NMI Holdings, Inc. Q2 FY2020 Earnings Call

Thank you for joining us for the NMI Holdings Inc. Second Quarter 2020 Earnings Conference Call. I would now like to hand it over to Mr. John Swenson. Please proceed.

Thank you, Cory. Good afternoon and welcome to the 2020 second quarter conference call for National MI. I’m John Swenson, Vice President of Investor Relations and Treasury. Joining us on the call today are Brad Shuster, Executive Chairman; Claudia Merkle, CEO; Adam Pollitzer, our Chief Financial Officer; and Julie Norberg, our Controller. Financial results for the quarter were released after the close today. The press release may be accessed on NMI’s website located at www.nationalmi.com under the Investors tab. During the course of this call, we may make comments about our expectations for the future. Actual results could differ materially from those contained in these forward-looking statements. Additional information about the factors that could cause actual results or trends to differ materially from those discussed on the call can be found on our website or through our regulatory filings with the SEC. If and to the extent the company makes forward-looking statements, we do not undertake any obligation to update those statements in the future in light of subsequent developments. Further, no one should rely on the fact that the guidance of such statements is current at any time other than the time of this call. Also note that on this call, we refer to certain non-GAAP measures; in today’s press release and on our website, we’ve provided a reconciliation of these measures to the most comparable measures under GAAP. Now I’ll turn the call over to Brad.

Thank you, John, and good afternoon, everyone. On today’s call, we’ll review our second quarter results, and share an update on how the COVID crisis is impacting our business performance and financial position, as well as the broader housing and mortgage insurance markets. We are now five months into this pandemic, and while we had hoped to see a rapid containment of the virus and quick rebound in economic activity, we planned from the start for a more protracted downturn and uncertain recovery. We built National MI to be a credible and sustainable counterparty through all market cycles. From day one, we focused on building a durable franchise in a risk responsible manner. We have worked hard to establish a comprehensive credit risk management framework and in doing so, we have built the highest quality insured portfolio in the mortgage insurance industry. Well before this crisis emerged we were using individual risk underwriting and granular Rate GPS pricing to target a higher quality mix of business and had sourced and secured comprehensive reinsurance protection on our in-force portfolio. Alongside our credit risk management efforts, we built a strong balance sheet foundation, we have been conservative in our investment portfolio and worked hard to establish a robust liquidity position. We have flexible access across a broad range of capital and reinsurance markets and a significant regulatory funding cushion. Over the last two months, we have taken steps to further strengthen this foundation, raising nearly $1 billion of debt, equity and ILN capital and securing additional reinsurance protection against adverse development in our insured portfolio. Our ability to raise so much capital in such a short period of time across multiple markets is a direct function of the strength and durability of the National MI franchise. Our broadly conservative stance heading into the crisis and the recent success we’ve had, we’ve achieved in the capital and reinsurance markets positions us to continue supporting our lenders, their borrowers and the overall housing market through the COVID crisis and to fully capitalize on a significant new business opportunity that has now emerged. We are encouraged by the resiliency we see in the housing market, demand is robust, house prices continue to show strength nationally, and record low interest rates are giving more Americans a chance to access home ownership, at a time when it’s most critical. Policy efforts are also playing an important and stabilizing role. We fully endorse the various forbearance, foreclosure moratorium and other assistance programs designed to help bridge borrowers past this point of acute stress and ensure they are able to remain in their homes and resume their lives with limited interruption, once the crisis has passed. Home ownership is essential, more so today than ever before. People need shelter in order to shelter in place and allowing borrowers who, through no fault of their own, are facing real strain to stay in their homes and avoid foreclosure is the right social policy. It will also help speed the ultimate pace of economic recovery. We encourage policymakers to maintain their focus and offer continued support as needed to carry homeowners through this crisis. In late June, the FHFA and GSEs updated PMIERs and clarified that loans subject to a COVID related forbearance program will benefit from a permanent risk-based haircut for the duration of the forbearance and subsequent repayment plan or trial modification periods. We were pleased with the update and the FHFA and GSEs’ recognition of the unique nature of this crisis. This change enhances the mortgage insurance industry’s ability to support existing borrowers through the duration of this stress and to continue serving new borrowers at a point of increased need. With that, let me turn it over to Claudia.

Thank you, Brad. I am very satisfied with how our team and business have performed during the COVID crisis. From the beginning, we prioritized the health and safety of our employees while ensuring that we could effectively support our lenders and their borrowers. We acted quickly to adjust our risk-based pricing and improve our underwriting guidelines to address the increased market uncertainty, which has strengthened our capital profile and reinsurance program, ensuring our solid funding and risk positions. Our GAAP net income for the quarter was $26.8 million, or $0.36 per diluted share, and our adjusted net income was $29.7 million, or $0.40 per diluted share. The GAAP return on equity for the quarter was 9.6%, and the adjusted ROE was 10.7%. We achieved record second quarter new insurance written of $13.1 billion, marking a 16% increase from the first quarter and an 8% rise compared to the second quarter of 2019. We have also started the third quarter strongly, writing nearly $6 billion in new insurance written in July. The new business environment is exceptionally robust, with the COVID crisis driving a behavioral shift that we anticipate will lead to sustained growth in purchase demand. More people are relocating from densely populated urban areas to suburban communities where social distancing is easier. Shelter-in-place mandates are highlighting the importance of home and sparking increased interest from first-time homebuyers. Record low interest rates are further enhancing affordability and attracting more buyers to the market. This unprecedented demand is significantly surpassing supply, resulting in continued appreciation of house prices and resilience in the housing market, despite the overall macroeconomic challenges posed by the COVID crisis. Our volume is at all-time highs, and we have a strong pipeline moving forward. We are experiencing a significant increase in new business demand, while pricing remains robust, and the risk profile of our new production is the best we have ever encountered. Lenders are increasingly turning to us to assist their borrowers during this challenging period and to manage their record origination volumes. In the second quarter, we onboarded 25 new lenders, and we now work with a diverse group of over 1,100 high-quality originators. Our sales team is signing new accounts and deepening our market presence, all while operating remotely. We see a genuine opportunity to support our lenders and their borrowers when they need us most, which in turn allows us to expand our reach in the market. Our company is built to thrive in all cycles. The steps we have taken to create a durable and profitable franchise—such as recruiting and retaining top talent, fostering the right culture, engaging customers in a consultative manner, and effectively managing risk, expenses, and capital—have positioned us to lead during this period of stress. Our strong position heading into this crisis has enabled us to remain entirely focused on our customers. We have maintained consistency in our sales messaging, pricing delivery through Rate GPS, and our underwriting responsiveness and operational readiness. We are operating as usual, which is a positive highlight for our customers amidst widespread uncertainty and change. Our recent capital and reinsurance efforts reinforce this perspective. Customers recognize our successes as a testament to our discipline, consistency, and future capabilities. In this environment, our achievements communicate a strong message that helps us accelerate the ongoing development of our customer franchise. We have discussed extensively the digital transformation of the mortgage landscape and the advantages provided by our modern, scalable IT platform. At the end of March, we established a long-term IT services partnership with Tata Consultancy Services, a leading global IT provider with significant experience in the mortgage market. Under this agreement, we are consolidating various IT functions previously handled by our internal team and multiple third-party vendors into a single partnership. We believe our collaboration with TCS will further strengthen our IT capabilities while also allowing us to realize substantial cost savings over the contract's duration. We project savings of $100 million over the next seven years while enhancing the IT experience for our internal and external users. Before handing it over to Adam, I want to express how proud I am that National MI has been recognized as a Great Place to Work for the fifth consecutive year. Great Place to Work is a global authority on workplace culture, employee experience, and leadership, partnering with Fortune magazine to compile the annual Fortune 100 Best Companies to Work For list. We believe that the quality of our team and the culture we have fostered provide us with competitive advantages, and it is truly rewarding to be acknowledged for these strengths again. Now, I’ll turn it over to Adam.

Thank you, Claudia. We delivered strong financial results in the second quarter in the face of unprecedented macro dislocation. We generated $13.1 billion of NIW in the quarter and reported primary insurance-in-force of $98.9 billion at June 30th. Net premiums earned for the quarter were $98.9 million. Adjusted net income was $29.7 million or $0.40 per diluted share, and adjusted return on equity was 10.7%. Total NIW of $13.1 billion included $11.9 billion of monthly production. Refinancing originations represented 41% of our volume in the quarter, up from 29% in the first quarter. Our mix of refinancing volume declined to 30% in July, as purchase origination activity continued to accelerate. As Claudia mentioned, the new business environment is exceptionally strong. Our unit economics on new production are up and capital demands are down, given how high quality risk is scored under the PMIERs framework. Taken together, expected risk-adjusted returns on new business are trending above our mid-teens long-term target. Equally as important, we expect our recent production will be highly persistent, given the record low interest rate environment, helping to build embedded value and seed our future financial results. Primary insurance-in-force was $98.9 billion compared to $98.5 billion at the end of the first quarter. While record low interest rates have helped spur exceptionally strong new business volume and contributed to the resiliency of the overall housing market, they’ve also driven a significant increase in refinancing activity and portfolio turnover. 12 month persistency in the primary portfolio was 64% at June 30th. We expect persistency will remain low in the near-term given the outlook for interest rates. Over time, however, we expect portfolio turnover will slow and persistency will rebound, as the business we’re writing in the current rate environment stays on our books for an extended period. Net premiums earned in the second quarter were $98.9 million, including $15.5 million from the cancellation of single premium policies. Reported yield for the quarter was 40 basis points compared to 41 basis points in the first quarter. Our premiums earned for the quarter reflect a decrease in the profit commission received under our quota share reinsurance treaties; our profit commission declined, as we ceded increased losses to our reinsurance partners. This is exactly how reinsurance coverage is designed to work; in a period of increased stress, we see that increasing amount of losses and required regulatory capital to our reinsurers. While this temporarily reduces our profit commission, it yields a directly offsetting benefit to our claims expense and additional benefits to our PMIERs and state regulatory capital positions. We also continue to receive our ceding commission in full without any reduction for loss experience. Investment income was $7.1 million in the second quarter compared to $8.1 million in the first quarter. Investment income declined modestly in the quarter, as we prioritized liquidity and increased our cash and equivalent position in late March and early April at the onset of the COVID crisis. We’ve since redeployed much of our excess liquidity position and expect net investment income to rebound in future periods. Underwriting and operating expenses were $30.4 million compared to $32.3 million in the first quarter. Expenses in the second quarter include $152,000 of cost incurred in connection with our recently completed ILN offering. We expect an additional $1.8 million of ILN-related transaction costs to come through in the third quarter. Excluding ILN-related transaction costs, adjusted underwriting and operating expenses were $30.2 million, our GAAP expense ratio was 30.7% and our adjusted expense ratio was 30.5% for the quarter, down from 32.2% in the first quarter. Our new long-term IT services agreement with TCS is expected to drive approximately $100 million of savings over the next seven years. In connection with the agreement, we will be streamlining and consolidating a range of our third-party vendor relationships under TCS and have successfully transitioned 50 of our full-time IT employees over to the TCS platform. Our expected cash savings from the TCS relationship will begin to emerge immediately. However, GAAP accounting treatment for the contract will yield an increasing income statement benefit as we progress through the seven-year term. Overall, we expect that our arrangement with TCS will allow us to maintain our technology lead and competitive advantage in an increasingly cost-efficient manner. We had 10,816 defaults in our primary portfolio at the end of the second quarter compared to 1,449 at the end of the first quarter. The significant increase in our default population is directly attributable to the COVID outbreak, as borrowers have faced increasing challenges and chosen to access the forbearance program for federally backed loans certified under the CARES Act and other similar assistance programs made available by private lenders. At quarter end, 28,555 or 7.7% of the loans we insured in our primary portfolio were enrolled in a forbearance program, including 9,502 of the loans in our default population, 6,752 loans that had missed at least one payment but not progressed into default status, and 12,301 or 43% of all forbearance loans that were fully performing without any missed payments. At the end of July, we had 14,175 defaults in our primary portfolio for a default ratio of 3.8% and identified 28,510 loans in forbearance programs. We’re generally encouraged by the slowing growth of our default population, rising level of cure activity among COVID impacted borrowers, and the general stability in our forbearance population. Claims expense was $34.3 million in the quarter, reflecting a significant increase in our COVID-related default population. The reserve we established for each defaulted loan and, by extension, the claims expense we incurred any given period reflects our best estimate of the future claim payment to be made for each individual loan in default. Our claims exposure is triggered by a property foreclosure; we don’t fund delinquencies and is ultimately a function of the number of defaulted loans that progressed to claim, which we refer to as frequency, and the amount we paid to settle such claims, which we refer to as severity. Our estimates of claims frequency and severity are not formulaic. Rather, they are broadly synthesized based on historical observed experience for similarly situated loans and assumptions about future macroeconomic factors. We generally observe that forbearance programs are an effective tool to bridge dislocated borrowers from a point of acute stress to a future date when they can resume timely payments of their mortgage obligation. The effectiveness of forbearance program is greatly enhanced by the availability of various repayment and loan modification options, which allow borrowers to amortize or in certain instances, outright defer payments otherwise due during the forbearance period over an extended length of time. In response to the COVID outbreak, the FHFA and GSEs have introduced new repayment and loan modification options to further assist borrowers with their transition out of forbearance and back into performing status. At June 30, we established lower case reserves for defaults that we consider to be connected to the COVID outbreak given our expectation that forbearance, repayment and modification and other assistance programs will aid affected borrowers, providing them a clear pathway to avoid foreclosure and keep their homes and ultimately drive higher cure rates on such defaults than we would otherwise experience. Balancing this is the approach we took with our incurred but not reported or IBNR reserves. We established IBNR reserves for loans that we estimate to be in default that have not yet formally been reported to us as such by our servicing partners. In the second quarter, we doubled our IBNR reserving factor to account for the possibility of reporting delays tied to the COVID crisis. Interest expense in the quarter was $5.9 million and includes $2.6 million of extinguishment costs related to the repayment and retirement of our $150 million term loan. We recorded a $1.2 million loss from the change in the fair value of our warrant liability. GAAP net income for the quarter was $26.8 million or $0.36 per diluted share. Adjusted net income, which excludes periodic transaction costs, warrant fair value changes and net realized investment gains, was $29.7 million or $0.40 per diluted share. As Brad noted, we completed a comprehensive series of capital and reinsurance transactions over the last few months. We raised $230 million of common equity, $400 million of senior debt, $322 million in the ILN market and entered into a new quota share reinsurance agreement covering our new business production from April 1 through December 31 of this year. In total, we raised nearly $1 billion of capital and secured additional risk protection against adverse development in our insured portfolio. The success that we’ve just achieved in the markets paired with the risk discipline, capital strength and comprehensive reinsurance program that we carried into this crisis position National MI to perform well through the COVID-19 pandemic. We’ve already downstreamed a significant majority of the net proceeds from our equity and debt offerings into NMIC and have immediately begun deploying this fresh capital in support of incremental, high-quality new business production. We also capitalized on continued interest from the traditional reinsurance community and chose to upsize our new quota share agreement from the 10.5% session rate we initially announced to 21%. The ILN that we closed on July 30, our fourth Oaktown reoffering, builds upon the success we’ve achieved in the risk transfer markets to date and is particularly valuable in light of the COVID outbreak. The transaction provides us with excess of loss reinsurance protection on nearly all of the remaining uncovered pre-COVID risk in our insured portfolio. The deal is similar in structure to our first three transactions, providing us with real working layer risk protection and capital benefit; it covers us for cumulative claims experience on risk originated between July 1, 2019 and March 31, 2020, from a 2.5% attachment point or deductible up to an 8% maximum detachment. The transaction carries a weighted average lifetime pre-tax cost of approximately 6%. The ILN further insulates our balance sheet and PMIERs position against the impact of forbearance activity and default experience. And in doing so, allows us to release the equity capital that we have previously allocated to support this pool and redeploy it in support of incremental high-quality, high-return new business production. Our ability to successfully execute a regular way ILN offering covering pre-COVID risk in the current environment broadly demonstrates the durability of the ILN market, as a source of support for mortgage insurance risk and highlights the confidence that investors have in our individual risk underwriting approach and consistent use of Rate GPS to target higher quality volume. Total cash and investments were $1.9 billion at quarter end, including $76 million of cash and investments at the holding company. At June 30th, our investment portfolio had an aggregate unrealized gain of $53 million. Shareholders’ equity at the end of the second quarter was $1.3 billion, equal to $14.82 per share. We have $400 million of outstanding senior notes and fully repaid and retired our previous $150 million term loan. Our $100 million revolver remains undrawn and fully available. At quarter end, we reported total available assets under PMIERs of $1.656 billion and risk-based required assets of $1.048 billion. Excess available assets were $609 million. The ILN issuance that we closed last week is not included in these figures, as it was completed after quarter end. The $322 million offering will further bolster our excess position and provide even more funding runway for future periods. The strength of our current funding profile and the comprehensive and uniquely expansive nature of our reinsurance program, with its significant over-collateralization provide us with meaningful PMIERs and state regulatory capital runway. We’re in a position to be fully focused on new business opportunities and provide leadership support to our lenders and their borrowers. Overall, the current environment is unlike any we’ve seen before. While this introduces general uncertainty, we believe that the conservative nature with which we manage our business across the board, and the proactive steps we’ve recently taken in the capital and reinsurance markets, will be valuable as we navigate through this stress. With that, let me turn it back to Claudia.

Thanks, Adam. The COVID crisis has brought into sharp focus the important role that National MI and the broader private mortgage insurance industry play in supporting a healthy and functioning housing finance system that works for borrowers, lenders and taxpayers across all market cycles. We came into this stress in a position of strength, bolstered by the conservatism with which we have managed our business, and we are here to provide support through this challenging period. Thank you for joining us today and I will now ask the operator to come back on so we can take your questions.

Your first question comes from Douglas Harter from Credit Suisse. You may proceed.

Thanks. I was hoping you could just help us think about kind of the magnitude of capital you raised and kind of size the opportunity that you see? And so how much of this was for being able to kind of grow the insurance-in-force and kind of grow into that capital versus kind of how much of this would be kind of defensive, if and when kind of the 70% haircut goes away a year from now when forbearance ends?

Yes, Doug. It’s a great question and certainly a fair question. I’d say we came into this stress in a really good position from an operational standpoint, from the perspective of our quality in our short portfolio, our liquidity position, the investment portfolio and also our capital position. But facing a stress of an unprecedented magnitude that is going to follow an unknown path because we’ve never seen something like it before, it was the natural time for us to consider bolstering our resources. We didn’t need to pursue a capital raise because of the risk in the in-force portfolio. The strength of the capital position that we came into this crisis with and the unique workings of our reinsurance program that provide us with accordion-like capacity to absorb an increasing amount of PMIERs strain, would have carried us through. But having more capital in the face of an uncertain environment is an unequivocal positive. But what really drove our decisioning around capital and focused our efforts was the new business environment. We knew pretty early on, based on the changes that we had made, that pricing would be up, that the risk profile of production coming through in the post-COVID environment would be down and that unit economics would be there in a meaningful way. But by early June, when we really launched the comprehensive series of quota share equity and debt, it was also clear that volume would be there in record size. And so the capital we raised is first and foremost about making sure that we have all of the funding needed to capitalize, fully capitalize on that enormously attractive market opportunity. And at some point though capital is fungible, and so having additional resources in the system provides additional value for the in-force portfolio. What we’ve done now though with our most recent ILN transaction, we’ve — let’s call it good bank, bad bank, but we’ve essentially ring-fenced the potential exposure that we have to PMIERs strain on the in-force portfolio because nearly every risk that we originated prior to March 31st of this year now sits under both the quota share agreement as well as an excess of loss agreement. So much, much more focused and driven by the new business opportunity, but obviously in a period of uncertainty, the additional capital and the fungibility of capital provides us with added protection on the in-force.

Got it. Any way to sort of size how you’re kind of seeing the market opportunity and kind of the ability to ramp back up after slower than peer growth in the second quarter?

Yes, Doug, I’ll take that. We don’t typically guide NIW, although, as I mentioned in my prepared remarks, we had a very, very strong July. I mean, we’re seeing a strong, even a stronger August coming through. The new business environment is just exceptionally strong, both in terms of volume and pricing and risk-adjusted returns. As Adam said, our rates are up, risk profile is strong; capital requirements on new business production are down. So we’re very excited about our new business opportunity and trajectories.

Great. Thank you.

Your next question comes from the line of Mark DeVries from Barclays. Sir, your line is open.

Thank you. I would like to ask a follow-up question regarding your previous comment. It was noteworthy that your share appeared to decline in the second quarter, which seemed to be your lowest growth quarter in terms of IIF. However, with the strong performance in July, it seems to be picking up again. Could you provide insight into how your pricing and risk parameters may have changed during that time? Additionally, has this impacted the level of risk you have been observing? It appears you took on a higher percentage of high FICO loans and a lower percentage of high LTV loans. Is this a result of adjustments in your pricing strategy, or is it primarily influenced by the risk levels generated by your clients?

Thank you for the question, Mark. I’d like to share some specifics about the quarter before discussing the quality aspect. We were proactive in raising prices and tightening our underwriting standards, demonstrating discipline in both risk and pricing, especially at the onset of COVID. We have the capability and reach through Rate GPS, allowing us to increase pricing as soon as we noticed market distress, ahead of many competitors, who took months to adjust. July showed strong new insurance written, but it’s crucial to emphasize that we are focusing on a significant volume of high-quality, high-return business. In this period of uncertainty, we are taking a conservative approach regarding new business risk, which aligns with our previous strategies. Now is not the time to increase our exposure to higher loan-to-value ratios, lower credit scores, or high debt-to-income ratios, especially with compounded risks. We intend to make full use of the underwriting and pricing tools we have meticulously developed.

Mark, I’ll add one for you. The pickup in volume that we enjoyed in July that Claudia mentioned actually came, if you look, we’ve got operating statistics that are out embedded in the 8-K that we released with the earnings results today. With a similarly strong, if not stronger, risk profile of new production from what we’ve been running in the last few months. And so the volume is there. Our pricing is driving us towards higher quality, but also the market has shifted meaningfully in terms of the quality that’s coming through.

Got it. That’s helpful. Adam, can you provide any insights on how the cost savings from the TCS contract will be reflected in the GAAP statements? I believe you mentioned that it builds over time.

Yes, that’s right. They’re going to build over time. The $100 million will come in over the next 7 years. It’s going to come from a range of different areas, streamlining and consolidating our third-party vendor relationships, transitioning 50 full-time employees over to their platform. The accounting for the contract requires us to match the expense alongside the services rendered and anytime we’re transitioning into such a significant relationship of that nature, the services rendered will be heavier earlier on, so the expense savings will start to, I’ll call it fully emerge until a few years into the contract.

Your next question comes from the line of Bose George from KBW.

And just want to follow up quickly on the expense contract, is there a way to think about sort of the benefit of that longer term to your expense ratio, or is there a way for us to kind of think about the benefit of that overall over time?

Yeah. Bose, not necessarily to our expense ratio, but what I’ll share is that I see it for us as it is, I think for most organizations, our largest expense department historically. Typically, people are our biggest cost and that is certainly the case throughout the organization, but IT has on top of our people costs, I’ll call them platform and project costs. The benefit of the TCS engagement is first and foremost strategic and that it will provide us a partnership with a global leading firm to drive continued innovation and success and leadership on the IT side, but the contractual nature of the engagement also taps where our expenses would otherwise grow in what is has otherwise been our largest department. And so there are savings or dollars of savings that are going to come through, but even more importantly, in the largest expense department that we have, set a ceiling on where expenses will grow over time, and so that will add significant leverage to our expense ratio over time.

And then just switching to the premium if you just disregard the impact of singles and profit commissions, did average prices have they increased to the point where our new business is special neutral to the premiums on the stuff that’s running off?

It is. And so you’re, Bose, the impact of the profit commission declined because of ceded losses and the increase in the contribution and cancellation earnings roughly cancel out in the yield calculation. The cost of the quota share went up by about 2.9 basis points and the contribution from cancellation earnings went up by about 2.7, so it’s almost perfectly canceling out. Our yield overall then was down by about 0.8 of a basis point from 40.9 in the first quarter to 40.1 in the second quarter that’s all core yield. And so what’s happening underpinning that core yield dynamic is still, there is still some premium-rich business from earlier years that we wrote prior to the implementation of tax reform that is running off, and it’s being replaced in a meaningful way and even more so because of the growth in it by new business production, but there still is a little bit of drag coming into the yield calculation because of that dynamic. It is certainly slowing and much slower than it otherwise would have been had we not pushed through the rate increases that we did in the immediate aftermath of COVID.

Your next question comes from the line of Jack Micenko from SIG.

Wanted to talk a little bit about the credit side. I know you threw out a lot of numbers Adam on forbearance-related defaults and maybe could you kind of run through that again for us? I guess, what I’d be curious to hear is, of the new defaults what percentage are forbearance? And it sounded like you said, you’ve got more forbearance loans than you have delinquency loans. So is that a positive, is that a risk that they may grow into a delinquency? Can I just get those numbers again?

So at the end of the quarter, we had 10,816 defaults in our primary portfolio; we separately identified 28,555 loans that were in forbearance programs, and there are three data points I gave for that 28,555. They are the loans that are in default, so a portion of those 10,816 are in forbearance, and that number is 9,502. So the overwhelming majority of loans that are in defaults are in a forbearance program; that’s a real positive for us. Essentially, everything that we identify that is COVID-related is in forbearance. There are a few hundred loans that, based on the timing and the details around how they progressed into default status, we also would say are related to COVID, but nearly everything that is a COVID-related default is in forbearance; that’s a positive. We want borrowers to be taking advantage of the programs that are offered to them to help themselves and ultimately put themselves on a pathway toward resuming timely payment of principal and interest. Then we have an additional amount of the loans in forbearance, right, another subset of the 28,555 that have missed at least one payment, but have not progressed into default status. They may not ever progress into default status; those borrowers may cure, they may continue to make payments and only have missed one; or some of them may progress into default status, that number was 6,752. And then fully 43% or 12,301 of those forbearance loans of that totaled 28,555 are continuing to make every payment; they’ve never missed a payment, they’re in fully performing status. What I would say is overall, we’re really encouraged by the slowing growth of our default population, rising level of cure activity among COVID impacted borrowers, and the general stability in our forbearance population. Claims expense was $34.3 million in the quarter, reflecting a significant increase in our COVID-related default population. The reserve we established for each defaulted loan and by extension the claims expense we incurred in any given period reflects our best estimate of the future claim payment to be made for each individual loan in default.

That’s super, super helpful. Yes. I mean the July numbers seem to show an inflection, and there’s a big percentage of these DQs that are forbearance-driven. So that’s all pretty constructive. What is your claim rate assumption that you’re running with now on these forbearance defaults?

Yes. So the

I’d say, look, overall, we certainly expect that this is going to be much more of a default event than a claims event. That was the perspective we had on our first quarter call and it’s certainly been reinforced by everything that’s happened over the last several months. At June 30, our reserve, and by extension, our claims expense assumes a roughly 7% default-to-claim rate on newly reported defaults in the quarter. Although that’s lower than what we would typically assume for similarly situated loans that weren’t in forbearance and weren’t otherwise benefiting from all of the massive assistance that’s being offered in response to COVID, but it’s also meaningfully, meaningfully higher than what our experience in the aftermath of the 2017 and 2018 hurricanes would indicate should be applied.

Okay. And just take one more. On the expense line, you had a nice step down about $2 million on a dollar basis. Was any of that this tech contract? Or is there something else at play there, sequentially, the step down in operating expenses?

Yes, I believe the TCS relationship is not the issue. In fact, we might see some modest growth in the next few quarters related to TCS due to the complexities involved in establishing that relationship and transitioning accounts. There's some overlap; we can't just abruptly switch from existing vendors to TCS. Learning is necessary, so we need to operate some parallel processes. This will occur in the third and fourth quarters. The drop from the first quarter to the second quarter primarily stems from the first quarter, when we pay bonuses and certain vesting events take place. The first quarter is heavier for us in terms of FICA expenses, leading to specific payroll costs introduced then that do not persist throughout the year.

Your next question is from the line of Rick Shane from JPMorgan. Sir, your line is open.

Follow-up on Jack’s question. Look, the mix is shifting towards more refi, which is somewhat of a historical anomaly for PMI. You guys historically have provided us with a lot of different metrics and ways to think about risk. Is there any risk factor, either positive or negative that we should consider with refi in terms of the portfolio over the longer term?

Yes. Rick, what I would say though is risk is coming out of the system broadly. And the changes we’ve made from a pricing and underwriting guideline standpoint are driving a lot of that, both across the purchase portfolio and the refi portfolio. I mentioned that our purchase origination volume in the second quarter was actually meaningfully higher than what it was for July. And in July, we still saw the credit metrics of new production strengthen. But some of the benefits of refinancing volume coming through. One, generally speaking, the borrowers have more equity. We’re not insuring cash out refis. And so the borrowers, who are coming to us for rate term refis, generally have built equity in their homes between the principal paydown that they had over the years, as well as some amount of home price appreciation. So it’s lower LTV production and also because the mortgage payment itself carries so much weight in the FICO score, on the margin, you tend to see higher FICO scores among refinancing borrowers than you do among purchase borrowers. But overall, I would say, the quality and the strengthening of the credit quality is happening on both the refi side and on the purchase side.

And I think the comment about not doing cash out refis is significant. I want to revisit the complicated topic that you guys just started to explore with Jack. I’m particularly interested in loans that fall under the bucket of default and forbearance. I’m assuming that that was a loan that was in default and then the borrower sought forbearance. Is that the way to, is that how you wind up in that? It’s 9,000 plus loans?

No, so in all other periods that was the case. In all other prior environments, borrowers had to, I’ll call it, demonstrate a hardship before they can access a forbearance program, and the way that hardship was demonstrated was they would first be in default, they would miss the payments on their mortgage and then call up to access a forbearance program or other assistance. In this environment, it is different; borrowers have the ability, without proving the hardship, simply claiming a hardship before they are in default, before they missed a payment, to call their servicer and get access to a forbearance program. So they’ve done that and a large number of those borrowers who are in forbearance continue to make payments. They’ve never missed a payment, right. 43% of the borrowers that we have, that we insure, who were in forbearance continue to make all of the payments due, but a subset of them have missed their payments. Right. The forbearance program is doing what it’s intended to do. Our instinct is where a borrower, who is fearful of some type of a layoff, fearful in the diminution of their income stream, at the immediate outset, they’re going to call up to access our forbearance program and if that diminution in income actually plays through, because they’ve been laid off or for some other reason, then they will pause the payments on their mortgage, and they will then progress into default status because they will have missed enough payments for a long enough period of time that it trips into the definition of default.

And I was under the impression, I misunderstood and I assumed that once you were in forbearance, your default status froze where you were, but it’s an important segue into my next question, which is that when we look at your reserve levels, one of the factors that is extremely influential is the number of payments that have been missed and because of the recency of that, I’m wondering if you assume reasonable default rate or roll rates and reasonable cure rates, if that suggests that you will see additional reserve build as we move into Q, or as we move through Q3, as those loans that are in default move from two payments missed to five payments missed?

Yeah. it’s a great question, Rick, and candidly, it’s something that we’re focused on. I would say in all other environments, the aging of that default, the borrower missing more and more payments is telling about the likelihood that they are going to ultimately progress to claim. Right. And so, we would typically carry a larger and larger reserve for assumed higher reserve factors, right, higher frequency of ultimate claim and depending on the duration perhaps some additional adjustment on severity, as that default grows in its age. But we’ve never had a situation like this before, where so many borrowers have gone into forbearance when they were otherwise current on their loans and it really raises an interesting question about whether a borrower, who is told from the outset that they don’t need to make a payment, is there really something that is fundamentally different in the information between the borrower who has missed, call it, three or four payments and the borrower who has missed six or seven payments. We’re going through that analysis now. We have to see what the data tells us. Right. This is all happening in real time. As we see the underlying risk profile of those borrowers who cure out forbearance and default status in the early days versus those who remain in forbearance and continue to progress the age of their default, we’ll be making that determination through the course of the third quarter and into the fourth quarter. I sense that we are going to carry a higher reserve factor for those borrowers who remain in a forbearance-driven default, even though, again, theoretically the borrower who is told to miss all of their payments whether they miss two or miss seven, it’s not necessarily the same information and same additional indication of higher risk, but there will likely be a higher reserve that we establish for those borrowers who age through the forbearance program as well.

Okay. So there is in fact some potential, so historically, I think that the reserve rate for a loan that’s two payments late is in the high single-digits it moves to 25% or 30% once it’s six months past due or six months late. Do you think we may end up in a scenario where it’s not as severe as that?

I’d say, Rick. I’m not, I, great question, again. The rates that you’ve just outlined aren’t necessarily aligned with the broad rates that we’ve applied. It very much depends on each individual loan, its underlying risk profile, the borrowers equity in the home and all variety of other items. Now, it’s something that we’re focused on is what is the aging of a default mean under a forbearance program and as we get through the third quarter and gather additional information about the macro environment, the path of house prices, the equity that our borrowers have, as well as the cure activity for those who remain in versus those who short out of forbearance defaults, we’ll make that determination as we go through the third quarter.

Okay, well imagine me trying to oversimplify something. Thank you very much for your time.

Your next question comes from the line of Mark Hughes with Truist Securities.

You touched on this in, Hello, Claudia. In your last answer you talked, you mentioned home price appreciation, how significant is that? And this analysis that rates are down, housing prices continuing to go up? What does that mean for eventual claim frequency or severity?

I would say that this is potentially the most significant influence on both the frequency and severity of any macro factor. Historically, national house prices have been the best indicator of mortgage insurance credit performance. Essentially, when borrowers have equity in their homes, they are much less likely to reach claim status, which affects the frequency. Additionally, if a borrower cannot afford their payments and moves toward claim status but has sufficient residual value, they have the option to sell their home to address the default, and we do see that happen at times. From a severity perspective, the more equity there is in the home, the more we can utilize different settlement options, reducing our claims exposure. This has historically been the largest factor driving mortgage insurance credit performance. For this quarter's reserves, we have anticipated a modest decline in house prices nationally over the next two years in our reserve analysis. We also acknowledge that recent market data indicates significant continued home price appreciation. Given the overall uncertainty, we believe it's prudent to adopt a more conservative approach for reserving and pricing. We will continue to monitor this closely, as the trajectory of house prices over the next two years is crucial. If they perform better than we expect, it could positively impact our ultimate claims experience.

And then I wonder, any observations about the credit overlays on the part of the lenders? How stiff are their standards? You’re doing your thing, but how much are they being strict in their underwriting? And could that diminish over time and probably support home prices?

Yes. Well, I’ll just mention, Mark, one of the things that we’re seeing for what you’re terming overlays. We’re seeing that lenders are just scrubbing the loans, especially as it relates to verifying income as close to closing as they can for the obvious reasons. And certainly making sure that they’ve got all of the particulars of the loan intact before they close. But their due diligence, they’re following GSE guidelines, but they’re very, very particular. It gets very expensive for whatever reason, they would deliver a loan and then that loan would go into forbearance. So they have a stake in this to make sure that all the overlays that they are putting in makes sense, especially about employment and continuance of income.

Your next question comes from the line of Geoffrey Dunn from Dowling & Partners. Sir, your line is open.

Thanks, good evening. Adam, can you parse out the incurred losses this quarter between the case reserving and the IBNR?

Geoff, I’ll have to come back to you with the detail. The Q will have and I think our earnings release has a table that provides a split between case reserves and IBNR per default. It’s about $5,600 in reserve per case reserve and about $900 per IBNR.

That’s on overall default, so that’s not the new notices this quarter, the incurred losses, right?

That’s correct.

Your next question comes from the line of Phil Stefano with Deutsche Bank.

Yes, thanks. Most questions have been asked and answered, but I just have a quick one. Adam, I believe you mentioned that the quota share percentage increased from 10.5% to 21%. Was that effective April 1st?

Yeah, Phil, it’s a good question. So we took it from 10.5% to 21% based on the really candidly broader interest that continued to emerge from the traditional reinsurance community. The treaty will be effective back to April 1st for all risk; in terms of what actually rolled through the quarter though because of how the timing of the additional session came through was a 12% cession that impacted the quarter. There’ll be a little bit of catch up in terms of additional profit commission a little bit of ceded premium, but our reinsurers are on risk for 21% of the production starting April 1st, and there’ll be a little bit of, I’ll call it, settlement on how that works through in the third quarter as well.

Okay. But so the...

It won’t be significant.

Okay. It won’t be significant. And any of the premium on profit commission impact will be as something we’ll see in 3Q, as opposed to what we saw in our second quarter results?

You will see the full 21% impact of the new quota share in the third quarter, along with a few hundred thousand dollars in adjustments due to the reinsurers being on risk effective April 1st. This will require a settlement, including a premium payment to them, as well as profit and ceding commissions received by us. Additionally, our PMIERs submission will benefit from the 21% effective April 1st, but the $609 million of excess we calculated reflects only 12% cede rather than the full 21%. This will result in some additional benefits to our regulatory capital position in the third quarter.

You do have a follow-up question from the line of Bose George.

Hi, thanks for taking the follow-up. And I know you referred to your strong NIW in July a couple of times, but was that in the 8-K or is that possible to get that number?

It’s not in the 8-K, Claudia mentioned nearly $6 billion of NIW.

And there are no further questions at this time. I’d like to turn the call back to the presenters for any closing remarks.

Thank you again for joining us. We will be participating in virtual investor conferences hosted by Barclays, the week of September 14th, and Zelman & Associates, the week of September 21st. We look forward to speaking with you at one of these events and hope all of you are staying safe and healthy through this crisis.

That does conclude today’s conference call. Thank you for your participation. You may now disconnect. Everyone have a wonderful afternoon.