10-Q 1 d10q.htm FORM 10-Q Form 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

 

 

FORM 10-Q

 

 

 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2010

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to             

Commission file number 1-13664

 

 

THE PMI GROUP, INC.

(Exact name of registrant as specified in its charter)

 

 

 

Delaware   94-3199675
(State of Incorporation)  

(IRS Employer

Identification No.)

 

3003 Oak Road,  
Walnut Creek, California   94597
(Address of principal executive offices)   (Zip Code)

(925) 658-7878

(Registrant’s telephone number, including area code)

 

 

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

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

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

 

Large accelerated filer   ¨    Accelerated filer   x
Non-accelerated filer   ¨    Smaller Reporting Company   ¨

Indicate by check mark whether the registration is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

    Class of Stock    

 

Par Value

 

Date

 

Number of Shares

Common Stock

  $0.01   July 30, 2010  

161,161,172

 

 

 


Table of Contents

TABLE OF CONTENTS

 

               Page

Part I- Financial Information

  
  

Item 1.

   Interim Consolidated Financial Statements and Notes    3
      Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2010 and 2009 (Unaudited)    3
      Consolidated Balance Sheets as of June 30, 2010 (Unaudited) and December 31, 2009    4
      Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2010 and 2009 (Unaudited)    5
      Notes to Consolidated Financial Statements (Unaudited)    6
  

Item 2.

   Management’s Discussions and Analysis of Financial Condition and Results of Operations    43
  

Item 3.

   Quantitative and Qualitative Disclosures about Market Risk    83
  

Item 4.

   Controls and Procedures    86

Part II- Other Information

  
  

Item 1.

   Legal Proceedings    87
  

Item 1A.

   Risk Factors    88
  

Item 6.

   Exhibits    93

Signatures

   92

Index to Exhibits

  

Exhibits

  

 

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PART I – FINANCIAL INFORMATION

 

ITEM 1. INTERIM CONSOLIDATED FINANCIAL STATEMENTS AND NOTES

THE PMI GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

 

     Three Months Ended June 30,     Six Months Ended June 30,  
     2010     2009     2010     2009  
     (Dollars in thousands, except per share data)  

REVENUES

        

Premiums earned

   $ 149,651      $ 181,600      $ 311,216      $ 369,694   

Net investment income

     23,861        29,116        50,549        63,721   

Net realized investment gains

     397        23,392        7,830        17,341   

Change in fair value of certain debt instruments

     (47,687     (39,079     (88,500     (20,603

Other income

     2,684        7,134        4,408        17,074   
                                

Total revenues

     128,906        202,163        285,503        447,227   
                                

LOSSES AND EXPENSES

        

Losses and loss adjustment expenses

     320,489        480,841        671,314        863,788   

Amortization of deferred policy acquisition costs

     4,163        3,753        8,039        7,098   

Other underwriting and operating expenses

     27,907        39,752        61,766        79,773   

Interest expense

     12,247        11,731        21,770        23,583   
                                

Total losses and expenses

     364,806        536,077        762,889        974,242   
                                

Loss before equity in losses from unconsolidated subsidiaries and income taxes

     (235,900     (333,914     (477,386     (527,015

Equity in losses from unconsolidated subsidiaries

     (3,917     (1,392     (8,327     (3,838
                                

Loss from continuing operations before income taxes

     (239,817     (335,306     (485,713     (530,853

Income tax benefit from continuing operations

     (89,257     (112,679     (178,166     (192,965
                                

Loss from continuing operations

     (150,560     (222,627     (307,547     (337,888

Income (loss) from discontinued operations, net of taxes

     —          7        —          (23
                                

NET LOSS

   $ (150,560   $ (222,620   $ (307,547   $ (337,911
                                

PER SHARE DATA

        

Basic loss from continuing operations

   $ (1.11   $ (2.71   $ (2.81   $ (4.12

Basic income from discontinued operations

     —          —          —          —     
                                

Basic net loss

   $ (1.11   $ (2.71   $ (2.81   $ (4.12
                                

Diluted loss from continuing operations

   $ (1.11   $ (2.71   $ (2.81   $ (4.12

Diluted income from discontinued operations

     —          —          —          —     
                                

Diluted net loss

   $ (1.11   $ (2.71   $ (2.81   $ (4.12
                                

 

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THE PMI GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

 

     June 30,
2010
    December 31,
2009
 
     (Unaudited)     (Audited)  
     (Dollars in thousands, except per share data)  

ASSETS

    

Investments - available-for-sale, at fair value:

    

Fixed income securities

   $ 2,185,119      $ 2,355,188   

Equity securities:

    

Common

     28,877        29,090   

Preferred

     163,823        186,023   

Short-term investments

     1,140        2,232   
                

Total investments

     2,378,959        2,572,533   

Cash and cash equivalents

     1,021,841        686,891   

Investments in unconsolidated subsidiaries

     132,670        139,775   

Related party receivables

     1,346        1,254   

Accrued investment income

     28,220        35,028   

Premiums receivable

     53,406        56,426   

Reinsurance receivables and prepaid premiums

     85,935        52,444   

Reinsurance recoverables

     613,646        703,550   

Deferred policy acquisition costs

     44,519        41,289   

Property, equipment and software, net of accumulated depreciation and amortization

     93,050        101,893   

Prepaid and recoverable income taxes

     48,902        50,250   

Deferred income tax assets

     282,768        178,623   

Other receivables

     121,118        88   

Other assets

     26,729        21,473   
                

Total assets

   $ 4,933,109      $ 4,641,517   
                

LIABILITIES

    

Reserve for losses and loss adjustment expenses

   $ 3,112,942      $ 3,253,820   

Unearned premiums

     63,508        72,089   

Debt (includes $302,148 and $213,648 measured at fair value at June 30, 2010 and December 31, 2009)

     588,043        389,991   

Reinsurance payables

     32,943        36,349   

Related party payables

     1,902        1,865   

Other liabilities and accrued expenses

     179,481        160,316   
                

Total liabilities

     3,978,819        3,914,430   
                

Commitments and contingencies (Notes 7 and 9)

    

SHAREHOLDERS’ EQUITY

    

Preferred stock - $0.01 par value; 5,000,000 shares authorized; none issued or outstanding

     —          —     

Common stock - $0.01 par value; 250,000,000 shares authorized; 197,078,767 shares issued; 160,775,604 and 82,580,410 shares outstanding

     1,971        1,193   

Additional paid-in capital

     1,381,730        873,010   

Treasury stock, at cost (36,303,163 and 36,733,357 shares)

     (1,305,873     (1,317,252

Retained earnings

     797,182        1,104,728   

Accumulated other comprehensive income, net of deferred taxes

     79,280        65,408   
                

Total shareholders’ equity

     954,290        727,087   
                

Total liabilities and shareholders’ equity

   $ 4,933,109      $ 4,641,517   
                

See accompanying notes to consolidated financial statements.

 

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THE PMI GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 

         Six Months Ended June 30,  
         2010     2009  
         (Dollars in thousands)  

CASH FLOWS FROM OPERATING ACTIVITIES FROM CONTINUING OPERATIONS

    

Net loss

   $ (307,547   $ (337,911

Less loss from discontinued operations, net of taxes

     —          23   

Adjustments to reconcile net loss to net cash used in operating activities:

    

Equity in losses from unconsolidated subsidiaries

     8,327        3,838   

Net realized investment gains

     (7,958     (18,502

Change in fair value of certain debt instruments

     88,500        20,603   

Depreciation and amortization

     16,732        15,951   

Deferred income taxes

     (136,108     (71,828

Compensation expense related to share-based payments

     1,536        2,253   

Deferred policy acquisition costs incurred and deferred

     (11,269     (13,035

Amortization of deferred policy acquisition costs

     8,039        7,098   

Amortization of debt discount and debt issuance cost

     1,191        —     

Changes in:

    

Accrued investment income

     6,515        3,525   

Premiums receivable

     2,581        639   

Reinsurance receivables, and prepaid premiums net of reinsurance payables

     (36,897     (6,264

Reinsurance recoverables

     89,904        (119,640

Prepaid and recoverable income taxes

     1,349        (11,605

Reserve for losses and loss adjustment expenses

     (135,402     527,422   

Unearned premiums

     (7,346     (15,919

Related party receivables, net of payables

     14,212        12   

Liability for pension benefit

     10,784        (44,960

Other receivables

     (121,030     (11,171

Other

     (3,971     13,732   
                  

Net cash used in operating activities from continuing operations

     (517,858     (55,739
                  

CASH FLOWS FROM INVESTING ACTIVITIES FROM CONTINUING OPERATIONS

    

Proceeds from sales and maturities of fixed income securities

     514,508        389,589   

Proceeds from sales of equity securities

     25,101        63,342   

Investment purchases:

 

Fixed income securities

     (329,863     (511,320
  Equity securities      (4,243     (27,585

Net change in short-term investments

     1,088        (19

Distributions from unconsolidated subsidiaries, net of investments

     (45     (92

Capital expenditures and capitalized software, net of dispositions

     (1,277     (2,014
                  

Net cash provided by (used in) investing activities from continuing operations

     205,269        (88,099
                  

CASH FLOWS FROM FINANCING ACTIVITIES FROM CONTINUING OPERATIONS

    

Proceeds from issuance of convertible notes, net of issuance costs of $8,500

     276,450        —     

Proceeds from issuance of common stock

     455,149        —     

Payment of stock offering issuance costs

     (1,965     —     

Payment of debt issuance costs

     (442     —     

Payments on credit facility

     (75,000     (75,250

Proceeds from issuance of treasury stock

     275        339   
                  

Net cash provided by (used in) financing activities from continuing operations

     654,467        (74,911
                  

CASH FLOWS FROM DISCONTINUED OPERATIONS:

    

Net cash used in operating activities from discontinued operations

     —          (23
                  

Net cash used in discontinued operations

     —          (23

Effect of foreign exchange rate changes on cash and cash equivalents from continuing operations

     (6,928     430   
                  

Net increase (decrease) in cash and cash equivalents

     334,950        (218,342

Cash and cash equivalents at the beginning of the period

     686,891        1,483,313   
                  

Cash and cash equivalents of continuing operations at end of period

   $ 1,021,841      $ 1,264,971   
                  

SUPPLEMENTAL CASH FLOW DISCLOSURES:

    

Cash paid during the year:

    

Interest paid, net of capitalization

   $ 17,066      $ 22,050   

Income taxes paid, net of refunds

   $ 1      $ 5,743   

See accompanying notes to consolidated financial statements.

 

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THE PMI GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1. BASIS OF PRESENTATION

The accompanying consolidated financial statements include the accounts of The PMI Group, Inc. (“The PMI Group” or “TPG”), a Delaware corporation and its direct and indirect wholly-owned subsidiaries, including: PMI Mortgage Insurance Co. (“MIC”), an Arizona corporation, and its affiliated U.S. mortgage insurance and reinsurance companies (collectively “PMI”); PMI Mortgage Insurance Company Limited and its holding company, PMI Europe Holdings Limited, the Irish insurance companies (collectively “PMI Europe”); PMI Mortgage Insurance Company Canada and its holding company, PMI Mortgage Insurance Holdings Canada Inc. (collectively “PMI Canada”); and other insurance, reinsurance and non-insurance subsidiaries. The PMI Group and its subsidiaries are collectively referred to as the “Company.” All material inter-company transactions and balances have been eliminated in the consolidated financial statements.

The Company has equity ownership interests in CMG Mortgage Insurance Company and CMG Mortgage Assurance Company (collectively “CMG MI”), which conduct residential mortgage insurance business for credit unions. In the third quarter of 2009, MIC and CUNA Mutual Insurance Society contributed the stock of CMG Mortgage Reinsurance Company, which provides reinsurance to residential mortgage insurers, to CMG Mortgage Assurance Company. The Company also had an approximately 42.0% equity ownership interest in FGIC Corporation, the holding company of Financial Guaranty Insurance Company (collectively “FGIC”), a New York-domiciled financial guaranty insurance company. The Company impaired its investment in FGIC in the first quarter of 2008 and reduced the carrying value of the investment to zero. The Company also has ownership interests in several limited partnerships. In addition, the Company owns 100% of PMI Capital I (“Issuer Trust”), an unconsolidated wholly-owned trust that privately issued debt in 1997. In the fourth quarter of 2009, the Company sold its equity ownership interest in RAM Holdings Ltd., the holding company of RAM Reinsurance Company, Ltd. (collectively “RAM Re”), a financial guaranty reinsurance company based in Bermuda.

Impact of Current Economic Environment

High unemployment rates and ongoing weakness in U.S. residential mortgage and housing markets continue to negatively affect the Company’s results of operations and overall financial condition. The Company’s consolidated net loss was $150.6 million and $307.5 million for the second quarter and first six months of 2010, respectively, compared to a net loss of $222.6 million and $337.9 million for the corresponding periods in 2009.

The Company continues to focus on its core U.S mortgage insurance business under difficult market conditions. In the second quarter of 2010, the Company completed the concurrent public offerings of additional shares of its common stock and convertible notes for aggregate net proceeds of approximately $732 million. The PMI Group contributed $610 million of the proceeds from the offerings to MIC in the form of a capital contribution and surplus notes issued by MIC to The PMI Group. The contributions caused MIC’s policyholders’ position and risk to capital ratio to comply with regulatory capital adequacy requirements. However, there can be no assurance that MIC’s policyholders’ position will not decline below, and the risk to capital ratio will not increase above, levels necessary to meet regulatory capital adequacy requirements.

MIC’s principal regulator is the Arizona Department of Insurance (the “Department”). On February 10, 2010, MIC received a letter from the Department waiving, until December 31, 2011, the requirement that MIC maintain the Arizona required minimum policyholders’ position to write new business. On May 24, 2010, PMI received a letter from the Department withdrawing this waiver, effective May 24, 2010. In its May 24, 2010 letter, the Department noted that MIC had recently received a capital contribution from the Company and had issued surplus notes to the Company in the amounts of $325 million and $285 million, respectively, and that these transactions increased the capital and surplus of PMI by a total of $610 million.

 

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In response to difficult economic and industry conditions and in order to preserve capital, the Company made changes to PMI’s underwriting guidelines and customer management strategies in 2008 and 2009, which had the effect of limiting PMI’s new business writings in 2009 and the first half of 2010. The Company is undertaking efforts to increase insurance writings from present levels. However, the Company expects a variety of factors to continue to impact its new business writings in 2010. Such factors include, among others, capital preservation initiatives, customer management strategies, and pricing and underwriting guideline changes adopted prior to 2010. Additionally, mortgage and private mortgage insurance market conditions, including a smaller mortgage origination market and significant growth in demand for mortgage insurance from the Federal Housing Authority (“FHA”), have negatively impacted the private mortgage insurance industry as a whole. The Company believes there is currently sufficient liquidity at the holding company to pay holding company expenses (including interest expense on its outstanding debt) through 2011 and there are sufficient assets at the insurance company level for PMI to meet its obligations through 2011.

NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

The preparation of financial statements in conformity with U.S. generally accepted accounting principles (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements, as well as the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates. In the opinion of management, all adjustments, consisting of normal recurring adjustments, considered necessary for a fair presentation for the periods presented have been included.

Significant accounting policies are as follows:

Investments — The Company has designated its entire portfolio of fixed income and equity securities as available-for-sale. These securities are predominantly recorded at fair value based on quoted market prices with unrealized gains and losses, net of deferred income taxes, accounted for as a component of accumulated other comprehensive income in shareholders’ equity. The Company’s short-term investments have maturities of greater than three and less than 12 months when purchased and are carried at fair value. The Company evaluates its portfolio of equity securities regularly to determine whether there are declines in value and whether such declines meet the definition of other-than-temporary impairment (“OTTI”) in accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 320 Investments-Debt and Equity Securities (“Topic 320”), previously SFAS No. 115, Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin (“SAB”) No. 59, Accounting for Noncurrent Marketable Equity Securities, and FASB Staff Position (“FSP”) Financial Accounting Standards (“FAS”) No. 115-2. When the Company determines that an equity security has suffered an OTTI, the impairment loss is recognized as a realized investment loss in the consolidated statement of operations.

The Company recognizes OTTI for debt securities classified as available for sale in accordance with Topic 320. The Company assesses whether it intends to sell or it is more likely than not that it will be required to sell a security before recovery of its amortized cost basis less any current-period credit losses. For debt securities that are considered other-than-temporarily impaired and that the Company does not intend to sell and will not be required to sell prior to recovery of its amortized cost basis, the Company separates the amount of the impairment into the amount that is credit-related (referred to as the credit loss component) and the amount due to all other factors. The credit loss component is recognized in net income and is the difference between the security’s amortized cost basis and the present value of its expected future cash flows. The remaining difference between the security’s fair value and the present value of future expected cash flows is due to factors that are not credit-related and is recognized in accumulated other comprehensive income (“AOCI”). For debt securities that are intended to be sold, or that management believes are more likely than not to be required to be sold prior to recovery, the full impairment is recognized immediately in earnings.

 

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Realized gains and losses on sales of investments are determined on a specific-identification basis. Investment income consists primarily of interest and dividends. Interest income and preferred stock dividends are recognized on an accrual basis. Dividend income on common stock investments is recognized on the date of declaration. Net investment income represents interest and dividend income, net of investment expenses.

Cash and Cash Equivalents — The Company considers all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents.

Investments in Unconsolidated Subsidiaries — Investments in the Company’s unconsolidated subsidiaries include both equity investees and other unconsolidated subsidiaries. Investments in equity investees with ownership interests of 20-50% are generally accounted for using the equity method of accounting, and investments of less than 20% ownership interest are generally accounted for using the cost method of accounting if the Company does not have significant influence over the entity. Limited partnerships with ownership interests greater than 3% but less than 50% are primarily accounted for using the equity method of accounting. The carrying value of the investments in the Company’s unconsolidated subsidiaries also includes the Company’s share of net unrealized gains and losses in the unconsolidated subsidiaries’ investment portfolios.

Periodically, or as events dictate, the Company evaluates potential impairment of its investments in unconsolidated subsidiaries. FASB ASC Topic 323 Investments-Equity Method and Joint Ventures (“Topic 323”), previously APB No. 18, provides criteria for determining potential impairment. In the event a loss in value of an investment is determined to be an other-than-temporary decline, an impairment charge would be recognized in the consolidated statement of operations. Evidence of a loss in value that could indicate impairment might include, but would not necessarily be limited to, the absence of an ability to recover the carrying amount of the investment or the inability of the investee to sustain an earnings capacity which would justify the carrying amount of the investment. Realized capital gains or losses resulting from the sale of the Company’s ownership interests of unconsolidated subsidiaries are recognized as net realized investment gains or losses in the consolidated statement of operations.

The Company reports the equity in earnings (losses) from CMG MI and FGIC on a current month basis and the Company’s interest in limited partnerships are reported on a one-quarter lag basis. Due to the impairment of the Company’s investment in FGIC in 2008, the carrying value of the Company’s investments in FGIC was reduced to and has remained at zero.

Related Party Receivables and Payables — As of June 30, 2010, related party receivables were $1.3 million and related party payables were $1.9 million compared to $1.3 million and $1.9 million as of December 31, 2009, respectively, which were comprised of non-trade receivables and payables from unconsolidated subsidiaries.

Deferred Policy Acquisition Costs — The Company defers certain costs of its mortgage insurance operations relating to the acquisition of new insurance and amortizes these costs against related premium revenue in order to match costs and revenues. To the extent the Company provided contract underwriting services on loans that did not require mortgage insurance, associated underwriting costs were not deferred. Costs related to the acquisition of mortgage insurance business are initially deferred and reported as deferred policy acquisition costs. Consistent with industry accounting practice, amortization of these costs for each underwriting year book of business is charged against revenue in proportion to estimated gross profits. Estimated gross profits are comprised of earned premiums, interest income, losses and loss adjustment expenses. The deferred costs are adjusted as appropriate for policy cancellations to be consistent with the Company’s revenue recognition policy. For each underwriting year, the Company estimates the rate of amortization to reflect actual experience and any changes to persistency or loss development. Deferred policy acquisition costs are reviewed periodically to determine that they do not exceed recoverable amounts, after considering investment income.

Property, Equipment and Software — Property and equipment, including software, are carried at cost and are depreciated using the straight-line method over the estimated useful lives of the assets, ranging from three to

 

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thirty nine years. Leasehold improvements are recorded at cost and amortized over the lesser of the useful life of the assets or the remaining term of the related lease. The Company’s accumulated depreciation and amortization from continuing operations was $199.1 million and $189.0 million as of June 30, 2010 and December 31, 2009, respectively.

The Company capitalizes costs incurred during the application development stage related to software developed for internal use and for which it has no substantive plan to market externally in accordance with FASB ASC Topic 350 Intangibles-Goodwill and Other, previously SOP No. 98-1. Capitalized costs are amortized at such time as the software is ready for its intended use on a straight-line basis over the estimated useful life of the asset, which is generally three to seven years.

Convertible Notes — In the second quarter of 2010, the Company issued 4.50% Convertible Senior Notes (“Convertible Notes”) due April 15, 2020, in a public offering for an aggregate principal amount of $285 million. The Convertible Notes bear interest at a rate of 4.5% per year. Interest is payable semi-annually in arrears on April 15 and October 15 of each year, beginning October 15, 2010. The Convertible Notes are senior unsecured obligations and rank senior in right of payment to the Company’s existing and future indebtedness that is expressly subordinated. Prior to January 15, 2020, the Convertible Notes are convertible only under certain circumstances. The initial conversion rate is 127.5307 shares of common stock per $1,000 principal amount of Convertible Notes, which represents an initial conversion price of approximately $7.84 per share. Upon conversion, the Company may deliver cash, shares of Common Stock or a combination thereof, at its option. The Company evaluated the accounting treatment for the Convertible Notes in accordance with FASB ASC Topic 470-20 Debt with Conversion and Other Options, previously APB No. 14-1 to determine if the instruments should be accounted for as debt, equity, or a combination of both. As the Convertible Notes are debt with a conversion option, the Company bifurcated the net proceeds between liability and equity components. A fair value was calculated for the debt component and the equity component is recorded net of that value.

Derivatives — Certain credit default swap contracts entered into by PMI Europe are considered credit derivative contracts under FASB ASC Topic 815 Derivatives and Hedging (“Topic 815”), previously SFAS No. 133 and SFAS No. 149. These credit default swap derivatives are recorded at their fair value on the consolidated balance sheet with subsequent changes in fair value recorded in consolidated net income or loss. The Company determines the fair values of its credit default swaps on a quarterly basis and uses internally developed models since observable market quotes are not regularly available. These models include future estimated claim payments and market input assumptions, including discount rates and market spreads to calculate a fair value and reflect management’s best judgment about current market conditions. Due to the illiquid nature of the credit default swap market, the use of available market data and assumptions used by management to estimate fair value could differ materially from amounts that would be realized in the market if the derivatives were traded. Due to the volatile nature of the credit market as well as the imprecision inherent in the Company’s fair value estimate, future valuations could differ materially from those reflected in the current period.

Special Purpose Entities — Certain insurance transactions entered into by PMI and PMI Europe require the use of foreign wholly-owned special purpose entities principally for regulatory purposes. These special purpose entities are consolidated in the Company’s consolidated financial statements.

Premium Deficiency Reserve — The Company performs an analysis for premium deficiency using assumptions based on management’s best estimate when the assessment is performed. The calculation for premium deficiency requires significant judgment and includes estimates of future expected premiums, expected claims, loss adjustment expenses and maintenance costs as of the date of the analysis. The calculation of future expected premiums uses assumptions for persistency and termination levels on policies currently in force. Assumptions for future expected losses include future expected average claim sizes and claim rates which are based on the current default rate and expected future defaults. Investment income is also considered in the premium deficiency calculation. The Company performs premium deficiency analyses quarterly. The Company determined that there were premium deficiencies for PMI Europe and PMI Canada and recorded premium deficiency reserves in 2009 and 2010. As of June 30, 2010, the premium deficiency reserves were $0.8 million and $1.5 million for PMI Europe and PMI Canada, respectively. Premium deficiency reserves are included in

 

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reserves for losses and loss adjustment expenses on the consolidated balance sheets and losses and loss adjustment expenses in the consolidated statements of operations. The Company determined there was no premium deficiency in its U.S. Mortgage Insurance Operations segment. To the extent premium levels and actual loss experience differ from the assumptions used, the results could be negatively affected in future periods.

Reserve for Losses and Loss Adjustment Expenses — The consolidated reserves for losses and loss adjustment expenses (“LAE”) for the Company’s U.S. Mortgage Insurance and International Operations are the estimated claim settlement costs on notices of default that have been received by the Company, as well as loan defaults that have been incurred but have not been reported by the lenders. For reporting and internal tracking purposes, the Company does not consider a loan to be in default until the borrower has missed two payments. Depending upon its scheduled payment date, a loan in default for two consecutive monthly payments could be reported to PMI between the 31st and the 60th day after the first missed payment due date. The Company’s U.S. mortgage insurance primary master policy defines “default” as the borrower’s failure to pay when due an amount equal to the scheduled periodic mortgage payment under the terms of the mortgage. Generally, however, the master policy requires an insured to notify PMI of a default no later than the last business day of the month following the month in which the borrower becomes three monthly payments in default. Consistent with industry accounting practices, the Company considers its mortgage insurance policies short-duration contracts and, accordingly, does not establish loss reserves for future claims on insured loans that are not currently in default. The Company establishes loss reserves when insured loans are identified as currently in default using estimated claim rates and claim amounts for each report year, net of recoverables. The Company also establishes loss reserves for defaults that it believes have been incurred but not yet reported to the Company prior to the close of an accounting period using estimated claim rates and claim amounts applied to the estimated number of defaults not reported.

The Company establishes loss reserves on a gross basis for losses and LAE for its deductible pool policies, which contain aggregate deductible and stop-loss limits, on a pool by pool basis. The gross reserves for each pool are based on reported delinquencies, claim rate and claim size assumptions which are determined based on the loan characteristics of the pool, delinquency trends and historical performance as well as expected economic conditions. After determining the gross loss reserve, deductible and stop-loss limits are applied to determine the net loss reserve.

The Company currently reinsures six financial guaranty contracts in PMI Europe and establishes reserves for losses and LAE for financial guaranty contracts on a case-by-case basis when specific insured obligations are in payment default or are likely to be in payment default. Financial guaranty contracts are recorded in accordance with the accounting guidance provided in Topic 944. These reserves represent an estimate of the present value of the anticipated shortfall between payments on insured obligations plus anticipated loss adjustment expenses and anticipated cash flows from, and proceeds to be received on sales of any collateral supporting the obligation and/or other anticipated recoveries. The discount rate used in calculating the net present value of estimated losses is based upon the risk-free rate for the duration of the anticipated shortfall.

Changes in loss reserves can materially affect the Company’s consolidated net income or loss. The process of estimating loss reserves requires the Company to forecast the interest rate, employment and housing market environments, which are highly uncertain. Therefore, the process requires significant management judgment and estimates. The use of different estimates would have resulted in the establishment of different reserves. In addition, changes in the accounting estimates are reasonably likely to occur from period to period based on the economic conditions. The Company reviews the judgments made in its prior period estimation process and adjusts the current assumptions as appropriate. While the assumptions are based in part upon historical data, the loss provisioning process is complex and subjective and, therefore, the ultimate liability may vary significantly from the Company’s estimates.

Reinsurance — The Company uses reinsurance to reduce net risk in force and optimize capital allocation. Under a captive reinsurance agreement, the Company reinsures a portion of its risk written on loans originated by a certain lender with the captive reinsurance company affiliated with such lender. In return, a commensurate amount of the Company’s gross premiums received is ceded to the captive reinsurance company less, in some

 

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instances, a ceding commission paid to us for underwriting and administering the business. To the extent the reinsurance agreements meet risk transfer requirements, ceded premiums are recorded in premiums earned and ceded losses are included in losses and loss adjustment expenses in the consolidated statements of operations. Effective January 1, 2009, the Company ceased seeking reinsurance under excess of loss (“XOL”) captive reinsurance agreements.

Revenue Recognition — Mortgage guaranty insurance policies are contracts that are generally non-cancelable by the insurer, are renewable at a fixed price, and provide for payment of premiums on a monthly, annual or single basis. Upon renewal, the Company is not able to re-underwrite or re-price its policies. Consistent with industry accounting practices, premiums written on a monthly basis are earned as coverage is provided. Monthly premiums accounted for 92.8% and 90.1% of gross premiums written from the Company’s mortgage insurance operations in the three and six months ended June 30, 2010, respectively, compared to 88.4% and 86.8% in the corresponding periods of 2009. Premiums written on an annual basis are amortized on a monthly pro rata basis over the year of coverage. Primary mortgage insurance premiums written on policies covering more than one year are referred to as single premiums. A portion of the revenue from single premiums is recognized in premiums earned in the current period, and the remaining portion is deferred as unearned premiums and earned over the expected life of the policy, a range of seven to fifteen years for the majority of the single premium policies. If single premium policies related to insured loans are cancelled due to repayment by the borrower, and the premium is non-refundable, then the remaining unearned premium related to each cancelled policy is recognized as earned premiums upon notification of the cancellation. Unearned premiums represent the portion of premiums written that is applicable to the estimated unexpired risk of insured loans. Rates used to determine the earning of single premiums are estimates based on actuarial analysis of the expiration of risk.

Income Taxes — The Company accounts for income taxes using the liability method in accordance with FASB ASC Topic 740 Income Taxes (“Topic 740”), previously SFAS No. 109. The liability method measures the expected future tax effects of temporary differences at the enacted tax rates applicable for the period in which the deferred asset or liability is expected to be realized or settled. Temporary differences are differences between the tax basis of an asset or liability and its reported amount in the consolidated financial statements that will result in future increases or decreases in taxes owed on a cash basis compared to amounts already recognized as tax expense in the consolidated statement of operations.

The Company also evaluates the need for a valuation allowance against its deferred tax assets. Under Topic 740, if it is more likely than not that the Company will not be able to realize the benefit associated with its deferred tax assets, then a valuation allowance is established. In evaluating whether a deferred tax benefit would be realized, the Company assesses all available evidence both positive and negative and future sources of income such as tax planning strategies, reversing temporary differences and future income. As of June 30, 2010, a tax valuation allowance of $253.0 million was recorded against a $535.7 million deferred tax asset primarily related to FGIC losses in excess of the Company’s tax basis, foreign and California net operating losses and certain foreign tax credits. Additional valuation allowance benefits or charges could be recognized in the future due to changes in management’s expectations regarding realization of tax benefits. (See Note 13, Income Taxes, for further discussion.)

Benefit Plans — The Company provides pension benefits through noncontributory defined benefit plans to all eligible U.S. employees under The PMI Group, Inc. Retirement Plan (the “Retirement Plan”) and to certain employees of the Company under The PMI Group, Inc. Supplemental Employee Retirement Plan. In addition, the Company provides certain health care and life insurance benefits for retired employees under another post-employment benefit plan. The Company applies FASB ASC Topic 715 Compensation-Retirement Benefits, previously SFAS No. 158 (“Topic 715”), for its treatment of U.S. employees’ pension benefits. This topic requires the Company to recognize the funded status (i.e., the difference between the fair value of plan assets and the projected benefit obligations) of its defined benefit postretirement plans, with a corresponding adjustment to accumulated other comprehensive income or loss.

Foreign Currency Translation — The financial statements of the Company’s foreign subsidiaries have been translated into U.S. dollars in accordance with FASB ASC Topic 830, Foreign Currency Matters, previously

 

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SFAS No. 52. Assets and liabilities denominated in non-U.S. dollar functional currencies are translated using the period-end spot exchange rates. Revenues and expenses are translated at monthly-average exchange rates. The effects of translating financial results with a functional currency other than the reporting currency are reported as a component of accumulated other comprehensive income (loss) included in total shareholders’ equity. Foreign currency translation gains in accumulated other comprehensive income before tax were $40.0 million as of June 30, 2010 compared with $50.1 million as of December 31, 2009. Gains and losses from foreign currency re-measurement for PMI Europe and PMI Canada are reflected in income and represent the revaluation of assets and liabilities denominated in non-functional currencies into the functional currency, the Euro and Canadian dollar, respectively.

Comprehensive Income (Loss) — Comprehensive income (loss) includes the net loss, the change in foreign currency translation gains or losses, pension adjustments, changes in unrealized gains and losses on investments, accretion of cash flow hedges and reclassifications of realized gains and losses previously reported in comprehensive income (loss), net of related tax effects.

Business Segments — The Company’s reportable operating segments are U.S. Mortgage Insurance Operations, International Operations and Corporate and Other. U.S. Mortgage Insurance Operations includes the results of operations of MIC., PMI Mortgage Assurance Co. (“PMAC”), formerly Commercial Loan Insurance Co., PMI Insurance Co., affiliated U.S. insurance and reinsurance companies and the equity in earnings from CMG MI. International Operations includes the results from continuing operations of PMI Europe and PMI Canada, and the results from discontinued operations of PMI Australia and PMI Asia. Effective December 31, 2009 the Company combined its former “Corporate and Other” and “Financial Guaranty” segments into a “Corporate and Other” segment for all periods presented. The Corporate and Other segment includes other income and related operating expenses of PMI Mortgage Services Co., change in fair value of certain debt instruments, interest expense, intercompany eliminations and corporate expenses of the Company; equity in earnings (losses) from certain limited partnerships and its equity investment in FGIC Corporation and its former investment in RAM Re.

Earnings (Loss) Per Share — Basic earnings (loss) per share (“EPS”) excludes dilution and is based on consolidated net income (loss) available to common shareholders giving effect to discontinued operations and the actual weighted-average common shares that are outstanding during the period. Diluted EPS is based on consolidated net income (loss) available to common shareholders giving effect to discontinued operations, adjusted for the effects of dilutive securities, and the weighted-average dilutive common shares outstanding during the period. The weighted-average dilutive common shares reflect the potential increase of common shares if contracts to issue common shares, including stock options issued by the Company that have a dilutive impact, were exercised, or if outstanding securities were converted into common shares. As a result of the Company’s net losses for the three and six months ended June 30, 2010 and 2009, 8.9 million and 8.6 million share equivalents issued under the Company’s share-based compensation plans in the respective periods were excluded from the calculation of diluted earnings per share as their inclusion would have been anti-dilutive. In addition, additional shares are considered for dilutive EPS purposes related to the Convertible Notes. The method of determining which method to use for calculating dilutive EPS for the Convertible Notes depends on the facts and circumstances of the Company’s liquidity position. No share equivalents were excluded from the calculation of diluted earnings per share under the Treasury Stock method and 36.3 million shares were excluded under the If Converted method for the three and six months ended June 30, 2010 as their inclusion would have been anti-dilutive.

 

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The following table presents for the periods indicated a reconciliation of the weighted average common shares used to calculate basic EPS to the weighted-average common shares used to calculate diluted EPS from continuing and discontinued operations:

 

     Three Months Ended June 30,     Six Months Ended June 30,  
     2010     2009     2010     2009  
     (Dollars and shares in thousands)  

Net loss :

        

Loss from continuing operations as reported

   $ (150,560   $ (222,627   $ (307,547   $ (337,888

Income (loss) from discontinued operations

     —          7        —          (23
                                

Net loss adjusted for diluted EPS calculation

   $ (150,560   $ (222,620   $ (307,547   $ (337,911
                                

Weighted-average shares for basic EPS

     135,993        82,238        109,532        82,067   

Weighted-average stock options and other dilutive components

     —          —          —          —     
                                

Weighted-average shares for diluted EPS

     135,993        82,238        109,532        82,067   
                                

Basic EPS from continuing operations

   $ (1.11   $ (2.71   $ (2.81   $ (4.12

Basic EPS from discontinued operations

     —          —          —          —     
                                

Basic EPS

   $ (1.11   $ (2.71   $ (2.81   $ (4.12

Dilutive EPS from continuing operations

   $ (1.11   $ (2.71   $ (2.81   $ (4.12

Dilutive EPS from discontinued operations

     —          —          —          —     
                                

Dilutive EPS

   $ (1.11   $ (2.71   $ (2.81   $ (4.12
                                

Dividends declared and accrued to common shareholders

   $ —        $ —        $ —        $ —     

Share-Based Compensation — The Company applies FASB ASC Topic 718 Compensation-Stock Compensation (“Topic 718”), previously SFAS No. 123R, in accounting for share-based payments. This topic requires share based payments such as stock options, restricted stock units and employee stock purchase plan shares to be accounted for using a fair value-based method and recognized as compensation expense in the consolidated results of operations. Share-based compensation expense for the three and six months ended June 30, 2010 was $0.8 million (pre-tax) and $1.9 million (pre-tax), respectively, compared to $1.3 million (pre-tax) and $3.0 million (pre-tax) for the corresponding periods in 2009.

Fair Value of Financial Instruments – Effective January 1, 2008, the Company adopted FASB ASC Topic 820 Fair Value Measurements and Disclosures (“Topic 820”), previously SFAS No. 157. This topic describes three levels of inputs that may be used to measure fair value, of which “Level 3” inputs include fair value determinations using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation. Due to the lack of available market values for the Company’s credit default swap contracts, the Company’s methodology for determining the fair value of its credit default swap contracts is based on “Level 3” inputs. (See Note 3. New Accounting Standards and Note 8. Fair Value Disclosures, for further discussion.) Effective January 1, 2008, the Company adopted Topic 820 and the fair value option outlined in FASB ASC Topic 825 Financial Instruments (“Topic 825”), previously SFAS No. 159. Topic 820 provides a framework for measuring fair value under GAAP. The fair value option allows an entity the irrevocable option to elect fair value for the initial and subsequent measurement of certain financial assets and liabilities on a contract-by-contract basis. The Company elected to adopt the fair value option for certain corporate debt on the adoption date. The fair value option requires that the difference between the carrying value before election of the fair value option and the fair value of these instruments be recorded as an adjustment to beginning retained earnings in the period of adoption. For the three and six months ended June 30, 2010, the Company’s net loss included a $47.7 million and $88.5 million loss, respectively, related to the subsequent measurement of fair value for these debt instruments compared to a $39.1 million and $20.6 million loss for the corresponding periods in 2009. The Company elected the fair value option for its 10 year and 30 year senior debt instruments as their market values are the most readily available.

 

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The fair value option was elected with respect to the senior debt as changes in value are expected to generally offset changes in the value of credit default swap contracts that are also accounted for at fair value. In considering the initial adoption of the fair value option presented by ASC Topic 825, the Company determined that the change in fair value of the 8.309% Junior Subordinated Debentures would not have a significant impact on the Company’s consolidated financial results. Therefore, the Company did not elect to adopt the fair value option for the 8.309% Junior Subordinated Debentures. As the fair value option is not available for financial instruments that are, in whole or in part, classified as a component of shareholders equity, the Convertible Notes are not remeasured at fair value.

Reclassifications Certain items in the prior years’ consolidated financial statements have been reclassified to conform to the current years’ consolidated financial statement presentation.

NOTE 3. NEW ACCOUNTING STANDARDS

Recently Adopted Standards

In January 2010, the FASB issued Accounting Standards Update (“ASU”) No. 2010-06, Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements (“ASU No. 2010-06”) that requires additional disclosures about fair value measurements. ASU No. 2010-06 is effective for interim and annual reporting periods beginning after December 15, 2009 and has not significantly impacted the Company’s consolidated financial statements.

NOTE 4. INVESTMENTS

Fair Values and Gross Unrealized Gains and Losses on Investments — The cost or amortized cost, estimated fair value and gross unrealized gains and losses on investments as of June 30, 2010 and December 31, 2009 are shown in the tables below:

 

     Cost or
Amortized Cost
   Gross Unrealized     Fair
Value
        Gains    (Losses)    
          (Dollars in thousands)      

As of June 30, 2010

          

Fixed income securities:

          

Municipal bonds

   $ 1,553,546    $ 45,670    $ (7,353   $ 1,591,863

Foreign governments

     34,072      1,269      —          35,341

Corporate bonds

     265,007      10,277      (307     274,977

FDIC corporate bonds

     141,003      4,429      (239     145,193

U.S. governments and agencies

     75,700      3,259      —          78,959

Asset-backed securities

     54,097      274      (29     54,342

Mortgage-backed securities

     4,988      357      (901     4,444
                            

Total fixed income securities

     2,128,413      65,535      (8,829     2,185,119

Equity securities:

          

Common stocks

     31,269      53      (2,445     28,877

Preferred stocks

     144,513      22,647      (3,337     163,823
                            

Total equity securities

     175,782      22,700      (5,782     192,700

Short-term investments

     1,137      3      —          1,140
                            

Total investments

   $ 2,305,332    $ 88,238    $ (14,611   $ 2,378,959
                            

 

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     Cost or
Amortized Cost
   Gross Unrealized     Fair
Value
        Gains    (Losses)    
          (Dollars in thousands)      

As of December 31, 2009

          

Fixed income securities:

          

Municipal bonds

   $ 2,044,600    $ 36,744    $ (15,949   $ 2,065,395

Foreign governments

     47,023      145      (1,135     46,033

Corporate bonds

     87,832      1,933      (2,305     87,460

FDIC corporate bonds

     137,900      1,836      (328     139,408

U.S. governments and agencies

     10,616      524      —          11,140

Mortgage-backed securities

     5,486      266      —          5,752
                            

Total fixed income securities

     2,333,457      41,448      (19,717     2,355,188

Equity securities:

          

Common stocks

     29,684      —        (594     29,090

Preferred stocks

     163,324      26,021      (3,322     186,023
                            

Total equity securities

     193,008      26,021      (3,916     215,113

Short-term investments

     2,232      —        —          2,232
                            

Total investments

   $ 2,528,697    $ 67,469    $ (23,633   $ 2,572,533
                            

As of June 30, 2010, the Company’s investment portfolio included 67 securities in an unrealized loss position compared to 129 securities as of December 31, 2009. At June 30, 2010, the Company had gross unrealized losses of $14.6 million on investment securities, including fixed maturity and equity securities that had a fair value of $2.4 billion. The improvement in unrealized losses on the fixed income portfolio from December 31, 2009 to June 30, 2010 was partially due to the disposition of certain municipal bonds and the improvement in the municipal bond market during the first half of 2010. Unrealized losses in our corporate bond portfolio are primarily due to foreign currency re-measurement from our International Operations segment. As of June 30, 2010, the total fair value of the agency mortgage backed securities portfolio was $4.4 million, with $2.4 million invested in residential mortgage backed securities and the remaining $2.0 million invested in commercial mortgage backed securities. In addition, included in the June 30, 2010 and December 31, 2009 gross unrealized losses are $0.3 million and $0.4 million, respectively, of non-credit related other-than-temporary impairments in accordance with Topic 320 on debt securities.

At June 30, 2010, the total preferred stock portfolio had a fair value of $163.8 million, with $36.1 million invested in public utility companies and the remaining $127.7 million invested in the financial services sector. The gross unrealized losses in the preferred stock portfolio as of June 30, 2010 did not materially change from December 31, 2009.

 

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Aging of Unrealized Losses — The following table shows the gross unrealized losses and fair value of the Company’s investments, aggregated by investment category and the length of time the individual securities have been in a continuous unrealized loss position as of June 30, 2010 and December 31, 2009:

 

     Less than 12 months     12 months or more     Total  
      Fair Value    Unrealized
Losses
    Fair Value    Unrealized
Losses
    Fair Value    Unrealized
Losses
 
     (Dollars in thousands)  

June 30, 2010

               

Fixed income securities:

               

Municipal bonds

   $ 187,964    $ (3,584   $ 53,272    $ (3,769   $ 241,236    $ (7,353

Corporate bonds

     73,594      (477     2,205      (69     75,799      (546

Asset-backed securities

     12,214      (29     —        —          12,214      (29

Mortgage backed securities

     283      (901     —        —          283      (901
                                             

Total fixed income securities

     274,055      (4,991     55,477      (3,838     329,532      (8,829

Equity securities:

               

Common stocks

     27,317      (2,445     —        —          27,317      (2,445

Preferred stocks

     14,150      (468     47,340      (2,869     61,490      (3,337
                                             

Total equity securities

     41,467      (2,913     47,340      (2,869     88,807      (5,782
                                             

Total

   $ 315,522    $ (7,904   $ 102,817    $ (6,707   $ 418,339    $ (14,611
                                             
     Less than 12 months     12 months or more     Total  
     Fair Value    Unrealized
Losses
    Fair Value    Unrealized
Losses
    Fair Value    Unrealized
Losses
 
     (Dollars in thousands)  

December 31, 2009

               

Fixed income securities:

               

Municipal bonds

   $ 559,817    $ (11,494   $ 62,032    $ (4,455   $ 621,849    $ (15,949

Foreign governments

     7,270      (237     7,151      (898     14,421      (1,135

Corporate bonds

     41,041      (1,709     7,031      (924     48,072      (2,633
                                             

Total fixed income securities

     608,128      (13,440     76,214      (6,277     684,342      (19,717

Equity securities:

               

Common stocks

     28,955      (594     —        —          28,955      (594

Preferred stocks

     —        —          54,706      (3,322     54,706      (3,322
                                             

Total equity securities

     28,955      (594     54,706      (3,322     83,661      (3,916
                                             

Total

   $ 637,083    $ (14,034   $ 130,920    $ (9,599   $ 768,003    $ (23,633
                                             

Evaluating Investments for Other-than-Temporary-Impairment

The Company reviews all of its fixed income and equity security investments on a periodic basis for impairment. The Company specifically assesses all investments with declines in fair value and, in general, monitors all security investments as to ongoing risk.

The Company reviews on a quarterly basis, or as needed in the event of specific credit events, unrealized losses on all investments with declines in fair value. These investments are then tracked to establish whether they meet the Company’s established other than temporary impairment criteria. This process involves monitoring market events and other items that could impact issuers. The Company considers relevant facts and circumstances in evaluating whether the impairment of a security is other-than-temporary.

Relevant facts and circumstances considered include, but are not limited to:

 

   

a decline in the market value of a security below cost or amortized cost for a continuous period of at least six months;

 

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the severity and nature of the decline in market value below cost regardless of the duration of the decline;

 

   

recent credit downgrades of the applicable security or the issuer by the rating agencies;

 

   

the financial condition of the applicable issuer;

 

   

whether scheduled interest payments are past due; and

 

   

whether it is more likely than not the Company will hold the security for a sufficient period of time to allow for anticipated recoveries in fair value.

Once a security is determined to have met certain of the criteria for consideration as being other-than-temporarily impaired, further information is gathered and evaluated pertaining to the particular security. If the security is an unsecured obligation, the additional evaluation is a security specific approach with particular emphasis on the likelihood that the issuer will meet the contractual terms of the obligation.

The Company assesses equity securities using the criteria outlined above and also considers whether, in addition to these factors, it has the ability and intent to hold the equity securities for a period of time sufficient for recovery to cost or amortized cost. Where the Company lacks that ability or intent, the equity security’s decline in fair value is deemed to be other than temporary, and the Company records the full difference between fair value and cost or amortized cost in earnings.

Once the determination is made that a debt security is other-than-temporarily impaired, an estimate is developed of the portion of such impairment that is credit-related. The estimate of the credit-related portion of impairment is based upon a comparison of ratings at the time of purchase and the current ratings of the security, to establish whether there have been any specific credit events during the time the Company has owned the security, as well as the outlook through the expected maturity horizon for the security. The Company obtains ratings from two nationally recognized rating agencies for each security being assessed. The Company also incorporates information on the specific securities from its management and, as appropriate, from its external investment advisors on their views on the probability of it receiving the interest and principal cash-flows for the remaining life of the securities.

This information is used to determine the Company's best estimate of what the credit related portion of the impairment is, based on a probability-weighted estimate of future cash flows. The probability weighted cash flows for the individual securities are modeled using internal models, which calculate the discounted cash flows at the implicit rate at purchase through maturity. If the cash flow projections indicate that the Company does not expect to recover its amortized cost basis, the Company recognizes the estimated credit loss in earnings. For debt securities that are intended to be sold, or that management believes are more likely than not to be required to be sold prior to recovery, the full impairment is recognized immediately in earnings. For debt securities that management has no intention to sell and believes it is more likely than not that they will not be required to be sold prior to recovery, only the credit component of the impairment is recognized in earnings, with the remaining impairment loss recognized in AOCI.

The total impairment for any debt security that is deemed to have an other-than-temporary impairment is recorded in the statement of operations as a net realized loss from investments. The portion of such impairment that is determined to be non-credit-related is deducted from net realized losses in the statement of operations and reflected in other comprehensive income (loss) and accumulated other comprehensive income (loss), the latter of which is a component of stockholders’ equity in the balance sheets.

 

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Other-than-temporary Impairment — During the three and six months ended June 30, 2010, the Company did not record other-than-temporary losses. The other-than-temporary losses recorded for the three months ended June 30, 2009 are as follows:

 

     Three Months Ended
June 30, 2009
     (Dollars in thousands)

Total other-than-temporary impairment losses on debt securities which the Company does not intend to sell or it is more-likely-than-not that it will not be required to sell

   $ —  

Less: portion of OTTI losses recognized in AOCI (before taxes)

     —  
      

Net impairment losses recognized in net (loss) income for securities that the Company does not intend to sell or it is more likely-than-not that it will not be required to sell

     —  

OTTI losses recognized in net (loss) income for debt securities that the Company intends to sell or more-likely-than-not will be required to sell before recovery

     281

Impairment losses related to equity securities

     540
      

Net impairment losses recognized in statement of operations

   $ 821
      

Activity related to the credit component recognized in net (loss) income on debt securities held by the Company for which a portion of other-than-temporary impairment was recognized in AOCI for the six months ended June 30, 2010 and 2009, respectively, is as follows:

 

     Cumulative Other-Than-Temporary Impairment Credit Losses
Recognized in Net (Loss) Income for Debt Securities
     January 1, 2010
Cumulative OTTI
credit losses
recognized for
securities still held
   Reductions
due to sales
of credit
impaired
securities
    Adjustments to
book value

of credit impaired
securities due

to changes in
cash flows
   June 30,  2010
Cumulative

OTTI credit
losses recognized
for securities still held
     (Dollars in thousands)

OTTI credit losses recognized for debt securities

          

Municipal Bonds

   $ 1,717    $ —        $ —      $ 1,717

Corporate Bonds

     789      (188     —        601
                            

Total OTTI credit losses recognized for debt securities

   $ 2,506    $ (188   $ —      $ 2,318
                            

 

     Cumulative Other-Than-Temporary Impairment Credit  Losses
Recognized in Net (Loss) Income for Debt Securities
     April 1, 2009
Cumulative OTTI
credit losses
recognized for
securities still held
   Reductions
due to sales
of credit
impaired
securities
   Adjustments to
book value

of credit impaired
securities due

to changes in
cash flows
   June 30,  2009
Cumulative

OTTI credit
losses recognized
for securities still held
     (Dollars in thousands)

OTTI credit losses recognized for debt securities

           

Municipal Bonds

   $ 1,575    $ —      $ —      $ 1,575

Corporate Bonds

     632      —        —        632
                           

Total OTTI credit losses recognized for debt securities

   $ 2,207    $ —      $ —      $ 2,207
                           

 

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Scheduled Maturities — The following table sets forth the amortized cost and fair value of fixed income securities by contractual maturity at June 30, 2010:

 

     Amortized Cost    Fair Value
     (Dollars in thousands)

Due in one year or less

   $ 3,409    $ 3,648

Due after one year through five years

     510,278      523,783

Due after five years through ten years

     578,805      601,247

Due after ten years

     1,030,933      1,051,997

Mortgage-backed securities

     4,988      4,444
             

Total fixed income securities

   $ 2,128,413    $ 2,185,119
             

Actual maturities may differ from those scheduled as a result of calls or prepayments by the issuers prior to maturity.

Net Investment Income — Net investment income consists of the following:

 

     Three Months Ended June 30,     Six Months Ended June 30,  
     2010     2009     2010     2009  
     (Dollars in thousands)  

Fixed income securities

   $ 20,068      $ 24,987      $ 43,687      $ 49,219   

Equity securities

     2,768        4,302        5,869        8,796   

Short-term investments, cash and cash equivalents and other

     1,766        157        2,583        6,616   
                                

Investment income before expenses

     24,602        29,446        52,139        64,631   

Investment expenses

     (741     (330     (1,590     (910
                                

Net investment income

   $ 23,861      $ 29,116      $ 50,549      $ 63,721   
                                

 

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Net Realized Investment Gains (Losses) — Net realized investment gains (losses) consist of the following:

 

     Three Months Ended June 30,     Six Months Ended June 30,  
     2010     2009     2010     2009  
     (Dollars in thousands)  

Fixed income securities:

        

Gross gains

   $ 3,146      $ 20,990      $ 9,041      $ 21,818   

Gross losses

     (3,706     (758     (5,188     (3,165
                                

Net (losses) gains

     (560     20,232        3,853        18,653   

Equity securities:

        

Gross gains

     281        4,034        3,773        4,034   

Gross losses

     —          (769     (148     (5,067
                                

Net gains (losses)

     281        3,265        3,625        (1,033

Short-term investments:

        

Net gains (losses)

     676        (105     352        (279
                                

Net realized investment gains before income taxes

     397        23,392        7,830        17,341   

Income tax expense

     139        8,187        2,740        6,069   
                                

Total net realized investment gains after income taxes

   $ 258      $ 15,205      $ 5,090      $ 11,272   
                                

Net realized investment gains for the first half of 2010 resulted primarily from sales of municipal bonds and preferred equity securities. Net realized investment gains for the first half of 2009 includes a $0.5 million loss related to the Company’s other-than-temporary impairment of certain preferred securities in its U.S. investment portfolio and a $0.3 million loss related to fixed income securities in its International investment portfolio. As a result of the adoption of Topic 320 on April 1, 2009, the Company recognized a cumulative effect adjustment to retained earnings in the amount of $2.5 million; $1.1 million of which related to impairments recognized in the first quarter of 2009 and $1.4 million of the losses were recorded in previous years.

Investment Concentrations and Other Items — The Company maintains an investment portfolio principally of U.S. municipal bonds. The following states and the District of Columbia represent the largest concentrations in the U.S. municipal bond portfolio, expressed as a percentage of the fair value of all U.S. municipal bond holdings. Holdings in states and the District of Columbia that exceed 5% of the U.S. municipal bond portfolio at the respective dates are presented below:

 

     June 30,
2010
    December 31,
2009
 

Florida

   14.8   13.9

Illinois

   10.9   11.5

New York

   10.7   13.3

California

   9.2   11.3

Texas

   8.2   9.7

At June 30, 2010, fixed income securities and short-term investments with an aggregate fair value of $10.3 million were on deposit with regulatory authorities as required by law.

NOTE 5. INVESTMENTS IN UNCONSOLIDATED SUBSIDIARIES

Investments in the Company’s unconsolidated subsidiaries include both equity investees and other unconsolidated subsidiaries. The carrying values of the Company’s investments in unconsolidated subsidiaries consisted of the following as of June 30, 2010 and December 31, 2009:

 

     June 30,
2010
   Ownership
Percentage
    December 31,
2009
   Ownership
Percentage
 
     (Dollars in thousands)  

FGIC

   $ —      42.0   $ —      42.0

CMG MI

     117,858    50.0     124,826    50.0

Other*

     14,812    various        14,949    various   
                  

Total

   $ 132,670      $ 139,775   
                  

 

* Other represents principally various limited partnership investments.

 

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Equity in losses from unconsolidated subsidiaries is shown for the periods presented:

 

     Three Months Ended June 30,     Six Months Ended June 30,  
     2010     Ownership
Percentage
    2009     Ownership
Percentage
    2010     Ownership
Percentage
    2009     Ownership
Percentage
 
     (Dollars in thousands)     (Dollars in thousands)  

FGIC

   $ —        42.0   $ —        42.0   $ —        42.0   $ —        42.0

CMG MI

     (3,856   50.0     (1,221   50.0     (8,145   50.0     (3,515   50.0

RAM Re

     —        0.0     —        23.7     —        0.0     —        23.7

Other

     (61   various        (171   various        (182   various        (323   various   
                                        

Total

   $ (3,917     $ (1,392     $ (8,327     $ (3,838  
                                        

Due to the impairment of its FGIC investment in the first quarter of 2008, the Company did not recognize any equity in earnings (losses) from FGIC in 2009 or 2010. Additionally, due to the impairment of RAM Re during 2008 and the sale of RAM Re during the fourth quarter of 2009, the Company did not recognize equity in earnings (losses) from RAM Re in 2009.

 

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CMG MI’s condensed balance sheets as of June 30, 2010 and December 31, 2009, and condensed statements of operations for the three and six months ended June 30, 2010 and 2009 are as follows:

 

     June 30,
2010
   December 31,
2009
     (Dollars in thousands)

Condensed Balance Sheets

     

Assets:

     

Cash and investments, at fair value

   $ 403,172      399,989

Deferred policy acquisition costs

     12,877      13,801

Other assets

     29,652      22,098
             

Total assets

   $ 445,701    $ 435,888
             

Liabilities:

     

Reserve for losses and loss adjustment expenses

   $ 190,062    $ 169,807

Unearned premiums

     14,891      17,408

Other liabilities

     11,738      5,728
             

Total liabilities

     216,691      192,943

Shareholders’ equity

     229,010      242,945
             

Total liabilities and shareholders’ equity

   $ 445,701    $ 435,888
             

 

     Three Months Ended June 30,     Six Months Ended June 30,  
     2010     2009     2010     2009  
     (Dollars in thousands)  

Condensed Statements of Operations

      

Gross revenues

   $ 26,568      $ 32,049      $ 53,526      $ 61,090   

Total expenses

     39,930        36,436        80,584        73,788   
                                

Loss before income taxes

     (13,362     (4,387     (27,058     (12,698

Income tax benefit

     (5,650     (1,945     (10,769     (5,668
                                

Net loss

     (7,712     (2,442     (16,289     (7,030
                                

PMI's ownership interest in common equity

     50.0     50.0     50.0     50.0
                                

Total equity in losses from CMG MI

   $ (3,856   $ (1,221   $ (8,145   $ (3,515
                                

 

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NOTE 6. DEFERRED POLICY ACQUISITION COSTS

The following table summarizes deferred policy acquisition cost activity as of and for the periods set forth below:

 

     Three Months Ended June 30,     Six Months Ended June 30,  
     2010     2009     2010     2009  
     (Dollars in thousands)  

Beginning balance

   $ 42,642      $ 39,061      $ 41,289      $ 34,791   

Policy acquisition costs incurred and deferred

     6,040        5,410        11,269        13,025   

Amortization of deferred policy acquisition costs

     (4,163     (3,753     (8,039     (7,098
                                

Balance at June 30,

   $ 44,519      $ 40,718      $ 44,519      $ 40,718   
                                

Deferred policy acquisition costs are affected by qualifying costs that are deferred in the period and amortization of previously deferred costs in such periods. Deferred policy acquisition costs are reviewed periodically to determine whether they exceed recoverable amounts, after considering investment income.

NOTE 7. RESERVE FOR LOSSES AND LOSS ADJUSTMENT EXPENSES (LAE)

The Company establishes reserves for losses and LAE to recognize the estimated liability for potential losses and LAE related to insured mortgages that are in default. The establishment of loss reserves is subject to inherent uncertainty and requires significant judgment by management. The following table provides a reconciliation of the beginning and ending consolidated reserves for losses and LAE between January 1 and June 30:

 

     2010     2009  
     (Dollars in thousands)  

Balance at January 1,

   $ 3,253,820      $ 2,709,286   

Less: reinsurance recoverables

     (703,550     (482,678
                

Net balance at January 1,

     2,550,270        2,226,608   

Losses and LAE incurred, principally with respect to defaults occurring in:

    

Current year

     504,456        748,650   

Prior years (1)

     166,858        115,138   
                

Total incurred

     671,314        863,788   

Losses and LAE payments, principally with respect to defaults occurring in:

    

Current year

     (2,251     (6,972

Prior years

     (714,630     (448,234
                

Total payments

     (716,881     (455,206
                

Foreign currency translation effects

     (5,407     (2,136

Net ending balance at June 30,

     2,499,296        2,633,054   

Reinsurance recoverables

     613,646        602,318   
                

Balance at June 30,

   $ 3,112,942      $ 3,235,372   
                

 

(1)

The $166.9 million and $115.1 million increases in prior years’ reserves in the first six months of 2010 and 2009, respectively, were due to re-estimations of ultimate loss rates from those established at the original notices of defaults, updated through the periods presented. The $166.9 million increase in prior years’ reserves during the first half of 2010 reflected a decline in rescission activity beyond our expectations which caused us to reduce our estimate of future rescissions, thereby increasing loss reserves. To a lesser extent, the increase in prior years’ reserves was due to reduced expectations in the second quarter of 2010 with respect to the levels of future loan modifications and adverse claim rate development in the modified pool and primary insurance portfolios. During the first six months of 2010,

 

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the Company restructured certain modified pool policies resulting in acceleration of $220.5 million in claim payments which is inclusive of retained contractual cash flows. As part of the restructurings, the Company retained a contractual right to future cash flow streams, with an estimated fair value of $82.3 million as of the restructure dates. The recognition of these assets decreased the losses and LAE incurred related to prior years. The $115.1 million increase in prior years’ reserves during the first half of 2009 reflected the significant weakening of the housing and mortgage markets and was driven by lower cure rates, higher claim rates and higher claim sizes in our primary and modified pool insurance portfolios.

The decrease in total consolidated loss reserves at June 30, 2010 compared to June 30, 2009 was primarily due to decreases in the reserve balances for U.S. Mortgage Insurance Operations primarily due to payment of claims on the Company’s primary and pool insurance portfolios. The payment of claims on the modified pool portfolio reflects the acceleration of claim payments related to the restructuring of certain modified pool policies in the first half of 2010. Upon receipt of default notices, future claim payments are estimated relating to those loans in default and a reserve is recorded. Generally, it takes approximately 12 to 36 months from the receipt of a default notice to result in a primary claim payment. Accordingly, almost all losses paid relate to default notices received in prior years.

NOTE 8. FAIR VALUE DISCLOSURES

The following tables present the difference between fair values as of June 30, 2010 and December 31, 2009 and the aggregate contractual principal amounts of the long-term debt for which the fair value option has been elected. Had the Company not adopted the fair value option, the Company’s diluted loss per share for the three and six months ended June 30, 2010 would have been $0.88 per share and $2.28 per share, respectively, compared to $1.11 per share and $2.81 per share as reported in 2010.

 

     Fair Value (including
accrued interest)
as of

June 30, 2010
   Principal amount and
accrued interest
   Difference
     (Dollars in thousands)

Long-term debt

        

6.000% Senior Notes

   $ 200,625    $ 254,375    $ 53,750

6.625% Senior Notes

   $ 101,523    $ 152,898    $ 51,375
     Fair Value (including
accrued interest)

as of
December 31, 2009
   Principal amount and
accrued interest
   Difference
     (Dollars in thousands)

Long-term debt

        

6.000% Senior Notes

   $ 149,063    $ 254,375    $ 105,312

6.625% Senior Notes

   $ 64,585    $ 152,898    $ 88,313

Topic 820 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (referred to as an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Topic 820 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value.

Level 1 Observable inputs with quoted prices in active markets for identical assets or liabilities. Level 1 assets and liabilities include debt and equity securities and derivative contracts that are traded in an active exchange market, as well as certain U.S. Treasury securities that are highly liquid and are actively traded in over-the-counter markets.

 

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Level 2 Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Level 2 assets and liabilities include debt securities with quoted prices that are traded less frequently than exchange-traded instruments and derivative contracts whose value is determined using a pricing model with inputs that are observable in the market or can be derived principally from or corroborated by observable market data.

Level 3 Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation.

When determining the fair value of its debt, the Company has considered the guidance presented in Topic 820 related to determining fair value when the volume and level of activity for the asset or liability have significantly decreased and identifying transactions that are not orderly.

Assets and liabilities measured at fair value on a recurring basis, including financial instruments for which the Company has elected the fair value option, are summarized below:

 

     June 30, 2010    Assets/Liabilities at Fair
Value
     Fair Value Measurements Using   
     Level 1    Level 2    Level 3   
     (Dollars in thousands)

Assets

           

Fixed income securities

   $ —      $ 2,183,058    $ 2,061    $ 2,185,119

Equity securities

     28,405      160,136      4,159      192,700

Short-term investments

     1,040      100      —        1,140

Cash and cash equivalents

     1,021,841      —        —        1,021,841
                           

Total assets

   $ 1,051,286    $ 2,343,294    $ 6,220    $ 3,400,800
                           

Liabilities

           

Credit default swaps

   $ —      $ —      $ 13,072    $ 13,072

6.000% Senior Notes

     —        200,625      —        200,625

6.625% Senior Notes

     —        101,523      —        101,523
                           

Total liabilities

   $ —      $ 302,148    $ 13,072    $ 315,220
                           

 

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Table of Contents
     December 31, 2009    Assets/Liabilities  at
Fair Value
     Fair Value Measurements Using   
     Level 1    Level 2    Level 3   
     (Dollars in thousands)

Assets

           

Fixed income securities

   $ —      $ 2,352,041    $ 3,147    $ 2,355,188

Equity securities

     28,955      182,188      3,970      215,113

Short-term investments

     2,232      —        —        2,232

Cash and cash equivalents

     686,891      —        —        686,891
                           

Total assets

   $ 718,078    $ 2,534,229    $ 7,117    $ 3,259,424
                           

Liabilities

           

Credit default swaps

   $ —      $ —      $ 17,331    $ 17,331

6.000% Senior Notes

     —        149,063      —        149,063

6.625% Senior Notes

     —        64,585      —        64,585
                           

Total liabilities

   $ —      $ 213,648    $ 17,331    $ 230,979
                           

PMI Europe’s risk in force related to its credit default swap (“CDS”) contracts was $1.1 billion as of June 30, 2010 and $4.0 billion as of December 31, 2009. Certain PMI Europe CDS contracts contain collateral support provisions which, upon certain circumstances, such as deterioration of underlying mortgage loan performance, require PMI Europe to post collateral for the benefit of the counterparty. The methodology for determining the amount of the required posted collateral varies and can include mark-to-market valuations, contractual formulae (principally related to expected loss performance) and/or negotiated amounts. The aggregate fair value of all derivative instruments with collateral support provisions that are in a liability position as of June 30, 2010 is $10.9 million, for which the Company has posted collateral of $10.9 million in the normal course of business. The Company estimates that the current collateral requirement of $10.9 million as of June 30, 2010 will decline in the remaining half of 2010. The actual level of collateral posted in 2010 will be dependent upon deal performance, claim payments, and the extent to which PMI Europe is successful in commuting certain contracts. To the extent PMI Europe is successful in commuting certain contracts the amount of collateral postings could be significantly reduced. The fair value of derivative liabilities was $13.1 million and $17.3 million as of June 30, 2010 and December 31, 2009, respectively, and is included in other liabilities on the balance sheet.

Fair Value of Credit Default Swap Contracts

PMI Europe’s CDS contracts are valued using internal proprietary models because these instruments are unique, complex, and private and are often customized transactions, for which observable market quotes are not regularly available. Due to the lack of observable inputs required to value CDS contracts, they are considered to be Level 3 under the Topic 820 fair value hierarchy. Valuation models and the related assumptions are continuously re-evaluated by management and refined, as appropriate.

Key inputs used in the Company’s valuation of CDS contracts include the transaction notional amount, expected term, premium rates on risk layers, changes in market spreads and cost of capital, estimated loss rates and loss timing, and risk free interest rates. As none of the instruments that the Company is holding are traded, the Company develops internal exit price estimates. Its internal exit price estimates are based on a number of factors, including its own expectations of loss payments and timing, as well as indications of current CDS spreads obtained through market surveys with investment banks, counterparty banks, and other relevant market sources in Europe. The Company validates market surveys obtained from these third-party sources by comparing them against each other for consistency. The assumed market CDS spread is a significant assumption that, if changed, could result in materially different fair values. Accordingly, market perceptions of credit deterioration are likely to result in the increase in the expected exit value (the amount required to be paid to exit the transaction).

 

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The values of the Company’s CDS contracts are affected by estimated changes in credit spreads of the underlying obligations and/or the cost of the Company’s capital. As credit spreads change, the values of these CDS contracts will change and the resulting gains and losses will be recorded in the Company’s operating results. In addition, the Company incorporates its non-performance risk into the market value of its derivative assets and liabilities. The fair value of these CDS liabilities was $13.1 million as of June 30, 2010. Excluding the Company’s non-performance risk, the fair value of these CDS liabilities would have been $13.7 million as of June 30, 2010.

In estimating the fair values of CDS contracts, PMI Europe incorporates expected life of contract dates in its internal valuation models. The Company estimates the life of contracts to coincide with expected call dates based on a number of factors, including past experience of counterparties, the underlying economics of the transactions, counterparties’ expressed intent and potential costs associated with extending transactions. The current state of capital markets, the financial conditions and perspectives of various counterparties and the general weakening of economic conditions in Europe may lead to decisions by customers to extend the credit protection offered by PMI Europe’s CDS contracts, which could be counteracted by PMI Europe’s counterparties’ assessments of its creditworthiness. If a CDS contract is extended beyond its expected call date, PMI Europe will be required to adjust its internal valuation model assumptions. To the extent that credit spreads are higher than at the time of inception of the transaction, extending the expected life from the call date to the maturity date could result in PMI Europe recognizing further significant mark-to-market losses. If counterparties elect to extend PMI Europe’s CDS contracts and spreads remain at their current levels, mark-to-market losses could be material and there will be a greater likelihood of incurring higher than currently expected realized losses in the form of paid claims on the contracts. To date, all of PMI Europe’s CDS contracts have either been called at the Company’s expected call date or have deviated from the Company’s expected call date in lengths of time that are not significant.

The fair value of investment grade contracts is determined by calculating the difference between the present value of expected future premiums from the contract and the estimated cost of hedging the transaction to the expected life of contract date. The estimated cost of hedging the transaction is established by reference to market spreads on residential mortgage backed securities in the countries in which the underlying reference portfolio is located. Spreads are obtained from banking groups and analysts. The expected life of contract date is determined by using the earlier of the next contractual call date or an estimated regulatory call date based upon discussions with the counterparty.

Similar third party information is not available for non-investment grade contracts, and, accordingly, for those contracts, fair value is estimated using the present value of expected future contractual payments and incorporating a market-based estimated cost of capital that would be required by a third party with similar credit standing as PMI to assume an identical contract. Expected future contractual payments are determined through the analysis of recent performance of the relevant transaction and similar transactions. Cash flows are discounted using a risk-free rate. The market-based cost of capital is based on an estimate of PMI’s cost of capital as of the period in which the value is being determined.

 

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The table below presents a reconciliation for all assets and liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the six months ended June 30, 2010 and 2009.

 

     Total Fair Value Measurements  
     Six Months Ended June 30, 2010  
     (Dollars in thousands)  
      Fixed Income
Securities
    Equity
Securities
    Credit Default
Swaps (Liabilities)
 

Level 3 Instruments Only

      

Balance, January 1, 2010

     3,148        3,970        (17,331

Total gains or (losses)

      

Included in earnings (1)

     —          (61     2,180   

Included in other comprehensive income (2)

     (1,087     —          2,404   

Purchase, sales, issuance and settlements (3)

     —          250        (325
                        

Balance, June 30, 2010

   $ 2,061      $ 4,159      $ (13,072
                        
        
     Six Months Ended June 30, 2009  
     (Dollars in thousands)  

Balance, January 1, 2009

     3,441        4,464        (54,542

Total gains or (losses)

      

Included in earnings (1)

     (237     —          14,759   

Included in other comprehensive income (2)

     —          —          481   

Purchase, sales, issuance and settlements (3)

     —          —          (950
                        

Balance, June 30, 2009

   $ 3,204      $ 4,464      $ (40,252
                        

 

(1) The losses on fixed income securities of $0.0 million and $0.2 million for the six months ended June 30, 2010 and 2009, respectively, are included in net investment income in the Company’s consolidated statement of operations. The gain on equity securities of $0.2 million for the six months ended June 30, 2010 is also included in net investment income in the Company’s consolidated statement of operations. The gains on credit default swaps of $2.2 million and $14.8 million for the six months ended June 30, 2010 and 2009, respectively, are included in other income in the Company’s consolidated statement of operations.
(2) The loss on fixed income securities of $0.9 million for the six months ended June 30, 2010 is a result of the adjustment of certain corporate bonds to market price and is included in other comprehensive income. The gain on credit default swaps of $2.4 million and $0.5 million for the six months ended June 30, 2010 and 2009, respectively, is a result of the translation from the Euro to the U.S. dollar and is included in other comprehensive income.
(3) The purchase, sales, issuance and settlements of $0.3 million and $1.0 million for the six months ended June 30, 2010 and 2009, respectively represent net cash received on credit default swaps.

NOTE 9. COMMITMENTS AND CONTINGENCIES

Income Taxes — As of June 30, 2010, no tax issues from the most recently closed or pending IRS audit would, in the opinion of management, give rise to a material assessment or have a material effect on the consolidated financial condition, results of operations or cash flows of the Company.

Guarantees — The PMI Group has guaranteed certain payments to the holders of the privately issued debt securities (“Capital Securities”) issued by PMI Capital I, an unconsolidated subsidiary of the Company. Payments with respect to any accrued and unpaid distributions payable, the redemption amount of any Capital Securities that are called and amounts due upon an involuntary or voluntary termination, winding up or liquidation of the Issuer Trust are subject to the guarantee. In addition, the guarantee is irrevocable, is an unsecured obligation of the Company and is subordinate and junior in right of payment to all senior debt of the Company.

 

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Funding Obligations — The Company has invested in certain limited partnerships with ownership interests greater than 3% but less than 50%. As of June 30, 2010, the Company had committed to fund, if called upon to do so, $2.7 million of additional equity in certain limited partnership investments. The Company is under no obligation to provide additional capital with respect to its investment in FGIC, an unconsolidated equity investee.

Legal Proceedings — Various legal actions and regulatory reviews are currently pending that involve the Company and specific aspects of its conduct of business. Although there can be no assurance as to the ultimate disposition of these matters, in the opinion of management, based upon the information available as of the date of these financial statements, the expected ultimate liability in one or more of these actions is not expected to have a material effect on the consolidated financial condition, results of operations or cash flows of the Company.

NOTE 10. RESTRICTED INVESTMENTS, CASH AND CASH EQUIVALENTS

Effective June 2008, PMI Guaranty, FGIC and Assured Guaranty Re Ltd ("AG Re") executed an agreement pursuant to which all of the direct FGIC business reinsured by PMI Guaranty was recaptured by FGIC and ceded by FGIC to AG Re. Pursuant to the Agreement, with respect to two of the exposures ceded to AG Re, PMI Guaranty agreed to reimburse AG Re for any losses it pays, subject to an aggregate limit of $22.9 million. PMI Guaranty has secured its obligation by depositing $22.9 million into a trust account for the benefit of AG Re and, to the extent AG Re’s obligations are less than $22.9 million, the remaining funds will be returned to the Company. As of June 30, 2010, the $20.8 million remaining deposit is included in cash and cash equivalents with a corresponding liability in losses and LAE reserves on the Company’s consolidated balance sheet.

Certain of PMI Europe’s CDS and reinsurance transactions contain collateral support provisions which, upon certain circumstances, require PMI Europe to post collateral for the benefit of the counterparty. As of June 30, 2010, PMI Europe posted collateral of $10.9 million on credit default swap transactions accounted for as derivatives and $17.8 million related to insurance and certain U.S. sub-prime related reinsurance transactions. The collateral of $28.7 million is included in investments and cash and cash equivalents on the Company’s consolidated balance sheet at June 30, 2010.

 

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NOTE 11. COMPREHENSIVE LOSS

The following table shows the components of comprehensive loss for the three and six months ended June 30, 2010 and 2009:

 

     Three Months Ended June 30,     Six Months Ended June 30,  
     2010     2009     2010     2009  
     (Dollars in thousands)  

Net Loss

   $ (150,560   $ (222,620   $ (307,547   $ (337,911

Unrealized gains (losses) on investments

        

Total change in unrealized gains (losses) arising during the year, net of tax benefit

     14,767        46,403        28,613        45,799   

Less: realized investment (losses) gains, net of tax (benefit) expense

     (181     15,273        4,861        11,453   
                                

Change in unrealized gains arising during the period, net of tax expense of $5,270, $16,523, $7,844 ,and $17,115, respectively

     14,948        31,130        23,752        34,346   

Defined benefit pension plans, net of tax expense of $0

     —          —          —          —     

Accretion of cash flow hedges, net of tax expense of $54, $54, $107 and $107, respectively

     100        100        199        199   

Foreign currency translation adjustments

        

Total change in unrealized (losses) gains on foreign currency translation, net of tax expense (benefit) of $3,958, $(2,519), $7,485, and $(2,519), respectively

     (7,512     4,679        (10,079     (600
                                

Other comprehensive income

     7,536        35,909        13,872        33,945   
                                

Comprehensive loss

   $ (143,024   $ (186,711   $ (293,675   $ (303,966
                                

The changes in unrealized gains in the second quarter and first half of 2010 were primarily due to improved valuation of the municipal, government and corporate bond portfolios partially offset by deterioration in the valuation of the preferred and common stock securities. The changes in unrealized gains/losses in the second quarter and first half of 2009 were primarily due to contracting market spreads in the U.S. fixed income portfolio and in the preferred securities portfolio as a result of an improvement in the equity securities’ markets as well as other market driven factors. The declines in foreign currency translation adjustments in the second quarter and first half of 2010 were due primarily to weakening of the Euro relative to the U.S. dollar. The increase in foreign currency translation adjustments in the second quarter of 2009 was due primarily to the strengthening of the Euro relative to the U.S. dollar.

 

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The following table shows the accumulated balances for each component of accumulated other comprehensive income (loss) net of tax for the six months ended June 30, 2010 and 2009:

 

     Unrealized gains
(losses) on investments
    Defined benefit
plans
    Accretion of cash
flow hedges
    Foreign currency
translation gains
    Total  
     (Dollars in thousands)  

Balance, December 31, 2008

     (65,115     (13,871     (4,952     48,259        (35,679

Current period change

     34,346        —          199        (600     33,945   
                                        

Balance, June 30, 2009

   $ (30,769   $ (13,871   $ (4,753   $ 47,659      $ (1,734
                                        

Balance, December 31, 2009

     28,444        (8,557     (4,554     50,075        65,408   

Current period change

     23,752        —          199        (10,079     13,872   
                                        

Balance, June 30, 2010

   $ 52,196      $ (8,557   $ (4,355   $ 39,996      $ 79,280   
                                        

NOTE 12. BENEFIT PLANS

The following table provides the components of net periodic benefit cost for the pension and other post-retirement benefit plans for the three and six months ended June 30, 2010 and 2009:

 

     Three Months Ended June 30,     Six Months Ended June 30,  
     2010     2009     2010     2009  
     (Dollars in thousands)  

Pension benefits

        

Service cost

   $ 1,485      $ 1,076      $ 2,985      $ 2,077   

Interest cost

     1,141        895        2,295        1,730   

Expected return on plan assets

     (894     (517     (1,798     (999

Amortization of prior service cost

     (293     (227     (588     (439

Recognized net actuarial loss

     336        523        676        1,011   

SERP settlement

     —          797        —          770   
                                

Net periodic benefit cost

   $ 1,775      $ 2,547      $ 3,570      $ 4,150   
                                
     Three Months Ended June 30,     Six Months Ended June 30,  
     2010     2009     2010     2009  
     (Dollars in thousands)  

Other post-retirement benefits

        

Service cost

   $ 107      $ 100      $ 214      $ 201   

Interest cost

     261        234        522        468   

Amortization of prior service cost

     (155     (143     (309     (287

Recognized net actuarial loss

     117        134        233        268   
                                

Net periodic post-retirement benefit cost

   $ 330      $ 325      $ 660      $ 650   
                                

In 2009, the Company contributed $15.7 million to its pension plans. The Company contributed $6.2 million to the Retirement Plan in 2010 and does not intend to make further contributions in 2010.

 

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NOTE 13. INCOME TAXES

The components of the deferred income tax assets and liabilities as of June 30, 2010 and December 31, 2009 are as follows:

 

     June 30,
2010
    December 31,
2009
 
     (Dollars in thousands)  

Deferred tax assets:

    

AMT and other credits

   $ 193,122      $ 192,819   

Discount on loss reserves

     34,932        35,558   

Unearned premium reserves

     3,768        4,128   

Basis difference on investments in unconsolidated subsidiaries

     215,944        215,944   

Pension costs and deferred compensation

     19,873        17,964   

Contingency reserve deduction, net of tax and loss bonds

     —          40,478   

Net operating losses

     170,241        19,151   

Basis difference in foreign subsidiaries

     28,272        25,375   

Other assets

     14,166        16,494   
                

Total deferred tax assets

     680,318        567,911   
                

Deferred tax liabilities:

    

Deferred policy acquisition costs

     15,581        14,451   

Unrealized net gains on investments

     14,668        11,118   

Unrealized net gains on debt

     46,087        77,097   

Software development costs

     6,002        8,499   

Equity in earnings from unconsolidated subsidiaries

     24,555        27,406   

Convertible Note discount

     35,151        —     

Other liabilities

     2,551        2,440   
                

Total deferred tax liabilities

     144,595        141,011   
                

Net deferred tax asset

     535,723        426,900   

Valuation allowance

     (252,955     (248,277
                

Net deferred tax asset

   $ 282,768      $ 178,623   
                

The Company evaluates the need for a valuation allowance quarterly taking into consideration the ability to carryback and carryforward tax credits and losses, available tax planning strategies and future income, including the reversal of temporary differences. In addition, the Company had benefits from the use of tax and loss bonds which have allowed the Company to deduct statutory contingency reserves on its federal tax return. Once redeemed, the tax and loss bonds result in taxable income which have offset the Company’s operating losses. As of June 30, 2010, the Company evaluated whether it was “more likely than not” that the deferred tax assets would be utilized in the future and determined that a valuation allowance of $253.0 million was required. The increase of $4.7 million from December 31, 2009 was due primarily to increased state net operating losses and certain foreign exchange losses that are not expected to provide future benefits to the Company. Any future changes in management’s assessment of the need for a valuation allowance will be recognized as a change in estimate in future periods.

The Company’s effective tax rates from continuing operations were 37.2% and 36.7% for the three and six months ended June 30, 2010, respectively, compared to the federal statutory rate of 35.0%. As the Company reported net losses for the three and six months ended June 30, 2010 and 2009, municipal bond investment income and income from certain international operations, which have lower effective tax rates, increased the Company’s effective tax rate in comparison to the federal statutory rate. PMI has historically provided for U.S. federal income tax on the undistributed earnings from its foreign subsidiaries, except to the extent such earnings are reinvested indefinitely.

In accordance with Topic 740, the Company has recorded a contingent liability of $3.2 million as of June 30, 2010, which, if recognized, would affect the Company’s future effective tax rate. Of this total, approximately $3.0 million had been accrued as of December 31, 2009.

 

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When incurred, the Company recognizes interest and penalties related to unrecognized tax benefits in tax expense. The Company accrued net interest and penalties of $0.2 million in the first half of 2010. The Company remains subject to examination in the following major tax jurisdictions:

 

Jurisdiction

  

Years Affected

United States

   From 2006 to present

California

   From 2004 to present

Ireland

   From 2006 to present

Canada

   From 2007 to present

As of June 30, 2010, there were no positions for which management believes it is reasonably possible that the total amounts of tax contingencies will significantly increase or decrease within 12 months of the reporting date.

As of June 30, 2010, the Company is subject to federal examination in the U.S. from 2006 through the present. In 2007, the IRS closed its audit for taxable years 2001 through 2003 and the statute of limitations lapsed for 2005 in 2009. Subsequent to the quarter ended June 30, 2010, the Company was notified that the IRS will be examining the 2008 tax year.

PMI has historically provided for U.S. federal income tax on the undistributed earnings from its foreign subsidiaries, except to the extent such earnings are reinvested indefinitely. During the quarter ended June 30, 2009, the Company determined that earnings from foreign subsidiaries, principally PMI Europe, were no longer deemed “permanently reinvested”. As such, related income tax amounts have subsequently been recorded as components in the consolidated statement of operations and accumulated other comprehensive income (loss).

The Company has foreign net operating loss carryforwards of approximately $12.5 million primarily related to the PMI Europe and Canada operations that will expire in 2012-2027.

The Company has tax credit carryforwards of approximately $193.1 million, primarily related to the payment of alternative minimum tax of $113.3 million and foreign taxes of $78.9 million. The alternative minimum tax credits do not expire and the foreign tax credits will expire if not utilized in 2018.

NOTE 14. REINSURANCE

The following table shows the effects of reinsurance on premiums written, premiums earned and losses and LAE of the Company’s operations for the periods presented:

 

     Three Months Ended June 30,     Six Months Ended June 30,  
     2010     2009     2010     2009  
     (Dollars in thousands)  

Premiums written

        

Direct, net of refunds

   $ 176,145      $ 211,470      $ 370,161      $ 436,079   

Assumed

     4        (2,296     8        (1,108

Ceded

     (31,859     (39,450     (65,803     (80,401
                                

Net premiums written

   $ 144,290      $ 169,724      $ 304,366      $ 354,570   
                                

Premiums earned

        

Direct, net of refunds

   $ 181,711      $ 221,900      $ 377,462      $ 449,756   

Assumed

     292        (126     245        1,840   

Ceded

     (32,352     (40,174     (66,491     (81,902
                                

Net premiums earned

   $ 149,651      $ 181,600      $ 311,216      $ 369,694   
                                

Losses and loss adjustment expenses

        

Direct

   $ 366,698      $ 556,142      $ 743,867      $ 1,026,480   

Assumed

     107        (100     117        (53

Ceded

     (46,316     (75,201     (72,670     (162,639
                                

Net losses and LAE

   $ 320,489      $ 480,841      $ 671,314      $ 863,788   
                                

 

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The majority of the Company’s existing reinsurance contracts are captive reinsurance agreements in the U.S. Mortgage Insurance Operations. Under captive reinsurance agreements, a portion of the risk insured by PMI is reinsured with the mortgage originator or investor through a reinsurer that is affiliated with the mortgage originator or investor. The majority of the Company’s ceded premiums in the first six months of 2010 and 2009 are from U.S. captive reinsurance arrangements. The Company recorded $613.6 million in reinsurance recoverables primarily from captive arrangements related to PMI’s gross loss reserves as of June 30, 2010, compared to $703.6 million as of December 31, 2009. As of June 30, 2010 and December 31, 2009, the total assets in captive trust accounts held for the benefit of PMI totaled approximately $900.2 million and $940.7 million, before quarterly net settlements, respectively.

NOTE 15. DEBT AND REVOLVING CREDIT FACILITY

 

     June 30, 2010    December  31,
2009
     Principal Amount    Fair Value    Carrying Value    Carrying Value
     (Dollars in thousands)

6.000% Senior Notes, due September 15, 2016 (1)

   $ 250,000    $ 200,625    $ 200,625    $ 149,063

6.625% Senior Notes, due September 15, 2036 (1)

     150,000      101,523      101,523      64,585

Revolving Credit Facility, due October 24, 2011

     49,750      49,750      49,750      124,750

8.309% Junior Subordinated Debentures, due February 1, 2027

     51,593      35,083      51,593      51,593

4.50% Convertible Notes due April 15, 2020

     285,000      204,630      184,552      —  
                           

Total debt

   $ 786,343    $ 591,611    $ 588,043    $ 389,991
                           

 

(1) The fair value and carrying value of the Company’s 6.000% Senior Notes and 6.625% Senior Notes at June 30, 2010 include accrued interest.

The Company amended its revolving credit facility (the “credit facility” or “facility”) effective May 29, 2009 following the satisfaction of certain conditions precedent agreed upon between the Company and the lenders under the facility on May 8, 2009. In connection with the Amended Agreement, MIC and The PMI Group entered into a Note Purchase Agreement pursuant to which The PMI Group purchased the contingent note from MIC which MIC received in connection with the sale of PMI Australia (the “QBE Note”). Upon the completion of the sale of the QBE Note to The PMI Group from MIC, The PMI Group granted a security interest in the QBE Note in favor of the Administrative Agent, for the benefit of the lenders under the Amended Agreement.

The Amended Agreement places certain limitations on the Company’s ability to pay dividends on its common stock, including a per year cap of $0.01 per share, subject to an annual aggregate limit of $5 million, and a prohibition from declaring any dividend at any time MIC is prohibited from writing new mortgage insurance by any state in the U.S. See Part II, Item 1A. Risk FactorsWe may face liquidity issues at our holding company, The PMI Group, and if an event of default were to occur under our credit facility, our business would suffer.

Pursuant to the terms of our credit facility, The PMI Group was required to use 33% of the net proceeds from its concurrent common stock and Convertible Notes offerings to repay the outstanding indebtedness under the credit facility, subject to a maximum repayment amount of $75 million. Accordingly, The PMI Group used $75 million of the net proceeds from the offerings to pay down the credit facility from $124.8 million to $49.8 million; the total maximum amount of the lenders’ commitments is $50 million. In April 2010, in connection with the offerings, the Company amended its credit facility. As part of the amendment, the net worth requirement was removed as a financial covenant.

The Company received proceeds of $276.5 million after the deduction of offering expenses of $8.5 million upon issuance of the 4.50% Convertible Notes due 2020. The Company used a portion of the proceeds from the note issuance and concurrent Common Stock offering to pay $75 million of its outstanding indebtedness under its credit facility and for working capital and general corporate purposes. The Company has allocated the Convertible

 

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Notes offering costs to the liability and equity components in proportion to the allocation of proceeds and accounted for them as debt issuance costs and equity issuance costs, respectively. At June 30, 2010, the following summarizes the liability and equity components of the Convertible Notes:

 

     June 30, 2010  
     (Dollars in thousands)  

Liability components:

  

4.50% Convertible Notes due 2020

   $ 285,000   

Less: Convertible Notes unamortized discount

     (100,448
        

Convertible Notes, net of discount

   $ 184,552   
        

Equity components:

  

Additional Paid in Capital:

  

Embedded conversion option

   $ 101,478   

Less: Embedded conversion option tax effect

     (35,517

Less: Issuance Costs

     (77
        
   $ 65,884   
        

At June 30, 2010, remaining unamortized debt issuance costs included in other non-current assets were $8.9 million and are being amortized to interest expense over the term of the Convertible Notes. Amortization expense for the period ended June 30, 2010 was $0.2 million. At June 30, 2010 the remaining amortization period for the unamortized Convertible Notes discount and debt issuance costs was 9.83 years.

The components of interest expense resulting from the Convertible Notes for the period ended June 30, 2010 are as follows:

 

     June 30, 2010
     (Dollars in thousands)

Contractual coupon interest

   $ 2,173

Amortization of Convertible Notes debt discount

     1,030

Amortization of debt issuance costs

     161
      
   $ 3,364
      

For the period ended June 30, 2010, the amortization of the Convertible Notes debt discount and debt issuance costs are based on an effective interest rate of 10.3%.

Holders may convert their Convertible Notes prior to January 15, 2020, only in specified circumstances, and holders may convert their Notes at any time thereafter until the second business day preceding maturity. The Convertible Notes will be convertible at an initial conversion rate of 127.5307 shares of common stock per $1,000 principal amount of Convertible Notes, which represents an initial conversion price of approximately $7.84 per share. Upon conversion, the Company may deliver cash, shares of Common Stock or a combination thereof, at its option. The Convertible Notes if converted value did not exceed the principal amount of $285 million at June 30, 2010.

On or after January 15, 2020 until the close of business on the second business day immediately preceding the maturity date, holders may convert their Convertible Notes, in multiples of $1,000 principal amount, at the option of the holder.

 

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The Company may redeem the Notes in whole or in part on or after April 15, 2015, if the last reported sale price of Common Stock exceeds 130% of the conversion price then in effect for 20 or more trading days in a period of 30 consecutive trading days ending on the trading day immediately prior to the date of redemption notice. The redemption price will be equal to the principal amount of the Convertible Notes to be redeemed plus accrued but unpaid interest plus a specified “make whole” premium.

NOTE 16. BUSINESS SEGMENTS

Reporting segments are based upon the Company’s internal organizational structure, the manner in which the Company’s operations are managed, the criteria used by the Company’s management to evaluate segment performance, the availability of separate financial information and overall materiality considerations.

Effective December 31, 2009, the Company combined its former “Corporate and Other” and “Financial Guaranty” segments into a “Corporate and Other” segment for all periods presented. The Company’s Corporate and Other segment, among other things, includes its investment in FGIC and its former investment in RAM Re. The Company impaired its investment in FGIC in 2008 and reduced the carrying value of the investment to zero. Effective January 1, 2010, PMAC was included in the Company’s U.S. Mortgage Insurance Operations segment.

The following tables present segment income or loss and balance sheets as of and for the periods indicated:

 

     Three Months Ended June 30, 2010  
     U.S. Mortgage
Insurance
Operations
    International
Operations
    Corporate and
Other
    Consolidated Total  
     (Dollars in thousands)  

Revenues

        

Premiums earned

   $ 148,416      $ 1,235      $ —        $ 149,651   

Net investment income

     21,330        2,400        131        23,861   

Net realized investment (losses) gains

     (1     122        276        397   

Change in fair value of certain debt instruments

     —          —          (47,687     (47,687

Net gains from credit default swaps

     —          462        —          462   

Other income (loss)

     2,225        (3     —          2,222   
                                

Total revenues (expenses)

     171,970        4,216        (47,280     128,906   
                                

Losses and expenses

        

Losses and loss adjustment expenses

     321,120        (631     —          320,489   

Amortization of deferred policy acquisition costs

     4,163        —          —          4,163   

Other underwriting and operating expenses

     25,440        1,269        1,198        27,907   

Interest expense

     2,175        —          10,072        12,247   
                                

Total losses and expenses

     352,898        638        11,270        364,806   
                                

(Loss) income before equity in losses from unconsolidated subsidiaries and income taxes

     (180,928     3,578        (58,550     (235,900

Equity in losses from unconsolidated subsidiaries

     (3,856     —          (61     (3,917
                                

(Loss) income from continuing operations before income taxes

     (184,784     3,578        (58,611     (239,817

Income tax benefit from continuing operations

     (69,149     (1,045     (19,063     (89,257
                                

Net (loss) income

   $ (115,635   $ 4,623      $ (39,548   $ (150,560
                                

 

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     Three Months Ended June 30, 2009  
     U.S. Mortgage
Insurance
Operations
    International
Operations
    Corporate and
Other
    Consolidated Total  
     (Dollars in thousands)  

Revenues

        

Premiums earned

   $ 178,178      $ 3,415      $ 7      $ 181,600   

Net investment income (loss)

     28,929        (540     727        29,116   

Net realized investment gains (losses)

     23,663        (271     —          23,392   

Change in fair value of certain debt instruments

     —          —          (39,079     (39,079

Net gains from credit default swaps

     —          7,003        —          7,003   

Other income

     12        14        105        131   
                                

Total revenues (expenses)

     230,782        9,621        (38,240     202,163   
                                

Losses and expenses

        

Losses and loss adjustment expenses

     476,829        4,012        —          480,841   

Amortization of deferred policy acquisition costs

     3,432        321        —          3,753   

Other underwriting and operating expenses

     32,781        3,909        3,062        39,752   

Interest expense

     16        —          11,715        11,731   
                                

Total losses and expenses

     513,058        8,242        14,777        536,077   
                                

(Loss) income before equity in losses from unconsolidated subsidiaries and income taxes

     (282,276     1,379        (53,017     (333,914

Equity in losses from unconsolidated subsidiaries

     (1,221     —          (171     (1,392
                                

(Loss) income from continuing operations before income taxes

     (283,497     1,379        (53,188     (335,306

Income tax (benefit) expense from continuing operations

     (107,720     14,831        (19,790     (112,679
                                

Loss from continuing operations

     (175,777     (13,452     (33,398     (222,627

Income from discontinued operations, net of taxes

     —          7        —          7   
                                

Net loss

   $ (175,777   $ (13,445   $ (33,398   $ (222,620
                                

 

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     Six Months Ended June 30, 2010  
     U.S. Mortgage
Insurance
Operations
    International
Operations
   Corporate and
Other
    Consolidated Total  
     (Dollars in thousands)  

Revenues

         

Premiums earned

   $ 308,579      $ 2,637    $ —        $ 311,216   

Net investment income

     46,363        3,925      261        50,549   

Net realized investment gains

     7,169        385      276        7,830   

Change in fair value of certain debt instruments

     —          —        (88,500     (88,500

Net gain from credit default swaps

     —          2,180      —          2,180   

Other income

     2,225        3      —          2,228   
                               

Total revenues (expenses)

     364,336        9,130      (87,963     285,503   
                               

Losses and expenses

         

Losses and loss adjustment expenses

     671,193        121      —          671,314   

Amortization of deferred policy acquisition costs

     8,039        —        —          8,039   

Other underwriting and operating expenses

     55,476        3,069      3,221        61,766   

Interest expense

     2,249        —        19,521        21,770   
                               

Total losses and expenses

     736,957        3,190      22,742        762,889   
                               

(Loss) income before equity in losses from unconsolidated subsidiaries and income taxes

     (372,621     5,940      (110,705     (477,386

Equity in losses from unconsolidated subsidiaries

     (8,145     —        (182     (8,327
                               

(Loss) income from continuing operations before income taxes

     (380,766     5,940      (110,887     (485,713

Income tax (benefit) expense from continuing operations

     (143,348     1,300      (36,118     (178,166
                               

Net (loss) income

   $ (237,418   $ 4,640    $ (74,769   $ (307,547
                               

 

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     Six Months Ended June 30, 2009  
     U.S. Mortgage
Insurance
Operations
    International
Operations
    Corporate and
Other
    Consolidated Total  
     (Dollars in thousands)  

Revenues

        

Premiums earned

   $ 363,792      $ 5,887      $ 15      $ 369,694   

Net investment income

     56,699        4,320        2,702        63,721   

Net realized investment gains (losses)

     19,395        (2,036     (18     17,341   

Change in fair value of certain debt instruments

     —          —          (20,603     (20,603

Net gain from credit default swaps

     —          14,759        —          14,759   

Other (loss) income

     (38     (21     2,374        2,315   
                                

Total revenues (expenses)

     439,848        22,909        (15,530     447,227   
                                

Losses and expenses

        

Losses and loss adjustment expenses

     856,675        7,113        —          863,788   

Amortization of deferred policy acquisition costs

     6,457        641        —          7,098   

Other underwriting and operating expenses

     66,301        6,700        6,772        79,773   

Interest expense

     32        —          23,551        23,583   
                                

Total losses and expenses

     929,465        14,454        30,323        974,242   
                                

(Loss) income before equity in losses from unconsolidated subsidiaries and income taxes

     (489,617     8,455        (45,853     (527,015

Equity in losses from unconsolidated subsidiaries

     (3,515     —          (323     (3,838
                                

(Loss) income from continuing operations before income taxes

     (493,132     8,455        (46,176     (530,853

Income tax (benefit) expense from continuing operations

     (189,789     15,177        (18,353     (192,965
                                

Loss from continuing operations

     (303,343     (6,722     (27,823     (337,888

Loss from discontinued operations, net of taxes

     —          (23     —          (23
                                

Net loss

   $ (303,343   $ (6,745   $ (27,823   $ (337,911
                                

 

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     June 30, 2010
     U.S. Mortgage
Insurance Operations
   International
Operations
   Corporate and
Other
    Consolidated Total
     (Dollars in thousands)

Assets

          

Cash and investments, at fair value

   $ 3,129,083    $ 173,850    $ 97,867      $ 3,400,800

Investments in unconsolidated subsidiaries

     117,858      —        14,812        132,670

Reinsurance recoverables

     613,646      —        —          613,646

Deferred policy acquisition costs

     44,519      —        —          44,519

Property, equipment and software, net of accumulated depreciation and amortization

     28,775      6      64,269        93,050

Other assets

     566,252      20,190      61,982        648,424
                            

Total assets

   $ 4,500,133    $ 194,046    $ 238,930      $ 4,933,109
                            

Liabilities

          

Reserve for losses and loss adjustment expenses

   $ 3,079,764    $ 33,178    $ —        $ 3,112,942

Unearned premiums

     56,150      7,358      —          63,508

Debt

     285,000      —        303,043        588,043

Other liabilities

     195,522      14,584      4,220        214,326
                            

Total liabilities

     3,616,436      55,120      307,263        3,978,819

Shareholders’ equity (deficit)

     883,697      138,926      (68,333     954,290
                            

Total liabilities and shareholders’ equity

   $ 4,500,133    $ 194,046    $ 238,930      $ 4,933,109
                            
     December 31, 2009
     U.S. Mortgage
Insurance Operations
   International
Operations
   Corporate and
Other
    Consolidated Total
     (Dollars in thousands)

Assets

          

Cash and investments, at fair value

   $ 2,979,683    $ 190,975    $ 88,766      $ 3,259,424

Investments in unconsolidated subsidiaries

     124,826      —        14,949        139,775

Reinsurance recoverables

     703,550      —        —          703,550

Deferred policy acquisition costs

     41,289      —        —          41,289

Property, equipment and software, net of accumulated depreciation and amortization

     35,606      27      66,260        101,893

Other assets

     323,521      11,755      60,310        395,586
                            

Total assets

   $ 4,208,475    $ 202,757    $ 230,285      $ 4,641,517
                            

Liabilities

          

Reserve for losses and loss adjustment expenses

   $ 3,213,735    $ 40,085    $ —        $ 3,253,820

Unearned premiums

     61,758      10,328      3        72,089

Debt

     —        —        389,991        389,991

Other liabilities (assets)

     172,070      34,763      (8,303     198,530
                            

Total liabilities

     3,447,563      85,176      381,691        3,914,430

Shareholders’ equity (deficit)

     760,912      117,581      (151,406     727,087
                            

Total liabilities and shareholders’ equity

   $ 4,208,475    $ 202,757    $ 230,285      $ 4,641,517
                            

 

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NOTE 17. EXIT AND DISPOSAL ACTIVITIES

In 2008 and 2009, the Company undertook initiatives to reduce and manage its expenses and to focus on its core U.S. mortgage insurance business. The following table provides a reconciliation of exit and disposal costs included in other underwriting expenses by operating segment in the first six months of 2010 and 2009:

 

     U.S. Mortgage
Insurance Operations
    International
Operations
    Consolidated Total  
     (Dollars in thousands)  

Balance at January 1, 2009

   $ 2,343      $ 2,775      $ 5,118   

Exit costs incurred

      

Severance

     1,014        —          1,014   

Lease termination & fixed asset disposal

     400        1,757        2,157   

Other

     31        —          31   
                        

Total incurred

     1,445        1,757        3,202   

Exit costs payments

      

Severance

     (2,219     (2,126     (4,345

Fringe benefits

     —          (36     (36

Lease termination & fixed asset disposal

     —          (1,757     (1,757

Other

     (141     (318     (459
                        

Total payments

     (2,360     (4,237     (6,597
                        

Balance at June 30, 2009

   $ 1,428      $ 295      $ 1,723   
                        
     U.S. Mortgage
Insurance Operations
    International
Operations
    Consolidated Total  
     (Dollars in thousands)  

Balance at January 1, 2010

   $ 2,072      $ 243      $ 2,315   

Exit costs payments

      

Severance

     (1,649     (165     (1,814

Lease termination & fixed asset disposal

     (26     —          (26

Other

     (57     (78     (135
                        

Total payments

     (1,732     (243     (1,975
                        

Balance at June 30, 2010

   $ 340      $ —        $ 340   
                        

The expenses in the U.S. Mortgage Insurance Operations segment are primarily payroll and related expenses from involuntary terminations in 2009. The expenses in the International Operations segment are primarily due to reductions in force from the closure of PMI Canada’s office in Toronto and reconfiguration of PMI Europe. Exit costs incurred since December 2008 were $21.8 million which consisted primarily of severance and related costs.

 

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NOTE 18. SUBSEQUENT EVENT

On July 29, 2010, the Company’s primary subsidiary, MIC, sold its equity ownership in FGIC, the holding company of Financial Guaranty Insurance Company. While the proceeds from the sale of FGIC were not significant, the Company could potentially realize certain tax benefits in future periods from the disposition of FGIC. Any potential tax benefits could be limited or delayed, and there can be no assurance whether or when any such tax benefits will be realized.

 

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

CAUTIONARY STATEMENT

Statements in this report that are not historical facts, or that are preceded by, followed by or include the words “believes,” “expects,” “anticipates,” “estimates” or similar expressions, and that relate to future plans, events or performance are “forward-looking” statements within the meaning of the federal securities laws. Forward-looking statements in this report include discussions of future potential trends relating to losses, claims paid, loss reserves, default inventories and cure rates of our various insurance subsidiaries, rescission and claim denial activity and the challenges thereto, persistency, premiums, new insurance written, refinance activity, the make-up of our various insurance portfolios, the impact of market and competitive conditions, rising unemployment, liquidity, capital requirements and initiatives, regulatory and contractual capital adequacy requirements, potential legislative changes, potential discretionary regulatory decisions by insurance regulators, captive reinsurance agreements, restructuring opportunities associated with our modified pool policies, fair value of certain debt instruments, the performance of our derivative contracts as well as certain securities held in our investment portfolios and potential litigation. These forward-looking statements are subject to uncertainties and other factors that could cause actual results to differ materially from such statements. These uncertainties and other factors are described in more detail under the heading “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2009 and our Quarterly Report on Form 10-Q for the quarter ended March 31, 2010 and in Part II, Item 1A. herein. All forward-looking statements are qualified by and should be read in conjunction with those risk factors, our consolidated financial statements, related notes and other financial information. Except as may be required by applicable law, we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

Financial Results for the Quarter and Six Months Ended June 30, 2010

In the second quarter of 2010, in concurrent public offerings, The PMI Group, Inc. (“The PMI Group”) sold 77,765,000 shares of common stock at $6.15 per share and issued $285 million aggregate principal value of 4.50% Convertible Senior Notes due 2020. Total net proceeds to The PMI Group from the offerings were approximately $732 million.

For the quarter and six months ended June 30, 2010, we recorded consolidated net losses of $150.6 million and $307.5 million, respectively, compared to consolidated net losses of $222.6 million and $337.9 million for the corresponding periods in 2009. Losses and loss adjustment expenses (“LAE”) decreased from $480.8 million in the second quarter of 2009 to $320.5 million in the second quarter of 2010 and from $863.8 million in the first half of 2009 to $671.2 million in the first half of 2010. These decreases were offset by lower premiums earned and net investment income in the second quarter and first half of 2010, and an increase in the fair value of our debt which reduced second quarter and first half of 2010 total revenues by $47.7 million and $88.5 million, respectively.

Overview of Our Business

We provide residential mortgage insurance products designed to protect mortgage lenders and investors from credit losses in the event of borrower default. By facilitating low down payment mortgages, mortgage insurance promotes homeownership and strengthens communities. We divide our business into three segments: U.S. Mortgage Insurance Operations, International Operations and Corporate and Other.

 

   

U.S. Mortgage Insurance Operations. The results of U.S. Mortgage Insurance Operations include PMI Mortgage Insurance Co. (“MIC”) and its affiliated U.S. mortgage insurance and reinsurance companies (collectively, “PMI”), and equity in earnings (losses) from PMI’s joint venture, CMG Mortgage Insurance Company and its affiliated companies (collectively, “CMG MI”). Effective January 1, 2010, we include PMI Mortgage Assurance Co. (“PMAC”) in U.S. Mortgage Insurance Operations. U.S. Mortgage Insurance Operations recorded net losses of $115.6 million and $237.4 million for the quarter and six months ended June 30, 2010, respectively, compared to net losses of $175.8 million and $303.3 million for the quarter and six months ended June 30, 2009.

 

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International Operations. Our International Operations segment includes the results of our European and Canadian subsidiaries, “PMI Europe” and “PMI Canada,” neither of which is writing new business. International Operations generated net income from continuing operations of $4.6 million and $4.6 million for the quarter and six months ended June 30, 2010, compared to net losses from continuing operations of $13.5 million and $6.7 million for the quarter and six months ended June 30, 2009.

 

   

Corporate and Other. Our Corporate and Other segment consists of corporate debt and expenses of our holding company, contract underwriting operations (which were discontinued in April 2009), our former investments in RAM Re (which we sold in the fourth quarter of 2009) and FGIC Corporation (which we sold on July 29, 2010), and equity in earnings or losses from investments in certain limited partnerships. Our Corporate and Other segment generated net losses from continuing operations of $39.5 million and $74.8 million for the quarter and six months ended June 30, 2010, respectively, compared to net losses of $33.4 million and $27.8 million for the quarter and six months ended June 30, 2009.

Conditions and Trends Affecting our Business

U.S. Mortgage Insurance Operations. The financial performance of our U.S. Mortgage Insurance Operations segment is affected by a number of factors, including:

 

   

MIC’s Capital Position. In the second quarter of 2010, we contributed $610 million of the proceeds from our public offerings to MIC in the form of a capital contribution and surplus notes issued by MIC to The PMI Group. The contributions caused MIC’s policyholders’ position and risk to capital ratio to comply with regulatory capital adequacy requirements. As of June 30, 2010, MIC’s policyholders’ position exceeded the required minimum by approximately $415.5 million and MIC’s risk to capital ratio was approximately 15.8 to 1.

High unemployment rates and ongoing weakness in U.S. residential mortgage and housing markets continue to negatively affect our U.S. Mortgage Insurance Operations segment. As discussed below under Losses and LAE, PMI continues to experience elevated losses. These losses have reduced, and will continue to reduce, PMI’s net assets. The ultimate amount and duration of PMI’s losses will depend upon various factors, including home price fluctuations and unemployment rates. Continued losses and/or the lack of material net income will negatively impact MIC’s policyholders’ position and risk to capital ratio throughout 2010 and in 2011. There can be no assurance that MIC’s policyholders’ position will not decline below, and risk to capital ratio will not increase above, levels necessary to meet regulatory capital adequacy requirements. See Part II, Item 1A. Risk Factors - There can be no assurance that higher than expected losses, or earlier than expected development of such losses, will not cause MIC to be out of compliance with applicable regulatory capital adequacy requirements in the future. In the event MIC’s capital position again approaches regulatory thresholds, we would seek to obtain the necessary waivers to continue to write new business.

MIC’s principal regulator is the Arizona Department of Insurance (the “Department”). On February 10, 2010, MIC received a letter from the Department waiving, until December 31, 2011, the requirement that MIC maintain the Arizona required minimum policyholders’ position to write new business. On May 24, 2010, PMI received a letter from the Department withdrawing this waiver due to our $610 million of capital contributions to MIC.

In 2008, we submitted written remediation plans to Fannie Mae and Freddie Mac (collectively, the “GSEs”) outlining, among other things, the steps we are taking or plan to take to bolster MIC’s financial strength. To date, each of the GSEs has continued to treat MIC as an eligible mortgage insurer. There can be no assurance that the GSEs will continue to treat MIC as an eligible mortgage insurer.

 

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Losses and LAE. PMI’s losses and LAE were $321.1 million and $671.2 million for the quarter and six months ended June 30, 2010, respectively, compared to $476.8 million and $856.7 million in the corresponding periods in 2009. Elevated levels of new delinquencies drove PMI’s higher losses and LAE in the first half of 2009. A decline in PMI’s default inventory from December 31, 2009, partially offset by higher claims paid, drove the decline in losses and LAE in the first half of 2010. PMI’s losses and LAE will be negatively affected if notices of default, claim rates and/or claim sizes continue to be elevated or increase beyond our current estimates. PMI’s rescission activity during the first half of 2010 was lower than we expected (see Rescission Activity, below), causing us to reduce our estimate of future rescissions. To a lesser extent, we also reduced our expectations in the second quarter with respect to the levels of future loan modifications. These reductions negatively affected PMI’s loss reserves, which increased losses and LAE during the second quarter of 2010. Changes, or lack of improvement, in economic conditions, including the U.S. credit and capital markets, mortgage interest rates, job creation, unemployment rates and home prices, could significantly impact our reserve estimates and, therefore, PMI’s losses and LAE.

 

   

Defaults. PMI’s primary default inventory was 138,431 as of June 30, 2010, 147,248 as of March 31, 2010, 150,925 as of December 31, 2009 and 126,431 as of June 30, 2009. The declines in PMI’s primary default inventory were due to lower levels of new notices of default, increased cures and a significant increase in the number of primary claims paid. PMI’s modified pool default inventory was 13,160 as of June 30, 2010, 20,453 as of March 31, 2010, 46,024 as of December 31, 2009 and 52,717 as of June 30, 2009. The decreases in the pool default inventory were primarily due to the modified pool restructurings discussed under Modified Pool, below. While we expect PMI’s default inventory and default rates to remain high through 2010, we believe that new delinquencies from our 2005, 2006 and 2007 primary book years have peaked. As a result, we expect PMI’s default inventory at the end of 2010 will be lower than at the end of 2009. PMI’s default inventories in the second quarter of 2010 were driven by a number of factors including:

Declining Home Prices and High Unemployment – Elevated levels of unemployment have made it significantly more difficult for many borrowers to remain current on their mortgage payments, while declining home prices have reduced the opportunities for borrowers to refinance their mortgages or sell their homes. These factors are negatively affecting PMI’s default inventories and default rates.

Claims Paid – PMI’s default inventory increased significantly in 2008 and 2009. As this inventory has aged, the associated claims paid has increased. For example, in the second quarter of 2010, PMI paid 8,284 claims (including claim denials) compared to 4,888 in the second quarter of 2009. We expect claims paid (both in number and aggregate dollar amounts) to continue to increase in the second half of 2010 and continue to reduce the number of loans in PMI’s default inventory.

Cure Rate – During 2009, the percentage of defaults that cure declined primarily due to elevated levels of unemployment, diminished refinancing opportunities and implementation of the U.S. Treasury’s Home Affordable Modification Program (“HAMP”). Typically, with a traditional loan modification, a loan default is cured within a relatively short time period after the modification is approved. For loans approved for HAMP modifications, however, borrowers are subject to 90-day trial periods, which in many cases can be considerably longer, during which borrowers must adhere to their trial modification plans and submit all required documentation in order to complete the modification process. As of June 30, 2010, 18,079 loans insured by PMI were in HAMP trial periods, compared to 23,181 loans at December 31, 2009. We do not remove from PMI’s default inventory a loan subject to a HAMP trial modification period unless and until the trial period is completed, all required documents have

been received, the loan modification is closed, and the default is officially cured. The decline in PMI’s cure rate in 2009 was partially offset by loss mitigation efforts unrelated to HAMP and by rescissions of insurance written in prior periods. In the second quarter of 2010, PMI’s

 

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cure rate improved, primarily as a result of fewer new notices of default and, to a lesser extent, higher loan modifications. Based on our recent experience with HAMP and other modification programs, we expect that a material percentage of loans in our default inventory will be successfully modified, and our loss reserve estimation process takes into consideration management’s expectations regarding the reduction to the claim rate that may occur as a result of modification programs. In the second quarter of 2010, we reduced our expectations with respect to the levels of future loan modifications. See Item 1A. Risk Factors – Loan modification and other