Net income for 1998 was $91.1 million, a 20.5% increase compared to $75.0 million for 1997. This improvement was a result of significant growth in premiums earned, net investment income and other income, partially offset by a higher provision for losses, policy acquisition costs and other operating expenses.
CMAC also has recently become involved in insuring non-conforming loans, specifically Alternative A and A minus loans. Alternative A borrowers have an equal or better credit profile than CMAC's typical insured borrowers, but these loans are underwritten with reduced documentation and verification of information. CMAC typically charges a higher premium rate for this business due to the reduced documentation, but does not consider this business to be significantly more risky than its normal primary business. The A minus loan programs typically have non-traditional credit standards which are less stringent than standard credit guidelines. To compensate for this additional risk, CMAC receives a significantly higher premium for insuring this product that is commensurate with the additional default risk. During 1998, Alternative A and A minus business accounted for 7.6% of CMAC's new primary insurance written.
Net premiums earned in 1998 were $282.2 million, an 18.7% increase compared to $237.7 million for 1997. This increase reflected the insurance in force growth resulting from strong new insurance volume and the increase in pool insurance written during 1998, and was partially offset by the decline in persistency levels. The strong volume led to an increase in direct primary insurance in force during 1998 of 14.6%, from $46.9 billion at December 31, 1997 to $53.8 billion at December 31, 1998. Direct pool risk in force also grew to $907.3 million at December 31, 1998 from $593.9 million at the end of 1997, an increase of 52.8% for the year. CMAC and the industry have entered into risk-sharing arrangements with various customers that are designed to allow the customer to participate in the risks and rewards of the mortgage insurance business. One such
The provision for losses was $132.0 million in 1998, an increase of 12.7% compared to $117.1 million in 1997. This increase reflected the significant growth and maturation of CMAC"s book of business over the past several years, which has caused an increase in the number of defaults reported to CMAC, the continued adverse experience of California loans (despite signs of an improving trend in California), and the continued poor experience of certain "affordable housing" program loans insured in 1994 and 1995, especially in Florida. Although the ultimate performance of the books of business that originated since 1994 cannot yet be determined, it appears that the ultimate loss levels will be slightly higher than average, partially due to the presence of these "affordable housing" loans. Claim activity is not evenly spread throughout the coverage period of a book of business. Relatively few claims are received during the first two years following issuance of the policy. Historically, claim activity has reached its highest level in the third through fifth years after the year of loan origination. Approximately 58% of CMAC's primary risk in force and almost all of CMAC's pool risk in force at December 31, 1998 had not yet reached its anticipated highest claim frequency years. CMAC's overall default rate at December 31, 1998 was 1.68% as compared to 1.82% at December 31, 1997, while the default rate on the primary business was 2.44% at December 31, 1998 as compared to 2.32% at December 31, 1997. The number of defaults rose from 12,359 at December 31, 1997 to 15,525 at December 31, 1998 and the average loss reserve per default rose from $12,026 at the end of 1997 to $12,965 at December 31, 1998. This increase in average loss reserve per default reflected the Company's continued implementation of a more conservative reserve calculation for certain loans in default perceived as having a higher risk of claim incidence. In addition, an increase in the average loan balance and the coverage percentage on loans originated beginning in 1995 has necessitated a higher reserve balance on loans in a default status due to the increased ultimate exposure on these loans. The default rate in California was 2.6% (including pool) at December 31, 1998 as compared to 3.6% at December 31, 1997 and claims paid in California during 1998 were $41.8 million, representing approximately 43.1% of total claims as compared to 57.0% in 1997. California represented 18.3% of primary risk in force at December 31, 1998 as compared to 18.6% at December 31, 1997. The default rate in Florida was 3.6% (including pool) at December 31, 1998 as compared to 3.8% at December 31, 1997 and claims paid in Florida during 1998 were $11.5 million, representing approximately 11.9% of total claims as compared to only 6.6% in 1997. Florida represented 8.2% of primary risk in force at December 31, 1998 as compared to 8.3% at December 31, 1997. The "affordable housing" early default experience is a result of insuring certain loans in which the borrowers' principal and interest reserves and other credit factors were not as strong as on prior years' books of business. Certain underwriting changes were implemented near the end of 1996 to compensate for the factors that contributed to the early default experience on these "affordable housing" loans; however, it is too early to determine the impact of such changes. In addition, the Company has
Policy acquisition costs were $36.1 million in 1998, an increase of 15.5% compared to $31.3 million in 1997. This increase reflects the growth in variable sales- and underwriting-related expenses relating to the Company's continued growth in new insurance written. The Company has continued development of its marketing infrastructure needed to support a focus on larger, national mortgage lenders in order to take advantage of the widespread consolidation occurring in the mortgage lending industry. Other operating expenses for 1998 were $39.0 million, an increase of 47.8% compared to $26.4 million for 1997. Most of the increase continued to result from an increase in expenses associated with the Company's ancillary services, specifically contract underwriting. Contract underwriting expenses for 1998 included in other operating expenses were $20.7 million as compared to $10.6 million for 1997, an increase of 96.3%. The $10.1 million increase in contract underwriting expenses during 1998 represented 80.9% of the $12.6 million increase in other operating expenses. Some of these additional contract underwriting expenses were correspondingly offset by increases to other income, which rose 112.2% from $5.0 million in 1997 to $10.6 million in 1998. During 1998, loans underwritten via contract underwriting accounted for 33% of applications, 29% of insurance commitments, and 24% of certificates issued by CMAC as compared to 29% of applications, 25% of commitments and 22% of certificates in 1997. In 1999, these percentages are expected to increase if there is a decrease in refinancing activity. Changing market conditions have caused the cost of contract underwriting to increase during 1997 and 1998 due to the high demand for available resources. However, as further efficiencies are realized in the contract underwriting process due to the integration with Freddie Mac's Loan Prospector and Fannie Mae's Desktop Underwriter origination systems, the cost per contract underwriting loan underwritten could decrease.
New primary insurance written during 1997 was $13.7 billion, an 11.4% increase compared to $12.3 billion for 1996. This increase reflected a market share increase which was primarily due to CMAC's continued focus on large, national primary insurance customers and continued geographic expansion into markets previously underrepresented by CMAC such as the Northwest and Midwest. The increase resulted despite a 4.4% decline in new insurance written volume in the private mortgage insurance industry in 1997. CMAC's market share of the industry increased to 11.2% in 1997, compared to 9.6% for 1996 and for the fourth quarter of 1997, CMAC's market share was 12.1%. Additionally, in 1997, CMAC wrote an increased amount of pool insurance which represented an addition to risk of $277.5 million as compared to $108.9 million in 1996. Most of this pool insurance volume related to a group of structured transactions composed primarily of Fannie Mae- and Freddie Mac-eligible conforming mortgage loans that are geographically dispersed throughout the United States and that have lower average loan-to-value ratios than CMAC's primary business. Under a pool insurance transaction, the exposure to CMAC on each individual loan is uncapped; however, the aggregate stop-loss percentage (typically 1.0% to 1.5% in the Fannie Mae/Freddie
The majority of CMAC's business in 1997 reflected the deeper insurance coverage required by Fannie Mae and Freddie Mac beginning in 1995. That coverage, which is 25% on loans written with an LTV between 85.01% and 90% and 30% on loans with LTVs greater than 90%, results in higher premiums and losses than the older coverages of 17% and 22%, respectively, but should not materially affect the Company's financial results. Approximately 60% of CMAC's direct primary insurance in force had such deeper coverage at the end of 1997. Monthly premium plans, which allow borrowers to pay premiums on a monthly basis rather than annually in advance, accounted for 93.8% of CMAC's primary new insurance written in 1997 as compared to 91.6% in 1996. Although this program reapportions the cash flow from an insured loan over the life of the loan, there should be no material financial effect from its widespread use. At the end of 1995, the industry and CMAC introduced a variation of the monthly premium plan in which the borrower does not need to pay any mortgage insurance premium at closing and under which some portion of the first month's premium can be deferred or forgiven. During 1997, business written under this program was approximately 31% of CMAC's total as compared to 11% in 1996.
Net premiums earned in 1997 were $237.7 million, a 26.5% increase compared to $187.9 million for 1996. This increase reflected a continuation of high persistency levels, the insurance in force growth resulting from strong new insurance volume, increased premium rates on deeper coverages and higher LTV-insured products during 1997 and the increase in pool insurance written during 1997. The strong volume and high persistency led to an increase in direct primary insurance in force during 1997 of 18.9%, from $39.4 billion at December 31, 1996 to $46.9 billion at December 31, 1997. Direct pool risk in force also grew to $593.9 million at December 31, 1997 from $341.9 million at the end of 1996, an increase of 73.7% for the year. Primary new insurance written on loans with LTVs greater than 90% represented 42.1% of the total amount written in 1997 as compared to 45.5% in 1996.
Net investment income for 1997 was $33.8 million, a 12.6% increase compared to $30.0 million in 1996. This increase was a result of continued growth in invested assets primarily due to positive operating cash flows of $93.5 million, offset slightly by a small decrease in investment yields. The Company's pre-tax investment yield declined from 6.2% at December 31, 1996 to 6.0% at December 31, 1997. The Company has continued to invest new operating cash flow in tax-advantaged securities, primarily municipal bonds.
Loss reserves increased from $148.6 million at December 31, 1997 to $201.3 million at December 31, 1998. This increase in loss reserves due to newly reported defaults, new loans in default that were not reported, and increases to loss reserves on existing defaults was a result of continued adverse California and Florida experience as well as the continued growth of the in force insurance book. In addition, an increase in the average loan balance and the coverage percentage on loans originated beginning in 1995 has necessitated a higher reserve balance on loans in a default status due to the increased ultimate exposure on these loans. CMAC has experienced abnormally high early defaults on the 1994 and 1995 origination year books of business, which reflected the increase in "affordable housing" program loans insured in the period. CMAC also experienced an increase in defaults under the Alternative A and A minus programs insured starting in late 1997 which is a typical pattern for such business. Unearned premiums increased slightly from $49.3 million at December 31, 1997 to $49.4 million at December 31, 1998 due to unearned premium resulting from the bulk loan transaction insured in 1998 and from certain pool insurance transactions.
As protection against a period of adverse loss development, the Company has entered into a variable quota share reinsurance treaty for the primary books of business originated in 1994, 1995, 1996 and 1997 as well as some portion of the pool book of business originated in 1997. As per the terms of the reinsurance treaties, the Company receives variable quota share loss relief at levels ranging from 7.5% to 15.0% based upon the loss ratio on the covered book of business. A ceding commission is paid by the reinsurer to the Company except for certain circumstances where the loss ratio on the covered book exceeds a stated level. These treaties remain in force for a period of ten years and are noncancelable by either party until after ten years have elapsed except under certain circumstances. Premiums are payable to the reinsurer on a quarterly basis net of ceding commissions due to the Company and any losses calculated under the variable quota share coverage are recovered on a quarterly basis. At the end of the fourth, seventh and tenth years of each treaty, depending on the extent of losses recovered to date on the calendar year quota share portion of the treaty, a calculation is made to determine an amount of Underwriting Year Excess Coverage, if any, due to the Company.
Many existing computer programs use only two digits to identify a year in the date field. These programs were designed and developed without considering the impact of the upcoming change in the century. If not corrected, many computer applications could fail or create erroneous results by or at the year 2000. The Company has conducted an analysis of its systems and has completed its Year 2000 project with the result that all of its systems were Year 2000 compliant by the end of 1998. "Year 2000 compliant" means fault-free performance in the processing of data and date related data (including, but not limited to, calculating, comparing and sequencing) by all hardware and software products, individually and in combination. Fault-free performance must include the manipulation of data when dates are in the 20th or 21st century and must be transparent to the user.
With respect to the Company's non-information technology systems, the Company has made reasonable efforts to contact providers of products and services concerning their Year 2000 readiness. Discussions with suppliers of electronic and electro-mechanical devices deemed critical to the Company's business operations are ongoing. Based on this contact and discussions, the Company believes that it does not have material exposure to the Year 2000 issue with respect to its non-information systems.