We currently lease approximately 120,800 square feet of office space in Walnut Creek, California for our home office from PMI Plaza LLC, a wholly-owned subsidiary of PMI, which lease terminates in 2009. PMI is in the process of subleasing its former home office of approximately 100,000 square feet in San Francisco under a lease which expires in December 2004. The remaining rent owed on this lease has been accrued as a charge associated with our relocation to Walnut Creek in August 2002. PMI leases branch offices throughout the United States and its operations data center in Rancho Cordova, California. PMI will consolidate certain field underwriting and sales offices and reduce the number of field personnel in 2004. We conduct our international operations in leased facilities in Ireland, the United Kingdom, Italy, Australia, New Zealand and Hong Kong.
Financial Guaranty. On December 18, 2003, we became the lead investor in FGIC Corporation, whose subsidiary, FGIC, primarily provides financial guaranty insurance. We also have a significant interest in RAM Re, a financial guaranty reinsurance company based in Bermuda. Net income from our Financial Guaranty segment was $10.4 million in 2003.
underwriting, acquisition and policy servicing costs, contract underwriting costs and remedies, and general administration and overhead expenses;
Our consolidated net income was $299.4 million in 2003, compared to $346.2 million in 2002. U.S. economic conditions in 2003 adversely affected our U.S. Mortgage Insurance Operations segment and, accordingly, our consolidated financial results. The U.S. economic recession contributed to increases in U.S. Mortgage Insurance Operations claims paid and our consolidated losses and loss adjustment expenses in 2003. Low U.S. mortgage interest rates leading to a record mortgage refinance market adversely affected U.S. Mortgage Insurance Operations premiums earned and expenses. There can be no assurance that these conditions will not continue in 2004. In addition, our share of the net losses at Fairbanks due to its regulatory issues, rating agency downgrades and related matters negatively impacted our consolidated net income. Favorable economic conditions in Australia and New Zealand, including a vibrant housing market and strengthening Australian dollar, contributed to net income growth in our International Operations segment in 2003, positively affecting our consolidated financial results.
financial results. Our primary goal in managing our investment portfolios is to achieve a predictable level of income while maintaining adequate levels of liquidity, safety and preservation of capital; growth is a secondary consideration and the realization of taxable gains is minimized. A substantial portion of our investment portfolio is invested in fixed income securities.
New Insurance Written (NIW). While PMI’s NIW increased by 20% in 2003, insurance in force and premiums earned decreased because NIW did not exceed the loss of insurance in force through policy cancellations. Changes in NIW can affect the average age of PMI’s insurance in force and, therefore, the portion of PMI’s insurance in force that consists of policies in their peak claims-paying years. Changes in NIW can also affect PMI’s average coverage levels and, therefore, PMI’s premiums written and earned. PMI’s ability to write new mortgage insurance is influenced by, among other factors, the sizes of the U.S. mortgage origination, purchase money mortgage, and private mortgage insurance markets. We currently expect the mortgage origination and refinance mortgage markets to decrease in 2004 compared to 2003, especially if U.S. mortgage interest rates increase or remain at current levels.
PMI’s Loss Experience and Reserves. PMI’s claims paid increased in 2003 compared to 2002 as a result of the aging of PMI’s insurance portfolio, higher levels of unemployment and higher claim rates associated with a portion of its portfolio that contains non-traditional and less-than-A quality mortgage loans. A significant majority of PMI’s mortgage insurance claims occur between the second and fifth years after loan origination. Approximately 85% of PMI’s insurance in force at December 31, 2003 was written after January 1, 2001. We expect PMI’s losses associated with claims paid to increase in 2004 compared to 2003 as a result of the aging of PMI’s relatively young insurance portfolio, unemployment in the U.S. and the non-traditional and less-than-A quality mortgage loans in the portfolio. Changes in economic conditions may not necessarily be reflected in PMI’s claims development in the quarter or year in which they occur.
Underwriting and Operating Expenses. The profitability of our business depends in part on our ability to control our underwriting and operating expenses. Our expense ratio, the ratio of underwriting expenses to net premiums written, in our U.S. Mortgage Insurance Operations segment has been adversely affected by lower persistency, which has reduced PMI’s premiums written, by the increased use of captive reinsurance, which decreases premiums written without a necessarily corresponding
Alternative Forms of Credit Enhancement-80/10/10s. 80/10/10 loans, which include a first mortgage lien with an LTV of 80%, a 10% second mortgage lien and a 10% down-payment, and other similar forms of credit enhancement reduce the available market for primary insurance. We believe that the use of 80/10/10 loans increased significantly in 2003 and 2002.
International Operations. The financial performance of our International Operations segment is affected by the following factors, among others:
PMI Europe. To date, PMI Europe has derived most of its revenues from capital markets products. PMI Europe intends to utilize its pending acquisition of the R&SA portfolio to expand into the first-loss mortgage insurance market in the U.K. PMI Europe’s ability to expand its business in the U.K. and elsewhere in Europe depends in part on the degree to which its products are accepted in Europe’s secondary mortgage market and as a method to reduce capital requirements with respect to the New Basel Capital Accord (Basel II).
Financial Guaranty. As a result of our recent strategic investment in FGIC Corporation, we expect that a significant portion of net income derived from our Financial Guaranty segment will be generated by our investment in FGIC Corporation. Although we own a significant portion of the equity of FGIC Corporation and are able to appoint representatives to its board of directors, we do not control the operations of FGIC Corporation. Factors affecting FGIC Corporation’s financial performance include the maintenance of FGIC’s ratings, interest rate movements, the level of public financings and FGIC’s ability to expand into new markets.
Other. Net income in 2003 from our Other segment included net investment income, net income from APTIC, classified as discontinued operations, expenses related to salaries and other corporate overhead, and interest expense and distributions on our mandatorily redeemable preferred securities.
The increases in other income in 2003 and 2002 were largely attributable to higher fees generated from our contract underwriting services. Contract underwriting services are included in our Other segment.
The increase in our losses and loss adjustment expenses in 2003 over 2002 was the result of an increase in claims paid in our U.S. Mortgage Insurance Operations, and an increase in loss reserves for PMI Europe, partially offset by a reduction of loss reserves for PMI Australia. The increase in losses and LAE in 2002 over 2001 was the result of higher levels of claims in our U.S. Mortgage Insurance Operations (see Critical Accounting Policies and Estimates, Reserves for Losses and LAE below).
During the fourth quarter of 2003, we changed our reporting segments primarily to reflect our investment in FGIC and the pending sale of APTIC, which has been accounted for as discontinued operations. The following table presents net income (loss) for each of our segments for the years ended December 31, 2003, 2002 and 2001.
exclusively, under captive reinsurance agreements. In captive reinsurance agreements, PMI transfers portions of its risk written on loans originated by certain lender-customers to captive reinsurance companies affiliated with such lender-customers. In return, a proportionate amount of PMI’s gross premiums written is ceded to captive reinsurance companies. The components of PMI’s net premiums written and premiums earned are as follows:
The increases in ceded premiums were driven primarily by the increasing percentage of primary insurance in force subject to captive reinsurance agreements. Heavy refinance volume resulted in an increasing penetration of loans subject to captive reinsurance agreements in PMI’s portfolio.
Losses and LAE-PMI’s total losses and LAE represent claims paid, certain expenses related to default notification and claim processing, and changes in loss reserves during the applicable period. PMI’s total losses and LAE and related claims data are shown in the following table.
As of December 31, 2003, PMI’s modified pool insurance (see Modified pool insurance below) default rate was 5.45% with 10,368 modified pool loans in default, compared to a default rate of 4.27% with 7,070 loans in default at December 31, 2002. The increase was primarily due to the seasoning of this portfolio and the condition of the U.S. economy. PMI believes that its modified pool insurance products’ risk reduction features, including a stated stop loss limit, exposure limits on each individual loan in the pool, and deductibles, in some instances, reduce PMI’s potential for loss exposure on loans insured by those products. PMI’s default rate for GSE Pool (see Pool insurance below) at December 31, 2003 was 3.60% with 3,870 GSE Pool loans in default compared to a default rate of 1.48% with 6,250 loans in default as of December 31, 2002. The increase in the default rate and the decrease in loans in default were driven by a decline in the number of loans covered by GSE pool policies.
Total underwriting and operating expenses-PMI’s total underwriting and operating expenses are as follows:
Policy acquisition costs consist of direct costs related to PMI’s acquisition, underwriting and processing of new insurance including contract underwriting and sales-related activities. These costs are initially recorded as assets and amortized against related premium revenue for each policy year book of business. Policy acquisition costs incurred and deferred are variable and fluctuate with the volume of new insurance applications processed and NIW, and are offset by increased efficiency from the use of PMI’s electronic origination and delivery
methods. Electronic delivery accounted for 80% of PMI’s insurance commitments from its primary flow channel in 2003, compared to 69% in 2002 and 52% in 2001.
PMI’s loss ratio is the ratio of total losses and LAE to premiums earned. The increases in the loss ratios in 2003 and 2002 were primarily driven by increases in total incurred losses. PMI’s expense ratio is the ratio of underwriting and operating expenses to net premiums written. The declines in PMI’s expense ratios in 2003 and 2002 were attributable partly to the increases in net premiums written. The expense ratio in 2002 included $9.3 million of expenses related to the relocation of the Company’s headquarters and a $12.2 million charge related to litigation settlement. The combined ratio is the sum of the loss ratio and the expense ratio.
The decreases in primary insurance in force and risk in force at December 31, 2003 compared to December 31, 2002 were primarily driven by higher policy cancellations. The moderate increases in 2002 primary insurance in force and risk in force from 2001 were driven by a higher volume of primary NIW, partially offset by policy cancellations. Policy cancellations increased by 28% to $59.6 billion in 2003, compared to an increase of 30% to $46.6 billion in 2002 and an increase of 110% to $35.8 billion in 2001. Low mortgage interest rates in 2003 and 2002 resulted in heavy mortgage refinancing activity, which have caused PMI’s policy cancellations to increase and PMI’s policy persistency rate to decline.
Less-than-A with FICO scores below 575 is a subset of less-than-A quality loan portfolio.
The table below sets forth the results of PMI Australia for the years ended December 31, 2003, 2002 and 2001.
The increase in PMI Australia’s net income in 2003 over 2002 was attributable to a decrease in losses and LAE and an increase in premiums written and earned. The increase in PMI Australia’s net income in 2002 over 2001 was due to an increase in premiums written and earned and the cumulative effect of a change in accounting
principle related to the write-off of negative goodwill. In addition, we made cumulative adjustments in 2002 for PMI Australia to conform its results to GAAP as applied in the U.S., and such adjustments resulted in an increase in PMI Australia’s premiums earned by $6.3 million, a decrease in net investment income by $9.8 million, an increase in realized investment gains by $4.4 million, and a decrease in amortization of deferred policy acquisition costs by $1.0 million.
The reported results of PMI Australia were favorably affected by the appreciation of the Australian dollar in 2003 and 2002. The average USD/AUD currency exchange rate was 0.6529 in 2003, 0.5440 in 2002 and 0.5201 in 2001.
Premiums written and earned-In addition to currency exchange rate appreciation, the increases in PMI Australia’s net premiums written and premiums earned in 2003 over 2002 were due to growth in its NIW and insurance portfolio, which was attributable to strong mortgage market activity and a reduction in the number of market participants underwriting mortgage insurance. The increases in 2002 over 2001 were due to an increase in NIW and the acquisition of PMI Indemnity Limited, which was completed in September 2001.
Losses and LAE-The decrease in losses and LAE in 2003 over 2002 was largely due to an $8.0 million reduction in loss reserves, which resulted from our third quarter 2003 review of PMI Australia’s loss provisioning. PMI Australia has continued to experience lower levels of claim payments and declining default rates attributable primarily to the current low interest rate environment, low unemployment levels and home value appreciation. The decrease in 2002 over 2001 was due to declines in average claim size and claim payments. PMI Australia’s default rate at December 31, 2003 was 0.17%, compared with 0.30% at December 31, 2002 and 0.28% at December 31, 2001.
Primary NIW and risk in force-PMI Australia’s primary NIW includes flow channel insurance and insurance on residential mortgage-backed securities, or RMBS. In Australia, an active securitization market exists due in part to the relative absence of government sponsorship of the mortgage market. RMBS transactions include insurance on seasoned portfolios comprised of prime credit quality loans that have LTVs often below 80%. The following table presents the components of PMI Australia’s primary NIW, insurance in force and risk in force for the years ended December 31, 2003, 2002 and 2001.
In October 2003, PMI Mortgage Insurance Company Limited entered into a definitive agreement to acquire a portion of R&SA’s U.K. lenders’ mortgage insurance portfolio. The portfolio to be acquired consists of U.K. residential mortgage loans originated in 1993 and subsequent years. The portfolio covers approximately $15
The increases in net investment income in 2003 over 2002 were primarily due to increases in interest and dividend income driven by growth of the investment portfolio. PMI Europe’s investment portfolio, including cash and cash equivalents, as of December 31, 2003, was $194.4 million compared to $94.2 million as of December 31, 2002 and $77.9 million as of December 31, 2001. The growth of the investment portfolio was driven by R&SA’s transfer of funds to PMI Europe, positive cash flows from operations and by the appreciation of the Euro relative to the U.S. dollar. The pre-tax book yield was 4.5% at December 31, 2003 and 4.7% at December 31, 2002 and 3.9% at December 31, 2001. PMI Europe incurred net realized investment gains of $0.5 million in 2003 compared with $1.6 million net realized investment losses in 2002, and $0.1 million net realized investment losses in 2001.
The increases in underwriting and operating expenses in 2003 and 2002 over the respective prior years were due primarily to increases in staff and costs associated with expansion efforts.
In April 2003, the Financial Accounting Standards Board (FASB) issued SFAS No. 149, Amendment of SFAS No. 133 on Derivative Instruments and Hedging Activities. SFAS No. 149 requires certain credit default swaps entered into by PMI Europe beginning in July 1, 2003 to be accounted for as derivatives and reported on the consolidated balance sheet at fair value, with subsequent changes in fair value recorded in earnings. In addition, as required by Emerging Issues Task Force (EITF) No. 02-3, Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities, for certain derivative contracts entered into by PMI Europe where the fair value cannot be determined by reference to quoted market prices, current market transactions for similar contracts, or based on a valuation technique incorporating observable market data or inputs, initial fair value related to the derivative contracts are deferred and recognized in earnings in proportion to the expiration of the associated insured risk. Gains or losses are recognized in earnings at inception for all other derivative contracts where the fair value can be determined in such a manner. During 2003, PMI Europe entered into two transactions which were classified as derivatives in accordance with SFAS No. 149. However, initial fair value gains were deferred in accordance with
EITF No. 02-3. As of December 31, 2003, $3.8 million of deferred gains related to initial fair value were included in other assets, of which $0.1 million was included in other income. Subsequent changes in the value of derivative contracts totaling $0.6 million of loss were also included in other income.
As of December 31, 2003, PMI Europe had assumed $2.9 billion of risk on $24.3 billion of mortgages on properties in the United Kingdom, and $230.6 million of risk on $7.3 billion of mortgages on properties in Germany. In September 2003, PMI Europe completed a German credit enhancement transaction with the assumption of approximately $25.3 million of first loss credit risk on $1.2 billion of German residential mortgages. As of December 31, 2003, PMI Europe had assumed first loss position default risk (including the R&SA acquired portfolio) of $2.3 billion.
The following table sets forth the results of PMI’s Hong Kong reinsurance revenues for the years ended December 31, 2003, 2002 and 2001.
reduction in the penetration rate of the Hong Kong Mortgage Corporation’s mortgage insurance program and the effect of a risk retention agreement between PMI and the Hong Kong Mortgage Corporation.
Our Financial Guaranty segment, which consists of our investments in FGIC and RAM Re, reported net income of $10.4 million for 2003, compared to $2.8 million for 2002 and $2.4 million for 2001. The increase in 2003 over 2002 was largely attributable to our investment in FGIC. We closed the FGIC transaction on December 18, 2003. Equity earnings from FGIC in 2003 was $2.4 million (pre-tax) excluding an extraordinary gain of $5.4 million (after tax) related to our share of negative goodwill written off by FGIC in connection with purchase accounting adjustments.
The results of our Other segment include: other income and related operating expenses of MSC; investment income, interest expense and corporate overhead of The PMI Group; the results of Commercial Loans Insurance Co. and WMAC Credit Insurance Corporation; equity in earnings (losses) from Fairbanks; and the discontinued operations of APTIC. Our Other segment results are summarized as follows:
The net loss of $35.1 million in 2003 compared to net income of $14.3 million in 2002 was primarily the result of losses at Fairbanks and increases in contract underwriting remedy expenses, partially offset by increased net income from APTIC which has been classified as discontinued operations due to its pending sale.
