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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

_______________________

FORM 10-Q

T	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2012

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)

(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 T No £

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes T No £

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes £ No T

Number of shares of common stock, par value $0.01 per share, outstanding as of November 2, 2012 was 15,368,128.

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TRIAD GUARANTY INC.

INDEX

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See accompanying notes.

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See accompanying notes.

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See accompanying notes.

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TRIAD GUARANTY INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2012

(Unaudited)

1.  The Company

Triad Guaranty Inc. ("TGI") is a holding company which, through its wholly-owned subsidiary, Triad Guaranty Insurance Corporation ("TGIC"), is a nationwide mortgage guaranty insurer pursuing a run-off of its existing in-force book of business.  Mortgage insurance allows buyers to achieve home ownership with a reduced down payment, facilitates the sale of mortgage loans in the secondary market, and protects lenders from credit default-related expenses. The term "run-off" as used in these financial statements means continuing to service existing mortgage guaranty insurance policies but not writing any new policies.

Unless the context requires otherwise, references to "Triad" in this Quarterly Report on Form 10-Q refer to the operations of TGIC and its wholly-owned subsidiary, Triad Guaranty Assurance Corporation ("TGAC").  References to the "Company" refer collectively to the operations of TGI and Triad.

TGIC is an Illinois-domiciled mortgage guaranty insurance company and TGAC is an Illinois-domiciled mortgage guaranty reinsurance company. The Illinois Department of Insurance (the "Insurance Department") is the primary regulator of both TGIC and TGAC.  The Illinois Insurance Code grants broad powers to the Insurance Department and its director (collectively, the "Department") to enforce rules or exercise discretion over almost all significant aspects of Triad's insurance business.

Triad ceased issuing new commitments for mortgage guaranty insurance coverage in 2008 and is operating its business in run-off under two Corrective Orders issued by the Department, as discussed in "Corrective Orders and Regulation" below. The first Corrective Order was issued in 2008.  The second Corrective Order was issued in 2009.  Servicing existing policies during run-off includes:

·	billing and collecting premiums on policies that remain in force;

·	working with borrowers in default to remedy the default and/or mitigate losses;

·	reviewing policies for the existence of misrepresentation, fraud or non-compliance with stated programs; and

·	settling all legitimate filed claims per the provisions of the policies and the two Corrective Orders issued by the Department.

The term "settled," as used in these financial statements in the context of the payment of a claim, refers to the satisfaction of Triad's obligations following the submission of valid claims by its policyholders.  As required by the second Corrective Order, effective on and after June 1, 2009, valid claims are settled by a combination of 60% in cash and 40% in the form of a deferred payment obligation ("DPO").  The Corrective Orders, among other things, allow management to continue to operate Triad under the close supervision of the Department, include restrictions on the distribution of dividends or interest on notes payable to TGI by Triad, and include certain requirements on the payment of claims.  Failure to comply with the provisions of the Corrective Orders, or other factors, could result in the imposition of fines or penalties or subject Triad to further legal proceedings, including receivership proceedings for the conservation, rehabilitation, or liquidation of Triad.  During the third quarter of 2012, Triad reported that it was not in compliance with a provision in the second Corrective Order, and Triad is currently awaiting recommendations of the Department regarding modifications to the Corrective Order.  See the discussion below under "Pending Regulatory Matters" for more information.

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Accounting Principles

The Company prepares its financial statements presented in this Quarterly Report on Form 10-Q in conformity with accounting principles generally accepted in the United States of America ("GAAP").  The financial statements for Triad that are provided to the Department are prepared in accordance with Statutory Accounting Principles ("SAP") as set forth in the Illinois Insurance Code or prescribed by the Department.  The primary difference between GAAP and SAP for Triad at September 30, 2012 and December 31, 2011 was the reporting requirements relating to the DPOs stipulated in the second Corrective Order.

A deficit in assets occurs when recorded liabilities exceed recorded assets in financial statements prepared under GAAP.  A deficiency in policyholders' surplus occurs when recorded liabilities exceed recorded assets in financial statements prepared under SAP.  A deficit in assets at any particular point in time under GAAP is not necessarily a measure of insolvency.  However, the Company believes that if Triad were to report a deficiency in policyholders' surplus under SAP for an extended period of time, Illinois law may require the Department to seek receivership of Triad, which could compel TGI to institute a proceeding seeking relief from creditors under U.S. bankruptcy laws, or otherwise consider dissolution of the Company.  The second Corrective Order was designed in part to help Triad maintain its positive policyholders' surplus.

2.  Going Concern

The Company has prepared its financial statements on a going concern basis under GAAP, which contemplates the realization of assets and the satisfaction of liabilities and commitments in the normal course of business.  However, there is substantial doubt as to the Company's ability to continue as a going concern.  This uncertainty is based on, among other things, Triad's current non-compliance with a provision of the second Corrective Order, the possible failure of Triad to comply with other provisions of the Corrective Orders, and the Company's ability to generate enough income over the term of the remaining run-off to overcome its $802.8 million deficit in assets at September 30, 2012.

The positive impact on statutory surplus resulting from the second Corrective Order has resulted in Triad reporting a policyholders' surplus in its SAP financial statements of $224.1 million at September 30, 2012, as opposed to a deficiency in policyholders' surplus of $834.5 million on the same date had the second Corrective Order not been implemented.  While the implementation of the second Corrective Order has deferred the institution of an involuntary receivership proceeding, no assurance can be given that the Department will not seek receivership of Triad in the future and there continues to be substantial doubt about the Company's ability to continue as a going concern.  

 

3.  Accounting Policies and Basis of Presentation

Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared in conformity with GAAP for interim financial information and with the instructions to Form 10-Q and Article 8 of Regulation S-X.  Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements.  In the opinion of management, all adjustments considered necessary for a fair presentation have been included.  Operating results for the three months and nine months ended September 30, 2012 are not necessarily indicative of the results that may be expected for the year ending December 31, 2012 or subsequent periods.  For further information, refer to the consolidated financial statements and footnotes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2011.

Consolidation

The consolidated financial statements include the accounts of TGI and its wholly owned subsidiary, TGIC, including TGIC's wholly-owned subsidiary, TGAC.  All significant intercompany accounts and transactions have been eliminated.

Corrective Orders and Regulation

Triad has entered into two Corrective Orders with the Department as detailed below and in the Company's Annual Report on Form 10-K for the year ended December 31, 2011.  Among other things, the Corrective Orders:

·	Require the oversight of the Department on substantially all operating matters;

·	Prohibit stockholder dividends from Triad to TGI without the prior approval of the Department;

·	Prohibit the accrual of interest and the payment of interest and principal on Triad's surplus note to TGI without the prior approval of the Department;

·	Restrict Triad from making any payments or entering into any transaction that involves the transfer of assets to, or liabilities from, any affiliated parties without the prior approval of the Department;

·	Require Triad to obtain prior written approval from the Department before entering into certain transactions with unaffiliated parties;

·	Require that all valid claims under Triad's mortgage guaranty insurance policies are settled 60% in cash and 40% by recording a DPO;

·	Require the accrual of simple interest on the DPO at the same average net rate earned by Triad's investment portfolio; and

·	Require that loss reserves in financial statements prepared in accordance with SAP be established to reflect the cash portion of the estimated claim settlement but not the DPO.

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The DPO is an interest-bearing subordinated obligation of Triad with no stated repayment terms.  The second Corrective Order requires that Triad hold assets to support the DPO liability in a separate account pursuant to a custodial arrangement.  As mentioned in Note 1, Triad is currently not in compliance with this provision of the second Corrective Order. See "Pending Regulatory Matters" above for more information.

 

The recording of a DPO does not impact reported settled losses as the Company continues to report the entire amount of a claim in its statements of comprehensive loss.  The accounting treatment for the recording of DPOs on Triad's balance sheet on a SAP basis is similar to a surplus note that is reported as a component of statutory surplus which serves to increase reported statutory surplus.  However, in the Company's financial statements prepared in accordance with GAAP included in this report, the DPOs and related accrued interest are reported as a liability.  At September 30, 2012, the cumulative effect of the DPO requirement on statutory policyholders' surplus, including the impact of establishing loss reserves at anticipated cash payment rather than the estimated full claim amount, was to increase statutory policyholders' surplus by $1.1 billion over the amount that would have been reported absent the second Corrective Order.  The cumulative increase to statutory policyholders' surplus as a result of the DPO requirement was $967.5 million at December 31, 2011. There was no such impact to loss reserves or stockholders' deficit calculated on a GAAP basis, which is the primary reason for the reported deficit in assets.  Any repayment of the DPO or the associated accrued interest is dependent on the financial condition and future prospects of Triad and is subject to the approval of the Department.

The second Corrective Order provides financial thresholds, specifically regarding the statutory risk-to-capital ratio and the level of statutory policyholders' surplus that, if met, may indicate that the Department should reduce the DPO percentage and/or require distributions to DPO holders.  In January 2012, the Department notified Triad that as of December 31, 2011, based upon Triad's surplus position, risk-to-capital ratio and the continued economic uncertainty, the Department determined that no change to the DPO percentage was in order nor would it be appropriate for Triad to make a distribution to the DPO holders.

Failure to comply with the provisions of the Corrective Orders or any other violation of the Illinois Insurance Code may result in the imposition of fines or penalties or subject Triad to further legal proceedings, including the institution by the Department of receivership proceedings for the conservation, rehabilitation or liquidation of Triad.  Any such actions would likely lead TGI to institute a proceeding seeking relief from creditors under U.S. bankruptcy laws or otherwise consider dissolution of the Company.

Triad is also subject to comprehensive regulation by the insurance departments of the various other states in which it is licensed to transact business. The insurance departments of the other states have been working with the Department in the administration and oversight of the Corrective Orders.

Insurance regulations generally limit the writing of mortgage guaranty insurance to an aggregate amount of insured risk no greater than twenty-five times the total of statutory capital, which is defined as the statutory surplus plus the statutory contingency reserve. The Corrective Orders under which Triad is currently operating specifically prohibit the writing of new insurance by Triad.  While the risk-to-capital ratio of Triad has benefitted from the DPO requirements of the Corrective Orders, it remains greater than the 25-to-1 regulatory guideline.  Even if Triad's risk-to-capital ratio were to be reduced to 25-to-1 or lower as a result of the second Corrective Order, Triad would continue to be prohibited by the Department as well as other states from issuing new commitments for insurance.

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Reinsurance

Prior to entering into run-off, the Company entered into various captive reinsurance agreements that were designed to allow lenders to share in the risks of mortgage insurance. All of the captive reinsurance agreements include, among other things, minimum capital requirements and require a trust be established to partially support the reinsurer's obligations under the agreement. Reinsurance agreements do not relieve the Company from its obligations to policyholders. Failure of the reinsurer to honor its obligation in excess of the minimum capital level required by the reinsurance agreement could result in losses to the Company; consequently, allowances are established for amounts deemed uncollectible from the captive reinsurance company. At September 30, 2012, reinsurance recoverable on loss reserves from captive reinsurers was approximately $15.9 million and captive reinsurance trust balances were $35.0 million. At September 30, 2012, approximately $1.8 million of reinsurance recoverable on loss reserves exceeded the available trust balance for which no benefit was recognized in these financial statements.

Loss Reserves

The Company establishes loss reserves to provide for the estimated costs of settling claims on loans reported in default and estimates on loans in default that are in the process of being reported to the Company as of the date of the financial statements.  Consistent with industry accounting practices, the Company does not establish loss reserves for future claims on insured loans that are not currently in default.  Loss reserves are established by management using historical experience and by making various assumptions and judgments about claim rates (frequency) and claim amounts (severity) to estimate ultimate losses to be paid on loans in default.  The Company's reserving methodology gives effect to current economic conditions and profiles delinquencies by such factors as, among others, default status, policy year, and the number of mortgage payments missed, as well as the combined loan-to-value ("LTV") ratio.  The Company also incorporates in the calculation of loss reserves the probability that a defaulted policy may be rescinded for underwriting violations.

A number of factors can impact the actual frequency and severity realized during the year compared to those utilized in the reserve assumptions including: changes in home prices at a faster rate than anticipated; the unanticipated impact of loan modification programs on cure rates; the impact of a higher or lower unemployment rate than anticipated; an unanticipated slowdown or acceleration of the overall economy; or social and cultural changes that are more accepting of mortgage defaults even when the borrower has the ability to pay.  Changes in the actual rescission rate compared to the rescission rate utilized in the reserve assumptions can also impact the frequency factor.

Rescissions are a key component in determining the level of estimated loss reserves and ultimately the level of paid claims.  During the three months and nine months ended September 30, 2012, the Company rescinded coverage on policies with risk in force of $95.3 million and $245.4 million, respectively, compared with $64.6 million and $321.7 million in the comparable prior year periods. The rescission factor utilized in the calculation of loss reserves resulted in a reduction to gross reserves of $104.5 million at September 30, 2012 compared to $205.7 million at December 31, 2011. Any change to the actual rescission rate compared to those utilized in the reserve methodology can have a material impact on the Company's financial condition. Such changes may come about for a number of reasons including legal determinations and agreements regarding Triad's ability to rescind coverage.

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The assumptions utilized in the calculation of the loss reserve estimate are continually reviewed and adjusted as necessary.  Such adjustments are reflected in the financial statements in the periods in which the adjustments are made.

The estimation of loss reserves requires assumptions as to future events, and there are inherent risks and uncertainties involved in making these assumptions. Economic conditions that have affected the development of loss reserves in the past may not necessarily affect development patterns in the future in either a similar manner or degree.

Recent Accounting Pronouncements

Changes to GAAP are established by the Financial Accounting Standards Board ("FASB") in the form of an Accounting Standards Update ("ASU") to the FASB's Accounting Standards Codification ("ASC").  The Company considers the applicability and impact of all ASUs.  ASUs not listed below were assessed and determined to be either not applicable or are expected to have minimal impact on the Company's financial statements.

In May 2011, the FASB, together with the International Accounting Standards Board ("IASB"), jointly issued ASU No. 2011-04, Fair Value Measurement (Topic 820):  Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS ("ASU 2011-04").  The adoption of ASU 2011-04 gives fair value the same meaning between GAAP and International Financial Reporting Standards ("IFRS"), and improves consistency of disclosures relating to fair value.  The Company adopted the provisions of ASU 2011-04 effective January 1, 2012 and included the required disclosures in these financial statements.  The adoption of this statement did not have a material impact on the financial statements.

In December 2011, the FASB issued ASU No. 2011-12, Comprehensive Income (Topic 220):  Deferral of the Effective Date for Amendments to the Presentation of Reclassification of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05 ("ASU 2011-12"), which defers the effective date required to comply with reclassification adjustments out of accumulated other comprehensive income found in ASU 2011-05.  The delay will allow the Board time to re-deliberate whether to require the presentation, on the face of the financial statements, of the effects of reclassifications out of accumulated other comprehensive income.  All other requirements in ASU 2011-05 are not affected by ASU 2011-12.  The Company does not expect the adoption of ASU 2011-12 to have a material impact on its financial statements.

4.  Litigation and Contingencies

The Company is involved in litigation and other legal proceedings in the ordinary course of business as well as the matters identified below.  No reserves have been established in the financial statements regarding current litigation as the potential liabilities, if any, are not probable or cannot be reasonably estimated.

On February 6, 2009, James L. Phillips served a complaint alleging violations of federal securities laws against TGI and two of its officers in the United States District Court, Middle District of North Carolina on behalf of a purported class of persons who acquired the common stock of the Company between October 26, 2006 and April 1, 2008.  TGI filed its motion to dismiss the amended complaint on August 21, 2009 and on January 27, 2012 the Magistrate Judge recommended that TGI's motion to dismiss be granted.  The plaintiff filed an amended complaint on March 30, 2012, TGI filed its motion to dismiss on May 15, 2012, the plaintiff filed its opposition to Triad's motion to dismiss on July 6, 2012, and TGI filed its reply brief on August 6, 2012.  TGI intends to vigorously defend this matter.

