We are a credit enhancement company with a primary strategic focus on domestic first-lien residential mortgage insurance. Our business segments are mortgage insurance, financial guaranty and financial services.
Ratings downgrades of Radian Insurance have significantly reduced our ability to continue to write international mortgage insurance business. In addition, as a result of the downgrades, the counterparties to each
In March 2008, we discontinued writing new insurance on synthetic CDOs and reduced significantly our structured products operations. This action was based on the deterioration and uncertainties in the credit markets in which we and other financial guarantors participate, which significantly reduced the volume of CDOs and other structured products available for our insurance. Subsequent to this, in June 2008, both Standard & Poor’s Ratings Service (“S&P”) and Moody’s Investor Service (“Moody’s”) downgraded the financial strength ratings of our financial guaranty insurance subsidiaries, and in August 2008, S&P again lowered the financial strength ratings on our financial guaranty insurance subsidiaries. See “Ratings-Recent Ratings Actions” below. These downgrades, combined with the difficult market conditions for financial guaranty insurance, severely limited our ability to write profitable new direct financial guaranty insurance and reinsurance both domestically and internationally. Accordingly, in the third quarter of 2008, we decided to discontinue, for the foreseeable future, writing any new financial guaranty business, including accepting new financial guaranty reinsurance, other than as may be necessary to commute, restructure, hedge or otherwise mitigate losses or reduce exposure in our existing portfolio. We initiated plans to reduce our financial guaranty operations, including a reduction of our workforce, commensurate with this decision. We also contributed the outstanding capital stock of Radian Asset Assurance to Radian Guaranty, strengthening Radian Guaranty’s statutory capital. We continue to maintain a large insured financial guaranty portfolio, including a portfolio of insured CDOs.
Provision for Losses. The provision for losses for 2008 was $2,205.3 million, compared to $1,308.1 million for 2007. Our mortgage insurance segment experienced a significant increase in delinquencies and claims paid for 2008 compared to 2007. In addition to the increase in delinquencies, the provision for losses was affected by an increase in delinquent loan sizes, an aging of existing delinquencies, an increase in the projected default to claim rates and a continued high level of severity, all of which require a higher loss reserve. See “Results of Operations-Mortgage Insurance-Year Ended December 31, 2008 Compared to Year Ended December 31, 2007-Provision for Losses” below. The provision for losses in our financial guaranty segment in 2008 increased slightly from the comparable period of 2007 due primarily to a deterioration of assumed structured mortgage credits and less favorable loss development with respect to our structured finance business.
Provision for Losses. The provision for losses for 2008 was $2,090.8 million, compared to $1,210.0 million for 2007. The 2008 amount reflects increases in delinquencies and claims paid, larger delinquent loan balances, a higher ratio at which delinquencies are moving to claim and a continued high level of severity. Deterioration in
Income Tax Provision (Benefit). We recorded an income tax provision of $188.0 million for 2008 and an income tax benefit of $265.6 million for 2007. The effective tax rate was 35.7% for 2008, compared to 37.6% for 2007. The effective tax rate for 2008 was impacted by additional tax expense relating to foreign operations and adjustments relating to prior year tax returns. The effective tax rate for 2007 reflects the losses incurred during 2007 and the additional tax benefit realized from tax-advantaged investment securities.
Our financial services segment had net income of $34.9 million in 2008, compared to a net loss of $154.7 million for 2007 and net income of $163.3 million for 2006. Equity in net income of affiliates was $59.8 million for 2008, compared to equity in net loss of affiliates of $416.5 million for 2007 and equity in net income of affiliates of $257.0 million for 2006. Sherman accounted for the total amount of equity in net income of affiliates for 2008, and accounted for $84.8 million and $123.1 million of equity in net income of affiliates for 2007 and
Setting the loss reserves in both our mortgage insurance and financial guaranty business segments involves significant reliance upon estimates with regard to the likelihood, magnitude and timing of a loss. The models and estimates we use to establish loss reserves may not prove to be accurate, especially during an extended economic downturn. We cannot be certain that we have correctly estimated the necessary amount of reserves or that the reserves established will be adequate to cover ultimate losses on incurred defaults.
In June 2008, we established a reserve for premium deficiency on our domestic first-lien mortgage insurance business. At December 31, 2008, our current mortgage insurance portfolio is expected to generate a cumulative net profit and, therefore, no premium deficiency reserve was determined to exist as of that date. The net present value of expected losses and expenses on our first-lien business at December 31, 2008 was $4.9 billion, offset by the net present value of expected premiums of $3.0 billion and already established reserves (net of reinsurance recoverables) of $2.4 billion. Expected losses include an assumed paid claim rate of approximately 14.0% on our total primary first-lien mortgage insurance portfolio, including 10% on prime, 33% on subprime and 27% on Alt-A. While deterioration in the macroeconomic environment has resulted in an increase in expected losses, new business originated during the second half of 2008 is expected to be profitable, which has contributed to the overall expected net profitability of the portfolio.
As required by SFAS No. 157, we established a fair value hierarchy by prioritizing the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level I measurements) and the lowest priority to unobservable inputs (Level III measurements). The three levels of the fair value hierarchy under SFAS No. 157 are described below:
In making our own determination of fair value for these credit derivatives, we use information provided to us by our counterparties to these reinsurance transactions, which are the primary insurers (the “primaries”) of the underlying credits, including the primaries’ fair valuations for these credits. The estimated fair value of pooled corporate CDO CDS contracts is based on the primaries’ pricing models that use the Dow Jones CDX for domestic corporate CDS contracts and iTraxx for European corporate CDS contracts. Each index provides price quotes for standard attachment and detachment points for contracts with maturities of three, five, seven and ten years. The quoted index price is calibrated by the primaries to the typical attachment points for that type of CDS contract in order to derive the appropriate value. The value of CDS and collateralized loan obligations (“CLO”) contracts is estimated with reference to the LIBOR spread in the current published JP Morgan High Yield CLO Triple-A Index, which includes a credit and funding component. In addition, these fair value estimates incorporate an adjustment for our non-performance risk that is based on our credit default swap spread. The primaries’ models used to estimate the fair values of these instruments include a number of factors, including credit spreads, changes in interest rates, changes in correlation assumptions, current delinquencies, recovery rates
and the credit ratings of referenced entities. In establishing our fair value marks for these transactions, we assess the reasonableness of the primaries’ valuations by (1) reviewing the primaries’ publicly available information regarding their mark-to-market processes, including methodology and key assumptions; and (2) discussing the changes in fair value with the primaries where the changes appear unusual or do not appear materially consistent with credit loss related information when provided by the primaries for these transactions. Despite significant volatility in relevant credit spreads during each of the four quarters ended December 31, 2008, in each of these quarters the change in fair value of our assumed financial guaranty credit derivatives represented less than 2.5% of our net gains or losses on all credit derivatives. These credit derivatives are categorized in Level III of the fair value hierarchy.
Changes in our expected credit losses on mortgage insurance domestic CDS could have a significant impact on our fair value estimate for this product, with a maximum principal loss exposure of $132.2 million and expected losses as of December 31, 2008 in the amount of $91.8 million. Changes in the loss estimates will impact the fair value directly, reduced only by the discount factor, which is dependent on the timing of the expected losses. However, in light of our comparatively small amount of notional exposure on mortgage insurance domestic CDS, we do not expect changes in the fair value of this product to materially impact the overall fair value of our credit derivatives. The mortgage insurance domestic CDS are categorized in Level III of the fair value hierarchy.
As discussed in Notes 2 and 4 to the consolidated financial statements, as of January 1, 2008, the Company adopted SFAS No. 157, “Fair value Measurements,” which resulted in a material reduction of derivative liabilities. As discussed in Note 1 to the consolidated financial statements, in 2008, the Company discontinued writing new financial guaranty business.
We conducted our audit in accordance with the auditing standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
Our financial guaranty segment has provided credit-related insurance coverage through financial guaranty insurance, CDS and certain other financial guaranty contracts to meet the needs of customers and counterparties in a wide variety of domestic and international markets. It has provided insurance on a direct and assumed basis related mainly to public finance bonds and structured finance obligations. In 2005, we placed our trade credit reinsurance line of business into run-off.
Potential adverse effects on us of continued deterioration in the housing and related credit markets and economic instability that resulted in an increase in loss reserves, including premium deficiency, to $3.3 billion as of December 31, 2008 and cumulative net losses of $1.7 billion during 2007 and 2008;
We establish reserves to provide for losses and LAE in both our mortgage insurance and financial guaranty segments. Setting loss reserves in both businesses involves significant use of estimates with regard to the likelihood, magnitude and timing of a loss. SFAS No. 60 specifically excludes mortgage guaranty insurance from its guidance relating to the reserve for losses. However, because of the lack of specific guidance, we establish reserves using the guidance contained in SFAS No. 60, supplemented with other SFAS guidance as described below.
With respect to delinquent loans that are in an early stage of delinquency, considerable judgment is exercised as to the adequacy of reserve levels. Adjustments in estimates for delinquent loans in the early stage of delinquency are more volatile in nature than for loans that are in the later stage of delinquency, which generally require a larger loss reserve. As the delinquency proceeds toward foreclosure, there is generally more certainty around these estimates, and adjustments are made to loss reserves to reflect this updated information. If a default cures, (historically, a large percentage of defaulted loans have cured before going to claim, although this rate has decreased significantly in the current deteriorating housing environment) the reserve for that loan is removed from the reserve for losses and LAE. This curing process causes an appearance of a reduction in reserves from prior years if the reduction in reserves from cures is greater than the additional reserves for those loans that are nearing foreclosure or have become claims. In the mortgage insurance segment, we also establish reserves for defaults that we believe to have occurred but that have not been reported to us on a timely basis by lending institutions.
Once a specific reserve is established with respect to an insured credit, an offsetting adjustment typically is made to the allocated non-specific reserve. This offsetting adjustment may or may not be on a dollar-for-dollar basis, depending on the size of the necessary case reserve and the adequacy of the remaining allocated non-specific reserve with respect to the other credits in our portfolio. In addition, establishing case reserves may require a provision beyond what is then included in allocated non-specific reserves. Establishing reserves can reduce our net income when unallocated non-specific reserves are increased, when allocated non-specific reserves are established in an amount that exceeds unallocated non-specific reserves, or when case reserves are
We adopted SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS No. 159”) effective January 1, 2008. SFAS No. 159 permits entities to choose to measure financial instruments and certain other items at fair value. Items eligible for fair value measurement by this statement are (i) recognized financial assets and financial liabilities (with some exceptions), (ii) firm commitments that would otherwise not be recognized at inception and that involve only financial instruments, (iii) non-financial insurance contracts and warranties that an insurer can settle by paying a third party to provide those goods or services and (iv) host financial instruments resulting from separation of an embedded non-financial derivative instrument from a non-financial hybrid instrument. We elected to fair value the consolidated NIMS variable interest entity (“VIE”) debt at the date the VIEs were consolidated during 2008.
Trading securities, hybrid securities, VIE debt, and derivative instruments are recorded at fair value as described in Notes 4 and 5. All derivative instruments and contracts are recognized on our consolidated balance sheets as either derivative assets or derivative liabilities, depending on the rights or obligations provided under the contracts. The interest rate swaps that we had entered into qualified as hedges and were accounted for as fair value hedges. The basis adjustment that was recorded at the termination of the swaps is being amortized to interest expense over the life of the corresponding debt. All changes in fair value of derivatives are included in the statements of operations.
Deferred policy acquisition costs in the financial guaranty business are comprised of those expenses that vary with, and are principally related to, the production of insurance premiums, including: commissions paid on reinsurance assumed, salaries and related costs of underwriting and marketing personnel, rating agency fees, premium taxes and certain other underwriting expenses, offset by commission income on premiums ceded to reinsurers. Acquisition costs are deferred and amortized over the period in which the related premiums are earned for each underwriting year. The amortization of deferred policy acquisition costs is adjusted regularly based on the expected timing of both upfront and installment-based premiums. The estimation of installment-based premiums requires considerable judgment, and different assumptions could produce different results. Total deferred acquisition costs for financial guaranty business amortized during 2008, 2007 and 2006 was $47.3 million, $45.4 million and $46.6 million, respectively.
A summary of our derivative assets and liabilities, as of and for the periods indicated, is as follows:
In 2008, credit spreads on underlying collateral, both corporate credit spreads and asset-backed spreads, widened significantly, which would have resulted in large unrealized losses on these positions. More than offsetting these losses, however, due to the incorporation of our non-performance risk into our fair value measurements as required by SFAS No. 157, the fair value of our liabilities was reduced by approximately $5.6 billion in the aggregate resulting in a net unrealized gain. The largest component of this reduction in value related to the valuation of our corporate CDOs. The credit protection we offer on corporate CDOs is generally senior investment grade debt, which carries a weighted average spread of approximately 319 basis points. Based on our December 31, 2008 CDS spread of 2,466 basis points, the market valuation of our credit protection of these highly rated underlying tranches is minimal at December 31, 2008, resulting in a very low fair premium amount.
The QSPE framework is applicable when an entity transfers (sells) financial assets to an SPE meeting certain criteria defined in SFAS No. 140. These criteria are designed to ensure that the activities of the entity are essentially predetermined at inception and that the transferor of the financial assets cannot exercise control over the entity and the assets therein. Entities meeting these criteria are not required to be consolidated by the transferor, or other counterparties, as long as they do not have the unilateral ability to liquidate or cause the entities to no longer meet the QSPE criteria.
(3) Aggregate investment in securities backed by MSA payments (the MSA obligated participating tobacco companies to compensate various states for health and other tobacco related expenses).
Reserves for our mortgage insurance business are recorded based on our modeled output for loss and LAE reserves. In light of the regular adjustments made to the underlying assumptions in our model as discussed above, we believe the amount generated by our model at December 31, 2008 best represents the most accurate estimate of our future losses and LAE. We believe the high and low amounts highlighted in the table above represent a reasonable estimate of the range of possible outcomes around our recorded reserve point for the period indicated.
In our financial guaranty reinsurance business, the primary obligation for assessing and mitigating claims rests with the ceding company. To help align the ceding company’s interests with ours, we generally require that the ceding company retain a portion of the exposure on any single risk that we reinsure. Our portfolio management group is responsible for the periodic diligence and evaluation of the underwriting and surveillance capabilities of the ceding companies. This evaluation includes an in depth review of the following areas: business strategy; underwriting approach and risk appetite; sector specific surveillance strategies; watch and reserve processes and procedures and reinsurance strategies. Each of the ceding companies provides us with quarterly updates to their watch and reserve lists, including reserve information. In the event that we have identified a potential deficiency in the surveillance activities of a ceding company, appropriate personnel in our risk management department may conduct an independent analysis to the extent adequate information is available. We also may have an independent view on assumed credits where we also have direct exposure based on the information obtained through our independent credit review. As a result, we may assess credits and establish reserves based upon information in addition to that received from the ceding company.
The components of our consolidated income tax (benefit) provision are as follows:
We adopted FIN 48 on January 1, 2007. The cumulative effect of applying the provisions of FIN 48 was a $21 million decrease in retained earnings. Prior to the implementation of FIN 48, we maintained reserves for contingent tax liabilities, which totaled approximately $20 million as of December 31, 2006. As of December 31, 2008, we have approximately $41.7 million of unrecognized tax benefits that, if recognized, would affect the effective tax rate. Our policy for the recognition of interest and penalties associated with uncertain tax positions is to record such items as a component of our income tax provision. The table below details the cumulative effect of applying the provisions of FIN 48 as of December 31, 2008.
retirement vehicle for our employees. On February 5, 2007, our board of directors approved the termination of the Pension Plan, effective June 1, 2007.
The Mercer Yield Curve is constructed using bid prices on bonds rated AA by Moody’s where the time to maturity is between 0.5 and 30 years, and determining a best-fit regression curve linking yield-to-maturity to time to maturity. After removing outliers with a yield-to-maturity more than two standard errors from the initial regressed yield-to-maturity, the revised regressed coupon yield curve is converted to a spot rate curve using bootstrapping. The cash flows after 30 years are discounted assuming the 30-year spot rate remains constant beyond 30 years.