Corporate and Other. Our Corporate and Other segment consists of corporate debt and expenses of our holding company (“The PMI Group” or “TPG”), contract underwriting operations, and equity in earnings or losses from investments in certain limited partnerships. Our Corporate and Other segment generated net income of $33.4 million in 2008 and a net loss of $47.8 million in 2007.
Based on current and expected future trends, we believe that we will continue to incur and pay material losses. The ultimate amount of losses will depend in part on general economic conditions and other factors, including the health of credit markets, home price fluctuations and unemployment rates. We are significantly limiting PMI’s new business writings to conserve capital and are exploring other available alternatives, including potentially obtaining capital or other relief under the U.S. Treasury’s Financial Stability Plan (including the Troubled Asset Relief Program, or TARP), obtaining reinsurance for our insurance subsidiaries’ future books of business, other capital relief initiatives at PMI, and/or debt or equity offerings. Unless we raise capital, PMI’s policyholders position will likely decline and risk-to-capital ratio will likely increase beyond levels necessary to meet regulatory capital adequacy requirements and, if we are unsuccessful in renegotiating our revolving credit facility by April 15, 2009, certain credit facility financial covenants. Especially given current and expected future market conditions, there can be no assurance that we will be able to raise any additional capital, either on
Defaults. PMI’s primary default inventory increased to 109,580 as of December 31, 2008 from 63,197 as of December 31, 2007. PMI’s primary default rate increased to 14.1% as of December 31, 2008 from 7.9% as of December 31, 2007. The increase in the default rate is due to the combined effect of the higher default inventory and fewer policies in force. We expect PMI’s primary default inventory and default rate to continue to increase in 2009. The increases in PMI’s primary default inventory and default rate in 2008 were driven by a number of factors including:
Declining Home Prices and Rising Unemployment-Declining home prices and rising unemployment have made it significantly more difficult for many borrowers to remain current on their mortgage payments, refinance their mortgages or sell their homes, and are negatively affecting PMI’s default inventory and default rate. In addition, accelerating job losses and rising unemployment rates are expected to negatively affect PMI’s default rates and default inventory.
Decline in Cure Rate-The percentage of defaults that cure has declined due to diminished refinancing opportunities as a result of declining home prices and diminished availability of loan products. This decline in the percentage of defaults that cure has negatively affected PMI’s default inventory and default rate. The decline in PMI’s cure rate has been partially offset by successful loss mitigation efforts and by increased rescissions of insurance written in prior periods.
Above-97s-PMI has experienced higher than expected levels of delinquent mortgages with loan-to-value ratios (“LTVs”) exceeding 97%, which we refer to as “Above 97s”, in its flow and structured channels. Effective March 1, 2008, we no longer insure Above-97s. Above-97s represented 4.8% of our total primary NIW for the year ended December 31, 2008 compared to 31.6% for the year ended December 31, 2007. As of December 31, 2008, risk in force from Above-97s in all book years represented 21.5% of PMI’s primary risk in force compared to 24.6% as of December 31, 2007. As of December 31, 2008, of the 21.5% of PMI’s primary risk in force from Above-97s, approximately half was from our 2007 book year. The default rate for Above-97s in PMI’s primary portfolio as of December 31, 2008 was 18.3% compared to 9.1% as of December 31, 2007. As of February 1, 2009, we stopped insuring loans with LTVs exceeding 95%.
Captive Reinsurance. As of December 31, 2008, 49.0% of PMI’s primary insurance in force was subject to captive reinsurance agreements. As of December 31, 2008, we recorded $482.7 million in reinsurance recoverables from ceded losses primarily from captive arrangements related to PMI’s gross loss reserves. Due to the delay between establishing a reserve and the payment of claims, we have only received $12.9 million in claim payments related to reinsurance recoverables from captive trust accounts in 2008. As of December 31, 2008, assets in captive trust accounts held for the benefit of PMI totaled approximately $860.1 million. We expect that reinsurance payments to PMI from captive trust assets will substantially increase in 2009.
Voluntary Early Retirement Program and Restructuring Charges. In 2008, we initiated involuntary terminations and a Voluntary Early Retirement Program (the “Program”). The Program was made available to employees (other than the CEO) who were at least 52 years of age and had seven or more years of service. We incurred net expenses of $45.9 million in 2008 as a result of these restructuring activities. We expect to incur an additional $1.0 million to $2.0 million of expenses in 2009 as a result of the Program.
PMI Europe has been downgraded, and currently has insurer financial strength ratings of “A-” (Negative Outlook), “BBB+” (Negative) and “B1” (Rating Developing), from Standard & Poor’s, Fitch and Moody’s, respectively. As a result of these rating agency actions and other contractual requirements, counterparties have required PMI Europe to post collateral of $64.2 million on CDS transactions as of March 15, 2009. As a result of such factors as changes in CDS valuations and/or deterioration in the performance of the underlying collateral referenced in such transactions, PMI Europe may be required to post additional collateral. (See Item 1A. Risk Factors-We are exposed to risk in our European operations.)
As a result of the changes in our International Operations described above, our International Operations will generate a substantially smaller portion of our revenues in 2009 and thereafter.
Financial Guaranty. Factors affecting the financial performance of our Financial Guaranty segment include:
Discontinued Operations of PMI Guaranty. During the third quarter of 2008, PMI Guaranty paid approximately $152 million of its excess capital to The PMI Group, of which $144 million was reinvested in U.S. Mortgage Insurance Operations. Having completed its runoff activities, we now report the results of operations of PMI Guaranty as discontinued operations in the Financial Guaranty segment and in the consolidated statement of operations for all periods presented.
As a result of the changes in our Financial Guaranty segment described above, we do not expect to generate significant revenues from our Financial Guaranty segment in 2009 or thereafter.
Contract Underwriting Services. As a result of lower levels of mortgage originations and a decline in requests for contract underwriting services, our contract underwriting activities and revenues have declined, and on March 12, 2009, we announced that we will discontinue offering contract underwriting services. Total contract underwriting expenses include allocated expenses and monetary remedies provided to customers in the event we failed to properly underwrite a loan. Contract underwriting remedies and related expenses were $4.8 million in 2008 compared to $7.1 million in 2007. We may still be obligated to pay remedies in the future even though we have ceased providing contract underwriting services.
The decrease in premiums earned in 2008 compared to 2007 was driven by lower premiums earned in our U.S. Mortgage Insurance Operations segment, which was primarily due to lower NIW and higher levels of rescissions of insurance previously written (which generate premium refunds), partially offset by higher persistency in 2008 compared to 2007. The increase in premiums earned in 2007 compared to 2006 was driven by higher levels of insurance in force caused by increased levels of NIW, higher persistency and higher insured loan sizes.
The increase in net investment income in 2008 compared to 2007 was primarily due to the growth of PMI’s investment portfolio. The increase in our investment portfolio was partially offset by a decrease in our pre-tax book yield. Our consolidated pre-tax book yield was 3.46%, 5.07% and 5.18% as of December 31, 2008, 2007, and 2006, respectively. The decrease in our consolidated pre-tax book yield in 2008 was primarily due to an increase in cash and cash equivalents generated from the sale of PMI Australia and Asia.
The net realized investment loss in 2008 of $139.2 million was primarily due to impairment of preferred securities in our investment portfolio of $96.5 million, impairments of our investment in FGIC of $88.0 million and impairment of our investment in RAM Re in the amount of $2.9 million, partially offset by gains on the sale of common stock in PMI’s investment portfolio. The net realized investment loss in 2007 was driven by the other-than-temporary impairment of our investment in RAM Re of $38.5 million. This loss was partially offset by a $12.7 million settlement gain related to the favorable resolution of certain indemnifications associated with the sale of our investment in Select Portfolio Servicing (“SPS”) in 2005. The decline in other income in 2007 was due to unrealized mark-to-market losses of $16.9 million from PMI Europe’s CDS derivative contracts as a result of the significant widening of market spreads.
The equity in losses in 2008 for RAM Re was $57.7 million, primarily due to RAM Re’s results of operations driven by increases in loss reserves. Due to the impairment of our FGIC investment in the first quarter of 2008, we did not recognize any equity in earnings (losses) from FGIC in 2008. The equity in losses in 2007 was primarily due to equity in losses from FGIC as a result of net unrealized mark-to-market losses predominantly related to CDS derivative contracts and loss reserve increases.
(Loss) income from discontinued operations includes the financial results of PMI Australia, PMI Asia and PMI Guaranty. Losses from discontinued operations for 2008 also include recorded impairments related to our sales of PMI Australia and PMI Asia.
The increase in gross premiums written in 2008 was primarily due to higher insurance in force in our monthly product category compared to 2007. The decrease in premiums earned in 2008 compared to 2007 was
primarily due to lower NIW and higher levels of rescissions of insurance previously written, both of which are expected to negatively impact our premiums earned in future periods. The increases in gross and net premiums written and premiums earned in 2007 compared to 2006 were primarily due to increased insurance in force from increased NIW as well as higher persistency.
As of December 31, 2008, 49.0% of PMI’s primary insurance in force and 49.5% of its risk in force were subject to captive reinsurance agreements compared to 52.2% and 52.3%, respectively, as of December 31, 2007. PMI no longer seeks reinsurance under excess-of-loss (“XOL”) reinsurance arrangements with lender affiliated captive reinsurers. On January 1, 2009, in-force XOL contracts went into runoff and will mature pursuant to their terms and conditions. PMI will continue to cede premiums to the captives in runoff but these cessions are expected to decrease over time as the number of loans in our portfolio subject to captive reinsurance arrangements decrease.
Net investment income-Net investment income increased in 2008 primarily due to increased holdings of fixed income securities and cash and cash equivalents in PMI’s investment portfolio at December 31, 2008 compared to at December 31, 2007, partially offset by a decrease in pre-tax book yield. PMI’s pre-tax book yield was 3.49% at December 31, 2008, 5.15% at December 31, 2007 and 5.28% at December 31, 2006. The pre-tax book yield for 2008 was lower than 2007 primarily due to interest rate decreases during the year. Fixed income securities and cash and cash equivalents in PMI’s portfolio increased to $3.0 billion as of December 31, 2008 from $1.8 billion as of December 31, 2007. The increase in net investment income in 2007 compared to 2006 was primarily due to an increase in municipal bond refundings in 2007.
Losses and LAE-PMI’s losses and LAE represent claims paid, certain expenses related to default notification and claim processing and changes to loss reserves during the applicable period. Because losses and LAE includes changes to loss reserves, it reflects our best estimate of PMI’s future claim payments and costs to process claims relating 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.
The increase in claims paid including LAE in 2008 compared to 2007 was driven by higher average primary claim sizes and an increase in the number of primary claims paid (or claim rate). The increases in PMI’s average
The increase in claims paid including LAE in 2007 compared to 2006 was primarily due to higher claim rates and higher average claim sizes as well as home price declines, as discussed above. For a discussion of the changes in net loss reserves in 2008 and 2007, see Conditions and Trends Affecting our Business-U.S. Mortgage Insurance Operations-Losses and LAE, above.
The increases in PMI’s primary default inventory and default rate in 2008 are discussed in Conditions and Trends Affecting our Business-U.S. Mortgage Insurance Operations-Defaults, above. The increases in PMI’s primary default inventory and default rate in 2007 compared to 2006 were driven by a number of factors including, declining home prices, particularly in California and Florida, weak economic conditions in the Auto States, and higher levels of default on Above-97, Alt-A and 2/28 hybrid ARM loans in PMI’s flow and structured channels.
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 we provided contract underwriting services on loans that did not require mortgage
PMI incurs underwriting expenses related to contract underwriting services for mortgage loans without mortgage insurance coverage. These costs are allocated to PMI Mortgage Services Co., or MSC, which is reported in our Corporate and Other segment, thereby reducing PMI’s underwriting and operating expenses. Contract underwriting expenses allocated to MSC were $9.7 million in 2008, $13.1 million in 2007, and $12.7 million in 2006.
Income taxes-U.S. Mortgage Insurance Operations statutory tax rate is 35%. The tax benefit recorded in the U.S. Mortgage Insurance Operations segment reflects tax benefits attributable to changes in the compositions of earnings and the effect of tax exempt income as a proportion of net income resulting in an effective tax rate of 37.1% for 2008.
Modified pool insurance-PMI wrote $4.1 million of modified pool risk in 2008 compared to $0.4 billion of modified pool risk in 2007. This decline was driven by a reduction in demand for this product by our customers and capital conservation in 2008. We did not enter into any new modified pool agreements in 2008, and we do not expect to write modified pool risk in the foreseeable future. Modified pool risk in force was $2.2 billion as of December 31, 2008, $2.9 billion as of December 31, 2007 and $2.5 billion as of December 31, 2006.
Primary insurance in force as of December 31, 2008 increased from December 31, 2007 primarily as a result of higher persistency. Primary insurance in force and risk in force as of December 31, 2007 increased from December 31, 2006 primarily as a result of higher persistency and higher levels of NIW. The increases in PMI’s persistency rate in 2008 and 2007 reflect lower levels of residential mortgage refinance activity and home price declines. Primary risk in force as of December 31, 2008 decreased primarily as a result of lower NIW in 2008.
The following table sets forth the percentages of PMI's primary risk in force as of December 31, 2008, 2007, and 2006 in the ten states with the highest risk in force as of December 31, 2008 in PMI’s primary portfolio:
Credit and portfolio characteristics-Less-than-A quality loans generally include loans with credit scores less than 620. In 2008, PMI’s NIW consisted of significantly lower percentages of less-than-A quality and Alt-A loans than in 2007 primarily as a result of changes in PMI’s pricing and underwriting guidelines in 2007 and 2008. The following table presents PMI’s less-than-A quality and Alt-A loans as percentages of its flow channel and structured finance channel primary NIW:
Less-than-A quality loans with FICO scores below 575 is a subset of PMI’s less-than-A quality loan portfolio.
2/28 Hybrid ARMs are loans whose interest rate is fixed for an initial two year period and floats thereafter.
International Operations’ results include continuing operations of PMI Europe and PMI Canada, and discontinued operations and losses on the sales of PMI Australia and PMI Asia:
The following table sets forth the financial results of PMI Europe for the periods set forth below:
Premiums written and earned-Net premiums written increased in 2008 compared to 2007 primarily due to growth in new reinsurance written in the U.K. We do not expect this trend to continue in 2009. Net premiums written increased in 2007 compared to 2006 primarily due to growth in primary NIW, particularly in Italy. The decrease in premiums earned in 2008 compared to 2007 and 2007 compared to 2006 was due primarily to decreases in premiums earned associated with the Royal & SunAlliance (“R&SA”) insurance portfolio acquired in 2003.
Net (losses) gains from credit default swaps-PMI Europe is currently a party to sixteen credit default swap (“CDS”) contracts that are classified as derivatives. PMI Europe’s net unrealized losses in 2008 from its credit default swaps were primarily a result of changes in the fair value of the derivative contracts in 2008 due to the significant widening of CDS spreads during the period. Net losses were partially offset by gains from increased cash flows from contracts concluded in the fourth quarter of 2007. We recorded unrealized mark-to-market loss of $17.9 million and $16.9 million in 2008 and 2007, respectively, on PMI Europe’s CDS derivative contracts as a result of the significant widening of market spreads. The underlying collateral of these credit derivatives are residential mortgage loans. Accordingly, continued adverse conditions in the residential mortgage credit market may continue to result in mark-to-market losses. See also Item 1A. Risk Factors-We are exposed to risk in our European operations.
Net investment income-PMI Europe’s net investment income consists primarily of interest income from its investment portfolio including cash deposits, and gains and losses on foreign currency re-measurement. The pre-tax book yield was 3.46%, 4.45% and 4.33% as of December 31, 2008, 2007 and 2006, respectively. The increase in net investment income in 2008 compared to 2007 was primarily due to foreign currency re-measurement from Sterling denominated investments to Euros. The increase in net investment income in 2008 was also attributable to the strengthening of the Euro relative to the dollar. The decrease in net investment income in 2007 compared to 2006 was primarily due to foreign currency re-measurement, partially offset by an increase in PMI Europe’s investment portfolio.
Losses and LAE-PMI Europe’s losses and LAE includes claim payments, excluding payments for CDS accounted as derivatives, and changes in reserves. Claim payments totaled $14.4 million in 2008 compared to $5.1 million and $1.9 million in 2007 and 2006, respectively. The increase in claim payments in 2008 resulted primarily as a result of claims paid of $10.3 million related to the US reinsurance business. We increased PMI Europe’s loss reserves by $48.8 million in 2008 primarily due to the deteriorating performance of certain U.S. subprime exposures on which PMI Europe provided reinsurance coverage in 2005 and, to a lesser extent in 2008, increased defaults on the Italian primary flow business. We increased PMI Europe’s loss reserves by $23.7 million in 2007 primarily due to a loss provision related to the deteriorating performance of a small number of U.S. exposures on which PMI Europe provided reinsurance coverage.
Risk in force-PMI Europe’s risk in force as of December 31, 2008 was $7.4 billion compared to $9.4 billion as of December 31, 2007 and $3.9 billion as of December 31, 2006. The decrease in 2008 was primarily due to a number of credit default swap contracts being called as scheduled, limited new business writings and weakening of the Euro against the U.S. dollar. The increase in 2007 compared to 2006 was primarily due to new credit default swaps written in 2007, increased primary insurance written and the strengthening of the Euro against the U.S. dollar.
The table below sets forth the financial results of PMI Canada. PMI Canada began operations in 2007.
Total revenues-Total revenues increased in 2008 compared to 2007 primarily due to foreign currency re-measurement gains from U.S. dollar denominated cash and cash equivalents and from premiums earned on a 2008 bulk primary transaction. PMI Canada did not write business in 2007. PMI Canada’s revenue in 2007 consisted primarily of investment income on its investment portfolio.
Losses and LAE-PMI Canada’s losses and LAE increased in 2008 compared to 2007 due to the notices of default received in 2008 on its 2008 business writings. PMI Canada did not write any business in 2007.
Underwriting and operating expenses-The increase in underwriting and operating expenses in 2008 compared to 2007 was primarily due to severance costs.
Having completed its runoff activities, we now report the results of operations of PMI Guaranty as discontinued operations in the Financial Guaranty segment and in the consolidated statement of operations for all periods presented.
Change in fair value of certain debt instruments-The change in fair value of certain debt instruments in 2008 resulted from our adoption of SFAS No. 159, effective January 1, 2008. In connection with our adoption of SFAS No. 159, we elected the fair value option presented by SFAS No. 159 with respect to certain of our long term debt instruments. The realized gain of $123.6 million in 2008 is the result of fluctuations of fair value in 2008 primarily due to widening credit spreads and changes in interest rates.
Share-based compensation expenses-The decrease in share-based compensation in 2008 from 2007 was primarily due to decreases in the fair value of share-based compensation and the number of stock units granted in 2008. The increase in share-based compensation in 2007 from 2006 was primarily due to our acceleration of out-of-the-money stock options in 2005, which reduced our share-based compensation expense in 2006.
Income taxes-The tax rate of 28.3% for 2008 declined from 38.0% and 29.2% for 2007 and 2006, respectively, due primarily to allocation of certain federal and state taxes (or benefits) to the Corporate and Other business segment.
The PMI Group Liquidity-The PMI Group is a holding company and conducts its business operations through various subsidiaries. Historically, The PMI Group’s liquidity is primarily dependent upon: (i) The PMI Group’s subsidiaries’ ability to pay dividends to The PMI Group; (ii) financing activities in the capital markets; (iii) maturing or refunded investments and investment income from The PMI Group’s investment portfolio; and (iv) receivables from PMI with respect to tax sharing agreements. The PMI Group’s ability to access dividend and financing sources is limited and depends on, among other things, the financial performance of The PMI Group’s subsidiaries, regulatory restrictions on the ability of The PMI Group’s insurance subsidiaries to pay dividends, The PMI Group’s and its subsidiaries’ ratings by the rating agencies, and restrictions and agreements to which The PMI Group or its subsidiaries are subject that restrict their ability to pay dividends, incur debt or issue equity securities. PMI did not pay dividends to The PMI Group in 2008 and we do not expect that PMI will be able to pay dividends in 2009 or 2010. In addition, the economic downturn has reduced returns on the PMI Group’s investment portfolio, and we expect these returns could continue to be adversely affected to the extent the dislocation in the credit markets and economic downturn continues. See Item 1A. Risk Factors-We may face liquidity issues at our holding company, The PMI Group.
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 and 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 $235.9 million at December 31, 2008 (including $200 million outstanding under our revolving credit facility described below) compared to $78.4 million at December 31, 2007.
Subject to the terms of the temporary suspension, the total amount available under the credit facility is $250 million, of which we have drawn $200 million. In addition, there is one outstanding letter of credit drawn under the facility totaling approximately $0.25 million. The availability under the credit facility is subject to reduction, potentially by up to an additional $100 million, in the event of certain asset sales or equity or debt issuances. The facility includes a $50 million letter of credit sub-limit. We have granted the lenders under the revolving credit facility a security interest under a Shared Collateral Pledge Agreement with U.S. Bank National Association as collateral agent (the “Collateral Agent”), pursuant to which we granted a security interest in the stock of MIC in favor of the Collateral Agent, for the benefit of both the lenders under the credit facility and the noteholders under certain of our senior notes. In addition, we have pledged to the lenders under the revolving credit facility the stock of four of TPG’s reinsurance subsidiaries.
The credit facility contains a number of financial covenants, including a minimum Adjusted Consolidated Net Worth (as defined in the facility) requirement of $1.5 billion (reduced to $1.2 billion through April 15, 2009 by the temporary suspension), a maximum total debt to total capitalization percentage requirement of 35%, and a maximum risk-to-capital ratio requirement of 20 to 1 (increased to 24 to 1 through April 15, 2009 by the temporary suspension). Events of default under the existing facility include, among others: (a) PMI being suspended as an approved mortgage insurer by either of the GSEs, and failing to cure such suspension within 30 days, or PMI being disqualified or terminated as an approved mortgage insurer by either of the GSEs; (b) PMI failing to maintain a financial strength rating of at least “Baa” from Moody’s while also failing to maintain a financial strength rating of at least “BBB” from S&P; and (c) our material insurance subsidiaries (as defined in
As of December 31, 2008, our Adjusted Consolidated Net Worth was $1.72 billion and our total debt to total capitalization percentage was 27.4% and PMI’s risk-to-capital ratio was 18.5 to 1. PMI’s insurer financial strength ratings are “Ba3 (Developing)” from Moody’s and “A- (Watch Negative)” from S&P. In addition, while we have submitted to the GSEs remediation plans, and to date each of the GSEs has continued to treat PMI as an eligible mortgage insurer, we cannot be sure that the GSEs will continue to treat PMI as an eligible mortgage insurer. We believe that we will continue to incur material losses that will reduce our Adjusted Consolidated Net Worth, increase our total debt to total capitalization percentage, and increase PMI’s risk-to-capital ratio. S&P may take additional ratings actions with respect to PMI and other mortgage insurers in the very near future. See also Item 1A. Risk Factors-Our credit facility contains restrictive and financial covenants and, if we are unable to comply with these covenants, we may trigger an event of default under the facility.
PMI’s ability to pay dividends to The PMI Group is affected by state insurance laws, credit agreements, 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 (“Arizona Director”), 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 Arizona Director. In 2006 and 2007, the Arizona Director approved two extraordinary dividend requests totaling $450 million. PMI paid $265 million of the $450 million of approved extraordinary dividends to The PMI Group in 2006 and 2007 but did not pay any dividend to The PMI Group in 2008. We do not anticipate that PMI will pay any dividends to The PMI Group in 2009 and 2010. Any payment of the remaining $185 million of approved dividends by PMI to The PMI Group requires prior written notice to the Arizona Director, who could withdraw approval of such dividends.
U.S. Mortgage Insurance Operations Liquidity-The principal uses of U.S. Mortgage Insurance Operations’ liquidity are the payment of operating expenses, claim payments, taxes, dividends to The PMI Group and the growth of its investment portfolio. The principal sources of U.S. Mortgage Insurance Operations’ liquidity are the investment portfolio including cash and cash equivalents, written premiums, net investment income and capital contributed from its holding company (TPG).
As a result primarily of higher losses and LAE beginning in 2007, we require additional capital as described further under Item 1A. Risk Factors-Capital and Liquidity Constraints. The amount and timing of capital required is affected by a variety of factors, many of which are difficult to predict and may be outside of our control. These factors include, among others:
PMI’s ability to comply with policyholders position requirements and risk-to-capital requirements imposed by regulators as well as under our credit facility;
determinations and views, many of which are subjective rather than quantitative in nature, of the GSEs and rating agencies;
performance of our investment portfolio and the extent of impairments to portions of the portfolio as a result of deteriorating capital markets;
the performance of PMI Europe, which is affected by, among other things, the U.S. mortgage market and changes in the fair value of CDS derivative contracts resulting from the widening of RMBS credit spreads; and
any requirements to provide capital under the PMI Europe or CMG capital support agreements.
Our consolidated contractual obligations include reserves for losses and LAE, long-term debt obligations, operating lease obligations, capital lease obligations, and purchase obligations. Most of our purchase obligations are capital expenditure commitments that will be used for technology improvements. We have lease obligations under certain non-cancelable operating leases. In addition, we may be committed to fund, if called upon to do so, $3.0 million of additional equity in certain limited partnership investments.
Cash payments related to our reserves for losses and LAE as of December 31, 2008 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. Minimum rental payments under non-cancelable capital and operating leases are provided in the table below.
Includes $651,593 million of principal debt and $482,637 million of scheduled interest.
In connection with structured finance transactions in the U.S. and Europe, we are required to provide narrative and/or financial information relating to us and our subsidiaries to mortgage-backed securities issuers for inclusion in the relevant offering documents and the issuers’ ongoing SEC filings. In connection with the provision of such information, we or our subsidiaries may be required to indemnify the issuer of the mortgage-backed securities and the underwriters of the offering with respect to the information’s accuracy and completeness and its compliance with applicable U.S. securities laws and regulations.
Certain of PMI Europe’s credit default swap contracts and reinsurance agreements contain collateral support provisions which, upon certain circumstances, such as a downgrade of PMI Europe’s insurer financial strength ratings and/or deterioration of underlying mortgage loan performance, require PMI Europe to post collateral for the benefit of the counterparty. The amount of the required posted collateral varies and can include the amount of loss reserves established by the counterparty, mark-to-market valuations by the counterparty, contractual formulae and/or a negotiated amount. PMI Europe has posted collateral of $64.2 million as of March 15, 2009 with respect to credit default swap transactions. PMI Europe has also posted collateral related to certain reinsurance transactions, and as of March 15, 2009, the posted collateral balance was $53.7 million. PMI Europe
may be required to post additional collateral on credit default swaps as a result of such factors as widening of credit spreads and/or deterioration in the performance of the underlying collateral referenced in such transactions and on reinsurance transactions due to continued loss development.
The increase in net investment income in 2008 compared to 2007 was primarily due to the growth of PMI’s fixed income portfolio, partially offset by a decrease in pre-tax book yield. Our consolidated pre-tax book yield was 3.55% and 5.11% as of December 31, 2008 and 2007, respectively. Net investment income decreased in 2007 compared to 2006, primarily due to declines in PMI’s short-term investments portfolio.
Realized investment (losses) gains for 2008 include a $96.5 million loss related to other-than-temporary impairments of certain preferred securities in our U.S. investment portfolio. See Item 1A. Risk Factors-As a result of significant volatility and uncertainty in the market, we impaired the value of certain securities held in our investment portfolio and there is a risk that additional impairments may occur in the future. Also included in realized investment (losses) gains for 2008 is the Company’s impairment of its investment in its unconsolidated subsidiaries, FGIC and RAM Re. Impairment of unconsolidated subsidiaries for 2008 includes an $88.0 million loss related to the impairment of the Company’s investment in FGIC and a $2.9 million loss related to the Company’s impairment of its investment in RAM Re. The net realized investment losses in 2007 were due primarily to our other-than-temporary impairment of our investment in RAM Re of $38.5 million, partially offset by a $12.7 million settlement gain related sale of an unconsolidated subsidiary.
The following table summarizes the rating distributions of our consolidated investment portfolio (including cash and cash equivalents, excluding common stocks) as of December 31, 2008:
We do not rely on the financial guarantees as a principal source of repayment when evaluating securities for purchase. Rather, securities are evaluated primarily based on the underlying issuer’s credit quality. During 2008, several of the financial guarantors listed above were downgraded by one or more of the rating agencies. A downgrade of a financial guarantor may have an adverse effect on the fair value of investments insured by the downgraded financial guarantor. If we determine that declines in the fair values of our investments are other-than-temporary, we record a realized loss. The table below illustrates the underlying rating distributions of our consolidated investment portfolio (including cash and cash equivalents, excluding common stocks) as of December 31, 2008, excluding the benefit of the financial guarantees provided by these financial guarantors. Underlying ratings, excluding the benefit of financial guarantors, are based upon the higher underlying rating assigned by S&P or Moody’s when an underlying rating exists from either rating agency or, when an external rating is not available, the underlying rating is included in the not rated category.
The following table summarizes the pre-tax book yield of our consolidated investment portfolio by segment as of December 31, 2008, 2007 and 2006.
The fair value and carrying value of the our 6.000% Senior Notes and 6.625% Senior Notes at December 31, 2008 include accrued interest.
Effective January 1, 2008, we elected to adopt the fair value option presented by SFAS No. 159 for our 6.000% Senior Notes and 6.625% Senior Notes. SFAS No. 159 requires that the difference between the carrying value before election of the fair value option and the fair value of these instruments be recorded as an adjustment to beginning retained earnings in the period of adoption. (See Note 8. Fair Value Disclosures, for further discussion.)
6.000% and 6.625% Senior Notes-In September 2006, we issued $250 million in principal amount of 6.000% Senior Notes, due September 15, 2016 and $150 million in principal amount of 6.625% Senior Notes, due September 15, 2036. The 6.000% Senior Notes and the 6.625% Senior Notes bear interest at a rate of 6.000% and 6.625% per annum, 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 6.000% and 6.625% 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 6.000% and 6.625% 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, the Company 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 is amortized into interest expense over the terms of the new senior debt that was issued. As of December 31, 2008, the unamortized balance in the other comprehensive income related to these fair value hedges was approximately $7.6 million (pre-tax).
5.568% Senior Notes-In August 2006, we completed the remarketing of approximately $345 million in principal amount of senior notes which matured and were paid in November 2008 and which are referred to as the 5.568% Senior Notes. As a result of the remarketing, the annual interest rate on these notes was reset from 3.00% per annum to 5.568% per annum, paid quarterly, effective from and including August 15, 2006. In connection with the remarketing, we purchased and cancelled $300.0 million in principal amount of the 5.568% Senior Notes, leaving $45.0 million in principal amount of these notes outstanding after completion of the remarketing which subsequently matured and was repaired in November 2008.
PMI has a capital support agreement with PMI Europe, with a corresponding guarantee from The PMI Group, under which PMI may be required to make additional capital contributions from time-to-time as necessary to maintain PMI Europe’s minimum capital requirements. PMI also has a capital support agreement whereby it agreed to contribute funds, under specified conditions, to maintain CMG MI’s risk-to-capital ratio at or below 19.0 to 1. PMI’s obligation under the CMG MI capital support agreement is limited to an aggregate of $37.7 million. As of December 31, 2008, CMG MI’s risk-to-capital ratio was 16.2 to 1.
On a consolidated basis, our principal sources of funds are cash flows generated by our insurance subsidiaries and investment income derived from our investment portfolios. One of the primary goals of our cash management policy is to ensure that we have sufficient funds on hand to pay obligations when they are due. We believe that we have sufficient cash to meet these and other of our short- and medium-term obligations. We believe that we currently have sufficient liquidity at our holding company to pay holding company expenses (including interest expense on our outstanding debt) in 2009 and 2010 and to repay the amounts outstanding under the credit facility if we were required to do so or in the event of a potential cross-default under our senior notes. We also believe we currently have sufficient assets at the insurance company level to meet our obligations in 2009. However, if an event of default under our revolving credit facility is not cured or we do not repay within 30 days, an event of default would occur under our outstanding senior notes. The PMI Group does not currently have sufficient funds or other sources of liquidity to enable it to repay both our credit facility and our senior notes if those obligations were required to be repaid. See Item 1A. Risk Factors-We may face liquidity issues at our holding company.
Consolidated cash flows generated by operating activities, including premiums, investment income, underwriting and operating expenses and losses, were $277.2 million in 2008 compared to $400.6 million in 2007 and $149.2 million in 2006. Cash flows from operations decreased in 2008 primarily due to increases in claim payments from PMI. Cash flows from operations increased in 2007 primarily due to increases in premiums written. We expect cash flows from operating activities to be negatively affected throughout 2009 due to payment of claims from loss reserves recorded by PMI in 2007 and 2008.
Consolidated cash flows provided by financing activities were $155.3 million in 2008 compared to cash flows used in financing activities of $197.4 million and $501.6 million in 2007 and 2006, respectively. The significant increase in cash provided by financing activities in 2008 was due to the $200 million of proceeds from our credit facility in 2008. The decrease in cash used in financing activities in 2007 was primarily due to cash used in repurchase of senior notes, repayment of long-term debt and purchase of treasury stock in 2006.
On July 9, 2008, Moody’s lowered its insurer financial strength rating on PMI from “Aa2” (On Review for Possible Downgrade) to “A3” (Negative Outlook), and The PMI Group’s senior debt rating from “A1” (On Review for Possible Downgrade) to “Baa3” (Negative Outlook). Moody’s also lowered the rating of PMI Europe from “Aa3” (On Review for Possible Downgrade) to “A3” (Negative Outlook).
On August 26, 2008, Standard & Poor’s downgraded its counterparty credit and insurer financial strength ratings on PMI Mortgage Insurance Co., PMI Insurance Co. and PMI Europe from “A+” (Negative Outlook) to “A-” (CreditWatch with Negative Implications). Standard & Poor’s also downgraded its counterparty credit rating on The PMI Group from “BBB+” (Negative Outlook) to “BBB-” (CreditWatch with Negative Implications).
On October 10, 2008, Moody’s announced that it placed on review for possible downgrade the “A3” insurance financial strength ratings of PMI Mortgage Insurance Co., PMI Insurance Co. and PMI Europe. Moody’s also placed the “Baa3” senior unsecured debt rating of The PMI Group under review for possible downgrade.
On October 17, 2008, Fitch lowered its insurer financial strength ratings on PMI Mortgage Insurance Co., PMI Insurance Co. and PMI Europe from “A+” (Rating Watch Negative) to “BBB+” (Negative). Fitch also lowered its long-term issuer debt rating of The PMI Group from “BBB+” (Negative) to “BB” (Rating Watch Negative).
On December 5, 2008, Standard & Poor’s placed its ratings on PMI Mortgage Insurance Co. and its core and dependent foreign subsidiaries on CreditWatch with negative implications. The CreditWatch placement reflected greater deterioration in the employment and housing markets than Standard & Poor’s had anticipated when they last conducted an extensive review of the mortgage insurance sector in late August. On December 19,
On February 13, 2009, Moody’s downgraded the insurer financial strength ratings of PMI Mortgage Insurance Co. and PMI Insurance Co. to “Ba3” from “A3”, and downgraded PMI Europe to “B1” from “A3”. Moody’s indicated that its rating outlook for each of these companies is “developing”. Moody’s also downgraded the senior unsecured debt ratings of The PMI Group to “B3” from “Baa3”, and they remain under review for further possible downgrade. Moody’s noted that its rating action reflected its view that there is significant stress on MIC’s risk-adjusted capital position as a result of higher expected mortgage losses due to the weak economic environment and continued deterioration in housing fundamentals. The downgrade also considered the continued pressure on MIC’s profitability and the constraints on its financial flexibility in the current market environment. In addition, Moody’s stated its belief that the franchise value among mortgage insurers generally has deteriorated in recent months, placing additional pressure on our ratings. The downgrade on The PMI Group reflected Moody’s view of the proximity to a potential breach of covenants in the bank credit facility, constrained financial flexibility, and meaningful liquidity and refinancing risks that The PMI Group may face if the deterioration in mortgage finance is protracted.
Determinations of ratings by the rating agencies are affected by a variety of factors, including macroeconomic conditions, economic conditions affecting the mortgage insurance industry, changes in business prospects, regulatory conditions, competition, underwriting and investment losses and the need for additional capital. There can be no assurance that our wholly-owned insurance subsidiaries will not be downgraded in the future. See Item 1A. Risk Factors-We have been and will continue to be negatively impacted by recent downgrades of PMI’s insurer financial strength ratings.
Management’s Discussion and Analysis of Financial Condition and Results of Operation, as well as disclosures included elsewhere in this report, are based upon our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosure of contingencies. Actual results may differ significantly from these estimates. We believe that the following critical accounting estimates involved significant judgments used in the preparation of our consolidated financial statements.
Changes in loss reserves can materially affect our consolidated net income or loss. The process of estimating loss reserves 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.
Effective December 31, 2008, PMI Guaranty’s reserves were merged into U.S. Mortgage Insurance Operations.
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.
The above loss reserve reconciliation shows the components of our losses and LAE reserve changes for the periods presented. Losses and LAE payments of $814.0 million, $362.2 and $242.7 million for the periods ended December 31, 2008, 2007, and 2006, respectively, reflect amounts paid during the periods presented and are not subject to estimation. Total losses and LAE incurred of $1.8 billion, $1.1 billion, and $263.0 million for years ended December 31, 2008, 2007 and 2006, respectively, are management’s best estimates of ultimate losses and LAE and are subject to change. The changes in our estimates are principally reflected in the losses and LAE incurred line item which shows an increase to losses and LAE incurred related to prior years of $147.7 million, $201.7 million and $2.2 million for the years ended December 31, 2008, 2007, and 2006, respectively. PMI Guaranty’s loss reserves of $22.9 million are related to the agreement between PMI Guaranty, FGIC, and AG Re under which PMI Guaranty commuted certain risks with FGIC. Effective December 31, 2008, PMI’s Guaranty’s loss reserves were merged into our U.S. Mortgage Insurance Operations.
