PMI Group 10-K 2011
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
For the fiscal year ended December 31, 2010
For the transition period from to
Commission file number 1-13664
THE PMI GROUP, INC.
(Exact name of registrant as specified in its charter)
(Registrants 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 ¨ No x
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 whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ¨ 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 30, 2010 was approximately $403.8 million 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 March 11, 2011: 161,309,088.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Proxy Statement for registrants Annual Meeting of Stockholders to be held on May 19, 2011 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. Forward-looking statements in this report include discussions of future potential trends relating to losses, claims paid, loss reserves, default inventories, claim rates, rescission and claim denial activity and the challenges thereto, persistency, premiums, new insurance written, refinance activity, the make-up of our various insurance portfolios, utilization of our deferred tax assets, the impact of market and competitive conditions, unemployment, liquidity, capital requirements and initiatives, captive reinsurance agreements, fair value of debt instruments, the performance of our derivative contracts as well as certain securities held in our investment portfolios, and potential litigation. 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.
Through our subsidiary, PMI Mortgage Insurance Co. (MIC), and its affiliated companies (collectively PMI), we provide residential mortgage insurance in the United States. Mortgage insurance provides loss 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 U.S. homebuyers.
Our business has undergone significant changes in the past few years. The protracted weak housing, credit and economic environments continue to negatively affect our financial condition and results of operations. Our consolidated net loss was $773.0 million for the year ended December 31, 2010. Our financial condition and results of operations for 2010 are discussed on both a consolidated and segment basis in Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations (MD&A), below. As a result of our significant net losses, we face a number of regulatory and other issues as discussed in C. Certain Regulatory and Other Issues Facing PMI, below, and in MD&A.
We are primarily focused on our U.S. Mortgage Insurance Operations. In 2010, the private mortgage insurance industry continued to be significantly challenged by the slow pace of economic recovery and instability in the housing and mortgage markets. While we experienced lower levels of new notices of default and a reduction in our delinquent loan inventory in 2010, we expect to continue to incur losses in 2011. Our new business writings in 2010 were limited as a result of continued competition with the Federal Housing Administration (FHA), which has become a significant competitor, and from the impact of Fannie Maes and Freddie Macs (collectively the GSEs) risk-based pricing structures, which include additive loan level pricing adjustments (LLPA) that the GSEs increased in 2010. Our new business writings were also limited by the continued impact of the changes we made to PMIs underwriting guidelines and customer management strategies prior to 2010. As discussed in D.2. CompetitionU.S. and State Government Agencies, we expect a variety of factors to continue to impact our new business writings. Such factors include, among others, mortgage and private mortgage insurance market and regulatory conditions and potential changes in the role of the GSEs and their business practices, including future increases to the GSEs LLPAs.
In 2010, we engaged in a number of capital and business initiatives, including:
Capital OfferingsIn the second quarter of 2010, we completed the sale of 77,765,000 shares of our common stock and $285 million aggregate principal amount of 4.50% Convertible Senior Notes due 2020 (Convertible Notes) and received aggregate net proceeds of approximately $732 million. Of these aggregate net proceeds, we contributed approximately $610 million to MIC in the form of capital and two surplus notes with aggregate face amounts of $285 million (the Surplus Notes). In addition to increasing the statutory capital of MIC, the proceeds from the capital offerings strengthened our holding company liquidity and reduced the outstanding borrowings on our revolving credit facility.
Homeownership PreservationIn 2007, we formed PMIs Homeownership Preservation Initiatives department (HPI) to develop and carry out our loss mitigation strategies. One of our strategies is to help loan servicers with their implementation of programs, including the Home Affordable Modification Program (HAMP), designed to assist troubled borrowers with finding solutions to avoid foreclosure and potentially cure and reinstate their loans. In 2010, the collective loss mitigation efforts by PMI and our servicer customers have resulted in loan modifications and other payment plans affecting approximately $1.9 billion of PMIs risk-in-force.
Modified Pool RestructuringIn 2010, we restructured a significant portion of our modified pool exposure, including through commutations, which resulted in the elimination of $0.5 billion of risk-in-force and the release of loss reserves, which in turn resulted in capital benefits to MIC, on both a statutory and GAAP basis.
Sale of FGICIn 2010, MIC sold its investment in FGIC Corporation, the holding company of Financial Guaranty Insurance Company (collectively FGIC). While the proceeds from the sale of FGIC were not significant, MIC could potentially realize certain tax benefits in future periods from the disposition of FGIC.
Reduction of PMI Europes Risk-In-ForceIn 2010, through contract commutations and terminations of credit default swap and other transactions, PMI Europes risk-in-force declined from $4.9 billion at December 31, 2009 to $0.7 billion at December 31, 2010.
Repositioning of Investment PortfolioIn response to operating losses in 2010, we significantly reduced our investments in tax-advantaged securities and we recorded realized investment gains of approximately $97 million.
We continue to focus on capital and capital relief initiatives. There can be no assurance that we will be able to achieve further statutory capital relief or improve our capital and liquidity position. See Item 1A. Risk FactorsRisks Relating to Capital and Liquidity Matters.
We divide our business into three segmentsU.S. Mortgage Insurance Operations, International Operations and Corporate and Other.
U.S. Mortgage Insurance Operations. As a U.S. residential mortgage insurer, PMI offers a variety of mortgage insurance products to meet the capital and credit risk mitigation needs of its customers. PMI also owns 50% of CMG Mortgage Insurance Company, or CMG MI, a joint venture that provides mortgage insurance exclusively to credit unions.
International Operations. Our International Operations segment consists of our European and Canadian subsidiaries (PMI Europe and PMI Canada), neither of which is writing new business. PMI Europe offered mortgage insurance and mortgage credit enhancement products tailored primarily to the European mortgage markets, through 2008. PMI Canada offered residential mortgage insurance products in Canada in 2007 and 2008. Our International Operations segment also consists of the discontinued operations of our former Australian and Asian mortgage insurance subsidiaries, which we sold in 2008. Our International Operations segment did not generate significant revenues in 2010. In connection with our sale of PMI Australia, we received a note in the principal amount of approximately $187 million, with interest accruing through September 2011, when it matures. Other than revenues from the amounts due on the note in 2011, we do not expect that our International Operations segment will generate significant revenues in the future.
Corporate and Other. Our Corporate and Other segment consists of corporate debt and expenses of our holding company, The PMI Group, Inc. (The PMI Group or TPG), contract underwriting operations (which were discontinued in April 2009), our former investments in FGIC Corporation which we sold in the third quarter of 2010 and RAM Re which was sold in the fourth quarter of 2009, and equity in earnings or losses from investments in certain limited partnerships.
As of December 31, 2010, our consolidated total assets were $4.2 billion, including our investment portfolio of $2.8 billion and total cash and cash equivalents of $0.3 billion. Our consolidated shareholders equity was $0.4 billion as of December 31, 2010. See Item 8. Financial Statements and Supplementary DataNote 18. Business Segments, for financial information regarding our business segments.
Our website address is http://www.pmi-us.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 founded in 1972. Our principal executive offices are located at 3003 Oak Road, Walnut Creek, California 94597-2098, and our telephone number is (925) 658-7878.
The insurance coverage issued by PMI and other U.S. mortgage insurers has several attributes that make mortgage insurance companies more susceptible to the cyclical nature of the economy in general and the housing and labor markets in particular than many other types of insurance companies. Mortgage insurance is generally renewable at the option of the insured at the premium rate fixed when the insurance on the loan was initially issued. As a result, losses from increased claims from policies originated in a particular year cannot be offset by renewal premium increases on policies in force. Because PMI recognizes its losses when it receives notices of default, the period over which PMI generates losses can be prolonged. In addition, we may not cancel the insurance coverage we issue except in the event of nonpayment of premiums or certain violations of PMIs master policies. Therefore, the average life of a PMI mortgage insurance policy generally has ranged from approximately four to ten years and may span a significant portion of an economic or real estate cycle. As a result, the loss ratios, which are the ratios of an insurers incurred losses to premiums earned, of PMI and the mortgage insurance industry are particularly affected by the cyclical nature of the U.S. economy and housing and labor markets. The chart below shows the mortgage insurance industrys average loss ratios between 1989 and September 30, 2010 (the most recent date for which industry data is available) and PMIs loss ratios between 1989 and 2010.
Continued high unemployment in the United States and the slow economic recovery (as compared to previous recoveries) in U.S. residential mortgage and housing markets are reflected in our and the industrys recent elevated loss ratios. We expect these factors to continue to negatively impact PMI. We currently do not expect PMI to report an operating profit in 2011. PMIs losses have reduced, and will continue to reduce, its net assets. This reduction in net assets and the prospect of continued losses have raised regulatory and other issues discussed in Section C (as well as in MD&A) below.
State Regulatory Capital Adequacy Requirements. In sixteen states, if a mortgage insurer does not meet a required minimum policyholders position (calculated in accordance with state statutory formulae) or exceeds a maximum permitted risk-to-capital ratio of 25 to 1, it may be prohibited from writing new business. In three of those states, the applicable regulations require a mortgage insurer to cease writing new business immediately if and so long as it fails to meet the applicable capital adequacy requirements. In the other thirteen states, the applicable regulations provide the regulators with discretion as to whether the mortgage insurer may continue
writing new business. We and other mortgage insurers continue to discuss with those states that have regulations requiring a mortgage insurer to immediately cease writing new business if capital adequacy requirements are not met the potential adoption of legislation giving the regulator discretion. Thirty-four states do not have specific capital adequacy requirements for mortgage insurers.
The graph below shows MICs risk-to-capital ratio and excess minimum policyholders position at the end of each quarter presented:
As of December 31, 2010, MICs risk-to-capital ratio was 19.9 to 1 and its excess minimum policyholders position was $184.3 million. In 2011, MICs policyholders position could decline below the minimum, and its risk-to-capital ratio increase above the maximum, levels necessary to meet state regulatory capital adequacy requirements, described below. If losses are higher or more accelerated than we currently estimate, and we do not raise capital or achieve offsetting capital relief, MIC will likely cease to satisfy capital adequacy requirements in 2011. Depending on the circumstances, the amount of additional capital we may need could be substantial.
MICs principal regulator is the Arizona Department of Insurance (the Department). Under applicable Arizona law, the Department may, but is not required to, order a mortgage insurer to cease transacting new business until it satisfies the minimum policyholders position requirement. In the first quarter of 2010, the Department granted MIC a waiver from its minimum policyholders position requirement. Following our April, 2010 capital raise, the Department withdrew the waiver due to MICs improved capital position. In January 2011, we submitted a request to the Department to again grant MIC a waiver. The Department recently advised us that it anticipates notifying us in writing that:
There can be no assurance that the Department will formally notify us in writing of the matters specified above, and any such notification may contain additional restrictions or limitations. If the Department were to determine that MICs liquidity, financial resources or, notwithstanding the above, a failure by MIC to maintain Arizonas minimum policyholders position warranted regulatory action, it could, among other actions, order MIC to suspend writing new business in all states.
Other states could require MIC to cease new business writings if we fail to maintain the particular states applicable capital adequacy requirement. Twelve states with minimum capital requirements permit an insurer to apply for a waiver, to be granted at the discretion of the state insurance regulator, should the insurer fail to meet the states capital adequacy requirement. In the first quarter of 2010, MIC was granted waivers in California, Illinois, and Missouri. The Illinois waiver expired on December 31, 2010. The waiver in California is still in effect, with no expiration date. The California Department of Insurance has the right to reevaluate its waiver and modify its position if circumstances change. The waiver in Missouri remains in effect until and unless MIC exceeds a 27 to 1 risk-to-capital ratio. If MICs capital position approaches regulatory thresholds in the additional states in which the insurance regulator has discretion to grant a waiver, we would submit waiver requests from insurance departments in those states to enable MIC to continue to write new business in those states. We cannot predict whether or under what circumstances insurance regulators might exercise discretion to permit MIC to continue to write new business. If we are successful in obtaining waivers, there is no assurance that any insurance department that has granted a waiver will not modify or revoke the waiver, or that it will renew a waiver when it expires. It is not clear what actions the insurance regulators in states that do not have capital adequacy requirements would take if MIC were to fail to meet capital adequacy requirements established by one or more states.
In the event that MIC is unable to continue to write new mortgage insurance in a limited number of states, we plan to write new mortgage insurance in those states through PMAC, a subsidiary of MIC. PMAC is currently licensed to write insurance in all states. Some of our customers may choose not to purchase mortgage insurance from us in any state unless we can offer mortgage insurance through the combined companies in all fifty states or if MIC were to exceed regulatory capital requirements. The GSEs approved the use of PMAC as a limited, direct issuer of mortgage guaranty insurance in certain states in which MIC is unable to continue to write new business. These approvals are subject to certain restrictions and expire on December 31, 2011. See Item 1A. Risk FactorsOur primary insurance subsidiary, MIC, is subject to capital adequacy requirements and could be required to cease writing new business and could be subject to the terms of its runoff support agreement with Allstate andOur plan to write certain new mortgage insurance in a subsidiary of MIC may not be successful and, even if it is implemented in some states, it may not allow us to continue to write mortgage insurance in other states.
Continued GSE Eligibility and Proposed GSE Eligibility Requirements. Lenders purchase mortgage insurance from us to reduce losses as a result of borrower default, to obtain capital relief and, most often, to facilitate the sale of their low down payment loans to Fannie Mae and Freddie Mac (collectively the GSEs). The GSEs purchase residential mortgages from lenders and investors as part of their mandate to provide liquidity in the secondary mortgage market. As a result of their purchases of low down payment mortgages, the GSEs are, and historically have been, PMIs largest customers.
The GSEs 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. Prior to the suspension of certain eligibility criteria in February 2008, the GSEs mandated that eligible mortgage insurers maintain at least two of the following three ratings: AA- by S&P or Fitch Ratings (Fitch), or Aa3 by Moodys. In response to ratings downgrades of MIC below AA-, the GSEs required us to submit remediation plans. Each GSE has required regular updates from MIC with respect to the remediation plans. To date, each GSE has continued to treat us as an eligible mortgage insurer, although there is no assurance that they will continue to do so. See Item 1A. Risk FactorsIf MICs counterparties negatively assess MICs financial strength, our new insurance writings and financial condition could be negatively impacted andThe exercise of certain rights reserved by the GSEs under eligibility requirements for mortgage insurers and the terms of the conditional approvals we have received relating to PMAC, could harm our profitability and reduce our operational flexibility.
In 2009, each of the GSEs circulated among all currently approved private mortgage insurers drafts of their respective revised eligibility requirements, to which we provided comments. The changes are principally focused on capital management and GSE review and consent of a wide array of operational, fiscal and product matters. In 2010, the GSEs circulated revised proposed eligibility requirements, to which we and other mortgage insurance companies provided additional comments. The fundamental concepts introduced in the GSEs 2009 drafts remained substantially the same in the subsequently released drafts. We expect that under the revised eligibility requirements, the GSEs will exercise increased oversight of eligible private mortgage insurers including placing limits on the types of mortgage loans upon which eligible mortgage insurers may place insurance coverage. Although the timing is uncertain, we expect that the GSEs will finalize their revised requirements in 2011.
Proposed GSE Reform. In September 2008, the U.S. Department of the Treasury (Treasury) placed the GSEs into conservatorship and appointed the Federal Housing Finance Agency (FHFA) as their conservator. In conservatorship, the GSEs could change their business practices with respect to the mortgage insurance industry or individual mortgage insurers, which could materially impact the quantity and level of mortgage insurance coverage required by the GSEs on residential mortgage loans or MICs status as an eligible mortgage insurer. Moreover, the GSEs business practices may be impacted by legislative or regulatory changes governing their operations. The U.S. Congress will likely examine the role and purpose of the GSEs in the U.S. housing market and propose structural and other changes to the GSEs in the future. The Dodd-Frank Act of 2010 required Treasury to conduct a study and develop recommendations to Congress regarding options for ending the conservatorship of the GSEs. Treasury published its proposals on February 11, 2011, which provide a broad outline for future proposed changes to the GSEs and the domestic housing finance system. Treasurys proposal includes a gradual (5 to 7 years) phase-out of the GSEs as participants in the mortgage finance industry. Federal legislation could reduce the level of private mortgage insurance coverage used by the GSEs as credit enhancement or eliminate the requirement altogether. See Item 1A. Risk FactorsIf the role of the GSEs in the U.S. housing market is changed, or if the GSEs change other policies or practices, the amount of insurance that PMI writes could further decrease, which could result in a decrease of our future revenue.
Dodd-Frank and Qualified Residential Mortgages. Among other things, the Dodd-Frank Act expands federal oversight of the insurance industry and consumer financial products and services, including mortgage loans. The Dodd-Frank Act requires mortgage lenders and securitizers to retain a portion of the risk on mortgage loans they sell or securitize, unless the mortgage loans are qualified residential mortgages or are insured by the FHA or another federal agency. Regulators are required to develop a definition of a qualified residential mortgage by April 15, 2011, and in doing so, the legislation requires regulators to consider the presence of mortgage insurance. We believe that the release of a draft rule will likely occur in the near future. The details of the regulation remain unknown. The proposed rule may positively or negatively affect the private mortgage insurance industry and our future insurance writings. See Item 1A. Risk FactorsImplementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) could negatively impact private mortgage insurers and PMI.
Counterparty Strength Concerns and Financial Strength Ratings. Our customers are more closely scrutinizing MICs counterparty strength. In December 2010, the Office of Thrift Supervision (OTS) released a memorandum underscoring the need for robust due diligence when savings associations select private mortgage insurance providers to insure residential mortgages. In its December memorandum, the OTS directs savings associations to establish and maintain prudent policies for identifying, selecting and monitoring private mortgage insurance providers. In a list of suggested policies and procedures, the OTS provides that regulated savings associations should perform a thorough upfront analysis, with ongoing monitoring and board review and approval, of each insurers viability, capital and reserves, and overall financial condition.
Independent rating agencies have assigned our insurance subsidiaries certain insurer financial strength ratings, which 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.
The insurer financial strength ratings of our insurance subsidiaries are set forth in the table below.
If our insurance subsidiaries are downgraded by one or more rating agencies, our business could be adversely affected. For a discussion of recent rating agency actions with respect to our holding companys ratings and subsidiaries insurer financial strength ratings, see Liquidity and Capital ResourcesRatings in MD&A.
Through PMI, we provide residential mortgage insurance products to mortgage lenders and investors throughout the United States. MIC 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, MIC may only offer mortgage insurance covering first lien, one-to-four family residential mortgages.
Residential mortgage insurance protects mortgage lenders and investors in the event of borrower default, by reducing and, in some instances, eliminating the resulting credit loss to the insured institution. By mitigating losses as a result of borrower default, residential mortgage insurance facilitates the origination of low down payment mortgages, generally mortgages to borrowers who make down payments of less than 20% of the value of the homes. Mortgage insurance also may reduce the capital that financial institutions are required to hold against insured loans and facilitates the sale of low down payment mortgage loans in the secondary mortgage market, primarily to the GSEs, or agency market. PMIs residential mortgage insurance products typically provide first loss protection on loans originated by residential mortgage lenders and sold to the GSEs and, to a lesser extent, on loans held by portfolio lenders. PMIs current product offerings are described 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 up to the maximum level of coverage.
Our core, primary mortgage insurance business is offered on a loan-by-loan basis to lenders through our flow channel. Prior to 2009, through its structured finance channel, PMI also offered and sold primary mortgage insurance products to non-agency mortgage-backed securities (MBS) issuers as credit enhancement covering portfolios of loans (non-agency market). PMIs primary insurance in force and primary risk-in-force at December 31, 2010 were $101.7 billion and $24.9 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 applicable policy. The chart below shows our U.S. primary new insurance written, or NIW, for the years ended December 31, 2010, 2009 and 2008. NIW refers to the original principal balance of all loans that receive new primary mortgage insurance coverage during a given period.
For a discussion of trends related to our new insurance writings, see Conditions and Trends Affecting our BusinessU.S. Mortgage Insurance OperationsNew Insurance Written (NIW), in MD&A.
In 2010, nearly all of our primary insurance written was on loans sold by lenders to the GSEs. 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; or (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.
Lenders that purchase mortgage insurance select specific coverage levels for insured loans. Lenders that intend to sell the loans they originate to the GSEs (or retain the option to do so) generally select a coverage percentage that conforms to the GSEs required coverage levels. 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%. The GSEs allow lenders to deliver loans with standard coverage, or, in exchange for lenders paying higher fees, lower charter minimum coverage levels. Historically, the large majority of loans are insured at standard coverage levels. If the relationship between the cost of mortgage insurance and the fees charged by the GSEs for various coverage levels changes, lenders may prefer to obtain charter minimum coverage levels on their loans. PMI charges higher premium rates for higher coverage, as higher coverage percentages generally result in higher amounts paid per claim. Depending on the loan, the premium payments for flow primary mortgage insurance coverage are typically borne by the insureds customer, the mortgage borrower (Borrower Paid MI), and less frequently, by the insured (Lender Paid MI). In either case, the payment of premiums to us is generally the responsibility of the insured. PMIs primary
insurance rates are based on rates that we have filed with the various state insurance departments. To establish these rates, we utilize pricing models that allow PMI to assess risk across a spectrum of variables, including coverage percentages, loan and property attributes, and borrower risk characteristics. We also offer Lender Paid MI products, which are priced and filed in the same manner as our standard Borrower Paid MI rates. Lender Paid MI represented 14.7%, 8.4% and 6.2% of flow NIW in 2010, 2009 and 2008, respectively.
Under the Treasurys Home Affordable Refinance Program (HARP), announced on March 4, 2009, certain borrowers whose loans are owned or guaranteed by the GSEs and have loan-to-value ratios that have risen as a result of declines in home prices, may refinance and take advantage of lower interest rates or a more stable loan product. HARP will remain in effect through June 2011. Under HARP, the GSEs do not require mortgage insurance as credit enhancement on refinances of mortgages that were originated at less than 80% LTV, but are now greater than 80% LTV. For loans that were originated with mortgage insurance, the original policies are generally expected to remain in place on the affected loans. In 2010, PMI approved 9,135 HARP requests and, of those, 7,762 were finalized, totaling approximately $1.7 billion in modified insurance in force.
Premium payments may be paid to us on a monthly, annual or single premium basis. Monthly payment plans represented 73.5%, 88.3% and 94.7% of NIW in 2010, 2009 and 2008, respectively. As of December 31, 2010, monthly plans represented 91.6% of our U.S. primary risk-in-force compared to 92.4% at December 31, 2009 and 92.8% at December 31, 2008. Single premium plans represented substantially all of the remaining NIW and primary risk-in-force. In 2010, we believe our customers selected single premium plans with greater frequency than in prior years primarily as a result of the premium rate structure and mortgage insurance transaction being more competitive with an FHA mortgage insurance transaction, where the borrower pays the mortgage insurance premium upfront and finances it into the mortgage loan. A portion of single premium plan payments may be refundable if the insured cancels coverage, which generally occurs when the loan is repaid, the loan amortizes to a sufficiently low amount to trigger a lender permitted or legally required cancellation or the value of the property has increased sufficiently.
Primary mortgage insurance premium rates are fixed when the insurance on the loan is initially issued. As a result, losses from increased claims on 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. However, the insured or the loans mortgage servicer generally may cancel mortgage insurance coverage issued through our flow channel 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 (based on the original value of the property) reaches 80%, upon satisfaction of conditions set forth in the statute.
PMI has offered primary mortgage insurance products through its structured finance channel, primarily to MBS issuers as credit enhancement covering portfolios of loans. While the terms varied, our structured finance products generally insured a group of pre-existing loans or loans that were to be originated in the future whose attributes were to conform to the terms of the negotiated agreement. A structured finance product can include primary insurance (first loss) and/or modified pool insurance (discussed below). Payment of premiums to us is generally the obligation of the insured. We did not offer structured finance products in 2010.
(b) Pool Insurance
Modified Pool Insurance. Prior to 2008, we offered modified pool insurance products, primarily to the GSEs for 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. The existence of stop-loss protection for PMIs modified pool exposure results in a maximum loss amount equal to PMIs modified pool risk-in-force. As of December 31, 2010, PMI had $0.3 billion of modified pool risk-in-force (net of loss reserves for delinquent modified pool risk which reduce PMIs risk layer upon accrual), representing 1.4% of PMIs total risk-in-force. Unless otherwise noted, primary insurance statistics in this report do not include pool insurance.
In 2009 and 2010, we restructured a significant portion of our modified pool exposure (including through commutations). When we restructure our modified pool contracts at a discount to the level of our associated recorded reserves, we realize a statutory capital benefit. In connection with the restructurings (including commutations) we completed in 2010, PMI paid the counterparties accelerated discounted claim payments of approximately $247.5 million (subject to certain adjustments) in the aggregate and eliminated $0.5 billion of risk-in force under the policies. The positive impact that these restructurings had on our loss reserves in 2010 resulted in an estimated aggregate capital benefit, on both a statutory and GAAP basis, to MIC of approximately $130 million as of the restructure dates, related to our restructuring of modified pool policies in 2010.
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, 2010, risk-in-force related to other pool insurance agreements was $257.9 million, representing 1.0% of PMIs total net risk-in-force.
(c) 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 MIC and CUNA Mutual Insurance Society (CMIS). CMIS is part of the CUNA Mutual Group, which provides insurance and financial services to credit unions and their members. Both MIC and CMIS provide services to CMG MI. CMG MI is a GSE-eligible mortgage insurer. As of December 31, 2010, CMG MI had $20.8 billion of primary insurance in force and $5.1 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 I 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, CMIS has the right on September 8, 2015, or earlier under certain limited conditions, to require MIC to sell, and MIC has the right to require CMIS to purchase, MICs interest in CMG MI for an amount equal to the then current fair market value of MICs interest. MIC and CMIS have also entered into a capital support agreement, which is subject to certain limitations, for the benefit of CMG MI. Under the capital support agreement, MIC and CMIS have an obligation, under specified conditions, to maintain CMG MIs risk-to-capital ratio at or below 23.0 to 1. CMG MIs risk-to-capital ratio as of December 31, 2010 was approximately 19.7 to 1. MICs capital support obligation is limited to an aggregate of $37.7 million.
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 Essent U.S. Holdings, Inc., a member of Essent Group Ltd, which commenced issuing mortgage insurance policies in 2010. Assured Guaranty Mortgage Insurance Company, a subsidiary of Assured Guaranty Ltd., is also licensed to offer mortgage insurance in the U.S.
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 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.
FHAs market share is higher as a result of private mortgage insurance companies adopting tighter underwriting guidelines limiting the types of loans they will insure and federal legislation enacted in 2008 designed to stabilize the mortgage markets by providing FHA with greater flexibility in establishing new products and temporarily increasing the maximum loan amount that FHA may insure, in some cases up to the GSE limits, including up to $729,750 in high-cost areas. FHA is also authorized to refinance distressed mortgages in return for lenders and investors agreeing to write-down the amount of the original mortgage. The 2008 legislation had the effect of broadening the scope of loans eligible for mortgage insurance from FHA.
