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EX-31.1 - EXHIBIT 31 - SOX 302 - TRIAD GUARANTY INCexhibit31.htm
EX-32.1 - EXHIBIT 32 - SOX 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 March 31, 2011

OR


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


Commission file number:  0-22342
_______________________

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

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

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

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

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

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

Number of shares of common stock, par value $0.01 per share, outstanding as of April 29, 2011 was 15,258,128.





 
 

 

TRIAD GUARANTY INC.

INDEX


   
Page
Part I.  Financial Information
 
     
Item 1.
Financial Statements
 
 
Consolidated Balance Sheets as of March 31, 2011 (Unaudited) and December 31, 2010
1
     
 
Consolidated Statements of Operations for the Three Months Ended March 31, 2011 and 2010 (Unaudited)
2
     
 
Consolidated Statements of Cash Flow for the Three Months Ended March 31, 2011 and 2010 (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
43
     
Item 4.
Controls and Procedures
43
     
Part II.  Other Information
 
     
Item 1.
Legal Proceedings
44
     
Item 6.
Exhibits
45
     
SIGNATURE
 
46
     
EXHIBIT INDEX
 
47

 
 

 

PART I.  FINANCIAL INFORMATION

Item 1.  Financial Statements


TRIAD GUARANTY INC.
 
CONSOLIDATED BALANCE SHEETS
 
   
   
March 31,
   
December 31,
 
 (dollars in thousands, except per share data)
 
2011
   
2010
 
   
(unaudited)
       
ASSETS
           
Invested assets:
           
Securities available-for-sale, at fair value:
           
Fixed maturities (amortized cost:  $778,262 and $777,545)
  $ 810,439     $ 812,335  
Short-term investments
    32,469       39,561  
Total invested assets
    842,908       851,896  
Cash and cash equivalents
    39,073       38,762  
Accrued investment income
    8,322       8,243  
Property and equipment
    1,868       2,136  
Reinsurance recoverable, net
    33,499       40,806  
Other assets
    38,338       49,782  
Total assets
  $ 964,008     $ 991,625  
                 
LIABILITIES AND STOCKHOLDERS' DEFICIT
               
Liabilities:
               
Losses and loss adjustment expenses
  $ 990,494     $ 1,060,036  
Unearned premiums
    9,220       9,057  
Deferred payment obligation, including interest
    464,342       415,657  
Accrued expenses and other liabilities
    93,691       93,075  
Total liabilities
    1,557,747       1,577,825  
Commitments and contingencies - Note 4
               
Stockholders' deficit:
               
Preferred stock, par value $0.01 per share --- authorized 1,000,000
               
shares; no shares issued and outstanding
    -       -  
Common stock, par value $0.01 per share --- authorized 32,000,000
               
shares; issued and outstanding 15,258,128 shares
    153       153  
Additional paid-in capital
    114,101       114,084  
Accumulated other comprehensive income, net of income tax
               
liability of $16,575
    15,963       18,609  
Accumulated deficit
    (723,956 )     (719,046 )
Deficit in assets
    (593,739 )     (586,200 )
Total liabilities and stockholders' deficit
  $ 964,008     $ 991,625  



 
See accompanying notes.

 
1

 

 
 
TRIAD GUARANTY INC.
 
CONSOLIDATED STATEMENTS OF OPERATIONS
 
(unaudited)
 
   
   
Three Months Ended
 
   
March 31,
 
 (dollars in thousands, except per share data)
 
2011
   
2010
 
             
Revenue:
           
Premiums written:
           
   Direct
  $ 39,355     $ 54,393  
   Ceded
    (2,060 )     (8,202 )
Net premiums written
    37,295       46,191  
Change in unearned premiums
    (167 )     (303 )
Earned premiums
    37,128       45,888  
                 
Net investment income
    8,491       9,873  
Net realized investment losses
    (436 )     (242 )
Other income (losses)
    27       (8 )
      45,210       55,511  
                 
Losses and expenses:
               
Net losses and loss adjustment expenses
    41,705       72,238  
Interest expense
    3,978       2,469  
Other operating expenses
    4,437       9,332  
      50,120       84,039  
Loss before income tax benefit
    (4,910 )     (28,528 )
Income tax benefit:
               
Deferred
    -       (717 )
Net loss
  $ (4,910 )   $ (27,811 )
                 
Loss per common and common equivalent share:
               
Basic and diluted loss per share
  $ (0.32 )   $ (1.84 )
                 
Shares used in computing loss per common and
   common equivalent share:
               
Basic and diluted
    15,224,684       15,099,299  
 
 
 
See accompanying notes.

 
2

 



TRIAD GUARANTY INC.
 
CONSOLIDATED STATEMENTS OF CASH FLOW
 
(unaudited)
 
   
   
Three Months Ended
 
   
March 31,
 
 (dollars in thousands)
 
2011
   
2010
 
             
Operating activities
           
Net loss
  $ (4,910 )   $ (27,811 )
Adjustments to reconcile net income (loss) to net cash provided by
operating activities:
               
Losses, loss adjustment expenses and unearned premium reserves
    (69,379 )     (68,267 )
Accrued expenses and other liabilities
    616       12,096  
Deferred payment obligation
    48,685       61,567  
Income taxes recoverable
    11,707       -  
Reinsurance, net
    7,307       180,536  
Accrued investment income
    (79 )     (410 )
Net realized investment losses
    436       242  
Provision for depreciation
    268       414  
Discount accretion (premium amortization) on investments
    467       (523 )
Deferred income taxes
    -       (717 )
Accrued interest payable
    -       (691 )
Other assets
    (162 )     728  
Other operating activities
    18       90  
Net cash (used in) provided by operating activities
    (5,026 )     157,254  
                 
Investing activities
               
Securities available-for-sale:
               
Purchases – fixed maturities
    (27,539 )     (72,318 )
Sales – fixed maturities
    4,942       174  
Maturities – fixed maturities
    21,572       50,553  
Sales – equities
    -       2  
Purchases (sales) of other investments
    (730 )     581  
Net change in short-term investments
    7,092       (119,425 )
Property and equipment
    -       2  
Net cash provided by (used in) investing activities
    5,337       (140,431 )
                 
Net change in cash and cash equivalents
    311       16,823  
Cash and cash equivalents at beginning of period
    38,762       21,839  
Cash and cash equivalents at end of period
  $ 39,073     $ 38,662  
                 
Supplemental schedule of cash flow information
               
Cash (received) paid during the period for:
               
Income taxes
  $ (11,707 )   $ -  
Interest
  $ -     $ 1,383  


See accompanying notes.

 
3

 

TRIAD GUARANTY INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2011
(Unaudited)

1.  The Company

Triad Guaranty Inc. (“TGI”) is a holding company which, through its wholly-owned subsidiary, Triad Guaranty Insurance Corporation (“TGIC”), is a nationwide mortgage insurer pursuing a run-off of its existing in-force book of business.  The term “run-off” as used in these financial statements means continuing to service existing mortgage guaranty insurance policies but not writing any new policies.  Unless the context requires otherwise, references to “Triad” in this Quarterly Report on Form 10-Q refer to the operations of TGIC and its wholly-owned subsidiary, Triad Guaranty Assurance Corporation (“TGAC”).  References to the “Company” refer collectively to the operations of TGI and Triad.  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 mortgage guaranty insurance company and TGAC is an Illinois-domiciled mortgage guaranty reinsurance company. The Illinois Department of Insurance (the “Insurance Department”) is the primary regulator of both TGIC and TGAC.  The Illinois Insurance Code grants broad powers to the Insurance Department and its director (collectively, the “Department”) to enforce rules or exercise discretion over almost all significant aspects of Triad’s insurance business.  Triad ceased issuing new commitments for mortgage guaranty insurance coverage on July 15, 2008 and is operating its business in run-off under two Corrective Orders issued by the Department, as discussed in “Corrective Orders” below. The first Corrective Order was issued in August 2008.  The second Corrective Order was issued in March 2009 and subsequently amended in May 2009.  As noted above and used in these financial statements, the term "run-off" means continuing to service existing policies, but writing no new mortgage guaranty insurance policies.  Servicing existing policies includes: billing and collecting 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 policies and the two Corrective Orders issued by the Department.  The term “settled,” as used in these financial statements in the context of the payment of a claim, refers to the satisfaction of Triad’s obligations following the submission of valid claims by its policyholders.  Prior to June 2009, valid claims were settled solely by a cash payment.  As required by the second Corrective Order, effective on and after June 1, 2009, valid claims are settled by a combination of 60% in cash and 40% in the form of a deferred payment obligation (“DPO”).  The Corrective Orders, among other things, allow management to continue to operate Triad under the close supervision of the Department, include restrictions on the distribution of dividends or interest on surplus notes payable to TGI by Triad, and include certain requirements on the payment of claims.  Failure to comply with the provisions of the Corrective Orders could result in the imposition of fines or penalties or subject Triad to further legal proceedings, including receivership proceedings for the conservation, rehabilitation, or liquidation of Triad.

 
4

 
Accounting Principles

The Company prepares its financial statements presented in this Quarterly Report on Form 10-Q in conformity with accounting principles generally accepted in the United States of America (“GAAP”).  The financial statements for Triad that are provided to the Department are prepared in accordance with Statutory Accounting Principles (“SAP”) as set forth in the Illinois Insurance Code or prescribed by the Department.  The primary differences between GAAP and SAP for Triad at March 31, 2011 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’ surplus under SAP, Illinois law may require the Department to seek receivership of Triad, which could possibly compel TGI to institute a proceeding seeking relief from creditors under U.S. bankruptcy laws, or otherwise consider dissolution of the Company.  The second Corrective Order was designed in part to help Triad maintain its policyholders’ surplus.

2.  Going Concern

The Company has prepared its financial statements on a going concern basis under GAAP, which contemplates the realization of assets and the satisfaction of liabilities and commitments in the normal course of business.  However, there is substantial doubt as to the Company's ability to continue as a going concern.  This uncertainty is based on, among other things, the possible 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 $593.7 million deficit in assets at March 31, 2011.

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 $238.2 million at March 31, 2011, as opposed to a deficiency in policyholders’ surplus of $605.1 million on the same date had the second Corrective Order not been implemented.  While the implementation of the second Corrective Order has deferred the institution of an involuntary receivership proceeding, no assurance can be given that the Department will not seek receivership of Triad in the future and there continues to be substantial doubt about the Company’s ability to continue as a going concern.  The Department may seek receivership of Triad based on its determination that Triad will ultimately become insolvent 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, or otherwise consider dissolution of the Company.  The consolidated financial statements that are presented in this report do not include any accounting adjustments that reflect the financial risks of Triad entering receivership proceedings or otherwise not continuing as a going concern.

3.  Accounting Policies and Basis of Presentation

Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared in conformity with GAAP for interim financial information and with the instructions to Form 10-Q and Article 8 of Regulation S-X.  Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements.  In the opinion of management, all adjustments considered necessary for a fair presentation have been included.  Operating results for the three months ended March 31, 2011 are not necessarily indicative of the results that may be expected for the year ending December 31, 2011 or subsequent periods.  For further information, refer to the consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.
 
 
5

 
Consolidation

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

Corrective Orders, 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, 2010. Among other things, the Corrective Orders:

 
·
Require the oversight of the Department on substantially all operating matters;
 
 
·
Prohibit all stockholder dividends from Triad to TGI without the prior approval of the Department;
 
 
·
Prohibit the accrual of interest or the payment of interest and principal on Triad’s surplus note to TGI without the prior approval of the Department;
 
 
·
Restrict Triad from making any payments or entering into any transaction that involves the transfer of assets to, or liabilities from, any affiliated parties without the prior approval of the Department;
 
 
·
Require Triad to obtain prior written approval from the Department before entering into certain transactions with unaffiliated parties;
 
 
·
Require that all valid claims under Triad’s mortgage guaranty insurance policies are settled 60% in cash and 40% by recording a DPO;
 
 
·
Require the accrual of simple interest on the DPO at the same average net rate earned by Triad’s investment portfolio; and
 
 
·
Require that loss reserves in financial statements prepared in accordance with SAP 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 requirement to settle claims with both the payment of cash and issuance of a DPO became effective in June 2009.  At March 31, 2011, the recorded DPO, including accrued interest of $16.4 million, amounted to $464.3 million and, as a result, approximately 55% of the Company’s total invested assets reported at March 31, 2011 were held in a separate account pursuant to a custodial arrangement to support this liability as required by the second Corrective Order.  The recording of the DPO does not affect reported settled losses as the Company continues to report the entire amount of a claim in its statements of operations.  The accounting treatment for the recording of the DPO on a SAP basis is similar to a surplus note that is reported as a component of statutory surplus; accordingly, any repayment of the DPO or the associated accrued interest is dependent on the financial condition and future prospects of Triad and is subject to the approval of the Department.  However, in the Company’s financial statements prepared in accordance with GAAP included in this report, the DPO, including the related accrued interest, is reported as a liability.  At March 31, 2011, 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 $843.3 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.

 
6

 
The second Corrective Order provides financial thresholds, specifically regarding the statutory risk-to-capital ratio and the level of statutory policyholders’ surplus that, if met, may indicate that the Department should reduce the DPO percentage and/or require distributions to DPO holders.  The second Corrective Order specifically required that the Department consider whether such changes should be made or payments allowed prior to December 31, 2010. In December 2010, Triad was notified by the Department that based upon Triad’s surplus position, risk-to-capital ratio and the continued economic uncertainty, the Department had determined that it was inappropriate to reduce the DPO percentage or require Triad to make a distribution to the DPO holders.

Failure to comply with the provisions of the Corrective Orders or any other violation of the Illinois Insurance Code may result in the imposition of fines or penalties or subject Triad to further legal proceedings, including the institution by the Department of receivership proceedings for the conservation, rehabilitation or liquidation of Triad.  Any such actions would likely lead TGI to institute a proceeding seeking relief from creditors under U.S. bankruptcy laws. See Item 1A, “Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010 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.  While the risk-to-capital ratio of Triad has benefitted from the DPO requirements of the Corrective Orders, it remains 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, Triad would continue to be prohibited by the Department from issuing new commitments for insurance.

Reinsurance

Prior to entering into run-off, the Company entered into various captive reinsurance agreements that were designed to allow lenders to share in the risks of mortgage insurance.  Because the Company is operating in run-off and is thus not issuing any new insurance policies, only policies previously reinsured under the agreements are covered until such time that the policy is cancelled (at the insured’s request or by payment of claim, rescission, or other means) or the captive reinsurance agreement is terminated.  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 TGIC in exchange for a percentage of the premiums that TGIC collected.  All of the 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, the Company retains the first loss position on the first aggregate layer of risk and reinsures a second defined aggregate layer with the captive reinsurer.  The Company requires 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, TGIC 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, the Company 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. The commutation of a captive reinsurance agreement is generally an indication that TGIC would receive all of the trust assets, plus any future ceded premium and interest on such assets, in the future regardless of whether the agreement was commuted or not due to the adverse performance of the policies reinsured under the agreement.

 
7

 
During the first quarter of 2010, the Company determined that its 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, the Company commuted both of these 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 commutations resulted in an increase in invested assets and a corresponding decrease in reinsurance recoverable.  The commutations had minimal impact on the results of operations or financial condition as the net amounts received were previously recorded as reinsurance recoverable on the balance sheet.  The commutations and receipt of the trust assets, however, positively impacted cash flows for the quarter ended March 31, 2010.  There were no commutations in the three months ended March 31, 2011.

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

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

During 2010, 2009, and 2008, we rescinded coverage on policies with risk in force of $714 million, $683 million, and $244 million, respectively.  Furthermore, in the first quarter of 2011, we rescinded coverage on policies with risk in force of $146 million.  Rescission activity has been concentrated in policies that were in default or with respect to which a claim had already been filed and would likely have ultimately progressed to a settled claim.

Rescissions are a key component in determining the level of estimated loss reserves and ultimately the level of paid claims and any change to the actual rescission rate compared to those utilized in the reserve methodology can have a material impact on the Company’s financial condition. Such changes may come about for a number of reasons including legal determinations and agreements regarding Triad’s ability to rescind coverage.  See Note 4, “Litigation” in this Form 10-Q and Item 1A, “Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010 for more information.

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

 
8

 
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, 2010, 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 the first quarter of 2011, the Company reached the aggregate stop loss limits on a settled basis on another Modified Pool transaction.  The net change in the accrual increased premium earned in the first quarter of 2011 by approximately $0.7 million.  The Company did not accrue any future premium in the first quarter of 2010.

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 January 2010, the FASB issued ASU No. 2010-06, Improving Disclosures about Fair Value Measurements, which requires additional disclosure related to the three-level fair value hierarchy.  For a more detailed description of ASU 2010-06, see “Recent Accounting Pronouncements" in Note 1 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.  The Company adopted the remaining disclosure requirements of ASU 2010-06 effective January 1, 2011, and has included the disclosures related to purchases, sales, issuances, and settlements for Level 3 fair value measurements in Note 6 of this Quarterly Report on Form 10-Q.

4.  Litigation
 
The Company is involved in litigation and other legal proceedings in the ordinary course of business as well as the matters identified below.  No liability has been established in the financial statements regarding current litigation as the potential liability, if any, cannot be reasonably estimated.

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 was filed on November 19, 2009 and oral arguments on the motion occurred on August 30, 2010.  The court has not yet issued its opinion. Triad intends to vigorously defend this matter.

 
9

 
On September 4, 2009, Triad filed a complaint against American Home Mortgage (“AHM”) in the United States Bankruptcy Court for the District of Delaware seeking rescission of multiple master mortgage guaranty insurance policies (“master policies”) and declaratory relief.  The complaint seeks relief from AHM as well as all owners of loans insured under the master policies by way of a defendant class action.  Triad alleged that AHM failed to follow the delegated insurance underwriting guidelines approved by Triad, that this failure breached the master policies as well as the implied covenants of good faith and fair dealing, and that these breaches were so substantial and fundamental that the intent of the master policies could not be fulfilled and Triad should be excused from its obligations under the master policies. Three groups of current owners and/or servicers of AHM-originated loans filed motions to intervene in the lawsuit, which were granted by the Court on May 10 and October 29, 2010.  On March 4, 2011, Triad amended its complaint to add a count alleging fraud in the inducement.  On March 25, 2011, each of the interveners filed a motion to dismiss. The total amount of risk originated under the AHM master policies, accounting for any applicable stop loss limits associated with Modified Pool contracts and less risk originated on policies which have been subsequently rescinded, was $1.4 billion, of which $0.8 billion remained in force at March 31, 2011.  Triad continues to accept premiums and process claims under the master policies, with the earned premiums and settled losses reflected in the Consolidated Statements of Operations.  However, as a result of the litigation, Triad ceased remitting claim payments to companies servicing loans originated by AHM and the liability for losses settled but not paid is included in “Accrued expenses and other liabilities” on the Consolidated Balance Sheets.  Triad has not recognized any benefit in its financial statements pending the outcome of the litigation.

On 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. Triad filed its answer on March 4, 2011.   In the event a settlement is not successfully concluded, Triad intends to vigorously defend this matter.

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.  Approximately 55% of the Company’s total invested assets reported at March 31, 2011 were held in a separate account pursuant to a custodial arrangement to support the liability for the DPO and related accrued interest as required by the second Corrective Order, compared to 49% at December 31, 2010.

 Unrealized gains on available-for-sale securities, net of tax, are reported as a separate component of accumulated other comprehensive income. Effective December 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 March 31, 2011 and December 31, 2010 were as follows:


   
As of March 31, 2011
 
(dollars in thousands)
 
Cost or Amortized Cost
   
Gross
Unrealized Gains
   
Gross
Unrealized Losses
   
Fair
Value
 
             
 Fixed maturity securities:
                       
 U. S. government and agency securities
  $ 40,981     $ 640     $ -     $ 41,621  
 Foreign government securities
    15,931       134       -       16,065  
 Corporate debt
    522,088       22,704       -       544,792  
 Residential mortgage-backed
    56,430       2,916       -       59,346  
 Commercial mortgage-backed
    23,739       10       -       23,749  
 Asset-backed bonds
    35,256       989       -       36,245  
 State and municipal bonds
    83,836       4,785       -       88,621  
Total fixed maturities
    778,261       32,178       -       810,439  
 Short-term investments
    32,469       -       -       32,469  
Total securities
  $ 810,730     $ 32,178     $ -     $ 842,908  



   
As of December 31, 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
  $ 42,650     $ 774     $ -     $ 43,424  
 Foreign government securities
    14,964       111       -       15,075  
 Corporate debt
    507,460       24,196       -       531,656  
 Residential mortgage-backed
    64,900       3,041       -       67,941  
 Commercial mortgage-backed
    21,954       2       -       21,956  
 Asset-backed bonds
    38,378       1,347       -       39,725  
 State and municipal bonds
    87,239       5,319       -       92,558  
Total fixed maturities
    777,545       34,790       -       812,335  
 Short-term investments
    39,561       -       -       39,561  
Total securities
  $ 817,106     $ 34,790     $ -     $ 851,896  
 
The unrealized gains are due in part to the recovery in value of previously impaired fixed maturity securities.  Unrealized gains do not necessarily represent future gains that the Company will realize.  The value of the Company’s investment portfolio will vary depending on overall market interest rates, credit spreads, and changing conditions related to specific securities, as well as other factors. Volatility may increase in periods of uncertain market or economic conditions.


 
11

 

The amortized cost and estimated fair value of fixed maturity available-for-sale securities at March 31, 2011 are summarized by stated maturity below.
 
   
Available-for-Sale
 
(dollars in thousands)
 
Amortized
Cost
   
Fair
Value
 
             
 Maturity:
           
 One year or less
  $ 47,379     $ 47,963  
 After one year through five years
    426,145       444,029  
 After five years through ten years
    198,639       205,635  
 After ten years
    106,099       112,812  
 Total
  $ 778,262     $ 810,439  
 
Actual and expected maturity for certain securities may differ from stated maturity due to call and prepayment provisions.
 
Realized Losses Related to Investments

The details of net realized investment losses are as follows:
 
   
Three Months Ended
 
   
March 31,
 
(dollars in thousands)
 
2011
   
2010
 
             
 Securities available-for-sale:
           
 Fixed maturity securities:
           
 Gross realized gains
  $ 429     $ 12  
 Gross realized losses
    (865 )     (255 )
 Equity securities:
               
 Gross realized gains
    -       4  
 Other investment losses
    -       (3 )
 Net realized losses
  $ (436 )   $ (242 )
 
Gross realized losses in the first quarter of both 2011 and 2010 were primarily attributable to the other-than-temporary write downs of securities whose market value was less than the respective book value.
 
6.  Fair Value Measurement

Fair Value of Financial Instruments

The carrying values and fair values of financial instruments as of March 31, 2011 and December 31, 2010 are summarized below:
 
   
March 31, 2011
   
December 31, 2010
 
(dollars in thousands)
 
Carrying
Value
   
Fair
Value
   
Carrying
Value
   
Fair
Value
 
                         
 Financial Assets
                       
 Fixed maturity securities available-for-sale
  $ 810,439     $ 810,439     $ 812,335     $ 812,335  
 Short-term investments
    32,469       32,469       39,561       39,561  
 Cash and cash equivalents
    39,073       39,073       38,762       38,762  


 
12

 
Valuation Methodologies and Associated Inputs

The Company utilizes the provisions of ASC 820 as amended by ASU 2010-06 in its estimation and disclosures about fair value.  ASC 820 establishes a fair value hierarchy that prioritizes the inputs to valuation methods used to measure fair value.  The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements).  The three levels of the fair value hierarchy under ASC 820 are as follows:

 
Level 1:
Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets.
 
 
Level 2:
Quoted prices for similar assets in active markets or for identical or similar assets in inactive markets.  Alternatively, quoted prices may be based on models where the significant inputs are observable or can be supported by observable market data.
 
 
Level 3:
Prices or valuation techniques where one or more of the significant inputs are unobservable (i.e., supported with little or no market activity). This includes broker quotes which are non-binding.
 
An asset’s or a liability’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.  An asset’s or a liability’s level within the fair value hierarchy as well as transfers in and out of Level 3 are determined at the end of the reporting period.  At March 31, 2011, approximately 0.2% of the Company’s 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.  

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 the Company’s available-for-sale securities.  The standard inputs used include 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 weighted 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.

 
13

 
The following is a description of the valuation methodologies used in determining the fair value of the Company’s 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 generally 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 and the Government National Mortgage Association (GNMA), as well as private-label securities. The fair value of residential mortgage-backed securities is based on prices of similar securities and discounted cash flow analysis incorporating prepayment and default assumptions.  Residential mortgage-backed securities are 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.

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.

 
14

 
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 generally 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 and current rates from market makers, as well as the coupon rate where appropriate.  Other short-term instruments are generally categorized as Level 2.
 
Fair Value of Investments

The following table summarizes the assets measured at fair value on a recurring basis and the source of the inputs in the determination of fair value as of March 31, 2011 and December 31, 2010:
 
         
Fair Value at Reporting Date Using
 
(dollars in thousands)
 
March 31,
2011
   
Quoted Prices in Active Markets for Identical Assets
 (Level 1)
   
Significant
Other
Observable
Inputs
(Level 2)
   
Significant Unobservable Inputs
(Level 3)
 
             
 Assets
                       
Securities available-for-sale
                       
Fixed maturities:
                       
U. S. government and agency securities
  $ 41,621     $ -     $ 41,621     $ -  
Foreign government securities
    16,065       -       16,065       -  
Corporate debt
    544,792       -       544,792       -  
Residential mortgage-backed
    59,346       -       59,346       -  
Commercial mortgage-backed
    23,749       -       23,749       -  
Asset-backed bonds
    36,245       -       34,617       1,628  
State and municipal bonds
    88,621       -       88,621       -  
Total fixed maturities
    810,439       -       808,811       1,628  
Short-term investments
                               
Money market instruments
    19,724       19,724       -       -  
Other
    12,745       -       12,745       -  
Total
  $ 842,908     $ 19,724     $ 821,556     $ 1,628  


 
15

 

         
Fair Value at Reporting Date Using
 
(dollars in thousands)
 
December 31, 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
  $ 43,424     $ -     $ 43,424     $ -  
Foreign government securities
    14,336       -       14,336       -  
Corporate debt
    532,395       -       532,395       -  
Residential mortgage-backed
    67,941       -       67,941       -  
Commercial mortgage-backed
    21,956       -       21,956       -  
Asset-backed bonds
    39,725       -       38,134       1,591  
State and municipal bonds
    92,558       -       92,558       -  
Total fixed maturities
    812,335       -       810,744       1,591  
Short-term investments
                               
Money market instruments
    22,126       22,126       -       -  
Other
    17,435       -       17,435       -  
Total
  $ 851,896     $ 22,126     $ 828,179     $ 1,591  
 
Significant unobservable inputs (Level 3) were used in determining the fair value on certain bonds in the fixed maturities portfolio during this period.  The following table provides a reconciliation of the beginning and ending balances of these Level 3 bonds and the related gains and losses related to these assets during the three months ended March 31, 2011 and 2010, respectively.
 
Fair Value Measurement Using Significant
Unobservable Inputs (Level 3)
 
             
   
Three Months Ended
 
   
March 31,
 
(dollars in thousands)
 
2011
   
2010
 
             
Securities available-for-sale
           
Asset-backed bonds:
           
 Beginning balance
  $ 1,591     $ 1,994  
 Transfers into Level 3
    -       -  
 Transfers out of Level 3
    -       -  
 Total gains and losses (realized and unrealized):
               
 Included in operations
    (35 )     (121 )
 Included in other comprehensive income
    20       17  
 Purchases, issuances and settlements
               
 Purchases
    52       93  
 Issuances
    -       -  
 Sales
    -       (1 )
 Settlements
    -       -  
 Ending balance
  $ 1,628     $ 1,982  
                 
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.
  $ (15 )   $ (104 )
 
 
 
16

 
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 March 31, 2011 and 2010, the Company reported a loss from operations and therefore had no dilutive effect of stock options and unvested restricted stock on the weighted-average shares outstanding.  The numerator used in both the basic EPS and diluted EPS calculation is the loss reported for the period represented.  For the three months ended March 31, 2011 and 2010, options to purchase approximately 2,538 and 6,900 shares, respectively, of the Company’s common stock were excluded from the calculation of EPS because they were antidilutive.

8.  Comprehensive Income (Loss)

Comprehensive income (loss) consists of the net loss and other comprehensive income (loss).  For the Company, other comprehensive income (loss) is normally composed of the change in unrealized gains or losses on available-for-sale securities, net of income taxes. 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 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 ended March 31, 2011 the Company’s other comprehensive loss was $2.6 million and the Company’s comprehensive loss was $7.6 million. For the three months ended March 31, 2010, the Company’s other comprehensive income was $1.3 million and the Company’s comprehensive loss was $26.5 million.

At March 31, 2011, the Company’s accumulated other comprehensive income of $16.0 million was comprised of unrealized gains on investments of $32.5 million, offset by income tax liability of $11.4 million and a valuation allowance against deferred tax assets of $5.1 million.  At December 31, 2010, the Company’s accumulated other comprehensive income of $18.6 million was comprised of unrealized gains on investments of $35.2 million, offset by income tax liability of $12.3 million and a valuation allowance against deferred tax assets of $4.3 million.

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 as outlined in ASC 740, Income Taxes (“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 (or loss) 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.

 
17

 
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 three months ended March 31, 2011, the Company reported a net loss; however, the Company is currently projecting the reporting of net income for the entire year ending December 31, 2011.  Therefore, the provisions of ASC 740 would require that no income tax effect be recorded in these interim financial statements.  However, the underlying impact is that both the deferred tax asset and the valuation allowance have been increased by the tax effect of the loss reported in the first quarter of 2011.

11. Subsequent Events

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


 
18

 

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

Management's Discussion and Analysis of Financial Condition and Results of Operations analyzes our consolidated financial condition, changes in financial position, and results of operations for the three months ended March 31, 2011 and 2010.  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, 2010, and should be read in conjunction with the interim financial statements and notes contained herein.

Certain of the statements contained in this Quarterly Report on Form 10-Q are "forward-looking statements" and are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements include estimates and assumptions related to economic, competitive, regulatory, operational and legislative developments and typically are identified by use of terms such as “may,” “will,” “should,” “could,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” “continue” and similar words, although some forward-looking statements are expressed differently. These forward-looking statements are subject to change, uncertainty and circumstances that are, in many instances, beyond our control and they have been made based upon our current expectations and beliefs concerning future developments and their potential effect on us. Actual developments and their results could differ materially from those expected by us, depending on the outcome of a number of factors, including: the possibility that the Illinois Department of Insurance may take various actions regarding Triad if we do not operate our business in accordance with the revised financial and operating plan and the Corrective Orders, including seeking receivership proceedings; our ability to operate our business in run-off and maintain a solvent run-off; our ability to continue as a going concern; the possibility of general economic and business conditions that are different than anticipated; legislative, regulatory, and other similar developments; changes in interest rates, employment rates, the housing market, the mortgage industry and the stock market; legal and other proceedings regarding modifications and refinancing of mortgages and/or foreclosure proceedings; the possibility that there will not be adequate interest in our common stock to ensure efficient pricing; and the relevant factors described in Item 1A, “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2010 and in the Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995 section below, as well as in other reports and statements that we file with the Securities and Exchange Commission (the “SEC”).  Forward-looking statements are based upon our current expectations and beliefs concerning future events and we undertake no obligation to update or revise any forward-looking statements to reflect the impact of circumstances or events that arise after the date the forward-looking statements are made, except as required by the federal securities laws.

Overview

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

 
19

 
TGIC is an Illinois-domiciled mortgage guaranty insurance company and TGAC is an Illinois-domiciled mortgage guaranty reinsurance company. The Illinois Department of Insurance (the “Insurance Department”) is the primary regulator of both TGIC and TGAC.  The Illinois Insurance Code grants broad powers to the Insurance Department and its director (collectively, the “Department”) to enforce rules or exercise discretion over almost all significant aspects of our insurance business. We ceased issuing new commitments for mortgage guaranty insurance coverage on July 15, 2008 and are operating our business in run-off under two Corrective Orders issued by the Department.  As noted above, the term "run-off" means continuing to service existing policies, but writing no new mortgage guaranty insurance policies.  Servicing existing policies includes: billing and collecting 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 or cure the default and/or mitigate our loss; reviewing policies for the existence of misrepresentation, fraud, or non-compliance with stated programs; and settling all legitimate filed claims per the provisions of the two Corrective Orders issued by the Department. The term “settled,” as used in this report in the context of the payment of a claim, refers to the satisfaction of Triad’s obligations following the submission of valid claims by our policyholders. Prior to June 1, 2009, valid claims were settled solely by a cash payment. As required by the second Corrective Order, effective on and after June 1, 2009, valid claims are settled by a combination of 60% in cash and 40% in the form of a deferred payment obligation (“DPO”). The Corrective Orders, among other things, allow management to continue to operate Triad under the close supervision of the Department, include restrictions on the distribution of dividends or interest on 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 a policy as Primary insurance when the policy is not part of a structured bulk transaction that has an aggregate stop-loss limit applied to the entire group of loans.  We classify all other insurance as Modified Pool insurance. The majority of our Primary insurance has been delivered through the flow channel, which is defined as loans originated by lenders and submitted to us on a loan-by-loan basis.  In addition, we have insured loans under Primary bulk coverage where we are in a first loss position for each loan in a group of loans, and where all loans have the same premium rate.  We also historically provided mortgage guaranty insurance to lenders and investors seeking additional default protection (typically secondary coverage or on loans for which the individual borrower has greater than 20% equity), capital relief, and credit-enhancement on groups of loans that are sold in the secondary market.  Insurance provided on these individual transactions was provided through the Modified Pool channel.  Policies insured as part of a Modified Pool transaction have individual coverage but there is an aggregate stop-loss limit applied to the entire group of insured loans.
 
Our insurance remains effective until one of the following events occurs:  the policy is cancelled at the insured’s request; we terminate the policy for non-payment of premium; the policy defaults and we satisfy our obligations under the insurance contract; or we rescind or deny coverage under the policy for violations of provisions of a master policy. Additionally, coverage may be cancelled on certain Modified Pool transactions if pre-determined aggregate stop loss limits are met, or if coverage is reduced to a de minimus amount of the initial amount insured.
 
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.

 
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In run-off, our expenses consist primarily of: settled claims (including LAE) 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 on the DPO and on our long-term debt prior to its repurchase and retirement in the third quarter of 2010.
 
As we are operating in run-off and are issuing no new insurance commitments, our results of operations largely depend on our ability to settle our liabilities (primarily loss reserves) at a lesser amount than that reported on our balance sheet through loss mitigation, litigation and settlements with servicers. Additionally, our results going forward are also dependent on the number of new defaults that are reported to us as well as the amount of future premium that we expect to earn. Our results of operations also depend on a number of other factors, many of which are not under our control. These factors include:

 
·
the conditions of the housing, mortgage and capital markets that have a direct impact on default rates, loss mitigation efforts, cure rates, and ultimately, the amount of claims settled;
 
 
·
the overall general state of the economy and job market;
 
 
·
persistency levels on our remaining insurance in force;
 
 
·
operating efficiencies; and
 
 
·
the level of investment yield, including realized gains and losses, on our investment portfolio.
 
Our results of operations in run-off could also be impacted significantly by recent federal government and private initiatives to limit foreclosures and provide stability and liquidity in the secondary mortgage market.  See the discussion below for further details on these initiatives. Lastly, our results of operations in run-off could be materially affected by our ability to recognize benefits from our net operating loss carryforwards.

Accounting Principles

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

As an insurance company, Triad is required to file financial statements prepared in accordance with SAP with the insurance departments of the states in which it conducts business. The financial statements for Triad that are provided to the Department and that form the basis for our corrective plan required by the Corrective Orders are prepared in accordance with SAP as set forth in the Illinois Insurance Code or prescribed by the Department.  However, the Company prepares its financial statements presented in this Quarterly Report on Form 10-Q and in our other SEC filings in conformity with GAAP.  The primary differences between GAAP and SAP for Triad at March 31, 2011 were the methodology utilized for the establishment of reserves and the reporting requirements relating to the establishment of the DPO stipulated in the second Corrective Order, which are described below.

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

 
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Corrective Orders

Triad has entered into two Corrective Orders with the Department. Among other things, the Corrective Orders:

 
·
Require oversight by the Department on substantially all operating matters;
 
 
·
Prohibit all stockholder dividends from Triad to TGI without the prior approval of the Department;
 
 
·
Prohibit the accrual of interest or the payment of interest and principal on Triad’s surplus note to TGI without the prior approval of the Department;
 
 
·
Restrict Triad from making any payments or entering into any transaction that involves the transfer of assets to, or liabilities from, any affiliated parties without the prior approval of the Department;
 
 
·
Require Triad to obtain prior written approval from the Department before entering into certain transactions with unaffiliated parties;
 
 
·
Require that all valid claims under Triad’s mortgage guaranty insurance policies are settled 60% in cash and 40% by recording a DPO;
 
 
·
Require the accrual of simple interest on the DPO at the same average net rate earned by Triad’s investment portfolio; and
 
 
·
Require that loss reserves in financial statements prepared in accordance with SAP 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 requirement to settle claims with both the payment of cash and issuance of a DPO became effective on June 1, 2009.  At March 31, 2011, the recorded DPO, which includes accrued interest of $16.4 million, amounted to $464.3 million and, as a result, approximately 55% of our total invested assets reported at March 31, 2011 were held in a separate account pursuant to a custodial arrangement to support this liability as required by the second Corrective Order.  The recording of a DPO does not impact reported settled losses as we continue to report the entire amount of a claim in our statements of operations.  The accounting treatment for the recording of the DPO on a SAP basis is similar to a surplus note that is reported as a component of statutory surplus; accordingly, any repayment of the DPO or the associated accrued interest is dependent on the financial condition and future prospects of Triad and is subject to the approval of the Department.  However, in our financial statements prepared in accordance with GAAP included in this report, the DPO and related accrued interest are reported as liabilities.  At March 31, 2011, 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 $843.3 million over the amount that would have been reported absent the second Corrective Order.  The cumulative increase to statutory policyholders’ surplus of the DPO requirement was $818.8 million at December 31, 2010.  There is no impact to our stockholders’ deficit calculated on a GAAP basis.

The second Corrective Order provides financial thresholds, specifically regarding our statutory risk-to-capital ratio and our level of statutory policyholders’ surplus that, if met, may indicate that the Department should reduce the DPO percentage and/or require distributions to DPO holders.  The second Corrective Order specifically required that the Department consider whether such changes should be made or payments allowed prior to December 31, 2010. In December 2010, we were notified by the Department that as of the time of the review and based upon Triad’s surplus position, risk to capital ratio, and the continued economic uncertainty, it had determined that no change to the DPO percentage was in order nor would it be appropriate for Triad to make a distribution to the DPO holders at that time.

 
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Failure to comply with the provisions of the Corrective Orders or any other violation of the Illinois Insurance Code may result in the imposition of fines or penalties or subject Triad to further legal proceedings, including the institution by the Department of receivership proceedings for the conservation, rehabilitation, or liquidation of Triad.  Any such actions would likely lead TGI to institute a proceeding seeking relief from creditors under U.S. bankruptcy laws, or otherwise consider dissolution.  See Item 1A, “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2010 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.

Going Concern

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

Prior to the issuance of the second Corrective Order, our recurring losses from operations and resulting decline in policyholders’ surplus as calculated in accordance with SAP increased the likelihood that Triad would be placed into receivership and raised substantial doubt about our ability to continue as a going concern.  The positive impact on surplus resulting from the second Corrective Order has resulted in Triad reporting a policyholders’ surplus in its SAP financial statements of $238.2 million at March 31, 2011, as opposed to what would have been a deficiency in policyholders’ surplus of $605.1 million on the same date had the second Corrective Order not been implemented.  Furthermore, we continued to report a deficit in assets under GAAP of $593.7 million at March 31, 2011. While implementation of the second Corrective Order has deferred the institution of an involuntary receivership proceeding, no assurance can be given that the Department will not seek receivership of Triad in the future and there continues to be substantial doubt about our ability to continue as a going concern.  The Department may seek receivership of Triad based on its determination that Triad will ultimately become insolvent 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 or otherwise consider dissolution of the Company.  Our consolidated financial statements that are presented in this report do not include any accounting adjustments that reflect the financial risks of Triad entering receivership proceedings and assume that we will continue as a going concern.

 
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Captive Reinsurance 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.  Because we are operating in run-off and are thus not issuing any new insurance policies, only policies previously reinsured under the agreements are covered until such time that the policy is cancelled (at the insured’s request or by payment of claim, rescission, or other means) or the captive reinsurance agreement is terminated.  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.  All of our 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, we retain the first loss position on the first aggregate layer of risk and reinsure a second defined aggregate layer with the captive reinsurer.  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. The commutation of a captive reinsurance agreement is generally an indication that we would receive all of the trust assets, plus any future ceded premium and interest on such assets, in the future regardless of whether the agreement was commuted or not due to the adverse performance of the policies reinsured under the agreement.

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 commutations resulted in an increase in our invested assets and a corresponding decrease in reinsurance recoverable.  The commutations had minimal impact on our results of operations or financial condition as the net amounts received were previously recorded as reinsurance recoverable on our balance sheet.  The commutations and receipt of the trust assets, however, positively impacted our cash flows for the quarter ended March 31, 2010.  There were no commutations in the three months ended March 31, 2011.

Foreclosure Prevention Initiatives and Moratoriums

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 seek to provide borrowers a more affordable mortgage 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. HAMP and other such programs have been responsible for a large percentage of our cures since 2009. However, we believe that the number of policies that are modified under these programs and subsequently cure will decrease in future periods as the number of policies eligible for the programs declines.

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, a number of the policies that have completed the trial modification period have subsequently re-defaulted and we believe the number of policies that re-default will increase in the future. The ultimate impact of HAMP and other such programs is dependent on the number of policies that are successfully modified and do not re-default. Currently, we are unable to estimate with any degree of precision these factors and are, therefore, unable to estimate the ultimate impact of these programs on our results of operations and financial condition. If HAMP and/or similar programs prove to be effective in preventing foreclosures, future settled claim activity could be reduced.

 
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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.  Policies that re-default under these programs may ultimately result in losses that are greater than the loss that would have occurred if the policy was never modified.  These programs could also 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.
 
Loan servicers have also implemented temporary foreclosure moratoriums for various reasons.  Because the completion of a valid foreclosure is a requirement for the filing of a claim for loss, these programs serve to temporarily reduce our claims settled, but may lead to greater ultimate claim costs due to the accrual of interest and other expenses. In the third and fourth quarters of 2010, foreclosure moratoriums were instituted by certain loan servicers in response to documentation problems and other issues with foreclosure proceedings. Federal banking regulators issued a report in April 2011 announcing their findings regarding foreclosure practices and changes that will be required of loan servicers. However, other parties, including a coalition of state attorneys general and the Justice Department, are continuing with their investigations and proposed settlement discussions with servicers.   We do not expect this issue to have a significant direct impact on our financial condition, other than the slowdown of settled claims due to the foreclosure moratoriums.

See Item 1A, “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2010 for more information on the risks and uncertainties associated with foreclosure moratoriums.

Consolidated Results of Operations

Following is selected financial information for the three months ended March 31, 2011 and 2010:
 
   
Three Months Ended
       
   
March 31,
       
(dollars in thousands, except per share data)
 
2011
   
2010
   
% Change
 
                   
Earned premiums
  $ 37,128     $ 45,888       (19 )
Net losses and loss adjustment expenses
    41,705       72,238       (42 )
Net loss
    (4,910 )     (27,811 )     (82 )
Diluted loss per share
    (0.32 )     (1.84 )     (82 )
 
We reported a smaller net loss for the first quarter of 2011 compared to the same quarter a year earlier, primarily due to improved loss development.  Improved loss development included both a smaller number of new defaults reported and better than anticipated results on previously reported defaults.

Net revenue declined by 18.6% during the first quarter of 2011 compared to the same period of 2010. The decrease in earned premium was primarily due to a lower amount of insurance in force as well as rescission activity and the related premium refunds, offset somewhat by lower ceded premium. Investment income in the first quarter of 2011 declined compared to the first quarter of 2010 due to lower average invested assets.

Net losses and LAE are comprised of net settled claims, LAE, and the change in loss reserves. The decline in net losses and loss adjustment expenses is primarily due to a lower number of newly reported defaults and improved loss development trends.

Interest expense increased during the first quarter of 2011 compared to the same period of 2010 due to the increase in the accrued interest related to the DPO liability. Other operating expenses declined significantly in the first quarter of 2011 compared to the first quarter of 2010 due to both lower personnel costs and expenses related to contract underwriting.

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

Production

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

Insurance and Risk in Force

Insurance in force is the total principal balance of our insured loans.  The following table provides detail on our direct insurance in force at March 31, 2011 and 2010:
 
   
March 31,
       
(dollars in millions)
 
2011
   
2010
   
% Change
 
                   
Primary insurance
  $ 27,764     $ 34,006       (18 )
Modified Pool insurance
    9,206       13,613       (32 )
Total insurance
  $ 36,970     $ 47,619       (22 )
 
The decline in Primary insurance in force at March 31, 2011 from March 31, 2010 reflects 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.  The decline in Modified Pool insurance in force for the same period is also due to claim settlement and rescission activity, as well as the termination of a number of Modified Pool transactions where pre-determined aggregate stop loss limits in the contracts were met on a settled basis.

A small portion of our Modified Pool contracts contain provisions that terminate both the coverage and the contract when cumulative settled losses reach the stop loss limit.  No future premium is received following the termination of these Modified Pool contracts.  During the first quarter of 2011, approximately $180 million of Modified Pool insurance in force under this type of contract was terminated compared to $919 million in the first quarter of 2010 and $1.2 billion for the year ended December 31, 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 these types of contracts, we recognize the net present value of the estimated future premium in the period during which our payments reach the maximum liability on a settled basis under the contract.  During the first quarter of 2011, approximately $291 million of Modified Pool insurance in force under this type of contract had settled losses reach the stop loss limit compared to $927 million in the first quarter of 2010 and $1.9 billion for the year ended December 31, 2010.  For both types of Modified Pool contracts, affected policies are excluded from in force statistics once the contractual stop loss limit is met on a settled basis.  We expect that other Modified Pool transactions will reach their contractual stop loss limits on a settled basis and terminate in the remainder of 2011, which will further accelerate the decline of Modified Pool insurance in force.

 
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Persistency measures the percentage of insurance in force remaining from one-year prior and 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 total premium revenue we will earn from the policy.  Primary insurance persistency declined slightly to 81.7% at March 31, 2011 compared to 83.2% at March 31, 2010. Modified Pool insurance persistency declined to 66.7% at March 31, 2011 compared to 69.3% at March 31, 2010. The persistency of our Modified Pool insurance has been adversely impacted by the cancellation of certain of the Modified Pool transactions. We believe our persistency has benefited from the temporary delays in foreclosures as well as the inability of many borrowers on loans that we have insured to sell or refinance existing homes due to the decline in home prices and stricter underwriting standards.

Approximately 70.6% of our Modified Pool insurance in force was originated from 2005 through 2007.  Given the adverse development of our Modified Pool insurance originated in these years, the majority of these transactions have already reached the stop loss limit on an incurred basis.  As the following table indicates, under our Modified Pool contracts, we have limited loss exposure for future defaults, or changes in loss reserves on existing defaults, from contracts originated from 2005 through 2007.  We have additional exposure to Modified Pool contracts originated in 2004 and prior years; however, given the performance to date for these policy years and our belief about the expected future performance, we expect losses from Modified Pool contracts to have significantly less bearing on our future results compared to our Primary business.
 
   
March 31,
   
December 31,
 
(dollars in millions)
 
2011
   
2010
 
             
Modified Pool Summary
           
Net risk in force (accounting for stop loss amounts and deductibles)
  $ 444     $ 476  
Carried reserves on net risk in force
    179       223  
Remaining aggregate loss exposure on Modified Pool contracts
  $ 265     $ 253  
                 
Remaining Aggregate Loss Exposure by Policy Year
               
2003 and Prior
  $ 116     $ 111  
2004
    74       67  
2005
    8       7  
2006
    60       60  
2007
    7       8  
    $ 265     $ 253  
 
Risk in force is the total amount of coverage for which we are at risk under our certificates of insurance.  The following table provides detail on our Primary risk in force at March 31, 2011 and 2010.
 
   
March 31,
       
(dollars in millions)
 
2011
   
2010
   
% Change
 
       
Gross Primary risk in force
  $ 7,267     $ 8,906       (18 )
Less: Ceded risk in force
    (181 )     (191 )     (5 )
Net Primary risk in force
  $ 7,086     $ 8,715       (19 )
 
The percentage of our Primary insurance in force subject to captive reinsurance arrangements decreased to 15.0% at March 31, 2011 from 15.5% at March 31, 2010.  The decline is primarily due to the cancellation of insurance coverage resulting from claim and rescission activity as well as the commutation of certain captive reinsurance agreements. Assets held in trusts supporting the reinsured risk also declined to $53.2 million at March 31, 2011 from $76.9 million at March 31, 2010.  Certain remaining captive reinsurance agreements have trust balances below the reserves ceded under the contracts.  In those cases, the net reserve credit that we recognize in our financial statements is limited to the trust balance.  Given this limitation, as well as the decline in insurance in force subject to captive reinsurance, we expect to only receive limited benefits in future periods from these agreements.

 
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At March 31, 2011, approximately 18.1% of our gross Primary risk in force was comprised of coverage on loans with the potential for negative amortization (“pay-option ARM”) and interest only loans.  An inherent risk in both a pay-option ARM loan and an interest-only loan is the impact of the scheduled milestone in which the borrower must begin making amortizing payments, which can be substantially greater than the minimum payments required before the milestone is met.  An additional risk to a pay-option ARM loan is that the payment being made may be less than the amount of interest accruing, creating negative amortization on the outstanding principal of the loan.  The majority of our pay-option ARM loan portfolio has accumulated negative amortization and we believe these pay-option ARM loans are or will be subject to significant payment shock, which increases our risk of loss.  Many of these pay-option ARM loans are also from the 2006 and 2007 vintage years and are located in Arizona, California, Florida, and Nevada, which we refer to as “distressed markets.”  The pay-option ARM loans that we insure typically reach the milestone where the borrower must begin making amortization payments no later than five years from the date the loan was issued.  Because many of the pay-option ARMs are from the 2006 and 2007 vintages, the default rates on pay-option ARM loans over the next two years may increase as the remaining loans convert to amortizing payments.

At March 31, 2011, approximately 15.6% of our gross Primary risk in force is comprised of coverage on “Alt-A” loans.  We define Alt-A loans as loans that have been underwritten with reduced or no documentation verifying the borrower’s income, assets, or employment and where the borrower has a FICO score greater than 619. We have found a substantial amount of misrepresentation, program violations, and fraud on the Alt-A loans in our portfolio and Alt-A loans have a relatively high rescission rate.  Due in part to depressed conditions in the housing markets, the Alt-A loans, pay-option ARM loans, and interest-only loans have, as a group, performed significantly worse than the remaining prime fixed rate loans.

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

A summary of the individual components of our revenue for the first quarter of 2011 and 2010 follows:
 
   
Three Months Ended
       
   
March 31,
       
(dollars in thousands)
 
2011
   
2010
   
% Change
 
                   
Direct premium written before the impact of refunds
  $ 54,718     $ 69,724       (22 )
Less:
                       
Cash refunds primarily related to rescissions
    (15,685 )     (15,010 )     (4 )
Change in refund accruals primarily related to rescissions
    322       (321 )     200  
Direct premium written
    39,355       54,393       (28 )
Less ceded premium written
    (2,060 )     (8,202 )     75  
Net premium written
    37,295       46,191       (19 )
Change in unearned premiums
    (167 )     (303 )     45  
Earned premiums
  $ 37,128     $ 45,888       (19 )
                         
Net investment income
  $ 8,491     $ 9,873       (14 )
Net realized investment losses
  $ (436 )   $ (242 )     (80 )
Other income (expense)
  $ 27     $ (8 )     438  
Total revenues
  $ 45,210     $ 55,511       (19 )
 
The decrease in direct premium written before the impact of refunds was primarily due to a 22.4% decline in insurance in force since March 31, 2010.  During the first quarter of 2011, the net change in the accrual for Modified Pool transactions that have exceeded their respective aggregate stop loss limits on a settled basis increased premium earned by approximately $0.7 million.

Premium refunds, primarily related to rescission activity, include cash premium refunded as well as the change in the accrual for expected premium refunds.  The activity related to premium refunds reduced direct premium written by 28.1% in the first quarter of 2011 compared to 22.0% in the respective period of 2010. While we experienced a slightly smaller amount of rescission activity, as measured by the risk in force rescinded, during the first quarter of 2011 as compared to the fourth quarter of 2010, the cash amount of the premium refunds was actually higher during the 2011 first quarter.  We expect actual rescissions to decline in the remainder of 2011 compared to the volume we experienced in 2010.  Accordingly, at March 31, 2011, the accrual for expected premium refunds, which is reported in “Accrued expenses and other liabilities” on our Consolidated Balance Sheet, declined slightly to $29.3 million compared to $29.6 million at December 31, 2010 and $47.2 million at March 31, 2010.

Ceded premium written is comprised of premiums written under excess of loss reinsurance treaties with captive reinsurers.  The decline in ceded premium in the first quarter of 2011 compared to the first quarter of 2010 was primarily due to a decrease in average insurance in force subject to captive reinsurance as we commuted our two largest captive reinsurance agreements late in the first quarter of 2010.

Net investment income declined in the first quarter of 2011 compared to the one-year prior period primarily due to a decline in average invested assets. The receipt of assets from the captive commutations in the first quarter of 2010 occurred late in the quarter and had minimal impact on investment income in that quarter.  Invested assets have been used as a source of cash to fund operating cash shortfalls.  We expect average invested assets to continue to decrease in 2011 as we anticipate a deficit in operating cash flow. For further discussion, see “Investment Portfolio.”

 
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Losses and Expenses

A summary of the significant individual components of losses and expenses for the three months ended March 31, 2011 and 2010 follows:
 
   
Three Months Ended
       
   
March 31,
       
(dollars in thousands)
 
2011
   
2010
   
% Change
 
                   
Net losses and loss adjustment expenses
  41,705     72,238       (42 )
Other operating expenses
    4,437       9,332       (52 )
Interest expense
    3,978       2,469       61  
Total losses and expenses
  $ 50,120     $ 84,039       (40 )
                         
Loss ratio
    112.3 %     157.4 %     (29 )
Expense ratio
    11.9 %     20.2 %     (41 )
Combined ratio
    124.2 %     177.6 %     (30 )
 
Net losses and LAE are comprised of settled claims, LAE, and the change in the loss and LAE reserve during the period. Net losses and LAE in the first quarter of 2011 declined compared to first quarter of 2010 primarily due to a decline in the number of newly reported defaults and, to a lesser extent, favorable development from loss reserves previously provided.

 The decline in the reserve for losses during the first quarter of 2011 was primarily the result of a decline in the inventory of loans in default as the number of new defaults continues to moderate. The frequency factor utilized in our reserve methodology decreased slightly during the first quarter of 2011, which also contributed to the decline in the reserve for losses.

The following table shows the default statistics for our Primary business by policy year and breaks out the impact of the distressed markets at March 31, 2011 and December 31, 2010:
 
   
March 31, 2011
 
   
Total Company
   
Distressed Markets
 
(dollars in thousands)
 
Primary
Risk in Force
   
Average Primary Risk in Force Per Policy
   
Primary
Loans in Default
   
Default
Rate
   
Percent of Primary Risk in Force
   
Average Primary Risk in Force Per Policy
   
Default
Rate
 
Policy Year
                                         
2004 & Prior
  $ 1,581,252     $ 29.0       5,471       10.0 %     15.1 %   $ 28.9       12.5 %
2005
    993,680       40.7       4,128       16.9 %     22.0 %     52.6       32.9 %
2006
    1,431,510       49.6       5,875       20.4 %     28.8 %     69.7       39.9 %
2007
    2,776,019       52.0       9,928       18.6 %     25.7 %     70.8       35.4 %
2008
    484,132       46.7       1,082       10.4 %     19.1 %     54.8       18.0 %
Total
  $ 7,266,593       42.4       26,484       15.4 %     23.1 %     55.7       28.7 %
 
 
30

 

   
December 31, 2010
 
   
Total Company
   
Distressed Markets
 
(dollars in thousands)
 
Primary
Risk in Force
   
Average Primary Risk in Force Per Policy
   
Primary
Loans in Default
   
Default
Rate
   
Percent of Primary Risk in Force
   
Average Primary Risk in Force Per Policy
   
Default
Rate
 
Policy Year
                                         
2004 & Prior
  $ 1,662,036     $ 29.1       5,673       9.9 %     15.0 %   $ 29.1       12.3 %
2005
    1,029,617       40.7       4,256       16.8 %     22.1 %     52.6       33.2 %
2006
    1,507,343       50.1       6,269       20.8 %     29.5 %     70.2       41.4 %
2007
    2,923,180       52.6       10,985       19.8 %     26.5 %     71.5       37.7 %
2008
    502,068       46.7       1,106       10.3 %     19.0 %     55.1       18.0 %
Total
  $ 7,624,244       42.6       28,289       15.8 %     23.5 %     56.4       29.9 %

The number of loans in default includes all reported delinquencies that are in excess of two payments in arrears at the reporting date and all reported delinquencies that were previously in excess of two payments in arrears and have not been brought current.  The decline in the number of loans in default and the risk in force is due to a number of factors, including settled claim activity, higher cure rates, rescission activity, and a decline in the number of new defaults being reported.

The following table presents a roll-forward of our Primary risk in default for the first three months of 2011 and 2010.  The majority of amounts included in “Rescinded/Denied risk in default” is comprised of risk on policies that were rescinded.
 
   
Three Months Ended
       
   
March 31,
       
(dollars in millions)
 
2011
   
2010
   
% Change
 
                     
Beginning risk in default
  $ 1,555     $ 2,241       (31 )
Plus:
New risk in default
    203       376       (46 )
Less:
Paid risk in default
    (80 )     (100 )     (20 )
 
Rescinded/Denied risk in default
    (125 )     (133 )     (6 )
 
Cured risk in default
    (133 )     (221 )     (40 )
Ending risk in default
  $ 1,420     $ 2,163       (34 )

The cure rate (cured risk in default as a percentage of beginning risk in default), was 8.6% in the first quarter of 2011 compared to 9.9% in the first quarter of 2010.  Cures are most likely to occur while the default is in its early stage.  In general, our expectation for a cure decreases significantly as the underlying mortgage becomes further delinquent until the borrower has missed ten payments.  Given the low expected cure rate once ten payments are missed, any further missed payments typically result in only a gradual decrease in the expectation for a cure.  Given the delays in foreclosure and recent decline in new default activity, the average age of the total default inventory continued to increase during the first quarter of 2011. At March 31, 2011, 61% of the default inventory was ten or more payments delinquent, compared to 58% at December 31, 2010 and 50% at March 31, 2010, which, all else being equal, is expected to produce a lower overall future cure rate.  HAMP and other lender loan modification programs have contributed to cure activity, including cures on policies that have been in default for more than ten months.  However, we expect the impact of these programs to diminish as the number of policies eligible for the programs decline.  Individual lenders are still actively seeking loan modifications as an alternative to foreclosure outside of the HAMP guidelines and we continue to see the positive results of those efforts, although these cures are primarily coming from more recently reported defaults.

 
31

 
We rescinded coverage on Primary and Modified Pool policies with $151 million and $208 million of total risk in default during the first quarter of 2011 and 2010, respectively.  Rescission activity remains concentrated on policies originated by certain originators and on those originated in 2006 and 2007. We believe the majority of the rescinded risk in default would have ultimately resulted in settled claims.  While we expect rescission activity to have a substantial impact on settled claim activity and our results of operations in 2011, we expect rescission levels will be lower in the remainder of 2011 from that experienced in 2010.  See Item 1A, “Risk Factors” for risks and uncertainties associated with rescission activity.

The following table details the amount of Primary risk in default and the Primary reserve balance as a percentage of risk in default at March 31, 2011 and 2010.  The table also provides the impact of the rescission factor, which is a component of the frequency factor utilized in the reserve model, on gross case reserves at the respective period end.
 
   
March 31,
   
December 31,
 
(dollars in millions)
 
2011
   
2010
 
Primary Business
           
Gross risk on loans in default
  $ 1,420     $ 1,555  
Risk expected to be rescinded on loans in default
    (258 )     (323 )
Risk in default net of expected rescissions
  $ 1,162     $ 1,232  
                 
Gross case reserve (1)
  $ 964     $ 1,029  
Gross case reserves on loans expected to be rescinded
    (181 )     (226 )
Gross case reserves net of expected rescissions
  $ 783     $ 803  
                 
Gross case reserves net of expected rescissions as a percentage of gross risk in default
    55.1 %     51.6 %
                 
Gross case reserves net of expected rescissions as a percentage of gross risk in default, net of expected rescissions
    67.4 %     65.2 %
                 
Percentage decrease in gross case reserves from rescission factor
    18.8 %     22.0 %
                 
(1) Reflects gross case reserves, which excludes IBNR and ceded reserves.
 
 
The following table provides details on both the dollar amount and number of settled claims of both Primary and Modified Pool insurance for the periods ended March 31, 2011 and 2010:
 
   
Three Months Ended
       
   
March 31,
       
(dollars in thousands)
 
2011
   
2010
   
% Change
 
                   
 Net settled claims:
                 
 Primary insurance
  $ 85,634     $ 104,810       (18 )
 Modified Pool insurance
    26,243       44,424       (41 )
 Total direct settled claims
    111,877       149,234       (25 )
 Ceded paid losses
    (4,968 )     (4,261 )     17  
 Total net settled claims
  $ 106,909     $ 144,973       (26 )
                         
 Number of claims settled:
                       
 Primary insurance
    1,610       1,859       (13 )
 Modified Pool insurance
    418       611       (32 )
 Total
    2,028       2,470       (18 )


 
32

 
The decrease in the amount of Primary direct settled claims in the first quarter of 2011 compared to the first quarter of 2010 is primarily due to: (i) delays in foreclosure proceedings resulting from, among other factors, foreclosure moratoriums implemented by servicers; (ii) the general decline in our default inventory over the past year resulting from settled claim and rescission activity; and (iii) a decline in average severity.  Average severity, which is calculated by dividing total direct settled claims by the number of claims settled, for Primary settled claims decreased 5.7% to $53,200 in the first quarter of 2011 from $56,400 in the first quarter of 2010.  We continue to see a smaller percentage of claims from the distressed markets and the 2006 and 2007 policy years, both of which have larger average risk per policy, although the decline has moderated.

The decrease in Modified Pool settled claims is primarily due to a number of transactions reaching the stop loss limit on a settled basis. These transactions were all originated in 2005, 2006, and 2007, which had a large percentage of insured policies in the distressed markets and were responsible for a larger percentage of our Modified Pool incurred losses in previous periods.  Average severity for Modified Pool settled claims declined to $62,800 in the first quarter of 2011 from $72,700 in the first quarter of 2010.

Average severity on settled claims is influenced by our ability to mitigate claims. Historically, the sale of properties by the borrower either before or during the foreclosure process was effective in reducing average severity.  However, the decline in home prices since 2007 across almost all markets, with significant declines in the distressed markets, combined with reduced mortgage credit availability has continued to negatively impact our ability to mitigate losses from sales of properties.  Policies originated in 2006 and 2007 have been particularly impacted by the decline in home prices because the properties were acquired by the borrowers at the peak of the market. We expect our ability to mitigate losses will continue to be adversely affected by these factors.  A greater concentration of settled claims in distressed markets or more recent policy years will exacerbate this effect.  Furthermore, recent issues with foreclosure proceedings may further negatively impact home sales.
 
Certain segments of our insured portfolio continue to perform more adversely when compared to the rest of the portfolio. These segments include:
 
Policies originated on properties in the distressed markets.
 
 
·
The distressed markets accounted for 40.9% of our Primary risk in default at March 31, 2011 while only comprising 23.1% of the Primary risk in force.
 
 
·
The Primary default rate for the distressed markets was 28.7% at March 31, 2011 compared to 12.6% for the non-distressed markets.
 
 
·
The distressed markets comprised 39.4% of Primary settled claims in the first quarter of 2011 while only comprising 17.8% of the policies in force at the beginning of the period.
 
 
·
The Primary claim rate, defined as the number of Primary claims paid over the previous twelve months as a percentage of the number of Primary policies in force at the beginning of the period, for the distressed markets was 8.0% at March 31, 2011 compared to 2.9% for the non-distressed markets.
 
Policies originated in 2006 and 2007.
 
 
·
These policy years accounted for 68.1% of our Primary risk in default at March 31, 2011 while only comprising 57.9% of the Primary risk in force.
 
 
33

 
 
·
The Primary default rate for these policy years was 19.2% at March 31, 2011 compared to 12.0% for the other policy years.
 
 
·
These policy years comprised 59.8% of Primary settled claims in the first quarter of 2011 while only comprising 47.9% of the policies in force at the beginning of the period.
 
 
·
The Primary claim rate for these policy years was 4.6% at March 31, 2011 compared to 3.1% for the other policy years.
 
We believe the adverse performance of these segments was due, in part, to non-sustainable levels of home price appreciation in the years prior to 2007 and the subsequent collapse in home prices as well as poor underwriting standards. These segments are also comprised of a large amount of pay-option ARM loans and Alt-A loans that have exhibited significant adverse performance. While these segments have performed adversely compared to the rest of the portfolio, performance in the other segments has, in general, also been adversely impacted by the same general depressed conditions in home prices and credit markets as well as high unemployment levels.

The table below provides a trend analysis of the gross cumulative incurred loss incidence rate by book year for our Primary business (calculated as cumulative gross losses settled plus loss reserves, excluding the impact of captive structures, divided by policy risk originated, in each case for a particular book year) as it has developed during each of the last five quarters.
 
   
March 31,
 
December 31,
 
September 30,
 
June 30,
 
March 31,
Book Year
 
2011
 
2010
 
2010
 
2010
 
2010
2000 & Prior
 
 1.05
%
 
 1.05
%
 
 1.03
%
 
 1.03
%
 
 1.02
%
2001
 
 1.81
%
 
 1.81
%
 
 1.74
%
 
 1.70
%
 
 1.68
%
2002
 
 2.27
%
 
 2.29
%
 
 2.17
%
 
 2.11
%
 
 2.07
%
2003
 
 2.96
%
 
 2.97
%
 
 2.72
%
 
 2.59
%
 
 2.47
%
2004
 
 6.13
%
 
 6.00
%
 
 5.73
%
 
 5.44
%
 
 5.31
%
2005
 
 14.25
%
 
 13.53
%
 
 13.44
%
 
 12.69
%
 
 12.16
%
2006
 
 16.07
%
 
 15.66
%
 
 15.74
%
 
 15.67
%
 
 15.61
%
2007
 
 14.15
%
 
 13.57
%
 
 13.87
%
 
 13.75
%
 
 13.82
%
2008
 
 5.73
%
 
 5.45
%
 
 5.49
%
 
 5.14
%
 
 4.95
%
 
Total
 
 6.99
%
 
 6.78
%
 
 6.75
%
 
 6.59
%
 
 6.51
%
 
Prior to 2007, the policies that we insured defaulted for a variety of reasons, but primarily due to loss of employment, divorce, or illness of a mortgage holder.  Historically, based on these primary determinants of default, we expected the gross cumulative incurred loss incidence rate for a specific book year to increase over time as the incidence of default is relatively low in the first two years following loan origination, typically reaches its peak in the second through the fifth year after loan origination, and will moderately increase over time as a small number of policies continue to default.  However, in addition to the above factors, the incidence of default in the current economic environment has been and continues to be adversely impacted by the earlier collapse in home prices, continued ongoing declines in home prices, and prolonged elevated levels of unemployment throughout the United States.  As the above table indicates, the 2005, 2006, and 2007 book years are exhibiting significantly worse performance compared to the more developed earlier book years.  We do not expect this adverse performance to subside and expect the gross cumulative incurred loss incidence rate of these book years to remain significantly higher than our previous books of business.


 
34

 
 
Expenses and Taxes

Other operating expenses in the first quarter of 2011 declined significantly compared to the same period of 2010.  A large portion of our variable operating expenses are related to personnel cost and our headcount has contracted significantly since we entered run-off in July 2008, including a 32% decline during the year ended December 31, 2010. We expect our headcount to continue to decline over time. We recognize the full cost of the severance benefits provided to terminated employees in the period that the individual is notified; therefore, the savings in compensation costs is generally not realized until the subsequent quarter.  During the first quarter of 2011, we expensed severance costs of $0.1 million compared to $1.1 million in the first quarter of 2010.

Another factor contributing to the decline in other operating expenses is the amount that we set aside for remedies related to contract underwriting.  In the first quarter of 2010, we recognized $1.9 million of expense related to contract underwriting which included an increase in the reserve for contract underwriting remedies of $0.9 million to reflect an increase in anticipated remedy payments.  In the first quarter of 2011, we only recognized costs of $0.5 million related to contract underwriting.

We lease office space with lease commitments through November 2012 and have sub-leased or relinquished our lease on a significant part of unused office space, which continues to provide a positive impact on expenses.

Interest expense increased 61% in the first quarter of 2011 compared to the same period of 2010 due to the increase in accrued interest related to the DPO liability.  Interest expense on the DPO, the only component of interest expense in the first quarter of 2011, was $4.0 million in the first quarter of 2011 compared to $1.8 million in the first quarter of 2010.  The payment of interest related to the DPO is dependent on attaining certain risk to capital and other operating ratios and is subject to approval by the Department.  No interest has been paid on the DPO since it was established in June 2008. In addition to interest expense on the DPO, interest expense in the first quarter of 2010 also included interest expense on the long-term debt of $0.7 million.

Because the Company has an NOL carryforward as of March 31, 2011, we are unable to obtain an immediate benefit from an operating loss.  Therefore, we did not recognize an income tax benefit in the Statement of Operations for the first quarter of 2011.  The NOL carryforward is calculated using the amounts reported on our income tax returns, which approximates amounts we reported under SAP as opposed to GAAP.  At March 31, 2011, our NOL carryforward was $448.4 million compared to $409.3 million at December 31, 2010.

Financial Position

Total assets decreased to $964.0 million at March 31, 2011 from $991.6 million at December 31, 2010.  Total cash and invested assets decreased to $882.0 million at March 31, 2011 from $890.7 million at December 31, 2010.

Total liabilities were $1.6 billion at both March 31, 2011 and December 31, 2010.  During the first quarter of 2011, the reserve for losses and loss adjustment expenses declined by $69.5 million while the DPO and related accrued interest increased by $48.7 million. Approximately 55% of our total invested assets reported at March 31, 2011 were held in a separate account pursuant to a custodial arrangement to support the liability for the DPO and related accrued interest as required by the second Corrective Order.  We expect the DPO liability to continue to increase during 2011.

 
35

 
If the Department determines that the DPO percentage should be reduced and/or distributions should be made to DPO holders, it would most likely result in a large cash payment by Triad, which would be funded by these assets held in escrow.  While we have structured the maturities of our investment portfolio to provide flexibility to accommodate any such possible payments, when and if they occur, the estimation of the timing of these payments requires assumptions as to future events and there are inherent risks and uncertainties involved in making these assumptions.

Investment Portfolio

The majority of our assets are included in our investment portfolio.  Our goal for managing our investment portfolio is to preserve capital, provide liquidity as necessary for the payment of claims, optimize investment returns, and adhere to regulatory requirements.  We have established a formal investment policy that describes our overall quality and diversification objectives and limits.  We classify our entire investment portfolio as available-for-sale.  All investments are carried on our balance sheet at fair value.

Our portfolio is primarily composed of taxable publicly-traded fixed income securities as well as tax-preferred state and municipal securities.  Our taxable publicly-traded fixed income securities primarily include corporate debt obligations, residential mortgage-backed securities, asset-backed securities, and obligations of the U.S. Government and its agencies.  Approximately 55% of our total invested assets reported at March 31, 2011 were held in a separate account pursuant to a custodial arrangement to support the liability for the DPO and related accrued interest as required by the second Corrective Order, compared to 49% at December 31, 2010.

The following table reflects the composition of our investment portfolio at March 31, 2011 and December 31, 2010:
 
   
March 31, 2011
   
December 31, 2010
 
(dollars in thousands)
 
Fair
Value
   
Percent
   
Fair
Value
   
Percent
 
             
Fixed maturity securities:
                       
 U. S. government and agency securities
  $ 41,621       4.9     $ 43,424       5.1  
 Foreign government securities
    16,065       1.9       15,075       1.8  
 Corporate debt
    544,792       64.6       531,656       62.4  
 Residential mortgage-backed
    59,346       7.0       67,941       8.0  
 Commercial mortgage-backed
    23,749       2.8       21,956       2.6  
 Asset-backed bonds
    36,245       4.3       39,725       4.7  
 State and municipal bonds
    88,621       10.6       92,558       10.9  
Total fixed maturities
    810,439       96.1       812,335       95.4  
Short-term investments
    32,469       3.9       39,561       4.6  
Total securities
  $ 842,908       100.0     $ 851,896       100.0  

The decline in our invested assets from December 31, 2010 is due to cash used to fund our negative cash flow from operations.  We anticipate negative cash flow from operations in 2011 due to the expected level of claims settled and declining net premium collections.  We expect the proceeds from the maturity and sale of securities will be used to fund these anticipated shortfalls.  We have attempted to structure maturities in our investment portfolio in anticipation of these funding needs.  The effective duration of our fixed maturity portfolio was 3.4 years at both March 31, 2011 and December 31, 2010.


 
36

 

Unrealized Gains and Losses

The following table summarizes by category our unrealized gains and losses in our securities portfolio at March 31, 2011:
 
   
As of March 31, 2011
 
(dollars in thousands)
 
Cost or Amortized Cost
   
Gross
Unrealized
Gains
   
Gross
Unrealized Losses
   
Fair
Value