Corporate and Other. Our Corporate and Other segment consists of our holding company (“The PMI Group” or “TPG”), contract underwriting operations, and equity in earnings or losses from investments in certain limited partnerships. Our Corporate and Other segment generated net losses of $47.8 million in 2007 and $71.4 million in 2006.
premiums earned on our U.S. and international mortgage insurance policies, financial guarantees and other credit enhancement products;
net realized investment gains (losses), including the partial impairment of RAM Re; and
other income, including fees from contract underwriting services and income (losses) from changes in the fair value of credit default swaps.
Declining home prices-Declining home prices have made it significantly more difficult for certain borrowers to refinance their mortgages or sell their homes, and are negatively affecting PMI’s default inventory and default rate.
Above-97s-PMI has experienced higher than expected levels of delinquent Above-97s in its flow and structured channels. As of December 31, 2007, risk in force from Above-97s in all book years represented 24.6% of PMI’s primary risk in force compared to 17.6% as of December 31, 2006. The default rate for Above-97s in PMI’s primary portfolio as of December 31, 2007 was 9.1% compared to 6.6% as of December 31, 2006. PMI’s 2007 book which is still in its initial stage of loss development, has been particularly affected by high levels of delinquent Above-97s. Above-97s represented approximately 35.3% of PMI’s primary risk in force for the 2007 book year.
Credit and Portfolio Characteristics. PMI’s primary risk in force as of December 31, 2007 consisted of higher percentages of Above-97s, interest only and Alt-A loans compared to December 31, 2006. We believe that these percentage increases generally reflected higher concentrations of these loans in the mortgage origination and private mortgage insurance markets in 2006 and the first half of 2007. In the second half of 2007, the percentages of PMI’s NIW comprised of Alt-A loans and ARMs significantly decreased as a result of changes in the mortgage origination market and PMI’s underwriting guidelines. We expect these decreases to continue. The higher percentages of Above-97s loans in PMI’s primary risk in force (24.6% as of December 31, 2007 compared to 17.6% as of December 31, 2006) and NIW (31.6% in 2007 compared to 19.3% in 2006) in 2007 compared to 2006 is consistent with trends in the mortgage origination market and reflects the decline in alternative loan product originations (particularly 80/20 loans) which serve as substitutes for low down payment mortgages that typically require mortgage insurance. As a result of changes made to PMI’s pricing and underwriting guidelines,
As discussed above, PMI expects higher default and claim rates on 2/28 hybrid ARMs, Above-97s and Alt-A loans. While we incorporate these assumptions into our underwriting approach, portfolio limits, pricing and loss and claim estimates, in 2007 we experienced higher delinquencies than expected for each of these loan types. There can be no assurance, however, that the premiums earned with respect to such insured loans will be adequate to cover related incurred losses.
New Insurance Written (NIW). PMI’s primary NIW increased by 43.1% in 2007 compared to 2006. These increases were attributable to higher levels generated by PMI’s flow channel in 2007. The increase in PMI’s flow channel NIW in 2007 was driven by a larger private mortgage insurance market. We believe that the private mortgage insurance market grew in 2007 primarily as a result of a decline in the origination of alternative loan products, particularly 80/20 piggyback loans, that do not require mortgage insurance. We believe that the decline in the use of alternative products was due to both diminished demand in the capital markets for these products and increased concern on the part of portfolio lenders with respect to rising credit losses in an environment of declining home prices. We also believe that the private mortgage insurance market increased as a result of tax deductibility for eligible borrowers of borrower-paid mortgage insurance premiums relating to loans closed in 2007.
Policy Cancellations and Persistency. PMI’s persistency rate, which is based upon the percentage of primary insurance in force at the beginning of a 12-month period that remains in force at the end of that period, was 75.5% as of December 31, 2007 and 69.6% as of December 31, 2006. The improvement in PMI’s persistency rate reflects lower levels of residential mortgage refinance activity and home price declines. If these trends continue, we expect that policy cancellation rates will continue to slow and PMI’s persistency rate will continue to improve.
PMI Australia. PMI Australia had net income of $80.0 million in 2007 compared to $84.5 million in 2006. PMI Australia’s losses and LAE increased to $77.5 million in 2007 from $36.3 million in 2006. These increases were primarily a result of higher actual and expected claims paid, driven by higher claim rates and average claim sizes. PMI Australia’s loss experience in 2007 has been negatively affected by interest rate increases in 2006 and 2007, and moderating home price appreciation and home price declines in some markets. PMI Australia’s claims paid were $47.4 million in 2007 compared to $15.5 million in 2006. PMI Australia’s loss reserves were increased by $30.1 million in 2007 primarily as a result of increases in claim rates, average claim sizes and PMI Australia’s default inventory.
PMI Europe. PMI Europe had a net loss in 2007 of $33.4 million compared to net income of $11.9 million in 2006. The 2007 loss was driven by a loss reserve increase of $23.7 million in 2007, due primarily to the deteriorating performance of a small number of U.S. exposures on which PMI Europe provided reinsurance coverage in 2005. The loss in 2007 was also due to changes in the fair value of PMI Europe’s credit default swap (“CDS”) derivative contracts. We recorded an unrealized mark-to-market loss of $16.9 million on PMI Europe’s CDS derivative contracts in 2007 primarily as a result of significant widening of market spreads. Credit deterioration predominantly in the U.S. sub-prime market has impacted market spreads in international markets, including spreads on the portion of PMI Europe’s CDS portfolio that relates only to European prime mortgage risks. Continuing volatility of market spreads may lead to positive or negative fair value adjustments of these contracts in the future. In our view, the volatility of these market spreads does not reflect the credit quality of PMI Europe’s European CDS portfolio and we do not expect that these spread-driven changes in fair value will have a significant impact on future estimated net cash flows.
PMI Asia. PMI Asia had net income of $10.3 million in 2007 compared to $7.1 million in 2006. PMI Asia’s net income is affected by, among other things, the level of mortgage originations in Hong Kong. PMI Asia’s reinsurance premiums written increased in 2007 compared to the corresponding periods in 2006 due to higher levels of origination activity in Hong Kong, partially offset by PMI Asia’s leading customer’s increased retention of risk. In 2007, there were minimal losses incurred in PMI Asia.
FGIC. FGIC had a significant net loss of $1.8 billion in 2007, related primarily to the guarantees it provided during 2006 and 2007 on CDOs of asset-backed securities (“ABS”) (comprised to a large extent of tranches of RMBS as well as other CDOs) and RMBS transactions. The adverse results in both of these areas was due primarily to negative developments in the U.S. housing and mortgage markets, particularly with regard to sub-prime mortgages and second liens. As a result of FGIC’s realized and unrealized losses in 2007, the carrying value of our investment in FGIC Corporation was reduced to $103.6 million as of December 31, 2007 from $856.5 million as of December 31, 2006. FGIC’s “AAA” ratings were downgraded by each of the three major rating agencies to “AA” by Fitch, “A” by Standard & Poor’s, and “A3” by Moody’s. Further downgrades are possible. FGIC Corporation has proposed a significant restructuring of its insurance operations, including the organization of a new financial guarantee insurer to be domiciled in New York to provide support for global public finance and infrastructure obligations currently insured by FGIC and to write new business to serve those
markets. We do not know what form such restructuring, if any, will ultimately take, and any restructuring will require approval of the New York Insurance Department, among others, as well as significant additional capital, which may or may not be available on favorable terms or at all, and may significantly dilute our ownership interest in FGIC Corporation. We do not currently intend to make additional investments in FGIC Corporation. As a result of the recent downgrades, FGIC has ceased writing new financial guaranty business, and we believe that it is unlikely that FGIC will be able to write new financial guaranty business in the future at its current ratings. In connection with the preparation of our financial statements, we conducted an analysis as to whether the significantly reduced value of our investment in FGIC as of December 31, 2007 was impaired. Because, among other things, we determined the fair value of our investment in FGIC to be greater than its current carrying value, we concluded that no impairment is necessary at the current time. We will continue to evaluate this investment for possible future impairment, including if our ownership of investment in FGIC were to become diluted in connection with any proposed restructuring or if the estimated fair value were to fall below our carrying value. (See Item 1A. Risk Factors - As a significant portion of our consolidated net income/loss is derived from FGIC and its financial guaranty business, we are subject to various risks and uncertainties associated with the financial guaranty business and Any capital raising activities in which FGIC Corporation engages could significantly dilute our ownership interest in FGIC Corporation, and Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations-Critical Accounting Estimates.)
PMI Guaranty. PMI Guaranty provides credit enhancement on both a reinsurance and direct basis, and its insured portfolio includes public finance sector transactions and mortgage-backed securities (“MBS”). PMI Guaranty’s net income for 2007 was $3.1 million and $0.6 million for 2006. As a result of capital constraints on our business as a whole, we do not expect PMI Guaranty to be a significant source of net income in 2008.
For the year ended December 31, 2007, we recorded a consolidated net loss of $915.3 million compared to consolidated net income of $419.7 million for 2006. Our net loss in 2007 was primarily due to our equity in losses of FGIC of $763.3 million and our U.S. Mortgage Insurance Operations’ net loss of $190.8 million. FGIC’s loss in 2007 was driven by $1.9 billion of unrealized mark-to-market losses and $1.2 billion of losses and loss adjustment expenses. U.S. Mortgage Insurance Operations’ loss in 2007 was driven by $1.1 billion of losses and loss adjustment expenses compared to $263.0 million in 2006. Our consolidated 2007 financial results were positively impacted by higher premiums earned in the U.S. and Australia. The increase in our net income in 2006 compared to 2005 was primarily due to higher equity in earnings from FGIC and higher premiums earned in the U.S. and Australia, partially offset by higher losses and LAE in Australia and the U.S. and $12.2 million of share-based compensation expenses upon adoption of SFAS No. 123R in January 2006.
