(5)Expense ratio is calculated by dividing other underwriting and operating expenses by net premiums earned.
(6)Combined statutory capital equals the sum of statutory capital of Essent Guaranty, Inc. plus Essent Guaranty of PA, Inc., after eliminating the impact of intercompany transactions.
(7)The combined risk to capital ratio equals the sum of the net risk in force of Essent Guaranty, Inc. and Essent Guaranty of PA, Inc. divided by combined statutory capital.
The following discussion should be read in conjunction with the "Selected Financial Data" and our financial statements and related notes thereto included elsewhere in this report. In addition to historical information, this discussion contains forward-looking statements that involve risks, uncertainties and assumptions that could cause actual results to differ materially from management's expectations. Factors that could cause such differences are discussed in the sections entitled "Special Note Regarding Forward-Looking Statements" and "Risk Factors." We are not undertaking any obligation to update any forward-looking statements or other statements we 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 or other statements were made.
Except as otherwise indicated, "Market Share" means our market share as measured by our share of total new insurance written ("NIW") on a flow basis (in which loans are insured in individual, loan-by-loan transactions) in the private mortgage insurance industry, and excludes NIW under the Home Affordable Refinance Program ("HARP" and such NIW, the "HARP NIW") and bulk insurance (in which each loan in a portfolio of loans is insured in a single transaction).
We are an established and growing private mortgage insurance company. We were formed to serve the U.S. housing finance industry at a time when the demands of the financial crisis and a rapidly changing business environment created the need for a new, privately funded mortgage insurance company. Since writing our first policy in May 2010, we have grown to an estimated 13.7% Market Share for the year ended December 31, 2014, up from 12.1% and 8.6% for the years ended December 31, 2013 and 2012, respectively. We believe that our success has been driven by the unique opportunity we offer lenders to partner with a well-capitalized mortgage insurer, unencumbered by business originated prior to the financial crisis, that provides fair and transparent claims payment practices, and consistency and speed of service.
In 2010, Essent became the first private mortgage insurer to be approved by the GSEs since 1995, and we are licensed to write mortgage insurance coverage in all 50 states and the District of Columbia. We completed our initial public offering in November 2013. The financial strength of Essent Guaranty, Inc., our wholly-owned insurance subsidiary, is rated Baa2 with a stable outlook by Moody's Investors Service and BBB+ with a stable outlook by Standard & Poor's Rating Services.
We had master policy relationships with approximately 1,175 customers as of December 31, 2014. Our holding company is domiciled in Bermuda and our U.S. insurance business is headquartered in Radnor, Pennsylvania. We operate additional underwriting and service centers in Winston-Salem, North Carolina and Irvine, California. We have a highly experienced, talented team with 332 employees as of December 31, 2014. For the years ended December 31, 2014, 2013 and 2012, we generated new insurance written of approximately $24.8 billion (including approximately $1.8 billion in NIW written on a bulk basis), $21.2 billion and $11.2 billion, respectively, and as of December 31, 2014, we had approximately $50.8 billion of insurance in force.
We also offer mortgage-related insurance and reinsurance through our wholly-owned Bermuda-based subsidiary, Essent Reinsurance Ltd., which we refer to as "Essent Re." In 2014, Essent Re issued two policies in connection with Freddie Mac's Agency Credit Insurance Structure (ACIS) program covering in the aggregate up to approximately $43.7 million of risk on mortgage loans in reference pools associated with debt notes issued by Freddie Mac. Essent Re also reinsures 25% of Essent Guaranty, Inc.'s GSE-eligible mortgage insurance NIW originated since July 1, 2014 under a quota share reinsurance agreement.
Our results are significantly impacted by, and our future success may be affected by, legislative and regulatory developments affecting the housing finance industry. Key regulatory and legislative developments that may affect us include:
The Dodd-Frank Act provides for an originator or issuer risk -retention requirement on securitized mortgage loans that do not meet the definition of a QRM. On December 24, 2014, the Office of the Comptroller of the Currency, the Federal Reserve Board, the Federal Deposit Insurance Commission, the Federal Housing Finance Agency, the Securities and Exchange Commission and the Department of Housing and Urban Development adopted a joint final rule to implement the Qualified Residential Mortgage, or QRM, regulations as required by Dodd-Frank. The final rule aligns the definition of a QRM loan with that of a QM loan and will take effect on December 24, 2015. Given the alignment of the QRM definition to QM, unless the QRM or QM definitions are revised we see little or no adverse impact to our current business from the final QRM standards. See "Business-Regulation-Federal Laws and Regulation-Dodd-Frank Act-Qualified Residential Mortgage Regulations-Risk Retention Requirements" and "Risk Factors-Risks Relating to Our Business-The amount of insurance we write could be adversely affected by the implementation of the Dodd-Frank Act's risk retention requirements and the definition of Qualified Residential Mortgage ("QRM")."
The FHA is our primary competitor outside of the private mortgage insurance industry and the FHA's role in the mortgage insurance industry is also significantly dependent upon regulatory developments. The U.S. Congress is considering reforms of the housing finance market, which includes consideration of the future mission, size and structure of the FHA, which is part of HUD. The most recent FHA report to Congress dated November 17, 2014 on the financial status of the FHA Mutual
Mortgage Insurance Fund, or MMIF showed the capital reserve ratio of the MMIF at 0.41%, an improvement from prior years, but still below the Congressionally mandated required minimum level of 2%. As a result of the financial improvements in the condition of the fund and the stated desire to support the housing recovery, in January 2015 President Obama announced a 50 basis point reduction in FHA premiums.
• Cancellations of our insurance policies, which are impacted by payments on mortgages, home price appreciation, or refinancings, which in turn are affected by mortgage interest rates. Cancellations are also impacted by the levels of claim payments and rescissions;
• Premium rates, which represent the amount of the premium due as a percentage of IIF. Premium rates are based on the risk characteristics of the loans insured, the percentage of coverage on the loans, competition from other mortgage insurers and general industry conditions; and
• Premiums ceded or assumed under reinsurance arrangements. To date, we have not entered into any third-party reinsurance contracts.
Premiums are paid either on a monthly installment basis ("monthly premiums"), in a single payment at origination ("single premiums"), or in some cases as an annual premium. For monthly premiums, we receive a monthly premium payment which is recorded as net premiums earned in the month the coverage is provided. Net premiums written may be in excess of net premiums earned due to single premium policies. For single premiums, we receive a single premium payment at origination, which is recorded as "unearned premium" and earned over the estimated life of the policy, which ranges from 36 to 156 months depending on the term of the underlying mortgage and loan-to-value ratio at date of origination. If single premium policies are cancelled due to repayment of the underlying loan and the premium is non-refundable, the remaining unearned premium balance is immediately recognized as earned premium revenue. Substantially all of our single premium policies in force as of December 31, 2014 were non-refundable. Premiums collected on annual policies are recognized as net
premiums earned on a straight-line basis over the year of coverage. For the year ended December 31, 2014, monthly and single premium policies comprised 80% and 20% of our NIW, respectively.
Our investment portfolio was comprised entirely of investment grade fixed income securities and money market investments as of December 31, 2014. The principal factors that influence investment income are the size of the investment portfolio and the yield. As measured by amortized cost (which excludes changes in fair market value, such as from changes in interest rates), the size of our investment portfolio is mainly a function of increases in capital and cash generated from or used in operations which is impacted by net premiums received, investment earnings, net claim payments and expenses. Realized gains and losses are a function of the difference between the amount received on the sale of a security and the security's amortized cost, as well as any "other than temporary" impairments recognized in earnings. The amount received on the sale of fixed income securities is affected by the coupon rate of the security compared to the yield of comparable securities at the time of sale.
In connection with the acquisition of our mortgage insurance platform, we entered into a services agreement with Triad Guaranty Inc. and its wholly-owned subsidiary, Triad Guaranty Insurance Corporation, which we refer to collectively as "Triad", to provide certain information technology maintenance and development and customer support-related services. In return for these services, we receive a fee which is recorded in other income. From the period from December 1, 2009 to November 30, 2010, this fee was based on a fixed amount. Effective December 1, 2010, the fee is adjusted monthly based on the number of Triad's mortgage insurance policies in force and, accordingly, will decrease over time as Triad's existing policies are cancelled. The services agreement provides for a minimum monthly fee of $150,000 for the duration of the services agreement. The services agreement was automatically extended until November 30, 2015 and provides for four subsequent one-year renewals at Triad's option. See Note 6 to our consolidated financial statements.
Other income also includes revenues associated with contract underwriting services and changes in the fair value of derivative instruments. The level of contract underwriting revenue is dependent upon the number of customers who have engaged us for this service and the number of loans underwritten for these customers. The insurance and reinsurance policies issued by Essent Re in connection with the ACIS program are accounted for as derivatives under GAAP with the fair value of these policies reported as an asset or liability and changes in the fair value of these policies reported in earnings. Changes in the fair value of these policies are impacted by changes in market observable factors. See Note 16 to our consolidated financial statements.
• the size of loans insured, with higher average loan amounts tending to increase losses incurred;
• the rate at which we may rescind policies. Because of tighter underwriting standards generally in the mortgage lending industry and terms set forth in our Clarity of Coverage master policy endorsement, we expect that our level of rescission activity will be lower than rescission activity seen in the mortgage insurance industry for vintages originated prior to the financial crisis; and
We believe, based upon our experience and industry data, that claims incidence for mortgage insurance is generally highest in the third through sixth years after loan origination. As of December 31, 2014, 47% of our IIF relates to business written in 2014 and substantially all of our policies in force are less than three years old. Although the claims experience on new insurance written by us to date has been favorable, we expect incurred losses and claims to increase as a greater amount of this book of insurance reaches its anticipated period of highest claim frequency. The actual default rate and the average reserve per default that we experience as our portfolio matures is difficult to predict and is dependent on the specific characteristics of our current in-force book (including the credit score of the borrower, the loan-to-value ratio of the mortgage, geographic concentrations, etc.), as well as the profile of new business we write in the future. In addition, the default rate and the average reserve per default will be affected by future macroeconomic factors such as housing prices, interest rates and employment.
Underwriting and other expenses include legal, consulting, other professional fees, premium taxes, travel, entertainment, marketing, licensing, supplies, hardware, software, rent, utilities, depreciation and amortization and other expenses. Depreciation and amortization expense represented 3%, 3% and 25% of other underwriting and operating expenses for the years ended December 31, 2014, 2013 and 2012, respectively. A significant portion of the depreciation expense recorded during 2012 related to the assets acquired from Triad for $30 million in cash and the assumption of certain contractual obligations under that certain asset purchase agreement, dated October 7, 2009, among Essent Guaranty, Inc. and Triad (the "Asset Purchase Agreement"). The purchase price of the assets acquired from Triad was allocated primarily to acquired technology (94%) and workforce-in-place (4%) and was amortized to expense on a straight-line basis over 36 months and 48 months, respectively, from the date of acquisition. The acquired technology component of the purchase price was fully depreciated as of November 30, 2012 and the workforce-in-place component of the purchase price was fully amortized as of November 30, 2013 and, accordingly, depreciation and amortization expense in 2014 and 2013 was lower than prior periods.
We anticipate that as we continue to add customers and increase our IIF, our expenses will also continue to increase. In addition, as a result of the increase in our IIF, we expect that our net premiums earned will grow faster than our underwriting and other expenses resulting in a decline in our expense ratio.
Income taxes are incurred based on the amount of earnings or losses generated in the jurisdictions in which we operate and the applicable tax rates and regulations in those jurisdictions. To date, substantially all of our business activity has been conducted in the United States where we are subject
As discussed above, premiums we collect and earn are generated based on our IIF, which is a function of our NIW and cancellations. From 2010, when we first began writing policies, through December 31, 2014, we have increased our NIW annually. We have also grown the number of customers who have approved us to provide mortgage insurance over this period, as well as increased our share of NIW from certain customers over time. The following table includes a summary of the change in our IIF for the years ended December 31, 2014, 2013 and 2012. In addition, this table
Our average premium rate is dependent on a number of factors, including: (1) the risk characteristics and average coverage on the mortgages we insure; (2) the mix of monthly premiums compared to single premiums in our portfolio; (3) cancellations of non-refundable single premiums during the period; and (4) changes to our pricing.
The risk to capital ratio is frequently used as a measure of capital adequacy in the U.S. mortgage insurance industry and is calculated as a ratio of net risk in force to statutory capital. Net risk in force represents total risk in force net of reinsurance ceded and net of exposures on policies for which loss reserves have been established. Statutory capital for our U.S. insurance companies is computed based on accounting practices prescribed or permitted by the Pennsylvania Insurance Department. See additional discussion in "-Liquidity and Capital Resources-Insurance Company Capital."
In the year ended December 31, 2014, unearned premiums increased by $53.5 million as a result of net premiums written on single premium policies of $84.1 million which was partially offset by $30.6 million of unearned premium that was recognized in earnings during the year. In the year ended December 31, 2013, unearned premiums increased by $62.8 million as a result of net premiums written on single premium policies of $78.5 million which was partially offset by $15.7 million of unearned premium that was recognized in earnings during the year. Included in unearned premium recognized was $8.2 million and $4.1 million related to policy cancellations for the year ended December 31, 2014 and 2013, respectively.
Other income includes fees earned for information technology and customer support services provided to Triad, contract underwriting revenues and changes in the fair value of the insurance and reinsurance policies issued by Essent Re under the ACIS program. The decrease in other income for the year ended December 31, 2014 compared to the same period in 2013 is primarily due to a reduction in the number of Triad's mortgage insurance policies in force, partially offset by an increase in contract underwriting revenue. The fees earned from Triad will continue to decrease over time as Triad's existing policies are cancelled.
The increase in the provision for losses and LAE in 2014 as compared to 2013 was primarily due to an increase in the number of insured loans in default partially offset by previously identified defaults that cured.
During the year ended December 31, 2014, the provision for losses and LAE was $6.3 million, comprised of $6.9 million of current year losses partially offset by $0.6 million of favorable prior years' loss development. During the year ended December 31, 2013, the provision for losses and LAE was $2.3 million, comprised of $3.0 million of current year losses partially offset by $0.7 million of favorable prior years' loss development. In both periods, the favorable prior years' loss development is the result of a re-estimation of amounts ultimately to be paid on prior year defaults in the default inventory.
During the year ended December 31, 2014, we paid 28 claims for a total amount of $0.9 million. During the year ended December 31, 2013, we paid 16 claims for a total amount of $0.7 million. Claim severity, representing the total amount of claims paid divided by the related RIF of the defaulted mortgage loans, for the years ended December 31, 2014 and 2013 was 79% and 90%, respectively.
Other underwriting and operating expenses increased to $97.2 million in the year ended December 31, 2014 as compared to $71.1 million in the year ended December 31, 2013. The significant factors contributing to the change in other underwriting and operating expenses are:
At December 31, 2014 and 2013, we concluded that it is more likely than not that our deferred tax assets would be realized. Beginning in 2015, we expect an increasing portion of our consolidated earnings will be generated in Bermuda and accordingly expect that our effective tax rate will decline below the U.S. federal statutory tax rate.
Net premiums earned increased in the year ended December 31, 2013 by 195% compared to the year ended December 31, 2012 primarily due to the increase in our average IIF from $7.6 billion in 2012 to $22.8 billion in 2013. Net premiums written increased in the year ended December 31, 2013 by 156% over the prior year.
The following tables include additional information about our loans in default as of the dates indicated:
The decrease in the average reserve per default is primarily due to changes in the composition (such as mark-to-market loan-to-value ratios, risk in force, and number of months past due) of the underlying loans in default. In addition, historical cure ratios showed continued improvement in 2013.
loss development. During the year ended December 31, 2012, the provision for losses and LAE was $1.5 million, comprised of $1.6 million current year losses partially offset by $0.1 million of favorable prior years' loss development. In both periods, the favorable prior years' loss development is the result of a re-estimation of amounts ultimately to be paid on prior year defaults in the default inventory.
We account for stock based compensation issued to employees using a fair value based method under which we measure the cost of employee services received in exchange for awards of equity instruments based on the grant date fair value of the award. Certain members of senior management were granted nonvested Common Shares in September 2013. The fair value for those grants of
$14.50 per Common Share was based on analysis at the time of the grant, provided by the underwriters associated with the offering, regarding the estimated fair value of Essent and the estimated IPO price range of $13.50 to $15.50 per Common Share. Factors considered in determining the IPO price range and Common Share valuation included prevailing market conditions, estimates of the Company's business potential and earnings prospects, the Company's historical operating results, market valuations of companies deemed comparable to the Company and an assessment of risks and opportunities. Employees that were not granted nonvested Common Shares in September 2013 were granted nonvested Common Share units on October 31, 2013. The fair value for those share unit grants was the initial public offering price of $17.00 per Common Share. The increase in the estimated fair value of Common Shares from September 2013 to October 31, 2013 was due to external factors including an increase in the valuations of publicly traded mortgage insurers during that period and Company-specific factors including the conclusion of the Company's IPO marketing efforts which resulted in an oversubscription at the IPO pricing range and setting the final IPO price at $17.00.
Subsequent to our initial public offering, quoted market prices were used for the valuation of Common Shares granted to employees.
• the substantial growth in our IIF which has driven the increase in net premiums earned experienced in 2012 and through June 30, 2013;
• our expectation that we would be in a three-year cumulative income position in 2013;
As of December 31, 2014, we had substantial liquidity with cash and short term investments of $235.1 million, which includes $125.1 million at the holding company. Our cash and short term investment position increased during the year ended December 31, 2014 primarily as a result of net proceeds of $126.7 million from our secondary offering of Common Shares which was completed in November 2014 plus cash flows from operations, net of amounts invested in our fixed income portfolio. As of December 31, 2014, we have $1.1 billion in cash and investments and no debt.
Our U.S. insurance subsidiaries are subject to certain capital and dividend rules and regulations prescribed by jurisdictions in which it is authorized to operate and the GSEs. Under the insurance laws of the Commonwealth of Pennsylvania, the insurance subsidiaries may pay dividends during any twelve-month period in an amount equal to the greater of (i) 10% of the preceding year-end statutory policyholders' surplus or (ii) the preceding year's statutory net income. The Pennsylvania statute also requires that dividends and other distributions be paid out of positive unassigned surplus without prior approval. At December 31, 2014, Essent Guaranty, Inc. had negative unassigned surplus and therefore would require prior approval by the Pennsylvania Insurance Commissioner to make any dividend payment or other distributions in 2015. At December 31, 2014, Essent PA, Inc. had unassigned surplus of $3.7 million. In 2014, Essent Guaranty of PA, Inc. paid a $200,000 dividend to Essent US Holdings, Inc. Essent Guaranty, Inc. has paid no dividends since its inception. Essent Re is subject to certain dividend restrictions as prescribed by the Bermuda Monetary Authority and under certain agreements with counterparties. In connection with a quota share reinsurance agreement with Essent Guaranty, Essent Re has agreed to maintain a minimum total equity of $100 million. As of December 31, 2014, Essent Re had total equity of $155.1 million. At December 31, 2014, our insurance subsidiaries were in compliance with these rules, regulations and agreements.
Cash flow used in investing activities totaled $727.7 million for the year ended December 31, 2014 as compared to cash used in investing activities of $96.8 million for the year ended December 31, 2013. The increase in cash flow used in investing activities was primarily related to investing proceeds from our IPO, secondary offering, capital contributions from our initial investors and cash flows from the business.
Cash flow provided by financing activities totaled $433.1 million for the year ended December 31, 2013 as compared to cash provided by financing activities of $46.9 million for the year ended December 31, 2012. In November 2013, the Company completed an initial public offering of Common Shares for $313.7 million in net proceeds, net of offering costs. In June and March 2013, the Company issued Class A common shares to its initial investors for net proceeds of $123.9 million. These cash inflows were partially offset by payments made to Triad under the Asset Purchase Agreement. Cash provided by financing activities in the year ended December 31, 2012 were principally due to Class A common shares issued to initial investors partially offset by the payment of the 2011 annual fee to initial investors and payments to Triad under the Asset Purchase Agreement. The annual fee was waived by our initial investors for the year ended December 31, 2012 and thereafter.
We compute a risk to capital ratio for our U.S. insurance companies on a separate company statutory basis, as well as for our combined insurance operations. The risk to capital ratio is our net risk in force divided by our statutory capital. Our net risk in force represents risk in force net of reinsurance ceded, if any, and net of exposures on policies for which loss reserves have been established. Statutory capital consists primarily of statutory policyholders' surplus (which increases as a result of statutory net income and decreases as a result of statutory net loss and dividends paid), plus the statutory contingency reserve. The statutory contingency reserve is reported as a liability on the statutory balance sheet. A mortgage insurance company is required to make annual contributions to the contingency reserve of 50% of net premiums earned. These contributions must generally be maintained for a period of ten years. However, with regulatory approval a mortgage insurance company may make early withdrawals from the contingency reserve when incurred losses exceed 35% of net premiums earned in a calendar year.
Our combined risk to capital calculation for our U.S. insurance subsidiaries as of December 31, 2014 is as follows:
For additional information regarding regulatory capital see Note 17 to our consolidated financial statements. Our combined statutory capital equals the sum of statutory capital of Essent Guaranty, Inc. plus Essent Guaranty of PA, Inc., after eliminating the impact of intercompany transactions. The combined risk to capital ratio equals the sum of the net risk in force of Essent Guaranty, Inc. and Essent Guaranty of PA, Inc. divided by combined statutory capital. The information above has been derived from the annual and quarterly statements of our insurance subsidiaries, which have been prepared in conformity with accounting practices prescribed or permitted by the Pennsylvania Insurance Department. Such practices vary from accounting principles generally accepted in the United States.
The financial strength of Essent Guaranty, our principal mortgage insurance subsidiary, is rated Baa2 by Moody's Investors Service ("Moody's") with a stable outlook. Standard & Poor's Rating Services' ("S&P") insurer financial strength rating of Essent Guaranty is BBB+ with a stable outlook. Essent Re is not currently rated by a nationally recognized statistical rating organization.
On July 10, 2014, the Federal Housing Finance Agency ("FHFA") released for public input draft Private Mortgage Insurer Eligibility Requirements ("PMIERs"). If implemented, the PMIERs represent revised standards by which private mortgage insurers would be eligible to provide mortgage insurance on loans owned or guaranteed by Fannie Mae and Freddie Mac. The PMIERs include new financial strength requirements incorporating a risk-based framework that would require approved insurers to have a sufficient level of liquid assets from which to pay claims. These new requirements also would impact the amount of capital a mortgage insurer must hold. The draft requirements also include enhanced operational performance expectations and define remedial actions that would apply should an approved insurer fail to comply with the new requirements. The public input period with respect to the PMIERs closed on September 8, 2014. The FHFA has advised us that it does not expect to release the final PMIERs until at least late in the first quarter of 2015.
As of December 31, 2014, stockholders' equity was $955.7 million compared to $722.1 million as of December 31, 2013. This increase was primarily due to net proceeds of $126.7 million from our secondary offering completed in November 2014 as well as net income generated in 2014.
as of December 31, 2013 along with investing proceeds from our secondary offering and cash flows from operations.
(1)At December 31, 2014, approximately 59.7% of municipal debt securities were special revenue bonds, 37.5% were general obligation bonds, 1.5% were tax allocation bonds, 0.8% were certification of participation bonds and 0.5% were special assessment bonds. At December 31, 2013, all municipal debt securities were general obligation bonds. For information regarding the amortized cost and fair value of the municipal debt securities, see Note 4 to our consolidated financial statements.
(1)As of December 31, 2014, for securities in unrealized loss positions, management believes decline in fair values is principally associated with the changes in the interest rate environment subsequent to their purchase and there are no other than temporary impairments. Also, see Note 4 to our consolidated financial statements, which summarizes the aggregate amount of gross unrealized losses by asset class in which the fair value of investments has been less than cost for more than 12 months and less than 12 months.
As of December 31, 2014, the approximate future payments under our contractual obligations of the type described in the table below are as follows:
(1)Our estimate of loss and LAE payments reflects the application of accounting policies described below in "-Critical Accounting Policies-Reserve for Losses and Loss Adjustment Expenses." The payments due by period are based on management's estimates and assume that all of the loss and LAE reserves included in the table will result in payments.
We establish reserves for losses based on our best estimate of ultimate claim costs for defaulted loans using the general principles contained in ASC No. 944, in accordance with industry practice. However, consistent with industry standards for mortgage insurers, we do not establish loss reserves for future claims on insured loans which are not currently in default. Loans are classified as defaulted when the borrower has missed two consecutive payments. Once we are notified that a borrower has defaulted, we will consider internal and third-party information and models, including the status of the loan as reported by its servicer and the type of loan product to determine the likelihood that a default will reach claim status. In addition, we will project the amount that we will pay if a default becomes a claim (referred to as "claim severity"). Based on this information, at each reporting date we determine our best estimate of loss reserves at a given point in time. Included in loss reserves are reserves for incurred but not reported ("IBNR") claims. IBNR reserves represent our estimated unpaid losses on loans that are in default, but have not yet been reported to us as delinquent by our customers. We will also establish reserves for associated loss adjustment expenses, consisting of the estimated cost of the claims administration process, including legal and other fees and expenses associated with administering the claims process. Establishing reserves is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. Our estimates of claim rates and claim sizes will be strongly influenced by prevailing economic conditions, such as the overall state of the economy, current rates or trends in unemployment, changes in housing values and/or interest rates, and our best judgments as to the future values or trends of these macroeconomic factors. Losses incurred are also generally affected by the characteristics of our insured loans, such as the loan amount, loan-to-value ratio, the percentage of coverage on the insured loan and the credit quality of the borrower.
• credit ratings from third-party rating agencies and changes in these credit ratings below investment grade;
• adverse conditions specifically related to the security, an industry, or a geographic area.
Essent PA received its certificate of authority from the Pennsylvania Insurance Department on March 15, 2010. Essent PA assumes that portion of the risk retained by Essent Guaranty that is in excess 25% of the balance of any mortgage loan insured by Essent Guaranty after consideration of other reinsurance agreements at Essent Guaranty, in accordance with certain state law requirements.
In September 2011, we formed CUW Solutions, LLC ("CUW Solutions"), a wholly-owned subsidiary of Essent Holdings. CUW Solutions is a Delaware limited liability company that provides, among other things, mortgage contract underwriting services to lenders and mortgage insurance underwriting services to affiliates. Its headquarters are in Radnor, Pennsylvania and it maintains operations centers in Winston-Salem, North Carolina and Irvine, California that are subleased from Essent Guaranty.
The Company operates as a single segment for reporting purposes as substantially all business operations, assets and liabilities relate to the private mortgage insurance business and management
reviews operating results for the Company as a whole to make operating decisions and assess performance.
Investments available for sale include securities that we sell from time to time to provide liquidity and in response to changes in the market. Debt and equity securities classified as available for sale are reported at fair value with unrealized gains and losses on these securities reported in other comprehensive income, net of deferred income taxes. See Note 16 for a description of the valuation methods for investments available for sale.
The cost of the acquired technology and related accumulated depreciation is included in property and equipment in the accompanying consolidated balance sheets.
Mortgage guaranty insurance policies are contracts that are generally non-cancelable by the insurer, are renewable at a fixed price, and provide for payment of premium on a monthly, annual or single basis. Upon renewal, we are not able to re-underwrite or re-price our policies. Consistent with industry accounting practices, premiums written on a monthly basis are earned as coverage is provided. Monthly policies accounted for 86% of earned premium in 2014. Premiums written on an annual basis are amortized on a pro rata basis over the year of coverage. Primary mortgage insurance written on policies covering more than one year are referred to as single premium policies. A portion of the revenue from single premium policies is recognized in earned premium in the current period, and the remaining portion is deferred as unearned premium 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 as earned premium upon notification of the cancellation. The Company recorded $8.2 million and $4.1 million of earned premium related to policy cancellations for the years ended December 31, 2014 and 2013, respectively. Unearned premium represents the portion of premium written that is applicable to the estimated unexpired risk of insured loans. Rates used to determine the earning of single premium policies are estimates based on an analysis of the expiration of risk.
We establish reserves for losses based on our best estimate of ultimate claim costs for defaulted loans using the general principles contained in ASC No. 944, in accordance with industry practice. However, consistent with industry standards for mortgage insurers, we do not establish loss reserves for future claims on insured loans which are not currently in default. Loans are classified as in default when the borrower has missed two consecutive payments. Once we are notified that a borrower has defaulted, we will consider internal and third-party information and models, including the status of the loan as reported by its servicer and the type of loan product to determine the likelihood that a default will reach claim status. In addition, we will project the amount that we will pay if a default becomes a
We are required to establish a premium deficiency reserve if the net present value of the expected future losses and expenses for a particular group of policies exceeds the net present value of expected future premium, anticipated investment income and existing reserves for that specified group of policies. We reassess our expectations for premium, losses and expenses of our mortgage insurance business periodically and update our premium deficiency analysis accordingly. As of December 31, 2014 and 2013, we concluded that no premium deficiency reserve was required to be recorded in the accompanying consolidated financial statements.
Deferred income tax assets and liabilities are determined using the asset and liability (or balance sheet) method. Under this method, we determine the net deferred tax asset or liability based on the tax effects of the temporary differences between the book and tax bases of the various assets and liabilities
In May 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") ASU 2014-09, Revenue from Contracts with Customers (Topic 606). This update is intended to provide a consistent approach in recognizing revenue. In accordance with the new standard, recognition of revenue occurs when a customer obtains control of promised goods or services in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. In addition, the new standard requires that reporting companies disclose the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. The provisions of this update are effective for interim and annual periods beginning after December 15, 2016. The Company is currently evaluating the impact the adoption of this ASU will have on the consolidated financial statements.
In November 2013, Essent Group completed an initial public offering ("IPO") in which we issued and sold approximately 20.0 million Common Shares at a public offering price of $17.00 per share and certain selling shareholders sold approximately 2.7 million Common Shares. We did not receive any proceeds from the sale of shares by the selling shareholders. The total net proceeds from the IPO were $313.7 million after deducting underwriting discounts commissions and other offering expenses.
Macquarie Capital (USA) Inc. ("Macquarie") was due a fee equal to 1% of the gross proceeds from the sale of Class A common shares (not to exceed $5.2 million) issued to certain shareholders who were party to the Class A Common Share Subscription Agreement for services rendered in connection with the equity funding for Essent Group. As of December 31, 2013, a total of $4 million was earned by Macquarie and charged to additional paid-in capital. As a result of the termination of the Amended Subscription Agreement, no additional fees are due Macquarie related to the sale of Class A shares.
The amortized cost and fair value of available for sale securities at December 31, 2014, 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 and asset-backed securities provide for periodic payments throughout their lives, they are listed below in separate categories.
$2.5 million each on the first and second anniversaries of the Closing Date. Contingent payments totaling $15 million are due commencing 30 months after the closing date, or June 1, 2012, in six equal semi-annual installments if Essent Guaranty or any affiliate US domestic insurance company have written mortgage insurance policies (other than mortgage reinsurance or other types of credit enhancement) on mortgage loans having an aggregate unpaid principal balance of not less than $500 million in the six months preceding such contingent payment. On December 1, 2009, $15.5 million was recorded as purchase price for these acquired assets, which included the net present value of the fixed payments. The depreciation for the fixed assets was recorded over three years from December 1, 2009 to November 30, 2012. In March 2011, based on Essent Guaranty's level of written mortgage insurance policies, management concluded that it was probable that the $15 million of contingent payments would be made. Accordingly, a liability was accrued effective March 31, 2011 for the net present value of the additional contingent payments due Triad, with an offsetting increase in the purchase price of the acquired assets allocated pro rata based on their relative fair value at the acquisition date. The depreciation of the fixed assets associated with the purchase for the contingent payments was recorded over the period from April 1, 2011 to November 30, 2012. Contingent payments totaling $5 million were made in each of the years ended December 31, 2014, 2013 and 2012. No further amounts are due to Triad under the Asset Purchase Agreement.
The components of the purchase price for the assets acquired reflected in the accompanying consolidated balance sheets are as follows:
We recorded interest expense associated with the liability due Triad of $0.1 million in each of the years ended December 31, 2014, 2013 and 2012.
Under the terms of the Services Agreement, we provide the following services to Triad in exchange for fees: (i) maintain and support the licensed technology and equipment and provide to Triad certain information and technology services; (ii) access to the Triad technology platform in order to support Triad's business pursuant to the license grant outlined in the Services Agreement; (iii) customer support-related services; and (iv) technology development services. The fee earned by Essent Group during the first contract year from December 1, 2009 to November 30, 2010 was a fixed amount. Effective December 1, 2010, the fee is based principally on the number of Triad's insurance policies in force on a monthly basis. Accordingly, this fee is reduced as Triad's policies in force decline. We earned fees under the Services Agreement of $2.3 million, $3.0 million and $3.8 million for the years ended December 31, 2014, 2013 and 2012, respectively, which are included in other income in the accompanying consolidated statements of comprehensive income (loss).
In addition to the indemnifications discussed above, in the normal course of business, we enter into agreements or other relationships with third parties pursuant to which we may be obligated under specified circumstances to indemnify the counterparties with respect to certain matters. Our contractual indemnification obligations typically arise in the context of agreements entered into by us to, among other things, purchase or sell services, finance our business and business transactions, lease real property and license intellectual property. The agreements we enter into in the normal course of business generally require us to pay certain amounts to the other party associated with claims or losses if they result from our breach of the agreement, including the inaccuracy of representations or warranties. The agreements we enter into may also contain other indemnification provisions that obligate us to pay amounts upon the occurrence of certain events, such as the negligence or willful misconduct of our employees, infringement of third-party intellectual property rights or claims that performance of the agreement constitutes a violation of law. Generally, payment by us under an indemnification provision is conditioned upon the other party making a claim, and typically we can challenge the other party's claims. Further, our indemnification obligations may be limited in time and/or amount, and in some instances, we may have recourse against third parties for certain payments made by us under an indemnification agreement or obligation. As of December 31, 2014, contingencies triggering material indemnification obligations or payments have not occurred historically and are not expected to occur. The nature of the indemnification provisions in the various types of agreements and relationships described above are believed to be low risk and pervasive, and we consider them to have a remote risk of loss or payment. We have not recorded any provisions on the consolidated balance sheets related to indemnifications.
the years ended December 31, 2014, 2013 and 2012, respectively. The future minimum lease payments of non-cancelable operating leases are as follows at December 31, 2014:
The Class A common shares ranked senior to the Class B-1 common shares and the Class B-2 common shares in all respects as to rights of payment and distribution. The Class B-1 common shares and the Class B-2 common shares ranked junior to the Class A common shares and pari passu with one another in all respects as to rights of payment and distribution. The holders of Class A common shares were entitled to receive cumulative compounding dividends prior and in preference to any declaration or payment of any dividend on any other class of shares in the capital of Essent Group, at the rate of 10% of the Original Class A Issue Price per annum, compounded annually, on each outstanding Class A common share. Any dividend or other distribution declared or paid on any Class B common shares shall have been ratably declared and paid on all of the outstanding Class A common shares (based on "as-if-converted" to Class B-1 common share amounts) at the same time as such dividend is paid on such Class B common shares.
On February 6, 2009, Essent Group adopted the 2009 Restricted Share Plan. In connection with the IPO in 2013, Essent Group's Board of Directors amended and restated the 2009 Restricted Share Plan, effective immediately prior to the initial public offering. In addition, Essent Group's Board of Directors adopted, and Essent Group's shareholders approved, the Essent Group Ltd. 2013 Long-Term Incentive Plan (the "2013 Plan"), which was effective upon completion of the initial public offering. The types of awards available under the 2013 Plan include nonvested shares, nonvested share units, non-qualified share options, incentive stock options, share appreciation rights, and other share-based or cash-based awards. The 2013 Plan authorized a total of 14.7 million Common Shares, which will be increased on the first day of each of the Company's fiscal years beginning with fiscal year 2014, in an amount equal to the lesser of (i) 1.5 million Common Shares, (ii) 2% of the Company's outstanding Common Shares on the last day of the immediately preceding fiscal year, or (iii) such number of Common Shares as determined by the Company's Board of Directors. The maximum number of common shares that may be issued in respect of incentive share options is 14.7 million. As of December 31, 2014, there were 13.5 million Common Shares available for future grant under the 2013 Plan.
Common Shares that will be earned based upon the achievement of compounded annual book value per share growth is as follows:
The following table summarizes nonvested Class B-2 common share activity for the years ended December 31:
The following table summarizes nonvested Class A common share activity for the years ended December 31:
In addition to the nonvested share activity above, 17,158 Common Shares were issued in 2014 under the 2013 Plan that vested upon issuance with a weighted average fair market value at date of grant of $24.71 per share. In 2013, 57,349 Class A common shares were issued that vested upon
The total fair value of nonvested shares that vested was $32.7 million, $4.0 million and $3.1 million for the years ended December 31, 2014, 2013 and 2012, respectively. As of December 31, 2014, there was $28.1 million of total unrecognized compensation expense related to nonvested shares outstanding at December 31, 2014 and we expect to recognize the expense over a weighted average period of 2.7 years.
In 2013, Essent Group exercised its right to purchase 1,135 vested Class A common shares at fair value of $10.92 per share and 4,990 vested Class B-2 common shares at fair value of $1.80 per share from former employees. In 2012, Essent Group exercised its right to purchase 710 vested Class A common shares from a former employee at fair value of $10.11 per share. The repurchased shares were recorded at cost and included in treasury stock. All treasury stock has been cancelled as of December 31, 2014 and 2013.
Our U.S. insurance subsidiaries are subject to certain capital and dividend rules and regulations as prescribed by jurisdictions in which they are authorized to operate. Under the insurance laws of the Commonwealth of Pennsylvania, Essent Guaranty and Essent PA may pay dividends during any 12-month period in an amount equal to the greater of (i) 10% of the preceding year-end statutory policyholders' surplus or (ii) the preceding year's statutory net income. The Pennsylvania statute also specifies that dividends and other distributions can be paid out of positive unassigned surplus without prior approval. Essent Guaranty currently has negative unassigned surplus and, therefore, would require prior approval by the Pennsylvania Insurance Commissioner to make any dividend payment or other distributions in 2015. Essent PA would be able to pay a dividend of $3.7 million in 2015. Essent Guaranty paid no dividends to Essent Group or any intermediate holding companies in the years ended December 31, 2014, 2013 or 2012. In March 2014, Essent PA paid a $200,000 dividend to its parent company, Essent Holdings and in December 2013, Essent PA paid a $5,000 dividend to Essent Holdings.
Essent Re is subject to certain dividend restrictions as prescribed by the Bermuda Monetary Authority and under certain agreements with counterparties. In connection with the quota share reinsurance agreement with Essent Guaranty, Essent Re had agreed to maintain a minimum total equity of $100 million. As of December 31, 2014, Essent Re had total equity of $155.1 million.
At December 31, 2014, our insurance subsidiaries were in compliance with these rules, regulations and agreements.
The components of the net deferred tax (liability) asset were as follows at December 31:
our statutory contingency reserves. During the years ended December 31, 2014 and 2013, we had net purchases of T&L Bonds in the amount of $51.7 million and $8.0 million, respectively, and held $59.7 million of T&L Bonds as of December 31, 2014.
In evaluating our ability to realize the benefit of our deferred tax assets, we consider the relevant impact of all available positive and negative evidence including our past operating results and our forecasts of future taxable income. As of December 31, 2012, Essent had generated a cumulative net operating loss from inception through each annual reporting period. ASC No. 740 states that forming a conclusion that a valuation allowance is not needed is difficult when there is negative evidence such as cumulative losses in recent years. Accordingly, we concluded that a valuation allowance was required in each reporting period from inception through December 31, 2012. As of December 31, 2012, the valuation allowance was $28.9 million. In the second quarter of 2013, based on actual results through June 30, 2013 as well as forecasted full year 2013 results, management anticipated that Essent would be in a cumulative GAAP net income position for the most recent three year period and expected that Essent would utilize our net operating loss carryforwards and would be in a cumulative net taxable income position since inception. At June 30, 2013, December 31, 2013 and December 31, 2014, after weighing all the evidence, management concluded that it was more likely than not that our deferred tax assets would be realized. In 2013, we released the valuation allowance on our deferred tax assets, and recognized a net deferred tax benefit of $8.3 million in the year ended December 31, 2013.
Essent Holdings and its subsidiaries are subject to income taxes imposed by U.S. authorities and file a U.S. Consolidated Income Tax Return. Each subsidiary has executed a tax sharing agreement with its parent company, which provides that taxes are settled in cash between parent and subsidiary on a quarterly basis based on separate company pro-forma calculations. Should Essent Holdings pay a dividend to Essent Irish Intermediate, withholding taxes at a rate of 5% under the U.S./Ireland tax treaty would likely apply assuming the Company avails itself of Treaty benefits under the U.S./Ireland tax treaty. Absent treaty benefits, the withholding rate on outbound dividends would be 30%. Currently, however, no withholding taxes are accrued with respect to such un-remitted earnings as management has no intention of remitting these earnings. Similarly, no taxes have been provided on the un-remitted earnings of the Company's U.S. subsidiaries as management has no intention of remitting these earnings, and any Ireland tax would be expected to be fully offset by credit for taxes paid in the U.S. An estimate of the cumulative amount of U.S. earnings that would be subject to withholding tax, if distributed outside of the U.S., is approximately $105 million. The associated withholding tax liability under the U.S./Ireland tax treaty would be approximately $5 million.
At December 31, 2014 and 2013, we had no unrecognized tax benefits. As of December 31, 2014, our U.S. federal income tax returns for the tax years 2009 through 2013 remain subject to examination. The Company has not recorded any uncertain tax positions as of December 31, 2014 or December 31, 2013.
The following table reconciles the net income (loss) and the weighted average common shares outstanding used in the computations of basic and diluted loss per common share for the years ended December 31:
The nonvested performance-based share awards are considered contingently issuable for purposes of the EPS calculation. Based on the compounded annual book value per share growth as of December 31, 2014, 100% of the performance-based share awards would be issuable under the terms of the arrangements if December 31, 2014 was the end of the contingency period.
As indicated in Note 9, Class A common shares were entitled to receive cumulative compounding dividends prior and in preference to any declaration or payment of any dividend on the Class B-2 common shares. In periods of income, the undistributed net income was allocated to the Class A common shares to satisfy this requirement. In periods of loss, the undistributed net loss has been allocated pro rata to the Class A and Class B-2 shares in proportion to their percentage of vested equity capital.
• Level 1-Quoted prices for identical instruments in active markets accessible at the measurement date.
• Level 2-Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and valuations in which all significant inputs are observable in active markets. Inputs are observable for substantially the full term of the financial instrument.
We use independent pricing sources to determine the fair value of securities available for sale in Level 1 and Level 2 of the fair value hierarchy. We use one primary pricing service to provide individual security pricing based on observable market data and receive one quote per security. To ensure securities are appropriately classified in the fair value hierarchy, we review the pricing techniques and methodologies of the independent pricing service and believe that their policies adequately consider market activity, either based on specific transactions for the issue valued or based on modeling of securities with similar credit quality, duration, yield and structure that were recently traded. We review the reasonableness of prices received from our primary pricing service by comparison to prices obtained from additional pricing sources. We have not made any adjustments to the prices obtained from our primary pricing service.
Our U.S. insurance subsidiaries prepare statutory-basis financial statements in accordance with the accounting practices prescribed or permitted by their respective state's department of insurance, which is a comprehensive basis of accounting other than GAAP. We did not use any prescribed or permitted statutory accounting practices (individually or in the aggregate) that resulted in reported statutory surplus or capital that was significantly different from the statutory surplus or capital that would have been reported had National Association of Insurance Commissioners' statutory accounting practices been followed. The following table presents Essent Guaranty's and Essent PA's statutory net income or loss, statutory surplus and contingency reserve liability as of and for the years ended December 31:
At December 31, 2014 and 2013, the statutory capital of our U.S. insurance subsidiaries, which is defined as the total of statutory surplus and contingency reserves, was well in excess of the statutory capital necessary to satisfy their regulatory requirements.
risk-based framework that would require approved insurers to have a sufficient level of liquid assets from which to pay claims. These new requirements would impact the amount of capital a mortgage insurer must hold. The draft requirements also include enhanced operational performance expectations and define remedial actions that would apply should an approved insurer fail to comply with the new requirements. The public input period with respect to the PMIERs closed on September 8, 2014. The FHFA has advised us that it does not expect to release the final PMIERs until at least late in the first quarter of 2015.
The following table summarizes the unaudited results of operations for each quarter of 2014 and 2013. We have prepared the consolidated quarterly information on a basis consistent with the audited consolidated financial statements. In the opinion of management, the financial information reflects all adjustments (which include normal recurring adjustments) required for a fair presentation of the financial information for the quarters presented. This information should be read in conjunction with
Under the insurance laws of the Commonwealth of Pennsylvania, the insurance subsidiaries may pay dividends during any 12-month period in an amount equal to the greater of (i) 10% of the preceding year-end statutory policyholders' surplus or (ii) the preceding year's statutory net income. The Pennsylvania statute also requires that dividends and other distributions be paid out of positive unassigned surplus without prior approval. Essent Guaranty currently has negative unassigned surplus and therefore, would require prior approval by the Pennsylvania Insurance Commissioner to make any dividend payment or other distributions in 2015. Essent PA would be able to pay a dividend of $3.7 million in 2015.