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Pmi Group Inc – ‘10-K’ for 12/31/03

On:  Monday, 3/15/04, at 6:27am ET   ·   For:  12/31/03   ·   Accession #:  1193125-4-41327   ·   File #:  1-13664

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Table of Contents

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-K

For the fiscal year ended December 31, 2003

OR

Commission file number 1-13664

THE PMI GROUP, INC.

(Exact name of registrant as specified in its charter)

(925) 658-7878

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act: None

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 by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).  Yes  x  No  ¨

The market value of the voting stock (common stock) held by non-affiliates of the registrant as of the close of business on June 30, 2003 was $2,371,655,002 based on the closing sale price of the common stock on the New York Stock Exchange consolidated tape on that date.

Number of shares outstanding of registrant’s common stock, as of close of business on February 27, 2004: 95,461,912

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement for registrant’s Annual Meeting of Stockholders to be held on May 27, 2004 are incorporated by reference into Items 10 through 14 of Part III.

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Cautionary Statement Regarding Forward-Looking Statements

Statements we make or incorporate by reference in this and other documents filed with the Securities and Exchange Commission that are not historical facts, that are preceded by, followed by or include the words “believes,” “expects,” “anticipates,” “estimates” or similar expressions, or that relate to future plans, events or performance are “forward-looking statements” within the meaning of the federal securities laws. 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 our forward-looking statements. Forward-looking statements involve a number of risks or uncertainties including, but not limited to, the Risk Factors addressed in the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section in Item 7. Other risks are referred to from time to time in our periodic filings with the Securities and Exchange Commission. All of our forward-looking statements are qualified by and should be read in conjunction with our risk disclosures. 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.

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PART I

The PMI Group, Inc. is an international provider of credit enhancement as well as other products that promote homeownership and facilitate mortgage transactions in the capital markets.

Our U.S. mortgage insurance operations generated 80% of our consolidated revenues and 82% of our consolidated net income in 2003. Our primary operating subsidiary, PMI Mortgage Insurance Co., or PMI, is a leading U.S. residential mortgage insurer. Residential mortgage insurance protects lenders and investors against potential losses in the event of borrower default. Its insurer financial strength is currently rated “AA+” (“Excellent”) with a negative outlook by Standard & Poor’s, or S&P, “Aa2” (“Excellent”) with a stable outlook by Moody’s Investors Service, or Moody’s, and “AA+” (“Very Strong”) with a stable outlook by Fitch Ratings, or Fitch.

Our international operations offer mortgage insurance and other credit enhancement products. Through our Australian subsidiaries, we believe we were one of the leading providers of mortgage insurance in Australia and New Zealand in 2003. Our Irish subsidiary, headquartered in Dublin, Ireland, offers mortgage insurance and mortgage credit enhancement products throughout Europe. PMI also reinsures residential mortgage insurance in Hong Kong.

On December 18, 2003, we became the lead investor in FGIC Corporation, an insurance holding company whose subsidiary, Financial Guaranty Insurance Company, or FGIC, is primarily engaged in the business of providing financial guaranty insurance for municipal bonds and asset-backed securities. We also have a significant interest in RAM Reinsurance Company, Ltd., or RAM Re, a financial guaranty reinsurance company based in Bermuda.

In the United States, we offer title insurance through our subsidiary, American Pioneer Title Insurance Company, or APTIC, and we participate in the mortgage loan servicing markets through a strategic investment. On October 27, 2003, we announced that we had entered into a definitive agreement to sell APTIC for $115 million in cash, subject to post-closing adjustments.

Our consolidated net income was $299.4 million for the year ended December 31, 2003. As of December 31, 2003, our consolidated total assets were $4.8 billion, including our investment portfolio of $2.8 billion as of that date. Our consolidated shareholders’ equity was $2.8 billion as of December 31, 2003. See Item 8. Financial Statements and Supplementary Data—Note 20. Business Segments, for financial information regarding our business segments. S&P has assigned us “A+” counterparty credit and senior unsecured debt ratings (negative outlook), Fitch has assigned us “A+” long term issuer and senior debt ratings (stable outlook), and Moody’s has assigned us an “A1” senior unsecured debt rating (stable outlook).

Our website address is http://www.pmigroup.com. Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports are available free of charge on our website via a hyperlink as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission.

Residential mortgage insurance facilitates the sale of low down-payment mortgages in the mortgage capital markets and expands homeownership opportunities by enabling borrowers to buy homes with down-payments of less than 20%. PMI provides primary mortgage insurance, or primary insurance, and pool mortgage insurance, or pool insurance, against losses in the event of borrower default. PMI’s mortgage insurance products are purchased by lenders and investors, including Fannie Mae and Freddie Mac, or the GSEs, and the Federal Home Loan

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Banks, seeking protection against default risk, capital relief or credit enhancement for mortgage transactions in the capital markets. PMI is licensed in all 50 states, the District of Columbia, Puerto Rico, Guam and the Virgin Islands. PMI is incorporated in Arizona and headquartered in Walnut Creek, California.

Primary Insurance

Primary insurance provides mortgage default protection to lenders and investors on individual loans at specified coverage percentages. PMI’s obligation to an insured with respect to a claim is generally determined by multiplying the coverage percentage selected by the insured by the loss amount on the defaulted loan, which includes any unpaid loan balance, delinquent interest and certain expenses associated with the loan’s default and property foreclosure. In lieu of paying the coverage percentage of the loss amount on a defaulted loan, PMI may pay the loss amount and take title to the mortgaged property.

PMI’s primary new insurance written, or NIW, for the year ended December 31, 2003 was $57.3 billion. PMI’s primary insurance in force and primary risk in force at December 31, 2003 were $105.2 billion and $24.7 billion, respectively. Primary insurance in force refers to the current principal balance of all outstanding mortgage loans with primary insurance coverage as of a given date. Primary risk in force is the aggregate dollar amount equal to the product of each individual insured mortgage loan’s current principal balance multiplied by the loan’s specified primary insurance coverage percentage.

PMI acquires primary insurance on a loan-by-loan basis (flow channel) and in bulk transactions (bulk channel). While their terms vary, bulk transactions generally involve bidding upon and, if successful, insuring a large group of loans on agreed terms. Some bulk transactions contain a risk-sharing component under which the insured shares in losses. Bulk transactions may involve loans that will be securitized, and in these instances, PMI may be asked to provide “down to” insurance coverage sufficient to reduce the insured’s exposure on each loan down to a percentage of the property value selected by the insured. PMI issued approximately $7 billion of primary insurance through the bulk channel in 2003, which accounted for approximately 12% of PMI’s NIW for 2003. In 2002, approximately 7% of PMI’s NIW was acquired through the bulk channel.

Premium payments may be paid to PMI on a monthly, annual or single premium basis. Monthly payment plans represented 91% of NIW in 2003 and 95% of NIW in 2002. As of December 31, 2003, monthly plans represented 92% of PMI’s primary risk in force. Single premium plan payments may be refundable if coverage is canceled by the insured, which generally occurs when the loan is repaid, the loan amortizes to a sufficiently low amount, or the value of the property has increased significantly.

Generally, mortgage insurance is renewable at the option of the insured at the premium rate fixed when the insurance on the loan was initially issued. As a result, the impact of increased claims and incurred losses from policies originated in a particular year cannot be offset by renewal premium increases on policies in force. Similarly, PMI may not cancel mortgage insurance coverage except for events of nonpayment of premiums or certain material violations of PMI’s master policies. With respect to PMI’s flow channel, the insured, the holder of the loan, or the loan’s mortgage servicer may generally cancel mortgage insurance coverage at any time. The GSEs’ guidelines generally provide that a borrower’s written request to cancel mortgage insurance should be honored if the borrower has a satisfactory payment record and the principal balance is not greater than 80% of the original value of the property or, in some instances, the current value of the property. The Homeowners Protection Act of 1998 also provides for the automatic termination, or cancellation upon a borrower’s request, of private mortgage insurance upon satisfaction of certain conditions.

