UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

 

Form 10-K

 

 

Commission file number 0-22342

 

 

 

 

Triad Guaranty Inc.

(Exact name of registrant as specified in its charter)

 

 

Registrant’s telephone number, including area code:

(336) 723-1282

 

Securities registered pursuant to Section 12(b) of the Act:

None

 

Securities registered pursuant to Section 12(g) of the Act:

 

Title of Each Class

Common Stock, par value $.01 per share

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ

 

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 o     No þ

 

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 þ     No o

 

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 registrant’s 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.  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act)  Yes o     No þ

 

State the aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant, computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter: $460,174,380 as of June 30, 2005, which amount excludes the value of all shares beneficially owned (as defined in Rule 13d-3 under the Securities Exchange Act of 1934) by officers and directors of the registrant (however this does not constitute a representation or acknowledgment that any such individual is an affiliate of the registrant).

 

The number of shares of the registrant’s common stock, par value $0.01 per share, outstanding as of February 28, 2006, was 14,825,642.

 

 

 

TABLE OF CONTENTS

 

 

Overview

 

Triad Guaranty Inc. is a holding company which, through its wholly-owned subsidiary, Triad Guaranty Insurance Corporation (“Triad”), provides private mortgage insurance (“MI”) coverage in the United States to residential mortgage lenders and investors. Triad Guaranty Inc. and its subsidiaries are collectively referred to as the “Company.” The “Company” when used within this document refers to the holding company and/or one or more of its subsidiaries, as appropriate.

 

Triad was formed in 1987 as a wholly-owned subsidiary of Primerica Corporation and began writing private mortgage insurance in 1988. In September 1989, Triad was acquired by Collateral Mortgage, Ltd. (“CML”), a mortgage banking and real estate lending firm located in Birmingham, Alabama. In 1990, CML contributed the outstanding stock of Triad to its affiliate, Collateral Investment Corp. (“CIC”), an insurance holding company.

 

The Company was incorporated by CIC in Delaware in August 1993, for the purpose of holding all the outstanding stock of Triad and to undertake the initial public offering of the Company’s common stock, which was completed in November 1993. Currently, CML owns 17.4% of the outstanding common stock of the Company, which it acquired in 1993, prior to the initial public offering. In November 2005, the Company completed a transaction in which CIC transferred all of its 2,573,551 shares of the Company’s common stock to the Company in exchange for 2,528,214 newly issued shares of the Company’s common stock. The newly issued shares were then distributed to CIC shareholders as part of CIC’s liquidation.

 

The principal executive offices of the Company are located at 101 South Stratford Road, Winston-Salem, North Carolina 27104. Its telephone number is (336) 723-1282.

 

Private mortgage insurance, also known as mortgage guaranty insurance, is issued in many home purchase and refinance transactions involving conventional residential first mortgage loans to borrowers with equity of less than 20%. If the homeowner defaults on the mortgage, private mortgage insurance reduces, and in some instances eliminates, any loss to the insured lender. Private mortgage insurance also facilitates the sale of low down payment mortgage loans in the secondary mortgage market, principally to the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”). Under risk-based capital regulations applicable to most financial institutions, private mortgage insurance also reduces the capital requirement for such lenders on residential mortgage loans not sold that have equity of less than 20%. Mortgage insurance is also purchased by investors and lenders who seek additional default protection or capital relief on loans with equity of greater than 20%.

 

Distribution Channels

 

Our flow channel consists of business originated by lenders and submitted to us on a loan-by-loan basis. Through the bulk channel, we participate in structured bulk transactions, which involve underwriting and insuring a group of loans with individual coverage for each loan. Structured bulk transactions are typically initiated by underwriters of mortgage-backed securities, mortgage lenders, and mortgage investors such as Fannie Mae and Freddie Mac, who seek additional default protection, capital relief, and credit enhancement on groups of loans sold in the secondary market. Coverage on structured bulk transactions is determined at the individual loan level, sufficient to reduce the insured’s exposure on any loan in the transaction down to a stated percentage of the loan balance (“down-to” coverage). We are provided loan-level information on the group of loans and, based on the risk characteristics of the entire group of loans and the requirements of the secondary mortgage market participant, we submit a price for insuring the entire group of loans. We compete against other mortgage insurers as well as other forms of credit enhancement provided by capital markets for these transactions.

 

Structured bulk transactions frequently include an aggregate stop-loss limit applied to the entire group of insured loans. Additionally, 39% of the structured bulk transactions we entered into in 2005 and 81% in 2004 included deductibles under which we will pay no losses until the losses exceed the deductible amount. Through

December 31, 2005, insurance written through the structured bulk channel has not been subject to captive mortgage reinsurance or other risk-sharing arrangements.

 

Historically, we have segregated information based only on the flow and bulk distribution channels. Although we continue to manage our business through these distribution channels, we believe that reporting information from a risk exposure perspective helps clarify our business and the risk factors associated with our portfolio. We believe risk exposure differs among our product types, particularly our two main product classifications. Therefore, where relevant in this Form 10-K and in future filings, we will report information using the Primary insurance and Modified Pool insurance product classifications defined below.

 

Mortgage Insurance Products

 

Primary Insurance

 

Primary insurance provides mortgage default protection to lenders on individual loans and covers a percentage of unpaid loan principal, delinquent interest, and certain expenses associated with the default and subsequent foreclosure (collectively, the “claim amount”). The claim amount, to which the appropriate coverage percentage is applied, generally ranges from 110% to 115% of the unpaid principal balance of the loan. Our obligation to an insured lender with respect to a claim is determined by applying the appropriate coverage percentage to the claim amount. Under our master policy, we have the option of paying the entire claim amount and taking title to the mortgaged property or paying the coverage percentage in full satisfaction of our obligations under the insurance written. “Insurance written” is defined as the entire loan balance for which a lender has requested mortgage insurance and is generally utilized as a term to measure sales production. We classify a policy as Primary insurance if it provides first dollar loss coverage and a) has a loan-to-value (LTV) ratio greater than 80% or b) is part of a structured transaction with an LTV ratio less than 80% and does not have a stop loss or deductible. Primary insurance can be delivered through our flow or bulk channels, although the majority is delivered through the flow channel. Primary insurance comprised approximately 67% and 79% of our total direct insurance in force at December 31, 2005 and 2004, respectively.

 

We offer primary coverage generally from 12% to 37% of the claim amount. The insured lender selects the coverage percentage that we provide, subject to our underwriting approval, usually in order to comply with their investors’ requirements to reduce investor loss exposure on loans they purchase.

 

Fannie Mae and Freddie Mac are the ultimate purchasers of a large percentage of the loans we insure. Generally they require a coverage percentage that will reduce their loss exposure on loans they purchase to 75% or less of the property’s value at the time the loan is originated. Since 1999, Fannie Mae and Freddie Mac have accepted lower coverage percentages for certain categories of mortgages when the loan is approved by their automated underwriting services. The reduced coverage percentages limit loss exposure to 80% or less of the property’s value at the time the loan is originated.

 

Our premium rates vary depending upon various factors including the LTV ratio, loan type, mortgage term, coverage amount, documentation required, credit score and use of property, which all affect the perceived risk of default on the insured mortgage loan. Usually, premium rates cannot be changed after issuance of coverage. Consistent with industry practice, we generally utilize a nationally based, rather than a regional or local, premium rate structure for business acquired through the flow channel. However, special risk rates may be utilized as well.

 

Premiums on mortgage insurance business acquired through the flow channel are paid by either the borrower (borrower paid) or the lender (lender paid). Under our borrower paid plan, mortgage insurance premiums are charged to the mortgage lender or servicer that collects the premium from the borrower and, in turn, remits the premiums to us. Under our lender paid plan, mortgage insurance premiums are charged to the mortgage lender or loan servicer that pays the premium to us. The lender may recover the premium through an increase in the borrower’s interest rate. Approximately 68% and 77% of Primary insurance was written under our borrower paid plan during 2005 and 2004, respectively. The remainder was written under our lender paid plan (32% and 23% of flow insurance during 2005 and 2004, respectively). Our lender paid volume is concentrated among larger mortgage lender customers.

Premiums may be remitted monthly, annually, or in one single payment. The monthly premium payment plan involves the payment of one or two months’ premium at the mortgage loan closing. Thereafter, level monthly premiums are collected by the loan servicer for monthly remittance to us. We also offer a plan under which the first monthly mortgage insurance payment is deferred until the first loan payment is made. This deferred monthly premium product decreases the amount of cash required from the borrower at closing, thereby making home ownership more affordable. Monthly premium plans represented approximately 96% and 92% of Primary insurance written through our flow channel in 2005 and 2004, respectively.

 

The annual premium payment plan requires a first-year premium paid at mortgage loan closing with annual renewal payments. With respect to our borrower-paid annual premium plans, renewal payments are collected monthly from the borrower and held in escrow by the mortgage lender or servicer for annual remittance to us in advance of each renewal year. Annual premium plans represented approximately 4% and 8% of Primary insurance written through our flow channel in 2005 and 2004, respectively.

 

The single premium payment plan requires a single payment paid at loan closing. The single premium payment can be financed by the borrower by adding it to the principal amount of the mortgage or can be paid in cash at closing by the borrower. Single premium plans represented less than 1% of Primary insurance written through our flow channel in 2005 and 2004.

 

Modified Pool Insurance

 

Modified Pool insurance is written only as part of a structured bulk transaction to provide credit enhancement to lenders and investors who seek additional default protection and capital relief. This type of insurance a) provides coverage that exceeds the protection provided by existing primary insurance or b) provides primary coverage on loans with a loan to value ratio of less than 80% that are part of a structured transaction with a stop loss or deductible. Modified Pool insurance comprised approximately 33% and 21% of our total direct insurance in force at December 31, 2005 and 2004, respectively.

 

Traditional Pool Insurance

 

Traditional pool insurance generally has been offered by private mortgage insurers to lenders as an additional credit enhancement for certain mortgage-backed securities and provides coverage for the full amount of the net loss on each individual loan included in the pool, subject to an aggregate stop loss limit and/or a deductible. We have not offered traditional pool insurance.

 

Risk-sharing Products

 

We offer mortgage insurance structures designed to allow lenders to share in the risks of mortgage insurance. One such arrangement is our captive reinsurance program. Under the captive reinsurance program, a reinsurance company, generally an affiliate of the lender, assumes a portion of the risk associated with the lender’s insured book of business in exchange for a percentage of the premium. Typically, the reinsurance program is an excess-of-loss arrangement with defined aggregate layers of coverage and a maximum exposure limit for the captive reinsurance company. Captive reinsurance programs may also take the form of a quota share arrangement, although we had no quota share arrangements in force under captive reinsurance programs as of December 31, 2005. Under our excess-of-loss programs, with respect to a given book year of business, Triad retains the first loss position on the first aggregate layer of risk and reinsures a second defined aggregate layer with the reinsurer. Triad generally retains the remaining risk above the layer reinsured. Of the reinsurance agreements in place at December 31, 2005, the first layer retained by Triad ranged from the first 3.0% to 6.5% of risk in force and the second layer ceded to reinsurers ranged from the next 4.0% to 10.0%. Ceded premiums, net of ceded commissions, under these arrangements ranged from 20.0% to 40.0% of premiums.

 

We require the counterparties to all of Triad’s reinsurance agreements to establish trust accounts to support the reinsurers’ obligations under the reinsurance agreements. The captive reinsurer is the grantor of the trust and Triad is the beneficiary of the trust. The trust agreement includes covenants regarding minimum and ongoing capitalization, required reserves, authorized investments, and withdrawal of assets and is funded by ceded premium and investment earnings on trust assets as well as capital contributions by the reinsurer.

