In addition, we lease office space for our mortgage insurance operations in: Worthington, Ohio; Dayton Ohio; and Hong Kong. Following the Clayton acquisition in 2014, we also have leases for office space for our MRES operations in various cities in Connecticut, Florida, Colorado, Georgia and Utah, as well as in Bristol, England.
The information in the following table should be read in conjunction with our Consolidated Financial Statements and Notes thereto included in Item 8 and the information included in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” As a result of the December 22, 2014 Radian Asset Assurance Stock Purchase Agreement to sell Radian Asset Assurance, Radian’s financial guaranty insurance subsidiary, we have reclassified the operating results related to the pending disposition as discontinued operations for all periods presented in our consolidated statements of operations. See Note 3 of Notes to Consolidated Financial Statements for additional information.
Calculated using amounts determined under GAAP, using provision for losses to calculate the loss ratio and policy acquisition costs and other operating expenses to calculate the expense ratio as a percentage of net premiums earned and net premiums written. Expense ratios include amounts that have been reallocated to the mortgage insurance segment that were previously allocated to the financial guaranty segment, but were not reclassified to discontinued operations.
The following analysis of our financial condition and results of operations should be read in conjunction with our Consolidated Financial Statements and Notes thereto included in Item 8 and the Risk Factors detailed in Item 1A of this Annual Report on Form 10-K.
The improvement in macroeconomic and credit trends has encouraged new entrants into the private mortgage insurance industry, while improving the financial strength of existing private mortgage insurers. This has resulted in an increasingly competitive environment for private mortgage insurers. See “Part I. Item 1. Business-Competition.” During the past several years, we have been focused on managing our businesses through the negative effects of the financial crisis while at the same time pursuing a number of strategic initiatives designed to strengthen and grow our mortgage insurance franchise to capitalize on improving trends. In particular, following the crisis, we expanded and diversified our customer base, wrote a significant amount of post-2008, high-quality NIW and pursued a reduction of our Legacy Portfolio through loss mitigation and settlements. As of December 31, 2014, our Legacy Portfolio had been reduced to approximately 31% of our total primary RIF, while insurance on loans written after 2008 constituted approximately 69% of our total primary RIF. During this period of time, as the negative impact from losses in our Legacy Portfolio has been reduced and we have continued to write a high volume of insurance on high credit quality loans, our results of operations have improved. This improvement continued in 2014 and we returned to full year profitability for the first time since the financial crisis.
Business Strategy. Currently, our business strategy is focused on: (1) growing our mortgage insurance business by writing insurance on high-quality mortgages in the U.S.; (2) diversifying our revenue sources by pursuing other potential opportunities for providing credit-related and other services to the mortgage finance market; (3) growing our fee-based revenues as a percentage of Radian’s total revenues, primarily by expanding Clayton’s presence in the real estate and mortgage finance industries; (4) continuing to manage losses and reduce our legacy exposure; (5) continuing to effectively manage our capital and liquidity positions, including efforts to ensure compliance with the PMIERs Financial Requirements and with other regulatory requirements, as well as strengthening our balance sheet with the objective of regaining investment grade credit ratings in the future. See Note 1 of Notes to Consolidated Financial Statements for information regarding the new, proposed GSE eligibility requirements that were issued in the form of proposed PMIERs for public comment on July 10, 2014.
On June 30, 2014, we acquired Clayton, which is a leading provider of services and solutions to the mortgage and real estate industries, providing outsourced services, information-based analytics and specialty consulting for buyers and sellers of, and investors in, mortgage- and real estate-related loans and securities and other debt instruments. Clayton’s primary services include:
Surveillance-Third-party performance oversight, risk management and consulting services, with offerings focused on RMBS surveillance, loan servicer oversight, loan-level servicing compliance reviews and operational reviews of mortgage servicers and originators;
REO Management-REO asset management services offered through Clayton’s subsidiary, Green River Capital, which includes management of the entire REO disposition process for our clients; and
Clayton’s customers include a wide range of financial institutions, the GSEs, securitization trusts, investors, regulators and other mortgage-related service providers, including mortgage originators, mortgage purchasers, mortgage-backed securities issuers, mortgage-backed securities investors and mortgage servicers.
The results of Clayton’s operations have been included in our financial statements in the MRES segment from the June 30, 2014 date of acquisition.
On December 22, 2014, Radian Guaranty entered into the Radian Asset Assurance Stock Purchase Agreement to sell Radian Asset Assurance, our principal financial guaranty subsidiary, to Assured, for a purchase price of approximately $810 million, subject to certain adjustments. The divestiture is part of Radian’s strategy to focus its business toward the mortgage and real estate markets and to accelerate its ability to comply with the proposed PMIERs. The consummation of the transaction is expected to increase Radian Guaranty’s Available Assets by the net cash proceeds of approximately $790 million, after closing costs and other adjustments. The purchase price is payable in cash on the closing date. Radian expects to complete the sale of Radian Asset Assurance to Assured in the first half of 2015, subject to satisfaction of customary closing conditions including regulatory approvals. For additional information related to discontinued operations, see Note 3 of Notes to Consolidated Financial Statements.
We continue to explore additional alternatives, including commutations and external reinsurance, in order to accelerate compliance with the final form of the PMIERs. See Note 1 of Notes to Consolidated Financial Statements for information on the PMIERs.
NIW increases our IIF and premiums written and earned. An increase or decrease in IIF will generally have a corresponding impact on premiums earned. Cancellations of our insurance policies and other reductions of IIF, such as rescissions of coverage and claims paid, generally have a negative effect on premiums earned. The measure for assessing the impact of policy cancellations on our IIF is our Persistency Rate, defined as the percentage of IIF that remains on our books after any 12-month period. Insurance premiums on our Monthly Premium insurance policies are paid and earned over time; therefore, higher Persistency Rates on Monthly Premium insurance policies enable us to earn more premiums and recover some or all of our policy acquisition costs, and generally result in increased profitability. When Single Premium policies are cancelled by the insured because the loan has been paid off or otherwise, we accelerate the recognition of any remaining unearned premiums. Therefore, assuming all other factors remain constant, profitability increases on our Single Premium business when Persistency Rates are lower. Rescissions, which are discussed in further detail below, result in a full refund of the inception-to-date premiums received, and therefore, premiums earned are affected by any changes in our accrual for estimated rescission refunds. Additionally, premiums ceded to third-party reinsurance counterparties decrease premiums written and earned.
Losses. Incurred losses represent the estimated future claim payments on newly defaulted insured loans as well as any change in our claim estimates for previously existing defaults. Our mortgage insurance incurred losses are driven primarily by new defaults and changes in the estimates we use to determine our losses, including estimates with respect to the likelihood, magnitude and timing of anticipated losses, and our estimate of the rate at which we expect defaults will ultimately result in paid claims. Other factors influencing incurred losses include:
The product mix of our total direct RIF (loans with higher risk characteristics generally result in more delinquencies and claims);
Changes in housing values (declines in housing values negatively impact our ability to mitigate our losses by either paying the full claim amount and acquiring the property for resale or facilitating a sale of the property, and also may negatively affect a borrower’s willingness to continue to make mortgage payments when the home value is less than the mortgage balance);
The distribution of claims over the life cycle of a portfolio (historically, claims are relatively low during the first two years after a loan is originated and then increase substantially over a period of several years before declining; however, as happened with much of our Legacy Portfolio, several factors can impact and change this cycle, including the economic environment, the quality of the underwriting of the loan, characteristics of the mortgage loan, the credit profile of the borrower, housing prices and unemployment rates);
Our ability to mitigate potential losses through rescissions, denials, cancellations and the curtailment of claims submitted to us. Generally, we rescind insurance coverage when we conclude, through our review of the underwriting of a loan, that the loan was not originated in accordance with our underwriting guidelines. Generally, we deny claims when the documentation we receive is not sufficient to perfect the claim in accordance with our Master Policies. In addition, we may cancel coverage or curtail claim payments when we identify servicer negligence, or we may curtail claims by making other adjustments to claims as permitted by our Master Policies. These actions all reduce our incurred losses. Conversely, if our Loss Mitigation Activities are successfully challenged at rates that are higher than expected or we agree to settle disputes related to our Loss Mitigation Activities at levels above our expected losses, our incurred losses will increase. In general, our Loss Mitigation Activities have been more frequent with respect to our insured loans underwritten during the poor underwriting years of 2005 through 2008, but have recently declined as these defaults have decreased and lenders have increased efforts to satisfy documentation requirements; and
Potential sales volume in our MRES business depends in part on the overall activity in the mortgage finance market and the health of related industries. We believe the diversity of the services offered by MRES, which is intended to cover all phases of the mortgage value chain, helps us to maintain a more stable fee income throughout various mortgage finance environments. For example, the demand for due diligence services may decrease due to lower mortgage origination and securitization volumes in an unfavorable mortgage finance environment, whereas the demand for REO management services may tend to increase in such an environment. In addition, while the size of the mortgage finance market may be adversely impacted by increased regulatory requirements, these increased requirements may increase the demand for certain of our services, including services related to compliance with the CFPB mortgage servicing standards and the regulatory requirements for third-party review of loans in asset-backed securities.
Our component services business provides service to the single family rental market, which is an emerging market that experienced rapid growth in 2014. In addition, we believe that the re-emergence of the non-agency residential mortgage-backed securitization market represents a potentially significant growth opportunity for loan review and due diligence and surveillance services. However, the size and timing for the return of this market are uncertain and will be impacted by factors outside of our control, including market demand and regulation.
Revenue for the MRES segment’s products and services is dependent on a limited number of large customers that represented a significant portion of revenues. The primary customers include buyers and sellers of, and investors in, mortgage- and real estate-related loans, securities and other debt instruments. Specifically, customers include financial institutions, the GSEs, securitization trusts, investors, regulators and other mortgage-related service providers, including mortgage originators, mortgage purchasers, mortgage-backed securities issuers, mortgage-backed securities investors and mortgage servicers. Revenue for the MRES segment also includes inter-segment revenues from services performed for our mortgage insurance segment.
Time-and-Expense Contracts. Under a time-and-expense contract, we are paid a fixed hourly rate for each direct labor hour expended, and we are reimbursed for billable out-of-pocket expenses as work is performed. To the extent our actual direct labor costs decrease or increase in relation to the fixed hourly billing rates provided in the contract, we may generate more or less profit, respectively. However, since these contracts are generally short-term in nature, the risk is limited to the periods covered by the contracts. These contracts are used in our loan review & due diligence and EuroRisk services offerings, as well as in the consulting services that we offer as part of our surveillance business.
Direct Cost of Services. Our direct cost of services is primarily affected by our level of services revenue. Our direct 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 direct costs of providing services such as travel and related expenses incurred in providing client services and costs paid to outside vendors. 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.
Radian Asset Assurance Stock Purchase Agreement. Radian expects to complete the sale of Radian Asset Assurance to Assured in the first half of 2015, subject to satisfaction of customary closing conditions including regulatory approvals.
Radian Group serves as the holding company for our operating subsidiaries and does not have any significant operations of its own. Our consolidated operating results for 2014 primarily reflect the financial results and performance of our two business segments-mortgage insurance and MRES. See “-Results of Operations-Mortgage Insurance,” and “-Results of Operations-MRES” for the operating results of these business segments.
We allocate to our MRES segment: (i) corporate expenses based on an allocated percentage of time spent on the MRES segment; and (ii) all interest expense related to the Senior Notes due 2019, the proceeds of which were used to fund our acquisition of Clayton. No corporate cash or investments are allocated to the MRES segment. Because the Clayton acquisition occurred on June 30, 2014, we have included its results of operations from the date of acquisition.
Effective with the fourth quarter of 2014, the MRES business undertook the management responsibilities of certain additional loan servicer surveillance functions that were previously considered part of our mortgage insurance segment. As a result, these services and activities are now reported in our MRES segment for all periods presented.
The following table highlights selected information related to our consolidated results of operations for the years ended December 31, 2014, 2013 and 2012:
The loss from discontinued operations consists of three components: (i) loss on classification as held for sale for the year ended December 31, 2014; (ii) income or loss from operations of businesses held for sale; and (iii) income tax provision. The divestiture of our financial guaranty business is part of Radian’s strategy to focus its business toward the mortgage and real estate markets and to accelerate its ability to comply with the proposed PMIERs.
Services Revenue and Direct Cost of Services. In 2014, services revenue and direct cost of services represent amounts related to our MRES segment as a result of our acquisition of Clayton. See “-Results of Operations-MRES” below for more information.
Other Operating Expenses. Among other items, our other operating expenses include compensation expense associated with changes in the estimated fair value of certain cash-settled long-term incentive awards that are valued, in large part, based on the stock price of Radian Group’s common stock, which increased during 2014 and 2013. During 2014, our expense related to these awards was approximately $43.9 million compared to approximately $96.9 million for 2013 and $29.5 million for 2012. During 2014 and 2013, this expense increased as compared to 2012, primarily due to increases in the estimated fair value of cash-settled long-term incentive awards resulting from the significant increases in Radian’s common stock price discussed above. Partially offsetting the decrease in expenses related to cash-settled long-term incentive awards in 2014 as compared to 2013 was an increase in other compensation costs, and contract underwriting expenses (as discussed in Results of Operations-Mortgage Insurance-Other Operating Expenses). Also offsetting operating expenses in 2014 and 2013 were ceding commissions earned related to the QSR Reinsurance Transactions. See “-Results of Operations-Mortgage Insurance-Net Premiums Written and Earned” for information regarding the QSR Reinsurance Transactions.
Interest Expense. These amounts reflect interest on our long-term debt. In May 2014, we issued $300 million principal amount of 5.500% Senior Notes due June 2019. In February 2013, we repaid the remaining $79.4 million outstanding balance of our 5.625% Senior Notes due February 2013. Also in the first quarter of 2013, we exchanged $195.5 million of our 5.375% Senior Notes due June 2015 for a new series of 9.000% Senior Notes due June 2017 and issued $400 million principal amount of 2.250% Convertible Senior Notes due March 2019 (the “Convertible Senior Notes due 2019”) with an effective interest rate of 6.250%. The debt issuance in 2014 was the primary reason for the increase in interest expense in 2014. The debt exchange and the issuance of the Convertible Senior Notes due 2019 were the primary reasons for the increase in interest expense in 2013. See Note 11 of Notes to Consolidated Financial Statements for additional information.
Amortization and Impairment of Intangible Assets. The amortization and impairment of intangible assets for 2014 primarily reflects the amortization of intangible assets acquired as part of the Clayton acquisition. We also recorded a $2.1 million impairment of a portion of our goodwill related to a small subsidiary within our MRES segment, which had been acquired in 2013. See Note 7 of Notes to Consolidated Financial Statements for additional information.
Income Tax (Benefit) Provision. The effective tax rate from continuing operations was (209.4)% for 2014 compared to 18.2% for 2013 and 17.7% for 2012. The change from our statutory tax rate of 35% for 2014 was primarily due to the reversal of substantially all of our valuation allowance. The change from our statutory tax rate of 35% for 2013 and 2012 was primarily due to changes in our overall valuation allowance against our DTA and the accounting for uncertainty of income taxes. See Note 13 of Notes to Consolidated Financial Statements for more information regarding our valuation allowance and the accounting for uncertainty of income taxes.
Although adjusted pretax operating income (loss) excludes certain items that have occurred in the past and are expected to occur in the future, the excluded items represent those that are: (1) not viewed as part of the operating performance of our primary activities; or (2) not expected to result in an economic impact equal to the amount reflected in pretax income (loss) from continuing operations. These adjustments, along with the reasons for their treatment, are described below.
Change in fair value of derivative instruments. Gains and losses related to changes in the fair value of insured credit derivatives are subject to significant fluctuation based on changes in interest rates, credit spreads, credit ratings and other market, asset-class and transaction-specific conditions and factors that may be unrelated or only indirectly related to our obligation to pay future claims. With the exception of the estimated present value of net credit (losses) recoveries incurred discussed in item 2 below, we believe these gains and losses will reverse over time and consequently these changes are not expected to result in economic gains or losses. Therefore, these gains and losses are excluded from our calculation of adjusted pretax operating income (loss).
Estimated present value of net credit (losses) recoveries incurred. The change in present value of insurance claims we expect to pay or recover on insured credit derivatives represents the amount of the change in credit derivatives from Item 1 above, that we expect to result in an economic loss or recovery based on our ongoing loss monitoring analytics. Therefore, this item is expected to have an economic impact and is included in our calculation of adjusted pretax operating income (loss). Also included in this item is the change in expected economic loss or recovery associated with our consolidated VIEs.
Net gains (losses) on investments and other financial instruments. The recognition of realized investment gains or losses can vary significantly across periods as the activity is highly discretionary based on the timing of individual securities sales due to such factors as market opportunities, our tax and capital profile and overall market cycles. Unrealized investment gains and losses arise primarily from changes in the market value of our investments that are classified as trading. These valuation adjustments may not necessarily result in economic gains or losses. We do not view them to be indicative of our fundamental operating activities. Trends in the profitability of our fundamental operating activities can be more clearly identified without the fluctuations of these realized and unrealized gains or losses. Therefore, these items are excluded from our calculation of adjusted pretax operating income (loss).
Total adjusted pretax operating income (loss) is not a measure of total profitability, and therefore should not be viewed as a substitute for GAAP pretax income (loss) from continuing operations. Our definition of adjusted pretax operating income (loss) may not be comparable to similarly-named measures reported by other companies.
The following table provides a reconciliation of our non-GAAP financial measure for the consolidated company, adjusted pretax operating income (loss), to the most comparable GAAP measure, pretax income (loss) from continuing operations:
Prior periods have been restated to reflect the reallocation of certain corporate income and expenses that were previously allocated to the financial guaranty segment, but were not reclassified to discontinued operations. These items now have been reallocated to the mortgage insurance segment.
During 2014, we continued our strategy of growing our mortgage insurance portfolio by writing insurance on mortgages with strong credit characteristics. At December 31, 2014, we had approximately $172 billion in IIF compared to approximately $161 billion in IIF at December 31, 2013. We also continued to focus on managing losses in our Legacy Portfolio, reducing the size of our Legacy Portfolio and effectively managing our capital and liquidity positions.
The following table summarizes our mortgage insurance segment’s results of operations for the years ended December 31, 2014, 2013 and 2012:
Adjusted Pretax Operating Income (Loss). Our mortgage insurance segment’s adjusted pretax operating income for 2014 was $336.9 million, compared to an adjusted pretax operating loss of $67.4 million for 2013. Our results for 2014 compared to 2013 primarily reflect: (i) an increase in net premiums earned; (ii) a significant reduction in the provision for losses; and (iii) a reduction in other operating expenses.
The improvement in the results for 2013 compared to 2012 primarily reflects an increase in net premiums earned and a significant decrease in the provision for losses, partially offset by an increase in other operating expenses and interest expense.
In 2009, the GSEs began offering HARP, which allows a borrower who is not delinquent to refinance a mortgage if the borrower has been unable to take advantage of lower interest rates because the borrower’s home has decreased in value. Radian Guaranty and other private mortgage insurers have agreed with the FHFA to facilitate the transfer of mortgage insurance on loans to be refinanced through HARP without regard to LTV. HARP 2 expanded the number of borrowers who can qualify for refinancing. The changes implemented by the enhanced HARP 2 program have increased the number of borrowers who are eligible to benefit from the program and, as of December 31, 2014, approximately 10% of our total primary RIF had successfully completed a HARP refinance. The HARP 2 program has been extended until December 31, 2015. The HARP programs have had a positive impact on the overall credit quality and composition of our mortgage insurance portfolio given that the refinancing generally results in terms under which a borrower has a greater ability to pay and more financial flexibility to cover the loan obligations. We exclude HARP loans from our NIW for the period in which the refinance occurs. During 2014, new HARP loans accounted for $1.7 billion of newly refinanced loans that were not included in Radian Guaranty’s NIW for that period, compared to $7.6 billion for 2013.
The level of our refinance originations has declined and the purchase origination volume as a percentage of our total NIW has increased during 2014. Because purchase borrowers tend to have lower FICO scores and higher LTV ratios than refinancings, the FICO score distribution of our NIW has generally become more heavily concentrated in higher level FICO scores and the LTV distribution of our NIW is generally more concentrated in lower LTV categories.
Net premiums earned increased for 2014 compared to 2013, primarily due to higher direct premiums earned in 2014 as a result of NIW, as well as an increase in Persistency Rates in 2014 that resulted in a significant increase in IIF. In addition, net premiums earned in 2014 compared to 2013 were impacted by an experience-related profit commission for the Initial QSR Transaction, a decrease in estimated premium refunds resulting from a lower level of rescissions, including lower rescission refunds under the BofA Settlement Agreement. Net premiums earned increased in 2013 compared to 2012, primarily due to increases in direct premiums earned as a result of an increase in NIW and a decrease in premiums refunded in connection with lower rescissions in 2013 compared to 2012. The increase in net premiums earned in 2013 was partially offset by an increase in ceded premiums earned related to the QSR Reinsurance Transactions.
RIF ceded under QSR Reinsurance Transactions and included in primary RIF.
Net Investment Income. Our mortgage insurance net investment income decreased in 2014 compared to 2013, and in 2013 compared to 2012, primarily due to the continuation of the lower interest rate environment, which resulted in lower market yields for our investments, combined with lower investment balances. Sales of certain securities, in addition to subsequent reinvestment of longer duration securities in the low interest rate environment, have resulted in a lower yield profile for the portfolio. All periods include an allocation to the mortgage insurance segment of net investment income from investments held at Radian Group.
Our mortgage insurance provision for losses also improved for 2013 relative to 2012. This decrease was driven primarily by a continued decline in new defaults and less adverse development in our estimate of future losses on existing defaults, mainly due to the higher rates of claim curtailments and cures that we experienced in 2013. Additionally in 2013, the adverse development on existing defaults in the provision for losses includes an incurred loss of approximately $22 million related to the Freddie Mac Agreement. This loss is expected to be offset by a reduction of incurred losses in future periods, as a portion of currently performing loans covered by the transaction (and for which we no longer have claim exposure) re-default in the future and ultimately become claims. In 2012, we experienced an increase in other losses related to a $44 million write-down in our estimated reinsurance recoverable from our remaining Smart Home reinsurance transactions. Our final Smart Home reinsurance transaction matured in May 2013.
The following table shows a rollforward of the number of our primary loans in default:
Amounts reflected are compiled monthly based on reports received from loan servicers. The number of new defaults and cures presented includes the following monthly defaults that both defaulted and cured within the periods indicated:
Our aggregate weighted average net Default to Claim Rate assumption for our primary loans used in estimating our reserve for losses, which is net of estimated denials and rescissions, was approximately 52% at December 31, 2014, and 50% at both December 31, 2013 and 2012. Contributing to this increase was a change in the gross Default to Claim Rate assumption for certain segments of our default inventory during 2014. We develop our Default to Claim Rate estimates on defaulted loans based on models that use a variety of loan characteristics to determine the likelihood that a default will reach claim status. During the third quarter of 2014, we continued to refine our approach to estimating loss reserves and developed additional portfolio segmentations, primarily based on a loan’s Time in Default and its current Stage of Default, in assessing the likelihood that a default will become a claim. Previously, we gave greater weight to other loan characteristics, including the status of the loan as reported by its servicer, as defined by the number of missed payments, and the type of loan product. In addition, based on observed trends, we lowered our estimated Claim Severity rate during 2014, which contributed to the favorable development in our estimate of future losses on existing defaults.
Our net Default to Claim Rate and loss reserve estimate incorporates our future expectations with respect to future claim denials and insurance rescissions. These expectations are based on our recent experience with respect to the number of claims that have been denied due to the policyholder’s failure to submit sufficient documentation to perfect a claim within the time period permitted under our Master Policies and also our recent experience with respect to the number of insurance certificates that have been rescinded due to fraud, underwriter negligence or other factors. As of December 31, 2014, we have adjusted these estimates to reflect the expected impact of the BofA Settlement Agreement. See Note 10 of Notes to Consolidated Financial Statements.
The following table illustrates the amount of First-lien claims submitted to us for payment that were rescinded or denied, net of any reinstatements of previously rescinded policies or denied claims for the periods indicated:
Our reported rescission and denial activity in any given period is subject to challenge by our lender and servicer customers through our claims rebuttal process. In addition, we are at times engaged in discussions with our lender and servicer customers regarding these Loss Mitigation Activities. Unless a liability associated with such activities or discussions become probable and can be reasonably estimated, we consider our claim payments and our rescissions, denials and curtailments to be resolved for financial reporting purposes. In accordance with the accounting standard regarding contingencies, we accrue for an estimated loss when we determine that the loss is probable and can be reasonably estimated.
Approximately 12% of the Subject Loans were neither held in portfolio by the Insureds nor owned by the GSEs, and will require the consent of certain other investors for these loans to be included in the BofA Settlement Agreement except with respect to certain limited rights of cancellation. See Note 10 of Notes to Consolidated Financial Statements for additional information about the BofA Settlement Agreement.
If calculated before giving effect to deductibles and stop losses in pool transactions, the pool reserve per default at December 31, 2014, 2013 and 2012 would be $15,881, $24,640 and $27,545, respectively.
In addition, as part of our claims review process, we assess whether defaulted loans were serviced appropriately in accordance with our insurance policies and servicing guidelines. To the extent a servicer has failed to satisfy its servicing obligations, our policies provide that we may curtail the claim payment for such default, and in some circumstances, cancel coverage or deny the claim. Since 2011, claim curtailments due to servicer noncompliance with our insurance policies and servicing guidelines have increased both in frequency and in size, which has contributed to a reduction in the severity of our claim payments during this period. Claim curtailments due to servicer noncompliance with our insurance policies and servicing guidelines decreased to approximately $40 million in 2014, compared to approximately $60 million for 2013. While we cannot give assurance regarding the extent or level at which such claim curtailments will continue, we expect the level of claim curtailments to remain elevated compared to historical levels (excluding claims processed in accordance with the BofA Settlement Agreement), in light of well publicized issues in the servicing industry and our existing Legacy Portfolio of aged defaults.
Policy Acquisition Costs. Policy acquisition costs for 2014 decreased compared to 2013 due to an increase in our Persistency Rate, which reflects the increase in the expected life of our insurance policies and therefore reduces the annual amortization of our policy acquisition costs. In comparison, policy acquisition costs for 2013, although down from 2012, reflected higher amortization as a result of a lower Persistency Rate, more than offset by higher ceding commissions received related to the QSR Reinsurance Transactions.
Interest Expense. These amounts reflect the allocated portion of interest on Radian Group’s long-term debt to our mortgage insurance segment. The increase in 2014 compared to 2013 is primarily related to the Convertible Senior Notes due 2017 and 2019. Interest expense for 2014, 2013 and 2012 include $53.3 million, $56.6 million and $44.4 million, respectively, as a result of the reallocation of financial guaranty segment interest expense that was not allocated to discontinued operations.
The increase in interest expense in 2013 compared to 2012 is primarily related to the issuance of $400 million of debt in March 2013.
The following table summarizes our MRES segment’s results of operations for the year ended December 31, 2014:
Services Revenue. For the year ended December 31, 2014, services revenue includes a significant loan review and due diligence project for a single client which represented approximately 13% of services revenue. The project is expected to continue in 2015, but the level of 2015 volume for the project is not known. Revenue from component services was also at an elevated level during 2014. Component services revenue for the year ended December 31, 2014 includes revenue from single family rental securitizations as well as revenue from financial institutions that extend loans to institutional investors to fund purchases of homes. Approximately 20% of services revenue in 2014 related to the single family rental market, which is an emerging market that experienced rapid growth in 2014. The Company provides component services in connection with single family rental securitizations and to financial institutions that extend loans to institutional investors to fund purchases of homes. However, there has been a decline in the pace of home purchases by the institutional investors and, as a result, we do not expect that revenue from lenders will continue at a similar level in 2015. The top 10 customers of the MRES segment generated approximately 64% of the services revenues for the period.
Gross Profit on Services. For the year ended December 31, 2014, our gross profit on services represented approximately 42.5% of total revenues.
Other Operating Expenses. For the year ended December 31, 2014, compensation-related costs represented approximately 42.9% of the segment’s operating expenses.
Interest Expense. For the year ended December 31, 2014, interest expense represents all of the interest expense related to our Senior Notes due 2019, the proceeds of which were used to fund Radian Group’s acquisition of Clayton.
The following table summarizes certain of our contractual obligations and commitments, including our expected claim payments on insurance policies, as of December 31, 2014, 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.
Includes one annual payment, totaling $2.0 million, on a seven year software contract that we expect to terminate at the end of 2015.
The timing of these potential payments is uncertain given the nature of the obligations.
Investment Commitments. As part of the non-investment grade component of our investment portfolio, we had unfunded commitments of $7.4 million at December 31, 2014, related to alternative investments that are primarily private equity structures. These commitments have capital calls expected through 2015, with the possibility of additional calls through 2017, and certain fixed expiration dates or other termination clauses.
Radian Guaranty has agreed to maintain Radian Insurance’s tangible net worth at a minimum of $30 million and to cause Radian Insurance to at all times have sufficient liquidity to meet its current obligations, pursuant to a Net Worth and Liquidity Maintenance Agreement (“NWLMA”) between the two companies.
In addition to the foregoing, we use reinsurance from affiliated companies to allow Radian Guaranty to remain in compliance with insurance regulations that limit the amount of risk that a mortgage insurance company may retain on a single loan to 25% of the indebtedness of the insured. In 2012, Radian Guaranty, to improve its capital position, entered into an excess-of-loss reinsurance transaction with Radian Mortgage Insurance under which Radian Guaranty initially transferred approximately $2.5 billion of RIF to Radian Mortgage Insurance. In 2011 and 2010, Radian Guaranty entered into similar excess-of-loss reinsurance agreements with Radian Insurance under which Radian Guaranty initially transferred a total of approximately $6.1 billion of RIF to Radian Insurance. The pools of loans that have been reinsured by Radian Mortgage Insurance and Radian Insurance under the excess-of-loss reinsurance agreements generally consist of high-quality loans from recent vintages. As of December 31, 2014, the remaining RIF under these excess-of-loss reinsurance agreements was $3.6 billion.
In 2004, we developed a program, referred to as Smart Home, for reinsuring risk associated with non-prime mortgages. From 2004 through 2007, we entered into four Smart Home transactions. As of December 31, 2012, we had terminated three of these transactions. The final Smart Home transaction matured in May 2013.
Radian Group serves as the holding company for our insurance and other subsidiaries and does not have any significant operations of its own. At December 31, 2014, Radian Group had immediately available, either directly or through an unregulated subsidiary, unrestricted cash and liquid investments of approximately $670 million, after giving effect to the $100 million capital contribution to Radian Guaranty in February 2015. This amount excludes certain additional cash and liquid investments that have been advanced from our subsidiaries for corporate expenses and interest payments.
In May 2014, we issued $300 million principal amount of Senior Notes due 2019 and 17.825 million shares of our common stock at a public offering price of $14.50 per share. We received aggregate net proceeds from these offerings of approximately $541 million after deducting underwriting discounts, commissions and offering expenses. Approximately $312 million of the proceeds from these offerings was used to fully fund the acquisition of Clayton. In addition, in accordance with the optional redemption provisions of our Senior Notes due 2015, we used a portion of the proceeds to redeem all $57.2 million of the remaining outstanding principal amount of these notes. See Note 11 of Notes to Consolidated Financial Statements for further information.
Corporate Expenses and Interest Expense. Radian Group has expense-sharing arrangements in place with its principal operating subsidiaries that require those subsidiaries to pay their allocated share of certain holding-company-level expenses, including interest payments on most of our outstanding long-term debt. Payments of such corporate expenses for the next 12 months, excluding interest payments on our long-term debt, are expected to be approximately $50.1 million, all of which is expected to be reimbursed by our subsidiaries under our existing expense-sharing arrangements. For the same period, payments of interest on our long-term debt are expected to be approximately $56.6 million, a significant portion of which is expected to be reimbursed by our subsidiaries under our existing expense-sharing arrangements. These expense-sharing arrangements, as amended, have been approved by applicable state insurance departments, but such approval may be modified or revoked at any time.
Capital Support for Subsidiaries. Radian Guaranty’s Risk-to-capital as of December 31, 2014, after giving effect to the $100 million capital contribution from Radian Group in February 2015, was 17.9 to 1. Given our financial projections for Radian Guaranty, which are subject to risks and uncertainties, we expect Radian Guaranty’s Risk-to-capital to decrease over time without the need for any additional capital contributions from Radian Group to satisfy current applicable state insurance regulatory requirements.
Dividends. Our quarterly common stock dividend is currently $0.0025 per share and, based on our current outstanding shares of common stock, we would require approximately $1.9 million in the aggregate to pay our quarterly dividends for the next 12 months. Radian Group is not subject to any limitations on its ability to pay dividends except those generally applicable to corporations, such as Radian Group, that are incorporated in Delaware. Delaware corporation law provides that dividends are only payable out of a corporation’s capital surplus or (subject to certain limitations) recent net profits. As of December 31, 2014, our capital surplus was $2.2 billion, representing our dividend limitation under Delaware law.
Tax Payments. Under our current tax-sharing agreement between Radian Group and its subsidiaries, our subsidiaries are required to pay to Radian Group, on a quarterly basis, amounts representing their estimated separate company federal tax liability for the current tax year. Annually, Radian Group is required to refund to each subsidiary any amount that such subsidiary overpaid to Radian Group for a taxable year, as well as any amount that the subsidiary could utilize through existing carryback provisions of the Internal Revenue Code had such subsidiary filed its federal tax return on a separate company basis. Any payments that Radian Group is expected to make during the next 12 months under the tax-sharing agreement are not expected to have a material impact on Radian Group’s available liquidity. Our tax-sharing agreement may not be changed without the pre-approval of Fannie Mae and the applicable state insurance departments for the insurance subsidiaries that are parties to the agreement.
$195.5 million principal amount of outstanding debt due in June 2017;
$450 million principal amount of convertible debt due in November 2017, plus, at our option, any related conversion premium that we elect to settle in cash;
potential payments to the U.S. Treasury resulting from our dispute with the IRS relating to the examination of our 2000 through 2007 consolidated federal income tax returns by the IRS.
On September 4, 2014, we received Notices of Deficiency from the IRS covering our 2000 through 2007 federal income tax returns. The Notices of Deficiency assert unpaid taxes and penalties of approximately $157 million related to the recognition of certain tax losses and deductions that were generated through our investment in a portfolio of non-economic REMIC residual interests currently held by RGRI. As of December 31, 2014, there would also be interest related to these matters of approximately $115 million. Depending on the outcome, additional state income taxes, penalties and interest (in the aggregate, estimated to be approximately $30 million as of December 31, 2014) also may be due when a final resolution is reached. The Notices of Deficiency also reflected additional amounts due of approximately $105 million, which are primarily associated with the disallowance of the previously filed carryback of the 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.
Radian Group and RGRI are parties to an Assumption and Indemnification Agreement with regard to a portion of these Deficiency Amounts. This indemnification agreement was made in lieu of an immediate capital contribution to RGRI that otherwise would have been required for RGRI to maintain its minimum statutory policyholders’ surplus requirements in light of the remeasurement as of December 31, 2011 of uncertain tax positions related to the portfolio of REMIC residual interests. See Note 13 of Notes to Consolidated Financial Statements for additional information regarding the IRS matter.
On December 3, 2014, we petitioned the U.S. Tax Court to litigate the Deficiency Amount. We can provide no assurance regarding the outcome of this IRS litigation, which may take several years to resolve, or whether a compromised settlement with the IRS will ultimately be reached. As such, there remains significant uncertainty with regard to the amount and timing of any potential payments under the indemnity agreement described above.
As of the balance sheet date, certain of our insurance subsidiaries, including Radian Guaranty, have incurred NOLs that could not be carried-back and utilized on a separate company tax return basis. As a result, we are not currently obligated under our tax-sharing agreement to reimburse these subsidiaries for their separate company NOL Carryforward. However, if in a future period our consolidated NOL is fully utilized before a subsidiary has utilized its share of NOLs on a separate entity basis, then Radian Group may be obligated to fund such subsidiary’s share of our consolidated tax liability to the IRS. Currently, we do not expect to fund material obligations under the provisions described in this paragraph with regard to subsidiary NOLs incurred to date.
We regularly evaluate opportunities, based on market conditions, to finance our operations by accessing the capital markets or other types of indebtedness with institutional lenders, and consider various measures to improve our capital and liquidity position, as well as to strengthen our balance sheet and improve our debt maturity profile. In the past, we have repurchased and exchanged, prior to maturity, some of our outstanding debt, and in the future, we may, from time to time, seek to redeem, repurchase or exchange for other securities, some or all of our outstanding debt, prior to maturity, in the open market, through other public or private transactions, including pursuant to one or more tender offers, or through any combination of the foregoing, as circumstances may allow. We may seek to refinance all or a portion of our long-term debt, but we may not be able to do so on favorable terms, if at all. The timing or amount of any potential transactions, which may or may not occur, will depend on a number of factors, including market opportunities and our capital and liquidity needs.
The principal demands for liquidity in our mortgage insurance business include the payment of claims and potential claim settlement transactions, operating expenses (including those allocated from Radian Group) and taxes. The principal sources of liquidity in our mortgage insurance business currently include insurance premiums, net investment income, and capital contributions from Radian Group. We believe that the operating cash flows generated by each of our mortgage insurance subsidiaries will provide these subsidiaries with a substantial portion of the funds necessary to satisfy their claim payments, operating expenses and taxes for the foreseeable future. We believe that we have the ability to fund any operating cash flow shortfall from sales and maturities of marketable securities in our investment portfolio maintained at our operating companies. In the event that we are unable to fund excess claim payments and operating expenses through the sale of these marketable securities and from maturing fixed-income investments, we may be required to incur unanticipated capital losses or delays in connection with the sale of less liquid marketable securities held by our operating companies.
In connection with the closing under the Freddie Mac Agreement, Radian Guaranty deposited $205 million of investment securities into a collateral account. This account remains on our consolidated balance sheets due to the rights that Radian Guaranty has with respect to those funds. From the time the collateral account was established through December 31, 2014, approximately $48 million of additional Loss Mitigation Activity had become final in accordance with the Freddie Mac Agreement and approximately $113 million of submitted claims had been rescinded, denied, curtailed or cancelled, but were not yet considered final in accordance with the Freddie Mac Agreement. If the BofA Settlement Agreement had been implemented as of December 31, 2014, these amounts would have been approximately $116 million and $23 million, respectively. Subject to certain conditions in the Freddie Mac Agreement, amounts in the collateral account may be released to Radian Guaranty from Freddie Mac over time to the extent that Loss Mitigation Activity becomes final in accordance with the terms of the Freddie Mac Agreement. If the amount of Loss Mitigation Activity that becomes final in accordance with the Freddie Mac Agreement after the collateral account was established is less than $205 million prior to the termination of the Freddie Mac Agreement, then any shortfall will be paid to Freddie Mac from the funds in the collateral account.
The principal demands for liquidity in our MRES business include the payment of employee compensation and other operating expenses (including those allocated from Radian Group), interest payments related to the Senior Notes due 2019, taxes, and dividends to Radian Group. The principal sources of liquidity in our MRES business are cash generated by operations and, to the extent necessary, capital contributions from Radian Group.
Reconciliation of Consolidated Net Income (Loss) to Cash Used in Operations
Stockholders’ equity was $2.1 billion at December 31, 2014, compared to $0.9 billion at December 31, 2013. The increase in stockholders’ equity resulted primarily from our net income of $959.5 million for 2014 and an increase in additional paid-in capital that resulted from the $247.2 million in net proceeds received in connection with our issuance of 17.825 million shares of our common stock in May 2014, partially offset by the reclassification of the equity component of currently redeemable convertible senior notes of $74.7 million to mezzanine equity. See Note 11 of Notes to Consolidated Financial Statements for additional information.
Moody’s outlook for Radian Group and all our rated mortgage insurance subsidiaries is currently Positive.
S&P’s outlook for Radian Group and Radian Guaranty is currently Positive. The outlook for all other subsidiaries is currently Stable.
Currently, RMAI is not writing new business and has no RIF.
SEC guidance defines Critical Accounting Policies as those that require the application of management’s most difficult, subjective or complex judgments, often because of the need to make estimates about the effect of matters that are inherently uncertain and that may change in subsequent periods. In preparing our consolidated financial statements in accordance with GAAP, management has made estimates, assumptions and judgments that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. In preparing these financial statements, management has utilized available information, including our past history, industry standards and the current and projected economic and housing environment, among other factors, in forming its estimates, assumptions and judgments, giving due consideration to materiality. Because the use of estimates is inherent in GAAP, actual results could differ from those estimates. In addition, other companies may utilize different estimates, which may impact comparability of our results of operations to those of companies in similar businesses. A summary of the accounting policies that management believes are critical to the preparation of our consolidated financial statements is set forth below.
We do not establish reserves for loans that are in default if we believe that we will not be liable for the payment of a claim with respect to that default. For example, for those defaults in which we are in a “second loss position” (i.e., we are not required to make a payment until a certain aggregate amount of losses have already been recognized on a given group of loans), we initially calculate the reserve for defaulted loans in the transaction as if there were no deductible. If the existing deductible for a given Structured Transaction is greater than the aggregate reserve amount for the defaults contained within the transaction, we do not establish a reserve for the defaults, or if appropriate, we record a partial reserve. We do not establish loss reserves for expected future claims on insured mortgages that are not in default. See “-Reserve for Premium Deficiency” below for an exception to this general principle.
After estimating the Default to Claim Rate, we estimate the severity of each product type, type of insurance and state grouping based on the average of recently observed severity rates. These average severity estimates are then applied to individual loan coverage amounts to determine reserves. Senior management regularly reviews the modeled frequency, rescission, denial and severity estimates, which are based on historical trends as described above. If recent emerging or projected trends differ significantly from the historical trends used to develop the modeled estimates, management evaluates these trends in determining how they should be considered in its reserve estimates.
We considered the sensitivity of our loss reserve estimates at December 31, 2014 by assessing the potential changes resulting from a parallel shift in Claim Severity and Default to Claim Rate for primary loans. For example, assuming all other factors remain constant, for every one percentage point change in primary Claim Severity (which we estimate to be 103.7% of risk exposure at December 31, 2014), we estimated that our loss reserves would change by approximately $12 million at December 31, 2014. For every one percentage point change in our primary net Default to Claim Rate (which we estimate to be approximately 52% at December 31, 2014), we estimate our loss reserves would change by approximately $23 million at December 31, 2014.
Evaluating the expected profitability of our existing mortgage insurance business and the need for a PDR for our First-lien business involves significant reliance upon assumptions and estimates with regard to the likelihood, magnitude and timing of potential losses and premium revenues. The models, assumptions and estimates we use to evaluate the need for a PDR may prove to be inaccurate, especially during any extended economic downturn or period of extreme market volatility and uncertainty. We cannot be certain that we have correctly estimated the expected profitability of our existing First-lien mortgage portfolio or that the Second-lien PDR established will be adequate to cover the ultimate losses on our Second-lien business.
Our estimated fair value measurements are intended to reflect the assumptions market participants would use in pricing an asset or liability based on the best information available. Assumptions include the risks inherent in a particular valuation technique (such as a pricing model) and the risks inherent in the inputs to the model. Changes in economic conditions and capital market conditions, including but not limited to, credit spread changes, benchmark interest rate changes, market volatility and changes in the value of underlying collateral or of any third-party guaranty or insurance, could cause actual results to differ materially from our estimated fair value measurements. We define fair value as the current amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
At December 31, 2014, there were no Level III assets, and total Level III liabilities accounted for 100% of total liabilities measured at fair value.
U.S. government and agency securities-The fair value of U.S. government and agency securities is estimated using observed market transactions, including broker-dealer quotes and actual trade activity as a basis for valuation. U.S. government and agency securities are categorized in either Level I or Level II of the fair value hierarchy.
State and municipal obligations-The fair value of state and municipal obligations is estimated using recent transaction activity, including market observations. Evaluation models are used, which incorporate bond structure, yield curve, credit spreads and other factors. These securities are generally categorized in Level II of the fair value hierarchy or in Level III when market-based transaction activity is unavailable.
In July 2013, the FASB issued an update to the accounting standard regarding income taxes. This update provides guidance concerning the balance sheet presentation of an unrecognized tax benefit when a Carryforward is available. This accounting standard requires an entity to present its DTAs for the Carryforwards net of its liability related to unrecognized tax benefits. A gross presentation will be required when the Carryforwards are not available under the tax law of the applicable jurisdiction or when the Carryforwards would not be used by the entity to settle any additional income taxes resulting from disallowance of the uncertain tax position. This update is effective for fiscal years and interim periods within such years beginning after December 15, 2013. We adopted this update in the first quarter of 2014. The adoption of this update did not affect the recognition or measurement of uncertain tax positions and did not have a significant impact on our consolidated financial statements or disclosures. See Note 13 of Notes to Consolidated Financial Statements for additional information.
The calculation of the estimated fair value of goodwill and other intangibles requires the use of significant estimates and assumptions that are highly subjective in nature, such as attrition rates, discount rates, future expected cash flows and market conditions. The most significant assumptions relate to the valuation of goodwill and client relationships. Our estimates are based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable.
In February 2013, the FASB issued an update to the accounting standard regarding comprehensive income, requiring additional information to be presented on the face of the financial statements or as separate disclosures. This update requires an entity to present the changes in each component of accumulated other comprehensive income. An entity is required to present certain amounts reclassified out of accumulated other comprehensive income to their respective line items in net income, by component. Other reclassifications out of accumulated other comprehensive income are required to be cross-referenced to existing disclosures. We adopted this update effective January 1, 2013. In Note 12 of Notes to Consolidated Financial Statements we have presented the changes in the balances for each component of accumulated other comprehensive income as well as current period reclassifications out of accumulated other comprehensive income. This update impacted disclosures only and did not affect our consolidated financial position, earnings or cash flows.
Management is responsible for the preparation, integrity and objectivity of the Consolidated Financial Statements and other financial information presented in this annual report. The accompanying Consolidated Financial Statements were prepared in accordance with accounting principles generally accepted in the United States of America, applying certain estimations and judgments as required.
As described in Management’s Report on Internal Control over Financial Reporting, management has excluded Clayton Holdings LLC from its assessment of internal control over financial reporting as of December 31, 2014 because it was acquired by the Company in a purchase business combination during 2014. We have also excluded Clayton Holdings LLC from our audit of internal control over financial reporting. Clayton Holdings LLC is a wholly-owned subsidiary whose total assets and total revenues represent 4.9% and 7.2%, respectively, of the related consolidated financial statement amounts as of and for the year ended December 31, 2014.
Our mortgage insurance segment provides credit-related insurance coverage, principally through private mortgage insurance, to mortgage lending institutions. We provide our mortgage insurance products and services mainly through our wholly-owned subsidiary, Radian Guaranty. Private mortgage insurance protects mortgage lenders from all or a portion of default-related losses on residential mortgage loans made to home buyers who generally make down payments of less than 20% of the home’s purchase price. Private mortgage insurance also facilitates the sale of these mortgage loans in the secondary mortgage market, most of which are sold to the GSEs.
Our MRES segment provides services and solutions to the mortgage and real estate industries. Our MRES business is a leading provider of services and solutions to the mortgage and real estate industries, providing outsourced services, information-based analytics and specialty consulting for buyers and sellers of, and investors in, mortgage- and real estate-related loans and securities and other debt instruments. The primary services of our MRES business include:
REO Management-REO asset management services offered through Clayton’s subsidiary, Green River Capital, which include management of the entire REO disposition process for our clients; and
The results of Clayton’s operations, included in our financial statements from the June 30, 2014 date of acquisition, are reflected in our MRES segment. See “Item 7.-Recent Developments-Acquisition of Clayton.”
The divestiture is part of Radian’s strategy to focus on the mortgage and real estate markets and to accelerate its ability to comply with the proposed PMIERs. The consummation of the transaction is expected to increase Radian Guaranty’s Available Assets, as required under the PMIERs, by the net proceeds of approximately $790 million, after closing costs and other adjustments. For additional information related to discontinued operations, see Note 3.
The business activities of Radian Asset Assurance primarily comprised our financial guaranty segment and, as a result, we have reclassified the operating results related to the pending disposition as discontinued operations for all periods presented in our consolidated statements of operations and no longer present a financial guaranty segment. Certain corporate income and expenses that were previously allocated to the financial guaranty segment but were not reclassified to discontinued operations, such as investment income, interest expense and corporate overhead expenses, have been reallocated to the mortgage insurance segment.
On June 30, 2014, we acquired all of the outstanding equity interests of Clayton for a purchase price, including working capital adjustments, of approximately $312 million. The acquisition is consistent with Radian’s growth and diversification strategy to pursue opportunities to provide additional mortgage- and real estate-related products and services to the mortgage finance market.
The acquisition of Clayton was treated as a purchase for accounting purposes. Therefore, the assets and liabilities were recorded based on their fair values as of June 30, 2014, the date of acquisition. At acquisition, the fair value of assets acquired was $152.4 million and the fair value of liabilities assumed was $31.8 million. The excess of the acquisition price over the estimated fair value of the net assets acquired resulted in goodwill of $191.9 million. The goodwill represents the estimated future economic benefits arising from the assets acquired that did not qualify to be identified and recognized individually, and includes the value of discounted expected future cash flows of Clayton, Clayton’s workforce, expected synergies with our other affiliates and other unidentifiable intangible assets. Goodwill is deemed to have an indefinite useful life and is subject to review for impairment annually, or more frequently, whenever circumstances indicate potential impairment. Currently, we believe approximately $189.0 million of the goodwill related to this transaction will be deductible for tax purposes over a period of 15 years. See Note 7 for additional information regarding goodwill and other intangible assets.
On September 16, 2014, Radian Guaranty entered into the BofA Settlement Agreement in order to resolve actual and potential claims or disputes related to the parties’ respective rights and duties as to mortgage insurance coverage on the Subject Loans. The required consent of the GSEs to implement the BofA Settlement Agreement was received in December 2014, and implementation of the agreement for Subject Loans owned by the GSEs or held in portfolio by the Insureds commenced on February 1, 2015.
The public comment period for the proposed PMIERs ended on September 8, 2014. The FHFA is currently reviewing and considering input before adopting the final PMIERs. All aspects of the final PMIERs are expected to become effective 180 days after their final publication. It is anticipated that approved insurers who fail to meet the PMIERs Financial Requirements when they become effective would, at the discretion of the GSEs, be permitted to operate under a transition plan during an extended transition period of up to two years from the final publication date, and would continue to be eligible insurers during that period. We expect the final PMIERs to be published during the first half of 2015 and to be effective by December 31, 2015.
In order for Radian Guaranty to comply with the PMIERs Financial Requirements as proposed, we expect to contribute a substantial portion of our holding company cash and investments to Radian Guaranty, while maintaining a sufficient level of holding company cash and investments to carry out our business strategy, and also that we will be successful in: (1) completing the pending sale of Radian Asset Assurance to Assured pursuant to the Radian Asset Assurance Stock Purchase Agreement; and (2) leveraging other options such as commutations of existing risk or external reinsurance for a portion of our mortgage insurance RIF in a manner that provides capital relief and is compliant with the PMIERs. In the event we are unable to successfully execute these or similar transactions or strategies, or such transactions are not available on terms that are attractive to us, we may seek additional capital by incurring additional debt, by issuing additional equity, or by selling assets, which we may not be able to do on favorable terms, if at all.
Our consolidated financial statements are prepared in accordance with GAAP and include the accounts of all wholly-owned subsidiaries. Companies in which we, or one of our subsidiaries, exercise significant influence (generally ownership interests ranging from 20% to 50%), are accounted for in accordance with the equity method of accounting. Any VIEs for which we are the primary beneficiary are consolidated. All intercompany accounts and transactions, and intercompany profits and losses, have been eliminated. Certain prior period amounts have been reclassified to conform to current period presentation.
The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. While the amounts included in our consolidated financial statements include our best estimates and assumptions, actual results may vary materially.
With respect to loans that are in default, considerable judgment is exercised as to the adequacy of reserve levels. Loss reserves are generally increased as defaulted loans age, because historically, as defaulted loans age, they have been more likely to result in foreclosure, and therefore, have been more likely to result in a claim payment. In the past, as the number of missed payments increased, there was generally more certainty regarding these estimates. However, following the financial crisis we experienced significant delays in foreclosures. As a result, significant uncertainty remains with respect to the ultimate resolution of aged defaults. This uncertainty requires management to use considerable judgment in estimating the rate at which these loans will result in claims. Once a default is considered to have reached Foreclosure Stage, the likelihood that the default will reach claim status increases. Once a claim is submitted, reserves are further increased to reflect the fact that the default has moved closer to resulting in a claim payment. If a default cures, the reserve for that loan is removed from the reserve for losses and LAE.
We also establish reserves for defaults that we estimate have been incurred but have not been reported (“IBNR”) to us on a timely basis by the servicer, as well as for previously rescinded policies and denied claims that we estimate will be reinstated and subsequently paid. We generally give the policyholder up to 90 days to challenge our decision to rescind coverage before we consider a policy to be rescinded and remove it from our defaulted inventory; therefore, we currently expect only a limited percentage of policies that were rescinded to be reinstated. We currently expect a significant percentage of claims that were denied to be resubmitted as a perfected claim and ultimately paid. Most often, a claim denial is the result of a servicer’s inability to provide the loan origination file or other servicing documents for review. Under the terms of our Master Policies with our lending customers, our policyholders have up to one year after the acquisition of borrower’s title to provide to us the necessary documents to perfect a claim. All estimates are periodically reviewed and adjustments are made as they become necessary.
The elevated levels of our Loss Mitigation Activities have led to an increased risk of litigation. Our Master Policies specify the time period during which a suit or action arising from any right of the insured under the policy must be commenced. We continue to face a significant number of challenges from certain lender customers regarding our Loss Mitigation Activities, which have resulted in some reversals of our decisions regarding rescissions, denials and curtailments. Although we believe that our Loss Mitigation Activities are justified under our policies, if we are not successful in defending these actions in any potential legal or other proceedings, including negotiated settlements, we may need to reassume the risk on, and increase loss reserves for, those policies or pay additional claims. The assumptions embedded in our estimated Default to Claim Rate on our in-force default inventory include an adjustment to our estimated rescission and denial rate, to account for the fact that we expect a certain number of policies to be reinstated and ultimately to be paid, as a result of valid challenges by such policy holders. As discussed above, we also establish reserves for IBNR defaults related to previously rescinded policies and denied or curtailed claims, which we believe are likely to be reinstated (in the case of previously rescinded policies) or resubmitted and paid (in the case of previously denied claims).
Included in our loss reserves is an estimate related to a potential additional payment to Freddie Mac under the Freddie Mac Agreement, which is dependent upon the Loss Mitigation Activity on the population of loans subject to that agreement. Our reserve related to this potential additional payment is based on the estimated rescissions, denials, curtailments, and cancellations for this population of loans, determined using assumptions that are consistent with those utilized to determine our overall loss reserves.
For our Second-lien insurance business, we project future premiums and losses for this business using historical results to help determine future performance for both prepayments and claims. An estimated expense factor is then applied, and the result is discounted using a rate of return that approximates our pre-tax investment yield. This net present value, less any existing reserves, is recorded as a premium deficiency and the reserve is updated at least quarterly based on actual results for that quarter, along with updated transaction level projections.
The MRES segment derives most of its revenue from professional service activities. A portion of these activities are provided under “time-and-materials” billing arrangements. Services revenue consisting of billed fees and pass-through expenses is recorded as work is performed and expenses are incurred. Services revenue also includes expenses billed to clients, which includes travel and other out-of-pocket expenses, and other reimbursable expenses.
Direct cost of services consists primarily of employee compensation and related payroll benefits, the cost of billable labor assigned to revenue-generating activities, as well as corresponding travel and related expenses incurred in providing such services to clients. Direct cost of services also includes costs paid to outside vendors, including real estate agents that provide valuation and related services. Direct cost of services does not include an allocation of overhead costs.
Our provision for income taxes for interim financial periods is based on an estimate of our annual effective tax rate for the full year of 2014. When estimating our full year 2014 effective tax rate, we adjust our forecasted pre-tax income for gains and losses on our derivative transactions and investments, changes in the accounting for uncertainty in income taxes, changes in our beginning of year valuation allowance, and other adjustments. The impact of these items is accounted for discretely at the federal applicable tax rate. During 2012 and 2013, given the impact on our pre-tax results of net gains or losses resulting from our derivative transactions and our investment portfolio, and the continued uncertainty regarding our ability to rely on certain short-term financial projections, which directly affected our ability to estimate an effective tax rate for the full year, we recorded our interim period income tax provision (benefit) based on actual results of operations.
Within our consolidated statements of cash flows, we classify cash receipts and cash payments related to items measured at fair value according to their nature and purpose. Because our trading activity relates to overall strategic initiatives and is not trading related, it is recorded as cash flows from investing activities. While our securities trading activity was significant in 2012, this activity was primarily a result of strategic repositioning of the portfolio in order to: (1) shorten duration for liquidity purposes; and (2) increase our allocation to taxable bonds to maximize our after-tax yields.
We group assets in our investment portfolio into one of three main categories: held to maturity, available for sale or trading securities. Fixed-maturity securities for which we have the positive intent and ability to hold to maturity are classified as held to maturity and are reported at amortized cost. Investments in securities not classified as held to maturity or trading securities are classified as available for sale and are reported at fair value, with unrealized gains and losses (net of tax) reported as a separate component of stockholders’ equity as AOCI. Investments classified as trading securities are reported at fair value, with unrealized gains and losses reported as a separate component of income. Short-term investments consist of money market instruments, certificates of deposit and highly liquid, interest-bearing instruments with an original maturity of three months or less at the time of purchase. Amortization of premium and accretion of discount are calculated principally using the interest method over the term of the investment. Realized gains and losses on investments are recognized using the specific identification method. See Notes 5 and 6 for further discussion on the fair value of investments.
We are the beneficiary of insurance policies on the lives of certain of our current and past officers and employees. We have recognized the amount that could be realized upon surrender of the insurance policies in other assets in our consolidated balance sheets. At December 31, 2014 and 2013, the cash surrender value of company-owned life insurance totaled $80.8 million and $78.4 million, respectively.
Property and equipment is carried at cost, net of depreciation. For financial statement reporting purposes, computer hardware and software is depreciated over three years and furniture, fixtures and office equipment is depreciated over seven years. Leasehold improvements are depreciated over the lesser of the life of the asset improved or the remaining term of the lease. For income tax purposes, we use accelerated depreciation methods.
Intangible assets, other than goodwill, primarily consist of Clayton’s client relationships, technology, trade name and trademarks, client backlog and non-competition agreements. Client relationships represent the value of the specifically acquired customer relationships and are valued using the excess earnings approach using estimated client revenues, attrition rates, implied royalty rates and discount rates. The excess earnings approach estimates the present value of expected earnings in excess of a traditional return on business assets. Technology represents proprietary software used for loan review and due diligence, managing the REO disposition process and performing surveillance of mortgage loan servicers. Trade name and trademarks reflect the value inherent in the recognition of the “Clayton” name and its reputation. For purposes of our intangible assets, we use the term client backlog to refer to the estimated present value of fees to be earned for services performed on loans currently under surveillance or REO assets under management. The value of a non-competition agreement is an appraisal of potential lost revenues that would arise from an individual leaving to work for a competitor or initiating a competing enterprise. For financial reporting purposes, intangible assets with finite lives are amortized over their applicable estimated useful lives in a manner that approximates the pattern of expected economic benefit from each intangible asset.
In April 2014, the FASB issued an update to the accounting standard for reporting discontinued operations and disclosures of disposals of components of an entity. This update changes the requirements for reporting discontinued operations. A disposal of a component of an entity or a group of components of an entity is required to be reported in discontinued operations if the disposal represents (or would represent) a strategic shift that has (or will have) a major effect on an entity’s operations and financial results when any of the following occurs: (a) the component of an entity or group of components of an entity meets the criteria to be classified as held for sale; (b) the component of an entity or group of components of an entity is disposed of by sale; or, (c) the component of an entity or group of components of an entity is disposed of other than by sale (for example, by abandonment or in a distribution to owners in a spin-off). The amendments in this update require expanded disclosures about discontinued operations. The provisions of this update are effective for all disposals (or classifications as held for sale) of components of an entity that occur within annual periods beginning on or after December 15, 2014, and interim periods within those years. Early adoption is permitted, but only for disposals (or classifications as held for sale) that have not been reported in financial statements previously issued or available for issuance. We did not elect early adoption of this update for the pending disposition of Radian Asset Assurance. The significance of this guidance for the Company is dependent on any future dispositions or disposals.
In May 2014, the FASB issued an update to the accounting standard regarding revenue recognition. This update is intended to provide a consistent approach in recognizing revenue. In accordance with the new standard, recognition of revenue occurs when a customer obtains control of promised goods or services in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. In addition, the new standard requires that reporting companies disclose the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. While this update is not expected to change revenue recognition principles related to our insurance products, this update may be applicable to revenues from our new MRES segment, which has been included in our consolidated statements of operations beginning with the third quarter of 2014. The provisions of this update are effective for interim and annual periods beginning after December 15, 2016. We are currently evaluating the impact of this update, if any.
On December 22, 2014, Radian Guaranty entered into the Radian Asset Assurance Stock Purchase Agreement to sell 100% of the issued and outstanding shares of Radian Asset Assurance, Radian’s financial guaranty insurance subsidiary, to Assured, for a purchase price of approximately $810 million, subject to certain adjustments. The purchase price is payable in cash on the closing date. Radian expects to complete the sale of Radian Asset Assurance to Assured in the first half of 2015, subject to satisfaction of customary closing conditions including regulatory approvals.
Although closing under the Radian Asset Stock Purchase Agreement is subject to conditions, the purchase price is not subject to adjustment based on Radian Asset Assurance’s results of operations, changes in valuation or market conditions occurring after December 31, 2014 through the closing date. Therefore, assuming satisfaction of the closing conditions, which we expect will be satisfied, the financial results of Radian Asset Assurance are not expected to have an impact on Radian’s financial condition or results of operations after December 31, 2014 and therefore, significant estimates associated with Radian Asset Assurance’s assets and liabilities are not subject to risks and uncertainties that could materially affect amounts reported in our financial statements in future periods.
Summarized financial information regarding discontinued operations is provided in the tables below.
The assets and liabilities associated with the discontinued operations have been segregated in the consolidated balance sheets. The following table summarizes the major components of Radian Asset Assurance’s assets and liabilities held for sale on the Consolidated Balance Sheets as of December 31, 2014 and 2013:
The following table provides highlights of financial guaranty derivative contracts as of the dates indicated:
Performing-Performing credits generally have investment grade internal ratings, denoting nominal to moderate credit risk.
Intensified Surveillance-This category includes transactions in financial guaranty’s insured portfolio that are rated below investment grade and indicate a severe and often permanent adverse change in the transaction’s credit profile. Transactions in this category are still performing, meaning they have not yet defaulted on a payment, but our risk management department has determined that there is a substantial likelihood of default.
Case Reserves-This category consists of insured transactions where a payment default on the insured obligation has occurred.
We currently have two strategic business units that we manage separately-mortgage insurance and, effective with the June 30, 2014 acquisition of Clayton, MRES. As a result of the Radian Asset Assurance Stock Purchase Agreement to sell 100% of the issued and outstanding shares of Radian Asset Assurance, we have reclassified the operating results related to the pending disposition as discontinued operations for all periods presented in our consolidated statements of operations and no longer present a financial guaranty segment. Certain corporate income and expenses that were previously allocated to the financial guaranty segment but were not reclassified to discontinued operations, such as investment income, interest expense and corporate overhead expenses, have been reallocated to the mortgage insurance segment. Prior periods have been revised to conform to the current period presentation for these changes. See Note 3 for additional information related to discontinued operations.
Our senior management, including our Chief Executive Officer (our chief operating decision maker), uses adjusted pretax operating income (loss) as our primary measure to evaluate the fundamental financial performance of Radian’s business segments and to allocate resources to the segments. Adjusted pretax operating income (loss) is defined as pretax income (loss) from continuing operations excluding the effects of net gains (losses) on investments and other financial instruments, acquisition-related expenses, amortization and impairment of intangible assets and net impairment losses recognized in earnings. It also excludes gains and losses related to changes in fair value estimates on insured credit derivatives and instead includes the impact of changes in the present value of expected insurance claims and recoveries on insured credit derivatives, based on our ongoing insurance loss monitoring. Management’s use of this measure as its primary measure to evaluate segment performance began with the quarter ended March 31, 2014. Accordingly, for comparison purposes, we also present the applicable measures from the corresponding periods of 2013 and 2012 on a basis consistent with the current year presentation.
Includes a de minimis amount of inter-segment revenues in the MRES segment.
Assets held for sale are not part of the mortgage insurance or MRES segments.
Net investment income of $6.5 million and $9.5 million has been reallocated to the mortgage insurance segment for the years ended December 31, 2013 and 2012, respectively.
Interest expense of $56.6 million and $44.4 million has been reallocated to the mortgage insurance segment for the years ended December 31, 2013 and 2012, respectively.
Does not include assets held for sale of $1.8 billion and $2.0 billion for the years ended December 31, 2013 and 2012, respectively, which are not a part of the mortgage insurance segment.
Certain corporate income and expenses have been reallocated to the mortgage insurance segment as listed above in notes (1) through (4) to the table. These amounts represent items that were previously allocated to the financial guaranty segment but were not reclassified to discontinued operations.
The reconciliation of adjusted pretax operating income (loss) to consolidated pretax income (loss) from continuing operations is as follows:
Includes inter-segment expenses of $0.8 million for the year ended December 31, 2014.
Includes certain corporate income and expenses that have been reallocated to the mortgage insurance segment for all periods presented, as listed in the preceding detailed tables. These amounts represent items that were previously allocated to the financial guaranty segment but were not reclassified to discontinued operations.
Includes inter-segment revenues of $0.8 million for the year ended December 31, 2014.
On a consolidated basis, “adjusted pretax operating income (loss)” is a measure not determined in accordance with GAAP. Total adjusted pretax operating income (loss) is not a measure of total profitability, and therefore should not be viewed as a substitute for GAAP pretax income (loss) from continuing operations. Our definition of adjusted pretax operating income (loss) may not be comparable to similarly-named measures reported by other companies.
Net premiums earned attributable to foreign countries and long-lived assets located in foreign countries were immaterial for the periods presented.
The largest single mortgage insurance customer (including branches and affiliates), measured by primary NIW, accounted for 4.0% of NIW during 2014, compared to 5.8% and 6.2% from the largest single customer in 2013 and 2012, respectively. Earned premiums from one mortgage insurance customer represented 19%, 21% and 19% of our consolidated revenues in 2014, 2013 and 2012, respectively. Earned premiums from an additional customer represented 17% of our consolidated revenues in 2012.
The following is a list of those assets and liabilities that are measured at fair value by hierarchy level as of December 31, 2014:
For the year ended December 31, 2014, $137.3 million of U.S. government and agency securities and $21.0 million of equity securities were transferred from Level II to Level I at the end of the period as a result of our ongoing review of the inputs to the valuations of our assets and liabilities, and the availability of unadjusted quoted prices in active markets for those identical securities as of that date. There were no investment transfers from Level I to Level II for the year ended December 31, 2014.
At December 31, 2013, our total Level III assets approximated less than 1% of total assets measured at fair value and our total Level III liabilities of $2.8 million accounted for 100% of total liabilities measured at fair value.
Rollforward activity of Level III assets and liabilities (including realized and unrealized gains and losses, purchases, sales, issuances, settlements and transfers) was not material during the years ended December 31, 2014 and 2013.
Equity securities-The fair value of these securities is generally estimated using observable market data in active markets or bid prices from market makers and broker-dealers. Generally, these securities are categorized in Level I or II of the fair value hierarchy, as observable market data are readily available. A small number of our equity securities, however, are categorized in Level III of the fair value hierarchy due to a lack of market-based transaction data or the use of model-based evaluations.
Our held to maturity and available for sale securities within our investment portfolio consisted of the following as of the dates indicated:
Comprising broadly diversified domestic equity mutual funds ($143.0 million fair value) and a preferred stock investment in Freddie Mac ($0.4 million fair value).
Comprising broadly diversified domestic equity mutual funds ($128.3 million fair value) and various preferred and common stocks invested across numerous companies and industries ($0.9 million fair value).
For trading securities that were held at December 31, 2014 and 2013, we had net unrealized gains during 2014 and net unrealized losses during 2013 associated with those securities in the amount of $65.7 million and $88.4 million, respectively.
For the years ended December 31, 2014, 2013 and 2012, we did not sell or transfer any fixed-maturity investments classified as held to maturity. For the years ended December 31, 2014, 2013 and 2012, we did not transfer any securities from the available for sale or trading categories.
Impairments due to credit deterioration that result in a conclusion that the present value of cash flows expected to be collected will not be sufficient to recover the amortized cost basis of the security are considered other-than-temporary. Other declines in fair value (for example, due to interest rate changes, sector credit rating changes or company-specific rating changes) that result in a conclusion that the present value of cash flows expected to be collected will not be sufficient to recover the amortized cost basis of the security also may serve as a basis to conclude that an other-than-temporary impairment has occurred. To the extent we determine that a security is deemed to have had an other-than-temporary impairment, an impairment loss is recognized.
We had securities in an unrealized loss position that we did not consider to be other-than-temporarily impaired as of December 31, 2014. For all investment categories, the unrealized losses of 12 months or greater duration as of December 31, 2014, 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, 2014, 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, 2014.
Securities on deposit with various state insurance commissioners amounted to $12.1 million at both December 31, 2014 and 2013.
As part of the Freddie Mac Agreement, Radian Guaranty had $209.3 million and $206.8 million at December 31, 2014 and 2013, respectively, in a collateral account currently invested primarily in trading securities, which is pledged to cover Loss Mitigation Activity on the loans subject to the agreement. Subject to certain conditions in the Freddie Mac Agreement, amounts in the collateral account may be released to Radian Guaranty over time to the extent that Loss Mitigation Activity becomes final in accordance with the terms of the Freddie Mac Agreement. However, if the amount of Loss Mitigation Activity that becomes final in accordance with the Freddie Mac Agreement after the collateral account was established is less than $205 million prior to the termination of the Freddie Mac Agreement, then any shortfall will be paid to Freddie Mac from the funds in the collateral account.
The following table shows the amounts related to the QSR Reinsurance Transactions for the periods indicated:
Ceded losses to date under the QSR Reinsurance Transactions have been immaterial.
Under the Initial QSR Transaction, Radian Guaranty agreed to cede to the third-party reinsurance provider 20% of its NIW beginning with the business written in the fourth quarter of 2011 up to $1.6 billion of ceded RIF. We have ceded the maximum amount permitted under the Initial QSR Transaction, and therefore, are no longer ceding NIW under this transaction. As of December 31, 2014, RIF ceded under the Initial QSR Transaction declined to $1.1 billion. Radian Guaranty had the ability, at its option, to recapture two-thirds of the reinsurance ceded as part of this transaction on December 31, 2014. However, we chose not to recapture that risk and negotiated an amendment to the transaction pursuant to which we received a $9.2 million profit commission based on experience to date, which increased net premiums earned, and a $15.0 million upfront supplemental ceding commission, which has been deferred and is expected to be amortized as a reduction to our policy acquisition costs over approximately the next five years. Effective January 1, 2015, the ceding commission was reduced from 25% to 20% for two-thirds of the reinsurance ceded under the Initial QSR Transaction.
Similar to the Initial QSR Transaction, the Second QSR Transaction also provides that, effective as of December 31, 2015, Radian Guaranty will have the ability, at its option (the “Commutation Option”), to recapture one-half of the reinsurance ceded with respect to conventional GSE loans, which would result in Radian Guaranty reassuming the related RIF potentially in exchange for a payment of a profit commission amount from the reinsurer. Pursuant to the original terms of the Second QSR Transaction:
Radian Guaranty had the ability to cede 100% of all premiums and losses incurred with respect to non-conventional portfolio loans and will receive a 25% ceding commission. We have not ceded any risk on non-conventional portfolio loans.
Approximately 43% of our total ceded losses recoverable at December 31, 2014 were related to two captive reinsurers.
In 2004, we developed a program, referred to as Smart Home, for reinsuring risk associated with non-prime mortgages. From 2004 through 2007, we entered into four Smart Home transactions. As of May 2013, all of the Smart Home transactions had been terminated.
Property and equipment, at cost less accumulated depreciation of $100,207 and $96,058 at December 31, 2014 and 2013, respectively.
Represents ceded losses on captive transactions and the QSR Reinsurance Transactions.
Does not include our Second-lien PDR that is included in other liabilities.
The following table presents information relating to our mortgage insurance reserves for losses, including IBNR, and LAE but excluding Second-lien PDR, for the periods indicated:
Related to ceded losses on captive transactions, Smart Home (for 2012) and QSR Reinsurance Transactions. See Note 8 for additional information.
Our mortgage insurance loss reserves also declined in 2013, primarily as a result of a decrease in our total inventory of defaults (due in large part to the Freddie Mac Agreement), and also because the volume of paid claims, cures and insurance rescissions and claim denials outpaced new default notices received. Total paid claims increased for 2013 from 2012, driven primarily by the $255 million payment made upon the closing of the Freddie Mac Agreement, and by greater efficiencies in our claims review process that allowed us to pay valid claims more quickly than in previous periods. In addition to reserves established for new default notices, which were the primary basis for our total incurred losses in 2013, losses incurred in 2013 were also favorably impacted by reserve development on prior year defaults, as the initial loss of $22 million related to prior year defaults included in the Freddie Mac Agreement was more than offset by a benefit from claim curtailments and cures that was higher than previously estimated.
The following table illustrates the amount of First-lien claims submitted to us for payment that were rescinded or denied, for the periods indicated, net of any reinstatements of previously rescinded policies or denied claims within each period:
Our reported rescission, denial and claim curtailment activity in any given period is subject to challenge by our lender and servicer customers. We expect that a large number of previously denied claims will be resubmitted with the required documentation and ultimately paid; therefore, we have considered this expectation in developing our IBNR reserve estimate. This IBNR estimate was $163.6 million and $281.9 million at December 31, 2014 and 2013, respectively. The significant decrease in our IBNR reserve estimate in 2014 reflects the terms of the BofA Settlement Agreement. For 2014, our IBNR estimate of $163.6 million included approximately $133.0 million for loans subject to the BofA Settlement Agreement. The remaining IBNR reserve included an estimate of future reinstatements of previously denied claims, rescinded policies and curtailments of $18.3 million, $1.4 million and $3.4 million, respectively. These IBNR reserves relate to $113.3 million of claims that were denied within the preceding 12 months, $90.5 million of policies rescinded within the preceding 24 months, and $34.8 million of claim curtailments within the preceding 24 months. The decrease in our IBNR reserve estimate as a result of the BofA Settlement Agreement was partially offset by an increase in our mortgage insurance case reserves to incorporate the fact that we have agreed not to take further action to effect rescissions and claims denials on a population of loans referred to in the settlement agreement as Future Legacy Loans.
We also accrue for the premiums that we expect to refund to our lender customers in connection with our estimated insurance rescission activity. Our accrued liability for such refunds, which is included within other liabilities on our consolidated balance sheets, was $9.0 million and $17.0 million as of December 31, 2014 and 2013, respectively.
On September 16, 2014, Radian Guaranty entered into the BofA Settlement Agreement, as referenced above, with Countrywide Home Loans, Inc. and Bank of America, N.A. (together, the “Insureds”), as a successor to BofA Home Loan Servicing f/k/a Countrywide Home Loans Servicing LP, 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 Subject Loans.
The BofA Settlement Agreement provides that all claims decisions by Radian Guaranty on Legacy Loans (including claims paid, coverage rescissions, claim denials and curtailments) that were communicated on or before February 13, 2013 will become final and will not be subject to future challenge or adjustment. With respect to a group of Legacy Loans referred to as Future Legacy Loans, the BofA Settlement Agreement provides that, subject to certain limited exceptions and conditions, Radian Guaranty will not effect any coverage rescissions, claim denials or curtailments on these loans. To the extent any such Loss Mitigation Activities previously have been taken on Future Legacy Loans, Radian Guaranty will reinstate coverage and pay a reimbursement amount equal to the difference between the amount actually paid by Radian Guaranty and the eligible claim amount. Radian Guaranty has further agreed that with respect to Future Legacy Loans it will not assert any origination error or servicing defect as a basis for a decision not to pay a claim, nor will it effect a curtailment of such claims; provided however, that Radian Guaranty retains the right to curtail Legacy Loans that are less than 90 days delinquent as of July 31, 2014 (“Potential Curtailment Loans”) and any Future Legacy Loans serviced by a servicer other than the Insureds (a “Protected Curtailment”).
The BofA Settlement Agreement further provides that for Servicing Only Loans: (i) if Radian Guaranty effected a claim payment on or before May 30, 2014, any curtailments on such loans will become final and will not be subject to future challenge, appeal or adjustment; and (ii) for claim payments for Servicing Only Loans paid after May 30, 2014, Radian Guaranty will not make any curtailments (excluding Protected Curtailments, which may continue in the ordinary course) and, to the extent any curtailments previously have been effected on such loans, Radian Guaranty will pay a reimbursement amount equal to the curtailment amount. The BofA Settlement Agreement does not affect Radian Guaranty’s right to effect rescissions or denials on any Servicing Only Loans and any such rescissions or denials will continue to be governed by the applicable Master Policies, subject to certain requirements in the BofA Settlement Agreement regarding the documents required to perfect such claims. Radian Guaranty has further agreed not to assert any right to cancel coverage on any Subject Loan for failure to initiate certain proceedings (most commonly foreclosure proceedings) within the timelines set forth in the applicable Master Policies.
Implementation of the BofA Settlement Agreement commenced on February 1, 2015 for Subject Loans held in portfolio by the Insureds or purchased by the GSEs on that date. Approximately 12% of the Subject Loans were neither held in portfolio by the Insureds nor owned by the GSEs, and will require the consent of certain other investors for these loans to be included in the BofA Settlement Agreement except with respect to certain limited rights of cancellation (described above). While we can provide no assurance whether one or more of the other investors will consent to have their Subject Loans included in the settlement, for purposes of the reserve established for the BofA Settlement agreement, we have assumed that these investors will provide consent. Therefore, to the extent that one or more of the other investors do not consent to the settlement, the associated Loss Mitigation Activities would not be reinstated under the terms of the BofA Settlement Agreement and the portion of the reserve related to those other investors would be reversed.
In August 2013, Radian Guaranty entered into the Freddie Mac Agreement, related to a group of First-lien mortgage loans guaranteed by Freddie Mac that were insured by Radian Guaranty and were in default as of December 31, 2011. This transaction significantly impacted our financial position in 2013 by reducing our primary delinquent loan inventory and capping Radian Guaranty’s total exposure on the entire population of loans subject to the agreement. At closing we paid Freddie Mac for claims related to these loans, and also deposited funds into a collateral account to cover future Loss Mitigation Activity on these loans. Subject to certain conditions, amounts in the collateral account may be released to Radian Guaranty over time to the extent that Loss Mitigation Activity becomes final in accordance with the terms of the Freddie Mac Agreement. However, if the amount of Loss Mitigation Activity that becomes final in accordance with the Freddie Mac Agreement after the collateral account was established is less than $205 million prior to the scheduled termination of the Freddie Mac Agreement, then any shortfall will be paid to Freddie Mac from the funds in the collateral account. Prior to consideration of the BofA Settlement Agreement, from the time the collateral account was established through December 31, 2014, approximately $48 million of additional Loss Mitigation Activity had become final in accordance with the Freddie Mac Agreement and $113 million of submitted claims had been rescinded, denied, curtailed or cancelled, but were not considered final in accordance with the Freddie Mac Agreement. Giving effect to the BofA Settlement Agreement as of December 31, 2014, these amounts would have been approximately $116 million and $23 million, respectively.
The carrying value of our long-term debt at December 31, 2014 and 2013 was as follows:
Senior Notes due 2015 and 2017. In June 2005, we issued $250 million of Senior Notes due 2015. During 2013, we exchanged $195.5 million of the Senior Notes due 2015 for a new series of 9.000% Senior Notes due June 2017 for the purpose of improving our debt maturity profile. These transactions, which are accounted for as extinguishments of debt, resulted in a loss of $4.0 million, primarily as a result of the requirement to record the Senior Notes due 2017 at fair value. During 2014, in accordance with the optional redemption provisions of the notes, we redeemed all of the remaining outstanding principal amount of our Senior Notes due 2015 at a price established in accordance with the indenture governing these senior notes. We paid $57.2 million to holders of the notes at redemption and recorded a loss of $2.8 million.
Covenants in Senior Notes. The Senior Notes due 2017 and the Senior Notes due 2019 have covenants customary for securities of this nature, including covenants related to the payments of the notes, reports, compliance certificates and modification of the covenants. Additionally, the indentures governing the Senior Notes due 2017 and the Senior Notes due 2019 include covenants restricting us from encumbering the capital stock of a designated subsidiary (as defined in the respective indentures for the notes) or disposing of any capital stock of any designated subsidiary unless either all of the stock is disposed of or we retain more than 80% of the stock.
Holders of these notes 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, 2014, we had approximately 51 million shares reserved to cover the potential issuance of shares under the Convertible Senior Notes due 2017.
At any time on or after March 8, 2016, we may redeem all or part of the notes, but only if the last reported sale price of our common stock for 20 or more trading days in a period of 30 consecutive trading days ending on, and including, the trading day prior to the date we provide notice of redemption exceeds 130% of the conversion price in effect on each such trading day. The redemption price will be equal to 100% of the unpaid principal amount of the notes to be redeemed, plus accrued and unpaid interest. At December 31, 2014, we had approximately 50 million shares reserved to cover the potential issuance of shares under the Convertible Senior Notes due 2019.
During any calendar quarter commencing after March 31, 2013 (and only during such calendar quarter), if the last reported sale price of our common stock for each of at least 20 trading days (whether or not consecutive) during the 30 consecutive trading days ending on, and including, the last trading day of the immediately preceding calendar quarter, is greater than or equal to 130% of the applicable conversion price on each applicable trading day. During the calendar quarter ended December 31, 2014, the sale price of our common stock met this criteria and therefore, the holders of the notes currently are able to convert the notes, at their option, during the first calendar quarter of 2015;
Furthermore, the indentures for the Convertible Senior Notes due 2017 and 2019 include, among other terms, provisions under which the bankruptcy of Radian Group or the appointment of a receiver for Radian Group or for certain of its subsidiaries or other material assets would constitute an event of default under the indentures. Upon such a default, the note holders of the Convertible Senior Notes due 2017 or 2019 could declare the applicable notes due and payable (which may, under certain circumstances, be automatically accelerated), which would constitute an event of default under the indentures for the Senior Notes due 2017 and 2019. Certain events could cause our applicable insurance regulator to appoint a receiver for our insurance subsidiaries. If this occurred, it would, unless waived by a majority of the applicable note holders, constitute an event of default under the indentures for the Convertible Senior Notes due 2017 and 2019, and therefore, also cause an event of default under the indentures for the Senior Notes due 2017 and the Senior Notes due 2019.
As of December 31, 2014, we recorded a net current income tax payable of approximately $132.8 million, which primarily consists of liabilities related to applying the standards of accounting for uncertainty in income taxes and a current federal income tax recoverable of approximately $3.5 million. Before consideration of uncertain tax positions, we have approximately $1.5 billion of U.S. NOL Carryforwards, $6.0 million of foreign tax credit carryforwards and approximately $2.3 million of alternative minimum tax credit carryforwards as of December 31, 2014. To the extent not utilized, the U.S. NOL Carryforwards will expire during tax years 2028 through 2032 and the foreign tax credit carryforwards will expire during tax years 2018 through 2020. The alternative minimum tax credit carryforwards have no expiration date. Certain entities within our consolidated group have also generated DTAs of approximately $34.9 million relating to state and local NOL Carryforwards, which if unutilized, will expire during various future tax periods.
During 2013 and 2014, we experienced significant positive trends in our mortgage insurance portfolio and in our core operating results. These positive trends are objectively verifiable as evidenced by GAAP operating profitability, reductions in mortgage insurance defaults and claims submitted, and improvement in the composition of our insured portfolio. In December 2014, we executed an agreement of sale for our wholly-owned financial guaranty subsidiary, Radian Asset Assurance. Based on expected net proceeds of approximately $790 million, while the pending Radian Asset Assurance sale generated a discrete GAAP pre-tax loss of approximately $468 million during the fourth quarter of 2014, it also reduces uncertainty of future results related to potential future defaults on these exposures.
Although the accounting standard regarding accounting for income taxes indicates that cumulative losses are a strong indicator of negative evidence, it does not define this term or the length of time to consider when calculating a cumulative loss position. While not a bright line, three years (i.e., current year plus two preceding years) is typically considered a reasonable starting point. We calculate our cumulative loss position as the cumulative pre-tax earnings (loss) for the most recent three years, adjusted for permanent differences and changes in OCI. As of December 31, 2014, our cumulative loss position was approximately $16 million, which represents a significant decrease from the cumulative loss as of December 31, 2010, when the valuation allowance was first established, of approximately $2.8 billion.
After analyzing all positive and negative evidence available as noted above, we believe there is significant positive, objectively verifiable evidence that outweighs all negative evidence and supports a conclusion that it is more-likely-than-not that substantially all of the Company’s DTAs will be realized. In evaluating the weight of evidence, we considered the concept of “core earnings” and the potential profitability of such earnings. Absent the uncertainty and conditions existing in previous years and given the ability to generate profits based on our improved book of business, forecasts related to our core business are significantly more positive, and more certain, than in prior years. In reaching our conclusions, we determined that certain non-insurance entities within the Group may continue to generate taxable losses on a separate company basis in the near term and may not be able to utilize certain state and local NOLs on their state and local tax returns. Therefore, we continue to believe that a valuation allowance of approximately $17.9 million with respect to DTAs relating to these state and local NOLs is appropriate.
Our ability to fully use our tax assets such as NOLs and tax credit Carryforwards would be substantially limited if we experience an “ownership change” within the meaning of Section 382. Section 382 rules governing when a change in ownership occurs are complex and subject to interpretation; however, in general, an ownership change would occur if any five percent shareholders, as defined under Section 382, collectively increase their ownership by more than 50 percentage points over a rolling three-year period. As of December 31, 2014, we have not experienced an ownership change under Section 382. However, if we were to experience a change in ownership under Section 382 in a future period, then we may be limited in our ability to fully utilize our NOL and tax credit Carryforwards in future periods.
As of December 31, 2014, we have approximately $61.1 million of unrecognized tax benefits, including approximately $60.9 million of interest and penalties, that would affect the effective tax rate, if recognized. 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 (benefit), of which approximately $2.5 million, $5.4 million and ($0.8) million were recorded as of December 31, 2014, 2013 and 2012, respectively.
In previous years, we took a return position in various jurisdictions that we are not required to remit taxes with regard to the income generated from our investment in certain partnership interests. Although we believe that these tax positions are more likely than not to succeed if adjudicated, measurement of the potential amount of liability for state and local taxes and the potential for penalty and interest thereon is performed on a quarterly basis. Our net unrecognized tax benefits related to prior years increased by approximately $22.8 million during 2014. This net increase primarily reflects the impact of unrecognized tax benefits associated with our recognition of certain premium income. Although unrecognized tax benefits for this item decreased by approximately $24.2 million due to the expiration of the applicable statute of limitations for the taxable period ended December 31, 2010, the related amounts continued to impact subsequent years resulting in a corresponding increase to the unrecognized tax benefits related primarily to the 2011 taxable year.
We petitioned the U.S. Tax Court to litigate the IRS Notices of Deficiency resulting from the examination of our 2000 through 2007 consolidated federal income tax returns. This litigation relates to the recognition of certain tax benefits associated with our investment in a portfolio of non-economic REMIC residual interests.
Arizona, California, Florida, Georgia, New York, Ohio, Pennsylvania and New York City.
State insurance regulators impose various capital requirements on our insurance subsidiaries. These include Risk-to-capital, risk-based capital measures and surplus requirements that limit the amount of insurance that each of our insurance subsidiaries may write. Our failure to maintain adequate levels of capital could lead to intervention by the various insurance regulatory authorities, which could materially and adversely affect our business, business prospects and financial condition.
Radian Group serves as the holding company for our insurance subsidiaries, through which we conduct our mortgage insurance business. These insurance subsidiaries are subject to comprehensive, detailed regulation by the insurance departments in the various states where our insurance subsidiaries are domiciled or licensed to transact business. Insurance laws vary from state to state, but generally grant broad supervisory powers to state agencies or officials to examine insurance companies and enforce rules or exercise discretion affecting almost every significant aspect of the insurance business, including the power to revoke or restrict an insurance company’s ability to write new business. The state insurance regulations include various capital requirements and dividend restrictions based on our insurance subsidiaries’ statutory financial position and results of operations, as described in Note 1 and below. Our failure to maintain adequate levels of capital could lead to intervention by the various insurance regulatory authorities, which could materially and adversely affect our business, business prospects and financial condition. As of December 31, 2014, the amount of restricted net assets held by our consolidated insurance subsidiaries (which represents our equity investment in those insurance subsidiaries) totaled $2.2 billion of our consolidated net assets.
The ability of Radian Guaranty, RMAI, Radian Insurance, Radian Mortgage Insurance and RGRI to pay dividends on their common stock is restricted by certain provisions of the insurance laws of Pennsylvania, their state of domicile. Under Pennsylvania’s insurance laws, dividends and other distributions may only be paid out of an insurer’s positive unassigned surplus, measured as of the end of the prior fiscal year, unless the Pennsylvania Insurance Commissioner approves the payment of dividends or other distributions from another source. Radian Guaranty, RMAI, Radian Insurance, Radian Mortgage Insurance and RGRI had negative unassigned surplus at December 31, 2014 of $715.7 million, $161.5 million, $279.5 million, $46.0 million and $341.2 million, respectively, compared to negative unassigned surplus of $623.1 million, $161.0 million, $305.0 million, $69.1 million and $360.7 million, respectively, at December 31, 2013. If any of these insurers had positive unassigned surplus as of the end of the prior fiscal year, unless the prior approval of the Pennsylvania Insurance Commissioner is obtained, such insurer only may pay dividends or other distributions during any 12-month period in an aggregate amount less than or equal to the greater of: (i) 10% of the preceding year-end statutory policyholders’ surplus; or (ii) the preceding year’s statutory net income. Due to the negative unassigned surplus at the end of 2014, no dividends or other distributions can be paid from Radian Guaranty, RMAI, Radian Insurance, Radian Mortgage Insurance or RGRI in 2015, without approval from the Pennsylvania Insurance Commissioner. None of Radian Guaranty, RMAI, Radian Insurance, Radian Mortgage Insurance or RGRI paid any dividends in 2014 or 2013.
Radian Guaranty was in compliance with the Statutory RBC Requirements or MPP Requirements, as applicable, in each of the RBC States as of December 31, 2014. See Note 1 for information regarding the Statutory RBC Requirements and MPP Requirements as well as the new, proposed GSE eligibility requirements that were issued in the form of the proposed PMIERs for public comment on July 10, 2014.
Radian Insurance is required to maintain a minimum statutory surplus of $20 million to remain an authorized reinsurer in all states. Radian Insurance’s statutory net income, statutory policyholders’ surplus and contingency reserve as of and for the years ended December 31, 2014, 2013 and 2012 were as follows:
Radian Mortgage Insurance is domiciled and licensed in Pennsylvania as a stock casualty insurance company authorized to carry on the business of credit insurance, which includes the authority to reinsure policies of mortgage guaranty insurance, and is only licensed or authorized to write direct mortgage guaranty insurance in Pennsylvania and Arizona.
Radian Mortgage Insurance is required to maintain a minimum statutory surplus of $20 million to remain an authorized reinsurer in all states. Radian Mortgage Insurance’s statutory net income, statutory policyholders’ surplus and contingency reserve as of and for the years ended December 31, 2014, 2013 and 2012 were as follows:
In July 2014, we invested $20 million to capitalize a newly formed, Pennsylvania domiciled wholly-owned insurance subsidiary of Radian Group. The strategic objective of this investment is to offer various mortgage credit-related products, which are currently in a developmental stage. Their statutory policyholders’ surplus as of December 31, 2014 was approximately $20 million and there is no RIF as of December 31, 2014.
The differences between the statutory financial statements and financial statements presented on a GAAP basis represent differences between GAAP and SAP for the following reasons:
Under SAP, mortgage guaranty insurance companies are required each year to establish a contingency reserve equal to 50% of premiums earned in such year. Such amount must be maintained in the contingency reserve for 10 years, after which time it is released to unassigned surplus. Prior to 10 years, the contingency reserve may be reduced with regulatory approval to the extent that losses in any calendar year exceed 35% of earned premiums for such year.
Under SAP, insurance policy acquisition costs are charged against operations in the year incurred. Under GAAP, such costs, other than those incurred in connection with the origination of derivative contracts, are deferred and amortized.
Under SAP, income tax expense is calculated on the basis of amounts currently payable. Generally, DTAs are recorded under both SAP and GAAP when it is more likely than not that the DTA will be realized. However, SAP standards impose additional admissibility requirements whereby DTAs are only recorded to the extent they are expected to be recovered within a one- to three-year period subject to a capital and surplus limitation. Changes in DTAs and DTLs are recognized as a direct benefit or charge to unassigned surplus, whereas under GAAP changes in DTAs and DTLs, except for changes in unrealized gains and losses on available-for-sale securities, are recorded as a component of income tax expense.
Under SAP, the accounting standard regarding accounting for transfers and servicing of financial assets and extinguishment of liabilities and the accounting standard regarding consolidation of VIEs are not applicable.
Under SAP, premiums written on a multi-year basis are initially deferred as unearned premiums. A portion of the premium written, which corresponds to the insurance policy acquisition costs, is earned immediately and the remaining premiums written are earned over the policy term. Under GAAP, these premiums written on a multi-year basis are initially deferred as unearned premiums and are earned over the policy term.
Under SAP, capital contributions satisfied by receipt of cash or readily marketable securities subsequent to the balance sheet date but prior to the filing of the statutory financial statement are treated as a recognized subsequent event and, as such, are considered an admitted asset based on the evidence of collection and approval of the domiciliary commissioner. Under GAAP, such capital contributions are treated as a nonrecognized subsequent event.
On May 14, 2014, our stockholders approved a new equity compensation plan, the 2014 Equity Plan, pursuant to which we grant equity awards. The 2014 Equity Plan replaced our prior equity plan, the 2008 Equity Compensation Plan. We also have awards outstanding under the 1995 Equity Plan, which preceded the 2008 Equity Plan. In adopting the 2014 Equity Plan, we agreed not to grant any new awards under the 2008 Equity Plan. The last awards granted pursuant to the 2008 and 1995 Equity Plans were granted in 2014 and 2008, respectively. All awards granted under the Equity Plans have been in the form of non-qualified stock options, restricted stock, RSUs, SARs, phantom stock and performance share awards. The maximum contractual term for all awards under the Equity Plans is 10 years.
Vesting of awards granted to executive officers in 2012 is dependent upon (1) Radian Group’s absolute TSR compared to the relative TSR of the companies listed on the NASDAQ 100 Financial Index and our most directly comparable mortgage insurance peer, and (2) Radian Group’s relative TSR (“2012 Relative TSR Measure”), in each case measured over a three-year performance period. The maximum payout at the end of the three-year performance period is 200% of a grantee’s target number of RSUs. If Radian Group’s absolute TSR during the performance period is negative, none of the performance-based RSUs granted to executive officers will vest. If Radian Group’s absolute TSR is positive, the payout will be determined based on an analysis of Radian Group’s relative TSR and absolute TSR.
Vesting of awards granted to both non-executives and executives in 2011 was dependent upon the performance of Radian Group’s TSR compared to TSRs of the Peer Groups, and resulted in a maximum payout at the end of the three-year performance period of 200% of a grantee’s target number of RSUs.
Timed-Vested RSUs-In 2014, 2013 and 2012, the Compensation Committee awarded to certain non-executives 1,470, 7,670 and 151,154, respectively, of cash-settled time-vested RSUs under the 2008 Equity Plan. The estimated fair value of the time-vested RSUs is based on the closing price of our common stock on the measurement date. These RSU awards entitle award recipients to a cash amount equal to the closing price of our common stock on the NYSE on the vesting date for employees or the conversion date for non-employee directors (generally defined as a director’s termination of service with us). These RSU awards vest in their entirety three years from the date of grant, or earlier, upon retirement, death or disability.
We use the Monte Carlo valuation model in determining the grant date fair value of performance-based stock options issued to executives and non-executives using the assumptions noted in the following table:
Volatility is determined at the date of grant using historical share price volatility and expected life of each award.
In the past, the Compensation Committee has granted phantom stock awards to non-employee directors under the Equity Plans, which entitle grantees to receive shares of our common stock on the conversion date (generally defined as a grantee’s termination of service with us). The estimated fair value of phantom stock is based on the closing share price of our common stock as reported by the NYSE on the date of grant. All outstanding shares of phantom stock are fully vested. Each share of phantom stock was granted at full value with no exercise price and accrues dividend equivalents until the conversion (as defined above). Upon conversion, all phantom stock will be paid in whole shares of our common stock, with fractional shares paid in cash. At December 31, 2014, there were approximately 4,452 dividend-equivalent phantom shares accrued that were not included in the total number of our outstanding shares. The cost recognized for these awards was recognized on a straight-line basis over the vesting period.
Vesting of awards granted to executive officers in 2014 and 2013 is dependent upon (1) Radian Group’s TSR compared to the relative TSR of the companies listed on the NASDAQ Financial Index and our most directly comparable mortgage insurance peers as of the date of grant (the “Relative TSR Measure”), and (2) Radian Group’s absolute TSR (“Absolute TSR Measure”), in each case measured over a three-year performance period. The maximum payout at the end of the three-year performance period is 200% of a grantee’s target number of RSUs, subject to a maximum cap of six times the value of the grantee’s award on the grant date. If Radian Group’s absolute TSR during the performance period is negative, the maximum payout percentage will be 50% of target. If Radian Group’s absolute TSR is positive, the payout will be determined based on an analysis of Radian Group’s Relative TSR Measure and Absolute TSR Measure, with executives only entitled to a 100% vesting if Radian Group’s Absolute TSR is equal to at least 25%. Vesting of awards granted to non-executive officers in 2014 and 2013 is subject to the same terms as the executive officer awards, except that the non-executive officer awards are not subject to the Absolute TSR Measure.
In 2009, the Compensation Committee granted 375,500 shares of restricted stock. No shares of restricted stock were granted during 2014, 2013 or 2012 and all restricted stock issued has vested.
The 2008 ESPP is designed to allow eligible employees to purchase shares of our common stock at a discount of 15% off the lower of the fair market value of our common stock at the beginning-of-period or end-of-period (each period being the first and second six calendar months in a calendar year).
The following are assumptions used in our calculation of ESPP compensation expense during 2014:
As of December 31, 2014, 2013 and 2012, unrecognized compensation expense related to the unvested portion of all of our share-based awards was approximately $17.5 million, $31.9 million and $22.4 million, respectively. Absent a change of control under the Equity Plans, this expense is expected to be recognized over a weighted average period of approximately two years.
The Savings Plan covers substantially all of our full-time and our part-time employees. Participants can contribute up to 100% of their base earnings as pretax and/or after-tax (Roth IRA) contributions up to a maximum amount of $17,500 for 2014. The Plan also includes a catch-up contribution provision whereby participants who are or will be age 50 and above during the Plan year, may contribute an additional contribution. The maximum catch-up contribution for Plan Year 2014 was $5,500. We will match up to 100% of the first 6% of base earnings contributed in any given year. Our expense for matching funds for the years ended December 31, 2014, 2013 and 2012 was $3.1 million, $2.7 million and $2.5 million, respectively.
permits Radian Group to make discretionary, pro rata (based on eligible pay) cash allocations to each eligible participant’s account, with vesting upon completion of three years of service with us; and
Loss estimates are inherently subjective, based on currently available information, and are subject to management’s judgment and various assumptions. Due to the inherently subjective nature of these estimates and the uncertainty and unpredictability surrounding the outcome of legal proceedings, actual results may differ materially from any amounts that have been accrued.
Each of the cases described below are putative class actions (with alleged facts substantially similar to the facts alleged in the JPMorgan Case discussed above) in which Radian Guaranty has been named as a defendant and has insured at least one loan of one of the plaintiffs:
On December 30, 2011, a putative class action under RESPA titled White v. PNC Financial Services Group (the “White Case”) was filed in the U.S. District Court for the Eastern District of Pennsylvania. On September 29, 2012, plaintiffs filed an amended complaint. On November 26, 2012, Radian Guaranty filed a motion to dismiss the plaintiffs’ claims as barred by the statute of limitations. On June 20, 2013, the court granted Radian Guaranty’s motion and dismissed plaintiffs’ claims, but granted plaintiffs leave to file a second amended complaint. Plaintiffs filed their second amended complaint on July 5, 2013, reasserting a putative claim under RESPA on substantially the same allegations. Radian Guaranty filed a motion to dismiss plaintiffs’ second amended complaint on July 22, 2013. The court denied Radian Guaranty’s motion on August 18, 2014, without prejudice to Radian Guaranty’s ability to raise the statute of limitations bar on a motion for summary judgment. On January 20, 2015, plaintiffs in the White Case filed a motion to strike certain of the affirmative defenses, but not the statute of limitations defense, that had been asserted by Radian Guaranty in its answer to plaintiffs’ second amended complaint. The parties are continuing to file procedural motions in this litigation. However, the White Case is currently stayed pending a decision by the Third Circuit Court of Appeals in the case Cunningham v. M&T Bank Corp., which is another putative class action under RESPA in which Radian Guaranty is not a party.
In addition to the litigation discussed above, we are involved in litigation that has arisen in the normal course of our business. We are contesting the allegations in each such pending action and management believes, based on current knowledge and after consultation with counsel, that the outcome of such litigation will not have a material adverse effect on our consolidated financial condition. However, the outcome of litigation and other legal and regulatory matters is inherently uncertain, and it is possible that one or more of the matters currently pending or threatened could have an unanticipated adverse effect on our liquidity, financial condition or results of operations for any particular period.
Under our Master Policies, any suit or action arising from any right of an insured under the policy generally must be commenced within two years after such right first arose for primary insurance and within three years for certain other policies, including certain pool insurance policies. We continue to face a number of challenges from certain lender and servicer customers regarding our Loss Mitigation Activities, which have resulted in some reversals of our decisions regarding rescissions, denials or claim curtailments. We are currently in discussions with customers regarding these Loss Mitigation Activities and our claim payment practices, which if not resolved, could result in arbitration or additional judicial proceedings. See Note 10 for further information.
The elevated levels of our Loss Mitigation Activities (related to servicer negligence) have led to an increased risk of litigation by lenders, policyholders and servicers challenging our right to rescind coverage, deny claims or curtail claim amounts. We believe that our Loss Mitigation Activities are justified under our policies. However, in the event we are not successful in defending our Loss Mitigation Activities, we may need to reassume the risk on and increase loss reserves for previously rescinded policies or pay additional claims on curtailed amounts. See Note 10 for further information.
Securities regulations became effective in 2005 that impose enhanced disclosure requirements on issuers of ABS (including mortgage-backed securities). To allow our customers to comply with these regulations at that time, we typically were required, depending on the amount of credit enhancement we were 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 $128.8 million of remaining credit exposure as of December 31, 2014.
As part of the non-investment-grade allocation component of our investment program, we had unfunded commitments of $7.4 million at December 31, 2014, related to alternative investments that are primarily private equity structures. These commitments have capital calls expected through 2015, with the possibility of additional calls through 2017, and certain fixed expiration dates or other termination clauses.
The commitment for non-cancelable operating leases in future years has not been reduced for future minimum receipts expected from sublease rental payments aggregating approximately $3.8 million at December 31, 2014.
This amount reflects a reversal of substantially all of our tax valuation allowance in the fourth quarter.