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:

 

 

Securities registered pursuant to Section 12(g) of the Act:
None

 

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: $530,001,050 as of June 30, 2006, 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, 2007, was 14,862,243.

 

 

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 as a credit-enhancement vehicle. 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., now called Collateral Holdings, Ltd. (“CHL”), a mortgage banking and real estate lending firm located in Birmingham, Alabama. In 1990, CHL 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. 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. Currently, CHL owns 17.3% of the outstanding common stock of the Company, which it acquired in 1993 from the Company in exchange for the cancellation of debt, prior to the initial public offering.

 

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.

 

MI 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, MI reduces, and in some instances eliminates, any loss to the insured lender. MI also facilitates the sale of low down payment mortgage loans in the secondary mortgage market, with the largest percentage to the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”). Investors and lenders also purchase MI to obtain additional default protection or capital relief on loans with equity of greater than 20%. Under risk-based capital regulations applicable to most financial institutions, MI reduces the capital requirement for such lenders on residential mortgage loans retained in the lender’s portfolio.

 

Currently, Triad is licensed to do business in all fifty U.S. states and the District of Columbia. In May 2006, we submitted an application to incorporate a Canadian subsidiary to begin operations in Canada. The Canadian company will be a monoline provider of MI and, pending regulatory approvals, is expected to start operations sometime in 2007.

 

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 “insured amount” or “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 when we are in the first loss position and the loan-to-value (“LTV”) ratio is 80% or greater when the loan

is first insured. Primary insurance comprised approximately 60% and 67% of our total direct insurance in force at December 31, 2006 and 2005, respectively.

 

We offer coverage generally from 12% to 37% of the insured 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, all of which may affect the 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 those loans originated by lenders and submitted to us on a loan-by-loan basis. However, special risk rates are often utilized as well.

 

Premiums on Primary insurance generally 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 57% and 68% of Primary insurance was written under our borrower paid plans during 2006 and 2005, respectively. The remainder was written under our lender paid plans (43% and 32% of Primary insurance during 2006 and 2005, 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 91% and 96% of Primary insurance written in 2006 and 2005, 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 8% and 4% of Primary insurance written in 2006 and 2005, 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 1% or less of Primary insurance written in 2006 and 2005.

 

Modified Pool Insurance

 

Modified Pool insurance is written only on structured bulk transactions through the structured bulk channel. Structured bulk transactions 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  (typically secondary coverage or on loans for which the individual borrower has greater than 20% equity), capital relief, and credit enhancement on groups of loans that are 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), which is typically between 50% and 65%. We are provided loan-level information on the group of loans, and, based on the risk characteristics of the entire group of loans, the requirements of the secondary mortgage market participant and any associated stop loss level or deductible amount, we submit a price for insuring the entire group of loans through a bid process. The majority of premiums for our Modified Pool insurance are remitted monthly. We compete primarily against other forms of credit enhancement provided by the capital markets for these transactions as well as other mortgage insurers.

 

Structured bulk transactions frequently include an aggregate stop-loss limit applied to the entire group of insured loans. Additionally, some of the structured bulk transactions we enter include deductibles under which we pay no claims until the losses exceed the deductible amount.

 

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, 2006. 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, 2006, the first layer retained by Triad ranged from the first 3.0% to 6.5% of risk originated 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 captive 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, 2006 and 2005, 35% and 39% of insurance in force was subject to captive reinsurance programs. Through December 31, 2006, we had not used captive mortgage reinsurance or other risk-sharing arrangements with Modified Pool insurance.

 

Distribution Channels

 

We sell mortgage insurance through two distribution channels. Our flow channel consists of loans originated by lenders and submitted to us on a loan-by-loan basis. All insurance delivered through the flow channel is classified as Primary insurance.

 

Through the structured bulk channel, we participate in bids for structured bulk transactions that meet our loan quality and pricing criteria. Modified Pool insurance is only written through the structured bulk channel, and some Primary insurance is written through the structured bulk channel.

 

Cancellation of Insurance

 

We cannot cancel mortgage insurance coverage except for nonpayment of premium or certain material violations of the master policy. Coverage generally remains renewable at the option of the insured lender. In most cases, 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 preceeding twelve-month period, was 23% and 31% for 2006 and 2005, 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 coverage. 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 that were agreed to by both parties in advance).

 

Competition within the mortgage insurance industry continues to increase as many large mortgage lenders have limited the number of mortgage insurers with whom they do business. At the same time, consolidation among national lenders has increased the share of the mortgage origination market controlled by the largest lenders and that has led to further concentrations of business with a relatively small number of lenders. Many of the national lenders allocate Primary business to several different mortgage insurers. These allocations can vary over time. Our strategy is to continue our focus on national lenders while maintaining the productive relationships that we have built with regional lenders.

 

In 2006, our ten largest customers were responsible for 80% of insurance written through the flow channel compared to 77% in 2005. The loss of, or considerable reduction in, business from one or more of our significant

customers, without a corresponding increase from other lenders, would have an adverse effect on our business. Those customers whose revenue comprised more than 10% of our consolidated revenue are listed below:

 

 

Sales and Marketing

 

We currently market our insurance products through a dedicated sales force of approximately 45 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 Senior Vice President and National Sales Manager oversees all of our sales activities and reports directly to our Chief Executive Officer. 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 with larger national mortgage originators.

 

The marketing department develops and implements programs in support of our sales objectives and to promote our image and reports directly to the Chief Executive Officer. 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.

 

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”). 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 largest percentage of our mortgage insurance policies, so their business practices have a significant influence on us. Changes in their practices could reduce the number of loans they purchase that are insured by us and consequently reduce our revenues. Some of the programs put into place by Fannie Mae and Freddie Mac in recent years 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 or reduce the level of coverage that we provide, both of which could 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, Radian Guaranty Inc., PMI Mortgage Insurance Co., United Guaranty Corporation, Genworth Financial, Inc. and Republic Mortgage Insurance Company. Triad is the smallest private mortgage insurer based on 2006 market share and, according to estimated industry data, had a 9.1% share of total net new insurance written in 2006 compared to 7.5% in 2005. In February 2007, Mortgage Guaranty Insurance Corporation and Radian Financial Group announced their intention to merge in the later part of 2007, subject to various regulatory approvals.

