The Company leases office space in its Winston-Salem headquarters and its seven underwriting offices located throughout the country under leases expiring between 2007 and 2012 and which require annual lease payments of approximately $1.5 million in 2007. With respect to all facilities, the Company either has renewal options or believes it will be able to obtain lease renewals on satisfactory terms. The Company believes its existing properties are well utilized and are suitable and adequate for its present circumstances.
Certain of the statements contained herein, other than statements of historical fact, are forward-looking statements. These statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and include estimates and assumptions related to economic, competitive, and legislative developments. These forward-looking statements are subject to change and uncertainty, which are, in many instances, beyond our control and have been made based upon our expectations and beliefs concerning future developments and their potential effect on us. Actual developments and their results could differ materially from those expected by us, depending on the outcome of certain factors, including the possibility of general economic and business conditions that are different than anticipated, legislative developments, changes in interest rates or the stock markets, stronger than anticipated competitive activity, as well as the factors described in the “Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995” section below with respect to forward-looking statements contained herein.
Frequency and severity are the two most significant assumptions in the establishment of our loss reserves. Frequency is used to estimate the ultimate number of paid claims associated with the current defaulted loans. The frequency estimate assumes that long-term historical experience, taking into consideration criteria such as those described in the preceding paragraph, and adjusted for current economic conditions that we believe will significantly impact the long-term loss development, provides a reasonable basis for forecasting the number of claims that will be paid. Severity is the estimate of the dollar amount per claim that will be paid. The severity factors are estimates of the percent of the risk in force that will be paid. The severity factors used are based on an analysis of the severity rates of recently paid claims, applied to the risk in force of the loans currently in default. The frequency and severity factors are updated quarterly. Economic conditions and other data upon which these factors are based may change more frequently than once a quarter. Therefore, significant changes in reserve requirements may become evident three or more months following the underlying events that would necessitate the change.
The impact on loss reserves on the balance sheet would be to decrease reserves under favorable development and to increase reserves for unfavorable development. There would be no impact on liquidity resulting from the change in reserves. However, there would be a change in cash or invested assets equal to the increase or decrease in the ultimate paid claims related to the change in reserves. We believe that a 10% increase or decrease in frequency or severity is reasonably likely based on potential changes in future economic conditions and past experience. Economic conditions that could give rise to an increase in the frequency rate could be a sudden increase, or a prolonged period of increase in the unemployment rate while, conversely, a sudden drop in interest rates or a sustained period of economic and job growth could decrease the frequency rate. A sudden nationwide or widespread regional decline in home prices, or a prolonged period of flat or slowly depreciating home prices could increase the severity while a significant increase, or steady sustained growth in house price appreciation could decrease the severity.
Because the estimate for loss reserves is sensitive to the estimates of claims frequency and severity, we perform analyses to test the reasonableness of the best estimate generated by our loss reserve process. Our loss reserve estimation process and our analyses support the reasonableness of the best estimate of loss reserves recorded in our financial statements. See the “Losses and Expenses” section below for a more detailed discussion of the reserves for losses and loss adjustment expenses.
Our expenses essentially consist of a) amounts paid on claims submitted, b) changes in reserves for estimated future claim payments on loans that are currently in default, c) general and administrative costs of acquiring new business and servicing existing policies, d) other general business expenses, and e) income taxes.
Growth and seasoning of our insurance in force combined with refinements in the frequency and severity factors utilized in our calculation of our reserves caused net losses and loss adjustment expenses for 2006 to increase significantly over 2005. Insurance in force was $56.8 billion at December 31, 2006 compared to $44.4 billion at December 31, 2005 and $36.8 billion at December 31, 2004. This growth along with a greater percentage of loans entering the peak claim paying period increased both the number and amount of paid claims during 2006. Direct paid losses increased to $59.0 million for 2006 from $48.8 million for 2005. The actual number of claims paid for 2006 increased 20.6% over 2005 as well. In addition to paid claims, net losses and loss adjustment expenses also includes the change in reserves. We increased reserves $33.3 million during 2006 compared to $17.0 million during 2005. The increase in 2006 was due to an increase in the number of defaults, but also reflects the impacts of the increase in the frequency and severity factors due to the declining housing market and growth in our average portfolio loan size.
The increase in diluted earnings per share for 2006 over 2005 was consistent with the increase in net income. Realized investment gains, net of taxes, increased diluted earnings per share in 2006 by $0.07 and had no impact on diluted earnings per share in 2005. Diluted realized gains and losses per share is a non-GAAP measure. We believe this is relevant and useful information to investors because, except for write-downs on other-than-temporarily impaired securities, it shows the effect that our discretionary sales of investments had on earnings.
Net income for 2005 declined from 2004, as losses and loss adjustment expenses grew faster than earned premium during 2005. The growth in net losses and loss adjustment expenses in 2005 was principally a result of the ongoing seasoning of our insurance portfolio. In 2005, we experienced an increase in the number of paid claims and the number of reported defaults that caused us to significantly increase our reserve for losses to reflect these trends. We experienced growth in earned premiums in 2005, driven by moderate growth of our risk in force combined with an increase in premium basis points related to specific lender programs and a change in the mix of business. Realized investment gains increased diluted earnings per share by $0.02 in 2004.
We describe our results in greater detail in the discussions that follow. The information is presented in three categories: Production and In Force, Revenues, and Losses and Expenses.
Primary new insurance written in 2006 increased over 2005 due to increased production primarily of products with risk-adjusted pricing such as Alt-A loans and ARMs, including loans with potential negative amortization. Primary new insurance written also increased due to an increase in lender paid transactions, which included, in some cases, products with risk-adjusted pricing. Loans with potential negative amortization include pay option ARMs. We classify all loans with adjustable interest rates as ARMs, including those for which the interest rate is fixed for a certain period of time. We define pay option ARMs as those that provide a fixed period of time during which the borrower has the option to pay monthly payments that are less than the interest accrued for those months. If the borrower elects this option, the LTV increases on the loan. Because the LTV can increase on a pay option ARM, these types of loans may present more risk to a mortgage insurer than traditional amortizing loans. We define ARMs with positive amortization as those that have scheduled loan principal amortization and those for which monthly payments are interest only for a fixed period of time and then convert to scheduled loan principal amortization. A relatively flat mortgage loan origination market in 2005 combined with a decline in the percentage of loan originations for which mortgage insurance was provided caused the decline in Primary insurance written in 2005 from that of 2004.
Using MICA definitions, net new primary insurance written for the entire industry declined approximately 5% for 2006 from 2005 based on information available from MICA and other public sources. Our increased production of products with risk-adjusted pricing combined with a gain in market share in 2006 mitigated the effects of this industry decline.
We believe that the overall mortgage loan origination market will continue to contract in 2007, which could reduce our Primary new insurance written. However, we believe that alternative credit enhancements such as 80-10-10’s, which can limit the need for mortgage insurance, have become less attractive to borrowers as short-term interest rates have risen. Further, the recent passing of legislation that makes mortgage insurance tax deductible in certain circumstances may also mitigate any potential reduction of Primary insurance written.
We write Modified Pool insurance only through our structured bulk channel. Structured bulk transactions for the entire industry increased approximately 9% for 2006 over 2005, according to information available from MICA and other publicly available data. Our Modified Pool insurance written for 2006 increased over 2005 as a result of this industry increase and a gain in our market share as shown in the table below. These same factors caused the increase in Modified Pool insurance written in 2005 over 2004. Our Modified Pool insurance written is likely to vary significantly from period to period due to: a) the limited number of transactions (but with larger size) occurring in this market, b) the level of competition from other mortgage insurers, c) the relative attractiveness in the marketplace of mortgage insurance versus other forms of credit enhancement, and d) the changing loan composition and underwriting criteria of the market. We believe there will continue to be opportunities in 2007 in the structured bulk transaction market that meet our loan quality and pricing objectives.
Our market share of new insurance written through the flow channel increased in 2006 and 2005 as a result of acquiring business from new lenders and increased writings with our targeted lenders, specifically with special lender-paid programs that applied primarily to non-prime loans. These special lender-paid programs are competitively priced among mortgage insurers and the production can vary from period to period, depending upon our willingness to accept the specific risk characteristics of these products. Our structured bulk market share will vary from period to period since our share of this market is dependent on the availability and size of transactions that meet our credit quality and pricing benchmarks and on our ability to bid successfully for these transactions.
The following table provides detail on our direct insurance in force at December 31, 2006, 2005 and 2004:
Our Primary insurance in force grew in 2006 and in 2005 as a result of production during those years and improving persistency rates. Primary insurance annual persistency improved to 76.6% at December 31, 2006 compared to 70.0% at December 31, 2005 and 68.5% at December 31, 2004. If interest rates remain near current levels, we anticipate that persistency rates will also continue near current levels for 2007. However, persistency may be adversely affected if interest rates decline significantly from the levels experienced during 2006.
The following table provides information on risk in force at December 31, 2006, 2005 and 2004. As is evidenced by the following table, we have moved further out on the risk curve based upon the trends in these risk characteristics. Indicators of increased risk would include the following:
Percentages represent distribution of direct risk in force on a per policy basis and does not account for applicable stop-loss amounts or deductibles.
We offer mortgage insurance structures designed to allow lenders to share in the risks of mortgage insurance. One such structure is our captive reinsurance program under which a reinsurance company, generally an affiliate of the lender, assumes a portion of the risk associated with the lender’s insured book of business in exchange for a percentage of the premium. The following table shows the percentage of our Primary flow channel insurance in force as well as the percentage of our total insurance in force that was subject to captive reinsurance arrangements at December 31, 2006, 2005 and 2004.
We believe captive reinsurance arrangements are an effective risk management tool as selected lenders share in the risk under these arrangements. Additionally, captive reinsurance arrangements are structured so that we receive credit against the capital required in certain risk-based capital models utilized by rating agencies. We remain committed to structuring captive reinsurance arrangements, including deep ceded arrangements where the net premium cede rate is greater than 25%, on a lender-by-lender basis as we deem it to be prudent depending on a number of considerations including competition, market share and lender quality. We will continue to be an active participant with our qualified lenders in captive reinsurance arrangements.
The table below provides data on insurance written that was subject to captive reinsurance arrangements for the years ended December 31, 2006, 2005 and 2004:
The difference between net written premiums and earned premiums is the change in the unearned premium reserve, which is established primarily on premiums received on annual products. Our unearned premium liability declined $0.3 million during 2006 compared to a decline of $2.4 million in 2005 and an increase of $0.3 million during 2004 due to fluctuations in the amount and timing of annual premiums received.
Assuming no significant decline in interest rates, we expect our persistency will remain near current levels in 2007. We anticipate that this should continue to have a positive effect on renewal earned premiums and total earned premiums in 2007.
Net realized investment gains, except for write-downs on other-than-temporarily impaired securities, are the result of our discretionary dispositions of investment securities in the context of our overall portfolio management strategies and are likely to vary significantly from period to period. We wrote down other-than-temporarily impaired securities by approximately $0.4 million in 2006 compared to $0.2 million in 2005 and $0.5 million in 2004. See further discussion of impairment write-downs in the “Realized Losses and Impairments” section below.
Net losses and LAE is comprised of the net claims paid and the change in loss reserves. Loss reserves represent our estimate of the ultimate claim costs of those loans reported to us as in default and those loans in default that are in the process of being reported to us. We will discuss each of these components separately and the impact on our financial results.
The following table provides detail on paid claims for the years ended December 31, 2006, 2005 and 2004:
Total paid claims increased in 2006 and in 2005 due to the overall growth of the insurance portfolio and the seasoning of our portfolio. As interest rates dropped to historical lows in 2003 and 2004, many borrowers refinanced. This meant most of the loans originated in years 2000 to 2002 canceled, and loans originated in 2003 and 2004 comprised a greater percentage of our total portfolio at the end of 2004. Historically, the highest anticipated claim frequency period is between years two to five from loan origination. Therefore, paid claims in 2004 were disproportionately low compared to the entire size of the portfolio because the portfolio was not seasoned. The growth in the number and amounts of Primary paid claims in 2005 and 2006 is consistent with aging of the portfolio as a greater percentage of policies are reaching their anticipated highest claim frequency period. The declines in both the dollar amount and number of paid claims on Modified Pool insurance in 2006 from 2005 were due to the seasoning of the business that was structured with deductibles. During 2006, a greater percentage of Modified Pool claims filed were on loans that were part of transactions structured with deductibles. Because of these deductibles, a greater percentage of the Modified Pool claims filed in 2006 did not result in a paid claim. The growth in paid losses in 2005 from 2004 was impacted by the increase in total average severity shown above. This increase was reflective of the growth of Alt-A loans that generally have a larger average loan balance than the rest of our portfolio, resulting in a higher claim payment.
Although for the year ended December 31, 2006 average severity remained relatively flat when compared to 2005, we experienced a significant increase in average severity for both Primary and Modified Pool insurance in the fourth quarter of 2006. The following table shows the average quarterly severity of paid claims during 2006:
quarter of 2006, full option settlements were a larger percentage of our paid claims. The lack of mitigation opportunities contributed to the increase in severity for the fourth quarter.
Net losses and loss adjustment expenses also include the change in reserves for losses and loss adjustment expenses. The following table provides further information about our loss reserves at December 31, 2006, 2005 and 2004 and the related changes for the years then ended:
The reserve for losses and loss adjustment expenses increased in 2006 primarily due to refinements in the frequency and severity factors utilized in our reserving methodology based upon the development of claims paid in 2006. An increase in the number of reported loans in default also contributed to the increase in the reserve for losses and LAE to a lesser extent. The number of loans in default includes all reported delinquencies that are in excess of two payments in arrears at the reporting date and all reported delinquencies that were previously in excess of two payments in arrears and have not been brought current.
We continually monitor our reserves and claim development. As new data emerges, we consider its impact on our reserve calculation, and when necessary, refine our estimates. During 2005 and the first three quarters of 2006, we refined our segmentation for the reserve calculation and monitored emerging trends. These changes resulted in an increase in frequency factors utilized in our reserve calculation, which increased reserves during 2006 significantly more than the 5% increase in the number of reserved defaults from December 31, 2005 to December 31, 2006.
Excludes loans written as part of structured bulk transactions with deductibles and defaults on these loans.
The decline in the default rate for Primary insurance at December 31, 2006 from December 31, 2005 is attributable to the strong production during the 2006 that has yet to move into the period of highest anticipated default frequency. During 2006, our number of Primary insured loans in force increased approximately 4%
compared to a small decline during 2005. As this business seasons, we expect default rates to increase. The increase in the Primary insurance default rate at December 31, 2005 from December 31, 2004 was due largely to seasoning of the portfolio.
At December 31, 2006, no individual structured bulk transaction with deductibles as part of the structure had incurred total losses that were nearing its individual deductible amount. We do not provide reserves on Modified Pool defaults with deductibles until the incurred losses for that specific structured bulk transaction is projected to exceed the deductible.
We have mentioned the increase in our writings of products subject to risk-adjusted pricing such as Alt-A and ARMs. The incidence rates of delinquencies on these products typically increase in the second through fourth year following loan origination. Much of the business that we have added subject to risk-adjusted pricing, especially those ARMs that have potential negative amortization, have not yet reached an age where we would expect to see an increase in delinquencies. We anticipate our number of loans in default for both Primary and Modified Pool insurance will increase as a larger percentage of our insurance in force reaches the period of the highest expected incidence of defaults, especially those newer products subject to risk-adjusted pricing. Most of the potential negative amortization ARM products that we insure have not yet been subject to rate resets. These rate resets could significantly increase the borrower’s required monthly payment, which we believe increases the risk of default over that of a fixed rate loan. We also expect default rates to increase, as these products become a larger percentage of our insurance in force. Consequently, we expect reserves will continue to increase.
Amortization of DAC increased in 2006 and 2005, primarily due to growth in the asset balance, partially offset by improved persistency. A full discussion of the impact of persistency on DAC amortization is included in the “Deferred Policy Acquisition Costs” section below.
Competition within the mortgage insurance industry continues to increase as many large mortgage lenders have limited the number of mortgage insurers with whom they do business. At the same time, consolidation among national lenders has increased the share of the mortgage origination market controlled by the largest lenders and that has led to further concentrations of business with a relatively small number of lenders. Many of the national lenders allocate Primary business to several different mortgage insurers. These allocations can vary over time. Our strategy is to continue our focus on national lenders while maintaining the productive relationships that we have built with regional lenders. Our ten largest customers were responsible for 80%, 77%, and 71% of insurance written through the flow channel during 2006, 2005, and 2004, respectively. In 2006, we had three customers that individually were responsible for more than 10% of insurance written through the flow channel. In the aggregate, these customers
were responsible for 65% of insurance written through the flow channel. In 2005 and 2004, we had two customers that individually were responsible for more than 10% of insurance written through the flow channel. In the aggregate, these customers were responsible for 58% and 55% of insurance written through the flow channel in 2005 and 2004, respectively. Through actively seeking business with other lenders that meet our criteria, we are broadening our customer base in order to limit our concentration among lenders. The loss of, or considerable reduction in, business from one or more of these significant customers, without a corresponding increase from other lenders, would have an adverse effect on our business.
Costs expended to acquire new business are capitalized as DAC and recognized as expense over the anticipated premium paying life of the policy in a manner that approximates the estimated gross profits. We employ a dynamic model that calculates amortization of DAC separately for each year of policy origination. The model relies on assumptions that we make based upon historical industry experience and our own unique experience regarding the annual persistency development of each year of policy origination. Persistency is the most important assumption utilized in determining the timing of reported amortization expense reflected in the income statement and the carrying value of DAC on the balance sheet. A change in the assumed persistency can impact the current and future amortization expense as well as the carrying value on the balance sheet. Our model accelerates DAC amortization through a dynamic adjustment when actual persistency for a particular year of policy origination is lower than the estimated persistency originally utilized in the model. This dynamic adjustment applies only to lower than assumed persistency, and we do not decrease DAC amortization below the levels assumed in the model when persistency increases above those levels. When actual persistency is lower than that assumed in our models, the dynamic adjustment effectively adjusts the estimated policy life utilized in the model to a policy life based upon the current actual persistency. As seen below, the actual persistency is very close to the persistency assumed in the model as evidenced by the declining impact of the dynamic adjustment.
Our DAC models separate the costs capitalized and the amortization streams between transactions arising from the structured bulk and flow distribution channels. Generally, structured bulk transactions have significantly lower acquisition costs associated with the production of the business and they also have a shorter original estimated policy life. We apply the dynamic adjustment to the structured bulk DAC models utilizing the same methodology. At December 31, 2006 and 2005, net unamortized DAC relating to structured bulk transactions amounted to 7.3% and 6.8% of the total DAC asset on the balance sheet.
The following table shows the DAC asset for the previous three years and the effect of persistency on amortization (dollar amounts in thousands):
We purchase ten-year non-interest bearing United States Mortgage Guaranty Tax and Loss Bonds (“Tax and Loss Bonds”) to take advantage of a special contingency reserve deduction that mortgage guaranty companies are allowed for tax purposes. We record these bonds on our balance sheet as prepaid federal income taxes. Purchases of Tax and Loss Bonds are essentially a prepayment of federal income taxes that will become due in ten years, when the contingency reserve is released, and the Tax and Loss Bonds mature. The proceeds from the maturity of the Tax and Loss Bonds are used to fund the income tax payments due in the same year. Prepaid income taxes were $166.9 million and $139.5 million at December 31, 2006 and 2005, respectively. The change from year to year approximates the change in the deferred income tax liability for the year.
We seek to provide liquidity in our investment portfolio through cash equivalent investments and through diversification and investment in publicly traded securities. We attempt to maintain a level of liquidity and duration in our investment portfolio consistent with our business outlook and the expected timing, direction, and degree of changes in interest rates. See Note 2 in Notes to Consolidated Financial Statements that describes the scheduled maturity of our fixed maturity investments.
We also manage risk and liquidity by limiting our exposure on individual securities. The following table shows the ten largest exposures to an individual creditor, or issuer in the case of equity securities, in our investment portfolio as of December 31, 2006:
The drop in the tax-equivalent yield-to-maturity shown above reflects the investment of our cash flows from operations and reinvestment of proceeds from the maturity or call of higher yielding investments at new money rates, which were and are projected to continue to be lower than that of our overall portfolio yield. We anticipate this trend to continue into 2007.
The following table summarizes by category our unrealized gains and losses in our securities portfolio at December 31, 2006:
Credit risk is inherent in an investment portfolio. We manage this risk through a structured approach to internal investment quality guidelines and diversification while assessing the effects of the changing economic landscape. One way we attempt to limit the inherent credit risk in our portfolio is to maintain investments with high ratings. The following table shows our investment portfolio by credit ratings (dollars in thousands).
We regularly review our entire investment portfolio to identify securities that may have suffered impairments in value that will not be recovered, termed potentially distressed securities. In identifying potentially distressed securities, we screen all securities held with a particular emphasis on those that have a fair value to cost or amortized cost ratio of less than 80%. Additionally, as part of this identification process, we utilize the following information:
Industry factors or conditions related to a geographic area negatively affecting the security
Of the approximate $0.9 million of gross unrealized losses at December 31, 2006, securities with a fair value to cost or amortized cost ratio of less than 90% had a combined unrealized loss of approximately $39,000.
Information about unrealized gains and losses is subject to changing conditions. The values of securities with unrealized gains and losses will fluctuate, as will the values of securities that we identify as potentially distressed. Our current evaluation of other-than-temporary impairments reflects our intent to hold securities for a reasonable period of time sufficient for a forecasted recovery of fair value. However, our intent to hold certain of these securities may change in future periods as a result of facts and circumstances impacting a specific security. If our intent to hold a security with an unrealized loss changes, and we do not expect the security to fully recover prior to the expected time of disposition, we will write down the security to its fair value in the period that our intent to hold the security changes.
Our sources of operating funds consist primarily of premiums written and investment income. Operating cash flow is generally applied to the payment of claims, interest, expenses, and prepaid federal income taxes in the form of Tax and Loss Bonds.
We generated positive cash flow from operating activities of $88.4 million in 2006 compared to $70.8 million for 2005 and $68.9 million for 2004. The increases in cash flow from operating activities reflects the growth in premiums and investment income received, partially offset by increases in paid losses and operating expenses.
paid-in-capital of $4.5 million resulting from activity related to share-based compensation to employees and the associated tax benefit.
Statutory capital, for the purpose of computing the net risk in force to statutory capital ratio, includes both policyholders’ surplus and the contingency reserve. The following table provides information regarding our statutory capital position at December 31, 2006 and 2005:
The primary difference between statutory policyholders’ surplus and equity computed under generally accepted accounting principles is the statutory contingency reserve. Mortgage insurance companies are required to add to the contingency reserve an amount equal to 50% of calendar year earned premiums and retain the reserve for 10 years, even if the insurance is no longer in force. Therefore, a growing company such as Triad normally has a greater increase in its contingency reserve rather than in statutory surplus. The contingency reserve can be released if the loss ratio exceeds 35%. Our loss ratio for 2006 exceeded this threshold, and we released approximately $19.7 million of contingency reserve to surplus.
Triad’s ability to write insurance depends on the maintenance of its financial strength ratings. A number of states generally limit Triad’s risk-to-capital ratio to 25-to-1. As of December 31, 2006, Triad’s risk-to-capital ratio was 12.5-to-1 as compared to 12.6-to-1 at December 31, 2005. The risk-to-capital ratio is calculated using net risk in force as the numerator and statutory capital as the denominator. Net risk in force accounts for risk ceded under reinsurance arrangements, including captive risk-sharing arrangements as well as any applicable stop-loss limits and deductible amounts.
We had no material off-balance sheet arrangements at December 31, 2006.
housing transactions requiring mortgage insurance may decrease for many reasons including changes in interest rates or economic conditions or alternative credit enhancement products;
the amount of insurance written could be adversely affected by changes in federal housing legislation, including changes in the Federal Housing Administration loan limits and coverage requirements of Freddie Mac and Fannie Mae (“Government-Sponsored Enterprises”);
our financial condition and competitive position could be affected by legislation or regulation impacting the mortgage guaranty industry or the Government-Sponsored Enterprises, specifically, and the financial services industry in general;
our financial and competitive position could be affected by regulatory activity requiring changes to mortgage industry business practices, such as captive reinsurance;
Accordingly, actual results may differ from those set forth in the forward-looking statements. Attention also is directed to other risk factors set forth in documents filed by the Company with the Securities and Exchange Commission.