Management’s Discussion and Analysis of Financial Condition and Results of Operations analyzes the consolidated financial condition, changes in financial position, and results of operations for the three years ended December 31, 2005, of Triad Guaranty Inc. and its consolidated subsidiaries, collectively the Company. The discussion should be read in conjunction with the Consolidated Financial Statements and Notes.
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 as of the date of our financial statements. Our reserving process incorporates various components in a model 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. We monitor the claims paid performance monthly and we assess the adequacy of our reserve quarterly. The process is based upon the assumption that long-term historical experience, taking into consideration factors such as those described above 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.
We believe captive reinsurance arrangements are an effective risk management tool as selected lenders share in the risk under these arrangements. Additionally, captive reinsurance arrangements are structured so that Triad receives credit against the capital required in certain risk-based capital models utilized by rating agencies. We remain committed to structuring captive reinsurance arrangements, including deep ceded arrangements where the net premium cede rate is greater than 25%, on a lender-by-lender basis as we deem it to be prudent. We will continue to be an active participant with our lender partners in captive reinsurance arrangements.
During 2005, the average premium rate on Primary risk in force increased as the result of a greater percentage of our risk in force in the Alt-A and ARM products that require higher premium rates. The following tables highlight the percentages of the Primary risk in force by credit quality and loan type at December 31 for the last three years:
force at December 31, 2005, 2004 and 2003 by policy year (which is defined as the year the insurance became effective):
The reserve for losses and loss adjustment expenses increased in 2005 over 2004, primarily due to an increase in defaults, changes in the frequency of defaults resulting in claims and an increase in severity utilized in our reserving methodology. The number of loans in default 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 Primary insurance is attributable to the continued seasoning of our business as a greater percentage of the insurance in force moves into the peak claim paying period. Additionally, as the Alt-A business becomes a larger percentage of the insurance in force, we expect default rates to increase.
Our objective is controlled, profitable growth in both Primary and Modified Pool business 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. Competition within the mortgage insurance industry continues to increase as many large mortgage lenders have limited the number of mortgage insurers with whom they do business. At the same time, consolidation among national lenders has increased the share of the mortgage origination market controlled by the largest lenders and that has led to further concentrations of business with a relatively small number of lenders. Many of the national lenders allocate Primary business to several different mortgage insurers. These allocations can go up or down over time. Our ten largest customers were responsible for 77%, 71%, and 74% of Primary insurance written during 2005, 2004, and 2003, respectively. Our two largest customers were responsible for 58%, 55%, and 58% of Primary insurance written during 2005, 2004, and 2003, respectively. Through actively seeking business with other lenders that meet our criteria, we are attempting to broaden our customer base and limit our concentration with these two largest lenders. The loss of or considerable reduction in business from one or more of these significant customers without a corresponding increase from other lenders would have an adverse effect on our business.
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 $727,000 related to bonds with a maturity date in excess of ten years. The largest individual unrealized loss on any one security at December 31, 2005 was approximately $78,000 on a corporate bond with an amortized cost of $5.0 million. Gross unrealized gains and losses at December 31, 2004 were $20.9 million and $(0.6) million, respectively.
Total stockholders’ equity increased to $499.2 million at December 31, 2005, from $437.3 million at December 31, 2004. This increase resulted primarily from 2005 net income of $56.8 million and additional paid-in-capital of $5.4 million resulting from activity related to equity awards to employees and the associated tax benefit.