 

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, product analysis, prudent underwriting, the use of automated risk evaluation models, sophisticated risk modeling, auditing, and knowledge of our customers are all important elements of our risk management process.

 

Underwriting Personnel

 

Our 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. She has been in her current position for less than one year, however, she has been with the Company for over 10 years and has over 30 years of industry experience. 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 March 2006 and has over 10 years of financial services industry experience.

 

We employed an underwriting staff of approximately 35 at December 31, 2006. 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:

 

 

We believe that 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 ratio is greater than a loan with a lower LTV ratio, all else being equal. Loans with an LTV ratio greater than 95% are offered primarily to low and moderate-income borrowers. These loans have often attracted borrowers with weaker credit histories, generally resulting in higher loss ratios. The State of Illinois Division of Insurance, as well as the insurance departments of several other states, permit mortgage insurers to write coverage on loans with LTV ratios 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 LTV ratios 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. In keeping with our established risk strategy, we have not aggressively solicited loans with high LTV ratios, and accept loans with LTV ratios greater than 97% on a limited basis. We do not routinely delegate the underwriting of high LTV loans. We believe the higher premium rates charged on high LTV loans adequately reflect the additional risk.

 

Generally, we seek loan types with sufficient historical data from which an assessment of risk can be readily made and the premium received sufficiently offsets that risk. However, the production of adjustable rate mortgages (“ARMs”) has increased in the mortgage market, and we have increased our production of ARMs as well. 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 (some significantly below then existing market rates sometimes referred to as teaser rates), and most of those included in our recent production have not yet had interest rate-related payment adjustments. These ARMs that are still in the fixed rate term of their contract may have a heightened propensity to default because of possible “payment shocks” due to interest rate increases, especially in a period of increasing interest rates and declining housing prices. We also insure a small percentage of interest-only mortgages, a variation of an ARM, where the borrower pays only the interest due 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 also be subject to a larger percentage of future defaults than fixed rate loans because of the same payment shocks due to the expiration of the initial period of interest-only payments, especially in a period of increasing interest rates and declining housing prices. We accept ARMs with “potential” negative amortization under certain conditions from approved lenders. ARMs with “potential” negative amortization include pay option ARMs, which we define as those that provide a fixed period of time for which the borrower has the option to pay monthly payments that are less than the interest accrued for those months. If the borrower elects this option, the LTV increases on the loan. Because the LTV can increase on a pay option ARM, these types of loans may present more risk to a mortgage insurer than traditional positive amortizing loans. We classify all loans with adjustable interest rates as ARMs, including those for which the interest rate is fixed for a certain period of time. 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. Loans, such as these, that do not have sufficient historical data are charged a higher premium.

 

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 type of property securing the insured loan also affects the risk of claim. 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.

 

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. We insure loans on properties not occupied by the owner (generally second homes or rental homes) 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.

 

 

Underwriting Process for Our Flow Distribution Channel

 

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 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 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 63% of applications received through the flow distribution channel in 2006 compared to 65% in 2005. 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 control 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 evaluate the risk factors of the individual loans contained within the transaction. The risk factors that we evaluate include the mortgage lender, purpose and type of loan, individual borrower, geography, and our risk dispersion as discussed in the “Risk Management Approach” section above. The pertinent risk characteristics of each loan are evaluated to determine the impact on the entire transaction’s persistency and frequency and severity of loss. We may utilize an outside due diligence firm in this process as well as mortgage risk analysis models such as Standard & Poor’s LEVELS^® or LoanPerformance. 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, depending on the results of the above evaluation as part of our risk management approach.

 

Other Risk Management

 

As discussed earlier, we have expanded the risk characteristics that we pursue in both the Primary and Modified Pool marketplaces based, in part, on the change in the overall mortgage origination market. That change has been overseen by our Credit Risk Committee, which is composed of certain 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.

 

We employ a comprehensive quality assurance 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 an LTV 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 a loan to 25% of the insured 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, 2006 and 2005, TGAC assumed approximately $127 million and $81 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. During 2006, we maintained $125 million of excess of loss reinsurance through non-affiliated reinsurers that had financial strength ratings of “AA” or better from Standard & Poor’s. Effective January 1, 2007, we elected not to renew $25 million of this excess of loss reinsurance.

 

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, our master policy provides that we are not liable to pay a claim for loss 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 (generally 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 continue to expand the use of our option to purchase properties in settlement of claims. At December 31, 2006, we held 68 properties with a combined net realizable value of approximately $10.2 million that were acquired by electing to pay the full claim amount compared to 48 properties with a combined net realizable value of approximately $5.7 million held at December 31, 2005. 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. In general, the claims severity is lower on properties acquired than on those for which we paid the settlement option, although the number of claims paid under the settlement option 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 77% and 75% of potential exposure on all claims in 2006 and 2005, respectively. However, as evidenced in the fourth quarter of 2006, factors such as the weakness in the housing market beginning in the last half of 2006 may hinder our ability to maintain this level of loss mitigation success.

 

Loss Reserves

 

We calculate our best estimate of the reserve for losses 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 segments defaults by a variety of criteria. The criteria include, among others, policy year, lender, geography and the number of months and number of times 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. See the “Critical Accounting Policies” section of “Management’s Discussion and Analysis of Financial Condition and Results of

Operations” for a more detailed discussion of the loss reserving process. Detailed analysis of the activity in loss reserves is provided in the “Losses and Expenses” section of “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 4 to the Consolidated Financial Statements.

 

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 credit quality 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 (for example fixed, positively or negatively amortizing ARM), 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.

 

We had $9.4 billion of direct risk in force as of December 31, 2006 compared to $8.0 billion 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.

 

Geographic Dispersion

 

The following tables reflect the percentage of direct risk in force on our book of business for the top ten states and the top ten metropolitan statistical areas (“MSAs”) by location of property as of December 31, 2006.

 

 

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.

