Attached files

file filename
EX-31.1 - EXHIBIT 31 - SOX SECTION 302 - TRIAD GUARANTY INCexhibit31.htm
EX-32.1 - EXHIBIT 32 - SOX SECTION 906 - TRIAD GUARANTY INCexhibit32.htm



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

FORM 10-Q
 
T  
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended 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:  0-22342
_______________________

Triad Guaranty Inc.
(Exact name of registrant as specified in its charter)
 
 
Delaware
 
56-1838519
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification No.)
         
101 South Stratford Road
Winston-Salem, North Carolina
 
27104
(Address of principal executive offices)
 
(Zip Code)
         
 
(336) 723-1282
 
 
(Registrant's telephone number, including area code)
 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes R 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 definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.  (Check one):

Large accelerated filer £
Accelerated filer £
Non-accelerated filer £
Smaller reporting company R
   
(Do not check if a smaller reporting company)
 

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

Number of shares of common stock, par value $0.01 per share, outstanding as of July 30, 2010 was 15,258,128.





 
 

 

TRIAD GUARANTY INC.

INDEX


   
Page
Part I.  Financial Information
 
     
Item 1.
Financial Statements
 
 
Consolidated Balance Sheets as of June 30, 2010 (Unaudited) and December 31, 2010
1
     
 
Consolidated Statements of Operations for the Three Months and Six Months Ended June 30, 2010 and 2009 (Unaudited)
2
     
 
Consolidated Statements of Cash Flow for the Six Months Ended June 30, 2010 and 2009 (Unaudited)
3
     
 
Notes to Consolidated Financial Statements
4
     
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
19
     
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
41
     
Item 4.
Controls and Procedures
41
     
Part II.  Other Information
 
     
Item 1.
Legal Proceedings
41
     
Item 6.
Exhibits
42
     
SIGNATURE
 
43
     
EXHIBIT INDEX
 
44
 

 
 

 

PART I.  FINANCIAL INFORMATION

Item 1.  Financial Statements


TRIAD GUARANTY INC.
 
CONSOLIDATED BALANCE SHEETS
 
             
   
June 30,
      December 31,  
 (dollars in thousands, except per share data)
 
2010
      2009  
   
(unaudited)
         
ASSETS
             
Invested assets:
             
Securities available-for-sale, at fair value:
             
Fixed maturities (amortized cost:  $853,337 and $738,149)
  $ 906,992     $ 784,830  
Short-term investments
    29,166       26,651  
Total invested assets
    936,158       811,481  
Cash and cash equivalents
    35,576       21,839  
Accrued investment income
    9,575       9,048  
Property and equipment
    2,688       3,515  
Reinsurance recoverable, net
    49,829       233,499  
Other assets
    51,737       45,444  
Total assets
  $ 1,085,563     $ 1,124,826  
                 
LIABILITIES AND STOCKHOLDERS' DEFICIT
               
Liabilities:
               
Losses and loss adjustment expenses
  $ 1,307,028     $ 1,537,043  
Unearned premiums
    11,346       12,153  
Long-term debt
    34,546       34,540  
Deferred payment obligation
    292,169       168,386  
Accrued interest
    2,476       2,476  
Accrued expenses and other liabilities
    86,143       76,586  
Total liabilities
    1,733,708       1,831,184  
Commitments and contingencies - Note 5
               
Stockholders' deficit:
               
Preferred stock, par value $0.01 per share --- authorized 1,000,000
               
shares; no shares issued and outstanding
    -       -  
Common stock, par value $0.01 per share --- authorized 32,000,000
               
shares; issued and outstanding 15,258,128 shares
    153       153  
Additional paid-in capital
    114,016       113,848  
Accumulated other comprehensive income, net of income tax
               
liability of $16,575
    37,516       30,782  
Accumulated deficit
    (799,830 )     (851,141 )
Deficit in assets
    (648,145 )     (706,358 )
Total liabilities and stockholders' deficit
  $ 1,085,563     $ 1,124,826  

 
See accompanying notes.

 
1

 

 
 
TRIAD GUARANTY INC.
 
CONSOLIDATED STATEMENTS OF OPERATIONS
 
(unaudited)
 
                         
   
Three Months Ended
   
Six Months Ended
 
   
June 30,
   
June 30,
 
 (dollars in thousands, except per share data)
 
2010
   
2009
   
2010
   
2009
 
                         
Revenue:
                       
Premiums written:
                       
   Direct
  $ 74,196     $ 73,821     $ 128,589     $ 129,444  
   Ceded
    (2,730 )     (10,027 )     (10,932 )     (21,157 )
Net premiums written
    71,466       63,794       117,657       108,287  
Change in unearned premiums
    864       1,039       561       904  
Earned premiums
    72,330       64,833       118,218       109,191  
                                 
Net investment income
    10,560       10,859       20,434       22,051  
Net realized investment (losses) gains
    (985 )     2,017       (1,227 )     (2,548 )
Other (losses) income
    -       2       (8 )     4  
      81,905       77,711       137,417       128,698  
                                 
Losses and expenses:
                               
Net (benefit) losses and loss adjustment expenses
    (7,770 )     431,368       64,468       532,945  
Interest expense
    2,816       1,895       5,285       2,589  
Other operating expenses
    7,021       8,680       16,353       18,091  
      2,067       441,943       86,106       553,625  
Income (loss) before income tax expense (benefit)
    79,838       (364,232 )     51,311       (424,927 )
Income tax expense (benefit):
                               
Current
    -       1,081       -       1,081  
Deferred
    717       (5,894 )     -       (11,415 )
      717       (4,813 )     -       (10,334 )
Net income (loss)
  $ 79,121     $ (359,419 )   $ 51,311     $ (414,593 )
                                 
Income (loss) per common and common equivalent share:
                               
Basic
  $ 5.24     $ (23.91 )   $ 3.40     $ (27.65 )
Diluted
  $ 5.24     $ (23.91 )   $ 3.40     $ (27.65 )
                                 
Shares used in computing income (loss) per common and
   common equivalent share:
                               
Basic
    15,112,227       15,031,394       15,105,799       14,994,535  
Diluted
    15,112,227       15,031,394       15,108,721       14,994,535  
 
 

 
See accompanying notes.

 
2

 

 
 
TRIAD GUARANTY INC.
 
CONSOLIDATED STATEMENTS OF CASH FLOW
 
(unaudited)
 
             
   
Six Months Ended
 
   
June 30,
 
 (dollars in thousands)
 
2010
   
2009
 
             
Operating activities
           
Net income (loss)
  $ 51,311     $ (414,593 )
Adjustments to reconcile net income (loss) to net cash provided by
operating activities:
               
Losses, loss adjustment expenses and unearned premium reserves
    (230,822 )     402,394  
Accrued expenses and other liabilities
    9,557       7,611  
Deferred payment obligation
    123,783       27,020  
Income taxes recoverable
    -       (6,576 )
Reinsurance, net
    183,670       (84,004 )
Accrued investment income
    (527 )     400  
Net realized investment losses
    1,227       2,548  
Provision for depreciation
    824       1,266  
(Premium amortization) discount accretion on investments
    (1,078 )     704  
Deferred income taxes
    -       (11,415 )
Real estate acquired in claim settlement, net of write-downs
    -       713  
Accrued interest payable
    -       1,201  
Other assets
    (9,924 )     577  
Other operating activities
    152       514  
Net cash provided by operating activities
    128,173       (71,640 )
                 
Investing activities
               
Securities available-for-sale:
               
Purchases – fixed maturities
    (251,268 )     (128,623 )
Sales – fixed maturities
    73,482       120,024  
Maturities – fixed maturities
    65,422       34,631  
Sales – equities
    14       533  
Purchases of other investments
    427       -  
Net (increase) decrease in short-term investments
    (2,516 )     36,769  
Property and equipment
    3       (34 )
Net cash used in investing activities
    (114,436 )     63,300  
                 
                 
Net change in cash and cash equivalents
    13,737       (8,340 )
Cash and cash equivalents at beginning of period
    21,839       39,940  
Cash and cash equivalents at end of period
  $ 35,576     $ 31,600  
                 
Supplemental schedule of cash flow information
               
Cash paid during the period for:
               
Income taxes and United States Mortgage Guaranty
   Tax and Loss Bonds
  $ -     $ 7,736  
Interest
  $ 1,383     $ 1,383  


See accompanying notes.

 
3

 

TRIAD GUARANTY INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2010
(Unaudited)

1.  The Company

Triad Guaranty Inc. (“TGI”) is a holding company that historically provided private mortgage insurance coverage in the United States through its wholly-owned subsidiary, Triad Guaranty Insurance Corporation (“TGIC”).  Unless the context requires otherwise, references to “Triad” in this quarterly report on Form 10-Q refer to the operations of TGIC and its wholly-owned subsidiary, Triad Guaranty Assurance Corporation (“TGAC”).  References to the “Company” refer collectively to the operations of TGI and Triad.  Mortgage insurance allows buyers to achieve homeownership with a reduced down payment, facilitates the sale of mortgage loans in the secondary market and protects lenders from credit default-related expenses.

TGIC is an Illinois-domiciled insurance company and TGAC is an Illinois-domiciled reinsurance company. The Illinois Department of Insurance (the “Insurance Department”) is the primary regulator of both TGIC and TGAC.  The Illinois Insurance Code grants broad powers to the Insurance Department and its director (collectively, the “Department”) to enforce rules or exercise discretion over almost all significant aspects of Triad’s insurance business.  Triad ceased issuing new commitments for mortgage guaranty insurance coverage on July 15, 2008 and is operating its business in run-off under two Corrective Orders issued by the Department.  As used in these financial statements, the term "run-off" means writing no new mortgage insurance policies, but continuing to service existing policies.  Servicing existing policies includes: receiving premiums on policies that remain in force; cancelling coverage at the insured’s request; terminating policies for non-payment of premium; working with borrowers in default to remedy the default and/or mitigate losses; reviewing policies for the existence of misrepresentation, fraud or non-compliance with stated programs; and settling all legitimate filed claims per the provisions of the two Corrective Orders issued by the Department.  The term “settled,” as used in these financial statements in the context of the payment of a claim, refers to the satisfaction of Triad’s obligations following the submission of valid claims by its policyholders.  Prior to June 1, 2009, valid claims were settled solely by a cash payment.  Effective on and after June 1, 2009, valid claims are settled by a combination of 60% in cash and 40% in the form of a deferred payment obligation (“DPO”).  The Corrective Orders, among other things, allow management to continue to operate Triad under the close supervision of the Department, include restrictions on the distribution of dividends or interest on notes payable to TGI by Triad, and include restrictions on the payment of claims.

2.  Going Concern

The Company prepares its financial statements presented in this quarterly report on Form 10-Q in conformity with accounting principles generally accepted in the United States of America (“GAAP”).  The financial statements for Triad that are provided to the Department were prepared in accordance with Statutory Accounting Principles (“SAP”) as set forth in the Illinois Insurance Code or prescribed by the Department.  The primary differences between GAAP and SAP for Triad at June 30, 2010 were the methodology utilized for the establishment of reserves and the reporting requirements relating to the DPOs stipulated in the second Corrective Order.

A deficit in assets occurs when recorded liabilities exceed recorded assets in financial statements prepared under GAAP.  A deficiency in policyholders’ surplus occurs when recorded liabilities exceed recorded assets in financial statements prepared under SAP.  A deficit in assets at any particular point in time under GAAP is not necessarily a measure of insolvency.  However, the Company believes that if Triad were to report an other-than-temporary deficiency in policyholders’
 
 
 
4

 
 
surplus under SAP, Illinois law may require the Department to seek receivership of Triad, which could lead TGI to institute a proceeding seeking relief from creditors under U.S. bankruptcy laws.  The second Corrective Order attempts to mitigate the possibility of a deficiency in policyholders’ surplus under SAP by providing estimated reserves for loan losses only for the settlement of claims that will be paid in cash. As noted above, the second Corrective Order further attempts to mitigate the possibility of a deficiency in policyholders’ surplus by requiring Triad to settle valid claims 60% in cash and 40% in a DPO, which is accounted for as a component of policyholders’ surplus under SAP.

The Company has prepared its financial statements on a going concern basis under GAAP, which contemplates the realization of assets and the satisfaction of liabilities and commitments in the normal course of business.  However, there is substantial doubt as to the Company's ability to continue as a going concern.  This uncertainty is based on, among other things, the possible inability of Triad to comply with the provisions of the Corrective Orders and the Company's ability to generate enough income over the term of the remaining run-off to overcome the existing $648.1 million deficit in assets.  The Company’s financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or amounts of liabilities that might be necessary should the Company be unable to continue in existence.

The accounting treatment for establishing loss reserves required by the second Corrective Order has resulted in Triad reporting a policyholders’ surplus in its SAP financial statements of $155.2 million at June 30, 2010.  Absent this requirement, Triad would have reported a deficiency in policyholders’ surplus of $624.5 million at June 30, 2010 under SAP.  The ultimate payment of the DPOs and related carrying charges will be subject to Triad’s future financial performance and will require approval of the Department.  Failure to comply with the provisions of the Corrective Orders could result in the imposition of fines or penalties or subject Triad to further legal proceedings, including receivership proceedings for the conservation, rehabilitation or liquidation of Triad. Any actions like this would likely lead TGI to institute a proceeding seeking relief from creditors under U.S. bankruptcy laws.  The Company’s ability to successfully comply with the Corrective Orders and maintain statutory solvency is unknown at this time and is dependent upon many factors, including improved macroeconomic conditions in the United States.

3.  Accounting Policies and Basis of Presentation

Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared in conformity with GAAP for interim financial information and with the instructions to Form 10-Q and Article 8 of Regulation S-X.  Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements.  In the opinion of management, all adjustments considered necessary for a fair presentation have been included.  Operating results for the three months and six months ended June 30, 2010 are not necessarily indicative of the results that may be expected for the year ending December 31, 2010 or subsequent quarterly periods.  For further information, refer to the consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009.

Consolidation

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


 
5

 

Corrective Orders, Dividend Restrictions, and Statutory Results

Triad has entered into two Corrective Orders with the Department as detailed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009. Among other things, the Corrective Orders:

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

The DPO is an interest bearing subordinated obligation of Triad with no stated repayment terms.  The DPO recording requirements became effective on June 1, 2009.  At June 30, 2010, the recorded DPOs, including a carrying charge of $6.0 million, amounted to $292.2 million.  The recording of a DPO does not impact reported settled losses as the Company continues to report the entire amount of a claim in its statement of operations.  The accounting for the DPOs on a SAP basis is similar to a surplus note which is reported as a component of statutory surplus; accordingly, any repayment of the DPOs or the associated carrying charges is dependent on the financial condition and future prospects of Triad and is subject to the approval of the Department.  However, in the Company’s financial statements prepared in accordance with GAAP included in this report, the DPOs and related accrued interest is reported as a liability.  At June 30, 2010, the cumulative effect of this requirement on statutory policyholders’ surplus, including the impact of establishing loss reserves, was to increase statutory policyholders’ surplus by $779.7 million over the amount that would have been reported absent the second Corrective Order.  There was no such impact to loss reserves or stockholders’ deficit calculated on a GAAP basis.

Failure to comply with the provisions of the Corrective Orders or any other violation of the Illinois Insurance Code may result in the imposition of fines or penalties or subject Triad to further legal proceedings, including the institution by the Department of receivership proceedings for the conservation, rehabilitation or liquidation of Triad.  Any such actions would likely lead TGI to institute a proceeding seeking relief from creditors under U.S. bankruptcy laws. See Item 1A, “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2009 for more information.

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


 
6

 

Reinsurance

Prior to entering into run-off, Triad entered into various captive reinsurance agreements that were designed to allow lenders to share in the risks of mortgage insurance.  Under the typical captive reinsurance agreement, a captive reinsurer, generally an affiliate of the lender, assumed a portion of the risk associated with the lender’s book of business insured by Triad in exchange for a percentage of the premiums that Triad collected.  All of Triad’s captive reinsurance agreements include, among other things, minimum capital requirements and excess-of-loss provisions that provide for defined aggregate layers of coverage and a maximum exposure limit for the captive reinsurer.  In accordance with the excess-of-loss provisions, Triad retains the first loss position on the first aggregate layer of risk and reinsures a second defined aggregate layer with the captive reinsurer.  Triad generally retains the remaining risk above the defined aggregate layer reinsured with the captive reinsurer.

Although a percentage of premiums and certain reserves and losses are ceded to the captive reinsurer under the captive reinsurance agreements, these agreements do not relieve Triad from its obligations to policyholders.  Failure of the captive reinsurer to honor its obligations under the captive reinsurance agreement could result in losses to Triad; consequently, Triad establishes allowances for amounts deemed uncollectible from the captive reinsurer.

Triad requires each captive reinsurer to establish a trust to partially support its obligations under the captive reinsurance agreement.  The captive reinsurer is the grantor of the trust and Triad is the beneficiary of the trust.  If certain capitalization requirements of the trust are not maintained, Triad retains the right to terminate the captive reinsurance agreement.  The termination of the captive reinsurance agreement is commonly referred to as a “commutation.”  Upon commutation, Triad generally receives all remaining trust assets, reduces the reinsurance recoverable for amounts due from the captive reinsurer, and ceases ceding premium to the captive reinsurer.

Triad commuted its two largest captive reinsurance agreements during the first quarter of 2010 and received approximately $188.7 million of aggregate trust assets from the two captive reinsurers.  These two commutations resulted in an increase in the Company’s invested assets and a corresponding decrease in reinsurance recoverable during the quarter ended March 31, 2010.  The commutations had no impact on  results of operations or financial condition, as the amount recorded as reinsurance recoverable under the captive reinsurance agreements was limited to the captive reinsurers’ accumulated trust balances.  The Company’s receipt of the $188.7 million of trust assets, however, positively impacted its cash flows for the quarter ended March 31, 2010 and the first six months of 2010.

At June 30, 2010, there were approximately $73.0 million in captive reinsurance trust balances supporting the risk transferred to the captive reinsurers, of which approximately $47.2 million has been recognized as a benefit in the Company’s financial statements.  As Triad cannot force capital contributions by captive reinsurers, the Company limits the amount of benefit recognized on reserves ceded to captives to the trust balance.  As of June 30, 2010, there were certain captive reinsurance agreements where the potential reserves that could be ceded based upon the terms of the captive reinsurance agreements, combined with any unpaid ceded claims, had exceeded the trust balance and the actual reserves ceded were limited to the trust balances.

Loss Reserves

The Company establishes loss reserves to provide for the estimated costs of settling claims on loans reported in default and estimates on loans in default that are in the process of being reported to the Company as of the date of the financial statements.  Consistent with industry accounting practices, the Company does not establish loss reserves for future claims on insured loans that are not currently in default.  Loss reserves are established by management using historical experience and by making various assumptions and judgments about claim rates (frequency) and claim amounts (severity) to estimate ultimate losses to be paid on loans in default.  The Company’s reserving methodology gives effect to current economic conditions and profiles delinquencies by such factors as, among others, default status, policy year, and the number of months the policy has been in default, as well as the
 
 
7

 
 
combined loan-to-value (“LTV”) ratio.  The Company also incorporates in the calculation of loss reserves the probability that a policy may be rescinded for underwriting violations.

A number of factors can impact the actual frequency and severity realized during the year compared to those utilized in the reserve assumptions at the beginning of the year including: changes in home prices at a faster rate than anticipated; the unanticipated impact of loan modification programs on cure rates; changes in the actual rescission rate compared to the rate utilized; the impact of a higher or lower unemployment rate than anticipated; an unanticipated slowdown or acceleration of the overall economy; or social and cultural changes that are more accepting of mortgage defaults even when the borrower has the ability to pay.  The assumptions utilized in the calculation of the loss reserve estimate are continually reviewed and adjusted as necessary.  Such adjustments are reflected in the financial statements in the periods in which the adjustments are made.

    Income Recognition

In addition to the income recognition policies related to premiums as described in the Notes to the Consolidated Financial Statements contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009, the Company recognizes the net present value of estimated future premiums of certain Modified Pool transactions where pre-determined aggregate stop loss limits in the related contracts have been met on a settled basis but for which the premium continues until the insurance in force declines to 10% of the original amount. During 2010, several Modified Pool transactions reached the aggregate stop loss limits on a settled basis and the Company has recorded approximately $11 million of estimated future premiums on these transactions.  The Company anticipates that it will continue to reach these thresholds of settled claims with respect to a number of Modified Pool transactions as claims continue to be settled.

Recent Accounting Pronouncements

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

In April 2010, the FASB issued ASU No. 2010-18, Effect of a Loan Modification When the Loan Is Part of a Pool That Is Accounted for as a Single Asset (“ASU 2010-18”).  ASU 2010-18 provides guidance on the accounting for loan modifications when the loan is part of a pool of loans accounted for as a single asset, such as acquired loans that have evidence of credit deterioration upon acquisition that are accounted for under the guidance in ASC 310-30.  ASU 2010-18 addresses diversity in practice on whether a loan that is part of a pool of loans accounted for as a single asset should be removed from that pool upon a modification that would constitute a troubled debt restructuring or remain in the pool after modification.  ASU 2010-18 clarifies that modifications of loans that are accounted for within a pool under ASC 310-30 do not result in the removal of those loans from the pool even if the modification of those loans would otherwise be considered a troubled debt restructuring.  An entity will continue to be required to consider whether the pool of assets in which the loan is included is impaired if the expected cash flows for the pool change.  The amendments in this update do not require any additional disclosures and are effective for modifications of loans accounted for within pools under ASC 310-30 occurring in the first interim or annual period ending on or after July 15, 2010.  The Company does not expect the adoption of this statement to have a material impact on its financial statements.

In April 2010, the FASB issued ASU No. 2010-13, Compensation – Stock Compensation (Topic 718): Effect of Denominating the Exercise Price of a Share-Based Payment Award in the Currency of the Market in which the Underlying Equity Security Trades (“ASU 2010-13”).  ASU 2010-13 clarifies that an employee share-based payment award with an exercise price denominated in the currency of a market in which a substantial portion of the entity’s equity shares trades should not be considered to contain a condition that is not a market, performance, or service condition. Therefore, an entity would not classify such an award as a liability if it otherwise
 
 
8

 
 
qualifies as equity. The amendments in this ASU are effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2010. Early adoption is permitted. The Company does not expect the adoption of this statement to have a material impact on its financial statements.

In February 2010, the FASB issued ASU No. 2010-09, Amendments to Certain Recognition and Disclosure Requirements (“ASU 2010-09”).  ASU 2010-09 amends FASB ASC Subtopic 855-10, Subsequent Events, to remove the requirement for a company that makes filings with the Securities and Exchange Commission (the “SEC”) to disclose the date through which subsequent events have been evaluated in both issued and revised financial statements.  This change alleviates potential conflicts between ASC Subtopic 855-10 and the SEC’s requirements.  The Company does not expect ASU 2010-09 to have any impact on its financial statements.

Effective March 31, 2010, the Company adopted ASU No. 2010-06, Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements (“ASU 2010-06”). ASU 2010-06 requires new disclosures and clarifies existing disclosure requirements about fair value measurement as set forth in Codification Subtopic 820-10.  ASU 2010-06 amends Codification Subtopic 820-10 to now require that (1) a reporting entity must disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements and describe the reasons for the transfers; (2) in the reconciliation for fair value measurements using significant unobservable inputs, a reporting entity should present separately information about purchases, sales, issuances, and settlements and (3) a reporting entity should provide disclosures about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements.  ASU 2010-06 was effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements.  Those disclosures are effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years.  The Company has included the disclosures required by ASU 2010-06 in the notes to its consolidated financial statements effective January 1, 2010, except for the disclosures related to Level 3 fair value measurements, which it plans to include in the notes to its consolidated financial statements effective January 1, 2011.

4.  Litigation

The Company is involved in litigation and other legal proceedings in the ordinary course of business as well as the matters identified below.

On February 6, 2009, James L. Phillips served a complaint against Triad Guaranty Inc., Mark K. Tonnesen and Kenneth W. Jones in the United States District Court, Middle District of North Carolina.  The plaintiff purports to represent a class of persons who purchased or otherwise acquired the common stock of the Company between October 26, 2006 and April 1, 2008 and the complaint alleges violations of federal securities laws by the Company and two of its present or former officers.  The court appointed lead counsel for the plaintiff and an amended complaint was filed on June 22, 2009.  TGI filed its motion to dismiss the amended complaint on August 21, 2009 and the plaintiff filed its opposition to the motion to dismiss on October 20, 2009.  TGI’s reply to the motion to dismiss was filed on November 19, 2009.  Oral arguments on the motion to dismiss are scheduled for August 30, 2010.

On September 4, 2009, Triad filed a complaint against American Home Mortgage (“AHM”) in the United States Bankruptcy Court for the District of Delaware seeking rescission of multiple master mortgage guaranty insurance policies (“master policies”) and declaratory relief.  The complaint seeks relief from AHM as well as all owners of loans insured under the master policies by way of a defendant class action.  Triad alleged that AHM failed to follow the delegated insurance underwriting guidelines approved by Triad, that this failure breached the master policies as well as the implied covenants of good faith and fair dealing, and that these breaches were so substantial and fundamental that the intent of the master policies could not be fulfilled and Triad should be excused from its obligations under the master policies. The total amount of risk originated under the AHM master policies, accounting for any applicable stop loss limits associated with Modified Pool contracts and less risk originated on
 
 
9

 
 
policies which have been subsequently rescinded, was $1.5 billion, of which $1.0 billion remains in force at June 30, 2010.  Triad continues to accept premiums and process claims under the master policies but, as a result of this action, Triad ceased remitting claim payments to companies servicing loans originated by AHM.  Both premiums and claim payments subsequent to the filing of the complaint have been segregated pending resolution of this action.  Triad has not recognized any benefit in its financial statements pending the outcome of the litigation.

On November 4, 2009, AHM filed an action in the Bankruptcy Court seeking to recover $7.6 million of alleged preferential payments made to Triad. AHM alleges that such payments constitute a preference and are subject to recovery by the bankrupt estate. The time period in which to respond to this request has been tolled pending settlement discussions in the above referenced AHM matter. In the event a settlement is not successfully concluded, Triad intends to vigorously defend this matter.

On December 11, 2009, American Home Mortgage Servicing, Inc. filed a complaint against Triad for damages, declaratory relief, and injunction in the United States District Court, Northern District of Texas.  The complaint alleged that Triad denied payment on legitimate claims on 15 mortgage insurance loans and sought damages, a declaration that Triad’s mortgage insurance policies prohibit denial of claim without evidence of harm, and an injunction against future like denials.  The parties filed a Joint Notice of Settlement and Motion for Dismissal with Prejudice on July 8, 2010, which the Court granted on July 13, 2010.  The settlement is not expected to have a material financial impact on the Company.

On March 5, 2010, Countrywide Home Loans, Inc. filed a lawsuit in the Los Angeles County Superior Court of the State of California alleging breach of contract and seeking a declaratory judgment that bulk rescissions of flow loans is improper and that Triad is improperly rescinding loans under the terms of its master policies. On May 10, 2010 the case was designated as complex and transferred to the Court’s Complex Litigation Program.  Triad intends to vigorously defend this matter.

5.  Investments

All fixed maturity securities are classified as “available-for-sale” and are carried at fair value. Unrealized gains on available-for-sale securities, net of tax, are reported as a separate component of accumulated other comprehensive income. Effective on and subsequent to December 31, 2008, the Company has recognized an impairment loss on all securities for which the fair value was less than the amortized cost at the balance sheet date because the Company may not be in a position to retain a security until it recovers value due to its financial condition and the regulatory oversight by the Department.


 
10

 

The amortized cost, gross unrealized gains and losses and fair value of available-for-sale securities as of June 30, 2010 and December 31, 2009 were as follows:


   
As of June 30, 2010
 
(dollars in thousands)
 
Cost or Amortized Cost
   
Gross Unrealized Gains
   
Gross Unrealized Losses
   
Fair
Value
 
             
 Fixed maturity securities:
                       
 U. S. government and agency securities
  $ 48,993     $ 1,305     $ -     $ 50,298  
 Foreign government securities
    10,044       79       -       10,123  
 Corporate debt
    541,043       37,564       -       578,607  
 Residential mortgage-backed
    102,505       5,130       -       107,635  
 Commercial mortgage-backed
    1,226       2       -       1,228  
 Asset-backed bonds
    50,222       2,424       -       52,646  
 State and municipal bonds
    99,304       7,151       -       106,455  
 Subtotal, fixed maturities
    853,337       53,655       -       906,992  
 Short term investments
    29,166       -       -       29,166  
 Total securities
  $ 882,503     $ 53,655     $ -     $ 936,158  



   
As of December 31, 2009
 
(dollars in thousands)
 
Cost or Amortized Cost
   
Gross Unrealized Gains
   
Gross Unrealized Losses
   
Fair
Value
 
             
 Fixed maturity securities:
                       
 U. S. government and agency securities
  $ 24,957     $ 303     $ -     $ 25,260  
 Foreign government securities
    9,991       311       -       10,302  
 Corporate debt
    468,998       32,001       -       500,999  
 Residential mortgage-backed
    102,392       5,014       -       107,406  
 Asset-backed bonds
    36,844       2,548       -       39,392  
 State and municipal bonds
    94,967       6,504       -       101,471  
 Subtotal, fixed maturities
    738,149       46,681       -       784,830  
 Short term investments
    26,650       1       -       26,651  
 Total securities
  $ 764,799     $ 46,682     $ -     $ 811,481  


The unrealized gains are partly due to the recovery in value of previous impairments of the fixed income securities.  These unrealized gains do not necessarily represent future gains that the Company will realize.  Changing conditions related to specific securities, overall market interest rates, or credit spreads, as well as the timing of a sale, may impact values the Company ultimately realizes.  Taxable securities typically exhibit greater volatility in value than tax-preferred securities and thus the Company expects greater volatility in unrealized gains and realized losses going forward as taxable securities represent a growing percentage of its overall investment portfolio.  Volatility may increase in periods of uncertain market or economic conditions.


 
11

 

The amortized cost and estimated fair value of fixed maturity available-for-sale securities at June 30, 2010 are summarized by stated maturity as follows:


   
Available-for-Sale
 
(dollars in thousands)
 
Amortized
Cost
   
Fair
Value
 
             
 Maturity:
           
 One year or less
  $ 92,279     $ 94,137  
 After one year through five years
    473,465       504,075  
 After five years through ten years
    153,053       163,915  
 After ten years
    134,540       144,865  
 Total
  $ 853,337     $ 906,992  


Actual maturities may differ from contractual maturities because issuers may have the right to call or pre-pay obligations.  Additionally, both residential and commercial mortgage-backed securities may realize different actual maturities due to the periodic principal pay downs, among other factors.

Realized (Losses) Gains Related to Investments

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


   
Three Months Ended
   
Six Months Ended
 
   
June 30,
   
June 30,
 
(dollars in thousands)
 
2010
   
2009
   
2010
   
2009
 
                         
 Securities available-for-sale:
                       
 Fixed maturity securities:
                       
 Gross realized gains
  $ 1,136     $ 1,844     $ 1,148     $ 2,682  
 Gross realized losses
    (2,103 )     (47 )     (2,357 )     (5,352 )
 Equity securities:
                               
 Gross realized gains
    11       58       15       62  
 Gross realized losses
    -       -       -       (83 )
 Foreign currency gross realized losses
    -       116       -       95  
 Other investment (losses) gains
    (29 )     46       (33 )     48  
 Net realized (losses) gains
  $ (985 )   $ 2,017     $ (1,227 )   $ (2,548 )



 
12

 

6.  Fair Value Measurement

Fair Value of Financial Instruments

The carrying values and fair values of financial instruments as of June 30, 2010 and December 31, 2009 are summarized below:


   
June 30, 2010
   
December 31, 2009
 
(dollars in thousands)
 
Carrying
Value
   
Fair
Value
   
Carrying
Value
   
Fair
Value
 
                         
 Financial Assets
                       
 Fixed maturity securities available-for-sale
  $ 906,992     $ 906,992     $ 784,830     $ 784,830  
 Short-term investments
    29,166       29,166       26,651       26,651  
 Cash and cash equivalents
    35,576       35,576       21,839       21,839  
 Financial Liabilities
                               
 Long-term debt
    34,546       4,903       34,540       7,268  


Valuation Methodologies and Associated Inputs

The Company utilizes the provisions of ASC 820 in its estimation and disclosures about fair value.  ASC 820 defines fair value, establishes a framework for measuring fair value under GAAP, and expands disclosures about fair value measurements.  ASC 820 applies to other accounting pronouncements that require or permit fair value measurements.  Effective for its fiscal year beginning January 1, 2010, the Company adopted the provisions of ASU 2010-06, which amended ASC 820 to require a number of additional disclosures regarding fair value measurements.

ASC 820 establishes a fair value hierarchy that prioritizes the inputs to valuation methods used to measure fair value.  The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements).  The three levels of the fair value hierarchy under ASC 820 are as follows:

 
Level 1:
Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.
 
Level 2:
Quoted prices in markets that are not active, or inputs that are observable either directly or indirectly, for substantially the full term of the asset or liability.
 
Level 3:
Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported with little or no market activity).

An asset’s or a liability’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement. An asset’s or liability’s level within the fair value hierarchy is determined at the end of the reporting period. At June 30, 2010, approximately 0.2% of our invested assets were Level 3 securities.

Investments carried at fair value are measured based on assumptions used by market participants in pricing the security.  The Company relies primarily on a third-party pricing service to determine the fair value of its investments. Prices received from third parties are not adjusted; however, the third-party pricing service’s valuation methodologies and related inputs are analyzed and additional evaluations are performed to determine the appropriate level within the fair value hierarchy. Fair value measurement is based on a market approach, which utilizes prices and other relevant information generated by market transactions involving identical or comparable securities.  In addition to the third-party pricing service, sources of inputs to the market approach may include independent broker quotations or pricing matrices.  
 
 
13

 
 
Observable and unobservable inputs are used in the valuation methodologies and these are based on a set of standard inputs that are generally used to evaluate all of our available-for-sale securities.  The standard inputs used in order of priority are benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers and reference data.  Depending on the type of security or the daily market activity, standard inputs may be prioritized differently or may not be available for all available-for-sale securities on any given day.  In addition, market indicators, industry and economic events are monitored and further market data is acquired if certain triggers are met.  For certain security types, additional inputs may be used, or some of the inputs described above may not be applicable.  

For broker-quoted only securities, quotes from market makers or broker-dealers are obtained from sources recognized to be market participants.   For those securities trading in less liquid or illiquid markets with limited or no pricing information, unobservable inputs are used in order to measure the fair value of these securities.  In cases where this information is not available, such as for privately placed securities, fair value is estimated using an internal pricing matrix.  This matrix relies on judgment concerning the discount rate used in calculating expected future cash flows, credit quality, industry sector performance and expected maturity.

The following is a description of the valuation methodologies used in determining the fair value of our assets and liabilities.

Fixed maturities

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

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

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

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

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

Asset-backed bonds – The fair value of asset-backed bonds is based on prices of similar securities and discounted cash flow analysis incorporating prepayment and default assumptions. Asset-backed bonds are generally categorized as Level 2. For certain securities, if cash flow or other security structure or market information is not available, the fair value may be based on broker quotes or benchmarked to an index. In such instances, these asset-backed bonds are generally categorized as Level 3.
 
 
14

 

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

Short-term investments

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

Other short-term instruments – Other short-term instruments primarily include discounted and coupon bearing commercial paper. The fair value is based on a matrix-based approach incorporating days to maturity, current rates from market makers, as well as the coupon rate where appropriate. Other short-term instruments are generally categorized as Level 2.

Long-term debt

The $35 million aggregate principal amount of 7.90% Notes due January 15, 2028 (the “Notes”) outstanding at June 30, 2010 is the obligation of TGI and not of Triad.  Debt service amounts to $2.8 million per year and is paid by TGI. Subsequent to June 30, 2010, the Company repurchased and retired all of the outstanding Notes from the individual holders for an aggregate purchase price of approximately $4.9 million and also paid accrued interest due to holders of record as of July 1, 2010.  Due to the repurchase and early retirement of the Notes subsequent to June 30, 2010, the fair value of the Company’s long-term debt at June 30, 2010 was determined to be the actual amount subsequently paid, while the fair value at December 31, 2009 was calculated using a discounted cash flow methodology, giving effect only to the anticipated interest payments based upon available funds at that date.


 
15

 

Fair Value of Investments

The Company did not have any material assets or liabilities measured at fair value on a non-recurring basis as of June 30, 2010 or at December 31, 2009.  During the first six months of 2010, there were no transfers of securities within the fair value hierarchy. The following table summarizes the assets measured at fair value on a recurring basis and the source of the inputs in the determination of fair value as of June 30, 2010 and December 31, 2009:


   
Fair Value at Reporting Date Using
 
(dollars in thousands)
 
June 30, 2010
   
Quoted Prices in Active Markets for Identical Assets
 (Level 1)
   
Significant Other Observable Inputs
(Level 2)
   
Significant Unobservable Inputs
(Level 3)
 
             
 Assets
                       
 Securities available-for-sale
                       
Fixed maturities:
                       
U. S. government and agency securities
  $ 50,298     $ -     $ 50,298     $ -  
Foreign government securities
    10,123       -       10,123       -  
Corporate debt
    578,607       -       578,607       -  
Residential mortgage-backed
    107,635       -       107,635       -  
Commercial mortgage-backed
    1,228       -       1,228       -  
Asset-backed bonds
    52,646       -       50,600       2,046  
State and municipal bonds
    106,455       -       106,455       -  
Total fixed maturities
    906,992       -       904,946       2,046  
 Short-term investments
                               
   Money market instruments
    26,388       26,388       -       -  
   Commercial paper
    2,778       -       2,778       -  
Total
  $ 936,158     $ 26,388     $ 907,724     $ 2,046  



   
Fair Value at Reporting Date Using
 
(dollars in thousands)
 
December 31, 2009
   
Quoted Prices in Active Markets for Identical Assets
 (Level 1)
   
Significant Other Observable Inputs
(Level 2)
   
Significant Unobservable Inputs
(Level 3)
 
             
 Assets
                       
 Securities available-for-sale
                       
 Fixed maturities:
                       
U. S. government and agency securities
  $ 25,260     $ -     $ 25,260     $ -  
Foreign government securities
    10,302       -       10,302       -  
Corporate debt
    500,999       -       500,999       -  
Residential mortgage-backed
    107,406       -       107,406       -  
Asset-backed bonds
    39,392       -       37,398       1,994  
State and municipal bonds
    101,471       -       101,471       -  
Total fixed maturities
    784,830       -       782,836       1,994  
 Short-term investments
                               
   Money market instruments
    25,889       25,889       -       -  
   Commercial paper
    762       -       762       -  
Total
  $ 811,481     $ 25,889     $ 783,598     $ 1,994  

 
 
16

 
 
Significant unobservable inputs (Level 3) were used in determining the fair value on certain bonds in the fixed maturities portfolio during this period.  The following table provides a reconciliation of the beginning and ending balances of these Level 3 bonds and the related gains and losses related to these assets during the three month and six month periods ended June 30, 2010 and 2009, respectively.


Fair Value Measurement Using Significant Unobservable Inputs (Level 3)
 
                         
   
Three Months Ended
   
Six Months Ended
 
   
June 30,
   
June 30,
 
(dollars in thousands)
 
2010
   
2009
   
2010
   
2009
 
                         
Securities available-for-sale
                       
Asset-backed bonds:
                       
 Beginning balance
  $ 1,982     $ 1,757     $ 1,994     $ 2,535  
 Transfers into Level 3
    -       -       -       -  
 Transfers out of Level 3
    -       -       -       -  
 Total gains and losses (realized and unrealized):
                               
 Included in operations
    (64 )     (43 )     (185 )     (331 )
 Included in other comprehensive income
    104       133       121       50  
 Purchases, issuances and settlements
                               
 Purchases
    46       -       139       -  
 Issuances
    -       -       -       -  
 Sales
    (22 )     (10 )     (23 )     (417 )
 Settlements
    -       -       -       -  
 Ending balance
  $ 2,046     $ 1,837     $ 2,046     $ 1,837  
                                 
 The amount of total gains and losses for the period included in operations attributable to realized losses and the change in unrealized gains or losses relating to assets still held at the reporting date.
  $ 41     $ 90     $ (63 )   $ (281 )

 
 
7.  Earnings (Loss) Per Share ("EPS")

Basic and diluted EPS are based on the weighted-average daily number of shares outstanding.  In computing diluted EPS, only potential common shares that are dilutive – those that reduce EPS or increase loss per share – are included.  Exercises of options and unvested restricted stock are not assumed if the result would be antidilutive, such as when a loss from operations is reported.  For the three months ended June 30, 2010, there is no dilutive effect of stock options and unvested restricted stock on the weighted-average shares outstanding.  For the six months ended June 30, 2010, the denominator used to calculate diluted EPS includes the dilutive effects of unvested restricted stock on 2,922 weighted-average shares outstanding.  For the three month and six month periods ended June 30, 2009, the basic and diluted EPS denominators are the same weighted-average daily number of shares outstanding.  The numerator used in both the basic EPS and diluted EPS calculation is the gain or loss reported for the period represented.

8.  Comprehensive Income (Loss)

Comprehensive income (loss) consists of net income (loss) and other comprehensive income (loss).  For the Company, other comprehensive income (loss) is normally composed of unrealized gains or losses on available-for-sale securities, net of income taxes. However, when an entity is in a net operating loss (“NOL”) carry forward position for income tax purposes, ASC 740, Income Taxes (“ASC 740”) requires that unrealized gains (losses) not be reported net of income taxes in those periods where taxable income is reported.  Effective with the issuance of the first Corrective Order, the Company no longer has the ability to hold securities in an unrealized loss position until such time that the securities recover in value or mature due to the possibility that Illinois law may require the
 
 
17

 
 
Department to seek receivership if the corrective plan were deemed ineffective.  Thus, any security with a fair value less than the book value at the balance sheet date is considered to be other-than-temporarily impaired and the loss is recognized as a realized loss in the Statements of Operations. For the three months and six months ended June 30, 2010, the Company’s other comprehensive income was $5.4 million and $6.7 million, respectively, and the Company’s comprehensive income was $84.5 million and $58.0 million, respectively.  For the three month and six month periods ended June 30, 2009, the Company’s other comprehensive income was $10.9 million and $21.2 million, respectively, and the Company’s comprehensive loss was $348.5 million and $393.4 million, respectively.

9.  Income Taxes

Income tax expense (or benefit) for each year is allocated to continuing operations, discontinued operations, extraordinary items, other comprehensive income, and other charges or credits recorded directly to shareholders’ equity. This allocation is commonly referred to as intra-period tax allocation of ASC 740. When considering intra-period tax allocations, a company also should consider the accounting for income taxes in interim periods. ASC 740-20-45-7 requires that the tax effect of pretax income from continuing operations be determined without regard to the tax effects of items not included in continuing operations. This is commonly referred to as the “incremental approach” where the tax provision is generally calculated for continuing operations without regard to other items.

ASC 740 also includes an exception to the general principle of intra-period tax allocation discussed above. This exception requires that all items (i.e., extraordinary items, discontinued operations, and so forth, including items charged or credited directly to other comprehensive income) be considered in determining the amount of tax benefit that results from a loss from continuing operations. That is, when a company has a current period loss from continuing operations, management must consider income recorded in other categories in determining the tax benefit that is allocated to continuing operations.

The exception in ASC 740 applies in all situations in which there is a loss from continuing operations and income from other items outside of continuing operations. This would include situations in which a company has recorded a full valuation allowance at the beginning and end of the period and the overall tax provision for the year is zero (i.e., a benefit would be recognized in continuing operations even though the loss from continuing operations does not provide a current year incremental tax benefit).  The ASC 740 exception, however, only relates to the allocation of the current year tax provision (which may be zero) and does not change a company’s overall tax provision. While intra-period tax allocation in general does not change the overall tax provision, it may result in a gross-up of the individual components, thereby changing the amount of tax provision included in each category.

The Company has established a full valuation allowance for the portion of deferred tax assets that are not expected to be realized, primarily the NOL tax carry forward.  For the 2010 first quarter, the Company qualified for the exception to the intra-period tax allocation rules under ASC 740 as the Company had a loss from continuing operations, was forecasting a loss from continuing operations for the year, and also had income outside of continuing operations. This exception required that the Company record the tax expense related to the increase in unrealized gains through other comprehensive income and the tax benefit related to the reduction in the valuation allowance through continuing operations.

For the 2010 second quarter, the exception to the intra-period tax allocation rules under ASC 740 no longer applied, as the Company was now forecasting income from both continuing operations and outside of continuing operations for the year. The standard intra-period tax allocation rules require that the reduction in the valuation allowance related to an increase in unrealized gains be recorded in other comprehensive income, and not through continuing operations. Accordingly, the Company has reversed the entry made to income tax benefit for the second quarter.  The income tax expense (benefit) for the three month and six month periods ended June 30, 2010 and June 30, 2009, respectively, differs substantially from that which is computed by applying the Federal statutory income tax rate of 35% to the income (loss) before income taxes. This difference is due to the Company’s NOL tax carry forward position as noted above.

 
18

 
 
10. Subsequent Events

During July 2010, TGI repurchased and retired the entire $35 million aggregate principal amount of its 7.90% Notes due January 15, 2028 for an aggregate purchase price of approximately $4.9 million. The Company expects to recognize a gain on the repurchase and early retirement of approximately $30 million in the period ending September 30, 2010.


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

Management's Discussion and Analysis of Financial Condition and Results of Operations analyzes our consolidated financial condition, changes in financial position, and results of operations for the three months and six months ended June 30, 2010 and 2009.  This discussion supplements Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2009, and should be read in conjunction with the interim financial statements and notes contained herein.

Certain of the statements contained in this quarterly report on Form 10-Q are "forward-looking statements" and are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements include estimates and assumptions related to economic, competitive, regulatory, operational and legislative developments and typically are identified by use of terms such as “may,” “will,” “should,” “could,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” “continue” and similar words, although some forward-looking statements are expressed differently. These forward-looking statements are subject to change, uncertainty and circumstances that are, in many instances, beyond our control and they have been made based upon our current expectations and beliefs concerning future developments and their potential effect on us. Actual developments and their results could differ materially from those expected by us, depending on the outcome of a number of factors, including: the possibility that the Illinois Department of Insurance may take various actions regarding Triad if it does not operate its business in accordance with its revised financial and operating plan and the Corrective Orders, including seeking receivership proceedings; our ability to operate our business in run-off and maintain a solvent run-off; our ability to continue as a going concern; the possibility of general economic and business conditions that are different than anticipated; legislative, regulatory, and other similar developments; changes in interest rates, employment rates, the housing market, the mortgage industry and the stock market; the possibility that there will not be adequate interest in our common stock to ensure efficient pricing; and the relevant factors described in this report under the heading "Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995," as well as the risks and uncertainties described in our Annual Report on Form 10-K for the year ended December 31, 2009 and in other reports and statements that we file with the Securities and Exchange Commission (the “SEC”).  Forward-looking statements are based upon our current expectations and beliefs concerning future events and we undertake no obligation to update or revise any forward-looking statements to reflect the impact of circumstances or events that arise after the date the forward-looking statements are made, except as required by the federal securities laws.

Overview

Triad Guaranty Inc. (“TGI”) is a holding company that historically provided private mortgage insurance coverage in the United States through its wholly-owned subsidiary, Triad Guaranty Insurance Corporation (“TGIC”).  Unless the context requires otherwise, references to “Triad” in this quarterly report on Form 10-Q refer to the operations of TGIC and its wholly-owned subsidiary, Triad Guaranty Assurance Corporation (“TGAC”).  References to “we,” “us,” “our,” and the “Company” refer collectively to the operations of TGI and Triad.

TGIC is an Illinois-domiciled insurance company and TGAC is an Illinois-domiciled reinsurance company. The Illinois Department of Insurance (the “Insurance Department”) is the primary regulator of both TGIC and TGAC.  The Illinois Insurance Code grants broad powers to the Insurance Department and its director (collectively,
 
 
19

 
 
the “Department”) to enforce rules or exercise discretion over almost all significant aspects of our insurance business.  Triad ceased issuing new commitments for mortgage guaranty insurance coverage on July 15, 2008 and is operating its business in run-off under two Corrective Orders issued by the Department.  As used in this quarterly report, the term "run-off" means writing no new mortgage insurance policies, but continuing to service existing policies.  Servicing existing policies includes: receiving premiums on policies that remain in force; cancelling coverage at the insured’s request; terminating policies for non-payment of premium; working with borrowers in default to remedy the default and/or mitigate our loss; reviewing policies for the existence of misrepresentation, fraud or non-compliance with stated programs; and settling all legitimate filed claims per the provisions of the two Corrective Orders issued by the Department.  The term “settled,” as used in this quarterly report in the context of the payment of a claim, refers to the satisfaction of Triad’s obligations following the submission of valid claims by our policyholders.  Prior to June 1, 2009, valid claims were settled solely by a cash payment.  Effective on and after June 1, 2009, valid claims are settled by a combination of 60% in cash and 40% in the form of a deferred payment obligation (“DPO”).  The Corrective Orders, among other things, allow management to continue to operate Triad under the close supervision of the Department, include restrictions on the distribution of dividends or interest on notes payable to TGI by Triad, and include restrictions on the payment of claims.