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On September 4, 2009, Triad filed a complaint against American Home Mortgage ("AHM") in the United States Bankruptcy Court for the District of Delaware seeking rescission of multiple master mortgage guaranty insurance policies ("master policies") and declaratory relief.  The complaint seeks relief from AHM as well as all owners of loans insured under the master policies by way of a defendant class action. Triad alleged that AHM failed to follow the delegated insurance underwriting guidelines approved by Triad, that this failure breached the master policies as well as the implied covenants of good faith and fair dealing, and that these breaches were so substantial and fundamental that the intent of the master policies could not be fulfilled and Triad should be excused from its obligations under the master policies. Three groups of current owners and/or servicers of AHM-originated loans filed motions to intervene in the lawsuit, which were granted by the Court on May 10 and October 29, 2010.  On March 4, 2011, Triad amended its complaint to add a count alleging fraud in the inducement.  On March 25, 2011, each of the interveners filed a motion to dismiss.  Triad filed its answer and answering brief in opposition to the motions to dismiss on May 27, 2011 and the interveners filed their reply briefs on July 13, 2011.  The total amount of risk originated under the AHM master policies, accounting for any applicable stop-loss limits associated with Modified Pool contracts and less risk originated on policies that have been subsequently rescinded, was $1.2 billion, of which $0.5 billion remained in force at September 30, 2012.  Triad continues to accept premiums and process claims under the master policies, with the earned premiums and settled losses reflected in the Consolidated Statements of Comprehensive Loss.  However, as a result of the litigation, Triad ceased remitting claim payments to companies servicing loans originated by AHM and the liability for losses settled but not paid is included in "Accrued expenses and other liabilities" on the Consolidated Balance Sheets.  Triad has not recognized any benefit in its financial statements pending the outcome of the litigation. On August 27, 2012, the Bankruptcy Court issued an order dismissing the lawsuit on jurisdictional grounds. Triad is evaluating whether to refile in jurisdictions where the current master policyholder is located.

On March 5, 2010, Countrywide Home Loans, Inc. filed a lawsuit in the Los Angeles County Superior Court of the State of California alleging breach of contract and seeking a declaratory judgment that bulk rescissions of flow loans is improper and that Triad is improperly rescinding loans under the terms of its master policies.  On May 10, 2010 the case was designated as complex and transferred to the Court's Complex Litigation Program.  Non-binding mediation occurred on July 22, 2011 with a follow-up mediation session on October 13, 2011. The parties have agreed to a proposed settlement which is subject to regulatory approval. In the event that the settlement is not approved, Triad intends to vigorously defend this matter.

On December 19, 2011, January 17, 2012, and April 12, 2012, complaints were served against TGIC in the United States District Court, Central District of California, United States District Court, Eastern District of Pennsylvania, and United States District Court, Eastern District of Pennsylvania, respectively.  The plaintiffs purport to represent a class of persons whose loans were insured by a mortgage guaranty insurance policy and reinsured through a captive reinsurer.  The complaints allege that such reinsurance is in violation of the Real Estate Settlement Procedures Act. In each case, the lender, captive reinsurer, and various mortgage guaranty insurers were sued. Triad did not provide mortgage guaranty insurance on the named plaintiffs' loans in any of these lawsuits.  Triad intends to vigorously defend these matters.

The Consumer Financial Protection Bureau (the "CFPB") issued a letter to TGI on January 3, 2012, advising TGI that the CFPB was investigating premium ceding practices by mortgage insurers, lenders, and their captive reinsurers and requested certain information from Triad.  The CFPB formally requested additional information on June 20, 2012.  Triad is cooperating with the CFPB in its investigation.

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Triad reported to the Department that as of August 31, 2012, Triad was not in compliance with the second Corrective Order because the aggregate amount of the DPO liability exceeded the cash and invested assets of Triad that were available for segregation in a separate account.  Triad has asked the Department to amend, modify or otherwise waive compliance with this provision of the second Corrective Order.  In addition, Triad also has requested that the calculation of the carrying charge on the DPO prescribed in the second Corrective Order be amended to limit the amount to a maximum equal to the actual aggregate net investment income that Triad earns rather than an amount based on the effective rate earned by Triad on its investments.  In response to Triad's requests for these modifications to the second Corrective Order, the Department held a public hearing on September 10, 2012, and invited Triad and its policyholders to provide testimony regarding these proposed amendments.  In addition, the Department invited Triad and its policyholders to provide testimony as to whether Triad should be permitted to continue to runoff its existing book of insurance business or whether the Department should implement a different regulatory approach.  The Department extended the period for comments and written testimony until November 30, 2012.  Triad's failure to comply with the provisions of the second Corrective Order or any other violation of the Illinois Insurance Code may result in the imposition of fines or penalties or subject Triad to further legal proceedings, including the institution by the Department of receivership proceedings for the conservation, rehabilitation or liquidation of Triad.  Moreover, if the Department determines that Triad is insolvent under applicable law, it would be required to institute a receivership proceeding over Triad.  In addition, the Department retains the inherent authority to institute such proceedings against Triad for any reason and Triad has previously agreed not to contest the taking of any such actions. As of the date of this Form 10-Q, the Department has not issued any final decision or order as a result of the public hearing and Triad's request to amend the second Corrective Order.  Because the subject matter of the hearing specifically included an assessment of whether the Department should implement a different regulatory approach with respect to Triad, including institution of receivership proceedings for the conservation, rehabilitation or liquidation of Triad, the Company believes institution of such a proceeding could be imminent.  If this should occur, among other things, TGI could lose control of Triad and could be forced to deconsolidate its financial statements.  Any such actions would likely lead TGI to institute a proceeding seeking relief from creditors under U.S. bankruptcy laws, or take other steps to wind up its business and liquidate.  See Item 1A, "Risk Factors" in the Company's Annual Report on Form 10-K for the year ended December 31, 2011 for more information.

5.  Investments

All fixed maturity securities are classified as "available-for-sale" and are carried at fair value.   Unrealized gains on available-for-sale securities, net of tax, are reported as a separate component of accumulated other comprehensive income in shareholders' equity.  Due to Triad's operating in run-off under the supervision by the Department and the uncertainty surrounding the Company's ability to continue as a going concern, the Company may be unable to retain a security that is in an unrealized loss position, even on a temporary basis, until it potentially recovers value. Accordingly, the Company recognizes an other-than-temporary impairment loss on all securities for which the fair value is less than the amortized cost at the balance sheet date. Impairment losses are recognized as realized investment losses in the Consolidated Statements of Comprehensive Loss. If the Company believes that the recorded impairment was due to reasons other than credit related, the difference between the impaired value and principal amount will be amortized as a component of interest income through the anticipated maturity date. The amortized cost, gross unrealized gains and losses and fair value of available-for-sale securities as of September 30, 2012 and December 31, 2011 were as follows:

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Unrealized gains do not necessarily represent future gains that the Company will realize.  The value of the Company's investment portfolio will vary depending on overall market interest rates, credit spreads, and changing conditions related to specific securities, as well as other factors. Volatility may increase in periods of uncertain market or economic conditions. Unrealized gains at both September 30, 2012 and December 31, 2011 were due primarily to a decline in interest rates from those at the time of initial purchase, although the recovery in value of previously impaired fixed maturity securities also contributed to the level of unrealized gains.

The amortized cost and estimated fair value of fixed maturity available-for-sale securities at September 30, 2012 are summarized by stated maturity below. Asset-backed, commercial mortgage-backed, and residential mortgage-backed securities are presented separately below because they generally provide for periodic payments of principal.

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Realized Gains (Losses) Related to Investments

The details of net realized investment gains (losses) for the three months and nine months are as follows:

Gross realized losses for the three months and nine months ended September 30, 2012 and 2011 were primarily attributable to the other-than-temporary write downs of securities whose market value was less than the respective cost basis.

 

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6.  Fair Value Measurement

Fair Value of Financial Instruments

The carrying values and fair values of financial instruments as of September 30, 2012 and December 31, 2011 are summarized below:

Valuation Methodologies and Associated Inputs

The Company utilizes the provisions of ASC 820 as amended by ASU 2010-06 in its estimation and disclosures about fair value of financial assets.  There are no liabilities as of September 30, 2012 or December 31, 2011 that meet the criteria of a financial instrument. ASC 820 establishes a fair value hierarchy that prioritizes the inputs to valuation methods used to measure fair value.  The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements).  The three levels of the fair value hierarchy under ASC 820 are as follows:

Level 1:

Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets.

Level 2:

Quoted prices for similar assets in active markets or for identical or similar assets in inactive markets.  Alternatively, quoted prices may be based on models where the significant inputs are observable or can be supported by observable market data.

Level 3:

Prices or valuation techniques where one or more of the significant inputs are unobservable (i.e., supported with little or no market activity). This includes broker quotes which are non-binding.

An asset's or a liability's level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.  An asset's or a liability's level within the fair value hierarchy as well as transfers in and out of Level 3 are determined at the end of the reporting period.  At September 30, 2012, none of the Company's invested assets were Level 3 securities.

The Company utilizes independent pricing services in the valuation of its invested assets. The independent pricing services primarily use generic models which use standard inputs including benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, market bids/offers, and other reference data. Market indicators as well as industry and economic events are also monitored.

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The Company utilizes its investment advisor to assist in determining if the pricing methodologies of the independent pricing services comply with ASC 820-10. Working under the Company's supervision, the investment advisor reviews the pricing techniques of the independent pricing services and has controls in place to ensure quality including, but not limited to:

·	reviewing price tolerance reports for month-over-month price changes that exceed certain thresholds;

·	reviewing evaluation dates for stale prices;

·	comparing with alternative pricing sources;

·	comparing with trade activity; and

·	comparing to a benchmarked price.

Based upon this review, prices submitted by the independent pricing services may be challenged and replaced if appropriate.

The investment advisor will obtain a price for any individual security not priced by the independent pricing services or for any individual security whose price is replaced as a result of the quality control review. The investment advisor seeks pricing from a variety of sources including external brokers, index pricing, internal sources of the investment advisor, and spread matrixes, among others. For broker-quoted only securities, quotes from market makers or broker-dealers are obtained from sources recognized to be market participants. For those securities trading in less liquid or illiquid markets with limited or no pricing information, unobservable inputs are used in order to measure the fair value of these securities. In cases where this information is not available, such as for privately placed securities, fair value is estimated using an internal pricing matrix. This matrix relies on judgment concerning the discount rate used in calculating expected future cash flows, credit quality, industry sector performance, and expected maturity. The following is a description of the valuation methodologies used in determining the fair value of the Company's assets.

Fixed maturities

U.S. Government and agency securities – U.S. Government and agency securities include U.S. Treasury securities, agency/government sponsored entity ("GSE") issues, and corporate government-backed obligations issued under the Temporary Liquidity Guarantee Program. The fair value for U.S. Treasury securities is based on regularly updated quotes from active market makers and brokers. The fair value for agency and other government-backed obligations is based on regularly updated dealer quotes, secondary trading levels, and the new issue market.  U.S. Government and agency securities are categorized as Level 2.

Foreign Government securities – The fair value of Foreign Government securities is based on discounted cash flow models incorporating observable option-adjusted spread features where necessary.  Foreign Government securities are categorized as Level 2.

Corporate debt – The fair value for corporate debt is based on regularly updated dealer quotes, secondary trading, and the new issue market incorporating observable option-adjusted spread features where necessary.  Corporate debt is categorized as Level 2.

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Residential mortgage-backed securities – Residential mortgage-backed securities include securities issued by the GSEs and the Government National Mortgage Association (GNMA), as well as private-label securities. The fair value of residential mortgage-backed securities is based on prices of similar securities and discounted cash flow analysis incorporating prepayment and default assumptions.  Residential mortgage-backed securities are categorized as Level 2.

Commercial mortgage-backed securities – The fair value of commercial mortgage-backed securities is based on prices of similar securities and discounted cash flow analysis incorporating prepayment and default assumptions.  Commercial mortgage-backed securities are categorized as Level 2.

Asset-backed securities – The fair value of asset-backed securities is based on prices of similar securities and discounted cash flow analysis incorporating prepayment and default assumptions. Asset-backed securities are generally categorized as Level 2. For certain securities, if cash flow or other security structure or market information is not available, the fair value may be based on broker quotes or benchmarked to an index.  In such instances, these asset-backed securities are generally categorized as Level 3.

State and municipal bonds – The fair value for state and municipal bonds is based on regularly updated trades, bid-wanted lists, and offerings from active market makers and brokers. Evaluations incorporate current market conditions, trading spreads, spread relationships and the slope of the yield curve, among others. Information is applied to bond sectors and individual bond evaluations are extrapolated.  Evaluation for distressed or non-performing bonds may be based on liquidation value or restructuring value.  State and municipal bonds are categorized as Level 2.

Short-term investments

Money market instruments – The fair value is based on unadjusted quoted prices that are readily and regularly available in active markets.  Money market instruments are categorized as Level 1.

Other short-term instruments – Other short-term instruments primarily include discounted and coupon bearing commercial paper as well as corporate securities purchased with maturity less than twelve months at time of purchase. Short term investments are carried at amortized cost which approximates fair market value or at fair market value utilizing regularly updated dealer or secondary trading quotes. Other short-term instruments are categorized as Level 2.

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Fair Value of Investments

The Company did not have any material assets measured at fair value on a non-recurring basis as of September 30, 2012 or at December 31, 2011. The following table summarizes the assets measured at fair value on a recurring basis and the source of the inputs in the determination of fair value as of September 30, 2012 and December 31, 2011:

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The Company did not have any securities priced using significant unobservable inputs (Level 3) as of September 30, 2012.  One security totaling $0.6 million was transferred from Level 3 to Level 2 during the third quarter of 2012 as quoted prices can now be supported by observable market data.  Quantitative information about the significant unobservable inputs used in the fair value measurement of Level 3 securities at September 30, 2012 and sensitivity to changes in unobservable inputs have not been disclosed in this Form 10-Q due to the immateriality of Level 3 securities.  The following table provides a reconciliation of the beginning and ending balances of these Level 3 bonds and the related gains and losses related to these assets during the three months and nine months ended September 30, 2012 and 2011, respectively.

7.  Loss Per Share ("EPS")

Basic and diluted EPS are based on the weighted-average daily number of shares outstanding.  In computing diluted EPS, only potential common shares that are dilutive – those that reduce EPS or increase loss per share – are included.  Exercises of options and unvested restricted stock are not assumed if the result would be antidilutive, such as when a loss from operations is reported.  For the three months and nine months ended September 30, 2012 and 2011, the Company reported a loss from operations and therefore had no dilutive effect of stock options and unvested restricted stock on the weighted-average shares outstanding.  The numerator used in both the basic EPS and diluted EPS calculation is the actual loss reported for the period represented.  For the three months and nine months ended September 30, 2012, options to purchase approximately 3,200 and 4,200 shares, respectively, of the Company's common stock were excluded from the calculation of EPS because they were antidilutive.  For the three months and nine months ended September 30, 2011, options to purchase approximately 8,000 and 8,500 shares, respectively, of the Company's common stock were excluded from the calculation of EPS because they were antidilutive.

