FORM 10-Q SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 [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 [ ] 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 1-10816 MGIC INVESTMENT CORPORATION (Exact name of registrant as specified in its charter) WISCONSIN 39-1486475 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 250 E. KILBOURN AVENUE 53202 MILWAUKEE, WISCONSIN (Zip Code) (Address of principal executive offices) (414) 347-6480 (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 $1.00 10/31/01 107,185,914 Page 1
MGIC INVESTMENT CORPORATION TABLE OF CONTENTS Page No. ---- PART I. FINANCIAL INFORMATION Item 1. Financial Statements (Unaudited) Consolidated Balance Sheet as of September 30, 2001 (Unaudited) and December 31, 2000 3 Consolidated Statement of Operations for the Three and Nine Month Periods Ended September 30, 2001 and 2000 (Unaudited) 4 Consolidated Statement of Cash Flows for the Nine Months Ended September 30, 2001 and 2000 (Unaudited) 5 Notes to Consolidated Financial Statements (Unaudited) 6-11 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 11-25 Item 3. Quantitative and Qualitative Disclosures About Market Risk 26 PART II. OTHER INFORMATION Item 6. Exhibits and Reports on Form 8-K 27 SIGNATURES INDEX TO EXHIBITS Page 2
PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS MGIC INVESTMENT CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET September 30, 2001 (Unaudited) and December 31, 2000 September 30, December 31, 2001 2000 ------------- ------------ ASSETS (In thousands of dollars) Investment portfolio: Securities, available-for-sale, at market value: Fixed maturities $ 3,837,447 $ 3,298,561 Equity securities 20,646 22,042 Short-term investments 171,504 151,592 ----------- ----------- Total investment portfolio 4,029,597 3,472,195 Cash 10,047 5,598 Accrued investment income 50,593 51,419 Reinsurance recoverable on loss reserves (note 3) 27,828 33,226 Reinsurance recoverable on unearned premiums (note 3) 8,618 8,680 Home office and equipment, net 33,253 31,308 Deferred insurance policy acquisition costs 29,536 25,839 Investments in joint ventures 164,084 138,838 Other assets 133,569 90,678 ----------- ----------- Total assets $ 4,487,125 $ 3,857,781 =========== =========== LIABILITIES AND SHAREHOLDERS' EQUITY Liabilities: Loss reserves $ 603,938 $ 609,546 Unearned premiums 174,825 180,724 Short- and long-term debt (note 2) 377,264 397,364 Other liabilities 353,422 205,265 ----------- ----------- Total liabilities 1,509,449 1,392,899 ----------- ----------- Contingencies (note 4) Shareholders' equity: Common stock, $1 par value, shares authorized 300,000,000; shares issued 121,110,800; shares outstanding, 9/30/01 - 107,220,914 12/31/00 - 106,825,758 121,111 121,111 Paid-in surplus 213,978 207,882 Treasury stock (shares at cost, 9/30/01 - 13,889,886 12/31/00 - 14,285,042 (607,311) (621,033) Accumulated other comprehensive income, net of tax (note 6) 98,687 75,814 Retained earnings 3,151,211 2,681,108 ----------- ----------- Total shareholders' equity 2,977,676 2,464,882 ----------- ----------- Total liabilities and shareholders' equity $ 4,487,125 $ 3,857,781 =========== =========== See accompanying notes to consolidated financial statements. Page 3
MGIC INVESTMENT CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF OPERATIONS Three and Nine Month Periods Ended September 30, 2001 and 2000 (Unaudited) Three Months Ended Nine Months Ended September 30, September 30, -------------------- ------------------- 2001 2000 2001 2000 (In thousands of dollars, except per share data) Revenues: Premiums written: Direct $288,288 $250,275 $803,797 $690,539 Assumed 126 245 353 662 Ceded (note 3) (17,408) (14,312) (46,653) (34,859) -------- -------- -------- -------- Net premiums written 271,006 236,208 757,497 656,342 (Increase) decrease in unearned premiums (6,226) (7,000) 5,837 1,404 -------- -------- -------- -------- Net premiums earned 264,780 229,208 763,334 657,746 Investment income, net of expenses 51,021 46,125 152,632 129,465 Realized investment gains, net 7,247 422 28,822 585 Other revenue 16,788 6,963 55,070 30,259 -------- -------- -------- -------- Total revenues 339,836 282,718 999,858 818,055 -------- -------- -------- -------- Losses and expenses: Losses incurred, net 43,468 21,442 109,149 66,597 Underwriting and other expenses 58,317 40,055 168,495 133,261 Interest expense 7,604 7,412 23,294 21,085 -------- -------- -------- -------- Total losses and expenses 109,389 68,909 300,938 220,943 -------- -------- -------- -------- Income before tax 230,447 213,809 698,920 597,112 Provision for income tax 71,455 67,454 220,786 187,434 -------- -------- -------- -------- Net income $158,992 $146,355 $478,134 $409,678 ======== ======== ======== ======== Earnings per share (note 5): Basic $ 1.48 $ 1.38 $ 4.46 $ 3.86 ======== ======== ======== ======== Diluted $ 1.47 $ 1.36 $ 4.43 $ 3.83 ======== ======== ======== ======== Weighted average common shares outstanding - diluted (shares in thousands, note 5) 108,218 107,339 108,036 107,065 ======== ======== ======== ======== Dividends per share $ 0.025 $ 0.025 $ 0.075 $ 0.075 ======== ======== ======== ======== See accompanying notes to consolidated financial statements. Page 4
MGIC INVESTMENT CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS Nine Months Ended September 30, 2001 and 2000 (Unaudited) Nine Months Ended September 30, ---------------------------- 2001 2000 (In thousands of dollars) Cash flows from operating activities: Net income $ 478,134 $ 409,678 Adjustments to reconcile net income to net cash provided by operating activities: Amortization of deferred insurance policy acquisition costs 14,712 14,646 Increase in deferred insurance policy acquisition costs (18,409) (18,266) Depreciation and amortization 5,145 5,366 Decrease in accrued investment income 826 1,671 Decrease in reinsurance recoverable on loss reserves 5,398 943 Decrease (increase) in reinsurance recoverable on unearned premiums 62 (2,466) Decrease in loss reserves (5,608) (27,125) (Decrease) increase in unearned premiums (5,899) 1,062 Equity earnings in joint ventures (23,007) (15,892) Other 70,698 35,138 ----------- ----------- Net cash provided by operating activities 522,052 404,755 ----------- ----------- Cash flows from investing activities: Purchase of equity securities - (14,629) Purchase of fixed maturities (2,162,273) (1,372,238) Additional investment in joint ventures (15,000) (15,023) Proceeds from sale of equity securities 1,585 14,315 Proceeds from sale or maturity of fixed maturities 1,700,427 1,010,528 ----------- ----------- Net cash used in investing activities (475,261) (377,047) ----------- ----------- Cash flows from financing activities: Dividends paid to shareholders (8,031) (7,951) Proceeds from issuance of long- and short-term debt 111,499 10,000 Repayment of long- and short-term debt (133,384) (25,000) Reissuance of treasury stock 15,307 10,803 Repurchase of common stock (7,821) (6,224) ----------- ----------- Net cash used in financing activities (22,430) (18,372) ----------- ----------- Net increase in cash and short-term investments 24,361 9,336 Cash and short-term investments at beginning of period 157,190 110,068 ----------- ----------- Cash and short-term investments at end of period $ 181,551 $ 119,404 =========== =========== See accompanying notes to consolidated financial statements. Page 5
MGIC INVESTMENT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2001 (Unaudited) Note 1 - Basis of presentation and summary of certain significant accounting policies The accompanying unaudited consolidated financial statements of MGIC Investment Corporation (the "Company") and its wholly-owned subsidiaries have been prepared in accordance with the instructions to Form 10-Q and do not include all of the other information and disclosures required by generally accepted accounting principles. These statements should be read in conjunction with the consolidated financial statements and notes thereto for the year ended December 31, 2000 included in the Company's Annual Report on Form 10-K for that year. The accompanying consolidated financial statements have not been audited by independent accountants in accordance with auditing standards generally accepted in the United States of America, but in the opinion of management such financial statements include all adjustments, including normal recurring accruals, necessary to summarize fairly the Company's financial position and results of operations. The results of operations for the nine months ended September 30, 2001 may not be indicative of the results that may be expected for the year ending December 31, 2001. Deferred insurance policy acquisition costs Costs associated with the acquisition of mortgage insurance business, consisting of employee compensation and other policy issuance and underwriting expenses, are initially deferred and reported as deferred acquisition costs (DAC). Because Statement of Financial Accounting Standards ("SFAS") No. 60 specifically excludes mortgage guaranty insurance from its guidance relating to the amortization of DAC, amortization of these costs for each underwriting year book of business are charged against revenue in proportion to estimated gross profits over the life of the policies using the guidance of SFAS No. 97, Accounting and Reporting by Insurance Enterprises For Certain Long Duration Contracts and Realized Gains and Losses From the Sale of Investments. This includes accruing interest on the unamortized balance of DAC. The estimates for each underwriting year are updated annually to reflect actual experience and any changes to key assumptions such as persistency or loss development. The Company amortized $14.6 million and $14.7 million of deferred insurance policy acquisition costs during the nine months ended September 30, 2000 and 2001, respectively. Page 6
Loss reserves Reserves are established for reported insurance losses and loss adjustment expenses based on when notices of default on insured mortgage loans are received. Reserves are also established for estimated losses incurred on notices of default not yet reported by the lender. Consistent with industry practices, the Company does not establish loss reserves for future claims on insured loans which are not currently in default. Reserves are established by management using estimated claims rates and claims amounts in estimating the ultimate loss. Amounts for salvage recoverable are considered in the determination of the reserve estimates. Adjustments to reserve estimates are reflected in the financial statements in the periods in which the adjustments are made. The liability for reinsurance assumed is based on information provided by the ceding companies. The incurred but not reported ("IBNR") reserves result from defaults occurring prior to the close of an accounting period, but which have not been reported to the Company. Consistent with reserves for reported defaults, IBNR reserves are established using estimated claims rates and claims amounts for the estimated number of defaults not reported. Reserves also provide for the estimated costs of settling claims, including legal and other expenses and general expenses of administering the claims settlement process. Income recognition The insurance subsidiaries write policies which are guaranteed renewable contracts at the insured's option on a single, annual or monthly premium basis. The insurance subsidiaries have no ability to reunderwrite or reprice these contracts. Premiums written on a single premium basis and an annual premium basis are initially deferred as unearned premium reserve and earned over the policy term. Premiums written on policies covering more than one year are amortized over the policy life in accordance with the expiration of risk, which is the anticipated claim payment pattern based on historical experience. Premiums written on annual policies are earned on a monthly pro rata basis. Premiums written on monthly policies are earned as coverage is provided. Fee income of the non-insurance subsidiaries is earned and recognized as the services are provided and the customer is obligated to pay. Note 2 - Short- and long-term debt In June of 2000, the Company filed a $500 million public debt shelf registration statement. During the fourth quarter of 2000, the Company issued, in public offerings, $300 million, 7-1/2% Senior Notes due 2005. The notes are unsecured and were rated "A1" by Moody's and "A+" by Standard and Poor's ("S&P"). The net proceeds were used to repay borrowings under bank credit facilities. Page 7
During the first quarter of 2001, the Company established a $200 million short term commercial paper program, rated "A-1" by S&P and "P-1" by Moody's. At September 30, 2001, the Company's outstanding par balance of commercial paper notes was $78.0 million. The proceeds of the commercial paper were used during the first quarter to repay all outstanding borrowings under the bank facilities. There were no borrowings outstanding under the bank facilities at September 30, 2001. These facilities are being used as liquidity back up facilities for the outstanding commercial paper. The remaining credit available under these facilities, after reduction for the amount necessary to back the commercial paper, was $122.0 million at September 30, 2001. The weighted average interest rates on the borrowings for the quarter were as follows: Senior notes 7.50% Commercial paper 3.90% Note 3 - Reinsurance The Company cedes a portion of its business to reinsurers and records assets for reinsurance recoverable on estimated reserves for unpaid losses and unearned premiums. Business written between 1985 and 1993 is ceded under various quota share reinsurance agreements with several reinsurers. The Company receives a ceding commission in connection with this reinsurance. Beginning in 1997, the Company has ceded business to captive reinsurance subsidiaries of certain mortgage lenders primarily under excess of loss reinsurance agreements. The reinsurance recoverable on loss reserves and the reinsurance recoverable on unearned premiums primarily represent amounts recoverable from large international reinsurers. The Company monitors the financial strength of its reinsurers, including their claims paying ability rating, and does not currently anticipate any collection problems. Generally, reinsurance recoverables on loss reserves and unearned premiums are backed by trust funds or letters of credit. No reinsurer represents more than $10 million of the aggregate amount recoverable. Note 4 - Contingencies and litigation settlement The Company is involved in litigation in the ordinary course of business. In the opinion of management, the ultimate resolution of this pending litigation will not have a material adverse effect on the financial position or results of operations of the Company. In addition, in June 2001, the Federal District Court for the Southern District of Georgia before which Downey et. al. v. MGIC is pending, issued a final order approving a settlement agreement and certified a nationwide class of borrowers. In the fourth quarter of 2000, the Company recorded a $23.2 million charge to cover the estimated costs of the settlement, including payments to borrowers. Due to appeals of related orders denying certain class members the right to intervene to challenge certain aspects of the settlement in Downey and two related cases, payments to borrowers in the settlement Page 8
