PMI Group 10-K 2008
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
For the fiscal year ended December 31, 2007
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, a non-accelerated filer or a smaller reporting company. See the definition of large accelerated filer and accelerated filer and smaller reporting company 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 29, 2007 was approximately $2.9 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 February 29, 2008: 81,212,154.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Proxy Statement for registrants Annual Meeting of Stockholders to be held on May 15, 2008 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 in a variety of countries.
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.
The significant weakening of the U.S. residential mortgage, housing, credit, and capital markets negatively affected our financial condition and results of operations in 2007. Our consolidated net loss was $915.3 million for the year ended December 31, 2007. We discuss the impact of the mortgage, housing, credit, and capital market declines on our operating segments in Items 1(B). U.S. Mortgage Insurance Operations, 1(C). International Operations and 1(D). Financial Guaranty, below. Our financial condition and results of operations for 2007 are discussed on both a consolidated and segment basis in Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations, below.
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 to meet the capital and credit risk mitigation needs of its customers. We also own 50% of CMG Mortgage Insurance Company, or CMG MI, a joint venture that provides mortgage insurance exclusively to credit unions.
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 reinsurance to residential mortgage lenders and investors in Asian markets. PMI Canada, our Canadian mortgage insurer, began offering residential mortgage insurance products in 2007.
Financial Guaranty. We are the lead investor in FGIC Corporation, whose wholly-owned subsidiary, Financial Guaranty Insurance Company (FGIC), provides financial guaranty insurance for public finance and structured finance obligations. As a result of the deterioration of the credit and capital markets in 2007 and the downgrades of FGIC in 2008 to A by Standard & Poors, AA by Fitch and A3 by Moodys, FGIC has ceased writing new business, and we believe it is unlikely that FGIC will be able to write new financial guaranty business at its current ratings. As described further below, FGIC Corporation has proposed a significant restructuring of its insurance operations to the New York Insurance Department, including the organization of a
new financial guaranty insurer to be domiciled in New York to provide support for the global public finance and infrastructure obligations previously insured by FGIC and to write new business to serve those markets. We do not know what form such restructuring, if any, will ultimately take. Our surety company, PMI Guaranty Co., provides financial guaranty insurance, financial guaranty reinsurance and related credit enhancement products and services. 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. Independent rating agencies have assigned our insurance subsidiaries the insurer financial strength ratings shown in the table below. These ratings are based on the rating agencies assessments 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. The rating agencies can change or withdraw their ratings at any time.
Many of our customers view the insurer financial strength ratings assigned to us as indicative of our strength as a counterparty. For example, the value of our credit enhancement products in capital markets transactions is determined in significant part by our applicable insurer financial strength ratings. In the United States, two of our largest customers, Fannie Mae and Freddie Mac (collectively, the GSEs), require eligible mortgage insurers such as PMI to be rated at a minimum of AA- or its equivalent by at least two of the national rating agencies. The GSEs also may limit the activities of eligible mortgage insurers who have been downgraded by one rating agency below AA- although they have stated that they will temporarily suspend imposition of such limitations provided that the downgraded insurer submits, and the GSE approves, a remediation plan. Accordingly, a ratings downgrade, or the announcement of a potential downgrade or other concern relating to the financial strength of our insurance subsidiaries could have a material adverse effect on our business prospects, our ability to compete, and our holding company debt ratings. A number of our insurance subsidiaries (PMI Australia, PMI Europe, PMI Guaranty, PMI Canada, CMG MI and, indirectly, PMI Asia) receive capital support from PMI and are, therefore, dependent in part upon the financial strength and ratings of PMI. Thus, the ratings or performance of our insurance subsidiaries who receive capital support from PMI would be adversely affected by a ratings downgrade of PMI. Ratings assigned to our holding company or its debt are set out below.
For a discussion of recent rating agency actions with respect to our holding companys ratings and subsidiaries insurer financial strength ratings and risk factors associated with these issues, see Item 1A. Risk
FactorsA downgrade of the financial strength ratings of our wholly-owned insurance subsidiaries would adversely affect our business and prospects and, consequently, our results of operations and financial condition and Recent downgrades relating to FGIC and the placing of RAM Re on negative credit watch have adversely affected our financial condition and results of operations. Additional adverse rating agency actions with respect to FGIC or RAM Re could further harm our financial condition and results of operations and Item 7. Managements Discussion and Analysis of Financial Condition and Results of OperationsLiquidity and Capital ResourcesRatings, below.
As of December 31, 2007, our consolidated total assets were $5.1 billion, including our investment portfolio of $3.7 billion. Our consolidated shareholders equity was $2.5 billion as of December 31, 2007. 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 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 credit 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 value of the homes. 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.
PMIs residential mortgage insurance products most frequently provide first loss protection on loans held by portfolio lenders and insured loans sold to the GSEs or the agency market. PMI also offers structured finance products, in the form of mortgage insurance, to the GSEs and offers first loss and/or mezzanine loss credit enhancement of mortgage-backed securities issued by capital market participants other than the GSEs (the non-agency market). The size of the non-agency market decreased significantly over the course of 2007. The mortgage insurance and structured finance products PMI offers to meet the demands of the mortgage origination, agency and non-agency markets are described below.
The deterioration of the U.S. residential mortgage, housing, credit, and capital markets significantly impacted PMI in 2007. Section 7. Defaults and Claims, below, shows the higher delinquency rates, higher claims paid and higher loss reserves experienced by PMI in 2007. Section 6. Risk Management, below, discusses underwriting guidelines and pricing changes made by PMI. For a detailed review of PMIs 2007 financial results, see Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations U.S. Mortgage Insurance Operations, below.
(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, 2007 were $123.6 billion and $31.0 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, 2007, 2006 and 2005. 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 conforming 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. The requirements mandate that eligible mortgage insurers must maintain at least two of the following three ratings: AA- by Standard & Poors or Fitch, or Aa3 by Moodys. In addition, even if only one rating agency assigns a rating below AA- or Aa3, the GSEs may require that the affected mortgage insurer limit certain activities and practices in order to remain a GSE eligible mortgage
insurer. Such limitations could include the preclusion of offering captive reinsurance (described below) without the GSEs consent and maximum risk-to-capital ratios. The GSEs recently announced that they have temporarily suspended imposition of the additional requirements that would otherwise automatically be applicable upon a downgrade by one rating agency provided that the downgraded insurer submits, and the GSE subsequently approves, a remediation plan within certain timeframes.
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. The sizes of the U.S. mortgage origination market and its purchase money and refinance components are influenced by many economic factors, including interest rates and home prices.
Premium payments may be paid to us on a monthly, annual or single premium basis. Monthly payment plans represented 93.5% of NIW in 2007, 96.4% of NIW in 2006 and 94.1% of NIW in 2005. As of December 31, 2007, monthly plans represented 92.9% of our U.S. primary risk in force compared to 93.5% at December 31, 2006 and 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. Lender Paid MI represented 20.1% of flow NIW in 2007, 17.5% in 2006 and 16.7% in 2005.
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 on most loans 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 Channel. We provide credit enhancement solutions 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.
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 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 and financial 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 non-agency 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. We expect that PMIs opportunities to participate in structured finance transactions will be limited in 2008 as a result of the projected smaller non-agency MBS market this year.
In the future, PMIs opportunities to participate in structured finance transactions will be 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. The U.S. banking regulators have also stated that in 2008 they will propose optional regulations for mid-size and small banks that reflect the standardized approach under Basel II. No date has been announced for the publication of these regulations. Finally, the Basel Committee has proposed a further review of international capital accords.
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 finance 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 losses (up to a loan-level benefit limit) 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. Such mezzanine-level coverage generally also includes a stop loss limit.
To date, PMI has issued modified pool insurance principally to the GSEs as supplemental coverage and to lenders and other capital markets participants. As of December 31, 2007, PMI had $2.9 billion of modified pool risk in force, representing 8.3% of PMIs total risk in force. With respect to modified pool coverage, we calculate risk in force by subtracting the deductible and claims paid, if any, from the applicable stop loss limit. In later coverage years, loan terminations within the covered pool may also reduce the pools 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 traditional pool insurance products, referred to principally as GSE Pool or Old Pool, to lenders, the GSEs and the non-agency market. As of December 31, 2007, other pool insurance represented 1.8% of PMIs total risk in force and 17.7% of PMIs total pool risk in force (including modified pool).
(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 commensurate 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 a bankruptcy-remote 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 that required under the minimum capital requirement, the captive reinsurer must deposit additional amounts into the trust account. 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. Because captive trust assets are not segregated by book or policy year, ceded premiums deposited into a trust in one year may be used to pay claims on policies reinsured by the captive in prior or later book years. As of December 31, 2007, assets in captive trust accounts held for the benefit of PMI totaled approximately $700 million.
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. The GSEs eligibility requirements for approved mortgage insurers have been
temporarily amended, with respect to business written on or after June 1, 2008, to prohibit cessions of gross risk or gross premium cedes greater than 25% to captive reinsurers. 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, less a ceding commission. Captive reinsurance agreements decrease the possibility of PMI incurring unacceptably high levels of losses in times of economic stress. In addition, 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.
In 2007, we received $1.2 million in claim payments from captive trusts. We expect this amount to increase in 2008 and increase substantially in 2009. See Item 1A. Risk FactorsThe U.S. mortgage insurance industry and PMI are subject to regulatory risk and have been subject to scrutiny relating to the use of captive reinsurance arrangements and other products and services, and Item 7. Managements Discussion and Analysis of Financial Condition and Results of OperationsU.S. Mortgage Insurance Operations, Premiums written and earned, below.
(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. As of December 31, 2007, CMG MI had $18.9 billion of primary insurance in force and $4.7 billion of primary risk in force. 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 insurer financial strength rating at AA- by Standard & Poors and AA by Fitch. CMG MI is a GSE eligible 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. 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.
