Approximately 500 square feet of office space for our Australian operations in Sydney, Australia. The lease for this space expires in March 2007; and
Our two data centers (Dayton and Philadelphia) serve as one another’s disaster recovery sites and support all of our businesses. We have verified that these data centers and disaster recovery sites work properly. We have established “hot site” recovery plans for London, New York and Philadelphia from a business continuity standpoint.
The following table sets forth our selected financial data. This information should be read in conjunction with our Consolidated Financial Statements, related notes included in Item 8 of this report and the information included in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
(2) Calculated on a GAAP basis using provision for losses to calculate the loss ratio and policy acquisition costs and other operating expenses to calculate the expense ratio as a percentage of net premiums earned.
Our mortgage insurance segment provides credit-related insurance coverage, principally through private mortgage insurance, and risk management services to mortgage lending institutions located throughout the United States and select countries outside the United States. We provide these products and services through our wholly-owned subsidiaries, Radian Guaranty Inc., Amerin Guaranty Corporation, Radian Insurance Inc. and our mortgage insurance subsidiaries located outside the United States, Radian Europe Limited and Radian Australia Limited (which we refer to as “Radian Guaranty,” “Amerin Guaranty,” “Radian Insurance,” “Radian Europe” and “Radian Australia,” respectively). Private mortgage insurance protects mortgage lenders from all or a portion of default-related losses on residential mortgage loans made mostly to home buyers who make down payments of less than 20% of the home’s purchase price. Private mortgage insurance also facilitates the sale of these mortgage loans in the secondary mortgage market, most of which are sold to Federal Home Loan Mortgage Corp. (“Freddie Mac”) and Federal National Mortgage Association (“Fannie Mae”). We sometimes refer to Freddie Mac and Fannie Mae collectively as “Government Sponsored Enterprises” or “GSEs”.
first-lien mortgages made up approximately 89% of our total domestic first-lien mortgage insurance risk in force, and pool insurance on domestic first-lien mortgages made up approximately 11% of our total domestic first-lien mortgage insurance risk in force. We use Radian Insurance to provide credit enhancement for mortgage-related capital market transactions and to write credit insurance on mortgage-related assets that monoline mortgage guaranty insurers are not permitted to insure, including net interest margin securities (“NIMs”), international insurance and reinsurance transactions, second-lien mortgages, home equity loans and credit default swaps (collectively, we refer to the risk associated with these transactions as “other risk in force”). We also insure second-lien mortgages through Amerin Guaranty. We expect to use Radian Europe and, when licensed, Radian Australia, to offer a variety of mortgage credit risk solutions, including traditional mortgage insurance, financial guaranty and other structured transactions involving residential mortgage assets, to clients outside the United States.
Early in 2005, we entered into a relationship with Standard Chartered Bank (Hong Kong) Limited, a subsidiary of Standard Chartered Bank and one of the largest mortgage lenders in the Hong Kong market. Through this relationship, we became the exclusive provider (on an offshore basis) of mortgage insurance for Standard Chartered in Hong Kong. In September 2006, Radian Insurance received a license authorizing it, through a local branch, to fully transact both mortgage insurance and financial guaranty business, including credit enhancement of structured transactions involving residential mortgage assets, in and from Hong Kong.
In March 2006, Radian Europe received authorization to conduct mortgage insurance operations in the United Kingdom and, subject to compliance with the European Union passporting rules, several other European Union jurisdictions. In 2006, Radian Europe was assigned an initial AA financial strength rating with a stable outlook by both Standard and Poor’s Ratings Services (“S&P”) and Moody’s Investor Service (“Moody’s”).
Our financial guaranty segment mainly insures and reinsures credit-based risks. Financial guaranty insurance provides an unconditional and irrevocable guaranty to the holder of a financial obligation of full and timely payment of principal and interest when due.
insurance of structured finance obligations, including collateralized debt obligations (“CDOs”) and asset-backed securities, consisting of funded and non-funded (“synthetic”) executions that are payable from or tied to the performance of a specific pool of assets. Examples of the pools of assets that underlie structured finance obligations include residential and commercial mortgages, a variety of consumer loans, corporate loans and bonds, equipment receivables and real and personal property leases. The structured finance obligations we insure are generally rated investment-grade without the benefit of our insurance;
financial solutions products (which we group as part of our structured finance business), including guaranties of securities exchanges, excess-Securities Investor Protection Corporation insurance for brokerage firms and excess-Federal Deposit Insurance Corporation insurance for banks; and
reinsurance of domestic and international public finance obligations, including those issued by sovereign and sub-sovereign entities, as well as reinsurance of structured finance, financial solutions and previously, trade credit reinsurance obligations.
We provide these products and services mainly through Radian Asset Assurance Inc., our principal financial guaranty subsidiary (“Radian Asset Assurance”) and through Radian Asset Assurance Limited (“RAAL”), an insurance subsidiary of Radian Asset Assurance authorized to conduct financial guaranty business in the United Kingdom.
In October 2005, we announced that we would be exiting the trade credit reinsurance line of business. Accordingly, this line of business has been placed into run-off and we have ceased initiating new trade credit reinsurance contracts going forward. For 2006, trade credit reinsurance accounted for 1.7% of financial guaranty’s net premiums written, down from 15.7% of financial guaranty’s net premiums written in 2005 (12.6% excluding the impact of the recapture of business in 2005 (referred to herein as the “2005 recapture”) by one of the primary insurer customers of our financial guaranty business, and 27.4% in 2004 (18.9% excluding the impact of the recapture of business in 2004 (referred to herein as the “2004 recapture”) by another of the primary insurer customers of our financial guaranty business). See Note 2 of Notes to Consolidated Financial Statements for more information regarding the recaptures.
C-BASS is a mortgage investment and servicing firm specializing in non-prime, residential mortgage assets and residential mortgage-backed securities. By using sophisticated analytics, C-BASS essentially seeks to take advantage of what it believes to be the mispricing of credit risk for certain of these assets in the marketplace. On February 16, 2007, C-BASS entered into an agreement to acquire Fieldstone Investment Corporation, a mortgage banking company that originates, sells, and invests primarily in non-conforming single-family residential mortgage loans with a current portfolio of over $5.7 billion, for approximately $259 million in cash. The transaction, which is expected to occur in the second quarter of 2007, subject to regulatory and other approvals, supports C-BASS’s
As a holder of credit risk, our results are subject to macroeconomic conditions and specific events that impact the credit performance of the underlying insured assets. We experienced generally positive results throughout the business for the year ended December 31, 2006, led by strong credit performance and good production despite the challenging business production environment for mortgage insurance and financial guaranty insurance.
We believe that the production environment for mortgage insurance has improved in 2006 as the industry appears to be recovering some of the business that has been lost to alternative products over the last few years. Although much of the prime mortgage market is still subject to these alternative products, such as “80-10-10” mortgages, higher interest rates and bank portfolios that are more concentrated with home equity loans have begun to shift some of that market back to the mortgage insurance industry. Purchase volume in the mortgage industry in 2006 remained relatively strong and refinancings decreased to 35% of primary new insurance written in 2006 compared to 41% in 2005.
The persistency rate, which is defined as the percentage of insurance in force that remains on our books after any 12-month period, was 67.3% for the twelve months ended December 31, 2006, compared to 58.2% for the twelve months ended December 31, 2005. Persistency during 2006 increased mostly due to the decline in refinancing activity as discussed above. Although persistency has trended up, the shift in our product mix during the last couple of years to a larger percentage of structured business will likely temper the continued growth in overall persistency rates. The persistency rate for structured products during the twelve months ended December 31, 2006 was 57.9% compared to 70.3% for our flow business.
There is a demand from lenders for structured transactions and non-traditional products, although the volume of such business we write typically fluctuates between periods and is driven by market factors such as credit spreads and competition from capital market transactions. Although the volume of structured transactions in the first half of 2006 was strong, our volume declined significantly in the second half of 2006 due to the lack of opportunities to write this business at adequate returns on equity. Revenues have remained relatively flat from the prior year due mainly to a small amount of growth in our insurance in force, offset by significantly lower premium rates on much of the recently written structured business.
We remain cautious about the outlook for the housing market, especially in certain parts of the country including the Midwest and the East and West Coasts. In addition, as has been the case for the last several years, much of our business has not yet reached its peak claim period. The mortgage insurance mix of business has continued to include a higher percentage of non-prime business such as Alternative A (“Alt-A”) and A minus mortgages and new unproven products such as interest-only loans and pay option Adjustable-Rate Mortgages (“ARMs”). We expect to continue to increase our insurance of new and emerging products with which we have less experience both domestically and internationally, which adds to the uncertainty of future credit performance. Premiums received for these products are usually higher than more traditional products and often have structuring features such as deductibles that benefit our risk position.
We protect against losses that may occur in excess of our expectations on some of the risk associated with non-prime and unproven products by reinsuring it through Smart Home transactions. In 2004, we developed “Smart Home” as a way to effectively transfer risk from our portfolio to investors in the capital markets. Ceded premiums written for the years ended December 31, 2006, 2005 and 2004 were $12.0 million, $3.5 million and $1.0 million, respectively. Ceded premiums earned for 2006, 2005 and 2004 were $12.3 million, $3.0 million and $0.7 million, respectively, related to the Smart Home transactions. As of December 31, 2006, there have been no ceded losses as a result of the Smart Home transactions.
our primary mortgage insurance risk in force was included in Smart Home arrangements at December 31, 2006 and 2005, 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 following table summarizes our consolidated results of operations for 2006 and 2005 (in thousands):
Net Premiums Written and Earned. Consolidated net premiums written for 2006 were $1,112.0 million, an $11.3 million or 1.0% increase from $1,100.7 million for 2005. Consolidated net premiums earned for 2006 were $1,015.8 million, a $2.9 million or 0.3% decrease from $1,018.7 million earned for 2005. Premiums earned in our mortgage insurance segment increased year over year, in part, due to an increase in premiums earned from the significant amount of non-traditional products, in particular international mortgage insurance that we wrote in 2005. Our financial guaranty segment experienced a decrease in premiums earned during 2006 due mostly to the run-off of the trade credit reinsurance business, offset in part by earned premiums on structured direct products. The amount reported for net premiums written in 2005 reflects a reduction of $54.7 million in financial guaranty written premiums related to the 2005 recapture, which also reduced earned premiums by $4.5 million.
on the sale of a partial interest in Sherman and a $3.2 million loss from a complete write-down of our investment in SBF Participacoes Ltda., a Brazilian insurer that we acquired in connection with our acquisition of Enhance Financial Services Group Inc. (“EFSG”), a New York-based insurance holding company that principally provides financial guaranty insurance and reinsurance, in 2001.
Other Income. Other income decreased to $20.8 million for 2006 from $25.3 million for 2005, mainly due to a lower level of income from contract underwriting.
Policy Acquisition Costs. Policy acquisition costs were $111.6 million for 2006, a decrease of $4.3 million or 3.7% from $115.9 million reported for 2005. The amount reported in 2006 reflects a $4.7 million acceleration of deferred policy acquisition cost amortization in the mortgage insurance segment and commissions related to international deals. In the fourth quarter of 2006, we updated our product mix assumptions and corresponding amortization periods based upon the latest available information. The changes resulted in a lesser amortization period for deferred costs related to our second-lien business and structured transactions compared to the amortization period for our first-lien business, due to the difference in credit quality of the underlying loans. The amount reported for 2005 includes a $5.1 million acceleration of deferred policy acquisition costs, which decreased the balance of the asset to be amortized in the future. A decrease in net premiums earned from trade credit caused a decrease in policy acquisition costs in 2006.
Other Operating Expenses. Other operating expenses were $242.6 million for 2006 compared to $226.0 million for 2005. The 2006 amount includes $7.0 million related to compensation expense (net of $3.8 million deferred as policy acquisition costs) recognized in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 123R “Share-Based Payment” (“SFAS No. 123R”) which requires compensation costs related to share-based payment transactions to be recognized in an issuer’s financial statements. Other increases in 2006 related to higher employee costs, software expense and outside consulting and a $6.0 million write-down of capitalized software that was deemed impaired.
Interest Expense. Interest expense of $48.1 million for 2006 increased $5.1 million or 11.9% from $43.0 million for 2005, mainly due to a full year of interest on debt issued at a higher interest rate in June 2005 and a negative impact from interest rate swaps that we entered into in 2004. The interest rate swaps effectively convert the interest rate on our 5.625% Senior Notes due 2013 to a variable rate based on a spread over the London Interbank Offered Rate (“LIBOR”). The 2005 interest expense was partially offset by the redemption of $220 million of senior convertible debentures in August 2005.
Provision for Income Taxes. The consolidated effective tax rate was 28.4% for 2006, compared to 29.4% for 2005. During the quarter ended June 30, 2006, we determined that certain liabilities to taxing authorities were no longer probable due to the expiration of the statute of limitations on the related tax positions. As a result, approximately $10 million in tax liabilities were reversed through the provision for income taxes in the second quarter of 2006. In addition, the lower tax rate reflects an overall increase in the ratio of income generated from tax-advantaged securities compared to income generated from operations.