The significant increase in our losses and LAE in 2007 compared to 2006 was primarily due to loss reserve increases and higher claims paid in the U.S. and to a lesser extent, PMI Australia and PMI Europe. The increase in U.S. Mortgage Insurance Operations’ losses and LAE in 2007 was due to a $733.8 million increase to net loss reserves in 2007 and a $119.5 million increase in claims paid compared to 2006. The increases in 2007 reflected the significant weakening of the housing and mortgage markets which drove higher default inventories, claim rates and average claim sizes. The increase in our consolidated losses and LAE in 2006 compared to 2005 was due primarily to increases in PMI Australia’s and U.S. Mortgage Insurance Operations’ losses and LAE in 2006. The increase in PMI Australia’s losses and LAE in 2006 compared to 2005 was due primarily to higher default inventories, claim rates, and average claim sizes as a result of less favorable housing market conditions. The increase in U.S. Mortgage Insurance Operations’ losses and LAE in 2006 compared to 2005 was due primarily to higher claim rates caused by the weakening housing market and changes in the mix of PMI’s portfolio and higher claim sizes caused by higher coverage levels and loan sizes.
The decrease in other underwriting and operating expenses in 2007 compared to 2006 was primarily a result of lower employee compensation expenses in 2007. The increase in other underwriting and operating expenses in 2006 compared to 2005 was primarily due to higher compensation expenses relating to our adoption of SFAS No. 123R in 2006, partially offset by cost savings from our field office restructurings.
The decrease in interest expense in 2007 compared to 2006 and increase in 2006 compared to 2005 were primarily due to debt and equity financing activities during 2006.
Premiums written and earned-PMI’s net premiums written refers to the amount of premiums recorded based on effective coverage during a given period, net of refunds and premiums ceded primarily under captive reinsurance agreements. Under captive reinsurance agreements, PMI transfers portions of its risk written on loans originated by certain lender-customers to captive reinsurance companies affiliated with such lender-customers. In return, portions of PMI’s gross premiums written are ceded to those captive reinsurance companies. We received $1.2 million in claim payments from captive trusts in 2007. As of December 31, 2007, assets in captive trust accounts held for the benefit of PMI totaled approximately $700 million.
PMI’s premiums earned refer to the amount of premiums recognized as earned, net of changes in unearned premiums. The components of PMI’s net premiums written and premiums earned are as follows:
The increases in gross and net premiums written and premiums earned in 2007 compared to 2006 were primarily due to higher levels of primary NIW, higher insured loan sizes, and higher average primary premium rates. PMI’s average primary premium rates increased primarily as a result of changes in the business mix of PMI’s portfolio. (For a discussion of these changes, see Credit and Portfolio Characteristics, below.) We expect PMI’s NIW generated through both its flow and structured finance channels to be lower in 2008 than in 2007. Our expectations are based upon the continuing slowdown in the mortgage origination and secondary mortgage markets and the previously described changes to PMI’s pricing and underwriting guidelines that have decreased the types of loans that PMI will insure. The anticipated decrease in NIW will negatively impact our premiums written and earned in future periods. Higher persistency could partially offset this trend.
LAE includes changes to loss reserves, it reflects our best estimate of PMI’s future claim payments and costs to process claims relating to PMI’s current inventory of loans in default. Claims paid including LAE includes amounts paid on primary and pool insurance claims, and LAE. PMI’s losses and LAE and related claims data are shown in the following table.
The decrease in claims paid including LAE in 2006 compared to 2005 was primarily due to the decrease in the number of primary claims paid in 2006, partially offset by higher claim sizes in 2006. The increase of net loss reserves in 2006 compared to 2005 was due in part to changes in the business mix of its mortgage insurance portfolio and the seasoning of NIW acquired through PMI’s structured finance channel.
The increases in PMI’s primary default inventory and default rate in 2007 have been driven by a number of factors including:
Declining home prices-Declining home prices have made it significantly more difficult for certain borrowers to refinance their mortgages or sell their homes, and are negatively affecting PMI’s default inventory and default rate. As discussed above, the significant decline in the percentage of defaults that cure has also negatively affected PMI’s default inventory and default rate. The declines in the percentage of defaults that cure have resulted from, among other things, a slowdown in the time to resolution of defaults (either through cure or claim payment) some of which is attributable to significant backlogs in workout activity by loan servicers attempting to resolve delinquencies and prevent foreclosures.
Above-97s-PMI has experienced higher than expected levels of delinquent Above-97s in its flow and structured channels. As of December 31, 2007, risk in force from Above-97s in all book years represented 24.6% of PMI’s primary risk in force compared to 17.6% as of December 31, 2006. The default rate for Above-97s in PMI’s primary portfolio as of December 31, 2007 was 9.1% compared to 6.6% as of December 31, 2006. PMI’s 2007 book which is still in its initial stage of loss development, has been particularly affected by high levels of delinquent Above-97s. Above-97s represented approximately 35.3% of PMI’s primary risk in force for 2007 book year.
Alt-A loans-The default rate for Alt-A loans was 13.9% as of December 31, 2007 compared to 5.7% as of December 31, 2006. Risk in force from Alt-A loans represented 22.8% of PMI’s primary risk in force as of December 31, 2007 compared to 19.9% as of December 31, 2006.
2/28 hybrid ARMs-PMI’s 2005 and 2006 structured finance books have been particularly affected by delinquencies of 2/28 hybrid ARMs. As of December 31, 2007, risk in force from 2/28 hybrid ARMs in all book years originated through PMI’s structured finance channel represented 3.3% of PMI’s primary risk in force compared to 6.2% as of December 31, 2006, with the decrease reflecting underwriting guideline changes we issued in late 2006. The default rate for 2/28 hybrid ARMs as of December 31, 2007 was 38.6% compared to 16.0% as of December 31, 2006. The significant majority of 2/28 hybrid ARMs were insured by PMI in connection with non-agency RMBS transactions.
of PMI’s 2005, 2006 and 2007 portfolios. PMI’s default rates in California and Florida increased steeply in 2007 from below PMI’s average default rate as of December 31, 2006 to well above it as of December 31, 2007. The default rate from California as of December 31, 2007 was 10.9% compared to 3.6% and 2.3% as of December 31, 2006 and 2005, respectively. The default rate from Florida as of December 31, 2007 was 10.6% compared to 3.4% and 3.9% as of December 31, 2006 and 2005, respectively. As of December 31, 2007, risk in force from California and Florida insured loans represented 8.1% and 10.8% of PMI’s primary risk in force, respectively. The average default rate of the Auto States as of December 31, 2007 was 10.6% compared to 8.1% and 7.2% as of December 31, 2006 and 2005, respectively. As of December 31, 2007, risk in force from the Auto States represented 13.6% of PMI’s primary risk in force.
The increase in PMI’s total modified pool default rate from December 31, 2006 to December 31, 2007 was primarily due to the increase in loans in default, partially offset by the increase in new modified pool policies written in 2007. We expect PMI’s modified pool default rate to increase in 2008 as PMI’s modified pool portfolio seasons. However, we believe that PMI’s modified pool insurance products’ risk reduction features, including a stated stop loss limit, exposure limits on each individual loan in the pool and, in some cases, deductibles, reduce our potential loss exposure on loans insured by those products. In 2007, we did not write any modified pool without deductibles.
The decrease in modified pool loans in default in 2006 was driven by higher numbers of delinquencies in the fourth quarter of 2005 from hurricane impacted areas and higher cure rates in 2006 in those areas.
Total pool loans in default (which includes modified and other pool products) as of December 31, 2007, 2006 and 2005 were 29,143, 15,898, and 20,379, respectively. The default rates for total pool loans as of December 31, 2007, 2006, and 2005 were 7.76%, 4.24%, and 6.84%, respectively.
Equity in earnings from unconsolidated subsidiaries-U.S. Mortgage Insurance Operations’ equity in earnings are derived entirely from the results of operations of CMG MI. Equity in earnings from CMG MI decreased in 2007 compared to 2006 primarily as a result of higher losses and underwriting expenses, partially offset by higher premiums earned. Equity in earnings from CMG MI increased in 2006 compared to 2005 primarily as a result of higher premiums earned due to insurance in force and risk in force growth.
PMI’s loss ratio is the ratio of losses and LAE to premiums earned. The loss ratio increased in 2007 compared to 2006 as a result of higher losses and LAE, partially offset by higher premiums earned. The loss ratio remained flat in 2006 compared to 2005 as a result of higher premiums earned offset by higher losses and LAE.
Modified pool insurance-PMI currently offers modified pool insurance products that may be attractive to investors and lenders seeking a reduction in the severity of the impact of borrower defaults beyond the protection
provided by existing primary insurance or with respect to loans that do not require primary insurance, or for capital relief purposes. PMI wrote $0.4 billion of modified pool risk in 2007 compared to $0.7 billion of modified pool risk in 2006 and $0.3 billion in 2005. We expect to write less modified pool risk in 2008. Modified pool risk in force was $2.9 billion at December 31, 2007, $2.5 billion at December 31, 2006, and $1.8 billion at December 31, 2005.
Primary insurance in force and risk in force as of December 31, 2007 increased from December 31, 2006 primarily as a result of lower policy cancellations and higher levels of NIW. Primary insurance in force and risk in force as of December 31, 2006 increased from December 31, 2005 due primarily to lower policy cancellations, partially offset by lower levels of NIW. The improvement in PMI’s persistency rate, which is based on the percentage of primary insurance in force at the beginning of a 12-month period that remains in force at the end of that period, reflects lower levels of residential mortgage refinance activity and home price declines.
The following table presents PMI’s ARMs (mortgage loans with interest rates that may adjust prior to their fifth anniversary) and Above-97s (loans exceeding 97% LTV) as percentages of its flow channel and structured finance channel primary NIW:
Interest only loans, also known as deferred amortization loans, and payment option ARMs have more exposure to declining home prices than fixed rate loans or traditional ARMs. Borrowers with interest only loans do not reduce principal during an initial deferral period. In 2007, interest only loans were insured primarily through PMI’s flow channel and such loans were primarily sold to the GSEs. The vast majority of interest only loans insured in 2007 have ten year terms and are subject to additional underwriting criteria to limit the potential for layered risk. With a payment option ARM, a borrower generally has the option every month to make a payment consisting of principal and interest, interest only, or an amount established by the lender that may be less than the interest owed in which case the interest shortfall is added to the principal amount of the loan. The following table presents PMI’s interest only loans and payment option ARMs as percentages of its flow channel and structured finance channel primary NIW for the years ended:
The following table presents PMI’s less-than-A quality loans, Alt-A loans, ARMs, Above-97s, interest only, and payment option ARMs loans as percentages of primary risk in force as of December 31 for the years presented:
As shown in the table above, PMI’s primary risk in force as of December 31, 2007 consisted of higher percentages of Above-97s, interest only and Alt-A loans compared to December 31, 2006. We believe that these percentage increases generally reflected higher concentrations of these loans in the mortgage origination and private mortgage insurance markets in 2006 and early 2007. In 2007, however, the percentages of PMI’s NIW comprised of Alt-A loans and ARMs significantly decreased as a result of changes in the mortgage origination market and PMI’s underwriting guidelines. We expect these decreases to continue. The higher percentages of Above-97s in PMI’s primary risk in force and NIW is consistent with trends in the mortgage origination market and reflects the decline in alternative loan product originations (particularly 80/20 loans) which serve as substitutes for low down payment mortgages that typically require mortgage insurance. Effective March 1, 2008, PMI will no longer insure Above-97s through its primary flow channel.
Reporting of financial and statistical information for International Operations is subject to foreign currency rate fluctuations in translation to U.S. dollar reporting. Our International Operations segment’s net income for the last three years is summarized as follows:
Premiums written and earned-PMI Australia’s insurance portfolio consists primarily of single premium policies. Written premiums are earned in accordance with the expected expiration of policy risk. Accordingly, written premium associated with a single premium policy is recognized as earned over a period up to nine years, with the majority of the premium recognized as earned in years two through four. In the event of policy cancellation, any unearned portion of the associated premium is recognized as earned upon notice of cancellation. The increases in PMI Australia’s premiums written and earned in 2007 compared to 2006 were driven by the continued strengthening of the Australian dollar relative to U.S. dollar, growth in its flow business and higher levels of premiums release due to growth in insurance in force. The increases in PMI Australia’s premiums written and earned in 2006 compared to 2005 were primarily due to NIW, the scheduled release of unearned premiums to earned associated with PMI Australia’s growth in insurance in force, and higher levels of policy cancellations in 2006.
Net investment income-The increase in net investment income in 2007 compared to 2006 was due to the growth of PMI Australia’s investment portfolio, a strengthening Australian dollar relative to the U.S. dollar and a higher book yield. PMI Australia’s investment portfolio, including cash and cash equivalents, increased to $1.3 billion at December 31, 2007 from $1.1 billion at December 31, 2006. The increase in net investment income in 2006 compared to 2005 was due primarily to the growth of PMI Australia’s investment portfolio, including cash and cash equivalents, to $1.1 billion at December 31, 2006 compared to $877.2 million at December 31, 2005. The pre-tax book yield was 6.3% at December 31, 2007, 6.1% at December 31, 2006 and 5.9% at December 31, 2005. The increases in book yield in 2007 and 2006 were primarily due to higher interest rate environments.
The increases in claims paid including LAE in 2007 and 2006 compared to their prior years were attributable to increases in interest rates in 2007 and 2006, and moderating home price appreciation and home price declines which in turn, caused PMI Australia’s claim rates and average claim sizes to increase. We increased PMI Australia’s net loss reserves in 2007 and 2006 by $30.1 million and $20.8 million, respectively, primarily due to increases in PMI Australia’s default inventory, higher claim rates and higher average claim sizes.
The following table sets forth the financial results of PMI Europe for the years ended:
The average USD/Euro currency exchange rate was 1.3709 in 2007, 1.2566 in 2006 and 1.2444 in 2005. Changes in the average USD/Euro currency exchange rates from 2006 to 2007 negatively impacted PMI Europe’s financial results by $2.8 million in 2007. Changes in the average USD/Euro currency exchange rates from 2005 to 2006 favorably impacted PMI Europe’s net income by $0.1 million in 2006. Net income from PMI Europe in 2007 includes a $0.1 million pre-tax realized loss related to foreign currency put options, 2006 includes a $0.1 million pre-tax realized loss and 2005 includes a $0.4 million pre-tax realized gain related to foreign currency put options.
Premiums written and earned-Net premiums written increased in 2007 compared to 2006 primarily due to growth in primary NIW, particularly in Italy. The decreases in premiums earned in 2007 compared to 2006 and 2006 compared to 2005 were due primarily to decreases in premiums earned associated with the Royal & Sun Alliance (“R&SA”) insurance portfolio acquired in 2003. We recognize premiums associated with the acquired portfolio in accordance with established earnings patterns that are based upon management’s estimation of the expiration of the portfolio’s risk. As the portfolio continues to age, we expect premiums earned and risk in force associated with the portfolio to continue to decline.
Net (loss) income from credit default swaps-PMI Europe is currently a party to seventeen credit default swaps contracts that are classified as derivatives. We recorded an unrealized mark-to-market loss of $16.9 million on PMI Europe’s CDS derivative contracts in 2007 as a result of the significant widening of market spreads. Credit deterioration predominantly in the U.S. sub-prime market has impacted market spreads in international markets, including spreads on PMI Europe’s CDS portfolio which relates only to European prime mortgage risks. Continuing volatility of market spreads may lead to positive or negative fair value adjustments of these contracts in the future. In our view, the volatility of these market spreads does not reflect the credit quality of PMI Europe’s European CDS portfolio and we do not expect that these spread-driven changes in fair value will have a significant impact on future estimated net cash flows. We believe that market conditions and capital constraints could limit PMI Europe’s opportunities to participate in CDS transactions in 2008. We recorded realized mark-to-market gains of $7.4 million and $2.4 million for the years ended December 31, 2006 and 2005, respectively.
Underwriting and operating expenses-The increase in underwriting and operating expenses in 2007 compared to 2006 was primarily due to expenses related to our continuing expansion in Europe and also due to a strengthening of the Euro against the U.S. dollar. The slight decrease in underwriting and operating expenses in 2006 compared to 2005 was primarily due to a reduction in provisions for profit sharing obligations on the R&SA portfolio, partially offset by a growth in headcount.
Risk in force-PMI Europe’s risk in force increased to $9.4 billion as of December 31, 2007 from $3.9 billion at December 31, 2006 and $2.8 billion at December 31, 2005. The increase in 2007 compared to 2006 was primarily due to new credit default swaps written in 2007, increased primary insurance written and the strengthening of the Euro against the U.S. dollar. The increase in 2006 compared to 2005 was the result of new risk-remote credit default swaps written in 2006.
The average USD/HKD currency exchange rate was 0.1282 for 2007, 0.1287 for 2006, and 0.1286 for 2005. Changes in the average USD/HKD currency exchange rates from 2006 to 2007 and from 2005 to 2006 did not significantly impact PMI Asia’s net income.
Premiums written and earned-Effective June 30, 2006, PMI Asia assumed all mortgage risk previously ceded to PMI’s Hong Kong branch. The increase in reinsurance premiums written and earned in 2007 compared to 2006 was primarily due to higher levels of mortgage origination activity in Hong Kong in 2007, partially offset by the increased retention of risk by PMI Asia’s leading customer.
Net investment income-Net investment income increased in 2007 and 2006 compared to their prior years primarily due to growth in PMI Asia’s investment portfolio as a result of the transfer of PMI’s Hong Kong investment portfolio to PMI Asia in 2006. PMI Asia had total cash and investments of $70.6 million and $62.4 million as of December 31, 2007 and 2006, respectively.
transfer. The income tax expense in 2007 was also positively affected by tax exempt income from tax exempt bonds purchased in 2007.
PMI Canada began offering residential mortgage insurance products in 2007. In 2007, PMI Canada incurred $4.1 million in operating expenses and generated $2.2 million in net investment income (pre-tax). PMI Canada did not provide mortgage insurance coverage in 2007 and has written a limited amount of insurance to date in 2008.
The net loss in 2007 was due to FGIC’s $1.9 billion of unrealized mark-to-market losses in 2007 related to derivative contracts issued by FGIC on mortgage-related collateralized debt obligations and loss reserve increases of $1.2 billion in 2007 as a result of credit deterioration of collateralized debt obligations comprised primarily of tranches of sub-prime RMBS and other CDOs, as well as direct exposure to RMBS. FGIC’s 2007 mark-to market losses and additions to loss reserves reflect the significant weakening of the U.S. residential mortgage, housing, credit and capital markets. The increase in equity in earnings from FGIC Corporation in 2006 compared to 2005 was primarily due to increases in premiums earned, release of loss reserves associated with Hurricane Katrina, and higher investment income, offset by higher interest expense.
PMI Guaranty began operations in the fourth quarter of 2006. PMI Guaranty’s net income of $3.1 million in 2007 was derived from investment income and earned premiums. We do not expect PMI Guaranty to be a significant source of income in 2008.
The table below shows FGIC’s financial results for the years ended:
Underwriting expenses-Underwriting expenses increased in 2007 compared to 2006 primarily due additional consulting expenses related to reviews of stressed credits, increased rent expense and increased soft capital expenses due to changes in market conditions.
Deferred policy acquisition costs-The deferred policy acquisition cost asset was $107.9 million at December 31, 2007, $93.2 million at December 31, 2006 and $63.3 million at December 31, 2005. The amortization of deferred policy acquisition costs increased in 2007 to $15.7 million compared to $11.5 million and $8.3 million in 2006 and 2005, respectively, due to the increase in the deferred policy acquisition costs asset.
The results of our Corporate and Other segment include income and operating expenses related to contract underwriting, and net investment income, interest expense and corporate overhead of The PMI Group, our holding company. Our Corporate and Other segment results are summarized as follows:
Net investment income-The decrease in net investment income in 2007 compared to 2006 was due to a decrease in the size of the investment portfolio as a result of repurchases of common shares and capital contributions to certain wholly-owned subsidiaries in 2007, and a decrease in book yield for Corporate and Other segment to 5.19% as of December 31, 2007 from 5.23% as of December 31, 2006, respectively. The increase in net investment income in 2006 compared to 2005 was a result of higher investment yields in 2006, partially offset by a decrease in the size of the investment portfolio in 2006 due to our repurchase of common shares and redemption of certain long-term capital instruments.
Share-based compensation expenses-The increases in share-based compensation in 2007 from 2006 were primarily due to our acceleration of out-of-the-money stock options in 2005 which reduced our share-based compensation expense in 2006. There were no share-based compensation expenses recorded in 2005 since we adopted SFAS 123R in 2006.
The PMI Group’s principal uses of liquidity are the payment of operating costs, income taxes (which are predominantly reimbursed by its subsidiaries), principal and interest on its capital instruments, payments of dividends to shareholders, repurchases of its common shares, purchases of investments, and capital investments in and for its subsidiaries.
U.S. Mortgage Insurance Operations Liquidity-The principal uses of U.S. Mortgage Insurance Operations’ liquidity are the payment of operating expenses, claim payments, taxes, dividends to The PMI Group, and the growth of its investment portfolio. The principal sources of U.S. Mortgage Insurance Operations’ liquidity are written premiums and net investment income. PMI received an $18.3 million dividend from CMG MI in June 2007. Due to the factors described above, we anticipate that PMI Mortgage Insurance Co. will likely require significant additional capital in 2008.
International Operations and Financial Guaranty Liquidity-The principal uses of these segments’ liquidity are the payment of operating expenses, claim payments, taxes, and growth of its investment portfolio. The principal sources of these segments’ liquidity are written premiums, investment maturities and net
We have reached an agreement to amend our existing revolving credit facility. The effectiveness of the amendment is subject to certain conditions, which we expect to be satisfied shortly. The amendment to the credit facility reduces the amount available under the facility from $400 million to $300 million, subject to additional reductions in the event of certain asset sales or equity or debt issuances, with the maximum amount by which the facility can be reduced equal to $150 million. The facility includes a $50 million letter of credit sub-limit.
There are no amounts outstanding related to the facility. There were three outstanding letters of credit totaling approximately $2 million as of December 31, 2007. Under the amendment to the facility, our ability to borrow under the facility is subject to a number of conditions, including that the stock of PMI have been pledged in favor of the lenders under the facility, in form and substance satisfactory to the administrative agent and a majority in interest of the lenders in their sole and absolute discretion. In addition, dispositions of assets outside the ordinary course of business are prohibited pursuant to the amendment until the pledge is implemented, with certain limited exceptions. The terms of the pledge agreement have not been agreed to and there is no assurance that we will be able to enter into a mutually agreeable pledge agreement. We expect to require additional funds in 2008, and if we were unable to borrow under the facility or were delayed in doing so, our operating flexibility would be harmed. We are dependent on the facility as a source of liquidity, and may not be able to find alternate forms of capital on favorable terms or at all.
The amendment contains changes and additions to the existing financial covenants. The amendment reduces the requirement for our Adjusted Consolidated Net Worth (as defined in the facility) from $2.19 billion to $1.5 billion. In addition, under the amended facility, mark-to-market unrealized losses and gains on swap contracts with respect to PMI Europe, FGIC and RAM Re are excluded from the calculation of Adjusted Consolidated Net Worth and accumulated other comprehensive income is included. The amended facility contains a risk-to-capital ratio requirement of 20 to 1 with respect to PMI and a maximum total debt to total capitalization percentage requirement of 35%.
The amended facility also contains additional covenants and restrictions. Among these are restrictions on asset dispositions and investments. While we are permitted under the amended facility to make additional investments in PMI and its subsidiaries, our ability to invest in our reinsurance subsidiaries is subject to dollar limitations, unless and until we pledge the stock of those subsidiaries. The amended facility does not permit us to make additional investments in PMI Guaranty (other than pursuant to existing support arrangements), FGIC or RAM Re. The amended facility also restricts our ability to pay dividends or make other distributions with respect to our capital stock or to repurchase our shares. Under the amended facility, so long as no default or event of default is continuing, we may pay dividends to our common stock holders in an amount not to exceed an aggregate of $0.05 per share or $10 million in each fiscal year.
The amended facility includes additional events of default, including PMI failing to maintain GSE eligibility, failing to maintain a financial strength rating of at least Baa from Moody’s and failing to maintain a
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 February 2007, our Board of Directors authorized a common share repurchase program in an amount not to exceed $150 million. Pursuant to this program, in June 2007, we repurchased 468,500 common shares for $22.7 million, or $48.48 per common share. In July 2007, our Board of Directors increased the $150 million repurchase authorization to $300 million. From July 1, 2007 through September 30, 2007, we repurchased 5,454,381 common shares for $178.0 million, or $32.64 per common share. While approximately $100 million remains on the $300 million repurchase authorization, we did not repurchase any common shares in the fourth quarter of 2007. In light of our current financial condition as well as the anticipated terms of any new credit facility, we do not expect to repurchase additional common shares under our common share repurchase program in the foreseeable future.
PMI’s ability to pay dividends is also subject to restriction under the terms of a runoff support agreement with Allstate Insurance Corporation. Under the Allstate agreement, 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, 2007, PMI’s risk-to-capital ratio was 10.8 to 1 compared to 8.1 to 1 at December 31, 2006 and 8.2 to 1 at December 31, 2005.
In addition to its consolidated subsidiaries, The PMI Group may in the future derive funds from its unconsolidated equity investments, including its investment in FGIC Corporation. FGIC Corporation’s ability to pay dividends is subject to restrictions contained in applicable state insurance laws and regulations, FGIC Corporation’s certificate of incorporation, a stockholders agreement between The PMI Group and other investors in FGIC Corporation, and covenants included in its 6.0% senior notes. As a result of FGIC Corporation’s deteriorating financial performance, we do not expect FGIC Corporation to be in a position to pay dividends for the foreseeable future.
Our consolidated contractual obligations include reserves for losses and LAE, long-term debt obligations, operating lease obligations, capital lease obligations, and purchase obligations. Most of our purchase obligations are capital expenditure commitments that will be used for technology improvements. We have lease obligations under certain non-cancelable operating leases. In addition, we may be committed to fund, if called upon to do so, $6.7 million of additional equity in certain limited partnership investments.
Includes $496,593 million of principal debt and $509,287 million of scheduled interest.
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 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 certain 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, 2007, we estimate that the total principal balance of indemnified loans was between approximately $38 million and $44 million. We believe a number of factors will cause our contingent liability with respect to these indemnifications to be significantly lower than this amount. These 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 (iv) we expect a portion of these loans to be refinanced, or their indemnification coverage to expire. In 2007, we paid customers $0.2 million pursuant to loan indemnifications compared to $0.6 million in 2006. These amounts are included in our expenses associated with contract underwriting remedies.
Certain of PMI Europe’s credit default swap contracts and excess-of-loss reinsurance agreements contain collateral review provisions which, upon certain circumstances, require PMI Europe to pledge collateral for the
benefit of the counterparty. The amount of the required pledged collateral varies, but generally is limited to the amount of loss reserves established. PMI Europe has pledged collateral of $4.2 million with respect to one credit default swap transaction. A downgrade of PMI Europe could require PMI Europe to pledge additional collateral. Certain of PMI Europe’s credit default swap contracts contain termination rights which, upon a downgrade of PMI Europe to a specified rating, allow the counterparty to terminate the credit default swap or reinsurance agreement and, in some cases, require PMI Europe to pay the counterparty applicable loss reserves and unearned premium reserves.
Net investment income increased in 2007 compared to 2006 primarily due to growth in PMI Australia’s investment portfolio and a stronger Australian dollar relative to U.S. dollar. Our consolidated pre-tax book yield was 5.45% at December 31, 2007 and 2006. Net investment income increased in 2006 compared to 2005 primarily due to growth in our Australian investment portfolio, combined with an increase in our consolidated book yield.
The net realized investment losses in 2007 were due primarily to an other-than-temporary impairment of the investment in RAM Re of $38.5 million, partially offset by a $12.7 million settlement gain related to SPS. We realized the impairment in RAM Re due to continuing deterioration of the credit market, rating agency actions and declines in RAM Re’s share price. We expect the carrying value of our investment in RAM Re to be further reduced in the first quarter of 2008 as a result of RAM Re’s losses and/or further impairment by us of our investment. We will continue to evaluate the investment for possible additional impairment in future periods. Net realized gains after income taxes decreased in 2006 compared with 2005 primarily due to impairment charges of $2.8 million on short-term investments in 2006.
The changes in unrealized gains in 2007, 2006 and 2005 were due primarily to changes in interest rates that caused market value fluctuations relative to our consolidated fixed income portfolio. In 2007, the changes in interest rates and to some extent widening credit spreads contributed to the changes in unrealized gains on our preferred stock in our equity portfolio. As interest rates, market and other economic conditions change, we expect the market value of the securities in our consolidated investment portfolio and of our unconsolidated equity investments to be affected.
As of December 31, 2007, 6.2% of our U.S. investment portfolio (which consists of the investment portfolio in our U.S. Mortgage Insurance Operations segment, Corporate and Other segment and PMI Guaranty) consists of FGIC-insured non-refunded municipal bonds. As a result of our investment in FGIC, we have amended our investment policy to provide that no more than 15% of our U.S. investment portfolio consists of FGIC-insured non-refunded municipal bonds.
5.568% Senior Notes-In August 2006, the Company completed the remarketing of approximately $345 million in principal amount of senior notes maturing in November 2008, which are referred to as the 5.568% Senior Notes. As a result of the remarketing, the annual interest rate on these notes was reset from 3.00% per annum to 5.568% per annum, paid quarterly, effective from and including August 15, 2006. In connection with the remarketing, the Company purchased and cancelled $300.0 million in principal amount of the 5.568% Senior Notes, leaving $45.0 million in principal amount of these notes outstanding after completion of the remarketing.
PMI has entered into various capital support agreements with PMI Australia, PMI Europe, PMI Guaranty, and PMI Canada that could require PMI to make additional capital contributions to those subsidiaries. The PMI Group guarantees the performance of PMI’s capital support obligations to PMI Australia, PMI Europe, and PMI Guaranty. The capital support agreement and corresponding guarantee for PMI Guaranty, and the capital support agreement for PMI Canada, are limited to $650 million and $300 million, respectively. In 2001, PMI executed 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 18.0 to 1. PMI’s obligation under the agreement is limited to an aggregate of $37.7 million.
Consolidated cash flows used in financing activities, including purchases of common shares and dividends paid to shareholders, were $197.0 million in 2007 compared to $497.3 million in 2006 and $236.5 in 2005. The difference was primarily due to proceeds from the issuance of long term debt in 2006 and decreases in treasury stock purchases.
Recent Developments Relating to Mortgage Insurance Companies and PMI Guaranty Ratings
In October 2007, Standard & Poor’s placed its “AA” counterparty credit and financial strength ratings on PMI Mortgage Insurance Co., PMI Guaranty, PMI Europe and PMI Australia and its “AA” financial strength rating on PMI Insurance Co. on CreditWatch with negative implications. At the same time, Standard & Poor’s placed its “A” counterparty credit rating on The PMI Group on CreditWatch with negative implications. In taking these actions, Standard & Poor’s indicated that these ratings would likely be removed from CreditWatch and affirmed with a negative or stable outlook if Standard & Poor’s concluded that PMI’s near-term operating performance was not significantly different than its peers and that the group was unlikely to report an underwriting loss in 2009. Standard & Poor’s also indicated that the rating could be lowered by one notch if Standard & Poor’s believed PMI’s operating performance compared unfavorably to its peers in the next two years or that the group was likely to report an underwriting loss for 2009.
The above actions followed the announcement of our net loss in the third quarter of 2007. Fitch indicated that the downgrade of debt ratings reflected a normalization of the notching between the operating company’s insurer financial strength rating and the holding company’s senior debt ratings to three notches and that the Rating Outlook revision to Negative for PMI Guaranty Co., PMI Insurance Co., PMI Europe, and PMI Australia was exclusively related to the Rating Outlook of and the capital support provided by PMI Mortgage Insurance Co. through capital support and related agreements to these entities.
On February 25, 2008, Fitch placed its “AA” insurer financial strength ratings on PMI Mortgage Insurance Co., PMI Insurance Co., PMI Australia, PMI Europe and PMI Guaranty Co., as well as the long-term issuer ratings of The PMI Group, Inc. and PMI Capital I on Rating Watch Negative. In taking these rating actions, Fitch indicated that it had updated its view on ultimate loss expectations and their impact on PMI Mortgage Insurance Co.’s capital position, particularly with respect to the company’s large exposure to Alt-A, interest-only and high LTV loans. Fitch indicated that it believes PMI Mortgage Insurance Co. currently has a capital shortfall at the “AA” rating level, and that its current assessment of PMI Mortgage Insurance Co. incorporates a view that The PMI Group, Inc. maintains additional financial flexibility through unutilized capital available at several affiliates. In addition, Fitch expressed its concern on the potential for further negative pressure on the earnings of The PMI Group, Inc. related to investments in financial guaranty insurers FGIC Corporation and RAM Holdings Ltd.
Also on February 25, 2008, Fitch affirmed the ‘AA’ insurer financial strength rating of CMG MI and revised the Rating Outlook from Stable to Negative. In its report Fitch stated that weakness experienced at PMI is tending to be a negative impact on CMG MI, at least over the near-to-intermediate term.
Determinations of ratings by the rating agencies are affected by a variety of factors, including macroeconomic conditions, economic conditions affecting the mortgage insurance industry, changes in business prospects, regulatory conditions, competition, underwriting and investment losses and the perceived need for additional capital. There can be no assurance that our wholly-owned insurance subsidiaries will not be downgraded or need additional capital in order to maintain their ratings. Indeed, we anticipate that PMI will likely require additional capital in 2008 to maintain a rating within the “double-A” category. As discussed above, there can be no assurance that we will be able to raise any additional capital in the future and, to the extent that we are unable to timely raise sufficient capital in relation to increased capital needs, our wholly-owned insurance subsidiaries’ ratings could be lowered.
On February 14, 2008, Moody’s downgraded its insurer financial strength rating on FGIC from “Aaa” to “A3” and maintained the rating on review for possible further downgrade. Moody’s noted that its ratings action reflected FGIC’s meaningfully weakened capitalization and business profile resulting, in part, from its exposures to the U.S. residential mortgage market. Moody’s stated that it estimated that FGIC would require capitalization of approximately $9 billion to cover stress-case losses at the “Aaa” target level and that it estimated FGIC’s claims paying resources to be approximately $5 billion.
On March 7, 2008, Moody’s affirmed its “Aa3” insurer financial strength rating of RAM Re with a negative outlook. Moody’s also confirmed its “Baa1” rating on the preference shares issued by the holding company, RAM Holdings Ltd., and a related financing trust with a negative outlook. Moody’s indicated this reflects the uncertainty regarding both the ultimate performance of mortgage and mortgage-related collateralized debt obligation exposure, as well as RAM Re’s future underwriting prospects given its reliance on the primaries for business.
We establish reserves for losses and LAE to recognize the liability of unpaid losses related to insured mortgages that are in default. We do not rely on a single estimate to determine our loss and LAE reserves. To ensure the reasonableness of our ultimate estimates, we develop scenarios using generally recognized actuarial projection methodologies that result in various possible losses and LAE. Our best estimate as of December 31, 2007 with respect to our consolidated loss and LAE reserves was approximately the midpoint of the actuarially determined range.
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, 2007 and December 31, 2006 on a segment and consolidated basis:
The above loss reserve reconciliation shows the components of our losses and LAE reserve changes for the periods presented. Losses and LAE payments of $362.2 million, $242.7 million, and $246.5 million for the periods ended 2007, 2006 and 2005, respectively, reflect amounts paid during the periods presented and are not subject to estimation. Total incurred of $1.1 billion, $263.0 million, and $253.3 million for the years ended 2007, 2006 and 2005 respectively, are management’s best estimates of ultimate losses and LAE and, therefore, are subject to change. The changes in our estimates are principally reflected in the losses and LAE incurred line item which shows an increase to incurred related to prior years of $201.7 million, $2.2 million, and $6.3 million for the years ended 2007, 2006 and 2005 respectively. The table below breaks down the 2007, 2006 and 2005 changes in reserves related to prior years by particular accident years:
The following table shows a breakdown of reserves for losses and LAE by loans in default, incurred but not reported or IBNR, and the cost to settle claims, or LAE:
Our best estimate as of December 31, 2007 with respect to our consolidated loss and LAE reserves was approximately the midpoint of the actuarially determined range. If either the claim rate or claim size, or a combination of the claim rate and claim size, were to increase up to approximately 20% compared to our current estimates, we would reach the top of our actuarially determined range. Conversely, if the claim rate or claim size, or a combination of the claim rate and claim size, were to decrease up to approximately 20% of our current estimates, we would reach the bottom end of our actuarially determined range.
PMI Asia’s loss reserves at December 31, 2007 were $ 0.2 million, which represents our best estimate. Our actuaries calculated a range for PMI Asia’s loss reserves at December 31, 2007 of $0.2 million to $0.3 million.
The increases in losses and LAE incurred relating to prior years of $36.7 million and $10.0 million in 2007 and 2006, respectively, were primarily due to our re-estimate of expected claim sizes and claim rates for PMI Australia. These increases were primarily the result of moderating home price appreciation and home price
whether we have the ability and intent to hold the security for a sufficient period of time to allow for anticipated recoveries in fair value.
If we believe a decline in the value of a particular investment is temporary and we have the intent and ability to hold to recovery, we record the decline as an unrealized loss on our consolidated balance sheet under “accumulated other comprehensive income” in shareholders’ equity. If we believe the decline is other-than-temporary, we write-down the carrying value of the investment and record a realized loss in our consolidated statement of operations under “net realized investment gains.” Our assessment of a decline in value includes 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.
We generate a significant portion of our revenues from mortgage insurance premiums on either a monthly, annual or single payment basis. Premiums written on a monthly basis are earned as coverage is provided. Premiums written on an annual basis are earned on a monthly pro-rata basis over the year of coverage. Primary mortgage insurance premiums written on policies covering more than one year are referred to as single premiums. A portion of revenue on single premiums is recognized in premiums earned in the current period, and the remaining portion is deferred as unearned premiums and earned over the expected life of the policy. 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 to earned premiums upon notification of the cancellation. The length of the earnings pattern for single premium products is based on a range of seven to fifteen years, and the rates used to determine the earnings of single premiums are estimates based on actuarial analysis of the expiration of risk. Single premiums written accounted for 19.0%, 15.0% and 15.3% of gross premiums written in 2007, 2006 and 2005 respectively, and came predominantly from PMI Australia in our International Operations segment. The premium earnings process generally begins upon receipt of the initial premium payment. The premiums earnings pattern methodology is an estimation process and, accordingly, we review the premium earnings cycle for each policy acquisition year (“Book Year”) annually and any adjustments to these estimates are reflected for each Book Year as appropriate.
Deferred policy acquisition costs are reviewed periodically to determine that they do not exceed recoverable amounts, after considering investment income. For the year ended December 31, 2007, we performed a recoverability analysis of deferred costs relating to new mortgage insurance policies acquired in 2007. As a result of this analysis, we impaired PMI’s deferred policy acquisition cost asset by $33.6 million relating to the 2007 book year. This impairment of all remaining costs associated with the 2007 book year as of December 31, 2007
was driven by our expected loss development under various scenarios and our determination that the remaining costs were not recoverable. We also determined that $2.2 million of deferred policy acquisition cost assets relating to PMI Europe was also impaired for the year ended December 31, 2007.
Periodically, or as events dictate, we evaluate potential impairment of our 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 loss would be recognized in our 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 our ownership interests of unconsolidated subsidiaries are recognized in net realized investment gains or losses in the consolidated statement of operations.
As of December 31, 2007, the carrying value of the Company’s investment in FGIC was $103.6 million, with the balance representing $617 million of cash and capitalized acquisition costs less equity in losses, and the Company’s proportionate share of FGIC’s net unrealized gains (losses) in its investment portfolio. In light of recent rating agency actions, the inability to write significant additional new business, and significant net losses, we have evaluated our investment for potential other-than-temporary impairment. We have determined the fair value of our investment in FGIC to be greater than its current carrying value and no impairment is necessary at the current time. Factors considered when we assessed the potential impairment of our investment in FGIC include:
equity in losses due to unrealized mark-to-market losses on the insured credit derivative portfolio;
internal and external valuation analyses that support a value in excess of the current cost basis.
As events in the financial guaranty sector continue to develop as well as any restructuring plans related to our specific investments in FGIC and RAM Re become finalized, additional impairment to our equity investments could be realized. Accordingly, we will continue to evaluate our investment in RAM Re and FGIC for possible additional impairment in future periods.
We perform an analysis for premium deficiency using assumptions based on our best estimate when the analysis 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 test. 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. For the calculation of investment income we use our pre-tax investment yield.
Management assessed the effectiveness of our internal control over financial reporting as of December 31, 2007. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework.
We have audited the accompanying consolidated balance sheets of The PMI Group, Inc. and subsidiaries (the Company) as of December 31, 2007 and 2006, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2007. Our audits also included the financial statement schedules listed in the Index at Item 15(a). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
In 2007, the Company adopted FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes-An Interpretation of FASB Statement No. 109. In 2006, the Company adopted FASB Statement No. 123(R), Share-Based Payment, and FASB Statement No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106 and 132(R). These matters are further described in Note 2 to the consolidated financial statements.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), The PMI Group, Inc. and subsidiaries’ internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 16, 2008 expressed an unqualified opinion thereon.
In our opinion, The PMI Group, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on the COSO criteria.
The Company has a 42.0% equity ownership interest in FGIC Corporation, the holding company of Financial Guaranty Insurance Company (collectively “FGIC”), a New York-domiciled financial guaranty insurance company. The Company also has equity ownership interests in CMG Mortgage Insurance Company, CMG Mortgage Reinsurance Company and CMG Mortgage Assurance Company (collectively “CMG MI”), which conduct residential mortgage insurance business for credit unions. The Company also has equity ownership interests in RAM Holdings Ltd., the holding company of RAM Reinsurance Company, Ltd. (collectively “RAM Re”), a financial guaranty reinsurance company based in Bermuda. The Company also has ownership interests in several limited partnerships. In addition, the Company owns 100% of PMI Capital I (“Issuer Trust”), an unconsolidated wholly-owned trust that privately issued debt in 1997.
The consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) and the requirements of Form 10-K and Article 7 of Regulation S-X. The 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 consolidated financial statements, as well as the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates. In the opinion of management, all adjustments, consisting only of normal recurring adjustments, considered necessary for a fair presentation for the periods presented, have been included.
experiencing accelerated delinquency and loss development in those states. In addition we expect higher default and claim rates for high LTV loans, ARMs, 2/28 Hybrid ARMs, Alt-A loans, interest only loans, payment option ARMS and less-than-A quality loans. We also insure loans that have more than one of the above risk characteristics. This “layering” of risk has, in recent experience, further increased the risk of borrower default. We have incorporated our best estimates for the higher default and claim rates associated with these loans into our underwriting and pricing models and reserve estimates. However, there can be no assurance that the premiums earned and the associated investment income will prove adequate to compensate for future losses from these loans or that future adverse loss development will not emerge.
The Company’s various U.S., Australian, European, Canadian and Asian insurance subsidiaries are subject to comprehensive regulation. These regulations are generally intended to protect policyholders, rather than to benefit investors. Although their scope varies, applicable laws and regulations grant broad powers to supervisory agencies or officials to examine companies and to enforce rules or exercise discretion covering almost every significant aspect of the insurance business. The licensing of the Company’s insurance subsidiaries, their premium rates, their forms and policies offered to customers, their financial statements and periodic financial reporting, and their permissible investments and adherence to financial standards relating to statutory surplus, dividends to the Company and other criteria of solvency are all subjects of detailed regulations.
The Company has made significant investments in the equity securities of several privately-held companies, including FGIC. FGIC is subject to a number of significant risks that arise from the nature of its business. Accordingly, the Company is subject to the risks and uncertainties associated with that business. In addition, the Company has limited ability to control FGIC and, accordingly, may be unable to take actions unilaterally to avoid or mitigate those risks. In the past, a significant portion of the Company’s consolidated net income has been derived from FGIC and its financial guaranty business. In 2007, the Company’s equity in losses from FGIC was $763.3 million due to $1.9 billion of unrealized mark-to-market losses in 2007 related to derivative contracts issued by FGIC on mortgage-related collateralized debt obligations and loss reserve increases of $1.2 billion in 2007 as a result of credit deterioration of insured collateralized debt obligations backed by sub-prime residential mortgage-backed securities (RMBS) as well as direct exposure to RMBS. FGIC’s 2007 mark-to market losses and additions to loss reserves reflect the significant weakening of the U.S. residential mortgage, housing, credit and capital markets. The financial guaranty market is subject to extensive regulation. Future legislative, regulatory, accounting or judicial changes may affect the financial guaranty industry or municipal or asset-backed obligations or markets.
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 and Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin (“SAB”) No. 59, Accounting for Noncurrent Marketable 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 consolidated statement of operations.
In connection with the preparation of the Company’s financial statements for the year ended December 31, 2007, the Company realized an other-than-temporary impairment of $38.5 million due to continuing deterioration of the credit market, rating agency actions and declines in RAM Re’s share price. Refer to Note 5, Investments in Unconsolidated Subsidiaries, for more details.
Company, (ii) the Company’s proportionate share of unconsolidated subsidiaries’ total assets is in excess of 10% of total consolidated assets of the Company, or (iii) equity in income from continuing operations before income taxes, extraordinary items and the cumulative effect of a change in accounting principle of the unconsolidated subsidiaries is in excess of 10% of such income of the Company. Furthermore, if certain of the above tests exceed 20% with respect to any unconsolidated subsidiary, separate audited financial statements of that unconsolidated subsidiary are required to be included in the registrant’s Form 10-K. For the year ended December 31, 2007, the Company’s equity in loss before tax as described in item (iii) above of FGIC exceeded 20% of such loss of the Company, and accordingly, separate audited financial statements of FGIC will be included in an amendment to the Company’s Form 10-K. Additionally, the condensed financial statements of FGIC and CMG MI are included in Note 5. Investments in Unconsolidated Subsidiaries. The Company has determined that its other equity investees do not meet any of the tests outlined above on a stand-alone or aggregate basis.
Related Party Receivables and Payables-As of December 31, 2007 and 2006, related party receivables were $1.4 million and $0.7 million, and related party payables were $1.9 million and $1.7 million, respectively, which were comprised of non-trade receivables and payables from unconsolidated subsidiaries.
Under the provisions of Statement of Position No. 98-1, Accounting for the Cost of Computer Software Developed or Obtained for Internal Use, the Company capitalizes costs incurred during the application development stage related to software developed for internal use purposes and for which it has no substantive plan to market externally. Capitalized costs are amortized at such time as the software is ready for its intended use on a straight-line basis over the estimated useful life of the asset, which is generally three to seven years.
Derivatives-Certain credit default swap contracts entered into by PMI Europe are considered credit derivative contracts under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended by SFAS No. 149, Amendment of SFAS No. 133 on Derivative Instruments and Hedging Activities. These credit default swap derivatives are recorded at their fair value on the consolidated balance sheet with subsequent changes in fair value recorded in consolidated net income. The Company determines the fair values of its credit default swaps on a quarterly basis and uses internally developed models since market values are not available. These models include future estimated claim payments and market input assumptions including discount rates and market spreads to calculate a fair value and reflect management’s best judgment about current market conditions. Due to the illiquid nature of the credit default swap market, the use of available market data and assumptions used by management to estimate fair value could differ materially from amounts that would be realized in the market if the derivatives were traded. Due to the volatile nature of the credit market as well as the imprecision inherent in the Company’s fair value estimate, future valuations could differ materially from those reflected in the current period.
In 2007, the Company purchased foreign currency put options to partially mitigate the negative financial impact of a potential strengthening U.S. dollar relative to both the Australian dollar and the Euro. These Australian dollar and Euro put options expire ratably over the calendar year and had a combined cost of $1.3 million, $1.4 million and $1.8 million in 2007, 2006 and 2005, respectively. The Company recorded a realized loss of $1.3 million, $1.3 million and $1.1 million (pre-tax) in other income related to amortization of option costs and mark-to-market adjustments in 2007, 2006 and 2005, respectively.
Special Purpose Entities-Certain insurance transactions entered into by PMI and PMI Europe require the use of foreign wholly-owned special purpose entities principally for regulatory purposes. These special purpose entities are consolidated in the Company’s consolidated financial statements.
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 it has been delinquent for two consecutive monthly payments. The Company’s U.S. mortgage insurance primary master policy defines “default” as the borrower’s failure to pay when due an amount equal to the scheduled monthly mortgage payment under the terms of the mortgage. Generally, however, the master policy requires an insured to notify PMI of a default no later than the last business day of the month following the month in which the borrower becomes three monthly payments in default. SFAS No. 60 specifically excludes mortgage guaranty insurance from its guidance relating to reserves for losses and LAE. 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 on a case-by-case basis when insured loans are identified as currently in default using estimated claim rates and claim amounts for each report year, net of salvage recoverable. 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 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 consolidated balance sheet date represent management’s best estimate of existing losses and LAE incurred. The estimates are continually reviewed and adjusted as necessary as experience develops or new information becomes known to the Company. Such adjustments, to the extent of increasing or decreasing loss reserves, are recognized in the current period’s consolidated results of operations.
Income Taxes-The Company accounts for income taxes using the liability method in accordance with SFAS No. 109, Accounting for Income Taxes. The liability method measures the expected future tax effects of temporary differences at the enacted tax rates applicable for the period in which the deferred asset or liability is expected to be realized or settled. Temporary differences are differences between the tax basis of an asset or liability and its reported amount in the consolidated financial statements that will result in future increases or decreases in taxes owed on a cash basis compared to amounts already recognized as tax expense in the consolidated statement of operations. The Company’s effective tax rates were 18.8% and 25.0% for the years ended December 31, 2007 and 2006, respectively, compared to the federal statutory rate of 35.0%. The effective tax rate for tax year 2007 reflects previously deferred tax liabilities attributable to equity in earnings from FGIC and RAM Re were reversed, and certain deferred tax assets were established but not to the full extent of the related losses incurred in 2007. In addition, the effective rate in 2007 reflects income derived from certain international operations, which have lower effective tax rates. The effective tax rate for tax year 2006 reflects our equity in earnings from FGIC and income derived from certain international operations, which have lower effective tax rates, combined with the Company’s municipal bond investment income. In 2006, The Company recorded a federal tax expense relating to its proportionate share of net income available to FGIC Corporation’s common shareholders at a rate of 7% based on its assessment that it will ultimately receive those earnings in the form of dividends.
As of January 1, 2007, the Company adopted FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes-An Interpretation of FASB Statement No. 109 (“FIN 48”). See Note 12. Income Taxes, for further discussion.
Foreign Currency Translation-The financial statements of the Company’s foreign subsidiaries have been translated into U.S. dollars in accordance with SFAS No. 52, Foreign Currency Translation. Assets and liabilities denominated in non-U.S. dollar functional currencies are translated using the period-end spot exchange rates. Revenues and expenses are translated at monthly-average exchange rates. The effects of translating operations with a functional currency other than the reporting currency are reported as a component of accumulated other comprehensive income included in total shareholders’ equity. Foreign currency translation gains in accumulated other comprehensive income were $281.0 million as of December 31, 2007 compared with $172.4 million as of December 31, 2006. Gains and losses on foreign currency re-measurement incurred by PMI Australia, PMI Europe, PMI Asia and PMI Canada represent the revaluation of assets and liabilities denominated in non-functional currencies into the functional currency, the Australian dollar, the Euro, the Hong Kong dollar and the Canadian dollar, respectively.
Comprehensive Income (loss)-Comprehensive income (loss) includes net income (loss), the change in foreign currency translation gains or losses, derivatives designated as cash flow hedges, pension adjustments, changes in unrealized gains and losses on investments and reclassification of realized gains and losses previously reported in comprehensive income (loss), net of related tax effects. The Company reports the components of comprehensive income (loss) in its consolidated statements of shareholders’ equity.
The following is a reconciliation of consolidated net (loss) income to net (loss) income for purposes of calculating diluted EPS for the years set forth below:
The following is a reconciliation of the weighted-average common shares used to calculate basic EPS to the weighted-average common shares used to calculate diluted EPS for the years ended set forth below:
Share-Based Compensation-The Company applies SFAS No. 123 (revised 2004), Share-Based Payment (“SFAS No. 123R”) for share-based payment transactions. SFAS No. 123R requires that such transactions be accounted for using a fair value-based method and recognized as expense in the consolidated results of operations. The Company recognizes the fair value of share-based payments granted and unvested, including employee stock options and employee stock purchase plan shares, as compensation expense in the consolidated results of operations. The Company adopted SFAS No. 123R as of January 1, 2006, which resulted in share-based compensation expenses of $16.1 million and $12.2 million, for 2007 and 2006, respectively.
Reclassifications-Certain items in the prior corresponding period’s consolidated financial statements have been reclassified to conform to the current period’s consolidated financial statement presentation. Certain items in the consolidated statements of cash flows for the years ended December 31, 2006 and 2005 were reclassified to reflect the effect of foreign currency exchange rate changes on cash and cash equivalents. In the prior year presentations, the line item, foreign currency translation adjustment increase (decrease), reflected the exchange rate effect on all the balance sheet items as reflected in the table below:
In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements - an amendment to ARB No. 51 (“SFAS No. 160”) which establishes accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. It requires consolidated net income to be reported at amounts that include the amounts attributable to both the parent and the noncontrolling interest. It also requires disclosure, on the face of the consolidated statement of income, of the amounts of consolidated net income attributable to the parent and to the noncontrolling interest. SFAS No. 160 is effective for fiscal years beginning after December 15, 2008. The Company is still evaluating the impact of SFAS No. 160 on its consolidated financial statements.
In December 2007, the FASB issued SFAS No. 141 (revised 2007), Business Combinations (“SFAS No. 141R”) which requires an entity that obtains control of one or more businesses in a business combination to recognize the assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree at the acquisition date, measured at their fair values as of that date, with limited exceptions specified in SFAS No. 141. SFAS No. 141R is effective for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. SFAS No. 141R is not currently expected to significantly impact the Company’s consolidated financial statements.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities-Including an Amendment of FASB Statement No. 115 (“SFAS No. 159”). SFAS No. 159 permits entities to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. SFAS No. 159 does not eliminate disclosure requirements included in other accounting standards, including requirements for disclosures about fair value measurements included in FASB Statements No. 157, Fair Value Measurements (“SFAS No. 157”), and No. 107, Disclosures about Fair Value of
Financial Instruments. SFAS No. 159 is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. The Company plans to adopt the fair value option of SFAS No. 159 related to its corporate debt. See the table within Note 10. Fair Value of Financial Instruments, below.
Fair Values and Gross Unrealized Gains and Losses on Investments-The cost or amortized cost, estimated fair value and gross unrealized gains and losses on investments are shown in the tables below:
Unrealized Investment Gains and Losses-The reclassification adjustment relating to the change in unrealized investment gains and losses 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, 2007 and 2006:
Unrealized losses on fixed income securities were primarily due to increases in interest rates in 2007 and are not considered to be other-than-temporarily impaired as the Company has the intent and ability to hold such investments until they recover in value or mature. The Company determined that the decline in the fair value of certain investments met the definition of other-than-temporary impairment and recognized realized pretax losses of $6.1 million, $6.2 million and $0.6 million in 2007, 2006, and 2005 respectively.
As of December 31, 2007, the carrying value of the Company’s investment in FGIC was $103.6 million compared to $856.5 million as of December 31, 2006. The carrying value includes the Company’s proportionate share of FGIC’s net unrealized gains (losses) in its investment portfolio.
In connection with the preparation of the Company’s financial statements for the year ended December 31, 2007, the Company realized an other-than-temporary impairment of $38.5 million due to continuing deterioration of the credit market, rating agency actions and declines in RAM Re’s share price. This impairment charge was based on the difference between our investment balance in RAM Re as of December 31, 2007 before the impairment and our share of RAM Re’s market value as of September 30, 2007, due to our one quarter accounting lag. The Company will continue to evaluate the investment for possible additional impairment in future periods.
Equity in earnings (losses) from unconsolidated subsidiaries consisted of the following for the periods presented below:
During the second quarter of 2006, the Company’s ownership percentage of RAM Re decreased from 24.9% to 23.7% as a result of the initial public offering of RAM Re.
Deferred policy acquisition costs are affected by qualifying costs that are deferred in the period and amortization of previously deferred costs in such periods. In periods where new business activity is declining, the asset will generally decrease because the amortization of previously deferred policy acquisition costs exceeds the
Deferred policy acquisition costs are reviewed periodically to determine that they do not exceed recoverable amounts, after considering investment income. For the year ended December 31, 2007, the Company performed a recoverability analysis of deferred costs relating to new mortgage insurance policies acquired in 2007. As a result of this analysis, the Company impaired its deferred policy acquisition cost asset related to its U.S. Mortgage Operations by $33.6 million relating to the 2007 book year. The impairment of all costs associated with the 2007 book year as of December 31, 2007 was driven by expected loss development under various scenarios and our determination that the costs were not recoverable. The Company also impaired a $2.2 million of deferred policy acquisition cost assets relating to PMI Europe for the year ended December 31, 2007.
The increase in total consolidated loss reserves at December 31, 2007 compared to December 31, 2006 was primarily due to increases in the reserve balances for U.S. Mortgage Insurance Operations as a result of increase in default inventory, higher claim rates and higher average claim sizes and severity. Continuing deterioration of the US. Housing and mortgage markets caused PMI’s Loss and LAE and default inventory to increase significantly in 2007. Higher claim rates have been driven by home price declines and diminished availability of certain loan products, both of which constrain refinancing opportunities, and result in a decrease in the percentage of the default inventory that is returning to current status. The increase in PMI’s average claim sizes has been driven by higher loan sizes and coverage levels in PMI’s portfolio, and declining home prices which limit PMI’s loss mitigation opportunities. Upon receipt of a default notice, future claim payments are estimated relating to those delinquent loans 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.
As of December 31, 2007 and 2006, the carrying value of long-term debt outstanding issued by The PMI Group, was as follows:
5.568% Senior Notes-In August 2006, the Company completed the remarketing of approximately $345 million in principal amount of senior notes maturing in November 2008, which are referred to as the 5.568%
The Company reached an agreement with its lenders on March 16, 2008 to amend its revolving credit facility. While the amendment reduces the facility size from $400 million to $300 million at the outset, the facility’s net worth covenant is reduced to $1.5 billion. In calculating the Company’s net worth under the covenant, the amendment allows the Company to exclude unrealized CDS-related mark-to-market losses of FGIC, RAM Re and PMI Europe and include accumulated other comprehensive income. The Company’s ability to borrow under the amended facility is subject to a number of conditions, including that the stock of PMI have been pledges in favor of the lenders under the facility in form and substance satisfactory to the administrative agent and a majority in interest of the lenders in their sole and absolute discretion. The revolving credit facility contains certain additional financial covenants and restrictions.
The following table shows the effects of reinsurance on premiums written, premiums earned and losses and LAE of the Company’s operations for the years ended:
The components of income tax (benefit) expense for the years ended December 31, 2007, 2006 and 2005 are as follows:
The components of the income tax expense for 2007 included a foreign provision for current tax expense of $36.1 million and a deferred tax benefit of $2.1 million primarily related to PMI Australia and PMI Europe.
The Company has foreign net operating loss carryforwards of approximately $18 million that will expire in 2012-2027, or will carryforward indefinitely. The Company has recorded a tax benefit of $0.9 million attributable to these losses, based on the expectation that such losses will be utilized in future years. Additionally, state deferred tax liabilities related to investments in certain subsidiaries reflect tax benefits of approximately $2.6 million attributable to approximately $21 million of state operating loss carryforwards that could reduce future dividend income.
The Company has tax credit carryforwards of approximately $55.5 million, primarily related to Alternative Minimum Taxes.
When incurred, the Company recognizes interest and penalties accrued related to unrecognized tax benefits in tax expense. The Company incurred interest and penalties of approximately $0.1 million in 2007. The Company remains subject to examination in the following major tax jurisdictions:
Leases-The Company leases certain office space and office equipment. Minimum rental payments under non-cancelable operating leases and capital leases in the aggregate for the five years subsequent to 2007 and thereafter are as follows:
Indemnification-mortgage-backed securities-In connection with structured transactions in the U.S., Europe and Australia, the Company is often required to provide narrative and/or financial information relating to the Company and its subsidiaries to mortgage-backed securities issuers for inclusion in the relevant offering documents and the issuers’ ongoing SEC filings. In connection with the provision of such information, the Company and its subsidiaries may be required to indemnify the issuer of the mortgage-backed securities and the underwriters of the offering with respect to the information’s accuracy and completeness and its compliance with applicable securities laws and regulations.
on the settlement agreement dated January 25, 2008, there was no indemnification obligation remaining related to SPS.
Collateral Support Agreements-PMI Europe has entered into a number of collateral support agreements in respect of certain credit default swap and reinsurance transactions it has concluded. Under these agreements PMI Europe may be required to pledge collateral for the benefit of the counterparty. PMI Europe has pledged collateral of $4.2 million for one credit default swap transaction.
Common Stock-In March 2007, the Company repurchased 325,000 common shares for $14.2 million under a $400 million common share repurchase program authorized by the Board of Directors in July 2006. In February 2007, the Board of Directors authorized a common share repurchase program 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 any common shares in the fourth quarter of 2007.
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 shares.
Dividends-PMI’s ability to pay dividends to The PMI Group is affected by state insurance laws, credit agreements, credit rating agencies, and the discretion of insurance regulatory authorities. The laws of Arizona, PMI’s state of domicile for insurance regulatory purposes, provide that PMI may pay dividends out of any available surplus account, without prior approval of the Director of the Arizona Department of Insurance, during any 12-month period in an amount not to exceed the lesser of 10% of policyholders’ surplus as of the preceding year end or the prior calendar year’s net investment income. A dividend that exceeds the foregoing threshold is
Effective January 1, 2003, all U.S. full-time and part-time employees of the Company are eligible to participate in The PMI Group, Inc. Retirement Plan (the “Plan”), a noncontributory defined benefit plan. The Plan generally has been funded by the Company to the fullest extent permitted by federal income tax rules and regulations. In addition, certain employees whose annual earnings exceed $220,000 under Internal Revenue Code (“IRC”) Section 401(a)(17) and limits established under IRC Section 415, participate in The PMI Group, Inc. Supplemental Employee Retirement Plan (“The SERP Plan”), a noncontributory defined benefit plan. Benefits under both pension plans are based upon the employees’ length of service, average annual compensation and estimated social security retirement benefits.
On May 17, 2007, The PMI Group’s Board of Directors approved an amendment to the Retirement Plan. The amendment changed the Plan’s benefit formula from a “final pay” pension formula to a cash balance formula. The amendment takes effect immediately for employees hired or rehired on or after September 1, 2007.
For employees hired before and continuously employed on September 1, 2007, the amendment will take effect on January 1, 2011. Under the new cash balance plan formula, the Company will contribute 8% of qualified employees’ compensation to cash balance accounts and credit interest at a rate equal to the 30-year Treasury Bond rate.
Included in the overfunded status of the pension benefits is the underfunded status of The SERP Plan of $6.8 million and the overfunded status of PMI’s retirement plan of $11.9 million resulting in a net overfunded status of $5.1 million. No plan assets are expected to be returned to the Company during the year ending December 31, 2008.
Equity Incentive Plan-The PMI Group’s Amended and Restated Equity Incentive Plan (the “Equity Incentive Plan”) provides for awards of both non-qualified stock options and incentive stock options, nonvested shares, stock appreciation rights subject to forfeiture and restrictions on transfer, and performance awards entitling the recipient to receive cash or common shares in the future following the attainment of performance goals determined by the Board of Directors. Stock options are granted with an exercise price equal to the market value on the date of grant, and generally expire ten years from the grant date and have a three-year vesting
period. The Equity Incentive Plan provides for the granting of nonvested shares to officers and key employees. Nonvested shares issued under the Equity Incentive Plan to date generally vest annually between two to four years and holders are entitled to dividends and voting rights. Under the Equity Incentive Plan, non-employee directors receive quarterly, non-discretionary grants of stock units with an initial value of $25,000. The number of units granted depends on the fair market value of the Company’s common shares on the grant date but each stock unit has an initial value equal to the fair market value of one common share on the grant date. Non-employee director grants of stock units vest on the earlier of the fifth anniversary of the applicable grant date and termination of board service.
Employee Stock Purchase Plan-The PMI Group, Inc. Employee Stock Purchase Plan (“ESPP”) allows eligible employees to purchase shares of the Company’s stock at a 15% discount to fair market value as determined by the plan. The ESPP offers participants the 15% discount to current fair market value or fair market value with a look-back provision of the lesser of the duration an employee has participated in the ESPP or two years. Based on the features of the ESPP, it is considered compensatory according to the provisions of SFAS No. 123R. Under the ESPP, the Company issued 151,953 treasury shares in 2007, 128,467 treasury shares in 2006 and 139,884 treasury shares in 2005. SFAS No. 123(R) requires expense recognition of the amount of the discount to current fair value of ESPP shares purchased by employees.
The Company recognized $16.1 million share-based compensation expense in 2007 compared to $12.2 million in 2006. As of December 31, 2007, there was $8.7 million of unrecognized compensation cost, adjusted for estimated forfeitures, related to non-vested share-based payments granted to employees. This unrecognized expense is expected to be recognized over a weighted average period of 1.9 years. Total unrecognized compensation cost will be adjusted for future changes in estimated forfeitures.
Reporting segments are based upon the Company’s internal organizational structure, the manner in which the Company’s operations are managed, the criteria used by the Company’s chief operating decision-maker to evaluate segment performance, the availability of separate financial information, and overall materiality considerations.
The following table presents PMI’s statutory net (loss) income, statutory surplus and contingency reserve liability as of and for the years ended as follows:
Under the insurance laws of the State of Arizona and several other states, mortgage insurers are required to establish a special contingency reserve included in total liabilities, with annual additions equal to 50% of premiums earned for that year. During 2007, PMI contributed $403.4 million to the reserve. This reserve is required to be maintained for a period of 120 months to protect against the effects of adverse economic cycles. After 120 months, the reserve is released to unassigned funds. During 2007, $191.7 million was released to unassigned funds. In the event an insurer’s loss ratio in any calendar year exceeds 35%, however, the insurer may withdraw from its contingency reserves an amount equal to the excess portion of such losses. In compliance with Arizona statute, the Company requested a withdrawal of $608.0 million from its contingency reserves related to actual losses that exceeded 35% of the corresponding earned premiums. The Arizona Department of Insurance approved the $608.0 million contingency reserve withdrawal in a letter dated February 12, 2008.
In 2001, PMI executed 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 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. As of December 31, 2007, CMG MI’s risk-to-capital ratio was 14.6 to 1 compared to 12.6 to 1 as of December 31, 2006.
PMI has entered into various capital support agreements with PMI Australia, PMI Europe, PMI Guaranty, and PMI Canada that could require PMI to make additional capital contributions to those subsidiaries. The PMI Group guarantees the performance of PMI’s capital support obligations to PMI Australia, PMI Europe and PMI Guaranty. The capital support agreement and corresponding guarantee for PMI Guaranty and capital support agreement for PMI Canada are limited to $650 million and $300 million, respectively.