ITEM 1. BUSINESS.
Triad Guaranty Inc. (the" Company") is a holding company which, through its wholly-owned subsidiary, Triad Guaranty Insurance Corporation ("Triad"), provides private mortgage insurance coverage in the United States to residential mortgage lenders, including mortgage bankers, mortgage brokers, commercial banks and savings institutions.
Private mortgage insurance, also known as mortgage guaranty insurance, is issued in most home purchases and refinancings involving conventional residential first mortgage loans to borrowers with equity of less than 20%. If the homeowner defaults, private mortgage insurance reduces, and in some instances eliminates, the loss to the insured lender. Private mortgage insurance also facilitates the sale of low down payment mortgage loans in the secondary mortgage market, principally to the Federal Home Loan Mortgage Corporation ("Freddie Mac") and the Federal National Mortgage Association ("Fannie Mae"). Under risk-based capital regulations applicable to savings institutions, private mortgage insurance also reduces the capital requirement for such lenders on residential mortgage loans with equity of less than 20%.
Triad was formed in 1987 as a wholly-owned subsidiary of Primerica Corporation and began writing private mortgage insurance in 1988. In September 1989, Triad was acquired by Collateral Mortgage, Ltd. ("CML"), a mortgage banking and real estate lending firm located in Birmingham, Alabama. In 1990, CML contributed the outstanding stock of Triad to its affiliate, Collateral Investment Corp. ("CIC"), an insurance holding company.
The Company was incorporated by CIC in Delaware in August 1993 for the purpose of holding all the outstanding stock of Triad and to undertake the initial public offering of the Company's Common Stock, which was completed in November 1993. CIC currently owns 20.1% and CML owns 19.3% of the outstanding Common Stock of the Company.
The principal executive offices of the Company are located at 101 South Stratford Road, Suite 500, Winston-Salem, North Carolina 27104. Its telephone number is (336) 723-1282.
TYPES OF MORTGAGE INSURANCE
There are two principal types of private mortgage insurance coverage: "primary" and "pool". The Company offers only primary insurance.
PRIMARY INSURANCE
Primary insurance provides mortgage default protection on individual loans and covers unpaid loan principal, delinquent interest and certain expenses associated with the default and subsequent foreclosure (collectively, the "claim amount"). The claim amount, to which the appropriate coverage percentage (typically 15% to 30% as of December 31, 1997) is applied, generally ranges from 110% to 115% of the unpaid principal balance of the loan. The Company's obligation to an insured lender with respect to a claim is determined by applying the appropriate coverage percentage to the claim amount. Under its master policy, the Company has the option of paying the entire claim amount and taking title to the mortgaged property or paying the coverage percentage in full satisfaction of its obligations under the insurance written. Primary insurance can be placed on many types of loan instruments and generally applies to loans secured by mortgages on owner occupied homes. The Company underwrites primary insurance on a loan-by-loan basis and on a "delegated underwriting" basis to a select group of lenders. Mortgage originators who participate in the Company's delegated program are allowed to issue a certificate of insurance on the loans it underwrites if certain strict qualifications are met.
The Company offers primary coverage generally ranging from 6% to 35% of the claim amount with most coverage in the 15% to 30% range as of December 31, 1997. The coverage percentage provided by the Company is selected by the insured lender, subject to the Company's underwriting approval, usually in order to comply with existing Freddie Mac and Fannie Mae requirements to reduce their loss exposure on loans they purchase to 75% or less of the property's value at the time the loan is originated.
The Company's premium rates vary depending upon the loan-to-value (LTV) ratio, loan type, mortgage term, coverage amount and type, which all affect the perceived risk of a claim on the insured mortgage loan. Generally, premium rates cannot be changed after the issuance of coverage. The Company, consistent with industry practice, generally utilizes a nationally based, rather than a regional or local, premium rate structure.
Mortgage insurance premiums are usually paid by the mortgage borrower to the mortgage lender or servicer, which in turn remits the premiums to the mortgage insurer. The Company has three basic types of borrower paid premium plans. The first is a monthly premium plan under which only one or two months' premium is paid at the mortgage loan closing and in some cases no premiums are paid at closing. Thereafter level monthly premiums are collected by the loan servicer for monthly remittance to the Company. In 1996, the Company introduced a variation of the monthly premium plan under which the initial mortgage insurance payment is deferred until the first loan payment is remitted to the Company. This deferred monthly premium product decreases the amount of cash required from the borrower at closing, therefore, making home ownership more affordable. Monthly premium plans represented 94% of new insurance written in
1997. Based on the positive response from mortgage borrowers to the monthly premium plan product, the Company expects that the percentage of new business written on monthly premium plans will remain at least at the current level.
The second type of premium payment plan is an annual premium plan in which a first-year premium is paid at the mortgage loan closing and annual renewal payments, which are generally less than the first year premium, are paid thereafter. Renewal payments are collected monthly and held in escrow by the mortgage lender or servicer for annual remittance in advance of each renewal year.
The third type of premium payment plan requires a single payment paid at the loan closing. The single premium payment can be financed by the borrower by adding it to the principal amount of the mortgage or can be paid in cash at closing by the borrower.
In addition to the borrower paid plans, the Company has a lender-paid plan whereby mortgage insurance premiums are charged to the mortgage lender or loan servicer, which pays the premium to the Company. The lender builds the mortgage insurance premium into the borrower's interest rate. The Company's lender-paid plan allows the lender to offer borrowers lower cost mortgages by reducing the necessary closing costs compared to certain borrower paid plans. The Company's lender-paid plan has been approved for use by Fannie Mae and Freddie Mac.
In 1997, the Company introduced a mortgage insurance program to enable the Company to better meet the needs and requirements of larger national lenders. The program increases the lender's share of the risk of loss on an insured book of business and provides for a fee to the lender for this increased risk. Regulatory and industry issues exist regarding the future of certain risk sharing programs, such as captive reinsurance, currently being marketed within the mortgage insurance industry. A significant portion of Triad's 1997 production, which does not include captive reinsurance, resulted from Triad's new risk sharing programs. However, the resolution of the regulatory and industry questions regarding risk sharing programs makes the continued viability of such programs uncertain.
POOL INSURANCE
Pool insurance has generally been offered by private mortgage insurers to lenders as an additional "credit enhancement" for certain mortgage-backed securities and provides coverage for the full amount of the net loss on each individual loan included in the pool, subject to a provision limiting aggregate losses to a specified percentage of the total original balances of all loans in the pool. Modified pool insurance provides coverage for a specified percentage of the claim amount for each loan insured, subject to an overall stop-loss provision applicable to the entire pool of loans insured. The Company does not offer pool insurance.
CANCELLATION OF INSURANCE
Mortgage insurance coverage cannot be canceled by the Company except for nonpayment of premium or certain material violations of the master policy, and remains renewable at the option of the insured lender. Generally, mortgage insurance is renewable at a rate fixed when the insurance on the loan was initially issued.
Insured lenders may cancel insurance at any time at their option. A borrower may request that an insured servicer cancel insurance on a mortgage loan when its loan balance is less than 80% of the property's current value, but loan servicers are generally restricted in their ability to grant such requests by secondary market requirements as well as by certain other regulatory restrictions. Legislation currently is being discussed, however, which could affect the cancellation of private mortgage insurance. See "Regulation - Indirect Regulation".
When a borrower refinances a Triad-insured mortgage loan by paying it off in full with the proceeds of a new mortgage, the insurance on that existing mortgage is canceled, and insurance on the new mortgage is considered to be new insurance written. Therefore, continuation of Triad's coverage from a refinanced loan to a new loan results in both a cancellation of insurance and new insurance written. The percentage of new insurance written represented by refinanced loans was 14.0%, 16.9%, and 9.3% in 1997, 1996, and 1995, respectively.
To the extent canceled insurance coverage in areas experiencing economic growth is not replaced by new insurance in such areas, the percentage of the Company's book of business in economically weaker areas may increase. This development may occur during periods of heavy mortgage refinancing. Refinanced loans in regions experiencing economic growth are less likely to require private mortgage insurance, while borrowers in economically distressed areas are less likely to qualify for refinancing because of depreciated real estate values. Throughout the 1990's high refinancing activity occurred because of lower mortgage interest rates. The percentage of the Company's policies in force at the end of the year that were canceled during the following year was 15.6%, 14.7%, and 13.6% in 1997, 1996, and 1995, respectively. The cancellations which have occurred since 1988 have not had a material impact on the geographic dispersion of the Company's risk in force.
CUSTOMERS
Residential mortgage lenders such as mortgage bankers, mortgage brokers, commercial banks and savings institutions are the principal customers of the Company. At December 31, 1997, approximately 53% of the Company's risk in force came from mortgage bankers, 22% from mortgage brokers, 16% from commercial banks and 9% from savings institutions. At December 31, 1996, 47% of the Company's risk in force came from mortgage bankers, 24% from mortgage brokers, 17% from
commercial banks and 12% from savings institutions. Although mortgage lenders are the Company's principal customers, individual mortgage borrowers generally bear the cost of primary insurance coverage.
To obtain primary insurance from the Company, a mortgage lender must first apply for and receive a master policy from the Company. The Company's approval of a lender as a master policyholder is based, among other factors, upon an evaluation of the lender's financial position and its management's demonstrated adherence to sound loan origination practices.
The master policy sets forth the terms and conditions of the Company's mortgage insurance policy. The master policy does not obligate the lender to obtain insurance from the Company, nor does it obligate the Company to issue insurance on a particular loan. The master policy provides that the lender must submit individual loans for insurance to the Company and the loan, subject to certain stringent criteria, must be approved by the Company to effect coverage (except in the case of delegated underwriting and when the originator has the authority to approve coverage within certain guidelines). The Company had approximately 6,096 master policy holders at December 31, 1997, compared to 5,750 at December 31, 1996.
The Company's ten largest customers were responsible for 32.2%, 23.4%, and 23.7% of direct risk in force at December 31, 1997, 1996, and 1995, respectively. The largest single customer of the Company (including branches and affiliates of that customer), measured by risk in force, accounted for 10.2%, 3.3%, and 3.4% at December 31, 1997, 1996, and 1995, respectively.
SALES AND MARKETING
The Company currently markets its insurance products through a field sales force of twenty-five salaried account executives, three regional sales managers, four national accounts representatives and two exclusive commissioned general agencies each serving a specific geographic market. The Company is licensed to do business in 43 states and the District of Columbia and has licenses pending in three states. The Company is actively serving mortgage originators in 34 states and the District of Columbia.
In 1997, the Company added to its existing sales force with new representation in the Pacific Northwest, the Upper Midwest, and two new representatives to service the national account market of larger mortgage lenders. Currently, the Company is approved to do business with 21 of the top 30 lenders. The Company will continue to evaluate geographic expansion opportunities, as well as the need for additional sales representation.
The success of the Company is dependent upon the services of its account executives and general agents. For 1997, the Company's two exclusive commissioned general agencies produced approximately 18% of the Company's new
direct insurance written while the salaried account executives and the national account representatives produced the remainder. The loss of the services of any of its key account executives or general agencies could have a material adverse effect on the Company's operations.
COMPETITION AND MARKET SHARE
Triad and other private mortgage insurers compete directly with federal and state governmental and quasi-governmental agencies, principally the Federal Housing Administration (" FHA"). These agencies sponsor government-backed mortgage insurance programs which accounted for approximately 46% of high LTV loans in 1997 and 45% in 1996. In addition to competition from federal agencies, Triad and other private mortgage insurers face competition from state-supported mortgage insurance funds. Several of these states (among them, California, Connecticut, Massachusetts, New York and Vermont) have state housing insurance funds which are either independent agencies or affiliated with state housing agencies. Indirectly, the Company also competes with certain mortgage lenders which forego private mortgage insurance and self-insure against the risk of loss from defaults on all or a portion of their low down payment mortgage loans.
Various proposals are being discussed by Congress and certain federal agencies to reform or modify the FHA. Management is unable to predict the scope and content of such proposals, or whether any such proposals will be enacted into law, and if enacted, the effect on the Company.
The private mortgage insurance industry consists of nine active mortgage insurance companies including Triad, Mortgage Guaranty Insurance Corporation, General Electric Mortgage Insurance Corporation, PMI Mortgage Insurance Co., CMG Mortgage Insurance Co., United Guaranty Residential Insurance Company, Republic Mortgage Insurance Company, Commonwealth Mortgage Assurance Company and Amerin Guaranty Corporation. Triad is the eighth largest private mortgage insurer based on 1997 market share and, according to industry data, had a 2.4% share of net new mortgage insurance written during 1997, up from 1.7% in 1996.
Management believes the Company competes with other private mortgage insurers principally on the basis of personalized and professional service, a strong management and sales team, an experience-based pricing structure and innovative products. Triad was the first in the industry to provide preferred rates to approved lenders that maintain lower loss ratios on loans which they insure with Triad.
UNDERWRITING PRACTICES
The Company considers effective risk management to be critical to its long-term financial stability. Market analysis, prudent underwriting, the use of automated risk evaluation models, auditing and customer service are all important elements of the Company's risk management process.
UNDERWRITING PERSONNEL
The Company's Vice Presidents of Risk Management and Underwriting report directly to the President of the Company and the Executive Vice President of Sales and Marketing, respectively. In addition to a centralized underwriting department in the home office, the Vice President of Underwriting is responsible for the Company's regional offices in Georgia, Texas, Illinois, Arizona and California. The Vice President of Risk Management is responsible for assessing the risk factors for the Company and for the quality control function.
The Company employed an underwriting staff of twenty at December 31, 1997. The Company's field underwriters and underwriting managers are limited in their authority to approve programs for certain mortgage loans. The authority levels are tied to underwriting position, knowledge and experience and relate primarily to loan amounts and property type. All loans insured by the Company are subject to quality control reviews.
RISK MANAGEMENT APPROACH
From its inception in 1988, Triad has adhered to conservative risk management strategies that were developed, in part, as a result of management's assessment of the private mortgage insurance industry's loss experience in the late 1980s. The Company's risk management objective is to build a portfolio of insurance in force with a claims incidence less than the expected claims rates on which its premium rates are based. In order to meet this objective the Company focuses its risk management efforts on five key elements:
o MORTGAGE LENDER. The Company reviews each lender's financial statements and management experience before issuing a master policy. This analysis permits the Company to determine if that lender is predisposed to maintaining a loss ratio on loans which it insures with the Company that will allow the continued use of the Company's preferred premium schedule after the three year grace period. The Company assigns delegated underwriting authority only to lenders with substantial financial resources and established records of originating good quality loans.
o PURPOSE AND TYPE OF LOAN. The Company analyzes four general characteristics of a loan to evaluate its level of risk: (i) LTV ratio; (ii) purpose of the loan; (iii) type of loan instrument; and
(iv) type of property. The Company seeks only the most basic loan types with proven track records for which an assessment of risk can be readily made and the premium received sufficiently offsets that risk. Loans having higher LTV ratios are charged a higher premium, as are other loans which have been shown to carry higher risks, such as adjustable rate mortgages ("ARMs"). Certain categories of loans are generally not insured by the Company because such loans are deemed to have an unacceptable level of risk, including negatively and potential negatively amortizing ARMs, ARMs with maximum annual and lifetime caps greater than two and six percentage points, respectively, and loans for investor properties.
o INDIVIDUAL LOAN AND BORROWER. Except to the extent that the Company's delegated underwriting program and Freddie Mac's and Fannie Mae's automated underwriting services are being utilized, the Company evaluates insurance applications based on its analysis of the borrower's ability and willingness to repay the mortgage loan and the characteristics and value of the mortgaged property. The analysis of the borrower includes reviewing the borrower's housing and total debt ratios as well as the borrower's Fair, Isaac and Co., Inc. ("FICO") credit score, as reported by credit rating agencies. Loans may be submitted under the Stick With Triad program provided the loans meet the program requirements. Further description of the Stick with Triad program is located in the Underwriting Process section. Within this program, the degree to which the borrower must meet certain underwriting standards, as well as the amount of documentation that is required, is a function of the credit score. In the case of delegated underwriting, compliance with program parameters is monitored by periodic audits of delegated business. With the automated underwriting services provided by Freddie Mac and Fannie Mae, lenders are able to obtain approval for mortgage guaranty insurance with any participating mortgage insurer. Triad works with both agencies in offering insurance services through their systems, while monitoring the risk quality of loans insured through such systems.
0 EXPERIENCE-BASED PREMIUM STRUCTURE. To increase profitability, the Company targets lower risk business through the Company's preferred premium rate schedules. The Company was the first in the industry to provide preferred rates to lenders maintaining lower loss ratios on loans which they insure with the Company. These rates, which are lower than those generally available throughout the industry, are offered to lenders for the first three years under a master policy so that a loss ratio on loans which a lender insures with the Company can be fairly determined. After that point, approved lenders maintaining a loss ratio of 40% or less will continue to operate under the preferred rate schedule. Those with loss ratios greater than 40% will be charged higher premiums on new business (as well as higher premiums on renewal business if a variable renewal program was chosen) until the loss ratio is reduced. These higher premiums are comparable to those premiums typically charged by the Company's competitors. This experience-based structure encourages lenders to maintain low loss ratios on loans which they insure with the Company.
o GEOGRAPHIC SELECTION OF RISK. The Company places significant emphasis on the condition of the regional housing markets in determining its marketing and underwriting policies. Using both internal and external data, the Company's risk management department continually monitors the economic conditions in the Company's active and potential markets.
UNDERWRITING PROCESS
The Company accepts applications for insurance under three basic programs: the traditional fully documented program, a credit score driven reduced documentation program, and a delegated underwriting program, which allows a lender's underwriters to commit insurance to a loan based on strict agreed upon underwriting guidelines.
The Company utilizes nationwide underwriting guidelines to evaluate the potential risk of default on mortgage loans submitted for insurance coverage. These guidelines have evolved over time and take into account the loss experience of the entire private mortgage insurance industry. They are also largely influenced by Freddie Mac and Fannie Mae underwriting guidelines. The Company believes its guidelines are generally consistent with those used by other private mortgage insurers with respect to the types of loans that the Company will insure. As a result of the Company's review of regional economies and housing patterns, specific underwriting guidelines applicable to a given local, state or regional market will be modified to address concerns in that market.
Subject to the Company's underwriting guidelines and exception approval procedures, the Company allows its underwriters to utilize their experience and business judgement in evaluating each loan on its own merits. Accordingly, the Company underwriters have discretionary authority to insure loans which deviate in certain minor respects from the Company's underwriting guidelines. More significant exceptions are subject to management approval. In all such cases, compensating factors must be identified. The predominant reason for such deviations involves instances where the borrower's debt-to-income ratio exceeds the Company's guidelines. To compensate for exceptions, the Company's underwriters give favorable consideration to such factors as excellent borrower credit history, the availability of satisfactory cash reserves after closing and employment stability.
In addition to the borrower's willingness and ability to repay the loan, the Company believes that mortgage default risk is affected by a variety of other factors, including the borrower's employment status. Insured mortgage loans made to self-employed borrowers are perceived by the Company to have higher risk of claim, all other factors being equal, than loans to borrowers employed by third parties. The Company's percentage of risk in force involving self-employed borrowers was 3.7% and 3.8% at December 31, 1997 and 1996, respectively.
In 1996, the Company introduced the Stick With Triad program featuring the Slam Dunk Loan(SM) approval process whereby Triad issues a certificate of insurance based on the borrower's FICO credit score or the approval of the loan through Fannie Mae's or Freddie Mac's automated underwriting programs. Under this program, the Company issues a certificate of insurance without the standard underwriting process if certain program parameters are met and the borrower has a predetermined minimum credit score. Documentation submission requirements for non-automated underwritten loans vary depending on the borrower's credit score. In 1997, the Stick With Triad program represented 60% of the Company's commitment volume.
The Company's delegated underwriting program, in addition to the Company's conservative risk management strategies, utilizes extensive "quality control" practices including reunderwriting, reappraisal and similar procedures following issuance of the policy. Standards for type of loan, property type and credit history of the borrower are established consistent with the Company's risk strategy. The program has allowed the Company to serve a greater number of the larger, well established mortgage originators. The Company's delegated underwriting program accounted for 18% of commitments received in 1997 compared to 38% in 1996 and 25% in 1995. The decline in the volume of delegated commitments is a result of the lenders' acceptance of the Company's Stick With Triad program. The performance of loans insured under the delegated underwriting program has been comparable to the Company's non-delegated business.
The Company utilizes its underwriting skills to provide a contract underwriting service to its customers. For a fee, Triad underwrites fully documented underwriting files for secondary market compliance, while at the same time assessing the file for mortgage insurance, if applicable. In 1996, the Company began offering Fannie Mae's Desktop Originator and Desktop Underwriter, as well as the personnel to conduct the underwriting tasks, as a service to its contract underwriting customers. The Company also offers its contract underwriting customers direct access to Freddie Mac's Loan Prospector. These products, which are designed to streamline and reduce costs in the mortgage origination process, supply the Company's customers with fast and accurate service regarding loan compliance and Fannie Mae's or Freddie Mac's decision for loan purchase or securitization.
OTHER RISK MANAGEMENT
Another important aspect of the Company's risk management is the tracking of risk exposure in condominium projects. The Company's risk management computer system tracks the exposure in each project and alerts the underwriter once predetermined limits are reached. The Company's computer system also identifies certain exceptions in loan files that deserve special underwriter attention.
The Company uses a comprehensive audit plan designed to determine whether the underwriting decisions being made are consistent with the policies, procedures and expectations for quality as set forth by management. All areas of
business activity which involve an underwriting decision are included, with emphasis on new products, procedures and new master policyholders. The process used to identify categories of loans selected for an audit begins with the identification and evaluation of certain defined and verifiable risk elements. Each loan is then tested against these elements to identify loans which fail to meet prescribed policies or an identified norm. The procedure allows the Company management to identify concerns not only at the loan level but also portfolio concerns which may exist within a given category of business.
CLAIMS-PAYING ABILITY RATINGS
Certain national mortgage lenders and a large segment of the mortgage securitization market, including Fannie Mae and Freddie Mac, generally will not purchase high LTV mortgages or mortgage-backed securities unless the private mortgage insurance coverage on the mortgages has been issued by an insurer with a claims-paying ability rating of at least "AA-" from Standard & Poor's Corporation ("S&P"), Fitch Investors Service, L.P. ("Fitch") or Duff & Phelps Credit Rating Co. ("Duff & Phelps") or a financial strength rating from Moody's Investor Service ("Moody's") of at least "Aa3". Fannie Mae and Freddie Mac require mortgage guaranty insurers to maintain two ratings of "AA-" or better. Private mortgage insurers are not rated by any other independent nationally-recognized insurance industry rating organization or agency (such as the A.M. Best Company).
Triad has its claims-paying ability rated by S&P, Fitch and Duff & Phelps. These ratings are an indication to a mortgage insurer's customers of the insurer's present financial strength and its capacity to pay future claims. Ratings are generally considered an important element in a mortgage insurer's ability to compete for new business. Triad's claims-paying ability rating by S&P was upgraded to "AA" from "AA-" in January 1997, and the "AA" rating was reaffirmed in January 1998. Triad's improved rating from S&P allows it to compete on similar risk-to-capital guidelines as its competitors. Triad is also rated "AA" by Fitch and Duff & Phelps. Triad has not sought and does not presently intend to seek a financial strength rating from Moody's.
S&P defines insurers rated "AA" as offering excellent financial security and having the capacity to meet policy holder obligations that is strong under a variety of economic and underwriting conditions. Fitch defines insurance companies rated "AA" as having a very strong claims-paying ability and to be only slightly more susceptible than companies rated "AAA" to exhibiting any weakening of financial strength due to adverse business and economic developments. Duff & Phelps defines insurers rated "AA" as having a very high claims-paying ability with only modest risk which may vary slightly over time due to economic and/or underwriting conditions. Ratings from S&P, Fitch and Duff & Phelps are modified with a "+" or "-" sign to indicate the relative position of a company within its category.
When assigning a claims-paying ability rating, S&P, Fitch, and Duff & Phelps generally consider: (i) the specific risks associated with the mortgage insurance industry, such as regulatory climate, market demand, growth and competition; (ii) management depth, corporate strategy and effectiveness of operations; (iii) historical operating results and expectations of current and future performance; and (iv) long-term capital structure, the ratio of debt to equity, the ratio of risk to capital, near-term liquidity and cash flow levels, as well as any reinsurance relationships and the claims-paying ability ratings of such reinsurers. Claims-paying ability ratings are based on factors relevant to policyholders, agents, insurance brokers, and intermediaries. Such ratings are not directed to the protection of investors and do not apply to any securities issued by the Company.
Rating agencies issue claims-paying ability ratings based, in part, upon a company's performance sensitivity to various economic depression scenarios. In determining capital levels required to maintain a company's claims-paying ability rating, the rating agencies allow the use of different forms of capital including statutory capital, reinsurance and debt. In January 1998 the Company completed a $35 million private offering of senior notes due January 15, 2028. The notes are rated "A" by S&P and "A+" by Fitch. The Company contributed $25 million of the net proceeds from the sale of the notes to Triad. The effect of the Company's contribution of $25 million to the capital of Triad will be to improve its risk-to- capital ratio and to provide additional capital considered in the rating agency's depression models.
S&P, Fitch and Duff & Phelps periodically review Triad's claims-paying ability, as they do with all rated insurers. Ratings can be withdrawn or changed at any time by a rating agency.
REINSURANCE
In January 1996 the Company eliminated quota share reinsurance on new business and recaptured substantial portions of its coverages on renewal business. In October 1997 the Company recaptured most of its remaining coverages on renewal business. The restructured reinsurance program reduced the Company's quota share cede rate to 1.7% of direct premium written in 1997 compared to 5.3% in 1996 and 20.8% in 1995. The recapture of business previously ceded resulted in increased premium revenues for the Company. The Company continues to maintain $25 million in excess of loss reinsurance designed to protect the Company in the event of catastrophic levels of losses.
Reinsurance does not legally discharge an insurer from its primary liability for the full amount of the risk it insures, although it does make the reinsurer liable to the primary insurer. There can be no assurance that the Company's reinsurers will be able to meet their obligations under the reinsurance agreements.
Pursuant to deeper coverage requirements imposed by Fannie Mae and Freddie Mac, loans eligible for sale to such agencies with a loan-to-value ratio of over 90% require insurance with a coverage percentage of 30%, in contrast to the 25% coverage previously required. Certain states limit the amount of risk a mortgage insurer may retain with respect to coverage of an insured loan to 25% of the claim amount, and, as a result, the deeper coverage portion of such insurance must be reinsured. To minimize reliance on third party reinsurers and to permit the Company to retain the premiums and related risk on deeper coverage business, Triad reinsures this deeper coverage business with its wholly-owned subsidiary Triad Guaranty Assurance Corporation ("TGAC"). As of December 31, 1997, TGAC had assumed approximately $81.5 million in risk from Triad.
DEFAULTS AND CLAIMS
DEFAULTS
The claim process on private mortgage insurance begins with the insurer's receipt of notification from the lender of a default on an insured's loan. Default is defined in the primary master policy as the failure by the borrower to pay, when due, an amount at least equal to the scheduled monthly mortgage payment under the terms of the mortgage. The master policy requires lenders to notify the Company of default on a mortgage payment within 10 days of either (i) the date on which the borrower becomes four months in default or (ii) the date on which any legal proceeding which affects the loan has been commenced, whichever occurs first. Notification is required within 45 days of the default if it occurs when the first payment is due. The incidence of default is affected by a variety of factors, including change in borrower income, unemployment, divorce, illness, the level of interest rates and general borrower creditworthiness. Defaults that are not cured result in a claim to the Company. Borrowers may cure defaults by making all delinquent loan payments or by selling the property and satisfying all amounts due under the mortgage.
The following table shows the number of loans insured, related loans in default, percentage of loans in default (default rate as of the dates indicated), dollar amount of insured loans in default, dollar amount of direct risk (gross of reinsurance) with respect to insured loans in default, and reserves per delinquent loan:
Default Statistics
CLAIMS
Claims result from defaults that are not cured. The frequency of claims does not directly correlate to the frequency of defaults due in part to the Company's loss mitigation efforts and the borrower's ability to overcome temporary financial setbacks. The likelihood that a claim will result from a default, and the amount of such claim, principally depend on the borrower's equity at the time of default and the borrower's (or the lender's) ability to sell the home for an amount sufficient to satisfy all amounts due under the mortgage, as well as the effectiveness of loss mitigation efforts. Claims are also affected by local housing prices, interest rates, unemployment levels, the housing supply and the borrower's desire to avoid foreclosure. During the default period, the Company works with the insured for possible early disposal of underlying properties when the chance of the loan reinstating is minimal. Such dispositions typically result in a reduced claim amount to the Company.
Claim activity is not evenly spread through the coverage period. Relatively few claims are received during the first two years following issuance of insurance. A period of rising claims follows, which, based on industry experience, has historically reached its highest level in the third through sixth years after the loan origination. Thereafter, the number of claims received has historically declined at a gradual rate, although the rate of decline can be affected by economic and other conditions. There can be no assurance that the historical pattern of claims will continue in the future.
Generally, the Company does not pay a claim for loss under the master policy if the application for insurance for the loan in question contains fraudulent information, material omissions or misrepresentations which increase the risk characteristics of the loan. The Company's master policy also excludes any cost or expense related to the repair or remedy of any physical damage (other than "normal wear and tear") to the property collateralizing an insured mortgage loan. Such physical damage may be caused by accident, natural occurrence or otherwise.
Under the terms of the master policy, the lender is required to file a claim with the Company no later than 60 days after it has acquired good and marketable title to the underlying property through foreclosure. A primary insurance claim amount includes (i) the amount of unpaid principal due under the loan; (ii) the amount of accumulated delinquent interest due on the loan (excluding late charges) to the date of claim filing; (iii) expenses advanced by the insured under the terms of the master policy, such as hazard insurance premiums, property maintenance expenses and property taxes to the date of claim filing; and (iv) certain foreclosure and other expenses, including attorneys fees. Such claim amount is subject to review and possible adjustment by the Company. An average of about 12 months elapses from the date of default to a payment of claim on an uncured default. The Company's experience indicates that the claim amount on a policy generally ranges from 110% to 115% of the unpaid principal amount of a foreclosed loan.
Within 60 days after the claim has been filed, the Company has the option of either (i) paying the coverage percentage specified on the certificate of insurance (usually 15% to 30% of the claim), with the insured retaining title to the underlying property and receiving all proceeds from the eventual sale of the property or (ii) paying 100% of the claim amount in exchange for the lender's conveyance of good and marketable title to the property to the Company, with the Company selling the property for its own account. The Company attempts to choose the claim settlement option which costs the least. In general, the Company settles claims by paying the coverage percentage of the claim amount. In 1997, the Company exercised the option to acquire the property on less than 1% of the primary claims processed for payment. At December 31, 1997, the Company owned $141,999 of real estate acquired through claim settlements valued at the lower of cost or net realizable value and owned no real estate as of December 31, 1996.
LOSS MITIGATION
Once a default notice is received, the Company attempts to mitigate its loss. Through proactive intervention with insured lenders and borrowers, the Company has been successful in reducing the number and severity of its claims for loss. Loss mitigation techniques include pre-foreclosure sales, advances to assist distressed borrowers who have suffered a temporary economic setback, and the use of new repayment schedules, refinances, loan modifications, forbearance agreements and deeds-in-lieu of foreclosure. Such mitigation efforts typically result in a savings to the Company over the percentage coverage amount payable under the certificate of insurance. Through loss mitigation efforts, the Company has paid out only 65% of its potential exposure on claims paid through December 31, 1997.
LOSS RESERVES
The Company establishes reserves to provide for the estimated costs of settling claims with respect to loans reported to be in default and estimates of loans in default which have not been reported. Consistent with industry
accounting practices, the Company does not establish loss reserves for future claims on insured loans which are not currently in default. Although the Company believes that its overall reserve levels at December 31, 1997, are adequate to meet its future obligations, due to the inherent uncertainty of the reserving process there can be no assurance that its reserves will prove to be adequate to cover ultimate loss developments.
In determining the liability for unpaid losses related to outstanding defaults, the Company establishes loss reserves on a case-by-case basis using historical experience and by making various assumptions and judgements about the ultimate amount to be paid on loans in default. The amount reserved for any particular loan is dependent upon the status of the loan as reported by the servicer of the insured loan. As the default progresses closer to foreclosure, the amount of loss reserve for that particular loan will be increased, in stages, to approximately 120% of the Company's exposure, which includes claims-related expenses. The Company periodically reviews and adjusts its reserve estimates to address changes in economic conditions as well as developments in its loss experience.
The Company also establishes reserves to provide for the estimated costs of settling claims, including legal and other fees, and general expenses of administering the claims settlement process ("loss adjustment expenses" or "LAE") and for losses and loss adjustment expenses incurred arising from defaults which have occurred, but which have not yet been reported to the insurer ("Incurred But Not Reported" or "IBNR").
The Company's reserving process is based upon the assumption that past experience, adjusted for the anticipated effect of current economic conditions and projected future economic trends, provides a reasonable basis for estimating future events. However, estimation of loss reserves is a difficult and inexact process, especially in light of the rapidly changing economic conditions over the past few years in certain regions of the United States. In addition, economic conditions that have affected the development of the loss reserves in the past may not necessarily affect development patterns in the future in either a similar manner or degree. Due to the inherent uncertainty in estimating reserves for losses and loss adjustment expenses, there can be no assurance that the reserves will prove to be adequate to cover ultimate loss developments on loans in default, currently or in the future. The Company's profitability and financial condition could be adversely affected to the extent that the Company's estimated reserves are insufficient to cover losses on loans in default.
The following table represents a reconciliation of the beginning and ending loss reserves (net of reinsurance) for the periods indicated.
Reconciliation of Losses and Loss Adjustment Expense Reserves
Year Ended December 31 (in thousands) 1997 1996 1995 1994 1993 ---- ---- ---- ---- ---- Reserve for losses and LAE, net of related reinsurance recoverables, at beginning of year.. $5,974 $3,703 $2,466 $1,805 $1,073
Add losses and LAE incurred in respect of defaults occurring in: Current year (1)................ 6,023 4,673 3,191 2,053 1,489 Prior years (1) (2)............. (846) (1,394) (974) (791) (205) ------- ------- ------- ------- ------ Total incurred losses and LAE........ 5,177 3,279 2,217 1,262 1,284
Deduct losses and LAE paid in respect of defaults occurring in: Current year..................... 210 167 216 86 95 Prior years...................... 2,032 841 764 515 457 ------- ------- ------- ------- ------ Total payments........................ 2,242 1,008 980 601 552
Reserve for losses and LAE, net of the related reinsurance recoverables, at end of year......... 8,909 5,974 3,703 2,466 1,805
Reinsurance recoverables on unpaid losses and LAE, at the end of year ............................. 51 331 886 698 450 ------- ------- ------- ------- ------ Reserve for unpaid losses and LAE, before deduction of reinsurance recoverables on unpaid losses, at end of year.......................... $8,960 $6,305 $4,589 $3,164 $2,255 ====== ====== ====== ====== ====== - -------------- (1) Includes loss and LAE reserves relating to loans which are in default but for which default notices have not been received. (2) Indicates a cumulative redundancy in loss reserves at the beginning of each period. Redundancies result from overestimating ultimate claim amounts.
The top section of the above table shows losses incurred on insurance policies with respect to defaults which occurred in the current and prior periods. The amount of losses incurred relating to defaults occurring in the current period represents the estimated amount to be ultimately paid on defaults occurring in that period. The amount of losses incurred relating to defaults occurring in prior periods represents an adjustment made in the current period for defaults which were included in the loss reserve at the end of the prior period.
The middle section of the above table shows claims paid on insurance policies with respect to defaults which occurred in the current period and in prior periods, respectively. Since it takes, on average, about 12 months for a default which is not cured to eventually develop into a paid claim, most losses paid relate to defaults occurring in prior periods.
ANALYSIS OF DIRECT RISK IN FORCE
A foundation of the Company's business strategy is proactive risk selection. The Company analyzes its portfolio in a number of ways to identify any concentrations of risk or imbalances in risk dispersion. The Company believes that the quality of its insurance portfolio is affected predominantly by (i) the quality of loan originations (including the strength of the borrower and the marketability of the property); (ii) the attributes of loans insured (including LTV ratio, purpose of the loan, type of loan instrument and type of underlying property securing the loan); (iii) the seasoning of the loans insured; (iv) the geographic dispersion of the underlying properties subject to mortgage insurance; and (v) the quality and integrity of lenders from which the Company receives loans to insure.
LENDER AND PRODUCT CHARACTERISTICS
The following table reflects the percentage of direct gross risk in force (as determined on the basis of information available on the date of mortgage origination) by the categories indicated on December 31, 1997 and 1996:
Direct Risk in Force
December 31 1997 1996 ---- ---- Product Type: Primary............................................... 100.0% 100.0% Pool.................................................. 0.0% 0.0% ------ ------ Total................................................. 100.0% 100.0% ====== ======
Direct Primary Risk in Force
December 31 1997 1996 ---- ---- Direct Risk in Force (dollars in millions)............ $2,231 $1,515 Lender Concentration: Top 10 lenders (by original applicant)................ 32.2% 23.4% LTV: 90.01% to 95.00% (1).................................. 52.0% 49.4% 90.00 and below....................................... 48.0% 50.6% ------ ------ Total................................................. 100.0% 100.0% ====== ====== Loan Type: Fixed................................................. 88.2% 85.6% ARM (positive amortization) (2)....................... 11.8% 14.4% ARM (potential negative amortization) (3)............. 0.0% 0.0% ARM (scheduled negative amortization) (3)............. 0.0% 0.0% Other................................................. 0.0% 0.0% ------ ------ Total................................................. 100.0% 100.0% ====== ====== Mortgage Term: 15 years and under.................................... 4.3% 5.6% Over 15 years......................................... 95.7% 94.4% ------ ------ Total................................................. 100.0% 100.0% ====== ====== Property Type: Noncondominium (principally single-family detached)... 94.9% 94.3% Condominium........................................... 5.1% 5.7% ------ ------ Total................................................. 100.0% 100.0% ====== ====== Occupancy Status: Primary residence..................................... 100.0% 100.0% Second home........................................... 0.0% 0.0% Nonowner occupied..................................... 0.0% 0.0% ------ ------ Total................................................. 100.0% 100.0% ====== ====== Mortgage Amount: $200,000 or less...................................... 95.3% 92.1% Over $200,000......................................... 4.7% 7.9% ------ ------ Total................................................. 100.0% 100.0% ====== ======
(1) Includes 97s, representing less than 1% of risk in force at December 31, 1997.
(2) Refers to loans where payment adjustments are the same as mortgage interest rate adjustments.
(3) Scheduled negative amortization is defined by the Company as the increase in loan balance that will occur if interest rates do not change. Loans with potential negative amortization will not have increasing principal balances unless interest rates increase.
One of the most important determinants of claim incidence is the relative amount of the borrower's equity in the home (which at the time of origination is the down payment). For the industry as a whole, historical evidence indicates that claim incidence on loans having a LTV ratio in excess of 90% is greater than the claim incidence on loans with LTV ratios equal to or less than 90%. The Company believes that the higher premium rates it charges on these high LTV loans adequately reflects the additional risk.
In 1995, the mortgage insurance industry introduced a 97% LTV product ("97s") which was offered to low and moderate income borrowers under certain pilot programs. The Company believes that these "affordable housing" loans have higher risks than its other insured business and has often attracted borrowers with weak credit histories, generally resulting in higher loss ratios. In keeping with the Company's established risk strategy, the Company has not aggressively solicited this segment of the industry, and, as of December 31, 1997, 97s constituted less than 1% of direct risk in force. The Company does not routinely delegate the underwriting of its 97% LTV product.
The Company generally insures only positively amortizing ARMs with maximum annual and lifetime caps of two and six percentage points, respectively. Payments on these loans adjust fully with interest rate adjustments. To date, the performance of the Company's ARM loans has been consistent with that of the fixed rate portfolio. However, since historical claim frequency data on ARMs has not yet been tested during a prolonged period of economic stress, there can be no assurance that claim frequency on ARMs may not eventually be higher, particularly during a period of rising interest rates combined with decreasing housing prices. In its normal course of operations, the Company's existing underwriting policy does not permit coverage of ARMs with "scheduled" or "potential" negative amortization.
Historical evidence indicates that higher priced properties experience wider fluctuations in value than moderately priced residences. These fluctuations exist primarily because there is a much smaller pool of qualified buyers for higher priced homes which, in turn, reduces the likelihood of achieving a quick sale at fair market value when necessary to avoid a default.
The Company believes that 15-year mortgages present a lower level of risk than 30-year mortgages, primarily as a result of the faster amortization and the more rapid accumulation of borrower equity in the property. Accordingly, the Company charges lower premium rates on these loans than on comparable 30-year mortgages.
The Company believes that the risk of claim is also affected by the type of property securing the insured loan. In management's opinion, loans on single-family detached housing are subject to less risk of claim incidence than loans on other types of properties. The Company believes that attached housing types, particularly condominiums and cooperatives, are a higher risk because in most areas condominiums and cooperatives tend to be more susceptible to downward fluctuations in value than single family detached dwellings in the same market. The term "single-family" applies to all one-to-four unit dwellings and includes
detached and attached townhouse units with fee simple ownership, condominiums and cooperatives.
Loans on primary residences that were owner occupied at the time of loan origination constituted almost all of the Company's risk in force at December 31, 1997. Because management believes that loans on nonowner occupied properties represent a substantially higher risk of claim incidence and are subject to greater value declines than loans on primary homes, the Company insures these types of loans only on a case-by-case basis and only after stringent management review.
The Company's book of business is less mature than that of the private mortgage insurance industry as a whole, with the Company's direct risk in force having a weighted average life of 2.3 years at December 31, 1997, and 2.4 years at December 31, 1996, compared to an estimated industry average of 3.3 years at December 31, 1997.
The following table shows the percentage of direct risk in force as of December 31, 1997, for policies written from 1988 through 1997 by the Company, as well as the cumulative loss ratio (calculated as losses paid divided by premiums written, in each case for a particular certificate year) which has developed, through December 31, 1997, for the policies written during the years indicated and excludes the effects of reinsurance:
Certificate Percent Cumulative Ratio of Losses Year Direct Risk in Force of Total Paid to Premiums Written(1) ---- -------------------- -------- --------------------------- (in millions) 1988 $ 1.9 0.1% 14.6 1989 2.6 0.1 23.8 1990 4.8 0.2 16.1 1991 18.9 0.8 10.6 1992 83.0 3.7 7.1 1993 184.9 8.3 4.2 1994 196.6 8.9 4.7 1995 319.9 14.3 3.1 1996 505.6 22.7 1.0 1997 913.2 40.9 0.0 -------- ------ Total $2,231.4 100.0% ======== ====== - ------------------------- (1) Claim activity is not spread evenly throughout the coverage period of the book of business. Based on the Company's and the industry's historical experience, claims incidence is highest in the third through sixth years after loan origination, and relatively few claims are paid during the first two years after loan origination. Thus, the cumulative loss experience of recent certificate years is not indicative of ultimate losses.
GEOGRAPHIC DISPERSION
The following tables reflect the percentage of direct risk in force, net of reinsurance, on the Company's book of business (by location of property) for the top ten states and the top ten metropolitan statistical areas ("MSAs") as of December 31, 1997. The Company continues to diversify its risk in force geographically. The percentage of the Company's direct risk in force by top ten states declined to 73.9% for 1997 compared to 77.5% and 78.6% for 1996 and 1995, respectively. The percentage of the Company's direct risk in force by top ten MSAs declined to 36.8% for 1997 compared to 41.9% and 42.9% for 1996 and 1995, respectively.
Ten States Top Ten MSAs ---------- ------------
December 31 December 31 1997 1997 ---- ---- Georgia 13.2% Chicago, IL 12.3% Illinois 12.9 Atlanta, GA 7.0 Florida 9.5 Washington D.C. 3.6 Virginia 7.2 San Francisco/Oakland, CA 2.2 California 7.1 Houston/Galveston, TX 2.0 Texas 5.8 Baltimore, MD 2.0 North Carolina 5.3 Minneapolis-St. Paul, MN 2.0 Pennsylvania 5.1 Richmond, VA 2.0 Colorado 3.9 Charlotte-Gastonia, NC 2.0 Maryland 3.9 Denver, CO 1.7 ----- ----- Total 73.9% Total 36.8% ===== =====
While the Company continues to diversify its risk in force geographically, a prolonged regional recession, particularly in its high concentration areas, such as the Southeastern, Middle Atlantic and upper Mid-Western states, or a prolonged national economic recession, could significantly increase loss development.
INVESTMENT PORTFOLIO
Income from its investment portfolio is one of the Company's primary sources of cash flow to support its operations and claims payments. Triad has an investment advisory agreement with CML for management of its portfolio.
The Company follows an investment policy which requires: (i) 75% of its investment portfolio (together with cash assets) to consist of cash, short-term investments and debt securities (including redeemable preferred stocks) which, at the date of purchase, were rated investment grade by a nationally recognized rating agency (e.g.,"BBB-" or better by S&P) and (ii) at least 50% of its investment portfolio (together with cash assets) to consist of cash, cash equivalents and securities which, at the date of purchase, were rated one of the
two highest investment grades by a nationally recognized rating agency. At December 31, 1997, the Company's total investment portfolio had a fair market value of $119.9 million and did not include any real estate or mortgage loans.
Liquidity is sought through cash equivalent investments and through diversification and investment in publicly traded securities. The Company attempts to maintain a level of liquidity and a duration in its investment portfolio consistent with its business outlook and the expected timing, direction and degree of changes in interest rates. As of December 31, 1997, no investment in the securities of any single issuer (other than the U.S. government and its agencies) exceeded 2% of the Company's investment portfolio.
The Company intends to invest the proceeds of the note offering in accordance with its investment policy. To date, the Company's investments have emphasized tax-preferred securities. Because of restrictions imposed under federal income tax laws, investment by the Company of proceeds of the note offering must be made principally in taxable securities. Through investment of a portion of the net proceeds of the note offering, the Company plans to increase its investments in higher yielding non-investment grade securities to approximately 10% of its consolidated portfolio, up from approximately 3% at December 31, 1997.
The Company's investment policies and strategies are subject to change depending upon regulatory, economic and market conditions and the existing or anticipated financial condition and operating requirements, including the tax position, of the Company.
The following table shows the results of the Company's investment portfolio for the periods indicated:
Investment Portfolio Results
(1) Excludes the Company's investment in Southwide Life Insurance Corp. for all periods during which it was held. (2) Based on historical cost adjusted for amortization and accretion of premium and discount. (3) Based on book value and the Company's marginal tax rate.
The diversification of the Company's investment portfolio at December 31, 1997, is shown in the table below:
Investment Portfolio Diversification
December 31, 1997 ----------------- Amortized Fair Cost Value Percent(1) ---- ----- ---------- Available-for-sale securities: Fixed maturity securities: U. S. government obligations.......... $ 9,823,960 $ 10,197,431 8.5% Mortgage-backed bonds................. 4,679,115 4,801,355 4.0 State and municipal bonds............. 68,789,100 71,819,355 59.9 Industrial & miscellaneous............ 12,463,961 12,907,346 10.7 ------------ ------------- Total fixed maturities............... 95,756,136 99,725,487
Equity securities....................... 8,666,815 11,466,028 9.6 ------------ ------------- Total available-for-sale securities.. 104,422,951 111,191,515 Short-term investments.................. 8,685,842 8,685,842 7.3 ------------ ------------- ------ _________________ $113,108,793 $119,877,357 100.0% ============ ============ ====== (1) Percentage of fair value.
The following table shows the scheduled maturities at December 31, 1997, of the fixed maturity securities held in the Company's investment portfolio:
Investment Portfolio Scheduled Maturity
December 31, 1997 ----------------- Fair Value Percent ---------- ------- One year or less............................ $ 1,181,270 1.2% After one year through five years........... 23,101,381 23.2 After five years through ten years.......... 19,592,870 19.6 After ten years though twenty years......... 45,984,210 46.1 After twenty years.......................... 5,064,401 5.1 Mortgage-backed securities (1).............. 4,801,355 4.8 ----------- ------ Total.............................. $ 99,725,487 100.0% =========== ====== - ------------ (1) Substantially all of these securities are guaranteed by U.S. Government Agencies.
The following table shows the ratings of the Company's investment portfolio as of December 31, 1997:
Investment Portfolio by S&P Rating
December 31, 1997 ----------------- Rating(1) Fair Value Percent ---------- -------
Fixed maturities: U.S. Treasury and U.S. agency bonds..... $ 4,801,355 4.8% AAA..................................... 43,965,748 44.1 AA...................................... 20,539,938 20.6 A....................................... 14,979,834 15.0 BBB..................................... 11,960,617 12.0 BB...................................... 287,798 0.3 B....................................... 282,000 0.3 NR...................................... 2,908,197 2.9 ------------- ------ Total fixed maturities............. $ 99,725,487 100.0% ============= ======
Equities: AAA..................................... $ 508,750 4.4% AA...................................... 1,208,441 10.5 A....................................... 8,974,909 78.3 B....................................... 773,928 6.8 -------------- ------ Total equities..................... $ 11,466,028 100.0% ============== ====== Total Portfolio.................................. $ 111,191,515 ============== - -------------- (1) Current ratings assigned by S&P.
REGULATION
DIRECT REGULATION
The Company's insurance subsidiaries are subject to comprehensive, detailed regulation, principally for the protection of policyholders rather than for the benefit of investors, by the insurance departments of the various states in which each insurer is licensed to transact business. Although their scope varies by state, state insurance laws in general grant broad powers to supervisory agencies or officials to examine companies and to enforce rules or exercise discretion touching almost every significant aspect of the insurance business. These include the licensing of companies to transact business, claims handling practices, reinsurance requirements, varying degrees of control over premium rates, the forms and policies offered to customers, financial statements, periodic financial reporting, permissible investments and adherence to financial standards relating to statutory surplus, dividends and other criteria of solvency intended to assure the satisfaction of obligations to policyholders.
All states have enacted legislation that requires each insurance company in a holding company system to register with the insurance regulatory authority of its state of domicile and furnish to the regulator financial and other information concerning the operations of companies within the holding company system that may materially affect the operations, management or financial condition of the insurers within the system. Generally, all transactions within a holding company system between an insurer and its affiliates must be fair and reasonable and the insurer's statutory policyholders' surplus following any transaction with an affiliate must be both reasonable in relation to its outstanding liabilities and adequate for its needs. Most states also regulate transactions between insurance companies and their parents and/or affiliates. There can be no assurance that state regulatory requirements will not become more stringent in the future and have an adverse effect on the Company.
Because the Company is an insurance holding company and Triad is an Illinois domiciled insurance company, the Illinois insurance laws regulate, among other things, certain transactions in the Company's Common Stock and certain transactions between Triad and the Company or affiliates. Specifically, no person may, directly or indirectly, offer to acquire or acquire beneficial ownership of more than 10% of any class of outstanding securities of the Company or its subsidiaries unless such person files a statement and other documents with the Illinois Director and obtains the Director's prior approval. In addition, material transactions between Triad and the Company or affiliates are subject to certain conditions, including that they be "fair and reasonable". These restrictions generally apply to all persons controlling or under common control with the insurance companies. "Control" is presumed to exist if 10% or more of Triad's voting securities is owned or controlled, directly or indirectly, by a person, although the Illinois Director may find that "control" in fact does or does not exist where a person owns or controls either a lesser or greater amount of securities. Other states in addition to Illinois may regulate affiliated transactions and the acquisition of control of the Company or its insurance subsidiaries.
Triad is required by Illinois insurance laws to provide for a contingency reserve in an amount equal to at least 50% of earned premiums. Such reserves must be maintained for a period of 10 years except in circumstances where high levels of losses exceed regulatory thresholds. The contingency reserve, designed to provide a cushion against the effect of adverse economic cycles, has the effect of reducing statutory surplus and restricting dividends and other distributions by Triad. At December 31, 1997, Triad had statutory policyholders' surplus of $60.9 million and statutory contingency reserve of $54.8 million. At December 31, 1996, Triad had statutory policyholders' surplus of $57.1 million and a statutory contingency reserve of $35.1 million. Triad's statutory earned surplus was $2.5 million at year end 1997 versus a deficit of $1.3 million at year end 1996, reflecting growth in statutory net income greater than the increase in the statutory contingency reserve.
The insurance laws of Illinois provide that Triad may pay dividends only out of statutory earned surplus as of the end of the preceding calendar year and further establish standards limiting the maximum amount of dividends which may be paid without prior approval by the Illinois Director. Under such standards, Triad may pay dividends during any 12-month period equal to the greater of (i) 10% of the preceding year-end statutory policyholders' surplus or (ii) the preceding year's net income. In addition, insurance regulatory authorities have broad discretion to limit the payment of dividends by insurance companies. As a mortgage guaranty insurer, Triad is required by Illinois insurance laws to provide a contingency reserve. The contingency reserve has the effect of reducing statutory surplus and restricting dividends and other distributions by Triad.
Although not subject to a rating law in Illinois, premium rates for mortgage insurance are subject to regulation in most states to protect policyholders against the adverse effects of excessive, inadequate or unfairly discriminatory rates and to encourage competition in the insurance marketplace. Any increase in premium rates must be justified, generally on the basis of the insurer's loss experience, expenses and future trend analysis. The general mortgage default experience may also be considered.
Triad is subject to examination of its affairs by the insurance departments of each of the states in which it is licensed to transact business. The Illinois Director periodically conducts a financial examination of insurance companies domiciled in Illinois. The most recent examination of Triad was issued by the Illinois Insurance Department on September 6, 1995, and covered the period January 1, 1991, through December 31, 1994. No material recommendations were made as a result of this examination. The next examination has not been scheduled.
TGAC was organized as a subsidiary of Triad under the insurance laws of the state of Illinois in December, 1994 and as an Illinois domiciled insurer, is subject to all Illinois insurance regulatory requirements applicable to Triad described above. To date the Illinois Director has not conducted or scheduled an examination of TGAC.
A number of states generally limit the amount of insurance risk which may be written by a private mortgage insurer to twenty-five times the insurer's total policyholders' surplus. This restriction is commonly known as the "risk-to-capital" requirement.
Mortgage insurers are generally restricted by state insurance laws and regulations to writing residential mortgage guaranty insurance business only. This restriction generally prohibits Triad from using its capital resources in support of other types of insurance and restricts its noninsurance business. However, noninsurance businesses of the Company would not generally be subject to regulation under state insurance laws.
Regulation of reinsurance varies by state. Except for Illinois, Wisconsin, New York, Ohio and California, most states have no special restrictions on reinsurance that would apply to private mortgage insurers other than standard reinsurance requirements applicable to property and casualty insurance companies. Certain restrictions, including reinsurance trust fund or letter of credit requirements, apply under Illinois law to domestic companies and under the laws of several other states to any licensed company ceding business to unlicensed reinsurers. If a reinsurer is not admitted or approved, the company doing business with the reinsurer cannot take credit in its statutory financial statements for the risk ceded to such reinsurer absent compliance with the reinsurance security requirements. In addition, some states in which Triad does business have limited private mortgage insurers to a maximum policy coverage limit of 25% of the insured's claim amount and require coverages in excess of 25% to be reinsured through another licensed mortgage insurer.
The National Association of Insurance Commissioners ("NAIC") adopted a risk-based capital ("RBC") formula designed to help regulators identify property/casualty insurers in need of additional capital. The RBC formula establishes minimum capital needs based upon risks applicable to individual insurers, including asset risks, off balance sheet risks (such as guarantees for affiliates and contingent liabilities), and credit risks (such as reinsurance ceded and receivables). The NAIC and the Illinois Department of Insurance currently do not require mortgage guaranty insurers to file RBC analysis in their annual statements.
As the dominant purchasers and sellers of conventional mortgage loans and beneficiaries of private mortgage guaranty insurance, Freddie Mac and Fannie Mae impose requirements on private mortgage insurers in order for such insurers to be eligible to insure loans sold to such agencies. Freddie Mac's current eligibility requirements impose limitations on the type of risk insured, standards for the geographic and customer diversification of risk, procedures for claims handling, acceptable underwriting practices and financial requirements which generally mirror state insurance regulatory requirements. These requirements are subject to change from time to time. Fannie Mae also has eligibility requirements, although such requirements are not published. Triad is an approved mortgage insurer for both Freddie Mac and Fannie Mae and meets all eligibility requirements. There can be no assurance, however, that such requirements will not change or that Triad will continue to meet such requirements.
Certain national mortgage lenders and a large segment of the mortgage securitization market, including Fannie Mae and Freddie Mac, generally will not purchase mortgages or mortgage-backed securities unless the private mortgage insurance on the mortgages has been issued by an insurer with a claims-paying ability rating of at least "AA-" from S&P, Fitch, or Duff & Phelps or a financial strength rating of at least "Aa3" from Moody's. Fannie Mae and Freddie Mac require mortgage guaranty insurers to maintain two ratings of "AA-" or better. Triad has a claims-paying ability rating of "AA" from S&P, Fitch, and Duff & Phelps. These ratings meet the eligibility requirements of Fannie Mae and Freddie Mac. S&P, Fitch, and Duff & Phelps include TGAC operations and financial position with those of Triad in rating Triad's claims-paying ability. There can be no assurance that Triad's claims-paying ability rating, the method by which this rating is determined or the eligibility requirements of Fannie Mae and Freddie Mac will not change.
The Real Estate Settlement and Procedures Act of 1974 ("RESPA") applies to most residential mortgages insured by Triad, and related regulations provide that mortgage insurance is a "settlement service" for purposes of loans subject to RESPA. Subject to limited exceptions, RESPA prohibits persons from accepting anything of value for referring real estate settlement services to any provider of such services. Although many states prohibit mortgage insurers from giving rebates, RESPA has been interpreted to cover many non-fee services as well. The recently renewed interest of the Department of Housing and Urban Development ("HUD") in investigating transactions for compliance with RESPA has increased awareness of both mortgage insurers and their customers of the possible implications of this law.
Most originators of mortgage loans are required to collect and report data relating to a mortgage loan applicant's race, nationality, gender, marital status and census tract to HUD or the Federal Reserve under the Home Mortgage Disclosure Act of 1975 ("HMDA"). The purpose of HMDA is to detect possible discrimination in home lending and, through disclosure, to discourage such discrimination. Mortgage insurers are not required pursuant to any law or regulation to report HMDA data although under the laws of several states mortgage insurers are currently prohibited from discriminating on the basis of certain classifications. The active mortgage insurers, through their trade association, the Mortgage Insurance Companies of America ("MICA"), have entered into an agreement with the Federal Financial Institutions Examinations Council ("FFIEC") to report the same data on loans submitted for insurance as is required for most mortgage lenders under HMDA.
INDIRECT REGULATION
The Company, Triad and TGAC are also indirectly, but significantly, impacted by regulations affecting purchasers of mortgage loans, such as Freddie Mac and Fannie Mae, and regulations affecting governmental insurers such as the FHA as well as lenders. Private mortgage insurers, including Triad, are highly dependent upon federal housing legislation and other laws and regulations which affect the demand for private mortgage insurance and the housing market generally. For example, housing legislation enacted in 1992 permits up to 100% of borrower closing cost to be financed by loans insured by FHA, a significant increase from the previous 57% limit. Also, in April 1994, HUD reduced the
initial premium (payable at loan origination) for FHA insurance from 3.0% to 2.25%. Effective January 1, 1998, the maximum individual loan amount that the FHA could insure was increased from $160,950 to $170,362. The maximum individual loan amount the VA can insure presently is $203,000. The maximum loan amounts that the FHA and VA can insure are subject to adjustment and may increase in the future. Any future legislation that increases the number of persons eligible for FHA or VA mortgages could have an adverse effect on the Company's ability to compete with the FHA or VA.
Pursuant to the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 ("FIRREA"), the Office of Thrift Supervision ("OTS") issued risk-based capital rules for savings institutions. These rules establish a lower capital requirement for a low down payment loan that is insured with private mortgage insurance, as opposed to remaining uninsured. Furthermore, the guidelines for real estate lending policies applicable to savings institutions and commercial banks provide that such institutions should require appropriate credit enhancement in the form of either mortgage insurance or readily marketable collateral for any high LTV mortgage. To the extent FIRREA's risk-based capital rules or the guidelines for real estate lending policies applicable to savings institutions and commercial banks are changed in the future, some of the anticipated benefits of FIRREA and the guidelines for real estate lending policies to the mortgage insurance industry, including Triad, may be curtailed or eliminated.
In 1995, Fannie Mae and Freddie Mac each introduced their own automated underwriting system to be used by mortgage originators selling mortgages to them. These systems, which are provided as a service to the Company's contract underwriting customers, streamline the mortgage process and reduce costs. As a result of the increased acceptance of these products in 1997 and for other reasons, the process by which mortgage originators sell loans to Fannie Mae and Freddie Mac is becoming increasingly automated, a trend which is expected to continue. As a result, Fannie Mae and Freddie Mac could develop the capability to become the decision maker regarding selection of a private mortgage insurer for loans sold to them, a decision traditionally made by the mortgage originator. The Company, however, is not aware of any plans to do so. The concentration of purchasing power that would be attained if such development in fact occurred could adversely affect, from the Company's perspective, the terms on which mortgage insurance is written on loans sold to Fannie Mae and Freddie Mac.
Additionally, proposals have been advanced which would allow Fannie Mae and Freddie Mac additional flexibility in determining the amount and nature of alternative recourse arrangements or other credit enhancements which they could utilize as substitutes for private mortgage insurance. The Company cannot predict if or when any of the foregoing legislation or proposals will be adopted, but if adopted and depending upon the nature and extent of revisions made, demand for private mortgage insurance may be adversely affected. There can be no assurance that other federal laws affecting such institutions and entities will not change, or that new legislation or regulation will not be adopted.
Upon request by an insured, Triad must cancel the mortgage insurance for a mortgage loan. Fannie Mae and Freddie Mac guidelines, as well as several existing and proposed state statutes, contain various provisions which give borrowers the right to request cancellation of mortgage insurance when specified conditions are met. In addition, legislation currently is being considered in the Senate and House banking committees regarding the cancellation of private mortgage insurance. Such legislation would require mortgage servicers to inform consumers of their right to cancel their private mortgage insurance once the home owners have achieved 20% equity in their home. Among other options being proposed regarding the cancellation of mortgage insurance are automatic cancellation of private mortgage insurance once the prescribed equity level of 20% has been achieved and automatic cancellation of private mortgage insurance half-way through the term of the loan. Because most mortgage borrowers who obtain private mortgage insurance do not achieve 20% equity in their homes before the homes are sold or the mortgages refinanced, the Company does not expect to lose a significant amount of its insurance in force if such proposals are adopted. The Company cannot predict, however, the financial burden associated with borrower notification or automatic termination if any of the related costs are delegated to mortgage insurers.
In 1996, the Office of the Comptroller of the Currency ("OCC") granted permission to national banks to have a reinsurance company as a wholly-owned operating subsidiary for the purpose of reinsuring mortgage insurance written on loans originated or purchased by such banks. Several subsequent applications by banks to offer reinsurance have been approved by the OCC including at least one request to engage in quota share reinsurance. The OTS, which regulates thrifts and savings institutions, has announced that it would consider applications for such captive arrangements as well. The reinsurance subsidiaries of national banks or savings institutions could become significant competitors of the Company in the future.
EMPLOYEES
As of December 31, 1997, the Company employed 119 persons. Employees are not covered by any collective bargaining agreement. The Company considers its employee relations to be satisfactory.
EXECUTIVE OFFICERS
The executive officers of the Company are as follows:
Name Position Age - ---- -------- --- William T. Ratliff, III Chairman of the Board of 44 the Company and Triad
Darryl W. Thompson President, Chief Executive 57 Officer and Director of the Company and Triad
David W. Whitehurst Executive Vice President, 48 Chief Financial Officer, Treasurer and Director of the Company; Vice President and Director of Triad
John H. Williams Executive Vice President and 50 Director of Triad
Ron D. Kessinger Executive Vice President of 43 Triad
Earl F. Wall Vice President, Secretary and 40 General Counsel of the Company and Triad
Henry B. Freeman Vice President of Triad 48
Michael R. Oswalt Vice President, Controller 36 and Principal Accounting Officer of the Company and Triad
WILLIAM T. RATLIFF, III has been the Chairman of the Board of the Company since 1993. Mr. Ratliff has also been Chairman of the Board of Triad since 1989, President of CIC since 1990 and was President and General Partner of CML from 1987 to 1995. Mr. Ratliff has been Chairman of New South Federal Savings Bank ("New South") since 1986 and President and Director of New South Bancshares, Inc., New South's parent company, since 1995. From March 1994 until December 1996, Mr. Ratliff served as President of Southwide Life Insurance Corp., of which he had been Executive Vice President since 1993. Mr. Ratliff joined CML in 1981 after completing his doctoral degree with a study of planning processes in an insurance company. Previously, he trained and worked as an educator, counselor and organizational consultant.
DARRYL W. THOMPSON has been the President, Chief Executive Officer and a Director of the Company since 1993. Mr. Thompson has also been President, Chief Executive Officer and a Director of Triad since its inception in 1987. From 1986 to 1989, Mr. Thompson also served as President and Chief Executive Officer of Triad Life Insurance Company, which sold mortgage insurance products. From 1976 to 1985, Mr. Thompson served as Senior Vice President/Southeast Division Manager of MGIC. Mr. Thompson joined MGIC in 1972.
DAVID W. WHITEHURST has been Executive Vice President, Chief Financial Officer, Treasurer and a Director of the Company since 1993, and served as Secretary of the Company from 1993 until 1996. Mr. Whitehurst has also been a Vice President and Director of Triad since 1989, Executive Vice President of CIC since 1995 (Vice President from 1990 to 1995), was Chief Financial Officer of CIC from 1990 through 1995, was Executive Vice President of Southwide Life Insurance Corp. from 1992 until 1996 and has been a director of New South since 1989. Since January 1997, Mr. Whitehurst has been the President, Treasurer and a Director of Southland National Insurance Corp. and its subsidiaries. Mr. Whitehurst joined CML in 1989 and served as Vice President of CML and its affiliates until 1992, when he began devoting all of his time to CIC and its affiliates. Mr. Whitehurst is a certified public accountant.
JOHN H. WILLIAMS has been Executive Vice President and a Director of Triad since its inception in 1987. From 1986 to 1987, Mr. Williams was employed by Triad Life Insurance Company to develop and organize Triad. From 1978 to 1985, Mr. Williams was employed by MGIC, most recently serving as Vice President of Secondary Market Trading.
RON D. KESSINGER has been Executive Vice President of Insurance Operations of Triad since June 1996 and was Vice President of Claims and Administration of Triad from January 1991 to June 1996. From 1985 to 1991, Mr. Kessinger was employed by Integon Mortgage Guaranty Insurance Corporation, most recently serving as Vice President of Operations. Prior to joining Integon Mortgage Guaranty Insurance Corporation, Mr. Kessinger was employed by the parent company of Integon Mortgage Guaranty Insurance Corporation.
EARL F. WALL has been Vice President and General Counsel of Triad since January 1996 and Secretary since June 1996. Mr. Wall has been Vice President, Secretary and General Counsel of the Company since September 1996. From 1982 to 1995, Mr. Wall was employed by Integon in a number of capacities including Vice President, Associate General Counsel and Director of Integon Life Insurance Corporation and Georgia International Life Insurance Corporation, Vice President and General Counsel of Integon Mortgage Guaranty Insurance Corporation, and Vice President, General Counsel and Director of Marketing One, Inc.
HENRY B. FREEMAN has been Vice President of Risk Management of Triad since its inception in 1987. From 1981 to 1987, Mr. Freeman was employed by Home Guaranty Insurance Corporation, where he performed underwriting and claims management services.
MICHAEL R. OSWALT has been Vice President and Controller of the Company since March 1994, Vice President of Triad since December 1994, and Controller of Triad since June 1996. Mr. Oswalt previously served as Vice President and Controller of CIC and Southwide Life Insurance Corp. from February 1994 until June 1996. From January 1993 to February 1994, Mr. Oswalt was employed by Complete Health Services, Inc. where he performed internal audit services. From 1991 to 1993, Mr. Oswalt was employed by Arthur Andersen & Co. Prior to joining Arthur Andersen & Co., Mr. Oswalt was employed by Deloitte & Touche from 1988 to 1991. Mr. Oswalt is a certified public accountant.
Officers of the Company serve at the discretion of the Board of Directors of the Company.
ITEM 2.
ITEM 2. PROPERTIES.
The Company leases office space in its Winston-Salem headquarters and its six underwriting offices located throughout the country comprising approximately 31,582 square feet under leases expiring between 1998 and 2002 and which require annual lease payments of $531,613 in 1998. With respect to all facilities, the Company has, or believes it will be able to obtain, lease renewals on satisfactory terms. The Company believes its existing properties are well utilized and are suitable and adequate for its present circumstances.
The Company maintains mid-range and micro-computer systems from its corporate data center located in its headquarters building to support its data processing requirements for accounting, claims, marketing, risk management and underwriting. The Company has in place back-up procedures in the event of emergency situations.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
The Company and its subsidiaries, in common with other private mortgage insurers, are subject to litigation in the normal course of their businesses. There is no material litigation currently pending against the Company or its subsidiaries.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
The Company's Common Stock trades on the Nasdaq National Market tier of the Nasdaq Stock MarketSM under the symbol "TGIC". At December 31, 1997, 13,293,721 shares were issued and outstanding. The following table sets forth the highest and lowest closing prices of the Company's Common Stock, $0.01 par value, as reported by Nasdaq during the periods indicated (closing prices have been restated to reflect the three-for-two stock split on June 28, 1996, and the two-for-one stock split on October 28, 1997).
1997 1996 ---- ---- High Low High Low First Quarter.......... 15 7/8 14 10 21/32 8 27/32 Second Quarter......... 22 11/16 14 3/4 12 1/4 10 Third Quarter.......... 28 1/2 20 1/2 14 3/4 11 5/8 Fourth Quarter ........ 31 26 1/4 16 3/4 13 5/8
As of March 4, 1998, the number of stockholders of record of Company Common Stock was approximately 176. In addition, there were an estimated 2,744 beneficial owners of shares held by brokers and fiduciaries.
Payments of future dividends are subject to declaration by the Company's Board of Directors. The dividend policy is dependent also on the ability of Triad to pay dividends to the Company. Because of regulatory dividend restrictions by the Illinois Department of Insurance and Triad's need to maintain capital levels required by rating agencies, the Company has no present intention to pay dividends.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
(1) Periods have been restated to reflect the three-for-two stock split on June 28, 1996, and the two-for-one stock split on October 28, 1997. (2) Based on statutory accounting practices and derived from consolidated statutory financial statements of Triad.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation.
RESULTS OF OPERATIONS
1997 COMPARED TO 1996
Net income for 1997 increased 54.0% to $17.2 million compared to $11.2 million in 1996. This improvement was primarily attributable to a 55.8% increase in earned premiums, a 14.5% increase in net investment income and an improved combined loss and expense ratio.
Net income per share on a diluted basis, which reflects the two-for-one stock split effective on October 28, 1997, increased 52.1% to $1.26 for 1997 compared to $0.83 per share for 1996. Operating earnings per share were $1.26 for 1997 compared to $0.84 for 1996, an increase of 50.3%. Operating earnings exclude net realized investment gains of approximately $34,000 in 1997 and net realized investment losses of approximately $162,000 in 1996.
New insurance written, which includes insurance on new and seasoned loans, was $3.8 billion for 1997 as compared to $2.2 billion in 1996, an increase of 74.0%. For the fourth quarter, new insurance written increased 32.9% to $740 million in 1997 compared to $557 million in 1996. This increase in gross new insurance written was the result of continued geographic expansion and the penetration of Triad's products in the marketplace including Triad's new risk sharing programs. Approximately 25% of 1997 new insurance written resulted from Triad's risk sharing programs. Uncertainty exists regarding the future of risk sharing programs in the mortgage insurance industry. The resolution of regulatory and industry questions regarding risk sharing programs makes the continued viability of such programs uncertain. Of the $3.8 billion in total new insurance production, approximately $950 million was attributable to seasoned loans. The Company does not expect to produce a significant amount of new business attributable to seasoned loans in 1998.
The growth in new insurance written also reflects the favorable interest rate environment in 1997 which caused home buying activities to remain strong. Refinance activity was 14.0% (18.3% in fourth quarter) of new insurance written in 1997 compared to 16.9% (11.2% in fourth quarter) of insurance written in 1996. Total direct insurance in force reached $9.2 billion at December 31, 1997 compared to $6.6 billion at December 31, 1997, an increase of 40.0%.
The Company also benefited from the January 1997 upgrade of Triad's claims-paying ability rating from "AA-" to "AA" by Standard & Poor's Corporation. In January 1998, Standard & Poor's Corporation affirmed Triad's "AA" claims-paying ability rating.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation -- Continued
Net new insurance written, which includes coverage on new loans only, was $2.9 billion for 1997 compared to $2.2 billion for 1996, an increase of 30.9%. According to industry data, Triad's national market share, which is calculated based on net new insurance written, increased by approximately 39% to 2.4% for 1997 (2.2% in the fourth quarter) compared to 1.7% for all of 1996.
Total direct premiums written were $40.1 million for 1997, an increase of 53.3% compared to $26.2 million in 1996. Net premiums written increased by 60.0% to $38.3 million in 1997 compared to $24.0 million in 1996. Earned premiums increased 55.8% to $38.5 million for 1997 from $24.7 million in 1996. This growth in written and earned premium resulted from the increase in new insurance written, offset slightly by the decline in the Company's persistency rate. Sales under the Company's monthly premium plan represented 94.3% of new insurance written in 1997 compared to 93.0% in 1996. Annualized persistency was 84.2% for 1997 compared to 85.3% for 1996.
In late 1996, Triad introduced its Stick With Triad program featuring the Slam Dunk Loan SM approval process whereby Triad issues a certificate of insurance based on the borrower's credit score. In 1997, the Stick With Triad products accounted for 60.1% of new commitments. The popularity, to a large extent, of this product has reduced customer use of Triad's delegated underwriting program in 1997. Commitments processed through Triad's delegated underwriting program accounted for 18.2% of commitments received for 1997, compared to 38.0% for 1996.
Net investment income for 1997 was $6.2 million, a 14.5% increase over $5.4 million in 1996. This increase resulted from the growth in the average book value of invested assets to $103.8 million at December 31, 1997 from $89.6 million at December 31, 1996. The yield on average invested assets was 6.0% for 1997 compared to 6.1% for 1996. This slight decrease is attributable to the Company's continued investment in lower yielding municipal tax-preferred securities. The portfolio's tax-equivalent yield was 8.0% for 1997 up from 7.7% for 1996. Approximately 71.8% or $68.7 million of the Company's fixed maturity portfolio at December 31, 1997 was composed of state and municipal tax-preferred securities as compared to 53% at December 31, 1996 and 37% at December 31, 1995.
The Company's loss ratio (the ratio of incurred losses to earned premiums) was 13.4% for 1997 compared to 13.3% for 1996. The loss ratio was 12.1% for the fourth quarter of 1997 compared to 14.3% for the same period of 1996. The Company's favorable loss ratio reflects the low level of delinquencies compared to the number of insured loans and the fact that approximately 73% of the Company's insurance in force was originated in the last 36 months. Management believes, based upon its experience and industry data, that claims incidence for it and other private mortgage insurers is generally highest in the third through
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation -- Continued
sixth years after loan origination. Although the claims experience on new insurance written in previous years has been quite favorable, the Company expects its incurred losses to increase as a greater amount of its insurance in force reaches its anticipated highest claim frequency years. Due to the inherent uncertainty of future premium levels, losses, economic conditions and other factors that impact earnings, it is impossible to predict with any degree of certainty the impact of such higher claims frequencies on future earnings.
During periods of significant refinancing activity, it is possible that policies on stronger loans may lapse and that weaker loans may remain in force, thus potentially increasing the loss ratio on older business. Substantial increases in production of new business during these periods can offset the increased loss ratio on the older business.
Net losses and loss adjustment expenses (net of reinsurance recoveries) increased by 57.9% in 1997 to $5.2 million compared to $3.3 million in 1996.This increase reflects the increase in the Company's insurance in force and the resulting recognition of a greater amount of insurance in force reaching itshigher claim frequency years.
Amortization of deferred policy acquisition costs increased by 27.4% to $4.1 million in 1997 compared to $3.2 million for 1996. The increase in amortization reflects a growing balance of deferred policy acquisition costs to amortize as the Company builds its total insurance in force.
Other operating expenses increased 41.3% to $10.3 million for 1997 compared to $7.3 million for 1996. This increase in expenses is primarily attributable to advertising, personnel, facilities and equipment costs required to support the Company's product development, technology enhancements, geographic expansion and increased production.
The expense ratio (ratio of underwriting expenses to net premiums written) for 1997 was 37.5% compared to 43.8% for 1996. Contributing to this improvement is the higher level of written premiums partially offset by the increase in expenses.
The effective tax rate for 1997 was 31.7% compared to 31.0% in 1996. This increase is primarily the result of the phase-in of the 35% federal statutory income tax rate applicable to companies with annual taxable income above $10 million. Management expects the Company's effective tax rate to increase slightly as new funds from the debt offering in January 1998 are invested in taxable securities and the Company's taxable income grows faster than its tax preferred investment income.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation -- Continued
1996 COMPARED TO 1995
Net income for 1996 increased 44.3% to $11.2 million compared to $7.8 million in 1995. This improvement was attributable to a 59.8% increase in earned premiums, a 12.6% increase in net investment income, an improved expense ratio and a continuing low loss ratio.
Net income per share on a diluted basis, reflecting stock splits, increased 42.1% to $0.83 for 1996 compared to $0.58 per share in 1995. Operating earnings per share were $0.84 for 1996 compared to $0.57 per share in 1995. Operating earnings exclude realized investment losses of approximately $162,000 in 1996 and realized investment gains of approximately $173,000 in 1995.
New insurance written was $2.2 billion in 1996 compared to $1.6 billion in 1995, an increase of 36.4%. New insurance written was $557 million in the fourth quarter of 1996 compared to $479 million in the same period of 1995. The increase in new insurance written in 1996 was the result of the continued penetration of Triad's products in the marketplace coupled with a favorable interest rate environment for much of 1996, which caused both refinance and home buying activities to remain strong for the year. Refinance activity accounted for 16.9% of new insurance written in 1996 compared to 9.3% for 1995. Total direct insurance in force reached $6.6 billion at December 31, 1996 compared to $5.1 billion the previous year, an increase of 29.1%.
According to industry data, Triad's share of total new mortgage insurance written increased to 1.7% for 1996 compared to 1.5% for all of 1995. This increase was primarily the result of the Company's geographic expansion into new territories and the success of a marketing focus on larger, national mortgage lenders.
Total direct premiums written were $26.2 million for 1996, an increase of 38.4% compared to $18.9 million in 1995. Net premiums written increased by 59.7% to $24.0 million for 1996 compared to $15.0 million for 1995. Earned premiums increased 59.8% to $24.7 million in 1996 from $15.5 million in 1995. Contributing to this growth were the strong mortgage market, the Company's continued expansion into new territories, the secondary mortgage market requirements for deeper coverages and increased renewal premium due to the growth of our monthly premium product. Sales under the Company's monthly premium plan represented 93.0% of new insurance written in 1996 compared to 82.6% in 1995. Offsetting the premium growth somewhat was the decrease in Triad's persistency rate, reflecting the 1996 increase in refinancing activity. Annualized persistency was 85.3% in 1996 compared to 86.4% in 1995.
In January 1996, the Company eliminated its quota share reinsurance on new business, recaptured substantial portions of its quota share coverage on renewal business and secured excess of loss reinsurance to protect against catastrophic losses. These changes reduced the Company's quota share cede rate to 5.3% of
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation -- Continued
direct premium written in 1996 compared to 20.8% in 1995. Premiums ceded under the Company's quota share reinsurance agreements for 1996 totaled $1.4 million compared to $3.9 million in 1995. Had the Company retained its quota share reinsurance in 1996 and maintained a cede rate comparable to 1995, the Company's net written premium would have increased approximately 38.0% rather than the 59.7% noted above.
Net investment income for 1996 was $5.4 million, a 12.6% increase over $4.8 million in 1995. This increase resulted from the growth in average invested assets of $10.3 million to $89.6 million at December 31, 1996. The yield on average invested assets was 6.1% for both 1996 and 1995. The portfolio's tax equivalent yield was 7.7% in 1996 and 7.5% in 1995. This yield reflected the Company's investment strategy to emphasize tax-preferred securities which yield lower pre-tax rates than similar fully-taxable securities.
The Company's loss ratio was 13.3% for 1996 compared to 14.3% for 1995. The favorable loss ratio reflects the low level of delinquencies compared to the number of insured loans and the fact that 71% of the insurance in force was originated in the prior 36 months.
Net losses and loss adjustment expenses (net of reinsurance recoveries) increased by 47.9% in 1996 to $3.3 million compared to $2.2 million in 1995, reflecting the increase in the Company's insurance in force and the resulting recognition of a greater amount of insurance in force reaching its higher claim frequency years. A decrease in reinsurance recoveries, attributable to the Company's restructuring of its reinsurance program for 1996, also contributed to the increase in net losses and loss adjustment expenses.
Amortization of deferred policy acquisition costs increased by 41.3% to $3.2 million in 1996 compared to $2.3 million for 1995. The increase in amortization reflects a growing balance of deferred policy acquisition costs to amortize as the Company builds its total insurance in force.
Other operating expenses increased to $7.3 million for 1996 compared to $4.8 million for 1995. This increase in expenses was primarily attributable to personnel, facilities and equipment costs required to support Triad's geographic expansion and increased production coupled with a reduction in ceding commissions earned following changes in the Company's reinsurance program for 1996. Ceding commissions paid to the Company are reported as a reduction in other operating expenses and decreased to $572,000 in 1996 compared to $1.5 million in 1995.
The Company's expense ratio for 1996 was 43.8% compared to 46.9% for 1995. Contributing to this improvement was the higher level of written premiums for 1996 offset somewhat by the increase in expenses.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation -- Continued
The effective tax rate for all of 1996 was 31.0% compared to 30.9% for 1995. In 1996, the Company began a phase-in of the 35% Federal statutory income tax rate applicable to companies with annual taxable income above $10 million.
LIQUIDITY AND CAPITAL RESOURCES
The Company's sources of operating cash flow consist primarily of premiums written and investment income. Operating cash flow is applied primarily to the payment of claims and expenses.
For 1997, the Company generated positive cash flow from operating activities of $17.9 million compared to $12.5 million for 1996. The increase in Triad's operating cash flow reflects the growth in renewal premiums and insurance written that has more than offset the increases in claims paid and other expenses.
The Company's business does not routinely require significant capital expenditures. Positive cash flows are invested pending future payments of claims and expenses. Cash flow shortfalls, if any, could be funded through sales of short term investments and other investment portfolio securities.
The parent company's cash flow is dependent on cash dividends and revenues from management fees from Triad. The insurance laws of the State of Illinois impose certain restrictions on dividends from Triad. These restrictions, based on statutory accounting practices, include requirements that dividends may be paid only out of statutory earned surplus as of the end of the preceding fiscal year and limit the amount of dividends that may be paid without prior approval of the Illinois Insurance Department. Triad had an earned surplus of $2.5 million at December 31, 1997 and a deficit of $1.3 million at December 31, 1996. The Illinois Insurance Department permits expenses of the parent company to be paid by Triad in the form of management fees.
In January 1998 the Company completed a $35 million private offering of senior notes due January 15, 2028. The notes, which represent unsecured obligations of the Company, bear interest at a rate of 7.9% per annum and are non-callable. The notes are rated "A" by Standard and Poor's Corporation and "A+" by Fitch Investors Service. The Company contributed $25 million of the net proceeds from the sale of the notes to Triad in exchange for a surplus debenture. The Company will be dependent upon payments under the surplus debenture issued by Triad and upon possible future dividends from Triad, all of which will be subject to significant payment restrictions under Illinois insurance laws, to provide funds for the payment of the Company's obligations under the notes. The Company retained the balance of the net proceeds of the offering, approximately $9.4 million, which will be available for general
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation -- Continued
corporate purposes, including, without limitation, investment, payments of principal and interest on the notes and possible future contributions to the capital of Triad.
The Company intends to invest the proceeds of the note offering in accordance with its investment policy. To date, the Company's investments have emphasized tax-preferred securities. Because of restrictions imposed under federal income tax laws, investment by the Company of proceeds of the note offering must be made principally in taxable securities. Through investment of a portion of the net proceeds of the note offering, the Company plans to increase its investments in higher yielding non-investment grade securities to approximately 10% of its consolidated portfolio, up from approximately 3% at December 31, 1997.
Consolidated invested assets were $119.9 million at December 31, 1997, including a total of $111.2 million in fixed maturity securities and equity securities classified as available-for-sale. Net unrealized investment gains were $2.8 million on equity securities and $4.0 million on fixed maturity securities at December 31, 1997.
Approximately 4.8% or $4.8 million of the Company's fixed maturity portfolio at December 31, 1997 was composed of mortgage-backed securities, substantially all of which are guaranteed by U.S. Government Agencies. Certain mortgage-backed securities are subject to significant prepayment risk due to the fact that, in periods of declining interest rates, mortgages may be repaid more rapidly than scheduled as borrowers refinance higher rate mortgages to take advantage of lower rates. As a result, holders of mortgage-backed securities may receive large prepayments on their investments which must be reinvested at then current rates.
The Company's loss reserves increased to $9.0 million at December 31, 1997 compared to $6.3 million at December 31, 1996. This growth is the result of the increases in new insurance written and the maturing of the Company's risk in force. Consistent with industry practices, the Company does not establish loss reserves for future claims on insured loans which are not currently in default. The Company's reserves per delinquent loan were $23,100 at both December 31, 1997 and December 31, 1996. The Company's ratio of delinquent insured loans to total insured loans was 0.47% at December 31, 1997 compared to 0.44% at December 31, 1996.
The Company's unearned premium reserve of $8.0 million at December 31, 1997 decreased from $8.2 million at December 31, 1996. This decline is attributable primarily to the continued production of the monthly premium product, which produces little unearned premium compared to annual and single premium products. Cancellation activity also can contribute to the decrease in unearned premiums, whereby older annual premium policies are canceled or replaced by monthly premium policies.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation -- Continued
Total stockholders' equity increased to $111.8 million at December 31, 1997 from $91.7 million at December 31, 1996. This increase resulted primarily from net income of $17.2 million for 1997 and an increase in net unrealized gains on invested assets classified as available-for-sale of $2.8 million (net of income tax).
Triad's total statutory policyholders' surplus increased to $60.9 million at December 31, 1997 from $57.1 million at December 31, 1996. This increase resulted from statutory net income of $22.9 million and unrealized gains on equity securities of $1.6 million offset primarily by an increase in the statutory contingency reserve of $19.7 million. Triad's statutory earned surplus was $2.5 million at December 31, 1997 compared to a deficit of $1.3 million at December 31, 1996, reflecting growth in statutory net income greater than the increase in the statutory contingency reserve. The balance in the statutory contingency reserve was $54.8 million at December 31, 1997 compared to $35.1 million at December 31, 1996.
The Company is undertaking modifications and upgrades to enhance its computer systems and technological capabilities. The Company expects that approximately $1.6 million will be expended in 1998 to complete this system upgrade and that the project will be funded through cash flow from operations. As a part of this effort, management has initiated a program to prepare the Company's computer systems and applications to be year 2000 compliant. The Company expects to incur internal staff costs as well as consulting and other expenses related to infrastructure and facilities enhancement necessary to prepare the systems for the year 2000. Most of the modifications will be made as part of the Company's capital upgrade to its computer systems throughout 1998.
Triad's ability to write insurance depends on the adequacy of its statutory capital in relation to risk in force. A significant reduction of capital or a significant increase in risk may impair Triad's ability to write additional insurance. A number of states limit Triad's risk-to-capital ratio to 25-to-1. As of December 31, 1997 Triad's risk-to-capital ratio was 19.3-to-1, and as of December 31, 1996 was 15.8-to-1, as compared to 19.4-to-1 for the industry as a whole at December 31, 1996, the latest industry data available.
Rating agencies also require capital levels based on a company's performance sensitivity to various depression scenarios. In determining capital levels, the rating agencies allow the use of different forms of capital including statutory capital, reinsurance and debt. The effect of the Company's contribution of $25 million of its $35 million senior note offering to the capital of Triad in January 1998 will be to improve its risk-to-capital ratio and to provide additional capital considered in the rating agency's depression models. Had the contribution been made as of year end 1997, Triad's risk-to-capital ratio would have been approximately 15.9-to-1. There can be no assurance that the Company will continue to meet such capital requirements.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation -- Continued
NEW ACCOUNTING STANDARDS
In 1997, the Financial Accounting Standards Board issued Statement No. 128, Earnings per Share. Statement No. 128 replaced the calculation of primary and fully diluted earnings per share with basic and diluted earnings per share. Unlike primary earnings per share, basic earnings per share excludes any dilutive effects of options, warrants and convertible securities. Diluted earnings per share is very similar to the previously reported fully diluted earnings per share. All earnings per share amounts for all periods have been presented, and where appropriate, restated to conform to Statement 128.
In June 1997, the Financial Accounting Standards Board issued Statement No. 130, Reporting Comprehensive Income, which is effective for fiscal years beginning after December 31, 1997. The Statement establishes standards for the reporting and display of comprehensive income and its components in financial statements. The Company expects to adopt the provisions of Statement No. 130 in the first quarter of 1998 and will present the financial statements for earlier periods provided for comparative purposes as required by the Statement. The application of the new rules will not have an impact on the Company's financial position or results of operations.
SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
Management's Discussion and Analysis and this Report contain forward looking statements relating to future plans, expectations and performance which involve various risks and uncertainties, including but not limited to the following: interest rates may increase from their current levels; housing transactions and mortgage issuance may decrease for many reasons including changes in interest rates or economic conditions; the Company's market share may change as a result of changes in underwriting criteria or competitive products or rates; the amount of new insurance written could be affected by changes in federal housing legislation, including changes in the Federal Housing Administration loan limits and coverage requirements of Freddie Mac and Fannie Mae; rating agencies may revise methodologies for determining the Company's claims-paying ability ratings and may revise or withdraw the assigned ratings at any time; the Company's performance may be impacted by changes in the performance of the financial markets and general economic conditions. Economic downturns in regions where Triad's risk is more concentrated could have a particularly adverse affect on Triad's financial condition and loss development. Accordingly, actual results may differ from those set forth in the forward looking statements. Attention is also directed to other risk factors set forth in documents filed by the Company with the Securities and Exchange Commission.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The Financial Statements and Supplementary Data are presented in a separate section of this report.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
Information regarding directors and nominees for directors of the Company is included in the Company's Proxy Statement for the 1998 Annual Meeting of Stockholders, and is hereby incorporated by reference.
For information regarding the executive officers of the Company, reference is made to the section entitled "Executive Officers of the Company" in Part I, Item 1 of this Report.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION.
This information is included in the Company's Proxy Statement for the 1998 Annual Meeting of Stockholders, and is hereby incorporated by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
This information is included in the Company's Proxy Statement for the 1998 Annual Meeting of Stockholders, and is hereby incorporated by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
This information is included in the Company's Proxy Statement for the 1998 Annual Meeting of Stockholders, and is hereby incorporated by reference.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(a) (1) and (2) The response to this portion of Item 14 is submitted as a separate section of this report.
(a) (3) Listing of Exhibits-- The response to this portion of Item 14 is submitted as a separate section of this report.
(b) Reports on Form 8-K.
No reports on form 8-K were filed during the quarter ended December 31, 1997.
(c) Exhibits-- The response to this portion of Item 14 is submitted as a separate section of this report.
(d) Financial Statement Schedules-- The response to this portion of Item 14 is submitted as a separated section of this report.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on the 26th day of March, 1998.
By /s/ Darryl W. Thompson ------------------------- Darryl W. Thompson President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on the 26th day of March, 1998 by the following persons on behalf of the Registrant in the capacities indicated.
SIGNATURE TITLE
/s/ William T. Ratliff, III Chairman of the Board - --------------------------- William T. Ratliff, III
/s/ Darryl W. Thompson President, Chief Executive Officer and Director - --------------------------- Darryl W. Thompson
/s/ David W. Whitehurst Executive Vice President, Chief Financial - --------------------------- Officer, Treasurer and Director David W. Whitehurst
/s/ Michael R. Oswalt Vice President and Controller, Principal - --------------------------- Accounting Officer Michael R. Oswalt
/s/ Robert T. David Director - --------------------------- Robert T. David
/s/ Raymond H. Elliott Director - --------------------------- Raymond H. Elliott
ANNUAL REPORT ON FORM 10-K
ITEM 8, ITEM 14(a)(1) and (2), (3), (c) and (d)
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES
INDEX TO EXHIBITS
FINANCIAL STATEMENTS
FINANCIAL STATEMENT SCHEDULES
CERTAIN EXHIBITS
YEAR ENDED DECEMBER 31, 1997
TRIAD GUARANTY INC.
WINSTON-SALEM, NORTH CAROLINA
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES
(Item 14(a) 1 and 2)
CONSOLIDATED FINANCIAL STATEMENTS PAGE - --------------------------------- ---- Report of Independent Auditors................ ....................... 54 Consolidated Balance Sheets at December 31, 1997 and 1996............. 55 - 56 Consolidated Statements of Income for each of the three years in the period ended December 31, 1997....................... 57 Consolidated Statements of Changes in Stockholders' Equity for each of the three years in the period ended December 31, 1997.. 58 Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 1997.............................. 59 Notes to Consolidated Financial Statements............................. 60 - 76
FINANCIAL STATEMENT SCHEDULES Schedules at and for each of the three years in the period ended December 31, 1997 Schedule I - Summary of investments - other than investments in related parties...................... 77 Schedule II - Condensed financial information of Registrant...... 78 - 81 Schedule IV - Reinsurance........................................ 82
All other schedules are omitted since the required information is not present or is not present in amounts sufficient to require submission of the schedules, or because the information required is included in the consolidated financial statements and notes thereto.
INDEX TO EXHIBITS (ITEM 14(A) 3)
EXHIBIT NUMBER DESCRIPTION OF EXHIBIT - ------ ---------------------- 3.1 Certificate of Incorporation of the Registrant, as amended (7) (Exhibit 3.1)
3.2 By-Laws of the Registrant (1) (Exhibit 3(b))
4.1 Form of Common Stock certificate (1) (Exhibit 4(a))
*4.2 Indenture Between Triad Guaranty Inc. and Banker's Trust Co. (Exhibit 4.2)
10.1 1993 Long-Term Stock Incentive Plan (1)(3) (Exhibit 10(a))
10.2 Proportional Reinsurance Agreement between Triad Guaranty Insurance Corporation and PMI Mortgage Insurance Co. (1) (Exhibit 10(b))
10.3 Agreement for Administrative Services among Triad Guaranty Insurance Corporation and Collateral Investment Corp. and Collateral Mortgage, Ltd. (1) (Exhibit 10(c))
10.4 Investment Advisory Agreement between Triad Guaranty Insurance Corporation and Collateral Mortgage, Ltd. (1) (Exhibit 10(d))
10.6 Registration Agreement among the Registrant, Collateral Investment Corp. and Collateral Mortgage, Ltd. (2) (Exhibit 10.6)
10.7 Employment Agreement between the Registrant and Darryl W. Thompson (2)(3) (Exhibit 10.7)
10.8 Employment Agreement between the Registrant and John H. Williams (2) (3)(Exhibit 10.8)
10.10 Employment Agreement between the Registrant and Henry B. Freeman (2) (3)(Exhibit 10.10)
10.11 Employment Agreement between the Registrant and Ron D. Kessinger (2) (3)(Exhibit 10.11)
10.13 Proportional Reinsurance Agreement between Triad Guaranty Insurance Corporation and PMI Mortgage Insurance Co. (4) (Exhibit 10.13)
10.15 Excess of Loss Reinsurance Agreement between Triad Guaranty Insurance Corporation and National Union Fire Insurance Company of Pittsburgh, PA.(5) (Exhibit 10.15)
10.16 Economic Value Added Incentive Bonus Program (Senior Management) (6) (Exhibit 10.16)
10.17 Amendment to Employment Agreement between the Registrant and Darryl W.Thompson (3)(6) (Exhibit 10.17)
10.18 Amendment to Employment Agreement between the Registrant and John H. Williams (3)(6) (Exhibit 10.18)
10.19 Amendment to Employment Agreement between the Registrant and Henry B. Freeman (3)(6) (Exhibit 10.19)
10.20 Amendment to Employment Agreement between the Registrant and Ron D. Kessinger (3)(6) (Exhibit 10.20)
*11.1 Statement Re Computation of Net Income per share (Exhibit 11.1)
21.1 Subsidiaries of the Registrant (6) (Exhibit 21.1)
*23.1 Consent of Ernst & Young LLP (Exhibit 23.1)
*27.1 Financial Data Schedule (Exhibit 27.1)
*27.2 Financial Data Schedule (Exhibit 27.2)
*27.3 Financial Data Schedule (Exhibit 27.3) - -----------------
* Filed Herewith.
(1) Incorporated by reference to the exhibit identified in parentheses, filed as an exhibit in the Registrant's Registration Statement on Form S-1 filed October 22, 1993 and amendments thereto.
(2) Incorporated by reference to the exhibit identified in parentheses, filed as an exhibit in the 1993 Form 10-K.
(3) Denotes management contract or compensatory plan of arrangement required to be filed as an exhibit to this report pursuant to Item 601 of Regulation S-K.
(4) Incorporated by reference to the exhibit identified in parentheses, filed as an exhibit in the 1994 Form 10-K.
(5) Incorporated by reference to the exhibit identified in parentheses, filed as an exhibit in the 1995 Form 10-K.
(6) Incorporated by reference to the exhibit identified in parentheses, filed as an exhibit in the 1996 Form 10-K.
(7) Incorporated by reference to the exhibit identified in parentheses, filed as an exhibit in the June 30, 1997 Form 10-Q.
Report of Independent Auditors
Board of Directors Triad Guaranty Inc.
We have audited the accompanying consolidated balance sheets of Triad Guaranty Inc. and subsidiaries as of December 31, 1997 and 1996, and the related consolidated statements of income, changes in stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1997. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financsent fairly, in all material respects, the consolidated financial position of Triad Guaranty Inc. and subsidiaries at December 31, 1997 and 1996, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1997 in conformity with generally accepted accounting principles.
Ernst & Young LLP
January 22, 1998
Triad Guaranty Inc.
Consolidated Balance Sheets
December 31 1997 1996 ---- ----
Assets Invested assets: Securities available-for-sale, at fair value: Fixed maturities (amortized cost: 1997-$95,756,136;1996-$86,069,753)............ $ 99,725,487 $ 87,229,855 Equity securities (cost: 1997-$8,666,815; 1996-$6,267,076).............................. 11,466,028 7,494,817 Short-term investments ......................... 8,685,842 3,302,125 ------------ ------------ 119,877,357 98,026,797
Cash .............................................. 8,557 360,586 Accrued investment income ......................... 1,460,168 1,126,642 Deferred policy acquisition costs ................. 12,587,355 10,198,397 Property and equipment, at cost less accumulated depreciation (1997-$1,563,289; 1996-$956,538) .. 2,524,228 1,705,389 Prepaid reinsurance premiums ...................... 23,263 300,200 Reinsurance recoverable ........................... 49,447 153,274 Other assets ...................................... 2,448,685 531,238
------------ ------------ Total assets ..................................... $138,979,060 $112,402,523 ============ ============
December 31 1997 1996 ---- ----
Liabilities and stockholders' equity Liabilities: Losses and loss adjustment expenses .......... $ 8,960,411 $ 6,305,397 Unearned premiums ............................ 7,988,342 8,216,478 Amounts payable to reinsurer ................. -- 1,993 Current taxes payable ........................ 3,318 1,596 Deferred income taxes ........................ 7,521,874 4,276,081 Unearned ceding commission ................... -- 80,573 Accrued expenses and other liabilities ....... 2,724,324 1,840,369 ----------- ------------ Total liabilities ............................... 27,198,269 20,722,487
Commitments and contingencies (Notes 5 and 7)
Stockholders' equity: Preferred stock, par value $.01 per share- authorized 1,000,000 shares, no shares issued and outstanding...................... - - Common stock, par value $.01 per share - authorized 20,000,000 shares,13,293,721 at December 31, 1997 and 6,645,361 at December 31, 1996 issued and outstanding shares......................... 132,937 66,453 Additional paid-in capital................... 59,369,223 59,346,832 Unrealized gain on available-for-sale securities, net of income tax liability of $2,368,998 at December 31, 1997 and $823,287 at December 31, 1996.............. 4,405,315 1,568,800 Retained earnings............................ 47,873,316 30,697,951 ------------ ------------ Total stockholders' equity...................... 111,780,791 91,680,03 ------------ ------------ Total liabilities and stockholders' equity...... $138,979,060 $112,402,523 ============ ============
See accompanying notes.
Triad Guaranty Inc.
Consolidated Statements of Income
See accompanying notes.
Triad Guaranty Inc.
Consolidated Statements of Changes in Stockholders' Equity
See accompanying notes.
Triad Guaranty Inc.
Consolidated Statements of Cash Flows
See accompanying notes.
Triad Guaranty Inc.
Notes to Consolidated Financial Statements
December 31, 1997
1. ACCOUNTING POLICIES
NATURE OF BUSINESS
Triad Guaranty Inc. (the "Company") is a holding company which, through its wholly-owned subsidiary, Triad Guaranty Insurance Corporation ("Triad"), provides private mortgage insurance coverage in the United States to mortgage lenders to protect the lender against loss from defaults on low down payment residential mortgage loans.
BASIS OF PRESENTATION
The accompanying financial statements have been prepared in conformity with generally accepted accounting principles, which vary in some respects from statutory accounting practices which are prescribed or permitted by the various insurance departments.
CONSOLIDATION
The consolidated financial statements include the amounts of Triad Guaranty Inc. and its wholly-owned subsidiaries, Triad Guaranty Insurance Corporation ("Triad") and Triad Guaranty Assurance Corporation ("TGAC"), a wholly-owned subsidiary of Triad Guaranty Insurance Corporation. All significant intercompany accounts and transactions have been eliminated.
USE OF ESTIMATES
The preparation of the consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.
INVESTMENTS
Securities classified as "available-for-sale" are carried at fair value and unrealized gains and losses on such securities are reported as a separate component of stockholders' equity. The Company does not have any securities classified as "held-to-maturity" or "trading."
Triad Guaranty Inc.
Notes to Consolidated Financial Statements(continued)
1. ACCOUNTING POLICIES (CONTINUED)
Fair value generally represents quoted market value prices for securities traded in the public market or prices analytically determined using bid or closing prices for securities not traded in the public marketplace. Realized investment gains or losses are determined primarily on a specific identification basis and are included in net income. Short-term investments are defined as short-term highly liquid investments both readily convertible to known amounts of cash and having maturities of three months or less upon acquisition by the Company.
DEFERRED POLICY ACQUISITION COSTS
The costs of acquiring new business, principally commissions and certain policy underwriting and issue costs, which generally vary with and are primarily related to the production of new business, are deferred. Amortization of such policy acquisition costs is charged to expense in proportion to premium revenue recognized over the estimated policy life. The Company reviews the persistency of policies in force and maar Property and Equipment
Property and equipment is recorded at cost and is amortized principally on a straight-line basis over the estimated useful lives of depreciable assets. Property and equipment primarily consists of furniture and equipment, and computer hardware and software.
LOSSES AND LOSS ADJUSTMENT EXPENSE RESERVES
Reserves are provided for the estimated costs of settling claims in respect of loans reported to be in default and estimates of loans in default which have not been reported to the Company. Consistent with industry accounting practices, the Company does not establish loss reserves for future claims on insured loans which are not currently in default. Loss reserves are established by management using historical experience and by making various assumptions and judgments about the ultimate amount to be paid on loans in default. The estimates are continually reviewed and, as adjustments to these liabilities become necessary, such adjustments are reflected in current operations.
Triad Guaranty Inc.
Notes to Consolidated Financial Statements(continued)
1. ACCOUNTING POLICIES (CONTINUED)
REINSURANCE
Certain premiums and losses are assumed from and ceded to other insurance companies under various reinsurance agreements. Reinsurance premiums, claim reimbursement and reserves related to reinsurance business are accounted for on a basis consistent with those used in accounting for the original policies issued and the terms of the reinsurance contracts. The Company receives a ceding commission in connection with ceded reinsurance. The ceding commission is earned on a monthly pro rata basis in the same manner as the premium and is recorded as a reduction of other operating expenses. The reinsurance treaties provide for profit commissions on ceded reinsurance based on the loss ratio associated with the business ceded.
INCOME TAXES
The Company uses the asset and liability method of accounting for income taxes. Under the asset and liability method, deferred tax assets, net of a valuation allowance, 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, and 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.
INCOME RECOGNITION
The Company writes policies that are guaranteed renewable contracts at the borrower's option on single premium, annual premium, and monthly premium bases. For annual payment policies, the first year premium exceeds the renewal premium. The Company does not have the option to reunderwrite these contracts. Premiums written on annual policies are earned on a monthly pro rata basis. Single premium policies covering more than one year are amortized over the estimated policy life in accordance with the expiration of risk. Premiums written on a monthly basis are generally earned when received.
Triad Guaranty Inc.
Notes to Consolidated Financial Statements(continued)
1. ACCOUNTING POLICIES (CONTINUED)
STOCK OPTIONS
The Company grants stock options for a fixed number of shares to employees with an exercise price equal to or greater than the fair value of the shares at the date of grant. The Company accounts for stock option grants in accordance with APB Opinion No. 25, Accounting for Stock Issued to Employees, and, accordingly, recognizes no compensation expense for the stock option grants.
EARNINGS PER SHARE
In 1997, the Financial Accounting Standards Board issued Statement No. 128, Earnings per Share. Statement 128 replaced the calculation of primary and fully diluted earnings per share with basic and diluted earnings per share. Unlike primary earnings per share, basic earnings per share excludes any dilutive effects of options. Diluted earnings per share is very similar to the previously reported fully diluted earnings per share. All earnings per share amounts for all periods have been presented, and where appropriate, restated to conform to the Statement 128 requirements.
Basic and diluted earnings per share are based on the weighted average daily number of shares outstanding. For diluted earnings per share, the denominator includes the dilutive effect of employee stock options on the weighted-average shares outstanding. There are no other reconciling items between the denominator used in basic earnings per share and diluted earnings per share, and the numerator used in basic earnings per share and diluted earnings per share is the same for all periods presented.
STOCK SPLITS
The Company had a three-for-two stock split in 1996 in the form of a 50% stock dividend. The Company also had a two-for-one stock split in 1997 in the form of a 100% stock dividend. All earnings per share amounts and stock option information prior to the stock splits have been restated to reflect post-split amounts.
Triad Guaranty Inc.
Notes to Consolidated Financial Statements(continued)
1. ACCOUNTING POLICIES (CONTINUED)
NEW ACCOUNTING PRONOUNCEMENT
In June 1997, the Financial Accounting Standards board issued Statement No. 130, "Reporting Comprehensive Income", which is effective for fiscal years beginning after December 31, 1997. The Statement establishes standards for the reporting and display of comprehensive income and its components in financial statements. The Company expects to adopt the provisions of Statement 130 in the first quarter of 1998 and will reclassify the financial statements for earlier periods provided for comparative purposes as required by the Statement. The application of the new rules will not have an impact on the Company's financial position or results of operations.
2. INVESTMENTS
The amortized cost and the fair value of investments are as follows:
Gross Gross Amortized Unrealized Unrealized Fair Cost Gains Losses Value ---- ----- ------ ----- At December 31, 1997 Available-for-sale securities: Fixed maturity securities: Corporate .............. $ 12,260,852 $ 475,211 $ 38,842 $ 12,697,221 U.S. Government ........ 9,823,960 374,877 1,406 10,197,431 Mortgage-backed ........ 4,679,115 127,190 4,950 4,801,355 State and municipal .... 68,789,100 3,039,784 9,529 71,819,355 Public utilities ....... 203,109 7,016 -- 210,125 ------------ ---------- -------- ------------ Total .................... 95,756,136 4,024,078 54,727 99,725,487 Equity securities ...... 8,666,815 2,810,028 10,815 11,466,028 ------------ ---------- -------- ------------ Total .................... $104,422,951 $6,834,106 $ 65,542 $111,191,515 ============ ========== ======== ============
At December 31, 1996 Available-for-sale securities: Fixed maturity securities: Corporate ............... $ 14,620,814 $ 427,065 $200,114 $ 14,847,765 U.S. Government ......... 9,311,329 360,899 16,484 9,655,744 Mortgage-backed ......... 16,545,818 84,823 381,003 16,249,638 State and municipal ..... 45,087,458 1,005,494 132,936 45,960,016 Public utilities ........ 504,334 12,358 -- 516,692 ------------ ---------- -------- ------------ Total ..................... 86,069,753 1,890,639 730,537 87,229,855 Equity securities ....... 6,267,076 1,294,831 67,090 7,494,817 ------------ ---------- -------- ------------ Total ..................... $ 92,336,829 $3,185,470 $797,627 $ 94,724,672 ============ ========== ======== ============
Triad Guaranty Inc.
Notes to Consolidated Financial Statements(continued)
2. INVESTMENTS (CONTINUED)
The amortized cost and estimated fair value of investments in fixed maturity securities, at December 31, 1997 are summarized by stated maturity as follows:
Available-for-Sale ------------------ Amortized Fair Cost Value ---- ----- Maturity: One year or less ................. $ 1,171,591 $ 1,181,270 After one year through five years 22,306,492 23,101,381 After five years through ten years 18,617,950 19,592,870 After ten years .................. 48,980,988 51,048,611 Mortgage-backed securities ....... 4,679,115 4,801,355 ----------- ----------- Total ............................... $95,756,136 $99,725,487 =========== ===========
Realized gains and losses on sales of investments are as follows:
Year ended December 31 1997 1996 1995 ---- ---- ---- Securities available-for-sale: Fixed maturity securities: Gross realized gains..... $ 35,274 $ 28,425 $ 131,968 Gross realized losses ... (270,818) (48,112) (202,123) Equity securities: Gross realized gains..... 360,066 86,607 208,061 Gross realized losses ... (117,810) (106,244) (7,372) Other investments: Gross realized gains..... 42,520 30,509 96,056 Gross realized losses ... (14,902) (153,570) (53,598) --------- --------- --------- Net realized gains (losses) .. $ 34,330 $(162,385) $ 172,992 ========= ========= =========
Net unrealized appreciation (depreciation) on fixed maturity securities changed by $2,809,249, $(1,228,326), and $6,689,443 in 1997, 1996 and 1995, respectively; the corresponding amounts for equity securities were $1,571,472, $961,475 and $495,328.
Triad Guaranty Inc.
Notes to Consolidated Financial Statements(continued)
2. INVESTMENTS (CONTINUED)
Major categories of the Company's net investment income are summarized as follows: Year ended December 31 1997 1996 1995 ---- ---- ---- Income: Fixed maturities .............. $5,849,084 $5,260,073 $4,677,448 Preferred stocks .............. 114,610 37,858 11,417 Common stocks ................. 279,640 236,715 234,249 Cash and short-term investments 212,033 122,461 153,087 ---------- ---------- ---------- 6,455,367 5,657,107 5,076,201 Expenses ......................... 221,225 210,435 239,740 ---------- ---------- ---------- Net investment income ............ $6,234,142 $5,446,672 $4,836,461 ========== ========== ==========
At December 31, 1997 and 1996, investments with an amortized cost of $6,404,051 and $6,214,410, respectively, were on deposit with state insurance departments to satisfy regulatory requirements.
3. DEFERRED POLICY ACQUISITION COSTS
An analysis of deferred policy acquisition costs is as follows:
Year ended December 31 1997 1996 1995 ---- ---- ---- Balance at beginning of year ....... $10,198,397 $ 7,576,684 $5,870,975 Acquisition costs deferred: Sales compensation .............. 4,039,086 2,766,809 1,995,312 Underwriting and issue expenses . 2,470,341 3,089,780 1,999,518 ----------- ----------- ---------- 6,509,427 5,856,589 3,994,830
Amortization of acquisition expenses 4,120,469 3,234,876 2,289,121 ----------- ----------- ---------- Net increase ....................... 2,388,958 2,621,713 1,705,709 ----------- ----------- ---------- Balance at end of year ............. $12,587,355 $10,198,397 $7,576,684 =========== =========== ==========
Triad Guaranty Inc.
Notes to Consolidated Financial Statements(continued)
4. RESERVE FOR UNPAID LOSSES AND LOSS ADJUSTMENT EXPENSES
Activity for the reserve for unpaid losses and loss adjustment expenses for 1997, 1996 and 1995 are summarized as follows:
1997 1996 1995 ---- ---- ---- Reserve for losses and loss adjustment expenses at January 1, net of reinsurance recoverables of $330,733, $885,852 and $697,393 in 1997, 1996, and 1995,respectively................... $5,974,664 $ 3,703,251 $2,466,461 Incurred losses and loss adjustment expenses net of reinsurance recoveries (principally in respect of default notices occurring in): Current year.................... 6,022,700 4,673,130 3,190,786 Redundancy on prior years....... (845,622) (1,394,000) (974,000) ---------- ----------- --------- Total incurred losses and loss adjustment expenses........ 5,177,078 3,279,130 2,216,786
Loss and loss adjustment expense payments net of reinsurance recoveries (principally in respect of default notices occurring in): Current year.................... 210,493 166,717 215,996 Prior years..................... 2,032,128 841,000 764,000 ---------- ----------- --------- Total loss and loss adjustment expense payments................... 2,242,621 1,007,717 979,996 ---------- ----------- --------- Reserve for losses and loss adjustment expenses at December 31, net of reinsurance recoverables of $51,290, $330,733, and $885,852 in 1997, 1996 and 1995, respectively................. $8,909,121 $ 5,974,664 3,703,251 ========== =========== =========
The foregoing reconciliation shows a redundancy in reserves has emerged for each of the years presented. These redundancies resulted principally from settling case-basis reserves for amounts less than expected or reducing incurred but not reported reserves on default notices occurring in prior years.
Triad Guaranty Inc.
Notes to Consolidated Financial Statements(continued)
5. COMMITMENTS
The Company leases certain office facilities and equipment under operating leases. Rental expense for all leases was $835,596, $609,215, and $512,692 for 1997, 1996 and 1995, respectively. Future minimum payments under noncancellable operating leases at December 31, 1997 are as follows:
1998............. $ 531,613 1999............. 456,945 2000............. 346,211 2001............. 280,674 2002............. 127,192 ---------- $1,742,635 ==========
6. FEDERAL INCOME TAXES
Triad purchases ten-year non-interest bearing United States Mortgage Guaranty Tax and Loss Bonds in lieu of paying federal income taxes. At December 31, 1997 and 1996, Triad was obligated to purchase approximately $425,000 and $215,000, respectively, of United States Mortgage Guaranty Tax and Loss Bonds.
Income tax expense differed from the amounts computed by applying the Federal statutory income tax rate to income before taxes as follows:
1997 1996 1995 ---- ---- ---- Income tax computed at statutory rate .. $ 8,835,231 $ 5,683,563 $ 3,817,830 Increase (decrease) in taxes resulting from: Tax-exempt interest ................. (1,002,062) (751,407) (352,486) Other ............................... 168,525 109,629 4,677 ----------- ----------- ----------- Income tax expense ................ $ 8,001,694 $ 5,041,785 $ 3,470,021 =========== =========== ===========
Triad Guaranty Inc.
Notes to Consolidated Financial Statements(continued)
6. FEDERAL INCOME TAXES (CONTINUED)
The tax effects of temporary differences that give rise to significant portions of deferred tax assets and deferred tax liabilities at December 31, 1997 and 1996 are presented below:
1997 1996 ---- ---- Deferred tax liabilities Statutory contingency reserve ....... $17,370,996 $10,708,063 Deferred policy acquisition costs ... 4,405,574 3,518,447 Prepaid reinsurance premiums ........ 53,911 159,792 Amounts payable to reinsurer ........ 11,367 169,947 Fixed maturities .................... 202,884 168,895 Unrealized investment gain .......... 2,368,998 823,287 Other ............................... 418,775 223,621 ----------- ----------- Total deferred tax liabilities ...... 24,832,505 15,772,052
Deferred tax assets United States Mortgage Guaranty Tax and Loss Bonds ................ 16,293,366 9,994,366 Unearned premiums ................... 611,467 706,015 Unearned ceding commission .......... -- 27,798 Losses and loss adjustment expenses.. 250,599 602,109 Other ............................... 155,199 165,683 ----------- ----------- Total deferred tax assets ........... 17,310,631 11,495,971 ----------- ----------- Net deferred tax liability .......... $ 7,521,874 $ 4,276,081 =========== ===========
Triad Guaranty Inc.
Notes to Consolidated Financial Statements(continued)
7. INSURANCE IN FORCE, DIVIDEND RESTRICTION AND STATUTORY RESULTS
Approximately 57% of Triad's net risk in force is concentrated in six states including 14% in Georgia, 13% in Illinois, 10% in Florida, 7% in Virginia, 7% in California, and 6% in Texas. While Triad continues to diversify its risk in force geographically, a prolonged recession in its high concentration areas could result in higher incurred losses and loss adjustment expenses for Triad.
Insurance regulations 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 and surplus and the statutory contingency reserve. The amount of net risk for insurance in force at December 31, 1997 and 1996, as presented below, was computed by applying the various percentage settlement options to the insurance in force amounts based on the original insured amount of the loan. Triad's ratio is as follows:
1997 1996 ---- ---- Net risk........................... $2,231,572,130 $1,452,824,414 ============== ==============
Statutory capital and surplus...... $ 60,929,830 $ 57,070,475 Contingency reserve................ 54,766,669 35,072,109 -------------- -------------- Total.............................. $ 115,696,499 $ 92,142,584 ============== ============== Risk-to-capital ratio.............. 19.3 to 1 15.8 to 1 ============== ==============
Triad and TGAC are each required under the Illinois Insurance Code (the "Code") to maintain minimum statutory capital and surplus of $5,000,000. The Code permits dividends to be paid only out of earned surplus, and also requires prior approval of extraordinary dividends. An extraordinary dividend is any dividend or distribution of cash or other property, the fair market value of which, together with that of other dividends or distributions made within a period of twelve consecutive months, exceeds the greater of (a) ten percent of statutory surplus as regards policyholders, or (b) statutory net income for the calendar year preceding the date of the dividend. Net income as determined in accordance with statutory accounting practices was $22,916,215, $13,369,769, and $9,337,430 for the years ended December 31, 1997, 1996 and 1995, respectively. At December 31, 1997, the amount of the Company's equity that can be paid out in dividends to the stockholders is $2,512,027, which is the earned surplus of Triad on a statutory basis.
Triad Guaranty Inc.
Notes to Consolidated Financial Statements(continued)
8. RELATED PARTY TRANSACTIONS
The Company and Triad pay affiliated companies for management, investment, and other services. The total expense incurred for such items was $284,660, $303,555 and $438,200 in 1997, 1996 and 1995, respectively. Management believes that the expenses incurred for suchtively. Management believes that the expenses incurred for such services approximate costs that the Company would have incurred if those services had been provided by unaffiliated third parties.
9. EMPLOYEE BENEFIT PLAN
Substantially all employees participate in the Company's 401(k) Profit Sharing Plan. Under the plan, employees elect to defer a portion of their wages, with the Company matching deferrals at the rate of 50% of the first 8% of the employee's salary deferred. The Company contributed $151,134, $123,699, and $81,675 for the years ended December 31, 1997, 1996 and 1995, respectively, to the plan.
10. REINSURANCE
Certain premiums and losses are assumed from and ceded to other insurance companies under various reinsurance agreements. The ceding agreement principally provides Triad with increased capacity to write business and achieve a more favorable geographic dispersion of risk.
Effective January 1, 1996, Triad eliminated quota share reof its coverage on renewal business. Triad received approximately $1,100,000 and re-established reserves, unearned premiums, and deferred acquisition costs for the previously ceded business with no effect on income. Also, effective January 1, 1996, Triad obtained $25 million in excess of loss reinsurance designed to provide reinsurance protection in case of catastrophic levels of losses.
Effective October 1, 1997, Triad recaptured most of the remaining coverage on renewal business. Triad received approximately $168,000 and re-established reserves, unearned premiums, and deferred acquisition costs for the previously ceded business with no effect on income.
Triad Guaranty Inc.
Notes to Consolidated Financial Statements(continued)
10. REINSURANCE (CONTINUED)
Reinsurance activity for the years ended December 31, 1997 and 1996 is as follows:
1997 1996 ---- ----
Earned premiums ceded ... $1,809,012 $2,319,927 Losses ceded ............ 140,734 165,224 Earned premiums assumed.. 19,804 29,012 Losses assumed .......... 67,903 99,910
Reinsurance contracts do not relieve Triad from its obligations to policyholders. Failure of the reinsurer to honor its obligation could result in losses to Triad; consequently, allowances are established for amounts deemed uncollectible. Triad evaluates the financial condition of its reinsurers and monitors credit risk arising from similar geographic regions, activities, or economic characteristics of its reinsurers to minimize its exposure to significant losses from reinsurer insolvency.
11. LONG-TERM STOCK INCENTIVE PLAN
In August 1993 the Company adopted the 1993 Long-Term Stock Incentive Plan (the "Plan"). Under the Plan, certain directors, officers and key employees are eligible to be granted various stock-based awards. The number of shares of common stock which may be issued or sold or for which options or stock appreciation rights may be granted under the Plan is 2,100,000 shares. All information relating to the number of shares and option price have been adjusted to reflect the three-for-two stock split in 1996 and the two-for-one stock split in 1997.
Triad Guaranty Inc.
Notes to Consolidated Financial Statements(continued)
11. LONG-TERM STOCK INCENTIVE PLAN (CONTINUED)
Information concerning the stock option plan is summarized below:
Weighted Average Number of Option Exercise Shares Price Price ------ ----- ----- Outstanding, beginning of year .. 570,000 5.33 - 6.93 6.22 Granted ......................... 227,850 4.58 - 8.92 5.84 Exercised ....................... -- -- -- Canceled ........................ -- -- -- Outstanding, end of year ........ 797,850 4.58 - 8.92 6.13 Exercisable, end of year ........ 638,950 4.58 - 8.92 6.17
Granted ......................... 239,254 8.84 - 15.13 11.47 Exercised ....................... 33,948 5.34 - 6.94 6.06 Canceled ........................ 9,462 5.96 - 11.49 9.56 Outstanding, end of year ........ 993,694 4.58 - 15.13 7.38 Exercisable, end of year ........ 738,229 4.58 - 11.49 6.54
Granted ......................... 184,550 14.81 - 38.27 20.13 Exercised ....................... 2,999 4.58 - 8.92 7.47 Canceled ........................ -- -- -- Outstanding, end of year ........ 1,175,245 4.58 - 38.27 9.39 Exercisable, end of year ........ 887,462 4.58 - 15.13 6.91
At December 31, 1997, 1,941,553 shares of the Company's common stock were reserved and 766,308 shares were available for issuance under the Plan. The weighted-average remaining contractual life of the options outstanding at December 31, 1997, is 7.1 years.
The options issued under the Plan in 1995, 1996 and 1997 vest over three years. Certain of the options will immediately vest in the event of a change in control of the Company. Options granted under the Plan terminate no later than 10 years following the date of grant.
Triad Guaranty Inc.
Notes to Consolidated Financial Statements(continued)
11. LONG-TERM STOCK INCENTIVE PLAN (CONTINUED)
Pro forma information required by Financial Accounting Standards Board Statement No. 123, Accounting for Stock-Based Compensation, has been estimated as if the Company had accounted for stock-based awards under the fair value method of that Statement. The fair value of options granted in 1995, 1996, and 1997 was estimated at the date of the grant using a Black-Scholes option pricing model with the following weighted-average input assumptions: risk-free interest rate of 6.4% for 1995, 6.2% for 1996, and 5.7% for 1997; dividend yield of 0.0%; expected volatility of .20 for 1995, .20 for 1996, and .29 for 1997; and a weighted-average expected life of the option of 7 years.
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.
The following table summarizes the fair value of options granted in 1995, 1996, and 1997:
Weighted-Average Weighted-Average Exercise Price Fair Value Type of Option 1997 1996 1995 1997 1996 1995 - ------------------------------ ------ ------ ----- ----- ----- ----- Stock Price equals Exercise Price........... $18.65 $11.44 $5.65 $5.73 $3.16 $1.59 Stock Price less than Exercise Price.......... $20.78 $11.48 $5.96 $3.88 $1.70 $0.90
Triad Guaranty Inc.
Notes to Consolidated Financial Statements(continued)
11. LONG-TERM STOCK INCENTIVE PLAN (CONTINUED)
For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period. Had compensation expense for stock options been recognized using the fair value method on the grant date, net income and earnings per share on a pro forma basis would have been (in thousands except for earnings per share information):
1997 1996 1995 ---- ---- ---- Net Income - as reported .............. $ 17,242 $ 11,197 $ 7,759
Net Income - pro forma ................ $ 16,937 $ 11,054 $ 7,713
Earnings per share - as reported Basic ............................ $ 1.30 $ 0.84 $ 0.59 Diluted .......................... $ 1.26 $ 0.83 $ 0.58
Earnings per share - pro forma Basic ............................ $ 1.28 $ 0.83 $ 0.59 Diluted .......................... $ 1.24 $ 0.82 $ 0.58
The preceding effects of applying Statement 123 are not likely to be indicative of the effects on net income and earnings per share in future years due to the vesting period of awards granted in these years.
Triad Guaranty Inc.
Notes to Consolidated Financial Statements(continued)
12. UNAUDITED QUARTERLY FINANCIAL DATA
The following is a summary of the unaudited quarterly results of operations for the years ended December 31, 1997 and 1996 (in thousands except per share data):
1997 Quarter First Second Third Fourth Year ----- ------ ----- ------ ---- Net premiums written ........... $7,379 $9,128 $10,611 $11,213 $38,331 Earned premiums ................ 7,849 8,985 10,378 11,310 38,522 Net investment income .......... 1,472 1,502 1,730 1,530 6,234 Net losses incurred ............ 1,196 1,090 1,520 1,371 5,177 Underwriting and other expenses 3,095 3,530 3,754 3,998 14,377 Net income ..................... 3,447 4,033 4,738 5,024 17,242 Basic EPS ...................... .26 .30 .36 .38 1.30 Diluted EPS .................... .25 .30 .34 .36 1.26
1996 Quarter First Second Third Fourth Year ----- ------ ----- ------ ---- Net premiums written ........... $5,073 $5,559 $ 6,684 $ 6,645 $23,961 Earned premiums ................ 5,479 5,763 6,513 6,973 24,728 Net investment income .......... 1,279 1,364 1,368 1,435 5,446 Net losses incurred ............ 653 614 1,013 999 3,279 Underwriting and other expenses 2,387 2,590 2,658 2,859 10,494 Net income ..................... 2,549 2,652 2,889 3,107 11,197 Basic EPS ...................... .19 .20 .22 .23 .84 Diluted EPS .................... .19 .20 .21 .23 .83
13. SUBSEQUENT EVENT
On January 22, 1998, the Company completed a $35 million private offering of notes due January 15, 2028. The notes, which represent unsecured obligations of the Company, bear int
Schedule I Summary of Investments - Other Than Investments In Related Parties Triad Guaranty Inc. December 31, 1997
Amount at Which Shown Amortized Fair in Balance Type of Investment Cost Value Sheet --------------------------------- (dollars in thousands) Fixed maturity securities, available-for-sale: Bonds: U.S. Government obligations ..... $ 9,824 $ 10,198 $ 10,198 Mortgage-backed securities ...... 4,679 4,801 4,801 State and municipal bonds ....... 68,789 71,819 71,819 Corporate bonds ................. 12,261 12,697 12,697 Public utilities ................ 203 210 210 ------- -------- ------- Total ............................. 95,756 99,725 99,725 -------- -------- -------
Equity securities, available-for-sale: Common stocks: Public utilities .............. 627 885 885 Industrial & miscellaneous .... 5,140 7,597 7,597 Preferred Stock ................... 2,900 2,984 2,984 ------- -------- ------- Total ............................ 8,667 11,466 11,466 ------- -------- ------- Short-term investments ............... 8,686 8,686 8,686 ------- -------- -------
Total investments other than investments in related parties .... $113,109 $119,877 $119,877 ======== ======== ========
Schedule Ii - Condensed Financial Information Of Registrant Condensed Balance Sheets Triad Guaranty Inc. (Parent Company)
December 31 1997 1996 ---- ---- (dollars in thousands)
Assets: Investment in subsidiaries ......................... $111,200 $91,136 Cash and short-term investments .................... 562 534 Other assets ....................................... 56 16 -------- ------- Total assets ....................................... $111,818 $91,686 ======== =======
Liabilities and stockholders' equity: Liabilities: Current taxes payable .............................. $ 3 $ 1 Accrued expenses and other liabilities ............. 35 5 -------- ------- Total liabilities .................................. 38 6
Stockholders' equity: Common stock ....................................... 133 66 Additional paid-in capital ......................... 59,369 59,347 Unrealized gain on invested assets (all from subsidiaries) ..................................... 4,405 1,569 Retained earnings .................................. 47,873 30,698 -------- ------- Total stockholders' equity ............................ 111,780 91,680 -------- ------- Total liabilities and stockholders' equity ............ $111,818 $91,686 ======== =======
See notes to condensed financial statements.
Schedule Ii - Condensed Financial Information Of Registrant Condensed Statements Of Income Triad Guaranty Inc. (Parent Company)rant
Year Ended December 31 1997 1996 1995 ---- ---- ---- (dollars in thousands) Revenues: Net investment income ....................... $ 22 $ 17 $ 14 ------- -------- ------- 22 17 14 ------- -------- ------- Expenses: Operating expenses .......................... 6 6 152 ------- -------- ------- 6 6 152 ------- -------- ------- Income (loss) before federal income taxes and equity in undistributed income of subsidiaries 16 11 (138)
Federal income tax expense ..................... 2 151 22 ------- -------- ------- Income (loss) before equity in undistributed income of subsidiaries ........................ 14 (140) (160) Equity in undistributed income of subsidiaries.. 17,228 11,337 7,919 ------- -------- -------
Net income ..................................... $17,242 $ 11,197 $ 7,759 ======= ======== =======
See notes to condensed financial statements.
Schedule II - Condensed Financial Information of Registrant Condensed Statements of Cash Flows Triad Guaranty Inc. (Parent Company)
Year Ended December 31 1997 1996 1995 ---- ---- ---- (dollars in thousands) Operating Activities Net income ..................................... $ 17,242 $ 11,197 $ 7,759
Adjustments to reconcile net income to net cash provided by (used in) operating activities: Equity in undistributed income of subsidiaries.. (17,228) (11,337) (7,919) Amortization of deferred compensation .......... -- -- 149 (Increase) decrease in other assets ............ (40) 20 (14) Decrease in deferred income taxes .............. -- 151 21 Increase (decrease) in current tax payable ..... 2 -- (3) Increase (decrease) in accrued expenses and other liabilities ........................... 30 (15) (18) -------- -------- ------- Net cash provided by (used in) operating activities......................... 6 16 (25)
Financing Activities Proceeds from exercise of stock options...... .. 22 206 -- -------- -------- ------- Net cash provided by financing activities ......... 22 206 -- -------- -------- ------- Increase (decrease) in cash and short-term investments.......................... 28 222 (25) Cash and short-term investments at beginning of year .............................. 534 312 337 -------- ------- ------- Cash and short-term investments at end of year .... $ 562 $ 534 $ 312 ======== ======= =======
See notes to condensed financial statements.
Schedule II - Condensed Financial Information of Registrant Triad Guaranty Inc. (Parent Company) Supplementary Notes
NOTE 1
In the parent company financial statements, the Company's investment in its subsidiaries is stated at cost plus equity in undistributed earnings of the subsidiaries. The Company's share of net income of its subsidiaries is included in income using the equity method. The accompanying Parent Company financial statements should be read in conjunction with the Consolidated Financial Statements and Notes to Consolidated Financial Statements included as part of this Form 10-K.
NOTE 2
Triad Guaranty Inc. (the "Company") is a holding company which, through its wholly-owned subsidiary, Triad Guaranty Insurance Corporation ("Triad"), provides private mortgage insurance coverage in the United States to mortgage lenders to protect the lender against loss from defaults on low down payment residential mortgage loans.
NOTE 3
In January 1998 the Company completed a $35 million private offering of notes due January 15, 2028. The notes, which represent unsecured obligations of the Company, bear interest at a rate of 7.9% per annum and are non-callable.
Schedule IV - Reinsurance
Triad Guaranty Inc. Mortgage Insurance Premium Earned Years Ended December 31, 1997, 1996 and 1995
Percentage of Ceded To Assumed Amount Gross Other From Other Net Assumed Amount Companies Companies Amount to Net ------ --------- --------- ------ ------ (dollars in thousands)
1997............ $40,311 $1,809 $20 $38,522 0.1% ======= ====== === ======= 1996............ $27,019 $2,320 $29 $24,728 0.1% ======= ====== === ======= 1995............ $19,699 $4,253 $32 $15,478 0.2% ======= ====== === =======