The table below breaks down 2008, 2007 and 2006 changes in reserves related to prior years by particular accident years:
The $147.7 million, $201.7 and $2.2 million increases related to prior years in 2008, 2007 and 2006, respectively, were due to re-estimations of ultimate loss rates from those established at the original notices of defaults, updated through the periods presented. The $147.7 million increase in prior years’ reserves during 2008 and the $201.7 million increase in prior years’ reserves in 2007 reflected the significant weakening of the housing and mortgage markets and was driven by lower cure rates, higher claim rates and higher claim sizes. The $2.2 million increase in prior years’ reserves during 2006 was driven by higher than estimated claim sizes on pending defaults, partially offset by a reduction in the incurred but not reported estimate. These re-estimations of ultimate loss rates are the result of management’s periodic review of estimated claim amounts in light of actual claim amounts, loss development data and ultimate claim rates. Future declines in PMI’s cure rate, or higher default and claim rates or claim sizes could lead to further increases in losses and LAE.
The following table shows a breakdown of reserves for losses and LAE by loans in default, incurred but not reported, or IBNR, and the cost to settle claims, or LAE:
Other relates to PMI Guaranty’s loss reserves of $22.9 million related to the agreement between PMI Guaranty, FGIC, and AG Re under which PMI Guaranty commuted certain risks with FGIC.
If either the claim rate or claim size, or a combination of the claim rate and claim size, were to increase approximately 17% above our current estimates, we would reach the top of our actuarially determined range. Conversely, if the claim rate or claim size, or a combination of the claim rate and claim size, were to decrease by approximately 17% of our current estimates, we would reach the bottom end of our actuarially determined range.
The establishment of loss reserves is subject to inherent uncertainty and requires judgment by management. The actual amount of claim payments may vary substantially from the loss reserve estimates. For example, the relationship of a change in assumption relating to future average claim sizes, claim rates or cost of claims settlement to the change in value may not be linear. Also, the effect of a variation in a particular assumption on the value of the loss and LAE reserves is calculated without changing any other assumption. Changes in one factor may result in changes in another which might magnify or counteract the sensitivities. Changes in factors such as persistency or cure rates can also affect the actual losses incurred. To the extent persistency increases and assuming all other variables remain constant, the absolute dollars of claims paid will increase as insurance in force will remain in place longer, thereby generating a higher potential for future incidences of loss. Conversely, if persistency were to decline, absolute claim payments would decline. In addition, changes in cure rates would positively or negatively affect total losses if cure rates increased or decreased, respectively.
International Operations-PMI Europe establishes loss reserves for all of its insurance and reinsurance business and for CDS transactions entered into before July 1, 2003. Revenue, losses and other expenses associated with CDS contracts 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, 2008 of $73.4 million to $90.8 million. PMI Europe’s recorded loss reserves at December 31, 2008 were $84.5 million, which represented our best estimate and an increase of $42.9 million from PMI Europe’s loss reserve balance of $41.6 million at December 31, 2007. The increase to PMI Europe’s loss reserves in 2008 was primarily due to the deteriorating performance of several U.S. subprime exposures on which PMI
Europe provided reinsurance coverage. The remaining loss reserves within International Operations segment relates to PMI Canada which ceased writing new business in 2008.
Other-Than-Temporary Impairment-We have a committee review process for all securities in our investment portfolio, including a process for reviewing impairment losses. Factors considered when assessing impairment include:
Unrealized losses in 2008 on fixed income securities were primarily due to the widening of credit spreads which have also increased market interest rates on most fixed income securities. Unrealized losses on preferred securities were primarily due to the widening of credit and sector spreads. These unrealized losses are not considered to be other-than temporarily impaired as the company has the intent and ability to hold such investments until they recover in value or mature. We determined that the decline in the fair value of certain investments met the definition of other-than-temporary impairment and recognized realized losses of $104.2 million for 2008.
At June 30, 2008, the carrying value of our investment in RAM Re had been reduced to zero due to equity in losses in RAM Re. During the third quarter of 2008, we recognized equity in earnings from RAM Re of $9.4 million and realized an other-than-temporary impairment charge of $2.9 million. During the fourth quarter of 2008, we recognized equity in losses from RAM Re of $6.5 million. The carrying value of our investment in RAM Re was zero at December 31, 2008.
We perform premium deficiency analyses quarterly on a single book basis for the U.S. Mortgage Insurance Operations. A premium deficiency analysis was performed as of December 31, 2008 on a GAAP basis. We determined there was no premium deficiency in our U.S. Mortgage Insurance Operations segment despite significant losses in 2008. To the extent premium levels and actual loss experience differ from our assumptions, our results could be negatively affected in future periods. See Item 1A. Risk Factors-We establish loss reserves with respect to our mortgage insurance policies only upon loan defaults, and because our loss reserve estimates are subject to uncertainties, our actual losses may substantially exceed our loss reserves. Further, due to higher losses we may be required to record a premium deficiency reserve in the future.
Management assessed the effectiveness of our internal control over financial reporting as of December 31, 2008. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework.
We have audited the accompanying consolidated balance sheets of The PMI Group, Inc. and subsidiaries (the Company) as of December 31, 2008 and 2007, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2008. Our audits also included the financial statement schedules listed in the Index at Item 15(a). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of The PMI Group, Inc. and subsidiaries at December 31, 2008 and 2007, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2008, 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.
In 2008, the Company adopted FASB Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, Including an amendment of FASB Statement No. 115. In 2007, the Company adopted FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes-An Interpretation of FASB Statement No. 109. These matters are further described in Note 2 to the consolidated financial statements.
The Board of Directors and Shareholders of The PMI Group, Inc.
In our opinion, The PMI Group, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, based on the COSO criteria.
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 Company Limited and its holding company, PMI Europe Holdings Limited, the Irish insurance companies (collectively “PMI Europe”); PMI Mortgage Insurance Company Canada and its holding company, PMI Mortgage Insurance Holdings Canada Inc. (collectively “PMI Canada”); and other insurance, reinsurance and non-insurance subsidiaries. Also included in the accompanying financial statements and reported as discontinued operations for all periods presented are the accounts of PMI Mortgage Insurance Ltd. and its holding company, PMI Mortgage Insurance Australia (Holdings) Pty Limited (collectively “PMI Australia”) and PMI Mortgage Insurance Asia Ltd. (“PMI Asia”) which were sold as of December 31, 2008; and the accounts of PMI Guaranty Co. (“PMI Guaranty”) which was considered disposed of other than by sale as of December 31, 2008. As of December 31, 2008, upon receiving regulatory approval, PMI Guaranty’s remaining assets and liabilities were merged into PMI. The PMI Group and its subsidiaries are collectively referred to as the “Company.” All material inter-company transactions and balances have been eliminated in the consolidated financial statements.
Notwithstanding the above, the Company believes that it currently has sufficient liquidity at its holding company to pay holding company expenses (including interest expense on its outstanding debt) in 2009 and has sufficient assets at the insurance company level to meet its obligations in 2009. (See Note 25. Subsequent Events, for further discussion.)
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 49.4%, 52.0%, and 43.9% of its premiums earned in 2008, 2007 and 2006, respectively.
The Company’s various U.S., European, and Canadian 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 covering 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 establishes loss reserves to recognize the liability for unpaid losses related to insured mortgages that are in default. These loss reserves are based upon the Company’s estimates of the claim rate and average claim size, as well as the estimated costs of settling claims. These estimates are regularly reviewed and updated using currently available information. Any adjustments due to positive or adverse developments, which may be material, resulting from these reviews would impact current reserve requirements. The Company’s reserves may not be adequate to cover ultimate loss development on incurred defaults. The Company’s consolidated financial condition, results of operations and cash flows could be harmed if the Company’s reserve estimates are insufficient to cover the actual related claims paid and loss-related expenses incurred.
Deferred Policy Acquisition Costs-The Company defers certain costs of 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 we provide contract underwriting services on loans that do not require mortgage insurance, associated underwriting costs are not deferred. Costs related to the acquisition 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. 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. For each underwriting year, the Company estimates the rate of amortization 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.
Derivatives-Certain credit default swap contracts entered into by PMI Europe are considered credit derivative contracts under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended by SFAS No. 149, Amendment of SFAS No. 133 on Derivative Instruments and Hedging Activities. These credit default swap derivatives are recorded at their fair value on the consolidated balance sheet with subsequent changes in fair value recorded in consolidated net income or loss. The Company determines the fair values of its credit default swaps on a quarterly basis and uses internally developed models since observable market quotes are not regularly available. These models include future estimated claim payments and market input assumptions, including discount rates and market spreads to calculate a fair value and reflect management’s best judgment about current market conditions. Due to the illiquid nature of the credit default swap market, the use of available market data and assumptions used by management to estimate fair value could differ materially from amounts that would be realized in the market if the derivatives were traded. Due to the volatile nature of the credit market as well as the imprecision inherent in the Company’s fair value estimate, future valuations could differ materially from those reflected in the current period.
Changes in loss reserves can materially affect the Company’s consolidated net income or loss. The process of estimating loss reserves requires the Company 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. The Company reviews the judgments made in its prior period estimation process and adjusts the current assumptions as appropriate. While the 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 the Company’s estimates.
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 for the majority of the single premium policies. 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.
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 temporary differences at the enacted tax rates applicable for the period in which the deferred asset or liability is expected to be realized or settled. Temporary differences are differences between the tax basis of an asset or liability and its reported amount in the consolidated financial statements that will result in future increases or decreases in taxes owed on a cash basis compared to amounts already recognized as tax expense in the consolidated statement of operations. The Company’s effective tax rates from continuing operations were 32.8% and 19.6% for the years ended December 31, 2008 and 2007, respectively, compared to the federal statutory rate of 35.0%. The effective tax rate for the year ended December 31, 2008 reflects income derived from certain international operations, which have lower effective tax rates, combined with the Company’s municipal bond investment income. In 2007, previously deferred tax liabilities attributable to equity in earnings from FGIC and RAM Re were reversed, and in 2007 and 2008 certain deferred tax assets were established.
