Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting
Consolidated Statements of Operations for the years ended December 31, 2009, 2008 and
Management assessed the effectiveness of our internal control over financial reporting as of December 31, 2009. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework.
In 2009, the Company adopted FSP FAS No. 115-2, codified in ASC Topic 320, Investments-Debt and Equity Securities. In 2008, the Company adopted FASB Statement No. 159, codified in ASC Topic 825, The Fair Value Option for Financial Assets and Financial Liabilities. In 2007, the Company adopted FASB Interpretation No. 48, codified in ASC Topic 740, Income Taxes. These matters are further described in Note 2 to the consolidated financial statements.
We have audited The PMI Group, Inc. and subsidiaries’ internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). The PMI Group, Inc. and subsidiaries’ management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.
The Company completed the sales of PMI Australia and PMI Asia to the QBE Insurance Group (“QBE”) in the fourth quarter of 2008. The Company has classified the results of its PMI Australia, PMI Asia and PMI Guaranty operations as discontinued operations for all periods presented. The assets and liabilities of PMI Guaranty which were disposed of other than by sale are classified in the consolidated balance sheets according to their nature. The results of discontinued operations, which include both disposed of by sale and disposed of other than by sale, are reported as “Loss from discontinued operations, net of taxes” in the consolidated statements of operations for all periods presented.
In sixteen states, if a mortgage insurer does not meet a required minimum policyholders’ position or exceeds a maximum permitted risk-to-capital ratio (generally 25 to 1), it may be prohibited from writing new business until its risk-to-capital ratio falls below the limit or its policyholders’ position meets the minimum, as applicable. In certain of those states, the applicable regulations require a mortgage insurer to immediately cease writing new business if and so long as it fails to meet the applicable capital adequacy requirements. In other states, the applicable regulator has discretion as to whether the mortgage insurer may continue writing new business. In 2009, North Carolina, Arizona and California adopted legislation giving the respective state’s insurance regulators such discretion. Thirty-four other states do not have specific capital adequacy requirements for mortgage insurers. MIC’s principal regulator is the Arizona Department of Insurance (the “Department”). On February 10, 2010, MIC received a letter from the Department waiving, until December 31, 2011, the requirement that MIC maintain the Arizona required minimum policyholders’ position to write new business. The waiver may be withdrawn by the Arizona Director of Insurance in her sole discretion at any time. If the Department were to withdraw the waiver and MIC fails to maintain Arizona’s minimum policyholders’ position, MIC would likely be required to suspend writing new business in all states. Even with the waiver from the Department, other states could require MIC to cease new business writings if MIC fails to maintain the applicable capital adequacy requirements.
In the event that MIC is unable to continue to write new mortgage insurance in one or more states, the Company is working on a plan to enable it to write new mortgage insurance in those states by PMAC. PMAC is a subsidiary of MIC, and was formerly known as Commercial Loan Insurance Corporation. PMAC is currently licensed to write insurance in all states except Connecticut, Michigan and New York. In several other states, PMAC is applying to revise the line of insurance business it is authorized to transact so that it may begin writing residential mortgage guaranty insurance in those states. There is no guarantee that PMAC will be able to obtain insurance licenses in Connecticut, Michigan or New York or approval to revise its existing licenses in other impacted states. In addition, before PMAC can begin writing new business, Freddie Mac must approve PMAC as an eligible mortgage insurer. On February 12, 2010, Fannie Mae approved PMAC as a direct issuer of mortgage guaranty insurance. Fannie Mae’s approval terminates on the earlier of December 31, 2011 or the date that MIC ceases to transact new business in all jurisdictions in which it is licensed. The approval is subject to a number of detailed conditions. Among other things, the approval contains limitations as to the jurisdictions, volume and types of new business PMAC may write, and restricts MIC and PMAC from taking a variety of actions, subject to enumerated exceptions, without Fannie Mae’s prior written consent, which is not to be unreasonably withheld, including engaging in certain transactions with affiliates, paying dividends or making distributions or payments of indebtedness or transferring assets outside the ordinary course of business or in excess of specified levels. Notwithstanding these restrictions, the agreement with Fannie Mae permits MIC to make dividend, interest, and principal payments in connection with the issuance of certain new debt or equity instruments up to specified levels. PMAC is currently in negotiations with Freddie Mac about becoming an eligible insurer under Freddie Mac’s criteria. Beginning January 1, 2010, PMAC will be included in U.S. Mortgage Insurance Operations.
Risks and Uncertainties-The Company is dependent upon mortgage originators to provide mortgage loans to insure. In the event any of its largest customers choose to stop providing the Company with mortgage loans to insure, the Company’s ability to generate new insurance business could be adversely affected. The Company’s U.S. Mortgage Insurance Operations’ ten largest customers generated 56.9%, 49.4%, and 52.0% of its premiums earned in 2009, 2008 and 2007, respectively.
