Our principal executive offices are located at 101 South Stratford Road, Winston-Salem, NC 27104. This five-story office building totals 79,254 square feet and we currently lease approximately 71,007 square feet under a lease that will expire in 2012. All staff functions are located within this office complex. Due to the reduction in force in June 2008, we are actively attempting to sublease at least one floor; however, the local market for commercial property is weak due to the recession. We believe this property is suitable and adequate for its present circumstances.
We maintain mid-range and micro-computer systems in our corporate data center located in our headquarters building to support our data processing requirements for accounting, policy administration, claims, and risk management. We have back-up procedures in place in the event of emergency situations.
Triad Guaranty Inc. is a holding company that historically provided private mortgage insurance coverage in the United States through its wholly-owned subsidiary, Triad Guaranty Insurance Corporation (“Triad”). Triad ceased issuing new commitments for mortgage guaranty insurance coverage on July 15, 2008 and we are operating our business in run-off. As used in this annual report on Form 10-K, the term “run-off” means writing no new mortgage insurance policies and continuing to service existing policies. Servicing includes: receiving premiums on policies that remain in force; cancelling coverage at the insured’s request; terminating policies for non-payment of premium; working with borrowers in default to remedy the default and/or mitigate our loss; and settling all legitimate filed claims per our contractual obligations. Triad has agreed to a Corrective Order from the Illinois Department of Financial and Professional Regulation, Division of Insurance (the “Division”) that, among other items, includes restrictions on the distribution of funds by Triad.
earned renewal premiums from the remaining insurance in force, net of:
refunds paid or accrued resulting from the cancellation of insurance in force or for coverage rescinded due to violations of certain provisions of a master policy; and
changes in reserves for estimated future claim payments on loans that are currently in default;
On August 5, 2008, Triad and TGAC (collectively, “TGIC”) entered into an Agreed Corrective Order with the Division. The Corrective Order was implemented as a result of our decision to cease writing new mortgage guaranty insurance and to commence a run-off of our existing insurance in force as of July 15, 2008. Among other things, the Corrective Order:
Prohibited all stockholder dividends from TGIC to its parent company without the prior approval of the Division;
Prohibited interest and principal payments on TGIC’s surplus note to its parent company without the prior approval of the Division;
Required TGIC to meet with the Division in person or via teleconference as necessary; and
Since the approval of our initial corrective plan, we have revised the assumptions we initially utilized in our run-off financial forecast model as a result of a number of factors, including continued deteriorating economic conditions impacting our financial condition, results of operations and future prospects. Our new assumptions produce a range of potential ultimate outcomes for our run-off, but include projections showing that on a likely case basis and absent additional action by the Division or favorable changes in our business, we will report a deficiency in policyholders’ surplus as calculated in accordance with SAP as early as March 31, 2009 and continuing at least through 2011. Although we currently project that this statutory insolvency will be temporary and our run-off will ultimately be successful, we believe such insolvency would likely lead to the institution by the Division of receivership proceedings against TGIC if not corrected. We are currently working with the Division to structure a revised corrective plan to address this issue, although no assurance can be given that we will be successful in these efforts. If we are unable to gain approval from the Division for a revised corrective plan that addresses this issue, the Division could place TGIC into receivership proceedings, which could force us to seek protection from creditors through a voluntary bankruptcy proceeding and we would likely be unable to continue as a going concern. See Item 1A, “Risk Factors” for more information.
Triad is also subject to comprehensive regulation by the insurance departments of the various other states in which it is licensed to transact business. Currently, the insurance departments of the other states are working with the Division in the implementation of the Corrective Order.
We have discovered a substantial number of underwriting or program violations and misrepresentations in defaults reported to us and we have subsequently rescinded or cancelled coverage on these policies at a rate substantially greater than we have historically experienced. In the fourth quarter of 2008, we expanded the criteria used to determine whether a default would be investigated for underwriting violations in accordance with our master policy provisions. While we will continue to settle legitimate claims, we expect an increase in rescission activity in 2009 based on the number of policies under review and the number of occurrences of underwriting violations discovered during 2008. Any impediment to our ability to rescind coverage for underwriting violations would be detrimental to our success in run-off.
Our focus remains on the efficient and effective servicing of our insured portfolio, particularly with respect to loss mitigation, as well as to adherence to the August 2008 Corrective Order.
