UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
---------------------
FORM 10-Q
[X] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934 For the quarterly period ended June 30, 2004
or
[ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934 For the transition period from ______ to _____
Commission File Number 0-22342
---------------
TRIAD GUARANTY INC.
(Exact name of registrant as specified in its charter)
DELAWARE 56-1838519
(State of Incorporation) (I.R.S. Employer Identification
Number)
101 SOUTH STRATFORD ROAD
WINSTON-SALEM, NORTH CAROLINA 27104
(Address of principal executive offices)
(336) 723-1282
(Registrant's telephone number, including area code)
------------------------------
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 is an accelerated filer (as
described in Exchange Act Rule 12b-2) Yes /X/ No / /
Number of shares of Common Stock, $.01 par value, outstanding as of July 15,
2004: 14,546,669 shares.
================================================================================
TRIAD GUARANTY INC.
INDEX
Page
Number
Part I. Financial Information:
Item 1. Financial Statements:
Consolidated Balance Sheets as of June 30, 2004 (Unaudited)
and December 31, 2003......................................... 1
Consolidated Statements of Income for the Three and Six Months
Ended June 30, 2004 and 2003 (Unaudited)...................... 2
Consolidated Statements of Cash Flows for the Six Months
Ended June 30, 2004 and 2003 (Unaudited)...................... 3
Notes to Consolidated Financial Statements........................ 4
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations..................................... 8
Item 3. Quantitative and Qualitative Disclosures about Market Risk..... 28
Item 4. Controls and Procedures........................................ 28
Part II. Other Information:
Item 1. Legal Proceedings.............................................. 29
Item 2. Changes in Securities and Use of Proceeds...................... 29
Item 3. Defaults Upon Senior Securities................................ 29
Item 4. Submission of Matters to a Vote of Security Holders............ 29
Item 5. Other Information.............................................. 29
Item 6. Exhibits and Reports on Form 8-K............................... 29
Signature............................................................ 30
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
TRIAD GUARANTY INC.
CONSOLIDATED BALANCE SHEETS
June 30 December 31
(Dollars in thousands except per share information) 2004 2003
----------- ---------
Assets (Unaudited)
Invested assets:
Fixed maturities, available-for-sale, at fair value $409,053 $375,097
Equity securities, available-for-sale, at fair value 11,865 12,771
Short-term investments 11,323 25,659
-------- --------
432,241 413,527
Cash 5,951 973
Real estate 145 146
Accrued investment income 5,195 4,575
Deferred policy acquisition costs 31,553 29,363
Prepaid federal income taxes 107,208 98,124
Property and equipment 9,796 9,369
Reinsurance recoverable 1,431 881
Other assets 14,594 18,621
-------- --------
Total assets $608,114 $575,579
======== ========
Liabilities and stockholders' equity
Liabilities:
Losses and loss adjustment expenses $ 30,766 $ 27,186
Unearned premiums 14,231 15,629
Amounts payable to reinsurer 4,113 3,243
Current taxes payable 1,058 6
Deferred income taxes 121,083 115,459
Unearned ceding commission 431 669
Long-term debt 34,490 34,486
Accrued interest on debt 1,275 1,275
Accrued expenses and other liabilities 6,412 7,696
-------- --------
Total liabilities 213,859 205,649
Commitments and contingent liabilities - Note 4
Stockholders'equity:
Preferred stock, par value $.01 per share --- authorized
1,000,000 shares; no shares issued and outstanding --- ---
Common stock, par value $.01 per share --- authorized
32,000,000 shares; issued and outstanding 14,545,669 shares
at June 30, 2004 and 14,438,637 shares at December 31, 2003 145 144
Additional paid-in capital 91,773 87,513
Accumulated other comprehensive income, net of income tax
liability of $2,074 at June 30, 2004 and $6,025 at
December 31, 2003 3,851 11,190
Deferred compensation (2,145) (1,128)
Retained earnings 300,631 272,211
-------- --------
Total stockholders' equity 394,255 369,930
-------- --------
Total liabilities and stockholders' equity $608,114 $575,579
======== ========
See accompanying notes.
1
TRIAD GUARANTY INC.
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
Three Months Ended Six Months Ended
June 30 June 30
--------------------------- ---------------------------
2004 2003 2004 2003
---- ---- ---- ----
(Dollars in thousands except per share information)
Revenue:
Premiums written:
Direct $ 43,029 $ 37,878 $ 83,345 $ 71,904
Ceded (8,752) (6,497) (16,722) (12,384)
----------- ----------- ----------- -----------
Net premiums written 34,277 31,381 66,623 59,520
Change in unearned premiums (94) (3,115) 1,372 (3,123)
----------- ----------- ----------- -----------
Earned premiums 34,183 28,266 67,995 56,397
Net investment income 4,598 4,333 9,184 8,666
Net realized investment gains (losses) (19) 546 558 765
Other income 2 4 5 17
----------- ----------- ----------- -----------
38,764 33,149 77,742 65,845
Losses and expenses:
Net losses and loss adjustment expenses
7,701 5,380 16,584 10,645
Interest expense on debt 693 693 1,386 1,386
Amortization of deferred policy acquisition costs 3,450 4,024 6,635 7,442
Other operating expenses (net of acquisition
costs deferred) 6,729 5,169 13,069 11,009
----------- ----------- ----------- -----------
18,573 15,266 37,674 30,482
----------- ----------- ----------- -----------
Income before income taxes 20,191 17,883 40,068 35,363
Income taxes:
Current 594 182 1,152 353
Deferred 5,222 5,070 10,497 10,027
----------- ----------- ----------- -----------
5,816 5,252 11,649 10,380
----------- ----------- ----------- -----------
Net income $ 14,375 $ 12,631 $ 28,419 $ 24,983
========== =========== ========== ==========
Earnings per common and common equivalent
share:
Basic $ .99 $ .88 $ 1.96 $ 1.75
========== =========== ========== ==========
Diluted $ .98 $ .87 $ 1.93 $ 1.73
========== =========== ========== ==========
Shares used in computing earnings per common
and common equivalent share:
Basic 14,502,215 14,278,727 14,480,514 14,250,145
========== =========== ========== ==========
Diluted 14,718,499 14,451,403 14,694,996 14,425,274
========== =========== ========== ==========
See accompanying notes.
2
TRIAD GUARANTY INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Six Months Ended
June 30
--------------------------
(Dollars in thousands) 2004 2003
---- ----
Operating activities
Net income $ 28,419 $ 24,983
Adjustments to reconcile net income to net cash provided
by operating activities:
Loss, loss adjustment expenses and unearned premium reserves 2,182 6,181
Accrued expenses and other liabilities (2,349) (2,740)
Current taxes payable 1,052 443
Amounts due to/from reinsurer 320 (1,540)
Accrued investment income (620) (728)
Policy acquisition costs deferred (8,825) (8,684)
Amortization of deferred policy acquisition costs 6,635 7,442
Net realized investment gains (558) (765)
Provision for depreciation 1,601 1,402
Accretion of discount on investments (442) (2,098)
Deferred income taxes 10,497 10,027
Prepaid federal income taxes (9,084) (9,937)
Unearned ceding commission (238) (358)
Real estate acquired in claim settlement 1 1,147
Other assets 4,027 (2,042)
Other operating activities 580 328
--------- ---------
Net cash provided by operating activities 33,198 23,061
Investing activities
Securities available-for-sale:
Purchases - fixed maturities (92,965) (60,359)
Sales - fixed maturities 50,214 34,238
Purchases - equities (286) (547)
Sales - equities 762 736
Net change in short-term investments 14,336 8,101
Purchases of property and equipment (2,028) (1,019)
--------- ---------
Net cash used in investing activities (29,967) (18,850)
Financing activities
Proceeds from exercise of stock options 1,747 1,118
--------- ---------
Net cash provided by financing activities 1,747 1,118
--------- ---------
Net change in cash 4,978 5,329
Cash at beginning of period 973 233
--------- ---------
Cash at end of period $ 5,951 $ 5,562
========= =========
Supplemental schedule of cash flow information
Cash paid during the period for:
Income taxes and United States Mortgage Guaranty
Tax and Loss Bonds $ 9,825 $ 10,401
Interest 1,383 1,383
See accompanying notes.