We have historically provided Primary and Modified Pool mortgage guaranty insurance coverage on U.S. residential mortgage loans.  We classify insurance as Primary when we are in the first loss position and the loan-to-value amount, or LTV, is 80% or greater when the loan is first insured.  We classify all other insurance as Modified Pool.  The majority of our Primary insurance has been delivered through the flow channel, which is defined as loans originated by lenders and submitted to us on a loan-by-loan basis.  We have also historically provided mortgage insurance to lenders and investors who seek additional default protection (typically secondary coverage or on loans for which the individual borrower has greater than 20% equity), capital relief, and credit-enhancement on groups of loans that are sold in the secondary market.  Insurance provided on these individual transactions was provided through the structured bulk channel.  Those individual loans in the structured bulk channel in which we are in the first loss position and the LTV ratio is greater than 80% are classified as Primary.

Our insurance remains effective until one of the following events occurs:  the policy is cancelled at the insured’s request; we terminate the policy for non-payment of premium; the policy defaults and we satisfy our obligations under the insurance contract; or we rescind or deny the policy for violations of provisions of a master policy. Additionally, coverage may be cancelled on certain Modified Pool transactions if pre-determined aggregate stop loss limits are met, or if coverage is reduced to a de minimus amount.

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

In run-off, our expenses consist primarily of: settled claims net of any losses ceded to captive reinsurers; changes in reserves for estimated future claim payments on loans that are currently in default net of any reserves ceded to captive reinsurers; general and administrative costs of servicing existing policies; other general business expenses; and interest expense.

Our results of operations in run-off depend largely on:
 
·  
the conditions of the housing, mortgage and capital markets that have a direct impact on default rates, mitigation efforts, cure rates and ultimately the amount of claims settled;
·  
the overall general state of the economy and job market;
·  
persistency levels on our remaining insurance in force;
·  
operating efficiencies; and
·  
the level of investment yield, including realized gains and losses, on our investment portfolio.
 
 
20

 
 
Our results of operations in run-off could also be impacted significantly by recent federal government and private initiatives to stabilize the housing and financial markets.  See the discussion below for further details on these initiatives.

Corrective Orders

Triad has entered into two Corrective Orders with the Department as detailed in our Annual Report on Form 10-K for the year ended December 31, 2009.  Among other things, the Corrective Orders:

·  
Require the oversight of the Department on substantively all operating matters;
·  
Prohibit all stockholder dividends from Triad to TGI without the prior approval of the Department;
·  
Prohibit interest and principal payments on Triad’s surplus note to TGI without the prior approval of the Department;
·  
Restrict Triad from making any payments or entering into any transaction that involves the transfer of assets to, or liabilities from, any affiliated parties without the prior approval of the Department;
·  
Require Triad to obtain prior written approval from the Department before entering into certain transactions with unaffiliated parties;
·  
Require that all valid claims under Triad’s mortgage guaranty insurance policies are settled 60% in cash and 40% by recording a DPO; and
·  
Require that loss reserves in financial statements prepared in accordance with Statutory Accounting Principles (“SAP”) as set forth in the Illinois Insurance Code or prescribed by the Department be established to reflect the cash portion of the estimated claim settlement but not the DPO.

The DPO is an interest bearing subordinated obligation of Triad with no stated repayment terms.  The DPO recording requirements became effective on June 1, 2009.  At June 30, 2010, the recorded DPOs, including a carrying charge of $6.0 million, amounted to $292.2 million.  The recording of a DPO does not impact reported settled losses as we continue to report the entire amount of a claim in our statement of operations.  The accounting for the recorded DPOs on a SAP basis is similar to a surplus note which is reported as a component of statutory surplus; accordingly, any repayment of the DPOs or the associated carrying charges is dependent on the financial condition and future prospects of Triad and is subject to the approval of the Department.  However, in our financial statements prepared in accordance with GAAP included in this report, the DPOs and related accrued interest are reported as a liability.  At June 30, 2010, the cumulative effect of the DPO requirement on statutory policyholders’ surplus, including the impact of establishing loss reserves, was to increase statutory policyholders’ surplus by $779.7 million over the amount that would have been reported absent the second Corrective Order.  There was no such impact to loss reserves or stockholders’ deficit calculated on a GAAP basis.

Failure to comply with the provisions of the Corrective Orders or any other violation of the Illinois Insurance Code may result in the imposition of fines or penalties or subject Triad to further legal proceedings, including the institution by the Department of receivership proceedings for the conservation, rehabilitation or liquidation of Triad.  Any such actions would likely lead TGI to institute a proceeding seeking relief from creditors under U.S. bankruptcy laws. See Item 1A, “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2009 for more information.

Triad is also subject to comprehensive regulation by the insurance departments of the other states in which it is licensed to transact business.  Currently, the insurance departments of the other states are working with the Department in the implementation of the Corrective Orders.


 
21

 

Going Concern

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

Prior to the Corrective Orders, our recurring losses from operations and resulting decline in policyholders’ surplus as calculated in accordance with SAP increased the likelihood that Triad would be placed into receivership and raised substantial doubt about our ability to continue as a going concern.  The positive impact on surplus resulting from the second Corrective Order has resulted in Triad reporting a policyholders’ surplus in its SAP financial statements of $155.2 million at June 30, 2010, as opposed to a deficiency in policyholders’ surplus of $624.5 million on the same date had the second Corrective Order not been implemented.  While implementation of the Corrective Orders have deferred the institution of an involuntary receivership proceeding, no assurance can be given that the Department will not seek receivership of Triad in the future and there continues to be substantial doubt about our ability to continue as a going concern.  The Department may seek receivership of Triad based on its determination that Triad will ultimately become insolvent or for other reasons stated above.  If the Department were to seek receivership of Triad, TGI could be compelled to institute a proceeding seeking relief from creditors under U.S. bankruptcy laws.  Our consolidated financial statements that are presented in this report do not include any adjustments that reflect the financial risks of Triad entering receivership proceedings and assume that we will continue as a going concern.

Although we reported net income of $79.1 million during our 2010 second quarter, we continued to report a deficit in assets under GAAP of $648.1 million at June 30, 2010 compared to a deficit in assets of $732.7 million at March 31, 2010 and $706.4 million at December 31, 2009.  A deficit in assets occurs when recorded liabilities exceed recorded assets in financial statements prepared under GAAP and is not necessarily a measure of insolvency. During the second quarter of 2010, we experienced a decline in the number of new defaults and an increase in the cures coming from both government-sponsored and servicer loan modification programs, and we made a change in the reserve factors utilized in our reserve methodology.  These factors, combined with an additional accrual of earned premium, were the primary drivers of the net income we reported in the second quarter of 2010.  Since the second quarter income was attributable to items that we believe are unlikely to occur again in the future in similar amounts, we do not expect to report similar levels of net income, and may report no net income at all, in future periods.  We will have to earn in excess of $648.1 million on a GAAP basis during the remaining run-off period in order to continue as a going concern.

See Item 1A, “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2009 for more information about our financial solvency and going concern risks and uncertainties.

Long-term Debt

During July 2010, we repurchased and retired early the entire $35 million aggregate principal amount of TGI’s outstanding 7.90% Notes due January 15, 2028 (the “Notes”).  We expect to recognize a gain on the repurchase and retirement of approximately $30.1 million in the quarter ending September 30, 2010, which will be reported as an “extraordinary item” under ASC 225-20.  We used a portion of TGI’s existing cash and invested assets to repurchase and retire the Notes.  Subsequent to the repurchase of the Notes, TGI’s existing cash and invested assets amounted to approximately $1.2 million, excluding amounts due to TGI from Triad.  On July 15, 2010, we also paid the semi-annual interest payment of $1.4 million due under the Notes. As a result of the repurchase and early retirement of the Notes, there will be no further interest due under the Notes. See further discussion under the heading, “Liquidity – Holding Company Specific”.


 
22

 

Captive Reinsurer Commutations

Prior to entering into run-off, we entered into various captive reinsurance agreements that were designed to allow lenders to share in the risks of mortgage insurance.  Under the typical captive reinsurance agreement, a captive reinsurer, generally an affiliate of the lender, assumed a portion of the risk associated with the lender’s book of business insured by us in exchange for a percentage of the premiums that we collected.  We require each captive reinsurer to establish a trust to partially support its obligations under the captive reinsurance agreement.  If certain capitalization requirements of the trust are not maintained, we retain the right to terminate the captive reinsurance agreement.  The termination of the captive reinsurance agreement is commonly referred to as a “commutation.”  Upon commutation, we generally receive all remaining trust assets, reduce the reinsurance recoverable for amounts due from the captive reinsurer, and cease ceding premium to the captive reinsurer.

During the first quarter of 2010, we determined that our two largest captive reinsurers had not maintained the required capitalization in their trusts.  As a result, and with the mutual agreement of each of the captive reinsurers, we commuted both of these captive reinsurance agreements during the first quarter and received approximately $188.7 million of aggregate trust assets from the two captive reinsurers.  These two commutations resulted in an increase in our invested assets and a corresponding decrease in reinsurance recoverable during the quarter ended March 31, 2010.  The commutations had no impact on our results of operations or financial condition for the quarter, as the amount recorded as reinsurance recoverable under the captive reinsurance agreements was limited to the captive reinsurers’ accumulated trust balances (see Note 3 to the consolidated financial statements).  Our receipt of the $188.7 million of trust assets, however, positively impacted our cash flows in the first quarter and first six months of 2010.

We are currently assessing our remaining captive reinsurers’ compliance with their capitalization requirements, and we are in discussions with several captive reinsurers regarding the potential commutation of their captive reinsurance agreements.  We currently do not expect the impact of any future commutations to have a material impact on our results of operations or financial condition.

Foreclosure Prevention Initiatives

Several programs have been initiated by the federal government and certain lenders that are, in general, designed to prevent foreclosures and provide relief to homeowners. These programs may involve modifications to the original terms of existing mortgages or their complete refinancing.  These programs are designed to provide a means for borrowers to qualify for lower payments by modifying the interest rate or extending the term of the mortgage.

One such program is the Home Affordable Modification Program (“HAMP”), which provides incentives to borrowers, servicers, and lenders to modify loans with the modifications jointly paid for by lenders and the U.S. government. A significant percentage of our cures over the previous six months have been attributable to HAMP and other foreclosure prevention programs. However, we believe that the number of policies that are successfully modified under these programs will decrease in future periods as the number of policies eligible for the programs decline.

We rely on information concerning HAMP provided to us by the GSEs and servicers.  We do not believe that we receive timely information on all of the loans participating in these programs nor the current status of the participating loans and we do not have the necessary information to determine the number of our policies in force that would be eligible for such modification programs.  Furthermore, once a policy completes the trial modification period, it may re-default and we currently cannot predict with any degree of precision the re-default rate. These factors affect our ability to evaluate the ultimate success rate of HAMP and other such programs and, therefore, the impact on our results of operations and financial condition.  If HAMP and/or similar programs prove to be effective in preventing ultimate foreclosure, future settled claim activity could be reduced.
 
 
23

 
 
If a loan is modified or refinanced as part of one of these programs, we intend to maintain insurance on the loan and are subject to the same ongoing risk if the policy were to re-default.  Furthermore, these programs could adversely affect us to the degree that borrowers who otherwise could make their mortgage payment choose to default in an attempt to become eligible for modification. The ultimate impact of these government programs on our future results of operations and prospects is unknown at this time.  See Item 1A, “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2009 for more information.

Consolidated Results of Operations

Following is selected financial information for the three-month and six-month periods ended June 30, 2010 and 2009:


   
Three Months Ended
 
Six Months Ended
   
June 30,
 
June 30,
(dollars in thousands, except
   per share data)
 
2010
   
2009
   
% Change
 
2010
   
2009
   
% Change
     
             
Earned premiums
  $ 72,330     $ 64,833       12     $ 118,218     $ 109,191       8  
Net (benefit) losses and loss adjustment expenses
    (7,770 )     431,368       (102 )     64,468       532,945       (88 )
Net income (loss)
    79,121       (359,419 )     (122 )     51,311       (414,593 )     (112 )
Diluted earnings (loss) per share
    5.24       (23.91 )     (122 )     3.40       (27.65 )     (112 )

We reported quarterly net income of $79.1 million for the 2010 second quarter, a significant change from the 2010 first quarter and the 2009 second quarter.  A decline in the number of new defaults, an increase in cures due primarily to government-sponsored and servicer loan modification programs, and a change to the reserve factors utilized in our reserve methodology, coupled with an additional accrual of earned premiums, were the primary factors contributing to our net income reported for the second quarter of 2010.

Net losses and loss adjustment expenses (“LAE”) were a benefit of $7.8 million and an expense of $64.5 million for the three and six months ended June 30, 2010, respectively, a considerable improvement from the expenses reported in the respective periods of 2009.  Net losses and LAE are comprised of net settled claims and LAE as well as the increase in the loss and LAE reserves net of any reinsurance recoverables. Improved cure rates experienced during the first two quarters of 2010 caused us to adjust our reserve factors during the second quarter of 2010 for future cure rates on existing defaults. These adjustments, along with modestly higher rescission expectations, resulted in a reduction to our estimated reserve for losses.

We also experienced a decrease in the number of loans in default and the amount of risk in default, which was due to improved cure rates, paid claim activity, rescission activity, and a consistent decline in the number of new defaults over the first six months of 2010. While we are pleased with the decrease in the number of defaults and the amount of risk in default during the second quarter of 2010, the continuation of these trends is uncertain given the ongoing weakness in the mortgage and housing markets, high unemployment, and the potential for re-default under HAMP and other foreclosure prevention programs.

Direct paid claims during the second quarter of 2010 were $150.3 million, generally consistent with the first quarter of 2010, but down from $163.8 million paid during the second quarter of 2009.  For the six months ended June 30, 2010, direct paid claims totaled $299.6 million, compared to $227.8 million for the six months ended June 30, 2009.

Earned premium during the second quarter of 2010 increased by 57.6% from the first quarter of 2010 and 11.6% from the one-year prior period.  In the second quarter of 2010, we recognized approximately $11.5 million of accrued premium for certain Modified Pool transactions where pre-determined aggregate stop loss limits in the contracts were met on a settled basis because the premium continues to accrue until the insurance in force declines
 
 
24

 
 
to 10% of the original amount.  Earned premium during the second quarter also benefitted from a smaller impact from expected premium refunds from rescission activity and the reduction in ceded premium due to the 2010 first quarter commutation of our two largest captive reinsurers.  For the six months ended June 30, 2010, earned premiums totaled $118.2 million, up 8.3% from the six-month period ended June 30, 2009.

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

·  
Loans on properties in California, Florida, Arizona, and Nevada (collectively referred to as "distressed markets") - At June 30, 2010, the distressed markets comprised 47% of risk in default while only comprising 31% of total risk in force.  We believe the adverse performance of the distressed markets was, in part, due to non-sustainable levels of house price appreciation in the years prior to 2007 and the subsequent unprecedented depreciation in house prices.  In general, the non-distressed markets have not experienced the same degree of collapse in house prices that have occurred in the distressed markets.  However, we believe performance in the non-distressed markets has also been adversely impacted by the general depressed conditions in house prices and credit markets as well as high unemployment levels. Defaults in the distressed markets have also comprised a large percentage of paid claims and rescinded policies over the previous twelve months.

·  
Policies originated in 2006 and 2007 - At June 30, 2010, defaults in these policy years comprised 66% of our gross risk in default while only comprising 56% of our total risk in force. These policy years have also comprised a large percentage of both paid claims and rescinded policies over the previous twelve months.

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

Production

On July 15, 2008, we ceased issuing commitments for mortgage insurance.  Production for the three and six month periods ended June 30, 2010 was immaterial and we do not expect any material amount of production in future periods while we operate our business in run-off.

Insurance and Risk in Force
 
    The following table provides detail on our direct insurance in force at June 30, 2010 and 2009:


   
June 30,
       
(dollars in millions)
 
2010
   
2009
   
% Change
 
       
Primary insurance
  $ 33,091     $ 39,548       (16 )
Modified Pool insurance
    12,262       17,965       (32 )
Total insurance
  $ 45,353     $ 57,513       (21 )


Primary insurance in force at June 30, 2010 declined by 16% from June 30, 2009, reflecting the lack of production during the previous twelve months as well as the cancellation of insurance coverage resulting primarily from claim settlement and rescission activity. Modified pool insurance in force at June 30, 2010 declined by 32% from June 30, 2009. The decline is primarily due to claim settlement and rescission activity, as well as the termination of a number of Modified Pool transactions where pre-determined aggregate stop loss limits in the contracts were met on a settled basis.  A small portion of our Modified Pool contracts contain provisions that
 
 
25

 
 
terminate coverage and the contract when cumulative settled losses reach the stop loss limit. No future premium is received following the termination of these Modified Pool contracts.  We expect that several other Modified Pool transactions will also reach their respective stop loss limits and terminate during the remainder of 2010.  The majority of our Modified Pool contracts do not terminate when settled losses reach the stop loss limit and premiums will continue to be collected until such time that the remaining insurance in force is less than 10% of the original amount.  For contracts where the premiums continue, we expect to recognize the net present value of the expected future premium in the period during which our payments reach the maximum liability under the contract.

Approximately 81.5% of our Modified Pool insurance in force was originated in 2005, 2006, and 2007. Given the adverse development of our Modified Pool insurance originated in these years, the majority of these transactions have already reached the stop loss limit on an incurred basis. As the following table indicates, because we do not provide reserves on Modified Pool defaults when the cumulative incurred losses to date for the related transaction exceed the stop loss limit, we have limited loss exposure remaining under our Modified Pool contracts,.  Accordingly new Modified Pool defaults will have a limited net impact on our future results.  As a result, while we have previously segmented our incurred loss disclosures between Primary and Modified Pool, we expect to focus our future disclosures on our Primary business.


   
June 30,
      December 31,  
(dollars in millions)
 
2010
      2009  
               
Modified Pool Summary
             
Gross risk in force prior to stop losses and deductibles
  $ 3,590     $ 4,331  
% of risk covered by stop losses and deductibles
    85.1 %     85.0 %
Net risk in force (accounting for stop loss amounts and deductibles)
  $ 535     $ 651  
Carried reserves on net risk in force
    272       388  
Remaining aggregate loss exposure on Modified Pool contracts
  $ 263     $ 263  
                 
Remaining Aggregate Loss Exposure by Policy Year
               
2003 and Prior
  $ 121     $ 125  
2004
    80       84  
2005
    8       9  
2006
    48       39  
2007
    6       6  
    $ 263     $ 263  


Persistency levels have declined somewhat over the previous twelve months due to cancellation activity. Persistency is an important metric in understanding our future premium revenue, especially in run-off as no new business is being written and our overall premium base declines over time.  Generally, the longer a policy remains on our books, or “persists”, the greater the amount of premium revenue we will earn from the policy.  Primary insurance persistency declined slightly to 83.7% at June 30, 2010 compared to 85.6% at June 30, 2009. Modified Pool insurance persistency declined to 68.2% at June 30, 2010 compared to 87.9% at June 30, 2009 and was adversely impacted by the cancellation of certain of the Modified Pool transactions. We believe persistency has benefited from the inability of many borrowers to sell or refinance existing homes due to the decline in home prices and stricter underwriting standards.

Given the lack of production since 2008 and the relatively high levels of persistency, the composition of our risk in force has remained relatively consistent with that of a year ago.  Additionally, while our exposure to the distressed markets expressed as a percentage of our total risk in force remained relatively constant, the contribution to losses from the distressed markets has been disproportionally higher.

At June 30, 2010 and 2009, respectively, approximately 18.3% and 29.0% of our Primary risk in force is comprised of coverage on loans with the potential for negative amortization (“pay option ARM”) and interest only loans.  An inherent risk in both a pay option ARM loan and an interest only loan is the impact of the scheduled
 
 
26

 
 
milestone in which the borrower must begin making amortizing payments.  These payments can be substantially greater than the minimum payments required before the milestone is met.  An additional risk to a pay option ARM loan is that the payment being made may be less than the amount of interest accruing, creating negative amortization on the outstanding principal of the loan.  We are not provided with information on whether a borrower is required to make amortizing payments but we are provided information on the accumulation of negative amortization.  The majority of our pay-option ARM loan portfolio has accumulated negative amortization and we believe the majority of this portfolio is approaching the milestone where amortizing payments will be required.  As a result, our pay-option ARM loans may face significant payment shock in the current and future periods which increases our risk of loss. Many of these pay-option ARM loans are also from the 2006 and 2007 vintage years and are located in the distressed states.  Historically, the performance of pay-option ARM loans has benefited from, and the risk has been mitigated by, home price appreciation and the ability to refinance before amortizing payments are required.  We do not believe these historical mitigating factors are present to any meaningful degree in the current environment.

At June 30, 2010, approximately 17.8% of our Primary risk in force is comprised of coverage on Alt-A loans.  We define Alt-A loans as loans that have been underwritten with reduced or no documentation verifying the borrower’s income, assets, or employment and where the borrower has a FICO score greater than 619. We have found a substantial amount of misrepresentation, program violations, and outright fraud on the Alt-A loans in our portfolio and have been able to rescind that coverage.  Due in part to recent conditions in the housing markets, the Alt-A loans, pay-option ARM loans, and interest-only loans have, as a group, performed significantly worse than the remaining prime fixed rate loans through June 30, 2010.

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


   
June 30, 2010
   
December 31, 2009
 
(dollars in thousands)
 
Gross Primary Risk
in Force *
   
Percent of Total
   
Average Primary Risk in Force per Policy
   
Gross Primary Risk
in Force *
   
Percent of Total
   
Average Primary Risk in Force per Policy
 
                                     
Vintage Year
                                   
2004 and before
  $ 1,861,754       21.6     $ 29.4     $ 2,018,297       21.5     $ 29.6  
2005
    1,129,092       13.0       40.7       1,207,288       12.8       40.8  
2006
    1,742,235       20.2       51.2       1,907,181       20.4       51.9  
2007
    3,346,623       38.8       53.8       3,649,172       39.0       54.4  
2008
    554,224       6.4       46.7       586,753       6.3       46.8  
Total
  $ 8,633,928       100.0       43.4     $ 9,368,691       100.0       43.8  
                                                 
* Gross risk in force is on a per policy basis
                         


Primarily due to the commutation of the captive reinsurance agreements during the first quarter of 2010, the percentage of our Primary flow insurance in force subject to captive reinsurance arrangements decreased to 15.7% at June 30, 2010 from 53.1% at December 31, 2009. Assets held in trusts supporting the reinsured risk also declined to $73.0 million at June 30, 2010 from $257.3 million at December 31, 2009. Certain of the remaining captive reinsurance arrangements have trust balances below the reserves ceded under the contracts.  In those cases, the net reserve credit that we recognize in our financial statements is limited to the trust balance.  Given this limitation as 
 
 
27

 
 
well as the decline in insurance in force subject to captive reinsurance, we expect limited benefit in future periods from these arrangements.

Revenues

A summary of the individual components of our revenue for the second quarter and first six months of 2010 and 2009 follows.

   
Three Months Ended
   
Six Months Ended
 
   
June 30,
   
June 30,
 
 (dollars in thousands)  
2010
   
2009
   
%
Change
   
2010
   
2009
   
%
Change
 
             
Direct premium written before the impact of refunds
  $ 73,037     $ 74,558       (2 )   $ 142,761     $ 155,331       (8 )
Less:
                                               
Cash refunds primarily related to rescissions
    (12,943 )     (11,403 )     14       (27,953 )     (17,502 )     60  
Change in refund accruals primarily related to rescissions
    14,102       10,666       32       13,781       (8,385 )     (264 )
Direct premium written
    74,196       73,821       1       128,589       129,444          
Ceded premium written
    (2,730 )     (10,027 )     (73 )     (10,932 )     (21,157 )     (48 )
Net premium written
    71,466       63,794       12       117,657       108,287       9  
Change in unearned premiums
    864       1,039       (17 )     561       904       (38 )
Earned premiums
  $ 72,330     $ 64,833       12     $ 118,218     $ 109,191       8  
                                                 
Net investment income
  $ 10,560     $ 10,859       (3 )   $ 20,434     $ 22,051       (7 )
                                                 
Net realized investment (losses) gains
  $ (985 )   $ 2,017       (149 )   $ (1,227 )   $ (2,548 )     (52 )
                                                 
Total revenues
  $ 81,905     $ 77,711       5     $ 137,417     $ 128,698       7  


The decline in direct premium written before the impact of refunds for the three months and six months ended June 30, 2010 was primarily due to a 21.1% decline in insurance in force since June 30, 2009. Mitigating the impact of the decline in insurance in force was the recognition of approximately $11.5 million of accrued premium in the second quarter of 2010 due to the revised accounting treatment of certain Modified Pool contracts where pre-determined aggregate stop loss limits were met on a settled basis.  Under these contracts, the premium will continue to accrue until the insurance in force declines to 10% of the original amount. The amount recorded represents the net present value of all expected future premiums on these contracts. The accelerated recognition of the future premium from these Modified Pool transactions should result in lower premium recognition in future periods.

Rescission-related premium refunds also contributed to reported premium during the second quarter of 2010 as the decline in the accrual for expected refunds exceeded paid refunds. Rescission-related premium refunds, including both the cash paid out and the change in the accrual, resulted in a slight reduction to direct premium written in the second quarter of 2009. Cash premium refunded in the second quarter of 2010 increased to $12.9 million from $11.4 million in the second quarter of 2009, while the accrual we establish for expected premium refunds on policies that are currently under investigation for rescission decreased by $14.1 million in the second quarter of 2010 compared to a $10.7 million decrease in the second quarter of 2009.  At June 30, 2010, the accrual we have established for expected premium refunds declined to $33.7 million compared to $47.5 million at December 31, 2009.

Ceded premium is comprised primarily of premiums written under excess of loss reinsurance treaties with captives.  The decline in ceded premium during the second quarter and first six months of 2010 compared to the respective periods of 2009 was primarily due to a decrease in insurance in force subject to captive reinsurance, as we commuted the two largest captive reinsurance agreements in the first quarter of 2010.
 
 
28

 
 
Net investment income decreased by 3% and 7% during the second quarter and first six months of 2010 compared to the same periods of 2009, primarily due to a decrease in average invested assets as well as a decline in the realized investment yield.  For a discussion of the composition of our investment portfolio, see “Investment Portfolio.”

Losses and Expenses

A summary of the significant individual components of losses and expenses for the three-month and six-month periods ended June 30, 2010 and 2009 follows:


   
Three Months Ended
   
Six Months Ended
 
   
June 30,
   
June 30,
 
 (dollars in thousands)  
2010
   
2009
   
%
Change
   
2010
   
2009
   
%
Change
 
             
Net (benefit) losses and loss adjustment expenses
  $ (7,770 )   $ 431,368       (102 )   $ 64,468     $ 532,945       (88 )
Other operating expenses
    7,021       8,680       (19 )     16,353       18,091       (10 )
Interest expense
    2,816       1,895       49       5,285       2,589       104  
Total losses and expenses
  $ 2,067     $ 441,943       (100 )     86,106       553,625       (84 )
                                                 
Loss ratio
    (10.7 )%     665.4 %     (102 )     54.5 %     488.1 %     (89 )
Expense ratio
    9.8 %     13.6 %     (28 )     13.9 %     16.7 %     (17 )
Combined ratio
    (0.9 )%     679.0 %     (100 )     68.4 %     504.8 %     (86 )


Net losses and LAE are comprised of settled claims and LAE as well as the increase in the loss and LAE reserve during the period. Due primarily to a decrease in loss reserves, net losses and LAE, which is generally an expense, was a net benefit of $7.8 million in the second quarter of 2010.  This benefit compares to a $72.2 million expense in the first quarter of 2010 and a $431.4 million expense in the second quarter of 2009. Net losses and LAE in the second quarter of 2009 contained a significant increase in reserves as a result of upward adjustments to the reserve factors.

The individual components of net losses and LAE for the six months ended June 30, 2010 were significantly affected by the commutation of our two largest captive reinsurance agreements. The funds received from the commutations are recorded as a reimbursement of claims paid and, as the table below illustrates, the recognition of these ceded paid losses resulted in a significant reduction to reported net settled claims for the six-months ended June 30, 2010. The statement of operations was not impacted, however, as the increase in ceded paid losses was offset by a decrease to reinsurance recoverable. The following table presents the impact of the captive commutations on the components of net losses and LAE for the first six months of 2010:
 
   
Three Months Ended
 
Six Months Ended
 
   
June 30, 2010
 
June 30, 2010
 
(dollars in thousands)
 
Before
Impact of Commutations
 
Impact of Commutations
   
After
Impact of Commutations
 
Before
Impact of Commutations
 
Impact of Commutations
 
After
Impact of Commutations
 
                             
Net settled claims
  $ 145,460   $ -     $ 145,460   $ 290,433   $ (188,657 ) $ 101,776  
Net change in loss reserves
    (158,058 )   -       (158,058 )   (235,511 )   188,657     (46,854 )
Loss adjustment expenses
    4,828     -       4,828     9,546     -     9,546  
Total
  $ (7,770 ) $ -     $ (7,770 ) $ 64,468   $ -   $ 64,468  


The following table provides details on the amount of settled claims and the number of settled claims of both Primary and Modified Pool insurance for the three-month and six-month periods ended June 30, 2010 and 2009:

 
29

 


   
Three Months Ended
   
Six Months Ended
 
   
June 30,
   
June 30,
 
 
(dollars in thousands)
 
2010
   
2009
   
%
Change
   
2010
   
2009
   
%
Change
 
             
 Net settled claims:
                                   
 Primary insurance
  $ 116,750     $ 114,947       2     $ 224,371     $ 171,224       31  
 Modified Pool insurance
    33,582       48,826       (31 )     75,195       56,561       33  
 Total direct settled claims
    150,332       163,773       (8 )     299,566       227,785       32  
 Ceded paid losses
    (4,873 )     (13,910 )     (65 )     (9,133 )     (24,002 )     (62 )
 Subtotal
    145,460       149,863       (3 )     290,433       203,783       43  
 Impact from captive commutations
    -       -       n/a       (188,657 )     -       n/a  
 Total net settled claims
  $ 145,460     $ 149,863       (3 )   $ 101,776     $ 203,783       (50 )