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ESNT > SEC Filings for ESNT > Form 10-K on 10-Mar-2014All Recent SEC Filings

Show all filings for ESSENT GROUP LTD.

Form 10-K for ESSENT GROUP LTD.


10-Mar-2014

Annual Report


ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with the "Selected Financial Data" and our financial statements and related notes thereto included elsewhere in this report. In addition to historical information, this discussion contains forward-looking statements that involve risks, uncertainties and assumptions that could cause actual results to differ materially from management's expectations. Factors that could cause such differences are discussed in the sections entitled "Special Note Regarding Forward-Looking Statements" and "Risk Factors." We are not undertaking any obligation to update any forward-looking statements or other statements we may make in the following discussion or elsewhere in this document even though these statements may be affected by events or circumstances occurring after the forward-looking statements or other statements were made.

Overview

We are an established and growing private mortgage insurance company. We were formed to serve the U.S. housing finance industry at a time when the demands of the financial crisis and a rapidly changing business environment created the need for a new, privately funded mortgage insurance company. Since writing our first policy in May 2010, we have grown to an estimated 12.1% market share based on new insurance written, or NIW, excluding NIW under the Home Affordable Refinance Program, for the year ended December 31, 2013, up from 8.6% and 4.5% for the years ended December 31, 2012 and 2011, respectively. We believe that our growth has been driven largely by the unique opportunity we offer lenders to partner with a well-capitalized mortgage insurer, unencumbered by legacy business, that provides fair and transparent claims payment practices, and consistency and speed of service.

In 2010, Essent became the first private mortgage insurer to be approved by the GSEs since 1995, and is licensed to write coverage in all 50 states and the District of Columbia. We completed our initial public offering in November 2013. The financial strength of Essent Guaranty, Inc., our wholly-owned insurance subsidiary, is rated Baa2 with a stable outlook by Moody's Investors Service and BBB+ with a stable outlook by Standard & Poor's Rating Services.

We had master policy relationships with approximately 935 customers as of December 31, 2013. We have a fully functioning, scalable and flexible mortgage insurance platform, which we acquired from Triad Guaranty Inc. and its wholly-owned subsidiary, Triad Guaranty Insurance Corporation, which we refer to collectively as "Triad", in exchange for up to $30 million in cash and the assumption of certain contractual obligations. Our holding company is domiciled in Bermuda and our U.S. insurance business is headquartered in Radnor, Pennsylvania. We operate additional underwriting and service centers in Winston-Salem, North Carolina and Irvine, California. We have a highly experienced, talented team with 289 employees as of December 31, 2013. For the years ended December 31, 2013, 2012 and 2011, we generated new insurance written of approximately $21.2 billion, $11.2 billion and $3.2 billion, respectively, and as of December 31, 2013, we had approximately $32.0 billion of insurance in force.

Legislative and Regulatory Developments

Our results are significantly impacted by, and our future success may be affected by, legislative and regulatory developments affecting the housing finance industry. Key regulatory and legislative developments that may affect us include:

Housing Finance and GSE Reform

The overwhelming majority of our current and expected future business is the provision of mortgage insurance on loans sold to the GSEs. Therefore, changes to the business practices of the GSEs or any regulation relating to the GSEs may impact our business and our results of operations. The FHFA is the regulator and conservator of the GSEs with authority to control and direct their


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operations. The FHFA has directed, and is likely to continue to direct, changes to the business operations of the GSEs in ways that affect the mortgage insurance industry. In addition, it is likely that Federal legislation will be necessary to resolve the conservatorship of the GSEs, and such legislation could materially affect the role and charter of the GSEs and the operation of the housing finance system. In 2011, the U.S. Department of the Treasury recommended options for winding down the GSEs and using a combination of Federal housing policy changes to contract the government's footprint in housing finance and restore a larger role for private capital. Since 2011, members of Congress have introduced several bills intended to reform the secondary market and the role of the GSEs, although no comprehensive housing finance or GSE reform legislation has been enacted to date. See "Business-Regulation-Federal Laws and Regulations-Housing Finance Reform", "Risk Factors-Risks Relating to Our Business-Legislative or regulatory actions or decisions to change the role of the GSEs in the U.S. housing market generally, or changes to the charters of the GSEs with regard to the use of credit enhancements generally and private mortgage insurance specifically, could reduce our revenues or adversely affect our profitability and returns", and "-Changes in the business practices of the GSEs, including actions or decisions to decrease or discontinue the use of mortgage insurance or changes in the GSEs' eligibility requirements for mortgage insurers, could reduce our revenues or adversely affect our profitability and returns."