The sizes of the FHA/VA and private mortgage insurance markets are impacted by, among other things, the maximum loan amounts that FHA and VA can insure. The size of the private mortgage insurance market is also influenced by GSE conforming loan limits, the maximum loan amount that the GSEs may purchase. In February 2008, Congress passed an economic stimulus package that included a provision that will temporarily raise the GSE conforming loan limits to allow the GSEs to purchase and/or guarantee certain jumbo mortgages originated between July 1, 2007 and December 31, 2008. The legislation temporarily increases the maximum conforming loan limit from $417,000 to $729,750. Because the legislation also includes a cap of 125 percent of the median home price for an area, the GSE conforming loan limit will remain at $417,000 in markets where the median home price is $333,600 or less. This increase will expire at the end of 2008 unless extended by new legislation.
The legislation also temporarily raised the FHA base loan limit ("floor") to 65% of the current GSE limit or $271,050, and temporarily raised the FHA maximum loan limit from $362,750 to $729,750. Permanent changes to FHA loan limits, as well as lower minimum down payment requirements, are being considered by Congress. These changes, if adopted, could significantly expand FHAs mortgage insurance program. Further increases in the amount that the FHA and VA 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 Mac The 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.
Federal Home Loan Banks
The Federal Home Loan Banks, or FHLBs, purchase single-family conventional 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
During the last several years, the private mortgage insurance industry faced increasing competition from the home equity lending operations of financial institutions and other mortgage lenders who structured their high
LTV residential lending in such a way that mortgage insurance was not required. Certain lenders originated mortgages that had 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 when acquiring only the first mortgage, even though the combined LTV exceeds 80%. These products grew in popularity between 2003 and early 2006 due to a number of factors, including low interest rates, rapid home price appreciation rates and an increased focus by lenders on home equity lending. The increased popularity and use of these and other similar products reduced the available market for primary mortgage insurance. In 2007, origination of these products declined dramatically, primarily as a result of the diminished demand in the capital markets for these products and new underwriting standards issued by bank and thrift regulators.
In addition, we and other private mortgage insurers compete with financial institutions, primarily commercial banks and thrifts, when they 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 Section 1Captive Reinsurance, above) also negatively impacts our premiums earned.
Structured Finance Competitors
In order to participate in structured finance transactions, we must compete against other mortgage insurers as well as other credit enhancement providers. In addition, the design and use of MBS structures that do not include external credit enhancement negatively affects the private mortgage insurance market and our NIW.
Our U.S. customers are primarily mortgage lenders, depository institutions, commercial banks, investors (including the GSEs), the FHLBs, and other capital market participants. In 2007, PMIs top ten customers generated 52.0% of PMIs premiums earned compared to 43.9% in 2006. 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. If the slowdown in the non-agency MBS market continues in 2008, the GSEs will likely become beneficiaries of an even greater portion of PMIs mortgage insurance coverage.
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.
Primary Risk in Force. The composition of PMIs primary risk in force is summarized in the table below. The table is based upon information available to PMI at the date of policy origination.
This layering of risk has, in recent experience, further increased the risk of borrower default.
We believe that the increases in Above-97s, Alt-A loans and interest only loans as percentages of PMIs risk in force in 2007, and the increase in average primary loan size, reflect higher concentrations of these types of loans as percentages of both the mortgage origination market and the private mortgage insurance market in the first half of 2007. See Item 7. Managements Discussion and Analysis of Financial Condition and Results of OperationsU.S. Mortgage Insurance Operations, Credit and portfolio characteristics below. In 2007, PMIs average premium rate increased primarily as a result of its primary portfolio containing higher percentages of Above-97s 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.
The following table shows U.S. primary risk in force by FICO score:
Pool Risk in Force. The following table shows components of PMIs pool risk in force as of December 31 for the last five years.
The two tables below show the operation of stop loss limits and deductibles in the calculation of PMIs modified pool risk in force. The first table presents data for the portion of PMIs modified pool portfolio that is subject to deductibles. The second table presents similar data for the portion of PMIs modified pool portfolio that is not subject to deductibles. The data in the tables below are organized by book year (the year in which the risk was written) and represent in each case the aggregate of modified pool transactions written during the applicable book year.
The following two tables show the composition of PMIs modified pool portfolio by book year based upon the effective date of coverage. Because modified pool stop loss limits and deductibles operate across a pool of loans, we show the composition of PMIs modified pool portfolio in the tables below on an insurance in force (IIF) rather than risk in force basis. The table immediately below shows the composition of the portion of PMIs modified pool portfolio that is subject to deductibles.
The table below shows the composition of the portion of PMIs modified pool portfolio that is not subject to deductibles.
We believe that the risk reduction features of our modified pool products, which may include deductibles and stop loss limits, mitigate our risk of loss from the loans insured. In addition, with the exception of 2006 (non-deductibles), the average LTVs of loans insured by PMIs modified pool products are typically significantly below LTV averages for PMIs primary portfolio. While we have not established loss reserves with respect to modified pool with deductibles, we have established reserves with respect to PMIs modified pool (non-deductible) portfolio. (See Section 7. Defaults and ClaimsPool Claims, below.)
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 graph and table show average annual mortgage interest rates and PMIs primary portfolio persistency rates from 1998 to 2007.
As shown by the above graph and 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 through 2007, the persistency rate improved partly as a result of stabilizing or increasing interest rates.
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 contributed to higher levels of refinance activity between 2001 and 2006. We also believe that alternative loan products, such as interest only loans and payment option ARMs, encouraged refinancing in recent years. In 2007, declining or moderating home price appreciation and the diminished availability of alternative loan products positively impacted PMIs persistency rate.
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. Historically, our underwriting guidelines have generally allowed us to place mortgage insurance coverage on any mortgage loan accepted by the GSEs automated underwriting systems for purchase by the GSEs. However, underwriting guideline changes described below limit in some cases PMIs coverage on such loans.
We continually monitor risk concentrations in our portfolio using various statistical tools. Among these are the pmiAURAsm System and the PMI U.S. 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 U.S. Market Risk Indexsm is a proprietary statistical model that predicts the probability of a decline in home prices two years from the quarter of issuance 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. During 2007, as part of our normal review process, we revised and re-estimated the variables in the model to adapt it to changes in the housing market.
2007 Underwriting Guidelines and Pricing Changes
We review PMIs portfolio on an on-going basis. Based upon our continuing review of PMIs portfolio and the significant weakening of the mortgage, housing and credit markets, we have initiated a number of underwriting guidelines and pricing actions. In late 2006, we issued guideline changes designed to preclude future coverage of 2/28 Hybrid ARMs through PMIs primary structured finance channels. During the course of 2007, we refined PMIs structured finance pricing and underwriting policies. In the third quarter of 2007, we amended certain PMI lender paid policies to reduce future coverage of Above-97s and Alt-A loans. Effective October 1, 2007, we instituted tighter underwriting guidelines and higher borrower paid pricing with respect to Above-97s. Effective January 1, 2008, we tightened PMIs borrower paid underwriting guidelines with respect to Alt-A loans. These initiatives, and changes in both the mortgage origination and mortgage insurance markets in the second half of 2007, reduced the percentage of Above-97s and Alt-A loans in PMIs NIW in the third and fourth quarters of 2007.
Effective March 1, 2008, we further tightened underwriting guidelines with respect to Alt-A loans and eliminated future coverage of Above-97s through our primary flow channel. Effective March 1, 2008, we also instituted loan to value and loan product limitations with respect to loans originated in certain distressed markets. We expect PMIs NIW to be lower in 2008 than 2007 in part because of these guideline changes and limitations.
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 83% of PMIs new policies issued in the primary flow channel in 2007, compared to approximately 79% in 2006 and 75% in 2005.
More than 86% of PMIs flow NIW is underwritten pursuant to a delegated underwriting program that allows approved lenders, subject to periodic quality-control audits, to determine whether loans meet program guidelines and are thus eligible for mortgage insurance. Delegated underwriting enables us to meet mortgage lenders demands for immediate insurance coverage of certain loans. If PMI determines that a lender participating in the program commits us to insure a loan that fails to meet all of the approved underwriting guidelines, subject to certain exceptions, PMI has the right to exclude or rescind the coverage on the loan. PMI
may also suspend or terminate the insureds ability to extend coverage to new loans if it determines that the insured has not been complying with approved underwriting guidelines. In 2007, as a result of a significant variance from our quality control standards, we terminated the delegated underwriting program made available to a large customer. 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 sufficient to satisfy applicable underwriting guidelines.
Structured Finance Transactions. Structured finance 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. While we do not re-underwrite all previously underwritten 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 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 finance 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 review of the actual loans delivered and typically 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 on mortgage loans for which PMI provides mortgage insurance and on 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. Contract underwriting remedies were $7.1 million in 2007 compared to $12.4 million in 2006.
New policies processed by MSC contract underwriters in 2007 declined to 10.8% of PMIs primary NIW from 14.8% in 2006. The number of contract underwriters utilized by MSC also decreased in 2007.
Defaults. Our claims 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, rising interest rate levels and declining home prices.
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. The rate at which defaults cure (the cure rate) is influenced by the borrowers financial resources, regional housing and economic conditions and, recently, the speed with which loan servicers process delinquencies. Because PMIs loss reserves are based upon its default inventory, delinquent loans that cure are no longer included in PMIs loss reserves. PMIs cure rate declined in 2007 as a result of, among other things, weakening home prices and other economic conditions and a slowdown in the time to resolution of defaults (either through cure or claim payment) attributable to significant backlogs in workout activity by loan servicers attempting to resolve delinquencies and prevent foreclosures. PMI partners with lenders and servicers to work with borrowers to cure defaults through repayment plans, loan modifications and short sales.
