-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, U+0vot+LzaEXiouJ/WaGo3Gtn4TdXg3U7ZuX3x1Qsyo5dsH3hpq36cvqUtQpedSr L7pWhZ2eELKvpF11UDSBzw== 0001032210-01-501381.txt : 20020410 0001032210-01-501381.hdr.sgml : 20020410 ACCESSION NUMBER: 0001032210-01-501381 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 20010930 FILED AS OF DATE: 20011114 FILER: COMPANY DATA: COMPANY CONFORMED NAME: PMI GROUP INC CENTRAL INDEX KEY: 0000935724 STANDARD INDUSTRIAL CLASSIFICATION: SURETY INSURANCE [6351] IRS NUMBER: 943199675 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 001-13664 FILM NUMBER: 1790507 BUSINESS ADDRESS: STREET 1: 601 MONTGOMERY ST CITY: SAN FRANCISCO STATE: CA ZIP: 94111 BUSINESS PHONE: 4157887878 MAIL ADDRESS: STREET 1: 601 MONTGOMERY ST CITY: SAN FRANCISCO STATE: CA ZIP: 94111 10-Q 1 d10q.txt QUARTERLY REPORT UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549 FORM 10 - Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2001 OR [_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from..........to.......... Commission file number 1-13664 THE PMI GROUP, INC. (Exact name of registrant as specified in its charter) Delaware 94-3199675 (State of Incorporation) (IRS Employer Identification No.) 601 Montgomery Street, San Francisco, California 94111 (Address of principal executive offices) (Zip Code) (415) 788-7878 (Registrant's telephone number including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No__ -- Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Class of Stock Par Value Date Number of Shares - -------------- --------- ---- ---------------- Common Stock $0.01 10/30/01 44,539,561 THE PMI GROUP, INC. Index to Quarterly Report on Form 10-Q September 30, 2001
Part I - Financial Information Page ---- Item 1. Interim Consolidated Financial Statements and Notes (unaudited) Consolidated Statements of Operations for the Three Months and Nine Months Ended September 30, 2001 and 2000 3 Consolidated Balance Sheets as of September 30, 2001 and December 31, 2000 4 Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2001 and 2000 5 Notes to Consolidated Financial Statements 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 13 Item 3. Quantitative and Qualitative Disclosures about Market Risk 35 Part II - Other Information Item 2. Changes in Securities and Use of Proceeds 36 Item 6. Exhibits and Reports on Form 8-K 38 Signatures 39 Index to Exhibits 40
2 PART I - FINANCIAL INFORMATION ITEM 1. INTERIM FINANCIAL STATEMENTS THE PMI GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)
Three Months Nine Months Ended September 30, Ended September 30, ------------------------------ -------------------------- 2001 2000 2001 2000 ------------ ------------ -------------- -------- (In thousands, except per share data) Revenues Premiums earned $ 193,265 $ 162,395 $ 540,963 $467,944 Net investment income 36,663 29,524 100,617 85,642 Net realized investment gains (losses) (1,431) 1,420 (4,096) 2,558 Other 8,320 1,707 20,527 6,213 ------------ ----------- -------------- -------- Total revenues 236,817 195,046 658,011 562,357 ------------ ----------- -------------- -------- Losses and Expenses Losses and loss adjustment expenses 26,029 22,413 73,308 77,346 Amortization of deferred policy acquisition costs 20,340 19,189 60,474 59,191 Other underwriting and operating expenses 71,224 49,964 187,270 132,337 Interest expense 4,314 2,632 9,695 7,575 Distributions on preferred capital securities 2,006 2,077 6,160 6,232 ------------ ----------- -------------- -------- Total losses and expenses 123,913 96,275 336,907 282,681 ------------ ----------- -------------- -------- Income before income taxes 112,904 98,771 321,104 279,676 Income tax expense 33,654 29,515 95,126 85,451 ------------ ----------- -------------- -------- Income before extraordinary item 79,250 69,256 225,978 194,225 Extraordinary loss on extinguishment of debt (less applicable income tax of $488) (906) - (906) - ------------ ----------- -------------- -------- Net income $ 78,344 $ 69,256 $ 225,072 $194,225 ============ =========== ============== ======== Per share data: Basic: Income before extraordinary item $ 1.78 $ 1.57 $ 5.09 $ 4.39 Extraordinary item, net of income tax (0.02) - (0.02) - ------------ ----------- -------------- -------- Basic net income $ 1.76 $ 1.57 $ 5.07 $ 4.39 ============ =========== ============== ======== Diluted: Income before extraordinary item $ 1.74 $ 1.53 $ 4.99 $ 4.33 Extraordinary item, net of income tax (0.02) - (0.02) - ------------ ----------- -------------- -------- Diluted net income $ 1.72 $ 1.53 $ 4.97 $ 4.33 ============ =========== ============== ======== Cash dividends declared $ 0.04 $ 0.04 $ 0.12 $ 0.12 ============ =========== ============== ========
See accompanying notes to consolidated financial statements. 3 THE PMI GROUP, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS
September 30, December 31, 2001 2000 ------------ ------------ (Dollars In thousands, except per share data) (Unaudited) Assets Investments: Available for sale, at fair value: Fixed income securities (amortized cost: $1,906,187; $1,536,291) $ 2,014,042 $ 1,613,330 Equity securities: Common (cost: $53,741; $53,315) 60,771 81,726 Preferred (cost: $107,548; $108,743) 116,040 111,743 Common stock of affiliates, at underlying book value 159,187 131,849 Short-term investments, at fair value 225,995 139,577 ------------ ------------ Total investments 2,576,035 2,078,225 Cash 58,898 21,969 Accrued investment income 28,473 23,494 Reinsurance recoverable and prepaid premiums 53,510 51,329 Premiums receivable 60,011 41,362 Deferred policy acquisition costs 72,052 67,009 Property and equipment, net 65,181 53,475 Other assets 77,587 55,794 ------------ ------------ Total assets $ 2,991,747 $ 2,392,657 ============ ============ Liabilities Reserve for losses and loss adjustment expenses $ 295,768 $ 295,089 Unearned premiums 179,958 170,866 Long-term debt 459,992 136,819 Reinsurance balances payable 30,305 26,581 Deferred income taxes 85,989 74,981 Other liabilities and accrued expenses 116,076 90,001 ------------ ------------ Total liabilities 1,168,088 794,337 ------------ ------------ Company-obligated mandatorily redeemable preferred capital securities of subsidiary trust holding solely junior subordinated deferrable interest debenture of the Company 83,500 99,109 Shareholders' equity Common stock - $.01 par value; 125,000,000 shares authorized, and 52,793,777 shares issued 528 528 Additional paid-in capital 267,762 267,762 Accumulated other comprehensive income 75,243 62,501 Retained earnings 1,731,481 1,511,751 Treasury stock, at cost (8,263,497 and 8,484,082 shares) (334,855) (343,331) ------------ ------------ Total shareholders' equity 1,740,159 1,499,211 ------------ ------------ Total liabilities and shareholders' equity $ 2,991,747 $ 2,392,657 ============ ============
See accompanying notes to consolidated financial statements. 4 THE PMI GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
Nine Months Ended September 30, ----------------------------------- 2001 2000 ------------- ------------- (In thousands) Cash flows from operating activities: Net income $ 225,072 $ 194,225 Adjustments to reconcile net income before extraordinary item: Extraordinary charge from early extinguishment of debt 906 - ------------- ------------- Income before extraordinary item 225,978 194,225 Adjustments to reconcile net income before extraordinary item to net cash provide by operating activities: Realized investment (gains) losses 4,096 (2,558) Equity in earnings of affiliates (12,249) (7,636) Depreciation and amortization 5,165 9,024 Deferred income taxes 5,543 (614) Changes in: Reserve for losses and loss adjustment expenses 679 13,297 Unearned premiums 9,092 (4,883) Deferred policy acquisition costs (5,043) 5,740 Accrued investment income (4,979) (2,771) Reinsurance balances payable 3,724 1,706 Reinsurance recoverable and prepaid premiums (2,181) (1,427) Premiums receivable (18,649) (4,776) Income tax payable (7,669) (9,530) Other 13,911 15,136 ------------- ------------- Net cash provided by operating activities 217,418 204,933 ------------- ------------- Cash flows from investing activities: Proceeds from sales and maturities of fixed income securities 168,841 132,556 Proceeds from sales of equity securities 79,938 40,395 Investment purchases: Fixed income securities (532,954) (255,409) Equity securities (82,052) (132,168) Net (increase) decrease in short-term investments (87,492) 56,249 Investment in affiliates (14,734) (20,738) Purchases of property and equipment (21,545) (13,157) ------------- ------------- Net cash used in investing activities (489,998) (192,272) ------------- ------------- Cash flows from financing activities: Proceeds from issuance of senior convertible debentures 360,000 - Repayment of bank note (35,732) - Purchase of redeemable capital securities (17,894) - Proceeds from exercise of stock options 8,475 5,482 Dividends paid to shareholders (5,340) (5,300) Purchases of The PMI Group, Inc. common stock - (24,017) ------------- ------------- Net cash provided by (used in) financing activities 309,509 (23,835) ------------- ------------- Net increase (decrease) in cash 36,929 (11,174) Cash at beginning of year 21,969 28,076 ------------- ------------- Cash at end of period $ 58,898 $ 16,902 ============= =============
See accompanying notes to consolidated financial statements. 5 THE PMI GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2001 (Unaudited) Note 1. Basis of Presentation The accompanying consolidated financial statements include The PMI Group, Inc. ("TPG" or "The PMI Group"), a Delaware corporation; its direct and indirect wholly-owned subsidiaries, PMI Mortgage Insurance Co. ("PMI"), an Arizona corporation; American Pioneer Title Insurance Company ("APTIC"), a Florida corporation; PMI Mortgage Insurance Ltd ("PMI Ltd"), an Australian mortgage insurance company; PMI Mortgage Insurance Company Limited, an Irish corporation; and other insurance, reinsurance and non-insurance companies. TPG and its subsidiaries are collectively referred to as the "Company." TPG also has equity interests in RAM Holdings Ltd. and RAM Holdings II Ltd. (collectively referred to as "RAM RE"), two financial guaranty reinsurance companies based in Bermuda. In addition, PMI has equity interests in CMG Mortgage Insurance Company, CMG Mortgage Reinsurance Company and CMG Mortgage Assurance Company (collectively referred to as "CMG"), which conduct residential mortgage insurance and reinsurance business; and Fairbanks Capital Holding Corp. ("Fairbanks"), a special servicer of single-family residential mortgages. CMG, Fairbanks and Ram Re are accounted for on the equity method of accounting in the Company's consolidated financial statements. All material intercompany transactions and balances have been eliminated in consolidation. The Company's unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States ("GAAP") for interim financial information and the requirements of Form 10-Q and Article 7 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 (consisting only of normal recurring adjustments) considered necessary for a fair presentation, have been included. Interim results for the three months and nine months ended September 30, 2001 are not necessarily indicative of the results that may be expected for the year ending December 31, 2001. The financial statements should be read in conjunction with the audited consolidated financial statements and footnotes included in The PMI Group, Inc. 2000 Annual Report to Shareholders. Note 2. Summary of Certain Significant Accounting Policies Changes in Accounting Policy - Effective January 1, 2000, the Company changed its accounting policy to report international subsidiaries and affiliates operations on a one-month lag from domestic operations. Accordingly, the results of PMI Ltd for the nine months ended September 30, 2001 represented eight months of activity. The Company expects to change this accounting policy to begin reporting international subsidiaries and affiliates operations on the same calendar month as our domestic operations as of and for the period ending December 31, 2001. Deferred Policy Acquisition Costs - The Company defers certain costs of its mortgage insurance operations relating to the acquisition of primary mortgage insurance and amortizes these costs against related premium revenues in order to match costs and revenues in accordance with GAAP. These acquisition costs vary with, and are primarily related to, the acquisition of new business and include underwriting, contract underwriting and sales related activities. To the extent the Company is compensated by customers for contract underwriting, those underwriting costs are not deferred. Costs associated with the acquisition of mortgage insurance business are initially deferred and reported as deferred policy acquisition costs ("DPAC"). The DPAC asset is amortized and charged against revenue in proportion to estimated gross profits over the life of the policies using the guidance provided by Statement of Financial Accounting Standards ("SFAS") 6 No. 97, Accounting and Reporting by Insurance Enterprises For Certain Long- Duration Contracts and For Realized Gains and Losses From the Sale of Investments. DPAC is summarized as follows:
Three Months Nine Months Ended September 30, Ended September 30, ------------------------------- ------------------------------- 2001 2000 2001 2000 ------------- -------------- ------------- -------------- (In Thousands) (In Thousands) Beginning DPAC balance $ 71,764 $ 68,769 $ 67,009 $ 69,579 U.S. operations acquisition costs incurred and deferred 18,287 16,602 59,685 53,109 U.S. operations amortization of deferred costs (19,306) (19,189) (57,634) (59,191) International operations acquisition costs incurred and deferred 2,072 (1,733)* 5,809 1,962 International operations amortization of deferred costs (1,034) (692) (2,840) (1,325) Currency translation adjustment 269 82 23 (295) ------------- -------------- ------------- -------------- Ending DPAC balance $ 72,052 $ 63,839 $ 72,052 $ 63,839 ============= ============== ============= ==============
* Includes a reversal of GST Tax adjustment for PMI Ltd. Reclassifications - Certain items in the prior period's financial statements have been reclassified to conform to the current period's presentation. Note 3. Earnings Per Share Basic earnings per share ("EPS") excludes dilution and is computed by dividing net income available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock. The weighted average common shares outstanding for computing diluted EPS includes only stock options issued by the Company that have a dilutive impact and are outstanding for the period, and had the potential effect of increasing common shares. Net income available to common shareholders does not change for computing diluted EPS. Weighted average common shares outstanding for the three months and nine months ended September 30, 2001 and 2000 follows:
Three Months Nine Months Ended September 30, Ended September 30, ------------------------------------- ------------------------------------- 2001 2000 2001 2000 ------------------- ----------------- ----------------- ------------------- Weighted Average Shares Outstanding For basic EPS 44,508,519 44,213,298 44,409,866 44,240,198 For diluted EPS 45,480,061 45,139,404 45,329,914 44,896,795
7 Note 4. Comprehensive Income The reconciliation of net income to comprehensive income for the three months and nine months ended September 30, 2001 and 2000 are as follow:
Three Months Nine Months Ended September 30, Ended September 30, ------------------------------- ------------------------------- 2001 2000 2001 2000 ------------- -------------- ------------- -------------- (In thousands) (In thousands) Net income $ 78,344 $ 69,256 $ 225,072 $ 194,225 Other comprehensive income, net of tax: Unrealized gains (losses) on investments: Unrealized holding gains arising during period 14,966 10,354 7,934 31,143 Less: reclassification adjustment for gains (losses) included in net income (930) 923 (2,662) 1,663 ------------- -------------- ------------- -------------- Net unrealized holding gains 15,896 9,431 10,596 29,480 Currency translation adjustment 4,301 215 2,146 (4,149) Transition adjustment for implementation of SFAS No.133 - - (1,009) - Fair value adjustment of derivatives 678 - 1,009 - ------------- -------------- ------------- -------------- Other comprehensive income, net of tax 20,875 9,646 12,742 25,331 ------------- -------------- ------------- -------------- Comprehensive income $ 99,219 $ 78,902 $ 237,814 $ 219,556 ============= ============== ============= ==============
Note 5. Business Segments The Company's reportable operating segments are U.S. Mortgage Insurance, International Mortgage Insurance, Title Insurance and Other. The "Other" segment includes the activity of the holding company, the results from PMI Mortgage Services Co. and the activity of an inactive broker-dealer. Intersegment profit and loss transactions are not significant. The Company evaluates performance primarily based on segment net income. The following tables present information about reported segment income (loss) and segment assets as of and for the periods indicated: 8
Three Months Ended September 30, 2001 ------------------------------------------------------------------------------ U.S. International Mortgage Mortgage Title Consolidated Insurance Insurance Insurance Other Total ------------------------------------------------------------------------------ (In thousands) Premiums earned $ 142,166 $ 7,285 $ 43,814 $ - $ 193,265 ============== ============== =========== ========== =============== Net underwriting and operating income (loss) before tax $ 83,013 $ 4,697 $ 3,358 $ (7,076) $ 83,992 Investment income & net realized investment gains 20,955 4,025 507 4,926 30,413 Equity in earnings of affiliates 2,600 (125) - 2,344 4,819 Interest expense (36) (226) - (4,052) (4,314) Distributions on preferred capital securities - - - (2,006) (2,006) -------------- -------------- ----------- ---------- --------------- Income (loss) before income tax expense 106,532 8,371 3,865 (5,864) 112,904 Income tax benefit (expense) (32,779) (1,844) (1,407) 2,376 (33,654) Extraordinary loss on extinguishment of debt, net of tax benefit of $488 - - - (906) (906) -------------- -------------- ----------- ---------- --------------- Net income (loss) $ 73,753 $ 6,527 $ 2,458 $ (4,394) $ 78,344 ============== ============== =========== ========== =============== Total assets $ 2,139,099 $ 364,794 $ 59,820 $ 428,034 $ 2,991,747 ============== ============== =========== ========== ===============
Three Months Ended September 30, 2000 ------------------------------------------------------------------------------ U.S. International Mortgage Mortgage Title Consolidated Insurance Insurance Insurance Other Total ------------------------------------------------------------------------------ (In thousands) Premiums earned $ 127,376 $ 7,439 $ 27,580 $ - $ 162,395 ============== ============== =========== ========== =============== Net underwriting and operating income (loss) before tax $ 74,794 $ 2,990 $ 2,387 $ (7,636) $ 72,535 Investment income & net realized investment gains 22,631 2,614 474 2,385 28,104 Equity in earnings of affiliates 2,237 (668) - 1,272 2,841 Interest expense (6) (762) - (1,864) (2,632) Distributions on preferred capital securities - - - (2,077) (2,077) -------------- -------------- ----------- ---------- --------------- Income (loss) before income tax expense 99,656 4,174 2,861 (7,920) 98,771 Income tax benefit (expense) 31,132 926 1,031 (3,574) 29,515 -------------- -------------- ----------- ---------- --------------- Net income (loss) $ 68,524 $ 3,248 $ 1,830 $ (4,346) $ 69,256 ============== ============== =========== ========== =============== Total assets $ 1,964,631 $ 180,354 $ 50,235 $ 141,713 $ 2,336,933 ============== ============== =========== ========== ===============
9
Nine Months Ended September 30, 2001 ------------------------------------------------------------------------------ U.S. International Mortgage Mortgage Title Consolidated Insurance Insurance Insurance Other Total ------------------------------------------------------------------------------ (In thousands) Premiums earned $ 407,757 $ 21,643 $ 111,563 $ - $ 540,963 ============== =============== =========== ========== =============== Net underwriting and operating income (loss) before tax $ 243,064 $ 12,937 $ 7,993 $ (23,556) $ 240,438 Investment income & net realized investment gains 63,987 10,536 1,528 8,221 84,272 Equity in earnings of affiliates 7,322 (306) - 5,233 12,249 Interest expense (45) (1,533) - (8,117) (9,695) Distributions on preferred capital securities - - - (6,160) (6,160) -------------- --------------- ----------- ---------- --------------- Income (loss) before income tax expense 314,328 21,634 9,521 (24,379) 321,104 Income tax benefit (expense) (95,634) (5,213) (3,406) 9,127 (95,126) Extraordinary loss on extinguishment of debt, net of tax benefit of $488 - - - (906) (906) -------------- --------------- ----------- ---------- --------------- Net income (loss) $ 218,694 $ 16,421 $ 6,115 $ (16,158) $ 225,072 ============== =============== =========== ========== =============== Total assets $ 2,139,099 $ 364,794 $ 59,820 $ 428,034 $ 2,991,747 ============== =============== =========== ========== ===============
Nine Months Ended September 30, 2000 ------------------------------------------------------------------------------ U.S. International Mortgage Mortgage Title Consolidated Insurance Insurance Insurance Other Total ------------------------------------------------------------------------------ (In thousands) Premiums earned $ 372,883 $ 20,114 $ 74,947 $ - $ 467,944 ============== =============== =========== ========== =============== Net underwriting and operating income (loss) before tax $ 203,910 $ 10,218 $ 6,455 $ (15,301) $ 205,282 Investment income & net realized investment gains 65,250 9,408 1,388 5,179 81,225 Equity in earnings of affiliates 6,308 (877) - 1,545 6,976 Interest expense (19) (2,048) - (5,508) (7,575) Distributions on preferred capital securities - - - (6,232) (6,232) -------------- --------------- ----------- ---------- --------------- Income (loss) before income tax expense 275,449 16,701 7,843 (20,317) 279,676 Income tax benefit (expense) 84,516 5,153 2,698 (6,916) 85,451 -------------- --------------- ----------- ---------- --------------- Net income (loss) $ 190,933 $ 11,548 $ 5,145 $ (13,401) $ 194,225 ============== =============== =========== ========== =============== Total assets $ 1,964,631 $ 180,354 $ 50,235 $ 141,713 $ 2,336,933 ============== =============== =========== ========== ===============
Note 6. New Accounting Standards SFAS 133 - In June 1998, the Financial Accounting Standards Board ("FASB") issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, which established accounting and reporting standards for derivative instruments and for hedging activities. These rules require that all derivative instruments be reported in the consolidated financial statements at fair value. Changes in the fair value of derivatives are to be recorded each period in earnings or other comprehensive income, depending on 10 whether the derivative is designated and effective as part of a hedged transaction, and on the type of hedge transaction. Gains and losses on derivative instruments reported in other comprehensive income must be reclassified as earnings in the period in which earnings are affected by the underlying hedged item, and the ineffective portion of all hedges must be recognized in earnings in the current period. The Company adopted this statement effective January 1, 2001. The Company's use of derivative financial instruments was generally limited to reducing its exposure to interest rate and currency exchange risk by utilizing interest rate and currency swap agreements which are accounted for as hedges. In 1999, the Company entered into an interest rate swap to hedge interest rate risk associated with the debt in connection with the acquisition of PMI Ltd. Upon adoption of SFAS No. 133, the Company recorded a $1.0 million liability for the fair value of the interest rate swap in the Consolidated Balance Sheet. This interest rate swap was terminated in July 2001 when the Company repaid the associated debt, which resulted in a realized loss of $0.8 million. As of September 30, 2001, the Company did not have any derivative instruments. SFAS 141 and 142 - In June 2001, the FASB issued SFAS No. 141, Business Combinations, and No. 142, Goodwill and other Intangible Assets, effective for fiscal years beginning after December 15, 2001. Under SFAS No. 141, use of the pooling-of-interest method is no longer permitted for all business combinations initiated after June 30, 2001 and the purchase method of accounting is required. Under SFAS No. 142, goodwill and intangible assets deemed to have an indefinite useful life will no longer be amortized but will be subject to an annual review for impairment. The Company has evaluated its intangible assets in relation to the provisions of SFAS No. 142 to determine the impact of adopting this statement. In connection with the acquisition of PMI Ltd in 1999, the Company recorded approximately $21.7 million negative goodwill, which will require write off upon adoption of SFAS No. 142 effective January 1, 2002. In accordance with the new standard, the Company will recognize the remaining balance of this negative goodwill as extraordinary income, net of tax, in an amount estimated to be approximately $5 million. Note 7. Short-term Investment Included in the Company's short-term investments is a face value of $10.0 million commercial paper issued by Pacific Gas and Electric Company ("PG&E"), which is currently in default. During the second quarter of 2001, the Company analyzed this investment and determined that the investment's $3.2 million decline in market value met the definition of an other-than-temporary impairment in accordance with SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. Based on the Company's analysis, a $3.2 million realized loss was recognized during the second quarter of 2001. In the third quarter, an increase in the fair value of this investment resulted in an unrealized gain of $1.6 million. The Company will re-evaluate this investment each quarter. Note 8. Long-term Debt Senior Convertible Debentures - In July 2001, the Company issued $360 million of 2.50% Senior Convertible Debentures due 2021 (the "Debentures") in a private offering to qualified institutional buyers. The Company intends to use the net proceeds of the offering for repayment or retirement of existing indebtedness, depending upon market conditions, and for general corporate purposes. The Debentures are due on July 15, 2021 and bear interest at a rate of 2.50% per annum. The Company will pay interest on the Debentures on January 15 and July 15 of each year, beginning January 15, 2002. The Company will also pay additional contingent interest for specified circumstances. For additional information concerning the terms of the Debentures, see Part II, Item 2 of this Form 10-Q and the Company's Current Report on Form 8-K, which was filed with the Securities and Exchange Commission on July 18, 2001, including the exhibits attached thereto. 11 In July 2001, the Company repaid an outstanding bank note in the amount of $35.7 million with Bank of America from the proceeds of the Debentures offering described above. In September 2001, the Company repurchased $16.5 million of $100.0 million PMI Capital I 8.309% Preferred Capital Securities from the proceeds of the Debentures. The partial extinguishment of this debt resulted in an extraordinary loss of $0.9 million, net of tax benefit of $0.5 million, in the third quarter of 2001. In October and November 2001, the Company repaid an additional $35.0 million of the outstanding principal amount of the preferred capital securities and $19.0 million of the $100.0 million of senior notes, which resulted in an approximately $3.1 million extraordinary loss, net of tax. Note 9. Other Assets In December 2000, the Company executed a purchase agreement for a seven-story commercial building to serve as the new headquarters. The total purchase price was $74.0 million in cash. The Company has made payments of $12.5 million to date and the balance of the purchase price is due at closing, which is expected to occur in 2002. At September 30, 2001, the Company has incurred $1.6 million of other costs and fees relating to the construction of the building. The payments and costs were included in other assets on the accompanying balance sheet. Note 10. Acquisition In September 2001, the Company completed its acquisition of the Australian mortgage insurance company, CGU Lenders Mortgage Insurance Limited (renamed PMI Indemnity Limited). The purchase price of this acquisition is subject to post-closing adjustments but is expected to be approximately $40 million. The acquisition was accounted for under the purchase method of accounting and there was no related goodwill. PMI Indemnity Limited's operations will be merged into the Company's existing Australian subsidiary, and the financial results will be included in the Company's fourth quarter results of operations. 12 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Cautionary Statement Regarding Forward-Looking Statements A number of written and oral statements made or incorporated by reference from time to time by us or our representatives in this document, other documents filed with the Securities and Exchange Commission, press releases, conferences, or otherwise that are not historical facts, or are preceded by, followed by or that include the words "believes," "expects," "anticipates," "estimates," or similar expressions, and that relate to future plans, events or performance are "forward-looking" statements within the meaning of the federal securities laws. Forward-looking statements in this document include: . our anticipation that the percentage of PMI's risk in force related to risk-sharing programs will continue to increase as a percentage of total risk in force in 2001; . our anticipation that contract underwriting services will continue to account for a significant portion of PMI's acquisition costs; and . our belief that continued increases in the electronic origination and delivery of our products could decrease our acquisition costs. When a forward-looking statement includes an underlying assumption, we caution that, while we believe the assumption to be reasonable and make it in good faith, assumed facts almost always vary from actual results, and the difference between assumed facts and actual results can be material. Where, in any forward-looking statement, we express an expectation or belief as to future results, there can be no assurance that the expectation or belief will result. Our actual results may differ materially from those expressed in any forward-looking statements made by us. Forward-looking statements involve a number of risks of uncertainties including, but not limited to, the risks described under the heading "Investment Considerations". All forward-looking statements are qualified by and should be read in conjunction with those risk factors. Except as may be required by applicable law, we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. 13 RESULTS OF CONSOLIDATED OPERATIONS: THREE MONTHS ENDED SEPTEMBER 30, 2001 AND 2000 Our consolidated net income was $78.3 million for the three months ended September 30, 2001, a 13% increase from the three months ended September 30, 2000. The gain was primarily due to: . an increase in premiums earned of $30.9 million or 19%; . an increase in net investment income of $7.1 million or 24%; and . an increase in other income of $6.6 million. This gain was partially offset by: . an increase in amortization of deferred policy acquisition costs and other underwriting and operating expenses of $22.4 million or 32%; . an increase in losses and loss adjustment expenses of $3.6 million or 16%; and . net realized investment losses of $1.4 million. Diluted net income per share, excluding an extraordinary loss, for the three months ended September 30, 2001 was $1.72, an increase of 12% from the corresponding period in 2000. Diluted operating earnings per share, excluding realized investment losses and an extraordinary loss, increased 17% from the comparable period of 2000 to $1.76. Consolidated revenues for the third quarter of 2001 increased 21% to $236.8 million from the third quarter of 2000. U.S. Mortgage Insurance Operations Our primary operating subsidiary, PMI Mortgage Insurance Co., or PMI, generated approximately 70% of our consolidated revenues for the three months ended September 30, 2001. During the third quarter of 2001, the total principal amount of mortgages newly insured by PMI, or PMI's new primary insurance written, increased 74% from the third quarter of 2000 to $12.0 billion. PMI's new insurance written does not include primary mortgage insurance placed upon loans more than 12 months after loan origination or pool transactions. We believe that the increase was primarily due to an increase in residential mortgage origination activity and the growth in the private mortgage insurance market. As reported by the Mortgage Bankers Association of America, or MBA, total residential mortgage originations increased 63% in the third quarter of 2001 from the third quarter of 2000. As reported by the industry's trade association, Mortgage Insurance Companies of America, or MICA, the private mortgage insurance industry experienced a 70% increase in total new insurance written to $76.9 billion for the quarter ended September 30, 2001 compared to $45.4 billion for the corresponding period in 2000. Total residential mortgage originations in connection with refinancing transactions represented approximately 45% of total mortgage originations during the third quarter of 2001 compared to approximately 17% during the corresponding period in 2000, according to the MBA. Based on reports by MBA and MICA, we estimate that the private mortgage insurance penetration rate was 16% for the third quarter of 2001, which was approximately the same as the third quarter of 2000. The penetration rate is the percentage of total mortgage originations insured by the private mortgage insurance industry. 14 New insurance written was $12.0 billion for the three months ended September 30, 2001 compared to $6.9 billion for the three months ended September 30, 2000, an increase of 74%. On a combined basis with CMG, new insurance written was $13.1 billion for the third quarter of 2001 compared to $7.5 billion for the third quarter of 2000. PMI's primary insurance in force increased 11% to $104.3 billion as of September 30, 2001 from September 30, 2000. Primary insurance in force refers to the current principal balance of all mortgage loans with primary insurance as of a given date. On a combined basis with CMG, primary insurance in force grew by 12% to $112.6 billion at September 30, 2001 from September 30, 2000 of $100.6 billion. PMI's primary risk in force as of September 30, 2001 was $25.2 billion, an 11% increase compared to September 30, 2000. Primary risk in force is the dollar amount equal to the product of each individual insured mortgage loan's current principal balance multiplied by the percentage specified in the policy of the insurance coverage. On a combined basis with CMG, primary risk in force grew by 11% to $27.2 billion at September 30, 2001 from September 30, 2000 of $24.5 billion. The growth in primary insurance in force and risk in force was due primarily to an increase in new insurance written, partially offset by an increase in the cancellation of policies. Cancellations of insurance in force during the third quarter of 2001 increased 128% to $9.7 billion from $4.3 billion during the comparable period of 2000, primarily due to high refinance activity. PMI's new insurance written from refinance activity as a percentage of total new insurance written increased to 29% for the quarter ended September 30, 2001 from 8% for the comparable period of 2000. PMI's persistency rate, which refers to the percentage of insurance policies at the beginning of a period that remain in force at the end of the twelve-month period, decreased to 67.3% at September 30, 2001 compared to 80.8% at September 30, 2000. Non-traditional loans, including Alternative A and less than A quality loans, accounted for approximately 13% of PMI's new insurance written during the third quarter of 2001, compared to approximately 7% in the third quarter of 2000. This increase was due largely to increased bulk transactions. Non-traditional loans accounted for approximately 6% of PMI's insurance in force at September 30, 2001 and approximately 2% at September 30, 2000. Loan characteristics, credit quality, loss development, pricing structures and persistency related to these non-traditional loans can be significantly different than PMI's traditional primary business. We expect higher delinquencies and default rates and lower persistency for non-traditional loans, and incorporate these assumptions into our pricing. However, mortgage insurance on non-traditional loans might not generate the same returns as the standard business, and the premiums generated by this insurance might not adequately offset the associated risk. Pool insurance is a type of mortgage insurance that covers all or a percentage of a loss on individual mortgage loans held within a group or pool of loans up to an agreed aggregate limit for the pool. PMI did not write GSE pool insurance during the three months ended September 30, 2001. GSE pool risk in force at September 30, 2001 was $802.2 million compared to $774.2 million at September 30, 2000. Old pool risk in force, which represents mortgage pool policies written prior to 1994 and, which are past their peak claim periods, was $1.35 billion as of September 30, 2001 and $1.41 billion as of September 30, 2000. PMI also provides structured insurance products that are not included in either new primary insurance written, new GSE pool risk written, or primary insurance in force and risk in force. These products vary significantly with individual investor requests, and include modified pool products and second layer coverage products that restructure primary risk. In addition to primary, GSE pool and old pool risk in force, total other risk in force as of September 30, 2001 was $607.1 million compared to $204.9 million as of September 30, 2000. Other risk written was $219.0 million for the quarter ended September 30, 2001 compared to $26.4 million for the corresponding period in 2000. Net premiums written were $137.1 million for the three months ended September 30, 2001, a 6% increase from the three months ended September 30, 2000. This increase was due, in large part, to the growth of insurance and risk in force as discussed above. Net premiums written refers to the amount of premiums received during a given period, net of refunds and premiums ceded under reinsurance arrangements or risk-sharing programs, including captive mortgage reinsurance agreements. Captive reinsurance is a 15 reinsurance product in which a portion of the risk insured by PMI is reinsured with the mortgage originator or investor through an affiliated entity. During the third quarter of 2001, 48% of new insurance written and 13% of total premiums were subject to captive reinsurance agreements compared to 38% of new insurance written and 9% of total premiums subject to captive reinsurance agreements during the corresponding period in 2000. We anticipate that the continued growth of captive reinsurance arrangements will reduce our net premiums written and earned over the long-term. Primary risk in force under risk-sharing programs with PMI's customers represented 39% of primary risk in force as of September 30, 2001 compared to 25% as of September 30, 2000. We anticipate that the percentage of PMI's risk in force related to risk-sharing programs will continue to increase as a percentage of total risk in force in 2001. Ceded premiums written increased by 63% to $16.6 million primarily as a result of the increase in captive reinsurance arrangements for the quarter ended September 30, 2001. Refunded premiums increased 72% to $4.3 million in the third quarter of 2001, due to the increased policy cancellations. The amount of premiums recognized as revenue for accounting purposes, or premiums earned, increased by 12% to $142.2 million for the three months ended September 30, 2001, primarily due to an increase in premiums written and to the growth of primary insurance in force as well as other risk in force. Losses and loss adjustment expenses increased by 15% to $23.4 million for the three months ended September 30, 2001, primarily due to an increase in loans in default. Loans in default were 22,420 at September 30, 2001, a 41% increase from September 30, 2000, primarily due to the maturation of the 1997 through 2000 books of business and to a higher level of defaults on non-traditional loans in PMI's portfolio. The delinquency rate is the percentage of insured loans in force that are in default at a given date. PMI's total primary mortgage insurance loan delinquency rate was 2.57% at September 30, 2001 compared to 2.21% at December 31, 2000 and 1.99% at September 30, 2000. PMI's primary insurance loan delinquency rate excluding bulk loans was 2.33% while the delinquency rate for bulk loans was 4.88% at September 30, 2001. Claims paid on direct primary insurance increased by 25% to $18.8 million, due to an increase in the number of claims paid in the third quarter of 2001 to 866 from 838 in the third quarter of 2000, and to an increase in the average claim size to $21,697 for the third quarter of 2001 from $18,165 for the comparable period of 2000. Total expenses reported in the current period by PMI can be divided into two categories: (1) amortization of deferred policy acquisition costs, which relate to previously incurred costs associated to acquiring, underwriting and processing new business; and (2) other general operating expenses and corporate overhead, which are all other costs that are not accounted for as acquisition costs are recorded as expenses when incurred. Total expenses, including the amortization of mortgage insurance policy acquisition costs and non-acquisition related operating costs, increased to $36.1 million for the three months ended September 30, 2001 from $32.3 million for the three months ended September 30, 2000. Amortization of deferred acquisition costs increased slightly to $19.3 million for the third quarter of 2001 compared to $19.2 million for the third quarter of 2000. Other operating expenses increased to $16.8 million, a 28% increase from the corresponding period of 2000, primarily due to increased payroll and related expenses, offset by an increase in allocation to the holding company associated with diversification efforts. Policy acquisition costs, which are deferred to the balance sheet, include all incurred underwriting, contract underwriting, field operations and sales related expenses. These costs are amortized to expenses based on the estimated gross profit (see Note 2 "Summary of Certain Significant Accounting Policies"). Mortgage insurance policy acquisition costs incurred and deferred increased by 10% to $18.3 million for the third quarter of 2001 due to the increase in new insurance written, partially offset by the use of PMI's electronic origination and delivery methods. A significant portion of PMI's policy acquisition costs relates to contract underwriting. New policies processed by contract underwriters represented 25% of new insurance written during the third quarter of 2001 compared to 23% during the corresponding period in 2000. We anticipate that contract underwriting services will continue to account for a significant portion of PMI's acquisition costs. However, we believe that continued increases in the electronic origination and delivery of our 16 products could decrease our acquisition costs. In the third quarter of 2001, electronic delivery accounted for 56% of PMI's commitments of insurance, a 143% increase from the corresponding period in 2000. The mortgage insurance loss ratio, which is the ratio of losses and loss adjustment expenses to net premiums earned, increased by 0.5 percentage points to 16.5% in the third quarter of 2001 from the corresponding period in 2000. The net expense ratio for the third quarter of 2001 increased by 1.3 percentage points from the third quarter of 2000 to 26.3%, primarily due to the increase in other operating expenses. The net expense ratio is the ratio of amortization of acquisition costs and other operating expenses to the net amount of premiums written during a given period. The combined ratio, which is the sum of the loss ratio and the net expense ratio, increased by 1.8 percentage points to 42.8% for the three months ended September 30, 2001. International Mortgage Insurance Operations International Mortgage Insurance operations include PMI Mortgage Insurance Ltd, or PMI Ltd, and PMI Mortgage Insurance Company Limited, or PMI Europe. The financial results of international operations are subject to currency rate risk. The reported results of PMI Ltd were affected by the devaluation in the Australian dollar from 2000 to 2001. The average AUD/USD exchange rate was 0.518 for the third quarter of 2001 compared to 0.588 for the third quarter of 2000, a 12% decrease. Net income for PMI Ltd was $5.9 million for the three months ended September 30, 2001 compared to $3.2 million for the three months ended September 30, 2000. PMI Ltd generated $12.5 million of net premiums written and $7.3 million in net premiums earned during the third quarter of 2001, compared to $9.6 million of net premiums written and $7.4 million in net premiums earned during the third quarter of 2000. Net investment income was $3.2 million for the third quarter of 2001 compared to $1.9 million for third quarter of 2000. Losses and loss adjustment expenses were $0.8 million for the quarter ended September 30, 2001 compared to $1.8 million for the corresponding period in 2000. Underwriting and other expenses were $2.0 million for the third quarter of 2001 compared to $3.4 million for the third quarter of 2000. In September 2001, PMI Ltd acquired the fourth largest mortgage insurance company in Australia, CGU Lenders Mortgage Insurance Limited, and its results will be recorded in the fourth quarter of 2001. PMI Europe generated $0.6 million of net income, consisting primarily of net investment income, for the three months ended September 30, 2001. Financial results for the operations in Hong Kong were immaterial during the third quarter of 2001. Title Insurance Operations Net income for American Pioneer Title Insurance Company, or APTIC, was $2.5 million for the three months ended September 30, 2001 compared to $1.8 million for the three months ended September 30, 2000. Title insurance premiums earned were $43.8 million in the third quarter of 2001, a 59% increase over the third quarter of 2000 due to continuing geographic expansion efforts and to the increase in residential mortgage originations and refinance activity as discussed above. APTIC is licensed in 45 states and the District of Columbia. During the third quarter of 2001, 49% of APTIC's premiums earned was generated from the State of Florida compared with 65% during the corresponding period in 2000. Underwriting and other expenses in the third quarter of 2001 increased by 55% compared to the third quarter of 2000 to $38.6 million, primarily due to an increase in agency fees and commissions related to the increase in premiums earned and to the costs associated with expansion efforts. The combined ratio for our title insurance operations for the third quarter of 2001 increased by 1.0 percentage point to 92.4% from the comparable period of 2000. Other Our consolidated net investment income, excluding realized investment gains and losses, was $36.7 million for the three months ended September 30, 2001, a 24% increase from the three months ended September 17 30, 2000. This increase was largely due to the investment income on the $351.9 million net proceeds from the issuance of the Senior Convertible Debentures on July 18, 2001. Net realized investment losses were $1.4 million during the third quarter of 2001 including a realized loss of $0.8 million from the termination of an interest rate swap associated with the repayment of a $35.7 million bank note (see Note 8 "Long-term Debt"). Interest expense for the third quarter of 2001 increased to $4.3 million compared to the third quarter 2000 amount of $2.6 million due primarily to the interest accrual for the Debentures. Investments in affiliates increased to $159.2 million as of September 30, 2001 from $120.6 million as of September 30, 2000, due to new capital investments in unconsolidated subsidiaries and their earnings. The pre-tax current portfolio book yield was 5.9% at September 30, 2001 and 6.2% at September 30, 2000. Other consolidated income, which was generated primarily by PMI Mortgage Services Co., or MSC, was $8.3 million for the three months ended September 30, 2001 compared to $1.7 million for the three months ended September 30, 2000. This increase was primarily attributed to an increase in contract underwriting services in connection with higher residential mortgage originations and to an increase in rates for contract underwriting services. Included in the other consolidated expenses were expenses incurred by the holding company and MSC, increased to $15.1 million for the third quarter of 2001 from $9.3 million for the comparable period of 2000, primarily due to an increase in contract underwriting activities, and to the increased expenses related to international expansion and diversification efforts. Our effective tax rate was 29.8% for the three months ended September 30, 2001 compared to 29.9% for the three months ended September 30, 2000. NINE MONTHS ENDED SEPTEMBER 30, 2001 AND 2000 Our consolidated net income was $225.1 million for the nine months ended September 30, 2001, a 16% increase from the nine months ended September 30, 2000. The gain was primarily due to: . an increase in premiums earned of $73.0 million or 16%; . an increase in net investment income of $15.0 million or 17%; . a decrease in losses and loss adjustment expenses of $4.0 million or 5%; and . an increase in other income of $14.3 million. This gain was partially offset by: . an increase in amortization of deferred policy acquisition costs and other underwriting and operating expenses of $56.3 million or 29%; and . net realized investment losses of $4.1 million. Diluted net income per share, excluding an extraordinary loss, for the nine months ended September 30, 2001 was $4.97, an increase of 15% from the corresponding period in 2000. Diluted operating earnings per share, excluding realized investment losses and an extraordinary loss, increased by 17% from the comparable period of 2000 to $5.04. Consolidated revenues for the nine months ended September 30, 2001 increased 17% to $658.0 million from the corresponding period in 2000. 18 U.S. Mortgage Insurance Operations Our primary operating subsidiary, PMI Mortgage Insurance Co., or PMI, generated approximately 73% of our consolidated revenues for the nine months ended September 30, 2001. During the nine months ended September 30, 2001, PMI's new primary insurance written increased 72% from the same period in 2000 to $33.4 billion. We believe the increase was primarily due to an increase in residential mortgage origination activity and the growth in the private mortgage insurance market. As reported by MBA, the total mortgage origination increased 79% in the first three quarters of 2001 from the comparable period of 2000. As reported by the industry's trade association, MICA, the private mortgage insurance industry experienced a 68% increase in total new insurance written to $201.2 billion for the first nine months of 2001 compared to $119.8 billion for the corresponding period in 2000. Total residential mortgage originations in connection with refinancing transactions represented approximately 50% of total mortgage originations during the first nine months of 2001 compared to approximately 17% during the corresponding period in 2000, according to MBA. New insurance written was $33.4 billion for the nine months ended September 30, 2001 compared to $19.4 billion for the nine months ended September 30, 2000, an increase of 72%. On a combined basis with CMG, new insurance written was $36.1 billion for the nine months ended September 30, 2001 compared to $21.0 billion for the corresponding period in 2000. Cancellations of insurance in force increased by 110% during the first three quarters of 2001 to $25.8 billion from $12.3 billion during the comparable period of 2000, primarily due to high refinance activity. PMI's new insurance written from refinance activity as a percentage of total new insurance written increased to approximately 34% for the first nine months of 2001 from approximately 9% for the corresponding period in 2000. Non-traditional loans, including Alternative A and less than A quality loans, accounted for approximately 9% of PMI's new insurance written during the first nine months of 2001. In comparison, approximately 17% of new insurance written was comprised of non-traditional loans during the corresponding period in 2000. GSE pool insurance risk written was $19.5 million for the nine months ended September 30, 2001 compared to $93.8 million for the corresponding period in 2000. Other risk written was $403.0 million for the nine months ended September 30, 2001 compared to $92.6 million for the corresponding period in 2000. Net premiums written were $402.0 million for the nine months ended September 30, 2001, a 9% increase from the nine months ended September 30, 2000. This increase was due, in large part, to the growth of insurance and risk in force as discussed above. During the first nine months of 2001, 46% of new insurance written and 12% of total premiums were subject to captive reinsurance agreements compared to 34% of new insurance written and 7% of total premiums subject to captive reinsurance agreements during the corresponding period in 2000. Ceded premiums written increased by 68% to $44.2 million primarily as a result of the increase in captive reinsurance arrangements during the first three quarters of 2001. Refunded premiums increased 71% to $12.9 million in the first nine months of 2001, due to the increased policy cancellations. The amount of premiums recognized as revenue for accounting purposes, or premiums earned, increased by 9% to $407.8 million for the nine months ended September 30, 2001, primarily due to an increase in premiums written and to the growth of primary insurance in force as well as other risk in force. Losses and loss adjustment expenses decreased by 9% to $66.3 million for the nine months ended September 30, 2001, primarily due to improved loss mitigation efforts by PMI. Claims paid on direct primary insurance increased by 11% to $55.2 million, due to an increase in the number of claims paid in the first nine months of 2001 to 2,690 from 2,604 in the comparable period in 2000, and to an increase in the 19 average claim size to $20,536 for the first nine months of 2001 from $19,045 for the comparable period of 2000. Total expenses, including the amortization of policy acquisition costs and non-acquisition related operating costs, increased to $99.1 million for the nine months ended September 30, 2001 from $96.5 million for the comparable period of 2000. This increase was due primarily to a 3% increase in amortization of deferred acquisition costs to $57.6 million for the third quarter of 2001. Other operating expenses increased to $41.5 million, 11% over the corresponding period of 2000, primarily due to increased payroll and related expenses offset by an increase in allocation to the holding company associated with diversification efforts. Mortgage insurance policy acquisition costs incurred and deferred increased by 12% to $59.7 million for the nine months ended September 30, 2001 due to an increase in new insurance written, partially offset by the efficiencies in PMI's electronic commerce business. New policies processed by contract underwriters represented 28% of new insurance written during the first nine months of 2001 compared to 23% during the corresponding period in 2000. In the nine months ended September 30, 2001, electronic delivery accounted for 49% of PMI's commitments of insurance, 129% increase from the corresponding period in 2000. The mortgage insurance loss ratio for the nine months ended September 30, 2001 decreased by 3.2 percentage points to 16.3% from the comparable period in 2000. The decline was attributed to the decrease in losses and loss adjustment expenses and to the increase in premiums earned. The net expense ratio for the first nine months of 2001 decreased by 1.6 percentage points from the corresponding period in 2000 to 24.6%, largely due to the decrease in the amortization of deferred policy acquisition costs and to the increase in net premiums written. The combined ratio decreased by 4.8 percentage points to 40.9% for the nine months ended September 30, 2001. International Mortgage Insurance Operations International mortgage insurance operations include PMI Mortgage Insurance Ltd, or PMI Ltd, and PMI Mortgage Insurance Company Limited, or PMI Europe. The financial results of international operations are subject to currency rate risk. The reported results of PMI Ltd were affected by the devaluation in the Australian dollar from 2000 to 2001. The average AUD/USD exchange rate was 0.524 for the nine months ended September 30, 2001 compared to 0.608 for the same period in 2000, a 14% decrease. Net income for PMI Ltd was $15.2 million for the nine months ended September 30, 2001 compared to $11.5 million for the nine months ended September 30, 2000. PMI Ltd generated $35.7 million of net premiums written and $21.6 million in net premiums earned during the nine months ended September 30, 2001, compared to $28.2 million of net premiums written and $20.1 million in net premiums earned during the corresponding period in 2000. Net investment income was $8.4 million for the nine months ended September 30, 2001 compared to $8.5 million for the same period in 2000. Losses and loss adjustment expenses were $3.2 million for the nine months ended September 30, 2001 compared to $4.0 million for the corresponding period in 2000. Underwriting and other expenses were $6.8 million for the nine months ended September 30, 2001 compared to $8.0 million for the same period in 2000. PMI Europe generated $1.2 million of net income, consisting primarily of net investment income, for the nine months ended September 30, 2001. Financial results for the operations in Hong Kong were immaterial during the first nine months of 2001. Title Insurance Operations Net income for American Pioneer Title Insurance Company, or APTIC, was $6.1 million for the nine months ended September 30, 2001 compared to $5.1 million for the nine months ended September 30, 2000. Title insurance premiums earned were $111.6 million in the nine months ended September 30, 2001, a 49% increase over the corresponding period in 2000 due to continuing geographic expansion efforts and to the increase in residential mortgage originations. APTIC is licensed in 45 states and the District of 20 Columbia. During the nine months ended September 30, 2001, 51% of APTIC's premiums earned was generated from the State of Florida compared with 68% during the corresponding period in 2000. Underwriting and other expenses during the nine months ended September 30, 2001 increased by 47% compared to the corresponding period in 2000 to $99.7 million, primarily due to an increase in agency fees and commissions related to the increase in premiums earned and to the costs associated with expansion efforts. The combined ratio for our title insurance operations for the nine months ended September 30, 2001 increased by 1.5 percentage points to 92.9% from the comparable period of 2000. Other Our consolidated net investment income, excluding realized investment gains and losses, was $100.6 million for the nine months ended September 30, 2001, a 18% increase from the nine months ended September 30, 2000. This increase was largely due to the investment income on the proceeds from the issuance of the Senior Convertible Debentures. Net realized investment losses were $4.1 million during the nine months ended September 30, 2001 including a realized loss of $3.2 million resulted from revaluation of our short-term investment in Pacific Gas and Electric Company (see Note 7 "Short-term Investment"). Interest expense was $9.7 million for the nine months ended September 30, 2001, an increase of 28% from $7.6 million for the corresponding period of 2000, due primarily to the interest accrual for the Debentures. Other consolidated income, which was generated primarily by PMI Mortgage Services Co., or MSC, was $20.5 million for the nine months ended September 30, 2001 compared to $6.2 million for the nine months ended September 30, 2000. This increase was primarily attributed to an increase in contract underwriting services in connection with higher residential mortgage originations and to an increase in rates for contract underwriting services. Included in the other consolidated expenses were expenses incurred by the holding company and MSC, increased to $43.4 million for the nine months ended September 30, 2001 from $21.3 million for the comparable period of 2000, primarily due to an increase in contract underwriting activities, and to the increased expenses related to international expansion and diversification efforts. Our effective tax rate was 29.6% for the nine months ended September 30, 2001 compared to 30.6% for the nine months ended September 30, 2000. This decrease was due primarily to the lower foreign effective tax rate contributing to the reduction of overall effective tax rate, and partly due to an increase in the proportion of tax-exempt investment income relative to total income. 21 Liquidity, Capital Resources and Financial Condition Liquidity and capital resource considerations are different for our holding company, The PMI Group, than they are for PMI. The PMI Group's principal sources of funds are dividends from PMI and APTIC, investment income, and funds that may be raised from time to time in the capital markets. PMI's ability to pay dividends to our holding company is affected by state insurance laws, credit agreements, credit rating agencies and the discretion of insurance regulatory authorities. The laws of Arizona, the state of PMI's domicile for insurance regulatory purposes, provide that PMI may pay out of any available surplus account without prior approval of the Director of the Arizona Department of Insurance dividends during any 12-month period not to exceed the lesser of 10% of policyholders' surplus as of the preceding year end, or the last calendar year's investment income. Other state insurance laws restrict the payment of dividends from the unassigned surplus account only. Under Arizona law, based on the amount of its policyholders' surplus, PMI would be able to pay dividends of approximately $16.0 million to us in 2001 without prior approval of the Director of the Arizona Department of Insurance. PMI received approval from the Arizona Department of Insurance for an extraordinary dividend of $50.0 million during 2001. PMI paid the first $25.0 million installment on October 31, 2001, and the second $25.0 million installment is expected to be paid in December 2001. The laws of Florida limit the payment of dividends by APTIC to The PMI Group in any one year to 10% of available and accumulated surplus derived from realized net operating profits and net realized capital gains. As with PMI, the various credit rating agencies and insurance regulatory authorities have broad discretion to affect the payment of dividends to us by APTIC. Under Florida law, APTIC would be able to pay dividends of $3.0 million to us in 2001 without prior permission from the Florida Department of Insurance, all of which was paid in the first half of 2001. As of September 30, 2001, our long-term debt and other capital securities outstanding was $543.5 million and was comprised of the following: . $360.0 million senior convertible debentures; . $100.0 million, at par, senior notes used for general corporate purposes; and . $83.5 million preferred capital securities. In July 2001, we repaid an outstanding bank note in the amount of $35.7 million with Bank of America. In September 2001, we repurchased $16.5 million of the $100.0 million preferred capital securities. In October and November 2001, we repurchased an additional $35.0 million of the preferred capital securities and $19.0 million of the $100.0 million senior notes. Including these repurchases, we intend to repurchase $100.0 million of preferred capital securities and senior notes depending upon market conditions. In addition, we have a bank credit line in the amount of $25.0 million with Bank of America. There are no outstanding borrowings under the credit line. This financial instrument contains certain financial covenants and restrictions, including risk to capital ratios, minimum capital and dividend restrictions. The PMI Group's principal uses of funds are common stock repurchases, the payment of dividends to shareholders, funding of acquisitions, additions to its investment portfolio, investments in affiliates, the payment of distributions on our preferred capital securities and the payment of interest and other expenses incurred. The PMI Group had $418.0 million of available funds at September 30, 2001, which has increased from the December 31, 2000 balance of $108.3 million. The increase was primarily due to the proceeds from the issuance of $360 million of 2.5% Senior Convertible Debentures. In November 1998, 22 we announced a stock repurchase program in the amount of $100.0 million authorized by our board of directors. No common stock was repurchased during the first three quarters of 2001, and $45.4 million remained available under the 1998 authorization as of September 30, 2001. We believe that we have sufficient cash to meet all of our short and medium-term obligations. The PMI Group's invested assets at September 30, 2001 increased $497.8 million from December 31, 2000 due primarily to the issuance of the Debentures. Consolidated reserves for losses and loss adjustment expenses increased by $0.7 million from December 31, 2000 to $295.8 million at September 30, 2001, due to the increases in the reserve balances for the primary insurance books of business. The principal sources of funds for PMI are premiums received on new and renewal business and amounts earned from its investment portfolio. The principal uses of funds by PMI are policy acquisition costs, payment of claims and related expenses, other operating expenses, investment in affiliates, and dividends to our holding company. PMI has entered into capital support agreements with its European and Australian subsidiaries that could require PMI to make additional capital contributions to those subsidiaries in order to maintain their credit ratings. With respect to the European and Australian subsidiaries, we have guaranteed the performance of PMI's capital support obligations. PMI's ratio of net risk in force to statutory capital, or statutory risk-to- capital ratio, at September 30, 2001 was 13.0 to 1 compared to 14.1 to 1 at December 31, 2000. The PMI Group's consolidated ratio of earnings to fixed charges for the nine months ended September 30, 2001, was 19.8. For purposes of the ratio of earnings to fixed charges, "earnings" represent income from continuing operations before income taxes plus fixed charges. "Fixed charges" represent interest expense plus that portion of rent expense that, in our opinion, approximates the interest factor included in rent expense plus distributions on preferred capital securities. As of the date of this report, we have no preferred stock outstanding. 23 INVESTMENT CONSIDERATIONS General economic factors may adversely affect our loss experience and the demand for mortgage insurance. Losses result from events, such as unemployment, that reduce a borrower's ability to continue to make mortgage payments. The amount of the loss, if any, depends in part on whether the home of a borrower who defaults on a mortgage can be sold for an amount that will cover unpaid principal and interest and the expenses of the sale. Favorable economic conditions generally reduce the likelihood that borrowers will lack sufficient income to pay their mortgages and also favorably affect the value of homes, reducing and in some cases even eliminating a loss from a mortgage default. We believe that our loss experience could materially increase as a result of: . national or regional economic recessions; . declining values of homes; . higher unemployment rates; . deteriorating borrower credit; . interest rate volatility; . shortages of electric power in California or other states; or . combinations of these factors These factors could also materially reduce the demand for housing and, consequently, the demand for mortgage insurance. The United States is currently experiencing an economic downturn. If this economic downturn continues or worsens, our loss experience could suffer and demand for mortgage insurance could decline. If interest rates decline, home values increase or mortgage insurance cancellation requirements change, the length of time that our policies remain in force and our revenues could decline. A significant percentage of the premiums we earn each year is generated from insurance policies that we have written in previous years. As a result, the length of time insurance remains in force is an important determinant of our revenues. The policy owner or servicer of the loan may cancel insurance coverage at any time. In addition, the Home Owners Protection Act of 1998 provides for the automatic termination or cancellation of mortgage insurance upon a borrower's request if specified conditions are satisfied. Factors that tend to reduce the length of time our insurance remains in force include: . current mortgage interest rates falling below the rates on the mortgages underlying our insurance in force, which frequently results in borrowers refinancing their mortgages and canceling their existing mortgage insurance; . the rate of appreciation in home values experienced by the homes underlying the mortgages of the insurance in force, which can result in the cancellation of mortgage insurance; and . changes in the mortgage insurance cancellation policies of mortgage lenders and investors. Although we have a history of expanding our business during periods of low interest rates, the resulting increase of new insurance written may not be adequate to compensate us for our loss of insurance in force arising from policy cancellations. 24 If the volume of low down payment home mortgage originations declines, the amount of insurance that we write could also decline, which could result in a decline in our future revenue. The factors that affect the volume of low down payment mortgage originations include: . the level of home mortgage interest rates; . the health of the domestic economy as well as conditions in regional and local economies; . consumer confidence, which may be adversely affected by economic instability, war or catastrophic events such as the attacks on the World Trade Center and the Pentagon; . housing affordability; . population trends, including the rate of household formation; . the rate of home price appreciation, which in times of heavy refinancing affects whether refinance loans have loan-to-value ratios that require private mortgage insurance; and . government housing policy encouraging loans to first-time homebuyers. A decline in the volume of low down payment housing could reduce the demand for private mortgage insurance and, therefore, our revenues. We cannot cancel mortgage insurance policies or adjust renewal premiums to protect from unanticipated claims, which could harm our financial performance. We cannot cancel the mortgage insurance coverage that we provide. In addition, we generally establish renewal premium rates for the life of the mortgage insurance policy when the policy is issued. As a result, the impact of unanticipated claims generally cannot be offset by premium increases on policies in force or limited by nonrenewal of insurance coverage. The premiums we charge may not be adequate to compensate us for the risks and costs associated with the insurance coverage we provide to our customers. The adoption of a risk-based capital rule by the Office of Federal Housing Enterprise Oversight could require us to obtain a claims-paying ability rating of "AAA" and could cause our business to suffer. On July 19, 2001, the Office of Federal Housing Enterprise Oversight announced a risk-based capital rule that treats credit enhancements issued by private mortgage insurance companies with claims-paying ability ratings of "AAA" more favorably than those issued by mortgage insurance companies with "AA" ratings. We do not have a "AAA" rating and may need to obtain such a rating as a result of the rule. To obtain a claims-paying ability rating of "AAA" we may need to dedicate significant capital to the mortgage insurance business that we might use in other ways and we would also have additional costs that we would not otherwise incur. Two of our direct competitors have "AAA" claims paying ratings, with the balance being rated "AA". While we are currently considering options to address the rule, we cannot be sure that we will be able to implement any of the options that we have under consideration to address the risk-based capital rule in a timely manner, or at all, or that these options, if implemented, will be effective to address the capital differential contained in the rule. If we are unable to address the capital differential contained in the rule in a timely manner, or at all, our business could be seriously harmed. Changes in the preferences of Fannie Mae and Freddie Mac, or the GSEs, for private mortgage insurance to other forms of credit enhancement, or a tiering of mortgage insurers based on their credit rating, as a result of the OFHEO rule could harm our financial condition and results of operations. 25 Because we compete with private mortgage insurers, governmental agencies and others in an industry that is highly competitive, our revenues and profits could decline substantially as we respond to competition or if we lose market share. The principal sources of our direct and indirect competition include: . other private mortgage insurers, some of which are subsidiaries of well capitalized, diversified public companies with direct or indirect capital reserves that provide them with potentially greater resources than we have; . federal and state governmental and quasi-governmental agencies, principally the Federal Housing Administration, or FHA, and to a lesser degree the Veterans Administration, or VA; . mortgage lenders that choose not to insure against borrower default, self-insure through affiliates, or offer residential mortgage products that do not require mortgage insurance; and . captive reinsurance subsidiaries of national banks, savings institutions and bank holding companies and other mortgage lenders. We cannot be sure that we will be able to compete successfully with our direct or indirect competitors. If we are unable to compete successfully, our business will suffer. If mortgage lenders and investors select alternatives to private mortgage insurance, the amount of insurance that we write could decline significantly, which could reduce our revenues and profits. Alternatives to private mortgage insurance include: . government mortgage insurance programs, including those of the FHA and the VA; . member institutions providing credit enhancement on loans sold to a Federal Home Loan Bank; . investors holding mortgages in their portfolios and self-insuring; . mortgage lenders maintaining lender recourse or participation with respect to loans sold to the GSEs; . investors using credit enhancements other than private mortgage insurance or using other credit enhancements in conjunction with reduced levels of private mortgage insurance coverage; and . mortgage lenders structuring mortgage originations to avoid private mortgage insurance, such as a first mortgage with an 80% loan-to-value ratio and a second mortgage with a 10% loan-to-value ratio, which is referred to as an 80-10-10 loan, rather than a first mortgage with a 90% loan-to-value ratio. The loan-to-value ratio is the ratio of the original loan amount to the value of the property. These alternatives, or new alternatives to private mortgage insurance that may develop, could reduce the demand for private mortgage insurance and cause our revenues and profitability to decline. The OFHEO risk-based capital rule may allow large banks and brokerage firms to provide or arrange for products that may efficiently substitute for some of the capital relief provided to the GSEs by private mortgage insurance. Many of these entities have significantly more capital than we have and a few have "AAA" ratings. The ability of these companies to offer or arrange for the products described above will be dependent upon, among other things, how the OFHEO risk-based capital rule is interpreted and administered and the willingness of the GSEs to utilize such forms of credit enhancement. 26 Legislation and regulatory changes may reduce demand for private mortgage insurance, which could harm our business. Increases in the maximum loan amount or other features of the FHA mortgage insurance program can reduce the demand for private mortgage insurance. Legislative and regulatory changes have caused, and may cause in the future, demand for private mortgage insurance to decrease and this could harm our financial condition and results of operations. As a result of the enactment of The Gramm-Leach-Bliley Act, we expect to experience increased competition from mortgage insurance companies owned by large, well capitalized financial services companies, which could significantly harm our business. The Gramm-Leach-Bliley Act allows bank holding companies to engage in a substantially broader range of activities, including insurance underwriting, than those companies could previously engage in and allows insurers and other financial service companies to acquire banks. Bank holding companies are now permitted to form insurance subsidiaries that issue insurance products, including mortgage insurance, directly to consumers. We expect that, over time, consumers will have the ability to shop for their insurance, banking and investment needs at one financial services company. We believe that this new law may lead to increased competition in the mortgage insurance industry by facilitating the development of new savings and investment products, resulting in mortgage lenders offering mortgage insurance directly to home borrowers rather than through captive reinsurance arrangements with us and encouraging large, well-capitalized financial service companies to enter the mortgage insurance business. We depend on a small number of customers and our business and financial performance could suffer if we were to lose the business of a major mortgage lender. We are dependent on a small number of customers. Our top ten customers were responsible for 35% of our new insurance written as of September 30, 2001. The concentration of business with our customers may increase as a result of mergers or other factors. These customers may reduce the amount of business currently given to us or cease doing business with us altogether. Our master policies and related lender agreements do not, and by law cannot, require our lenders to do business with us. The loss of business from any major customer could seriously harm our business and results of operations. We acquire a significant percentage of our new business through secondary market bulk transactions with a limited number of parties. Secondary market bulk transactions are negotiated transactions in which we insure a large group of loans or commit to insure new loans on agreed-upon terms. Our business could be harmed if these investors substitute other types of credit enhancement for private mortgage insurance. We could lose premium revenue if Fannie Mae or Freddie Mac continue to reduce the level of private mortgage insurance coverage required for low down payment mortgages. Fannie Mae and Freddie Mac are the beneficiaries on a substantial majority of the insurance policies we issue as a result of their purchases of home loans from lenders or investors. Fannie Mae and Freddie Mac offer programs that require less mortgage insurance coverage on mortgages approved by their automated underwriting systems. Fannie Mae and Freddie Mac might further reduce coverage requirements. If the reduction in required levels of mortgage insurance becomes widely accepted by mortgage lenders, our premium revenue would decline and our financial condition and results of operations could suffer. New products introduced by Fannie Mae or Freddie Mac, if widely accepted, could harm our profitability. 27 Fannie Mae and Freddie Mac have separately introduced new products for which they will, upon receipt from lenders of loans with primary mortgage insurance, restructure the mortgage insurance coverage by reducing the amount of primary insurance coverage and adding a second layer of insurance coverage, usually in the form of pool insurance. Pool insurance is a type of mortgage insurance that covers all or a percentage of a loss on individual mortgage loans held within a group or pool of loans up to an agreed aggregate limit for the pool. Under these programs, Fannie Mae and Freddie Mac may provide services to the mortgage insurer and the mortgage insurer may be required to pay fees to Fannie Mae or Freddie Mac for the reduced insurance coverage or the services provided. These new products may prove to be less profitable than PMI's traditional mortgage insurance business. If these products prove to be less profitable than PMI's traditional mortgage insurance business, and become widely accepted, our financial condition and operating results could seriously suffer. Efforts by Fannie Mae and Freddie Mac to reduce the need for private mortgage insurance could reduce our revenues. Freddie Mac has made several announcements that it would pursue a permanent charter amendment that would allow it to utilize alternative forms of default loss protection or otherwise forego the use of private mortgage insurance on higher loan-to-value mortgages. Such a result could severely harm our financial condition and results of operation. In October 2000, Fannie Mae announced its intention to increase its share of revenue associated with the management of mortgage credit risk and interest rate risk during the next three years by retaining mortgage credit risk previously borne by a number of other parties, including mortgage insurers. Part of any attempt by Fannie Mae to increase its share of revenue associated with mortgage credit risk could include a reduction in the use or level of mortgage insurance, which could reduce our revenue. Lobbying activities by large mortgage lenders calling for expanded federal oversight and legislation relating to the role of Fannie Mae and Freddie Mac in the secondary mortgage market could damage our relationships with those mortgage lenders, Fannie Mae and Freddie Mac. Together with Fannie Mae, Freddie Mac and mortgage lenders, we jointly develop and make available various products and programs. These arrangements involve the purchase of our mortgage insurance products and frequently feature cooperative arrangements between the three parties. In 1999, a coalition of financial services and housing related trade associations, including the Mortgage Insurance Companies of America and several large mortgage lenders, formed FM Watch, a lobbying organization that supports expanded federal oversight and legislation relating to the role of Fannie Mae and Freddie Mac in the secondary mortgage market. Fannie Mae and Freddie Mac have criticized, and lobbied against, FM Watch. These lobbying activities could, among other things, polarize Fannie Mae, Freddie Mac and members of FM Watch as well as our customers and us. As a result of this polarization, our relationships with Fannie Mae and Freddie Mac may limit our opportunities to do business with some mortgage lenders, particularly the large mortgage lenders that have formed FM Watch. Conversely, our relationships with these large mortgage lenders may limit our ability to do business with Fannie Mae and Freddie Mac. Either of these outcomes could seriously harm our financial condition and results of operations. If we are unable to introduce and successfully market new products and programs, our competitive position could suffer. From time to time we introduce new mortgage insurance products or programs. Our competitive position and financial performance could suffer if we experience delays in introducing competitive new products and programs or if these products or programs are less profitable than our existing products and programs. 28 Mortgage lenders increasingly require us to reinsure a portion of the mortgage insurance default risk on mortgages that they originate with their captive mortgage reinsurance companies, which will reduce our net premiums written. Our customers have indicated an increasing demand for captive mortgage reinsurance arrangements. Under these arrangements, a reinsurance company, which is usually an affiliate of the mortgage lender, assumes a portion of the mortgage insurance default risk on mortgage loans originated by the lender in exchange for a portion of the insurance premiums. An increasing percentage of our new insurance written is being generated by customers with captive reinsurance companies, and we expect that this trend will continue. An increase in captive mortgage reinsurance arrangements will decrease our net premiums written, which may negatively impact the yield that we obtain on net premiums earned for customers with captive mortgage reinsurance arrangements. If we do not provide our customers with acceptable risk-sharing structured transactions, including potentially increasing levels of premium cessions in captive mortgage reinsurance arrangements, our competitive position may suffer. Our risk in force consists of mortgage loans with high loan-to-value ratios, which generally result in more claims than mortgage loans with lower loan-to-value ratios. At September 30, 2001: . 43.8% of our risk in force consisted of mortgages with loan-to-value ratios greater than 90% but less than or equal to 95%, which we refer to as 95s. Risk in force is the dollar amount equal to the product of each individual insured mortgage loan's current principal balance and the percentage specified in the insurance policy of the claim amount that would be payable if a claim were made. In our experience, 95s have claims frequency rates approximately twice that of mortgages with loan- to-value ratios greater than 85% but less than or equal to 90%, which we refer to as 90s. . 6.0% of our risk in force consisted of mortgages with loan-to-value ratios greater than 95% but less than or equal to 97%, which we refer to as 97s. In our experience 97s have higher claims frequency rates than 95s and greater uncertainty as to pricing adequacy. . 0.5% of our risk in force consisted of mortgages with loan-to-value ratios greater than 97%, which in our experience have claims frequency rates higher than 97s. . 9.5% of our risk in force consisted of adjustable rate mortgages, which we refer to as ARMs. In our experience ARMs, although priced higher, have claims frequency rates that exceed the rates associated with our book of business as a whole. The premiums we charge for mortgage insurance on non-traditional loans, and the associated investment income, may not be adequate to compensate us for future losses from these products. Our new insurance written includes non-traditional, Alternative A and less than A loans, which we refer to as non-traditional loans. Non-traditional loans represented approximately 19.0% of our total new insurance written in 2000 and approximately 9.06% of our total new insurance written in the nine months ended September 30, 2001. Loan characteristics, credit quality, loss development, pricing structures and persistency, which is the percentage of insurance policies at the beginning of a period that remain in force at the end of the period, on non-traditional loans can be significantly different than our traditional prime business. In addition, non-traditional loans generally do not meet the standard underwriting guidelines of Fannie Mae and Freddie Mac. We expect higher delinquency rates and default rates, which is the percentage of insured loans in force that are in default, for non-traditional loans. We cannot be sure that this book of business will generate the same returns as our standard business or that the premiums that we charge on non-traditional loans will adequately offset the associated risk. 29 Paying a significant number of claims under the pool insurance we write could harm our financial performance. We offer pool insurance that is generally used as an additional credit enhancement for secondary market mortgage transactions. Pool insurance provides coverage for conforming and non-conforming loans, and is generally considered riskier than primary insurance. The premiums that we charge for pool insurance may not adequately compensate us if we experience higher delinquency and default rates than we anticipate at the time we set the premiums for the policies. If we are required to pay a significant number of claims under our pool insurance, then our financial condition and results of operations could be seriously harmed. The concentration of insurance in force in relatively few states could increase claims and losses and harm our financial performance. In addition to being affected by nationwide economic conditions, we could be particularly affected by economic downturns in specific regions of the United States where a large portion of our business is concentrated. As of September 30, 2001: . 12.7% of our total risk in force was on mortgages for homes located in California, where the percentage of insured loans in force that were in default, or default rate, on our policies was 2.50% on that date; . 8.3% of our total risk in force was on mortgages for homes located in Florida, where the default rate on our policies was 2.86% on that date; and . 6.9% of our total risk in force was on mortgages for homes located in Texas, where the default rate on our policies was 2.60% on that date. This compares with a nationwide default rate on our policies of 2.57% as of September 30, 2001. Continued and prolonged adverse economic conditions in any of these states could result in high levels of claims and losses. In addition, refinancing of mortgage loans can have the effect of concentrating our insurance in force in economically weaker areas, because mortgages in areas experiencing appreciation of home values are less likely to require mortgage insurance at the time of refinancing than are mortgages in areas experiencing limited or no appreciation of home values. We delegate underwriting authority to mortgage lenders that may cause us to insure unacceptably risky mortgage loans, which could increase claims and losses. The majority of our new insurance written is underwritten pursuant to a delegated underwriting program. Once a mortgage lender is accepted into our delegated underwriting program, that mortgage lender may determine whether mortgage loans meet our program guidelines and may commit us to issue mortgage insurance. We expect to continue offering delegated underwriting to approved lenders and may expand the availability of delegated underwriting to additional customers. If an approved lender commits us to insure a mortgage loan, we may not refuse to insure, or rescind coverage on, that loan even if we reevaluate that loan's risk profile or the lender failed to follow our delegated underwriting guidelines, except in very limited circumstances. In addition, our ability to take action against an approved lender that fails to follow our program guidelines and requirements is limited by access to data that would be needed to assess the lender's compliance with those guidelines and requirements. Therefore, an approved lender could cause us to insure a material amount of mortgage loans with unacceptable risk profiles prior to our termination of the lender's delegated underwriting authority. We expect our loss experience to increase significantly as our policies continue to age. 30 The majority of claims under private mortgage insurance policies have historically occurred during the third through the sixth years after issuance of the policies. As of September 30, 2001, approximately 80.03% of our risk in force was written after December 31, 1997. This means that less than half of our risk in force has reached the beginning of the expected peak claims period. As a result, our loss experience is expected to increase significantly as our policies continue to age. If the claim frequency, which is the percentage of loans insured that have resulted in a paid claim, on our risk in force significantly exceeds the claim frequency that was assumed in setting our premium rates, our financial condition and results of operations and cash flows would be seriously harmed. Our loss reserves may be insufficient to cover claims paid and loss-related expenses incurred. We establish loss reserves to recognize the liability for unpaid losses related to insurance in force on mortgages that are in default. These loss reserves are based upon our estimates of the claim rate and average claim amounts, as well as the estimated costs, including legal and other fees, of settling claims. These estimates are regularly reviewed and updated using currently available information. Any adjustments, which may be material, resulting from these reviews are reflected in our then current consolidated results of operations. Our reserves may not be adequate to cover ultimate loss development on incurred defaults. Our financial condition and results of operations could be seriously harmed if our reserve estimates are insufficient to cover the actual related claims paid and loss-related expenses incurred. If we fail to properly underwrite mortgage loans under our contract underwriting services, we may be required to assume the cost of repurchasing those loans. We provide contract underwriting services for a fee. These services help enable our customers to improve the efficiency and quality of their operations by outsourcing all or part of their mortgage loan underwriting to us. As part of our contract underwriting services, we generally provide remedies to our customers in the event that our underwriters fail to properly underwrite the mortgage loans. These remedies may include the assumption of the cost of repurchasing loans that are not properly underwritten, a remedy not available under our master primary insurance policies. Worsening economic conditions could cause us to increase the number and severity of the remedies that we offer, which could harm our financial condition. There are limitations on the number of available underwriting personnel and heavy price competition among mortgage insurance companies. Our inability to recruit and maintain a sufficient number of qualified underwriters or any significant increase in the cost we incur to satisfy our underwriting services obligations could harm our financial condition and results of operations. If our claims-paying ability is downgraded, then mortgage lenders and the mortgage securitization market may not purchase mortgages or mortgage-backed securities insured by us, which could materially harm our financial performance. The claims-paying ability of PMI Mortgage Insurance Co., our largest wholly owned subsidiary, which we refer to as "PMI", is currently rated "AA+" (excellent) by Standard and Poor's, "Aa2" (excellent) by Moody's and "AA+" (very strong) by Fitch. These ratings may be revised or withdrawn at any time by one or more of the rating agencies. These ratings are based on factors relevant to PMI's policyholders and are not applicable to our common stock or outstanding debt. The rating agencies could lower or withdraw our ratings at any time as a result of a number of factors, including: . underwriting or investment losses; . the necessity to make capital contributions to our subsidiaries pursuant to capital support agreements; . other adverse developments in PMI's financial condition or results of operations; or . changes in the views of rating agencies. 31 If PMI's claims-paying ability rating falls below "AA-" from Standard and Poor's or "Aa3" from Moody's, then investors, including Fannie Mae and Freddie Mac, will not purchase mortgages insured by us, which would seriously harm our financial condition and results of operations. Our ongoing ability to pay dividends to our stockholders and meet our obligations primarily depends upon the receipt of dividends and returns of capital from our insurance subsidiaries and our investment income. Our principal sources of funds are dividends from our subsidiaries, investment income and funds that may be raised from time to time in the capital markets. Factors that may affect our ability to maintain and meet our capital and liquidity needs include: . the level and severity of claims experienced by our insurance subsidiaries; . the performance of the financial markets; . standards and factors used by various credit rating agencies; . financial covenants in our credit agreements; and . standards imposed by state insurance regulators relating to the payment of dividends by insurance companies. Any significant change in these factors could prevent us from being able to maintain the capital resources required to meet our business needs. An increase in PMI's risk-to-capital ratio could prevent it from writing new insurance, which would seriously harm our financial performance. The State of Arizona, PMI's state of domicile for insurance regulatory purposes, and other states limit the amount of insurance risk that may be written by PMI, based on a variety of financial factors, primarily the ratio of net risk in force to statutory capital, or the risk-to-capital ratio. Other factors affecting PMI's risk-to-capital ratio include: . limitations under the runoff support agreement with Allstate Insurance Company, or Allstate, our former parent company, which prohibit PMI from paying any dividends if, after the payment of the dividend, PMI's risk-to-capital ratio would equal or exceed 23 to 1; . our credit agreement; and . capital requirements necessary to maintain our credit rating and PMI's claims-paying ability ratings. 32 Generally, the methodology used by the rating agencies to assign credit or claims-paying ability ratings permits less capital leverage than under statutory or other requirements. Accordingly, we may be required to meet capital requirements that are higher than statutory or other capital requirements to satisfy rating agency requirements. Standard & Poor's has advised us that it is considering a change to its methodology for computing the amount of capital we need in relation to insured domestic loans. We do not know when Standard & Poor's will make a final decision on its new methodology or how any new capital formulation will affect our business and operations. If Standard & Poor's were to significantly increase the capital PMI may be required to maintain against our insured domestic loans, our business and operations could suffer. PMI has several alternatives available to help control its risk-to-capital ratio, including: . obtaining capital contributions from The PMI Group; . obtaining third party credit enhancements; and . reducing the amount of new business written. We may not be able to raise additional funds, or to do so on a timely basis, in order to make a capital contribution to PMI. In addition, third party credit enhancements may not be available to PMI or, if available, may not be available on satisfactory terms. A material reduction in PMI's statutory capital, whether resulting from underwriting or investment losses or otherwise, or a disproportionate increase in risk in force, could increase its risk-to-capital ratio. An increase in PMI's risk-to-capital ratio could limit its ability to write new business, impair PMI's ability to pay dividends to The PMI Group and seriously harm our financial condition and results of operations. Our international insurance subsidiaries subject us to numerous risks associated with international operations. We have subsidiaries in Australia and Europe and may commit significant resources to expand our international operations. Accordingly, we are subject to a number of risks associated with international business activities. These risks include: . the need for regulatory and third party approvals; . challenges attracting and retaining key foreign-based employees, customers and business partners in international markets; . economic downturns in the foreign mortgage origination markets targeted, particularly the economies of Australia and Europe; . interest rate volatility in a variety of countries; . unexpected changes in foreign regulations and laws; . burdens of complying with a wide variety of foreign laws; . potentially adverse tax consequences; . restrictions on the repatriation of earnings; . foreign currency exchange rate fluctuations; . potential increases in the level of defaults and claims on policies insured by foreign-based subsidiaries; . the need to integrate our domestic insurance subsidiaries' risk management technology systems and products with those of our foreign operations; 33 . the need to successfully develop and market products appropriate to the foreign market, including the development and marketing of credit enhancement products to European lenders and mortgage securitizations; . risks related to global economic turbulence; and . political instability. The performance of our strategic investments could harm our financial results. At September 30, 2001, we had investments in affiliates with a book value of $159.2 million. The performance of our strategic investments in affiliates could be harmed by: . changes in the real estate, mortgage lending, mortgage servicing, title and financial guaranty markets; . future movements in interest rates; . those operations' future financial condition and performance; . the ability of those entities to execute future business plans; and . our dependence upon management to operate those companies in which we do not own a controlling share. In September 2001, we completed our previously announced acquisition of the Australian mortgage insurance company, CGU Lenders Mortgage Insurance Limited (renamed PMI Indemnity Limited). The purchase price of this acquisition is subject to post-closing adjustments but is expected to be approximately $40 million. PMI Indemnity Limited's operations will be integrated into our existing Australian subsidiary and the success of our acquisition of PMI Indemnity Limited will be dependent upon the success of this integration, among other factors. In addition, our ability to engage in additional strategic investments is subject to the availability of capital and maintenance of our claims-paying ability ratings by rating agencies. Our failure or inability to keep pace with the technological demands of our customers or with the technology-related products and services offered by our competitors could significantly harm our business and financial performance. Participants in the mortgage lending and mortgage insurance industries increasingly rely on e-commerce and other technology to provide and expand their products and services. An increasing number of our customers require that we provide our products and services electronically via the Internet or electronic data transmission, and the percentage of our new insurance written delivered electronically is increasing. We expect this trend to continue and, accordingly, believe that it is essential that we continue to invest substantial resources on maintaining electronic connectivity with our customers and, more generally, on e-commerce and technology. Our business will suffer if we do not satisfy all technological demands of our customers and keep pace with the technological capabilities of our competitors. If we are not reimbursed by our insurance carriers for costs incurred by us in connection with our settlement of the Baynham litigation, we may be required to take an additional charge against earnings. To account for the settlement of the Baynham litigation, we have taken certain charges which represent our estimate of the cost of settlement less our estimate of insurance payments we will receive from our insurance carriers as reimbursement for costs incurred by us in connection with our defense and settlement of the 34 action. We have participated in non-binding mediation with our insurance carriers with respect to the amount of the payments to be reimbursed to us without achieving settlement. If we do not realize our estimated amount of insurance proceeds, we could be required to take an additional charge against earnings and this could harm our financial condition and results of operations. 35 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK Our borrowings under credit facilities are subject to interest rates that are variable. As of September 30, 2001, the effective duration of our investment portfolio was 5.2 years. The result of a 100 basis points increase in interest rates would be a 5.2% decrease in the value of our investment portfolio, while the result of a 100 basis points decrease in interest rates would be a 4.1% increase in the value of our investment portfolio. At September 30, 2001 $221.5 million of our invested assets were held by PMI Ltd and were denominated in Australian dollars, which has experienced devaluation during the first nine months of 2001 compared to the corresponding period of 2000. In July 2001, the Company repaid an outstanding bank note of AUS$70.5 million with Bank of America in the amount of US$35.7 million. 36 PART II - OTHER INFORMATION ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS The Company sold $360 million aggregate principal amount of its 2.50% Senior Convertible Debentures due 2021 (the "Debentures") in a private offering to qualified institutional buyers in compliance with Rule 144A under the Securities Act of 1933, resulting in net proceeds of approximately $350.8 million. The closings of the offering took place on July 16, 2001 and July 18, 2001. The initial purchasers of the Debentures were Banc of America Securities LLC and Lehman Brothers Inc. In July 2001, the Company used $35.7 million of the net proceeds of the offering to repay an outstanding bank note with Bank of America. In September 2001, the Company used a portion of the net proceeds of the offering to repurchase $16.5 million of the $100.0 million preferred capital securities. In October and November 2001, the Company repurchased an additional $35.0 million of the preferred capital securities and $19.0 million of $100.0 million of senior notes. The Company intends to use the remaining net proceeds of the offering for repayment or retirement of other existing indebtedness, depending upon market conditions, and for general corporate purposes. The Debentures are due on July 15, 2021 and bear interest at a rate of 2.50% per annum. The Company will pay interest on the Debentures on January 15 and July 15 of each year, beginning January 15, 2002. The Debentures will pay additional contingent interest in specified circumstances. The Debentures will be redeemable at the Company's option beginning in 2006, and the Holders may require the Company to repurchase the Debentures on July 15, 2004, 2006, 2008, 2011 or 2016, and in certain other circumstances. Holders of the Debentures may convert their Debentures prior to stated maturity under any of the following circumstances: . during any quarterly conversion period if the closing sale price of the Company's common stock for a period of at least 20 trading days in the period of 30 consecutive trading days ending on the first day of such conversion period is more than 120% of the conversion price on that thirtieth day; . during the five business day period following any 10 consecutive trading- day period in which the average of the trading prices (as defined in the Indenture) for a Debenture was less than 105% of the average sale prices (as defined in the Indenture) of the Company's common stock multiplied by the number of shares into which such Debenture is then convertible; . during such period, if any, after the 30th day following the initial issuance of the Debentures that the credit rating assigned to the Debentures by both Moody's Investors Service, Inc. and Standard & Poor's Rating Services is below "Baa3" and "BBB-", respectively, or if neither rating agency is rating the Debentures; . if the Company has called those Debentures for redemption; or . upon the occurrence of specified corporate transactions described in the Indenture. Holders may convert any of their outstanding Debentures (or portions of outstanding Debentures) as described above into the Company's common stock initially at the conversion price of $88.31 per share (equal to a conversion rate of 11.324 shares per $1,000 principal amount of Debentures). The conversion price (and the conversion rate) may be adjusted for certain reasons, but will not be adjusted for accrued 37 interest, if any. Upon conversion, holders will not receive any cash payment representing accrued interest. Instead, accrued interest will be deemed paid by the common stock received by holders on conversion. Debentures called for redemption may be surrendered for conversion until the close of business one business day prior to the redemption date. For additional information about the terms of the Debentures, including the circumstances under which contingent interest will be payable, see the Company's Current Report on Form 8-K, filed with the SEC on July 18, 2001, including the exhibits attached thereto. 38 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits - The exhibits listed in the accompanying Index to Exhibits are filed as part of this Form 10-Q. (b) Reports on Form 8-K: (i) On July 6, 2001, the Company filed a report on Form 8-K relating to the RESPA class action lawsuit filed against PMI Mortgage Insurance Co. by G. Craig Baynham and Linnie Baynham on December 17, 1999. (ii) On July 10, 2001, the Company filed a report on Form 8-K relating to a press release issued by the Company on July 9, 2001 entitled, "PMI Announces Proposed Private Offering of Senior Convertible Debentures." (iii) On July 10, 2001, the Company filed a report on Form 8-K relating to PMI Mortgage Insurance Co.'s new insurance written, insurance in force, persistency rate and delinquency rate during the three months ended June 30, 2001. (iv) On July 11, 2001, the Company filed a report on Form 8-K relating to a press release issued by the Company on July 10, 2001 entitled, "PMI Announces Sale of 2.50% Senior Convertible Debentures due 2021." (v) On July 16, 2001, the Company filed a report on Form 8-K relating to a press release issued by the Company on July 16, 2001 entitled, "PMI Announces Exercise of Initial Purchasers' Over-Allotment Option to Purchase an Additional $60 million of 2.50% Senior Convertible Debentures due 2021." (vi) On July 18, 2001, the Company filed a report on Form 8-K relating to the closing of the sale of $360 million aggregate principal amount of its 2.50% Senior Convertible Debentures due 2021. (vii) On July 20, 2001, the Company filed a report on Form 8-K relating to a press release issued by the Company on July 19, 2001 entitled, "PMI to Address OFHEO Regulations." (viii) On July 26, 2001, the Company filed a report on Form 8-K relating to the Company's second quarter 2001 earnings conference call held on July 25, 2001. (ix) On November 2, 2001, the Company filed a report on Form 8-K relating to the Company's financial results for the quarter ended September 30, 2001. 39 SIGNATURES Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of San Francisco, State of California, on the 14th day of November, 2001. The PMI Group, Inc. /s/ John M. Lorenzen, Jr. -------------------------- John M. Lorenzen, Jr. Executive Vice President and Chief Financial Officer /s/ Brian P. Shea ------------------ Brian P. Shea Vice President, Controller and Assistant Secretary Chief Accounting Officer 40 INDEX TO EXHIBITS (Part II, Item 6) Exhibit Number Description of Exhibit -------------- ---------------------- 3.1 Restated Certificate of Incorporation of The PMI Group, Inc., incorporated by reference to Exhibit 3.1 to the Company's Amendment No. 1 to Form S-1 (No. 33- 88542) filed on March 2, 1995. 3.2 By-laws of The PMI Group, Inc., as amended and restated September 15, 1998, incorporated by reference to Exhibit 3(ii) to the Company's report on Form 8-K filed on September 29, 1998. 4.1 Indenture dated as of July 16, 2001 between The PMI Group, Inc. and The Bank of New York, as Trustee, incorporated by reference to Exhibit 4.1 to the Company's report on Form 8-K filed on July 18, 2001. 4.2 Resale Registration Rights Agreements, dated as of July 16, 2001, among The PMI Group, Inc., Bank of America Securities LLC and Lehman Brothers Inc., incorporated by reference to Exhibit 4.2 to the Company's report on Form 8-K filed on July 18, 2001. 11.1 Computation of Net Income Per Share 41 EX-11.1 3 dex111.txt COMPUTATION OF NET INCOME PER SHARE EXHIBIT 11.1 ------------ THE PMI GROUP, INC. AND SUBSIDIARIES COMPUTATION OF NET INCOME PER SHARE
Three Months Ended Nine Months Ended Sept 30, Sept 30, 2001 2000 2001 2000 -------------- -------------- ------------- ------------ Basic net income per common share: Net income 78,344 69,256 225,072 194,225 Average common shares outstanding 44,509 44,213 44,410 44,240 ------------- ------------- ------------ ------------ Basic net income per common share 1.76 1.57 5.07 4.39 ============= ============= ============ ============ Diluted net income per common share: Net Income 78,344 69,256 225,072 194,225 ------------- ------------- ------------ ------------ Average common shares outstanding 44,509 44,213 44,410 44,240 Net shares to be issued upon exercise of dilutive stock option after applying treasury stock method 971 926 920 657 ------------- ------------- ------------ ------------ Average shares outstanding 45,480 45,139 45,330 44,897 ------------- ------------- ------------ ------------ Diluted net income per common share 1.72 1.53 4.97 4.33 ============= ============= ============ ============
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