The GSEs are the predominant purchasers of conventional mortgage loans in the United States, providing a direct link between mortgage origination and the capital markets. The GSEs may purchase conventional mortgages with high ratios of the original loan amount to the value of the property, or LTVs, only if the lender (i) secures private mortgage insurance from an eligible insurer on those loans; (ii) retains a participation of not less than 10% in the mortgage; or (iii) agrees to repurchase or replace the mortgage in the event of a default under

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specified conditions. However, if the lender retains a participation in the mortgage or agrees to repurchase or replace the mortgage, applicable federal bank and savings institution regulations may increase the level of capital required to be held by the lender, and thus, the lender’s cost of doing business may be adversely affected. Consequently, lenders tend to originate loans that can be sold in the secondary market utilizing mortgage insurance from insurers deemed eligible by the GSEs. Lenders that purchase private mortgage insurance in connection with the sale of loans to the GSEs must comply with the GSEs’ mortgage insurance coverage percentage requirements. The GSEs have some discretion to increase or decrease the amount of mortgage insurance coverage they require on loans, provided that minimum charter requirements are met. PMI is a GSE-authorized mortgage insurer.

Pool Insurance

Traditional Pool Insurance.    Prior to 2002, PMI offered “traditional” pool insurance, which covers the entire loss on a defaulted mortgage loan that exceeds the claim payment under any primary insurance coverage, up to a stated aggregate loss limit, or stop loss limit, for all of the loans in a pool. PMI offered traditional pool insurance primarily to two different customer segments: lenders and the GSEs (GSE Pool), and capital market participants (Old Pool).

Modified Pool Insurance.    PMI offers modified pool insurance products that, in addition to having stop loss limits and other risk reduction features, have exposure limits on each individual loan in the pool. To date, PMI has issued modified pool insurance principally to the GSEs as supplemental coverage and to other mortgage capital markets participants. PMI issued all of its modified pool insurance through bulk-type transactions between 2001 and 2003.

Unless otherwise noted, primary insurance statistics in this report do not include pool insurance.

Captive Reinsurance

Captive reinsurance is a reinsurance product in which PMI shares portions of its risk written on loans originated by certain lenders with captive reinsurance companies, or captive reinsurers, affiliated with such lenders. In return, a proportionate amount of PMI’s gross premiums written is ceded to the captive reinsurers. PMI’s captive reinsurance agreements primarily provide for excess-of-loss reinsurance, under which PMI retains a first loss position on a defined set of mortgage insurance risk, reinsures a second loss layer of this risk with a captive reinsurer and retains the remaining risk above the second loss layer up to the maximum coverage level. PMI is also a party to two quota share captive reinsurance agreements under which the captive reinsurer assumes a pro rata share of all losses in return for a pro rata share of the premiums collected. We believe that captive reinsurance provides PMI with an additional means by which to manage its portfolio risk and enhance capital efficiency.

In 2003, the percentages of primary NIW, primary insurance in force and total primary risk in force subject to captive reinsurance agreements increased. See Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations, U.S. Mortgage Insurance Operations, Premiums written and earned. These increases were driven by heavy refinance activity and a higher percentage of NIW generated by lenders with captive reinsurance programs. We anticipate that higher levels of captive reinsurance cessions will continue to reduce PMI’s premiums earned, and that the percentage of PMI’s primary risk in force subject to captive reinsurance agreements will continue to increase as a percentage of total risk in force.

Other Risk-Sharing Products

In addition to captive reinsurance, PMI offers other risk-sharing products, including layered co-insurance, a primary insurance program under which the insured retains liability for losses between certain levels of aggregate losses. PMI also offers various products designed for, and in cooperation with, the GSEs and lenders that involve some aspect of risk-sharing.

