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.  þ

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the 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: $10,782,902 as of June 30, 2008, which amount excludes the value of all shares beneficially owned (as defined in Rule 13d-3 under the Securities Exchange Act of 1934) by executive officers, directors and 10% or greater stockholders of the registrant (however, this does not constitute a representation or acknowledgment that any such individual or entity is an affiliate of the registrant, or that there are not other persons who may be deemed to be our affiliates).

 

The number of shares of the registrant’s common stock, par value $0.01 per share, outstanding as of March 6, 2009, was 15,206,709.

 

 

TABLE OF CONTENTS

 

 

 

Overview of Triad

 

Triad Guaranty Inc. is a holding company that historically has provided private mortgage insurance (“MI”) coverage in the United States through its wholly-owned subsidiary, Triad Guaranty Insurance Corporation (“Triad”). Triad Guaranty Inc. and its subsidiaries are collectively referred to as the “Company.”

 

Triad ceased issuing new commitments for mortgage guaranty insurance coverage on July 15, 2008 and we are operating our business in run-off under a Corrective Order issued by the Illinois Department of Financial and Professional Regulation, Division of Insurance (the “Division”). As used in this annual report, the term “run-off” refers to Triad no longer being able to write new mortgage insurance policies, but continuing to service its existing policies. Servicing existing policies includes: receiving premiums on policies that remain in force; cancelling coverage at the insured’s request; terminating policies for non-payment of premium; working with borrowers in default to remedy the default and/or mitigate our loss; and settling all legitimate filed claims per our contractual obligations. The Corrective Order from the Division, among other items, allows the executive officers of the Company to continue to operate Triad under close supervision and includes restrictions on the distribution of dividends and payment by Triad of interest on notes payable to its parent.

 

Triad was formed in 1987 and was acquired by Collateral Mortgage, Ltd., now called Collateral Holdings, Ltd. (“CHL”), a mortgage banking and real estate lending firm, in 1989. As of December 31, 2008, CHL owns 17.0% of the outstanding common stock of the Company.

 

MI is issued in many home purchases 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 of sales being made to the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”), which are collectively referred to as “GSEs”. Investors and lenders also purchase MI to obtain additional default protection or capital relief on loans with equity of greater than 20%.

 

Currently, Triad is licensed to do business in all fifty U.S. states and the District of Columbia. Another wholly-owned subsidiary, Triad Guaranty Insurance Corporation Canada (“TGICC”), was formed in 2007 for the purpose of exploring opportunities for providing mortgage insurance in Canada. TGICC was liquidated in the fourth quarter of 2008. TGICC did not write any business and only incurred start-up expenses prior to its liquidation.

 

Our success in run-off is dependent on our ability to operate effectively under the Corrective Order, our ability to mitigate our insurance losses, and our ability to maintain operating efficiency, as well as a number of external factors including: the general condition of the economy, the capital markets and the housing market; legislative and regulatory developments; interest rates and their effect on our persistency; and unemployment rates. For a detailed description of the components of our revenue and expenses, please refer to the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section of this annual report on Form 10-K. A detailed description of the insurance regulations to which we are subject is discussed further in this Item 1.

 

Our principal executive offices are located at 101 South Stratford Road, Winston-Salem, North Carolina 27104 in properties that we lease. We do not require a significant amount of fixed assets for our operations and property and equipment, consisting primarily of computer equipment and software, are the extent of our long-lived assets. Our telephone number is (336) 723-1282.

 

Our web site is www.triadguaranty.com. Information contained on, or that can be accessed through, our web site does not constitute part of this annual report. We have included our website address as a factual reference and do not intend it as an active link to our web site. We make available on our web site our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports. This information is made available free of charge and as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission (“SEC”).

Corrective Order

 

Triad is an Illinois-domiciled insurance company and the Division is our primary regulator. Triad Guaranty Assurance Corporation (“TGAC”) is a wholly-owned subsidiary of Triad and is subject to all Illinois insurance regulatory requirements applicable to Triad. The Illinois Insurance Code grants broad powers to the Division and its Director to enforce rules or exercise discretion over almost all significant aspects of our insurance business.

 

On August 5, 2008, Triad and TGAC (collectively, “TGIC”) entered into an Agreed Corrective Order with the Division. The Corrective Order was implemented as a result of our decision to cease writing new mortgage guaranty insurance and to commence a run-off of our existing insurance in force as of July 15, 2008. Among other things, the Corrective Order:

 

 

We submitted a corrective plan to the Division as required under the Corrective Order. The corrective plan we submitted included, among other items, a five-year statutory financial projection for TGIC and a detailed description of our planned course of action to address our current financial condition. The financial statements that form the basis of our corrective plan were prepared in accordance with Statutory Accounting Principles (“SAP”) set forth in the Illinois Insurance Code. SAP differs from GAAP, which are followed to prepare the financial statements presented in this annual report on Form 10-K. We received approval of the corrective plan from the Division in October 2008.

 

Since the approval of our initial corrective plan, we have revised the assumptions we initially utilized in our run-off financial forecast model as a result of a number of factors, including continued deteriorating economic conditions impacting our financial condition, results of operations and future prospects. Our new assumptions produce a range of potential ultimate outcomes for our run-off, but include projections showing that on a likely case basis and absent additional action by the Division or favorable changes in our business, we will report a deficiency in policyholders’ surplus as calculated in accordance with SAP as early as March 31, 2009 and continuing at least through 2011. Although we currently project that this statutory insolvency will be temporary and our run-off will ultimately be successful, we believe such insolvency would likely lead to the institution by the Division of receivership proceedings against TGIC if not corrected. We are currently working with the Division to structure a revised corrective plan to address this issue, although no assurance can be given that we will be successful in these efforts. If we are unable to gain approval from the Division for a revised corrective plan that addresses this issue, the Division could place TGIC into receivership proceedings, which could force us to seek protection from creditors through a voluntary bankruptcy proceeding and we would likely be unable to continue as a going concern. See Item 1A, “Risk Factors” for more information.

 

Failure to comply with the provisions of the Corrective Order or any other violation of the Illinois Insurance Code may result in the imposition of fines or penalties or subject TGIC to further legal proceedings, including receivership proceedings for the conservation, rehabilitation or liquidation of TGIC. See Item 1A, “Risk Factors” for more information.

Our recurring losses from operations and resulting decline in policyholders’ surplus as calculated in accordance with SAP increases the likelihood that TGIC will be placed into conservatorship or liquidated and raises substantial doubt about our ability to continue as a going concern. Our consolidated financial statements that are presented in this annual report on Form 10-K do not include any adjustments that reflect the financial risks of TGIC entering receivership proceedings and assume that we will continue as a going concern. We expect losses from operations to continue and our ability to continue as a going concern is dependent on the successful development, approval, and implementation of a revised corrective plan. See Item 1A, “Risk Factors” for more information.

 

Triad is also subject to comprehensive regulation by the insurance departments of the various other states in which it is licensed to transact business. Currently, the insurance departments of the other states are working with the Division in the implementation of the Corrective Order.

 

Overview of Market Conditions

 

The adverse events in the real estate, mortgage and financial markets during 2008 were unprecedented. Steep declines in real estate values, tightening markets for obtaining capital or credit, and the liquidity concerns of financial institutions have created a significant amount of uncertainty in the capital markets, resulting in significant downward pressure on asset values, including single family homes. Like many other financial companies, the Company has not been immune to these adverse developments and has seen its financial position and results of operations deteriorate substantially.

 

The profitability and growth of the mortgage insurance industry is subject to conditions in the residential mortgage market which, over the long-term, has experienced a substantial amount of growth and profitability and was particularly strong between 2001 and 2006. Some of the factors that contributed to this strength, including rapid home price appreciation, the strong demand for mortgage securitizations in the secondary market, and the introduction of certain new mortgage products gradually led to deterioration in underwriting practices by mortgage loan originators over that five-year period.

 

Beginning in early 2007, the residential mortgage market began slowing due in part to rising mortgage delinquencies and foreclosures. Since then, home prices have declined significantly, mortgage delinquency and foreclosure rates have soared, and the availability of capital to potential borrowers has declined considerably.

 

During 2008, a number of well-known financial institutions failed or were acquired by other financial institutions. While the U.S. government has taken action to improve liquidity, restore confidence to the capital markets, stem the level of foreclosures, and improve the employment situation (see “Recent Government Initiatives” below), the results to date have been limited. The U.S. economy is in a recession and the unemployment rate of 8.1% in January 2009 was the highest since unemployment was 8.3% in December 1983. Defaults and foreclosures continue to increase and home prices continue to decline. Many economists are projecting significant negative macroeconomic trends, including widespread job losses, higher unemployment, lower consumer spending, continued declines in home prices and substantial increases in delinquencies on consumer debt, including defaults on home mortgages. Moreover, recent disruptions in the financial markets, particularly the reduced availability of credit and tightened lending requirements, have impacted the ability of borrowers to refinance loans at more affordable rates. In addition, while tight credit markets facilitate higher persistency, they also limit the flexibility of borrowers when dealing with a loan in default, and may lead to a greater number of foreclosures. A longer or more severe recession will have more negative impacts on our business.

 

Recent Government Initiatives

 

Over the past several months, several government programs have been initiated which, in general, are designed to provide relief to homeowners and the financial markets. Many of these programs have been expanded since originally developed and may continue to change.

 

In July 2008, the Housing and Economic Recovery Act of 2008 was enacted, which established the Federal Housing and Finance Agency (“FHFA”) as the successor regulatory agency to both Fannie Mae and Freddie Mac. FHFA has broad legal and regulatory authority to ensure the safety and soundness of both of the GSEs. On September 7, 2008, both Fannie Mae and Freddie Mac were placed into conservatorship with FHFA acting as

conservator. Conservatorship is a process designed to stabilize a troubled institution with the objective of returning the troubled institution to normal business operations. FHFA has stated that the purpose of this action is to restore confidence in these GSEs, to enhance their capacity to fulfill their mission, and to mitigate the systemic risk that has contributed directly to the instability in the market.

 

The Housing and Economic Recovery Act of 2008 also includes the HOPE for Homeowners Act, which created a new, temporary, voluntary program within the Federal Housing Administration (“FHA”) to back FHA-insured mortgages to distressed borrowers. The new mortgages offered by FHA-approved lenders will refinance distressed loans at a significant discount for owner-occupants at risk of losing their homes to foreclosure. In exchange, homeowners will share future appreciation with the FHA.

 

During October 2008, the Emergency Economic Stabilization Act of 2008 (“EESA”) was enacted. EESA, among other things, created the Troubled Asset Relief Program (“TARP”), which provides authority for the Federal government to purchase assets and equity from financial institutions in order to strengthen the financial sector. The goal of TARP is to encourage banks to resume lending again at levels seen before the financial crisis. TARP allows the U.S. Department of the Treasury to purchase or insure up to $700 billion in residential or commercial mortgages and securities based on or related to such mortgages as well as any other financial instrument that the Secretary of the Treasury determines would promote stability in the financial market.

 

The Streamlined Modification Program (“SMP”) was adopted by the GSEs in December 2008 and is designed to reduce foreclosures on mortgage loans owned or guaranteed by the GSEs. The SMP standardized the modification criteria for such mortgage loans with the goal of enabling loan servicers to proactively solicit borrower participation. A number of eligibility criteria apply to the SMP. Modifications available include the capitalization of accrued interest and other fees, the extension of the term of the mortgage loan, the reduction of the interest rate on the mortgage loan, as well as a provision for principal forbearance. Additionally, several large lenders have announced plans to implement their own loan modification programs. The GSEs also established a moratorium on foreclosures that began in December 2008 and expired on March 6, 2009.

 

In February 2009, the Federal government unveiled The Homeowner Affordability and Stability Plan (“HASP”), which is designed to replace the SMP and reduce the number of foreclosures. HASP, which was detailed in March 2009, includes the Home Affordable Modification Program (“HMP”) which provides incentives to borrowers, servicers, and lenders to modify loans with the modifications jointly paid for by lenders and the U.S. government. HASP also includes the Home Affordable Refinance Program which provides refinance opportunities to certain borrowers who have conforming mortgage loans owned or guaranteed by the GSEs. The borrowers targeted for this refinance opportunity are those who have experienced significant depreciation in the value of their home, thereby making refinancing difficult or prohibitive given current underwriting standards in the marketplace.

 

Certain members of the Obama administration have discussed providing TARP funds to private mortgage insurers. No assurance can be given that TARP funds would be provided to mortgage insurers or, if funds were provided, that they would be provided to us or that they would be offered under terms acceptable or beneficial to our stockholders.

 

As of the date of this annual report on Form 10-K, we are unable to predict the impact that these recent government initiatives and the conservatorship of Fannie Mae and Freddie Mac will have on our future results of operations and prospects.

 

Mortgage Insurance Products

 

Prior to the commencement of run-off on July 15, 2008, we offered principally two products, Primary and Modified Pool mortgage insurance, which are described below. Insurance on these products comprised all of our insurance in force as of December 31, 2008 and 2007. Risk-sharing products are a component of Primary insurance and serve to reduce our ultimate risk, which we insure through the payment of premiums to captive reinsurers (see “Reinsurance” below). Premium rates are determined at origination of coverage, based on perceived risk of the policy at that time, and generally cannot be subsequently changed. In run-off, we will receive only the ongoing

premiums of the remaining insurance in force, which we refer to as renewal premiums only to differentiate them from premiums on new business.

 

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”). 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. Our obligation to an insured lender with respect to a claim is determined by applying the appropriate coverage percentage to the claim amount, which generally ranges from 12% to 37%. Under our master policies, we have the option of paying the entire claim amount and taking title to the mortgaged property, or paying the coverage percentage on the claim amount in full satisfaction of our obligations. Primary insurance was written through the flow channel and the structured bulk channel (see “Distribution Channel” below).

 

Primary insurance comprised approximately 67% and 66% of our total direct insurance in force at December 31, 2008 and 2007, respectively. Primary insurance written comprised 100% of total insurance written during 2008 compared to 85% during 2007. We ceased issuing commitments for primary insurance on July 15, 2008. Going forward, our production will consist of certificates issued from commitments for Primary mortgage insurance that were entered into prior to July 15, 2008.

 

Modified Pool Insurance

 

Modified Pool insurance, which we have not written since the quarter ended June 30, 2007, was 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. Coverage on structured bulk transactions was 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, which was typically between 50% and 65%.

 

Structured bulk transactions included an aggregate stop-loss limit applied to the entire group of insured loans. Additionally, some of the structured bulk transactions included deductibles representing a percentage of the total risk originated under which we pay no claims until the losses exceed the deductible amount. Modified Pool insurance comprised approximately 33% and 34% of our total direct insurance in force at December 31, 2008 and 2007, respectively.

 

Distribution Channels

 

Prior to entering run-off on July 15, 2008, we sold mortgage insurance through two distribution channels. Our flow channel consisted of loans originated by lenders and submitted to us on a loan-by-loan basis. All insurance that was delivered through the flow channel is classified as Primary insurance.

 

Through the structured bulk channel, we participated in a competitive bid process for structured bulk transactions that met our loan quality and pricing criteria. Modified Pool insurance was only written through the structured bulk channel, and some Primary insurance was written through the structured bulk channel.

 

We formally ceased issuing commitments for mortgage insurance through both channels on July 15, 2008. Going forward, our production will consist of certificates issued from commitments for Primary mortgage insurance entered into prior to July 15, 2008 that were written through the flow channel, which is expected to be nominal.

 

Cancellation of Insurance

 

We generally cannot cancel mortgage insurance coverage except for nonpayment of premiums, misrepresentation or fraud on the loan application, non-compliance with certain lender programs or certain other 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 premium 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 MI 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 satisfied. A borrower may request that a loan servicer cancel borrower-paid MI 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.

 

MI coverage is also cancelled when an insured loan is refinanced. Because we are a company operating in run-off, a refinancing will have the impact of reducing future premiums as we can not replace the refinanced premium with new MI coverage. Any refinance activity that takes place may occur with better performing loans or in areas experiencing comparatively better economic or house price conditions. If this were to occur, the percentage of our insurance in force covering poor performing loans or from economically distressed areas or from areas experiencing unfavorable house price depreciation would increase. This would adversely affect the amount of premium we receive as well as our loss ratio and capital position.

 

Our cancellation rate, defined as the percentage of insurance in force from twelve months prior that was cancelled during the preceding twelve-month period, was approximately 13% and 18% for 2008 and 2007, respectively, and was as high as 49% during 2003.

 

Recent government and industry initiatives to reduce the record level of foreclosures often include loan modifications whereby original terms of the mortgage are modified. Generally, in the case of a loan modification, the original amount of MI coverage will continue on the mortgage.

 

Renewal premiums are our primary source of revenue and are dependent on our insurance policies remaining in force. An increase in the cancellation rate or, alternatively, a decrease in the persistency rate reduces the amount of our insurance in force and our renewal premiums. Our renewal premium on a loan modification also may be affected due to a change in the insured balance of a mortgage loan.

 

Reinsurance

 

Certain premiums and losses are ceded to other insurance companies under various reinsurance agreements, the majority of which are reinsurance agreements with captive reinsurance affiliates of certain customers. Reinsurance contracts do not relieve Triad from its obligations to policyholders. Failure of the reinsurer to honor its obligation could result in losses to Triad; consequently, allowances are established for amounts deemed uncollectible.

 

Prior to run-off, we offered captive reinsurance structures designed to allow lenders to share in the risks of MI. Under the typical 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 premiums. All of our existing captive reinsurance programs are excess-of-loss arrangements that have defined aggregate layers of coverage and a maximum exposure limit for the captive reinsurance company. 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, 2008, 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 required 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 premiums and investment earnings on trust assets as well as capital contributions by the reinsurer. If certain conditions are met, the captive reinsurers are allowed to withdraw funds from the account. The captive reinsurers are also generally allowed to withdraw funds to pay taxes and certain operating expenses. If certain capitalization requirements of the

trust are not maintained we may be allowed to terminate the trust agreement, although the captive reinsurer would have the right to dispute such action. Upon termination, we would receive all remaining trust assets, reassume all remaining risk and liabilities, and cease ceding premium to the captive reinsurer. As of December 31, 2008, Triad had two captive reinsurance arrangements where the total ceded reserves, combined with any unpaid ceded claims, had exceeded the trust balance and the recoverable was therefore limited to the trust balance. During the first quarter of 2009, one of these captive reinsurance agreements was terminated and we received $8.1 million of trust assets and reassumed $15.9 million of reserves and $23.5 million of risk.

 

At December 31, 2008, we had approximately $258 million in captive reinsurance trust balances supporting the risk transferred to captives. At December 31, 2008, we had ceded $157 million of loss reserves to these captive reinsurers.

 

At December 31, 2008 and 2007, approximately 58% and 59% of our Primary flow insurance in force was subject to captive reinsurance programs. We did not use captive mortgage reinsurance or other risk-sharing arrangements with Modified Pool insurance or Primary bulk insurance.

 

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. TGAC is a wholly-owned subsidiary of Triad that was formed to retain the premiums and related risk on deeper coverage business. As of December 31, 2008 and 2007, TGAC assumed approximately $189 million and $213 million in risk from Triad, respectively.

 

Triad maintains a $95 million Excess-of-Loss reinsurance treaty that provides a benefit when Triad’s risk-to-capital ratio exceeds 25-to-1 and its combined ratio exceeds 100% (the “attachment point”). Once the attachment point has been reached, following a one-time deductible of $25 million, the carrier is responsible for reimbursement of all paid losses in each quarter that the attachment point is breached up to the one-time $95 million policy limit. The coverage period is for 10 years. Additionally, terms of the treaty require Triad to continue the payment of premiums to the reinsurer amounting to approximately $2 million per year for the entire ten year period. The reinsurance treaty attached at the end of the first quarter of 2008, however, the reinsurance carrier subsequently provided a purported notice of termination of the agreement. The matter is currently in arbitration and we expect a decision in the second quarter of 2009.

 

Customers

 

We ceased issuing commitments for mortgage insurance on July 15, 2008. We are not actively selling mortgage insurance through either the flow channel or bulk channel to any customers. Going forward, our production will consist of certificates issued from commitments for Primary mortgage insurance that were entered into prior to July 15, 2008, which is expected to be nominal.

 

Sales

 

On July 15, 2008, we ceased issuing commitments for mortgage insurance and transitioned our business to run-off. As a result, we terminated the employment of approximately 100 employees, including all of our sales, marketing and underwriting groups. The majority of these terminations were effective on June 30, 2008.

 

Contract Underwriting

 

Prior to entering into run-off, we provided fee-based contract underwriting services to certain, approved mortgage originators. The fee charged was intended to cover the cost of providing the services. Contract underwriting involved examining a prospective borrower’s information contained in a lender’s mortgage application file and making a determination as to whether the borrower should be approved for a mortgage loan subject to the lender’s underwriting guidelines. We provided contract underwriting services through our own employees as well as independent contractors, and these services were provided for loans that required MI as well as loans that did not require MI. If it were determined that Triad failed to properly underwrite a loan subject to the lender’s underwriting guidelines, Triad could be required to provide monetary or other remedies to the lender customer. We ceased providing contract underwriting services in 2008, although we retain potential liability for our previous

underwriting activities. During 2008, expenses for contract underwriting remedies increased from historical levels to approximately $1.1 million. We currently do not expect to incur material contract underwriting remedy expenses in 2009.

 

Competition and Market Share

 

Prior to July 15, 2008, our competition for insurance written through the flow channel primarily included:

 

 

We previously competed in the structured bulk market with both the other private mortgage insurers and providers of other forms of credit enhancements.

 

According to industry data, Triad had an estimated 2.3% share of total net new insurance written in the first six months of 2008 compared to 6.4% in 2007. Triad ceased issuing commitments for mortgage insurance on July 15, 2008 and, as a result, our market share in the second half of 2008 continued to decline and was not material.

 

Underwriting Practices

 

Effective July 15, 2008, we entered into run-off and we no longer issue commitments for MI. Prior to run-off, we evaluated risk based on historical performance and utilized automated underwriting systems in the risk selection process to assist the underwriter with decision-making. The process evaluated the mortgage lender, the geographic area of the property securing the loan, the borrower’s ability and willingness to repay the mortgage loan, as well as the purpose and type of loan. Loan characteristics that we analyzed included: (i) LTV ratio; (ii) type of loan instrument and the amortization schedule; (iii) purpose of the loan; (iv) level of documentation; (v) type of property; and (vi) occupancy. In determining the borrower’s ability and willingness to repay the mortgage loan, we examined the borrower’s Fair, Isaac and Co., Inc. (“FICO”) credit score, the borrower’s housing and total debt ratios, as well as the borrower’s employment status.

 

During the fourth quarter of 2007 and first quarter of 2008, we announced and began to implement adjustments in our underwriting guidelines specific to our flow business. These adjustments placed limitations on maximum LTVs, minimum FICO credit scores and acceptable documentation, among other items. Furthermore, these limitations were more restrictive in certain geographic markets that had depressed housing markets and high default rates. These adjustments led to significant reductions in the level of new insurance written in the first half of 2008 from the level written in 2007.

 

Financial Strength Rating

 

We and other mortgage insurers have generally considered a financial strength rating of AA- or Aa3 from at least two of the three rating agencies, Standard & Poor’s Ratings Services, Moody’s Investor Services and Fitch Ratings (collectively, the “rating agencies”), as an important element in a mortgage insurer’s ability to compete for new business. In connection with the decision to transition our business into run-off, we notified the rating agencies that we were terminating all agreements with them regarding the issuance of ratings on the Company. As a result, the rating agencies have since withdrawn their ratings for us and for our subsidiaries, including Triad.

Defaults and Claims

 

Defaults

 

The claim process on mortgage insurance begins with the lender’s notification to the insurer of a default on an insured’s loan. We define a default as an insured loan that is reported to be in excess of two payments in arrears at the reporting date and all reported delinquencies that were previously in excess of two payments in arrears and have not been brought current. The master policies require lenders to notify us of default on a mortgage payment within ten 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 forty-five 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, declining value in the underlying property, changes in borrower income, unemployment, divorce, illness and the level of interest rates. The level of delinquencies has historically followed a seasonal pattern, in which delinquencies will generally decrease during the first part of the year and will generally increase during the latter part of the year. However, given the current state of the housing and mortgage market as well as the general state of the economy, such a decrease in the first part of the year may not materialize. In addition, the MI industry has little historical experience in projecting defaults in a market environment characterized by widespread declining house prices. Such declines, which could result in the value of the borrower’s home being less than the amount owed under the mortgage, may cause otherwise financially capable borrowers to stop making mortgage payments and allow their mortgages to go into default.

 

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. In certain instances, we may advance the borrower the delinquent loan payments in order to cure the default. In such cases, we institute a repayment plan for the borrower. If the insured loan subsequently defaults and results in a submission of a claim, the unpaid amount of the advance reduces the claim amount.

 

See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” below for a summary of Triad’s default statistics at December 31, 2008 and 2007.

 

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, the borrower’s ability to overcome temporary financial setbacks and our ability to rescind coverage on the loan due to misrepresentation or program violations at origination. 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. Recently, the time frame between first notice of default to ultimate claim payment has increased for a variety of reasons including:

 

 

Historically, the payment of claims is not evenly spread throughout the insurance coverage period. Prior to 2007, relatively few claims were paid during the first year following loan origination. A period of rising claim payments historically followed. Thereafter, the number of claim payments historically declined at a gradual rate, although the rate of decline could be affected by local economic conditions. We are currently experiencing increased early default and claim activity on loans originated in 2006, 2007 and 2008 that differs significantly from

historical levels. We believe this is primarily the result of a deterioration in the housing market evidenced by a decline in home prices, as well as a larger percentage of loans originated with high LTVs during these years, coupled with poor underwriting standards by mortgage loan originators in the mortgage market. It is difficult to project the claim pattern peak of these books of business given the early accelerations, the risk composition of the underlying loans and the general conditions in the housing market. Accordingly, we cannot predict when, if ever, the historical pattern of claims will return in the future.

 

Under the terms of Triad’s master policies, the lender is required to file a claim with us no later than 60 days after it has acquired the 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 policies, 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 amounts are subject to review and possible adjustment by us. Our experience indicates that the claim amount on a policy generally ranges from 105% to 110% of the unpaid principal amount of a foreclosed loan.

 

Generally, 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. While we continue to use the option to purchase properties in settlement of claims, given the generally nationwide house price deterioration, the number of instances in which we chose this option diminished considerably during 2008. At December 31, 2008, we held 5 properties with a combined fair value of approximately $713,000 that were acquired by electing to pay the full claim amount compared to 57 properties with a combined fair value of approximately $10.9 million held at December 31, 2007. 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. Where we choose to purchase the property in settlement of claims, our risk of loss may increase. There can be no assurance that our current inventory of purchased properties can be disposed of for the current fair value nor can there be any assurance that the purchase option method will be a viable option for settling claims in 2009.