3
TRIAD GUARANTY INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2004
(Unaudited)
NOTE 1 - THE COMPANY
Triad Guaranty Inc. (the "Company") is a holding company which, through its
wholly owned subsidiary, Triad Guaranty Insurance Corporation, provides
residential private mortgage insurance coverage in the United States to mortgage
lenders and investors to protect the lender or investor against loss from
defaults on low down payment residential mortgage loans and to facilitate the
sale of mortgage loans in the secondary market.
NOTE 2 - ACCOUNTING POLICIES AND BASIS OF PRESENTATION
BASIS OF PRESENTATION - The accompanying unaudited consolidated financial
statements have been prepared in accordance with accounting principles generally
accepted in the United States for interim financial information and with the
instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do
not include all of the information and footnotes required by accounting
principles generally accepted in the United States for complete financial
statements. In the opinion of management, all adjustments (consisting of normal
recurring accruals) considered necessary for a fair presentation have been
included. Operating results for the three and six months ended June 30, 2004 are
not necessarily indicative of the results that may be expected for the year
ending December 31, 2004. For further information, refer to the consolidated
financial statements and footnotes thereto included in the Triad Guaranty Inc.
annual report on Form 10-K for the year ended December 31, 2003.
STOCK OPTIONS - Currently, the Company grants stock options to employees
for a fixed number of shares with an exercise price equal to or greater than the
fair value of the shares at the date of grant. The Company accounts for stock
option grants using the intrinsic value method prescribed in Accounting
Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and
accordingly, recognizes no compensation expense for the stock option grants.
4
For purposes of pro forma disclosures, the estimated fair value of the
options is amortized to expense over the options' vesting period. Had
compensation expense for stock options been recognized using the fair value
method on the grant date, net income and earnings per share on a pro forma basis
would have been (in thousands, except for earnings per share information):
Three Months Ended Six Months Ended
June 30 June 30
----------------- ----------------
2004 2003 2004 2003
---- ---- ---- ----
Net income - as reported $14,375 $12,631 $28,419 $24,983
Net income - pro forma $14,250 $12,461 $28,157 $24,638
Earnings per share - as reported:
Basic $ 0.99 $ 0.88 $ 1.96 $ 1.75
Diluted $ 0.98 $ 0.87 $ 1.93 $ 1.73
Earnings per share - pro forma:
Basic $ 0.98 $ 0.87 $ 1.94 $ 1.73
Diluted $ 0.97 $ 0.86 $ 1.92 $ 1.71
NOTE 3 - CONSOLIDATION
The consolidated financial statements include Triad Guaranty Inc. and its
wholly owned subsidiary, Triad Guaranty Insurance Corporation ("Triad"), and
Triad's wholly owned subsidiaries, Triad Guaranty Assurance Corporation and
Triad Re Insurance Corporation (collectively referred to as "the Company"). All
significant intercompany accounts and transactions have been eliminated.
NOTE 4 -- COMMITMENTS AND CONTINGENT LIABILITIES
REINSURANCE - Triad cedes certain premiums and losses to reinsurers under
various reinsurance agreements. Reinsurance contracts do not relieve Triad from
its obligations to policyholders. Failure of the reinsurer to honor its
obligation could result in losses to Triad; consequently, allowances are
established for amounts when and if deemed uncollectible.
5
INSURANCE IN FORCE, DIVIDEND RESTRICTIONS, AND STATUTORY RESULTS -
Insurance regulations generally limit the writing of mortgage guaranty insurance
to an aggregate amount of insured risk no greater than 25 times the total of
statutory capital and surplus and the statutory contingency reserve. The amount
of net risk for insurance in force at June 30, 2004 and December 31, 2003, as
presented below, was computed by applying the various percentage settlement
options to the insurance in force amounts, adjusted by risk ceded under
reinsurance agreements and by applicable stop-loss limits, based on the original
insured amount of the loan. Triad's ratio is as follows (dollars in thousands):
June 30 December 31
2004 2003
---------- ----------
Net risk $6,796,532 $6,590,222
========== ==========
Statutory capital and surplus $ 132,068 $ 128,212
Statutory contingency reserve 335,043 302,740
---------- ----------
Total $ 467,111 $ 430,952
========== ==========
Risk-to-capital ratio 14.6-to-1 15.3-to-1
========== ==========
Triad and its wholly owned subsidiaries, Triad Guaranty Assurance
Corporation and Triad Re Insurance Corporation, are each required under their
respective domiciliary states' insurance code to maintain a minimum level of
statutory capital and surplus. Triad, an Illinois domiciled insurer, is required
under the Illinois Insurance Code (the "Code") to maintain minimum statutory
capital and surplus of $5 million. The Code permits dividends to be paid only
out of earned surplus and also requires prior approval of extraordinary
dividends. An extraordinary dividend is any dividend or distribution of cash or
other property, the fair value of which, together with that of other dividends
or distributions made within a period of twelve consecutive months, exceeds the
greater of (a) ten percent of statutory surplus as regards policyholders, or (b)
statutory net income for the calendar year preceding the date of the dividend.
Net income as determined in accordance with statutory accounting practices
was $37.5 million and $33.2 million for the six months ended June 30, 2004 and
2003, respectively, and $69.8 million for the year ended December 31, 2003.
At June 30, 2004 and December 31, 2003, the amount of Triad's equity that
could be paid out in dividends to stockholders was $48.4 million and $44.5
million, respectively, which was the earned surplus of Triad on a statutory
basis on those dates.
LOSS RESERVES - The Company establishes loss reserves to provide for the
estimated costs of settling claims with respect to loans reported to be in
default and loans in default which have not been reported to the Company.
Reserves are established by management using estimated claim rates (frequency)
and claim amounts (severity) to estimate ultimate losses. The reserving process
gives effect to current economic conditions and profiles delinquencies by such
factors as policy year, geography, chronic late payment characteristics and age.
Due to the inherent uncertainty in estimating reserves for losses and loss
adjustment expenses, there can be no assurance that the reserves will prove to
be adequate to cover ultimate loss development.
6
Litigation - Two lawsuits have been filed against the Company in the
ordinary course of the Company's business alleging violations of the Real Estate
Settlement Procedures Act and the Fair Credit Reporting Act. In the opinion of
management, the ultimate resolution of these pending litigation matters will not
have a material adverse effect on the financial position or results of
operations of the Company.
NOTE 5 - EARNINGS PER SHARE
Basic and diluted earnings per share are based on the weighted-average
daily number of shares outstanding. For diluted earnings per share, the
denominator includes the dilutive effect of stock options on the
weighted-average shares outstanding. There are no other reconciling items
between the denominators used in basic earnings per share and diluted earnings
per share. The numerator used in basic earnings per share and diluted earnings
per share is the same for all periods presented.
NOTE 6 - COMPREHENSIVE INCOME
Comprehensive income consists of net income and other comprehensive income.
For the Company, other comprehensive income is composed of unrealized gains or
losses on available-for-sale securities, net of income tax. For the three months
ended June 30, 2004 and 2003, the Company's comprehensive income was $5.4
million and $17.2 million, respectively. For the six months ended June 30, 2004
and 2003, comprehensive income totaled $21.1 million and $30.6 million,
respectively.
NOTE 7 - INCOME TAXES
Income tax expense differs from the amounts computed by applying the
Federal statutory income tax rate to income before income taxes primarily due to
tax-exempt interest that the Company earns from its investments in municipal
bonds.
