In connection with our mortgage insurance operations, we also lease office space in: Worthington, Ohio; Dayton, Ohio; Plano, Texas; St. Louis, Missouri; and Hong Kong. In addition, we lease office space for our Services operations in various cities in California, Colorado, Florida, Pennsylvania, Texas and Utah.
We currently have two co-location agreements with TierPoint that support data center space and services at their Norristown, Pennsylvania and Philadelphia, Pennsylvania locations. These agreements expire in May 2018 and March 2019, respectively. TierPoint serves as a production and disaster recovery location.
We believe our existing properties are well utilized, suitable and adequate for our present circumstances.
The following analysis of our financial condition and results of operations should be read in conjunction with our Consolidated Financial Statements and Notes thereto included in Item 8. Certain terms and acronyms used throughout this report are defined in the Glossary of Abbreviations and Acronyms included as part of this report. Some of the information included in this discussion and analysis or included elsewhere in this report, including with respect to our projections, plans and our strategy for our business, includes forward-looking statements that involve risks, uncertainties and assumptions. Our actual results and the timing of events could differ materially from those anticipated by these forward-looking statements as a result of many factors, including those discussed under “Cautionary Note Regarding Forward-Looking Statements-Safe Harbor Provisions” and in the Risk Factors detailed in Item 1A of this Annual Report on Form 10-K.
We are a diversified mortgage and real estate services business with two business segments-Mortgage Insurance and Services. Our Mortgage Insurance segment provides credit-related insurance coverage, principally through private mortgage insurance, as well as other credit risk management solutions, to mortgage lending institutions nationwide. We provide our mortgage insurance products mainly through our wholly-owned subsidiary, Radian Guaranty. Our Services segment is a fee-for-service business that offers a broad array of both mortgage and real estate services to market participants across the mortgage and real estate value chain, as further detailed in “Results of Operations-Services.” These services are provided primarily through Clayton and its subsidiaries, including Green River Capital, Red Bell and ValuAmerica.
On December 22, 2017, the TCJA was signed into law. The TCJA significantly changes the U.S. tax system, and includes, among other things, a reduction of the federal corporate tax rate from 35% to 21%, effective January 1, 2018. Because deferred tax assets and liabilities are measured using the enacted tax rates that are expected to apply to taxable income in the periods in which the deferred tax assets or liabilities are expected to be realized or settled, the enactment of the TCJA resulted in a material reduction of our net deferred tax assets.
The overall improvements in the U.S. economy and the housing finance market since 2008 led to increased home purchase activity and, due to the low interest rate environment, a high level of refinance transactions. However, as rates recently have been increasing, refinance activity has declined. In 2017, an increase in home purchase transactions and a decrease in refinance transactions resulted in a smaller total mortgage origination market in 2017 as compared to 2016. Mortgage insurance penetration in the insurable mortgage market is generally three to five times higher for purchase originations than for refinancings. We believe that the mortgage insurance market for 2017 was slightly larger than 2016, as a result of this meaningfully higher penetration for purchase originations. We have recently observed that the increase in home purchase activity has resulted in home price appreciation and a declining inventory of homes available for sale, which may limit the pace of future industry growth until additional homes become available.
Notwithstanding the LTVs and debt-to-income trends referenced above, loan originations since 2008 consist primarily of high credit quality loans with significantly better credit performance than the loans originated during 2008 and prior periods. As of December 31, 2017, our portfolio of business written subsequent to 2008, including HARP refinancings, represented approximately 92% of our total primary RIF. The high volume of insurance that we have written on high credit quality loans has led to an improved portfolio mix and, together with favorable credit trends, has had a significant positive impact on our results of operations.
As expected, Radian Guaranty has experienced a recent increase in reported delinquencies in these hurricane-affected areas in the third and fourth quarters of 2017. We believe that these hurricane-related delinquencies have reached their peak and, based on past experience, expect that most of these defaults will cure within the next 12 months. Although the number of these defaults that will ultimately result in paid claims is uncertain, we do not expect the incremental defaults to result in a material number of paid claims, given the limitations on our coverage related to property damage. Radian has been working with loan servicers to obtain information about forbearance plans and the status of the properties. The future reserve impact of these defaults may be affected by various factors, including the pace of economic recovery in the FEMA Designated Areas.
Although, as discussed above, we believe that most of the incremental hurricane-related defaults will cure within the next 12 months without resulting in a material number of paid claims or a material impact on our loss reserves, because the PMIERs require a higher level of Minimum Required Assets with respect to defaults notwithstanding our claim expectations, the temporary increase in defaults has increased our Minimum Required Assets and reduced our cushion under the PMIERs. Our Minimum Required Assets from hurricane-affected areas increased by approximately $100 million as of December 31, 2017 as compared to September 30, 2017. This expected temporary impact has not affected Radian Guaranty’s compliance with the PMIERs financial requirements. See “Liquidity and Capital Resources-Radian Group-Short-Term Liquidity Needs-Capital Support for Subsidiaries” for additional information on PMIERs.
As part of our comprehensive relief program initiated in response to these hurricanes, we are supporting the disaster relief policies issued by the GSEs that provide various forms of assistance to accommodate the financial needs of homeowners in the affected areas, including temporary suspension of foreclosures, penalty waivers, and forbearance or modification plans that provide more flexible mortgage payment terms.
For all areas other than the FEMA Designated Areas associated with Hurricanes Harvey and Irma, the number of total new primary mortgage insurance defaults in our insured portfolio decreased by 7.2% for 2017, as compared to 2016. Similarly, for all areas other than the FEMA Designated Areas associated with Hurricanes Harvey and Irma, the primary default rate for the portfolio declined from 2.9% at December 31, 2016 to 2.2% at December 31, 2017. See “Results of Operations-Mortgage Insurance-NIW, IIF, RIF-Provision for Losses” for more information on defaults.
In our mortgage insurance business, our competitors include other private mortgage insurers and governmental agencies, principally the FHA and the VA. We currently compete with other private mortgage insurers that are eligible to write business for the GSEs on the basis of price, underwriting guidelines, overall service, customer relationships, perceived financial strength (including based on comparative credit ratings) and reputation. Overall service includes services offered through our Services business that complement our mortgage insurance products. We compete with the FHA and VA on the basis of loan limits, pricing, credit guidelines, terms of our insurance policies (including certain assumability features in FHA and VA loans) and loss mitigation practices. Although the FHA’s reduction of its annual mortgage insurance premiums in January 2015, combined with our premium changes in April 2016 to increase pricing for borrowers with lower FICO scores, has negatively impacted our ability to compete with the FHA on certain high-LTV loans to borrowers with FICO scores below 720, we believe that our pricing changes made during the first half of 2016 have enabled us to compete more effectively with the FHA on certain high-LTV loans to borrowers with FICO scores above 720.
The GSEs have significant discretion under the PMIERs and may amend the PMIERs at any time. Radian Guaranty received, on a confidential basis, a summary of proposed changes to the PMIERs on December 18, 2017. Based on this initial summary, which remains subject to comment by the private mortgage insurance industry, it is reasonably likely that updates to the PMIERs could, among other things, result in a material increase to Radian Guaranty’s capital requirements under the PMIERs financial requirements. Radian expects to be able to fully comply with the proposed PMIERs as of the expected effective date in late 2018, without a need to take further actions beyond those actions taken to date and without giving effect to the Surplus Note currently outstanding. See “Liquidity and Capital Resources-Radian Group-Short-Term Liquidity Needs-Capital Support for Subsidiaries” and Note 1 of Notes to Consolidated Financial Statements for additional information.
Business Strategy. Radian is focused on a number of strategic objectives, as described in “Radian’s Long-Term Strategic Objectives” in “Item 1. Business-General.” In our mortgage insurance business, we monitor competitive and economic factors while seeking to balance both profitability and market share considerations in developing our strategies. We have taken a disciplined, risk-based approach to establishing our premium rates and writing a mix of business that we expect to produce our targeted level of returns on a blended basis and an acceptable level of NIW. See “-Results of Operations-Mortgage Insurance-NIW, IIF, RIF.”
Our growth strategy includes leveraging our core expertise in mortgage credit risk management and expanding our presence in the mortgage finance industry. During 2016 and 2017, we participated in Front-end credit risk transfer programs developed by Fannie Mae and Freddie Mac as part of their initiative to increase the role of private capital in the mortgage market. We expect to continue to participate in these and other similar programs in the future, subject to availability and our evaluation of risk-adjusted returns. We participate in these Front-end programs as part of a panel of mortgage insurance company affiliates, subject to pre-established credit parameters. These transactions provide the GSEs with credit risk coverage on a Flow Basis that is incremental to primary mortgage insurance. In these transactions the credit risk coverage becomes effective as a loan is acquired by the GSE. During 2017, we also participated in similar credit risk transfer programs covering existing loans in the GSEs’ portfolios (i.e., Back-end). As of December 31, 2017, our total RIF under the Front-end and Back-end credit risk transfer transactions was $100.4 million.
Notwithstanding the improvement in the U.S. economy and the housing and finance markets, in 2017 our Services business underperformed relative to our expectations, as described further below. Therefore, to support our strategic objectives and based on our strategic review of the Services business lines, we committed to a restructuring plan for our Services business in order to make changes that we believe are necessary to reposition this business for sustained profitability.
The financial results in some of our Services business lines have been negatively impacted by, among other things: (i) competition, including price competition and development of alternative services that compete with the services we offer; (ii) a decrease in the demand for certain services as our customers are relying on internal resources rather than outsourcing to us; (iii) lower than expected customer acceptance for certain of our services; and (iv) delays in the realization of efficiencies and margin improvements associated with technology initiatives. Our Chief Executive Officer joined the Company in March 2017 and initiated a strategic review of this business. Based on this strategic review, in the second quarter of 2017, we made several decisions with respect to business strategy for this segment in order to reposition the Services business to drive future growth and profitability. We determined to discontinue certain initiatives and rationalize expenses for this business while focusing on our core services that have higher growth potential and are expected to produce more predictable and recurring fee-based revenue streams over time, and that better align with our market expertise and the needs of our customers. Our strategic decisions made in the second quarter of 2017, combined with the decrease in projected volumes based on current market trends, resulted in a significant reduction in expected future net cash flows for the Services business compared to our previous projections. As a result, we recorded an impairment of the goodwill and other intangible assets related to the Services segment in the second quarter of 2017. These charges were primarily due to the changes in expectations regarding the future growth of certain Services business lines resulting from changes in our business strategy, combined with market trends observed during the second quarter of 2017 that we expect to persist. See Note 7 of Notes to Consolidated Financial Statements for additional information.
Based on our strategic assessment of the Services business, on September 5, 2017, the Company committed to a plan to restructure the Services business and incurred pretax restructuring charges of $17.3 million in 2017, including $6.8 million in cash payments. Additional pretax restructuring charges of approximately $3.8 million, including approximately $3.0 million in cash, are expected to be recognized within the next 12 months. The total restructuring charges of approximately $21.1 million are expected to consist of: (i) asset impairment charges (including the loss recognized on the sale of our EuroRisk business) of approximately $11.3 million; (ii) employee severance and benefit costs of approximately $7.1 million; (iii) facility and lease termination costs of approximately $1.8 million; and (iv) contract termination and other restructuring costs of approximately $0.9 million.
Capital and Liquidity Actions. During 2017, we completed a series of transactions that strengthened our capital and liquidity position and improved our financial flexibility. This series of capital and liquidity actions included:
the issuance of $450 million aggregate principal amount of Senior Notes due 2024;
tender offers resulting in the purchase of aggregate principal amounts of $141.4 million, $115.9 million and $152.3 million of our Senior Notes due 2019, 2020 and 2021, respectively, for a total of $450.8 million in cash;
the purchase of an aggregate principal amount of $21.6 million of our outstanding Convertible Senior Notes due 2017 for $31.6 million in cash;
the entry into a three-year, $225 million unsecured revolving credit facility.
Radian Group entered into its $225 million unsecured revolving credit facility with a syndicate of bank lenders on October 16, 2017. Borrowings under the credit facility may be used for working capital and general corporate purposes, including, without limitation, capital contributions to Radian Group’s insurance and reinsurance subsidiaries as well as growth initiatives. At December 31, 2017, no borrowings were outstanding under this credit facility. See Note 12 of Notes to Consolidated Financial Statements for additional information.
Restructuring and other exit costs. As discussed above, we incurred pretax restructuring charges of $17.3 million in 2017. Additional pretax restructuring charges of approximately $3.8 million are expected to be recognized within the next 12 months. See Notes 1 and 7 of Notes to Consolidated Financial Statements for additional information.
Impairment of Goodwill and Other Intangible Assets. As discussed above, during the second quarter of 2017, we recorded a goodwill impairment charge of $184.4 million, as well as an impairment charge for other intangible assets of $15.8 million, in each case related to our Services segment. As of December 31, 2017 the remaining balances of goodwill and other intangible assets reported in our consolidated balance sheet were $10.9 million and $53.3 million, respectively. See Note 7 of Notes to Consolidated Financial Statements for additional information.
Reinsurance. During 2017, we took actions with respect to our reinsurance program to effectively manage our capital position in a cost-efficient manner, improve our return on capital, proactively manage the retained mix of single-premium business in our mortgage insurance portfolio and strengthen Radian Guaranty’s financial position under PMIERs.