Net Income. Net income for 2005 was $522.9 million or $5.91 per share (diluted), compared to $518.7 million or $5.33 per share (diluted) for 2004. Diluted net income per share reflects the inclusion of 2.2 million and 3.8 million shares, respectively, for 2005 and 2004, underlying our contingently convertible debt, which was redeemed in its entirety on August 1, 2005. Including these shares in the calculation of diluted net income per share resulted in a reduction in diluted net income per share of $0.13 for 2005 and $0.18 for 2004. The results for 2005 reflect an immediate reduction in net income of $4.0 million or $0.04 per share (diluted) related to the 2005 recapture. The results for 2004 reflect an immediate reduction in net income of $10.3 million or $0.11 per share (diluted) related to the 2004 recapture. Also affecting net income for 2005 was a decrease in the provision for losses and a significant increase in equity in net income of affiliates, partially offset by a decrease in earned premiums, an increase in operating expenses and a reduction in both net gains on securities and the change in fair value of derivative instruments.
Net Premiums Written and Earned. Consolidated net premiums written for 2005 were $1,100.7 million, an $18.2 million, or 1.7% increase from $1,082.5 million for 2004. Consolidated net premiums earned for 2005 were $1,018.7 million, a $10.8 million or 1.1% decrease from $1,029.5 million reported for 2004. The amount of net premiums written for 2005 reflects a $54.7 million reduction related to the 2005 recapture, which also reduced 2005 net premiums earned by $4.5 million. The amount of net premiums written in 2004 reflects a reduction of $96.4 million related to the 2004 recapture, which also reduced 2004 net premiums earned by $24.9 million. Net premiums written and earned for both years also reflect changes in the mix of business written, substantial cancellations in the mortgage insurance business and a challenging new production environment for our structured business due to tight credit spreads.
Policy Acquisition Costs. Policy acquisition costs were $115.8 million for 2005, a decrease of $6.0 million or 4.9% from $121.8 million reported for 2004. The amortization of policy acquisition costs in the mortgage insurance segment in 2005 was lower due to an $11.6 million acceleration of deferred policy acquisition cost amortization in 2004 coinciding with the cancellation of business in our mortgage insurance segment, which reduced the base asset that was subject to amortization. The amount reported for 2005 includes approximately $5.1 million of acceleration of deferred policy acquisition cost amortization in the mortgage insurance segment. The amortization of policy acquisition costs reported for 2005 and 2004 in the financial guaranty segment reflects an increase of $1.7 million and a decrease of $9.8 million related to the 2005 and 2004 recaptures, respectively. The business recaptured in the first quarter of 2004 included business originated before the acquisition of EFSG that carried a lower amount of deferred acquisition costs as a result of purchase accounting adjustments.
Other Operating Expenses. Other operating expenses increased to $226.0 million for 2005 from $205.7 million for 2004. Other operating expenses in 2005 included increases in employee costs and software expenses, as well as the write-off of debt issuance costs from the redemption of the $220 million of senior convertible debentures in 2005. Other operating expenses in 2005 compared to 2004 included higher information technology expenditures and the amortization of information technology projects that were placed into service in 2004, as well as increased compliance costs, including Sarbanes-Oxley compliance.
The following table summarizes our mortgage insurance segment’s results of operations for the years ended December 31, 2006 and 2005 (in thousands):
Net Income. Our mortgage insurance segment’s net income for 2006 was $282.8 million, an increase of $14.2 million or 5.3% from $268.6 million in 2005. This increase was mainly due to an increase in net investment income and a decrease in the provision for losses, partially offset by an increase in other operating expenses.
Net Premiums Written and Earned. Net premiums written for 2006 were $849.1 million, a $28.5 million or 3.2% decrease from $877.6 million for 2005. Net premiums earned for 2006 were $812.0 million, a $5.1 million or 0.6% increase compared to $806.9 million for 2005. The decrease in net premiums written in 2006 was mainly due to a decrease in primary new insurance written during the period and premiums written from NIMs, partially offset by an increase in premiums written in domestic credit default swaps. The increase in premiums earned mainly related to an increase of $7.3 million from international transactions, partially offset by a decrease in premiums earned related to our NIMs transactions.
The following table provides additional information related to premiums written and earned as of and for the years indicated:
Net Gains on Securities. Net gains on securities in our mortgage insurance business were $30.2 million for 2006, compared to $27.6 million for 2005. Included in net gains on securities for 2006 is an allocation of net gains on securities to the mortgage insurance segment, most of which came from the sale of our remaining interest in Primus. The 2006 amount also includes approximately $9.4 million in losses related to the write-down of other-than-temporarily impaired securities.
Other Income. Other income for 2006 was $13.1 million, a $5.9 million or 31.2% decrease from $19.0 million in 2005. Other income mostly includes income related to contract underwriting services, which was lower for 2006 as compared to 2005 due to less demand for this service.
Provision for Losses. The provision for losses for 2006 was $348.6 million, compared to $359.1 million for 2005. This decrease is mostly due to a decrease in primary delinquencies and claims received year over year, as well as the incorporation into our loss reserve model of positive results from our heightened loss management efforts throughout 2006 on both first- and second-lien delinquencies. Despite a decrease in delinquencies, there has been a shift in existing delinquencies to the later stages of delinquencies, which requires a higher reserve as these delinquencies are closer to a claim payment or foreclosure. In addition, we experienced a significant increase in filed claims during the third quarter of 2006 related to a second-lien structured transaction in which we split losses with our counterparty on a 50-50 basis. Our total net exposure under this second-lien structured transaction is approximately $70 million, or half of the $140 million in total gross exposure relating to the transaction. We continue to closely examine every claim filed in this deal. Based on currently available information, we expect that claims will not significantly exceed premiums over the life of this deal.
Other Operating Expenses. Other operating expenses were $172.0 million for 2006, an increase of $19.3 million or 12.6% compared to $152.7 million for 2005. For 2006, other operating expenses included increases in employee costs due to the implementation of SFAS No. 123R, consulting costs, office equipment, software depreciation and a $6.0 million write-off of capitalized software that was deemed impaired, partially offset by a decrease in contract underwriting expenses and reserves for remedies. Contract underwriting expenses for 2006 and 2005, including the impact of reserves for remedies, were $28.1 million and $35.7 million, respectively. During 2006, loans underwritten via contract underwriting for flow business accounted for 12.6% of applications, 12.3% of commitments for insurance and 11.4% of insurance certificates issued, compared to 16.6%, 16.3% and 15.7%, respectively, for 2005.
The following table summarizes our mortgage insurance segment’s results of operations for the years ended December 31, 2005 and 2004 (in thousands):
Net Income. Our mortgage insurance segment’s net income for 2005 was $268.6 million, a decrease of $3.3 million or 1.2% from $271.9 million in 2004. This decrease was mainly due to a decrease in net premiums earned, net gains on securities, change in fair value of derivative instruments and other income and an increase in other operating expenses, partially offset by a decrease in the provision for losses and policy acquisition costs.
Net Investment Income. Net investment income attributable to our mortgage insurance business for 2005 was $118.3 million, compared to $118.7 million for 2004. Investment income for 2005 reflects a higher level of investment expenses and a decrease in dividend income, partially offset by an increase in interest income on bonds.
Provision for Losses. The provision for losses for 2005 was $359.1 million, compared to $400.9 million for 2004. Our mortgage insurance business experienced a significant decrease in claims paid in 2005; however, there was an approximate 10% increase in delinquencies at December 31, 2005, compared to December 31, 2004, which was mainly related to the large number of hurricane-related delinquencies.
Policy Acquisition Costs. Policy acquisition costs were $62.9 million for 2005, compared to $75.5 million for 2004. This decrease was mainly the result of the $5.1 million acceleration of the amortization of policy acquisition costs for 2005 and the $11.6 million acceleration of the amortization of policy acquisition costs in 2004, related to prior years’ books of business that had canceled more quickly than anticipated.
Other Operating Expenses. Other operating expenses were $152.7 million for 2005, an increase of $11.6 million or 8.2% compared to $141.1 million for 2004. For 2005, other operating expenses included increases in employee costs, depreciation expense, outside services and the write-off of debt issuance costs, partially offset by a decrease in the reserve for contract underwriting remedies. During 2005, we processed requests for remedies on less than 1% of loans underwritten via contract underwriting. In 2004, as a result of increased contract underwriting in the previous two years, which significantly increased our exposure to underwriting errors, an increase in the contract underwriting reserve for remedies was necessary. Provisions for contract underwriting remedies were $8.0 million in 2005 compared to $11.9 million in 2004. Contract underwriting expenses for 2005 and 2004, including the impact of reserves for remedies included in other operating expenses, were $35.7 million and $46.8 million, respectively. During 2005, loans underwritten via contract underwriting accounted for 16.6% of applications, 16.3% of commitments for insurance and 15.7% of insurance certificates issued compared to 23.4%, 22.8% and 21.5%, respectively, in 2004.
Provision for Income Taxes. The effective tax rate for 2005 was 28.8% compared to 27.7% in 2004. The increased tax rate reflects a lower proportion of tax-exempt income to total income.
(1) Includes approximately 1,161 and 452 defaults at December 31, 2006 and December 31, 2005, respectively, where reserves have not been established because no claim payment is currently anticipated.
(2) Includes approximately 13,309 and 3,699 defaults at December 31, 2006 and December 31, 2005, respectively, where reserves have not been established because no claim payment is currently anticipated.
The default and claim cycle in the mortgage insurance business begins with our receipt of a default notice from the insured. Generally, the insured notifies us of a default within 15 days after the loan has become 60 days past due. For reporting and internal tracking purposes, we do not consider a loan to be in default until the loan has been in default for 60 days. The total number of loans in default increased to 67,173 at December 31, 2006, from 57,088 at December 31, 2005 and 48,940 at December 31, 2004. The average loss reserve per default at December 31, 2006 was $9,725, compared to $10,444 and $11,435 at December 31, 2005 and 2004, respectively. Primary and pool defaults at December 31, 2006 included approximately 1,161 and 13,309 defaults, respectively, on loans where reserves have not been established because no claim payment is currently anticipated. At December 31, 2005, primary and pool defaults included 452 and 3,699 defaults, respectively, on loans where reserves have not been established. Excluding those defaults without a related reserve, the average loss reserve per default was $12,395 and $12,518 at December 31, 2006 and 2005, respectively.
Claim activity is not spread evenly throughout the coverage period of a book of business. Relatively few claims on prime business are received during the first two years following issuance of a policy and on non-prime business during the first year. Historically, claim activity on prime loans has reached its highest level in the third through fifth years after the year of policy origination, and on non-prime loans this level is expected to be reached in the second through fourth years. Approximately 67.1% of our primary risk in force and approximately 41.2% of our pool risk in force at December 31, 2006 had not yet reached its highest claim frequency years. Because it is difficult to predict both the timing of originating new business and the cancellation rate of existing business, it is also difficult to predict, at any given time, the percentage of risk in force that will reach its highest claim frequency years on any future date. Direct claims paid for 2006 were $313.4 million compared to $320.3 million for 2005 and $364.4 million for 2004. The average claim paid has fluctuated over the past few years mostly due to differing coverage amounts and loan balances. In addition, changes in real estate values may also affect the amount of the average claim paid. Claims paid on second-lien mortgages continue to increase as a result of an increase in the volume of second-lien business written over the past few years on which we have begun paying claims, partially offset by an increase in recoveries. A significant amount of risk written on second-lien business during the year ended December 31, 2006 and 2005, was in a second-loss position.
A higher level of claims exist in the auto states of Ohio, Michigan and Indiana, as problems with the domestic auto industry and related industries depress economic growth, employment and house prices in these states.
A higher level of claims in Texas resulted, in part, from unemployment levels that were higher than the national average and lower home price appreciation. We believe that claims in the Midwest and Southeast have been rising (and will continue to rise) due to the weak industrial sector of the economy. We also believe that increased claims in Michigan and North Carolina are a result of declining economic conditions in those areas and that in Colorado, increased claims are a result of a significant decline in property values in that area.
Since August 29, 2005, the date that Hurricane Katrina first struck and caused extensive property damage to the U.S. Gulf Coast, we have paid approximately $16.2 million in claims on mortgage insurance written in areas damaged by Hurricanes Katrina and Rita (as designated by Freddie Mac, the “designated areas”) as of December 31, 2006, including approximately $12.7 million for claims received after August 29, 2005.
(1) Primarily related to a first-loss, second-lien captive originated as a quota-share transaction.
Net Income. Our financial guaranty segment’s net income for 2006 was $136.1 million, an $18.0 million or 15.3% increase from $118.1 million for 2005. Net income for 2005 reflects a $4.1 million immediate after-tax reduction as a result of the 2005 recapture. The increase for 2006 was mainly due to a decrease in the provision for losses, policy acquisition costs and other operating expenses, and an increase in net investment income and change in fair value of derivative instruments, partially offset by a decrease in net premiums earned and a higher provision for income taxes.