 

Generally, our master policies provide that we are not liable to pay a claim for loss if the application for insurance for the loan in question contains fraudulent information, misrepresentations, or other underwriting violations (“underwriting violations”). Where we find such underwriting violations, we may rescind, or cancel, coverage on the loan retroactive to the date the insurance was written. In cases where we do rescind coverage, we return all premiums paid on the policy. During 2008, we completed reviews on approximately 7,300 policies, and rescinded coverage on approximately 35% of these policies. In addition, we had 21,169 policies under investigation as of December 31, 2008. During 2007, we reviewed approximately 3,300 policies and rescinded coverage on approximately 11% of these policies. This activity was concentrated in policies originated during 2006 and 2007. We also experienced a higher rescission rate with policies originated through the structured bulk channel. In late 2008, we expanded the criteria used to determine whether a default would be investigated for underwriting violations. We currently expect that an elevated level of rescission activity will continue in 2009.

 

Our master policies also exclude 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.

 

Loss Mitigation

 

Once a default notice is received, we attempt to mitigate our 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. When available, such mitigation efforts typically result in reduced losses from the coverage percentage stated in the certificate of insurance. During 2007 and 2008, we experienced

limited opportunity to employ loss mitigation techniques and when employed, the results generally did not provide the same degree of savings as we have historically experienced. As a result, we paid out approximately 88% and 81% of potential exposure on all claims in 2008 and 2007, respectively, compared to approximately 77% in 2006. We believe this increase is primarily the result of the declining prices in the housing market, the lack of credit in the mortgage market, and an increase in paid claims from the most recent vintage years.

 

Recent Loss Mitigation Initiatives

 

Success in mitigating losses is important to our success. Given the level of home price depreciation over the past two years, we have had limited opportunity to utilize loss mitigation techniques that previously proved very successful.

 

As a result, we created a Strategic Initiatives Group to identify, evaluate, prioritize, implement and measure new loss mitigation and quality assurance tactics and strategies, and to identify other opportunities to reduce losses and add value. Over the past year, new initiatives implemented include:

 

 

We are also active participants in the SMP and HMP and have provided our delegated approval to the GSEs to make modifications under these programs.

 

In addition, we also may obtain deficiency judgments against borrowers in order to recoup some of our losses from the payment of a claim. While this loss mitigation technique has previously been employed, we have expanded use of this technique due to the current economic environment. The availability and limitations on obtaining deficiency judgments vary state-by-state.

 

We continue efforts to identify, evaluate, and recommend additional loss mitigation activities.

 

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. In accordance with GAAP, we generally do not establish loss reserves for the estimated cost of settling claims on insured loans that are not currently in default. 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 that the loan has been in default, as well as whether the defaults were underwritten as flow business or as part of a structured bulk transaction. Beginning in 2007, we incorporated in the calculation of loss reserves the probability that a policy may be rescinded for underwriting violations due to borrower misrepresentation or program violations at origination. 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 our loss reserving process. Detailed analysis of our 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 5 to the Consolidated Financial Statements.

Gross Risk in Force

 

We had $16.9 billion of gross risk in force as of December 31, 2008 compared to $18.5 billion as of December 31, 2007. Gross risk in force includes risk from both Primary and Modified Pool insurance, prior to adjustment for risk ceded to captives in our Primary flow business and applicable stop loss limits and deductibles for Modified Pool contracts. An analysis of the quality of our insured portfolio is provided in the “Insurance and Risk in Force” section of “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

Geographic Dispersion

 

The following tables reflect the percentage of gross risk in force and the default rates on our book of business by location of property as of December 31, 2008.

 

Geographic Distribution of Risk in Force

 

 

The table above shows that California, Florida, Arizona, and Nevada contribute 34.4% of our gross risk in force as of December 31, 2008. Our policies in these states have higher default rates than the rest of the country and also have significantly higher average loan amounts. Furthermore, these states have also experienced some of the largest declines in home prices, which reduces the availability of loss mitigation opportunities for a default.

 

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

 

Regulation

 

Our insurance subsidiaries are subject to comprehensive, detailed regulation, principally for the protection of policyholders rather than for the benefit of stockholders, 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.

 

Because the parent 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 parent company’s common stock and certain transactions between Triad and the Company or its 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 Division and obtains the Division’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 Division 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.

 

The insurance laws of Illinois generally limit the payments of dividends by an insurance company unless it has sufficient capital and surplus. However, under the Corrective Order, Triad is currently prohibited, and expects to be prohibited for the foreseeable future, from paying any dividends to its parent. Triad also has a $25 million outstanding surplus note held by the Company. Under the terms of the Corrective Order, Triad is prohibited from paying interest or principal on the surplus note until otherwise approved by the Division. See Item 1A, “Risk Factors” for more information.

 

Mortgage insurers are 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. Federal tax law permits mortgage guaranty insurance companies to deduct from taxable income, subject to certain limitations, the amounts added to contingency loss reserves. As a result of operating losses in 2007 and 2008, the previously established contingency reserve was released earlier than the scheduled ten years in an amount that offset the operating loss for federal tax reporting purposes. Accordingly, the previously purchased ten-year non-interest bearing United States Mortgage Guaranty Tax and Loss Bonds (“Tax and Loss Bonds”) associated with the contingency reserve release were redeemed earlier than originally scheduled. As of December 31, 2008, Triad has redeemed substantially all of its previously purchased Tax and Loss Bonds. Triad expects operating losses for tax purposes to continue and net operating loss carry forwards to be generated for federal income tax reporting purposes for which it will be unable to receive any immediate benefit in its statement of operations.

 

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.

 

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 Division and Vermont Insurance Commissioner periodically conduct financial condition examinations of insurance companies domiciled in their states. On March 3, 2008, the Division began examinations of Triad and TGAC for the fiscal years 2004 through 2007. The results of the examinations are reports on the condition of the companies, which are certified by the Division and filed with all state insurance departments. The examination was concluded in August 2008, and the reports from this examination have not yet been issued. We have received preliminary results that indicate no adjustments or material recommendations are needed as a result of this examination.

 

On February 9, 2009, the State of Vermont Department of Banking, Insurance, Securities and Health Care Administration began an examination of Triad Re for the fiscal years 2004 through 2008. We have received preliminary results that indicate no adjustments or material recommendations are needed as a result of this examination.

A number of states prohibit the writing of new business if the insurer’s net risk in force is greater than 25 times the insurer’s total policyholders’ surplus. This restriction is commonly known as the risk-to-capital requirement. The Division has additional restrictions that limit our ability to write new business. At December 31, 2008, Triad’s risk-to-capital ratio was 125.2-to-1.

 

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.

 

The Company, Triad, and Triad’s subsidiaries are also indirectly 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 regulations affecting lenders. Triad is highly dependent upon federal housing legislation and other laws and regulations that affect the housing market. As previously mentioned, Fannie Mae and Freddie Mac were placed into conservatorship by the FHFA in August of 2008. Furthermore, recent government initiatives to address the disruptions in the capital markets, the decline in home prices and increasing foreclosures involve the operations of Fannie Mae, Freddie Mac, and the FHA. As of the date of this annual report on Form 10-K, we are unable to predict the impact that these recent government initiatives and the conservatorship of Fannie Mae and Freddie Mac will have on our future results of operations and prospects. Additional federal or state government regulations could be announced that may further affect our operations, either positively or negatively.

 

See “Corrective Order” and “Recent Government Initiatives” under this Item 1 for additional information about regulatory restrictions and initiatives.

 

Available Information

 

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 SEC. This material may be accessed by visiting the Investors/SEC Filings section of our web site at www.triadguaranty.com. These filings are also accessible on the SEC’s website, www.sec.gov. You may read and copy any materials the Company files with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. You may obtain information on the operation of the Public Reference Room by calling the SEC at (800) 732-0330.

 

Employees

 

As of March 6, 2009, we employed approximately 150 persons, with 149 persons being employed full-time. Employees are not covered by any collective bargaining agreement. We consider our employee relations to be satisfactory.

Executive Officers of the Registrant and its Primary Subsidiaries

 

Our executive officers are as follows:

 

 

 

 

Kenneth W. Jones has been employed as our President and Chief Executive Officer since October 2008, and also serves as our principal financial officer. Prior to his current position, Mr. Jones served as our Senior Vice President and Chief Financial Officer from April 2006 to October 2008. Mr. Jones has over 25 years of experience in the financial management of companies. Prior to joining Triad, he was employed by RBC Liberty Insurance Corporation, where he served as Senior Vice President and Chief Financial Officer from November 2000 to December 2005. 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 employed by Ernst & Young LLP for 14 years.

 

Kenneth S. Dwyer has been employed as the Vice President and Chief Accounting Officer of Triad Guaranty since September 2003. Previously, Mr. Dwyer served as Vice President and Controller of Jefferson Pilot from 1997 to 2003. Prior to that, he was the Vice President and Controller of Pan American Life Insurance and was also employed by Deloitte & Touche as a senior manager.

 

Shirley A. Gaddy joined Triad in 1996 and has been Senior Vice President, Operations since April 2002. Previously, Ms. Gaddy was employed by Life of the South from 1995 to 1996 as Assistant Vice President. She was with Integon Life Insurance Corporation from March 1972 to December 1994, most recently as Assistant Vice President, Manager Credit Insurance. Ms. Gaddy has been in the insurance/mortgage industry for over 33 years.

 

Stephen J. Haferman has been employed as our Senior Vice President, Strategic Initiatives since July 2008. Previously, Mr. Haferman served as Vice President, Risk Management and Information Technology from March 2006 to July 2008. Mr. Haferman was previously employed by Cheryl and Company from February 2003 to March 2006, where he served as Senior Vice President, Chief Operating Officer. From June 2001 to January 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; and Vice President, Risk Department Manager. From 1988 to 1992, he worked for National City Bank where he was Risk Manager.

 

George L. Jackson has been Vice President, Information Services and Chief Information Officer since July 2008. Mr. Jackson served as our Vice President, Information Services from January 2005 to July 2008 and Assistant Vice President, Technology Services from January 2000 to December 2004. He joined Triad in 1998 as a Project Manager. Mr. Jackson has 23 years of management experience in the Information Technology industry. Previously,

Mr. Jackson held IT management positions at Unifi, ISSI, Roy F. Weston, and Aquidneck Data Corporation (Kodak).

 

William T. Ratliff, III served as the interim President and Chief Executive Officer from July 18, 2008 until October 22, 2008, and continued to serve as an executive officer from October 22, 2008 until March 10, 2009. Mr. Ratliff, III has been the Chairman of the Board of the Company since 1993. Mr. Ratliff, III was Chairman of the Board of Triad from 1989 to 2005 and President of Collateral Investment Corp. from 1990 to 2005. Mr. Ratliff, III has also been President of Collat, Inc. since 1995 and a director since 1987. Mr. Ratliff, III has been Chairman of the Board of Directors of New South Federal Savings Bank since 1986 and President and a director of New South Bancshares, Inc., New South’s parent company, since 1994.

 

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 also served as Vice President of Triad from 1996 until 1999. From 1982 to 1995, Mr. Wall was employed by Integon Life Insurance Corporation 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 our actual results to differ materially from the results contemplated by forward-looking statements made by us in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” or elsewhere. Investors should consider these factors carefully in reading this annual report on Form 10-K.

 

A deeper or prolonged recession in the United States coupled with continued tightened credit in mortgage markets may increase mortgage defaults and limit opportunities for borrowers to cure defaults or for our company to mitigate its losses, which would adversely impact the future value of our company.

 

The United States is in one of the most severe recessions in modern history and has experienced significant negative macroeconomic trends, including widespread job losses, higher unemployment, lower consumer spending, continued declines in home prices and substantial increases in delinquencies on consumer debt, including defaults on home mortgages. Moreover, disruptions in the financial markets during 2008 and continuing into 2009, particularly the reduced availability of credit and tightened lending requirements, have impacted the ability of borrowers to refinance loans or sell their existing homes. Economists are predicting a longer and more severe recession, which will have a substantial negative impact on our business. Similarly, while tight credit markets facilitate higher persistency, they also limit the flexibility of borrowers when dealing with a loan in default. In particular, recessionary forces and tight credit markets can lead to greater defaults in both number and in severity and otherwise adversely impact the performance of our existing mortgage insurance in force, including reducing our default cure rates, increasing the amount or accelerating the timing of our claims payments, and limiting our ability to mitigate losses. A recession more severe than we have anticipated may cause our future performance to vary significantly from the projections we submitted to the Division in our corrective plan, which could cause the Division to place us in rehabilitation or to appoint a receiver to liquidate our assets, in which case the market value of our common stock would be reduced or eliminated and little or no funds would ever be available for distribution to our stockholders.

 

In October 2008, we received approval of a corrective plan provided to the Division. The corrective plan, among other items, provided our best estimate of the financial results of Triad through December 31, 2012. Substantial adverse changes in the U.S. economy have occurred since we submitted the corrective plan, including a continuing decline of home prices, increasing unemployment rates, and a continuation of tight credit markets. If we are unable to demonstrate to the satisfaction of the Division that our financial and operating plan will likely produce a solvent run-off, the Division may take additional actions regarding Triad that may have a material adverse effect on our financial condition or results of operations.

 

In addition to enforcing the normal regulatory requirements, the Division has a significant amount of oversight pursuant to the Corrective Order issued in August 2008. Our corrective plan approved by the Division in October 2008 anticipated a solvent run-off based upon our best estimate at the time of future defaults and claims. The financial statements for our insurance operating subsidiaries that are provided to the Division and that form the basis of our corrective plan were prepared in accordance with Statutory Accounting Principles (“SAP”) set forth in the Illinois Insurance Code. SAP differs from GAAP, which are followed to prepare the financial statements presented in this annual report on Form 10-K. The primary differences between GAAP and SAP for Triad at December 31, 2008 are the methodology utilized for the establishment of reserves and the recognition of the net amount for the excess of loss reinsurance policy that is currently in arbitration. Triad’s policyholders’ surplus calculated in accordance with SAP declined from $220 million at September 30, 2008 to $88 million at December 31, 2008. We have already recorded a deficit in assets calculated in accordance with GAAP as of December 31, 2008.

 

Since the submission of the corrective plan, the worsening recession has negatively impacted the number of Triad’s reported defaults and caused increased losses from operations, in each case in amounts greater than the amounts originally forecasted in our corrective plan. We are currently refining our projections based upon updated assumptions concerning a number of factors, including higher default rates, further declines in home prices, and increases in unemployment rates. Our new assumptions produce a range of potential ultimate outcomes for our run-off, but include projections showing that on a likely case basis and absent additional action by the Division or favorable changes in our business, we will report a deficiency in policyholders’ surplus in our SAP balance sheet as early as March 31, 2009 and continuing at least through 2011. Although we currently project that this insolvency under SAP will be temporary and our run-off will ultimately be successful, we believe such insolvency would likely lead to the institution by the Division of receivership proceedings against TGIC if not corrected, which would have a material adverse effect on our business and stockholders and likely would cause us to cease to continue as a going concern.

 

If the Division does not believe that our financial and operating plan is likely to produce a solvent run-off, it may appoint a conservator or liquidator of Triad for the protection of its existing policyholders. Any receivership proceeding involving Triad could effectively eliminate all value associated with the parent company’s ownership of Triad.

 

We are currently working with the Division to structure a revised corrective plan to address our projected SAP deficiency in policyholders’ surplus, although no assurance can be given that we will be successful in these efforts. If we are unable to gain approval from the Division for a revised corrective plan that addresses this issue, the Division could place TGIC into receivership proceedings, including the placement of Triad in rehabilitation, the appointment of a conservator for Triad or the appointment of a receiver to liquidate Triad’s assets. Any receivership proceeding involving Triad could effectively eliminate all value associated with our ownership of this operating subsidiary, in which case the market value of our common stock would be reduced or eliminated and little or no funds would ever be available for distribution to our stockholders. If Triad were placed in receivership proceedings by the Division or if we were unable to pay our indebtedness or other obligations when due, we would cease to continue as a going concern and we could be forced to seek protection from creditors under Chapter 11 of the United States Bankruptcy Code, and little or no funds would ever be available for distribution to our stockholders.

 

Under terms of the Corrective Order with the Division and the terms of the original surplus note, Triad is prohibited from making interest payments on its $25 million surplus note to the holding company. If the financial condition of Triad continues to deteriorate, then the Division will be unable to lift that restriction for the foreseeable future, which would jeopardize the ability of the holding company to make the required interest payments on its $35 million outstanding long-term debt.

 

The terms of the $25 million surplus note at Triad restrict the accrual or payment of interest if the statutory surplus at the time the scheduled interest payment is due falls below the level of the statutory surplus at origination of this note. In the second quarter of 2008, the statutory surplus fell below the balance at origination of the note, effectively prohibiting the payment of interest for the foreseeable future. Additionally, the Corrective Order prohibits the payment of interest or principal on the surplus note. The holding company has limited assets and even more limited sources of revenues. Current financial projections do not anticipate any growth in surplus through the foreseeable future that would enable the payment of interest on the surplus note nor do we expect to seek to obtain

the approval from the Division to lift this restriction under the Corrective Order. Without the payment of interest from Triad on the $25 million surplus note, the Company’s ability to service its existing debt would be limited and would eventually result in a default on its existing long-term debt.

 

There is substantial doubt about our ability to continue as a going concern.

 

We have prepared our financial statements on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities and commitments in the normal course of business. However, there is substantial doubt as to our ability to continue as a going concern. This uncertainty is based on the ability of Triad to comply with the provisions of the Corrective Order, our recurring losses from operations and a deficit in assets at December 31, 2008. Our financial statements included in this annual report do not include any adjustments relating to the recoverability and classification of recorded asset amounts or amounts of liabilities that might be necessary should we be unable to continue in existence.

 

The report of our independent registered public accounting firm dated March 13, 2009 on our consolidated financial statements for the two years ended December 31, 2008 and 2007 notes that there is substantial doubt about our ability to continue as a going concern.

 

Triad has historically reimbursed its parent company for operating expenses incurred on behalf of the operating subsidiary under terms of a capital management agreement. Terms of the Corrective Order require the approval of the Division for all intercompany transactions. If we are unable to obtain the Division’s approval for Triad to reimburse certain operating costs of the parent company, then the limited assets of the parent company will dissipate at a much greater pace, which would further jeopardize the ability of the parent company to make the required interest payments on its $35 million outstanding long-term debt.

 

During 2008, Triad reimbursed its parent in excess of $4 million for certain operating expenses. Examples of items reimbursed in 2008 include directors’ fees, legal and accounting fees and certain insurance premiums. The parent company has minimal investment income and a limited amount of assets and is currently paying the debt service on its $35 million long-term debt from these assets. If the holding company is unable to recoup the majority of its cash expenses from Triad, the length of time in which the holding company will be able to make the required debt service payments on the $35 million outstanding long-term debt will be reduced.

 

Our operating cash flow consists of net premium received plus investment income less losses and expenses paid. We expect a deficit in our operating cash flow in 2009 and beyond. During 2008, we began to reposition our existing investment portfolio reflecting our inability to benefit from tax-advantaged securities and to match maturities in the investment portfolio to expected operating cash flow deficits in 2009 and beyond. In 2008, the financial markets, including the fixed-maturity debt markets, experienced unprecedented turbulence, causing prices to drop precipitously from period to period. While we successfully completed the repositioning of the majority of the portfolio at December 31, 2008, we had approximately $159 million of municipal securities remaining in our portfolio that we plan to sell in the future. If the proceeds from maturities of securities are not sufficient to cover operating cash flow deficits we could be forced to liquidate securities which, depending on market conditions, may result in realized investment losses.

 

As it became evident early in 2008 that we would no longer be able to achieve tax benefits from the tax-exempt income provided by municipal securities due to the significant tax losses being generated from operations, we developed a strategy to liquidate those securities and convert to higher-yielding taxable bonds. During 2008, the additional credit enhancement provided by financial guarantors on approximately 60% of our municipal portfolio proved to be of limited value due primarily to the guarantors’ involvement in the subprime mortgage crisis, causing the fair value of these securities to decline. While we transitioned approximately 80% of our municipal portfolio to taxable securities by the end of 2008, falling prices and illiquidity in the marketplace contributed to our inability to execute our strategy completely.

 

At the same time we were repositioning the portfolio to a higher yielding taxable portfolio, we also shortened the maturity of our portfolio to better match our anticipated cash needs resulting from the anticipated increase in claims. If our planned matching of investment maturities to anticipated cash needs fails to provide sufficient cash flow, then we could be forced to liquidate securities which may result in realized investment losses.

The Company is currently listed on The NASDAQ Stock Market. The NASDAQ Stock Market has certain continued listing requirements regarding public float, minimum bid price, and net worth, among others. If we are unable to meet these continued listing requirements, our common stock may be delisted in which case trading would be available only in over-the-counter markets and stockholder liquidity would be adversely affected.

 

The Company is currently listed on the NASDAQ Stock Market. The financial crisis that has developed over the past year has had a severe impact on the stock markets. Generally, most stock market indices have reported declines in the 40% to 50% range over the past year. Due to the significant decline in stock prices, NASDAQ has temporarily suspended certain of its listing requirements. If these temporary suspensions are lifted, we may be in violation of certain listing requirements and may be delisted. While NASDAQ does provide for an appeals process that could enable us to remain listed on NASDAQ, there is no guarantee that we would be successful in an appeal or that we would choose to appeal. If we are delisted from the NASDAQ stock market, our common stock likely would be traded only in the over-the-counter markets and stockholder liquidity would be adversely affected.

 

Fannie Mae and Freddie Mac were both placed under the conservatorship of FHFA, an agency of the United States Government in 2008. They are currently in the process of re-examining their capitalization, business practices, rules surrounding modifications of existing mortgages, and other items that could impact our business during run-off. Changes in the business practices or legislation relating to Fannie Mae and Freddie Mac could significantly impact our results in run-off.

 

Fannie Mae and Freddie Mac are the beneficiaries of the majority of our policies, and their business practices have a significant influence on us. 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. FHFA has placed both Fannie Mae and Freddie Mac in conservatorship. Furthermore, the recent housing turmoil has prompted a number of actions by the federal government to support the housing market in general as well as specifically supporting distressed borrowers. These actions and future federal government actions may impact Fannie Mae and Freddie Mac. If the business practices of Fannie Mae and Freddie Mac change as a result of conservatorship or legislation or other federal government initiatives, our financial condition and results of operations could be adversely impacted.

 

Risks Related to Economic Conditions

 

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 results of operations.

 

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 segment defaults by a variety of criteria. The criteria include, among others, policy year, lender, geography, the number of months and number of times the policy has been in default, the probability the policy may be rescinded for underwriting violations, as well as whether the defaults were underwritten as flow business or as part of a Primary or 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 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. An important consideration in determining the frequency factor is the cure rate. In general, the cure rate is the percentage of reported defaults that ultimately are brought current (1) through payments of all past due payments or (2) by disposing of the property securing the mortgage before foreclosure with no claim ever filed because the proceeds of the sale satisfied the mortgage. During 2007 and 2008, our cure rate declined as home prices declined and the ability to dispose of the property through a sale before foreclosure diminished. If our assumptions regarding anticipated cure rates as well as other considerations used in the frequency factor vary from those actually

experienced in the future, actual paid claims on the existing delinquent loans may exceed the reserves that we have established and require an additional charge to results of operations.

 

A growing consideration in the establishment of our frequency factor assumptions during 2008 was the impact of rescissions. Loans that are four or more months past due within the first twenty three months since origination are classified as an Early Payment Default (EPD). Terms of our master policies allow Triad to rescind coverage on an EPD for fraud or program violations that occurred during the mortgage loan origination process. When a certificate is rescinded, the treatment is similar to a cure for reserving purposes and we no longer calculate a reserve on that loan. Due to the unusually high levels of rescissions on those EPDs for which we completed our investigation, our reserving methodology incorporates an expected rescission percentage on the EPDs that we are in the process of investigating. In the fourth quarter of 2008, in response to increased rescission activity we expanded the criteria used to determine whether a default would be investigated for underwriting violations in accordance with our master policy provisions. If our assumptions regarding anticipated rescission rates used in the frequency factor vary from those actually experienced in the future, actual paid claims on the existing delinquent loans may exceed the reserves that we have established and require an additional subsequent charge to results of operations. Any impediment to our ability to rescind coverage for underwriting violations would be detrimental to our success in run-off.

 

Severity is the estimate of the dollar amount per claim that will be paid. The severity factors are estimates of the percentage of the risk in default that will ultimately be paid. The severity factors used in setting loss reserves 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. An important component in the establishment of the severity factor is the expected value of the underlying home for loans in default compared to the outstanding mortgage loan amount. If our assumptions regarding anticipated house price depreciation as well as other considerations used in the severity factor vary from those actually experienced in the future, actual paid claims on the existing delinquent loans may exceed the reserves that we have established and require an additional charge to results of operations.

 

The frequency and severity factors are updated quarterly to respond to the most recent data. 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 declining cure 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 results of operations.

 

Consistent with industry practice, we provide reserves only for loans in default that have been reported to us rather than on our estimate of the ultimate loss. As such, our results of operations in certain periods could be disproportionately affected by the timing of reported defaults.

 

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. During 2008, the loans in default for which we provide reserves grew 139% to 40,286 at December 31, 2008. 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 even larger percentage increase in the level of loans in default than that experienced in 2008. An increase in the number of loans in default would require additional reserves and a charge to results of operations as they are reported to us.

 

During 2008 the United States housing market experienced a significant amount of home price depreciation, which had a direct negative impact on our loss reserves and paid claims during 2008. If home prices continue to decline on a more significant or larger geographic basis than what we experienced in 2008, we may incur a higher level of losses from paid claims and also be required to increase our loss reserves.

 

Primary components of our loss mitigation efforts include selling a property prior to foreclosure as well as purchasing the property in lieu of paying the coverage percentage specified in the insurance policy. Home prices

affect both these mitigation options. The S&P/Case-Shiller^© Home Price Index for the 20-City Composite as of December 2008 indicated an annual 18.6% decline in home prices from one year ago, the largest annual decline since the index was first published. There were declines in every city comprising the index during 2008, indicating that home price depreciation is not limited to certain geographical locations in the United States. This high level of home price depreciation has negatively affected our ability to mitigate losses. 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 significant portion of 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, 2008, approximately 33% of our Primary gross risk in force and approximately 74% of our Modified Pool gross risk in force was 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, 2008, approximately 12% of our Primary gross risk in force and 14% of our Modified Pool gross risk in force was comprised of pay option ARMs with the potential for negative amortization on the loan. These loans provide borrowers the option, for a stated period of time, to make monthly payments that do not cover the interest due on the loan. If the borrower chooses this payment option, the unpaid interest is added to the outstanding loan amount, which creates negative amortization. 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. We already have experienced a substantially higher default rate on pay option ARMs than the remainder of our portfolio, even before many of these loans were scheduled to shift to amortizing payments. 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, the lack of long-term historical performance data associated with pay option ARMs across all market conditions makes it difficult to project performance and could increase the volatility of the estimates used in our reserve models. If interest rates increase and cause “payment shocks” to borrowers with ARMs, our default rate could increase, which could have a material adverse impact on our business, financial condition and operating results.

 

Geographic concentration of our risk in force in certain distressed markets has resulted in increased defaults and higher risk in default from the significantly larger loans in these states. Ongoing house price depreciation in these distressed markets could lead to further increases in reserves and paid claims, which could further negatively impact our financial performance.

 

At December 31, 2008, our risk in force for California, Florida, Arizona and Nevada, which we classify as “distressed markets,” represented approximately 34% of our gross risk in force on a per policy basis. These distressed markets have experienced some of the most rapid home price depreciation in 2007 and 2008 and disruption in the housing markets when compared to the rest of the country. Moreover, they represented 60% of both our risk in default and our loss reserves. The default rate at December 31, 2008 in these distressed markets amounted to 22.7% compared to 11.7% for the remainder of our portfolio. If the housing markets continue to decline at a steep rate or for an extended period of time in these distressed markets, we could experience additional adverse effects on our operating results and financial condition due to the large concentration of our business in these distressed markets.

 

We experienced a significant increase in reported defaults and paid claims during 2008. If the pace of declining home prices and ongoing credit problems in the mortgage marketplace continues or remains unsettled, we anticipate an increased number of defaults and paid claims, which would have a negative impact on our results of operations.

 

Beginning in 2006 and continuing in 2007 and 2008, home prices in most geographic areas declined. Many borrowers that had qualified for mortgages under less restrictive credit standards have found it difficult to meet their ongoing mortgage payments. Faced with declining home values and a tight market for credit, borrowers unable to meet their payment obligations often cannot refinance, and are not able to sell their homes for an amount sufficient to pay off their mortgage. These conditions have resulted in greater borrower defaults, contributing to a 139% increase in our default rate during 2008. The default rates on the 2006 and 2007 vintage years, which contain increased risk factors such as Alt-A and pay option ARMs, especially in the distressed market states of California, Florida, Arizona and Nevada, have been particularly high. These factors contributed significantly to the substantial increase in our reserves during the year and, if they continue, are expected to result in additional and significant increases in our reserves in the future.

 

The inability of borrowers to sell their homes or refinance their mortgages in the current environment has resulted in a greater percentage of defaulted loans becoming claims by lenders against mortgage insurers. As a result, we have lowered our assumptions regarding the cure rates for the purpose of our reserve models, which causes an increase in our frequency factor. The decrease in the cure rate was a significant reason for the increase in our reserves during the year. If the factors described above continue, we expect further increases in actual defaults, further decreases in our cure rates and corresponding increases in our reserves that would significantly and adversely affect our results of operations.

 

Due to the fact that we are in run-off and cannot replace our existing business, an extended period of low mortgage interest rates and relaxed credit terms for our existing borrowers could lead to increased refinance activity that could have a negative impact on persistency, which would lead ultimately to reduced premiums.

 

In an effort to stimulate the housing markets, the Obama administration has announced plans to attempt to lower mortgage interest rates. Interest rates fell over the last several months of 2008 and are generally expected to remain at historical low levels for some period of time. This could allow certain borrowers with sufficient LTV and credit scores to refinance their mortgages at a lower rate. Additionally, an extended period of low interest rates presents borrowers with an ARM product the opportunity to refinance to a fixed rate product. When borrowers refinance, our coverage terminates and we cannot provide coverage on the refinanced loan because we are in run-off. An extended period of low mortgage interest rates could lead to increased refinancings, which would have a negative impact on persistency and could result in decreased revenues due to a reduction of insurance in force. Additionally, those that could qualify for refinancing would be deemed to be the better credit risks and thereby create anti-selection for the remaining portfolio as those remaining would be deemed to be a worse credit risk.

 

Risks Related to Products

 

A large portion of our insurance in force consists of loans with high loan-to-value ratios, which could result in a greater number of defaults and larger claims than loans with lower loan-to-value ratios during periods of declining home prices.

 

At December 31, 2008, approximately 14% of our mortgage insurance in force consisted of insurance on mortgage loans with LTVs at origination greater than 95%. In periods of declining home prices such as 2007 and 2008, these loans have a greater propensity to default due to the limited equity investment of the borrower. Loans with greater than 95% LTV at origination have experienced a significantly greater default rate than lower LTVs as of December 31, 2008. Many of the high LTV loans also contain other risk factors such as geographic location in distressed markets and were originated with reduced documentation. Faced with mortgages that are greater than the value of the home, a number of borrowers are simply abandoning the property and walking away from the mortgage, without regard to their ability to pay. This limits the ability of the servicer to work with the borrowers to avoid defaults and foreclosure and increases the imbalance of the housing inventory for sale, which in turn further depresses home prices. If we are required to pay a claim on a high LTV loan, our loss mitigation opportunities are limited during these periods of declining home prices and we generally are required to pay the full option payment, which is the highest amount that we could pay under our contracts with lenders. If we experience an increased default rate and paid claims on high LTV loans, our results of operations could be adversely affected.

Risks Related to Operations

 

Because we generally cannot cancel mortgage insurance policies or adjust renewal premiums due to changing economic conditions, unanticipated defaults and claims could cause our financial performance to suffer significantly.

 

We generally cannot cancel the mortgage insurance coverage that we provide or adjust renewal premiums during the life of a mortgage insurance policy, even as economic factors change. As a result, the impact of unanticipated changes, such as the dramatic decline in home prices resulting in increased defaults and claims like those experienced in 2008, generally cannot be offset by premium increases on policies in force 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, especially in distressed financial markets. An increase in the number or size of unanticipated defaults and claims could adversely affect our financial condition and operating results because we could not cancel existing policies or increase renewal premiums.

 

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

 

Historically, 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. However, in recent years, we experienced an earlier default and claim pattern, with 74% of our risk in default at December 31, 2008 coming from the 2006 and 2007 vintage years. While we experienced an earlier default rate among our 2006 and 2007 vintages, we are still experiencing the normal seasoning on our older vintage years that are now in the peak default and claim paying period. Total insurance written from the period of January 1, 2004 through December 31, 2007 (vintage years within the historical highest default and claim paying period) represented 86% of our risk in force as of December 31, 2008. Accordingly, a significant majority of our 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.

 

Insurance written under our delegated underwriting program may subject our mortgage insurance business to unanticipated claims.

 

A significant percentage of our insurance in force was underwritten pursuant to a delegated underwriting program. These programs permitted certain mortgage lenders to determine whether mortgage loans meet our program guidelines and enabled these lenders to commit us to issue mortgage insurance. If an approved lender committed us to insure a mortgage loan, we may rescind coverage on that loan if the lender failed to follow our delegated underwriting guidelines. We generally remain at risk for any loans previously insured on our behalf by the lender, absent fraud or other similar circumstances. The performance of loans insured through programs of delegated underwriting has not been tested over a period of extended adverse economic conditions such as we currently find ourselves in, 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.

 

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

 

Under the terms of our contract underwriting agreements with certain lenders, we agreed 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. The indemnification may be in the form of monetary or other remedies. As a result, we assumed risk in connection with our contract underwriting services. Factors that could affect the performance of loans for which we contract underwrote, including but not limited to worsening economic conditions and falling home prices, 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 in establishing reserves for these potential liabilities, and these reserves may not be adequate to cover liabilities that may arise.

If many of our lender partners for which we have entered into risk-sharing agreements, such as captive reinsurance treaties, continue under financial stress for an extended period of time, then the ability of these lenders to meet their financial obligations under the captive reinsurance treaties may be limited to the trust balances maintained within the reinsurance structures, which could have an adverse impact on our future results of operations.

 

Several of the lenders for which we had established captive reinsurance programs are in bankruptcy or have been taken over by Governmental agencies or lenders and many more are suffering financial stress. An integral component of the reinsurance treaties include trust balances, which remain under our control, to support a portion of the risk assumed by the reinsurer. As defaults increase and we reach the point where the attachment point is exceeded for individual vintage years, we cede reserves to the captive. When reserves are initially ceded to the captive, the requirement for additional trust balances generally increases. When the need for additional trust balances cannot be met through ceded reinsurance premiums, then additional capital contributions could be required by the lender. The ability of the lenders that are currently under financial stress to meet their future financial obligations under the captive reinsurance agreements beyond the existing trust balances may be limited, which could have an adverse impact on future results of operations. If for any reason a lender is unable to fund its reinsurance obligations, Triad would remain obligated to pay the claims, which would increase our losses.

 

We have not recorded any of the benefits or liabilities of the $95 million Excess of Loss reinsurance treaty in our GAAP financial statements. If we are unsuccessful in our arbitration hearings with the reinsurer, this could have a significant adverse impact on our ability to complete a successful run-off.

 

Triad maintains a $95 million Excess-of-Loss reinsurance treaty that provides a benefit when Triad’s risk-to-capital ratio exceeds 25-to-1 and its combined ratio exceeds 100% (the “attachment point”). Once the attachment point has been reached, following a one-time deductible of $25 million, the carrier is responsible for reimbursement of all paid losses in each quarter that the attachment point is breached up to the one-time $95 million policy limit. The coverage period is for 10 years. Additionally, terms of the treaty require Triad to continue the payment of premiums to the reinsurer amounting to approximately $2 million per year for the entire ten year period. The reinsurance treaty attached at the end of the first quarter of 2008, however, the reinsurance carrier subsequently provided a purported notice of termination of the agreement. The matter is currently in arbitration and we expect a decision in the second quarter of 2009. If we are unsuccessful in our arbitration hearings with the reinsurer, this could have a significant adverse impact on future viability for a successful run-off.

 

Loan servicers have recently experienced a significant increase in their workload due to the rapid growth in defaults and foreclosures. If the loan servicer fails to act proactively with delinquent borrowers in an effort to avoid foreclosure, then the number of delinquent loans eventually going to claim status could increase.

 

The loan servicer maintains the primary contact with the borrowers throughout the life of the loan but we can become involved with any potential loss mitigation. During periods of declining home prices and increased delinquencies, such as that currently being experienced in the mortgage business, it is important to us that the servicer be proactive in dealing with borrowers rather than simply allowing the loan to go to foreclosure. Historically, when a servicer becomes involved at an earlier stage of delinquency with workout programs and credit counseling, there is a greater likelihood that the loan will not go to foreclosure and will not result in a claim. During periods of increased delinquencies, it becomes extremely important that the servicer be properly staffed and trained to assist borrowers to avoid foreclosure. From our perspective, it is also extremely important to involve us as part of the loss mitigation effort as early as possible. If loan servicers do not properly staff and train their personnel or enlist our assistance in loss mitigation efforts, then the number of loans going to foreclosure may increase, resulting in a greater number of claims that we are required to pay, which will have an adverse impact on our future operating results.

 

Triad is operating in run-off under a Corrective Order from the Division and the outlook for the entire mortgage insurance industry remains uncertain. Maintaining experienced staff is critical to achieving a successful run-off.

 

We took significant actions in 2008 to eliminate all sales, marketing, and underwriting personnel as well as a number of personnel supporting those functions as we transitioned into run-off. The very nature of run-off as well as

the recent negative news concerning the financial markets, especially the mortgage markets, has introduced some level of stress and uncertainty among our remaining employees. We established severance and retention plans to help retain our key personnel that are scheduled to expire at the end of 2009. If we fail to adopt or gain approval from the Division of replacement plans, we may be unable to keep key personnel from moving to other industries that may offer better short-term opportunities and a more promising outlook. The loss of any key personnel could limit our ability to properly execute an efficient and effective run-off.

 

 

None.

 

 

Our principal executive offices are located at 101 South Stratford Road, Winston-Salem, NC 27104. This five-story office building totals 79,254 square feet and we currently lease approximately 71,007 square feet under a lease that will expire in 2012. All staff functions are located within this office complex. Due to the reduction in force in June 2008, we are actively attempting to sublease at least one floor; however, the local market for commercial property is weak due to the recession. We believe this property is suitable and adequate for its present circumstances.

 

We have closed all of our remote underwriting offices. We exited the lease for our facility in Toronto, Canada in the third quarter of 2008 and we liquidated our Canadian subsidiary in the fourth quarter of 2008.

 

We maintain mid-range and micro-computer systems in our corporate data center located in our headquarters building to support our data processing requirements for accounting, policy administration, claims, and risk management. We have back-up procedures in place in the event of emergency situations.

 

 

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

 

On February 6, 2008, James L. Phillips served a complaint against Triad Guaranty Inc., Mark K. Tonnesen and Kenneth W. Jones in the United States District Court, Middle District of North Carolina. The plaintiff purports to represent a class of persons who purchased or otherwise acquired the common stock of the Company between October 26, 2006 and November 10, 2008 and the complaint alleges violations of federal securities laws by the Company and two of its present or former officers. An extension to answer the complaint has been granted. We intend to contest the lawsuit vigorously.

 

Triad maintains a $95 million Excess-of-Loss reinsurance treaty that provides a benefit when Triad’s risk-to-capital ratio exceeds 25-to-1 and the combined ratio exceeds 100% (the “attachment point”). Once the attachment point has been reached, following a one-time deductible of $25 million, the carrier is responsible for the reimbursement of all paid losses in each quarter that the attachment point is breached up to the one-time $95 million policy limit. The coverage period is for 10 years. Additionally, terms of the treaty require Triad to continue the payment of premiums to the reinsurer amounting to approximately $2 million per year for the entire ten year period. The reinsurance treaty attached at the end of the first quarter of 2008; however, in April 2008, the reinsurance carrier provided a purported notice of termination of the agreement. By letter dated May 5, 2008, Triad notified the reinsurer that we considered the treaty to still be in effect and that we demanded arbitration seeking a ruling that the reinsurance remained in effect and requested that the reinsurer comply with terms of the treaty. The arbitration took place in front of a three-person panel in December 2008 and January 2009, with post-hearing briefs and oral arguments in February 2009. We expect a decision to be rendered by the arbitration panel in the second quarter of 2009.

 

 

None.

 

 

Market information

 

The Company’s common stock trades on The NASDAQ Global Select Market^® under the symbol “TGIC.” At December 31, 2008, 15,161,259 shares were issued and outstanding. The following table sets forth the high and low sales prices of the Company’s common stock as reported by NASDAQ during the periods indicated.

 

 

Holders

 

As of February 27, 2009, the number of stockholders of record of the Company’s common stock was approximately 326. In addition, there were approximately 4,400 beneficial owners of shares held by brokers and fiduciaries.

 

Dividends

 

Payments of future dividends are subject to declaration by the Company’s Board of Directors. Payment of dividends is dependent on the ability of Triad to pay dividends to the parent company. Under the Corrective Order, Triad is prohibited from paying dividends to the parent company without the prior approval of the Division. In addition, the insurance laws of the State of Illinois impose certain restrictions on dividends that an insurance subsidiary can pay its parent company. These restrictions, based on SAP, include requirements that dividends may be paid only out of statutory earned surplus and that limit the amount of dividends that may be paid without prior approval of the Division. In addition to these statutory limitations on dividends, Illinois regulations provide that a mortgage guaranty insurer may not declare any dividends except from undivided profits remaining on hand over and above the amount of its policyholder reserve. Currently, there are no intentions to pay dividends. See “Liquidity and Capital Resources” in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for a more detailed discussion of dividend payment restrictions.

 

Issuer purchases of equity securities and unregistered sales of equity securities

 

None.

 

The information required by this Item 6 is not required to be provided by issuers that satisfy the definition of “smaller reporting company” under SEC rules.

 

 

The following discussion is intended to provide information that the Company believes is relevant to an assessment and understanding of the Company’s consolidated financial position, results of operations and cash flows and should be read in conjunction with the Consolidated Financial Statements and Notes contained herein. In addition, the current adverse market conditions in the home mortgage and residential housing markets are unprecedented from an historical standpoint and have subjected our business, financial condition and results of operations to substantial risks, many of which are summarized under “Risk Factors” above, which should be read in conjunction with the following discussion.

 

Certain of the statements contained in this release are “forward-looking statements” and are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements include estimates and assumptions related to economic, competitive, regulatory, operational and legislative developments. These forward-looking statements are subject to change, uncertainty and circumstances that are, in many instances, beyond our control and they have been made based upon our current 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 a number of factors, including our ability to operate our business in run-off, the possibility of general economic and business conditions that are different than anticipated, legislative, regulatory, and other similar developments, changes in interest rates, employment rates, the housing market, the mortgage industry and the stock market, as well as the relevant factors described under “Risk Factors” and in the “Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995” section below with respect to forward-looking statements contained herein. Forward-looking statements are based upon our current expectations and beliefs concerning future events and we undertake no obligation to update or revise any forward-looking statements to reflect the impact of circumstances or events that arise after the date the forward-looking statements are made.

 

Overview

 

Triad Guaranty Inc. is a holding company that historically provided private mortgage insurance coverage in the United States through its wholly-owned subsidiary, Triad Guaranty Insurance Corporation (“Triad”). Triad ceased issuing new commitments for mortgage guaranty insurance coverage on July 15, 2008 and we are operating our business in run-off. As used in this annual report on Form 10-K, the term “run-off” means writing no new mortgage insurance policies and continuing to service existing policies. Servicing includes: receiving premiums on policies that remain in force; cancelling coverage at the insured’s request; terminating policies for non-payment of premium; working with borrowers in default to remedy the default and/or mitigate our loss; and settling all legitimate filed claims per our contractual obligations. Triad has agreed to a Corrective Order from the Illinois Department of Financial and Professional Regulation, Division of Insurance (the “Division”) that, among other items, includes restrictions on the distribution of funds by Triad.

 

We have historically provided Primary and Modified Pool mortgage guaranty insurance coverage on U.S. residential mortgage loans. We classify insurance as Primary when we are in the first loss position and the loan-to-value amount, or 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 has been delivered through the flow channel, which is defined as loans originated by lenders and submitted to us on a loan-by-loan basis. We have also historically provided 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 has been delivered through the structured bulk channel. Our insurance remains effective until one of the following

events occurs: the policy is cancelled at the insured’s request; we terminate the policy for non-payment of premium; the policy defaults and we satisfy all amounts due under the insurance contact; or we rescind the policy for violations of provisions of a master policy.

 

In run-off, our revenues principally consist of:

 

 

 

 

We also realize investment gains and investment losses on the sale and impairment of securities, with the net gain or loss reported as a component of revenue.

 

Our expenses consist primarily of:

 

 

Our results of operations in run-off depend largely on:

 

 

Our results of operations in run-off could also be impacted significantly by recent Federal government and private initiatives to stabilize the housing and financial markets. See Item I, “Business” and the discussion below for further details on these initiatives.

 

Persistency is an important metric in understanding our premium revenue, especially in run-off as no new business is being written, so our overall premium base is essentially fixed and will decline over time. The longer a policy remains on our books, or “persists”, the greater the amount of renewal premium revenue that we will earn from the policy. Cancellations result primarily from the borrower refinancing or selling insured mortgaged residential properties, from policies being rescinded due to fraud, misrepresentation or other underwriting violations, from a servicer choosing to cancel the insurance, from the payment of a claim, and, to a lesser degree, from the borrower achieving prescribed equity levels, at which point the lender no longer requires mortgage guaranty insurance.

 

Recent Events Affecting our Business

 

Triad is an Illinois-domiciled insurance company and the Division is our primary regulator. Triad Guaranty Assurance Corporation (“TGAC”) is a wholly-owned subsidiary of Triad and is subject to all Illinois insurance regulatory requirements applicable to Triad. The Illinois Insurance Code grants broad powers to the Division and its Director to enforce rules or exercise discretion over almost all significant aspects of our insurance business.

On August 5, 2008, Triad and TGAC (collectively, “TGIC”) entered into an Agreed Corrective Order with the Division. The Corrective Order was implemented as a result of our decision to cease writing new mortgage guaranty insurance and to commence a run-off of our existing insurance in force as of July 15, 2008. Among other things, the Corrective Order:

 

 

We submitted a corrective plan to the Division as required under the Corrective Order. The corrective plan we submitted included, among other items, a five-year statutory financial projection for TGIC and a detailed description of our planned course of action to address our current financial condition. The financial statements that form the basis of our corrective plan were prepared in accordance with Statutory Accounting Principles (“SAP”) set forth in the Illinois Insurance Code. SAP differs from GAAP, which are followed to prepare the financial statements presented in this annual report on Form 10-K. We received approval of the corrective plan from the Division in October 2008.

 

Since the approval of our initial corrective plan, we have revised the assumptions we initially utilized in our run-off financial forecast model as a result of a number of factors, including continued deteriorating economic conditions impacting our financial condition, results of operations and future prospects. Our new assumptions produce a range of potential ultimate outcomes for our run-off, but include projections showing that on a likely case basis and absent additional action by the Division or favorable changes in our business, we will report a deficiency in policyholders’ surplus as calculated in accordance with SAP as early as March 31, 2009 and continuing at least through 2011. Although we currently project that this statutory insolvency will be temporary and our run-off will ultimately be successful, we believe such insolvency would likely lead to the institution by the Division of receivership proceedings against TGIC if not corrected. We are currently working with the Division to structure a revised corrective plan to address this issue, although no assurance can be given that we will be successful in these efforts. If we are unable to gain approval from the Division for a revised corrective plan that addresses this issue, the Division could place TGIC into receivership proceedings, which could force us to seek protection from creditors through a voluntary bankruptcy proceeding and we would likely be unable to continue as a going concern. See Item 1A, “Risk Factors” for more information.

 

Failure to comply with the provisions of the Corrective Order or any other violation of the Illinois Insurance Code may result in the imposition of fines or penalties or subject TGIC to further legal proceedings, including receivership proceedings for the conservation, rehabilitation or liquidation of TGIC. See Item 1A, “Risk Factors” for more information.

 

Our recurring losses from operations and resulting decline in policyholders’ surplus as calculated in accordance with SAP increases the likelihood that TGIC will be placed into conservatorship or liquidated and raises substantial doubt about our ability to continue as a going concern. Our consolidated financial statements that are presented in this annual report on Form 10-K do not include any adjustments that reflect the financial risks of TGIC entering receivership proceedings and assume that we will continue as a going concern. We expect losses from

operations to continue and our ability to continue as a going concern is dependent on the successful development, approval, and implementation of a revised corrective plan. See Item 1A, “Risk Factors” for more information.

 

Triad is also subject to comprehensive regulation by the insurance departments of the various other states in which it is licensed to transact business. Currently, the insurance departments of the other states are working with the Division in the implementation of the Corrective Order.

 

Mark K. Tonnesen, our former President and Chief Executive Officer and a former director, resigned from those positions effective July 18, 2008 and subsequently retired on August 15, 2008. The Board of Directors appointed William T. Ratliff, III, the Chairman of the Board, as the interim President and Chief Executive Officer effective July 18, 2008. On October 22, 2008, the Board of Directors appointed Kenneth W. Jones, who had been serving as our Chief Financial Officer, as our new President and Chief Executive Officer. Mr. Jones retained the responsibilities of Chief Financial Officer following his appointment as our President and Chief Executive Officer. Mr. Ratliff continues to serve as our Chairman of the Board and served as an executive officer following his relinquishment of the role of President and Chief Executive Officer until March 10, 2009.

 

At December 31, 2008, the Company reported a deficit in assets of $136.7 million compared to a deficit in assets of $28.4 million at September 30, 2008 and stockholders’ equity of $498.9 million at December 31, 2007. A deficit in assets occurs when recorded liabilities exceed recorded assets and is not necessarily a measure of insolvency. The deficit in assets is primarily the result of an increase in loss reserves of over $800 million since December 31, 2007. In addition, we have paid in excess of $230 million of claims during the last 12 months. Although we have reported a deficit in assets at December 31, 2008, we had approximately $935 million of cash and invested assets at December 31, 2008 compared to $910 million at December 31, 2007. We expect to continue to report a deficit in assets in future periods. While we do not expect the deficit in assets to have a direct impact on our operations, it could adversely impact our continued listing on The NASDAQ Stock Market.

 

We have discovered a substantial number of underwriting or program violations and misrepresentations in defaults reported to us and we have subsequently rescinded or cancelled coverage on these policies at a rate substantially greater than we have historically experienced. In the fourth quarter of 2008, we expanded the criteria used to determine whether a default would be investigated for underwriting violations in accordance with our master policy provisions. While we will continue to settle legitimate claims, we expect an increase in rescission activity in 2009 based on the number of policies under review and the number of occurrences of underwriting violations discovered during 2008. Any impediment to our ability to rescind coverage for underwriting violations would be detrimental to our success in run-off.

 

Triad maintains a $95 million Excess-of-Loss reinsurance treaty that is currently in arbitration. The arbitration hearing began in 2008 and we expect to have a decision in the second quarter of 2009. As the matter is in dispute as a gain contingency, we have not recorded any benefit from this reinsurance treaty in our GAAP financial statements. However, in consultation with the Division, we recorded in our statutory financial statements for the year ended December 31, 2008 the net benefit of the reinsurance treaty of $51.5 million, which included the $95 million benefit and an accrual for the present value of the future 10-year premium expense due the reinsurer, reduced by a required reserve reflecting the dispute and aging of the recoverables.

 

Our focus remains on the efficient and effective servicing of our insured portfolio, particularly with respect to loss mitigation, as well as to adherence to the August 2008 Corrective Order.

 

Over the past several months, several government programs have been initiated which, in general, are designed to provide relief to homeowners and the financial markets. Many of these programs have been expanded since originally developed and may continue to change.

 

In July 2008, the Housing and Economic Recovery Act of 2008 was enacted, which established the Federal Housing and Finance Agency (“FHFA”) as the successor regulatory agency to both Fannie Mae and Freddie Mac. FHFA has broad legal and regulatory authority to ensure the safety and soundness of both of the GSEs. On September 7, 2008, both Fannie Mae and Freddie Mac were placed into conservatorship with FHFA acting as conservator. Conservatorship is a process designed to stabilize a troubled institution with the objective of returning the troubled institution to normal business operations. FHFA has stated that the purpose of this action is to restore

confidence in these GSEs, to enhance their capacity to fulfill their mission, and to mitigate the systemic risk that has contributed directly to the instability in the market.

 

The Housing and Economic Recovery Act of 2008 also includes the HOPE for Homeowners Act, which created a new, temporary, voluntary program within the Federal Housing Administration (“FHA”) to back FHA-insured mortgages to distressed borrowers. The new mortgages offered by FHA-approved lenders will refinance distressed loans at a significant discount for owner-occupants at risk of losing their homes to foreclosure. In exchange, homeowners will share future appreciation with the FHA.

 

During October 2008, the Emergency Economic Stabilization Act of 2008 (“EESA”) was enacted. EESA, among other things, created the Troubled Asset Relief Program (“TARP”), which provides authority for the Federal government to purchase assets and equity from financial institutions in order to strengthen the financial sector. The goal of TARP is to encourage banks to resume lending again at levels seen before the financial crisis. TARP allows the U.S. Department of the Treasury to purchase or insure up to $700 billion in residential or commercial mortgages and securities based on or related to such mortgages as well as any other financial instrument that the Secretary of the Treasury determines would promote stability in the financial market.

 

The Streamlined Modification Program (“SMP”) was adopted by the GSEs in December 2008 and is designed to reduce foreclosures on mortgage loans owned or guaranteed by the GSEs. The SMP standardized the modification criteria for such mortgage loans with the goal of enabling loan servicers to proactively solicit borrower participation. A number of eligibility criteria apply to the SMP. Modifications available include the capitalization of accrued interest and other fees, the extension of the term of the mortgage loan, the reduction of the interest rate on the mortgage loan, as well as a provision for principal forbearance. Additionally, several large lenders have announced plans to implement their own loan modification programs. The GSEs also established a moratorium on foreclosures that began in December 2008 and expired on March 6, 2009.

 

In February 2009, the Federal government unveiled The Homeowner Affordability and Stability Plan (“HASP”), which is designed to replace the SMP and reduce the number of foreclosures. HASP, which was detailed in March 2009, includes the Home Affordable Modification Program (“HMP”) which provides incentives to borrowers, servicers, and lenders to modify loans with the modifications jointly paid for by lenders and the U.S. government. HASP also includes the Home Affordable Refinance Program which provides refinance opportunities to certain borrowers who have conforming mortgage loans owned or guaranteed by the GSEs. The borrowers targeted for this refinance opportunity are those who have experienced significant depreciation in the value of their home, thereby making refinancing difficult or prohibitive given current underwriting standards in the marketplace.

 

Certain members of the Obama administration have discussed providing TARP funds to private mortgage insurers. No assurance can be given that TARP funds would be provided to mortgage insurers or, if funds were provided, that they would be provided to us or that they would be offered under terms acceptable or beneficial to our stockholders.

 

As of the date of this annual report on Form 10-K, we are unable to predict the impact that these recent government initiatives and the conservatorship of Fannie Mae and Freddie Mac will have on our future results of operations and prospects.

 

Consolidated Results of Operations

 

Following is selected financial information for the last two years:

 

 

Incurred losses and loss adjustment expenses (“LAE”) increased by $550 million during 2008 and is primarily responsible for the substantial increase in our net loss. The incurred losses in 2008 were composed of an increase in

the reserve for losses and LAE of $828 million and direct paid losses and LAE of $245 million, offset partially by an increase in reinsurance recoverables of $151 million.

 

The growth in the reserve for losses and LAE is the result of an increase in the number of reported loans in default as well as the characteristics of the loans in default. The number of loans in default increased by 139% during the year. However, risk in default increased by 173% as new defaults had a substantially higher average risk per loan than the default inventory at December 31, 2007.

 

Certain segments of our insured portfolio have contributed more than others to the growth rate in the number of defaults and risk in default. These segments include:

 

 

Gross paid losses for 2008 were $238 million compared to $101 million for 2007, an increase of 135%. The average paid loss was approximately $54,000 in 2008 compared to $37,000 in 2007. The increase in the average paid loss is primarily the result of a higher percentage of claims from the more recent vintage years and from the distressed markets, both of which reflect larger loan balances, as well as a decline in our ability to mitigate losses. During the third and fourth quarters of 2008, we experienced a moderation in claim paid activity due to a number of factors including state and lender foreclosure moratoriums, delays by the servicers, continued efforts on our part to investigate policies for fraud, misrepresentation or other underwriting violations, as well as an increase in the number of policies rescinded.

 

Revenue decreased by 12% during 2008, primarily the result of a decrease in premium earned as our insurance in force declined 8% from a year ago. The decline in insurance in force resulted from reduced production in the first half of 2008 and our decision to cease issuing new commitments for insurance and enter into run-off on July 15, 2008.

 

Other operating expenses increased by 35% during 2008, primarily due to the transition to run-off, which resulted in a number of non-recurring charges principally related to severance. Additionally, we wrote off all existing deferred acquisition costs of approximately $34 million during 2008.

 

We describe our results of operations in greater detail in the discussion that follows. The information is presented in four categories: Production; Insurance and Risk in Force; Revenues; and Losses and Expenses.

 

Production

 

For the twelve months ended December 31, 2008, we wrote $3.5 billion of new insurance compared to $22.9 billion for the same period of 2007. All production in 2008 was from our Primary flow channel, while insurance written in 2007 was comprised of $15.9 billion from the flow channel and $7.0 billion from the bulk channel. We ceased issuing commitments for mortgage insurance on July 15, 2008 and the minimal production subsequent to July 15, 2008 consisted of commitments for mortgage insurance that were entered into prior to that date. We do not expect any material amount of production going forward.

 

The following table provides a summary of new insurance written for the years ended December 31, 2008 and 2007:

 

 

Insurance and Risk in Force

 

The following table provides detail on our direct insurance in force at December 31, 2008 and 2007:

 

 

The decline in insurance in force is primarily due to the low amount of insurance written during the year, although the decline was offset somewhat by continued improvements in persistency.

 

Primary insurance persistency improved to 86.6% at December 31, 2008 compared to 81.4% at December 31, 2007. Modified pool insurance persistency improved to 88.3% at December 31, 2008 compared to 82.6% at December 31, 2007. We believe the increase in our persistency reflects the general inability of borrowers to refinance or sell their homes due to stricter underwriting guidelines by lenders, as well as the nationwide decline in home prices. We anticipate that persistency rates will be maintained near these levels for 2009. However, mortgage interest rates are at historically low levels and the majority of our insurance in force has associated interest rates greater than the prevailing rates. Recent government and private industry initiatives were developed, in part, to promote liquidity in the mortgage markets. Given the interest rate environment and these initiatives, persistency could fall in 2009, which could have a significant adverse impact on our future earned premiums.

 

The following tables provide information on selected risk characteristics of our business based on gross risk in force at December 31, 2008 and 2007. The following is a list of characteristics we believe are important indicators of increased risk in our portfolios:

 

 

Risk in Force(1)

 

 

 

 

Given the lack of production during 2008 and the high level of persistency, the risk composition of our portfolio has remained relatively constant. Our portfolio contains significant exposure to Alt-A loans, loans with the potential for negative amortization (“PNAMs”), as well as interest only loans. An inherent risk in both PNAMs and interest only loans is the scheduled milestone in which the borrower must begin making amortizing payments. These payments can be substantially greater than the minimum payments required before the milestone is met. An additional risk to PNAMs is the payment being made may be less than the amount of interest due, creating negative amortization on the outstanding principal of the loan. These features add uncertainty and potential risk. Due in part to recent market conditions, the Alt-A loans, PNAM loans, and interest only loans have, as a group, performed significantly worse than the remaining prime fixed rate loans through December 31, 2008.

 

We believe that a policy with a high LTV, all else being equal, will have a greater risk of default than a policy with a low LTV, especially in periods such as we are in currently with declining home prices. In the table above, the percentage of risk in force by LTV is based on the LTV at the time the loan was originated. We have not been provided with the “mark-to-market” LTV of our insured portfolio. To the extent that an insured loan in our portfolio has experienced a decline in the underlying value, and we believe this to be the case for a large percentage of our insured portfolio, the “mark-to-market” LTV of the policy may be substantially higher than that at origination.

 

The premium rates we charge vary depending on the perceived risk of a loan and generally cannot be changed after issuance of coverage. We do not believe that the premium rates charged for business originated in 2005, 2006 and 2007, and specifically for high risk products including PNAMs and Alt-A loans, will generate premium revenue sufficient to cover future losses.

 

The following table shows direct risk in force as of December 31, 2008 and December 31, 2007 by year of loan origination. Business originated in 2006 and 2007 continues to comprise the majority of our risk in force. This is due to the significant amounts of production during these two years as well as the amount of refinancing that took place in 2002 through 2005. In general, policies originated during these years have significantly higher amounts of average risk per policy than policies originated prior to 2006. Furthermore, policies originated during these vintage years have also exhibited higher default rates than preceding vintage years. For additional information regarding these vintage years, see “Losses and Expenses,” below.

 

 

 

 

Approximately 58% of our Primary flow insurance in force was subject to captive reinsurance arrangements at December 31, 2008 and 2007. Under captive reinsurance programs, reinsurance companies that are affiliates of the lenders assume a portion of the risk associated with the lender’s insured book of business in exchange for a percentage of the premium. The risk reinsured by the captive is supported by assets held in trust with Triad as the beneficiary. At December 31, 2008, we had approximately $258 million in captive reinsurance trust balances with $157 million of reserves ceded to those captives, which helps limit our future loss exposure.

Revenues

 

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

 

 

The decrease in direct premium written in 2008 is reflective of the decline in insurance in force and was partially due to lower premium written from new production. Rescission activity had a significant impact on both direct premium written and earned premium during 2008. When we rescind coverage due to underwriting violations in the origination of a loan, we refund all of the premium previously paid to us. During 2008, cash premiums refunded amounted to $10.3 million compared to $2.9 million in 2007. Rescissions have also impacted the frequency factor that we utilize in providing reserves. We provide an accrual for the estimated partial refunds of premiums based upon the early payment defaults that are currently under investigation and historical rescission rates. At December 31, 2008 we had accrued $17.1 million of premium refunds, the majority of which was accrued in the fourth quarter as we expanded our definition of early payment defaults. The accrual for premium refunds related to rescissions at December 31, 2007 was negligible.

 

Ceded premium written is comprised of premiums written under excess of loss reinsurance treaties with captives as well as non-captive reinsurance companies. The growth in ceded premium during 2008 over 2007 was primarily due to an increase in average insurance in force subject to captive reinsurance. The premium cede rate increased to 19.2% for 2008 compared to 16.5% for 2007 reflecting, primarily, the impact of refunds on direct premium written. We did not establish a corresponding accrual to account for the potential impact of expected refunds on ceded premium previously paid to captives.

 

Net investment income grew primarily due to the growth in average invested assets. Average invested assets at cost or amortized cost grew by 21.4% in 2008 as a result of the investment of positive operating cash flows, which included $116.0 million from the redemption of Tax and Loss Bonds. The book yield on our investment portfolio was 4.62% at December 31, 2008 compared to 4.56% at December 31, 2007. Realized investment losses were $26.6 million during 2008 compared to a loss of $3.0 million for 2007, primarily due to an increase in other-than-temporary impairment losses. For a further discussion, see “Investment Portfolio”.

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 LAE are comprised of paid losses and LAE as well as the increase in the loss and LAE reserve during the period. The following paragraphs look at some of the specifics of the individual components of net losses and LAE.

 

The following table provides details on both the amount and the number of paid claims of both Primary and Modified Pool insurance prior to the effect of ceded paid claims for the years ended December 31, 2008 and 2007:

 

 

Although we experienced a large increase in the dollar amount and number of paid claims during 2008, these increases were tempered somewhat in the second half of 2008 primarily due to foreclosure moratoriums, rescission activity and policy investigations. Average severity increased to $53,800 in 2008 from $36,700 in 2007 reflecting a larger percentage of our paid claims from (i) the more recent vintage years, specifically the 2005, 2006 and 2007 vintage years, and (ii) the distressed markets.

The following table shows the average loan size and average risk per policy by vintage year. The 2006 and 2007 books are exhibiting adverse development patterns and thus are expected to impact the amount of paid claims and the average paid claim earlier than what we have experienced historically. We expect average severity to continue to increase in 2009 as policies originated during 2006 and 2007 continue to comprise a greater proportion of our paid claims.

 

 

The increase in paid severity was also influenced by our reduced ability to mitigate claims. Beginning in late 2006, we began to experience a significant reduction in our ability to reduce the severity of our claims paid through the sale of properties. Subsequent declines in home prices across almost all markets, with significant declines in the distressed markets, has continued to negatively impact our ability to mitigate losses through the sale of properties. We expect our ability to mitigate losses will continue to be adversely affected by the continued pressure on home prices combined with the limited availability of credit in the U.S. financial markets.

 

The number of paid claims during both the third and fourth quarters of 2008 were lower than the number of paid claims during the second quarter of 2008, although the inventory of filed claims has continued to increase. The slowdown in the second half of 2008 was due to a number of factors, including lender and GSE foreclosure moratoriums, delays by the servicers due to a large increase in the number of defaults, our ongoing effort to identify fraud, misrepresentation or other underwriting violations in policies which are currently in default, as well as increased rescission activity.

 

The table below provides the cumulative paid loss ratios by certificate year (calculated as direct losses paid divided by direct premiums received, in each case for a particular policy year) that have developed through December 31, 2008 and 2007. The data below excludes the effects of reinsurance.

 

During 2008, we experienced large increases in the cumulative paid loss ratios for the 2005, 2006, and 2007 vintage years and more gradual increases for the other vintage years. While we have historically expected higher claim payments in the second through the fifth years after loan origination, the more recent vintage years have developed at a much faster rate from a default and claim perspective than historical trends would indicate. We do not expect this adverse development to subside and expect the cumulative paid loss ratios for the 2005, 2006 and 2007 books of business to ultimately be significantly higher than our previous books of business and possibly greater than 100%.

 

Net losses and LAE also include the change in reserves for losses and LAE. The following table provides further information about our reported loss reserves, excluding the effects of reinsurance, at December 31, 2008 and 2007:

 

 

The above table does not account for reserves ceded to the lender sponsored captive reinsurers. The amount recoverable under captive reinsurance contracts, net of liabilities where the right of offset exists, is shown as an asset on the balance sheet and amounted to approximately $157 million and $7 million at December 31, 2008 and 2007, respectively.

 

The following table shows the net change in reserves for losses and LAE for 2008 and 2007:

 

 

The large increase in reserves in 2008 primarily reflects the increase in the number of defaults, a decline in the cure rate of defaults, as well as the changing composition of our default inventory, with higher concentrations in distressed market states and recent policy years. Our reserving model incorporates management’s judgment regarding the impact of the current housing and economic environment on our estimate of the ultimate claims we will pay on loans currently in default. To reflect the significant adverse changes in the economy, including declining home prices and our reduced ability to mitigate claims, we have increased the severity factor utilized in the calculation of the reserve.

 

We have experienced an increasing number of defaults that contained underwriting violations in the original application for insurance. Generally, our master policies provide that we are not liable to pay a claim for loss when this occurs. We are currently reviewing the majority of the claims for losses and defaults that occur soon after loan origination, especially with respect to the 2006 and 2007 vintage years, to determine whether the limitations on our

liability contained in our master policies are applicable. Beginning in the third quarter of 2007, we incorporated an adjustment in the frequency factor utilized in the calculation of our provision for losses to account for expected rescissions. The expected rescission factor, for specific sub-sections of our portfolio, increased in each quarter of 2008. This increase in the number of policies that have been rescinded, combined with the large increase in number of policies under review for possible violations of our master policies, resulted in a decline in the frequency factor at December 31, 2008 from that used at December 31, 2007, which mitigated the reserve increase.

 

Although defaults increased across the country in general, the distressed markets have experienced substantially higher growth rates in defaults. Defaults in the distressed markets increased 254% during 2008 compared to an increase of 84% in states not identified as distressed markets. Additionally, on average, defaults in the distressed market states have a higher average loan balance and average risk in default than the remainder of our defaults. At December 31, 2008, the distressed markets had average loan balances of approximately $248,000 compared to approximately $161,000 for the remainder of the portfolio.

 

The following table indicates the growth in both the gross risk in default in these four distressed market states and reserves attributable to these states at December 31, 2008 and December 31, 2007.

 

 

Certificates originated during 2007 and 2006 comprise 62.7% of our loans in default, but 73.4% of the risk in default at December 31, 2008. The difference in percentages of loans in default and risk in default primarily reflects the higher loan amounts associated with the 2007 and 2006 policy years.

To illustrate the impact of the changes in the frequency and severity factors utilized in the reserve model, the following table details the amount of risk in default and the reserve balance as a percentage of risk in default at December 31, 2008 and December 31, 2007.

 

 

 

 

The following table shows default statistics as of December 31, 2008 and 2007:

 

 

The percentage of total loans in default increased to 11.68% as of December 31, 2008 from 4.44% at December 31, 2007, an overall increase of 163% during 2008. The number of loans in default includes all reported delinquencies that are in excess of two payments in arrears at the reporting date and all reported delinquencies that were previously in excess of two payments in arrears and have not been brought current. The percentage of loans in default, or default rate, has increased considerably during 2008. The default rate is affected by the number of policies in default as well as the number of policies in force. As we are in run-off and are no longer issuing commitments for mortgage insurance, we expect the number of policies in force to continue to decrease which will have an adverse effect on the default rate. We currently expect the overall default rate as well as the number of loans in default to increase in 2009, and the increase may be greater than that experienced in 2008.

We do not provide reserves on Modified Pool defaults with deductibles until the incurred losses for that transaction reach the deductible threshold. At December 31, 2008, 39% of our structured bulk transactions with deductibles as part of the structure, including all such transactions originated in 2006 and 2007, had incurred losses that had exceeded these individual deductible amounts. On these structured bulk contracts, we recognized $169.6 million of losses in excess of the aggregate deductibles. Although a majority of our structured bulk transactions have not exceeded the individual deductible amounts, given the large increases in default and paid claim activity related to the transactions, we have realized the majority of the benefit from the deductibles and do not expect any material benefit going forward.

 

We also do not provide reserves on Modified Pool defaults where the incurred losses to date for the related structure have exceeded the stop loss amount. As of December 31, 2008, 5% of our structured transactions have incurred losses that exceeded the stop loss amount. This had the effect of limiting reserves by $37.5 million at December 31, 2008. We believe that based on the recent development of our modified pool business, we will continue to provide additional reserves on structured bulk transactions with deductibles and we will continue to limit the addition of reserves due to modified pool contracts reaching stop loss limits.

 

As part of our overall risk management strategy, we have entered into excess of loss captive reinsurance agreements with several of our lender customers. As detailed under “Business — Reinsurance” in Part I, Item 1 of this report, we retain the first loss position on the first aggregate layer of risk and reinsure a second finite layer with the captive reinsurer. Certain captives have exceeded the first loss layer in incurred losses, which resulted in the ceding of reserves and paid losses related to specific book years. We recorded a net of $157 million of ceded reserve from these captive arrangements at December 31, 2008 and ceded $497,000 of paid claims during 2008. If the current default and paid claim trends continue, we expect to cede additional reserves and paid losses to the captive reinsurers in 2009.

 

Expenses and Taxes

 

We wrote off the remaining deferred policy acquisition costs (“DAC”) asset balance of $34.8 million during the first quarter of 2008 as estimated gross loss in the remaining portfolio no longer supported the asset value.

 

The increase in other operating expenses during 2008 resulted from significant non-recurring expenses in the first half of 2008, including expenses associated with the attempted capital raising efforts, severance and other termination costs associated with the transition to run-off, and expenses associated with our exit from Canada.

 

Our effective tax rate decreased to 16.4% for 2008 from 40.7% for 2007. The effective tax rate for 2008 is lower than the marginal rate of 35% and decreased substantially from the rate in 2007 due primarily to the large operating loss reported in 2008 and the inability to recognize future tax benefits in accordance with U.S. generally accepted accounting principles.

 

Federal tax law permits mortgage guaranty insurance companies to deduct from taxable income, subject to certain limitations, the amounts added to contingency reserves. As a result of substantial operating losses for 2007 and 2008, the previously established contingency reserve was released earlier than the scheduled ten years in an amount that offset the operating loss for federal tax reporting purposes. Accordingly, the previously purchased Tax and Loss Bonds associated with the contingency reserve release were redeemed earlier than originally scheduled. As of December 31, 2008, we have redeemed substantially all of our previously purchased Tax and Loss Bonds. We expect to continue to incur operating losses for tax purposes and generate net operating loss carry forwards for federal income tax reporting purposes for which we will be unable to receive any immediate benefit in our statement of operations.

 

Significant Customers

 

On July 15, 2008, we ceased issuing commitments for insurance written and are operating our business in run-off. Going forward, our production will consist of certificates issued from commitments for mortgage insurance that were entered into prior to July 15, 2008. As such, we do not have any significant customers on whom we rely for new business.

Financial Position

 

Total assets were $1.1 billion at both December 31, 2008 and December 31, 2007. For the year ended December 31, 2008, total assets reflect the liquidation of certain assets in connection with the repayment of the $80.0 million credit facility and the write-off of the remaining $34.8 million of DAC as well as an increase of $145.0 million of ceded reinsurance recoverable, primarily related to loss reserves ceded to captive reinsurers. Total liabilities increased substantially to $1.3 billion at December 31, 2008 from $634.0 million at December 31, 2007 primarily reflecting the $827.9 million increase in loss and LAE reserves. This increase was partially offset by the repayment of the $80.0 million credit facility in the first quarter of 2008 and a decline in deferred income taxes of $123.3 million related to the reversal of previously established deferred taxes.

 

This section identifies several items on our balance sheet that are important in the overall understanding of our financial position. These items include DAC as well as prepaid federal income tax and related deferred income taxes. The majority of our assets are included in our investment portfolio. A separate Investment Portfolio section follows the Financial Position section and reviews our investment portfolio, key portfolio management strategies, and methodologies by which we manage credit risk within the investment portfolio.

 

Deferred Policy Acquisition Costs

 

Prior to the write-off of the DAC asset at March 31, 2008, we capitalized costs to acquire new business as DAC and recognized these as expenses against future gross profits. At March 31, 2008, we determined that the net present value of the estimated future cash flows on the remaining book of business exceeded the recorded reserves (net of the unamortized DAC) which required the establishment of a premium deficiency reserve. The actual mechanics of recording the premium deficiency reserve require that we first reduce the DAC balance to zero before recording any additional premium deficiency reserve. Therefore, we wrote down the DAC asset by $34.8 million in the first quarter of 2008. We have not capitalized any costs to acquire new business subsequent to the first quarter of 2008, but included such costs in the line item “Other operating expenses” on our statement of operations. We will not be capitalizing any costs to acquire new business going forward.

 

Prepaid Federal Income Taxes and Deferred Income Taxes

 

During the period that the Company was reporting positive results of operations, we purchased Tax and Loss Bonds to take advantage of a special contingency reserve deduction that mortgage guaranty companies are allowed for tax purposes. We recorded these bonds on our balance sheet as prepaid federal income taxes. Purchases of Tax and Loss Bonds are essentially a prepayment of federal income taxes that are scheduled to become payable in ten years, when the contingency reserve is scheduled to be released, and the Tax and Loss Bonds are scheduled to mature. The scheduled proceeds from the maturity of the Tax and Loss Bonds were anticipated to be utilized to fund the income tax payments.

 

Deferred income taxes are provided for the differences in reporting taxable income in the financial statements and on the tax return. The largest cumulative difference has historically been the special contingency reserve deduction for mortgage insurers mentioned above. During 2008, deferred income taxes declined by $120.5 million, primarily the result of the reversal of the contingency reserve. The remainder of the deferred tax liability has primarily arisen from book and tax reporting differences related to DAC and unrealized investment gains (losses).

 

In years when the taxable income of a mortgage insurer results in a loss before the application of the special contingency reserve, the prior established contingency reserve can be reversed earlier than originally scheduled (effectively recognizing as taxable income the prior contingency reserve that had been deferred) to offset the current year loss. When the special contingency reserve for tax purposes is reversed to offset a current year operating loss, the Tax and Loss Bonds can be redeemed earlier than the originally scheduled ten years. During 2008, we reversed $335.0 million of contingency reserve and redeemed all of the remaining $116.0 million of Tax and Loss Bonds. During the second half of 2007, we reversed $113 million of contingency reserve for tax purposes earlier than originally scheduled and redeemed $50.9 million of Tax and Loss Bonds related to that reversal.

Investment Portfolio

 

Portfolio Description

 

Our goal for managing our investment portfolio is to optimize investment returns, provide liquidity when necessary, preserve capital and adhere to regulatory requirements. We have established a formal investment policy that describes our overall quality and diversification objectives and limits. Historically, the majority of our investment portfolio had been comprised of tax-preferred state and municipal fixed income securities. Given the operating losses reported since the third quarter of 2007, we currently do not anticipate the realization of tax benefits normally associated with state and municipal securities. As a result, we made the decision in the second quarter of 2008 to restructure the investment portfolio into taxable publicly-traded securities, primarily corporate debt obligations, asset-backed securities, and mortgage-backed securities. Furthermore, as we anticipate negative cash flow from operations in 2009 due to the expected increase in claims paid, we expect the proceeds from the maturity and sale of securities will be required to fund the shortfall. In connection with the restructuring of our investment portfolio, we shortened the portfolio duration to better match the maturities with our anticipated cash needs. At December 31, 2008, we had $159 million of municipal securities remaining in our portfolio. In the current market there are significant risks involved in attempting to liquidate the remaining tax-preferred portfolio. These risks include execution risk in the selling and buying of securities, additional credit risk moving from primarily insured, highly rated municipal bonds to lower rated corporate bonds, and uncertainty surrounding mortgage-backed and asset-backed securities.

 

Our investment policy and strategies are subject to further change depending upon regulatory, economic and market conditions as well as our existing financial condition and operating requirements, including our tax position. We classify our entire investment portfolio as available for sale. This classification allows us the flexibility to dispose of securities in order to meet our investment objectives and operating requirements. All investments are carried on our balance sheet at fair value.

 

The following table shows the growth and transition of our investment portfolio:

 

 

The following table shows the results of our investment portfolio for the last two years:

 

The book yield is comparable for 2008 and 2007 as the taxable securities purchased during 2008 generally have a lower duration but a similar yield as the longer duration municipals that comprised the majority of the portfolio at December 31, 2007. The largest portion of the realized investment losses in 2008 are from write downs due to other-than-temporary impairments as described in “Realized Gains (Losses) and Impairments” below.

 

Unrealized Gains and Losses

 

The following table summarizes by category our unrealized gains and losses in our securities portfolio at December 31, 2008: