Financial Guaranty. We are the lead investor in FGIC Corporation, whose subsidiary, Financial Guaranty Insurance Company (collectively, “FGIC”), provides financial guaranty insurance. We also have a significant interest in RAM Reinsurance Company, Ltd., or RAM Re, a financial guaranty reinsurance company based in Bermuda. Net income from our Financial Guaranty segment was $72.2 million in 2005 and $60.7 million in 2004.
Other Items Affecting this Segment. Our Other segment also includes net investment income from our holding company, expenses related to corporate overhead, including employee compensation expense not included in U.S. Mortgage Insurance Operations, interest expense and, in the first quarter of 2004, the net income from discontinued operations and the gain on the sale of APTIC.
We account for our unconsolidated subsidiaries and limited partnerships using the equity method of accounting. Equity in earnings from FGIC, our largest strategic investment, was $74.9 million in 2005 compared to $61.6 million in 2004. This increase was primarily due to higher premiums earned and higher investment income, partially offset by a $20.8 million increase in FGIC’s reserves in the third quarter of 2005 resulting from Hurricane Katrina. We invested in FGIC in December 2003. Our 2003 consolidated equity in earnings was negatively affected by charges taken by SPS in that year of $55.0 million (pre-tax) primarily in connection with its settlement of certain regulatory and civil actions. Our proportionate share of the SPS charges was $17.8 million net of tax.
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, a proportionate amount of PMI’s gross premiums written is ceded to these captive reinsurance companies. 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:
Equity in earnings from unconsolidated subsidiaries-U.S. Mortgage Insurance Operation’s equity in earnings are derived entirely from the results of operations of CMG. Equity in earnings from CMG increased to $18.8 million in 2005 from $15.3 million in 2004 and $13.6 million in 2003, primarily as a result of increases in CMG’s primary insurance and risk in force.
Net loss reserves increased by $7.0 million in 2005 due to increases in PMI’s expected claim rates associated with the portion of PMI’s portfolio that contains ARMs, high LTV and less-than-A quality loans and increased delinquencies related to the 2005 hurricanes. Changes in net loss reserves increased in 2004 compared to 2003 due to an increase in 2004 in PMI’s primary loans in default inventory. (See Critical Accounting Polices-Reserves for Losses and LAE.)
PMI’s modified pool default data are presented in the table below.
The table below shows the main components of FGIC’s 2005, 2004, and 2003 financial results prior to, and after, our investment in FGIC on December 18, 2003.
The 6.75% Senior Notes described above relate to our issuance in November 1996 of $100.0 million in face amount of 6.75% senior notes, of which $62.95 million remain outstanding. The Senior Notes bear interest at the rate of 6.75% per annum paid semiannually and mature on November 15, 2006. No sinking fund is required or provided for the Senior Notes and they are not redeemable prior to maturity. We expect to refinance or repay the Senior Notes at or prior to maturity.
PMI has entered into various capital support agreements with its Australian and European subsidiaries that could require PMI to make additional capital contributions to those subsidiaries for rating agency purposes. With respect to the Australian and European subsidiaries, The PMI Group guarantees the performance of PMI’s capital support obligations. In 2001, PMI executed a capital support agreement whereby it agreed to contribute funds, under specified conditions, to maintain CMG’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, exclusive of capital contributions that PMI made prior to April 10, 2001. On December 31, 2005, CMG’s risk-to-capital ratio was 12.2 to 1 compared to 13.0 to 1 as of December 31, 2004.
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 any 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, 2005, we estimate that the total principal balance of indemnified loans was between approximately $60 million and $80 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 2005, we paid customers $1.1 million pursuant to loan indemnifications compared to approximately $1.4 million in 2004. These amounts are included in our expenses associated with contract underwriting remedies.
International Operations includes reserves for losses and LAE for PMI Australia and PMI Europe.
The above loss reserve reconciliation shows the components of changes in our reserves for losses and LAE for the periods presented. Losses and LAE payments of $246.5 million, $219.0 million and $204.6 million for the periods ended 2005, 2004 and 2003, respectively, reflect amounts paid during the period presented and are not subject to estimation. Losses and LAE incurred, net of changes to prior years, of $253.3 million, $233.2 million and $214.7 million for the periods ended 2005, 2004 and 2003, respectively, are management’s best estimates of ultimate losses and LAE and, therefore, are subject to change. These estimation changes are principally reflected within the total losses and LAE incurred line item which reflects an increase to incurred related to prior years of $6.3 million for the period ended 2005 and reductions to incurred related to prior years of $5.9 million and $3.6 million for the periods ended 2004 and 2003,
respectively. The table below breaks down the 2005, 2004 and 2003 changes in reserves by particular accident years.
consistent with our revenue recognition policy. We review our estimation process, specifically related to single premium policies, on a regular basis and any adjustments made to the estimates are reflected in the current period’s consolidated net income. Deferred policy acquisition costs are reviewed periodically to determine that they do not exceed recoverable amounts, after considering investment income.
The $2.6 million, $11.1 million and $19.1 million reductions in total losses and LAE incurred in prior years were due to re-estimations of ultimate loss rates and amounts from those established at the original notice of default, updated through the period presented. These re-estimations of ultimate loss rates and amounts are the result of management’s periodic review of estimated claim amounts in light of actual claim amounts, loss development data or ultimate claim rates. The $19.1 million reduction in prior years’ reserves during 2003 was due primarily to a reduction in PMI Australia’s loss reserves and favorable PMI pool portfolio loss development trends.
Revolving Credit Facility-In December 2004, the Company entered into a five-year $175.0 million revolving credit facility agreement with Bank of America, N.A. and a consortium of lenders. The interest rate is LIBOR plus a margin. The agreement provides the availability of additional liquidity and capital, which the Company can utilize for working capital, capital expenditures and other business purposes. The facility may be increased by $25.0 million to $200.0 million at the Company’s discretion subject to approval by the lenders. In June 2005, the Company entered into a $25 million letter of credit sub-limit. The $25 million letter of credit sub-limit is part of, and not in addition to, the existing $175 million revolving credit agreement. The revolving credit facility contains certain financial covenants and restrictions, the most restrictive being debt-to-capital and risk-to-capital ratio thresholds. The Company was in compliance with all debt covenants for the year ended December 31, 2005. There were no amounts related to the revolving credit facility outstanding as of December 31, 2005. A $1.2 million standby letter of credit is outstanding under the letter of credit sub-limit facility as of December 31, 2005.
The Company’s accumulated benefit obligation for its pension plans at December 31, 2005 was $54.5 million and $10.6 million, the combination of which equals the $65.1 million accumulated benefit obligation. As of December 31, 2005, the combined fair value of plan assets approximates our combined accumulated benefit obligation. The health care cost trend on covered charges for other postretirement benefits was 10% in 2005, which will be reduced by 1% per year to 5% in 2010. In 2005, the Company contributed $4.4 million to its qualified pension plan, approximating the maximum annual deductible under IRS rules, which was $4.5 million for 2005. Benefits paid during 2004 increased primarily as a result of lump sum distributions to former APTIC employees. During 2004, the Company exceeded certain threshold tests related to these lump sum distributions due primarily to the sale of APTIC, and as such, a $1.7 million increase was recorded to the Company’s benefit obligations. This occurrence triggered settlement accounting under SFAS No. 88, Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits, which requires immediate recognition in current reported consolidated net income of the delayed recognition in net periodic pension cost of certain elements arising from adoption or modification of a pension plan; namely projected benefit obligation gains and losses, plan asset gains and losses, transition amounts, and costs of retroactive plan amendments. This charge was recorded as an offset to the Company’s net gain on sale of APTIC in accordance with SFAS No. 144. Additional Cost in Components of Net Periodic Benefit Cost in the above table includes this charge and a $1.4 million curtailment charge recorded in the first quarter of 2004 also relating to the sale of APTIC.