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, 1998 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 4/30/98 32,111,169 THE PMI GROUP, INC. INDEX TO QUARTERLY REPORT ON FORM 10-Q MARCH 31, 1998 PART I - FINANCIAL INFORMATION PAGE ---- Item 1. Interim Consolidated Financial Statements and Notes. Consolidated Statements of Operations for the Three Months Ended March 31, 1998 and 1997. 3 Consolidated Balance Sheets as of March 31, 1998 and December 31, 1997. 4 Consolidated Statements of Cash Flows for the Three Months Ended March 31, 1998 and 1997. 5 Notes to Consolidated Financial Statements. 6-7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. 8-17 Item 3. Quantitative and Qualitative Disclosures About Market Risk 17 PART II - OTHER INFORMATION Item 6. Exhibits and Reports on Form 8-K. 18 SIGNATURES 19 INDEX TO EXHIBITS 20 2 PART I. FINANCIAL INFORMATION ITEM 1. INTERIM FINANCIAL STATEMENTS THE PMI GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS THREE MONTHS ENDED MARCH 31, ------------------------------- (In thousands except for per share amounts) 1998 1997 ------------------------------- REVENUES Premiums earned $116,846 $108,091 Investment income, less investment expense 21,577 19,995 Realized capital gains, net 7,965 18,268 Other income 4,246 1,192 -------- -------- TOTAL REVENUES 150,634 147,546 -------- -------- LOSSES AND EXPENSES Losses and loss adjustment expenses 38,087 39,515 Underwriting and other expenses 44,177 34,415 Interest expense 1,706 1,688 Distributions on redeemable preferred capital securities 2,079 1,385 -------- -------- TOTAL LOSSES AND EXPENSES 86,049 77,003 -------- -------- INCOME BEFORE INCOME TAXES 64,585 70,543 INCOME TAX EXPENSE 18,817 21,371 -------- -------- NET INCOME $ 45,768 $ 49,172 ======== ======== BASIC NET INCOME PER SHARE $1.41 $1.44 ======== ======== DILUTED NET INCOME PER SHARE $1.40 $1.43 ======== ======== See accompanying notes to consolidated financial statements. 3 THE PMI GROUP, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS MARCH 31, DECEMBER 31, (Dollars in thousands) 1998 1997 ------------------ ------------------ ASSETS Investments: Available for sale, at market: Fixed income securities (amortized cost $1,257,199 and $1,234,178) $1,331,619 $1,308,768 Equity securities: Common stock (cost $43,433 and $38,221) 81,423 73,596 Preferred stock (cost $22,224 and $12,049) 22,599 12,360 Common stock of affiliates, at underlying book value 41,352 16,987 Short-term investments (at cost, which approximates market) 78,714 78,890 ---------- ---------- TOTAL INVESTMENTS 1,555,707 1,490,601 Cash 8,842 11,101 Accrued investment income 20,959 20,794 Reinsurance recoverable and prepaid premiums 33,600 31,676 Premiums receivable 21,106 19,756 Receivable from affiliates 7,853 8,605 Receivable from Allstate 16,822 16,822 Deferred policy acquisition costs 40,690 37,864 Property and equipment, net 32,395 31,393 Other assets 16,622 17,991 ---------- ---------- TOTAL ASSETS $1,754,596 $1,686,603 ========== ========== LIABILITIES Reserve for losses and loss adjustment expenses $ 207,897 $ 202,387 Unearned premiums 82,692 94,150 Long-term debt 99,426 99,409 Reinsurance balances payable 12,749 11,828 Deferred income taxes 77,972 76,395 Other liabilities and accrued expenses 72,382 42,248 ---------- ---------- TOTAL LIABILITIES 553,118 526,417 ---------- ---------- COMPANY-OBLIGATED MANDATORILY REDEEMABLE PREFERRED CAPITAL SECURITIES OF SUBSIDIARY TRUST HOLDING SOLELY JUNIOR SUBORDINATED DEFERRABLE INTEREST DEBENTURE OF THE COMPANY 99,015 99,006 SHAREHOLDERS' EQUITY Preferred stock -- $.01 par value; 5,000,000 shares authorized - - Common stock -- $.01 par value; 125,000,000 shares authorized; 35,171,738 and 35,145,247 issued 352 351 Additional paid-in capital 263,392 262,448 Accumulated other comprehensive income 72,312 71,936 Retained earnings 920,734 876,588 Treasury stock (2,745,700 and 2,684,000 shares at cost) (154,327) (150,143) ---------- ---------- TOTAL SHAREHOLDERS' EQUITY 1,102,463 1,061,180 ---------- ---------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $1,754,596 $1,686,603 ========== ========== See accompanying notes to consolidated financial statements. 4 THE PMI GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS THREE MONTHS ENDED MARCH 31, ------------------------------------ (In thousands) 1998 1997 ---------------- ------------------ CASH FLOWS FROM OPERATING ACTIVITIES Net income $ 45,768 $ 49,172 Adjustments to reconcile net income to net cash provided by operating activities: Realized capital gains, net (7,965) (18,268) Equity in earnings of affiliate (511) (352) Depreciation and amortization 1,583 961 Changes in: Reserve for losses and loss adjustment expenses 5,510 1,422 Unearned premiums (11,458) (12,657) Deferred policy acquisition costs (2,826) (1,124) Accrued investment income (165) (1,793) Reinsurance balances payable 921 (4,282) Reinsurance recoverable and prepaid premiums (1,924) 61,348 Premiums receivable (1,350) (16,644) Income taxes 1,375 227 Receivable from affiliates 752 (2,821) Other 31,489 17,459 -------- --------- Net cash provided by operating activities 61,199 72,648 -------- --------- CASH FLOWS FROM INVESTING ACTIVITIES Proceeds from sales of equity securities 15,774 64,769 Investment collections of fixed income securities 13,636 6,520 Proceeds from sales of fixed income securities 21,269 162,892 Investment purchases: Fixed income securities (57,988) (304,168) Equity securities (25,088) (10,559) Net (increase) decrease in short-term investments 175 (56,982) Investment in affiliates (23,868) -- Purchases of property and equipment (2,504) (2,416) -------- --------- Net cash used in investing activities (58,594) (139,944) -------- --------- CASH FLOWS FROM FINANCING ACTIVITIES Issuance of redeemable capital securities -- 99,000 Proceeds from exercise of stock options 943 168 Dividends paid to shareholders (1,623) (1,725) Purchases of The PMI Group, Inc. common stock (4,184) (30,222) -------- --------- Net cash provided by (used in) financing activities (4,864) 67,221 -------- --------- NET DECREASE IN CASH (2,259) (75) CASH AT BEGINNING OF PERIOD 11,101 6,592 -------- --------- CASH AT END OF PERIOD $ 8,842 $ 6,517 ======== ========= See accompanying notes to consolidated financial statements. 