Certain of the statements contained herein, other than statements of historical fact, are forward-looking statements. These statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and include estimates and assumptions related to economic, competitive, and legislative developments. These forward-looking statements are subject to change and uncertainty, which are, in many instances, beyond our control and have been made based upon our expectations and beliefs concerning future developments and their potential effect on us. Actual developments and their results could differ materially from those expected by us, depending on the outcome of certain factors, including the possibility of general economic and business conditions that are different than anticipated, legislative developments, changes in interest rates or the stock markets, stronger than anticipated competitive activity, and the factors described in the forward-looking statements.
The preparation of financial statements, in conformity with accounting principles generally accepted in the United States, requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. The ultimate outcome could differ from those estimates and assumptions utilized in the preparation of the financial statements.
We have identified the following as critical accounting estimates in that they involve a higher degree of judgment and are subject to a significant degree of variability: reserves for losses and loss adjustment expenses, the timely identification of potentially impaired securities and valuation of those securities, and deferred policy acquisition costs. In developing these estimates, we make subjective and complex judgments that are inherently uncertain and subject to material change as facts and circumstances develop. Although variability is inherent in these estimates, we believe the amounts provided are appropriate based on the facts available upon compilation of the financial statements.
We calculate our best estimate of reserves to provide for the estimated costs of settling claims on loans reported in default and loans in default that are in the process of being reported to us. Our reserving process incorporates various components in a formula that gives effect to current economic conditions and profiles delinquencies by such factors as policy year, geography, chronic late payment characteristics, the number of months the policy has been in default, as well as whether the defaults were underwritten as flow business or as part of a structured bulk transaction. The process is based upon the assumption that long-term historical experience, taking into consideration the above factors and adjusted for current economic events that we believe will significantly impact the long-term loss development, provides a reasonable basis for estimating projected claim rates (frequency) and claim amounts (severity). We consider severity and frequency to be the most significant assumptions in the establishment of our loss reserves. Estimation of loss reserves is a difficult and inexact process and there are inherent risks and uncertainties involved in making these assumptions. Economic conditions that have affected the development of loss reserves in the past may not necessarily affect development patterns in the future in either a similar manner or degree. Due to the inherent uncertainty in estimating reserves for losses and loss adjustment expenses, there can be no assurance that reserves will be adequate to cover ultimate loss developments on loans in default, currently or in the future. The Company’s profitability and financial condition could be adversely affected to the extent that the Company’s estimated reserves are insufficient to cover losses on loans in default.
We regularly monitor our investment portfolio to ensure that investments that may be other-than-temporarily impaired are identified in a timely fashion, properly valued, and any other-than-temporary impairments are charged against earnings in the proper period. Our methodology to identify potential impairments is further described in the Investments section below.
The costs of acquiring new business, principally commissions and certain policy underwriting and issue costs which vary with and are primarily related to the production of new business, are capitalized as deferred policy acquisition costs (DAC). Amortization of such policy acquisition costs is charged to expense in proportion to premium recognized over the estimated policy life. We make judgments in the identification of deferrable acquisition costs and the determination of estimated policy life utilized in the amortization assumptions. See further discussion of DAC under the Financial Position section below.
Through our subsidiaries, we provide mortgage guaranty insurance coverage to residential mortgage lenders and investors as a credit-enhancement vehicle, typically when individual borrowers have less than 20% equity in the property. Business originated by lenders and submitted to us on a loan-by-loan basis is referred to as flow business. Mortgage guaranty insurance facilitates the sale of individual low down payment loans in the secondary market and provides protection to lenders who choose to keep the loans in their own portfolios. Additionally, we provide mortgage insurance to lenders and investors who seek additional default protection, capital relief, and credit-enhancement on groups of loans that are sold in the secondary market. This business is referred to as structured bulk transactions.
Our expenses essentially consist of a) amounts ultimately paid on claims submitted, b) increases in reserves for estimated future claim payments, c) general and administrative costs of acquiring new business and servicing existing policies, d) other general business expenses, and e) income taxes.
Our profitability depends largely on a) the adequacy of our product pricing and underwriting discipline relative to the risks insured, b) persistency levels, c) operating efficiencies, and d) the level of investment yield, including realized gains and losses, on our investment portfolio. We define persistency as the percentage
of insurance in force remaining from twelve months prior. Cancellations of policies originated during the past twelve months are not considered in our calculation of persistency. This method of calculating persistency may vary from that of other mortgage insurers. We believe that our calculation presents an accurate measure of the percentage of insurance in force remaining from twelve months prior. Cancellations result primarily from the borrower refinancing or selling mortgaged residential properties and, to a lesser degree, from the borrower achieving prescribed equity levels at which the lender no longer requires mortgage guaranty insurance.
Net income for 2004 increased 14.3% over 2003 driven by a 17.8% increase in earned premiums and a 21.3% decline in DAC amortization. Net loss and loss adjustment expense increased 50.5%, partially offsetting these favorable impacts. Net income per share on a diluted basis increased 13.1% over 2003. Net realized
investment gains, after taxes, contributed income of $0.02 per share on a diluted basis in 2004 compared to $0.13 per share for 2003. Diluted realized gains and losses per share is a non-GAAP measure. We believe this is relevant and useful information to investors because, except for write-downs on other-than-temporarily impaired securities, it shows the effect that our discretionary sales of investments had on earnings.
The following table provides estimates of our national market share of net new primary insurance written based on information available from the industry association and other public sources:
Total direct insurance in force reached $36.8 billion at December 31, 2004, compared to $31.7 billion at December 31, 2003 as a result of continued production and an improvement in persistency. The following table shows our persistency rates for our flow and structured bulk business at December 31, 2004 and 2003:
Our direct insurance in force grew 16.1% from December 31, 2003 to December 31, 2004, and the credit quality of our in force portfolio has remained relatively consistent. As shown below, the credit quality of our structured bulk business at December 31, 2004 has improved over December 31, 2003 as we have focused our efforts on transactions consisting of higher quality loans. FICO credit scores are one of the major factors used in assessing credit risk. The following table presents the FICO credit score distribution of our risk in force for both flow and structured bulk business at December 31, 2004 and 2003.
During 2004, 55.8% of flow insurance written and 33.9% of total insurance written was subject to captive reinsurance arrangements, compared to 46.1% of flow insurance written and 37.3% of total insurance written in 2003. The increase in the percentage of flow insurance written subject to captive reinsurance arrangements is primarily a result of decreased production in our lender-paid mortgage insurance program that is generally not subject to captive reinsurance arrangements. Additionally, none of our insurance written in 2004 and 2003 attributable to structured bulk transactions was subject to captive reinsurance arrangements.
Earned premiums increased 17.8% to $141.0 million for 2004 from $119.7 million for 2003. The difference between net written premiums and earned premiums is the change in the unearned premium reserve. Our unearned premium liability increased $0.3 million from December 31, 2003 to December 31, 2004 compared to an increase of $7.1 million from December 31, 2002 to December 31, 2003. The growth in 2003 was the result of growth in sales of products with premiums paid on an annual basis during that year. Direct written premium from the annual premium product represented 15.5% of direct premium written in both 2004 and 2003.
As mentioned earlier, assuming interest rates do not decline, we anticipate our persistency will continue to improve. This improvement should have a positive effect on renewal earned premiums and total earned premiums in 2005.
Net losses and loss adjustment expenses (net of reinsurance recoveries) increased 50.5% in 2004 over 2003. This increase was due to the growth in the number of delinquencies and paid losses and is reflective of our overall growth of insurance in force and the seasoning of our in force business. Net paid losses, excluding loss adjustment expenses, increased to $28.3 million for 2004 from $17.5 million for 2003, an increase of 61.7%. Average severity (direct paid losses divided by number of claims paid) for all loans combined was approximately $24,200 for 2004 compared to $24,100 for 2003. However, the average severity on structured bulk loans was $23,800 for 2004 compared to $21,100 for 2003. The following table provides detail on direct paid losses for our flow business and structured bulk business for the years ended December 31, 2004 and 2003 (in thousands):
structured bulk production that included deductibles. Beginning in fourth quarter 2004 as the loss development pattern began to emerge on these books with deductibles, we began taking these deductibles into consideration when calculating our reserves and did not establish reserves for those claims on which we were in the second loss position.
The following table shows our loss ratios (the ratio of incurred losses and loss adjustment expense to premiums earned) for our flow business and our structured bulk business for the years ended December 31, 2004 and 2003:
The increase in the loss ratio for the flow business shown above is consistent with our expectations, again, as a greater amount of our insurance in force reaches its anticipated highest claim frequency years. For our structured bulk business, the deductible structures put in place over the past two years have caused the decline in the loss ratio.
Amortization of DAC decreased by 21.3% in 2004 from 2003 and is reflective of the increase in persistency experienced in 2004. A full discussion of the impact of persistency on DAC amortization is included in the Deferred Policy Acquisition Costs section below.
The increase in other operating expenses in 2004 over 2003 of 16.3% is relatively consistent with our growth in the insurance in force. Further, we experienced increased expenses in 2004 related to compliance with the Sarbanes-Oxley requirements and other compliance oriented expenses that we do not expect to repeat at the same level in 2005. We have made substantial investments in technology that allow for growth in both our flow and structured bulk business without proportional increases in operating expenses. The expense ratio (ratio of the amortization of deferred policy acquisition costs and other operating expenses to net premiums written) for 2004 was 28.8% compared to 32.3% for 2003. The improvement in the expense ratio for 2004 was due primarily to the decrease in DAC amortization expense mentioned above.
Total direct insurance in force reached $31.7 billion at December 31, 2003, compared to $25.4 billion at December 31, 2002. Significant refinance activity in 2003 and 2002 resulted in a high level of policy cancellations that substantially offset the impact that the high level of insurance written had on in force growth. As a result, insurance in force increased by only $6.3 billion in 2003, even though insurance written during 2003 was $20.5 billion. The following table shows our persistency rates for our flow and structured bulk business at December 31, 2003 and 2002:
The following table presents the FICO credit score distribution of our risk in force for both flow and structured bulk business at December 31, 2003 and 2002.
Total direct premiums written were $154.0 million for 2003, an increase of 24.0% compared to $124.2 million for 2002. Net premiums written increased by 19.7% to $126.7 million in 2003 from $105.9 million for 2002. Contributing to the increase in premiums written for 2003 were significant writings under our annual premium payment plan. During 2003, 34% of total insurance written was under the annual premium payment plan compared to 18% of total insurance written during 2002.
Approximately 54.2% of direct flow insurance in force (43.6% of total insurance in force) was subject to captive reinsurance arrangements at December 31, 2003, compared to 51.6% (45.7% of total insurance in force) at December 31, 2002. This increase was due primarily to the increased market penetration of our captive reinsurance arrangements and the high level of refinance activity in 2003, as policies that were previously not subject to captive reinsurance arrangements refinanced and new policies issued were subject to captive reinsurance arrangements.
Net investment income for 2003 was $17.1 million, a 6.1% increase over $16.1 million in 2002. Average invested assets at cost or amortized cost grew by $60 million to $364 million for the year ended December 31, 2003, an increase of 19.9% from $304 million for 2002. The increase in average invested assets was attributable
We reported $3.0 million of net realized investment gains during 2003 and $2.5 million of net realized investment losses during 2002. Net realized gains during 2003 included approximately $0.8 million of impairment writedowns. The writedowns primarily involved securities in the automotive, energy, and pharmaceutical sectors as well as a commercial mortgage-backed security.
Net incurred losses and loss adjustment expenses (net of reinsurance recoveries) increased by 69.5% in 2003 to $23.8 million from $14.1 million in 2002. The increase in losses and loss adjustment expenses was reflective of our overall growth of insurance in force, relative growth of our participation in the bulk market, and the seasoning of our in force business. Net paid losses, excluding loss adjustment expenses, increased to $17.5 million during 2003 from $10.3 million during 2002, an increase of 70.3%. Average severity was approximately $24,100 for 2003 compared to $21,400 for 2002. The following table provides detail on direct paid losses from flow business and structured bulk business for the years ended December 31, 2003 and 2002 (in thousands):
The following table shows our loss ratios for our flow business and our structured bulk business for the years ended December 31, 2003 and 2002:
The increases in the loss ratios shown above were consistent with the growth of our overall insurance in force, relative growth of our participation in the structured bulk market and the seasoning of our in force business.
Other operating expenses decreased 0.5% to $22.8 million for 2003 from $22.9 million for 2002. The expense ratio for 2003 was 32.3% compared to 34.6% for 2002. The expense ratio for 2003 improved because other operating expenses decreased and net written premium increased, offset somewhat by the accelerated amortization of DAC.
Our objective is controlled, profitable growth in both the flow and bulk arenas while adhering to our risk management strategies. Our strategy is to continue our focus on national lenders while maintaining the productive relationships that we have built with regional lenders. Our ten largest customers were responsible for 71%, 74%, and 73% of flow insurance written during 2004, 2003, and 2002, respectively. Our two largest customers were responsible for 55%, 58%, and 53% of flow insurance written during 2004, 2003, and 2002, respectively. The loss of one or more of these significant customers could have an adverse effect on our business.
Costs expended to acquire new business are capitalized as DAC and recognized as expense over the anticipated premium paying life of the policy. We employ a dynamic model that calculates amortization of DAC separately for each book year of business. The model relies on assumptions that we make based upon historical industry experience and our own unique experience regarding the annual persistency development of each book year. Persistency is the most important assumption utilized in determining the timing of reported amortization expense reflected in the income statement and the carrying value of DAC on the balance sheet. A change in the assumed persistency can impact the current and future amortization expense as well as the carrying value on the balance sheet. Our model accelerates DAC amortization through a dynamic adjustment when actual persistency for a book year is lower than the estimated persistency originally utilized in the model. This dynamic adjustment is capped at the levels assumed in the models, and we do not decrease DAC amortization below the levels assumed in the model when persistency increases above those levels. The dynamic adjustment effectively adjusts the estimated policy life originally utilized in the model to a revised policy life based upon the current actual persistency.
In 2003 as the amount of structured bulk transactions grew, we revised our DAC models to separate the costs capitalized and the amortization streams between transactions arising from structured bulk and the flow business. Generally, structured bulk transactions have significantly less acquisition costs associated with the production of the business and they also have a shorter original estimated policy life. We apply the dynamic adjustment utilizing the same methodology to the separate structured bulk DAC models. At December 31, 2004 and 2003, net unamortized DAC relating to structured bulk transactions amounted to 5.4% and 4.8% of the total DAC on the balance sheet.
Low persistency levels during the past three years have caused accelerated DAC amortization. If persistency continues to improve in 2005, we would expect the accelerated DAC amortization to continue to moderate, depending on the level of improvement. Otherwise, we will continue to experience increased DAC amortization through the dynamic adjustment. Differences in persistency in the flow and structured bulk portfolios will not have the same impact on their respective DAC amortization because of the lower balance and the shorter estimated policy life on structured bulk transactions. See further information on the accounting for DAC in Note 1 in the Notes to Consolidated Financial Statements.
Deferred income taxes are provided for the differences in reporting taxable income in the financial statements and on the tax return. These cumulative differences are enumerated in Note 6 in the Notes to Consolidated Financial Statements. The largest cumulative difference is the special contingency reserve deduction for mortgage insurers mentioned above. The remainder of the deferred tax liability has primarily arisen from book and tax reporting differences related to deferred policy acquisition costs and unrealized investment gains.
We calculate our best estimate of reserves to provide for the estimated costs of settling claims on loans reported in default and loans in default that are in the process of being reported to us, utilizing various factors that have been developed and tested over time. With respect to loans reported in default, loss and loss adjustment expense reserves are established when notices of default are received. Consistent with industry practices, we do not establish loss reserves for future claims on insured loans that are not currently in default.
We analyze various components in determining the loss severity factor, including the baseline severity, policy year, geography and salvage recoverable. In determining the frequency factor, we focus our analysis on the policy year/policy age, the number of previous reported defaults to identify chronic late payers, and the number of months that the payment is past due. We utilize historical long-term performance in our reserving methodology and adjust our factors for current economic events when we believe the events will significantly impact the long-term loss development. For these reasons, there may be fluctuations in the reserve factors utilized from year to year. Further, we analyze individual defaults within structured bulk transactions to determine whether the business was written with a deductible that would put us in a second loss position. Until the projected loss reserve for the aggregate defaults within a transaction structured with a deductible exceed a pre-established threshold, no reserves are established. Because the estimate for loss reserves is sensitive to the estimates of claims frequency and severity, we perform analyses to test the reasonableness of the best estimate generated by the loss reserve process. Adjustments to reserve estimates are reflected in the financial statements in the periods in which the adjustments are made.
Experience indicates that years three through six have the highest incidence of defaults. Because of this fact, we expect loss reserves to continue to grow, reflecting the growth and aging of our insurance in force. However, we anticipate the increase in the loss reserves to be moderated somewhat as the number of structured bulk transactions with deductibles incorporated into the risk structure continues to increase. Based upon the current and reasonable estimates of future economic conditions, we expect cash flows from operations to be sufficient to cover the anticipated increase in expected claim payments.
Alt-A is included in flow and structured bulk business amounts above
The number of loans in default reported above includes all reported delinquencies that are in excess of two payments in arrears at the reporting date and all reported delinquencies that were previously in excess of two payments in arrears and have not been brought current. The increase in the default rate for flow business is attributable primarily to the maturing of the flow portfolio for reasons consistent with the increase in reserves explained above. The default occurrences for both flow business and structured bulk business are consistent with management’s expectation.
The following schedule shows the growth and diversification of our investment portfolio (dollars in thousands).
We seek to provide liquidity in our investment portfolio through cash equivalent investments and through diversification and investment in publicly traded securities. We attempt to maintain a level of liquidity and duration in our investment portfolio consistent with our business outlook and the expected timing, direction, and degree of changes in interest rates. See Note 2 in Notes to Consolidated Financial Statements that describes the scheduled maturity of our fixed maturity investments. The duration to maturity of the fixed maturity portfolio was 10.6 years at December 31, 2004 compared to 11.2 years at December 31, 2003.
Another way that we manage risk and liquidity is to limit our exposure on individual securities. The following table shows the ten largest exposures to an individual creditor in our investment portfolio as of December 31, 2004 (dollars in thousands):
The following table shows the results of our investment portfolio for the last three years (dollars in thousands).
These unrealized gains and losses do not necessarily represent future gains or losses that we will realize. Changing conditions related to specific securities, overall market interest rates, or credit spreads, as well as our decisions concerning the timing of a sale, may impact values we ultimately realize. We monitor unrealized losses through further analysis according to maturity date, credit quality, individual creditor exposure and the length of time the individual security has continuously been in an unrealized loss position. Of the gross unrealized losses on fixed maturity securities shown above, approximately $327,000 related to bonds with a maturity date in excess of ten years. The largest individual unrealized loss on any one security at December 31, 2004 was approximately $105,000 on a bond with an amortized cost of $2.0 million. Gross unrealized gains and losses at December 31, 2003 were $18.0 million and $(0.8) million, respectively.
landscape. One way we attempt to limit the inherent credit risk in the portfolio is to maintain investments with high ratings. The following table shows our investment portfolio by credit ratings (dollars in thousands).
In analyzing our potentially distressed securities list for other-than-temporary impairments, we pay special attention to securities that have been on the list for a period greater than six months. Our ability and intent to retain the investment for a sufficient time to recover its value is also considered. We assume that, absent reliable contradictory evidence, a security that is potentially distressed for a continuous period greater than nine months has incurred an other-than-temporary impairment. Such reliable contradictory evidence might include, among other factors, a liquidation analysis performed by our investment advisors or outside consultants, improving financial performance of the issuer, or valuation of underlying assets specifically pledged to support the credit.
Approximately $165,000 was a write-down on common stock of a pharmaceutical company for which patents on various products were expiring. The market value of the equity had fluctuated below 55% of its cost. We subsequently sold these securities at an amount that approximated its carrying value after
the write-down. The circumstances surrounding this impairment did not impact other securities in our portfolio.
Total stockholders’ equity increased to $437.3 million at December 31, 2004, from $369.9 million at December 31, 2003. This increase resulted primarily from 2004 net income of $58.4 million and additional paid-in-capital of $5.7 million resulting from the exercise of employee stock options and the related tax benefit.
Total statutory policyholders’ surplus for our insurance subsidiaries increased to $135.7 million at December 31, 2004, from $128.2 million at December 31, 2003. The primary difference between statutory policyholders’ surplus and equity computed under generally accepted accounting principles is the statutory contingency reserve. The balance in the statutory contingency reserve was $369.4 million at December 31, 2004, compared to $302.7 million at December 31, 2003. Statutory capital, for the purpose of computing the net risk in force to statutory capital ratio, includes both policyholders’ surplus and the contingency reserve. Statutory capital amounted to $505.1 million at December 31, 2004, compared to $430.9 million at December 31, 2003.
Triad’s ability to write insurance depends on the maintenance of its financial strength ratings and the adequacy of its capital in relation to risk in force. A significant reduction of capital or a significant increase in risk may impair Triad’s ability to write additional insurance. A number of states also generally limit Triad’s risk-to-capital ratio to 25-to-1. As of December 31, 2004, Triad’s risk-to-capital ratio was 14.0-to-1 as compared to 15.3-to-1 at December 31, 2003. The risk-to-capital ratio is calculated using net risk in force, which takes into account risk ceded under reinsurance arrangements, including captive risk-sharing arrangements as well as any applicable stop-loss limits, as the numerator, and statutory capital as the denominator.
Triad is rated “AA” by both Standard & Poor’s Ratings Services and Fitch Ratings and “Aa3” by Moody’s Investors Service. S&P has not changed its “Negative” rating outlook for the U.S. private mortgage insurance industry that was issued in July of 2003. In December 2004, Fitch maintained its “Negative” rating outlook for the U.S. private mortgage insurance industry. Currently, Fitch, S&P, and Moody’s all report a “Stable” ratings outlook for Triad. A reduction in Triad’s rating or outlook could adversely affect our operations.
We lease office facilities, automobiles, and office equipment under operating leases with minimum lease commitments that range from one to ten years. We have no capitalized leases or material purchase commitments.
The other long-term liabilities reflected on the Registrant’s balance sheet under GAAP category above is comprised of our reserve for losses and loss adjustment expenses.
Fixed maturity securities represented approximately 95% of our invested assets at December 31, 2004. While the fair value of these fixed rate securities generally bears an inverse relationship to changes in prevailing market interest rates, a change in market interest rates would not immediately impact earnings because we generally hold these securities until maturity. However, a decrease in market interest rates generally will have the effect of initiating an early call provision of those securities possessing such provisions. The proceeds relating to the early called securities in a decreasing interest rate environment generally are invested in lower yielding investments that would ultimately decrease earnings. Our long-term debt matures in 2028 with no early call or put provisions and bears interest at a fixed rate of 7.9% per annum. The fair value of this debt is sensitive to changes in prevailing interest rates; however, a change in rates would not impact earnings. We believe that a 20% increase or decrease in market interest rates is reasonable for the upcoming year. A 20% relative increase or decrease in market interest rates that affect our financial instruments would not have a material impact on earnings during the next fiscal year.
Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995
our financial condition and competitive position could be affected by legislation or regulation impacting the mortgage guaranty industry or the Government Sponsored Entities, specifically, and the financial services industry in general;
rating agencies may revise methodologies for determining our financial strength ratings and may revise or withdraw the assigned ratings at any time;
decreases in persistency, which are affected by loan refinancings in periods of low interest rates, may have an adverse effect on earnings;
There have been no significant changes in Triad Guaranty Inc.’s internal control over financial reporting during the quarter ended December 31, 2004 that would have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting in an adverse manner. There were several remediation efforts that improved the internal control over financial reporting that occurred in the fourth quarter of 2004, specifically in the area of documentation of management reviews of interim financial data.
Management of Triad Guaranty Inc. is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities and Exchange Act of 1934. Triad Guaranty Inc.’s internal control over financial reporting is a process designed to
Ernst & Young, LLP, Triad Guaranty Inc.’s independent registered public accounting firm that audits the consolidated financial statements of Triad Guaranty Inc. included in this report has audited management’s assessment of the effectiveness of internal control over financial reporting as of December 31, 2004 as stated in their report which appears below.
We have audited management’s assessment, included in the accompanying Management’s Annual Report on Internal Control over Financial Reporting, that Triad Guaranty Inc. maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Triad Guaranty Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.
In our opinion, management’s assessment that Triad Guaranty Inc. maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Triad Guaranty Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on the COSO criteria.
This information is included in our Proxy Statement for the 2005 Annual Meeting of Stockholders, and is hereby incorporated by reference.
(a) (1) and (2) The response to this portion of Item 15 is submitted as a separate section of this report.
October 29, 2004 - Triad Guaranty Inc. issued a news release announcing its financial results for the three-month and nine-month periods ended September 30, 2004.
January 27, 2005 - Triad Guaranty Inc. issued a news release announcing its financial results for the fourth quarter and the fiscal year ended December 31, 2004.
Senior Executive Vice President, Chief Operating Officer and Acting Chief Financial Officer
All other schedules are omitted since the required information is not present or is not present in amounts sufficient to require submission of the schedules, or because the information required is included in the consolidated financial statements and notes thereto.
Excess of Loss Reinsurance Agreement between Triad Guaranty Insurance Corporation and Ace Capital Mortgage Reinsurance Company.(8) (Exhibit 10.22)
Consulting Agreement between the Registrant, Triad Guaranty Insurance Corporation, Triad Guaranty Assurance Company and Collateral Mortgage, Ltd. Providing advice and counsel regarding the investment strategy and tactics of Conning Asset Management Company, the Registrant’s new investment advisor. (Exhibit 10.27)
Acting Chief Financial Officer Sarbanes-Oxley Act Section 302 Certification dated March 11, 2005, for the Triad Guaranty Inc.’s Annual report on Form 10-K for the year ended December 31, 2004
Acting Chief Financial Officer Sarbanes-Oxley Act Section 906 Certification dated March 11, 2005, for the Triad Guaranty Inc.’s Annual report on Form 10-K for the year ended December 31, 2004
Incorporated by reference to the exhibit identified in parentheses, filed as an exhibit in the Registrant’s Registration Statement on Form S-1 filed October 22, 1993 and amendments thereto.
Incorporated by reference to the exhibit identified in parentheses, filed as an exhibit in the 1999 Form 10-K.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Triad Guaranty Inc.’s internal control over financial reporting as of December 31, 2004, 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 10, 2005 expressed an unqualified opinion thereon.
Triad Guaranty Inc. (the “Company”) is a holding company which, through its wholly-owned subsidiary, Triad Guaranty Insurance Corporation (“Triad”), provides private mortgage insurance coverage in the United States to mortgage lenders or investors to protect the lender or investor against loss from defaults on low down payment residential mortgage loans.
The costs of acquiring new business, principally commissions and certain policy underwriting and issue costs, which vary with and are primarily related to the production of new business, are deferred. Amortization of such policy acquisition costs is charged to expense in proportion to premium revenue recognized over the estimated policy life.
of deferred costs is tested by calculating an estimated gross profit for each book year and comparing that to the unamortized asset balance by book year. If this comparison indicates a premium deficiency for a given book year, any unamortized acquisition cost to the extent of that deficiency is charged to expense.
Property and equipment is recorded at cost and is depreciated principally on a straight-line basis over the estimated useful lives, generally three to five years, of the depreciable assets. Property and equipment primarily consists of computer hardware, software, furniture, and equipment.
The Company uses the asset and liability method of accounting for income taxes. Under the asset and liability method, deferred tax assets and deferred tax liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
Federal tax law permits mortgage guaranty insurance companies to deduct from taxable income, subject to certain limitations, the amounts added to contingency loss reserves. Generally, the amounts so deducted must be included in taxable income in the tenth subsequent year. This deduction is allowed only to the extent that non-interest bearing United States Mortgage Guaranty Tax and Loss Bonds are purchased and held in an amount equal to the tax benefit attributable to such deduction. The Company accounts for these purchases as a prepayment of federal income taxes. Current income tax expense is primarily associated with the addition to taxable income in the current year of the contingency reserve deduction from ten years prior.
The Company writes policies that are guaranteed renewable contracts at the policyholder’s option on single premium, annual premium, and monthly premium bases. The Company does not have the option to re-underwrite these contracts. Premiums written on a monthly basis are earned in the month coverage is provided. Premiums written on annual policies are earned on a monthly pro rata basis. Single premium policies covering more than one year are amortized over the estimated policy life in accordance with the expiration of risk.
Cancellation of a policy generally results in the unearned portion of the premium paid being refunded to the policyholder. However, many of the annual paying policies are paid by the lender and are non-refundable. The cancellation of one of these policies would impact earned premium through the release of the unearned premium reserve at the time of the cancellation. The amounts earned through the cancellation of annual paying policies are not significant to earned premium.
During 2004, one customer accounted for approximately 16% and another customer accounted for approximately 14% of total revenue. In 2003, these same two customers accounted for approximately 14% each of the Company’s revenue while one customer accounted for approximately 11% of the Company’s revenue in 2002.
For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options’ vesting period. Had compensation expense for stock options been recognized using the fair value method on the grant date, net income and earnings per share on a pro forma basis would have been (in thousands, except for earnings per share data):
Basic and diluted earnings per share are based on the weighted-average daily number of shares outstanding. For diluted earnings per share, the denominator includes the dilutive effect on the weighted-average shares outstanding of employee stock options and nonvested restricted stock. There are no other reconciling items between the denominator used in basic earnings per share and diluted earnings per share.
The numerator used in basic earnings per share and diluted earnings per share is the same for all periods presented.
In December 2004, the Financial Accounting Standards Board issued Statement of Financial Standards (SFAS) No. 123 (revised 2004), “Share-Based Payment” (SFAS 123R). SFAS 123R requires the compensation cost relating to stock-based payment transactions to be recognized in financial statements. That cost will be measured based on the fair value of the equity instruments issued on the grant date of such instruments, and will be recognized over the period during which an individual is required to provide service in exchange for the award (typically the vesting period). SFAS 123R covers a wide range of stock-based compensation arrangements including stock options, restricted stock plans, performance-based awards, stock appreciation rights, and employee stock purchase plans. SFAS 123R replaces SFAS 123 and supersedes APB Opinion 25. SFAS 123R must be adopted no later than July 1, 2005. Early adoption will be permitted in periods in which financial statements have not yet been issued. The Company tentatively plans to adopt SFAS 123R in the first quarter of 2005, although a final decision has not been made.
SFAS 123R permits public companies to adopt its requirement using one of two methods: 1) A “modified prospective” method in which compensation cost is recognized beginning with the effective date (a) based on the requirements of SFAS 123R for all share-based payments granted after the effective date and (b) based on the requirements of SFAS 123R for all awards granted to employees prior to the effective date of SFAS 123R that remain unvested on the effective date; or 2) A “modified retrospective” method which includes the requirements of the modified prospective method described above, but also permits entities to restate based on the amounts previously recognized under SFAS 123R for purposes of pro forma disclosures either (a) all prior periods presented or (b) prior interim periods of the year of adoption. The Company plans to adopt SFAS 123R using the modified prospective method.
As permitted by SFAS 123, the Company currently accounts for share-based payments to employees using APB Opinion 25’s intrinsic value method and, as such, generally recognizes no compensation cost for employee stock options. Accordingly, the adoption of SFAS 123R’s fair value method will have a slight impact on the Company’s results of operations, although it will have no impact on our overall financial position. The impact of adoption of SFAS 123R cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. However, had the Company adopted SFAS 123R in prior periods, the
impact of that standard would have approximated the impact of SFAS 123 as described in the disclosure of pro forma net loss and loss per share in Note 1 to our consolidated financial statements. SFAS 123R also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. The Company cannot estimate what those amounts will be in the future (because they depend on, among other things, when employees exercise stock options, and whether the Company will be in a taxable position).
At December 31, 2004, the Company had 32 securities with gross unrealized losses. The following table shows the gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2004 (in thousands):
The majority of the gross unrealized losses related to fixed maturities that have been in a continuous loss position less than 12 months are due to changes in interest rates. The majority of the fixed maturities that have unrealized losses continuously for 12 months or more are the result of thinly traded securities that tend to have lower valuations than actively traded securities. None of the fixed maturity securities with unrealized losses have ever missed, or been delinquent on, a scheduled principal or interest payment. The unrealized losses related to equity securities are the result of what we perceive to be temporary market fluctuations. The Company reviews its investments quarterly to identify and evaluate whether any investments have indications of possible impairment. Factors considered in determining whether a loss is temporary include the length of time and extent to which fair value has been less than the cost basis, the financial condition and near-term prospects of the investee, and the Company’s intent and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery in market value. The Company believes at this point in time that the positive evidence far outweighs the negative evidence and all of these unrealized losses are temporary. Charges of $480,000 were recognized in 2004 and $785,000 in 2003 related to other-than-temporary declines in the fair values of certain fixed maturity and equity investments.
Net unrealized appreciation (depreciation) on fixed maturity securities changed by $3,477,000, $1,479,000, and $13,410,000 in 2004, 2003, and 2002, respectively; the corresponding amounts for equity securities were ($356,000), $2,460,000, and ($1,626,000).
The foregoing reconciliation indicates a deficiency in 2004. During the fourth quarter of 2003, claim severity had increased, particularly on paid claims related to structured bulk transactions from the 2001 and 2002 book years. At that time, the Company concluded that this extremely limited number of actual claim payments related to the 2001 and 2002 bulk book years did not constitute a long-term trend and did not adjust
Income tax expense differed from the amounts computed by applying the Federal statutory income tax rate to income before taxes as follows (in thousands):
At December 31, 2004, Triad had purchased $903,000 of Tax and Loss Bonds in excess of its current obligations.
At December 31, 2004, approximately 55% of Triad’s direct risk in force was concentrated in 10 states, with 10% in California, 8% each in Florida and Texas, 5% each in Georgia and Illinois, 4% each in North Carolina, Arizona, New York, and New Jersey, and 3% in Pennsylvania. While Triad continues to diversify its risk in force geographically, a prolonged recession in its high concentration areas could result in higher incurred losses and loss adjustment expenses.
Triad and its wholly-owned subsidiaries, TGAC and Triad Re, are each required under their respective domiciliary states’ insurance code to maintain a minimum level of statutory capital and surplus. Triad, an Illinois domiciled insurer, is required under the Illinois Insurance Code (the “Code”) to maintain minimum capital and surplus of $5,000,000.
Under the Company’s 1993 Long-Term Stock Incentive Plan (the “Plan”), certain directors, officers, and key employees are eligible to be granted various stock-based awards. The number of options or restricted shares of common stock authorized to be granted or issued under the Plan is 2,600,000 shares. The options issued under the Plan in 2004, 2003, and 2002 vest over three years. Certain of the options will immediately vest in the event of a change in control of the Company. Options granted under the Plan terminate no later than 10 years following the date of grant.
Information concerning the stock options under the plan is summarized below:
Information concerning stock options outstanding and exercisable at December 31, 2004, is summarized below:
At December 31, 2004, 950,095 shares of the Company’s common stock were reserved and 331,313 shares were available for issuance under the Plan.
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company’s stock options have characteristics significantly different from those of traded options and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options. The following table summarizes the fair value of options granted in 2004, 2003, and 2002:
Information about restricted stock granted under the plan for the years ended December 31, 2004, 2003 and 2002 is as follows:
The majority of these restricted stock grants vest over three years. Total compensation cost for these stock-based awards recognized in the accompanying consolidated statements of income was approximately $1,232,000 in 2004, $690,000 in 2003 and $392,000 in 2002.
The fair values of fixed maturity securities and equity securities have been determined using quoted market prices for securities traded in the public market or prices using bid or closing prices for securities not traded in the public marketplace.
The following is a summary of the unaudited quarterly results of operations for the years ended December 31, 2004 and 2003. (The sum of the quarterly basic earnings per share does not equal the amount
for the year as the basis for calculating average outstanding number of shares differs.) (dollars in thousands except per share data):
In the parent company financial statements, the Company’s investment in its subsidiaries is stated at cost plus equity in undistributed earnings of the subsidiaries. The Company’s share of net income of its subsidiaries is included in income using the equity method. The accompanying Parent Company financial statements should be read in conjunction with the Consolidated Financial Statements and Notes to Consolidated Financial Statements included as part of this Form 10-K.
Triad Guaranty Inc. (the “Company”) is a holding company which, through its wholly-owned subsidiary, Triad Guaranty Insurance Corporation (“Triad”), provides private mortgage insurance coverage in the United States to mortgage lenders to protect the lender against loss from defaults on mortgage loans.
Major categories of the parent company’s investment income are summarized as follows (in thousands):