UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10 - Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2001
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from.......to......
Commission file number 1-13664
THE PMI GROUP, INC.
(Exact name of registrant as specified in its charter)
Delaware 94-3199675
(State of Incorporation) (IRS Employer Identification No.)
601 Montgomery Street,
San Francisco, California 94111
(Address of principal executive offices) (Zip Code)
(415) 788-7878
(Registrant's telephone number including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes X No ___
--
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
Class of Stock Par Value Date Number of Shares
- -------------- --------- ---- ----------------
Common Stock $0.01 04/30/01 44,348,380
THE PMI GROUP, INC.
Index to Quarterly Report on Form 10-Q
March 31, 2001
Part I - Financial Information Page
----
Item 1. Interim Consolidated Financial Statements and Notes (unaudited)
Consolidated Statements of Operations for the Three Months Ended
March 31, 2001 and 2000 3
Consolidated Balance Sheets as of March 31, 2001 and
December 31, 2000 4
Consolidated Statements of Cash Flows for the Three Months Ended
March 31, 2001 and 2000 5
Notes to Consolidated Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of
Operations 10
Item 3. Quantitative and Qualitative Disclosures about Market Risk 17
Part II - Other Information
Item 6. Exhibits and Reports on Form 8-K 29
Signatures 30
Index to Exhibits 31
2
PART I - FINANCIAL INFORMATION
ITEM 1. INTERIM FINANCIAL STATEMENTS
THE PMI GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
Three Months Ended March 31,
---------------------------------------------------
(In thousands, except per share amounts) 2001 2000
----------------------- -----------------------
Revenues
Premiums earned $ 170,132 $ 148,716
Investment income 31,232 27,083
Net realized investment gains (losses) (991) 768
Other 4,200 2,851
----------------------- -----------------------
Total revenues 204,573 179,418
----------------------- -----------------------
Losses and Expenses
Losses and loss adjustment expenses 23,008 28,223
Amortization of deferred policy acquisition costs 20,383 20,398
Other underwriting and operating expenses 54,480 39,204
Interest expense 2,700 2,370
Distributions on preferred capital securities 2,077 2,077
----------------------- -----------------------
Total losses and expenses 102,648 92,272
----------------------- -----------------------
Income before income taxes 101,925 87,146
Income tax expense 30,394 27,156
----------------------- -----------------------
Net income $ 71,531 $ 59,990
======================= =======================
Per share data:
Basic net income $ 1.61 $ 1.36
======================= =======================
Diluted net income $ 1.59 $ 1.34
======================= =======================
Cash dividends declared $ 0.04 $ 0.04
======================= =======================
See accompanying notes to consolidated financial statements.
3
THE PMI GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
March 31, December 31,
(In thousands, except per share amounts) 2001 2000
----------------------- -----------------------
Assets (Unaudited)
Investments:
Available for sale, at fair value:
Fixed income securities
(amortized cost: $1,487,760; $1,536,291) $ 1,579,990 $ 1,613,330
Equity securities:
Common (cost: $54,851; $53,315) 69,018 81,726
Preferred (cost: $127,252; $108,743) 129,337 111,743
Common stock of affiliates (at underlying book value) 136,239 131,849
Short-term investments, at fair value 242,503 139,577
----------------------- -----------------------
Total investments 2,157,087 2,078,225
Cash 25,553 21,969
Accrued investment income 23,322 23,494
Reinsurance recoverable and prepaid premiums 53,377 51,329
Premiums receivable 42,863 41,362
Receivable from affiliate 2,040 739
Deferred policy acquisition costs 67,270 67,009
Property and equipment, net 54,866 53,475
Other assets 61,881 55,055
----------------------- -----------------------
Total assets $ 2,488,259 $ 2,392,657
======================= =======================
Liabilities
Reserve for losses and loss adjustment expenses $ 294,341 $ 295,089
Unearned premiums 171,751 170,866
Long-term debt 136,730 136,819
Reinsurance balances payable 29,062 26,581
Deferred income taxes 71,567 74,981
Other liabilities and accrued expenses 115,973 90,001
----------------------- -----------------------
Total liabilities 819,424 794,337
----------------------- -----------------------
Company-obligated mandatorily redeemable preferred capital
securities of subsidiary trust holding solely junior subordinated
deferrable interest debenture of the Company 99,117 99,109
Shareholders' equity
Common stock - $.01 par value; 187,500,000 shares authorized,
and 52,793,777 issued 528 528
Additional paid-in capital 267,762 267,762
Accumulated other comprehensive income 60,147 62,501
Retained earnings 1,582,905 1,511,751
Treasury stock, at cost (8,450,147 and 8,484,082 shares) (341,624) (343,331)
----------------------- -----------------------
Total shareholders' equity 1,569,718 1,499,211
----------------------- -----------------------
Total liabilities and shareholders' equity $ 2,488,259 $ 2,392,657
======================= =======================
See accompanying notes to consolidated financial statements.
4
THE PMI GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Three Months Ended March 31,
---------------------------------------------------
(Dollars in thousands) 2001 2000
----------------------- -----------------------
Cash flows from operating activities
Net income $ 71,531 $ 59,990
Adjustments to reconcile net income to net cash provided by
operating activities:
Realized investment gains 991 (768)
Equity in earnings of affiliates (3,651) (1,532)
Depreciation and amortization 1,439 1,475
Deferred income taxes (3,216) 10,844
Changes in:
Reserve for losses and loss adjustment expenses (748) 5,073
Unearned premiums 885 (7,140)
Deferred policy acquisition costs (261) 751
Accrued investment income 172 (1,206)
Reinsurance balances payable 2,481 2,976
Reinsurance recoverable and prepaid premiums (2,048) (4,793)
Premiums receivable (1,501) 272
Income taxes payable 30,595 26,048
Receivable from affiliate (1,301) 2,288
Other (12,972) (28,308)
----------------------- -----------------------
Net cash provided by operating activities 82,396 65,970
----------------------- -----------------------
Cash flows from investing activities
Proceeds from sales and maturities of fixed income securities 83,303 39,974
Proceeds from sales of equity securities 19,175 24,880
Investment purchases:
Fixed income securities (33,271) (98,697)
Equity securities (40,007) (15,405)
Net (increase) decrease in short-term investments (102,926) 15,546
Investment in affiliates (1,174) (17,017)
Purchases of property and equipment (3,843) (2,777)
----------------------- -----------------------
Net cash used in investing activities (78,743) (53,496)
----------------------- -----------------------
Cash flows from financing activities
Proceeds from exercise of stock grants and options 1,707 -
Dividends paid to shareholders (1,776) (1,776)
Purchases of The PMI Group, Inc. common stock - (24,017)
----------------------- -----------------------
Net cash used in financing activities (69) (25,793)
----------------------- -----------------------
Net increase (decrease) in cash 3,584 (13,319)
Cash at beginning of year 21,969 28,076
----------------------- -----------------------
Cash at end of period $ 25,553 $ 14,757
======================= =======================
See accompanying notes to consolidated financial statements.
5
THE PMI GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Note 1. Basis of Presentation
The accompanying consolidated financial statements include The PMI Group, Inc.
("TPG"), a Delaware corporation; its direct and indirect wholly-owned
subsidiaries, PMI Mortgage Insurance Co. ("PMI"), an Arizona Corporation;
Residential Guaranty Co. ("RGC"), an Arizona corporation; American Pioneer Title
Insurance Company ("APTIC"), a Florida corporation; PMI Mortgage Insurance Ltd
("PMI Ltd"), an Australian mortgage insurance company; PMI Mortgage Insurance
Company Limited ("PMI Europe"), an Irish corporation; PMI Mortgage Services Co.
("MSC"), a California corporation; and other insurance, reinsurance and non-
insurance companies. TPG and its subsidiaries are collectively referred to as
the "Company." TPG also has equity interests in RAM Holdings Ltd. and RAM
Holdings II Ltd. (collectively referred to as "RAM RE"), two financial guaranty
reinsurance companies based in Bermuda. In addition, PMI has equity interests
in CMG Mortgage Insurance Company, CMG Mortgage Reinsurance Company and CMG
Mortgage Assurance Company (collectively referred to as "CMG"), which conduct
residential mortgage insurance and reinsurance business; and Fairbanks Capital
Holding Corp. ("Fairbanks"), a special servicer of single-family residential
mortgages. CMG, Fairbanks and Ram Re are accounted for on the equity method of
accounting in the Company's consolidated financial statements. All material
intercompany transactions and balances have been eliminated in consolidation.
The company's unaudited consolidated financial statements have been prepared in
accordance with accounting principles generally accepted in the United States
("GAAP") for interim financial information and the requirements of Form 10-Q and
Article 7 of regulation S-X. Accordingly, they do not include all of the
information and footnotes required by GAAP for complete financial statements.
