SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-K
[x] Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act
of 1934
For the fiscal year ended December 31, 2002
[ ] 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 0-22342
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TRIAD GUARANTY INC.
(Exact name of registrant as specified in its charter)
DELAWARE 56-1838519
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
101 SOUTH STRATFORD ROAD
WINSTON-SALEM, NORTH CAROLINA 27104
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (336) 723-1282
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Securities registered pursuant to Section 12(b) of
the Act:
None
Securities registered pursuant to Section 12(g) of
the Act:
Title of each class
Common Stock, par value $.01 per share
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 RegulationS-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 by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes /X/ No / /.
State the aggregate market value of the voting and non-voting common equity held
by non-affiliates of the registrant, computed by reference to the price at which
the common equity was last sold, or the average bid and asked price of such
common equity, as of the last business day of the registrant's most recently
completed second fiscal quarter: $353,805,876 as of June 28, 2002, which amount
excludes the value of all shares beneficially owned (as defined in Rule 13d-3
under the Securities Exchange Act of 1934) by officers and directors of the
registrant (however this does not constitute a representation or acknowledgment
that any such individual is an affiliate of the registrant).
The number of shares of the registrant's common stock, par value $.01 per share,
outstanding as of February 15, 2003, was 14,218,674.
Portions of the following documents are Part of this Form 10-K
incorporated by reference into this into which the document is
Form 10-K: incorporated by reference
Triad Guaranty Inc. Part III
Proxy Statement for 2003 Annual Meeting
of Stockholders
PART I
ITEM 1. BUSINESS.
Triad Guaranty Inc. is a holding company which, through its wholly-owned
subsidiary, Triad Guaranty Insurance Corporation ("Triad"), provides private
mortgage insurance ("MI") coverage in the United States to residential mortgage
lenders and investors. Triad Guaranty Inc. and its subsidiaries are collectively
referred to as the "Company". The "Company" when used within this document
refers to the holding company and/or one or more of its subsidiaries, as
appropriate.
Private mortgage insurance, also known as mortgage guaranty insurance, is
issued in most home purchases and refinancings involving conventional
residential first mortgage loans to borrowers with equity of less than 20%. If
the homeowner defaults, private mortgage insurance reduces, and in some
instances eliminates, the loss to the insured lender. Private mortgage insurance
also facilitates the sale of low down payment mortgage loans in the secondary
mortgage market, principally to the Federal National Mortgage Association
("Fannie Mae") and the Federal Home Loan Mortgage Corporation ("Freddie Mac").
Under risk-based capital regulations applicable to most financial institutions,
private mortgage insurance also reduces the capital requirement for such lenders
on residential mortgage loans with equity of less than 20%. In addition,
mortgage insurance is purchased by investors and lenders who seek additional
default protection or capital relief on loans with equity of greater than 20%.
Private mortgage insurance has traditionally involved underwriting and
insuring an individual loan. This type of mortgage insurance is known as
"traditional flow" mortgage insurance and will be referred to as such throughout
this document. In 2001, the Company began participating in structured bulk
transactions which involve underwriting and insuring a group of loans. This type
of mortgage insurance is known as "structured bulk" mortgage insurance and will
be referred to as such throughout this document.
Triad was formed in 1987 as a wholly-owned subsidiary of Primerica
Corporation and began writing private mortgage insurance in 1988. In September
1989, Triad was acquired by Collateral Mortgage, Ltd. ("CML"), a mortgage
banking and real estate lending firm located in Birmingham, Alabama. In 1990,
CML contributed the outstanding stock of Triad to its affiliate, Collateral
Investment Corp. ("CIC"), an insurance holding company.
The Company was incorporated by CIC in Delaware in August 1993, for the
purpose of holding all the outstanding stock of Triad and to undertake the
initial public offering of the Company's Common Stock, which was completed in
November 1993. CIC currently owns 18.9% and CML owns 18.2% of the outstanding
Common Stock of the Company.
The principal executive offices of the Company are located at 101 South
Stratford Road, Winston-Salem, North Carolina 27104. Its telephone number is
(336) 723-1282.
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TYPES OF MORTGAGE INSURANCE PRODUCTS
PRIMARY INSURANCE
Primary insurance provides mortgage default protection on individual loans
and covers unpaid loan principal, delinquent interest, and certain expenses
associated with the default and subsequent foreclosure (collectively, the "claim
amount"). The claim amount, to which the appropriate coverage percentage is
applied, generally ranges from 110% to 115% of the unpaid principal balance of
the loan. The Company's obligation to an insured lender with respect to a claim
is determined by applying the appropriate coverage percentage to the claim
amount. Under its master policy, the Company 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.
Primary insurance can be placed on many types of loan instruments and generally
applies to loans secured by mortgages on owner occupied homes.
The Company offers primary coverage generally from 6% to 45% of the claim
amount, with most coverage from 12% to 40% as of December 31, 2002. The coverage
percentage provided by the Company is selected by the insured lender, subject to
the Company's underwriting approval, usually in order to comply with investor
requirements to reduce investor loss exposure on loans they purchase.
Fannie Mae and Freddie Mac are the ultimate purchasers of a large
percentage of the loans insured by the Company. Generally they require a
coverage percentage that will reduce their loss exposure on loans they purchase
to 75% or less of the property's value at the time the loan is originated. Since
1999, Fannie Mae and Freddie Mac have accepted lower coverage percentages for
certain categories of mortgages when the loan is approved by their automated
underwriting services. The reduced coverage percentages limit loss exposure to
80% or less of the property's value at the time the loan is originated.
The Company's premium rates vary depending upon the loan-to-value (LTV)
ratio, loan type, mortgage term, coverage amount, documentation required, and
use of property, which all affect the perceived risk of a claim on the insured
mortgage loan. Generally, premium rates cannot be changed after issuance of
coverage. The Company, consistent with industry practice, generally utilizes a
nationally based, rather than a regional or local, premium rate structure,
although special risk rates are utilized as well.
With respect to its traditional flow mortgage insurance, the premiums are
paid by either the borrower (borrower-paid) or the lender (lender-paid). Under
the Company's borrower-paid plan, mortgage insurance premiums are charged to the
mortgage lender or servicer which collects the premium from the borrower and, in
turn, remits the premiums to the Company. Under the Company's lender-paid plan,
mortgage insurance premiums are charged to the mortgage lender or loan servicer,
which pays the premium to the Company. The lender typically builds the mortgage
insurance premium into the borrower's interest rate. Approximately 72% and 82%
of the Company's traditional flow insurance was written under its borrower-paid
plan during 2002 and 2001, respectively. The remainder was written under its
lender-paid plan (28% and 18% of traditional flow insurance during 2002 and
2001, respectively). The Company's lender-paid volume is concentrated among
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larger mortgage lender customers. The premium rate structures associated with
the lender-paid plan are lower than standard borrower-paid rates. The Company is
able to have lower premium rate structures with lender-paid plans due to lower
acquisition costs, higher expected persistency, and expected favorable loss
development associated with lender-paid plans.
Premiums may be remitted to the Company monthly, annually, or in one single
payment. The monthly premium payment plan involves the payment of one or two
months' premium at the mortgage loan closing. Thereafter, level monthly premiums
are collected by the loan servicer for monthly remittance to the Company. The
Company also offers a plan under which the first monthly mortgage insurance
payment is deferred until the first loan payment is remitted to the Company.
This deferred monthly premium product decreases the amount of cash required from
the borrower at closing, therefore making home ownership more affordable.
Monthly premium plans represented approximately 80% and 88% of traditional flow
insurance written in 2002 and 2001, respectively.
The annual premium payment plan requires a first-year premium paid at
mortgage loan closing with annual renewal payments. With respect to the
Company's borrower-paid plan, renewal payments are collected monthly from the
borrower and held in escrow by the mortgage lender or servicer for annual
remittance to the Company in advance of each renewal year. Annual premium plans
represented approximately 20% and 11% of traditional flow insurance written in
2002 and 2001, respectively. The increase in the percentage of traditional flow
insurance written under the Company's annual premium plan is primarily the
result of a large mortgage lender customer choosing the Company's annual premium
plan for its lender-paid volume in 2002.
The single premium payment plan requires a single payment paid at loan
closing. The single premium payment can be financed by the borrower by adding it
to the principal amount of the mortgage or can be paid in cash at closing by the
borrower. Single premium plans represented less than 1% of traditional flow
insurance written in 2002 and 2001.
POOL INSURANCE
Pool insurance generally has been offered by private mortgage insurers to
lenders as an additional credit enhancement for certain mortgage-backed
securities and provides coverage for the full amount of the net loss on each
individual loan included in the pool, subject to a provision limiting aggregate
losses to a specified percentage of the total original balances of all loans in
the pool. The Company does not offer this traditional form of pool insurance.
In the second quarter of 2000, the Company began to participate in modified
pool insurance programs on loans purchased by Freddie Mac. Modified pool
insurance provides coverage for a specified percentage of the claim amount for
each loan insured, subject to an overall stop-loss provision applicable to the
entire pool of loans insured. At December 31, 2002, Freddie Mac modified pool
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insurance programs represented less than 1% of the Company's insurance in force.
The Company ceased participation in the Freddie Mac modified pool insurance
programs in September of 2002 and has not entered into any new Freddie Mac
programs subsequent to that date.
STRUCTURED BULK TRANSACTIONS
The Company participates in structured bulk transactions. Structured bulk
transactions involve insuring a group of loans where the insured loans have
individual loan level coverage. These transactions frequently include an
aggregate stop-loss limit applied to the entire group of insured loans.
Insurance issued in structured bulk transactions is generally either primary,
supplemental if the policy already has primary coverage, or a combination of
both. Individual loan level coverage is determined in order to reduce the
insured's exposure on a given loan down to a percentage of the loan's balance
("down to" coverage). Through December 31, 2002, insurance written through the
structured bulk channel has not been subject to captive mortgage reinsurance or
other risk-sharing arrangements.
Structured bulk transactions are generally initiated by secondary mortgage
market participants, including underwriters of mortgage-backed securities,
mortgage lenders, and mortgage investors such as Fannie Mae and Freddie Mac,
where mortgage insurance is used as a credit enhancement. The Company is
provided loan-level information on the group of loans and, based on the risk
characteristics of the entire group of loans and the requirements of the
secondary mortgage market participant, the Company will submit a price for
insuring the entire group of loans. The Company competes against other mortgage
insurers as well as other forms of credit enhancements provided by capital
markets for these transactions.
The structured bulk market can be divided into three broad segments: the
Prime segment (predominantly fully underwritten loans, high credit scores, high
percentage of low LTV's), the Alternative - A segment (generally high credit
score, low to moderate LTV loans that have been underwritten with reduced
documentation), and the Sub-prime segment (generally fully underwritten loans
with credit impaired borrowers). Although the Company has evaluated transactions
in all segments of the structured bulk market, all of the Company's insurance in
force from structured bulk transactions at December 31, 2002 was in the Prime
segment and the Alternative - A segment. During 2002, all of the Company's
structured bulk insurance written was in the Alternative - A segment of the
structured bulk market. During 2001, approximately 80% of the Company's
structured bulk insurance written was in the Prime segment of the structured
bulk market and approximately 20% was in the Alternative - A segment. The
Company anticipates bidding on and insuring loans across all market segments in
2003.
During 2002, structured bulk transactions represented approximately 9% of
the Company's insurance written for the year. Insurance written during 2001
attributed to structured bulk transactions represented approximately 36% of the
Company's total insurance written. The Company expects to continue to be
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competitive in the structured bulk transaction market. However, it is difficult
to predict the Company's volume of business during 2003 due to the relatively
small number of transactions that encompass this market (as opposed to the
traditional flow market), competitiveness with other mortgage insurers, the
attractiveness in the marketplace of mortgage insurance versus other forms of
credit enhancements, and the changing loan composition of the market.
RISK-SHARING PRODUCTS
The Company offers mortgage insurance programs designed to allow lenders to
share in the risks of mortgage insurance in exchange for a portion of the
insurance premium. One such program is the captive reinsurance program. Under
the captive reinsurance program, a reinsurance company, generally an affiliate
of the lender, assumes a portion of the risk associated with the lender's
insured book of business in exchange for a percentage of the premium. Typically,
the reinsurance program is an excess of loss arrangement with defined entry and
exit points and a maximum exposure limit for the captive reinsurance company.
These captive reinsurance programs may also be in the form of a quota share
arrangement, although the Company had no quota share arrangements in force as of
December 31, 2002. Under excess-of-loss programs, with respect to a given book
year of business, Triad retains a first loss position on a defined aggregate
layer of risk and reinsures a second defined aggregate layer with the reinsurer.
Triad generally retains the remaining risk above the layer reinsured. Because
claims incidence is generally highest in the third through six years after loan
origination, Triad is likely to retain all losses in the earlier years,
particularly in the first two years after loans for a given book year are
originated, and the reinsurer will assume the losses in subsequent years subject
to the defined layer of risk and up to their aggregate limit. The ultimate
impact on the Company's financial performance of an excess-of-loss captive
structure is dependent on the operating environment, primarily the total level
of losses and the persistency rates, during the life of a given book year of
business. The Company believes that its excess-of-loss captive reinsurance
programs provide valuable reinsurance protection by limiting the aggregate level
of losses, and under normal operating environments potentially reduces the
degree of volatility in the Company's earnings from the development of such
losses over a period of years.
The Company believes that its excess-of-loss captive reinsurance programs
provide valuable reinsurance protection and potentially reduce the risk of
volatility in the Company's earnings.
In addition to captive reinsurance programs, the Company has insurance in
force under programs, which are in run-off, that increase a lender's share of
the risk of loss on an insured book of business and provide a fee to the lender
for the increased risk. Approximately 46% and 35% of the Company's insurance in
force at December 31, 2002 and December 31, 2001, respectively, was subject to
risk-sharing programs. This increase in insurance in force subject to
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risk-sharing arrangements is due primarily to the increased market penetration
of the Company's risk-sharing arrangements and the high level of refinance
activity during the past twelve months, as policies that were previously not
subject to risk-sharing arrangements refinanced and new policies issued were
subject to risk-sharing arrangements. One of the Company's competitors has
announced that as of March 31, 2003 it will not participate in excess of loss
risk-sharing arrangements where the net premium cede rate is greater than 25%
("deep ceded"). The Company currently participates in excess of loss
risk-sharing arrangements where the net premium cede rate is greater than 25%.
As of December 31, 2002, the Company had "deep ceded" captive arrangements with
15% of the lenders participating in risk-sharing programs. Insurance in force
subject to risk-sharing arrangements from these lenders represented
approximately 69% of the Company's total insurance in force subject to
risk-sharing arrangements at December 31, 2002. The Company believes that, based
upon historical data and actuarial studies, its deep ceded captive arrangements
will produce acceptable returns on capital. It is uncertain at this time what
impact, if any, the competitor's decision to exit this business will have on the
Company.
Regulatory issues exist regarding the future of risk-sharing programs
currently being marketed within the mortgage insurance industry. Management is
unable to predict the impact of the regulatory issues on these products.
CANCELLATION OF INSURANCE
Mortgage insurance coverage cannot be canceled by the Company except for
nonpayment of premium or certain material violations of the master policy, and
remains renewable at the option of the insured lender. Generally, mortgage
insurance is renewable at a rate fixed when the insurance on the loan was
initially issued.
Insured lenders may cancel insurance at any time at their option. Pursuant
to the Homeowners Protection Act, most loans with borrower-paid mortgage
insurance made on or after July 29, 1999 are required to have their private
mortgage insurance canceled automatically by lenders when the outstanding loan
amount is 78% or less of the property's original purchase price and certain
other conditions are met. A borrower may request that a loan servicer cancel
borrower-paid mortgage insurance on a mortgage loan when the loan balance is
less than 80% of the property's current value, but loan servicers are generally
restricted in their ability to grant such requests by secondary market
requirements and by certain other regulatory restrictions.
Mortgage insurance coverage can also be cancelled when an insured loan is
refinanced. If the Company provides insurance on the refinanced mortgage, the
policy on the refinanced home loan is considered new insurance written.
Therefore, continuation of the Company's coverage from a refinanced loan to a
new loan results in both a cancellation of insurance and new insurance written.
The percentage of insurance written from refinanced loans was 40.1%, 35.8%, and
13.2% in 2002, 2001, and 2000, respectively.
To the extent canceled insurance coverage in areas experiencing economic
growth is not replaced by new insurance in such areas, the percentage of the
Company's book of business in economically weaker areas may increase. This
development may occur during periods of heavy mortgage refinancing. Refinanced
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loans in regions experiencing economic growth are less likely to require private
mortgage insurance, while borrowers in economically distressed areas are less
likely to qualify for refinancing because of depreciated real estate values. The
percentage of the Company's insurance in force at the end of the previous year
that was canceled during 2002, 2001, and 2000 was 39.1%, 32.4%, and 17.4%,
respectively. The high cancellation levels in 2002 were due to significant
refinance activity as mortgage rates remained low throughout the year. The
cancellations have not had a material impact on the geographic dispersion of the
Company's risk in force.
CUSTOMERS
Residential mortgage lenders such as mortgage bankers, mortgage brokers,
commercial banks and savings institutions are the principal customers of
traditional flow insurance written by the Company. At December 31, 2002,
approximately 73% of the Company's traditional flow risk in force came from
mortgage bankers, 15% from commercial banks, 9% from mortgage brokers, and the
remainder from savings institutions and credit unions. At December 31, 2001,
approximately 67% of the Company's traditional flow risk in force came from
mortgage bankers, 16% from commercial banks, 13% from mortgage brokers, and the
remainder from savings institutions and credit unions.
To obtain primary insurance from the Company written on a traditional flow
basis, a mortgage lender must first apply for and receive a master policy from
the Company. The Company's approval of a lender as a master policyholder is
based, among other factors, upon evaluation of the lender's financial position
and demonstrated adherence to sound loan origination practices.
The master policy sets forth the terms and conditions of the Company's
mortgage insurance policy. The master policy does not obligate the lender to
obtain insurance from the Company, nor does it obligate the Company to issue
insurance on a particular loan. The master policy provides that the lender must
submit individual loans for insurance to the Company and the loan, subject to
certain underwriting criteria, must be approved by the Company to effect
coverage (except in the case of delegated underwriting and when the originator
has the authority to approve coverage within certain guidelines). The Company
had 7,809 master policyholders at December 31, 2002, compared to 7,337 at
December 31, 2001.
The Company's ten largest customers generated 73.0%, 64.3%, and 47.1% of
traditional flow insurance written during 2002, 2001, and 2000, respectively.
The Company's two largest customers generated 53.4%, 42.0%, and 24.8% of
traditional flow insurance written during 2002, 2001, and 2000, respectively.
The Company's ten largest customers were responsible for 58.9%, 42.3%, and
30.0% of traditional flow risk in force at December 31, 2002, 2001, and 2000,
respectively. The two largest customers of the Company accounted for 39.7%,
24.8%, and 11.5% of traditional flow risk in force at December 31, 2002, 2001,
and 2000, respectively.
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Premium revenue for the Company is comprised of premium from current year
originated business plus renewal premiums from insurance originated in prior
years. There was no single customer whose revenue from current year originated
business accounted for 10% or more of the Company's consolidated revenue in
2002, 2001, or 2000. However, approximately 11% of the Company's consolidated
revenue in 2002 was from current year and prior years originated business from
Countrywide Credit Industries, Inc. There was no single customer whose revenue
from current and prior years originated business accounted for 10% or more of
the Company's consolidated revenue in 2001 or 2000.
The mortgage lending industry continues to experience consolidation and a
greater percentage of origination volume is being generated by the large
lenders. The top 30 lenders in the United States, as ranked by mortgage
origination volume, accounted for approximately 82% of originated mortgage
volume in 2002 compared to 73% in 2001. As a result of this continued
consolidation, the number of lenders making decisions as to which insurer to
select for mortgage insurance is being reduced. The Company could be adversely
affected if one of its large customers is consolidated with a lender with which
the Company is not approved to do business or if one of its large lenders
terminates its relationship with the Company for any reason. Currently the
Company is approved to do business with 21 of the top 30 lenders and production
from these lenders accounted for approximately 60% of the Company's traditional
flow insurance written in 2002 compared to 51% in 2001.
Structured bulk transactions are generally initiated by secondary mortgage
market participants such as underwriters of mortgage-backed securities.
SALES AND MARKETING
The Company currently markets its insurance products through a dedicated
sales force, including sales management, of approximately 41 professionals and
an exclusive commissioned general agency serving a specific geographic market.
The Company is licensed to do business in 46 states and the District of Columbia
and has license applications pending in four states. The Company will continue
to evaluate geographic expansion opportunities as well as the need for
additional sales representation.
The Company's field sales force is divided into two sales divisions, each
with its own manager, regional account representatives, and national account
executives. The division managers report to a senior executive who oversees all
sales and marketing activities for the Company. The national account executives
are primarily responsible for managing the Company's sales efforts toward the
larger national mortgage originators. The division managers and the regional
account executives serve key regional accounts and provide support for national
account sales efforts. This reporting structure allows the senior executive in
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charge of all sales activities to focus time on large, national accounts while
maintaining responsibility of all other sales activities. This senior executive
reports directly to the President of the Company.
The success of the Company is dependent upon the services of its sales
force and its general agency. For 2002, the Company's commissioned general
agency produced approximately 4% of the Company's traditional flow insurance
written while the salaried account executives and the national account
representatives produced the remainder.
The marketing department's mission is to develop and implement programs in
support of the Company's sales objectives and to promote the Company's image. A
variety of tools are used to achieve these goals including public relations,
marketing materials, internal/external publications, convention trade shows, and
the Internet. A national advertising and public relations campaign designed to
raise corporate visibility to lenders and investors is also part of the
Company's integrated marketing approach.
CONTRACT UNDERWRITING
The Company provides fee-based contract underwriting services that enable
customers to improve the efficiency of their operations by outsourcing all or
part of their mortgage loan underwriting. Contract underwriting involves
examining a prospective borrower's information contained in a lender's mortgage
application file and making a determination whether the borrower is approved for
a mortgage loan subject to the lender's underwriting guidelines. This service is
provided for loans that require mortgage insurance as well as loans that do not
require mortgage insurance. In the event that Triad fails to properly underwrite
a loan subject to the lender's underwriting guidelines, Triad may be required to
provide monetary or other remedies to the lender customer.
Contract underwriting services have become increasingly important to
lenders as they seek to reduce fixed costs. Accordingly, contract underwriting
significantly contributes to the Company's mortgage insurance production. The
Company provides contract underwriting services through its own employees as
well as independent contractors. If the Company becomes unable to maintain and
provide a sufficient number of qualified underwriters, the Company's operations
could be materially adversely affected.
COMPETITION AND MARKET SHARE
The Company and other private mortgage insurers compete directly with
federal and state governmental and quasi-governmental agencies, principally the
Federal Housing Administration ("FHA"). These agencies sponsor government-backed
mortgage insurance programs which accounted for approximately 36% of high LTV
loans in 2002 and 37% in 2001. In addition to competition from federal agencies,
the Company and other private mortgage insurers face competition from
state-supported mortgage insurance funds, some of which are either independent
agencies or affiliated with state housing agencies. Indirectly, the Company also
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competes with certain mortgage lenders which forego private mortgage insurance
and self-insure against the risk of loss from defaults on all or a portion of
their low down payment mortgage loans.
Fannie Mae and Freddie Mac have the ability to modify the required level of
mortgage insurance coverage which should be maintained by lenders on loans for
resale to the secondary market. Both Fannie Mae and Freddie Mac have programs
that reduce the amount of private mortgage insurance they require in exchange
for the lender providing an upfront delivery fee. The Company's financial
condition and results of operations could be adversely affected as a result of
these programs or if Fannie Mae and/or Freddie Mac adopt private mortgage
insurance substitutes.
Various proposals are periodically discussed by Congress and certain
federal agencies to reform or modify the FHA. Management is unable to predict
the scope and content of such proposals, or whether any such proposals will be
enacted into law, and if enacted, the effect on the Company.
The private mortgage insurance industry consists of eight active mortgage
insurance companies including Triad, Mortgage Guaranty Insurance Corporation,
PMI Mortgage Insurance Co., United Guaranty Residential Insurance Company,
Radian Guaranty Inc, General Electric Mortgage Insurance Corporation, Republic
Mortgage Insurance Company, and CMG Mortgage Insurance Co. Triad is the seventh
largest private mortgage insurer based on 2002 market share and, according to
industry data, had a 3.7% share of net new primary insurance written in 2002
compared to 3.6% in 2001. Net new primary insurance written includes insurance
written on a traditional flow basis as well as that attributed to structured
bulk transactions. Triad's national market share of net new primary insurance
written on a traditional flow basis was 4.3% for 2002 compared to 3.4% for 2001.
Management believes the Company competes with other private mortgage
insurers principally on the basis of personalized and professional service, a
strong management and sales team, responsive and versatile technology, and
innovative products.
Underwriting Practices
The Company considers effective risk management to be critical to its
long-term financial stability. Market analysis, prudent underwriting, the use of
automated risk evaluation models, auditing, and customer service are all
important elements of the Company's risk management process.
UNDERWRITING PERSONNEL
The Company's Senior Vice President of Audit and Senior Vice President of
Underwriting have been in their positions since shortly after the Company was
formed. The Company's Senior Vice President of Risk Management has been with the
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Company since 2001 and has more than 20 years of industry experience. In
addition to a centralized underwriting department in the home office, the Senior
Vice President of Underwriting is responsible for the Company's regional offices
in Arizona, California, Colorado, Georgia, Illinois, Ohio, Pennsylvania, Texas,
and Washington. The Senior Vice President of Audit is responsible for the
quality control function. The Senior Vice President of Risk Management is
responsible for assessing the risk factors used by the Company in its
underwriting procedures
The Company employed an underwriting staff of 46 at December 31, 2002. The
Company's field underwriters and underwriting managers are limited in their
authority to approve programs for certain mortgage loans. The authority levels
are tied to underwriting position, knowledge, and experience and relate
primarily to loan amounts and property type. All loans insured by the Company
are subject to quality control reviews.
The Company also utilizes various non-employee underwriters to perform
contract underwriting services. The number can vary substantially depending on
the need for this service.
RISK MANAGEMENT APPROACH
The Company evaluates risk based on historical performance of risk factors
and utilizes automated underwriting systems in the risk selection process to
assist the underwriter with decision making. This process evaluates the
following categories of risk:
o MORTGAGE LENDER. The Company reviews each lender's financial
statements and management experience before issuing a master policy.
The Company also tracks the historical risk performance, including
loan level risk characteristics, of all customers that hold a master
policy. This information is factored into determining the loan
programs the Company approves for various lenders. The Company assigns
delegated underwriting authority only to lenders with substantial
financial resources and established records of originating good
quality loans.
o PURPOSE AND TYPE OF LOAN. The Company analyzes five general
characteristics of a loan to evaluate its level of risk: (i) LTV
ratio; (ii) purpose of the loan; (iii) type of loan instrument; (iv)
level of documentation; and, (v) type of property. Generally, the
Company seeks loan types with proven track records for which an
assessment of risk can be readily made and the premium received
sufficiently offsets that risk. Loan types that do not have a proven
track record are charged a higher premium, as are other loans which
have been shown to carry higher risks, such as adjustable rate
mortgages ("ARMs") and loans having higher LTV ratios. Certain
categories of loans are not actively pursued by the Company because
such loans have a disproportionate amount of risk, including scheduled
negatively amortizing ARMs and investment properties.
o INDIVIDUAL LOAN AND BORROWER. Except to the extent that the Company's
delegated underwriting program and Freddie Mac's and Fannie Mae's
automated underwriting services are being utilized, the Company
evaluates insurance applications based on analysis of the borrower's
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ability and willingness to repay the mortgage loan and the
characteristics and value of the mortgaged property. The analysis of
the borrower includes reviewing the borrower's housing and total debt
ratios as well as the borrower's Fair, Isaac and Co., Inc. ("FICO")
credit score, as reported by credit rating agencies. Loans may be
submitted under the Stick With Triad program provided the loans meet
the program requirements. Within this program, the degree to which the
borrower must meet certain underwriting standards, as well as the
amount of documentation required, is a function of the credit score.
(For a further description of the Stick With Triad program, see
Underwriting Process below.) In the case of delegated underwriting,
compliance with program parameters is monitored by periodic audits of
delegated business. With the automated underwriting services provided
by Fannie Mae and Freddie Mac, lenders are able to obtain approval for
mortgage guaranty insurance with any participating mortgage insurer.
Triad works with both agencies in offering insurance services through
their systems, while monitoring the risk quality of loans insured
through such systems.
o GEOGRAPHIC SELECTION OF RISK. The Company places significant emphasis
on the condition of the regional housing markets in determining
marketing and underwriting policies. Using both internal and external
data, the Company's risk management department continually monitors
the economic conditions in the Company's active and potential markets.
UNDERWRITING PROCESS FOR TRADITIONAL FLOW BUSINESS
The Company accepts applications for insurance under three basic programs:
a traditional fully-documented program, a credit-score driven reduced
documentation program, and a delegated underwriting program which allows a
lender's underwriters to commit insurance to a loan based on strict, agreed upon
underwriting guidelines. The Company also accepts loans approved through Feddie
Mac's or Fannie Mae's automated underwriting systems.
The Company generally utilizes nationwide underwriting guidelines to
evaluate the potential risk of default on mortgage loans submitted for insurance
coverage. These guidelines have evolved over time and take into account the loss
experience of the entire private mortgage insurance industry. They also are
largely influenced by Fannie Mae and Freddie Mac underwriting guidelines. The
Company believes its guidelines generally are consistent with those used by
other private mortgage insurers with respect to the types of loans that the
Company will insure. Specific underwriting guidelines applicable to a given
local, state, or regional market are modified to address concerns resulting from
the Company's review of regional economies and housing patterns.
Subject to the Company's underwriting guidelines and exception approval
procedures, the Company expects its internal underwriters and contract
underwriters to utilize their experience and business judgment in evaluating
each loan on its own merits. Accordingly, the Company's underwriting staff has
discretionary authority to insure loans which deviate in certain minor respects
from the Company's underwriting guidelines. More significant exceptions are
subject to management approval. In all such cases, compensating factors must be
identified. The predominant reason for such deviations involves instances where
the borrower's debt-to-income ratio exceeds the Company's guidelines. To
compensate for exceptions, the Company's underwriters give favorable
consideration to such factors as excellent borrower credit history, the
availability of satisfactory cash reserves after closing, and employment
stability.
13
In addition to the borrower's willingness and ability to repay the loan,
the Company believes that mortgage default risk is affected by a variety of
other factors, including the borrower's employment status. Insured mortgage
loans made to self-employed borrowers are perceived by the Company to have
higher risk of claim, all other factors being equal, than loans to borrowers
employed by third parties. The Company's percentage of risk in force involving
self-employed borrowers was 2.6% at December 31, 2002 and 1.8% at December 31,
2001.
The Company's Stick With Triad program featuring the Slam Dunk Loan SM
approval process allows lenders to submit insurance applications with reduced
documentation. Under this program, Triad issues a certificate of insurance based
on the borrower's FICO credit score or the approval of the loan through Fannie
Mae's or Freddie Mac's automated underwriting system. The Company issues a
certificate of insurance without the standard underwriting process if certain
program parameters are met and the borrower has a credit score above established
thresholds. Documentation submission requirements for non-automated underwritten
loans vary depending on the borrower's credit score. The Stick With Triad
program represented approximately 33% of the Company's traditional flow
applications in 2002 and 36% in 2001. The Company randomly and through adverse
selection audits lenders' files on loans submitted under the Stick With Triad
program.
The Company's delegated underwriting program, in addition to the Company's
risk management strategies, utilizes extensive quality control practices
including reunderwriting, reappraisal, and similar procedures following issuance
of the policy. Standards for type of loan, property type, and credit history of
the borrower are established consistent with the Company's risk strategy. The
program has allowed the Company to serve a greater number of the larger,
well-established mortgage originators. The Company's delegated underwriting
program accounted for 44% of traditional flow applications received in 2002
compared to 40% in 2001. Many lenders who are not part of the delegated
underwriting program participate in the Stick With Triad underwriting program.
The performance of loans insured under the delegated underwriting program has
been comparable to the Company's non-delegated business.
The Company utilizes its underwriting staff as well as contract personnel
to provide contract underwriting services to customers. For a fee, Triad
underwrites applications for secondary market compliance, while at the same time
assessing the application for mortgage insurance, if applicable. In addition,
the Company offers Fannie Mae's Desktop Originator(R) and Desktop Underwriter(R)
and Freddie Mac's Loan Prospector(R), as well as the personnel to conduct the
underwriting tasks, as a service to its contract underwriting customers. These
products, which are designed to streamline and reduce costs in the mortgage
origination process, supply the Company's customers with fast and accurate
service regarding loan compliance and Fannie Mae's or Freddie Mac's decision for
loan purchase or securitization.
UNDERWRITING STRUCTURED BULK TRANSACTIONS
The Company employs a risk review process in underwriting structured bulk
transactions that is designed to identify the loans which pose the greatest risk
of nonperformance. High risk loans are identified based on an analysis of
14
multiple risk factors including, but not limited to, credit score,
loan-to-value, documentation type, loan purpose, and loan amount. The pertinent
risk characteristics of each loan are evaluated to determine the impact on the
transaction's frequency and severity of loss and persistency. The Company may
utilize an outside due diligence firm in this process as well as mortgage risk
analysis systems such as Standard & Poor's Levels. The Company's pricing for
structured bulk transactions is commensurate with a transaction's risk profile.
The Company also employs an audit procedure to test the integrity of the loan
level data provided to Triad. The risk review and audit procedure may result in
a request by the Company to remove certain loans from the transaction.
OTHER RISK MANAGEMENT
A comprehensive audit plan determines whether underwriting decisions being
made are consistent with the policies, procedures, and expectations for quality
set forth by management. All areas of business activity which involve an
underwriting decision are examined, with emphasis on new products, new
procedures, contract underwritten loans, delegated loans, new employees, new
master policyholders, and new branches of an existing master policyholder. The
process used to identify categories of loans selected for audit begins with
identification and evaluation of certain defined and verifiable risk elements.
Each loan is then tested against these elements to identify loans which fail to
meet prescribed policies or an identified norm. The procedure allows the
Company's management to identify concerns, not only at the loan level, but also
portfolio concerns which may exist within a given category of business.
TECHNOLOGY
Triad's TAXI - Transactions Across the Internet - allows qualified
customers to view, update, and process certain data within their borrowers'
private mortgage insurance records. TAXI is an internet-based service. Business
areas that can be addressed through TAXI include applying for mortgage
insurance, contract underwriting through eU Xpress, loan servicing, claims and
default processing, and risk-sharing performance.
eU Xpress is an internet-based service that automates the contract
underwriting and mortgage insurance commitment process. The Company introduced
eU Xpress in 2002. eU Xpress is accessed through TAXI and provides an interface
with automated underwriting systems.
FINANCIAL STRENGTH RATING
Credit ratings generally are considered an important element in a mortgage
insurer's ability to compete for new business, indicating the insurer's present
financial strength and capacity to pay future claims. Certain national mortgage
15
lenders and a large segment of the mortgage securitization market, including
Fannie Mae and Freddie Mac, generally will not purchase high LTV mortgages or
mortgage-backed securities unless the insurer issuing private mortgage insurance
coverage has a financial strength rating of at least "AA-" by either Standard &
Poor's Ratings Services ("S&P") or Fitch Ratings ("Fitch") or a rating of at
least "Aa3" from Moody's Investors Service ("Moody's"). Fannie Mae and Freddie
Mac require mortgage guaranty insurers to maintain two ratings of "AA- " or
better. Triad is rated "AA" by both S&P and Fitch and "Aa3" by Moody's. Private
mortgage insurers are not rated by any other independent nationally-recognized
insurance industry rating organization or agency (such as the A.M. Best
Company).
S&P defines insurers rated "AA" as having very strong financial security
characteristics, differing only slightly from those rated higher. Fitch defines
insurance companies rated "AA" as possessing very strong capacity to meet
policyholder and contract obligations, risk factors that are modest, and the
impact of any adverse business and economic factors is expected to be very
small. Moody's defines insurers rated "Aa" as offering exceptional financial
security but appearing to have somewhat larger long-term risks than companies
rated "Aaa". Ratings from S&P and Fitch are modified with a "+" or "-" sign to
indicate the relative position of a company within its category. Moody's uses
numeric modifiers to refer to the ranking within a group - with "1" being the
highest and "3" being the lowest.
When assigning a financial strength rating, S&P, Fitch, and Moody's
generally consider: (i) the specific risks associated with the mortgage
insurance industry, such as regulatory climate, market demand, growth, and
competition; (ii) management depth, corporate strategy, and effectiveness of
operations; (iii) historical operating results and expectations of current and
future performance; and, (iv) long-term capital structure, the ratio of debt to
equity, the ratio of risk to capital, near-term liquidity, and cash flow levels,
as well as any reinsurance relationships and the financial strength ratings of
such reinsurers. Ratings are based on factors relevant to policyholders, agents,
insurance brokers, and intermediaries. Such ratings are not directed to the
protection of investors and do not apply to any securities issued by the
Company.
Rating agencies issue financial strength ratings based, in part, upon a
company's performance sensitivity to various economic depression scenarios. In
determining capital levels required to maintain a company's rating, the rating
agencies allow the use of different forms of capital including statutory
capital, reinsurance and debt. In January 1998, the Company completed a $35
million private offering of notes due January 15, 2028. The notes, which are
rated "A" by S&P and "A+" by Fitch, were issued to provide additional capital
considered in the rating agency's depression models.
S&P, Fitch, and Moody's will periodically review Triad's rating, as they do
with all rated insurers. Ratings can be withdrawn or changed at any time by a
rating agency. A reduction in the Company's rating by S&P, Fitch, or Moody's
could materially impact the ability of the Company to write new business.
In January of 2003, Fitch revised its rating outlook for the U.S. private
mortgage insurance industry to "Negative" from "Stable". As it relates to the
mortgage insurance industry, Fitch defines a negative industry outlook as the
16
expectation that insurers' ratings or ratings outlook downgrades will exceed
upgrades during a 12-18 month time frame and that the number of downgrades are
expected to be material to the rated universe. As of the end of 2002, Fitch,
S&P, and Moody's all report a "Stable" ratings outlook for Triad. A reduction in
the Company's rating outlook by Fitch, S&P, or Moody's could adversely impact
the Company's operations.
REINSURANCE
The use of reinsurance as a source of capital and as a risk management tool
is well established within the mortgage insurance industry. Reinsurance does not
legally discharge an insurer from its primary liability for the full amount of
the risk it insures, although it does make the reinsurer liable to the primary
insurer. There can be no assurance that the Company's reinsurers will be able to
meet their obligations under the reinsurance agreements.
RISK-SHARING ARRANGEMENTS
Triad's product offerings include captive mortgage reinsurance programs
whereby an affiliate of a lender reinsures a portion of the insured risk on
loans originated or purchased by the lender. Triad entered the captive
reinsurance market in 1999 with the LEAPSM (Lower Entry- Additional
Profitability) program. The LEAP program is an excess of loss mortgage
reinsurance program that provides lenders an opportunity to share in the risk
and return of mortgage insurance on loans the lender originates or services.
Under LEAP, the lender may elect a risk band with a flexible entry and exit
point. LEAP also permits cessions greater than the 25% industry standard
arrangements that existed prior to this program. Ceded premium under captive
reinsurance agreements represented 12.7% of direct written premiums in 2002
compared to 6.6% in 2001.
In November 1999, Triad formed Triad Re Insurance Corporation ("Triad Re")
as a wholly-owned sponsored captive reinsurance company domiciled in Vermont.
Triad Re was formed to allow small and mid-sized lenders to participate in
captive reinsurance arrangements with reduced up-front capital costs and without
co-mingling its risk with other lenders. Triad Re was initially capitalized in
February 2000, with regulatory capital of $1.0 million. As of December 31, 2002,
approximately $5 million of Triad's risk in force had been ceded to sponsored
captive reinsurer cells under participating agreements with Triad Re.
Triad's captive reinsurance agreements provide for trust arrangements
whereby the captive reinsurer is the grantor of the trust and Triad is the
beneficiary of the trust. Trusts are established to support the reinsurers'
obligations under the reinsurance agreements. The trust agreement includes
covenants regarding minimum and ongoing capitalization, required reserves,
authorized investments, and withdrawal of assets and is funded by ceded premium
and investment earnings on trust assets as well as capital contributions by the
reinsurer.
The Company also has in place an agreement with a non-affiliated reinsurer
in association with certain of the Company's non-captive risk sharing programs,
which will indemnify the Company with respect to losses covered as defined by
17
the agreement. In 2002, less than one percent of the Company's direct written
premium was ceded under this agreement as compared to 2.1% in 2001.
At the end of 2002, 45.7% of Triad's insurance in force had been insured
under some type of risk-sharing arrangement as compared to 34.6% at the end of
2001. Risk-sharing arrangements represented 50.5% of Triad's traditional flow
insurance written in 2002 as compared to 57.9% in 2001.
OTHER REINSURANCE
Certain premiums and losses are assumed from and ceded to non-affiliated
insurance companies under various quota share reinsurance agreements. The ceding
agreement principally provides the Company with increased capacity to write
business and achieve a more favorable geographic dispersion of risk. Less than
0.1% of Triad's risk in force at December 31, 2002 and direct premiums written
in 2002 were ceded in quota share arrangements to non-affiliated reinsurance
companies.
Pursuant to deeper coverage requirements imposed by Fannie Mae and Freddie
Mac, certain loans eligible for sale to such agencies with a loan-to-value ratio
over 90% require insurance with a coverage percentage of 30% or more. Certain
states limit the amount of risk a mortgage insurer may retain with respect to
coverage of an insured loan to 25% of the claim amount, and, as a result, the
deeper coverage portion of such insurance must be reinsured. To minimize
reliance on third-party reinsurers and to permit the Company to retain the
premiums and related risk on deeper coverage business, Triad reinsures this
deeper coverage business with its wholly-owned subsidiary, Triad Guaranty
Assurance Corporation ("TGAC"). As of December 31, 2002, TGAC had assumed
approximately $59.4 million in risk from Triad.
The Company continues to maintain excess of loss reinsurance arrangements
designed to protect the Company in the event of a catastrophic level of losses.
The Company currently maintains $125 million of excess of loss reinsurance
through non-affiliated reinsurers that have financial strength ratings of "AA"
or better from Standard & Poor's.
DEFAULTS AND CLAIMS
DEFAULTS
The claim process on private mortgage insurance begins with the insurer's
receipt of notification from the lender of a default on an insured's loan.
Default is defined in the primary master policy as the failure by the borrower
to pay, when due, an amount at least equal to the scheduled monthly mortgage
payment under the terms of the mortgage. The master policy requires lenders to
notify the Company of default on a mortgage payment within 10 days of either (i)
the date on which the borrower becomes four months in default or (ii) the date
18
on which any legal proceeding affecting the loan commences, whichever occurs
first. Notification is required within 45 days of default if it occurs when the
first payment is due. The incidence of default is affected by a variety of
factors including, but not limited to, changes in borrower income, unemployment,
divorce, illness, the level of interest rates, and general borrower
creditworthiness. Defaults that are not cured generally result in a claim to the
Company. 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 default statistics as of December 31, 2002, and
the preceding four year ends:
Default Statistics
December 31
-----------
2002 2001 2000 1999 1998
---- ---- ---- ---- ----
Number of insured loans in force.......................... 190,480 159,400 123,046 108,623 97,222
Number of loans in default................................ 2,379 1,420 740 690 518
Percentage of loans in default (default rate)............. 1.25% 0.89% 0.60% 0.64% 0.53%
Number of insured loans in force excluding bulk loans..... 171,723 141,220 - - -
Number of loans in default excluding bulk loans........... 2,120 1,420 - - -
Percentage of loans in default excluding bulk loans....... 1.23% 1.01% - - -
Number of bulk loans in force............................. 18,757 18,180 - - -
Number of bulk loans in default........................... 259 0 - - -
Percentage of bulk loans in default....................... 1.38% 0.00% - - -
The number of loans in default includes all reported delinquencies that are
three or more payments in arrears at the reporting date and all reported
delinquencies that were previously three or more payments in arrears and have
not made payments to the current date.
CLAIMS
Claims result from defaults that are not cured. The frequency of claims
does not directly correlate to the frequency of defaults due, in part, to the
Company's loss mitigation efforts and the borrower's ability to overcome
temporary financial setbacks. The likelihood that a claim will result from a
default, and the amount of such claim, principally depend on the borrower's
equity at the time of default and the borrower's (or the lender's) ability to
sell the home for an amount sufficient to satisfy all amounts due under the
mortgage, as well as the effectiveness of loss mitigation efforts. The ability
to mitigate a claim is affected by the local housing market, interest rates,
employment growth, the housing supply, and the borrower's desire to avoid
foreclosure. During the default period, the Company works with the insured as
well as the borrower in an effort to either reinstate the loan or sell the
property for an amount which results in a reduced claim prior to foreclosure.
The payment of claims is not evenly spread through the coverage period.
Relatively few claims are paid during the first two years following issuance of
19
insurance. A period of rising claim payments follows, which, based on industry
experience, has historically reached its highest level in the third through
sixth years after the loan origination. Thereafter, the number of claim payments
made has historically declined at a gradual rate, although the rate of decline
can be affected by local economic conditions. There can be no assurance that the
historical pattern of claims will continue in the future.
Generally, the Company does not pay a claim for loss under the master
policy if the application for insurance for the loan in question contains
fraudulent information, material omissions, or misrepresentations which increase
the risk characteristics of the loan. The Company's master policy also excludes
any cost or expense related to the repair or remedy of any physical damage
(other than "normal wear and tear") to the property collateralizing an insured
mortgage loan. Such physical damage may be caused by accident, natural
occurrence or otherwise.
Under the terms of the master policy, the lender is required to file a
claim with the Company no later than 60 days after it has acquired borrower's
title to the underlying property through foreclosure or a deed-in-lieu of
foreclosure. A primary insurance claim amount includes (i) the amount of unpaid
principal due under the loan; (ii) the amount of accumulated delinquent interest
due on the loan (excluding late charges) to the date of claim filing; (iii)
expenses advanced by the insured under the terms of the master policy, such as
hazard insurance premiums, property maintenance expenses and property taxes
prorated to the date of claim filing; and (iv) certain foreclosure and other
expenses, including attorneys fees. Such claim amount is subject to review and
possible adjustment by the Company. Depending on the applicable state
foreclosure law, an average of about 12 months elapses from date of default to
payment of claim on an uncured default. The Company's experience indicates that
the claim amount on a policy generally ranges from 110% to 115% of the unpaid
principal amount of a foreclosed loan.
Within 60 days after the claim has been filed, the Company has the option
of either (i) paying the coverage percentage specified on the certificate of
insurance (usually 12% to 40% of the claim), with the insured retaining title to
the underlying property and receiving all proceeds from the eventual sale of the
property, or (ii) paying 100% of the claim amount in exchange for the lender's
conveyance of good and marketable title to the property to the Company, with the
Company selling the property for its own account. The Company chooses the claim
settlement option believed to cost the least. In most cases, the Company settles
claims by paying the coverage percentage of the claim amount. At December 31,
2002, the Company held properties with a combined net realizable value of $1.6
million which were acquired by electing to pay 100% of the claim amount.
LOSS MITIGATION
Once a default notice is received, the Company attempts to mitigate its
loss. Through proactive intervention with insured lenders and borrowers, the
Company has been successful in reducing the number and severity of its claims
for loss. Loss mitigation techniques include pre-foreclosure sales, property
20
sales after foreclosure, advances to assist distressed borrowers who have
suffered a temporary economic setback, and the use of repayment schedules,
refinances, loan modifications, forbearance agreements, and deeds-in-lieu of
foreclosure. Such mitigation efforts typically result in a savings to the
Company over the percentage coverage amount payable under the certificate of
insurance. Through loss mitigation efforts, the Company paid out approximately
65% of its potential exposure on claims in 2002 and 69% of its ever-to-date
exposure.
LOSS RESERVES
The Company establishes reserves to provide for the estimated costs of
settling claims on loans reported in default and estimates of loans in default
which have not been reported. Consistent with industry accounting practices, the
Company does not establish loss reserves for future claims on insured loans
currently not in default. Although the Company believes that overall reserve
levels at December 31, 2002, are adequate to meet future obligations, due to the
inherent uncertainty of the reserving process there can be no assurance that
reserves will prove to be adequate to cover ultimate loss developments.
In determining the liability for unpaid losses related to outstanding
defaults, the Company establishes loss reserves using estimated claim rates
(frequency) and claim amounts (severity) to estimate ultimate losses. The
Company relies on historical experience in the estimation of claim rates and
claim amounts. The Company also establishes reserves for the estimated costs of
settling claims ("loss adjustment expenses" or "LAE"), which include, but are
not limited to, legal fees and general expenses of administering the claims
settlement process, and for losses and loss adjustment expenses incurred from
defaults which have occurred but have not yet been reported to the insurer
("Incurred But Not Reported" or "IBNR").
Management periodically reviews the loss reserve process in order to
improve its estimate of ultimate losses. In 2001, management refined its
methodology for setting loss reserves for outstanding defaults and for IBNR
defaults. The enhancements made to the reserving process incorporate a more
multi-dimensional analytical form, which gives effect to current economic
conditions and profiles delinquencies by such factors as age, policy year,
geography, and chronic late payment characteristics.
The Company's reserving process is based upon the assumption that past
experience, adjusted for the anticipated effect of current economic conditions
and projected future economic trends, provides a reasonable basis for estimating
future events. However, estimation of loss reserves is a difficult and inexact
process. Economic conditions that have affected the development of loss reserves
in the past may not necessarily affect development patterns in the future in
either a similar manner or degree. Due to the inherent uncertainty in estimating
reserves for losses and loss adjustment expenses, there can be no assurance that
reserves will be adequate to cover ultimate loss developments on loans in
default, currently or in the future. The Company's profitability and financial
condition could be adversely affected to the extent that the Company's estimated
reserves are insufficient to cover losses on loans in default.
21
The following table represents a reconciliation of the beginning and
ending loss reserves (net of reinsurance) for the periods indicated:
Reconciliation of Losses and Loss Adjustment Expense Reserves
Year Ended December 31
----------------------
(in thousands)
2002 2001 2000 1999 1998
---- ---- ---- ---- ----
Reserve for losses and LAE, net of related reinsurance
recoverables, at beginning of year........................... $17,981 $14,976 $14,723 $12,116 $ 8,909
Add losses and LAE incurred in respect of defaults
occurring in:
Current year (1)........................................ 14,798 14,219 11,229 9,322 7,953
Prior years (1) (2)..................................... (735) (5,200) (3,642) (2,211) (944)
------- ------- ------- ------- -------
Total incurred losses and LAE................................ 14,063 9,019 7,587 7,111 7,009
Deduct losses and LAE paid in respect of defaults
occurring in:
Current year............................................ 508 286 574 236 267
Prior years............................................. 10,181 5,728 6,760 4,268 3,535
------- ------- ------- ------- -------
Total payments............................................... 10,689 6,014 7,334 4,504 3,802
Reserve for losses and LAE, net of related reinsurance
recoverables, at end of year ................................ 21,355 17,981 14,976 14,723 12,116
Reinsurance recoverables on unpaid losses and LAE, at
the end of year ............................................. 5 10 11 28 27
------- ------- ------- ------- -------
Reserve for unpaid losses and LAE, before deduction
of reinsurance recoverables on unpaid losses, at
end of year.................................................. $21,360 $17,991 $14,987 $14,751 $12,143
======= ======= ======= ======= =======
- ---------------------------
(1) Includes loss and LAE reserves relating to loans which are in default but
for which default notices have not been received.
(2) Indicates a cumulative redundancy in loss reserves at the beginning of each
period. Redundancies result from overestimating ultimate claim amounts.
The top section of the above table shows losses incurred on insurance
policies with respect to defaults which occurred in the current and prior
periods. The amount of losses incurred relating to defaults occurring in the
22
current period represents the estimated amount to be ultimately paid on defaults
occurring in that period. The amount of losses incurred relating to defaults
occurring in prior periods represents an adjustment made in the current period
for defaults which were included in the loss reserve at the end of the prior
period.
The middle section of the above table shows claims paid on insurance
policies with respect to defaults which occurred in the current period and in
prior periods, respectively. Since it takes, on average, about 12 months for a
default which is not cured to eventually develop into a paid claim, most losses
paid relate to defaults occurring in prior periods.
ANALYSIS OF DIRECT RISK IN FORCE
A foundation of the Company's business strategy is proactive risk
selection. The Company analyzes its portfolio in a number of ways to identify
any concentrations of risk or imbalances in risk dispersion. The Company
believes that the quality of its insurance portfolio is affected predominantly
by (i) the quality of loan originations (including the strength of the borrower
and the marketability of the property); (ii) the attributes of loans insured
(including LTV ratio, purpose of the loan, type of loan instrument and type of
underlying property securing the loan); (iii) the seasoning of the loans
insured; (iv) the geographic dispersion of the underlying properties subject to
mortgage insurance; and, (v) the quality and integrity of lenders from which the
Company receives loans to insure.
23
LENDER AND PRODUCT CHARACTERISTICS
The following table reflects the percentage of direct gross risk in force
(as determined on the basis of information available on the date of mortgage
origination) by the categories indicated on December 31, 2002 and 2001:
Direct Risk in Force
December 31
-----------
PRODUCT TYPE: 2002 2001
---- ----
Primary............................................. 100.0% 100.0%
Pool................................................ 0.0% 0.0%
------ ------
Total............................................... 100.0% 100.0%
====== ======
Direct Primary Risk in Force
December 31
-----------
2002 2001
---- ----
DIRECT PRIMARY RISK IN FORCE (dollars in millions).. $5,791 $4,582
Lender Concentration (excludes bulk):
Top 10 lenders (by original applicant).............. 58.9% 42.3%
LTV:
95.01% and above.................................... 5.1% 2.3%
90.01% to 95.00%.................................... 42.0% 41.4%
90.00% and below.................................... 52.9% 56.3%
------ ------
Total............................................... 100.0% 100.0%
====== ======
Loan Type:
Fixed............................................... 87.3% 86.2%
ARM (positive amortization) (1)..................... 12.7% 13.8%
ARM (potential negative amortization) (2)........... 0.0% 0.0%
ARM (scheduled negative amortization) (2)........... 0.0% 0.0%
Other............................................... 0.0% 0.0%
------ ------
Total............................................... 100.0% 100.0%
====== ======
Mortgage Term:
15 years and under.................................. 5.2% 3.8%
Over 15 years....................................... 94.8% 96.2%
------ ------
Total............................................... 100.0% 100.0%
====== ======
Property Type:
Noncondominium (principally single-family detached). 94.6% 95.2%
Condominium......................................... 5.4% 4.8%
------ ------
Total............................................... 100.0% 100.0%
====== ======
Occupancy Status:
Primary residence................................... 94.4% 95.9%
Second home......................................... 2.1% 1.7%
Nonowner occupied................................... 3.5% 2.4%
------ ------
Total............................................... 100.0% 100.0%
====== ======
Mortgage Amount:
$200,000 or less.................................... 72.2% 70.8%
Over $200,000....................................... 27.8% 29.2%
------ ------
Total............................................... 100.0% 100.0%
====== ======
- ---------------
(1) Refers to loans where payment adjustments are the same as mortgage interest
rate adjustments.
(2) Scheduled negative amortization is defined by the Company as the increase
in loan balance that will occur if interest rates do not change. Loans with
potential negative amortization will not have increasing principal balances
unless interest rates increase.
24
An important determinant of claim incidence is the relative amount of
borrower's equity in the home (which at the time of origination is the down
payment). For the industry as a whole, historical evidence indicates that claim
incidence on loans having a LTV ratio in excess of 90% is greater than claim
incidence on loans with LTV ratios equal to or less than 90%. The Company
believes the higher premium rates charged on high LTV loans adequately reflects
the additional risk.
Approximately 5.1% of the Company's risk in force is comprised of loans
with an LTV greater than 95%. These high LTV loans are offered primarily to low
and moderate income borrowers. The Company believes that these loans have higher
risks than its other insured business and has often attracted borrowers with
weak credit histories, generally resulting in higher loss ratios. In keeping
with the Company's established risk strategy, the Company has not aggressively
solicited this segment of the industry. The Company does not routinely delegate
the underwriting of high LTV loans.
In 2000 the State of Illinois Insurance Department, as well as the
insurance departments of several other states, began to permit mortgage insurers
to write coverage on loans with LTV's in excess of 97% up to 100% and, in
certain instances, up to 103%. This determination was made in response to the
development by certain entities in the mortgage securitization market, including
Fannie Mae and Freddie Mac, of programs that allowed LTV's in excess of 97%.
These programs are designed to accommodate the credit-worthy borrower who lacks
the ability or otherwise chooses not to provide a down payment on a home. The
Company accepts loans with LTV's greater than 97% on a limited basis.
The Company actively pursues only positively amortizing ARMs with industry
standard caps. Payments on these loans adjust fully with interest rate
adjustments. To date, the performance of the Company's ARM loans has been
consistent with that of its fixed rate portfolio. However, since historical
claim frequency data on ARMs has not yet been tested during a prolonged period
of economic stress, there can be no assurance that claim frequency on ARMs may
not eventually be higher, particularly during a period of rising interest rates
combined with decreasing housing prices. In its normal course of operations, the
Company's existing underwriting policy does not permit coverage of ARMs with
"scheduled" negative amortization. ARMs with "potential" negative amortization
characteristics due to possible interest rate increases and borrower payment
option changes are accepted under limited conditions for approved lenders.
Historical evidence indicates that higher-priced properties experience
wider fluctuations in value than moderately priced residences. These
fluctuations exist primarily because there is a smaller pool of qualified buyers
for higher-priced homes which, in turn, reduces the likelihood of achieving a
quick sale at fair market value when necessary to avoid a default.
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. Accordingly, the
Company charges lower premium rates on these loans than on comparable 30-year
mortgages.
25
The Company believes that the risk of claim is also affected by the type of
property securing the insured loan. In management's opinion, loans on
single-family detached housing are subject to less risk of claim incidence than
loans on other types of properties. The Company believes that attached housing
types, particularly condominiums and cooperatives, are a higher risk because in
most areas condominiums and cooperatives tend to be more susceptible to downward
fluctuations in value than single-family detached dwellings in the same market.
Loans on primary residences that were owner occupied at the time of loan
origination constituted approximately 94% of the Company's risk in force at
December 31, 2002. Because management believes that loans on non-owner occupied
properties represent a substantially higher risk of claim incidence and are
subject to greater value declines than loans on primary homes, the Company does
not actively pursue these loans.
The Company's book of business is less mature than that of the private
mortgage insurance industry as a whole, with the Company's direct risk in force
having a weighted average life of 2.3 years at December 31, 2002 and 2.6 years
at December 31, 2001, compared to an estimated industry average of 2.8 years at
December 31, 2002.
26
The following table shows the percentage of direct risk in force as of
December 31, 2002, for policies written from 1988 through 2002, as well as the
cumulative loss ratio (calculated as direct losses paid divided by direct
premiums written, in each case for a particular certificate year) which has
developed through December 31, 2002, for the policies written during the years
indicated and excludes the effects of reinsurance:
Certificate Percent Cumulative Ratio of Losses
Year Direct Risk in Force of Total Paid to Premiums Written(1)
---- -------------------- -------- ---------------------------
(in millions)
1988 $ 0.4 0.0% 15.3%
1989 0.4 0.0 24.0
1990 0.9 0.0 18.7
1991 3.7 0.1 11.9
1992 9.4 0.2 8.5
1993 34.2 0.6 5.2
1994 30.0 0.5 10.1
1995 50.1 0.9 12.4
1996 79.9 1.4 13.1
1997 148.8 2.5 8.4
1998 403.0 7.0 4.6
1999 346.4 6.0 3.7
2000 314.4 5.4 11.2
2001 1,730.8 29.9 1.4
2002 2,638.5 45.5 0.0
--------- -----
Total $ 5,790.9 100.0%
========= =====
- ---------------------
(1) Claim activity is not spread evenly throughout the coverage period of the
book of business. Based on the Company's and the industry's historical
experience, claims incidence is highest in the third through sixth years after
loan origination, and relatively few claims are paid during the first two years
after loan origination. Thus, the cumulative loss experience of recent
certificate years is not indicative of ultimate losses.
The above table reflects a relatively higher cumulative ratio of losses
paid to premium written for the 2000 policy year at this stage of development.
This is due, in part, to the high level of refinancing for this policy year and
the resulting lower aggregate level of premium written.
27
GEOGRAPHIC DISPERSION
The following tables reflect the percentage of direct risk in force on the
Company's book of business (by location of property) for the top ten states and
the top ten metropolitan statistical areas ("MSAs") as of December 31, 2002:
Top Ten States Top Ten MSAs
-------------- ------------
December 31 December 31
2002 2002
---- ----
California 11.9% Chicago, IL 4.6%
Florida 7.8 Atlanta, GA 3.1
Texas 7.7 Los Angeles/Long Beach, CA 2.8
North Carolina 5.6 Phoenix/Mesa, AZ 2.7
Georgia 5.5 Houston, TX 2.1
Illinois 5.1 Riverside/San Bernardino, CA 1.7
Pennsylvania 3.9 Dallas, TX 1.5
Arizona 3.7 New York, NY 1.5
Colorado 3.4 Denver, CO 1.4
New Jersey 3.3 Philadelphia, PA 1.3
----- -----
Total 57.9% Total 22.7%
===== =====
While the Company continues to diversify its risk in force geographically,
a prolonged regional recession, particularly in its high concentration areas, or
a prolonged national economic recession, could significantly increase loss
development.
INVESTMENT PORTFOLIO
Income from its investment portfolio is one of the Company's primary
sources of cash flow to support its operations and claims payments. The Company
has an investment advisory agreement with CML for management of its portfolio.
The Company follows an investment policy which requires: (i) 80% of its
investment portfolio (together with cash assets) to consist of cash, short-term
investments, 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 (ii) at least 50% of its
investment portfolio (together with cash assets) to consist of cash, cash
equivalents, and securities which, at the date of purchase, were rated one of
the two highest investment grades by a nationally recognized rating agency.
28
At December 31, 2002, the Company's total investment portfolio had a fair
market value of $344.6 million. The investment portfolio was composed of
approximately 87% fixed maturity securities, 3% equities, and 10% short-term
investments.
Liquidity is sought through cash equivalent investments and through
diversification and investment in publicly traded securities. The Company
attempts to maintain a level of liquidity and a duration in its investment
portfolio consistent with its business outlook and the expected timing,
direction, and degree of changes in interest rates. As of December 31, 2002, no
investment in the securities of any single issuer (other than the U.S.
government and its agencies) exceeded 2% of the Company's investment portfolio.
The Company actively monitors investment securities considered to be at
risk for impairment. When the Company determines that a decline in the value of
a security below its amortized cost is other-than-temporary, an impairment loss
has occurred. In the event of impairment, the Company writes down the cost basis
of the security to its fair value and recognizes a realized loss for the amount
of the writedown. During 2002, the Company realized approximately $2.0 million
of impairment writedowns on securities held in its portfolio.
The Company's investment policies and strategies are subject to change
depending upon regulatory, economic, and market conditions and the existing or
anticipated financial condition and operating requirements, including the tax
position, of the Company.
The following table shows the results of the Company's investment portfolio
for the periods indicated:
INVESTMENT PORTFOLIO RESULTS
(dollar amounts in thousands)
2002 2001 2000 1999 1998
---- ---- ---- ---- ----
Average investments (1)................ $301,434 $252,509 $212,029 $183,988 $151,712
Pre-tax net investment income.......... $ 16,099 $ 14,765 $ 12,645 $ 10,546 $ 9,289
Effective pre-tax yield (1)............ 5.3% 5.8% 6.0% 5.7% 6.1%
Tax-equivalent yield-to-maturity (2)... 7.9% 8.0% 8.2% 7.7% 7.9%
Pre-tax realized investment (loss) gain $(2,519) $ 297 $ 286 $ 1,153 $ 881
- -----------------
(1) Based on historical cost adjusted for amortization and accretion of premium
and discount.
(2) Based on book value and the Company's marginal tax rate.
29
The diversification of the Company's investment portfolio at December 31,
2002, is shown in the table below:
Investment Portfolio Diversification
(dollar amounts in thousands)
December 31, 2002
-----------------
Amortized Cost Fair Value Percent(1)
-------------- ---------- -------
Available-for-sale securities:
Fixed maturity securities:
U. S. government obligations............... $ 10,189 $ 10,596 3.1%
Mortgage-backed bonds...................... 167 186 0.1
State and municipal bonds.................. 231,210 242,336 70.3
Corporate bonds............................ 43,171 45,352 13.2
-------- --------
Total fixed maturities................. 284,737 298,470
Equity securities............................ 11,266 10,808 3.1
-------- --------
Total available-for-sale securities.... 296,003 309,278
Short-term investments....................... 35,303 35,303 10.2
-------- -------- ------
$331,306 $344,581 100.0%
======== ======== ======
- ---------------------
(1) Percentage of fair value.
The following table shows the scheduled maturities at December 31, 2002, of
the fixed maturity securities held in the Company's investment portfolio:
Investment Portfolio Scheduled Maturity
(dollar amounts in thousands)
December 31, 2002
-----------------
Fair Value Percent
---------- -------
One year or less......................... $ 4,115 1.4%
After one year through five years........ 17,000 5.7
After five years through ten years....... 35,366 11.8
After ten years though twenty years...... 165,662 55.5
After twenty years....................... 76,141 25.5
Mortgage-backed securities (1)........... 186 0.1
-------- ------
Total.......................... $298,470 100.0%
======== ======
---------------------
(1)Substantially all of these securities are guaranteed by U.S. Government
Agencies.
30
The following table shows the ratings of the Company's investment portfolio
as of December 31, 2002 and December 31, 2001:
Investment Portfolio by Rating
(dollar amounts in thousands)
December 31, 2002 December 31, 2001
------------------ -----------------
Rating(1) Fair Value Percent Fair Value Percent
-------- ---------- ------- ---------- -------
Fixed maturities:
U.S. Treasury and U.S. agency bonds..... $ 9,040 3.0% $ 12,923 5.3%
AAA..................................... 185,346 62.1 119,418 48.5
AA...................................... 32,114 10.8 28,574 11.6
A....................................... 42,433 14.2 42,724 17.4
BBB..................................... 14,784 5.0 26,086 10.6
BB...................................... 8,534 2.9 9,348 3.8
B....................................... 2,437 0.8 4,420 1.8
C....................................... 361 0.1 215 0.1
D....................................... 38 0.0 120 0.0
NR...................................... 3,383 1.1 2,157 0.9
-------- ------ -------- ------
Total fixed maturities............. $298,470 100.0% $245,985 100.0%
======== ====== ======== ======
Equities:
AAA..................................... $ 361 3.3% $ 359 2.9%
AA...................................... 1,432 13.2 2,301 18.4
A....................................... 4,622 42.8 4,860 39.0
BBB..................................... 2,132 19.7 1,404 11.2
BB...................................... 180 1.7 632 5.1
B....................................... 2,081 19.3 2,920 23.4
-------- ------ -------- ------
Total equities.................... $ 10,808 100.0% $ 12,476 100.0%
======== ====== ======== ======
Total portfolio.................................. $309,278 $258,461
======== ========
- -------------------------------
(1) Current ratings as assigned by the NRSRO (Nationally Recognized Statistical
Rating Organization). The NRSRO includes the following nationally
recognized rating agencies: S&P, Moody's, and Fitch.
31
REGULATION
DIRECT REGULATION
The Company's insurance subsidiaries are subject to comprehensive, detailed
regulation, principally for the protection of policyholders and their borrowers
rather than for the benefit of investors, by the insurance departments of the
various states in which each insurer is licensed to transact business. Although
their scope varies, state insurance laws in general grant broad powers to
supervisory agencies or officials to examine companies and to enforce rules or
exercise discretion touching almost every significant aspect of the insurance
business. These include the licensing of companies to transact business, and
varying degrees of control over claims handling practices, reinsurance
requirements, premium rates, the forms and policies offered to customers,
financial statements, periodic financial reporting, permissible investments, and
adherence to financial standards relating to statutory surplus, dividends, and
other criteria of solvency intended to assure the satisfaction of obligations to
policyholders.
All states have enacted legislation that requires each insurance company in
a holding company system to register with the insurance regulatory authority of
its state of domicile and furnish to the regulator financial and other
information concerning the operations of companies within the holding company
system that may materially affect the operations, management, or financial
condition of the insurers within the system. Generally, all transactions within
a holding company system between an insurer and its affiliates must be fair and
reasonable and the insurer's statutory policyholders' surplus following any
transaction with an affiliate must be both reasonable in relation to its
outstanding liabilities and adequate for its needs. Most states also regulate
transactions between insurance companies and their parents and/or affiliates.
There can be no assurance that state regulatory requirements will not become
more stringent in the future and have an adverse effect on the Company.
Because the Company is an insurance holding company and Triad is an
Illinois domiciled insurance company, the Illinois insurance laws regulate,
among other things, certain transactions in the Company's Common Stock and
certain transactions between Triad and the Company or affiliates. Specifically,
no person may, directly or indirectly, offer to acquire or acquire beneficial
ownership of more than 10% of any class of outstanding securities of the Company
or its subsidiaries unless such person files a statement and other documents
with the Illinois Director of Insurance and obtains the Director's prior
approval. In addition, material transactions between Triad and the Company 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 the insurance companies. "Control" is presumed to
exist if 10% or more of Triad's voting securities is owned or controlled,
directly or indirectly, by a person, although the Illinois Director may find
that "control" in fact does or does not exist where a person owns or controls
either a lesser or greater amount of securities. Other states in addition to
Illinois may regulate affiliated transactions and the acquisition of control of
the Company or its insurance subsidiaries.
32
Triad is required by Illinois insurance laws to provide for a contingency
reserve in an amount equal to at least 50% of earned premiums in its statutory
financial statements. Such reserves must be maintained for a period of 10 years
except in circumstances where high levels of losses exceed regulatory
thresholds. The contingency reserve, designed to provide a cushion against the
effect of adverse economic cycles, has the effect of reducing statutory surplus
and restricting dividends and other distributions by Triad. At December 31,
2002, Triad had statutory policyholders' surplus of $112.9 million and a
statutory contingency reserve of $245.0 million. At December 31, 2001, Triad had
statutory policyholders' surplus of `$105.3 million and a statutory contingency
reserve of $193.7 million. Triad's statutory earned surplus was $29.2 million at
December 31, 2002 and $21.6 million at December 31, 2001, reflecting growth in
statutory net income greater than the increase in the statutory contingency
reserve.
The insurance laws of Illinois provide that Triad may pay dividends only
out of statutory earned surplus and further establish standards limiting the
maximum amount of dividends which may be paid without prior approval by the
Illinois Director. Under such standards, Triad may pay dividends during any
12-month period equal to the greater of (i) 10% of the preceding year-end
statutory policyholders' surplus or (ii) the preceding year's net income. In
addition, insurance regulatory authorities have broad discretion to limit the
payment of dividends by insurance companies.
Although not subject to a rating law in Illinois, premium rates for
mortgage insurance are subject to regulation in most states to protect
policyholders against the adverse effects of excessive, inadequate, or unfairly
discriminatory rates and to encourage competition in the insurance marketplace.
Any increase in premium rates must be justified, generally on the basis of the
insurer's loss experience, expenses, and future trend analysis. The general
mortgage default experience also may be considered.
TGAC was organized as a subsidiary of Triad under the insurance laws of the
state of Illinois in December 1994, and as an Illinois domiciled insurer, is
subject to all Illinois insurance regulatory requirements applicable to Triad.
Triad Re was organized as a subsidiary of Triad under the insurance laws of
the state of Vermont in November 1999, and as a Vermont domiciled insurer, is
subject to Vermont insurance regulatory requirements.
Triad, TGAC, and Triad Re are each subject to examination of their affairs
by the insurance departments of every state in which they are licensed to
transact business. The Illinois Insurance Director and Vermont Insurance
Commissioner periodically conduct financial examinations of insurance companies
domiciled in their states. The most recent examinations of Triad and TGAC were
issued by the Illinois Insurance Department on February 3, 2000, and covered the
33
period January 1, 1995, through December 31, 1998. No material recommendations
were made as a result of these examinations.
A number of states generally limit the amount of insurance risk which may
be written by a private mortgage insurer to 25 times the insurer's total
policyholders' surplus. This restriction is commonly known as the
risk-to-capital requirement.
Mortgage insurers are generally restricted by state insurance laws and
regulations to writing residential mortgage guaranty insurance business only.
This restriction generally prohibits Triad from using its capital resources in
support of other types of insurance and restricts its noninsurance business.
However, noninsurance businesses of the Company would not generally be subject
to regulation under state insurance laws.
Regulation of reinsurance varies by state. Except for Illinois, Wisconsin,
New York, Ohio, and California, most states have no special restrictions on
reinsurance that would apply to private mortgage insurers other than standard
reinsurance requirements applicable to property and casualty insurance
companies. Certain restrictions, including reinsurance trust fund or letter of
credit requirements, apply under Illinois law to domestic companies and under
the laws of several other states to any licensed company ceding business to
unlicensed reinsurers. If a reinsurer is not admitted or approved, the company
doing business with the reinsurer cannot take credit in its statutory financial
statements for the risk ceded to such reinsurer absent compliance with the
reinsurance security requirements. In addition, some states in which Triad does
business have limited private mortgage insurers to a maximum policy coverage
limit of 25% of the insured's claim amount and require coverages in excess of
25% to be reinsured through another licensed mortgage insurer.
The National Association of Insurance Commissioners ("NAIC") adopted a
risk-based capital ("RBC") formula designed to help regulators identify property
and casualty insurers in need of additional capital. The RBC formula establishes
minimum capital needs based upon risks applicable to individual insurers,
including asset risks, off-balance sheet risks (such as guarantees for
affiliates and contingent liabilities), and credit risks (such as reinsurance
ceded and receivables). The NAIC and the Illinois Department of Insurance
currently do not require mortgage guaranty insurers to file RBC analysis in
their annual statements.
As the dominant purchasers and sellers of conventional mortgage loans and
beneficiaries of private mortgage guaranty insurance, Government Sponsored
Enterprises (GSEs) Fannie Mae and Freddie Mac 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 types of risk insured, standards for 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. Freddie Mac most recently modified its eligibility guidelines in March
2002.
Fannie Mae is in the process of revising its approval requirements for
mortgage insurers. The new requirements, which have not yet been finalized,
34
would require prior approval by Fannie Mae for many of Triad's activities and
new products, allow for other approved types of mortgage insurers rated less
than "AA," and give Fannie Mae increased rights to revise the eligibility
standards of mortgage insurers. The form the eligibility guidelines ultimately
will take is unknown at this time, but new guidelines, if issued, could have an
adverse effect on the Company.
Triad is an approved mortgage insurer for both Fannie Mae and Freddie Mac
and meets all existing eligibility requirements. There can be no assurance,
however, that such requirements or the interpretation of the requirements will
not change or that Triad will continue to meet such requirements. In addition,
to the extent Fannie Mae or Freddie Mac assumes default risk for itself that
would otherwise be insured, changes current guarantee fee arrangements, allows
alternative credit enhancements, alters or liberalizes underwriting guidelines
on low down payment mortgages it purchases, or otherwise changes its business
practices or processes with respect to such mortgages, private mortgage insurers
may be affected. Triad could be particularly adversely affected if changes in
eligibility requirements regarding captive arrangements that permit premium
cessions greater than 25% were to impede Triad's ability to offer this form of
captive reinsurance.
Fannie Mae and Freddie Mac both accept reduced mortgage insurance coverage
from lenders that deliver loans approved by the their automated underwriting
services, Desktop Underwriter and Loan Prospector, respectively. Generally,
Fannie Mae's and Freddie Mac's reduced mortgage insurance coverage options
provide for: (i) across-the-board reductions in required MI coverage on 30-year
fixed-rate loans recommended for approval by the their automated underwriting
services to the levels in effect in 1994; (ii) reduction in required MI coverage
for loans with only a 5% down payment (a 95% LTV) from 30% to 25% of the
mortgage loan covered by MI; and, (iii) reduction in required MI coverage for
loans with a 10% down payment (a 90% LTV loan) from 25% to 17% of the mortgage
loan covered by MI. In addition, Fannie Mae and Freddie Mac have implemented
other programs that further reduce MI coverage upon the payment of an additional
fee by the lender. Under this option, a 95% LTV loan will require 18% of the
mortgage loan to have mortgage insurance coverage. Similarly, a 90% LTV loan
will require 12% of the mortgage loan to have mortgage insurance. In order for
the homebuyer to have MI at these levels, such loans would require a payment at
closing or a higher note rate.
Certain national mortgage lenders and a large segment of the mortgage
securitization market, including Fannie Mae and Freddie Mac, generally will not
purchase mortgages or mortgage-backed securities unless the private mortgage
insurance on the mortgages has been issued by an insurer with a financial
strength rating of at least "AA-" from S&P or Fitch or a rating of at least
"Aa3" from Moody's. Fannie Mae and Freddie Mac require mortgage guaranty
insurers to maintain two ratings of "AA-" or better. Triad has a financial
strength rating of "AA" from S&P and Fitch and a rating of "Aa3" from Moody's.
S&P, Fitch, and Moody's consider Triad's consolidated operations and financial
35
position in determining the rating. There can be no assurance that Triad's
rating, the method by which this rating is determined, or the eligibility
requirements of Fannie Mae and Freddie Mac will not change.
The Real Estate Settlement and Procedures Act of 1974 ("RESPA") applies to
most residential mortgages insured by Triad, and related regulations provide
that the provision of services involving mortgage insurance is a "settlement
service" for purposes of loans subject to RESPA. Subject to limited exceptions,
RESPA prohibits persons from accepting anything of value for referring real
estate settlement services to any provider of such services. Although many
states prohibit mortgage insurers from giving rebates, RESPA has been
interpreted to cover many non-fee services as well.
Various lawsuits filed in US district court in Augusta, Georgia as well as
other jurisdictions against each of the national mortgage insurers, including
the Company, assert that defendant mortgage insurers have violated RESPA
guidelines by offering pool insurance, captive reinsurance, contract
underwriting, and other services at preferential below market prices as an
illegal inducement to persuade lenders to use those mortgage insurers for
primary insurance coverage. The lawsuits seek class action status. Four mortgage
insurers have entered into settlements of the lawsuits. In August 2000, Triad
filed a motion for summary judgment in the case which was granted on February
13, 2001. The summary judgment was overturned by the 11th Circuit Court of
Appeals in January 2002. In overturning the judgment, the court addressed the
applicability of the McCarron-Ferguson Act (regarding federal preemption of
state law) to the case; it did not address the merits of the case. Triad
subsequently filed a motion opposing class certification which was granted.
Plaintiffs have appealed this decision. Triad believes that its products and
services comply with RESPA as well as all other applicable laws and regulations.
While the ultimate outcome of the RESPA litigation is uncertain, the litigation
is not expected to have a material adverse affect on the financial position of
the Company.
Most originators of mortgage loans are required to collect and report data
relating to a mortgage loan applicant's race, nationality, gender, marital
status, and census tract to HUD or the Federal Reserve under the Home Mortgage
Disclosure Act of 1975 ("HMDA"). The purpose of HMDA is to detect possible
discrimination in home lending and, through disclosure, to discourage such
discrimination. Mortgage insurers are not required pursuant to any law or
regulation to report HMDA data, although under the laws of several states,
mortgage insurers are currently prohibited from discriminating on the basis of
certain classifications. The active mortgage insurers, through their trade
association, the Mortgage Insurance Companies of America ("MICA"), have entered
into an agreement with the Federal Financial Institutions Examinations Council
("FFIEC") to report the same data on loans submitted for insurance as is
required for most mortgage lenders under HMDA.
Upon request by an insured, Triad must cancel the mortgage insurance for a
mortgage loan. Fannie Mae and Freddie Mac guidelines, as well as several
existing and proposed state statutes, contain various provisions which give
borrowers the right to req