 

See the “Production and In Force” section of “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section of this document for further detailed discussion on the characteristics of our direct risk in force.

 

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 prescribed levels of losses exceed regulatory thresholds. During 2006, Triad experienced a loss ratio in excess of 35%, which allowed it to release approximately $19 million of previously established contingency reserves to surplus. 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, 2006, Triad had statutory policyholders’ surplus of $168.4 million and a statutory contingency reserve of $521.8 million. At December 31, 2005, Triad had statutory policyholders’ surplus of $131.6 million and a statutory contingency reserve of $447.8 million. Triad’s statutory earned surplus was $84.7 million at December 31, 2006, and $47.9 million at December 31, 2005, reflecting statutory net income for 2006 and a reduction in the deferred tax liability, partially offset by an increase in the statutory contingency reserve.

 

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. In addition, insurance regulatory authorities have broad discretion to limit the payment of dividends by insurance companies. Through December 31, 2006, there have been no dividends paid by the insurance subsidiaries to our parent company. Further, as of December 31, 2006, there are no specific restrictions or requirements for capital support arrangements between the parent company and Triad or its subsidiaries.

 

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. At December 31, 2006 Triad’s risk-to-capital ratio was 12.5-to-1.

 

State insurance laws and regulations generally restrict mortgage insurers to writing residential mortgage guaranty insurance business only. This restriction generally prohibits Triad from using its capital resources in support of other types of insurance and restricts its noninsurance business. However, noninsurance businesses of the Company would not be subject to regulation under state insurance laws.

 

Regulation of reinsurance varies by state. Except for Illinois, Wisconsin, New York, Ohio, and California, most states have no special restrictions on reinsurance that would apply to private mortgage insurers other than standard reinsurance requirements generally applicable to property and casualty insurance companies. Certain restrictions, including reinsurance trust fund or letter of credit requirements, apply under Illinois law to domestic companies and under the laws of several other states to any licensed company ceding business to unlicensed reinsurers. If a reinsurer is not admitted or approved, the company doing business with the reinsurer cannot take credit in its statutory financial statements for the risk ceded to such reinsurer absent compliance with the reinsurance security requirements. In addition, some states in which Triad does business have limited private mortgage insurers to a maximum policy coverage limit of 25% of the insured’s claim amount and require coverages in excess of 25% to be reinsured through another licensed mortgage insurer.

 

The National Association of Insurance Commissioners (“NAIC”) adopted a risk-based capital (“RBC”) formula designed to help regulators identify property and casualty insurers in need of additional capital. The RBC formula establishes minimum capital needs based upon risks applicable to individual insurers, including asset risks, off-balance sheet risks (such as guarantees for affiliates and contingent liabilities), and credit risks (such as reinsurance ceded and receivables). The NAIC and the Illinois Insurance Division currently do not require mortgage guaranty insurers to file RBC analysis in their annual statements.

 

As of the date of this report, we have not received a license to operate in Canada. The Office of the Superintendent of Financial Institutions (“OSFI”) functions as the national regulator of insurance companies in Canada, and our application with OSFI is proceeding as expected. After OSFI approval, there remain other approvals, including a Department of Finance guaranty and certain provincial approvals.

As significant purchasers and sellers of conventional mortgage loans and beneficiaries of private mortgage guaranty insurance, Fannie Mae and Freddie Mac impose eligibility requirements on private mortgage insurers in order for such insurers to acquire business from them. These requirements include limitations on the types of risk insured, standards for geographic and customer diversification of risk, procedures for claims handling and acceptable underwriting practices. These requirements generally mirror the financial requirements of statutory insurance regulations and are subject to change from time to time.

 

While Triad is an approved mortgage insurer for both Fannie Mae and Freddie Mac and meets all existing eligibility requirements, there can be no assurance that such requirements or the interpretation of the requirements will not change or that Triad will continue to meet such requirements. In addition, to the extent Fannie Mae or Freddie Mac assumes default risk for itself that would otherwise be insured, changes current guarantee fee arrangements, allows alternative credit enhancements, alters or liberalizes underwriting guidelines on low down payment mortgages it purchases, or otherwise changes its business practices or processes with respect to such mortgages, private mortgage insurers may be affected. Triad could be adversely affected if changes in eligibility requirements regarding captive arrangements were to impede Triad’s ability to offer this form of captive reinsurance.

 

Fannie Mae and Freddie Mac both accept reduced mortgage insurance coverage from lenders that deliver loans approved by their automated underwriting services. Generally, Fannie Mae’s and Freddie Mac’s reduced mortgage insurance coverage options provide for (i) across-the-board reductions in required MI coverage on 30-year fixed-rate loans recommended for approval by their automated underwriting services to the levels in effect in 1994; (ii) a reduction in required MI coverage for loans with only a 5% down payment (a 95% LTV loan) from 30% to 25% of the mortgage loan covered by MI; and (iii) a reduction in required MI coverage for loans with a 10% down payment (a 90% LTV loan) from 25% to 17% of the mortgage loan covered by MI. In addition, Fannie Mae and Freddie Mac have implemented other programs that further reduce MI coverage upon the payment of an additional fee by the lender. Under this option, a 95% LTV loan will require 18% of the mortgage loan to have mortgage insurance coverage. Similarly, a 90% LTV loan will require 12% of the mortgage loan to have mortgage insurance coverage. In order for the homebuyer to have MI at these levels, such loans would require a payment at closing or a higher note rate.

 

Certain national mortgage lenders and a large segment of the mortgage securitization market, including Fannie Mae and Freddie Mac, generally will not purchase mortgages or mortgage-backed securities unless the private mortgage insurance on the mortgages has been issued by an insurer with a financial strength rating of at least “AA−” from S&P or Fitch or a rating of at least “Aa3” from Moody’s. Fannie Mae and Freddie Mac require mortgage guaranty insurers to maintain two ratings of “AA−” or better. Triad has a financial strength rating of “AA” from S&P and Fitch and a rating of “Aa3” from Moody’s. S&P, Fitch, and Moody’s consider Triad’s consolidated operations and financial position in determining the rating. There can be no assurance that Triad’s ratings, the methods by which the ratings are determined, or the eligibility requirements of Fannie Mae and Freddie Mac will not change.

 

The Real Estate Settlement and Procedures Act of 1974 (“RESPA”) applies to most residential mortgages insured by Triad, and related regulations provide that the provision of services involving mortgage insurance is a “settlement service” for purposes of loans subject to RESPA. Subject to limited exceptions, RESPA prohibits persons from accepting anything of value for referring real estate settlement services to any provider of such services. Although many states prohibit mortgage insurers from giving rebates, RESPA has been interpreted to cover many non-fee services as well.

 

Most originators of mortgage loans are required to collect and report data relating to a mortgage loan applicant’s race, nationality, gender, marital status, and census tract to HUD or the Federal Reserve under the Home Mortgage Disclosure Act of 1975 (“HMDA”). The purpose of HMDA is to detect possible discrimination in home lending and, through disclosure, to discourage such discrimination. Mortgage insurers are not required pursuant to any law or regulation to report HMDA data, although under the laws of several states, mortgage insurers are currently prohibited from discriminating on the basis of certain classifications. All but one of the active mortgage

insurers (including Triad), through their trade association, the Mortgage Insurance Companies of America (“MICA”), have entered into an agreement with the Federal Financial Institutions Examinations Council (“FFIEC”) to report the same data on loans submitted for insurance as is required for most mortgage lenders under HMDA.

 

The Homeowners Protection Act of 1998 provides for certain termination and cancellation requirements for borrower-paid mortgage insurance and requires mortgage lenders to periodically update borrowers about their private mortgage insurance. Under the legislation, borrowers may generally request termination of mortgage insurance once the LTV reaches 80%, provided that certain conditions are met. The legislation further requires lenders to automatically cancel borrower-paid private mortgage insurance when the LTV reaches 78% if certain conditions are met. The legislation also requires lenders to notify borrowers that they have private mortgage insurance and requires certain disclosures to borrowers of their rights under the law. Because most mortgage borrowers who obtain private mortgage insurance do not achieve 20% equity in their homes before the homes are sold or the mortgages are refinanced, we have not lost and do not expect to lose a significant amount of insurance in force due to the enactment of this legislation.

 

Indirect Regulation

 

The Company, Triad, and Triad’s subsidiaries are also indirectly, but significantly, impacted by regulations affecting purchasers of mortgage loans, such as Fannie Mae and Freddie Mac, and regulations affecting governmental insurers, such as the FHA and the Department of Veterans Affairs (“VA”), as well as regulation affecting lenders. Private mortgage insurers, including Triad, are highly dependent upon federal housing legislation and other laws and regulations that affect the demand for private mortgage insurance and the housing market. FHA loan limits are adjusted in response to changes in the Freddie Mac/Fannie Mae conforming loan limits. Currently, the maximum single-family home mortgage that the FHA can insure is $362,790. The maximum FHA loan amount is subject to adjustment and may increase in the future. Any future legislation that increases the number of persons eligible for FHA or VA mortgages could have an adverse effect on Triad’s ability to compete with the FHA or VA.

 

Pursuant to the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (“FIRREA”), the Office of Thrift Supervision (“OTS”) issued risk-based capital rules for savings institutions. These rules establish a lower capital requirement for a low down payment loan that is insured with private mortgage insurance, as opposed to remaining uninsured. Furthermore, the guidelines for real estate lending policies applicable to savings institutions and commercial banks provide that such institutions should require appropriate credit enhancement in the form of either mortgage insurance or readily marketable collateral for any high LTV mortgage. Future changes, if any, to FIRREA’s risk-based capital rules or the guidelines for real estate lending policies applicable to savings institutions and commercial banks could affect demand for private mortgage insurance products.

 

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/Financials/SEC Filings section of our web site at www.triadguaranty.com.

 

Employees

 

As of December 31, 2006, we employed approximately 250 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:

 

 

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.

 

Kenneth C. Foster has been Executive Vice President, Structured Transactions and Business Development of Triad since November 2006. Since joining Triad in June 2001, Mr. Foster has served in several senior management roles in the areas of product development and risk management. 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.

 

Stephen J. Haferman was employed as Senior Vice President, Risk Management and Information Technology of the Company in March 2006. Mr. Haferman was previously with Cheryl and Company, Columbus, Ohio from 2003, most recently as Senior Vice President, Chief Operating Officer. From 2001 to 2003 Mr. Haferman was employed by American Electric Power as Vice President, Marketing Information Management. From 1992 to 2001 he worked for Bank One Corporation in a number of divisions and a variety of senior management positions including; Senior Vice President, Direct Marketing for Bank One Retail; Senior Vice President, Technology Program Manager, Bank One Retail; Vice President, Risk Department Manager. From 1988 to 1992 he worked for National City Bank where he was Risk Manager.

 

Kenneth W. Jones was employed as Senior Vice President and Chief Financial Officer of the Company in April 2006. Mr. Jones has over 25 years experience in the financial management of companies. He had been at RBC Liberty Insurance Corporation, where he served as Senior Vice President, Chief Financial Officer, since 2000. Previously, Mr. Jones was associated with The Liberty Corporation, where he held a number of management positions, most recently Vice President, Controller and Acting Chief Financial Officer. Before joining The Liberty Corporation, Mr. Jones was with Ernst & Young for 14 years.

 

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.

 

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.

 

We calculate our best estimate of the reserve for losses 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 segments defaults by a variety of criteria. The criteria include, among others, policy year, lender, geography and the number of months and number of times 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.

 

Frequency and severity are the two most significant assumptions in the establishment of our loss reserves. Frequency is used to estimate the ultimate number of paid claims associated with the current defaulted loans. The

frequency estimate assumes that long-term historical experience, taking into consideration criteria such as those described in the preceding paragraph, and adjusted for current economic conditions that we believe will significantly impact the long-term loss development, provides a reasonable basis for forecasting the number of claims that will be paid. Severity is the estimate of the dollar amount per claim that will be paid. The severity factors are estimates of the percent of the risk in force that will be paid. The severity factors used are based on an analysis of the severity rates of recently paid claims, applied to the risk in force of the loans currently in default. The frequency and severity factors are updated quarterly.

 

The estimation of loss reserves requires assumptions as to future events, 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. 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 ultimate costs of settling claims on both loans reported in default and loans in default that are in the process of being reported to us. Generally accepted accounting principles preclude us from establishing 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. A prolonged 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 number 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. During 2006, our top ten lenders were responsible for 80% of our Primary flow new insurance written, compared to 77% in 2005. Additionally, our top three lenders were responsible for approximately 65% of our Primary flow new insurance written during 2006. This concentration of business could 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 on a more significant and larger geographic basis, we may incur a higher level of losses from paid claims and also be required to increase reserves.

 

A component of our mitigation efforts on mortgage insurance claims is our option of paying the 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. The purchase option proved successful during the first three quarters of 2006 in mitigating losses, but was less successful in the fourth quarter of 2006. The assumptions utilized in our reserve methodology have factored in a certain amount of loss mitigation resulting from the utilization of the purchase option. If housing values fail to appreciate or decline on a more significant and larger geographic basis, the frequency of loans going into default and eventually to a paid claim could increase and our ability to mitigate our losses on defaulted mortgages may be further reduced, which could have a material adverse effect on our business, financial condition and operating results.

 

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

 

At December 31, 2006, approximately 30% of our Primary risk in force and 69% of our Modified Pool risk in force is comprised of 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 large 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.

 

At December 31, 2006, approximately 12% of our Primary risk in force and 13% of our Modified Pool risk in force is comprised of pay option ARMs with the potential for negative amortization on the loan. These percentages have grown substantially over the past year. These loans allow borrowers, for a stated period of time, to make monthly payments that do not cover the interest on the loan meaning the loan balance will increase. These pay option ARM 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. The risk of default may be further increased if the interest rate paid during the payment option period is significantly below current market rates. Additionally, it is important to note the lack of long-term historical performance data associated with pay option ARMs across all market conditions, could increase the volatility of the estimates used in our reserve models. 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 a 3.64% delinquency rate on our Primary Alt-A loan portfolio compared to a 2.47% delinquency rate on our overall Primary loan portfolio. 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. Additionally, long-term historical performance data associated with non-prime loans, ARMs and Alt-A loans across all market conditions does not exist. We cannot be sure that the premiums including the additional risk charge that we apply to 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 and paid claims 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 our 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, 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 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 other private mortgage insurance providers are Mortgage Guaranty Insurance Corporation, Radian Guaranty Inc., PMI Mortgage Insurance Company, Genworth Financial Mortgage Insurance Company, United Guaranty Residential Insurance Company, 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, 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.

 

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 to 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 to which we have also responded fully. 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, 2002 through December 31, 2005 represented 63% of our Primary risk in force as of December 31, 2006. Accordingly, a significant majority of our Primary portfolio is in, or approaching, its peak claim years. 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 enable 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, we may refuse to insure, or we may rescind coverage on that loan 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. If losses are significantly greater than anticipated, our delegated underwriting program could have a material adverse effect on our business, financial condition and operating results.

 

Geographic concentration of our risk in force could increase claims and losses and harm our financial performance.

 

We could be affected by economic downturns, natural disasters and other events in specific regions of the United States where a large portion of our business is concentrated. As of December 31, 2006, 14% of our risk in force was located in California, 11% was located in Florida and 7% was located in Texas. California and Florida have seen some of the highest house price appreciation over the last several years and in certain areas, have recently experienced house price depreciation. If housing declines continue or deepen, this could have an additional impact

on the ultimate amount of paid claims in certain geographic areas and could have a material adverse impact on our business, financial condition and operating results.

 

If we fail to properly underwrite mortgage loans when we provide contract underwriting services, we may be required to provide monetary and other remedies to the customer.

 

Under the terms of our contract underwriting agreements existing with certain lenders, we agree to indemnify the lender against losses incurred in the event that we make material errors in determining whether loans processed by our contract underwriters meet specified underwriting or purchase criteria, subject to contractual limitations on liability. As a part of the contract underwriting services, we provide monetary and other remedies to our customers in the event that we fail to properly underwrite a mortgage loan. As a result, we assume credit and interest rate risk in connection with our contract underwriting services. Worsening economic conditions, a deterioration in the quality of our underwriting services or other factors could cause our contract underwriting liabilities to increase and have an adverse effect on our financial condition and results of operations. Although we have established a reserve to provide for potential claims in connection with our contract underwriting services, we have limited historical experience that we can use to establish reserves for these potential liabilities, and these reserves may not be adequate to cover liabilities that may arise.

 

We have committed to an operational presence in Canada during 2007. Our ability to successfully organize, develop successful administrative systems and gain meaningful market share in Canada is dependent on many factors over which we have no control.

 

As of the date of this report, we have not received a license to operate in Canada. There are several regulatory approvals that we are awaiting including an approval by the Department of Finance that allows lenders in Canada to obtain capital relief for lenders requiring borrowers to purchase mortgage insurance on mortgage loans. Obtaining all regulatory approvals is a process that cannot be accelerated and our ultimate entrance date into Canada is unknown at this time. Additionally, we are in the process of building policy administrative systems and lender interfaces that are different than those used in the U.S. These systems will allow the interchange of data to facilitate the underwriting process.

 

In Canada, we will compete with Canada Mortgage and Housing Corporation (CMHC), a Crown corporation that is not subject to the same capital requirements or profit objectives as we will be. Additionally, we will compete with Genworth Financial Mortgage Insurance Company Canada which is a well-established private mortgage insurer that has been in Canada for many years as well as several other mortgage insurers that have announced plans to enter that market. Our ability to differentiate ourselves from the other mortgage insurance companies as well as CMHC and gain a meaningful market share in Canada is dependent on our ability to execute our entrance strategy effectively. Success in Canada is expected to have a meaningful impact on our bottom line in the long term; however, we do not expect the Canadian operations to have a significant financial impact in 2007.

 

We received a letter from the Division of Corporate Finance of the Securities and Exchange Commission dated December 22, 2006, requesting additional information relating to our Form 10-K for 2005. Specifically, the Commission staff requested information to better understand our disclosure relating to the following points:

 

 

On January 31, 2007, we responded to the Commission’s comments in a detailed letter addressing each of the above items. On March 9, 2007, we had further conversations with the Commission and the staff requested additional clarification of certain issues and an additional schedule.

 

The Company leases office space in its Winston-Salem headquarters and its seven underwriting offices located throughout the country under leases expiring between 2007 and 2012 and which require annual lease payments of approximately $1.5 million in 2007. 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.

 

Effective March 2007, the Company has entered into a lease to rent office space in Toronto, Canada for its Canadian operations under a lease expiring in 2009. Annual lease payments would be approximately $135,000 in 2007.

 

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, policy administration, 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 Global Select Market^® under the symbol “TGIC.” At December 31, 2006, 14,856,401 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.

 

 

(b) Holders

 

As of March 1, 2007, the number of stockholders of record of the Company’s Common Stock was approximately 325. In addition, there were an estimated 6,650 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. Currently, there are no 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, 2006, of the Company. The discussion should be read in conjunction with the Consolidated Financial Statements and Notes contained herein.

 

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” section below 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.

 

Reserve for Losses and Loss Adjustment Expenses

 

We calculate our best estimate of the reserve for losses to provide for the estimated costs of settling claims on loans reported in default, as of the date of our financial statements. Additionally, we provide a reserve for loans in default that are in the process of being reported to us (incurred by not reported) using an estimate based on the percentage of actual reported defaults. Our reserving process incorporates various components in a model that gives effect to current economic conditions and segment defaults by a variety of criteria. The criteria include, among others, policy year, lender, geography and the number of months and number of times 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.

 

Frequency and severity are the two most significant assumptions in the establishment of our loss reserves. Frequency is used to estimate the ultimate number of paid claims associated with the current defaulted loans. The frequency estimate assumes that long-term historical experience, taking into consideration criteria such as those described in the preceding paragraph, and adjusted for current economic conditions that we believe will significantly impact the long-term loss development, provides a reasonable basis for forecasting the number of claims that will be paid. Severity is the estimate of the dollar amount per claim that will be paid. The severity factors are estimates of the percent of the risk in force that will be paid. The severity factors used are based on an analysis of the severity rates of recently paid claims, applied to the risk in force of the loans currently in default. The frequency and severity factors are updated quarterly. Economic conditions and other data upon which these factors are based may change more frequently than once a quarter. Therefore, significant changes in reserve requirements may become evident three or more months following the underlying events that would necessitate the change.

The estimation of loss reserves requires assumptions as to future events, 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. To provide a measure of the sensitivity on pretax income and loss reserves carried on the balance sheet, we have provided the following table that quantifies the impact of percentage increases and decreases in both the average frequency and severity as of December 31, 2006:

 

 

The impact on loss reserves on the balance sheet would be to decrease reserves under favorable development and to increase reserves for unfavorable development. There would be no impact on liquidity resulting from the change in reserves. However, there would be a change in cash or invested assets equal to the increase or decrease in the ultimate paid claims related to the change in reserves. We believe that a 10% increase or decrease in frequency or severity is reasonably likely based on potential changes in future economic conditions and past experience. Economic conditions that could give rise to an increase in the frequency rate could be a sudden increase, or a prolonged period of increase in the unemployment rate while, conversely, a sudden drop in interest rates or a sustained period of economic and job growth could decrease the frequency rate. A sudden nationwide or widespread regional decline in home prices, or a prolonged period of flat or slowly depreciating home prices could increase the severity while a significant increase, or steady sustained growth in house price appreciation could decrease the severity.

 

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 our loss reserve process. Our loss reserve estimation process and our analyses support the reasonableness of the best estimate of loss reserves recorded in our financial statements. See the “Losses and Expenses” section below 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 developed by our outside investment advisors 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. 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 and the methodology to identify potential impairments 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 DAC 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. We classify insurance as Primary when we are in the first loss position and the LTV is 80% or greater when the loan is first insured. We classify all other insurance as Modified Pool. The majority of our Primary insurance is delivered through the flow channel, which is defined as loans originated by lenders and submitted to us on a loan-by-loan basis. We also provide mortgage insurance to lenders and investors who seek additional default protection (typically secondary coverage or on loans for which the individual borrower has greater than 20% equity), 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. Those individual loans in the structured bulk channel in which we are in the first loss position and the LTV ratio is greater than 80% are classified as Primary. All of our Modified Pool insurance is delivered through the structured bulk channel.

 

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 paid on claims submitted, b) changes in reserves for estimated future claim payments on loans that are currently in default, 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 volume of business insured combined with 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 insured 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:

 

 

Net income for 2006 grew over 2005 as a result of strong growth in earned premiums that exceeded growth of operating expenses and net losses and loss adjustment expenses. Growth of our insurance in force and strong persistency coupled with an increase in basis points on Primary business generated the growth in earned premiums. Basis points on Primary business increased due to higher premiums charged on new insurance with risk-adjusted rates such as Alt-A loans and adjustable rate mortgages (“ARMs”), including potential negative amortization loans. Production of these products increased throughout 2006 as discussed further in the “Production and In Force” and “Revenues” sections below.

 

Growth and seasoning of our insurance in force combined with refinements in the frequency and severity factors utilized in our calculation of our reserves caused net losses and loss adjustment expenses for 2006 to increase significantly over 2005. Insurance in force was $56.8 billion at December 31, 2006 compared to $44.4 billion at December 31, 2005 and $36.8 billion at December 31, 2004. This growth along with a greater percentage of loans entering the peak claim paying period increased both the number and amount of paid claims during 2006. Direct paid losses increased to $59.0 million for 2006 from $48.8 million for 2005. The actual number of claims paid for 2006 increased 20.6% over 2005 as well. In addition to paid claims, net losses and loss adjustment expenses also includes the change in reserves. We increased reserves $33.3 million during 2006 compared to $17.0 million during 2005. The increase in 2006 was due to an increase in the number of defaults, but also reflects the impacts of the increase in the frequency and severity factors due to the declining housing market and growth in our average portfolio loan size.

