Forward-looking statements in this document include discussions relating to persistency rates, default and claim rates, the seasoning of PMI’s insurance portfolio, reserves for losses and LAE, and our liquidity and capital resources.
We are a global provider of credit enhancement products that promote homeownership and the provision of services essential to the building of strong communities. Through our U.S., International and Financial Guaranty segments, we offer first loss, mezzanine and risk remote financial insurance across the credit spectrum and around the world. We divide our business into four segments:
Corporate and Other. Our Corporate and Other segment consists of our holding company (“The PMI Group” or “TPG”), contract underwriting operations, and equity in losses from investments in certain limited partnerships. Our Corporate and Other segment generated net losses of $71.4 million in 2006 and $43.9 million in 2005.
equity in earnings from our unconsolidated subsidiaries, primarily from FGIC, RAM Re and CMG MI; and
other income, including fees from contract underwriting services and income from changes in the fair value of credit default swaps.
Our consolidated net income for 2006 was $419.7 million compared to $409.2 million for 2005. (See Results of Operations table below). This increase was primarily due to higher equity in earnings from FGIC and higher premiums earned in our U.S. Mortgage Insurance Operations segment and at PMI Australia. The increase in our consolidated net income in 2006 was partially offset by higher losses and loss adjustment expenses (“LAE”) in Australia and the U.S. and $12.2 million of pre-tax expenses relating to our January 2006 adoption of Statement of Financial Accounting Standards No. 123R, Share-Based Payment, or SFAS No. 123R.
Policy Cancellations and Persistency. Low interest rates and home price appreciation over the past several years have driven mortgage refinance activity and policy cancellations, which in turn have negatively affected PMI’s insurance in force. While policy cancellations negatively affect PMI’s insurance in force, cancellations due to borrower prepayments positively affect premiums earned on PMI’s single premium policies in the year in which the cancellations occur. Upon notification of cancellation of a loan under a non-refundable single premium policy, any unearned premium with respect to that loan is recognized as earned premium. PMI’s persistency rate, which is based upon the percentage of primary insurance in force at the beginning of a 12-month period that remains in force at the end of that period, was 69.6% as of December 31, 2006 and 61.9% as of December 31, 2005. The improvement in PMI’s persistency rate in 2006 reflects lower levels of residential mortgage refinance activity. If mortgage interest rates remain at current levels or continue to increase, we expect that refinancing activity will continue to slow and PMI’s persistency rate will continue to improve.
Credit and Portfolio Characteristics. Compared to December 31, 2005, PMI’s primary risk in force as of December 31, 2006 consisted of higher percentages of interest only, payment option ARMs, Alt-A, and high LTV loans. We believe that these percentage increases generally reflect higher concentrations of these loans in the mortgage origination and private mortgage insurance markets. We expect higher default and claim rates for ARMs, payment option ARMs, interest only, Alt-A and high LTV loans and incorporate these assumptions into our underwriting approach, portfolio limits, pricing and loss and claim estimates.
Losses and LAE. PMI’s losses and LAE, which includes claims paid, LAE and changes in loss reserves during the applicable period, increased 3.8% in 2006 compared to 2005. PMI’s higher losses and LAE in 2006 was due to increases in loss reserves of $20.2 million during 2006. We increased PMI’s loss reserves primarily as a result of higher average primary claim sizes and higher claim rates in 2006 and our expectation that average claims sizes and claim rates will continue to increase in 2007. PMI’s average claim sizes increased in 2006 as a result of higher loan sizes and coverage levels in PMI’s NIW and insurance in force. PMI’s claim rates increased in part as a result of changes in the business mix of PMI’s mortgage insurance portfolio (described in Credit and Portfolio Characteristics above), and the seasoning of our primary NIW acquired through our structured finance channel. The increases in PMI’s claim sizes and claim rates have been partially mitigated by favorable economic conditions, including job creation and low interest rates.
Captive Reinsurance. Under captive reinsurance agreements, PMI transfers portions of its risk written on loans originated by certain lender-customers to captive reinsurance companies affiliated with such lender-customers. In return, PMI cedes a share of its gross premiums written to these captive reinsurance companies. As of December 31, 2006, 52.9% of PMI’s primary insurance in force was subject to captive reinsurance agreements compared to 53.4% as of December 31, 2005. This decrease was due to a higher percentage of PMI’s 2006 NIW being generated by our structured finance channel, which NIW is generally not subject to captive reinsurance agreements.
PMI Australia. PMI Australia’s losses and LAE increased to $36.3 million in 2006 from $2.5 million in 2005. In 2006, we increased PMI Australia’s net loss reserves by $21.9 million. These increases were due in large part to interest rate increases and moderating or declining home price appreciation which, in turn, caused PMI Australia’s default inventory, claim rates and average claim sizes to increase. We expect these default and claims trends to continue in 2007. PMI Australia’s NIW increased by 39.5% in 2006 compared to 2005. The increase was due primarily to higher demand for flow and residential mortgage-backed securities related mortgage insurance and to PMI Australia’s streamlined flow product offerings and new marketing initiatives in 2006.
PMI Asia. In June 2006, our wholly-owned subsidiary, PMI Asia, received its insurance authorization from the Hong Kong Insurance Authority. Subsequent to its receipt of authorization, we transferred our Hong Kong branch’s entire mortgage reinsurance portfolio to PMI Asia. In connection with this restructuring, our International Operations incurred a $1.1 million U.S. tax charge during the second quarter of 2006. PMI Asia’s gross written premium declined in 2006 compared to 2005 as a result of a decrease in mortgage origination activity in Hong Kong in 2006 and the increased retention of risk by PMI Asia’s leading customer. This customer will further increase its risk retention in 2007.
FGIC. A majority of the net income derived from our Financial Guaranty segment in 2006 was generated by equity in earnings from FGIC. Equity in earnings from FGIC was $98.5 million in 2006 compared to $74.9 million in 2005. The increase in equity in earnings from FGIC in 2006 compared to 2005 was primarily due to increases in premiums earned, the increase in FGIC’s loss and LAE reserves in 2005 related to Hurricane Katrina, the partial release in 2006 of Hurricane Katrina-related loss
Contract Underwriting Services. As a result of lower levels of mortgage originations and a decline in customers’ requests for contract underwriting services, our contract underwriting activities and revenues have declined, and will likely continue to decline in the future. Total contract underwriting expenses primarily include allocated expenses as well as monetary remedies provided to customers in the event we failed to properly underwrite a loan. Expenses associated with contract underwriting remedies, and accruals thereof, decreased from $14.5 million in 2005 to $12.4 million in 2006.
The following table presents our consolidated financial results for the years ended:
Our consolidated net income for 2006 was $419.7 million compared to $409.2 million for 2005. (See Results of Operations table above). This increase was primarily due to higher equity in earnings from FGIC and higher premiums earned in our U.S. Mortgage Insurance segment and at PMI Australia. The increase in our consolidated net income in 2006 was partially offset by higher losses and loss adjustment expenses (“LAE”) in Australia and the U.S. and $12.2 million of pre-tax expenses relating to our January 2006 adoption of SFAS No. 123R.
by a $20.4 million (pre-tax) realized capital loss on our equity investment in SPS Holding Corp. (“SPS”). Our consolidated net income from continuing operations after taxes in 2005 was $409.2 million compared to $366.5 million in 2004. The increases in net income and income from continuing operations after taxes in 2005 compared to 2004 were due primarily to higher premiums earned in U.S Mortgage Insurance Operations and PMI Australia in 2005, and increases in our equity in earnings from FGIC in 2005.
The increases in net investment income in 2006 and 2005 compared to their prior years were due primarily to the growth in PMI Australia’s investment portfolio and increases in our consolidated book yield. As of December 31, 2006, our consolidated pre-tax book yield was 5.45% compared to 5.18% and 5.07% as of December 31, 2005 and 2004, respectively. These increases in our pre-tax book yield were primarily due to the higher interest rate environment in Australia.
We account for our unconsolidated subsidiaries and limited partnerships using the equity method of accounting. Equity in earnings from FGIC Corporation was $98.5 million in 2006 compared to $74.9 million and $61.6 million in 2005 and 2004, respectively. The increase in 2006 compared to 2005 was primarily due to an increase in premiums earned, the partial release of loss reserves in 2006 associated with Hurricane Katrina, and higher investment income. In 2005, FGIC incurred losses and LAE of $20.1 million primarily related to insured credits impacted by Hurricane Katrina in 2005. Equity in earnings from FGIC increased in 2005 compared to 2004, notwithstanding the Hurricane Katrina-related reserve increases in 2005, primarily as a result of higher premiums earned and higher investment income.
The increase in our consolidated losses and LAE in 2006 compared to 2005 was due primarily to increases in PMI Australia’s and U.S. Mortgage Insurance Operations’ losses and LAE in 2006. The increase in PMI Australia’s losses and LAE in 2006 was due primarily to higher default inventories, claim rates, and average claim sizes as a result of less favorable housing market conditions. The increase in U.S. Mortgage Insurance Operations’ losses and LAE in 2006 was due primarily to higher claim rates caused by changes in the mix of PMI’s portfolio and higher claim sizes caused by higher coverage levels and loan sizes. The increase in our losses and LAE in 2005 compared to 2004 was due primarily to higher claims paid in our U.S. Mortgage Insurance Operations as a result of the seasoning of PMI’s insurance portfolio, an increased number of claims paid in 2005 that were previously delayed by bankruptcy protection, and higher claim rates associated with the changes in the mix of PMI’s loan portfolio.
Losses and LAE-PMI’s losses and LAE represent claims paid, certain expenses related to default notification and claim processing and changes in loss reserves during the applicable period. Because losses and LAE includes changes in net loss reserves, it reflects our best estimate of PMI’s future claim payments and costs to process those claims relative to PMI’s current inventory of loans in default. Claims paid including LAE includes amounts paid on primary and pool insurance claims, and LAE. PMI’s losses and LAE and related claims data are shown in the following table.
Primary claims paid were $214.0 million in 2006, $214.9 million in 2005, and $193.2 million in 2004. Pool insurance claims paid were $18.3 million in 2006, $21.6 million in 2005, and $19.4 million in 2004. As a result of increases in our modified pool risk in force in 2005 and 2006, we do not expect pool insurance claims paid to continue to decrease in 2007.
We expect a significant majority of claims on insured loans in PMI’s current portfolio to occur between the second and fourth years after loan origination. To the extent we continue to have high levels of PMI’s insurance in force that are in, or approaching, their peak loss development years, losses and LAE will be unfavorably impacted. Changes in economic conditions, including mortgage interest rates, job creation, and home prices could significantly impact our reserve estimates, and therefore, PMI’s losses and LAE. In addition, changes in economic conditions may not necessarily be reflected in PMI’s loss development in the quarter or year in which such changes occur.
PMI’s primary mortgage insurance master policies define “default” as the borrower’s failure to pay when due an amount equal to the scheduled monthly mortgage payment under the terms of the mortgage. Generally, the master policies require an insured to notify PMI of a default no later than the last business day of the month following the month in which the borrower becomes three monthly payments in default. For reporting and internal tracking purposes, we do not consider a loan to be in default until the borrower has missed two consecutive payments. Depending upon its scheduled payment date, a loan delinquent for two consecutive monthly payments could be reported to PMI between the 31st and the 60th day after the first missed payment.
The increase in PMI’s primary default rate as of December 31, 2005 compared with December 31, 2004 was due to an increase in the number of primary loans in default and a decline in the number of primary insurance policies in force. Increases in primary loans in default were mainly due to increases in structured loans in default as a result of higher concentrations of Alt-A and high LTV loans.
PMI’s policy acquisition costs are those costs that vary with, and are related to, our acquisition, underwriting and processing of new mortgage insurance policies, including contract underwriting and sales related activities. To the extent that we are compensated by customers for contract underwriting, those
underwriting costs are not deferred. We defer policy acquisition costs when incurred and amortize these costs in proportion to estimated gross profits for each policy year by type of insurance contract (i.e. monthly, annual and single premium). Policy acquisition costs incurred and deferred are variable and fluctuate with the volume of new insurance applications processed and NIW, and can also be reduced by increased use of PMI's electronic origination and delivery methods.
The decreases in amortization of deferred policy acquisition costs and policy acquisition costs incurred and deferred in 2006 and 2005 compared to prior years were primarily due to expense savings realized from field office restructurings and lower levels of NIW. PMI’s deferred policy acquisition cost asset decreased by $4.8 million from December 31, 2005 to $43.5 million at December 31, 2006, and by $5.7 million from December 31, 2004 to December 31, 2005 as a result of these same factors. Continued declines in PMI’s deferred policy acquisition cost asset would reduce future amortization of deferred policy acquisition costs.
Other underwriting and operating expenses generally consist of all costs that are not attributable to the acquisition of new business and are recorded as expenses when incurred. Other underwriting and operating expenses in 2006 were reduced by approximately $7.5 million pursuant to a re-allocation of certain costs from U.S. Mortgage Insurance Operations to our Corporate and Other segment as a result of a refinement of our allocation of operating costs between segments. The increase in expenses in 2005 compared to 2004 was due primarily to higher compensation, insurance and depreciation related expenses. The litigation settlement refund received in 2006 relates to the settlement in 2001 of the Baynham litigation.
PMI’s loss ratio is the ratio of losses and LAE to premiums earned. The loss ratio remained flat in 2006 compared to 2005 as a result of higher premiums earned offset by higher losses and LAE. The increase in the loss ratio in 2005 compared with 2004 was primarily driven by increases in losses and LAE.
NIW from PMI’s structured finance channel increased in 2006 compared to 2005, and 2005 compared to 2004, mainly due to increased customer opportunities as a result of the favorable MBS market.
Primary insurance in force as of December 31, 2006 increased due primarily to lower policy cancellations, partially offset by lower levels of NIW. Primary risk in force at December 31, 2006 increased compared to December 31, 2005 due to a greater number of high LTV loans with deeper coverage and higher average loan balances, offset by lower levels of NIW. Higher or stabilizing mortgage interest rates and corresponding declines in refinance activity caused policy cancellations to decrease, and primary persistency to increase, in 2006 and
The following table presents PMI’s ARMs (mortgage loans with interest rates that may adjust prior to their fifth anniversary) and high LTV loans (loans exceeding 97% LTV) as percentages of its flow channel and structured finance channel primary NIW for the years ended:
Since 2004, interest only loans, also known as deferred amortization loans, and payment option ARMs have been popular with some borrowers and we have insured an increased amount of these loans through our primary flow and structured finance channels. Interest only loans and payment option ARMs have more exposure to declining home prices than fixed rate loans or traditional ARMs.
The following table presents PMI’s interest only loans and payment option ARMs as percentages of its flow channel and structured finance channel primary NIW for the years ended:
* Less-than-A with FICO scores below 575 is a subset of PMI’s less-than-A quality loan portfolio
We expect higher default rates and claim payment rates for less-than-A quality loans, Alt-A loans, high LTV loans, interest only loans, and payment option ARMs than our traditional primary portfolio and incorporate these assumptions into our underwriting approach, portfolio limits, pricing and loss and claim estimates. In 2006, PMI’s average premium rate generally increased primarily as a result of PMI’s primary portfolio consisting of higher percentages of these types of loans. PMI also insures less-than-A quality loans, Alt-A loans, ARMs, interest only loans, payment option ARMs, and high LTV loans through its modified pool products. We believe that the structure of PMI’s modified pool products mitigates the risk of loss to PMI from the loans insured by those products.
The change in the average foreign currency exchange rates from December 31, 2005 to December 31, 2006 negatively impacted our International Operations’ net income by $1.2 million, as a result of the weakening of the Australian dollar relative to the U.S. dollar. This foreign currency translation impact is calculated using the year over year change in the average monthly exchange rate to the current year ending net income in the local currency. The change in the average foreign currency exchange rates from December 31, 2004 to December 31, 2005 favorably impacted our International Operations’ net income by $2.9 million, as result of the strengthening of the Australian dollar relative to the U.S. dollar.
Premiums written and earned-PMI Australia’s insurance portfolio consists primarily of single premium policies. Written premiums are earned in accordance with the expected expiration of policy risk. Accordingly, written premium associated with a single premium policy is recognized as earned over a period up to nine years, with the majority of the premium recognized as earned in years two through four. In the event of policy cancellation, any unearned portion of the associated premium is recognized as earned upon notice of cancellation to PMI Australia. The increases in PMI Australia’s premiums written and earned in 2006 compared to 2005 were primarily due to the scheduled release of unearned premiums to earned associated with PMI Australia’s growth in insurance in force over the last several years, and premiums earned from higher levels of policy cancellations in 2006. The increase in PMI Australia’s net premiums earned in 2005 compared to 2004 was due to higher levels of insurance in force and the continued strengthening of the Australian dollar relative to the U.S. dollar.
Net investment income-The increase in net investment income in 2006 compared to 2005 was due primarily to the growth of PMI Australia’s investment portfolio, including cash and cash equivalents, to $1.1 billion at December 31, 2006 compared to $877.2 million at December 31, 2005 and $801.5 million at December 31, 2004. This growth was driven by positive cash flows from operations, partially offset by a weakening of the Australian dollar relative to the U.S. dollar. The pre-tax book yield was 6.1% at December 31, 2006 and 5.9% at December 31, 2005 and 2004. The increase in the pre-tax book yield in 2006 was primarily due to a higher interest rate environment. The increase in net investment income in 2005 compared to 2004 was also attributable to the growth of the investment portfolio.
The increase in losses and LAE in 2006 compared to 2005 was attributable to interest rate increases in 2006 and moderating or declining home price appreciation in 2005 and 2006 which, in turn, caused PMI Australia’s default inventory, claim rates and average claim size to increase. We increased PMI Australia’s net loss reserves in 2006 due to, among other factors, an increase in PMI Australia’s default inventory in 2006, and our expectation that average claim sizes and claim rates will continue to increase. PMI Australia’s default inventory increased to 2,281 loans as of December 31, 2006 from 1,264 loans and 751 loans as of December 31, 2005 and December 31, 2004, respectively. PMI Australia’s default rate at December 31, 2006 was 0.22%, 0.13% at December 31, 2005, and 0.08% at December 31, 2004. The increase in losses and LAE in 2005 compared to 2004 was attributable to increased claims paid during 2005, slightly offset by a $1.1 million reserve reduction in the third quarter of 2005.
NIW, insurance and risk in force-PMI Australia’s NIW consists primarily of single premium policies and includes flow channel insurance and insurance on RMBS. RMBS transactions include insurance on seasoned portfolios comprised of prime credit quality loans that have LTVs often below 80%. The following table presents the components of PMI Australia’s NIW, insurance in force and risk in force for the years ended:
The average annual Euro/USD currency exchange rate was 1.2566 in 2006, 1.2444 in 2005, and 1.2443 in 2004. Changes in the average Euro/USD currency exchange rates from 2005 to 2006, and 2004 to 2005, favorably impacted PMI Europe’s net income by $0.1 million in 2006, $0.1 million in 2005. Net income from PMI Europe in 2006 includes a $0.1 million pre-tax realized loss related to foreign currency put options and 2005 includes a $0.4 million pre-tax realized gain related to foreign currency put options.
Premiums earned-The decreases in premiums earned in 2006 compared to 2005, and 2005 compared to 2004, were due primarily to a decrease in premiums earned associated with the R&SA lenders’ mortgage insurance portfolio acquired by PMI Europe in 2003. We recognize premiums associated with the acquired portfolio in accordance with established earnings patterns that are based upon management’s estimation of the expiration of the portfolio’s risk. As the portfolio continues to age, we expect premiums earned and risk in force associated with the portfolio to continue to decline.
Income from changes in fair value of credit default swaps-PMI Europe is currently a party to eleven transactions that are classified as derivatives. PMI Europe’s income increased from these transactions in 2006 primarily due to mark-to-market gains in 2006 of $7.4 million compared to $2.4 million in 2005. Mark-to-market gains on derivatives include any accretion from deferred gains. For the years ended December 31, 2006 and 2005, $2.2 million and $1.6 million, respectively, of accretion from deferred gains was recorded in income from changes in the fair value of credit default swaps. While changes in the fair value of PMI Europe’s derivatives may occur as a result of a number of factors, the primary drivers are actual and projected claim payments. As of December 31, 2006 and December 31, 2005, $13.3 million and $6.8 million, respectively, of deferred gains related to the initial fair value were included in other liabilities. PMI Europe’s income from derivatives decreased in 2005 compared to 2004 as a result of the reduction in gains related to the change in the derivatives’ fair value to $0.8 million in 2005 from $5.6 million in 2004. Claims paid related to credit default swaps accounted for as derivatives totaled $2.0 million in 2006, $1.8 million in 2005 and $0.4 million in 2004. These claims paid are offset against estimated claims paid and, to the extent they are different from those estimates, the differences are included in the changes in fair value of credit default swaps.
Net investment income and net realized investment gains (losses)-PMI Europe’s net investment income and realized investment gains (losses) consist primarily of interest income from its investment portfolio and, to a lesser extent, gains and losses on foreign currency re-measurement, realized investment gains and losses from investment activity, and foreign currency exchange gains and losses when investments are sold. Net investment income decreased in 2006 compared to 2005 primarily due to a decline in the average investment portfolio balance in 2006 caused by the payment of profit sharing obligations discussed below. The increase in net investment income in 2005 from 2004 was primarily due to the growth of the investment portfolio.
PMI Europe’s investment portfolio, including cash and cash equivalents, as of December 31, 2006 was $215.3 million, $216.3 million as of December 31, 2005, and $229.3 million as of December 31, 2004. The decrease in PMI Europe’s investment portfolio in 2006 was primarily driven by the payment of an accrued profit commission relating to the termination of future profit sharing obligations on the R&SA portfolio. The pre-tax book yield was 4.3% for the year ended December 31, 2006, and 4.5% for both the years ended December 31, 2005 and 2004.
Risk in force - PMI Europe’s risk in force increased from $2.8 billion at December 31, 2005 to $3.9 billion at December 31, 2006 as a result of new risk-remote credit default swaps written in 2006.
Income taxes-The transfer of our Hong Kong branch’s mortgage reinsurance portfolio to PMI Asia resulted in a $1.1 million tax charge in the second quarter of 2006. As of July 2006, PMI Asia’s statutory tax rate is 17.5%.
Losses and LAE-The decrease in FGIC’s losses and loss adjustment expenses in 2006 compared to 2005, and the increase in 2005 compared to 2004, were primarily due to loss reserve activity related to insured credits impacted by Hurricane Katrina. In 2005, FGIC recorded $20.1 million of loss reserves, primarily related to insured obligations in areas affected by Hurricane Katrina. In 2006, FGIC reduced Hurricane Katrina-related reserves by $7.9 million. Total reserves, net of reinsurance recoverables, were $38.8 million as of December 31, 2006 compared to $51.5 million as of December 31, 2005.
Underwriting expenses-Underwriting expenses increased in 2006 compared to 2005 due to FGIC’s adoption of SFAS No. 123R and growth in headcount, partially offset by higher ceding commissions. Underwriting expenses increased in 2005 compared to 2004 primarily due to increases in headcount, partially offset by ceding commissions.
Deferred policy acquisition costs-The deferred policy acquisition cost asset was $93.2 million at December 31, 2006, $63.3 million at December 31, 2005 and $33.8 million at December 31, 2004. The amortization of deferred policy acquisition costs increased in 2006 to $11.5 million from $8.3 million in 2005 due to the increase in the deferred policy acquisition costs asset.
Net investment income-The increase in net investment income in 2006 compared to 2005 was a result of higher investment yields in The PMI Group’s investment portfolio in 2006, partially offset by a decrease in the size of the investment portfolio in 2006 due to our repurchase of common shares and redemption of certain long-term capital instruments. The decrease in net investment income in 2005 compared to 2004 was due primarily to a decrease in the size of our investment portfolio due to repurchases of our common shares.
Other income-Other income primarily includes contract underwriting revenue. Other income decreased in 2006 compared to 2005 as a result of a decline in contract underwriting activity. In 2005, other income was offset by $1.7 million of losses relating to our investment in SPS.
The PMI Group’s principal uses of liquidity are the payment of operating costs, income taxes (which are predominantly reimbursed by its subsidiaries), principal and interest on its capital instruments, payments of dividends to shareholders, repurchases of its common shares, purchases of investments and capital investments in and for its subsidiaries.
The PMI Group’s available funds, consisting of cash and cash equivalents and investments, were $182.1 million at December 31, 2006, compared to $570.1 million at December 31, 2005. This decrease in The PMI Group’s available funds was primarily due to our redemption of approximately $300 million of remarketed
senior notes in connection with our hybrid securities and our common share repurchases in 2006. It is our present intention to maintain at least $75 million of liquidity at our holding company in connection with rating agency considerations. We believe that we have sufficient liquidity to meet all of our short- and medium-term obligations, and that we maintain excess liquidity to support our operations as needed.
In addition to its consolidated subsidiaries, The PMI Group may in the future derive funds from its unconsolidated equity investments, including its investment in FGIC Corporation. FGIC Corporation’s ability to pay dividends is subject to restrictions contained in applicable state insurance laws and regulations, FGIC Corporation’s certificate of incorporation, a stockholders agreement between The PMI Group and other investors in FGIC Corporation, and covenants included in its 6.0% senior notes. Under New York insurance law, FGIC may pay dividends out of statutory earned surplus, provided that, together with all dividends declared or distributed by FGIC during the preceding twelve months, the dividends would not exceed the lesser of (i) 10% of policyholders’ surplus as of its last statement filed with the New York Superintendent of Insurance and (ii) adjusted net investment income during this period. Any dividend distribution in excess of these requirements would require the prior approval of the New York Superintendent of Insurance.
The stockholders agreement between The PMI Group and the other investors in FGIC Corporation also restricts the payment of dividends by FGIC. The stockholders agreement provides that FGIC will not declare or pay cash dividends to holders of its common stock prior to the earlier of the fifth anniversary of the closing of the investment and the completion of the first underwritten public offering of FGIC Corporation’s common stock, and, in any event, that such dividends will not be paid prior to the redemption of FGIC Corporation’s senior preferred stock and class B common stock. FGIC Corporation is further restricted in the payment of dividends by the terms of its 6% senior notes, due 2034.
Our consolidated contractual obligations include reserves for losses and LAE, long-term debt obligations, operating lease obligations, and purchase obligations. Cash payments related to our reserves for losses and LAE as of December 31, 2006 shown below are based upon management’s best estimate from historical experience as well as current economic conditions. These estimates could vary significantly based on, among other things, changes to claim rates and claim sizes. Most of our purchase obligations are capital expenditure commitments that will be used for technology improvements. Minimum rental payments under non-cancelable operating leases are provided in the table below.
Includes $496.6 million of principal debt and $540.9 million of scheduled interest.
We have invested in certain limited partnerships with ownership interests greater than 3% but less than 50%. As of December 31, 2006, we had committed to fund, if called upon to do so, approximately $5.2 million of additional equity in certain limited partnership investments. This commitment to fund is excluded from the above table.
Net investment income increased in 2006 compared to 2005 primarily due to growth in our Australian investment portfolios, combined with an increase in our consolidated book yield. As of December 31, 2006, our consolidated pre-tax book yield was 5.45% compared to 5.18% as of December 31, 2005. This increase was driven primarily by interest rate increases in Australia and the U.S., which offset the reinvestment of maturing, higher yielding securities into lower yielding securities in our U.S. investment portfolio. Net investment income increased from 2004 to 2005 due to growth in our investment portfolio and increased book yields in Australia which reflects a higher interest rate environment.
Net realized gains after income taxes increased by $0.5 million in 2006 compared with 2005 primarily due to the sales volume of fixed income securities to fund The PMI Group’s capital initiatives, offset by $2.8 million impairment charges of short-term investments in 2006. Net realized gains after income taxes decreased $0.4 million in 2005 compared with 2004 primarily due to $2.1 million pre-tax realized capital loss on a private equity limited partnership agreement in 2005.
The changes in net unrealized gains, net of deferred taxes, consist of:
As of December 31, 2006, 7.3% of our U.S. investment portfolio (which consists of U.S. Mortgage Insurance Operations segment, Corporate and Other segment and PMI Guaranty) consists of FGIC-insured non-refunded municipal bonds. As a result of our investment in FGIC, we have amended our investment policy to provide that no more than 15% of our U.S. investment portfolio consists of FGIC-insured non-refunded municipal bonds.
We issued $250 million in principal amount of our 6.000% Senior Notes, due September 15, 2016 and $150 million in principal amount of our 6.625% Senior Notes, due September 15, 2036, in September 2006 (collectively referred to as the “Senior Notes”). We utilized most of the proceeds from the issuance of the Senior Notes to redeem our 2.50% Senior Convertible Debentures due 2021, as discussed further below. The Senior Notes are payable semi-annually in arrears on March 15 and September 15 of each year, beginning on March 15, 2007. The PMI Group may redeem the Senior Notes in whole or in part at any time at the “make-whole redemption price.” The “make-whole redemption price” will be equal to the greater of (a) 100% of the principal amount of the Senior Notes to be redeemed and (b) the sum of the present values of the remaining scheduled payments thereon discounted to the date of redemption, on a semi-annual basis (assuming a 360-day year consisting of twelve 30-day months), at a rate equal to the applicable treasury rate plus 25 basis points for the 6.000% Senior Notes and 35 basis points for the 6.625% Senior Notes, plus in the case of either (a) or (b), any interest accrued but not paid to but excluding the date of redemption. In connection with the issuance of these Senior Notes, we entered into two interest rate lock agreements which were designated as cash flow hedges. The fair value of the cash flow hedges was settled for $9.0 million and will be amortized into interest expense over the terms of the Senior Notes. As of December 31, 2006, the unamortized balance in the other comprehensive income related to these fair value hedges was approximately $8.8 million (pre-tax). The Senior Notes are unsecured and will rank equally in right of payment with all of The PMI Group’s other existing and future senior unsecured indebtedness.
In July 2006, we commenced an exchange offer pursuant to which we offered to exchange a new series of our 2.50% senior convertible debentures due 2021 (referred to as the “new debentures”) and an exchange fee of $3.50 per $1,000 principal amount of debentures for all of our existing 2.50% senior convertible debentures due 2021 (referred to as the “old debentures”). The purpose of the exchange offer was to change certain terms of the old debentures, including the addition of a net share settlement feature. This feature allows us to satisfy a portion of our obligation due upon conversion of the debentures in cash, thereby reducing the dilution associated with the conversion of the new debentures. This feature also limits the dilutive impact of the new debentures on our diluted earnings per share. Following completion of the exchange offer in August 2006, we had approximately $341.5 million in principal amount of our new debentures outstanding and approximately $18.4 million in principal amount of our old debentures outstanding.
redeemed the $359.6 million aggregate principal amount of debentures that were not converted for a price equal to principal amount of the debentures plus accrued and unpaid interest.
In July 2006, The PMI Group announced that its board of directors authorized a common share repurchase program in an amount not to exceed $400 million. The $400 million share repurchase authorization was designed to address the additional common shares we issued on November 15, 2006 (discussed above) under the terms of our Equity Units.
In August 2006, The PMI Group entered into an accelerated stock buyback program with a major financial institution pursuant to which The PMI Group agreed to purchase shares of our common stock for an aggregate purchase price of $345 million. Until conclusion of the program in the second quarter of 2007 (which may in certain circumstances be accelerated or extended), the total number of common shares to be purchased cannot be determined. The number of common shares to be repurchased under the program generally will be based on the volume weighted average share price of our common stock during the term of the program. The program is subject to collar provisions that establish minimum and maximum number of shares based on the volume weighted average share price over an initial hedge period (the “Hedge Period”), which concluded at the end of September 2006. With the conclusion of the Hedge Period, the minimum number of common shares to be repurchased has been set at 7.2 million and the maximum number of common shares to be repurchased has been set at 8.2 million. As of the end of the Hedge Period, the financial institution has delivered to us the 7.2 million minimum number of common shares. The final number of common shares that we will receive depends on the share price of our common stock during the remaining term of the program. Pursuant to the July 2006 Board authorization, we repurchased an additional 0.9 million shares in the fourth quarter of 2006 for $40 million for an average price per common share of $44.11. In February, 2007, our Board of Directors authorized an additional common share repurchase program of $150 million.
Consolidated cash flows generated by operating activities, including premiums, investment income, underwriting and operating expenses and losses, were $392.4 million in 2006 compared to $385.8 million in 2005. Cash flows from operations increased due to increase in loss reserves and unearned premiums and increase in net income from continuing operations.
We establish reserves for losses and LAE to recognize the liability of unpaid losses related to insured mortgages that are in default. We do not rely on a single estimate to determine our loss and LAE reserves. To ensure the reasonableness of our ultimate estimates, we develop scenarios using generally recognized actuarial projection methodologies that result in a range of possible losses and LAE. Each scenario in the loss and LAE reserve model is assigned different weightings and is based upon actual claims experience in prior years to project the current liability. Our best estimates with respect to our consolidated loss and LAE reserves were approximately the midpoints of the actuarially determined ranges at December 31, 2006 and December 31, 2005.
Changes in loss reserves can materially affect our consolidated net income. The process of reserving for losses requires us to forecast the interest rate, employment and housing market environments, which are highly uncertain. Therefore, the process requires significant management judgment and estimates. The use of different estimates would have resulted in the establishment of different reserves. In addition, changes in the accounting estimates are reasonably likely to occur from period to period based on the economic conditions. We review the judgments made in our prior period estimation process and adjust our current assumptions as appropriate. While our assumptions are based in part upon historical data, the loss provisioning process is complex and subjective and, therefore, the ultimate liability may vary significantly from our estimates.
Our best estimate of PMI’s reserves for losses and LAE is derived primarily from our analysis of PMI’s default and loss experience. The key assumptions used in the estimation process are expected claim rates, average claim sizes, and costs to settle claims. We evaluate our assumptions in light of PMI’s historical patterns of claim payment, loss experience in past and current economic environments, the seasoning of PMI’s various books of business, PMI’s coverage levels, the credit quality profile of PMI’s portfolios, and the geographic mix of PMI’s business. Our assumptions are influenced by historical loss patterns and are adjusted to reflect recent loss trends. Our assumptions are also influenced by our assessment of current and future economic conditions, including trends in housing prices, unemployment and interest rates. Our estimation process uses generally recognized actuarial projection
methodologies. As part of our estimation process, we also evaluate various scenarios representing possible losses and LAE under different economic assumptions. We established PMI’s reserves at December 31, 2006 and December 31, 2005 at the approximate midpoint of the actuarial range based on, among other reasons, our evaluation of PMI’s number of delinquencies, average claim rate and average claim size.
Our increase to the December 31, 2006 reserve balance from December 31, 2005 was primarily due to higher expected primary claim rates and claim sizes on pending delinquencies. The table below provides a reconciliation of our U.S. Mortgage Insurance segment’s beginning and ending reserves for losses and LAE for each of the last three years:
The above loss reserve reconciliation shows the components of our losses and LAE reserve changes for the periods presented. Losses and LAE payments of $242.7 million, $246.5 million and $219.0 million for the periods ended 2006, 2005 and 2004, respectively, reflect amounts paid during the period presented and are not subject to estimation. Total incurred, net of changes to prior years, of $263.0 million, $253.3 million and $233.2 million for the periods ended 2006, 2005 and 2004, respectively, are management’s best estimates of ultimate losses and LAE and, therefore, are subject to change. The changes in our estimates are principally reflected in the losses and LAE incurred line item which shows increases to incurred related to prior years of $2.2 million and $6.3 million for the periods ended 2006 and 2005, respectively, and a reduction to incurred related to prior years of $5.9 million for the period ended 2004. The table below breaks down the 2006, 2005 and 2004 changes in reserves by particular accident years:
To provide a measure of sensitivity on pre-tax income to changes in loss reserve estimates, we estimate that: (i) for every 5% change in our estimate of the future average claim size or every 5% change in our estimate of the future claim rate with respect to the December 31, 2006 reserve for losses and LAE, the effect on pre-tax income would be an increase or decrease of approximately $18 million; (ii) for every 5% change in our estimate of incurred but not reported loans in default as of December 31, 2006, the effect on pre-tax income would be approximately $2 million; and (iii) for every 5% change in our estimate of the future cost of claims settlement expenses as of December 31, 2006, the effect on pre-tax income would be approximately $1 million.
PMI Europe establishes loss reserves for all of its insurance and reinsurance business and for credit default swap transactions consummated before July 1, 2003. Revenue, losses and other expenses associated with credit default swaps executed on or after July 1, 2003 are recognized through derivative accounting treatment. PMI Europe’s loss reserving methodology contains two components: case reserves and IBNR reserves. Case and IBNR reserves are based upon factors which include, but are not limited to, our analysis of arrears and loss payment reports, loss assumptions derived from pricing analyses, our view of current and future economic conditions and industry information. Our actuaries calculated a range for PMI Europe’s loss reserves at December 31, 2006 of $12.7 million to $27.9 million. The primary driver of this loss reserve range is our German first loss credit default swap transactions. PMI Europe’s recorded loss reserves at December 31, 2006 were $17.9 million, which represented management’s best estimate and an increase of $3.1 million from PMI Europe’s reserve balance of $14.8 million at December 31, 2005. The increase to PMI Europe’s reserves in 2006 was primarily due to expected higher loss severities, higher levels of defaults and an increase in the value of Euro exchange rate relative to the U.S. dollar.
a decline in the market value of a security below cost or amortized cost for a continuous period of at least nine months;
If we believe a decline in the value of a particular investment is temporary and we have the intent and ability to hold to recovery, we record the decline as an unrealized loss on our consolidated balance sheet under “accumulated other comprehensive income” in shareholders’ equity. If we believe the decline is other-than-temporary, we write-down the carrying value of the investment and record a realized loss in our consolidated statement of operations under “net realized investment gains.” Our assessment of a decline in value includes
The following table shows our investments’ gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2006:
The following table provides the composition of fixed income securities with an unrealized loss at December 31, 2006 in relation to the total of all fixed income securities with an unrealized loss by contractual maturities.
We generate a significant portion of our revenues from mortgage insurance premiums on either a monthly, annual or single payment basis. Premiums written on a monthly basis are earned as coverage is provided. Premiums written on an annual basis are earned on a monthly pro-rata basis over the year of coverage. Primary mortgage insurance premiums written on policies covering more than one year are referred to as single
Effective January 1, 2006, we adopted the provisions of, and account for share-based compensation in accordance with SFAS No. 123R. We elected the modified-prospective method, under which prior periods are not revised for comparative purposes. Under the fair value recognition provisions of this statement, share-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as an expense over the requisite service period, which is generally the vesting period.
We aggregate similar groups of employees with respect to exercise and post-vesting employment-termination behaviors for our option pricing model assumption estimation process. We estimate the expected term of options granted by analyzing historical exercise and post-vesting behavior of employees for similar stock
option grants. Expected volatility is estimated using the historical volatility of our common share price over the expected term of the options. If new or different information that would be useful in estimating expected volatility becomes available, we may incorporate that information into future estimates. We consider expected changes of future dividend policy for selection of expected dividends. The risk-free interest rate that we use in the option pricing model is based on the U.S. Treasury zero-coupon yield curve with remaining terms similar to the expected terms on the options. We are required to estimate forfeitures at the time of grant and revise those estimates in subsequent periods if actual forfeitures differ from those estimates. We use historical data to estimate pre-vesting option forfeitures and record share-based compensation expense only for those awards that are expected to vest. Stock option awards are amortized using the accelerated method.
The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable, characteristics not present in our option grants. Existing valuation models, including the Black-Scholes and lattice binomial models, may not provide reliable measures of the fair value of our share-based compensation. Consequently, there is a risk that our estimates of the fair values of our share-based compensation awards on the grant dates may bear little resemblance to the actual values related upon the exercise, expiration, early termination or forfeiture of those share-based payments in the future. Certain share-based payments, such as employee stock options, may expire worthless or otherwise result in zero intrinsic value as compared to the fair values originally estimated on the grant date and reported in our financial statements. Alternatively, value may be realized from those instruments that are significantly higher than the fair values originally estimated on the grant date and reported in our financial statements. There currently is no market-based mechanism or other practical application to verify the reliability and accuracy of the estimates stemming from these valuation models, nor is there a means to compare and adjust the estimates to actual values.
In 2004, the SEC staff reviewed the accounting practices for loss reserves of publicly held financial guaranty industry companies and upon noting various differences in accounting practices requested the Financial Accounting Standards Board (“FASB”) Staff to review and potentially clarify the applicable existing accounting guidance. As noted in the minutes of its June 8, 2005 meeting, the FASB agreed to consider whether additional accounting guidance is necessary for the financial guaranty industry as well as other insurance products with similar characteristics, such as mortgage guarantee contracts and credit insurance.
Consolidated Statements of Operations for the years ended December 31, 2006, 2005 and 2004
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, 2006 and 2005, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles. 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.
We have audited management’s assessment, included in the accompanying report from management, that The PMI Group, Inc. maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). The PMI Group, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.
The accompanying consolidated financial statements include the accounts of The PMI Group, Inc. (“The PMI Group” or “TPG”), a Delaware corporation and its direct and indirect wholly-owned subsidiaries, including: PMI Mortgage Insurance Co., an Arizona corporation, and its affiliated U.S. mortgage insurance and reinsurance companies (collectively “PMI”); PMI Mortgage Insurance Ltd and its holding company, PMI Mortgage Insurance Australia (Holdings) Pty Limited (collectively “PMI Australia”); PMI Mortgage Insurance Company Limited and its holding company TPG Reinsurance Company Limited, the Irish insurance companies (collectively “PMI Europe”); PMI Mortgage Insurance Asia Ltd. (“PMI Asia”); PMI Guaranty Co. (“PMI Guaranty”), which was formed in 2006; and other insurance, reinsurance and non-insurance subsidiaries. The PMI Group and its subsidiaries are collectively referred to as the “Company.” All material intercompany transactions and balances have been eliminated in the consolidated financial statements.
The Company has a 42.0% equity ownership interest in FGIC Corporation, the holding company of Financial Guaranty Insurance Company (collectively “FGIC”), a New York-domiciled financial guaranty insurance company. The Company also has equity ownership interests in CMG Mortgage Insurance Company, CMG Mortgage Reinsurance Company and CMG Mortgage Assurance Company (collectively “CMG MI”), which conduct residential mortgage insurance business for credit unions. The Company also has equity ownership interests in RAM Holdings Ltd., the holding company of RAM Reinsurance Company, Ltd. (collectively “RAM Re”), a financial guaranty reinsurance company based in Bermuda. The Company also has ownership interests in several limited partnerships. In addition, the Company owns 100% of PMI Capital I (“Issuer Trust”), an unconsolidated wholly-owned trust that privately issued debt in 1997. As of December 31, 2003, the Company deconsolidated PMI Capital I upon adoption of Financial Accounting Standards Board (“FASB”) Interpretation (“FIN”) 46, Consolidation of Variable Interest Entities, which provides guidance on identifying and assessing interests in variable interest entities to determine if consolidation or deconsolidation of that entity is required.
The consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) and the requirements of Form 10-K and Article 7 of Regulation S-X. The
Risks and Uncertainties-The Company is dependent upon mortgage originators to provide mortgage loans to insure. In the event any of its largest customers choose to stop providing the Company with mortgage loans to insure, the Company’s ability to generate new insurance business could be adversely affected. The Company’s U.S. Mortgage Insurance Operations’ ten largest customers generated 43.9%, 42.8% and 42.0% of its premiums earned in 2006, 2005 and 2004, respectively.
The Company’s various U.S., Australian, European, and Asian insurance subsidiaries are subject to 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 regulations.
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 and preferred stock dividends are recognized on an accrual basis. Dividend income on common stock is recognized on the date of declaration. Net investment income represents interest and dividend income, net of investment expenses.
Investments in Unconsolidated Subsidiaries-Investments in the Company’s unconsolidated subsidiaries include both equity investees and unconsolidated majority-owned subsidiaries. Investments in equity investees with ownership interests of 20-50% are generally accounted for using the equity method of accounting, and investments of less than 20% ownership interest are generally accounted for using the cost method of accounting if the Company does not have significant influence over the entity. Limited partnerships with ownership interests greater than 3% but less than 50% are primarily accounted for using the equity method of accounting. The Company reports the equity in earnings from FGIC and CMG MI on a current month basis, and RAM Re and the Company’s interest in limited partnerships on a one-quarter lag basis. The carrying value of the investments in the Company’s unconsolidated subsidiaries also includes the Company’s share of net unrealized gains and losses in the unconsolidated subsidiaries’ investment portfolios.
statements of FGIC are included in the Company’s Form 10-K. Additionally, the condensed financial statements of FGIC are included in Note 5. The Company has determined that its other equity investees do not meet any of the tests outlined above on a stand-alone or aggregate basis.
Deferred Policy Acquisition Costs-The Company defers certain costs in its mortgage insurance operations relating to the acquisition of new insurance and amortizes these costs against related premium revenue in order to match costs and revenues. To the extent the Company is compensated by customers for contract underwriting, those underwriting costs are not deferred. Costs related to the issuance of mortgage insurance business are initially deferred and reported as deferred policy acquisition costs. SFAS No. 60, Accounting and Reporting by Insurance Enterprises, (“SFAS No. 60”), specifically excludes mortgage guaranty insurance from its guidance relating to the amortization of deferred policy acquisition costs. Consistent with industry accounting practice, amortization of these costs for each underwriting year book of business is charged against revenue in proportion to estimated gross profits. Estimated gross profits are composed of earned premiums, interest income, losses and loss adjustment expenses as well as the amortization of deferred policy acquisition costs. The rate of amortization is not adjusted for monthly and annual policy cancellations unless it is determined that the policy cancellations are of such magnitude that impairment of the deferred costs is probable. The deferred costs related to single premium policies are adjusted as appropriate for policy cancellations to be consistent with the Company’s revenue recognition policy. The amortization estimates for each underwriting year are monitored regularly to reflect actual experience and any changes to persistency or loss development. Deferred policy acquisition costs are reviewed periodically to determine that they do not exceed recoverable amounts, after considering investment income.
In 2006 and 2005, the Company purchased foreign currency put options to mitigate the negative financial impact of a strengthening U.S. dollar relative to both the Australian dollar and the Euro. These Australian dollar and Euro put options expired ratably over the calendar years and had combined costs of $1.4 million and $1.8 million in 2006 and 2005, respectively. In 2006, the Company recorded a realized loss of $1.4 million (pre-tax) in other income related to amortization of option costs, partially offset by realized gains of $0.1 million. In 2005, the Company recorded a realized loss of $1.7 million (pre-tax) in other income related to amortization of option costs, partially offset by realized gains of $0.6 million.
Reserve for Losses and Loss Adjustment Expenses-The consolidated reserve for losses and loss adjustment expenses (“LAE”) for our U.S. Mortgage Insurance and International Operations 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. For reporting and internal tracking purposes, the Company does not consider a loan to be in default until it has been delinquent for two consecutive monthly payments. The Company’s U.S. mortgage insurance primary master policy defines “default” as the borrower’s failure to pay when due an amount equal to the scheduled monthly mortgage payment under the terms of the mortgage. Generally, however, the master policy requires an insured to notify PMI of a default no later than the
Revenue Recognition-Mortgage guaranty insurance policies are contracts that are generally non-cancelable by the insurer, are renewable at a fixed price, and provide payment of premiums on a monthly, annual or single basis. Upon renewal, the Company is not able to re-underwrite or re-price its policies. SFAS No. 60 specifically excludes mortgage guaranty insurance from its guidance relating to the earning of insurance premiums. Premiums written on a monthly basis are earned as coverage is provided. Monthly premiums accounted for 70.1% of gross premiums written from the Company’s mortgage insurance operations in 2006 and 70.8% in 2005 and 71.3% in 2004. Premiums written on an annual basis are amortized on a monthly pro rata basis over the year of coverage. Primary mortgage insurance premiums written on policies covering more than one year are referred to as single premiums. A portion of the revenue from single premiums is recognized in premiums earned in the current period, and the remaining portion is deferred as unearned premiums and earned over the expected life of the policy, a range of seven to fifteen years. If single premium policies related to insured loans are cancelled due to repayment by the borrower, and the premium is non-refundable, then the remaining unearned premium related to each cancelled policy is recognized as earned premiums upon notification of the cancellation. Unearned premiums represent the portion of premiums written that is applicable to the estimated unexpired risk of insured loans. Rates used to determine the earning of single premiums are estimates based on actuarial analysis of the expiration of risk. The premiums earnings pattern calculation methodology is an estimation process and, accordingly, the Company reviews its premium earnings cycle for each policy acquisition year (“Book Year”) annually and any adjustments to these estimates are reflected for each Book Year as appropriate.
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 effects of
Benefit Plans-The Company provides pension benefits to all employees under The PMI Group, Inc. Retirement Plan, and to certain employees of the Company under The PMI Group, Inc. Supplemental Employee Retirement Plan. In addition, the Company provides certain health care and life insurance benefits for retired employees under another post-employment benefit plan. On December 31, 2006, the Company adopted the recognition and disclosure provisions of SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plan, an amendment of FASB Statements No. 87, 88, 106 and 132(R) (“SFAS No. 158”) (See Notes 3 and 15). SFAS No. 158 required the Company to recognize the funded status (i.e., the difference between the fair value of plan assets and the projected benefit obligations) of its defined benefit postretirement plans as of December 31, 2006, with a corresponding adjustment to accumulated other comprehensive income.
All U.S. 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. Contract underwriters are covered under The PMI Group, Inc. Alternate 401(k) Plan, under which there are no matching Company contributions. In addition to the 401(k) Plan, the Company has an officers’ deferred compensation plan (“ODCP”) available to certain employees, and an Employee Stock Purchase Plan (“ESPP”). The ODCP is available to certain of the Company’s officers, and permits each participant to elect to defer receipt of part or all of his or her eligible compensation on a pre-tax basis. Under the ODCP, the Company makes a matching contribution of its common shares for each participant equal to 25% of the initial contribution to the extent the participant elects to select the Company’s common shares from the investment choices available under the ODCP. These matching contributions are subject to a three year vesting period. The ESPP allows eligible employees to purchase shares of the Company’s stock at a 15% discount to fair market value as determined by the plan. The ESPP offers participants the 15% discount to current fair market value or fair market value with a look-back provision of the lesser of the duration an employee has participated in the ESPP or two years.
Foreign Currency Translation-The financial statements of the Company’s foreign subsidiaries have been translated into U.S. dollars in accordance with SFAS No. 52, Foreign Currency Translation. Assets and liabilities denominated in non-U.S. dollar functional currencies are translated using the year-end spot exchange rates. Revenues and expenses are translated at monthly-average exchange rates. The effects of translating operations with a functional currency other than the reporting currency are reported as a component of accumulated other comprehensive income included in consolidated shareholders’ equity. Gains and losses on foreign currency re-measurement incurred by PMI Australia and PMI Europe represent the revaluation of assets and liabilities denominated in non-functional currencies into the functional currency, the Australian dollar and Euro, respectively. Effective July 1, 2006, the functional currency of PMI Asia is the Hong Kong dollar.
Business Segments-The Company’s reportable operating segments are U.S. Mortgage Insurance Operations, International Operations, Financial Guaranty, and Corporate and Other. U.S. Mortgage Insurance Operations includes the results of operations of PMI Mortgage Insurance Co., affiliated U.S. reinsurance companies and the equity in earnings from CMG MI. International Operations include the results of operations of PMI Australia, PMI Europe and PMI Asia. Financial Guaranty includes the equity in earnings from FGIC and RAM Re, and the results of PMI Guaranty effective October 1, 2006. The Company’s Corporate and Other segment consists of our holding company and contract underwriting operations.
In July 2006, the Company commenced an offer to exchange a new series of its 2.50% senior convertible debentures due 2021 (the “new debentures”) and an exchange fee of $3.50 per $1,000 principal amount of debentures for all of its existing 2.50% senior convertible debentures due 2021 (the “old debentures”). The purpose of the exchange offer was to change certain terms of the old debentures, including the addition of a net share settlement feature. This feature allowed the Company to satisfy a portion of its obligation due upon conversion of the debentures in cash, thereby reducing the dilution associated with the new debentures. This feature also limits the dilutive impact of the new debentures on the Company’s diluted earnings per share. Following completion of the exchange offer in August 2006, the Company had approximately $341.5 million in principal amount of its new debentures outstanding and approximately $18.4 million in principal amount of its old debentures outstanding. On October 27, 2006, the Company redeemed all of the $359.6 million aggregate principal amount of debentures that were not converted for a price equal to the principal amount of the debentures plus accrued and unpaid interest.
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:
Share-Based Compensation-On January 1, 2006, the Company adopted SFAS No. 123R, which addresses the accounting for share-based compensation in which an enterprise receives employee services in exchange for either equity instruments of the enterprise or liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments. The statement eliminates the ability to account for share-based payment transactions, using the intrinsic value method as prescribed by APB Opinion No. 25, Accounting for Stock Issued to Employees (“APB No. 25”), and generally requires that such transactions be accounted for using a fair-value-based method and recognized as expense in the consolidated results of operations. For share-based payments granted or unvested upon the adoption of SFAS No. 123R, the Company recognizes the fair value of share-based payments, including employee stock options and employee stock purchase plan shares, granted to employees as compensation expense in the consolidated results of operations.
The Company adopted SFAS No. 123R using the modified prospective method which requires the application of the accounting standard as of January 1, 2006. The Company’s consolidated financial statements for 2006 reflect the impact of adopting SFAS No. 123R. In accordance with the modified prospective method, the consolidated financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS No. 123R. With the adoption of SFAS No. 123R, the Company elected to recognize compensation costs related to employee stock option shares using the accelerated method.
Share-based compensation expense recognized during the year is based on the value of the portion of share-based payment awards that is ultimately expected to vest. Share-based compensation expense recognized in the consolidated statement of operations during 2006 includes compensation expense for share-based payment awards granted prior to, but not yet vested, as of December 31, 2005, based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure, (“SFAS No. 148”). Compensation expense for the share-based payment awards granted subsequent to December 31, 2005 is based on the grant date fair value estimated in accordance with SFAS No. 123R. As share-based compensation expense recognized in the consolidated
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities-Including an amendment of FASB Statement No. 115 (“SFAS No. 159”). SFAS No. 159 permits entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. The Statement does not eliminate disclosure requirements included in other accounting standards, including requirements for disclosures about fair value measurements included in FASB Statements No. 157, Fair Value Measurements, and No. 107, Disclosures about Fair Value of Financial Instruments. SFAS No. 159 is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. The Company is still evaluating the impact of SFAS No. 159 on its consolidated financial statements.
In September 2006, the FASB issued SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and other Postretirement Plans (“SFAS No. 158”), an amendment of SFAS No. 87, Employers’ Accounting for Pensions, SFAS No. 88, Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits, SFAS No. 106, Employers’ Accounting for Postretirement Benefits Other Than Pensions, and SFAS No. 132R, Employers’ Disclosures about Pensions and Other Postretirement Benefits. SFAS No. 158 requires an employer to recognize the funded status of a defined benefit postretirement plan in its balance sheet, measure the fair value of plan assets and benefit obligations as of the date of the fiscal year-end balance sheet and provide certain disclosures. On December 31, 2006, the Company adopted the recognition and disclosure provisions of SFAS No. 158. The effect of adopting SFAS No. 158 on the Company’s financial condition at December 31, 2006 has been included in the accompanying consolidated financial statements. SFAS No. 158 did not have an effect on the Company’s consolidated financial condition at December 31, 2005 or 2004. See Note 15 for further discussion of the effect of adopting SFAS No. 158 on the Company’s consolidated financial statements. The adjustment for initially applying SFAS No. 158, net of tax, to accumulated other comprehensive income as of December 31, 2006 was $1.2 million.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements, (“SFAS No. 157”) which defines fair value, establishes a framework for measuring fair value in GAAP, and expands disclosures about fair value measurements. SFAS No. 157 applies under other accounting pronouncements that require or permit fair
value measurements but does not expand the use of fair value in any new circumstances. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company is still evaluating the impact of SFAS No. 157 on its consolidated financial statements.
In February 2006, the FASB issued SFAS No. 155, Accounting for Certain Hybrid Financial Instruments-An amendment of FASB Statements No. 133 and 140 (“SFAS No. 155”), which amends SFAS No. 133 and SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, (“SFAS No. 140”). SFAS No. 155 simplifies the accounting for certain derivatives embedded in other financial instruments by allowing them to be accounted for as a whole instrument if the holder elects to account for the whole instrument on a fair value basis. SFAS No. 155 also clarifies and amends certain other provisions of SFAS No. 133 and SFAS No. 140. SFAS No. 155 is effective for all financial instruments acquired, issued or subject to a remeasurement event occurring in fiscal years beginning after September 15, 2006. SFAS No. 155 is not currently expected to significantly impact the Company’s consolidated financial statements.
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, 2006:
Aging of Unrealized Losses-The following table shows the gross unrealized losses and fair value of the Company’s investments, aggregated by investment category and the length of time the individual securities have been in a continuous unrealized loss position as of December 31, 2006.
Investments in the Company’s unconsolidated subsidiaries include both equity investees and unconsolidated majority-owned subsidiaries. The carrying values of the Company’s investments in unconsolidated subsidiaries consisted of the following for the years ended December 31, 2006 and 2005:
Equity in earnings (losses) from unconsolidated subsidiaries and equity investment held for sale consisted of the following for the years ended December 31, 2006, 2005 and 2004:
The following represents FGIC’s condensed balance sheet information as of December 31, 2006 and 2005, and condensed statement of operations information for year ended December 31, 2006, 2005 and 2004:
On October 4, 2005, the Company completed the sale of SPS to CSFB. The Company received cash payments of approximately $99 million for its holdings in SPS. The Company also received a residual interest in mortgage servicing assets with an estimated fair value at closing of approximately $20.7 million and expects to
receive additional monthly cash payments through the first quarter of 2008. As of December 31, 2006, the carrying value of the residual interest was $2.2 million. The Company and SPS’s other shareholders have agreed to indemnify CSFB for certain liabilities relating to SPS’s operations. As of December 31, 2006, the Company has recorded a liability of $6.4 million in respect of this indemnification obligation.
Depreciation and amortization expense related to property, equipment and software totaled $31.7 million in 2006, $28.9 million in 2005 and $27.5 million in 2004. Capitalized costs associated with software developed for internal use were $15.6 million in 2006, $24.9 million in 2005 and $29.5 million in 2004.
The Company establishes reserves for losses and LAE to recognize the estimated liability for potential losses and related LAE related to insured mortgages that are in default. The establishment of a loss reserve is subject to inherent uncertainty and requires significant judgment by management. The following table provides a reconciliation of the beginning and ending consolidated reserves for losses and LAE for each of the three years:
The $12.2 million increase and $2.6 million and $11.1 million reductions in total losses and LAE incurred in prior years were due to re-estimates of ultimate loss rates and amounts from those established at the original notice of default, updated through the years presented. These re-estimates of ultimate loss rates and amounts are the result of management’s periodic review of estimated claim amounts in light of actual claim amounts, loss development data or ultimate claim rates. The $12.2 million increase in prior years’ reserves during 2006 was due primarily to re-estimates of claim sizes and claim rates for PMI Australia as a result of the impact of rising interest rates in 2006 and moderating or declining home price appreciation in 2005 and 2006.
8.309% Junior Subordinated Debentures-The Junior Subordinated Debentures bear interest at the rate of 8.309% per annum paid semiannually and mature on February 1, 2027. The Junior Debentures are redeemable at the option of the Company on or after February 1, 2007. The Junior Subordinated Debentures are subordinated to all senior indebtedness of The PMI Group.
Considerable judgment is required in interpreting market data to develop the estimates of fair value and, therefore, changes in the assumptions may have a material effect on the fair valuation estimates. A number of the Company’s other significant assets and liabilities, including deferred policy acquisition costs, real estate owned, property, equipment and software, loss and LAE reserves, unearned premiums, and deferred income taxes are not considered financial instruments.
The majority of the Company’s existing reinsurance contracts are captive reinsurance agreements in U.S. Mortgage Insurance Operations. Under captive reinsurance agreements, a portion of the risk insured by PMI is reinsured with the mortgage originator or investor through a reinsurer that is affiliated with the mortgage originator or investor. Ceded premiums for U.S. captive reinsurance accounted for 91% of total ceded premiums written in 2006 compared to 89% in 2005 and 87% in 2004. Reinsurance recoverables on losses incurred in U.S. Mortgage Insurance Operations were $2.9 million at December 31, 2006, $2.5 million at December 31, 2005 and $2.4 million at December 31, 2004.
PMI has provided for U.S. federal income tax on the undistributed earnings from its foreign subsidiaries and foreign corporate joint ventures, except to the extent that such earnings are reinvested indefinitely.
Leases-The Company leases certain office space and office equipment. Minimum rental payments under non-cancelable operating leases in the aggregate for the five years subsequent to 2006 are as follows:
Income Taxes-In March 2005, the Internal Revenue Service commenced its regular audit examination of the Company’s taxable years 2001 to 2003. As of December 31, 2006, no tax issues have been presented that would, in the opinion of management, give rise to a material assessment or have a material effect on the consolidated financial condition, results of operations or cash flows of the Company.
Indemnification-SPS-As part of the sale of the Company’s interest in SPS on October 4, 2005, the Company and SPS’s other prior shareholders have indemnified CSFB for certain liabilities relating to SPS’s operations, including litigation and regulatory actions, and this indemnification obligation may potentially reduce the monthly proceeds that the Company receives post sale. The maximum indemnification obligation for SPS’s operations is $33.7 million. The Company’s portion of this obligation is 61.4% or $20.7 million. As of December 31, 2006, the Company had recorded a liability of $6.4 million with respect to this indemnification obligation.
In August 2006, The PMI Group entered into an accelerated stock buyback program with a major financial institution pursuant to which The PMI Group agreed to purchase shares of common stock for an aggregate purchase price of $345 million. Until conclusion of the program in the second quarter of 2007 (which may in certain circumstances be accelerated or extended), the total number of common shares to be purchased cannot be determined. The number of common shares to be repurchased under the program generally will be based on the volume weighted average share price of the common stock during the term of the program. The program is subject to collar provisions that establish minimum and maximum number of shares based on the volume weighted average share price over an initial hedge period (the “Hedge Period”), which concluded at the end of September 2006. With the conclusion of the Hedge Period, the minimum number of common shares to be repurchased has been set at 7.2 million and the maximum number of shares to be repurchased has been set at 8.2 million. As of the end of the Hedge Period, the financial institution has delivered the 7.2 million minimum number of shares. The final number of shares that the Company will receive depends on the share price of the common stock during the remaining term of the program. In addition to the accelerated stock buyback program, in the fourth quarter of 2006, the Company repurchased 0.9 million shares for $40 million for an average price per common share of $44.11.
Dividends-PMI’s ability to pay dividends to The PMI Group is affected by state insurance laws, credit agreements, credit rating agencies, and the discretion of insurance regulatory authorities. The laws of Arizona, PMI’s state of domicile for insurance regulatory purposes, provide that PMI may pay dividends out of any available surplus account, without prior approval of the Director of the Arizona Department of Insurance, during any 12-month period in an amount not to exceed the lesser of 10% of policyholders’ surplus as of the preceding year end or the prior calendar year’s net investment income. A dividend that exceeds the foregoing threshold is deemed an “extraordinary dividend” and requires the prior approval of the Director of the Arizona Department of Insurance. On June 7, 2006, the Director of the Arizona Department of Insurance approved an extraordinary dividend request of $250 million. This dividend was paid to The PMI Group in two installments of $150 million in August of 2006 and $100 million in September of 2006, respectively. In December 2006, the Director of the
Effective January 1, 2003, all full-time and part-time employees of the Company are eligible to participate in The PMI Group, Inc. Retirement Plan (the “Plan”), a noncontributory defined benefit plan. The Plan generally has been funded by the Company to the fullest extent permitted by federal income tax rules and regulations. In addition, certain employees whose annual earnings exceed $220,000 under Internal Revenue Code (“IRC”) Section 401(a)(17) and limits established under IRC Section 415, participate in The PMI Group, Inc. Supplemental Employee Retirement Plan (“The SERP Plan”), a noncontributory defined benefit plan. Benefits under both pension plans are based upon the employees’ length of service, average annual compensation and estimated social security retirement benefits.
The Company provides certain health care and life insurance benefits for retired employees under another post-employment benefit plan. Generally, qualified employees may become eligible for these benefits if they retire in accordance with the Company’s established retirement policy and are continuously insured under the Company’s group plans or other approved plans for ten or more years prior to retirement. The Company contributes a fixed dollar subsidy towards the cost of coverage. Retirees are expected to pay all amounts in excess of the Company’s fixed dollar subsidy. The Company assessed the impact on liabilities due to the Medical Prescription Drug, Improvement and Modernization Act of 2003 and determined that it is not material to the Company’s liability under these benefit plans.
On December 31, 2006, the Company adopted the recognition and disclosure provisions of SFAS No. 158. SFAS No. 158 required the Company to recognize the funded status (i.e., the difference between the fair value of plan assets and the projected benefit obligations) of its defined benefit postretirement plans in the December 31, 2006 balance sheet, with a corresponding adjustment to accumulated other comprehensive income, net of tax. The adjustment to accumulated other comprehensive income at adoption represents the net unrecognized actuarial gains/losses and unrecognized prior service costs which were previously netted against the funded status. These amounts will be subsequently recognized as net periodic benefit cost pursuant to the Company’s historical accounting policy for amortizing such amounts. Further, actuarial gains and losses that arise in subsequent periods and are not recognized as net periodic benefit cost in the same periods will be recognized as component of other comprehensive income. Those amounts will be subsequently recognized as a component of net periodic benefit cost on the same basis as the amounts recognized in accumulated other comprehensive income at adoption of SFAS No. 158.
The incremental effects of adopting the provision of SFAS No. 158 on the Company’s balance sheet as of December 31, 2006 are presented in the following table. The adoption of SFAS No. 158 had no effect on the Company’s consolidated statement of operations for the year ended December 31, 2006 or for any prior periods presented.
Employee Stock Purchase Plan-The PMI Group, Inc. Employee Stock Purchase Plan (“ESPP”) allows eligible employees to purchase shares of the Company’s stock at a 15% discount to fair market value as determined by the plan. The ESPP offers participants the 15% discount to current fair market value or fair market value with a look-back provision of the lesser of the duration an employee has participated in the ESPP or two years. Based on the features of the ESPP, it is considered compensatory according to the provisions of SFAS No. 123R. Under the ESPP, the Company issued 128,467 treasury shares in 2006, 139,884 treasury shares in 2005 and 96,021 treasury shares in 2004. The Company’s adoption of SFAS No. 123(R) in the first quarter of 2006 required expense recognition of the amount of the discount to current fair value of ESPP shares purchased by employees.
Impact of the Adoption of SFAS No. 123R-The Company adopted SFAS No. 123R using the modified prospective method beginning January 1, 2006. Accordingly, during 2006, the Company recorded stock-based compensation expense for awards granted prior to, but not yet vested at January 1, 2006, as if the fair value method required for pro forma disclosure under SFAS No. 123 were in effect for expense recognition purposes, adjusted for estimated forfeitures.
As SFAS No. 123R requires that share-based compensation expense be based on awards that are ultimately expected to vest, share-based compensation for the year ended December 31, 2006 has been reduced for estimated forfeitures. The Company is required to estimate forfeitures at the time of grant and revise those estimates in subsequent periods if actual forfeitures differ from those estimates. The Company uses historical data to estimate pre-vesting option forfeitures and record share-based compensation expense only for those awards that are expected to vest.
been reported under prior accounting rules. As a result of adopting SFAS No. 123R, $1.3 million of excess tax benefits for the year ended December 31, 2006 have been classified in cash flows from financing activities. Cash received from option exercises and the ESPP for the years ended December 31, 2006, 2005 and 2004, was $41.6 million, $20.7 million and $25.4 million, respectively. The actual tax benefit realized for the tax deductions from option exercise of the share-based payment arrangements totaled $6.2 million, $3.8 million and $8.2 million, respectively.
The following table summarizes the effect of adopting SFAS 123R for the year ended December 31, 2006:
As of December 31, 2006, there was $6.3 million of unrecognized compensation cost, adjusted for estimated forfeitures, related to non-vested share-based payments granted to employees. This unrecognized expense is expected to be recognized over a weighted average period of 2.1 years. Total unrecognized compensation cost will be adjusted for future changes in estimated forfeitures.
Valuation Assumptions-The fair value of share options granted to employees is estimated on the date of the grant using the Black-Scholes option pricing model. This option pricing model was 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. The model also requires considerable judgment, including assumptions regarding future share price volatility and expected time to exercise, which greatly affect the calculated value of stock option grants.
The fair value of each stock option grant is estimated on the date of the grant using the Black-Scholes option pricing model with the following weighted-average assumptions:
A summary of the share-based compensation activity under the Equity Incentive Plan as of December 31, 2006 and changes during the year then ended is presented below:
Share-based employee compensation expense, net of related tax effects, for 2005 includes the acceleration of employee stock options during 2005. On May 19, 2005, the Company approved the acceleration of the vesting of certain unvested out-of-the-money stock options awarded under the Company’s Equity Incentive Plan to all officers and employees. The affected options were those unvested options outstanding with exercise prices greater than $37.00 per share, which was the closing price of the Company’s common stock on May 19, 2005. As a result of this acceleration, unvested options granted in 2005 and 2004 to acquire approximately 2.3 million shares of the Company’s common stock, which otherwise would have vested on an annual basis through March 14, 2008, became immediately vested.
Reporting segments are based upon our internal organization structure, the manner in which the Company’s operations are managed, the criteria used by our chief operating decision-maker to evaluate segment performance, the availability of separate financial information, and overall materiality considerations.
The following tables present information for reported segment income or loss and segment assets as of and for the years indicated:
PMI has entered into capital support agreements with PMI Australia, PMI Europe and PMI Guaranty that could require PMI to make additional capital contributions to those subsidiaries for rating agency purposes. The PMI Group guarantees the performance of PMI’s capital support obligations.