The net loss from Fairbanks was largely a result of its recording aggregate expenses of approximately $55 million pre-tax in connection with its preliminary settlement of potential civil charges with the FTC and HUD. These charges included the costs of settlement, estimated costs of potential settlements of certain putative class actions, and the estimated costs relating to certain pending state regulatory actions. Our proportionate share of such expected aggregate expenses was $17.8 million after tax. As of December 31, 2003, our investments in Fairbanks totaled $141.8 million, consisting of $115.8 million book value of equity investment and $26.0 million of related party receivables. We evaluated these investments as of December 31, 2003 and determined that there was no other-than-temporary decline in the carrying value. Accordingly, we have not recognized an impairment charge with respect to our total investment in Fairbanks. We will continue to evaluate our investment balance for potential impairment in accordance with GAAP.
Other income, which was generated by MSC, increased in 2003 and 2002 due primarily to increased contract underwriting activity in connection with heavy mortgage originations and refinance volume. Other
operating expenses, which were incurred by MSC and The PMI Group, Inc., increased in 2003 over 2002 due to increased salary expense and other corporate overhead and contract underwriting remedies expenses. The increase in other operating expenses in 2002 over 2001 was due to increased contract underwriting activity and increased salary expense and other corporate overhead.
Our effective tax rate was 30.2% for 2003, compared to 27.7% for 2002 and 30.0% for the 2001. Our effective tax rate can vary for a number of reasons, including differences in the proportion of earnings taxed at lower marginal tax rates in certain foreign jurisdictions and differences in the proportion of tax-exempt earnings relative to consolidated pre-tax income. The increase in our effective tax rate in 2003 over 2002 was due primarily to the loss related to Fairbanks recorded at an effective tax benefit of 7% compared to the statutory rate of 35%. The decrease in 2002 over 2001 was attributable to a larger portion of income derived from PMI Australia and Fairbanks, which have lower effective tax rates than PMI.
PMI’s ability to pay dividends to The PMI Group is affected by state insurance laws, credit agreements, credit rating agencies and the discretion of insurance regulatory authorities. The laws of Arizona, PMI’s state of domicile for insurance regulatory purposes, provide that PMI may pay out of any available surplus account, without prior approval of the Director of the Arizona Department of Insurance, dividends 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 last calendar year’s investment income.
PMI’s ability to pay dividends is also subject to restriction under the terms of a runoff support agreement with Allstate. In particular, PMI may not pay a dividend if, after the payment of that dividend, PMI’s risk-to-capital ratio would equal or exceed 23 to 1. As of December 31, 2003, PMI’s risk-to-capital ratio was 9.1 compared to 11.3 at December 31, 2002.
profits and realized net capital gains derived during the immediately preceding calendar year. As with PMI, the various credit rating agencies and insurance regulatory authorities have broad discretion to affect the payment of dividends to The PMI Group by APTIC. In 2003, APTIC did not pay any dividends to The PMI Group, compared to $2.5 million in 2002. In 2004, APTIC paid $13 million in dividends to The PMI Group. While APTIC would be able to pay additional dividends of $1.4 million in 2004 without prior permission from the Florida Department of Insurance, APTIC’s ability to pay future dividends to The PMI Group is limited by the definitive agreement we entered into to sell APTIC.
The stockholders agreement between The PMI Group and the other investors in FGIC Corporation also restricts the payment of dividends by FGIC Corporation. The stockholders agreement provides that FGIC Corporation will not declare or pay cash dividends to holders of its common stock prior to the earlier of the fifth anniversary of the closing of the investment and the completion of the first underwritten public offering of FGIC Corporation’s common stock, and, in any event, that such dividends will not be paid prior to the redemption of FGIC Corporation’s senior preferred stock and class B common stock.
Our consolidated investment portfolio holds primarily investment grade securities comprised of readily marketable fixed income and equity securities. At December 31, 2003, the fair value of these securities in our consolidated investment portfolio increased to $2.8 billion from $2.5 billion at December 31, 2002. The increase was primarily the result of positive cash flows from consolidated operations and unrealized gains in our portfolio. As interest rates, market and other economic conditions change, we expect the market value of the securities in our investment portfolio to be affected.
The following table summarizes our consolidated investment portfolio as of December 31, 2003 and 2002:
The significant components of net investment income are presented in the following table.
Net investment income increased in 2003 over 2002 primarily due to growth in our investment portfolio and $10.3 million in pre-tax adjustments in 2003 to reflect the appropriate accounting treatment related to the accretion of discounts and call premiums on bonds that have been called for early redemption. The decrease in 2002 over 2001 was primarily attributable to cumulative adjustments by PMI Australia in 2002 of $11.2 million that decreased interest income. Our pre-tax book yield was 5.38% at December 31, 2003, down from 5.56% at December 31, 2002, and 5.95% at December 31, 2001. The decreases reflect the lower interest rate environment. The decrease in the book yield for 2003 also reflects our higher cash positions in anticipation of our liquidity needs related to the FGIC acquisition.
We manage our capital resources based on our cash flows, total capital and rating agency requirements. As of December 31, 2003, our shareholders’ equity was $2.8 billion. Our long-term debt outstanding at December 31, 2003 was $819.5 million, consisting of the following:
$345 million in principal amount of senior notes, maturing on November 15, 2008, with a coupon initially of 3% per annum.
The PMI Group’s principal uses of funds are payments of dividends to shareholders, common stock repurchases, investments and acquisitions, and interest payments. The PMI Group’s available funds (consisting of cash and cash equivalents and investments) were $307.9 million at December 31, 2003, compared to $356.5 million at December 31, 2002. In the normal course of business, we evaluate The PMI Group’s capital and liquidity needs in light of its debt-related costs, holding company expenses, our dividend policy, and rating agency considerations. It is our present intention to maintain between $75 million to $100 million of liquidity at our holding company for rating agency purposes. We believe that we have sufficient cash to meet all of our short- and medium-term obligations, and that we maintain excess liquidity to support our operations.
During the first quarter of 2003, we repurchased approximately $20 million of our common stock, completing a $100 million stock repurchase program authorized in 1998. In February 2003, The PMI Group’s Board of Directors authorized a new stock repurchase program in the amount of $100 million. To date, no repurchases have occurred under this authorization.
Consolidated cash flows generated by financing activities, including proceeds from issuance of debt and equity, repayment of debt, purchase of treasury stock and dividends paid to shareholders, was $528.7 million in 2003 and $16.0 million in 2002. The variance was due primarily to the issuance of the equity units of $345 million and common stock of approximately $220 million.
We have guaranteed approximately two-thirds of the funds that may become due under a $30.7 million letter of credit which may be drawn upon by the FTC as security for a portion of a $40 million redress fund to be established pursuant to the terms of the settlement reached by Fairbanks with the FTC and HUD. In addition, we have guaranteed approximately $7 million of obligations owed by Fairbanks to its principal lenders in connection with the refinancing of amounts owed to another creditor.
Under certain circumstances, when we make an underwriting error in the course of providing contract underwriting services to a customer, we issue to the customer a loan indemnification. Such an indemnification is in lieu of paying a monetary remedy to the customer at the time the underwriting error is discovered and, accordingly, is usually issued on a loan by loan basis. While the terms of the indemnifications vary, each indemnification generally requires us to reimburse the customer for any costs (excess of insurance recoverables) it incurs as a result of the borrower’s default on the loan in question. If the indemnified loan remains current, or is repaid or refinanced, we have no actual liability under the indemnification. As of December 31, 2003, we estimate that the total principal balance for indemnified loans was between approximately $85 million and $125 million. For a variety of factors, we believe our contingent liability with respect to these indemnifications to be significantly lower than this amount. The factors include the following: (i) we generally only indemnify performing loans; (ii) we expect only a small portion of the indemnified loans to default; (iii) loans in default may not cause our customers to incur losses due to home appreciation and the underlying security; and (iv) we expect a portion of these loans to be refinanced, or their indemnification coverage to expire, in the near- to mid-term. In 2003, we paid customers approximately $2.5 million pursuant to loan indemnifications.
PMI has entered into various capital support agreements with its Australian and European subsidiaries that could require PMI to make additional capital contributions to those subsidiaries for rating agency purposes. With respect to the Australian and European subsidiaries, The PMI Group guarantees the performance of PMI’s capital support obligations. In 2001, PMI executed a capital support agreement whereby it agreed to contribute funds, under specified conditions, to maintain CMG’s risk-to-capital ratio at or below 18.0 to 1. PMI’s obligation under the agreement is limited to an aggregate of $37.7 million, exclusive of capital contributions that PMI made prior to April 10, 2001. On December 31, 2003, CMG’s risk-to-capital ratio was 13.4.
