FORM 10-Q ------------------ UNITED STATES 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 June 30, 2002 or [ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the transition period from ______ to _____ Commission File Number 0-22342 TRIAD GUARANTY INC. (Exact name of registrant as specified in its charter) Delaware 56-1838519 (State of Incorporation) (I.R.S. Employer Identification Number) 101 SOUTH STRATFORD ROAD WINSTON-SALEM, NORTH CAROLINA 27104 (Address of principal executive offices) (336) 723-1282 (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 / / Number of shares of Common Stock, $.01 par value, outstanding as of August 1, 2002: 14,134,449 shares. TRIAD GUARANTY INC. INDEX Page Number ------ Part I. Financial Information: Item 1. Financial Statements: Consolidated Balance Sheets as of June 30, 2002 (Unaudited) and December 31, 2001................................................ 3 Consolidated Income Statements for the Three and Six Months Ended June 30, 2002 and 2001 (Unaudited)............................ 4 Consolidated Statements of Cash Flow for the Six Months Ended June 30, 2002 and 2001 (Unaudited)............................ 5 Notes to Consolidated Financial Statements............................. 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations............................................... 9 Part II. Other Information: Item 1. Legal Proceedings............................................. 17 Item 2. Changes in Securities and Use of Proceeds...................... 17 Item 3. Defaults Upon Senior Securities................................ 17 Item 4. Submission of Matters to a Vote of Security Holders............ 17 Item 5. Other Information.............................................. 17 Item 6. Exhibits and Reports on Form 8-K............................... 17 Signatures............................................................. 18 2 TRIAD GUARANTY INC. CONSOLIDATED BALANCE SHEETS June 30, December 31, 2002 2001 ----------- ------------ (Unaudited) (Dollars in thousands except per share information) Assets Invested assets: Fixed maturities, available-for-sale, at fair value.......... $275,148 $245,986 Equity securities, available-for-sale, at fair value......... 12,332 12,476 Short-term investments....................................... 17,029 18,739 -------- -------- 304,509 277,201 Cash ............................................................ 72 854 Real estate...................................................... 506 162 Accrued investment income........................................ 3,161 3,196 Deferred policy acquisition costs................................ 28,669 25,944 Prepaid federal income taxes..................................... 69,425 62,619 Property and equipment........................................... 10,796 11,169 Reinsurance recoverable.......................................... 630 5 Other assets..................................................... 15,597 15,305 -------- -------- Total assets..................................................... $433,365 $396,455 ======== ======== Liabilities and stockholders' equity Liabilities: Losses and loss adjustment expenses.......................... $ 18,739 $ 17,991 Unearned premiums............................................ 7,478 7,650 Amounts payable to reinsurer................................. 2,444 2,445 Current taxes payable........................................ 519 40 Deferred income taxes........................................ 81,342 74,773 Unearned ceding commission................................... 1,861 2,324 Long-term debt............................................... 34,476 34,473 Accrued interest on debt..................................... 1,275 1,275 Accrued expenses and other liabilities....................... 5,108 9,415 -------- -------- Total liabilities................................................ 153,242 150,386 Commitments and contingent liabilities - Note 4 Stockholders' equity: Preferred stock, par value $.01 per share --- authorized 1,000,000 shares; no shares issued and outstanding........ --- --- Common stock, par value $.01 per share --- authorized 32,000,000 shares; issued and outstanding 14,134,149 shares at June 30, 2002 and 13,691,672 at December 31, 2001...................................... 141 137 Additional paid-in capital................................... 79,536 69,057 Accumulated other comprehensive income, net of income tax liability of $2,127 at June 30, 2002 and $522 at December 31, 2001......................................... 3,955 975 Deferred compensation........................................ (855) (118) Retained earnings............................................ 197,346 176,018 -------- -------- Total stockholders' equity....................................... 280,123 246,069 -------- -------- Total liabilities and stockholders' equity....................... $433,365 $396,455 ======== ======== See accompanying notes. 3 TRIAD GUARANTY INC. CONSOLIDATED INCOME STATEMENTS (Unaudited) Three Months Ended Six Months Ended June 30 June 30 ----------------------- --------------------- 2002 2001 2002 2001 ---- ---- ---- ---- (Dollars in thousands except per share information) Revenue: Premiums written: Direct........................................... $29,784 $21,998 $57,622 $43,791 Assumed.......................................... 1 1 2 3 Ceded............................................ (4,494) (2,222) (7,842) (4,205) ---------- ---------- ---------- ---------- Net premiums written................................ 25,291 19,777 49,782 39,589 Change in unearned premiums......................... 208 366 252 237 ---------- ---------- ---------- ---------- Earned premiums..................................... 25,499 20,143 50,034 39,826 Net investment income............................... 3,953 3,657 7,717 7,134 Realized investment gains (losses).................. (729) 162 (2,228) 614 Other income........................................ 15 15 42 1,882 ---------- ---------- ---------- ---------- 28,738 23,977 55,565 49,456 Losses and expenses: Losses and loss adjustment expenses................. 2,875 2,135 5,396 4,334 Reinsurance recoveries.............................. 4 (1) (1) 3 ---------- ---------- ---------- ---------- Net losses and loss adjustment expenses............. 2,879 2,134 5,395 4,337 Interest expense on debt............................ 693 693 1,386 1,385 Amortization of deferred policy acquisition costs... 3,059 2,674 6,045 5,009 Other operating expenses (net)...................... 5,764 4,293 11,833 8,645 ---------- ---------- ---------- ---------- 12,395 9,794 24,659 19,376 ---------- ---------- ---------- ---------- Income before income taxes ......................... 16,343 14,183 30,906 30,080 Income taxes: Current.......................................... 172 92 332 93 Deferred......................................... 4,881 4,261 9,246 9,237 ---------- ---------- ---------- ---------- 5,053 4,353 9,578 9,330 ---------- ---------- ---------- ---------- Net income.......................................... $11,290 $ 9,830 $21,328 $20,750 ========== ========== ========== ========== Earnings per common and common equivalent share: Basic............................................ $.80 $.73 $1.53 $1.55 ========== ========== =========== ======== Diluted.......................................... $.78 $.71 $1.49 $1.49 ========== ========== =========== ======== Shares used in computing earnings per common and common equivalent share: Basic............................................ 14,115,220 13,444,388 13,976,165 13,399,891 ========== ========== ========== ========== Diluted.......................................... 14,390,101 13,939,338 14,295,372 13,885,145 ========== ========== ========== ========== See accompanying notes. 4 TRIAD GUARANTY INC. CONSOLIDATED STATEMENTS OF CASH FLOW (Unaudited) Six Months Ended June 30 --------------------- 2002 2001 ---- ---- (Dollars in thousands) Operating activities Net income.................................................. $21,328 $20,750 Adjustments to reconcile net income to net cash provided by operating activities: Loss and unearned premium reserves....................... 577 1,311 Accrued expenses and other liabilities................... (5,397) (3,578) Current taxes payable.................................... 478 93 Amounts due to/from reinsurer............................ (706) (955) Accrued investment income................................ 35 (240) Policy acquisition costs deferred........................ (8,771) (7,073) Amortization of policy acquisition costs................. 6,045 5,008 Net realized investment losses (gains)................... 2,228 (614) Provision for depreciation............................... 1,424 1,079 Accretion of discount on investments..................... (2,137) (1,305) Deferred income taxes.................................... 9,246 9,237 Prepaid federal income tax............................... (6,806) (7,047) Unearned ceding commission............................... (463) 1,415 Real estate acquired in claim settlement................. (343) 1 Other assets............................................. (144) (1,029) Other operating activities............................... 198 127 ------- ------- Net cash provided by operating activities................... 16,792 17,180 Investing activities Securities available-for-sale: Purchases - fixed maturities.......................... (46,879) (42,927) Sales - fixed maturities.............................. 24,382 15,843 Purchases - equities.................................. (2,040) (1,896) Sales - equities...................................... 1,035 2,255 Purchase of property and equipment....................... (1,050) (2,593) ------- ------- Net cash used in investing activities....................... (24,552) (29,318) Financing activities Proceeds from exercise of stock options..................... 5,268 2,797 ------- ------- Net cash provided by financing activities................... 5,268 2,797 ------- ------- Net change in cash and short-term investments............... (2,492) (9,341) Cash and short-term investments at beginning of period...... 19,593 18,525 ------- ------- Cash and short-term investments at end of period............ $17,101 $ 9,184 ======= ======= Supplemental schedule of cash flow information Cash paid during the period for: Income taxes and United States Mortgage Guaranty Tax and Loss Bonds.................................... $ 7,306 $ 7,032 Interest................................................. $ 1,383 $ 1,383 See accompanying notes. 5 TRIAD GUARANTY INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS June 30, 2002 (Unaudited) NOTE 1 -- THE COMPANY Triad Guaranty Inc. is a holding company which, through its wholly-owned subsidiary, Triad Guaranty Insurance Corporation ("Triad"), provides private mortgage insurance coverage in the United States to mortgage lenders and investors to protect the lender or investor against loss from defaults on low down payment residential mortgage loans. NOTE 2 -- BASIS OF PRESENTATION The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and six months ended June 30, 2002 are not necessarily indicative of the results that may be expected for the year ending December 31, 2002. For further information, refer to the consolidated financial statements and footnotes thereto included in the Triad Guaranty Inc. annual report on Form 10-K for the year ended December 31, 2001. NOTE 3 -- CONSOLIDATION The consolidated financial statements include Triad Guaranty Inc. and its wholly-owned subsidiary, Triad Guaranty Insurance Corporation ("Triad"), and Triad's wholly-owned subsidiaries, Triad Guaranty Assurance Corporation and Triad Re Insurance Corporation (collectively referred to as "the Company"). All significant intercompany accounts and transactions have been eliminated. NOTE 4 -- COMMITMENTS AND CONTINGENT LIABILITIES REINSURANCE - Triad assumes and cedes certain premiums and losses from/to reinsurers under various reinsurance agreements. Reinsurance contracts do not relieve Triad from its obligations to policyholders. Failure of the reinsurer to honor its obligation could result in losses to Triad; consequently, allowances are established for amounts when deemed uncollectible. 6 TRIAD GUARANTY INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS June 30, 2002 (Unaudited) INSURANCE IN FORCE, DIVIDEND RESTRICTIONS, AND STATUTORY RESULTS - Insurance regulations limit the writing of mortgage guaranty insurance to an aggregate amount of insured risk no greater than 25 times the total of statutory capital and surplus and the statutory contingency reserve. The amount of net risk for insurance in force at June 30, 2002 and December 31, 2001, as presented below, was computed by applying the various percentage settlement options and applicable stop-loss parameters to the insurance in force amounts based on the original insured amount of the loan. Triad's ratio is as follows: June 30, December 31, 2002 2001 (Dollars in thousands) Net risk.............................. $ 5,039,445 $ 4,471,705 =========== =========== Statutory capital and surplus......... $ 104,261 $ 105,306 Statutory contingency reserve......... 218,243 193,747 ----------- ----------- Total................................. $ 322,504 $ 299,053 =========== =========== Risk-to-capital ratio................. 15.6-to-1 15.0-to-1 =========== =========== Triad and its wholly-owned subsidiaries, Triad Guaranty Assurance Corporation and Triad Re Insurance Corporation, are each required under their respective domiciliary states' insurance code to maintain a minimum level of statutory capital and surplus. Triad, an Illinois domiciled insurer, is required under the Illinois Insurance Code (the "Code") to maintain minimum statutory capital and surplus of $5 million. The Code permits dividends to be paid only out of earned surplus and also requires prior approval of extraordinary dividends. An extraordinary dividend is any dividend or distribution of cash or other property, the fair value of which, together with that of other dividends or distributions made within a period of twelve consecutive months, exceeds the greater of (a) ten percent of statutory surplus as regards policyholders, or (b) statutory net income for the calendar year preceding the date of the dividend. Net income as determined in accordance with statutory accounting practices was $27.8 million for the six months ended June 30, 2002 and $55.4 million for the year ended December 31, 2001. At June 30, 2002 and December 31, 2001, the amount of Triad's equity that could be paid out in dividends to stockholders was $20.5 million and $21.6 million, respectively, which was the earned surplus of Triad on a statutory basis on those dates. LOSS RESERVES - The Company establishes loss reserves to provide for the estimated costs of settling claims with respect to loans reported to be in default and loans in default which have not been reported to the Company. 7 TRIAD GUARANTY INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS June 30, 2002 (Unaudited) Reserves are established by management using estimated claim rates (frequency) and claim amounts (severity) to estimate ultimate losses. The reserving process gives effect to current economic conditions and profiles delinquencies by such factors as policy year, geography, chronic late payment characteristics and age. Due to the inherent uncertainty in estimating reserves for losses and loss adjustment expenses, there can be no assurance that the reserves will prove to be adequate to cover ultimate loss development. NOTE 5 - - EARNINGS PER SHARE Basic and diluted earnings per share are based on the weighted-average daily number of shares outstanding. For diluted earnings per share, the denominator includes the dilutive effect of stock options on the weighted-average shares outstanding. There are no other reconciling items between the denominator used in basic earnings per share and diluted earnings per share. The numerator used in basic earnings per share and diluted earnings per share is the same for all periods presented. NOTE 6 - - COMPREHENSIVE INCOME Comprehensive income consists of net income and other comprehensive income. For the Company, other comprehensive income is composed of unrealized gains or losses on available-for-sale securities, net of income tax. For the three months ended June 30, 2002 and 2001, the Company's comprehensive income was $15.1 million and $8.7 million, respectively. For the six months ended June 30, 2002 and 2001, the Company's comprehensive income was $24.3 million and $20.4 million, respectively. 8 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS Net income for the first six months of 2002 increased 2.8% to $21.3 million or $1.49 per diluted share compared to $20.8 million or $1.49 per diluted share for the first six months of 2001. Net income for the first six months of 2001 included the receipt of a nonrecurring incentive payment of approximately $1.9 million or $0.09 per diluted share relating to the cancellation of one of the Company's excess of loss reinsurance contracts. The payment was reported as other income in the first quarter of 2001. Net income for the second quarter of 2002 increased 14.9% to $11.3 million or $0.78 per diluted share from $9.8 million or $0.71 per diluted share in the second quarter of 2001. Earnings per share for the first six months of 2002 includes $0.10 per share of net realized investment losses compared to $0.02 per share of net realized investment gains in the first six months of 2001. For the second quarter of 2002 and 2001, earnings per share includes $0.04 per share of net realized investment losses and $0.01 per share of net realized investment gains, respectively. Operating earnings for the first six months of 2002 increased 11.9% to $22.8 million from $20.4 million for the first six months of 2001. For the second quarter of 2002, operating earnings increased 21.0% to $11.8 million from $9.7 million in the second quarter of 2001. Operating earnings exclude realized investment losses of $2.2 million in the first six months of 2002 and realized investment gains of $614,000 in the first six months of 2001. For the second quarter of 2002 and 2001, operating earnings exclude realized investment losses of $729,000 and realized investment gains of $162,000, respectively. Operating earnings per share on a diluted basis were $1.59 for the first six months of 2002 compared to $1.47 per share for the same period of 2001. For the second quarter of 2002, operating earnings per share on a diluted basis were $0.82 compared to $0.70 per share for the second quarter of 2001. Excluding the effects of the nonrecurring incentive payment from operating results for the first six months of 2001, operating earnings increased 19.0% and operating earnings per diluted share increased 15.2% for the first six months of 2002 compared to the first six months of 2001. The improvement in operating earnings is attributable primarily to a 25.6% (26.6% in the second quarter) increase in earned premiums and an 8.2% (8.1% in the second quarter) increase in net investment income. Insurance written was $6.2 billion for the first six months of 2002 as compared to $4.7 billion for the first six months of 2001, an increase of 32.8%. For the second quarter of 2002, insurance written was $3.5 billion compared to $1.9 billion for the second quarter of 2001, an increase of 77.9%. Traditional flow production for the first six months of 2002 increased 62.6% to $5.5 billion from $3.4 billion in the first six months of 2001. For the second quarter of 2002, traditional flow production was $2.7 billion compared to $1.9 billion in the second quarter of 2001, an increase of 38.4%. The increase in new insurance written from traditional flow production was primarily the result of expanding relationships with national lenders, strong demand for risk-sharing arrangements, and a lower interest rate environment. Insurance written in the first six months of 2002 attributable to bulk transactions totaled $766 million (all in the second quarter of 2002) compared to $1.3 billion in the first six months of 2001 (all in the first quarter of 2001). 9 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS -- CONTINUED Consolidation within the mortgage origination industry and Triad's continued focus on national lenders has resulted in a greater percentage of production volume being concentrated among a smaller customer base. The loss of one or more of these significant customers could have a significant adverse effect on the Company's business. According to industry data, Triad's national market share of net new primary insurance written increased to 3.2% for the second quarter and 3.4% for the first six months of 2002 from 2.6% and 2.7% for the respective periods in 2001. Net new primary insurance written excludes insurance placed on loans more than 12 months after loan origination, insurance placed on loans already covered by primary mortgage insurance, and insurance placed on loans where lender exposure is effectively reduced below defined minimums. This treatment is consistent with the new definitions adopted by the Company and the industry in the third quarter of 2001 regarding the computation of new insurance written for market share purposes. Total direct insurance in force reached $23.8 billion at June 30, 2002, compared to $17.3 billion at June 30, 2001, an increase of 37.3%. Total direct premiums written were $57.6 million for the first six months of 2002, an increase of 31.6% from $43.8 million for the first six months of 2001. Direct premiums written for the second quarter of 2002 increased 35.4% to $29.8 million compared to $22.0 million for the same period of 2001. Net premiums written were $49.8 million in the first six months of 2002, an increase of 25.7% from $39.6 million for the same period of 2001. Net premiums written for the second quarter of 2002 increased by 27.9% to $25.3 million compared to $19.8 million for the same period of 2001. Earned premiums increased 25.6% to $50.0 million for the first six months of 2002 from $39.8 million for the first six months of 2001. Earned premiums for the second quarter of 2002 were $25.5 million compared to $20.1 million for the same period of 2001, an increase of 26.6%. This growth in written and earned premiums resulted from strong levels of new insurance written offset by the impact of a low persistency rate. Growth in direct premiums written was partially offset by the increase in ceded premiums written. Driven by increases in risk-sharing arrangements, ceded premium written increased 86.5% to $7.8 million for the first six months of 2002 from $4.2 million for the first six months of 2001. Ceded premiums written in the second quarter of 2002 were $4.5 million compared to $2.2 million in the same period of 2001, an increase of 102.2%. The Company's premium ceded rate (the ratio of ceded premiums written to direct premiums written) was 13.6% in the first six months of 2002 (15.1% in the second quarter) compared to 9.6% in the first six months of 2001 (10.1% in the second quarter). Approximately 50% of flow insurance written (44% including bulk transactions) during the first six months of 2002 is subject to risk-sharing arrangements compared to 57% of insurance written (41% including bulk transactions) in the first six months of 2001. Management anticipates ceded premiums will continue to increase as a result of the expected increase in risk-sharing programs. Refinance activity was 39.9% of insurance written in the first half of 2002 compared to 29.9% of insurance written in the first half of 2001. Refinance activity was 33.0% of insurance written in the second quarter of 2002 compared 10 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS -- CONTINUED to 40.1% of insurance written in the same period of 2001. Persistency, or the percentage of insurance in force remaining from one-year prior, was 62.4% at June 30, 2002 compared to 67.6% at December 31, 2001, and 75.8% at June 30, 2001. The decrease in persistency is reflective of the low interest rate environment that has been in place over the previous 12 months, and the resulting high level of refinance activity. The annualized quarterly persistency run rate for the second quarter of 2002 was 65.5%, up from 60.7% in the second quarter of 2001. Net investment income for the first six months of 2002 was $7.7 million, an 8.2% increase over $7.1 million in the first six months of 2001. Net investment income for the second quarter of 2002 was $4.0 million compared to $3.7 million in the same period of 2001, an increase of 8.1%. This increase in investment income is the result of growth in the average book value of invested assets by $46.7 million to $286.8 million at June 30, 2002 from $240.1 million at June 30, 2001. The growth in invested assets is attributable to normal operating cash flow. The pre-tax yield on average invested assets decreased to 5.4% for the first six months of 2002 compared to 5.9% for the first six months of 2001, reflecting the current low interest rate environment for new money investments and the disposal of a number of higher yielding, lower quality securities during the past twelve months to enhance the overall quality of the portfolio. The portfolio's tax-equivalent yield-to-maturity was 7.9% for the first half of 2002 versus 8.0% for the first half of 2001. Based on fair value, approximately 77% and 71% of the Company's fixed maturity portfolio at June 30, 2002 and 2001, respectively, was composed of state and municipal tax-preferred securities. At June 30, 2002, based on fair value, approximately 95% of the Company's fixed maturity portfolio was either a U.S. government or U.S. agency obligation or was rated investment grade by at least one nationally recognized securities rating organization compared to approximately 92% of the Company's fixed maturity portfolio at June 30, 2001. The Company actively monitors investment securities considered to be at risk for impairment. When the Company determines that it is probable that it will be unable to collect all amounts due according to the contractual terms of a security, an other-than-temporary impairment loss has occurred. In the event of permanent impairment, the Company writes down the cost basis of the security to its fair value and recognizes a realized loss for the amount of the writedown. Realized losses in the first six months of 2002 included impairment writedowns of approximately $1.3 million on bonds held in the Company's portfolio, with approximately $600,000 of impairment writedowns occurring in the second quarter. The writedowns involved securities in the telecommunications and technology sectors. Net losses and loss adjustment expenses (net of reinsurance recoveries) increased by 24.4% in the first six months of 2002 to $5.4 million from $4.3 million for the same period of 2001. Net losses and loss adjustment expenses were $2.9 million in the second quarter of 2002 compared to $2.1 million in the second quarter of 2001, an increase of 34.9%. This rise reflects an increase in paid losses and delinquent loans as the Company's insurance in force matures. Net paid losses and loss adjustment expenses were $4.6 million in the first six months of 2002, up from $2.8 million in the first six months of 2001. Net paid losses and loss adjustment expenses were $2.4 million in the second quarter of 2002 compared to $1.7 million in the second quarter of 2001. Reported delinquent loans totaled 1,684 at June 30, 2002, compared to 1,420 at December 31, 2002 and 928 at June 30, 2001. The delinquency inventory count includes all reported delinquencies that are three or more payments in arrears at the reporting date 11 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS -- CONTINUED and all reported delinquencies that were previously three or more payments in arrears and have not made payments to the current due date. Reserves are established for all insured loans reported as delinquent to the Company by the loan servicer. The Company's loss ratio (the ratio of incurred losses to earned premiums) was 10.8% for the first half of 2002 compared to 10.9% for the first half of 2001 and 10.7% for all of 2001. The loss ratio was 11.3% for the second quarter of 2002 and 10.6% for the second quarter of 2001. As of June 30, 2002, approximately 78% of the Company's insurance in force was originated in the last 36 months. Management believes, based upon its experience and industry data, that claims incidence for it and other private mortgage insurers is generally highest in the third through sixth years after loan origination. Although the claims experience on insurance written in previous years has been quite favorable, management does not expect losses to remain at the low levels currently reported. The Company expects its incurred losses to increase as a greater amount of its insurance in force reaches its anticipated highest claim frequency years. Furthermore, changes in the economic environment could accelerate paid and incurred loss development. Due to the inherent uncertainty of future premium levels, losses, economic conditions, and other factors that affect earnings, it is impossible to predict with any degree of certainty the impact of such higher claim frequencies on future earnings. Amortization of deferred policy acquisition costs increased by 20.7% to $6.0 million in the first six months of 2002 from $5.0 million for the first six months of 2001. These costs were $3.1 million in the second quarter of 2002 compared to $2.7 million in the second quarter of 2001, an increase of 14.4%. The increase in amortization reflects growth in deferred policy acquisition costs related to the expansion of the Company's insurance in force and accelerated amortization due to higher cancellations from refinance activity in the first half of 2002, although this trend abated in the second quarter. Other operating expenses increased 36.9% to $11.8 million for the first half of 2002 from $8.6 million for the same period of 2001. For the second quarter of 2002, other operating expenses were $5.8 million compared to $4.3 million in the second quarter of 2001, an increase of 34.3%. This increase in expenses is primarily attributable to personnel, technology amortization, and equipment costs required to support the Company's increased levels of production, product development, system enhancements, and geographic expansion. The expense ratio (ratio of underwriting expenses to net premiums written) for the first six months of 2002 was 35.9% compared to 34.5% for the first six months of 2001 and 35.1% for all of 2001. The expense ratio for the second quarter of 2002 was 34.9% compared to 35.2% for the second quarter of 2001. The effective tax rate for both the first six months of 2002 and 2001 was 31.0%. The effective tax rate was 30.9% for the second quarter of 2002 compared to 30.7% for the second quarter of 2001. Management expects the Company's effective tax rate to remain near current levels as long as yields from new funds invested in tax-preferred securities remain favorable in relation to fully taxable securities. 12 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS -- CONTINUED LIQUIDITY AND CAPITAL RESOURCES The Company's sources of operating funds consist primarily of premiums written and investment income. Operating cash flow is applied primarily to the payment of claims, interest, operating expenses, and taxes. The Company generated positive cash flow from operating activities for the first six months of 2002 of $16.8 million compared to $17.2 million for the same period of 2001. Triad's positive operating cash flow in the first half of 2002 reflects premiums and investment income received that were greater than expenses and losses paid. The decrease in operating cash flow from the prior-year level reflects primarily the receipt of a $1.9 million cash payment in the prior-year period from the cancellation of an excess of loss reinsurance contract. The Company's business does not routinely require significant capital expenditures other than for enhancements to its computer systems and technological capabilities. Positive cash flows are invested pending future payments of claims and expenses. Cash flow shortfalls, if any, could be funded through sales of short-term investments and other investment portfolio securities. The parent company's cash flow is dependent on interest income and payments from Triad including management fees and interest payments under surplus notes. The Illinois Insurance Department permits expenses of the parent company to be reimbursed by Triad in the form of management fees. Payment of dividends also is permitted although none have been paid. The insurance laws of the State of Illinois impose certain restrictions on dividends that Triad can pay the parent company. These restrictions, based on statutory accounting practices, include requirements that dividends may be paid only out of statutory earned surplus and limit the amount of dividends that may be paid without prior approval of the Illinois Insurance Department. Consolidated invested assets were $304.5 million at June 30, 2002 compared to $277.2 million at December 31, 2001. Fixed maturity securities and equity securities classified as available-for-sale totaled $287.5 million at June 30, 2002. Net unrealized investment gains were $6.2 million on fixed maturity securities and net unrealized investment losses were $119,000 on equity securities at June 30, 2002. Based on fair value, the fixed maturity portfolio consisted of approximately 77% municipal securities, 18% corporate securities, and 5% U.S. government obligations at June 30, 2002. The Company's loss reserves were $18.7 million at June 30, 2002 compared to $18.0 million at December 31, 2001. Reserves are established for reported insurance losses and loss adjustment expenses based on when notices of default on insured mortgage loans are received. Reserves also are established for estimated losses incurred on notices of default not yet reported by the lender. 13 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS -- CONTINUED Consistent with industry practices, the Company does not establish loss reserves for future claims on insured loans that are not currently in default. The growth in loss reserves is the result of the increase in reported defaults and the maturing of the Company's risk in force. The Company expects loss reserves to continue to grow, reflecting the growth and aging of its insurance in force. Including bulk loans, the Company's delinquency ratio (the ratio of delinquent insured loans to total insured loans) was 0.95% at June 30, 2002 compared to 0.89% at December 31, 2001. The Company's delinquency ratio for bulk loans was 0.88% at June 30, 2002. There were no reported delinquencies for bulk loans at December 31, 2001. Reserves are established by management using estimated claim rates (frequency) and claim amounts (severity) to estimate ultimate losses. The reserving process incorporates a multi-dimensional analytical form that gives effect to current economic conditions and profiles delinquencies by such factors as policy year, geography, and chronic late payment characteristics in addition to profiling them by age. Because the estimate for loss reserves is sensitive to the estimates of claims frequency and severity, management performs sensitivity analyses to test the reasonableness of the best estimate generated by the loss reserve process. These sensitivity analyses allow management to use alternative assumptions related to claims frequency and claims severity to develop a range of reasonably possible loss reserve outcomes that can be used to challenge the best estimate. The loss reserve estimation process and the sensitivity analyses support the reasonableness of the best estimate of loss reserves recorded as a liability in the financial statements. Management periodically reviews the loss reserve process in order to improve its estimate of ultimate losses on loans currently in default. Adjustments to reserve estimates are reflected in the financial statements in the periods in which the adjustments are made. Total stockholders' equity increased to $280.1 million at June 30, 2002 from $246.1 million at December 31, 2001. This increase resulted primarily from net income of $21.3 million for the first half of 2002, additional paid-in-capital of $10.5 million resulting from the exercise of employee stock options and the related tax benefit, and from net unrealized gains on invested assets classified as available-for-sale of $3.0 million (net of income tax). Triad's total statutory policyholders' surplus decreased to $104.3 million at June 30, 2002 from $105.3 million at December 31, 2001. Triad's statutory earned surplus decreased to $20.5 million at June 30, 2002 from $21.6 million at December 31, 2001. The decrease in Triad's statutory policyholders' surplus and statutory earned surplus resulted from the increase in the statutory contingency reserve and the increase in non-admitted assets which offset the increase in statutory net income. The balance in the statutory contingency reserve was $218.2 million at June 30, 2002 compared to $193.7 million at December 31, 2001. Triad's ability to write insurance depends on the maintenance of its financial strength ratings and the adequacy of its capital in relation to risk in force. A lowered financial strength rating, a significant reduction of capital, or a significant increase in risk may impair Triad's ability to write additional insurance. A number of states also generally limit Triad's risk-to-capital ratio to 25-to-1. As of June 30, 2002, Triad's risk-to-capital ratio was 15.6-to-1 compared to 15.0-to-1 at December 31, 2001, and to 11.1-to-1 for the industry as a whole at December 31, 2001, the latest industry data available. 14 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS -- CONTINUED Triad is rated "AA" by both Standard & Poor's Ratings Services and Fitch Ratings and "Aa3" by Moody's Investors Service. The Office of Federal Housing Enterprise Oversight (OFHEO) issued its risk-based capital rules for Fannie Mae and Freddie Mac in the first quarter of 2002. The regulation provides a more preferential capital credit for insurance from a "AAA" rated private mortgage insurer than for insurance from a "AA" rated private mortgage insurer. The phase-in period for the new rules is ten years. The presence of a capital charge differential in the new rules could adversely affect Triad. Triad is evaluating various business approaches and options available to address the capital differential contained in the rule. What response, if any, Triad makes and the ultimate impact of the regulation on Triad is unknown at this time, and will not be known until Fannie Mae and Freddie Mac determine their requirements under the rules. Based on information available at this time, the Company does not believe that the new rules will have a significant adverse impact on the Company. SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 Management's Discussion and Analysis and this Report contain forward-looking statements relating to future plans, expectations, and performance which involve various risks and uncertainties, including but not limited to the following: interest rates may increase from their current levels; housing transactions and mortgage insurance may decrease for many reasons including changes in interest rates or economic conditions; the Company's market share may change as a result of changes in underwriting criteria or competitive products or rates; the amount of insurance written could be adversely affected by changes in federal housing legislation, including changes in the Federal Housing Administration loan limits and coverage requirements of Freddie Mac and Fannie Mae; the Company's financial condition and competitive position could by affected by legislation impacting the mortgage guaranty industry specifically and the financial services industry in general; rating agencies may revise methodologies for determining the Company's financial strength ratings and may revise or withdraw the assigned ratings at any time; decreases in persistency, which are affected by loan refinancings in periods of low interest rates, may have an adverse effect on earnings; the amount of insurance written and the growth in insurance in force or risk in force as well as the performance of the Company may be adversely impacted by the competitive environment in the private mortgage insurance industry, including the type, structure, and pricing of products and services offered by the Company and its competitors; if the Company fails to properly underwrite mortgage loans under contract underwriting service agreements, the Company may be required to assume the cost of repurchasing those loans; with consolidation occurring among mortgage lenders and the Company's concentration of insurance in force generated through relationships with significant lender customers, the loss of a significant customer may have an adverse effect on earnings; the Company's performance may by impacted by changes in the performance of the financial markets and general economic conditions. Economic downturns in regions where Triad's risk is more concentrated could have a particularly adverse effect on Triad's financial condition and loss development. New OFHEO risk-based capital rules for Fannie Mae and Freddie Mac could severely limit the ability of Triad to compete with "AAA" rated private mortgage 15 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS -- CONTINUED insurers. The ultimate effect of the new rules on Triad and the mortgage insurance industry in general is not known at this time and will not be known until Fannie Mae and Freddie Mac determine their requirements under the rules. Accordingly, actual results may differ from those set forth in the forward-looking statements. Attention also is directed to other risk factors set forth in documents filed by the Company with the Securities and Exchange Commission. 16 PART II ITEM 1. LEGAL PROCEEDINGS - None ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS - None ITEM 3. DEFAULTS UPON SENIOR SECURITIES - None ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The Annual Meeting of Stockholders was held on May 16, 2002. Shares entitled to vote at the Annual Meeting totaled 14,079,538 of which 13,185,267 shares were represented at the meeting. The following five directors were elected at the Annual Meeting. Also shown are the number of shares cast for and authorization withheld for each nominee. Name of Nominee Number of Votes for Authorization withheld --------------- ------------------- ---------------------- Robert T. David 13,059,786 125,481 Michael A. F. Roberts 13,059,676 125,591 William T. Ratliff, III 13,062,970 122,297 Darryl W. Thompson 12,212,738 972,529 David W. Whitehurst 13,059,917 125,350 ITEM 5. OTHER INFORMATION - None ITEM 6. a. EXHIBITS 10.23 Employment Agreement between Registrant and Earl F. Wall (Exhibit 10.23) 10.24 Employment Agreement between Registrant and Michael R. Oswalt (Exhibit 10.24) b. REPORTS ON FORM 8-K - None 17 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. TRIAD GUARANTY INC. Date: August 14, 2002 /s/ Michael E. Crow ------------------------------ Michael E. Crow Vice President and Controller, Principal Accounting Officer 18