PMI completed the purchase of a seven-story office building consisting of approximately 200,500 square feet in Walnut Creek, California in June 2002. PMI subsequently transferred this asset, named PMI Plaza, to PMI Plaza LLC, a wholly-owned subsidiary of PMI. PMI, which relocated its home office from San Francisco to PMI Plaza in August 2002, currently leases approximately 120,800 square feet of office space from PMI Plaza LLC. PMI is in the process of subleasing its former home office of approximately 100,000 square feet in San Francisco under a lease which expires in December 2004. The remaining rent owed on this lease has been written off as a one-time charge associated with the relocation to Walnut Creek. PMI leases 21 branch offices throughout the United States and its operations data center in Rancho Cordova, California. We conduct our international operations in leased facilities in Ireland, Australia, New Zealand and Hong Kong. We believe our existing properties are well-utilized and are suitable and adequate for our operations.
When a forward-looking statement includes an underlying assumption, we caution that, while we believe the assumption to be reasonable and make it in good faith, assumed facts almost always vary from actual results, and the difference between assumed facts and actual results can be material. Where, in any forward-looking statement, we express an expectation or belief as to future results, there can be no assurance that the expectation or belief will result. Our actual results may differ materially from those expressed in any forward-looking statement made by us. Forward-looking statements involve a number of risks of uncertainties including, but not limited to, the risks described under the heading “Investment Considerations.” All forward-looking statements are qualified by and should be read in conjunction with those risk factors. Except as may be required by applicable law, we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.
primary NIW by our U.S. mortgage insurance operations and the corresponding growth in our primary mortgage insurance portfolio. The inclusion of PMI Indemnity’s results also contributed to the growth of our insurance portfolio and premiums earned. We acquired PMI Indemnity, one of our Australian subsidiaries, in September 2001 and included its results in our results of operations beginning in the fourth quarter of 2001. The increase in premiums earned in 2001 compared to 2000 was attributable primarily to an increase in the volume of primary NIW by our U.S. mortgage insurance operations and the corresponding growth in our insurance portfolio. Additional revenue discussions are included in the business segment sections below.
Deferred policy acquisition costs consist of direct costs related to PMI’s acquisition, underwriting and processing of new insurance including contract underwriting and sales related activities. These costs are initially recorded as assets and amortized against related premium revenue for each policy year book of business. Policy acquisition costs incurred and deferred are variable and fluctuate in line with the volume of NIW, and are offset by increased efficiencies due to the use of PMI’s electronic origination and delivery methods. Electronic delivery accounted for approximately 69% of PMI’s insurance commitments from its primary flow channel in 2002, 52% in 2001 and 23% in 2000.
Losses and loss adjustment expenses-PMI Australia’s losses and loss adjustment expenses were $7.1 million in 2002, compared to $9.3 million in 2001 and $5.7 million in 2000. The decrease in 2002 was due largely to declines in average claim size and claim payments. The increase in 2001 was a result of the acquisition of PMI Indemnity, and the refinement of PMI Australia’s claims provisioning methodology. Effective December 31, 2001, we revised PMI Australia’s reserving methodology to be based on defaults reported and defaults incurred but not reported, which is consistent with our methodology for our U.S. operations. This revision increased loss reserves by $3.3 million in 2001. PMI Australia’s loss ratios were 11.9% in 2002, and 21.3% in 2001 and 2000.
Premiums earned for PMI Europe were $2.1 million in 2002 compared to $0.2 million in 2001, and the increase was largely attributable to new business written and to the growth of PMI Europe’s portfolio. PMI Europe incurred $0.9 million of operating expenses in 2002 compared to $0.4 million in 2001, primarily driven by business expansion.
The PMI Group’s principal sources of funds are dividends from its subsidiaries, primarily PMI and APTIC, investment income, and funds that may be raised from time to time in the capital markets. PMI generates substantial cash flows from premiums written on its insurance business and from investment returns on its investment portfolio.
PMI’s ability to pay dividends to The PMI Group is affected by state insurance laws, credit agreements, rating agency actions and the discretion of insurance regulatory authorities. The laws of Arizona, PMI’s state of
government mortgage insurance programs, including those of the FHA and the VA;
42% of PMI’s primary risk in force consisted of mortgages with loan-to-value ratios greater than 90% but less than or equal to 95%, which we refer to as 95s. Risk in force is the dollar amount equal to the product of each individual insured mortgage loan’s current principal balance and the percentage specified in the insurance policy of the claim amount that would be payable if a claim were made. In our experience, 95s have higher claims frequency rates than mortgages with loan-to-value ratios greater than 85% but less than or equal to 90%, which we refer to as 90s.
standards imposed by state insurance regulators relating to the payment of dividends by insurance companies.
Basis of Accounting-The financial statements have been prepared in accordance with GAAP. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates.
Investments in Unconsolidated Subsidiaries-Investments in unconsolidated subsidiaries with ownership interests of 20-50% are accounted for on the equity method of accounting, and investments of less than 20% ownership interest are generally accounted for on the cost method of accounting if the Company does not have significant influence over the entity. The Company generally reports the equity earnings of its unconsolidated subsidiaries on either a one-month or one-quarter lag basis. Fairbanks, the Company’s most significant unconsolidated subsidiary, is accounted for on a one-month lag. The investment in Fairbanks includes a goodwill component of approximately $35 million. During the third quarter of 2002, the Company acquired an additional
Business Segment-The Company’s reportable operating segments include U.S. Mortgage Insurance Operations, International Mortgage Insurance, Title Insurance and Other. The Other segment includes the income and expenses of TPG (including equity earnings of unconsolidated subsidiaries except CMG, which is included in U.S. Mortgage Insurance Operations), contract underwriting services and an inactive broker-dealer.
Equity Incentive Plan-In 2001, the shareholders approved the amendment of The PMI Group, Inc. Equity Incentive Plan (“Equity Incentive Plan”) and The PMI Group, Inc. Stock Plan for Non-Employee Directors (“Directors Plan”), to reflect the merger of the Directors Plan into the Equity Incentive Plan. Pursuant to the merger, the director awards are now made under the Equity Incentive Plan on substantially the same terms and conditions as were in effect under the Director Plan before the plan merger date. The Equity Incentive Plan provides for awards of both non-qualified stock options and incentive stock options, stock appreciation rights, restricted stock subject to forfeiture and restrictions on transfer, and performance awards entitling the recipient to receive cash or common stock in the future following the attainment of performance goals determined by the Board of Directors. Generally, options are granted with an exercise price equal to the market value on the date of grant, expire ten years from the grant date and have a three-year vesting period. The directors’ award program provides that each director who is not an employee of the Company receives an annual grant of up to 675 shares of common stock and receives 5,625 shares of stock options annually, after an initial option of up to 2,500 shares. The shares are granted on June 1 of each year or as soon as administratively practicable after each anniversary of the director’s commencement of 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 of fair market value of the stock at the beginning or ending of each six-month enrollment period, whichever is lower. Under the ESPP, the Company sold approximately 66,635 shares in 2002, 53,386 shares in 2001 and 47,276 shares in 2000. The Company applies APB 25 in accounting for the ESPP. The pro forma effect on the Company’s net income and earnings per share had compensation cost been determined under SFAS No. 123 was deemed immaterial.
Accounting changes adopted to conform to the provisions of the NAIC Accounting Practices and Procedures Manual are reported as changes in accounting principles. The cumulative effect of changes in accounting principles is reported as an adjustment to unassigned funds, or surplus, at the end of the period in which the change in accounting principle occurs. The cumulative effect is the difference between the amount of capital and surplus at the beginning of the period and the amount of capital and surplus that would have been reported at that date if the new accounting principles had been applied retroactively for all prior periods. As a result of these changes, the Company reported an increase in statutory unassigned funds of $6.2 million in January 2001.
Under the insurance laws of the state of Arizona and several other states, mortgage insurers are required to establish a special contingency reserve from unassigned funds, with annual additions equal to 50% of premiums earned for that year. 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 2002, $69 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 reserve an amount equal to the excess portion of such losses.