Over the past several months, several government programs have been initiated which, in general, are designed to provide relief to homeowners and the financial markets. Many of these programs have been expanded since originally developed and may continue to change.
In July 2008, the Housing and Economic Recovery Act of 2008 was enacted, which established the Federal Housing and Finance Agency (“FHFA”) as the successor regulatory agency to both Fannie Mae and Freddie Mac. FHFA has broad legal and regulatory authority to ensure the safety and soundness of both of the GSEs. On September 7, 2008, both Fannie Mae and Freddie Mac were placed into conservatorship with FHFA acting as conservator. Conservatorship is a process designed to stabilize a troubled institution with the objective of returning the troubled institution to normal business operations. FHFA has stated that the purpose of this action is to restore
confidence in these GSEs, to enhance their capacity to fulfill their mission, and to mitigate the systemic risk that has contributed directly to the instability in the market.
During October 2008, the Emergency Economic Stabilization Act of 2008 (“EESA”) was enacted. EESA, among other things, created the Troubled Asset Relief Program (“TARP”), which provides authority for the Federal government to purchase assets and equity from financial institutions in order to strengthen the financial sector. The goal of TARP is to encourage banks to resume lending again at levels seen before the financial crisis. TARP allows the U.S. Department of the Treasury to purchase or insure up to $700 billion in residential or commercial mortgages and securities based on or related to such mortgages as well as any other financial instrument that the Secretary of the Treasury determines would promote stability in the financial market.
The Streamlined Modification Program (“SMP”) was adopted by the GSEs in December 2008 and is designed to reduce foreclosures on mortgage loans owned or guaranteed by the GSEs. The SMP standardized the modification criteria for such mortgage loans with the goal of enabling loan servicers to proactively solicit borrower participation. A number of eligibility criteria apply to the SMP. Modifications available include the capitalization of accrued interest and other fees, the extension of the term of the mortgage loan, the reduction of the interest rate on the mortgage loan, as well as a provision for principal forbearance. Additionally, several large lenders have announced plans to implement their own loan modification programs. The GSEs also established a moratorium on foreclosures that began in December 2008 and expired on March 6, 2009.
The growth in the reserve for losses and LAE is the result of an increase in the number of reported loans in default as well as the characteristics of the loans in default. The number of loans in default increased by 139% during the year. However, risk in default increased by 173% as new defaults had a substantially higher average risk per loan than the default inventory at December 31, 2007.
Loans on properties in California, Florida, Arizona and Nevada (which we refer to collectively as “distressed markets”). Defaults in these distressed markets comprised 49% of our default inventory and 60% of our gross risk in default at December 31, 2008, compared to 33% and 48%, respectively, at December 31, 2007;
Revenue decreased by 12% during 2008, primarily the result of a decrease in premium earned as our insurance in force declined 8% from a year ago. The decline in insurance in force resulted from reduced production in the first half of 2008 and our decision to cease issuing new commitments for insurance and enter into run-off on July 15, 2008.
Other operating expenses increased by 35% during 2008, primarily due to the transition to run-off, which resulted in a number of non-recurring charges principally related to severance. Additionally, we wrote off all existing deferred acquisition costs of approximately $34 million during 2008.
For the twelve months ended December 31, 2008, we wrote $3.5 billion of new insurance compared to $22.9 billion for the same period of 2007. All production in 2008 was from our Primary flow channel, while insurance written in 2007 was comprised of $15.9 billion from the flow channel and $7.0 billion from the bulk channel. We ceased issuing commitments for mortgage insurance on July 15, 2008 and the minimal production subsequent to July 15, 2008 consisted of commitments for mortgage insurance that were entered into prior to that date. We do not expect any material amount of production going forward.
The following table provides detail on our direct insurance in force at December 31, 2008 and 2007:
The decline in insurance in force is primarily due to the low amount of insurance written during the year, although the decline was offset somewhat by continued improvements in persistency.
The following tables provide information on selected risk characteristics of our business based on gross risk in force at December 31, 2008 and 2007. The following is a list of characteristics we believe are important indicators of increased risk in our portfolios:
The presence of multiple risk factors on a single insured loan.
Percentages represent distribution of gross risk in force on a per policy basis and does not account for risk ceded to captive reinsurers or applicable stop-loss amounts and deductibles on Modified Pool structured bulk transactions.