Dodd-Frank Act

Various regulatory agencies have produced, and are now in the process of developing additional, new rules under the Dodd-Frank Act that are expected to have a significant impact on the housing finance industry, including the Qualified Mortgage, or QM, definition and the risk retention requirement and related Qualified Residential Mortgage, or QRM, definition.

QM Definition

Under the Dodd-Frank Act, the CFPB is authorized to issue regulations governing a loan originator's determination that, at the time a loan is originated, the consumer has a reasonable ability to repay the loan. The Dodd-Frank Act provides a statutory presumption that a borrower will have the ability to repay a loan if the loan has characteristics satisfying the QM definition. On January 10, 2014, the CFPB implemented a final rule regarding QMs, which we refer to as the "QM Rule". Under the QM Rule, a loan is deemed to be a QM if it has certain loan features, satisfies extensive documentation requirements and meets limitations on fees and points and APRs. The QM Rule also provides for a second temporary category with more flexible requirements if the loan is eligible to be purchased or guaranteed by the GSEs while they are in conservatorship, which is the overwhelming majority of our business. This second temporary category still requires that loans satisfy certain criteria, including the requirement that the points and fees represent 3% or less of the total loan amount.

Failure to comply with the ability-to-repay requirement exposes a lender to substantial potential liability. As a result, we believe that the QM regulations may cause changes in the lending standards and origination practices of our customers. Such changes may include a further tightening of mortgage origination practices and lending standards, which may further improve the credit quality of new mortgages, but may also result in a reduction of the overall volume of mortgage originations. To the extent the use of private mortgage insurance causes a loan not to meet the definition of a QM, the volume of loans originated with mortgage insurance may decline. In addition, the impact of the mortgage insurance premiums on the calculation of points and fees for purposes of QM may influence the use of mortgage insurance, as well as our mix of premium plans and therefore our profitability. See "-Factors Affecting Our Results of Operations-Persistency and Business Mix." Finally, to the extent that government agencies that offer mortgage insurance adopt their own definitions of a qualified mortgage and those definitions are more favorable to lenders than those applicable in the market we operate in, our business may be adversely affected. See "Business-Regulation-Federal Laws and


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Regulation-Dodd-Frank Act-Qualified Residential Mortgage Regulations-Risk Retention Requirements" and "Risk Factors-Risks Relating to Our Business-Our business prospects and operating results could be adversely impacted if, and to the extent that, the Consumer Financial Protection Bureau's ("CFPB") final rule defining a qualified mortgage ("QM") reduces the size of the origination market or creates incentives to use government mortgage insurance programs."

Risk Retention Requirements and QRM Definition

The Dodd-Frank Act provides for an originator or issuer risk-retention requirement on securitized mortgage loans that do not meet the definition of a QRM. Federal regulators issued the proposed risk-retention rule in March 2011, and in response to public comment on such proposed rule, issued a revised proposed-risk retention rule on August 28, 2013, including a definition of QRM that generally defines QRM as a mortgage meeting the requirements of QM (see "Business-Regulation-Federal Laws and Regulations-Dodd-Frank Act-Qualified Mortgage Regulations-Ability to Repay Requirements"). In addition, the regulators also requested public comments on an alternative definition that, among other things, incorporates a maximum LTV standard of 70% and certain other restrictions selected to reduce the risk of default. Neither of the revised proposed definitions of QRM incorporate the use of private mortgage insurance. Under the proposed rule, the GSEs satisfy the risk retention requirements of the Dodd-Frank Act while they are in conservatorship. The public comment period for the proposed rule ended on October 30, 2013 and final rules have yet to be issued. The final timing of the adoption of any risk retention regulation and the definition of QRM remains uncertain.

Issuers may prefer not to retain risk and may therefore have a strong incentive to originate loans that meet the definition of a QRM. If the final rule gives consideration to private mortgage insurance in the definition of QRM, issuers may benefit from the use of private mortgage insurance for mortgage securitizations subject to the risk retention requirements. However, if the final QRM rule does not give consideration to mortgage insurance in the definition of QRM, the attractiveness of originating and securitizing loans with lower down payments may be reduced, which may adversely affect the future demand for mortgage insurance and our business. In addition, changes in the final regulations regarding treatment of GSE-guaranteed mortgage loans, could impact our business. The ultimate impact of these rules on the use of mortgage insurance depends on, among other things, (i) the final definition of QRM,
(ii) under the proposed definition, the extent to which the presence of private mortgage insurance may adversely affect the ability of a loan to qualify as a QM and therefore as a QRM, (iii) under the QM-plus definition or any other final definition with an LTV requirement, the level of the final LTV requirement and the extent to which credit would be given for the use of mortgage insurance, if any, in satisfying the LTV requirement, (iv) if, in the future, sellers of loans to the GSEs become subject to risk-retention requirements, and (v) the degree to which originators or issuers subject to risk retention requirements would see it as beneficial to utilize mortgage insurance on non-QRM loans to mitigate their retained credit exposure. See "Business-Regulation-Federal Laws and Regulation-Dodd-Frank Act-Qualified Residential Mortgage Regulations-Risk Retention Requirements" and "Risk Factors-Risks Relating to Our Business-The amount of insurance we write could be adversely affected by the implementation of the Dodd-Frank Act's risk retention requirements and the definition of Qualified Residential Mortgage ("QRM")."

Basel III

In July 2013, the Federal Reserve Board, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation approved publication of the Basel III Rules governing almost all U.S. banking organizations regardless of size or business model. The Basel III Rules revise and enhance the Federal banking agencies' general risk-based capital, advanced approaches and leverage rules. The Basel III Rules became effective on January 1, 2014, with a mandatory compliance date of


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January 1, 2015 for banking organizations other than advanced approaches banking organizations that are not savings and loan holding companies.

The Federal banking agencies previously issued proposed rules that would have made extensive changes to the capital requirements for residential mortgages, including eliminating capital recognition for certain low down payment mortgages covered by mortgage insurance. After consideration of extensive comments with regard to the proposed capital rules for residential mortgages, the Federal banking agencies decided to retain in the Basel III Rules the treatment for residential mortgage exposures that is currently set forth in the general risk-based capital rules and the treatment of mortgage insurance.

The Basel III Rules continue to afford FHA-insured loans a lower risk-weighting than low down payment loans insured with private mortgage insurance, and Ginnie Mae mortgage-backed securities are afforded a lower risk weighting than Fannie Mae and Freddie Mac mortgage-backed securities. Therefore, with respect to capital requirements, FHA-insured loans will continue to have a competitive advantage over loans insured by private mortgage insurance and then sold to and securitized by the GSEs.

In addition, with regard to the separate Basel III Rules applicable to general credit risk mitigation for banking exposures, insurance companies engaged predominantly in the business of providing credit protection, such as private mortgage insurance companies, are not eligible guarantors.

If implementation of the Basel III Rules increases the capital requirements of banking organizations with respect to the residential mortgages we insure, it could adversely affect the size of the portfolio lending market, which in turn would reduce the demand for our mortgage insurance, but may create incentives for banks to originate and sell loans to the GSEs which could expand demand for mortgage insurance. If the Federal banking agencies revise the Basel III Rules to reduce or eliminate the capital benefit banks receive from insuring low down payment loans with private mortgage insurance, or if our bank customers believe that such adverse changes may occur at some time in the future, our current and future business may be adversely affected. Furthermore, if mortgage insurance companies do not meet the requirements to be an eligible guarantor for purposes of general credit mitigation, our future business prospects may be adversely affected. "Risk Factors-Risks Relating to Our Business-The implementation of the Basel III Capital Accord, or other changes to our customers' capital requirements, may discourage the use of mortgage insurance."

FHA Reform

The FHA is our primary competitor outside of the private mortgage insurance industry and the FHA's role in the mortgage insurance industry is also significantly dependent upon regulatory developments. The U.S. Congress is considering reforms of the housing finance market, which includes consideration of the future mission, size and structure of the FHA, which is part of HUD. In HUD's annual report to Congress on the financial status of the FHA Mutual Mortgage Insurance Fund, or MMIF, dated November 16, 2012, the capital reserve ratio of the MMIF turned to a negative 1.44%, below the congressionally mandated required minimum level of 2%. In part as a result of this capital shortfall, Congress is considering legislation to reform the FHA. If FHA reform were to raise FHA premiums, tighten FHA credit guidelines, make other changes which make lender use of FHA less attractive, or implement credit risk sharing between FHA and private mortgage insurers, these changes may be beneficial to our business. However, there can be no assurance that any FHA reform legislation will be enacted into law, and what provisions may be contained in any final legislation, if any. Therefore, the future impact on our business is uncertain. See "Business-Regulation-Federal Laws and Regulation-FHA Reform" and "Risk Factors-Risks Relating to Our Business-The amount of insurance we may be able to write could be adversely affected if lenders and investors select alternatives to private mortgage insurance."


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Factors Affecting Our Results of Operations

Net Premiums Written and Earned

Premiums are based on insurance in force, or IIF, during all or a portion of a period. A change in the average IIF during a period causes premiums to increase or decrease as compared to prior periods. Average premiums rates in effect during a given period will also cause premiums to differ when compared to earlier periods. IIF at the end of a reporting period is a function of the IIF at the beginning of such reporting period plus NIW less policy cancellations (including claims paid) during the period. As a result, premiums are generally influenced by:


NIW, which is the aggregate principal amount of the new mortgages that are insured during a period. Many factors affect NIW, including, among others, the volume of low down payment home mortgage originations and the competition to provide credit enhancement on those mortgages;


Cancellations of our insurance policies, which are impacted by payments on mortgages, home price appreciation, or refinancings, which in turn are affected by mortgage interest rates. Cancellations are also impacted by the levels of rescissions and claim payments;


Premium rates, which represent the amount of the premium due as a percentage of IIF. Premium rates are based on the risk characteristics of the loans insured, the percentage of coverage on the loans, competition from other mortgage insurers and general industry conditions; and


Premiums ceded or assumed under reinsurance arrangements. To date, we have not entered into any reinsurance contracts.

Premiums are paid either on a monthly installment basis ("monthly premiums"), in a single payment at origination ("single premiums"), or in some cases as an annual premium. For monthly premiums, we receive a monthly premium payment which is recorded as net premiums earned in the month the coverage is provided. Net premiums written may be in excess of net premiums earned due to single premium policies. For single premiums, we receive a single premium payment at origination, which is recorded as "unearned premium" and earned over the estimated life of the policy, which ranges from 36 to 156 months depending on the term of the underlying mortgage and loan-to-value ratio at date of origination. If single premium policies are cancelled due to repayment of the underlying loan and the premium is non-refundable, the remaining unearned premium balance is immediately recognized as earned premium revenue. Substantially all of our single premium policies in force as of December 31, 2013 were non-refundable. Premiums collected on annual policies are recognized as net premiums earned on a straight line basis over the year of coverage. For the year ended December 31, 2013, monthly and single premium policies comprised 80% and 20% of our NIW, respectively.

Persistency and Business Mix

The percentage of IIF that remains on our books after any 12-month period is defined as our persistency rate. Because our insurance premiums are earned over the life of a policy, higher persistency rates can have a significant impact on our profitability. The persistency rate on our portfolio was 86.1% at December 31, 2013. Generally, higher prepayment speeds lead to lower persistency.

Prepayment speeds and the relative mix of business between single premium policies and monthly premium policies also impact our profitability. Our premium rates include certain assumptions regarding repayment or prepayment speeds of the mortgages. Because premiums are paid at origination on single premium policies, assuming all other factors remain constant, if loans are prepaid earlier than expected, our profitability on these loans is likely to increase and, if loans are repaid slower than expected, our profitability on these loans is likely to decrease. By contrast, if monthly premium loans


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are repaid earlier than anticipated, our premium earned with respect to those loans and therefore our profitability declines. Currently, the expected return on single premium policies is less than the expected return on monthly policies.

Net Investment Income

Our investment portfolio was comprised entirely of investment grade fixed income securities and money market investments as of December 31, 2013. The principal factors that influence investment income are the size of the investment portfolio and the yield. As measured by amortized cost (which excludes changes in fair market value, such as from changes in interest rates), the size of our investment portfolio is mainly a function of increases in capital and cash generated from or used in operations which is impacted by net premiums received, investment earnings, net claim payments and expenses. Realized gains and losses are a function of the difference between the amount received on the sale of a security and the security's amortized cost, as well as any "other than temporary" impairments recognized in earnings. The amount received on the sale of fixed income securities is affected by the coupon rate of the security compared to the yield of comparable securities at the time of sale.

Other Income

In connection with the acquisition of our mortgage insurance platform, we entered into a services agreement with Triad to provide certain information technology maintenance and development and customer support-related services. In return for these services, we receive a fee which is recorded in other income. From the period from December 1, 2009 to November 30, 2010, this fee was based on a fixed amount. Effective December 1, 2010, the fee is adjusted monthly based on the number of Triad's mortgage insurance policies in force and, accordingly, will decrease over time as Triad's existing policies are cancelled. The services agreement provides for a minimum monthly fee of $150,000 for the duration of the services agreement. The services agreement expires on November 30, 2014 and provides for two subsequent five year renewals at Triad's option. See Note 6 to our consolidated financial statements.

Other income also includes revenues associated with contract underwriting services. The level of contract underwriting revenue is dependent upon the number of customers who have engaged us for this service and the number of loans underwritten for these customers.

Provision for Losses and Loss Adjustment Expenses

The provision for losses and loss adjustment expenses reflect the current expense that is recorded within a particular period to reflect actual and estimated loss payments that we believe will ultimately be made as a result of insured loans that are in default.

Losses incurred are generally affected by:


the overall state of the economy, which broadly affects the likelihood that borrowers may default on their loans and have the ability to cure such defaults;


changes in housing values, which affect our ability to mitigate our losses through the sale of properties with loans in default as well as borrower willingness to continue to make mortgage payments when the value of the home is below or perceived to be below the mortgage balance;


the product mix of IIF, with loans having higher risk characteristics generally resulting in higher defaults and claims;


the size of loans insured, with higher average loan amounts tending to increase losses incurred;


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the loan-to-value ratio, with higher average loan-to-value ratios tending to increase losses incurred;


the percentage of coverage on insured loans, with deeper average coverage tending to increase losses incurred;


credit quality of borrowers, including higher debt-to-income ratios and lower FICO scores, which tend to increase incurred losses;


the rate at which we rescind policies. Because of tighter underwriting standards generally in the mortgage lending industry and terms set forth in our Clarity of Coverage master policy endorsement, we expect that our level of rescission activity will be lower than recent rescission activity seen in the mortgage insurance industry; and


the distribution of claims over the life of a book. The average age of our insurance portfolio is young with 94% of our IIF as of December 31, 2013 having been originated since January 1, 2012. As a result, based on historical industry performance, we expect the number of defaults and claims we experience, as well as our provision for losses and loss adjustment expenses, to increase as our portfolio seasons. See "-Mortgage Insurance Earnings and Cash Flow Cycle" below.

We establish loss reserves for delinquent loans when we are notified that a borrower has missed at least two consecutive monthly payments ("Case Reserves"), as well as estimated reserves for defaults that may have occurred but not yet been reported to us ("IBNR Reserves"). We also establish reserves for the associated loss adjustment expenses ("LAE"), consisting of the estimated cost of the claims administration process, including legal and other fees. Using both internal and external information, we establish our reserves based on the likelihood that a default will reach claim status and estimated claim severity. See "-Critical Accounting Policies" for further information.

We believe, based upon our experience and industry data, that claims incidence for mortgage insurance is generally highest in the third through sixth years after loan origination. As of December 31, 2013, 64% of our IIF relates to business written in 2013 and substantially all of our policies in force are less than three years old. Although the claims experience on new insurance written by us to date has been favorable, we expect incurred losses and claims to increase as a greater amount of this book of insurance reaches its anticipated period of highest claim frequency. The actual default rate and the average reserve per default that we experience as our portfolio matures is difficult to predict and is dependent on the specific characteristics of our current in-force book (including the credit score of the borrower, the loan to value ratio of the mortgage, geographic concentrations, etc.), as well as the profile of new . . .

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