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Joint Venture—CMG Mortgage Insurance Company

CMG Mortgage Insurance Company and its affiliates, or CMG, offer mortgage insurance for loans originated by credit unions. CMG is a joint venture, equally owned by PMI and CUNA Mutual Investment Corporation, or CMIC. CMIC is part of the CUNA Mutual Group, which provides insurance and financial services to credit unions and their members. Both PMI and CMIC provide services to CMG. At December 31, 2003, CMG had $12.6 billion of primary insurance in force. CMG’s financial results are reported in PMI’s financial statements under the equity method of accounting in accordance with generally accepted accounting principles in the United States, or GAAP. CMG’s operating results are not included in PMI’s results shown in Part I of this Report on Form 10-K, unless otherwise noted.

Under the terms of the restated joint venture agreement effective as of June 1, 2003, CMIC has the right on September 8, 2015, or earlier under certain limited conditions, to require PMI to sell, and PMI has the right to require CMIC to purchase, PMI’s interest in CMG for an amount equal to the then current fair market value of PMI’s interest. PMI and CMIC have also entered into a capital support agreement for the benefit of CMG in order to maintain CMG’s claims-paying ability rating at “AA-” by S&P and “AA” by Fitch. CMG is a GSE-authorized mortgage insurer.

U.S. Private Mortgage Insurance Industry

The U.S. private mortgage insurance industry consists of eight active mortgage insurers: PMI; CMG; Mortgage Guaranty Insurance Corporation; GE Capital Mortgage Insurance Corporation, an affiliate of GE Capital Corporation; United Guaranty Residential Insurance Company, an affiliate of American International Group, Inc.; Radian Guaranty Inc.; Republic Mortgage Insurance Co., an affiliate of Old Republic International; and Triad Guaranty Insurance Corp.

U.S. and State Government Agencies

PMI and other private mortgage insurers compete with federal and state government agencies that sponsor their own mortgage insurance programs. The private mortgage insurers’ principal government competitor is the Federal Housing Administration, or FHA, and to a lesser degree, the Veterans Administration, or VA. The following table shows the relative mortgage insurance market share of FHA/VA and private mortgage insurers over the past five years.

Source: FHA, VA, Mortgage Insurance Companies of America and Inside Mortgage Finance.

Effective January 1, 2004, the U.S. Housing and Urban Development Department, or HUD, in accordance with its index, increased the maximum single-family loan amount that the FHA can insure to $290,319 in high-cost areas. While there is no maximum VA loan amount, lenders will generally limit VA loans to $240,000. Private mortgage insurers have no limit as to maximum individual loan amounts that they can insure. Increases in the amount that these agencies can insure could cause future demand for private mortgage insurance to decrease.

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Federal Home Loan Banks.    The Federal Home Loan Banks, or FHLBs, purchase single-family conforming mortgage loans originated by participating member institutions. Purchases of secondary mortgage loans by participating FHLBs increased in 2002 and 2003. Although the FHLBs are not required to purchase insurance for mortgage loans, they currently use mortgage insurance on substantially all mortgage loans with an LTV above 80% and have become a source of increasing new business for PMI. Any expansion of the FHLBs’ ability to use, or increased use of, alternatives to mortgage insurance could reduce the demand for private mortgage insurance and harm our financial condition and results of operations.

Fannie Mae and Freddie Mac—The GSEs

Mortgage insurers, including PMI, compete with the GSEs when the GSEs seek to assume mortgage default risk that could be covered by mortgage insurance. The GSEs have introduced programs that allow lenders to purchase reduced mortgage insurance coverage, as well as programs that provide for the restructuring of existing mortgage insurance with reduced amounts of primary insurance coverage and the addition of pool insurance coverage. In the past, Freddie Mac stated that it would pursue a permanent charter amendment allowing it to utilize alternative forms of default risk protection or otherwise forego the use of private mortgage insurance on higher LTV mortgages.

Mortgage Lenders

PMI and other private mortgage insurers compete with mortgage lenders that elect to retain the risk of loss from defaults on all or a portion of their high LTV mortgage loans rather than obtain insurance for such risk. Certain lenders originate mortgages that have a first mortgage lien with an LTV of 80%, a 10% second mortgage lien, and 10% of the purchase price from the borrower’s funds, or an 80/10/10. This 80/10/10 product and other similar products have reduced the available market for primary insurance. These products also compete with mortgage insurance as an alternative for lenders selling loans in the mortgage capital markets. PMI believes that the use of 80/10/10 loans increased significantly in 2003 and 2002 due primarily to the narrower differential in banks’ interest rates for the second mortgage lien in those years, and may continue to increase in the future.