 

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8.  Comprehensive Loss

Comprehensive loss consists of the net loss and other comprehensive income (loss).  For the Company, other comprehensive income (loss) is normally composed of the change in unrealized gains on available-for-sale securities, net of deferred income taxes.  Given the Company's previous substantial losses from operations, regulatory oversight of its operations, and the significant doubt regarding its ability to continue as a going concern, the Company may be unable to hold impaired assets for a sufficient time to recover their value.  Thus, any security with a fair value less than the book value at the balance sheet date is considered to be other-than-temporarily impaired and the loss is recognized as a realized loss in the Consolidated Statements of Comprehensive Loss.  For the three months and nine months ended September 30, 2012, the Company reported other comprehensive income of $1.9 million and $3.1 million, respectively.  For the same three month and nine month periods of 2012, the Company had a comprehensive loss of $31.4 million and $99.2 million, respectively.  For the three month and nine month periods ended September 30, 2011, the Company reported other comprehensive loss of $0.1 million and comprehensive income of $2.1 million, respectively.  The Company had comprehensive loss of $37.6 million and $44.7 million, respectively, for the three month and nine month periods ended September 30, 2011.

At September 30, 2012, the Company's accumulated other comprehensive income of $12.1 million was comprised of unrealized gains on investments of $28.7 million, offset by income tax liability of $10.1 million and a valuation allowance against deferred tax assets of $6.5 million.  At December 31, 2011, the Company's accumulated other comprehensive income of $9.0 million was comprised of unrealized gains on investments of $25.6 million, offset by income tax liability of $9.0 million and a valuation allowance against deferred tax assets of $7.6 million.

9.  Income Taxes

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Shareholders have approved a Tax Benefits Preservation Plan ("Plan") and amended the TGI certificate of incorporation to help protect its ability to recognize certain potential tax benefits in future periods from NOLs and tax credits, as well as any net operating losses that may be generated in future periods (the "Tax Benefits").  Section 382 of the Internal Revenue Code limits the ability of a company to take advantage of Tax Benefits when an ownership change occurs.  In general, an "ownership change" under Section 382 occurs if there is a cumulative percentage change in the Company's ownership by certain stockholders over a rolling three-year period.  The Plan is designed to reduce the likelihood that the Company will experience an ownership change.  In connection with the adoption of the Plan in 2010, the Company declared a dividend of one preferred stock purchase right ("Rights"), for each outstanding share of its common stock to holders of record on September 27, 2010.  Subject to certain exceptions, the Rights generally are not exercisable until certain stockholders increase their ownership in the Company in excess of certain percentages.

10. Subsequent Events

We are not aware of any significant events that occurred subsequent to the balance sheet date but prior to the filing of this report that would have a material impact on the Company's Consolidated Financial Statements and related disclosures except as previously disclosed.

 

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Management's Discussion and Analysis of Financial Condition and Results of Operations analyzes our consolidated financial condition, changes in financial position, and results of operations for the three months and nine month periods ended September 30, 2012 and 2011.  This discussion supplements Management's Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2011, and should be read in conjunction with the interim financial statements and notes contained herein.

Certain of the statements contained in this Quarterly Report on Form 10-Q are "forward-looking statements" and are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements include estimates and assumptions related to economic, competitive, regulatory, operational and legislative developments and typically are identified by use of terms such as "may," "will," "should," "could," "expect," "plan," "anticipate," "believe," "estimate," "predict," "potential," "continue" and similar words, although some forward-looking statements are expressed differently. These forward-looking statements are subject to change, uncertainty and circumstances that are, in many instances, beyond our control and they have been made based upon our current expectations and beliefs concerning future developments and their potential effect on us. Actual developments and their results could differ materially from those expected by us, depending on the outcome of a number of factors, including: the possibility that the Illinois Department of Insurance may take various actions regarding Triad if we do not operate our business in accordance with the revised financial and operating plan and the Corrective Orders, or for other reasons, including seeking receivership proceedings; our ability to operate our business in run-off and maintain a solvent run-off; our ability to continue as a going concern; the possibility of general economic and business conditions that are different than anticipated; legislative, regulatory, and other similar developments; changes in interest rates, employment rates, the housing market, the mortgage industry and the stock market; legal and other proceedings regarding modifications and refinancing of mortgages and/or foreclosure proceedings; the possibility that there will not be adequate interest in our common stock to ensure efficient pricing; and the relevant factors described in Item 1A, "Risk Factors" in our Annual Report on Form 10-K for the year ended December 31, 2011 and in the Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995 section below, as well as in other reports and statements that we file with the Securities and Exchange Commission (the "SEC").  Forward-looking statements are based upon our current expectations and beliefs concerning future events and we undertake no obligation to update or revise any forward-looking statements to reflect the impact of circumstances or events that arise after the date the forward-looking statements are made, except as required by the federal securities laws. Any forward-looking statements that are made are current only as of the date on which we filed this report.

Overview

Triad Guaranty Inc. ("TGI") is a holding company which, through its wholly-owned subsidiary, Triad Guaranty Insurance Corporation ("TGIC"), is a nationwide mortgage guaranty insurer pursuing a run-off of its existing in-force book of business.  The term "run-off" means continuing to service existing mortgage guaranty insurance policies but not writing any new policies.  Unless the context requires otherwise, references to "Triad" in this Quarterly Report on Form 10-Q refer to the operations of TGIC and its wholly-owned subsidiary, Triad Guaranty Assurance Corporation ("TGAC").  References to "we," "us," "our," and the "Company" refer collectively to the operations of TGI and Triad.

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TGIC is an Illinois-domiciled mortgage guaranty insurance company and TGAC is an Illinois-domiciled mortgage guaranty reinsurance company. The Illinois Department of Insurance (the "Insurance Department") is the primary regulator of both TGIC and TGAC.  The Illinois Insurance Code grants broad powers to the Insurance Department and its director (collectively, the "Department") to enforce rules or exercise discretion over almost all significant aspects of our insurance business. We ceased issuing new commitments for mortgage guaranty insurance coverage in 2008 and are operating our business in run-off under two Corrective Orders issued by the Department.  As noted above and throughout this report, the term "run-off" means continuing to service existing policies, but writing no new mortgage guaranty insurance policies.  Servicing existing policies during run-off includes:

·	billing and collecting premiums on policies that remain in force;

·	working with borrowers in default to remedy or cure the default and/or mitigate our loss;

·	reviewing policies for the existence of misrepresentation, fraud, or non-compliance with stated programs; and

·	settling all legitimate filed claims per the provisions of the policies and the two Corrective Orders issued by the Department.

The term "settled," as used in this report in the context of the payment of a claim, refers to the satisfaction of Triad's obligations following the submission of valid claims by our policyholders. As required by the second Corrective Order, effective on and after June 1, 2009, valid claims are settled by a combination of 60% in cash and 40% in the form of a deferred payment obligation ("DPO"). The Corrective Orders, among other things, allow management to continue to operate Triad under the close supervision of the Department, include restrictions on the distribution of dividends or interest on surplus notes payable to TGI by Triad, and include restrictions on the payment of claims.

 

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Business Summary

We have historically provided Primary and Modified Pool mortgage guaranty insurance coverage on U.S. residential mortgage loans.  We classify a policy as Primary insurance when the policy is not part of a structured bulk transaction that includes an aggregate stop-loss limit applied to the entire group of loans.  We classify all other insurance as Modified Pool insurance. Policies insured as part of a Modified Pool transaction have individual coverage but there is an aggregate stop-loss limit applied to the entire group of insured loans.

Our insurance remains effective until one of the following events occurs:  the policy is cancelled at the insured's request; we terminate the policy for non-payment of premium; the policy defaults and we satisfy our obligations under the insurance contract; or we rescind or deny coverage under the policy for violations of provisions of a master policy. Additionally, coverage may be cancelled on certain Modified Pool transactions if pre-determined aggregate stop loss limits are met, or if coverage is reduced to a de minimus amount of the initial amount insured or, for some contracts, ten years from the date of the contract.

Persistency, which measures the percentage of insurance in force remaining from one-year prior, is an important metric in understanding our future premium revenue. The longer a policy remains on our books, or "persists", the greater the amount of total premium revenue we will earn from the policy.

In run-off, our revenues principally consist of earned renewal premiums, which are reported net of reinsurance premiums ceded to captive reinsurers and premium refunds paid or accrued related primarily to rescissions, and investment income. We also realize investment gains and investment losses on the sale and impairment of securities, with the net gain or loss reported as a component of revenue.

In run-off, our expenses consist primarily of: settled claims (including loss adjustment expenses) net of any losses ceded to captive reinsurers; changes in reserves for estimated future claim payments on loans that are currently in default (including new defaults that are reported during the period) net of any reserves ceded to captive reinsurers; general and administrative costs of servicing existing policies; other general business expenses; and interest expense on the DPO.

As we are operating in run-off and are issuing no new insurance commitments, our future results of operations largely depend on the amount of future premium that we earn less the amount of losses that we incur each period on the new defaults reported to us. In addition, our results may be significantly impacted by the favorable or adverse development of our loss reserves. Our results from operations will benefit if we are able to settle our loss reserves at a lesser amount than that reported on our balance sheet through loss mitigation, litigation and settlements with servicers. Conversely, our results from operations will be negatively impacted if the settled losses are greater than the loss reserves provided.  Our results of operations also depend on a number of other factors, many of which are not under our control. These factors include:

·	the conditions of the housing, mortgage and capital markets that have a direct impact on default rates, loss mitigation efforts, cure rates, and ultimately, the amount of claims settled;

·	the overall general state of the economy and job market;

·	persistency levels on our remaining insurance in force; and

·	operating efficiencies.

Our results of operations in run-off could also be impacted by Federal government and private initiatives to limit foreclosures through loan modifications, refinancing mortgages at lower interest rates, or debt forgiveness.  See the discussion below for further details on these initiatives. Lastly, our results of operations in run-off could be materially affected by our ability to recognize benefits from our NOL carryforwards.

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Accounting Principles

To better comprehend our financial position and results of operations, it is important to understand the difference between accounting principles generally accepted in the United States of America ("GAAP") and statutory accounting principles ("SAP") applicable to insurance companies and how we use these accounting principles.

As an insurance company, Triad is required to file financial statements prepared in accordance with SAP with the Department as well as the insurance departments of the states in which it conducts business. The financial statements for Triad that are provided to the Department and that form the basis for our corrective plan required by the Corrective Orders are prepared in accordance with SAP as set forth in the Illinois Insurance Code or prescribed by the Department.  However, the Company prepares its financial statements presented in this Quarterly Report on Form 10-Q and in our other SEC filings in conformity with GAAP.  The primary difference between GAAP and SAP for Triad at September 30, 2012 was the reporting requirements relating to the establishment of the DPO stipulated in the second Corrective Order, which is described below.

A deficit in assets occurs when recorded liabilities exceed recorded assets in financial statements prepared under GAAP.  A deficiency in policyholders' surplus occurs when recorded liabilities exceed recorded assets in financial statements prepared under SAP. A deficit in assets at any particular point in time under GAAP is not necessarily a measure of insolvency. However, we believe that if Triad were to report a deficiency in policyholders' surplus under SAP for an extended period of time, Illinois law may require the Department to seek receivership of Triad, which could compel TGI to institute a proceeding seeking relief from creditors under U.S. bankruptcy laws, or otherwise consider dissolution of the Company. The second Corrective Order was designed in part to help Triad maintain its policyholders' surplus.

Corrective Orders

Triad has entered into two Corrective Orders with the Department as detailed below and in the Company's Annual Report on Form 10-K for the year ended December 31, 2011. Among other things, the Corrective Orders:

·	Require oversight by the Department on substantially all operating matters;

·	Prohibit stockholder dividends from Triad to TGI without the prior approval of the Department;

·	Prohibit the accrual of interest and the payment of interest and principal on Triad's surplus note to TGI without the prior approval of the Department;

·	Restrict Triad from making any payments or entering into any transaction that involves the transfer of assets to, or liabilities from, any affiliated parties without the prior approval of the Department;

·	Require Triad to obtain prior written approval from the Department before entering into certain transactions with unaffiliated parties;

·	Require that all valid claims under Triad's mortgage guaranty insurance policies are settled 60% in cash and 40% by recording a DPO;

·	Require the accrual of simple interest on the DPO at the same average net rate earned by Triad's investment portfolio; and

·	Require that loss reserves in financial statements prepared in accordance with SAP be established to reflect the cash portion of the estimated claim settlement but not the DPO.

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The DPO is an interest-bearing subordinated obligation of Triad with no stated repayment terms.  The second Corrective Order requires that Triad hold assets to support the DPO liability in a separate account pursuant to a custodial arrangement.  As previously mentioned, Triad is currently not in compliance with this provision of the second Corrective Order.  See "Pending Regulatory Matters" above for more information.

 

The recording of a DPO does not impact reported settled losses as we continue to report the entire amount of a claim in our statements of comprehensive loss under both bases of accounting.  The accounting treatment for the recording of DPOs on our balance sheet on a SAP basis is similar to a surplus note that is reported as a component of statutory surplus, which serves to increase reported statutory surplus.  However, in our financial statements prepared in accordance with GAAP included in this report, the DPOs and related accrued interest are reported as a liability.  At September 30, 2012, the cumulative effect of the DPO requirement on statutory policyholders' surplus, including the impact of establishing loss reserves at anticipated cash payment rather than the estimated full claim amount, was to increase statutory policyholders' surplus by $1.1 billion over the amount that would have been reported absent the second Corrective Order.  The cumulative increase to statutory policyholders' surplus of the DPO requirement was $967.5 million at December 31, 2011.  There was no such impact to loss reserves or stockholders' deficit calculated on a GAAP basis which is the primary reason for the reported deficit in assets.  Any repayment of the DPO or the associated accrued interest is dependent on the financial condition and future prospects of Triad and is subject to the approval of the Department.

The second Corrective Order provides financial thresholds, specifically regarding the statutory risk-to-capital ratio and the level of statutory policyholders' surplus that, if met, may indicate that the Department should reduce the DPO percentage and/or require distributions to DPO holders.  In January 2012, the Department notified Triad that as of December 31, 2011, based upon Triad's surplus position, risk-to-capital ratio and the continued economic uncertainty, the Department determined that no change to the DPO percentage was in order nor would it be appropriate for Triad to make a distribution to the DPO holders.

Failure to comply with the provisions of the Corrective Orders or any other violation of the Illinois Insurance Code may result in the imposition of fines or penalties or subject Triad to further legal proceedings, including the institution by the Department of receivership proceedings for the conservation, rehabilitation, or liquidation of Triad.  Any such actions would likely lead TGI to institute a proceeding seeking relief from creditors under U.S. bankruptcy laws, or otherwise consider dissolution of the Company.  See Item 1A, "Risk Factors" in our Annual Report on Form 10-K for the year ended December 31, 2011 for more information.

Triad is also subject to comprehensive regulation by the insurance departments of the various other states in which it is licensed to transact business.  Currently, the insurance departments of the other states have been working with the Department in the administration and oversight of the Corrective Orders.

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Going Concern

Foreclosure Prevention Initiatives and Moratoriums

Several programs have been initiated by the federal government, the GSEs, and certain lenders that are, in general, designed to prevent foreclosures and provide relief to homeowners. These programs may involve modifications to the original terms of existing mortgages or their complete refinancing.  These programs seek to provide borrowers a more affordable mortgage by modifying the interest rate, extending the term of the mortgage or, in limited cases, reducing the principal amount of the mortgage. We are active participants in many of these programs, including government-initiated programs such as the Home Affordable Modification Program ("HAMP") and the Home Affordable Refinance Program ("HARP").

HAMP provides incentives to borrowers, servicers, and lenders to modify loans that are currently in default. HAMP and other such programs have been responsible for a large percentage of our cures since 2009. The number of policies cured under these programs declined in 2011 from levels experienced in 2010; however, recent changes to these programs have proven beneficial.  HAMP was scheduled to expire at the end of 2012, but the U.S. government has extended the program until December 2013.

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A number of the borrowers that have completed the trial modification period have subsequently re-defaulted and we believe the number of borrowers that re-default will increase in the future, especially if the economic recovery stalls or moves slowly.  This could be exacerbated by additional deterioration in the housing market or economy in general.  The ultimate impact of HAMP and other modification programs is dependent on the number of borrowers that successfully modify their loans and do not re-default. Currently, we are unable to estimate with any degree of precision the number of policies that will ultimately cure and not re-default and are, therefore, unable to estimate the ultimate impact of these programs on our results of operations and financial condition.  If HAMP or similar programs prove to be effective in preventing ultimate foreclosure, future settled claim activity could be reduced.

If a loan is modified as part of one of these programs, the previously reported default would be cured, but we would maintain insurance on the loan and would be subject to the same ongoing risk if the policy were to re-default.  Policies that re-default under these programs may ultimately result in losses that are greater than the loss that would have occurred if the policy were never modified.  However, we do not provide loss reserves to account for the potential for re-default.  These programs could adversely affect us to the degree that borrowers who otherwise could make their mortgage payment choose to default in an attempt to become eligible for modification.

HARP was launched in 2009 and revised in the third quarter of 2011.  This program is designed to provide a borrower who is current on all mortgage payments with the opportunity to take advantage of existing lower interest rates through a refinancing that would make the loan more affordable.  We do not expect the revised HARP program will have a significant impact on our short-term results because: (i) these loans must not be in default to qualify; and (ii) we would continue to provide mortgage insurance on the refinanced loan.

Foreclosure moratoriums typically serve to temporarily reduce our claims settled because the completion of a valid foreclosure is a requirement for the filing of a claim for loss. However, such programs may lead to greater ultimate claim costs due to the accrual of interest and other expenses. While moratoriums have delayed our claims settled in recent years and increased the time a policy remains in our default inventory and may continue to do so, we do not expect a significant direct impact on our results of operations or financial condition from foreclosure moratoriums.

In February 2012, the federal government and state attorneys general reached a $25 billion settlement agreement with five of the nation's largest banks regarding claims that alleged, among other things, improper foreclosure practices.  The funds generally will be used for principal reductions, refinancing underwater mortgages, forbearance and short sales, and foreclosure prevention programs.  The banks have three years to implement the settlement agreement.  A great deal of uncertainty currently remains over how the program will be implemented as well as borrower eligibility, but currently we do not believe the settlement will have a meaningful impact on our future results of operations or financial condition.

See Item 1A, "Risk Factors" in our Annual Report on Form 10-K for the year ended December 31, 2011 for more information on the risks and uncertainties associated with foreclosure moratoriums.

 

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Consolidated Results of Operations

Following is selected financial information for the three months and nine months ended September 30, 2012 and 2011:

The financial results for the three months and nine months ended September 30, 2012 as compared to the same period of 2011 were affected by the following:

·

A significant decline in earned premium during the third quarter of 2012 compared to the respective period of 2011 due to a 22% decline in average insurance in force coupled with a substantial negative impact of premium refunds in the 2012 third quarter.  Additionally, earned premium in the 2011 third quarter benefitted from a $9.3 million accrual for the net present value of the future premiums for Modified Pool transactions where contractual aggregate stop-loss limits in specific contracts were reached on a settled basis compared to only a $0.8 million accrual in the 2012 third quarter for such contracts.

·	A decline in investment income for both comparable periods due to declines in average invested assets and lower realized yields.

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A significant decrease in net losses and loss adjustment expenses ("LAE") during the 2012 third quarter  compared to the third quarter of 2011, primarily due to a smaller impact from new default activity. The increase in net losses and LAE for the first nine months of 2012 compared to the one year prior period was primarily due to reserve factor changes.

·	An increase in other operating expenses in the third quarter of 2012 and first nine months of 2012 primarily due to increases in the reserve for expected contract underwriting remedies.

We describe our results of operations in greater detail in the discussion that follows.  The information is presented in four sub-headings:  Production; Insurance and Risk in Force; Revenues; and Losses and Expenses.

Production

On July 15, 2008, we ceased issuing commitments for mortgage insurance, only issuing coverage to borrowers for which we had made a commitment as of that date.  We have had no material production since 2008.

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Insurance and Risk in Force

The term "Insurance in force" is described as the total principal balance of our insured loans. Net risk in force is computed by applying the various percentage settlement options to the insurance in force amounts, adjusted by risk ceded under reinsurance agreements on Primary coverage and applicable stop-loss limits and deductibles on Modified Pool coverage, but before accounting for carried loss reserves.   The following table provides detail on our direct insurance in force at September 30, 2012 and 2011:

The decline in Primary insurance in force over the twelve month period ended September 30, 2012 is due to cancellation of insurance coverage, which includes cancellations resulting from claim settlement and rescission activity.  The decline in Modified Pool insurance in force for the same period was also affected by the termination of a number of Modified Pool transactions where pre-determined aggregate stop loss limits in the contracts were met on a settled basis.

Primary insurance persistency was 82.1% at September 30, 2012 compared to 82.3% at September 30, 2011. Modified Pool insurance persistency decreased to 62.5% at September 30, 2012 compared to 67.0% at September 30, 2011. Modified Pool persistency is subject to significant changes between periods due primarily to the timing and size of Modified Pool transactions reaching their pre-determined aggregate stop loss limits on a settled basis.  We believe our persistency has benefited from the temporary delays in foreclosures as well as the inability of many borrowers on loans that we have insured to sell or refinance existing homes due to the decline in home prices and stricter underwriting standards.

A portion of our Modified Pool contracts contain provisions that terminate both the coverage and the contract when cumulative settled losses reach the stop loss limit.  No future premium is received following the termination of these Modified Pool contracts.  During the first nine months of 2012, approximately $152 million of Modified Pool insurance in force under this type of contract was terminated compared to approximately $390 million during the same period of 2011.

The majority of our Modified Pool contracts do not terminate when settled losses reach the stop loss limit and premiums will continue to be collected until such time that the remaining insurance in force is reduced to a de minimus amount or, in some cases, ten years from the date of the contract.  For these types of contracts, we recognize the net present value of the estimated future premium in the period during which our settled losses reach the stop loss limit.  During the first nine months of 2012, approximately $612 million of Modified Pool insurance in force under this type of contract was terminated compared to approximately $1.5 billion during the same period of 2011.  For both types of Modified Pool contracts, affected policies are excluded from in force statistics once the contractual stop loss limit is met on a settled basis.  We expect that other Modified Pool transactions will reach their contractual stop loss limits on a settled basis which will further accelerate the decline of our Modified Pool insurance in force.

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Approximately 61% of our Modified Pool insurance in force was originated from 2005 through 2007.  Given the adverse development of our Modified Pool insurance originated in these years, the majority of these transactions have already reached the stop loss limit on an incurred basis.  As the following table indicates, under our Modified Pool contracts, we have limited loss exposure for future defaults, or changes in loss reserves on existing defaults, from contracts originated from 2005 through 2007.  The majority of our exposure on Modified Pool insurance is with transactions originated in 2004 and prior years and, given the performance to date for these policy years, we expect losses from Modified Pool insurance to have significantly less bearing on our future results compared to our Primary business.

Total net risk in force was $5.7 billion at September 30, 2012 compared to $6.9 billion at September 30, 2011.  Primary insurance accounted for approximately 95% of our net risk in force at September 30, 2012 compared to 94% at September 30, 2011.  The following table provides detail on our Primary risk in force, net of risk ceded to captives.

The percentage of our Primary insurance in force subject to captive reinsurance arrangements was 9.9% at September 30, 2012 and assets held in trusts supporting the reinsured risk was $36.3 million.  Certain remaining captive reinsurance agreements have trust balances below the reserves ceded under the contracts.  In those cases, the net reserve credit that we recognize in our financial statements is limited to the trust balance.  Given this limitation, as well as the decline in insurance in force subject to captive reinsurance, we expect to only receive limited benefits in future periods from these agreements.

At September 30, 2012, approximately 17% of our gross Primary risk in force was comprised of coverage on loans with the potential for negative amortization ("pay-option ARM") and interest only loans.  An inherent risk in these types of loan products is the impact of the scheduled milestone in which the borrower must begin making amortizing payments, which can be substantially greater than the minimum payments required before the milestone is met.  An additional risk to a pay-option ARM loan is that the payment being made may be less than the amount of interest accruing, creating negative amortization on the outstanding principal of the loan.  The majority of our pay-option ARM loan portfolio has accumulated negative amortization and we believe these pay-option ARM loans have been or will be subject to significant payment shock, which increases our risk of loss.

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At September 30, 2012, approximately 15% of our gross Primary risk in force is comprised of coverage on "Alt-A" loans.  We define Alt-A loans as loans that have been underwritten with reduced or no documentation verifying the borrower's income, assets, or employment and where the borrower has a FICO score greater than 619.  Due in part to depressed conditions in the housing markets, the Alt-A loans, pay-option ARM loans, and interest-only loans have, as a group, performed significantly worse than the remaining prime fixed rate loans.

Business originated in 2005, 2006, and 2007 comprise the majority of our risk in force. In general, policies originated during these years have exhibited higher default rates and claim rates than preceding vintage years. In addition, these policy years have significantly higher amounts of average risk per policy than policies originated prior to 2005.  For additional information regarding these vintage years, see "Losses and Expenses," below.

Revenues

A summary of the individual components of our revenue for the third quarter and first nine months of 2012 and 2011 follows:

The decrease in direct premium written before the impact of refunds was primarily due to the decline in insurance in force over the previous twelve months.  Additionally, we accrue the net present value of the estimated premium stream for certain Modified Pool transactions where we continue to receive premium income once the transaction reaches its stop loss on a settled basis.  As a result of such Modified Pool transactions reaching their respective stop loss limit on a paid basis and the establishment of the accrual, reported earned premium during the third quarter of 2011 increased by $9.3 million compared to an increase of only $0.8 million during the third quarter of 2012.

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Premium refunds, primarily related to rescission activity, include cash premiums refunded as well as the change in the accrual for expected premium refunds.  Cash premiums refunded is dependent on the number of policies rescinded and the amount previously collected while the accrual for expected premium refunds is dependent on our future expectations for these items.  Rescission activity was significant in the third quarter of 2012 and resulted in a large amount of premium refunds.  Rescission activity in the third quarter of 2012 was concentrated with a specific originator whose policies in general have higher average loan balances and premium rates, which contributed to this increase. The accrual we have established for expected premium refunds, which is reported in "Accrued expenses and other liabilities" on our Consolidated Balance Sheets, was $13.7 million at September 30, 2012, down from $19.5 million at June 30, 2012 and $30.9 million at September 30, 2011. The impact of premium refunds on our financial statements going forward will be determined primarily by our expectations for future cash premium refunds and the number of policies for which we retain the right to rescind coverage.  We expect rescissions and cash premium refunds to continue to be strong in the fourth quarter of 2012 and then decline significantly during 2013.

Ceded premium written is comprised of premiums written under excess of loss reinsurance treaties with captive reinsurers. Ceded premium continues to decline as the amount of insurance in force subject to captive reinsurance declines. Ceded premium in the third quarter of 2012 declined by 26% when compared to the one year-prior period and 6% on a sequential basis.

Net investment income declined in the third quarter and first nine months of 2012 compared to the respective periods in 2011 primarily due to a decline in invested assets as well as a decline in investment yield.  We expect invested assets to continue to decline for the foreseeable future as we anticipate funding our deficit in operating cash flow with the proceeds from the maturity and sale of these assets. Settlements of certain liabilities could result in large one-time payments which would hasten the decline in invested assets.  For further discussion, see "Investment Portfolio."

Losses and Expenses

A summary of the significant individual components of losses and expenses for the three month and nine month periods ended September 30, 2012 and 2011 follows:

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Net losses and LAE are comprised of settled claims, LAE, and the change in the loss and LAE reserve during the period. The decrease in net losses and LAE during the third quarter of 2012 compared to the respective period of 2011 was due to a lower amount of new risk in default. The increase in net losses and LAE in the first nine months of 2012 compared to the respective period of 2011 was primarily due to reserve factor changes made based on loss development trends and future expectations, offset somewhat by lower amounts of new risk in default during the first nine months of 2012 compared to the respective period of 2011.  For the first nine months of 2011, incurred losses were reduced by approximately $30.5 million due to reserve factor changes, whereas for the same period of 2012, changes to reserve factors increased incurred losses by approximately $11.6 million.  The increase in incurred losses in the first nine months of 2012 due to reserve factor changes primarily resulted from a decrease in the expected rescission factor for policies being investigated for possible underwriting violations.

The following table presents a roll-forward of our Primary risk in default for the three month and nine month periods ended September 30, 2012 and 2011.  Risk in default includes the risk in force for all reported delinquencies that are in excess of two payments in arrears at the reporting date and the risk in force for all reported delinquencies that were previously in excess of two payments in arrears that have not been brought current.  For the three month and nine month periods ended September 30, 2012, Primary new risk in default has declined considerably compared to the comparable prior-year periods.

The cure rate (cured risk in default as a percentage of beginning risk in default) for Primary risk in default  increased to 7.7% for the third quarter of 2012 compared to 7.1% in both the second quarter of 2012 and in the third quarter of 2011. Cures result when a delinquent borrower makes all past due mortgage payments. Cures are most likely to occur while the default is in its early stage and the borrower has missed only a few payments.  In general, our expectation for a cure decreases as the underlying mortgage becomes further delinquent.  The average age of the total default inventory has increased over the past year due in part to continued delays in foreclosure activity and other factors slowing settled claim activity.  At September 30, 2012, the weighted average number of payments missed on loans in default was 19.6 compared to 16.7 payments missed at September 30, 2011.

 

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The following table presents the distribution of Primary risk in default at September 30, 2012 and 2011 by the number of payments for which the borrower is in default.  The most significant increase has been with policies that have missed more than 30 payments.

HAMP and other lender loan modification programs have contributed to cure activity, including cures on policies that have been in default for more than 12 months.  However, the benefit we have received from these programs has generally declined as the number of policies eligible for the programs has declined.

Rescission activity continues to mitigate our level of loss reserves and settled losses. During the third quarter of 2012, we rescinded coverage on Primary policies with $65.8 million of risk in force compared to $51.4 million of risk in force during the second quarter of 2012 and $52.3 million in the third quarter of 2011.  The rescission rate during the third quarter of 2012 was consistent with our expectations, although the level of activity increased during the quarter, which resulted in the larger amount of risk being rescinded.  We expect rescission activity and the resulting impact on our level of incurred losses to continue in the fourth quarter of 2012 and decline significantly in 2013 as we complete the current investigations.  Additionally, some of the recent rescission activity has come from Modified Pool deals where the stop loss is expected to be reached over the next year.  We believe the majority of the rescinded risk in default would have ultimately resulted in settled claims.  See Item 1A, "Risk Factors" in our Annual Report on Form 10-K for the year ended December 31, 2011 for risks and uncertainties associated with rescission activity.

The following table details the amount of Primary risk in default and the Primary reserve balance as a percentage of risk in default at September 30, 2012 and 2011.  Primarily due to the increase in the average age of the default inventory and a lower percentage of risk in default that is projected to be rescinded in the future, the gross case reserves, net of expected rescissions, expressed as a percentage of gross risk in default has increased to 66% at September 30, 2012 compared to 57% one-year prior.  The table also provides the impact of the rescission factor, which is a component of the frequency factor utilized in the reserve model, on gross case reserves at the respective period end, and illustrates the expected decline in rescission activity compared to previous levels.

 

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