In the opinion of management, all adjustments (consisting only of normal
recurring adjustments) considered necessary for a fair presentation, have been
included. Interim results for the three months ended March 31, 2001 are not
necessarily indicative of the results that may be expected for the year ending
December 31, 2001. The financial statements should be read in conjunction with
the audited consolidated financial statements and footnotes included in The PMI
Group, Inc. 2000 Annual Report to Shareholders.
Note 2. Summary of Certain Significant Accounting Policies
Changes in Accounting Policy - Effective January 1, 2000, the Company changed
its accounting policy for international subsidiaries and affiliates to report
operations on a one-month lag from domestic operations. Accordingly, the
results of PMI Ltd for the quarter ended March 31, 2000 represented two months
of activity. In February 2001, PMI began offering mortgage insurance and other
credit enhancement products in Europe through its indirect wholly owned
subsidiary, PMI Europe. The financial results of PMI Europe were immaterial for
the quarter ended March 31, 2001.
Deferred Policy Acquisition Costs - The Company defers certain costs in its
mortgage insurance operations relating to the acquisition of primary mortgage
insurance and amortizes these costs against related premium revenues in order to
match costs and revenues in accordance with GAAP. These acquisition costs vary
with, and are primarily related to, the acquisition of new business and include
all underwriting, contract underwriting and sales related activities. To the
extent the Company is compensated by customers for contract underwriting, those
underwriting costs are not deferred. Costs associated with the acquisition of
mortgage insurance business are initially deferred and reported as deferred
policy acquisition costs ("DPAC").
6
The DPAC asset is amortized and charged against revenue in proportion to
estimated gross profits over the life of the policies using the guidance
provided by Statement of Financial Accounting Standards ("SFAS") No. 97,
Accounting and Reporting by Insurance Enterprises For Certain Long-Duration
Contracts and For Realized Gains and Losses From the Sale of Investments.
DPAC is summarized as follows:
Three Months Ended March 31,
-----------------------------------------------------
2001 2000
------------------------ ------------------------
(In thousands)
Beginning DPAC balance $ 67,009 $ 69,579
U.S. acquisition costs incurred and deferred 18,710 19,646
U.S. amortization of deferred costs (19,430) (20,398)
PMI Ltd acquisition costs incurred and deferred 1,934 -
PMI Ltd amortization of deferred costs (953) -
------------------------ ------------------------
Ending DPAC balance $ 67,270 $ 68,827
======================== ========================
Note 3. Earnings Per Share
Basic earnings per share ("EPS") excludes dilution and is computed by dividing
net income available to common shareholders by the weighted average number of
common shares outstanding for the period. Diluted EPS reflects the potential
dilution that could occur if securities or other contracts to issue common stock
were exercised or converted into common stock. The weighted average common
shares outstanding for computing diluted EPS includes only stock options issued
by the Company that have a dilutive impact and are outstanding for the period,
and had the potential effect of increasing common shares. Net income available
to common shareholders does not change for computing diluted EPS. Weighted
average common shares outstanding for the three months ended March 31, 2001 and
2000 follows:
Three Months Ended March 31,
---------------------------------------------------
Weighted Average Shares Outstanding 2001 2000
------------------------ ---------------------
For basic EPS 44,324,686 44,403,785
For diluted EPS 45,101,720 44,767,197
Note 4. Comprehensive Income
The reconciliation of net income to comprehensive income for the three months
ended March 31, 2001 and 2000 are as follow:
7
Three Months Ended March 31,
-----------------------------------------------------
2001 2000
------------------------ ------------------------
(In thousands)
Net income $ 71,531 $ 59,990
Other comprehensive income, net of tax:
Unrealized gains (losses) on investments:
Unrealized holding gains (losses) arising during period (39) 18,595
Less: reclassification adjustment for gains (losses)
included in net income (644) 499
------------------------ ------------------------
Net unrealized holding gains (losses) (683) 18,096
Currency translation adjustment (271) (318)
Transition adjustment for implementation
of SFAS No. 133 (1,000) -
Fair value adjustment of derivatives (400) -
------------------------ ------------------------
Other comprehensive income (loss), net of tax (2,354) 17,778
------------------------ ------------------------
Comprehensive income $ 69,177 $ 77,768
======================== ========================
Note 5. Business Segments
The Company's reportable operating segments are U.S. Mortgage Insurance,
International Mortgage Insurance, Title Insurance and Other. The "Other"
segment includes the income and expenses of the holding company, the results
from PMI Mortgage Services Co. and the activity of an inactive broker-dealer.
Intersegment transactions are not significant. The Company evaluates performance
primarily based on segment net income. The following tables present information
about reported segment income (loss) and segment assets as of and for the
periods indicated:
U.S. International
Quarter Ended March 31, 2001 Mortgage Mortgage Title Consolidated
(In thousands) Insurance Insurance Insurance Other Total
- -----------------------------------------------------------------------------------------------------------------------------
Premiums earned $ 132,015 $ 7,127 $ 30,990 $ - $ 170,132
============ ================ ============ ========== ===============
Net underwriting income (expenses)
before tax - external customers $ 77,965 $ 4,547 $ 1,768 $ (7,819) $ 76,461
Investment income & net realized
investment gains 22,317 2,053 517 1,703 26,590
Equity in earnings of affiliates 2,278 - - 1,373 3,651
Interest expense - (675) - (2,025) (2,700)
Distributions on preferred capital
securities - - - (2,077) (2,077)
------------ ---------------- ------------ ---------- ---------------
Income (loss) before income tax
expense 102,560 5,925 2,285 (8,845) 101,925
Income tax benefit (expense) (31,443) (1,435) (785) 3,269 (30,394)
------------ ---------------- ------------ ---------- ---------------
Net income (loss) $ 71,117 $ 4,490 $ 1,500 $ (5,576) $ 71,531
============ ================ ============ ========== ===============
Total assets $ 2,015,326 $ 261,467 $ 53,415 $ 158,051 $ 2,488,259
============ ================ ============ ========== ===============
8
U.S. International
Quarter Ended March 31, 2001 Mortgage Mortgage Title Consolidated
(In thousands) Insurance Insurance Insurance Other Total
- -----------------------------------------------------------------------------------------------------------------------------
Premiums earned $ 120,536 $ 5,590 $ 22,590 $ - $ 148,716
============ ================ ============ ========== ===============
Net underwriting income (expenses)
before tax - external customers $ 59,530 $ 3,718 $ 1,531 $ (1,037) $ 63,742
Investment income & net realized
investment gains 21,084 3,328 457 1,449 26,318
Equity in earnings of affiliates 1,780 - - (248) 1,532
Interest expense (13) (519) - (1,837) (2,369)
Distributions on preferred capital
securities - - - (2,077) (2,077)
------------ ---------------- ------------ ---------- ---------------
Income (loss) before income tax
expense 82,381 6,527 1,988 (3,750) 87,146
Income tax benefit (expense) (24,901) (2,114) (598) 457 (27,156)
------------ ---------------- ------------ ---------- ---------------
Net income (loss) $ 57,480 $ 4,413 $ 1,390 $ (3,293) $ 59,990
============ ================ ============ ========== ===============
Total assets $ 1,827,103 $ 177,799 $ 47,785 $ 120,447 $ 2,173,134
============ ================ ============ ========== ===============
Note 6 - Adoption of a New Accounting Standard
In June 1998, the Financial Accounting Standards Board ("FASB") issued SFAS No.
133, Accounting for Derivative Instruments and Hedging Activities, which
established accounting and reporting standards for derivative instruments and
for hedging activities. These rules require that all derivative instruments be
reported in the consolidated financial statements at fair value. Changes in the
fair value of derivatives are to be recorded each period in earnings or other
comprehensive income, depending on whether the derivative is designated and
effective as part of a hedged transaction, and on the type of hedge transaction.
Gains and losses on derivative instruments reported in other comprehensive
income must be reclassified as earnings in the period in which earnings are
affected by the underlying hedged item, and the ineffective portion of all
hedges must be recognized in earnings in the current period.
The Company adopted this statement effective January 1, 2001. The Company's use
of derivative financial instruments is generally limited to reducing its
exposure to interest rate and currency exchange risk by utilizing interest rate
and currency swap agreements which are accounted for as hedges. In 1999, the
Company entered into an interest rate swap to hedge interest rate risk
associated with the debt in connection with the acquisition of PMI Ltd. Upon
adoption of SFAS No. 133, the Company recorded a $1.0 million liability for the
fair value of the interest rate swap in the Consolidated Balance Sheet. The
fair value of this liability increased by $0.4 million during the first quarter
of 2001.
Note 7 - Subsequent Event
Included in the Company's short-term investments is $10 million of commercial
paper issued by Pacific Gas and Electric Company ("PG&E"). On April 6, 2001,
PG&E filed for bankruptcy protection. While PG&E has made interest payments
through March 31, 2001, the commercial paper obligation is currently in default.
At this time, the amount of any recovery on this obligation is uncertain.