PMI’s customers are primarily mortgage lenders, savings institutions, commercial banks and investors, including the GSEs, the FHLBs, and other capital market participants. As the beneficiary under PMI’s master policies is the owner of the insured loan, the purchaser of that loan is entitled to the policy benefits. The GSEs, as the predominant purchasers of conventional mortgage loans in the U.S., are the beneficiaries of a substantial majority of PMI’s mortgage insurance coverage.

In 2003, PMI’s top ten customers generated approximately 42% of PMI’s premiums earned compared to approximately 44% in 2002.

Persistency; Policy Cancellations

Historically, a significant percentage of PMI’s premiums earned has been generated from insurance policies written in previous years. Consequently, the length of time that insurance remains in force is a key determinant of PMI’s revenues and earnings. Lower interest rates beginning in 2001 have resulted in heavy mortgage refinance activity, causing PMI’s policy cancellations to increase and thereby negatively impacting earned premiums. For example, calendar year 2003 exhibited the lowest average interest rate in the period 1993 to 2003 and was the third consecutive year of declines in those rates. PMI’s persistency rate for its entire primary portfolio decreased to 44.6% at December 31, 2003 from 62.0% at December 31, 2001. The persistency rate is the percentage of primary insurance policies at the beginning of a 12-month period that remains in force at the end of that period.

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The following table shows average annual mortgage interest rates and PMI’s primary portfolio persistency rates from 1993 to 2003.

The declining interest rate environment in the last three years has been a major factor in shortening the length of time our primary insurance in force has remained in effect. The cumulative percentages of primary loans in force for policy years 2000 through 2003 are lower than for comparably aged policy years in the 1993 through 1999 period.

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PMI’s Risk in Force.    PMI’s primary risk in force was $24.7 billion as of December 31, 2003 and $25.2 billion as of December 31, 2002. The composition of PMI’s primary and pool risk in force is summarized in the table below. The table is based upon information available on the date of mortgage origination.

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The following table shows PMI’s primary risk in force by FICO score as of December 31, 2003, 2002 and 2001:

We expect higher default rates and claim payment rates for high LTV loans, ARMs, less-than-A quality loans and non-traditional loans. PMI offers pre- and post-purchase borrower counseling to borrowers with high LTV loans in an effort to reduce the risk of default on those loans. PMI also believes that the structure of its modified pool products mitigates the risk of loss to PMI from the less-than-A quality loans and non-traditional loans insured by those products. PMI incorporates its assumptions into its pricing. However, there can be no assurance that the premiums earned and the associated investment income will prove adequate to compensate for future losses from these loans.

PMI employs a sales force located throughout the country to sell its products and provide services to lenders located throughout the United States. PMI’s sales force receives compensation comprised of a base salary and incentive compensation tied to performance objectives. PMI’s product development department has primary responsibility for advertising, sales materials and the creation of new products and services.

Risk Management Approach

PMI analyzes its primary insurance business based upon the historical performance of risk factors of individual loan profiles. PMI uses national and territorial underwriting guidelines to evaluate the potential risk of default on mortgage loans submitted for insurance coverage. PMI has developed and refined its national guidelines over time, taking into account its loss experience and the GSEs’ underwriting guidelines. PMI’s underwriting guidelines generally allow PMI to place mortgage insurance coverage on any mortgage loan accepted by the GSEs’ automated underwriting systems for purchase by the GSEs.

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PMI’s underwriting guidelines are based, in part, on several statistical models that PMI employs to predict default and to measure performance as well as capital requirements. The pmiAURA^SM System, a proprietary system developed by PMI, includes economic and demographic information and assigns a risk score corresponding to the predicted likelihood of an insurance policy going to claim.

Underwriting Process

To obtain mortgage insurance on a specific mortgage loan, a customer typically submits an application and supporting documentation to PMI. If the loan is approved for mortgage insurance, PMI issues a certificate of insurance to the customer. During the last several years, advances in technology have enabled PMI to offer its customers the option of electronic submission of applications and electronic receipt of insurance commitments and certificates. In 2003, 80% of PMI’s primary insurance commitments (excluding bulk transactions) were issued electronically, compared to 69% in 2002. PMI expects the use of electronic delivery mechanisms by customers to continue to increase.

Delegated Underwriting.    More than 60% of PMI’s flow NIW is underwritten pursuant to a delegated underwriting program that allows approved lenders, subject to routine audit by PMI, to determine whether loans meet program guidelines and are thus eligible for mortgage insurance. If a lender participating in the program commits PMI to insure a loan that fails to meet all of the applicable underwriting guidelines, PMI is obligated to insure such a loan except under certain narrowly-drawn exceptions, such as a failure to meet maximum LTV criteria. Delegated underwriting enables PMI to meet mortgage lenders’ demands for immediate insurance coverage of certain loans. Delegated underwriting has become standard industry practice. PMI believes that the performance of its delegated insured loans will not vary materially over the long-term from the performance of all other insured loans.

Non-Delegated Underwriting.    Customers that are not approved to participate in the delegated program generally must submit to PMI an application for each loan, supported by various documents. Verifications of the borrower’s employment, income and funds needed for the loan closing are required in addition to other documents, unless the loan is submitted by a lender that has been approved to participate in PMI’s Quick Application Program. This program allows selected lenders to submit insurance applications that do not include all standard documents. The lender is required to maintain written verification of employment and source of funds needed for closing and other supporting documentation in its origination file. PMI may schedule on-site audits of lenders’ files on loans submitted under this program. Currently, PMI performs non-delegated underwriting on less than 5% of all insured loans.

Bulk Primary and Modified Pool Transactions.    Bulk primary insurance and modified pool insurance transactions generally involve PMI bidding for a customer’s delivery to PMI of a portfolio of loans that have been previously underwritten and closed under one or more loan programs. PMI evaluates each transaction on a loan-by-loan basis and as a portfolio. In the loan-by-loan review, PMI analyzes the characteristics of each loan and compares them to forecasts of performance generated by proprietary performance and pricing models. In the portfolio review, PMI analyzes the diversity and the aggregate risk characteristics of the portfolio as a whole. PMI also reviews the risks and potential mitigating factors inherent in the proposed coverage structure, which may include, among other things, coverage limits, stop loss limits, or deductibles.

In some cases, PMI provides commitments for the future delivery of bulk primary or modified pool transactions. The same processes described above are used to review an indicative portfolio of loans. PMI’s commitments are contingent upon a loan-by-loan review of the actual loans delivered and allow for adjustments if the characteristics of the actual delivery vary from those of the indicative portfolio.

Contract Underwriting

Contract underwriting services are provided by PMI’s wholly-owned subsidiary, PMI Mortgage Services Co., or MSC. MSC enables customers to improve the efficiency and quality of their operations by outsourcing all

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or part of their mortgage loan underwriting. MSC provides contract underwriting services for mortgage loans for which PMI provides mortgage insurance and for mortgage loans for which PMI does not provide insurance. MSC also performs the contract underwriting activities of CMG.

As a part of its contract underwriting services, MSC provides to its customers monetary and other remedies, including loan indemnifications under certain circumstances, in the event that MSC fails to properly underwrite a mortgage loan. MSC paid $13.1 million in contract underwriting remedies in 2003, compared to $6.5 million in 2002. Worsening economic conditions or other factors that could lead to increases in PMI’s primary insurance default rate could also cause the number and magnitude of the remedies that must be offered by MSC to further increase. Such an increase could have a material adverse effect on our consolidated financial condition and results of operations.

New policies processed by MSC contract underwriters represented 25% of PMI’s NIW in 2003, compared to 30% in 2002. PMI anticipates that loans underwritten by MSC will continue to make up a significant percentage of PMI’s NIW and that contract underwriting will remain the preferred method among many mortgage lenders for processing loan applications. The number of contract underwriters deployed by us is related to the volume of mortgage originations and/or refinancing.

Expanding homeownership opportunities for low- and moderate-income individuals and communities is an important priority of PMI. PMI’s approach to affordable lending is to develop products and services that assist responsible borrowers who may not qualify for mortgage loans under traditional underwriting practices. These products and services do not accommodate borrowers who have failed to manage their affairs responsibly; rather they seek to identify those home buyers who have met or will meet their obligations in a timely and conscientious manner. The beneficiaries of these programs have included recent immigrants who have not established traditional credit histories, borrowers not accustomed to using traditional savings institutions, borrowers with less than five percent for a down-payment, and home buyers who, although consistently employed, lack the stability traditionally associated with having a single employer due to the nature of their employment.

To further promote affordable housing, PMI has entered into risk-sharing agreements or “layered co-insurance” with certain institutional lenders, Native American tribes and housing authorities. Layered co-insurance is utilized primarily by financial institutions to meet Community Reinvestment Act lending goals and by Native American tribes and housing authorities to provide homeownership opportunities to traditionally underserved populations. Under such agreements, the mortgage insurance is structured so that financial responsibility is shared between the lender, Native American tribe or housing authority, and PMI.

PMI has also established partnerships with numerous national organizations to mitigate affordable housing risks and expand the understanding of responsibilities of home ownership. These community partners include Consumer Credit Counseling Services, Neighborhood Reinvestment Corp. and the affiliated Neighborhood Housing Services of America, the National Black Caucus, Social Compact, the National American Indian Housing Conference, the AFLCIO Housing Advancement Trust, the American Homeownership and Counseling Institute, the National Association of La Raza and the National Association of Real Estate Professionals. In addition, PMI has developed partnerships with local organizations in an effort to expand homeownership opportunities and promote community revitalization.

Although programs offered under PMI’s affordable housing initiatives receive the same credit and actuarial analysis as all other standard programs, some programs utilize affordable underwriting guidelines established by lenders that differ from PMI’s criteria. PMI believes that some of its insured affordable housing loans may carry higher risks than its other insured loans. As a result, PMI has instituted various programs including pre- and post-purchase borrower counseling and risk-sharing approaches, seeking to mitigate the additional risks that may be associated with some affordable housing loan programs.

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Defaults

PMI’s claim process begins with notification by the insured to PMI of a default on an insured loan. “Default” is defined in PMI’s master policies as the borrower’s failure to pay when due an amount equal to the scheduled monthly mortgage payment under the terms of the mortgage. Generally, the master policies require an insured to notify PMI of a default no later than the last business day of the month following the month in which the borrower becomes three monthly payments in default. In most cases, defaults are reported earlier. PMI’s insureds typically report defaults within approximately 60 days of the initial default. Borrowers default for a variety of reasons, including a reduction of income, unemployment, divorce, illness, inability to manage credit and interest rate levels. Borrowers may cure defaults by making all of the delinquent loan payments or by selling the property in full satisfaction of all amounts due under the mortgage. Defaults that are not cured result, in most cases, in a claim to PMI.

Primary defaults.    Primary default rates differ from region to region in the United States depending upon economic conditions and cyclical growth patterns. The two tables below set forth primary default rates by region for the various regions of the United States and the ten largest states by PMI’s risk in force. Default rates are shown by region based on location of the underlying property.

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Claim activity is not spread evenly throughout the coverage period of a primary insurance book of business. Based on PMI’s experience, the majority of claims on traditional primary insurance loans occur in the third through sixth years after loan origination, and relatively few claims are paid during the first two years after loan origination. Primary insurance written from the period of January 1, 1997 through December 31, 2001 represented 23% of PMI’s primary insurance in force at December 31, 2003. This portion of PMI’s book of business is in its expected peak claim period with respect to traditional primary loans. We believe that loans in PMI’s less-than-A quality and non-traditional primary book will have earlier incidences of default than loans in PMI’s traditional book. Loans in PMI’s non-traditional primary book generally begin to peak 18 to 22 months after origination.

The following table sets forth the dispersion of PMI’s primary insurance in force and risk in force as of December 31, 2003, by year of policy origination and average annual mortgage interest rate since PMI began operations in 1972.

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Pool defaults. The number of pool loans PMI insured steadily decreased during 2003, primarily due to heavy mortgage refinance activity. Accordingly, the number of outstanding delinquent loans decreased in 2003. In 2003, pool claims paid represented approximately 9% of PMI’s total claims paid.

Claims and Policy Servicing

Primary insurance claims paid by PMI in 2003 increased to $175.0 million from $99.8 million in 2002. Pool insurance claims paid by PMI in 2003 (excluding Old Pool) increased to $17.2 million from $10.0 million in 2002. Old Pool claims paid by PMI in 2003 decreased to $0.1 million from $0.6 million in 2002.

The frequency of defaults is not directly proportional to the number of claims PMI receives. This is because the rate at which defaults cure is influenced by borrowers’ financial resources and circumstances and regional economic differences. Whether an uncured default leads to a claim principally depends on the borrower’s equity in the underlying property at the time of default and the borrower’s or the insured’s ability to sell the home for an amount sufficient to satisfy all amounts due under the mortgage loan. When the likelihood of a defaulted loan being reinstated is minimal, PMI works with the servicer of the loan for a possible loan workout or early disposal of the underlying property. Property dispositions typically result in savings to PMI over the percentage coverage amount payable under PMI’s master policies.

Within 60 days after a primary insurance claim and supporting documentation have been filed, PMI has the option of:

While PMI attempts to choose the claim settlement option which best mitigates the amount of its claim payment, PMI generally settles by paying the coverage percentage multiplied by the loss amount. In 2003 and 2002, PMI settled 23% and 22%, respectively, of the primary insurance claims processed for payment on the basis of a prearranged sale. In 2003 and 2002, PMI exercised the option to acquire the property on approximately 8% and 7%, respectively, of the primary claims processed for payment. At December 31, 2003, PMI owned $37.0 million of REO valued at the lower of cost or estimated realizable value.

Claim severity.    The severity of a claim, which is the ratio of the claim paid to the original risk in force relating to the loan, depends in part upon the specified coverage percentage for that loan. A higher coverage percentage on a loan generally decreases the potential severity of a claim on that loan, even though the claim amount may increase. PMI generally charges higher premium rates for higher coverage. PMI’s average primary coverage percentage was 24% for NIW in 2003 and in 2002.

The main determinants of the severity of a claim are the value of the underlying property, accrued interest on the loan, expenses advanced by the insured and foreclosure expenses, and the amount of mortgage insurance coverage placed on the loan. These amounts depend in part on the time required to complete foreclosure, which varies depending on state laws. Pre-foreclosure sales, acquisitions and other early workout efforts help to reduce overall claim severity. The average primary claim severity level has decreased from 100% in 1994 to 81% in 2003. PMI’s primary claim severity level in 2002 was 77%.

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Pool claims.    Pool claims are generally filed after the underlying property is sold. PMI settles a pool claim in accordance with the agreed upon terms of the applicable pool insurance policy, which includes a stop loss limit and, in some cases, a specified deductible. Subject to such stop loss limit and any deductible, PMI generally covers 100% of the loss minus net proceeds from the sale of the property and any primary claim proceeds. Other pool insurance policies may include a maximum coverage percentage or a defined benefit. Claims relating to policies with a maximum coverage percentage are settled at the lesser of the actual loss or the maximum coverage set forth in the applicable policy. Claims relating to policies with defined benefits are settled at the maximum coverage percentage set forth in the applicable policy. PMI settles pool claims immediately upon receipt of all supporting documentation.

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Loan Performance

The table below shows cumulative losses paid by PMI at the end of each successive year after the year of original policy issuance, referred to as a “policy year,” expressed as a percentage of the cumulative premiums written on such policies.

Percentage of Cumulative Primary Insurance Losses Paid (Gross)

To Cumulative Primary Insurance Premiums Written