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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
(MARK ONE)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 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 1-11356
CMAC INVESTMENT CORPORATION
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 23-2691170
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
1601 MARKET STREET, PHILADELPHIA, PA 19103
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
(215) 564-6600
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
TITLE OF EACH CLASS NAME OF EACH EXCHANGE ON WHICH REGISTERED
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COMMON STOCK, $.001 PAR VALUE NEW YORK STOCK EXCHANGE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: NONE
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 by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
Indicate the number of shares outstanding of each of the issuer's classes
of common stock, as of the latest practicable date: 22,727,536 shares of Common
Stock, $.001 par value, outstanding on March 25, 1999, and the aggregate market
value of the voting stock held by non-affiliates of the registrant is
$799,725,173.
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PART I
ITEM 1. BUSINESS
GENERAL
CMAC Investment Corporation (the "Company") provides, through its wholly
owned subsidiary, Commonwealth Mortgage Assurance Company ("CMAC"), private
mortgage insurance coverage in the United States on residential mortgage loans.
Private mortgage insurance protects mortgage lenders and investors from
default-related losses on residential first mortgage loans made primarily to
home buyers who make down payments of less than 20% of the home's purchase
price. Private mortgage insurance also facilitates the sale of such mortgage
loans in the secondary mortgage market, principally to Freddie Mac and Fannie
Mae. CMAC is restricted, both by state insurance laws and regulations and the
eligibility requirements of Fannie Mae and Freddie Mac, to providing insurance
on residential first mortgage loans only. CMAC currently offers two principal
types of private mortgage insurance coverage, primary and pool. At December 31,
1998, primary insurance represented 92.8% of CMAC's direct risk in force and
pool insurance represented 7.2% of CMAC's direct risk in force. The volume of
pool insurance written has increased significantly in 1997 and 1998, but is
expected to decline in 1999 and beyond due primarily to capital restrictions.
CMAC has been engaged in the mortgage insurance business since 1977. The
Company acquired all of the outstanding common stock of CMAC in October 1992 in
order to facilitate the initial public offering of the Company's common stock.
In the offering, the Company's sole stockholder, Commonwealth Land Title
Insurance Company, then an indirect subsidiary of Reliance Group Holdings, Inc.,
sold all of the shares of common stock of the Company owned by it. As a result
of the offering, which was completed in November 1992, the Company became an
independent public company.
Merger with Amerin
By Agreement and Plan of Merger dated as of November 22, 1998, the Company
and Amerin Corporation agreed on a merger. The anticipated merger calls for
Amerin stockholders to receive 0.5333 shares of the Company's common stock in a
tax-free exchange for each share of Amerin common stock. The Company's
stockholders will continue to own their existing shares after the merger.
Completion of the merger is subject to approval by the stockholders of both
companies. The transaction is expected to close in May 1999 and to be accounted
for on a pooling of interests basis. Following the merger, Frank P. Filipps,
president and chief executive officer of the Company, will be chairman and chief
executive officer. Roy J. Kasmar, president and chief operating officer of
Amerin, will hold the same positions with the Company. Gerald L. Friedman,
chairman and chief executive officer of Amerin, will become chairman emeritus,
and Herbert Wender, chairman of the Company, will become chairman of the
executive committee of the board of directors. The new board will initially be
made up of the Company's board, Roy J. Kasmar and four individuals nominated by
Amerin. Based on the independent results for Amerin and the Company at December
31, 1998, and for the twelve-month period then ended, on a pro forma basis, the
combined company would have been the second largest mortgage insurance company
in the industry, measured by market share, with a combined market share of over
19%. The combined company would have had assets of $1.5 billion, common
stockholders' equity of $932 million and net income of $142 million.
Primary Insurance
Primary insurance provides mortgage default protection on individual loans
at a specified coverage percentage which is applied to the unpaid loan
principal, delinquent interest and certain expenses associated with the default
and subsequent foreclosure (collectively, the "claim amount"). CMAC's obligation
to an insured lender in respect of a claim is determined by applying the
appropriate coverage percentage to the claim amount. CMAC's "risk" on each
insured loan is the loan amount multiplied by the coverage percentage. Most of
CMAC's current business is written with 30% coverage on loans with a
loan-to-value ("LTV") ratio between 90.01% and 95% ("95s") and 25% coverage on
loans with an LTV ratio between 85.01% and 90%
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("90s"). As of December 31, 1998, approximately 60% of CMAC's insurance in force
had such "deeper coverage". Deeper coverage refers to a higher percentage of
insurance coverage than previous historical levels on 90s and 95s. Beginning in
1995, both Fannie Mae and Freddie Mac began to require such coverage on 90s and
95s. Prior to 1995, the coverage requirements were 22% on 95s and 17% on 90s. In
January 1999, Fannie Mae announced a new program which allows for lower levels
of required mortgage insurance for certain low down payment loans approved
through its "Desktop Underwriter" automated underwriting system. The insurance
levels are similar to those required prior to 1995. In March 1999, Freddie Mac
announced a similar program for loans approved though its "Loan Prospector"
automated underwriting system. The Company does not believe that these
developments will adversely affect the demand for (or profitability of) mortgage
insurance. For more information on these developments, see "Freddie Mac and
Fannie Mae" on page 17. Under its master policy, CMAC has the option of paying
the entire claim amount and taking title to the mortgaged property, or paying
the coverage percentage in full satisfaction of its obligations under the
insurance written. Recently, CMAC has underwritten most of its primary insurance
by utilizing automated or streamlined underwriting methods.
Pool Insurance
Pool insurance differs from primary insurance in that the exposure on pool
insurance is not limited to a specific coverage percentage on each individual
loan. Because of this feature and the generally lower premium rates associated
with pool insurance, the rating agency capital requirements for the pool product
are more restrictive than the capital requirements for primary insurance. There
is an aggregate exposure limit ("stop loss") on a "pool" of loans which is
generally between 1% and 10% of the initial aggregate loan balance. Modified
pool insurance has a stop loss like pool insurance, but also has exposure limits
on each individual loan. The use of modified pool insurance is much more limited
than traditional pool insurance.
CMAC offers pool insurance on a selected basis to various state housing
finance agencies on the collateral for their bond issues, as a credit
enhancement to mortgage loans included in mortgage-backed securities or in whole
loan sales, and in certain other specific situations. Since 1996, CMAC has
offered significant amounts of pool insurance on mortgage product sold to
Freddie Mac and Fannie Mae by CMAC's primary insurance customers ("GSE Pool").
This GSE Pool insurance has a very low stop loss, generally 1.0% to 1.5%, and
the insured pools contain loans with and without primary insurance. Premium
rates on this business are significantly lower than primary insurance rates and
the expected profitability on this business is lower than that of primary
insurance. The volume of such business increased significantly in 1997 and 1998
due to the strong demand for this product from CMAC's customers and due to the
increased size of the mortgage market. During 1998, CMAC had pool risk written
of $368.4 million relating specifically to GSE Pool business compared to $264.5
million in 1997. It is expected that CMAC will write less pool insurance in
1999. It is CMAC's current intention to reduce its net pool risk in force to no
more than 5% of CMAC's total risk in force. Net pool risk in force at December
31, 1998 represented 7.8% of total risk force. New premiums written for pool
insurance were $11.1 million in 1998, $4.8 million in 1997 and $2.1 million in
1996. The New York Insurance Department has issued a Circular Letter, which is
described more fully on page 16 of this Form 10-K, that could impact the terms
and conditions of future pool insurance transactions.
Structured Transactions
CMAC, from time to time, engages in structured transactions which may
include either primary insurance, pool insurance or some form of combination
thereof. A structured transaction generally involves insuring a large pool of
seasoned loans or issuing a commitment to insure new loan originations under
negotiated terms. Some structured transactions contain a risk-sharing component
under which the insured assumes a first-loss position or shares in losses in
some other manner. The amount of new premiums written in structured transactions
by CMAC were $4.7 million in 1998, $300,000 in 1997 and $400,000 in 1996.
Revenue Sharing Products
CMAC and the industry offer financial products to their customers that are
designed to allow the customer to participate in the risks and rewards of the
mortgage insurance business. One such product is
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captive reinsurance, in which a mortgage lender sets up a mortgage reinsurance
company that assumes part of the risk associated with that lender's insured book
of business. In most cases, the risk assumed by the reinsurance company is an
excess layer of aggregate losses that would be penetrated only in a situation of
adverse loss development. CMAC had four captive reinsurance agreements in place
at December 31, 1998 and expects to enter into several new agreements in 1999.
Premiums ceded to captive reinsurance companies in 1998 were $1.5 million,
representing less than 1% of total premiums written. Another revenue sharing
product is a performance note ("SUPER Note"), which allows a mortgage lender to
invest a portion of capital needed to support its insured mortgage insurance
book and to receive a return on investment that approximates the return that
CMAC achieves on that same book of business. At December 31, 1998, CMAC had $1.9
million of outstanding SUPER Notes. The aggregate amount of captive reinsurance
and SUPER Note business is not expected to have a material impact on CMAC's
balance sheet or financial results in 1999. Clarification of the Letter, which
is described more fully on page 16 of this Form 10-K, could impact the terms and
conditions of future revenue sharing transactions.
CUSTOMERS
Mortgage originators such as mortgage bankers, mortgage brokers, commercial
banks and savings institutions are CMAC's principal customers, although mortgage
borrowers generally bear the cost of primary insurance coverage. CMAC does, on a
limited basis, offer lender-paid mortgage insurance whereby mortgage insurance
premiums are charged to the mortgage lender or loan servicer. On the lender-paid
product, the interest rate to the borrower is usually higher to compensate for
the mortgage insurance premium that the lender is paying. In 1998, approximately
2.8% of CMAC's primary insurance was done on a lender-paid basis, however this
percentage could increase in 1999 and beyond if borrowers become less sensitive
to the stated interest rate and instead focus more on total monthly costs.
To obtain primary insurance from CMAC, a mortgage lender must first apply
for and receive a master policy from CMAC. CMAC's approval of a lender as a
master policyholder is based, among other factors, upon an evaluation of the
lender's financial position and its management's demonstrated adherence to sound
loan origination practices. CMAC's quality control function then monitors the
master policyholder.
The number of primary individual policies in force was 491,836 at December
31, 1998, 441,605 at December 31, 1997 and 382,243 at December 31, 1996.
CMAC's top 10 customers were responsible for 40.3% of new primary risk
written in 1998 compared to 28.4% in 1997 and 21.8% in 1996. The largest single
customer of CMAC, (including branches and affiliates of such customer), measured
by risk written, accounted for 14.4% of new primary risk written during 1998
compared to 4.9% in 1997 and 4.0% in 1996. In 1998, the Company's largest single
customer was Norwest Mortgage, Inc.
SALES, MARKETING AND COMPETITION
Sales and Marketing
CMAC employs a field sales force of approximately 100 persons, organized
into three divisions, providing local sales representation throughout the United
States. During 1997, CMAC reorganized by reducing the number of divisions from
six to three and introducing the new position of Area Sales Manager in order to
provide more direct supervision of the field sales force. Each of the three
divisions is supervised by a Divisional Sales Manager who is directly
responsible for several Area Sales Managers. The Area Sales Managers are
responsible for managing a small sales force in different areas within the
division. An increase to five regions within this structure is anticipated in
1999. CMAC sales personnel are compensated by salary, commissions on new
insurance written and a production incentive based on the achievement of various
goals. During 1998, these goals were related to volume, market share, change in
market share and business quality as measured by CMAC's mortgage scoring model
and this is generally expected to continue in 1999. In early 1997, CMAC expanded
its effort to serve larger national accounts, which have become a more integral
part of the mortgage insurance market due to consolidation in the mortgage
lending industry. Two dedicated national account positions were created and a
more focused effort to support national accounts was implemented. CMAC
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added to this effort in 1998 with two additional dedicated positions and expects
the national account area to be particularly important in 1999 and beyond.
Competition
CMAC and other private mortgage insurers compete directly with various
federal government agencies, principally the Federal Housing Administration
("FHA"). In addition to competition from federal agencies, CMAC and other
private mortgage insurers face competition from state-supported mortgage
insurance funds. The private mortgage insurance industry consists of CMAC and
seven other active mortgage insurance companies. During 1998, CMAC was the fifth
largest private mortgage insurer, measured by market share, and had, according
to industry data, a market share of new primary mortgage insurance written of
11.5%.
UNDERWRITING PRACTICES
CMAC considers effective risk management to be critical to its long-term
financial stability. Market analysis, prudent underwriting, the use of automated
risk evaluation models, quality control and customer service are all important
elements of CMAC's risk management process.
Underwriting Personnel
In addition to a centralized National Underwriting department in the home
office, each of CMAC's service divisions has a Divisional Service Manager
responsible for evaluating risk and managing all underwriting field staff in the
region. CMAC employs an underwriting and support staff of approximately 110 who
are located in CMAC's 25 service centers. Additionally, CMAC has two agency
operations in place.
Underwriting Process
CMAC has generally accepted applications for primary insurance (other than
in connection with structured transactions) under three basic programs: the
traditional fully documented program, a limited documentation program and the
delegated underwriting program. Programs that involve less than fully documented
file submissions have become more prevalent in recent years. In order to meet
this demand, in the fourth quarter of 1996, CMAC introduced to the marketplace
the process referred to as "ExpressTrac(sm)". A lender utilizing ExpressTrac can
submit loans to CMAC for insurance with abbreviated levels of documentation
based on the type of loan being submitted for insurance. During 1998, 61% of the
commitments issued for primary insurance were received by CMAC under the
ExpressTrac program. In the ExpressTrac Program, CMAC has agreed to underwrite
certain loans with less documentation by relying upon a scoring model created by
CMAC during 1996 and referred to as "Prophet Score(sm)" (described below). The
ExpressTrac program also allows for a reduction in standard premium rates (4
basis points) for loans having FICO credit scores (described below) of 680 or
greater although there is no assurance that this discount will continue in the
future. During 1998, 54% of the commitments issued by CMAC for primary insurance
qualified for this discounted rate.
Delegated Underwriting
CMAC has a delegated underwriting program with certain customers. CMAC's
delegated underwriting program, which was implemented in 1989, currently
involves only lenders that are approved by CMAC's risk management department.
Delegated underwriting programs allow the lender's underwriters to commit CMAC
to insure loans based on agreed upon underwriting guidelines. CMAC routinely
audits loans submitted under these programs. As of December 31, 1998,
approximately 41% of the primary loans on CMAC's books were originated on a
delegated basis and during 1998, 60% of the primary loans insured by CMAC were
originated on a delegated basis. This compares with 33% of the primary loans on
CMAC's books at December 31, 1997 and 55% of the primary loans originated during
1997.
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Automated Underwriting
In 1994, CMAC installed an automated underwriting system which uses
artificial intelligence technology to assist CMAC's underwriting staff in the
processing of loan files. The system allows the underwriter to eliminate the
rudimentary underwriting steps and to focus on key aspects of the loan file,
with the ultimate goal of increasing underwriting efficiency while maintaining
the same level of risk exposure. During 1995, the system was fully integrated
into the CMAC underwriting process and improved efficiency was realized. In
1996, CMAC further enhanced the automated underwriting system by adding its
Prophet Score model to the automated underwriting system's decision making
process. Direct connections between the CMAC network and Fannie Mae's Desktop
Underwriter and Freddie Mac's Loan Prospector systems were implemented in
January 1998.
Mortgage Scoring Models
During the last few years, the use of scoring mechanisms to predict loan
performance has become prevalent in the marketplace, especially with Fannie Mae
and Freddie Mac's advocacy of the use of credit scores in the mortgage loan
underwriting process. The use of credit scores was pioneered by Fair Isaac and
Company and became popular in the mid-1980s. The FICO model calculates a score
based on a borrower's credit history. This credit score based "scorecard" is
used to predict the future performance of a loan over a one or two year time
horizon. The higher the credit score the lower the likelihood that a borrower
will default on a loan. CMAC's Prophet Score begins with a FICO score then adds
specific additional data regarding the borrower, the loan and the property. CMAC
believes that it is this additional mortgage data that expands the integrity of
CMAC's Prophet Score over the entire life of the loan. In addition to the
Prophet Score, CMAC's housing analysts regularly review major metropolitan areas
to assess the impact that key indicators such as housing permits, employment
trends, and median home sale prices have on local lending. The healthier the
real estate market, the lower the risk. CMAC refers to this score as a GEOScore.
Beginning in October 1996, the Prophet Score and GEOScore appeared on each
insurance commitment that CMAC issued. In 1998, the Prophet and GEOScores were
combined into a more powerful "Composite Prophet Score" that aggregates the
credit and economic factors into one decision tool.
Alternative Products
An increasingly popular form of mortgage lending is in the area of
non-conforming loans. Two subsets of this category in which CMAC has recently
become involved are Alternative A loans and A minus loans. Alternative A
borrowers have an equal or better credit profile than CMAC's typical insured
borrowers, but these loans are underwritten with reduced documentation and
verification of information. CMAC typically charges a higher premium rate for
this business due to the reduced documentation, but does not consider this
business to be significantly more risky than its normal primary business. The A
minus loan programs typically have non-traditional credit standards which are
less stringent than standard credit guidelines. This market was created as an
avenue to homeownership for borrowers who had not properly maintained their
credit profile over time. CMAC receives a significantly higher premium for
insuring this product that is commensurate with the additional default risk and
is often a variable rate based on the Prophet Score. CMAC intends to limit its
participation in the non-conforming market to Alternative A and A minus loans
rather than "B" or "C" (lower credit) loans and to limit the business insured to
specific targeted lenders with proven good results and servicing experience in
this area. Alternative products made up less than 8% of CMAC's primary insurance
written during 1998, and most of this non-conforming product was categorized as
Alternative A business.
Contract Underwriting
CMAC utilizes its underwriting skills to provide an outsource contract
underwriting service to its customers. For a fee, CMAC underwrites fully
documented underwriting files for secondary market compliance, while at the same
time assessing the file for mortgage insurance, if applicable. The automated
underwriting service introduced in the latter part of 1997 has become a major
part of CMAC's contract underwriting service. This service offers customers
access to Fannie Mae's Desktop Underwriter and Freddie Mac's Loan Prospector
automated underwriting systems. Contract underwriting continues to be a popular
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service to our customers. During 1998, loans underwritten via contract
underwriting accounted for 33% of applications, 29% of commitments for insurance
and 24% of insurance certificates issued by CMAC. Record mortgage origination
volume during 1998 resulted in increased costs which were offset somewhat by
higher fees. CMAC gives recourse to its customers on loans it underwrites for
compliance. If the loan does not meet agreed upon guidelines and is not salable
in the secondary market for that reason, CMAC agrees to remedy the situation
either by placing mortgage insurance coverage on the loan or by purchasing the
loan. During 1998, CMAC processed requests for remedies on less than 1% of the
contract loans underwritten and sold a number of loans previously acquired as
part of the remedy process. Providing these remedies means CMAC assumes some
credit risk and interest rate risk if an error is found during the limited
remedy period in our agreements. Rising mortgage interest rates or an economic
downturn may expose CMAC to higher losses. During 1998, the financial impact of
these remedies was insignificant although there is no assurance that such
results will continue in 1999 and beyond.
RATINGS
CMAC, along with other active private mortgage insurers, has its
claims-paying ability and financial strength rated by Standard & Poor's ("S&P"),
Moody's Investors Service, Inc. ("Moody's") and Duff & Phelps Credit Rating
Company ("DCR"). These ratings are an indication to a mortgage insurer's
customers of the insurer's present financial strength and its capacity to honor
its future claims payment obligations. Ratings are generally considered critical
to an insurer's ability to compete for new insurance business. Currently, CMAC
is rated "AA" by S&P and DCR, and "Aa3" by Moody's. CMAC has received assurance
from Moody's, S&P and DCR that the merged company will maintain a rating similar
to the current rating upon completion of the merger
REINSURANCE
CMAC reinsures all direct insurance in force under an excess of loss
reinsurance program which CMAC considers to be an effective catastrophic
reinsurance coverage. Under this program, the reinsurer is responsible for 100%
of CMAC's covered losses in excess of CMAC's retention. CMAC's annual retention
is determined by a formula which contains variable components. The estimated
1999 retention is approximately $480 million of loss which represents 150% of
expected premiums earned. The reinsurer's aggregate annual limit of liability is
also determined by a formula with variable components and is currently estimated
to be $92.5 million. In addition, for 1999, a limit has been set on the amount
of annual pool insurance losses that can be counted in the reinsurance
recoverable calculation. For 1999, this limit is $90 million. If the reinsurer
decides not to renew the reinsurance arrangement and is not replaced by CMAC,
the reinsurer must provide six years of runoff coverage. There is an overall
aggregate limit of liability applicable to any runoff period equal to four times
the annual limit in effect for the calendar year of such nonrenewal. For 1999,
this aggregate limit is estimated to be $370 million. The excess of loss
reinsurance program also provides restrictions and limitations on the payment of
dividends by CMAC, investments, mergers or acquisitions involving other private
mortgage insurance companies and reinsurance of exposure retained by CMAC.
In addition, CMAC has entered into a variable quota-share ("VQS") treaty
for primary risk in the 1994 to 1997 origination years and a portion of the pool
risk written in 1997. In this treaty, quota-share loss relief is provided at
varying levels ranging from 7.5% to 15.0% based upon the loss ratio on the
reinsured book. The higher CMAC's loss ratio, the greater the potential
reinsurance relief which protects CMAC in adverse loss situations. A ceding
commission is paid by the reinsurer to CMAC and the agreement is noncancelable
for ten years by either party. As of December 31, 1998, the risk in force
covered by the VQS treaty was approximately $6.1 billion, or approximately 53%
of CMAC's primary risk in force and $84 million, or approximately 10% of CMAC's
pool risk in force. It is CMAC's present intention not to reinsure any
additional business pursuant to the VQS treaty for the 1999 origination year,
although the ultimate decision on reinsurance could be impacted by business
volume, capital adequacy and other factors.
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DEFAULTS AND CLAIMS
Defaults
The default and claim cycle on loans which have private mortgage insurance
begins with the insurer's receipt from the lender of notification of a default
on an insured loan. The master policy requires lenders to notify CMAC of an
uncured default on a mortgage loan within 75 days (45 days for an uncured
default in the first year of the loan), although many lenders do so earlier. The
incidence of default is affected by a variety of factors, including change in
borrower income, unemployment, divorce and illness, the level of interest rates
and general borrower creditworthiness. Defaults that are not cured result in
claims to CMAC. Borrowers may cure defaults by making all delinquent loan
payments or by selling the property and satisfying all amounts due under the
mortgage.
The following table shows the number of primary and pool loans insured,
related loans in default and the percentage of loans in default (default rate)
as of the dates indicated:
DEFAULT STATISTICS
DECEMBER 31
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1998 1997 1996 1995 1994
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PRIMARY INSURANCE:
Insured loans in force................. 491,836 441,605 382,243 321,090 261,750
Loans in default(1).................... 12,025 10,245 9,115 6,734 5,377
Percentage of loans in default......... 2.4% 2.3% 2.4% 2.1% 2.1%
POOL INSURANCE(2):
Insured loans in force................. 432,740 236,101 93,531 43,969 31,658
Loans in default(1).................... 3,500 2,114 1,012 595 549
Percentage of loans in default......... 0.8% 0.9% 1.1% 1.4% 1.7%
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(1) Loans in default exclude those loans 45 days past due or less and loans in
default for which CMAC feels it will not be liable for a claim payment.
(2) Includes traditional and modified pool insurance.
Regions of the United States may experience different default rates due to
varying economic conditions. The following table shows the default rates by CMAC
region as of the dates indicated, including both primary and pool loans.
DEFAULT RATES BY CMAC REGION
DECEMBER 31
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1998 1997 1996 1995 1994
---- ---- ---- ---- ----
North................................................... 2.13% 2.51% 2.64% 2.56% 2.59%
East.................................................... 2.43 3.11 3.38 3.34 3.36
Southeast............................................... 2.20 2.35 2.10 1.53 1.51
Midwest................................................. 1.03 1.16 1.28 1.12 0.61
Southwest............................................... 1.77 1.84 1.61 1.38 1.35
West.................................................... 1.88 2.42 2.87 2.52 2.14
Alaska.................................................. 0.55 1.02 0.45 0.74 0.67
As of December 31, 1998, default rates for CMAC's two largest states
measured by risk in force were 2.6% for California and 3.6% for Florida compared
to 3.6% for California and 3.8% for Florida at December 31, 1997. The relatively
high default rate in Florida is due primarily to the increased "affordable
housing" business done in Florida since 1994 and the relatively high default
development on such business.
Claims
The likelihood that a claim will result from a default and the amount of
such claim depend principally on the borrower's equity at the time of default
and the borrower's (or the lender's) ability to sell the home for an
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amount sufficient to satisfy all amounts due under the mortgage, as well as the
effectiveness of loss mitigation efforts. Claims are also affected by local
housing prices, interest rates, unemployment levels and the housing supply.
Claim activity is not evenly spread through the coverage period of a book
of business. Relatively few claims are received during the first two years
following issuance of the policy. This is followed by a period of rising claims
which, based on industry experience, has historically reached its highest level
in the third through fifth years after the year of loan origination. Thereafter,
the number of claims received has historically declined at a gradual rate,
although the rate of decline can be affected by conditions in the economy.
Approximately 58% of CMAC's primary risk in force and almost all of CMAC's pool
risk in force at December 31, 1998 had not yet reached its anticipated highest
claim frequency years. CMAC's cumulative claim incidence on insurance written,
determined four years after policy issuance, was 1.5% for insurance written in
1992, 1.5% for insurance written in 1993, and 2.0% for insurance written in
1994. Certain "affordable housing" loans insured in 1994 and 1995 have
experienced higher than normal early default and claim rates, although these
results are not anticipated to have a material effect on the Company's financial
statements due to the relatively small component of such loans in CMAC's book.
Many of the reasons for these early defaults have been addressed in the
underwriting of such loans since 1996.
LOSS MITIGATION
CMAC's loan workout staff consists of 20 employees, including 13 full-time
loan workout specialists who proactively intervene in the default process,
working with borrowers to reduce the frequency and severity of foreclosure
losses. Once a notice of default is received, CMAC scores the default using a
proprietary model that predicts the likelihood that the default will become a
claim. Using this model, the loan workout specialists prioritize cases for
proactive intervention to counsel and assist borrowers. Loss mitigation
techniques include pre-foreclosure sales, extensions of credit to borrowers to
reinstate insured loans, loan modifications and deficiency settlements. CMAC
considers its loss mitigation efforts to be an effective way to reduce claim
payments.
HOMEOWNERSHIP COUNSELING
In 1995, CMAC established a Homeownership Counseling Center (the "Center")
to work with borrowers receiving insured loans under Community Homebuyer, 97%
loan-to-value ("97s") or other "affordable housing" programs. CMAC considers
this counseling to be very important to the future success of those particular
borrowers with regard to sustaining their mortgage payments. In addition, the
Center counsels such borrowers early in the default process in an attempt to
help cure the loan and assist the borrower in meeting their mortgage obligation.
LOSS RESERVES
CMAC establishes reserves to provide for the estimated costs of settling
claims in respect of loans reported to be in default and loans that are in
default which have not yet been reported to CMAC. Consistent with generally
accepted accounting principles and industry accounting practices, CMAC does not
establish loss reserves for future claims on insured loans which are not
currently in default. In determining the liability for unpaid losses related to
reported outstanding defaults, CMAC establishes loss reserves on a case-by-case
basis. The amount reserved for any particular loan is dependent upon the status
of the loan as reported by the servicer of the insured loan, as well as the
economic condition and estimated foreclosure period in the area in which the
default exists. As the default progresses closer to foreclosure, the amount of
loss reserve for that particular loan will be increased, in stages, to
approximately 100% of CMAC's exposure. CMAC also reserves for defaults that have
occurred but have not been reported using historical information on defaults not
reported on a timely basis by lending institutions. The estimates are
continually reviewed and adjustments are made to the liability as necessary.
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ANALYSIS OF PRIMARY RISK IN FORCE
CMAC's business strategy has been to disperse risk as widely as possible.
CMAC analyzes its portfolio in a number of ways to identify any concentrations
or imbalances in risk dispersion. CMAC believes the quality of its insurance
portfolio is affected significantly by:
- the geographic dispersion of the properties securing the insured loans;
- the quality of loan originations;
- the types of loans insured (including LTV ratio, purpose of the loan,
type of loan instrument and type of underlying property securing the
loan); and
- the age of the loans insured.
Geographic Dispersion
The following tables reflect the percentage of direct primary risk in force
on CMAC's book of business (by location of property) for the top ten states and
top 15 metropolitan statistical areas ("MSAs") as of December 31, 1998 and 1997:
TOP TEN STATES 1998 1997
- -------------- ---- ----
California.................................................. 18.1% 18.6%
Florida..................................................... 8.2 8.3
New York.................................................... 7.9 8.4
Texas....................................................... 5.4 5.5
Georgia..................................................... 4.8 5.0
New Jersey.................................................. 4.6 4.5
Pennsylvania................................................ 4.1 4.5
Arizona..................................................... 4.1 4.3
Illinois.................................................... 2.6 N/A
Maryland.................................................... 2.5 2.6
Tennessee................................................... N/A 2.5
--- ---
Total............................................. 62.3% 64.2%
=== ===
TOP FIFTEEN MSAs 1998 1997
- ---------------- ---- ----
Los Angeles, CA............................................. 4.7% 5.3%
Atlanta, GA................................................. 3.8 3.9
Phoenix, AZ................................................. 3.4 3.5
Philadelphia, PA............................................ 3.0 3.2
New York, NY................................................ 2.8 3.0
Nassau/Suffolk, NY.......................................... 2.6 2.7
Washington, DC-MD-VA........................................ 2.5 2.5
Chicago, IL................................................. 2.3 2.1
Orange County, CA........................................... 2.0 2.2
Riverside-San Bernadino, CA................................. 2.0 1.8
Dallas, TX.................................................. 1.6 1.8
Miami, FL................................................... 1.5 1.4
Tampa-St. Petersburg, FL.................................... 1.4 1.5
Ft. Lauderdale, FL.......................................... 1.4 1.4
Houston, TX................................................. 1.3 N/A
Boston, MA.................................................. N/A 1.5
--- ---
Total............................................. 36.3% 37.8%
=== ===
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Lender and Product Characteristics
While geographic dispersion is an important component of overall risk
dispersion and it has been a strategy of the Company to reduce its exposure in
the top 10 states and top 15 MSAs, the Company believes the quality of the risk
in force should be considered in conjunction with other elements of risk
dispersion, such as product distribution, as well as CMAC's risk management and
underwriting practices.
The following table reflects the percentage of direct risk in force (as
determined on the basis of information available on the date of mortgage
origination) by the categories indicated as of December 31, 1998 and 1997.
DIRECT RISK IN FORCE
1998 1997
----- -----
Product Type:
Primary................................................... 92.8% 94.4%
Pool(1)................................................... 7.2 5.6
----- -----
Total............................................. 100.0% 100.0%
===== =====
DIRECT PRIMARY RISK IN FORCE
1998 1997
------- -------
Direct Primary Risk in Force (dollars in millions).......... $11,595 $10,009
Lender Concentration:
Top 10 lenders (by original applicant).................... 28.8% 24.0%
Top 20 lenders (by original applicant).................... 38.3% 33.6%
LTV:
95.01% to 97.00%.......................................... 3.5% 2.6%
90.01% to 95.00%.......................................... 44.8 45.4
85.01% to 90.00%.......................................... 44.2 46.0
85.00% and below.......................................... 7.5 6.0
------- -------
Total............................................. 100.0% 100.0%
======= =======
Loan Type:
Fixed..................................................... 87.9% 82.9%
Adjustable rate mortgage ("ARM") (fully indexed)(2)....... 10.8 14.7
ARM (potential negative amortization)(3).................. 1.3 2.4
------- -------
Total............................................. 100.0% 100.0%
======= =======
Mortgage Term:
15 years and under........................................ 3.5% 3.4%
Over 15 years............................................. 96.5 96.6
------- -------
Total............................................. 100.0% 100.0%
======= =======
Property Type:
Non-condominium (principally single-family detached)...... 96.2% 95.7%
Condominium or cooperative................................ 3.8 4.3
------- -------
Total............................................. 100.0% 100.0%
======= =======
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1998 1997
------- -------
Occupancy Status:
Primary residence......................................... 96.9% 97.2%
Second home............................................... 1.4 1.1
Non-owner occupied........................................ 1.7 1.7
------- -------
Total............................................. 100.0% 100.0%
======= =======
Mortgage Amount:
$200,000 or less.......................................... 86.4% 88.4%
Over $200,000............................................. 13.6 11.6
------- -------
Total............................................. 100.0% 100.0%
======= =======
Loan Purpose:
Purchase.................................................. 80.5% 84.0%
Refinance................................................. 19.5 16.0
------- -------
Total............................................. 100.0% 100.0%
======= =======
- ---------------
(1) Includes traditional and modified pool insurance.
(2) Refers to loans where payment adjustments are the same as mortgage interest
rate adjustments.
(3) Loans with potential negative amortization will not have increasing
principal balances unless interest rates increase as contrasted with
scheduled negative amortization where an increase in loan balance will occur
even if interest rates do not change.
One of the most important determinants of claim incidence is the relative
amount of borrower's equity in the home, or down payment. The expectation of
claim incidence on 95s is approximately two times the expected claim incidence
on 90s. CMAC believes that the higher premium rates it charges on 95s adequately
reflect the additional risk on these loans. The industry and CMAC have been
insuring 97s since 1995. These loans are expected to have a higher claim
incidence than 95s; however, with proper counseling efforts and by limiting
insurance on these loans to sensible affordable housing programs, it is CMAC's
belief that the claim incidence should not be materially (more than one and
one-half times) worse than on 95s, although this cannot be certain. Early
defaults on 97s as compared to other loans have confirmed CMAC's expectations,
although the eventual performance of these loans cannot yet be accurately
projected. Premium rates on 97s are higher than on 95s to compensate for the
additional risk and the higher expected frequency and severity of claims. The
amount of 97s insured in 1998 and 1997 was between 3% and 4% of the total loans
insured each year and the percentage of primary risk in force on insured 97s
went from 2.6% at the end of 1996 to 3.5% at the end of 1998. The percentage of
97s written in 1999 should approximate the 1998 and 1997 figures.
In recent years, CMAC has increased its insurance on mortgages identified
by its customers as "affordable housing" loans. These loans are typically made
to low- and moderate-income borrowers in conjunction with special programs
developed by state or local housing agencies, Fannie Mae or Freddie Mac. Such
programs usually include 95s and 97s and may require certain underwriting
guidelines to be liberalized in order to achieve their objectives. CMAC's
participation in these programs is dependent upon acceptable borrower
counseling. Early default experience on these programs has been worse than
non-"affordable housing" loans, however CMAC does not believe the ultimate
claims will materially affect its financial results due to the relatively small
amount of such business combined with higher premium rates and risk-sharing
elements.
CMAC's claim frequency on insured ARMs has been higher than on all other
loan types. The Company believes that the risk on ARM loans is greater than on
fixed rate loans due to possible monthly payment increases if interest rates
rise.
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The Company believes that 15-year mortgages present a lower level of risk
than 30-year mortgages, primarily as a result of the faster amortization and the
more rapid accumulation of borrower equity in the property. Premium rates for
15-year mortgages are lower to reflect the lower risk.
The Company believes that the risk of claim is also affected by the type of
property securing the insured loan. In the Company's opinion, loans on
single-family detached housing are subject to less risk of claim incidence than
loans on other types of properties. Conversely, loans on attached housing types,
particularly condominiums and cooperatives, are generally considered by the
Company to be a higher risk, due to the higher density of such properties and
because a detached unit is the preferred housing type in most areas. CMAC's more
stringent underwriting guidelines on condominiums and cooperatives reflect this
higher expected risk.
The Company believes that the risk of claim on relocation loans and loans
originated by credit unions is extremely low and offers lower premium rates on
such loans to compensate for the lower risk.
The Company believes that loans on non-owner occupied homes purchased for
investment purposes represent a substantially higher risk of claim incidence,
and are subject to greater value declines than loans on either primary or second
homes. CMAC underwrites loans on non-owner occupied homes more stringently, and
sometimes requires that the investor indemnify CMAC directly for any loss
suffered by CMAC.
CMAC also charges a significantly higher premium rate than the rate charged
for insuring loans on owner occupied homes.
The Company believes that higher priced properties experience wider
fluctuations in value than moderately priced residences and that the income of
many people who buy higher priced homes is less stable than that of people with
moderate incomes. Underwriting guidelines for such higher priced properties
reflect this concern.
INVESTMENT PORTFOLIO
The Company's income from its investment portfolio is one of the Company's
primary sources of cash flow to support its operations and claim payments.
The Company follows an investment policy which, at a minimum, requires:
- 95% of its investment portfolio to consist of cash equivalents and debt
securities (including redeemable preferred stocks) which, at the date of
purchase, were rated investment grade by a nationally recognized rating
agency (e.g., "BBB" or better by S&P); and
- at least 50% of its investment portfolio (together with cash assets) to
consist of cash, cash equivalents and debt securities (including
redeemable preferred stocks) which, at the date of purchase, were rated
the highest investment grade by a nationally recognized rating agency
(e.g., "AAA" by S&P).
In December 1997, the Company's investment policy was amended to permit
investment in equity securities (which includes convertible debt and convertible
preferred stock). This equity component is not permitted to exceed 20% of the
total investment portfolio and the Company began investing in equity securities
in 1998. The 95% investment-grade requirement was not changed. In addition, all
investments purchased in 1998 were classified as available for sale in contrast
to primarily held to maturity, as was typical during prior years. However, the
portfolio still contains mostly held to maturity investments.
At December 31, 1998, the Company's investment portfolio had a carrying
value of $736.3 million and a market value of $743.7 million, including $18.6
million of short-term investments. At December 31, 1998, the Company's
investment portfolio did not include any real estate or mortgage loans. The
portfolio included 10 privately placed, investment-grade securities with an
aggregate carrying value of $6.4 million. At December 31, 1998, 96.3% of the
Company's investment portfolio (which excludes cash) consisted of cash
equivalents and debt securities (including redeemable preferred stocks) rated
investment grade.
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The Company's investment policies and strategies are subject to change
depending upon regulatory, economic and market conditions and the then existing
or anticipated financial condition and operating requirements, including the tax
position, of the Company.
The diversification of the Company's investment portfolio (other than
short-term investments) at December 31, 1998 is shown in the table below:
INVESTMENT PORTFOLIO DIVERSIFICATION
DECEMBER 31, 1998
-------------------------------------
AMORTIZED
COST FAIR VALUE PERCENT(1)
--------- ---------- ----------
(IN THOUSANDS)
Fixed maturities held to maturity:
US government securities(2).............................. $ 12,551 $ 13,156 2.6%
State and municipal obligations(3)....................... 464,967 499,212 97.4
-------- -------- -----
Total............................................ $477,518 $512,368 100.0%
======== ======== =====
Fixed maturities available for sale:
U.S. government securities(2)............................ 186 191 0.1%
U.S. government agency securities(2)..................... 32,276 32,783 15.8
State and municipal obligations(3)....................... 116,131 117,056 56.6
Corporate obligations(3)................................. 16,034 16,522 7.8
Redeemable preferred stock(3)............................ 40,420 46,219 19.7
-------- -------- -----
Total............................................ $205,047 $212,771 100.0%
======== ======== =====
Equity securities available for sale:
Equity securities........................................ $ 25,109 $ 27,425 100.0%
======== ======== =====
- ---------------
(1) Percentage of amortized cost.
(2) Substantially all of these securities are backed by the full faith and
credit of the U.S. government.
(3) Consists of investment-grade securities.
The following table shows the scheduled maturities of the securities held
in the Company's investment portfolio at December 31, 1998:
INVESTMENT PORTFOLIO SCHEDULED MATURITY (1)
DECEMBER 31, 1998
-------------------------
CARRYING
VALUE PERCENT
-------------- -------
(IN THOUSANDS)
Short-term investments...................................... $ 18,596 2.5%
Less than one year.......................................... 3,642 0.5
One to five years........................................... 94,652 12.9
Five to ten years........................................... 206,054 28.0
Over ten years.............................................. 306,939 41.7
Mortgage-backed securities(2)............................... 32,783 4.4
Redeemable preferred stock(3)............................... 46,219 6.3
Equity securities(3)........................................ 27,425 3.7
-------- -----
Total............................................. $736,310 100.0%
======== =====
- ---------------
(1) Actual maturities may differ as a result of calls prior to scheduled
maturity.
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(2) Substantially all of these securities are backed by the Government National
Mortgage Association ("GNMA").
(3) No stated maturity date.
The following table shows the ratings of the Company's investment portfolio
(other than short-term investments) as of December 31, 1998:
INVESTMENT PORTFOLIO BY S&P RATING
DECEMBER 31, 1998
-------------------------
CARRYING
RATING(1) VALUE PERCENT
- --------- -------------- -------
(IN THOUSANDS)
Fixed maturities:
U.S. government and agency securities....................... $ 45,525 6.3%
AAA......................................................... 443,891 61.8
AA.......................................................... 103,714 14.5
A........................................................... 37,725 5.3
BBB......................................................... 14,859 2.1
Not rated(2)................................................ 44,575 6.2
Equity securities........................................... 27,425 3.8
-------- -----
Total............................................. $717,714 100.0%
======== =====
- ---------------
(1) Current ratings assigned by S&P.
(2) These securities are not rated by S&P, but are rated investment grade by at
least one other nationally recognized securities rating agency.
REGULATION
Direct Regulation
State Regulation
The Company and its insurance subsidiaries are subject to comprehensive,
detailed regulation principally designed for the protection of policyholders,
rather than for the benefit of investors, by the insurance departments in the
various states where the Company and its insurance subsidiaries are licensed to
transact business. Insurance laws vary from state to state, but generally grant
broad supervisory powers to agencies or officials to examine insurance companies
and enforce rules or exercise discretion affecting almost every significant
aspect of the insurance business.
Insurance regulations relate, among other things to:
- the licensing of companies to transact business;
- claims handling;
- reinsurance requirements;
- premium rates and policy forms offered to customers;
- financial statements;
- periodic reporting;
- permissible investments; and
- adherence to financial standards relating to surplus, dividends and other
criteria of solvency intended to assure the satisfaction of obligations
to policyholders.
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Mortgage insurers are generally restricted to writing residential mortgage
guaranty insurance business only. This restriction essentially prohibits CMAC
from using its capital resources in support of other types of insurance or
non-insurance business. The non-insurance businesses of the Company, which
consist of mortgage insurance related services, are not generally subject to
regulation under state insurance laws.
Insurance Holding Company Regulation. All states have enacted legislation
that requires each insurance company in an insurance holding company system to
register with the insurance regulatory authority of its state of domicile and to
furnish to such regulator financial and other information concerning the
operations of companies within the holding company system that may materially
affect the operations, management or financial condition of insurers within the
system.
Because the Company is an insurance holding company and CMAC is a
Pennsylvania insurance company, the Pennsylvania insurance laws regulate, among
other things, certain transactions in the Company's common stock and certain
transactions between CMAC, the company's other insurance subsidiaries and their
parent or affiliates. Specifically, no person may, directly or indirectly, offer
to acquire or acquire "control" of the Company, CMAC or the other insurance
subsidiaries unless such person files a statement and other documents with the
Pennsylvania Commissioner of Insurance and obtains the Commissioner's prior
approval. The Commissioner may hold a public hearing on the matter. "Control" is
presumed to exist if 10% or more of CMAC or another of the Company's insurance
subsidiaries' voting securities is owned or controlled, directly or indirectly,
by a person, although the Pennsylvania Commissioner of Insurance may find that
"control" in fact does or does not exist where a person owns or controls a
lesser amount of securities. In addition, material transactions between CMAC and
the Company's other insurance subsidiaries and their parent or affiliates are
subject to certain conditions, including that they be "fair and reasonable."
These restrictions generally apply to all persons controlling or under common
control with CMAC or the Company's other insurance subsidiaries. Certain
transactions between the Company's insurance subsidiaries and their parent or
affiliates may not be entered into unless the Pennsylvania Commissioner of
Insurance is given 30 days prior notification and does not disapprove the
transaction during such 30-day period.
Dividends. The insurance laws of Pennsylvania establish a test limiting
the maximum amount of dividends which may be paid without prior approval by the
Pennsylvania Insurance Commissioner. Under such test, CMAC may pay dividends
during any 12-month period in an amount equal to the greater of:
- 10% of the preceding year-end statutory policyholders' surplus; or
- the preceding year's statutory net income.
In accordance with such restrictions, $105.3 million would be available for
dividends in 1999. However, an amendment to the Pennsylvania statute, effective
in 1994, requires that dividends and other distributions be paid out of an
insurer's unassigned surplus. Because of the unique nature of the method of
accounting for contingency reserves, CMAC has negative unassigned surplus. Thus,
prior approval by the Pennsylvania Insurance Commissioner is required for CMAC
to pay dividends or make other distributions so long as CMAC has negative
unassigned surplus. The Pennsylvania Insurance Commissioner has approved all
distributions by CMAC since the passage of this amendment, and management has
every expectation that the Insurance Department will continue to approve such
distributions in the future, provided that the financial condition of CMAC does
not materially change. The State of California has a statute requiring mortgage
insurers to pay dividends or make other distributions out of unassigned surplus.
CMAC and the California Department of Insurance have reached an understanding
under which CMAC will be able to pay dividends or make other distributions to
the Company provided that the financial condition of CMAC does not materially
change.
Risk to Capital. A number of states and Freddie Mac limit a private
mortgage insurer's risk in force to 25 times the total of the insurer's
policyholders' surplus plus the statutory contingency reserve, commonly known as
the "risk-to-capital" requirement. As of December 31, 1998, CMAC's
risk-to-capital ratio was 18.1 to 1, compared to 18.3 to 1 in 1997.
15
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Reserves. For statutory reporting, CMAC is annually required to provide
for additions to the contingency reserve in an amount equal to 50% of earned
premiums. Such amounts cannot be withdrawn for a period of 10 years except under
certain circumstances. The contingency reserve, designed to be a reserve against
catastrophic losses, essentially restricts dividends and other distributions by
CMAC. Prior to 1995, CMAC had included the contingency reserve as a component of
policyholders' surplus. The Pennsylvania Insurance Department has determined
that the contingency reserve should be classified as a liability in the
statutory balance sheet rather than as a component of policyholders' surplus. In
response to this determination, commencing in January 1995, CMAC began
classifying the contingency reserve as a liability. At December 31, 1998, CMAC
had policyholders' surplus of $149.3 million and a contingency reserve of $467.9
million.
Premium Rates and Policy Forms. CMAC's premium rates and policy forms are
subject to regulation in every state in which it is licensed to transact
business in order to protect policyholders against the adverse effects of
excessive, inadequate or unfairly discriminatory rates and to encourage
competition in the insurance marketplace. In most states, premium rates and
policy forms must be filed prior to their use. In some states, such rates and
forms must also be approved prior to use. Changes in premium rates are subject
to justification, generally on the basis of the insurer's loss experience,
expenses and future trend analysis. The general default experience in the
mortgage insurance industry may also be considered.
Reinsurance. Certain restrictions apply under the laws of several states
to any licensed company ceding business to an unlicensed reinsurer. Under such
laws, if a reinsurer is not admitted or approved in such states, the company
ceding business to the reinsurer cannot take credit in its statutory financial
statements for the risk ceded to such reinsurer absent compliance with certain
reinsurance security requirements. In addition, several states also have special
restrictions on mortgage guaranty insurance. Also, several states limit the
amount of risk a mortgage insurer may retain with respect to coverage on an
insured loan to 25% of the insured's claim amount. Coverage in excess of 25%
(i.e., deep coverage) must be reinsured.
Examination. The Company's insurance subsidiaries are subject to
examination of their affairs by the insurance departments of each of the states
in which they are licensed to transact business.
New York Circular Letter. The New York Insurance Department (the
"Department") issued Circular Letter No. 2 dated February 1, 1999 (the "Letter")
which discusses the Department's position concerning various transactions
between mortgage guaranty insurance companies licensed in New York and mortgage
lenders. The Letter confirms that captive reinsurance transactions are
permissible if they "constitute a legitimate transfer of risk" and "are fair and
equitable to the parties." The Department is currently in the process of
developing guidelines for determining which captives are, in fact, permissible.
In addition, the Letter states that "supernotes/performance notes," "dollar
pool" insurance, and "un-captive captives" violate New York law. The Company is
in the process of seeking further guidance with regard to the Letter and
revising its revenue-sharing products as appropriate to ensure compliance with
the Letter's requirements.
Federal Regulation
RESPA. The origination or refinance of a federally regulated mortgage loan
is a settlement service, and therefore subject to the Real Estate Settlement
Practices Act of 1974, and the regulations promulgated thereunder (collectively,
"RESPA"). In December 1992, regulations were issued which made clear that
mortgage insurance is also a settlement service, and therefore, that mortgage
insurers are subject to the provisions of Section 8(a) of RESPA, which generally
prohibits persons from accepting anything of value for referring real estate
settlement services to any provider of such services. Although many states
prohibit mortgage insurers from giving rebates, RESPA has been interpreted to
cover many non-fee services as well. HUD's interest in pursuing violations of
RESPA has increased awareness of both mortgage insurers and their customers of
the possible sanctions of this law.
HMDA. Most originators of mortgage loans are required to collect and
report data relating to a mortgage loan applicant's race, nationality, gender,
marital status and census tract to HUD or the Federal Reserve under the Home
Mortgage Disclosure Act of 1975 ("HMDA"). The purpose of HMDA is to detect
possible discrimination in home lending and, through disclosure, to discourage
such discrimination. Mortgage
16
18
insurers are not required pursuant to any law or regulation to report HMDA data,
although under the laws of several states, mortgage insurers are currently
prohibited from discriminating on the basis of certain classifications.
The active mortgage insurers, through their trade association, Mortgage
Insurance Companies of America ("MICA"), entered into an agreement with the
Federal Financial Institutions Examinations Council ("FFIEC") to report the same
data on loans submitted for insurance as is required for most mortgage lenders
under HMDA. The first report of HMDA-type data was collected by MICA from its
members for the fourth quarter of 1993 and reported to the FFIEC in the first
quarter of 1994. Subsequent reports of HMDA-type data for the mortgage insurance
industry were submitted by MICA to the FFIEC in March 1995, 1996 and 1997.
Management is not aware of any pending or expected actions by governmental
agencies in response to the reports submitted by MICA to the FFIEC.
Mortgage Insurance Cancellation. The Homeowners Protection Act of 1998
(the "Act") was signed into law on July 29, 1998. The legislation imposes
certain cancellation and termination requirements for borrower-paid private
mortgage insurance and requires certain disclosures to borrowers regarding their
rights under the law. Specifically, the Act provides that private mortgage
insurance on most loans originated on or after July 29, 1999 may be canceled at
the request of the borrower once the LTV reaches 80%, provided that certain
conditions are satisfied. Private mortgage insurance must be canceled
automatically once the LTV reaches 78% or, if the loan is not current on that
date, on the date that the loan becomes current. The Act establishes special
rules for the termination of private mortgage insurance in connection with loans
that are "high risk". The Act does not define "high risk" loans but leaves that
determination to Fannie Mae and Freddie Mac for loans up to the conforming loan
limit and to the mortgagee for any other loan. For "high risk" conforming loans,
it appears from the Act that Fannie Mae and Freddie Mac can determine how long
private mortgage insurance must remain in effect. For "high risk" loans above
the conforming loan limit, private mortgage insurance must be terminated on the
date that the LTV is first scheduled to reach 77%. In no case, however, may
private mortgage insurance be required beyond the midpoint of the amortization
period of the loan if the mortgagor is current on the payments required by the
terms of the mortgage. The Company does not believe that the Act will have a
material effect on its financial condition or results of operations.
Other Direct Regulation
Freddie Mac and Fannie Mae
As the most significant purchasers and sellers of conventional mortgage
loans and beneficiaries of private mortgage insurance, Freddie Mac and Fannie
Mae impose requirements on private mortgage insurers in order for such insurers
to be eligible to insure loans sold to such agencies. Freddie Mac's current
eligibility requirements impose limitations on the type of risk insured,
standards for the geographic and customer diversification of risk, procedures
for claims handling, acceptable underwriting practices and financial
requirements which generally mirror state insurance regulatory requirements.
These requirements are subject to change from time to time. Fannie Mae also has
eligibility requirements, although such requirements are not published. CMAC is
an approved mortgage insurer for both Freddie Mac and Fannie Mae.
In 1995, Freddie Mac and Fannie Mae began to require deeper coverage on
certain loans with LTV ratios greater than 85%. The Company believes that this
deeper coverage does not have a material effect on its financial results,
although premiums earned and the provision for losses increased and the
risk-to-capital ratio is higher as a result of the increase in risk.
In 1995, CMAC issued a new Master Policy which applied to all business
written after June 1, 1995. Changes in the terms included a broader scope of
coverage for certain environmental and bankruptcy related claims, and somewhat
more limited rights to reject claim payments, neither of which the Company
believes will have a material adverse effect on CMAC's operations or financial
results. The new Master Policy was approved by Fannie Mae and Freddie Mac, as
well as by all states which require approval of policy forms.
In January 1999, Fannie Mae announced a new program which allows for lower
levels of required mortgage insurance coverage for low down payment 30-year
fixed rate loans approved through its Desktop Underwriter automated underwriting
system. The insurance levels are similar to those required prior to 1995.
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In March 1999, Freddie Mac announced a similar program for loans approved
through its Loan Prospector underwriting system. Fannie Mae will replace some of
the coverage with a layer of investor mortgage insurance coverage provided by at
least two mortgage insurers, one of which will be CMAC. Fannie Mae also
announced that it intends to purchase additional insurance for certain eligible
"Flex 97" and investor loans, and CMAC has been selected to provide this
coverage on a pilot basis. The Company does not believe that these developments
will adversely affect the demand for or the profitability of mortgage insurance
in the near future.
Indirect Regulation
The Company and CMAC are also indirectly, but significantly, impacted by
regulations affecting originators and purchasers of mortgage loans, particularly
Freddie Mac and Fannie Mae, and regulations affecting governmental insurers such
as the FHA and VA. Private mortgage insurers, including CMAC, are highly
dependent upon federal housing legislation and other laws and regulations which
affect the demand for private mortgage insurance and the housing market
generally. For example, legislation which increases the number of persons
eligible for FHA or VA mortgages could have a material adverse effect on the
Company's ability to compete with the FHA or VA.
The FHA single family loan limits were raised in the fall of 1998. These
increased loan limits vary by geographic region from $109,032 to $197,620. The
Company does not believe that demand for private mortgage insurance has been or
will be materially adversely affected by this change.
Proposals have been advanced which would allow Fannie Mae and Freddie Mac
additional flexibility in determining the amount and nature of alternative
recourse arrangements or other credit enhancements which they could utilize as
substitutes for private mortgage insurance. The Company cannot predict if or
when any of the foregoing legislation or proposals will be adopted, but if
adopted and depending upon the nature and extent of revisions made, demand for
private mortgage insurance may be adversely affected. There can be no assurance
that other federal laws affecting such institutions and entities will not
change, or that new legislation or regulations will not be adopted. In addition,
Fannie Mae and Freddie Mac have entered into, and may in the future seek to
enter into, alternative recourse arrangements or other credit enhancements based
on their existing legislative authority.
In the fall of 1998, Freddie Mac proposed to Congress an amendment to its
charter that would have permitted it to substitute other forms of loss
protection for private mortgage insurance. Although the proposed amendment was
defeated, Freddie Mac may be actively exploring alternatives to conventional
mortgage insurance. Although it is not clear what, if any, changes or new
products may emerge, there is a possibility that any changes in this regard may
materially affect the mortgage insurance industry.
Recent discussions with the Federal Trade Commission with regard to the
adverse action disclosure provisions of the Fair Credit Reporting Act ("FCRA")
have raised the possibility that CMAC will need to make certain changes to its
loan servicing and tracking procedures in order to give FCRA adverse action
notices directly to borrowers. The Company does not believe that such changes
will have a material effect on its operations.
There can be no assurance that the above-mentioned federal laws and
regulations or other federal laws and regulations affecting lenders, private and
governmental mortgage insurers, or purchasers of insured mortgage loans, will
not be amended, or that new legislation or regulations will not be adopted, in
either case, in a manner which will adversely affect the demand for private
mortgage insurance.
YEAR 2000 ISSUE
Starting with the year 2000 ("Y2K"), computerized systems and computer
programs which store the year component of a date as two digits may experience
difficulties and produce unexpected results. Arithmetic calculations involving
dates, Boolean expressions involving dates, and program logic testing for the
occurrence of an event may produce errors.
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In 1997, the Company replaced all strategic and mission critical hardware,
including computers, network and communications devices. Additionally, all
operating systems, network operating systems and layered products were upgraded
to Y2K certified versions.
In 1998, the Company allocated approximately 80% of Information Services
("IS") staff to the Y2K software remediation project. Program modifications were
completed in early September 1998. All programs were then unit and system tested
in a dedicated environment capable of date shifting. Testing was performed by
the Company's IS programmers. Their results were verified and the systems
retested by the Company's IS Quality Control department. All test scripts,
procedures and results were documented. The Company believes that it does not
have material exposure to the Y2K issue with respect to its information systems.
The Company continues to analyze whether others with whom it does business
have Y2K issues. These include lenders and the custodian of the Company's
investment accounts. The Company is currently unable to predict the extent to
which the Y2K issue will affect these persons, or the extent to which the
Company would be vulnerable to their failure to remediate any Y2K issues on a
timely basis. The failure of any one of these persons subject to the Y2K issue
to convert its systems on a timely basis or a conversion that is incompatible
with the Company's systems could have a material adverse effect on the Company's
operations.
Currently, the Company believes its most reasonably likely Y2K worst case
scenario would involve the failure of its business partners' loan origination,
renewal processing or default reporting systems. The Company is an active
participant in the mortgage industry Y2K testing project and has developed
contingency plans to minimize the risks of business disruptions resulting from
business partners' Y2K issues. These include:
- accepting non-Y2K compliant data and using "windowing" logic to process
dates correctly;
- encouraging customers to order mortgage insurance via the internet using
the Company's MI Online system;
- accepting paper or fax submissions;
- encouraging customers to effect servicing transactions via the internet
using the Company's ServiceLink system;
- deferring or delaying renewal billing of policyholders to a mutually
agreed upon date; and
- suspending automatic cancellation for non-payment.
With respect to the Company's non-information technology systems, the Company
has made reasonable efforts to contact providers of products and services
concerning their Y2K readiness. Discussions with suppliers of electronic and
electro-mechanical devices deemed critical to the Company's business operations
are ongoing. Based on this contact and discussions, the Company believes that it
does not have material exposure to the Y2K issue with respect to its
non-information systems.
The Company did not incur any significant incremental expense related to
Y2K issues as of December 31, 1998 and does not expect that its Y2K compliance
program will result in any material costs or have any material impact on its
financial condition or results of operations. The Company has not used any
independent verification and/or validation processes to assure the reliability
of its risk and cost estimates.
EMPLOYEES
At December 1998, CMAC had 825 employees, of which approximately one-third
were located at its Philadelphia headquarters facility. CMAC's employees are not
unionized and management considers employee relations to be very good.
ITEM 2. PROPERTIES
The Company leases approximately 59,000 square feet for its corporate
headquarters in Philadelphia under leases which expire in 2003. In addition,
CMAC leases space for its Divisional, Service Center and On-Site offices
throughout the United States comprising approximately 57,000 square feet with
leases expiring
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between 1999 and 2001. With respect to all facilities, the Company believes it
will be able to obtain satisfactory lease renewal terms.
The Company believes its existing properties are well utilized and are
suitable and adequate for its present circumstances.
The Company maintains a mini-computer network from its corporate data
center located in its headquarters building to support its data processing
requirements for accounting, claims, marketing, risk management, underwriting
and non-insurance operations. In 1997, the Company centralized all computer
operations. All the service centers are linked to the home office in
Philadelphia via a high speed frame-relay network. The centralized environment
is based on the Business Recovery Server ("BRS") architecture. The BRS consists
of two geographically dispersed, identical data centers. Each data center is
currently running at 30% of capacity. Either data center is capable of
supporting the entire company. The data centers are linked via a fibre-optic
link allowing simultaneous data updates through disk shadowing. Each center is
part of a separate power grid. This redundant configuration provides disaster
tolerance and automatic back-up, resource sharing and fail-over.
ITEM 3. LEGAL PROCEEDINGS
CMAC is involved in certain litigation arising in the normal course of its
business. CMAC is contesting the allegations in each pending action and
believes, based on current knowledge and after consultation with counsel, that
the outcome of such litigation will not have a material adverse effect on the
Company's consolidated financial position and results of operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matter was submitted during the fourth quarter of 1998 to a vote of
holders of the Company's common stock.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
CMAC Investment Corporation common stock is listed on the New York Stock
Exchange under the symbol CMT. At December 31, 1998, there were 22,705,958
shares outstanding and approximately 6,800 holders of record. The following
table sets forth the high and low sale prices of the Company's common stock as
reported on the New York Stock Exchange Composite Tape:
1998 1997
---------------- ----------------
HIGH LOW HIGH LOW
---- ---- ---- ----
1st Quarter............................................... $69 1/4 $55 15/16 $37 3/8 $32 3/8
2nd Quarter............................................... 67 1/4 57 1/16 47 7/8 33 1/4
3rd Quarter............................................... 68 11/16 36 5/8 55 44 1/16
4th Quarter............................................... 48 13/16 28 60 13/16 50 13/16
Cash dividends for each share of the Company's common stock were $.03 for
each quarter during 1997 and 1998. For a description of restrictions on the
payment of dividends applicable to the Company and to CMAC, see note 7 of Notes
to Consolidated Financial Statements set forth on page F-15 herein.
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ITEM 6. SELECTED FINANCIAL DATA
CMAC INVESTMENT CORPORATION AND SUBSIDIARIES
SELECTED FINANCIAL AND STATISTICAL DATA
1998 1997 1996 1995 1994
------- ------- ------- ------- ------
(IN MILLIONS, EXCEPT PER-SHARE AMOUNTS AND RATIOS)
CONSOLIDATED STATEMENT OF INCOME
Premiums earned........................... $ 282.2 $ 237.7 $ 187.9 $ 137.1 $106.1
Net investment income..................... 38.6 33.8 30.0 25.9 22.6
Total revenues............................ 333.0 277.3 222.6 165.6 130.5
Provision for losses...................... 132.0 117.1 91.9 57.8 38.6
Policy acquisition costs and other
operating expenses...................... 75.1 57.7 48.1 39.6 35.6
Pretax income............................. 125.8 102.5 82.6 68.2 56.4
Net income................................ 91.1 75.0 62.2 50.8 41.1
Net income per share(1)(2)................ $ 3.72 $ 3.06 $ 2.55 $ 2.09 $ 1.70
Average shares outstanding(1)(2).......... 23.6 23.4 23.1 22.7 22.2
CONSOLIDATED BALANCE SHEET
Assets.................................... $ 968.2 $ 782.1 $ 649.2 $ 540.3 $435.5
Investments............................... 736.3 596.9 513.2 437.5 358.7
Unearned premiums......................... 49.4 49.3 53.4 56.1 61.9
Reserve for losses........................ 201.3 148.6 108.2 67.3 46.7
Redeemable preferred stock................ 40.0 40.0 40.0 40.0 40.0
Common stockholders' equity............... 523.0 429.9 356.3 298.6 239.7
Book value per share(2)................... $ 23.03 $ 19.08 $ 15.91 $ 13.42 $10.91
STATUTORY RATIOS
Loss ratio................................ 47.7% 50.6% 50.6% 44.3% 37.7%
Expense ratio............................. 24.2 21.2 23.2 28.5 27.6
------- ------- ------- ------- ------
Combined ratio............................ 71.9% 71.8% 73.8% 72.8% 65.3%
======= ======= ======= ======= ======
OTHER STATUTORY DATA
New primary insurance written............. $21,880 $13,707 $12,301 $10,607 $9,354
Direct primary insurance in force......... 53,763 46,900 39,438 32,362 25,809
Direct primary risk in force.............. 11,595 10,010 8,352 6,672 5,031
Direct pool risk in force................. 907 594 342 223 167
- ---------------
(1) Diluted net income per share and share information per Statement of
Financial Accounting Standards No. 128, "Earnings Per Share." See note 1 of
Notes to Consolidated Financial Statements set forth on page F-7 herein.
(2) All share and per-share data for prior periods have been restated to reflect
the stock split. See note 1 of Notes to Consolidated Financial Statements
set forth on page F-7 herein.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
1998 COMPARED TO 1997
Net income for 1998 was $91.1 million, a 20.5% increase compared to $75.0
million for 1997. This improvement was a result of significant growth in
premiums earned, net investment income and other income, partially offset by a
higher provision for losses, policy acquisition costs and other operating
expenses.
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New primary insurance written during 1998 was $21.9 billion, a 59.6%
increase compared to $13.7 billion for 1997. The increase in CMAC's primary new
insurance written was primarily due to a 55.3% increase in primary new insurance
written volume in the private mortgage insurance industry for 1998 as compared
to 1997. In addition, CMAC completed a bulk transaction in the second quarter of
1998, insuring approximately $700 million of seasoned California loans with a
risk profile similar to the Company's regular business. CMAC's market share of
the industry volume increased to 11.5% in 1998, compared to 11.2% for 1997.
Additionally, in 1998, CMAC wrote an increased amount of pool insurance which
represented risk written of $389.4 million as compared to $277.5 million in
1997. Most of this pool insurance volume relates to a group of structured
transactions composed primarily of Fannie Mae- and Freddie Mac-eligible
conforming mortgage loans that are geographically well dispersed throughout the
United States and have lower average loan-to-value ratios than CMAC's primary
business. The performance of this business to date has been better than
anticipated although the business is relatively young and the historical
performance might not be an indication of future performance. Under a pool
insurance transaction, the exposure to CMAC on each individual loan is uncapped;
however, the aggregate stop-loss percentage (typically 1.0% to 1.5% of the
aggregate original loan balance in the Fannie Mae/Freddie Mac transactions) is
the maximum that can be paid out in losses before the insurer's exposure
terminates. The Company expects its pool insurance activity to decline during
1999 as certain outstanding commitments expire and are not renewed. Premium
rates on such pool insurance are significantly lower than on primary insurance
loans due to the low stop-loss levels, which limit the overall risk exposure to
CMAC, and the focus of such product on high quality primary insurance customers.
Both S&P and Moody's have determined that the capital requirements to support
such pool insurance will be significantly more stringent than on primary
insurance due to the low premium rates.
CMAC's volume in 1998 was positively impacted by low interest rates which
affected the entire mortgage industry. The trend toward lower interest rates,
which began in the third quarter of 1997, caused refinancing activity during
1998 to continue at a higher rate than normal and strong housing prices have
caused a large percentage of the refinanced loans to be closed without private
mortgage insurance at an LTV of 80% or below. Therefore, the rate of growth in
the private mortgage industry has not been as high as that of the entire
mortgage market. CMAC's refinancing activity as a percentage of primary new
insurance written was 32.0% for 1998 as compared to 17.0% in 1997. However, for
the fourth quarter of 1998, refinanced loans represented 38.0% of new primary
insurance written as compared to only 24.0% for the third quarter of 1998 as a
result of the slight decline in interest rates during the fourth quarter. The
persistency rate, which is defined as the percentage of policies in force that
are renewed in any given year, was 68.0% for 1998 as compared to 84.2% for 1997.
This large decline was consistent with the increase in the level of refinancing
activity during 1998. The persistency rate for the beginning of 1999 should
continue at a level similar to 1998 although if the current refinance boom
slows, the persistency rate could improve.
CMAC also has recently become involved in insuring non-conforming loans,
specifically Alternative A and A minus loans. Alternative A borrowers have an
equal or better credit profile than CMAC's typical insured borrowers, but these
loans are underwritten with reduced documentation and verification of
information. CMAC typically charges a higher premium rate for this business due
to the reduced documentation, but does not consider this business to be
significantly more risky than its normal primary business. The A minus loan
programs typically have non-traditional credit standards which are less
stringent than standard credit guidelines. To compensate for this additional
risk, CMAC receives a significantly higher premium for insuring this product
that is commensurate with the additional default risk. During 1998, Alternative
A and A minus business accounted for 7.6% of CMAC's new primary insurance
written.
Net premiums earned in 1998 were $282.2 million, an 18.7% increase compared
to $237.7 million for 1997. This increase reflected the insurance in force
growth resulting from strong new insurance volume and the increase in pool
insurance written during 1998, and was partially offset by the decline in
persistency levels. The strong volume led to an increase in direct primary
insurance in force during 1998 of 14.6%, from $46.9 billion at December 31, 1997
to $53.8 billion at December 31, 1998. Direct pool risk in force also grew to
$907.3 million at December 31, 1998 from $593.9 million at the end of 1997, an
increase of 52.8% for the year. CMAC and the industry have entered into
risk-sharing arrangements with various customers that are designed to allow the
customer to participate in the risks and rewards of the mortgage insurance
business. One such
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product is captive reinsurance, in which a mortgage lender sets up a mortgage
reinsurance company that assumes part of the risk associated with that lender's
insured book of business. In most cases, the risk assumed by the reinsurance
company is an excess layer of aggregate losses that would be penetrated only in
a situation of adverse loss development. For 1998, premiums ceded under captive
reinsurance arrangements were $1.5 million or less than 1% of total premiums
earned during 1998 and new primary insurance written under captive reinsurance
arrangements was $2.6 billion, or 12.1% of total new primary insurance written.
CMAC expects to enter into several new agreements in 1999, although the
aggregate amount of captive reinsurance is not expected to have a material
financial impact on CMAC's balance sheet or financial results in 1999.
Net investment income for 1998 was $38.6 million, a 14.1% increase compared
to $33.8 million in 1997. This increase was a result of continued growth in
invested assets primarily due to positive operating cash flows of $132.3 million
during 1998. The Company has continued to invest new operating cash flow in tax-
advantaged securities, primarily municipal bonds, although the Company did
modify its investment policy to allow the purchase of various other asset
classes, including common stock and convertible securities, beginning in the
second quarter of 1998. The Company's intent is to target the common equity
exposure at a maximum of 5% of the investment portfolio's market value while the
convertible securities and mortgage-backed securities exposures are targeted not
to exceed 10% each. During 1998, the Company purchased a total of $26.0 million
of common equities which led to a slight decrease in the growth in investment
income during 1998. Although there will be a short-term decline in investment
income from this change in investment policy, the Company expects no material
long-term impact on total investment returns as a result of this investment
diversification.
The provision for losses was $132.0 million in 1998, an increase of 12.7%
compared to $117.1 million in 1997. This increase reflected the significant
growth and maturation of CMAC"s book of business over the past several years,
which has caused an increase in the number of defaults reported to CMAC, the
continued adverse experience of California loans (despite signs of an improving
trend in California), and the continued poor experience of certain "affordable
housing" program loans insured in 1994 and 1995, especially in Florida. Although
the ultimate performance of the books of business that originated since 1994
cannot yet be determined, it appears that the ultimate loss levels will be
slightly higher than average, partially due to the presence of these "affordable
housing" loans. Claim activity is not evenly spread throughout the coverage
period of a book of business. Relatively few claims are received during the
first two years following issuance of the policy. Historically, claim activity
has reached its highest level in the third through fifth years after the year of
loan origination. Approximately 58% of CMAC's primary risk in force and almost
all of CMAC's pool risk in force at December 31, 1998 had not yet reached its
anticipated highest claim frequency years. CMAC's overall default rate at
December 31, 1998 was 1.68% as compared to 1.82% at December 31, 1997, while the
default rate on the primary business was 2.44% at December 31, 1998 as compared
to 2.32% at December 31, 1997. The number of defaults rose from 12,359 at
December 31, 1997 to 15,525 at December 31, 1998 and the average loss reserve
per default rose from $12,026 at the end of 1997 to $12,965 at December 31,
1998. This increase in average loss reserve per default reflected the Company's
continued implementation of a more conservative reserve calculation for certain
loans in default perceived as having a higher risk of claim incidence. In
addition, an increase in the average loan balance and the coverage percentage on
loans originated beginning in 1995 has necessitated a higher reserve balance on
loans in a default status due to the increased ultimate exposure on these loans.
The default rate in California was 2.6% (including pool) at December 31, 1998 as
compared to 3.6% at December 31, 1997 and claims paid in California during 1998
were $41.8 million, representing approximately 43.1% of total claims as compared
to 57.0% in 1997. California represented 18.3% of primary risk in force at
December 31, 1998 as compared to 18.6% at December 31, 1997. The default rate in
Florida was 3.6% (including pool) at December 31, 1998 as compared to 3.8% at
December 31, 1997 and claims paid in Florida during 1998 were $11.5 million,
representing approximately 11.9% of total claims as compared to only 6.6% in
1997. Florida represented 8.2% of primary risk in force at December 31, 1998 as
compared to 8.3% at December 31, 1997. The "affordable housing" early default
experience is a result of insuring certain loans in which the borrowers'
principal and interest reserves and other credit factors were not as strong as
on prior years' books of business. Certain underwriting changes were implemented
near the end of 1996 to compensate for the factors that contributed to the early
default experience on these "affordable housing" loans; however, it is too early
to determine the impact of such changes. In addition, the Company has
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reported an increased number of defaults on the Alternative A and A minus
business insured beginning in 1997. Although the default rate for this business
is higher than on CMAC's normal books, it is not currently higher than was
expected for this type of business and the higher premium rates charged are
expected to compensate for the increased level of risk. Direct losses paid in
1998 were $83.8 million as compared to direct losses paid during 1997 of $82.1
million, an increase of only 2.1%.
Underwriting and other operating expenses were $75.1 million for 1998, an
increase of 30.3% compared to $57.7 million for 1997. These expenses consisted
of policy acquisition expenses, which relate directly to the acquisition of new
business, and other operating expenses, which primarily represent contract
underwriting expenses, overhead and administrative costs.
Policy acquisition costs were $36.1 million in 1998, an increase of 15.5%
compared to $31.3 million in 1997. This increase reflects the growth in variable
sales- and underwriting-related expenses relating to the Company's continued
growth in new insurance written. The Company has continued development of its
marketing infrastructure needed to support a focus on larger, national mortgage
lenders in order to take advantage of the widespread consolidation occurring in
the mortgage lending industry. Other operating expenses for 1998 were $39.0
million, an increase of 47.8% compared to $26.4 million for 1997. Most of the
increase continued to result from an increase in expenses associated with the
Company's ancillary services, specifically contract underwriting. Contract
underwriting expenses for 1998 included in other operating expenses were $20.7
million as compared to $10.6 million for 1997, an increase of 96.3%. The $10.1
million increase in contract underwriting expenses during 1998 represented 80.9%
of the $12.6 million increase in other operating expenses. Some of these
additional contract underwriting expenses were correspondingly offset by
increases to other income, which rose 112.2% from $5.0 million in 1997 to $10.6
million in 1998. During 1998, loans underwritten via contract underwriting
accounted for 33% of applications, 29% of insurance commitments, and 24% of
certificates issued by CMAC as compared to 29% of applications, 25% of
commitments and 22% of certificates in 1997. In 1999, these percentages are
expected to increase if there is a decrease in refinancing activity. Changing
market conditions have caused the cost of contract underwriting to increase
during 1997 and 1998 due to the high demand for available resources. However, as
further efficiencies are realized in the contract underwriting process due to
the integration with Freddie Mac's Loan Prospector and Fannie Mae's Desktop
Underwriter origination systems, the cost per contract underwriting loan
underwritten could decrease.
The effective tax rate for 1998 was 27.6% as compared to 26.9% for 1997.
Operating income accounted for 68.1% of net income in 1998 as compared to 66.2%
in 1997 thus resulting in the increase in effective tax rate for 1998.
1997 COMPARED TO 1996
Net income for 1997 was $75.0 million, a 20.5% increase compared to $62.2
million for 1996. This improvement was a result of significant growth in
premiums earned and net investment income, partially offset by a higher
provision for losses, policy acquisition costs and other operating expenses.
New primary insurance written during 1997 was $13.7 billion, an 11.4%
increase compared to $12.3 billion for 1996. This increase reflected a market
share increase which was primarily due to CMAC's continued focus on large,
national primary insurance customers and continued geographic expansion into
markets previously underrepresented by CMAC such as the Northwest and Midwest.
The increase resulted despite a 4.4% decline in new insurance written volume in
the private mortgage insurance industry in 1997. CMAC's market share of the
industry increased to 11.2% in 1997, compared to 9.6% for 1996 and for the
fourth quarter of 1997, CMAC's market share was 12.1%. Additionally, in 1997,
CMAC wrote an increased amount of pool insurance which represented an addition
to risk of $277.5 million as compared to $108.9 million in 1996. Most of this
pool insurance volume related to a group of structured transactions composed
primarily of Fannie Mae- and Freddie Mac-eligible conforming mortgage loans that
are geographically dispersed throughout the United States and that have lower
average loan-to-value ratios than CMAC's primary business. Under a pool
insurance transaction, the exposure to CMAC on each individual loan is uncapped;
however, the aggregate stop-loss percentage (typically 1.0% to 1.5% in the
Fannie Mae/Freddie
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Mac transactions) is the most that can be paid out in losses before the
insurer's exposure terminates. The Company expects its pool insurance activity
to continue at this same level in 1998 due its demand in the marketplace.
Premium rates on such pool insurance are significantly lower than on primary
insurance loans due to the low stop-loss levels, which limit the overall risk
exposure to CMAC, and the focus of such product on high quality primary
insurance customers. Nonetheless, this pool insurance has contributed to the
increase in earned premiums during 1997. Standard & Poor's has recently
determined that the capital requirements to support such pool insurance will be
significantly more stringent than on primary insurance due to the low premium
rates and CMAC has reviewed its capital levels to ensure compliance with these
requirements. The average stop-loss on pool insurance written during 1997 was
1.5%.
Refinanced loans represented 17.0% of new primary insurance written during
1997 as compared to 16.5% in 1996. However, for the fourth quarter of 1997,
refinanced loans represented 21.8% of new primary insurance written as compared
to only 13.4% for the fourth quarter of 1996 as lower interest rates in the
third quarter of 1997 caused refinance activity to increase significantly in the
fourth quarter. The persistency rate was 84.2% for 1997 as compared to 83.9% for
1996. This increase was consistent with the slight decline in the level of
refinancing activity during 1997.
The majority of CMAC's business in 1997 reflected the deeper insurance
coverage required by Fannie Mae and Freddie Mac beginning in 1995. That
coverage, which is 25% on loans written with an LTV between 85.01% and 90% and
30% on loans with LTVs greater than 90%, results in higher premiums and losses
than the older coverages of 17% and 22%, respectively, but should not materially
affect the Company's financial results. Approximately 60% of CMAC's direct
primary insurance in force had such deeper coverage at the end of 1997. Monthly
premium plans, which allow borrowers to pay premiums on a monthly basis rather
than annually in advance, accounted for 93.8% of CMAC's primary new insurance
written in 1997 as compared to 91.6% in 1996. Although this program reapportions
the cash flow from an insured loan over the life of the loan, there should be no
material financial effect from its widespread use. At the end of 1995, the
industry and CMAC introduced a variation of the monthly premium plan in which
the borrower does not need to pay any mortgage insurance premium at closing and
under which some portion of the first month's premium can be deferred or
forgiven. During 1997, business written under this program was approximately 31%
of CMAC's total as compared to 11% in 1996.
Net premiums earned in 1997 were $237.7 million, a 26.5% increase compared
to $187.9 million for 1996. This increase reflected a continuation of high
persistency levels, the insurance in force growth resulting from strong new
insurance volume, increased premium rates on deeper coverages and higher
LTV-insured products during 1997 and the increase in pool insurance written
during 1997. The strong volume and high persistency led to an increase in direct
primary insurance in force during 1997 of 18.9%, from $39.4 billion at December
31, 1996 to $46.9 billion at December 31, 1997. Direct pool risk in force also
grew to $593.9 million at December 31, 1997 from $341.9 million at the end of
1996, an increase of 73.7% for the year. Primary new insurance written on loans
with LTVs greater than 90% represented 42.1% of the total amount written in 1997
as compared to 45.5% in 1996.
Net investment income for 1997 was $33.8 million, a 12.6% increase compared
to $30.0 million in 1996. This increase was a result of continued growth in
invested assets primarily due to positive operating cash flows of $93.5 million,
offset slightly by a small decrease in investment yields. The Company's pre-tax
investment yield declined from 6.2% at December 31, 1996 to 6.0% at December 31,
1997. The Company has continued to invest new operating cash flow in
tax-advantaged securities, primarily municipal bonds.
The provision for losses was $117.1 million in 1997, an increase of 27.5%
compared to $91.9 million in 1996. This increase reflected the significant
growth and maturation of CMAC's book of business over the past several years,
the continued adverse experience of California loans, and the relatively poor
experience of certain "affordable housing" program loans insured starting in
1994. Although the ultimate performance of the books of business that originated
since 1994 cannot yet be determined, it appears that the ultimate loss levels
will be higher than average, due in part to the presence of these "affordable
housing" loans. CMAC's overall default rate at December 31, 1997 was 1.8% as
compared to 2.1% at December 31, 1996. The number of defaults rose from 10,127
at December 31, 1996 to 12,359 at December 31, 1997 and the average loss reserve
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per default rose from $10,685 at the end of 1996 to $12,026 at December 31,
1997. This increase in average loss reserve per default reflected the Company's
continued implementation of a more conservative reserve calculation for certain
loans in default perceived as having a higher risk of claim incidence. In
addition, an increase in the coverage percentage on loans originated beginning
in 1995 has necessitated a higher reserve balance on loans in a default status
due to the increased ultimate exposure on these loans. The default rate in
California was 3.6% (including pool) at December 31, 1997 as compared to 4.0% at
December 31, 1996 and claims paid in California during 1997 were $48.2 million,
representing approximately 57.0% of total claims as compared to 61.9% in 1996.
The "affordable housing" early default experience is a result of insuring
certain loans in which the borrowers' principal and interest reserves and other
credit factors were not as strong as on prior years' books of business. Certain
underwriting changes were implemented near the end of 1996 to compensate for the
factors that contributed to the early default experience on these "affordable
housing" loans; however, it is too early to determine the impact of such
changes. The Company believes that many loan servicers have changed the timing
of reporting loans in default, which has continued to result in an incremental
increase in the number of loans in default. This change allows for earlier
intervention with borrowers in default, which might lead to a higher cure rate
for such loans.
Underwriting and other operating expenses were $57.7 million for 1997, an
increase of 19.8% compared to $48.1 million for 1996. These expenses consisted
of policy acquisition expenses, which relate directly to the acquisition of new
business, and other operating expenses, which primarily represent overhead and
administrative costs.
Policy acquisition costs were $31.3 million in 1997, an increase of 16.5%
compared to $26.9 million in 1996. This reflects the increase in sales-and
underwriting-related expenses relating to the Company's continued market share
expansion and the development of the Company's marketing infrastructure needed
to support a focus on larger, national mortgage lenders in order to take
advantage of the widespread consolidation occurring in the mortgage lending
industry. Other operating expenses for 1997 were $26.4 million, an increase of
24.0% compared to $21.3 million for 1996. Much of the increase continued to
result from an expansion of the Company's technology efforts and an increase in
expenses associated with the company's ancillary services, specifically contract
underwriting. Some of these additional contract underwriting expenses were
correspondingly offset by increases to other income, which rose 31.9% from $3.8
million in 1996 to $5.0 million in 1997, although the main purpose of the
contract underwriting effort is to support the sales effort by generating
incremental mortgage insurance business. During 1997, loans underwritten via
contract underwriting accounted for 29% of applications, 25% of insurance
commitments, and 22% of certificates issued by CMAC as compared to 35% of
applications, 21% of commitments and 18% of certificates in 1996. Changing
market conditions caused the cost of contract underwriting to increase during
1997 due to the shortage of available resources.
The effective tax rate for 1997 was 26.9% as compared to 24.6% for 1996.
Operating income was 66.2% of pretax income in 1997 as compared to 62.6% in
1996, thus resulting in the increase in effective tax rate for 1997.
LIQUIDITY AND CAPITAL RESOURCES
The Company's sources of funds consist primarily of premiums and investment
income. Funds are applied primarily to the payment of CMAC's claims and
operating expenses. The Company generated positive cash flows from operating
activities in 1998, 1997 and 1996 of $132.3 million, $93.5 million and $84.5
million. The significant increases in operating cash flows reflect the growth in
premiums written and insurance in force that has more than offset any increases
in claims paid and other expenses. Positive cash flows are invested pending
future payments of claims and other expenses; cash flow shortfalls, if any, are
funded primarily through sales of short-term investments and other investment
portfolio securities.
Total investments were $736.3 million at December 31, 1998, including $18.6
million of short-term investments with maturities of 90 days or less and $45.5
million of U.S. Treasury equivalents and government agency securities. At
December 31, 1998, approximately 96.3% of the Company's investments consisted of
money market and investment-grade, readily marketable, fixed-income securities,
concentrated in maturities
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of greater than five years. In addition, at December 31, 1998, the Company's
investment portfolio included $27.4 million of equity securities, which includes
convertible debt and convertible preferred stock.
Loss reserves increased from $148.6 million at December 31, 1997 to $201.3
million at December 31, 1998. This increase in loss reserves due to newly
reported defaults, new loans in default that were not reported, and increases to
loss reserves on existing defaults was a result of continued adverse California
and Florida