Operating Environment. As a seller of mortgage credit protection and mortgage and real estate products and services, our results are subject to macroeconomic conditions and specific events that impact the mortgage origination environment and the credit performance of our underlying insured assets. As evidenced by the improved job market and increased housing prices, the operating environment for our businesses has improved over the past several years as the U.S. economy and housing market have been recovering from the financial crisis that began in 2007.
Early default experience (“EDE”) within the first 12 months of a mortgage loan is an early indicator of underwriting quality. Radian’s EDE has declined significantly as underwriting quality has improved. In addition, we have expanded our quality control reviews to encompass all 12-month early defaults. These reviews have indicated historically low material loan manufacturing defect rates. The following table provides a historical perspective on Radian’s EDE from 2001 to present on its Flow Basis mortgage insurance.
Private mortgage insurers, including Radian Guaranty, are required to comply with the PMIERs to remain eligible insurers of loans purchased by the GSEs. Radian Guaranty currently is an approved mortgage insurer under the PMIERs and is in compliance with the PMIERs Financial Requirements. The PMIERs are comprehensive, covering virtually all aspects of a private mortgage insurer’s business and operations, including internal risk management and quality controls, the relationship between the GSEs and the approved insurer and the approved insurer’s financial condition. The PMIERs require private mortgage insurers to obtain the prior written consent of the GSEs before taking certain actions. The PMIERs also specifically provide for the factors that are applied to calculate and determine a mortgage insurer’s Minimum Required Assets to be updated every two years, with the next review scheduled to take place in 2017. See “Liquidity and Capital Resources-Radian Group-Short-Term Liquidity Needs” and Note 1 of Notes to Consolidated Financial Statements for additional information.
As a result of the actions described above and as demonstrated by our strong NIW generated in 2016, we believe we are well positioned to compete for the high-quality business being originated today, including the generally more profitable, borrower-paid business, while at the same time maintaining projected returns on NIW within our targeted ranges. In addition, the changes that we implemented to our filed premium rates in the first half of 2016 are expected to generate more consistent returns across the credit spectrum and provide more stable loss ratios in the event of further credit expansion. Over the life of the policies, we expect our current pricing (including the impact of the Single Premium QSR Transaction) will produce returns on required capital on new business on an unlevered basis (i.e., after-tax underwriting returns plus projected investment income) of approximately 13% to 14%, and approximately 16% to 17% on a levered basis (i.e., after-tax returns taking into consideration a targeted corporate debt to capital ratio which is consistent with our current level). Our actual portfolio returns will depend on a number of factors, including economic conditions, the amount and mix of NIW that we are able to write at these new pricing levels and the amount of reinsurance we use.
Operating Expenses. Our operating expenses primarily consist of salaries and benefits not classified as cost of services because they are related to employees, such as sales and corporate employees, that are not directly involved in providing client services. Operating expenses also include other selling, general and administrative expenses, depreciation, and allocations of corporate general and administrative expenses.
The change in expected economic loss or recovery associated with our previously owned VIEs is included in adjusted pretax operating income above for the year ended December 31, 2014, although it represents amounts that are not included in net income. Therefore, for purposes of this reconciliation, net gains (losses) on investments and other financial instruments has been adjusted by income of $0.1 million for the year ended December 31, 2014, to reverse this item.
The table below illustrates the improved composition of our direct primary mortgage insurance RIF at December 31, 2016 compared to prior years, based on various risk characteristics.
Net premiums earned increased for 2015 compared to 2014, primarily as a result of the impact of the acceleration of the recognition of premiums earned on Single Premium Policies that were cancelled during 2015 due to: (i) increased refinance activity in 2015 and (ii) prepayments that servicers had not previously reported to Radian. In addition, the increase in net premiums earned in 2015 compared to 2014 was also driven by an increase in the overall level of our IIF.
Cost of Services. Our cost of services is primarily affected by our level of services revenue. Our cost of services primarily consists of employee compensation and related payroll benefits, including the cost of billable labor assigned to revenue-generating activities and, to a lesser extent, other costs of providing services such as travel and related expenses incurred in providing client services and costs paid to outside vendors, data acquisition costs and other compensation-related expenses to maintain software application platforms that directly support our businesses. The level of these costs may fluctuate if market rates of compensation change, or if there is decreased availability or a loss of qualified employees.
The following table summarizes certain of our contractual obligations and commitments, including our expected claim payments on insurance policies, as of December 31, 2016, and the future periods in which such obligations are expected to be settled in cash. Additional details regarding these obligations are provided in the narrative following the table and in the Notes to Consolidated Financial Statements that are referenced in the table.
Radian Group and RMAI are parties to a guaranty agreement, which provides that Radian Group will make sufficient funds available to RMAI to ensure that RMAI has a minimum of $5 million of statutory policyholders’ surplus every calendar quarter. RMAI had $8.6 million of statutory policyholders’ surplus and no RIF exposure as of December 31, 2016.
Net cash provided by investing activities increased in 2015, compared to net cash used in investing activities in 2014. During 2015, net cash provided by investing activities was not significant, as the proceeds received from the sale of Radian Asset Assurance and the sales and redemptions of trading securities, equity securities available for sale and short-term investments were primarily reinvested in fixed-maturity investments available for sale. During 2014, net cash used in investing activities was primarily the result of investing a significant portion of the proceeds we received from our issuances of long-term debt and common stock. These investments included the acquisition of Clayton and purchases of short-term investments.
The PMIERs are comprehensive, covering virtually all aspects of a private mortgage insurer’s business and operations, including internal risk management and quality controls, the relationship between the GSEs and the approved insurer and the approved insurer’s financial condition. The GSEs have a broad range of consent rights to approve various actions of the approved insurer. If Radian Guaranty is unable to satisfy the requirements set forth in the PMIERs, the GSEs could restrict it from conducting certain types of business with them or take actions that may include not purchasing loans insured by Radian Guaranty.
Rollforward activity of Level III assets and liabilities (including realized and unrealized gains and losses, purchases, sales, issuances, settlements and transfers) was immaterial for the years ended December 31, 2016 and 2015.
We had securities in an unrealized loss position that we did not consider to be other-than-temporarily impaired as of December 31, 2016. For all investment categories, the unrealized losses of 12 months or greater duration as of December 31, 2016, were generally caused by interest rate or credit spread movements since the purchase date, and as such, we expect the present value of cash flows to be collected from these securities to be sufficient to recover the amortized cost basis of these securities. As of December 31, 2016, other than as discussed above, we did not have the intent to sell any debt securities in an unrealized loss position and we determined that it is more likely than not that we will not be required to sell the securities before recovery of their cost basis, which may be at maturity; therefore, we did not consider these investments to be other-than-temporarily impaired at December 31, 2016.
During the financial crisis, losses increased significantly and almost all captive reinsurance arrangements attached, thereby requiring our captive reinsurers to make payments to us. The reinsurance recoverable on loss reserves related to captive agreements was $0.4 million at December 31, 2016, compared to $7.3 million as of December 31, 2015.
We attempted to reach a compromised settlement with Appeals, but in September 2014 we received Notices of Deficiency covering the 2000 through 2007 tax years that assert unpaid taxes and penalties of $157 million. The Deficiency Amount has not been reduced to reflect our NOL carryback ability. As of December 31, 2016, there also would be interest of approximately $136 million related to these matters. Depending on the outcome, additional state income taxes, penalties and interest (estimated in the aggregate to be approximately $35 million as of December 31, 2016) also may become due when a final resolution is reached. The Notices of Deficiency also reflected additional amounts due of $105 million, which are primarily associated with the disallowance of the previously filed carryback of our 2008 NOL to the 2006 and 2007 tax years. We currently believe that the disallowance of our 2008 NOL carryback is a precautionary position by the IRS and that we will ultimately maintain the benefit of this NOL carryback claim.
On September 16, 2014, Radian Guaranty entered into the BofA Settlement Agreement in order to resolve various actual and potential claims or disputes related to the parties’ respective rights and duties as to mortgage insurance coverage on certain Subject Loans. Implementation of the BofA Settlement Agreement commenced on February 1, 2015 and was effectively completed by December 31, 2015.
The information about net incurred losses and paid claims development for the years ended prior to 2016 is presented as supplementary information.
Pursuant to the original terms, holders of the remaining Convertible Senior Notes due 2017 may convert their notes from August 15, 2017 up to the close of business on the second scheduled trading day immediately preceding the maturity date (the “Conversion Period”), subject to certain conditions. Upon a conversion, we will pay cash up to the aggregate principal amount of the notes to be converted and pay or deliver, as the case may be, cash, shares of our common stock or a combination of cash and shares of our common stock, at our election, in respect of the remainder, if any, of our conversion obligation that is in excess of the aggregate principal amount of the notes being converted. The conversion rate initially is 85.5688 shares of our common stock per $1,000 principal amount of notes (corresponding to an initial conversion price of approximately $11.69 per share of common stock prior to the consideration of the capped call transactions discussed below). The conversion rate is subject to adjustment in certain events, but is not adjusted for any accrued and unpaid interest. In addition, following certain corporate events, we will, under certain circumstances increase the conversion rate for a holder who elects to convert their notes in connection with that corporate event. At December 31, 2016, we had approximately 13 million shares reserved to cover the potential issuance of shares under the Convertible Senior Notes due 2017.
We may purchase shares on the open market to settle stock options exercised by employees and to fund 401(k) matches and purchases under our ESPP. In addition, upon the vesting of certain restricted stock awards under our equity compensation plans, we may withhold from such vested awards shares of our common stock to satisfy the tax liability of the award recipients.
The vesting of 100% of the target awards granted to executive officers and non-executives in 2015 and 2014 is dependent upon Radian Group’s TSR Measures, as described above.
The following table summarizes information concerning outstanding and exercisable options at December 31, 2016:
Services revenue for the first quarter of 2015 includes $0.1 million that had previously been included in other income.