121,093 square feet of office space for our financial guaranty operations in New York City. The lease for this space expires in 2015. We occupy 40,553 square feet of this space and sublease 80,540 square feet, including 36,140 square feet to C-BASS, 3,847 square feet to Sherman, and 40,553 square feet to Akerman Senterfitt LLP. C-BASS currently is engaged in bankruptcy proceedings. As a result, we are exploring alternative possibilities for this sublease in the event C-BASS decides not to continue in the space.
Approximately 500 square feet of office space for our mortgage insurance operations in Hong Kong. The lease for this space expires on January 31, 2012.
We currently have an agreement with DBSI Inc., to provide a production and disaster recovery location. This agreement expires May 30, 2015.
We cannot be certain that we will be able to obtain satisfactory lease renewal terms for our operations, as necessary. We believe our existing properties are well utilized, suitable and adequate for our present circumstances.
(2) Calculated using amounts determined under GAAP, using provision for losses to calculate the loss ratio and policy acquisition costs and other operating expenses, excluding merger expenses, to calculate the expense ratio as a percentage of net premiums earned. The 2008 expense ratio for our mortgage insurance segment includes the write-off of $50.8 million of deferred policy acquisition costs as a result of the establishment of a first-lien premium deficiency reserve. The financial guaranty expense ratio increased in the last three years due to our discontinuation of new business writings in 2008 and the recaptures of reinsurance business by certain of our primary reinsurance customers noted in (4) below.
(4) Reflects the recaptures of reinsurance business by certain of our financial guaranty ceding companies in 2008 and 2009.
Our financial guaranty segment has mainly provided direct insurance and reinsurance on credit-based risks through Radian Asset Assurance Inc. (“Radian Asset Assurance”), a wholly-owned subsidiary of Radian Guaranty. In the past, we also wrote financial guaranty business internationally through Radian Asset Assurance Limited (“RAAL”), an insurance company licensed in the United Kingdom and a subsidiary of Radian Asset Assurance. All of our exposure written through RAAL has been novated to Radian Asset Assurance or commuted, and we placed RAAL into liquidation in 2010. We expect the liquidation of RAAL to be completed during 2011.
Reinsurance-Reinsurance of domestic and international public finance obligations, including those issued by sovereign and sub-sovereign entities, and structured finance obligations.
In 2008, in light of market conditions and the downgrade of the financial strength ratings of our financial guaranty insurance subsidiaries, we discontinued writing any new financial guaranty business, including accepting new financial guaranty reinsurance, other than as necessary to commute, restructure, hedge or otherwise mitigate losses or reduce exposure in our existing portfolio. Following this decision, we reduced our financial guaranty operations, including a significant reduction in our financial guaranty workforce. Since 2008, we have also reduced our financial guaranty exposures through commutations in order to eliminate uncertainty, maximize the ultimate capital available for our mortgage insurance business and accelerate the potential access to that capital.
Assurance Corporation (the “FG Insurance Shell”), a New York domiciled financial guaranty insurance company that has not written any business, but has obtained licenses to do so in 36 states and the District of Columbia. The acquisition, which remains subject to regulatory approval, provides Radian Asset Assurance with the flexibility to consider using the FG Insurance Shell to pursue strategic alternatives in the public finance market, including possibly partnering with third-party investors to write new public finance insurance and/or reinsuring all or a portion of Radian Asset Assurance’s existing public finance business. We are in the early stages of exploring these potential uses, and expect that any new initiative for the FG Insurance Shell would be consistent with our ultimate goal of reducing our financial guaranty exposure. The expected purchase price of approximately $82 million is $7 million above the value of the statutory capital base of the FG Insurance Shell, consisting of approximately $75 million of cash, cash equivalents and treasury securities.
Financial Guaranty Exposure Subject to Recapture or Termination. As a result of multiple ratings downgrades of Radian Asset Assurance, approximately $57.9 billion of our total net par outstanding as of December 31, 2010 (representing 73.5% of financial guaranty’s total net par outstanding), remains subject to recapture or termination at the option of our primary reinsurance customers and credit derivative counterparties.
Historically, C-BASS operated as a mortgage investment and servicing company specializing in the credit risk of subprime single-family residential mortgages. As a result of the disruption in the subprime mortgage market during 2007, C-BASS ceased purchasing mortgages and mortgage securities and its securitization activities in the third quarter of 2007 and sold its loan-servicing platform in the fourth quarter of 2007. We recorded a full write off of our equity interest in C-BASS in the third quarter of 2007 and wrote off a $50 million credit facility with C-BASS in the fourth quarter of 2007.
Provision for Losses. Our mortgage insurance provision for losses was $1,730.8 million for 2010. Our loss provision for 2010 was positively impacted by a decrease in new default notices received during 2010 compared to 2009. This impact was offset, however, by an increase in the rate at which defaults move to claim (“default to claim rate”), an increase in the expected payment amount (“severity”) of expected pool insurance claims and the breach of subordination levels for certain pool insurance structured transactions in which we are in a second loss position. The severity of pool insurance claims has increased significantly in 2010, and is reflected by first-lien reserves per pool default increasing to $24,911 per pool loan at December 31, 2010, from $16,118 at December 31, 2009. See “Risk Factors-A large portion of our mortgage insurance risk in force consists of higher risk loans, such as high-LTV and non-prime loans, as well as pool mortgage insurance.” While there has been continued slowing in the rate at which later stage defaults become submitted claims, the estimated default to claim rate increased slightly during 2010, mainly due to the aging of our default inventory and a decrease in our estimate of future insurance rescission and claim denials.
Claims paid. Total mortgage insurance claims paid in 2010 were $1,258.0 million. Claims paid for 2010 included a net reduction of $90.4 million related to the net impact of recoveries from the termination of captive reinsurance transactions and payments made in connection with the termination
New Insurance Written. We wrote $11.6 billion of primary mortgage insurance during 2010, representing a decrease of 31.9% compared to primary mortgage insurance written in 2009. This decrease is mainly the result of an overall smaller mortgage market, increased competition from the Federal Housing Administration (“FHA”), which is currently insuring 80.2% of the total insured mortgage market (significantly more than before the recent economic downturn), our more restrictive underwriting guidelines and the limited secondary market for mortgage securitizations (other than the GSEs). We have been more aggressively marketing our product offerings that favorably compete with the FHA prices in order to gain market share back from the FHA. While the private mortgage insurance industry has made some progress in recapturing business from the FHA in 2010, including as a result of the FHA’s raising pricing in 2010, the FHA’s market share remains historically high, and this competition, in conjunction with the other factors identified above, is likely to continue to negatively affect the volume of our new insurance written.
Starting in 2008, we implemented a series of changes to our underwriting guidelines aimed at improving the long-term risk profile and profitability of our business. As a result of these changes, the credit profile of our mortgage insurance portfolio has improved. For 2010 and 2009, almost all of our new business production was categorized as prime business. In addition, Fair Isaac and Company (“FICO”) scores for the borrowers of these insured mortgages have increased, while the loan-to-value (“LTV”) on these mortgage loans has decreased, meaning that borrowers generally are making larger down payments in connection with the more recent mortgage loans that we are insuring.
Terminations. In 2009, we began pursuing opportunities to reduce our legacy mortgage insurance portfolio and non-traditional mortgage insurance risk in force. We executed upon this strategy through a series of commutations, transaction settlements and terminations, including the following notable transactions during 2010:
In the third quarter, we paid $142.8 million to terminate two structured transactions, consisting of $187.8 million of first-lien risk in force. Because the existing aggregate loss reserves for these transactions were $159.7 million, these terminations resulted in approximately $17 million of pre-tax income. These transactions had the effect of reducing our primary insurance in force by $3.6 billion, and reduced our primary default count by 4,325 loans.
Credit Performance. While we experienced improvement in our claims paid and provision for losses in 2010 compared to 2009, there continues to be deterioration in the internal ratings of certain portions of our insured portfolio. The percentage of credits internally rated below investment grade (“BIG”) increased to 6.2% of our net par outstanding at December 31, 2010 from 5.5% at December 31, 2009, while the percentage of internally rated AAA credits in our portfolio increased to 43.0% of our net par outstanding at December 31, 2010 from 41.2% at December 31, 2009. The increase in the percentage of BIG credits was primarily due to credit deterioration in the second-to-pay collateralized loan obligations (“CLO”), one project finance credit and, to a lesser extent, the Alternative A (“Alt-A”) residential mortgage-backed securities (“RMBS”) segments of our insured portfolio.
Public Finance. Our public finance insured portfolio continues to experience stress from the general economic downturn, with the greatest level of stress continuing in the healthcare and long-term care sectors. Although we have seen some stabilization and modest improvement in the performance of some healthcare credits in the portfolio, the outlook for credit performance for the healthcare sector remains challenging, particularly due to uncertainty regarding the future of healthcare reform and state and federal funding for healthcare expenditures. We have observed an increase in refundings of our public finance exposure in 2010 (in particular within our investment-grade healthcare and long-term care sectors); however, we do not expect the same level of refundings in 2011 as a result of the expiration of certain laws that provided issuers with incentives to refinance and anticipated increases in interest rates that issuers will be required to pay in future offerings.
We may experience future credit deterioration and municipal defaults in our government-related insured credits, as the difficulties experienced by government entities to maintain balanced budgets and adequate liquidity to meet near-term financial obligations continue to strain municipalities and their public authorities. To date, the states and municipalities included within our government-related insured credits have generally been able to withstand this stress. As of December 31, 2010, 95.4% of our insured public finance portfolio was rated investment grade (at least BBB-) internally, compared to 96.5% as of December 31, 2009. The small decline in the percentage of our public finance portfolio rated investment grade was primarily due to a downgrade of one transaction within our project finance sector.
Structured Finance. We saw signs of credit improvement in our structured finance portfolio in 2010. We experienced significantly fewer defaults in the collateral underlying our corporate CDOs in 2010 (three in 2010, compared to 11 in 2009). While the subordination and interest coverage ratio levels in many of our insured TruPs CDOs were further reduced in 2010, we also began to see some stabilization and positive developments in the collateral pools of our insured TruPs CDOs, with some issuers of TruPs having benefited from earnings growth and greater access to the capital markets. The internal ratings of two directly insured TruPs bonds that were rated BIG as of December 31, 2009, were upgraded to BBB during 2010, due to improved collateral performance. See “Results of Operations-Financial Guaranty-Financial Guaranty Exposure Information” below for additional information regarding material changes in the credit performance of our insured TruPs CDO portfolio.
Our results of operations were significantly impacted by a valuation allowance of $841.5 million recognized in the fourth quarter of 2010 against our deferred tax assets (“DTA”), which represented almost the entire asset balance. The valuation allowance is primarily a result of our history of losses, including our significant loss in the fourth quarter of 2010, and the uncertainty of our future results. While we continue to expect a return to profitability in the long-term, this turnaround remains uncertain based on macroeconomic factors such as the slower-than-expected pace of the economic recovery as well as the ultimate timing and magnitude of our losses. If we return to a period of sustained profitability, as we currently expect, all or a portion of this valuation allowance would be reversed.
Our results for 2010 were also negatively impacted by the change in fair value of derivative instruments, which occurred primarily as a result of our five-year CDS spread tightening by 70% from December 2009. Because we have the ability to hold our financial guaranty contracts to maturity, changes in market spreads are not necessarily indicative of our expected ultimate net credit loss payments with respect to these obligations.
(1) Represents the present value of our estimated credit loss payments (net of estimated recoveries) for those transactions where we currently anticipate paying net losses, calculated using a discount rate ranging from 2.4% to 3.0%, which represents our current investment yield. At a discount rate of 5%, our estimated credit loss payments would decrease by approximately $136.8 million to $371.8 million, with most of this decrease related to financial guaranty derivatives and VIEs.
Net Premiums Written and Earned. Net premiums written in 2010 increased from 2009. For 2009, new premiums written were negatively impacted by $185.6 million due to the commutation of $9.8 billion in net par outstanding. For 2010, net premiums earned decreased slightly compared to 2009, as a result of a decline in net premiums earned in our financial guaranty segment, partially offset by an increase in net premiums earned in our mortgage insurance segment. See “Results of Operations-Mortgage Insurance-Year Ended December 31, 2010 Compared to Year Ended December 31, 2009-Net Premiums Written and Earned” and “Results of Operations-Financial Guaranty-Year Ended December 31, 2010, Compared to Year Ended December 31, 2009-Net Premiums Earned” below for further information.
See “Results of Operations-Financial Guaranty-Year Ended December 31, 2010 Compared to Year Ended December 31, 2009-Change in Fair Value of Derivative Instruments” below for further information.
The unrealized losses experienced during 2010 are primarily due to the significant tightening of our CDS spread. The following table quantifies the impact of our non-performance risk on our derivative assets, derivative liabilities, as well as net VIE liabilities (in aggregate by type, excluding assumed financial guaranty derivatives) presented in our consolidated balance sheets. The five-year CDS spread is presented as an illustration of the market’s view of our non-performance risk; the CDS spread used in the valuation of specific fair value liabilities is typically based on the remaining term of the instrument.
The results for 2010 were driven by losses on financial guaranty VIE debt. As a result of the adoption in 2010 of the accounting standard update regarding improvements to financial reporting by enterprises involving VIEs, we identified and consolidated additional VIEs with the related fair value gains (losses) recorded in this line item. Also negatively impacting the results for 2010, were losses related to NIMS VIE debt. The losses on our VIE debt were primarily caused by a tightening in Radian Group’s CDS spread during the year, which had the effect of increasing the fair value liabilities of our VIEs. Our CDS spreads also tightened during 2009. Partially offsetting these losses in 2010 were realized gains on investments, with the majority of gains occurring as a result of sales from our trading portfolio, in connection with the strategic repositioning of our investment portfolio from tax advantaged securities to securities that provide taxable investment income, and for which we recorded unrealized gains as a result of positive market conditions. New investments acquired during 2010 have all been classified as trading securities. During 2010, total gains (losses) on sales and redemptions of investments were $165.0 million and $(103.7) million, respectively.
Policy Acquisition Costs. Policy acquisition costs decreased during 2010 as compared to 2009, due to a decrease in policy acquisition costs in our financial guaranty segment, which was partially offset by an increase in policy acquisition costs in our mortgage insurance segment. See “Results of Operations-Mortgage Insurance-Year Ended December 31, 2010 Compared to Year Ended December 31, 2009-Policy Acquisition Costs” and “Results of Operations-Financial Guaranty-Year Ended December 31, 2010 Compared to Year Ended December 31, 2009-Policy Acquisition Costs” below for further information.
Other Operating Expenses. The decrease in other operating expenses in 2010 compared to 2009 was the result of (i) a $12 million decrease in severance, (ii) a $7 million decrease in salaries, and (iii) a $3 million decrease in rent expense. These decreases were partially offset by a $5 million increase in cash and stock-based compensation and a $2 million increase in mortgage insurance sales commissions.
resulted in large unrealized losses, but was offset by the adoption, in 2008, of a new accounting standard that impacted our fair valuation, as it incorporated the market’s perception of non-performance risk into our valuation methodology and resulted in large unrealized gains.
Other Income. Other income was higher in 2009 compared to 2008, due to an increase in pricing on our contract underwriting services in our mortgage insurance business.
Provision for Losses. The provision for losses for 2009 decreased from the comparable period of 2008, due to a decrease in both our mortgage insurance and financial guaranty provision for losses. The provision for losses in our mortgage insurance segment decreased as a result of increased levels of estimated insurance rescissions and denials. See “Results of Operations-Mortgage Insurance-Year Ended December 31, 2009 Compared to Year Ended December 31, 2008-Provision for Losses” below for further information. See “Results of Operations-Financial Guaranty-Year Ended December 31, 2009 Compared to Year Ended December 31, 2008-Provision for Losses” below for further information regarding the decrease in our financial guaranty provision for losses.
Provision for Premium Deficiency. In 2009 and 2008, we recorded a decrease in the provision for second-lien premium deficiency due to the transfer of premium deficiency reserves to loss reserves and changes in estimates due to the settlement of certain second-lien transactions at less than our estimates of reserves.
Policy Acquisition Costs. Policy acquisition costs for 2009 reflect the write-off of $8.9 million of deferred policy acquisition costs in connection with the commutation of $9.8 billion of financial guaranty net par outstanding. Policy acquisition costs for 2008 reflect the write-off of $50.8 million of deferred policy acquisition costs on our domestic first-lien mortgage insurance business originated prior to July 2008, in connection with the establishment of a first-lien premium deficiency reserve for this business.
Other Operating Expenses. The decrease in other operating expenses in 2009 compared to 2008 resulted from (i) a $28.6 million reduction in employee compensation costs, (ii) an $11.6 million decrease in contract underwriting related expenses, (iii) a $5.0 million decrease in audit and legal fees and (iv) a decrease in compensation expense related to our stock- and cash-based performance plans that are correlated to our stock price.
Interest Expense. Interest expense for 2009 decreased compared to 2008, due to the termination in August 2009 of our revolving credit facility and repayment of the remaining balance of $100 million. In 2008, we reduced the amount of this credit facility by $100 million, which further reduced our interest expense in 2009 related to the facility. In addition, during 2009, we repurchased approximately $57.7 million of outstanding principal amount of our 7.75% debentures due in 2011.
Equity in Net Income of Affiliates. Equity in net income of affiliates reflects reduced business volumes from Sherman’s credit card origination business, which led to a decrease in revenues.
Net Investment Income. The decrease in net investment income during 2010, compared to 2009, was due to lower yields in our investment portfolio, as a result of a continued reallocation of our investment portfolio to shorter term investments in anticipation of future claim payments. In addition, assets were also reallocated from longer duration, higher yielding tax exempt municipal securities to taxable securities of intermediate duration with lower interest rates.
Change in Fair Value of Derivative Instruments. The components of the gains (losses) included in change in fair value of derivative instruments for our mortgage insurance segment for the years indicated are as follows:
The change in fair value of derivative instruments for 2010 includes an allocation of unrealized gains related to derivatives held on CPS trusts that were consolidated by Radian Group. See “Off-Balance-Sheet Arrangements-Put Options on CPS” below for further information. The change in fair value of derivative instruments for 2009 includes a loss related to the termination of all of our remaining domestic CDS transactions in our mortgage insurance business.
The gains (losses) on other financial instruments continued to be positively impacted in 2010 by net realized gains on investments as we continued to reallocate our investment portfolio. The gains (losses) on other financial instruments for both 2010 and 2009 were negatively impacted by losses related to NIMS VIE debt. The losses on our NIMS VIE debt were primarily caused by a tightening in Radian Group’s CDS spread, which had the effect of reducing the impact of our non-performance risk adjustment included within the fair value estimate of our NIMS VIE debt. Additionally, Radian Group purchased CPS securities, which resulted in the allocation of losses associated with these investments and related VIE debt.
Provision for Losses. Our mortgage insurance provision for losses for 2010 increased compared to 2009, primarily as a result of a decrease in the impact of changes in our estimated insurance rescissions and claim denials in 2010 compared to 2009. During 2009, we significantly increased our estimate for rescissions and denials, which resulted in a lower default to claim rate used in determining our loss reserve estimate as of December 31, 2009, and benefited our loss reserve estimate by approximately $1 billion in 2009. During 2010, the impact to our loss reserve from estimated rescissions and denials declined, primarily due to the realization of actual rescissions and denials.
(2) Related to claims from policies in which we were in a second loss position. These rescissions or denials may not have resulted in a claim payment obligation due to deductibles and other exposure limitations included in our policies.
(3) Includes a small amount of submitted claims that were subsequently withdrawn by the insured.
We received fewer notices of new defaults during 2010, which positively impacted our provision for losses in 2010 compared to 2009. Also in 2010, our provision for losses increased due to an aging of our default inventory, an increase in primary and pool severity, and the breach of subordination levels for certain pool insurance transactions in which we are in a second loss position.
Our reported rescission and denial activity in any given period is subject to future challenges by our lender customers. Our reserve for defaults that we estimate had been incurred but not reported to us on a timely basis, as
The following table illustrates the total amount of first-lien claims submitted to us for payment that were rescinded during 2010 and 2009, and then subsequently were challenged (“rebutted”) by the lenders and policyholders, but have not been reinstated:
Provision for Premium Deficiency. For 2010, the provision for second-lien premium deficiency was impacted by the transfer of incurred losses to second-lien loss reserves and by updates to our underlying assumptions. This had the effect of reducing our second-lien premium deficiency reserve. The provision for premium deficiency in 2009 reflects the transfer of incurred losses to second-lien loss reserves and changes in estimates due to the settlement of certain second-lien transactions at less than our estimate of reserves. See “Critical Accounting Policies-Reserve for Premium Deficiency” below for a description of our reserving process.
Net Premiums Written and Earned. Net premiums written and earned decreased during 2009, primarily as a result of the overall industry-wide decrease in the volume of new primary insurance written during 2008 and 2009. Additionally, net premiums earned were reduced in 2009 by $72.8 million, due to a significant increase in estimated premium refunds associated with our expectation of increased rescissions. In addition, we ceased writing second-lien business in the second half of 2007, which resulted in a decrease in premiums written and earned from this product in 2008 and 2009, as this business runs off. We also reduced the level of international business written during 2008 and 2009, and terminated certain existing international transactions, resulting in a reduction of premiums written and earned.
Net Investment Income. The decrease in investment income in 2009 compared to 2008 reflects a decrease in yields related to invested assets, as a result of a reallocation of our investment portfolio to shorter term investments in anticipation of future claim payments. In addition, assets were also reallocated from longer duration, higher yielding tax exempt municipal securities to taxable securities of intermediate duration in a lower interest rate environment.
Net Gains (Losses) on Other Financial Instruments. Net gains (losses) on other financial instruments increased from a loss in 2008 to a gain in 2009. During 2009, market prices of our investments strengthened as a result of the improving domestic and global economic environment, and we made the decision to opportunistically realize gains in the investment portfolio, primarily through the sale of taxable bonds, convertible securities and municipal bonds.
Provision for Premium Deficiency. In 2009 and 2008, we recorded a decrease in the provision for second-lien premium deficiency due to the transfer of premium deficiency reserves to loss reserves. Also in 2009, we terminated certain second-lien transactions at less than our estimate, which also reduced our premium deficiency reserve.
Interest Expense. Interest expense for 2009 and 2008 included an allocation to the mortgage insurance segment of interest on our long-term debt and other borrowings based on allocated capital. For 2009, this allocation decreased for our mortgage insurance segment relative to our financial guaranty segment.
Income Tax Benefit. The effective tax rate was 34.3% for 2009 compared to 37.8% for 2008. The effective tax rate for 2009 reflected an increase in the ratio of income generated from tax-advantaged investment securities compared to loss generated from operations, and an increase in tax expense relating to the accounting standard regarding accounting for uncertainty in income taxes.
The following table shows the number of modified pool loans that we have insured, the number of loans in default and the percentage of loans in default as of the dates indicated. All modified pool statistics are also included within our primary insurance statistics.
The following table shows a rollforward of our primary loans in default:
The following table shows additional information about our primary loans in default as of the dates indicated:
(2) Calculated without giving effect to the impact of terminations of captive reinsurance transactions and first- and second-lien transactions.
Our mortgage insurance total loss reserve as a percentage of our mortgage insurance total risk in force was 10.2% at December 31, 2010, compared to 9.2% at December 31, 2009 and 7.0% at December 31, 2008.
California accounted for 12.8% of our mortgage insurance segment’s direct primary new insurance written for the year ended December 31, 2010, compared to 16.9% and 17.3% for the years ended December 31, 2009 and 2008, respectively. At December 31, 2010, California accounted for 11.4% of our mortgage insurance segment’s primary risk in force, compared to 11.6% at December 31, 2009. California also accounted for 10.9% of our mortgage insurance segment’s pool risk in force, compared to 11.6% for 2009.
The largest single customer of our mortgage insurance segment (including branches and affiliates of such customer), measured by primary new insurance written, accounted for 15.5% of primary new insurance written for 2010 compared to 16.1% for 2009 and 20.5% for 2008.
The following table reconciles our mortgage insurance segment’s beginning and ending reserves for losses and LAE for the years indicated:
Net (Loss) Income. The net loss in 2010 compared to net income in 2009 is primarily due to the significant unrealized losses on financial instruments, including derivatives, in 2010. These unrealized losses resulted primarily from the tightening of our CDS spread. The 2010 results were also negatively impacted by the recording of a valuation allowance against our DTA.
The following table shows net premiums earned by our financial guaranty segment’s various product lines for the periods indicated:
Net Investment Income. The decrease in net investment income during 2010, compared to 2009, is due to lower yields in our investment portfolio as a result of a continued reallocation of our investment portfolio to shorter term investments. In addition, assets were also reallocated from longer duration, higher yielding tax exempt municipal securities to taxable securities of intermediate duration with lower interest rates.
Change in Fair Value of Derivative Instruments. The components of the (losses) gains included in change in fair value of derivative instruments for our financial guaranty segment for the periods indicated are as follows:
Net (Losses) Gains on Other Financial Instruments. The components of the (losses) gains on other financial instruments for the periods indicated are as follows:
Policy Acquisition Costs. The decrease in policy acquisition costs for 2010 compared to 2009 is primarily due to the decrease in net premiums earned in 2010 and the commutation of $9.8 billion of net par outstanding in the second quarter of 2009, which resulted in our accelerating $8.9 million of policy acquisition costs and reduced the base asset to be amortized.
Other Operating Expenses. The decrease in other operating expenses for 2010 compared to 2009 is primarily due to decreases in salaries, severance, audit fees and consulting fees, which was partially offset by an increase in expenses related to consolidated VIEs.
Interest Expense. Interest expense for 2010 and 2009 includes interest on our long-term debt, which was allocated to the financial guaranty segment based on allocated capital.
Income Tax Provision. The financial guaranty segment had an income tax provision of $51.5 million for 2010 compared to an income tax provision of $68.6 million for 2009. The difference between the effective tax rate and the statutory tax rate of 35% for 2010, was mainly related to the recording of a valuation allowance against our DTA, the tax benefit relating to our tax exempt interest income, and the tax provision relating to our foreign subsidiary operations.
(6) Represents other types of structured finance obligations, including DPRs, collateralized guaranteed investment contracts (“GICs”) or letters of credit, foreign commercial assets and life insurance securitizations, none of which individually constitutes a material amount of our financial guaranty net par outstanding.
(1) Represents our exposure to the aggregate outstanding principal on insured obligations.
(4) Legally defeased bond issuances where our financial guaranty policy is not extinguished, but cash or securities in an amount sufficient to pay remaining obligations under such bonds have been deposited in an escrow account for the benefit of the bond holders.
(6) Represents other types of structured finance obligations, including DPRs, guarantees of excess clearing losses of securities exchange clearinghouses, GICs or letters of credit, foreign commercial assets and life insurance securitizations, none of which individually constitutes a material amount of our financial guaranty net par outstanding.
We have reinsured several primary financial guaranty insurers’ obligations with respect to $229.6 million in net par outstanding as of December 31, 2010 related to Jefferson County, Alabama (the “County”) sewer bonds. We began paying claims related to these sewer bonds in June 2008, and have paid $21.3 million of claims on this transaction as of December 31, 2010. The County’s sewer system operations have generated sufficient revenues since the beginning of 2009 to pay interest on its outstanding debt, as well as regularly scheduled annual installments of principal in February 2010 and 2011 primarily due to historically low prevailing interest rates on the county’s variable rate obligations. However, we believe a number of factors are adversely affecting the performance of these obligations, including the County’s highly leveraged capital position, the sub-par performance of the sewer facilities and the possibility that the County would be unable to generate sufficient revenues to repay the bonds if interest rates were to increase. In addition, it remains possible that the County will file for bankruptcy protection. In September 2010, a court-appointed receiver over the sewer system was installed with the power to raise sewer rates and increase revenues, which could result in increased revenues being available to repay outstanding bonds. This receiver has not yet announced specific plans for addressing the financial performance of the County sewer system.
There have been several public reports of settlement discussions, including a public announcement by the County in September 2010 that it has proposed a settlement with its creditors that, if approved, could eliminate nearly half of the County’s $3.2 billion sewer debt. We cannot provide any assurance regarding the ability of the relevant parties to reach a settlement, or what the impact of any settlement would be on our exposure. As of December 31, 2010, we had $22.4 million of loss and LAE reserves for this transaction.
Many of the issuers in our insured TruPs bonds have been negatively affected by the recent U.S. economic recession. Certain of these issuers have defaulted on their obligation to pay interest on their TruPs bonds or have voluntarily chosen to defer interest payments, which is permissible for up to five years. Since we believe there is a significant likelihood that TruPs that are subject to interest deferrals will ultimately result in a default, we closely monitor deferrals, as well as defaults, in assessing the subordination remaining beneath our insured TruPs bonds. Nine of the TruPs bonds that we insure (representing a net par outstanding of $1.4 billion) were internally rated BIG as of December 31, 2010. The weighted average internal rating for all of our directly insured TruPs bonds remained at B+ as of December 31, 2010. The fair value liability of our directly insured TruPs transactions, which are accounted for as derivatives, was $368.0 million as of December 31, 2010.
In addition to the transactions described above, we are monitoring developments, exploring potential alternatives and conducting additional analysis with respect to our exposure to Reliance Rail, a project finance transaction for the design, construction and maintenance of commuter trains for the Sydney, Australia suburban rail network. As of December 31, 2010, we provided an aggregate of $408.1 million of credit protection on the secured debt of Reliance Rail through reinsurance ($222.6 million), direct second-to-pay obligations ($153.3 million) and assumed second-to-pay obligations ($32.2 million). While most of our exposure is to Reliance Rail’s senior secured debt, approximately $10.9 million of our reinsurance exposure is to Reliance Rail’s junior secured debt. As of December 31, 2010, we have a derivative liability in the amount of $41.4 million for this transaction. Due to delays in the delivery of equipment combined with structural risks, including debt due in 2015 that will likely need to be refinanced and the potential withdrawal of unfunded commitments, we downgraded our internal ratings of this obligation from investment-grade to BB in 2010.
Change in Fair Value of Derivative Instruments. The decrease in the change in fair value of derivative instruments in 2009 compared to 2008 was due to credit spreads on our insured CDOs tightening significantly,
Net Gains (Losses) on Other Financial Instruments. Net gains (losses) on other financial instruments increased from a loss in 2008 to a gain in 2009. During 2009, market prices of our investments strengthened as a result of the improved domestic and global economic environment, and we made the decision to realize gains in the investment portfolio, primarily through the sale of taxable bonds, convertible securities and municipal bonds.
Provision for Losses. The provision for losses for 2009 reflects expected losses in our structured finance reinsurance and public finance lines of business, which were reduced by $38.6 million due to the commutation of a large portfolio and favorable developments in our structured finance direct line of business. The provision for losses was higher in 2008 as a result of ongoing deterioration in our assumed reinsurance business.
Policy Acquisition Costs. The decrease in policy acquisition costs for 2009 compared to 2008 was mainly due to the decrease in net premiums earned during 2009. In addition, in 2009, we wrote off $8.9 million of deferred policy acquisition costs related to the commutation of a large portfolio, which reduced the base asset to be amortized.
Other Operating Expenses. Other operating expenses for 2009 as compared to 2008 included a decrease in employee costs, primarily due to lower severance and retention expense, bonus and stock-based compensation expense, as well as lower outside consulting costs.
Interest Expense. Interest expense for 2009 and 2008 included an allocation to the financial guaranty segment of interest on our long-term debt and other borrowings, based on allocated capital. For 2009, this allocation increased for our financial guaranty segment relative to our mortgage insurance segment.
Income Tax Provision. The effective tax rate was 29.3% for 2009 compared to 35.7% for 2008. The effective tax rate for 2009 reflects an increase in the ratio of income generated from tax-advantaged investment securities compared to income generated from operations and an increase in tax expense relating to the accounting standard regarding accounting for uncertainty in income taxes.
On May 3, 2010, Radian Guaranty sold to Sherman all of its remaining 28.7% equity interest in Sherman for approximately $172 million in cash, pursuant to a Securities Purchase Agreement (the “Sherman Purchase Agreement”) dated as of May 3, 2010, between Radian Guaranty and Sherman. We recorded a pre-tax gain of
(1) Amounts represent management’s estimate of credit loss payments related to these instruments as described in “Results of Operations” above.
(2) Our reserve for losses and LAE reflects the application of accounting policies described below in “Critical Accounting Policies-Reserve for Losses.” The payments due by period are based on management’s estimates and assume that all of the loss reserves included in the table will result in claim payments, net of expected recoveries. Included in the uncertain category is $18.4 million of unearned premium reserves, which are included in our reserve for losses and LAE. Negative amounts presented are primarily related to expected recoveries on our financial guaranty claims.
As of December 31, 2010, $33.2 million of our total $124.0 million of gross liability for unrecognized tax benefits associated with the provisions of the accounting standard regarding accounting for income taxes is expected to be paid in less than a year. We cannot make a reasonably reliable estimate of the period of cash settlement for the remaining $90.8 million of liability for unrecognized tax benefits due to the high degree of uncertainty regarding the timing of future cash outflows associated with certain of our liabilities for unrecognized tax benefits.
In addition to the contractual obligations set forth in the table above, we have the following contractual obligations and commitments.
Radian Guaranty and Amerin Guaranty are parties to a cross-guaranty agreement. 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 insurance department of the payor’s state of domicile. Amerin Guaranty had no risk in force exposure as of December 31, 2010.
Radian Group has agreed to guarantee, up to a maximum amount of $300 million, Radian Guaranty’s obligations to Radian Insurance under the Net Worth and Liquidity Maintenance Agreement discussed immediately above, in the event that Radian Guaranty is not able to or permitted by the Pennsylvania Insurance Department to perform under the agreement.
Our interests in VIEs may be accounted for as insurance contracts or financial guaranty derivatives or in some cases, as described more fully below, we have consolidated the VIEs. For insurance contracts with VIEs that we do not consolidate, we record reserves for losses and LAE, and for derivative interests in VIEs that we do not consolidate, we record changes in the fair value as a corresponding derivative asset or derivative liability. Our primary involvement with VIEs relates to transactions in which we provide a financial guaranty to one or more classes of beneficial interest holders in the VIE. VIEs may also be used to create securities with a unique risk profile desired by investors and as a means of transferring risk, such as our Smart Home transactions. We do not record the underlying assets or liabilities of the VIEs on our balance sheets unless we are the primary beneficiary of the VIE.
In 2004, we developed a program referred to as “Smart Home,” for reinsuring risk associated with non-prime mortgages and riskier products. These reinsurance transactions, through the use of VIE structures, effectively transfer risk from our portfolio to investors in the capital markets. Since August 2004, we have completed four Smart Home reinsurance transactions. Details of these transactions (aggregated) as of the initial closing of each transaction and as of December 31, 2010 are as follows:
Each transaction began with the formation of an unaffiliated, offshore reinsurance company. We then entered into an agreement with the Smart Home reinsurer to cede to the reinsurer a portion of the risk (and premium) associated with a portfolio of loans. Each class relates to the loss coverage levels on the reinsured portfolio and is assigned a rating by one or more of the three major rating agencies. We do not hold any of the credit-linked notes issued as part of this structure; therefore, we have no significant variable interests in the structures, and are not subject to consolidation under this standard. We exercised our option to terminate two of these transactions in February 2011 with risk in force of approximately $41 million. See Note 9 of Notes to Consolidated Financial Statements for more information.
In September 2003, Radian Asset Assurance entered into a contingent capital transaction pursuant to which three custodial trusts issued an aggregate of $150 million in CPS ($50 million by each custodial trust) to various holders. Based on our additional involvement in these trusts, we concluded that we are the party that directs the activities that most significantly influence the economic performance of these VIEs and has the right to receive benefits that would be significant to these VIEs. We have now purchased substantially all of the CPS. See Note 6 of Notes to Consolidated Financial Statements for more information.
Radian Group serves as the holding company for our insurance subsidiaries and does not have any significant operations of its own. Radian Group’s principal liquidity demands for the next 12 months include funds for: (i) the payment of certain corporate expenses (which are expected to be fully reimbursed through expense-sharing arrangements with our subsidiaries), (ii) interest payments on our outstanding long-term debt (which are expected to be fully reimbursed through expense-sharing arrangements with our subsidiaries), (iii) a payment to Radian Guaranty in October 2011 under our tax-sharing agreement, (iv) potential capital support for our mortgage insurance subsidiaries, (v) repayment of approximately $160 million in principal amount of our long-term debt due June 2011, and (vi) the payment of dividends on our common stock.
At December 31, 2010, we did not have the intent to sell any debt securities in an unrealized loss position and determined that it is more likely than not that we will not be required to sell the securities before recovery or maturity.
Corporate Expenses and Interest Expense. Radian Group has expense-sharing arrangements in place with its principal operating subsidiaries that require those subsidiaries to pay their share of holding-company-level expenses, including coupon rate interest payments on our long-term debt. Payments of such corporate expenses for the next 12 months, other than interest payments, are expected to be approximately $59.4 million, which are expected to be fully reimbursed by our subsidiaries. For the same period, payments of interest on our long-term debt are expected to be approximately $47.2 million, which also are expected to be fully reimbursed by our subsidiaries. These expense-sharing arrangements, as amended, have been approved by applicable state insurance departments, but such approval may be changed at any time.
As of the balance sheet dates, certain of our insurance subsidiaries have incurred estimated NOLs that, if computed on a separate company return basis, could not be fully utilized through existing carryback provisions of the IRC. As a result, we are not currently obligated to reimburse them for these unutilized tax losses. However, if in a future period, any of these subsidiaries generate taxable income such that they are able to realize their individual NOL carryforward under the IRC, then we will be obligated under the tax-sharing agreement to fund such subsidiary’s portion of its operating loss that has been utilized on a consolidated group tax return basis. Currently, we do not expect to fund material obligations under the provisions described in this paragraph with regard to subsidiary NOLs incurred to date.
Radian Group contributed $322 million to Radian Guaranty in 2010 to support its capital position. Radian Group may make additional capital contributions to Radian Guaranty in 2011 in order to further support its capital position and to maintain Radian Guaranty’s risk-to-capital ratio below the statutory maximum of 25 to 1. See “Risk Factors-Losses in our mortgage insurance business have reduced Radian Guaranty’s statutory surplus and increased Radian Guaranty’s risk-to-capital ratio; additional losses in our mortgage insurance portfolio or financial guaranty portfolio without a corresponding increase in new capital or capital relief could further negatively impact these ratios, which could limit Radian Guaranty’s ability to write new insurance and could increase restrictions and requirements placed on Radian Guaranty.”
Dividends. Our quarterly common stock dividend is $0.0025 per share. Assuming that our outstanding common stock remains constant at 133,049,213 shares (the number of shares outstanding at December 31, 2010), we would require approximately $1.3 million in the aggregate to pay our quarterly dividends for the next 12 months.
In addition to existing available cash and marketable securities, dividends from our insurance subsidiaries and permitted payments to Radian Group under tax- and expense-sharing arrangements with our subsidiaries are Radian Group’s principal sources of cash. Our insurance subsidiaries’ ability to pay dividends to Radian Group is subject to various conditions imposed by the GSEs and rating agencies, and by insurance regulations requiring insurance department approval. In general, dividends in excess of prescribed limits are deemed “extraordinary” and require insurance department approval. In light of ongoing losses in our mortgage insurance subsidiaries, we do not anticipate that these subsidiaries will be permitted under applicable insurance laws to issue dividends to Radian Group for the foreseeable future. To the extent Radian Asset Assurance is permitted to issue dividends, these dividends will be issued to its direct parent, Radian Guaranty, and not to Radian Group.
transactions, substantially all of the face amount of the CPS issued by the custodial trusts at a weighted average purchase price approximately equal to 55% of the face amount of such CPS.
1. During any calendar quarter after December 31, 2010 (and only during such calendar quarter), if the last reported sale price of our common stock for each of at least 20 trading days (whether or not consecutive) during the 30 consecutive trading days ending on, and including, the last trading day of the immediately preceding calendar quarter, is greater than or equal to 130% of the applicable conversion price on each applicable trading day;
In connection with the offering of the convertible notes, we also entered into capped call transactions with an affiliate of Morgan Stanley & Co., Incorporated, whose obligations have been guaranteed by Morgan Stanley.
The principal liquidity requirements of our mortgage insurance business include the payment of claims, operating expenses (including those allocated from Radian Group), taxes and potential capital support for its mortgage insurance subsidiaries. The principal sources of liquidity in our mortgage insurance business are capital contributions from Radian Group (Radian Group contributed $322 million to Radian Guaranty in 2010), insurance premiums, net investment income, cash dividends from Radian Asset Assurance, and potential payments from Radian Group under our tax allocation agreement. Our mortgage insurance business has incurred significant losses during the past four years due to the housing and related credit market downturns. We believe that the operating cash flows generated by each of our mortgage insurance subsidiaries will provide these subsidiaries with a portion of the funds necessary to satisfy their claim payments and operating expenses for the foreseeable future. We believe that any shortfall can be funded from sales of short-term marketable securities held by our mortgage insurance subsidiaries, from maturing fixed-income investments and from the sale of less liquid marketable securities held by our mortgage insurance business.
As discussed above, as a result of losses incurred by CMAC of Texas and Radian Mortgage Insurance during 2010, Radian Guaranty contributed approximately $74 million to Radian Mortgage Insurance and $12 million to CMAC of Texas during 2010, to enable these subsidiaries to satisfy their minimum statutory capital requirements. Additional capital support for these and other subsidiaries may be required in the near and long term.
The amount, if any, and timing of Radian Asset Assurance’s dividend paying capacity will depend, in part, on the performance of our insured financial guaranty portfolio, including the establishment or increase in statutory reserves, as well as the amount we pay to commute transactions. If the exposure in our financial
guaranty business is reduced on an accelerated basis through the recapture of business from the primary customers in our financial guaranty reinsurance business or otherwise, we may have the ability to release capital to our mortgage insurance business more quickly and in a greater amount. However, if the performance of our financial guaranty portfolio deteriorates materially, Radian Asset Assurance may have limited or no capacity to issue dividends to Radian Guaranty. In the event of a default giving rise to a claim payment obligation in our financial guaranty business, the statutory capital of Radian Asset Assurance (and consequently Radian Guaranty) would be reduced in an amount equal to the present value of our expected future net claim liability (net of taxes) for such transactions. Any reduction in statutory capital would also likely reduce Radian Asset Assurance’s capacity to issue dividends to Radian Guaranty, and Radian Asset Assurance could be restricted from issuing dividends altogether without prior approval from the New York State Insurance Department.
We transferred our equity interest in Sherman to Radian Guaranty in the fourth quarter of 2009. Following this transfer, Radian Guaranty received a $1.5 million dividend from Sherman in the first quarter of 2010, and a $28 million dividend in April 2010. On May 3, 2010, Radian Guaranty sold all of its remaining equity interest in Sherman for approximately $172 million in cash.
The principal short-term and long-term liquidity requirements of our financial guaranty business include the payment of operating expenses (including those allocated from Radian Group), claim and commutation payments, taxes, and dividends to Radian Guaranty. As of December 31, 2010, we have eight CDS contracts with respect to seven TruPs bonds pursuant to which we may be required to pay our counterparty the outstanding par amount of our insured TruPs bonds (a “liquidity claim”). A liquidity claim may arise if an event of default under the TruPs bond (e.g., a failure to pay interest or a breach of covenants requiring the maintenance of a certain level of performing collateral) existed as of the termination date of the CDS contract. The termination dates of these CDS contracts currently range between 2015 and 2017, but automatically extend for additional one year increments (but no later than the maturity date of the TruPs CDO) unless terminated by our counterparty. If we are required to pay a liquidity claim, our counterparty would be obligated under the CDS to either deliver the insured TruPs bond to us or to periodically pay us cash in an amount equal to any future amounts paid in respect of principal and interest on the insured TruPs bond. We may be required to pay a liquidity claim on one CDS contract (representing $115.9 million in net par outstanding, for which we are currently paying interest shortfalls) that is currently scheduled to terminate in July 2016. We are exploring loss mitigation alternatives with respect to this TruPs bond, including the possibility of commuting our remaining risk on this bond. We can provide no assurance that we will be successful in such loss mitigation efforts.
Reconciliation of Consolidated Net Loss to Cash (Used in) Provided by Operations
On January 24, 2011, S&P released proposed changes to its ratings criteria for financial guarantors, which among other things, adds additional qualitative and quantitative tests to their criteria. S&P has indicated that it expects that, if implemented, the proposed changes would significantly increase the capital required by financial guarantors in order for them to achieve the highest investment-grade ratings from S&P. Because Radian Asset Assurance is currently rated below investment-grade, we are uncertain what impact, if any, the proposed changes will have on Radian Asset Assurance or Radian Group. These changes could, however, have a material adverse effect on other financial guarantors or the financial guaranty industry in general, and could make it more difficult for us to successfully utilize the FG Insurance Shell or further reduce our financial guaranty exposure through commutations or recaptures of business by our primary ceding customers.
Estimating the loss reserves in both our mortgage insurance and financial guaranty business segments involves significant reliance upon assumptions and estimates with regard to the likelihood, magnitude and timing of each potential loss. The models, assumptions and estimates we use to establish loss reserves may not prove to be accurate, especially during an extended economic downturn or a period of extreme market volatility as currently exists. We cannot be certain that we have correctly estimated the necessary amount of reserves or that the reserves established will be adequate to cover ultimate losses on incurred defaults.
In the mortgage insurance segment, reserves for losses are not established until a borrower has missed two monthly payments. We also establish reserves for associated LAE, consisting of the estimated cost of the claims administration process, including legal and other fees and expenses associated with administering the claims process. We maintain an extensive database of claim payment history and use models, based on a variety of loan characteristics, including the status of the loan as reported by its servicer and the type of loan product to determine the likelihood that a default will reach claim status. We also forecast the impact of our loss mitigation efforts in protecting us against fraud, underwriting negligence, breach of representation and warranties, and other items that may give rise to insurance rescissions and claim denials, to help determine the default to claim rate. Lastly, we project the amount that we will pay if a default becomes a claim (referred to as “claim severity”). Based on these estimates, we arrive at our estimate of loss reserves at a given point in time.
Our default to claim rate assumption was 40% at December 31, 2010, 36% at December 31, 2009, and 46% at December 31, 2008. The increase from 2009 to 2010 was attributable to the aging of underlying defaulted loans and a decrease in our estimate of rescissions and denials for our ending default inventory as of December 31, 2010, which was primarily attributable to the realization of rescissions and denials during 2010. The decrease from 2008 to 2009 was primarily as a result of an increase in our estimate of rescissions and denials, which was based on actual recent experience at that time. A key assumption affecting our reserving methodology is that our default to claim rates and severities will be consistent with our recent experience. Our estimate of expected insurance rescissions and claim denials embedded in our default to claim rate is generally based on our experience over the past year, with consideration given for differences in characteristics between those rescinded policies and denied claims and the remaining default inventory. We expect our rescission and denial rates to remain at elevated levels as long as defaults related to the poor underwriting periods of 2005 through 2008 represent a significant percentage of our total default portfolio. The elevated levels in the rate of rescissions and denials during 2009 and 2010 have led to an increased risk of litigation by lenders and policyholders challenging our right to rescind coverage or deny claims. Such challenges may be made several years after we have rescinded a certificate of insurance or denied a claim. Recently, we have faced an increasing number of challenges from certain lender customers regarding our insurance rescissions and claim denials, which have resulted in some reversals of our decisions regarding rescissions and denials. Although we believe that our rescissions and denials are justified under our policies, if we are not successful in defending the rescissions and denials in any potential legal or other actions, we may need to reassume the risk on, and reestablish loss reserves for, those policies or pay additional claims. The assumptions embedded in our estimated default to claim rate on our in-force default inventory includes an adjustment to our estimated rescission and denial rate, to account for the fact that we expect a certain number of policies for which an initial intent to rescind letter has been sent to our lender customers to remain in-force and ultimately be paid, as a result of valid challenges by such policy holders.
Reserves for our mortgage insurance business are recorded based on our estimate of loss and LAE reserves. We make regular adjustments to the underlying assumptions in our model as discussed above, and believe the amount generated by our model at December 31, 2010 represents our best estimate of our future losses and LAE on existing defaults.
In our financial guaranty segment, we recognize a claim liability on our non-derivative transactions prior to an event of default (insured event) when there is evidence that credit deterioration has occurred for a particular policy, and when the present value of the expected claim loss will exceed the unearned premium revenue. The expected claim loss is based on the probability-weighted present value of expected net cash outflows to be paid under the policy. In measuring the claim liability, we develop the present value of expected net cash outflows by using our own assumptions about the likelihood of all possible outcomes, based on information currently available. We determine the existence of credit deterioration on directly insured policies based on periodic reporting from the insured party, indenture trustee or servicer, and based on our surveillance efforts. These expected cash outflows are discounted using a risk-free rate. Our assumptions about the likelihood of outcomes, expected cash outflows and the appropriate risk-free rate are updated each reporting period. For assumed policies, we use information provided by the ceding company, as well as our specific knowledge of the credit for determining expected loss.
There are both performing and under-performing credits in our financial guaranty portfolio. Performing credits generally have investment-grade internal ratings, denoting nominal to moderate credit risk. However, claim liabilities may be established for performing credits if the expected losses on the credit exceed the unearned premium revenue for the contract based on the present value of the expected net cash outflows. If our risk management department concludes that a directly insured transaction should no longer be considered performing, it is placed in one of three designated watch list categories for deteriorating credits: Special Mention, Intensified Surveillance or Case Reserve. Assumed exposures in financial guaranty’s reinsurance portfolio are generally placed in one of these categories if the ceding company for such transaction downgrades it to an equivalent watch list classification. However, should our financial guaranty risk management group disagree with the risk rating assigned by the ceding company, we may assign our own risk rating rather than use the risk rating assigned by the ceding company.
We have a second-lien premium deficiency reserve (“PDR”) of $10.7 million as of December 31, 2010. Insurance enterprises are required to establish a PDR if the net present value of the expected future losses and expenses for a particular product exceeds the net present value of expected future premiums and existing reserves for that product. We reassess our expectations for premiums, losses and expenses for each of our mortgage insurance businesses at least quarterly and update our premium deficiency analysis accordingly. For purposes of our premium deficiency analysis, we group our mortgage insurance products into two categories, first-lien and second-lien.
For our first-lien mortgage insurance business, because the combination of the net present value of expected premiums and already established reserves (net of reinsurance recoverables) exceeds the net present value of expected losses and expenses, a first-lien PDR was not required as of December 31, 2010. Expected losses are based on an assumed paid claim rate of approximately 11.7% on our total primary first-lien mortgage insurance portfolio, which includes both delinquent loans and current loans, comprising 8.8% on prime, 25.6% on subprime and 24.4% on Alt-A. While deterioration in the macroeconomic environment has resulted in an increase in expected losses, new business originated since the beginning of 2009 is expected to be profitable, which has contributed to the overall expected net profitability of our first-lien portfolio. In addition, our estimated rescissions and denials on insured loans, as part of our loss mitigation efforts, partially offset the impact of expected defaults and claims.
Our fair value measurements are intended to reflect the assumptions market participants would use in pricing an asset or liability based on the best information available. Assumptions include the risks inherent in a particular valuation technique (such as a pricing model) and/or the risks inherent in the inputs to the model. We define fair value as the current amount that would be exchanged to sell an asset or transfer a liability, other than in a forced liquidation. In the event that our investments or derivative contracts were sold or transferred in a forced liquidation, the amounts received or paid may be materially different than those determined in accordance with this standard. Effective January 1, 2010, we adopted the update to the accounting standard regarding fair
State and municipal obligations-The fair value of state and municipal obligations is estimated using recent transaction activity, including market and market-like observations. Evaluation models are used, which
RMBS-The fair value of RMBS is estimated based on prices of comparable securities and spreads, and observable prepayment speeds. These securities are generally categorized in Level II of the fair value hierarchy or in Level III when market-based transaction activity is unavailable. The fair value of the Level III securities is generally estimated by discounting estimated future cash flows.
Hybrid securities-These instruments are convertible securities measured at fair value. The estimated fair value is derived, in part, by utilizing dealer quotes and observed bond and stock prices. For certain securities, the underlying security price may be adjusted to account for observable changes in the conversion and investment value from the time the quote was obtained. These securities are categorized in Level II of the fair value hierarchy.
Other investments-These securities primarily consist of short-term commercial paper within CPS trusts, which are categorized in Level II of the fair value hierarchy. The fair value of the remaining securities is categorized in Level III of the fair value hierarchy, and is generally estimated by discounting estimated future cash flows.
We define fair value as the current amount that would be exchanged to sell an asset or transfer a liability, other than in a forced liquidation. In determining an exit market, we consider the fact that most of our derivative contracts are unconditional and irrevocable, and contractually prohibit us from transferring them to other capital market participants. Accordingly, there is no principal market for such highly structured insured credit derivatives. In the absence of a principal market, we value these insured credit derivatives in a hypothetical market where market participants include other monoline mortgage and financial guaranty insurers with similar credit quality to us, as if the risk of loss on these contracts could be transferred to these other mortgage and financial guaranty insurance and reinsurance companies. We believe that in the absence of a principal market, this hypothetical market provides the most relevant information with respect to fair value estimates.
Present Value of Expected Future Contractual Premiums- Our contractual premiums are subject to change primarily for two reasons: (1) all of our contracts provide our counterparties with the right to terminate upon our default and (2) 86% of the aggregate net par outstanding of our corporate CDO transactions (as of December 31, 2010) provide our counterparties with the right to terminate these transactions based on certain rating agency downgrades that occurred in the past. In determining the expected future premiums of these transactions, we adjust the contractual premiums for such transactions to reflect the estimated fair value of those premiums based on our estimate of the probability of our counterparties exercising this downgrade termination right and the impact it would have on the remaining expected lifetime premium. In these circumstances, we also cap the total estimated fair value of the contracts at zero, such that none of the contracts subject to immediate termination are in a derivative asset position. The discount rate we use to determine the present value of expected future premiums is our CDS spread plus a risk-free rate. This discount rate reflects the risk that we may not collect future premiums due to our inability to satisfy our contractual obligations, which provides our counterparties the right to terminate the contracts.
Determining the Fair Premium Amount-For each Corporate CDO transaction, we perform three principal steps in determining the fair premium amount:
transactions that captures the credit characteristics of each transaction. We estimate projected claims based on our internal credit analysis, which is based on the current performance of each underlying reference obligation. The present value of the expected cash flows to the TruPs transaction is then determined using a discount rate derived from the observed market pricing for a TruPs transaction with similar characteristics. The present value of the insured cash flows is determined using a discount rate that is equal to our CDS rate plus a risk-free rate.
Prior to January 1, 2010, our guaranty on our sole outstanding directly insured CDO of ABS transaction was accounted for as a derivative. Upon the adoption of the accounting standard update regarding improvements to financial reporting by enterprises involving VIEs, we determined that we are the primary beneficiary for this CDO of ABS transaction and consolidated the VIE assets and liabilities as of January 1, 2010. Upon consolidation, we elected the fair value option for all financial assets and financial liabilities held by this VIE, which primarily consist of trading securities, interest rate swaps and VIE debt to note holders in the trust. The fair value election results in a net fair value of the VIE assets and VIE liabilities that is equal to the fair value liability of our exposure as previously accounted for as a derivative. See Note 6 of Notes to Consolidated Financial Statements for further discussion of the primary beneficiary analysis and the related financial impact to our financial position, financial performance and cash flows.
The investment securities in this consolidated CDO of ABS transaction have experienced significant credit deterioration. Fair value for these securities is estimated using a discounted cash flow analysis. We estimate cash flows for the transaction based on our internal credit analysis, which is based on the current performance of each security. The present value of the expected cash flows from the securities is then determined using a discount rate derived from the BBB- ABX.HE index. The present value of the insured cash flows (which represents the VIE debt) is determined using a discount rate that is equal to our CDS rate plus a risk-free rate. We continue to utilize this model to estimate the fair value of our exposure, and to derive the fair value of this consolidated VIE debt.
In determining the estimated fair value of our mortgage insurance international and domestic CDS, we used the following information: (1) non-binding fair value quotes from our counterparties on each respective transaction, which are based on quotes for transactions with similar underlying collateral from market makers and other broker dealers, and (2) in the absence of observable market data for these transactions, a review of quarterly information regarding the performance of the underlying collateral and discussion with our counterparties regarding any unusual or inconsistent changes in fair value. In either case, in the event there were material inconsistencies in the inputs to determine estimated fair value, they were reviewed and a final determination was made by management in light of the specific facts and circumstances surrounding each price. We made an adjustment to the fair value amount described above to incorporate our own non-performance risk. The amount of the adjustment was computed based on the correlation between the default probability of the transaction and our default probability as described more fully under Non-Performance Risk Adjustments on Corporate CDOs. Prior to their termination, our CDS transactions were categorized in Level III of the fair value hierarchy. In December 2010, we terminated our remaining mortgage insurance international CDS and in the second quarter of 2009, we terminated our remaining mortgage insurance domestic CDS.
in money market instruments, certificates of deposit and highly liquid, interest bearing instruments with an original maturity of three months or less at the time of purchase. Amortization of premium and accretion of discount are calculated principally using the interest method over the term of the investment. Realized gains and losses on investments are recognized using the specific identification method. See Note 5 of Notes to Consolidated Financial Statements for further discussion on the fair value of investments, and “Investment Policy and Portfolio” in Item 1 for more information on our investment portfolio.
On April 1, 2009, we adopted a new accounting standard regarding recognition and presentation of other-than-temporary impairments (“OTTI”). In accordance with this new standard, we record an other-than-temporary impairment on a security if we intend to sell the impaired security or if it is more likely than not that we will be required to sell the impaired security prior to recovery of its amortized cost basis, or we expect to be unable to collect cash flows sufficient to recover the amortized cost basis of the security. If a sale is likely, the security is classified as other-than-temporarily impaired and the full amount of the impairment is recognized as a loss in the statement of operations. Otherwise, losses on securities which are other-than-temporarily impaired are separated into: (i) the portion of loss which represents the credit loss; and (ii) the portion which is due to other factors. The credit loss portion is recognized as a loss in the statement of operations, while the loss due to other factors is recognized in accumulated other comprehensive income (loss), net of taxes. A credit loss is determined to exist if the present value of discounted cash flows expected to be collected from the security is less than the cost basis of the security. The present value of discounted cash flows is determined using the original yield of the security. For securities held as of April 1, 2009 that had previously been other-than-temporarily impaired, an after-tax transition adjustment of $21.5 million was booked to reclassify the non-credit loss portion of these impairments from retained earnings to accumulated other comprehensive income (loss).
Effective January 1, 2010, we adopted the accounting standard update regarding improvements to financial reporting by enterprises involving VIEs. As a provider of credit enhancement, we have entered into insurance contracts with VIEs and derivative contracts with counterparties where we have provided credit protection directly on variable interests and, in some cases, obtained the contractual rights of our counterparties with respect to the VIEs. As defined by the accounting standard, VIEs include corporations, trusts or partnerships in which equity investors do not have a controlling financial interest or do not have sufficient equity at risk to finance activities without additional subordinated financial support. In addition, as a result of the update to the standard regarding accounting for transfers of financial assets, effective January 1, 2010, special purpose entities that were previously considered QSPEs are to be considered in the VIE accounting framework as prescribed by the standard regarding financial reporting by enterprises involving VIEs.
An entity is considered the primary beneficiary and is required to consolidate a VIE if its variable interest (i) gives it the power to most significantly impact the economic performance of the VIE, and (ii) has the obligation to absorb losses or the right to receive residual benefits that could potentially be significant to the VIE. For all VIEs in which we have a variable interest, we determine whether we are the primary beneficiary. In determining whether we are the primary beneficiary, a number of factors are considered, including the structure of the entity, contractual provisions that grant us additional rights to influence or control the economic performance of the VIE upon the occurrence of an event of default or a servicer termination event or the breach of a performance trigger, and our obligation to absorb significant losses. Due to the continued deterioration of the performance of many of our financial guaranty transactions, the breach of these performance tests or other events giving rise to our right to influence or control the economic performance of the VIE could occur. When we obtain control rights, we perform an analysis to reassess our involvement with these VIEs to determine whether we have become the primary beneficiary.
As of December 31, 2010, before consideration of our valuation allowance, we had a net DTA in the amount of $879.4 million. We are required to establish a valuation allowance against our DTA when it is more likely than not that all or some portion of our DTA will not be realized. At each balance sheet date, we assess our need for a valuation allowance and this assessment is based on the relative impact of all available evidence, both positive and negative, and requires management to exercise judgment and make assumptions regarding the weight given to the potential effect of negative and positive evidence and whether the DTA will be realized in future periods. Future realization of our DTA will ultimately depend on the existence of sufficient taxable income of the appropriate character (ordinary income versus capital gains) within the applicable carryback and carryforward periods provided under the tax law. The primary sources of negative evidence considered are our cumulative losses in recent years, and the increased uncertainty around our future operating results. We also consider several sources of positive evidence when assessing the need for a valuation allowance such as future reversals of existing taxable temporary differences, future projections of taxable income, taxable income within the applicable carryback periods, and any potential tax planning strategies. In making our assessment of the more
likely than not standard, the weight assigned to the effect of both negative and positive evidence is commensurate with the extent to which it can be objectively verified.
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, changes in common stockholders’ equity and cash flows present fairly, in all material respects, the financial position of Radian Group Inc. and its subsidiaries (the “Company”) at December 31, 2010 and 2009, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2010 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the index appearing under Item 15(a)(2) as of and for the year ended December 31, 2010 present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements and financial statement schedules, maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Report on Internal Control over Financial Reporting appearing under Item 9A. Our responsibility is to express opinions on these financial statements, on the financial statement schedules, and on the Company’s internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
Radian Group Inc. (“Radian Group”) provides, through its subsidiaries and affiliates, credit-related insurance coverage and financial services to mortgage lenders and other financial institutions. Our business segments are mortgage insurance, financial guaranty and financial services.
Radian Guaranty offers primary mortgage insurance coverage on residential first-lien mortgages (“first-lien”). At December 31, 2010, primary insurance on domestic first-liens comprised approximately 92.8% of domestic first-lien mortgage insurance risk in force. We also offer pool insurance on a limited basis. Pool insurance comprised approximately 7.2% of domestic first-lien mortgage insurance risk in force at December 31, 2010. In addition to traditional mortgage insurance, in the past, we have used Radian Insurance and Amerin Guaranty to provide other forms of credit enhancement on residential mortgage assets. These products include mortgage insurance on second-lien mortgages (“second-lien”), credit enhancement on net interest margin securities (“NIMS”), credit default swaps (“CDS”) on domestic and international mortgages and primary mortgage insurance on international mortgages (collectively, we refer to the risk associated with these transactions as “non-traditional” or “other risk”). We stopped writing non-traditional business in 2007, other than a small amount of international mortgage insurance, which we discontinued writing in 2008. Currently, our main business focus is primary mortgage insurance on domestic first-liens.
If all of our direct insurance that is subject to termination was terminated as of December 31, 2010, our net par outstanding would have been reduced by $34.3 billion, with a corresponding decrease in unearned premium reserves of $8.7 million and a decrease in the present value of expected future installment premiums of $114.2 million. Net unrealized losses on derivatives and VIEs of $729.3 million would also have been reversed had these transactions been terminated. If any of our derivative transactions were terminated by our credit derivative counterparties, such terminations would not result in a payment by either party.
Assuming all of this business was recaptured as of December 31, 2010, Radian Asset Assurance’s statutory surplus would have increased by approximately $164.4 million, primarily as a result of the release of contingency reserves. The net present value of installment premiums on derivative contracts would have decreased by $4.9 million.
As a result of the sale of our remaining interest in Sherman on May 3, 2010, our financial services segment consists solely of our 46% interest in Credit-Based Asset Servicing and Securitization LLC (“C-BASS”), which filed for Chapter 11 bankruptcy protection on November 12, 2010. As a consequence of the complete write-off of our investment in C-BASS in 2007, we have no carrying value related to our interest in C-BASS.
Our future financial condition, results of operations and cash flows are subject to significant risks and uncertainties, including but not limited to, the following:
Potential adverse effects on us of the failure or significant delay of the United States (“U.S.”) economy to recover from deterioration in the housing and related credit markets and economic instability, which could increase our mortgage insurance or financial guaranty incurred losses beyond existing reserves (See Notes 10, 11 and 12).
Potential adverse effects on Radian Group liquidity if regulators or the GSEs limit, disallow or terminate our expense allocation agreements among Radian Group and its subsidiaries. During 2010, Radian Group received $105 million in reimbursements from its subsidiaries under these agreements.
Certain prior period balances have been reclassified to conform to the current period presentation. Restricted cash is excluded from our cash balance in 2010, and prior years have been revised to conform to the 2010 presentation. Hybrid securities previously reported as a separate line item are now reported in trading securities on our consolidated balance sheets and in our statements of cash flows. Deferred interest on notes receivable previously reported in accounts payable and accrued expenses is now reported in accounts and notes receivable on our consolidated balance sheets.
Estimating the loss reserves in both our mortgage insurance and financial guaranty business segments involves significant reliance upon assumptions and estimates with regard to the likelihood, magnitude and timing of each potential loss. The models, assumptions and estimates we use to establish loss reserves may not prove to
In the mortgage insurance segment, reserves for losses are not established until a borrower has missed two monthly payments. We also establish reserves for associated LAE, consisting of the estimated cost of the claims administration process, including legal and other fees and expenses associated with administering the claims process. We maintain an extensive database of claim payment history and use models, based on a variety of loan characteristics, including the status of the loan as reported by its servicer and the type of loan product to determine the likelihood that a default will reach claim status. We also forecast the impact of our loss mitigation efforts in protecting us against fraud, underwriting negligence, breach of representation and warranties, and other items that may give rise to insurance rescissions and claim denials, to help determine the rate at which defaults move to claim (“default to claim rate”). Lastly, we project the amount that we will pay if a default becomes a claim (referred to as “claim severity”). Based on these estimates, we arrive at our estimate of loss reserves at a given point in time.
We do not establish reserves for loans that are in default if we believe that we will not be liable for the payment of a claim with respect to that default. For example, for those defaults in which we are in a second loss position, we initially calculate the reserve for defaulted loans in the transaction as if there were no deductible. If the existing deductible for a given structured transaction is greater than the reserve amount for the defaults contained within the transaction, we do not establish a reserve for the defaults, or if appropriate, we record a partial reserve. We do not establish loss reserves for expected future claims on insured mortgages that are not in default. See “Reserve for Premium Deficiency” below for an exception to this general principle.
In our financial guaranty segment, we recognize a claim liability on our non-derivative transactions prior to an event of default (insured event) when there is evidence that credit deterioration has occurred for a particular policy and when the present value of the expected claim loss will exceed the unearned premium revenue. The expected claim loss is based on the probability-weighted present value of expected net cash outflows to be paid under the policy. In measuring the claim liability, we develop the present value of expected net cash outflows by using our own assumptions about the likelihood of all possible outcomes, based on information currently available. We determine the existence of credit deterioration on directly insured policies based on periodic reporting from the insured party, indenture trustee or servicer, and based on our surveillance efforts. These expected cash outflows are discounted using a risk-free rate. Our assumptions about the likelihood of outcomes, expected cash outflows and the appropriate risk-free rate are updated each reporting period. For assumed policies, we use information provided by the ceding company, as well as our specific knowledge of the credit for determining expected loss.
The risk management function in our financial guaranty business is responsible for the identification, analysis, measurement and surveillance of credit, market, legal and operational risk associated with our financial guaranty insurance contracts. Risk management, working with our legal group, is also primarily responsible for claims prevention and loss mitigation strategies. This discipline is applied during the ongoing monitoring and surveillance of each exposure in the portfolio as well as at the point of origination of a transaction.
Numerous factors affect our ultimate claim rates, including home price changes, unemployment, the impact of our loss mitigation efforts and interest rates, as well as potential benefits associated with lender and governmental initiatives to modify loans and ultimately reduce foreclosures. To assess the need for a PDR on our first-lien mortgage insurance portfolio, we develop loss projections based on modeled loan defaults related to our current risk in force. This projection is based on recent trends in default experience, severity, and rates of defaulted loans moving to claim (such default to claim rates are net of our estimates of rescissions and denials), as well as recent trends in the rate at which loans are prepaid.
We record premiums and origination costs related to our CDS and certain other derivative contracts in change in fair value of derivative instruments and policy acquisition costs, respectively, on our consolidated statements of operations. Our classification of these contracts is the same whether we are a direct insurer or we reinsure these contracts.
Effective January 1, 2010, we adopted the accounting standard update regarding improvements to financial reporting by enterprises involving VIEs. As a provider of credit enhancement, we have entered into insurance contracts with VIEs and derivative contracts with counterparties where we have provided credit protection directly on variable interests and, in some cases, obtained the contractual rights of our counterparties with respect to the VIEs. As defined by the accounting standard, VIEs include corporations, trusts or partnerships in which equity investors do not have a controlling financial interest or do not have sufficient equity at risk to finance activities without additional subordinated financial support. In addition, as a result of the update to the standard regarding accounting for transfers of financial assets, effective January 1, 2010, special purpose entities that were previously considered qualifying special purpose entities (“QSPEs”) are to be considered in the VIE accounting framework as prescribed by the standard regarding financial reporting by enterprises involving VIEs. As of December 31, 2009, we consolidated the assets and liabilities of two of the CPS trusts with which we are involved as we had acquired a majority of the securities issued by these two trusts at that date. We purchased substantially all of the securities issued by the remaining CPS trust in 2010, and we consolidated the assets and liabilities of that trust during 2010. We recognized a loss of $13.9 million within net (losses) gains on other financial instruments upon consolidation, based on the difference between the consideration paid for the CPS trust securities and the net amount of the trust’s identifiable assets and liabilities recognized and measured at fair value at the date of consolidation.
When evaluating whether we are the primary beneficiary of a VIE, we determine which activities most significantly impact the economic performance of the VIE. As part of our qualitative analysis, we consider
whether we have any contractual rights that would allow us to direct those activities. As of December 31, 2010, we have determined that we are the primary beneficiary of our NIMS transactions, our CPS transactions and certain financial guaranty structured transactions. As a result of the adoption of this accounting standard, in addition to the VIEs we had consolidated prior to January 1, 2010, we concluded that we are the primary beneficiary of two additional VIEs with respect to which we provided credit protection pursuant to financial guaranty insurance contracts and one additional VIE with respect to which we provided credit protection pursuant to a financial guaranty derivative contract. While the implementations of this accounting standard impacted the classification of our assets, liabilities, and certain line items in our statements of operations, we recorded no transition adjustments at January 1, 2010, because the net liabilities associated with these transactions remained unchanged. Our control rights in these VIEs, which we obtained due to an event of default or breach of a performance trigger as defined in the transaction, generally provide us with either a right to replace the VIE servicer, or, in some cases, the right to direct the sale of the VIE assets. In those instances where we have determined that we are the primary beneficiary, we consolidate the assets and liabilities of the VIE. We have elected to carry the financial assets and financial liabilities of these VIEs at fair value.
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 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 liabilities are measured using the enacted tax rates expected to apply to taxable income in the periods in which the deferred tax asset or liability is expected to be realized or settled.
We are required to establish a valuation allowance against our deferred tax assets (“DTA”) when it is more likely than not that all or some portion of our DTA will not be realized. At each balance sheet date, we assess our need for a valuation allowance and this assessment is based on the relative impact of all available evidence, both positive and negative, and requires management to exercise judgment and make assumptions regarding the weight given to the potential effect of negative and positive evidence and whether the DTA will be realized in future periods. Future realization of our DTA will ultimately depend on the existence of sufficient taxable income of the appropriate character (ordinary income versus capital gains) within the applicable carryback and carryforward periods provided under the tax law.
On April 1, 2009, we adopted a new accounting standard regarding recognition and presentation of OTTI. In accordance with this new standard, we record an OTTI on a security if we intend to sell the impaired security or if it is more likely than not that we will be required to sell the impaired security prior to recovery of its amortized cost basis, or we expect to be unable to collect cash flows sufficient to recover the amortized cost basis of the security. If a sale is likely, the security is classified as other-than-temporarily impaired and the full amount of the impairment is recognized as a loss in the statement of operations. Otherwise, losses on securities which are other-than-temporarily impaired are separated into: (i) the portion of loss which represents the credit loss; and (ii) the portion which is due to other factors. The credit loss portion is recognized as a loss in the statement of operations, while the loss due to other factors is recognized in accumulated other comprehensive income (loss), net of taxes. A credit loss is determined to exist if the present value of discounted cash flows expected to be collected from the security is less than the cost basis of the security. The present value of discounted cash flows is determined using
the original yield of the security. For securities held as of April 1, 2009 that had previously been other-than-temporarily impaired, an after-tax transition adjustment of $21.5 million was booked to reclassify the non-credit loss portion of these impairments from retained earnings to accumulated other comprehensive income (loss).
the financial condition of and near term prospects of the issuer.
Effective July 1, 2010, we adopted the update to the accounting standard regarding derivatives and hedging. This update clarifies how to determine whether embedded credit derivatives, including those interests held in collateralized debt obligations and synthetic collateralized debt obligations, should be bifurcated and accounted for separately. The adoption of this standard did not have a significant impact on our results of operations.
Summarized financial information concerning our operating segments, as of and for the years indicated, are as follows:
The following table sets forth our gross unrealized gains and gross unrealized losses on derivative assets and liabilities as at the dates indicated. Certain contracts are in an asset position because the net present value of the contractual premium exceeds the net present value of our estimate of the expected future premiums that a financial guarantor of similar credit quality to us would charge to provide the same credit protection assuming a transfer of our obligation to such financial guarantor as of the measurement date.
CMBS-The fair value of CMBS is estimated based on prices of comparable securities and spreads, and observable prepayment speeds. These securities are generally categorized in Level II of the fair value hierarchy or in Level III when market-based transaction activity is unavailable. The fair value of the Level III securities is generally estimated by discounting estimated future cash flows.
The cumulative impact attributable to the market’s perception of our non-performance risk decreased by $1,248.2 million during 2010, as presented in the table above. This decrease was primarily the result of the tightening of our CDS spreads.
We determine the fair value of our derivative instruments primarily using internally-generated models. We utilize market observable inputs, such as credit spreads on similar products, whenever they are available. When
one of our transactions develops characteristics that are inconsistent with the characteristics of transactions that underlie the relevant market-based index that we use in our credit spread valuation approach, and more relevant inputs or projections become available that we believe would represent the view of a typical market participant, we change to an approach that is based on the relevant available information. This change in approach is generally prompted when the credit component, and not market factors, becomes the dominant driver of the estimated fair value for a particular transaction. There is a high degree of uncertainty about our fair value estimates since our contracts are not traded or exchanged, which makes external validation and corroboration of our estimates difficult, particularly given the current market environment, where very few, if any, contracts are being traded or originated. In very limited recent instances, we have negotiated terminations of financial guaranty contracts with our counterparties and believe that such terminations provide the most relevant data with respect to validating our fair value estimates and such data has been generally consistent with our fair value estimates.
NIMS are financial guarantees that we have issued on NIMS. NIMS derivative assets primarily represent derivative assets in the NIMS trusts that we are required to consolidate. NIMS VIE debt represents the debt of consolidated NIMS trusts, which we account for at fair value. The estimated fair value amounts of these financial instruments are derived from internally-generated discounted cash flow models. We estimate losses in each securitization underlying either the NIMS credit derivatives, NIMs derivative assets or NIMS VIE debt by applying expected default rates separately to loans that are delinquent and those that are paying currently. These default rates are based on historical experience of similar transactions. We then estimate the rate of prepayments on the underlying collateral in each securitization, incorporating historical prepayment experience. The estimated loss and rate of prepayments are used to estimate the cash flows for each underlying securitization and NIMS bond, and ultimately, to produce the projected credit losses for each NIMS bond. In addition to expected credit losses, we consider the future expected premiums to be received from the NIMS trust for each credit derivative. The projected net losses are then discounted using a rate of return that incorporates our own non-performance risk, and based on our current CDS spread, results in a reduction of the derivative liability. Since NIMS guarantees are not market-traded instruments, considerable judgment is required in estimating fair value. The use of different assumptions and/or methodologies could have a significant effect on estimated fair values. The NIMS credit derivatives, NIMS derivative assets and NIMS VIE debt are all categorized in Level III of the fair value hierarchy. As a result of our having to consolidate our NIMS VIEs, the fair value of derivative assets held by the NIMS VIEs and the NIMS VIE debt are determined by using the same internally generated valuation model.
Present Value of Expected Future Contractual Premiums-Our contractual premiums are subject to change primarily for two reasons: (1) all of our contracts provide our counterparties with the right to terminate upon our default and (2) 86% of the aggregate net par outstanding of our corporate CDO transactions (as of December 31, 2010) provide our counterparties with the right to terminate these transactions based on certain rating agency downgrades that occurred in the past. In determining the expected future premiums of these transactions, we adjust the contractual premiums for such transactions to reflect the estimated fair value of those premiums based on our estimate of the probability of our counterparties exercising this downgrade termination right and the impact it would have on the remaining expected lifetime premium. In these circumstances, we also cap the total estimated fair value of the contracts at zero, such that none of the contracts subject to immediate termination are in a derivative asset position. The discount rate we use to determine the present value of expected future premiums is our CDS spread plus a risk-free rate. This discount rate reflects the risk that we may not collect future premiums due to our inability to satisfy our contractual obligations, which provides our counterparties the right to terminate the contracts.
Our corporate CDO transactions possess similar structural features to the standard CDX tranches, but often differ with respect to the referenced corporate entities, the term, the attachment points and the detachment points. Therefore, in order to determine the equivalent-risk tranche for each of our corporate CDO transactions, we determine the attachment and detachment points on the CDX index that have comparable estimated probabilities of loss as the attachment and detachment points in our transactions. We begin by performing a simulation analysis of referenced entity defaults in our transactions to determine the probability of portfolio losses exceeding our attachment and detachment points. The referenced entity defaults are primarily determined based on the following inputs: the market observed CDS credit spreads of the referenced corporate entities, the correlations between each of the referenced corporate entities, and the term of the transaction.
The reduction in our fair premium amount related to our non-performance risk is limited to a minimum fair premium amount, which is determined based on our estimate of the minimum fair premium that a market participant would require to assume the risks of our obligations. Our non-performance risk adjustment currently results in a material reduction of our typical fair premium amounts, which in turn has a positive impact on the fair value of these derivatives.
Prior to January 1, 2010, our guaranty on our sole outstanding directly insured CDO of ABS transaction was accounted for as a derivative. Upon the adoption of the accounting standard update regarding improvements to financial reporting by enterprises involving VIEs, we determined that we are the primary beneficiary for this CDO of ABS transaction and consolidated the VIE assets and liabilities as of January 1, 2010. Upon consolidation, we elected the fair value option for all financial assets and financial liabilities held by this VIE, which primarily consist of trading securities, interest rate swaps and VIE debt to note holders in the trust. The fair value election results in a net fair value of the VIE assets and VIE liabilities that is equal to the fair value liability of our exposure as previously accounted for as a derivative. See Note 6 for further discussion of the primary beneficiary analysis and the related financial impact to our financial position, financial performance and cash flows.
All Other Non-Corporate CDOs and Other Derivative Transactions-For all of our other non-corporate CDO and other derivative transactions, observed prices and market indices are not available. As a result, we
utilize an internal model that estimates fair premium. The fair premium amount is calculated such that the expected profit (fair premium amount net of expected losses and other expenses) is proportional to an internally-developed risk-based capital amount. Expected losses and our internally developed risk-based capital amounts are projected by our model using the credit rating, term, and current par outstanding for each transaction.
In making our determination of fair value for assumed credit derivatives, we use information provided to us by our counterparties to these reinsurance transactions, which are the primary insurers (the “primaries”) of the underlying credits, including the primaries’ fair valuations for these credits. The information obtained from our counterparties is not received with sufficient time for us to properly record the mark-to-market liability as of the balance sheet date. Therefore, the amount recorded as of December 31, 2010, is based on the most recent available financial information, which is reported on a quarterly lag. The lag in reporting is consistent from period to period. The fair value is based on credit spreads obtained by the primaries from market data sources published by third parties (e.g., dealer spread tables for collateral similar to assets within the transactions being valued) as well as collateral-specific spreads provided by trustees or obtained from market sources if such data is available. If observable market spreads are not available or reliable for the underlying reference obligations, then the primaries’ valuations are predominantly based on market indices that most closely resemble the underlying reference obligations, considering asset class, credit quality rating and maturity of the underlying reference obligations. In addition, these valuations incorporate an adjustment for non-performance risk. The primaries’ models used to estimate the fair value of these instruments include a number of factors, including credit spreads, changes in interest rates and the credit ratings of referenced entities. In establishing our fair value for these transactions, we assess the reasonableness of the primaries’ valuations by (1) reviewing the primaries’ publicly available information regarding their mark-to-market processes, including methodology and key assumptions; and (2) analyzing and discussing the changes in fair value with the primaries where the changes appear unusual or do not appear materially consistent with credit loss related information when provided by the primaries for these transactions. These credit derivatives are categorized in Level III of the fair value hierarchy.
The fair value of the VIE debt related to these other financial guaranty VIEs is estimated based on prices of comparable securities and spreads observed in the market. The overall net fair value for these transactions is determined using a discounted cash flow analysis. We do not currently estimate any projected claims based on our internal credit analysis, which is based on the current performance of the underlying collateral and the remaining subordination available to support the transaction. The present value of the insured cash flows is
(1) Comprised of broadly diversified domestic equity mutual funds included within Level I, and various preferred and common stocks invested across numerous companies and industries included within Level II and III.
(2) Comprised of short-term commercial paper within CPS trusts included in Level II and lottery annuities included in Level III.
(3) Does not include fixed-maturities held to maturity ($19.3 million), short-term investments ($0.6 million), primarily invested in time deposits, and other invested assets ($25.8 million), primarily invested in limited partnerships, accounted for as cost-method investments and not measured at fair value.
The following is a rollforward of Level III assets and liabilities measured at fair value for the year ended December 31, 2010:
(4) Includes impact of consolidation of VIE from CPS Trust I as of June 30, 2010, in the amount of $27.1 million.
(5) Includes impact of consolidation of VIE from CPS Trust I in the amount of $11.1 million. Offsetting this increase was $186.6 million related to NIMS purchases, $36.3 million related to financial guaranty VIE debt paydowns, and $31.2 million for CPS VIE debt purchases.
(2) Transfers are assumed to be made at the end of the period as the availability of market observed inputs change from period to period.
(3) This amount primarily represents derivative liabilities reclassified to VIE debt related to NIMS and CPS trusts that we were required to consolidate during the period.
The carrying value and estimated fair value of other selected assets and liabilities not carried at fair value on our consolidated balance sheets is as follows:
Short-Term Investments Carried at Cost-These investments are primarily time deposits that are near maturity, and are carried at cost, which approximates fair value for these short-term instruments.
(1) The difference between the carrying amounts of the net asset/liability position and maximum exposure related to VIEs is primarily driven by the difference between the face amount of the obligation and the recorded fair values, which includes an adjustment for our non-performance risk. For all VIEs, the maximum exposure is based on the net par amount of our insured obligation as of the reporting date, except for the put options on CPS, which is based on our carrying amounts of the investments.
Our continued involvement with the NIMS VIEs also includes a risk mitigation initiative, under which we purchased $198.5 million face value of NIMS bonds during 2010, at a purchase price of $169.6 million, which effectively eliminates the guarantee that we had issued to the VIE with respect to such bonds and limits our risk to the discounted purchase price. In total, our net cash outflow related to NIMS during 2010 was $187.1 million, primarily as a result of these purchases. The maximum principal exposure related to NIMS consolidated VIE assets and liabilities was $135.8 million at December 31, 2010, and comprises 26 transactions. The average remaining maturity of our existing NIMS transactions is approximately two years.
Based on our additional involvement in these trusts, combined with the put options Radian Asset Assurance holds on these trusts (which together are considered in the determination of the primary beneficiary), we concluded that we are the party that directs the activities that most significantly influence the economic performance of these VIEs and has the right to receive benefits that would be significant to these VIEs. This determination was based on a qualitative analysis which demonstrates that we have a variable interest in each of these VIEs, and therefore, we concluded that we are the primary beneficiary. As such, the assets and liabilities of these trusts were consolidated at their respective fair values. The assets of the consolidated trusts, which are reported in short-term investments, may only be used to settle obligations of the trusts, and there are no liabilities of the trusts for which creditors have recourse to our general credit.
Our interests in VIEs for which we are not the primary beneficiary may be accounted for as insurance, reinsurance or credit derivatives. For insurance contracts, we record reserves for losses and LAE; for derivative interests, we record cumulative changes in fair value as a corresponding derivative asset or derivative liability. Our primary involvement with VIEs relates to transactions in which we provide a financial guaranty to one or more classes of beneficial interest holders in the VIE. Underlying collateral in the VIEs includes residential and commercial mortgages, manufactured housing loans, consumer receivables and other financial assets sold to a VIE and repackaged into securities or similar beneficial interests. For all VIEs, the maximum exposure is based on the net par amount of our insured obligation as of the reporting date.
The following table provides a summary of our maximum exposure to losses, and the financial impact on our consolidated balance sheets, our consolidated statements of operations and our consolidated statements of cash flows as of and for the year ended December 31, 2010, as it relates to unconsolidated VIEs:
(2) Represents the amount paid for interest and the amount paid for the purchase of NIMS bonds we insure, offset by premiums received.
In continually assessing our involvement with VIEs, we consider certain events such as the VIE’s failure to meet certain contractual conditions, such as performance tests and triggers, servicer termination events and events of default, that should they occur, may provide us with additional control rights over the VIE. These events would cause us to reassess our initial determination of whether we are the primary beneficiary of a VIE. In addition, changes to its governance structure that would allow us to direct the activities of a VIE or our acquisition of additional financial interests in the VIE would also cause us to reassess our determination of whether we are the primary beneficiary of a VIE. Since many of our financial guaranty contracts provide us with substantial control rights over the activities of VIEs upon the occurrence of default or other performance triggers described above, we expect that additional VIEs may be consolidated by us if these events occur.
Our trading securities, which are recorded at fair value, consisted of the following at December 31, 2010 and 2009:
For trading securities that are still held at December 31, 2010 and 2009, we had net gains during 2010 and 2009 associated with those securities in the amount of $27.0 million and $11.7 million, respectively.
During 2010, we recorded $3.1 million in gains on securities transferred from the available for sale category into the trading category. For the years ended December 31, 2010, 2009 and 2008, we did not sell or transfer any fixed-maturity investments classified as held to maturity.
The sources of our proceeds and related investment gains (losses) on our available for sale securities are as follows:
There was a negligible amount of impairment losses recognized in earnings for the year ended December 31, 2010, none of which were attributable to credit losses. The following table provides a rollforward of the amount related to credit losses recognized in earnings for which a portion of an OTTI was recognized in other comprehensive income (“OCI”) from April 1, 2009 (the inception date of the new accounting standard regarding OTTI) through December 31, 2009 (in thousands):
Impairments due to deterioration in credit that result in a conclusion that the present value of cash flows expected to be collected will not be sufficient to recover the amortized cost basis of the security are considered other-than-temporary. Other declines in fair value (for example, due to interest rate changes, sector credit rating changes or company-specific rating changes) that result in a conclusion that the present value of cash flows expected to be collected will not be sufficient to recover the amortized cost basis of the security, may also result in a conclusion that an OTTI has occurred. To the extent we determine that a security is deemed to be other-than-temporarily impaired, an impairment loss is recognized.
During 2010, we recorded a negligible amount of charges related to declines in fair value of securities considered to be other-than-temporary. During 2009, we recorded approximately $9.3 million of charges related to declines in fair value of securities (primarily equity securities) considered to be other-than-temporary. During 2008, we recorded approximately $55.2 million of charges related to declines in fair value of securities (primarily municipal and taxable bonds and preferred stocks) considered to be other-than-temporary. Realized gains and losses are determined on a specific identification method and are included in income.
The unrealized losses of 12 months or greater duration as of December 31, 2010 on the remaining securities in this category were caused by interest rate or credit spread movement. We did not consider these investments to be other-than-temporarily impaired at December 31, 2010.
For all investment categories, unrealized losses of less than 12 months in duration were generally attributable to interest rate or credit spread movements. All securities were evaluated in accordance with our impairment recognition policy covering various time and price decline scenarios.
(1) Actual maturities may differ as a result of calls before scheduled maturity.
(2) RMBS, CMBS and other ABS are shown separately, as they are not due at a single maturity date.
At December 31, 2010, investments in any person and its affiliates that exceeded 10% of total stockholders’ equity were as follows (in thousands):
At December 31, 2010, we owned a 46% interest in C-BASS, a credit-based mortgage securitization business. As a consequence of the complete write-off of our investment in C-BASS in 2007, we have no carrying value related to our interest in C-BASS. C-BASS filed for Chapter 11 bankruptcy protection on November 12, 2010. The likelihood that we will recoup any of our investment in C-BASS is extremely remote. Accordingly, we believe that the likelihood that our investment in C-BASS will have anything more than a negligible impact on our financial position, results of operations or cash flows at any time in the future is extremely remote.
On May 3, 2010, Radian Guaranty sold to Sherman all of its remaining 28.7% equity interest in Sherman for approximately $172 million in cash, pursuant to a Securities Purchase Agreement (the “Sherman Purchase Agreement”) dated as of May 3, 2010, between Radian Guaranty and Sherman. As a result of the sale, in the second quarter of 2010, we recorded a pre-tax gain of approximately $34.8 million, net of transaction related expenses of $1.3 million and a pre-tax decrease in accumulated comprehensive income of $29.7 million. In addition, under the Sherman Purchase Agreement, we agreed to terminate certain rights, including our right to a future contingent payment from a previous sale of our interest in Sherman.
In our mortgage insurance business, we utilize reinsurance as a risk management tool to reduce our net risk in force, to manage regulatory risk-to-capital requirements, and to comply with the insurance regulations of states that require us to limit our coverage percentage of any single risk to 25%. We have only used reinsurance in our financial guaranty business to the extent necessary in specific transactions to comply with applicable single risk limits. Although the use of reinsurance does not discharge an insurer from its primary liability to the insured, the reinsuring company assumes the related liability under these arrangements. Included in other assets are unearned premiums on risk that we have ceded of $1.0 million and $4.4 million at December 31, 2010 and 2009, respectively.
We and other companies in the mortgage insurance industry have participated in reinsurance arrangements with mortgage lenders commonly referred to as “captive reinsurance arrangements.” Under captive reinsurance arrangements, a mortgage lender typically establishes a reinsurance company that assumes part of the risk associated with the portfolio of that lender’s mortgages insured by us on a flow basis (as compared to mortgages insured in structured transactions, which typically are not eligible for captive reinsurance arrangements). In return for the reinsurance company’s assumption of a portion of the risk, we cede a portion of the mortgage insurance premiums paid to us to the reinsurance company. In most cases, the risk assumed by the reinsurance company is an excess layer of aggregate losses that would be penetrated only in a situation of adverse loss development. The captive reinsurers are typically required to maintain minimum capitalization equal to 10% of the risk assumed. We have concluded that all of our captive reinsurance arrangements transfer risk to the captive reinsurer. We have also offered, on a limited basis, “quota share” captive reinsurance agreements under which the captive reinsurance company assumes a pro rata share of all losses in return for a pro rata share of the premiums collected.
In most cases, the risk assumed by the reinsurance company is an excess layer of aggregate losses that would be penetrated only in a situation of adverse loss development. However, during the recent housing and related credit market downturn in which losses have increased significantly, many captive reinsurance arrangements have attached, requiring our captive reinsurers to make payments to us. In all cases, the captive reinsurer establishes a trust to secure our potential cash recoveries. We generally are the sole beneficiary under these trusts, and therefore have the ability to initiate disbursements under the trusts in accordance with the terms of our captive reinsurance agreements.
We have protected against losses in excess of our expectations on some of the risk associated with non-prime and riskier products by reinsuring this business through Smart Home reinsurance transactions. In 2004, we developed Smart Home as a way to effectively transfer risk from our portfolio to investors in the capital markets. Smart Home mitigates our risk against losses, concentrated positions and riskier products. Approximately 3.2% and 3.4% of our primary mortgage risk in force was ceded through Smart Home reinsurance transactions at December 31, 2010 and 2009, respectively. In these transactions, we reinsure the middle layer risk positions, while retaining a significant portion of the total risk comprising the first-loss and most remote risk positions.
The most significant driver of the $557.8 million 2010 prior year adverse development related to the impact of aging of underlying defaulted loans on our default to claim rate beyond the extent we expected at December 31, 2009. With continuing declines in home values, persistently high unemployment and delays by servicers in either modifying loans or foreclosing on properties, the ability to cure a delinquent loan within our expected timeframe has become increasingly difficult to achieve. Consequently, our default inventory has experienced an increase in aging, and we apply higher estimated default to claim rates on our more aged delinquencies, resulting in higher reserves. The protracted amount of time it has taken for servicers to resolve certain aged loans has extended the period of uncertainty with regard to our ultimate claim liability beyond what we predicted at the
The significant decrease in our default to claim rate in 2009 was primarily related to an increase in our estimate during that year related to future insurance rescissions and claim denials, which was the primary reason for our 2009 prior year favorable development of $411.7 million. Our incurred losses in 2009 for defaults from prior years was favorably impacted by increased levels of insurance rescissions and claim denials, as compared to the level of rescission and denial activity anticipated in the reserves established at December 31, 2008. As a result of the significant increase in our loss mitigation activities in 2009, our incurred losses were reduced by approximately $650 million as of December 31, 2009 related to prior year defaults. Partially offsetting this impact was the effect of an increase in our default to claim rate prior to consideration of our loss mitigation activities, primarily as a result of the aging of delinquent loans.
The following table illustrates the amount of first-lien claims submitted to us for payment that were rescinded or denied, for the years ended December 31, 2010 and 2009, net of reinstatements within each period:
(1) Related to claims from policies in which we were in a first loss position and would have paid the claim absent the rescission or denial.
The following table illustrates the total amount of first-lien claims submitted to us for payment that were rescinded in the years noted, and then subsequently were challenged (“rebutted”) by the lenders and policyholders, but not reinstated:
While the total potential claim amount of non-overturned rebuttals outstanding represents all challenged rescissions for which coverage has not been reinstated, our ongoing, active engagement with our lender customers typically involves a small number of these non-overturned rebuttals. Absent litigation or other legal proceedings in which we are not successful, we do not expect that these discussions are likely to result in settlements that would materially impact our liquidity or results of operations.
The following table shows the cumulative denial and rescission rates as of December 31, 2010 on our total first-lien portfolio in the quarter the claims were received for the periods indicated:
Deteriorating markets in California and Florida, where non-prime and non-traditional mortgage products such as adjustable rate mortgages (“ARMs”) and interest-only loans are prevalent and where home prices have fallen significantly, have resulted in significant losses in our mortgage insurance business. During the prolonged period of rising home prices that preceded the current downturn in the U.S. housing market, very few mortgage delinquencies and claims were attributable to insured loans in California, despite the significant growth during this period of riskier, non-traditional mortgage products in this state. As mortgage credit performance in California and Florida has deteriorated, given the size of these markets, our loss experience has been significantly affected and will continue to be negatively affected if conditions do not improve or continue to deteriorate.
In addition to California and Florida, approximately 12.6% of our primary mortgage insurance risk in force at December 31, 2010 was concentrated in the Midwestern states of Michigan, Illinois and Ohio. The region’s
The following table presents information relating to our financial guaranty reserves and LAE:
The PDR in our mortgage insurance business at December 31, 2010 and 2009, relates to our second-lien business.
The following table illustrates our net projected premium excess on our first-lien portfolio:
For our first-lien mortgage insurance business, because the combination of the net present value of expected premiums and already established reserves (net of reinsurance recoverables) exceeds the net present value of expected losses and expenses, a first-lien PDR was not required as of December 31, 2010. Expected losses are based on an assumed paid claim rate of approximately 11.7% for our total primary first-lien mortgage insurance portfolio, which includes both delinquent loans and current loans, comprising 8.8% for prime, 25.6% for subprime and 24.4% for Alt-A. While deterioration in the macroeconomic environment has resulted in an increase in expected losses, new business originated since the beginning of 2009 is expected to be profitable, which has contributed to the overall expected net profitability of our first-lien portfolio. In addition, estimated rescissions and denials on insured loans, as part of our loss mitigation efforts, is expected to partially offset the impact of higher expected defaults and claims.
During 2010, the second-lien PDR decreased by approximately $14.6 million, primarily as a result of the normal transfer of incurred losses to second-lien loss reserves and by updates to our underlying assumptions.
Upon continued performance deterioration, we may conduct additional or more frequent reviews of a credit, downgrade the internal credit rating for a credit or if appropriate, move the credit to the financial guaranty Watch List. All amendments, consents and waivers related to a transaction are also reviewed and evaluated by the appropriate risk manager. In addition to individual credit analysis, the risk management department is responsible for following economic, environmental and regulatory trends and for determining their potential impact on our insured portfolio.
Due to the additional efforts involved in monitoring Special Mention credits, consultants and/or legal counsel may be engaged to assist in claim prevention or loss mitigation strategies.
Intensified Surveillance. This category includes transactions in financial guaranty’s insured portfolio that are internally rated below investment-grade and indicate a severe and often permanent adverse change in the transaction’s credit profile. Transactions in this category are still performing, meaning they have not yet defaulted on a payment, but our risk management department has determined that there is a substantial likelihood of default. Transactions that are placed in this category may have some or all of the following characteristics:
Insured transactions are generally elevated into this category from the Special Mention list as a result of continuing declining credit trends. Occasionally, however, transactions may enter this category directly due to an unexpected financial event that leads to rapid and severe deterioration. Direct and assumed exposures in this category that satisfy certain criteria, including minimum outstanding par thresholds, are generally reviewed and reported on quarterly. Other exposures that do not satisfy applicable criteria are reviewed at the discretion of the risk manager, senior management, the Watch and Reserve Committee Chairperson or the Chief Risk Officer for our financial guaranty business.
In our directly insured financial guaranty business, we establish loss and LAE reserves on our non-derivative financial guaranty contracts. The assumptions used to determine reserves for directly insured credits are based upon the analysis as more fully described above. In our financial guaranty reinsurance business, the primary obligation for assessing and mitigating claims rests with the ceding company. We generally establish reserves for our assumed Watch List credits based upon information provided by the ceding company. Expected losses on derivative financial guaranty contracts are considered as part of the determination of fair value of derivative instruments.
when appropriate, exercising applicable rights to replace servicers, trustees, advisers or the other parties responsible for the performance of the transaction; and
Issuers typically are under no obligation to restructure insured transactions to prevent losses, but often will cooperate to avoid being associated with an obligation that experiences losses. When appropriate, we discuss potential settlement options regarding particular obligations with appropriate parties. On occasion, loss mitigation may include an early termination of our obligations, which could result in payments to or from us. To determine the appropriate loss mitigation approach, we generally consider various factors relevant to such insured transaction, which may include:
The following table includes additional information as of December 31, 2010 regarding our financial guaranty claim liabilities broken out by the surveillance categories described above:
The accretion of these balances is included in premiums written and premiums earned for premiums receivable and policy acquisition costs for commissions on our consolidated statements of operations. The amounts of the accretion included in premiums written, premiums earned and policy acquisition costs for the years ended December 31, 2010 and 2009 are as follows (in millions):
The following table shows the expected contractual premium revenue from our existing financial guaranty portfolio, assuming no prepayments or refunding of any financial guaranty obligations, as of December 31, 2010:
Weighted-average risk-free rates (used for discounting gross claim liability and gross potential recoveries):
The composition of our long-term debt at December 31, 2010 and 2009 was as follows:
In May 2001, we issued $250 million of 7.75% debentures due June 1, 2011. Interest on the debentures is payable semi-annually on June 1 and December 1. We have the option to redeem some or all of the debentures at any time with not less than 30 days’ notice at a redemption price equal to the greater of the principal amounts of the notes plus accrued interest or the sum of the present values of the remaining scheduled payments of principal and interest on the notes to be redeemed. During 2009, we repurchased $57.7 million of outstanding principal on these debentures at an average purchase price of approximately $0.79 per dollar of principal, and recorded a gain of $12.0 million. During 2010, we repurchased an additional $31.9 million of this debt at an average purchase price of approximately $0.92 per dollar of principal, and recorded a gain of $2.5 million. The gains on these repurchases are included in net (losses) gains on other financial instruments on our consolidated statements of operations.
In June 2005, we issued $250 million of unsecured senior notes. These notes bear interest at the rate of 5.375% per annum, payable semi-annually on June 15 and December 15. The notes mature on June 15, 2015. We have the option to redeem some or all of the notes at any time with not less than 30 days’ notice at a redemption price equal to the greater of the principal amount of the notes or the sum of the present values of the remaining scheduled payments of principal and interest on the notes to be redeemed.
In November 2010, we issued $450 million principal amount of 3.0% convertible, unsecured senior notes due November 2017 ( the “2017 Convertible Senior Notes”) and received net proceeds of $391.3 million. Interest is payable semi-annually on May 15 and November 15 of each year, commencing on May 15, 2011.
This transaction is accounted for under the accounting standard for convertible debt instruments that may be settled in cash upon conversion (including partial cash settlement) and specifies that issuers of convertible debt instruments that may be settled in cash upon conversion (including partial cash settlement) should separately account for the liability and equity components in a manner that reflects the entity’s nonconvertible debt borrowing rate when the interest cost is recognized in subsequent periods. Our convertible notes fall within the scope of this standard due to our ability to elect to repay the convertible notes in cash.
(1) Included within long-term debt and is being amortized over the life of the convertible notes.
In connection with the offering of the convertible notes, we also entered into capped call transactions with an affiliate of Morgan Stanley & Co., Incorporated, whose obligations have been guaranteed by Morgan Stanley. The capped call transactions are intended to offset the potential dilution to our common stock and/or any potential cash payments that may be required to be made by us upon conversion of the notes in excess of the principal amount of the notes, up to a stock price of approximately $14.11 per share, which is the initial cap on the counterparty’s share delivery obligation under the call option. If, however, the market value per share of our common stock, as measured under the terms of the capped call transactions, exceeds the applicable cap price of the capped call transactions, the number of shares of our common stock and/or the amount of cash we expect to receive upon the exercise of the capped call transactions will be capped and the anti-dilutive and/or offsetting effect of the capped call transactions will be limited. We paid approximately $46.1 million from the net proceeds from the issuance and sale of the convertible notes to purchase the capped call transactions.
The components of our consolidated income tax provision (benefit) are as follows:
The reconciliation of taxes computed at the statutory tax rate of 35% for 2010, 2009 and 2008 to the provision (benefit) for income taxes is as follows:
an “ownership change” under U.S. federal income tax rules. These provisions restrict or discourage certain transfers of our common stock that would (i) create or result in a person becoming a five-percent shareholder under Section 382 of the IRC or (ii) increase the stock ownership of any existing five-percent shareholder under Section 382 of the IRC.
As of December 31, 2010, we have approximately $44.0 million of unrecognized tax benefits that, if recognized, would affect the effective tax rate. Our policy for the recognition of interest and penalties associated with uncertain tax positions is to record such items as a component of our income tax provision. The table below details the cumulative effect of applying the provisions of the standard relating to accounting for uncertainty of income taxes as of December 31, 2010.
We have taken a 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 in a court of last resort, measurement under this standard 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 decreased approximately $7.8 million. This net decrease primarily reflects the impact of the tentative settlement agreement that we have reached with the IRS Appeals Division, as described below, and our recognition of certain premium income. The unrecognized tax benefits for this premium income position reflects a decrease due to the expiration of the applicable statute of limitations for the 2005 and 2006 tax years. However, the premium income position continued to impact subsequent years resulting in an increase to the unrecognized tax benefits related to prior years, primarily the 2008 taxable year. Over the next 12 months, additional income or losses may be generated from an investment in a certain lower tier, minority owned, partnership interest, which would require increases or
decreases in our calculations of potential state and local taxes, including any penalty and interest thereon. An estimate of the taxable income or loss, the character of such income or loss, and its impact to the current income taxes payable over the next 12-month period cannot be reasonably made at this time. As described in more detail below, we have reached a tentative settlement agreement with the IRS Appeals Division relating to the 2000 through 2007 tax years. If we are able to execute a final closing agreement with Appeals within the next 12 months on substantially similar terms as the tentative settlement agreement, then we estimate the net reduction within our unrecognized tax benefits will range from approximately $2.0 to $3.5 million. In the event we are not successful in our defense of the tax positions taken for U.S. Federal income tax purposes, and for which we have recorded unrecognized tax benefits, then such adjustments originating in NOL or NOL carryback years may serve as a reduction to our existing NOL.
We are currently contesting proposed adjustments resulting from the examination by the IRS for the 2000 through 2007 tax years. The IRS opposes the recognition of certain tax losses and deductions that were generated through our investment in a portfolio of residual interests in Real Estate Mortgage Investment Conduits (“REMICs”) and has proposed adjustments denying the associated tax benefits of these items. The originally proposed adjustments relating to the 2000 through 2007 tax years, if sustained, would have increased our original tax liability for those years by approximately $128 million, in addition to any associated penalties and interest. We appealed these proposed adjustments to the IRS Office of Appeals (“Appeals”) and made “qualified deposits” with the U.S. Department of the Treasury of approximately $89 million to avoid the accrual of above-market-rate interest with respect to the proposed adjustments. In late December 2010, we reached a tentative settlement agreement with Appeals. Additionally, under the terms of this tentative settlement agreement, we believe that we will be entitled to receive a substantial majority of the $89 million in qualified deposits. However, we do not expect to execute a final closing agreement with Appeals for several months and until such time there can be no assurance that the terms of our tentative agreement with Appeals will not change materially or that we will successfully conclude a final closing agreement with respect to this matter. After discussions with outside counsel about the issues raised in the examination and the tentative settlement agreement reached, we believe that an adequate provision for income taxes has been made for potential liabilities that may result. However, if the final closing agreement differs materially from our current expectations or we are unable to enter into a final closing agreement, there could be a material impact on our effective tax rate, results of operations and cash flows.
(1) We are currently contesting proposed adjustments resulting from the examination by the IRS for the 2000 through 2007 tax years. As part of this process, we have agreed to extend all relevant statute of limitations for the assessment of tax to December 31, 2011. All such statute of limitation extensions have limited the scope of the examinations to the recognition of certain tax benefits that were generated through our investment in a portfolio of residual interests in REMICs.
Radian Guaranty’s, Amerin Guaranty’s and Radian Insurance’s ability to pay dividends on their common stock is restricted by certain provisions of the insurance laws of Pennsylvania, their state of domicile. Under Pennsylvania’s insurance laws, dividends and other distributions may only be paid out of an insurer’s positive unassigned surplus, measured as of the end of the prior fiscal year, unless the Pennsylvania Insurance Commissioner approves the payment of dividends or other distributions from another source. Radian Guaranty, Amerin Guaranty and Radian Insurance had negative unassigned surplus at December 31, 2010 of $168.6 million, $161.9 million, and $384.1 million, respectively, compared to negative unassigned surplus of
$400.9 million, $169.4 million, and $427.0 million, respectively, at December 31, 2009. In addition, in the event an insurer had positive unassigned surplus as of the end of the prior fiscal year, without the prior approval of the Pennsylvania Insurance Commissioner, such insurer only may pay dividends or other distributions during any 12-month period in an aggregate amount less than or equal to the greater of (i) 10% of the preceding year-end statutory policyholders’ surplus, or (ii) the preceding year’s statutory net income. Due to the negative unassigned surplus at the end of 2010, no dividends or other distributions can be paid from Radian Guaranty, Amerin Guaranty or Radian Insurance in 2011, without approval from the Pennsylvania Insurance Commissioner. Neither Radian Guaranty, Amerin Guaranty or Radian Insurance paid any dividends in 2010 or 2009. Radian Group contributed the outstanding capital stock of Radian Asset Assurance to Radian Guaranty in 2008. Radian Group contributed $322 million to Radian Guaranty in 2010. Both of these transactions strengthened Radian Guaranty’s statutory capital at that time.
Radian Guaranty’s statutory net loss, statutory policyholders’ surplus and contingency reserve as of and for the years ended December 31 were as follows:
Radian Insurance’s statutory net income (loss), statutory policyholders’ surplus and contingency reserve as of and for the years ended December 31 were as follows:
As a mortgage guaranty insurer, Radian Mortgage Insurance is required under the insurance laws of Arizona to maintain a minimum policyholder position (“MPP”) calculated for each loan it insures based on the face amount, loan-to-value ratio and coverage percentage for the loan. The total calculated MPP must be less than Radian Mortgage Insurance’s total statutory policyholders’ position, which is defined as contingency reserve plus surplus as regards to policyholders, or Radian Mortgage Insurance is required to cease transacting new business until such time that its MPP is greater than its total statutory policyholders’ position. At December 31, 2010, Radian Mortgage Insurance policyholders’ position was $10.1 million and total MPP was $9.1 million and, as such, Radian Mortgage Insurance is currently permitted to transact new business in the state of Arizona.
As a result of the increase in severity estimates for our pool insurance loss reserves and the resulting increase in losses incurred during 2010, Radian Mortgage Insurance required capital contributions totaling approximately $74 million in order to maintain the minimum MPP level.
Radian Group could be required to provide capital support for our mortgage insurance subsidiaries if additional capital is required pursuant to insurance laws and regulations or by the GSEs or the rating agencies. In connection with a financial examination of CMAC of Texas by the Texas Department of Insurance (“TXDOI”) for the January 1, 2007 through December 31, 2008 period, the TXDOI examiners notified us that they do not agree with our statutory accounting treatment pertaining to the proposed tax adjustments resulting from the IRS examination of Radian Group’s 2000 through 2004 tax years. The TXDOI examiners have proposed a reduction
to CMAC of Texas’s statutory surplus of approximately $128 million, which relates to our dispute with the IRS described above, and, if such adjustment is sustained, CMAC of Texas would require additional capital support to maintain the minimum $20 million statutory surplus. We disagree with the TXDOI’s proposed adjustment to CMAC of Texas’s statutory surplus, and we have requested a hearing to appeal the TXDOI proposed adjustment, which hearing is set for April 5, 2011. We can give no assurance that we will prevail in our appeal or that we will not be required to provide the additional capital support required. In addition, due to the disagreement regarding the statutory accounting treatment for these issues, CMAC of Texas has not been able to file its annual audited statutory financial statements for 2009, which were due on June 30, 2010. The TXDOI has informed us that it does not plan to take any action with regard to CMAC of Texas not being in compliance with this filing requirement. However, given our current non-compliance, we believe the TXDOI could revoke or restrict CMAC of Texas’s ability to write new intercompany reinsurance at any time. Because CMAC of Texas provides reinsurance to Radian Guaranty, any such action could have a significant negative impact on Radian Guaranty’s ability to write new mortgage insurance business and potentially harm the value of our mortgage insurance franchise.
Radian Asset Assurance’s ability to pay dividends is restricted by certain provisions of the insurance laws of New York, its state of domicile. Under the New York insurance laws, Radian Asset Assurance may only pay dividends from earned surplus. Without the prior approval from the New York Superintendent of Insurance, Radian Asset Assurance can only pay a dividend, which when totaled with all other dividends declared or distributed on it during the preceding 12 months, is the lesser of 10% of its surplus to policyholders as shown by its last statement on file with the New York Superintendent of Insurance, or 100% of adjusted net investment income. During 2008, Radian Asset Assurance declared an ordinary dividend of $107.5 million to Radian Group, which was subsequently contributed to Radian Guaranty. In addition, Radian Group contributed its equity interest in Radian Asset Assurance to Radian Guaranty in the latter part of 2008. This restructuring provided significant regulatory capital credit to Radian Guaranty and is intended to provide cash dividends to Radian Guaranty over time. In June 2009, Radian Asset Assurance paid a dividend of $99.7 million to Radian Guaranty. On June 30, 2010, Radian Asset Assurance paid an ordinary dividend of $69.2 million to Radian Guaranty. The amount, if any, and timing of Radian Asset Assurance’s dividend paying capacity will depend, in part, on the performance of our insured financial guaranty portfolio, including the payment of claims, as well as the amounts we may pay to commute transactions.
During 2010, we initiated the liquidation of RAAL by novating, transferring or commuting the remaining exposures of RAAL to Radian Asset Assurance. This has been substantially completed at December 31, 2010, and is expected to be completed during 2011.
New York insurance law requires financial guaranty insurers to maintain minimum policyholders’ surplus of $65 million. When added to the minimum policyholders’ surplus of $1.4 million separately required for the other lines of insurance that it is licensed to write, our financial guaranty insurance subsidiary is required to have an aggregate minimum policyholders’ surplus of $66.4 million. Radian Asset Assurance’s statutory net income, statutory policyholders’ surplus and contingency reserve as of and for the years ended December 31 were as follows:
any single risk, net of reinsurance and collateral, is limited to 75% of the insurer’s policyholders’ surplus and contingency reserves. Additional single risk limits, which generally are more restrictive than the municipal bond single risk limit, are also specified for several other categories of insured obligations.
The differences between the statutory financial statements and financial statements presented on a GAAP basis represent differences between GAAP and Statutory Accounting (“STAT”) for the following reasons:
(b) In accordance with New York insurance law, financial guaranty insurance companies are required to establish a contingency reserve in the amount prescribed by legislation. Such legislation requires that, for financial guaranty policies, each insurer must establish a contingency reserve equal to the greater of 50% of premiums written or a stated percentage of the principal guaranteed, ratably over 15 to 20 years dependent upon the category of obligation insured. Contingency reserves may be discontinued if the total reserve established for all categories of obligations exceeds the sum of the stated percentages for such categories multiplied by the unpaid principal guaranteed. The contingency reserve may be released with regulatory approval to the extent that losses in any calendar year exceed a pre-determined percentage of earned premiums for such year, with the percentage threshold dependent upon the category of obligation insured. Such reserves may also be released, subject to regulatory approval in certain instances, upon demonstration that the reserve amount is excessive in relation to the outstanding obligations. Reinsurers are required to establish a contingency reserve equal to their proportionate share of the reserve established by the ceding company. Also under STAT, case reserves are required to be established in the year in which a default occurs based on the guarantor’s best estimate of ultimate loss payment, rather than when the probability weighted expected net cash out flows exceed unearned premium reserves.
(d) STAT financial statements only include a provision for current income taxes as a component of net income. Deferred taxes, subject to certain limitations set forth in Statement of Statutory Accounting Principles (“SSAP”) 10R, are recorded in the STAT balance sheets with any changes thereto recognized via a change in statutory surplus. Purchases of tax and loss bonds are accounted for as investments under STAT. GAAP financial statements provide for current and deferred income taxes in our consolidated statements of operations, and purchases of tax and loss bonds are recorded as prepaid federal income taxes in our consolidated balance sheets.
(e) Under STAT, investment-grade fixed-maturity investments are valued at amortized cost, and below investment-grade securities are carried at the lower of amortized cost or market value. Under GAAP, those investments that the statutory insurance entities do not have the ability or intent to hold to maturity are considered to be either available for sale or trading securities, and are recorded at fair value, with the unrealized gain or loss recognized, net of tax, as an increase or decrease to stockholders’ equity or current operations, as applicable.
Under the 2008 Equity Plan, if any third party were to acquire beneficial ownership of 40% or more of our outstanding common stock (20% or more of our outstanding common stock under the 1995 Equity Plan), a significant portion of the equity issued under the Equity Plans would become fully vested and transferable. At December 31, 2010, our largest single stockholder owned slightly less than 10.0% of our outstanding common stock. Beginning in May 2009, awards granted under the 2008 Equity Plan 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. We estimate that the vesting of awards as a result of a change in control, including “double trigger” terminations in connection with a change in control, would result in a pre-tax accounting charge to us of approximately $7.8 million, representing an acceleration of compensation expense.
We have a long-term incentive cash program, the Radian Group Inc. 2008 Long-Term Performance Cash Plan (the “Officer LTI Plan”). Participants in the Officer LTI Plan include certain officers of Radian Group and our mortgage insurance subsidiaries. In 2008, the Compensation Committee granted awards under the Officer LTI Plan that were based on our stock price as noted below. Additional awards have been granted under the Officer LTI Plan and another of our long-term incentive cash plans, the Executive Long-Term Performance Cash Plan (the “Executive LTI Plan”), that are not directly correlated to our stock price. See discussion below.
Depending on certain characteristics of the awards granted under the various compensation programs noted above, they are accounted for as either equity instruments or liabilities. Compensation programs that are cash settled and not based on our stock price are accrued as of the balance sheet date. The following table summarizes awards outstanding and compensation expense recognized for each type of share-based award as of and for the periods indicated:
(1) For purposes of calculating compensation cost recognized, we consider awards effectively vested (and we recognize the full compensation costs) when grantees become retirement eligible. Under the terms of our awards, legal vesting upon retirement occurs when the grantee actually separates from service.
The Officer LTI Plan is structured as a performance-based, long-term cash plan that consists of grants of cash performance award opportunities. The Compensation and Human Resources Committee of our board of directors (the “Compensation Committee”) administers the Officer LTI Plan and is responsible for, among other items, establishing the target values of awards to participants and selecting the specific performance factors, which can include retention-based service goals, for such awards. At the end of each performance period, the Compensation Committee determines the specific cash payout to each participant, which may range from a minimum of 0% of the target award to up to 400% of the target award (with the maximum specified in the award agreements), based on the degree to which each of the performance measures has been satisfied. All payouts will be in cash in a lump sum (there is no stock awarded under the Officer LTI Plan), net of applicable withholdings.
For 2008 grants, performance over the initial performance period, which began July 1, 2008 and ended December 31, 2010, was based on our stock price growth (above a minimum threshold price), with a range of possible payouts corresponding to ranges of certain stock prices achieved. In February 2011, we paid $8.4 million related to these awards representing a range of 146% to 172% of the target awards. In 2009 and 2010, the Compensation Committee granted cash incentive awards under the Officer LTI Plan that are not based on our stock price but contain discretionary payments based on overall corporate performance. See discussion below.
In 2010 and 2009, the Compensation Committee awarded cash-settled SARs under the 2008 Equity Plan, which upon exercise, entitle grantees to receive a cash amount equal to the excess of the closing share price of our common stock on the date of exercise over the exercise price. The exercise price for the SARs is equal to the closing share price of our common stock on the grant date. The exercise prices of the SARs awarded in 2010 and 2009 are $10.42 and $2.68, respectively. As of December 31, 2010, the estimated fair value of the SARs granted in 2010 and 2009 are $6.60 and $7.17, respectively. The SARs have a five-year term, and vest over a four-year period, with 50% vesting on the third anniversary and 50% vesting on the fourth anniversary of the grant date. The SARs will vest earlier upon the grantee’s termination of employment as a result of a grantee’s retirement, death or disability. The SARs provide for “double trigger” vesting in the event of a change of control. If a 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 a change of control, the unvested SARs will become fully vested.
We use the Monte Carlo valuation model in determining the fair value of SARs issued to employees. The Monte Carlo valuation model incorporates multiple input variables, including expected life, volatility, risk-free rate of return and dividend yield of each award. In using these assumptions in the Monte Carlo valuation model, we consider historical and observable market data.
The Monte Carlo valuation model incorporates multiple input variables, along with correlation factors, to estimate the probability that a vesting condition will be achieved. In using the Monte Carlo valuation model, the following assumptions were applied: (1) the RSUs will be held to maturity, consistent with historical exercise behavior, (2) there will be no event during the vesting period that would trigger accelerated vesting (i.e., change of control), and (3) estimates of the expected volatility of Radian Group and each of the companies in the peer group. The cost recorded for these awards, which is based on the fair value of the units at each measurement date, is recognized over the vesting period.
Timed-Vested RSUs-In 2010 and 2009, the Compensation Committee awarded 108,921 and 423,503, respectively, of time vested RSUs (to be settled in cash) to our non-employee directors. The estimated fair value of RSUs to be settled in cash is based on our stock price at the measurement date. These RSUs entitle our non-employee directors to a cash amount equal to the fair market value of the RSUs that have vested on the conversion date (generally defined as a director’s termination of service with us). The RSUs vest in their entirety three years from the date of grant, or earlier, upon the director’s retirement, death or disability, and RSU award payments are made upon the non-employee directors’ separation from service. In addition, vesting may be accelerated under certain circumstances if the non-employee director has a separation from service following a change of control of Radian Group. If a non-employee director’s service with us is terminated during any period in which the vesting restrictions apply, the RSU award to such non-employee director will terminate as to all RSUs covered by the award for which vesting restrictions have not lapsed and such award will be forfeited.
December 31, 2010, there were approximately 4,422 dividend-equivalent phantom shares accrued that were not included in the total number of outstanding shares. The cost recognized for these awards is based on the fair value at date of grant and is recognized on a straight line basis over the vesting period. Our non-employee directors were awarded 417,330 shares of phantom stock in 2008. There were no shares of phantom stock granted in 2009 or 2010.
Upon the exercise of stock options, we generally issue shares from the authorized, unissued share reserves when the exercise price is less than the treasury stock repurchase price, and from treasury stock when the exercise price is greater than the treasury stock repurchase price.
The table below summarizes information regarding fully vested share options as of December 31, 2010:
Each unvested stock option award outstanding at December 31, 2010 vests over four years, in most cases with 50% vesting on the third anniversary and 50% vesting on the fourth anniversary of the date of grant. As long as the grantee is still employed by Radian Group or its participating affiliates or serving as a non-employee director of Radian Group, if not sooner vested by its terms, each option fully vests upon the earliest of:
the occurrence of a double trigger event for awards granted on or after May 13, 2009.
We elected to apply the short-cut method in accounting for the windfall tax benefits under the accounting standard regarding share-based payment. Should future offsets to the windfall as a result of cancellations, expirations or exercise shortfalls exceed the balance of $20.9 million at December 31, 2010, the excess would be reflected in the consolidated statements of operations.
The following are assumptions used in our calculation of the 2010 grant date fair value of performance based RSUs to be settled in equity:
Changes in our RSUs to be settled in stock under the 2008 Equity Plan were as follows:
We have an Employee Stock Purchase Program. In the past, we issued shares under this program pursuant to our 1997 Employee Stock Purchase Plan (the “1997 ESPP Plan”), which terminated February 11, 2009. A new employee stock purchase plan (the “2008 ESPP Plan”) was approved by our board of directors in December 2008 and was approved by our stockholders at our 2009 Annual Meeting of Stockholders. A total of 2,000,000 shares of our authorized but unissued common stock have been reserved for issuance under the 2008 ESPP Plan. Under the ESPP Plans, we sold 99,781, 172,192 and 245,693 shares to employees during the years ended December 31, 2010, 2009 and 2008, respectively.
We surrendered certain of the split-dollar life insurance policies issued under our prior supplemental retirement plan to fund the BRP. Each participant in the prior plan received an initial balance in the BRP equal to the present value of the participant’s benefit as of January 1, 2007. As of December 31, 2010, we had $8.7 million of split-dollar life insurance policies outstanding. The expense for our BRP for the years ended December 31, 2010, 2009 and 2008 was immaterial to our financial statements.
The assumed discount rate for each of our benefit plans mentioned above is based on assumptions intended to estimate the actual termination liability of the plan. The discount rate is a composite rate used to approximate the actual termination liability comprised of lump sum payments and an annuity purchase.
provide certain participants who were active in the Pension Plan with yearly cash “transition credits” (initially for up to five years, if employed by us during this time) under the Savings Plan equal to a fixed percentage of their eligible pay, calculated based on a formula that takes into account their age and years of completed vesting service as of January 1, 2007.
The plans are not funded and the amounts deferred are not segregated from our general assets. Accordingly, participants in each plan are general unsecured creditors of Radian Group with respect to the amounts due under the plans. The amount recorded as deferred compensation expense for the years ended December 31, 2010, 2009 and 2008 was immaterial to our financial statements.
total claim liability. These settlements resolved the declaratory judgment action as it pertains to Ambac and MBIA, and the arbitrations commenced by Ambac and MBIA were dismissed with prejudice. An arbitration hearing with FGIC has been postponed pending settlement discussions with FGIC, which are ongoing.
As part of the non-investment-grade component of our investment portfolio, we have committed to invest $90.0 million in alternative investments ($13.8 million of unfunded commitments at December 31, 2010) that are primarily private equity securities. These commitments have capital calls expected through 2015, with the possibility of additional calls through 2017, and certain fixed expiration dates or other termination clauses.
regulatory agency responsible for the supervision and control of the insurance market in Brazil. Although we wrote off our entire interest in this company in 2005 and have sold our ownership interest, under Brazilian law, it is possible that we could become liable for our proportionate share of the liabilities of the company related to the period in which we were a significant shareholder, if the company was to become insolvent and had insufficient capital to satisfy its outstanding liabilities. Our share of the liabilities of the company was approximately $103.4 million as of December 31, 2010.
In December 2009, we entered into incentive, retention and severance agreements with certain employees in our financial guaranty business. The total cost expected to be incurred under these new agreements is $8.7 million, of which $6.1 million has not been recorded as of December 31, 2010. The remaining cost for these agreements is expected to be recorded over the next two years.
The commitment for non-cancelable operating leases in future years has not been reduced by future minimum sublease rental payments aggregating approximately $20.3 million at December 31, 2010. A portion of these payments relates to subleases to our affiliates.
(3) On May 3, 2010, we sold our remaining equity interest in Sherman, which resulted in a gain on sale of affiliate. We no longer record equity in net income of affiliates as a result of the sale.
(5) The net loss for 2010 was due primarily to the establishment of an $841.5 million valuation allowance against our DTA during the fourth quarter, an increase in the provision for losses and unrealized losses in the change in fair value of derivative instruments.
(7) Net (loss) income per share is computed independently for each period presented. Consequently, the sum of the quarters may not equal the total net (loss) income per share for the year.
We may also purchase shares in the open market to meet option exercise obligations, to fund 401(k) matches and purchases under our ESPP, and may consider additional stock repurchase programs in the future.
On February 1, 2011, Radian Asset Assurance signed an agreement to purchase Municipal and Infrastructure Assurance Corporation (the “FG Insurance Shell”), a New York domiciled financial guaranty insurance company that has not written any business, but has obtained licenses to do so in 36 states and the District of Columbia. The acquisition, which remains subject to regulatory approval, provides Radian Asset Assurance with the flexibility to consider using the FG Insurance Shell to pursue strategic alternatives in the public finance market, including possibly partnering with third-party investors to write new public finance insurance and/or reinsuring all or a portion of Radian Asset Assurance’s existing public finance business. We are in the early stages of exploring these potential uses, and expect that any new initiative for the FG Insurance Shell would be consistent with our ultimate goal of reducing our financial guaranty exposure. The expected purchase price of approximately $82 million is $7 million above the value of the statutory capital base of the FG Insurance Shell, consisting of approximately $75 million of cash, cash equivalents and treasury securities.