Fitch Ratings, or Fitch, has assigned The PMI Group “A+” long-term issuer and senior debt ratings; has assigned PMI a “AA+” insurer financial strength rating; has assigned PMI Australia and PMI Europe insurer financial strength ratings of “AA;” and has assigned PMI Capital I, the issuer of the 8.309% Capital Securities, an “A+” capital securities rating. Fitch’s rating outlook is stable with respect to these ratings.
Any significant decreases in our ratings may adversely affect the ratings of FGIC Corporation and FGIC. FGIC’s ability to attract new business and to compete with other triple-A rated financial guarantors is largely dependent on its triple-A financial strength ratings. Also, the stockholders agreement entered into in connection with the acquisition of FGIC Corporation provides that The PMI Group will not acquire a majority of the voting stock of FGIC Corporation or cause its designees to constitute a majority of FGIC Corporation’s Board of Directors unless, at the time of such action, Moody’s, S&P and Fitch, as applicable, reaffirm FGIC’s then current financial strength rating and outlook and FGIC Corporation’s then current senior unsecured debt rating and outlook. The value of our investment in FGIC Corporation, and our ability to increase our ownership interest in FGIC Corporation in the future, to the extent opportunities arise to do so, depend in part on The PMI Group’s and PMI’s ratings and on the views of the rating agencies with respect to any such transaction.
“Management’s Discussion and Analysis of Financial Condition and Results of Operation,” as well as disclosures included elsewhere in this Annual Report on Form 10-K, are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. 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 under different assumptions or conditions. We believe that the following critical accounting policies involved significant judgments and estimates used in the preparation of our financial statements.
The following table shows the reasonable range of loss and LAE reserves, as determined by our actuaries, and recorded reserves for losses and LAE (gross of reinsurance recoverables) as of December 31, 2003 on a segment and consolidated basis.
Our best estimate of PMI’s loss and LAE reserves is derived primarily from our analysis of PMI’s default and recovery experience. The key assumptions used in the estimation process are expected claim rates, average claim sizes, and costs to settle claims. We evaluate our assumptions in light of PMI’s historical patterns of claim payment, loss experience in past and current economic environments, the seasoning of PMI’s various books of business, PMI’s coverage levels, the credit quality profile of PMI’s portfolios, and the geographic mix of PMI’s business. Our assumptions are influenced by historical loss patterns and are adjusted to reflect recent loss trends. Our assumptions are also influenced by our assessment of current and future economic conditions, including trends in housing prices, unemployment and interest rates. Our estimation process uses generally recognized actuarial projection methodologies. As part of our estimation process, we also evaluate various scenarios representing possible losses and LAE under different economic assumptions. With respect to PMI’s reserves at December 31, 2003, our recording of $325.3 million, the approximate mid-point of the actuarial range, was influenced by our belief that PMI’s number of delinquencies, average claim rate and average claim size are currently less volatile relative to prior periods.
The following table provides a reconciliation of our International Operations segment’s beginning and ending reserves for losses and loss adjustment expenses for each of the last three years:
a decline in the market value of a security by 15% or more below cost or amortized cost for a continuous period of at least six months;
If we believe a decline in the value of a particular investment is temporary, we record the decline as an unrealized loss on our consolidated balance sheet under “accumulated other comprehensive income” in shareholder’s equity. If we believe the decline is “other-than-temporary,” we write-down the carrying value of the investment and record a realized loss in our consolidated statement of operations. Our assessment of a decline in value includes management’s current assessment of the factors noted above. If that assessment changes in the future, we may ultimately record a loss after having originally concluded that the decline in value was temporary. Other-than-temporary declines in the fair value of the investment portfolio were $0.3 million in 2003 and $6.9 million in 2002.
The following table provides the composition of fixed income securities with an unrealized loss at December 31, 2003 in relation to the total of all fixed income securities with an unrealized loss by contractual maturities.
Periodically, or as events dictate, the Company evaluates potential impairment of its investments in unconsolidated subsidiaries. Accounting Principles Board (APB) Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock, provides criteria for determining potential impairment. In the event a loss in value of an investment is determined to be an other-than-temporary decline, an impairment charge would be recognized in the consolidated statement of operations. Evidence of a loss in value that could indicate impairment might include, but would not necessarily be limited to, the absence of an ability to recover the carrying amount of the investment or the inability of the investee to sustain an earnings capacity which would justify the carrying amount of the investment. Realized gains or losses resulting from the sale of the Company’s ownership interests of unconsolidated subsidiaries are recognized in net realized investment gains or losses in the consolidated statement of operations.
As of December 31, 2003, our total investments in Fairbanks totaled $141.8 million, consisting of $115.8 million book value of equity investment and $26.0 million of related party receivables. We evaluated these investments as of December 31, 2003 and determined that there was no other-than-temporary decline in the carrying value. Accordingly, we have not recognized an impairment charge with respect to our total investment in Fairbanks. We will continue to evaluate our investment balance in Fairbanks for potential impairment in accordance with GAAP.
Concentration of PMI’s primary insurance in force could increase claims and losses and harm our financial performance.
A significant percentage of the premiums PMI earns each year is generated from insurance policies written in previous years. As a result, a decrease in the length of time that PMI’s policies remain in force could cause our revenues to decline. Factors that lead to borrowers canceling their mortgage insurance include: current mortgage interest rates falling below the rates on the mortgages underlying PMI’s insurance in force, which frequently results in borrowers refinancing their mortgages; and appreciation in home values experienced by the homes underlying the mortgages PMI insures.
If the volume of low down payment home mortgage originations declines, the amount of insurance that PMI writes could decline, which could result in a decline in our future revenue.
PMI’s primary risk in force consists of mortgage loans with high loan-to-value ratios and adjustable rate mortgages, which generally result in more claims than mortgage loans with lower loan-to-value ratios and fixed rate mortgages.
In our experience, mortgage loans with high loan-to-value ratios have higher claims frequency rates than mortgages with lower loan-to-value ratios. At December 31, 2003, approximately 54% of PMI’s primary risk in force consisted of mortgages with loan-to-value ratios greater than 90%. Risk in force is the dollar amount equal to the product of each individual insured mortgage loan’s current principal balance and the percentage specified in the insurance policy of the claim amount that would be payable if a claim were made.
Also as of December 31, 2003, approximately 10% of PMI’s primary risk in force consisted of adjustable rate mortgages, which we refer to as ARMs. In our experience, ARMs have claims frequency rates that exceed the rates associated with PMI’s book of business as a whole. We cannot be sure that the premiums that PMI charges will adequately offset the associated risk of higher loan-to-value loans and ARMs.
PMI delegates underwriting authority to mortgage lenders which could cause PMI to insure mortgage loans outside of its underwriting guidelines, and thereby increase claims and losses.
The Office of Federal Housing Enterprise Oversight, or OFHEO, has issued a risk-based capital rule that treats credit enhancements issued by private mortgage insurance companies with claims-paying ability ratings of “AAA” more favorably than those issued by private mortgage insurance companies with “AA” ratings. The rule also provides capital guidelines for Fannie Mae and Freddie Mac, or the GSEs, in connection with their use of other types of credit protection counterparties in addition to mortgage insurers. PMI has an “AA+” rating. Although it has not occurred to date, if the rule resulted in the GSEs increasing their use of either “AAA”-rated mortgage insurers instead of “AA”-rated entities or credit protection counterparties other than mortgage insurers, our consolidated financial condition and results of operations could be adversely affected. Legislation is pending in Congress concerning the GSEs which would empower a new regulator to issue new capital rules for the GSEs. We cannot estimate whether this legislation will be enacted, its content or its impact on our consolidated financial condition and results of operations.
If mortgage lenders and investors select alternatives to private mortgage insurance, the amount of insurance that PMI writes could decline, which could reduce our revenues and profits.
Alternatives to private mortgage insurance include: (1) government mortgage insurance programs, including those of the Federal Housing Administration, or FHA, and the Veterans Administration, or VA; (2) mortgage lenders structuring mortgage originations to avoid private mortgage insurance, such as a first mortgage with an 80% loan-to-value ratio and a second mortgage with a 10% loan-to-value ratio, which is referred to as an 80/10/10 loan, rather than a first mortgage with a 90% loan-to-value ratio; (3) member institutions providing credit enhancement on loans sold to a Federal Home Loan Bank, or FHLB; (4) investors holding mortgages in their portfolios and self-insuring; (5) mortgage lenders maintaining lender recourse or participation with respect to loans sold to the GSEs; and (6) investors using credit enhancements as a partial or complete substitute to private mortgage insurance.
Our revenues and profits could decline if PMI loses market share as a result of industry competition or if our competitive position suffers as a result of our inability to introduce and successfully market new products and programs.
If PMI is unable to compete successfully against other insurers or private mortgage insurance alternatives or if we experience delays in introducing competitive new products and programs or if these products or programs are less profitable than our existing products and programs, our business will suffer.
Legislation and regulatory changes, including changes impacting the GSEs, could significantly affect PMI’s business and could reduce demand for private mortgage insurance.
Mortgage origination transactions are subject to compliance with various federal and state consumer protection laws, including the Real Estate Settlement Procedures Act, the Equal Credit Opportunity Act, the fair Housing Act, the Homeowners Protection Act, the Federal Fair Credit Reporting Act, the Fair Debt Collection Practices Act and others. Among other things, these laws prohibit payments for referrals of settlement service business, require fairness and non-discrimination in granting or facilitating the granting of credit, require cancellation of insurance and refunding of unearned premiums under certain circumstances, govern the circumstances under which companies may obtain and use consumer credit information, and define the manner in which companies may pursue collection activities. Changes in these laws or regulations could adversely affect the operations and profitability of our mortgage insurance business.
PMI could lose premium revenue if the GSEs reduce the level of private mortgage insurance coverage required for low down payment mortgages or reduce their need for mortgage insurance.
The GSEs have products for which they will, upon receipt from lenders of loans with primary insurance, restructure the mortgage insurance coverage by reducing the amount of primary insurance coverage and adding a second layer of insurance coverage, usually in the form of pool insurance. Under these programs, the GSEs may provide services to the mortgage insurer and the mortgage insurer may be required to pay fees to the GSEs for the benefits provided through the reduced insurance coverage or the services provided. These new products may prove to be less profitable than PMI’s traditional mortgage insurance business and, if they become widely accepted, could harm our consolidated financial condition and results of operations.
The implementation of new eligibility guidelines by Fannie Mae could harm our profitability and reduce our operational flexibility.
Fannie Mae has revised its approval requirements for mortgage insurers, including PMI, with the guidelines effective January 1, 2005. The guidelines cover substantially all areas of PMI’s mortgage insurance operations, require the disclosure of certain activities and new products, give Fannie Mae the right to purchase mortgage insurance from other than existing approved mortgage insurers, including insurers that are either rated below
“AA” or are unrated, and provide Fannie Mae with increased rights to revise the eligibility standards of insurers. We do not know how Fannie Mae will enforce the terms of the guidelines, especially in those areas in which it has retained significant discretion, such as the right to purchase mortgage insurance from other than existing approved mortgage insurers. Depending on how the guidelines are implemented, our operational flexibility as well as our profitability could suffer.
HUD’s proposed RESPA reform regulation, if implemented in its current form, could harm our profitability.
The Real Estate Settlement Procedures Act of 1974, or RESPA, prohibits paying lenders for the referral of settlement services, including mortgage insurance. HUD has proposed a rule under RESPA which if implemented as proposed would, among other things, give lenders and other packagers the option of offering a Guaranteed Mortgage Package, or GMP, or providing a good faith estimate of settlement costs subject to a 10% tolerance level. To promote the use of a GMP, qualifying packages would be entitled to a “safe harbor” from litigation under RESPA’s anti-kickback rules. Mortgage insurance and title insurance are included in the package to the extent an upfront premium is charged. This could encompass some, but not all, of the policies written and the premiums charged by a mortgage insurer or a title insurer with respect to a single loan. Inclusion in the package could cause settlement service providers, such as mortgage insurers and title insurers, to experience reductions in the prices of their services or products, which could harm our profitability. HUD’s proposed rule has been submitted to the Office of Management and Budget for review. We do not know what form, if any, the final rule will ultimately take.
RESPA precludes PMI from providing services or products to mortgage lenders free of charge, charging fees for services that are lower than their reasonable or fair market value, and paying fees for services that others provide that are higher than their reasonable or fair market value. A number of lawsuits have challenged the actions of private mortgage insurers, including PMI, under RESPA, alleging that the insurers have provided products or services at improperly reduced prices in return for the referral of mortgage insurance. We and several other mortgage insurers, without admitting any wrongdoing, reached a settlement in these cases, which includes an injunction that prohibited certain specified practices and details the basis on which mortgage insurers may provide agency pool insurance, captive mortgage reinsurance, contract underwriting and other products and services and be deemed to be in compliance with RESPA. The injunction expired on December 31, 2003, and it is not clear whether the expiration of the injunction will result in new litigation against private mortgage insurers to extend the injunction or to seek damages under RESPA. Our competitors could change their pricing structure or business practices after the expiration of the injunction. U.S. federal and state officials are authorized to enforce RESPA and to seek civil and criminal penalties. We cannot predict whether civil, regulatory or criminal actions might be brought against us or other mortgage insurers. Any such proceedings could have an adverse effect on our consolidated financial condition and results of operations.
PMI’s claims-paying ability is currently rated “AA+” (“Excellent”) by S&P, “Aa2” (“Excellent”) by Moody’s, and “AA+” (“Very Strong”) by Fitch.
These ratings may be revised or withdrawn at any time by one or more of the rating agencies and are based on factors relevant to PMI’s policyholders and are not applicable to our common stock or debt. The rating agencies could lower or withdraw our ratings at any time as a result of a number of factors, including: underwriting or investment losses; the necessity to make capital contributions to our subsidiaries pursuant to capital support agreements; other adverse developments in PMI’s financial condition or results of operations; or changes in the views of rating agencies of our risk profile or of the mortgage insurance industry.
If PMI’s claims-paying ability rating falls below “AA-” from S&P or “Aa3” from Moody’s, investors, including Fannie Mae and Freddie Mac, may not purchase mortgages insured by PMI. Such a downgrade could also negatively affect our holding company ratings or the ratings of our other licensed insurance subsidiaries or our ability to further implement our strategic diversification program. Any of these events would harm our consolidated financial condition and results of operations.
An increase in PMI’s risk-to-capital ratio could prevent it from writing new insurance, which would seriously harm our financial performance.
PMI’s risk-to-capital ratio is also affected by capital requirements necessary to maintain our credit ratings and PMI’s claims-paying ability ratings. Generally, the methodology used by the rating agencies to assign credit or claims-paying ability ratings permits less capital leverage than under statutory or other requirements. Accordingly, we may be required to meet capital requirements that are higher than statutory or other capital requirements to satisfy rating agency requirements.
our investment returns and net income to decline and reduce our ability to maintain all of our capital and liquidity needs.
While we are protesting assessments we received, and intend to protest any future assessment we may receive, from the California Franchise Tax Board, we cannot provide assurance as to the ultimate outcome of these matters.
An adverse outcome of litigation against PMI or any of our other subsidiaries could harm our consolidated financial position and results of operations.
In June 2003, an action against PMI was filed in the federal district court of Orlando, Florida seeking certification of a nationwide class of consumers who allegedly were required to pay for private mortgage insurance written by PMI and whose loans allegedly were insured at less than PMI’s “best available rate”. The action alleges violations of the federal Fair Credit Reporting Act. In September 2003, an action against our wholly-owned title insurance company, American Pioneer Title Insurance Company, or APTIC, was filed in Florida state court seeking certification of a statewide class of consumers and alleging that, under Florida laws and regulations applicable to title insurance companies, APTIC was required to but failed to disclose to the plaintiffs that they were entitled to a reduced fee on the title insurance policies purchased by plaintiffs in connection with refinancings of their mortgages. APTIC is also subject to a similar lawsuit in New York and may be subject to additional similar lawsuits in the future. These actions seek, among other things, damages and declaratory and injunctive relief. PMI and APTIC intend to vigorously defend these respective claims. However, we cannot be sure that the outcome of the litigation or any similar litigation will not materially affect our consolidated financial position or results of operations. See Item 1.C.3. Residential Lender Services regarding our pending sale of APTIC.
Our Australian and New Zealand mortgage insurance operations, PMI Australia, is subject to many of the same risks facing PMI.
PMI Australia is currently rated “AA” by S&P and Fitch and “Aa3” by Moody’s. These ratings are based in part upon a capital support agreement between PMI and PMI Australia and a guarantee of that agreement by The PMI Group. Termination or amendment of this support structure could negatively impact PMI Australia’s ratings. PMI Australia’s business is dependent on maintaining its ratings. Any negative impact on its ratings will negatively affect its financial results.
HUD’s criminal investigation into Fairbanks Capital’s servicing practices has concluded, and Fairbanks believes that the Department of Justice criminal investigation is closed. A criminal indictment could have a material adverse effect on Fairbanks and its business and, therefore, on our investment in Fairbanks.
Fannie Mae has found certain business practices at Fairbanks Capital to be out of compliance with a servicing agreement between the parties. Fairbanks Capital and Fannie Mae have agreed that Fairbanks Capital will not service any new Fannie Mae-owned loans without the approval of Fannie Mae.
Fairbanks and Fairbanks Capital are subject to private litigation, including a number of putative class action suits, alleging violations of federal and state laws governing the activities of servicers. We expect that as a result of the publicity surrounding lending and servicing practices, Fairbanks Capital may be subject to other putative class action suits in the future. Fairbanks has entered into a settlement agreement with the plaintiffs in certain of these cases which provides for the payment by Fairbanks of attorney’s fees and costs, the implementation of the $40 million redress fund negotiated jointly with the FTC, a “reverse or reimburse” program through which affected customers’ accounts will be credited or refunds will be issued for certain previously assessed amounts,
Our investment in Fairbanks, and consequently our consolidated financial results, could be negatively impacted by the ultimate resolution of the state regulatory actions, the class action litigation, and/or pending FTC and HUD actions involving Fairbanks and Fairbanks Capital. If the FTC/HUD settlement is not implemented, the class action settlements are not finalized, or Fairbanks Capital is required as a result of state regulatory proceedings to make significant payments or changes to its business practices so that it becomes materially more expensive to operate, Fairbanks’ financial condition and results of operations could be adversely affected. Furthermore, regulatory actions and putative class actions have generated negative publicity for Fairbanks Capital which has caused and may continue to cause Fairbanks Capital to suffer losses in its customer base. These losses could also harm our investment in Fairbanks.
Fairbanks Capital has undergone ratings downgrades that have adversely affected its business, and any future downgrade could seriously harm Fairbanks and the value of our investment in Fairbanks.
As a result of Fairbanks Capital’s ratings downgrades by S&P, Moody’s and Fitch, and unless and until there are upgrades in these ratings, Fairbanks Capital is no longer qualified to be named as a primary servicer on future residential mortgage-backed securities, or RMBS, transactions rated by Moody’s or S&P. While Fairbanks Capital may serve as a subservicer on these rated transactions under certain circumstances, its inability to be named as a primary servicer has adversely affected its results of operations. Future negative rating agency actions could also negatively impact Fairbanks and could have a material adverse effect on Fairbanks. As a result of the
Fairbanks Capital is highly leveraged and dependent upon debt facilities with lenders to make servicing and delinquency advances in the regular course of its business, and for other business purposes. If Fairbanks Capital were to lose access to debt facilities for any reason, Fairbanks Capital would be unable to continue funding its operations or pay its debts as they become due. In addition, an event of default under one or more of Fairbanks Capital’s significant debt facilities could accelerate Fairbanks Capital’s obligation to repay amounts outstanding under its debt facilities and could cause Fairbanks Capital to lose access to funding, either of which could prevent Fairbanks Capital from continuing to operate. If Fairbanks Capital were to cease operations, the value of our investment in Fairbanks would be seriously harmed and we might be required to write off our entire investment in Fairbanks.
In order to complete the FGIC investment, we employed a significant portion of our borrowing capacity and significantly increased our leverage. Accordingly, we may not be able to raise significant amounts of capital in the near term without the use of equity.
We expect that a significant portion of our net income will be derived from FGIC and its financial guaranty business. Accordingly, we will be subject to various risks and uncertainties associated with the financial guaranty business.
The ability of a triple-A rated financial guarantor to compete is heavily dependent on maintaining such ratings. We cannot be sure that FGIC will be able to maintain its ratings. FGIC’s ability to compete with other triple-A rated financial guarantors and otherwise to engage in its business as currently conducted, and FGIC Corporation’s consolidated results of operations and financial condition, would be materially and adversely affected by any reduction in FGIC’s ratings or the announcement of a potential reduction or change in outlook.
FGIC is subject to extensive competition. We cannot be sure that FGIC will be able to continue to compete effectively in its current markets or in any markets or asset classes into which it expands.
Any expansion by FGIC into other markets and other asset classes will entail risks associated with engaging in new business lines, including, among others, the challenges in attracting and retaining employees with relevant experience and establishing name recognition in new markets and obtaining new experience in those markets and asset classes, as well as the risk that FGIC may not appropriately price insurance written in new business lines to compensate for the associated risk.
Terrorism and other hostilities may adversely impact the ratings of specific obligations insured by FGIC, and could lead to a significantly higher rate of default for those obligations.
As of December 31, 2003, approximately 8% of our U.S. investment portfolio consists of FGIC-insured non-refunded bonds. As a result of our investment in FGIC, we have amended our investment policy to provide that no more than $200 million of our U.S. investment portfolio consists of FGIC-insured non-refunded bonds.
On December 18, 2003, the Company completed its acquisition of a 42% ownership interest in Financial Guaranty Insurance Company (“FGIC”), together with its immediate holding company FGIC Corporation, from General Electric Capital Corporation (“GECC”). The Company is the strategic investor in a group of investors, and funded $611 million in cash of the $1.6 billion total purchase price. FGIC is a leading triple-A rated monoline bond insurer. FGIC provides financial guaranty insurance policies for public finance and structured finance obligations issued by clients in both the public and private sectors. In connection with the acquisition of FGIC, the Company issued 5.75 million shares of common stock and 13.8 million of 5.875% equity units. The investment in FGIC is accounted for under the equity method of accounting.
The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates.
The Company has made significant investments in the equity securities of several privately-held companies including FGIC and Fairbanks. The nature of the businesses conducted by these companies differs significantly from our core business of providing residential mortgage insurance. These companies are subject to a number of significant risks that arise from the nature of their businesses. In addition, we have limited ability to control these companies and, accordingly, may be unable to take actions unilaterally to avoid or mitigate those risks.
Investments-The Company has designated its entire portfolio of fixed income and equity securities as available- for-sale. These securities are recorded at fair value based on quoted market prices with unrealized gains and losses, net of deferred income taxes, accounted for as a component of accumulated other comprehensive income in shareholders’ equity. The Company evaluates its investments regularly to determine whether there are declines in value and whether such declines meet the definition of other-than-temporary impairment in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 115, Accounting for Certain Investments in Debt and Equity Securities. The fair value of a security below cost or amortized cost for consecutive quarters is a potential indicator of an other-than-temporary impairment. When the Company determines a security has suffered an other-than-temporary impairment, the impairment loss is recognized, to the extent of the decline, as a realized investment loss in the current period’s earnings.
Investments in Unconsolidated Subsidiaries-Investments in the Company’s unconsolidated subsidiaries include both equity investees and unconsolidated majority owned subsidiaries. Investments in equity investees with ownership interests of 20-50% are generally accounted for on the equity method of accounting, and investments of less than 20% ownership interest are generally accounted for on the cost method of accounting if the Company does not have significant influence over the entity. Limited partnerships with ownership interests greater than 3% but less than 50% are primarily accounted for using the equity method of accounting. The Company reports the equity earnings of FGIC and CMG on a current month basis, Fairbanks on a one-month lag basis, and all other unconsolidated subsidiaries on a one-quarter lag basis. Management is evaluating the possibility of eliminating the one-month lag reporting for Fairbanks in the first quarter of 2004 due to efficiencies Fairbanks has achieved in its monthly closing process. The book value of the investments in the Company’s unconsolidated subsidiaries includes the Company’s share of net unrealized gains and losses in the unconsolidated subsidiaries’ investment portfolio.
the issuance of mortgage insurance business are initially deferred and reported as deferred policy acquisition costs. SFAS No. 60, Accounting and Reporting for Insurance Enterprises, 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 and losses and loss adjustment expenses. The estimates for each underwriting year are monitored regularly to reflect actual experience and any changes to persistency or loss development. Deferred policy acquisition costs are reviewed periodically to determine that they do not exceed recoverable amounts, after considering investment income.
Derivatives-Until the quarter ended June 30, 2003, the Company’s use of derivative financial instruments was generally limited to reducing its exposure to interest rate risk and currency exchange risk by utilizing interest rate and currency swap agreements that are accounted for as hedges. However, in April 2003, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 149, Amendment of SFAS No. 133 on Derivative Instruments and Hedging Activities. SFAS No. 149 requires certain credit default swaps entered into by PMI Europe beginning in July 1, 2003 to be accounted for as derivatives and reported on the consolidated balance sheet at fair value, and subsequent changes in fair value are recorded in earnings. In addition, as required by EITF No. 02-3, Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities, for certain derivative contracts entered into by PMI Europe where the fair value cannot be determined by reference to quoted market prices, current market transactions for similar contracts, or based on a valuation technique incorporating observable market data or inputs, initial fair value related to the derivative contracts are deferred and recognized in earnings in proportion to the expiration of the associated insured risk. Gains or losses are recognized in earnings at inception for all other derivative contracts where the fair value can be determined in such a manner.
During 2003, PMI Europe entered into two transactions which were classified as derivatives in accordance with SFAS No. 149. However, initial fair value gains were deferred in accordance with EITF No. 02-3. As of December 31, 2003, approximately $3.8 million of deferred gains related to initial fair value of these derivative contracts was included in other assets, of which $0.1 million was recognized in consolidated net income in 2003 and was included in other income. In addition, a loss of $0.6 million related to the change in value of derivative contracts was also included in other income.
Losses and Loss Adjustment Expenses-The reserves for mortgage insurance losses and loss adjustment expenses are the estimated claim settlement costs on notices of default that have been received by the Company, as well as loan defaults that have been incurred but have not been reported by the lenders. SFAS No. 60 specifically excludes mortgage guaranty insurance from its guidance relating to reserves for losses. Consistent with industry accounting practices, the Company does not establish loss reserves for future claims on insured loans that are not currently in default. The Company establishes loss reserves on a case-by-case basis when insured loans are identified as currently in default using estimated claim rates and average claim amounts for each report year, net of salvage recoverable. The Company also reserves for defaults that have been incurred but have not been reported to the Company prior to the close of an accounting period, using estimated claim rates and claim amounts applied to the estimated number of defaults not reported. The reserve levels as of the balance sheet date represent management’s best estimate of existing losses incurred. The estimates are continually reviewed and adjusted as necessary as experience develops or new information becomes known. Such adjustments to the extent of increasing or decreasing loss reserves, are recognized in current period results of operations.
Revenue Recognition-Mortgage guarantee insurance policies are contracts that are generally non-cancelable by the insurer, are renewable at a fixed price, and provide payment of premiums on a monthly, annual or single basis. Upon renewal, the Company is not able to re-underwrite or re-price its policies. SFAS No. 60 specifically excludes mortgage guarantee insurance from its guidance relating to the earning of insurance premiums. Premiums written on a monthly basis are earned as coverage is provided. Monthly premiums accounted for approximately 62% of gross premiums written from the Company’s mortgage insurance operations in 2003, 75% in 2002 and 79% in 2001. Premiums written on an annual basis are amortized on a monthly pro rata basis over the year of coverage. Primary mortgage insurance premiums written on policies covering more than one year are referred to as single premiums. A portion of revenue on single premiums is recognized in consolidated net income 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 15 years. Rates used to determine the earning of single premiums are estimates based on actuarial analysis of the expiration of risk. Accordingly, the unearned premiums represent the portion of premiums written that is applicable to the estimated unexpired risk of insured loans.
Business Segment-During the fourth quarter of 2003, the Company changed its reportable segments to reflect the change in management’s views on operating segments primarily as a result of the investment in FGIC and the pending sale of APTIC, which has been accounted for as discontinued operations. The Company’s reportable operating segments are U.S. Mortgage Insurance Operations, International Operations, Financial
Guaranty and Other. U.S. Mortgage Insurance Operations includes the results of PMI Mortgage Insurance Co., affiliated U.S. reinsurance companies and equity in earnings of CMG. International Operations include the results of PMI Australia, PMI Europe and the results of operations for Hong Kong. Financial Guaranty includes the equity in earnings of FGIC and RAM Re. The Other segment includes the income and expenses of the holding company, equity in earnings or losses of Fairbanks and limited partnerships, contract underwriting operations and dormant insurance companies. Segment information for prior years has been reclassified to conform to the current year presentation.
Comprehensive Income-Comprehensive income includes net income, foreign currency translation gains or losses, changes in unrealized gains and losses on investments, and the reclassification of realized gains and losses previously reported in comprehensive income. The Company reports the components of comprehensive income in its consolidated statements of stockholders’ equity.
Earnings Per Share-Basic earnings per share (“EPS”) excludes dilution and is based on consolidated net income available to common stockholders and the actual weighted-average of the common stock shares that are
In February 2004, the FASB issued EITF No. 03-01, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. The issue relates to determining the meaning of other-than-temporary impairment and its application to investments classified as available-for-sale or held-to-maturity under SFAS No. 115, and investments accounted for under the cost method or the equity method. This issue is effective for fiscal years ending after December 15, 2003. It requires disclosure of quantitative information related to aging of unrealized losses for investments as well as qualitative discussion regarding considerations in reaching conclusions that impairments are not other-than-temporary.
In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity. SFAS No. 150 establishes standards for the classification and measurement of certain financial instruments with characteristics of both liabilities and equity. SFAS No. 150 was effective for financial instruments entered into or modified after May 31, 2003, and otherwise was effective at the beginning of the first interim period beginning after June 15, 2003. SFAS No. 150 is to be implemented by reporting the cumulative effect of a change in an accounting principle for financial instruments created before the issuance date of the statement and still existing at the beginning of the interim period of adoption. In October 2003, FASB voted to defer the effective date for applying certain provisions of SFAS No. 150 including the provision which would require the Company to reclassify its Company-obligated mandatorily redeemable preferred securities to liabilities on the consolidated balance sheet. It is uncertain at this time if the provision will be required in the future or eliminated entirely. Currently, the Company does not believe the adoption of this pronouncement will have a material impact to its consolidated financial condition or results of operations.
In January 2003, the FASB issued FASB Interpretation (“FIN”) No. 46, Consolidation of Variable Interest Entities, which provides guidance on identifying and assessing interests in variable interest entities to determine if consolidation or deconsolidation of that entity is required. FIN No. 46 requires consolidation of existing
Realized Investment Gains and Losses-Realized gains and losses on investments are composed of:
Unrealized Investment Gains and Losses-The change in unrealized gains and losses net of deferred taxes consists of:
In 2002, the Company entered into an agreement with a customer to provide mortgage insurance coverage for a three-year period on a pool of loans; the Company received funds to cover future claim payments on these loans. The transaction does not transfer insurance risk. Accordingly, the contract is being accounted for under the guidelines of SOP No. 98-7, Deposit Accounting: Accounting for Insurance and Reinsurance Contracts That Do Not Transfer Risk. As of December 31, 2003, $8.4 million of deposits received under this agreement were included in cash and cash equivalents, and can only be utilized to pay claims related to the agreement.
Investments in unconsolidated subsidiaries consisted of the following as of December 31, 2003 and 2002.
Equity in earnings from unconsolidated subsidiaries consisted of the following for the years ended December 31, 2003, 2002 and 2001.
On December 18, 2003, the Company completed its investment in FGIC. The investment is accounted for using the equity method of accounting in accordance with APB Opinion No. 18. The Company is the strategic investor in a group of investors, and funded $611 million in cash of the $1.6 billion total purchase price for the investment in FGIC. Our investment in FGIC, as of December 31, 2003, was $621.9 million which included $611 million cash for the investment, capitalized acquisition costs related to the transaction, equity in earnings and the extraordinary gain.
Equity in earnings of FGIC for 2003, as presented in the above table, excludes the extraordinary gain of $5.4 million after-tax related to the Company’s share of negative goodwill recognized by FGIC resulting from the application of purchase accounting adjustments. In accordance with APB No. 18, we reflected our proportionate share of FGIC’s extraordinary gain as a separate line item in our consolidated statement of operations. FGIC’s net income for the period from December 18, 2003 through December 31, 2003 was $20.5 million, which included an extraordinary gain of $13.9 million. Income available to common shareholders excluded preferred stock dividends of $0.6 million.
As of December 31, 2003, the Company’s carrying value of Fairbanks, including cumulative equity earnings, was $115.8 million. In addition, the Company holds receivables of $26.0 million from Fairbanks which is included in related party receivables. Included in the investment in Fairbanks is a component of goodwill of approximately $36 million. The Company evaluated its total investment in Fairbanks, including related party receivables as of December 31, 2003, and determined that there was no other-than-temporary decline in the carrying value. Accordingly, the Company has not recognized an impairment charge with respect to its total investment in Fairbanks. The Company will continue to evaluate this investment for potential impairment.
