6,748 square feet of office space, which was used for our financial guaranty operations in London. This lease, with a term through June 2012, has been assigned to a third party. Radian Group remains as a guarantor on the lease should the assignee fail to perform.
Traditional Mortgage Insurance. Our mortgage insurance segment, through Radian Guaranty, offers primary mortgage insurance coverage on residential first-lien mortgages (“first-lien”). At December 31, 2010, primary insurance on first-liens made up approximately 92.8% of our total first-lien mortgage insurance risk in force. We also offer pool insurance on first-liens on a limited basis. Pool insurance comprised approximately 7.2% of our total first-lien mortgage insurance risk in force at December 31, 2010.
The following table summarizes the fair value amounts reflected on our consolidated balance sheet at December 31, 2010, related to these instruments and the present value of our estimated credit loss payments on these instruments.
As a result of the consolidation in 2010 of certain VIEs in which we are the primary beneficiary, amounts which had previously been reported in change in fair value of derivative instruments are currently reported as change in fair value of VIE debt, which is included in net (losses) gains on other financial instruments.
(1) Rescission rates represent the ratio of claims rescinded or denied to claims received (by claim count) and represent (as of December 31, 2010) the cumulative rate for each quarter based on number of claims received during that quarter. Until all of the claims received during the periods shown have been resolved, the rescission rates for each quarter will be subject to change. These rates are also subject to change based on reinstatements of previously rescinded policies or denied claims.
Net Impairment Losses Recognized in Earnings. Net impairment losses for 2009, compared to 2008, included a lesser amount of impairments on fixed maturity investments available for sale and equity securities available for sale.
The following table shows financial guaranty claims paid and reserve for losses for each of the periods indicated:
(1) Includes $53.9 million related to the June 2009 commutation of $9.8 billion in assumed net par outstanding.
Radian Group had immediately available, directly or through an unregulated direct subsidiary, unrestricted cash and marketable securities of $797.5 million at December 31, 2010, which includes $150 million of investments contained in our CPS custodial trusts as discussed below.
We expect to meet the long-term liquidity needs of Radian Group with (i) available cash and marketable securities, including $150 million held in the CPS trust fund accounts(ii) additional potential private or public issuances of debt or equity securities, (iii) cash received under tax- and expense-sharing arrangements with our subsidiaries and (iv) the sale of assets or from dividends from our subsidiaries. If necessary, we may need to refinance all or a portion of our long-term debt, but we cannot assure you that we will be able to do so on favorable terms, if at all.
3. Upon the occurrence of specified corporate events as described in the indenture for the notes.
We establish reserves to provide for losses and LAE and the estimated costs of settling claims in both our mortgage insurance and financial guaranty segments. The accounting standard regarding accounting and reporting by insurance enterprises specifically excludes mortgage insurance from its guidance relating to the reserve for losses but does not provide any other specific guidance. Therefore, because of the lack of specific guidance, we establish reserves for mortgage insurance using the guidance contained in this standard, supplemented with other accounting guidance as described below.
Potential impact on our businesses as a result of the implementation of regulations under the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), including in particular: (i) whether and to what extent loans with mortgage insurance are considered “qualified residential mortgages” for purposes of the Dodd-Frank Act securitization provisions or “qualified mortgages” for purposes of the ability to repay provisions; and (ii) the possibility that additional reporting, capital and collateral requirements will be imposed on our financial guaranty business, including potentially, the posting of collateral for existing derivative contracts; and
With respect to loans that are in an early stage of default, considerable judgment is exercised as to the adequacy of reserve levels. Adjustments in estimates for loans in the early stage of default are more volatile in nature than for loans that are in the later stage of default, which generally require a larger reserve. As the default proceeds towards foreclosure, there is generally more certainty around these estimates as a result of the aged status of the defaulted loan, 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), the reserve for that loan is removed from the reserve for losses and LAE. We also establish reserves for defaults that we believe have been incurred but not reported (“IBNR”) to us on a timely basis, and for defaults related to previously rescinded policies and denied claims which are likely to be reinstated (in the case of previously rescinded policies), or resubmitted (in the case of previously denied claims). Due to the period of time (generally up to 90 days) we give the insured to rebut our decision to rescind coverage before we consider a policy to be rescinded and removed from our default inventory, we do not currently expect a material amount of policies that were ultimately rescinded to be reinstated. All estimates are periodically reviewed and adjustments are made as they become necessary.
There are both performing and under-performing credits in our financial guaranty portfolio. Performing credits generally have investment-grade internal ratings, denoting nominal to moderate credit risk. However, claim liabilities may be established for performing credits if the expected losses on the credit exceed the unearned premium revenue for the contract based on the present value of the expected net cash outflows. If our risk management department concludes that a directly insured transaction should no longer be considered performing, it is placed in one of three designated watch list categories for deteriorating credits: Special Mention, Intensified Surveillance or Case Reserve. Assumed exposures in financial guaranty’s reinsurance portfolio are generally placed in one of these categories if the ceding company for such transaction downgrades it to an equivalent watch list classification. However, if our financial guaranty risk management group disagrees with the risk rating assigned by the ceding company, we may assign our own risk rating rather than use the risk rating assigned by the ceding company. See Note 12 for further information.
$36.1 million, $27.5 million and $89.1 million, respectively. As a result of the establishment of a first-lien PDR at June 30, 2008, all remaining deferred policy acquisition costs, totaling $50.8 million, related to first-lien domestic mortgage insurance written prior to that date were written off.
The notional value of our derivative contracts at December 31, 2010 and 2009 was $41.6 billion and $46.1 billion, respectively.
(2) Represents the fair value of an interest rate swap included in the consolidation of one of our financial guaranty transactions. The notional amount of the interest rate swap does not represent additional par exposure, and therefore, is not presented in this table. See Note 6 for information on our maximum exposure to loss from our consolidated financial guaranty transactions.
Determining the Fair Premium Amount -For each Corporate CDO transaction, we perform three principal steps in determining the fair premium amount:
(4) Comprised of consolidated debt related to NIMS VIEs ($288.0 million) and CPS trusts ($8.1 million).
During 2009, all of our NIMS transactions were consolidated, and we recategorized some of our hybrid and MBS securities from Level III to Level II. These were initially categorized as Level III because there was no active market or observable inputs when the securities were initially purchased. These securities are now more frequently traded, which provided observable inputs for our valuation.
(1) Activity displayed above reflects the impact for the periods prior to June 30, 2010, for one CPS custodial trust that was not consolidated prior to that date.
The following table shows the components of our investment in affiliates balance:
Many of the key assumptions used to develop our reserve estimate are inter-related and inter-dependent, including our default to claim rate, our estimated rate of insurance rescissions and claim denials on future claims, and our estimated claim severity, among other assumptions. Such inter-dependencies make it difficult to isolate and quantify the effects of changes in individual factors. The principal drivers of changes in prior year development typically relate to our default to claim rate (including our estimated rate of rescissions and denials), and our estimated claim severity.
Our reserve for losses includes the impact of our estimated rescissions and denials, which are significantly higher than historical levels. Generally, rescissions and denials reduce the default to claim rate used in determining our loss reserve estimate, which lowered our loss reserves as of December 31, 2010, by approximately $0.9 billion. The amount of estimated rescissions and denials incorporated into our reserve analysis at any point in time is affected by a number of factors, including not only our estimated rate of rescissions and denials on future claims, but also the volume and attributes of our defaulted insured loans, our estimated default to claim rate, and our estimated claim severity, among other assumptions. We expect the amount of estimated rescissions and denials embedded within our reserve analysis to ultimately decrease over time, as the defaults related to the poor underwriting periods of 2005 through 2008 decline as a proportion of our total default portfolio and as we realize the results through actual rescissions and denials and commutations.