Management will re-evaluate the status of this investment during the quarter
ending June 30, 2001.
9
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
Cautionary Statement Regarding Forward-Looking Statements
A number of written and oral statements made or incorporated by reference from
time to time by us or our representatives in this document, other documents
filed with the Securities and Exchange Commission, press releases, conferences,
or otherwise that are not historical facts, or are preceded by, followed by or
that include the words "believes," "expects," "anticipates," "estimates," or
similar expressions, and that relate to future plans, events or performance are
"forward-looking" statements within the meaning of the federal securities laws.
Forward-looking statements in this document include:
. Our belief that the refinancing trend may continue to increase in 2001
. Our anticipation that negotiated bulk transactions will continue to be an
increasing portion of total volume of insurance originated in the residential
mortgage insurance market
. Our expectation that there will be volatility in the market share of
individual companies, including PMI, as a result of bulk transactions
. Our expectation that persistency will decrease
. Our expectation that the amount of GSE pool risk written will continue to
decrease in 2001
. Our anticipation that the percentage of PMI's risk in force related to risk-
sharing programs will continue to increase as a percentage of total risk in
force in 2001 and that such growth will reduce our net premiums written and
earned over the long-term
. Our anticipation that contract underwriting will continue to account for a
significant portion of PMI's acquisition costs
. Our expectation that, as PMI increases the electronic origination and
delivery of its products, its acquisition costs should decline
When a forward-looking statement includes a statement of the assumptions or
bases underlying the forward-looking statement, we caution that, while we
believe such assumptions or bases are reasonable and have made them in good
faith, assumed facts or bases may vary from actual results, and the difference
between assumed facts or bases and actual results can be material, depending on
the circumstances. Where, in any forward-looking statement, we or our management
expresses an expectation or belief as to future results, there can be no
assurance that the statement of expectation or belief will result or be achieved
or accomplished. Our actual results may differ materially from those expressed
in any forward-looking statements made by us. These forward-looking statements
involve a number of risks or uncertainties including, but not limited to, the
items addressed in the section titled "Investment Considerations" set forth
below and other risks referred to from time to time in our periodic filings with
the Securities and Exchange Commission.
All forward-looking statements made by us are qualified by and should be read in
conjunction with the Investment Considerations set forth below and in our other
periodic filings with the Securities and Exchange Commission. Except as may be
required by applicable law, we and our management undertake no obligation to
publicly update or revise any forward-looking statements, whether as a result of
new information, future events or otherwise.
10
RESULTS OF CONSOLIDATED OPERATIONS:
THREE MONTHS ENDED MARCH 31, 2001 AND 2000
Our consolidated net income was $71.5 million for the three months ended March
31, 2001, a 19% increase from the same period of 2000. The growth was due to:
. an increase in premiums earned of 14%;
. an increase in net investment income of 15%;
. a decrease in losses and loss adjustment expenses of 19%; and
. an increase in other income of 47%.
This growth was partially offset by:
. an increase in underwriting and other operating expenses of 40%; and
. net realized investment losses of $1.0 million.
Diluted net income per share for the three months ended March 31, 2001 was
$1.59, an increase of 19%. Diluted operating earnings per share, excluding
realized investment losses, increased by 20% to $1.60. Consolidated revenues for
the first quarter of 2001 increased 14% from the first quarter of 2000 to $204.6
million.
U.S. Mortgage Insurance Operations
Our primary operating subsidiary, PMI Mortgage Insurance Co., or PMI, generated
77% of our consolidated revenues for the three months ended March 31, 2001.
During the first quarter of 2001, the total principal amount of mortgages newly
insured by PMI, or PMI's new primary insurance written, increased 25% from the
comparable period of 2000 to $7.4 billion. We believe the increase was
primarily the result of an increase in residential mortgage origination activity
and a corresponding increase in the volume of the private mortgage insurance
market.
As reported by the industry's trade association, Mortgage Insurance Companies of
America, the private mortgage insurance industry experienced a 50% increase in
total new insurance written of $49.1 billion for the first three months ended
March 31, 2001 compared to $32.7 billion for the same period last year. We
believe that this increase was primarily due to an increase in total residential
mortgage originations in the first quarter of 2001. As mortgage interest rates
declined during the first three months of 2001, mortgage originations were, in
large part, driven by refinance activity. Refinance represented approximately
50% of total mortgage originations compared to 21% a year ago. The shift from
purchase activity to refinancing generally decreases the private mortgage
insurance penetration rate, which is the percentage of total mortgage
originations insured by the private mortgage insurance industry. The private
mortgage insurance penetration rate was approximately 12% for the quarter
compared to approximately 15% for the first quarter of 2000. We believe that
the refinancing trend may continue to increase in 2001 due to the expected low
interest rate environment, which could cause the penetration rate to decline
further.
As reported by Mortgage Insurance Companies of America, the private mortgage
insurance industry's market share of the total insured market increased to 60.2%
for the three months ended March 31, 2001
11
compared with 58.8% for the corresponding period in 2000. We believe the
increase was due primarily to market expansion through negotiated secondary
market bulk transactions. Secondary market bulk transactions are negotiated
transactions in which private mortgage insurance companies insure a large group
of loans or commit to insure new loans on agreed upon terms. Secondarily, we
believe that this increase was due to an increase in 2001 of the maximum single-
family principal balance loan limit eligible for purchase by Fannie Mae and
Freddie Mac, or the GSEs, to $275,000. An increase in the GSEs' loan limit
increases the number of loans requiring mortgage insurance and the size of the
mortgage insurance market. Based upon the industry's total new insurance written
of $49.1 billion as reported by Mortgage Insurance Companies of America, we
believe that PMI's market share for the first quarter of 2001 was 15.1% compared
to 18.1% for the same period last year. On a combined basis with CMG Mortgage
Insurance Company or CMG, PMI's partially owned subsidiary, PMI's market share
in the first quarter of 2001 was 16.4% compared to 19.5% in the comparable
period of 2000. We believe the decrease in our market share was primarily due to
a decline in the volume of bulk transactions generated by PMI during the first
quarter of 2001. Negotiated secondary market bulk transactions with primary
mortgage insurance accounted for approximately 3% of new insurance written
during the first three months of 2001 and approximately 25% a year ago. We
anticipate that negotiated bulk transactions will continue to be an increasing
portion of total volume of insurance originated in the residential mortgage
insurance market. We also expect that there will be volatility in the market
share of individual companies, including PMI, as a result of these bulk
transactions.
New insurance written was $7.4 billion for the three months ended March 31, 2001
compared to $5.9 billion for the same period of 2000, a 25% gain. PMI's new
insurance written does not include primary mortgage insurance placed upon loans
more than 12 months after loan origination or pool transactions. PMI's primary
insurance in force increased 10% to $97.8 billion as of March 31, 2001 compared
to March 31, 2000. Primary insurance in force refers to the current principal
balance of all mortgage loans with primary insurance as of a given date. On a
combined basis with CMG, primary insurance in force grew by 11% to $105.1
billion at March 31, 2001 from $94.9 billion at March 31, 2000. PMI's primary
risk in force as of March 31, 2001 was $23.8 billion, a 10% increase compared to
March 31, 2000. Primary risk in force is the dollar amount equal to the product
of each individual insured mortgage loan's current principal balance multiplied
by the percentage specified in the policy of the insurance coverage. On a
combined basis with CMG, primary risk in force grew by 11% to $25.6 billion at
March 31, 2001 from $23.1 billion a year ago. In addition to new insurance
written, the growth in primary insurance in force and risk in force was due in
part to an increase in the percentage of insurance policies at the beginning of
a period that remain in force at the end of the period, which is referred to as
persistency, offset by an increase in the cancellation of policies. PMI's
persistency rate increased to 77.7% at March 31, 2001 compared to 75.6% at March
31, 2000. Cancellations of insurance in force increased in the first quarter of
2001 by 73% to $6.5 billion, primarily due to high refinance activity. PMI's
new insurance written from refinance activity as a percentage of total new
insurance written increased to 35% for the quarter ended March 31, 2001 from 10%
for the comparable period last year. Due to the anticipated declining interest
rate environment in 2001, we expect persistency to decrease.
Non-traditional loans, including Alternative A and less than A quality loans,
accounted for approximately 6% of PMI's new insurance written during the first
three months of 2001. In comparison, approximately 21% of new insurance written
was non-traditional loans in the first quarter of 2000. Generally, non-
traditional loans are insured through negotiated secondary market bulk
transactions. Loan characteristics, credit quality, loss development, pricing
structures and persistency related to these non-traditional loans can be
significantly different than PMI's traditional primary business. We expect
higher delinquencies and default rates and lower persistency for non-traditional
loans, and incorporate these assumptions into our pricing. However, insurance
on non-traditional loans might not generate the same returns as the standard
business and the premiums generated by this insurance might not adequately
offset the associated risk.
12
GSE pool insurance risk written was $10.4 million for the three months ended
March 31, 2001 compared to $24.3 million for the same period of 2000. Pool
insurance is a type of mortgage insurance that covers all or a percentage of a
loss on individual mortgage loans held within a group or pool of loans up to an
agreed aggregate limit for the pool. We expect that the amount of GSE pool risk
written will continue to decrease in 2001. GSE pool risk in force at March 31,
2001 was $795.5 million compared to $705.2 million at March 31, 2000. The old
pool insurance in force was $1.38 billion as of March 31, 2001 and $1.41 billion
as of March 31, 2000.
PMI also provides structured insurance products that are not included in either
new primary insurance written or new GSE pool risk written. These products vary
significantly with individual investor requests, and include modified pool
products and second layer coverage products that restructure primary risk. In
addition to primary and pool risk in force, total all other risk in force was
$269.2 million as of March 31, 2001 compared to $144.2 million as of March 31,
2000.
In 1995, the GSEs increased the amount of mortgage insurance coverage they
required lenders to maintain and, as a result, PMI's proportion of risk in force
with deeper coverage percentages increased and contributed to the growth in
premiums earned. The coverage percentage is the percentage of the total amount
of a loan's principal balance subject to payment by mortgage insurance in the
event of a claim. In 1999, the GSEs reduced the coverage percentage required
for some loans approved for purchase by the GSEs' automated loan underwriting
systems. In addition, the GSEs will further reduce the coverage percentage
required on loans approved for purchase by their automated underwriting systems
if lenders pay a delivery fee to the GSEs. We believe that the changes by the
GSEs to mortgage insurance coverage requirements, if widely accepted by lenders,
could materially decrease PMI's level of primary risk in force and the growth of
premiums written. PMI's average coverage percentage on insurance in force at
March 31, 2001 was 24.3% and 24.4% at March 31, 2000.
Net premiums written were $129.8 million for the three months ended March 31,
2001, an 11% increase from the same period of 2000. This increase was due, in
large part, to the growth of insurance and risk in force as discussed above.
Net premiums written refers to the amount of premiums received during a given
period, net of refunds and premiums ceded under reinsurance arrangements,
including captive reinsurance agreements. Captive reinsurance is a reinsurance
product in which a portion of the risk insured with PMI is reinsured with the
insured or an affiliate of the insured. During the first three months of 2001,
42% of new insurance written was subject to captive mortgage reinsurance
agreements. In comparison, 25% of new insurance written was subject to captive
mortgage reinsurance agreements during the first quarter of 2000. We anticipate
that the continued growth of captive reinsurance arrangements will reduce our
net premiums written and earned over the long-term. Primary risk in force under
risk-sharing programs with PMI's customers represented 31% of primary risk in
force as of March 31, 2001. We anticipate that the percentage of PMI's risk in
force related to risk-sharing programs will continue to increase as a percentage
of total risk in force in 2001. Ceded premiums written increased by 59% to
$12.9 million as a result of the increase in captive reinsurance arrangements
during the first quarter of 2001. Refunded premiums increased by 40% to $3.4
million in the first quarter of 2001, due to the increase in policy
cancellations. The amount of premiums recognized as revenue for accounting
purposes, or premiums earned, increased by 10% to $132.0 million during the
first three months of 2001, primarily due to the increase in premiums written.
Losses and loss adjustment expenses decreased by 23% to $21.2 million for the
three months ended March 31, 2001, primarily due to the continuing improved loss
reduction efforts resulted from favorable economic conditions and the strong
housing market, and the corresponding decrease in claim payments. Loans in
default were 18,314 at March 31, 2001, a 19% increase from a year ago, primarily
due to the maturation of the 1998 and 1999 books of business and to a higher
level of defaults on non-traditional loans in PMI's portfolio. The default
rate, which is the percentage of insured loans in force that are in default at a
given
13
date, for PMI's primary insurance increased to 2.22% at March 31, 2001 from
2.01% at March 31, 2000 and 2.21% at December 31, 2000. Claims paid on direct
primary insurance decreased by 4% to $18.5 million, due to a decrease in the
number of claims paid to 899, offset by an increase in the average claim size to
$20,628 for the first quarter of 2001 from $20,491 for the comparable period of
2000. The decrease in the number of claims paid was due largely to the loss
reduction opportunities discussed above.
Total expenses, including the amortization of policy acquisition costs and non-
acquisition related operating costs, decreased to $33.0 million for the three
months ended March 31, 2001 from $33.4 million for the same period of
2000. Mortgage insurance policy acquisition costs incurred and deferred to the
balance sheet decreased slightly to $18.7 million for the first quarter of 2001
due to increased efficiencies in PMI's electronic commerce business.
Correspondingly, amortization of deferred policy acquisition costs decreased by
5% to $19.4 million. A significant portion of PMI's policy acquisition costs
relates to contract underwriting. New policies processed by contract
underwriters represented 31% of new insurance written in the first quarter of
2001 compared to 22% in the same period of 2000. We anticipate that contract
underwriting will continue to account for a significant portion of PMI's
acquisition costs. As PMI increases the electronic origination and delivery of
our products, the acquisition costs should decline. During the first quarter of
2001, electronic delivery accounted for 31% of PMI's commitments of insurance,
an increase of 18% from the comparable period of 2000. Total expenses incurred
by PMI can be divided into two categories: (i) acquisition costs related
directly to acquiring, underwriting and processing new business; and (ii)
general operating and corporate overhead. Acquisition costs include all
underwriting, contract underwriting, field operations and sales related expenses
that are deferred to the balance sheet and amortized to the expenses over a 24-
month period. Other operating expenses, which are all other costs that are not
accounted for as acquisition costs, are recorded as expenses when incurred.
Other operating expenses increased by 5% to $13.6 million, primarily due to
increased payroll and related expenses, offset by an increase in allocation to
the holding company associated with diversification efforts.
The mortgage insurance loss ratio, which is the ratio of incurred losses to net
premiums earned, decreased 6.8 percentage points from the first quarter of 2000
to 16.1% in the first quarter of 2001. Incurred losses are the total amount of
estimated future claim payments, including a number of related expenses. The
decline was attributed largely to the decrease in losses and loss adjustment
expenses coupled with the increase in premiums earned. The net expense ratio
decreased 3.1 percentage points to 25.4% in the first quarter of 2001, primarily
due to the decrease in the amortization of deferred policy acquisition costs
along with the increase in net premiums written. The net expense ratio is the
ratio of amortization of acquisition costs and other operating expenses to the
net amount of premiums received during a given period. The combined ratio,
which is the sum of the loss ratio and the net expense ratio, decreased 9.9
percentage points to 41.5% for the first three months of 2001.
International Mortgage Insurance Operations
International Mortgage Insurance operations include PMI Mortgage Insurance Ltd,
or PMI Ltd, and PMI Mortgage Insurance Company Limited, or PMI Europe, which was
formed in February 2001 and located in Ireland. The financial results of
international operations are subject to currency rate risk. Effective January
1, 2000, we changed our accounting policy for international subsidiaries and
affiliates to report operations on a one-month lag from our domestic operations.
Therefore, the results of our foreign operations for the first quarter of 2000
represented two months of activity while the corresponding period for 2001
represents three months of activity. The reported results of PMI Ltd were
affected by the devaluation in the Australian dollar from 2000 to 2001. The
average AUD/USD exchange rate was 0.55 for the first quarter of 2001 compared to
0.64 for the first quarter of 2000, a 15% decrease. Net income for PMI Ltd was
$4.3 million for the three months ended March 31, 2001 compared to $4.4 million
for the same period of 2000. PMI Ltd generated $10.4 million of net premiums
written and $7.1 million in net premiums earned during the first quarter of
2001, compared to $6.0 million of net premiums written and $5.6 million in net
14
premiums earned for the quarter ended March 31, 2000. Losses and loss
adjustment expenses were $1.0 million for the first three months of 2001
compared to $0.4 million in the corresponding period of 2000. Underwriting and
other expenses were $2.2 million for the first quarter of 2001 compared to $2.0
million a year ago. Net income for PMI Europe was $0.2 million for the quarter
ended March 31, 2001. Financial results for the operations in Hong Kong were
immaterial during the first quarter of 2001.
Title Insurance Operations
Net income for American Pioneer Title Insurance Company, or APTIC, was $1.5
million for the three months ended March 31, 2001 compared to $1.4 million for
the same period of 2000. Title insurance premiums earned increased by 37% to
$31.0 million in the first quarter of 2001, due to continuing geographic
expansion efforts and the increase in residential mortgage originations. APTIC
is licensed in 44 states and the District of Columbia. During the first quarter
of 2001, 53% of APTIC's premiums earned was generated from the State of Florida
compared with 69% during the corresponding period in 2000. Underwriting and
other expenses increased by 37% to $28.5 million primary due to an increase in
agency fees and commissions related to the increase in premiums earned and to
the costs associated with expansion efforts. The combined ratio for our title
insurance operations increased by 1.0 percentage point to 94.3% for the first
three months of 2001.
Other
Our net investment income, excluding realized investment gains and losses, was
$31.2 million for the three months ended March 31, 2001, a 15% increase from the
comparable period of 2000. This increase was largely due to the growth in our
investment portfolio of $78.9 million and an increase in equity earnings of $2.1
million. Investments in affiliates increased to $136.2 million as of March 31,
2001 from $94.4 million as of March 31, 2000, due primarily to additional
capital investments in unconsolidated subsidiaries and their earnings. The pre-
tax current portfolio book yield was 6.1% at the quarter ended March 31, 2001,
the same as the book yield at the quarter ended March 31, 2000. Net realized
investment losses were $1.0 million during the first quarter of 2001. Interest
expense increased 14% for the quarter to $2.7 million, up $0.3 million over the
first quarter of 2000.
Other income, which was generated primarily by PMI Mortgage Services Co., or
MSC, was $4.0 million for the three months ended March 31, 2001 compared to $2.9
million for the same period of 2000. This increase was primarily attributed to
an increase in contract underwriting services in connection with higher mortgage
originations. Other expenses, which were incurred by the holding company and
MSC, increased to $11.8 million for the first quarter of 2001 from $3.9 million
for the comparable period of 2000, primarily due to an increase in contract
underwriting activities, and the increased expenses incurred by the holding
company related to international expansion and diversification efforts.
Our effective tax rate was 29.8% for the three months ended March 31, 2001
compared to 31.2% for the corresponding period in 2000, as a result of an
increase in the proportion of tax-exempt investment income relative to total
income.
Liquidity, Capital Resources and Financial Condition
Liquidity and capital resource considerations are different for the holding
company than they are for PMI. The holding company's principal sources of funds
are dividends from PMI and APTIC, investment income, and funds that may be
raised from time to time in the capital markets.
PMI's ability to pay dividends to the holding company is affected by state
insurance laws, credit agreements, credit rating agencies and the discretion of
insurance regulatory authorities. The laws of
15
Arizona, the state of PMI's domicile for insurance regulatory purposes, provide
that PMI may pay out of any available surplus account without prior approval of
the Director of the Arizona Department of Insurance dividends during any 12-
month period not to exceed the lesser of 10% of policyholders' surplus as of the
preceding year end, or the last calendar year's investment income. Other state
insurance laws restrict the payment of dividends from the unassigned surplus
account only.
The laws of Florida limit the payment of dividends by APTIC to the holding
company in any one year to 10% of available and accumulated surplus derived from
realized net operating profits and net realized capital gains. As with PMI, the
various credit rating agencies and insurance regulatory authorities have broad
discretion to affect the payment of dividends to us by APTIC.
As of March 31, 2001, our long-term debt was $136.7 million and was comprised of
the followings:
. $100 million, at par, senior notes used for general corporate purposes;
. $37.1 million Australian bank note used for the purchase of PMI Ltd.
In addition, we have a bank credit line in the amount of $25 million with Bank
of America. As of March 31, 2001, there were no outstanding borrowings under
the credit line. These financial instruments contain certain financial
covenants and restrictions, including cross-default provisions, risk to capital
ratios and minimum capital and dividend restrictions.
Our holding company's principal uses of funds are common stock repurchases, the
payment of dividends to shareholders, funding of acquisitions, additions to its
investment portfolio, investments in subsidiaries, and the payment of interest
and other expenses incurred. As of March 31, 2001, available funds were $108.7
million compared to $108.3 million as of December 31, 2000. In November 1998, we
announced a stock repurchase program in the amount of $100 million authorized by
our board of directors. No common stock was repurchased during the first quarter
of 2001, and $45.4 million remained available under the 1998 authorization at
the quarter end.
Our invested assets increased $78.9 million from December 31, 2000 as a result
of positive cash flows from consolidated operations. Consolidated reserves for
losses and loss adjustment expenses decreased by $0.7 million to $294.3 million
at the quarter ended March 31, 2001, due primarily to decreases in the reserve
balances for the primary and GSE pool insurance books of business.
The principal sources of funds for PMI are premiums received on new and renewal
business and amounts earned from its investment portfolio. The principal uses
of funds by PMI are policy acquisition costs, payment of claims and related
expenses, other operating expenses, investment in subsidiaries, and dividends.
PMI has entered into capital support agreements with its European and Australian
subsidiaries that could require PMI to make additional capital contributions to
those subsidiaries in order to maintain their credit ratings. With respect to
the European and Australian subsidiaries, we have guaranteed the performance of
PMI's capital support obligations.
PMI's ratio of net risk in force to statutory capital, or statutory risk-to-
capital ratio, at March 31, 2001 was 13.7 to 1 compared to 14.7 to 1 at March
31, 2000.
16
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
Our borrowings under credit facilities are subject to interest rates that are
variable. As of March 31, 2001, the effective duration of our investment
portfolio was 4.8 years. The result of a 100 basis points increase in interest
rates would be a 5.2% decrease in the value of our investment portfolio, while
the result of a 100 basis points decrease in interest rates would be a 4.2%
increase in the value of our investment portfolio. $37.1 million of our long-
term debt and $165.2 million of our invested assets are held by PMI Ltd and are
denominated in Australian dollars, which has experienced significant devaluation
during the first quarter of 2001 compared to the first quarter of 2000.
INVESTMENT CONSIDERATIONS
General economic factors may adversely affect our loss experience and the demand
for mortgage insurance.
Losses result from events, such as unemployment, that reduce a borrower's
ability to continue to make mortgage payments. The amount of the loss, if any,
depends in part on whether the home of a borrower who defaults on a mortgage can
be sold for an amount that will cover unpaid principal and interest and the
expenses of the sale. Favorable economic conditions generally reduce the
likelihood that borrowers will lack sufficient income to pay their mortgages and
also favorably affect the value of homes, reducing and in some cases even
eliminating a loss from a mortgage default. We believe that our loss experience
could materially increase as a result of:
. national or regional economic recessions;
. declining values of homes;
. higher unemployment rates;
. deteriorating borrower credit;
. interest rate volatility;
. shortages of electric power in California or other states; or
. combinations of these factors.
These factors could also materially reduce the demand for housing and,
consequently, the demand for mortgage insurance.
If interest rates decline, home values increase or mortgage insurance
cancellation requirements change, the length of time that our policies remain in
force and our revenues could decline.
A significant percentage of the premiums we earn each year are generated from
insurance policies that we have written in previous years. As a result, the
length of time insurance remains in force is an important determinant of our
revenues. The policy owner or servicer of the loan may cancel insurance
coverage at any time. In addition, the Home Owners Protection Act of 1998
provides for the automatic termination or cancellation of mortgage insurance
upon a borrower's request if specified conditions are satisfied. Factors that
tend to reduce the length of time our insurance remains in force include:
17
. current mortgage interest rates falling below the rates on the mortgages
underlying our insurance in force, which frequently results in borrowers
refinancing their mortgages and canceling their existing mortgage insurance;
. the rate of appreciation in home values experienced by the homes underlying
the mortgages of the insurance in force, which can result in borrowers
requesting, and lenders agreeing to, the cancellation of mortgage insurance;
and
. changes in the mortgage insurance cancellation policies of mortgage lenders
and investors.
Although we have a history of expanding our business during periods of low
interest rates, the resulting increase of new insurance written may not be
adequate to compensate us for our loss of insurance in force arising from policy
cancellations.
If the volume of low down payment home mortgage originations declines, the
amount of insurance that we write could also decline, which could result in a
decline in our future revenue.
The factors that affect the volume of low down payment mortgage originations
include:
. the level of home mortgage interest rates;
. the health of the domestic economy as well as conditions in regional and
local economies;
. housing affordability;
. population trends, including the rate of household formation;
. the rate of home price appreciation, which in times of heavy refinancing
affects whether refinance loans have loan-to-value ratios that require
private mortgage insurance; and
. government housing policy encouraging loans to first-time homebuyers.
We cannot cancel mortgage insurance policies or adjust renewal premiums to
protect from unanticipated claims, which could harm our financial performance.
We cannot cancel the mortgage insurance coverage that we provide. In addition,
we generally establish renewal premium rates for the life of the mortgage
insurance policy when the policy is issued. As a result, the impact of
unanticipated claims generally cannot be offset by premium increases on policies
in force or limited by nonrenewal 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.
Because we compete with private mortgage insurers, governmental agencies and
others in an industry that is highly competitive, our revenues and profits could
decline substantially as we respond to competition or if we lose market share.
The principal sources of our direct and indirect competition include:
. other private mortgage insurers, some of which are subsidiaries of well
capitalized, diversified public companies with direct or indirect capital
reserves that provide them with potentially greater resources than we have;
18
. federal and state governmental and quasi-governmental agencies, principally
the Federal Housing Administration and to a lesser degree the Veterans
Administration;
. mortgage lenders that choose not to insure against borrower default, self-
insure through affiliates, or offer residential mortgage products that do not
require mortgage insurance; and
. captive reinsurance subsidiaries of national banks, savings institutions and
bank holding companies and other mortgage lenders.
If mortgage lenders and investors select alternatives to private mortgage
insurance, the amount of insurance that we write could decline significantly,
which could reduce our revenues and profits.
Alternatives to private mortgage insurance include:
. government mortgage insurance programs, including those of the Federal
Housing Administration and the Veterans Administration;
. investors holding mortgages in their portfolios and self-insuring;
. investors using credit enhancements other than private mortgage insurance or
using other credit enhancements in conjunction with reduced levels of private
mortgage insurance coverage; and
. mortgage lenders structuring mortgage originations to avoid private mortgage
insurance, such as a first mortgage with an 80% loan-to-value ratio and a
second mortgage with a 10% loan-to-value ratio, which is referred to as an
80-10-10 loan, rather than a first mortgage with a 90% loan- to-value ratio.
In October 1999, the Federal Housing Finance Board authorized each Federal Home
Loan Bank to offer programs to purchase single-family conforming mortgage loans
originated by participating member institutions under the single-family member
mortgage assets program. In July 2000, the Federal Housing Finance Board gave
permanent authority to each Federal Home Loan Bank to purchase these loans from
member institutions without any volume cap. Under the Board's rules, member
institutions are also authorized to provide credit enhancement for eligible
loans. Any expansion of the Federal Home Loan Banks' ability to use
alternatives to mortgage insurance could reduce the demand for private mortgage
insurance and harm our financial condition and results of operations.
Legislation and regulatory changes may reduce demand for private mortgage
insurance, which could harm our business.
Increases in the maximum loan amount that the Federal Housing Authority, or FHA,
can insure can reduce the demand for private mortgage insurance. Effective
January 1, 2001, the maximum individual loan amount that the FHA can insure was
increased to $239,250. In addition, the FHA has streamlined its down-payment
formula and made FHA insurance more competitive with private mortgage insurance
in areas with higher home prices. As of January 1, 2001, the FHA reduced the
up-front mortgage insurance premiums it charges on loans from 2.25% to 1.5% of
the original loan amounts. These and other legislative and regulatory changes
have caused, and may cause in the future, demand for private mortgage insurance
to decrease and this could harm our financial condition and results of
operations.
19
As a result of the enactment of The Gramm-Leach-Bliley Act, we expect to
experience increased competition from mortgage insurance companies owned by
large, well capitalized financial services companies, which could significantly
harm our business.
The Gramm-Leach-Bliley Act allows bank holding companies to engage in a
substantially broader range of activities, including insurance underwriting,
than those companies could previously engage in and allows insurers and other
financial service companies to acquire banks. Bank holding companies are now
permitted to form insurance subsidiaries that issue insurance products,
including mortgage insurance, directly to consumers. We expect that, over time,
consumers will have the ability to shop for their insurance, banking and
investment needs at one financial services company. We believe that this new law
may lead to increased competition in the mortgage insurance industry by
facilitating the development of new savings and investment products, resulting
in mortgage lenders offering mortgage insurance directly to home borrowers
rather than through captive reinsurance arrangements with us and encouraging
large, well-capitalized financial service companies to enter the mortgage
insurance business.
We depend on a small number of customers and our business and financial
performance could suffer if we were to lose the business of a major mortgage
lender.
We are dependent on a small number of customers. Our top ten customers were
responsible for 40% of our new insurance written as of March 31, 2001. The
concentration of business with our customers may increase as a result of mergers
or other factors. These customers may reduce the amount of business currently
given to us or cease doing business with us altogether. Our master policies and
related lender agreements do not, and by law cannot, require our lenders to do
business with us. The loss of business from any major customer could seriously
harm our business and results of operations.
We acquire a significant percentage of our new business through secondary market
"bulk" transactions with a limited number of investors. Our business could be
harmed if these investors substitute other types of credit enhancement for
private mortgage insurance.
We could lose premium revenue if Fannie Mae or Freddie Mac continue to reduce
the level of private mortgage insurance coverage required for low down payment
mortgages.
Fannie Mae and Freddie Mac offer programs that require less mortgage insurance
coverage on mortgages approved by their automated underwriting systems. Fannie
Mae and Freddie Mac might further reduce coverage requirements. If the
reduction in required levels of mortgage insurance becomes widely accepted by
mortgage lenders, we would lose premium revenue and our financial condition and
results of operations could suffer.
New products introduced by Fannie Mae or Freddie Mac could cause us to lose
premium revenue if those products are successful.
Fannie Mae and Freddie Mac have separately introduced new products pursuant to
which they will, upon receipt from lenders of loans with primary mortgage
insurance, restructure the mortgage insurance coverage with reduced amounts of
primary coverage, usually deeper pool coverage, and, in some instances, payment
of fees to Fannie Mae or Freddie Mac. If these products prove to be less
profitable than PMI's traditional mortgage insurance business, and become widely
accepted, they could have a material adverse effect upon the Company's financial
condition.
If Fannie Mae and Freddie Mac give mortgage lenders an incentive, such as a
reduced guarantee fee, to select a mortgage insurer that has a claims-paying
ability rating of "AAA," our business would be materially harmed unless we are
successful in obtaining a "AAA" rating.
20
In 1999 the Office of Federal Housing Enterprise Oversight announced proposed
risk-based capital regulations that would treat credit enhancements issued by
private mortgage insurance companies with claims-paying ability ratings of "AAA"
more favorably than those issued by companies with lower ratings. The Office of
Federal Housing Enterprise Oversight expects to publish final regulations in
2001. We do not have a "AAA" rating. If the proposed capital rules are adopted
in a form that gives greater capital credit to private mortgage insurers with
"AAA" ratings, we may need to obtain a "AAA" rating. To obtain a claims-paying
ability rating of "AAA" we would need to dedicate significant capital to the
mortgage insurance business that we might use in other ways and we would also
have additional costs that we would not otherwise incur. Changes in the
preferences of Fannie Mae and Freddie Mac for private mortgage insurance to
other forms of credit enhancement, or a tiering of mortgage insurers based on
their credit rating, could harm our financial condition and results of
operations.
Efforts by Fannie Mae and Freddie Mac to reduce the need for private mortgage
insurance could reduce our revenues.
Freddie Mac has made several announcements that it would pursue a legislative
amendment that would allow it to utilize alternative forms of default loss
protection or otherwise forego the use of private mortgage insurance on higher
loan-to-value mortgages. In October 2000, Fannie Mae announced its intention to
increase its share of revenue associated with the management of mortgage credit
risk and interest rate risk during the next three years by retaining mortgage
credit risk previously borne by its "risk-sharing partners," including mortgage
insurers. Part of any attempt by Fannie Mae to increase its share of revenue
associated with mortgage credit risk could include a reduction in the use or
level of mortgage insurance, which could reduce our revenue.
Lobbying activities by large mortgage lenders calling for expanded federal
oversight and legislation relating to the role of Fannie Mae and Freddie Mac in
the secondary mortgage market could damage our relationships with those mortgage
lenders, Fannie Mae and Freddie Mac.
Together with Fannie Mae, Freddie Mac and mortgage lenders, we jointly develop
and make available various products and programs. These arrangements involve
the purchase of our mortgage insurance products and frequently feature
cooperative arrangements between the three parties. In 1999, a coalition of
financial services and housing related trade associations, including the
Mortgage Insurance Companies of America and several large mortgage lenders,
formed FM Watch, a lobbying organization that supports expanded federal
oversight and legislation relating to the role of Fannie Mae and Freddie Mac in
the secondary mortgage market. Fannie Mae and Freddie Mac have criticized, and
lobbied against, FM Watch. These lobbying activities could, among other things,
polarize Fannie Mae, Freddie Mac and members of FM Watch as well as our
customers and us. As a result of this polarization, our relationships with
Fannie Mae and Freddie Mac may limit our opportunities to do business with some
mortgage lenders, particularly the large mortgage lenders that have formed FM
Watch. Conversely, our relationships with these large mortgage lenders may
limit our ability to do business with Fannie Mae and Freddie Mac. Either of
these outcomes could seriously harm our financial condition and results of
operations.
If we are unable to introduce and successfully market new products and programs,
our competitive position could suffer.
From time to time we introduce new mortgage insurance products or programs. Our
competitive position and financial performance could suffer if we experience
delays in introducing competitive new products and programs or if these products
or programs are less profitable than our existing products and programs.
21
Mortgage lenders increasingly require us to reinsure a portion of the mortgage
insurance default risk on mortgages that they originate with their captive
mortgage reinsurance companies, which will reduce our net premiums written.
Our customers have indicated an increasing demand for captive mortgage
reinsurance arrangements. Under these arrangements, a reinsurance company,
which is usually an affiliate of the mortgage lender, assumes a portion of the
mortgage insurance default risk on mortgage loans originated by the lender in
exchange for a portion of the insurance premiums. An increasing percentage of
our new insurance written is being generated by customers with captive
reinsurance companies, and we expect that this trend will continue. An increase
in captive mortgage reinsurance arrangements will decrease our net premiums
written which may negatively impact the yield that we obtain on net premiums
earned for customers with captive mortgage reinsurance arrangements. If we do
not provide our customers with acceptable risk-sharing structured transactions,
including potentially increasing levels of premium cessions in captive mortgage
reinsurance arrangements, our competitive position may suffer.
Our risk in force consists of mortgage loans with high loan-to-value ratios,
which generally result in more claims than mortgage loans with lower loan-to-
value ratios.
At March 31, 2001:
. 45% of our risk in force consisted of mortgages with loan-to-value ratios
greater than 90% but less than or equal to 95%, which we refer to as "95s".
In our experience 95s have claims frequency rates approximately twice that of
mortgages with loan-to-value ratios greater than 85% but less than or equal
to 90%, which we refer to as "90s."
. 5.6% of our risk in force consisted of mortgages with loan-to-value ratios
greater than 95% but less than or equal to 97%, which we refer to as "97s".
In our experience 97s have higher claims frequency rates than 95s and greater
uncertainty as to pricing adequacy.
. 0.2% of our risk in force consisted of mortgages with loan-to-value ratios
greater than 97%, which in our experience have claims frequency rates higher
than 97s.
. 9% of our risk in force consisted of adjustable rate mortgages, which we
refer to as "ARMs." In our experience ARMs, although priced higher, have
claims frequency rates that exceed the rates associated with our book of
business as a whole.
The premiums we charge for mortgage insurance on non-traditional loans, and the
associated investment income, may not be adequate to compensate us for future
losses from these products.
Our new insurance written includes non-traditional, Alternative A and less than
A loans, which we refer to as "non-traditional loans." Non-traditional loans
represented approximately 6% of our total new insurance written in the first
quarter of 2001. Loan characteristics, credit quality, loss development,
pricing structures and persistency on non-traditional loans can be significantly
different than our traditional prime business. In addition, non-traditional
loans generally do not meet the standard underwriting guidelines of Fannie Mae
and Freddie Mac. We expect higher delinquency rates and default rates for non-
traditional loans. We cannot be assured that this book of business will
generate the same returns as our standard business or that the premiums that we
charge on non-traditional loans will adequately offset the associated risk.
Paying a significant number of claims under the pool insurance we write could
harm our financial performance.
22
We offer pool insurance that is generally used as an additional credit
enhancement for secondary market mortgage transactions. Pool insurance provides
coverage for non-conforming loans, and is generally considered riskier than
primary insurance. Under primary insurance, an insurer's exposure is limited to
a specified percentage of any unpaid principal, delinquent interest and related
expenses on an individual loan. Under traditional pool insurance, there is an
aggregate exposure limit -- a "stop loss" -- on a pool of loans, which is
generally a percentage of the initial aggregate loan balance of the entire pool
of loans. Under our pool insurance, we could be required to pay the full amount
of every loan in the pool that is in default and upon which a claim is made
until the stop loss is reached, rather than a percentage of that amount. The
premiums that we charge for these policies may not adequately compensate us if
we experience higher delinquency and default rates than we anticipate at the
time we set the premiums for the policies. If we are required to pay a
significant number of claims under our pool insurance, then our financial
condition and results of operations could be seriously harmed.
The concentration of insurance in force in relatively few states could increase
claims and losses and harm our financial performance.
In addition to being affected by nationwide economic conditions, we could be
particularly affected by economic downturns in specific regions of the United
States where a large portion of our business is concentrated. As of March 31,
2001:
. 14% of our total risk in force was on mortgages for homes located in
California, where the default rate on our policies was 2.31%;
. 8% of our total risk in force was on mortgages for homes located in
Florida, where the default rate on our policies was 2.87%; and
. 7% of our total risk in force was on mortgages for homes located in Texas,
where the default rate on our policies was 2.12%.
This compares with a nationwide default rate on our policies of 2.22% in the
first quarter of 2001. Continued and prolonged adverse economic conditions in
any of these states could result in high levels of claims and losses. In
addition, refinancing of mortgage loans can have the effect of concentrating our
insurance in force in economically weaker areas, because mortgages in areas
experiencing appreciation of home values are less likely to require mortgage
insurance at the time of refinancing than are mortgages in areas experiencing
limited or no appreciation of home values.
We delegate underwriting authority to mortgage lenders that may cause us to
insure unacceptably risky mortgage loans, which could increase claims and
losses.
The majority of our new insurance written is underwritten pursuant to a
delegated underwriting program. Once a mortgage lender is accepted into our
delegated underwriting program, that mortgage lender may determine whether
mortgage loans meet our program guidelines and may commit us to issue mortgage
insurance. We expect to continue offering delegated underwriting to approved
lenders and may expand the availability of delegated underwriting to additional
customers. If an approved lender commits us to insure a mortgage loan, we may
not refuse to insure, or rescind coverage on, that loan even if we reevaluate
that loan's risk profile or the lender failed to follow our delegated
underwriting guidelines, except in very limited circumstances. In addition, our
ability to take action against an approved lender that fails to follow our
program guidelines and requirements is limited by access to data that would be
needed to assess the lender's compliance with those guidelines and requirements.
Therefore, an approved lender could cause us
23
to insure a material amount of mortgage loans with unacceptable risk profiles
prior to our termination of the lender's delegated underwriting authority.
We expect our loss experience to increase significantly as our policies continue
to age.
The majority of claims under private mortgage insurance policies have
historically occurred during the third through the sixth years after issuance of
the policies. As of March 31, 2001, approximately 73% of our risk in force was
written after December 31, 1997. This means that less than half of our risk in
force has reached the beginning of the expected peak claims period. As a result,
our loss experience is expected to increase significantly as our policies
continue to 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 and cash flows would be seriously
harmed.
Our loss reserves may be insufficient to cover claims paid and loss-related
expenses incurred.
We establish loss reserves to recognize the liability for unpaid losses related
to insurance in force on mortgages that are in default. These loss reserves are
based upon our estimates of the claim rate and average claim amounts, as well as
the estimated costs, including legal and other fees, of settling claims. These
estimates are regularly reviewed and updated using currently available
information. Any adjustments, which may be material, resulting from these
reviews are reflected in our then current consolidated results of operations.
Our reserves may not be adequate to cover ultimate loss development on incurred
defaults. Our financial condition and results of operations could be seriously
harmed if our reserve estimates are insufficient to cover the actual related
claims paid and loss-related expenses incurred.
If we fail to properly underwrite mortgage loans under our contract underwriting
services, we may be required to assume the cost of repurchasing those loans.
We provide contract underwriting services for a fee. These services help enable
our customers to improve the efficiency and quality of their operations by
outsourcing all or part of their mortgage loan underwriting to us. As part of
our contract underwriting services, we generally provide remedies to our
customers in the event that our underwriters fail to properly underwrite the
mortgage loans. These remedies may include the assumption of the cost of
repurchasing loans that are not properly underwritten, a remedy not available
under our master primary insurance policies. Worsening economic conditions
could cause us to increase the number and severity of the remedies that we
offer, which could harm our financial condition. Due to the demand of contract
underwriting services, limitations on the number of available underwriting
personnel, and heavy price competition among mortgage insurance companies, our
inability to recruit and maintain a sufficient number of qualified underwriters
or any significant increase in the cost we incur to satisfy our underwriting
services obligations could harm our financial condition and results of
operations.
If our claims-paying ability is downgraded, then mortgage lenders and the
mortgage securitization market may not purchase mortgages or mortgage-backed
securities insured by us, which could materially harm our financial performance.
The claims-paying ability of PMI Mortgage Insurance Co., our largest wholly
owned subsidiary, which we refer to as "PMI", is currently rated "AA+"
(Excellent) by Standard and Poor's Rating Services, "Aa2" (Excellent) by Moody's
Investors Service, Inc., and "AA+" (Very Strong) by Fitch IBCA. These ratings
may be revised or withdrawn at any time by one or more of the rating agencies.
These ratings are based on factors relevant to PMI's policyholders and are not
applicable to our common stock or outstanding debt. Adverse developments in
PMI's financial condition or results of operations, whether by virtue of
underwriting or investment losses, the necessity to make capital contributions
to our subsidiaries pursuant to capital support agreements, changes in the views
of rating agencies, or other factors, could cause the
24
rating agencies to lower or withdraw their ratings. If PMI's claims-paying
ability rating falls below "AA-" from Standard and Poor's or "[Aa3]" from
Moody's, then investors, including Fannie Mae and Freddie Mac, will not purchase
mortgages insured by us, which would have a material and adverse effect on our
financial condition and results of operations.
Our ongoing ability to pay dividends to our stockholders and meet our
obligations primarily depends upon the receipt of dividends and returns of
capital from our insurance subsidiaries and our investment income.
Our principal sources of funds are dividends from our subsidiaries, investment
income and funds that may be raised from time to time in the capital markets.
Factors that may affect our ability to maintain and meet our capital and
liquidity needs include:
. the level and severity of claims experienced by our insurance
subsidiaries;
. the performance of the financial markets;
. standards and factors used by various credit rating agencies;
. financial covenants in our credit agreements; and
. standards imposed by state insurance regulators relating to the payment of
dividends by insurance companies.
Any significant change in these factors could adversely affect our ability to
maintain capital resources to meet our business needs.
Regulatory authorities in Illinois and New York are considering whether our
business has been conducted in compliance with applicable state law.
On January 31, 2000, the Illinois Department of Insurance issued a letter
addressed to all mortgage guaranty insurers licensed in Illinois. The letter
states that it may be a violation of Illinois law for mortgage insurers to offer
to Illinois mortgage lenders the opportunity to purchase certain notes issued by
a mortgage insurer or an affiliate, or to participate in loan guaranty programs.
The letter also states that a violation might occur if mortgage insurers offer
lenders coverage on pools of mortgage loans at a discounted or below market
premium in return for the lenders' referral of primary mortgage insurance
business. In addition, the letter stated that, to the extent a performance
guaranty actually transfers risk to the lender in return for a fee, the lender
may be deemed to be doing an insurance business in Illinois without
authorization. The letter announced that any mortgage guaranty insurer that is
participating in the described or similar programs in the State of Illinois
should cease such participation or, alternatively, provide the Department with a
description of any similar programs, giving the reason why the provisions of
Illinois are not applicable or not violated. If the Illinois Department of
Insurance were to determine that we were not in compliance with Illinois law,
our financial condition and results of operations could suffer.
In February 1999, the New York Department of Insurance stated in Circular Letter
No. 2, addressed to all private mortgage insurers licensed in New York, that
certain pool, risk-share and structured products and programs would be
considered to be illegal under New York law. If the New York Department of
Insurance determined we were not in compliance with Circular Letter No. 2, our
financial condition and results of operations could suffer.
25
If adopted, a proposed elimination of a federal tax deduction relating to
contingency reserves could harm our financial performance.
In April 2001, the Congressional Joint Committee on Taxation proposed the
elimination of a federal income tax deduction given for amounts added to
contingency reserves that are required to be established by mortgage insurers
such as PMI by state insurance regulations. The deduction presently allows
mortgage insurers to deduct payments made to such reserves subject to
limitations and requirements including the purchase of non-interest bearing tax
and loss bonds equal to the tax benefit of the deduction. The elimination of
this deduction could harm our financial condition and results of operation.
An increase in PMI's risk-to-capital ratio could prevent it from writing new
insurance, which would seriously harm our financial performance.
The State of Arizona, PMI's state of domicile for insurance regulatory purposes,
and other states limit the amount of insurance risk that may be written by PMI,
based on a variety of financial factors, primarily risk-to-capital ratios. For
example, Arizona law provides that if a mortgage guaranty insurer domiciled in
Arizona does not have the amount of minimum policyholders position required, it
must cease transacting new business until its minimum policyholders position
meets the requirements. Under Arizona law, minimum policyholders position is
calculated based on policyholders surplus, contingency reserves, the face amount
of the mortgage, the percentage coverage or claim settlement option and the loan
to value ratio category, net of reinsurance ceded, but including reinsurance
assumed.
Other factors affecting PMI's risk-to-capital ratio include:
. limitations under the runoff support agreement with Allstate, which
prohibit PMI from paying any dividends if, after the payment of the
dividend, PMI's risk-to-capital ratio would equal or exceed 23 to 1;
. our credit agreements and the terms of our guaranty of the debt incurred
to purchase PMI Mortgage Insurance Ltd, which is our insurance
subsidiary in Australia; and
. capital requirements necessary to maintain our credit rating and PMI's
claims-paying ability ratings.
Generally, the methodology used by the rating agencies to assign credit or
claims-paying ability ratings permits less capital leverage than under statutory
requirements. Accordingly, statutory capital requirements may be lower than the
capital necessary to satisfy rating agency requirements.
PMI has several alternatives available to help control its risk-to-capital
ratio, including:
. obtaining capital contributions from us;
. purchasing additional quota share or excess of loss reinsurance; and
. reducing the amount of new business written.
We may not be able to raise additional funds, or to do so on a timely basis, in
order to make a capital contribution to PMI. In addition, reinsurance may not
be available to PMI or, if available, may not be available on satisfactory
terms. A material reduction in PMI's statutory capital, whether resulting from
underwriting or investment losses or otherwise, or a disproportionate increase
in risk in force, could increase its risk-to-capital ratio. An increase in
PMI's risk-to-capital ratio could limit its ability to write new business. The
inability to write new business could seriously harm our financial condition and
results of operations.
Our international insurance subsidiaries subject us to numerous risks associated
with international operations.
We have subsidiaries in Australia and Europe and may commit significant
resources to expand our international operations. Accordingly, we are subject to
a number of risks associated with international business activities. These
risks include:
26
. the need for regulatory and third party approvals;
. challenges attracting and retaining key foreign-based employees, customers
and business partners in international markets;
. the economic strength of the foreign mortgage origination markets targeted,
particularly the economies of Australia and Europe;
. interest rate volatility in a variety of countries;
. unexpected changes in foreign regulations and laws;
. burdens of complying with a wide variety of foreign laws;
. potentially adverse tax consequences;
. restrictions on the repatriation of earnings;
. foreign currency exchange rate fluctuations;
. potential increases in the level of defaults and claims on policies insured
by foreign-based subsidiaries;
. the need to integrate our domestic insurance subsidiaries' risk management
technology systems and products with those of our foreign operations;
. the need to successfully develop and market products appropriate to the
foreign market, including the development and marketing of credit enhancement
products to European lenders and mortgage securitizations;
. risks related to global economic turbulence; and
. political instability.
The performance of our strategic investments could harm our financial results.
The performance of our strategic investments could be harmed by:
. changes in the real estate, mortgage lending, mortgage servicing, title and
financial guaranty markets;
. future movements in interest rates;
. those operations' future financial condition and performance;
. the ability of those entities to execute future business plans; and
. our dependence upon management to operate those companies in which we do not
own a controlling share.
27
In addition, our ability to engage in additional strategic investments is
subject to the availability of capital and maintenance of our claims-paying
ability ratings by rating agencies.
Our failure or inability to keep pace with the technological demands of our
customers or with the technology-related products and services offered by our
competitors could significantly harm our business and financial performance.
Participants in the mortgage lending and mortgage insurance industries
increasingly rely on e-commerce and other technology to provide and expand their
products and services. An increasing number of our customers require that we
provide our products and services electronically via the Internet or electronic
data transmission, and the percentage of our new insurance written delivered
electronically is increasing. We expect this trend to continue and, accordingly,
believe that it is essential that we continue to invest substantial resources on
maintaining electronic connectivity with our customers and, more generally, on
e-commerce and technology.
If we are not reimbursed by our insurance carriers for costs incurred by us in
connection with our settlement of the Baynham litigation, we may be required to
take an additional charge against earnings.
We have entered into a settlement agreement with the plaintiffs in the putative
class action lawsuit filed against us. We currently estimate that the gross
amount of the settlement will be between $20 million and $22 million. To
account for the settlement, we took a pre-tax charge against fourth quarter 2000
earnings of $5.7 million. This charge represented our estimate of the cost of
settlement less our estimate of insurance payments we will receive from our
insurance carriers as reimbursement for costs incurred by us in connection with
our defense and settlement of the action. We have agreed to participate in
non-binding mediation with our insurance carriers with respect to the amount of
the payments to be reimbursed to us. If we do not realize our estimated amount
of insurance proceeds, we could be required to take an additional charge against
earnings and this could harm our financial condition and results of operations.
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PART II - OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits - The exhibit listed in the accompanying Index to Exhibits is
filed as part of this Form 10-Q.
(b) Reports on Form 8-K:
None.
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SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by
the undersigned, thereunto duly authorized, in the City of San Francisco,
State of California, on the 14/th/ day of May, 2001.
The PMI Group, Inc.
/s/ John M. Lorenzen, Jr.
------------------------------
John M. Lorenzen, Jr.
Executive Vice President and
Chief Financial Officer
/s/ Brian P. Shea
----------------------
Brian P. Shea
Vice President, Controller and Assistant
Secretary
Chief Accounting Officer
30
INDEX TO EXHIBITS
(Part II, Item 6)
Exhibit Number Description of Exhibit
-------------- -----------------------
11.1 Computation of Net Income Per Share
31