PMI Group 10-K 2007
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
For the fiscal year ended December 31, 2006
For the transition period from to
Commission file number 1-13664
THE PMI GROUP, INC.
(Exact name of registrant as specified in its charter)
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to Section 12(g) of the Act:
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x No ¨
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No x
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and larger accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
The aggregate market value of the voting stock (common stock) held by non-affiliates of the registrant as of the close of business on June 30, 2006 was approximately $2.8 billion based on the closing sale price of the common stock on the New York Stock Exchange consolidated tape on that date. All executive officers and directors, and beneficial owners of 10% or more of the outstanding shares, of the registrant have been deemed, solely for the purpose of the foregoing calculation, to be affiliates of the registrant.
Number of shares outstanding of registrants common stock, as of close of business on January 31, 2007: 86,873,215
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Proxy Statement for registrants Annual Meeting of Stockholders to be held on May 17, 2007 are incorporated by reference into Items 10 through 14 of Part III.
TABLE OF CONTENTS
Cautionary Statement Regarding Forward-Looking Statements
Statements we make or incorporate by reference in this and other documents filed with the Securities and Exchange Commission that are not historical facts, that are preceded by, followed by or include the words believes, expects, anticipates, estimates or similar expressions, or that relate to future plans, events or performance are forward-looking statements within the meaning of the federal securities laws. 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 our forward-looking statements. Forward-looking statements involve a number of risks or uncertainties including, but not limited to, the Risk Factors addressed in Item 1A below. Other risks are referred to from time to time in our periodic filings with the Securities and Exchange Commission. All of our forward-looking statements are qualified by and should be read in conjunction with our risk disclosures. 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.
We provide financial products designed to reduce risk, lower costs and expand market access for residential mortgages, public finance obligations and asset-backed securities. Our products include:
Through our U.S., International and Financial Guaranty segments, we offer these products across the credit spectrum and around the world.
Our mortgage insurance and structured finance products support the mortgage finance system by providing protection to mortgage lenders and investors in the event of borrower default. By protecting lenders and investors from credit losses, we help to ensure that mortgages are available to prospective homebuyers. Our financial guaranty products also support the infrastructure on which homeownership depends, including transportation, schools, hospitals, and utilities.
U.S. Mortgage Insurance Operations. Our U.S. subsidiary, PMI Mortgage Insurance Co., including its affiliated U.S. companies, collectively referred to as PMI, is a leading U.S. residential mortgage insurer. PMI offers a variety of mortgage insurance and structured finance products, each tailored to the needs of the U.S. market. By mitigating borrower default risk, PMI helps financial institutions reduce the capital needed to meet regulatory and rating agency capital requirements. By providing first and mezzanine loss credit enhancement for the mortgage-backed security markets, PMI allows investors to manage and diversify credit risk and achieve greater confidence in their portfolios performance.
We own 50% of CMG Mortgage Insurance Company, or CMG MI, a joint venture that provides mortgage insurance exclusively to credit unions. Our U.S. Mortgage Insurance Operations segment generated 67.8% of our consolidated revenues in 2006.
International Operations. Through our Australian subsidiaries (collectively, PMI Australia), we are one of the leading providers of mortgage insurance in Australia and New Zealand. PMI Australia provides credit enhancement products to lending institutions as well as credit enhancement for residential mortgage-backed securitizations. Our European subsidiaries (collectively, PMI Europe) offer mortgage insurance and mortgage credit enhancement products, including primary mortgage insurance, structured portfolio products and reinsurance products, primarily tailored to the European mortgage markets. Our Hong Kong subsidiary, PMI Asia, offers mortgage insurance and reinsurance to residential mortgage lenders and investors in Asian markets. We expect to begin offering mortgage insurance in Canada in the first half of 2007.
Financial Guaranty. We are the lead investor in FGIC Corporation, whose triple-A rated wholly-owned subsidiary, Financial Guaranty Insurance Company (FGIC), provides financial guaranty insurance for public finance and structured finance obligations. FGIC provides credit enhancement solutions that enable municipal and asset-backed issuers to reduce their borrowing costs and facilitate access to capital markets. In 2006, we established a surety company, PMI Guaranty Co., to provide credit enhancement at the mezzanine and remote loss levels for mortgage- and asset-backed securities, and reinsurance on public finance obligations. PMI Guaranty offers direct insurance to issuers and lenders and reinsurance to financial guarantors. We also have a substantial ownership stake in RAM Holdings Ltd., the parent company of RAM Reinsurance Company Ltd. (RAM Re), a Bermuda-based financial guaranty reinsurance company.
Financial Strength Ratings. Insurer financial strength ratings are provided by independent rating agencies and are based on their assessment of the financial risks associated with historical business activities and new
business initiatives. In their assessments, the rating agencies model the adequacy of capital to withstand severe loss scenarios and review, among other things, corporate strategy, operational performance, available liquidity, the outlook for the relevant industry, and competitive position. Maintenance of financial strength ratings is crucial to our ability to issue our products in the future. The rating agencies can change or withdraw their ratings at any time.
S&P and Fitch have assigned our holding company, The PMI Group, Inc., an A and A+ counterparty credit rating and senior unsecured debt rating, respectively, and Moodys has assigned an A1 senior unsecured debt rating.
Our consolidated net income was $419.7 million for the year ended December 31, 2006. As of December 31, 2006, our consolidated total assets were $5.3 billion, including our investment portfolio of $3.3 billion. Our consolidated shareholders equity was $3.6 billion as of December 31, 2006. See Item 8. Financial Statements and Supplementary DataNote 17. Business Segments, for financial information regarding our business segments.
Our website address is http://www.pmigroup.com. Information on our website does not constitute part of this report. Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports are available free of charge on our website via a hyperlink as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission.
The PMI Group, Inc. is a Delaware corporation. Our principal executive offices are located at 3003 Oak Road, Walnut Creek, California 94597-2098, and our telephone number is (925) 658-7878.
Through PMI, we provide residential mortgage insurance and structured finance products to mortgage lenders, capital market participants and investors throughout the United States. PMI is incorporated in Arizona, headquartered in Walnut Creek, California, and licensed in all 50 states, the District of Columbia, Puerto Rico, Guam, and the Virgin Islands. Under its monoline insurance licenses, PMI may only offer mortgage insurance covering first lien, one to four family residential mortgages.
Residential mortgage insurance protects mortgage lenders, and subsequent holders of insured mortgage loans, in the event of borrower default, by reducing and, in some instances, eliminating the resulting loss to the insured institution. By mitigating default risk, residential mortgage insurance facilitates the origination of low down payment mortgages, generally mortgages with down payments of less than 20% of the homes values. Mortgage insurance also reduces the capital that financial institutions are required to hold against low down payment mortgages and facilitates the sale of low down payment mortgage loans in the secondary mortgage market.
Traditionally, residential mortgage insurance has provided first loss protection on loans held by portfolio lenders and insured loans sold to Fannie Mae and Freddie Mac (the GSEs or the agency market). Structured
finance products, in the form of mortgage insurance, have become increasingly important as first loss and mezzanine loss forms of credit enhancement of mortgage-backed securities issued by capital market participants other than the GSEs (the non-agency market). As described below, PMI offers a variety of mortgage insurance and structured finance products to meet the demands of the mortgage origination, agency and non-agency markets.
(a) Primary Mortgage Insurance
Primary insurance provides the insured with first loss mortgage default protection on individual loans at specified coverage percentages. Our maximum obligation to an insured with respect to a claim is generally determined by multiplying the coverage percentage selected by the insured by the loss amount on the defaulted loan. The loss amount includes any unpaid loan balance, delinquent interest and certain expenses associated with the loans default and property foreclosure. In lieu of paying the coverage percentage of the loss amount on a defaulted loan, we generally may: (i) pay the full loss amount and take title to the mortgaged property, or (ii) in the event that the property is sold prior to settlement of the claim, pay the insureds actual loss.
We offer primary mortgage insurance on a loan-by-loan basis to lenders through our flow channel. We also offer issuers of mortgage-backed securities (MBS) and portfolio investors primary mortgage insurance that covers large portfolios of mortgage loans. These structured finance products may provide regulatory capital relief and default protection to portfolio investors, including the GSEs, or may serve as credit enhancement for agency and non-agency MBS transactions.
PMIs primary insurance in force and primary risk in force at December 31, 2006 were $102.6 billion and $25.7 billion, respectively. Primary insurance in force refers to the current principal balance of all outstanding mortgage loans with primary insurance coverage as of a given date. Primary risk in force is the aggregate dollar amount of each primary insured mortgage loans current principal balance multiplied by the insurance coverage percentage specified in the policy. The chart below shows our U.S. primary new insurance written, or NIW, for the years ended December 31, 2006, 2005 and 2004. NIW refers to the original principal balance of all loans that receive new primary mortgage insurance coverage during a given period.
Primary Flow Channel. Lenders purchase primary mortgage insurance through our flow channel to reduce default risk, to obtain capital relief and, most often, to facilitate the sale of their low down payment loans to the GSEs and other investors. The GSEs purchase residential mortgages from lenders and investors as part of their governmental mandate to provide liquidity in the secondary mortgage market. As the GSEs have traditionally been the principal purchasers of conventional mortgage loans, mortgage lenders have typically originated such loans in conformance with GSE guidelines for sellers and servicers. These guidelines reflect the GSEs own charter requirements which, among other things, allow the GSEs to purchase low down payment mortgage loans only if the lender: (i) secures mortgage insurance on those loans from an eligible insurer, such as PMI; (ii) retains a participation of not less than 10% in the mortgage; or (iii) agrees to repurchase or replace the mortgage in the event of a default under specified conditions. If the lender retains a participation in the mortgage or agrees to repurchase or replace the mortgage, banking regulations may increase the level of capital required to be held by the lender to reflect the lenders increased obligations, which could in turn increase the lenders cost of doing business.
The GSEs also have established approval requirements for eligible mortgage insurers. The approval requirements cover substantially all areas of PMIs mortgage insurance operations and require disclosure of
certain activities and new products to the GSEs. In addition, the requirements mandate that eligible mortgage insurers must maintain at least two of the following three ratings: AA- by S&P or Fitch, or Aa3 by Moodys.
Lenders that purchase mortgage insurance select specific coverage levels for insured loans. As a result of the GSEs coverage requirements, lenders generally select a coverage percentage that effectively reduces the ratio of the original loan amount to the value of the property, or LTV, to not more than 80%. We charge higher premium rates for higher coverage, as higher coverage percentages generally result in higher amounts paid per claim. Higher LTV loans generally have higher coverage percentages and higher average premiums. Refinanced mortgage loans we insure typically have lower LTVs, and therefore lower coverage percentages and premium rates, than purchase money mortgages due to the home price appreciation often associated with refinanced loans. Purchase money mortgages, which generally have higher LTVs, tend to have higher coverage percentages, or deeper coverage. Accordingly, the relative sizes of the purchase money and refinance mortgage origination markets influence the average LTV, coverage rate and premium of our NIW and insurance in force.
Premium payments may be paid to us on a monthly, annual or single premium basis. Monthly payment plans represented 96.4% of NIW in 2006 and 94.1% of NIW in 2005. As of December 31, 2006, monthly plans represented 93.5% of our U.S. primary risk in force compared to 93.1% at December 31, 2005. Single premium plans represented substantially all of the remaining NIW and primary risk in force. Single premium plan payments may be refundable if coverage is canceled by the insured, which generally occurs when the loan is repaid, the loan amortizes to a sufficiently low amount or the value of the property has increased sufficiently.
Depending upon the loan, the premium payments for flow primary mortgage insurance coverage may ultimately be borne by the insured (Lender Paid MI) or by the insureds customer, the mortgage borrower (Borrower Paid MI). In either case, the payment of premiums to us is the responsibility of the insured. PMIs primary insurance rates for Borrower Paid MI are based on rates that we have filed with the various state insurance departments. To establish these rates, we utilize pricing models that consider a number of variables, including coverage percentages, loan and property attributes, and borrower risk characteristics. Because Lender Paid MI products are frequently designed to meet the needs of a lenders particular loan program, we attempt to calibrate our Lender Paid MI pricing to a loan programs specific borrower and loan-type risk characteristics. In addition, as a significant percentage of Lender Paid MI is processed through our electronic delivery channels, lenders use of Lender Paid MI serves to increase our efficiency and reduce our policy acquisition costs.
The majority of NIW is comprised of Borrower Paid MI. Lender Paid MI represented 17.5% of flow NIW in 2006, 16.7% in 2005 and 10.3% in 2004. In 2005 and 2006, lenders use of Lender Paid MI was driven by, among other things, higher levels of originations of non-traditional loans, particularly Alt-A loans, and our ability to offer Lender Paid MI products and pricing tailored to these loans. We define Alt-A loans as loans where the borrowers FICO score is 620 or higher and the loan includes certain characteristics such as reduced documentation verifying the borrowers income, assets, deposit information, and/or employment. Although Alt-A and prime borrowers generally have similar credit profiles, we consider Alt-A loans to be riskier than prime loans because of the reduced documentation requirements. Accordingly, we expect higher rates of default for Alt-A loans than the traditional loan portfolio.
Primary mortgage insurance is renewable at the option of the insured at the premium rate fixed when the insurance on the loan was initially issued. As a result, increased claims from policies originated in a particular year cannot be offset by renewal premium increases on policies in force. We may not cancel mortgage insurance coverage except in the event of nonpayment of premiums or certain material violations of PMIs master policies. With respect to our flow channel, the insured or the loans mortgage servicer generally may cancel mortgage insurance coverage at any time. In addition, the GSEs guidelines generally provide that a borrowers written request to cancel Borrower Paid MI should be honored if the borrower has a satisfactory payment record and the principal balance is not greater than 80% of the original value of the property or, in some instances, the current value of the property. The Homeowners Protection Act of 1998 also provides for the automatic termination of Borrower Paid MI when the LTV ratio (based upon the loans amortization schedule) reaches 78%, and provides
for cancellation of Borrower Paid MI upon a borrowers request when the LTV ratio reaches 80%, upon satisfaction of conditions set forth in the statute.
Structured Finance. We provide credit enhancement solutions across the credit spectrum to agency and non-agency MBS issuers as well as portfolio investors. While the terms vary, our structured finance products generally insure a large group of pre-existing loans or loans to be originated in the future whose attributes will conform to the terms of the negotiated agreement. A structured finance product can include primary insurance (first loss), modified pool insurance which may be subject to deductibles and which is discussed below, or both. Premiums for structured finance coverage are paid and borne by the issuers or investors.
While demand for mortgage insurance as a form of credit enhancement of MBS has increased, most non-agency MBS transactions do not utilize mortgage insurance. Instead, non-agency MBS issuers often use other third party credit enhancement products, such as financial guaranty insurance, or, most often, forego all third party credit enhancement products by using over-collateralized structures. As a result, we must compete against both MBS transactions that forego third party credit enhancement and third party credit enhancers, such as other mortgage insurers and financial guarantors. The extent to which we may bid upon, and if successful participate in, non-agency MBS transactions is subject to a number of factors, including:
All of the above factors are affected by domestic and international economic conditions including, but not limited to, levels of liquidity in the U.S. and international capital markets, interest rates, home price appreciation, employment levels, and the relative attractiveness of MBS compared to other debt securities. Because economic factors and the diverse array of competitors in the capital markets affect our opportunities to write mortgage insurance for structured transactions, PMIs NIW from structured finance can vary significantly from year to year.
PMIs opportunities to participate in structured finance transactions may be significantly impacted by the implementation in the United States of Basel II, the Basel Committee on Banking Supervisions proposal to implement a new international capital accord. Basel II will affect the capital treatment provided to mortgage insurance by domestic and international banks in both their origination and securitization activities. The Basel II provisions related to residential mortgages and mortgage insurance could alter the competitive positions of mortgage insurers. U.S. federal banking agencies have announced that the U.S. implementation of Basel II will be delayed until at least 2008 and have proposed an additional capital accord (known as Basel IA) that has not been finalized.
PMI, our European insurance subsidiary, and FGIC, a financial guaranty insurance company in which we hold a 42.0% interest, have jointly provided combinations of first loss, mezzanine and risk remote credit enhancement in MBS transactions. In 2007, we expect to continue to partner with FGIC on MBS transactions. In 2007, we also expect PMI to partner with our recently established surety company, PMI Guaranty, on structured finance transactions.
In addition to MBS issuances, we offer primary mortgage insurance on large groups of loans that lenders and investors intend to hold in their portfolios. In these instances, the lender or investor purchases mortgage insurance to achieve capital relief, liquidity or to receive protection against default risk.
We utilize risk-based pricing models to establish premium rates for our structured transactions business. These models consider variables relating to the structure of the transaction, real estate loss scenarios, and the loans within the insured portfolio, including coverage levels selected by the insured, loan and property attributes, and borrower risk characteristics.
(b) Pool Insurance
Modified Pool Insurance. We currently offer modified pool insurance products that may be attractive to agency and non-agency MBS issuers, investors and lenders seeking credit enhancement for MBS transactions, regulatory capital relief or the reduction of mortgage default risk. Modified pool insurance may be used in tandem with primary mortgage insurance or may be placed on loans that do not require primary insurance. The extent of coverage of modified pool products varies. Some products provide first loss protection by covering a percentage of the losses on individual loans held within the pool of insured loans up to a stated aggregate loss limit (stop loss limit) for the entire pool. Some modified pool products offer mezzanine-level coverage by providing for claims payments only after a predetermined cumulative claims level, or deductible, is reached.
To date, PMI has issued modified pool insurance principally to the GSEs as supplemental coverage and to other mortgage capital markets participants. Like primary structured transactions, PMIs modified pool products insure significant percentages of Alt-A loans and adjustable rate mortgages (see 4. Business Composition, below). As of December 31, 2006, PMI had $2.5 billion of modified pool risk in force compared to $1.8 billion as of December 31, 2005. As of December 31, 2006, PMIs modified pool risk in force represented 9.8% of PMIs total risk in force. Unless otherwise noted, primary insurance statistics in this report do not include pool insurance.
Other Pool Insurance. Prior to 2002, PMI offered certain pool insurance products, referred to principally as GSE or Old Pool, to lenders, the GSEs and the non-agency market.
(c) Captive Reinsurance
Mortgage insurers including PMI offer products to lenders that are designed to allow them to participate in the risks and rewards of the mortgage insurance business. Many of the major mortgage lenders have established affiliated captive reinsurance companies. Under a captive reinsurance agreement, PMI reinsures a portion of its risk written on loans originated by a certain lender with the captive reinsurance company affiliated with such lender. In return, a proportionate amount of PMIs gross premiums received is ceded to the captive reinsurance company less, in some instances, a ceding commission paid to us for underwriting and administering the business. Ceded premiums, as well as capital deposits required of the captive reinsurer, are held in trust for our benefit to secure the payment of potential future claims. Captive reinsurers must comply with applicable insurance regulations and must adhere to minimum risk-to-capital ratios, which consider only eligible assets held in trust specifically for our benefit. If during predetermined reporting periods, the value of assets in the trust is less than required under the minimum capital requirement, the captive reinsurer must deposit additional amounts into the trust account. Additionally, dividends from the trust accounts are only permissible once specified capital ratios are exceeded. In addition to adherence to minimum capital ratios, some captive reinsurance agreements disallow any dividends until book years have been reinsured for a minimum time period, typically three years.
PMIs captive reinsurance agreements primarily provide for excess-of-loss reinsurance, in which PMI retains a first loss position on a defined set of mortgage insurance risk, reinsures a second loss layer of this risk with the captive reinsurance company and retains the remaining risk above the second loss layer up to the maximum coverage level. PMI also offers quota share captive reinsurance agreements under which the captive
reinsurance company assumes a pro rata share of all losses in return for a pro rata share of the premiums collected. We believe that captive reinsurance agreements serve to better align credit decisions with respect to loans which require mortgage insurance and provide lenders with an ongoing stake in the outcome of the lending decision. This risk transfer approach also decreases the possibility of PMI incurring unacceptably high levels of losses in times of economic stress. Finally, certain rating agency capital models recognize the trust balances of the captive reinsurers and, thus, also recognize the reinsurance value and transfer of risk criteria of captive reinsurance. Typically only flow Borrower Paid MI is subject to captive reinsurance agreements. The captive reinsurance agreements must comply with both federal and state statutes and regulations, including the Real Estate Settlement Procedures Act of 1974, as well as criteria established by the GSEs. (See Item 7. Managements Discussion and Analysis of Financial Condition and Results of OperationsResults of Operations, U.S. Mortgage Insurance Operations, Premiums written and earned, and Item 1A. Risk FactorsThe U.S. mortgage insurance industry and PMI are subject to regulatory risk.)
(d) Other Risk-Sharing Products
In addition to captive reinsurance, we offer other risk-sharing products, including layered co-insurance, a primary insurance program under which the insured retains liability for losses between certain levels of aggregate losses. Layered co-insurance is primarily targeted to affordable housing programs. We also offer various products designed for, and in cooperation with, the GSEs and lenders that involve some aspect of risk-sharing.
(e) Joint VentureCMG Mortgage Insurance Company
CMG Mortgage Insurance Company and its affiliates (collectively CMG MI) offer mortgage insurance for loans originated by credit unions. CMG MI is a joint venture, equally owned by PMI and CUNA Mutual Investment Corporation (CMIC). CMIC is part of the CUNA Mutual Group, which provides insurance and financial services to credit unions and their members. Both PMI and CMIC provide services to CMG MI. At December 31, 2006, CMG MI had $16.3 billion of primary insurance in force and $4.0 billion of primary risk in force compared to $15.5 billion of primary insurance in force and $3.7 billion of primary risk in force at December 31, 2005. CMG MIs financial results are reported in our consolidated financial statements under the equity method of accounting in accordance with U.S. generally accepted accounting principles, or GAAP. CMG MIs operating results are not included in our results shown in Part II of this Report on Form 10-K, unless otherwise noted.
Under the terms of the restated joint venture agreement effective as of June 1, 2003, CMIC has the right on September 8, 2015, or earlier under certain limited conditions, to require PMI to sell, and PMI has the right to require CMIC to purchase, PMIs interest in CMG MI for an amount equal to the then current fair market value of PMIs interest. PMI and CMIC have also entered into a capital support agreement, which is subject to certain limitations, for the benefit of CMG MI in order to maintain CMG MIs claims-paying ability rating at AA- by S&P and AA by Fitch. CMG MI is a GSE-authorized mortgage insurer.
U.S. Private Mortgage Insurance Industry
The U.S. private mortgage insurance industry presently consists of eight active mortgage insurers: PMI; CMG MI; Mortgage Guaranty Insurance Corporation, or MGIC; Genworth Mortgage Insurance Corporation, an affiliate of Genworth Financial, Inc.; United Guaranty Residential Insurance Company, an affiliate of American International Group, Inc.; Radian Guaranty Inc., or Radian; Republic Mortgage Insurance Co., an affiliate of Old Republic International; and Triad Guaranty Insurance Corp. In February 2007, the parents of MGIC and Radian announced that they had entered into an agreement and plan of merger. Assured Guaranty Mortgage Insurance Company, a subsidiary of Assured Guaranty Ltd., is also licensed to offer mortgage insurance in the U.S. Other companies may also be considering offering mortgage insurance.
U.S. and State Government Agencies
PMI and other private mortgage insurers compete with federal and state government agencies that sponsor their own mortgage insurance programs. The private mortgage insurers principal government competitor is the Federal Housing Administration, or FHA, and to a lesser degree, the Veterans Administration, or VA. The following table shows the relative mortgage insurance market share of FHA/VA and private mortgage insurers over the past five years.
Effective January 1, 2006, the U.S. Housing and Urban Development Department, or HUD, in accordance with its indices, set the maximum single-family loan amount that the FHA can insure at $362,790 in high-cost areas. Excluding high-cost areas, the maximum mortgage loan amount that the FHA can insure is 95% of the median area home price as determined by HUD. Private mortgage insurers have no limit as to maximum individual loan amounts that they can insure. Increases in the amount that these agencies can insure could cause future demand for private mortgage insurance to decrease. We and other private mortgage insurers also face competition in several states from state-supported mortgage insurance funds.
Fannie Mae and Freddie MacThe GSEs
Mortgage insurers, including PMI, compete with the GSEs when the GSEs seek to assume mortgage default risk that could be covered by mortgage insurance. The GSEs have introduced programs that allow lenders to purchase reduced mortgage insurance coverage, as well as programs that provide for the restructuring of existing mortgage insurance with reduced amounts of primary insurance coverage and the addition of pool insurance coverage. One of the GSEs has expressed its intention to increase its use of alternative structures, including credit default swaps, to manage its credit risk.
Federal Home Loan Banks
The Federal Home Loan Banks, or FHLBs, purchase single-family conforming mortgage loans originated by participating financial institutions. Typically, mortgage insurance coverage is placed on these loans when the LTV exceeds 80%.
Financial Institutions and Mortgage Lenders
The private mortgage insurance industry faces competition from the home equity lending operations of financial institutions and other mortgage lenders who structure their high LTV residential loans in such a way that mortgage insurance is not required. Certain lenders originate mortgages that have a first mortgage lien with an LTV of 80%, and a second mortgage lien ranging from 5% to 20% LTV. These loans are commonly referred to as simultaneous seconds, piggybacks, 80/10/10, 80/20 or 80/15/5 loans. Since the first mortgage is only an 80% LTV, the GSEs do not require mortgage insurance with respect to either mortgage, even though the combined LTV exceeds 80%. These products have grown in popularity since 2003 due to a number of factors, including low interest rates, high home appreciation rates and an increased focus by lenders on home equity lending. The increased popularity and use of these and other similar products have reduced the available market for primary mortgage insurance.
In addition, we and other private mortgage insurers compete with financial institutions, primarily commercial banks and thrifts, which retain risk on all or a portion of their high LTV mortgage portfolios rather than obtain insurance for this risk. Our use of captive reinsurance with certain lenders with whom we do business (see Captive Reinsurance, above) also negatively impacts our risk in force and premiums earned.
In order to participate in structured finance transactions, we must compete against other mortgage insurers as well as other well-capitalized credit enhancement providers, including financial guarantors. In addition, the frequent design and use of MBS structures that do not include third party credit enhancement negatively affects the private mortgage insurance market and our insurance in force and NIW.
Our U.S. customers are primarily mortgage lenders, savings institutions, commercial banks, investors (including the GSEs), the FHLBs, and other capital market participants. In 2006, PMIs top ten customers generated 43.9% of PMIs premiums earned compared to 42.8% in 2005. The beneficiary under PMIs master policies is the owner of the insured loan. The GSEs, as major purchasers of conventional mortgage loans in the U.S., are the beneficiaries of a substantial portion of PMIs mortgage insurance coverage.
Persistency; Policy Cancellations. A significant percentage of PMIs premiums earned is generated by insurance policies written in previous years. Consequently, the level of policy cancellations and resulting length of time that insurance remains in force are key determinants of PMIs revenues and net income. One measure of the impact of policy cancellations on insurance in force is our persistency rate, which is based upon the percentage of primary insurance in force at the beginning of a 12-month period that remains in force at the end of that period. The following table shows average annual mortgage interest rates and PMIs primary portfolio persistency rates from 1997 to 2006.
As shown by the above table, low or declining interest rate environments are major factors in shortening the length of time our primary insurance in force has remained in effect. Between 2001 and 2003, declining interest rates resulted in heavy mortgage refinance activity, causing PMIs policy cancellations to increase, thereby negatively impacting earned premiums. In 2004, 2005 and 2006, the persistency rate improved as a result of stabilizing or increasing interest rates and declining levels of mortgage refinance activity.
In addition to interest rates, we believe that refinance activity is influenced by levels of home price appreciation, consumer behavior and the availability of certain alternative loan products. We believe that higher levels of home price appreciation and increasing consumer acceptance of refinance transactions have contributed to the high levels of refinance activity since 2001. We also believe that alternative loan products, such as interest only loans and payment option adjustable rate mortgages (see below), which provide borrowers with the opportunity to at least temporarily decrease their monthly loan payments, have encouraged refinancing during the period of relatively stable interest rates.
Risk in Force. PMIs primary risk in force was $25.7 billion as of December 31, 2006 and $25.0 billion as of December 31, 2005. The composition of primary and pool risk in force is summarized in the table below. The table is based upon information available on the date of mortgage origination.
As shown in the table above, the percentages of risk in force containing Above 97s, interest only loans, payment option ARMs, and Alt-A loans increased in 2006. We believe that these increases were driven by, and reflect, higher concentrations of these types of loans as percentages of both the 2006 mortgage origination market and the 2006 private mortgage insurance market. (See also Item 7. Managements Discussion and Analysis of Financial Condition and Results of OperationsU.S. Mortgage Insurance Operations, Credit and portfolio characteristics.)
We expect higher default and claim rates for high LTV loans, ARMs, interest only loans, payment option ARMs, less-than-A quality, and Alt-A loans and incorporate these assumptions into our underwriting approach, portfolio limits, pricing, and loss and claim estimates. In 2006, PMIs average premium rate increased primarily as a result of its primary portfolio containing higher percentages of high LTV and Alt-A loans. However, there can be no assurance that the premiums earned and the associated investment income will prove adequate to compensate for future losses from these loans. We offer pre- and post-purchase borrower counseling as part of certain expanding markets programs in an effort to reduce the risk of default on those loans. We also believe that the risk reduction features of our modified pool products, which may include deductibles, mitigate our risk of loss from the loans insured.
The following table shows U.S. primary risk in force by FICO score:
We employ a sales force located throughout the U.S. to directly sell products and services to lenders. Our U.S. sales force is comprised entirely of PMI employees who receive compensation consisting of a base salary and incentive compensation tied to performance objectives. PMIs product development and structured finance departments have primary responsibility for the creation of new products and services.
Risk Management Approach
We utilize proprietary and other statistical models to measure and predict loan performance based on the historical prepayment and loss experience of loans. We analyze performance based on borrower, loan and property characteristics, along with geographic factors, through historic economic and real estate cycles. We use the outputs from these models to develop and refine how we price our coverage and in the establishment of national and regional underwriting guidelines to control the concentrations of risk in PMIs portfolio. In developing guidelines, we also take into account the GSEs underwriting guidelines. Our underwriting guidelines generally allow us to place mortgage insurance coverage on any mortgage loan accepted by the GSEs automated underwriting systems for purchase by the GSEs.
We continually monitor risk concentrations in our portfolio using various statistical tools. Among these are the pmiAURAsm System and the PMI Market Risk Indexsm. The pmiAURAsm System is a proprietary risk scoring tool we developed over 19 years ago that assigns a unique risk score to each loan in PMIs portfolio corresponding to the predicted likelihood of an insured loan going to claim based on demographic, geographic, economic, and loan specific characteristics. The PMI Market Risk Indexsm is a proprietary statistical model that predicts the probability of a decline in home prices during the next two years in the Metropolitan Statistical Areas in the United States based on local, historical home price appreciation, changes in the local labor markets and local home affordability. We publish the output of this model on a quarterly basis.
To obtain mortgage insurance on an individual mortgage loan, a customer submits an application to us. If the loan is approved for mortgage insurance, we issue a commitment to the customer. During the last several years, advances in technology have enabled us to offer customers the option of electronic submission of applications and supporting documentation, as well as electronic receipt of insurance commitments and certificates. Customer use of our electronic delivery options accounted for approximately 79% of PMIs new policies issued in the primary flow channel in 2006, compared to approximately 75% in 2005 and 69% in 2004.
Delegated Underwriting. More than 81% of PMIs flow NIW is underwritten pursuant to a delegated underwriting program that allows approved lenders, subject to our routine audit, to determine whether loans meet program guidelines and are thus eligible for mortgage insurance. If a lender participating in the program commits us to insure a loan that fails to meet all of the applicable underwriting guidelines, we are obligated to insure such a loan except under certain narrowly-drawn exceptions, such as a failure to meet maximum LTV criteria. Delegated underwriting enables us to meet mortgage lenders demands for immediate insurance coverage of certain loans. We believe that the performance of our delegated insured loans will not vary materially over the long-term from the performance of all other insured loans.
Non-Delegated Underwriting. Flow customers that are not approved to participate in the delegated program generally must submit to us an application for each loan, supported by various documents. Verification of the borrowers employment, income and funds needed for the loan closing are required in addition to the appraisal.
Structured Transactions. Structured transactions (including both primary and modified pool insurance) generally involve our bidding for a customers delivery to us of a portfolio of loans that have been previously underwritten and closed under one or more loan programs. Regardless of the fact that the customer or lender has previously underwritten the loans, we evaluate each transaction on a loan-by-loan basis and as a portfolio. In the loan-by-loan review, we analyze the characteristics of each loan and compare them to forecasts of performance generated by proprietary performance and pricing models. In the portfolio review, we analyze the diversity and the aggregate risk characteristics of the portfolio as a whole. We also review the applicable servicer ratings and origination practices as well as the risks and potential mitigating factors inherent in the proposed coverage structure, which may include, among other things, coverage limits, stop loss limits and deductibles.
In some structured transactions, we provide commitments for the future delivery of insurance coverage. The same processes described above are used to review an indicative portfolio of loans. Our commitments are contingent upon a loan-by-loan review of the actual loans delivered and allow for adjustments if the characteristics of the actual delivery vary materially from those of the indicative portfolio.
Contract underwriting services are provided by our wholly-owned subsidiary, PMI Mortgage Services Co., or MSC. MSC provides contract underwriting services for mortgage loans for which PMI provides mortgage insurance and for mortgage loans for which PMI does not provide insurance. MSC also performs the contract underwriting activities of CMG MI.
As a part of its contract underwriting services, MSC provides to its customers monetary and other remedies, including loan indemnifications under certain circumstances, in the event that MSC fails to properly underwrite a mortgage loan. These remedies are separate from the insurance coverage provided by PMI. MSC paid or accrued $12.4 million in contract underwriting remedies in 2006, compared to $14.5 million in 2005. Worsening economic conditions or other factors that could lead to increases in PMIs primary insurance default rate could also cause the number and magnitude of the remedies that must be offered by MSC to increase.
New policies processed by MSC contract underwriters in 2006 declined to 14.8% of PMIs primary NIW from 18.1% in 2005. We anticipate that loans underwritten by MSC will continue to make up a significant percentage of PMIs NIW and that contract underwriting will remain the preferred method among some mortgage lenders for processing loan applications. The number of contract underwriters deployed by MSC is related to the volume of mortgage originations.
Expanding homeownership opportunities for low- to moderate-income individuals and typically underserved communities is important to us. Our approach to affordable lending is to develop, insure and
promote products and services that assist responsible borrowers who may not qualify for mortgage loans under traditional underwriting practices. These products and services do not accommodate borrowers who have failed to manage their affairs responsibly; rather, they seek to identify those home buyers who have met or will meet their obligations in a timely and conscientious manner. The beneficiaries of these programs have included recent immigrants who have not established traditional credit histories, borrowers not accustomed to using traditional savings institutions, borrowers with less than five percent for a down payment, and home buyers who, although consistently employed, lack the stability traditionally associated with having a single employer due to the nature of their employment.
We have also established partnerships with numerous national and local organizations to mitigate affordable housing risks, expand the understanding of responsibilities of homeownership and promote community revitalization. Although programs offered under our affordable housing initiatives receive the same credit and actuarial analysis as all other standard programs, some programs utilize affordable underwriting guidelines established by lenders that differ from our standard criteria. We believe that some insured affordable housing loans may carry higher risks than other insured loans. As a result, we have instituted various programs, including pre- and post-purchase borrower counseling, risk-sharing and risk-based pricing, seeking to mitigate the additional risks that may be associated with some affordable housing loan programs.
Our claim process begins with notification by the insured or servicer to us of a default on an insured loan. Default is defined in PMIs primary master policies as the borrowers failure to pay when due an amount equal to the scheduled monthly mortgage payment under the terms of the mortgage. Generally, the master policies require an insured to notify us of a default no later than the last business day of the month following the month in which the borrower becomes three monthly payments in default. For reporting and internal tracking purposes, we do not consider a loan to be in default for the purposes of reporting defaults and default rates until a loan has been delinquent for two consecutive monthly payments. Depending upon its scheduled payment date, a loan delinquent for two consecutive payments could be reported to us between the 31st and 60th day after the first missed payment. Borrowers default for a variety of reasons, including a reduction of income, unemployment, divorce, illness, inability to manage credit, and interest rate levels. Borrowers may cure defaults by making all of the delinquent loan payments or by selling the property in full satisfaction of all amounts due under the mortgage.
In most cases, defaults that are not cured result in claims. However, because the rate at which defaults cure is influenced by borrowers financial resources and regional housing and economic conditions, the frequency of claims is not directly proportional to the number of defaults we receive. PMI partners with lenders to work with borrowers to cure defaults through repayment plans, loan modifications and short sales.
Primary default rates differ from region to region in the United States depending upon economic conditions and cyclical growth patterns. The two tables below set forth primary default rates by region for the various regions of the United States and the ten largest states by PMIs primary risk in force. Default rates are shown by region based on location of the underlying property.
Claims and Policy Servicing
Whether an uncured default leads to a claim principally depends on the borrowers equity in the underlying property at the time of default and the borrowers or the insureds ability to sell the home for an amount sufficient to satisfy all amounts due under the mortgage loan. When the likelihood of a defaulted loan being reinstated is minimal, we work with the servicer of the loan for a possible loan workout or early disposal of the
underlying property. Property dispositions typically result in a reduction in our losses compared to the percentage coverage option amount payable under PMIs master policies.
Within 60 days after a primary insurance claim and supporting documentation have been filed, we have the option of:
While we select the claim settlement option that best mitigates the amount of our claim payment, we generally pay the coverage percentage multiplied by the loss amount. In 2006 and 2005, we processed 22.9% and 25.1%, respectively, of the paid primary insurance claims on the basis of a prearranged sale. In 2006 and 2005, we exercised the option to acquire the property on 4.6% and 3.6%, respectively, of the primary claims processed for payment. At December 31, 2006, our carrying value, which approximates fair value, of REO properties was $26.9 million compared to $18.5 million at December 31, 2005.
Claims and the Aging of PMIs Insurance Portfolio. Claims activity is not spread evenly throughout the coverage period of a primary insurance book of business. We expect the significant majority of claims on insured loans in PMIs current portfolio to occur in the second through fourth years after loan origination. Primary insurance written from the period of January 1, 2003 through December 31, 2005 represented 58.1% of PMIs primary insurance in force at December 31, 2006.
The following table sets forth the dispersion of PMIs primary insurance in force and risk in force as of December 31, 2006, by year of policy origination and average annual mortgage interest rate.
Claim Severity. The severity of an individual claim is calculated as the ratio of the claim paid to the original risk in force relating to the loan. The main determinants of the severity of a claim are the value of the underlying property, accrued interest on the loan, expenses advanced by the insured, foreclosure expenses, the amount of mortgage insurance coverage placed on the loan, and the time required to complete foreclosure, which varies depending on state laws. Pre-foreclosure sales, acquisitions and other early workout efforts help to reduce overall claim severity. The average primary claim severity has decreased from 100% in 1994 to 86.1% in 2005 and 2006. Average primary claim severity is, for a given period, primary claims paid as a percentage of the total risk in force of primary loans for which claims were paid.
Pool Claims. Pool claims are generally filed after the underlying property is sold. We settle a pool claim in accordance with the terms of the applicable pool insurance policy, which includes a stop loss limit and, in some cases, a specified deductible. Subject to such stop loss limit and any deductible, our modified pool insurance generally covers a specified percentage of the particular loss less net proceeds from the sale of the property and any primary claim proceeds. Our traditional pool insurance generally covers 100% of the loss less net proceeds from the sale of the property and any primary claim proceeds. Other pool insurance policies may include a maximum coverage percentage or a defined benefit. Claims relating to policies with a maximum coverage percentage are settled at the lesser of the actual loss or the maximum coverage set forth in the applicable policy. Claims relating to policies with defined benefits are settled at the maximum coverage percentage set forth in the applicable policy. We settle pool claims upon receipt of all supporting documentation.
Primary insurance claims paid by PMI in 2006 decreased to $214.0 million from $214.9 million in 2005. Pool insurance claims paid by PMI in 2006 (excluding Old Pool) decreased to $18.3 million from $21.6 million in 2005.
The table below shows cumulative losses paid by PMI at the end of the year of original policy issuance (policy year) and each successive year thereafter, expressed as a percentage of the cumulative premiums written on such policies.
Percentage of Cumulative Primary Insurance Losses Paid (Gross)
To Cumulative Primary Insurance Premiums Written (Gross)*
The above table shows that all policy years through 1996 have cumulative loss payment ratios at the end of 2006 that differ by no more than 0.1% from the end of 2005, an indication that these ratios have stabilized and reached their ultimate development for each of these policy years. Policy years 1997 through 1999 also have seen only slight claims development since the end of 2005.
Policy years 1987 through 1988 have developed to cumulative loss payment ratios of 28.5% and 35.2%, respectively. Policy years 1989 through 1992 have developed to somewhat higher ratios between 41.0% and 61.5%, reflecting both higher levels of claims on California loans insured in those years, as well as higher prepayment speeds when market rates dropped to relatively low levels from late 1992 through early 1994. Loss payment ratios continued to decline year-to-year after 1993, bottoming out at 9.0% at the end of nine years for the 1998 policy year, a record low. The declines were due to an improvement in Californias economy and a strong national economy with no material regional weaknesses. The 1999 policy year is developing at a level slightly higher than 1998, but still at low levels. Given the small amount of business left in the 1996 through 1999 books, further development is expected to be immaterial.
The higher levels of claims in the 2000 and 2001 policy years were a result of an expansion into less-than-A quality and Alt-A loan product offerings primarily through the introduction of our structured transactions channel. These loan types generally have shorter lives and earlier incidence of default than A quality loans, leading to earlier emergence of claims and shorter streams of premium income. In addition, our A quality business written in 2000 and 2001 was subject to high levels of policy cancellations in 2003 due to low interest rates and heavy refinancing. These policy cancellations decreased the accumulated premium received from the 2000 and 2001 policy years, affecting the cumulative loss payment ratio development by increasing the ratio of claims paid to premiums received.
The 2002 book year is developing favorably compared to 2000 and 2001 due to a lower level of claims. 2003 is performing favorably compared to 2002 due to lower levels of claims and higher persistency. 2004 has a slightly higher cumulative loss payment ratio development at two and three years than 2003, due to slightly higher claims development and comparable persistency. 2005 has a higher cumulative loss payment ratio development at two years primarily due to higher claims development associated with the portion of PMIs portfolio that contains ARMs, high LTV and less-than-A quality loans and the seasoning of primary NIW acquired principally through our structured finance channel.
A period of time may elapse between the occurrence of the borrowers default on mortgage payments (the event triggering a potential future claims payment), the reporting of such default to us and the eventual payment of the claim related to such default. To recognize the liability for unpaid losses related to the loans in default, PMI, in accordance with industry practice, establishes loss reserves in respect of loans in default based upon the estimated claim rate and estimated average claim amount of loans in default. Included in loss reserves are loss adjustment expense (LAE) reserves, and incurred but not reported (IBNR) reserves. IBNR reserves represent our estimated unpaid losses on loans that are in default but have not yet been reported to us as delinquent by our customers. Loss reserves are estimates and there can be no assurance that PMIs reserves will prove to be adequate to cover ultimate loss developments on reported defaults. Consistent with industry accounting practices, PMI does not establish loss reserves for estimated potential defaults that have not occurred but that may occur in the future. For a full discussion of our loss reserving policy and process, see Item 7. Managements Discussion and Analysis of Financial Condition and Results of OperationsCritical Accounting Estimates, Reserves for Losses and LAE. For a reconciliation of the beginning and ending reserve for losses and loss adjustment expenses on a consolidated basis, see Item 8. Financial Statements and Supplementary DataNote 8. Reserve for Losses and Loss Adjustment Expenses.
We and other mortgage insurers use reinsurance for capital and risk management purposes. Reinsurance does not discharge PMI, as the primary insurer, from liability to a policyholder. The reinsurance company simply agrees to indemnify PMI for the reinsurance companys share of losses incurred under designated insurance policies, unlike an assumption and novation agreement, where the assuming reinsurance companys liability to the policyholder is substituted for that of PMI.
PMI has a 5% quota share reinsurance agreement in place with a participating reinsurance company relating to primary insurance business written by PMI from 1994 through 1997. Under the terms of this agreement, the reinsurance company indemnifies PMI for 5% of all losses paid under the reinsured primary insurance business and PMI cedes 5% of the related premiums, less a ceding commission paid to PMI for underwriting and administering the business. In addition, PMI may be entitled to a profit commission in the event specified profit targets are met on the ceded business.
Effective January 1, 2001, PMI commenced reinsuring our wholly-owned Australian subsidiary, PMI Mortgage Insurance Ltd, on an excess-of-loss basis. Under the terms of the agreement, for each of the calendar years from 2001 through 2005, PMI is obligated to indemnify PMI Mortgage Insurance Ltd for losses that exceed 130% of PMI Mortgage Insurance Ltds net earned premiums for each such year, but not for losses that exceed 220% of such net earned premiums. Beginning January 1, 2006, PMI is obligated to indemnify PMI Mortgage Insurance Ltd for losses that exceed 100% of PMI Mortgage Insurance Ltds net earned premiums for each such year, but not for losses that exceed 190% of such net earned premiums. The agreement provides for automatic one-year extensions, unless terminated upon prior notice by either party. Upon such notice of termination, the agreement would continue in effect in the year of such notice and for the next four calendar years.
Certain states limit the amount of risk a mortgage insurer may retain on a single loan to 25% of the indebtedness to the insured, and as a result, the portion of such insurance in excess of 25% must be reinsured. To minimize reliance on third party reinsurance companies and to permit PMI to retain the premiums (and related risk) on deep coverage business, The PMI Group, our parent company, formed several wholly-owned subsidiaries including Residential Guaranty Co., or RGC, Residential Insurance Co., or RIC, and PMI Mortgage Guaranty Co., or PMG, to provide reinsurance of such deep coverage to PMI. These deep cede reinsurance agreements with RGC, PMG and RIC replaced reciprocal deep cede reinsurance agreements that PMI had with certain non-affiliate mortgage insurance companies, which have now largely runoff. PMI uses reinsurance provided by its reinsurance affiliates solely for purposes of compliance with statutory coverage limits. CMG MI also uses reinsurance provided by its reinsurance affiliate, CMG Reinsurance Company, to comply with statutory limits.
As discussed in Section B.1, Products, above, PMI also reinsures portions of its risk written on loans originated by certain lenders with captive reinsurance companies affiliated with such lenders.
General. Our U.S. mortgage insurance subsidiaries are subject to comprehensive, detailed regulation by the insurance departments of the various states in which they are licensed to transact business. The principal aim of this regulation is to safeguard their solvency for the protection of policyholders. Although their scope varies, state insurance laws generally grant broad powers to supervisory agencies or officials to examine the financial books and records of companies, as well as their market conduct and practices, and to enforce rules or exercise discretion touching most significant aspects of the insurance business.
Mortgage insurers are generally restricted by state insurance laws and regulations to writing mortgage insurance business only. This restriction prohibits our mortgage insurance subsidiaries from directly writing other kinds of insurance. Our non-insurance subsidiaries are not subject to regulation under state insurance laws except with respect to transactions with their insurance affiliates.
Insurance Holding Company Regulations. All states have enacted legislation that requires each insurance company in a holding company system to register with the insurance regulatory authority of its state of domicile and to furnish to such regulatory authority financial and other information concerning the operations of, and the interrelationships and transactions among, companies within the holding company system that may materially
affect the operations, management or financial condition of the insurers within the system. The states also regulate transactions between insurance companies and their parents and affiliates.
The PMI Group is treated as an insurance holding company under the laws of the State of Arizona. The Arizona insurance laws govern, among other things, certain transactions in our common stock and certain transactions between or among The PMI Group and its domestic and international subsidiaries. For example, no person may, directly or indirectly, offer to acquire or acquire voting securities of The PMI Group or any one of the Arizona subsidiaries, if after consummation thereof, such person would be in control, directly or indirectly, of such entity, unless such person obtains the Arizona Director of Insurances prior approval. For purposes of the foregoing, control is rebuttably presumed to exist if such person, following the acquisition, would, directly or indirectly, own, control or hold with the power to vote or hold proxies representing 10% or more of the entitys voting securities. In addition, all material transactions involving PMI Mortgage Insurance Co., referred to as MIC, PMG, RGC, and/or RIC and any of their affiliates, such as PMI Australia and PMI Europe, are subject to prior approval of the Arizona Director of Insurance, and are subject to disapproval if they are found to be not fair and reasonable. MIC, on behalf of itself and its affiliates, is required to file an annual insurance holding company system registration statement with the Arizona and Wisconsin Departments of Insurance (and any other states that so request) disclosing all inter-affiliate relationships, transactions and arrangements that occurred or were in effect during the prior calendar year, and providing information on The PMI Group, the holding companys ultimate controlling person. We must also submit and update biographical information about the executive officers and directors of the holding companys insurance subsidiaries, as well as executive officers and directors of The PMI Group.
The insurance holding company laws and regulations are substantially similar in Wisconsin (where CMG MI, Commercial Loan Insurance Corporation, or CLIC, and WMAC Credit Insurance Corporation, or WMAC Credit, are domiciled), and transactions among these subsidiaries, or any one of them and another affiliate (including The PMI Group) are subject to regulatory review and approval in the respective states of domicile. FGIC is subject to regulation under insurance holding company statutes of New York, where it is domiciled, as well as other jurisdictions where FGIC is licensed to do insurance business. Transactions between FGIC and The PMI Group and its subsidiaries are subject to prior approval of the New York Department of Insurance.
Risk-to-Capital. A number of states generally limit the amount of insurance risk that may be written by a mortgage insurer to 25 times the insurers total policyholders surplus. PMIs risk-to-capital ratio as of December 31, 2006 was 8.1 to 1.
Reserves. Our mortgage insurance subsidiaries are required under the insurance laws of their state of domicile and many other states, including New York and California, to establish a special contingency reserve with annual additions of amounts equal to 50% of premiums earned. Contingency reserves are required to be held for ten years (and then released into surplus), although earlier releases may be authorized by state insurance regulators in certain cases. The first year that MIC released contingency reserves into surplus, following the ten year holding period, was 2002. At December 31, 2006, PMI had statutory policyholders surplus of $638.0 million and statutory contingency reserves of $2.7 billion.
Dividends. MIC paid extraordinary dividends of $350 million and RGC paid ordinary dividends of $10 million to The PMI Group in 2006. Our Arizona insurance subsidiaries ability to pay dividends (including returns of capital) to The PMI Group as their sole shareholder is limited, among other things, by the insurance laws of Arizona and other states. Under Arizona law, an insurance subsidiary may pay dividends out of available surplus without prior approval of the Arizona Director of Insurance, as long as such dividends during any 12-month period do not exceed the lesser of (i) 10% of policyholders surplus as of the preceding calendar year end, or (ii) the preceding calendar years net investment income. MIC is permitted to pay ordinary dividends (as such are termed under the Arizona statute) to The PMI Group of $51.8 million in 2007 without prior approval of the Arizona Director of Insurance, provided that any such dividends are paid after the first anniversary of payment of the last installment of 2006 dividends. Any dividend in excess of this amount (either alone or
together with other dividends/distributions made in the last 12 months) is an extraordinary dividend and requires the prior approval of the Arizona Director of Insurance. The Arizona Director of Insurance may approve an extraordinary dividend if he or she finds that, following the distribution, the insurers policyholders surplus is reasonable in relation to its liabilities and adequate to its financial needs. On June 7, 2006, the Director of the Arizona Department of Insurance approved an extraordinary dividend request of $250 million. This dividend was paid to the PMI Group in two installments of $150 million in August of 2006 and $100 million in September of 2006. On December 14, 2006, the Director of the Arizona Department of Insurance approved an additional extraordinary dividend request of $250 million. In December 2006, a $100 million installment of this dividend was paid to The PMI Group. The second installment of the approved $250 million dividend is expected to be paid in the first half of 2007.
In addition to Arizona, other states may limit or restrict our insurance subsidiaries abilities to pay shareholder dividends. For example, California, New York and Illinois prohibit mortgage insurers from declaring dividends except from undivided profits remaining on hand over and above the aggregate of their paid-in capital, paid-in surplus and contingency reserves. CMG MI is subject to shareholder dividend/distribution restrictions under Wisconsin laws similar to those applicable to PMI.
Insurance regulatory authorities have broad discretion to limit the payment of dividends by insurance companies. For example, if insurance regulators determine that payment of a dividend or any other payments to an affiliate (such as payments under a tax-sharing agreement, payments for employee or other services, or payments pursuant to a surplus note) would, because of the financial condition of the paying insurance company or otherwise, be hazardous to such insurance companys policyholders or creditors, the regulators may block payments that would otherwise be permitted without prior approval.
Premium Rates and Policy Forms. Our insurance subsidiaries borrower-paid premium rates and policy forms are subject to regulation in every jurisdiction in which each is licensed to transact business. In most U.S. jurisdictions, policy rates must be filed prior to their use. In some U.S. jurisdictions, forms must also be approved prior to use.
Reinsurance. Regulation of reinsurance varies by state. With the notable exceptions of Arizona, Illinois, Wisconsin, New York, and California, most states have no special restrictions on mortgage guaranty reinsurance other than standard reinsurance requirements applicable to property and casualty insurance companies. Certain restrictions apply under Arizona law to domestic companies and under the laws of several other states to any licensed company ceding business to unlicensed or unaccredited reinsurance companies. Under such laws, if a reinsurance company is not admitted or accredited in such states, the domestic company ceding business to the reinsurance company cannot take credit in its statutory financial statements for the risk ceded to such reinsurance company absent compliance with certain minimum statutory capital and reinsurance security requirements. In addition, Arizona prohibits reinsurance unless the reinsurance agreements meet certain requirements even if no statutory financial statement credit is taken.
Examinations. Our licensed insurance and reinsurance subsidiaries are subject to examination of their financial condition and market conduct by the insurance departments of each of the states in which they are licensed to transact business. The Arizona Director of Insurance periodically conducts a financial examination of insurance companies domiciled in Arizona. The Arizona Director of Insurance last examined MIC in 2003 for the five year period ended December 31, 2002. In lieu of examining a foreign insurer (i.e., an insurer licensed but not domiciled in a state), the insurance supervisors may accept an examination report by a state that has been accredited by the National Association of Insurance Commissioners. Thus, while states have the authority to examine all licensed insurers, in practice, insurance supervisors for the most part defer to the examination reports issued by the domiciliary supervisor. CMG MI, CLIC and WMAC Credit were examined by the Wisconsin Department of Insurance in 2003 for the three year period ended December 31, 2002. The final examination reports are public records and can be obtained from the applicable states department of insurance.
GSEs. In order to be eligible to insure loans purchased by the GSEs, mortgage insurers must meet Fannie Maes and Freddie Macs eligibility requirements. These requirements, among other things, impose standards for minimum ratings, legal compliance, use of reinsurance, including captive reinsurance, policies and procedures, risk-sharing, and reporting requirements.
National Association of Insurance Commissioners. The National Association of Insurance Commissioners, or NAIC, is an organization of the state insurance regulators of all 50 states, the District of Columbia, Puerto Rico, Guam, and U.S. Territories. A major objective of the NAIC is to promote uniformity and harmonization of insurance regulation among the states by the adoption and promulgation of model laws and regulations. The NAIC has developed a rating system, the Insurance Regulatory Information System, or IRIS, primarily intended to assist state insurance departments in overseeing the statutory financial condition of all insurance companies operating within their respective states. IRIS consists of key financial ratios, which are intended to indicate unusual fluctuations in an insurers statutory financial position and/or operating results. The NAIC applies its IRIS financial ratios to PMI on a continuing basis in order to monitor PMIs financial condition.
Federal Laws and Regulation
Certain federal laws, such as the Homeowners Protection Act discussed below, directly affect private mortgage insurers. Private mortgage insurers, including PMI, are impacted indirectly by federal legislation and regulation affecting mortgage originators and lenders, purchasers of mortgage loans, such as the GSEs, and governmental insurers such as the FHA and VA. For example, changes in federal housing legislation and other laws and regulations that affect the demand for private mortgage insurance may have a material adverse effect on PMI. Legislation that increases the number of persons eligible for FHA or VA mortgages could have a material adverse effect on our ability to compete with the FHA or VA.
Mortgage origination transactions are subject to compliance with various federal and state consumer protection laws, including the Real Estate Settlement Procedures Act of 1974, or RESPA, the Equal Credit Opportunity Act, the Fair Housing Act, the Homeowners Protection Act, the Fair Credit Reporting Act, or FCRA, the Fair Debt Collection Practices Act, and others. Among other things, these laws and their implementing regulations prohibit payments for referrals of settlement service business, require fairness and non-discrimination in granting or facilitating the granting of credit, require cancellation of insurance and refunding of unearned premiums under certain circumstances, govern the circumstances under which companies may obtain and use consumer credit information, and define the manner in which companies may pursue collection activities. Changes in these laws or regulations could adversely affect the operations and profitability of our mortgage insurance business.
The Homeowners Protection Act of 1998, or HOPA, provides for the automatic termination, or cancellation upon a borrowers request, of private mortgage insurance upon satisfaction of certain conditions. HOPA applies to owner-occupied residential mortgage loans regardless of lien priority and to borrower-paid mortgage insurance closed on or after July 29, 1999. FHA loans are not covered by HOPA. Under HOPA, automatic termination of mortgage insurance would generally occur once the LTV reaches 78%. A borrower who has a good payment history, as defined by HOPA, may generally request cancellation of mortgage insurance once the LTV reaches 80% of the homes original value or when actual payments reduce the loan balance to 80% of the homes original value, whichever occurs earlier.
The Real Estate Settlement Procedures Act of 1974, or RESPA, applies to most residential mortgages insured by PMI. Mortgage insurance has been considered in some cases to be a settlement service for purposes of loans subject to RESPA. Subject to limited exceptions, RESPA prohibits persons from giving or accepting any thing of value in connection with the referral of real estate settlement services. RESPA is enforced by HUD and the U.S. Department of Justice, and also provides for private rights of action. In late 2004, HUD announced that it intended to submit a rule proposal under RESPA to the Office of Management and Budget for review. HUD has taken no further action to date but senior officials have publicly stated that they continue to work on a new proposed rule. We do not know what form, if any, the rule will take and whether it will be approved.
Home Mortgage Disclosure Act of 1975. Most originators of mortgage loans are required to collect and report data relating to a mortgage loan applicants race, nationality, gender, marital status, and census tract to HUD or the Federal Reserve under the Home Mortgage Disclosure Act of 1975, or HMDA. Mortgage insurers are not required pursuant to any law or regulation to report HMDA data, although, under the laws of several states, mortgage insurers are currently prohibited from discriminating on the basis of certain classifications. Mortgage insurers have, through the Mortgage Insurance Companies of America, entered voluntarily into an agreement with the Federal Financial Institutions Examinations Council to report the same data on loans submitted for insurance as is required for most mortgage lenders under HMDA.
Privacy and Information Security. The Gramm-Leach-Bliley Act of 1999, or GLB, imposes privacy requirements on financial institutions, including obligations to protect and safeguard consumers nonpublic personal information and records, and limitations on the re-use of such information. Federal regulatory agencies have issued the Interagency Guidelines Establishing Information Security Standards (Security Guidelines), and interagency regulations regarding financial privacy (Privacy Rule) implementing sections of GLB. The Security Guidelines establish standards relating to administrative, technical and physical safeguards to ensure the security, confidentiality, integrity, and the proper disposal of consumer information. The Privacy Rule limits a financial institutions disclosure to nonpublic personal information to unaffiliated third parties unless certain notice requirements are met and the consumer does not elect to prevent, or opt out of the disclosure. The Privacy Rule also requires that privacy notices provided to customers and consumers describe the financial institutions policies and practices to protect the confidentiality and security of the information. With respect to PMI, GLB is enforced by the U.S. Federal Trade Commission (FTC) and state insurance regulators. Many states have enacted legislation implementing GLB and establishing information security regulation. Many states have enacted privacy and data security laws which impose compliance obligations beyond GLB, including obligations to provide notification in the event that a security breach results in a reasonable belief that unauthorized persons may have obtained access to consumer nonpublic information. Privacy and data security in the financial service industry continue to be the subject of pending legislation on both federal and state levels.
Fair Credit Reporting Act. The Fair Credit Reporting Act of 1970, as amended, or FCRA, imposes restrictions on the permissible use of credit report information. FCRA has been interpreted by some FTC staff to require mortgage insurance companies to provide adverse action notices to consumers in the event an application for mortgage insurance is declined on the basis of a review of the consumers credit. The Fair Accurate Credit Transactions Act of 2003, or FACTA, amends and reauthorizes certain provisions of FCRA, including provisions which direct the FTC, and the Federal Reserve Board, or FRB, to promulgate regulations requiring notice to any consumer receiving an extension or grant of credit based on a counter offer by the creditor on material terms, including interest rate, that are materially less favorable than the terms generally available from the creditor to consumers, based in whole or in part on a consumer report. No regulations have yet been proposed, and the FTC and FRB have stated that those provisions of FACTA that require regulation will not be effective until the date specified in the final regulations. The risk-based pricing notice provision is among the affected provisions. It is not clear at this point what that regulation will provide or what its impact, if any, will be on our mortgage insurance operations. See Item 3. Legal Proceedings below for information about litigation against PMI involving FCRA allegations.
Our International Operations segment generated 20.6% of our consolidated revenues in 2006 compared to 19.0% in 2005. Revenues from PMI Australia were $202.0 million and 16.8% of our consolidated revenues in 2006 and $170.8 million and 15.3% of our consolidated revenues in 2005. Revenues from PMI Europe were $33.9 million and 2.8% of our consolidated revenues in 2006 and $30.2 million and 2.7% of our consolidated revenues in 2005. Revenues from PMI Asia were $12.7 million and 1.0% of our consolidated revenues in 2006 and $11.4 million and 1.0% of our consolidated revenues in 2005. See Item 7. Managements Discussion and Analysis of Financial Condition and Results of OperationsInternational Operations, and Item 8. Financial Statements and Supplementary DataNote 17. Business Segments, for additional information about geographic areas.
Our international mortgage insurance and credit enhancement operations include our operations in Australia and New Zealand, the European Union and Hong Kong. We expect to begin operations in Canada in the first half of 2007 and are exploring other international opportunities.
Australia and New Zealand
Our Australia and New Zealand mortgage insurance operations, collectively PMI Australia, are headquartered in Sydney, Australia, with offices throughout Australia and New Zealand. PMI Australias financial strength is rated AA by S&P and Fitch, and Aa2 by Moodys. PMI Australia is a party to capital support agreements, guaranteed by The PMI Group, in which PMI agrees to provide funds to ensure that PMI Australia holds prudent levels of capital sufficient to maintain its credit ratings. At December 31, 2006, the total assets of PMI Australia were $1.1 billion compared to $0.9 billion at December 31, 2005.
Australian mortgage insurance, known as lenders mortgage insurance, or LMI, is characterized by single premiums and coverage of 100% of the loan amount. Lenders usually collect the single premium from a prospective borrower and remit the amount to PMI Australia as the mortgage insurer. PMI Australia recognizes earnings from single premiums in its financial statements over time in accordance with an actuarially determined multi-year schedule. Premiums are partly refundable if the policy is cancelled within the first year.
LMI covers the unpaid loan balance, plus selling costs and expenses, following the sale of the underlying property. Historically, loss severities have normally ranged from 20% to 30% of the original loan amount. In New Zealand, insurance coverage is predominantly top cover, where the total loss (including expenses) is paid up to a prescribed percentage of the original loan amount. Typical top cover in New Zealand ranges between 20% and 30% of the original loan amount. Approximately 96% of PMI Australias risk in force covers Australian mortgages.
The substantial majority of the loans insured by PMI Australia are variable interest rate loans with terms up to 30 years. Interest rate changes impact the frequency of defaults and claims with respect to these loans. Since mortgage interest is not tax deductible in Australia or New Zealand on owner-occupied properties, borrowers have a strong incentive to accelerate reduction of their principal balance by amortizing or prepaying their mortgages.
PMI Australias NIW includes flow channel insurance and insurance on loans underlying residential mortgage-backed securities, or RMBS. RMBS transactions include insurance on seasoned portfolios comprised of prime credit quality loans that often have LTVs below 80%. In 2006, 49.5% of PMI Australias NIW was RMBS insurance written, compared to 36.8% in 2005. Activity levels in the Australian RMBS market vary from quarter to quarter and are strongly influenced by macro-economic factors.
The five largest Australian banks collectively provide 75% or more of Australias residential housing financing. These banks represented approximately 20% of PMI Australias gross premiums written in 2006,
compared to approximately 26% in 2005. Other market participants in Australian and New Zealand mortgage lending include regional banks, building societies, credit unions, and non-bank mortgage originators. PMI Australias five largest customers provided 57.6% of PMI Australias 2006 gross premiums written, compared to 62.9% in 2005.
A significant portion of PMI Australias business is acquired through quota share reinsurance agreements with several of its lending customers captive LMI companies. These quota share reinsurance agreements typically contain a contractual period under which the lender agrees to send PMI Australia a proportion of business written. PMI Australia wrote approximately 31% of its new business premiums under these agreements in 2006, compared to approximately 37% in 2005.
PMI Australias principal competitor is Genworth Financial. Two other U.S.-based mortgage insurance companies, which have agreed to merge, have announced their intention to issue mortgage insurance in Australia in 2007. In addition, several large banks have captive LMI companies in Australia. We expect PMI Australia will face increased competition in the future. Such competition may take a number of forms including domestic and offshore LMI companies, reinsurers of residential mortgage credit risk, increased risk appetite from lender owned captive insurers and non insurance forms of credit risk transfer. New market competitors have the potential to impact PMI Australias market share and to impact pricing of credit risk in the market as a whole.
PMI Australia is subject to regulation and examination by both the Australia and New Zealand regulatory authorities concerning many aspects of its business, including the ability to pay dividends. The Australian Prudential Regulation Authority (APRA) regulates financial services institutions in Australia, including mortgage insurance companies. APRA sets minimum capital levels and corporate governance requirements for PMI Australia, and reviews PMI Australias management, controls, underwriting, reporting, and reinsurance strategies.
APRA intends to implement Basel II capital requirements for financial institutions effective January 1, 2008. Such implementation may have a significant impact on the future market acceptance of LMI in Australia. PMI Australia has provided comments on APRAs initial Basel II proposals. If adopted as APRA has proposed, the proposals could reduce the available market for LMI among PMI Australias bank customers. It is not known at this time whether APRA will revise its Basel II proposals in response to comments it received from LMI industry participants.
Risk in Force. The composition of PMI Australias risk in force is summarized in the table below. The table is based upon information available on the date of mortgage origination.
Underwriting and Claims Management. PMI Australia utilizes the pmiAURAsm System, a statistical model used to analyze PMI Australias claims frequency risk, as part of its underwriting and risk analysis program. This methodology is the same as that applied by PMI in the U.S., but was developed for PMI Australia using Australian claims, economic and demographic information. The pmiAURAsm System assigns a predictive claim risk score to individual policies. PMI Australia also commenced the electronic submission of applications and delivery of underwriting decisions in 2004.
As in the United States, mortgage insurance underwriting decisions have been delegated by PMI Australia to certain of its customers. Delegated underwriting allows approved customers, subject to agreed policy limitations, to commit PMI Australia to offering LMI with respect to a mortgage loan. The pmiAURAsm System is also used to analyze these arrangements which are subject to regular compliance audit by PMI Australia. PMI Australia may be committed to insure a loan that fails to meet all the agreed delegated guidelines. Long-term performance of delegated insured loans is not expected to vary materially from the performance of all other insured loans.
The claims processes in Australia and New Zealand are similar to the process followed by PMI in the U.S. Claims activity in Australia and New Zealand is not spread evenly throughout the coverage period of an insurance book of business. We expect the significant majority of claims on insured loans in PMI Australias current portfolio to principally occur in the second through fourth years after loan origination. The following table sets forth the dispersion of PMI Australias risk in force as of December 31, 2006, by year of policy origination:
The following table sets forth default and claims experience for PMI Australia for the years 2004 through 2006:
Default rates differ from state to state in Australia depending upon economic conditions and cyclical growth patterns. The table below sets forth default rates by state for PMI Australias risk in force. Default rates are shown by state based on location of the underlying property.
The higher default rates in nearly all of the above states in 2006 were driven primarily by higher interest rates and moderating or declining home prices across Australia. The largest increases in default rates were in the Sydney (NSW) area. The portion of PMI Australias risk in force relating to Low Doc loans also contributed to the increases in the default rates in 2006. (See Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations, International OperationsPMI Australia.) For discussion of PMI Australias loss reserves, see Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations, Critical Accounting Estimates, Reserves for Losses and LAEInternational Operations.
Privacy. As in the United States, the collection and use of personal information in Australia is subject to strict regulation at both the federal and state levels. For example, the Federal Privacy Act establishes a series of national privacy principles that apply to all businesses, including insurance companies. In general, companies may only collect, store, disclose, and use personal information if consent has been obtained from the persons concerned or if certain other conditions are met.
PMI Mortgage Insurance Company Limited (collectively with our other European subsidiaries referred to as PMI Europe) is a mortgage insurance and credit enhancement company incorporated and located in Dublin, Ireland, with branches or offices in Milan, Frankfurt and Brussels, and an affiliated services company in London. PMI Europe is fully authorized to provide credit, suretyship and miscellaneous financial loss insurance by Irelands Financial Regulator. This authorization enables PMI Europe to offer its products in the European Union member states and certain other jurisdictions. PMI Europes claims paying ability is rated AA by S&P and Fitch and Aa3 by Moodys. These ratings are based upon PMI Europes capitalization, its management expertise, a capital support agreement provided by PMI, and a guarantee by The PMI Group of PMIs obligations under the capital support agreement. At December 31, 2006, the total assets of PMI Europe were $243.4 million compared to $227.6 million at December 31, 2005.
PMI Europe currently offers capital markets products, reinsurance and primary insurance, all of which are related to credit default risk on residential mortgage loans. As of December 31, 2006, PMI Europe had provided credit protection with respect to German, Dutch, British, U.S. and Italian residential mortgage loans. Capital markets products are designed to support secondary market transactions, notably credit-linked notes, collateralized debt obligations, mortgage-backed securities, or synthetic securities transactions (principally, credit
default swap transactions). Lenders frequently engage in these transactions to reduce the capital they must hold pursuant to local banking capital regulations or to provide funding for their mortgage lending activities.
At December 31, 2006, approximately 63% of PMI Europes risk in force was indirectly derived from fourteen credit default swap transactions, all of which were designed primarily to allow the mortgage lenders involved to reduce the level of required regulatory capital. In six of these transactions, PMI Europe assumed a first loss, unrated risk position. In the remaining transactions, PMI Europes risk position was rated at least investment grade, the majority being rated AAA. Competitors in this product line include mortgage insurance companies, financial guaranty insurance companies, banks, hedge funds, traditional bond investors and other structuring alternatives where no third party credit enhancement is provided.
PMI Europe offers reinsurance coverage to both captive insurers and financial guaranty companies. The typical arrangement is excess-of-loss reinsurance where PMI Europe reinsures a mortgage lenders captive insurance company above the level of expected losses but less than a catastrophic level of losses. These transactions are believed to be risk-remote in that the lender or its captive insurer assumes a significant amount of first loss risk. This insurance structure is used occasionally in the United Kingdom by its larger mortgage lenders.
Financial guaranty companies also purchase reinsurance to manage risk exposure and capital requirements. PMI Europe provides excess-of-loss reinsurance where it assumes a second loss position behind over-collateralization, excess spread mechanisms and potentially other forms of credit enhancement in a mortgage-backed security that absorb losses before PMI Europe. PMI Europe has completed six such transactions to date.
PMI Europe also provides quota share reinsurance where it assumes risk pari passu with an insurer. PMI Europe has completed one such transaction to date. As of December 31, 2006, approximately 8% of PMI Europes risk in force stemmed from excess-of-loss reinsurance and 1% stemmed from quota share reinsurance. Potential competitors with respect to these products include mortgage insurance companies, other financial guarantors and multi-line insurers.
PMI Europes third product line, primary insurance, is similar to the primary insurance products offered in the U.S., Australia and New Zealand. As of December 31, 2006, approximately 28% of PMI Europes risk in force stemmed from primary insurance. Primary insurance is mortgage insurance applied to, priced and settled on each loan. This product is currently purchased regularly in several European countries. PMI Europe is attempting to develop greater interest and use of primary insurance in other European countries. PMI Europe commenced writing this product in Italy in 2005 and established a branch in 2006 to write this product in Germany in 2007. Potential competitors at the moment include mortgage insurers and multi-line insurers. A majority of PMI Europes primary insurance in force stems from its acquisition of a portion of the U.K. lenders mortgage insurance portfolio of Royal and Sun Alliance in the fourth quarter of 2003. PMI Europe recognizes premiums associated with this portfolio in accordance with established earnings patterns that are based upon managements estimation of the expiration of the portfolios risk. Accordingly, we expect the premiums earned and risk in force associated with the portfolio to continue to decline through the remaining life of the portfolio.
For discussion on PMI Europes loss reserves, refer to Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations, Critical Accounting Estimates, Reserves for Losses and LAEInternational Operations.
The applicable regulator of PMI Europe is the Irish Financial Regulator (the IFR). Ireland is a member of the European Union and applies the harmonized system of regulation set out in the European Union directives. Under applicable regulations, PMI Europe may provide insurance only in the classes for which it has authorization and must maintain required capital reserves. Irish insurance companies are required, among other things, to submit comprehensive annual returns to the IFR. The IFR has broad powers to intervene in the affairs of insurance companies including the power to enforce, and take remedial and disciplinary action with respect to,
its regulations. Under IFR regulations, insurance companies must maintain a margin of solvency, the calculation of which is based on recent years premium volumes and claims experience, and which supplements technical loss and premium reserve requirements.
In October 2005, the European Union adopted new legislation, the Capital Requirements Directive (CRD), which provides a revised framework for EU member nation banking supervisors to implement new Basel II risk based capital guidelines starting in 2007. The CRD prescribes standard criteria for credit risk mitigation instruments eligible to provide banks with risk relief. We believe the CRD facilitates recognition of mortgage insurance benefits for European banks and, as a result, could increase demand for mortgage insurance products if such recognition of mortgage insurance is ultimately incorporated into the regulatory framework of EU member countries, which we believe will occur in many such countries in 2007.
In Europe, the collection and use of personal information is subject to detailed regulation. The European Unions Data Protection Directive establishes a series of privacy requirements that EU member states are obliged to enact in their national legislation. These requirements generally apply to all businesses, including PMI Europe, and include the provision of notice to borrowers concerning how their personal information is used and disclosed and provisions limiting the transfer of personal information to countries outside the European Union.
We have been providing mortgage reinsurance in Hong Kong since 1999. Prior to 2006, we offered mortgage reinsurance through a Hong Kong branch office. In June 2006, our newly formed subsidiary, PMI Asia, received its insurance authorization from the Hong Kong Insurance Authority. Subsequent to its receipt of authorization, PMI Asia assumed our Hong Kong branchs entire mortgage reinsurance portfolio. PMI Asias principal reinsurance agreement is with the Hong Kong Mortgage Corporation, a public sector entity created to add liquidity to the Hong Kong residential mortgage market. For the year ended December 31, 2006, we reinsured a total of approximately $0.5 billion of loans. Insurance in force was $2.5 billion at December 31, 2006, compared to $2.4 billion at December 31, 2005. In 2005 and 2006, the Hong Kong Mortgage Corporation increased, and will increase further in 2007, the percentage of mortgage insurance risk and associated premiums that it retains, thereby reducing our reinsurance and premiums written. In light of these reductions, future growth by PMI Asia in Hong Kong will be increasingly dependent upon growth in the Hong Kong mortgage market and mortgage insurance penetration of that market.
PMI Asia, among other reinsurers, generally provides reinsurance down-to coverage in Hong Kong which, with the underlying mortgage insurance, reduces the insureds exposure on each loan down to a specified coverage percentage, usually 70% LTV. Unlike in the United States, the underlying mortgage insurance and reinsurance coverage generally expires when loans amortize below their down-to coverage percentage, i.e., 70% LTV. Approximately 30% of PMIs reinsurance written in 2006 was comprised of loans with LTVs between 90.01% and 95.00%, compared with 35% of loans with LTVs between 85.01% and 90.00% and 35% of loans with LTVs between 70.01% and 85.00%.
PMI generally delegates underwriting decisions with respect to particular loans to the reinsured pursuant to detailed written underwriting guidelines agreed to in advance by the parties. The significant majority of reinsurance written by PMI Asia is single premium coverage. In 2006, PMI made claim payments of $0.2 million (net of recoveries). PMI Asias payment of its claims obligations with respect to its Hong Kong reinsurance portfolio is guaranteed by PMI Europe.
We hope to expand our product offerings to one or more other Asian countries in 2007.
We are forming a wholly-owned Canadian subsidiary (PMI Canada), with headquarters in Toronto, Ontario. We expect PMI Canada to begin offering residential mortgage insurance products to Canadian lenders
and mortgage originators in 2007. Prior to offering such products, PMI Canada must obtain a license to write mortgage insurance from the Canadian Office of the Superintendent of Financial Institutions (OSFI), the primary regulator of mortgage insurers in Canada. In addition, PMI Canada must obtain a government guarantee, described further below, from the Canadian Ministry of Finance in order to compete effectively. We have applied for the license and the guarantee and expect to receive both in the first half of 2007.
Federally regulated financial institutions, or FRFIs, are not required to maintain regulatory capital on mortgages backed by a sovereign guarantee. We are seeking to enter into an agreement with the Canadian Ministry of Finance pursuant to which it will guarantee, in the event PMI Canada became insolvent, the benefits payable under mortgage insurance policies we issue in Canada, less 10% of the original principal amount of the insured loan. In the event we successfully enter into this agreement, which we expect to do in 2007, the guarantee would permit FRFIs who purchase our mortgage insurance to reduce their regulatory capital charges for credit risks on insured mortgages by 90%. In exchange for this guarantee, we expect that we will be required to pay the Canadian government a quarterly premium and, for a period of time, quarterly guarantee fund deposits. Our largest private competitor in Canada already operates with the benefit of a similar government issued guarantee.
Prior to offering mortgage insurance in Canada, PMI Canada intends to seek a financial strength rating from DBRS, the principal rating agency in Canada. In order to acquire this rating, PMI and PMI Canada will enter into a capital support agreement for the benefit of PMI Canada.
In Canada, we expect to offer primary flow mortgage insurance, similar to primary insurance in Australia, and structured finance products. Currently, the OSFI requires FRFIs to obtain credit enhancement for residential mortgages that are greater than 75% loan-to-value. Non-regulated originators and FRFIs also are interested in limiting default risk in order to offer more flexible loan terms. We expect to offer structured product solutions to portfolio lenders seeking capital relief or credit enhancement, and to investors seeking to facilitate MBS transactions or mortgage portfolio sales. We expect that our products will generally be single-premium and provide coverage for the insured loans unpaid principal balance, interest and expenses, following the sale of the underlying property.
Five large banks in Canada provide approximately 70% of the financing for Canadas residential mortgage market. Other market participants include regional banks, trust companies, mortgage loan companies, and credit unions. The non-bank lender sectors of the mortgage market, sectors in which we expect to participate, increased in 2005 and 2006, and the credit union lending sector now represents approximately 6% of the origination market. The typical mortgage product in the Canadian market has a one to five year rate reset and a 25 year amortization schedule.
The market for primary mortgage insurance in Canada is well established and, excluding PMI Canada, currently has two main mortgage insurers, the Canadian Mortgage and Housing Corporation (CMHC) and Genworth. The CMHC is a government-owned entity that provides lenders with 100% capital relief from bank capital requirements. Additional U.S. based mortgage insurers have stated their intent to enter the Canadian market.
Foreign Currency Exchange
We are subject to foreign currency exposure due to operations in foreign countries whose currencies fluctuate relative to the U.S. dollar, the basis of our consolidated financial reporting. Such exposure falls into two general categories: economic exposure and transaction exposure.
Economic exposure is defined as the change between anticipated net cash flows in currencies other than the U.S. dollar and the actual results that are reflected in our consolidated financial statements after translation. To the extent there are changes in the average translation rates from local currencies to the U.S. dollar, our recorded consolidated net income can be positively or negatively affected. If the U.S. dollar strengthens relative to other
applicable foreign currencies, our net income from our International Operations segment will be negatively impacted by translation losses. Conversely, if the U.S. dollar weakens against other applicable foreign currencies, our net income from International Operations will be positively impacted by translation gains. Through the purchase of foreign currency put options, we have mitigated the negative impact to consolidated net income due to a strengthening U.S. dollar. As the options purchased increase in value as the U.S. dollar strengthens, such increases in the value of the options are reflected in our consolidated results of operations as derivative option gains. If the U.S. dollar were to weaken relative to the Australian dollar or the Euro, our consolidated net income would continue to be positively affected (less the cost of the options purchased) by translation gains and the purchased options would expire unexercised. In March 2006, to mitigate the negative impact to net income of a strengthening U.S. dollar, PMI Australia purchased foreign currency (Australian dollar) put options at a total pre-tax cost of $1.3 million. To mitigate the negative impact to net income of a strengthening of the U.S. dollar, PMI Europe also purchased foreign currency (Euro) put options at a total pre-tax cost of $0.1 million. These options expired ratably over the course of 2006. As of December 31, 2006, the total cost of these options, net of realized gains recognized to net income, was net losses of $1.2 million and $0.1 million for PMI Australia and PMI Europe, respectively. We have entered into a similar foreign exchange put option program in 2007 at a pre-tax cost of $1.3 million.
We do not currently hedge foreign currency exposures of net investments in our foreign operations. If the spot exchange rates of the U.S. dollar relative to other applicable foreign currencies change, our net investment in our foreign operations will be impacted. Foreign currency translation gains in accumulated other comprehensive income were $172.4 million as of December 31, 2006, due primarily to the strengthening of the spot exchange rates of the Australia Dollar and the Euro relative to the U.S. dollar. This cumulative foreign currency translation gain benefits PMIs statutory surplus as PMI Australia and PMI Europe are its wholly-owned subsidiaries.
Transaction exposure refers to currency risk related to specific transactions and occurs between the time a firm commitment in a foreign currency is entered into and the time the cash is actually paid. Under our Derivative Use Plans Foreign Exchange Policy Guidelines, we are authorized to hedge our transaction exposure through the purchase of forward currency contracts. We did not engage in any hedging activities of transaction risk in 2006.
We are the largest shareholder of FGIC Corporation, with a common equity ownership interest of 42.0%. FGIC Corporations wholly-owned subsidiary, Financial Guaranty Insurance Company ( FGIC), is a triple-A rated financial guaranty company. The other principal investors in FGIC Corporation are affiliates of The Blackstone Group, L.P., The Cypress Group L.L.C. and CIVC Partners L.P. We account for this investment under the equity method of accounting in accordance with Accounting Principles Board (APB) Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock and, accordingly, the investment is not consolidated. We believe that this investment allows us to realize our strategic goal of becoming a global provider of credit enhancement products across multiple asset and risk classes, as well as achieving a major presence in the primary financial guaranty industry.
At December 31, 2006, FGIC had consolidated total assets of $5.0 billion, including $3.9 billion of cash, short-term investments and fixed maturity securities. At December 31, 2006, FGICs net insured par outstanding was $299.9 billion.
FGIC is primarily engaged in the business of providing financial guaranty insurance for public finance, structured finance and international finance (which is comprised of public finance and structured finance business outside the U.S.) obligations. FGIC is licensed to engage in financial guaranty insurance in all 50 states, the District of Columbia, the Commonwealth of Puerto Rico, U.S. Virgin Islands, the United Kingdom, and other
European Union member countries. FGICs financial strength is rated AAA by S&P and Fitch, and Aaa by Moodys. FGIC Corporations senior unsecured debt is rated AA by S&P and Fitch and Aa2 by Moodys.
Financial guaranty insurance generally provides an unconditional and irrevocable guarantee that protects the holder of an insured financial obligation against non-payment of principal and interest by an obligor when due. If the issuer of an insured obligation cannot make the scheduled debt service payment, the financial guarantor assumes this responsibility as and when due. Payment by the financial guarantor does not extinguish the underlying obligation of the issuer, and such payments may be recoverable from the issuer. The financial guarantor is subrogated to the rights of the holders of the insured obligations and, in the event of payment under the policy, has rights in the underlying collateral, if any.
Financial guaranty insurance may be issued at inception of an insured obligation or may be issued in the secondary market, mainly to institutional holders. Financial guaranty insurance lowers an issuers cost of borrowing; the spread between the yield on the insured obligation (carrying the credit rating of the insurer) and the yield on the obligation if sold on the basis of its uninsured credit rating defines the maximum insurance premium available to the insurer. Financial guaranty insurance also increases the marketability of obligations issued by infrequent or unknown issuers or obligations with complex structures. Investors benefit from increased liquidity in the secondary market, reduced exposure to price volatility caused by changes in the credit quality of the underlying insured issue and added protection against loss in the event of the issuers default on its obligation.
U.S. Public Finance. The U.S. public finance market includes municipal general obligation bonds supported by the issuers taxing power and special revenue bonds and other obligations of state and local governments supported by the issuers ability to impose and collect fees and charges for specific public services or projects. The issuer typically pays a one time premium to FGIC at the time the policy is issued. Proposed new public finance bond issues are submitted to FGIC by issuers, their investment bankers or financial advisors to determine their suitability for financial guaranty insurance. FGIC also provides financial guarantees on public finance bonds outstanding in the secondary market. A financial guarantee generally affords a wider secondary market and therefore greater marketability to previously issued bonds. As is the case with new issues, the premium is generally payable in full at the time of policy issuance. FGIC employs the same underwriting standards on secondary market issues that it does on new public finance issues. As of December 31, 2006, $219.3 billion, or 73.1%, of FGICs total net par outstanding represented insurance of public finance obligations. While this 73.1% represents a decline from 78.1% at December 31, 2005, we believe that FGICs public finance concentration remains higher than the industry average.
U.S. Structured Finance. Most U.S. structured finance obligations are secured by, or represent interests in, diverse pools of specific assets, such as residential mortgage loans, auto loans, credit card receivables, other consumer receivables, corporate loans or bonds, small business loans, and commercial real estate loans. The pool of assets underlying the obligations has an identifiable cash flow or market value. Structured finance obligations insured by FGIC generally have the benefit of over-collateralization and/or other forms of credit enhancement to mitigate credit risks associated with the related assets. These forms of credit enhancement are designed to absorb losses in these transactions. Currently, the largest component of FGICs structured finance business relates to the securitization of residential mortgages and home equity loans.
Premiums for structured finance policies are typically based on a percentage of par insured, and can be collected in a single payment at the policy inception date or collected periodically (e.g., monthly, quarterly or annually) from the cash flow generated by the underlying assets. The U.S. structured finance market in which FGIC provides financial guarantees is broad and varied, comprising public issues and private placements. As of December 31, 2006, $68.0 billion, or 22.7%, of FGICs total net par outstanding, represented insurance of U.S. structured finance.
International Public Finance and Structured Finance. Issuers are increasingly using financial guaranty products outside of the United States, particularly in markets throughout Western Europe. FGIC launched its
international finance operation in late 2004 and to date has focused on insuring essential infrastructure transactions and triple-A rated collateralized loan and debt obligations. Premiums for international finance policies are based on a percentage of either par or par and interest insured. Depending upon the terms of the transaction, premiums are collected in a single payment at the policy inception date or are collected periodically. As of December 31, 2006, FGICs net par outstanding related to international finance transactions was $12.6 billion.
Competition. The financial guaranty industry is highly competitive. FGICs principal competitors are three major triple-A rated financial guaranty insurance companies, two smaller triple-A rated financial guaranty insurance companies and one split-rated financial guaranty insurance company. Banks, multiline insurers and reinsurers represent additional participants in the market. Financial guaranty insurance competes with other forms of credit enhancement, including senior-subordinate structures and letters of credit issued by other financial institutions. Senior subordinated structures in the mortgage-backed sector reduce the number of transactions eligible for insurance. Financial guaranty insurance also competes, in nearly all instances, with the issuers alternative of foregoing credit enhancement and paying a higher interest rate. If the interest savings from insurance are not greater than the cost of insurance, the issuer will generally choose to issue bonds without credit enhancement. Accordingly, credit spreadsthe difference in interest cost for issuers under different credit rating scenarios are a significant factor in the issuers determination of whether to seek credit enhancement. As credit spreads tighten, the likelihood that issuers will choose to issue bonds without credit enhancement increases. (The tighter credit spreads reduce the insurance premium margin available, and an insurer is unlikely to offer insurance below a certain level of profitability.)
Loss Reserves. FGICs and the financial guaranty industrys incidence of payment default on insured bond issues has historically been very low. FGICs provision for losses and loss adjustment expenses fall into two categories: case reserves and watchlist reserves.
Case reserves are established for estimated losses on specific insured obligations that are presently or likely to be in payment default for which future loss is probable and can be reasonably estimated. These reserves represent an estimate of the present value of the anticipated shortfall, net of reinsurance, between (i) anticipated claims payments on insured obligations plus anticipated loss adjustment expenses and (ii) anticipated cash flow from, and proceeds to be received on, sales of any collateral supporting the obligation and/or other anticipated recoveries. The discount rate used in calculating the net present value of the estimated losses is based upon the risk-free rate for the period of the anticipated shortfall.
Watchlist reserves recognize the potential for claims against FGIC on insured obligations that are not presently in payment default, but that have migrated to an impaired level where there is a substantially increased probability of default. These reserves reflect an estimate of probable loss given evidence of impairment, and a reasonable estimate of the amount of loss given default. The methodology for establishing and calculating the watchlist reserves relies on a categorization and assessment of the probability of default, and loss severity in the event of default, of the specifically identified impaired obligations on the list based on historical trends and other factors. FGIC conducts ongoing insured portfolio surveillance to identify all impaired obligations and thereby provide a materially complete recognition of losses for each accounting period. Reserves are adjusted each period based on claim payments and the results of ongoing surveillance. Adjustments of estimates made in prior years may result in additional loss and loss adjustment expenses or a reduction of loss and loss adjustment expenses for the period in which the adjustment is made. See Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations Conditions and Trends Affecting our BusinessFinancial Guaranty.
Regulation; Dividend Restrictions. FGIC is subject to the insurance laws and regulations of the State of New York, where FGIC is domiciled, including Article 69, a comprehensive financial guaranty insurance statute. FGIC is also subject to the insurance laws and regulations of all other jurisdictions in which it is licensed to transact insurance business. The insurance laws and regulations, as well as the level of supervisory authority that may be exercised by the various insurance regulators, vary by jurisdiction, but generally require insurance
companies to maintain minimum standards of business conduct and solvency, to meet certain financial tests, to comply with requirements concerning permitted investments and the use of policy forms and premium rates, and to file quarterly and annual statutory statements and other reports. FGICs accounts and operations are subject to periodic examination by the Superintendent of Insurance of the State of New York and by insurance regulatory authorities in the other jurisdictions in which FGIC is licensed to write insurance.
FGICs ability to pay dividends is subject to restrictions contained in the insurance laws and related regulations of New York and the other jurisdictions in which FGIC is licensed to do insurance business. Under New York insurance law, FGIC may pay dividends out of statutory earned surplus, provided that, together with all dividends declared or distributed by FGIC during the preceding 12 months, the dividends would not exceed the lesser of (i) 10% of policyholders surplus as of its last statement filed with the New York Superintendent of Insurance and (ii) adjusted net investment income during this period. Adjusted net investment income includes a two-year carry-forward for undistributed investment income. Any dividend distribution in excess of these requirements would require the prior approval of the New York Superintendent of Insurance.
In addition, so long as any FGIC Corporation senior preferred stock (or class B common stock issued upon conversion of that preferred stock) is outstanding, FGIC Corporations certificate of incorporation generally prohibits the payment of dividends or other payments on any of FGIC Corporations capital stock, except the senior preferred stock, without the consent of the holder of two-thirds of the outstanding shares of that preferred stock (or the class B common stock issued upon conversion of that preferred stock). This restriction does not apply to cash dividends declared and paid on the class A common stock after the ninth anniversary of the closing of the FGIC Corporation investment, provided that those dividends are paid from retained earnings in excess of the amount of FGIC Corporations retained earnings on the closing date of such investment, the amount of the dividends in any fiscal year does not exceed one-third of one percent of FGIC Corporations stockholders equity, and equivalent dividends are paid on the class B common stock.
The stockholders agreement between The PMI Group and the other investors in FGIC Corporation also restricts the payment of dividends by FGIC Corporation. The stockholders agreement provides that FGIC Corporation will not declare or pay cash dividends to holders of its common stock prior to the earlier of the fifth anniversary of the closing of the investment and the completion of the first underwritten public offering of FGIC Corporations common stock, and, in any event, that such dividends will not be paid prior to the redemption of FGIC Corporations senior preferred stock and class B common stock.
FGIC Corporation is further restricted in the payment of dividends by the terms of its 6% senior notes, due 2034. Except as described in the following sentence, FGIC Corporation may not pay dividends unless the amount of the dividends, together with other similar payments, or restricted payments, during any fiscal year does not exceed the greater of (i) 30% of FGIC Corporation and its subsidiaries consolidated net income for the previous fiscal year and (ii) 2.5% of the stockholders equity on the consolidated balance sheet of FGIC Corporation and its subsidiaries as of the end of the previous fiscal year. FGIC Corporation may make restricted payments regardless of amount so long as the payments would not reasonably be expected to cause an adverse change to either (i) the then current insurance financial strength rating and outlook of FGIC or (ii) FGIC Corporations then current senior unsecured debt rating and outlook.
Other. FGIC operates as an independent company. Our stockholders agreement with the other members of the investor group provides for certain corporate governance arrangements with respect to FGIC and other important corporate matters.
In 2006, we formed PMI Guaranty, a wholly-owned surety company based in New Jersey. PMI Guaranty received its certificate of authority from the New Jersey Department of Banking and Insurance in July 2006 and began operations in the fourth quarter of 2006. PMI Guaranty has financial strength ratings of AA+ by Fitch
Ratings, AA by Standard & Poors, and Aa3 by Moodys Investors Service. In addition, Standard & Poors assigned a AA Financial Enhancement Rating to PMI Guaranty. PMI Guaranty competes in the markets for AA-rated financial guaranty insurance, financial guaranty reinsurance and related credit enhancement products and services.
We initially capitalized PMI Guaranty with $200 million, which included $150 million of paid-in equity and a $50 million junior surplus note issued to The PMI Group. In addition, PMI Guaranty benefits from a capital support agreement with PMI, which is guaranteed by The PMI Group. The capital support agreement and corresponding guarantee are for a maximum of $650 million. As of December 31, 2006, PMI Guaranty had net reinsured par outstanding of $562.2 million.
Mortgage Related Credit Enhancement. PMI Guaranty offers AA-rated financial guaranty type insurance for bonds that are backed by a broad array of mortgage-related assets, including first lien mortgages, second lien mortgages, Home Equity Lines of Credit, and mortgages with high LTV ratios. These products also insure bonds that are backed by the excess cash flow associated with the issuance of mortgage-backed securities, generally referred to as Net Interest Margin Securities. The excess cash flow results from the difference between the interest on the mortgages underlying the security and the interest paid on the bond (excess spread) and the fact that the principal value of the mortgages typically exceeds the principal amount of the offered bonds (over-collateralization). PMI Guarantys credit enhancement products guarantee that the principal and interest associated with the insured bonds will be paid to investors on the date due.
PMI Guarantys products differ from FGICs in several respects. First, while FGIC offers coverage on municipal bonds and structured finance obligations secured by a wide range of assets, PMI Guarantys current principal focus is to offer credit protection on bonds backed by mortgage-related assets. Second, as described below, PMI Guaranty typically insures MBS bonds that are less senior in priority than bonds typically insured by FGIC.
In a typical mortgage backed securitization structure, there are three levels of exposure to loss: first loss, mezzanine loss and remote loss. First loss usually refers to the over-collateralization and excess spread in the structure, sometimes augmented by mortgage insurance, as well as the non-rated tranches of the securitization structure. Losses associated with the pool of securitized loans will first be absorbed by mortgage insurance (if due to borrower default), excess spread and over-collateralization. If over-collateralization is depleted, and there is insufficient excess spread to make scheduled interest payments on issued securities, losses will then be allocated to the non-rated tranches and, once that is depleted, to those bonds in the securitization structures mezzanine tranches.
The mezzanine risk level generally consists of the non-investment grade rated tranches up to and including lower investment grade tranches. PMI Guaranty, as a AA-rated insurer, generally guarantees payment obligations on the tranches of the securitization structure that commence at a lower investment grade level (for example, BBB-) and end at the AA attachment point (i.e., up to and including the AA level). With the guarantee, issuers are able to offer AA-rated securities equal to the entire notional amount of these wrapped tranches.
We expect PMI Guaranty, through its financial guaranty product offerings, to capitalize on our expertise in the mortgage-related securities sector and complement the operations of PMI. While both PMI Guaranty and PMI will offer their products independently, we believe that the combination of first loss coverage from PMI and mezzanine loss coverage from PMI Guaranty in a securitization provides issuers with a more comprehensive credit enhancement solution.
Financial Guaranty Reinsurance. PMI Guaranty also offers financial guaranty reinsurance to triple-A rated primary financial guarantors. PMI Guarantys reinsurance portfolio is expected to consist of securities that are backed by mortgage-related assets as well as municipal bonds. PMI Guarantys obligation to make payments of principal and interest to investors through its financial guaranty reinsurance product will arise when triple-A rated financial guarantors provide PMI Guaranty with notice that they will be responsible for making payments
of principal and interest to investors. When provided with such notice, PMI Guaranty will be obligated to pay its proportionate share of any losses based upon the reinsurance treaty.
Triple-A rated financial guarantors, including FGIC, are required by the rating agencies to maintain amounts of capital exceeding those required of AA-rated financial guarantors. By providing reinsurance to triple-A rated financial guarantors, PMI Guaranty can reduce the amount of total capital held by the triple-A rated financial guarantors.
Competition. PMI Guaranty faces significant competition in both the financial guaranty insurance and financial guaranty reinsurance arenas. In addition to PMI Guaranty, there is currently one AA-rated financial guarantor that provides financial guaranty insurance and at least three financial guarantee reinsurance competitors. PMI Guaranty also competes with alternative credit enhancement products and structures and capital market participants.
PMI Guaranty is subject to the insurance laws and regulations of the State of New Jersey, where it is domiciled. As a licensed surety corporation, PMI Guaranty is regulated by the New Jersey Department of Banking and Insurance.
We own 23.7% of RAM Holdings Ltd., a holding company for RAM Re. RAM Re is a financial guaranty reinsurance company based in Bermuda. RAM Re is currently rated AAA by S&P and Aa3 by Moodys. RAM Re and its holding company are subject to regulation under the laws of Bermuda. RAM Holdings Ltd. completed an initial public offering in the first quarter of 2006 and is publicly traded on the Nasdaq National Market.
RAM Re commenced business in February 1998 with the purpose of reinsuring municipal, structured finance and international debt obligations originally underwritten by triple-A rated guarantors. RAM Re provides reinsurance to primary financial guarantor companies that market credit enhancement of debt securities through insurance on scheduled payments on an issuers obligations. RAM Res insured portfolio consists primarily of municipal securities and structured products, principally asset-backed securities. RAM Re derives substantially all of its financial guaranty revenues from premiums ceded by the major primary financial guarantors.
When a primary financial guaranty company cedes a portion of a particular transaction to a reinsurer such as RAM Re, that reinsurer becomes obligated to pay its proportionate share of any losses should the reinsured transaction default. The ceding companies use such reinsurance for a variety of reasons, including to increase insurance capacity, assist in meeting applicable regulatory and rating agency requirements, in particular with respect to single risk and risk concentration limits, manage single risks and risk aggregations among servicers on asset backed transactions as well as for broader risk management purposes (such as addressing sector or geographic concentrations).
The financial guaranty policies which RAM Re reinsures typically cover full and timely payment of scheduled principal and interest on debt securities. A reinsurance company receives its share of the premium from the primary insurer, and typically pays a ceding commission to the primary insurer as compensation for underwriting expenses. Insurance is ceded by the primaries to the reinsurance companies either on a treaty or facultative basis. Treaty reinsurance typically involves an agreement covering a defined class of business where the reinsurance company must assume, and the insurer must cede, a portion of all risks defined by the terms of the treaty. In facultative agreements, reinsurance is negotiated on a case-by-case basis for coverage of individual transactions or business segments, giving both parties control over the credit process.
As of December 31, 2006, The PMI Group and its consolidated subsidiaries had total cash and cash equivalents of $457 million and investments of $3.3 billion. In 2004, The PMI Groups Board of Directors formed the Investment and Finance Committee of the Board of Directors to oversee our investment portfolio, including our unconsolidated subsidiaries, approve investment strategies, monitor our investment performance, and oversee other capital matters. The U.S. companies included in the consolidated financial statements, or the U.S. Portfolio, held cash and cash equivalents and investments of $2.4 billion as of December 31, 2006. We manage the fixed income portion of the U.S. Portfolio internally. The 4.8% of the U.S. Portfolio invested in common stock of publicly-traded corporations is managed by Mt. Eden Investment Advisors.
We manage the U.S. Portfolio to achieve the goals of providing a predictable, high level of investment income, while maintaining adequate levels of liquidity, safety and preservation of capital. Growth of capital and surplus through long-term market appreciation are a secondary consideration. Realization of taxable capital gains is minimized and emphasis is given to credit quality, price volatility and diversification, for each investment category as well as for the portfolio as a whole. As of December 31, 2006, based on market value and excluding cash and cash equivalents, approximately 81.8% of the U.S. Portfolio was invested in fixed income securities and approximately 18.1% was invested in equity securities. 96.8% of the fixed income investments were rated A or better by at least one nationally recognized securities rating organization, and of those, 68.9% were rated AAA, 19.4% were rated AA, and 8.5% were rated A. The U.S. Portfolios fixed income portfolios option-adjusted duration, including cash and cash equivalents, was 4.8 as of December 31, 2006. We generally do not invest in mortgage backed securities.
Investments held by The PMI Groups U.S. insurance subsidiaries are subject to the insurer investment laws of each of the states in which they are licensed. These statutes, designed to preserve insurer assets for the protection of policyholders, set limits on the percentage of assets that an insurer can hold in certain investment categories (e.g., under Arizona law, no more than 20% in equity securities) and with a single issuer (e.g., 10% under Arizona law).
PMI Australias, PMI Europes and PMI Asias investments are subject to the investment policies adopted by their respective boards of directors and are managed by investment advisory firms under separate investment management agreements. We regularly review these entities investment strategies and performances. The investment policies specify that the portfolios must be invested predominantly in intermediate-term and high-grade bonds.
As of December 31, 2006, PMI Australia had $105.0 million in cash and cash equivalents and $966.3 million of investments which are managed by Deutsche Asset Management (Australia) Limited. The investment portfolio consists mainly of high-grade Australian currency-denominated fixed income securities issued by sovereign, semi-government and corporate entities. At December 31, 2006, the portfolios option-adjusted duration, including cash and cash equivalents, was 3.7. The entire Australian bond portfolio is investment grade rated. The portfolio also contains a small allocation of investments in Australian equity securities.
As of December 31, 2006, PMI Europe had $23.6 million in cash and cash equivalents and $191.7 million of investments which are managed by Morgan Stanley Investment Management Limited. The investment portfolio consists of Euro and British Pounds Sterling currency-denominated fixed income securities issued by sovereign, agency and corporate entities. The portfolios option-adjusted duration, including cash and cash equivalents, was 4.7 at December 31, 2006. PMI Europes portfolio did not contain investments in equity securities as of December 31, 2006.
As of December 31, 2006, PMI Asia had $3.6 million in cash and cash equivalents and $58.9 million of investments which are managed by Deutsche Asset Management (Hong Kong) Limited. The investment portfolio consists of Hong Kong dollar denominated fixed income securities issued by sovereign, agency and corporate
entities. The portfolios option-adjusted duration, including cash and cash equivalents, was 3.4 at December 31, 2006. PMI Asias portfolio did not contain investments in equity securities as of December 31, 2006.
We review the investment portfolios and strategies of our unconsolidated subsidiaries on a quarterly basis. Through our representation on their boards of directors, we have a limited ability to influence their investment management decisions.
As of December 31, 2006, The PMI Group, together with its wholly-owned subsidiaries and CMG MI, had approximately 1,000 full-time and part-time employees, of which 720 persons performed services primarily for PMI, 226 were employed by PMI Australia, 23 were employed by PMI Europe, 5 were employed by PMI Asia, 24 performed services primarily for CMG MI and 4 for PMI Guaranty. Our employees are not unionized and we consider our employee relations to be good. In addition, MSC had 179 temporary workers and contract underwriters as of December 31, 2006.
If the volume of low down payment home mortgage originations declines or if the number of mortgage loans originated and purchased by the GSEs continues to decline, the amount of insurance that PMI writes could decrease, which could result in a decrease of our future revenue.
A decline in the volume of low down payment mortgage originations could reduce the demand for private mortgage insurance and consequently, our revenues. The volume of low down payment mortgage originations is affected by, among other factors: the level of home mortgage interest rates; domestic economy and regional economic conditions; consumer confidence; housing affordability; the rate of household formation; the rate of home price appreciation, which in times of heavy refinancing affects whether refinance loans have loan-to-value ratios that require private mortgage insurance; and government housing policy. The GSEs are principal beneficiaries of PMIs flow mortgage insurance policies and the decline in the number of low down payment mortgage loans originated and purchased by the GSEs has adversely affected our revenues from this channel. The GSEs lost market share in 2005 and 2006 due in part to higher percentages of less-than-A loans, adjustable rate mortgages, which we refer to as ARMs, and reduced documentation loans originated in 2005 and 2006. Such loans are generally either retained by loan originators and not sold to the GSEs or are placed in mortgage-backed securities that are privately issued and not guaranteed by the GSEs.
If interest rates decline, home values increase or mortgage insurance cancellation requirements change, the length of time that PMIs policies remain in force and our revenues could decline.
A significant percentage of the premiums PMI earns each year is generated from insurance policies written in previous years. As a result, a decrease in the length of time that PMIs policies remain in force could cause our revenues to decline. Factors that lead to borrowers canceling their mortgage insurance include: current mortgage interest rates falling below the rates on the mortgages underlying insurance in force, which frequently results in borrowers refinancing their mortgages; appreciation in the values of the homes underlying the mortgages we insure; and the availability of alternative loan products, which provide borrowers with the opportunity to at least temporarily decrease their monthly loan payments.
If mortgage lenders and investors select alternatives to private mortgage insurance, such as piggyback loans, the amount of insurance that we write could decline, which could reduce our revenues and profits.
In the U.S., mortgage lenders have been increasingly structuring mortgage originations to avoid private mortgage insurance, primarily through the use of simultaneous seconds, piggybacks, 80/10/10s, 80/15/5s or 80/20 loans. Such mortgages are structured to include a first mortgage with an 80% loan-to-value ratio and a second mortgage with a loan-to-value ratio ranging from 5% to 20%. Over the past several years, the volume of
these loans, or variations thereof, as alternatives to loans requiring mortgage insurance has increased significantly and may continue to do so for the foreseeable future.
Other alternatives to private mortgage insurance include:
These alternatives, or new alternatives to private mortgage insurance that may develop, could reduce the demand for private mortgage insurance and cause our revenues and profitability to decline.
Although the FHLBs are not required to purchase insurance for mortgage loans, they currently use mortgage insurance on substantially all mortgage loans with a loan-to-value ratio above 80%. If the FHLBs were to purchase uninsured mortgage loans or increase the loan-to-value ratio threshold above which they require mortgage insurance, the market for mortgage insurance could decrease and we could be adversely affected.
The risk-based capital rule applicable to the GSEs may allow large financial entities such as banks, financial guarantors, insurance companies, and brokerage firms to provide or arrange for products that may efficiently substitute for some of the capital relief provided to the GSEs by private mortgage insurance. Our consolidated financial condition and results of operations could be harmed if the GSEs were to use these products in lieu of mortgage insurance.
We reinsure a portion of our mortgage insurance default risk with lender-affiliated captive reinsurance companies, which reduces our net premiums written and earned.
Mortgage insurers including PMI offer products to lenders that are designed to allow them to participate in the risks and rewards of the mortgage insurance business. Many of the major mortgage lenders have established affiliated captive reinsurance companies. These captive reinsurance companies assume a portion of the risks associated with the lenders insured mortgage loans in exchange for a percentage of the associated gross premiums. An increasing percentage of PMIs primary flow insurance in force has been generated by customers with captive reinsurance companies. Because a number of our major customers have made the business decision to participate in the mortgage insurance business by establishing reinsurance companies, we believe that if we did not offer captive reinsurance agreements, our competitive position would suffer. Captive reinsurance agreements negatively impact our net premiums written and earned.
Economic factors have adversely affected and may continue to adversely affect PMIs loss experience.
PMIs loss experience has increased over the past year and could continue to increase in the year(s) to come as a result of: national or regional economic recessions and downturns; declining values of homes; higher unemployment rates; higher levels of consumer credit; deteriorating borrower credit; interest rate volatility; war or terrorist activity; adverse weather events; or other economic factors.
PMIs loss experience may increase as its policies continue to age.
We expect the majority of losses and LAE on insured loans in PMIs current portfolio to occur during the second through the fourth years after loan origination. Primary insurance written from the period of January 1,
2003 through December 31, 2005 represented 57.7% of PMIs primary risk in force as of December 31, 2006. Accordingly, a majority of the primary portfolio is in, or approaching, its peak claim years. We believe our loss experience could increase as these policies age. If the claim frequency on PMIs risk in force significantly exceeds the claim frequency that was assumed in setting premium rates, our consolidated financial condition and results of operations would be harmed.
Since we generally cannot cancel mortgage insurance policies or adjust renewal premiums, unanticipated claims could cause our financial performance to suffer.
We generally cannot cancel the mortgage insurance coverage that it provides or adjust renewal premiums during the life of a mortgage insurance policy. As a result, the impact of unanticipated claims generally cannot be offset by premium increases on policies in force or mitigated by non-renewal or cancellation of insurance coverage. The premiums we charge may not be adequate to compensate us for the risks and costs associated with the insurance coverage provided to customers. An increase in the number or size of unanticipated claims could adversely affect our consolidated financial condition and results of operations.
Geographic concentration of PMIs primary insurance in force could increase claims and losses and harm our financial performance.
We could be affected by economic downturns, natural disasters and other events in specific regions of the United States where a large portion of our U.S. business is concentrated. As of December 31, 2006, 10.7% of PMIs primary risk in force was located in Florida, 7.4% was located in Texas and 7.0% was located in California. In addition, refinancing of mortgage loans can have the effect of concentrating our insurance in force in economically weaker areas of the U.S. As of December 31, 2006, 13.2% of U.S. policies in force related to loans located in Michigan, Kentucky, Indiana, and Ohio. Collectively these states experienced higher default rates in 2006 than other regions of the U.S.
The premiums we charge for mortgage insurance on high LTV loans, ARMs, less-than-A quality loans, Alt-A loans, interest only loans, and payment option ARMs, and the associated investment income, may not be adequate to compensate for future losses from these loans.
PMIs primary new insurance written and risk in force includes:
We expect higher default and claim rates for high LTV loans, ARMs, Alt-A loans, interest only loans, payment option ARMs, and less-than-A quality loans. Although we attempt to incorporate these higher default and claim rates into our underwriting and pricing models, there can be no assurance that the premiums earned and the associated investment income will prove adequate to compensate for future losses from these loans.
Our loss reserves may be insufficient to cover claims paid and loss-related expenses incurred.
We establish loss reserves to recognize the liability for unpaid losses related to insurance in force on mortgages that are in default. These loss reserves are regularly reviewed and are based upon our estimates of the claim rate and average claim amounts, as well as the estimated costs, including legal and other fees, of settling claims. Any adjustments, which may be material, resulting from these reviews are reflected in our consolidated results of operations. Our consolidated financial condition and results of operations could be harmed if our reserve estimates are insufficient to cover the actual related claims paid and loss-related expenses incurred.
We delegate underwriting authority to mortgage lenders which could cause us to insure mortgage loans that do not conform to our underwriting guidelines, and thereby increase claims and losses.
A significant percentage of PMIs new insurance written is underwritten pursuant to a delegated underwriting program under which, subject to routine audit, certain mortgage lenders may determine whether mortgage loans meet our program guidelines and commit us to issue mortgage insurance. We may expand the availability of delegated underwriting to additional customers. If an approved lender commits us to insure a mortgage loan, we generally may not refuse, except in limited circumstances, to insure, or rescind coverage on, that loan even if we reevaluate that loans risk profile and determine the risk profile to be unacceptable or the lender fails to follow our delegated underwriting guidelines.
If we fail to properly underwrite mortgage loans when we provide contract underwriting services, we may be required to provide monetary and other remedies to the customer.
We provide contract underwriting services for a fee. As a part of the contract underwriting services, we provide monetary and other remedies to customers in the event that we fail to properly underwrite a mortgage loan. As a result, we assume credit and, to a lesser extent, interest rate risk in connection with our contract underwriting services. Generally, the remedies provided are in addition to those contained in PMIs master policies. Contract underwriting services apply to a significant percentage of PMIs insurance in force and the costs relating to the investigation and/or provision of remedies could have a material adverse effect on our consolidated financial condition and results of operations. Worsening economic conditions or other factors that could increase default rates could also cause the number and severity of remedies to increase.
Our revenues and profits could decline if PMI loses market share as a result of industry competition or if our competitive position suffers as a result of our inability to introduce and successfully market new products and programs.
The principal sources of PMIs competition include: other private mortgage insurers, one of which is a wholly-owned subsidiary of a well-capitalized, diversified public company with direct or indirect capital reserves that provide it with potentially greater resources than we have, as well as the various alternatives to private mortgage insurance discussed above. See also, If mortgage lenders and investors select alternatives to private mortgage insurance, such as piggyback loans, the amount of insurance that we write could decline, which could reduce our revenues and profit, above.
With respect to our structured finance channel, PMI competes with other external credit enhancers, primarily other private mortgage insurers and financial guarantors, as well as with capital markets participants, including aggregators and loan originators, who are continually devising new forms of structures in which to securitize mortgage loans without external credit enhancement, including private mortgage insurance. To successfully compete in the structured finance arena, we must introduce competitive new products and programs and maintain competitive pricing. If we are unable to successfully compete with other private mortgage insurers, other external credit enhancers and the various other private mortgage insurance alternatives, or if we experience delays in introducing competitive new products and programs or if these products or programs are less profitable than our existing products and programs, our business will suffer.
Changes to the risk-based capital rule issued by the Office of Federal Housing Enterprise Oversight could cause PMIs business to suffer.
The Office of Federal Housing Enterprise Oversight, the agency which currently regulates the GSEs, or OFHEO, has issued a risk-based capital rule that proscribes treatment of credit enhancements issued by private mortgage insurers and provides capital guidelines for the GSEs in connection with their use of other types of credit protection counterparties in addition to mortgage insurers. OFHEO has the authority to make changes to the risk-based capital rule. If changes to the rule resulted in the GSEs increasing their use of either AAA rated mortgage insurers, if any, instead of AA rated entities or credit protection counterparties other than mortgage insurers, our consolidated financial condition and results of operations could be adversely affected.
Legislation and regulatory changes, including changes impacting the GSEs, could significantly affect PMIs business and could reduce demand for private mortgage insurance.
Mortgage origination transactions are subject to compliance with various federal and state consumer protection laws, including RESPA, the Equal Credit Opportunity Act, the Fair Housing Act, the Homeowners Protection Act, FCRA, the Fair Debt Collection Practices Act, and others. Among other things, these laws prohibit payments for referrals of settlement service business, require fairness and non-discrimination in granting or facilitating the granting of credit, require cancellation of insurance and refunding of unearned premiums under certain circumstances, govern the circumstances under which companies may obtain and use consumer credit information, and define the manner in which companies may pursue collection activities. Changes in these laws or regulations could adversely affect the operations and profitability of our mortgage insurance business.
Congress may approve proposed legislation this year that would overhaul the GSEs existing regulatory structure. The legislation, as currently proposed, encompasses substantially all of the GSEs operations, including their affordable housing initiatives, the GSEs products and marketing activities, the GSEs loan limits, the GSEs minimum capital standards, and their risk-based capital requirements. Congress may choose to draft legislation in such a way that might limit the growth of the GSEs, which could result in a reduction in the size of the mortgage insurance market. It could also provide the GSEs with alternatives to the use of mortgage insurance. We do not know what form, if any, the legislation will take, or when it will be enacted.
Congress may also consider legislation to modernize the FHA program this year. Legislation to reform the FHA may include an increase in the FHAs base maximum loan limits, enhanced product innovation and a provision allowing FHA to use risk-based pricing when setting its mortgage insurance premiums. Depending upon the final details, these features have the potential to make the FHA program more competitive, which could result in reduced demand for private mortgage insurance. We do not know what form such legislation will take, if any, or, if it is enacted, its impact, if any, on our financial condition and results of operations.
In July 2002, HUD proposed a rule under RESPA that, if implemented as proposed, would have, among other things, given lenders and other packagers the option of offering a Guaranteed Mortgage Package, or GMP, or providing a good faith estimate of settlement costs subject to a 10% tolerance level. The proposed rule provided that qualifying packages were entitled to a safe harbor from litigation under RESPAs anti-kickback rules. Mortgage insurance would have been included in the package to the extent an upfront premium is charged. Inclusion in the package could have caused mortgage insurers to experience reductions in the prices of their services or products. HUD withdrew that proposed rule in March 2004. In late 2004, HUD announced that it will submit a new proposed rule under RESPA to the Office of Management and Budget for review. HUD has taken no further action to date but senior officials have stated publicly that they continue to work on a new proposed rule. We do not know what form, if any, the rule will take or whether it will be approved.
