We currently maintain three Data Centers (Dayton, New York and Philadelphia) and two Disaster Recovery (DR) sites (Dayton and Philadelphia) to support all of our businesses. We have verified that these Data Centers and DR sites work properly and have transitioned from the establishment of these Data Centers and DR sites to a program to operate and administer them. We have “hot site” recovery plans for London, New York and Philadelphia from a Business Continuity standpoint. During 2005, we will be introducing a new contract underwriting system for underwriters at our Service Centers and On-Sites. This new system includes access through a web-based Portal and ordering, billing, fulfillment and payment functionality, along with integrated document management and reporting capabilities. Our strategic direction for all new application development continues to include deploying web-based custom or off-the-shelf software running on a UNIX, Linux and/or Windows platform. PeopleSoft Financial Systems is currently installed and operational. We maintain our current legacy systems that support claims, risk management and mortgage insurance underwriting in the Philadelphia data center and at the Philadelphia DR site. We will continue to fortify our legacy systems and adjunct components as appropriate through a policy enforcement and data interchange strategy. Over the next twelve months, we will migrate our data operations from the New York data center to the data center in Dayton. This will provide continuous availability at the Dayton data center and full business recovery capability at the Philadelphia data center.
The following table sets forth selected financial data of the Company. This information should be used in conjunction with the Consolidated Financial Statements and notes thereto included in Item 8 of this report and the information set forth in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
(3) Diluted net income per share and average share information per Statement of Financial Accounting Standards No. 128, “Earnings Per Share.” Amounts reported for 2002 and 2003 have been adjusted to reflect the inclusion of shares underlying contingently convertible debt. See Note 1 and 2 of Notes to Consolidated Financial Statements.
(4) All share and per-share data for periods prior to 2001 have been adjusted to reflect a 2-for-1 stock split in 2001.
(7) Amounts for 2004 reflect the recapture of previously ceded business by one of the primary insurer customers of Financial Guaranty in the first quarter of 2004.
The Company believes that its diversified credit enhancement and prudent capital management strategies are sound and intends to continue to implement these strategies. The Company sees a convergence between the mortgage insurance and financial guaranty markets, with an emphasis on structured credit enhancement products. In the mortgage insurance business, the Company is hopeful that an economic recovery and job growth can positively impact performance and that modestly rising interest rates will help reduce cancellation rates, although these macroeconomic factors are outside of the Company’s control. The Company will continue to be challenged to solidify the AA financial guaranty business platform by continuing to demonstrate the ability to grow and write quality business. This will be difficult in a competitive, tight credit spread environment. The Company expects to increase its efforts in the global markets for both mortgage and financial guaranty business to allow it to take advantage of its core competencies of credit risk analysis and capital allocation to write profitable business in Europe and Asia.
In November 2004, the Company announced that its Chairman and Chief Executive Officer, Frank Filipps, intends to retire on or before June 30, 2005. The board of directors has formed a special committee to lead the selection of Mr. Filipps’ successor and the committee has begun that process, which will include both external and internal candidates.
Effective June 1, 2004, the two main operating subsidiaries of Enhance Financial Services Group Inc. (“EFSG”), Radian Asset Assurance Inc. (“Radian Asset Assurance”) and Radian Reinsurance Inc. (“Radian Reinsurance”) were merged, with Radian Asset Assurance as the surviving company. Through this merger, the financial guaranty reinsurance business formerly conducted by Radian Reinsurance was combined with the direct financial guaranty business conducted by Radian Asset Assurance. The merger combined the assets, liabilities and shareholder’s equity of the two companies and the combined company (“Financial Guaranty”) is rated “Aa3” by Moody’s Investor Service (“Moody’s”), “AA” (negative outlook) by Standard & Poor’s Insurance Rating Service (“S&P”) and “AA” by Fitch Ratings (“Fitch”), the ratings assigned to Radian Asset Assurance prior to the merger. Total net debt service outstanding (par plus interest) on transactions insured by Financial Guaranty decreased from $117.9 billion at December 31, 2003 to $101.6 billion at December 31, 2004, primarily as a result
Consolidated net premiums written for 2004 were $1,082.5 million, compared to $1,110.5 million for 2003. The amount of net premiums written reported in 2004 reflects a reduction of $96.4 million of Financial Guaranty written premiums related to the first quarter 2004 recapture of business by one primary insurer, which also reduced earned premiums by $24.9 million. Net premiums earned for 2004 were $1,029.5 million, an increase of $21.3 million or 2.1% from the $1,008.2 million recorded in 2003. Net investment income of $204.3 million for 2004 increased $18.1 million or 9.7% from $186.2 million in 2003, primarily due to growth in the investment portfolio funded by continued positive operating cash flows. The Company has continued to invest some of its net operating cash flow in tax-advantaged securities, primarily municipal bonds, although the Company’s investment policy allows the purchase of various other asset classes, including common stock and convertible securities. The Company’s common equity exposure is targeted at a maximum of 5% of the investment portfolio’s market value, while the investment-grade convertible securities and investment-grade taxable bond exposures are each targeted not to exceed 10%. Other income decreased to $32.3 million in 2004 from $63.3 million in 2003, primarily due to the cessation of operations at RadianExpress.
The provision for losses was $456.8 million for 2004, a net decrease of $19.3 million or 4.1% from $476.1 million in 2003. The decrease in the provision for losses in 2004 resulted primarily from the $111.0 million attributable to Conseco Finance Corp. in 2003, partially offset by a $91.7 million increase in the provision for losses to support the $93.2 million increase in claims paid by Mortgage Insurance in 2004. Policy acquisition costs for 2004 were $121.8 million, down $6.7 million or 5.2% from $128.5 million in 2003. The amount reported in 2004 reflects the $9.8 million reduction of Financial Guaranty acquisition costs resulting from the recapture of previously written business by one primary insurer customer in the first quarter of 2004. Also included in the amount reported in 2004 was a charge of $11.6 million related to an acceleration of deferred policy acquisition cost amortization in the Mortgage Insurance business resulting from high cancellation rates and higher default rates.
Other operating expenses of $205.7 million for 2004 decreased $5.4 million or 2.6% from $211.1 million in 2003. Other operating expenses in 2004 included higher Information Technology (“IT”) expenditures and the amortization of IT projects that were placed into service in 2004, as well as increased compliance costs, including Sarbanes-Oxley compliance. Other operating expenses for 2003 included the $13.0 million charge for the cessation of operations at RadianExpress, as well as normal operating expenses of RadianExpress of $25.7 million up to the time of its cessation of business. The $13.0 million charge includes the write-off of the carrying cost of the investment of $7.2 million and provisions for severance, leasehold commitments and other charges of $5.8 million.
Interest expense of $34.7 million for 2004 decreased $2.8 million from $37.5 million in 2003 due to the positive impact of the interest rate swap that the Company entered into in the second quarter of 2004, which effectively converted the interest rate on the Company’s 5.625% Senior Notes due 2013 to a variable rate based on a spread over the London Interbank Offered rate (“LIBOR”). The consolidated effective tax rate was 28.5%
The following schedule shows the Consolidated Statements of Income as reported (Column 1) and adjustments (Column 2) to reflect the income statement impact of the recapture (referred to in the table as the clawback) of business previously ceded to the Company by one of the primary insurer customers of Financial Guaranty that occurred in the first quarter of 2004. The adjusted numbers are shown in Column 3. The impact of the clawback (Column 2) reflects the clawback of business recorded by the Company in prior periods. This clawback affected the first quarter (and, as a result, the year-to-date period) of 2004. Accordingly, management believes that Column 3 provides useful information to investors by presenting a more meaningful basis of comparison for the Company’s past and future results.
2002, primarily due to strong results at C-BASS and Sherman. Equity in net income of affiliates for 2003 also included $9.1 million (pre-tax) related to the Company’s investment in Primus. The results of Primus for 2002 were immaterial to the Company’s Consolidated Financial Statements.
The provision for losses was $476.1 million for 2003, an increase of $232.8 million or 95.7% from $243.3 million in 2002. Approximately $114.8 million of this increase was related to Mortgage Insurance to support an increase in claims payments and delinquency rates, and $118.0 million was related to Financial Guaranty, of which $96.0 million was added during the fourth quarter of 2003 in anticipation of approximately $111.0 million in claims from a single manufactured housing transaction originated and serviced by Conseco Finance Corp. The remaining reserve increase was at Financial Guaranty to support business growth and an increase in trade credit reinsurance claims. Policy acquisition costs for 2003 were $128.5 million, up $27.7 million or 27.5% from $100.8 million in 2002. Other operating expenses of $211.1 million for 2003 increased $35.8 million or 20.4% from $175.3 million in 2002. Included in operating expenses in 2003 was a $13.0 million charge for the cessation of operations of RadianExpress. The Company recorded a pension gain of $2.3 million in 2002 related to the curtailment of Financial Guaranty’s pension plan. Interest expense of $37.5 million for 2003 increased from $28.8 million in 2002 as a result of interest payments on $250 million of long-term debt issued in February 2003. The Company’s consolidated effective tax rate was 27.4% for 2003 compared to 29.0% for 2002. The decline in the effective tax rate in 2003 resulted from a higher proportion of tax-exempt securities as compared to taxable income.
Mortgage Insurance’s net income for 2004 was $271.9 million, a decrease of $7.9 million or 2.8% from $279.8 million in 2003. This decrease was due to increases in the provision for losses, policy acquisition costs and other operating expenses, as well as a decrease in other income, partially offset by an increase in earned premiums, net investment income, gains on sales of investments and the change in fair value of derivative instruments.
Although home purchases have increased, the mortgage insurance industry did not benefit from this increase as it relates to insurance written due to equity appreciation, which decreased the percentage of loans requiring mortgage insurance, and an increase in alternative mortgage executions that exclude mortgage insurance, particularly so-called “80-10-10” arrangements. In addition, refinance activity remained high, which often results in the elimination of mortgage insurance on the refinanced loan, reducing volume in 2004 throughout the industry. Primary new insurance written during 2004 was $44.8 billion, a 34.5% decrease from $68.4 billion written in 2003. This decrease in Mortgage Insurance’s primary new insurance written in 2004 was primarily due to a smaller overall market which led to a large decrease in insurance written both through flow business (loans insured on an individual basis) and structured transactions. During 2004, Mortgage Insurance wrote $8.5 billion in structured transactions compared to $18.9 billion in 2003. The amount originated in 2003 included a large structured transaction for one customer composed of prime mortgage loans originated throughout the United States. The Company’s participation in the structured transactions market is likely to vary significantly from year-to-year because the Company competes with other mortgage insurers, as well as capital market executions, for these transactions. In 2004, Mortgage Insurance wrote $304 million of pool insurance risk compared to $933 million in 2003. A lower level of structured transactions, which includes those composed of pool insurance risk, and a lower level of GSE pool risk written, contributed to this decline. The large transaction in 2003 referred to above also included a portion of the risk written as pool insurance coverage.
