Triad Guaranty Inc. Q2 2008 Earnings Call Transcript

| About: Triad Guaranty (TGIC)

Triad Guaranty Inc. (OTC:TGIC) Q2 2008 Earnings Call Transcript August 5, 2008 10:00 AM ET

Executives

Ken Jones – SVP and CFO

Will Ratliff– Chairman, President and CEO

Analysts

Jerry Bruni – J.V. Bruni

Eman Torroni [ph] – Leadfeld Capital [ph]

Gregory Pitner [ph]

Scott Redmond – Redmond Asset Management

Dale Brown – Salem Investment

Peter Horn – Gates Capital

Peter Hemmick [ph] – Lehman Brothers

Geoffrey Dunn – Dowling & Partners

Operator

Good morning, ladies and gentlemen. At this time, I would like to welcome everyone to the Triad Guaranty Inc. second quarter 2008 earnings release conference call. All lines have been placed on mute to prevent any background noise. After the speakers remarks we will conduct a question-and-answer session. (Operator instructions) As a reminder, ladies and gentlemen, this conference is being recorded today, Tuesday, August 5, 2008.

Your host today is Ken Jones, Senior Vice President and Chief Financial Officer. I would now like to turn the conference over to Mr. Jones. Please go ahead, sir.

Ken Jones

Good morning, and thanks for joining the call today. My name is Ken Jones, and I'm the Chief Financial Officer, Triad. Joining me on the call today is Will Ratliff, our Chairman who is also now serving as President and Chief Executive Officer.

Just as a reminder, the information that we will be discussing today may include certain forward-looking statements that are protected under the Private Securities Litigation Reform Act of 1995.

Obviously, our actual results could differ materially from those projected and I'd like to direct your attention to the risk factors included in item 1A of our Form 10-K and other reports and statements in the Safe Harbor statement that we've included in the management discussion and analysis section of our Form 10- K and other reports, which outline some of the various factors that could cause our actual results to differ. If we do make forward-looking statements, we undertake no obligation to update those statements in the light of future subsequent events.

I will open with some brief comments on our financial results for the quarter and provide an update on our transition to run-off. Then I will turn the call over to Will Ratliff for his comments. I welcome Will to our conference call today. I've enjoyed working with him in his role as Chairman, and look forward to working with him in his new role as well. Following Will's comments, we will open up the lines for questions.

Our earnings release that was distributed last night includes additional financial and statistical information about Triad's quarterly results that we will refer to you during the call and also include certain non-GAAP financial measures, which we believe are relevant and useful to investors in understanding our business.

Furthermore, we've updated the supplemental information in the Investor Relations section of our Web site that provides expanded disclosures on our product lines, our portfolio characteristics and portfolio performance.

We do not plan to go through all of the details of what's been posted on the Web site, but I would encourage you to have that information available as we will reference it in our prepared remarks and possibly in the Q&A session. We believe this type of transparency into the composition and performance of our insured portfolio is beneficial to an informed analysis about future performance.

The earnings release and supplemental information may be accessed on the Investor Relations page of our Web site under investors and then under webcast and presentations located at www.triadguaranty.com.

We are disappointed to report that our net loss for the second quarter was a $198.8 million or $13.36 per diluted share compared to net income of $12 million or $0.80 per diluted share for the 2007 second quarter.

The book value of our common stock at June 30, 2008 was $9.32 per share compared to $33.43 per share at December 31st 2007 and $39.85 per share at June 30, 2007. The incurred losses continue to dominate our results and they increased to $292.7 million, a 32% increase from the first quarter 2008 and a six-fold increase over the second quarter of last year.

While we felt the impact of nationwide, the distressed markets of California, Florida, Arizona and Nevada continue to be the primary drivers of the growth in the default rates. Loss reserves increased $219 million during the quarter compared to approximately $175 million in the first quarter this year and $23 million in the prior one year period.

The gross default rate now stands at 7.3%, compared to 5.9% last quarter, and 2.7% one year ago. And the composition of default inventories continues to shift to the newer policy years and the distressed markets.

Paid losses during the second quarter of 2008 were $68 million compared to $40 million in the first quarter of 2008, and $18 million in the second quarter 2007. The average paid loss severity continues to increase and was 53,000 in the second quarter compared to 47,000 in the first quarter 2008 and 31,000 in the second quarter of '07. The premium deficiency was eliminated primarily as a result of a significant increase in loss reserves during the second quarter.

Because of the lower production levels of the past year, we saw a 3% reduction in premium earned from the first quarter level as insurance in force decreased in spite of the ever higher persistency levels. Annual primary persistency was 85.1% at June 30th 2008, compared to 83.3% at March 31st this year and 77.7% a year ago.

Overall, expenses increased 93% from the first quarter 2008 levels and a 154% in the second quarter 2007. A number of nonrecurring charges led to the barge increase. Nonrecurring items totaled more than $12 million and related primarily to the reporting of severance costs and other expenses related to transitioning the company into run-off.

There were additional nonrecurring expenses related to attempts to raise capital. Also, we do not defer any expenses related to the second quarter production which also contributes to the increase from prior periods.

Going forward, we expect a significant reduction in expenses from lower staffing level and elimination of the ancillary costs associated with acquiring servicing new business. As we discussed last quarter, we have $95 million excess of loss reinsurance policy that has attached according to its terms. The insurer is currently not honoring the policy by claiming violation of covenants in the agreement.

We strongly believe that there were no violation and the matter is now on arbitration. We have not recognized any benefits from the agreement and our GAAP financial statements given the exceptionally high standards required under GAAP to recognize benefits from matters of dispute. However, after consulting with our primary regulator, we will recognize the expected net benefit in our second quarter statutory financial statement.

Our liquidity remains strong despite the reported losses over the past four quarters and the corresponding reduction in our stockholders equity. Both have been driven by non-cash increases in reserves. Our year-to-date and second quarter operating cash flow were positive. Additionally, we expect to have positive cash flow the remainder of the year, primarily due to results of liquidating tax and loss funds that were originally purchased to pay expected federal income taxes.