In 2003, the Company invested $24.4 million of a total of $92 million of additional capital raised by RAM Re. The Company’s ownership percentage as a result of this capital investment did not change.
The unaudited pro forma condensed combined statements of operations of the Company give effect to the investment in FGIC Corporation and the issuance of securities from common stock and equity units offering. The unaudited pro forma condensed combined statements of operations for the years ended December 31, 2003 and 2002 were prepared assuming these transactions were completed as of the first day of the periods presented.
The pro forma adjustments are based on estimates which are derived from available information and contain assumptions. The pro forma financial statements do not purport to represent what the consolidated results of operations actually would have been if these transactions had occurred on the dates indicated or what such results will be for any future date or future periods. The pro forma consolidated statements of operations are based on historical consolidated financial statements of The PMI Group and FGIC Corporation, primarily giving effect to our debt and equity offering, reduction of interest income due to investment in FGIC and our 42% ownership share of FGIC Corporation’s historical income adjusted for the application of purchase accounting adjustments.
The following table summarizes deferred policy acquisition cost activity as of and for the years ended December 31, 2003, 2002 and 2001:
The Company establishes reserves for losses and loss adjustment expenses (“LAE”) to recognize the estimated liability for potential losses and related loss expenses in connection with borrower default on their mortgage payments. The establishment of loss reserves is subject to inherent uncertainly and requires significant judgment by management. The following table provides a reconciliation of the beginning and ending reserves for losses and loss adjustment expenses for each of the three years:
PMI Europe increased its loss reserves primarily due to a $7.9 million loss reserve established for Royal & Sun Alliance (“R&SA”) transaction, discussed below, and additional risk written by PMI Europe during 2003. PMI Australia reduced its loss reserves primarily due to a decrease in the proportion of reported defaults developing into claims and declining default rates attributable to strong economic conditions in Australia.
Upon the adoption of FIN No. 46 as of December 31, 2003, the Company deconsolidated the trust subsidiary that issued the mandatorily redeemable preferred securities. The underlying securities of $48.5 million issued by the trust are backed by junior subordinated debentures issued by the Company to the trust in the amount of $51.5 million. As the subordinated debentures issued by the Company to the trust were previously
eliminated in consolidation, the amount of $51.5 million was not previously reflected in the Company’s consolidated financial statements. Upon deconsolidation of the trust, the subordinated debentures due to the trust are no longer eliminated and have been classified as long-term debt.
Senior Notes-In November 1996, the Company issued unsecured debt securities in the face amount of $100.0 million (“Notes”). The Notes mature and are payable on November 15, 2006 and are not redeemable prior to maturity. No sinking fund is required or provided for prior to maturity. Interest on the Notes is 6.75% and is payable semiannually. In 2001, the Company repurchased $37.1 million of the Notes, resulting in an extraordinary loss of $1.9 million, net of tax.
Revolving Credit Facility-The Company’s credit line in the amount of $25 million with Bank of America was determined by management to be no longer required and was allowed to expire on December 29, 2003. The credit facility contained certain financial covenants and restrictions, the most restrictive being risk-to-capital ratios and minimum capital and dividend restrictions. The Company was in compliance with all debt covenants for the year ended December 31, 2003.
Rent expense for all leases was $7.8 million for 2003, $11.2 million for 2002 and $12.8 million for 2001.
$13.9 million. Such amounts do not include the federal tax benefits from the payment of such assessment or interest that might be included on amounts, if any, ultimately paid to the FTB. The assessments are the result of a memorandum issued by the FTB in April 2002. The memorandum, which is based partly on the California Court of Appeals decision in Ceridian v. Franchise Tax Board, provides for the disallowance of the deduction for dividends received by holding companies from their insurance company subsidiary, in determining California taxable income of the holding company for tax years ending on or after December 1, 1997. As of December 31, 2003, the Company has reserved $4.7 million related to this contingency. While the Company is protesting this assessment, there can be no assurance as to the ultimate outcome of these protests.
Guarantees to Related Party-In the fourth quarter of 2003, Fairbanks reached a settlement of civil charges with the FTC and the HUD. The terms of the settlement require changes in Fairbanks’ operations and the creation of a $40 million fund for the benefit of consumers allegedly harmed by Fairbanks. The Company has guaranteed approximately two-thirds of the funds that may become due to Fairbanks’ lenders under a $30.7 million letter of credit, which may be drawn upon by the FTC as security for a portion of a $40 million redress fund as part of the settlement. In addition, the Company guaranteed approximately $7 million of obligations owed by Fairbanks to its principal lenders in connection with the refinancing of amounts owed to another creditor.
The following table presents certain information with respect to the Company’s benefit plans as of and for the years ended December 31, 2003, 2002 and 2001:
Savings and Profit Sharing Plans-All full-time, part-time and certain temporary employees of the Company are eligible to participate in The PMI Group, Inc. Savings and Profit-Sharing Plan (“401(k) Plan”). Eligible employees who participate in the 401(k) Plan may receive, within certain limits, matching Company contributions. The Company contributions recognized as expense were $1.3 million for 2003, $3.3 million for 2002 and $2.7 million for 2001. Contract underwriters are covered under The PMI Group, Inc. Alternate 401(k) Plan, under which there are no matching Company contributions. In addition to the 401(k) Plan, the Company has an officers’ deferred compensation plan available to certain employees. The obligation related to the deferred compensation plan is $13.3 million as of December 31, 2003 and is included in other liabilities and accrued expenses.
Equity Incentive Plan-The PMI Group, Inc. Equity Incentive Plan provides for awards of both non-qualified stock options and incentive stock options, stock appreciation rights, restricted stock subject to forfeiture and restrictions on transfer, and performance awards entitling the recipient to receive cash or common stock in the future following the attainment of performance goals determined by the Board of Directors. Generally, options are granted with an exercise price equal to the market value on the date of grant, expire ten years from the grant date and have a three-year vesting period.
The following is a summary of the stock option activity in the Equity Incentive Plan during 2003, 2002 and 2001:
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. Under the ESPP, the Company sold 70,493 treasury shares in 2003, 66,635 treasury shares in 2002 and 53,386 treasury shares in 2001. The Company applies APB No. 25 in accounting for the ESPP.
In October 2003, the Company announced that it had reached a definitive agreement to sell APTIC for $115.0 million in cash subject to post-closing adjustments. The transaction is subject to regulatory approvals and other customary closing conditions and is expected to close in the first half of 2004. In accordance with SFAS No. 144, Accounting for Impairment or Disposal of Long-Lived Assets, the results of operations for APTIC are classified as discontinued operations for the fourth quarter of 2003 with prior periods adjusted for comparability. The Company expects to realize a gain on the transaction in the first or second quarter of 2004, upon receiving regulatory approval.
The results of operations of APTIC for the years ended December 31 are as follows:
The assets and liabilities of APTIC as of December 31 are as follows:
During the fourth quarter of 2003, the Company changed its reportable segments to reflect current business activities, and the prior years’ information has been reclassified to conform to the change in reportable segments. Transactions between segments are not significant. The following tables present information for reported segment income or loss and segment assets as of and for the periods indicated:
The National Association of Insurance Commissioners (“NAIC”) revised the NAIC Accounting Practices and Procedures Manual in a process referred to as codification. The revised manual was adopted by the respective states effective January 1, 2001. The Company prepares its statutory financial statements in conformity with accounting practices prescribed or permitted by the State of Arizona. Effective January 1, 2001, the state of Arizona required that state domiciled insurance companies prepare their statutory basis financial statements in accordance with the NAIC Accounting Practices and Procedures Manual-Version effective January 1, 2001 subject to any deviations prescribed or permitted by the Director.
The statutory net income, statutory surplus and the contingency reserve liability of PMI as of and for the years ended December 31 are as follows:
The differences between the statutory-basis net income and equity presented above and the consolidated net income and equity presented on a GAAP basis primarily reflects the differences between GAAP and statutory accounting principles.
In 2001, PMI executed a capital support agreement whereby it agreed to contribute funds, under specified conditions, to maintain CMG’s risk-to-capital at or below 18.0 to 1. PMI’s obligation under the agreement is limited to an aggregate amount of $37.7 million, exclusive of capital contributions made prior to April 10, 2001. A 1999 CMG capital support agreement was superceded by execution of the new agreement. On December 31, 2003, CMG’s risk-to capital ratio was 13.4 to 1.
As of December 31, 2003, the Company was in compliance with all covenants included in its capital support agreements.
Earnings per share is computed independently for the quarters presented. Therefore, the sum of the quarterly earnings per share amounts may not equal the total computed for the year.