Mortgage Insurance is dependent on a small number of lenders for providing a substantial portion of its business. Mortgage Insurance’s top 10 lenders were responsible for 42.2% of the direct primary risk in force at December 31, 2004. The top 10 lenders were also responsible for 46.7% of primary new insurance written in 2004. The largest single customer of Mortgage Insurance (including branches and affiliates of such customer), measured by new insurance written, accounted for 9.6% of new insurance written during 2004, compared to 10.4% in 2003. The concentration of business with lenders may increase or decrease as a result of many factors. These lenders may reduce the amount of business currently given to Mortgage Insurance or cease doing business with it altogether. Mortgage Insurance’s master policies and related lender agreements do not, and by law cannot, require lenders to do business with it. The loss of business from a major lender could materially adversely affect Mortgage Insurance’s and the Company’s business and financial results. The Company expects customer concentration to be a continuous trend as a result of the ongoing consolidation in the financial services industry in general and the mortgage industry in particular.
Mortgage Insurance’s volume in 2004 continued to be impacted by lower interest rates that affected the entire mortgage insurance industry. The continued low interest rate environment caused refinancing activity to remain relatively high, although not as high as in 2003. Mortgage Insurance’s refinancing activity as a percentage of primary new insurance written was 40% for 2004 compared to 50% for 2003. The persistency rate, which is defined as the percentage of insurance in force that remains on the Company’s books after any 12-month period, was 58.8% for the 12 months ended December 31, 2004, compared to 46.7% for the 12 months ended December 31, 2003. This increase in the persistency rate reflects a decline in refinancing activity during 2004. The Company’s expectation for 2005 is that persistency rates will continue to slowly rise throughout the year, influenced by relatively stable or slowly rising interest rates.
Net premiums earned by Mortgage Insurance in 2004 were $814.6 million, a $55.0 million or 7.2% increase from $759.6 million for 2003. The net premiums earned in 2004 reflect an increase in premiums from non-traditional new insurance volume in Radian Insurance and Amerin Guaranty. Certain portions of this business are included in “other risk in force” and include a high percentage of credit enhancements on net interest margin securities (“NIMs”) and second lien mortgage insurance business. During the second quarter of 2004, the Company announced its intent to reduce the amount of second lien business it expected to originate in the future, but the Company continues to evaluate this decision and may increase its participation in second lien business if it believes it can do so at acceptable levels of risk and return. Premiums earned in Radian Insurance and Amerin Guaranty, primarily from credit insurance on mortgage-related assets and second mortgages, were $128.8 million in 2004, compared to $93.1 million in 2003 and $46.1 million in 2002. During 2003 and continuing into 2004, Mortgage Insurance also experienced a change in the mix of new insurance written. The mix now includes a higher percentage of non-prime business, which has higher premium rates intended to compensate for the increased level of expected loss associated with this type of insurance. Direct primary insurance in force was $115.3 billion at December 31, 2004, compared to $119.9 billion at December 31, 2003. Total pool risk in force was $2.4 billion at December 31, 2004 and December 31, 2003. Other risk in force in Radian Insurance and Amerin Guaranty was $1.2 billion at December 31, 2004 and $1.1 billion at December 31, 2003.
The Office of Federal Housing Enterprise Oversight issued new risk-based capital regulations for Fannie Mae and Freddie Mac, which took effect September 13, 2002. The most relevant provision to the Company is a distinction between “AAA”-rated insurers and “AA”-rated insurers. The new regulations impose a credit haircut that Fannie Mae and Freddie Mac are given for exposure ceded to “AAA” insurers by 3.5% and to “AA” insurers by 8.75%. Currently, Radian Guaranty is rated “AA”; one other mortgage insurance provider is rated “AAA.” As a result, there may be an incentive for the GSEs to use private mortgage insurance provided by a “AAA” rated insurer. The provisions of the new regulations are being phased in over a 10-year period commencing on the effective date of the regulation. There has been no noticeable impact on the Company as a result of this change.
In addition to insuring prime loans, Mortgage Insurance insures non-traditional loans, primarily Alt-A and A minus loans (collectively, referred to as “non-prime” business). Alt-A borrowers generally have a similar credit profile to the Company’s prime borrowers, but these loans are underwritten with reduced documentation and verification of information. The Company typically charges a higher premium rate for Alt-A business due to reduced or no documentation. Alt-A loans tend to have higher balances than other loans insured by Mortgage Insurance. The Company considers Alt-A loans to be more risky than prime business, particularly Alt-A loans to borrowers with FICO credit scores below 660. The Company also insures Alt-A loans with FICO scores ranging from 620 to 660, but the Company has measures in place to limit this exposure and it charges a significantly higher premium for the level of increased risk. Although the Company previously has disclosed an intent to reduce its insurance of lower FICO Alt-A loans, the Company continually re-evaluates this decision and will increase its participation in this business if it believes it can do so at acceptable levels of risk and return. The Company’s A minus loan programs typically have non-traditional credit standards that are less stringent than standard credit guidelines and include loans to borrowers with FICO scores ranging from 570 to 619. In an attempt to compensate for this additional risk, the Company receives a higher premium for insuring this product, which the Company believes is commensurate with the additional default risk. During 2004, non-prime business accounted for $16.4 billion or 36.6% of Mortgage Insurance’s new primary insurance written compared to $27.4 billion or 40.1% for 2003. Of the $16.4 billion of non-prime business written for 2004, $10.2 billion or 61.9% was Alt-A. At December 31, 2004, non-prime insurance in force was $35.7 billion or 31.0% of total primary insurance in force, compared to $37.8 billion or 31.5% for 2003. Of the $35.7 billion of non-prime insurance in force at December 31, 2004, $22.1 billion or 61.9% was Alt-A. The Company anticipates that the trend of a significant and, perhaps, increasing mix of non-prime mortgage insurance business and non-traditional insurance products will continue as a result of structural changes and competitive products in the mortgage lending and mortgage insurance businesses.
Holders of the Smart Home credit-linked notes bear the risk of loss from losses paid to the Company under the reinsurance agreement. Smart Home will invest the proceeds of the notes in high-quality short-term investments approved by S&P and Moody’s. Income earned on those investments and a portion of the reinsurance premiums paid by the Company will be applied to pay interest on the notes as well as certain of Smart Home’s expenses. The liquidation proceeds from the investments will be used to pay reinsured loss amounts to the Company, and any remaining proceeds will be applied to pay principal on the notes. In February 2005, the Company completed a second reinsurance arrangement under which it ceded a portion of the risk associated with a $1.68 billion portfolio of first lien, non-prime residential mortgages insured by the Company.
Mortgage Insurance and other companies in the industry have entered into risk/revenue-sharing arrangements with various customers that are designed to allow the customer to participate in the risks and rewards of the mortgage insurance business. One such product is captive reinsurance, in which a mortgage lender establishes a mortgage reinsurance company that assumes part of the risk associated with that lender’s mortgages that are insured on a flow basis. In return for the reinsurance company’s assumption of risk, the mortgage insurer cedes a portion of its mortgage insurance premiums to the reinsurance company. In most cases, the risk assumed
The provision for losses was $400.9 million for 2004, an increase of $91.6 million or 29.6% from $309.3 million in 2003, primarily to support an increase in claims paid and a higher mix of non-traditional insured loans in default that have a higher probability of going to claim. The seasoning of this higher mix of non-traditional insured loans resulted in an increase in claims coupled with higher delinquency (or default) rates. The default and claim cycle in the mortgage insurance business begins with the Company’s receipt of a default notice from the insured. Generally, the master policy of insurance requires the insured to notify the Company of a default within 15 days after the loan has become 60 days past due. Claim activity is not spread evenly throughout the coverage period of a book of business. Relatively few claims on prime business are received during the first two years following issuance of a policy and on non-prime business during the first year. Historically, claim activity on prime loans has reached its highest level in the third through fifth years after the year of policy origination, and on non-prime loans this level is expected to be reached in the second through fourth years. Approximately 80.4% of the primary risk in force and approximately 30.4% of the pool risk in force at December 31, 2004 had not yet reached its highest claim frequency years. Because it is difficult to predict both the timing of originating new business and the run-off rate of existing business, it also is difficult to predict, at any given time, the percentage of risk in force that will reach its highest claim frequency years on any future date. The combined default rate for both primary and pool insurance, excluding second-lien insurance coverage, was 3.3% at December 31, 2004, compared to 3.2% at December 31, 2003, while the default rate on the primary business was 4.8% at December 31, 2004 compared to 4.7% at December 31, 2003.
In 2004, other operating expenses also included an increase in the reserve for contract underwriting remedies. During 2004, the Company processed requests for remedies on less than 1% of loans underwritten but, as a result of increased underwriting in the previous two years, which significantly increased the Company’s exposure to underwriting errors, a strengthening of the contract underwriting reserve for remedies was necessary. Provisions for contract underwriting remedies were $11.9 million in 2004 and $2.9 million in 2003. Contract underwriting expenses for 2004, including the impact of reserves for remedies for 2004 included in other operating expenses, were $46.8 million, compared to $55.7 million in 2003. Other income, which primarily includes income related to contract underwriting services, was $24.2 million for 2004, compared to $32.0 million in 2003. This decrease in contract underwriting expenses and income in 2004 compared to 2003 reflected a decreased demand for contract underwriting services as a result of lower volumes of new insurance written. During 2004, loans written via contract underwriting accounted for 20.6% of applications, 19.7% of commitments, and 17.9% of certificates issued by Mortgage Insurance, compared to 26.8%, 25.8% and 22.6%, respectively, in 2003. From time to time, the Company sells, on market terms, loans it has purchased under contract underwriting remedies to its affiliate, C-BASS. During 2004, loans sold to C-BASS had an aggregate principal balance of $4.3 million, compared to $12.5 million during 2003.
The effective tax rate for 2004 was 27.7% compared to 27.1% in 2003 and 27.6% in 2002. The difference between the effective tax rate and the statutory rate of 35% reflects the significant investment in tax-advantaged securities.
Primary new insurance written during 2003 was $68.4 billion, a 40.2% increase from $48.8 billion written in 2002. This increase in Mortgage Insurance’s primary new insurance written in 2003 was primarily due to a large increase in insurance written both through flow business and structured transactions. During 2003, Mortgage Insurance wrote $18.9 billion in structured transactions compared to $11.8 billion in 2002. Of the 2003 amount, $11.0 billion was written in the first three months of the year. The amount written in the first quarter of 2003 includes a large structured transaction for one customer composed of prime mortgage loans originated throughout the United States. During 2003, Mortgage Insurance wrote $932.5 million of pool insurance risk compared to $173.6 million in 2002. The majority of this pool risk consisted of prime and Alt-A loans.