5 THE PMI GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS MARCH 31, 1998 NOTE 1 - BASIS OF PRESENTATION The accompanying unaudited consolidated financial statements include the accounts of The PMI Group, Inc. ("TPG"), its wholly-owned subsidiaries, PMI Mortgage Insurance Co. ("PMI"), Residential Guaranty Co., American Pioneer Title Insurance Company ("APTIC"), PMI Mortgage Guaranty Co., PMI Reinsurance Co. and PMI Capital I, and PMI's wholly-owned subsidiaries, PMI Mortgage Services Co. ("MSC") and PMI Securities Co., collectively referred to as the "Company". All material intercompany transactions and balances have been eliminated in consolidation. The Company's unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the requirements of Form 10-Q. In the opinion of management, all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation of the Company's consolidated financial condition at March 31, 1998, and its consolidated statements of operations and cash flows for the periods ended March 31, 1998 and 1997, have been included. Interim results for the period ended March 31, 1998 are not necessarily indicative of the results that may be expected for the year ending December 31, 1998. The financial statements should be read in conjunction with the audited consolidated financial statements and footnotes included in The PMI Group, Inc. 1997 Annual Report to Shareholders. NOTE 2 - INVESTMENTS In February 1998, TPG purchased 200,000 shares of RAM Holdings Ltd. and RAM Holdings II Ltd. (collectively referred to as "RAM Re"), representing 22.3% of RAM Re's outstanding shares. RAM Re is accounted for on the equity method in the Company's consolidated financial statements. Ram Re is a financial guaranty reinsurance holding company domiciled in Bermuda. In addition, PMI owns 45% of CMG Mortgage Insurance Company ("CMG"). CMG is accounted for on the equity method in the Company's consolidated financial statements. NOTE 3 - EARNINGS PER SHARE The weighted average common shares outstanding for computing basic earnings per share ("EPS") were 32,431,065 for the three months ended March 31, 1998 and 34,231,775 for the three months ended March 31, 1997. 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 to 32,607,864 for the three months ended March 31, 1998 and 34,341,954 for the three months ended March 31, 1997. Net income available to common shareholders does not change for computing diluted EPS. NOTE 4 - COMPREHENSIVE INCOME In 1998, the Company adopted Financial Accounting Standards Board ("FASB") Statement of Financial Accounting Standards ("SFAS") No. 130, Reporting Comprehensive Income. SFAS No. 130 requires that an enterprise report, by major component and as a single total, the change in its net assets during the period from non-owner sources. 6 The reconciliation of net income to comprehensive income for the three months ended March 31, 1998 and March 31, 1997 is as follows: Three Months Ended March 31 (In thousands) 1998 1997 ------------------- -------------------- COMPREHENSIVE INCOME Net Income $45,768 $ 49,172 ------------------- -------------------- Other comprehensive income, net of tax: Unrealized gains on securities: Unrealized holding gains (losses) arising during period 5,554 (12,393) Less: reclassification adjustment for gains included in net income (5,178) (11,874) ------------------- -------------------- Other comprehensive income (loss), net of tax 376 (24,267) ------------------- -------------------- COMPREHENSIVE INCOME $46,144 $ 24,905 =================== ==================== NOTE 5 - NEW ACCOUNTING PRONOUNCEMENTS In June 1997, the FASB issued SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information. SFAS No. 131 establishes annual and interim reporting standards for an enterprise's operating segments and related disclosures about its products, services, geographic areas and major customers. Adoption of SFAS No. 131 will not impact the Company's financial condition, results of operations or cash flows, and any effect will be limited to the form and content of its disclosures. The statement is effective for the fiscal years beginning after December 15, 1997, and is not required for interim financial statements in the initial year of application. NOTE 6 - SUBSEQUENT EVENTS On April 15 1998, The Allstate Corporation ("Allstate Corp.") delivered 8,602,650 shares of TPG's common stock to redeem the 6.76% exchangeable notes due April 15, 1998 which Allstate Corp. issued to the public concurrently with TPG's initial public offering in April 1995. Upon completion of the exchange, Allstate Corp.'s direct and indirect equity ownership of TPG was reduced to 1,897,350 shares, or approximately 6% of the Company's outstanding common stock. 7 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF CONSOLIDATED OPERATIONS THREE MONTHS ENDED MARCH 31, 1998 AND 1997 Consolidated net income in the three months ended March 31, 1998 was $45.8 million, a 6.9% decrease over net income of $49.2 million in the corresponding period of 1997. The decrease was attributable primarily to a decrease in realized capital gains of $10.3 million, and secondarily to an increase in underwriting and other expenses of $9.8 million, partially offset by increases primarily in premiums earned of $8.8 million and secondarily in other income of $3.0 million. Diluted earnings per share were $1.40 in the three months ended March 31, 1998 compared with $1.43 in the corresponding period of 1997, a 2.1% decrease. Excluding capital gains, diluted earnings per share were $1.24 in the first quarter of 1998 compared with $1.09 in the first quarter of 1997, a 13.8% increase. Revenues in the first quarter of 1998 were $150.6 million, a 2.1% increase over revenues of $147.5 million in the first quarter of 1997. MORTGAGE INSURANCE OPERATIONS PMI's new insurance written ("NIW") totaled $4.8 billion in the first quarter of 1998 compared with $3.1 billion in the first quarter of 1997, a 54.8% increase. The increase in NIW resulted primarily from the number of new mortgage insurance policies issued increasing by 51.9%, to 36,600 policies in the first quarter of 1998 from 24,100 policies in the first quarter of 1997, and secondarily from an increase in the average loan size to $131,500 from $127,200. The primary factor contributing to the increase in new policies issued was the growth in the total number of loan originations in the private mortgage insurance industry in the first quarter of 1998 compared with the corresponding period of 1997. The private mortgage insurance industry experienced an increase in total new insurance written of 39.4% to $35.0 billion in the first quarter of 1998 from $25.1 billion in the corresponding period of 1997, which was caused primarily by an increase in refinancing activity brought on by lower interest rates coupled