Claims and Policy Servicing. As a result of the portion of delinquent loans that cure, the frequency of claims is not directly proportional to the number of defaults we receive. In most cases, however, defaults that are not cured result in claims. 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. At December 31, 2007, our carrying value, which approximates fair value, of REO properties was $20.3 million compared to $26.9 million at December 31, 2006 and $18.5 million at December 31, 2005.
Primary Claim Sizes and 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 time required to complete foreclosure (which varies by state), and the amount of mortgage insurance coverage placed on the loan. Pre-foreclosure sales, acquisitions and other early workout efforts help to reduce overall claim severity. As a result of changing market conditions, our ability to engage in early workout efforts was reduced in 2007. In 2007, we processed 20.0% of the paid primary insurance claims on the basis of a prearranged sale, compared to 22.9% and 25.1% in 2006 and 2005, respectively. In 2007, we exercised the option to acquire the property on 2.4% of the primary claims processed for payment, compared to 4.6% and 3.6% for 2006 and 2005, respectively.
PMIs 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. The increase in average primary claim severity in 2007 (shown in the table below) reflects, among other factors, declining home prices, higher coverage levels, delays in delinquency and claim resolutions and the related decline in early workout opportunities. Because severity reflects regional as well as national market conditions, PMIs average primary claim severity varies from region to region. The table below shows average primary claim severity, by region, for the years 2004 through 2007.
The table below sets out by channel primary claims paid (which does not include changes in loss reserves):
Primary Default Rates by Region. Primary default rates and claim activity differ from region to region in the United States depending upon economic conditions and cyclical growth patterns. PMIs default rates are calculated by dividing the number of insured loans in default in the particular portfolio by the total number of policies in force in that portfolio. 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.
Primary Default Rates by Channel and Loan Characteristics. As discussed in Section 5. Business Composition, above, certain borrower and loan characteristics increase the risk, on average, of loan delinquency and ultimate claims. Insured loans in PMIs portfolio may contain one, more than one or none of the loan characteristics identified above and in the table below. The following table shows default rates for PMIs flow and structured finance channels and for loans that contain certain of the characteristics identified by PMI as having heightened risk.
The higher default rates exhibited by PMIs structured finance channel are primarily the result of a larger concentration of loans insured through that channel that have multiple higher risk characteristics.
Primary Default Rates and the Aging of PMIs Insurance Portfolio. Default and claims activity are not spread evenly throughout the coverage period of a primary insurance book of business. Based upon our experience, we generally expect the majority of default and claims activity 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, 2004 through December 31, 2006 represented 45.6% of PMIs primary insurance in force at December 31, 2007. The table below, which sets out default rates by book year, shows that PMI has experienced adverse and accelerated delinquency development in its 2006 and 2007 insured loan portfolios.
The following table sets forth, for each of the years 2005, 2006 and 2007, the dispersion of PMIs losses and loss adjustment expenses by book year. Losses and loss adjustment expenses represent claims paid, certain expenses related to default notification and claim processing, and changes to loss reserves during the applicable year.
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. Pool insurance claims paid by PMI in 2007 increased to $21.0 million from $18.3 million in 2006.
Modified Pool Performance. The tables Modified Pool (with Deductibles) by Book Year and Modified Pool (without Deductibles) by Book Year, in Section 5 above, summarize the loss development of PMIs modified pool portfolio. Those tables show that, to date, PMI has paid no claims with respect to its deductible modified pool portfolio and an immaterial amount of claims on its non-deductible modified pool portfolio. As the 2004 and prior book years are relatively seasoned, we do not expect their applicable deductibles to be pierced or claims paid with respect to non-deductible modified pool written in those years to increase materially. As the 2005 and later modified pool portfolios are aging under more difficult economic conditions, we expect certain deductibles within those book years to be pierced. PMI has established significant loss reserves with respect to the 2006 non-deductible modified pool portfolio.
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 Operations Critical 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 Data Note 8. Reserve for Losses and Loss Adjustment Expenses (LAE).
The table below shows PMIs total risk in force and loss reserves as of December 31, 2005, 2006 and 2007.
While loss reserves increased in 2006 roughly in proportion to PMIs increase in total risk in force, increases to loss reserves in 2007 significantly outpaced the increase in risk in force. The higher loss reserve balance for 2007 shown in the table above reflects, among other factors, accelerated delinquency development of the 2007 book and significant additions to reserves in 2007 for the 2004, 2005 and 2006 book years, both as a result of higher delinquency and claim rates, higher claim severity and a slowdown in delinquency resolution.
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 1997 have cumulative loss ratios at the end of 2007 that differ by no more than 0.1% from the end of 2006, an indication that these ratios have stabilized and reached their ultimate development for each of these policy years. Policy years 1998 through 1999 also have seen only slight claims development since the end of 2006.
The table shows that performance of policies originally issued in the years 1980 through 1984 was adverse, with cumulative loss ratios ranging from 114.0% to 258.1% at the end of 2007. Such adverse experience was significantly impacted by deteriorating economic and real estate market conditions in the Oil Patch states in the 1980s. In 1985, PMI adopted substantially more conservative underwriting standards which we believe, along with increased premium rates and generally improving economic conditions, contributed to the lower cumulative loss ratios in subsequent years.
Policy years 1985 through 1992 have developed to cumulative loss ratios between 28.5% and 65.9%, reflecting 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 ratios declined year-to-year from 1993 and bottoming out at 9.2% at the end of ten 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 finance channel. These loan types generally had shorter lives and earlier incidences 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 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 higher cumulative loss ratio development at two and three years than 2003, due to higher claims development and comparable persistency. The 2005 book year has a cumulative loss ratio development at two years similar to the 2000 and 2001 book years at year two primarily due to higher claim rates and claim severity in 2007 associated with the weakening mortgage and housing markets. The 2006 book year experienced a large increase in its cumulative loss ratio in 2007 for similar reasons.
Expanding homeownership opportunities for low- to moderate-income individuals, first-time home buyers, and typically underserved communities is important to us. Home buyers who fit these profiles may find it challenging to qualify for a mortgage loan under traditional underwriting practices. Our approach to affordable lending is to develop, insure and promote products and services that encourage an equity down payment of at least 3% to help improve the likelihood of sustainable homeownership. The beneficiaries of our programs have included borrowers who: (a) have not yet established traditional credit histories, (b) are not accustomed to using traditional savings institutions, (c) have less than 20% for a down payment, and (d) although consistently employed, lack the stability traditionally associated with having a single employer due to the nature of their employment.
In response to current market conditions, we have recently changed our underwriting guidelines for all loan programs, including expanding markets programs, to require that all loans meet a maximum loan-to-value of 97%. In addition, 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. An important and ongoing initiative has been to establish partnerships with numerous national and community organizations in order to mitigate credit risk on these loans and promote community revitalization. We have strong affiliations with major organizations such as: AREAA (Asian Real Estate Association of America), NAHREP (National Association of Hispanic Real Estate Professionals), NHC (National Housing Conference), National NCLR (National Council of La Raza), LULAC (League of United Latin American Citizens), NeighborWorks America and others.
Additionally, through education, our goal is to ensure that borrowers have a thorough understanding of the responsibilities and challenges of homeownership. As a result, we have instituted various programs that utilize pre- and post-purchase borrower counseling to increase the likelihood of homeowner success.
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.
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 PMI Reinsurance Co., or PRC, 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 PRC, PMG and RIC replaced reciprocal deep cede reinsurance agreements that PMI had with certain non-affiliate mortgage insurance companies, which have now largely run off. Prior to January 2008, Residential Guaranty Co. (now known as PMI Insurance Co., or PIC) also provided such reinsurance to PMI. 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 company 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 non-insurer 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, PRC, PIC, 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 as required by the states.
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 statutory capital, or a formula for minimum policyholders position. PMIs risk-to-capital ratio as of December 31, 2007 was 10.8 to 1 and in excess of required minimum policyholders position.
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 or if, and to the extent, the mortgage insurers loss ratio exceeds 35%. For the year ended December 31, 2007, MIC released $503.1 million of contingency reserves into surplus attributable to losses in excess of 35% of earned premiums. PIC released $104.9 million of contingency reserves into surplus for excess of 35% losses. The first year that MIC released contingency reserves into surplus, following the ten year holding period, was 2002. At December 31, 2007, PMI had statutory policyholders surplus of $605.9 million and statutory contingency reserves of $2.3 billion.
Dividends. MIC paid extraordinary dividends of $165 million to The PMI Group in 2007. 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. A dividend that exceeds the foregoing threshold is deemed 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. In December 2006, the Director of the Arizona Department of Insurance approved an extraordinary dividend request of $250 million and a $100 million installment was paid to The PMI Group. In April 2007, an additional $200 million extraordinary dividend was approved by the Director of the Arizona Department of Insurance. In the second and third quarters of 2007, MIC paid $165 million in dividends to The PMI Group. There is $185 million of remaining approved dividends.
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 MIC.
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, North Carolina, and California, many 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 completed an examination of MIC in 2003 for the five year period ended December 31, 2002. They are scheduled to begin their examination of the five-year period between January 1, 2003 and December 31, 2007 at the end of March 2008. 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 mortgage insurer 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.
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.
Our International Operations segment generated 22.4% of our consolidated revenues in 2007 compared to 23.0% in 2006. Revenues from PMI Australia were $240.7 million and 20.3% of our consolidated revenues in 2007 and $202.0 million and 18.7% of our consolidated revenues in 2006. Revenues from PMI Europe were $8.3 million and 0.7% of our consolidated revenues in 2007 and $33.9 million and 3.1% of our consolidated revenues in 2006. Revenues from PMI Asia were $13.7 million and 1.2% of our consolidated revenues in 2007 and $12.7 million and 1.2% of our consolidated revenues in 2006. 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, Hong Kong and Canada.
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. As of December 31, 2007, the total assets of PMI Australia were $1.4 billion compared to $1.1 billion at December 31, 2006.