7
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATION
Management's Discussion and Analysis of Financial Condition and Results of
Operations analyzes the consolidated financial condition, changes in financial
position, and results of operations for the three month and six month periods
ended June 30, 2004 and 2003, of Triad Guaranty Inc. and its consolidated
subsidiaries, collectively the Company. The discussion supplements Management's
Discussion and Analysis in Form 10-K for the year ended December 31, 2003 and
should be read in conjunction with the interim financial statements and notes
contained therein.
Certain of the statements contained herein, other than statements of
historical fact, are forward-looking statements. These statements are made
pursuant to the safe harbor provisions of the Private Securities Litigation
Reform Act of 1995 and include estimates and assumptions related to economic,
competitive, and legislative developments. These forward-looking statements are
subject to change and uncertainty, which are, in many instances, beyond our
control and have been made based upon our expectations and beliefs concerning
future developments and their potential effect on us. There can be no assurance
that future developments will be in accordance with our expectations or that the
effect of future developments on the Company will be those anticipated by us.
Actual results could differ materially from those expected by us, depending on
the outcome of certain factors, including the possibility of general economic
and business conditions that are different than anticipated, legislative or
regulatory developments, changes in interest rates or the stock markets,
stronger than anticipated competitive activity, and the factors described in the
forward-looking statements.
UPDATE ON CRITICAL ACCOUNTING ESTIMATES
Our Form 10-K describes the accounting policies that are critical to the
understanding of our results of operations and our financial position. These
critical accounting policies relate to the assumptions and judgments utilized in
establishing the reserve for losses and loss adjustment expenses, determining if
declines in fair values of investments are other than temporary, and
establishing appropriate initial amortization schedules for deferred policy
acquisition costs ("DAC") and subsequent adjustments to that amortization.
We believe that these continue to be the critical accounting policies
applicable to the Company and that these policies were applied in a consistent
manner during the first six months of 2004.
OVERVIEW
Through our subsidiaries, we provide mortgage guaranty insurance coverage
to residential mortgage lenders and investors in the United States as a
credit-enhancement vehicle, typically when individual borrowers have less than
20% equity in the property. Mortgage guaranty insurance also facilitates the
sale of individual low down payment loans in the secondary market and provides
8
protection to lenders who choose to keep the loans. Business originated by
lenders and submitted to us on an individual basis is referred to as flow
business. Premiums on flow business can be either lender paid or borrower paid,
although the majority is borrower paid. We also provide mortgage insurance to
lenders and investors who seek additional default protection, capital relief,
and credit-enhancement on groups of loans that are sold in the secondary market.
This business is referred to as structured bulk business.
We derive our revenues principally from a) initial and renewal earned
premiums from flow business (net of reinsurance premiums ceded as part of our
risk management strategies), b) initial and renewal earned premiums from
structured bulk transactions, and c) investment income on invested assets. We
also realize investment gains, net of investment losses, periodically as a
source of revenue when the opportunity presents itself within the context of our
overall investment strategy.
Our expenses essentially consist of a) amounts ultimately paid on claims
submitted, b) increases in reserves for estimated future claim payments, c)
general and administrative costs of acquiring new business and servicing
existing policies, d) other general business expenses, and (e) income taxes.
Our profitability depends largely on a) the adequacy of our product pricing
and underwriting discipline relative to the risks insured, b) persistency
levels, c) operating efficiencies, and d) the level of investment yield,
including realized gains and losses, on our investment portfolio. We define
persistency as the percentage of insurance in force remaining from twelve months
prior.
For a more detailed description of our industry and operations, refer to
the "Business" section of our Form 10-K.
9
CONSOLIDATED RESULTS OF OPERATIONS
Following is a summary of our results for the three months and six months
ended June 30, 2004 and 2003 (in thousands except per share information) along
with a column indicating a favorable or unfavorable change from 2003:
Three Months Ended Six Months Ended
------------------------------------ ------------------------------------
June 30 June 30 Favorable/ June 30 June 30 Favorable/
2004 2003 (Unfavorable) 2004 2003 (Unfavorable)
------- ------- ------------- ------- ------- -------------
Earned premiums $34,183 $28,266 20.9% $67,995 $56,397 20.6%
Net investment income 4,598 4,333 6.1 9,184 8,666 6.0
Net realized investment
(losses)/gains (19) 546 (103.5) 558 765 (27.1)
Other income 2 4 (50.0) 5 17 (70.6)
------- ------- ------- -------
Total revenues 38,764 33,149 16.9 77,742 65,845 18.1
Net losses and loss adjustment
expenses 7,701 5,380 (43.1) 16,584 10,645 (55.8)
Interest expense on debt 693 693 - 1,386 1,386 -
Amortization of deferred policy
acquisition costs 3,450 4,024 14.3 6,635 7,442 10.8
Other operating expenses (net of
acquisition costs deferred)
6,729 5,169 (30.2) 13,069 11,009 (18.7)
------- ------- ------- -------
Income before income taxes 20,191 17,883 12.9 40,068 35,363 13.3
Income taxes 5,816 5,252 (10.7) 11,649 10,380 (12.2)
------- ------- ------- -------
Net income $14,375 $12,631 13.8% $28,419 $24,983 13.8%
======= ======= ======= =======
Diluted earnings per share $ 0.98 $ 0.87 12.6% $ 1.93 $ 1.73 11.6%
======= ======= ======= =======
Our results for the three months and six months ended June 30, 2004 were
positively impacted by improvements in persistency levels. The quarterly
persistency run rate for the second quarter of 2004 was 56.9% compared to 33.6%
for the second quarter of 2003. Increased persistency affects our net income
primarily in two ways: a) renewal earned premiums increase and b) expenses
decrease because of reduced amortization of DAC.
Losses and loss adjustment expenses for the second quarter of 2004
increased 43% over the second quarter of 2003 and 56% when comparing the six
months ended June 30, 2004 to the same period of 2003. Our insurance in force
has grown 46% over the past two years, and this, coupled with the low levels of
persistency for that period, has resulted in a book of business that is
relatively unseasoned. Experience has shown that the highest claims incidence
generally occurs three to six years after the policy is written. As our book of
business ages, we expect a continued increase in both delinquencies and claims.
Further, because a higher proportion of our insurance in force is in the
refinance segment, anticipated losses could develop sooner than originally
anticipated.
10
We discuss our results in greater detail in the discussions that follow.
The information is presented in three categories: Production and In Force,
Revenues, and Losses and Expenses.
THREE MONTHS ENDED JUNE 30, 2004 COMPARED TO THREE MONTHS ENDED JUNE 30, 2003
Net income increased 13.8% for the second quarter of 2004 over the second
quarter of 2003 driven by a 20.9% increase in earned premiums combined with a
14.3% decrease in the amortization of DAC. The second quarter of 2004 had
essentially no diluted earnings per share impact from net realized investment
gains or losses after taxes, compared to a $0.02 per share contribution for the
second quarter of 2003. Diluted realized gains and losses per share is a
non-GAAP measure. We believe this is relevant and useful information to
investors because, except for write-downs on other-than-temporarily impaired
securities, it shows the effect that our discretionary sales of investments had
on earnings.
PRODUCTION AND IN FORCE
Total insurance written in the second quarter of 2004 decreased 10.2% to
$4.4 billion from $4.9 billion for the same period of 2003. Total insurance
written includes insurance written from flow production and structured bulk
transactions.
Flow insurance written for the second quarter of 2004 decreased 38.3% to
$2.9 billion from $4.7 billion in the second quarter of 2003. Refinancing
activity was very strong during the second quarter of 2003 as interest rates
generally declined during that quarter while interest rates generally increased
during the second quarter of 2004. Loan originations for the entire industry
declined because of this change in interest rates. The Mortgage Bankers
Association estimates that 2004 mortgage loan production will be approximately
35% less than the 2003 production. Additionally, the continued expansion of
other alternative credit enhancements such as 80/10/10 structures (a combination
of an 80% first mortgage loan, a 10% second mortgage loan usually issued by the
same lender, and a 10% down payment) has limited the mortgage insurance
industry's overall penetration into the mortgage marketplace.