with a strong home purchase activity. Refinancing as a percentage of PMI's NIW increased to 34.7% in the three months ended March 31, 1998 from 16.7% in the corresponding period of 1997. The secondary factor contributing to the increase in PMI's new policies issued was the growth in PMI's market share in the first quarter of 1998. PMI's market share of NIW increased to 13.7% in the first quarter of 1998 compared with 12.2% in the corresponding period of 1997, 12.4% in the fourth quarter of 1997 and 12.7% for the year ended December 31, 1997. On a combined basis with CMG, market share was 15.0% in the first quarter of 1998 compared with 13.0% in the corresponding period of 1997, 13.7% in the fourth quarter of 1997 and 13.8% for the year ended December 31, 1997. The increase in market share was primarily due to the expansion of PMI's contract underwriting resources, the expansion of other value-added products offered to mortgage lenders during 1997 and the first quarter of 1998, and the introduction of a government sponsored enterprises ("GSE") pool insurance product to selected lenders commencing in the fourth quarter of 1997. New pool risk written was $14 million in the first quarter of 1998, while insurance in force under risk-share programs represented 2.7% of total insurance in force at March 31, 1998. Management expects new pool risk written and the percent of risk share programs to increase in 1998. See Cautionary Statement. 8 PMI's cancellations of insurance in force were $5.2 billion in the first quarter of 1998 compared with $2.7 billion in the first quarter of 1997. This increase was primarily due to the increase in refinancing activity as discussed above. As a result of the higher cancellation activity, insurance in force declined to $77.4 billion at March 31, 1998 compared with $77.8 billion at December 31, 1997 and $77.7 billion at March 31, 1997. The decrease in insurance in force caused PMI's persistency rate (percentage of insurance remaining in force from one year prior) to decrease to 77.6% as of March 31, 1998 compared with 80.8% as of December 31, 1997. However, risk in force remained flat at $18.1 billion as of March 31, 1998 and December 31, 1997 and grew by $0.5 billion compared with $17.6 billion as of March 31, 1997. In addition, PMI experienced increased termination activity in April 1998 over the March level resulting in a decrease in insurance in force at April 30, 1998. Risk in force remained constant at April 30, 1998, compared to March 31, 1998. Mortgage insurance net premiums written were $89.1 million in the first quarter of 1998 compared with $83.4 million in the corresponding period of 1997, an increase of 6.8%. The increase was attributable to higher average premium rates and higher average loan sizes, the growth of risk in force from one year prior, and the growth in NIW, partially offset by the policy cancellations discussed above. The decrease in insurance in force will have an adverse impact on PMI's future renewal premiums. PMI is currently experiencing a shift in the composition of policies in force to deeper-coverage loans with higher premium rates along with higher average loan sizes. Mortgages with original loan-to-value ratios greater than 90% and equal to or less than 95% ("95s") with 30% insurance coverage increased to 30.0% of risk in force as of March 31, 1998 from 23.5% as of March 31, 1997. Similarly, mortgages with original loan-to-value ratios greater than 85% and equal to or less than 90% ("90s") with 25% insurance coverage increased to 24.9% of risk in force as of March 31, 1998 compared with 20.6% as of March 31, 1997. Mortgage insurance premiums earned were $100.1 million in the first quarter of 1998 compared with $95.7 million in the first quarter of 1997, an increase of 4.6%. This increase is due primarily to higher premium rates and higher average loan sizes, secondarily to the growth of risk in force from one year prior and also to the increase in NIW, partially offset by the insurance cancellations as discussed above. Mortgage insurance losses and loss adjustment expenses decreased slightly to $37.8 million in the first quarter of 1998 from $39.2 million in the corresponding period of 1997 due primarily to the strengthening of the California housing markets and the corresponding decrease in claims. Primary direct claims paid by PMI decreased to $32.9 million in the first quarter of 1998 from $37.2 million in the first quarter of 1997, a decrease of 11.6%. This decrease is attributable to a decrease in the average claim size in the first quarter of 1998 compared to the corresponding period of 1997 and a decrease in the number of claims filed. The improved claim results are due primarily to a smaller percentage of claims originating from the California book of business, and also to increased loss mitigation. PMI's default rate decreased to 2.36% at March 31, 1998 from 2.38% at December 31, 1997 due primarily to the continuing improvements in the California real estate market. Management believes that PMI's total default rate could increase in 1998 due to the continued maturation of its 1994 and 1995 books of business. See Cautionary Statement. The default rates on PMI's California policies decreased to 3.58% at March 31, 1998, from 3.73% at December 31, 1997 primarily due to a decrease in the number of loans in default to 3,742 at March 31, 1998 from 3,987 at December 31, 1997. However, PMI has been experiencing increases on the default rates on its New Jersey, New York, and Florida books of business. Policies written in California accounted for approximately 55% and 71% of the total dollar amount of claims paid in the first quarter of 1998 and 1997, respectively. Although management expects that California should continue to account for a significant portion of total claims paid, management 9 anticipates that with continued improvement in the California economy, increased benefits of loss mitigation and improved default reinstatement rates, California claims paid as a percentage of total claims paid should continue to decline. See Cautionary Statement. Mortgage insurance underwriting and other expenses increased 19.5% to $23.9 million in the first quarter of 1998 from $20.0 million in the corresponding period of 1997. This increase was primarily attributable to the growth in NIW which caused increases in sales and contract underwriting expenses. New policies processed by contract underwriters represented 29.9% of PMI's NIW in the first quarter of 1998 compared with 16.7% in the first quarter of 1997. Contract underwriting is generally more expensive for the Company on a per-application basis than underwriting a loan in-house, and has become the preferred method among many mortgage lenders for processing loan applications. PMI has established a new Certificate Priority Center in Dallas, Texas to centralize the processing of underwriting documentation. Management anticipates that contract underwriting will continue to generate a significant percentage of PMI's NIW and that demand for contract underwriting will increase. In addition, management anticipates that the rate of growth of sales and contract underwriting expenses will exceed the growth rate of premiums, if any, for the remainder of the year. See Cautionary Statement. The mortgage insurance loss ratio decreased to 37.8% in the first quarter of 1998 from 41.0% in the corresponding period of 1997. This decrease was due to the growth in premiums earned and the decrease in losses and loss adjustment expenses discussed above. The expense ratio increased to 26.9% in the first quarter of 1998 from 24.0% in the first quarter of 1997 due primarily to the increase in sales and contract underwriting expenses, resulting in a combined ratio of 64.7% in the first quarter of 1998, 0.3 percentage points lower than the first quarter of 1997 ratio of 65.0%. TITLE INSURANCE OPERATIONS Title insurance premiums earned increased to $16.7 million in the three months ended March 31, 1998 compared with $12.4 million in the corresponding period of 1997. This improvement was due to the increase in residential mortgage originations, including both new home sales and refinancings, in the states where APTIC operates. Underwriting and other expenses increased to $14.9 million in the first quarter of 1998 compared with $11.4 million in the first quarter of 1997. This increase was attributable to the increase in fees and commissions payable to third parties based on premiums earned. The title insurance combined ratio decreased to 90.3% in the first quarter of 1998 from 94.4% in the first quarter of 1997 due to the increase in premiums earned. OTHER The Company's net investment income in the first quarter of 1998 was $21.6 million compared with $20.0 million in the first quarter of 1997, an increase of 8.0%. The increase was primarily attributable to the growth in the average amount of invested assets, which resulted from positive cash flows generated by operating activities, and secondarily to a slight increase in the average investment yield (pretax) to 6.1% in the first quarter of 1998 from 6.0% in the first quarter of 1997. Realized capital gains (net of losses) reported a decrease of 56.3% to $8.0 million in the first quarter of 1998 from $18.3 million in the first quarter of 1997. Other income, primarily revenues generated by MSC, increased to $4.2 million in the first quarter of 1998 from $1.2 million in the first quarter of 1997. Other expenses, primarily expenses incurred by MSC, increased to $5.4 million in the first quarter of 1998 from $3.0 million in the first quarter of 1997. These increases are primarily due to contract underwriting activities provided to the Company's mortgage insurance customers. See discussions above and Cautionary Statement. The Company's effective tax rate decreased to 29.1% in the first quarter of 1998 compared to 30.3% in the first quarter of 1997 due to an increase in the percentage of tax-exempt income included in income before taxes during the first quarter of 1998. 10 LIQUIDITY, CAPITAL RESOURCES AND FINANCIAL CONDITION Liquidity and capital resource considerations are different for TPG and PMI, its principal insurance operating subsidiary, as discussed below. There are no material liquidity requirements for the remaining subsidiaries of the Company. TPG's principal sources of funds are dividends from PMI and APTIC, cash and investment income thereon and funds that may be raised from time to time in the capital markets. During the first quarter of 1998, APTIC declared and paid a cash dividend of $3.2 million to TPG, substantially the full amount of a dividend that can be paid by APTIC in 1998 without prior permission from the Florida Department of Insurance. On March 24, 1998, the Arizona Department of Insurance authorized PMI to declare and pay an extraordinary dividend of $50 million to TPG, which was paid in cash on April 3, 1998. In addition, the Arizona Department of Insurance also authorized an extraordinary dividend of $50 million payable after the Department has reviewed the operating results of PMI for the six months ended June 30, 1998. It is not expected that PMI will declare and pay any dividends in 1998 in addition to those already authorized by the Arizona Department of Insurance. TPG has two bank credit lines available totaling $50.0 million. At March 31, 1998, there were no outstanding borrowings under the credit lines. TPG'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. In November 1997, an additional $150 million stock buy-back program was authorized by the TPG Board of Directors. During the first quarter, TPG purchased $4.2 million of the Company's common stock. As of March 31, 1998, TPG had available funds of approximately $128 million. This amount decreased from the December 31, 1997 balance of $134 million due primarily to the investment in RAM Re and the common stock repurchases in the first quarter of 1998. On April 3, 1998, PMI declared and paid ordinary and extraordinary dividends to TPG totaling $50.0 million, which significantly increased TPG's available funds. The principal sources of funds for PMI are premiums received on new and renewal business and amounts earned from the investment of this cash flow. The principal uses of funds by PMI are the payment of claims and related expenses, underwriting and other operating expenses, and dividends to TPG. PMI generates substantial positive cash flows from operations as a result of premiums being received in advance of the payment of claims. Cash flows generated from PMI's operating activities totaled $52.8 million and $73.0 million in the first quarter of 1998 and 1997, respectively. The first quarter of 1997 included the collection of $53.6 million as a result of a termination and commutation of a reinsurance treaty. PMI has commenced a project to prepare the Company's operating and insurance systems for the year 2000 (see Factors That May Affect Future Results and Market Price of Stock - Year 2000 Issues). Management expects to complete this project in the first quarter of 1999 at a total cost of $3 million, which will be funded through operating cash flows. These costs are being expensed as they are incurred. Consolidated shareholders' equity increased from $1,061.2 million at December 31, 1997, to $1,102.5 million at March 31, 1998. The change in shareholders' equity consisted of increases of $45.8 million from net income, $0.9 million from stock option activity, and an increase of $0.4 million in net unrealized gains on investments available for sale (net of tax), offset by common stock repurchases of $4.2 million, and dividends declared of $1.6 million. 