Statements made or incorporated by reference from time to time in this document, other documents filed with the Securities and Exchange Commission, press releases, conferences or otherwise that are not historical facts, or are preceded by, followed by or that include the words “believes,” “expects,” “anticipates,” “estimates” or similar expressions, and that relate to future plans, events or performance are “forward-looking” statements within the meaning of the federal securities laws. Forward-looking statements in this document include our belief that operating income and operating income per share are meaningful measurements of our underlying profits, our belief that the structure of PMI’s modified pool products mitigates the risk of loss to PMI from the less-than-A quality loans and non-traditional loans insured by those products, and our belief that we have sufficient cash to meet all of our short- and medium-term obligations.
We use various measurements to evaluate our business and profitability. In addition to our net income and net income per share, we use operating income and operating income per share to measure our performance. Our operating income represents net income excluding realized investment gains and losses, and non-operating and non-recurring items. Non-operating expenses for the financial periods presented were litigation charges relating to a class action settlement, lease abandonment and relocation costs relating to the relocation of our corporate headquarters, and extraordinary losses relating to the early extinguishment of debt. The non-recurring item for the financial periods presented was the cumulative effect of a change in accounting principle relating to the write-off of negative goodwill. We believe that operating income and operating income per share are meaningful measurements of our underlying profits because operating income represents income from ongoing operations excluding gains or charges that are infrequent or unusual in nature, or one-time events reasonably unlikely to recur. Accordingly, we use operating income and operating income per share to measure the performance of our management team. However, operating income should not be considered in isolation or as a substitute for net income prepared in accordance with GAAP. Our operating income may not be comparable to similarly titled measures used by other companies.
Our consolidated financial results for the years ended December 31, 2002, 2001 and 2000 and reconciliation of the total and per share amounts of net income and operating income are presented in the following table:
Earnings per share calculations are based on the number of common stock shares outstanding on a fully-diluted basis. Per share data has been adjusted to reflect the two-for-one stock split effective on June 17, 2002.
We account for our unconsolidated strategic investments on the equity method of accounting. The growth in equity earnings from our unconsolidated strategic investments in 2002 over 2001 was attributable to the increase in our ownership of Fairbanks to 56.8% as of December 31, 2002 and the expansion of Fairbanks’ special servicing operations, and to securitization activity by Truman Fund. The increase in equity earnings in 2001 over 2000 was due primarily to growth in Fairbanks’ servicing portfolio.
Our losses and underwriting and operating expenses excluded non-operating and non-recurring items as discussed above. Losses and underwriting and operating expenses increased in 2002 over 2001 as the result of higher levels of claims for our U.S. mortgage insurance operations and increased agency commissions for our title insurance operations. The increases in our losses and underwriting and operating expenses in 2001 over 2000 were due primarily to increased expenses related to higher business activity for our title insurance operations and U.S. mortgage insurance operations. More details are provided below in our discussion of the business segments results.
The decrease in interest expense and distributions on the preferred capital securities in 2002 was attributable largely to partial repayment of our long-term debt and preferred capital securities. Approximately $136 million of the proceeds from our convertible debentures offering in July 2001 was used to extinguish portions of our long-term debt and preferred capital securities during the fourth quarter of 2001. The increase in interest expense and distributions on the preferred capital securities in 2001 was due to the overall increase in our total outstanding debt resulting from issuance of the convertible debentures.
Primary new insurance written-PMI issues primary insurance coverage on individual loans at specified coverage percentages. PMI is generally in a first loss position when a borrower defaults on an insured mortgage. PMI’s primary NIW includes insurance that PMI underwrites on a loan-by-loan basis (flow channel) and insurance that PMI acquires in bulk transactions (bulk channel), primarily in the capital mortgage markets. PMI’s NIW does not include primary mortgage insurance placed upon loans more than 12 months after loan origination.
In August 2001, the mortgage insurance industry’s trade association MICA revised several categories of insurance that are reported by mortgage insurers to MICA. These categories included flow channel primary insurance, bulk channel primary insurance and pool insurance. We implemented the definitional changes during the third quarter of 2001, and PMI’s primary NIW and primary insurance in force reported through the third quarter of 2002 were based upon these newly-defined categories. As a result of the implementation of these definitional changes, a portion of the insurance that the mortgage insurance industry had traditionally classified as pool insurance was classified as primary insurance, and certain insurance that traditionally had been classified as primary insurance was classified as pool insurance. Beginning in the fourth quarter of 2002, PMI returned to its traditional definitions of primary insurance and pool insurance that reflect more appropriately the way PMI structures its products and manages its risk. Accordingly, the operating and statistical results in this document, unless otherwise noted, are based on PMI’s definitions. The differences in primary NIW and primary insurance in force under PMI’s definitions and MICA’s definitions, as shown below, are primarily the result of reclassifications of primary insurance and pool insurance. These changes do not impact our consolidated financial results.
PMI’s increases in NIW in 2002 and 2001 were driven by the significantly higher volume of residential mortgage originations in those years, due to the historically low interest rate environment and the pronounced refinance market. Total U.S. residential mortgage originations in 2002 increased by approximately 20% over 2001 to $2.5 trillion, while 2001 total mortgage originations nearly doubled in volume from 2000, as estimated by Mortgage Bankers Association of America.
Pool insurance-PMI provides pool insurance coverage to lenders and investors for risk reduction, capital relief or credit enhancement for capital market mortgage transactions. Pool insurance is typically issued in negotiated GSE and capital market transactions. Prior to 2002, PMI offered pool insurance to two different customer segments: lenders and the GSEs (GSE Pool), and the capital markets (Old Pool). These products insure all losses on individual loans held within a pool of insured loans up to an agreed aggregate amount, or stop loss,
Insurance and risk in force-PMI’s primary insurance in force refers to the current principal balance of all mortgage loans with primary insurance as of a given date. PMI’s primary risk in force is the aggregate dollar
amount equal to the sum of each individual primary insured mortgage loan’s current principal balance multiplied by the percentage of the insurance coverage specified in the policy. Primary insurance in force based on PMI’s definitions and MICA’s definitions, and total risk in force for PMI are shown in the table below:
Primary insurance and risk in force grew moderately in 2002 as a result of high levels of policy cancellations offsetting primary NIW. The growth in 2001 primary insurance and risk in force was driven by a substantial volume of primary NIW, partially offset by policy cancellations. Policy cancellations increased by 30% to $46.6 billion in 2002, and increased by 110% to $35.8 billion in 2001. Downward movements in mortgage interest rates during 2002 and 2001 resulted in heavy mortgage refinancing activity, which caused the increases in PMI’s policy cancellations and the decreases in PMI’s policy persistency in 2002 and 2001. PMI defines persistency as the percentage of insurance policies at the beginning of the 12-month period that remain in force at the end of the month period. PMI’s persistency rate was 56.2% at December 31, 2002, 62.0% at December 31, 2001 and 80.3% at December 31, 2000. The growth in pool risk in force was largely driven by modified pool insurance written in 2002 and 2001.
PMI’s net premiums written and premiums earned increased in 2002 and 2001 despite lower policy persistency. The increase in 2002 was due largely to modified pool insurance written and to primary NIW, offset by higher ceded premiums related to captive agreements. The increase in 2001 was primarily attributable to new primary and modified pool insurance written and the growth of PMI’s primary and modified pool insurance in force as discussed above.
Losses and loss adjustment expenses-PMI’s total losses and loss adjustment expenses represent total claims paid, certain expenses related to default notification and claim processing, and changes in net loss reserves during the corresponding period. We establish loss reserves based upon estimated claim rates and claim sizes for reported mortgage loans in default, as well as estimated defaults incurred but not reported. PMI’s losses and loss adjustment expenses and related claims data are illustrated as follows:
In the third quarter of 2002, we reclassified remedies expenses in connection with contract underwriting services from the U.S. mortgage insurance operations business segment to the Other business segment, including all periods from January 1, 2000. Remedies expenses were $6.5 million in 2002, $3.3 million in 2001 and $2.3 million in 2000.