Mortgage Insurance’s top 10 lenders were responsible for 42.5% of the direct primary risk in force at December 31, 2003. The top 10 lenders were also responsible for 53.3% of primary new insurance written in 2003. The largest single customer of Mortgage Insurance (including branches and affiliates of such customer), measured by new insurance written, accounted for 10.4% of new insurance written during 2003, compared to 8.1% in 2002. The highest state concentration of risk is California at 14.7%. At December 31, 2003, California also accounted for 14.8% of Mortgage Insurance’s total direct primary insurance in force and 15.2% of Mortgage Insurance direct primary new insurance written for 2003.
Net premiums earned by Mortgage Insurance in 2003 were $759.6 million, a $99.1 million or 15.0% increase from $660.5 million for 2002. This increase reflected a significant increase in non-prime business, which has higher premium rates intended to compensate for the increased level of risk associated with such insurance. Premiums earned in Radian Insurance and Amerin Guaranty, primarily from credit insurance on mortgage-related assets and second mortgages, were $93.1 million in 2003 compared to $46.1 million in 2002 and $40.0 million in 2001. The insurance in force growth resulting from strong new insurance volume in 2003 was offset by a decrease in persistency levels. Direct primary insurance in force increased to $119.9 billion at December 31, 2003 from $110.3 billion at December 31, 2002. Total pool risk in force was $2.4 billion at December 31, 2003 compared to $1.7 billion at December 31, 2002.
The following table provides selected information as of and for the periods indicated for the Mortgage Insurance Segment:
(e) Government Sponsored Enterprises (“GSEs”); i.e., Freddie Mac and Fannie Mae.
In May 2004, Moody’s provided Radian Asset Assurance with an initial insurance financial strength rating of “Aa3.” Concurrently, and in anticipation of the merger of Radian Reinsurance with and into Radian Asset Assurance, Moody’s downgraded the insurance financial strength rating of Radian Reinsurance to “Aa3” from “Aa2.” As a result of this downgrade, two of the primary insurer customers of the financial guaranty reinsurance business had the right to recapture previously written business ceded to Financial Guaranty. One of these customers has agreed, without cost to or concessions by the Company, to waive its recapture rights. On November 8, 2004, the remaining primary insurer customer with recapture rights notified the Company of its intent to recapture, effective February 28, 2005, approximately $6.4 billion of par in force that it had ceded to Financial Guaranty through December 31, 2004, including $50.6 million of written premiums as of December 31, 2004, $3.9 million of which already had been treated as earned under accounting principles generally accepted in the United States of America (“GAAP”) and would be recorded as an immediate reduction of earned premiums at the time of the recapture. This return of unearned premiums would also require an increase in policy acquisition costs of $0.9 million. The aggregate result would be a reduction in pre-tax income of $4.8 million, or approximately $0.03 per share after tax. The amount of future lost premiums due to this recapture is expected to be approximately $129.7 million, which is made up of the unearned premium balance and the value of future installment premiums. The total approximate reduction in pre-tax income for 2005 including the immediate impact is expected to be $12.3 million or approximately $.08 per share after tax. Despite the recapture, the primary insurer customer also informally advised the Company that, going forward, the customer intends to continue its reinsurance relationship with the Company on the same terms as before the May 2004 downgrade. In March 2005, without cost to or concessions by the Company, this customer waived its remaining right to recapture an additional $5.2 billion of par in force that it had ceded to Financial Guaranty through December 31, 2004.
related to certain insurance policies associated with the recapture. The sum of the above adjustments related to this recapture resulted in an immediate reduction of pre-tax income of $15.9 million and is summarized as follows:
The following schedule shows the Financial Guaranty Segment Income Statement as reported (Column 1) and adjustments (Column 2) to reflect the income statement impact of the recapture (referred to in the table as the clawback) of business previously ceded to the Company by one of the primary insurer customers Financial Guaranty that occurred in the first quarter of 2004. The adjusted numbers are shown in Column 3. The impact of the clawback (Column 2) reflects the clawback of business recorded by the Company in prior periods. This clawback affected the first quarter (and, as a result, the year-to-date period) of 2004. Accordingly, management believes that Column 3 provides useful information to investors by presenting a more meaningful basis of comparison for the Financial Guaranty segment’s past and future results.
Included in net premiums earned for 2004, 2003 and 2002 were refundings of $5.1 million, $7.9 million and $7.8 million, respectively. Also included in net premiums earned for 2004, 2003 and 2002 were other credit enhancement fees of $50.3 million, $42.0 million and $19.8 million, respectively, associated with financial guaranty contracts treated as derivatives.
(2) Amounts recorded related to the immediate impact of the recapture of previously ceded business by one of the primary insurer customers of the Financial Guaranty reinsurance business in the first quarter of 2004.
Approximately 37.2% of total gross written premiums for Financial Guaranty (including the impact of the recapture of business previously ceded to the Company by one of the primary insurer customers that occurred in the first quarter of 2004) were derived from two insurers during 2004. This percentage was 25.9% excluding the impact of the recapture. The recapture resulted in a reduction of written premiums of $96.4 million and earned premiums of $24.9 million in the first quarter (and, as a result, the year-to-date-period) of 2004. Five trade credit insurers were responsible for 25.1% of gross premiums written in the financial guaranty segment (including the impact of the recapture of business previously ceded to the Company by one of the primary insurer customers) in 2004. This percentage was 17.5% excluding the impact of the recapture.
Net investment income attributable to Financial Guaranty was $85.6 million for 2004 compared to $78.4 million for 2003. This increase was a result of continued growth in invested assets primarily due to positive operating cash flows and a $65.0 million capital contribution in January 2004. Equity in net income of affiliates attributable to the Financial Guaranty segment for 2004 was $1.4 million compared to $10.0 million in 2003, primarily related to the Company’s investment in Primus. The results of Primus tend to fluctuate because much of their earnings are derived from mark-to-market gains and losses. In September 2004, Primus sold shares of its common stock in a public offering. The Company sold a portion of its shares in Primus in this initial public offering. As a result of the sale of a portion of its shares, the Company recorded a gain of approximately $1.0 million. The sale of its shares reduced the Company’s percentage ownership of Primus to approximately 11%. Also, as a result of the Company’s reduced ownership and influence over Primus resulting from its becoming a public company, the Company transferred its investment in Primus to its equity investment portfolio and began recording change in market value from Primus securities as other comprehensive income rather than recording income or loss as equity in net income of affiliates beginning with the fourth quarter of 2004.
Policy acquisition costs and other operating expenses were $98.7 million for 2004 compared to $96.4 million for 2003. The amount reported in 2004 reflects a $9.8 million reduction in acquisition costs resulting from the recapture. The expense ratio of 45.9% (including the impact of the recapture) for 2004 was up from 38.8% for 2003, due to higher expenses, primarily in personnel costs and outside service costs, to support the current and expected increase in the volumes of business and to gain deeper expertise in the risk management area. The expense ratio was 45.2% for 2004, excluding the impact of the recapture. Included in policy acquisition costs for 2004 were $8.7 million of origination costs related to derivative financial guaranty contracts, compared to $6.6 million for 2003. For 2004 and 2003, interest expense was $12.0 million and $12.9 million, respectively. The amount reported in 2003 included interest on $75.0 million of EFSG’s short-term debt that matured during the first quarter of 2003. The amount reported in 2003 and 2004 includes interest on the parent company’s outstanding indebtedness allocated to the Financial Guaranty segment. Changes in the fair value of derivative instruments increased to $34.9 million for 2004 compared to $0.8 million in 2003. These changes related to mark-to-market gains and losses on derivative instruments that resulted from tighter credit spreads in 2004. The amount reported in 2004 included a $0.8 million loss related to the recapture. During 2004, the Company received $2.9 million as settlement proceeds on derivative financial guaranty contracts and paid $14.6 million as settlements on derivative financial guaranty contracts. The Company received $11.5 million as settlement proceeds on derivative financial guaranty contracts in 2003 and paid $14.0 million as settlements on derivative financial guaranty contracts during 2003.
The effective tax rate was 23.9% for 2004, compared to 17.2% for 2003 and 27.6% for 2002. The low effective tax rate for 2004 reflects the lower level of pre-tax income driven primarily by the recapture, which caused a higher percentage of pre-tax income to be from investment income, much of which is derived from investments in tax-advantaged securities. The lower effective tax rate for 2003 reflects a higher proportion of tax-exempt income to total income resulting from the overall decline in 2003 earnings as a result of the charge for Conseco Finance Corp.
Net income attributable to Financial Guaranty for 2003 was $63.6 million, a $29.5 million or 31.7% decrease from $93.1 million for 2002. In the fourth quarter of 2003, Financial Guaranty added $96.0 million to its loss reserves in anticipation of approximately $111.0 million in claims from a single manufactured housing transaction originated and serviced by Conseco Finance Corp. Net premiums written and earned for 2003 were $368.6 million and $248.6 million, respectively, compared to $286.3 million and $186.6 million, respectively, for 2002. Increases were achieved in earned premiums as a result of continued business growth in all areas of the business, gains on sales of investments and changes in the fair value of derivative instruments, investment income, equity in net income of affiliates and other income, offset by the increase in the provision for losses, policy acquisition costs, other operating expenses and interest expense. Included in net premiums written and earned for 2003 were $54.1 million and $42.0 million, respectively, of credit enhancement fees on derivative financial guaranty contracts, compared to $40.4 million and $19.8 million of net premiums written and earned in 2002.
Net investment income was $78.4 million for 2003 compared to $71.5 million for 2002. Equity in net income of affiliates for 2003 was $10.0 million and primarily includes the results related to the Company’s investment in Primus. The results for Primus in 2002 were immaterial to the Company’s Consolidated Financial Statements. The provision for losses was $166.8 million for 2003 compared to $48.8 million for 2002. The provision for losses represented 67.1% of net premiums earned for 2003 compared to 26.2% for 2002. The 2003 provision for losses includes $111.0 million related to Conseco Finance Corp. Policy acquisition and other
The financial services segment includes the credit-based businesses conducted through the Company’s affiliates, C-BASS and Sherman. The Company owns a 46% interest in C-BASS. Effective January 1, 2003, Sherman’s management exercised its rights to acquire additional ownership of Sherman, reducing the Company’s ownership interest in Sherman from 45.5% to 41.5%. The Company recorded a $1.3 million loss on this transaction. C-BASS is a mortgage investment and servicing firm specializing in credit-sensitive, single-family residential mortgage assets and residential mortgage-backed securities. By using sophisticated analytics, C-BASS essentially seeks to take advantage of what it believes to be the mispricing of credit risk for certain of these assets in the marketplace. Sherman is a consumer asset and servicing firm specializing in charged-off and bankruptcy plan consumer assets and charged-off high loan-to-value mortgage receivables that it purchases at deep discounts from national financial institutions and major retail corporations and subsequently collects upon these receivables. The financial services segment also includes the operations of RadianExpress. In December 2003, the Company announced that it would cease operations at RadianExpress. The Company’s decision followed its receipt in July 2003 of a decision by the California Commissioner of Insurance sustaining a California cease and desist order applicable to the Company’s offering of its Radian Lien Protection product. The California Superior Court’s denial is on appeal, but the decision significantly reduced the potential for increased revenues at RadianExpress, which was the entity through which Radian Lien Protection sales would have been processed. During the first quarter of 2004, RadianExpress ceased processing new orders and is completing the final processing of all remaining transactions. Following the cessation of operations at RadianExpress, the Company’s financial services business consists primarily of its ownership interest in C-BASS and its interest in Sherman.
RadianExpress, currently operating on a run-off basis, had revenues of $2.0 million and expenses of $3.2 million in 2004 compared to $19.8 million and $38.7 million, respectively, in 2003. Included in operating expenses for 2003 was a $13.0 million charge for the cessation of business at RadianExpress, as well as a $2.3 million provision for uncollectible accounts.
Net income attributable to the financial services segment for 2003 was $42.5 million, up from $40.3 million in 2002. Equity in net income of affiliates (pre-tax) was $95.5 million for 2003, up $13.6 million or 16.6% from the $81.9 million (pre-tax) in 2002. C-BASS accounted for $66.1 million (pre-tax) of the total income from affiliates in 2003 compared to $63.5 million (pre-tax) in 2002. During 2003, Sherman accounted for $29.4 million (pre-tax) of the total income from affiliates compared to $18.3 million (pre-tax) in 2002.
The Company, through its ownership of EFSG, owned an indirect 36.0% equity interest in EIC Corporation Ltd. (“Exporters”), an insurance holding company that, through its wholly owned insurance subsidiary licensed in Bermuda, insures primarily foreign trade receivables for multinational companies. In December 2004, the Company sold its interest in Exporters for $4.0 million recording a loss of $1.2 million on the sale. Financial Guaranty provides significant reinsurance capacity to Exporters on a quota-share, surplus-share and excess-of-loss basis. The Company’s related reinsurance exposure at December 31, 2004 was approximately $137.2 million compared to $318.0 million at December 31, 2003. This exposure is expected to run off over approximately seven years. The Company had reserves of $11.9 million and $14.5 million at December 31, 2004 and December 31, 2003, respectively, for this exposure.
The Company has various contractual obligations that are recorded as liabilities in its Consolidated Financial Statements. Other items, including payments under operating lease agreements, are not recorded on the balance sheet as liabilities but represent a contractual commitment to pay.
(1) The Company’s reserve for losses and loss adjustment expenses reflects the application of accounting policies described in “Critical Accounting Policies-Reserve for Losses.” The Company has financial guaranty non-specific reserves of $66.5 million that are not included in the table. The payments due by period are rough estimates and assume that all of the loss reserves included in the table will result in claim payments.
The Company also has certain contractual arrangements that would require the Company to make payments or provide funding if certain circumstances occur (“contingent commitments”). The Company does not currently expect that these contingent commitments will result in any amounts being paid by the Company.
performance, financial condition and general economic conditions. If the decline in fair value is judged to be other-than-temporary, the cost basis of the individual security is written down to fair value through earnings as a realized loss and fair value becomes the new basis. At December 31, 2004 and 2003, there were no investments held in the portfolio that met these criteria. During 2003, the Company recorded $4.3 million (pre-tax) of charges related to declines in fair value considered to be other-than-temporary. There were no such charges in 2004. Realized gains and losses are determined on a specific identification method and are included in income. Other invested assets consist of residential mortgage-backed securities and are carried at fair value.
At December 31, 2004, fixed-maturity investments available for sale had gross unrealized losses of $9.8 million. At December 31, 2004, there were no gross unrealized losses on equity securities available for sale. For these securities in an unrealized loss position at December 31, 2004, the length of time such securities have been in an unrealized loss position, as measured by their month-end fair values was as follows:
Stockholders’ equity increased to $3.7 billion at December 31, 2004 compared to $3.2 billion at December 31, 2003. This increase in stockholders’ equity resulted from net income of $518.7 million, proceeds from the issuance of common stock of $22.9 million and an increase in the market value of securities available for sale of $35.9 million, net of tax, offset by dividends of $7.6 million, and the purchase of 2.8 million shares of the Company’s common stock, net of reissues, for approximately $115.7 million pursuant to the Company’s repurchase plan described below.
On September 24, 2002, the Company announced that its Board of Directors authorized the repurchase of up to 2.5 million shares of its common stock on the open market. Shares were purchased from time to time depending on the market conditions, share price and other factors. These repurchases were funded from available working capital. At March 31, 2004, all 2.5 million shares had been repurchased under this program at a cost of approximately $87.0 million.
On May 11, 2004, the Company announced that its Board of Directors authorized the repurchase of up to 3.0 million shares of its common stock on the open market. On September 8, 2004, the Company announced that its Board of Directors authorized the repurchase of up to 2.0 million additional shares of its common stock on the open market. Shares were repurchased from time to time depending on market conditions, share price and other factors. These purchases were funded from available working capital. At December 31, 2004, 2.2 million shares had been repurchased under this program at a cost of approximately $102.0 million. All remaining shares under the program were purchased subsequent to December 31, 2004, at a cost of approximately $133.8 million.
The Company owns a 41.5% interest in Sherman. In January 2003, Sherman’s management exercised its right to acquire additional ownership of Sherman, reducing the Company’s ownership interest in Sherman from 45.5% to 41.5%. The Company received $3.4 million in cash for the 4% interest, recording a $1.3 million loss on the transaction. The Company guarantees the payment of up to $25.0 million of a revolving credit facility issued to Sherman that expires in December 2005. There have been no drawdowns on this facility. The Company has provided to an affiliate of Sherman, in an arms-length transaction, a $150 million financial guaranty policy in connection with the structured financing of several pools of receivables previously acquired by Sherman. Sherman paid $49.8 million of dividends to an insurance subsidiary of the Company during 2004 and $12.5 million during 2003. An additional $51.9 million dividend was received from Sherman in January 2005.
rate of 2.25% per year and interest is payable semi-annually on January 1 and July 1. The Company may also be required to pay contingent interest, on specified semi-annual dates, if the sale price of its common stock for a specified period of time is less than 60% of the conversion price. The debentures are convertible into shares at a conversion price of $57.75 per share in the following circumstances: (1) if the closing price of the Company’s outstanding common stock exceeds $69.30 per share for twenty out of any thirty consecutive trading days; (2) if the trading price of the debentures is more than a specified amount below the conversion value of the debentures for ten consecutive trading days; (3) at any time before the close of business on the second business day after the date fixed for redemption pursuant to the Company’s exercise of its call right; (4) following the issuance of securities by the Company at a rating below a specified level; (5) following a downgrade of the debentures below a specified level; or (6) following certain major corporate events, such as a change of control. The Company may redeem all or some of the debentures at any time after providing the requisite notice to holders. On January 3, 2005, $663,000 in principal amount of the debentures was redeemed by holders, leaving $219.3 million in principal amount outstanding. The remaining debenture holders may not require the Company to repurchase the debentures until January 1, 2007, and may do so thereafter only on January 1, 2009, 2012 and 2017.
The Company’s insurance subsidiaries have the ability to allocate capital resources within certain guidelines by making direct investments. In April 2003, Radian Guaranty invested $100 million in EFSG, for an approximate 11% ownership interest. This amount was subsequently contributed by EFSG to Radian Asset Assurance to support growth in the direct financial guaranty business. In January 2004, the Company contributed an additional $65 million in capital to EFSG that was subsequently contributed to Radian Asset Assurance. During the first quarter of 2004, EFSG transferred its investment in Sherman in the form of a dividend to Radian Guaranty.
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 the Consolidated Financial Statements, management has made estimates and assumptions 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 the Company’s past history, industry standards and the current economic environment, among other factors, in forming its estimates and judgments, giving due consideration to materiality. Actual results may differ from those estimates. In addition, other companies may utilize different estimates, which may impact comparability of the Company’s 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 the Consolidated Financial Statements is set forth below.
In the mortgage insurance business, reserves for losses generally are not established until the Company is notified that a borrower has missed two payments. The Company also establishes reserves for associated loss adjustment expenses (“LAE”), consisting of the estimated cost of the claims administration process, including legal and other fees and expenses associated with administering the claims process. Statement of Financial Accounting Standards (“SFAS”) No. 60 specifically excludes mortgage guaranty insurance from its guidance relating to the reserve for losses. The Company maintains an extensive database of claim payment history and uses historical models, based on a variety of loan characteristics, including the status of the loan as reported by its servicer and macroeconomic factors such as regional economic conditions that involve significant variability over time, as well as more static factors such as the estimated foreclosure period in the area where the default exists, to help determine the appropriate loss reserve at any point in time. With respect to delinquent loans that are in an early stage of delinquency, considerable judgment is exercised as to the adequacy of reserve levels.
The Company establishes loss reserves on its non-derivative financial guaranty contracts as discussed in Note 2 to the Company’s Consolidated Financial Statements. As discussed below, the reserving policies used by the financial guaranty industry are continuing to evolve and are subject to change.
The Company’s financial guaranty loss reserve policy requires management to make the following key estimates and judgments:
Setting both case reserves and allocated non-specific reserves requires the Company to exercise judgment in estimating the severity of the claim that is likely to result from an identified reserving event, which may be any amount up to the full amount of the insured obligation. The reliability of this estimate depends on the reliability of the information regarding the likely severity of the claim and the judgments made by management with respect to that information. Even when the Company is aware of the occurrence of an event that requires the establishment of a reserve, the Company’s estimate of the severity of the claim that is likely to result from that event may not be correct.
- At December 31, 2004, one credit was included in the Company’s allocated non-specific reserves. The Company has a high degree of certainty that it will suffer losses with respect to this insured obligation equal to the amount reserved, which is the total $9.8 million par amount of the insured obligation.
The Company’s unallocated non-specific reserves are established over time by applying expected default factors to the premiums earned during each reporting period on each credit for which the Company has not established a case reserve or an allocated non-specific reserve. The expected default factor for each credit is derived by dividing the expected losses on that credit over its life by the premiums expected to be earned on that credit over its life. The expected life-time losses for each credit are determined by multiplying the expected frequency of losses on that credit by the expected severity of losses on that credit and multiplying this number, the loss factor, by that credit’s outstanding par amount. The expected frequency and severity of losses for each credit are generated from three sources - two that are published by major rating agencies and one that is generated by a proprietary internal model - based on the product class, published rating and term to maturity for each credit. The Company sets the expected life-time losses for each credit at the approximate
mid-point of the range between the highest and lowest expected life-time loss factors generated by the rating agency and internally generated models. The default rates published by rating agencies tend to be very low because the Company primarily insures investment-grade obligations that, historically, have a very low probability of default. Although the default rate is low, the amount of losses upon default can be very high because the Company tends to insure large financial obligations. Because of the low incidence of losses on financial guaranty obligations, it is also very difficult to estimate the timing of losses on the Company’s insured obligations for which the Company has not yet established a case reserve or allocated non-specific reserve. The default factors for the years ended December 31, 2004, 2003 and 2002 approximated 10% of earned premiums on public finance credits and 20% of earned premiums on structured finance credits.
The Company’s estimates of its reserves for losses and LAE for Financial Guaranty’s other lines of business, primarily trade credit reinsurance, depend upon the receipt of accurate reports and individual loss estimates from ceding companies. The time lag in receiving reports on individual loss estimates in trade credit reinsurance is generally three to six months. The Company uses historical loss information and makes inquiries to the cedants of known events as a means of validating its loss assumptions while awaiting more formal updated reports. Any differences in viewpoints are resolved expeditiously and have historically not resulted in material adjustments. In addition, a reserve is included for losses and LAE incurred but not reported (“IBNR”), on trade credit insurance.
Setting the loss reserves in both business segments involves significant reliance upon estimates with regard to the likelihood, magnitude and timing of a loss. The models and estimates the Company uses to establish loss reserves may not prove to be accurate, especially during an extended economic downturn. There can be no assurance that the Company has correctly estimated the necessary amount of reserves or that the reserves established will be adequate to cover ultimate losses on incurred defaults.
In January and February of 2005, the Company discussed with the SEC staff, both separately and together with other members of the financial guaranty industry, the differences in loss reserve practices followed by different financial guaranty industry participants. The Company understands from those discussions that the Financial Accounting Standards Board (the “FASB”) staff is considering whether additional accounting guidance is necessary to address the financial guaranty industry. When and if the FASB or the SEC reaches a conclusion on this issue, the Company and the rest of the financial guaranty industry may be required to change some aspects of their accounting policies. If the FASB or the SEC were to determine that the Company should account for its financial guaranty contracts differently, for example by requiring them to be treated solely as one or the
The Company accounts for derivatives under SFAS No. 133, as amended and interpreted. The convertible debt securities included in the Company’s investment portfolio and certain of the Company’s financial guaranty contracts are considered “derivatives.” Under SFAS No. 133, the convertible debt and redeemable preferred securities included in the Company’s investment portfolio must be characterized as hybrid securities because they generally combine both debt and equity characteristics. The hybrid classification requires that the convertible security valuation be separated into a fixed-income component and an equity derivative component. Valuation changes on the fixed-income component are recorded as other comprehensive income on the Consolidated Balance Sheets while valuation changes on the equity derivative component are recorded as gains and losses on the Statements of Income. The Company believes that the market valuation of each hybrid convertible security is appropriately allocated to its fixed-income and equity derivative components. The gains and losses on direct derivative financial guaranty contracts are derived from internally generated models. The gains and losses on assumed derivative financial guaranty contracts are provided by the primary insurance companies. Estimated fair value amounts are determined by the Company using market information to the extent available, and appropriate valuation methodologies. Significant differences may exist with respect to the available market information and assumptions used to determine gains and losses on derivative financial guaranty contracts. Considerable judgment is required to interpret market data to develop the estimates of fair value. Accordingly, the estimates are not necessarily indicative of amounts the Company could realize in a current market exchange due to the lack of a liquid market. The use of different market assumptions and/or estimation methodologies may have a significant effect on the estimated fair value amounts.
The Company records premiums and origination costs related to credit default swaps and certain other financial guaranty contracts in premiums written and policy acquisition costs, respectively, on the Consolidated Statements of Income. See Management’s Discussion and Analysis of Financial Condition and Results of Operations-Financial Guaranty-Results of Operations. The Company’s classification of these contracts is the same whether the Company is a direct writer or the Company assumes these contracts.
The Company has entered into a derivative to hedge the interest rate risk related to the issuance of certain long-term debt in accordance with the Company’s risk management policies. As of December 31, 2004, there were two interest rate swaps. The interest rate swaps have been designed as fair value hedges and hedge the change in fair value of the debt arising from interest rate movements. During 2004, the fair value hedge was 100% effective. Therefore, the changes in the derivative instruments in the Consolidated Statements of Income were offset by the change in the fair value of the hedged debt.
Costs associated with the acquisition of mortgage insurance business, consisting of compensation and other policy issuance and underwriting expenses, are initially deferred and reported as deferred policy acquisition costs. Because SFAS No. 60 specifically excludes mortgage guaranty insurance from its guidance relating to the amortization of deferred policy acquisition costs, amortization of these costs for each underwriting year book of business is charged against revenue in proportion to estimated gross profits over the estimated life of the policies using the guidance provided by SFAS No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments.” This includes accruing interest on the unamortized balance of deferred policy acquisition costs. Estimates of expected gross profit including persistency and loss development assumptions for each underwriting year used as a basis for amortization are evaluated regularly, and the total amortization recorded to date is adjusted by a charge or credit to the statement of earnings if actual experience or other evidence suggests that earlier estimates should be revised. Considerable judgment is used in evaluating these factors when updating the assumptions. The use of different assumptions would have a significant effect on the amortization of deferred policy acquisition costs. In 2004, as a result of these evaluations, the Company accelerated the amortization of $11.6 million of deferred policy acquisition costs.
In January 2003, the FASB issued FASB Interpretation (“FIN”) No. 46, “Consolidation of Variable Interest Entities.” FIN 46 clarifies the application of Accounting Research Bulletin No. 51, “Consolidated Financial Statements,” to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. In December 2003, FIN 46 was revised in FIN 46R. FIN 46R scopes out many but not all businesses, as business is defined in FIN 46. The FASB partially delayed FIN 46’s implementation until no later than the end of the first reporting period after March 15, 2004. However, the Company has been a transferor of financial assets to entities that are considered to be qualifying special-purpose entities (“QSPEs”) as described in SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” These QSPEs are not within the scope of FIN 46. In management’s opinion, FIN 46 did not have a material effect on the Company’s financial statements.
In May 2003, the FASB issued SFAS No. 150, “Accounting For Certain Financial Instruments with Characteristics of both Liabilities and Equity.” SFAS No. 150 amends certain paragraphs of FASB Statements No. 128 and No. 133 and is effective for financial instruments entered into or modified after May 31, 2003. SFAS No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires an issuer to classify a financial instrument that is within its scope as a liability (or an asset, in some circumstances). SFAS No. 150 has not had a material impact on the Company’s financial statements. The FASB is addressing certain implementation issues associated with the application of SFAS No. 150. In October 2003, the FASB decided to defer certain provisions of SFAS No. 150 related to mandatory redeemable financial instruments representing noncontrolling interests in subsidiaries included in consolidated financial statements. The Company will monitor the actions of the FASB and assess the impact, if any, that these actions may have on the Company’s financial statements.
The FASB ratified EITF Issue 04-08 “The Effects of Contingently Convertible Instruments on Diluted Earnings per Share,” which requires that contingently convertible debt be included in calculating diluted earnings per share regardless of whether the contingent feature has been met. The Company’s convertible debt outstanding of $220 million is contingently convertible. The effective date is for reporting periods after December 15, 2004. At December 31, 2004, diluted earnings per share included the impact of shares that were subject to issuance upon conversion of the Company’s contingently convertible debt and prior period earnings per share amounts presented for comparative purposes have been restated to comply with the requirements.
Deloitte & Touche LLP, independent registered public accounting firm, was retained to audit the Company’s financial statements. The accompanying report of Deloitte & Touche LLP is based on its audits, which it is required to conduct in accordance with the standards of the Public Company Accounting Oversight Board (United States), and which include the consideration of the Company’s internal control over financial reporting to establish a basis for reliance thereon in determining the nature, timing and extent of audit tests to be applied.
Radian’s management assessed the effectiveness of Radian’s internal control over financial reporting, as of December 31, 2004, using the Internal Control-Integrated Framework established by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, management did not identify any material weaknesses in Radian’s internal control over financial reporting and believes that, as of December 31, 2004, Radian’s internal control over financial reporting is effective in providing reasonable assurance regarding the reliability of Radian’s financial reporting and preparation of financial statements for external purposes in accordance with generally accepted accounting principles.
We have audited management’s assessment, included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting, that Radian Group Inc. and subsidiaries (the “Company”) maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements and financial statement schedules as of and for the year ended December 31, 2004 of the Company and our report dated March 7, 2005 expressed an unqualified opinion on those financial statements and financial statement schedules.
On February 28, 2001, the Company acquired the financial guaranty insurance (“Financial Guaranty”) and other businesses of Enhance Financial Services Group Inc. (“EFSG”), a New York-based insurance holding company that primarily insures and reinsures credit-based risks, at a purchase price of approximately $581.5 million. In addition, as part of the acquisition, the Company has an interest in two active credit-based asset businesses (see Note 4). Several smaller businesses are either in run-off or have been terminated. The purchase price represented the value of the Company’s common stock and stock options issued in connection with the acquisition and other consideration in accordance with an Agreement and Plan of Merger, dated November 13, 2000, by and among the Company, a wholly owned subsidiary of the Company and EFSG. The acquisition, which was structured as a merger of a wholly owned subsidiary of the Company with and into EFSG, entitled EFSG stockholders to receive 0.22 shares of the Company’s common stock in a tax-free exchange for each share of EFSG’s common stock that they owned at the time of the merger. The acquisition was treated as a purchase for accounting purposes, and accordingly, the assets and liabilities were recorded based on their fair values at the date of acquisition. The fair value of assets acquired was $1,357.9 million. The liabilities assumed were $833.1 million. The excess of purchase price over fair value of net assets acquired of $56.7 million represents the future value of insurance profits, which is being amortized over a period that approximates the future life of the insurance book of business. During 2004 and 2003, the Company amortized $12.5 million and $3.7 million, respectively, related to this transaction. The 2004 amount includes $10.0 million related to the recapture of previously ceded business that occurred in the first quarter of 2004.
In September 2004, Primus Guaranty, Ltd. (“Primus”), a Bermuda holding company and parent to Primus Financial Products, LLC, issued common stock in an initial public offering of its common shares. The Company, which owned an approximate 15% interest in Primus prior to the offering, sold 177,556 shares of its Primus common stock in this offering, receiving approximately $2.2 million and recording a gain of $1.0 million. After this transaction, the Company now owns 4,744,506 shares of Primus or approximately 11% of the common shares outstanding. These shares had a market value of $64.1 million at September 30, 2004. The Company’s investment in Primus, which had previously been included in investment in affiliates on the Consolidated Balance Sheets, has now been reclassified to the equity securities available for sale category of investments. In the future, the Company will no longer report earnings or loss from Primus as equity in earnings of affiliates. All changes in the fair value of the Primus stock will be recorded as accumulated other comprehensive income. The Company believes this treatment and presentation is appropriate because after the public offering the Company no longer has influence or control over Primus disproportionate to its percentage of equity ownership.
The accompanying financial statements include the accounts of all subsidiaries. Companies in which the Company, or one of its subsidiaries, owns interests ranging from 20% to 50%, or over which the Company has significant influence, are accounted for in accordance with the equity method of accounting (see Note 4). All intercompany accounts and transactions, and intercompany profits and losses, have been eliminated.
In January 2003, the Financial Accounting Standards Board (“FASB”) issued FIN No. 46, “Consolidation of Variable Interest Entities.” FIN 46 clarifies the application of Accounting Research Bulletin No. 51, “Consolidated Financial Statements,” to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. In December 2003, FIN 46 was revised in FIN 46R. FIN 46R scopes out many but not all businesses, as business is defined in FIN 46. The FASB partially delayed FIN 46’s implementation until no later than the end of the first reporting period after March 15, 2004. However, the Company has been a transferor of financial assets (as discussed below in “Other Operations”) considered to be qualifying special-purpose entities (“QSPEs”) described in SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” These QSPEs are not within the scope of FIN 46. In management’s opinion, FIN 46 did not have a material effect on the Company’s financial statements.
The consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”).
Statement of Financial Accounting Standards (“SFAS”) No. 60, “Accounting and Reporting by Insurance Enterprises,” specifically excludes mortgage insurance from its guidance relating to the earning of insurance premiums. Consistent with GAAP and industry accounting practices, mortgage insurance premiums written on an annual and multi-year basis are initially deferred as unearned premiums and earned over the policy term, and premiums written on a monthly basis are earned over the period that coverage is provided. Annual premiums are amortized on a monthly, straight-line basis. Multi-year premiums are amortized over the terms of the contracts in accordance with the anticipated claim payment pattern based on historical industry experience. Ceded premiums written are initially set up as prepaid reinsurance and are amortized in accordance with direct premiums earned.
In the financial guaranty business, insurance premiums are earned in proportion to the level of amortization of insured principal over the contract period or over the period that coverage is provided. Unearned premiums represent that portion of premiums that will be earned over the remainder of the contract period, based on information reported by ceding companies and management’s estimates of amortization of insured principal on policies written on a direct basis. When insured issues are refunded or called, the remaining premiums are generally earned at that time because the risk to the Company is eliminated. Credit enhancement fees on derivative financial guaranty contracts are included in premiums written and are earned over the period that credit protection is provided.
With the exception of the Company’s trade credit product, net premiums written in the Company’s financial guaranty reinsurance business are recorded using actual information received from cedants on a one-month lag. Accordingly, the written premiums for any given period exclude those from the last month of that period and include those from the last month of the immediately preceding period. The use of information from cedants does not require the Company to make significant judgments or assumptions because historic collection rate and counterparty strength makes collection of all assumed premiums highly likely. Net premiums written for the years ended December 31, 2004, 2003 and 2002 includes $59.3 million, $64.8 million and $48.4 million, respectively, of assumed premiums related to the Company’s trade credit reinsurance products. Included in these amounts are estimates based on quarterly projections provided by ceding companies. Over the life of the reinsured business, these projections are replaced with actual results and, historically, the difference between the projections and actual results has not been material. Accordingly, the Company does not record any related provision for doubtful accounts.
The following description of the Company’s financial guaranty loss reserving policy relates only to non-derivative financial guaranty contracts provided through financial guarantees of direct and assumed insurance business. The Company’s financial guaranty insurance contracts provide an unconditional and irrevocable guaranty to the holder of a financial obligation that, upon payment default by the insured party, the Company will pay the full amount of principal and interest on an insured obligation when due. The Company’s financial guaranty reinsurance contracts provide for reimbursement to the primary insurer under a reinsured financial guaranty contract when the primary insurer is obligated to pay principal and interest on an insured obligation.
The Company discounts financial guaranty case reserves arising from defaults that involve claim payments over an extended period of time. The discount rate corresponds to the Company’s individual statutory company investment yield of 4.14% in 2004, compared to a 4.05% and 4.75% in 2003 and 4.10% and 5.25% in 2002 (different rates were used for Radian Reinsurance and Radian Asset Assurance prior to their merger in 2004). Discounted liabilities at December 31, 2004 were $5.8 million, net of discounts of $0.2 million, compared to discounted liabilities of $17.5 million, net of discounts of $3.2 million at December 31, 2003 and discounted liabilities of $18.5 million, net of discounts of $7.3 million at December 31, 2002. The Company does not discount its non-specific reserves. The Company does not discount or include installment payments in its estimate of salvage or subrogation rights because their effects are not material.
As an insurance enterprise, the Company relies principally on SFAS No. 60, “Accounting and Reporting by Insurance Enterprises,” in establishing loss reserves with respect to its financial guaranty business. With respect to its case reserves, the Company follows the guidance of SFAS No. 60 regarding the establishment of reserves upon the occurrence of an insured event. Although SFAS No. 60 provides guidance to insurance enterprises, it was adopted before the financial guaranty industry came into prominent existence and it does not comprehensively address the unique attributes of financial guaranty insurance. For example, SFAS No. 60 prescribes differing reserving treatment depending on whether a contract fits within SFAS No. 60’s definition of a short-duration contract or a long-duration contract. Financial guaranty contracts have elements of long-duration insurance contracts in that they are irrevocable and extend over a period that may extend 30 years or more but are reported for regulatory purposes as property and liability insurance, normally considered short-duration contracts. Because of these ambiguities in the application of SFAS No. 60 to the Company’s loss reserving policy, the Company does not believe that SFAS No. 60 alone provides sufficient guidance for the Company’s reserving policy, particularly with respect to the establishment of non-specific reserves before an insured event occurs. As a result, the Company and, to the Company’s knowledge, other members of the financial guaranty industry, supplement the principles of SFAS No. 60 with those of SFAS No. 5, “Accounting for Contingencies,” which calls for the establishment of reserves when it is probable that a liability has been incurred at the date of the financial statements and the amount of loss can be reasonably estimated. The Company also relies by analogy on SFAS No. 114, “Accounting by Creditors for Impairment of a Loan” and EITF Issue No. 85-20, “Recognition of Fees for Guaranteeing a Loan,” which state that a guarantor should perform an ongoing assessment of the probability of loss to determine if a liability (and a loss) should be recognized under SFAS No. 5. The establishment of non-specific reserves for credits that have not yet defaulted is a practice followed by the entire financial guaranty industry, although the Company acknowledges that there may be differences in the specific methodologies used by other financial guarantors in establishing these reserves. The Company believes that its financial guaranty loss reserve policy is appropriate under the applicable accounting literature, and that it best reflects the fact that credit-based insurance involves a gradual deterioration of credit over time. However, because of the lack of specific accounting literature comprehensively addressing the unique attributes of financial guaranty contracts, the accounting principles applicable to the Company’s loss reserving policy are subject to change.
The following table shows the Company’s case and non-specific reserves for losses and loss adjustment expenses for its financial guaranty business, and case reserves and IBNR related to the non-financial guaranty businesses included in the Company’s financial guaranty segment as of the indicated dates (in thousands):
Other restructurings in the financial guaranty business segment may consist of purchasing the insured debt security to mitigate losses. Insured debt securities purchased to mitigate losses are included in other assets on the Consolidated Balance Sheets at the lower of cost or net realizable value. Gains or losses from the holding or disposition of the securities acquired are recorded as net gains and losses on the sale of investments. At December 31, 2004 and 2003, the Company held $6.5 million and $11.2 million, respectively, of insured debt securities purchased to mitigate losses.
revised. Considerable judgment is used in evaluating these factors when updating the assumptions. The use of different assumptions would have a significant effect on the amortization of deferred policy acquisition costs. In 2004, as a result of these evaluations, the Company accelerated the amortization of $11.6 million of policy acquisition costs.
The Company, as a mortgage guaranty and financial guaranty insurance writer, is eligible for a tax deduction, subject to certain limitations, under Section 832(e) of the Internal Revenue Code for amounts required by State law or regulation to be set aside in statutory contingency reserves. The deduction is allowed only to the extent that the Company purchases non-interest-bearing U.S. Mortgage Guaranty Tax and Loss Bonds (“T&L bonds”) issued by the Treasury Department in an amount equal to “the tax benefit derived” from deducting any portion of the Company’s statutory contingency reserves.
The Company is required to group assets in its investment portfolio into one of three categories: held to maturity, available for sale or trading securities. Fixed-maturity securities for which the Company has the positive intent and ability to hold to maturity are classified as held to maturity and reported at amortized cost. Investments classified as available for sale are reported at fair value, with unrealized gains and losses (net of tax) reported as a separate component of stockholders’ equity as accumulated other comprehensive income. Investments classified as trading securities are reported at fair value, with unrealized gains and losses (net of tax) reported as a separate component of income. For securities classified as either available for sale or held to maturity, the Company conducts a quarterly evaluation of declines in market value of the investment portfolio asset basis to determine whether the decline is other-than-temporary. This evaluation includes a review of (1) the length of time and extent to which fair value is below amortized cost; (2) issuer financial condition; and (3) intent and ability of the Company to retain its investment over a period of time to allow recovery in fair value. The Company uses a 20% decline in price over four continuous quarters as a guide in identifying those securities that should be evaluated for impairment. For securities that have experienced rapid price declines or unrealized losses of less than 20% over periods in excess of four consecutive quarters, classification as other-than-temporary is considered. Factors influencing this consideration include an analysis of the security issuer’s financial performance, financial condition and general economic conditions. If the decline in fair value is judged to be other-than-temporary, the cost basis of the individual security is written down to fair value through earnings as a
realized loss and the fair value becomes the new basis. At December 31, 2004 and 2003, there were no investments held in the portfolio that met these criteria. Realized gains and losses are determined on a specific identification method and are included in income. Other invested assets consist of residential mortgage-backed securities and are carried at fair value.
In March 2004, the FASB Emerging Issues Task Force (“EITF”) reached a consensus regarding EITF 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments”. The consensus provides guidance for evaluating whether an investment is other-than-temporarily impaired and was effective for other-than-temporary impairment evaluations made in reporting periods beginning after June 15, 2004.
SFAS No. 133 requires that the Company split the convertible fixed-maturity securities in its investment portfolio into the derivative and fixed-maturity security components. Over the term of the securities, changes in the fair value of fixed-maturity securities available for sale are recorded in the Company’s Consolidated Statement of Changes in Common Stockholders’ Equity through accumulated other comprehensive income or loss. Concurrently, a deferred tax liability or benefit is recognized as the recorded value of the fixed-maturity security increases or decreases. A change in the fair value of the derivative is recorded as a gain or loss in the Company’s Consolidated Statements of Income.
This interest rate swap contracts mature in February 2013. Terms of the interest rate swap contracts at December 31, 2004 were as follows (dollars in thousands):
In October 2004, the Company entered into transactions to lock in treasury rates that would have served as a hedge in the event the Company issued long-term debt. The notional value of the hedges is $120 million at a blended rate of 4.075%. At December 31, 2004, the Company had a $1.5 million unrealized gain recorded on the hedges.
In January 2005, the Company discontinued the hedge arrangements and received payments from its counterparties. The Company realized a gain of $1.0 million at termination in 2005.
The Company is the beneficiary of insurance policies on the lives of certain officers and employees of the Company. The Company has recognized the amount that could be realized under the insurance policies as an asset in its Consolidated Balance Sheets. At December 31, 2004 and 2003, the amount of Company-owned life insurance totaled $57.4 million and $55.5 million, respectively, and is included as a component of other assets.
In December 2004, the FASB issued Statement 123 (revised 2004) (“SFAS No. 123R”) that will require compensation costs related to share-based payment transactions to be recognized in the financial statements. The compensation costs, with limited exceptions, will be measured based on the grant-date fair value of the equity or liability instrument issued. Liability awards will be required to be re-measured each reporting period. Compensation cost will be recognized over the period that an employee provides service in exchange for the award. SFAS No. 123R replaces SFAS No. 123 and supersedes APB 25. This statement is effective for interim periods beginning after June 15, 2005 and applies to all awards granted after the effective date and requires the reporting of the cumulative effect of applying this statement as of this date. Management is in the process of reviewing this Statement and assessing the impact it will have on the Company’s financial statements.
The weighted average fair values of the stock options granted during 2004, 2003 and 2002 were $18.19, $14.26 and $21.50, respectively. The fair value of each stock option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions used for grants:
The Company is required to disclose both “basic” net income per share and “diluted” net income per share. Basic net income per share is based on the weighted average number of common shares outstanding, while diluted net income per share is based on the weighted average number of common shares outstanding and common share equivalents that would arise from the exercise of stock options. Preferred stock dividends are deducted from net income in the net income per share computation. Diluted shares assume the conversion of the Company’s senior convertible debentures.
The Company has three reportable segments: mortgage insurance, financial guaranty insurance and financial services. The mortgage insurance segment provides mortgage credit protection primarily via private mortgage insurance and risk management services to mortgage lending institutions located throughout the United States and globally. Private mortgage insurance primarily protects lenders from all or part of default-related losses on residential first-mortgage loans made primarily to homebuyers who make down payments of less than 20% of the home’s purchase price. Private mortgage insurance also facilitates the sale of these mortgages in the secondary market. The financial guaranty segment provides credit-related insurance coverage, credit default swaps and certain other financial guaranty contracts to meet the needs of customers in a wide variety of domestic and international markets. The Company’s insurance businesses within the financial guaranty insurance segment includes the assumption of reinsurance from monoline financial guaranty insurers for both public finance bonds and structured finance obligations, the provision of direct financial guaranty insurance for public finance bonds and structured transactions, and trade credit reinsurance. The financial services segment consists of the Company’s equity interest in two companies that deal primarily with credit-based servicing and securitization of assets in underserved markets, in particular, the purchase, servicing and securitization of special assets, including sub-performing/non-performing mortgages and delinquent consumer assets. In addition, the financial services segment includes the results of RadianExpress, an Internet-based settlement company that provided real estate information products and services to the first- and second-lien mortgage industry. During the first quarter of 2004, RadianExpress ceased processing new orders and is completing the final processing of the remaining transactions. The Company’s reportable segments are strategic business units that are managed separately because each business requires different marketing and sales expertise. Certain corporate income and expenses have been allocated to the segments. For each of the years ended December 31, 2004, 2003 and 2002, the Company’s revenue attributable to foreign countries was approximately 6%. In addition, long-lived assets located in foreign countries were immaterial for the periods presented.
Also in connection with the recapture, Financial Guaranty was reimbursed for policy acquisition costs of approximately $31.0 million for which the carrying value under GAAP was $21.3 million. In addition, the recapture included approximately $11.5 million that had been recorded as case reserves under GAAP. Finally, Financial Guaranty took a charge of $0.8 million for mark-to-market adjustments related to certain insurance policies associated with the recapture.
The Company is seeking to sell or otherwise dispose of the remaining assets and operations of Singer Asset Finance Company, L.L.C. (“Singer”), an entity acquired in connection with the purchase of Financial Guaranty. The Company has sold portions of the business to the extent possible. The remainder is in run-off. During this process, any net servicing expenses will be charged against an existing servicing liability and any gains or losses on assets will be charged against an existing asset reserve. If and when these reserves become depleted, future results will be recorded in current operations.
Company’s operations. In August 2002, the Company sold substantially all of the assets of a related subsidiary, Enhance Consumer Services LLC (“ECS”), which had been engaged in the purchase, servicing and securitization of viatical settlements, to an independent third-party for an aggregate purchase price of $8.4 million, which approximated the carrying value.
The FASB ratified EITF Issue 04-08, “The Effects of Contingently Convertible Instruments on Diluted Earnings per Share,” which requires that contingently convertible debt be included in calculating diluted earnings per share regardless of whether the contingent feature has been met. The effective date is for reporting periods after December 15, 2004 and prior period earnings per share amounts presented for comparative purposes must be restated. The Company’s convertible debt outstanding of $220 million is contingently convertible. The Company’s diluted earnings per share has been reduced by the application of this EITF by $0.18, $0.13 and $0.14 for the years ended December 31, 2004, 2003 and 2002, respectively.
Fixed-maturity and equity investments at December 31, 2004 and 2003 consisted of (in thousands):
The contractual maturity of securities in an unrealized loss position at December 31, 2004 was as follows:
Securities on deposit with various state insurance commissioners amounted to $15.9 million at December 31, 2004 and $18.5 million at December 31, 2003. The Company also had $52.2 million on deposit at December 31, 2004 and $58.6 million at December 31, 2003 for the benefit of reinsurers.
The Company owned a 36.0% interest in EIC Corporation Ltd. (“Exporters”), an insurance holding company that, through its wholly owned insurance subsidiary licensed in Bermuda, insures primarily foreign trade receivables for multinational companies. Prior to 2003, this ownership percentage was 36.5%. In December 2004, the Company sold its interest in Exporters for $4.0 million, recording a loss of $1.2 million on the sale. Financial Guaranty provides significant reinsurance capacity to this joint venture on a quota-share, surplus-share and excess-of-loss basis. The Company’s reinsurance exposure at December 31, 2004 was approximately $137.2 million and is expected to run off over a seven-year period. At December 31, 2003, Exporters had total assets of $168.3 million and total liabilities $109.7 million. Exporters had net income of $1.5 million for the first nine months of 2004 and $1.5 million for the full year of 2003 and a loss of $1.9 million for the full year of 2002.
The Company utilizes reinsurance as a risk management tool, to reduce net risk in force to meet regulatory risk-to-capital requirements and, with respect to mortgage insurance, to comply with the regulatory maximum per loan coverage percentage limitation of 25%. Although the use of reinsurance does not discharge an insurer from its primary liability to the insured, the reinsuring company assumes the related liability. Included in other assets are unearned premiums (prepaid reinsurance) of $3.6 million and $6.8 million at December 31, 2004 and 2003, respectively.
The 2004, 2003 and 2002 amounts in the preceding table included ($2,815,000), ($1,327,000) and ($15,000) respectively, for premiums written and ($2,722,000), ($1,181,000) and $173,000, respectively, for premiums earned, for reinsurance ceded under variable quota-share treaties entered into in 1997, 1996, 1995 and 1994 covering the books of business originated by Radian Guaranty in those years. Commissions under these treaties were $358,000, $1,251,000 and $3,840,000 for the years ended December 31, 2004, 2003 and 2002, respectively. The Company recovered variable quota-share losses under these treaties of $165,000, $528,000 and $1,809,000 in 2004, 2003 and 2002, respectively. Due to the rapid run-off of the underlying business as a result of lower persistency levels, the Company has recovered amounts under the variable quota share relief provisions of the treaty in excess of the underwriting-year coverage premiums during 2004, 2003 and 2002, as reflected in the negative ceded premiums written and earned during those years.
Provisional losses recoverable were $38.3 million for 2004 and $48.6 million for 2003, and represented amounts due under variable quota-share treaties entered into in 1997, 1996, 1995 and 1994, covering the books of business originated by Radian Guaranty in those years. The term of each treaty is 10 years and is non-cancelable by either party except under certain conditions. Under the terms of treaties, Radian Guaranty cedes premiums to the reinsurer based on 15% of the premium received on the covered business. Radian Guaranty is entitled to receive a commission ranging from 30% to 32% of the premium paid under the treaty provided that certain loss rates are not exceeded. In return for the payment of the ceded premium, Radian Guaranty receives variable quota-share loss relief at levels ranging from 7.5% to 15.0% based upon the loss ratio on the covered business. The treaties also include underwriting-year excess coverage that entitles Radian Guaranty to receive 8% of the premium written on the covered business under each treaty at the end of the fourth, seventh and tenth years to the extent that this amount is greater than the total amount previously received under the variable quota-share coverage provision of the treaty. Premiums are payable to the reinsurer on a quarterly basis net of commissions due and any losses calculated under the variable quota-share coverage.
At December 31, 2003, the breakdown of the $48.6 million reinsurance recoverable was as follows (in thousands):
The Company believes that the reinsurance recoverable is collectible because the counterparty to the reinsurance agreement is a highly rated, solvent insurance company. During 2004, the Company received reimbursement from the reinsurer for the amount due related to quota-share losses recoverable. In addition, the reinsurer reimbursed the Company for underwriting-year excess of loss coverage due under the tenth year of the 1994 treaty and the seventh year of the 1997 treaty. The remaining amounts due under the underwriting-year excess coverage provision of the treaties will be paid out at the end of 2005 and 2006, to the extent the amounts due under this provision have not yet been received by the Company under the quota-share relief provision of the treaties.
Radian Guaranty has also entered into captive reinsurance arrangements with certain customers. The arrangements are typically structured on an excess-layer basis with insured loans grouped by loan origination year. Radian Guaranty retains the first layer of risk on a particular book of business, the captive reinsurer assumes the next layer, and Radian Guaranty assumes all losses above that point. The captive reinsurers are typically required to maintain minimum capitalization equal to 10% of the risk assumed. Risk ceded under captive reinsurance arrangements at December 31, 2004 and December 31, 2003, was $1.8 billion and $1.5 million, respectively. For the years ended December 31, 2004, 2003 and 2002, Radian Guaranty had ceded premiums written of $88.4 million, $73.4 million and $57.1 million, respectively, and ceded premiums earned of $86.6 million, $72.8 million and $56.6 million, respectively, under these various captive reinsurance arrangements.
On August 3, 2004, the Company entered into a reinsurance agreement under which it ceded a significant portion of the risk associated with an $882 million portfolio of first-lien, non-prime residential mortgage loans insured by the Company. The Company’s counterparty under the reinsurance agreement is SMART HOME Reinsurance 2004-1 Limited (“Smart Home”), a Bermuda reinsurance company that is not affiliated with the Company, which was formed solely to enter into the reinsurance arrangement. Smart Home was funded in the capital markets by its issuance of credit-linked notes rated between AA and BB by S&P, and between Aa2 and Ba1 by Moody’s, that were issued in separate classes related to loss coverage levels on the reinsured portfolio. The Company anticipates retaining the risk associated with the first loss coverage levels, and may retain or sell, in a separate risk transfer agreement, the risk associated with the AAA-rated coverage level.
Premiums written (ceded) in 2004 includes $1.0 million related to the Smart Home transaction. There were no ceded losses in 2004 as a result of the Smart Home transaction.
As described in Note 2, the Company establishes reserves to provide for the estimated losses from claims and the estimated costs of settling claims on defaults (or delinquencies) reported and defaults that have occurred but have not been reported.
In the financial guaranty business, each policy is monitored by the Company or the primary insurers over the life of the policy. When the policy’s performance deteriorates below underwriting expectations, or if the circumstances dictate, the related transaction is more actively monitored, which may include communication
with the borrower, site inspection or the engagement of a third-party consultant. If the transaction continues to deteriorate to a point where a default is reasonably probable, based on all the facts and circumstances then known and estimable, the Company will establish a specific loss reserve that represents the present value of the amount of the claim Financial Guaranty expects that it will ultimately have to pay. Financial Guaranty has a regular surveillance committee meeting where experts in the risk management and surveillance area provide input before any case reserves are determined, and the surveillance team actively monitors any problem deals and notifies the committee if a change in the loss reserve is necessary. Financial Guaranty establishes a reserve based on the present value of the estimated loss, including expenses associated with the settlement of the loss that Financial Guaranty expects that it will ultimately have to pay.
In May 2001, the Company issued $250 million of 7.75% debentures due June 1, 2011. Interest on the debentures is payable semi-annually on June 1 and December 1. The Company has the option to redeem some or all of the debentures at any time with not less than 30 days’ notice.
In January 2002, the Company issued $220 million of 2.25% senior convertible debentures due 2022. Approximately $125 million of the proceeds from the offering were used to increase capital at Radian Asset Assurance. The remainder was used to redeem the Company’s preferred stock, to buy back the Company’s common stock and for general corporate purposes. Interest on the debentures is payable semi-annually on January 1 and July 1. The Company may also be required to pay contingent interest, on specified semi-annual dates, if the sale price of its common stock for a specified period of time is less than 60% of the conversion price. The debentures are convertible into shares at a conversion price of $57.75 per share in the following circumstances: (1) if the closing price of the Company’s outstanding common stock exceeds $69.30 per share for twenty out of any thirty consecutive trading days; (2) if the trading price of the debentures is more than a specified amount below the conversion value of the debentures for ten consecutive trading days; (3) at any time before the close of business on the second business day after the date fixed for redemption pursuant to the
The composition of long-term debt at December 31, 2004 and 2003 was as follows:
The Company maintained a $250 million Revolving Credit Facility that expired in December 2004. There were no drawdowns on this facility. The Company replaced this with a $400 million unsecured facility, comprised of a $100 million 364-day facility that expires on December 15, 2005, and a $300 million five-year facility that expires on December 16, 2009. The facility bears interest on any amounts drawn at a rate dependent on the Company’s credit rating at the time of such borrowing and will be calculated according to, at the Company’s option, a base rate or a Eurocurrency rate, plus an applicable margin and utilization fee. This facility will be used for working capital and general corporate purposes. There have been no drawdowns on this facility as of December 31, 2004.
The components of the Company’s consolidated provision for income taxes are as follows (in thousands):
Amerin Guaranty’s ability to pay dividends on its common stock is restricted by certain provisions of the insurance laws of the State of Illinois, its state of domicile. The insurance laws of Illinois establish a test limiting the maximum amount of dividends that may be paid from positive unassigned surplus by an insurer without prior approval by the Illinois Insurance Commissioner. Under this test, Amerin Guaranty may pay dividends during any 12-month period in an amount equal to the greater of (i) 10% of the preceding year-end statutory policyholders’ surplus or (ii) the preceding year’s statutory net income. In accordance with these restrictions, $19.0 million is available for dividends in 2005 without prior regulatory approval. During December 2004, Amerin Guaranty declared dividends of $100 million, which was paid in January 2005.
Under New York insurance law, the financial guaranty insurance subsidiaries may declare or distribute dividends only out of earned surplus. The maximum amount of dividends that may be paid by these insurance subsidiaries without prior approval of the New York Superintendent of Insurance is subject to restrictions relating to statutory surplus and net investment income as defined by statute. Under these requirements, Radian Asset Assurance would be able to pay dividends of approximately $100.4 million in 2005 without prior approval.
The Company has one stock option plan, the Radian Group Inc. Equity Compensation Plan, which provides for the grant of non-qualified stock options, either alone or together with stock appreciation rights, as well as other forms of equity-based compensation. These options may be granted to directors, officers and key employees of the Company at a price not less than 100% of the fair market value of the Company’s stock at the date of grant. Each stock option is exercisable for a period of 10 years from the date of grant and is subject to a vesting schedule as approved by the Company’s Compensation and Human Resources Committee.
Information with regard to the Company’s stock option plan is as follows:
The following table summarizes information concerning currently outstanding and exercisable options at December 31, 2004:
The Company’s option plan used to include a “reload” feature. The award of a “reload” option allowed the optionee to receive the grant of an additional stock option, at the then current market price, in the event that such optionee exercised all or part of an option (the “original option”) by surrendering already owned shares of common stock in full or partial payment of the exercise price of such original option. The exercise of an additional option issued in accordance with the “reload” feature will reduce the total number of shares eligible for award under the stock option plan. While there are outstanding options with this “reload” feature, new options issued will not have this feature.
The Company has an Employee Stock Purchase Plan (the “ESPP”). A total of 200,000 shares of the Company’s authorized non-issued common stock has been made available under the ESPP. The ESPP allows eligible employees to purchase shares of the Company’s stock at a discount of 15% of the beginning-of-period or end-of-period (each period being the first and second six calendar months) fair market value of the stock, whichever is lower. Eligibility under the ESPP is determined based on standard weekly work hours and tenure with the Company, and eligible employees are limited to a maximum contribution of $400 per payroll period toward the purchase of the Company’s stock. Under the ESPP, the Company sold 18,793, 17,899 and 10,101 shares to employees in 2004, 2003 and 2002, respectively. The Company applies APB 25 in accounting for the ESPP. The pro forma effect of the issuance of shares under the ESPP on the Company’s net income and earnings per share had compensation cost been determined under SFAS 123 was immaterial in 2004, 2003 and 2002.
In addition to providing pension benefits, the Company provides certain healthcare and life insurance benefits to retired employees of the Company, Radian Guaranty and EFSG and its subsidiaries, who were hired
The accumulated benefit obligation at December 31, 2004 and 2003 for the Radian Pension Plan/SERP was $21.1 million and $16.5 million, respectively.
Weighted average assumptions used to determine net pension and net periodic postretirement benefit obligation at December 31, 2004 and 2003 were as follows:
The following benefit payments, which reflect expected future service, as appropriate, are expected to be paid according to the following schedule (in thousands):
The Company expects to contribute $2.8 million to its pension plan and $20 thousand to its other postretirement benefit plans in 2005. The Company expects to contribute $40 thousand to EFSG’s other post retirement benefit plan in 2005.
At December 31, 2004 and 2003, the accumulated postretirement benefit obligation under the EFSG Postretirement Medical Plan was $0.4 million and $1.0 million, respectively, and was not funded. At December 31, 2004, the discount rate used in determining the accumulated postretirement benefit obligation was 5.75% and the healthcare trend was 8.5% graded to 5.5% after 6 years.
In addition to the Pension Plan, the SERP and the Postretirement Welfare Plan, the Company also maintains a Savings Incentive Plan, which covers substantially all full-time and all part-time employees of the Company, Radian Guaranty, RadianExpress and, effective January 1, 2003, EFSG and its subsidiaries, employed for a minimum of 90 consecutive days. Participants can contribute up to 25% of their base earnings as pretax contributions. The Company will match at least 25% of the first 6% of base earnings contributed in any given year. These matching funds are subject to certain vesting requirements. The expense to the Company for matching funds for the years ended December 31, 2004, 2003 and 2002 was $2.8 million, $2.7 million and $1.4 million, respectively.
Until its termination on December 31, 2002, Financial Guaranty had a savings incentive plan. Under this plan, employees of EFSG and its subsidiaries could contribute up to 15% of their base earnings as pretax contributions. EFSG would match 50% of the first 6% of base salary made to the plan by eligible employees. The expense to EFSG in 2002 was $176,000. Effective January 1, 2003, EFSG’s savings incentive plan participants became part of the Company’s Savings Incentive Plan.
The U.S. Department of Housing and Urban Development (“HUD”) proposed a rule under the Real Estate Settlement Procedures Act (“RESPA”) to create an exemption from Section 8(a) of RESPA. The proposed rule would have made the exemption available to lenders that, at the time a borrower submits a loan application, give the borrower a firm, guaranteed price for all the settlement services associated with the loan, commonly referred to as “bundling.” In 2003, HUD withdrew the proposed rule and submitted another proposed rule to the Office of Management and Budget, which also subsequently was withdrawn. If bundling is exempted from RESPA, mortgage lenders may have increased leverage over the Company and the premiums the Company is able to charge for mortgage insurance could be negatively affected.
(3) Includes $96 million related to a single manufactured housing transaction.
Fixed-Maturity and Equity Securities-The fair values of fixed-maturity securities and equity securities are based on quoted market prices or dealer quotes. For investments that are not publicly traded, management has made estimates of fair value that consider each issuer’s financial results, conditions and prospects, and the values of comparable public companies.
Other Invested Assets-The fair value of other invested assets (residential mortgage-backed securities) is based on the present value of the estimated net future cash flows, including annual distributions and net cash proceeds from the exercise of call rights, using relevant market information.
On November 8, 2004, the remaining primary insurer customer with recapture rights notified the Company of its intent to recapture, effective February 28, 2005, approximately $6.4 billion of par in force that it had ceded to Financial Guaranty through December 31, 2004, including $50.6 million of written premiums as of December 31, 2004, $3.9 million of which already had been treated as earned under GAAP and would be recorded as an immediate reduction of earned premiums at the time of the recapture. This return of unearned premiums would also require an increase in policy acquisition costs of $0.9 million. The aggregate result would be a reduction in pre-tax income of $4.8 million, or approximately $0.03 per share after tax. The amount of future lost premiums due to this recapture will be approximately $129.7 million, which is made up of the unearned premium balance and the value of future installment premiums. The total approximate reduction in pre-tax income for 2005 including the immediate impact is expected to be $12.3 million or approximately $.08 per share after tax.