The Company establishes loss reserves to recognize the liability for unpaid losses related to insured mortgages that are in default. These loss reserves are based upon the Company’s estimates of the claim rate and average claim size, as well as the estimated costs of settling claims. These estimates are regularly reviewed and updated using currently available information. Any adjustments due to positive or adverse developments, which may be material, resulting from these reviews would impact current reserve requirements. The Company’s
Investments-The Company has designated its entire portfolio of fixed income and equity securities as available-for-sale. These securities are predominantly 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’s short-term investments have maturities of greater than three and less than 12 months when purchased and are carried at fair value. The Company evaluates its portfolio of equity securities regularly to determine whether there are declines in value and whether such declines meet the definition of other-than-temporary impairment (“OTTI”) in accordance with FASB ASC Topic 320 Investments-Debt and Equity Securities (“Topic 320”), previously SFAS No. 115, Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin (“SAB”) No. 59, Accounting for Noncurrent Marketable Equity Securities, and FSP FAS No. 115-2. When the Company determines that an equity security has suffered an OTTI, the impairment loss is recognized, to the extent of the credit related portion of the decline, as a realized investment loss in the consolidated statement of operations.
Periodically, or as events dictate, the Company evaluates potential impairment of its investments in unconsolidated subsidiaries. FASB ASC Topic 323 Investments-Equity Methods and Joint Ventures (“Topic 323”), previously APB No. 18, 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 capital gains or losses resulting from the sale of the Company’s ownership interests of unconsolidated subsidiaries are recognized as net realized investment gains or losses in the consolidated statement of operations.
Related Party Receivables and Payables-As of December 31, 2009, related party receivables were $1.3 million and related party payables were $1.9 million compared to $1.5 million and $1.9 million as of December 31, 2008, respectively, which were comprised of non-trade receivables and payables from unconsolidated subsidiaries.
Deferred Policy Acquisition Costs-The Company defers certain costs of its mortgage insurance operations relating to the acquisition of new insurance and amortizes these costs against related premium revenue in order to match costs and revenues. To the extent the Company provided contract underwriting services on loans that did not require mortgage insurance, associated underwriting costs were not deferred. Costs related to the acquisition of mortgage insurance business are initially deferred and reported as deferred policy acquisition costs. Consistent with industry accounting practice, amortization of these costs for each underwriting year book of business is charged against revenue in proportion to estimated gross profits. Estimated gross profits are composed of earned premiums, interest income, losses and loss adjustment expenses. The deferred costs are adjusted as appropriate for policy cancellations to be consistent with the Company’s revenue recognition policy. For each underwriting year, the Company estimates the rate of amortization to reflect actual experience and any changes to persistency or loss development. Deferred policy acquisition costs are reviewed periodically to determine that they do not exceed recoverable amounts, after considering investment income.
Property, Equipment and Software-Property and equipment, including software, are carried at cost and are depreciated using the straight-line method over the estimated useful lives of the assets, ranging from three to thirty nine years. Leasehold improvements are recorded at cost and amortized over the lesser of the useful life of the assets or the remaining term of the related lease. The Company’s accumulated depreciation and amortization from continuing operations was $189.0 million and $206.4 million as of December 31, 2009 and December 31, 2008, respectively.
Premium Deficiency Reserve-The Company performs an analysis for premium deficiency using assumptions based on management’s best estimate when the assessment is performed. The calculation for premium deficiency requires significant judgment and includes estimates of future expected premiums, expected claims, loss adjustment expenses and maintenance costs as of the date of the analysis. The calculation of future expected premiums uses assumptions for persistency and termination levels on policies currently in force. Assumptions for future expected losses include future expected average claim sizes and claim rates which are based on the current default rate and expected future defaults. Investment income is also considered in the premium deficiency calculation. The Company performs premium deficiency analyses quarterly. Premium deficiency analyses were performed as of December 31, 2009. The Company determined that there were premium deficiencies at two companies in the International Operations segment and recorded premium deficiency reserves of $2.4 million and $1.4 million for PMI Europe and PMI Canada, respectively. The effects of establishing premium deficiency reserves were included in losses and loss adjustment expenses in the consolidated statements of operations. The Company determined there was no premium deficiency in its U.S. Mortgage Insurance Operations segment. To the extent premium levels and actual loss experience differ from the assumptions used, the results could be negatively affected in future periods.
Reserve for Losses and Loss Adjustment Expenses-The consolidated reserves for losses and loss adjustment expenses (“LAE”) for the Company’s U.S. Mortgage Insurance and International Operations are the estimated claim settlement costs on notices of default that have been received by the Company, as well as loan defaults that have been incurred but have not been reported by the lenders. For reporting and internal tracking purposes, the Company does not consider a loan to be in default until the borrower has missed two payments. Depending upon its scheduled payment date, a loan in default for two consecutive monthly payments could be reported to PMI between the 31st and the 60th day after the first missed payment due date. The Company’s U.S. mortgage insurance primary master policy defines “default” as the borrower’s failure to pay when due an amount equal to the scheduled monthly mortgage payment under the terms of the mortgage. Generally, however, the master policy requires an insured to notify PMI of a default no later than the last business day of the month following the month in which the borrower becomes three monthly payments in default. Consistent with industry accounting practices, the Company considers its mortgage insurance policies short-duration contracts and, accordingly, does not establish loss reserves for future claims on insured loans that are not currently in default. The Company establishes loss reserves when insured loans are identified as currently in default using estimated claim rates and claim amounts for each report year, net of recoverables. The Company also establishes loss reserves for defaults that it believes have been incurred but not yet reported to the Company prior to the close of
Reinsurance-The Company uses reinsurance to reduce net risk in force, optimize capital allocation and comply with a statutory provision adopted by several states that limits the maximum mortgage insurance coverage that can be provided by a single company to 25% of the original principle balance for any single risk. The Company’s reinsurance agreements typically provide for a recovery of a proportionate level of claim expenses from reinsurers, and a reinsurance receivable is recorded as an asset based on the type of reinsurance coverage. The Company remains liable to its policyholders if the reinsurers are unable to satisfy their obligations under the agreements. Reinsurance recoverables on loss estimates are based on the Company’s actuarial analysis of the applicable business. Amounts the Company will ultimately recover could differ from amounts recorded as reinsurance recoverables. Accordingly, management assesses, among other factors, risk transfer criteria for all reinsurance arrangements.
deferred as unearned premiums and earned over the expected life of the policy, a range of seven to fifteen years for the majority of the single premium policies. If single premium policies related to insured loans are cancelled due to repayment by the borrower, and the premium is non-refundable, then the remaining unearned premium related to each cancelled policy is recognized as earned premiums upon notification of the cancellation. Unearned premiums represent the portion of premiums written that is applicable to the estimated unexpired risk of insured loans. Rates used to determine the earning of single premiums are estimates based on actuarial analysis of the expiration of risk.
The Company also evaluates the need for a valuation allowance against its deferred tax assets. Under Topic 740, if it is more likely than not that the Company will not be able to realize the benefit associated with its deferred tax assets, then a valuation allowance is established. In evaluating whether a deferred tax benefit would be realized, the Company assesses all available evidence both positive and negative and future sources of income such as tax planning strategies, reversing temporary differences and future income. As of December 31, 2009, a tax valuation allowance of $248.3 million was recorded against a $567.9 million deferred tax asset primarily related to FGIC losses in excess of the Company’s tax basis, foreign and California net operating losses and certain foreign tax credits. Additional valuation allowance benefits could be recognized in the future due to changes in management’s expectations regarding realization of tax benefits. (See Note 12, Income Taxes, for further discussion.)
Benefit Plans-The Company provides pension benefits through noncontributory defined benefit plans to all eligible U.S. employees under The PMI Group, Inc. Retirement Plan (the “Retirement Plan”) and to certain employees of the Company under The PMI Group, Inc. Supplemental Employee Retirement Plan. In addition, the Company provides certain health care and life insurance benefits for retired employees under another post-employment benefit plan. The Company applies FASB ASC Topic 715 Compensation-Retirement Benefits,
Foreign Currency Translation-The financial statements of the Company’s foreign subsidiaries have been translated into U.S. dollars in accordance with FASB ASC Topic 830 Foreign Currency Matters, previously SFAS No. 52. Assets and liabilities denominated in non-U.S. dollar functional currencies are translated using the period-end spot exchange rates. Revenues and expenses are translated at monthly-average exchange rates. The effects of translating financial results with a functional currency other than the reporting currency are reported as a component of accumulated other comprehensive income (loss) included in total shareholders’ equity. Foreign currency translation gains in accumulated other comprehensive income before tax were $50.1 million as of December 31, 2009 compared with $48.3 million as of December 31, 2008. Gains and losses from foreign currency re-measurement for PMI Europe and PMI Canada are reflected in income and represent the revaluation of assets and liabilities denominated in non-functional currencies into the functional currency, the Euro and Canadian dollar, respectively.
Comprehensive Income (Loss)-Comprehensive income (loss) includes net income (loss), the change in foreign currency translation gains or losses, pension adjustments, changes in unrealized gains and losses on investments, accretion of cash flow hedges and reclassification of realized gains and losses previously reported in comprehensive income (loss), net of related tax effects.
Earnings (Loss) Per Share-Basic earnings (loss) per share (“EPS”) excludes dilution and is based on consolidated net income (loss) available to common shareholders giving effect to discontinued operations and the actual weighted-average common shares that are outstanding during the period. Diluted EPS is based on consolidated net income (loss) available to common shareholders giving effect to discontinued operations, adjusted for the effects of dilutive securities, and the weighted-average dilutive common shares outstanding
Effective July 1, 2009, FASB ASC (“Codification”) Topic 105 Generally Accepted Accounting Principles (“Topic 105”) establishes the FASB ASC as the single source of authoritative U.S. generally accepted accounting principles (“GAAP”) used by nongovernmental entities in the preparation of financial statements, except for rules and interpretive releases of the SEC under authority of federal securities laws, which are sources of authoritative accounting guidance for SEC registrants. The Codification is meant to simplify user access to all authoritative accounting guidance by reorganizing GAAP pronouncements into roughly 90 accounting topics within a consistent structure; its purpose is not to create new accounting and reporting guidance. The Codification supersedes all existing non-SEC accounting and reporting standards and is effective for the Company beginning July 1, 2009. Following Topic 105, the FASB will not issue new standards in the form of Statements, FASB Staff Positions, or Emerging Issues Task Force Abstracts; instead, it will issue Accounting Standards Updates. The FASB will not consider Accounting Standards Updates as authoritative in their own right; these updates will serve only to update the Codification, provide background information about the guidance, and provide the bases for conclusions on the change(s) in the Codification. As the Codification was not intended to change or alter existing GAAP, the adoption of the Codification did not have any impact on the Company’s consolidated financial statements.
In June 2009, the FASB updated guidance in FASB ASC Topic 810 Consolidation (“Topic 810”), previously SFAS No. 167, to provide additional consolidation guidance to enterprises involved with variable interest entities. Topic 810 requires an enterprise to perform an analysis to determine whether the enterprise’s variable interest gives it a controlling financial interest in a variable interest entity. Topic 810 also requires an ongoing reassessment of and eliminates the quantitative approach previously required for determining whether an enterprise is the primary beneficiary. Topic 810 is effective as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009. Topic 810 is not expected to impact the Company’s consolidated financial statements.
In February 2010, FASB issued Accounting Standards Update No. 2010-09, Subsequent Events (Topic 855): Amendments to Certain Recognition and Disclosure Requirements (“ASU No. 2010-09”) that removed the requirement to disclose a date through which subsequent events have been evaluated in issued financial statements. ASU No. 2010-09 is effective as of February 24, 2010 and has not significantly impacted the Company’s consolidated financial statements.
In April 2009, the FASB updated guidance in Topic 820 related to determining fair value when the volume and level of activity for the asset or liability have significantly decreased and identifying transactions that are not orderly. Topic 820 is effective for interim and annual reporting periods ending after June 15, 2009. Topic 820 has not significantly impacted the Company’s consolidated financial statements.
In December 2008, the FASB amended FASB ASC Topic 715 Compensation-Retirement Benefits, to provide guidance on an employer’s disclosures about plan assets of a defined benefit pension or other postretirement plan. It requires companies to provide users of financial statements with an understanding of how investment decisions are made, the major categories of plan assets, inputs and valuation techniques used to measure fair value of plan assets, the effect of fair value measurements when using unobservable inputs and significant concentrations of risk within plan assets. Topic 715 was implemented as of December 31, 2009 and has not significantly impacted the Company’s consolidated financial statements.
In addition, included in the gross unrealized losses are debt securities that the Company determined had non-credit related other-than-temporary impairments in accordance with Topic 320.
the severity and nature of the decline in market value below cost regardless of the duration of the decline;
Once a security is determined to have met certain of the criteria for consideration as being other-than-temporarily impaired, further information is gathered and evaluated pertaining to the particular security. If the security is an unsecured obligation, the additional research is a security specific approach with particular emphasis on the likelihood that the issuer will meet the contractual terms of the obligation.
Once the determination is made that a debt security is other-than-temporarily impaired, an estimate is developed of the portion of such impairment that is credit-related. The estimate of the credit-related portion of impairment is based upon a comparison of ratings at the time of purchase and the current ratings of the security, to establish whether there have been any specific credit events during the time the Company has owned the security, as well as the outlook through the expected maturity horizon for the security. The Company obtains ratings from two nationally recognized rating agencies for each security being assessed. The Company also incorporates information on the specific securities from its management and, as appropriate, from its external investment advisors on their views on the probability of it receiving the interest and principal cash-flows for the remaining life of the securities.
This information is used to determine the Company’s best estimate of what the credit related portion of the impairment is, based on a probability-weighted estimate of future cash flows. The probability weighted cash flows for the individual securities are modeled using internal models, which calculate the discounted cash flows at the implicit rate at purchase through maturity. If the cash flow projections indicate that the Company does not expect to recover its amortized cost basis, the Company recognizes the estimated credit loss in earnings. For debt securities that are intended to be sold, or that management believes are more likely than not to be required to be sold prior to recovery, the full impairment is recognized immediately in earnings. For debt securities that management has no intention to sell and believes it is more likely than not that they will not be required to be sold prior to recovery, only the credit component of the impairment is recognized in earnings, with the remaining impairment loss recognized in AOCI.
Activity related to the credit component recognized in net (loss) income on debt securities held by the Company for which a portion of other-than-temporary impairment was recognized in AOCI for the year ended December 31, 2009 is as follows:
Aging of Unrealized Losses-The following table shows the gross unrealized losses and fair value of the Company’s investments, aggregated by investment category and the length of time the individual securities have been in a continuous unrealized loss position as of December 31, 2009 and December 31, 2008:
Investments in the Company’s unconsolidated subsidiaries include both equity investees and other unconsolidated subsidiaries. The carrying values of the Company’s investments in unconsolidated subsidiaries consisted of the following as of December 31, 2009 and December 31, 2008:
Equity in (losses) earnings from unconsolidated subsidiaries is shown for the periods presented:
Depreciation and amortization expense related to property, equipment including capital leases, and software totaled $25.2 million in 2009, $29.3 million in 2008 and $30.6 million in 2007. Capitalized costs associated with software developed for internal use were $2.7 million in 2009, $8.1 million in 2008 and $15.8 million in 2007.
relating to those loans in default and a reserve is recorded. Generally, it takes approximately 12 to 36 months from the receipt of a default notice to result in a claim payment. Accordingly, most losses paid relate to default notices received in prior years.
Revolving Credit Facility-The Company amended its revolving credit facility (the “credit facility” or “facility”) effective May 29, 2009 following the satisfaction of certain conditions precedent agreed upon between the Company and the lenders under the facility on May 8, 2009. In connection with the Amended Agreement, MIC and The PMI Group entered into a Note Purchase Agreement pursuant to which The PMI Group purchased the contingent note (the “QBE Note”) described below. Upon the completion of the sale of the QBE Note to The PMI Group from MIC, The PMI Group granted a security interest in the QBE Note in favor of the Administrative Agent, for the benefit of the lenders under the Amended Agreement. Among other things, the amended credit facility reduced the facility size to a maximum of $125 million and eliminated certain financial covenants and events of default previously contained in the facility (including the elimination of the maximum debt to total capitalization percentage covenant, the maximum risk to capital ratio covenant, and the financial strength ratings event of default). The amended credit facility requires a minimum Adjusted Consolidated Net Worth (as defined in the facility) of at least $700 million through December 31, 2009, and at least $500 million from January 1, 2010 through the facility’s October 24, 2011 maturity date. As of December 31, 2009, The Company’s Adjusted Consolidated Net Worth, as defined in the credit facility, was $1.0 billion, as compared to a net worth requirement of $700 million. The Company’s Adjusted Consolidated Net Worth will be adversely affected by its continued losses and other factors negatively affecting its financial position. Absent significant additional capital, The Company’s Adjusted Consolidated Net Worth will decline in 2010. Although the Company currently expects to remain in compliance, due to continuing losses and other factors negatively affecting its financial position, there is a risk that in 2010 it will not be able to maintain the minimum Adjusted Consolidated Net Worth as required by the credit facility. If the Company were to anticipate being, or were to become, unable to maintain the required minimum Adjusted Consolidated Net Worth, it intends to pursue one or more of the following actions-(1) negotiate with the lenders under its credit facility to amend or waive compliance with the covenant, (2) seek to sell certain assets, including the QBE note prior to maturity, for an amount sufficient to repay the credit facility and (3) other corporate initiatives, inclusive of expense reductions, within its control to maintain compliance with the covenant. The amended facility also contains restrictions on, among other things, asset dispositions, dividends and investments. While the Company is generally permitted under the amended facility to make additional investments in the Company’s reinsurance subsidiaries, the Company’s ability to make additional investments in MIC and MIC’s subsidiaries is subject to dollar limitations.
Topic 820 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (referred to as an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Topic 820 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value.
Level 1 Observable inputs with quoted prices in active markets for identical assets or liabilities. Level 1 assets and liabilities include debt and equity securities and derivative contracts that are traded in an active exchange market, as well as certain U.S. Treasury securities that are highly liquid and are actively traded in over-the-counter markets.
Level 3 Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation.
When determining the fair value of its debt, the Company has considered the guidance presented in Topic 820 related to determining fair value when the volume and level of activity for the asset or liability have significantly decreased and identifying transactions that are not orderly.
PMI Europe’s risk in force related to its credit default swap (“CDS”) contracts was $4.0 billion as of December 31, 2009. Certain PMI Europe CDS contracts contain collateral support provisions which, upon certain circumstances, such as deterioration of underlying mortgage loan performance, require PMI Europe to post collateral for the benefit of the counterparty. The amount of the required posted collateral varies and can include mark-to-market valuations, contractual formulae and/or negotiated amounts. The aggregate fair value of all derivative instruments with collateral support provisions that are in a liability position as of December 31, 2009 is $15.8 million, for which the Company has posted collateral of $14.7 million in the normal course of business. The Company estimates that the amount of additional collateral it may be required to post could range from $4.4 million to $11.4 million in the next twelve months. The actual level of collateral posted at the end of 2010 will be dependent upon deal performance, claim payments, and the extent to which PMI Europe is successful in commuting certain contracts. To the extent PMI Europe is successful in commuting certain contracts the amount of collateral postings could be significantly reduced. The fair value of derivative liabilities was $17.3 million and $54.5 million as of December 31, 2009 and December 31, 2008, respectively, and is included in other liabilities on the balance sheet.
PMI Europe’s CDS contracts are valued using internal proprietary models because these instruments are unique, complex, and private and are often customized transactions, for which observable market quotes are not regularly available. Due to the lack of observable inputs required to value CDS contracts, they are considered to be Level 3 under the Topic 820 fair value hierarchy. Valuation models and the related assumptions are continuously re-evaluated by management and refined, as appropriate.
Key inputs used in the Company’s valuation of CDS contracts include the transaction notional amount, expected term, premium rates on risk layers, changes in market spreads and cost of capital, estimated loss rates and loss timing, and risk free interest rates. As none of the instruments that the Company is holding are traded, the Company develops internal exit price estimates. Its internal exit price estimates are based on a number of factors, including its own expectations of loss payments and timing, as well as indications of current CDS spreads obtained through market surveys with investment banks, counterparty banks, and other relevant market sources in Europe. The Company validates market surveys obtained from these third-party sources by comparing them against each other for consistency. The assumed market CDS spread is a significant assumption that, if changed, could result in materially different fair values. Accordingly, market perceptions of credit deterioration are likely to result in the increase in the expected exit value (the amount required to be paid to exit the transaction).
In estimating the fair values of CDS contracts, PMI Europe incorporates expected life of contract dates in its internal valuation models. The Company estimates the life of contracts to coincide with expected call dates based on a number of factors, including past experience of counterparties, the underlying economics of the transactions, counterparties’ expressed intent and potential costs associated with extending transactions. The current state of capital markets, the financial conditions and perspectives of various counterparties and the general weakening of economic conditions in Europe may lead to decisions by customers to extend the credit protection offered by PMI Europe’s CDS contracts, which could be counteracted by PMI Europe’s counterparties’ assessments of its
The table below presents a reconciliation for all assets and liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the year ended December 31, 2009. Level 3 instruments presented in the table, including credit default swaps, and certain fixed income and equity securities, were carried at fair value prior to the adoption of Topic 820.
The majority of the Company’s existing reinsurance contracts are captive reinsurance agreements in the U.S. Mortgage Insurance Operations. Under captive reinsurance agreements, a portion of the risk insured by PMI is reinsured with the mortgage originator or investor through a reinsurer that is affiliated with the mortgage originator or investor. Ceded premiums for U.S. captive reinsurance accounted for 99.9% of total ceded premiums written in 2009 compared to 98.9% and 99.2% in 2008 and 2007, respectively. The Company recorded $703.6 million in reinsurance recoverables primarily from captive arrangements related to PMI’s gross loss reserves as of December 31, 2009, compared to $482.7 million as of December 31, 2008. As of December 31, 2009 and December 31, 2008, the total assets in captive trust accounts held for the benefit of PMI totaled approximately $940.7 million and $860.1 million, respectively. As of December 31, 2009, overall assumed premium for the year ended December 31, 2009 was negative due to the restructuring of two contracts in the Company’s European operations and a contract in the Company’s U.S. Mortgage Insurance Operations that resulted in premium reversals of approximately $7.3 million and $1.0 million, respectively.
The Company adopted the provisions of Topic 740 on January 1, 2007. As a result of the implementation, the Company recognized an approximately $15.6 million increase in deferred tax liabilities, which was accounted for as a reduction to the January 1, 2007 balance of consolidated retained earnings. This liability was accrued upon adoption of Topic 740 and after consideration of certain 2004 California legislation relating to the taxation of insurance companies that could impact the Company’s future tax payments. In accordance with Topic 740, the Company has recorded a contingent liability of $3.0 million as of December 31, 2009, which, if recognized, would affect the Company’s future effective tax rate. Of this total, approximately $2.8 million had been accrued as of December 31, 2008.
As of December 31, 2009, the Company is subject to federal examination in the U.S. from 2006 through the present. In 2007, the IRS closed its audit for taxable years 2001 through 2003 and the statute of limitations lapsed for 2005 in 2009.
Leases-The Company leases certain office space and office equipment. Minimum rental payments under non-cancelable operating leases in the aggregate for the five years subsequent to 2009 and thereafter are as follows:
Rent expense for all leases was $0.4 million for 2009, $3.8 million for 2008 and $3.5 million for 2007.
Income Taxes-As of December 31, 2009, no tax issues from the most recently closed or pending IRS audit would, in the opinion of management, give rise to a material assessment or have a material effect on the consolidated financial condition, results of operations or cash flows of the Company.
Guarantees-The PMI Group has guaranteed certain payments to the holders of the privately issued debt securities (“Capital Securities”) issued by PMI Capital I, an unconsolidated subsidiary of the Company. Payments with respect to any accrued and unpaid distributions payable, the redemption amount of any Capital Securities that are called and amounts due upon an involuntary or voluntary termination, winding up or liquidation of the Issuer Trust are subject to the guarantee. In addition, the guarantee is irrevocable, is an unsecured obligation of the Company and is subordinate and junior in right of payment to all senior debt of the Company.
Funding Obligations-The Company has invested in certain limited partnerships with ownership interests greater than 3% but less than 50%. As of December 31, 2009, the Company had committed to fund, if called upon to do so, $2.7 million of additional equity in certain limited partnership investments. The Company is under no obligation to fund FGIC, an unconsolidated equity investee.
Common Stock-In February 2007, the Board of Directors authorized the repurchase of additional common shares in an amount not to exceed $150 million. Pursuant to this program, in June 2007, the Company repurchased 468,500 common shares for $22.7 million, or $48.48 per common share. In July 2007, the Board of
Directors increased the $150 million repurchase authorization to $300 million. From July 1, 2007 through September 30, 2007, the Company repurchased 5,454,381 common shares for $178.0 million, or $32.64 per common share. While approximately $100.0 million remains on the $300 million repurchase authorization, the Company did not repurchase additional common shares in 2008 and 2009.
In March 2007, the Company repurchased 325,000 common shares for $14.2 million under a $400 million common share repurchase program authorized by the Board of Directors in July 2006. In May 2007, upon completion of a $345 million accelerated share repurchase program entered into in 2006, The PMI Group received the final delivery of 436,152 common shares bringing the total received under the accelerated share repurchase program to 7,624,700 shares. The average price paid per common share upon completion of this program was $45.25 per common share.
Dividends-The payment of dividends to holders of The PMI Group common stock is subject to the discretion of the Company’s Board of Directors, which will consider, among other factors, the Company’s consolidated operating results, the Company’s overall financial condition and capital requirements, as well as general business conditions. In addition, The PMI Group’s credit agreement with Bank of America, N.A. and certain lenders places certain limitations on The PMI Group’s ability to pay dividends on its common stock including a cap of $0.01 per share per year, subject to an aggregate per year limit of $5 million and a prohibition from declaring any dividend at any time MIC is prohibited from writing new mortgage insurance by any state in the U.S. The PMI Group, as a holding company, is dependent upon dividends and any other permitted payments from its subsidiaries to enable it to pay dividends and to service outstanding debt. The PMI Group has not declared a dividend on its common stock since 2008. The Company does not expect that the Board of Directors of The PMI Group will declare a quarterly dividend in the foreseeable future. The Company last paid regular dividends on the common stock of $0.0025 per share in each of the quarters in the period from July 1, 2008 through December 31, 2008; and $0.0125 per share in each of the quarters in the period from January 1, 2008 through June 30, 2008.
MIC did not pay dividends to The PMI Group in 2008 and 2009, and the Company does not expect that MIC will pay dividends to The PMI Group in 2010. MIC’s ability to pay dividends to The PMI Group is affected by state insurance laws, credit agreements, rating agencies, and the discretion of insurance regulatory authorities, and its agreement with Fannie Mae relating to PMAC, as discussed in Note 1, Basis of Presentation. The laws of Arizona, MIC’s state of domicile for insurance regulatory purposes, provide that MIC may pay dividends out of any available surplus account, without prior approval of the Director of the Arizona Department of Insurance (“Arizona Director”), during any 12-month period in an amount not to exceed the lesser of 10% of policyholders’ surplus as of the preceding year end or the prior calendar year’s net investment income. A dividend that exceeds the foregoing threshold is deemed an “extraordinary dividend” and requires the prior approval of the Arizona Director. In 2006 and 2007, the Arizona Director approved two extraordinary dividend requests totaling $450 million. MIC paid $265 million of the $450 million of approved extraordinary dividends to The PMI Group in 2006 and 2007. Any payment of the remaining $185 million of approved dividends by MIC to The PMI Group requires prior written notice to the Director of the Arizona Department of Insurance, who could withdraw approval of such dividends.
dividends, the price and terms and conditions on which shares may be redeemed, the amount payable in the event of voluntary or involuntary liquidation, the terms and conditions for conversion or exchange into any other class or series of the shares, voting rights, and other terms. The Company may issue, without the approval of the holders of common shares, preferred stock that has voting, dividend or liquidation rights superior to the common stock, which may adversely affect the rights of holders of common stock. At December 31, 2009, there were no outstanding shares of The PMI Group preferred stock.
In the third quarter of 2008, the Company initiated a Voluntary Early Retirement Program (VERP). The Program was made available to employees (other than CEO) who were at least 52 years of age and had seven or more years of service. PMI did not incur any expenses in 2009 as a result of this Program. PMI incurred expenses of $33.1 million in 2008 as a result of this Program, primarily in the fourth quarter of 2008. In 2008, the Company contributed $41.0 million to the Plan, which exceeded the maximum deductible limit of $17.0 million. In the third quarter of 2009, the Company received approval from the IRS to have the nondeductible portion of approximately $24.0 million refunded to the Company to avoid excise tax penalties. This amount was returned to the Company in the third quarter of 2009. This refund was consistent with the terms of the Plan which call for the return of excess contributions which exceed the tax deductible limits. The Company contributed an additional $9.1 million to the Plan in the third quarter of 2009, which brought the Plan to 100% of the target funding level as of December 31, 2008. The Company generally makes contributions that are sufficient to fully fund its actuarially determined costs.
The Company’s accumulated benefit obligation for the Plan and SERP Plan at December 31, 2009 was $56.4 million and $6.6 million, respectively, the combination of which equals the $63.0 million accumulated benefit obligation. As of December 31, 2009, the combined fair value of plan assets is approximately $18.7 million lower than the Company’s combined accumulated benefit. The health care cost trend on covered charges for other postretirement benefits was 8.5% in 2009, which will be reduced to 5% in 2016.
The fair values of the assets in the Company’s pension plan at December 31, 2009, by asset category are as follows:
The primary objective of the Plan is to provide and secure retirement income for the Plan participants and their beneficiaries. As such, the key investment objective is to promote the attainment over a long-term horizon of consistent, competitive total returns that ultimately minimizes reliance on contributions from the plan sponsor. At the same time, a strong emphasis is placed on maintaining adequate levels of liquidity, safety and preservation of the Plan assets. Appropriate emphasis is given to credit quality, price volatility, and diversification for each investment category as well as for the portfolio as a whole. Plan assets are invested in a manner consistent with ERISA fiduciary standards and in accordance with all other relevant legislation and governing documents.
Contract underwriters and temporary employees are eligible to participate in the PMI Alternate Savings Plan, under which there are no matching Company contributions.
Deferred Compensation Plan-In addition to the Savings Plan, the Company has an officers’ deferred compensation plan available to certain employees. The obligation related to the deferred compensation plan was $4.8 million and $7.4 million as of December 31, 2009 and 2008, respectively, and is included in other liabilities and accrued expenses.
Impact of Topic 718-The Company has recognized compensation expense for stock options granted based on the estimated grant date fair value method using the Black-Scholes option pricing model to determine the fair value. For stock options, compensation expense is recognized using the accelerated amortization method. The determination of the fair value of share-based payment awards on the date of grant using an option-pricing model is affected by the Company’s share price as well as assumptions regarding a number of complex and subjective variables. These variables include the Company’s expected share price volatility over the expected term of the awards, actual and projected employee stock option exercise behaviors, risk-free interest rates, and expected dividends.
As Topic 718 requires that share-based compensation expense be based on awards that are ultimately expected to vest, share-based compensation has been reduced for estimated forfeitures. The Company is required to estimate forfeitures at the time of grant and revise those estimates in subsequent periods if actual forfeitures differ from those estimates. The Company uses historical data to estimate pre-vesting forfeitures and record share-based compensation expense only for those awards that are expected to vest.
Topic 718 requires cash flows resulting from gross excess tax benefits to be classified as a part of cash flows from financing activities. Excess tax benefits are realized tax benefits from tax deductions for exercised options in excess of the deferred tax asset attributable to share compensation costs for such options. Cash received from ESPP for the years ended December 31, 2009, 2008 and 2007, was $0.6 million, $1.6 million and $3.3 million, respectively. Cash received from option exercises in 2007 was $23.9 million. There were no option exercises in 2009 or 2008. The actual tax benefit realized for the tax deductions from option exercise of the share-based payment arrangements totaled $0.0 million, $0.0 million and $7.0 million, respectively.
The Company recognized share-based compensation expense for non-employee directors of $0.7 million (pre-tax), $1.2 million (pre-tax) and $1.3 million (pre-tax) for the years ended December 31, 2009, 2008 and 2007, respectively.
The total intrinsic value of options exercised during 2009, 2008 and 2007, was $0.0 million, $0.0 million and $19.8 million, respectively. The weighted-average remaining contractual life of options outstanding as of December 31, 2009 and vested and exercisable as of December 31, 2009 was 4.9 and 3.7 years, respectively. The aggregate intrinsic value for the options outstanding as of December 31, 2009 or for the options vested and exercisable as of December 31, 2009 was $1.7 million and $0.0 million, respectively.
A summary of the restricted stock unit activity under the Equity Incentive Plan as of December 31, 2009 and changes during the year then ended is presented below:
The weighted-average remaining contractual life of employee restricted stock units unvested as of December 31, 2009 was 1.0 years. The aggregate intrinsic value for the employee restricted stock units unvested as of December 31, 2009 was $2.7 million.
A summary of the phantom share activity under the Non-Employee Director Phantom Stock Plan as of December 31, 2009 and changes during the year then ended is presented below:
The following table represents PMI Australia’s results of operations for the years ended December 31, 2009, 2008 and 2007, respectively, which were recorded as discontinued operations:
In the third quarter of 2009, the Company recorded tax expense of $6.6 million due to refinement of the tax estimate associated with the sale of PMI Australia.
Discontinued Operations of PMI Guaranty-PMI Guaranty has completed its runoff activities, and is reported as discontinued operations in the Corporate and Other segment and in the consolidated statement of operations for the year ended December 31, 2008. As of December 31, 2008, upon receiving regulatory approval, PMI Guaranty’s remaining assets and liabilities were merged into U.S. Mortgage Insurance Operations.
On February 2, 2009, MIC received written approval from the Department for a permitted accounting practice allowing it to report the GAAP value of PMI Plaza, LLC (“PMI Plaza”), a subsidiary, in MIC’s statutory and annual statements without obtaining a GAAP audit as required by Statements of Statutory Accounting Principles (“SSAP”) No. 97, Investment in Subsidiary, Controlled and Affiliated Entities, A Replacement of SSAP No. 88 (“SSAP No. 97”).
MIC has a capital support agreement with PMI Europe, with a corresponding guarantee from The PMI Group, under which MIC may be required to make additional capital contributions from time-to-time as necessary to maintain PMI Europe’s minimum capital requirements. MIC also has a capital support agreement, whereby it agreed to contribute funds, under specified conditions, to maintain CMG MI’s risk-to-capital ratio at or below 19.0 to 1. MIC’s obligation under the CMG MI capital support agreement is limited to an aggregate of $37.7 million. As of December 31, 2009, CMG MI’s risk-to-capital ratio was 17.2 to 1.
MIC also has a capital support agreement with PMI Canada. Because the Company terminated its Canadian operations in PMI Canada, it believes it is unlikely that there is any remaining material support obligation under the PMI Canada capital support agreement.
The changes in unrealized gains/losses in 2009 were primarily due to contracting market spreads in the U.S. fixed income portfolio and in the preferred securities portfolio as a result of an improvement in the securities markets as well as other market driven factors. The changes in unrealized gains/losses in 2008 were primarily due to widening market spreads principally in the U.S fixed income portfolio and the preferred securities portfolio. The changes in foreign currency translation adjustments in 2009 were due primarily to strengthening of the Euro spot exchange rate relative to the U.S. dollar. The changes in foreign currency translation adjustments in 2008 were due primarily to the recognition of approximately $124.4 million of accumulated currency translation gains in connection with the sale of PMI Australia and PMI Asia.
The following table shows the accumulated balances for each component of accumulated other comprehensive income (loss) income for the years ended December 31, 2009, 2008 and 2007:
In the fourth quarter of 2008 and 2009, the Company undertook initiatives to reduce and manage its expenses to focus on its core U.S. mortgage insurance business. The following table provides a reconciliation of exit and disposal costs included in other underwriting expenses by operating segment in 2009 and 2008: