UNITED STATES SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

or

Commission File Number 0-22342

Triad Guaranty Inc.

101 South Stratford Road
Winston-Salem, North Carolina 27104
(Address of principal executive offices)

(336) 723-1282
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes [X] No [  ]

Indicate by check mark whether the registrant is an accelerated filer (as described in Exchange Act Rule 12b-2)    Yes [X] No [  ]

Number of shares of Common Stock, $.01 par value, outstanding as of October 15, 2004:
14,548,522 shares.

TRIAD GUARANTY INC.

INDEX

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

TRIAD GUARANTY INC.

See accompanying notes.

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TRIAD GUARANTY INC.

See accompanying notes.

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TRIAD GUARANTY INC.

See accompanying notes.

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TRIAD GUARANTY INC.

NOTE 1 — THE COMPANY

     Triad Guaranty Inc. (the “Company”) is a holding company which, through its wholly owned subsidiary, Triad Guaranty Insurance Corporation, provides residential private mortgage insurance coverage in the United States to mortgage lenders and investors to protect the lender or investor against loss from defaults on low down payment residential mortgage loans and to facilitate the sale of mortgage loans in the secondary market.

NOTE 2 — ACCOUNTING POLICIES AND BASIS OF PRESENTATION

     Basis of Presentation — The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and nine months ended September 30, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004. For further information, refer to the consolidated financial statements and footnotes thereto included in the Triad Guaranty Inc. annual report on Form 10-K for the year ended December 31, 2003.

     Stock Options — Currently, the Company grants stock options to employees for a fixed number of shares with an exercise price equal to or greater than the fair value of the shares at the date of grant. The Company accounts for stock option grants using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and accordingly, recognizes no compensation expense for the stock option grants.

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     For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options’ vesting period. Had compensation expense for stock options been recognized using the fair value method on the grant date, net income and earnings per share on a pro forma basis would have been (in thousands, except for earnings per share information):

NOTE 3 — CONSOLIDATION

     The consolidated financial statements include Triad Guaranty Inc. and its wholly owned subsidiary, Triad Guaranty Insurance Corporation (“Triad”), and Triad’s wholly owned subsidiaries, Triad Guaranty Assurance Corporation and Triad Re Insurance Corporation (collectively referred to as “the Company”). All significant intercompany accounts and transactions have been eliminated.

NOTE 4 — COMMITMENTS AND CONTINGENT LIABILITIES

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

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     Insurance In Force, Dividend Restrictions, and Statutory Results - Insurance regulations generally limit the writing of mortgage guaranty insurance to an aggregate amount of insured risk no greater than 25 times the total of statutory capital and surplus and the statutory contingency reserve. The amount of net risk for insurance in force at September 30, 2004 and December 31, 2003, as presented below, was computed by applying the various percentage settlement options to the insurance in force amounts, adjusted by risk ceded under reinsurance agreements and by applicable stop-loss limits, based on the original insured amount of the loan. Triad’s ratio is as follows (dollars in thousands):

     Triad and its wholly owned subsidiaries are each required under their respective domiciliary states’ insurance code to maintain a minimum level of statutory capital and surplus. Triad, an Illinois domiciled insurer, is required under the Illinois Insurance Code (the “Code”) to maintain minimum statutory capital and surplus of $5 million. The Code permits dividends to be paid only out of earned surplus and also requires prior approval of extraordinary dividends. An extraordinary dividend is any dividend or distribution of cash or other property, the fair value of which, together with that of other dividends or distributions made within a period of twelve consecutive months, exceeds the greater of (a) ten percent of statutory surplus as regards policyholders, or (b) statutory net income for the calendar year preceding the date of the dividend.

     Net income as determined in accordance with statutory accounting practices was $57.9 million and $51.0 million for the nine months ended September 30, 2004 and 2003, respectively, and $69.8 million for the year ended December 31, 2003.

     At September 30, 2004 and December 31, 2003, the amount of Triad’s equity that could be paid out in dividends to stockholders was $47.6 million and $44.5 million, respectively, which was the earned surplus of Triad on a statutory basis on those dates.

     Loss Reserves — The Company establishes loss reserves to provide for the estimated costs of settling claims with respect to loans reported to be in default and loans in default which have not been reported to the Company. Reserves are established by management using estimated claim rates (frequency) and claim amounts (severity) to estimate ultimate losses. The reserving process gives effect to current economic conditions and profiles delinquencies by such factors as policy year, geography, chronic late payment characteristics and age. Due to the inherent uncertainty in estimating reserves for losses and loss adjustment expenses, there can be no assurance that the reserves will prove to be adequate to cover ultimate loss development.

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     Litigation - A lawsuit has been filed against the Company in the ordinary course of the Company’s business alleging violations of the Fair Credit Reporting Act. In the opinion of management, the ultimate resolution of this pending litigation will not have a material adverse effect on the financial position or results of operations of the Company.

     A previous lawsuit filed against the Company alleging violations of the Real Estate Settlement Procedures Act was settled on August 11, 2004 for an immaterial amount.

NOTE 5 — EARNINGS PER SHARE

     Basic and diluted earnings per share are based on the weighted-average daily number of shares outstanding. For diluted earnings per share, the denominator includes the dilutive effect of stock options on the weighted-average shares outstanding. There are no other reconciling items between the denominators used in basic earnings per share and diluted earnings per share. The numerator used in basic earnings per share and diluted earnings per share is the same for all periods presented.

NOTE 6 — COMPREHENSIVE INCOME

     Comprehensive income consists of net income and other comprehensive income. For the Company, other comprehensive income is composed of unrealized gains or losses on available-for-sale securities, net of income tax. For the three months ended September 30, 2004 and 2003, the Company’s comprehensive income was $23.6 million and $8.7 million, respectively. For the nine months ended September 30, 2004 and 2003, comprehensive income totaled $44.7 million and $39.3 million, respectively.

NOTE 7 — INCOME TAXES

     Income tax expense differs from the amounts computed by applying the Federal statutory income tax rate to income before income taxes primarily due to tax-exempt interest that the Company earns from its investments in municipal bonds.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

     Management’s Discussion and Analysis of Financial Condition and Results of Operations analyzes the consolidated financial condition, changes in financial position, and results of operations for the three month and nine month periods ended September 30, 2004 and 2003, of Triad Guaranty Inc. and its consolidated subsidiaries, collectively the Company. The discussion supplements Management’s Discussion and Analysis in Form 10-K for the year ended December 31, 2003 and should be read in conjunction with the interim financial statements and notes contained therein.

     Certain of the statements contained herein, other than statements of historical fact, are forward-looking statements. These statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and include estimates and assumptions related to economic, competitive, and legislative developments. These forward-looking statements are subject to change and uncertainty, which are, in many instances, beyond our control and have been made based upon our expectations and beliefs concerning future developments and their potential effect on us. There can be no assurance that future developments will be in accordance with our expectations or that the effect of future developments on the Company will be those anticipated by us. Actual results could differ materially from those expected by us, depending on the outcome of certain factors, including the possibility of general economic and business conditions that are different than anticipated, legislative or regulatory developments, changes in interest rates or the stock markets, stronger than anticipated competitive activity, and the factors described in the forward-looking statements.

Update on Critical Accounting Estimates

     Our Form 10-K describes the accounting policies that are critical to the understanding of our results of operations and our financial position. These critical accounting policies relate to the assumptions and judgments utilized in establishing the reserve for losses and loss adjustment expenses, determining if declines in fair values of investments are other than temporary, and establishing appropriate initial amortization schedules for deferred policy acquisition costs (“DAC”) and subsequent adjustments to that amortization.

     We believe that these continue to be the critical accounting policies applicable to the Company and that these policies were applied in a consistent manner during the first nine months of 2004.

Overview

     Through our subsidiaries, we provide mortgage guaranty insurance coverage to residential mortgage lenders and investors in the United States as a credit-enhancement vehicle, typically when individual borrowers have less than 20% equity in the property.

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Mortgage guaranty insurance also facilitates the sale of individual low down payment loans in the secondary market and provides protection to lenders who choose to keep the loans. Business originated by lenders and submitted to us on a loan-by-loan basis is referred to as flow business. Premiums on flow business can be either lender paid or borrower paid, although the majority is borrower paid. We also provide mortgage insurance to lenders and investors who seek additional default protection, capital relief, and credit-enhancement on groups of loans that are sold in the secondary market. This business is referred to as structured bulk business.

     We derive our revenues principally from a) initial and renewal earned premiums from flow business (net of reinsurance premiums ceded as part of our risk management strategies), b) initial and renewal earned premiums from structured bulk transactions, and c) investment income on invested assets. We also realize investment gains, net of investment losses, periodically as a source of revenue when the opportunity presents itself within the context of our overall investment strategy.

     Our expenses essentially consist of a) amounts ultimately paid on claims submitted, b) increases in reserves for estimated future claim payments, c) general and administrative costs of acquiring new business and servicing existing policies, d) other general business expenses, and (e) income taxes.

     Our profitability depends largely on a) the adequacy of our product pricing and underwriting discipline relative to the risks insured, b) persistency levels, c) operating efficiencies, and d) the level of investment yield, including realized gains and losses, on our investment portfolio. We define persistency as the percentage of insurance in force remaining from twelve months prior.

     For a more detailed description of our industry and operations, refer to the “Business” section of our Form 10-K.

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Consolidated Results of Operations

     Following is a summary of our results for the three months and nine months ended September 30, 2004 and 2003 (in thousands except per share information) along with a column indicating the favorable or unfavorable change from 2003:

     Our results for the three months and nine months ended September 30, 2004 were again positively impacted by improvements in persistency levels. The quarterly persistency run rate, which we define as the annualized percentage of insurance in force remaining from the end of the prior quarter excluding business written in the current year, was 63.0% for the third quarter of 2004 compared to 19.3% for the third quarter of 2003. Increased persistency affects our net income primarily in two ways: a) renewal earned premiums increase and b) expenses decrease because of reduced amortization of DAC.

     Losses and loss adjustment expenses for the third quarter of 2004 increased 52.6% over the third quarter of 2003 and 54.6% for the nine months ended September 30, 2004 over the same period of 2003, primarily due to the significant growth and continued seasoning of our insurance in force. Low levels of persistency during 2003 and 2002 have resulted in a book of business that is relatively unseasoned. Experience has shown that the highest claims incidence usually occurs three to six years after the policy is written. As our book of business ages, we anticipate this increase in claims to continue, and we expect an increase in the severity of losses as well.

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     We describe our results in greater detail in the discussions that follow. The information is presented in three categories: Production and In Force, Revenues, and Losses and Expenses.

Three Months Ended September 30, 2004 Compared to Three Months Ended September 30, 2003

     Net income increased 17.9% for the third quarter of 2004 over the third quarter of 2003 driven by an 18.1% increase in earned premiums combined with a 31.0% decrease in the amortization of DAC. Realized investment losses after taxes reduced third quarter 2004 income by $0.01 per share on a diluted basis, compared to a contribution from realized investment gains after taxes of $0.03 per share contribution on a diluted basis for the third quarter of 2003. Diluted realized gains and losses per share is a non-GAAP measure. We believe this is relevant and useful information to investors because, except for write-downs on other-than-temporarily impaired securities, it shows the effect that our discretionary sales of investments had on earnings.

Production and In Force

     Total insurance written in the third quarter of 2004 decreased 39.4% to $4.0 billion from $6.6 billion for the same period of 2003. Total insurance written includes insurance written from flow production and structured bulk transactions.

     Flow insurance written for the third quarter of 2004 decreased 46.0% to $2.7 billion from $5.0 billion in the third quarter of 2003. Refinancing activity was very strong during the third quarter of 2003 as interest rates remained near record lows. Refinances comprised 22.0% of our flow insurance written in the third quarter of 2004 compared to 52.3% for the third quarter of 2003. Loan originations for the entire industry have declined in 2004 because of a drop in refinancing activity. Further, the continued expansion of alternative credit enhancements such as 80/10/10 structures (a combination of an 80% first mortgage loan, a 10% second mortgage loan usually issued by the same lender, and a 10% down payment) continues to erode the mortgage insurance industry’s overall penetration into the mortgage marketplace.

     Insurance written in the third quarter of 2004 attributable to structured bulk transactions decreased to $1.3 billion from $1.6 billion in the same period of 2003. Insurance written attributed to structured bulk transactions is likely to vary significantly from period to period due to: a) the limited number of transactions (but with larger size) occurring in this market; b) the level of competition from other mortgage insurers; c) the relative attractiveness in the marketplace of mortgage insurance versus other forms of credit enhancement; and d) the changing loan composition and underwriting criteria of the market.

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     The following table provides estimates of our national market share of net new primary insurance written based on preliminary information available from the industry association and other public sources:

     Our market share of flow business declined slightly in the third quarter of 2004 from the third quarter of 2003 due to the decline in production of a product driven primarily by the refinance segment. The increase in our structured bulk transactions market share shown above was the result of the greater availability of transactions that met our credit quality and pricing benchmarks.

     Periodically we enter into structured bulk transactions involving loans that have insurance effective dates within the current reporting period but for which detailed loan information regarding the insured loans is not provided by the issuer of the transaction until later. When this situation occurs, we accrue premiums that are due but not yet paid based upon the estimated commitment amount of the transaction in the reporting period with respect to each loan’s insurance effective date. However, the policies are not reflected in our in force, insurance written, or related industry data totals until the loan level detail is reported to us. At September 30, 2004, there were $67 million of structured bulk transactions with effective dates within the third quarter for which loan level detail had not been received. These transactions will be reflected as new production and included in related in force data in the fourth quarter of 2004. As of September 30, 2003, there were $1.2 billion of structured bulk transactions for which the loan level detail had not been received. Premium written and premium earned for the third quarter of 2003 include the respective amounts due and earned related to this insurance, while these amounts were reported as new production and insurance in force in the fourth quarter of 2003.

     Total direct insurance in force reached $35.8 billion at September 30, 2004, compared to $31.7 billion at December 31, 2003, and $29.3 billion at September 30, 2003, as a result of continued production and an improvement in persistency.

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     The following table shows our persistency trends since September 30, 2003: