premiums upon notification of the cancellation. The earning cycle for single premium products is based on a range of seven to fifteen years, and the rates used to determine the earnings of single premiums are estimates based on actuarial analysis of the expiration of risk. Single premiums written accounted for 19.0% and 27.8% of gross premiums written from mortgage insurance in 2004 and 2003, respectively, and come predominantly from PMI Australia in our International Operations segment with the exception of a large single premium policy written in the fourth quarter of 2003 in our U.S. Mortgage Insurance Operations segment. The premium earnings process generally begins upon receipt of the initial premium payment. The earnings pattern calculation is an estimation process and, accordingly, we review the premium earnings cycle for each policy acquisition year (“Book Year”) annually and any adjustments to the estimates are reflected to each Book Year as appropriate.
Periodically, or as events dictate, we evaluate potential impairment of its investments in unconsolidated subsidiaries. Accounting Principles Board (APB) Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock, provides criteria for determining potential impairment. In the event a loss in value of an investment is determined to be an other-than-temporary decline, an impairment charge would be recognized in our consolidated statement of operations. Evidence of a loss in value that could indicate impairment might include, but would not necessarily be limited to, the absence of an ability to recover the carrying amount of the investment or the inability of the investee to sustain an earnings capacity which would justify the carrying amount of the investment. Realized gains or losses resulting from the sale of our ownership interests of
If the volume of low down payment home mortgage originations declines or if the number of mortgage loans originated that may be purchased by the GSEs declines, the amount of insurance that PMI writes could decrease, which could result in a decrease our future revenue.
A decline in the volume of low down payment mortgage originations could reduce the demand for private mortgage insurance and consequently, our revenues. The volume of low down payment mortgage originations is affected by, among other factors: the level of home mortgage interest rates; domestic economy and regional economic conditions; consumer confidence; housing affordability; the rate of household formation; the rate of home price appreciation, which in times of heavy refinancing affects whether refinance loans have loan-to-value ratios that require private mortgage insurance; and government housing policy.
Mortgage lenders have been increasingly structuring mortgage originations to avoid private mortgage insurance, primarily through the use of piggyback, 80/10/10 or 80/20 loans. Such mortgages are structured to include a first mortgage with an 80% loan-to-value ratio and a second mortgage with a loan-to-value ratio ranging from 10% to 20%. Over the past several years, the volume of these loans, or variations thereof, as alternatives to loans requiring mortgage insurance, has increased significantly and may continue to do so for the foreseeable future.
government mortgage insurance programs, including those of the Federal Housing Administration, or FHA, and the Veterans Administration, or VA;
mortgage lenders maintaining lender recourse or participation with respect to loans sold to the GSEs; and
investors using credit enhancements as a partial or complete substitute to private mortgage insurance.
PMI reinsures a portion of its mortgage insurance default risk with lender-affiliated captive reinsurance companies, which reduces PMI’s net premiums written.
An increasing percentage of PMI’s insurance in force has been generated by customers with captive reinsurance companies, and we expect that this trend will continue. Because a number of our major customers have made the business decision to participate in the mortgage business by establishing reinsurance companies, we believe that if PMI did not offer captive reinsurance agreements, PMI’s competitive position would suffer. Captive reinsurance agreements negatively impact PMI’s net premiums written, and negatively impact the yield that we obtain on net premiums earned for customers with captive reinsurance agreements.
Economic factors have adversely affected and may continue to adversely affect PMI’s loss experience.
PMI’s loss experience has increased over the past year and could continue to increase as a result of: national or regional economic recessions; declining values of homes; higher unemployment rates; higher levels of consumer credit; deteriorating borrower credit; interest rate volatility; war or terrorist activity; or other economic factors.
We expect the majority of claims on insured loans in PMI’s current portfolio to occur during the second through the fourth years after loan origination. Primary insurance written from the period of January 1, 2001 through December 31, 2003 represented 57.8% of PMI’s primary risk in force as of December 31, 2004. Accordingly, a significant majority of PMI’s primary portfolio is in, or approaching, its peak claim years. In addition, PMI’s 2003 book of business represents 36.1% of its insurance in force as December 31, 2004 and we believe that it will enter its peak claim year in 2005 with some continued impact in 2006. We believe PMI’s loss experience may increase as PMI’s policies age. If the claim frequency on PMI’s risk in force significantly exceeds the claim frequency that was assumed in setting PMI’s premium rates, our consolidated financial condition and results of operations would be harmed.
PMI generally cannot cancel the mortgage insurance coverage that it provides or adjust renewal premiums during the life of a mortgage insurance policy. As a result, the impact of unanticipated claims generally cannot be offset by premium increases on policies in force or limited by non-renewal or cancellation of insurance coverage. The premiums PMI charges may not be adequate to compensate us for the risks and costs associated with the insurance coverage provided to PMI’s customers. An increase in the number or size of unanticipated claims could adversely affect our consolidated financial condition and results of operations.
We could be affected by economic downturns in specific regions of the United States where a large portion of PMI’s business is concentrated. As of December 31, 2004, 10.0% of PMI’s primary risk in force was located in Florida, 7.2% was located in Texas and 6.8% was located in California. In addition, refinancing of mortgage loans can have the effect of concentrating PMI’s insurance in force in economically weaker areas of the U.S. As of December 31, 2004, 16.4% of PMI’s policies in force related to loans located in Wisconsin, Michigan, Illinois, Indiana and Ohio. Collectively these states experienced higher default rates in 2004 than other regions of the U.S.
The premiums PMI charges for mortgage insurance on less-than-A quality loans and Alt-A loans, and the associated investment income, may not be adequate to compensate for future losses from these products.
In our experience, mortgage loans with high loan-to-value ratios have higher claims frequency rates than mortgages with lower loan-to-value ratios. At December 31, 2004, 54.9% of PMI’s primary risk in force consisted of mortgages with loan-to-value ratios greater than 90%. Risk in force is the dollar amount equal to the product of each individual insured mortgage loan’s principal balance and the percentage specified in the insurance policy of the claim amount that would be payable if a claim were made.
Also as of December 31, 2004, 14.5% of PMI’s primary risk in force consisted of adjustable rate mortgages, which we refer to as ARMs. In our experience, ARMs have claims frequency rates that exceed the rates associated with PMI’s book of business as a whole. We cannot be sure that the premiums that PMI charges will adequately offset the associated risk of higher loan-to-value loans and ARMs.
may not refuse, except in limited circumstances, to insure, or rescind coverage on, that loan even if it reevaluates that loan’s risk profile and determines the risk profile to be unacceptable or the lender fails to follow PMI’s delegated underwriting guidelines.
The number of available and qualified underwriting personnel is limited, and there is heavy price competition among mortgage insurance companies for such personnel. MSC’s inability to recruit and maintain a sufficient number of qualified underwriters at a low cost could harm our consolidated financial condition and results of operations.
The principal sources of PMI’s competition include: other private mortgage insurers, some of which are wholly-owned or partially-owned subsidiaries of well-capitalized, diversified public companies with direct or indirect capital reserves that provide them with potentially greater resources than we have; and alternatives to private mortgage insurance discussed above.
Congress is currently considering proposed legislation relating to the regulatory oversight of the GSEs, their affordable housing initiatives, the GSEs’ products and marketing activities, the GSEs’ minimum capital standards, and their risk-based capital requirements. If adopted in its present form, OFHEO would be replaced by a new federal agency, the Federal Housing Enterprise Regulatory Agency, and its director would be given significant authority over the GSEs including, among other things, oversight of the prudential operations of the GSEs, capital adequacy and internal controls and new program approval. The proposed legislation encompasses substantially all of the operations of the GSEs and is intended to be a comprehensive overhaul of the existing regulatory structure. The proposed legislation could limit the growth of the GSEs, which could result in a reduction in the size of the mortgage insurance market. We do not know what form, if any, such legislation will take, if any, or, if it is enacted, its impact, if any, on our financial condition and results of operations.
In July 2002, HUD proposed a rule under RESPA that, if implemented as proposed, would have, among other things, given lenders and other packagers the option of offering a Guaranteed Mortgage Package, or GMP, or providing a good faith estimate of settlement costs subject to a 10% tolerance level. The proposed rule provided that qualifying packages were entitled to a “safe harbor” from litigation under RESPA’s anti-kickback rules. Mortgage insurance would have been included in the package to the extent an upfront premium is charged. Inclusion in the package could have caused mortgage insurers to experience reductions in the prices of their services or products. HUD withdrew that proposed rule in March 2004. In late 2004, HUD announced that it will submit a new proposed rule under RESPA to the Office of Management and Budget for review. We do not know what form, if any, the rule will take and whether it will be approved.
In addition, increases in the maximum loan amount or other features of the FHA mortgage insurance program can reduce the demand for private mortgage insurance. Future legislative and regulatory actions could decrease the demand for private mortgage insurance, which could harm our consolidated financial condition and results of operations.
The GSEs are the beneficiaries on a substantial majority of the insurance policies we issue as a result of their purchases of home loans from lenders or investors. The GSEs offer programs that require less mortgage insurance coverage on mortgages approved by their automated underwriting systems. In the past Freddie Mac and Fannie Mae have indicated their intent to reduce their use or required level of mortgage insurance. If the reduction in required levels of mortgage insurance becomes widely accepted by mortgage lenders, or if the GSEs further reduce mortgage insurance coverage requirements for loans they purchase, PMI’s premium revenue would decline and our consolidated financial condition and results of operations could suffer.
Products introduced by the GSEs, if widely accepted, could harm our profitability.
The GSEs have products for which they will, upon receipt from lenders of loans with primary insurance, restructure the mortgage insurance coverage by reducing the amount of primary insurance coverage and adding a second layer of insurance coverage, usually in the form of pool insurance. Under these programs, the GSEs may provide services to the mortgage insurer and the mortgage insurer may be required to pay fees to the GSEs for
the benefits provided through the reduced insurance coverage or the services provided. These new products may harm PMI’s traditional mortgage insurance business and, if they become widely accepted, could prove to be less profitable to our consolidated financial condition and results of operations.
The implementation of new eligibility guidelines adopted by Fannie Mae could harm our profitability and reduce our operational flexibility.
PMI’s insurer financial strength is currently rated “AA” by S&P, “Aa2” by Moody’s, and “AA+” by Fitch. These ratings may be revised or withdrawn at any time by one or more of the rating agencies and are based on factors relevant to PMI’s policyholders and are not applicable to our common stock or debt. The rating agencies could lower or withdraw our ratings at any time as a result of a number of factors, including: underwriting or investment losses; the necessity to make capital contributions to our subsidiaries pursuant to capital support agreements; other developments negatively affecting PMI’s risk-to-capital ratio, financial condition or results of operations; or changes in the views or modeling of rating agencies of our risk profile or of the mortgage insurance industry.
If PMI’s insurer financial strength rating falls below “AA-” from S&P or “Aa3” from Moody’s, investors, including Fannie Mae and Freddie Mac, may not purchase mortgages insured by PMI. Such a downgrade could also negatively affect our holding company ratings or the ratings of our other licensed insurance subsidiaries or our ability to further implement our strategic diversification program. Any of these events would harm our consolidated financial condition and results of operations.
Our ongoing ability to pay dividends to our shareholders and meet our obligations primarily depends upon the receipt of dividends and returns of capital from our insurance subsidiaries.
In addition, a protracted economic downturn, or other factors, could cause issuers of the fixed-income securities that we, FGIC and RAM Re own to default on principal and interest payments, which could cause our investment returns and net income to decline and reduce our ability to maintain all of our capital and liquidity needs.
U.S. implementation of Basel II standards for credit risk exposures, including residential mortgages, is focused on application of the Advanced Internal Rating Based (A-IRB) approach by large internationally active banking organizations. U.S. bank supervisors have indicated their intent to recognize the loss mitigating impacts of private mortgage insurance policies for banking organizations computing minimum capital requirements under the A-IRB approach.
The Basel II Capital Accords will affect the capital treatment provided to mortgage insurance by domestic and international banks in both their origination and securitization activities. We expect that the United States, Europe and Australia will include the capital recognition of mortgage insurance under Basel II. The Basel II proposals require that large banks and others who adopt the more advanced capital guidelines establish their own capital models and it is unclear whether those models will affect the demand by those entities for mortgage insurance. Our results of operation could suffer if demand for our mortgage insurance products was diminished as a result of such modeling or the failure to give appropriate capital recognition to mortgage insurance.
We have subsidiaries in Australia and Europe and a branch office in Hong Kong. We have committed and may in the future commit additional significant resources to expand our international operations. Accordingly, in addition to the general economic and insurance business-related factors discussed above, we are subject to a number of risks associated with our international business activities. These risks include: the need for regulatory and third party approvals; challenges in attracting and retaining key foreign-based employees, customers and business partners in international markets; economic downturns in targeted foreign mortgage origination markets; interest rate volatility in a variety of countries; unexpected changes in foreign regulations and laws; the burdens of complying with a wide variety of foreign laws; potentially adverse tax consequences; restrictions on the repatriation of earnings; foreign currency exchange rate fluctuations; potential increases in the level of defaults and claims on policies insured by foreign-based subsidiaries; the need to successfully develop and market products appropriate to the foreign market, including the development and marketing of credit enhancement products to European lenders and for mortgage securitizations; and natural disasters and other events (e.g., floods and toxic contamination) that would damage properties and that could precipitate borrower default.
PMI Australia is currently rated “AA” by S&P and Fitch and “Aa2” by Moody’s. These ratings are based in part upon a capital support agreement between PMI and PMI Australia and a guarantee of that agreement by The PMI Group. Termination or amendment of this support structure could negatively impact PMI Australia’s ratings. PMI Australia’s business is dependent on maintaining its ratings. Any negative impact on its ratings will negatively affect its financial results.
PMI Australia’s five largest customers provided 65.2% of PMI Australia’s gross premiums written in 2004 and one of these customers represented the majority of this percentage. PMI Australia’s loss of a significant customer, if not replaced, could harm PMI Australia’s and our consolidated financial condition and results of operations. PMI Australia’s insurance in force at December 31, 2004 was $113.6 billion and its risk in force was $103.1 billion. A significant increase in PMI Australia’s claims could harm our financial condition and results of operations.
Our investments in FGIC Corporation, SPS and RAM Re are accounted for on the equity method of accounting in our consolidated financial statements. The nature of the businesses conducted by these companies differs significantly from our core business of providing residential mortgage insurance. These companies are subject to a number of significant risks that arise from the nature of their businesses. Some of the various risks affecting SPS and FGIC Corporation are discussed below. Because we do not control these companies, we are dependent upon the management of these companies to independently operate their businesses and, accordingly, we may be unable to take actions unilaterally to avoid or mitigate those risks.
Select Portfolio Servicing’s servicing practices have been the subject of investigations by the FTC, HUD, and the Department of Justice, as well as putative state and national class actions. In October 2003, the United States District Court for the District of Massachusetts approved a settlement that resolves the investigations by the FTC and HUD. In May 2004, the District Court approved a nationwide settlement that resolves claims raised in approximately 40 putative class action lawsuits. The FTC and HUD settlement provides for the implementation of a $40.0 million redress fund and certain changes to Select Portfolio Servicing’s servicing practices. In addition, SPS has entered into consent orders with eight states under which it has agreed to change certain of its practices and refund certain amounts to borrowers in those states. Other states could also seek to require such refunds or consent orders. SPS continues to be subject to a number of civil lawsuits relating to its servicing practices. Several of these suits also seek relief from PMI.
Our investment in SPS, and consequently our consolidated financial results, could be negatively impacted by the ultimate resolution of the state regulatory actions and the outstanding litigation. If Select Portfolio Servicing is required as a result of state regulatory proceedings or litigation to make significant payments or changes to its business practices so that it becomes materially more expensive to operate, SPS’s financial condition and results of operations could be adversely affected. Furthermore, regulatory actions and putative class actions have generated negative publicity for Select Portfolio Servicing which has caused and may continue to cause Select Portfolio Servicing to suffer losses in its customer base. These losses could also harm our investment in SPS.
On January 19, 2005, we entered into a Summary of Terms with Credit Suisse First Boston (USA), Inc. (“CSFB”) that provides that CSFB shall have the option, exercisable on or before July 31, 2005 to acquire 100% of the outstanding capital stock of SPS from PMI and the other shareholders of SPS. Based on the transactions contemplated by the Summary of Terms, PMI recorded a realized capital loss relating to its investment in SPS of $20.4 million on a pre-tax basis, or $13.3 million on an after-tax basis, for the fourth quarter of 2004. As of December 31, 2004, our total investment balance in SPS was $126.2 million, consisting of $109.5 million book value of equity investment and $16.7 million in subordinated participation interests and advances to SPS which are current. Our total investment could become further impaired or uncollectible as a result of the risks involving SPS, which would harm our consolidated financial condition and results of operations.
As a result of ratings downgrades by S&P and Moody’s in 2003, Select Portfolio Servicing was unable to be named as a primary servicer on newly issued residential mortgage-backed securities, or RMBS, transactions rated by Moody’s or S&P. Upgrades by Moody’s on April 28, 2004 and S&P on May 7, 2004 from “below average” to “average” allow Select Portfolio Servicing to be named as a primary servicer on newly issued RMBS transactions rated by S&P and/or Moody’s. However, several competitors of Select Portfolio Servicing have servicer ratings that are higher than “average” and this has affected Select Portfolio Servicing’s ability to profitably acquire new servicing rights. Select Portfolio Servicing’s inability to raise its ratings or future negative rating agency actions could negatively impact Select Portfolio Servicing and could have a material adverse effect on Select Portfolio Servicing. Select Portfolio Servicing has a very limited number of customers and losses in Select Portfolio Servicing’s customer base due to rating agency actions or otherwise could have an adverse effect on SPS and our investment in SPS.