In our financial guaranty reinsurance business, the primary obligation for assessing and mitigating claims rests with our ceding companies. To help align the ceding company’s interests with ours, we generally have required that the ceding company retain a significant 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. Each of the ceding companies is obligated to provide us with quarterly updates to their own 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.
In February 2003, we issued $250 million of unsecured senior notes. These notes bear interest at the rate of 5.625% per annum, payable semi-annually on February 15 and August 15. These notes mature in February 2013. We have the option to redeem some or all of the notes at any time with not less than 30 days’ notice at a redemption price equal to the greater of the principal amount of the notes or the sum of the present values of the remaining scheduled payments of principal and interest on the notes to be redeemed. In April 2004, we entered into interest-rate swap contracts that effectively converted the interest rate on this fixed-rate debt to a variable rate based on a spread over the six-month London Interbank Offered Rate (“LIBOR”). We terminated these swaps in January 2008. The basis adjustment of $11.5 million that resulted from the interest-rate swaps, and that was recorded as an increase to the long-term debt carrying value, is being amortized to interest expense over the remaining term of the debt.
We have determined that the embedded conversion option in the convertible notes is not required to be separately accounted for as a derivative under the accounting standard for derivatives and hedging. The carrying amount of the liability component was calculated by measuring the fair value of a similar liability that does not have an associated equity component. The carrying amount of the equity component representing the embedded conversion option was determined by deducting the fair value of the liability component from the initial proceeds ascribed to the convertible notes as a whole. The excess of the principal amount of the liability component over its carrying amount is amortized as a component of interest expense over the expected life of a similar liability that does not have an associated equity component using the effective interest method. The equity component is not remeasured as long as it continues to meet the conditions for equity classification as prescribed in the accounting standard for derivative financial instruments indexed to, and potentially settled in, an entity’s own common stock and the accounting standard for determining whether an instrument (or an embedded feature) is indexed to an entity’s own stock.
The following table sets forth total interest expense recognized related to the convertible notes for the period indicated:
Changes in our unvested phantom stock under the Equity Plans were as follows:
We use the Black-Scholes model in determining the fair value of stock options issued to employees and non-employee directors. The fair value of the stock options granted was estimated using this model on the date of grant using the assumptions noted in the following table for options granted in that year:
Performance Based RSUs-During 2010, the Compensation Committee granted a total of 203,300 performance-based RSUs to be settled in common stock. The underlying award is issued in consideration for services rendered. The grant date estimated fair value of RSUs subject to performance vesting conditions is determined using the Monte Carlo valuation model. The Monte Carlo valuation model incorporates multiple input variables, along with correlation factors, to estimate the probability that a vesting condition will be achieved. The performance and vesting conditions and potential payouts relative to target for these performance based RSUs are the same as those described above under “RSUs (Cash Settled)-Performance Based RSUs.”
We expect to contribute nominal amounts to Radian Group’s and EFSG’s other postretirement benefit plans in 2011. Due to the nature of the Postretirement Welfare Plan, no increase is assumed in our obligation due to any increases in the per-capita cost of covered healthcare benefits.
Securities regulations became effective in 2005 that impose enhanced disclosure requirements on issuers of ABS (including mortgage-backed securities (“MBS”)). To allow our customers to comply with these regulations, we typically are required, depending on the amount of credit enhancement we are providing, to provide (1) audited financial statements for the insurance subsidiary participating in the transaction, or (2) a full and unconditional holding-company-level guarantee for our insurance subsidiaries’ obligations in such transactions. Radian Group has guaranteed two structured transactions for Radian Guaranty involving approximately $189.6 million of remaining credit exposure.
(6) Diluted net (loss) income per share and average shares outstanding per the accounting standard regarding earnings per share.
(8) The second quarter of 2009 reflects a decrease in the provision for losses as a result of increased levels of estimated insurance rescissions and claim denials, which resulted in a lower default to claim rate used in determining our loss reserve estimate.