The ultimate impact on our financial performance of an excess-of-loss captive structure is primarily dependent on the total level of losses and the persistency rates during the life of the business. We define persistency as the percentage of insurance in force remaining from twelve months prior. We believe that our excess-of-loss captive reinsurance programs provide valuable reinsurance protection by limiting the aggregate level of losses, and, under normal operating environments, potentially reduce the degree of volatility in our earnings from the development of such losses over time. At December 31, 2005 and 2004, 39% and 43% of insurance in force was subject to captive reinsurance programs.

 

Cancellation of Insurance

 

We cannot cancel mortgage insurance coverage except for nonpayment of premium or certain material violations of the master policy, and coverage remains renewable at the option of the insured lender. Generally, mortgage insurance is renewable at a rate determined when the insurance on the loan was initially issued.

 

Insured lenders may cancel insurance acquired through the flow channel at any time at their option. Pursuant to the Homeowners Protection Act, lenders are required to automatically cancel the borrower paid private mortgage insurance on most loans made on or after July 29, 1999, when the outstanding loan amount is 78% or less of the property’s original purchase price and certain other conditions are met. A borrower may request that a loan servicer cancel borrower-paid mortgage insurance on a mortgage loan when the loan balance is less than 80% of the property’s current value, but loan servicers are generally restricted in their ability to grant those requests by secondary market requirements and by certain other regulatory restrictions.

 

Mortgage insurance coverage can also be cancelled when an insured loan is refinanced. If we provide insurance on the refinanced mortgage, the policy on the refinanced home loan is considered new insurance written. Therefore, continuation of coverage from one of our refinanced loans to a new loan results in both a cancellation of insurance and new insurance written. During periods of high refinance activity, our earnings and risk profile are more subject to fluctuations. Our cancellation rate, defined as the percentage of insurance in force from twelve months prior that was cancelled during the twelve month period, was 31% and 32% for 2005 and 2004, respectively.

 

Customers

 

Residential mortgage lenders such as mortgage bankers, mortgage brokers, commercial banks, and savings institutions are the principal originators of our insurance written through the flow channel.

 

To obtain insurance through our flow channel, a mortgage lender must first apply for and receive a master policy from us. Our approval of a lender as a master policyholder is based upon evaluation of the lender’s financial position and demonstrated adherence to sound lending practices as well as other factors.

 

The master policy sets forth the terms and conditions of our mortgage insurance policy. The master policy does not obligate the lender to obtain insurance from us, nor does it obligate us to issue insurance on a particular loan. The master policy provides that the lender must submit individual loans for insurance to us, and we must approve each loan, subject to certain underwriting criteria, to effect coverage (except in the case of delegated underwriting when the originator has the authority to approve coverage within certain guidelines).

 

Consolidation within the mortgage origination industry has resulted in a greater percentage of production volume being concentrated among a smaller customer base. According to industry sources, the top 30 lenders in the United States, as ranked by mortgage origination volume, accounted for approximately 88% of originated mortgage volume in 2005 compared to 84% in 2004. Many of these top 30 lenders are our customers. In 2005, production from our top 10 lenders accounted for approximately 77% of insurance written through our flow channel compared to 71% in 2004. The loss of one or more of these significant customers could have an adverse effect on our business.

Our premium revenue is comprised of premium from business originated in the current year plus renewal premium from insurance originated in prior years. Those customers whose revenue comprised more than 10% of our consolidated revenue are listed below:

 

 

See further discussion regarding significant customers in Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

Sales and Marketing

 

We currently market our insurance products through a dedicated sales force of approximately 40 professionals, including sales management, and an exclusive commissioned general agency serving a specific geographic market. We are licensed to do business in all 50 states and the District of Columbia.

 

Our Executive Vice President of Sales and Operations oversees all of our sales and marketing activities and reports directly to our Chief Executive Officer. Our Senior Vice President and National Sales Manager is responsible for all of our sales activities and reports to our Executive Vice President of Sales and Operations. Division managers serve key regional accounts through area sales directors and account executives and report to our Senior Vice President and National Sales Manager. Also reporting to our Senior Vice President and National Sales Manager are national account executives who are responsible for sales efforts toward larger national mortgage originators.

 

The marketing department develops and implements programs in support of our sales objectives and to promote our image. A variety of tools and venues are utilized to achieve these goals including public relations, marketing materials, internal/external publications, convention trade shows, and the internet.

 

Contract Underwriting

 

We provide fee-based contract underwriting services that enable customers to improve the efficiency of their operations by outsourcing all or part of their mortgage loan underwriting. The fee charged is intended to cover the cost of providing the services. Contract underwriting involves examining a prospective borrower’s information contained in a lender’s mortgage application file and making a determination whether the borrower is approved for a mortgage loan subject to the lender’s underwriting guidelines. In addition, we offer Fannie Mae’s Desktop Originator^® and Desktop Underwriter^® and Freddie Mac’s Loan Prospector^® as a service to our contract underwriting customers. These products, which are designed to streamline and reduce costs in the mortgage origination process, supply our customers with fast and accurate information regarding compliance with underwriting standards and Fannie Mae’s or Freddie Mac’s decision for loan purchase or securitization. We provide contract underwriting services through our own employees as well as independent contractors, and these services are provided for loans that require mortgage insurance as well as loans that do not require mortgage insurance. In the event that Triad fails to properly underwrite a loan subject to the lender’s underwriting guidelines, Triad may be required to provide monetary or other remedies to the lender customer. The amounts historically paid and the estimated potential liabilities associated with this activity are not significant.

 

Competition and Market Share

 

We and other private mortgage insurers compete directly with federal and state governmental and quasi-governmental agencies, principally the Federal Housing Administration (“FHA”). These agencies sponsor government-backed mortgage insurance programs under which approximately 24% of all high LTV loans were insured in 2005 compared to 33% in 2004. In addition to competition from federal agencies, we and other private mortgage insurers face competition from state-supported mortgage insurance funds, some of which are either independent

agencies or affiliates of state housing agencies. Indirectly, we also compete with mortgage lenders that forego private mortgage insurance to self-insure against the risk of loss from defaults on all or a portion of their low down payment mortgage loans, and we compete with products designed to avoid mortgage insurance 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).

 

Fannie Mae and Freddie Mac are the beneficiaries of the majority of our mortgage insurance policies, so their business practices have a significant influence on us. Changes in their practices could reduce the number of policies they purchase that are insured by us and consequently reduce our revenues. Some of Fannie Mae and Freddie Mac’s more recent programs require less insurance coverage than they historically have required, and they have the ability to further reduce coverage requirements, which could reduce demand for mortgage insurance and have a material adverse effect on our business, financial condition and operating results.

 

Fannie Mae and Freddie Mac also have the ability to implement new eligibility requirements for mortgage insurers and to alter or liberalize underwriting standards on low-down-payment mortgages they purchase. We cannot predict the extent to which any new requirements may be enacted or how they may affect the operations of our mortgage insurance business, our capital requirements and our products.

 

Various proposals have been periodically discussed by Congress and certain federal agencies to reform or modify the charters under which Fannie Mae and Freddie Mac do business. Management is unable to predict the scope and content of such proposals, or whether any such proposals will be enacted into law, and if enacted, what effect they may have on us.

 

The private mortgage insurance industry consists of seven major mortgage insurance companies including Triad, Mortgage Guaranty Insurance Corporation, PMI Mortgage Insurance Co., United Guaranty Corporation, Radian Guaranty Inc., Genworth Financial, Inc. and Republic Mortgage Insurance Company. Triad is the smallest private mortgage insurer based on 2005 market share and, according to estimated industry data, had a 7.5% share of total net new insurance written in 2005 compared to 6.0% in 2004.

 

We believe we compete favorably with other private mortgage insurers principally on the basis of personalized and professional service, a strong management and sales team, responsive and versatile technology, innovative products in the flow market and attractive pricing with respect to certain products. We compete in competitive bid transactions in the structured bulk market with both the other private mortgage insurers and providers of other forms of credit enhancements.

 

Underwriting Practices

 

We consider effective risk management to be critical to our long-term financial stability. Market analysis, prudent underwriting, the use of automated risk evaluation models, auditing, and knowledge of our customers are all important elements of our risk management process.

 

Underwriting Personnel

 

Our Senior Vice President of Underwriting is responsible for the underwriting of business written through the flow channel in the home office as well as regional offices in Arizona, California, Georgia, Illinois, Ohio, Pennsylvania, and Texas. He has been in his position since shortly after the Company was formed. Our Senior Vice President of Risk Management is responsible for assessing the risk factors used in our underwriting procedures. He has been with the Company since 2001 and has more than 20 years of industry experience.

 

We employed an underwriting staff of approximately 35 at December 31, 2005. Our field underwriters and underwriting managers are limited in their authority to approve programs for certain mortgage loans. The authority levels are tied to underwriting position, knowledge, and experience and relate primarily to loan amounts and property type. All of our loans insured are subject to quality control reviews.

Risk Management Approach

 

We evaluate risk based on historical performance of risk factors and utilize automated underwriting systems in the risk selection process to assist the underwriter with decision-making. This process evaluates the following categories of risk:

 

 

Underwriting Process for Our Flow Distribution Channel

 

We accept applications for insurance under three basic programs: a fully-documented program, a credit-score driven reduced documentation program, and a delegated underwriting program which allows a lender’s underwriters to commit insurance to a loan based on strict, agreed upon underwriting guidelines. We also accept loans approved through Freddie Mac’s or Fannie Mae’s automated underwriting systems.

 

We generally utilize nationwide underwriting guidelines to evaluate the potential risk of default on mortgage loans submitted for insurance coverage. These guidelines have evolved over time and take into account the loss experience of the entire private mortgage insurance industry. They also are largely influenced by the underwriting guidelines of Fannie Mae and Freddie Mac. Specific underwriting guidelines applicable to a given local, state, or regional market are utilized to address concerns resulting from our review of regional economies and housing patterns.

 

Subject to our underwriting guidelines and exception approval procedures, we expect our internal underwriters and contract underwriters to utilize their experience and business judgment in evaluating each loan on its own merits. Accordingly, our underwriting staff has discretionary authority to insure loans that deviate in certain minor respects from our underwriting guidelines. More significant exceptions are subject to management approval. In all such cases, other compensating factors must be identified. The predominant deviations involve instances where the borrower’s debt-to-income ratio exceeds our guidelines. To compensate for exceptions, our underwriters give favorable consideration to factors such as excellent borrower credit history, the availability of satisfactory cash reserves after closing, and borrower employment stability.

 

We also allow lenders to submit insurance applications with reduced documentation through automated and non-automated underwriting programs. Under the automated underwriting program, Triad issues a commitment of insurance based on the borrower’s FICO credit score or the approval of the loan through either Fannie Mae’s or Freddie Mac’s automated underwriting system. We issue a commitment of insurance without the standard underwriting process if certain program parameters are met and the borrower has a credit score above established thresholds. We audit lenders’ files on loans submitted under the automated underwriting program randomly and through specific identification of selected risk factors. Documentation submission requirements for non-automated underwritten loans vary depending on the borrower’s credit score.

 

We utilize a delegated underwriting program to serve many of the larger, well-established mortgage originators. Under this program, standards for type of loan, property type, and credit history of the borrower are established consistent with our risk strategy, and the lender’s underwriters are able to commit insurance to a loan based on these standards. Re-underwriting, re-appraisal, and similar procedures are utilized following issuance of the policy to ensure quality control. Our delegated underwriting program accounted for 37% of applications received through the flow distribution channel in 2005 compared to 41% in 2004. To date, the performance of loans insured under the delegated underwriting program has been comparable to non-delegated business. The use of Fannie Mae’s or Freddie Mac’s automated underwriting programs or our delegated underwriting programs with selected lenders could lead to loss development patterns different than those experienced when we controlled the entire underwriting process.

 

Underwriting Process for Our Structured Bulk Distribution Channel

 

Our pricing for structured bulk transactions is commensurate with a transaction’s overall risk profile based upon its individual loan-by-loan analysis as well as any associated stop loss level or deductible amount. We analyze structured bulk transactions during the bid process to identify the individual loans that pose the greatest risk of nonperformance. High-risk loans are identified based on an analysis of multiple risk factors including, but not limited to, credit score, loan-to-value ratio, documentation type, loan purpose, and loan amount. The pertinent risk characteristics of each loan are evaluated to determine the impact on the transaction’s frequency and severity of loss and persistency. We may utilize an outside due diligence firm in this process as well as mortgage risk analysis models such as Standard & Poor’s Levels. We may request to remove certain loans from the transaction as a result of the risk review before we submit a competitive bid. We do not bid on all structured bulk transactions of which we are notified.

Other Risk Management

 

As discussed earlier, we have expanded the risk characteristics that we pursue in both the Primary and Modified Pool marketplaces. That change has been overseen by our Credit Risk Committee, which is composed of all members of senior management. The Credit Risk Committee must approve all new product offerings and changes in types of risk that we are willing to assume. This includes approval of the expansion of credit characteristics and review of the overall underwriting guidelines utilized.

 

Additionally, the Committee approves all structured bulk transactions before a bid is submitted. The Committee reviews the summary analysis of the transaction and challenges the conclusions reached concerning the pricing of a given structure based upon the estimated frequency and severity of projected losses and persistency. After all of these points are considered, the Committee decides whether or not to submit the bid on the transaction.

 

We employ a comprehensive quality assurance internal audit plan to determine whether underwriting decisions being made are consistent with the policies, procedures, and expectations for quality set forth by management. All areas of business activity that involve an underwriting decision are examined, with emphasis on new products, new procedures, contract underwritten loans, delegated loans, new employees, new master policyholders, and new branches of an existing master policyholder. The process used to identify categories of loans selected for audit begins with identification and evaluation of certain defined and verifiable risk elements. Each loan is then tested against these elements to identify loans that fail to meet prescribed policies or an identified norm. The procedure allows management to identify concerns that may exist within individual loans as well as concerns that may exist within a given category of business and take appropriate action.

 

Financial Strength Rating

 

Credit ratings generally are considered an important element in a mortgage insurer’s ability to compete for new business, indicating the insurer’s present financial strength and capacity to pay future claims. Certain national mortgage lenders and a large segment of the mortgage securitization market, including Fannie Mae and Freddie Mac, generally will not purchase high LTV mortgages or mortgage-backed securities containing high LTV mortgages unless the insurer issuing private mortgage insurance coverage has a financial strength rating of at least “AA−” by either Standard & Poor’s Ratings Services (“S&P”) or Fitch Ratings (“Fitch”) or a rating of at least “Aa3” from Moody’s Investors Service (“Moody’s”). Triad is rated “AA” by both S&P and Fitch and “Aa3” by Moody’s. Private mortgage insurers are not rated by any other independent nationally-recognized insurance industry rating organization or agency (such as the A.M. Best Company).

 

When assigning a financial strength rating, S&P, Fitch, and Moody’s generally consider: (i) the specific risks associated with the mortgage insurance industry, such as regulatory climate, market demand, growth, and competition; (ii) management depth, corporate strategy, and effectiveness of operations; (iii) historical operating results and expectations of current and future performance of the insurer’s specific portfolio; and (iv) long-term capital structure, the ratio of debt to equity, the ratio of risk to capital, near-term liquidity, and cash flow levels, as well as any reinsurance relationships and the financial strength ratings of such reinsurers. Ratings are based on factors relevant to policyholders. Such ratings are not directed to the protection of shareholders and do not apply to any securities issued by us.

 

Some rating agencies issue financial strength ratings based, in part, upon a company’s performance sensitivity to various economic depression scenarios. In determining capital levels required to maintain a company’s rating, the rating agencies may allow the use of different forms of capital including statutory capital, reinsurance, and debt. In January 1998, we completed a $35 million private offering of notes due January 15, 2028. The notes, which were rated “A” by S&P and “A+” by Fitch at the time of issuance, were issued to provide additional capital considered in the rating agency’s depression models.

 

S&P, Fitch and Moody’s will periodically review Triad’s rating as they do with all rated insurers. Ratings can be withdrawn or changed at any time by a rating agency. A reduction in our rating by S&P, Fitch or Moody’s, while not anticipated, could materially impact our ability to write new business.

Reinsurance

 

Triad’s product offerings include captive mortgage reinsurance programs whereby an affiliate of a lender reinsures a portion of the insured risk on loans originated or purchased by the lender. These programs are designed to allow the lenders to share in the risk of the business. See further discussion of these programs under the Risk-sharing Products section above.

 

Pursuant to deeper coverage requirements imposed by Fannie Mae and Freddie Mac, certain loans eligible for sale to such enterprises with a loan-to-value ratio over 90% require insurance with a coverage percentage of 30% or more. Certain states limit the amount of risk a mortgage insurer may retain with respect to coverage of an insured loan to 25% of the claim amount, and, as a result, the deeper coverage portion of such insurance must be reinsured. To minimize reliance on third-party reinsurers and to permit it to retain the premiums and related risk on deeper coverage business, Triad reinsures this deeper coverage business with its wholly-owned subsidiary, Triad Guaranty Assurance Corporation (“TGAC”). As of December 31, 2005 and 2004, TGAC assumed approximately $81 million and $73 million in risk from Triad, respectively.

 

We maintain excess of loss reinsurance arrangements designed to limit our exposure in the event of a catastrophic level of losses. We currently maintain $125 million of excess of loss reinsurance through non-affiliated reinsurers that have financial strength ratings of “AA” or better from Standard & Poor’s.

 

The use of reinsurance as a source of capital and as a risk management tool is well established within the mortgage insurance industry. Reinsurance does not legally discharge an insurer from its primary liability for the full amount of the risk it insures, although it does make the reinsurer liable to the primary insurer. There can be no assurance that our reinsurers will be able to meet their obligations under the reinsurance agreements.

 

Defaults and Claims

 

Defaults

 

The claim process on private mortgage insurance begins with the lender’s notification to the insurer of a default on an insured’s loan. Default is defined in the primary master policy as the failure by the borrower to pay, when due, an amount at least equal to the scheduled monthly mortgage payment under the terms of the mortgage. The master policy requires lenders to notify us of default on a mortgage payment within 10 days of either (i) the date on which the borrower becomes four months in default or (ii) the date on which any legal proceeding affecting the loan commences, whichever occurs first. Notification is required within 45 days of default if it occurs when the first payment is due. The incidence of default is affected by a variety of factors including, but not limited to, changes in borrower income, unemployment, divorce, illness, and the level of interest rates. Borrowers may cure defaults by making all delinquent loan payments or by selling the property and satisfying all amounts due under the mortgage. Defaults that are not cured generally result in submission of a claim to us. Refer to the Management’s Discussion and Analysis of Financial Condition and Results of Operations section of this document for default statistics at December 31 for the last two years.

 

Claims

 

Claims result from defaults that are not cured. During the default period, we work with the insured as well as the borrower in an effort to reduce losses through the loss mitigation efforts described below. The frequency of claims may not directly correlate to the frequency of defaults due, in part, to our loss mitigation efforts and the borrower’s ability to overcome temporary financial setbacks. The likelihood that a claim will result from a default, and the amount of such claim, principally depend on the borrower’s equity at the time of default and the borrower’s (or the lender’s) ability to sell the home for an amount sufficient to satisfy all amounts due under the mortgage, as well as the effectiveness of loss mitigation efforts. The time frame from when we first receive a notice of default until the ultimate claim is paid generally ranges from six to eighteen months. Changes in various macroeconomic conditions such as house price appreciation, employment, and other market conditions over that time frame also positively or negatively impact the amount of the ultimate claim paid.

 

The payment of claims is not evenly spread throughout the insurance coverage period. For Primary insurance, relatively few claims are paid during the first year following loan origination. A period of rising claim payments

follows, which, based on industry experience, has historically reached its highest level in the second through fifth years after loan origination. Thereafter, the number of claim payments made has historically declined at a gradual rate, although the rate of decline can be affected by local economic conditions. For Modified Pool insurance, the claim pattern peaks somewhat earlier, with the highest claim payment levels reached in the second through fourth years. There can be no assurance that the historical pattern of claims will continue in the future.

 

Generally, we do not pay a claim for loss under the master policy if the application for insurance for the loan in question contains fraudulent information, material omissions, or misrepresentations that increase the risk characteristics of the loan. Our master policy also excludes any cost or expense related to the repair or remedy of any physical damage (other than “normal wear and tear”) to the property collateralizing an insured mortgage loan. Such physical damage may be caused by accident, natural occurrence, or other conditions.

 

Under the terms of the master policy, the lender is required to file a claim with us no later than 60 days after it has acquired borrower’s title to the underlying property through foreclosure, a negotiated short sale, or a deed-in-lieu of foreclosure. A primary insurance claim amount includes (i) the amount of unpaid principal due under the loan; (ii) the amount of accumulated delinquent interest due on the loan (excluding late charges) to the date of claim filing; (iii) expenses advanced by the insured under the terms of the master policy, such as hazard insurance premiums, property maintenance expenses and property taxes prorated to the date of claim filing; and (iv) certain foreclosure and other expenses, including attorneys fees. Such claim amount is subject to review and possible adjustment by us. Our experience indicates that the claim amount on a policy generally ranges from 110% to 115% of the unpaid principal amount of a foreclosed loan.

 

Within 60 days after the claim has been filed, we have the option of either (i) paying the coverage percentage of the claim as specified on the certificate of insurance (usually 12% to 37% of the claim), with the insured retaining title to the underlying property and receiving all proceeds from the eventual sale of the property, or (ii) paying the full claim amount in exchange for the lender’s conveyance of good and marketable title to the property to us, and selling the property for our own account. We choose the claim settlement option believed to cost the least. In most cases, we settle claims by paying the coverage percentage of the claim amount; however we have expanded the use of our option to purchase properties in settlement of claims. At December 31, 2005, we held 48 properties with a combined net realizable value of approximately $5.7 million that were acquired by electing to pay the full claim amount compared to two properties with a combined net realizable value of approximately $0.2 million held at December 31, 2004. We record the estimated loss amount on properties purchased in settlement of claims at the time of acquisition and refine this estimate when appropriate until the property is sold. During 2005, we added additional personnel with real estate expertise to enable us to better utilize the property acquisition option. In general, the claims severity was lower on properties acquired than on those for which we paid the settlement option, although the number of paid claims is far greater than those utilizing the property acquisition option.

 

Loss Mitigation

 

Once a default notice is received, we attempt to mitigate our loss. Through proactive intervention with insured lenders and borrowers, we have been successful in reducing the number and severity of our claims for loss. Loss mitigation techniques include pre-foreclosure sales, property sales after foreclosure, advances to assist distressed borrowers who have suffered a temporary economic setback, and the use of repayment schedules, refinances, loan modifications, forbearance agreements, and deeds-in-lieu of foreclosure. Such mitigation efforts typically result in reduced losses from the coverage percentage stated in the certificate of insurance. As a result of loss mitigation efforts, we paid out approximately 75% and 60% of potential exposure on claims in 2005 and 2004, respectively.

 

Loss Reserves

 

We establish reserves to provide for the estimated costs of settling claims on loans reported in default and loans in default that are in the process of being reported to us. Consistent with industry practices, we do not establish loss reserves for future claims on insured loans that are not currently in default. Our reserving process is based upon the assumption that long-term historical experience, adjusted for current economic events that we believe will significantly impact the long-term loss development, provides a reasonable basis for estimating future events. See the Financial Position section of Management’s Discussion and Analysis of Financial Condition and Results of

Operations for a more detailed discussion of the loss reserving process, and see Note 4 to the Consolidated Financial Statements for a detailed analysis of the activity in this account for the year.

 

Analysis of Direct Risk in Force

 

A foundation of our business strategy is proactive risk selection. We analyze our portfolio in a number of ways to identify any concentrations of risk or imbalances in risk dispersion. We believe that the quality of our insurance portfolio is affected predominantly by (i) the quality of loan originations (including the strength of the borrower and the marketability of the property); (ii) the attributes of loans insured (including LTV ratio, purpose of the loan, type of loan instrument, and type of underlying property securing the loan); (iii) the seasoning of the loans insured; (iv) the geographic dispersion of the underlying properties subject to mortgage insurance; and (v) the quality, integrity and past performance of lenders from which we receive loans to insure.

 

Lender and Product Characteristics

 

We had $8.0 billion of direct risk in force as of December 31, 2005. Direct risk in force includes risk from both Primary and Modified Pool insurance, adjusted for applicable stop loss limits and deductibles.

 

The following table provides information on risk in force (as determined on the basis of information available on the date of mortgage origination) by the categories indicated on December 31, 2005 and 2004. In our 2004 Form 10-K, risk in force amounts did not reflect deductibles. The table below adjusts for deductibles in the data for both years presented.

 

Risk in Force(1)

 

 

 

 

An important determinant of claim incidence is the relative amount of borrower’s equity in the home. For the industry as a whole, historical evidence indicates that, in general, claim incidence on loans with a higher LTV is greater than a loan with a lower LTV, all else being equal. We believe the higher premium rates charged on high LTV loans adequately reflect the additional risk.

 

At December 31, 2005, approximately 8.9% of our risk in force was comprised of loans with an LTV greater than 95%. These high LTV loans are offered primarily to low and moderate-income borrowers. We believe that these loans have higher risks than loans with lower LTVs and have often attracted borrowers with weaker credit histories, generally resulting in higher loss ratios. In keeping with our established risk strategy, we have not aggressively solicited this segment of the industry. We do not routinely delegate the underwriting of high LTV loans.

 

In 2000, the State of Illinois Insurance Division, as well as the insurance departments of several other states, began to permit mortgage insurers to write coverage on loans with LTVs in excess of 97% up to 100% and, in certain instances, up to 103%. This determination was made in response to the development by certain entities in the mortgage securitization market, including Fannie Mae and Freddie Mac, of programs that allowed LTVs in excess of 97%. These programs are designed to accommodate the credit-worthy borrower who lacks the ability or otherwise chooses not to provide a down payment on a home. We accept loans with LTVs greater than 97% on a limited basis.

 

We write policies on ARMs that primarily are positively amortizing. Payments on these loans are adjusted periodically with interest rate movements. Many of the ARMs have a fixed rate for a stated period of time, and accordingly, most have not yet had payment adjustments. In addition, we insure a small percentage of interest-only mortgages, a variation of an ARM, where the borrower pays only the interest charge on a mortgage for a specified period of time, usually five to ten years, after which the loan payment increases to include principal payments. The interest rate charged on these loans is often adjusted to reflect market interest rate changes. These interest-only loans may have a heightened propensity to default because of possible “payment shocks” due to interest rate increases or the expiration of the initial period of interest-only payments. In a period of economic stress, defined as increasing interest rates and declining housing prices, ARMs and interest-only loans could perform substantially worse than fixed-rate loans. Although, to date, we have not seen the delinquency rates on ARMs vary significantly

from fixed-rate loans, we do not believe that we have sufficient default and claim data under distressed economic conditions to give assurances of their future performance.

 

In our normal course of operations, our existing underwriting policy does not permit coverage of ARMs with “scheduled” negative amortization. ARMs with “potential” negative amortization characteristics, because of possible interest rate increases and borrower payment option changes, are accepted under limited conditions for approved lenders. If a “potential” negative amortization loan does indeed go to a negative amortization status, there will be a greater risk of default, especially in a period of rising interest rates.

 

We believe that 15-year mortgages present a lower level of risk than 30-year mortgages, primarily as a result of the faster amortization and the more rapid accumulation of borrower equity in the property. Accordingly, we charge lower premium rates on these loans than on comparable 30-year mortgages.

 

We believe that the risk of claim is also affected by the type of property securing the insured loan. In our opinion, loans on single-family detached housing are subject to less risk of claim incidence than loans on other types of properties. We believe that attached housing types, particularly condominiums and cooperatives, are a higher risk because, in most areas, condominiums and cooperatives tend to be more susceptible to downward fluctuations in value than single-family detached dwellings in the same market.

 

Loans on primary residences that were owner occupied at the time of loan origination constituted approximately 85% of our risk in force at December 31, 2005. We believe that loans on non-owner occupied properties represent a substantially higher risk of claim incidence and are subject to greater value declines than loans on primary homes. While we do not actively pursue loans on properties not occupied by the owner, we do accept these types of loans as a normal part of our business from our existing customers.

 

Historical evidence indicates that higher-priced properties experience wider fluctuations in value than moderately priced residences. These fluctuations exist primarily because there is a smaller pool of qualified buyers for higher-priced homes, which, in turn, reduces the likelihood of achieving a quick sale at fair market value when necessary to avoid a default. The majority of our direct risk in force is on mortgages of $200,000 or below.

 

Our book of business is relatively unseasoned, having a weighted average life of 2.4 years at December 31, 2005, and 2.2 years at December 31, 2004.

The following table shows direct risk in force as of December 31, 2005 by year of loan origination and the cumulative loss ratios (calculated as direct losses paid divided by direct premiums received, in each case for a particular policy year) that have developed through December 31, 2005 and 2004. It excludes the effects of reinsurance.

 

 

The table above reflects relatively higher cumulative ratios of losses paid to premium received for the 2000 and 2002 policy years at this stage of development. This is due, in part, to a large portion of this business refinancing in recent years and the resulting lower aggregate level of premium received for these policy years.

 

Alt-A continues to grow as a percentage of our Primary insurance in force, and the majority of our Modified Pool insurance is classified as Alt-A. The following table shows the percentage of our insurance in force that we have classified as Alt-A at December 31, 2005 and 2004:

 

Geographic Dispersion

 

The following tables reflect the percentage of direct risk in force on our book of business (by location of property) for the top ten states and the top ten metropolitan statistical areas (“MSAs”) as of December 31, 2005.

 

 

While we continue to diversify our risk in force geographically, a prolonged regional recession, particularly in high concentration areas, or a prolonged national economic recession could significantly increase loss development.

 

Investment Portfolio

 

See a complete discussion of investments in the Investment Portfolio section in the Management’s Discussion and Analysis of Financial Condition and Results of Operations section of this document.

 

Regulation

 

Direct Regulation

 

Our insurance subsidiaries are subject to comprehensive, detailed regulation, principally for the protection of policyholders rather than for the benefit of investors, by the insurance departments of the various states in which each insurer is licensed to transact business. Although their scope varies, state insurance laws, in general, grant broad powers to supervisory agencies or officials to examine companies and to enforce rules or exercise discretion over almost every significant aspect of the insurance business. These include the licensing of companies to transact business and varying degrees of control over claims handling practices, reinsurance requirements, premium rates, the forms and policies offered to customers, financial statements, periodic financial reporting, permissible investments, and adherence to financial standards relating to statutory surplus, dividends, and other criteria of solvency intended to assure the satisfaction of obligations to policyholders.

 

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 furnish to the regulator financial and other information concerning the operations of companies within the holding company system that may materially affect the operations, management, or financial condition of the insurers within the system. Generally, all transactions within a holding company system between an insurer and its affiliates must be fair and reasonable and the insurer’s statutory policyholders’ surplus following any transaction with an affiliate must be both reasonable in relation to its outstanding liabilities and adequate for its needs. Most states also regulate transactions between insurance companies and their parents and/or affiliates. There can be no assurance that state regulatory requirements will not become more stringent in the future and have an adverse effect on us.

 

Because the Company is an insurance holding company and Triad is an Illinois domiciled insurance company, the Illinois insurance laws regulate, among other things, certain transactions in the Company’s common stock and certain transactions between Triad and the Company or affiliates. Specifically, no person may, directly or indirectly, offer to acquire or acquire beneficial ownership of more than 10% of any class of outstanding securities of the

Company or its subsidiaries unless such person files a statement and other documents with the Illinois Director of Insurance and obtains the Director’s prior approval. These restrictions generally apply to all persons controlling or under common control with the insurance companies. “Control” is presumed to exist if 10% or more of Triad’s voting securities is owned or controlled, directly or indirectly, by a person, although the Illinois Director may find that “control,” in fact, does or does not exist where a person owns or controls either a lesser or greater amount of securities. Other states in addition to Illinois may regulate affiliated transactions and the acquisition of control of the Company or its insurance subsidiaries.

 

Triad is required by Illinois insurance laws to provide for a contingency reserve in an amount equal to at least 50% of earned premiums in its statutory financial statements. Such reserves must be maintained for a period of 10 years except in circumstances where high levels of losses exceed regulatory thresholds. The contingency reserve, designed to provide a cushion against the effect of adverse economic cycles, has the effect of reducing statutory surplus and restricting dividends and other distributions by Triad. At December 31, 2005, Triad had statutory policyholders’ surplus of $131.6 million and a statutory contingency reserve of $447.8 million. At December 31, 2004, Triad had statutory policyholders’ surplus of $135.7 million and a statutory contingency reserve of $369.5 million. Triad’s statutory earned surplus was $47.9 million at December 31, 2005, and $51.9 million at December 31, 2004, reflecting an increase in the statutory contingency reserve and the deferred tax liability greater than statutory net income in 2005.

 

The insurance laws of Illinois provide that Triad may pay dividends only out of statutory earned surplus and further establish standards limiting the maximum amount of dividends that may be paid without prior approval by the Illinois Director. Under such standards, Triad may pay dividends during any 12-month period equal to the greater of (i) 10% of the preceding year-end statutory policyholders’ surplus or (ii) the preceding year’s net income to be paid out of earned surplus. In addition, insurance regulatory authorities have broad discretion to limit the payment of dividends by insurance companies. Triad has never paid dividends to the Company. In January 2006, the Company’s Board of Directors authorized it to buy back up to 1,000,000 shares of its common stock dependent on market conditions. Although it is not currently anticipated that Triad would pay dividends to the Company in 2006 in order to fund such stock repurchases, there is no regulatory prohibition preventing the payment of dividends. Triad could pay dividends of $47.9 million to the Company in 2006 without prior regulatory approval.

 

Although not subject to a rating law in Illinois, premium rates for mortgage insurance are subject to regulation in most states to protect policyholders against the adverse effects of excessive, inadequate, or unfairly discriminatory rates and to encourage competition in the insurance marketplace. Any increase in premium rates must be justified, generally on the basis of the insurer’s loss experience, expenses, and future trend analysis. The general mortgage default experience also may be considered.

 

TGAC, organized as a subsidiary of Triad under the insurance laws of the state of Illinois in December 1994, is subject to all Illinois insurance regulatory requirements applicable to Triad.

 

Triad Re, organized as a subsidiary of Triad under the insurance laws of the state of Vermont in November 1999, is subject to all Vermont insurance regulatory requirements applicable to Triad.

 

Triad, TGAC, and Triad Re are each subject to examination of their affairs by the insurance departments of every state in which they are licensed to transact business. The Illinois Insurance Director and Vermont Insurance Commissioner periodically conduct financial condition examinations of insurance companies domiciled in their states. The most recent examinations of Triad and TGAC were issued by the Illinois Insurance Division on June 27, 2005, and covered the period January 1, 1999, through December 31, 2003. No adjustments or material recommendations were made as a result of these examinations. The most recent examination of Triad Re was issued by the Insurance Division of the State of Vermont on September 29, 2005, and covered the period of November 16, 1999 through December 31, 2003. No adjustments or material recommendations were made as a result of the examination.

 

A number of states generally limit the amount of insurance risk that may be written by a private mortgage insurer to 25 times the insurer’s total policyholders’ surplus. This restriction is commonly known as the risk-to-capital requirement.

In the first quarter of 2002, the Office of Federal Housing Enterprise Oversight (OFHEO) released its risk-based capital rules for Fannie Mae and Freddie Mac. The regulation provides capital guidelines for Fannie Mae and Freddie Mac in connection with their use of various types of credit protection counterparties including a more preferential capital credit for insurance from a “AAA” rated private mortgage insurer than for insurance from a “AA” rated private mortgage insurer. The phase-in period for the new rule is ten years. We do not believe the new rules had an adverse impact on us when issued or that the new rules will have a significant adverse impact on us in the future. However, if the new capital guidelines result in future changes to the preferences of Fannie Mae and Freddie Mac regarding their use of the various types of credit enhancements or their choice of mortgage insurers based on credit rating, our financial condition could be significantly harmed.

 

Fannie Mae and Freddie Mac each provide their own automated underwriting system to be used by mortgage originators selling mortgages to them. These systems, which are provided by Triad as a service to the Company’s contract underwriting customers, streamline the mortgage process and reduce costs. The increased acceptance of these products is driving the automation of the process by which mortgage originators sell loans to Fannie Mae and Freddie Mac, a trend that is expected to continue. As a result, Fannie Mae and Freddie Mac could develop the capability to become the decision maker regarding selection of a private mortgage insurer for loans sold to them, a decision traditionally made by the mortgage originator. We, however, are not aware of any plans to do so. The concentration of purchasing power that would be attained if such development, in fact, occurred could adversely affect, from our perspective, the terms on which mortgage insurance is written on loans sold to Fannie Mae and Freddie Mac.

 

Additionally, proposals have been advanced which would allow Fannie Mae and Freddie Mac additional flexibility in determining the amount and nature of alternative recourse arrangements or other credit enhancements that could be utilized as substitutes for private mortgage insurance. We cannot predict if or when any of the foregoing legislation or proposals will be adopted, but if adopted, and depending upon the nature and extent of revisions made, demand for private mortgage insurance may be adversely affected. There can be no assurance that other federal laws affecting such institutions and entities will not change, or that new legislation or regulation will not be adopted.

 

In 1996, the Office of the Comptroller of the Currency (“OCC”) granted permission to national banks to have a reinsurance company as a wholly-owned operating subsidiary for the purpose of reinsuring mortgage insurance written on loans originated, purchased, or serviced by such banks. Several subsequent applications by banks to offer reinsurance have been approved by the OCC including at least one request to engage in quota share reinsurance. The OTS, which regulates thrifts and savings institutions, has approved applications for such captive arrangements as well. The reinsurance subsidiaries of national banks or savings institutions could become significant competitors of ours in the future.

 

In November 1999, the Gramm-Leach-Bliley Act, also known as the Financial Services Modernization Act of 1999, became effective and allows holding companies of banks also to own a company that underwrites insurance. As a result of this Act, banking organizations that previously were not allowed to be affiliated with insurance companies may now do so. This legislation has had very little impact on us to date. However, the evolution of federal law making it easier for banks to engage in the mortgage guaranty business through affiliates may subject mortgage guaranty insurers to more intense competition and risk-sharing with bank lender customers in the future.

 

Web Site Access to Company Reports

 

Through our web site we make available, free of charge, our Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports as soon as reasonably practicable after this material is electronically filed with or furnished to the Securities and Exchange Commission. This material may be accessed by visiting the Investors/Financial Information/SEC Filing Information section of our web site at www.triadguaranty.com.

 

Employees

 

As of December 31, 2005, we employed approximately 230 persons. Employees are not covered by any collective bargaining agreement. We consider our employee relations to be satisfactory.

Executive Officers

 

Our executive officers are as follows:

 

 

William T. Ratliff, III has been the Chairman of the Board of the Company since 1993. Mr. Ratliff has also been Chairman of the Board of Triad since 1989, and was President and General Partner of CML from 1987 to 1995. Since 1995, he has served as President of Collat, Inc., CML’s corporate general partner. Mr. Ratliff has been Chairman of New South Federal Savings Bank (“New South”) since 1986 and President and Director of New South Bancshares, Inc., New South’s parent company, since 1994. From March 1994 until December 1996, Mr. Ratliff served as President of Southwide Life Insurance Corp., of which he had been Executive Vice President since 1993. Mr. Ratliff joined CML in 1981 after completing his doctoral degree with a study of planning processes in an insurance company. Previously, he worked as an educator, counselor, and organizational consultant.

 

Mark K. Tonnesen was employed as President, Chief Executive Officer, and a Director of the Company in September 2005. Previously, Mr. Tonnesen was employed by the Royal Bank of Canada, Toronto, since 1997, where he held a number of positions, including Vice Chairman and Chief Financial Officer, RBC Insurance and Executive Vice President, Card Services and Point of Sale. From 1987 to 1997, he was associated with Banc One Corporation, Columbus, Ohio, where he served in a variety of senior positions, including Chief Development Officer and President, Banc One Credit Card Services Company.

 

Eric B. Dana was employed as Senior Vice President and Chief Financial Officer of the Company in April 2005. Previously, Mr. Dana was employed by The Bankers Bank, since July 2004, most recently as Chief Financial Officer. From 2001 to 2004, he was employed by Lighthouse Financial Services as Chief Operating Officer/Chief Financial Officer. Mr. Dana was in a variety of senior management positions with First Union Corporation from 1988 to 2001.

 

Kenneth N. Lard has been Executive Vice President of the Company and Executive Vice President, Sales and Operations of Triad since October 2004. Mr. Lard was Senior Vice President, Sales and Marketing of Triad from June 2002 to January 2003. From November 1997 to May 2002, Mr. Lard was Senior Vice President, National Sales Director of Triad. From November 1995 to September 1996 Mr. Lard was Vice President, National Accounts of Triad. Prior to joining Triad, Mr. Lard was employed by Signet Bank from 1987 to 1995 as Vice President, Capital Markets Division and most recently as Vice President, Secondary Marketing. Mr. Lard has been with Triad for 9 years and has over 20 years experience in the mortgage industry.

 

Earl F. Wall has been Senior Vice President of Triad since November 1999, General Counsel of Triad since January 1996, and Secretary since June 1996. Mr. Wall was Vice President of Triad from 1996 till 1999. Mr. Wall has been Senior Vice President of the Company since December 1999, and Secretary and General Counsel of the Company since September 1996. Mr. Wall was Vice President of the Company from 1996 to 1999. From 1982 to 1995, Mr. Wall was employed by Integon in a number of capacities including Vice President, Associate General Counsel, and Director of Integon Life Insurance Corporation and Georgia International Life Insurance Corporation, Vice President, and General Counsel of Integon Mortgage Guaranty Insurance Corporation, and Vice President, General Counsel, and Director of Marketing One, Inc.

Kenneth C. Foster has been Senior Vice President, Risk Management of Triad since April 2002. From June 2001 to April 2002 Mr. Foster was Senior Vice President, Product Development of Triad. Prior to joining Triad, Mr. Foster was Principal of Applied Mortgage Solutions from 1994 to 2001. Previously Mr. Foster was employed by MGIC from 1980 to 1994, most recently as Vice President of Business/Information Development. Mr. Foster has been associated with Triad for 9 years and in the insurance/mortgage industry for over 30 years.

 

Officers of the Company serve at the discretion of the Board of Directors of the Company.

 

Our results could be affected by the risk factors discussed below. These factors may also cause actual results to differ materially from the results contemplated by forward-looking statements in our Management’s Discussion and Analysis. Investors should consider these factors in reading this document.

 

If deteriorating economic conditions alter the frequency and severity patterns utilized in our estimates for reserves for losses, we may be required to take additional charges to earnings.

 

Our reserve for losses is based upon the existing level of delinquent loans and our estimate of the ultimate amount for claims that will be paid on those existing delinquent loans. The estimate of losses is based upon the historical frequency and severity patterns of the migration from delinquent loan status to actual claim paid status, adjusted for shifts in the underlying mix and age of business. To the extent that possible future adverse economic conditions such as increasing unemployment rates or declining housing prices alter those historical frequency and severity patterns, actual paid claims on the existing delinquent loans may be greater than the reserves that we have provided and require a charge to earnings.

 

Since, consistent with industry practice, we generally provide reserves only for loans in default that have been reported to us and an estimate of loans in default not yet reported to us, any increase in the level of delinquent loans reported would require an increase to reserves and a charge to earnings.

 

Reserves are provided for the estimated costs of settling claims on loans reported in default and estimates of loans in default that are in the process of being reported to the Company. Consistent with industry accounting practices, the Company does not establish loss reserves for future claims on insured loans that are not currently in default. We generally do not establish reserves until we are notified that a borrower has failed to make at least two payments when due. Deterioration of general economic conditions such as increasing unemployment rates or declining housing prices could adversely alter the historical delinquency patterns resulting in an increase in the level of loans in default. An increase in the level of loans in default would require additional reserves and a charge to earnings as they are reported to us.

 

Because our business is concentrated among relatively few major lenders, our revenues and net income could decline if we lose a significant customer.

 

Our business depends on a relatively small number of customers. Our top ten lenders were responsible for approximately three quarters of our primary new insurance written during the last two years. Additionally, our top two lenders were responsible for approximately half of our Primary new insurance written during the last two years. This concentration of business may increase as a result of further consolidation in the lending industry or other factors. The loss of business from one or more of our major lenders could have an adverse effect on our business, financial condition and operating results.

 

If housing values fail to appreciate or decline significantly, we may incur a higher level of losses from paid claims and also be required to increase reserves.

 

An essential component of our mitigation efforts on mortgage insurance claims is our option of paying our coverage percentage in full satisfaction of our obligations under the policy or paying off the entire loan amount and taking title to the mortgaged property underlying a defaulted loan. The critical assumption behind the purchase option is that the property has appreciated in value since the loan was originated and that we will be able to recover some, or the entire amount at risk, through the acquisition and subsequent sale of the property. We have been

successful to date in our ability to take title to properties and sell them at prices that mitigate these losses. Further, the assumptions utilized in our reserve methodology also have factored in a certain amount of loss mitigation resulting from the utilization of the purchase option. If housing values fail to appreciate or begin to decline, our ability to mitigate our losses on defaulted mortgages may be reduced, which could have an adverse effect on our business, financial condition and operating results.

 

Because a growing portion our business is sensitive to interest rates, a significant increase in rates would cause higher monthly mortgage payments for borrowers that could lead to a greater number of defaults, which would adversely impact our business.

 

A growing portion of our mortgage insurance in force is on adjustable-rate mortgage loans or ARMs. Monthly payments on these loans are altered periodically through an adjustment of the interest rate. Many ARMs have a fixed interest rate for a stated period of time, and accordingly, have not yet been subject to an interest rate adjustment. In periods of rising interest rates, a borrower’s monthly payment will increase. A significant increase in interest rates over a short period of time could lead to “payment shocks” for borrowers that could potentially lead to more reported defaults. In addition, we insure a small percentage of interest-only mortgages, a variation of an ARM, where the borrower pays only the interest charge on a mortgage for a specified period of time, usually five to ten years, after which the loan payment increases to include principal payments. These interest-only loans may have a heightened propensity to default because of possible “payment shocks” after the initial low-payment period expires and because the borrower does not automatically build equity through loan amortization as payments are made. If interest rates increase causing “payment shock” to borrowers with ARMs, our default rate could increase which could have a material adverse impact on our business, financial condition and operating results.

 

The premiums we charge for mortgage insurance on non-prime loans, ARMs and Alt-A loans may not be adequate to compensate for future losses from these products.

 

Our new insurance written includes non-prime loans, ARMs and Alt-A loans that have an increased premium over prime, fixed rate and fully documented loans. The credit quality, loss development and persistency on these loans can vary significantly from our traditional prime loan business. For example, we have experienced higher delinquency and claims rates, and higher average claims paid amounts on the Alt-A loans than in our prime flow portfolios. We expect that we will continue to experience higher default rates for non-prime loans, Alt-A loans and ARMs than for our prime fixed rate loans. We cannot be sure that the premiums including the additional risk charge that we charge on non-prime, ARMs and Alt-A loans will adequately offset the associated risk which could adversely impact operating results.

 

A growing portion of our insurance in force consists of loans with high loan-to-value ratios or loans that are non-prime or both, which could result in more and larger claims than loans with lower loan-to-value ratios or prime loans.

 

A growing portion of our mortgage insurance in force consists of insurance on mortgage loans with LTVs at origination of more than 95%. When we are required to pay a claim on a higher LTV loan, it is generally more difficult to recover our costs from the underlying property, especially in areas with declining property values. Therefore, if we experience a higher default rate on higher LTV loans, our results of operations could be adversely affected.

 

We also insure non-prime loans. The majority of the non-prime loans we insure are known as “Alt-A” loans, which have credit scores commensurate with prime loans but are processed with reduced or no documentation. Our Alt-A loans also tend to have larger loan balances relative to our other loans. Because we have been insuring non-prime loans for a limited period of time, we are still developing data regarding the performance of these loans and there can be no assurance that our estimated default rates and losses will match our actual results. If our estimates prove to be inaccurate, our financial condition and operating results could be adversely affected. Further, we cannot be sure that the increased premiums that we charge for mortgage insurance on non-prime loans will be adequate to compensate us for the losses we incur on these products.

A downgrade or potential downgrade of the financial strength ratings assigned to our primary insurance subsidiary could weaken its competitive position.

 

One or more of S&P, Moody’s or Fitch could downgrade the financial strength ratings assigned to our primary insurance subsidiary, Triad Guaranty Insurance Corporation, if they believe that we have experienced adverse developments in our business, financial condition or operating results. These ratings are important to our ability to market our products and to maintain our competitive position and customer confidence in our products. A downgrade in these ratings could have a material adverse effect on our business, financial condition and operating results. If the financial strength rating assigned to our insurance subsidiary were to fall below “Aa3” from Moody’s or the “AA−” level from S&P and Fitch, then mortgage lenders would not purchase mortgage insurance from us and a large segment of the mortgage securitization market, including Fannie Mae and Freddie Mac, generally would not purchase mortgages or mortgage-backed securities insured by us.

 

Changes in the business practices or legislation relating to Fannie Mae and Freddie Mac could significantly impact our business.

 

Fannie Mae and Freddie Mac are the beneficiaries of the majority of our policies, so their business practices have a significant influence on us. Changes in their practices could reduce the number of policies they purchase that are insured by us and consequently reduce our revenues. Some of Fannie Mae and Freddie Mac’s newer programs require less insurance coverage than they historically have required, and they have the ability to further reduce or eliminate coverage requirements, which would reduce demand for mortgage insurance and have a material adverse effect on our business, financial condition and operating results.

 

Fannie Mae and Freddie Mac also have the ability to implement new eligibility requirements for mortgage insurers and to alter or liberalize underwriting standards on low-down-payment mortgages they purchase which thereby affect the quality of the risk insured by the mortgage insurer and the availability of mortgage loans. Additionally, Fannie Mae and Freddie Mac can alter the terms on which mortgage insurance coverage can be canceled before reaching the cancellation thresholds established by law, and the circumstances in which mortgage servicers must perform activities intended to avoid or mitigate loss on insured mortgages that are delinquent. We cannot predict the extent to which any new requirements may be enacted or how they may affect the operations of our mortgage insurance business, our capital requirements and our products.

 

Legislation and regulatory changes, including changes impacting the GSEs, could significantly affect our business and could reduce demand for private mortgage insurance.

 

Mortgage origination transactions are subject to compliance with various federal and state consumer protection laws, including 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, the Fair Debt Collection Practices Act and others. Among other things, these laws prohibit payments for referrals of settlement service business, require fairness and non-discrimination in granting or facilitating the granting of credit, require cancellation of insurance and refunding of unearned premiums under certain circumstances, govern the circumstances under which companies may obtain and use consumer credit information, and define the manner in which companies may pursue collection activities. Changes in these laws or regulations could adversely affect our operations and profitability.

 

Congress is currently considering proposed legislation relating to the regulatory oversight of the GSEs, their affordable housing initiatives, the GSEs’ products and marketing activities, the GSEs’ minimum capital standards, and their risk-based capital requirements. If adopted in its present form, OFHEO would be replaced by a new federal agency, the Federal Housing Enterprise Regulatory Agency, and its director would be given significant authority over the GSEs including, among other things, oversight of the operations of the GSEs, capital adequacy and internal controls and new program approval. The proposed legislation encompasses substantially all of the operations of the GSEs and is intended to be a comprehensive overhaul of the existing regulatory structure. The proposed legislation could limit the growth of the GSEs, which could result in a reduction in the size of the mortgage insurance market. We do not know what form, if any, such legislation will take, if any, or, if it is enacted, its impact, if any, on our financial condition and results of operations.

In addition, increases in the maximum loan amount or other features of the FHA mortgage insurance program can reduce the demand for private mortgage insurance. Future legislative and regulatory actions could decrease the demand for private mortgage insurance, which could harm our consolidated financial condition and results of operations.

 

Our revenues and profits could decline if we lose market share as a result of industry competition or if our competitive position suffers as a result of our inability to introduce and successfully market new products and programs.

 

There are seven main mortgage insurance providers, of which we are the smallest. The mortgage insurance industry is highly dynamic and intensely competitive. The private mortgage insurance providers are Mortgage Guaranty Insurance Corporation, PMI Mortgage Insurance Company, Genworth Mortgage Insurance Corporation, United Guaranty Residential Insurance Company, Radian Guaranty, Inc and Republic Mortgage Insurance Company. Two of these are subsidiaries of well-capitalized companies with stronger insurance financial strength ratings and greater access to capital than we have.

 

If we are unable to compete successfully against other private mortgage insurers, all of which are larger than we are or if we experience delays in introducing competitive new products and programs or if these products or programs are less profitable than our existing products and programs, our business will suffer

 

If mortgage lenders and investors select alternatives to private mortgage insurance, the amount of insurance that we write could decline, which could reduce our revenues and profits.

 

Competition for private mortgage insurance premiums occurs not only among private mortgage insurers but also with mortgage lenders through captive mortgage reinsurance transactions. In these transactions, a lender’s affiliate reinsures a portion of the insurance written by a private mortgage insurer on mortgages originated or serviced by the lender. Our captive reinsurance program reduces the amount of net premium that we collect through risk sharing, and if we did not establish proper terms or rates, our profitability could suffer. In addition, there are an increasing number of alternatives to traditional private mortgage insurance, and new alternatives may develop, which could reduce the demand for our mortgage insurance. Existing alternatives include:

 

 

Changes in regulatory requirements could impact captive mortgage insurance arrangements for all industry participants.

 

State insurance departments or other officials may conduct investigations or reviews of our business practices such as our captive reinsurance or other risk sharing arrangements. The anti-referral fee provisions of RESPA provide that the Department of Housing and Urban Development (“HUD”) as well as the insurance commissioner or attorney general of any state may bring an action to enjoin violations of these provisions of RESPA. The insurance law provisions of many states prohibit paying for the referral of insurance business and provide various mechanisms to enforce this prohibition. In the summer of 2005, we received an inquiry from the New York Insurance Department relating to captive mortgage insurance arrangements for which we have responded fully. In January of 2006, we received a request for information from the Minnesota Insurance Department regarding our lender captive reinsurance arrangements. While we believe our captive reinsurance arrangements are in conformity with applicable laws and regulations, it is not possible to predict the outcome of any such reviews or investigations nor is it possible to predict their effect on Triad or the entire mortgage insurance industry.

Since we generally cannot cancel mortgage insurance policies or adjust renewal premiums, unanticipated claims could cause our financial performance to suffer.

 

We generally cannot cancel the mortgage insurance coverage that we provide or adjust renewal premiums during the life of a mortgage insurance policy. As a result, the impact of unanticipated claims generally cannot be offset by premium increases on policies in force or limited by non-renewal or cancellation of insurance coverage. The premiums we charge may not be adequate to compensate us for the risks and costs associated with the insurance coverage provided to our customers. An increase in the number or size of unanticipated claims could adversely affect our financial condition and operating results.

 

Our loss experience is likely to increase as our policies continue to age.

 

We expect the majority of claims on insured loans in our current portfolio to occur during the second through the fifth years after loan origination. Primary insurance written from the period of January 1, 2001 through December 31, 2004 represented 64.4% of our Primary risk in force as of December 31, 2005. Accordingly, a significant majority of our Primary portfolio is in, or approaching, its peak claim years. In addition, our 2003 book of business represents 26.3% of its insurance in force as of December 31, 2005, and we believe that it entered its peak claim year in 2005 and will have a continued impact in 2006. We believe our loss experience is likely to increase as our policies age. If the claim frequency on our risk in force significantly exceeds the claim frequency that was assumed in setting our premium rates, our financial condition and results of operations could be adversely affected.

 

Our revenues and DAC amortization depend on the renewal of policies that may terminate or fail to renew.

 

The large majority of our premiums each month have been derived from the monthly renewal of policies that we previously have written. Factors that could cause an increase in non-renewals of our policies include falling mortgage interest rates (which tend to lead to increased refinancings and associated cancellations of mortgage insurance), appreciating home values which can lead to more refinances and mortgage insurance cancellations, and changes in the mortgage insurance cancellation requirements applicable to mortgage lenders and homeowners. Additionally, the amount of DAC amortization expense would be adversely impacted if policies terminate at a rate faster than was originally estimated in our DAC models. A decrease in the length of time that our mortgage insurance policies remain in force reduces our revenues and could have an adverse effect on our business, financial condition and operating results.

 

Our delegated underwriting program may subject our mortgage insurance business to unanticipated claims.

 

A significant percentage of our new insurance written is underwritten pursuant to a delegated underwriting program. These programs permit certain mortgage lenders to determine whether mortgage loans meet our program guidelines and enables these lenders to commit us to issue mortgage insurance. We may expand the availability of delegated underwriting to additional customers. If an approved lender commits us to insure a mortgage loan, generally, we may not refuse, except in limited circumstances, to insure, or rescind coverage on, that loan even if the lender fails to follow our delegated underwriting guidelines. Even if we terminate a lender’s underwriting authority, we remain at risk for any loans previously insured on our behalf by the lender before that termination. The performance of loans insured through programs of delegated underwriting has not been tested over a period of extended adverse economic conditions, meaning that the program could lead to greater losses than we anticipate. Greater than anticipated losses could have a material adverse effect on our business, financial condition and operating results.

 

None.

 

The Company leases office space in its Winston-Salem headquarters and its nine underwriting offices located throughout the country under leases expiring between 2006 and 2012 and which require annual lease payments of approximately $1.3 million in 2006. With respect to all facilities, the Company either has renewal options or believes it will be able to obtain lease renewals on satisfactory terms. The Company believes its existing properties are well utilized and are suitable and adequate for its present circumstances.

 

The Company maintains mid-range and micro-computer systems from its corporate data center located in its headquarters building to support its data processing requirements for accounting, claims, marketing, risk management, and underwriting. The Company has in place back-up procedures in the event of emergency situations.

 

The Company is involved in litigation in the ordinary course of business including the named case below. No pending litigation is expected to have a material adverse affect on the financial position of the Company.

 

Triad is a defendant in Broessel v. Triad. This action was commenced on January 15, 2004 with a filing in Federal District Court for the Western District of Kentucky seeking class action status on behalf of a nationwide class of home mortgage borrowers. The complaint alleges that Triad violated the Fair Credit Reporting Act (“FCRA”) by failing to provide notices to certain borrowers when mortgage insurance was offered to lenders with respect to those borrowers’ mortgage loans at a rate in excess of Triad’s lowest available rate. Discovery is currently underway with respect to class certification. While the ultimate outcome of the FCRA litigation is uncertain, the litigation is not expected to have a material adverse effect on the financial position of the Company.

 

None.

 

 

(a) Market information

 

The Company’s Common Stock trades on The NASDAQ Stock Market^® under the symbol “TGIC.” At December 31, 2005, 14,774,153 shares were issued and outstanding. The following table sets forth the highest and lowest closing prices of the Company’s Common Stock, $0.01 par value, as reported by NASDAQ during the periods indicated.

 

 

In November of 2005, we completed a transaction with Collateral Investment Corp. (“CIC”) in which CIC transferred all of its 2,573,551 shares of our common stock to the Company in exchange for 2,528,514 newly issued shares of our common stock. The 2,573,551 shares transferred by CIC were subsequently retired by us, resulting in a reduction of our outstanding shares of 45,037. CIC has since liquidated and distributed the newly issued Company shares to the CIC shareholders.

 

The newly issued shares were issued by the Company in reliance upon the exemption provided by section 3(a)(9) of the Securities Act of 1933, as amended (“Securities Act”) as an exchange of its common shares with

its existing common stockholders of the Company where no commission or other remuneration was paid or given directly or indirectly for soliciting such exchange.

 

The distribution of the newly issued shares of Company common stock to the CIC shareholders upon liquidation of CIC was made in reliance on section 2(a)(3) under the Securities Act as not an “offer to sell” or “sale” of securities within the meaning of that section of the Securities Act. The Division of Corporate Finance of the Securities and Exchange Commission (the “Commission”) issued its letter dated August 12, 2005 stating that on the basis of the representations made it will not recommend enforcement action to the Commission.

 

(b) Holders

 

As of March 1, 2006, the number of stockholders of record of the Company’s Common Stock was approximately 200. In addition, there were an estimated 7,800 beneficial owners of shares held by brokers and fiduciaries.

 

(c) Dividends

 

Payments of future dividends are subject to declaration by the Company’s Board of Directors. The dividend policy is dependent also on the ability of Triad to pay dividends to the parent company. In January of 2006, the Company’s Board of Directors authorized the repurchase of up to 1,000,000 shares based upon opportunities that may exist from time to time in the marketplace. Currently, there are no present intentions to pay dividends.

 

(d) Issuer purchases of equity securities

 

None.

 

 

 

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations analyzes the consolidated financial condition, changes in financial position, and results of operations for the three years ended December 31, 2005, of Triad Guaranty Inc. and its consolidated subsidiaries, collectively the Company. The discussion should be read in conjunction with the Consolidated Financial Statements and Notes.

 

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. Actual developments and their 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 developments, changes in interest rates or the stock markets, stronger than anticipated competitive activity, as well as the factors described in the Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995 with respect to forward-looking statements contained herein.

 

Critical Accounting Policies and Estimates

 

Accounting estimates and assumptions discussed in this section are those that we consider to be the most critical to an understanding of our financial statements because they inherently involve significant judgments and uncertainties. In developing these estimates, we make subjective and complex judgments that are inherently uncertain and subject to material change as facts and circumstances develop. Although variability is inherent in these estimates, we believe the amounts provided are appropriate based on the facts available upon compilation of the financial statements. Also, see Note 1 to the Consolidated Financial Statements, Summary of Significant Accounting Policies for a complete discussion of our significant accounting policies.

 

Reserves for Losses and Loss Adjustment Expenses

 

We calculate our best estimate of reserves to provide for the estimated costs of settling claims on loans reported in default and loans in default that are in the process of being reported to us as of the date of our financial statements. Our reserving process incorporates various components in a model that gives effect to current economic conditions and profiles delinquencies by such factors as policy year, geography, chronic late payment characteristics, the number of months the policy has been in default, as well as whether the defaults were underwritten as flow business or as part of a structured bulk transaction. We monitor the claims paid performance monthly and we assess the adequacy of our reserve quarterly. The process is based upon the assumption that long-term historical experience, taking into consideration factors such as those described above and adjusted for current economic events that we believe will significantly impact the long-term loss development, provides a reasonable basis for estimating projected claim rates (frequency) and claim amounts (severity). We consider severity and frequency to be the most significant assumptions in the establishment of our loss reserves.

 

The estimation of loss reserves is an inexact process and there are inherent risks and uncertainties involved in making these assumptions. Economic conditions that have affected the development of loss reserves in the past may not necessarily affect development patterns in the future in either a similar manner or degree. Due to the inherent uncertainty in estimating reserves for losses and loss adjustment expenses, there can be no assurance that reserves will be adequate to cover ultimate loss developments on loans in default, currently or in the future. The Company’s profitability and financial condition could be adversely affected to the extent that the Company’s estimated reserves are insufficient to cover losses on loans in default.

 

Because the estimate for loss reserves is sensitive to the estimates of claims frequency and severity, we perform analyses to test the reasonableness of the best estimate generated by the loss reserve process. The loss reserve estimation process and the analyses support the reasonableness of the best estimate of loss reserves recorded in our financial statements. See Losses and Expenses under Consolidated Results of operations for a more detailed discussion of the reserves for losses and loss adjustment expenses.

Investments

 

Valuing our investment portfolio involves a variety of assumptions and estimates, particularly for investments that are not actively traded. We rely on external pricing sources for highly liquid, publicly traded securities and use an internal pricing matrix for privately placed securities. This matrix relies on our judgment concerning a) the discount rate we use in calculating expected future cash flows, b) credit quality and c) expected maturity.

 

We regularly monitor our investment portfolio to ensure that investments that may be other-than-temporarily impaired are identified in a timely fashion, properly valued, and any other-than-temporary impairments are charged against earnings in the proper period. Our methodology to identify potential impairments is further described in the Investment Portfolio section below. The timely identification and valuation of potentially impaired securities involves many judgments. The most significant judgments that we make relate to the estimated future cash flows on potentially impaired securities and our intent and ability to hold a security to anticipated recovery of value. Inherently, there are risks and uncertainties involved in making these judgments. See further discussion of the valuation of our investment portfolio under the Investment Portfolio section below.

 

Deferred Policy Acquisition Costs

 

The costs of acquiring new business, principally commissions and certain policy underwriting and issue costs which are primarily related to the production of new business, are capitalized as deferred policy acquisition costs (DAC). Amortization of such policy acquisition costs is charged to expense in proportion to premium recognized over the estimated policy life. We make judgments in the determination of estimated policy life utilized in the amortization assumptions. The most significant judgment that we make is the estimated life of the DAC. See further discussion of DAC under the Financial Position section below.

 

Overview

 

Through our subsidiaries, we provide Primary and Modified Pool mortgage guaranty insurance coverage to residential mortgage lenders and investors as a credit-enhancement vehicle, typically when individual borrowers have less than 20% equity in the property. Business originated by lenders and submitted to us on a loan-by-loan basis is referred to as our flow channel business. Mortgage guaranty insurance facilitates the sale of individual low down payment loans in the secondary market and provides protection to lenders who choose to keep the loans in their own portfolios. Additionally, we 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. These transactions are referred to as our structured bulk channel business.

 

Our revenues principally consist of 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. Cancellations of policies originated during the past twelve months are not considered in our calculation of persistency. This method of calculating persistency may vary from that of other mortgage insurers. We believe that our calculation presents an accurate measure of the percentage of insurance in force remaining from twelve months prior. Cancellations result primarily from the borrower refinancing or selling mortgaged residential properties and, to a lesser degree, from the borrower achieving prescribed equity levels at which the lender no longer requires mortgage guaranty insurance.

Consolidated Results of Operations

 

Following is selected financial information for the last three years and the percentage change from year-to-year:

 

 

Net income for 2005 declined from 2004, as losses and loss adjustment expenses grew faster than earned premium during 2005. The growth in net losses and loss adjustment expenses in 2005 is principally a result of the ongoing seasoning of our insurance portfolio. In 2005, we experienced an increase in the number of paid claims, the number of reported defaults, and the severity of paid claims causing us to significantly increase our reserve for losses to reflect these trends. We experienced growth in earned premiums in 2005, driven by moderate growth of our risk in force combined with an increase in premium basis points related to specific lender programs and a change in the mix of business.

 

Comparing 2004 to 2003, losses and loss adjustment expenses grew at a rate exceeding the growth in earned premium, but at a much more moderate rate than occurred in 2005. This increase in losses and loss adjustment expenses reflected the seasoning of our insurance portfolio as over 80% of the insurance in force was less than two years old at December 31, 2003. A substantial increase in persistency in 2004 contributed to both the increase in earned premiums and a reduction in expenses through lower DAC amortization when compared to 2003.

 

The changes in diluted earnings per share in 2005 and 2004 were consistent with the changes in net income for those years. Diluted realized investment gains, net of taxes, had no impact on diluted earnings per share in 2005 compared to an increase of $0.02 in 2004 and $0.13 in 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.

 

We describe 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.

 

Production and In Force

 

A summary of new production broken out between Primary and Modified Pool and the year-to-year percentage changes follows:

 

 

The overall mortgage loan origination market was relatively flat in 2005 compared to 2004. Additionally, the percentage of loan originations for which mortgage insurance was provided declined in 2005. The decline was due primarily to the continued expansion of alternative credit enhancements such as 80-10-10 structures. In spite of the relatively flat overall loan origination market in 2005, we were able to show an increase in production reflected in a net gain in market share. Refinances were a large part of the overall mortgage loan origination market in 2003 when borrowers took advantage of historically low rates during that period, resulting in a record amount of originations in

2003. Refinances comprised 52% of our Primary insurance written in 2003 compared to 31% in 2005 and 30% in 2004. These factors caused our Primary insurance written to decline in 2005 and 2004 from levels achieved in 2003.

 

We anticipate that the overall mortgage loan origination market will be smaller in 2006 than in 2005, which could further moderate our Primary new insurance written. Assuming mortgage interest rates remain constant or continue to slowly increase, we expect to see production of Primary new insurance written in 2006 to be at levels slightly lower than that achieved in 2005. Further, we believe that the 80-10-10 loan penetration will soften in 2006. If short-term interest rates continue to rise, this type of financing should become less attractive to borrowers, which could partially mitigate the overall reduction of Primary insurance written.

 

Our Modified Pool insurance written grew significantly in 2005 and 2004 due to strong production in that market. We write Modified Pool insurance only through our structured bulk channel. We believe there will continue to be additional opportunities in the structured bulk market in 2006, and we will pursue those transactions that meet our loan quality and pricing objectives. Modified Pool insurance written is likely to vary significantly from period to period due to: a) the limited number of transactions (but with larger size) occurring in this market, b) the level of 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.

 

Although terms vary, the structured bulk market can be broadly categorized into three different segments, or tiers, depending on the risk characteristics of the loans comprising a transaction. The loan characteristics of the three segments are a) predominantly high credit quality, low loan to value (LTV), fully underwritten loans that may have niche characteristics such as non-conforming loan balances and risk concentrations related to geography, transaction purpose, or occupancy type; b) loans that generally have high credit quality and low to moderate LTVs that have been underwritten with reduced, streamlined, or no documentation; and c) generally fully underwritten loans with credit impaired borrowers (FICO credit score less than 575). In general, we believe that structured bulk business originated in segments b) and c) will report a higher default rate than our Primary business. However, we also believe that the lower LTVs associated with the structured bulk business originated in segments a) and b) will ultimately generate lower claim rates as a proportion of the reported defaults and lower levels of severity than Primary business. We have entered into structured bulk transactions primarily in the first two segments mentioned above. At December 31, 2005 and 2004, only approximately 1% of our insurance in force attributable to structured bulk transactions was categorized in segment c) above.

 

The following table provides estimates of our national market share of net new insurance written, using industry definitions, through our flow and structured bulk channels based on information available from the industry association and other public sources for the years ended December 31, 2005, 2004 and 2003:

 

 

Our market share of flow business increased in 2005 due to increased writings with our targeted lenders, specifically with special lender-paid programs that applied primarily to non-prime loans. These special lender-paid programs are competitively priced among mortgage insurers and the production can vary from period to period, depending upon our willingness to accept the specific risk characteristics of these products. As mentioned earlier, our structured bulk market share will vary from period to period since this market can have significantly larger transactions and our share of this market is dependent on the availability of transactions that meet our credit quality and pricing benchmarks and on our ability to bid successfully for these transactions.

 

The risk characteristics applicable to our Primary production have changed somewhat over the past three years. The most significant trend over the last three years has been our increased participation in the Alt-A marketplace. We have defined Alt-A as individual loans having FICO scores greater than 619 and that have been underwritten

with reduced or no documentation. The following table summarizes the credit quality characteristics of our Primary new insurance written over the past three years and reflects the growth in our Alt-A production:

 

 

Other risk characteristics that we consider in our underwriting discipline include the percentage of adjustable rate mortgages (ARMs) and the percentage of loans with LTV greater than 95%. The following table summarizes the percentage of our Primary production in ARMs and higher LTV loans over the past three years:

 

 

The majority of our Modified Pool production has been in the Alt-A marketplace over the last three years. As mentioned earlier, the LTVs on policies originated in the structured bulk channels are generally lower than those on policies we receive via the flow channel. Those policies may also have other Primary coverage in front of our risk. The percentages of ARMs included in our Modified Pool production approximate those included in our Primary production during the last three years.

 

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, these policies are not reflected in our insurance in force, new insurance written, or related industry data totals until we verify the loan level detail. At December 31, 2005, we had approximately $979 million of structured transactions with effective dates within the fourth quarter for which loan level detail had not been received and, therefore, are not included in our own data or industry totals. These amounts will be reported as new production and insurance in force totals in 2006, when the issuer of the transactions provides accurate loan level detail to us. We have included in premium written and premium earned the respective estimated amounts due and earned during 2005 related to this insurance. At December 31, 2004 we had $685 million of structured transactions with effective dates within 2004 for which loan level detail had not been received.

 

The following table provides detail on our direct insurance in force at December 31, 2005, 2004 and 2003 (in millions, except percentages):

 

 

Our Primary insurance in force grew in 2005 and in 2004 as a result of continued production and improvements in persistency. Primary insurance persistency improved to 70.0% at December 31, 2005 compared to 68.5% at December 31, 2004 and 52.2% at December 31, 2003. The average mortgage coupon rates in our existing portfolio have declined over the past three years as a result of relatively heavy refinancings and lower rates on mortgages for home purchases than our existing average rate. Additionally, mortgage rates in the market have recently remained flat or increased slightly which will deter those borrowers seeking lower coupon rates. These conditions have caused a reduction in cancellations from refinancing and, therefore, an increase in persistency. We anticipate that persistency rates will continue near current levels or increase moderately for 2006. However, persistency may be adversely affected if market interest rates decline significantly from the levels experienced during 2005.

Our Modified Pool insurance in force grew significantly in 2005 and in 2004 due to our strong production in that market. Approximately 39%, 81% and 60% of our insurance written attributable to our structured bulk channel during 2005, 2004, and 2003, respectively, was structured with deductibles that put us in the second loss position. The decline in Modified Pool insurance written with deductibles in 2005 was the result of increased business with entities that do not utilize deductibles in their structures, although the use of deductibles remains an effective part of our Modified Pool risk management strategy.

 

Alt-A continues to grow as a percentage of our Primary insurance in force, and the majority of our Modified Pool insurance is classified as Alt-A. The following table shows the percentage of our insurance in force broken out by product and in total that we have classified as Alt-A at December 31, 2005, 2004 and 2003:

 

 

We offer mortgage insurance structures designed to allow lenders to share in the risks of mortgage insurance. One such structure is our captive reinsurance program under which a reinsurance company, generally an affiliate of the lender, assumes a portion of the risk associated with the lender’s insured book of business in exchange for a percentage of the premium. The following table shows the percentage of our direct insurance in force that was subject to captive reinsurance arrangements at December 31, 2005, 2004 and 2003.

 

 

The growth of the percentage of Primary direct insurance in force that was subject to captive reinsurance arrangements in 2005 and in 2004 was the result of increased production from lenders that participate in captive reinsurance arrangements. The declines in the percentage of total direct insurance in force subject to captive reinsurance in 2005 and in 2004 reflect the fact that a greater portion of our insurance in force consists of Modified Pool insurance in force. None of our Modified Pool insurance in force is subject to captive reinsurance arrangements.

 

We believe captive reinsurance arrangements are an effective risk management tool as selected lenders share in the risk under these arrangements. Additionally, captive reinsurance arrangements are structured so that Triad receives credit against the capital required in certain risk-based capital models utilized by rating agencies. We remain committed to structuring captive reinsurance arrangements, including deep ceded arrangements where the net premium cede rate is greater than 25%, on a lender-by-lender basis as we deem it to be prudent. We will continue to be an active participant with our lender partners in captive reinsurance arrangements.

Revenues

 

A summary of the individual components of our revenue for the past three years and the year-to-year percentage changes follows:

 

 

We experienced strong growth in earned premiums in both 2005 and 2004, primarily due to an increase in net premium written. Direct premium written is comprised of premium written for both Primary and Modified Pool business. Our growth in total direct premiums written in 2005 over 2004 was the result of the growth of our insurance in force, offset somewhat by a decline in average basis points as Modified Pool business comprised a greater percentage of our insurance in force. The premium rate for Modified Pool business, when calculated on insurance in force, is generally lower than that of Primary business due to the structures of the bulk transactions (which may include a stop loss limit and/or a deductible) that serve to reduce the overall risk assumed in the transaction. Renewal premiums increased $33.8 million or 21.2% in 2005 over 2004 as a result of growth in overall production and improved persistency. Initial, or new, premiums declined $3.2 million or 18.2% due to net lower premium basis points on Modified Pool transactions, especially those that are subject to deductibles, and a higher percentage of our production from Modified Pool business. Our growth in total direct premiums written in 2004 over 2003 was primarily due to a $31.3 million growth in renewal premiums partially offset by an $8.6 million decline in direct initial premiums. The growth of risk in force in 2004, resulting from improved persistency, drove the increase in renewal premiums over 2003. The declines in refinancing activity combined with increased popularity of alternative credit enhancements were the primary drivers of the decline in initial premiums in 2004 from 2003.

 

During 2005, the average premium rate on Primary risk in force increased as the result of a greater percentage of our risk in force in the Alt-A and ARM products that require higher premium rates. The following tables highlight the percentages of the Primary risk in force by credit quality and loan type at December 31 for the last three years:

 

Ceded premium written is comprised of premiums written under excess of loss reinsurance treaties with captive as well as non-captive reinsurance companies. Ceded premiums written increased in 2005 and 2004 due to an increase in the amount of premium subject to captive reinsurance arrangements. The following table provides further data on ceded premiums for the years ended December 31, 2005, 2004 and 2003:

 

 

The table below provides data on insurance written that was subject to captive reinsurance arrangements for the years ended December 31, 2005, 2004 and 2003:

 

 

The percentage of Primary insurance written subject to captive reinsurance arrangements was relatively flat in 2005 compared to 2004. The increase in the percentage of Primary insurance written subject to captive reinsurance arrangements in 2004 from 2003 was due to the decline of production of certain lender-paid programs that were not subject to captive reinsurance arrangements in 2003. The declines in the percentage of total insurance written subject to captive reinsurance in 2005 and in 2004 were a result of Modified Pool insurance written comprising a greater portion of our total insurance written in both of these years. None of our Modified Pool insurance written in 2005, 2004 and 2003 was subject to captive reinsurance arrangements.

 

The difference between net written premiums and earned premiums is the change in the unearned premium reserve. Our unearned premium liability declined $2.4 million from December 31, 2004 to December 31, 2005 compared to an increase of $0.3 million from December 31, 2003 to December 31, 2004. An unearned premium reserve is established primarily on premiums received on annual products, which prior to 2005 was largely attributed to Modified Pool transactions. During 2005, many of the new transactions required the remittance of premium on a quarterly or monthly basis as opposed to annually, which will further decrease the unearned premium liability going forward. Direct written premiums from the annual premium product represented 11.8% of direct premium written in 2005 compared to 15.5% of direct premium written in both 2004 and 2003, respectively.

 

Assuming no significant decline in interest rates, we anticipate our persistency will remain at current levels with a bias toward improvement in 2006. This should continue to have a positive effect on renewal earned premiums and total earned premiums in 2006. Overall, based upon the above production and persistency assumptions, we expect that earned premiums will continue to increase in 2006, but at a lower level of growth than was achieved in 2005.

 

Net investment income grew in 2005 and in 2004 primarily due to the growth in average invested assets in both years, partially offset by declines in portfolio yields. Average invested assets at cost or amortized cost grew by 17.6% in 2005 and 20.6% in 2004 as a result of the investment of cash flows from operations throughout those years. Our investment portfolio tax-equivalent yield was 6.77%, 6.99%, and 7.13% at December 31, 2005, 2004 and 2003, respectively. We expect to see a growth in invested assets in 2006; however, we anticipate a continuing decline in the overall portfolio tax-equivalent yield as current interest rates are still below our average portfolio rate. See further discussion of the Investment Portfolio later in this document.

 

Net realized investment gains, except for write-downs on other-than-temporarily impaired securities, are the result of our discretionary dispositions of investment securities in the context of our overall portfolio management strategies and are likely to vary significantly from period to period. We wrote down other-than-temporarily impaired

securities by approximately $0.2 million in 2005 compared to $0.5 million in 2004 and $0.8 million in 2003. See further discussion of impairment write-downs in the Realized Losses and Impairments section below.

 

Losses and Expenses

 

A summary of the individual components of losses and expenses and the year-to-year percentage change follows:

 

 

Net losses and loss adjustment expenses (LAE) are comprised of both paid losses and the change in loss and LAE reserves during the period. Net losses and LAE increased significantly in 2005 over 2004 due to increases in both paid claims and reserves as a result of the continued seasoning of our portfolio. We will focus separately on both paid claims and the increase in defaults.

 

The following table provides detail on paid claims and the average severity for our Primary and Modified Pool insurance for the years ended December 31, 2005, 2004 and 2003:

 

 

Paid claims increased in 2005 and in 2004 due to the overall growth of the insurance portfolio and the seasoning of our portfolio as a larger percentage of our insurance in force reaches its anticipated highest claim frequency period of years two to five from loan origination. To assist in the understanding of the seasoning process and the impact on paid claims, we have provided the following table that presents the percentage of Primary risk in

force at December 31, 2005, 2004 and 2003 by policy year (which is defined as the year the insurance became effective):

 

 

At December 31, 2003, 80.3% of the insurance in force was originated in the prior two years and would not have generated a significant amount of paid claims in 2003. The percentage of insurance in force less than two years old decreased to 75.3% at December 31, 2004 and 57.9% at December 31, 2005 and thus, more of our insurance in force is currently in its peak claim paying period.

 

The increase in average severity also contributed to the growth in paid losses. The increase is reflective of the larger loan sizes and, as mentioned earlier, also reflects the growth of Alt-A loans that generally have a larger average loan balance than the rest of our portfolio.

 

We expect the average severity will continue to trend upward as the newer policy years develop and the average loan amounts rise with the increase in housing prices. However, our average severity on paid losses can fluctuate from year to year as a result of the relatively small number of claims paid in a given period. The anticipated increase in severity and the further seasoning of the insurance portfolio indicate that paid losses will trend upward in 2006.

 

Net losses and loss adjustment expenses also include the change in reserves for losses and loss adjustment expenses. The following table provides further information about our loss reserves at December 31, 2005, 2004 and 2003 broken out by Primary and Modified Pool insurance (in thousands):