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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549
_______________________

FORM 10-Q


T
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2012

OR


£
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from __________ to __________


Commission file number:  0-22342
_______________________

Triad Guaranty Inc.
(Exact name of registrant as specified in its charter)

Delaware
(State or other jurisdiction of
incorporation or organization)
56-1838519
(I.R.S. Employer Identification No.)
   
101 South Stratford Road
Winston-Salem, North Carolina
(Address of principal executive offices)
 
27104
(Zip Code)


(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 T No £

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes T No £

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer £
Accelerated filer £
Non-accelerated filer £
Smaller reporting company T
   
(Do not check if a smaller reporting company)
 
 
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes £ No T

Number of shares of common stock, par value $0.01 per share, outstanding as of April 30, 2012 was 15,328,128.



 
 

 

TRIAD GUARANTY INC.

INDEX


   
Page
Part I.  Financial Information
 
     
Item 1.
Financial Statements
 
 
Consolidated Balance Sheets as of March 31, 2012 (Unaudited) and December 31, 2011
1
     
 
Consolidated Statements of Comprehensive Loss for the Three Months Ended March 31, 2012 and 2011 (Unaudited)
2
     
 
Consolidated Statements of Cash Flow for the Three Months Ended March 31, 2012 and 2011 (Unaudited)
3
     
 
Notes to Consolidated Financial Statements
4
     
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
20
     
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
47
     
Item 4.
Controls and Procedures
47
     
Part II.  Other Information
 
     
Item 1.
Legal Proceedings
48
     
Item 6.
Exhibits
49
     
SIGNATURE
 
50
     
EXHIBIT INDEX
 
51
 
 
 
 

 
PART I.  FINANCIAL INFORMATION

Item 1.  Financial Statements


TRIAD GUARANTY INC.
 
CONSOLIDATED BALANCE SHEETS
 
   
   
March 31,
   
December 31,
 
 (dollars in thousands, except per share data)
 
2012
   
2011
 
   
(unaudited)
       
ASSETS
           
Invested assets:
           
Securities available-for-sale, at fair value:
           
Fixed maturities (amortized cost:  $712,185 and $721,168)
  $ 740,802     $ 746,238  
Short-term investments
    44,094       30,102  
Total invested assets
    784,896       776,340  
Cash and cash equivalents
    17,355       40,590  
Accrued investment income
    7,222       6,680  
Property and equipment
    921       1,140  
Reinsurance recoverable, net
    19,712       22,988  
Other assets
    45,589       48,489  
Total assets
  $ 875,695     $ 896,227  
                 
LIABILITIES AND STOCKHOLDERS' DEFICIT
               
Liabilities:
               
Losses and loss adjustment expenses
  $ 821,512     $ 854,188  
Unearned premiums
    7,171       6,871  
Deferred payment obligation, including interest
    674,191       629,700  
Accrued expenses and other liabilities
    110,600       109,042  
Total liabilities
    1,613,474       1,599,801  
Commitments and contingencies - Note 4
               
Stockholders' deficit:
               
Preferred stock, par value $0.01 per share --- authorized 1,000,000
               
shares; no shares issued and outstanding
    -       -  
Common stock, par value $0.01 per share --- authorized 32,000,000
               
shares; issued and outstanding 15,328,128 and 15,258,128 shares
    153       153  
Additional paid-in capital
    114,115       114,111  
Accumulated other comprehensive income, net of income tax
               
liability of $16,575
    12,493       8,977  
Accumulated deficit
    (864,540 )     (826,815 )
Deficit in assets
    (737,779 )     (703,574 )
Total liabilities and stockholders' deficit
  $ 875,695     $ 896,227  
 
See accompanying notes.
 
 
 
1

 
 
TRIAD GUARANTY INC.
 
CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
 
(unaudited)
 
   
   
Three Months Ended
 
   
March 31,
 
 (dollars in thousands, except per share data)
 
2012
   
2011
 
             
Revenue:
           
Premiums written:
           
   Direct
  $ 36,149     $ 39,355  
   Ceded
    (1,310 )     (2,060 )
Net premiums written
    34,839       37,295  
Change in unearned premiums
    (302 )     (167 )
Earned premiums
    34,537       37,128  
                 
Net investment income
    6,109       8,491  
Net realized investment gains (losses)
    173       (436 )
Other income
    3       27  
      40,822       45,210  
                 
Losses and expenses:
               
Net losses and loss adjustment expenses
    67,982       41,705  
Interest expense on the deferred payment obligation
    4,981       3,978  
Other operating expenses
    5,584       4,437  
      78,547       50,120  
Loss before income taxes
    (37,725 )     (4,910 )
Income taxes
    -       -  
Net loss
  $ (37,725 )   $ (4,910 )
                 
Other comprehensive income (loss), net of tax:
               
Change in unrealized gains on investments
  $ 3,516     $ (2,646 )
Comprehensive loss
  $ (34,209 )   $ (7,556 )
                 
Loss per common and common equivalent share:
               
Diluted loss per share
  $ (2.47 )   $ (0.32 )
                 
Shares used in computing loss per common and common equivalent share:
               
Diluted
    15,258,128       15,224,684  

See accompanying notes.

 
2

 

TRIAD GUARANTY INC.
 
CONSOLIDATED STATEMENTS OF CASH FLOW
 
(unaudited)
 
   
   
Three Months Ended
 
   
March 31,
 
 (dollars in thousands)
 
2012
   
2011
 
             
Operating activities
           
Net loss
  $ (37,725 )   $ (4,910 )
Adjustments to reconcile net loss to net cash used in operating activities:
               
Losses, loss adjustment expenses and unearned premium reserves
    (32,376 )     (69,379 )
Accrued expenses and other liabilities
    1,558       616  
Deferred payment obligation, including accrued interest
    44,491       48,685  
Income taxes recoverable
    -       11,707  
Reinsurance, net
    3,276       7,307  
Accrued investment income
    (542 )     (79 )
Net realized investment (gains) losses
    (173 )     436  
Provision for depreciation
    219       268  
Discount accretion on investments
    920       467  
Other assets
    2,641       (162 )
Other operating activities
    4       18  
Net cash used in operating activities
    (17,707 )     (5,026 )
                 
Investing activities
               
Securities available-for-sale:
               
Purchases – fixed maturities
    (19,837 )     (27,539 )
Sales – fixed maturities
    8,481       4,942  
Maturities – fixed maturities
    19,581       21,572  
Other investment activity
    217       (730 )
Sales (purchases) of short-term investments
    (13,970 )     7,092  
Net cash (used in) provided by investing activities
    (5,528 )     5,337  
                 
Net change in cash and cash equivalents
    (23,235 )     311  
Cash and cash equivalents at beginning of period
    40,590       38,762  
Cash and cash equivalents at end of period
  $ 17,355     $ 39,073  
                 
Supplemental schedule of cash flow information
               
Cash (received) paid during the period for:
               
Income taxes
  $ -     $ (11,707 )
Interest
  $ -     $ -  
 
See accompanying notes.
 
 
 
3

 
 
TRIAD GUARANTY INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2012
(Unaudited)

1.  The Company

Triad Guaranty Inc. (“TGI”) is a holding company which, through its wholly-owned subsidiary, Triad Guaranty Insurance Corporation (“TGIC”), is a nationwide mortgage guaranty insurer pursuing a run-off of its existing in-force book of business.  Mortgage insurance allows buyers to achieve homeownership with a reduced down payment, facilitates the sale of mortgage loans in the secondary market, and protects lenders from credit default-related expenses. The term “run-off” as used in these financial statements means continuing to service existing mortgage guaranty insurance policies but not writing any new policies.

Unless the context requires otherwise, references to “Triad” in this Quarterly Report on Form 10-Q refer to the operations of TGIC and its wholly-owned subsidiary, Triad Guaranty Assurance Corporation (“TGAC”).  References to the “Company” refer collectively to the operations of TGI and Triad.

TGIC is an Illinois-domiciled mortgage guaranty insurance company and TGAC is an Illinois-domiciled mortgage guaranty reinsurance company. The Illinois Department of Insurance (the “Insurance Department”) is the primary regulator of both TGIC and TGAC.  The Illinois Insurance Code grants broad powers to the Insurance Department and its director (collectively, the “Department”) to enforce rules or exercise discretion over almost all significant aspects of Triad’s insurance business.

Triad ceased issuing new commitments for mortgage guaranty insurance coverage in 2008 and is operating its business in run-off under two Corrective Orders issued by the Department, as discussed in “Corrective Orders” below. The first Corrective Order was issued in 2008.  The second Corrective Order was issued in 2009.  Servicing existing policies during run-off includes:

 
·
billing and collecting premiums on policies that remain in force;
 
·
working with borrowers in default to remedy the default and/or mitigate losses;
 
·
reviewing policies for the existence of misrepresentation, fraud or non-compliance with stated programs; and
 
·
settling all legitimate filed claims per the provisions of the policies and the two Corrective Orders issued by the Department.

The term “settled,” as used in these financial statements in the context of the payment of a claim, refers to the satisfaction of Triad’s obligations following the submission of valid claims by its policyholders.  Prior to June 2009, valid claims were settled solely by a cash payment.  As required by the second Corrective Order, effective on and after June 1, 2009, valid claims are settled by a combination of 60% in cash and 40% in the form of a deferred payment obligation (“DPO”).  The Corrective Orders, among other things, allow management to continue to operate Triad under the close supervision of the Department, include restrictions on the distribution of dividends or interest on notes payable to TGI by Triad, and include certain requirements on the payment of claims.  Failure to comply with the provisions of the Corrective Orders could result in the imposition of fines or penalties or subject Triad to further legal proceedings, including receivership proceedings for the conservation, rehabilitation, or liquidation of Triad.

 
4

 
TGI is the public company whose stock is traded on the OTC Bulletin Board (“OTCBB”) and the OTC Markets Group’s OTCQB tier (“Pink Sheets”) under the symbol “TGIC”. TGI owns TGIC, which is its only operating subsidiary. Aside from its ownership of TGIC, TGI’s assets amount to approximately $1.3 million, which consist primarily of cash holdings. The remainder of the $875.7 million of assets reported on the Consolidated Balance Sheets presented in this Form 10-Q are the assets of Triad. Triad is prohibited from paying dividends or distributing assets to TGI without the approval of the Department. The Company believes that, absent significant positive changes in the economy and the residential real estate market, the existing assets combined with the future premiums of Triad likely will not be sufficient to meet Triad’s current and future policyholder obligations and, therefore, none of Triad’s assets would be available to TGI and its stockholders other than to reimburse certain TGI expenses incurred on behalf of TGIC. Therefore, the ultimate value of TGI will be determined by its cash holdings less any future expenses not reimbursed by Triad.  TGI is exploring strategies to acquire profitable, growing businesses and leverage its insurance industry knowledge, management expertise, and Net Operating Loss (“NOL”) carryforwards that were generated on a consolidated basis with Triad in order to increase its value for the benefit of its stockholders. No assurance can be given that TGI will be able to successfully implement such a strategy, or, if implemented, to increase its stockholder value.

Accounting Principles

The Company prepares its financial statements presented in this Quarterly Report on Form 10-Q in conformity with accounting principles generally accepted in the United States of America (“GAAP”).  The financial statements for Triad that are provided to the Department are prepared in accordance with Statutory Accounting Principles (“SAP”) as set forth in the Illinois Insurance Code or prescribed by the Department.  The primary difference between GAAP and SAP for Triad at March 31, 2012 was the reporting requirements relating to the DPOs stipulated in the second Corrective Order.

A deficit in assets occurs when recorded liabilities exceed recorded assets in financial statements prepared under GAAP.  A deficiency in policyholders’ surplus occurs when recorded liabilities exceed recorded assets in financial statements prepared under SAP.  A deficit in assets at any particular point in time under GAAP is not necessarily a measure of insolvency.  However, the Company believes that if Triad were to report a deficiency in policyholders’ surplus under SAP for an extended period of time, Illinois law may require the Department to seek receivership of Triad, which could compel TGI to institute a proceeding seeking relief from creditors under U.S. bankruptcy laws, or otherwise consider dissolution of the Company.  The second Corrective Order was designed in part to help Triad maintain its policyholders’ surplus.

2.  Going Concern

The Company has prepared its financial statements on a going concern basis under GAAP, which contemplates the realization of assets and the satisfaction of liabilities and commitments in the normal course of business.  However, there is substantial doubt as to the Company's ability to continue as a going concern.  This uncertainty is based on, among other things, the possible failure of Triad to comply with the provisions of the Corrective Orders and the Company's ability to generate enough income over the term of the remaining run-off to overcome its $737.8 million deficit in assets at March 31, 2012.

 
5

 
The positive impact on statutory surplus resulting from the second Corrective Order has resulted in Triad reporting a policyholders’ surplus in its SAP financial statements of $228.9 million at March 31, 2012, as opposed to a deficiency in policyholders’ surplus of $770.3 million on the same date had the second Corrective Order not been implemented.  While the implementation of the second Corrective Order has deferred the institution of an involuntary receivership proceeding, no assurance can be given that the Department will not seek receivership of Triad in the future and there continues to be substantial doubt about the Company’s ability to continue as a going concern.  The Department may seek receivership of Triad based on its determination that Triad will ultimately become insolvent, if Triad fails to comply with provisions of the Corrective Orders, or for other reasons.  If the Department seeks receivership of Triad, TGI could be compelled to institute a proceeding seeking relief from creditors under U.S. bankruptcy laws, or otherwise consider dissolution of the Company.  The consolidated financial statements that are presented in this report do not include any accounting adjustments that reflect the financial risks of Triad entering receivership proceedings or otherwise not continuing as a going concern.  See Item 1A, “Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011 for more information about our financial solvency and going concern risks and uncertainties.

3.  Accounting Policies and Basis of Presentation

Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared in conformity with GAAP for interim financial information and with the instructions to Form 10-Q and Article 8 of Regulation S-X.  Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements.  In the opinion of management, all adjustments considered necessary for a fair presentation have been included.  Operating results for the three months ended March 31, 2012 are not necessarily indicative of the results that may be expected for the year ending December 31, 2012 or subsequent periods.  For further information, refer to the consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011.

Consolidation

The consolidated financial statements include the accounts of TGI and its wholly owned subsidiary, TGIC, including TGIC’s wholly-owned subsidiary, TGAC.  All significant intercompany accounts and transactions have been eliminated.

Corrective Orders and Regulation

Triad has entered into two Corrective Orders with the Department as detailed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011. Among other things, the Corrective Orders:

 
·
Require the oversight of the Department on substantially all operating matters;
 
·
Prohibit stockholder dividends from Triad to TGI without the prior approval of the Department;
 
·
Prohibit the accrual of interest and the payment of interest and principal on Triad’s surplus note to TGI without the prior approval of the Department;
 
·
Restrict Triad from making any payments or entering into any transaction that involves the transfer of assets to, or liabilities from, any affiliated parties without the prior approval of the Department;
 
·
Require Triad to obtain prior written approval from the Department before entering into certain transactions with unaffiliated parties;
 
·
Require that all valid claims under Triad’s mortgage guaranty insurance policies are settled 60% in cash and 40% by recording a DPO;
 
·
Require the accrual of simple interest on the DPO at the same average net rate earned by Triad’s investment portfolio; and
 
·
Require that loss reserves in financial statements prepared in accordance with SAP be established to reflect the cash portion of the estimated claim settlement but not the DPO.
 
 
 
6

 
The DPO is an interest-bearing subordinated obligation of Triad with no stated repayment terms. The requirement to settle claims with both the payment of cash and recording of a DPO became effective in June 2009.  The second Corrective Order requires that Triad hold assets to support the DPO liability in a separate account pursuant to a custodial arrangement. At March 31, 2012, the recorded DPO, including accrued interest of $35.6 million, amounted to $674.2 million or 86% of total invested assets. Triad is currently in discussions with the Department regarding a possible amendment to the second Corrective Order that would require the escrow of DPOs and accrued carrying charges only if requested by the Director and would limit the amount of carrying charges credited to the DPO holders to the amount of net investment income earned by Triad.

The recording of a DPO does not impact reported settled losses as the Company continues to report the entire amount of a claim in its statements of comprehensive loss.  The accounting treatment for the recording of DPOs on Triad’s balance sheet on a SAP basis is similar to a surplus note that is reported as a component of statutory surplus which serves to increase reported statutory surplus.  However, in the Company’s financial statements prepared in accordance with GAAP included in this report, the DPOs and related accrued interest are reported as a liability.  At March 31, 2012, the cumulative effect of the DPO requirement on statutory policyholders’ surplus, including the impact of establishing loss reserves at anticipated cash payment rather than the estimated full claim amount, was to increase statutory policyholders’ surplus by $999.2 million over the amount that would have been reported absent the second Corrective Order. The cumulative increase to statutory policyholders’ surplus as a result of the DPO requirement was $967.5 million at December 31, 2011. There was no such impact to loss reserves or stockholders’ deficit calculated on a GAAP basis, which is the primary reason for the reported deficit in assets. Any repayment of the DPO or the associated accrued interest is dependent on the financial condition and future prospects of Triad and is subject to the approval of the Department.

The second Corrective Order provides financial thresholds, specifically regarding the statutory risk-to-capital ratio and the level of statutory policyholders’ surplus that, if met, may indicate that the Department should reduce the DPO percentage and/or require distributions to DPO holders.  In January 2012, the Department notified Triad that as of December 31, 2011, based upon Triad’s surplus position, risk-to-capital ratio and the continued economic uncertainty, the Department had determined that no change to the DPO percentage was in order nor would it be appropriate for Triad to make a distribution to the DPO holders.

Failure to comply with the provisions of the Corrective Orders or any other violation of the Illinois Insurance Code may result in the imposition of fines or penalties or subject Triad to further legal proceedings, including the institution by the Department of receivership proceedings for the conservation, rehabilitation or liquidation of Triad.  Any such actions would likely lead TGI to institute a proceeding seeking relief from creditors under U.S. bankruptcy laws or otherwise consider dissolution of the Company. See Item 1A, “Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011 for more information.

Triad is also subject to comprehensive regulation by the insurance departments of the various other states in which it is licensed to transact business. The insurance departments of the other states have been working with the Department in the administration and oversight of the Corrective Orders.

 
7

 
Insurance regulations generally limit the writing of mortgage guaranty insurance to an aggregate amount of insured risk no greater than twenty-five times the total of statutory capital, which is defined as the statutory surplus plus the statutory contingency reserve. The Corrective Orders under which Triad is currently operating specifically prohibit the writing of new insurance by Triad.  While the risk-to-capital ratio of Triad has benefitted from the DPO requirements of the Corrective Orders, it remains greater than the 25-to-1 regulatory guideline.  Even if Triad’s risk-to-capital ratio were to be reduced to 25-to-1 or lower as a result of the second Corrective Order, Triad would continue to be prohibited by the Department from issuing new commitments for insurance.

Reinsurance

Prior to entering into run-off, the Company entered into various captive reinsurance agreements that were designed to allow lenders to share in the risks of mortgage insurance. All of the captive reinsurance agreements include, among other things, minimum capital requirements and require a trust be established to partially support the reinsurer’s obligations under the agreement. Reinsurance agreements do not relieve the Company from its obligations to policyholders. Failure of the reinsurer to honor its obligation in excess of the minimum capital level required by the reinsurance agreement could result in losses to the Company; consequently, allowances are established for amounts deemed uncollectible from the captive reinsurance company. At March 31, 2012, reinsurance recoverable on loss reserves from captive reinsurers was approximately $18.7 million and captive reinsurance trust balances were $37.7 million. At March 31, 2012, approximately $1.2 million of reinsurance recoverable on loss reserves exceeded the available trust balance for which no benefit was recognized in our financial statements.

Loss Reserves

The Company establishes loss reserves to provide for the estimated costs of settling claims on loans reported in default and estimates on loans in default that are in the process of being reported to the Company as of the date of the financial statements.  Consistent with industry accounting practices, the Company does not establish loss reserves for future claims on insured loans that are not currently in default.  Loss reserves are established by management using historical experience and by making various assumptions and judgments about claim rates (frequency) and claim amounts (severity) to estimate ultimate losses to be paid on loans in default.  The Company’s reserving methodology gives effect to current economic conditions and profiles delinquencies by such factors as, among others, default status, policy year, and the number of mortgage payments missed, as well as the combined loan-to-value (“LTV”) ratio.  The Company also incorporates in the calculation of loss reserves the probability that a policy may be rescinded for underwriting violations.

A number of factors can impact the actual frequency and severity realized during the year compared to those utilized in the reserve assumptions at the beginning of the year including: changes in home prices at a faster rate than anticipated; the unanticipated impact of loan modification programs on cure rates; the impact of a higher or lower unemployment rate than anticipated; an unanticipated slowdown or acceleration of the overall economy; or social and cultural changes that are more accepting of mortgage defaults even when the borrower has the ability to pay.  Changes in the actual rescission rate compared to the rate utilized in the reserve assumptions can also impact the frequency factor.

 
8

 
Rescissions are a key component in determining the level of estimated loss reserves and ultimately the level of paid claims. During 2011 and 2010, the Company rescinded coverage on policies with risk in force of $371 million and $714 million, respectively.  During the first quarter of 2012, the Company rescinded coverage on policies with risk in force of $85 million compared with $151 million in the comparable prior year period. Furthermore, the rescission factor utilized in the calculation of our loss reserves resulted in a reduction to our gross reserves of $181.6 million at March 31, 2012 compared to $205.7 million at December 31, 2011. Any change to the actual rescission rate compared to those utilized in the reserve methodology can have a material impact on the Company’s financial condition. Such changes may come about for a number of reasons including legal determinations and agreements regarding Triad’s ability to rescind coverage.  See Note 4, “Litigation” in this Form 10-Q and Item 1A, “Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011 for more information.

The assumptions utilized in the calculation of the loss reserve estimate are continually reviewed and adjusted as necessary.  Such adjustments are reflected in the financial statements in the periods in which the adjustments are made.

The estimation of loss reserves requires assumptions as to future events, and there are inherent risks and uncertainties involved in making these assumptions. 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.

Recent Accounting Pronouncements

Changes to GAAP are established by the Financial Accounting Standards Board (“FASB”) in the form of an Accounting Standards Update (“ASU”) to the FASB’s Accounting Standards Codification (“ASC”).  The Company considers the applicability and impact of all ASUs.  ASUs not listed below were assessed and determined to be either not applicable or are expected to have minimal impact on the Company’s financial statements.

In May 2011, the FASB, together with the International Accounting Standards Board (“IASB”), jointly issued ASU No. 2011-04, Fair Value Measurement (Topic 820):  Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS (“ASU 2011-04”).  The adoption of ASU 2011-04 gives fair value the same meaning between GAAP and International Financial Reporting Standards (“IFRS”), and improves consistency of disclosures relating to fair value.  The Company adopted the provisions of ASU 2011-04 effective January 1, 2012 and included the required disclosures in these financial statements.  The adoption of this statement did not have a material impact on the financial statements.

In December 2011, the FASB issued ASU No. 2011-12, Comprehensive Income (Topic 220):  Deferral of the Effective Date for Amendments to the Presentation of Reclassification of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05 (“ASU 2011-12”), which defers the effective date required to comply with reclassification adjustments out of accumulated other comprehensive income found in ASU 2011-05.  The delay will allow the Board time to re-deliberate whether to require the presentation, on the face of the financial statements, of the effects of reclassifications out of accumulated other comprehensive income.  All other requirements in ASU 2011-05 are not affected by ASU 2011-12.  The Company does not expect the adoption of ASU 2011-12 to have a material impact on its financial statements.
 
 
9

 
4.  Litigation

The Company is involved in litigation and other legal proceedings in the ordinary course of business as well as the matters identified below.  No reserves have been established in the financial statements regarding current litigation as the potential liabilities, if any, are not probable or cannot be reasonably estimated.

On February 6, 2009, James L. Phillips served a complaint alleging violations of federal securities laws against TGI and two of its officers in the United States District Court, Middle District of North Carolina on behalf of a purported class of persons who acquired the common stock of the Company between October 26, 2006 and April 1, 2008.  TGI filed its motion to dismiss the amended complaint on August 21, 2009 and on January 27, 2012 the Magistrate Judge recommended that TGI’s motion to dismiss be granted.  The plaintiff filed an amended complaint on March 30, 2012. TGI intends to vigorously defend this matter.

On September 4, 2009, Triad filed a complaint against American Home Mortgage (“AHM”) in the United States Bankruptcy Court for the District of Delaware seeking rescission of multiple master mortgage guaranty insurance policies (“master policies”) and declaratory relief. The complaint seeks relief from AHM as well as all owners of loans insured under the master policies by way of a defendant class action. Triad alleged that AHM failed to follow the delegated insurance underwriting guidelines approved by Triad, that this failure breached the master policies as well as the implied covenants of good faith and fair dealing, and that these breaches were so substantial and fundamental that the intent of the master policies could not be fulfilled and Triad should be excused from its obligations under the master policies. Three groups of current owners and/or servicers of AHM-originated loans filed motions to intervene in the lawsuit, which were granted by the Court on May 10 and October 29, 2010. On March 4, 2011, Triad amended its complaint to add a count alleging fraud in the inducement. On March 25, 2011, each of the interveners filed a motion to dismiss. Triad filed its answer and answering brief in opposition to the motions to dismiss on May 27, 2011 and the interveners filed their reply briefs on July 13, 2011. The total amount of risk originated under the AHM master policies, accounting for any applicable stop-loss limits associated with Modified Pool contracts and less risk originated on policies that have been subsequently rescinded, was $1.3 billion, of which $0.7 billion remained in force at March 31, 2012. Triad continues to accept premiums and process claims under the master policies, with the earned premiums and settled losses reflected in the Consolidated Statements of Comprehensive Loss.  However, as a result of the litigation, Triad ceased remitting claim payments to companies servicing loans originated by AHM and the liability for losses settled but not paid is included in “Accrued expenses and other liabilities” on the Consolidated Balance Sheets. Triad has not recognized any benefit in its financial statements pending the outcome of the litigation.

On March 5, 2010, Countrywide Home Loans, Inc. filed a lawsuit in the Los Angeles County Superior Court of the State of California alleging breach of contract and seeking a declaratory judgment that bulk rescissions of flow loans is improper and that Triad is improperly rescinding loans under the terms of its master policies. On May 10, 2010 the case was designated as complex and transferred to the Court’s Complex Litigation Program. Non-binding mediation occurred on July 22, 2011 with a follow-up mediation session on October 13, 2011. The parties are in discussions to settle this matter. In the event that a settlement is not successfully concluded, Triad intends to vigorously defend this matter.

 
10

 
On December 19, 2011, January 17, 2012, and April 12, 2012, complaints were served against TGIC in the United States District Court, Central District of California, United States District Court, Eastern District of Pennsylvania, and United States District Court, Eastern District of Pennsylvania, respectively. The plaintiffs purport to represent a class of persons whose loans were insured by a mortgage guaranty insurance policy and reinsured through a captive reinsurer. The complaints allege that such reinsurance is in violation of the Real Estate Settlement Procedures Act. In each case, the lender, captive reinsurer, and various mortgage guaranty insurers were sued. Triad did not provide mortgage guaranty insurance on the named plaintiffs’ loans in any of these lawsuits. Triad intends to vigorously defend these matters. The cases have been stayed at the request of the plaintiff pending the outcome of another case pending before the U.S. Supreme Court.

The Consumer Financial Protection Bureau (“CFPB”) issued a letter to Triad Guaranty Inc. on January 3, 2012, advising TGI that it was investigating premium ceding practices by mortgage insurers, lenders, and their captive reinsurers and requested certain information from Triad. Triad is cooperating with the CFPB in its investigation.

5.  Investments

All fixed maturity securities are classified as “available-for-sale” and are carried at fair value.   Unrealized gains on available-for-sale securities, net of tax, are reported as a separate component of accumulated other comprehensive income in shareholders’ equity. Due to the Company operating in run-off under the supervision by the Department and the uncertainty surrounding the Company’s ability to continue as a going concern, the Company is no longer in a position to retain a security that is in an unrealized loss position, even on a temporary basis, until it potentially recovers value. Accordingly, the Company recognizes an other than temporary impairment loss on all securities for which the fair value is less than the amortized cost at the balance sheet date. Impairment losses are recognized as realized investment losses in the Consolidated Statements of Comprehensive Loss. If the Company believes that the recorded impairment was due to reasons other than credit related, the difference between the impaired value and principal amount will be amortized as a component of interest income through the anticipated maturity date. The amortized cost, gross unrealized gains and losses and fair value of available-for-sale securities as of March 31, 2012 and December 31, 2011 were as follows:


   
As of March 31, 2012
 
(dollars in thousands)
 
Cost or
Amortized
Cost
   
Gross
Unrealized
Gains
   
Gross
Unrealized
Losses
   
Fair
Value
 
             
 Fixed maturity securities:
                       
 U. S. government and agency securities
  $ 13,623     $ 257     $ -     $ 13,880  
 Foreign government securities
    9,586       501       -       10,087  
 Corporate debt
    499,289       20,350       -       519,639  
 Residential mortgage-backed
    22,492       1,428       -       23,920  
 Commercial mortgage-backed
    30,376       375       -       30,751  
 Asset-backed
    75,908       739       -       76,647  
 State and municipal bonds
    60,911       4,967       -       65,878  
 Total fixed maturities
    712,185       28,617       -       740,802  
 Short-term investments
    44,069       25       -       44,094  
 Total securities
  $ 756,254     $ 28,642     $ -     $ 784,896  


 
11

 

   
As of December 31, 2011
 
(dollars in thousands)
 
Cost or
Amortized
Cost
   
Gross
Unrealized
Gains
   
Gross
Unrealized
Losses
   
Fair
Value
 
             
 Fixed maturity securities:
                       
 U. S. government and agency securities
  $ 13,662     $ 341     $ -     $ 14,003  
 Foreign government securities
    9,585       439       -       10,024  
 Corporate debt
    498,919       16,708       -       515,627  
 Residential mortgage-backed
    28,036       1,280       -       29,316  
 Commercial mortgage-backed
    31,184       374       -       31,558  
 Asset-backed
    76,006       730       -       76,736  
 State and municipal bonds
    63,776       5,198       -       68,974  
 Total fixed maturities
    721,168       25,070       -       746,238  
 Short-term investments
    30,099       3       -       30,102  
 Total securities
  $ 751,267     $ 25,073     $ -     $ 776,340  


Unrealized gains do not necessarily represent future gains that the Company will realize.  The value of the Company’s investment portfolio will vary depending on overall market interest rates, credit spreads, and changing conditions related to specific securities, as well as other factors. Volatility may increase in periods of uncertain market or economic conditions. Unrealized gains at both March 31, 2012 and December 31, 2011 were due primarily to a decline in interest rates from those at the time of initial purchase, although the recovery in value of previously impaired fixed maturity securities also contributed to the level of unrealized gains. The increase in unrealized gains during the first quarter of 2012 was largely due to a tightening of credit spreads.

The amortized cost and estimated fair value of fixed maturity available-for-sale securities at March 31, 2012 are summarized by stated maturity below. Asset-backed, commercial mortgage-backed, and residential mortgage-backed securities are presented separately below because they generally provide for periodic payments of principal.


   
Available-for-Sale
 
(dollars in thousands)
 
Amortized
Cost
   
Fair
Value
 
             
 Maturity:
           
 One year or less
  $ 99,619     $ 100,460  
 After one year through five years
    429,029       447,560  
 After five years through ten years
    33,167       36,376  
 After ten years
    21,594       25,088  
      583,409       609,484  
 Assets with periodic principal payments:
               
 Asset-backed securities
    75,908       76,647  
 Commercial mortgage-backed securities
    30,376       30,751  
 Residential mortgage-backed securities
    22,492       23,920  
 Total
  $ 712,185     $ 740,802  


Actual and expected maturity for certain securities may differ from stated maturity due to call and prepayment provisions.

 
12

 
Realized Gains (Losses) Related to Investments

The details of net realized investment gains (losses) are as follows:


   
Three Months Ended
 
   
March 31,
 
(dollars in thousands)
 
2012
   
2011
 
             
 Securities available-for-sale:
           
 Fixed maturity securities:
           
 Gross realized gains
  $ 222     $ 429  
 Gross realized losses
    (49 )     (865 )
 Net realized gains (losses)
  $ 173     $ (436 )


Gross realized losses in the first quarter of both 2012 and 2011 were primarily attributable to the other-than-temporary write downs of securities whose market value was less than the respective cost basis.

6.  Fair Value Measurement

Fair Value of Financial Instruments

The carrying values and fair values of financial instruments as of March 31, 2012 and December 31, 2011 are summarized below:


   
March 31, 2012
   
December 31, 2011
 
(dollars in thousands)
 
Carrying
Value
   
Fair
Value
   
Carrying
Value
   
Fair
Value
 
                         
 Financial Assets
                       
 Fixed maturity securities available-for-sale
  $ 740,802     $ 740,802     $ 746,238     $ 746,238  
 Short-term investments
    44,094       44,094       30,102       30,102  


Valuation Methodologies and Associated Inputs

The Company utilizes the provisions of ASC 820 as amended by ASU 2010-06 in its estimation and disclosures about fair value of financial assets.  There are no liabilities as of March 31, 2012 or December 31, 2011 that meet the criteria of a financial instrument. ASC 820 establishes a fair value hierarchy that prioritizes the inputs to valuation methods used to measure fair value.  The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements).  The three levels of the fair value hierarchy under ASC 820 are as follows:

 
Level 1:
Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets.
 
 
Level 2:
Quoted prices for similar assets in active markets or for identical or similar assets in inactive markets.  Alternatively, quoted prices may be based on models where the significant inputs are observable or can be supported by observable market data.
 
 
Level 3:
Prices or valuation techniques where one or more of the significant inputs are unobservable (i.e., supported with little or no market activity). This includes broker quotes which are non-binding.
 

 
13

 
An asset’s or a liability’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.  An asset’s or a liability’s level within the fair value hierarchy as well as transfers in and out of Level 3 are determined at the end of the reporting period.  At March 31, 2012, approximately 0.1% of the Company’s invested assets were Level 3 securities.

The Company utilizes independent pricing services in the valuation of its invested assets. The independent pricing services primarily use generic models which use standard inputs including benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, market bids/offers, and other reference data. Market indicators as well as industry and economic events are also monitored.

The Company utilizes its investment advisor to assist in determining if the pricing methodologies of the independent pricing services comply with ASC 820-10. Working under the Company’s supervision, the investment advisor reviews the pricing techniques of the independent pricing services and has controls in place to ensure quality including, but not limited to:

 
·
reviewing price tolerance reports for month-over-month price changes that exceed certain thresholds;
 
·
reviewing evaluation dates for stale prices;
 
·
comparing with alternative pricing sources;
 
·
comparing with trade activity; and
 
·
comparing to a benchmarked price.

Based upon this review, prices submitted by the independent pricing services may be challenged and replaced if appropriate.

The investment advisor will obtain a price for any individual security not priced by the independent pricing services or for any individual security whose price is replaced as a result of the quality control review. The investment advisor seeks pricing from a variety of sources including external brokers, index pricing, internal sources of the investment advisor, and spread matrixes, among others. For broker-quoted only securities, quotes from market makers or broker-dealers are obtained from sources recognized to be market participants. For those securities trading in less liquid or illiquid markets with limited or no pricing information, unobservable inputs are used in order to measure the fair value of these securities. In cases where this information is not available, such as for privately placed securities, fair value is estimated using an internal pricing matrix. This matrix relies on judgment concerning the discount rate used in calculating expected future cash flows, credit quality, industry sector performance, and expected maturity. The following is a description of the valuation methodologies used in determining the fair value of the Company’s assets.

Fixed maturities

U.S. Government and agency securities – U.S. Government and agency securities include U.S. Treasury securities, agency/government sponsored entity (“GSE”) issues, and corporate government-backed obligations issued under the Temporary Liquidity Guarantee Program. The fair value for U.S. Treasury securities is based on regularly updated quotes from active market makers and brokers. The fair value for agency and other government-backed obligations is based on regularly updated dealer quotes, secondary trading levels, and the new issue market.  U.S. Government and agency securities are categorized as Level 2.

 
14

 
Foreign Government securities – The fair value of Foreign Government securities is based on discounted cash flow models incorporating observable option-adjusted spread features where necessary.  Foreign Government securities are categorized as Level 2.

Corporate debt – The fair value for corporate debt is based on regularly updated dealer quotes, secondary trading, and the new issue market incorporating observable option-adjusted spread features where necessary.  Corporate debt is categorized as Level 2.

Residential mortgage-backed securities – Residential mortgage-backed securities include securities issued by the GSEs and the Government National Mortgage Association (GNMA), as well as private-label securities. The fair value of residential mortgage-backed securities is based on prices of similar securities and discounted cash flow analysis incorporating prepayment and default assumptions.  Residential mortgage-backed securities are categorized as Level 2.

Commercial mortgage-backed securities – The fair value of commercial mortgage-backed securities is based on prices of similar securities and discounted cash flow analysis incorporating prepayment and default assumptions.  Commercial mortgage-backed securities are categorized as Level 2.

Asset-backed securities – The fair value of asset-backed securities is based on prices of similar securities and discounted cash flow analysis incorporating prepayment and default assumptions. Asset-backed securities are generally categorized as Level 2. For certain securities, if cash flow or other security structure or market information is not available, the fair value may be based on broker quotes or benchmarked to an index.  In such instances, these asset-backed securities are generally categorized as Level 3.

State and municipal bonds – The fair value for state and municipal bonds is based on regularly updated trades, bid-wanted lists, and offerings from active market makers and brokers. Evaluations incorporate current market conditions, trading spreads, spread relationships and the slope of the yield curve, among others. Information is applied to bond sectors and individual bond evaluations are extrapolated.  Evaluation for distressed or non-performing bonds may be based on liquidation value or restructuring value.  State and municipal bonds are categorized as Level 2.

Short-term investments

Money market instruments – The fair value is based on unadjusted quoted prices that are readily and regularly available in active markets.  Money market instruments are categorized as Level 1.

Other short-term instruments – Other short-term instruments primarily include discounted and coupon bearing commercial paper as well as corporate securities purchased with maturity less than twelve months at time of purchase. Short term investments are carried at amortized cost which approximates fair market value or at fair market value utilizing regularly updated dealer or secondary trading quotes. Other short-term instruments are categorized as Level 2.

 
15

 
Fair Value of Investments

The Company did not have any material assets measured at fair value on a non-recurring basis as of March 31, 2012 or at December 31, 2011. The following table summarizes the assets measured at fair value on a recurring basis and the source of the inputs in the determination of fair value as of March 31, 2012 and December 31, 2011:


         
Fair Value at Reporting Date Using
 
(dollars in thousands)
 
March 31,
2012
   
Quoted Prices in Active Markets for Identical Assets
 (Level 1)
   
Significant
Other
Observable
Inputs
(Level 2)
   
Significant Unobservable Inputs
(Level 3)
 
             
 Assets
                       
 Securities available-for-sale:
                       
 Fixed maturities:
                       
 U. S. government and agency securities
  $ 13,880     $ -     $ 13,880     $ -  
 Foreign government securities
    10,087       -       10,087       -  
 Corporate debt
    519,639       -       519,639       -  
 Residential mortgage-backed
    23,920       -       23,920       -  
 Commercial mortgage-backed
    30,751       -       30,751       -  
 Asset-backed
    76,647       -       76,280       367  
 State and municipal bonds
    65,878       -       65,878       -  
Total fixed maturities
    740,802       -       740,435       367  
 Short-term investments:
                               
 Money market instruments
    18,075       18,075       -       -  
 Other
    26,019       -       26,019       -  
 Total
  $ 784,896     $ 18,075     $ 766,454     $ 367  



         
Fair Value at Reporting Date Using
 
(dollars in thousands)
 
December 31,
2011
   
Quoted Prices in Active Markets for Identical Assets
 (Level 1)
   
Significant
Other
Observable
Inputs
(Level 2)
   
Significant Unobservable Inputs
(Level 3)
 
             
 Assets
                       
 Securities available-for-sale:
                       
 Fixed maturities:
                       
 U. S. government and agency securities
  $ 14,003     $ -     $ 14,003     $ -  
 Foreign government securities
    10,024       -       10,024       -  
 Corporate debt
    515,627       -       515,627       -  
 Residential mortgage-backed
    29,316       -       29,316       -  
 Commercial mortgage-backed
    31,558       -       31,558       -  
 Asset-backed
    76,736       -       75,736       1,000  
 State and municipal bonds
    68,974       -       68,974       -  
Total fixed maturities
    746,238       -       745,238       1,000  
 Short-term investments:
                               
 Money market instruments
    4,575       4,575       -       -  
 Other
    25,527       -       25,527       -  
 Total
  $ 776,340     $ 4,575     $ 770,765     $ 1,000  


 
16

 
Significant unobservable inputs (Level 3) were used in determining the fair value on certain bonds in the fixed maturities portfolio during this period.  The following table provides a reconciliation of the beginning and ending balances of these Level 3 bonds and the related gains and losses related to these assets during the three months ended March 31, 2012 and 2011, respectively.


Fair Value Measurement Using
Significant Unobservable Inputs (Level 3)
 
             
   
Three Months Ended
 
   
March 31,
 
(dollars in thousands)
 
2012
   
2011
 
             
Securities available-for-sale:
           
Asset-backed bonds:
           
 Beginning balance
  $ 1,000     $ 1,591  
 Transfers into Level 3
    -       -  
 Transfers out of Level 3
    -       -  
 Total gains and losses (realized and unrealized):
               
 Included in operations
    126       (35 )
 Included in other comprehensive income
    (71 )     20  
 Purchases, issuances, sales, and settlements:
               
 Purchases
    -       52  
 Issuances
    -       -  
 Sales
    (688 )     -  
 Settlements
    -       -  
 Ending balance
  $ 367     $ 1,628  
                 
 The amount of total gains and losses for the period included in operations attributable to realized gains and losses and the change in unrealized gains and losses relating to assets still held at the reporting date.
  $ 55     $ (15 )

 
 
7.  Loss Per Share ("EPS")

Basic and diluted EPS are based on the weighted-average daily number of shares outstanding.  In computing diluted EPS, only potential common shares that are dilutive – those that reduce EPS or increase loss per share – are included.  Exercises of options and unvested restricted stock are not assumed if the result would be antidilutive, such as when a loss from operations is reported.  For the three months ended March 31, 2012 and 2011, the Company reported a loss from operations and therefore had no dilutive effect of stock options and unvested restricted stock on the weighted-average shares outstanding.  The numerator used in both the basic EPS and diluted EPS calculation is the loss reported for the period represented.  For the three months ended March 31, 2012 and 2011, options to purchase approximately 30,830 and 2,538 shares, respectively, of the Company’s common stock were excluded from the calculation of EPS because they were antidilutive.

8.  Comprehensive Loss

Comprehensive loss consists of the net loss and other comprehensive income (loss).  For the Company, other comprehensive income (loss) is normally composed of the change in unrealized gains on available-for-sale securities, net of deferred income taxes. Given the Company’s previous substantial losses from operations, regulatory oversight of its operations, and the significant doubt regarding its ability to continue as a going concern, the Company may be unable to hold impaired assets for a sufficient time to recover their value.  Thus, any security with a fair value less than the book value at the balance sheet date is considered to be other-than-temporarily impaired and the loss is recognized as a realized loss in the Consolidated Statements of Comprehensive Loss. For the three months ended March 31, 2012 the Company’s other comprehensive income was $3.5 million and the Company’s comprehensive loss was $34.2 million. For the three months ended March 31, 2011, the Company’s other comprehensive loss was $2.6 million and the Company’s comprehensive loss was $7.6 million.

 
17

 
At March 31, 2012, the Company’s accumulated other comprehensive income of $12.5 million was comprised of unrealized gains on investments of $29.1 million, offset by income tax liability of $10.2 million and a valuation allowance against deferred tax assets of $6.4 million.  At December 31, 2011, the Company’s accumulated other comprehensive income of $9.0 million was comprised of unrealized gains on investments of $25.6 million, offset by income tax liability of $9.0 million and a valuation allowance against deferred tax assets of $7.6 million.

9.  Income Taxes

The Company uses the asset and liability method of accounting for income taxes. Under the asset and liability method, deferred tax assets and deferred tax liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

Federal tax law permits mortgage guaranty insurance companies to deduct from taxable income, subject to certain limitations, the amounts added to contingency loss reserves required under SAP. Generally, the amounts so deducted must be included in taxable income in the tenth subsequent year.  However, due to the large amount of losses generated through March 31, 2012, the Company has extensive Net Operating Loss (“NOL”) carryforwards that will not allow it to take advantage of these special tax deductions until such time as future profits exceed the amounts on the NOL carryforwards.

The Company uses the provisions of ASC 740, Income Taxes (“ASC 740”) to account for and report tax positions taken or expected to be taken in its tax return that directly or indirectly affect amounts reported in its financial statements, including the accounting and disclosure for uncertainty in tax positions.

The Company’s policy for recording interest and penalties, if any, associated with audits is to record such items as a component of income before taxes.  Penalties would be recorded in “other operating expenses” and interest paid or received would be recorded as interest expense or interest income, respectively, in the statements of comprehensive loss.

The Company cannot determine that any of its deferred tax assets will result in future tax benefits with any degree of certainty; therefore, a valuation allowance was established for the portion of these assets that are not currently expected to be realized.  At March 31, 2012, the Company established a valuation allowance of approximately $358.3 million against a $369.2 million deferred tax asset.  Based upon a review of the Company's anticipated future taxable income, and also including all other available evidence, both positive and negative, the Company concluded that it is more likely than not that the $369.2 million of the gross deferred tax assets, net of $11.0 million of deferred tax liabilities, will not be realized. 

 
18

 
As of March 31, 2012, the Company had a NOL carryforward on a regular tax basis of approximately $679.6 million.  Of this amount, if it remains unused, $195.3 million expires in 2028, $85.6 million expires in 2029, $126.6 million expires in 2030, $219.5 million expires in 2031, and $52.7 million will expire in 2032. The amount and timing of realizing the benefit of NOL carryforwards depends on future taxable income and limitations imposed by tax laws.  The benefit of the NOL carryforward has not been recognized in the consolidated financial statements.

In May 2011, shareholders approved a Tax Benefits Preservation Plan (“Plan”) (previously approved by the Board of Directors in September 2010) and amended the TGI certificate of incorporation to help protect its ability to recognize certain potential tax benefits in future periods from net operating loss carryforwards and tax credits, as well as any net operating losses that may be generated in future periods (the “Tax Benefits”).  Section 382 of the Internal Revenue Code limits the ability of a company to take advantage of Tax Benefits when an ownership change occurs.  In general, an “ownership change” under Section 382 occurs if there is a cumulative percentage change in the Company’s ownership by certain stockholders over a rolling three-year period.  The Plan is designed to reduce the likelihood that the Company will experience an ownership change.  In connection with the adoption of the Plan in 2010, the Company declared a dividend of one preferred stock purchase right (“Rights”), for each outstanding share of its common stock to holders of record on September 27, 2010.  Subject to certain exceptions, the Rights generally are not exercisable until certain stockholders increase their ownership in the Company in excess of certain percentages.

10. Subsequent Events

We are not aware of any significant events that occurred subsequent to the balance sheet date but prior to the filing of this report that would have a material impact on the Company’s Consolidated Financial Statements.

 
19

 
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 our consolidated financial condition, changes in financial position, and results of operations for the three months ended March 31, 2012 and 2011.  This discussion supplements Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2011, and should be read in conjunction with the interim financial statements and notes contained herein.

Certain of the statements contained in this Quarterly Report on Form 10-Q are "forward-looking statements" and are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements include estimates and assumptions related to economic, competitive, regulatory, operational and legislative developments and typically are identified by use of terms such as “may,” “will,” “should,” “could,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” “continue” and similar words, although some forward-looking statements are expressed differently. These forward-looking statements are subject to change, uncertainty and circumstances that are, in many instances, beyond our control and they have been made based upon our current expectations and beliefs concerning future developments and their potential effect on us. Actual developments and their results could differ materially from those expected by us, depending on the outcome of a number of factors, including: the possibility that the Illinois Department of Insurance may take various actions regarding Triad if we do not operate our business in accordance with the revised financial and operating plan and the Corrective Orders, or for other reasons, including seeking receivership proceedings; our ability to operate our business in run-off and maintain a solvent run-off; our ability to continue as a going concern; the possibility of general economic and business conditions that are different than anticipated; legislative, regulatory, and other similar developments; changes in interest rates, employment rates, the housing market, the mortgage industry and the stock market; legal and other proceedings regarding modifications and refinancing of mortgages and/or foreclosure proceedings; the possibility that there will not be adequate interest in our common stock to ensure efficient pricing; and the relevant factors described in Item 1A, “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2011 and in the Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995 section below, as well as in other reports and statements that we file with the Securities and Exchange Commission (the “SEC”).  Forward-looking statements are based upon our current expectations and beliefs concerning future events and we undertake no obligation to update or revise any forward-looking statements to reflect the impact of circumstances or events that arise after the date the forward-looking statements are made, except as required by the federal securities laws. Any forward-looking statements that are made are current only as of the date on which we filed this report.

Overview

Triad Guaranty Inc. (“TGI”) is a holding company which, through its wholly-owned subsidiary, Triad Guaranty Insurance Corporation (“TGIC”), is a nationwide mortgage guaranty insurer pursuing a run-off of its existing in-force book of business.  The term “run-off” means continuing to service existing mortgage guaranty insurance policies but not writing any new policies.  Unless the context requires otherwise, references to “Triad” in this Quarterly Report on Form 10-Q refer to the operations of TGIC and its wholly-owned subsidiary, Triad Guaranty Assurance Corporation (“TGAC”).  References to “we,” “us,” “our,” and the “Company” refer collectively to the operations of TGI and Triad.

 
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TGIC is an Illinois-domiciled mortgage guaranty insurance company and TGAC is an Illinois-domiciled mortgage guaranty reinsurance company. The Illinois Department of Insurance (the “Insurance Department”) is the primary regulator of both TGIC and TGAC.  The Illinois Insurance Code grants broad powers to the Insurance Department and its director (collectively, the “Department”) to enforce rules or exercise discretion over almost all significant aspects of our insurance business. We ceased issuing new commitments for mortgage guaranty insurance coverage in 2008 and are operating our business in run-off under two Corrective Orders issued by the Department.  As noted above and throughout this report, the term "run-off" means continuing to service existing policies, but writing no new mortgage guaranty insurance policies.  Servicing existing policies during run-off includes:

 
·
billing and collecting premiums on policies that remain in force;
 
·
working with borrowers in default to remedy or cure the default and/or mitigate our loss;
 
·
reviewing policies for the existence of misrepresentation, fraud, or non-compliance with stated programs; and
 
·
settling all legitimate filed claims per the provisions of the policies and the two Corrective Orders issued by the Department.

The term “settled,” as used in this report in the context of the payment of a claim, refers to the satisfaction of Triad’s obligations following the submission of valid claims by our policyholders. Prior to June 1, 2009, valid claims were settled solely by a cash payment. As required by the second Corrective Order, effective on and after June 1, 2009, valid claims are settled by a combination of 60% in cash and 40% in the form of a deferred payment obligation (“DPO”). The Corrective Orders, among other things, allow management to continue to operate Triad under the close supervision of the Department, include restrictions on the distribution of dividends or interest on surplus notes payable to TGI by Triad, and include restrictions on the payment of claims.

TGI is the public company whose stock is traded on the OTC Bulletin Board (“OTCBB”) and the OTC Markets Group’s OTCQB tier (“Pink Sheets”) under the symbol “TGIC”. TGI owns TGIC, which is its only operating subsidiary. Aside from its ownership of TGIC, TGI’s assets amount to approximately $1.3 million, which consist primarily of cash holdings. The remainder of the $875.7 million of assets reported on the Consolidated Balance Sheets presented in this Form 10-Q are the assets of Triad. Triad is prohibited from paying dividends or distributing assets to TGI without the approval of the Department. We believe that, absent significant positive changes in the economy and the residential real estate market, the existing assets combined with the future premiums of Triad likely will not be sufficient to meet Triad’s current and future policyholder obligations and, therefore, none of Triad’s assets would be available to TGI and its stockholders other than to reimburse certain TGI expenses incurred on behalf of TGIC. Therefore, the ultimate value of TGI will be determined by its cash holdings less any future expenses not reimbursed by Triad (see “Liquidity and Capital Resources” for more information).  TGI is exploring strategies to acquire profitable, growing businesses and leverage its insurance industry knowledge, management expertise, and Net Operating Loss (“NOL”) carryforwards that were generated on a consolidated basis with Triad in order to increase its value for the benefit of its stockholders. No assurance can be given that TGI will be able to successfully implement such a strategy, or, if implemented, to increase its stockholder value.

 
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We have historically provided Primary and Modified Pool mortgage guaranty insurance coverage on U.S. residential mortgage loans.  We classify a policy as Primary insurance when the policy is not part of a structured bulk transaction that has an aggregate stop-loss limit applied to the entire group of loans.  We classify all other insurance as Modified Pool insurance. The majority of our Primary insurance has been delivered through the flow channel, which is defined as loans originated by lenders and submitted to us on a loan-by-loan basis.  In addition, we have insured loans under Primary bulk coverage where we are in a first loss position for each loan in a group of loans, and where all loans have the same premium rate.  We also historically provided mortgage guaranty insurance to lenders and investors seeking additional default protection (typically secondary coverage or on loans for which the individual borrower has greater than 20% equity), capital relief, and credit-enhancement on groups of loans that are sold in the secondary market.  Insurance provided on these individual transactions was provided through the Modified Pool channel.  Policies insured as part of a Modified Pool transaction have individual coverage but there is an aggregate stop-loss limit applied to the entire group of insured loans.

Our insurance remains effective until one of the following events occurs:  the policy is cancelled at the insured’s request; we terminate the policy for non-payment of premium; the policy defaults and we satisfy our obligations under the insurance contract; or we rescind or deny coverage under the policy for violations of provisions of a master policy. Additionally, coverage may be cancelled on certain Modified Pool transactions if pre-determined aggregate stop loss limits are met, or if coverage is reduced to a de minimus amount of the initial amount insured or, for some contracts, ten years from the date of the contract.
 
Persistency, which measures the percentage of insurance in force remaining from one-year prior, is an important metric in understanding our future premium revenue. The longer a policy remains on our books, or “persists”, the greater the amount of total premium revenue we will earn from the policy.

In run-off, our revenues principally consist of earned renewal premiums, which are reported net of reinsurance premiums ceded to captive reinsurers and premium refunds paid or accrued related primarily to rescissions, and investment income. We also realize investment gains and investment losses on the sale and impairment of securities, with the net gain or loss reported as a component of revenue.

In run-off, our expenses consist primarily of: settled claims (including loss adjustment expenses) net of any losses ceded to captive reinsurers; changes in reserves for estimated future claim payments on loans that are currently in default (including new defaults that are reported during the period) net of any reserves ceded to captive reinsurers; general and administrative costs of servicing existing policies; other general business expenses; and interest expense on the DPO.

As we are operating in run-off and are issuing no new insurance commitments, our future results of operations largely depend on the amount of future premium that we earn less the amount of losses that we incur each period on the new defaults reported to us. In addition, our results may be significantly impacted by the favorable or adverse development of our loss reserves. Our results from operations will benefit if we are able to settle our loss reserves at a lesser amount than that reported on our balance sheet through loss mitigation, litigation and settlements with servicers. Conversely, our results from operations will be negatively impacted if the settled losses are greater than the loss reserves provided.  Our results of operations also depend on a number of other factors, many of which are not under our control. These factors include:

 
·
the conditions of the housing, mortgage and capital markets that have a direct impact on default rates, loss mitigation efforts, cure rates, and ultimately, the amount of claims settled;
 
·
the overall general state of the economy and job market;
 
·
persistency levels on our remaining insurance in force;
 
·
operating efficiencies; and
 
·
the level of investment yield, including realized gains and losses, on our investment portfolio.

 
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Our results of operations in run-off could also be impacted significantly by Federal government and private initiatives to limit foreclosures through loan modifications.  See the discussion below for further details on these initiatives. Lastly, our results of operations in run-off could be materially affected by our ability to recognize benefits from our NOL carryforwards.

Accounting Principles

To better comprehend our financial position and results of operations, it is important to understand the difference between accounting principles generally accepted in the United States of America (“GAAP”) and statutory accounting principles (“SAP”) applicable to insurance companies and how we use these accounting principles.

As an insurance company, Triad is required to file financial statements prepared in accordance with SAP with the Department as well as the insurance departments of the states in which it conducts business. The financial statements for Triad that are provided to the Department and that form the basis for our corrective plan required by the Corrective Orders are prepared in accordance with SAP as set forth in the Illinois Insurance Code or prescribed by the Department.  However, the Company prepares its financial statements presented in this Quarterly Report on Form 10-Q and in our other SEC filings in conformity with GAAP.  The primary difference between GAAP and SAP for Triad at March 31, 2012 was the reporting requirements relating to the establishment of the DPO stipulated in the second Corrective Order, which is described below.

A deficit in assets occurs when recorded liabilities exceed recorded assets in financial statements prepared under GAAP.  A deficiency in policyholders’ surplus occurs when recorded liabilities exceed recorded assets in financial statements prepared under SAP. A deficit in assets at any particular point in time under GAAP is not necessarily a measure of insolvency. However, we believe that if Triad were to report a deficiency in policyholders’ surplus under SAP for an extended period of time, Illinois law may require the Department to seek receivership of Triad, which could compel TGI to institute a proceeding seeking relief from creditors under U.S. bankruptcy laws, or otherwise consider dissolution of the Company. The second Corrective Order was designed in part to help Triad maintain its policyholders’ surplus.

Corrective Orders

Triad has entered into two Corrective Orders with the Department as detailed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011. Among other things, the Corrective Orders:

 
·
Require oversight by the Department on substantially all operating matters;
 
·
Prohibit stockholder dividends from Triad to TGI without the prior approval of the Department;
 
·
Prohibit the accrual of interest and the payment of interest and principal on Triad’s surplus note to TGI without the prior approval of the Department;
 
·
Restrict Triad from making any payments or entering into any transaction that involves the transfer of assets to, or liabilities from, any affiliated parties without the prior approval of the Department;
 
·
Require Triad to obtain prior written approval from the Department before entering into certain transactions with unaffiliated parties;
 
·
Require that all valid claims under Triad’s mortgage guaranty insurance policies are settled 60% in cash and 40% by recording a DPO;
 
·
Require the accrual of simple interest on the DPO at the same average net rate earned by Triad’s investment portfolio; and
 
·
Require that loss reserves in financial statements prepared in accordance with SAP be established to reflect the cash portion of the estimated claim settlement but not the DPO.

 
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The DPO is an interest bearing subordinated obligation of Triad with no stated repayment terms.  The requirement to settle claims with both the payment of cash and recording of a DPO became effective on June 1, 2009.  The second Corrective Order requires that Triad hold assets to support the DPO liability in a separate account pursuant to a custodial arrangement. At March 31, 2012, the recorded DPO, including accrued interest of $35.6 million, amounted to $674.2 million or 86% of total invested assets compared to $629.7 million or 81% of total invested assets at December 31, 2011.  We are currently in discussions with the Department regarding a possible amendment to the second Corrective Order that would require the escrow of DPOs and accrued carrying charges only if requested by the Director and would limit the amount of carrying charges credited to the DPO holders to the amount of net investment income earned by Triad.

 The recording of a DPO does not impact reported settled losses as we continue to report the entire amount of a claim in our statements of comprehensive loss under both bases of accounting.  The accounting treatment for the recording of DPOs on our balance sheet on a SAP basis is similar to a surplus note that is reported as a component of statutory surplus, which serves to increase reported statutory surplus.  However, in our financial statements prepared in accordance with GAAP included in this report, the DPOs and related accrued interest are reported as a liability.  At March 31, 2012, the cumulative effect of the DPO requirement on statutory policyholders’ surplus, including the impact of establishing loss reserves at anticipated cash payment rather than the estimated full claim amount, was to increase statutory policyholders’ surplus by $999.2 million over the amount that would have been reported absent the second Corrective Order.  The cumulative increase to statutory policyholders’ surplus of the DPO requirement was $967.5 million at December 31, 2011.  There was no such impact to loss reserves or stockholders’ deficit calculated on a GAAP basis and is the primary reason for the reported deficit in assets.  Any repayment of the DPO or the associated accrued interest is dependent on the financial condition and future prospects of Triad and is subject to the approval of the Department.

The second Corrective Order provides financial thresholds, specifically regarding the statutory risk-to-capital ratio and the level of statutory policyholders’ surplus that, if met, may indicate that the Department should reduce the DPO percentage and/or require distributions to DPO holders.  In January 2012, the Department notified Triad that as of December 31, 2011, based upon Triad’s surplus position, risk-to-capital ratio and the continued economic uncertainty, the Department had determined that no change to the DPO percentage was in order nor would it be appropriate for Triad to make a distribution to the DPO holders.

Failure to comply with the provisions of the Corrective Orders or any other violation of the Illinois Insurance Code may result in the imposition of fines or penalties or subject Triad to further legal proceedings, including the institution by the Department of receivership proceedings for the conservation, rehabilitation, or liquidation of Triad.  Any such actions would likely lead TGI to institute a proceeding seeking relief from creditors under U.S. bankruptcy laws, or otherwise consider dissolution of the Company.  See Item 1A, “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2011 for more information.

Triad is also subject to comprehensive regulation by the insurance departments of the various other states in which it is licensed to transact business.  Currently, the insurance departments of the other states have been working with the Department in the administration and oversight of the Corrective Orders.

 
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Going Concern

Our ability to continue as a going concern is dependent on the Department’s ongoing review of our operating results compared to updated forecasts and our ability to reverse a large deficit in assets through possible future earnings.

Prior to the issuance of the second Corrective Order, our recurring losses from operations and resulting decline in policyholders’ surplus as calculated in accordance with SAP increased the likelihood that Triad would be placed into receivership and raised substantial doubt about our ability to continue as a going concern.  The positive impact on surplus resulting from the second Corrective Order has resulted in Triad reporting a policyholders’ surplus in its SAP financial statements of $228.9 million at March 31, 2012, as opposed to what would have been a deficiency in policyholders’ surplus of $770.3 million on the same date had the second Corrective Order not been implemented.  Furthermore, we continued to report a deficit in assets under GAAP of $737.8 million at March 31, 2012. While implementation of the second Corrective Order has deferred the institution of an involuntary receivership proceeding, no assurance can be given that the Department will not seek receivership of Triad in the future and there continues to be substantial doubt about our ability to continue as a going concern.  The Department may seek receivership of Triad based on its determination that Triad will ultimately become insolvent, if Triad fails to comply with provisions of the Corrective Orders, or for other reasons including those stated above.  If the Department were to seek receivership of Triad, TGI could be compelled to institute a proceeding seeking relief from creditors under U.S. bankruptcy laws or otherwise consider dissolution of the Company.  Our consolidated financial statements that are presented in this report do not include any accounting adjustments that reflect the financial risks of Triad entering receivership proceedings or otherwise not continuing as a going concern.

Foreclosure Prevention Initiatives and Moratoriums

Several programs have been initiated by the federal government, the GSEs, and certain lenders that are, in general, designed to prevent foreclosures and provide relief to homeowners. These programs may involve modifications to the original terms of existing mortgages or their complete refinancing.  These programs seek to provide borrowers a more affordable mortgage by modifying the interest rate, extending the term of the mortgage or, in limited cases, reducing the principal amount of the mortgage. We are active participants in many of these programs, including government-initiated programs such as the Home Affordable Modification Program (“HAMP”) and the Home Affordable Refinance Program (“HARP”).

HAMP provides incentives to borrowers, servicers, and lenders to modify loans that are currently in default. HAMP and other such programs have been responsible for a large percentage of our cures since 2009. The number of policies cured under these programs declined in 2011 from levels experienced in 2010; however, recent changes to these programs have proven beneficial to us and have made a meaningful impact on our results.  In January 2012, the U.S. government announced that it was revising HAMP by expanding eligibility requirements and increasing the incentive it pays servicers/lenders for principal forgiveness.  For the first time, beginning in the second quarter of 2012, the U.S. government will also pay Fannie Mae and Freddie Mac an incentive fee for principal forgiveness.  HAMP was scheduled to expire at the end of 2012, but the U.S. government has extended the program until December 2013.  We cannot estimate the impact of these changes on the number of loans eligible for participation or the effect on our results of operations or financial condition.

 
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In determining the number of policies participating in HAMP as well as other foreclosure prevention programs, we rely on information provided to us primarily by the GSEs and servicers.  However, we do not believe that we receive timely information on all participating loans or on the current status of the participating loans and we do not have the necessary information to determine the number of our policies in force that would be eligible for such modification programs.  Furthermore, a number of the policies that have completed the trial modification period have subsequently re-defaulted and we believe the number of policies that re-default will increase in the future, especially as the economic recovery lingers.  This could be exacerbated by adverse conditions in the housing market or economy in general.  The ultimate impact of HAMP and other modification programs is dependent on the number of policies that are successfully modified and do not re-default. Currently, we are unable to estimate with any degree of precision the number of policies that will ultimately cure and not re-default and are, therefore, unable to estimate the ultimate impact of these programs on our results of operations and financial condition.  If HAMP or similar programs prove to be effective in preventing ultimate foreclosure, future settled claim activity could be reduced.

If a loan is modified as part of one of these programs, the previously reported default would be cured, but we would maintain insurance on the loan and would be subject to the same ongoing risk if the policy were to re-default.  Policies that re-default under these programs may ultimately result in losses that are greater than the loss that would have occurred if the policy were never modified.  However, we do not provide loss reserves to account for the potential for re-default.  These programs could adversely affect us to the degree that borrowers who otherwise could make their mortgage payment choose to default in an attempt to become eligible for modification.

HARP was launched in 2009 but revised in the third quarter of 2011.  This program is designed to provide a borrower who is current on all mortgage payments with the opportunity to take advantage of existing lower interest rates through a refinancing that would make the loan more affordable.  Under the original HARP program, only fixed-rate loans with a maximum current loan-to-value (“LTV”) ratio of 125% were eligible, although this restriction was later removed.  The LTV limit for ARMs continues to be 105% of the current value.  We do not expect the revised HARP program will have a significant impact on our short-term results because: (i) these loans must not be in default to qualify; and (ii) we would continue to provide mortgage insurance on the refinanced loan.

Loan servicers and certain government entities have also implemented temporary foreclosure moratoriums in recent years for various reasons, some of which were in response to documentation problems and other issues with foreclosure proceedings.  Because the completion of a valid foreclosure is a requirement for the filing of a claim for loss, these programs serve to temporarily reduce our claims settled, but may lead to greater ultimate claim costs due to the accrual of interest and other expenses. While some of these moratoriums have subsequently been terminated, unresolved legal matters remain for certain mortgages.  While these moratoriums have delayed our claims settled and increased the time a policy remains in our default inventory, we do not expect a significant direct impact on our results of operations or financial condition from these temporary moratoriums.

In February 2012, the federal government and state attorneys general reached a $25 billion settlement agreement with five of the nation’s largest banks regarding claims that alleged, among other things, improper foreclosure practices.  The funds generally will be used for principal reductions, refinancing underwater mortgages, forbearance and short sales, and foreclosure prevention programs.  The banks have three years to implement the settlement agreement.  A great deal of uncertainty currently remains over how the program will be implemented as well as borrower eligibility, but currently we do not believe the settlement will have a meaningful impact on our future results of operations or financial condition.

See Item 1A, “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2011 for more information on the risks and uncertainties associated with foreclosure moratoriums.

 
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Consolidated Results of Operations

Following is selected financial information for the three months ended March 31, 2012 and 2011:


   
Three Months Ended
       
   
March 31,
   
%
 
(dollars in thousands, except per share data)
 
2012
   
2011
   
Change
 
                   
                   
Earned premiums
  $ 34,537     $ 37,128       (7 )
Net losses and loss adjustment expenses
    67,982       41,705       63  
Net loss
    (37,725 )     (4,910 )     (668 )
Diluted loss per share
    (2.47 )     (0.32 )     (672 )


The net loss for the three months ended March 31, 2012 as compared to the same period of 2011 were affected by the following:

 
·
A decrease in earned premium for the first quarter of 2012 compared to the 2011 first quarter due to a 22% decline in insurance in force over the twelve month period, which was mitigated in part by a smaller impact from premium refunds related to rescissions in the first quarter of 2012.
 
·
A decline in investment income in the first quarter of 2012 due to lower average invested assets and lower market yields.
 
·
An increase in net losses and loss adjustment expenses during the first quarter of 2012, primarily due to the effects on loss reserves provided for new defaults during the quarter ended March 31, 2012 from the changes in the reserve factors adopted in the 2011 fourth quarter.  Loss and LAE reserves declined by 4% and 7% while Primary risk in default declined by 7% and 9% during the first quarters of 2012 and 2011, respectively.
 
·
An increase in interest expense during the three months ended March 31, 2012, which was due to the continued growth in accrued carrying charges related to the DPO liability.
 
·
An increase in other operating expenses during the first quarter of 2012 due to an increase in expenses related to contract underwriting remedies, which was offset in part by declines in employee and other variable costs.

We describe our results of operations in greater detail in the discussion that follows.  The information is presented in four sub-headings:  Production; Insurance and Risk in Force; Revenues; and Losses and Expenses.

Production

On July 15, 2008, we ceased issuing commitments for mortgage insurance, only issuing coverage to borrowers for which we had made a commitment as of that date.  We have had no material production since 2008.


 
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Insurance and Risk in Force

Insurance in force is the total principal balance of our insured loans.  The following table provides detail on our direct insurance in force at March 31, 2012 and 2011:


   
March 31,
   
%
 
(dollars in thousands)
 
2012
   
2011
   
Change
 
                   
Primary insurance
  $ 23,147,300     $ 27,764,063       (17 )
Modified Pool insurance
    5,611,674       9,205,543       (39 )
Total insurance
  $ 28,758,974     $ 36,969,606       (22 )


The decline in Primary insurance in force at March 31, 2012 from March 31, 2011 is due to cancellation of insurance coverage resulting primarily from claim settlement and rescission activity.  The decline in Modified Pool insurance in force for the same period is also due to claim settlement and rescission activity, as well as the termination of a number of Modified Pool transactions where pre-determined aggregate stop loss limits in the contracts were met on a settled basis.

Primary insurance persistency increased to 83.4% at March 31, 2012 compared to 81.7% at March 31, 2011. Modified Pool insurance persistency decreased to 61.0% at March 31, 2012 compared to 67.6% at March 31, 2011.  While the cancellation of Modified Pool transactions affected the persistency during both twelve-month periods, the adverse impact was greater during the period ended March 31, 2012.  We believe our persistency has benefited from the temporary delays in foreclosures as well as the inability of many borrowers on loans that we have insured to sell or refinance existing homes due to the decline in home prices and stricter underwriting standards.

A portion of our Modified Pool contracts contain provisions that terminate both the coverage and the contract when cumulative settled losses reach the stop loss limit.  No future premium is received following the termination of these Modified Pool contracts.  During the first quarter of 2012, approximately $36 million of Modified Pool insurance in force under this type of contract was terminated compared to approximately $180 million during the first quarter of 2011.

The majority of our Modified Pool contracts do not terminate when settled losses reach the stop loss limit and premiums will continue to be collected until such time that the remaining insurance in force is reduced to a de minimus amount or, in some cases, ten years from the date of the contract.  For these types of contracts, we recognize the net present value of the estimated future premium in the period during which our payments reach the maximum liability on a settled basis under the contract.  During the first quarter of 2012, there were no Modified Pool transactions under this type of contract that were terminated as a result of cumulative settled losses reaching the stop loss limit. During the first quarter of 2011, however, approximately $291 million of Modified Pool insurance in force under this type of contract was terminated as a result of cumulative settled losses reaching the stop loss limit. For both types of Modified Pool contracts, affected policies are excluded from in force statistics once the contractual stop loss limit is met on a settled basis.  We expect that other Modified Pool transactions will reach their contractual stop loss limits on a settled basis and terminate in the remainder of 2012, which will further accelerate the decline of our Modified Pool insurance in force.
 
 
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Approximately 67% of our Modified Pool insurance in force was originated from 2005 through 2007.  Given the adverse development of our Modified Pool insurance originated in these years, the majority of these transactions have already reached the stop loss limit on an incurred basis.  As the following table indicates, under our Modified Pool contracts, we have limited loss exposure for future defaults, or changes in loss reserves on existing defaults, from contracts originated from 2005 through 2007.  We have additional exposure to Modified Pool contracts originated in 2004 and prior years; however, given the performance to date for these policy years and our belief about the expected future performance, we expect losses from Modified Pool contracts to have significantly less bearing on our future results compared to our Primary business.


     
March 31,
 
(dollars in thousands)
 
2012
   
2011
 
               
Modified Pool Summary
           
 
Net risk in force (1)
  $ 332,468     $ 443,573  
 
Carried reserves on net risk in force
    109,966       179,155  
 
Remaining aggregate loss exposure on Modified Pool contracts
  $ 222,502     $ 264,418  
                   
 
Remaining Aggregate Loss Exposure by Policy Year
               
 
2003 and Prior
  $ 106,897     $ 114,709  
 
2004
    60,106       74,412  
 
2005
    4,213       8,070  
 
2006
    47,602       60,207  
 
2007
    3,684       7,020  
      $ 222,502     $ 264,418  
                   
(1)
Net risk in force for Modified Pool business reflects the remaining stop loss limits for Modified Pool transaction less any remaining deductible amount.
 


Net risk in force is computed by applying the various percentage settlement options to the insurance in force amounts, adjusted by risk ceded under reinsurance agreements and applicable stop-loss limits and deductibles, but before accounting for carried loss reserves.  Net risk in force inclusive of both Primary and Modified Pool insurance was $7.4 billion at March 31, 2012 compared to $9.6 billion at March 31, 2011.  Primary insurance accounted for approximately 81% of our net risk in force at March 31, 2012 compared to 74% at March 31, 2011.  Given the relatively small amount of remaining exposure attributable to Modified Pool insurance, our incurred loss discussions and disclosures in this Form 10-Q are focused on Primary insurance.  The following table provides detail on our Primary risk in force, net of risk ceded to captives.


   
March 31,
   
%
 
(dollars in thousands)
 
2012
   
2011
   
Change
 
       
Gross Primary risk in force
  $ 6,080,253     $ 7,266,593       (16 )
Less: Ceded risk in force
    (84,802 )     (180,569 )     53  
Net Primary risk in force
  $ 5,995,451     $ 7,086,024       (15 )


The percentage of our Primary insurance in force subject to captive reinsurance arrangements decreased to 9% at March 31, 2012 from 14% at March 31, 2011.  The decline is primarily due to the commutation of several captive reinsurance agreements, as well as the cancellation of insurance coverage resulting from claim and rescission activity. Assets held in trusts supporting the reinsured risk also declined to $37.7 million at March 31, 2012 compared to $53.2 million at March 31, 2011.  Certain remaining captive reinsurance agreements have trust balances below the reserves ceded under the contracts.  In those cases, the net reserve credit that we recognize in our financial statements is limited to the trust balance.  Given this limitation, as well as the decline in insurance in force subject to captive reinsurance, we expect to only receive limited benefits in future periods from these agreements.

 
29

 
At March 31, 2012, approximately 17% of our gross Primary risk in force was comprised of coverage on loans with the potential for negative amortization (“pay-option ARM”) and interest only loans.  An inherent risk in both a pay-option ARM loan and an interest-only loan is the impact of the scheduled milestone in which the borrower must begin making amortizing payments, which can be substantially greater than the minimum payments required before the milestone is met.  An additional risk to a pay-option ARM loan is that the payment being made may be less than the amount of interest accruing, creating negative amortization on the outstanding principal of the loan.  The majority of our pay-option ARM loan portfolio has accumulated negative amortization and we believe these pay-option ARM loans are or will be subject to significant payment shock, which increases our risk of loss.  Many of these pay-option ARM loans are also from the 2006 and 2007 vintage years and are located in Arizona, California, Florida, and Nevada, which we refer to as “distressed markets.”  The pay-option ARM loans that we insure typically reach the milestone where the borrower must begin making amortization payments no later than five years from the date the loan was issued.  Because many of the pay-option ARMs are from the 2006 and 2007 vintages, the default rates on pay-option ARM loans over the next two years may increase as the remaining loans convert to amortizing payments.

At March 31, 2012, approximately 15% of our gross Primary risk in force is comprised of coverage on “Alt-A” loans.  We define Alt-A loans as loans that have been underwritten with reduced or no documentation verifying the borrower’s income, assets, or employment and where the borrower has a FICO score greater than 619.  We have found a substantial amount of misrepresentation, program violations, and fraud on the Alt-A loans in our portfolio and Alt-A loans have a relatively high rescission rate.  Due in part to depressed conditions in the housing markets, the Alt-A loans, pay-option ARM loans, and interest-only loans have, as a group, performed significantly worse than the remaining prime fixed rate loans.

Business originated in 2006 and 2007 continues to comprise the majority of our risk in force.  This is due to the significant amounts of production during these two years as well as the large number of policies that have been cancelled from prior vintage years.  In general, policies originated during these years have significantly higher amounts of average risk per policy than policies originated prior to 2006.  Furthermore, policies originated during these vintage years have also exhibited higher default and claim rates than preceding vintage years.  For additional information regarding these vintage years, see “Losses and Expenses,” below.
 
 
30

 
The following table shows risk in force and default statistics for our Primary business by policy year and breaks out the impact of the distressed markets at March 31, 2012 and March 31, 2011:


   
March 31, 2012
 
   
Total Company
   
Distressed Markets
 
(dollars in thousands)
 
Primary
Risk in
Force
   
Average
Primary Risk
in Force Per
Policy
   
Primary
Loans in
Default
   
Default
Rate
   
Percent of
Primary
Risk in
Force
   
Average
Primary Risk
in Force Per
Policy
   
Default
Rate
 
Policy Year
                                         
2004 & Prior
  $ 1,246,789     $ 28.4       4,652       10.6 %     15.3 %   $ 27.9       13.1 %
2005
    840,792       40.3       3,578       17.1 %     21.3 %     51.7       32.1 %
2006
    1,205,070       48.6       4,503       18.2 %     25.9 %     67.9       34.7 %
2007
    2,365,392       51.2       7,872       17.0 %     23.8 %     69.4       31.5 %
2008
    422,210       46.6       916       10.1 %     19.1 %     54.1       14.8 %
Total
  $ 6,080,253       42.0       21,521       14.9 %     21.8 %     54.1       26.0 %



   
March 31, 2011
 
   
Total Company
   
Distressed Markets
 
(dollars in thousands)
 
Primary
Risk in
Force
   
Average
Primary Risk
in Force Per
Policy
   
Primary
Loans in
Default
   
Default
Rate
   
Percent of
Primary
Risk in
Force
   
Average
Primary Risk
in Force Per
Policy
   
Default
Rate
 
Policy Year
                                         
2004 & Prior
  $ 1,581,252     $ 29.0       5,471       10.0 %     15.1 %   $ 28.9       12.5 %
2005
    993,680       40.7       4,128       16.9 %     22.0 %     52.6       32.9 %
2006
    1,431,510       49.6       5,875       20.4 %     28.8 %     69.7       39.9 %
2007
    2,776,019       52.0       9,928       18.6 %     25.7 %     70.8       35.4 %
2008
    484,132       46.7       1,082       10.4 %     19.1 %     54.8       18.0 %
Total
  $ 7,266,593       42.4       26,484       15.4 %     23.1 %     55.7       28.7 %


The number of loans in default includes all reported delinquencies that are in excess of two payments in arrears at the reporting date and all reported delinquencies that were previously in excess of two payments in arrears and have not been brought current.
 
 
 
31

 
Revenues

A summary of the individual components of our revenue for the first quarter of 2012 and 2011 follows:


   
Three Months Ended
       
   
March 31,
   
%
 
(dollars in thousands)
 
2012
   
2011
   
Change
 
                   
Direct premium written before the impact of refunds
  $ 42,673     $ 54,718       (22 )
Less:
                       
Cash refunds primarily related to rescissions
    (12,658 )     (15,685 )     19  
Change in refund accruals primarily related to rescissions
    6,134       322       1,805  
Direct premium written
    36,149       39,355       (8 )
Less ceded premium
    (1,310 )     (2,060 )     36  
Net premium written
    34,839       37,295       (7 )
Change in unearned premiums
    (302 )     (167 )     (81 )
Earned premiums
  $ 34,537     $ 37,128       (7 )
                         
Net investment income
  $ 6,109     $ 8,491       (28 )
Net realized investment gains (losses)
  $ 173     $ (436 )     140  
Total revenues
  $ 40,822     $ 45,210       (10 )


The decrease in direct premium written before the impact of refunds was primarily due to a 22% decline in insurance in force since March 31, 2011.  Premium refunds, primarily related to rescission activity, include cash premium refunded as well as the change in the accrual for expected premium refunds.  Cash premiums refunded is dependent on the number of policies rescinded and the amount previously collected while the accrual for expected premium refunds is dependent on our future expectations for these items. The activity related to premium refunds reduced direct premium written by 15% in the first quarter of 2012 compared to 28% in the first quarter of 2011. The smaller negative impact from premium refunds in the first quarter of 2012 was primarily due to a larger decrease in the accrual for expected premium refunds reflecting our expectations for lower future rescission activity.  Cash refunds in the first quarter of 2012 declined by 19% compared to the first quarter of 2011, but comprised 30% of direct premium written, which is consistent with the first quarter of 2011.  The accrual we have established for expected premium refunds, which is reported in “Accrued expenses and other liabilities” on our Consolidated Balance Sheets, was $26.5 million at March 31, 2012 compared to $29.3 million at March 31, 2011. The impact of premium refunds on our financial statements going forward will be determined primarily by our expectations for future cash premium refunds and the number of policies for which we retain the right to rescind, which may alter our premium refund accrual as well as the actual cash refunds themselves. We expect actual rescissions and cash premium refunds to decline in the remainder of 2012 compared to the volume we experienced in 2011 and in the first quarter of 2012.

Ceded premium written is comprised of premiums written under excess of loss reinsurance treaties with captive reinsurers.  The decline in ceded premium in the first quarter of 2012 compared to the first quarter of 2011 reflects the decline in insurance in force subject to captive reinsurance.

Net investment income declined in the first quarter of 2012 compared to the one-year prior period primarily due to a decline in invested assets as well as a decline in the net realized investment yield.  We expect invested assets to decline in the remainder of 2012 as we anticipate funding our deficit in operating cash flow with the proceeds from the maturity and sale of these assets.  For further discussion, see “Investment Portfolio.”

 
32

 
Losses and Expenses

A summary of the significant individual components of losses and expenses for the three months ended March 31, 2012 and 2011 follows:


   
Three Months Ended
       
   
March 31,
   
%
 
(dollars in thousands)
 
2012
   
2011
   
Change
 
                   
Net losses and loss adjustment expenses:
                 
Net settled claims
  $ 97,131     $ 106,909       (9 )
Net change in loss reserves
    (30,531 )     (66,694 )     54  
Loss adjustment expenses
    1,382       1,490       (7 )
Total
    67,982       41,705       63  
Other operating expenses
    5,584       4,437       26  
Interest expense, including interest on the deferred payment obligation
    4,981       3,978       25  
Total losses and expenses
  $ 78,547     $ 50,120       57  
                         
Loss ratio
    196.8 %     112.3 %        
Expense ratio
    16.0 %     11.9 %        
Combined ratio
    212.9 %     124.2 %        


Net losses and LAE are comprised of settled claims, LAE, and the change in the loss and LAE reserve during the period. The increase in net losses and LAE in the first quarter of 2012 compared to the first quarter of 2011 was primarily due to differences in the loss reserves established for new defaults.

The following table presents a roll-forward of our Primary risk in default for the first three months of 2012 and 2011.  While both the amount of new risk in default and the rate of new risk in default (new risk in default as a percentage of performing risk in force) were down considerably in the first quarter of 2012 compared to the prior period, our incurred losses increased for the first three months of 2012 as the adjustment to our frequency factors during the 2011 fourth quarter had the effect of increasing the level of reserves for newly reported defaults.  As a result, the reserve established for new defaults had a much greater impact on net losses and LAE during the first quarter of 2012 compared to the same period of 2011.


   
Three Months Ended
       
   
March 31,
   
%
 
(dollars in thousands)
 
2012
   
2011
   
Change
 
                     
Beginning risk in default
  $ 1,192,890     $ 1,555,499       (23 )
Plus:   
New risk in default
    148,922       203,167       (27 )
Less:   
Paid risk in default
    (79,817 )     (79,528 )     (0 )
 
Rescinded/Denied risk in default (1)
    (62,120 )     (125,407 )     50  
 
Cured risk in default
    (94,715 )     (133,247 )     29  
Ending risk in default
  $ 1,105,160     $ 1,420,484       (22 )
                           
(1) The majority of amounts included in "Rescinded/Denied risk in default" is comprised of risk on policies that were rescinded.
 


 
33

 
The cure rate for Primary risk in default (cured risk in default as a percentage of beginning risk in default) declined to 7.9% in the first quarter of 2012 compared to 8.6% in the first quarter of 2011. Cures are most likely to occur while the default is in its early stage.  In general, our expectation for a cure decreases significantly as the underlying mortgage becomes further delinquent until the borrower has missed ten payments.  Given the delays in foreclosure and other factors slowing settled claim activity, the average age of the total default inventory has increased over the past year which, all else being equal, is expected to produce a lower overall cure rate.  At March 31, 2012, 56% of Primary risk in default has missed more than 12 payments compared to 50% at March 31, 2011.  The following table presents the distribution of primary risk in default by the number of payments for which the borrower is in default. The most significant increase has been with policies that have missed more than 30 payments.


   
March 31,
 
   
2012
   
2011
 
Primary Business
           
 0 - 3 payments
    8.7 %     9.5 %
 4 - 6 payments
    13.8 %     14.9 %
 7 - 9 payments
    12.1 %     14.0 %
 10 - 12 payments
    9.1 %     11.4 %
 13 - 15 payments
    7.4 %     10.1 %
 16 - 18 payments
    6.4 %     8.8 %
 19 - 21 payments
    6.5 %     7.4 %
 22 - 30 payments
    15.0 %     14.1 %
 More than 30 payments
    21.0 %     9.8 %
      100.0 %     100.0 %


HAMP and other lender loan modification programs have contributed to cure activity, including cures on policies that have been in default for more than 12 months.  However, the benefit we have received from these programs has generally declined as the number of policies eligible for the programs has declined.  The U.S. government announced changes to HAMP in January 2012 and has extended the program until 2013. We cannot estimate the impact these changes will have on our loss development in 2012. Individual lenders are still actively seeking loan modifications as an alternative to foreclosure outside of the HAMP guidelines and we continue to see the positive results of those efforts, although these cures are primarily coming from more recently reported defaults.

Rescission activity continues to mitigate our level of loss reserves and settled losses, although the impact is down considerably compared to 2011.  We rescinded coverage on Primary policies with $55 million and $119 million of total risk in force during the first quarter of 2012 and 2011, respectively.  While we expect rescission activity to continue to have a material impact on settled claim activity and our results of operations, we expect rescission activity to decline going forward.  Rescission activity remains concentrated on policies originated by certain originators and on those originated in 2006 and 2007.  We believe the majority of the rescinded risk in default would have ultimately resulted in settled claims.  See Item 1A, “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2011 for risks and uncertainties associated with rescission activity.

The following table details the amount of Primary risk in default and the Primary reserve balance as a percentage of risk in default at March 31, 2012 and December 31, 2011.  The table also provides the impact of the rescission factor, which is a component of the frequency factor utilized in the reserve model, on gross case reserves at the respective period end.  Due to the changes in the assumptions utilized in our reserve methodology that were adopted in the 2011 fourth quarter and the change in the mix of defaults, the gross case reserves, net of expected rescissions, expressed as a percentage of gross risk in default has increased to 62% at March 31, 2012 compared to 55% one-year prior.


 
34

 

   
March 31,
   
March 31,
 
(dollars in thousands)
 
2012
   
2011
 
Primary Business
           
 Gross risk on loans in default
  $ 1,105,160     $ 1,420,481  
 Risk expected to be rescinded on loans in default
    (183,164 )     (258,330 )
 Risk in default net of expected rescissions
  $ 921,996     $ 1,162,151  
                 
 Gross case reserve (1)
  $ 819,878     $ 963,693  
 Gross case reserves on loans expected to be rescinded
    (139,507 )     (180,845 )
 Gross case reserves net of expected rescissions
  $ 680,371     $ 782,848  
                 
 Gross case reserves net of expected rescissions as a percentage of gross risk in default
    61.6 %     55.1 %
                 
 Gross case reserves net of expected rescissions as a percentage of gross risk in default, net of expected rescissions
    73.8 %     67.4 %
                 
 Percentage decrease in gross case reserves from rescission factor
    17.0 %     18.8 %
                 
(1) Reflects gross case reserves, which excludes IBNR and ceded reserves.
 


The following table provides details on both the dollar amount and number of settled claims of both Primary and Modified Pool insurance for the periods ended March 31, 2012 and 2011:


   
Three Months Ended
       
   
March 31,
   
%
 
(dollars in thousands)
 
2012
   
2011
   
Change
 
                   
 Net settled claims:
                 
 Primary insurance
  $ 86,139     $ 85,634       1  
 Modified Pool insurance
    13,241       26,243       (50 )
 Total direct settled claims
    99,380       111,877       (11 )
 Ceded paid losses
    (2,249 )     (4,968 )     55  
 Total net settled claims
  $ 97,131     $ 106,909       (9 )
                         
 Number of claims settled:
                       
 Primary insurance
    1,613       1,610       0  
 Modified Pool insurance
    242       418       (42 )
 Total
    1,855       2,028       (9 )

We believe that primary direct settled claim activity in both periods presented has been slowed due to delays in foreclosure proceedings resulting from, among other factors, foreclosure moratoriums implemented by servicers. Settled claim activity has also been affected by other factors including our investigation of policies for underwriting violations. Average severity, which is calculated by dividing total direct settled claims by the number of claims settled, for Primary settled claims increased slightly to $53,700 in the first quarter of 2012 compared to $53,100 in the first quarter of 2011. Average severity for Modified Pool settled claims declined to $56,100 in the first quarter of 2012 from $62,600 in the first quarter of 2011.

Average severity on settled claims is influenced by our ability to mitigate claims. Historically, the sale of properties by the borrower either before or during the foreclosure process was effective in reducing average severity.  However, the decline in home prices since 2007 across almost all markets, with significant declines in the distressed markets, combined with reduced mortgage credit availability has continued to negatively impact our ability to mitigate losses from sales of properties.  Policies originated in 2006 and 2007 have been particularly impacted by the decline in home prices because the properties were acquired by the borrowers at the peak of the market. We expect our ability to mitigate losses will continue to be adversely affected by these factors.  A greater concentration of settled claims in distressed markets or more recent policy years will exacerbate this effect.  Furthermore, recent issues with foreclosure proceedings may further negatively impact home sales.

 
35

 
Certain segments of our insured portfolio continue to perform more adversely when compared to the rest of the portfolio. These segments include:

Policies originated on properties in the distressed markets (1)
 
 
·
The distressed markets accounted for 37% of our Primary risk in default at March 31, 2012 while comprising only 22% of the Primary risk in force.
 
·
The Primary default rate for the distressed markets was 26% at March 31, 2012 compared to 13% for the non-distressed markets.
 
·
The distressed markets comprised 32% of Primary settled claims in the first quarter of 2012 while comprising only 17% of the policies in force at the beginning of the period.
 
·
The Primary claim rate, defined as the number of Primary claims paid over the previous twelve months as a percentage of the number of Primary policies in force at the beginning of the period, was 9% at March 31, 2012 for the distressed markets compared to 3% for the non-distressed markets.

 
Policies originated in 2006 and 2007 (1)
 
 
·
These policy years accounted for 66% of our Primary risk in default at March 31, 2012 while comprising only 59% of the Primary risk in force.
 
·
The Primary default rate for these policy years was 17% at March 31, 2012 compared to 12% for the other policy years.
 
·
These policy years comprised 60% of Primary settled claims in the first quarter of 2012 while comprising only 49% of the policies in force at the beginning of the period.
 
·
The Primary claim rate for these policy years was 5% at March 31, 2012 compared to 3% for the other policy years.

(1) Percentages are not mutually exclusive and there are many borrowers that qualified under both segments.

We believe the adverse performance of these segments has been due, in part, to non-sustainable levels of home price appreciation in the years prior to 2007 and the subsequent unprecedented depreciation in home prices, combined with less restrictive underwriting standards when the loans were originated.  These segments are also comprised of a large amount of pay-option ARM loans and Alt-A loans that have exhibited significant adverse performance.  While these segments have performed adversely compared to the rest of the portfolio, performance in the other segments has, in general, also been adversely impacted by the same general depressed conditions in home prices and credit markets as well as high unemployment levels.

The table below provides a trend analysis of the gross cumulative incurred loss incidence rate by book year for our Primary business (calculated as cumulative gross losses settled plus loss reserves, excluding the impact of captive structures, divided by policy risk originated, in each case for a particular book year) as it has developed during each of the last five quarters.

 
36

 

   
March 31,
   
December 31,
   
September 30,
   
June 30,
   
March 31,
 
Book Year
 
2012
   
2011
   
2011
   
2011
   
2011
 
2000 & Prior
    1.06 %     1.06 %     1.06 %     1.06 %     1.05 %
2001
    1.86 %     1.87 %     1.86 %     1.84 %     1.81 %
2002
    2.44 %     2.43 %     2.39 %     2.33 %     2.27 %
2003
    3.34 %     3.30 %     3.20 %     3.12 %     2.96 %
2004
    6.97 %     6.86 %     6.65 %     6.46 %     6.13 %
2005
    16.60 %     16.22 %     15.57 %     15.22 %     14.26 %
2006
    17.46 %     16.88 %     16.49 %     15.87 %     16.09 %
2007
    16.48 %     15.83 %     15.07 %     14.29 %     14.16 %
2008
    7.78 %     7.23 %     6.55 %     6.15 %     5.72 %
 
Total
    7.94 %     7.71