We have begun the process of repositioning our entire investment portfolio out of municipal securities and into taxable securities as we no longer expect to receive the tax benefit of municipal securities. We expect the new composition of the portfolio will have a significantly shorter duration.

Going forward, we will no longer be writing new business but we will continue to receive renewal premiums and continue to work with borrowers and our customers secure policies and defaults, thereby keeping people in their homes. We expect to honor our obligations under insurance policies and pay all legitimate claims. But we have found that there's a much higher than expected amount of fraud and misrepresentation in the recent vintages, and we will continue to work to uncover these violations of our master policy.

Let me briefly talk about the role to be played by captive reinsurance and modified pool structures in the run-off period. The benefit we expect to realize from captive reinsurance and the modified pool structures is key to understanding the financial condition of the company. These benefits are currently being realized, but we believe the full benefit is further down the road and second half of this year and in 2009 and 2010.

Loss reserves ceded to lender-affiliated captive re-insurers now stand at $63 million and we expect this will continue to grow as more captives reach the attachment point and as current attached captives report further losses. Once the captive reaches the attachment point we see all further losses to the captives until basically losses double or triple from the attachment point level depending on the captive structure.

We currently have $239 million in trust accounts supporting the risk reinsured by captive reinsurers and expect this balance to grow based upon the receipt of future renewal premiums and investment incomes. The funds are not reported on a balance sheet however, we expect large percentage of these funds will be used to reimburse Triad for future paid losses.

All of our modified pool transactions have been structured with staff loss with stop loss limits applied to the entire group of insured loans. We find ourselves approaching the stop loss limit on a number of modified pool (inaudible) transactions. Once we reach this limit and every modified pool transactions has such a limit, we will no longer incur losses on the transaction.

We believe the protection provided by both captive reinsurance arrangements and modified pool structures will play a pivotal role in reducing our future incurred losses.

Now I'd like to turn the call over to Will Ratliff, our Chairman of the board and President and Chief Executive Officer.

Will Ratliff

Thanks, Ken. I look forward to working more closely with Triad management team as I assume my new responsibilities at Triad, and hope to serve all our stakeholders well. I have a long history with Triad dating back to 1989 and I have been chairman of the board since 1993. I care about this company and will work to the best of my ability to see it succeed in this difficult environment.

I want to briefly touch on a couple of items before we open the lines up for questions. First of all, I want to thank Mark Tonnesen for his hard work and dedication to the company. Mark will be retiring August 15, an event that we had anticipated and had planned to take place at some point prior to year-end.

When the negotiations with Lightyear Capital ended Mark and the board agreed that this past month was an appropriate time for his role to shift. We continue to work well together and I look forward to maintaining our working relationship over the next two years in his new role as consultant, drawing on his deep and broad knowledge of the company and the industry.

As you know, on June 19th we announced that we had ended negotiations with Lightyear Capital to form a new mortgage insurance company. This was an unfortunate conclusion that was dictated by events outside of our control. While we are disappointed that we were unable to complete the transaction, we have turned our full attention to successfully managing Triad through run-off.

As we began the transition into run-off, one of our most difficult decisions was to terminate approximately 45% of our workforce. While this contingency had been considered and planned for, it was nonetheless painful to implement. There were coworkers and friends, some of whom had been with Triad for many years. I want to thank them for their hard work, their contribution to the company, add success and wish them success in their future.

We are doing our best to assist them in their transition and I'm pleased that many of our customers and even some of our competitors have offered to help. As we move forward, we will continue working closely with the Illinois Division of Insurance, the GSEs and our services to ensure that every legitimate claim is honest.

We will position ourselves to manage an efficient run-off and in doing so, maximize the ultimate value to our stockholders. We will continue to focus on loss mitigation efforts to try to keep people in their homes, minimize losses on claims, and identify fraud and misrepresentation, and we will continue to manage our expenses in an effort to avoid unnecessary costs while incurring those costs that we believe will add benefit to the financial performance of the company.

Also, we are vigorously pursuing the benefit that we believe are due us under the excessive loss reinsurance contract. We have accomplished a lot on this matter in the past months and we will continue to see this through to the best of our abilities. We have a remarkable dedicated group, talented employees at Triad, and I could not be more proud of how they have accepted the current situation and collectively devoted themselves to the success of the organization.

With that, I would like to open the lines and invite questions.

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from Jerry Bruni of J.V. Bruni.

Jerry Bruni – J.V. Bruni

Yes. Could you give us a little bit – more information about the methodology used to calculate your loss provision?

Ken Jones

Yes, Jerry, this is Ken. What we do obviously is record reserves against all reported defaults and our estimate of defaults that have incurred and not been reported to us. So basically, we look at the risk and default on the reserves – on the reported incurred defaults and that's the starting basis for determining reserves and then we estimate the frequency of those defaults that will go to claim and then the ultimate severity of those claims that will be paid. So ultimately what we're trying to project is the claim costs, the paid loss dollars that will be recognized or be paid out of the default inventory at any point in time. And we do that by estimating the frequency, that's the number the default will go to claim and then the severity, which is the amount of the claims that we'll pay on each of those defaults.

Jerry Bruni – J.V. Bruni

Can you expand on any changes or either in terms of the method or terms of the estimates you’re using for severity, et cetera, over the last three months?

Ken Jones

We have disclosed I think in our supplemental release what our reserves are as a percent of risk and default. And I believe our growth in case reserves are about 45% of the risk and default at June 30th and compared to approximately 40% at the end of March. What we do in determining severity as well as frequency to a certain extent as we look at the recent experience and estimate – based on that recent experience what we expect to pay loss to severity for the inventory defaults currently. And we did increase that severity in the second quarter to recognize that we are now incurring a higher percent of risk and default in terms of pay losses. That has an impact when you do that, obviously, on the overall default pool or the overall risk in default. So within the quarter there was some additional reserves provided to recognize an increase in severity factor across our default inventory.

Jerry Bruni – J.V. Bruni

Number of loans that are in default, recorded default, has increased steadily in recent quarters. Can you give us some insight as to what you anticipate going forward?

Ken Jones

Again, in our earnings release with the supplemental attachment that as well as our financial supplement we provide a lot of information around the growth in defaults on a vintage year basis, which by that it means the year the insurance was booked, as well as the history of those trends. And one of the things we try to do is to estimate the future default is to look at that history, and try to develop patterns for that. Obviously, in the current environment is very difficult to know exactly how things are going to play out by facing anything on past history. So it's difficult for us even given the information we have to project when the default curves will flatten. By that I mean at some point in time the mathematically that growth rate in defaults will have to slow. And at this point, there is some sign at the margins that could be happening, but when that's going to happen and the strength of that flattening is difficult for us to project. That's why we think it's critically important that we provide the transparency into our historical performance including updated through the end of June and provide that in a great level of detail in the supplement.

Jerry Bruni – J.V. Bruni

And you – I know you mentioned premium deficiency reserve from the first quarter and the fact that it's not there now. Can you go over that one more time?

Ken Jones

I will be glad to. It's a tough time to understand and I will be glad to go through it. I'll try to explain it without get into all of the details of calculation involve, but basically, the premium deficiency reserve looks at the expected present value of your future cash flows. So we look at the present value of our future premiums, project those back or discount those back to the current days, and then look at the present value of our future paid claims as well as our future maintenance expense, and get a present value of that number. To the extent that number is negative, or indicative of a deficiency, in the future cash flow is then compared to current reserves. And if that deficit in cash flows is greater than your current reserve, you have a premium deficiency reserve. At the end of the first quarter, we had that position and we recoded $15 million basic premium deficiency reserve at that point of time. Because of the growth of actual reserves in the second quarter we no longer need a premium deficiency reserve. The premium deficiency reserve does not address the timing of the cash flows except in the present value of them.

So what's happening is we have – as we talked about significant protection from our captives and stop losses in the future, that we will recognize, that we will have coming into our income statement in the forms of what I will call unencumbered premium. There won’t be any losses associated with those. So what we are now doing is recognizing all the claim costs on those contracts, on the captive contracts that haven't attached on the modified pool contracts with stop losses where we do expect ultimately the stop losses to be met. All the claims are being recognized, but the future premium is not. So that's the difference in the timing of the actual GAAP accounting and the way the premium deficiency reserve works. The premium deficiency has no concept of timing in its cash flows whereas GAAP accounting does try to measure incurred losses on a particular time period.

Jerry Bruni – J.V. Bruni

Those – we have captive insurance arrangements. Do you book your reserves based on what you think you're going to end up paying net of the captive contribution? Or do you book at based on the total amount that you're going to pay, and then at some future point book the contribution from the captives?

Ken Jones

In our financial supplement that's posted on our Web site we provided an example of how a captive insurance contract actually works. But basically, we book – and again to go back and say, let’s make sure the listeners understand. Our captive reinsurance contract is an excess of loss cover which basically has a band of risk that the captive reinsurer picks up. In most cases, these are what we call 4-10-40 captives and the 4 being that we pick up the first 4% of any given book years losses. The captive will then step in and pick up a next 10% of those losses in return for a 40% ceded premium. The accounting works is that we recognize all the losses, up we cede the premiums as we receive it. We will back up and take the premium stream for every dollar premium we collect we cede 40% into the captive and report a net 40% – net 60% earned premium from the business. We report all losses until the attachment point is received. So we book losses until we have incurred the attachment point in the case of 4-10-40 and amount of losses equaled to 4% of the original risk in force. At that point the captive picks up and for the risk band we have no further losses that we will record, but we will continue to receive premium and record as earned premium our share of that. So we front end, if you will, when captives are going to attach, we will be front ending the losses in the way the accounting works. And again, there is an example in the supplement that goes to that at some level these of detail. I would encourage you to take a look at that.

Jerry Bruni – J.V. Bruni

I will let somebody else ask the questions.

Operator

Your next question comes from the line of Gregory Pitner [ph], a private investor.

Ken Jones

Good morning, Gregory. Hello.

Operator

Gregory, please go ahead.

Ken Jones

Could you move to next question and Gregory can obviously come back at the end of the queue?

Operator

Your next question comes from Eman Torroni [ph] of Leadfeld Capital [ph].

Eman Torroni – Leadfeld Capital

Hi, guys. How are you?

Ken Jones

Morning. How are you?

Eman Torroni – Leadfeld Capital

I'm trying to understand what will be the cost to run the business by the fourth quarter, I believe in third quarter you still have some expenses related to severance and all those things. So if you could give us an idea of what kind of costs (inaudible)?

Will Ratliff

As we indicated in the script and in our earnings release we had this significant amount of nonrecurring expenses in the second quarter related to the downsizing as we moved into run-off as well as expenses related for the capital raise and other issues that, that obviously will be nonrecurring. What has been eliminated from our run rate is all of our expenses related to our sales activities which would include the direct cost of sales as well as expenses related to industry, industry affiliations such as MICA and our rating agency costs which were significant in relation to our expense base. So we don't have an exact number, but I think it’s fair to say that we can't compare to the second quarter's run rate, but you look back on a regulatory or statutory basis, I think we were running about $60 million a year in expenses in 2007. It certainly is going to be a significant reduction against that. We don't give guidance around that, but obviously, go forward we would expect that to be reduced and the amount could be – the 30%, 40%, 50% range is with the things finally settle down, but it will be a significant reduction in the historical run rate of expenses.

Eman Torroni – Leadfeld Capital

My second question is related to loss mitigation. What programs or what things we have in place right now to kind of reduce losses going forward?

Will Ratliff

Well, obviously, it is a focus of our efforts going forward. It's a run-off company, servicing our policies efficiently and effectively and that includes loss mitigation, will be critically important to our success. As we moved into run-off one of the things that we look at is how best we can accomplish that. We have actually created a group of individuals who are dedicated to working with our servicers, exploring the options that are existing within some of the programs that are out there. You heard of the Hope Now program, there is state programs we're looking at, there are programs that the GSEs are implementing, so we got a group of people, some of our best people out of the claims side, some of our best people that have worked out of risk management. We have taken a dedicated to coming up with the most comprehensive and complete programs that we can have around loss mitigation. Of course, we've always worked with our servicers in loan modifications and we will continue to do that to the best of our ability. We are also now working to assist our servicers where necessary and where they could use our help and contacting the borrowers. We’ve found its critical that you contact the borrowers early on in default process, and right now, it’s difficult because of the volume of default that are going on for a servicers to do that, so we are supplementing those resources with some very – what becomes a very sophisticated call routines so we can try to get in touch with the borrowers when they go in default reserve as early as possible. Because we've observed particularly at this point in time as default cycle, the quicker you can get to them, explain their options, the more likely you're to have a successful resolution. And that's where we're all about is working with our servicers to making sure that we would obviously prefer never to have to mitigate a loss if we can keep the person in their home through modification or some other circumstance, the claim advance for example, that solves the short-term problem. That’s our first goal is to basically keep people in their home.

The second goal when that is not going to be available is to then mitigate the loss as effectively as we can through REO programs which is acquiring the real estate working through short-sell all of that. So it's the traditional metrics as well as it’s a strategic focus on the best implementation of what's coming out from best practices in the industry. Let me just add to what Ken has said there, by saying that the entire – not just mortgage insurance but the entire mortgage industry is dealing with – in effect a tidal wave of defaults that's unprecedented in anybody's experience who is in the business today. And so, these are areas where we’re making our best efforts – Ken has summarized those very, very well in some detail, but it’s an evolving process as well, there is a new federal legislation now, that opens new doors to preventing losses and to mitigating losses so, this is going to be one of the primary focuses of the Triad management team as well as many people throughout the industry over the next months and years as we work hard to develop effective techniques, share best practices with the GSEs, with other services, and make a concerted effort to keep as many people in their homes who are – who continue to be willing and able to bear the responsibilities in home ownership, where that’s not possible reducing our losses as best we can using a whole variety of tools, some of which we know well and are using today and others of which we will develop over time.

Eman Torroni – Leadfeld Capital

Second – last question was related to the trust capital. You guys mentioned roughly $239 million.

Will Ratliff

Correct.

Eman Torroni – Leadfeld Capital

I'm trying to understand how much is it growing, how much is the premium contribution which is coming in right now?

Will Ratliff

In terms of the captive for us?

Eman Torroni – Leadfeld Capital

Captive trust.

Ken Jones

Yes, the balance we have is about $239 million, I think we reported at the end of year end it was $200 million, at the end of the first quarter, it was $216 million to $217 million so, basically, in the run rate of $15 million to $17 million a quarter.

Eman Torroni – Leadfeld Capital

Okay. And what happens if the losses exceed the amount available in those captives?

Ken Jones

I guess there is two parts to that question. On an incurred loss basis for example, I say incurred losses, what I mean is the paid losses plus reserves in any point in time the accounting requirement – under GAAP accounting would be if our incurred losses exceed the captive trust, that we will not recognize a benefit if that were to occur in that situation. So that's the accounting answer to that. The practical answer is that we continue to fund future premiums into those trust and we will be looking in terms of our overall estimated the ultimate losses we would be looking at what we would expect to be the capital and the trust today versus our future premiums and then look at the paid losses that would ultimately come from that. So I'm not sure I totally answer your question, but the accounting loss we don't recognize a benefit if there is not assets in the trust to support the ceded losses.

On a long-term basis, there is certain capital requirements that the captives need to meet to maintain their status, obviously, depending on where these are domiciled they have certain rights as captives in that. In today, also existing within the captive trust are capital requirements, that lenders, the lender sponsor needs to meet. For example, the capital requirement for the captive trust is generally 10 to 1. And it is the capital – risk to capital ratio, when I say capital requirements speaking to the risk to capital ratio. If the risk to capital ratio moves above 10 to 1, then we would place a capital call to the lender sponsor; and if that capital call is not met, there is certain actions depending on the individual trust that could occur as well. So I guess the important thing is right now, in terms of our modeling is we look at – in looking at the modeling we did for the premium deficiency reserves as well as our best estimates of our thinking today is that we believe largely for our major captives that there will be sufficient capital in the trust which would include capital days plus future premium to cover the losses we expect to see.

Eman Torroni – Leadfeld Capital

Okay, thank you.

Operator

Your next question comes from the line of Gregory Pitner, a private investor.

Ken Jones

Good morning, Gregory.

Gregory Pitner

Good morning. Can you hear me this time?

Ken Jones

We got you.

Gregory Pitner

Okay. Great. Thank you for taking my question. At the end of each quarter, a fairly sophisticated calculation is made in order to determine whether a premium deficiency reserve needs to be established. And I guess – I understand the calculation I'm asking the company's performance this quarter is this has envisioned at the end of the first quarter or does it differ and if it does differ how, how does it differ?

Will Ratliff

Basically, we did not change – we reviewed the current quarter's performance in light of what our assumptions were in the calculation of the premium deficiency reserve at the end of the second quarter and have not changed our assumptions around what the ultimate losses will be or the ultimate premiums will be. So to answer your question there were no changes in the assumptions for the cash flows used to determine the premium deficiency reserve. So largely, that would imply that the performance today in terms of risk and default – and again, keep in mind, that the premium deficiency reserve does not address the timing of any of the accounting, but in terms of the risk and default, the quarter's performance is largely in line with our expectations underlying the premium deficiency reserve calculation.

Gregory Pitner

Okay. That’s exactly what I'm asking. That sounds fairly good. What is the status of the complaint filed by American Home Mortgage on November 5, 2007? Has that been resolved?

Will Ratliff

We will be filing our 10Q next week and obviously, we will make the appropriate disclosure around the status of litigation in the Q, but otherwise we don't have comments on ongoing litigation.

Gregory Pitner

Okay. And lastly, I'm trying to get a handle on the percentage of claims or the percentage of defaults that flow into the company that are deemed or expected to be connected with sufficient meaningful level of fraud, such that the claim should be rejected. What – how important role is fraud playing in your ability to mitigate losses overall?

Ken Jones

Our process is to look at what we define is early payment default. And early payment default will be anything within the first 12 months, and broadly, what we are looking for in terms of that is it's not really fraud, but it's misrepresentation in the underwriting process that like the rises to a level that had we – had the facts been presented properly to the lender or to us the loan would not have been insured. And obviously, there is – it's no secret that if you read in the press that the 2006 vintage, the 2007 vintages contain a much higher than normal amount of fraud and misrepresentation. It takes a while for us to work through those quality assurance reviews and we have a quality assurance department that looks at that, to make an assessment. We don't take – we take our responsibility around decisions very seriously in terms of making sure that we're fully justified when we take the action to rescind a loan. So we have a very rigorous investigation process and review through our legal department and ultimately our general counsel around those decisions. It's hard to provide a percentage as to what's going to be the ultimate amount of default today that we rescinded, we just don't know that. Historically, the rescissions have not been that great in terms of the ultimate claims we paid. Clearly, in this environment, there are lot more rescissions that will go on, but it's too early to tell how much of an impact that will ultimately have on our default pool at this point in time.

Gregory Pitner

Has an estimate of those rescissions been factored in to the premium deficiency reserve calculation?

Ken Jones

We do look at all factors available to us in determining what we expect to pay in terms of future losses. So we have tried to the best of our ability, but again, it is difficult because a historical information that we have would not support the fact that you're going to have the amount of rescissions. However, in this environment, particularly, with the level of early payment default, we do expect that there will be a meaningful number of rescissions. And basically, what we’re seeing in the performance of the pool is that – the performance of the pool is inconsistent with the overall credit quality of the pool. And that's giving us the reason to believe that there exist a significant amount of misrepresentation that we need to be diligent, and reviewing, but fair in our treatment of our customers and policyholders around what is our obligation in terms of what we've insured and what we should not have insured based on the facts that were known to us at the time.

Gregory Pitner

Understood. Thank you very much.

Operator

Your next question comes from the line of Scott Redmond of Redmond Asset Management.

Ken Jones

Good morning, Scott.

Scott Redmond – Redmond Asset Management

Morning. First of all concerned when you all were going to go and start something with Lightyear and then primary concern would be that if you're starting, key employees or executives starting a new business, that's going to use Triad, customers as primary source of their new revenue that maybe Triad would be less assertive in contesting policies. Was my understanding that, that there is no new company to be developed here, and then – would does that allow you all to be more assertive in contesting policies?

Will Ratliff

We have a policy that we have followed historically around how we review rescission, how we review what is our obligation and what was the responsibility of the lender, originator of the policy, that has not changed, and it won't change going forward. We're going to honor the terms of our master policy as we would have always honored them, as we would have honored them whether or not we were still originating business for ourselves, whether or not Lightyear was originating and working with our sales force and customers or whether we had run-off. Our policy is not changing, and I can honestly say that there has been no discussion around here that we can take a different view of anything in this environment. We believe that enforcing our policy will give us the ability to weed out the loans that we should not have covered. We don't need any policy at this point in time and don't intend to go down that route.

Scott Redmond – Redmond Asset Management

The gross case reserves of 45%, does that exclude policies that you’re currently contesting?

Will Ratliff

There is – and again, getting to the technical aspects of the reserve calculation but since we talked a little bit about earlier we do have – we do apply a frequency factor against the number of loans in default. So let’s say for round numbers we have 26,000 loans in default right now and that we’re going to think 50% of those are going to go to claim. We would build in to that frequency factor and estimate of how many of those loans will get rescinded. Of course, we don't have a lot of historical information to base that on, so, we are trying to be realistic – and I don't want to say that we were being conservative in the number we are using, we are trying to be realistic in assessing what the likelihood that we will be rescinding. But yes, we do try to have an estimate in our reserves of that fact, and all other relevant facts will have a bearing on what the ultimate paid claims will be from those reserves.

Scott Redmond – Redmond Asset Management

And I'm fairly new to story. Can you describe just a little bit about the – I think you said $95 million arbitration case that – ?

Will Ratliff

We disclosed that in our 10-Q last quarter, and again, we will be updating in the 10-Q this quarter, and we have no comments other than what we made already today.

Scott Redmond – Redmond Asset Management

Thank you very much.

Operator

Your next question comes from the line of Dale Brown of Salem Investment.

Dale Brown – Salem Investment

Good morning.

Ken Jones

Hi, Dale, how are you?

Dale Brown – Salem Investment

I am doing well. My question was regarding the premium deficiency reserve it's largely been answered, but I do want to clarify one point if I could. Back on the – during the May conference call, near the end of the call, Ken mentioned that given the calculations of the premium deficiency reserve that based on the estimates at that time you felt the book value of the company was probably secure. This quarter, of course, we have written book value down $13 a share, I understand the way you answered one of the other questions that there is a timing issue between the recognition of losses and the recognition of income. Is it possible that the book value of the company will increase in coming quarters as the losses recede and revenues continue to come in?

Ken Jones

Dale, I think you've done a very good job of explaining the nuances of the premium deficiency reserve, and as we've indicated earlier it doesn't deal with the timing of the cash flows in that regard. And you’re correct that basically the premium deficiency reserve would be a confirmation when calculated of the view on an accounting basis of the deficiency of the reserves, meaning that the book value would be – believe to be a good number in terms of that. Going forward, the timing of those losses on an accounting basis changes and since we have not basically changed, was indicated we've not changed in our view, what the ultimate assumptions are that would be necessary to calculate the premium deficiency reserve we would still largely subject to the what has occurred in terms of the passage of time in terms of the collection of premium in the paid losses, come to the same conclusion that we had at the end of the second quarter around the amount of the deficit at that point in time.

Dale Brown – Salem Investment

So you do not – when you said at the end of the first quarter that based on your estimates at that time that you believe the book value were secure you would still hold to that point over the long-term.

Ken Jones

Correct. Again, that's what the premium deficiency reserve concept of life. One also has to keep in mind that this is a very volatile environment we're in, and we're trying to estimate basically a premium persistency over – but 7 year to 10 year period over our book of business as well as future paid losses. So there is a wide range of outcome that is possible at that point, but based on our best estimate on those outcome at this point in time, we did not change the underlying assumptions use to calculate the premium deficiency reserve from the first quarter to the second quarter.

Dale Brown – Salem Investment

That answers my question.

Will Ratliff:

Dale, I just want to reemphasize Ken's last point which is that the kinds of assumptions that had to be built into any future projection are taken into account so many variables and variables that today are in territory that is entirely without precedent historically in terms of both how rapidly loan default has escalated and the severity of those default. So while what Ken is saying in terms of our best estimates is accurate, it's important to realize how many variables there are that are most of which are out of our control as a company and so to acknowledge also the significant uncertainties associated with any effort to look down the road and peg a particular number whether that number is ultimate losses, ultimate book value whatever it is.

Dale Brown – Salem Investment

Okay.

Operator

Our next question comes from the line of Peter Horn with Gates Capital.

Peter HornGates Capital

Yes, thank you. Couple quick ones. First, of the 26,000 loans that are currently in default what approximate percentage do you expect to contest due to misrepresentation or fraud? Just to get some understand of the magnitude and kind of what we are talking about.

Ken Jones

I don’t have that number available, but again, if you look at our supplement, most of – we review all early payment default. And basically, that's default that occur within the first year. So if you look at our supplement, we disclosed vintage year performance and you can get an idea of most of default that would be from the 2007 vintage year would fall in the classification of early payment default subject to QA review, some of the loans from 2006 would be in that category as well.

Peter HornGates Capital

Right. But not necessarily just reviewing, I mean, given your experience thus far of the loans you reviewed in the 2007 vintage, what percentage do you expect to contest and what's the prominence of misrepresentation or fraud?

Ken Jones

It varies by originator. We don't have a percentage – I'm not thought of it in terms of percentage. We're just looking as the facts emerge and as again, we’re in the very early stages of a lot of this process so as the facts emerge we try to estimate for purposes of reserving for example, what – how many will rescind, but largely, we don’t know because as Will indicated, this is unchartered territory. The volume of early payment default in the – is significant, in the book years and we will – as I said earlier, we're applying our historical practices and policies in terms of looking at QA in rescissions, –

Peter HornGates Capital

Okay. That makes sense. So you didn't spend much time doing this?

Ken Jones

No. We don't. Again it’s early on and we're just going through the process.

Will Ratliff

Let me just make – we spend – we’ve spent a tremendous amount of time and resources in the investigation and review process that, that is where the time and resources are being extended as opposed to the estimation of future levels. In part, because as Ken mentioned, this is a relatively narrow window. Since we are not writing new business today, 12 months from now, our ability to review loans on the basis of early payment default is basically going to have expired so we're – it's much more important to be putting our efforts into looking at the individual loans today and making sure we are making the best determinations that we can make based on sound review and investigation of the individual file than it is to be thinking in terms of is it going to be 5% or 6% or some other overall numbers.

Peter HornGates Capital

And as a mortgage insurer what foreclosure related expenses do you guys pick up?

Ken Jones

The biggest – and what we're talking about here is when the loan goes to default there is certain eligible expenses that we cover our percentage of as well. The biggest expenses are the accrued interest up through the foreclosure process. The other expenses are limited to certain attorney fees and certain other costs to maintain the property and a relatively minor in terms of what the overall exposure would be. The biggest is the accrued interest element of it through the foreclosure process.

Peter HornGates Capital

Do you pay taxes and insurance as well?

Ken Jones

We will pay our share of taxes and insurance during that process, yes. Our percentage covers on those.

Peter HornGates Capital

Okay. And the timing of these cash payments, would this be – I mean ultimately through the foreclosure process you don’t have to pay – ?

Ken Jones

We don't pay. The servicer is responsible for managing the loans through the foreclosure process. If we are picking up these we include them in the calculation of our claim for loss and our coverage percentage on that claim for loss.

Peter HornGates Capital

Okay. So the actual claim paid though is at the end of the day your severity is just higher and you make it up to the servicer?

Ken Jones

Yes, that’s correct.

Peter HornGates Capital

Okay. Last question. Several days ago there was a Wall Street Journal article basically saying the GSEs are going to spend more money with the servicers effectively subsidizing their efforts to help work out and modify more loans than previously have been doing. Is this money that's going to be reimbursed by the mortgage insurance industry? Or is this money that the GSEs just paying out of pocket, because they feel it's in their best interests to do so?

Ken Jones

I've heard no mention of the fact that there will be any kind of mortgage industry participation in that. It’s in the best interest of the GSEs, it's in the best interest of the servicers, it’s in the best interest of the mortgage insurance companies, it's in the best interest of the economy for those kind of efforts to go on. And that’s what we're working with our strategic initiative group is to try to find out. We know what historically is were, we're trying to find out what new will work and we're in close contact with the servicers, with the GSEs as we look at what are all the options available, but we applaud the efforts by the GSEs to do that, because anything that helps stabilize the housing market will ultimately benefit our business and benefit the economy as a whole.

Peter HornGates Capital

Okay. Well, thank you very much.

Will Ratliff

Additionally, I would add to that the GSEs are in a unique position given the very, very large numbers of loans that they own, and guarantee. They have access to data across huge numbers of loans and so they are in a unique position to provide support to lenders and mortgage insurers on best practices, successful approaches, and I would presume most other industry participants are actively engaged with the GSEs to work with them in these efforts.

Operator

Your next question comes from the line of Peter Hemmick [ph] of Lehman Brothers.

Peter Hemmick – Lehman Brothers

Thanks for taking my call. I wanted to actually follow-up on the point about the GSEs. Thanks for the segue. Could you please comment on what your relationship with them has been – now that you’re in run-off and how they are acting, and has there been any change in the relationship? How are they doing? And then I have a quick housekeeping follow-up.

Ken Jones

Okay. We’ve always valued our relationship with the GSEs. At some level they were a competitor of ours, but they are also a partner of ours. And right now, we have a share in mutual interest and basically making sure that we have a solvent run-off and then we’re able to honor all of our obligations to the GSEs as well as our other customers. And working with the GSEs, working with our customers around effective loss mitigation efforts, how we can keep people in their home, how we can reduce default, is in our best interest and our partnership is stronger than ever around that, and we have been very pleased with the support we've gotten from the GSEs and working with our loss mitigation team, obviously, they are looking at us in terms of what a counterparty risk if you will, and we have been open and discussing our performance with them and we have carried our view of transparency to the utmost level with the GSEs and ensuring what we think around our book of business and making sure that they are comfortable as they can possibly be relative to our performance going forward. So if anything, our partnership is closer and stronger than it’s ever been.

Peter Hemmick – Lehman Brothers

Thanks. And then just on sort of you're a regulated insurer and I guess you guys risk in force to capital, across the 40 line this quarter – what – where is the conversations with the Illinois regulator, how are they viewing you guys?

Ken Jones

Well, as you indicated the risk to capital ratio is about 40, but largely, that's not a measure that’s relevant other than what is the capitalization required to write new business and just we’re not writing new business going forward. That's not an important level. What is important is that Illinois understand – Illinois being our state of domicile and our primary regulator. The Illinois division of insurance understands with the transparency that we're going to be providing to them. The ultimate solvency of the company was that we believe in terms of the run-off, and they are appropriately engaged and working with us and looking at our financial forecast, our financial models and developing at projections around the run-off plan and we are working with them and making again – making sure that they are fully informed and fully aware of everything that we know relative to our future financial performance. So at this point, we are working with them, and we will – there will be some further communication as we go with and move into run-off – or fully into a run-off plan.

Peter Hemmick – Lehman Brothers

Okay. Thanks. And then on the housekeeping front, as you report risk in force is that fully net of the captive reinsurance?

Ken Jones

The risk in force that we would report will be net of the captive reinsurance and net of – let me back up and rephrase that – would reflect the stop losses under our modified pool contract. We’re reporting that net in our financial supplement and some of as posted on our Web site and some of our performance statistics we show you – we show the gross risk in force – that's a more meaningful way to measure it. But in terms of our risk to capital ratio that has always been defined against the net risk in force.

Peter Hemmick – Lehman Brothers

Okay. So then the captive reinsurance if I understood you they initially had to fund about 10% of their slice of the risk, is that right? They had needed a 10 to 1 risk to capital ratio. So does that mean that risk in force from the captive is only 10% funded? Is that a correct way to think about that?

Ken Jones

Yes. 10 to 1 risk to capital ratio, that's a correct way to think about that.

Peter Hemmick – Lehman Brothers

And the 200 – I apologize – 69 that –

Ken Jones

239.

Peter Hemmick – Lehman Brothers

239, sorry. Thank you. That number was not net of any of the allocated losses – I think were in the $60 million. Is that right?

Ken Jones

Correct. We – again, we are taking credits in our reserves against what we would expect future paid claims that we’re ceding them a negligible amount of actual paid losses on it so. Let me come back and follow-up on that, that prior question, we say 10 to 1, that's the maximum ratio, that's not the ratio that they're running at today. The actual capitalization levels within the cap is generally much lower than 10 to 1. That is the maximum ratio per the captive agreement.

Peter Hemmick – Lehman Brothers

Okay. So can you sort of indicate where you’re funded versus how much risk in force generically your captives?

Ken Jones

I don't have that information available and I wouldn’t want to speculate. I know for some of the larger captives we look at, but I wouldn’t speculate across the board.

Peter Hemmick – Lehman Brothers

Okay. Thank you.

Operator

Your next question comes from the line of Geoffrey Dunn of Dowling & Partners.

Geoffrey Dunn – Dowling & Partners

Thank you. Good morning.

Ken Jones

Hey, Geoff. How are you?

Geoffrey Dunn – Dowling & Partners

Good. Thanks. Just a couple accounting number questions. First of all, with respect to reserving now that you are in run-off, you have more leeway of trying to be more aggressive early on with reserving, or are you still restricted to the traditional way of waiting for a delinquency to emerge?

Ken Jones

We are continuing – as a public company we are continuing to follow the same accounting standards in our reporting that we always have. We reserve for known defaults as well as an estimated defaults that have occurred, but have not been reported to us.

Geoffrey Dunn – Dowling & Partners

Okay. In terms of your investment portfolio, you indicated you're going to shift to taxables in the shorter duration. How quickly do you anticipate shifting that portfolio? And what type of duration of should we be thinking?

Ken Jones

We are about half way through that I think in terms of the reallocation process. We don't see the need to fire sale at this point in time, so we are making sure that we get the best value out of that as we can. But basically, and I don't recall the expected duration, but it's probably going to be in the 3 – 3 range in terms of the cash flow. So what we're trying to do is basically maximize our current yields in terms of the investment yield, and as best we can make sure that we have matched our future liabilities – our future cash liabilities against the maturity of the portfolio.

Geoffrey Dunn – Dowling & Partners

And the last question, as we look at the persistency of your business how does hitting the stop loss of a deal – to translate into the risk in force. Does that fall off your risk in force as soon as that happens or is it included there, and kind of falsely grosses up your exposure?

Ken Jones

Today, we reflect the stop loss in our risk in force calculation. So let's just going to go through an example. Let’s say that we would have on a deal that gross risk in force of $10 million on an individual contract. And we would have a stop loss equal to $3 million against that. So we would reflect in our risk in force the $3 million. And that’s the maximum exposure we have on that. So that already reflected the stop losses structures under the modified pool contracts already reflected in the risk calculation.

Geoffrey Dunn – Dowling & Partners

And last question. Do you have an anticipated date for your staff cuts?

Ken Jones

They are published. They are posted.

Geoffrey Dunn – Dowling & Partners

For second quarter?

Ken Jones

Yes.

Geoffrey Dunn – Dowling & Partners

Okay, great. Thank you

Operator

Your next question comes from the line of Jerry Bruni of J.V. Bruni.

Jerry Bruni – J.V. Bruni

On page 18 of the supplemental information material, I want to see if I'm reading this correct. As I look at this it appears as if approximately 90% of the 2006 book year is already attached. Is that correct interpretation?

Ken Jones

Let me make sure; let me get that page in front of me here. You’re looking at the captive information relative to the captive supplement. So just to make sure altogether on that. And which book you're looking at? The 2006 book year?

Jerry Bruni – J.V. Bruni

Yes.

Ken Jones

That's correct. We would – just to go through the way this chart works, the 2006 book year has $1.48 billion of risk in force on the captive book, and of that, 89.6% or 90% is attached.

Jerry Bruni – J.V. Bruni

And that ramped up quite quickly in the last three months. So I'm assuming that in short order it's going to be 100% or very close.

Ken Jones

Again, if you can kind of look and see where the rest of the books are in terms of attachment there is still 5% that's in the 0 to 50 band, but yes, you’re looking at the – that’s the correct way to look at. And if you were to look out to 2007 book year, you would see that we have 25% attached. 42% of the risk in force has incurred 75% to 99% of the attachment point. So then if you look back at the prior quarter, you can see the progression as it moves towards the attachment.

Jerry Bruni – J.V. Bruni

Okay. So back to the 2006 year for a moment, is it safe to assume that you won’t be creating a provision for losses for that year to a great extent, given the large amount that is already attached?

Ken Jones

Right. For this portion of our book, and again, this is – as we have shown here we have $1.48 billion of our risk in force, and this book – that we will have largely attached that and as long as the losses don't exceed the band, we will record no further losses once attached.

Jerry Bruni – J.V. Bruni

Okay. And if you – there is a column here that says ever to-date captive benefit –

Ken Jones

Correct.

Jerry Bruni – J.V. Bruni

For the June 30 quarter, it says $62.7 million. A quarter ago was $15.9. So the difference is 46.8 million. Is it fair to assume then that captive insurance procedures have paid $46.8 million of losses in the second quarter?

Ken Jones

Not paid, but they absorbed that amount that we would have otherwise reflected on our balance sheet. We had defaults come in that required reserves $62.7 million that we ceded to our captive. So on a gross basis; let’s just say we had reserves of $800 million. We would have ceded $63 million of those to the captives and recorded a net benefit of $737 million for example.

Jerry Bruni – J.V. Bruni

Now, you actually paid losses of $68 million in the second quarter?

Ken Jones

Correct.

Jerry Bruni – J.V. Bruni

So how does the $46 million, $47 million increment that was attributed to the captives. How does that number relate? Would the $68 million have been roughly $47 million greater or – ?

Ken Jones

No. Our incurred losses would have been $47 million greater, but it would have been in a reserve provision. We are not yet to the point where we are ceding paid losses to the captives. The way that works is that we would have to pay in the risk layer before we see the paid loss. Right now, we have default that based on our paid losses plus our reserves take us into that risk layer, we will see paid losses and get a reserve credit – credit on paid losses when we move into that risk layer on a paid basis.

Jerry Bruni – J.V. Bruni

Given the increase in the captive benefit of from roughly $16 million to roughly $63 million in the most recent quarter, is it fair to assume that this number is going to ramp up meaningfully in the coming quarters?

Ken Jones

It will certainly continue to increase. Now the benefit is going to be based on the default performance of – once you are in – once we have attached the captive the benefit will simply be that we will have, will increase by the reserves or paid losses on defaults reported within that book year. So largely the benefit is – again, it's – I wouldn't want to sit here and say that we went from $6 million to $15 million to $62 million and you can draw any trends from that progression. The benefits will increase. No doubt about that. But will they increase $45 million in the next quarter or something greater or less than that, will actually depends on the performance of the defaults within the captive book, and when those start to change or slow down for example, the 2006 book when it's fully attached. The default there will obviously slow down quicker than they will off the 2007 book and will ultimately influence the amount of that benefit.

Jerry Bruni – J.V. Bruni

If you could see the pig going through the python in the 2007 book in the statistics that you provided?

Ken Jones

Correct.

Jerry Bruni – J.V. Bruni

Okay. Thank you.

Operator

Mr. Jones, there are no further questions at this time. Please continue with closing remarks.

Ken Jones

Okay. We do appreciate your interest today and again, look forward to continue to work with you. And hopefully with the information we shared today, the information that's available on our statistical supplement will be valuable as you work with us to look at our long-term performance going forward. Again, we appreciate your interest and thanks for taking the time today.

Operator

Ladies and gentlemen, this concludes today's conference. The webcast replays will be available on the TGIC Web site at www.triadguaranty.com. Thank you for participating, and you may now disconnect.

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