A significant portion of our net income is derived from FGIC and its financial guaranty business. Accordingly, we are subject to all the risks and uncertainties associated with that business. In addition, FGIC has historically operated its financial guaranty business principally in limited portions of the public finance and structured finance markets. FGIC has expanded its business lines and products into markets and asset classes that historically have experienced higher default rates than those in which it has historically operated. The risks and uncertainties to which we will be exposed as a result of the FGIC acquisition include the following, among others:
FGIC’s ability to attract new business and to compete with other large, triple-A rated monoline financial guarantors is largely dependent on the triple-A financial strength ratings assigned to it by the major rating agencies. FGIC’s current ratings may be lowered or withdrawn at any time by one or more of the rating agencies. FGIC’s ability to compete or otherwise engage in its business as currently conducted, and FGIC Corporation’s consolidated results of operations and financial condition, would be materially and adversely affected by any reduction in FGIC’s ratings or the announcement of a potential reduction or change in outlook.
Prior to 2004, FGIC operated its financial guaranty business principally in limited portions of the public finance and structured finance markets in the United States. However, in 2004 FGIC began expanding
into new markets and plans to continue its expansion, both domestically and internationally. Unanticipated issues may arise in the implementation of FGIC’s strategy, which could impair its ability to expand its business as expected. In addition, any expansion of its business may be subject to challenges in attracting and retaining employees with relevant experience, establishing name recognition in new markets and gaining knowledge of those markets and asset classes. The execution of FGIC’s expansion plans could result in it having greater losses than those it has historically experienced.
FGIC loss reserves are necessarily based on estimates and subjective judgments about the outcome of future events. We cannot be sure that losses in FGIC’s insured portfolio will not exceed by a material amount the loss reserves previously established by FGIC or that additional significant reserves will not need to be established.
FGIC’s structured finance portfolio contains concentrations of individual issuers and servicers of those obligations as well as a concentration of mortgage-related securities. FGIC also has a number of individual large exposures to single obligors in its public finance portfolio, concentration in infrastructure sectors, and concentrations in certain geographic areas. An adverse event or series of events with respect to one or more of these concentrations that is more severe than the assumptions used by FGIC in its stress scenario at the time of the underwriting of the related credit could result in disproportionate and significant losses to FGIC and could harm its financial position and consolidated results of operations.
Pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of our assets;
Management assessed the effectiveness of our internal control over financial reporting as of December 31, 2004. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework.
Based on management’s assessment and those criteria, management has concluded that we maintained effective internal control over financial reporting as of December 31, 2004.
Our independent registered public accounting firm has issued an attestation report on management’s assessment of our internal control over financial reporting. That report appears below in Item 8.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of The PMI Group, Inc. and subsidiaries at December 31, 2004 and 2003, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2004, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
The accompanying consolidated financial statements include the accounts of The PMI Group, Inc. (“The PMI Group”), a Delaware corporation; its direct and indirect wholly-owned subsidiaries including: PMI Mortgage Insurance Co., an Arizona corporation, and its affiliated U.S. mortgage insurance and reinsurance companies (collectively “PMI”); PMI Mortgage Insurance Ltd and PMI Indemnity Limited, the Australian mortgage insurance companies, and their holding company, PMI Mortgage Insurance Australia (Holdings) Pty Limited (collectively “PMI Australia”); PMI Mortgage Insurance Company Limited and its holding company TPG Reinsurance Company Limited, the Irish insurance corporations (collectively “PMI Europe”); American Pioneer Title Insurance Company (“APTIC”), a Florida corporation reported as discontinued operations in the consolidated financial statements and sold by The PMI Group on March 19, 2004; and other insurance, reinsurance and non-insurance subsidiaries. The PMI Group and its subsidiaries are collectively referred to as the “Company.” All material intercompany transactions and balances have been eliminated in the consolidated financial statements.
On December 18, 2003, the Company completed its acquisition of a 42.1% equity ownership interest in FGIC Corporation, the holding company of Financial Guaranty Insurance Company (collectively “FGIC”), a New York-domiciled financial guaranty insurance company, from General Electric Capital Corporation (“GECC”). The Company also has equity ownership interests in CMG Mortgage Insurance Company, CMG Mortgage Assurance Company and CMG Mortgage Reinsurance Company (collectively “CMG”), which conducts residential mortgage insurance business for credit unions; and through the holding companies, RAM Holdings Ltd. and RAM Holdings II Ltd., RAM Reinsurance Company, Ltd. (collectively “RAM Re”), a financial guaranty reinsurance company based in Bermuda. In addition, the Company has various ownership interests in limited partnerships.
The Company also has an equity ownership interest in SPS Holding Corp. (“SPS”), whose subsidiary, Select Portfolio Servicing, Inc. (“Select Portfolio Servicing”), is a servicer of single-family residential mortgages. Prior to June 30, 2004, SPS was known as Fairbanks Capital Holding Corp. and Select Portfolio Servicing was known as Fairbanks Capital Corp. In January 2005, the Company signed a Summary of Terms with Credit Suisse First Boston (USA), Inc. (“CSFB”) to enter into a strategic transaction with Select Portfolio Servicing and its parent SPS. Under the Summary of Terms, CSFB received an option to acquire 100% of PMI’s outstanding investment in SPS. Based on the proposed purchase price, the Company recorded an impairment of its equity investment in SPS of $20.4 million pre-tax as of December 31, 2004. The impairment was recorded as a realized capital loss on equity investment held for sale due to the Company’s decision to dispose of SPS. Statement of Financial Accounting Standards (“SFAS”) No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, (“SFAS No. 144”), does not allow discontinued operations treatment of an equity investment, and accordingly, the realized capital loss related to the SPS write-down is included in income from continuing operations (see Note 6. Investments in Unconsolidated Subsidiaries for further discussion).
