MGIC INVESTMENT CORP quarterly report, Q3 FY2011

MGIC Investment Corporation — Q3 2011 Form 10-Q

Reporting period: Quarter and nine months ended September 30, 2011. MGIC principally provides private mortgage insurance to lenders and government-sponsored enterprises (GSEs). Unless otherwise noted, amounts below are in millions of dollars.

Financial performance and condition

Metric	Q3 2011	Q3 2010	Nine months 2011	Nine months 2010
Total revenue	$337.2	$382.3	$1,057.3	$1,159.5
Net premiums earned	$275.1	$296.5	$848.1	$877.6
Losses incurred, net	$462.7	$384.6	$1,232.6	$1,159.2
Net loss	$(165.2)	$(51.5)	$(350.6)	$(177.1)
Loss per diluted share	$(0.82)	$(0.26)	$(1.74)	$(1.05)

Insurance-operation loss ratio was 168.2% for Q3 and 145.3% for the first nine months, versus 129.7% and 132.1%. Combined ratios were 184.6% and 161.6%, versus 146.3% and 148.7%. These ratios indicate losses and underwriting expenses exceeded premiums earned.
Net investment income was $48.9 million in Q3 and $160.9 million year to date, down from $58.5 million and $190.2 million. Realized investment gains were also lower: $11.4 million for Q3 and $38.9 million year to date. Q3 2011 included $0.3 million of impairment losses.
At September 30, total assets were $7.75 billion, shareholders’ equity $1.39 billion, cash and cash equivalents $866.6 million, and the investment portfolio $6.46 billion. Cash and investments were lower than at year-end 2010; equity declined from $1.67 billion.
Operating cash flow was $(1.42) billion for the first nine months, compared with $(453.4) million in 2010. Investing activities provided $1.11 billion; financing activities used $129.2 million, principally for debt repayment. Cash declined $437.5 million to $866.6 million.
Balance-sheet debt carrying amounts were $244.3 million of senior notes, $345 million of convertible senior notes, and $336.7 million of convertible junior debentures. The junior debentures’ principal amount was $389.5 million. MGIC repaid $77.4 million of senior notes at maturity and repurchased $55 million par value of 2015 notes, recognizing a $3.2 million gain.
MGIC’s statutory risk-to-capital ratio was 22.2:1 and its policyholder position exceeded Wisconsin’s minimum by $50 million. Combined insurance operations were at 24.0:1. Total loss reserves were $4.79 billion; the premium deficiency reserve was $146.5 million.

Material changes and operating trends

Revenue and premiums declined year over year, primarily reflecting lower average insurance in force. Average invested assets also fell as claims were paid, reducing investment income.
New primary insurance written increased to $3.9 billion in Q3 and $10.0 billion year to date, from $3.5 billion and $8.0 billion. Management expected 2011 new insurance written to increase modestly from $12 billion in 2010.
Cancellations exceeded new business: primary insurance in force fell $3.4 billion in Q3 and $12.3 billion year to date. Direct primary insurance in force was $179.0 billion, versus $196.9 billion a year earlier.
Primary default inventory declined to 180,894 loans from 223,373 a year earlier, and the reported default rate fell to 15.85% from 17.67%. However, 57% of defaults had been delinquent for at least 12 months, up from 55%; management noted aged defaults are more likely to become claims.
Net losses and loss-adjustment expenses paid were $715 million in Q3 and $2.22 billion year to date, up from $553 million and $1.65 billion. Management believed quarterly paid claims peaked in Q2 2011, assuming foreclosure patterns continued.
Favorable prior-period reserve development of $96 million in the first nine months partly offset $1.33 billion of current-year loss development. Rescissions reduced paid claims by an estimated $0.5 billion year to date, but did not significantly reduce incurred losses in 2011.

Outlook, risks, and unusual items

Management expected annual net losses to continue and could not say when, or whether, the company would return to annual profitability. It expected average insurance in force and investment income to decline further in Q4, as claims were expected to exceed premiums received.
Capital and eligibility are key risks. Several regulatory capital waivers generally expired at year-end 2011; MGIC expected to seek extensions but could not assure renewal. New capital rules effective in 2012 may reduce the statutory benefit of deferred tax assets. MGIC planned to contribute $200 million of holding-company cash and investments to insurance entities in Q4. Its holding company had $763 million in cash and investments at quarter-end.
MGIC’s Fannie Mae approval for subsidiary MIC was due to expire December 31, 2011; Freddie Mac’s conditional approval ran through December 31, 2012. Competitors RMIC and PMI had stopped writing new commitments, but MGIC said the consequences for its own regulatory waivers and GSE approvals were uncertain.
Rescission disputes pose potentially material, unquantified exposure. Countrywide sought almost $700 million in additional damages, plus exemplary damages; arbitration bellwether hearings were scheduled for September 2012. MGIC had not accrued for an adverse outcome because it could not reasonably estimate the potential loss. Countrywide-related loans were 21% of primary delinquency inventory. Overall, MGIC estimated rescissions had reduced loss reserves by about $800 million at quarter-end.
MGIC and Freddie Mac disputed the aggregate loss limit on certain pool policies. Freddie Mac’s interpretation would increase the limit by about $535 million; applying it would have increased Q2 and Q3 2011 incurred losses by $126 million in total. Management expected the difference to grow in future quarters.
Other uncertainties include housing prices, unemployment, foreclosure and servicing delays, loan-modification redefaults, customer disputes, contract-underwriting remedies, GSE reform, and the proposed definition of qualified residential mortgages. Management estimated that roughly 50% of modified loans could redefault for internal reporting, but said the actual rate was uncertain.
The $286 million auction-rate-securities portfolio remained subject to failed auctions, limiting access to principal. Management expected liquidity by December 31, 2014; approximately 87% of the portfolio was rated AAA/Aaa, and interest had continued to be collected.
The company recorded a $47.9 million increase in its tax valuation allowance in Q3. The total valuation allowance was $533.0 million at September 30. Management also disclosed $109.9 million of unrecognized tax benefits and $26.5 million accrued interest on those benefits.

Important facts for investors to verify

Whether regulatory waivers and GSE approvals are renewed, and whether the planned $200 million capital contribution is completed and sufficient.
How loss severity, aged delinquencies, paid claims, rescission rates, and reserve estimates develop relative to management’s assumptions.
The outcomes and financial effects of the Countrywide arbitration, other rescission disputes, and the Freddie Mac pool-policy interpretation disagreement.
Whether cash, liquid investments, and holding-company resources can support claim payments and debt service as claims continue to exceed premiums.
Whether 2011 new-business growth and any competitor share gains can offset runoff, and how GSE, FHA, and QRM policy changes affect future demand.