PMI Australias financial strength is rated AA by Standard & Poors and Fitch, and Aa2 by Moodys. PMI Australias ratings are based in part upon the capital support of PMI which is guaranteed by The PMI Group. A downgrade of PMI would likely cause a downgrade of PMI Australia, and could adversely affect its business. See Item 1A. Risk FactorsA downgrade of the financial strength ratings of our wholly-owned insurance subsidiaries would adversely affect our business and prospects and, consequently, our results of operations and financial condition.
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 generally 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 97% of PMI Australias risk in force covers Australian mortgages.
The 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 2007, 39.3% of PMI Australias NIW was RMBS insurance written, compared to 49.5% in 2006. Activity levels in the Australian RMBS market vary from
quarter to quarter and are strongly influenced by macro-economic factors. In 2008, Moodys placed PMI Australias Aa2 rating on review for possible downgrade and Standard & Poors placed Australias AA rating on creditwatch with negative implications. Fitch also revised the Rating Outlook of PMI Australia to Negative from Stable. These rating agency actions will likely negatively impact PMIs participation in RMBS transactions in 2008.
The five largest Australian banks collectively provide 75% or more of Australias residential housing financing. These banks represented approximately 15.9% of PMI Australias gross premiums written in 2007, compared to approximately 20% in 2006. 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 61.0% of PMI Australias 2007 gross premiums written, compared to 57.6% in 2006. We expect this increase to continue in 2008.
PMI Australias principal competitor is Genworth Financial. One other U.S.-based mortgage insurance company began offering 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 and reinsurers of residential mortgage credit risk. 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. The minimum capital requirements set by APRA are significantly more stringent than state insurance capital requirements in the U.S. See Item 1A. Risk FactorsPMI Australia is subject to many of the same risks facing PMI, below.
APRA has implemented 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. These new requirements could reduce the available market for LMI among PMI Australias bank customers.
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.
PMI has delegated LMI underwriting decisions to certain 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. Long-term performance of delegated insured loans is not expected to vary materially from the performance of all other insured loans.
Claims activity in Australia and New Zealand is not spread evenly throughout the coverage period of an insurance book of business. We expect that the majority of claims on insured loans in PMI Australias current portfolio will 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, 2007, by year of policy origination:
The following table sets forth default information for PMI Australia as of December 31, 2007, 2006 and 2005, and claims experience for the years 2005 through 2007:
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 many of the above states in 2007 were driven primarily by higher interest rates and moderating or declining home prices across Australia. The largest increases in default rates were in the Western Sydney (NSW) area. (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.
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, Madrid and Brussels, and an affiliated services company in London. PMI Europe is 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. At December 31, 2007, the total assets of PMI Europe were $272.2 million compared to $233.8 million at December 31, 2006.
PMI Europes claims paying ability is rated AA by Standard & Poors 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. A downgrade of PMI would likely cause a downgrade of PMI Europe. See the discussion below under Capital Markets Products and Item 1A. Risk FactorsA downgrade of the financial strength ratings of our wholly-owned insurance subsidiaries would adversely affect our business and prospects and consequently, our results of operations and financial condition.
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, 2007, PMI Europes insurance in force and risk in force with respect to these products were $62.9 billion and $9.4 billion, respectively. The table below shows PMI Europes risk in force by country, as of December 31, 2007.
The table below summarizes PMI Europes credit enhancement portfolio by transaction type.
Approximately 84% of PMI Europes risk in force represents capital market transactions that consist of investment grade risk. Default protection written by PMI Europe that attaches at the first loss, unrated position is considered sub-investment grade. PMI Europes investment grade coverage attaches at a mezzanine or remote loss level and is rated at least BBB- by Standard & Poors, BBB- by Fitch and/or Baa3 by Moodys. PMI Europes European portfolio does not include any credit impaired insured mortgages as commonly understood in Europe. Approximately 2.4% of PMI Europes risk in force consists of investment grade U.S. credit impaired mortgages (i.e., mortgages granted to borrowers whose credit history and/or application type is not sufficient to get a conventional mortgage at the prevailing mortgage rate).
Capital Markets Products. Capital markets products are designed to support secondary market transactions, notably credit-linked notes, 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. As of December 31, 2007, approximately 85.4% of PMI Europes risk in force was derived from twenty-one 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 eight of these transactions, PMI Europe assumed a sub-investment grade or an 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.
Certain of PMI Europes credit default swap contracts and excess-of-loss reinsurance agreements contain collateral review provisions which, upon certain circumstances, require PMI Europe to pledge collateral for the benefit of the counterparty. The amount of the required pledged collateral varies, but generally is limited to the amount of loss reserves established. PMI Europe has pledged collateral of $4.2 million with respect to one credit default swap transaction. A downgrade of PMI Europe could require PMI Europe to pledge additional collateral. Certain of PMI Europes credit default swap contracts contain termination rights which, upon a downgrade of PMI Europe to a specified rating, allow the counterparty to terminate the credit default swap or reinsurance agreement and, in some cases, require PMI Europe to pay the counterparty applicable loss reserves and unearned premium reserves. Negative ratings actions with respect to PMI Europe could adversely affect PMI Europes ability to compete in the capital, reinsurance and primary markets.
Reinsurance. PMI Europe offers reinsurance coverage to both captive insurers and financial guaranty companies. Financial guaranty companies purchase reinsurance to manage risk exposure and capital requirements. PMI Europe provides 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 absorbs losses before PMI Europe. PMI Europe has completed six such transactions to date which consist of U.S. credit impaired mortgages. In five of these transactions, PMI Europe provides excess of loss reinsurance. In the other transaction, PMI Europe provides quota share reinsurance where it assumes risk pari passu with the financial guarantor.
When PMI Europe provides excess of loss reinsurance to captive insurers, it reinsures a mortgage lenders captive above the level of expected losses but up to a stop loss limit that is less than a catastrophic level of losses. PMI Europe has completed one such transaction to date. As of December 31, 2007, approximately 2.4% of PMI Europes risk in force stemmed from reinsurance of financial guaranty companies and 0.5% stemmed from reinsurance of captives. Potential competitors with respect to these products include mortgage insurance companies, other financial guarantors and multi-line insurers. In 2007, PMI Europe established loss reserves of $19.3 million in respect of its reinsurance portfolio.
Primary Insurance. 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, 2007, approximately 11.6% of PMI Europes risk in force consisted of 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 has branches in Germany and Spain with the expectation of writing this business during 2008. 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.
The following table shows default rates for each of the last three years by type of credit enhancement coverage.
The increase in the default rate for primary mortgage insurance in 2007 reflects the growth and seasoning of that portfolio. Higher default rates in the reinsurance portfolio reflect that books concentration of credit impaired U.S. loans.
PMI Europes reserves for losses and LAE are shown below for the years 2005 through 2007.
The loss reserve on reinsurance as of December 31, 2007 was related to the deteriorating performance of a small number of U.S. credit impaired exposures on which PMI Europe provided reinsurance coverage in 2005. We have not received any notices of claim related to the reinsurance coverage. 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.
PMI Europes loss reserves shown above do not include credit default swap (CDS) transactions classified as derivatives. Changes in the fair value of CDS derivative contracts may occur as a result of a number of factors, including changes in market spreads and the extent to which actual claim payments differ from estimated claim payments. We recorded an unrealized mark-to-market loss of $16.9 million on PMI Europes CDS derivative contracts in 2007 as a result of the significant widening of market spreads. Credit deterioration predominantly in the U.S. sub-prime market has impacted market spreads worldwide, including spreads on PMI Europes CDS portfolio which relates only to European prime mortgage risks. Continuing volatility of market spreads may lead
to positive or negative fair value adjustments of these contracts in the future. In our view, the volatility of these market spreads does not necessarily reflect the credit quality of PMI Europes CDS portfolio and we do not expect these spread-driven changes in fair value to have a significant impact on future estimated net cash flows.
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.
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, 2007, we reinsured a total of approximately $0.9 billion of loans. Insurance in force was $2.7 billion at December 31, 2007, compared to $2.5 billion at December 31, 2006. In 2006 and 2007, the Hong Kong Mortgage Corporation increased 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, 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 32% of PMIs reinsurance written in 2007 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 33% 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 2007, PMI made claim payments of $0.03 million (net of recoveries) compared to $0.2 million (net of recoveries) in 2006.
PMI Asias payment of its claims obligations with respect to its Hong Kong reinsurance portfolio is guaranteed by PMI Europe. Accordingly, a ratings downgrade of PMI Europe could negatively affect PMI Asias future business prospects and competitiveness.
In 2007, we began offering residential mortgage insurance products to Canadian lenders and mortgage originators through our wholly-owned Canadian subsidiary (PMI Canada). PMI Canada has 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 has a government guarantee,
described further below, from the Canadian Ministry of Finance. PMI Canada has also received license approval from all Canadian provinces and territories with the exception of Quebec. The Quebec authorities have indicated that they may not grant PMI Canadas request for the provincial license until the financial condition of The PMI Group and our U.S. Mortgage Insurance Operations stabilizes. Continued delay with respect to, or denial of, the Quebec provincial license would negatively affect PMI Canadas business prospects and competitiveness. During 2007, PMI Canada also received approval as an authorized private mortgage insurer for Canadas National Housing Act MBS program. PMI Canada did not provide any mortgage insurance coverage in 2007 and has written a limited amount of insurance so far in 2008.
Federally regulated financial institutions, or FRFIs, are not required to maintain regulatory capital on mortgages backed by a sovereign guarantee. Pursuant to its agreement with the Canadian Ministry of Finance, the Ministry of Finance will guarantee, in the event PMI Canada became insolvent, the benefits payable under mortgage insurance policies we issue in Canada on eligible mortgages, less 10% of the original principal amount of the insured loan. The guarantee permits FRFIs who purchase our mortgage insurance to eliminate their regulatory capital charges for credit risks on the 90% of the original principal amount of mortgages guaranteed by the government. In exchange for this guarantee, we are 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 also operates with the benefit of a similar government issued guarantee.
PMI Canada is rated AA by DBRS, the principal rating agency in Canada. In order to acquire this rating, PMI and PMI Canada entered into a capital support agreement for the benefit of PMI Canada. This agreement is limited to $300 million and capital support may only be provided to the extent that it does not cause MIC to fall below minimum capital and surplus requirements. Accordingly, a downgrade of PMIs insurer financial strength ratings by DBRS would likely cause a downgrade of PMI Canada. (See Item 1A. Risk FactorsA downgrade of the financial strength ratings of our wholly-owned insurance subsidiaries would adversely affect our business and prospects and, consequently, our results of operations and financial condition.)
In Canada, we offer primary flow mortgage insurance, similar to primary insurance in Australia, and structured finance products. Currently, FRFIs are required to obtain insurance for residential mortgages that are greater than 80% loan-to-value. Non-regulated originators and FRFIs also are interested in limiting default risk in order to offer more flexible loan terms. We offer structured product solutions to lenders seeking capital relief or credit enhancement on portfolios of mortgages, and to investors seeking to facilitate MBS transactions or mortgage portfolio sales. Our products generally are 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 the majority of the financing for Canadas residential mortgage market. Other market participants include regional banks, trust companies, mortgage loan companies, and credit unions. The typical mortgage product in the Canadian market has a one to five year maturity and a 25 to 40 year amortization schedule. Lenders routinely allow borrowers to refinance and choose the maturity and interest rate option.
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 entered or 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 2007, 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 $1.2 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 2007. As of December 31, 2007, the total cost of these options, net of realized losses recognized to net income, was net losses of $1.2 million and $0.1 million for PMI Australia and PMI Europe, respectively. PMI Australia has entered into a similar foreign exchange put option program in 2008 at a pre-tax cost of $1.1 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 $281.0 million as of December 31, 2007, 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 2007.
Overview. 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 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.
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.
Recent Developments Relating to FGIC. At December 31, 2007, FGIC had total shareholders equity of $584.4 million compared to $2.4 billion at December 31, 2006. This significant decline in shareholders equity
was due to FGICs $1.9 billion of unrealized mark-to-market losses in 2007 related to derivative contracts issued by FGIC on mortgage-related collateralized debt obligations and loss reserve increases of $1.2 billion in 2007. FGICs loss reserve increases in 2007 were driven by the credit deterioration of insured collateralized debt obligations backed by sub-prime residential mortgage-backed securities (RMBS) as well as direct exposure to RMBS. FGICs 2007 mark-to market losses and additions to loss reserves reflect the significant weakening of the U.S. residential mortgage, housing, credit and capital markets. (See Item 1A. Risk Factors Our net income and earnings have become more volatile due to the application of fair value accounting, or FAS 133, to the portion of PMI Europes, FGICs and RAM Res credit enhancement business which is executed in credit derivative form, below.)
Historically, the ability of FGIC to attract new business and to compete in the financial guaranty industry has been highly dependent on the AAA insurer financial strength ratings assigned to it by rating agencies. In January 2008, Fitch downgraded FGICs insurance financial strength rating from AAA to AA and placed FGIC on CreditWatch Negative, and Standard & Poors downgraded FGIC from AAA to AA and placed FGIC on CreditWatch with developing implications. On February 14, 2008, Moodys downgraded FGICs Aaa rating to A3, and FGIC remains on review for possible further downgrade. On February 25, 2008, Standard & Poors downgraded its insurer financial strength rating on FGIC from AA to A. Standard & Poors also placed its rating of FGIC on CreditWatch with developing implications. As a result of these downgrades, FGIC has ceased writing new financial guaranty business, and we believe that it is unlikely that FGIC will be able to write new financial guaranty business in the future at its current ratings. A downgrade of FGICs financial strength ratings below specified levels may allow certain issuers and counterparties, subject to the terms of their contractual arrangements with FGIC, to terminate those agreements, which could result in the loss of future revenues.
As a result of, and in response to, FGICs financial performance and the rating agencies actions, FGIC Corporation has proposed a significant restructuring of its insurance operations to the New York Insurance Department, including the organization of a new financial guaranty insurer to be domiciled in New York to provide support for global public finance and infrastructure obligations previously insured by FGIC and to write new business to serve such markets. We do not know what form such restructuring, if any, will ultimately take, and any restructuring will require approval from the New York Insurance Department, among others. We expect that a restructuring of FGICs business will require significant additional capital, which may not be available on favorable terms or at all. Moreover, there can be no assurance that any such plan will be implemented in a manner that satisfies the rating agencies requirements so as to enable the new company to obtain the AAA rating it would need to execute its business plan. Given our current capital needs and resources, we do not expect to make a further investment in FGIC Corporation. Accordingly, equity securities issued by FGIC Corporation in a capital-raising transaction would result in significant dilution of our ownership interest in FGIC Corporation.
Overview of Financial Guaranty Business. 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 guaranty 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, 2007, $222.1 billion, or 70.7%, of FGICs total net par outstanding represented insurance of U.S. public finance obligations.
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. 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 has provided financial guarantees has been broad and varied, comprising public issues and private placements. As of December 31, 2007, $70.7 billion, or 22.5%, of FGICs total net par outstanding, represented insurance of U.S. structured finance. For the year ended December 31, 2007, $1.2 billion of losses were recorded with respect to the structured finance obligations.
International Finance. FGIC launched its international finance operation in late 2004 and until the recent ratings downgrades, 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, 2007, FGICs net par outstanding related to international finance transactions was $21.2 billion.
Competition. Competitive conditions in the financial guaranty industry are rapidly changing. FGIC and other financial guaranty insurers ability to compete has been highly dependent on their triple-A ratings. Although a certain number of FGICs competitors have also been downgraded, some financial guaranty insurers have remained triple-A rated. In addition, Berkshire Hathaway Assurance Corporation, a newly formed financial guaranty insurance company, has provided AAA credit enhancement. As a result of the recent downgrades in FGICs financial strength ratings, FGIC is unable to compete for new business in the segments of the financial guaranty industry in which it has historically operated and has ceased writing new business. In order for FGIC Corporation to again meaningfully compete in the financial guaranty insurance industry, especially in the area of public finance, FGIC will need to regain its triple-A rating or form a new company with a triple-A rating.
Banks, multi-line 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 for the bonds. 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 scenariosare 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 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 non-derivative obligations that are presently or likely to be in payment default for which future loss is probable and can be reasonably estimated. These reserves are determined using internally developed models and represent an estimate of the present value of the anticipated shortfall, net of reinsurance, between (i) anticipated claims payments on 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. FGICs case reserve models are dependent on a number of assumptions that require management to make judgments about the outcomes of future events using historical and current market data. Significant assumptions include the liquidation value of the assets supporting the insured obligations, volume and timing of collateral cash flows and the behavior of the underlying borrower. FGICs case reserves will likely change, possibly materially, in future periods as additional information becomes available.
Watchlist reserves recognize the potential for claims against FGIC on non-derivative insured public finance 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. 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. There are significant risks and uncertainties that could result in material adverse deviation of FGICs reserves at December 31, 2007. There remains a considerable amount of uncertainty relating to risks in real estate prices, credit markets and the economy as a whole. There is no historical precedent for these conditions. Consequently, the ultimate liability associated with such claims will likely differ, possibly materially, from such estimates. See Item 7. Managements Discussion and Analysis of Financial Condition and Results of OperationsConditions 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.
In addition to the regulatory and contractual restrictions described above, we expect that FGIC Corporation will be further restricted in the payment of dividends in light of its financial performance in 2007, as well as the likelihood that it will need significant additional capital to execute its proposed restructuring plan.
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. A downgrade of PMI would likely cause a downgrade of PMI Guaranty. (See Item 1A. Risk FactorsA downgrade of the financial strength ratings of our wholly-owned insurance subsidiaries would adversely affect our business and prospects and, consequently, our results of operations and financial condition.) As of December 31, 2007, PMI Guaranty had total par outstanding of $962.9 million which includes $914.4 million of par outstanding consisting of municipal securities and $48.5 million consisting of mortgage-related assets. PMI Guaranty has not entered into any CDS contracts nor has it provided credit enhancement on any collateralized debt obligations (CDOs).
Financial Guaranty Insurance. PMI Guaranty offers AA rated financial guaranty insurance and related credit enhancement products and services for asset-backed securities. PMI Guarantys credit enhancement products guarantee that the principal and interest associated with the insured securities will be paid to investors on the date due. 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 guaranty, issuers are able to offer AA rated securities equal to the entire notional amount of these wrapped tranches.
Financial Guaranty Reinsurance. PMI Guaranty also offers financial guaranty reinsurance to primary financial guarantors. By providing reinsurance to financial guarantors, PMI Guaranty can reduce the amount of total capital required to be held by the financial guarantors. As of December 31, 2007, reinsurance transactions represented approximately 97% of the total insured portfolio, including reinsured par outstanding of $18.9 million of securities that are backed by mortgage-related assets and $914.4 million of reinsured par outstanding consisting of municipal securities. PMI Guarantys obligation to make payments of principal and interest to investors through its financial guaranty reinsurance product will arise when 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 agreement.
Competition. PMI Guaranty faces significant competition in both the financial guaranty insurance and financial guaranty reinsurance arenas. In addition to PMI Guaranty, there are many publically rated financial guarantors that provide direct financial guaranty insurance and/or reinsurance in the credit enhancement marketplace. PMI Guaranty also competes with alternative credit enhancement products and structures and capital market participants. (See Item 1A. Risk FactorsWe do not expect PMI Guaranty to be a significant source of net income in 2008, below.)
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 do not expect PMI Guaranty to be a significant source of net income in 2008.