The decrease in direct premium written in 2008 is reflective of the decline in insurance in force and was partially due to lower premium written from new production. Rescission activity had a significant impact on both direct premium written and earned premium during 2008. When we rescind coverage due to underwriting violations in the origination of a loan, we refund all of the premium previously paid to us. During 2008, cash premiums refunded amounted to $10.3 million compared to $2.9 million in 2007. Rescissions have also impacted the frequency factor that we utilize in providing reserves. We provide an accrual for the estimated partial refunds of premiums based upon the early payment defaults that are currently under investigation and historical rescission rates. At December 31, 2008 we had accrued $17.1 million of premium refunds, the majority of which was accrued in the fourth quarter as we expanded our definition of early payment defaults. The accrual for premium refunds related to rescissions at December 31, 2007 was negligible.
Ceded premium written is comprised of premiums written under excess of loss reinsurance treaties with captives as well as non-captive reinsurance companies. The growth in ceded premium during 2008 over 2007 was primarily due to an increase in average insurance in force subject to captive reinsurance. The premium cede rate increased to 19.2% for 2008 compared to 16.5% for 2007 reflecting, primarily, the impact of refunds on direct premium written. We did not establish a corresponding accrual to account for the potential impact of expected refunds on ceded premium previously paid to captives.
A summary of the significant individual components of losses and expenses and the year-to-year percentage changes follows:
Net losses and LAE are comprised of paid losses and LAE as well as the increase in the loss and LAE reserve during the period. The following paragraphs look at some of the specifics of the individual components of net losses and LAE.
Although we experienced a large increase in the dollar amount and number of paid claims during 2008, these increases were tempered somewhat in the second half of 2008 primarily due to foreclosure moratoriums, rescission activity and policy investigations. Average severity increased to $53,800 in 2008 from $36,700 in 2007 reflecting a larger percentage of our paid claims from (i) the more recent vintage years, specifically the 2005, 2006 and 2007 vintage years, and (ii) the distressed markets.
The following table shows the average loan size and average risk per policy by vintage year. The 2006 and 2007 books are exhibiting adverse development patterns and thus are expected to impact the amount of paid claims and the average paid claim earlier than what we have experienced historically. We expect average severity to continue to increase in 2009 as policies originated during 2006 and 2007 continue to comprise a greater proportion of our paid claims.
During 2008, we experienced large increases in the cumulative paid loss ratios for the 2005, 2006, and 2007 vintage years and more gradual increases for the other vintage years. While we have historically expected higher claim payments in the second through the fifth years after loan origination, the more recent vintage years have developed at a much faster rate from a default and claim perspective than historical trends would indicate. We do not expect this adverse development to subside and expect the cumulative paid loss ratios for the 2005, 2006 and 2007 books of business to ultimately be significantly higher than our previous books of business and possibly greater than 100%.
Net losses and LAE also include the change in reserves for losses and LAE. The following table provides further information about our reported loss reserves, excluding the effects of reinsurance, at December 31, 2008 and 2007:
Although defaults increased across the country in general, the distressed markets have experienced substantially higher growth rates in defaults. Defaults in the distressed markets increased 254% during 2008 compared to an increase of 84% in states not identified as distressed markets. Additionally, on average, defaults in the distressed market states have a higher average loan balance and average risk in default than the remainder of our defaults. At December 31, 2008, the distressed markets had average loan balances of approximately $248,000 compared to approximately $161,000 for the remainder of the portfolio.
The following table indicates the growth in both the gross risk in default in these four distressed market states and reserves attributable to these states at December 31, 2008 and December 31, 2007.
Certificates originated during 2007 and 2006 comprise 62.7% of our loans in default, but 73.4% of the risk in default at December 31, 2008. The difference in percentages of loans in default and risk in default primarily reflects the higher loan amounts associated with the 2007 and 2006 policy years.
The following table shows default statistics as of December 31, 2008 and 2007:
We do not provide reserves on Modified Pool defaults with deductibles until the incurred losses for that transaction reach the deductible threshold. At December 31, 2008, 39% of our structured bulk transactions with deductibles as part of the structure, including all such transactions originated in 2006 and 2007, had incurred losses that had exceeded these individual deductible amounts. On these structured bulk contracts, we recognized $169.6 million of losses in excess of the aggregate deductibles. Although a majority of our structured bulk transactions have not exceeded the individual deductible amounts, given the large increases in default and paid claim activity related to the transactions, we have realized the majority of the benefit from the deductibles and do not expect any material benefit going forward.