In October 2017, in anticipation of the expiration of the 2016 Single Premium QSR Transaction, we entered into the 2018 Single Premium QSR Transaction with a panel of third-party reinsurers. Under the terms of the 2018 Single Premium QSR Transaction, we will cede 65% of our Single Premium NIW during 2018 and 2019.
Our strategy has been to write a mix of Single Premium Policies and Monthly Premium Policies in order to manage the overall impact on our results if actual prepayment speeds are significantly different from expectations. In addition, the 2016 and 2018 Single Premium QSR Transactions support our strategy to balance our retained mix of Single Premium Policies and Monthly Premium Policies. The impact of all of our third-party QSR transactions reduced our retained Single Premium RIF from 30.9% to 19.3% at December 31, 2017. See “Overview-Operating Environment and Business Strategy” for more information.
NIW; Origination Market; Penetration Rate. NIW increases our IIF and our premiums written and earned. NIW is affected by the overall size of the mortgage origination market, the penetration percentage of private mortgage insurance into the overall mortgage origination market and our market share of the private mortgage insurance market. The overall mortgage origination market is influenced by macroeconomic factors such as household formation, household composition, home affordability, interest rates, housing markets in general, credit availability and the impact of various legislative and regulatory actions that may influence the housing and mortgage finance industries. The penetration percentage of private mortgage insurance is mainly influenced by: (i) the competitiveness of private mortgage insurance for GSE conforming loans compared to FHA and VA insured loans and (ii) the relative percentage of mortgage originations that are for purchased homes versus refinances. We believe, for example, that better execution for borrowers with higher FICO scores, lender preference and the inability to cancel FHA insurance for certain loans are factors that continue to provide a competitive advantage for private mortgage insurers. See “Results of Operations-Mortgage Insurance-NIW, IIF, RIF.”
•the composition of the insured mortgage market between private mortgage insurance and FHA insurance.
Based on actual dollars generated in credit enhanced market, as reported by the U.S. Department of Housing and Urban Development, the International Monetary Fund and company publicly reported information. 2017 estimates based upon average of Mortgage Bankers Association, Freddie Mac and Fannie Mae December 2017 Financial Forecasts and Radian internal assumptions.
Premiums. The premium rates we charge for our insurance are based on a number of borrower, loan and property characteristics. The mortgage insurance industry is highly competitive and private mortgage insurers compete with each other and with the FHA and VA with respect to price and other factors. We expect price competition to continue throughout the mortgage insurance industry and future price reductions from private mortgage insurers or the FHA could impact our future premium rates or our ability to compete.
Recently, we have expected that our current pricing (including the impact of our reinsurance transactions) would, over the life of the policies, produce returns on required capital on new business on an unlevered basis (i.e., after-tax underwriting returns plus projected investment income) of approximately 14% to 15%, and approximately 17% to 18% on a levered basis (i.e., after-tax returns taking into consideration a corporate debt-to-capital ratio of 25%). If all other factors were to remain constant, we would expect that, beginning in 2018, the TCJA would increase our unlevered and levered returns to 17% to 18% and 21% to 22%, respectively. However, this projected improvement due to the TCJA will be impacted by changes in various other factors, which may include the likely unfavorable impact of changes in the PMIERs financial requirements or other competitive factors. The GSEs have informed us that they expect updates to the PMIERs will become effective in the fourth quarter of 2018. It is reasonably likely that updates to the PMIERs could, among other things, result in a material increase to Radian Guaranty’s capital requirements under the PMIERs financial requirements, which could negatively impact our returns. See “Liquidity and Capital Resources-Radian Group-Short-Term Liquidity Needs-Capital Support for Subsidiaries” and Note 1 of Notes to Consolidated Financial Statements for additional information.
Premiums on our mortgage insurance products are generally paid either on a monthly installment basis (“Monthly Premiums”) or in a single payment (“Single Premiums”) at the time of loan origination. See “Item 1. Business-Mortgage Insurance-Mortgage Insurance Business Overview-Premium Rates-Primary Mortgage Insurance.” Our expected rate of return on our Single Premium Policies is lower than on our Monthly Premium Policies because our premium rates are generally lower for our Single Premium Policies. However, as discussed above, the ultimate profitability of Single Premium Policies may be higher or lower than expected due to prepayments. See “-IIF; Persistency Rate; Mix of Business.”
Approximately 64% of the loans in our total primary mortgage insurance portfolio at December 31, 2017 have Monthly Premium Policies that provide a level monthly premium for the first 10 years of the policy, followed by a reduced level monthly premium thereafter. If a loan is refinanced under HARP, the initial 10-year period is reset. Due to the borrower’s ability to cancel the policy generally when the LTV reaches 80% of the original value, and the automatic cancellation of the policy when the LTV reaches 78% of the original value, the volume of loans that remain insured after 10 years and would be subject to the premium reset is generally not material in relation to the total loans originated. However, to the extent the volume of loans resetting from year to year varies significantly, the trend in earned premiums may also vary.
The mix of credit characteristics in our total direct RIF (e.g., loans with higher risk characteristics, or loans with layered risk that combine multiple higher-risk attributes within the same loan, generally result in more delinquencies and claims). See “Results of Operations-Mortgage Insurance-NIW, IIF, RIF.
The average loan size (relatively higher priced properties with larger average loan amounts may result in higher incurred losses).
Our ability to mitigate potential losses through Rescissions, Claim Denials, cancellations and Claim Curtailments on claims submitted to us. These actions all reduce our incurred losses. However, if these Loss Mitigation Activities are successfully challenged at rates that are higher than expected or we agree to settle disputes related to our Loss Mitigation Activities, our incurred losses will increase. As our portfolio originated prior to 2009 has become a smaller percentage of our overall insured portfolio, there has been a decrease in the amount of Loss Mitigation Activity with respect to the claims we receive, and we expect this trend to continue, particularly given the limitations on our Loss Mitigation Activities imposed in the 2014 Master Policy. See “Item 1A. Risk Factors-Our Loss Mitigation Activity is not expected to mitigate losses to the same extent as in prior years; Loss Mitigation Activity could continue to negatively impact our customer relationships.”
Agreements such as (i) the Freddie Mac Agreement, which established certain terms for the treatment of the loans subject to that agreement, including claim payments, Loss Mitigation Activity and insurance coverage, and capped Radian Guaranty’s claim exposure on such loans and (ii) the BofA Settlement Agreement, which, for certain loans, finalized claims decisions and limited Loss Mitigation Activities. Because the Freddie Mac Agreement reached its scheduled final settlement date in 2017 and cash payments under the BofA Settlement Agreement were effectively completed in 2015, we do not expect a material impact from either of these two agreements in the future. See Note 11 of Notes to Consolidated Financial Statements for additional information.
In contrast to our Mortgage Insurance business, the Services segment is a fee-for-service business without significant balance sheet risk. Key factors impacting results for our Services business include:
The Services segment is dependent on a limited number of large customers that represent a significant portion of its revenues. Access to Radian Guaranty’s mortgage insurance customer base provides additional opportunities to expand the segment’s existing customers. However, an unexpected loss of a major customer could significantly impact the level of Services revenue. Generally, our contracts do not contain volume commitments and may be terminated by clients at any time.
Net Gains (Losses) on Investments. The recognition of realized investment gains or losses can vary significantly across periods as the activity is highly discretionary based on such factors as market opportunities, our tax and capital profile and overall market cycles that impact the timing of the sales of securities. Unrealized investment gains and losses arise primarily from changes in the market value of our investments that are classified as trading and these unrealized gains and losses are generally the result of changes in interest rates or credit spreads and may not necessarily result in economic gains or losses.
Impairment of Goodwill or Other Intangible Assets. The periodic review of goodwill and other intangible assets for potential impairment may impact consolidated results. Our goodwill and other intangible assets primarily relate to the acquisition of Clayton, and their valuation is based on management’s assumptions, which are inherently subject to risks and uncertainties. In 2017, we recorded total impairment charges of $200.2 million related to the goodwill and other intangible assets of the Services segment. See Note 7 of Notes to Consolidated Financial Statements for additional information.
The measurement of certain of our deferred taxes was recorded provisionally, and may be adjusted within the next year. The ultimate impact of the TCJA may differ from our provisional estimates due to, among other things, future guidance that may be issued, changes in our interpretation or assumptions with respect to reversal periods, the outcome of our potential settlement of the IRS Matter and future actions that we may take as a result of the new tax law.
For periods beginning January 1, 2018, we expect the TCJA, excluding the impact of Discrete Items, to have a significant favorable impact on the Company’s net income, diluted earnings per share and cash flows, as compared to the tax laws in effect in 2017, primarily due to the reduction in the federal corporate tax rate from 35% to 21%. We are continuing to assess the effects of the TCJA on our future results. See “-Results of Operations-Consolidated-Income Tax Provision” and Note 10 of Notes to Consolidated Financial Statements for additional information on the TCJA.
Radian Group serves as the holding company for our operating subsidiaries and does not have any operations of its own. Our consolidated operating results for 2017 primarily reflect the financial results and performance of our two business segments-Mortgage Insurance and Services. See Note 4 of Notes to Consolidated Financial Statements for information regarding the basis of our segment reporting, including the related allocations. See “Results of Operations-Mortgage Insurance,” and “Results of Operations-Services” for the operating results of these business segments.
The following table highlights selected information related to our consolidated results of operations for the years ended December 31, 2017, 2016 and 2015:
The improvement in our results for 2016 compared to 2015 primarily reflect an increase in net investment income and a decrease in loss on induced conversion and debt extinguishment.
The decrease in average diluted shares for 2017 compared to 2016 is primarily due to the full-year impact of the series of capital management transactions effected in 2016, which included: (i) the purchases of portions of our Convertible Senior Notes due 2017 and 2019, and (ii) the purchase of 9.4 million shares of Radian Group common stock. In addition, in January 2017, we settled our obligations with respect to the remaining $68.0 million aggregate principal amount of our Convertible Senior Notes due 2019 which, as of the settlement date, resulted in a decrease of an additional 6.4 million diluted shares for purposes of determining diluted net income per share.
The increase in diluted net income per share for 2016, compared to 2015, is primarily due to the increase in net income from continuing operations, as discussed above, combined with the decrease in average diluted shares. The average diluted shares decreased from 246.3 million shares for 2015 to 229.3 million shares for 2016. This decrease in average diluted shares is primarily due to the impact of the June 2015 repurchase of $389.1 million of our Convertible Senior Notes due 2017, combined with the impact of the series of 2016 capital management transactions described above, included as of their effective dates. See Notes 3 and 12 of Notes to Consolidated Financial Statements for additional information.
Reflects the net equity impact of the extinguishment of the remaining Convertible Senior Notes due 2019 and the purchases of a portion of the Convertible Senior Notes due 2017, excluding the loss on conversion and debt extinguishment, which is included in net income. See “Overview-Other 2017 Developments” for additional information.
Net Gains (Losses) on Investments and Other Financial Instruments. The decrease in net gains on investments and other financial instruments in 2017 as compared to 2016 is primarily due to: (i) the decrease in net realized gains attributable to sales and redemptions of fixed-maturities available for sale and trading securities and (ii) the decrease in unrealized gains on investments and other financial instruments in 2017, as compared to 2016, primarily related to the change in fair value of trading securities and other investments.
Restructuring and other exit costs. For 2017, restructuring and other exit costs include charges associated with our plan to restructure the Services business. Charges are primarily due to severance and related benefit costs and impairment of long-lived assets and loss from the sale of a business line. See “-Overview” for more information.
Interest expense for 2016 decreased compared to 2015. This decrease was primarily due to reductions in interest expense from: (i) the March 2016 and June 2015 purchases of aggregate principal amounts of $30.1 million and $389.1 million, respectively, of Convertible Senior Notes due 2017; (ii) the 2016 purchases of $322.0 million aggregate principal amount of Convertible Senior Notes due 2019; and (iii) the August 2016 redemption of the remaining $195.5 million aggregate principal amount of our Senior Notes due 2017. These reductions were partially offset by increased interest expense from the March 2016 issuance of $350 million aggregate principal amount of Senior Notes due 2021 and the June 2015 issuance of $350 million aggregate principal amount of Senior Notes due 2020.
The ultimate impact of the TCJA may differ from our provisional estimates due to, among other things, future guidance that may be issued, changes in our interpretation or assumptions with respect to reversal periods, the outcome of our potential settlement of the IRS Matter and future actions that we may take as a result of the new tax law. See “-Overview-Tax Cuts and Jobs Act” and Note 10 of Notes to Consolidated Financial Statements for additional information on the TCJA.
Our 2016 effective tax rate was slightly higher than the federal statutory rate of 35%, primarily as a result of the non-deductible portion of the purchase premium relating to our Convertible Senior Notes due 2017 and 2019. The increase was partially offset by the income tax benefit resulting from our return-to-provision adjustment. For 2015, the additional expense related to the accounting for uncertainty of income taxes and the impact of state and local income taxes was substantially offset by the tax benefit from the deductible portion of the premium associated with the purchases of Convertible Senior Notes due 2017.
Adjusted pretax operating income is defined as GAAP consolidated pretax income (loss) from continuing operations excluding the effects of: (i) net gains (losses) on investments and other financial instruments; (ii) loss on induced conversion and debt extinguishment; (iii) acquisition-related expenses; (iv) amortization or impairment of goodwill and other intangible assets; and (v) net impairment losses recognized in earnings and losses from the sale of lines of business.
Trends in the profitability of our fundamental operating activities can be more clearly identified without the fluctuations of these realized and unrealized gains or losses. We do not view them to be indicative of our fundamental operating activities. Therefore, these items are excluded from our calculation of adjusted pretax operating income (loss).
Total adjusted pretax operating income is not a measure of total profitability, and therefore should not be considered in isolation or viewed as a substitute for GAAP pretax income. Our definition of adjusted pretax operating income may not be comparable to similarly-named measures reported by other companies.
During 2017, we continued our strategy of growing our mortgage insurance portfolio by writing insurance on mortgages with strong credit characteristics. At December 31, 2017, we had $200.7 billion in IIF compared to $183.5 billion in IIF at December 31, 2016. We also continued to focus on effectively managing our capital and liquidity positions. See “Liquidity and Capital Resources-Radian Group-Short-Term Liquidity Needs-Capital Support for Subsidiaries” and Note 1 of Notes to Consolidated Financial Statements for additional information.
Net of ceded premiums written under the QSR Transactions and the 2016 Single Premium QSR Transaction. Effective December 31, 2017, we amended the 2016 Single Premium QSR Transaction to increase the amount of ceded risk on performing loans under the agreement from 35% to 65% for the 2015 through 2017 vintages, resulting in a reduction of $145.7 million in net premiums written on Single Premium Policies for the fourth quarter of 2017. During 2016, we entered into the 2016 Single Premium QSR Transaction, resulting in $233.2 million in ceded premiums written in 2016. See Note 8 of Notes to Consolidated Financial Statements for more information.
The table below illustrates the composition of our direct primary mortgage insurance RIF at December 31, 2017 compared to selected prior years, based on various risk characteristics.
As the demand from first-time home buyers has increased, the mortgage industry has been responding by expanding high-LTV lending. Recently enhanced GSE programs, including Fannie Mae’s HomeReady program and Freddie Mac’s Home Possible and Home Possible Advantage programs, are designed to make home ownership more affordable for low- to moderate-income borrowers, particularly in low-income or under-served communities. These programs include features such as: (i) lower down payments; (ii) gifts and grants as an approved source of funds for down payment and closing costs; (iii) improved affordability through a reduced mortgage insurance coverage requirement and GSE risk-based pricing waivers; and (iv) homeownership education options. As a result of all of these factors, home purchases by first-time home buyers, who traditionally require mortgage loans with higher LTVs and may have higher debt-to-income ratios, are becoming an increasingly significant portion of the total market.
Historical loan data indicates that credit scores and underwriting quality are key drivers of credit performance. As illustrated by the preceding chart, the FICO scores and internal risk grades of our primary RIF has significantly improved in business written after 2008. In addition, we have limited layered risk that combines multiple higher-risk attributes within the same loan, specifically low FICO scores combined with other higher risk characteristics, such that, for example, a de minimis amount of our primary RIF originated after 2008 relates to mortgages with (i) FICO scores less than 680 combined with cash-out refinancings or original LTVs greater than 95% or (ii) FICO scores less than or equal to 720 on an investment property or second home.
The chart below illustrates the composition of our direct primary mortgage insurance RIF at December 31, 2017, based on origination vintages.
In 2009, the GSEs began offering HARP loans, which allow a borrower who is not delinquent to refinance a mortgage if the borrower has been unable to take advantage of lower interest rates because the borrower’s home has decreased in value. Refinancings under the HARP programs have had a positive impact on the overall credit quality and composition of our mortgage insurance portfolio because the refinancing generally results in terms under which a borrower has a greater ability to pay and more financial flexibility to cover the loan obligations. We exclude HARP loans from our NIW for the period in which the refinance occurs. During 2017, new HARP loans accounted for $79.6 million of newly refinanced loans that were not included in Radian Guaranty’s NIW for the period, compared to $202.9 million for 2016. The HARP deadline for refinancing has been extended to December 31, 2018. See “Item 1. Business-Regulation-Federal Regulation-Homeowner Assistance Programs” for more information.
Represents inception-to-date losses incurred as a percentage of net premiums earned.
Represents the percentage of single premium IIF, after giving effect to all reinsurance ceded.
The Persistency Rate for the 12 months ended December 31, 2016 was less than in 2017 and 2015, primarily due to increased refinancing activity and the cancellations of Single Premium Policies. See “-Net Premiums Written and Earned” below.
Represents the dollar amount and percentage, respectively, of Single Premium RIF, after giving effect to all reinsurance ceded.
At December 31, 2017, 2016 and 2015, consists of 97.3%, 97.0% and 96.1%, respectively, of RIF related to fixed-rate mortgages.
The table below provides additional information about the components of net premiums earned for the periods indicated.
Effective December 31, 2017, we amended the 2016 Single Premium QSR Transaction to increase the amount of ceded risk on performing loans under the agreement from 35% to 65% for the 2015 through 2017 vintages. As of the effective date, the result of this amendment increased the amount of risk ceded on Single Premium Policies, including for the purposes of calculating any future ceding commissions and profit commissions that Radian Guaranty will earn. It will also increase the future amounts of ceded earned premiums and ceded losses. See “Liquidity and Capital Resources-Radian Group-Short-Term Liquidity Needs” for more information about the impact of the 2016 Single Premium QSR Transaction amendment on our PMIERs financial requirements.
On December 31, 2017, our ability to cede Single Premium NIW under the 2016 Single Premium QSR Transaction expired. In anticipation of this expiration, in October 2017 we entered into the 2018 Single Premium QSR Transaction. Under the 2018 Single Premium QSR Transaction, beginning with the business written in January 2018, we expect to cede 65% of our Single Premium NIW, subject to certain conditions and a limitation on ceded premiums written equal to $335 million for policies issued between January 1, 2018 and December 31, 2019.
The following table provides information related to the premium impact of our reinsurance transactions. See Note 8 of Notes to Consolidated Financial Statements for more information about our reinsurance transactions, including the ceded amounts related to the QSR Transactions.
Net Investment Income. For 2017, net investment income increased compared to 2016, as we have continued to refine our investment liquidity targets and cash management strategies, consistent with rising short-term rates and an increased book yield in our portfolio. Net investment income increased in 2016 compared to 2015, primarily due to our extending portfolio duration as we progressed toward more fully investing our portfolio. All periods include an allocation to the Mortgage Insurance segment of net investment income from investments held at Radian Group.
Provision for Losses. The following table details the financial impact of the significant components of our provision for losses for the periods indicated :
Our mortgage insurance provision for losses for 2017 decreased by $68.0 million as compared to 2016. Reserves established for new default notices were the primary driver of our total incurred losses for 2017 and 2016. Current year primary defaults increased by 5.9% for 2017, compared to 2016, due to elevated new default notices in 2017 in the FEMA Designated Areas associated with Hurricanes Harvey and Irma received subsequent to those two natural disasters, which occurred during the third quarter of 2017. Due to exclusions in our Master Policies for physical damage, including damage caused by floods or physical damage, we do not believe that these elevated defaults will result in a material number of incremental claims paid. As a result, based on our past experience with similar natural disasters, we assumed a 3% gross Default to Claim Rate for new primary defaults in FEMA Designated Areas associated with Hurricanes Harvey and Irma received subsequent to those two natural disasters. Radian has been working with loan servicers to obtain information about forbearance plans and the status of the properties. See “-Overview” for additional information.
Part II Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Includes 253; 5,850; and 7,353 insured loans subject to the Freddie Mac Agreement at December 31, 2017, 2016 and 2015, respectively.
The following table shows a rollforward of the number of our primary loans in default, including new defaults from our Legacy Portfolio and Post-legacy Portfolio:
Included in this amount for the year ended December 31, 2017 are the new defaults and cures in the FEMA Designated Areas associated with Hurricanes Harvey and Irma, which occurred during the third quarter of 2017. For the years ended December 31, 2017, 2016 and 2015, new defaults and cures in these areas were as follows:
Net of any previous Rescission and Claim Denials that were reinstated during the period (excluding activity related to the BofA Settlement Agreement). Such reinstated Rescissions and Claim Denials may ultimately result in a paid claim.
Our aggregate weighted-average net Default to Claim Rate assumption for our primary loans used in estimating our reserve for losses, which is net of estimated Claim Denials and Rescissions, was approximately 31%, 42% and 46%, at December 31, 2017, 2016 and 2015, respectively. The change in our Default to Claim Rate in 2017 resulted primarily from the lower Default to Claim Rate of 3% on new primary defaults in FEMA Designated Areas associated with Hurricanes Harvey and Irma subsequent to those two natural disasters. We develop our Default to Claim Rate estimates on defaulted loans based on models that use a variety of loan characteristics to determine the likelihood that a default will reach claim status. Our Default to Claim Rate estimates on defaulted loans are mainly developed based on the Stage of Default and Time in Default of the underlying defaulted loans, as measured by the progress toward foreclosure sale and the number of months in default. As of December 31, 2017, our gross Default to Claim Rate assumptions for our primary portfolio, other than for new primary defaults in FEMA Designated Areas associated with Hurricanes Harvey and Irma received subsequent to those two natural disasters, ranged from 10% for new defaults, up to 62% for other defaults not in foreclosure stage, and 81% for Foreclosure Stage Defaults. As of December 31, 2016, these gross Default to Claim Rate assumptions were 12% for new defaults, up to 62% for other defaults not in foreclosure stage, and 81% for Foreclosure Stage Defaults.
Our net Default to Claim Rate and loss reserve estimate incorporates our expectations with respect to future Rescissions, Claim Denials and Claim Curtailments. Our estimate of such net future Loss Mitigation Activities reduced our loss reserve as of December 31, 2017 and 2016 by approximately $21 million and $39 million, respectively. These expectations are based primarily on our recent experience with respect to the number of claims that have been denied due to the policyholder’s failure to submit sufficient documentation to perfect a claim within the time period permitted under our Master Policies and also our recent experience with respect to the number of insurance certificates that have been rescinded due to fraud, underwriter negligence or other factors. See Note 11 of Notes to Consolidated Financial Statements.
On September 16, 2014, Radian Guaranty entered into the BofA Settlement Agreement in order to resolve various actual and potential claims or disputes related to the parties’ respective rights and duties as to mortgage insurance coverage on the specific population of loans covered by the agreement. Implementation of the agreement commenced on February 1, 2015 and cash payments under the agreement were substantially completed by December 31, 2015. We do not expect the BofA Settlement Agreement to have a material impact on our future results of operations or cash flows. See Note 11 of Notes to Consolidated Financial Statements for additional information about the BofA Settlement Agreement.
We expect that a portion of previously rescinded policies will be reinstated and previously denied claims will be resubmitted with the required documentation and ultimately paid; therefore, we have incorporated this expectation into our IBNR reserve estimate. Our IBNR reserve estimate was $10.4 million, $14.3 million and $26.6 million at December 31, 2017, 2016 and 2015, respectively.
Factors that impact the severity of a claim include, but are not limited to: (i) the size of the loan; (ii) the amount of mortgage insurance coverage placed on the loan; (iii) the amount of time between default and claim during which we are expected to cover interest (capped at two years under our Prior Master Policy and capped at three years under our 2014 Master Policy) and certain expenses; and (iv) the impact of certain loss management activities with respect to the loan. The average Claim Severity experienced for loans covered by our primary insurance was 104.7% for 2017, compared to 104.1% in 2016 and 105.8% in 2015.
The following table shows net claims paid by product and the average claim paid by product for the periods indicated:
Primarily related to net recoveries collected on claims paid in prior years on second-lien mortgage loans.
Calculated without giving effect to the impact of the termination of captive transactions and commutations.
Represents total first-lien direct claims paid, excluding impact of reinsurance and LAE expenses.
Interest Expense. These amounts reflect the allocated portion of interest on Radian Group’s long-term debt to our Mortgage Insurance segment, excluding the Senior Notes due 2019. The allocated interest decreased in 2017 and 2016 compared to 2015. These decreases were primarily due to the capital management transactions described in “-Results of Operations-Consolidated-Interest Expense.”
The following table summarizes our Services segment’s results of operations for the years ended December 31, 2017, 2016 and 2015:
Our senior management uses adjusted pretax operating income (loss) as our primary measure to evaluate the fundamental financial performance of each of our business segments.
Includes allocation of corporate operating expenses of $14.3 million, $8.5 million and $4.8 million for 2017, 2016 and 2015, respectively.
Our Services segment is a fee-for-service business that offers a broad array of both mortgage and real estate services to market participants across the mortgage and real estate value chain, primarily through Clayton and its subsidiaries, including Green River Capital, Red Bell and ValuAmerica. In connection with the restructuring of our Services business, we have refined our Services business strategy going forward to focus on our core mortgage and real estate services. These services provide mortgage lenders, financial institutions, mortgage and real estate investors and government entities, among others, with information and other resources and services that are used to originate, evaluate, acquire, securitize, service and monitor residential real estate and loans secured by residential real estate.
The services that we will no longer offer as a result of restructuring our Services business have not had a material impact on our consolidated cash flows or results of operations in recent periods. Therefore, as compared to our results in 2016 or 2015, there was no material impact on our consolidated cash flows or results of operations from discontinuing these services. See “Overview-Operating Environment and Business Strategy” for more information. See Note 1 of Notes to Consolidated Financial Statements, “Item 1. Business-Services-Services Business Overview” and “Overview-Other 2017 Developments” for additional information regarding the Services segment.
Services Revenue. Revenue decreased in 2017, as compared to 2016, primarily due to the decline in volume in: (i) loan review; (ii) REO asset management; and (iii) servicer and loan surveillance services. The decline in loan review volume was primarily driven by a decline in demand for outsourcing because the market decline in refinance origination volume has provided our customers with excess internal capacity to perform these services in-house. The decline in REO asset management volume was primarily driven by a decline in REO asset inflow reflecting current market conditions. Our surveillance business is transactional and the decrease in surveillance services volume was primarily due to fewer transactions and pricing changes with one of our top 10 Services customers. These decreases were partially offset by an increase in title and settlement services and an increase in valuation services.
For the year ended December 31, 2017, the top 10 Services customers (which include our affiliates) generated approximately 49% of the Services segment’s revenues, as compared to 52% for 2016 and 48% for 2015. Approximately 4%, 5% and 4% of services revenue on a segment basis for the years ended December 31, 2017, 2016 and 2015, respectively, related to sales to our affiliates, and has been eliminated in our consolidated results. The largest single customer generated approximately 11% of the services revenue for the years ended December 31, 2017 and December 31, 2016, as compared to 9% for the year ended December 31, 2015.
Although compensation-related costs for 2016 compared to 2015 decreased as a percentage of other operating expenses, primarily due to a reduction in force during 2016, the decrease was partially offset by increased expenses in 2016 associated with ValuAmerica and Red Bell which were acquired in October 2015 and March 2015, respectively, as well as, to a lesser extent, an increase in underwriting expenses.
Restructuring and other exit costs. Restructuring and other exit costs were incurred in 2017 and include charges associated with our plan to restructure the Services business. The portion of these charges that are included in adjusted pretax operating income are primarily due to severance and related benefit costs. See “-Overview” for more information.
Includes $197.7 million of Senior Notes due 2021 that may be redeemed, in whole or in part at any time prior to maturity.
Includes $450 million of Senior Notes due 2024 that may be redeemed, in whole or in part at any time prior to maturity.
Radian Guaranty and Radian Mortgage Assurance were parties to a cross-guaranty agreement that was terminated effective July 1, 2016. However, it remains in effect for insurance written prior to the termination date. This agreement provides that if either party fails to make a payment to a policyholder, then the other party will step in and make the payment. The obligations of both parties are unconditional and irrevocable; however, no payments may be made without prior approval by the Pennsylvania Insurance Department.
Radian Group and Radian Mortgage Assurance are parties to a guaranty agreement, which provides that Radian Group will make sufficient funds available to Radian Mortgage Assurance to ensure that Radian Mortgage Assurance has a minimum of $5 million of statutory policyholders’ surplus every calendar quarter. Radian Mortgage Assurance had $8.7 million of statutory policyholders’ surplus and no RIF exposure as of December 31, 2017.
To allow our mortgage insurance customers to comply with applicable securities regulations for issuers of ABS (including mortgage-backed securities), we have been required, depending on the amount of credit enhancement we were providing, to provide: (i) audited financial statements for the insurance subsidiary participating in these transactions or (ii) a full and unconditional holding-company level guarantee for our insurance subsidiaries’ obligations in such transactions. Radian Group has guaranteed two structured transactions for Radian Guaranty with approximately $97.8 million of aggregate remaining credit exposure as of December 31, 2017.
Radian Group and Radian Guaranty Reinsurance are parties to an Assumption and Indemnification Agreement with regard to Radian Guaranty Reinsurance’s portion of the Deficiency Amounts relating to the IRS Matter. See Note 10 of Notes to Consolidated Financial Statements for additional information regarding the IRS Matter. We can provide no assurance regarding the outcome of the IRS Matter, which could take several years to resolve. As such, there remains significant uncertainty with regard to the amount and timing of any potential payments under the indemnity agreement described above. See “Item 1A. Risk Factors-Resolution of our dispute with the IRS could adversely affect us.”
Our Mortgage Insurance segment currently offers primary mortgage insurance coverage on residential first-lien mortgage loans. Our total direct primary mortgage insurance RIF was $51.3 billion as of December 31, 2017. We provide our mortgage insurance products and services mainly through our wholly-owned subsidiary, Radian Guaranty.
The GSEs and state insurance regulators impose various capital and financial requirements on our insurance subsidiaries. These include Risk-to-capital, other risk-based capital measures and surplus requirements, as well as the PMIERs financial requirements discussed below. Failure to comply with these capital and financial requirements may limit the amount of insurance that our insurance subsidiaries may write or prohibit our insurance subsidiaries from writing insurance altogether. The GSEs and state insurance regulators also possess significant discretion with respect to our insurance subsidiaries and all aspects of their business. See Note 19 for additional regulatory information.
PMIERs. In order to be eligible to insure loans purchased by the GSEs, mortgage insurers such as Radian Guaranty must meet the GSEs’ eligibility requirements, or PMIERs. At December 31, 2017, Radian Guaranty is an approved mortgage insurer under the PMIERs and is in compliance with the PMIERs financial requirements.
The PMIERs are comprehensive, covering virtually all aspects of the business and operations of a private mortgage insurer, including internal risk management and quality controls, the relationship between the GSEs and the approved insurer, as well as the approved insurer’s financial condition. In addition, private mortgage insurers are required under the PMIERs to obtain the prior consent of the GSEs before taking certain actions, which may include paying dividends, entering into various intercompany agreements, and commuting or reinsuring risk, among others. If Radian Guaranty is unable to satisfy the requirements set forth in the PMIERs, the GSEs could restrict it from conducting certain types of business with them or take actions that may include not purchasing loans insured by Radian Guaranty.
From time to time, we enter into reinsurance transactions as part of our strategy to manage our capital position and risk profile, which includes managing Radian Guaranty’s position under the PMIERs financial requirements. The credit that we receive under the PMIERs financial requirements for these transactions is subject to the periodic review of the GSEs.
Our mortgage services offerings include transaction management services such as loan review, RMBS securitization and distressed asset reviews, servicer and loan surveillance and underwriting. Our real estate services include: REO asset management; review and valuation services related to single family rental properties; real estate valuation services; real estate brokerage services; and title and settlement services that include title search, settlement and closing services.
Capital and Liquidity Actions. During 2017, we completed a series of capital and liquidity actions, including: (i) extending the weighted average maturity of our Senior Notes by purchasing a portion of our Senior Notes due 2019, 2020 and 2021 through tender offers and issuing our Senior Notes due 2024; (ii) eliminating our Convertible Senior Notes due 2017 and 2019; (iii) entering into a $225 million unsecured revolving credit facility; and (iv) renewing our share repurchase program. These transactions strengthened our capital and liquidity position and improved our financial flexibility, including by improving our debt maturity profile. See Notes 12 and 14 for additional information.
Radian Group and its subsidiaries are subject to risks and uncertainties that could affect amounts reported in our financial statements in future periods. Our future performance and financial condition are subject to significant risks and uncertainties that could cause actual results to be materially different from our estimates and forward-looking statements.
The impact to our reserve due to estimated future Loss Mitigation Activities incorporates our expectations regarding the number of policies that we expect to be reinstated as a result of our claims rebuttal process. Rescissions, Claim Denials and Claim Curtailments may occur for various reasons, including, without limitation, underwriting negligence, fraudulent applications and appraisals, breach of representations and warranties and inadequate documentation, primarily related to our Legacy Portfolio. The level of Rescissions, Claim Denials and Claim Curtailments has been declining in recent periods as our defaulted Legacy Portfolio continues to decline, and we expect this trend to continue.
Insurance enterprises are required to establish a PDR if the net present value of the expected future losses and expenses for a particular product line exceeds the net present value of expected future premiums and existing reserves for that product line. We reassess our expectations for premiums, losses and expenses for our mortgage insurance business at least quarterly and update our premium deficiency analyses accordingly. For our mortgage insurance business, we group our mortgage insurance products into two categories: first-lien and second-lien mortgage loans. As of December 31, 2017 and 2016, the combination of the net present value of our expected future premiums and existing reserves (net of reinsurance recoverables) significantly exceeded the net present value of our future expected losses and expenses associated with our first lien mortgage insurance portfolio. Our second-lien PDR is recorded as a component of other liabilities.
- Prices or valuations that require inputs that are both significant to the fair value measurement and unobservable. Level III inputs are used to measure fair value only to the extent that observable inputs are not available.
For markets in which inputs are not observable or are limited, we use significant judgment and assumptions that a typical market participant would use to evaluate the market price of an asset or liability. Given the level of judgment necessary, another market participant may derive a materially different estimate of fair value. These assets and liabilities are classified in Level III of our fair value hierarchy.
Available for sale securities, trading securities, and certain other assets are recorded at fair value as described in Note 5. All changes in fair value of trading securities and certain other assets are included in our consolidated statements of operations. All changes in the fair value of available for sale securities are recorded in accumulated other comprehensive income (loss).
The Services segment also derives revenue from REO management activities, and is generally paid a fixed fee or a percentage of the sale proceeds upon the sale of a property. Services revenue is recognized when the sale of a property closes and the client has confirmed receipt of the sale proceeds from a buyer. In certain instances, fees are received at the time that an asset is assigned to Radian for REO management. These fees are recorded as deferred revenue and are recognized on a straight-line basis over the average period of time required to sell an asset and complete the earnings process.
Cost of services consists primarily of employee compensation and related payroll benefits, the cost of billable labor assigned to revenue-generating activities, as well as corresponding travel and related expenses incurred in providing such services to clients in our Services segment. Cost of services also includes costs paid to outside vendors, including real estate agents that provide valuation and related services, as well as data acquisition costs and other compensation-related expenses to maintain software application platforms that directly support our businesses. Cost of services does not include an allocation of overhead costs.
We provide for income taxes in accordance with the provisions of the accounting standard regarding accounting for income taxes. As required under this standard, our deferred tax assets and deferred tax liabilities are recognized under the balance sheet method, which recognizes the future tax effect of temporary differences between the amounts recorded in our consolidated financial statements and the tax bases of these amounts. Deferred tax assets and deferred tax liabilities are measured using the enacted tax rates that are expected to apply to taxable income in the periods in which the deferred tax asset or deferred tax liability is expected to be realized or settled.
Our provision for income taxes for interim financial periods is based on an estimate of our annual effective tax rate for the full year of 2017 and 2016. When estimating our full year 2017 and 2016 effective tax rates, we adjust our forecasted pre-tax income for gains and losses on our investments, changes in the accounting for uncertainty in income taxes, changes in our beginning of year valuation allowance, and other adjustments. The impact of these items is accounted for as Discrete Items at the applicable federal tax rate.
Included in our restricted cash balances as of December 31, 2017 were: (i) funds for a mortgage insurance reserve policy held in escrow for any future duties, rights and liabilities; (ii) funds held in trust for the benefit of certain policyholders; (iii) escrow funds held for servicer liabilities; and (iv) escrow funds held for title services obligations. Total cash and restricted cash shown in the consolidated statement of cash flows as of December 31, 2017 of $96.2 million comprise cash and restricted cash of $80.6 million and $15.7 million, respectively, as shown on the consolidated balance sheet as of December 31, 2017. Total cash and restricted cash shown in the consolidated statement of cash flows as of December 31, 2016 of $61.8 million comprise cash and restricted cash of $52.1 million and $9.7 million, respectively, as shown on the consolidated balance sheet as of December 31, 2016.
Within our consolidated statements of cash flows, we classify cash receipts and cash payments related to items measured at fair value according to their nature and purpose. Because our investment activity for trading securities relates to overall strategic initiatives and is not trading related, it is recorded as cash flows from investing activities.
Property and equipment is carried at cost, net of depreciation. For financial statement reporting purposes, computer hardware and software is generally depreciated over three or five years and furniture, fixtures and office equipment is depreciated over seven years. Leasehold improvements are depreciated over the lesser of the estimated useful life of the asset improved or the remaining term of the lease. See Note 9 for additional information.
The calculation of the estimated fair value of goodwill and other intangibles is performed primarily using an income approach and requires the use of significant estimates and assumptions that are highly subjective in nature, such as attrition rates, discount rates, future expected cash flows and market conditions. The most significant assumptions relate to the valuation of customer relationships. Our estimates are based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable.
The stock-based compensation cost related to share-based liability awards is based on the fair value as of the measurement date. The compensation cost for equity instruments is measured based on the grant-date fair value at the date of issuance. For share-based awards with performance conditions related to our own operations, the expense recognized is dependent on the probability of the performance measure being achieved. Compensation cost is generally recognized over the periods that an employee provides service in exchange for the award. See Note 15 for further information.
In accordance with the terms of the 2016 Single Premium QSR Transaction, rather than making a cash payment or transferring investments for ceded premiums written, Radian Guaranty holds the related amounts to collateralize the reinsurers’ obligations and has established a corresponding funds withheld liability. Any loss recoveries and any potential profit commission to Radian Guaranty will be realized from this account. The reinsurers’ share of earned premiums is paid from this account on a quarterly basis. This liability also includes an interest credit on funds withheld, which is recorded as ceded premiums at a rate specified in the agreement and, depending on experience under the contract, may be paid to either Radian Guaranty or the reinsurers. Ceded premiums written are recorded on the balance sheet as prepaid reinsurance premiums and amortized to ceded premiums earned in a manner consistent with the recognition of income on direct premiums. The ceding commission received for premiums ceded pursuant to this transaction is attributable to other underwriting costs. The unamortized portion of the ceding commission is reflected in other liabilities. See Note 8 for further discussion of our reinsurance transactions.
In 2015, we had an accelerated share repurchase program that consisted of the combination of the purchase of Radian Group common stock from an investment bank and a forward contract with that investment bank indexed to Radian Group common stock. We accounted for the accelerated share repurchase program in accordance with the provisions of the accounting standards regarding derivatives and hedging for contracts indexed to an entity’s own stock, and the accounting standard regarding equity. The up-front payment to the investment bank as part of the accelerated share repurchase program was accounted for as a reduction to stockholders’ equity in our consolidated balance sheets in the second quarter of 2015, the period in which the payment was made. The shares of Radian Group common stock received were retired, resulting in a decrease in shares issued and outstanding and a corresponding increase in unissued shares in the periods delivered. We reflect the accelerated share repurchase program as a repurchase of common stock in the periods delivered for purposes of calculating earnings per share and as forward contracts indexed to the Company’s own common stock. The accelerated share repurchase program met all of the applicable criteria for equity classification, and therefore, was not accounted for as a derivative instrument.
In March 2016, the FASB issued an update to the accounting standards for share-based payment transactions, including: (i) accounting for income taxes; (ii) classification of excess tax benefits on the statement of cash flows; (iii) forfeitures; (iv) minimum statutory tax withholding requirements; (v) classification of employee taxes paid on the statement of cash flows when an employer withholds shares for tax withholding purposes; (vi) the practical expedient for estimating the expected term; and (vii) intrinsic value. Among other things, the update requires: (i) all excess tax benefits and tax deficiencies to be recognized as income tax expense or benefit in the income statement as they occur; (ii) recognition of excess tax benefits, regardless of whether the benefits reduce taxes payable in the current period; and (iii) excess tax benefits to be classified along with other cash flows as an operating activity, rather than separated from other income tax cash flows as a financing activity. This update is effective for public companies for fiscal years beginning after December 15, 2016. Our adoption of this update, effective January 1, 2017, had an immaterial impact on our financial statements at implementation. As a result of implementing this new standard, however, we expect the potential for limited increased volatility in our effective tax rate and net earnings, and possible additional dilution in earnings per share calculations.
In January 2017, the FASB issued an update to the accounting standard regarding goodwill and other intangibles. This update simplifies the subsequent measurement of goodwill by eliminating step two of the goodwill impairment test. Instead, an entity should perform its annual or interim goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount and recognize an impairment charge for any excess of the reporting unit’s carrying amount over the reporting unit’s estimated fair value, after adjusting the carrying value for any impairment of other intangibles or long-lived assets. The provisions of this update are effective for interim and annual goodwill impairment tests in fiscal years beginning after December 15, 2019, with early adoption permitted for interim or annual goodwill impairment tests performed after January 1, 2017. We elected to early adopt this update to perform the quantitative analysis for our goodwill impairment test as of June 30, 2017. See “-Goodwill and Other Intangible Assets, Net” above and Note 7 for additional information.
In January 2016, the FASB issued an update that makes certain changes to the standard for the accounting of financial instruments. Among other things, the update requires: (i) equity investments to be measured at fair value with changes in fair value recognized in net income (loss); (ii) the use of the exit price notion when measuring the fair value of financial instruments for disclosure purposes; (iii) separate presentation of financial assets and financial liabilities by measurement category and form of financial asset; and (iv) separate presentation in other comprehensive income of the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk (also referred to as “own credit”) when the organization has elected to measure the liability at fair value in accordance with the fair value option for financial instruments. The update also eliminates the requirement to disclose the methods and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet. This update is effective for public companies for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Early adoption is not permitted, with the exception of the “own credit” provision. Our adoption of this update effective January 1, 2018 had an immaterial impact to our financial statements and expected disclosures. As a result of implementing this standard, we expect the potential for increased volatility in earnings.
In February 2016, the FASB issued an update that replaces the existing accounting and disclosure requirements for leases of property, plant and equipment. The update requires lessees to recognize, as of the lease commencement date, assets and liabilities for all leases with lease terms of more than 12 months, which is a change from the current GAAP requirement to recognize only capital leases on the balance sheet. Pursuant to the new standard, the liability initially recognized for the lease obligation is equal to the present value of the lease payments not yet made, discounted over the lease term at the implicit interest rate of the lease, if available, or otherwise at the lessee’s incremental borrowing rate. The lessee is also required to recognize an asset for its right to use the underlying asset for the lease term, based on the liability subject to certain adjustments, such as for initial direct costs. Leases are required to be classified as either operating or finance, with expense on operating leases recorded as a single lease cost on a straight-line basis. For finance leases, interest expense on the lease liability is required to be recognized separately from the straight-line amortization of the right-of-use asset. Quantitative disclosures are required for certain items, including the cost of leases, the weighted-average remaining lease term, the weighted-average discount rate and a maturity analysis of lease liabilities. Additional qualitative disclosures are also required regarding the nature of the leases, such as basis, terms and conditions of: (i) variable interest payments; (ii) extension and termination options; and (iii) residual value guarantees. This update is effective for public companies for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early adoption is permitted. The new standard must be adopted by applying the new guidance as of the beginning of the earliest comparative period presented, using a modified retrospective transition approach with certain optional practical expedients. We are currently evaluating the impact to our financial statements and future disclosures as a result of this update. See Note 13 for additional information.
In June 2016, the FASB issued an update to the accounting standard regarding the measurement of credit losses on financial instruments. This update requires that financial assets measured at their amortized cost basis be presented at the net amount expected to be collected. Credit losses relating to available-for-sale debt securities are to be recorded through an allowance for credit losses, rather than a write-down of the asset, with the amount of the allowance limited to the amount by which fair value is less than amortized cost. This update is effective for public companies for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. Early adoption is permitted for the fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. We are currently evaluating the impact to our financial statements and future disclosures as a result of this update.
In March 2017, the FASB issued an update to the accounting standard regarding receivables. The new standard requires certain premiums on purchased callable debt securities to be amortized to the earliest call date. The amortization period for callable debt securities purchased at a discount will not be impacted. The provisions of this update are effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period. We are currently evaluating the impact to our financial statements and future disclosures as a result of this update.
Management responsibilities for all contract underwriting activities are performed by the Services segment. We include underwriting-related expenses for mortgage insurance, based on a pro-rata volume of mortgage applications excluding third-party contract underwriting services, in our Mortgage Insurance segment’s other operating expenses before corporate allocations. We include underwriting-related expenses for third-party contract underwriting services, based on a pro-rata volume of mortgage applications, in our Services segment’s cost of services and other operating expenses before corporate allocations, as applicable.
We allocate to our Services segment: (i) corporate expenses based on an allocated percentage of time spent on the Services segment and (ii) as noted above, allocated interest expense based on the original amount of debt issued to fund our acquisition of Clayton. No material corporate cash or investments are allocated to the Services segment. Inter-segment activities are recorded at market rates for segment reporting and eliminated in consolidation.
Effective December 31, 2017, we amended the 2016 Single Premium QSR Transaction to increase the amount of ceded risk for performing loans under the agreement from 35% to 65% for the 2015 through 2017 vintages, resulting in a reduction of $145.7 million in net premiums written.
The decrease in total assets for the Services segment at December 31, 2017, as compared to December 31, 2016, is primarily due to the impairment of goodwill and other intangible assets. See Note 7 for further details.
Net of ceded premiums written under the QSR Transactions. See Note 8 for additional information.
Does not include certain other invested assets ($0.3 million), primarily invested in limited partnerships, accounted for as cost-method investments and not measured at fair value. Includes cash collateral held under securities lending agreements ($19.4 million) reinvested in money market instruments.
At December 31, 2016, total Level III assets of $1.0 million accounted for less than 0.1% of total assets measured at fair value. Within other investments is a Level III investment which was purchased during the second quarter of 2016, and there were no related gains or losses recorded during the year ended December 31, 2016. Within equity securities is a Level III investment that was purchased during the second quarter of 2015, and there were no related gains or losses recorded during the year ended December 31, 2016. There were no Level III liabilities at December 31, 2016.
Rollforward activity of Level III assets and liabilities (including realized and unrealized gains and losses, purchases, sales, issuances, settlements and transfers) was immaterial for the years ended December 31, 2017 and 2016.
State and municipal obligations. The fair value of state and municipal obligations is estimated using recent transaction activity, including market observations. Valuation models are used, which incorporate bond structure, yield curve, credit spreads and other factors. These securities are generally categorized in Level II of the fair value hierarchy or in Level III when market-based transaction activity is unavailable.
Equity securities. The fair value of these securities is generally estimated using observable market data in active markets or bid prices from market makers and broker-dealers. Generally, these securities are categorized in Level I or II of the fair value hierarchy, as observable market data are readily available. From time to time, certain equity securities may be categorized in Level III of the fair value hierarchy due to a lack of market-based transaction data or the use of model-based valuations.
Other investments. These securities primarily consist of commercial paper and short-term certificates of deposit, which are categorized in Level II of the fair value hierarchy. Other investments also contains convertible notes of non-reporting issuers, which are categorized in Level III of the fair value hierarchy due to a lack of market-based transaction data.
Includes $14.7 million and $13.2 million of fixed maturities and equity securities, respectively, of securities loaned to third-party Borrowers under securities lending agreements, classified as other assets in our consolidated balance sheets, as further described below.
Primarily consists of investments in Federal Home Loan Bank stock as required in connection with the memberships of Radian Guaranty and Radian Reinsurance in the FHLB.
For securities deemed “available for sale” and that are in an unrealized loss position, the following tables show the gross unrealized losses and fair values, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, as of the dates indicated. Included in the amounts as of December 31, 2017, are loaned securities under securities lending agreements that are classified as other assets in our condensed consolidated balance sheets, as further described below.
For the year ended December 31, 2017, we recorded other-than-temporary impairment losses in earnings of $1.4 million. These losses comprised $0.4 million due to our intent to sell certain corporate bonds at a loss and $1.0 million due to credit deterioration, which included $0.5 million related to a convertible note of a non-public company issuer included in debt securities and $0.5 million related to a privately-placed equity security. For the year ended December 31, 2016, we recognized an other-than-temporary impairment loss in earnings of $0.5 million due to our intent to sell certain corporate bonds at a loss. For the year ended December 31, 2017 there were no credit-related impairment losses recognized in accumulated other comprehensive income (loss). For the years ended December 31, 2016 and 2015, there were no credit-related impairment losses recognized in earnings or in accumulated other comprehensive income (loss).
Includes a de minimis amount of loaned securities under securities lending agreements that are classified as other assets in our consolidated balance sheets, as further described below.
For trading securities held as of December 31 of each respective year, we had net unrealized gains of $8.8 million during 2017, compared to net unrealized gains of $16.8 million during 2016 and net unrealized losses of $25.2 million during 2015.
Key components of our securities lending agreements at December 31, 2017, consisted of the following:
Our securities loaned under securities lending agreements are included at fair value within other assets on our consolidated balance sheets. All of our securities lending agreements are classified as overnight and revolving. None of the amounts are subject to offsetting.
Securities collateral on deposit with us from Borrowers may not be transferred or re-pledged unless the Borrower is in default, and is therefore not reflected in our consolidated financial statements.
All cash collateral received has been reinvested in accordance with the securities lending agreements and is included in short-term investments. Amounts payable on the return of cash collateral under securities lending agreements are included within other liabilities on our consolidated balance sheets.
Net realized gains (losses) on equities available for sale is equal to the gross amount of gains and losses, respectively, realized for those periods.
As of December 31, 2017 and 2016, our investment portfolio included no securities of countries that have obligations that have been under particular stress due to economic uncertainty, potential restructuring and ratings downgrades.
For the years ended December 31, 2017, 2016 and 2015, we did not sell or transfer any fixed-maturity investments classified as held to maturity. For the years ended December 31, 2017, 2016 and 2015, we did not transfer any securities from the available for sale or trading categories.
As of December 31, 2017, we did not have any investment in any person (including affiliates thereof) that exceeded 10% of our total stockholders’ equity.
For purposes of performing our goodwill impairment test, we have concluded that the Services segment constitutes one reporting unit to which all of our recorded goodwill is related. We generally perform our annual goodwill impairment test during the fourth quarter of each year, using balances as of the prior quarter. However, if there are events and circumstances that indicate that it is more likely than not that the fair value of a reporting unit is less than the carrying amount, we will perform a quantitative analysis on an interim basis. As part of our quantitative goodwill impairment assessment, we estimate the fair value of the reporting unit using primarily an income approach and, at a lower weighting, a market approach. The key driver in our fair value analysis is forecasted future cash flows.
We performed an interim goodwill impairment test as of June 30, 2017, due to events and circumstances identified during our June 30, 2017 qualitative analysis that indicated that it was more likely than not that the fair value was less than the carrying amount. We performed our qualitative assessment of goodwill at June 30, 2017, focusing on the impact of certain key factors affecting our Services segment, including: (i) decisions related to changes in the business strategy for our Services segment determined in the second quarter of 2017, following our Chief Executive Officer’s evaluation of both existing products and new product development opportunities and (ii) second quarter 2017 results for our Services segment which were negatively impacted by market trends. Our expectation that these market trends will persist negatively impacted our projected future cash flows compared to the projections used in our prior valuation.
Our Chief Executive Officer joined Radian in March 2017 and initiated a review to evaluate the strategic direction of the Services segment. Based on this strategic review, in the second quarter of 2017, we made several decisions with respect to business strategy for the segment in order to reposition the Services business to drive future growth and profitability. We determined to: (i) discontinue certain initiatives, as discussed below and (ii) shift the strategy of the Services segment to focus on core products and services that, in the current market environment, are expected to have higher growth potential, to produce more predictable, recurring revenue streams over time and to better align with our market expertise and the needs of our customers. Our recent strategic decisions include an intent to scale back or, in certain cases, discontinue certain planned or existing initiatives, such as discontinuing a new product line which, based on a market study received in the second quarter of 2017, would require significant additional investment to achieve the growth rates that had been expected. The impact of the strategic decisions determined during the second quarter resulted in a meaningful reduction in the fair value of the Services segment since the previous annual impairment test.
As of June 30, 2017, we also evaluated the recoverability of our other intangible assets. Factors affecting the estimated fair value of our goodwill, as described above, also affected the estimated recoverability of our other intangible assets. Based on our analysis in the second quarter of 2017, impairment was indicated for the Services segment’s client relationships and technology, related to certain product lines that were affected by the factors above. There was no impairment indicated for the remaining intangible assets, as the remaining carrying amounts were estimated to be recoverable despite the decline in projected earnings.
Client relationships represent the value of the specifically acquired customer relationships and are valued using the excess earnings approach using estimated client revenues, attrition rates, implied royalty rates and discount rates. The excess earnings approach estimates the present value of expected earnings in excess of a traditional return on business assets. For the three months ended June 30, 2017, we recorded an impairment charge of $14.9 million related to the segment’s client relationships, primarily due to the changes in estimated client revenues based on the factors discussed above in “-Impairment Analysis.” The remaining carrying value of client relationships is supported by projected earnings.
For the three months ended June 30, 2017, we also recorded an impairment charge of $0.9 million related to technology, representing the estimated unrecoverable value of a portion of the acquired proprietary software used to provide services in a product line impacted by the factors described above in “-Impairment Analysis.” The remaining carrying value of technology is supported by technology that we expect to continue to use in its current form, in either the same or an alternative capacity.
The following is a summary of the gross and net carrying amounts and accumulated amortization of our other intangible assets as of and for the year to date periods indicated:
For financial reporting purposes, other intangible assets with finite lives will be amortized over their applicable estimated useful lives in a manner that approximates the pattern of expected economic benefit from each intangible asset, as follows:
For the years ended December 31, 2017, 2016 and 2015, amortization expense was $11.8 million, $13.2 million and $13.0 million, respectively. The estimated aggregate amortization expense for 2018 and thereafter is as follows:
35% of its Single Premium NIW from January 1, 2016 to December 31, 2017, subject to a limitation on ceded premiums written equal to $195 million for policies issued between January 1, 2016 and December 31, 2017.
Effective December 31, 2017, we amended the 2016 Single Premium QSR Transaction to increase the amount of ceded risk on performing loans under the agreement from 35% to 65% for the 2015 through 2017 vintages. As of the effective date, the result of this amendment increases the amount of risk ceded on Single Premium Policies, including for the purposes of calculating any future ceding commissions and profit commissions that Radian Guaranty will earn. It will also increase the future amounts of our ceded premiums and ceded losses. RIF ceded under the 2016 Single Premium QSR Transaction was $6.9 billion and $3.8 billion as of December 31, 2017 and 2016, respectively.
In October 2017, we entered into the 2018 Single Premium QSR Transaction with a panel of third-party reinsurers. Under the 2018 Single Premium QSR Transaction, beginning with the business written in January 2018, we expect to cede 65% of our Single Premium NIW, subject to certain conditions and a limitation on ceded premiums written equal to $335 million for policies issued between January 1, 2018 and December 31, 2019. Notwithstanding this limitation, the parties may mutually agree to increase the amount of ceded risk above this level.
Radian Guaranty will receive a 25% ceding commission for premiums ceded pursuant to this transaction. Radian Guaranty will also receive an annual profit commission based on the performance of the loans subject to the agreement, provided that the loss ratio on the subject loans is below 56% for that calendar year. Radian Guaranty may discontinue ceding new policies under the agreement at the end of any calendar quarter.
In the past, we and other companies in the mortgage insurance industry also participated in reinsurance arrangements with mortgage lenders commonly referred to as “captive reinsurance arrangements.” Under captive reinsurance arrangements, a mortgage lender typically established a reinsurance company that assumed part of the risk associated with the portfolio of that lender’s mortgages insured by us on a Flow Basis. In return for the reinsurance company’s assumption of a portion of the risk, we ceded a portion of the mortgage insurance premiums paid to us to the reinsurance company.
During the financial crisis, losses increased significantly and almost all captive reinsurance arrangements attached, thereby requiring our captive reinsurers to make payments to us. The reinsurance recoverable on loss reserves related to captive agreements was $0.3 million at December 31, 2017, compared to $0.4 million as of December 31, 2016.
Property and equipment at cost, less accumulated depreciation of $106.0 million and $118.5 million at December 31, 2017 and 2016, respectively. Depreciation expense was $17.4 million, $11.7 million and $6.7 million for the years ended December 31, 2017, 2016 and 2015 respectively.
Includes $44.0 million and $49.7 million at December 31, 2017 and 2016, respectively, related to our technology upgrade project and $15.5 million at December 31, 2017 of leasehold improvements related to our new corporate headquarters.
We are required to establish a valuation allowance against our deferred tax assets when it is more likely than not that all or some portion of our deferred tax assets will not be realized. At each balance sheet date, we assess our need for a valuation allowance. Our assessment is based on all available evidence, both positive and negative. This requires management to exercise judgment and make assumptions regarding whether our deferred tax assets will be realized in future periods. We have determined that certain non-insurance entities within Radian may continue to generate taxable losses on a separate company basis in the near term and may not be able to fully utilize certain state and local NOLs on their state and local tax returns. Therefore, with respect to deferred tax assets relating to these state and local NOLs and other state timing adjustments, we retained a valuation allowance of $65.0 million at December 31, 2017 and $46.9 million at December 31, 2016.
Our ability to fully use our tax assets such as NOLs and tax credit carryforwards could be limited if we experience an “ownership change” within the meaning of IRC Section 382. IRC Section 382 rules governing when a change in ownership occurs are complex and subject to interpretation; however, in general, an ownership change would occur if any “five-percent shareholders,” as defined under IRC Section 382, collectively increase their ownership by more than 50 percentage points over a rolling three-year period. As of December 31, 2017, we have not experienced an ownership change under IRC Section 382. However, if we were to experience a change in ownership under IRC Section 382 in a future period, then we may be delayed in our ability to utilize our NOL and tax credit carryforwards in future periods.
In 2009, we adopted a Tax Benefit Preservation Plan (the “Plan”), which, as amended, was approved by our stockholders at our 2010, 2013 and 2016 annual meetings. We also adopted certain amendments to our amended and restated bylaws (the “Bylaw Amendment”) and at our 2010, 2013 and 2016 annual meetings, our stockholders approved certain amendments to our amended and restated certificate of incorporation (the “Charter Amendment”). These steps were taken to protect our ability to utilize our NOLs and other tax assets and to attempt to prevent an “ownership change” under U.S. federal income tax rules by discouraging and in most cases restricting certain transfers of our common stock that would: (i) create or result in a person becoming a five-percent shareholder under IRC Section 382 or (ii) increase the stock ownership of any existing five-percent shareholder under IRC Section 382. The continued effectiveness of the Plan, the Bylaw Amendment and the Charter Amendment are subject to periodic examination by Radian Group’s board of directors and the reapproval of the Plan and the Charter Amendment by our stockholders every three years. We currently expect that our tax benefit preservation measures will be terminated no later than 2019.
On December 3, 2014, we petitioned the U.S. Tax Court (“Tax Court”) to litigate the Deficiency Amount. On September 1, 2015, we received a notice that the case had been scheduled for trial. However, the parties jointly filed, and the Tax Court approved, motions for continuance in this matter to postpone the trial date. Also, in February 2016, the Tax Court approved a joint motion to consolidate for trial, briefing and opinion our case with a similar case involving MGIC Investment Corporation. During 2016, we held several meetings with the IRS in an attempt to reach a compromised settlement on the issues presented in our dispute. In October 2017, the parties informed the Tax Court that they believe they have reached agreement in principle on all issues in the dispute. In November 2017, as required by law, the agreement was reported to the JCT for review. The agreement cannot be finalized until the IRS considers the views, if any, expressed by the JCT about the matter. If we are unable to complete a compromised settlement, then the ongoing litigation could take several years to resolve and may result in substantial legal expenses. We can provide no assurance regarding the outcome of any such litigation or whether a compromised settlement with the IRS will ultimately be reached. We currently believe that an adequate provision for income taxes has been made for the potential liabilities that may result from this matter. However, if the ultimate resolution of this matter produces a result that differs materially from our current expectations, there could be a material impact on our effective tax rate, results of operations and cash flows.
As of December 31, 2017, we have $112.3 million of unrecognized tax benefits, including $65.7 million of interest and penalties, that would affect the effective tax rate, if recognized. Our policy for the recognition of interest and penalties associated with uncertain tax positions is to record such items as a component of our income tax provision, of which $2.2 million, $1.8 million and $0.8 million were recorded for the years ended December 31, 2017, 2016 and 2015, respectively.
In previous years, we took a return position in various jurisdictions that we are not required to remit taxes with regard to the income generated from our investment in certain partnership interests. Although we believe that these tax positions are more likely than not to succeed if adjudicated, measurement of the potential amount of liability for state and local taxes and the potential for penalty and interest thereon is performed on a quarterly basis. Our net unrecognized tax benefits related to prior years increased by $22.7 million during 2017. This net increase primarily reflects the impact of unrecognized tax benefits associated with our recognition of certain premium income. Although unrecognized tax benefits for this item decreased by $24.1 million due to the expiration of the applicable statute of limitations for the taxable period ended December 31, 2013, the related amounts continued to impact subsequent years, resulting in a corresponding increase to the unrecognized tax benefits related primarily to the 2014 taxable year.
At December 31, 2016, primarily related to expected payments under the Freddie Mac Agreement. During the third quarter of 2017, the scheduled final settlement date under the Freddie Mac Agreement occurred and therefore, except for loans with loss mitigation and claims activity already in process, most of the loans subject to the Freddie Mac Agreement were removed from RIF and IIF because the insurance no longer remains in force. See “-Agreements-Freddie Mac Agreement,” below for additional information.
Related to ceded losses recoverable, if any, on captive reinsurance transactions, the QSR Transactions and the 2016 Single Premium QSR Transaction. See Note 8 for additional information.
During the third quarter of 2017, Hurricanes Harvey and Irma caused extensive property damage to areas of Texas, Florida and Georgia, as well as other general disruptions including power outages and flooding. At December 31, 2017, our total primary mortgage insurance exposure to mortgages in counties affected by these storms and subsequently designated as FEMA Designated Areas is approximately $4.6 billion of RIF on approximately $17.4 billion of IIF. This exposure represents approximately 9% of our primary mortgage insurance RIF as of December 31, 2017. Although the mortgage insurance we write protects the lenders from a portion of losses resulting from loan defaults, it does not provide protection against property loss or physical damage. Our Master Policies contain an exclusion against physical damage, including damage caused by floods or other natural disasters. Depending on the policy form and circumstances, we may, among other things, deduct the cost to repair or remedy physical damage above a de minimis amount from a claim payment and/or, under certain circumstances, deny a claim where (i) the property underlying a mortgage in default is subject to unrestored physical damage or (ii) the physical damage is deemed to be the principal cause of default. While we observed an increase in new primary defaults from FEMA Designated Areas associated with Hurricanes Harvey and Irma following those two natural disasters, we expect most of these to cure within the next 12 months, and at rates higher than our general population of defaults. We therefore assigned a 3% Default to Claim Rate assumption to the new primary defaults from FEMA Designated Areas associated with Hurricanes Harvey and Irma that were reported subsequent to those two natural disasters. These incremental defaults did not have a material impact on our provision for losses as of December 31, 2017. However, the future reserve impact may be affected by various factors, including the pace of economic recovery in the FEMA Designated Areas.
Total claims paid decreased for 2017, compared to 2016, consistent with the ongoing decline in outstanding default inventory, partially offset by payments that, as expected, were made in connection with the final settlement of the Freddie Mac Agreement in the third quarter of 2017. See “-Agreements-Freddie Mac Agreement” below for additional information.
Although our estimates of future Loss Mitigation Activities have been declining, they remain elevated compared to levels experienced before 2009. The elevated levels of our rate of Rescissions, Claim Denials and Claim Curtailments have significantly reduced our paid losses and have resulted in a reduction in our loss reserve. Our estimate of net future Loss Mitigation Activities reduced our loss reserve as of December 31, 2017 and 2016 by approximately $21 million and $39 million, respectively. The amount of estimated Loss Mitigation Activities incorporated into our reserve analysis at any point in time is affected by a number of factors, including not only our estimated rate of Rescissions, Claim Denials and Claim Curtailments on future claims, but also the volume and attributes of our defaulted insured loans, our estimated Default to Claim Rate and our estimated Claim Severity, among other assumptions.
Our reported Rescission, Claim Denial and Claim Curtailment activity in any given period is subject to challenge by our lender and servicer customers. We expect that a portion of previous Rescissions will be reinstated and previous Claim Denials will be resubmitted with the required documentation and ultimately paid; therefore, we have incorporated this expectation into our IBNR reserve estimate. Our IBNR reserve estimate of $10.4 million and $14.3 million at December 31, 2017 and 2016, respectively, includes reserves for this activity.
We considered the sensitivity of first-lien loss reserve estimates at December 31, 2017 by assessing the potential changes resulting from a parallel shift in Claim Severity and Default to Claim Rate estimates for primary loans. For example, assuming all other factors remain constant, for every one percentage point change in primary Claim Severity (which we estimate to be 97.6% of risk exposure at December 31, 2017), we estimated that our loss reserves would change by approximately $4.8 million at December 31, 2017. Assuming all other factors remain constant, for every one percentage point change in our overall primary net Default to Claim Rate (which we estimate to be 31% at December 31, 2017, including our assumptions related to Rescissions and Claim Denials), we estimated a $14.2 million change in our loss reserves at December 31, 2017.
On September 16, 2014, Radian Guaranty entered into the BofA Settlement Agreement in order to resolve various actual and potential claims or disputes related to the parties’ respective rights and duties as to mortgage insurance coverage on the specific population of loans covered by the agreement. Implementation of the BofA Settlement Agreement commenced on February 1, 2015 and cash payments under the BofA Settlement Agreement were effectively completed by December 31, 2015.
The following is supplementary information about average historical claims duration as of December 31, 2017, representing the average distribution of when claims are paid relative to the year of default:
Repurchases of Senior Notes due 2019, 2020 and 2021. During the third quarter of 2017, pursuant to cash tender offers, we purchased aggregate principal amounts of $141.4 million, $115.9 million and $152.3 million of our Senior Notes due 2019, 2020 and 2021, respectively. We funded the purchases with $450.8 million in cash (plus accrued and unpaid interest due on the purchased notes). These purchases resulted in a loss on induced conversion and debt extinguishment of $45.8 million. At December 31, 2017, the remaining principal amounts of our outstanding Senior Notes due 2019, 2020 and 2021 were $158.6 million, $234.1 million and $197.7 million, respectively.
Repurchases of Convertible Senior Notes due 2017. During the second quarter of 2017, we purchased an aggregate principal amount of $21.6 million of our outstanding Convertible Senior Notes due 2017. We funded the purchases with $31.6 million in cash (plus accrued and unpaid interest due on the purchased notes). These purchases of Convertible Senior Notes due 2017 resulted in a loss on induced conversion and debt extinguishment of $1.2 million.
Conversion of Convertible Senior Notes due 2019. In November 2016, we announced our intent to exercise our redemption option for the remaining $68.0 million aggregate principal amount of our Convertible Senior Notes due 2019. As a result of the average closing price of our common stock exceeding the conversion price of $10.60 prior to the redemption date, all of the holders of these notes elected to exercise their conversion rights. Radian elected to settle all of the notes surrendered for conversion with cash. We settled our obligations with respect to these conversions on January 27, 2017, with a cash payment of $110.1 million. At the time of settlement, this transaction resulted in a pretax charge of $4.5 million, representing the difference between the fair value and the carrying value, net of unamortized issuance costs, of the liability component of the Convertible Senior Notes due 2019. This transaction also resulted in an aggregate decrease as of the settlement date of 6.4 million diluted shares for the purposes of determining diluted net income per share.
Repurchases of Convertible Senior Notes due 2017 and 2019. During 2016, we entered into privately negotiated agreements to purchase, for cash or a combination of cash and shares of Radian Group common stock, aggregate principal amounts of $30.1 million and $322.0 million, respectively, of our outstanding Convertible Senior Notes due 2017 and 2019. We funded the purchases with $235.0 million in cash (plus accrued and unpaid interest due on the purchased notes) and by issuing to certain of the sellers 17.0 million shares of Radian Group common stock. These purchases of Convertible Senior Notes due 2017 and 2019 resulted in a pretax charge of $60.1 million. This loss represents:
the $41.8 million market premium representing the excess of the fair value of the total consideration delivered to the sellers of the Convertible Senior Notes due 2017 and 2019 over the fair value of the common stock issuable pursuant to the original conversion terms of the purchased notes;
the $17.2 million difference between the fair value and the carrying value, net of unamortized issuance costs, of the liability component of the purchased notes; and
Repurchase of Convertible Senior Notes due 2017. In June 2015, we entered into privately negotiated agreements with certain holders of our Convertible Senior Notes due 2017 to purchase an aggregate principal amount of $389.1 million of our outstanding Convertible Senior Notes due 2017 for a combination of cash and shares of Radian Group common stock. We funded the purchases with $126.8 million in cash (plus accrued and unpaid interest due on the purchased notes) and by issuing to the sellers 28.4 million shares of Radian Group common stock. These purchases of Convertible Senior Notes due 2017 resulted in a pretax charge of $91.9 million.
Senior Notes due 2021. In March 2016, we issued $350 million aggregate principal amount of Senior Notes due 2021 and received net proceeds of $343.4 million. These notes mature on March 15, 2021 and bear interest at a rate of 7.000% per annum, payable semi-annually on March 15 and September 15 of each year, commencing on September 15, 2016.
Redemption Terms in Senior Notes. We have the option to redeem the Senior Notes due 2019, 2020, 2021 and 2024 in whole or in part, at any time or from time to time prior to maturity, at a redemption price equal to the greater of: (i) 100% of the aggregate principal amount of the notes to be redeemed or (ii) a “make-whole amount,” which is the sum of the present values of the remaining scheduled payments of principal and interest (excluding any portion of interest accrued to the redemption date) in respect of the notes to be redeemed, discounted to the redemption date at the applicable treasury rate plus 50 basis points, plus, in each case, accrued and unpaid interest thereon to, but excluding, the redemption date.
Covenants in Senior Notes. The Senior Notes due 2019, 2020, 2021 and 2024 have covenants customary for securities of this nature, including covenants related to the payments of the notes, reports, compliance certificates and modification of the covenants. Additionally, the applicable indentures include covenants restricting us from encumbering the capital stock of a designated subsidiary (as defined in the respective indentures for the notes) or disposing of any capital stock of any designated subsidiary unless either all of the stock is disposed of or we retain more than 80% of the stock.
Included within long-term debt and is being amortized over the life of the convertible notes.
As described in Note 10, on September 4, 2014 we received formal Notices of Deficiency from the IRS related to certain losses and deductions resulting from our investment in a portfolio of non-economic REMIC residual interests. We believe that an adequate provision for income taxes has been made for the potential liabilities that may result from this matter. However, if the ultimate resolution of this matter produces a result that differs materially from our current expectations, there could be a material impact on our effective tax rate, results of operations and cash flows.
On December 22, 2016, Ocwen Loan Servicing, LLC and Homeward Residential, Inc. (collectively, “Ocwen”) filed a complaint against Radian Guaranty (the “Complaint”). Ocwen has also initiated legal proceedings against several other mortgage insurers. The action filed against Radian Guaranty, titled Ocwen, et al. v. Radian Guaranty, is pending in the U.S. District Court for the Eastern District of Pennsylvania (the “Court”). The Complaint alleged breach of contract and bad faith claims and sought monetary damages and declaratory relief regarding certain claims handling practices on future insurance claims. On December 17, 2016, Ocwen separately filed a parallel arbitration petition against Radian Guaranty (the “Petition”) before the American Arbitration Association (“AAA”) asserting substantially the same allegations as in the Complaint (the Complaint and the Petition are collectively referred to as the “Filings”). The Filings listed 9,420 mortgage insurance certificates (“Certificates”) issued under multiple insurance policies, including Pool Insurance Policies, as subject to the dispute. On March 3, 2017, Radian Guaranty filed with the Court: (i) a motion to dismiss Ocwen’s Complaint or, in the alternative, for a more definite statement and (ii) a motion to enjoin Ocwen’s parallel arbitration. On June 5, 2017, Ocwen filed an Amended Complaint and an Amended Petition (collectively, the “Amended Filings”) with the Court and the AAA, respectively, together listing 8,870 Certificates as subject to the dispute. In December 2017 and January 2018, Ocwen and Radian Guaranty filed motions for partial summary judgment in connection with a small number of bellwether certificates selected from the Certificates subject to the Court proceedings (“Bellwether Certificates”). On February 1, 2018, the Court issued an Order and Memorandum decision granting in part and denying in part both parties’ motions for partial summary judgment, and ordering the parties to proceed to trial on certain claims regarding a portion of the Bellwether Certificates. The trial regarding a portion of the Bellwether Certificates is currently scheduled to start in April 2018. Radian Guaranty believes that Ocwen’s allegations and claims in the legal proceedings described above are without merit and legally deficient, and plans to defend these claims vigorously. We are not able to estimate a reasonably possible loss, if any, or range of loss in this matter because of the preliminary stage of the proceedings.
We also are periodically subject to reviews and audits, as well as inquiries, information-gathering requests and investigations. In connection with these matters, from time to time we receive requests and subpoenas seeking information and documents related to aspects of our business. In March 2017, Green River Capital, a subsidiary of Clayton, received a letter from the staff of the SEC stating that it is conducting an investigation captioned, “In the Matter of Certain Single Family Rental Securitizations,” and that it is requesting information from market participants. The letter requested that Green River Capital provide information regarding broker price opinions that Green River Capital provided on properties included in single family rental securitization transactions. Green River Capital is cooperating with the SEC.
Further, there are loans in our total defaulted portfolio (in particular, our older defaulted portfolio) for which actions or proceedings (such as foreclosure that provide the insured with title to the property) may not have been commenced within the outermost deadline in our Prior Master Policy. We are evaluating these loans regarding this potential violation and our corresponding rights under the Prior Master Policy. While we can provide no assurance regarding the ultimate resolution of these issues, it is possible that arbitration or legal proceedings could result.
We provide contract underwriting as an outsourced service to our customers. Under our current contract underwriting program the remedy we offer is limited indemnification to our contract underwriting customers only with respect to those loans that we simultaneously underwrite for both secondary market compliance and for potential mortgage insurance eligibility. In 2017, payments for losses related to contract underwriting remedies were de minimis. In 2017, our provision for contract underwriting expenses was de minimis and our reserve for contract underwriting obligations at December 31, 2017 was $0.5 million. We monitor this risk and negotiate our underwriting fee structure and recourse agreements on a client-by-client basis. We also routinely audit the performance of our contract underwriters.
We lease office space for use in our operations. The lease agreements, which expire periodically through August 2032, contain provisions for scheduled periodic rent increases. Net rental expense in connection with these leases totaled $5.7 million in 2017, $5.0 million in 2016 and $5.0 million in 2015, excluding the net rental expense related to discontinued operations. The commitment for non-cancelable operating leases in future years is as follows:
On August 9, 2017, Radian Group’s board of directors renewed its share repurchase program and authorized the Company to spend up to $50 million to repurchase Radian Group common stock in the open market or in privately negotiated transactions, based on market and business conditions, stock price and other factors. Radian has established a trading plan under Rule 10b5-1 of the Exchange Act to implement the program. As of December 31, 2017, no shares had been purchased and therefore the full purchase authority of up to $50 million remained available under this program, which expires on July 31, 2018.
On June 18, 2015, we authorized an accelerated share repurchase program to repurchase an aggregate of $202 million of Radian Group common stock. Under the accelerated share repurchase program, the total number of shares ultimately delivered to Radian Group was based on the average of the daily volume-weighted-average price of Radian Group common stock during the term of the transaction, less a negotiated discount and subject to certain other adjustments pursuant to the terms and conditions of the program. During the three-month period ended June 30, 2015, 9.2 million shares were repurchased under this program. The counterparty delivered to Radian Group 1.8 million additional shares of Radian Group common stock at final settlement of the accelerated share repurchase program in August 2015, based on the calculated price of $18.32 during the term of the transaction. The shares of Radian Group common stock received pursuant to the accelerated share repurchase and the termination of the capped call transactions were retired, resulting in a decrease in shares issued and outstanding and a corresponding increase in unissued shares. All share repurchases pursuant to the accelerated share repurchase program were funded in the second quarter of 2015 from the proceeds of the Senior Notes due 2020.
The Amended and Restated Equity Compensation Plan authorizes the issuance of up to 8,954,109 shares, plus such number of shares of common stock subject to awards outstanding under the Amended and Restated Equity Compensation Plan and the 2008 Equity Plan that subsequently terminate, expire or are cancelled and become available for issuance under the Amended and Restated Equity Compensation Plan (“Prior Plan Shares”). There were 8,851,531 shares available for grant under the Amended and Restated Equity Compensation Plan as of December 31, 2017 (the “share reserve”), which includes Prior Plan Shares. Each grant of restricted stock, RSUs, or performance share awards under the Amended and Restated Equity Compensation Plan (other than those settled in cash) reduces the share reserve available for grant under the Amended and Restated Equity Compensation Plan by 1.31 shares for every share subject to such grant. Absent this share reserve adjustment for outstanding restricted stock, RSUs, phantom stock or performance share awards, our shares remaining available for grant under the Amended and Restated Equity Compensation Plan would have been 11,691,367 shares as of December 31, 2017. Awards under the Amended and Restated Equity Compensation Plan that provide for settlement solely in cash (and not common shares) do not count against the share reserve.
Most awards vest at the end of the performance or service period. In the event of a grantee’s death or disability, awards generally vest immediately. Upon retirement, awards generally vest immediately or at the end of the performance period, if any. Awards granted under the Equity Plans to officers provide for “double trigger” vesting in the event of a change of control, meaning that awards will vest in connection with a change of control only in the event the grantee’s employment is terminated by us without cause or the grantee terminates employment for “good reason,” in each case within 90 days before or one year after the change of control. In the event of a hypothetical change of control as of December 31, 2017, we estimate that the vesting of awards, assuming for purposes of this hypothetical that “double trigger” vesting occurred, would have resulted in a pretax accounting charge to us of approximately $10.2 million, representing the acceleration of compensation expense.
Depending on certain characteristics of the awards granted under the various Equity Plans noted above, they are accounted for as either liabilities or equity instruments. The following table summarizes awards outstanding and compensation expense recognized for each type of share-based award as of and for the years ended:
Performance-Based RSUs- In 2012, a total of 2,211,640 performance-based RSUs (to be settled in cash) were granted to eligible officers under the 2008 Equity Plan. These performance-based RSUs entitled grantees to a cash amount equal to the fair market value of RSUs that vested at the end of a three-year performance period in 2015. Vesting of awards granted to both non-executives and executives in 2012 was dependent upon the performance of Radian Group’s total stockholder return (“TSR”) relative to the TSR of a performance peer group. Based on performance during the three-year performance period, grantees were entitled to a maximum payout of 200% of their target number of RSUs.
Performance-Based RSUs-In 2017, 2016 and 2015, executive and non-executive officers were granted a total of 456,510; 701,110; and 499,740; respectively, of performance-based RSUs to be settled in common stock. The maximum payout at the end of the three-year performance period is 200% of a grantee’s target number of RSUs. The maximum payout for awards based on the TSR Measures described below is generally subject to a maximum cap of six times the value of the grantee’s award on the grant date.
The vesting of approximately 50% of the target performance-based RSUs granted to each executive officer in 2017 and 2016 is dependent upon (i) Radian Group’s TSR compared to the median TSR of a designated peer group of companies as of the date of grant (the “Relative TSR Measure”) and (ii) Radian Group’s absolute TSR (“Absolute TSR Measure,” and together with the Relative TSR Measure, the “TSR Measures”), in each case measured over a three-year performance period and subject to certain conditions. The remaining 50% of each executive officer’s target award will vest based on the cumulative growth in Radian’s book value per share, adjusted for certain defined items, over a three-year performance period. The vesting of performance-based RSUs granted to non-executives in 2017 is the same as described above for executive officers. The vesting of performance-based RSUs granted to non-executives in 2016 is entirely based on the TSR Measures described above and does not include a book value measure.
The grant date fair value of the performance-based RSUs that are based on the cumulative growth in Radian’s book value per share is calculated based on the stock price as of the grant date, discounted for the lack of dividends earned over the vesting period and the one-year post-vesting holding period, as applicable. The compensation cost that is recognized over the remaining requisite service period is based on our expectations of the probable level of achievement of the performance condition.
The time-vested RSU awards granted in 2017 are scheduled to vest in: (i) pro rata installments on each of the first three anniversaries of the grant date or (ii) generally at the end of three years.
The grant date fair value of time-vested RSUs was calculated based on the closing price of our common stock on the New York Stock Exchange on the date of grant, discounted for the lack of dividends earned over the vesting period, and is recognized as compensation expense over the service period.
The following table summarizes information concerning outstanding and exercisable options at December 31, 2017:
We elected to apply the short-cut method, under the accounting standard regarding share-based payment, to account for the windfall tax benefits that may result from the exercise of stock options. Effective January 1, 2017, upon the implementation of the update to the accounting standard regarding stock-based compensation, windfalls and shortfalls resulting from cancellations, expirations or exercises of stock options are reflected in the consolidated statements of operations as part of our income tax provision, as they occur. See Note 2.
We have an Employee Stock Purchase Plan, the 2008 ESPP, under which 2,000,000 shares of our authorized but unissued common stock initially were reserved for issuance. Under the 2008 ESPP, we issued 105,476; 151,121; and 94,676 shares to employees during the years ended December 31, 2017, 2016 and 2015, respectively. In January 2018, we issued 52,464 shares from the shares available for issuance under our 2008 ESPP. As a result, 850,004 shares currently remain available for issuance under the 2008 ESPP.
The following assumptions were used in our calculation of Employee Stock Purchase Plan compensation expense during 2017:
The Radian Group Inc. Savings Incentive Plan (“Savings Plan”) covers substantially all of our full-time and our part-time employees. Participants can contribute up to 100% of their base earnings as pretax and/or after-tax (Roth IRA) contributions up to a maximum amount of $18,000 for 2017. The Savings Plan also includes a catch-up contribution provision whereby participants who are or will be age 50 and above during the Savings Plan year may contribute an additional contribution. The maximum catch-up contribution for the Savings Plan in 2017 was $6,000. Effective January 1, 2016, we match up to 100% of the first 4.5% of base earnings contributed in any given year. Previously, the match was up to 100% of the first 6% of annual base earnings exclusive of Clayton, which had its own employee match of 25% of the first 6% of base earnings contributed in any given year. Beginning January 1, 2016, Clayton was merged into the Savings Plan. Our expense for matching funds for the years ended December 31, 2017, 2016 and 2015 was $4.8 million, $4.9 million and $3.1 million, respectively.
We contributed immaterial amounts to other postretirement benefit plans in 2017.
Included in restructuring and other exit costs on our consolidated statements of operations.
Represents the recognition of investment gains included in income from discontinued operations, net of tax, as a result of the completion of the sale of Radian Asset Assurance on April 1, 2015. Previously, pursuant to accounting standards, such investment gains had been deferred and recorded in accumulated other comprehensive income (loss).
Radian Asset Assurance, Radian Group’s former financial guaranty subsidiary, was accounted for as a discontinued operation as of December 31, 2014, based on the applicable terms of the Radian Asset Assurance Stock Purchase Agreement. Pursuant to the agreement, on April 1, 2015, Radian Guaranty completed the sale of 100% of the issued and outstanding shares of Radian Asset Assurance for a purchase price of approximately $810 million. After closing costs and other adjustments, Radian Guaranty received net proceeds of $789 million.
We prepare our statutory financial statements in accordance with the accounting practices required or permitted, if applicable, by the insurance departments of the respective states of domicile of our insurance subsidiaries. Required SAPP are established by a variety of NAIC publications, as well as state laws, regulations and general administrative rules. In addition, insurance departments have the right to permit other specific practices that may deviate from prescribed practices. As of December 31, 2017, we did not have any prescribed or permitted statutory accounting practices that resulted in reported statutory surplus or risk-based capital being different from what would have been reported had NAIC statutory accounting practices been followed.
Radian Group serves as the holding company for our insurance subsidiaries, through which we conduct our mortgage insurance business. These insurance subsidiaries are subject to comprehensive, detailed regulation by the insurance departments in the various states where our insurance subsidiaries are domiciled or licensed to transact business. Insurance laws vary from state to state, but generally grant broad supervisory powers to state agencies or officials to examine insurance companies and enforce rules or exercise discretion affecting almost every significant aspect of the insurance business, including the power to revoke or restrict an insurance company’s ability to write new business. The state insurance regulations include various capital requirements and dividend restrictions based on our insurance subsidiaries’ statutory financial position and results of operations, as described below. Our failure to maintain adequate levels of capital could lead to intervention by the various insurance regulatory authorities, which could materially and adversely affect our business, business prospects and financial condition. As of December 31, 2017, the amount of restricted net assets held by our consolidated insurance subsidiaries (which represents our equity investment in those insurance subsidiaries) totaled $3.6 billion of our consolidated net assets.
On March 31, 2017, we reallocated $175 million of capital, in the form of cash and marketable securities, from Radian Guaranty to Radian Reinsurance. The reallocation was accomplished by way of an Extraordinary Dividend, approved by the Pennsylvania Department of Insurance, from Radian Guaranty to Radian Group, and a simultaneous capital contribution from Radian Group to Radian Reinsurance in the same amount. These transactions resulted in a $175 million decrease in Radian Guaranty’s statutory policyholders’ surplus (i.e., statutory capital and surplus) and a corresponding increase in Radian Reinsurance’s statutory policyholders’ surplus. Until September 30, 2017, the reallocation of capital had no impact on Radian Guaranty’s Available Assets under the PMIERs, because Radian Reinsurance was considered an exclusive affiliated reinsurer of Radian Guaranty and, as such, Radian Guaranty’s Available Assets and Minimum Required Assets were determined on an aggregate basis, taking into account the assets and insured risk of Radian Guaranty and any exclusive affiliated reinsurers. However, effective in the third quarter of 2017, Radian Reinsurance is no longer considered an exclusive affiliated reinsurer of Radian Guaranty, due to its participation in the credit risk transfer programs with Fannie Mae and Freddie Mac. Although this change impacted Radian Guaranty’s Available Assets and Minimum Required Assets under the PMIERs, it did not affect Radian Guaranty’s compliance with the PMIERs financial requirements.
Radian Guaranty was in compliance with the Statutory RBC Requirements or MPP Requirements, as applicable, in each of the RBC States as of December 31, 2017. The NAIC is in the process of developing a new Model Act for mortgage insurers, which is expected to include, among other items, new capital adequacy requirements for mortgage insurers. In May 2016, a working group of state regulators released an exposure draft of a risk-based capital framework to establish capital requirements for mortgage insurers. While the outcome and timing of this process are uncertain, the new Model Act, if and when finalized by the NAIC, has the potential to increase capital requirements in those states that adopt the Model Act. However, we continue to believe the changes to the Model Act will not result in financial requirements that require greater capital than the level currently required under the PMIERs financial requirements. See Note 1 for information regarding the PMIERs, which set requirements for private mortgage insurers to remain eligible insurers of loans purchased by the GSEs.
Radian Guaranty’s statutory net income, statutory policyholders’ surplus and contingency reserve as of or for the years ended December 31, 2017, 2016 and 2015 were as follows:
Effective December 2015, Radian Reinsurance is domiciled and licensed in Pennsylvania as a stock casualty insurance company authorized to carry on the business of credit insurance, which includes the authority to reinsure policies of mortgage guaranty insurance. Radian Reinsurance is only licensed or authorized to write direct mortgage guaranty insurance in Pennsylvania. Radian Reinsurance is required to maintain a minimum statutory surplus of $20 million to remain an authorized reinsurer in all states. As discussed above, Radian Reinsurance received capital contributions from Radian Group of $175 million during the year ended December 31, 2017.
Radian Reinsurance’s statutory net income, statutory policyholders’ surplus and contingency reserve as of and for the years ended December 31, 2017 and 2016 were as follows:
The Risk-to-capital ratio for our combined mortgage insurance operations was 12.1 to 1 as of December 31, 2017, compared to 13.6 to 1 as of December 31, 2016. In addition to Radian Guaranty and Radian Reinsurance, this combined ratio also includes Radian Guaranty Reinsurance, Radian Mortgage Assurance, Radian Investor Surety Inc., Radian Insurance, Radian Mortgage Insurance, and Radian Mortgage Guaranty Inc. Radian Insurance is the only entity that had any remaining RIF as of December 31, 2017, totaling $24.1 million. The aggregate statutory net income, statutory policyholders’ surplus and contingency reserve for these six subsidiaries as of and for the years ended December 31, 2017, 2016 and 2015 were as follows:
During 2015, Radian Mortgage Guaranty Inc. was newly established as a mortgage guaranty insurer domiciled in Pennsylvania, and received capital contributions from Radian Group totaling $20 million.
Under SAPP, income tax expense is calculated on the basis of amounts currently payable. Generally, deferred tax assets are recognized under both SAPP and GAAP when it is more likely than not that the deferred tax asset will be realized. However, SAPP standards impose additional admissibility requirements whereby deferred tax assets are only recognized to the extent they are expected to be recovered within a one- to three-year period subject to a capital and surplus limitation. Changes in deferred tax assets and deferred tax liabilities are recognized as a direct benefit or charge to unassigned surplus, whereas under GAAP changes in deferred tax assets and deferred tax liabilities, except for changes in unrealized gains and losses on available-for-sale securities, are recorded as a component of income tax expense.
Diluted net income per share is computed independently for each period presented. Consequently, the sum of the quarters may not equal the total net income per share for the year. For all calculations, the determination of whether potential common shares are dilutive or anti-dilutive is based on net income.