 

Other operating expenses for 2006 increased over 2005 due to organizational changes and staff additions to support our growth, expensing of stock options in 2006, and strategic initiatives, including expenses associated with entering the Canadian market. In July 2006, we announced our intention to submit an application to incorporate a Canadian subsidiary to begin operations in Canada. The Canadian company will be a monoline provider of mortgage guaranty insurance and, pending regulatory approvals, could start operations sometime in 2007. We incurred approximately $690,000 of expenses in 2006 relating to legal fees, consulting, personnel and application fees in connection with this process. We expect these expenses to increase during 2007 as we continue to put the necessary personnel and infrastructure into place in anticipation of the commencement of business in that year.

 

The increase in diluted earnings per share for 2006 over 2005 was consistent with the increase in net income. Realized investment gains, net of taxes, increased diluted earnings per share in 2006 by $0.07 and had no impact on diluted earnings per share in 2005. 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.

 

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 was principally a result of the ongoing seasoning of our insurance portfolio. In 2005, we experienced an increase in the number of paid claims and the number of reported defaults that caused 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. Realized investment gains increased diluted earnings per share by $0.02 in 2004.

 

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

 

Below is a summary of new production:

 

 

Primary new insurance written in 2006 increased over 2005 due to increased production primarily of products with risk-adjusted pricing such as Alt-A loans and ARMs, including loans with potential negative amortization. Primary new insurance written also increased due to an increase in lender paid transactions, which included, in some cases, products with risk-adjusted pricing. Loans with potential negative amortization include pay option ARMs. We classify all loans with adjustable interest rates as ARMs, including those for which the interest rate is fixed for a certain period of time. We define pay option ARMs as those that provide a fixed period of time during which the borrower has the option to pay monthly payments that are less than the interest accrued for those months. If the borrower elects this option, the LTV increases on the loan. Because the LTV can increase on a pay option ARM, these types of loans may present more risk to a mortgage insurer than traditional amortizing loans. We define ARMs with positive amortization as those that have scheduled loan principal amortization and those for which monthly payments are interest only for a fixed period of time and then convert to scheduled loan principal amortization. A relatively flat mortgage loan origination market in 2005 combined with a decline in the percentage of loan originations for which mortgage insurance was provided caused the decline in Primary insurance written in 2005 from that of 2004.

 

Using MICA definitions, net new primary insurance written for the entire industry declined approximately 5% for 2006 from 2005 based on information available from MICA and other public sources. Our increased production of products with risk-adjusted pricing combined with a gain in market share in 2006 mitigated the effects of this industry decline.

 

We believe that the overall mortgage loan origination market will continue to contract in 2007, which could reduce our Primary new insurance written. However, we believe that alternative credit enhancements such as 80-10-10’s, which can limit the need for mortgage insurance, have become less attractive to borrowers as short-term interest rates have risen. Further, the recent passing of legislation that makes mortgage insurance tax deductible in certain circumstances may also mitigate any potential reduction of Primary insurance written.

 

We write Modified Pool insurance only through our structured bulk channel. Structured bulk transactions for the entire industry increased approximately 9% for 2006 over 2005, according to information available from MICA and other publicly available data. Our Modified Pool insurance written for 2006 increased over 2005 as a result of this industry increase and a gain in our market share as shown in the table below. These same factors caused the increase in Modified Pool insurance written in 2005 over 2004. Our 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. We believe there will continue to be opportunities in 2007 in the structured bulk transaction market that meet our loan quality and pricing objectives.

 

The following table provides estimates of our national market share of net new insurance written, using MICA definitions, through our flow and structured bulk channels based on information available from MICA and other public sources for the years ended December 31, 2006, 2005 and 2004:

 

Our market share of new insurance written through the flow channel increased in 2006 and 2005 as a result of acquiring business from new lenders and 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. Our structured bulk market share will vary from period to period since our share of this market is dependent on the availability and size of transactions that meet our credit quality and pricing benchmarks and on our ability to bid successfully for these transactions.

 

A significant trend over the last three years in our Primary production has been our increased participation in the Alt-A marketplace. We have defined Alt-A loans 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. We have defined A Minus loans as those loans having FICO credit scores greater than 574, but less than 620. We have defined Sub Prime loans as those loans with credit scores less than 575.

 

 

Another significant trend in our Primary production over the past three years was the increase in ARMs, especially those loans subject to potential negative amortization. The following table summarizes the loan type characteristics of our Primary new insurance written over the past three years and reflects the growth in ARMs, especially the loans subject to potential negative amortization in 2006:

 

 

Risk characteristics that we consider in our underwriting discipline also include, among other factors, the LTV of the loan. The following table summarizes the percentage of our Primary production by LTV over the past three years:

 

 

LTVs on policies originated in the structured bulk channel are generally lower than those on policies we receive via the flow channel. Those policies generally also have other Primary coverage in front of our risk.

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, 2006, we had approximately $119 million of structured transactions with effective dates within 2006 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 2007, 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 2006 related to this insurance. At December 31, 2005, we had approximately $979 million of structured transactions with effective dates within 2005 for which loan level detail had not been received.

 

The following table provides detail on our direct insurance in force at December 31, 2006, 2005 and 2004:

 

 

Our Primary insurance in force grew in 2006 and in 2005 as a result of production during those years and improving persistency rates. Primary insurance annual persistency improved to 76.6% at December 31, 2006 compared to 70.0% at December 31, 2005 and 68.5% at December 31, 2004. If interest rates remain near current levels, we anticipate that persistency rates will also continue near current levels for 2007. However, persistency may be adversely affected if interest rates decline significantly from the levels experienced during 2006.

 

Our Modified Pool insurance in force grew significantly in 2006 and in 2005 due to our strong production in the structured bulk channel as well as an improving persistency rate. Approximately 34%, 39% and 81% of our insurance written attributable to our structured bulk channel during 2006, 2005, and 2004, respectively, was structured with deductibles that put us in the second loss position. The declines in Modified Pool insurance written with deductibles in 2006 and 2005 were 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.