The increases in primary loans in default and default rates as of December 31, 2002 and 2001 were related to the seasoning and composition of PMI’s portfolios as discussed above, and the weaker U.S. economy. The default rates for bulk transactions at December 31, 2002 and 2001 were higher than the overall primary default rates due primarily to the higher concentration of less-than-A quality and non-traditional loans in PMI’s bulk portfolio.
At December 31, 2002, PMI’s modified pool default rate was 4.30% with 7,176 modified pool loans in default, and PMI’s GSE pool default rate was 1.48% with 6,250 GSE pool loans in default.
Other underwriting and operating expenses consist of all other costs that are not attributable to the acquisition of new policies and are recorded as expenses when incurred. The decrease in 2002 over 2001 was
Ratios-PMI’s loss, expense and combined ratios are illustrated in the following table:
The financial and statistical results of PMI Australia for 2002, 2001 and 2000 were affected by the fluctuation in the exchange rates, the acquisition of PMI Indemnity, the change in the reporting periods, and the cumulative adjustments. We recorded cumulative adjustments for PMI Australia during the fourth quarter of 2002 to conform the results to U.S. GAAP, as described earlier. The net effect of these adjustments was an increase to net income of $1.3 million. The average USD/AUD currency exchange rate was 0.544 in 2002, 0.520 in 2001 and 0.585 in 2000. We completed the acquisition of PMI Indemnity in September 2001, and its results are included in our Australian operations beginning in the fourth quarter of 2001. In 2001, we changed our reporting periods for international operations from a one-month lag to the same calendar month as our domestic operations. Therefore, 2000 financial results reflected eleven months of activity and 2001 financial results reflected thirteen months of activity of PMI Australia.
The table below sets forth net income and operating income for PMI Australia:
PMI Australia’s net income in 2002 included the cumulative effect of a change in accounting principle for the write-off of negative goodwill. The increases in 2002 and 2001 operating income were attributable primarily to growth in premiums earned and a stable loss environment.
The increases in net premiums written in 2002 and 2001 were attributable to the increases in PMI Australia’s NIW and the acquisition of PMI Indemnity. The increases in premiums earned in 2002 and 2001 were due largely to growth in the insurance portfolio.
Underwriting and operating expenses-PMI Australia’s underwriting and operating expenses were $18.4 million in 2002, compared to $11.1 million in 2001 and $7.2 million in 2000. The increases in 2002 and 2001 were primarily due to the acquisition of PMI Indemnity and the change in accounting principle related to negative goodwill. Underwriting and operating expenses in 2002 reflected a $1.0 million reduction in amortization of deferred policy acquisition costs as a result of cumulative adjustments. Underwriting and operating expenses were reduced by the amortization of negative goodwill of $4.5 million in 2001 and $4.7 million in 2000. The remaining balance of negative goodwill was written off in the first quarter of 2002 and was not included as a reduction of 2002 operating expenses. PMI Australia’s expense ratios were 24.7% in 2002, 19.9% in 2001 and 19.6% in 2000.
PMI Europe, which commenced operations in February 2001, generated $1.5 million of net income in 2002 compared to $5.5 million of net income in 2001. Net income in 2002 included premiums earned while net income in 2001 consisted primarily of interest and dividend income and currency re-measurement gains. Currency re-measurement gains and losses represent the revaluation of assets and liabilities held by PMI Europe that are denominated in non-functional currencies into the functional currency, the Euro. Realized investment gains and losses include currency exchange gains and losses when the investments are sold. We manage the investment portfolio held by PMI Europe to meet capital needs and regulatory requirements. PMI Europe incurred realized investment losses of $1.6 million and re-measurement losses of $0.9 million in 2002, compared to realized investment losses of $0.1 million and re-measurement gains of $4.3 million in 2001.
PMI Europe’s investment portfolio at December 31, 2002 totaled $93.1 million compared to $77.9 million at December 31, 2001. The growth of the investment portfolio reflected the appreciation of the Euro relative to the U.S. dollar in 2002. The pre-tax book yield was 4.7% at December 31, 2002 and 3.9% at December 31, 2001. PMI Europe’s portfolio yield improved in 2002 due to the reallocation of money market funds to fixed income securities.
PMI Europe completed three credit default swap transactions in 2002 and two credit default swap transactions in 2001. Such transactions are designed to allow the participating mortgage lenders to reduce their regulatory capital requirements. In each transaction, PMI Europe assumed a specific layer of risk in a portfolio of prime-quality residential mortgages. As of December 31, 2002, PMI Europe had assumed $402.5 million of mortgage default risk on $2.9 billion of mortgages on properties in the United Kingdom, and $136.0 million of default risk on $3.6 billion of mortgages on properties in Germany.
The results of our Other business segment include contract underwriting revenue and related operating expenses of PMI Mortgage Services Co., or MSC, interest and dividend income, interest expense and corporate overhead of our holding company, or The PMI Group, as well as the equity earnings of our unconsolidated strategic investments except CMG, which are included in the results of U.S. mortgage insurance operations.
Our effective tax rate was 28.0% in 2002 compared to 30.2% in 2001 and 30.4% in 2000. The decreases were primarily due to a larger portion of income derived from PMI Australia and Fairbanks, which have lower effective tax rates. Our effective tax rate varies due to changes in statutory tax rates of countries in which foreign subsidiaries generate taxable profits, and to fluctuations in the taxable earnings of those foreign subsidiaries relative to total taxable earnings as a whole. In addition, our effective tax rate is driven by the proportion of tax-exempt earnings relative to total pre-tax income.
The PMI Group’s available funds were $356.5 million at December 31, 2002, an increase from the December 31, 2001 balance of $335.5 million, principally due to dividend payments from PMI and APTIC, offset by our additional investment in Fairbanks and the repurchase of our common stock.
We believe that the Company has sufficient cash to meet all of our short- and medium-term obligations, and we maintain excess liquidity to support our operations. As of December 31, 2002, we had $254.2 million of liquid funds in cash and cash equivalents and short-term investments to meet ongoing cash requirements. In 2002, we reclassified certain highly liquid investments with maturities of three months or less from short-term investments to cash equivalents. The amount of the reclassification was approximately $168 million and $108 million as of December 31, 2002 and 2001, respectively. Our investment portfolios hold primarily investment grade securities comprised of readily marketable fixed income and equity securities. At December 31, 2002, the fair value of our consolidated investment portfolios which are designated as available-for-sale increased to $2.5 billion from $2.3 billion at December 31, 2001 as a result of positive cash flows from consolidated operations. Our investments are recorded at fair value, and the differences between the fair value and amortized cost, net of applicable taxes, are reflected in accumulated other comprehensive income in shareholders’ equity. Our accumulated other comprehensive income consists of changes in unrealized net gains and losses on investments, less realized gains and losses included in net income and currency translation gains and losses, net of deferred taxes.
We have a bank credit line in the amount of $25.0 million with a major financial institution and there are no outstanding borrowings under the credit line. The agreement expires on December 29, 2003. This financial instrument contains certain financial covenants and restrictions, including risk-to-capital ratios and minimum capital and dividend restrictions.
In July 2001, we issued $360.0 million of 2.50% Senior Convertible Debentures. The convertible debentures are due in 2021 and are redeemable at our option beginning in 2006. The holders of the debentures may require us to repurchase the debentures on July 15, 2004, 2006, 2008, 2011 or 2016, and in certain other circumstances, at a price equal to the principal amount thereof plus any accrued and unpaid interest, including contingent interest and additional interest, if any, to the date of purchase. We may choose to pay the purchase price in cash, common stock, or a combination of cash and shares of common stock. If we elect to pay all or a portion of the purchase price in common stock, the shares of common stock will be valued at 97.5% of the average sale price for the 20 trading days ending on the third day prior to the repurchase date. Holders of the debentures may convert their debentures prior to the stated maturity under certain circumstances. Under the terms of the indenture, an event of default would occur upon a failure to pay when due any indebtedness for borrowed money of The PMI Group or any of our “designated subsidiaries,” as defined by the indenture. If there is an event of default on our convertible debentures, the principal amount of our convertible debentures, plus any accrued and unpaid interest, including contingent interest, may be declared immediately due and payable. As of February 28, 2003, PMI, PMI Australia and Fairbanks were designated subsidiaries under the indenture. We cannot necessarily prevent Fairbanks from failing to pay or defaulting on its indebtedness because provisions of an agreement among the shareholders of Fairbanks limit our ability to control Fairbanks’ operations, and also because events of default under the agreements governing Fairbanks’ indebtedness may result from events outside Fairbanks’ or our control, including but not limited to certain actions by rating agencies with respect to Fairbanks’ ratings.
In 2001, PMI executed a capital support agreement, whereby it agreed to contribute funds, under specified conditions, to maintain CMG’s risk-to-capital at or below 18.0 to 1. PMI’s obligation under the agreement is limited to an aggregate amount of $37.7 million, exclusive of capital contributions made prior to April 10, 2001. On December 31, 2002, CMG’s risk-to-capital ratio was 14.2 to 1.
PMI has entered into various capital support agreements with its European and Australian subsidiaries for ratings agency purposes that could require PMI to make additional capital contributions to those subsidiaries. In the capital support agreement with its Australian subsidiary, PMI Ltd, PMI has agreed to maintain PMI Ltd’s net assets, as defined by Australian insurance law, at a prudent level of capital but, in any event, not less than 2% of PMI Ltd’s net aggregate risk, as that term is defined by the agreement, plus $50,000,000 Australian dollars. For rating agency purposes, PMI has agreed that the support required by the phrase “a prudent level of capital” is all amounts necessary to maintain PMI Ltd’s stand-alone financial strength rating at not less than “A.” In addition, PMI agreed to provide funds to PMI Ltd to ensure that PMI Ltd is able to meet its obligations under its insurance policies. In no event, however, shall the amounts payable cause PMI to become insolvent or fall below the minimum capital requirements under Arizona law. The agreement continues indefinitely but may be terminated by mutual agreement of PMI and PMI Ltd at any time. Such termination shall not, however, adversely affect the rights of PMI Ltd policyholders that accrued prior to such termination.
In the capital support agreement with its Australian subsidiary, PMI Indemnity, PMI has agreed to maintain PMI Indemnity’s net assets at a prudent level of capital but, in any event, not less than 2% of PMI Indemnity’s net aggregate risk. For rating agency purposes, PMI has agreed that the support required by the phrase “a prudent level of capital” is all amounts necessary to maintain PMI Indemnity’s stand-alone financial strength rating at not less than “A-.” PMI also agreed to provide funds to PMI Indemnity to ensure that it is able to meet its obligations under its insurance policies. In no event, however, shall the amounts payable cause PMI to become insolvent or fall below the minimum capital requirements under Arizona law. The agreement with PMI Indemnity continues indefinitely but may be terminated upon terms similar to those contained in the PMI Ltd capital support agreement.
Under the terms of PMI’s capital support agreement with PMI Europe, PMI has agreed to provide funds, as necessary, to ensure that PMI Europe is able to meet its obligations in respect of all contracts of insurance when such obligations are due and to maintain PMI Europe’s minimum capital at an amount sufficient to maintain its S&P and Moody’s ratings at “AA-” and “Aa3.” The agreement may be terminated or amended by written agreement of PMI and PMI Europe, but any amendment that adversely affects insureds will not be effective as to insurance contracts entered into prior to such amendment. The PMI Group guarantees the obligations of PMI under its capital support agreements with PMI Ltd, PMI Indemnity and PMI Europe.
are earned in proportion to the expiration of the underlying risk. A portion of single premiums are recognized in income in the current period, with the remaining portion deferred as unearned premiums and earned over the expected policy terms. The earning cycle for single premiums is a range of seven to 15 years. The premiums earning process begins with the notification of risk generally upon receipt of initial premium payment.
We recognize earnings for single premiums based on expiration of risk to match premiums earned with the related risk. Generally risk is higher in the earlier years of each policy, and thus we recognize a greater portion of premium earnings in the earlier years of a policy life. Single premiums written accounted for approximately 10% of gross premiums written from mortgage insurance operations in 2002. The earnings pattern calculations are based on estimated expiration of risk and, accordingly, we review our premium earnings cycle regularly and any adjustments to the estimates are reflected in the current year’s operating results.
In 2001, we refined the loss reserve estimation process of our international mortgage insurance operations to be based upon a methodology and estimates consistent with those applied to our U.S. operations. In connection with the refinement in the provisioning policy, we updated the assumptions used to determine the rates of premiums earned and shortened the duration of the expected policy life of single premium products, which resulted in an acceleration of earnings in the first two policy years.
Title insurance premiums are recognized as revenue on the effective date of the title insurance policy. Fee income of the non-insurance subsidiaries is earned as the services are provided.
A significant percentage of the premiums we earn each year is generated from insurance policies that we have written in previous years. As a result, the length of time that insurance remains in force is an important determinant of PMI’s revenues. Under certain of our master policies, the policy owner or servicer of the loan may cancel insurance coverage at any time. In addition, the Homeowners Protection Act of 1998 provides for the automatic termination or cancellation of mortgage insurance upon a borrower’s request if specified conditions are satisfied. Factors that tend to reduce the length of time that PMI’s insurance remains in force include:
current mortgage interest rates falling below the rates on the mortgages underlying PMI’s insurance in force, which frequently results in borrowers refinancing their mortgages and canceling their existing mortgage insurance;
If the volume of low down payment home mortgage originations declines, the amount of insurance that we write could also decline, which could result in a decline in our future revenue.
the health of the domestic economy as well as conditions in regional and local economies;
consumer confidence, which may be adversely affected by economic instability, war or terrorist events;
the rate of home price appreciation, which in times of heavy refinancing affects whether refinance loans have loan-to-value ratios that require private mortgage insurance; and
Since we generally cannot cancel mortgage insurance policies or adjust renewal premiums, our financial performance could suffer.
other private mortgage insurers, some of which are subsidiaries of well-capitalized, diversified public companies with direct or indirect capital reserves that provide them with potentially greater resources than we have;
mortgage lenders that choose not to insure against borrower default, self-insure through affiliates or offer residential mortgage products that do not require mortgage insurance.
If we are unable to compete successfully, our business will suffer.
mortgage lenders maintaining lender recourse or participation with respect to loans sold to the GSEs;
investors using credit enhancements other than private mortgage insurance or using other credit enhancements in conjunction with reduced levels of private mortgage insurance coverage; and
The OFHEO risk-based capital rule may allow large financial entities such as banks, financial guarantors, insurance companies and brokerage firms to provide or arrange for products that may efficiently substitute for some of the capital relief provided to the GSEs by private mortgage insurance. Many of these entities have significantly more capital than we have and a few have “AAA” ratings. The ability of these companies to offer or arrange for the products described above will be dependent upon, among other things, how the OFHEO risk-based capital rule is interpreted and administered and the willingness of the GSEs to utilize such forms of credit enhancement. Our financial condition and results of operations could be harmed if the GSEs were to use these products in lieu of mortgage insurance.
Legislation and regulatory changes may reduce demand for private mortgage insurance, which could harm our business.
Increases in the maximum loan amount or other features of the FHA mortgage insurance program can reduce the demand for private mortgage insurance. Legislative and regulatory changes have caused, and may cause in the future, demand for private mortgage insurance to decrease and this could harm our financial condition and results of operations.
PMI depends on a small number of customers and our business and financial performance could suffer if PMI were to lose the business of a major customer.
The GSEs are the beneficiaries on a substantial majority of the insurance policies we issue as a result of their purchases of home loans from lenders or investors. The GSEs offer programs that require less mortgage insurance coverage on mortgages approved by their automated underwriting systems. If the reduction in required levels of mortgage insurance becomes widely accepted by mortgage lenders, or if they further reduce mortgage insurance coverage requirements for loans they purchase, PMI’s premium revenue would decline and our financial condition and results of operations could suffer.
In the past, Freddie Mac has sought a permanent charter amendment that would allow it to utilize alternative forms of default loss protection or otherwise forego the use of private mortgage insurance on higher loan-to-value mortgages. Fannie Mae has announced its intention to increase its share of revenue associated with the management of mortgage credit risk and interest rate risk by retaining mortgage credit risk previously borne by a number of other parties, including mortgage insurers. The reduction by the GSEs in their use or required level of mortgage insurance could reduce our revenue.
Together with the GSEs and mortgage lenders, we jointly develop and make available various products and programs. These arrangements involve the purchase of PMI’s mortgage insurance products and frequently feature cooperative arrangements between the parties. In 1999, a coalition of financial services and housing-related trade associations, including the Mortgage Insurance Companies of America and several large mortgage lenders, formed FM Watch, a lobbying organization that supports federal oversight of the GSEs. The GSEs in turn have criticized the activities of FM Watch. These activities could polarize Fannie Mae, Freddie Mac and members of FM Watch as well as PMI’s customers and us. As a result of any such polarization, PMI’s relationships with the GSEs could limit PMI’s opportunities to do business with some mortgage lenders. Conversely, PMI’s relationships with these large mortgage lenders could limit PMI’s ability to do business with the GSEs. Either of these outcomes could harm our financial condition and results of operations.
Fannie Mae is in the process of revising its approval requirements for mortgage insurers, including PMI. We have been in discussions with Fannie Mae about its proposed guidelines, and we anticipate that the new requirements will be finalized during 2003 to be effective at a later date. The guidelines as proposed would cover substantially all areas of PMI’s mortgage insurance operations, require the disclosure of certain activities and new products, allow for other approved types of mortgage insurers rated below “AA,” and give Fannie Mae increased rights to revise the eligibility standards of mortgage insurers. We do not know what form the eligibility guidelines will ultimately take or whether any new guidelines will be issued.
The U.S. Housing and Urban Development Department, or HUD, has proposed the Real Estate Settlement Procedures Act of 1974, or RESPA, Proposed Rule to Simplify and Improve the Process of Obtaining Mortgages to Reduce Settlement Costs to Consumers, or RESPA Rule, which if implemented would give lenders and other packagers the option of offering a Guaranteed Mortgage Package, or GMP, or providing a good faith estimate of settlement costs subject to a 10% tolerance level. To promote the use of a GMP, qualifying packages would be entitled to a “safe harbor” from litigation under RESPA’s anti-kickback rules. Mortgage insurance and title insurance are included in the package to the extent an upfront premium is charged. This could encompass some, but not all, of the premiums charged by a mortgage insurer or a title insurer with respect to a single loan. Inclusion in the package could cause settlement service providers, such as mortgage insurers and title insurers, to experience reductions in the prices of their services or products. The public comment period on the RESPA Rule terminated on October 28, 2002. The Mortgage Insurance Companies of America submitted comments on behalf of the mortgage guaranty insurance industry, including PMI. The American Land Title Association, the trade association for title insurers, also submitted comments on behalf of its members, including our title insurance company American Pioneer Title Insurance Company. We do not know what form the final rule will ultimately take. HUD has stated that it intends to publish the final RESPA Rule in the spring of 2003.
PMI’s customers have indicated an increasing demand for captive mortgage reinsurance agreements. Under these agreements, a reinsurance company, which is usually an affiliate of the customer, assumes a portion of the mortgage insurance default risk on mortgage loans originated by the customer in exchange for a portion of the insurance premiums. An increasing percentage of PMI’s new insurance written is being generated by customers with captive reinsurance companies, and we expect that this trend will continue. An increase in captive mortgage reinsurance agreements will decrease PMI’s net premiums written, which may negatively impact the yield that we obtain on net premiums earned for customers with captive mortgage reinsurance agreements. If we do not provide PMI’s customers with acceptable risk-sharing structured transactions, including potentially increasing levels of premium cessions in captive mortgage reinsurance agreements, PMI’s competitive position may suffer.
PMI’s primary risk in force consists of mortgage loans with high loan-to-value ratios, which generally result in more claims than mortgage loans with lower loan-to-value ratios.
7% of PMI’s primary risk in force consisted of mortgages with loan-to-value ratios greater than 95% but less than or equal to 97%, which we refer to as 97s. In our experience 97s have higher claims frequency rates than 95s. We also insure mortgages with loan-to-value ratios greater than 97%, which we believe have claims frequency rates higher than 97s. In 2002, 2.7% of PMI’s primary risk in force consisted of mortgages with loan-to-value ratios greater than 97%
In addition to being affected by nationwide economic conditions, we could be particularly affected by economic downturns in specific regions of the United States where a large portion of PMI’s business is concentrated. In addition, refinancing of mortgage loans can have the effect of concentrating PMI’s insurance in force in economically weaker areas because mortgages in areas experiencing appreciation of home values are less likely to require mortgage insurance at the time of refinancing than are mortgages in areas experiencing limited or no appreciation of home values.
The majority of PMI’s new insurance written is underwritten pursuant to a delegated underwriting program. Once a mortgage lender is accepted into PMI’s delegated underwriting program, that mortgage lender may determine whether mortgage loans meet PMI’s program guidelines and may commit us to issue mortgage insurance. We expect to continue offering delegated underwriting to approved lenders and may expand the availability of delegated underwriting to additional customers. If an approved lender commits us to insure a mortgage loan, we may not refuse to insure, or rescind coverage on, that loan even if we reevaluate that loan’s risk profile or the lender failed to follow PMI’s delegated underwriting guidelines, except in very limited circumstances. Therefore, an approved lender could cause us to insure mortgage loans with unacceptable risk profiles prior to PMI’s termination of the lender’s delegated underwriting authority.
We provide contract underwriting services for a fee. These services help PMI’s customers to improve the efficiency and quality of their operations by outsourcing all or part of their mortgage loan underwriting to us. As
a part of PMI’s contract underwriting services, we provide monetary and other remedies to PMI’s customers in the event that we fail to properly underwrite a mortgage loan. Such remedies may include:
Generally, the scope of these remedies is in addition to those contained in PMI’s master policies. The number of remedies we provided in 2002 increased compared to 2001. Worsening economic conditions or other factors that could continue to increase PMI’s default rate could also cause the number and severity of the remedies that must be offered by PMI’s wholly-owned subsidiary, PMI Mortgage Services Co., to increase. Such an increase could have a material effect on our financial condition or results of operations. There are limitations on the number of available underwriting personnel and heavy price competition among mortgage insurance companies. PMI’s inability to recruit and maintain a sufficient number of qualified underwriters or any significant increase in the cost we incur to satisfy PMI’s underwriting services obligations could harm our financial condition and results of operations.
From time to time, we introduce new mortgage insurance products or programs. Our competitive position and financial performance could suffer if we experience delays in introducing competitive new products and programs or if these products or programs are less profitable than our existing products and programs.
PMI’s settlement in the Baynham litigation contains a three-year injunction terminating on December 31, 2003 which relates, in part, to the terms upon which we offer certain products and services. As some of PMI’s competitors have not agreed to abide by the terms of the injunction, PMI’s compliance with the injunction could inhibit its ability to compete with respect to the offering of new products and structures through the end of this year, and this could have a material adverse effect upon our financial condition and results of operations.
If our claims-paying ability is downgraded below “AA-”, mortgage lenders and the mortgage securitization market may not purchase mortgages or mortgage-backed securities insured by us, which could materially harm our financial performance.
The claims-paying ability of PMI, our largest wholly-owned subsidiary, is currently rated “AA+” (“excellent”) by Standard and Poor’s, or S&P, “Aa2” (“excellent”) by Moody’s Investor Service, or Moody’s, and “AA+” (“very strong”) by Fitch Ratings, or Fitch. These ratings may be revised or withdrawn at any time by one or more of the rating agencies. These ratings are based on factors relevant to PMI’s policyholders and are not applicable to our common stock or outstanding debt. The rating agencies could lower or withdraw our ratings at any time as a result of a number of factors, including:
other adverse developments in PMI’s financial condition or results of operations; or
If PMI’s claims-paying ability rating falls below “AA-” from S&P or “Aa3” from Moody’s, investors, including Fannie Mae and Freddie Mac, will not purchase mortgages insured by us, which would seriously harm our financial condition and results of operations. In January 2003, Fitch announced that it had revised its rating outlook for the U.S. private mortgage insurance industry from “Stable” to “Negative,” due to a variety of factors affecting the industry’s long-term fundamentals. Fitch currently maintains a “Stable” rating outlook on all eight U.S. private mortgage insurers, including PMI, but it has stated that it may change some insurers’ rating outlooks to “Negative” in 2003.
Our ongoing ability to pay dividends to our stockholders and meet our obligations primarily depends upon the receipt of dividends and returns of capital from our insurance subsidiaries and our investment income.
the level and severity of claims experienced by our insurance subsidiaries;
Any significant change in these factors could prevent us from being able to maintain the capital resources required to meet our business needs.
limitations under the runoff support agreement with Allstate Insurance Company, which prohibit PMI from paying any dividends if, after the payment of the dividend, PMI’s risk-to-capital ratio would equal or exceed 23 to 1;
capital requirements necessary to maintain our credit ratings and PMI’s claims-paying ability ratings.
Generally, the methodology used by the rating agencies to assign credit or claims-paying ability ratings permits less capital leverage than under statutory or other requirements. Accordingly, we may be required to meet capital requirements that are higher than statutory or other capital requirements to satisfy rating agency requirements.
economic downturns in the foreign mortgage origination markets targeted, particularly the economies of Australia and Europe;
Fairbanks, which is the parent company of Fairbanks Capital, a third-party servicer of single-family residential mortgages specializing in the resolution of nonperforming, subperforming, subprime, Alternative A and home equity loans;
RAM Re Holdings, which are the holding companies for RAM Re, a financial guaranty reinsurance company based in Bermuda;
Truman, which is the general partner and majority-owner of Truman Fund, a purchaser of residential whole loans.
State and federal banking regulatory agencies, state attorneys general offices, the Federal Trade Commission, the U.S. Department of Justice, the U.S. Department of Housing and Urban Development and state and local governmental authorities have increased their focus on lending and servicing practices in the subprime lending industry. State, local and federal governmental agencies have imposed sanctions for practices, including, but not limited to, charging borrowers excessive fees and failing to adequately disclose the material terms of loans or servicing or collection requirements to borrowers. It is possible that in the future, state, local or federal authorities will seek to require changes in Fairbanks’ business, including reimbursement to borrowers of fees previously charged, impose fines on Fairbanks, or move to revoke its licenses to operate as a servicing organization.
RAM Re is also subject to various risks. For example, RAM Re could be harmed by a downgrade or withdrawal of its claims paying ratings by one or more of the rating agencies or failing to establish itself as a significant market participant since it is currently the smallest of the financial guaranty reinsurers.
Our unconsolidated strategic investments could also be harmed by interest rate volatility, the loss of key personnel and their failure to execute their future business plans. Fairbanks could also be harmed by a devaluation of its servicing portfolio.
We do not control the companies in which we strategically invest. Accordingly, we are entirely dependant upon their management to operate their businesses. We may never realize any return on these investments and we may suffer a complete loss of these investments, which could materially and adversely affect our financial condition and results of operations.
Under the terms of the indenture for our 2.5% Senior Convertible Debentures due July 15, 2021, an event of default would occur upon a failure to pay when due, or a default that results in the acceleration of, any indebtedness for borrowed money of The PMI Group or of our designated subsidiaries in an aggregate amount of $25 million or more, unless the acceleration is rescinded, stayed or annulled within 30 days after written notice of default is given to us. If there is an event of default on our convertible debentures, the principal amount of our convertible debentures, plus any accrued and unpaid interest, including contingent interest, may be declared immediately due and payable. Under the indenture, “designated subsidiaries” means PMI, PMI Australia, PMI Mortgage Insurance Australia (Holdings) Pty Limited, or PMI Australia Holdings, and any other existing or future, direct or indirect, subsidiary of The PMI Group whose assets constitute 15.0% or more of the total assets of The PMI Group on a consolidated basis. Under the indenture, a company is a “subsidiary” of The PMI Group if we own or control at least a majority of its outstanding voting stock. As of February 28, 2003, PMI, PMI Australia, PMI Australia Holdings and Fairbanks were designated subsidiaries of The PMI Group for purposes of the indenture.
We cannot necessarily prevent Fairbanks from failing to pay or defaulting on its indebtedness because provisions of an agreement among the shareholders of Fairbanks limit our ability to control Fairbanks’ operations, and also because events of default under the agreements governing Fairbanks’ indebtedness may result from events outside Fairbanks’ or our control. For example, under some of these agreements, a default may
While we intend to protest the tax assessments we received in 2002 and 2003, and any future assessment we may receive, from the California Franchise Tax Board, there can be no assurance as to the ultimate outcome of these protests.
In the fourth quarter of 2002, we received a notice of assessment from the California Franchise Tax Board, or FTB, for 1997 in the amount of $2.8 million, not including the federal tax benefits from the payment of such assessment or interest that might be included on amounts, if any, ultimately paid to the FTB. In the first quarter of 2003, we received a second notice of assessment from the FTB for the years 1998 through 2000 in the amount of $11.1 million, not including federal tax benefits or interest. The assessments are the result of a memorandum issued by the FTB in April 2002. The memorandum, which is based partly on the California Court of Appeals decision in Ceridian v. Franchise Tax Board, challenges the exclusion from California income tax of dividends received by holding companies from their insurance company subsidiaries during the tax years ended on or after December 1, 1997. While we intend to protest the current and any future assessments, we cannot assure you as to the ultimate outcome of these protests.
Consolidated Statements of Cash Flows for the years ended December 31, 2002, 2001 and
The accompanying consolidated financial statements include the accounts of The PMI Group, Inc. (“TPG”), a Delaware corporation; its direct and indirect wholly-owned subsidiaries, PMI Mortgage Insurance Co. (“PMI”), an Arizona corporation; American Pioneer Title Insurance Company (“APTIC”), a Florida corporation; PMI Ltd and PMI Indemnity (collectively, “PMI Australia”), Australian mortgage insurance companies; PMI Europe, an Irish insurance corporation; and other insurance, reinsurance and non-insurance subsidiaries. TPG and its subsidiaries are collectively referred to as the “Company.” The Company has equity interests in CMG Mortgage Insurance Company (“CMG”), which conducts residential mortgage insurance business; Fairbanks Capital Holding Corp. (“Fairbanks”), a servicer of single-family residential mortgages; Truman Capital Founders, LLC (“Truman”), and RAM Holdings Ltd. and RAM Holdings II Ltd. (collectively, “RAM Re”), financial guaranty reinsurance companies based in Bermuda. The Company’s percentage ownership of voting and non-voting equity securities of Fairbanks, CMG, RAM Re, and Truman as of December 31, 2002 were 56.8%, 50.0%, 24.9% and 19.6%, respectively. Because the Company has significant but not controlling interests in these entities they are accounted for on the equity method of accounting in the Company’s consolidated financial statements in accordance with accounting principles generally accepted in the United States (“GAAP”). The results of Fairbanks and Truman are reported on a one-month lag basis, and RAM Re is reported on a quarter lag basis. All material intercompany transactions and balances have been eliminated in consolidation.
Business-The Company, through its subsidiaries, primarily writes residential mortgage guaranty insurance, or primary insurance, and mortgage pool insurance, or pool insurance. In addition, the Company writes title insurance through its title insurance subsidiary, APTIC. Primary insurance and pool insurance provide protection to mortgage lenders against losses in the event of borrower default and assist lenders and investors in selling mortgage loans in the secondary market. Title insurance protects mortgagors and lenders against losses resulting from title defects, liens and encumbrances in existence as of the effective date of the policy. The Company currently employs contract underwriters to underwrite loans in connection with our mortgage insurance operations as directed by certain mortgage originators. The Company receives a fee from the mortgage originator for underwriting services.
Risks and uncertainties-PMI is dependent upon mortgage originators in order to insure mortgage loans. In the event any of its top ten customers choose to stop providing PMI with mortgage loans to insure, the Company’s ability to generate new insurance business could be adversely affected. Our U.S. mortgage insurance operations’ top ten customers generated approximately 44% of its premiums earned in 2002.
The Company’s various U.S. insurance subsidiaries are subject to comprehensive federal and state regulation. The Company’s Australian and Irish insurance subsidiaries are subject to similarly comprehensive regulation. These regulations are generally intended to protect policyholders, rather than to benefit investors. Although their scope varies, applicable laws and regulations grant broad powers to supervisory agencies or officials to examine companies and to enforce rules or exercise discretion touching almost every significant aspect of the insurance business. The licensing of the Company’s insurance subsidiaries, their premium rates, their forms and policies offered to customers, their financial statements and periodic financial reporting, and their permissible investments and adherence to financial standards relating to statutory surplus, dividends to the Company and other criteria of solvency are all subjects of detailed regulation.
The Company does not control Fairbanks and cannot prevent Fairbanks from defaulting on its indebtedness. Such a default could under certain circumstances constitute an event of default under the indenture relating to the Company’s convertible debentures. Upon the occurrence of an event of default, the Company may not have sufficient funds to pay the amounts due under the convertible debentures. If the Company does not have sufficient funds on hand or available to it through the declaration and payment of dividends by its subsidiaries (which dividends are subject to significant restrictions), the Company would need to seek additional financing to obtain the cash due on the convertible debentures. Additional financing may not be available in the amounts necessary or on favorable terms.
Cash and Cash Equivalents-The Company considers all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents. The Company reclassified all cash equivalents previously reflected as short-term investments to conform to the current year presentation. The amount reclassified was approximately $168 million as of December 31, 2002 and approximately $108 million as of December 31, 2001.
The Company’s short-term investments have maturities of greater than three and less than 12 months when purchased and are carried at fair value. Realized gains and losses on sales of investments are determined on a specific-identification basis. Investment income consists primarily of interest and dividends. Interest income is recognized on an accrual basis and dividend income is recorded on the date of declaration.
Under the provisions of Statement of Position (“SOP”) No. 98-1, Accounting for the Cost of Computer Software Developed or Obtained for Internal Use, the Company capitalizes costs incurred during the application development stage related to software developed for internal use purposes and for which it has no substantive plan to market externally. Capitalized costs are amortized on a straight-line basis over the estimated useful life of the asset at such time as the software is ready for its intended use, generally three to five years. As a result, the Company capitalized costs associated with software developed for internal use of $25.2 million in 2002, $16.1 million in 2001 and $16.3 million in 2000.
Losses and Loss Adjustment Expenses-The reserves for mortgage guaranty insurance losses and loss adjustment expenses are the estimated claim settlement costs on notices of default that have been received by the Company, as well as loan defaults that have been incurred but have not been reported by the lenders. SFAS No. 60 specifically excludes mortgage guaranty insurance from its guidance relating to reserves for losses. Consistent with industry accounting practices, the Company does not establish loss reserves for future claims on insured loans that are not currently in default. The Company establishes loss reserves on a case-by-case basis when insured loans are identified as currently in default using estimated claim rates and average claim sizes for each report year, net of salvage recoverable. The Company also reserves for defaults that have been incurred but have not been reported to the Company prior to the close of an accounting period, using estimated claim rates and claim sizes for the estimated number of defaults not reported.
In 2001, the Company refined the loss reserve estimation process of its international mortgage insurance operations to be based upon a default model consistent with the process of its U.S. subsidiaries. In connection with the refinement in the provisioning policy and premium earning estimates, the Company updated the assumptions used to determine the rates of premiums earned and shortened the duration of the expected policy life of single premium products, which resulted in an acceleration of earnings in the first two policy years. The new methodology and estimates are consistent with those applied to the U.S. mortgage insurance operations.
Title insurance premiums are recognized as revenue on the effective date of the title insurance policy. Fee income of the non-insurance subsidiaries is earned as the services are provided including contract underwriting. Contract underwriting revenue is recorded in other income.
the Company’s actuarial analysis of the applicable business. Amounts the Company will ultimately recover could differ materially from amounts recorded as reinsurance recoverable. Reinsurance transactions are recorded in accordance with the provisions of the reinsurance agreements and the accounting guidance provided in SFAS No. 113, Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts. Reinsurance recoverable on paid losses was $3.8 million at December 31, 2002, $6.1 million at December 1, 2001 and $9.2 million at December 31, 2000. Prepaid reinsurance premiums were $1.5 million in 2002, $1.6 million in 2001 and $1.8 million in 2000.
Derivatives-Derivative financial instruments are reported at fair value. Changes in the fair value of derivatives are recorded each period in earnings or other comprehensive income, depending on whether the derivative is designated a fair value or cash flow hedge transaction. In order to qualify as a hedge transaction for accounting purposes the Company must demonstrate that the hedge is effective. Gains or losses on derivative instruments reported in other comprehensive income are reclassified to earnings in the period in which earnings are affected by the underlying hedged item, and the ineffective portion of hedges are recognized in earnings in the current period.
The Company’s use of derivative financial instruments is generally limited to reducing its exposure to interest rate risk and currency exchange risk by utilizing interest rate and currency swap agreements that are accounted for as hedges. Hedge accounting requires a hedge to be effective which means there is a high correlation between changes in fair value or cash flows of the derivative instrument and the specific item being hedged, both at inception and throughout the life of the hedge. In 1999, the Company entered into an interest rate swap to hedge interest rate risk associated with the debt obtained to finance the acquisition of PMI Mortgage Insurance Ltd. (“PMI Ltd”). This interest rate swap was terminated in July 2001 when the Company repaid the associated debt, and the termination of the swap resulted in a realized loss of $0.8 million. The Company did not enter into any transaction involving derivative instruments for the year ended December 31, 2002.
Stock-Based Compensation-The Company accounts for stock-based compensation to employees and directors using the intrinsic value method prescribed in Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”), and its related interpretations. Under APB 25, compensation cost for stock-based awards is measured as the excess, if any, of the market price of the underlying stock on the grant date over the employees’ excise price of the stock options. As all options have been granted
with an exercise price equal to the fair value at the date of the grants, no compensation expense has been recognized for the Company’s stock option program. SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS No. 123”), requires the pro forma disclosure of net income and earnings per share using the fair value method, and provides that the employers may continue to account for the stock-based compensation under APB 25.
The fair value of stock-based compensation to employees is calculated using the option pricing models that are developed to estimate the fair value of freely tradable and fully transferable options without vesting restrictions, which differ from the Company’s stock option program. These models also require subjective assumptions, including future stock price volatility and expected time to exercise, which greatly affect calculated value.
Income Taxes-The Company accounts for income taxes using the liability method in accordance with SFAS No. 109, Accounting for Income Taxes. The liability method measures the expected future tax consequences of temporary differences at the enacted tax rates applicable for the period in which the deferred
The following is a reconciliation of the weighted-average common shares used to calculate basic EPS to the weighted-average common shares used to calculate diluted EPS for the years ended December 31, 2002, 2001 and 2000:
The table below indicates the pro forma effects of removal of negative goodwill write-off and amortization for the three years ended December 31, 2002, 2001 and 2000:
In April 2002, FASB issued SFAS No. 145, “Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections” which eliminated the exception to applying APB Opinion No. 30, Reporting the Results of Operations Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions (“Opinion 30”) to all gains and losses related to extinguishments of debt. As a result, gains and losses from extinguishment of debt will be classified as extraordinary items only if they meet the criteria in Opinion 30. Applying the provisions of Opinion 30 will distinguish transactions that are part of an entity’s recurring operations from those that are unusual or infrequent or that meet the criteria for classification as an extraordinary item. The provisions of this statement relating to the rescission of SFAS No. 4 are effective for fiscal years beginning after May 15, 2002. Certain provisions of the statement relating to SFAS No. 13 are effective for transactions occurring after May 15, 2002. All other provisions of the statement are effective for financial statements issued on or after May 15, 2002. The Company believes that the provisions of this statement will have an impact on its results of operations only in the event of future early extinguishment of debt.
In July 2002, FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities which requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. Previous accounting guidelines required that a liability for an exit cost be recognized at the date of an entity’s commitment to an exit plan. SFAS No. 146 also establishes that fair value is the objective for initial measurement of the liability. SFAS No. 146 is effective for exit or disposal activities initiated after December 31, 2002 with earlier application permitted. During the second quarter of 2002, the Company recorded a liability of $12.2 million under the previous accounting guidelines related to its relocation to the new corporate headquarters. The Company does not believe SFAS No. 146 will have a material impact on its financial position or results of operations.
No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The transition guidance and annual disclosure provisions of SFAS No. 148 are effective for fiscal years ending after December 15, 2002. The interim disclosure provisions are effective for financial reports containing financial statements for interim periods beginning after December 15, 2002. Although the Company has not currently elected to expense the fair value of stock options granted, this alternative continues to be evaluated. If the Company elects to adopt SFAS No. 148, the impact on its financial position and results of operations are expected to be consistent with SFAS No. 123 pro forma disclosure included in the financials.
Fair Values and Gross Unrealized Gains and Losses on Investments-The cost or amortized cost, estimated fair value, and gross unrealized gains and losses on investments are shown in the table below:
Scheduled Maturities-The following table sets forth the amortized cost and fair value of fixed income securities by contractual maturity at December 31, 2002:
Actual maturities may differ from those scheduled as the result of calls or prepayments by the issuers prior to maturity.
Realized Investment Gains and Losses-Net realized gains and losses on investments are composed of:
Investment Concentrations and Other Items- The Company maintains a diversified portfolio of municipal bonds. The following states represent the largest concentrations in the municipal bond portfolio, expressed as a percentage of the carrying value of all municipal bond holdings. Holdings in states that exceed 5% of the municipal bond portfolio at December 31, for the respective years are presented below:
In March 2002, the Company entered into an agreement with a customer to provide mortgage insurance coverage for three years on a pool of loans; the Company received funds to cover future claim payments on these loans. The transaction does not transfer insurance risk. Accordingly, the contract is being accounted for under the guidelines of SOP 98-7, Deposit Accounting: Accounting for Insurance and Reinsurance Contracts That Do Not Transfer Risk (“SOP 98-7”). As of December 31, 2002, $11.7 million of deposits received under this agreement were included in cash and cash equivalents, and can only be utilized to pay claims related thereto.
The following table sets forth the cost basis and accumulated depreciation of property and equipment for the years ended December 31, 2002 and December 31, 2001:
Depreciation and amortization expense related to property and equipment totaled $17.8 million in 2002, $10.6 million in 2001 and $7.1 million in 2000.
The following table provides a reconciliation of the beginning and ending reserves for losses and loss adjustment expenses for each of the last three years:
The increases in 2002 and 2001 losses and loss adjustment expenses incurred were due, in part, to the economic downturn and corresponding increases in claims paid. Primary insurance default inventory increased to 36,537 at December 31, 2002, compared to 25,228 at December 31, 2001 and 18,093 at December 31, 2000. The default rate was 4.18% at year-end 2002, up from 2.86% at year-end 2001 and 2.21% at year-end 2000. Generally it takes approximately twelve to thirty six months from the receipt of a default notice to result in a claim payment. Therefore, most losses paid related to default notices received in prior years.
Debentures are due on July 15, 2021 and bear interest at a rate of 2.50% per annum. The Company pays interest on the Debentures on January 15 and July 15 of each year, beginning January 15, 2002, and additional contingent interest under certain circumstances. The Debentures may be convertible at the registered holders’ option, prior to stated maturity, into shares of the Company’s common stock at an initial conversion price of $44.16 per share if specified requirements are met, subject to adjustments in specified circumstances. The most significant requirement for such conversion is that the trading price of the Company’s common stock must exceed 120% of the initial conversion price for 20 consecutive trading days within a 30 day trading period. The Company may redeem some or all of the Debentures on or after July 15, 2006 for a price equal to the principal amount of the Debentures plus any accrued and unpaid interest. The holders may put the Debentures to the Company on July 15, 2004, 2006, 2008, 2111 and 2116. Upon a change of control of the Company, holders may also require the Company, subject to certain conditions, to repurchase all or a portion of the Debentures. The Company may repurchase the Debentures with cash, common stock, or a combination of cash and shares of common stock. If we elect to pay all or a portion of the purchase price in common stock, the shares of common stock will be valued at 97.5% of the average sale price for twenty trading days ending on the third day prior to the repurchase date.
Senior Notes-In November 1996, the Company issued unsecured debt securities in the face amount of $100.0 million (“Notes”). The Notes mature and are payable on November 15, 2006 and are not redeemable prior to maturity. No sinking fund is required or provided for prior to maturity. Interest on the Notes is 6¾% and is payable semiannually. In 2001, the Company repurchased $37.1 million of the Notes, resulting in an extraordinary loss of $1.9 million, net of tax.
Revolving Credit Facility-The Company has a credit line in the amount of $25.0 million with Bank of America and there are no outstanding borrowings under the credit line. The interest rate is the specified spread to LIBOR based on the Company’s credit ratings at the time of borrowing. The agreement expires on December 29, 2003. This financial instrument contains certain financial covenants and restrictions, the most restrictive being risk-to-capital ratios and minimum capital and dividend restrictions. The Company was in compliance with all debt covenants as of and for the year ended December 31, 2002.
During 1999, PMI entered into a reinsurance agreement with three reinsurers to provide coverage for a ten year period in the event of excessive losses on PMI’s pool business. PMI paid the reinsurers a one-time premium of $16.4 million. This agreement does not transfer risk as prescribed in SFAS No. 113, and therefore, is being reported in accordance with SOP 98-7. The expense attributable to the expiration of coverage provided under the contract was $2.1 million in 2002, $2.1 million in 2001 and $2.2 million in 2000.
Section 832(e) of the Internal Revenue Code permits mortgage guaranty insurers to deduct, within certain limitations, additions to statutory contingency reserves. This provision allows mortgage guaranty insurers to increase statutory unassigned surplus through the purchase of non-interest bearing “tax and loss bonds” from the federal government. The tax and loss bonds purchased are limited to the tax benefit of the deduction for additions to the contingency reserves. The Company purchased tax and loss bonds of $106.1 million in 2002, $99.0 million in 2001 and $103.4 million in 2000. The purchase and redemption of tax and loss bonds are included as a deferred component of income tax expense.
The components of the deferred income tax assets and liabilities at December 31, 2002 and 2001 are as follows:
In February 1997, TPG, through a wholly-owned trust, privately issued $100.0 million of 8.309% preferred Capital Securities, Series A (the “Capital Securities”). The Capital Securities are redeemable after February 1, 2007 at a premium or upon occurrence of certain tax events and mature on February 1, 2027. The net proceeds of $99.0 million were used for general corporate purposes, including common stock repurchases and additions to the investment portfolio. The Capital Securities were issued by PMI Capital I (“Issuer Trust”). The sole asset of the Issuer Trust consists of $103.1 million principal amount of a junior subordinated debenture issued by TPG to the Issuer Trust. The subordinated debenture bears interest at the rate of 8.309% per annum and matures on February 1, 2027. The amounts due to the Issuer Trust under the subordinated debenture and the related transactions have been eliminated in the Company’s consolidated financial statements. Distributions on the Capital Securities occur on February 1 and August 1 of each year. The obligations of TPG under the subordinated
Leases-The Company leases certain office equipment. Minimum rental payments under non-cancelable operating leases in the aggregate and the obligation recorded under capital lease for the five years subsequent to 2002 are as follows:
their insurance company subsidiaries during the tax years ended on or after December 1, 1997. The assessed amount if paid, may be offset, in part, by federal tax benefits. While the Company intends to protest the assessment, there can be no assurance as to the ultimate outcome of the protest. Additionally, during the fourth quarter, the FTB commenced an audit of the Company’s tax returns for the years 1998 through 2000 regarding the same issue covered by the assessment. See Note 23. Subsequent Events for a discussion of FTB actions resulting from its audit.
Legal Proceedings-On December 15, 2000, the Company announced that PMI entered into an agreement with the plaintiffs to settle the class action litigation captioned Baynham et al. v. PMI Mortgage Insurance Company. PMI denied all facts and allegations in the lawsuit that alleged violations of Section 8 of the Real Estate Settlement Procedures Act (“RESPA”) and other related claims. To account for the settlement, PMI took a pre-tax charge of $5.7 million in the fourth quarter of 2000, a $1.5 million pre-tax charge in the third quarter of 2001, and an additional pre-tax charge of $12.2 million due to an adverse ruling in December 2002 by the trial court in the Company’s litigation against its insurance carriers for coverage of costs and expenses incurred in the fourth quarter of 2002. The Company is appealing the decision. The charges are based upon the estimate of the cost of settlement. The total amount accrued as of December 31, 2002 is approximately $19 million.
Various other legal actions and regulatory reviews are currently pending that involve the Company and specific aspects of its conduct of business. In the opinion of management, the ultimate liability in one or more of these actions is not expected to have a material effect on the financial condition or results of operations of the Company.
Sensitivity of retiree welfare results. Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plans. A one-percentage-point change in assumed health care cost trend rates would have the following effects:
Savings and Profit Sharing Plans. All full-time, part-time and certain temporary employees of the Company are eligible to participate in The PMI Group, Inc. Savings and Profit-Sharing Plan (“401(k) Plan”). Eligible employees who participate in the 401(k) Plan may receive, within certain limits, matching Company contributions. Costs relating to the 401(k) Plan were $6.2 million for 2002, $2.7 million for 2001 and $2.4 million for 2000. Contract underwriters are covered under The PMI Group, Inc. Alternate 401(k) Plan, under which there are no matching Company contributions. In addition to 401(k) Plan, the Company has an officers’ deferred compensation plan available to certain employees. The obligation related to the deferred compensation plan is $9.4 million as of December 31, 2002 and is included in other liabilities and accrued expenses.
In the normal course of business, the Company invests in various financial assets and incurs various financial liabilities. The estimated fair value of the financial instruments indicated in the table below has been determined by available market information and appropriate valuation methodology. The carrying values of cash and cash equivalents and accrued investment income approximate the fair values primarily due to their liquidity and short-term nature. The estimated fair value of the outstanding debt has been determined by quoted market price.
Transactions between segments are not significant. The Company evaluates performance primarily based on segment net income. The following tables present information for reported segment income or loss and segment assets as of and for the periods indicated:
During the third quarter of 2002, the Company changed its classification of remedies expenses incurred in connection with contract underwriting services. As a result, the remedies expenses were reclassified from losses and loss adjustment expenses for U.S. Mortgage Insurance Operations to other underwriting and operating expenses for the Other segment.
The National Association of Insurance Commissioners (“NAIC”) revised the NAIC Accounting Practices and Procedures Manual in a process referred to as codification. The revised manual was adopted by the respective states effective January 1, 2001. The Company prepares its statutory financial statements in conformity with accounting practices prescribed or permitted by the State of Arizona. Effective January 1, 2001, the state of Arizona required that insurance companies domiciled in the state of Arizona prepare their statutory basis financial statements in accordance with the NAIC Accounting Practices and Procedures Manual-Version effective January 1, 2001 subject to any deviations prescribed or permitted by the state of Arizona insurance commissioner.
The statutory net income, statutory surplus and contingency reserve liability of PMI as of and for the years ended December 31 are as follows:
The differences between the statutory net income and equity presented above and the consolidated net income and equity presented on a GAAP basis primarily reflect the differences between GAAP and statutory accounting practices as well as the results of operations and equity of other subsidiaries of the Company.
The Runoff Support Agreement contains certain covenants, including covenants that (i) PMI will write no new business after its risk-to-capital ratio equals or exceeds 23 to 1; (ii) PMI will pay no dividends if, after the payment of any such dividend, PMI’s risk-to-capital ratio would equal or exceed 23 to 1; and (iii) on the date that any of the following events occur: (a) PMI’s risk-to-capital ratio exceeds 24.5 to 1, (b) Allstate shall have paid any claims relating to PMI policies directly to a policyholder or by paying an amount equal to such claims to PMI, or to TPG for contribution to PMI, pursuant to the Runoff Support Agreement, or (c) any regulatory order is issued restricting or prohibiting PMI from making full or timely payments under policies, PMI will transfer substantially all of its assets in excess of $50.0 million to a trust account established for the payment of claims.
Effective December 31, 2002, PMI terminated a September 18, 1997 capital support agreement in favor of its sister corporation, APTIC, under which PMI agreed to maintain APTIC’s capital and surplus at an amount not less than that required for a Fitch claims paying ability rating of “AA-,” subject to an aggregate limit of $10 million. The support agreement was replaced on the same date by a substantially equivalent guarantee of TPG in favor of APTIC, its direct subsidiary, under which TPG agrees to maintain APTIC’s capital and surplus at a Fitch “AA-” level subject to an aggregate limit of $10 million.
We have audited the accompanying consolidated balance sheets of The PMI Group, Inc. and subsidiaries (the Company) as of December 31, 2002 and 2001, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2002. Our audits also included the financial statement schedules listed in the Index at Item 15(a). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of The PMI Group, Inc. and subsidiaries at December 31, 2002 and 2001, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
As further described in Note 3 to the consolidated financial statements, during the year ended December 31, 2002 the Company changed its method of accounting for goodwill and intangible assets.