In December 2006, Congress passed and the President signed into law The Tax Relief and Health Care Act of 2006, which includes a provision that treats certain premiums paid or accrued for mortgage insurance in connection with mortgage insurance contracts issued after December 31, 2006 as qualified residence interest and, thus, tax deductible. The amount allowable as a deduction under the provision is phased out ratably by 10% for
each $1,000 by which the taxpayers adjusted gross income exceeds $100,000. The provision terminates for any amount paid or accrued after December 31, 2007. Congress may consider proposed legislation that would extend the deduction to tax years beyond 2007. If the provision is not extended, any positive impact from the legislation will cease.
We could lose premium revenue if the GSEs reduce the level of private mortgage insurance coverage required for low down payment mortgages or reduce their need for mortgage insurance.
The GSEs are the beneficiaries on a significant portion of the insurance policies we issue as a result of their purchases, statutorily required or otherwise, of qualifying mortgage loans from lenders or investors. The GSEs offer programs that require less mortgage insurance coverage on mortgages approved by their automated underwriting systems. They also have reduced coverage requirements for certain expanding market products. If mortgage insurance is no longer required to be placed on high LTV loans purchased by the GSEs, or if the reduction in required levels of mortgage insurance becomes widely accepted by mortgage lenders, or if the GSEs further reduce mortgage insurance coverage requirements for loans they purchase, PMIs premium revenue would decline and our consolidated financial condition and results of operations could suffer.
Products introduced by the GSEs, if widely accepted, could harm our profitability.
The GSEs have products for which they will, upon receipt from lenders of loans with primary insurance, restructure the mortgage insurance coverage by reducing the amount of primary insurance coverage and adding a second layer of insurance coverage, usually in the form of pool insurance. Under these programs, the GSEs may provide services to the mortgage insurer and the mortgage insurer may be required to pay fees to the GSEs for the benefits provided through the reduced insurance coverage or the services provided. If they become widely accepted, these products could harm our consolidated financial condition and results of operations.
The exercise of certain rights reserved by the GSEs under eligibility requirements for mortgage insurers could harm our profitability and reduce our operational flexibility.
The GSEs have issued eligibility requirements for qualified mortgage insurers, including PMI. Fannie Maes eligibility requirements apply only to borrower paid and lender paid mortgage insurance. The GSEs eligibility requirements cover substantially all areas of PMIs mortgage insurance operations, require the disclosure of certain activities and new products, give the GSEs the right to purchase mortgage insurance from other than existing approved mortgage insurers, including insurers that are either rated below AA or are unrated, and provide the GSEs with rights to revise the eligibility standards of insurers. The exercise of rights under the eligibility requirements, future changes to the requirements, or the purchase directly by Fannie Mae of mortgage insurance from insurers not subject to its eligibility requirements could reduce our operational flexibility and cause our profitability to suffer.
Our business and financial performance could suffer if PMI were to lose the business of a major customer.
Through their various origination channels, PMIs top ten customers accounted for 43.9% of its premiums earned in 2006. A single customer represented 11.8% of its earned premiums in 2006. Mortgage insurers, including PMI, may acquire significant percentages of their business through negotiated, structured finance transactions with a limited number of customers. The loss of a significant customer could reduce our revenue, and if not replaced, harm our consolidated financial condition and results of operations.
The U.S. mortgage insurance industry and PMI are subject to litigation risk.
The mortgage insurance industry and PMI face litigation risk in the ordinary course of operations, including the risk of class action lawsuits. Consumers are bringing a growing number of lawsuits against home mortgage lenders and settlement service providers. In recent years, mortgage insurers, including PMI, have been involved in litigation alleging violations of RESPA and FCRA.
In the past, a number of lawsuits have been filed against private mortgage insurers, including PMI, alleging that the mortgage insurers violated FCRA by failing to send adverse action notices to borrowers who were required to pay for private mortgage insurance written by the mortgage insurer at rates greater than the mortgage insurers best available rate. In September 2005, such an action was filed against us in the federal district court for the Northern District of California entitled Hogan, et al. v. PMI Mortgage Insurance Company. In the action, the plaintiffs sought certification of a nationwide class of consumers and sought, among other relief, actual and statutory damages and declaratory and injunctive relief. On January 4, 2006, plaintiffs filed an amended complaint in the action, which adds additional claims under state law and FCRA, alleging that PMI did not have a permissible purpose to access the plaintiffs credit information. PMI has entered into a class action settlement agreement with the plaintiffs counsel, which was preliminarily approved by the court on December 22, 2006. A hearing on final approval of the settlement is set for April 4, 2007. In the future, we cannot predict whether other actions might be brought against us or other mortgage insurers. Any such proceedings could have an adverse effect on our consolidated financial position, results of operations or cash flows.
In the past, a number of lawsuits have challenged the actions of private mortgage insurers, including PMI, under RESPA, alleging that the insurers have provided products or services at improperly reduced prices in return for the referral of mortgage insurance. RESPA precludes PMI from providing services or products to mortgage lenders free of charge, charging fees for services that are lower than their reasonable or fair market value, and paying fees for services that others provide that are higher than their reasonable or fair market value, in exchange for the referral of settlement services. We are aware of three putative class action lawsuits filed against mortgage lenders in federal district courts in California in December 2006, alleging RESPA violations in connection with payments received from mortgage insurers under reinsurance agreements with reinsurers affiliated with such mortgage lenders. We cannot predict whether we will be added to those lawsuits or whether other civil, regulatory or criminal actions might be brought against us or other mortgage insurers asserting claims similar to those contained in the putative class actions. The outcome of such proceedings could have an adverse effect on our consolidated financial condition, results of operations or cash flows.
The U.S. mortgage insurance industry and PMI are subject to regulatory risk and have been subject to recent scrutiny relating to the use of captive reinsurance arrangements and other products and services.
PMI and the mortgage insurance industry are also subject to comprehensive, detailed regulation by state insurance departments. Although their scope varies, state insurance laws generally grant broad powers to supervisory agencies and officials to examine and investigate insurance companies and to enforce rules or exercise discretion touching almost every aspect of PMIs business. Recently, the insurance industry has become the focus of increased scrutiny by regulatory and law enforcement authorities concerning certain practices, including captive reinsurance arrangements. Increased federal or state regulatory scrutiny could lead to new legal precedents, new regulations or new practices, or regulatory actions or investigations, which could adversely affect our financial condition and results of operation.
In 2005, we responded to a request from the New York Insurance Department, or the NYID, for information regarding captive reinsurance arrangements. In February 2006, the NYID requested additional information regarding captive reinsurance arrangements, including the business purpose of those arrangements. The NYID also requested that we review the mortgage insurance premium rates currently in use in New York based upon recent years experience. We have responded to the NYIDs February 2006 letter.
In January 2006, we and certain other mortgage insurers received administrative subpoenas for information from the Minnesota Department of Commerce primarily regarding captive reinsurance arrangements. We have provided the Minnesota Department of Commerce with information about such arrangements and other products and services pursuant to this subpoena. Other federal and state regulatory agencies, including state insurance departments, attorneys general or other regulators may also request information regarding captive reinsurance arrangements or other of our products and services. We cannot predict whether the NYIDs requests or the Minnesota Department of Commerces administrative subpoena will lead to further inquiries, or investigations,
of these matters, or the scope, timing or outcome of any inquiry or actions by those Departments or any inquiry or actions that may be commenced by state insurance departments, attorneys general or other regulators.
A downgrade of PMI Mortgage Insurance Co.s insurer financial strength ratings could materially harm our financial performance.
Our principal licensed U.S. mortgage insurance company, PMI Mortgage Insurance Co., or MIC, is rated AA by S&P, AA+ by Fitch, and Aa2 by Moodys. These ratings may be revised or withdrawn at any time by one or more of the rating agencies and are based on factors relevant to MICs policyholders and are not applicable to our common stock or debt. The rating agencies could lower or withdraw our ratings or outlooks at any time as a result of a number of factors, including: underwriting or investment losses; the necessity to make capital contributions to our subsidiaries pursuant to capital support agreements; other developments negatively affecting MICs risk-to-capital ratio, financial condition or results of operations; or changes in the views or modeling of rating agencies of our risk profile or of the mortgage insurance industry.
If MICs insurer financial strength rating for two out of the following three rating agencies falls below AA- from S&P or Fitch, or Aa3 from Moodys, investors, including Fannie Mae and Freddie Mac, may not purchase mortgages insured by MIC. Such a downgrade from any of the rating agencies could also negatively affect our ability to compete in the capital markets, our holding company ratings, the ratings of our other wholly-owned insurance subsidiaries, or the ratings of FGIC or CMG MI. Any of these events would harm our consolidated financial condition and results of operations.
Our ongoing ability to pay dividends to our shareholders and meet our obligations primarily depends upon the receipt of dividends and returns of capital from our insurance subsidiaries.
We are a holding company and conduct all of our business operations through our subsidiaries. Our principal sources of funds are dividends from our insurance subsidiaries and funds that may be raised from time to time in the capital markets. Factors that may affect our ability to maintain and meet our capital and liquidity needs as well as to pay dividends to our shareholders include: the level and severity of claims experienced by our insurance subsidiaries; the performance of the financial markets; standards and factors used by various credit rating agencies; financial covenants in our credit agreements; and standards imposed by state insurance regulators relating to the payment of dividends by insurance companies.
In addition, a protracted economic downturn, or other factors, could cause issuers of the fixed-income securities that we, FGIC Corporation, FGIC and RAM Re own to default on principal and interest payments, which could cause our investment returns and net income to decline and reduce our ability to satisfy all of our capital and liquidity needs.
We record federal income tax expense relating to our proportionate share of net income available to FGIC Corporation common stockholders at a rate of 7% based on our assessment that we will ultimately receive those earnings in the form of dividends from FGIC Corporation. That assessment could change due to a number of factors, some of which may be outside our control. If that assessment were to change, our results of operations would be adversely affected.
We account for our investment in FGIC Corporation using the equity method of accounting in accordance with generally accepted accounting principles, or GAAP. In accordance with GAAP, we have recorded, and currently continue to record, federal income tax expense relating to our proportionate share of net income available to FGIC Corporation common stockholders at a tax rate of 7%. The use of the 7% tax rate is based on our assessment, initially made in 2003 at the time of our initial investment in FGIC Corporation, that we would ultimately receive our proportionate share of net income available to FGIC Corporation common stockholders in the form of dividends rather than through a sale of our equity investment in FGIC Corporation. This tax rate is employed based on our assessment that we will receive a dividends received deduction for federal income tax
purposes on our proportionate share of net income available to FGIC Corporation common stockholders. This assessment was based upon, among other things, the terms of the stockholders agreement between us and the other investors in FGIC Corporation and FGIC Corporations capital structure in place immediately after our investment.
However, if the facts and circumstances were to change in the future in a manner that would cause our management to change its assessment as to the likelihood of receiving our proportionate share of net income available to FGIC Corporation common stockholders through the receipt of dividends, we would be required to change the manner in which we record the related income tax expense. For example, managements assessment could change if FGIC Corporation were to become subject to sufficiently lengthy and severe limitations on its ability to pay dividends, whether as a result of restrictions imposed by contract, the terms of securities it may issue, rating agency or legal requirements or otherwise.
If managements assessment were to change, we would apply a federal income tax rate of approximately 35% to our proportionate share of net income available to FGIC Corporation common stockholders in subsequent periods. We would also be required to establish a higher deferred tax liability to account for the difference between the 7% tax rate we have used to account for our proportionate share of net income available to FGIC Corporation common stockholders since our investment in FGIC Corporation in 2003 and the 35% tax rate that would apply to gain recognized on a sale of our interest in FGIC Corporation. Accordingly, in those circumstances, we would recognize an immediate expense relating to deferred federal income tax liability in the quarter in which we establish such an increased deferred tax liability in an amount equal to approximately 28% of the cumulative amount of our proportionate share of net income available to FGIC Corporation common stockholders recorded as of the date we determine to effect such a change. As of December 31, 2006, the cumulative amount of our proportionate share of net income available to FGIC Corporation common stockholders subject to the 7% tax rate was approximately $230.7 million. Therefore, a change in the federal income tax rate applicable to our proportionate share of net income available to FGIC Corporation common stockholders as of December 31, 2006 would have required us to recognize a federal expense of approximately $64.6 million and an additional state expense of approximately $13.3 million as of December 31, 2006. The amount of such a potential expense will increase in subsequent periods to the extent that FGIC Corporation continues to generate net income.
If we are unable to keep pace with the technological demands of our customers or with the technology-related products and services offered by our competitors, our business and financial performance could be significantly harmed.
Participants in the mortgage lending and mortgage insurance industries rely on e-commerce and other technology to provide and expand their products and services. Our customers generally require that we provide our products and services electronically via the Internet or electronic data transmission, and the percentage of our new insurance written and claims processing which is delivered electronically has increased. We expect this trend to continue, and accordingly, we believe that it is essential that we continue to invest substantial resources in maintaining electronic connectivity with our customers and, more generally, in e-commerce and technology. Our business may suffer if we do not keep pace with the technological demands of our customers and the technological capabilities of our competitors.
The implementation of the Basel II Capital Accord may limit the domestic and international use of mortgage insurance.
The Basel II Capital Accord, the Basel Committee on Banking Supervisions proposal to implement a new international capital accord, will affect the capital treatment provided to mortgage insurance by domestic and international banks in both their origination and securitization activities. Accordingly, the Basel II provisions related to residential mortgages and mortgage insurance could alter the competitive positions and financial performance of mortgage insurers as well as the capital available to our bank customers for their mortgage origination and securitization activities.
PMIs opportunities to participate in structured transactions, and U.S. financial institutions preferences with respect to mortgage insurance, may be significantly impacted by the implementation in the United States of Basel II and any interim capital accord. U.S. federal banking agencies have jointly announced that the U.S. implementation of Basel II will be delayed until at least 2008, and perhaps 2009, and proposed an additional capital accord (known as Basel IA) that has not been finalized. U.S. implementation of Basel II standards for credit risk exposures, including residential mortgages, is focused on application of the Advanced Internal Rating Based (A-IRB) approach by large internationally active banking organizations. U.S. bank supervisors have indicated their intent to recognize the loss mitigating impacts of private mortgage insurance policies for banking organizations computing minimum capital requirements under the A-IRB approach, as well as under Basel IA.
The Australian Prudential Regulation Authority, or APRA, the primary regulator of our Australian mortgage insurance operations, intends to implement Basel II capital requirements for financial institutions effective January 1, 2008. APRA is currently considering public comments that have been submitted on a discussion paper regarding implementation of Basel II. Such implementation may have a significant impact on the future market acceptance of mortgage insurance in Australia. APRAs Basel II proposals, if adopted as proposed, could reduce the available market for mortgage insurance among our Australian mortgage insurance operations bank customers. It is not known at this time whether APRA will revise its Basel II proposals in response to comments received.
Currently, European banking supervisors are in the process of deciding how mortgage insurance will be recognized as a risk mitigant for bank capital requirements. In 2005, the European Union adopted new legislation, the Capital Requirements Directive, or CRD, which provides a revised framework for EU member states banking supervisors to implement new Basel II risk based capital guidelines starting in 2007. The CRD prescribes standard criteria for credit risk mitigation instruments that are eligible to provide banks with risk-based capital relief. Currently, under the transposition of the CRD into national laws, several EU member states have recognized mortgage insurance as a credit risk mitigant. We believe the CRD facilitates recognition of mortgage insurance benefits for European banks under certain circumstances. The implementation of the CRD into the regulatory framework of EU member states is subject to further clarification by the European Commission.
Our consolidated results of operations and cash flows could suffer if demand for our mortgage insurance products is diminished as a result of the implementation of the Basel II and Basel IA proposals.
Our international insurance subsidiaries subject us to numerous risks associated with international operations.
We have operations in Australia, New Zealand, Europe, and Hong Kong. We expect to begin operations in Canada in 2007. We have committed and may in the future commit additional significant resources to expand our international operations. Accordingly, in addition to the general economic and insurance business-related factors discussed above, we are subject to a number of risks associated with our international business activities. These risks include: the need for regulatory and third-party approvals; challenges in attracting and retaining key foreign-based employees, customers and business partners in international markets; economic downturns in targeted foreign mortgage origination markets; interest rate volatility in a variety of countries; unexpected changes in foreign regulations and laws; the burdens of complying with a wide variety of foreign laws; potentially adverse tax consequences; restrictions on the repatriation of earnings; foreign currency exchange rate fluctuations; potential increases in the level of defaults and claims on policies insured by foreign-based subsidiaries; and the need to successfully develop and market products appropriate to the foreign market, including the development and marketing of credit enhancement products to European lenders and for mortgage securitizations.
We do not currently hedge foreign currency exposures of net investments in our foreign operations. If the spot exchange rates of the U.S. dollar relative to other applicable foreign currencies change, our net investment in
our foreign operations will be impacted. Foreign currency translation gains in accumulated other comprehensive income were $172.4 million as of December 31, 2006, due primarily to the strengthening of the spot exchange rates of the Australia dollar and the Euro relative to the U.S. dollar. This cumulative foreign currency translation gain benefits PMIs statutory surplus as PMI Australia and PMI Europe are its wholly-owned subsidiaries. A weakening of the spot exchange rates of currencies in countries where we operate relative to the U.S. dollar will negatively affect our foreign operations net investment, PMIs statutory surplus and, consequently, PMIs potential ability to pay dividends to its parent.
PMI Australia is subject to many of the same risks facing PMI.
Like PMI, the financial results of our Australian and New Zealand mortgage insurance operations, or PMI Australia, are affected by domestic and regional economic conditions, including movements in interest and unemployment rates and property value fluctuations. These economic factors could impact PMI Australias loss experience or the demand for mortgage insurance in the markets PMI Australia serves. PMI Australia is also subject to significant regulation. PMI Australias primary regulator, APRA, has issued regulations or sought comment on proposals to, among other things, increase the capital requirements for lenders mortgage insurance companies, change the requirements for acceptable lenders mortgage insurers and increase compliance and governance requirements for general insurers including lenders mortgage insurers. In addition to these regulations and proposals, PMI Australia will face new competition in the future. Such competition may take a number of forms including domestic and off-shore lenders mortgage insurers, reinsurers of residential mortgage credit risk, increased risk appetite from lender owned captive insurers, and non insurance forms of credit risk transfer. New market competitors have the potential to impact PMI Australias market share and to impact pricing of credit risk in the market as a whole.
PMI Australia had revenues of $202.0 million in 2006, representing 16.8% of our consolidated revenues. PMI Australias five largest customers provided 57.6% of PMI Australias gross premiums written in 2006. In 2006, one of PMI Australias largest customers restructured its captive arrangements and this restructuring will negatively impact PMI Australias premiums written associated with this customer. Future losses of significant customers business, if not replaced, could harm PMI Australias results of operations. PMI Australias claims and loss ratio increased in 2006 and will likely be higher for the full year 2007. A significant portion of PMI Australias risk in force is concentrated in the populous state of New South Wales, where default rates were highest in 2006. A significant increase in PMI Australias claims could harm our financial condition and results of operations.
PMI Australia is currently rated AA by S&P and Fitch and Aa2 by Moodys. These ratings are based in part upon a capital support agreement between MIC and PMI Australia and a guarantee of that agreement by The PMI Group. Termination or amendment of this support structure could negatively impact PMI Australias ratings. PMI Australias business is dependent on maintaining its ratings. Any negative impact on its ratings will negatively affect its financial results.
We may not be able to execute our strategy to expand our European operations.
The success of our efforts to expand our European operations will depend partly upon legislative and regulatory policies in Europe that support homeownership and provide capital relief for institutions that obtain credit enhancement with respect to their mortgage loan portfolios. If European legislative and regulatory agencies do not adopt such policies, our European operations may be adversely affected. See, The implementation of the Basel II Capital Accord may limit the domestic and international use of mortgage insurance, above. PMI Europe is also likely to face increased competition from other mortgage insurers and third party credit enhancement providers in 2007.
PMI Europe had revenues of $33.9 million in 2006, representing 2.8% of our consolidated revenues. PMI Europe is currently rated AA by S&P and Fitch and Aa3 by Moodys. These ratings are based in part upon a
capital support agreement between MIC and PMI Europe and a guarantee of that agreement by The PMI Group. Termination or amendment of this support structure could negatively impact PMI Europes ratings. PMI Europes business is dependent on maintaining its ratings. Any negative impact on its ratings will negatively affect its financial results.
We may not be able to execute our strategy to develop our Canadian operations.
We have devoted resources to develop our Canadian operations, PMI Canada, and we plan to continue these efforts. The success of our efforts will depend upon, among other factors, our ability to obtain a license to write mortgage insurance from the Canadian Office of the Superintendent of Financial Institutions as well as a government guarantee from the Canadian Ministry of Finance. We have applied for the license and the guarantee and expect to receive both in the first half of 2007 but there can be no assurance that this will, in fact, occur. In addition, prior to offering mortgage insurance in Canada, PMI Canada intends to seek and acquire a financial strength rating from the DBRS, the principal rating agency in Canada. Our ability to execute our Canadian strategy would be significantly impeded in the event we are unable to obtain a satisfactory rating for our Canadian subsidiary.
Competition in the Canadian mortgage insurance market is intense. Such competition may take a number of forms, including domestic mortgage insurers, substitute products or self insurance for unregulated lenders. A number of internationally-active mortgage insurers are entering or have stated their intent to enter the Canadian market. Regulations in Canada currently require the use of mortgage insurance for all mortgage loans extended by banks and trust companies with LTVs greater than 75%. The Canadian Parliament is considering legislation to change the requirement for mortgage insurance to apply only to loans with LTVs greater than 80%. A change in the statutory requirement for mortgage insurance could result in a reduction in the size of the Canadian mortgage insurance market.
We have recently expanded our operations with PMI Guaranty, which will subject us to new risks and uncertainties.
PMI Guaranty began operations during the fourth quarter of 2006. As a start-up corporation, PMI Guaranty may be unable to execute its business strategy and gain a foothold in the markets that it has targeted. If PMI Guaranty is unable to execute its business strategy or unanticipated issues arise in its implementation, PMI Guarantys financial results could be materially and adversely affected. As a provider of financial guaranty type credit enhancement products, PMI Guaranty is subject to various risks and uncertainties associated with those areas. For example, PMI Guaranty will have exposures in the public finance arena to particular infrastructure sectors and certain geographic areas. An adverse event or series of events with respect to one or more of these sectors or areas that is more severe than the assumptions used by PMI Guaranty at the time of underwriting could result in disproportionate and significant losses to PMI Guaranty.
In addition, PMI Guarantys financial results will be dependent on the market for financial guaranty insurance. Credit spreads, the difference in interest cost for bond issuers under different credit rating scenarios, are a significant factor in an issuers determination of whether to seek credit enhancement. As credit spreads tighten, the likelihood that issuers will choose to issue bonds without credit enhancement increases. Tightening of credit spreads may therefore negatively impact demand for the products offered by PMI Guaranty.
PMI Guaranty is subject to significant competition in both its financial guaranty insurance and financial guaranty reinsurance endeavors. In addition to other AA-rated financial guaranty insurers and financial guaranty reinsurers, PMI Guaranty competes with alternative risk and capital market participants such as hedge funds. Further, new market competitors have the potential to impact PMI Guarantys market share and to impact the pricing of financial guaranty insurance and financial guaranty reinsurance products. We cannot be sure that PMI Guaranty will be able to compete effectively in its current markets or in any markets or asset classes into which it expands.
PMI Guarantys financial strength is currently rated AA+ by Fitch Ratings, AA by Standard & Poors and Aa3 by Moodys Investors Service. These ratings are based in part upon a capital support agreement between PMI Guaranty and MIC and a guarantee of that agreement by The PMI Group. Termination or amendment of this support structure could negatively impact PMI Guarantys ratings. PMI Guarantys ability to compete or otherwise engage in the financial guaranty insurance and financial guaranty reinsurance business would be materially and adversely affected by any reduction in PMI Guarantys ratings or the announcement of a potential reduction or change in outlook.
The performance of our financial guaranty equity investees could harm our consolidated financial results.
We have made significant investments in the equity securities of several companies, including FGIC (through FGIC Corporation) and RAM Re (through RAM Holdings Ltd.).
Our investments in FGIC Corporation and RAM Re are accounted for on the equity method of accounting in our consolidated financial statements. The nature of the businesses conducted by these companies differs significantly from our core business of providing residential mortgage insurance. These companies are subject to a number of significant risks that arise from the nature of their businesses. Some of the various risks affecting FGIC are discussed below. Because we do not control these companies, we are dependent upon the management of these companies to independently operate their businesses and report their financial results, and, accordingly, we may be unable to take actions unilaterally to avoid or mitigate those risks. In addition, any prospective or retroactive change in their financial reporting could affect our financial condition and results of operations. Such changes could occur as a result of, among other things, changes in accounting principles or comments made by regulatory agencies, including the SEC in connection with its ordinary course review of filings made with it.
As a significant portion of our consolidated net income is derived from FGIC and its financial guaranty business, we are subject to various risks and uncertainties associated with the financial guaranty business.
A significant portion of our consolidated net income is derived from FGIC and its financial guaranty business. Accordingly, we are subject to the risks and uncertainties associated with that business. In addition, FGIC has historically operated its financial guaranty business principally in limited portions of the public finance and structured finance markets. FGIC has expanded its business lines and products into markets and asset classes that historically have experienced higher default rates than those in which it has historically operated. The risks and uncertainties to which we may be exposed as a result of the FGIC Corporation investment include the following, among others:
As of December 31, 2006, 7.3 % of our U.S. investment portfolio consists of FGIC-insured non-refunded bonds. As a result of our investment in FGIC, we have amended our investment policy to provide that no more than 15% of our U.S. investment portfolio consists of FGIC-insured non-refunded bonds.
We are subject to various risks and uncertainties in connection with the sale of equity interest in SPS Holding Corp., or SPS.
In October 2005, we sold our interest in SPS to Credit Suisse First Boston (USA), Inc., or CSFB. Under the terms of the transaction, we agreed to indemnify CSFB for certain liabilities relating to SPSs operations, including litigation and regulatory actions. Our maximum indemnification obligation for SPSs operations will not exceed approximately $21 million. Our consolidated financial position and results of operations could be harmed if we are required to indemnify CSFB for claims or liabilities relating to SPSs operations up to the date of closing.
We currently own approximately 200,000 square feet of office space in Walnut Creek, California for our home office. PMI leases offices throughout the United States. We conduct our international operations in leased facilities in Ireland, the United Kingdom, Italy, Germany, Belgium, Canada, Australia, New Zealand, and Hong Kong.
As previously reported, in September 2005, an action against PMI was filed in the federal district court of the Northern District of California located in San Francisco, California, entitled Hogan, et al. v. PMI Mortgage Insurance Company (Case No. 3:2005-CV-03851). The action sought certification of a nationwide class of consumers. The plaintiffs alleged that they were required to pay for private mortgage insurance written by PMI and that their loans allegedly were insured at greater than PMIs best available rate. The plaintiffs further alleged that PMI had an obligation to notify them of an adverse action based upon their credit information and failed to do so in violation of the Fair Credit Reporting Act (FCRA). The action sought, among other relief, actual and statutory damages and declaratory and injunctive relief. On January 4, 2006, plaintiffs filed an amended complaint adding additional claims under state law and FCRA. PMI has entered into a class action settlement agreement with the plaintiffs counsel, which was preliminarily approved by the court on December 22, 2006. A hearing on final approval of the settlement is set for April 4, 2007. Pursuant to the settlement, PMI has agreed to provide certain payments and provide a free credit report to class members who submit a completed claim form. The settlement, if approved, will not be material to PMI. In the event that the settlement does not receive final approval by the court, PMI intends to vigorously defend the action.
In April 2002, PMI commenced litigation in the United States District Court for the Northern District of California (PMI Mortgage Insurance Co. v. American International Specialty Lines Insurance Company, et al., Case No. 3:02-CV-01774) to obtain reimbursement from its former primary and excess insurance carriers for costs incurred by PMI, in connection with its defense and settlement of the class action litigation captioned Baynham et al. v. PMI Mortgage Insurance Co. The insurance carriers counterclaimed against PMI to recover defense costs previously advanced to PMI in conjunction with the Baynham action. In November 2002, PMI and its former insurance carriers filed competing motions for partial summary judgment on the issue of whether the activities of PMI that were the subject of the Baynham action were professional services and, therefore, covered under the relevant insurance policies. On December 16, 2002, the District Court denied PMIs motion for partial summary judgment and granted the insurance carriers motion for partial summary judgment. On January 14, 2005, pursuant to PMIs appeal of the District Courts judgment, the United States Court of Appeals for the Ninth Circuit reversed the rulings of the District Court and remanded the case to the District Court with instructions to enter partial summary judgment in favor of PMI. (PMI Mortgage Insurance Co. v. American International Specialty Lines Insurance Company, et al., Case Nos. 03-15728 and 03-16007). In September 2006, PMI reached a settlement of the litigation with the excess carriers and received a payment of $2.5 million in October 2006 in exchange for a release of all claims against such carriers. The remanded case involving the primary insurance carrier was tried without a jury on October 23, 2006. On December 5, 2006, the court entered judgment in PMIs favor of approximately $7.6 million, plus approximately $2.4 million in prejudgment interest. Post-judgment interest will accrue at the weekly average 1-year constant maturity Treasury yield. On December 12, 2006, the primary insurance carrier filed a motion requesting that the court amend its findings of fact and conclusions of law. PMI filed its opposition to the motion on January 17, 2007. The court has not yet ruled on the motion.
Various other legal actions and regulatory reviews are currently pending that involve us and specific aspects of our conduct of business. In the opinion of management, the ultimate liability or resolution in one or more of these actions or reviews is not expected to have a material effect on our business.
EXECUTIVE OFFICERS OF THE REGISTRANT
Set forth below is certain information regarding our executive officers as of February 28, 2006.
L. STEPHEN SMITH, 57, has been one of our directors since February 2002. He has been the Chief Executive Officer of The PMI Group since June 1, 2006 and President and Chief Operating Officer of The PMI Group since September 1998. He has served as Chief Executive Officer of PMI since January 2004. He was President and Chief Operating Officer of PMI from September 1998 to June 2006. He was elected Executive Vice President of Marketing and Field Operations of PMI in May 1994 and elected to the same positions with The PMI Group in January 1995, serving in such capacities until September 1998. Prior thereto, he held various executive positions with the Company from 1991 to 1994. Mr. Smith joined us in 1979. He is a member of our Financial Guaranty Oversight Committee. He is currently the President of the Mortgage Insurance Companies of America, the trade association for the mortgage insurance industry. He serves on the Board of the National Association of Hispanic Real Estate Professionals (NAHREP) and the Fannie Mae National Housing Advisory Council (NAHC). He is also a member of the National Association of Home Builders NAHB Roundtable.
BRADLEY M. SHUSTER, 52, has been President, International and Strategic Investments of The PMI Group and President and Chief Executive Officer of PMI Capital Corporation since January 1, 2003. Prior thereto, he was Executive Vice President, Corporate Development of The PMI Group since February 1999. Prior thereto he was Senior Vice President, Treasurer and Chief Investment Officer of PMI since August 1995, and was elected to the same position with The PMI Group, in September 1995. Prior to joining PMI, he was an audit partner with the accounting firm of Deloitte & Touche LLP, where he was employed from January 1978 to July 1995.
DAVID H. KATKOV, 51, has been Executive Vice President of The PMI Group since August 2001 and President and Chief Operating Officer of PMI since June 2006. Prior thereto, Mr. Katkov held a variety of executive management positions in Sales, Structured Transactions, Product Development, and Portfolio Management. Prior to joining The PMI Group, Mr. Katkov was a Vice President of US Bank Corporation, Minneapolis, Minnesota.
DONALD P. LOFE, JR., 50, has been Executive Vice President of The PMI Group since January 2003 and has been Chief Financial Officer of The PMI Group since April 1, 2003. Prior to joining The PMI Group, Mr. Lofe was Senior Vice President, Corporate Finance for The CNA Financial Corporation from October 1998 until January 2003. From October 1991 until November 1998, Mr. Lofe was an audit partner with the accounting firm of PricewaterhouseCoopers LLP, where he was employed for approximately 20 years. Mr. Lofe is a certified public accountant.
VICTOR J. BACIGALUPI, 63, has served The PMI Group as Executive Vice President and Chief Administrative Officer since February 2005, and as General Counsel and Secretary since joining The PMI Group in November 1996. He served the Company as Senior Executive Vice President from February 2003 to February 2005, as Executive Vice President from August 1999 to February 2003, and as Senior Vice President from November 1996 to August 1999. Mr. Bacigalupi is a member of the Board of Directors of RAM Holdings Ltd.
LLOYD A. PORTER, 47, has been Executive Vice President and Managing Director, International Mortgage Insurance of PMI Capital Corporation since August 2004. Prior thereto, he was Senior Vice President and Managing Director, International Markets of The PMI Group since February 1999. Mr. Porter joined The PMI Group in 1983 and has held a variety of positions relating to marketing, capital markets, strategy, and corporate development.
DANIEL L. ROBERTS, 56, has been Executive Vice President, Chief Information Officer of The PMI Group since March 2000. Prior thereto he was Senior Vice President, Chief Information Officer of The PMI Group since December 1997. Prior to joining The PMI Group, he was Vice President and Chief Information Officer of St. Joseph Health System, a position he held since he joined that company in October 1994. Prior thereto, he was Vice President, Information Services and Chief Information Officer for a division of Catholic Healthcare West, positions he held since joining the company in December 1990. Mr. Roberts was a consulting partner with the accounting firm of Deloitte & Touche LLP from July 1985 to December 1990.
JOANNE M. BERKOWITZ, 46, has served as Executive Vice President, Chief Enterprise Risk Officer of The PMI Group since October 2005. She served as Group Senior Vice President, Chief Enterprise Risk Officer of The PMI Group from July 2004 through September 2005. Ms. Berkowitz began her career with PMI in 1983, and has held various executive risk management positions.
As of December 31, 2006, we were listed on the New York Stock Exchange and the NYSE Arca under the trading symbol PMI. On January 16, 2007, we voluntarily withdrew the listing of our common stock from the NYSE Arca. Our common stock continues to trade on the New York Stock Exchange. As of February 1, 2007, there were approximately 66 stockholders of record.
The following table shows the high, low and closing common stock prices by quarter from the New York Stock Exchange Composite Listing for the years ended:
Our Board of Directors is authorized to issue up to 5,000,000 shares of preferred stock of The PMI Group in classes or series and to fix the designations, preferences, qualifications, limitations or restrictions of any class or series with respect to the rate and nature of dividends, the price and terms and conditions on which shares may be redeemed, the amount payable in the event of voluntary or involuntary liquidation, the terms and conditions for conversion or exchange into any other class or series of the stock, voting rights, and other terms. We may issue, without the approval of the holders of common stock, preferred stock that has voting, dividend or liquidation rights superior to the common stock and which may adversely affect the rights of the holders of common stock. We have reserved up to 400,000 shares of preferred stock for issuance under the Rights Plan described below.
Preferred Share Purchase Rights Plan
On January 13, 1998, we adopted a Preferred Share Purchase Rights Plan, or the Rights Plan. Under the Rights Plan, all shareholders of record as of January 26, 1998 received rights to purchase shares of a new series of preferred stock on the basis of one right for each common stock held on that date. However, rights issued under the Rights Plan will not be exercisable initially. The rights will trade with The PMI Groups common stock and no certificates will be issued until certain triggering events occur. The Rights Plan has a ten year term from the record date, but our Board of Directors periodically reviews the merits of redeeming or continuing the Rights Plan. Rights issued under the Rights Plan will be exercisable only if a person or group acquires 10% or more of our common stock or announces a tender offer for 10% or more of the common stock. If a person or group acquires 10% or more of our common stock, all rights holders except the buyer will be entitled to acquire our common stock at a discount and/or, under certain circumstances, to purchase shares of the acquiring company at a discount. The Rights Plan contains an exception that would allow passive institutional investors to acquire up to a 15% ownership interest before the rights would become exercisable.
Payment of Dividends and Policy
We paid regular dividends on our common stock of:
The payment of future dividends is subject to the discretion of our Board of Directors, which will consider, among other factors, our consolidated operating results, overall financial condition and capital requirements, as well as general business conditions. The PMI Group, as a holding company, is dependent upon dividends and any other permitted payments from its subsidiaries to enable it to pay dividends and to service outstanding debt. PMIs ability to pay dividends or make distributions or returns of capital to The PMI Group is affected by state insurance laws, credit agreements, rating agencies, the discretion of insurance regulatory authorities, and the terms of our runoff support agreement with Allstate Insurance Company and capital support agreements with our subsidiaries. See Item 1, Section B.10. Regulation, Item 1A. Risk Factors, Item 7. Managements Discussion and Analysis of Financial Condition and Results of OperationsLiquidity and Capital Resources, and Item 8. Financial Statements and Supplementary DataNote 14. Dividends and Shareholders Equity.
Common Share Repurchases
In February 2006, our Board of Directors authorized a common share repurchase program in an amount not to exceed $150 million. We completed this authorization in June 2006.
In July 2006, our Board of Directors authorized a common share repurchase program of up to $400 million. In August 2006, we entered into an accelerated stock buyback program with a major financial institution pursuant to which we agreed to purchase shares of our common stock from it for an aggregate maximum purchase price of $345 million. The maximum number of shares to be repurchased under the program has been set at 8.2 million common shares and the minimum number has been set at 7.2 million, representing a purchase price range per common share from $41.88 to $47.99, respectively. The actual number of shares received and the average per share cost will depend on the weighted average share price of common stock over the period of the program which will terminate in or around the second quarter of 2007. In the third quarter of 2006, we received the minimum allotment of 7.2 million common shares. We will receive additional common shares at the programs expiration to the extent our weighted average common share net price does not exceed $47.99 during the program. Pursuant to the July 2006 Board authorization, we repurchased an additional 0.9 million shares in the fourth quarter of 2006 for $40 million for an average price per common share of $44.11.
On February 21, 2007, our Board of Directors authorized a common share repurchase program of $150 million. See Item 7. Managements Discussion and Analysis of Financial Condition and Results of OperationsLiquidity and Capital Resources.
The following table contains information with respect to common share purchases made by or on behalf of the Company during the fourth quarter of 2006.
Issuer Purchases of Equity Securities
Securities Authorized for Issuance Under Equity Compensation Plans
See Part III, Item 12, below.
The following Performance Graph and related information shall not be deemed soliciting material or to be filed with the Securities and Exchange Commission, nor shall such information be incorporated by reference into any future filing under the Securities Act of 1933 or Securities Exchange Act of 1934, each as amended, except to the extent that The PMI Group specifically incorporates it by reference into such filing.
Comparison of The PMI Group, Inc. and Benchmarks
Total Return Index
The following financial data should be read in conjunction with Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations and Item 8. Financial Statements and Supplementary Data.
THE PMI GROUP, INC. AND SUBSIDIARIES
TEN-YEAR SUMMARY OF FINANCIAL DATA
THE PMI GROUP, INC. AND SUBSIDIARIES
TEN-YEAR SUMMARY OF FINANCIAL DATA(Continued)