11 PMI's risk-to-capital ratio at March 31, 1998 was 14.1:1, compared to 14.6:1 at December 31, 1997. If the April dividend declaration occurred on or prior to March 31, 1998, PMI's risk to capital ratio would have been 14.7:1 on March 31, 1998. CAUTIONARY STATEMENT Certain written and oral statements made or incorporated by reference from time to time by the Company or its representatives in this document, other documents filed with the Securities and Exchange Commission, press releases, conferences, or otherwise that are not historical facts, and that relate to future plans, events or performance are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements include the following: (i) management expects new pool risk written and the percent of risk share programs to increase in 1998; (ii) management believes that PMI's total default rate could increase in 1998 due to the continued maturation of its 1994 and 1995 books of business; (iii) although management expects that California should continue to account for a significant portion of total claims paid, management anticipates that with continued improvement in the California economy, increased benefits of loss mitigation and improved default reinstatement rates, California claims paid as a percentage of total claims paid should continue to decline; (iv) Management anticipates that contract underwriting will continue to generate a significant percentage of PMI's NIW and that demand for contract underwriting will increase. In addition, management anticipates that the rate of growth of sales and contract underwriting expenses will exceed the growth rate of premiums, if any, for the remainder of the year; and (v) management presently believes that the current statutes will not have a material impact on the Company's financial condition or results of operations. The Company's actual results may differ materially from those expressed in any forward-looking statements made by the Company. These forward-looking statements involve a number of risks or uncertainties including, but not limited to, the factors set forth below and in the Company's periodic filings with the Securities and Exchange Commission. FACTORS THAT MAY AFFECT FUTURE RESULTS AND MARKET PRICE OF STOCK General Conditions Several factors such as economic recessions, declining housing values, higher unemployment rates, deteriorating borrower credit, rising interest rates, increases in refinance activity caused by declining interest rates, legislation impacting borrowers' rights, or combinations of such factors might affect the mortgage insurance industry and demand for housing in general and could materially and adversely affect the Company's financial condition and results of operations. Such economic events could materially and adversely impact the demand for mortgage insurance, cause claims on policies issued by PMI to increase, and/or cause a similar adverse increase in PMI's loss experience. Other factors that may influence the amount of NIW by PMI include: mortgage insurance industry volumes of new business; the impact of competitive underwriting criteria and product offerings and services, including mortgage pool insurance and contract underwriting services; the ability to recruit and maintain a sufficient number of qualified underwriters; the effect of risk- sharing structured transactions; changes in the performance of the financial markets; general economic conditions that affect the demand for or acceptance of the Company's products; changes in government housing policy; changes in government regulations or interpretations regarding the Real Estate Settlement Procedures Act ("RESPA"); changes in the statutory charters, regulations, powers and coverage requirements of government sponsored enterprises ("GSEs"), banks and savings institutions; and customer consolidation. 12 MARKET SHARE AND COMPETITION The Company's financial condition and results of operations could be materially and adversely affected by a decline in its market share, or a decline in market share of the private mortgage insurance industry as a whole. Numerous factors bear on the relative position of the private mortgage insurance industry versus government and quasi-governmental competition as well as the competition of lending institutions that choose to remain uninsured, self-insure through affiliates, or offer residential mortgage products that do not require mortgage insurance. The impact of competitive underwriting criteria and product offerings, including mortgage pool insurance and contract underwriting, has a direct impact on the Company's market share. Further, several of the Company's competitors have greater direct or indirect capital reserves that provide them with potentially greater flexibility than the Company in addressing competitive issues. PMI competes directly with federal and state governmental and quasi-governmental agencies, principally the FHA and, to a lesser degree, the VA. Further, the Office of the Comptroller of the Currency has granted permission to certain national banks to form reinsurance companies as wholly-owned operating subsidiaries for the purpose of reinsuring mortgage insurance written on loans originated or purchased by such banks. In addition, the Federal Reserve Board and the Office of Thrift Supervision are in the process of considering whether similar activities are permitted for bank holding companies and savings institutions, respectively. The reinsurance subsidiaries of national banks, savings institutions, or bank holding companies could become significant competitors of the Company in the future. Mortgage lenders, other than banks, thrifts or their affiliates, are forming reinsurance affiliates that are typically regulated solely by the insurance authority of their state of domicile. Management believes that such reinsurance affiliates will increase competition in the mortgage insurance industry and may materially and adversely impact PMI's market share. Certain lenders originate a first mortgage lien with an 80 percent LTV ratio, a 10 percent second mortgage lien, and 10 percent of the purchase price from borrower's funds ("80/10/10"). This 80/10/10 product competes with mortgage insurance as an alternative for lenders selling loans in the secondary mortgage market. If the 80/10/10 product becomes a widely accepted alternative to mortgage insurance, it could have a material and adverse impact on the Company's financial condition and results of operations. Legislation and regulatory changes affecting the FHA and certain commercial banks that forego insurance have affected demand for private mortgage insurance. The maximum individual loan amount that the FHA can insure is currently $170,362 and the maximum individual loan amount that the VA can insure is $203,150. The Clinton administration and Congress are considering increasing the single-family loan limit which FHA could purchase to $227,150. The Company believes that any increase in the FHA loan limit, or other expansion of eligibility for the FHA and VA would likely have an adverse affect on the competitive position of PMI and consequently could materially and adversely affect the Company's financial condition and results of operations. INSURANCE IN FORCE A significant percentage of PMI's premiums earned is generated from its existing insurance in force and not from new insurance written. PMI's policies for insurance coverage typically have a policy duration of five to seven years. Insurance coverage may be canceled by the policy owner or servicer of the loan at any time. PMI has no control over the owner's or servicer's decision to cancel insurance coverage and self-insure or place coverage with another mortgage insurance company. There can be no assurance that policies for insurance coverage originated in a particular year or for a particular customer will not be canceled at a later time or that the Company will be able to regain such insurance coverage at a later time. As a result, the Company's financial condition and results of operation could be materially and adversely affected by greater than anticipated policy cancellations or lower than projected persistency resulting in declines in insurance in force. 13 During an environment of falling interest rates, an increasing number of borrowers refinance their mortgage loans. PMI and other mortgage insurance companies generally experience an increase in the prepayment rate of insurance in force, resulting from policy cancellations of older books of business. Although PMI has a history of expanding business during low interest rate environments, the resulting increase of NIW may ultimately prove to be inadequate to compensate for the loss of insurance in force arising from policy cancellations. Any significant decrease in PMI's insurance in force could materially and adversely affect the Company's financial condition and results of operations. Insurance in force as of March 31, 1998 was $77.4 billion compared with $77.8 billion as of December 31, 1997. The decrease in insurance in force is primarily due to higher policy cancellations caused by the refinancing activity in the first quarter of 1998. The decline in insurance in force will have an adverse impact on PMI's future renewal premiums. FANNIE MAE, FREDDIE MAC AND FHA; STATE AND FEDERAL MORTGAGE CANCELLATION LEGISLATION PMI and other private mortgage insurers are affected by Fannie Mae and Freddie Mac. These GSEs are permitted by statute to purchase conventional high-LTV mortgages from lenders who obtain mortgage insurance on those loans. Fannie Mae and Freddie Mac have the discretion to reduce the amount of private mortgage insurance they require on loans. Any reduction in the amount of private mortgage insurance coverage could materially and adversely affect the Company's financial condition and results of operations. Fannie Mae and Freddie Mac impose requirements on private mortgage insurers for such insurers to be eligible to insure loans sold to such agencies. Under Fannie Mae and Freddie Mac regulations, PMI needs to maintain at least an "AA-" or equivalent claims-paying ability rating in order to provide mortgage insurance on loans purchased by the GSEs. Failure to maintain such a rating would effectively cause PMI to be ineligible to provide mortgage insurance. A loss of PMI's existing eligibility status, either due to a failure to maintain a minimum claims-paying ability rating from the various rating agencies or non-compliance with other eligibility requirements, would have a material, adverse effect on the Company's financial condition and results of operations. In the mortgage guaranty insurance industry, liquidity refers to the ability of an enterprise to generate adequate amounts of cash from its normal operations, including premiums received and investment income, in order to meet its financial commitments, which are principally obligations under the insurance policies it has written. Liquidity requirements are significantly influenced by the level and severity of claims. PMI's claims-paying ability is currently rated "AA+" (Excellent) by Standard and Poor's Rating Services, "Aa2" (Excellent) by Moody's Investors Service, Inc., "AA+" (Very Strong) by Fitch IBCA, and "AA+" (Very High) by Duff & Phelps Credit Rating Co. These ratings are subject to revisions or withdrawal at any time by the assigning rating organization. The ratings by the organizations are based upon factors relevant to PMI's policyholders and are not applicable to the Company's common stock or outstanding debt. However, any decrease in PMI's claims-paying ratings could have a material, adverse effect on the Company's financial condition and results of operations. Although PMI cannot generally cancel its mortgage insurance policies once issued, PMI must cancel mortgage insurance for a mortgage loan upon the request of the insured. Fannie Mae and Freddie Mac have guidelines which give borrowers the right to request cancellation of mortgage insurance when specified conditions are met. In addition, federal legislation and legislation in approximately a dozen states has been introduced that also addresses this issue. Proposals concerning borrower notification of their cancellation rights, cancellation criteria, or the point at which mortgage insurance premiums may no longer be charged to borrowers are still being formulated and their enactment remains uncertain. Statutes giving borrowers cancellation rights and/or preventing premiums from being charged to borrowers presently exist in five states, including California. Management presently believes that the existing statutes will not have a material impact on the Company's 14 financial condition or results of operations. Management believes it is too early to ascertain the impact of the enactment of any additional mortgage cancellation proposals. CONTRACT UNDERWRITING SERVICES; NEW PRODUCTS The Company provides contract underwriting services that enable customers to improve the efficiency and quality of their operations by outsourcing all or part of their mortgage loan underwriting. Contract underwriting services have become increasingly important to mortgage lenders as they seek to reduce costs, including the cost of repurchasing loans from the GSEs and other investors which are not underwritten to relevant guidelines. As a part of its contract underwriting services, PMI provides remedies which may include the assumption of some of the costs of repurchasing insured and uninsured loans from the GSEs and other investors. Generally, the scope of these remedies exceed those contained in PMI's master primary insurance policies. Contract underwriting currently generates a significant percentage of PMI's NIW. Management anticipates that contract underwriting will continue to generate a significant percentage of PMI's NIW. Due to the increasing demand of contract underwriting services, the limited number of underwriting personnel available, and heavy price competition among mortgage insurance companies, PMI's inability to recruit and maintain a sufficient number of qualified underwriters could materially and adversely affect its market share and materially and adversely affect the Company's financial condition and results of operations. TPG and PMI, from time to time, introduce new mortgage insurance products or programs. The Company's financial condition and results of operations could be materially and adversely affected if PMI or the Company experiences delays in introducing competitive new products and programs. In addition, for any introduced product, there can be no assurance that such products, including any mortgage pool type products, or programs will be as profitable as the Company's existing products and programs. YEAR 2000 ISSUES The Company is heavily dependent upon complex computer systems for all phases of its operations, including customer service, servicing the insurance portfolio, risk analysis, underwriting, and loss reserves. Since many of the Company's older computer software programs recognize only the last two digits of the year in any date (e.g., "97" for 1997), some software may fail to operate properly in 1999 or 2000 if the software is not reprogrammed or replaced (the "Year 2000 Issue"). The Company believes that many of its suppliers and customers may have Year 2000 Issues that could adversely affect the Company; however, it is uncertain what impact, if any, such Year 2000 Issues would have on the Company. The Company has commenced a plan intended to mitigate and/or prevent the adverse effects of internal Year 2000 Issues and estimates the cost of this work at approximately $3 million. The Company presently believes that it will be able to resolve its internal Year 2000 Issues in a timely manner and that the cost of addressing such matters will not have a material effect on the Company's current financial condition, liquidity or results of operations. Management believes its failure or its customers or suppliers failure to resolve the Year 2000 Issues in a timely manner could materially and adversely affect the Company's financial condition and results of operations. NEW YORK DEPARTMENT OF INSURANCE The Company offers a number of risk-share and structured products and programs that are designed to encourage quality originations and loss mitigation by its customers. To date, these products and programs do not represent a significant portion of the Company's revenues or a significant percent of PMI's NIW. In March 1997, the New York Department of Insurance stated in a letter addressed to all private mortgage insurers that certain risk-share and structured products and programs would be considered to be illegal under New York law. Representatives of the mortgage insurance industry have been in discussions with the New York Department of Insurance regarding its March 1997 letter. Management is unable to predict at this time the results of these discussions. 15 RISK-TO-CAPITAL RATIO Regulators specifically limit the amount of insurance risk that may be written by PMI to a multiple of 25 times PMI's statutory capital (which includes the contingency reserve). Other factors affecting PMI's risk-to-capital ratio include: (i) regulatory review and oversight by the State of Arizona, PMI's state of domicile for insurance regulatory purposes; (ii) limitations under the Runoff Support Agreement with Allstate, which prohibit PMI from paying any dividends if, after the payment of any such dividend, PMI's risk-to-capital ratio would equal or exceed 23 to 1; (iii) TPG's credit agreements; and (iv) TPG's and PMI's credit or claims-paying ability ratings which require that the risk-to-capital ratio not exceed 20 to 1. Significant losses could cause a material reduction in statutory capital, causing an increase in the risk-to-capital ratio and thereby limit PMI's ability to write new business. The inability to write new business could materially and adversely affect the Company's financial condition and results of operations. CHANGES IN COMPOSITION OF INSURANCE WRITTEN; POOL INSURANCE The composition of PMI's NIW has included an increasing percentage of mortgages with LTVs in excess of 90% and less than or equal to 95% ("95s"). At March 31, 1998, 46.2% of PMI's risk in force consisted of 95s, which, in PMI's experience, have had a claims frequency approximately twice that of mortgages with LTVs equal to or less than 90% and over 85% ("90s"). PMI also offers coverage for mortgages with LTVs in excess of 95% and up to 97% ("97s"). At March 31, 1998, 2.0% of PMI's risk in force consisted of 97s which have even higher risk characteristics than 95s and greater uncertainty as to pricing adequacy. PMI's NIW also includes adjustable rate mortgages ("ARMs"), which, although priced higher, have risk characteristics that exceed the risk characteristics associated with PMI's book of business as a whole. During the fourth quarter of 1997, PMI began offering a pool insurance product to state housing finance authorities and certain lenders. This product is similar in structure to the pool insurance product previously offered by PMI during 1990 through 1993, but has different risk characteristics, including limits on total exposure, diversification and loan to value ratios. Pool insurance is generally used as an additional credit enhancement for certain secondary market mortgage transactions and generally covers the loss on a defaulted mortgage loan that exceeds the claim payment under the primary coverage, if primary insurance is required on that mortgage loan. Pool insurance also generally covers the total loss on a defaulted mortgage loan which did not require primary insurance, in each case up to a stated aggregate loss limit. New pool risk written was $14 million in the first quarter of 1998. Management expects new pool risk written to increase significantly throughout the year and into 1999. Although PMI charges higher premium rates for loans that have higher risk characteristics, including ARMs, 95s, 97s and pool insurance products, the premiums earned on such products, and the associated investment income, may ultimately prove to be inadequate to compensate for future losses from such products. Such losses could materially and adversely affect the Company's financial condition and results of operations. POTENTIAL INCREASE IN CLAIMS Mortgage insurance coverage generally cannot be canceled by PMI and remains renewable at the option of the insured for the life of the loan. As a result, the impact of increased claims from policies originated in a particular year generally cannot be offset by premium increases on policies in force or mitigated by nonrenewal of insurance coverage. There can be no assurance, however, that the premiums charged will be adequate to compensate PMI for the risks and costs associated with the coverage provided to its customers. LOSS RESERVES PMI establishes loss reserves based upon estimates of the claim rate and average claim amounts, as well as the estimated costs, including legal and other fees, of settling claims. Such reserves are based on estimates, which 16 are regularly reviewed and updated. There can be no assurance that PMI's reserves will prove to be adequate to cover ultimate loss development on incurred defaults. The Company's financial condition and results of operations could be materially and adversely affected if PMI's reserve estimates are insufficient to cover the actual related claims paid and expenses incurred. REGIONAL CONCENTRATION In addition to nationwide economic conditions, PMI could be particularly affected by economic downturns in specific regions where a large portion of its business is concentrated, particularly California, Florida, and Texas, where PMI has 20.1%, 7.1%, and 6.6% of its risk in force concentrated and where the default rate on all PMI policies in force is 3.58%, 2.95% and 2.16% compared with 2.36% nationwide as of March 31, 1998. CONTINUING RELATIONSHIPS WITH ALLSTATE AND AFFILIATE In December 1993, PMI entered into a Reinsurance Treaty with Forestview Mortgage Insurance Company ("Forestview") whereby Forestview agreed to reinsure all liabilities (net of amounts collected from third party reinsurers and indemnitors) in connection with PMI's mortgage pool insurance business in exchange for premiums received. In 1994, Forestview also agreed that as soon as practicable after November 1, 1994, Forestview and PMI would seek regulatory approval for the Reinsurance Treaty to be deemed to be an assumption agreement and that, upon receipt of the requisite approvals, Forestview would assume such liabilities. The parties are in the process of seeking regulatory approval to complete the assumption of the mortgage pool insurance policies. Until Forestview has assumed directly such mortgage pool insurance policies, PMI will remain primarily liable on the unassumed policies. Forestview's previous claims-paying ability rating of "AA" (Excellent) was withdrawn by Standard and Poor's Rating Services ("S&P"). Management is uncertain at this time what impact the withdrawal of the claims-paying ability rating will have on the parties' ability to timely consummate the assumption transaction. Pursuant to this agreement, PMI ceded $2.4 million of pool premiums to Forestview and Forestview reimbursed PMI for pool claims on the covered policies in the amount of $7.9 million in the first quarter of 1998. It is anticipated that additional pool claims significantly in excess of pool premiums will be paid in 1998 and beyond. As of March 31, 1997, the Company has a $72.9 million reinsurance recoverable from Forestview. The failure of Forestview to meet its contractual commitments would materially and adversely affect the Company's financial condition and results of operations. On October 28, 1994, TPG entered into a Runoff Support Agreement (the "Runoff Support Agreement") with Allstate Insurance Company ("Allstate") to replace various capital support commitments that Allstate had previously provided to PMI. Allstate agreed to pay claims on certain insurance policies issued by PMI prior to October 28, 1994, if PMI's financial condition deteriorates below specified levels, or if a third party brings a claim thereunder. Alternatively, Allstate may make contributions directly to PMI or TPG. In the event that Allstate makes payments or contributions under the Runoff Support Agreement (which possibility management believes is remote), Allstate would receive subordinated debt or preferred stock of PMI or TPG in return. During 1997, no payment obligation arose under the Runoff Support Agreement. Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK Not Applicable. 17 THE PMI GROUP, INC. AND SUBSIDIARIES PART II - OTHER INFORMATION MARCH 31, 1998 ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits - The exhibits listed in the accompanying Index to Exhibits on page 21 are filed as part of this Form 10-Q (b) Reports on Form 8-K: On January 15, 1998, TPG filed a report on Form 8-K to announce that its Board of Directors authorized the adoption of a Shareholder Rights Plan. 18 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, on May 14, 1998. THE PMI GROUP, INC. /s/ John M. Lorenzen, Jr. -------------------------- John M. Lorenzen, Jr. Executive Vice President and Chief Financial Officer /s/ William A. Seymore ----------------------- William A. Seymore Vice President and Chief Accounting Officer 19 INDEX TO EXHIBITS (PART II, ITEM 6) Exhibit Number DESCRIPTION OF EXHIBIT - --------------------------------- ----------------------------------------------------------------- 11.1 Computation of Net Income Per Share 27.1 Financial Data Schedule 20