We also do not provide reserves on Modified Pool defaults where the incurred losses to date for the related structure have exceeded the stop loss amount. As of December 31, 2008, 5% of our structured transactions have incurred losses that exceeded the stop loss amount. This had the effect of limiting reserves by $37.5 million at December 31, 2008. We believe that based on the recent development of our modified pool business, we will continue to provide additional reserves on structured bulk transactions with deductibles and we will continue to limit the addition of reserves due to modified pool contracts reaching stop loss limits.
The increase in other operating expenses during 2008 resulted from significant non-recurring expenses in the first half of 2008, including expenses associated with the attempted capital raising efforts, severance and other termination costs associated with the transition to run-off, and expenses associated with our exit from Canada.
Our effective tax rate decreased to 16.4% for 2008 from 40.7% for 2007. The effective tax rate for 2008 is lower than the marginal rate of 35% and decreased substantially from the rate in 2007 due primarily to the large operating loss reported in 2008 and the inability to recognize future tax benefits in accordance with U.S. generally accepted accounting principles.
Federal tax law permits mortgage guaranty insurance companies to deduct from taxable income, subject to certain limitations, the amounts added to contingency reserves. As a result of substantial operating losses for 2007 and 2008, the previously established contingency reserve was released earlier than the scheduled ten years in an amount that offset the operating loss for federal tax reporting purposes. Accordingly, the previously purchased Tax and Loss Bonds associated with the contingency reserve release were redeemed earlier than originally scheduled. As of December 31, 2008, we have redeemed substantially all of our previously purchased Tax and Loss Bonds. We expect to continue to incur operating losses for tax purposes and generate net operating loss carry forwards for federal income tax reporting purposes for which we will be unable to receive any immediate benefit in our statement of operations.
This section identifies several items on our balance sheet that are important in the overall understanding of our financial position. These items include DAC as well as prepaid federal income tax and related deferred income taxes. The majority of our assets are included in our investment portfolio. A separate Investment Portfolio section follows the Financial Position section and reviews our investment portfolio, key portfolio management strategies, and methodologies by which we manage credit risk within the investment portfolio.
Prior to the write-off of the DAC asset at March 31, 2008, we capitalized costs to acquire new business as DAC and recognized these as expenses against future gross profits. At March 31, 2008, we determined that the net present value of the estimated future cash flows on the remaining book of business exceeded the recorded reserves (net of the unamortized DAC) which required the establishment of a premium deficiency reserve. The actual mechanics of recording the premium deficiency reserve require that we first reduce the DAC balance to zero before recording any additional premium deficiency reserve. Therefore, we wrote down the DAC asset by $34.8 million in the first quarter of 2008. We have not capitalized any costs to acquire new business subsequent to the first quarter of 2008, but included such costs in the line item “Other operating expenses” on our statement of operations. We will not be capitalizing any costs to acquire new business going forward.
During the period that the Company was reporting positive results of operations, we purchased Tax and Loss Bonds to take advantage of a special contingency reserve deduction that mortgage guaranty companies are allowed for tax purposes. We recorded these bonds on our balance sheet as prepaid federal income taxes. Purchases of Tax and Loss Bonds are essentially a prepayment of federal income taxes that are scheduled to become payable in ten years, when the contingency reserve is scheduled to be released, and the Tax and Loss Bonds are scheduled to mature. The scheduled proceeds from the maturity of the Tax and Loss Bonds were anticipated to be utilized to fund the income tax payments.
Deferred income taxes are provided for the differences in reporting taxable income in the financial statements and on the tax return. The largest cumulative difference has historically been the special contingency reserve deduction for mortgage insurers mentioned above. During 2008, deferred income taxes declined by $120.5 million, primarily the result of the reversal of the contingency reserve. The remainder of the deferred tax liability has primarily arisen from book and tax reporting differences related to DAC and unrealized investment gains (losses).
In years when the taxable income of a mortgage insurer results in a loss before the application of the special contingency reserve, the prior established contingency reserve can be reversed earlier than originally scheduled (effectively recognizing as taxable income the prior contingency reserve that had been deferred) to offset the current year loss. When the special contingency reserve for tax purposes is reversed to offset a current year operating loss, the Tax and Loss Bonds can be redeemed earlier than the originally scheduled ten years. During 2008, we reversed $335.0 million of contingency reserve and redeemed all of the remaining $116.0 million of Tax and Loss Bonds. During the second half of 2007, we reversed $113 million of contingency reserve for tax purposes earlier than originally scheduled and redeemed $50.9 million of Tax and Loss Bonds related to that reversal.
The following table shows the growth and transition of our investment portfolio:
The book yield is comparable for 2008 and 2007 as the taxable securities purchased during 2008 generally have a lower duration but a similar yield as the longer duration municipals that comprised the majority of the portfolio at December 31, 2007. The largest portion of the realized investment losses in 2008 are from write downs due to other-than-temporary impairments as described in “Realized Gains (Losses) and Impairments” below.
The following table summarizes by category our unrealized gains and losses in our securities portfolio at December 31, 2008:
Given our recurring losses from operations and the significant doubt regarding our ability to continue as a going concern, we may no longer have the ability to hold impaired assets for a sufficient time to recover their value. As a result, we made the decision to recognize an impairment loss on all securities whose amortized cost is greater than the market value and thus have no unrealized losses at December 31, 2008.
These unrealized gains do not necessarily represent future gains that we will realize. Changing conditions related to specific securities, overall market interest rates, or credit spreads, as well as our decisions concerning the timing of a sale, may impact values we ultimately realize. Taxable securities typically exhibit greater volatility in value than tax-preferred securities and thus we expect greater volatility in unrealized gains and realized losses going forward. Volatility may increase in periods of uncertain market or economic conditions.
The change in the credit quality of the portfolio is primarily due to the restructuring of the portfolio out of tax-preferred securities, which have historically carried credit ratings of “AAA” as a result of credit enhancements provided by financial guaranty insurers, and into taxable securities. The credit rating of a bond will carry the higher of a financial guarantor’s credit rating or the credit rating on the bond’s underlying credit qualities if such a credit rating exists. Taxable securities generally do not have such credit enhancements and the credit rating reflects the securities’ underlying credit qualities.
As of December 31, 2008, we did not invest directly in any financial guaranty insurers, but we were indirectly exposed to the risk of financial guaranty insurer default through the credit enhancements provided on the majority of our state and municipal fixed maturity bond portfolio.
For the quarter ended December 31, 2008, we made the decision to recognize an impairment loss on all securities whose amortized cost was greater than the market value. This decision was made as a result of our recurring losses from operations and the significant doubt regarding our ability to continue as a going concern as opposed to resulting from an analysis of any specific security. Going forward, we will recognize an impairment loss for all securities whose amortized cost is greater than the reported market value.
Prior to this decision, we regularly reviewed 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 these securities, we paid special attention to the length of time a security’s fair value was below its amortized cost and the degree to which the fair value was below amortized cost, as well as other factors. When we concluded that a decline was other-than-temporary, the security was written down to fair value through a charge to realized investment gains and losses. If a decision was made to sell a security or type of security, we recognized an impairment loss on those securities whose book value was greater than the market value at the time the decision was
made. In the second quarter of 2008, we made the decision to liquidate the tax-preferred bond portfolio and recognized subsequent impairment losses of approximately $7.5 million during 2008 specifically on that portfolio.
Realized gains (losses) include both write-downs of securities with other-than-temporary impairments and gains (losses) from the sales of securities. Net realized losses for 2008 totaled $26.6 million. The net realized loss was primarily composed of: (1) an impairment loss of $36.8 million on bonds offset by $8.5 million gain on the sale of bonds; (2) an impairment loss of $1.7 million on preferred stock; and (3) a gain of $3.4 million on foreign currency.
The accompanying consolidated financial statements have been prepared in accordance with GAAP and assume that we will continue as a going concern, which contemplates the realization of assets and the satisfaction of liabilities and commitments in the normal course of business. However, our ability to continue as a going concern will be dependent on the successful development, approval, and implementation of a revised corrective plan as previously discussed. If we are unable to develop, gain approval from the Division of, or implement a revised corrective plan, the Division could place TGIC into receivership proceedings for conservatorship, rehabilitation, or liquidation. Each of these outcomes effectively removes all of the assets and future cash flows of TGIC from the ownership of the parent company and its stockholders and allocates it to TGIC’s policyholders. As TGIC is the Company’s primary source of cash flow, if TGIC were placed in receivership proceedings by the Division, we could be forced to seek protection from creditors under Chapter 11 of the United States Bankruptcy Code and little or no funds would ever be available for distribution to our stockholders. The report of our independent registered public accounting firm with respect to our December 31, 2008 financial statements indicates that there is substantial doubt about our ability to continue as a going concern.
Generally, our sources of operating funds consist of premiums written and investment income. Operating cash flow has historically been applied to the payment of claims, interest, expenses and prepaid federal income taxes in the form of Tax and Loss Bond purchases. However, beginning in the second half of 2007, the early redemption of Tax and Loss Bonds due to our operating losses has provided a source of funds. See “Prepaid Federal Income Taxes and Deferred Income Taxes” for additional information concerning the Tax and Loss Bonds. We redeemed $116.0 million and $50.9 million of Tax and Loss Bonds in 2008 and 2007, respectively, related to operating losses. As of December 31, 2008, our remaining holdings of Tax and Loss Bonds are insignificant.
We generated positive cash flow from operating activities of $147.1 million during 2008 compared to $191.1 million in 2007. The positive cash flow from operations in 2008 included the redemption of Tax and Loss Bonds of $116.0 million. Going forward, Tax and Loss Bonds are not expected to be a source of operating cash flow.
In 2008, we experienced a significant operating loss, primarily due to an increase in net loss and LAE reserves of $678.4 million, which did not impact our operating cash flow. Generally, there is about a 12 to 18 month delay from when reserves are initially established on a default to when a claim is ultimately paid. During 2008, direct paid losses amounted to $237.6 million compared to $100.6 million in 2007. While the level of paid claims increased substantially in 2008 from the levels experienced in 2007, the amount was less than anticipated. We believe the lower than anticipated amount of paid claims was due to a number of factors that have delayed claim payments, including GSE and state foreclosure moratoriums, delays by the servicers due to a large increase in the number of policies in default, a continued effort on our part in investigating policies for underwriting violations, and an increase in rescission activity.
On June 28, 2007, the Company entered into a three-year, $80.0 million unsecured revolving credit facility with three domestic banks to provide short-term liquidity for insurance operations and general corporate purposes. On August 22, 2007, we drew down $80 million under the credit facility and it remained outstanding until the entire balance was repaid on March 31, 2008. The entire $80 million credit facility was terminated on the same day. We do not have any credit facility in place at December 31, 2008, nor do we anticipate that it would be feasible to obtain one given our current financial condition and the state of the current credit markets.
The insurance laws of the State of Illinois impose certain restrictions on dividends that an insurance subsidiary can pay its parent company. As discussed previously, the Corrective Order prohibits the payment of dividends by our insurance subsidiary to the parent corporation without prior approval from the Division.
Included in policyholders’ surplus of the primary insurance subsidiary, Triad, is a “surplus note” of $25 million payable to the registrant, its parent. The accrual of and payment of the interest on the surplus note must be approved by the Division, which has broad discretion to approve or disapprove any such payment. In June 2008, we requested permission to accrue and pay the interest on the $25 million surplus note from the Division. Our request was formally denied. The Corrective Order from the Division prohibits Triad from paying interest on the surplus note to its parent company without prior approval from the Division. We do not expect Triad will be able to pay any principal or interest on this note for the foreseeable future.
Triad ceased accepting commitments to write new mortgage commitments on July 15, 2008 and is operating in run-off. The risk-to-capital ratio, which is utilized as a measure by many states and regulators of an insurer’s capital adequacy and ability to underwrite new business, is no longer relevant for this purpose to Triad. Generally, states limit a mortgage insurer’s statutory risk-to-capital ratio to 25-to-1. At December 31, 2008, Triad’s statutory risk-to-capital ratio substantially exceeded that level.
For statutory reporting purposes, during 2008 we adopted the reserve requirements as outlined in the Illinois Insurance Code that requires loss reserves be established for all loans that are four or more payments in arrears or in foreclosure. The utilization of these standards results in a smaller reserve recorded for statutory purposes than the reserve recorded in the Company’s GAAP financial statements, which provide reserves on all loans that are three or more months in default. The difference in the two methodologies is approximately $192 million as of December 31, 2008. This accounting change was deemed to be a change in statutory accounting method adopted on a prospective basis, and, accordingly, we recorded a cumulative effect to surplus as of the beginning of 2008 of approximately $107 million. As a result, beginning with the quarter ended September 30, 2008, the net loss and loss adjustment expense reserve reported in Triad’s statutory financial statements has been and will continue to be different than that reported in our GAAP financial statements.
During the second quarter of 2008, we recorded the full impact of the Excess of Loss reinsurance treaty for statutory reporting purposes. We recorded reinsurance recoverables, accrued premiums and expenses in accordance with the terms of the contract, which had the effect of increasing policyholders’ surplus in Triad’s statutory financial statements at June 30, 2008 by approximately $78 million. In accordance with statutory accounting treatment for reinsurance in dispute and past due billed reinsurance recoverable amounts, we recorded an allowance for uncollectible reinsurance of approximately $25 million in the fourth quarter of 2008. At December 31, 2008, we recognized approximately $53 million from the excess of loss reinsurance treaty in policyholders’ surplus for statutory reporting purposes that had not been recognized in the GAAP financial statements.
Our long-term debt has a single maturity date of 2028. The following table represents our aggregate contractual obligations as of December 31, 2008:
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 inventory of loans in default. 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. Our expectations regarding future rescissions have been incorporated into the frequency factor. Severity is the estimate of the dollar amount per claim that will be paid. The severity factors are estimates of the percentage 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.
loss reserves carried on the balance sheet, we have provided the following table that quantifies the impact of percentage increases and decreases in both the average frequency and severity as of December 31, 2008:
The impact on loss reserves on the balance sheet would be to decrease reserves for favorable developments and to increase reserves for unfavorable developments. There would be no impact on liquidity resulting from the change in reserves. However, there would be a change in cash or invested assets equal to the increase or decrease in the ultimate paid claims related to the change in reserves. We believe that a 30% increase or decrease in frequency is reasonably likely based on potential changes in future economic conditions and past experience, although we believe there is a greater propensity during 2009 for an increase in the frequency factor given the current conditions of the housing market. Our loss severity is ultimately limited by the coverage percentage on individual loans but can increase from the current level. We believe that a 15% increase or decrease in severity is reasonably likely based on potential changes in future economic conditions and past experience, although we believe there is a greater propensity during 2009 for an increase in the severity factor given the current conditions of the housing market. Economic conditions that could give rise to an increase in the frequency rate could be a sudden increase or a prolonged period of increase in the unemployment rate or a continued downward trend in home prices while, conversely, an improved housing market, a sudden drop in interest rates or a sustained period of economic and job growth could decrease the frequency rate. Any factor that would affect our ability to sell a home of a borrower in default prior to foreclosure would affect our severity. The most prominent of these would be the value of the underlying home.
Our level of loss reserves as well as our recognition of premium income are both impacted by the estimate of future rescissions in the existing default portfolio. In general, a rescission occurs when an investigation finds that fraud, misrepresentation or other specified violations occurred in the origination of a loan. When this occurs, insurance coverage from the date of issuance is cancelled and all of the previously paid premium is refunded.
We initially established a premium deficiency reserve at March 31, 2008 on our entire book of business, which included a $34.8 million acceleration of DAC amortization in that period. Due to the significant amount of reserves recorded during 2008 on the existing reported defaults, we no longer have a need to record a premium deficiency reserve in addition to those loss reserves already established. However, the estimation of the premium deficiency reserve requires assumptions as to future events, and there are inherent risks and uncertainties involved in making these assumptions. The computation is extremely sensitive to future economic conditions. Economic conditions that have impacted our judgment and affected our computation of the premium deficiency in the past may not necessarily affect development patterns in the future in either a similar manner or degree. There can be no guarantee that we will not be required to establish a premium deficiency reserve in the future.
a deeper or more prolonged recession in the United States coupled with the tightening of the mortgage credit markets could increase defaults and limit opportunities for borrowers to cure defaults or for Triad to mitigate losses, which could have an adverse material impact on our business or results of operations;
whether we ultimately prevail in arbitration with the Excess-of-Loss reinsurance treaty, which will have an impact on our financial performance in run-off;
if house prices continue to fall, additional borrowers may default and claims could be higher than anticipated;
if unemployment rates continue to rise, especially in those areas that have already experienced significant declines in house prices, defaults and claims could be higher than anticipated;
the appointment of FHFA as the conservator of both Fannie Mae and Freddie Mac has resulted in changes in the business practices of the GSEs;
if we have failed to properly underwrite mortgage loans under contract underwriting service agreements, we may be required to assume the costs of repurchasing those loans or face other remedies;