The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) and the requirements of Form 10-K and Article 7 of Regulation S-X. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements, as well as the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates. In the opinion of management, all adjustments, consisting only of normal recurring adjustments, considered necessary for a fair presentation, have been included.
Property, Equipment and Software-Property and equipment, including software, are carried at cost and are depreciated using the straight-line method over the estimated useful lives of the assets, ranging from three to 39 years. Leasehold improvements are recorded at cost and amortized over the lesser of the useful life of the assets or the remaining term of the related lease.
Derivatives-The Company enters into credit default swap contracts and purchases certain foreign currency put options, both of which are considered derivatives under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (“SFAS No. 133”). The Company has not designated either the credit default swaps or foreign currency put options as SFAS No. 133 hedges. Accordingly, both categories of derivatives are determined to be free standing, with changes in fair values recognized in current period’s consolidated results of operations.
During 2003, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 149, Amendment of SFAS No. 133 on Derivative Instruments and Hedging Activities (“SFAS No. 149”). SFAS No. 149 requires certain credit default swaps similar to those entered into by PMI Europe after July 1, 2003 to be accounted for as derivatives and reported on the consolidated balance sheet at fair value, and subsequent changes in fair value are recorded in consolidated net income. In addition, as required by EITF Issue No. 02-3, Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities (“EITF No. 02-3”), for certain credit default swaps entered into by PMI Europe where the fair value cannot be determined by reference to quoted market prices, current market transactions for similar contracts, or based on a valuation technique incorporating observable market data or inputs, initial fair value related to the credit default swaps are deferred and recognized in consolidated net income in proportion to the expiration of the associated insured risk. Gains or losses are recognized in consolidated net income at inception for all other derivative contracts where the fair value can be readily determined from market sources.
Special Purpose Entities-Certain insurance transactions entered into by PMI and PMI Europe require the use of foreign special purpose wholly-owned subsidiaries that are consolidated in the Company’s consolidated financial statements.
EITF Issue No. 04-8, The Effect of Contingently Convertible Instruments on Diluted Earnings per Share, (“EITF No. 04-8”), states that the dilutive effect of contingently convertible debt and other instruments (“CoCo’s”) must be included in dilutive earnings per share. See Note 3. New Accounting Standards below. For purposes of determining dilutive earnings per share, the interest expense, net of tax, was added back to consolidated net income and an additional 8.15 million common shares were added to diluted shares outstanding for all periods presented. Inclusion of the CoCo’s in diluted shares outstanding resulted in a decrease to diluted earnings per share of $0.24, $0.20 and $0.24 for the years ended December 31, 2004, 2003 and 2002, respectively.
The following is a reconciliation of the weighted-average common stock shares used to calculate basic EPS to the weighted-average common stock shares used to calculate diluted EPS for the years ended:
Stock-Based Compensation-The Company accounts for stock-based compensation to employees and directors using the intrinsic value method prescribed in APB Opinion No. 25, Accounting for Stock Issued to Employees, (“APB No. 25”), and its related interpretations. Under APB No. 25, compensation cost for stock-based awards is measured as the excess, if any, of the market price of the underlying stock on the grant date over the employees’ exercise price for the stock options. As all options have been granted with an exercise price equal to the fair value at the date of the grants, no compensation expense has been recognized for the Company’s stock option program. SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS No. 123”), requires the pro forma disclosure of net income and earnings per share using the fair value method, and provides that the employers may continue to account for the stock-based compensation under APB No. 25. SFAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure, amends SFAS No. 123 and requires prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results.
SFAS No. 123 requires pro forma disclosure of consolidated net income and earnings per share using the fair value method. If the computed fair values of the awards had been amortized to expense over the vesting period of the awards, the Company’s consolidated net income, basic net income per share and diluted net income per share would have been reduced to the pro forma amounts indicated below:
Stock Split-In 2002, the Company effected a two-for-one stock split in the form of a stock dividend. All common share and per share data have been adjusted to reflect the stock split.
Reclassifications-Certain items in the prior corresponding period’s consolidated financial statements have been reclassified to conform to the current period’s financial statement presentation.
At its meeting on September 30, 2004, the EITF reached a final consensus, EITF No. 04-8, that the dilutive effect of CoCo’s must be included in dilutive earnings per share regardless of whether the triggering contingency based on the market price of the issuer’s shares has been satisfied. This change in accounting principle was applied on a retroactive basis and required restatement of prior period dilutive earnings per share. This EITF issue is effective for all periods ending after December 15, 2004. The EITF issue resulted in an additional 8.2 million shares of dilution to the Company’s diluted earnings per share calculation due to the Company’s $360.0 million 2.5% senior convertible debentures, which are CoCo’s.
SFAS No. 123(R) permits public companies to adopt its requirements using one of two methods: (i) a “modified prospective” method in which compensation cost is recognized beginning with the effective date (a) based on the requirements of SFAS No. 123(R) for all share-based payments granted after the effective date and (b) based on the requirements of SFAS No. 123 for all awards granted to employees prior to the effective date of SFAS No. 123(R) that remain unvested on the effective date; or (ii) a “modified retrospective” method which includes the requirements of the modified prospective method described above, but also permits entities to restate based on the amounts previously recognized under SFAS No. 123 for purposes of pro forma disclosures either (a) all prior periods presented or (b) prior interim periods of the year of adoption. The Company plans to adopt SFAS No. 123(R) using the modified prospective method.
In January 2003, the FASB issued FASB Interpretation (“FIN”) No. 46, Consolidation of Variable Interest Entities, which provides guidance on identifying and assessing interests in variable interest entities to determine if consolidation or deconsolidation of that entity is required. FIN No. 46 requires consolidation of existing unconsolidated variable interest entities if the entities do not effectively disperse risk among the parties involved. In October 2003, FASB deferred the effective date for applying the provisions of FIN No. 46 until the end of the first interim or annual period ending after December 15, 2003. Upon adoption of FIN No. 46, as revised, at December 31, 2003, the Company deconsolidated the trust subsidiary that issued mandatorily redeemable preferred securities. The mandatorily redeemable preferred securities outstanding in the amount of $48.5 million are no longer recognized in the consolidated balance sheets. Rather, as of December 31, 2003, the Company recognized $51.6 million of junior subordinated debentures which are included in long-term debt, $3.1 million of which represents its investment in the trust in other assets.
Effective January 1, 2002, the Company adopted SFAS No. 141, Business Combinations and SFAS No. 142, Goodwill and Other Intangible Assets, (“SFAS No. 142”). Under SFAS No. 142, any unamortized negative goodwill related to an excess of fair value over cost arising from business combinations completed before July 1, 2001 must be expensed and recognized as a cumulative effect of a change in accounting principle upon the adoption of SFAS No. 142. Accordingly, the Company realized a $7.2 million gain for the remaining balance of negative goodwill in the first quarter of 2002, which was originally recorded in connection with the acquisition of PMI Ltd in 1999.
Investment Concentrations and Other Items-The Company maintains a diversified portfolio principally of U.S. municipal bonds. The following states represent the largest concentrations in the U.S. municipal bond portfolio, expressed as a percentage of the fair value of all U.S. municipal bond holdings. Holdings in states that exceed 5% of the U.S. municipal bond portfolio at December 31, for the respective years are presented below:
The carrying values of the Company’s investments in unconsolidated subsidiaries consisted of the following for the years ended:
Due to the Company’s decision to enter into an agreement with CSFB, the Company reclassified its equity investment in SPS of $109,519 to equity investment held for sale.
percentage of SPS’s net book value as of December 31, 2004. Pursuant to the Summary of Terms with CSFB described in Note 1. Basis of Presentation, the remaining balance of the Company’s $16.7 million related party receivable will be payable in full at closing if CSFB exercises its option to purchase all of the Company’s shares in SPS. In the event CSFB exercises its option, the Company expects based on December 31, 2004 book values to receive $69.7 million in cash at closing exclusive of its related party receivable. The remaining carrying value of SPS of $39.8 million will be received over time through 2007 with cash flows generated from certain mortgage servicing assets held by SPS. To the extent the net book value of SPS changes prior to CSFB exercising its option, the above cash flows could increase or decrease.
Equity in earnings (losses) from unconsolidated subsidiaries and equity investment held for sale consisted of the following for the years ended:
On December 18, 2003, the Company completed its investment in FGIC by acquiring 42.1% equity ownership interest in that entity. The Company is the strategic investor in a group of investors, and funded $611.4 million in cash of the $1.6 billion total purchase price ($1.9 billion including GECC’s retained ownership interest) for the investment in FGIC. The Company’s investment in FGIC, as of December 31, 2004, was $693.7 million, which included $611.4 million cash, with the balance representing equity in earnings, capitalized acquisition costs related to the transaction and the Company’s proportionate share of FGIC’s net unrealized gains in its investment portfolio.
Equity in earnings from FGIC for 2003, as presented in the above table, excludes the extraordinary gain of $5.4 million after-tax related to the Company’s share of negative goodwill recognized by FGIC resulting from the application of purchase accounting adjustments. In accordance with APB No. 18, the Company reflected its proportionate share of FGIC’s extraordinary gain as a separate line item in the Company’s consolidated statement of operations.
In connection with the settlement reached between SPS and the FTC and HUD, SPS recognized aggregate charges of approximately $55 million pre-tax in September 2003 related to the costs of settlement, settlement of certain putative class actions pending against SPS, and estimated costs relating to certain pending state regulatory actions. The Company’s proportionate share of such charges was $19.1 million pre-tax, which was recognized in equity in earnings from unconsolidated subsidiaries in September 2003.
In September 2003, the Company sold its ownership interest in Truman Capital Founders, LLC and Truman Capital Advisors, LLC. The loss in Other in 2003 was due primarily to the $2.6 million loss from certain private equity limited partnership investments occurring in the first quarter of 2003.
Deferred policy acquisition costs are affected by qualifying costs that are deferred in the period and amortization of previously deferred costs in such period. In periods where there is significant growth in new business, the asset will generally increase because the amount of deferred acquisition costs incurred exceeds the amortization of previously deferred policy acquisition costs. Conversely, in periods where new business activity is declining, the asset will generally decrease because the amortization of previously deferred policy acquisition costs exceeds the amount of deferred acquisition costs incurred.
(1) The $11.1 million, $19.1 million and $88.6 million reductions in total losses and LAE incurred in prior years were due to re-estimations of ultimate loss rates and amounts from those established at the original notice of default, updated through the period presented. These re-estimations of ultimate loss rates and amounts are the result of management’s periodic review of estimated claim amounts in light of actual claim amounts, loss development data or ultimate claim rates. The $19.1 million reduction in prior years’ reserves during 2003 was due primarily to a reduction in PMI Australia’s loss reserves and favorable PMI pool portfolio loss development trends. The $88.6 million total reductions in prior years’ reserves during 2002 was due primarily to more favorable loss trends than expected compared to PMI’s historic loss experience, evidenced by lower claim amounts, a robust real estate market and strong home price appreciation.
Equity Units-In November 2003 and in connection with the Company’s investment in FGIC, the Company sold 13.8 million of 5.875% Equity Units and raised $345.0 million of gross proceeds. Each unit has two components: a senior note component and a purchase contract component. The senior note has a $25 principal amount with a 3.0% annual interest rate paid quarterly and maturing on November 15, 2008. The purchase contract component pays a 2.875% annual contract payment quarterly and obligates the holders to purchase $345 million of newly issued shares of the Company’s common stock, no later than November 15, 2006. Further details are provided in Note 16. Dividends and Shareholders’ Equity. In addition, the senior notes have a remarketing feature and will be remarketed on or about August 2006. The senior notes rank equally with all other senior unsecured debt securities of The PMI Group. If the senior notes are not successfully remarketed the holders of the senior notes will have the right to put the senior notes to the Company on the purchase contract settlement date which is November 15, 2006.
Senior Convertible Debentures-In July 2001, the Company issued $360.0 million of 2.50% Senior Convertible Debentures (“the Debentures”) in a private offering to qualified institutional buyers, and subsequently filed a shelf registration statement for the resale of the Debentures and the common stock of The PMI Group issuable upon conversion of the Debentures. The Company used a portion of the net proceeds for the repayment or retirement of existing indebtedness and the remainder for general corporate purposes. The Debentures are due on July 15, 2021 and bear interest at a rate of 2.50% per annum, payable semiannually. The Debentures are convertible at the registered holders’ option, prior to stated maturity, into shares of the Company’s common stock at an initial conversion price of $44.16 per share if specified requirements are met, subject to adjustments in specified circumstances. The most significant requirement for such conversion is that the trading price of the Company’s common stock must exceed 120% of the initial conversion price for 20 consecutive trading days within a 30-day trading period. The Company may redeem some or all of the Debentures on or after July 15, 2006 for a price equal to the principal amount of the Debentures plus any accrued and unpaid interest. The holders may put the Debentures to the Company on July 15, 2006, 2008, 2011 and 2016. On July 15, 2004, certain debenture holders required us to repurchase a nominal amount of the debentures. Upon a change of control of the Company, holders may also require the Company, subject to certain conditions, to repurchase all or a portion of the Debentures. The Company may repurchase the Debentures with cash, common stock, or a combination of cash and shares of common stock. If the Company elects to pay all or a portion of the purchase price in common stock, the shares of common stock will be valued at 97.5% of the average sale price for twenty trading days ending on the third day prior to the repurchase date. The Debentures are senior unsecured debt securities and rank equally with all other senior unsecured debt of The PMI Group.
Upon the adoption of FIN No. 46 as of December 31, 2003, the Company deconsolidated the Issuer Trust subsidiary that issued $48.5 million of the Capital Securities. The underlying securities of $48.5 million issued
The following table shows the effects of reinsurance on premiums written, premiums earned and losses and loss adjustment expenses of the Company’s operations for the years ended:
The majority of the Company’s existing reinsurance contracts are captive reinsurance agreements in U.S. Mortgage Insurance Operations. Under captive reinsurance agreements, a portion of the risk insured by PMI is reinsured with the mortgage originator or investor through a reinsurer that is affiliated with the mortgage originator or investor. Ceded premiums for U.S. captive reinsurance accounted for 87% of total ceded premiums written in 2004 compared to 82% in 2003 and 82% in 2002. Reinsurance recoverables on losses incurred were $2.4 million at December 31, 2004, $3.3 million at December 31, 2003 and $3.8 million at December 31, 2002.
On October 22, 2004, the American Jobs Creation Act (“AJCA”) was signed into law. The AJCA includes a provision allowing a deduction of 85% for certain foreign earnings that are repatriated. The AJCA provides The PMI Group with the opportunity to elect to apply this provision to qualifying earnings repatriations in 2005. Based on the existing language in the AJCA and current guidance, The PMI Group does not expect to repatriate undistributed earnings. To the extent Congress or the Treasury Department provides additional clarifying language on key elements of the provision, The PMI Group will consider the effects, if any, of such information and will re-evaluate, as necessary, its intentions with respect to the repatriation of certain foreign earnings. Should The PMI Group, upon consideration of any such potential clarifying language, ultimately elect to apply the repatriation provision to the AJCA, The PMI Group does not expect that the impact of such an election would be material to its results of operations.
The components of the deferred income tax assets and liabilities as of the years ended:
subsidiaries in determining California taxable income of the holding company for tax years ending on or after December 1, 1997. In 2003, the Company established a reserve of $4.7 million representing a portion of the total assessments sought by the FTB.
Funding Obligations-We have invested in certain limited partnerships with ownership interests greater than 3% but less than 50%. As of December 31, 2004, the Company had committed to fund, if called upon to do so, $5.6 million of additional equity in certain limited partnership investments.
Legal Proceedings-On December 15, 2000, the Company announced that PMI entered into an agreement with the plaintiffs to settle the class action litigation captioned Baynham et al v. PMI Mortgage Insurance Company. PMI denied all facts and allegations in the lawsuit that alleged violations of Section 8 of the Real Estate Settlement Procedures Act (“RESPA”) and other claims. To account for the settlement, PMI took a pre-tax charge of $5.7 million in the fourth quarter of 2000, a $1.5 million pre-tax charge in the third quarter of 2001 and an additional pre-tax charge of $12.2 million in the fourth quarter of 2002. The charges were based upon the estimate of the cost of settlement. PMI received a $2.6 million pre-tax settlement refund in the third quarter of 2004. There was no accrual as of December 31, 2004.
Various other legal actions and regulatory reviews are currently pending that involve the Company and specific aspects of its conduct of business. In the opinion of management, the ultimate liability in one or more of these actions is not expected to have a material effect on the consolidated financial condition, results of operations or cash flows of the Company.
In August 2004, the Company’s Board of Directors approved a $0.03 per share annual dividend increase to $0.18 per share annually beginning in the third quarter of 2004 and the establishment of a dividend reinvestment plan.
In addition to its consolidated subsidiaries, The PMI Group may in the future derive funds from its unconsolidated equity investments, including its investment in FGIC. FGIC’s ability to pay dividends is subject to restrictions contained in applicable state insurance laws and regulations, FGIC’s certificate of incorporation, a stockholders’ agreement between the PMI Group and other investors in FGIC, and FGIC’s 6.0% senior notes. Under New York insurance law, FGIC may pay dividends out of statutory earned surplus, provided that statutory surplus after any dividend may not be less than the minimum required paid-in capital and provided that together with all dividends declared or distributed by FGIC during the preceding 12 months, the dividends do not exceed the lesser of (i) 10% of policyholders’ surplus as of its last statement filed with the New York superintendent or (ii) adjusted net investment income during this period. In addition, in accordance with the normal practice of the New York Insurance Department in connection with change in control applications, FGIC is subject to commitments to the department that it will prevent FGIC from paying any dividends on its common stock for a period of two years from the date of the acquisition, December 18, 2005, without the prior written consent of the New York Insurance Department.
of voluntary or involuntary liquidation, the terms and conditions for conversion or exchange into any other class or series of the stock, voting rights and other terms. The Company may issue, without the approval of the holders of common stock, preferred stock that has voting, dividend or liquidation rights superior to the common stock, which may adversely affect the rights of holders of common stock.
Pursuant to the support agreement described in Note 22. Capital Support Agreements, the Company has agreed that, in the event that Allstate, the Company’s former parent, makes a payment contemplated by the Allstate Support Agreements or the runoff support agreement, Allstate will have the right to receive preferred stock of The PMI Group or PMI with a liquidation preference equal to the amount of such payment. Such preferred stock will rank senior in right of payment to the issuer’s common stock and, so long as such preferred stock is outstanding, the issuer thereof will be prohibited from paying any dividends or making any other distributions on its common stock.
Effective January 1, 2003, all full-time and part-time employees of the Company are eligible to participate in The PMI Group, Inc. Retirement Plan (the “Plan”), a noncontributory defined benefit plan. The Plan generally has been funded by the Company to the fullest extent permitted by federal income tax rules and regulations. In addition, certain employees whose annual earnings exceed $205,000 under Internal Revenue Code (“IRC”) Section 401(a)(17) and limits established under IRC Section 415 participate in The PMI Group, Inc. Supplemental Employee Retirement Plan, a noncontributory defined benefit plan. Benefits under both pension plans are based upon the employees’ length of service, average annual compensation and estimated social security retirement benefits.
The Company’s accumulated benefit obligation for its pension plans at December 31, 2004 was $44.5 million and $9.2 million, the combination of which equals the $53.7 million accumulated benefit obligation. As of December 31, 2004, the combined fair value of plan assets exceeded our combined accumulated benefit obligation. The health care cost trend on covered charges for other postretirement benefits was 9% in 2004, which will be reduced by 2% per year to 5% in 2006. In 2004, the Company contributed $16.0 million to its pension plan. The maximum annual deductible under IRS rules was approximately $16 million for 2004. Benefits paid during 2004 increased primarily as a result of lump sum distributions to former APTIC employees. During 2004, the Company exceeded certain threshold tests related to these lump sum distributions due primarily to the sale of APTIC, and as such, a $1.7 million increase was recorded to the Company’s benefit obligations. This occurrence triggered settlement accounting under SFAS No. 88, Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits which requires immediate recognition in current reported consolidated net income of the delayed recognition in net periodic pension cost of certain elements arising from adoption or modification of a pension plan; namely projected benefit obligation gains and losses, plan asset gains and losses, transition amounts, and costs of retroactive plan amendments. This charge was recorded as an offset to the Company’s net gain on sale of APTIC in accordance with SFAS No. 144. Additional cost in Components of net periodic benefit cost in the above table includes this charge and a $1.4 million curtailment charge recorded in the first quarter of 2004 also relating to the sale of APTIC.
The Company makes contributions that are sufficient to fully fund its actuarially determined costs, generally exceeding the minimum amounts required by the Employee Retirement Income Security Act. Currently, the Company estimates the allowable contributions to be between approximately $0 to $8 million. Accordingly, the Company expects to contribute approximately $5 million to $8 million to the Plan in 2005, subject to the approval of the Finance and Investment Committee of the Board of Directors.
The following is a summary of the stock option activity in the Equity Incentive Plan for the years ended:
The weighted-average remaining contractual life of options outstanding as of December 31, 2004 was 6.2 years, and the range of exercise price on those options was $8.79 to $43.96.
Employee Stock Purchase Plan-The PMI Group, Inc. Employee Stock Purchase Plan (“ESPP”) allows eligible employees to purchase shares of the Company’s stock at a 15% discount to fair market value as determined by the plan. The ESPP offers participants the 15% discount to current fair market value or fair market value with a look-back provision of the lesser of the duration an employee has participated in the ESPP or two years. Under the ESPP, the Company sold 96,021 treasury shares in 2004, 70,493 treasury shares in 2003 and 66,635 treasury shares in 2002. The Company applies APB No. 25 in accounting for the ESPP. The Company’s adoption of SFAS No. 123(R) will require expense recognition of the amount of the discount to current fair value of ESPP shares purchased by employees. The Company does not expect the effect of the adoption to be material as it relates to the ESPP.
PMI’s statutory net income, statutory surplus and contingency reserve liability as of and for the years ended:
The Runoff Support Agreement contains certain covenants, including covenants that (i) PMI will write no new business after its risk-to-capital ratio equals or exceeds 23 to 1; (ii) PMI will pay no dividends if, after the payment of any such dividend, PMI’s risk-to-capital ratio would equal or exceed 23 to 1; and (iii) on the date that any of the following events occur: (a) PMI’s risk-to-capital ratio exceeds 24.5 to 1, (b) Allstate shall have paid any claims relating to PMI policies directly to a policyholder or by paying an amount equal to such claims to PMI, or to The PMI Group for contribution to PMI, pursuant to the Runoff Support Agreement, or (c) any regulatory order is issued restricting or prohibiting PMI from making full or timely payments under policies, PMI will transfer substantially all of its assets in excess of $50.0 million to a trust account established for the payment of claims. As of December 31, 2004, less than $0.3 billion of RIF was subject to the Runoff Support Agreement.
As of December 31, 2004, the Company was in compliance with all covenants included in its capital support agreements.