As of December 31, 2008, a tax valuation allowance of $174.6 million was recorded against a $322.8 million deferred tax asset related to the recognition of losses from FGIC and RAM Re in excess of our tax basis. The Company did not record a full valuation allowance against the deferred tax asset as it is management’s expectation that a portion of the tax benefit will be realized. Additional benefits could be recognized in the future due to changes in management’s expectations regarding the realization of tax benefits. (See Note 12, Income Taxes, for further discussion.)
Benefit Plans-The Company provides pension benefits to all eligible U.S. employees under The PMI Group, Inc. Retirement Plan (the “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. The Company applies SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106 and 132(R) (“SFAS No. 158”) for pension benefits to U.S. employees. SFAS No. 158 requires 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, with a corresponding adjustment to accumulated other comprehensive income or loss.
On May 17, 2007, The PMI Group’s Board of Directors approved an amendment to the Retirement Plan. The amendment changed the Plan’s benefit formula from a “final pay” pension formula to a cash balance formula. The amendment took effect immediately for employees hired or rehired on or after September 1, 2007. For employees hired before and continuously employed on September 1, 2007, the amendment will take effect on January 1, 2011. Under the new cash balance plan formula, the Company will contribute 8% of qualified employees’ compensation to cash balance accounts and credit interest at a rate equal to the 30-year Treasury bond rate.
In the third quarter of 2008, the Company initiated a Voluntary Early Retirement Program (the “Program”). The Program was made available to employees (other than the CEO) who were at least 52 years of age and had seven or more years of service. PMI incurred expenses of $33.1 million in 2008 as a result of this Program. In addition, the Company contributed $41.0 million to the Retirement Plan in 2008. Approximately $24.0 million of this contribution was nondeductible for tax purposes. The Company has filed with the Internal Revenue Service (“IRS”) to have the nondeductible portion refunded to avoid excise tax penalties.
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 period-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 (loss) included in total shareholders’ equity. In conjunction with the sale of PMI Australia and PMI Asia and their classifications as assets held for sale, the Company recognized $124.1 million of accumulated currency translation gains for PMI Australia and $0.3 million for PMI Asia during 2008. Foreign currency translation gains in accumulated other comprehensive income were $48.3 million as of December 31, 2008 compared with $281.0 million as of December 31, 2007. Gains and losses from foreign currency re-measurement incurred by PMI Europe and PMI Canada represent the revaluation of assets and liabilities denominated in non-functional currencies into the functional currency, the Euro and Canadian dollar, respectively.
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. insurance and reinsurance companies and the equity in earnings from CMG MI. International Operations includes the results from continuing operations of PMI Europe and PMI Canada, and the results from discontinued operations of PMI Australia and PMI Asia. Financial Guaranty includes the equity in earnings (losses) from FGIC and RAM Re, and the financial results of PMI Guaranty, which are reported as discontinued operations. As of December 31, 2008, upon receiving regulatory approval, PMI Guaranty’s remaining assets and liabilities were merged into U.S. Mortgage Insurance Operations. The Company’s Corporate and Other segment mainly consists of our holding company and contract underwriting operations.
Share-Based Compensation-The Company applies SFAS No. 123 (revised 2004), Share-Based Payment (“SFAS No. 123R”) in accounting for share-based payments. SFAS No. 123R requires that such transactions be accounted for using a fair value-based method and recognized as expense in the consolidated results of operations. The Company recognizes the fair value of share-based payments granted and unvested, including employee stock options, restricted stock units, and employee stock purchase plan shares, as compensation expense in the consolidated results of operations. Share-based compensation expense was $8.8 million (pre-tax), $16.1 million (pre-tax) and $12.2 million (pre-tax) for the years ended December 31, 2008, 2007 and 2006, respectively.
Fair Value of Financial Instruments-Effective January 1, 2008, the Company adopted SFAS No. 157 and 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. 157 provides a framework for measuring fair value under GAAP. SFAS No. 159 allows an entity the irrevocable option to elect fair value for the initial and subsequent measurement of certain financial assets and liabilities on a contract-by-contract basis. The Company elected to adopt the fair value option for certain corporate debt on the adoption date. SFAS No. 159 requires that the difference between the carrying value before election of the fair value option and the fair value of these instruments be recorded as an adjustment to beginning retained earnings in the period of adoption. The Company recognized a net of tax gain of $31.8 million in retained earnings as of January 1, 2008 related to the initial adoption of SFAS No. 159 for certain debt instruments held by the Company. For the year ended December 31, 2008, the Company’s net loss included a $123.6 million gain related to the subsequent measurement of fair value for these debt instruments. We selected our 10 year and 30 year senior debt instruments for the fair value option as their market values are the most readily available. The fair value option was elected with respect to the senior debt as changes in value are expected to generally offset changes in the value of credit default swap contracts that are also accounted for at fair value. (See Note 10. Fair Value Disclosures, for further discussion.)
In October 2008, the FASB issued FSP FAS No. 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active. This FSP clarifies the application of SFAS Statement No. 157, Fair Value Measurements, in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is not active. FSP FAS No. 157-3 is effective upon issuance and has not impacted the Company’s consolidated financial statements.
In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements-an amendment to ARB No. 51 (“SFAS No. 160”), which establishes accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. It requires consolidated net income to be reported at amounts that include the amounts attributable to both the parent and the noncontrolling interest. It also requires disclosure, on the face of the consolidated statement of operations, of the amounts of consolidated net income attributable to the parent and to the noncontrolling interest. SFAS No. 160 is effective for fiscal years beginning after December 15, 2008. SFAS No. 160 is not currently expected to significantly impact the Company’s consolidated financial statements.
In December 2007, the FASB issued SFAS No. 141 (revised 2007), Business Combinations (“SFAS No. 141R”), which requires an entity that obtains control of one or more businesses in a business combination to recognize the assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree at the acquisition date, measured at their fair values as of that date, with limited exceptions specified in SFAS No. 141.
SFAS No. 141R is effective for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. SFAS No. 141R is not currently expected to significantly impact the Company’s consolidated financial statements.
Scheduled Maturities-The following table sets forth the amortized cost and fair value of fixed income securities by contractual maturity at December 31, 2008:
Investment Concentrations and Other Items-The Company maintains an investment portfolio principally of U.S. municipal bonds. The following states and the District of Columbia represent the largest concentrations in the U.S. municipal bond portfolio, expressed as a percentage of the fair value of all U.S. municipal bond holdings. Holdings in states and the District of Columbia that exceed 5% of the U.S. municipal bond portfolio at December 31, for the respective years are presented below:
Investments in the Company’s unconsolidated subsidiaries include both equity investees and other unconsolidated subsidiaries. The carrying values of the Company’s investments in unconsolidated subsidiaries consisted of the following as of December 31, 2008 and December 31, 2007:
Due to the impairment of its FGIC investment in the first quarter of 2008, the Company did not recognize any equity in earnings (losses) from FGIC in 2008. During 2008, the Company realized an other-than-temporary impairment charge of $2.9 million and recognized equity in losses from RAM Re of $57.7 million which decreased the value of the Company’s investment in RAM Re to zero.
Deferred policy acquisition costs are reviewed periodically to determine that they do not exceed recoverable amounts, after considering investment income. For the year ended December 31, 2007, as a result of a recoverability analysis of deferred costs relating to new mortgage insurance policies acquired in 2007, the Company impaired its deferred policy acquisition cost asset related to its U.S. Mortgage Insurance Operations by $33.6 million relating to the 2007 book year. The deferred policy acquisition cost asset at December 31, 2008 includes only costs associated with the 2008 book of business and book years prior to 2007. In the second quarter of 2008, PMI Guaranty impaired its remaining deferred policy acquisition cost assets by $3.6 million, reducing its value to zero. PMI Guaranty did not incur any deferred policy acquisition costs during the last half of 2008 as runoff activities were effectively completed. The Company also impaired $1.2 million of deferred policy acquisition cost assets relating to PMI Europe during 2008. Due to higher persistency levels experienced in the Company’s U.S. Mortgage Insurance portfolio in 2008 the Company changed the period over which it amortizes deferred policy acquisition costs in its U.S. Mortgage Insurance Operations. The change in the period over which deferred policy acquisition costs are amortized resulted in a decrease of $8.1 million in amortization of deferred policy acquisition costs.
The $192.9 million, $208.6 million and $5.0 million increases in losses and LAE incurred in prior years, in 2008, 2007 and 2006, respectively, were due to re-estimates of ultimate claim rates and claim sizes from those established at the original notices of default, updated through the periods 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 and/or expected ultimate claim rates. The increases in prior years’ reserves in 2008 and 2007 were primarily due to the significant weakening of the U.S. housing and mortgage markets and were driven by lower cure rates, higher claim rates and higher claim sizes.
The fair value and carrying value of the Company’s 6.000% Senior Notes and 6.625% Senior Notes at December 31, 2008 include accrued interest.
6.000% and 6.625% Senior Notes-In September 2006, the Company issued $250 million in principal amount of 6.000% Senior Notes, due September 15, 2016 and $150 million in principal amount of 6.625% Senior Notes, due September 15, 2036. The 6.000% Senior Notes and the 6.625% Senior Notes bear interest at a rate of 6.000% and 6.625% per annum, 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 6.000% and 6.625% 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 6.000% and 6.625% 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, the Company 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 is amortized into interest expense over the terms of the new senior debt that was issued. As of December 31, 2008, the unamortized balance in the other comprehensive income related to these fair value hedges was approximately $7.6 million (pre-tax).
In early 2008 the Company amended the facility and in May 2008 the Company drew $200 million on the facility. The facility includes a $50 million letter of credit sub-limit. The facility was reduced to $300 million in the first quarter of 2008 and was further reduced to $250 million on or about October 22, 2008 upon the sale of PMI Australia. Pursuant to the terms of the amendment, the Company’s ability to borrow under the facility was subject to a number of conditions, including that the stock of PMI Mortgage Insurance Co. (“MIC”) be pledged in favor of the lenders under the facility and noteholders under certain of the Company’s senior notes. The amended facility also contains additional restrictions on asset dispositions and investments. While the Company is generally permitted under the amended facility to make additional investments in MIC and its subsidiaries, the Company’s ability to invest in its reinsurance subsidiaries is subject to dollar limitations (other than with regard to four of TPG’s subsidiaries whose capital stock was pledged to the bank group on or about September 29, 2008). In the third quarter of 2008, the Company requested and received 100% of the lenders’ consent for the sale of PMI Australia and PMI Asia to a third party. (See Note 25, Subsequent Events, for further discussion.)
Effective January 1, 2008, the Company adopted SFAS No. 157 and SFAS No. 159. In particular, the Company elected to adopt the fair value option presented by SFAS No. 159 for certain corporate debt liabilities on the adoption date. SFAS No. 159 requires that the difference between the carrying value before election of the fair value option and the fair value of these instruments at the time of election of the fair value option be recorded as an adjustment to beginning retained earnings in the period of adoption.
The following table summarizes the impact of adopting SFAS No. 157 for derivative contracts and the impact of adopting the fair value option for certain financial instruments on January 1, 2008. Amounts shown represent the carrying value of the affected instruments before and after the adoption of the new accounting pronouncements.
Level 1 Quoted prices in active markets for identical assets or liabilities. Level 1 assets and liabilities include debt and equity securities and derivative contracts that are traded in an active exchange market, as well as certain U.S. Treasury securities that are highly liquid and are actively traded in over-the-counter markets.
Fixed income and equity securities classified as Level 3 under SFAS No. 157 are not publicly or actively traded, and the prices are not readily available. The fair values of these investments are management’s best estimate and will be reassessed periodically.
The combined losses on equity and fixed income securities of $1.5 million for 2008 are included in net investment income in the Company’s consolidated statement of operations. The loss on credit default swaps of $11.3 million for the year ended December 31, 2008 is included in other (loss) income in the Company’s consolidated statement of operations.
The majority of the Company’s existing reinsurance contracts are captive reinsurance agreements in the 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 98.9% of total ceded premiums written in 2008 compared to 99.2% and 99.8% in 2007 and 2006, respectively. The Company recorded $482.7 million in reinsurance recoverables primarily from captive arrangements related to PMI’s gross loss reserves as of December 31, 2008, compared to $36.9 million as of December 31, 2007. As of December 31, 2008 and 2007, the total assets in captive trust accounts held for the benefit of PMI totaled approximately $860.1 million and $702.6 million, respectively.
federal government. The tax and loss bonds purchased are limited to the tax benefit of the deduction for additions to the contingency reserves. The Company purchased $51.0 million of tax and loss bonds in 2006 and did not purchase any tax and loss bonds in 2007 and 2008. The Company redeemed tax and loss bonds of $396.3 million in 2008, $62.7 million in 2007 and $48.6 million in 2006. The purchase and redemption of tax and loss bonds are included as a deferred component of income tax expense. The increase/decrease in current and deferred income tax expense in 2008 as compared to 2007 is primarily attributable to an increase in deferred tax assets due primarily to loss reserves and unrealized investment losses. The decrease in current and deferred income tax expense in 2007 as compared to 2006 is primarily attributable to the reversal of contingency reserve deductions related to tax and loss bonds.
The Company has foreign net operating loss carryforwards of approximately $61.4 million that will expire in 2012-2027, or will carryforward indefinitely. The Company has recorded a tax benefit of $3.7 million attributable to these losses, based on the expectation that such losses will be utilized in future years. Additionally, state deferred tax liabilities related to investments in certain subsidiaries reflect tax benefits of approximately $5.9 million attributable to approximately $66.8 million of state operating loss carryforwards that could reduce future dividend income.
The components of the deferred income tax assets and liabilities for the period ended are as follows:
As of December 31, 2008, a tax valuation allowance of $174.6 million was recorded against a $322.8 million deferred tax asset related to unrealized losses primarily related to FGIC, RAM Re and preferred investments. The Company did not record a valuation allowance against the remaining deferred tax assets as it is management’s expectation that these will “more likely than not” be utilized. Additional benefits could be recognized in the future due to changes in management’s expectations regarding realization of tax benefits.
When incurred, the Company recognizes interest and penalties accrued related to unrecognized tax benefits in tax expense. The Company incurred interest and penalties of approximately $0.5 million in 2008. The Company remains subject to examination in the following major tax jurisdictions:
As of December 31, 2008, the Company is subject to federal examination in the U.S. from 2005 through the present as in 2007 the IRS closed its audit for taxable years 2001 through 2003 and the statute of limitations lapsed for 2004 in 2008.
Leases-The Company leases certain office space and office equipment. Minimum rental payments under non-cancelable operating leases and capital leases in the aggregate for the five years subsequent to 2008 and thereafter are as follows:
Rent expense for all leases was $3.8 million for 2008, $3.5 million for 2007 and $5.1 million for 2006.
Legal Proceedings-Various legal actions and regulatory reviews are currently pending that involve the Company and specific aspects of its conduct of business. Although there can be no assurance as to the ultimate disposition of these matters, in the opinion of management, based upon the information available as of the date of these financial statements, the expected ultimate liability in one or more of these actions is not expected to have a material effect on the consolidated financial condition, results of operations or cash flows of the Company.
Effective June 2008, PMI Guaranty, FGIC and Assured Guaranty Re Ltd (“AG Re”) executed an Agreement pursuant to which all of the direct FGIC business reinsured by PMI Guaranty was recaptured by FGIC and ceded by FGIC to AG Re. Pursuant to the Agreement, with respect to two of the exposures ceded to AG Re, PMI Guaranty agreed to reimburse AG Re for any losses it pays, subject to an aggregate limit of $22.9 million. PMI Guaranty has secured its obligation by depositing $22.9 million into a trust account for the benefit of AG Re
PMI Europe is required to pledge collateral for the benefit of the counterparty under the terms of certain credit default swap and reinsurance transactions it has concluded. As of December 31, 2008, PMI Europe pledged collateral of $32.8 million on credit default swap transactions and $60.7 million related to U.S. sub-prime related reinsurance transactions. The collateral of $93.5 million is included in investments and cash and cash equivalents on the Company’s consolidated balance sheet at December 31, 2008.
Common Stock-In March 2007, the Company repurchased 325,000 common shares for $14.2 million under a $400 million common share repurchase program authorized by the Board of Directors in July 2006. In May 2007, upon completion of a $345 million accelerated share repurchase program entered into in 2006, The PMI Group received the final delivery of 436,152 common shares bringing the total received under the accelerated share repurchase program to 7,624,700 shares. The average price paid per common share upon completion of this program was $45.25 per common share.
In February 2007, the Board of Directors authorized the repurchase of additional common shares in an amount not to exceed $150 million. Pursuant to this program, in June 2007, the Company repurchased 468,500 common shares for $22.7 million, or $48.48 per common share. In July 2007, the Board of Directors increased the $150 million repurchase authorization to $300 million. From July 1, 2007 through September 30, 2007, the Company repurchased 5,454,381 common shares for $178.0 million, or $32.64 per common share. While approximately $100.0 million remains on the $300 million repurchase authorization, the Company did not repurchase additional common shares in 2008.
Pursuant to the support agreement described in Note 21, Capital Support Agreements, the Company has agreed that, in the event that Allstate, the Company’s former parent, makes a payment contemplated by the Allstate Support Agreements or the runoff support agreement, Allstate will have the right to receive preferred stock of The PMI Group or PMI with a liquidation preference equal to the amount of such payment. Such preferred stock will rank senior in right of payment to the issuer’s common stock and, so long as such preferred stock is outstanding, the issuer thereof will be prohibited from paying any dividends or making any other distributions on its common stock.
Effective January 1, 2003, all U.S. 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. 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.
In the third quarter of 2008, the Company initiated a Voluntary Early Retirement Program (the “Program”). The Program was made available to employees (other than the CEO) who were at least 52 years of age and had seven or more years of service. PMI incurred expenses of $33.1 million in 2008 as a result of this Program. In addition, the Company contributed $10 million to the Retirement Plan in January 2008 and an additional $31.0 million in December 2008. Approximately $24.0 million of this contribution was nondeductible for tax purposes. The Company has filed with the IRS to have the nondeductible portion refunded to avoid excise tax penalties.
The reconciliation of the beginning and ending balances of the projected benefit obligation and fair value of plan assets for the years ended and the accumulated benefit obligation at year end is as follows:
In 2008, the Company contributed $41.0 million to its Retirement Plan. Approximately $24.0 million of this contribution was nondeductible for tax purposes. The Company has filed with the IRS to have the nondeductible portion refunded to avoid excise tax penalties. The Company intends to contribute between $15 million and $20 million to its Retirement Plan in 2009. The benefit costs increased in 2008 compared to 2007 primarily due to pension settlement costs associated with the VERP initiated in the third quarter of 2008 (discussed above). The benefit costs for 2007 decreased from 2006 primarily due to the amendment to the Retirement Plan in May 2007 (discussed above). The amendment reduced the Plan’s projected benefit obligation by $11.8 million and the reduction was recorded as an adjustment to accumulated other comprehensive income on the Company’s consolidated balance sheet. The adjustment will be amortized through other underwriting and operating expenses over time.
The Company’s accumulated benefit obligation for its Retirement Plan and SERP Plan at December 31, 2008 was $53.1 million and $12.0 million, respectively, the combination of which equals the $65.1 million accumulated benefit obligation. As of December 31, 2008, the combined fair value of plan assets is approximately $32.0 million lower than our combined accumulated benefit obligation excluding the nondeductible contribution of $24 million. The health care cost trend on covered charges for other postretirement benefits was 9% in 2008, which will be reduced to 5% in 2013.
In 2008, excludes $24 million of cash and cash equivalents related to the nondeductible contributions.
The primary objective of the Plan is to provide retirement income for Plan participants and their beneficiaries in accordance with the terms of the Plan. As such, the key objective in the Plan’s financial management is to promote stability and, to the extent appropriate, growth in funded status. A secondary financial objective is to reduce reliance on contributions as a source of benefit payments. As such, Plan assets are invested to maximize the Plan’s funded ratios over the long-term while managing the downside risk. The strategic asset allocation ranges represent a long-term perspective. Rapid unanticipated market shifts or changes in economic conditions may cause the asset mix to fall outside the policy range. These divergences should be of a relatively short-term nature, unless the circumstances warrant a longer term divergence from the permissible ranges. The Company evaluates and rebalances asset allocations as appropriate and reviews the Plan to make sure that the Plan remains properly funded to protect the benefit security of the participants. The Company makes contributions that are sufficient to fully fund its actuarially determined costs, generally exceeding the minimum amounts required by the Employee Retirement Income Security Act.
Plan, under which there are no matching Company contributions. In addition to the 401(k) Plan, the Company has an officers’ deferred compensation plan available to certain employees. The obligation related to the deferred compensation plan was $7.4 million and $17.7 million as of December 31, 2008 and 2007, respectively, and is included in other liabilities and accrued expenses.
Equity Incentive Plan-The PMI Group’s Amended and Restated Equity Incentive Plan (the “Equity Incentive Plan”) provides for awards of both non-qualified stock options and incentive stock options, nonvested shares, stock appreciation rights subject to forfeiture and restrictions on transfer, and performance awards entitling the recipient to receive cash or common shares in the future following the attainment of performance goals determined by the Board of Directors. Stock options are granted with an exercise price equal to the market value on the date of grant, and generally expire ten years from the grant date and have a three-year vesting period. The Equity Incentive Plan provides for the granting of nonvested shares to officers and key employees. Nonvested shares issued under the Equity Incentive Plan to date generally vest annually between two to four years and holders are entitled to dividends and voting rights. Under the Equity Incentive Plan, non-employee directors receive quarterly, non-discretionary grants of stock units with an initial value of $25,000. The number of units granted depends on the fair market value of the Company’s common shares on the grant date but each stock unit has an initial value equal to the fair market value of one common share on the grant date. Non-employee director grants of stock units vest on the earlier of the fifth anniversary of the applicable grant date and termination of board service.
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 470,671 treasury shares in 2008, 151,953 treasury shares in 2007, and 128,467 treasury shares in 2006. SFAS No. 123(R) requires expense recognition of the amount of the discount to current fair value of ESPP shares purchased by employees.
Impact of SFAS No. 123R-The Company has recognized compensation expense for all awards granted based on the estimated grant date fair value method using the Black-Scholes option pricing model to determine the fair value of stock options and ESPP shares. For stock options, compensation expense is recognized using the accelerated amortization method. The determination of the fair value of share-based payment awards on the date of grant using an option-pricing model is affected by the Company’s share price as well as assumptions regarding a number of complex and subjective variables. These variables include the Company’s expected share price volatility over the expected term of the awards, actual and projected employee stock option exercise behaviors, risk-free interest rates, and expected dividends.
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, 2007 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 forfeitures and record share-based compensation expense only for those awards that are expected to vest.
The Company recognized share-based compensation expense of $8.8 million (pre-tax), $16.1 million (pre-tax) and $12.2 million (pre-tax) for the years ended December 31, 2008, 2007 and 2006, respectively. As of December 31, 2008, there was approximately $4.6 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 1.2 years. Total unrecognized compensation cost will be adjusted for future changes in estimated forfeitures.
The Company aggregates similar groups of employees with respect to exercise and post-vesting employment-termination behaviors for its option pricing model assumption estimation process. The Company estimates 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 the common stock over the expected term of the options. If new or different information that would be useful in estimating expected volatility becomes available, the Company may incorporate that information into future estimates. The Company considers expected changes of future dividend policy for selection of expected dividends. The risk-free interest rate that the Company uses 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.
Since the Company’s restricted stock units do not participate in dividends during their vesting period, their fair value is determined using the closing price of the Company’s stock on the date of grant less the present value of anticipated dividends over the vesting period. The discount rate used is the risk-free rate as of the date of grant of 2.12%.
A summary of the share-based compensation activity under the Equity Incentive Plan as of December 31, 2008, 2007 and 2006 and changes during the three years then ended is presented below:
The total intrinsic value of options exercised during 2007 and 2006, was $19.8 million and $18.7 million, respectively. The weighted-average remaining contractual life of options outstanding as of December 31, 2008 and vested and exercisable as of December 31, 2008 was 4.3 and 3.5 years, respectively. There was no aggregate intrinsic value for the options outstanding as of December 31, 2008 or for the options vested and exercisable as of December 31, 2008.
A summary of the restricted stock unit activity under the Equity Incentive Plan as of December 31, 2008 and changes during the year then ended is presented below:
The following tables present segment income or loss and balance sheets as of and for the years ended:
During the third quarter of 2008, PMI Australia, PMI Asia and PMI Guaranty were reported as discontinued operations. As a result, the Company classifies the assets and liabilities of PMI Australia and PMI Asia as discontinued operations for all periods presented. The assets and liabilities of PMI Guaranty, which were disposed of other than by sale, are classified in the consolidated balance sheet according to their nature. In addition, where applicable, the notes to the consolidated financial statements have been restated to reflect these discontinued operations for all periods presented. A summary of the composition of operating results included in discontinued operations is as follows:
Sale of PMI Australia-On October 22, 2008, the Company sold PMI Australia to a third party. As a result of the sale, the Company classified the operations, and assets and liabilities of PMI Australia as discontinued operations for all periods presented. The Company received approximately $746 million in cash (including certain adjustments for pre-completion interest and changes in the value of PMI Australia’s investment portfolio) and a note receivable in the principal amount of approximately $187 million from the sale of PMI Australia. The Company recorded a loss on the sale primarily due to the contingent nature of the note, which cannot currently be recognized and selling and other costs, including a $46.5 million reinsurance premium associated with the transaction, which was partially offset by a net realized gain of $124.1 million from realization of accumulated currency translation gains in accumulated other comprehensive income.
The following table represents PMI Australia’s results of operations, which were recorded as discontinued operations, and loss on the impairment of PMI Australia:
Sale of PMI Asia-On December 17, 2008, the Company completed the sale of PMI Asia and received approximately $51.6 million in cash equal to 92.5% of PMI Asia’s book value as of June 30, 2008. The Company classified the operations, assets and liabilities of PMI Asia as discontinued operations for all periods presented.
The following table represents PMI Asia’s results of operations, which were recorded as discontinued operations, and the loss from the impairment of PMI Asia:
Discontinued Operations of PMI Guaranty-PMI Guaranty has completed its runoff activities, and is reported as discontinued operations in the Financial Guaranty segment and in the consolidated statement of operations for all periods presented. As of December 31, 2008, upon receiving regulatory approval, PMI Guaranty’s remaining assets and liabilities were merged into U.S. Mortgage Insurance Operations.
The results of operations of PMI Guaranty are as follows for the years ended:
Under the insurance laws of the State of Arizona and several other states, mortgage insurers are required to establish a special contingency reserve included in total liabilities, with annual additions equal to 50% of premiums earned for that year. During 2008, PMI contributed $410.4 million to the reserve. This reserve is required to be maintained for a period of 120 months to protect against the effects of adverse economic cycles. After 120 months, the reserve is released to unassigned funds. In the event an insurer’s loss ratio in any calendar year exceeds 35%, however, the insurer may withdraw from its contingency reserves an amount equal to the excess portion of such losses. The Company withdrew $1.7 billion from its contingency reserves predominantly due to actual losses exceeding 35% of the corresponding earned premiums.
The revenues do not include equity in (losses) earnings from unconsolidated subsidiaries.
In 2008, the Company undertook initiatives to reduce and manage its expenses to focus on its core U.S. mortgage insurance business. The following table provides a reconciliation of exit and disposal expenses included in other underwriting expenses by operating segment in 2008:
The Company is actively engaged in discussions with the lenders under its revolving credit facility to amend the financial covenants and certain events of default under its revolving credit facility. Pending negotiation and execution of an amendment to the credit facility, the lenders under the credit facility have agreed to suspend the financial strength ratings event of default, reduce the minimum Adjusted Consolidated Net Worth requirement from $1.5 billion to $1.2 billion, and increase the maximum PMI risk-to-capital ratio requirement to 24.0 to 1, through April 15, 2009. As part of this agreement, the Company has agreed not to borrow additional amounts under the facility or contribute additional capital to its subsidiaries unless and until it is in compliance with these ratings, Adjusted Consolidated Net Worth and risk-to-capital ratio provisions as they were set forth in the credit facility prior to their suspension. The Company cannot be sure that it will complete an amendment to the credit agreement on terms acceptable to the Company prior to the expiration of this temporary suspension or at all. The Company currently has sufficient liquidity at its holding company to repay the credit facility in the event it no longer complies with its terms or in the event of a potential cross-default under its senior notes.