Essent Group Ltd. annual report, FY2014

Business context and reporting period

Essent Group Ltd. filed this Form 10-K for the fiscal year ended December 31, 2014. The company provides U.S. private mortgage insurance and related reinsurance; the filing also presents unaudited fourth-quarter results. Essent reported an estimated 13.7% share of flow private-mortgage-insurance new insurance written (NIW), compared with 12.1% in 2013. Its mortgage-insurance subsidiary was approved by Fannie Mae and Freddie Mac.

Financial and operating metrics

Fourth-quarter 2014 revenue was approximately $72.7 million, pretax income $44.0 million and net income $28.9 million, versus approximately $42.4 million, $19.4 million and $19.0 million, respectively, in fourth-quarter 2013. Quarterly results are unaudited.

• NIW was $24.8 billion, up 17% from $21.2 billion; year-end insurance in force (IIF) increased 58% to $50.8 billion. Risk in force was $12.2 billion.
• Loss, expense and combined ratios were 2.8%, 43.6% and 46.4%, respectively, versus 1.9%, 57.6% and 59.5% in 2013.
• Net investment income rose to $12.3 million from $4.1 million; the average investment portfolio yield was 1.5%, compared with 1.1%.
• Cash and investments totaled about $1.082 billion at year-end, including $24.4 million cash and $1.058 billion investments. Management said liquidity was sufficient for expected needs over the next 12 months. The company reported no debt.
• U.S. insurance subsidiaries’ combined statutory capital was $705.9 million and combined risk-to-capital was 16.2:1. Their statutory capital exceeded applicable regulatory requirements at year-end.

Material changes versus the prior comparable period

Revenue and earnings grew principally with the expansion in average IIF, from $22.8 billion to $40.6 billion. Net premiums earned increased 81%, while net premiums written increased 49%. Operating expenses rose 37% to $97.2 million as staffing and business activity expanded; employees increased to 332 from 289. The provision for losses and loss-adjustment expenses rose to $6.3 million from $2.3 million, while the year-end default rate increased to 0.20% from 0.11%.

Investment assets increased substantially as cash from prior capital raises, the 2014 secondary offering and operating cash flows was invested. Net cash decreased by $453.2 million, mainly reflecting investment purchases; operating cash flow remained positive. Stockholders’ equity increased 32%, including $126.7 million of net proceeds from a November 2014 share offering.

Outlook, commentary, risks and unusual items

• Management expects defaults and claims to rise as the relatively young portfolio seasons; historical peak claim incidence is typically in years three to six after origination. At year-end, the portfolio’s weighted-average life was 13.7 months, and 82% of IIF was from 2013–2014 vintages.
• The FHFA’s proposed Private Mortgage Insurer Eligibility Requirements (PMIERs) could require additional liquid assets or capital and affect Essent’s eligibility or capacity to write business. Final requirements were not expected before late first-quarter 2015.
• Essent depends substantially on the GSEs and low-down-payment mortgage originations. GSE policy or housing-finance reform, competition from government programs (including the FHA’s January 2015 premium reduction), and changes in QM, QRM or capital rules could reduce demand or alter product mix.
• Customer concentration remains relevant: one lender represented 15% of 2014 revenue, although the top ten customers’ share of flow NIW declined to 42.6% from 49.6%. Loss of a major customer could materially affect results.
• Loss reserves are established for loans in default, not for all potential future claims on loans currently performing. Reserve estimates are uncertain and sensitive to housing prices, employment, interest rates, cures and claim severity.
• Insurance-subsidiary dividends are constrained. Essent Guaranty had negative unassigned surplus and could not pay ordinary dividends without regulatory approval; management said the holding company may have limited access to subsidiary dividends for several years. Essent Re agreed to maintain at least $100 million equity and reported $155.1 million.
• Tax expense was $47.4 million in 2014, versus a $7.4 million tax benefit in 2013, when a deferred-tax valuation allowance was released. Management expected a lower effective tax rate from 2015 as a greater portion of earnings was expected to arise in Bermuda; this outlook depends on operating and tax circumstances.
• Essent Re began a 25% quota-share reinsurance arrangement on eligible new business effective July 1, 2014, and issued two Freddie Mac ACIS policies covering up to approximately $43.7 million of risk. ACIS policies are accounted for as derivatives; year-end fair value included a $0.7 million Level 3 liability.
• The filing reports no material legal proceedings and no dividends expected for the foreseeable future. The auditor gave an unqualified opinion on the financial statements and internal control over financial reporting; management also concluded controls were effective.

Important facts for investors to verify

• Final PMIERs requirements, resulting capital needs and Essent’s continuing GSE eligibility.
• Default, cure and paid-claim trends as the portfolio seasons, including reserve adequacy and loss severity.
• Customer concentration and the sustainability of NIW, market share, premium rates and persistency.
• Holding-company liquidity and the practical effects of insurance-subsidiary dividend restrictions.
• Actual tax rate and earnings mix as Bermuda reinsurance activity develops, including applicable tax and regulatory changes.
• Investment portfolio liquidity, interest-rate sensitivity and the valuation assumptions for ACIS derivative liabilities.