The following table shows the breakdown of net premiums written and earned by our financial guaranty segment’s various product lines for 2006, 2005 and 2004:
The financial guaranty segment derives a substantial portion of its premiums written from a small number of direct primary insurers. In 2006, three primary insurers accounted for $91.3 million or 34.7% of the financial guaranty segment’s gross written premiums. In 2005, one primary insurer accounted for $43.3 million or 19.3% of the financial guaranty segment’s gross written premiums. Excluding the 2005 recapture, two primary insurers accounted for $74.9 million or 26.8% of the financial guaranty segment’s gross written premiums in 2005. No other primary insurer accounted for more than 10% of the financial guaranty segment’s gross written premiums in either 2006 or 2005.
Despite a challenging operating environment, our public finance direct insured par increased by 9.8% in 2006, compared to 2005 while our average premium rate on this business was 137 basis points in 2006 as compared to 152 basis points in 2005. This includes $306 million in public finance par insured in the United Kingdom in 2005, compared with no par insured in the United Kingdom in 2006. The growth in our domestic public finance business occurred despite a 5.0% decrease in new domestic municipal bond issuance, which was $387.7 billion in 2006 compared to $408.3 billion in 2005.
Two of the six intensified surveillance credits with $25 million or greater in exposure identified at December 31, 2005 and one of the six intensified surveillance credits with $25 million or greater in exposure identified at December 31, 2004 were derivative financial guaranty contracts. One of these credits at December 31, 2005, representing $248 million in exposure, was terminated in March 2006 as discussed above in “Change in Fair Value of Derivative Instruments.” The second credit at December 31, 2005, which represented $60.0 million in exposure, expired in November 2006, without claim. There were no direct derivative financial guaranty contracts on the intensified surveillance list as of December 31, 2006. In accordance with accounting principles generally accepted in the United States of America (“GAAP”), we do not establish loss reserves on our derivative financial guaranty contracts. Instead, gains and losses on derivative financial guaranty contracts are derived from internally generated models that take into account both credit and market spreads and are recorded through our consolidated statements of income. See “Critical Accounting Policies-Derivative Instruments and Hedging Activity” for a discussion of how we account for derivatives under Financial Accounting Standards Board (“FASB”) Statement No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS No. 133”).
Policy Acquisition Costs. Policy acquisition costs were $46.6 million for 2006, compared to $53.0 million for 2005. The year over year decrease was largely the result of the continued run-off in our trade credit reinsurance line of business. Included in policy acquisition costs for 2006 were $11.9 million of origination costs related to derivative financial guaranty contracts, compared to $10.9 million for 2005.
Provision for Income Taxes. The effective tax rate was 17.7% for 2006, compared to 23.2% for 2005. The lower tax rate for 2006 reflects an allocation of the reversal of prior years’ tax exposures that expired June 30, 2006. The lower tax rate also reflects an overall increase in the ratio of income generated from tax-advantaged securities compared to income generated from operations.
Net Premiums Written and Earned. Net premiums written and earned for 2005 were $223.1 million and $211.8 million, respectively, compared to $216.4 million and $214.9 million, respectively, for 2004. Net premiums written and earned in 2005 were negatively impacted by the 2004 and 2005 recaptures as well as by a reduction in trade credit reinsurance, which offset increases in our direct business. Also included in net premiums written and earned for 2005 were $50.5 million and $59.1 million, respectively, of other credit enhancement fees on derivative financial guaranty contracts, compared to $66.1 million and $50.3 million, respectively, for 2004.
Provision for Losses. The provision for losses was $31.5 million for 2005, compared to $55.9 million for 2004. This decrease was due to favorable loss development in the financial guaranty insurance business, including a reduction in trade credit reinsurance reserves from prior years and a lower volume of trade credit reinsurance business written in 2005, which generally has a higher loss ratio. The provision for losses in 2005 represented 14.9% of net premiums earned for 2005 (including the impact of the 2005 recapture), compared to 26.0% for 2004 (including the impact of the 2004 recapture). The provision for losses was 14.6% and 23.3% of net premiums earned for 2005 and 2004, respectively, excluding the impact of the respective recaptures. Our financial guaranty business paid $29.6 million in insurance claims for 2005 and $30.7 million in claims for 2004 related to a single manufactured housing transaction.
Policy Acquisition Costs. Policy acquisition costs were $53.0 million for 2005, compared to $46.3 million for 2004. Included in policy acquisition costs for 2005 were $10.9 million of origination costs related to derivative financial guaranty contracts, compared to $8.7 million for 2004. Included in 2005 and 2004 policy acquisition costs was a $9.8 million reduction of policy acquisition costs in 2004 related to the 2004 recapture and a $1.7 million increase in policy acquisition costs in 2005 related to the 2005 recapture.
Other Operating Expenses. Operating expenses were $65.0 million for 2005 compared to $52.3 million for 2004. The expense ratio, which includes other operating expenses and policy acquisition costs was 55.7% for 2005 (53.8% excluding the impact of the 2005 recapture) which was up from 45.9% for 2004 (45.2% excluding the impact of the 2004 recapture). There were slightly higher expenses in 2005 due to higher technology and severance costs and the write-off of software that we are no longer using. This was partially offset by the release of liabilities related to the disposition of Van-Am Insurance Company, Inc., an insurance subsidiary of Radian Asset Assurance that was engaged on a run-off basis in reclamation bonds for the coal mining industry and surety bonds covering closure and post-closure obligations of landfill operations.
Provision for Income Taxes. The effective tax rate was 23.2% for 2005, compared to 23.9% for 2004. The low tax rate for both periods reflects a higher percentage of pre-tax income derived from tax-advantaged securities compared to income generated from operations.
The following table shows the breakdown of the reserve for losses and loss adjustment expenses for our financial guaranty segment at the end of each period indicated:
significantly from period to period because a portion of C-BASS’ income is dependent on its ability to sell mortgage-backed securities in the capital markets. The mortgage capital markets can be volatile, subject to changes in interest rates, credit spreads and liquidity. In addition, C-BASS owns mortgage-backed securities which can be called for redemption, often in low interest-rate environments, such as have existed recently, which can lead to volatility in its quarterly results, as can C-BASS’ requirement to mark many of its balance sheet components to market. Redemptions during 2006 contributed to the increase in equity in net income of affiliates. Sherman accounted for $123.1 million of the total equity in net income of affiliates for 2006 compared to $110.3 million in 2005 and $83.3 million in 2004. The increase in 2006 equity in net income of affiliate reflects growth in, and strong collections on, Sherman’s portfolio, as well as strong performance by its origination business. Sherman booked a significant amount of gains on portfolios sold during 2006 and 2005.
Singer Asset Finance Company L.L.C. (“Singer”), a wholly-owned subsidiary of EFSG, is currently operating on a run-off basis. Singer had been engaged in the purchase, servicing, and securitization of assets, including state lottery awards and structured settlement payments. Singer’s run-off operations consist of servicing and/or disposing of Singer’s previously originated assets and servicing its non-consolidated special-purpose vehicles. The results of this subsidiary are not material to our financial results. At December 31, 2006, we had approximately $289 million and $269 million of non-consolidated assets and liabilities, respectively, associated with Singer special-purpose vehicles. Our investment in these special-purpose vehicles was $20 million at December 31, 2006.
The following table summarizes our contractual obligations and commitments as of December 31, 2006, and the future periods in which such obligations are expected to be settled in cash. Although the majority of our loss reserves do not represent contractual obligations and commitments under the Securities and Exchange Commission (“SEC”) definition, they are included in the table because they represent management’s estimate of the claims that we will be required to pay on our mortgage insurance and financial guaranty contracts. The table also reflects the timing of principal and interest payments on outstanding debt. Additional details regarding these obligations are provided in the Notes to Consolidated Financial Statements as referenced in the table:
We also have certain contractual arrangements that would require us to make payments or provide funding if certain circumstances occur (“contingent commitments”). We do not currently expect that these contingent commitments will result in any amounts being paid by us.
We also utilize letters of credit to back assumed reinsurance contracts, medical insurance policies and an excise tax-exemption certificate used for ceded premiums from our domestic operations to our international operations. These letters of credit are with various financial institutions, have terms of one-year and will automatically renew unless we specify otherwise. The letters of credit outstanding at December 31, 2006 and 2005 were $15.5 million and $17.1 million, respectively.
New securities regulations became effective in 2005 that impose enhanced disclosure requirements on issuers of asset-backed (including mortgaged-backed) securities, including most customers in our structured business. To allow these customers to comply with the new regulations, we may be required in any given transaction, depending on the amount of credit enhancement that we are providing, to provide audited financial statements for the insurance subsidiary participating in the transaction. We are in the process of producing financial statements (and having them audited) for each of our primary insurance subsidiaries. We anticipate that these financial statements will be available sometime in 2007. Until they are available, we will provide full and unconditional holding-company level guarantees for our insurance subsidiaries’ obligations in such transactions, principally on our mortgage insurance business for which financial statements prepared in accordance with GAAP have never previously been available. To date, we have guaranteed two structured transactions for Radian Guaranty with approximately $537 million of remaining credit exposure.
We are required to group assets in our investment portfolio into one of three categories: held to maturity, available for sale or trading securities. Fixed-maturity securities for which we have the positive intent and ability to hold to maturity are classified as held to maturity and reported at amortized cost. Investments classified as available for sale are reported at fair value, with unrealized gains and losses (net of tax) reported as a separate component of stockholders’ equity as accumulated other comprehensive income. Investments classified as trading securities are reported at fair value, with unrealized gains and losses (net of tax) reported as a separate component of income. During 2006, we began classifying certain new security purchases as trading securities.
The following table shows the gross unrealized losses and fair value of our investments with unrealized losses that are not deemed to be other-than-temporarily impaired (in thousands), aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2006.
The unrealized losses of 12 months or greater duration as of December 31, 2006 on our investments in U.S. Treasury obligations were caused by interest rate increases. During 2006, the Federal Reserve raised the federal funds rates four times for a total of 100 basis points. A majority of the securities remained at an unrealized loss
position due to the rate increases. The contractual terms of these investments do not permit the issuer to settle the securities at a price less than the par value of the investment. Because we have the ability and intent to hold these investments until a full recovery of fair value, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at December 31, 2006.
The unrealized losses of 12 months or greater duration as of December 31, 2006 on our investments in tax-exempt state and municipal securities were caused by interest rate increases. During 2006, the taxable yield curve movements for 3-month U.S. treasury bills and 10-year U.S. treasury bonds ranged from an increase of 93 basis points to a decrease of 31 basis points and the tax-exempt yield curve movements for 1-year municipal bonds and 10-year municipal bonds ranged from an increase of 30 basis points to a decrease of 8 basis points. The majority of our bonds in this category reflected maturities under 10 years where tax-exempt yields increased the most. We believe that credit quality did not impact security pricing due to the relative high quality of the holdings (i.e., the majority of the securities were either AAA/Aaa rated bonds, insured, partially pre-refunded or partially escrowed to maturity). Because we have the ability and intent to hold these investments until a full recovery of fair value, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at December 31, 2006.
The unrealized losses of 12 months or greater duration as of December 31, 2006 on the securities in this category were caused by market interest rate increases. A majority of the securities remained at an unrealized loss position due to the rate increases. Because we have the ability and intent to hold these investments until a full recovery of fair value, which may be maturity, we do not consider the investment in these securities to be other-than-temporarily impaired at December 31, 2006.
The unrealized losses of 12 months or greater duration as of December 31, 2006 on the majority of the securities in this category were caused by market interest rate increases. We believe that credit quality did not impact security pricing due to the relative high quality of the holdings (i.e., the majority of the securities were highly-rated governments and government agencies or corporate issues with minimum ratings of single-A). Because we have the ability and intent to hold these investments until a full recovery of fair value, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at December 31, 2006.
The unrealized losses of 12 months or greater duration as of December 31, 2006 on the majority of the securities in this category were caused by market interest rate increases. We believe that while interest rate changes contributed to a decline in investment value in almost all cases, credit quality, whether industry or company specific, did not have a significant or irrecoverable impact on security pricing. Because we have the ability and intent to hold these investments until a full recovery of fair value, which may be maturity, we do not consider the investment in these securities to be other-than-temporarily impaired at December 31, 2006.
For all investment categories, unrealized losses of less than 12 months in duration were generally attributable to interest rate increases. All securities were evaluated in accordance with our impairment recognition policy covering various time and price decline scenarios. Because we have the ability and intent to hold these investments until a full recovery of fair value, which may be maturity, we do not consider the investment in these securities to be other-than-temporarily impaired at December 31, 2006.
The following table show the gross unrealized losses and fair value of our investments with unrealized losses that are not deemed to be other-than-temporarily impaired (in thousands), aggregated by investment category and length of time that individuals securities had been in a continuous unrealized loss position, December 31, 2005.
We are currently under examination by the Internal Revenue Service (“IRS”) for the 1999 through 2005 tax years. To date, the IRS examination remains in the discovery phase and no formal notice of proposed adjustment has been received. However, the IRS has indicated that it opposes the recognition of certain tax losses that were generated through our investment in a portfolio of residual interests in Real Estate Mortgage Investment Conduits (“REMICs”). The IRS has indicated that it may issue a formal notice of proposed adjustment upon its completion of discovery which is anticipated to conclude during the fourth quarter of 2007. We will contest any proposed adjustment relating to the IRS’s opposition of the tax losses in question. Upon receipt of the IRS’s proposed adjustment we may make a “payment on account” with the United States Department of the Treasury in order to avoid the accrual of the above-market-rate interest associated with management’s estimate of the
Our insurance subsidiaries are permitted to allocate capital resources within certain insurance department and rating agency guidelines by making direct investments. In March 2006, Radian Guaranty contributed approximately $500 million in capital to Radian Insurance to support the additional risk that has been, and is expected to be, written in that entity, mostly through non-traditional products, such as domestic or international credit default swaps. In February 2006, in order to receive authorization for Radian Europe, Radian Guaranty contributed $53 million in capital to Radian Europe to fund its operations. An additional $5.0 million was contributed to Radian Europe in June 2006 to fund its operations. In addition, Radian Guaranty has agreed to maintain Radian Europe’s capital at or above the amount required by the Financial Service Authority (“FSA”), the regulator of financial services in the United Kingdom. To the extent that Radian Guaranty is prohibited under applicable insurance regulations from performing its capital maintenance obligations, Radian Group Inc. has agreed to maintain Radian Europe’s capital at or above the greater of the amount required by the FSA Regulations and £30 million, up to $300 million.
Our sources of working capital consist mostly of premiums written by our insurance operating subsidiaries and investment income at both the holding company and operating subsidiary levels. Working capital is applied mainly to the payment of our insurance operating subsidiaries’ claims, operating expenses and to fund our stock repurchase programs. Cash flows from operating activities for the year ended December 31, 2006, were $488.5 million, compared to $607.6 million for the year ended December 31, 2005. The lower cash flow from operations in 2006 resulted mainly from higher net payments on the settlement of financial guaranty contracts and an increase in prepaid federal income taxes. In 2005, we paid $37.6 million as a result of the 2005 recapture. Positive cash flows are invested pending future payments of claims and other expenses.
In February 2005, the SEC declared effective our $800 million universal shelf registration statement. On June 7, 2005, we issued under the shelf registration statement $250 million of unsecured senior notes at a price of 99.822% of their principal amount. 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. We used a portion of the proceeds from the sale of the notes to redeem at par, on August 1, 2005, all $219.3 million in aggregate principal amount outstanding of our 2.25% Senior Convertible Debentures due 2022. We used the balance of the proceeds for general corporate purposes. We may use the shelf registration statement to offer and sell additional debt securities and various other types of securities to the public. However, we may be unable to issue additional securities under the shelf registration statement or otherwise on favorable terms, if at all.
In February 2003, we issued $250 million of unsecured senior notes. These notes bear interest at the rate of 5.625% per annum, payable semi-annually on February 15 and August 15. These notes mature in February 2013. We have the option to redeem some or all of the notes at any time with not less than 30 days’ notice at a redemption price equal to the greater of the principal amount of the notes or the present values of the remaining scheduled payments of principal and interest on the notes to be redeemed.
On December 13, 2006, we replaced a $400 million unsecured credit facility, comprised of a $100 million 364-day facility that was scheduled to expire on December 14, 2006 and a $300 million five-year facility that was to expire on December 16, 2009, with a $400 million unsecured revolving credit facility that is scheduled to expire on December 13, 2011. The new facility includes a $100 million uncommitted line that we may exercise at our option, subject to our obtaining necessary commitments from lenders. There were no drawdowns on the expired facility, and we have not drawn down any amounts under the new facility through December 31, 2006.
In September 2003, Radian Asset Assurance closed on $150 million of money market committed preferred custodial trust securities, pursuant to which it entered into a series of three perpetual put options on its own preferred stock to Radian Asset Securities Inc. (“Radian Asset Securities”), our wholly-owned subsidiary. Radian Asset Securities in turn entered into a series of three perpetual put options on its own preferred stock (on substantially identical terms to the Radian Asset Assurance preferred stock). The counterparties to the Radian Asset Securities put options are three trusts established by two major investment banks. The trusts were created as a vehicle for providing capital support to Radian Asset Assurance by allowing Radian Asset Assurance to obtain immediate access to additional capital at its sole discretion at any time through the exercise of one or more
The following table reconciles net income to cash flows from operations for the years ended December 31, 2006, 2005 and 2004 (in thousands):
Cash flows from operations for the year ended 2006 decreased compared to the comparable period of 2005. An increasing portion of our net income has been derived from our equity in earnings of affiliates, which is a non-cash item. This has been partially offset by higher distributions from our affiliates. Cash flows for 2006 were reduced by a $68.0 million payment to terminate a derivative financial guaranty contract, the cash impact of which was more than offset by a higher deferred tax provision that resulted in a significant increase in prepaid federal income taxes. We do not expect net income to greatly exceed cash flows from operations in the future.
cost of approximately $87.0 million. At March 31, 2005, we had repurchased an additional 5.0 million shares under the second program (announced May 11, 2004, and extended to September 8, 2004) at a cost of approximately $235.9 million, and at June 30, 2005, we had repurchased all 5.0 million shares under the third program (announced February 15, 2005) at a cost of approximately $240.0 million. At December 31, 2005, we had repurchased all 3.0 million shares authorized under the fourth repurchase program (announced August 9, 2005) at a cost of approximately $160.0 million. All share repurchases made to date were funded from available working capital, and were made from time to time depending on market conditions, share price and other factors.
We establish reserves to provide for losses and the estimated costs of settling claims in both the mortgage insurance and financial guaranty segments. Setting loss reserves in both businesses involves significant use of estimates with regard to the likelihood, magnitude and timing of a loss.
In the mortgage insurance segment, reserves for losses generally are not established until we are notified that a borrower has missed two payments. We also establish reserves for associated loss adjustment expenses (“LAE”), consisting of the estimated cost of the claims administration process, including legal and other fees and
expenses associated with administering the claims process. SFAS No. 60, (“SFAS 60”) “Accounting and Reporting by Insurance Enterprises,” specifically excludes mortgage guaranty insurance from its guidance relating to the reserve for losses. 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 macroeconomic factors such as regional economic conditions that involve significant variability over time, as well as more static factors such as the estimated foreclosure period in the area where the default exists, to help determine the likelihood that a default will result in a claim (referred to as the “claim rate”), the amount that we will pay if a default becomes a claim (referred to as “claim severity”) and based on these estimates, the appropriate loss reserve at any point in time. As a result of our continued evaluation of historical data, in the fourth quarter of 2006, we made adjustments to the claim rate estimates of our model, mostly to incorporate the results of our intensified loss management efforts throughout 2006.
Our model differentiates between prime and non-prime products and takes into account the different loss development patterns and borrower behavior that is inherent in these products, whether we are in a first- or second-loss position and whether there are deductibles on the loan. We use actuarial projection methodologies to produce a range of reserves by product and a midpoint for each product based on historical factors such as ultimate claim rates and claim severity. In determining the amount of reserve to be recorded, we begin with the calculated midpoint and then we evaluate other conditions, such as current economic conditions, regional housing conditions and the reliability of historical data for new products, to determine if an adjustment to the midpoint calculated by the model is necessary.
Our unallocated non-specific reserves are established over time by applying expected default factors to the premiums earned during each reporting period. The expected lifetime losses for each credit are determined by multiplying the expected frequency of losses on that credit by the expected severity of losses on that credit and multiplying this number, the loss factor, by that credit’s outstanding par amount. The expected frequency and severity of losses for each credit is generated from three sources-two that are published by major rating agencies and one that is generated by a proprietary internal model-based on the product class, published rating and term to maturity for each credit. We set the expected lifetime losses for each credit at a point in the range between the highest and lowest expected lifetime loss factors generated by the rating agency and internally generated models. The default rates published by rating agencies tend to be very low because we mostly insure investment-grade obligations that, historically, have a very low probability of default. Although the default rate is low, the amount of losses upon default can be very high because we tend to insure large financial obligations. Because of
the low incidence of losses on financial guaranty obligations, it is also very difficult to estimate the timing of losses on our insured obligations for which we have not yet established a case reserve or allocated non-specific reserve. The default factors for the years ended December 31, 2006 and 2005, approximated 10% of earned premiums on public finance credits and 20% of earned premiums on structured finance credits.
In February 2006, the FASB issued Statement No. 155, “Accounting for Certain Hybrid Financial Instruments” (“SFAS No. 155”), an amendment of SFAS No. 133 and Statement No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (“SFAS No. 140”). SFAS No. 155 (i) permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation, (ii) clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS No. 133, (iii) establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation, (iv) clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives, and (v) amends SFAS No. 140 to eliminate the exemption from applying the requirements of SFAS No. 133 on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. We are required to adjust retained earnings for fair value amounts related to financial instruments now recorded at fair value. The implementation of SFAS No. 155, effective January 1, 2007, will not have a material impact on our consolidated financial statements.
The following table presents information at December 31, 2006 and 2005 related to net unrealized gains (losses) on derivative financial guaranty contracts (included in other assets on our consolidated balance sheets).
balance of deferred policy acquisition costs. Estimates of expected gross profit including persistency and loss development assumptions for each underwriting year and product type used as a basis for amortization are evaluated regularly, and the total amortization recorded to date is adjusted by a charge or credit to the statement of income if actual experience or other evidence suggests that earlier estimates should be revised. Considerable judgment is used in evaluating these factors when updating the assumptions. The use of different assumptions would have a significant effect on the amortization of deferred policy acquisition costs.
Origination costs for derivative mortgage and financial guaranty contracts are expensed as incurred.
As a mortgage guaranty and financial guaranty insurer, we are eligible for a tax deduction, subject to certain limitations, under Section 832(e) of the Internal Revenue Code for amounts required by state law or regulation to be set aside in statutory contingency reserves. The deduction is allowed only to the extent that we purchase non-interest-bearing U.S. Mortgage Guaranty Tax and Loss Bonds (“T&L bonds”) issued by the Treasury Department in an amount equal to “the tax benefit derived” from deducting any portion of our statutory contingency reserves. See Note 9 of Notes to Consolidated Financial Statements.
In June 2006, the FASB issued FASB Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes.” FIN 48 is effective for fiscal years beginning after December 15, 2006, and clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. It prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. Management will adopt FIN 48 in the first quarter of 2007. The cumulative effect of applying the provisions of FIN 48 will be an increase of approximately $20 to $22 million in the liability for uncertain income taxes and will be accounted for as a corresponding decrease in the January 1, 2007 balance of retained earnings.
In September 2006, the SEC released Staff Accounting Bulletin (“SAB”) No. 108 (“SAB No. 108”). This release expresses the staff’s views regarding the process of quantifying financial statement misstatements and addresses diversity in practice in quantifying financial statement misstatements and the potential under current practice for the build up of improper amounts on the balance sheet. SAB No. 108 is effective for annual financial statements covering the first fiscal year ending after November 15, 2006. Management has reviewed the SAB in connection with our Consolidated Financial Statements for the current and prior periods, and has determined that its adoption did not have an impact on any of these financial statements.
The Emerging Issues Tax Force (“EITF”) reached a consensus on EITF Issue No. 06-4, “The Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements” (“EITF 06-4”). EITF 06-4 addresses whether the postretirement benefit associated with an endorsement split-dollar life insurance arrangement is effectively settled in accordance with Statement of Financial Accounting Standards No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions” and Accounting Principles Board (“APB”) Opinion No. 12 “Omnibus Opinion-1967” upon entering into such an arrangement. EITF 06-4 is effective for fiscal years beginning after December 15, 2007. Management is considering the impact, if any, that may result from the adoption of EITF 06-4.
The EITF reached a consensus on EITF Issue No. 06-5, “Accounting for Purchases of Life Insurance-Determining the Amount that Could be Realized in Accordance with FASB Technical Bulletin No. 85-4” (“EITF 06-5”). EITF 06-5 addresses (i) whether a policyholder should consider any additional amounts included in the contractual terms of the insurance policy other than the cash surrender value in determining the amount that could be realized under the insurance contract in accordance with Technical Bulletin 85-4, (ii) whether a policyholder should consider the contractual ability to surrender all of the individual-life policies (or certificates in a group policy) at the same time in determining the amount that could be realized under the insurance contract in accordance with Technical Bulletin 85-4 and (iii) whether the cash surrender value component of the amount that could be realized under the insurance contract in accordance with Technical Bulletin 85-4 “Accounting for Purchases of Life Insurance” should be discounted in accordance with APB Opinion No. 21 “Interest on Receivables and Payables”, when contractual limitations on the ability to surrender a policy exist. EITF 06-5 is effective for fiscal years beginning after December 15, 2006. Management believes the impact, as a result of adopting EITF 06-5 effective January 1, 2007, will not be material to our Consolidated Financial Statements.
Radian’s management assessed the effectiveness of Radian’s internal control over financial reporting, as of December 31, 2006, using the Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, management did not identify any material weaknesses in Radian’s internal control over financial reporting and believes that, as of December 31, 2006, Radian’s internal control over financial reporting is effective in providing reasonable assurance regarding the reliability of Radian’s financial reporting and preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America.
Deloitte & Touche LLP, the independent registered public accounting firm that audited the financial statements included in this Annual Report on Form 10-K for the year ended December 31, 2006, has issued an attestation report on management’s Annual Report on Internal Control over Financial Reporting. This report appears on page 132.
We have audited management’s assessment, included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting, that Radian Group Inc. and subsidiaries (the “Company”) maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
In our opinion, based on our audits and (as to the amounts included for Sherman Financial Group LLC for the year ended December 31, 2006) the report of the other auditors, such consolidated financial statements present fairly, in all material respects, the financial position of Radian Group Inc. and subsidiaries at December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, based on our audits and (as to the amounts included for Sherman Financial Group LLC for the year ended December 31, 2006) the report of the other auditors, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
As discussed in Note 2 to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standards No. 123R, Share-Based Payment, on January 1, 2006.
In our opinion, the 2006 consolidated financial statements referred to above present fairly, in all material respects, the financial position of Sherman Financial Group LLC and subsidiaries as of December, 31, 2006, and the results of their operations and their cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America.
Radian Group Inc. provides, through its subsidiaries and affiliates, credit-related insurance coverage and financial services to mortgage lenders and other financial institutions. Our principal business segments are mortgage insurance, financial guaranty and financial services.
Private mortgage insurance and risk management services are provided to mortgage lending institutions located throughout the United States and select countries outside the United States through our principal mortgage guaranty subsidiaries, Radian Guaranty Inc. (“Radian Guaranty”), Amerin Guaranty Corporation (“Amerin Guaranty”), Radian Insurance Inc. (“Radian Insurance”), Radian Europe Limited (“Radian Europe”) and Radian Australia Limited (“Radian Australia”). Private mortgage insurance generally protects lenders from all or a portion of default-related losses on residential mortgage loans made to home buyers who make down payments of less than 20% of the home’s purchase price. Private mortgage insurance also facilitates the sale of these mortgages in the secondary market, most which are sold to Federal Home Loan Mortgage Corp (“Freddie Mac”) and Federal National Mortgage Association (“Fannie Mae”), collectively referred to as Government Sponsored Enterprises (“GSEs”). Radian Guaranty currently offers two principal types of private mortgage insurance coverage, primary and pool. At December 31, 2006, primary insurance on domestic first-lien mortgages comprised approximately 89% of Mortgage Insurance’s domestic first-lien mortgage insurance risk in force and pool insurance comprised approximately 11% of Mortgage Insurance’s domestic first-lien mortgage insurance risk in force. Amerin Guaranty writes mortgage insurance on second-lien mortgages, and Radian Insurance provides credit enhancement for mortgage-related capital market transactions and writes credit insurance on mortgage-related assets that monoline mortgage insurers are not permitted to insure such as second-lien mortgages, home equity loans, net interest margin securities (“NIMs”), international insurance and reinsurance transactions and credit default swaps (collectively, we refer to the risk associated with these transactions as “other risk in force”).
Early in 2005, we entered into a relationship with Standard Chartered Bank (Hong Kong) Limited, a subsidiary of Standard Chartered Bank. Through this relationship, we provide mortgage insurance (on an offshore basis) for Standard Chartered in Hong Kong. In September 2006, Radian Insurance received a license authorizing it, through a local branch, to fully transact both mortgage insurance and financial guaranty business, including credit enhancement of structured transactions involving residential mortgage assets, in and from Hong Kong.
We formed Radian Australia in November 2006 and filed an application to conduct mortgage insurance business with the Australian Prudential Regulation Authority in December 2006. We have several reinsurance arrangements in place in Australia, including a recent transaction with St. George Insurance Australia, a wholly owned subsidiary of St. George Bank. The license we are seeking for Radian Australia will authorize it to fully transact both mortgage insurance and financial guaranty business in and from Australia.
excess of purchase price over fair value of net assets acquired of $56.7 million represents the future value of insurance profits, which is being amortized over a period that approximates the future life of the insurance book of business. At December 31, 2006, $28.2 million of this amount remained on our consolidated balance sheets. During 2006 and 2005, we amortized $1.8 million and $2.1 million, respectively, related to this transaction.
Our financial guaranty segment provides credit-related insurance coverage, credit default swaps and certain other financial guaranty contracts to meet the needs of customers and counterparties in a wide variety of domestic and international markets. Our insurance businesses within the financial guaranty segment include the assumption of reinsurance from monoline financial guaranty insurers for both public finance bonds and structured finance obligations and direct financial guaranty insurance for public finance bonds and structured finance obligations. In 2005, we decided to place our trade credit reinsurance line of business into run-off. We expect that the bulk of the remaining risk will expire over the next year.
Statement of Financial Accounting Standards No. 60, (“SFAS No. 60”), “Accounting and Reporting by Insurance Enterprises,” specifically excludes mortgage insurance from its guidance relating to the earning of insurance premiums. Consistent with GAAP and industry accounting practices, mortgage insurance premiums written on an annual and multi-year basis are initially deferred as unearned premiums and earned over the policy term, and premiums written on a monthly basis are earned over the period that coverage is provided. Annual premiums are amortized on a monthly, straight-line basis. Multi-year premiums are amortized over the terms of the contracts in accordance with the anticipated claim payment pattern based on historical industry experience. Ceded premiums written are initially set up as prepaid reinsurance and are amortized in accordance with direct premiums earned. Premiums on certain structured transactions are recognized over the period that coverage is provided. Deferred residual premiums on certain structured transactions are recognized in income when collectibility is reasonably certain. Credit enhancement fees on derivative contracts in the mortgage insurance business are included in premiums written and are earned over the period that credit protection is provided.
In our financial guaranty business, insurance premiums are earned in proportion to the level of amortization of insured principal over the contract period or over the period that coverage is provided. Unearned premiums represent that portion of premiums that will be earned over the remainder of the contract period, based on information reported by ceding companies and management’s estimates of amortization of insured principal on policies written on a direct basis. When insured issues are refunded or called, the remaining premiums are generally earned at that time because the risk to us is eliminated. Credit enhancement fees on derivative contracts in the financial guaranty business are included in premiums written and are earned over the period that credit protection is provided.
With the exception of our trade credit reinsurance products, net premiums written in our financial guaranty reinsurance business are recorded using actual information received from cedants on a one-month lag. Accordingly, the net written premiums for any given period exclude those from the last month of that period and include those from the last month of the immediately preceding period. The use of information from cedants does not require us to make significant judgments or assumptions because historic collection rates and counterparty strength makes collection of all assumed premiums highly likely. Net premiums written for the years ended December 31, 2006, 2005 and 2004 include $4.6 million, $35.0 million and $59.3 million, respectively, of assumed premiums related to our trade credit reinsurance products, which currently is operating in a run-off capacity. Included in these amounts are estimates based on quarterly projections provided by ceding companies. Over the life of the reinsured business, these projections are replaced with actual results and, historically, the difference between the projections and actual results has not been material. Accordingly, we do not record any related provision for doubtful accounts with respect to our trade credit reinsurance product.
reimbursement to the primary insurer under a reinsured financial guaranty contract when the primary insurer is obligated to pay principal and interest on an insured obligation.
Our unallocated non-specific reserves are established over time by applying expected default factors to the premiums earned during each reporting period on each credit for which we have not established a case reserve or an allocated non-specific reserve. The expected frequency and severity of losses for each credit is generated from three sources-two that are published by major rating agencies and one that is generated by a proprietary internal model-based on the product class, published rating and term to maturity for each credit. We set the expected life-time losses for each credit at a point in the range between the highest and lowest expected life-time loss factors generated by the rating agency and internally generated models. The default rates published by rating agencies tend to be very low because we mainly insure investment-grade obligations that, historically, have a very low probability of default. Although the default rate is low, the amount of losses upon default can be very high because we tend to insure large financial obligations. Because of the low incidence of losses on financial guaranty obligations, it is also very difficult to estimate the timing of losses on our insured obligations for which we have not yet established a case reserve or allocated non-specific reserve. The default factors for the years ended December 31, 2006, 2005 and 2004 approximated 10% of earned premiums on public finance credits and 20% of earned premiums on structured finance credits.
At each balance sheet date, we also evaluate both the model-generated default factors and our unallocated non-specific reserves against management’s subjective view of qualitative factors to ensure that the default factors and the unallocated non-specific reserves represent management’s best estimate of the expected losses on our portfolio of credits for which we have not established a case reserve or an allocated non-specific reserve. These qualitative factors include existing economic and business conditions, overall credit quality trends resulting from industry, geographic, economic and political conditions, recent loss experience in particular segments of the portfolio, changes in underwriting policies and procedures and seasoning of the book of business. The macroeconomic factors that we evaluate are outside of our control and are subject to considerable variability. Our specific factors that we evaluate also require that we make subjective judgments. In addition, a significant change in the size of our portfolio underlying the unallocated non-specific reserves, such as through the expiration of policies or the refunding or recapture of insured exposures, could require an adjustment to the default factors or our level of unallocated non-specific reserves. To date, our evaluation of these qualitative factors has not led us to adjust the default factors or our level of unallocated non-specific reserves. Our estimates of the reserves for losses and LAE for our financial guaranty segment’s other lines of business, principally trade credit reinsurance, depend upon the receipt of accurate information on claims and loss estimates from ceding companies. In addition, a reserve is included for losses and LAE incurred but not reported (“IBNR”), on trade credit reinsurance. Management reviews the estimates provided and makes appropriate adjustments based on additional relevant information. We use historical loss information and make inquiries to the cedants of known events as a means of validating our loss assumptions.
We discount financial guaranty case reserves arising from defaults that involve claim payments over an extended period of time. The discount rate corresponds to our individual statutory company investment yield of 4.36% in 2006 and 4.40% in 2005. Discounted liabilities at December 31, 2006, were $9.9 million, net of discounts of $4.2 million, compared to discounted liabilities of $0.5 million, net of discounts of $0.1 million at December 31, 2005. We do not discount our non-specific reserves.
definition of a short-duration contract or a long-duration contract. Financial guaranty contracts have elements of long-duration insurance contracts in that they are irrevocable and extend over a period that may extend 30 years or more but are reported for regulatory purposes as property and liability insurance, normally considered short- duration contracts. Reserves for losses and LAE for financial guaranty’s other lines of business, mainly trade credit reinsurance, we believe, fits within the short-duration contract framework of SFAS No. 60. These reserves are based on reports and individual loss estimates received from ceding companies, net of anticipated estimated recoveries under salvage and subrogation rights. We use historical loss information and make inquiries to the cedants of known events as a means of validating our loss assumptions. With respect to receiving reports on individual loss estimates in the other lines of reinsurance business, we have historically experienced prompt reporting and consistent results in determining reserves. In addition, the frequency of loss in the other lines of reinsurance business is low.
On June 8, 2005, the FASB added a project to its agenda to consider the accounting by insurers for financial guaranty insurance. The FASB’s objective is to provide guidance with respect to the timing of claim liability recognition, premium recognition and the related amortization of deferred policy acquisition costs, specifically for financial guaranty contracts issued by insurance companies that are not accounted for as derivative contracts under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS No. 133”). The goal is to reduce diversity in accounting by financial guaranty insurers, thereby enabling users to better understand and more readily compare the insurers’ financial statements. The FASB is also expected to examine the appropriate accounting model for other insurance products with similar characteristics, such as mortgage guaranty contracts and trade credit insurance. Proposed and final guidance from the FASB regarding accounting for financial guaranty insurance is expected to be issued in 2007. When and if the FASB or the Securities and Exchange Commission (“SEC”) reaches a conclusion on these issues, we and the rest of the financial guaranty and mortgage insurance industries may be required to change some aspects of our accounting policies. If the FASB or the SEC were to determine that we should account for our financial guaranty contracts differently, for example by requiring them to be treated solely as one or the other of short-duration or long-duration contracts under SFAS No. 60, this determination could impact our accounting for loss reserves, premium revenue and deferred acquisition costs, all of which are covered by SFAS No. 60. Management is unable to estimate what impact, if any, the ultimate resolution of this issue will have on our financial condition or operating results.
The following table shows our case and non-specific reserves for losses and loss adjustment expenses for our financial guaranty business, and case reserves and IBNR related to the non-financial guaranty businesses included in our financial guaranty segment as of the indicated dates (in thousands):
We account for derivatives under SFAS No. 133, as amended and interpreted. In general, SFAS No. 133 requires that all derivative instruments be recorded on the balance sheet at their respective fair values. All derivative instruments are recognized in our consolidated balance sheets as either assets or liabilities depending on the rights or obligations under the contracts. Transactions that we have entered into that are accounted for under SFAS No. 133 include investments in convertible debt securities, interest rate swaps, selling credit protection in the form of credit default swaps and certain financial guaranty and mortgage insurance contracts that are considered credit default swaps or NIMs. Credit default swaps and certain financial guaranty and mortgage insurance contracts that are accounted for under SFAS No. 133 are part of our overall business strategy of offering mortgage credit enhancement and financial guaranty protection to our customers. The premiums for these contracts are included in net premiums written and earned. The interest rate swaps that we have entered into qualify as hedges and are accounted for as fair value hedges. The embedded equity derivatives contained within our investments in fixed-maturity securities, forward foreign currency contracts and credit protection in the form of credit default swaps do not qualify as hedges under SFAS No. 133, so changes in their fair value are included in current earnings in our consolidated statements of income. Net unrealized gains and losses on credit default swaps and certain other derivative contracts are included in other assets on our consolidated balance sheets. We do not record a reserve for losses on derivative contracts. Any equivalent reserve would be embedded in the unrealized gains and losses on derivative financial contracts. Settlements under derivative contracts are charged to assets or liabilities, as appropriate, on the consolidated balance sheets. During the year ended December 31, 2006, we received $4.6 million, net, of recoveries of previous default payments, paid $68.0 million in connection with the termination of a derivative contract and paid $0.2 million for default payments. See below for further discussion. During 2005, we received $7.6 million as recoveries of previous default payments, and paid $0.1 million for default payments. During 2004, we received $4.0 million of recoveries of previous default payments, paid $18.6 million for default payments and received $2.9 million of early termination receipts.
The following table presents information related to net unrealized gains or losses on derivative financial guaranty contracts (included in other assets on our consolidated balance sheets).
The application of SFAS No. 133, as amended, could result in volatility from period to period in gains and losses as reported on our consolidated statements of income. These gains and losses are mostly the result of changes in credit spreads, changes in the creditworthiness of underlying entities, and the equity performance of entities underlying convertible investments. Any incurred gains or losses on such contracts would be recognized as a change in the fair value of derivatives. We are unable to predict the affect this volatility may have on our financial condition or results of operations.
(a) The December 31, 2006 six-month London Interbank Offered Rate (“LIBOR”) forward rate at the next swap payment date plus 87.4 basis points.
In October 2004, we entered into transactions to lock in treasury rates that would have served as a hedge in the event we had issued long-term debt. The notional value of the hedges was $120 million at a blended rate of 4.075%. At December 31, 2004, we had a $1.5 million unrealized gain recorded on the hedges. In January 2005, we discontinued the hedge arrangements and received payments from our counterparties. We realized a gain of $1.0 million at termination in 2005.
Included in cash were amounts restricted as to use of $3.6 million and $3.7 million as of December 31, 2006 and 2005, respectively, representing reserve accounts designed to cover losses on business insured by Radian Guaranty and Radian Insurance under two separate agreements.
Real estate is acquired in our mortgage insurance business segment to mitigate losses. The real estate acquired is included in other assets on our consolidated balance sheets at the lower of cost or net realizable value. Gains or losses from the holding or disposition of real estate acquired are recorded as a decrease or increase to the provision for losses. At December 31, 2006 and 2005, we held $4.6 million and $5.8 million, respectively, of real estate acquired to mitigate losses.
Origination costs of derivative mortgage and financial guaranty contracts are expensed as incurred.
As a mortgage guaranty and financial guaranty insurer, we are eligible for a tax deduction, subject to certain limitations, under Section 832(e) of the Internal Revenue Code for amounts required by state law or regulation to be set aside in statutory contingency reserves. The deduction is allowed only to the extent that we purchase non-interest-bearing U.S. Mortgage Guaranty Tax and Loss Bonds (“T&L bonds”) issued by the Treasury Department in an amount equal to “the tax benefit derived” from deducting any portion of our statutory contingency reserves. See Note 9 below.
In June 2006, the FASB issued FASB Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes.” FIN 48 is effective for fiscal years beginning after December 15, 2006, and clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes.” It prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. Management will adopt FIN 48 in the first quarter of 2007. The cumulative effect of applying the provisions of FIN 48 will be an increase of approximately $20 to $22 million in the liability for uncertain income taxes and will be accounted for as a corresponding decrease in the January 1, 2007 balance of retained earnings.
We are required to group assets in our investment portfolio into one of three categories: held to maturity, available for sale or trading securities. Fixed-maturity securities for which we have the positive intent and ability to hold to maturity are classified as held to maturity and reported at amortized cost. Investments classified as available for sale are reported at fair value, with unrealized gains and losses (net of tax) reported as a separate component of stockholders’ equity as accumulated other comprehensive income. Investments classified as trading securities are reported at fair value, with unrealized gains and losses (net of tax) reported as a separate component of income. During 2006, we began classifying certain new security purchases as trading securities. Similar securities were classified as available for sale for periods prior to 2006. For securities classified as either available for sale or held to maturity, we conduct a quarterly evaluation of declines in market value of the securities to determine whether the decline is other-than-temporary. See Note 3.
On January 1, 2006, we adopted SFAS No. 123R using a modified prospective application as permitted by SFAS No. 123R. Accordingly, prior period amounts have not been restated. Under this application, we are required to record compensation expense for all awards granted after the date of adoption and for the unvested portion of previously granted awards that remain outstanding at the date of adoption. Compensation cost is recognized over the periods that an employee provides service in exchange for the award. See Note 11 for further discussion.
We are required to disclose both “basic” net income per share and “diluted” net income per share. Basic net income per share is based on the weighted average number of common shares outstanding, while diluted net income per share is based on the weighted average number of common shares outstanding and common share equivalents that would arise from the exercise of stock options. Diluted shares assume the conversion of our senior convertible debentures, which were outstanding for a full year in 2004. We redeemed the entire principal amount outstanding of our senior convertible debentures on August 1, 2005, as discussed in Note 7.
At December 31, 2006, 2005 and 2004, there were 1,176,250 options, 268,878 options and 274,810 options, respectively, excluded from the net income per share calculation because the options were anti-dilutive.
The financial services segment includes the credit-based businesses conducted through our affiliates, C-BASS and Sherman. We allocate corporate income and expenses to each of the segments.
On June 24, 2005, we entered into agreements to restructure our ownership interest in Sherman. Before the restructuring, Sherman was owned 41.5% by us, 41.5% by Mortgage Guaranty Insurance Corporation (“MGIC”) and 17% by an entity controlled by Sherman’s management team. As part of the restructuring, we and MGIC each agreed to sell a 6.92% interest in Sherman to a new entity controlled by Sherman’s management team, thereby reducing our ownership interest and MGIC’s ownership interest to 34.58% for each of us. In return, the new entity controlled by Sherman’s management team paid approximately $15.65 million (which resulted in a $3.3 million loss) to us and the same amount to MGIC. Regulatory approval for this transaction was received in August 2005, and our ownership interest was reduced to 34.58%, retroactive to May 1, 2005. Effective June 15, 2005, Sherman’s employees were transferred to this new entity controlled by Sherman’s management team, and this entity agreed to provide management services to Sherman. Sherman’s management team also agreed to reduce significantly its maximum incentive payout under its annual incentive plan for periods beginning on or after May 1, 2005. In connection with the restructuring, we and MGIC each paid $1 million for each of us to
On September 14, 2006, we and MGIC each agreed to restructure our respective options. In order to accommodate this restructuring, the equity interests of Sherman were reclassified, effective July 1, 2006, from a single class of equity interests into Class A Common Units and a combination of Preferred Units and Class B Common Units. As part of the reclassification, all of the authorized Class B Common Units were granted to an entity controlled by Sherman’s management. The Class B Common Units entitle Sherman’s management to 3% of Sherman’s earnings above $200 million (on an annual basis) and a right in liquidation of up to 6% of any amounts after satisfaction of a liquidation preference on the Preferred Units. The actual percentage received by the holders of Class B Common Units upon a liquidation or sale of Sherman will depend on when the sale or liquidation occurs and the value of Sherman at that time.
As restructured, we and MGIC each were granted an identical option to purchase, effective July 1, 2006:
A preferred equity interest that entitles both us and MGIC to:
- Three percent (6% in total for both of us) of the first $200 million of Sherman’s annual earnings, which amount shall be allocated to the Preferred Units on a cumulative basis before any amounts are allocated to the Class B Common Units, and 1.5% (3% in total for both of us) of Sherman’s annual earnings above $200 million; and
- A preference in the proceeds received upon a liquidation or sale of Sherman equal to the tax basis in the preferred equity.
For each of the years ended December 31, 2006, 2005 and 2004, our domestic net premiums earned were $970.0 million, $959.0 million, and $1,020.2 million, respectively, and our net premiums earned attributable to foreign countries were approximately $45.8 million, $59.7 million, and $62.2 million, respectively. Because a significant amount of our trade credit reinsurance business line, which we placed in run-off during the fourth quarter of 2005, is written internationally, we anticipate that international net premiums earned from the trade credit reinsurance business will decline over the next few years as existing business runs off and new business is not originated. In addition, long-lived assets located in foreign countries were immaterial for the periods presented.
The largest single customer of our mortgage insurance segment (including branches and affiliates of such customer), measured by primary new insurance written, accounted for 18.6% of primary new insurance written in 2006 compared to 10.6% in 2005 and 9.6% in 2004.
We evaluate operating segment performance based principally on net income. Summarized financial information concerning our operating segments, as of and for the year-to-date periods indicated, are as follows:
On April 27, 2005, Fitch affirmed the “AA” insurance financial strength rating of Radian Asset Assurance and RAAL, but revised its Ratings Outlook for the two entities to negative from stable. None of the primary insurance customers of our financial guaranty business have any recapture rights as a result of this ratings action by Fitch.
In May 2004, Moody’s provided Radian Asset Assurance with an initial insurer financial strength rating of Aa3. Prior to the merger of Radian Reinsurance with and into Radian Asset Assurance, Moody’s downgraded the insurance financial strength rating of Radian Reinsurance from Aa2 to Aa3. As a result of this downgrade, two of the primary insurer customers of our financial guaranty reinsurance business had the right to recapture previously written business ceded to our financial guaranty reinsurance business. One of these customers agreed, without cost to or concessions by us, to waive its recapture rights. Effective February 28, 2005, the remaining primary insurer customer with recapture rights recaptured approximately $7.4 billion of par in force that it had ceded to us, including $54.7 million of net premiums written, $4.5 million of which already had been treated as earned under GAAP and was required to be recorded as an immediate reduction of net premiums earned at the time of the recapture. Also in connection with the recapture in the first quarter of 2005, we were reimbursed for policy acquisition costs of approximately $17.1 million for which the carrying value under GAAP was $18.8 million. This required us to write off policy acquisition costs of $1.7 million. The aggregate result was a reduction in pre-tax income of $6.2 million, or approximately $0.04 per share after tax.
Despite the recapture, this primary insurer customer renewed its reinsurance treaty with us for 2005 and 2006 on substantially the same terms as in 2004 prior to the May 2004 downgrade. In March 2005, without cost to or concessions by us, this customer waived all of its remaining recapture rights with respect to the May 2004 downgrade by Moody’s. There are no remaining recapture rights with respect to the May 2004 downgrade by Moody’s.
The sum of the above adjustments related to this recapture, (the “2004 recapture”) resulted in an immediate reduction of pre-tax income of $15.9 million and is summarized as follows:
Without cost to or concessions by us, the remaining primary insurer customers with recapture rights agreed not to exercise those rights with respect to the October 2002 downgrade by S&P. None of the primary insurer customers of our financial guaranty reinsurance business have any remaining recapture rights as a result of prior downgrades of Radian Asset Assurance’s or Radian Reinsurance’s financial strength ratings from any of the ratings agencies.
In addition, the merger with MGIC will provide certain of our primary insurer customers with similar recapture rights. See Note 18 for more information regarding these recapture rights, including any potential financial impact.
Singer Asset Finance Company, L.L.C. (“Singer”), an entity acquired in connection with the purchase of EFSG is currently operating on a run-off basis. We have sold portions of this business. During the run-off, any net servicing expenses will be charged against an existing servicing liability and any gains or losses on assets will be charged against an existing asset reserve. If and when these reserves become depleted, future results will be recorded in current operations.
Singer had been engaged in the purchase, servicing and securitization of assets, including state lottery awards and structured settlement payments. Its operations currently consist of servicing and/or disposing of Singer’s previously originated assets and servicing of Singer’s non-consolidated special-purpose vehicles. The results of this subsidiary are not material to our financial results. At December 31, 2006, we had approximately $289 million and $269 million of non-consolidated assets and liabilities, respectively, associated with Singer special-purpose vehicles, representing a net investment of $20.2 million at December 31, 2006. At December 31, 2005, we had approximately $349 million and $328 million of non-consolidated assets and liabilities, respectively, associated with Singer special-purpose vehicles, representing a net investment of $21.0 million at December 31, 2005.
We account for guarantees under FIN No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, including Indirect Guarantees of Indebtedness of Others.” This Interpretation elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. This Interpretation also incorporates, without change, the guidance in FIN No. 34, “Disclosure of Indirect Guaranties of Indebtedness of Others,” which was superseded. The Interpretation does not apply to the financial guaranty insurance policies that we issue. However, we have guaranteed the performance of Sherman under a $25 million revolving credit facility that expires in December 2007. There are no amounts outstanding on this facility at December 31, 2006.
In September 2006, the FASB issued Statement No. 157, “Fair Value Measurements” (“SFAS No. 157”). SFAS No. 157 (i) defines fair value, (ii) establishes a framework for measuring fair value in GAAP and (iii) expands disclosure requirements about fair value measurements. SFAS No. 157 is effective for all financial statements issued for fiscal years beginning after November 15, 2007. Management currently is considering the impact that may result from the adoption of SFAS No. 157.
Fixed-maturity and equity investments at December 31, 2006 and 2005 consisted of (in thousands):
For the years ended December 31, 2006, 2005 and 2004, we did not sell any fixed-maturity investments held to maturity.
The unrealized losses of 12 months or greater duration as of December 31, 2006 on our investments in U.S. Treasury obligations were caused by interest rate increases. During 2006, the Federal Reserve raised the federal funds rates four times for a total of 100 basis points. A majority of the securities remained at an unrealized loss position due to the rate increases. The contractual terms of these investments do not permit the issuer to settle the securities at a price less than the par value of the investment. Because we have the ability and intent to hold these investments until a full recovery of fair value, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at December 31, 2006.
The unrealized losses of 12 months or greater duration as of December 31, 2006 on the majority of the securities in this category were caused by market interest rate increases. A majority of the securities remained at an unrealized loss position due to these rate increases. Unrealized losses for the remaining securities in this category are attributable to changes in business operations, resulting in widened credit spreads from December 31, 2005 to December 31, 2006. Because we have the ability and intent to hold these investments until a full recovery of fair value, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at December 31, 2006
For all investment categories, unrealized losses of less than 12 months in duration are generally attributable to interest rate increases. All securities are individually evaluated in accordance with our impairment recognition policy covering various time and price decline scenarios. Because we have the ability and intent to hold these investments until a full recovery of fair value, which may be maturity, we do not consider the investment in these securities to be other-than-temporarily impaired at December 31, 2006.
In January 2007, a dividend of $51.5 million was received from Sherman.
The following tables show selected financial information for C-BASS and Sherman for the years ended December 31, 2005 and 2006:
We utilize reinsurance as a risk management tool, to reduce net risk in force to meet regulatory risk-to-capital requirements and, with respect to mortgage insurance, to comply with the insurance regulations of states that require us to limit our coverage percentage of any single risk to 25%. Although the use of reinsurance does not discharge an insurer from its primary liability to the insured, the reinsuring company assumes the related liability. Included in other assets are unearned premiums (prepaid reinsurance) of $1.0 million and $3.0 million at December 31, 2006 and 2005, respectively.
Radian Guaranty entered into variable quota share treaties in each of the years 1994 through 1997 to reinsure its primary risk originated in each of these years and a portion of its pool risk written in 1997. The 2006, 2005 and 2004 amounts in the preceding table included ($593,000), ($294,000) and ($2,815,000), respectively, for ceded premiums written and ($571,000), ($242,000) and ($2,722,000), respectively, for ceded premiums earned, for reinsurance ceded under these variable quota share treaties. Commissions under these treaties were $114,000, $289,000 and $358,000 for the years ended December 31, 2006, 2005 and 2004, respectively. We recovered variable quota-share losses under these treaties of $129,000, $657,000, and $165,000 in 2006, 2005, and 2004, respectively. Due to the rapid run-off of the underlying business as a result of lower persistency levels, we had recovered amounts under the variable quota share relief provisions of the treaty in excess of the underwriting-year coverage premiums during 2006, 2005 and 2004, as reflected in the negative ceded premiums written and earned during those years.
In 2006, the reinsurer reimbursed us for underwriting-year excess of loss coverage due under the tenth year of the 1996 treaty. The 1997 amount due under the underwriting-year excess coverage provision of the treaties was received from the reinsurer in 2007. In December 2006, Radian Guaranty terminated the remaining variable quota-share reinsurance treaty, as allowed under the terms of the treaty.
Effective December 31, 2004, Radian Guaranty canceled its excess of loss reinsurance program that was in a run-off period scheduled to expire in 2007. Under this program, the reinsurer was responsible for 100% of Radian Guaranty’s covered losses (subject to an annual and aggregate limit) in excess of an annual retention limit. Premiums were paid to the reinsurer on a quarterly basis, net of any losses due to Radian Guaranty. This treaty was accounted for under SOP 98-7, “Deposit Accounting: Accounting for Insurance and Reinsurance Contracts That Do Not Transfer Insurance Risk” (“SOP 98-7”) and therefore, ($10.7) million was included in incurred losses during 2004, relating to the excess of loss reinsurance program. In connection with the cancellation of the policy in 2004, $17.1 million of liabilities for withheld funds was released.
The following tables present information relating to our mortgage insurance reserves, and the liability for unpaid claims and related expenses (in thousands):
During 2006 and 2005, our incurred losses and LAE in the financial guaranty insurance business for prior years were reduced by $6.8 million and $15.9 million, respectively, mainly related to favorable loss development in trade credit.
On December 13, 2006, we replaced a $400 million unsecured credit facility, comprised of a $100 million 364-day facility that was scheduled to expire on December 14, 2006 and a $300 million five-year facility that was to expire on December 16, 2009, with a $400 million unsecured revolving credit facility that is scheduled to expire on December 13, 2011. The new facility includes a $100 million uncommitted line that we may exercise at our option, subject to our obtaining necessary commitments from lenders. This new facility bears interest on any amounts drawn at a rate dependent on our credit rating at the time of borrowing and will be calculated according to, at the our option, a base rate or a Eurocurrency rate, plus an applicable margin and utilization fee. If necessary, this facility will be used for working capital and general corporate purposes. There were no drawdowns on the expired facility, and we have not drawn down any amounts under the new facility through December 31, 2006.
In September 2003, Radian Asset Assurance completed a transaction for $150 million of money market committed preferred custodial trust securities, pursuant to which it entered into a series of three perpetual put options on its own preferred stock to Radian Asset Securities Inc. (“Radian Asset Securities”), our wholly-owned subsidiary. Radian Asset Securities in turn entered into a series of three perpetual put options on its own preferred stock (on substantially identical terms to the Radian Asset Assurance preferred stock). The counterparties to the Radian Asset Securities put options are three trusts established by two major investment banks. The trusts were created as a vehicle for providing capital support to Radian Asset Assurance by allowing Radian Asset Assurance to obtain immediate access to additional capital at its sole discretion at any time through the exercise of one or more of the put options and the corresponding exercise of one or more corresponding Radian Asset Securities put options. If the Radian Asset Assurance put options were exercised, Radian Asset Securities, through the Radian Asset Assurance preferred stock thereby acquired, and investors, through their equity investment in the Radian Asset Securities preferred stock, would have rights to the assets of Radian Asset Assurance of an equity investor in Radian Asset Assurance. Such rights would be subordinate to policyholders’ claims, as well as to claims of general unsecured creditors of Radian Asset Assurance, but ahead of ours, through EFSG, as the owner of the common stock of Radian Asset Assurance. If all the Radian Asset Assurance put options were exercised, Radian Asset Assurance would receive up to $150 million in return for the issuance of its own perpetual preferred stock, the proceeds of which would be usable for any purpose, including the payment of claims. Dividend payments on the preferred stock will be cumulative only if Radian Asset Assurance pays dividends on its common stock. Each trust will be restricted to holding high-quality, short-term commercial paper investments to ensure that it can meet its obligations under the put option. To fund these investments, each trust will issue its own auction market perpetual preferred stock. Each trust is currently rated “A” by each of S&P and Fitch. The initial costs to issue this facility were recorded as a reduction to additional paid-in capital. Ongoing costs of the put premium are charged to other operating expenses. Ongoing costs in 2006 and 2005 were $2.0 million for each year and $1.7 million in 2004.
Cumulative T&L bonds purchased and subsequent redemptions are reflected in the balance of prepaid federal income taxes on our consolidated balance sheets. During 2006, we purchased approximately $223.2 million of T&L bonds, net of redemptions of T&L bonds purchased in prior years. Prepaid federal income taxes include T&L bonds of $808.7 million and $585.5 million at December 31, 2006 and 2005, respectively.
We act principally as a holding company for our insurance subsidiaries and do not have any significant operations of our own. Dividends from our subsidiaries, which include amounts received from our affiliates (C-BASS and Sherman), and permitted payments to us under our tax-and expense-sharing arrangements with our subsidiaries, along with income from our investment portfolio, are our principal sources of cash to pay stockholder dividends and to meet our obligations. These obligations include our operating expenses, taxes and interest and principal payments on our long-term debt. The payment of dividends and other distributions to us by our insurance subsidiaries are regulated by insurance laws and regulations. In general, dividends in excess of prescribed limits are deemed “extraordinary” and require insurance regulatory approval. In addition, although we have expense-sharing arrangements in place with our principal operating subsidiaries that require those subsidiaries to pay their share of holding company-level expenses, including interest expense on long-term debt, these expense-sharing arrangements may be changed at any time by the applicable state insurance departments. In addition, our insurance subsidiaries’ ability to pay dividends to us, and our ability to pay dividends to our stockholders, is subject to various conditions imposed by the rating agencies for us to maintain our ratings. If the cash we receive from our subsidiaries pursuant to tax- and expense-sharing arrangements is insufficient for us to fund our obligations, we may be required to seek capital by incurring additional debt, by issuing additional equity or by selling assets, which we may be unable to do on favorable terms, if at all. The need to raise additional capital or the failure to make timely payments on our obligations could have a material adverse effect on our business, financial condition and operating results.
Radian Guaranty’s and Radian Insurance’s ability to pay dividends to us is restricted by certain provisions of the insurance laws of the Commonwealth of Pennsylvania, their state of domicile. The insurance laws of Pennsylvania establish a test limiting the maximum amount of dividends that may be paid by an insurer without prior approval by the Pennsylvania Insurance Commissioner. Under this test, an insurer may pay dividends during any 12-month period in an amount equal to the greater of (i) 10% of the preceding year-end statutory policyholders’ surplus; or (ii) the preceding year’s statutory net income. In accordance with these restrictions, $384.7 million and $62.8 million would be available for dividends from Radian Guaranty and Radian Insurance, respectively, in 2007. However, an amendment to the Pennsylvania statute requires that dividends and other distributions be paid out of an insurer’s unassigned surplus. Radian Guaranty and Radian Insurance have positive unassigned surplus at December 31, 2006 of $302.5 million and $92.2 million, respectively, which represents the dividend limitations for 2007. The Pennsylvania Insurance Commissioner has approved all distributions by Radian Guaranty since the passage of this amendment. Radian Insurance has not paid any dividends to its immediate parent, Radian Guaranty.
Amerin Guaranty’s ability to pay dividends on its common stock is restricted by certain provisions of the insurance laws of the State of Illinois, its state of domicile. The insurance laws of Illinois establish a test limiting the maximum amount of dividends that may be paid from positive unassigned surplus by an insurer without prior approval by the Illinois Insurance Commissioner. Under this test, Amerin Guaranty may pay dividends during any 12-month period in an amount equal to the greater of (i) 10% of the preceding year-end statutory policyholders’ surplus; or (ii) the preceding year’s statutory net income. In accordance with these restrictions, $20.2 million is available for dividends in 2007 without prior regulatory approval.
Radian Asset Assurance’s ability to pay dividends is restricted by certain provisions of the insurance laws of the State of New York, its state of domicile. Under the New York insurance law, Radian Asset Assurance may only declare or distribute dividends from earned surplus. Unless the company has prior approval from the New York Superintendent of Insurance, the company can only pay a dividend, which when totaled with all other dividends declared or distributed by it during the next preceding 12 months, is the lesser of 10% of its surplus to policyholders as shown by its last statement on file with the Superintendent, or one hundred percent of adjusted net investment income. At December 31, 2006, Radian Asset Assurance had $100.1 million available for dividends that could be paid in 2007 without prior approval.
Radian Guaranty’s statutory net income, statutory policyholders’ surplus and contingency reserve as of and for the years ended December 31 was as follows:
Under Illinois insurance regulations, Amerin Guaranty is required to maintain statutory-basis capital and surplus of $1.5 million. Amerin Guaranty’s statutory net income and statutory policyholders’ surplus as of and for the years ended December 31 was as follows:
Radian Insurance’s statutory net income, statutory policyholders’ surplus and contingency reserve as of and for the years ended December 31 was as follows:
debt service for a single risk, net of reinsurance and collateral, may not exceed 10% of the sum of the insurer’s policyholders’ surplus and contingency reserves. In addition, insured principal of municipal bonds attributable to 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.
We prepare our statutory financial statements in accordance with the accounting practices required or permitted by the insurance departments of the respective states of domicile of our insurance subsidiaries. Required statutory accounting practices include a variety of publications of the National Association of Insurance Commissioners (“NAIC”) as well as state laws, regulations and general administrative rules.
(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 written after June 30, 1989, each primary 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 15-20 years dependent upon the category of obligation insured. Reinsurers are required to establish a contingency reserve equal to their proportionate share of the reserve established by the primary insurer. Also under STAT, case reserves are required to be established in the year in which the default occurred. We establish non-specific reserves under GAAP as described in Note 2.
We use the Black-Scholes model in determining the fair value of stock-based compensation issued to employees and directors. The fair value of the stock options granted was estimated using this model on the date of grant using the assumptions noted in the following table:
(1) Beginning in 2006, with the adoption of SFAS No. 123R, the expected life of stock options granted was based on the simplified method. Stock options have historically been granted with a vesting period of four years, expiring over seven or 10 years.
For the year ended December 31, 2006, the adoption of SFAS No. 123R resulted in incremental stock-based compensation of $10.8 million, of which $3.8 million was deferred as policy acquisition costs. The incremental stock-based compensation expense for the year ended December 31, 2006 caused income before income taxes and net income to decrease by $7.0 million and $4.6 million, respectively, and both, basic and diluted earnings per share to decrease by $0.06 per share. In computing the pro-forma expense in prior years, there was no assumption that any compensation expense related to stock options would be deferred, therefore, pro-forma adjustments in prior periods do not include adjustments related to acquisition costs. Cash provided by operating activities decreased and cash provided by financing activities for the year ended December 31, 2006 increased by $4.8 million related to excess tax benefits from stock-based payment arrangements.
Unless otherwise specified, each option vests ratably over four years, beginning one year after the date of grant. As long as the grantee is still with Radian, if not sooner vested by its terms, each option fully vests upon the earliest of:
In addition, we have in the past accelerated the vesting of options upon a grantee’s election to retire upon reaching the age of 55, with at least 10 years of service. A grantee may pay the option price in cash or, with the consent of the Compensation and Human Resources Committee of our board of directors (the “Compensation Committee”), shares of our common stock, or by making other arrangements satisfactory to us.
The amount of cash received from the exercise of stock options in the year ended December 31, 2006 was approximately $26.9 million and the related tax benefit was approximately $9.4 million. The total intrinsic value of options exercised, at the date of exercise, during the year ended December 31, 2006, was $15.1 million.
The table summarizes information regarding fully vested share options as of December 31, 2006:
Under the provisions of SFAS No. 123R, the recognition of deferred compensation as a separate line item on the consolidated balance sheets is no longer required. Therefore, in 2006, the amount that had been included in “deferred compensation” in the consolidated balance sheets at December 31, 2005 was reclassified to
additional paid-in-capital. The amount recorded as stock-based compensation expense related to restricted stock for the years ended December 31, 2006 and 2005 was $1.4 million and $0.5 million respectively. No stock-based compensation expense related to restricted stock was recorded in 2004.
to a maximum contribution of $400 per payroll period toward the purchase of our stock. Under the ESPP, we sold 15,362 and 17,368 shares to employees during the years ended December 31, 2006 and 2005, respectively. Beginning in 2006, we applied SFAS No. 123R in accounting for the ESPP. The effect of the issuance of shares under the ESPP on our net income and earnings per share was immaterial in 2005 and 2004. The amount recorded as stock-based compensation related to the ESPP for the year ended December 31, 2006 was $0.2 million. No stock-based compensation expense related to the ESPP was recorded for 2005 and 2004.
The following are assumptions used in our calculation of ESPP compensation expense during 2006:
We have a Performance Share Plan (the “Program”). The Program is intended to motivate our executive officers by focusing their attention on critical financial indicators that measure our success. The performance share awards granted pursuant to the Program are funded by equity awards under the Plan. We are currently using phantom stock grants to fund awards under the Program. The Compensation Committee grants performance share awards to eligible participants with respect to performance periods of overlapping durations. Both the first and second performance periods under the Program are three-year periods that began on January 1, 2005 and January 1, 2006, respectively. The Compensation Committee expects that future performance periods will cover additional three-year periods beginning on January 1 of each year.
At the establishment of each performance period, a target number of performance shares are established for each participant in the Program. The performance shares are denominated in shares of common stock and are settled in common shares. The maximum payout under any performance share award is 250,000 shares of common stock. The amount of stock-based compensation expense related to performance shares for the year ended December 31, 2006 was $3.2 million.
We maintain a noncontributory defined benefit pension plan (the “Pension Plan”) covering substantially all of our full-time employees. On November 14, 2006, the board approved, effective December 31, 2006, the suspension of (1) all benefits accruing under the Pension Plan and (2) all forms of participation under the Pension Plan. All salaried and hourly employees of Radian and its participating subsidiaries currently are eligible to participate in the Pension Plan upon attaining 20 1/2 years of age and one year of eligible service. A participant generally is fully vested in the Pension Plan after five years of service after the age of 18. We recorded a curtailment loss of approximately $370,000 as a result of the freezing of the Pension Plan.
In February of 2007 we terminated the Pension Plan, effective June 1, 2007.
Retirement benefits are a function of the years of service and the level of compensation. Assets of the plan are allocated in a balanced fashion with approximately 60% in equity securities and 40% in fixed-income securities.
The Savings Plan covers substantially all our full-time and all our part-time employees employed for a minimum of 90 consecutive days. Participants can contribute up to 25% of their base earnings as pretax contributions. We will match at least 25% of the first 6% of base earnings contributed in any given year. These matching funds are subject to certain vesting requirements. Our expense for matching funds for the years ended December 31, 2006, 2005 and 2004 was $2.9 million, $2.6 million and $2.8 million, respectively.
On November 14, 2006, the board also approved the termination of the Radian Group Inc. Supplemental Executive Retirement Plan (the “SERP”) effective December 31, 2006, and the adoption of a new nonqualified restoration plan (the “Benefit Restoration Plan” or “BRP”), effective January 1, 2007. The BRP is intended to provide additional retirement benefits to Radian employees that are eligible to participate in the Radian Group Inc. Savings Incentive Plan (the “Savings Plan”) and whose benefits under the Savings Plan are limited by applicable IRS limits on eligible compensation.
Participants in the BRP will be entitled, among other things, to the following:
each participant in the SERP at December 31, 2006 will receive an initial balance in the BRP equal to the present value of the participant’s SERP benefit as of such date;
the board also may make discretionary, pro rata (based on eligible compensation) contributions to each participant under the BRP.
In addition to providing pension benefits, we provide certain healthcare and life insurance benefits to our retired employees who were hired before January 1, 1990, under a postretirement welfare plan (the “Postretirement Welfare Plan”). Until its curtailment on August 31, 2002, EFSG had a plan that provided certain healthcare benefits for retired employees (the “EFSG Postretirement Medical Plan”). The expense for postretirement benefit costs for 2006 was $33,600 as compared to $34,800 for 2005, and $12,100 for 2004. We accrue the estimated cost of retiree medical and life benefits over the period during which employees render the service that qualifies them for benefits.
In 2006, we implemented FASB issued Statement No. 158, “Employer’s Accounting for Defined Benefit Pension and Other Postretirement Plans” (“SFAS No. 158”). SFAS No. 158 requires us to recognize the funded
status of a benefit plan-measured as the difference between plan assets at fair value (with limited exceptions) and the benefit obligation-in our consolidated balance sheets. For a pension plan, the benefit obligation is the projected benefit obligation; for any other postretirement benefit plan, such as a retiree health care plan, the benefit obligation is the accumulated postretirement benefit obligation. SFAS No. 158 also requires us to recognize as a component of accumulated other comprehensive income, net of tax, the gains or losses and prior service costs or credits that arise during the period but are not recognized as components of net periodic benefit cost. Amounts recognized in accumulated other comprehensive income, including the gains or losses, prior service costs or credits, and the transition asset or obligation remaining, are adjusted as they are subsequently recognized as components of net periodic benefit cost pursuant to the recognition and amortization provisions of those statements. In addition, SFAS No. 158 requires us to measure defined benefit plan assets and obligations as of the date of our fiscal year-end consolidated balance sheets (with limited exceptions), and to disclose in the notes to financial statements additional information about certain effects on net periodic benefit cost for the next fiscal year that arise from delayed recognition of the gains or losses, prior service costs or credits, and transition asset or obligation. Employers with publicly traded equity securities are required to initially recognize the funded status of a defined benefit postretirement plan and to provide the required disclosures as of the end of the fiscal year ending after December 15, 2006. The requirement to measure plan assets and benefit obligations as of the date of the employer’s fiscal year-end statement of financial position is effective for fiscal years ending after December 15, 2008.
The funded status of the Pension Plan, SERP and the Postretirement Welfare Plan for the periods stated were as follows (in thousands):
Weighted average assumptions used to determine net pension and net periodic postretirement benefit obligation at December 31, 2006 and 2005 were as follows:
The selected long-term rate on assets (8.50%) was principally based on the allocation of the Pension Plan’s assets (approximately 60% equities and 40% fixed-income investments) coupled with the actual expected returns provided by our investment advisor by asset type. This assumption is a long-term assumption that has been in place for many years. We have periodically reviewed our assumptions against various capital market simulations to assure that our assumptions remain reasonable. We believe that an 8.5% long-term return assumption remains reasonable in calculating pension expense.
Due to the nature of the Postretirement Welfare Plan, no increase is assumed in our obligation due to any increases in the per-capita cost of covered healthcare benefits.
We are involved in certain litigation arising in the normal course of our business. We are contesting the allegations in each such other action and believe, based on current knowledge and consultation with counsel, that the outcome of such litigation will not have a material adverse effect on our consolidated financial position or results of operations.
Our mortgage insurance business utilizes its underwriting skills to provide an outsourced underwriting service to its customers. We give recourse to our customers on loans we underwrite for compliance. Typically, we agree that if we make a material error in underwriting a loan, we will remedy, indemnify, make whole, repurchase, or place additional mortgage insurance coverage on the loan. During 2006, we processed requests for remedies on less than 1% of the loans underwritten and sold a number of loans previously acquired as part of the remedy process. We paid losses for sales and remedies from reserves in 2006 of approximately $5.9 million. Providing these remedies means we assume some credit risk and interest-rate risk if an error is found during the limited remedy period in the agreements governing our provision of contract underwriting services. Rising mortgage interest rates or an economic downturn may expose the mortgage insurance business to higher losses. In 2005, we had provisions for contract underwriting remedies of $8.0 million. In 2006, our provisions were approximately $5.7 million and our reserve at December 31, 2006, was $3.4 million. We closely monitor this risk and negotiate our underwriting fee structure and recourse agreements on a client-by-client basis.
(1) Diluted net income per share and average shares outstanding per SFAS No. 128, “Earnings Per Share.” Amounts for the first three quarters of 2005 reflect the inclusion of shares underlying contingently convertible debt. See Note 2.
(2) Net income per share is computed independently for each period presented. Consequently, the sum of the quarters may not equal the total net income per share for the year.
(1) The fair value of other invested assets is based on carrying value for equity-method investments and cost for cost-method investments.
We have committed to invest $10 million in a fund sponsored and managed by C-BASS. The fund invests in real estate related securities and had total assets of $361.0 million at December 31, 2006. C-BASS is also a co-investor in the fund. We had $7.3 million invested in the fund at December 31, 2006 and $5.2 million at December 31, 2005.
On February 6, 2007, we and MGIC entered into an Agreement and Plan of Merger pursuant to which we agreed, subject to the terms and conditions of the merger agreement, to merge with and into MGIC, with the combined company to be re-named MGIC Radian Financial Group Inc.
Subject to the terms and conditions of the merger agreement, which has been unanimously approved by the boards of directors of both companies, upon the completion of the merger, each share of Radian common stock will be converted into 0.9658 shares of MGIC common stock, with cash to be paid in lieu of fractional shares of MGIC common stock. Radian stock options and other equity awards will automatically convert upon completion of the merger into stock options and equity awards with respect to MGIC common stock, subject to adjustment to reflect the exchange ratio.
The merger agreement contains certain termination rights for both us and MGIC. Under certain circumstances, including those relating to competing business combination proposals, termination of the merger agreement may result in a party paying a termination fee of $185 million.
Upon completion of the merger, certain of our financial guaranty reinsurance customers will have the right to recapture financial guaranty reinsurance business previously assumed by us. At December 31, 2006, we have assumed an aggregate of approximately $10.0 billion par in force and approximately $70.3 million of unearned
premium reserves from these customers. If all these customers were to recapture all of their financial guaranty reinsurance business assumed by us, based on December 31, 2006 figures, we would experience an estimated reduction of $87.9 million of written premiums, as well as immediate reductions of $17.6 million of earned premiums, $12.1 million in acquisition costs, and $6.0 million in incurred losses, which would result in a pretax gain of approximately $0.5 million. If all this reinsurance business were recaptured, we estimate that we would have to disburse $55 million in cash to settle the recaptures. A small portion of this reinsurance business from these customers is not subject to recapture. We cannot provide any assurances as to whether the merger shall be consummated, and if so whether any or which of these customers will recapture all or any portion of this business upon consummation of the merger described above or the exact impact of the actual recapture, if any.