 

As mentioned earlier, our Modified Pool insurance in force is comprised entirely of structured bulk transactions. 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 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. Most of our structured bulk insurance in force is comprised of the first two segments mentioned above, while only approximately 1% of our insurance in force attributable to structured bulk transactions was categorized in segment c) above.

Similar to the trend in new insurance written discussed above, Alt-A continues to grow as a percentage of our insurance in force. The following table shows the percentage of our insurance in force that we have classified as Alt-A at December 31, 2006, 2005 and 2004:

 

 

The following table provides information on risk in force at December 31, 2006, 2005 and 2004. As is evidenced by the following table, we have moved further out on the risk curve based upon the trends in these risk characteristics. Indicators of increased risk would include the following:

 

 

This increase in risk embedded in our portfolio increased the basis points that we charged for mortgage insurance in 2006 and 2005.

Risk in Force(1)

 

 

 

Our book of business is relatively unseasoned, having a weighted average life of 2.3 years at December 31, 2006 compared to 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, 2006, 2005 and 2004 by year of loan origination.

 

 

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 Primary flow channel insurance in force as well as the percentage of our total insurance in force that was subject to captive reinsurance arrangements at December 31, 2006, 2005 and 2004.

 

 

The growth of the percentage of Primary direct insurance in force that was subject to captive reinsurance arrangements in 2006 and in 2005 was the result of the addition of new lenders that participate in captive reinsurance arrangements as well as increased writings with existing lenders that participate in captive reinsurance arrangements. The declines in the percentage of total direct insurance in force subject to captive reinsurance in 2006 and in 2005 reflect the fact that a greater portion of our insurance in force consists of Modified Pool business. 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 we receive 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 depending on a number of considerations including competition, market share and lender quality. We will continue to be an active participant with our qualified lenders in captive reinsurance arrangements.

 

Revenues

 

A summary of the individual components of our revenue for the past three years follows:

 

 

We experienced strong growth in earned premiums in both 2006 and 2005 due to increases in net premium written in both years. Direct premium written is comprised of premium written for both Primary and Modified Pool business. Our growth in total direct premiums written in 2006 and 2005 was the result of the growth of our insurance in force through the strong production of Primary insurance products with risk-based pricing as noted previously in the “Production and In Force” section as well as growth in our Modified Pool business. Because of the increased production of products with risk-based pricing, the premium rate expressed in terms of basis points on our average Primary insurance in force for 2006 has risen approximately 7% over 2005. Additionally, favorable persistency levels increased renewal premium in both years, which is included in direct premium written. Annual persistency was at 76.8% at December 31, 2006 compared to 68.7% at December 31, 2005 and 67.6% at December 31, 2004.

 

Ceded premium written is comprised of premiums written under excess of loss reinsurance treaties with captive as well as non-captive reinsurance companies. The growth in ceded premium written in 2006 and 2005 was not as large as the increase in direct premium written as a result of Modified Pool business comprising a larger percentage of direct premium written in both years. Further, ceded premium written in 2006 was reduced by a no claims bonus on a terminated excess of loss reinsurance treaty of approximately $840 thousand. The following table provides further data on ceded premiums for the years ended December 31, 2006, 2005 and 2004:

 

 

The table below provides data on insurance written that was subject to captive reinsurance arrangements for the years ended December 31, 2006, 2005 and 2004:

 

 

The percentage of Primary flow insurance written subject to captive reinsurance declined in 2006 from 2005 due to increased production of certain lender-paid programs that were not subject to captive reinsurance arrangements. The percentage of Primary flow insurance written subject to captive reinsurance was relatively flat in 2005 compared to 2004. The declines in the percentage of total insurance written subject to captive reinsurance in 2006 and in 2005 is again reflective of the fact that Modified Pool insurance written comprised a greater portion of our total insurance written in both of these years.

 

The difference between net written premiums and earned premiums is the change in the unearned premium reserve, which is established primarily on premiums received on annual products. Our unearned premium liability declined $0.3 million during 2006 compared to a decline of $2.4 million in 2005 and an increase of $0.3 million during 2004 due to fluctuations in the amount and timing of annual premiums received.

 

Assuming no significant decline in interest rates, we expect our persistency will remain near current levels in 2007. We anticipate that this should continue to have a positive effect on renewal earned premiums and total earned premiums in 2007.

 

Net investment income grew in 2006 and in 2005 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 13.4% in 2006 and 17.6% in 2005 as a result of the investment of positive cash flows from operations. Our investment portfolio tax-equivalent yield was 6.71%, 6.77%, and 6.99% at December 31, 2006, 2005 and 2004, respectively. We expect to see a growth in invested assets in 2007; however, we anticipate a continuing decline in the overall portfolio tax-equivalent yield as current interest rates remain below our average portfolio rate. See further discussion in the “Investment Portfolio” section of 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 $0.4 million in 2006 compared to $0.2 million in 2005 and $0.5 million in 2004. See further discussion of impairment write-downs in the “Realized Losses and Impairments” section below.

 

Losses and Expenses

 

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

 

 

Net losses and loss adjustment expenses (“LAE”) for 2006 increased over 2005 due to growth and seasoning of our insurance in force combined with refinements in the frequency and severity factors utilized in our calculation of our reserves. These refinements, most of which occurred in the fourth quarter of 2006, were made primarily to reflect a weakening housing market. The increases in the amortization of deferred policy acquisition costs in 2006 and 2005 are consistent with the growth in that asset balance. Other operating expenses increased in 2006 over 2005, reflecting the growth of our insurance in force as well as several key initiatives that have taken place in 2006. The discussion below provides more detail on both losses and expenses.

 

Net losses and LAE is comprised of the net claims paid and the change in loss reserves. Loss reserves represent our estimate of the ultimate claim costs of those loans reported to us as in default and those loans in default that are in the process of being reported to us. We will discuss each of these components separately and the impact on our financial results.

 

The following table provides detail on paid claims for the years ended December 31, 2006, 2005 and 2004: