Portfolio revenue, which in turn is primarily affected by net interest income, gain on sale and liquidation and hedging gains and losses related to portfolio assets, net of mark-to-market and whole loan reserve changes.
Underwriting and other expenses decreased in 2005, compared to 2004, primarily as a result of decreases in expenses related to contract underwriting activity.
In 2005, to reduce exposure to certain geographical areas and categories of risk, including Alt A loans (loans with reduced levels of borrower disclosure or verification of borrower disclosure), the Company entered into two separate excess of loss reinsurance agreements under which it ceded approximately $85.5 million of risk in force in the aggregate to two special purpose reinsurance companies (the “SPRs”). The SPRs are not affiliated with the Company and were formed solely to enter into the reinsurance arrangements. The SPRs obtained their capital from institutional investors by issuance of various classes of notes the return on which is linked to the performance of the reinsured portfolio. The SPRs invested the proceeds of the notes in high quality short-term investments. Income earned on those investments and reinsurance premiums paid by the Company are applied to pay interest on the notes as well as expenses of the SPRs. The investments will be liquidated to pay reinsured loss amounts to the Company. Proceeds not required to pay reinsured losses will be applied to pay principal on the notes. Premiums ceded under these agreements have not been material and are included in “ceded premiums.”
In 2005, net losses incurred were $554 million, of which $680 million pertained to current year loss development and ($126) million pertained to favorable prior years’ loss development. In 2004, net losses incurred were $701 million, of which $714 million pertained to current year loss development and ($13) million pertained to favorable prior years’ loss development. See “Note 6. Loss reserves” to the Company’s consolidated financial statements.
Information about net losses paid in 2005, 2004 and 2003 appears in the table below.
Reserves are established by management using estimated claims rates and claims amounts in estimating the ultimate loss. The estimated claims rates and claims amounts represent what management believes best reflect the estimate of what will actually be paid on the loans in default. These estimates are based on management’s review of trends in the default inventory, such as defaults that have resulted in a claim, the amount of the claim, the change in the level of defaults by geography and the change in average loan exposure. Amounts for salvage recoverable are considered in the determination of the reserve estimates. The establishment of loss reserves is subject to inherent uncertainty and requires significant judgment by management. Adjustments to reserve estimates are reflected in the financial statements in the years in which the adjustments are made. The liability for reinsurance assumed is based on information provided by the ceding companies.
When the policy term ends, the primary mortgage insurance written by the Company is renewable at the insured’s option through continued payment of the premium in accordance with the schedule established at the inception of the policy term. The Company has no ability to reunderwrite or reprice these policies after issuance. Premiums written under policies having single and annual premium payments are initially deferred as unearned premium reserve and earned over the policy term. Premiums written on policies covering more than one year are amortized over the policy life in accordance with the expiration of risk which is the anticipated claim payment pattern based on historical experience. Premiums written on annual policies are earned on a monthly pro rata basis. Premiums written on monthly policies are earned as the monthly coverage is provided. When a policy is cancelled, all premium that is non-refundable is immediately earned. Any refundable premium is returned to the lender and will have no effect on earned premium. Policy cancellations also lower the persistency rate which is a variable used in calculating the rate of amortization of deferred policy acquisition costs discussed below.
The following consolidated financial statements of the Company are filed pursuant to this Item 8:
The Company’s short-term investments consist entirely of money market funds and commercial paper with maturities of less than 90 days. For purposes of the consolidated statement of cash flows, the Company considers short-term investments to be cash equivalents. A reconciliation follows:
In December 2004 the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123R, “Share-Based Payment”. This statement is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation”. The fair value recognition provisions of SFAS No. 123 were voluntarily adopted by the Company in 2003 prospectively to all employee awards granted or modified on or after January 1, 2003 under SFAS No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure”. The adoption did not have a material effect on the Company’s results of operations or its financial position. SFAS No. 123R requires that the compensation cost relating to share-based payment transactions be measured based on the fair value of the equity or liability instrument issued and be recognized in the financial statements of the company. In April 2005 the effective date of this statement was delayed. SFAS No. 123R is now effective for annual reporting periods that begin after June 15, 2005. The statement will be adopted by the Company beginning January 1, 2006 under the modified prospective method. The adoption will not have a material effect on the Company’s results of operations or its financial position.
The amortized cost, gross unrealized gains and losses and fair value of the investment portfolio at December 31, 2005 and 2004 are shown below. Debt securities consist of fixed maturities and short-term investments.
Total rental expense under operating leases was $7.6 million, $8.0 million and $8.2 million in 2005, 2004 and 2003, respectively.