are delayed pending the outcome of the appeals. The settlement includes an injunction that prohibits certain practices and specifies the basis on which agency pool insurance, captive mortgage reinsurance, contract underwriting and other products may be provided in compliance with the Real Estate Settlement Procedures Act. The complaint in the case alleges that MGIC violated the Real Estate Settlement Procedures Act by providing agency pool insurance, captive mortgage reinsurance, contract underwriting and other products that were not properly priced, in return for the referral of mortgage insurance. The complaint seeks damages of three times the amount of the mortgage insurance premiums that have been paid and that will be paid at the time of judgment for the mortgage insurance found to be involved in a violation of the Real Estate Settlement Procedures Act. The complaint also seeks injunctive relief, including prohibiting MGIC from receiving future premium payments. If the settlement is not fully implemented, the litigation will continue. In these circumstances, there can be no assurance that the ultimate outcome of the litigation will not materially affect the Company's financial position or results of operations. Note 5 - Earnings per share The Company's basic and diluted earnings per share ("EPS") have been calculated in accordance with SFAS No. 128, Earnings Per Share. The following is a reconciliation of the weighted-average number of shares used for basic EPS and diluted EPS. Three Months Ended Nine Months Ended September 30 September 30, ------------------ ------------------ 2001 2000 2001 2000 ------- ------- ------- ------- (Shares in thousands) Weighted-average shares - Basic EPS 107,305 106,334 107,099 106,036 Common stock equivalents 913 1,005 937 1,029 ------- ------- ------- ------- Weighted-average shares - Diluted EPS 108,218 107,339 108,036 107,065 ======= ======= ======= ======= Note 6 - New accounting standards The Company adopted SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended, on January 1, 2001, in accordance with the transition provisions of SFAS No. 133. The Company recorded a net-of-tax cumulative-effect-type adjustment of $1.0 million in accumulated other comprehensive income to recognize at fair value all derivatives that are designated as cash-flow hedging instruments. Net losses on derivatives of $7.6 million that had been previously deferred were reclassified on the balance sheet through a net-of-tax cumulative-effect-type adjustment of $5.0 million to other comprehensive income. Page 9
In 2001, The Financial Accounting Standards Board issued SFAS No. 141 "Business Combinations" and SFAS No. 142, "Goodwill and Other Intangible Assets", which are effective for the Company on January 1, 2002. SFAS No. 141 requires business combinations initiated after June 30, 2001 be accounted for using the purchase method of accounting. It also specifies the types of acquired intangible assets that are required to be recognized and reported separately from goodwill. SFAS No. 142 requires goodwill and certain intangibles no longer be amortized, but instead be tested for impairment at least annually. The Company does not have any material amounts of goodwill and therefore, does not expect any significant impairment of goodwill upon adoption. Note 7 - Comprehensive income The Company's total comprehensive income, as calculated per SFAS No. 130, Reporting Comprehensive Income, was as follows: Three Months Ended Nine Months Ended September 30 September 30, ------------------- ------------------- 2001 2000 2001 2000 -------- -------- -------- -------- (Shares in thousands) Net income $158,992 $146,355 $478,134 $409,678 Other comprehensive income 42,078 19,524 22,873 49,737 -------- -------- -------- -------- Total comprehensive income $201,070 $165,879 $501,007 $459,415 ======== ======== ======== ======== Other comprehensive income (loss) (net of tax): Cumulative effect - FAS 133 $ N/A $ N/A $ (5,982) $ N/A Net derivative losses (2,654) N/A (3,819) N/A Amortization of deferred losses and Ineffectiveness of cash flow hedge 270 N/A 810 N/A FAS 115 44,462 19,524 31,864 49,737 -------- -------- -------- -------- Comprehensive income $ 42,078 $ 19,524 $ 22,873 $ 49,737 ======== ======== ======== ======== The difference between the Company's net income and total comprehensive income for the nine months ended September 30, 2001 and 2000 is due to the change in unrealized appreciation/depreciation on investments, the cumulative effect of the adoption of SFAS No. 133 and the market value adjustment of the hedges, all net of tax. Note 8 - Accounting for derivatives and hedging activities Generally, the Company's use of derivatives is limited to entering into interest rate swap agreements intended to hedge its debt financing terms. All derivatives are recognized on the balance sheet at their fair value. On the date the derivative contract is entered into, the Company designates the derivative as a hedge of the fair value of a recognized asset or liability ("fair value" hedge), or as a hedge of a forecasted transaction or of the variability of cash flows to be received or paid related to a recognized asset or liability ("cash flow" hedge). Changes in the fair value of a derivative that is highly effective as, and that is designated and qualifies as, a fair-value hedge, along with the loss or gain on the hedged Page 10
asset or liability that is attributable to the hedged risk, are recorded in current-period earnings. Changes in the fair value of a derivative that is highly effective as, and that is designated and qualifies as, a cash-flow hedge are recorded in other comprehensive income, until earnings are affected by the variability of cash flows (e.g. when periodic settlements on a variable-rate asset or liability are recorded in earnings). The Company formally documents all relationships between hedging instruments and hedged items, as well as its risk-management objective and strategy for undertaking various hedge transactions. This process includes linking all derivatives that are designated as fair-value or cash-flow hedges to specific assets and liabilities on the balance sheet or forecasted transactions. The Company also formally assesses, both at the hedge's inception and on an ongoing basis, whether the derivatives that are used in hedging transactions are highly effective in offsetting changes in fair values or cash flows of hedged items. When it is determined that a derivative is not highly effective as a hedge or that it has ceased to be a highly effective hedge, the Company discontinues hedge accounting prospectively. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Consolidated Operations Three months Ended September 30, 2001 Compared With Three months Ended September 30, 2000 Net income for the three months ended September 30, 2001 was $159.0 million, compared to $146.4 million for the same period of 2000, an increase of 9%. Diluted earnings per share for the three months ended September 30, 2001 was $1.47 compared with $1.36 in the same period last year, an increase of 8%. As used in this report, the term "Company" means the Company and its consolidated subsidiaries, which do not include joint ventures in which the Company has an equity interest. Total revenues for the third quarter 2001 were $339.8 million, an increase of 20% from the $282.7 million for the third quarter 2000. This increase was primarily attributed to an increase in new business writings, which included $19.7 billion in bulk transactions year-to-date, of which $6.7 billion was written in the third quarter of 2001. Also contributing to the increase in revenues was an increase in investment income resulting from strong cash flows during the prior twelve months, and increases in realized gains and other revenue. See below for a further discussion of premiums, investment income and other revenue. Losses and expenses for the third quarter were $109.4 million, an increase of 59% from $68.9 million for the same period of 2000. The increase from last year can be attributed to an increase in notice inventories and increases in insured volume and in Page 11
contract underwriting. See below for a further discussion of losses incurred and underwriting expenses. The amount of new primary insurance written by MGIC during the three months ended September 30, 2001 was $23.4 billion, compared to $12.7 billion in the same period of 2000. The increase in new primary insurance written principally reflected the increase in refinancing activity on the non-bulk business and the increase in bulk transactions written in the third quarter of 2001 compared to the third quarter of 2000. The Company does not expect comparable increases in the volume of bulk transactions after the fourth quarter of 2001. The $23.4 billion of new primary insurance written during the third quarter of 2001 was offset by the cancellation of $15.4 billion of insurance in force, and resulted in a net increase of $8.0 billion in primary insurance in force, compared to new primary insurance written of $12.7 billion, the cancellation of $7.6 billion of insurance in force and a net increase of $5.1 billion in primary insurance in force during the third quarter of 2000. Direct primary insurance in force was $179.6 billion at September 30, 2001 compared to $160.2 billion at December 31, 2000 and $157.0 billion at September 30, 2000. In addition to providing primary insurance coverage, the Company also insures pools of mortgage loans. New pool risk written during the three months ended September 30, 2001 and September 30, 2000, which was virtually all agency pool insurance, was $133 million and $87 million, respectively. The Company's direct pool risk in force was $1.8 billion at September 30, 2001, $1.7 billion at December 31, 2000, and was $1.8 billion at September 30, 2000. Cancellation activity has historically been affected by the level of mortgage interest rates, with cancellations generally moving inversely to the change in the direction of interest rates. Cancellations increased during the third quarter of 2001 compared to the cancellation levels of 2000 principally due to the lower mortgage interest rate environment which resulted in a decrease in the MGIC persistency rate (percentage of insurance remaining in force from one year prior) to 67.7% at September 30, 2001 from 80.4% at December 31, 2000 and 80.3% at September 30, 2000. Future cancellation activity could be somewhat higher than it otherwise would have been as a result of legislation that went into effect in July 1999 regarding cancellation of mortgage insurance. Cancellation activity could also increase as more of the Company's bulk loans season. The Company anticipates that the bulk loans will have materially lower persistency than the Company's flow business. New insurance written for bulk transactions was 29% of new insurance written during the third quarter of 2001 compared to 23% for the same period a year ago. The Company expects that the loans that are included in these bulk transactions will have delinquency and claim rates in excess of those on the Company's flow business. While the Company believes it has priced its bulk transactions to generate acceptable returns, there can be no assurance that the assumptions underlying the premium rates adequately address the risk and persistency of this business. Page 12
Net premiums written increased 15% to $271.0 million during the third quarter of 2001, from $236.2 million during the third quarter of 2000. Net premiums earned increased 16% to $264.8 million for the third quarter of 2001 from $229.2 million for the same period in 2000. The increases were primarily a result of the growth in insurance in force and a higher percentage of renewal premiums on products with higher premium rates offset in part by an increase in ceded premiums to $17.4 million in the third quarter of 2001 compared to $14.3 million during the same period a year ago, primarily due to an increase in captive mortgage reinsurance. Mortgages (newly insured during the nine months ended September 30, 2001 or in previous periods) approximating 27% of MGIC's new insurance written during both the third quarter of 2001 and 2000 were subject to captive mortgage reinsurance and similar arrangements. Such arrangements entered into during a reporting period customarily include loans newly insured in a prior reporting period. As a result, the percentages cited above would be lower if only the current reporting period's newly insured mortgages subject to such arrangements were included. At September 30, 2001, approximately 23% of MGIC's risk in force was subject to captive reinsurance and similar arrangements, compared to 21% at December 31, 2000. The amount of premiums ceded under captive mortgage reinsurance arrangements and the amount of risk in force subject to such arrangements are expected to continue to increase. Investment income for the third quarter of 2001 was $51.0 million, an increase of 11% over the $46.1 million in the third quarter of 2000. This increase was the result of increases in the amortized cost of average invested assets to $3.8 billion for the third quarter of 2001 from $3.1 billion for the third quarter of 2000, an increase of 19%, and offset by a slight decrease in the investment yield. The portfolio's average pre-tax investment yield was 5.5% for the third quarter of 2001 and 6.0% for the same period in 2000. The portfolio's average after-tax investment yield was 4.7% for the third quarter of 2001 and 5.0% for the third quarter of 2000. The Company's net realized gains were $7.2 million for the three months ended September 30, 2001 compared to net realized gains of $0.4 million during the same period in 2000, resulting primarily from the sale of corporate and taxable municipal securities. Other revenue, which is composed of various components, was $16.8 million for the third quarter of 2001, compared with $7.0 million for the same period in 2000. The increase is primarily the result of an increase in contract underwriting revenue, an increase in equity earnings from Credit-Based Asset Servicing and Securitization LLC ("C-BASS"), a joint venture with Radian Group Inc. ("Radian"), and equity earnings from Sherman Financial Group LLC ("Sherman"), also a joint venture with Radian. C-BASS engages in the acquisition and resolution of delinquent single-family residential mortgage loans ("mortgage loans"). C-BASS also purchases and sells mortgage-backed securities ("mortgage securities"), interests in real estate mortgage investment conduit residuals and performs mortgage loan servicing. In addition, C-BASS issues Page 13
mortgage-backed debt securities collateralized by mortgage loans and mortgage securities. C-BASS's results of operations are affected by the timing of these securitization transactions. Substantially all of C-BASS's mortgage-related assets do not have readily ascertainable market values and, as a result, their value for financial statement purposes is estimated by the management of C-BASS. Market value adjustments could impact C-BASS's results of operations and the Company's share of those results. Total combined assets of C-BASS at September 30, 2001 and 2000 were approximately $960 million and $955 million, respectively, of which approximately $764 million and $826 million, respectively, were mortgage-related assets, including open trades. Total liabilities at September 30, 2001 and 2000 were approximately $676 million and $716 million, respectively, of which approximately $591 million and $627 million, respectively, were funding arrangements, including accrued interest, virtually all of which were short-term. For the three months ended September 30, 2001 and 2000, revenues of approximately $39 million and $25 million, respectively, and expenses of approximately $27 million and $18 million, respectively, resulted in income before tax of approximately $12 million and $7 million, respectively. Sherman is engaged in the business of purchasing, servicing and securitizing delinquent unsecured consumer assets such as credit card loans and Chapter 13 bankruptcy debt. A substantial portion of Sherman's consolidated assets are investments in receivable portfolios that do not have readily ascertainable market values and as a result their value for financial statement purposes is estimated by the management of Sherman. Market value adjustments could impact Sherman's results of operations and the Company's share of those results. Net losses incurred increased 103% to $43.5 million during the third quarter of 2001 from $21.4 million during the same period in 2000. The increase from a year ago was due to an increase in the primary notice inventory related to bulk delinquency activity, the maturation of the 1998 and 1999 books of business which were larger than books written in years preceding 1998 that have passed through their historical peak delinquency years, and increased delinquencies on the 2000 and 2001 books of business which are likely due to the higher risk profile of these books compared to prior books. The delinquency rate at September 30, 2001 was 3.14% compared to 2.58% at December 31, 2000, and the primary notice inventory increased from 37,422 at December 31, 2000 to 48,820 at September 30, 2001. Excluding bulk transaction loans, the delinquency rate was 2.41% at September 30, 2001 and 2.19% at December 31, 2000. The Company expects the primary notice inventory, the delinquency rate, incurred losses and claims paid, to increase from current levels due to the factors discussed above relating to the increase in incurred losses. The average primary claim paid during the third quarter was $17,700 compared to $19,500 in the third quarter of 2000. The pool notice inventory increased from 18,209 at December 31, 2000 to 20,760 at September 30, 2001. At September 30, 2001, 64% of MGIC's insurance in force was written subsequent to December 31, 1998. Based on all of the loans in the Company's insurance in force, the Page 14
highest claim frequency years have typically been the third through fifth year after the year of loan origination. However, the pattern of claims frequency for refinance loans may be different from this historical pattern and the Company expects the period of highest claims frequency on bulk transaction loans will occur earlier than in this historical pattern. Underwriting and other expenses increased to $58.3 million in the third quarter of 2001 from $40.1 million in the same period of 2000, an increase of 46%. The increase can be attributed to increases in both insurance and non-insurance expenses related to increased volume and contract underwriting. The consolidated insurance operations loss ratio was 16.4% for the third quarter of 2001 compared to 9.4% for the third quarter of 2000. The consolidated insurance operations expense and combined ratios were 16.0% and 32.4%, respectively, for the third quarter of 2001 compared to 13.8% and 23.2% for the third quarter of 2000. The effective tax rate was 31.0% in the third quarter of 2001, compared to 31.5% in the third quarter of 2000. During both periods, the effective tax rate was below the statutory rate of 35%, reflecting the benefits of tax-preferenced investment income. The lower effective tax rate in 2001 resulted from a higher percentage of total income before tax being generated from the tax-preferenced investments. Nine months Ended September 30, 2001 Compared With Nine months Ended September 30, 2000 Net income for the nine months ended September 30, 2001 was $478.1 million, compared to $409.7 million for the same period of 2000, an increase of 17%. Diluted earnings per share for the nine months ended September 30, 2001 was $4.43 compared with $3.83 in the same period last year, an increase of 16%. As used in this report, the term "Company" means the Company and its consolidated subsidiaries, which do not include joint ventures in which the Company has an equity interest. Total revenues through September 30, 2001 were $1.0 billion, an increase of 22% from the $818.1 million for the same period in 2000. This increase was primarily attributed to an increase in new business writings, which included $19.7 billion in bulk transactions for the nine months ended September 30, 2001. Also contributing to the increase in revenues was an increase in investment income resulting from strong cash flows during the prior twelve months, and increases in realized gains and other revenue. See below for a further discussion of premiums, investment income and other revenue. Losses and expenses through September 30, 2001 were $300.9 million, an increase of 36% from $220.9 million for the same period of 2000. The increase from last year can be attributed to an increase in notice inventories and increases in both insurance and non-insurance expenses relating to increased volume and contract underwriting. See below for a further discussion of losses incurred and underwriting expenses. Page 15
The amount of new primary insurance written by MGIC during the nine months ended September 30, 2001 was $62.5 billion, compared to $30.7 billion in the same period of 2000. The increase in new primary insurance written principally reflected the increase in refinancing activity on the non-bulk business and the increase in bulk transactions written through the third quarter of 2001, compared to the same period of 2000. The Company does not expect comparable increases in the volume of bulk transactions after the fourth quarter of 2001. The $62.5 billion of new primary insurance written during the first nine months of 2001 was offset by the cancellation of $43.1 billion of insurance in force, and resulted in a net increase of $19.4 billion in primary insurance in force, compared to new primary insurance written of $30.7 billion, the cancellation of $21.3 billion of insurance in force and a net increase of $9.4 billion in primary insurance in force during the same period of 2000. Direct primary insurance in force was $179.6 billion at September 30, 2001 compared to $160.2 billion at December 31, 2000 and $157.0 billion at September 30, 2000. In addition to providing primary insurance coverage, the Company also insures pools of mortgage loans. New pool risk written during the nine months ended September 30, 2001 and 2000, which was virtually all agency pool insurance, was $291 million and $270 million, respectively. The Company's direct pool risk in force was $1.8 billion at September 30, 2001 and at September 30, 2000 and $1.7 billion at December 31, 2000. Cancellation activity has historically been affected by the level of mortgage interest rates, with cancellations generally moving inversely to the change in the direction of interest rates. Cancellations increased during the first nine months of 2001 compared to the cancellation levels of 2000 principally due to the lower mortgage interest rate environment which resulted in a decrease in the MGIC persistency rate (percentage of insurance remaining in force from one year prior) to 67.7% at September 30, 2001 from 80.4% at December 31, 2000 and 80.3% at September 30, 2000. Future cancellation activity could be somewhat higher than it otherwise would have been as a result of legislation that went into effect in July 1999 regarding cancellation of mortgage insurance. Cancellation activity could also increase as more of the Company's bulk loans season. The Company anticipates that the bulk loans will have materially lower persistency than the Company's flow business. New insurance written for bulk transactions was 31% of new insurance written during the first nine months of 2001 compared to 16% for the same period a year ago. The Company expects that the loans that are included in these bulk transactions will have delinquency and claim rates in excess of those on the Company's flow business. While the Company believes it has priced its bulk transactions to generate acceptable returns, there can be no assurance that the assumptions underlying the premium rates adequately address the risk and persistency of this business. Page 16
Net premiums written increased 15% to $757.5 million during the first nine months of 2001, from $656.3 million during the same period in 2000. Net premiums earned increased 16% to $763.3 million for the first nine months of 2001 from $657.7 million for the same period in 2000. The increases were primarily a result of the growth in insurance in force and a higher percentage of renewal premiums on products with higher premium rates offset in part by an increase in ceded premiums to $46.7 million through September 30, 2001 compared to $34.9 million during the same period a year ago, primarily due to an increase in captive mortgage reinsurance. Mortgages (newly insured during the nine months ended September 30, 2001 or in previous periods) approximating 25% of MGIC's new insurance written during the first nine months of 2001 were subject to captive mortgage reinsurance and similar arrangements compared to 30% during the same period in 2000. Such arrangements entered into during a reporting period customarily include loans newly insured in a prior reporting period. As a result, the percentages cited above would be lower if only the current reporting period's newly insured mortgages subject to such arrangements were included. At September 30, 2001, approximately 23% of MGIC's risk in force was subject to captive reinsurance and similar arrangements, compared to 21% at December 31, 2000. The amount of premiums ceded under captive mortgage reinsurance arrangements and the amount of risk in force subject to such arrangements are expected to continue to increase. Investment income for the first nine months of 2001 was $152.6 million, an increase of 18% over the $129.5 million in the first nine months of 2000. This increase was the result of increases in the amortized cost of average invested assets to $3.6 billion for the first nine months of 2001 from $3.0 billion for the same period in 2000, an increase of 19%, and offset by a slight decrease in the investment yield. The portfolio's average pre-tax investment yield was 5.6% for the nine months ending September 30, 2001 and 6.0% for the same period in 2000. The portfolio's average after-tax investment yield was 4.7% for the first nine months of 2001 and 4.9% for the same period in 2000. The Company's net realized gains were $28.8 million for the nine months ended September 30, 2001 compared to net realized gains of $0.6 million during the same period in 2000, resulting primarily from the sale of corporate and taxable municipal securities. Other revenue, which is composed of various components, was $55.1 million for the first nine months of 2001, compared with $30.3 million for the same period in 2000. The increase is primarily the result of an increase in contract underwriting revenue, an increase in equity earnings from Credit-Based Asset Servicing and Securitization LLC ("C-BASS"), a joint venture with Radian Group Inc. ("Radian"), and equity earnings (compared to a loss in the prior period) from Sherman Financial Group LLC ("Sherman"), also a joint venture with Radian. C-BASS engages in the acquisition and resolution of delinquent single-family residential mortgage loans ("mortgage loans"). C-BASS also purchases and sells mortgage-backed securities ("mortgage securities"), interests in real estate mortgage investment conduit residuals and performs mortgage loan servicing. In addition, C-BASS issues Page 17
mortgage-backed debt securities collateralized by mortgage loans and mortgage securities. C-BASS's results of operations are affected by the timing of these securitization transactions. Substantially all of C-BASS's mortgage-related assets do not have readily ascertainable market values and, as a result, their value for financial statement purposes is estimated by the management of C-BASS. Market value adjustments could impact C-BASS's results of operations and the Company's share of those results. Total combined assets of C-BASS at September 30, 2001 and 2000 were approximately $960 million and $955 million, respectively, of which approximately $764 million and $826 million, respectively, were mortgage-related assets, including open trades. Total liabilities at September 30, 2001 and 2000 were approximately $676 million and $716 million, respectively, of which approximately $591 million and $627 million, respectively, were funding arrangements, including accrued interest, virtually all of which were short-term. For the nine months ended September 30, 2001 and 2000, revenues of approximately $160 million and $121 million, respectively, and expenses of approximately $90 million and $71 million, respectively, resulted in income before tax of approximately $70 million and $50 million, respectively. Sherman is engaged in the business of purchasing, servicing and securitizing delinquent unsecured consumer assets such as credit card loans and Chapter 13 bankruptcy debt. A substantial portion of Sherman's consolidated assets are investments in receivable portfolios that do not have readily ascertainable market values and as a result their value for financial statement purposes is estimated by the management of Sherman. Market value adjustments could impact Sherman's results of operations and the Company's share of those results. Net losses incurred increased 64% to $109.1 million during the first nine months of 2001 from $66.6 million during the same period in 2000. The increase from a year ago was due to an increase in the primary notice inventory related to bulk delinquency activity, the maturation of the 1998 and 1999 books of business which were larger than books written in years preceding 1998 that have passed through their historical peak delinquency years, and increased delinquencies on the 2000 and 2001 books of business which are likely due to the higher risk profile of these books compared to prior books. The delinquency rate at September 30, 2001 was 3.14% compared to 2.58% at December 31, 2000, and the primary notice inventory increased from 37,422 at December 31, 2000 to 48,820 at September 30, 2001. Excluding bulk transaction loans, the delinquency rate was 2.41% at September 30, 2001 and 2.19% at December 31, 2000. The average primary claim paid through the third quarter was $18,300 compared to $19,100 through the third quarter of 2000. The Company expects the primary notice inventory, the delinquency rate, incurred losses and claims paid, to increase from current levels due to the factors discussed above relating to the increase in incurred losses. The pool notice inventory increased from 18,209 at December 31, 2000 to 20,760 at September 30, 2001. The redundancy in loss reserves in 2001 was relatively consistent with the same period in 2000. Page 18
At September 30, 2001, 64% of MGIC's insurance in force was written subsequent to December 31, 1998. Based on all of the loans in the Company's insurance in force, the highest claim frequency years have typically been the third through fifth year after the year of loan origination. However, the pattern of claims frequency for refinance loans may be different from this historical pattern and the Company expects the period of highest claims frequency on bulk transaction loans will occur earlier than in this historical pattern. Underwriting and other expenses increased to $168.5 million in the first nine months of 2001 from $133.3 million in the same period of 2000, an increase of 26%. The increase can be attributed to increases in both insurance and non-insurance expenses related to increased volume and contract underwriting. Interest expense increased to $23.3 million in the first nine months of 2001 from $21.1 million during the same period in 2000 primarily due to higher weighted-average interest rates during the nine months ended September 30, 2001 compared to the comparable period in 2000. The consolidated insurance operations loss ratio was 14.3% for the first nine months of 2001 compared to 10.1% for the same period in 2000. The consolidated insurance operations expense and combined ratios were 16.4% and 30.7%, respectively, for the first nine months of 2001 compared to 17.0% and 27.1% for the first nine months of 2000. The effective tax rate was 31.6% through September 30, 2001, compared to 31.4% in the same period of 2000. During both periods, the effective tax rate was below the statutory rate of 35%, reflecting the benefits of tax-preferenced investment income. The higher effective tax rate in 2001 resulted from a lower percentage of total income before tax being generated from the tax-preferenced investments. Liquidity and Capital Resources The Company's consolidated sources of funds consist primarily of premiums written and investment income. Funds are applied primarily to the payment of claims and expenses. The Company generated positive cash flows from operating activities of approximately $522.1 million and $404.8 million for the nine months ended September 30, 2001 and 2000, respectively, as shown on the Consolidated Statement of Cash Flows. Positive cash flows are invested pending future payments of claims and other expenses. Cash-flow shortfalls, if any, could be funded through sales of short-term investments and other investment portfolio securities. Consolidated total investments and cash balances increased approximately $562 million to $4.0 billion at September 30, 2001 from $3.5 billion at December 31, 2000, primarily due to positive net cash flow, and by increases in unrealized gains on securities marked to market of $49 million. The Company generated consolidated cash flows from operating activities of $522.1 million through September 30, 2001, compared to $404.8 Page 19
million generated during the same period in 2000. The increase in operating cash flows through the first nine months of 2001 compared to 2000 is due primarily to increases in renewal premiums and investment income. As of September 30, 2001, the Company had $171.5 million of short-term investments with maturities of 90 days or less, and 70% of the portfolio was invested in tax-preferenced securities. In addition, at September 30, 2001, based on book value, the Company's fixed income securities were approximately 98% invested in 'A' rated and above, readily marketable securities, concentrated in maturities of less than 15 years. At September 30, 2001, the Company had an immaterial amount of derivative financial instruments in its investment portfolio. The Company's philosophy is to invest in instruments that meet high credit quality standards as specified in the Company's investment policy guidelines; the policy also limits the amount of credit exposure to any one issue, issuer and type of instrument. The Company's investments in joint ventures increased $25.3 million from $138.8 million at December 31, 2000 to $164.1 million at September 30, 2001 as a result of additional investments of $15.0 million and equity earnings of $23.0 million offset by $12.8 million of dividends received. Consolidated loss reserves at September 30, 2001, net of reinsurance recoverable of $27.8 million, decreased slightly to $576.1 million from $576.3 million, net of reinsurance recoverable of $33.2 million, at December 31, 2000, reflecting a reduction in the primary and pool reserve factors partially offset by increases in the primary and pool insurance notice inventories, as discussed earlier. The Company currently expects that consolidated loss reserves will increase in the fourth quarter of 2001 and throughout 2002 due to higher levels of incurred losses as discussed above. Consistent with industry practices, the Company does not establish loss reserves for future claims on insured loans which are not currently in default. Consolidated unearned premiums decreased $5.8 million from $172.0 million, net of reinsurance recoverable of $8.7 million, at December 31, 2000, to $166.2 million, net of reinsurance recoverable of $8.6 million, at September 30, 2001, primarily reflecting the continued high level of monthly premium policies written. During the first quarter of 2001, the Company established a $200 million short term commercial paper program, rated "A-1" by S&P and "P-1" by Moody's. At September 30, 2001, the Company's outstanding par balance of commercial paper notes was $78.0 million. The proceeds of the commercial paper were used to repay all outstanding borrowings under the bank facilities. At September 30, 2001, the Company's outstanding debt was $377.3 million. Consolidated shareholders' equity increased to $3.0 billion at September 30, 2001, from $2.5 billion at December 31, 2000, an increase of 21%. This increase consisted of $478.1 million of net income through the third quarter of 2001, $19.8 million from the Page 20
reissuance of treasury stock and other comprehensive gains, net of tax, of $22.9 million, offset by dividends declared of $8.0 million. MGIC is the principal insurance subsidiary of the Company. MGIC's risk-to-capital ratio was 9.5:1 at September 30, 2001 compared to 10.6:1 at December 31, 2000. The decrease was due to MGIC's increased policyholders' reserves, partially offset by the net additional risk in force of $2.1 billion, net of reinsurance, during the first nine months of 2001. The risk-to-capital ratios set forth above have been computed on a statutory basis. However, the methodology used by the rating agencies to assign claims-paying ability ratings permits less leverage than under statutory requirements. As a result, the amount of capital required under statutory regulations may be lower than the capital required for rating agency purposes. In addition to capital adequacy, the rating agencies consider other factors in determining a mortgage insurer's claims-paying rating, including its competitive position, business outlook, management, corporate strategy, and historical and projected operating performance. For certain material risks of the Company's business, see "Risk Factors" below. Risk Factors Our revenues and losses could be affected by the risk factors discussed below. These factors may also cause actual results to differ materially from the results contemplated by forward looking statements that the Company may make. Forward looking statements consist of statements which relate to matters other than historical fact. Among others, statements that include words such as the Company "believes", "anticipates" or "expects", or words of similar import, are forward looking statements. 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 - -------------------------------------------------------------------------- declines in our future revenues. - -------------------------------- The factors that affect the volume of low down payment mortgage originations include: o the level of home mortgage interest rates, o the health of the domestic economy as well as conditions in regional and local economies, o housing affordability, o population trends, including the rate of household formation, Page 21
o 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 o government housing policy encouraging loans to first-time homebuyers. For the third quarter of 2001, our new insurance written volume increased 84% compared to the same period in 2000. One of the reasons our volume was higher in 2001 was because many borrowers refinanced their mortgages during the first nine months of 2001 due to a lower interest rate environment, which also led to lenders canceling insurance that we wrote in the past. While we have not experienced lower volume in recent years other than as a result of declining refinancing activity, one of the risks we face is that substantially higher interest rates will substantially reduce purchase activity by first time homebuyers and that the decline in cancellations of insurance that in the past have accompanied higher interest rates will not be sufficient to offset the decline in premiums from loans that are not made. If lenders and investors select alternatives to private mortgage insurance, --------------------------------------------------------------------------- the amount of insurance that we write could decline, which could result in - -------------------------------------------------------------------------- declines in our future revenues. - -------------------------------- These alternatives to private mortgage insurance include: o lenders using government mortgage insurance programs, including those of the Federal Housing Administration and the Veterans Administration, o investors holding mortgages in portfolio and self-insuring, o 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 o 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 (referred to as an 80-10-10 loan) rather than a first mortgage with a 90% loan- to-value ratio. We believe that during 2000 lenders and investors were self-insuring and making 80-10-10 loans at about the same percentage as they did over the last several years. Although during 2000, the share of the low down payment market held by loans with Federal Housing Administration and Veterans Administration mortgage insurance was lower than in 1999, during three of the prior four years, the Federal Housing Administration and Veterans Administration's collective share of this market increased. In the last quarter of 2000, the Federal Housing Administration reduced its mortgage insurance premiums. Page 22
Investors are using reduced mortgage insurance coverage on a somewhat higher percentage of loans that we insure than they had over the last several years. Because most of the loans MGIC insures are sold to Fannie Mae and Freddie ------------------------------------------------------------------------- Mac, changes in their business practices could reduce our revenues or increase - ------------------------------------------------------------------------------ our losses. - ----------- The business practices of Fannie Mae and Freddie Mac affect the entire relationship between them and mortgage insurers and include: o the level of private mortgage insurance coverage, subject to the limitations of Fannie Mae and Freddie Mac's charters, when private mortgage insurance is used as the required credit enhancement on low down payment mortgages, o whether Fannie Mae or Freddie Mac influence the mortgage lender's selection of the mortgage insurer providing coverage and, if so, any transactions that are related to that selection, o whether Fannie Mae or Freddie Mac will give mortgage lenders an incentive, such as a reduced guaranty fee, to select a mortgage insurer that has a "AAA" claims-paying ability rating to benefit from the lower capital requirements for Fannie Mae and Freddie Mac when a mortgage is insured by a company with that rating, o the underwriting standards that determine what loans are eligible for purchase by Fannie Mae or Freddie Mac, which thereby affect the quality of the risk insured by the mortgage insurer and the availability of mortgage loans, o the terms on which mortgage insurance coverage can be canceled before reaching the cancellation thresholds established by law, and o the circumstances in which mortgage servicers must perform activities intended to avoid or mitigate loss on insured mortgages that are delinquent. Because we participate in an industry that is intensely competitive, -------------------------------------------------------------------- changes in our competitors' business practices could reduce our revenues or - --------------------------------------------------------------------------- increase our losses. - -------------------- Competition for private mortgage insurance premiums occurs not only among private mortgage insurers but increasingly with mortgage lenders through captive mortgage reinsurance transactions. In these transactions, a lender's affiliate reinsures a portion of the insurance written by a private mortgage insurer on mortgages originated by the lender. The low level of losses that has recently prevailed in the private mortgage insurance industry has encouraged competition to assume default risk through captive reinsurance arrangements, self insurance, 80-10-10 loans and other means. In 1996, we reinsured Page 23
under captive reinsurance arrangements virtually none of our primary insurance. At September 30, 2001, about 23% of our risk in force was subject to captive reinsurance arrangements. The level of competition within the private mortgage insurance industry has also increased as many large mortgage lenders have reduced the number of private mortgage insurers with whom they do business. At the same time, consolidation among mortgage lenders has increased the share of the mortgage lending market held by large lenders. Our top ten customers generated 27.0% of the new primary insurance that we wrote in 1997 compared to 36.2% in 2000. Our private mortgage insurance competitors include: o PMI Mortgage Insurance Company o GE Capital Mortgage Insurance Corporation o United Guaranty Residential Insurance Company o Radian Guaranty Inc. o Republic Mortgage Insurance Company o Triad Guaranty Insurance Corporation o CMG Mortgage Insurance Company If interest rates decline, house prices appreciate or mortgage insurance ------------------------------------------------------------------------ cancellation requirements change, the length of time that our policies remain in - -------------------------------------------------------------------------------- force could decline and result in declines in our revenue. - ---------------------------------------------------------- In each year, most of MGIC's premiums are from insurance that has been written in prior years. As a result, the length of time insurance remains in force is an important determinant of revenues. The factors affecting the length of time our insurance remains in force include: o the level of current mortgage interest rates compared to the mortgage coupon rates on the insurance in force, which affects the vulnerability of the insurance in force to refinancings, and o mortgage insurance cancellation policies of mortgage investors along with the rate of home price appreciation experienced by the homes underlying the mortgages in the insurance in force. While it is difficult to measure the extent of the decline, in recent years, the length of time that our policies remain in force has declined somewhat. Due to this decline, our premium revenues were lower than they would have been if the length had not declined. Page 24
As the domestic economy deteriorates, more homeowners may default and our ------------------------------------------------------------------------- losses may increase. - -------------------- Losses result from events that reduce a borrower's ability to continue to make mortgage payments, such as unemployment, and whether the home of a borrower who defaults on his 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, thereby reducing and in some cases even eliminating a loss from a mortgage default. In recent years, due in part to the strength of the economy, we have had low losses by historical standards. While our losses could increase for other reasons, we expect the weaker economic conditions prevalent today will probably increase our losses. Also, we expect that the bulk loans we insure will generate higher losses. We believe the premiums we charge on these loans will generate acceptable returns but we cannot guaranty this result. Our industry is subject to litigation risk. ------------------------------------------- In recent years, consumers have brought a growing number of lawsuits against home mortgage lenders and settlement service providers. As of the end of September 2001, seven mortgage insurers, including our MGIC subsidiary, were involved in litigation alleging violations of the Real Estate Settlement Procedures Act. Our MGIC subsidiary and two other mortgage insurers have entered into an agreement to settle the cases against them. The Court entered a final order approving this settlement in June 2001, although due to appeals of orders denying certain class members the right to intervene to challenge certain aspects of the settlement, the final implementation of the settlement will not occur until the appeals are resolved. We took a $23.2 million pretax charge in 2000 to cover our share of the estimated costs of the settlement. While the settlement includes an injunction that prohibits certain practices and specifies the basis on which other practices may be done in compliance with the Real Estate Settlement Procedures Act, we may still be subject to future litigation. Because we expect the pace of change in our industry and in home mortgage ------------------------------------------------------------------------- lending to remain high, we will be disadvantaged unless we are able to respond - ------------------------------------------------------------------------------ to new ways of doing business. - ------------------------------ We expect the processes involved in home mortgage lending will continue to evolve through greater use of technology. This evolution could effect fundamental changes in the way home mortgages are distributed. Affiliates of lenders who are regulated depositary institutions gained expanded insurance powers under financial modernization legislation and the capital markets may emerge as providers of insurance in competition with traditional insurance companies. These trends and others increase the level of uncertainty in our business, demand rapid response to change and place a premium on innovation. Page 25
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK At September 30, 2001, the Company's derivative financial instruments in its investment portfolio were immaterial. The Company's philosophy is to invest in instruments that meet high credit quality standards, as specified in the Company's investment policy guidelines; the policy also limits the amount of credit exposure to any one issue, issuer and type of instrument. At September 30, 2001, the effective duration of the Company's investment portfolio was 5.7 years. The effect of a 1% increase/decrease in market interest rates would result in a 5.7% decrease/increase in the value of the Company's investment portfolio. The Company's borrowings under the commercial paper program are subject to interest rates that are variable. See note 2 to the consolidated financial statements. Page 26
PART II. OTHER INFORMATION 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 - No reports were filed on Form 8-K during the quarter ended September 30, 2001. Page 27
SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized, on November 13, 2001. MGIC INVESTMENT CORPORATION \s\ J. Michael Lauer ------------------------------------ J. Michael Lauer Executive Vice President and Chief Financial Officer \s\ Patrick Sinks ------------------------------------ Patrick Sinks Senior Vice President, Controller and Chief Accounting Officer Page 28
INDEX TO EXHIBITS (Item 6) Exhibit Number Description of Exhibit - ------- ---------------------- 11 Statement Re Computation of Net Income Per Share Page 29