Insurance written in the second quarter of 2004 attributable to structured
bulk transactions increased to $1.5 billion from $0.2 billion in the same period
of 2003. Insurance written attributed to structured bulk transactions is likely
to vary significantly from period to period, as opposed to insurance written
from flow originations, due to: a) the limited number of transactions (but with
larger size) occurring in this market; b) competition from other mortgage
insurers; c) the relative attractiveness in the marketplace of mortgage
insurance versus other forms of credit enhancement; and d) the changing loan
composition and underwriting criteria of the market.
11
The following table provides estimates of our national market share of net
new primary insurance written based on preliminary information available from
the industry association and other public sources:
Three Months Ended
June 30
--------------------
2004 2003
------ -----
Flow business 4.8% 5.4%
Structured bulk transactions 11.8% 2.7%
Total 5.8% 4.7%
The decrease in our market share of flow business in the second quarter of
2004 compared to the second quarter of 2003 was the result of a decline in
production of a product driven by the refinance segment. As explained earlier,
refinancing activity was very strong in the second quarter of 2003 as compared
to the second quarter of 2004. The increase in our structured bulk transactions
market share shown above is the result of our increased efforts to further
penetrate this market. Insurance written under structured bulk business may vary
widely between periods due to variations in the availability of transactions
that meet our required returns and in the level of competition for this
business.
Periodically we enter into structured bulk transactions involving loans
that have insurance effective dates within the current reporting period but for
which detailed loan information regarding the insured loans is not provided by
the issuer of the transaction until later. When this situation occurs, we accrue
premiums that are due but not yet paid based upon the estimated commitment
amount of the transaction in the reporting period with respect to each loan's
insurance effective date. However, the policies are not reflected in our in
force, insurance written, or related industry data totals until the loan level
detail is reported to us. At June 30, 2004, there were no structured
transactions with effective dates within the second quarter for which loan level
detail had not been received. At June 30, 2003, there were $1.0 billion of
structured transactions for which the loan level detail had not been received.
Premium written and premium earned for the second quarter of 2003 include the
respective amounts due and earned related to this insurance, while these amounts
were reported as new production and insurance in force in the third quarter of
2003.
Total direct insurance in force reached $34.8 billion at June 30, 2004,
compared to $31.7 billion at December 31, 2003, and $26.9 billion at June 30,
2003 as we continue to gain overall market share and as persistency levels
improve.
12
The following table shows our persistency trends since June 30, 2003:
Annual Quarterly Persistency
Persistency Run Rate
------------- ---------------------
June 30, 2004 59.9% 56.9%
March 31, 2004 54.6% 68.5%
December 31, 2003 50.7% 46.3%
September 30, 2003 49.0% 19.3%
June 30, 2003 54.6% 33.6%
As mentioned earlier, the primary driver of our increasing persistency
rates has been the general rise in mortgage interest rates that led to a
corresponding decline in refinancing activity. Refinancings accounted for 32.3%
of flow insurance written during the second quarter of 2004 compared to 55.1% in
the second quarter of 2003. The slight dip in the quarterly persistency run rate
in the second quarter of 2004 reflects a drop in interest rates in March and
April that affected persistency rates in the second quarter.
The credit quality of our existing insurance in force portfolio has
remained relatively consistent despite a 29.4% growth in direct insurance in
force from June 30, 2003 to June 30, 2004. As shown below, the credit quality of
our bulk business at June 30, 2004 has improved over June 30, 2003 as we have
focused our efforts on structured transactions consisting of Alt-A loans. Fair,
Isaac and Co., Inc. ("FICO") credit scores are one of the major factors used in
determining credit risk in an existing book of business. The following table
presents the FICO credit score distribution of our risk in force for both flow
and bulk business at June 30, 2004 and 2003.
Flow Bulk
--------------- ---------------
2004 2003 2004 2003
---- ---- ---- ----
Credit score less than 575 0.8% 0.8% 2.3% 3.8%
Credit score between 575 and 619 4.7% 4.6% 5.2% 12.5%
Credit score greater than 619 94.5% 94.6% 92.5% 83.7%
As the table shows, we insure some loans that have FICO credit scores below
575. We believe that these loans have a higher probability of loss than a loan
with a FICO credit score of 575 or greater. We do not expect loans with FICO
scores less than 575 to become a significant portion of our insurance in force.
We enter into bulk transactions that predominantly insure loans that are
classified as Alt-A, which we have defined as having high credit quality, an
average loan-to-value ("LTV") of 75%, and that have been underwritten with
reduced or no documentation. Additionally, approximately 95% of our insurance
written attributable to bulk transactions during the second quarter of 2004 was
structured with deductibles putting us in the second loss position.
13
REVENUES
Total direct premiums written increased 13.6% to $43.0 million for the
second quarter of 2004 from $37.9 million for the second quarter of 2003. This
increase was primarily due to an $8.8 million increase in renewal direct
premiums partially offset by a $3.7 million decline in initial premiums. As
mentioned earlier, increased persistency is the main contributor to the increase
in renewal premiums while a decline in refinancings caused the decline in
initial premiums.
As further described in our Form 10-K, we cede a portion of premiums under
risk-sharing arrangements with our lender partners (referred to as captive
reinsurance arrangements) as well as under excess of loss reinsurance treaties.
The primary difference between direct premiums written and net premiums written
is ceded premium. Net premiums written increased 9.2% to $34.3 million for the
second quarter of 2004 from $31.4 million for the second quarter of 2003. Ceded
premiums written increased 34.7% to $8.8 million for the second quarter of 2004
over $6.5 million for the second quarter of 2003 primarily due to an increase in
the amount of our premium subject to captive reinsurance arrangements. Our
premium cede rate (the ratio of ceded premiums written to direct premiums
written) was 20.3% for the second quarter of 2004 compared to 17.2% for the same
period of 2003. During the second quarter of 2004, 54.0% of flow insurance
written and 36.1% of total insurance written was subject to captive reinsurance
arrangements compared to 43.3% of flow insurance written and 41.6% of total
insurance written in the same period of 2003. The increase in the percentage of
flow insurance written subject to captive reinsurance arrangements from 2003 to
2004 is primarily a result of decreased production in our lender-paid mortgage
insurance program that is generally not subject to captive reinsurance
arrangements. Additionally, none of our structured bulk transactions are subject
to captive reinsurance arrangements. We anticipate that ceded premium will
continue to increase in connection with an increase in our insurance in force
subject to captive reinsurance arrangements.
The primary difference between net premiums written and earned premiums is
the change in the unearned premium reserve. Our unearned premium liability
remained flat from March 31, 2004 to June 30, 2004. Our unearned premium
liability increased $3.1 million from March 31, 2003 to June 30, 2003 due to
growth in sales of products with premiums paid on an annual basis during that
period.
Net investment income for the second quarter of 2004 increased 6.1% over
the second quarter of 2003 despite a 16.9% increase in average invested assets
over the same periods due to a significant decline in investment portfolio
yields.
Net realized investment gains/(losses), except for write-downs on
other-than-temporarily impaired securities, are the result of our discretionary
transactions to sell investment securities based on the context of our overall
portfolio management strategies and are likely to vary significantly from period
to period. The second quarter of 2004 included write-downs on
other-than-temporarily impaired securities of $39 thousand compared to $175
thousand in the second quarter of 2003. See further discussion of impairment
write-downs in the Realized Gains, Losses and Impairments section below.
14
LOSSES AND EXPENSES.
The increase in losses and loss adjustment expenses for the second quarter
of 2004 over the second quarter of 2003 was due to the growth in the number of
delinquencies and is reflective of overall growth of our insurance in force and
the seasoning of our in force business. Net paid losses, excluding loss
adjustment expenses, increased to $6.7 million during the second quarter of 2004
from $3.9 million during the second quarter of 2003, an increase of 71.8%.
Average severity (direct paid losses divided by number of claims paid) for flow
business was approximately $25,600 for the second quarter of 2004 compared to
$22,500 for the same period of 2003.
The following table provides detail on direct paid losses from flow
business and structured bulk business for the three months ended June 30, 2004
and 2003 (in thousands):
2004 2003
---- ----
Flow business $5,883 $3,692
Bulk business 832 233
------ ------
Total $6,715 $3,925
====== ======
Our loss ratio (the ratio of incurred losses to earned premiums) increased
to 22.5% for the second quarter of 2004 from 19.0% for the second quarter of
2003. As mentioned earlier, the increase in the loss ratio is consistent with
our expectations given the increase in severity of claims due to the lack of
seasoning of our in force business. Generally, unseasoned mortgage loans have
only slight principal amortization in the early years and the underlying
collateral has had only limited opportunity for market value appreciation;
therefore, the severity of the losses paid on these loans is higher than on more
seasoned loans. We expect loss ratios to continue to increase as a greater
amount of our insurance in force reaches its anticipated highest claim frequency
years. Because of the higher proportion of our insurance in force in the
refinance segment, the anticipated loss curve could possibly develop sooner than
originally anticipated. Changes in the economic environment could accelerate
paid and incurred loss development. Due to the inherent uncertainty of future
premium levels, losses, economic conditions, and other factors that affect
earnings, it is difficult to predict with any degree of certainty the impact of
such higher claim frequencies on future earnings. Most of our bulk production in
2003 and 2004 has been structured with deductibles that put us in the second
loss position, which we expect to moderate the loss development in the bulk
portfolio.
The decrease in DAC amortization for the second quarter of 2004 over the
second quarter of 2003 again reflects the increase in persistency for these
periods. A full discussion of the impact of persistency on DAC amortization is
included in the Deferred Policy Acquisition Costs section below.
15
The increase in other operating expenses for the second quarter of 2004
over the second quarter of 2003 is relatively consistent with our growth in the
insurance in force. The expense ratio (ratio of the amortization of deferred
policy acquisition costs and other operating expenses to net premiums written)
for the second quarter of 2004 remained relatively flat at 29.7% compared to
29.3% for the second quarter of 2003.
Our effective tax rate decreased to 28.8% for the second quarter of 2004
from 29.4% for the second quarter of 2003 due primarily to a higher proportion
of interest income from tax-preferred municipal securities. We expect our
effective tax rate to range between 28% and 29% for the remainder of the year
depending on the relationship of tax-free investment income from our municipal
bond portfolio to total revenues.
SIX MONTHS ENDED JUNE 30, 2004 COMPARED TO SIX MONTHS ENDED JUNE 30, 2003
Net income increased 13.8% for the first six months of 2004 over the first
six months of 2003, driven by a 20.6% increase in earned premiums combined with
a 10.8% decrease in the amortization of DAC. Net realized investment gains
contributed $0.02 to earnings per share on a diluted basis in the first half of
2004 compared to $0.03 for the first half of 2003.
PRODUCTION AND IN FORCE
Total insurance written in the first six months of 2004 increased 5.8% to
$9.1 billion from $8.6 billion for the same period of 2003. Total insurance
written includes insurance written from flow production and structured bulk
transactions.
Flow insurance written for the first six months of 2004 decreased 36.1% to
$5.3 billion from $8.3 billion in the first six months of 2003. Refinancing
activity was very strong during the first half of 2003 as interest rates
generally declined during that period and generally increased during the first
half of 2004. Production for the entire industry declined because of this change
in interest rates. Refinancings accounted for 33.7% of flow insurance written
during the first six months of 2004 compared to 56.0% in the first six months of
2003. Insurance written in the first six months of 2004 includes $3.8 billion
attributable to structured bulk transactions compared to $0.3 billion in the
first six months of 2003.
REVENUES
Total direct premiums written were $83.3 million in the first half of 2004
compared to $71.9 million for the same period of 2003, an increase of 15.9%
primarily due to a $14.7 million increase in renewal direct premiums. As
mentioned earlier, increased persistency is the main contributor to this
increase in renewal premiums.
Net premiums written increased 11.9% to $66.6 million for the first six
months of 2004 from $59.5 million for the first six months of 2003. Ceded
premiums written increased 35.0% to $16.7 million for the first half of 2004 as
16
compared to $12.4 million for the first half of 2003, primarily due to an
increase in the amount of our premium subject to captive reinsurance
arrangements. Our premium cede rate was 20.1% for the first six months of 2004
compared to 17.2% for the same period of 2003. During the first six months of
2004, 56.8% of flow insurance written and 33.4% of total insurance written was
subject to captive reinsurance arrangements, compared to 45.6% of flow insurance
written and 43.9% of total insurance written in the same period of 2003. The
increase in the percentage of flow insurance written subject to captive
reinsurance arrangements from 2003 to 2004 is primarily a result of continued
decreased production in our lender-paid mortgage insurance program that
generally is not subject to captive reinsurance arrangements as mentioned
earlier. Additionally, none of our structured bulk transactions are subject to
captive reinsurance arrangements. We anticipate that ceded premium will continue
to increase in connection with an increase in insurance in force subject to
captive reinsurance arrangements.
The primary difference between net premiums written and earned premiums is
the change in the unearned premium reserve. Our unearned premium liability
decreased $1.4 million from December 31, 2003 to June 30, 2004, as compared to
an increase of $3.1 million from December 31, 2002 to June 30, 2003.
Net investment income for the first half of 2004 increased 6.0% over the
first half of 2003 despite a 17.2% increase in average invested assets over the
same periods due to a significant decline in investment portfolio yields in the
comparable interest rate environments.
Net realized investment gains for the first six months of 2004 included
write-downs on other-than-temporarily impaired securities of $139,000 compared
to $614,000 in the same period of 2003. See further discussion of impairment
write-downs in the Realized Gains, Losses and Impairments section below.
LOSSES AND EXPENSES
The increase in losses and loss adjustment expenses for the first half of
2004 over the first half of 2003 was based upon the growth in the number of
delinquencies and is reflective of overall growth of our insurance in force and
the seasoning of our in force business. Net paid losses, excluding loss
adjustment expenses, increased to $12.7 million during the first six months of
2004 from $7.4 million during the first six months of 2003, an increase of
72.6%. Average severity for flow business was approximately $26,400 for the
first six months of 2004 compared to $22,500 for the same period of 2003.
17
The following table provides detail on direct paid losses from flow
business and structured bulk business for the six months ended June 30, 2004 and
2003 (in thousands):
2004 2003
---- ----
Flow business $11,137 $7,001
Bulk business 1,587 370
------- ------
Total $12,724 $7,371
======= ======
Our loss ratio increased to 24.4% for the first half of 2004 from 18.9% for
the first half of 2003. As mentioned earlier, the increase in the loss ratio is
consistent with our expectations given the overall growth of insurance in force
and the increase in severity of claims due to the lack of seasoning of our in
force business.
The decrease in DAC amortization for the first half of 2004 over the first
half of 2003 again reflects the increase in persistency for these periods.
The increase in other operating expenses for the first six months of 2004
over the first six months of 2003 is relatively consistent with our growth in
the insurance in force. The expense ratio for the first half of 2004 declined to
29.6% compared to 31.0% for the first half of 2003 due to the realization of
expense efficiencies within our operations combined with the decrease in the DAC
amortization mentioned above.
Our effective tax rate decreased to 29.1% for the first six months of 2004
from 29.4% for the first six months of 2003 due primarily to a higher proportion
of interest income from tax-preferred municipal securities.
SIGNIFICANT CUSTOMERS
Our objective is controlled, profitable growth in both the flow and bulk
arenas while adhering to our risk management strategies. Our strategy is to
continue our focus on national lenders while maintaining the productive
relationships that we have built with regional lenders. Consolidation within the
mortgage origination industry has resulted in a greater percentage of production
volume being concentrated among a smaller customer base. Our ten largest
customers were responsible for 71% of flow insurance written during both the
three and six month periods ending June 30, 2004, compared to 76% and 75% for
the three and six month periods ending June 30, 2003, respectively. Our two
largest customers were responsible for 53% of flow insurance written during the
three and six month periods ending June 30, 2004, compared to 61% and 59% for
the three and six month periods ending June 30, 2003, respectively. The loss of
one or more of these significant customers could have an adverse effect on our
business.
18
FINANCIAL POSITION
Total assets increased 5.7% to $608 million at June 30, 2004 over December
31, 2003. Total liabilities increased to $214 million at June 30, 2004, from
$206 million at December 31, 2003. Our mortgage insurance operations and
reserves are primarily supported by our investment portfolio, which contains
most of our assets. This section identifies several items on our balance sheet
other than invested assets that are important in the overall understanding of
our financial position. These items include deferred policy acquisition costs,
prepaid federal income tax and related deferred income taxes, and loss and loss
adjustment expense reserves. A separate Investment Portfolio discussion follows
this section and reviews our investment portfolio, key portfolio management
strategies, and methodologies by which we manage credit risk.
DEFERRED POLICY ACQUISITION COSTS
In accordance with generally accepted accounting principles, costs expended
to acquire new business are capitalized as DAC and recognized as expense over
the anticipated life of the policy. We employ models that calculate amortization
of DAC separately for each book year. The models rely on assumptions that we
make based upon historical industry experience and our own unique experience
regarding the annual persistency development of each book year.
Persistency is the most important assumption utilized in determining the
timing of reported amortization expense reflected in the income statement and
the carrying value of DAC on the balance sheet. A change in the assumed
persistency can impact the current and future amortization expense as well as
the carrying value on the balance sheet. However, our models are dynamic and
adjust when actual book year persistency is lower than the assumptions employed
in the models. When this happens, the DAC amortization is accelerated through a
dynamic adjustment in order to match the amortization expense with the life of
the policies on which the acquisition costs were originally deferred.
19
The following table shows the DAC asset for the three months and six months
ended June 30, 2004 and 2003 and the effect of persistency on amortization (in
thousands):
Three Months Ended Six Months Ended
June 30 June 30
------------------ ------------------
2004 2003 2004 2003
---- ---- ---- ----
Balance - beginning of period $30,863 $30,050 $29,363 $28,997
Costs capitalized 4,140 4,213 8,825 8,684
Amortization - normal (3,029) (3,101) (6,126) (6,223)
Amortization - dynamic adjustment
(421) (923) (509) (1,219)
---------------- -----------------
Total amortization (3,450) (4,024) (6,635) (7,442)
---------------- -----------------
Balance - end of period $31,553 $30,239 $31,553 $30,239
================ =================
Quarterly persistency rate 56.9% 33.6%
================
PREPAID FEDERAL INCOME TAXES AND DEFERRED INCOME TAXES
We purchase ten-year non-interest bearing United States Mortgage Guaranty
Tax and Loss Bonds ("Tax and Loss Bonds") in lieu of paying current federal
income taxes to take advantage of a special contingency reserve deduction for
mortgage guaranty companies. See our Form 10-K for a more complete description
of these transactions. During the six months ended June 30, 2004, $655,000 of
Tax and Loss Bonds matured, and we purchased an additional $9.7 million of these
bonds.
LOSS AND LOSS ADJUSTMENT EXPENSE RESERVE
We establish reserves using estimated claim rates (frequency) and claim
amounts (severity) to estimate ultimate losses. Our reserving process
incorporates numerous factors in a formula that gives effect to current economic
conditions and profiles delinquencies by such factors as policy year, geography,
chronic late payment characteristics, and the number of months the policy has
been in default. Because the estimate for loss reserves is sensitive to the
estimates of claims frequency and severity, we perform sensitivity analyses to
test the reasonableness of the best estimate generated by the loss reserve
process. Changes to reserve estimates are reflected in the financial statements
in the periods in which the adjustments are determined.
Our loss and loss adjustment expense reserves increased to $30.8 million at
June 30, 2004, compared to $27.2 million at December 31, 2003 and $24.4 million
at June 30, 2003.
20
Loss and loss adjustment expense reserves are established on insured
mortgage loans when any notices of default are received, no matter what the age
of the default. Reserves also are established for estimated losses incurred on
notices of default not yet reported by the lender. Consistent with industry
practices, we do not establish loss reserves for future claims on insured loans
that are not currently in default. Approximately 72% of our insurance in force
was written within the last two years. Experience indicates that years three
through six have the highest incidence of claims. The increase in reserves shown
above is indicative of the increase in the number of loans in default as more of
our insurance in force approaches the years with the highest incidence of claims
and an expected growth in the severity of claims. As mentioned earlier, because
of the higher proportion of our in force in the refinance segment, the
anticipated loss curve could possibly develop sooner than originally
anticipated. We expect this trend to continue as our insurance in force grows
and continues to season.
The following table shows default statistics as of June 30, 2004, December
31, 2003, and June 30, 2003:
Default Statistics
--------------------------------
June 30 December 31 June 30
2004 2003 2003
-------- -------- -------
Number of insured loans in force 254,510 236,234 205,046
Number of loans in default 4,765 4,242 3,351
Percentage of loans in default
(default rate) 1.87% 1.80% 1.63%
Number of insured loans in force
excluding bulk loans 208,384 205,033 189,161
Number of loans in default
excluding bulk loans 3,319 3,053 2,510
Percentage of loans in default
excluding bulk loans 1.59% 1.49% 1.33%
Number of bulk loans in force 46,126 31,201 15,885
Number of bulk loans in default 1,446 1,189 841
Percentage of bulk loans in default 3.13% 3.81% 5.29%
The number of loans in default reported above includes all reported
delinquencies that are in excess of two payments in arrears at the reporting
date and all reported delinquencies that were previously in excess of two
payments in arrears and have not been brought current. The increase in the
default rate for the flow business is attributable primarily to the maturing of
the flow portfolio for reasons consistent with the increase in reserves
explained above. The default occurrences for both flow business and structured
bulk business are consistent with management's expectation.
21
INVESTMENT PORTFOLIO
PORTFOLIO DESCRIPTION
We manage our investment portfolio to meet or exceed regulatory and rating
agency requirements. We invest for the long term, and most of our investments
are held until they mature. Our investment portfolio includes primarily fixed
income securities, and the majority of these are tax-preferred state and
municipal bonds. We have established a formal investment policy that describes
our overall quality and diversification objectives and limits. Our investment
policies and strategies are subject to change depending upon regulatory,
economic, and market conditions, as well as our anticipated financial condition
and operating requirements, including our tax position. While we invest for the
long-term and most of our investments are held until they mature, we classify
our entire investment portfolio as available for sale. This classification
allows us the flexibility to dispose of securities in order to meet our
investment strategies and operating requirements. All investments are carried on
our balance sheet at fair value. The following schedule shows the growth and
diversification of our investment portfolio (in thousands).
June 30, 2004 December 31, 2003
------------------ -------------------
Amount Percent Amount Percent
-------- ------- -------- -------
Fixed maturity securities:
U. S. government obligations $ 13,802 3.2% $ 15,623 3.8%
Mortgage-backed bonds 88 0.0 99 0.0
State and municipal bonds 369,786 85.6 330,228 79.9
Corporate bonds 25,377 5.9 29,147 7.0
-------- ------ -------- ------
Total fixed maturities 409,053 94.7 375,097 90.7
Equity securities 11,865 2.7 12,771 3.1
-------- ------ -------- ------
Total available-for-sale
securities 420,918 97.4 387,868 93.8
Short-term investments 11,323 2.6 25,659 6.2
-------- ------ -------- ------
$432,241 100.0% $413,527 100.0%
======== ====== ======== ======
We seek to provide liquidity in our investment portfolio through cash
equivalent investments and through diversification and investment in publicly
traded securities. We attempt to maintain a level of liquidity and duration in
our investment portfolio consistent with our business outlook and the expected
timing, direction, and degree of changes in interest rates. The duration to
maturity of the fixed maturity portfolio was 10.7 years at June 30, 2004 with an
effective maturity of 8.5 years compared to a duration of 11.4 years with an
effective maturity of 6.4 years at December 31, 2003. Another way that we manage
risk and liquidity is to limit our exposure on individual securities. As of June
30, 2004 and December 31, 2003, no investment in the securities of any single
issuer exceeded 2% of our investment portfolio.
22
The growth in net investment income has moderated recently in spite of an
increase in our overall investment portfolio. The drop in the effective pre-tax
yield reflects the decrease in new money rates available for investment coupled
with our strategies to increase the overall credit quality of the portfolio and
increase our investment in state and municipal bonds.
CREDIT RISK
Credit risk is inherent in an investment portfolio. We manage this risk
through a structured approach to internal investment quality guidelines and
diversification while assessing the effects of the changing economic landscape.
One way we attempt to limit the inherent credit risk in the portfolio is to
maintain investments with high ratings. The following table describes our fixed
maturity holdings by credit ratings (in thousands):
June 30, 2004 December 31, 2003
------------------ -------------------
Amount Percent Amount Percent
-------- ------- -------- -------
U.S. treasury and agency bonds $ 13,890 3.4% $ 15,722 4.2%
AAA 284,691 69.6 256,291 68.3
AA 47,302 11.6 50,428 13.4
A 44,164 10.8 35,937 9.6
BBB 9,816 2.4 10,347 2.8
BB 235 0.0 2,204 0.7
B 1,174 0.3 1,669 0.4
CCC and lower 473 0.1 525 0.1
Not rated 7,308 1.8 1,974 0.5
-------- ------ -------- ------
Total fixed maturities $409,053 100.0% $375,097 100.0%
======== ====== ======== ======
Further, we regularly review our investment portfolio to identify
securities that may have suffered impairments in value that will not be
recovered, termed potentially distressed securities. In identifying potentially
distressed securities, we first screen for all securities that have a fair value
to cost or amortized cost ratio of less than 80%. Additionally, as part of this
identification process, we utilize the following information:
o Length of time the fair value was below amortized cost
o Industry factors or conditions related to a geographic area negatively
affecting the security
o Downgrades by a rating agency
o Past due interest or principal payments or other violation of
covenants
o Deterioration of the overall financial condition of the specific
issuer
In analyzing our potentially distressed securities list for
other-than-temporary impairments, we pay special attention to securities that
have been on the list for a period greater than six months. Our ability and
intent to retain the investment for a sufficient time to recover its value is
also considered. We assume that, absent reliable contradictory evidence, a
security that is potentially distressed for a continuous period greater than
nine months has incurred an other-than-temporary impairment. Such reliable
23
contradictory evidence might include, among other factors, a liquidation
analysis performed by our investment advisors or outside consultants, improving
financial performance of the issuer, or valuation of underlying assets
specifically pledged to support the credit.
Should we conclude that the decline is other than temporary, the security
is written down to fair value through a charge to realized investment gains and
losses. We adjust the amortized cost for securities that have experienced
other-than-temporary impairments to reflect fair value at the time of the
impairment. We consider factors that lead to an other-than-temporary impairment
of a particular security in order to determine whether these conditions have
impacted other similar securities.
UNREALIZED GAINS AND LOSSES
The following table summarizes by category our unrealized gains and losses
in our securities portfolio at June 30, 2004:
Cost or Gross Gross
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
--------- ---------- ---------- -----
Fixed maturity securities:
Corporate $ 22,774 $ 2,671 $ 68 $ 25,377
U.S. Government 14,027 98 323 13,802
Mortgage-backed 80 8 - 88
State and municipal 367,795 5,605 3,614 369,786
-------- ------- ------- --------
Subtotal, debt securities 404,676 8,382 4,005 409,053
Equity securities 10,317 1,759 211 11,865
-------- ------- ------- --------
Total securities $414,993 $10,141 $ 4,216 $420,918
======== ======= ======= ========
These unrealized gains and losses do not necessarily represent future gains
or losses that we will realize. Changing conditions related to specific
securities, overall market interest rates, or credit spreads, as well as our
decisions concerning the timing of a sale, may impact values we ultimately
realize. We monitor unrealized losses through further analysis according to
maturity date, credit quality, individual creditor exposure and the length of
time the individual security has continuously been in an unrealized loss
position. The preponderance of the gross unrealized losses on debt securities
shown above related to bonds with a maturity date in excess of ten years. The
largest individual unrealized loss on any one security at June 30, 2004 was
$185,000 on a bond with an amortized cost of $1.9 million.
Of the $4.2 million gross unrealized losses at June 30, 2004, none had a
fair value to cost or amortized cost ratio of less than 80%.
Information about unrealized gains and losses is subject to changing
conditions. Securities with unrealized gains and losses will fluctuate, as will
those securities that we have identified as potentially distressed. The recent
24
volatility of financial markets has led to an increase in both unrealized gains
and losses. Our current evaluation of other-than-temporary impairments reflects
our intent to hold certain securities until maturity. However, we may
subsequently decide to sell certain of these securities in future periods within
the overall context of our portfolio management strategies. If we make the
decision to dispose of a security with an unrealized loss, we will write down
the security to its fair value if we have not sold it by the end of the
reporting period.
REALIZED GAINS, LOSSES AND IMPAIRMENTS
During the second quarter and first six months of 2004, we wrote down one
security in the amounts of $39,000 and $139,000, respectively. These write-downs
were on a $250,000 par value preferred stock in an international airline for
which the value had fluctuated below 80% of amortized cost for over a year. The
additional write-down in the second quarter on this security resulted from our
assessment that the security was other than temporarily impaired because of a
further reduction in credit quality by rating agencies. However, this particular
security is not currently in default. We hold no other securities in the airline
industry.
LIQUIDITY AND CAPITAL RESOURCES
Our sources of operating funds consist primarily of premiums written and
investment income. Operating cash flow is applied primarily to the payment of
claims, interest, expenses, and prepaid federal income taxes in the form of Tax
and Loss Bonds.
We generated positive cash flow from operating activities of $33.2 million
in the first six months of 2004 compared to $23.1 million for the same period of
2003. The increase in cash flow from operating activities reflects the growth in
premiums and investment income in excess of increases in claims and other
operating expenses paid. Our business does not routinely require significant
capital expenditures other than for enhancements to our computer systems and
technological capabilities. Positive cash flows are invested pending future
payments of claims and expenses. Cash flow shortfalls, if any, could be funded
through sales of short-term investments and other investment portfolio
securities.
The insurance laws of the State of Illinois impose certain restrictions on
dividends that an insurance subsidiary can pay the parent company. These
restrictions, based on statutory accounting practices, include requirements that
dividends may be paid only out of statutory earned surplus and that limit the
amount of dividends that may be paid without prior approval of the Illinois
Insurance Department. There have been no dividends paid by the insurance
subsidiaries to the parent company.
We cede business to captive reinsurance subsidiaries of certain mortgage
lenders ("Captives"), primarily under excess of loss reinsurance agreements.
Generally, reinsurance recoverables on loss reserves and unearned premiums ceded
to these Captives are backed by trust funds or letters of credit.
Total stockholders' equity increased to $394.3 million at June 30, 2004
from $369.9 million at December 31, 2003. This increase resulted primarily from
25
net income for the first six months of 2004 of $28.4 million and an increase in
additional paid-in-capital of $4.3 million resulting from the exercise of
employee stock options and the related tax benefit. This was partially offset by
a decrease in net unrealized gains on invested assets classified as
available-for-sale of $7.3 million (net of income tax).
Total statutory policyholders' surplus for our insurance subsidiaries
increased to $132.1 million at June 30, 2004 from $128.2 million at December 31,
2003. The primary difference between statutory policyholders' surplus and equity
computed under generally accepted accounting principles is the statutory
contingency reserve. The balance in the statutory contingency reserve was $335.0
million at June 30, 2004, compared to $302.7 million at December 31, 2003.
Statutory capital, for the purpose of computing the total risk in force to
statutory capital, includes both policyholders' surplus and the contingency
reserve. Statutory capital amounted to $467.1 million at June 30, 2004, compared
to $430.9 million at December 31, 2003.
Triad's ability to write insurance depends on the maintenance of its
financial strength ratings and the adequacy of its capital in relation to risk
in force. A significant reduction of capital or a significant increase in risk
may impair Triad's ability to write additional insurance. A number of states
also generally limit Triad's risk-to-capital ratio to 25-to-1. As of June 30,
2004, Triad's risk-to-capital ratio was 14.6-to-1 as compared to 15.3-to-1 at
December 31, 2003, and 11.0-to-1 for the industry as a whole at December 31,
2002, the latest industry data available. The risk-to-capital ratio is
calculated using net risk in force, which takes into account risk ceded under
reinsurance arrangements, including captive risk-sharing arrangements and any
applicable stop-loss limits, as the numerator, and statutory capital as the
denominator.
There have been no changes in our financial ratings or outlook by the
rating agencies since December 31, 2003 as detailed in our Form 10-K. Triad is
rated "AA" by both Standard & Poor's Ratings Services and Fitch Ratings and
"Aa3" by Moody's Investors Service. A reduction in Triad's rating or outlook
could adversely affect our operations.
There have been legislative and regulatory proposals to change the
oversight of both Fannie Mae and Freddie Mac. Significant changes in the
regulation of these entities could impact Triad and the entire mortgage
industry.
OFF BALANCE SHEET ARRANGEMENTS AND AGGREGATE CONTRACTUAL OBLIGATIONS
We lease office facilities, automobiles, and office equipment under
operating leases with minimum lease commitments that range from one to ten
years. We have no capitalized leases or material purchase commitments. Our
long-term debt has a single maturity date of 2028. There have been no material
changes to the aggregate contractual obligations shown in our Form 10-K.
26
SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
Management's Discussion and Analysis and this Report contain
forward-looking statements relating to future plans, expectations, and
performance, which involve various risks and uncertainties, including, but not
limited to, the following:
o interest rates may increase or decrease from their current levels;
o housing prices may increase or decrease from their current levels;
o housing transactions requiring mortgage insurance may decrease for
many reasons including changes in interest rates, economic conditions
or alternative credit enhancement products;
o our market share may change as a result of changes in underwriting
criteria or competitive products or rates;
o the amount of insurance written could be adversely affected by changes
in federal housing legislation, including changes in the Federal
Housing Administration loan limits and coverage requirements of
Freddie Mac and Fannie Mae (Government Sponsored Enterprises);
o our financial condition and competitive position could be affected by
legislation or regulation impacting the mortgage guaranty industry or
the Government Sponsored Enterprises, specifically, and the financial
services industry in general;
o rating agencies may revise methodologies for determining our financial
strength ratings and may revise or withdraw the assigned ratings at
any time;
o decreases in persistency, which are affected by loan refinancings in
periods of low interest rates, may have an adverse effect on earnings;
o the amount of insurance written and the growth in insurance in force
or risk in force as well as our performance may be adversely impacted
by the competitive environment in the private mortgage insurance
industry, including the type, structure, and pricing of our products
and services and our competitors;
o if we fail to properly underwrite mortgage loans under contract
underwriting service agreements, we may be required to assume the
costs of repurchasing those loans;
o with consolidation occurring among mortgage lenders and our
concentration of insurance in force generated through relationships
with significant lender customers, our margins may be compressed and
the loss of a significant customer may have an adverse effect on our
earnings;
o our performance may be impacted by changes in the performance of the
financial markets and general economic conditions;
o economic downturns in regions where our risk is more concentrated
could have a particularly adverse effect on our financial condition
and loss development;
o Revisions in risk-based capital rules by the Office of Federal Housing
Enterprise Oversight for Fannie Mae and Freddie Mac could severely
limit our ability to compete against various types of credit
protection counterparties, including "AAA" rated private mortgage
insurers;
27
o changes in the eligibility guidelines of Fannie Mae or Freddie Mac
could have an adverse effect on the Company;
o proposed regulation by the Department of Housing and Urban Development
to exclude packages of real estate settlement services, which may
include any required mortgage insurance premium paid at closing, from
the anti-referral provisions of the Real Estate Settlement Procedures
Act could adversely affect our earnings.
Accordingly, actual results may differ from those set forth in the
forward-looking statements. Attention also is directed to other risk factors set
forth in documents filed by the Company with the Securities and Exchange
Commission.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company's market risk exposures at June 30, 2004 have not materially
changed from those identified in Form 10-K for the year ended December 31, 2003.
ITEM 4. CONTROLS AND PROCEDURES
a) We carried out an evaluation, under the supervision and with the
participation of our management, including the Chief Executive Officer
(CEO) and Chief Financial Officer (CFO), of the effectiveness of our
disclosure controls and procedures pursuant to Securities Exchange Act
of 1934 (Act) Rule 13a-15. Based on that evaluation, our management,
including our CEO and CFO, concluded, as of the end of the period
covered by this report, that our disclosure controls and procedures
were effective. Disclosure controls and procedures include controls
and procedures designed to ensure that management, including our CEO
and CFO, is alerted to material information required to be disclosed
in our filings under the Act so as to allow timely decisions regarding
our disclosures. In designing and evaluating disclosure controls and
procedures, we recognized that any controls and procedures, no matter
how well designed and operated, can provide only reasonable assurance
of achieving the desired control objectives, as ours are designed to
do.
b) There have been no changes identified in connection with the
evaluation described in the above paragraph that occurred during the
second quarter 2004 that have materially affected, or are reasonably
likely to materially affect, our internal controls over financial
reporting.
28
Part II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS - None
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS - None
ITEM 3. DEFAULTS UPON SENIOR SECURITIES - None
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Annual Meeting of Stockholders was held on May 20, 2004. Shares
entitled to vote at the Annual Meeting totaled 14,476,623 of which
14,138,751 shares were represented.
The following seven directors were elected at the Annual Meeting.
Shares voted for and authorized withheld for each nominee were as follows:
Name of Nominee Number of Votes for Authorization withheld
--------------- ------------------- ----------------------
Glenn T. Austin, Jr. 14,094,648 44,103
Robert T. David 13,992,918 145,833
William T. Ratliff, III 13,943,743 195,008
Michael A. F. Roberts 14,094,548 44,203
Richard S. Swanson 13,978,877 159,874
Darryl W. Thompson 13,943,643 195,108
David W. Whitehurst 10,784,899 3,353,852
ITEM 5. OTHER INFORMATION - None
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
See exhibit index on page 31.
(b) Reports on Form 8-K since December 31, 2003
January 30, 2004 - Triad Guaranty Inc. issued a news release
announcing its financial results for the fourth quarter and the fiscal
year ended December 31, 2003.
April 27, 2004 - Triad Guaranty Inc. issued a news release announcing
its financial results for the first quarter of 2004.
July 29, 2004 - Triad Guaranty Inc. issued a news release announcing
its financial results for the second quarter of 2004.
29
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
TRIAD GUARANTY INC.
Date: August 9, 2004
/s/ Kenneth S. Dwyer
-----------------------
Kenneth S. Dwyer
Vice President and Chief
Accounting Officer
30
EXHIBIT INDEX
Exhibit Number Description
-------------- ------------------------------------------------------------
31(i) Certification of Chief Executive Officer pursuant to
Exchange Act Rule 13a-14(a), as adopted pursuant to Section
302 of the Sarbanes-Oxley Act of 2002.
31(ii) Certification of Chief Financial Officer pursuant to
Exchange Act Rule 13a-14(a), as adopted pursuant to Section
302 of the Sarbanes-Oxley Act of 2002.
32 Certifications of Chief Executive Officer and Chief
Financial Officer pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002.