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 Holdings Ltd. is publicly traded on the Nasdaq National Market. RAM Re and its holding company are subject to regulation under the laws of Bermuda.
RAM Re reinsures municipal, structured finance and international debt obligations originally underwritten by primary financial guarantors. RAM Re provides reinsurance to primary financial guaranty 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 primary insurers 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 may cede a portion of risks as 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.
RAM Re is currently rated AAA by Standard & Poors on CreditWatch with negative implications and Aa3 by Moodys, with a negative outlook. Moodys announced in February 2008 that it had placed RAM Res Aa3 insurance financial strength rating on review for possible downgrade. Moodys stated that its rating actions reflected Moody's revised expected loss projections for RMBS and related collateralized debt obligation (CDO) risk, and the corresponding implications for RAM Re's capital adequacy. Moodys also stated that during the review process, it would, among other things, evaluate the impact of mortgage-related exposures on RAM Res risk adjusted capital adequacy and the companys future business prospects due to possible reduced business flow from its primary financial guaranty clients. On March 7, 2008, Moodys confirmed the Aa3 rating and changed the outlook to negative to reflect the uncertainty regarding both the ultimate performance of mortgage and mortgage-related collateralized debt obligation exposure, as well as RAM Res future underwriting prospects. On February 14, 2008, Standard & Poors placed RAM Res AAA rating on CreditWatch with negative implications, reflecting the view of a shortfall in RAM Res capital cushion relative to projected sub-prime losses. Any downgrade of RAM Res ratings by Moodys or Standard & Poors could have a material adverse effect on RAM Res business, financial condition and results of operations.
In response to Moodys and Standard & Poors rating actions, RAM Re has stated that it is pursuing a number of alternatives to improve its capital position, including obtaining reinsurance for selected policies and slowing its growth. RAM Re stated that it does not intend to raise new capital at the present time due to current market conditions. RAM Re further stated that its strategy remains subject to change, and there can be no assurance that RAM Re will be successful in improving its capital position, maintaining its ratings or in restoring its ratings in the event of a downgrade. (See Item 1A. Risk FactorsRecent downgrades relating to FGIC and the placing of RAM Re on negative credit watch have adversely affected our financial condition and results of operations. Additional adverse rating agency actions with respect to FGIC or RAM Re could further harm our financial condition and results of operations, below.)
A downgrade of RAM Res ratings below AAA by Standard & Poors or Aa3 by Moodys could negatively affect the value of RAM Res reinsurance. Under Standard & Poors current guidelines for assigning credit to reinsurance, if RAM Res rating were downgraded from AAA to AA, the credit received by RAM Res AAA rated customers for its reinsurance would be decreased from 100% to 70%. If RAM Res ratings by Moodys were downgraded below Aa3, the amount of credit for reinsurance would be reduced from 85% to an amount less than 80% to be determined by Moodys.
Under RAM Res treaty contracts with its customers, the primary financial guaranty insurers, the downgrade of RAM Res ratings would generally allow RAM Res customers, after a cure period, to increase the ceding commission, which is the commission paid to a primary insurer by a reinsurer based on the amount of the
premiums ceded, or terminate the contract and either leave their existing business with RAM Re or recapture it. A downgrade of RAM Res ratings, the placing of RAM Res ratings on negative credit watch or under review for a ratings downgrade, or a decrease in the credit given for its reinsurance to the primaries could also negatively affect its ability to negotiate favorable terms with primary insurers in the future.
Due to, among other things, the continuing deterioration of the credit market, rating agency actions and the decline in RAM Res share price, in the fourth quarter of 2007 we realized an other-than-temporary impairment of our investment in RAM Re of $38.5 million. After impairment, the carrying value of our investment in RAM Re as of December 31, 2007 was $60.0 million. We expect the carrying value of our investment in RAM Re to be further reduced in the first quarter of 2008 as a result of RAM Res losses and/or further impairment. We will continue to evaluate this investment for possible future impairment.
As of December 31, 2007, The PMI Group and its consolidated subsidiaries had total cash and cash equivalents of $427.9 million and investments of $3.7 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, and monitor our investment performance. The U.S. companies (including PMI Guaranty) included in the consolidated financial statements, or the U.S. Portfolio, held cash and cash equivalents and investments of $2.5 billion as of December 31, 2007. We manage the fixed income portion of the U.S. Portfolio internally. The 4.2% of the U.S. Portfolio (including cash and cash equivalents) 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, 2007, based on market value and excluding cash and cash equivalents, approximately 80.7% of the U.S. Portfolio was invested in fixed income securities and approximately 19.2% was invested in equity securities. 97.5% of the U.S. portfolio (including cash and cash equivalents and excluding common stocks) were rated A or better by at least one nationally recognized securities rating organization, and of those, 68.8% were rated AAA, 17.5% were rated AA, and 11.2% were rated A. The U.S. Portfolios fixed income portfolios option-adjusted duration, including cash and cash equivalents, was 5.87 as of December 31, 2007. We generally do not invest in non-agency 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, PMI Asias and PMI Canadas 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, 2007, PMI Australia had $69.8 million in cash and cash equivalents and $1.2 billion of investments which are managed by Aberdeen Fund Managers Australia Limited. The investment portfolio consists mainly of high-grade Australian currency-denominated fixed income securities issued by sovereign,
semi-government and corporate entities. As of December 31, 2007, the portfolios option-adjusted duration, including cash and cash equivalents, was 3.62. 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, 2007, PMI Europe had $53.3 million in cash and cash equivalents and $200.8 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 3.9 as of December 31, 2007. PMI Europes portfolio did not contain investments in equity securities as of December 31, 2007.
As of December 31, 2007, PMI Asia had $3.6 million in cash and cash equivalents and $67.0 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 3.3 as of December 31, 2007. PMI Asias portfolio did not contain investments in equity securities as of December 31, 2007.
As of December 31, 2007, PMI Canada had $9.0 million in cash and cash equivalents and $64.8 million of investments which are managed by Morgan Stanley Investment Management. The investment portfolio consists of Canadian dollar denominated fixed income securities issued by sovereign, agency and corporate entities. The portfolios option-adjusted duration, including cash and cash equivalents, was 3.2 at December 31, 2007. PMI Canadas portfolio did not contain investments in equity securities as of December 31, 2007.
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, 2007, The PMI Group, together with its wholly-owned subsidiaries and CMG MI, had approximately 1,084 full-time and part-time employees, of which 764 persons performed services primarily for PMI, 8 were employed by PMI Guaranty, 232 were employed by PMI Australia, 36 were employed by PMI Europe, 6 were employed by PMI Asia, 12 were employed by Canada, and 26 performed services primarily for CMG MI. Our employees are not unionized and we consider our employee relations to be good. In addition, MSC had 205 temporary workers and contract underwriters as of December 31, 2007.
Our holding company structure and certain regulatory and other constraints, including adverse business performance, could affect our ability to pay dividends and make other payments.
We are a holding company and conduct our business operations through our various subsidiaries. Our principal sources of funds are dividends from our insurance subsidiaries, income from our investment portfolio and funds that may be raised from time to time in the capital markets. We are largely dependent on dividends from PMI to pay dividends on our capital stock, to pay principal and interest on our indebtedness, to pay holding company operating expenses, to make capital investments in our subsidiaries and to purchase our common stock in the open market. State insurance regulations restrict the amount of dividends that may be paid by our insurance subsidiaries without the consent of the regulator. The inability of PMI and our other subsidiaries to pay dividends in amounts sufficient to enable us to meet our cash requirements at the holding company level could affect our ability to repay our debt, pay holding company expenses, continue paying dividends on our common stock and/or raise capital or otherwise have a material adverse effect on our operations. Factors that may affect PMIs and our other insurance subsidiaries ability to pay dividends to meet our capital and liquidity needs
include: adverse business circumstances, including higher levels and severity of claims experience and reduced demand for our insurance and credit enhancement products; standards and factors used by various credit rating agencies that may require the maintenance of certain levels of capital at our insurance subsidiaries; financial covenants in our credit agreement; and standards imposed by state insurance regulators relating to the payment of dividends by insurance companies.
In addition to dividends, we also rely on returns from our investment portfolio to meet our capital needs. A protracted economic downturn, or other factors, could cause issuers of the fixed-income securities that we 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 expect that we will need to raise significant amounts of additional capital in 2008. We may be unable to do so at all or pursuant only to unfavorable terms. If we are successful in raising capital, such additional capital could contain restrictive covenants and/or have a dilutive effect on our outstanding equity capital or future earnings.
As a result of higher losses in 2007, higher projected losses in 2008 and growth in insurance in force, we expect that we will need to raise significant amounts of additional capital in 2008 to maintain The PMI Groups, PMIs and our other insurance subsidiaries ratings. Although we do not yet know what form these capital raising activities will take, we expect to seek to raise additional capital through a variety of types of transactions, including through one or more debt or equity offerings. On an ongoing basis, we intend to explore other available alternatives to enhance our liquidity, including obtaining reinsurance for our insurance subsidiaries existing or future books of business, limiting the new insurance written by our insurance subsidiaries and/or the disposition of equity investments (which could include certain wholly-owned subsidiaries) or portions thereof. Given current market conditions generally and in our industry, there can be no assurance that we will be able to consummate any capital raising transactions on favorable terms or at all. In addition, a rapid escalation of losses or sudden ratings downgrades could make it more difficult for us to raise the necessary capital. Moreover, to the extent a capital raising transaction is undertaken in an effort to avoid a ratings downgrade, there can be no assurance that the transaction could be completed in a timely manner to avoid an adverse ratings agency action. The terms of a capital raising transaction could require us to agree to stringent financial and operating covenants and to grant security interests on our assets to lenders or holders of our debt securities that could limit our flexibility in operating our business or our ability to pay dividends on our common stock and could make it more difficult for us to obtain capital in the future. We may not be able to access additional debt financing on acceptable terms or at all. Any future equity offerings could be dilutive to our existing shareholders or could result in the issuance of securities that have rights, preferences and privileges that are senior to those of our common stock. Further, any capital initiatives in the form of reinsurance, or other risk transfer transactions of our existing portfolios, would have a dilutive effect on our future earnings.
A downgrade of our senior unsecured debt ratings would adversely affect our liquidity and increase our borrowing costs.
Our senior unsecured debt is rated A (CreditWatch with negative implications) by Standard & Poors; A (Rating Watch Negative) by Fitch; and A1 (under review for possible downgrade) by Moody's.
Our access to external sources of financing, as well as the cost of financing, is dependent on various factors and would be adversely affected by a deterioration of our unsecured debt ratings. Debt ratings are influenced by a number of factors, including, but are not limited to: financial leverage on an absolute basis or relative to peers, the composition of the balance sheet and/or capital structure, material changes in earning trends and volatility, inability to dividend monies from subsidiaries, our competitive position, and the rating agencies views on the future earnings prospects of our insurance subsidiaries and the mortgage insurance industry. Material deterioration in any one or a combination of these factors, including our recent weak financial results and continued weak earnings performance, could result in a downgrade of our debt ratings, thus increasing the cost of
and/or limiting the availability of unsecured financing. Recent placement of our senior unsecured debt ratings on credit watch by the rating agencies increases the risk that our debt ratings may be downgraded in the near future. If we cannot obtain adequate capital on favorable terms or at all, our business, operating results and financial condition would be adversely affected.
Capital constraints could require us to limit our subsidiaries operations.
Our insurance subsidiaries, to a varying degree, face or could face significant capital constraints in the form of existing or new rating agency capital requirements, regulatory risk to capital requirements, internally-imposed capital limitations in light of our companys overall capital needs and higher than expected losses. In light of current conditions, including increasing losses and projected new insurance written in 2008, we expect that PMIs capital requirements will likely significantly increase in 2008. In addition, in the case of PMI Australia, higher losses, declines in its investment portfolio and/or adjustments by APRA to PMI Australias minimum capital requirements could cause PMI Australia to fall below APRA capital requirements. To satisfy the capital requirements of PMI, we may be required to limit the operations (including new insurance written) of our insurance subsidiaries, obtain reinsurance for our insurance subsidiaries existing or future books of business, and/or dispose of equity investments (which could include certain wholly-owned subsidiaries) or portions thereof. Either of these events could harm our consolidated financial condition, results of operations and cash flows.
A downgrade of the financial strength ratings of our wholly-owned insurance subsidiaries would adversely affect our business and prospects and, consequently, our results of operations and financial condition.
To date, the ability of our wholly-owned insurance subsidiaries (including our mortgage insurance subsidiaries and PMI Guaranty) to attract new business and to compete has been highly dependent on the insurer financial strength ratings assigned to them by the rating agencies. Our insurance subsidiaries PMI, PMI Australia, PMI Europe, and PMI Guaranty hold AA financial strength ratings from Standard & Poors Ratings Services (Standard & Poors) and Fitch Ratings (Fitch). PMI and PMI Australia are rated Aa2 and PMI Europe and PMI Guaranty are rated Aa3 by Moodys Investors Services (Moodys). PMI Canada is rated AA by DBRS. The ratings of PMI Australia, PMI Europe, PMI Canada, and PMI Guaranty are dependent in part upon the capital support of PMI. A downgrade of PMIs ratings, therefore, would likely cause a downgrade of the ratings of our other insurance subsidiaries. The objective of these ratings is to provide an opinion on an insurer's financial strength and its ability and intent to pay under its insurance policies and contracts in accordance with their terms.
The rating agencies have indicated that they are engaged in on-going monitoring of the mortgage insurance and financial guaranty industries to assess the adequacy of, and where necessary refine, their capital models. As a result of these reviews and adverse developments in the loss experience of, and outlook for, our business:
Determinations of ratings by the rating agencies are affected by a variety of factors, including macroeconomic conditions, economic conditions affecting the mortgage insurance industry, changes in business prospects, regulatory conditions, competition, underwriting and investment losses and the perceived need for additional capital. There can be no assurance that our mortgage insurance subsidiaries or PMI Guaranty will not be downgraded or required by one or more of the rating agencies to raise additional capital in order to maintain their ratings. As discussed above, there can be no assurance that we will be able to raise any additional capital in the future and, to the extent that we are unable to timely raise sufficient capital in relation to increased capital needs, our mortgage insurance subsidiaries or PMI Guarantys ratings could be lowered.
A ratings downgrade, or the announcement of a potential downgrade or other concern relating to the financial strength of our mortgage insurance subsidiaries or PMI Guaranty could have a material adverse effect on our business prospects and revenues, our ability to compete, our holding company debt ratings, the ratings or performance of our other insurance subsidiaries (who may receive capital support from the downgraded subsidiary), or the ratings of CMG MI. Any of these events would harm our consolidated financial condition, results of operations and cash flows.
If PMIs insurer financial strength rating for two out of the following three rating agencies falls below AA- from Standard & Poors or Fitch, or Aa3 from Moodys, investors, including the GSEs, may cease to accept PMIs mortgage insurance products. In addition, even if only one rating agency assigns PMI a rating below AA- or Aa3, the GSEs could require PMI to limit certain activities and practices in order to remain a GSE eligible mortgage insurer. Such limitations could include the preclusion of offering captive reinsurance without the GSEs consent and maximum risk-to-capital ratios, either of which could harm our consolidated financial condition and results of operations.
In addition, a downgrade of PMI Europes financial strength ratings below specified levels would allow certain derivative counterparties to terminate their agreements, resulting in a possible payment of a settlement amount or a requirement that PMI Europe pledge collateral for the benefit of the counterparty.
Recent downgrades relating to FGIC and the placing of RAM Re on negative credit watch have adversely affected our financial condition and results of operations. Additional adverse rating agency actions with respect to FGIC or Ram Re could further harm our financial condition and results of operations.
Our net loss of $915.3 million in 2007 was due in significant part to our equity in losses of FGIC Corporation of $763.3 million. FGIC may continue to incur losses in 2008. Recent downgrades of FGIC as well as adverse rating agency actions with respect to RAM Re are expected to continue to adversely affect the performance of our Financial Guaranty segment, as well as our financial condition and results of operations as a whole. Historically, the abilities of FGIC and RAM Re to attract new business and to compete in the financial guaranty industry have been highly dependent on the AAA insurer financial strength ratings assigned to them by the rating agencies. In the fall of 2007, each of the major rating agencies began a review of the capital adequacy of the financial guaranty industry. As a result of these reviews and other developments:
The downgrades of FGICs AAA ratings will have a material adverse effect on FGICs competitive position and its ability to write new business. We believe that it is unlikely that FGIC will be able to write new financial guaranty insurance at its present A rating by Standard & Poors and A3 rating by Moodys.
FGIC Corporation has proposed a significant restructuring of its insurance operations to the New York Insurance Department, including the organization of a new financial guaranty insurer to be domiciled in New York to provide support for the global public finance and infrastructure obligations currently insured by FGIC and to write new business to serve such markets. We do not know what form such restructuring, if any, will ultimately take or how it might impact the value of our investment. Any restructuring will require approval from the New York Insurance Department, among others. We expect that a restructuring of FGICs business or any other alternative business plan will require significant additional capital, which may not be available on favorable terms or at all. Moreover, there can be no assurance that any such plan will be implemented in a manner that satisfies the rating agencies requirements so as to enable the new company to obtain the AAA rating it would need to execute its business plan. Moreover, any litigation or threats of litigation by any constituency arising out of any proposed reorganization, including claims from insureds in respect of structured finance obligations, which would continue to be insured by FGIC under the proposed reorganization, could further harm the value of our investment.
The rating agencies continue to monitor FGICs financial position, and one or more rating agencies could further downgrade FGICs financial strength ratings in the near future. Any further downgrade in FGICs financial strength ratings could have further material adverse effects on its long-term competitive position and its prospects for future business. In addition, a downgrade of its financial strength ratings below specified levels may allow certain of FGICs counterparties to terminate certain agreements and cease paying FGIC premiums for the terminated credit protection, possibly resulting in a requirement that FGIC pay a settlement amount or pledge collateral for the benefit of the counterparty. Our investment in FGIC Corporation has been adversely affected by the events leading to the reductions in FGICs ratings as well as the downgrades themselves, and could be further harmed by any future reductions and/or any further losses at FGIC. (See Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations Financial Guaranty.)
With respect to RAM Re:
Any downgrade of RAM Res ratings by Moodys or Standard & Poors could have a material adverse effect on RAM Res business, financial condition and results of operations. Among other things, a downgrade could allow RAM Res customers, after a cure period, to increase the ceding commission, which is the commission paid to a primary insurer by a reinsurer based on the amount of the premiums ceded, or terminate the contract and either leave their existing business with RAM Re or recapture it. A downgrade could also result in a decrease in the credit given for RAM Res reinsurance, which could impact pricing under certain existing and future contracts, which could negatively affect RAM Res financial condition and results of operations. In turn, our investment in RAM Re could be adversely affected by any reduction in RAM Res ratings. As discussed in Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations, due to the continuing deterioration of the credit market, RAM Res financial condition and the decline in RAM Res share price, we realized an other-than-temporary impairment of our investment in RAM Re of $38.5 million in the fourth quarter of 2007.
Changes in the rating agencies capital models and rating methodologies may adversely affect our business results and prospects.
Changes in the rating agencies capital models and rating methodologies could require our insurance subsidiaries to hold more capital against specified credit risks in their insured portfolios. These requirements could place stress on our insurance subsidiaries ratings and force us to raise additional capital, which we may be unable to accomplish on favorable terms, in a timely manner to avoid a downgrade, or at all. The terms of any additional capital also may dilute our common stockholders interest in the company. Changes in the rating agencies capital models and rating methodology could also cause us to impose limitations on the areas and amount of new business in which we engage. These changes could adversely affect future amounts of new insurance written, and in turn our financial results and prospects. Alternatively, if we do not comply with any new requirements, our insurance subsidiaries insurer strength ratings could be downgraded.
Any capital raising activities in which FGIC Corporation engages could significantly dilute our ownership interest in FGIC Corporation.
As discussed above, FGIC Corporation has proposed a significant restructuring of its insurance operations to the New York Insurance Department, including the organization of a new financial guaranty insurer to be domiciled in New York to provide support for the global public finance and infrastructure obligations currently insured by FGIC and to write new business to serve those markets. As part of that plan, it is expected that FGIC Corporation will need to raise significant additional capital, which may not be available on acceptable terms, or at all. Even if available, such additional capital could be provided through the issuance by FGIC Corporation or its subsidiaries to third parties of debt or equity securities that contain rights and preferences that are senior to our common stock investment in FGIC Corporation, and could include significant operational and financial covenants that limit FGICs future operating and financial flexibility. Given our capital needs and resources, we do not expect to make a further investment in FGIC Corporation. Accordingly, equity securities issued by FGIC Corporation in a capital-raising transaction would result in significant dilution of our ownership interest in FGIC Corporation.
Our credit facility contains restrictive and financial covenants and, if we are unable to comply with these covenants, or if we are unable to reach agreement with our lenders regarding the pledge of the capital stock of PMI, we may lose access to the facility.
As discussed under Item 7. Managements Discussion and Analysis of Financial Condition and Results of OperationsLiquidity and Capital Resources, below, we have reached agreement with our lenders regarding an amendment to our credit facility. The effectiveness of the amendment is subject to certain conditions, which we expect to satisfy shortly. The credit facility contains requirements to maintain certain specified financial ratios and restricts our ability to engage in certain asset dispositions or investments, including investments in certain of our subsidiaries, as well as our ability to pay dividends on our common stock over certain levels or if we are in default under the facility. The amendment to the credit facility also contains significant new events for an event of default under the facility. These covenants and event of default provisions could reduce our operating flexibility. In addition, if an event of default under the facility were to occur, we could have to repay all outstanding indebtedness and would be unable to draw on the facility, and the lenders would have the right to terminate their loan commitments under the facility.
Our ability to borrow under the amended facility is subject to a number of conditions, including that the stock of PMI have been pledged in favor of the lenders under the facility (and noteholders under certain of our senior notes), in form and substance satisfactory to the administrative agent and a majority in interest of the lenders in their sole and absolute discretion. The terms of the pledge agreement have not been agreed to, and there is no assurance that we will be able to enter into a mutually agreeable pledge agreement.
We expect to require additional funds in 2008, and if we were unable to borrow under the facility for any reason or were delayed in doing so, our operating flexibility would be harmed. We are dependent on the facility as a source of liquidity, and may not be able to find alternate forms of capital on favorable terms or at all.
We are subject to substantial residential mortgage credit risk throughout our businesses and through our equity investees.
Through our main operating businesses, we are exposed to the risk that borrowers will default on residential mortgage loans we have insured or in the case of PMI Europe, with respect to which we have written credit derivatives for which the underlying collateral is residential mortgage loans. As of December 31, 2007, our wholly-owned insurance subsidiaries had risk in force of $205.6 billion.
In addition, FGIC has insured and written credit default swaps with respect to mortgage-backed securities. RAM Re also has substantial residential mortgage-related credit risk through the issuers of debt that it has reinsured as well as through the reinsurance of credit derivatives with underlying residential mortgage loans as collateral.
These transactions subject us to all of the risks relating to the housing market, including those discussed below under Market and economic factors have adversely affected and may continue to adversely affect our business results and prospects. This credit risk could cause increased losses and loss reserves, and mark-to-market losses with respect to credit derivatives in our European operations as well as with respect to our equity investees, FGIC Corporation and RAM Re. The rating agencies could require us to hold additional capital against insured exposures whether or not they downgrade the ratings of our insurance subsidiaries. Either of these outcomes would decrease our financial strength.
Our net income and earnings have become more volatile due to the application of fair value accounting, or FAS 133, to the portion of PMI Europes, FGICs and RAM Res credit enhancement business which is executed in credit derivative form.
FAS 133 requires that credit derivative transactions be recorded at fair value. PMI Europe, FGIC and RAM Re have written credit derivatives that are subject to mark-to-market treatment under FAS 133. Since quoted
market prices for these derivative contracts are generally not available, PMI Europe, FGIC and RAM Re estimate fair value by using modeling methodologies, which are less objective than using quoted market prices. Changes in estimated fair values can be caused by general market conditions, perception of credit risk generally and events affecting particular credit derivative transactions (e.g. impairment or improvement of specific reference entities or reference obligations).
Decreases in estimated fair values relative to credit derivatives have caused decreases in the value of such credit derivative transactions. Those changes in value are reflected in our financial statements and have adversely affected our reported earnings. For example, we recorded mark-to-market losses of $16.9 million on PMI Europes derivative contracts in 2007. Our Financial Guaranty segments net loss of $731.7 million in 2007 was driven by FGICs and RAM Res $1.9 billion and $28.4 million, respectively, mark-to-market losses in 2007 related to derivative contracts. Further decreases or increases in estimated fair values in the future can affect our reported earnings. The underlying collateral for certain of these credit derivatives are residential mortgage loans. Accordingly, continued adverse conditions in the residential mortgage credit market may continue to result in mark-to-market losses.
Because we establish loss reserves with respect to our mortgage insurance policies only upon loan defaults, our ultimate actual losses may be substantially higher than our loss reserve estimates.
In accordance with GAAP for the mortgage insurance industry, we establish loss reserves for our mortgage insurance subsidiaries only for loans in default. Reserves are established for reported losses and loss adjustment expenses based on when notices of default on insured loans are received. Reserves are also established for estimated losses incurred on notices of default that have not yet been reported to us by servicers. Our mortgage insurance reserving process does not take account of the impact of future losses that could occur from loans that are not delinquent. As a result, future notices of defaults on insured loans may have a material impact on our financial results and our ultimate actual losses may be substantially higher than our loss reserve estimates.
Our loss reserve estimates are subject to uncertainties and our actual losses may substantially exceed our loss reserves. Further, due to higher losses we may be required to record a premium deficiency reserve in the future. Changes in loss reserves or establishment of premium deficiency reserves may result in further volatility of net income and earnings.
Loss reserves established with respect to our mortgage insurance business and PMI Guaranty are based upon estimates and judgments by management, including estimates and judgments with respect to the rate and severity of claims. The establishment of loss reserves is subject to inherent uncertainty and requires judgment by management. Our actual losses may be substantially higher than our loss reserve estimates. Continued adverse economic and other conditions and resulting uncertainty with respect to the rate and severity of claims may result in substantial increases in loss reserves in the future. Additional increases in loss reserves would negatively affect our consolidated financial condition and results of operations. Our results of operations and financial condition relating to FGIC Corporation and RAM Re are similarly subject to risks that those companies loss reserves may not be sufficient to cover losses or may increase in the future.
We perform premium deficiency analysis using assumptions based on our best estimates when the analysis is performed. The calculation for premium deficiency requires significant judgment and includes estimates of future expected premiums, expected claims, loss adjustment expenses, investment income, and maintenance costs as of the date of the analysis. To the extent losses are higher or expected premiums are lower than our estimates, we could be required to record a premium deficiency reserve in the future, which would negatively affect our financial condition and results of operations.
Market and economic factors have adversely affected and may continue to adversely affect our business results and prospects.
National or regional recessions, changes in interest rate levels, continued stress in the credit and capital markets, rate adjustments under adjustable rate mortgages, a continued downturn in the U.S. housing market (especially further home price declines), higher unemployment rates, higher levels of consumer debt, deteriorating borrower credit, changes in domestic and international laws, intervention by governments in financial markets, wars, terrorist acts and other events could negatively impact the performance of our insured portfolios and our investment portfolio by causing increases in losses and loss reserves in our insured portfolios and decreases in the value of our investment portfolio and, therefore, our consolidated financial condition and results of operations. In addition, a continued downturn in our business may make it difficult for us to attract or retain our employees, which could harm our business.
As discussed in Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations, we increased PMIs net loss reserves in 2007 as a result of the increase in PMIs default inventory, higher claim rates and higher average claim sizes. Higher claim rates were driven in part by home price declines and the diminished availability of certain loan products, both of which constrain refinancing opportunities and decrease the cure rate. The increase in PMIs average claim sizes was driven by higher loan sizes and coverage levels in PMIs portfolio, as well as declines in home prices, which limit PMIs loss mitigation opportunities. Our loss experience significantly increased in 2007 and we expect it to increase in 2008 as a result of the severe downturn in the housing and mortgage markets and changes in economic conditions.
Our underwriting and risk management policies and practices may not anticipate all risks and/or the magnitude of potential for loss as the result of unforeseen risks.
We have established underwriting and risk management policies and practices which seek to mitigate our exposure to borrower default risk in our insured portfolio by anticipating future risks and the magnitude of those risks. To the extent that a risk is unforeseen or is underestimated in terms of magnitude of loss, these policies and practices will not insulate us from the effects of those risks. When establishing loss reserves, we rely on models that have been developed internally and by third parties to analyze and predict estimated losses relating to our current inventory of loans in default. Flaws in these models and/or in assumptions used by these models could lead to increased losses and loss reserving.
The premiums we charge for mortgage insurance on insured loans and the associated investment income may not be adequate to compensate for future losses from these loans.
We charge premium rates in effect at the time a policy is issued based upon our expectations regarding likely performance over the life of insurance coverage. We generally cannot cancel mortgage insurance coverage 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 on our insurance in force 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.
PMIs primary new insurance written and risk in force includes: