Represents contractual aggregate loss limits and, for the years ended December 31, 2005, 2004, 2003 and 2002, for $5.0 billion, $4.9 billion, $4.9 billion and $3.0 billion, respectively, of risk without such limits, risk is calculated at $51 million, $65 million, $192 million and $147 million, respectively, for new risk written and $469 million, $418 million, $353 million and $161 million, respectively, for risk in force, the estimated amount that would credit enhance these loans to a ‘AA’ level based on a rating agency model.
The average claim payment, which is affected by the size of loans insured (higher average loan amounts tend to increase losses incurred), the percentage coverage on insured loans (deeper average coverage tends to increase incurred losses), and housing values, which affect the Company’s ability to mitigate its losses through sales of properties with delinquent mortgages.
The distribution of claims over the life of a book. Historically, the first two years after a loan is originated are a period of relatively low claims, with claims increasing substantially for several years subsequent and then declining, although persistency and the condition of the economy can affect this pattern.
The operating expenses of the Company generally vary primarily due to contract underwriting volume, which in turn generally varies with the level of mortgage origination activity. Contract underwriting generates fee income included in “Other revenue.”
The Company’s results of operations are also affected by income from joint ventures. Joint venture income principally consists of the aggregate results of the Company’s investment in two less than majority owned joint ventures, Credit-Based Asset Servicing and Securitization LLC (“C-BASS”) and Sherman Financial Group LLC (“Sherman”).
Net interest income is principally a function of the size of C-BASS’s portfolio of whole loans and mortgages and other securities, and the spread between the interest income generated by these assets and the interest expense of funding them. Interest income from a particular security is recognized based on the expected yield for the security.
The Company’s results of operations in 2005 were principally affected by:
The Company’s written and earned premiums in 2005 were lower than in 2004 due to a decline in the average insurance in force.
Income from joint ventures increased in 2005, compared to 2004, due to higher income from each of C-BASS and Sherman.
As discussed under “Forward Looking Statements and Risk Factors” in Item 1A, actual results may differ materially from the results contemplated by forward looking statements. The Company is not undertaking any obligation to update any forward looking statements it may make in the following discussion or elsewhere in this document even though these statements may be affected by events or circumstances occurring after the forward looking statements were made.
In addition to providing primary insurance coverage, the Company also insures pools of mortgage loans. New pool risk written during the years ended December 31, 2005, 2004 and 2003 was $358 million, $208 million and $862 million, respectively. The Company’s direct pool risk in force was $2.9 billion, $3.0 billion and $2.9 billion at December 31, 2005, 2004 and 2003, respectively. These risk amounts represent pools of loans with contractual aggregate loss limits and those without such limits. For pools of loans without such limits, risk is estimated based on the amount that would credit enhance the loans in the pool to a ‘AA’ level based on a rating agency model. Under this model,at December 31, 2005, 2004 and 2003, for $5.0 billion, $4.9 billion and $4.9 billion, respectively, of risk without such limits, risk in force is calculated at $469 million, $418 million and $353 million, respectively. New risk written, under this model, for the years ended December 31, 2005 and 2004 was $51 million and $65 million, respectively.
Net premium written and earned decreased in 2004, compared to 2003, due to a decline in the average insurance in force, as well as a decrease in new insurance written through the flow and bulk channels.
For the nine months ended September 30, 2005, approximately 47.8% of the Company’s new insurance written on a flow basis was subject to arrangements with reinsurance subsidiaries of certain mortgage lenders or risk sharing arrangements with the GSEs compared to 50.6% for the year ended December 31, 2004 and 52.3% for the year ended December 31, 2003. The percentage of new insurance written during a period covered by such arrangements normally increases after the end of the period because, among other reasons, the transfer of a loan in the secondary market can result in a mortgage insured during a period becoming part of such an arrangement in a subsequent period. Therefore, the percentage of new insurance written covered by such arrangements is not shown for the current quarter. Premiums ceded in such arrangements are reported in the period in which they are ceded regardless of when the mortgage was insured.
Investment income for 2004 increased compared to 2003 due to an increase in the amortized cost of average invested assets to $5.2 billion for 2004 from $4.7 billion for 2003. The Company’s net realized gains for 2003 resulted primarily from the sale of fixed maturities.
The Company anticipates that losses incurred in 2006 will exceed their 2005 level.
The average primary claim paid for 2005 was $26,361 compared to $24,438 in 2004 and $22,925 in 2003.
As of December 31, 2005, 77% of the Company’s primary insurance in force was written subsequent to December 31, 2002. On the Company’s flow business, the highest claim frequency years have typically been the third and fourth year after the year of loan origination. However, the pattern of claims frequency can be affected by many factors, including low persistency (which can have the effect of accelerating the period in the life of a book during which the highest claim frequency occurs) and deteriorating economic conditions (which can result in increasing claims following a period of declining claims). On the Company’s bulk business, the period of highest claims frequency has generally occurred earlier than in the historical pattern on the Company’s flow business.
The decrease in underwriting and other expenses in 2005, compared to 2004, as well as the decrease in 2004, compared to 2003, is primarily attributable to decreases in expenses related to contract underwriting activity. The Company anticipates that expenses in 2006 will increase compared to 2005, due to an increase in expenses related to Myers Internet, Inc. acquired in January 2006 (see “Note 16. Subsequent Events” to the Company’s consolidated financial statements), international operations, and expensing of unvested stock options granted in 2002. (Beginning in 2003, the Company has expensed the fair value of stock options granted on or after January 1, 2003.)
The effective tax rate was 27.0% in 2005, compared to 26.9% in 2004 and 25.4% in 2003. During those periods, the effective tax rate was below the statutory rate of 35%, reflecting the benefits recognized from tax-preferenced investments. Tax-preferenced investments of the Company include tax-exempt municipal bonds, interests in mortgage related securities with flow through characteristics and investments in real estate ventures which generate low income housing credits. Changes in the effective tax rate principally result from a higher or lower percentage of total income before tax being generated from tax-preferenced investments.
The increased contribution from C-BASS for 2005, compared to 2004, was primarily due to increased servicing revenue, net interest income and portfolio mark-to-market and hedging gains. The increased servicing revenue was due primarily to Litton’s higher average servicing portfolio. Higher net interest income was the result of a higher average investment portfolio and higher earnings on trust deposits for securities serviced by Litton. The portfolio mark-to-market resulted from securities called by C-BASS and securities obtained by C-BASS through risk sharing arrangements where C-BASS owned the securities at a discount. The realized gains from hedging reflected hedging on whole loans securitized.
The increased contribution from C-BASS in 2004 compared to 2003 was primarily due to an increase in gains on sales and liquidation to third parties of securities and mortgage loans, higher net interest income, higher mark-to-market from calls by C-BASS of CBO securitizations and lower hedging losses. Gains on sale and liquidation to third parties increased principally due to calls of securities at par which had a book value below par. Higher net interest income was principally the result of a higher average portfolio of mortgage loans. Higher mark-to-market and lower hedging losses were reflective of changes in interest rates.
The Company’s investment in C-BASS on an equity basis at December 31, 2005 was $362.6 million. The Company received $33.5 million in distributions from C-BASS during 2005.
The increased contribution from Sherman in 2005, compared to 2004, and in 2004 compared to 2003, was primarily due to increased revenue, net of amortization, from delinquent receivable portfolios owned
during the comparison periods attributable to continuing collections and lower amortization and from higher collections due to growth in the amount of delinquent receivable portfolios owned by Sherman in sequential periods. The increase in revenue for 2005 was also due to credit card income and fees generated by Credit One; the increase in expenses in 2005 was also related to Credit One.
The Company anticipates that Sherman’s income before tax in 2006 will be less than its income before tax in 2005.
In connection with these transactions, the payout under Sherman’s annual incentive plan (which is based on a percentage of Sherman’s pre-bonus results) was reduced effective May 1, 2005.
The Company had $300 million, 5.375% Senior Notes due in November 2015 and $200 million, 6% Senior Notes due in March 2007 outstanding at December 31, 2005. At December 31, 2004 the Company had $300 million, 7.5% Senior Notes due in October 2005 and $200 Million, 6% Senior Notes due in March 2007. In October 2005 the Company issued, in a public offering, $300 million, 5.375% Senior Notes due in 2015. Interest on the Notes is payable semiannually in arrears on May 1 and November 1 of each year, beginning on May 1, 2006. The Senior Notes were rated “A-1” by Moody’s, “A” by S&P and “A+” by Fitch. The Company utilized the proceeds from the sale of these Senior Notes, together with available cash, to repay the $300 million, 7.5% Senior Notes that matured October 17, 2005. At December 31, 2005 and 2004, the market value of the outstanding debt was $687.9 million and $661.3 million, respectively.
The Company’s consolidated sources of funds consist primarily of premiums written and investment income. Positive cash flows are invested pending future payments of claims and other expenses. Management believes that future cash inflows from premiums will be sufficient to meet future claim payments. Cash flow shortfalls, if any, could be funded through sales of short-term investments and other investment portfolio securities subject to insurance regulatory requirements regarding the payment of dividends to the extent funds were required by other than the seller. Substantially all of the investment portfolio securities are held by the Company’s insurance subsidiaries.
The Company has a $300 million commercial paper program, which is rated “A-1” by S&P and “P-1” by Moody’s. At December 31, 2005 and 2004, the Company had $187.8 and $139.5 million in commercial paper outstanding with a weighted average interest rate of 4.39% and 2.36%, respectively.
continue to be used as a liquidity back up facility for the outstanding commercial paper. The remaining credit available under the facility after reduction for the amount necessary to support the commercial paper was $112.2 million and $145.5 million at December 31, 2005 and 2004, respectively.
In March 2005, an outstanding swap was amended to coincide with the new credit facility. Under the terms of the swap contract, the Company pays a fixed rate of 5.07% and receives a variable interest rate based on LIBOR. The swap has an expiration date coinciding with the maturity of the credit facility and is designated as a cash flow hedge. The cash flow swap outstanding at December 31, 2005 and 2004 are evaluated quarterly with any ineffectiveness being recorded as an expense. To date this evaluation has not resulted in any hedge ineffectiveness. Swaps are subject to credit risk to the extent the counterparty would be unable to discharge its obligations under the swap agreements.
Expense on the interest rate swaps in 2005, 2004 and 2003 of approximately $0.8 million, $3.3 million and $3.4 million, respectively, was included in interest expense. Gains or losses arising from the amendment or termination of interest rate swaps are deferred and amortized to interest expense over the life of the hedged items.
During 2005, the Company repurchased 8.7 million shares of Common Stock under publicly announced programs at a cost of $533.8 million, a portion of which is subject to adjustment based on the price of the Company’s stock in the first part of 2006. At December 31, 2005, the Company had authority covering the purchase of an additional 0.8 million shares under these programs. In January 2006, the Company’s Board of Directors authorized the repurchase of an additional 10 million shares. From mid-1997 through December 31, 2005, the Company has repurchased 35.5 million shares under publicly announced programs at a cost of $2.0 billion. Funds for the shares repurchased by the Company since mid-1997 have been provided through a combination of debt, including the Senior Notes and the commercial paper, and internally generated funds.
The Company’s consolidated risk-to-capital ratio was 7.4:1 at December 31, 2005 compared to 7.9:1 at December 31, 2004. The decrease was due to an increase in capital and a decrease in risk in force during 2005.
For certain material risks of the Company’s business, see Item 1A. The discussion in Item 1A is an integral part of Management’s Discussion and Analysis.
At December 31, 2005, the approximate future payments under the contractual obligations of the Company of the type described in the table below are as follows:
The Company’s long-term debt obligations consist of $300 million, 5.375% Senior Notes due in 2015 and $200 million, 6% Senior Notes due in 2007, as discussed in “Note 5. Short and long-term debt” to the Company’s consolidated financial statements and under “Liquidity and Capital Resources” above. The Company’s operating lease obligations include operating leases on certain office space, data processing equipment and autos, as discussed in “Note 12. Leases” to the Company’s consolidated financial statements. The Company’s purchase obligations included obligations to purchase computer software, home office furniture and equipment, and Myers Internet, Inc., as discussed in “Note 16. Subsequent Events” to the Company’s consolidated financial statements.
The Company believes that the accounting policies described below involved significant judgments and estimates used in the preparation of its consolidated financial statements.
Reserves are established for reported insurance losses and loss adjustment expenses based on when notices of default on insured mortgage loans are received. A default is defined as an insured loan with a mortgage payment that is 45 days or more past due. Reserves are also established for estimated losses incurred on notices of default not yet reported. Consistent with industry practices, the Company does not establish loss reserves for future claims on insured loans which are not currently in default.
The incurred but not reported (“IBNR”) reserves referred to above result from defaults occurring prior to the close of an accounting period, but which have not been reported to the Company. Consistent with reserves for reported defaults, IBNR reserves are established using estimated claims rates and claims amounts for the estimated number of defaults not reported. As of December 31, 2005 and 2004, the Company has established IBNR reserves in the amount of $112 million and $113 million, respectively.
Consolidated statements of operations for each of the three years in the period ended December 31, 2005
At December 31, 2005, the Company’s direct primary insurance in force (representing the principal balance in the Company’s records of all mortgage loans that it insures) and direct primary risk in force (representing the insurance in force multiplied by the insurance coverage percentage) was approximately $170.0 billion and $44.9 billion, respectively. In addition to providing direct primary insurance coverage, the Company also insures pools of mortgage loans. The Company’s direct pool risk in force at December 31, 2005 was approximately $2.9 billion.
The insurance subsidiaries write policies which are guaranteed renewable contracts at the insured’s option on a single, annual or monthly premium basis. The insurance subsidiaries have no ability to reunderwrite or reprice these contracts. Premiums written on a single premium basis and an annual premium basis are initially deferred as unearned premium reserve and earned over the policy term. Premiums written on policies covering more than one year are amortized over the policy life in accordance with the expiration of risk which is the anticipated claim payment pattern based on historical experience. Premiums written on annual policies are earned on a monthly pro rata basis. Premiums written on monthly policies are earned as coverage is provided. When a policy is cancelled, all premium that is non-refundable is immediately earned. Any refundable premium is returned to the lender and will have no effect on earned premium. Policy cancellations also lower the persistency rate which is a variable used in calculating the rate of amortization of deferred policy acquisition costs.
agreement exists between the Company and its subsidiaries. Each subsidiary determines income taxes based upon the utilization of all tax deferral elections available. This assumes tax and loss bonds are purchased and held to the extent they would have been purchased and held on a separate company basis since the tax sharing agreement provides that the redemption or non-purchase of such bonds shall not increase such member’s separate taxable income and tax liability on a separate company basis.
The Company accrues the estimated costs of retiree medical and life benefits over the period during which employees render the service that qualifies them for benefits. The Company offers both medical and dental benefits for retired employees and their spouses. Benefits are generally funded on a pay-as-you-go basis. The cost to the Company was not significant in 2005, 2004 and 2003. (See note 9.)
The Company has certain stock-based compensation plans. (See note 11). Effective January 1, 2003, the Company adopted the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation, prospectively to all employee awards granted or modified on or after January 1, 2003. The adoption of SFAS No. 123 did not have a material effect on the Company’s results of operations or its financial position. Under the fair value method, compensation cost is measured at the grant date based on the fair value of the award and is recognized over the service period which generally corresponds to the vesting period. Awards under the Company’s plans generally vest over periods ranging from one to five years. The cost related to stock-based employee compensation included in the determination of net income for 2005, 2004 and 2003 is less than that which would have been recognized if the fair value based method had been applied to all awards since the original effective date of SFAS No. 123. The following table illustrates the effect on net income and earnings per share if the fair value method had been applied to all outstanding and unvested awards in each period.
In July 2005, the FASB published an Exposure Draft of a proposed interpretation, “Accounting for Uncertain Tax Positions.” The Exposure Draft seeks to reduce the significant diversity in practice associated with recognition and measurement in the accounting for income taxes. The FASB has reopened deliberations to consider comments that were received regarding the Exposure Draft. At this time, the FASB has decided that the final interpretation would apply to all tax positions accounted for in accordance with SFAS No. 109, “Accounting for Income Taxes.” When evaluating a tax position for recognition and measurement, an entity should presume that a taxing authority will examine a tax position. The interpretation will most probably adopt a benefit recognition model with a two-step approach, a more-likely-than-not threshold for recognition and derecognition, and a best estimate measurement attribute. It is expected to be finalized in the first or second quarter of 2006 with an effective date as of the start of the first annual period beginning after December 15, 2006. The Company will continue to evaluate the impact, if any, this interpretation would have on the Company’s results of operations and financial position.
Certain reclassifications have been made in the accompanying financial statements to 2004 and 2003
The Company provided certain services to C-BASS and Sherman in 2005, 2004 and 2003 in exchange for fees. In addition, C-BASS provided certain services to the Company during 2005, 2004 and 2003 in exchange for fees. The net impact of these transactions was not material to the Company.
The amortized cost and fair values of debt securities at December 31, 2005, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Because most mortgage-backed securities provide for periodic payments throughout their lives, they are listed below in a separate category.
At December 31, 2005 and 2004, fixed maturity investments had gross unrealized losses of $17.7 million and $10.5 million, respectively. For those securities in an unrealized loss position, the length of time the securities were in such a position, as measured by their month-end fair values, is as follows:
The tax benefit related to the changes in net unrealized (depreciation) appreciation was $25.9 million, $12.0 million and $11.3 million for 2005, 2004 and 2003, respectively.
The Company has a $300 million commercial paper program, which is rated “A-1” by Standard and Poors (“S&P”) and “P-1” by Moody’s. At December 31, 2005 and 2004, the Company had $187.8 million and $139.5 million in commercial paper outstanding with a weighted average interest rate of 4.39% and 2.36%, respectively.
Senior Notes that came due October 17, 2005. At December 31, 2005 and 2004, the market value of the outstanding debt was $687.9 million and $661.3 million, respectively.
Interest payments on all long-term and short-term debt were $43.5 million, $42.1 million and $41.8 million for the years ended December 31, 2005, 2004 and 2003, respectively.
In March 2005, an outstanding swap was amended to coincide with the new credit facility. Under the terms of the swap contract, the Company pays a fixed rate of 5.07% and receives a variable interest rate based on LIBOR. The swap has an expiration date coinciding with the maturity of the credit facility and is designated as a cash flow hedge. The cash flow swap outstanding at December 31, 2005 and 2004 are evaluated quarterly with any ineffectiveness being recorded as an expense. To date these evaluations have not resulted in any hedge ineffectiveness. Swaps are subject to credit risk to the extent the counterparty would be unable to discharge its obligations under the swap agreements.
Current year losses incurred decreased in 2005 compared to 2004 primarily due to decreases in the estimates regarding how many primary default notices will eventually result in a claim, when compared to the prior period. The primary insurance notice inventory increased from 85,487 at December 31, 2004 to 85,788 at December 31, 2005 and pool insurance notice inventory decreased from 25,500 at December 31, 2004 to 23,772 at December 31, 2005. The average primary claim paid for 2005 was $26,361 compared to $24,438 in 2004.
The Company monitors the claims paying ability of its reinsurers and does not currently anticipate any collection problems. Generally, reinsurance recoverables on primary loss reserves and prepaid reinsurance premiums are backed by trust funds or letters of credit. No reinsurer represents more than $10 million of the aggregate amount recoverable.
C-BASS is a mortgage investment and servicing firm specializing in credit-sensitive single-family residential mortgage assets and residential mortgage-backed securities. C-BASS principally invests in whole loans (including subprime loans) and mezzanine and subordinated residential mortgage-backed securities backed by non-conforming residential mortgage loans. C-BASS’s principal sources of revenues during the last three years were net interest income (including accretion on mortgage securities), servicing fees, money management fees from C-BASS CBOs and investment funds sponsored by C-BASS, and gains on securitization and liquidation of mortgage-related assets, offset by hedging losses. C-BASS’s results of operations are affected by the timing of its securitization transactions. Virtually all of C-BASS’s assets do not have readily ascertainable market values and, as a result, their value for financial statement purposes is estimated by the management of C-BASS based on, among other things, valuations provided by financing counterparties. The ultimate value of these assets is the net present value of their future cash flows, which depends on, among other things, the level of losses on the underlying mortgages and prepayment activity by the mortgage borrowers. Market value adjustments could impact C-BASS’s results of operations and the Company’s share of those results. The Company’s investment in C-BASS on an equity basis at December 31, 2005 was $362.6 million.
Included in total assets and total liabilities at December 31, 2004 were approximately $457 million of assets and the same amount of liabilities from securitizations that did not qualify for off-balance sheet treatment. The liabilities from these securitizations are not included in Debt in the table above. There were no such assets and liabilities at December 31, 2005.
Sherman is principally engaged in the business of purchasing and collecting for its own account delinquent consumer assets which are primarily unsecured. The borrowings used to finance these activities are included in Sherman’s balance sheet. A substantial portion of Sherman’s consolidated assets are investments in consumer receivable portfolios that do not have readily
ascertainable market values. Sherman’s results of operations are sensitive to estimates by Sherman’s management of ultimate collections on these portfolios.
In June 2005, MGIC, Radian (MGIC and Radian are collectively referred to as the “Corporate Partners”) and entities (the “Management Entities”) owned by the senior management (“Senior Management”) of Sherman entered into a Securities Purchase Agreement and a Call Option Agreement. Under the Securities Purchase Agreement, each of MGIC and Radian agreed to sell to one of the Management Entities 6.92% of the 41.5% interest in Sherman owned by each (a total of 13.84% for both MGIC and Radian) for approximately $15.7 million, which is $1.0 million in excess of the approximate book value of the interest at April 30, 2005. Upon completion of the sale, Senior Management of Sherman owns an interest in Sherman of 30.84% and each of MGIC and Radian own interests of 34.58%. The sale closed in early August 2005. Under the Call Option Agreement, one of the Management Entities granted separate options (each an “Option”) to each Corporate Partner to purchase a 6.92% interest in Sherman (a total of 13.84% under both Options). Each Option is exercisable beginning in July 2006 at the option price provided in the Call Option Agreement. If one Corporate Partner does not exercise its Option, the other Corporate Partner may exercise that Option. The Securities Purchase Agreement and Call Option Agreement were filed as exhibits to the Company’s Current Report on Form 8-K filed on June 30, 2005; the description above is qualified by the terms of the actual agreements. In connection with these transactions, the payout under Sherman’s annual incentive plan (which is based on a percentage of Sherman’s pre-bonus results) was reduced effective May 1, 2005.
The Company’s investment in Sherman on an equity basis at December 31, 2005 was $79.3 million.
Because C-BASS and Sherman are accounted for using the equity method, they are not consolidated with the Company and their assets and liabilities do not appear in the Company’s balance sheet. The “investments in joint ventures” item in the Company’s balance sheet reflects the amount of capital contributed by the Company to joint ventures plus the Company’s share of their comprehensive income (or minus its share of their comprehensive loss) and minus capital distributed to the Company by the joint ventures. (See note 2.)
Employer pension and postretirement contributions for the fiscal year ending December 31, 2006 are expected to approximate $10.3 million and $4.6 million, respectively. The ERISA minimum required pension contribution is zero.
The Company’s pension plan portfolio returns are expected to achieve the following objectives over each market cycle and for at least 5 years:
The Company’s postretirement plan portfolio returns are expected to achieve the following objectives over each market cycle and for at least 5 years:
The primary focus in developing asset allocation ranges for the account is the assessment of the account’s investment objectives and the level of risk that is acceptable to obtain those objectives. To achieve these goals the minimum and maximum allocation ranges for fixed income securities and equity securities are:
next $2,000 contributed. The Company recognized profit sharing expense and 401(k) savings plan expense of $5.6 million, $5.7 million and $7.7 million in 2005, 2004 and 2003, respectively.
The components of the net deferred tax asset as of December 31, 2005 and 2004 are as follows:
The Company paid $264.5 million, $203.2 million and $182.1 million in federal income tax in 2005, 2004 and 2003, respectively. At December 31, 2005, 2004 and 2003, the Company owned $1,625.3 million, $1,468.5 million and $1,316.9 million, respectively, of tax and loss bonds.
The Internal Revenue Service (“IRS”) has been conducting an examination of the federal income tax returns of the Company for 2000 and 2001. During 2005, the IRS expanded the examination to include the 2002, 2003 and 2004 taxable years. In this examination, they have summonsed documents which include communications with outside legal counsel engaged by the Company. Management believes that these documents are protected by the attorney-client privilege and has declined to waive that privilege, so it has not provided them to the IRS. The documents relate to a portfolio of investments in the residual interests of Real Estate Mortgage Investment Conduits (“REMICs”). This portfolio has been managed and maintained during years prior to, during and subsequent to the examination period. The tax returns have included the flow through of income and losses from these investments in the computation of taxable income. The IRS has indicated that they do not believe that the Company has established sufficient tax basis in the REMIC residual interests to deduct some portion of the flow through losses from income. To date, they have not provided a detailed explanation of their position or the calculation of the dollar amount of any potential adjustment. The Company will contest any such proposal to increase taxable income and believes that income taxes related to these years have been properly provided for in the financial statements.
insurance subsidiaries may pay in any twelve-month period without regulatory approval by the Office of the Commissioner of Insurance of the State of Wisconsin (“OCI”) is the lesser of adjusted statutory net income or 10% of statutory policyholders’ surplus as of the preceding calendar year end. Adjusted statutory net income is defined for this purpose to be the greater of statutory net income, net of realized investment gains, for the calendar year preceding the date of the dividend or statutory net income, net of realized investment gains, for the three calendar years preceding the date of the dividend less dividends paid within the first two of the preceding three calendar years. As a result of extraordinary dividends paid, MGIC cannot currently pay any dividends without regulatory approval. The other insurance subsidiaries of the Company can pay $1.8 million of dividends to the Company without such regulatory approval.
In 2005, 2004 and 2003, the Company paid dividends of $48.4 million, $22.0 million and $11.1 million, respectively, or $0.525 per share in 2005, $0.225 per share in 2004 and $0.1125 per share in 2003.
Under statutory accounting practices, mortgage guaranty insurance companies are required to maintain contingency loss reserves equal to 50% of premiums earned. Such amounts cannot be withdrawn for a period of ten years except as permitted by insurance regulations. Changes in contingency loss reserves impact the statutory statement of operations. Contingency loss reserves are not reflected as liabilities under GAAP and changes in contingency loss reserves do not impact GAAP operations.
Under statutory accounting practices, the Company’s share of the net income or loss of its investments in joint ventures is credited directly to statutory surplus.
Under GAAP, income from joint ventures is shown separately, net of tax, on the statement of operations.
The statutory net income, policyholder’s surplus, and the contingency reserve liability of the insurance subsidiaries (excluding the non-insurance companies), as well as the dividends paid by MGIC to the Company, are as follows:
The Company has 1991 and 2002 stock incentive plans. When the 2002 plan was adopted in 2002, no further awards could be made under the 1991 plan. The maximum number of shares covered by awards under the 2002 plan is the total of 7.1 million shares plus the number of shares that must be purchased at a purchase price of not less than the fair market value of the shares as a condition to the award of restricted stock under the 2002 plan. The maximum number of shares of restricted stock that can be awarded under the 2002 plan is 5.9 million shares. Both plans provide for the award of stock options with maximum terms of 10 years and for the grant of restricted stock or restricted stock units, and the 2002 plan also provides for the grant of stock appreciation rights. The exercise price of options is the closing price of the common stock on the New York Stock Exchange on the date of grant. The vesting provisions of options and restricted stock are determined at the time of grant. Directors may receive awards under the 2002 plan and were eligible for awards of restricted stock under the 1991 plan.
A summary of option activity in the stock incentive plans during 2003, 2004 and 2005 is as follows:
The exercise price of the options granted in 2003 and 2004 was equal to the market value of the stock on the date of grant. The options are exercisable between one and ten years after the date of grant.
Information about restricted stock or restricted stock units granted during 2003, 2004 and 2005 is as follows:
For the year ended December 31, 2005, approximately 144 thousand shares of restricted stock became vested and approximately 1 thousand shares of restricted stock were forfeited. At December 31, 2005, 4,988,341 shares were available for future grant under the 2002 stock incentive plan. Of the shares available for future grant, 4,915,510 are available for restricted stock awards.
For purposes of determining the pro forma net income disclosure in Note 2, the fair value of these options was estimated at grant date using the binomial option pricing model for the 2004 options and the Black-Scholes model for the 2003 and prior options with the following weighted average assumptions for each year:
The following is a summary of stock options outstanding at December 31, 2005:
At December 31, 2004 and 2003, option shares of 1,465,301 and 1,754,929 were exercisable at an average exercise price of $49.47 and $45.88, respectively. The Company also granted an immaterial amount of equity instruments other than options and restricted stock during 2003, 2004 and 2005.
Consumers are bringing a growing number of lawsuits against home mortgage lenders and settlement service providers. In recent years, seven mortgage insurers, including MGIC, have been involved in litigation alleging violations of the anti-referral fee provisions of the Real Estate Settlement Procedures Act, which is commonly known as RESPA, and the notice provisions of the Fair Credit Reporting Act, which is commonly known as FCRA. MGIC’s settlement of class action litigation against it under RESPA became final in October 2003. MGIC settled the named plaintiffs’ claims in litigation against it under FCRA in late December 2004 following denial of class certification in June 2004. There can be no assurance that MGIC will not be subject to future litigation under RESPA or FCRA or that the outcome of any such litigation would not have a material adverse effect on the Company. In August 2005, the United States Court of Appeals for the Ninth Circuit decided a case under FCRA to which the Company was not a party that may make it more likely that the Company will be subject to future litigation regarding when notices to borrowers are required by FCRA.
In June 2005, in response to a letter from the New York Insurance Department (“NYID”), the Company provided information regarding captive mortgage reinsurance arrangements and other types of arrangements in which lenders receive compensation. In February 2006, in response to an administrative subpoena from the Minnesota Department of Commerce (the “MDC”), which regulates insurance, the Company provided the MDC with information about captive mortgage reinsurance and certain other matters. In the spring of 2005, spokesmen for insurance commissioners in Colorado and North Carolina were publicly reported as saying that those commissioners are considering investigating or reviewing captive mortgage reinsurance arrangements. Insurance departments or other officials in other states may also conduct such investigations or reviews. The anti-referral fee provisions of RESPA provide that the Department of Housing and Urban Development (“HUD”) as well as the insurance commissioner or attorney general of any state may
bring an action to enjoin violations of these provisions of RESPA. The insurance law provisions of many states prohibit paying for the referral of insurance business and provide various mechanisms to enforce this prohibition. While the Company believes its captive reinsurance arrangements are in conformity with applicable laws and regulations, it is not possible to predict the outcome of any such reviews or investigations nor is it possible to predict their effect on the Company or the mortgage insurance industry.
On January 10, 2006, MGIC acquired Myers Internet, Inc., a provider of web-based point of sale solutions for mortgage originators and real estate agents. The Company does not believe that the acquisition will have a material impact on future results of operations or financial position of the Company.
We have completed integrated audits of MGIC Investment Corporation and Subsidiaries’ December 31, 2005 and 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2005 and 2004, and an audit of its December 31, 2003 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions on MGIC Investment Corporation and Subsidiaries’ December 31, 2005, 2004, and 2003 consolidated financial statements and on its internal control over financial reporting as of December 31, 2005, based on our audits, are presented below.
control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.