On January 20, 2010, FHA announced a number of changes to its eligibility criteria and increased its premium rates. In the fourth quarter of 2010, FHA again increased its mortgage insurance premiums, which were effective for FHA insured loans originated on or after October 4, 2010. Private mortgage insurers market share has increased modestly over the course of 2010, in part, as a result of the changes FHA implemented in 2010. On February 11, 2011, Treasury released its proposals for reform of the U.S. housing market, including FHAs mortgage insurance program. Treasury stated that it proposes to strengthen FHA, while at the same time reducing the size of the FHA program. Treasury outlined certain steps designed to meet the objective of reducing the size of FHAs mortgage insurance program, including returning the FHA to its pre-crisis role as a targeted insurer for low- and moderate-income borrowers and first-time homebuyers; decreasing the maximum insured loan size; and increasing the price of FHA mortgage insurance. Consistent with Treasurys objective, on February 14, 2011, FHA announced that it is increasing its annual mortgage insurance premium by a quarter of a percentage point on all 30- and 15-year loans. The premium change will go into effect on new loans insured by FHA on or after April 18, 2011. Future changes to the FHA program may impact demand for private mortgage insurance. The future size of FHAs market share will also depend on whether Congress will lower the FHA maximum loan limit from its current level.
Private mortgage insurers ability to compete with FHA has been negatively impacted on certain loans by the GSEs risk-based pricing structures. The GSEs guaranty fees are typically comprised of two components: (i) a base fee, calculated as a percentage of the loans unpaid principal balance, which is remitted to the GSEs by the lender on a periodic schedule; and (ii) additive loan level pricing adjustments (LLPA), based on the risk characteristics of the particular loan and paid up-front by the lender at the time of the loan sale transaction. Under
the GSEs current pricing structure, LLPAs include a standard 0.25% Adverse Market Delivery Charge and may include additional fees based on the loan product type, the specific features of the loan or property and the borrower. Both GSEs recently announced LLPA increases on all loans with LTV ratios in excess of 70%, which will be effective for both GSEs in April 2011. LLPAs have increased lenders origination costs on certain conforming loans sold to the GSEs, which in turn results in higher borrowing costs on those loans. Lenders may sell certain FHA-insured mortgage loans through Ginnie Mae securitizations. Ginnie Mae charges a significantly lower guaranty fee than the GSEs. As a result, lenders and borrowers may continue to find it more advantageous to pursue a loan with FHA mortgage insurance, rather than pay higher costs in order to sell the loan to one of the GSEs (although other factors may influence the lenders loan sale decision). Any future increases to the GSEs LLPAs will negatively impact demand for private mortgage insurance. On March 1, 2011, Freddie Mac announced that, for mortgages closing on or after June 1, 2011, it will cease purchasing mortgages with LTVs exceeding 95%. Freddie Macs LTV limitation may have the effect of reducing the size of the private mortgage insurance market and could negatively impact our ability to compete with FHA and our ability to increase our new insurance writings.
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, which temporarily raised (until December 31, 2008) the GSE conforming loan limits for certain statutorily defined high cost areas to $729,750, and the American Recovery and Reinvestment Act of 2009 extended the 2008 GSE loan limits through 2009, which remained unchanged in 2010. In November 2010, the FHFA announced that the maximum conforming loan limits, including those for high cost areas, will remain the same as existing loan limits through September 2011. The increase to the GSE conforming loan limit could increase demand for mortgage insurance products. We and other private mortgage insurers also face competition in several states from state-supported mortgage insurance funds.
Our U.S. customers are primarily mortgage lenders, depository institutions, commercial banks and investors, including the GSEs. In 2010, PMIs top ten customers generated 51.0% of PMIs premiums earned compared to 59.7% in 2009. 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 primary beneficiaries of PMIs mortgage insurance coverage. In 2010, we received $92.9 million in premium revenues from Wells Fargo Bank, N.A., which exceeded 10% of our consolidated revenues.
We employ a sales force located throughout the U.S. to directly sell our mortgage insurance 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 certain performance objectives. PMIs product development and marketing department has primary responsibility for supporting our existing products and 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 on information available to PMI at the date of policy origination.
This layering of risk further increases the risk of borrower default.
The following table shows primary risk-in-force by FICO score:
Pool Risk-in-force. The following table shows components of PMIs net pool risk-in-force as of December 31 for the last five years.
The first table below 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. We did not write new pool insurance business in 2008, 2009 and 2010. The data presented are as of December 31, 2010.
Our maximum exposure is equal to our remaining modified pool risk-in-force, which is set out in the tables above. Our loss reserve balance for all modified pool loans decreased from $225.3 million as of December 31, 2009 to $109.0 million as of December 31, 2010. Additions to loss reserves on modified pool risk were significantly offset by the modified pool restructurings and commutations we completed in 2010. (See Section 7. Defaults and ClaimsPool Claims, below.) In 2010, PMI completed modified pool restructurings and commutations which resulted in PMI paying accelerated discounted claim payments of $247.5 million to the counterparty and the elimination of $0.5 billion of risk-in-force under the policies.
The following table shows the composition of the portion of PMIs modified pool portfolio that is not subject to deductibles based upon the effective date of coverage. We did not write any modified pool without deductibles risk after December 31, 2006. We do not expect losses on our modified pool without deductibles contracts to reach our maximum loss limits for all book years. However, we and our industry have experienced material losses, particularly on insurance written in 2005 and 2006, and the ultimate amount of loss on pool risk from such book years may depend on, among other things, the portfolio risk characteristics. Because modified pool stop loss limits operate across a pool of loans, we show the composition of PMIs modified pool portfolio (without deductibles) in the table below on an insurance-in-force (IIF) rather than risk-in-force basis.
Persistency; Policy Cancellations. A significant percentage of PMIs insurance-in-force is comprised of polices written in previous years, and our premiums earned are generated by the policies that remain in force over time. Consequently, the level of policy cancellations and resulting length of time that insurance remains in force are key determinants of PMIs revenue and net income. One measure of the impact of policy cancellations on insurance in force is our persistency rate, which is based on 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 MICs primary portfolio persistency rates from 2000 to 2010.
As shown above, until 2006, there was a close correlation between low or declining interest rate environments and lower persistency rates. Though interest rates declined between 2007 and 2010, refinance activity in our insured loan portfolio decreased, primarily as a result of nationwide home price depreciation coupled with reduced consumer access to credit, particularly for borrowers with low-down payment mortgage loans. As a result, even in a relatively low interest rate environment, PMIs primary persistency rate increased. Persistency declined slightly in 2010 but remained at an elevated level, due primarily to the continued effects of depressed home values and limited access to credit. To the extent that home prices experience low appreciation rates or decline from current levels, we expect that PMIs persistency rate will likely remain high and therefore limit the rate of policy cancellations.
Risk Management Approach. Our major credit-related risks include macroeconomic risk, regional/local economic and housing risk, customer risk and, generally stated, loan risk. We deploy multiple techniques to identify, monitor and manage these risks. These techniques include diversification of our insured loan portfolio, auditing and quality control efforts, pricing, credit policy, statistical analysis and financial management.
Macroeconomic risks reflect uncertainty posed by general economic conditions. PMIs Economics and Strategy Department monitors and forecasts key economic variables including gross-domestic product, employment, interest rates, mortgage and housing markets and demographic shifts. As a result of changes in our macroeconomic outlook, we may, among other things, revise premium rates on new business writings.
Regional and local housing markets have historically been the largest contributing factor to our losses. Accordingly, our economic department forecasts the movement of regional housing prices and business conditions as shown in the PMI Market Risk Indexsm. The PMI Market Risk Indexsm is a proprietary statistical model that predicts the probability of a decline in home prices at the end of two years in Metropolitan Statistical Areas, or MSAs, in the United States based on local, historical home price appreciation, changes in the local labor markets and local home affordability. We use the PMI Market Risk Index and other proprietary models to adjust our underwriting guidelines in certain markets with higher risk levels. PMI also has a Distressed Markets Policy, where loan-to-value ratios and loan products are limited on loans originated in designated markets primarily MSAs. These markets vary over time according to our expectations of the local housing and economic trends. PMI assesses MSAs on a regular basis.
Customer risk includes the quality and consistency of how mortgage lenders acquire borrowers business, how loans are documented or processed, and how the loans are underwritten and serviced. We review customer practices on an ongoing basis.
Loan-risk includes several dimensions, including mortgage type (e.g., fixed-rate mortgage or interest only), borrower characteristics (e.g., debt-to-income ratio or employment status), loan purpose (e.g., primary residence or second home, refinance or purchase) and property type (e.g., single-family home or condominium). We monitor these risks and risk concentrations in our portfolio using various statistical tools. Among these are the pmiAURAsm System, which is a proprietary risk scoring tool that assigns a unique risk score to each loan in PMIs portfolio corresponding to the relative likelihood of an insured loan going to claim based on demographic, geographic, economic, and loan specific characteristics. Over the past several years, PMI has declined to insure loans with LTVs above 97%, 2/28 Hybrid ARMs, investor loans, limited documentation loans, and interest only loans, and has restricted eligibility for cash out refinances and second homes. We utilize our loan level database in addition to proprietary and other statistical models to measure and predict loan performance based on historical prepayment and loss experience. We use our analysis 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.
As a result of PMIs models and processes, the eligibility changes we have implemented and the general changes in residential mortgage origination practices, we expect our business written in 2009 and 2010 to perform well and generate underwriting profits, although there can be no assurance that either will occur.
Underwriting Process. To obtain mortgage insurance from PMI, an individual loan must meet the eligibility criteria we establish for loan documentation type and other loan, borrower and property attributes. Lenders may submit loan file documents to PMI for underwriting review or, if they are deemed eligible by PMI, certain customers may bind the mortgage insurance following their own underwriting review. The latter process delegated underwritingrequires the lender to meet PMIs qualifications for the program. PMI reviews the customers skills, experience and resources to determine whether the customer may be approved by PMI for its delegated underwriting program. Approximately 82.7% of PMIs flow NIW is underwritten pursuant to our delegated underwriting program that allows approved lenders, subject to review and periodic quality-control audits, to determine whether loans meet program guidelines and are thus eligible for mortgage insurance.
In performing periodic underwriting reviews, PMI evaluates the general performance of the delegated customers insured loan portfolio, including, among other things, delinquency rates, early-payment default rates, and appraisal quality. PMI generally performs periodic quality control audits of a sampling of loans for concurrence with the delegated program rules and for data integrity. The latter audit is conducted because, at the time loans are insured by delegated customers, PMI receives loan data electronically and does not receive or review the original loan documentation. If PMI subsequently 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 delegated authority to extend coverage to new loans if it determines that the insured has not been complying with approved underwriting guidelines.
Contract Underwriting. In early 2009, we announced the discontinuation of contract underwriting services provided by our wholly-owned subsidiary, PMI Mortgage Services Co., or MSC. MSC performed contract underwriting services for PMI and CMG MI. As a part of its contract underwriting services, MSC provided to its customers monetary and other remedies, including loan indemnifications under certain circumstances, in the event that MSC failed to properly underwrite a mortgage loan. These remedies are separate from the insurance coverage provided by PMI. Contract underwriting remedies were $2.5 million in 2010 compared to $8.3 million and $4.8 million in 2009 and 2008, respectively. MSC may still be obligated to pay remedies in the future even though it has ceased providing contract underwriting services.
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 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 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 borrower has failed to pay two regularly scheduled payments. Depending upon its scheduled payment date, when a borrower fails to make two consecutive payments, the loan default could be reported to us between the 31st and 60th day after the first missed payment due date. 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. PMIs primary default inventories have decreased in 2010 as a result of lower levels of new notices of default, increased cures relative to prior years and a significant increase in the number of primary claims paid. While PMIs default inventory and default rates have been high in 2010, we believe that new delinquencies from our 2005, 2006 and 2007 primary book years have peaked.
Primary Default Rates by Region. Primary default rates differ from region to region in the United States. 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. Declining home prices and weak economic conditions, particularly in California and Florida, have negatively affected PMIs default rates in those states. 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 default and ultimate claims. Insured loans in PMIs portfolio may contain one, more than one or none of the loan characteristics identified in Section 5 above. The table below shows default rates for loans that contain certain of the characteristics identified by PMI as having heightened risk.
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, 2006 through December 31, 2010 represented 69.9% of PMIs primary insurance in force at December 31, 2010. The table below, which sets out default rates by book year, shows that PMI has experienced adverse and accelerated delinquency development in its 2005, 2006, 2007 and 2008 insured loan portfolios.
Loss Mitigation. PMIs Homeownership Preservation Initiatives department (HPI) was formed in 2007 to facilitate and enhance retention workouts on PMI-insured loans. Retention workouts include loan modifications and other loan repayment options discussed below, which may enable borrowers to cure mortgage defaults and retain ownership of their homes. HPI coordinates with loan servicers to provide them with delegated authority to approve workouts on certain categories of loans within specified parameters, places PMI loss mitigation staff on-site at loan servicers offices and trains servicer staff on loan workout strategies. HPI also supplements loan servicers outreach efforts to delinquent borrowers on PMI-insured loans to educate them about workout options and to facilitate loan workout discussions with their loan servicers. HPI provides these outreach efforts through the use of PMIs loss mitigation professionals and through the engagement of specialty vendors and non-profit housing counseling agencies. If a retention workout is not viable for a borrower, PMI attempts to mitigate loss on the loan through a liquidation workout option, including a pre-foreclosure sale or a deed-in-lieu of foreclosure.
Retention workouts are designed to assist borrowers in curing, or satisfying in full, their delinquent loans. The ability of borrowers to cure delinquent loans is influenced by borrowers financial resources, regional housing and economic conditions, such as unemployment rates and home prices, and in recent periods, the speed and efficiency with which loan servicers process delinquencies and engage in loss mitigation efforts. A retention workout is often preceded by a forbearance plan, which temporarily allows the suspension of all or part of a borrowers regularly scheduled payment for a specified time period to permit time to explore retention workouts. Retention workout options include refinances, loan modifications (HAMP and non-HAMP), and repayment plans. With a loan refinance, the borrower obtains a new loan and uses the proceeds to satisfy in full the existing loan. Modification of a PMI-insured loan is a process whereby any or some of the terms of a loan are modified with the approval of the insured lender and PMI. In a loan modification, the parties may agree to adjust the interest rate, extend the amortization period, and/or increase the amount of principal by the delinquent amount. In a small number of instances to date, an insured lender may also agree to modify a loan to decrease the amount of principal a borrower owes. Primarily because loan modifications often include any combination of modified terms, we do not separately track our modified risk-in-force with respect to the individual components of the loan modification. A loan repayment plan permits a delinquent borrower to satisfy its past-due loan amount by making additional payments along with regularly scheduled payments until the borrower becomes current on the loan. Because it results in a curing of the underlying default, when a retention workout is completed, we remove the loan from PMIs default inventory and cease to include it in our loss reserve estimates. While a loan is in forbearance, the underlying default remains and we continue to include the loan in PMIs default inventory.
A liquidation workout may be in the form of a pre-foreclosure sale (early disposal of the underlying property, usually in an amount less than what the borrower owes) or a deed-in-lieu of foreclosure (where the borrower conveys title of a property securing a loan to the lender in satisfaction of the debt), both of which avoid the lengthy and more costly foreclosure process. Both options can mitigate PMIs loss by reducing foreclosure and other costs, resulting in a lower claim size to PMI.
Rescission Activity. PMI routinely investigates early payment default loans (loans that default prior to the thirteenth payment), or EPDs, and also investigates certain other non-EPD loans, for misrepresentation, negligent underwriting and eligibility for coverage. Based upon PMIs investigations, industry data and other data, we believe that there were significantly higher levels of mortgage origination fraud and decreases in the quality of mortgage origination underwriting in 2006 and 2007 when compared to historical levels.
PMIs mortgage insurance policies, certain endorsements, and certain of its lender-paid mortgage insurance commitment agreements contain provisions giving PMI the right to unilaterally rescind coverage of an insured loan for breach of representations and warranties, material misrepresentation, negligent underwriting and/or ineligibility. PMI may also have rescission rights under general principles of contract law. Generally, PMI exercises its contractual rights following an investigation and upon establishing a reasonable belief that at loan origination there was a material misrepresentation by the originator or an agent of the originator, that the loan was negligently underwritten, or that the loan was not eligible for coverage under an approved loan program or set of underwriting guidelines. When PMI rescinds coverage, we notify the insured in writing, identify the bases for the rescission, summarize the evidence supporting the rescission decision and refund all premiums associated with the rescinded loan to the insured, whether or not the loan was delinquent. Our inventory of files under review peaked in 2010 and, as a result, rescission levels are generally declining relative to prior periods. For further discussion of rescission activity and challenges we have received to our rescission decisions, see MD&AConditions and Trends Affecting our BusinessU.S. Mortgage Insurance OperationsRescission Activity and Claim Denials.
When PMI rescinds coverage of a delinquent loan, we remove it from our delinquent loan inventory upon which we base loss reserves and from our calculation of PMIs risk-in-force and insurance in force. For a discussion of the impact of our rescission activity on our loss reserves, see MD&ACritical Accounting EstimatesReserves for Losses and LAEU.S. Mortgage Insurance OperationsRescission Activity and Loss Reserves.
Claim denials. In some cases, our servicing customers do not produce documents necessary to perfect the claim (documentation claim denials). This is often the result of the servicers inability to provide the loan origination file or other servicing records for our review. If the requested documents are not produced after repeated requests by PMI, the claim will be denied. If our servicing customers ultimately produce documents we had previously requested, PMI will review the file for potential claim payment. Beginning in 2010, claim denials also include claims denied or curtailed as a result of servicers failure to adhere to customary standards relating to the servicing of delinquent loans (servicer-related claim denials). We expect the number of servicer-related claim denials to significantly increase in 2011. For a discussion of the impact of claim denials on our loss reserves, see MD&ACritical Accounting EstimatesReserves for Losses and LAEU.S. Mortgage Insurance Operations- Claim denials and loss reserves.
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. As discussed above under Loss Mitigation, when the likelihood of a defaulted loan being reinstated through a retention workout is minimal, we work with the servicer to explore the possibility of a liquidation workout. Ultimately, whether an uncured default leads to a claim principally depends on the borrowers employment status, 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.
Generally, our master policies provide that within 60 days after an insured or servicer files a valid primary insurance claim and supporting documentation, we have the option of:
If we do not settle a valid claim within the 60-day claim settlement period, we must pay interest on the insurance benefit at the rate due under the loan from the last day of the 60-day claim settlement period until the claim is actually paid.
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, 2010, our carrying value, which approximates fair value, of REO properties was $0.3 million compared to $0.1 million at December 31, 2009 and $4.8 million at December 31, 2008.
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, including those described above, help to reduce overall claim severity. In 2010, we processed 4.9% of the paid primary insurance claims on the basis of a prearranged sale, compared to 6.9% and 10.9% in 2009 and 2008, respectively. In 2008 to 2010, we exercised the option to acquire the property on less than 0.3% of the primary claims processed for payment.
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 2008 (shown in the table below) reflects the deterioration of the mortgage, housing, labor and credit markets. 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 2007 through 2010. In 2010, severity improved in almost every region, with a slight increase in the South Central region. The general decline in severity in 2010 was driven primarily by the increase in claims denials, which are settled as claims with a zero dollar payment.
The table below sets out by channel primary claims paid (which does not include changes in loss reserves):
The following table sets forth, for each of the years 2008, 2009 and 2010, the dispersion of PMIs losses and loss adjustment expenses (LAE) by book year. PMIs losses and LAE includes net changes in the period to loss reserves on PMIs delinquent loan inventories. Losses and LAE also includes expenses related to default, loss mitigation and claim processing.
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 decreased from $618.5 million in 2009 to $243.7 million in 2010. In 2010, claims paid included amounts we paid in connection with restructurings and commutations of certain modified pool policies, which resulted in the acceleration of claims paid at a discount of the reserves established on such modified pool policies of approximately $248 million (subject to certain adjustments) and the release of loss reserves.
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.
A period of time may elapse between the occurrence of the borrowers default on mortgage payments (the event triggering a potential future claim 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 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. We also consider the effect of projected future rescission, claim denial and loan modification activity with respect to the current inventory of delinquent loans, which has materially reduced our loss reserve estimates. 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. MD&ACritical Accounting EstimatesReserves for Losses and LAE. For a reconciliation of the beginning and ending reserve for losses and loss adjustment expenses on a consolidated basis, see Item 8. Financial Statements and Supplementary DataNote 8. Reserve for Losses and Loss Adjustment Expenses (LAE).
The table below shows PMIs total risk-in-force and loss reserves as of December 31, 2010, 2009 and 2008.
Our loss reserve balance was lower as of December 31, 2010 compared to December 31, 2009 primarily as a result of high levels of claim payments in 2010. The reduction in loss reserves in 2010 was partially offset by additional loss reserves as a result of re-estimations of loss rates on prior years incurred losses.
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.
As the above table shows, 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 2010. 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.
The above table also shows that the cumulative loss ratios for all policy years through 1999 did not change by a material amount from the end of 2008, which indicates that these ratios have stabilized and reached their ultimate development for each of these policy years. The 2002 and 2003 book years are developing favorably compared to 2000 and 2001 due to a lower level of claims and higher persistency. 2004 has a higher cumulative loss ratio development than 2003, due to higher claims development and comparable persistency.
Book years 2005 through 2007 are developing under sustained negative economic conditions. These years high loss ratios are primarily due to higher delinquencies, claim rates and claim severity associated with the ongoing weakness in the residential mortgage and housing markets, as well as loan products that have experienced higher levels of losses. In particular, the cumulative loss ratio from book year 2007 reflects significant exposure to insurance written on Alt-A loans as well as loans with higher LTVs with greater exposure to home price declines. We do not expect business written in the 2005-2007 book years to be profitable.
The 2008 book year experienced a cumulative loss ratio of 28.9% in its third year. The loss ratio for 2008, while elevated, is lower than 2006 and 2007, reflecting the gradual transition in credit quality of our new insurance business during the year, as a result of our adoption of tighter underwriting guidelines and customer management strategies. Negative performance of business written in the first half of 2008 has offset the better performance of the higher quality business we wrote in the latter half of the year. The 2009 and 2010 book years are in their early stages of development and have significantly lower early default activity than prior book years. As a result of their improved credit quality, we expect these book years to perform favorably.
We support certain nonprofit organizations whose stated goals are to foster sustainable homeownership. Fostering sustainable homeownership includes preparing families for their ownership responsibilities and helping them meet that obligation. In line with these two goals, we support community-based organizations that offer homebuyer education programs and, through our HPI department, endeavor to facilitate loan servicers efforts to keep families in their homes. PMI is committed to creating sustainable homeownership opportunities by sponsoring organizations with national reach that provide counseling related services. We also work with various nonprofit counseling agencies to assist in their efforts to reach borrowers who are in financial distress.
Reinsurance does not discharge PMI, as the primary insurer, from liability to a policyholder. The reinsurance company indemnifies PMI for the reinsurance companys share of losses incurred under specific insurance policies, unlike an assumption and novation agreement, where the assuming companys liability to the policyholder is substituted for that of PMI. PMIs reinsurance arrangements include captive reinsurance, both excess-of-loss (XOL) and quota-share and other reinsurance structures, as well as reinsurance agreements with affiliates to comply with state statutory requirements.
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, PMI cedes premiums pursuant to its captive reinsurance arrangements in exchange for the reinsurance of a portion of the PMIs risk 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 PMIs benefit to secure the payment of potential future claims. Captive reinsurers must comply with applicable insurance regulations and must adhere to minimum capital requirements, which consider only eligible assets held in trust specifically for our benefit. If, at the end of 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. If a captive reinsurer does not meet its capital deposit obligations, the agreement will either be placed into run-off or commuted according to its express terms or by mutual agreement of the parties, in which case PMI would reassume the ceded risk and recover all trust assets.
Dividends from the trust accounts are only permissible once specified capital ratios are exceeded and then, only to the extent of such excess. For example, with respect to XOL arrangements, only amounts held in the trust that exceed 20% of the ceded risk may be dividended to the captive. In addition to adherence to dividend capital ratios, some captive reinsurance agreements prohibit 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, 2010, assets in captive trust accounts held for the benefit of PMI totaled approximately $724.3 million. Because premium cessions are decreasing and paid claims ceded to captives are increasing, we expect that the aggregate amount of assets held for the benefit of PMI in captive trust accounts will decrease in 2011.
Most of PMIs captive reinsurance agreements are XOL arrangements, under 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. In the first quarter of 2008, the GSEs eligibility requirements for approved mortgage insurers were 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. As of that date, we amended existing agreements that ceded greater than 25% to cede no more than 25% or, in some cases, such agreements were cancelled and placed into runoff. In 2009, PMI placed all remaining XOL agreements into run-off and no longer cedes premiums to such captives. PMI continues, however, to cede premiums to the captives with respect to risk-in-force written prior to run-off. Captive cessions, therefore, will decrease over time as the number of loans in PMIs portfolio subject to captives decreases. PMI did not enter into any new captive reinsurance agreements in 2010.
Captive reinsurance agreements mitigate catastrophic 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 associated with 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. Claim payments from captive trusts were $748.1 million in 2010 compared to $213.2 million in 2009.
Reinsurance with Affiliates
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% (deep coverage) 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 MIC. These deep cede reinsurance agreements with PRC, PMG and RIC replaced reciprocal deep cede reinsurance agreements that MIC had with certain non-affiliate mortgage insurance companies, which have now largely run off. Prior to 2008, Residential Guaranty Co. (now known as PMI Insurance Co., or PIC) also provided such reinsurance to MIC. MIC uses reinsurance provided by its reinsurance affiliates primarily 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.
In 2009, MIC entered into three XOL reinsurance agreements with three affiliated reinsurance companies. Taken together, the agreements provide MIC with a layer of risk remote reinsurance of its 2007 non-delinquent risk-in-force as of September 30, 2009, subject to potential adjustment each quarter based on the relevant affiliates risk-to-capital ratio. By entering into these agreements, MICs excess minimum policyholders position increased as of the effective date of the agreements.
General. Our U.S. mortgage insurance subsidiaries are subject to comprehensive, detailed regulation by the insurance departments of the 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 the most significant aspects of the insurance business. In light of current negative economic conditions and the impacts on our financial condition and results of operations, we expect greater scrutiny from state insurance regulators certain of whom have increased their reporting requirements.
Mortgage insurers are required under various state insurance laws and regulations to transact 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 MIC, PIC, PMAC, PMG, PRC, and/or RIC and any of their affiliates, such as PMI Europe and PMI Canada, are subject to prior approval of the Arizona Director of Insurance, and may be disapproved 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 those states. The insurance holding company laws and regulations are substantially similar in Wisconsin (where CMG MI is 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.
Risk-to-Capital and Minimum Policyholders Position. As discussed above in Item 1(C). BusinessCertain Regulatory and Other Issues Facing PMI, in sixteen states, if a mortgage insurer does not meet a required minimum policyholders position or exceeds a maximum permitted risk-to-capital ratio of 25 to 1 it may be prohibited from writing new business. In certain of those states, the applicable regulations require a mortgage insurer to cease writing new business immediately if and so long as it fails to meet the applicable capital adequacy requirements. In other states, the applicable regulator has discretion as to whether the mortgage insurer may continue writing new business. Thirty-four states do not have specific capital adequacy requirements for mortgage insurers. As of December 31, 2010, MICs risk-to-capital ratio was 19.9 to 1 and its excess minimum policyholders position was $184.3 million. See Item 1A. Risk FactorsOur primary insurance subsidiary, MIC is subject to various capital adequacy requirements and could be required to cease writing new business and could be subject to the terms of its runoff support agreement with Allstate.
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 are 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, 2010, MIC released $261.4 million of contingency reserves into surplus attributable to losses in excess of 35% of earned premiums. PIC released $31.2 million of contingency reserves into surplus for excess of 35% losses. At December 31, 2010, PMI had statutory policyholders surplus of $790.2 million and statutory contingency reserves of $34.0 million.
Dividends. MIC did not pay shareholder dividends to The PMI Group in 2010 and we do not expect that MIC will pay dividends to The PMI Group in 2011. 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. The laws of Arizona, MICs state of domicile for insurance regulatory purposes, provide that MIC may pay dividends out of any available surplus account, without prior approval of the Director of the Arizona Department of Insurance (Arizona Director), during any 12-month period in an amount not to exceed the lesser of 10% of policyholders surplus as of the preceding year end or the prior 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. See Item 7. MD&ALiquidity and Capital ResourcesThe PMI Group LiquidityDividends to The PMI Group.
Other states may also limit or restrict MICs ability to pay shareholder dividends. For example, California and New York prohibit mortgage insurers from declaring dividends except from the surplus of undivided profits over the aggregate of their paid-in capital, paid-in surplus and contingency reserves. Insurance regulatory authorities have broad discretion to limit the payment of dividends by insurance companies. MICs ability to pay dividends is also subject to restriction under the terms of a runoff support agreement with Allstate Insurance Company (Allstate). MICs ability to pay dividends is also limited by the terms of our agreements with the GSEs relating to PMAC. Under the agreements, MIC may not, without the GSEs prior written consent, pay dividends or make distributions or payments of indebtedness outside the ordinary course of business or in excess of specified levels. Notwithstanding these restrictions, our agreements with Fannie Mae and Freddie Mac permit MIC to make dividend, interest and principal payments in connection with the issuance of certain new debt or equity instruments up to specified levels.
Premium Rates and Policy Forms. Our insurance subsidiaries 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 and forms must be filed prior to their use. In some U.S. jurisdictions, these rates and forms must be approved by the state regulator prior to use.
Reinsurance. Regulation of reinsurance varies by state. With the 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 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. Under the Dodd-Frank Act, if the state of domicile of a ceding insurer is accredited by the National Association of Insurance Commissioners (NAIC), and recognizes credit for reinsurance for the insurers ceded risk, then no other state may deny such credit for reinsurance. In addition, the Act prohibits states from applying their laws to reinsurance agreements of ceding insurers not domiciled in their state. These Dodd-Frank provisions take effect July 21, 2011.
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 Department of Insurance (the Department) periodically conducts a financial examination of insurance companies domiciled in Arizona. In 2008 and 2009, the Department conducted its regularly scheduled financial examination of MIC, PMG, PRC, PIC and RIC for the five year period between January 1, 2003 and December 31, 2007 and filed its report on June 29, 2009. The Department recently gave us notice that it intends to conduct a financial examination of MIC, PMG, PMAC, PIC, PRC and RIC for the three year period between January 1, 2008 and December 31, 2010. The Department has advised us that the financial examination is an important factor in its continuing financial oversight and evaluation of MICs financial condition. The Wisconsin Office of the Commissioner of Insurance examined CMG MI, CLIC (now PMAC) and WMAC in 2008 for the five year period ended December 31, 2008 and issued its final examination report in 2009. 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 NAIC. Thus, while states have the authority to examine all licensed insurers, in practice, insurance supervisors for the most part defer to the financial examination reports issued by the domiciliary supervisor. The final financial examination reports are public records and may be obtained from the applicable states department of insurance.
On July 12, 2010, the California Department of Insurance (the California Department) issued a market conduct examination report of MIC indicating no unresolved or substantial allegations of error. On October 8, 2010, the California Department issued its final reports following its market conduct examination of CMG MI in 2010, indicating no allegations of error. The Nevada Division of Insurance initiated a premium tax and market conduct examination of MIC on May 19, 2010. This examination is ongoing. In 2006, the Minnesota Department of Commerce (MN DOC) initiated an examination of the use of captive reinsurers in the mortgage insurance industry. The U.S. Department of Housing and Urban Development (HUD) has made inquiries related to this MN DOC examination. This examination is ongoing. No allegations of wrongdoing have been issued by MN DOC or HUD.
National Association of Insurance Commissioners. The 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. State insurance regulators apply NAIC IRIS financial ratios to MIC and its insurer affiliates on a continuing basis in order to monitor their financial condition. The NAICs Financial Analysis Working Group has been facilitating the exchange of information among regulators of mortgage guaranty insurers.
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. Changes in federal housing legislation and other laws and regulations that affect the demand for private mortgage insurance, such as the recently enacted Dodd-Frank Act, could affect PMI. As noted in Item 1(D)(2). BusinessU.S. Mortgage Insurance OperationsCompetition U.S. and State Government Agencies above, the FHA has substantially increased its market share of the U.S. primary mortgage insurance business, in part due to federal legislation temporarily increasing the maximum loan amount that the FHA may insure, in some cases up to the GSE limits, including up to $729,750 in high-cost areas. Further legislation that increases the number of persons eligible for FHA or VA insured mortgages could have a material adverse effect on our ability to compete with the FHA or VA.
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. MICs continued status as an eligible mortgage insurer and the GSEs 2009 and 2010 proposed revised eligibility requirements are discussed in BusinessCertain Regulatory and Other Issues Facing PMIContinued GSE Eligibility and Proposed GSE Eligibility Requirements, above. On February 11, 2011, Treasury published proposals regarding the future structure and role of the GSEs in the housing markets. New federal legislation and regulations, including rules promulgated under the Dodd-Frank Act, or Treasury programs such as those discussed below could reduce the level of private mortgage insurance coverage used by the GSEs as credit enhancement or eliminate the requirement altogether, and thereby materially affect our ability to compete, and impact the demand for our products and the profitability of our mortgage insurance business. See Item 1A. Risk FactorsIf the role of the GSEs in the U.S. housing market is changed, or if the GSEs change other policies or practices, the amount of insurance that PMI writes could further decrease, which could result in a decrease of our future revenue. In addition, in connection with the approval by Fannie Mae and Freddie Mac of the use of PMAC as a direct issuer of mortgage guaranty insurance, MIC and PMAC are restricted from taking a variety of actions.
Dodd-Frank Act. Under the Dodd-Frank Act, regulators are required to issue a rule defining a qualified residential mortgage, and depending on the outcome of the definition and whether and to what extent mortgage insurance is included, the final rule may positively or negatively affect the private mortgage insurance industry. See Item 1(C). BusinessCertain Regulatory and Other Issues Facing PMIDodd-Frank and Qualified Residential Mortgages. In addition, the Dodd-Frank Act established the Bureau of Consumer Financial Protection to regulate the offering and provision of consumer financial products or services under federal law. It is uncertain whether the new agency will promulgate rules or regulations that may affect our business. See Item 1A. Risk FactorsImplementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) could negatively impact private mortgage insurers and PMI.
Homeowner Affordability and Stability Plan (the Plan). On February 18, 2009, President Obama announced his administrations Plan, which was designed to keep certain borrowers in their homes and reduce the rate of foreclosures. In 2009, the Treasury began implementing two programs under the Plan: HARP and HAMP. The refinance and modification programs are designed to keep homeownership affordable for borrowers who remain current on their mortgages but whose LTVs have risen because of declining home values and to aid
struggling borrowers with high mortgage debt to income ratios. The Plan also includes a component requiring participating lenders to adhere to the Treasurys uniform modification guidelines. Under the Plan, the Treasury increased its funding commitment to the GSEs to ensure strength and liquidity in the mortgage markets as well as to keep mortgage rates affordable. In 2010, PMI approved 9,135 HARP modification requests and, of those, 7,762 were finalized, totaling approximately $1.7 billion in modified insurance in force. As of December 31, 2010, 7,434 delinquent loans in our default inventory were subject to HAMP trial periods compared to approximately 23,180 loans at December 31, 2009. HAMP is expected to expire in June of 2012.
American Recovery and Reinvestment Act of 2009 (the Act). The Act, signed by President Obama on February 17, 2009, was designed to stimulate the economy through a combination of tax breaks, infrastructure investment and program enhancement. The components of the Act related to housing: (1) increased the first time homebuyer tax credit and extended the credit through December 2009 (which was further extended through April 30, 2010 by the enactment of The Worker, Homeownership, and Business Assistance Act of 2009); (2) extended the 2008 GSE loan limits (up to $729,750 in high cost areas) through 2009 (which have been further extended through September 2011); and (3) increased funding to states to rehabilitate and dispose of foreclosed homes.
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 certain 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, voluntarily agreed 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 of 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 subjects 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.
Our International Operations segment includes the results of PMI Europe and PMI Canada and our former subsidiaries, PMI Australia and PMI Asia, which are reported as discontinued operations for all periods presented. Prior to 2010, we ceased writing new business in Europe and Canada. Revenues from PMI Europe were $19.3 million and 3.0% of our consolidated revenues in 2010 compared to $45.1 million and 5.1% of our consolidated revenues in 2009. Premium revenues from PMI Canada in 2009 and 2010 were negligible. See Item 7. MD&AInternational Operations, and Item 8. Financial Statements and Supplementary DataNote 18. Business Segments, for additional information about geographic areas. Excluding revenue from the discontinued operations of PMI Australia and PMI Asia, our International Operations segment generated 3.1% of our consolidated revenues in 2010 compared to 5.1% in 2009, and we expect revenue from our International Operations to continue to be minimal in 2011.
PMI Europe is a mortgage insurance and credit enhancement company incorporated and located in Dublin, Ireland. PMI Europe is authorized to provide credit, suretyship and miscellaneous financial loss insurance by the Central Bank of Ireland (CBI), Irelands Financial Regulator. In 2008, PMI Europe stopped assuming new risk and reduced staff and facilities. At December 31, 2010, the total assets of PMI Europe were $168.0 million compared to $183.3 million at December 31, 2009.
PMI Europes insured portfolio consists of capital markets products, reinsurance and primary insurance, all of which are related to credit default risk on residential mortgage loans. As of December 31, 2010, PMI Europes risk-in-force with respect to these products was $0.7 billion. The table below shows PMI Europes risk-in-force by country, as of December 31, 2010 and December 31, 2009.
The table below summarizes PMI Europes credit enhancement portfolio by transaction type.
The reduction in PMI Europes risk-in-force was due to commutations and maturities of credit default swap (CDS) and other insured transactions.
Capital Markets Products. PMI Europes capital markets products were designed to support secondary market transactions, notably credit-linked notes or synthetic securities transactions (principally, CDS transactions). As of December 31, 2010 approximately 3% of PMI Europes risk-in-force was derived from three capital markets transactions where PMI Europe assumed a sub-investment grade or an unrated risk position. PMI may incur losses on its CDS exposures if losses on the underlying mortgage loans reach PMIs risk layer. Losses on underlying mortgages may only occur following a credit event, which is typically defined as borrower default or bankruptcy, and only if recoveries (typically foreclosure proceeds) are less than the total outstanding mortgage balances and foreclosure expenses, and, in the case of some transactions, accrued interest. In 2010, four of PMI Europes CDS transactions were called pursuant to contractual call dates, decreasing PMI Europes risk-in-force by approximately $4.0 billion.
Certain of PMI Europes CDS contracts contain collateral support provisions which, upon certain defined circumstances, including deterioration of the underlying mortgage loan performance, require PMI Europe to post collateral for the benefit of the counterparty. The methodology for determining the amount of the required posted collateral varies and can include mark-to-market valuations, contractual formulae (principally related to expected loss performance) and/or negotiated amounts. PMI Europe has posted collateral, consisting of corporate securities and cash, of $12.1 million as of December 31, 2010 on these CDS transactions. See Item 1A. Risk FactorsWe are exposed to risk in the winding down of our European operations and MD&ALiquidity and Capital ResourcesOff-Balance Sheet Arrangements.
Reinsurance. Approximately 16% of PMI Europes risk-in-force relates to six reinsurance transactions. PMI Europes reinsurance transactions relate to securities backed by U.S. credit impaired mortgages, and PMI
Europe holds second loss positions behind over-collateralization, excess spread mechanisms and other forms of credit enhancement. In five of the 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. PMI Europe established loss reserves of $16.4 million as of December 31, 2010 in respect of its reinsurance portfolio, which includes reinsurance of FGIC transactions. FGICs financial condition is severely impaired, and its primary regulator, the New York State Insurance Department, has issued an order requiring it to suspend paying any and all claims. As PMI Europe is contractually entitled to reinsurance premiums, as well as certain recoveries and reimbursements, from FGIC under the reinsurance transactions, there is a risk that PMI Europe may incur higher costs on the FGIC reinsurance transactions than it would have if FGIC was not impaired. For FGIC reinsurance transactions, PMI Europe has posted collateral related to the amount of loss reserves ceded by FGIC to PMI Europe. As of December 31, 2010, the posted collateral balance was $2.5 million. PMI Europe is currently engaged in negotiations with FGIC regarding the appropriate amounts of collateral required to be posted by PMI Europe under the terms of the applicable reinsurance transactions. PMI Europe may be required to post additional collateral on these reinsurance transactions. See Item 1A. Risk FactorsWe are exposed to risk in the winding down of our European operations.
Primary Insurance. As of December 31, 2010, approximately 81% of PMI Europes risk-in-force consisted of primary insurance written in Italy, Germany and the U.K. PMI Europes primary insurance is structured similarly to the primary mortgage insurance products written in the U.S. 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 SunAlliance in the fourth quarter of 2003. However, as this portfolio is seasoned, losses being generated from the remaining risk are de minimus. 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. 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.
PMI Europes reserves for losses and LAE are shown below for the years 2008 through 2010.
The reduction of PMI Europes total loss reserves during 2010 was primarily the result of claims paid during 2010 and payments made in connection with certain early contract terminations. For discussion on PMI Europes loss reserves, refer to Item 7. MD&ACritical Accounting EstimatesReserves for Losses and LAEInternational Operations.
PMI Europes loss reserves shown above do not include two CDS transactions which are considered derivatives and marked to market through earnings under the requirements of FASB ASC Topic 815 Derivatives and Hedging (Topic 815). As of December 31, 2010, the fair value of derivative liabilities was $5.4 million. The fair value of these CDS liabilities includes payment obligations that have been incurred but unpaid as of the balance sheet date. Our CDS exposures are dependent on the performance of certain prime residential mortgage loans originated throughout Europe, which are the reference assets for the underlying mortgage-related securities.
We do not currently expect that the fair value portion of the CDS liability related to fluctuations in market spreads and our cost of capital will result in additional cash outflows. However, higher than expected defaults, higher loss severities or the acceleration in the timing of claim payments would likely result in an increase in PMIs expected discounted future net cash outflows and fair value liability, which could impact our results of operations.
The applicable regulator of PMI Europe is CBI. 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 CBI. CBI 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 CBI regulations, insurance companies must maintain a margin of solvency, the calculation of which is based on recent years premium volumes or claims experience, and which supplements technical loss and premium reserve requirements. PMI Europes substantial reduction in risk-in-force in 2010 generated a capital surplus above the current required minimum margin of solvency. As a result, PMI Europe may return a portion of its capital to MIC, subject to approval by CBI. There is no assurance that CBI will approve returns of capital to MIC in the amounts proposed by PMI Europe, a lesser amount or any amount at all. Our current calculations of MICs risk-to-capital ratio and excess minimum policyholders position include MICs ownership of PMI Europe.
In 2007, we began offering residential mortgage insurance products to Canadian lenders and mortgage originators through PMI Canada. PMI Canada did not provide any mortgage insurance coverage in 2007, wrote a limited amount of insurance in 2008 and wrote no insurance thereafter. In 2010, we continued the process of closing PMI Canada. To fully close our operations in Canada, we must remove PMI Canadas risk-in-force and obtain regulatory approvals.
Discontinued Operations in PMI Australia and PMI Asia
On October 22, 2008, we sold PMI Australia for an aggregate purchase price of approximately $920 million. In connection with the sale, MIC received approximately $746 million in cash and a note receivable (the QBE Note) in the principal amount of approximately $187 million, with interest accruing through September 2011 when it matures and is payable. The actual amount owed under the QBE Note is subject to reduction to the extent that the sum of (i) claims paid between June 30, 2008 and June 30, 2011, with respect to PMI Australias policies in force at June 30, 2008, (ii) increases in reserves with respect to such policies at June 30, 2011 as compared to June 30, 2008 and (iii) projected ultimate unpaid losses in excess of such reserves as of June 30, 2011 (together, the ultimate projected losses) exceeds $237.6 million (50% of the unearned premium reserve of such policies at June 30, 2008). See Item 1A. Risk FactorsIf the value of the contingent note we received in connection with our sale of PMI Australia is reduced, our financial condition could suffer.
In connection with the sale of PMI Australia, MIC funded premiums of approximately $46.5 million to procure an excess-of-loss reinsurance cover for PMI Australia. The agreement provides for potential reinsurance profit-sharing for one-half of the reinsurance premiums (equivalent to $25 million) at the end of the three-year policy life (September 2011), provided that PMI Australias losses do not exceed a certain loss amount specified in the PMI Australia sale agreement. PMI Australia is recorded as discontinued operations in the international segment for all periods.
On December 17, 2008, we sold PMI Asia for a cash purchase price of approximately $51.6 million, which is 92.5% of PMI Asias net tangible asset value under U.S. GAAP as of June 30, 2008, plus a pre-completion adjustment of $0.1 million. PMI Asia is recorded as discontinued operations in the international segment for all periods presented.
Foreign Currency Exchange
We are subject to foreign currency exposure due to operations in Europe and Canada, whose currencies fluctuate relative to the U.S. dollarthe basis of our consolidated financial reporting. Such exposure falls into two general categories: economic exposure and transaction exposure.