At our corporate headquarters in Philadelphia, Pennsylvania, we lease approximately 151,697 square feet of office space and 1,240 square feet of space for data storage under a lease that expires in August 2017. In addition, we also lease the following:
18,962 square feet of office space (including 3,813 square feet in Atlanta, Georgia which is subleased until the expiration of the lease in November 2009) for our mortgage insurance regional offices, service centers and on-site offices throughout the U.S. The leases for this space expire between 2009 and 2012. We are seeking to sublease or potentially buyout a service center lease in Blue Bell, Pennsylvania. This lease expires March 2012;
Approximately 600 square feet of office space for our international financial guaranty operations in London until May 2010, with early termination rights beginning May 2009. The lease of the original space, comprising 6,600 square feet, with a term through June 2012 has been assigned to a third party. Radian Group remains as a guarantor on the lease should the assignee fail to perform;
The following table sets forth our selected financial data. This information should be read in conjunction with our Consolidated Financial Statements and Notes thereto included in Item 8 and the information included in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
(3) Consists mostly of international insurance risk, second-lien mortgage insurance risk and other structured mortgage-related insurance risk.
(4) Reflects the recapture of a portion of our reinsurance portfolio by certain of our financial guaranty reinsurance customers in 2004, 2005 and 2008.
(5) The 2007 amount has been revised to reflect the reclassification of $8.7 million of loss adjustment expenses from other operating expenses to provision for losses.
(6) The 2007 amount has been revised to reflect the reclassification of the $5.4 million of unrealized loss on the fair value of the long-term debt, previously included in long-term debt at December 31, 2007, to other liabilities.
of our active international transactions have the right to terminate these transactions, which could require us to return unearned premiums or transfer unearned premiums to a replacement insurer. On March 4, 2008, Standard Chartered Bank in Hong Kong informed us that they wished to terminate their contract for new business with Radian Insurance. There is a possibility that Radian Insurance could be required to return unearned premiums related to this transaction to Standard Chartered Bank, or to transfer such unearned premiums to another insurer. In addition, we have used Radian Guaranty to assume or reinsure most of our Australian transactions.
Our financial guaranty business has mainly provided direct insurance and reinsurance on credit-based risks through Radian Asset Assurance Inc. (“Radian Asset Assurance”), a wholly-owned subsidiary of Radian Guaranty, and through Radian Asset Assurance’s wholly-owned subsidiary Radian Asset Assurance Limited (“RAAL”), located in the United Kingdom.
Financial guaranty insurance typically provides an unconditional and irrevocable guaranty to the holder of a financial obligation of full and timely payment of principal and interest when due. Financial guaranty insurance may be issued at the inception of an insured obligation or may be issued for the benefit of a holder of an obligation in the secondary market. Historically, financial guaranty insurance has been used to lower an issuer’s cost of borrowing when the insurance premium is less than the value of the spread (commonly referred to as the “credit spread”) between the market yield required to be paid on the insured obligation (carrying the credit rating of the insurer) and the market yield required to be paid on the obligation if sold on the basis of its uninsured credit rating. Financial guaranty insurance also has been used to increase the marketability of obligations issued by infrequent or unknown issuers or obligations with complex structures. Until recently, investors generally have benefited from financial guaranty insurance through increased liquidity in the secondary market, reduced exposure to price volatility caused by changes in the credit quality of the underlying insured issue, and added protection against loss in the event of the obligor’s default on its obligation. Recent market developments, including ratings downgrades of most financial guaranty insurance companies (including our own), have significantly reduced the perceived benefits of financial guaranty insurance.
We have provided financial guaranty credit protection either through the issuance of a financial guaranty insurance policy or through credit default swaps. Either form of credit enhancement can provide the purchaser of such credit protection with a guaranty of the timely payment of interest and scheduled principal when due on a covered financial obligation. By providing credit default swaps, we have been able to participate in transactions with superior collateral quality involving asset classes (such as corporate collateralized debt obligations (“CDOs”)) that may not have been available to us through the issuance of a traditional financial guaranty insurance policy. Either form of credit enhancement requires substantially identical underwriting and surveillance skills.
loans, bonds or other borrowed money, residential and commercial mortgages, diversified payment rights, a variety of consumer loans, equipment receivables, real and personal property leases or a combination of asset classes or securities backed by one or more of these pools of assets. We have also guaranteed excess clearing losses of securities exchange clearinghouses. The structured finance obligations we insure were generally rated investment-grade at the time we issued our insurance policy, without the benefit of our insurance; and
In October 2005, we exited the trade credit reinsurance line of business. Accordingly, this line of business was placed into run-off and we ceased initiating new trade credit reinsurance contracts. We have also been novating or cancelling several of the trade credit insurance agreements that were in place.
Our financial services segment mainly consists of our 28.7% equity interest in Sherman Financial Group LLC (“Sherman”), a consumer asset and servicing firm. In August 2008, our equity interest in Sherman increased to 28.7% from 21.8% as a result of a reallocation of the equity ownership of Sherman following a sale by Mortgage Guaranty Insurance Corporation (“MGIC”) of its remaining interest in Sherman back to Sherman. As a result of Sherman’s repurchase of MGIC’s interests, our investment in affiliates decreased by $25.8 million ($16.8 million after taxes) and is reflected as a reduction in our equity. Our financial services segment also includes our 46% interest in Credit-Based Asset Servicing and Securitization LLC (“C-BASS”), a mortgage investment company which we have written off completely and whose operations are currently in run-off.
Sherman. Sherman is a consumer asset and servicing firm specializing in charged-off and bankruptcy plan consumer assets, which are generally unsecured, that Sherman typically purchases at deep discounts from national financial institutions and major retail corporations and subsequently seeks to collect. In addition, Sherman originates subprime credit card receivables through its subsidiary CreditOne and has a variety of other similar ventures related to consumer assets.
As a consequence of the complete write-off of our investment in C-BASS in 2007, we have no continuing interest of value in C-BASS. The effect of C-BASS on our financial position and results of operations as of and for the year ended December 31, 2008, was negligible. We have no contractual obligations to C-BASS or its creditors to fund C-BASS’s shareholders’ deficit as of December 31, 2007 or continuing losses in 2008 or thereafter. All of C-BASS’s business is currently in run-off and we anticipate that all future cash flows of C-BASS will be used to service the outstanding debt. Given its approximately $1 billion shareholders’ deficit as of December 31, 2007, the likelihood that we will recoup any of our investment is extremely remote. Accordingly, we believe that the chance that our investments in C-BASS will have anything more than a negligible impact on our financial position, results of operation or cash flows at any time in the future is extremely remote.
(1) Each Moody’s rating for our financial guaranty subsidiaries is currently under review for possible downgrade.
On May 2, 2008, Fitch Ratings (“Fitch”) withdrew its ratings for Radian Group and all of our insurance subsidiaries, citing a lack of available information regarding these entities. We had requested that Fitch withdraw these ratings in September 2007, following Fitch’s downgrade of Radian Group and our financial guaranty subsidiaries.
Recent Ratings Actions-Moody’s. On June 25, 2008, Moody’s lowered its senior debt rating on Radian Group to Ba1 from A2 and its insurance financial strength ratings on Radian Guaranty and Amerin Guaranty to A2 from Aa3. In downgrading our mortgage insurance subsidiaries, Moody’s cited deterioration in our insured portfolio, including NIMS and second-liens. Moody’s further stated that our ability to retain our eligibility status with the GSEs will continue to be an important ratings consideration for our mortgage insurance subsidiaries. Moody’s lowered its insurance financial strength rating on Radian Insurance to Baa1 (two notches below Radian Guaranty) from Aa3 as a result of the higher-risk nature of its insurance portfolio of second-liens and NIMS and the fact that Radian Insurance is no longer strategically important to our overall mortgage insurance business.
Also on June 25, 2008, Moody’s lowered its insurance financial strength ratings on Radian Asset Assurance and RAAL to A3 from Aa3, citing the likelihood that Radian Asset Assurance will cease writing new business going forward and the possible diversion of capital from Radian Asset Assurance to support our mortgage insurance business.
Recent Ratings Actions-S&P. On August 26, 2008, S&P lowered its senior debt rating on Radian Group to BB+ from BBB and its insurance financial strength ratings on Radian Guaranty and Amerin Guaranty to BBB+
from A. In lowering its ratings for Radian Group and our mortgage insurance subsidiaries, S&P cited the significant operating losses incurred by our mortgage insurance business as well as S&P’s reassessment of the mortgage insurance industry’s long-term fundamentals. S&P also cited Radian Group’s financial flexibility as a potential concern. S&P also lowered its insurance financial strength ratings for our financial guaranty subsidiaries to BBB+ from A. S&P stated that it had lowered its ratings for these entities based on the diminished business prospects for our financial guaranty business and our intention to use this business to provide capital support to our mortgage insurance business.
in the cure rate of defaults and an increase in claims paid. In 2008, we paid total claims of $916.1 million, representing a 76.8% increase over the $518.1 million of claims paid in 2007. We expect that claims paid will significantly increase in 2009 to between $1.4 billion and $1.7 billion. Recent legislation and loan modification programs by the U.S. Treasury and certain of our lender customers aimed at mitigating the current housing downturn could have a positive impact on our business by potentially reducing the number of defaults going to claim. Many of these programs are in the early stages of implementation and we cannot be certain of their impact on our business, results of operations, or the timing of any potential impact. Accordingly, we have not incorporated any such potential benefit into our projections. See “Risk Factors-Loan modification and other similar programs may not provide us with a material benefit.”
Smart Home/Captives. We have protected against some of our future expected losses relating to riskier products that we insure by reinsuring our exposure through transactions (referred to as “Smart Home”) that effectively transfer risk to investors in the capital markets. Approximately 3.7% of our primary mortgage insurance risk in force was included in Smart Home transactions at December 31, 2008. Our mortgage insurance provision for losses for the year ended December 31, 2008 was reduced by $81.2 million due to recoverables from Smart Home. Ceded losses recoverable related to Smart Home were $91.1 million at December 31, 2008. In addition to Smart Home, we transfer a substantial portion of our mortgage insurance risk to captive reinsurance companies affiliated with our lender customers. We currently have 16 active captive reinsurance agreements in which new business continues to be placed. We also have 45 captive reinsurance arrangements operating on a run-off basis, meaning that no new business is being placed in these captives. Our mortgage insurance provision for losses for the year ended December 31, 2008 was reduced by $396.9 million due to recoverables from captive reinsurance transactions. Ceded losses recoverable on captive reinsurance transactions were $400.7 million at December 31, 2008. In light of the significant amount of ultimate losses we expect to incur in our mortgage insurance business, we expect to receive total reinsurance recoveries from Smart Home and captive reinsurance of approximately $791 million.
New Insurance Written. We experienced a 22.5% decrease in traditional flow business written during the year ended December 31, 2008, compared to 2007. Overall, primary new insurance written, which includes both structured and flow business, decreased by 43.1% for the year ended December 31, 2008, compared to 2007. This decrease is mainly the result of a decrease in the volume of mortgage originations during the current housing and economic downturn, our more restrictive underwriting guidelines, the absence of a secondary market for mortgage securitizations and increased competition from the Federal Housing Administration (“FHA”). Throughout 2008, we implemented a series of changes to our underwriting guidelines aimed at improving the long-term risk profile and profitability of our business. As a result of these changes, we have experienced a positive shift in our overall business mix. For the year ended December 31, 2008, approximately 94.1% of our new business production was categorized as prime business compared to 58.2% for 2007.
Persistency. The persistency rate, which is defined as the percentage of insurance in force that remains on our books after any 12 month period, was 85.8% for the year ended December 31, 2008, compared to
Second-Lien Mortgages. We experienced further deterioration in our second-lien portfolio during 2008, which resulted in a $23.8 million increase in second-lien loss reserves to approximately $136.6 million. Our premium deficiency reserve for second-liens decreased during 2008 by $108.8 million due, in part, to a negotiated settlement which resulted in a reduction in our second-lien premium deficiency reserve of $49.2 million, as discussed below, resulting in a total premium deficiency reserve for second-liens of approximately $86.9 million at December 31, 2008. As of December 31, 2008, our total exposure to second-liens was $622.1 million, compared to $924.7 million at December 31, 2007. As of December 31, 2008, we held reserves, including our second-lien premium deficiency reserve, of $223.5 million against our total second-lien mortgage portfolio, representing approximately 36% of the total exposure. In January 2009, we executed a settlement on certain second-lien mortgage insurance transactions, comprising the worst performing second-lien collateral in our portfolio. This settlement reduced our risk in force by approximately $209 million to approximately $400 million. The settlement amount was $49.2 million less than our reserve amount, and as a result, we reduced our second-lien premium deficiency reserve through the provision for premium deficiency by $49.2 million at December 31, 2008, related to this settlement.
New Business Production. A difficult business environment for financial guaranty insurance has existed since 2007. These conditions include the widening of credit spreads, a lack of price transparency and illiquidity in many of the structured products that we insure. In addition, there were losses by financial guarantors on RMBS, CDOs of ABS and other credit positions, ratings actions on financial guaranty industry participants, including us, and perceived instability in the franchise values and ratings of many of the financial guarantors, including us. These conditions have materially diminished the financial benefit that our credit protection provides to issuers in the current, market of both public and structured finance transactions and to our primary insurer customers and have reduced the perceived benefit of our insurance to holders of insured debt. Many transactions that would normally have been marketed with some form of financial guaranty insurance are either not going to market or are being sold without the benefit of financial guaranty insurance. As a result, there has been a significant reduction in the volume of transactions for which financial guaranty insurance is a viable option, which has made it more difficult for us and many other financial guarantors to write new business. These conditions also resulted in fewer opportunities to obtain reinsurance business from our primary insurance customers. Consequently, new business production across all of our financial guaranty product lines was significantly reduced in 2008. As discussed above, in the third quarter of 2008, we decided to discontinue, for the foreseeable future, writing any new financial guaranty business, including accepting new financial guaranty reinsurance, other than as may be necessary to commute, restructure, hedge or otherwise mitigate losses or reduce exposure in our existing portfolio.
Reductions in Net Par Outstanding. Our financial guaranty net par outstanding decreased by 13.2% from $116.0 billion as of December 31, 2007 to $100.7 billion as of December 31, 2008. This reduction in outstanding net par was primarily due to recaptures of reinsurance business by certain of our primary reinsurance customers, terminations of certain CDO obligations, prepayments or refundings of public finance transactions and the amortization or scheduled maturity of our insured portfolio.
As a result of the downgrade of Radian Asset Assurance’s financial strength ratings by S&P to BBB in August 2008, the counterparties in four of our synthetic credit default swap transactions obtained the right to terminate the transactions with settlement on a mark-to-market basis. In September 2008, we voluntarily terminated one of these transactions and novated a second transaction to an unaffiliated third party before the termination rights for our counterparty vested, with no material impact to our consolidated financial statements.
Our financial results for 2008 were affected by significant unrealized gains on derivatives, offset by a significant increase in the provision for losses related to deterioration in our mortgage insurance portfolio. Credit spreads on underlying collateral, both corporate credit spreads and asset-backed spreads, widened significantly during 2008, which would have resulted in large unrealized losses on these positions. Offsetting these losses, however, is the impact of a change to our valuation methodology, effective January 1, 2008, that incorporates the market’s perception of our non-performance risk. This change in methodology is required under the provisions of SFAS No. 157. Given the significant widening of our credit default swap spread since early 2007, the reduction in the valuation of our derivative liabilities related to our non-performance risk more than offset the credit spread widening on underlying collateral for 2008. These two drivers of our fair values can move in tandem, or in opposite directions, and this unpredictability could contribute to significant continued volatility of our operating results. See “Risk Factors-Our reported earnings are subject to fluctuations based on changes in our credit derivatives that require us to adjust their fair market value as reflected on our income statement.”
Net Loss. We incurred a consolidated net loss for 2008 of $410.6 million or $5.12 per share (diluted), compared to a net loss of $1,290.3 million or $16.22 per share (diluted) for 2007. Our results for 2008 were negatively affected by a large increase in the provision for losses in our mortgage insurance business, an increase in net losses on other financial instruments such as our hybrid securities, losses related to other-than-temporarily impaired securities in our investment portfolio, and an increase in other operating expenses. Our 2008 losses were partially offset by an increase in the change in fair value of derivative instruments due to the implementation of SFAS No. 157 and a reduction of our second-lien premium deficiency reserve. Our results for 2007 were negatively affected by the impairment of our investment in C-BASS, a significant decrease in the change in fair value of derivative instruments, a significant increase in the provision for losses in both our financial guaranty and mortgage insurance segments and our creation of a second-lien premium deficiency reserve. Our 2007 losses were partially offset by the gain on the sale of a portion of our interest in Sherman and a large income tax benefit due to the losses incurred in that year.
Change in Fair Value of Derivative Instruments. For 2008, the change in fair value of derivative instruments was a net gain of $710.9 million, compared to a net loss of $1,214.4 million for 2007. In 2008, credit spreads on underlying collateral, both corporate credit spreads and asset-backed spreads, widened significantly, which would have resulted in large unrealized losses on these positions. Offsetting these losses, due to the incorporation of our non-performance risk into our fair value measurements as required by SFAS No. 157, the fair value of our liabilities was reduced by approximately $5.6 billion.
Provision for Premium Deficiency. The reserve for premium deficiency decreased by $108.8 million in 2008, compared to an increase of $195.6 million in 2007. We reassess our expectations for premiums, losses and expenses for our mortgage insurance business at least quarterly and record or adjust the premium deficiency reserve, if necessary, as actual losses are incurred and premiums are received. A provision for second-lien premium deficiency in the amount of $155.2 million was initially established in 2007. The second-lien premium deficiency reserve decreased by $108.8 million during 2008 primarily due to the transfer of premium deficiency
reserves to loss reserves and premiums earned, as actual losses were incurred and premiums were received, and assumptions of future premiums and losses were updated. In January 2009, we settled on certain second-lien mortgage insurance transactions, which reduced our risk in force by approximately $209 million to approximately $400 million. The settlement amount was $49.2 million less than our December 31, 2008 reserve amount, and as a result we reduced our second-lien premium deficiency reserve through the provision for premium deficiency by $49.2 million at December 31, 2008. A provision for first-lien premium deficiency in the amount of $421.8 million was established in June 2008. During the second half of 2008, the first-lien premium deficiency reserve was reduced to $0 primarily as a result of increased loss reserves recorded on our domestic first-lien mortgage insurance portfolio. See “Critical Accounting Policies-Reserve for Premium Deficiency” below.
Other Operating Expenses. Other operating expenses were $255.5 million for 2008, compared to $183.4 million for 2007. The increase in 2008 includes: (i) a $10.5 million increase in our reserve for contract underwriting services, (ii) a $9.3 million increase in compensation expense related to our stock- and cash-based performance plans, (iii) an increase in severance costs primarily related to the reduction in our financial guaranty operations, (iv) expenses and fees related to the termination of our pension plan, (v) fees associated with our credit facility and (vi) an increase in audit and legal fees. The increase in 2008 was partially offset by a decrease in salary expense, premium taxes and lower depreciation on software. Included in 2007 operating expenses is $14.0 million of expenses related to our terminated merger with MGIC and foreign exchange gains.
Interest Expense. Interest expense of $53.5 million for 2008 increased $0.5 million or 0.9% from $53.0 million for 2007. These amounts reflect interest on our long-term debt and other borrowings. Included in interest expense for 2008 and 2007 was $9.3 million and $4.2 million, respectively, of interest related to the $200 million that we drew down from our unsecured revolving credit facility in August 2007. See Note 13 of Notes to Consolidated Financial Statements. On January 18, 2008, we terminated certain interest rate swaps that we entered into in 2004, which converted 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 basis adjustment of $11.5 million that was recorded as an increase to the long-term debt carrying value is being amortized into interest expense over the life of the debt.
Net (Loss) Income. We incurred a consolidated net loss for 2007 of $1,290.3 million or $16.22 per share (diluted), compared to net income of $582.2 million or $7.08 per share (diluted) for 2006. The decrease in earnings for 2007 was mainly due to the significant disruption in the housing and mortgage credit markets during 2007, which impacted all of our business segments. In particular, our results for 2007 were negatively impacted by the impairment of our investment in C-BASS, a significant decrease in the change in fair value of derivative instruments, a significant increase in the provision for losses in both our financial guaranty and mortgage insurance segments and a premium deficiency for our second-lien mortgage business. These results were partially offset by the gain on the sale of a portion of our interest in Sherman in September 2007, an income tax benefit due to the losses incurred, a decrease in other operating expenses and an increase in net investment income.
Net Premiums Written and Earned. Consolidated net premiums written for 2007 were $1,085.2 million, an $80.9 million or 8.1% increase from $1,004.3 million for 2006. Consolidated net premiums earned for 2007 were $912.3 million, a $5.3 million or 0.6% increase from $907.0 million earned for 2006. Our mortgage insurance business experienced an increase in flow business written during 2007, reflecting an increase in demand for our traditional mortgage insurance products. Partially offsetting this increase in net premiums written in our mortgage insurance business was a year over year decrease in net premiums written in our financial guaranty business as a result of the difficult business production environment, particularly for our public finance business, resulting from the disruption in the credit markets and corresponding widening of credit spreads on Radian Asset Assurance. The year over year increase in net premiums earned was mainly due to an increase in premiums earned on our primary mortgage insurance business, international mortgage business and our financial guaranty public finance business. This increase was partially offset by a decrease in premiums earned from our financial guaranty structured products business.
Net Gains on Other Financial Instruments. Net gains on other financial instruments for 2007 were $53.6 million, compared to $40.8 million for 2006. Included in net gains on other financial instruments for 2007 was a $37.9 million net gain related to the sale of hybrid securities. Also included in 2007 was $1.7 million of net losses related to the change in fair value of hybrid securities and trading securities. Included in 2006 was a $21.4 million pre-tax gain resulting from the sale of our remaining equity interest in Primus Guaranty, Ltd. (“Primus”) in the first quarter of 2006. The 2007 and 2006 net gains were partially offset by approximately $9.4 million and $10.6 million of losses on investment securities that were other-than-temporarily impaired in 2007 and 2006, respectively.
Other Income. Other income decreased to $11.7 million for 2007 from $20.9 million for 2006, mainly due to a decrease in fee income from affiliates and a decrease in mortgage insurance contract underwriting income as a result of less demand for this business in 2007.
business, but also reflects credit deterioration in our financial guaranty portfolio. Our mortgage insurance segment experienced a significant increase in delinquencies compared to 2006, as well as an increase in delinquent loan sizes, a continuation of the aging on existing delinquencies, an increase in the projected default to claim rates and an increase in severity, all of which require a higher loss reserve. The provision for losses in our financial guaranty segment increased in 2007 compared to 2006, as a result of a $100 million reserve established for one CDO of ABS transaction. See “Results of Operations-Financial Guaranty-Year Ended December 31, 2008 Compared to Year Ended December 31, 2007-Provision for Losses.” This was partially offset by a reduction of reserves on our trade credit reinsurance business.
Provision for Premium Deficiency. A provision for second-lien premium deficiency of $195.6 million was initially established in 2007. No reserve was required in 2006.
Other Operating Expenses. Other operating expenses were $183.4 million for 2007 compared to $242.6 million for 2006. Included in 2007 operating expenses is $14.0 million of expenses related to our terminated merger with MGIC. Excluding these merger related expenses, the decrease in other operating expenses was mainly due to foreign exchange gains and a decrease in employee costs, consulting costs, software expense, and depreciation expense on office equipment.
Equity in Net (Loss) Income of Affiliates. Equity in net loss of affiliates was $416.5 million for 2007, compared to equity in net income of affiliates of $257.0 million for 2006. The decrease in 2007 was driven by the impairment of our total equity investment in C-BASS and the complete write-down of our $50 million credit facility with C-BASS. While Sherman’s earnings remained relatively stable, our equity in net income of affiliates for the second half of 2007 reflects our reduced holdings in Sherman, effective September 1, 2007, as a result of our sale of a portion of our interests in Sherman. Included in equity in net loss of affiliates for 2007 is $451.4 million of losses related to C-BASS, compared to equity in net income of affiliates of $133.9 million for 2006. Sherman contributed $84.8 million of equity in net income of affiliates for 2007 compared to $123.8 million for 2006.
Income Tax (Benefit) Provision. We recorded an income tax benefit of $778.6 million for 2007 and an income tax provision of $231.1 million for 2006. The consolidated effective tax rate was 37.6% for 2007, compared to 28.4% for 2006. The higher effective tax rate for 2007 reflects the losses incurred during 2007 and an increase in the ratio of income generated from tax-advantaged investment securities compared to loss generated from operations. The tax rate for 2006 reflects the reversal of prior years’ tax exposures that expired June 30, 2006.
The following table summarizes our mortgage insurance segment’s results of operations for the years ended December 31, 2008, 2007 and 2006 (in millions):
(1) Excludes premiums written and earned on credit derivatives. These premiums are reported within the change in fair value of derivative instruments. Premiums written on credit derivatives for the year ended December 31, 2008 were $18.7 million, compared to $56.6 million and $47.6 million, for 2007 and 2006, respectively. Premiums earned on credit derivatives for the year ended December 31, 2008 were $26.1 million, compared to $64.3 million and $37.3 million, for 2007 and 2006, respectively.
Net (Losses) Gains on Other Financial Instruments. Net losses on other financial instruments in our mortgage insurance investment portfolio were $83.1 million for 2008, compared to net gains of $39.9 million for 2007. Included in the 2008 net loss were: (i) losses related to the change in fair value of hybrid securities and trading securities of $111.5 million, (ii) $20.2 million of losses on other-than-temporarily impaired investment securities and (iii) $18.4 million of gains related to the change in fair value of the NIMS VIE debt and VIE assets that we were required to consolidate in 2008. Included in net gains for 2007 were net gains related to the sale of hybrid securities of approximately $26.2 million, partially offset by losses related to the change in fair value of other hybrid securities and trading securities of $1.9 million. The 2007 net gain also includes approximately $9.4 million in losses related to the write-down of other-than-temporarily impaired securities.
Policy Acquisition Costs. Policy acquisition costs were $89.1 million for 2008, compared to $67.8 million for 2007. In 2008, we accelerated $50.8 million of deferred policy acquisition cost amortization in connection with the creation of a first-lien premium deficiency reserve in 2008. During 2007, amortization expense was impacted by an increase in persistency rates and updates to our loss ratios assumptions, both of which affected the rate at which deferred policy acquisition costs were amortized.
Other Operating Expenses. Other operating expenses were $155.4 million for 2008, an increase of $20.2 million or 14.9%, compared to $135.2 million for 2007. The increase in other operating expenses in 2008 was primarily due to a $10.5 million increase in reserves established for our contract underwriting business and outside consulting fees, partially offset by a decrease in premium taxes as a result of a decrease in new business written, and software depreciation. Contract underwriting expenses for 2008, including the impact of reserves for remedies in other operating expenses, were $31.5 million, compared to $22.6 million for 2007. During 2008, loans underwritten via contract underwriting for flow business accounted for 12.4% of applications, 11.5% of commitments for insurance and 10.7% of insurance certificates issued compared to 12.4%, 11.5%, and 10.1%, respectively for 2007. Included in 2007 was $13.4 million of expense related to our terminated merger with MGIC and foreign currency gains.
Interest Expense. Interest expense attributable to our mortgage insurance business for 2008 was $27.6 million compared to $27.9 million for 2007. Both periods include interest on our long-term debt and other borrowings that was allocated to the mortgage insurance segment.
and mortgage credit markets during 2007, which resulted in a significant increase in our mortgage insurance provision for losses, a significant net loss related to NIMS and CDS, and a provision for second-lien premium deficiency. Partially offsetting these losses was an income tax benefit due to the losses incurred in 2007 and a decrease in operating expenses.
Net Investment Income. Net investment income attributable to our mortgage insurance business for 2007 was $148.3 million, an increase of $10.0 million or 7.2%, compared to $138.3 million for 2006. Investment income for 2007 reflects an increase in invested assets and higher interest rates.
Other Income. Other income for 2007 was $11.3 million, a $1.8 million or 13.7% decrease from $13.1 million in 2006. Other income decreased in 2007 as a result of lower contract underwriting volume.
Provision for Losses. The provision for losses for 2007 was $1,210.0 million, compared to $348.6 million for 2006. The increase in 2007 was mainly attributable to increases in delinquencies and claims paid, the aging of existing delinquencies, larger loan balances, a higher ratio at which delinquencies were moving to claim and increased severity.
Provision for Premium Deficiency. A provision for second-lien premium deficiency of $195.6 million was established in 2007. No premium deficiency was required in 2006.
Interest Expense. Interest expense attributable to our mortgage insurance business for 2007 was $27.9 million compared to $26.6 million for 2006. These amounts include interest on our long-term debt and other borrowings that was allocated to the mortgage insurance segment as well as the impact of interest-rate swaps.
(b) Loan-to-value (“LTV”) ratios: The ratio of the original loan amount to the original value of the property.
During 2006 through 2008, we wrote pool risk in a second-loss position. In these transactions, we will only pay claims if the losses on these pools of mortgages are greater than any applicable deductible.
Direct primary insurance in force was $155.2 billion at December 31, 2008, compared to $143.1 billion at December 31, 2007 and $113.9 billion at December 31, 2006. Primary insurance in force has steadily increased during these periods as a result of the high level of flow business generated during 2007 and 2008, and the increased persistency rates in 2007 and 2008.
Other risk in force was $5.1 billion at December 31, 2008, compared to $10.5 billion at December 31, 2007 and $10.3 billion at December 31, 2006. Most of this risk in force relates to the two large international mortgage
We ceased writing new NIMS business during the second quarter of 2007. See “Overview of Business Results-Mortgage Insurance-Discontinued Non-Traditional Products-NIMS” for a discussion of our ultimate loss projections with respect to NIMS.
In January 2009, we settled certain second-lien mortgage insurance transactions, which reduced our risk in force by approximately $209 million. The settlement amount was $49.2 million less than our reserve amount, and as a result, we reduced our second-lien premium deficiency reserve through the provision for premium deficiency by $49.2 million at December 31, 2008.
We generally do not establish reserves for loans that are in default if we do not believe we will be liable for the payment of a claim with respect to that default. For example, for those defaults in which we are in a second-loss position, we calculate what the reserve would have been if there had been no deductible. If the existing deductible is greater than the reserve amount for any given default, we do not establish a reserve for the default.
Claims paid in California and Florida have increased significantly as home price depreciation in those states has been at a much greater level than the national average. Those states also contain a higher percentage of Alt-A loans, which have had a higher claim frequency. 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 in those areas. A much higher
In the mortgage insurance segment, the highest state concentration of primary risk in force at December 31, 2008 was California at 10.8% compared to 8.8% at December 31, 2007 and 7.8% at December 31, 2006. California accounted for 17.3% of our mortgage insurance segment’s direct primary new insurance written for the year ended December 31, 2008, compared to 15.8% and 12.8% for the years ended December 31, 2007 and December 31, 2006, respectively. Although very early in its existence, the new business we have written in California in 2008 currently is performing better than the business we have written in other states in 2008 with respect to early payment defaults. We believe our new California business also is generally less risky than our total 2008 business. We have taken steps to limit our new business written in California for 2009 to levels that reflect that state’s share of the overall mortgage insurance market.
Our mortgage insurance loss reserve as a percentage of our mortgage insurance risk in force was 7.0% at December 31, 2008, compared to 3.0% at December 31, 2007 and 1.7% at December 31, 2006.
The following table reconciles our mortgage insurance segment’s beginning and ending reserves for losses and loss adjustment expenses (“LAE”) for 2008 and 2007:
(c) Insurance in force (“IIF”) on captives as a percentage of total insurance in force.
Net Premiums Written and Earned. Our financial guaranty segment’s net premiums written for 2008 were $29.6 million, a $157.1 million or 84.2% decrease compared to $186.7 million for 2007. Net premiums written for 2008 were reduced by $51.1 million due to the 2008 FG Recaptures. In addition, the decrease in net premiums written in 2008 compared to 2007 was attributable to our decision in the third quarter of 2008 to discontinue writing new financial guaranty business for the foreseeable future. Premiums earned in 2008 were $163.0 million, a $30.0 million or 22.6% increase compared to $133.0 million in 2007. Premiums earned in 2008 were reduced by $17.1 million due to the 2008 FG Recaptures. Included in net premiums earned for 2008 were premiums related to prepayments or refundings of public finance obligations of $75.1 million compared to $23.3 million for 2007.
(1) Excludes premiums written on credit derivatives for the year ended December 31, 2008 of $50.1 million, compared to $43.0 million and $60.1 million, respectively, for 2007 and 2006. Excludes premiums earned on credit derivatives for the year ended December 31, 2008 of $54.1 million, compared to $62.0 million and $71.5 million, respectively, for 2007 and 2006. These premiums are reported in change in fair value of derivative instruments.
Change in Fair Value of Derivative Instruments. Change in the fair value of derivative instruments was a gain of $608.8 million for 2008, compared to a loss of $746.8 million for 2007. Although credit spreads on underlying collateral, both corporate credit spreads and asset-backed spreads, widened significantly in 2008, our non-performance risk adjustment more than offset these unrealized losses, resulting in a net unrealized gain due to the adoption of SFAS No. 157 on January 1, 2008. We determine the fair value of our derivative financial guaranty contracts and incorporate our non-performance risk as discussed in “Critical Accounting Policies-Derivative Instruments and Hedging Activity” in this Item 7 below. Our 2008 results include a net gain of $445.5 million related to financial guaranty credit derivatives and a net gain of $109.3 million related to our put options on CPS.
Other Income. Other income was $0.3 million for both 2008 and 2007.
We provide credit protection on $479.7 million net par outstanding of the senior-most tranche of a CDO of ABS transaction, where the underlying collateral consists of mezzanine tranches of predominately mortgage-backed securities. As of December 31, 2008, 54 RMBS credits and 20 CDOs of ABS credits (collectively representing $342.3 million (or 58.3%) of the $586.9 million collateral pool) had been downgraded by S&P or Moody’s and 30 of these credits, with a notional value of $136.2 million, have defaulted. The transaction, which is accounted for as a derivative, is currently internally rated CCC-, B+ by S&P and Ba2 by Moody’s. Due to substantial deterioration of the underlying collateral, which has accelerated over the past few quarters, and based on available projections, we currently expect that losses from the remaining collateral will exceed the remaining subordination. Based on current anticipated cash flows, we expect to begin paying unreimbursed claims
We reinsure a portion of one primary financial guarantor’s obligations on two securitizations backed by private student loans, a substantial portion of which are auction-rate securities. Our net par outstanding as of December 31, 2008 for these transactions, (both with a legal final maturity date in 2038), was $176.6 million and $176.5 million, respectively. Due to weaker than expected performance of the underlying student loans and escalating interest obligations for the insured notes due to stresses in the auction-rate securities market and ratings downgrades of the primary insurer for these transactions, the cash flows, which are increasingly needed to cover current interest payments, may be insufficient to meet our insured obligations in the future.
Other than the one derivative transaction identified above as having more than $100 million in net par outstanding, there were no other derivative transactions with $25 million or greater in net par outstanding as of December 31, 2008. 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.
We only have one credit with a net par outstanding of greater than $100 million for which we have established a case reserve. For this credit, we have reinsured several primary financial guaranty insurers’ obligations with respect to $274.1 million in net par outstanding related to Jefferson County, Alabama (the “County”) sewer bonds. The County currently faces increased financing costs on its debt and could possibly face more rapid amortization on its bank liquidity support, which has contributed to financial stress on the County’s sewer system. The County and certain primary insurers entered into forbearance agreements with the liquidity banks, the latest of which are scheduled to expire on April 20, 2009. These agreements prevent the banks from demanding payment of accrued default rate interest under their liquidity agreements or taking other actions to enforce their rights under the liquidity agreements until the expiration of such forbearance agreements. Certain insurers, including the primary financial guaranty insurers, have been working with the County and other parties to structure a resolution to the financial problems of the County’s sewer system, and a settlement has been proposed. It is uncertain whether a solution, including the proposed settlement, can be obtained that is acceptable to all parties before the expiration of the forbearance period, or whether new forbearance agreements will be entered into by the parties. Through December 31, 2008, we have paid $6.4 million in the aggregate in connection with extensions of the forbearance agreements and for interest payments on the bond which have not been paid. At December 31, 2008, we had posted a case reserve for this credit of $16.0 million, net of expected recoveries from salvage. This case reserve is intended to cover our share of interest and principal payments through July 2009, and our share of a proposed settlement between the County and certain insurers, including the primary financial guaranty insurer. We have concluded that no additional loss beyond this amount is probable or estimable at this time.
For purposes of comparison with prior periods, the following schedule shows the impact of the 2008 FG Recaptures on our financial guaranty segment’s income statement for the year ended December 31, 2008.
Net Gains on Other Financial Instruments. Net gains on other financial instruments in our financial guaranty segment were $12.5 million for 2007, compared to $7.8 million for 2006. Included in net gains on other financial instruments for 2007 was $11.7 million related to the sale of hybrid securities. The 2006 amount includes an allocation of the gain on the sale of our remaining interest in Primus, partially offset by approximately $1.2 million in losses related to the write-down of other-than-temporarily impaired investment securities.
Other Income. Other income was $0.3 million for 2007, compared to $0.7 million for 2006. This decrease was mostly due to lower advisory fee income during 2007.
Provision for Losses. The provision for losses was $98.0 million for 2007, compared to $20.7 million for 2006. The provision for losses reported for 2007 includes a $100 million allocated non-specific reserve on the one direct market value transaction then remaining is our portfolio as discussed above. The increase in the provision for losses in 2007 was partially offset by favorable loss development on trade credit reinsurance.
Policy Acquisition Costs. Policy acquisition costs were $45.4 million for 2007, compared to $46.6 million for 2006. The slight 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 2007 were $12.0 million of origination costs related to derivative financial guaranty contracts, compared to $11.9 million for 2006.
Other Operating Expenses. Other operating expenses were $49.3 million for 2007, compared to $59.8 million for 2006. The year over year decrease resulted primarily from a decrease in employee costs and depreciation. Our financial guaranty expense ratio (which includes other operating expenses and policy acquisition costs) of 48.2% for 2007 decreased from 52.2% for 2006.
Interest Expense. Interest expense was $19.8 million for 2007, compared to $16.6 million for 2006. Both periods include interest on our long-term debt and other borrowings, which was allocated to the financial guaranty segment.
Income Tax (Benefit) Provision. We recorded an income tax benefit of $265.6 million for 2007 and an income tax provision of $40.9 million for 2006. The effective tax rate was 37.6% for 2007, compared to 23.1% for 2006. The higher effective tax rate for 2007 reflects the losses incurred during 2007 and an increase in the ratio of income generated from tax-advantaged investment securities compared to loss generated from operations. The tax rate for 2006 reflects an allocation of the reversal of prior years’ tax exposures that expired June 30, 2006.
The following table shows financial guaranty claims paid and incurred losses by category for each period indicated:
(1) Our reserve for losses and loss adjustment expenses reflects the application of accounting policies described below in “Critical Accounting Policies-Reserve for Losses.” The payments due by period are management’s estimates and assume that all of the loss reserves included in the table will result in claim payments.
Borrowings under Credit Facility. We currently have $100 million in principal amount outstanding under our credit facility, which matures in February 2011. We have no unused commitment that we may draw on. In addition, we have $250 million in 7.75% debentures due in June 2011, $250 million in 5.625% senior notes due in February 2013 and $250 million in 5.375% senior notes due in June 2015.
We would also be in default under our credit facility if, among other things:
any of our main insurance subsidiaries fails to pay any shared expense reimbursement payment to Radian Group under our expense sharing arrangements; or
an insurance regulatory authority or other governmental authority voids, terminates, prohibits, suspends or otherwise causes to be invalid or ineffective, any of our expense sharing arrangements with our insurance subsidiaries.
If we default under our credit agreement, the agent or the lenders representing a majority of the debt under our credit agreement would have the right to terminate all commitments under the credit agreement and declare the outstanding debt due and payable. See “Risk Factors-Our credit facility was amended in 2008, reducing our liquidity and adding additional restrictions on our ability to operate our business. Our failure to comply with, cure breaches of, or obtain waivers for, covenants could result in an acceleration of the due dates of our credit facility and our publicly-traded debt.”
Financial Accounting Standards Board Interpretation No. 48 (“FIN 48”) Liability. As of December 31, 2008, our expected payment for significant contractual obligations includes approximately $77.2 million of our total $160.7 million of gross liability for unrecognized tax benefits in 2008 associated with the provisions of FIN 48.
Investment Commitments. As part of the non-investment-grade allocation component of our investment program, we have committed to invest $55.0 million in alternative investments that are primarily private equity structures. At December 31, 2008, we had unfunded commitments of $20.9 million. These commitments have capital calls over a period of at least the next six years, and certain fixed expiration dates or other termination clauses.
Letters of Credit. 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 elect otherwise. The letters of credit outstanding at December 31, 2008, 2007 and 2006 were $4.7 million, $10.8 million and $15.5 million, respectively.
Radian Guaranty and Amerin Guaranty are parties to a cross-guaranty agreement. This agreement provides that if either party fails to make a payment to a policyholder, then the other party will step in and make the payment. The obligations of both parties are unconditional and irrevocable; however, no payments may be made without prior approval by the insurance department of the payor’s state of domicile, Pennsylvania for Radian Guaranty and Illinois for Amerin Guaranty.
Prior to our acquisition of Enhance Financial Services Group (“EFSG”) in 2001, EFSG issued a guaranty of payment of the liabilities and obligations of its subsidiary, Radian Reinsurance (Bermuda) Limited, deriving from any insurance or reinsurance contract (the “Enhance Guaranty”), for the purpose of maintaining certain regulatory solvency and liquidity margin requirements of the Bermuda Monetary Authority. Following our acquisition of EFSG, Radian Group issued a guaranty for the benefit of EFSG to make funds available to EFSG for its performance of the Enhance Guaranty, to the extent that EFSG is unable to satisfy those obligations.
payments by Radian Asset Assurance pursuant to this agreement are specifically subject to the prior approval of the New York Superintendent of Insurance.
Securities regulations became effective in 2005 that impose enhanced disclosure requirements on issuers of asset-backed (including mortgage-backed) securities. To allow our mortgage insurance customers to comply with these regulations, we typically have been required, depending on the amount of credit enhancement we are providing, to provide (1) audited financial statements for the insurance subsidiary participating in these transactions or (2) a full and unconditional holding-company level guarantee for our insurance subsidiaries’ obligations in such transactions. To date, Radian Group has guaranteed two structured transactions for Radian Guaranty with approximately $363.6 million of remaining credit exposure.
The qualifying special purpose entities (“QSPE”) framework is applicable when an entity transfers (sells) financial assets to an special purpose entity (“SPE”) meeting certain criteria defined in SFAS No. 140 “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities” (“SFAS No. 140”). These criteria are designed to ensure that the activities of the entity are essentially predetermined at the inception of the vehicle and that the transferor of the financial assets cannot exercise control over the entity and the assets therein. Entities meeting these criteria are not consolidated by the transferor, or other counterparties, as long as they do not have the unilateral ability to liquidate or to cause the entity to no longer meet the QSPE criteria.
When an SPE does not meet the QSPE criteria, consolidation is assessed pursuant to FIN 46R, “Consolidation of Variable Interest Entities (revised)-an interpretation of Accounting Research Bulletin (“ARB”) No. 51 (“FIN 46R”). Under FIN 46R, a VIE is defined as an entity that: (1) lacks enough equity investment at risk to permit the entity to finance its activities without additional subordinated financial support from other parties; (2) has equity owners that lack the right to make significant decisions affecting the entity’s operations; and/or (3) has equity owners that do not have an obligation to absorb the entity’s losses or the right to receive the entity’s returns. FIN 46R requires a variable interest holder (i.e., a counterparty to a VIE) to consolidate the VIE if that party will receive the majority of the expected residual returns of the VIE, absorb a majority of the expected losses of the VIE, or both. This party is considered the primary beneficiary.
guaranty to one or more classes of beneficial interest holders in the SPE. Underlying collateral in the SPEs typically includes residential or commercial mortgages, consumer receivables, securities and other financial assets sold to a SPE and repackaged into securities or similar beneficial interests. SPEs may also be used to create securities with a unique risk profile desired by investors and as a means of transferring risk, such as our Smart Home transactions. We consolidate those VIEs in which we are the primary beneficiary. See Note 6 of Notes to Consolidated Financial Statements for a complete discussion of SPEs.
Certain other SPEs do not meet the requirements of a QSPE, because all of their activities are not sufficiently limited or they have entered into certain non-qualifying transactions. In some circumstances, a QSPE may not be exempt from consolidation if we have the unilateral ability to make significant changes to the QSPE. We follow the criteria under FIN 46R in determining whether we should consolidate such entities.
A determination of whether we have a controlling financial interest in an entity is initially made at the time we become involved with the entity. In those instances where we are the primary beneficiary, the assets and liabilities of the VIE are consolidated on our balance sheets. Certain reconsideration events may occur which cause us to re-assess our initial determination of whether an entity is a VIE or non-VIE. If the entity becomes a VIE, we perform an assessment of consolidation of that entity. Those reconsideration events generally are:
Participants in the entity acquire or sell interests in the entity; and
NIMS-We provide credit enhancement on NIMS bonds. A NIMS bond represents the securitization of a portion of the excess cash flow and prepayment penalties from a mortgage-backed security comprised mostly of subprime mortgages. The majority of this excess cash flow consists of the spread between the interest rate on the mortgage-backed security and the interest generated from the underlying mortgage collateral. Historically, issuers of mortgage-backed securities would have earned this excess interest over time as the collateral aged, but market efficiencies enabled these issuers to sell a portion of their residual interests to investors in the form of NIMS bonds. Typically, the issuer retained a significant portion of the residual interests, which are subordinated to the NIMS bond in a first-loss position, so that the issuer would suffer losses associated with any shortfalls in residual cash flows before the NIMS bond experienced any losses. NIMS bonds have largely been susceptible to the disruption in the housing market and the subprime mortgage market during 2007 and 2008. See “Overview of Business Results-Mortgage Insurance-Discontinued Non-Traditional Products-NIMS” for information regarding our total loss expectations with respect to NIMS. Our NIMS are generally structured as QSPEs. There are certain circumstances and triggers outside of our control, however, which would give us the ability to call some or all of the outstanding NIMS bonds. The effective control that we attain if the call option is triggered, renders the QSPE a VIE under FIN 46R. We then assess whether we are required to consolidate the VIE. At December 31, 2008, there were 19 such transactions that required consolidation in our financial statements. The consolidated NIMS VIE debt is recorded at fair value on our consolidated balance sheets.
Smart Home-In 2004, we developed a program referred to as “Smart Home,” for reinsuring risk associated with non-prime mortgages and riskier products. These reinsurance transactions, through the use of SPE structures, effectively transfer risk from our portfolio to investors in the capital markets. Since August 2004, we have completed four Smart Home reinsurance transactions. Details of these transactions (aggregated) as of the initial closing of each transaction and as of December 31, 2008 are as follows:
Each transaction began with the formation of an unaffiliated, offshore reinsurance company. We then entered into an agreement with the Smart Home reinsurer to cede to the reinsurer a portion of the risk (and premium) associated with a portfolio of loans. Each class relates to the loss coverage levels on the reinsured portfolio and is assigned a rating by one or more of the three major rating agencies. We do not hold any of the credit-linked notes issued as part of this structure; and therefore, we have no significant variable interests in the structures, which are not subject to consolidation under FIN 46R. See “Overview of Business Results-Mortgage Insurance-Traditional Mortgage Insurance” above for further discussion.
Financial guaranty contracts written with SPEs may be written directly with the SPE or indirectly through a CDS done with a primary financial guarantor who issues a financial guaranty to the beneficial interest holders in the SPE. These SPEs are commonly used in CDO transactions where portfolio managers are permitted to buy and sell assets.
Effective January 1, 2007, we began classifying convertible securities (including the fixed-maturity component of securities previously classified as available for sale and the derivative component previously classified as available for sale and trading securities) as hybrid securities. Hybrid securities generally combine both debt and equity characteristics. Prior to 2007, the changes in fair value of the fixed-maturity component of these securities were recorded in our consolidated statements of changes in common stockholders’ equity through accumulated other comprehensive income or loss and the changes in fair value of the derivative component of these securities were recorded as a gain or loss in our consolidated statements of operations. In accordance with SFAS No. 155 “Accounting for Certain Hybrid Financial Instruments” (“SFAS No. 155”), effective January 1, 2007, all changes in the fair value of the entire convertible security are now recorded as net gains or losses on other financial instruments in our consolidated statements of operations. Our transition adjustment related to the adoption of SFAS No. 155 increased retained earnings at January 1, 2007 by $9.8 million, and reduced accumulated other comprehensive income by the same amount. The transition amount includes unrealized gains of $14.1 million (net of tax) and unrealized losses of $4.3 million (net of tax) related to convertible securities at December 31, 2006.
For securities in our investment portfolio, we conduct a quarterly evaluation of declines in market value of the securities to determine whether the decline is other-than-temporary. If a security’s fair value is below the cost basis, and it is judged to be an other-than-temporary decline, the cost basis of the individual security is written down to fair value through earnings as a realized loss and the fair value becomes the new basis for the security. During 2008, we recorded approximately $55.2 million of charges related to declines in the fair value of securities (primarily municipal and taxable bonds, and preferred stocks) considered to be other-than-temporary. During 2007 and 2006, we recorded $9.4 million and $10.6 million, respectively, of charges related to declines in the fair value of securities considered to be other-than-temporary.
Other invested assets consist of $21.9 million of alternative investments that are primarily private equity investments, including an investment in a fund sponsored and co-managed by C-BASS that invests in real estate related securities. During 2007, we recorded a $5.1 million loss considered to be other-than-temporary on our investment in this fund. Other invested assets are carried under the cost method or under the equity method and are evaluated for other-than-temporary impairment.
category 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, 2008.
The unrealized losses of 12 months or greater duration as of December 31, 2008 on the majority of the securities in this category were caused by market interest rate movement. 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 government 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, 2008.
For all investment categories, unrealized losses of less than 12 months duration were generally attributable to interest rate and credit spread movement. Certain securities experienced spread widening due to issuers’ exposure to subprime residential mortgages. 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, 2008.
The following table shows the gross unrealized losses and fair value of our investments with unrealized losses that were not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities had been in a continuous unrealized loss position, at December 31, 2007.
Radian Group serves as the holding company for our insurance subsidiaries and does not have any significant operations of its own. Radian Group’s principal liquidity demands over the next 12 months include funds for: (i) the payment of dividends on our common stock, (ii) the payment of certain corporate expenses (which are fully reimbursed through expense-sharing arrangements with our subsidiaries), (iii) interest payments on our outstanding long-term debt and borrowings under our credit facility (which are fully reimbursed through expense-sharing arrangements with our subsidiaries), (iv) payments to our insurance subsidiaries under our tax- sharing agreement, and (v) potential capital support for our insurance subsidiaries. Radian Group held directly or through an unregulated direct subsidiary, unrestricted cash and marketable securities of approximately $399 million at December 31, 2008.
Dividends. In July 2008, we reduced our quarterly common stock dividend from $0.02 per share to $0.0025 per share. Assuming that our common stock outstanding remains constant at 81,034,883 shares at December 31, 2008, we would require approximately $0.8 million to pay our quarterly dividends for the next 12 months.
Corporate Expenses and Interest Expense. Radian Group has expense-sharing arrangements in place with its principal operating subsidiaries that require those subsidiaries to pay their share of holding company level expenses, including interest expense on long-term debt and other borrowings. For 2009, payments of such corporate expenses, other than interest payments, are expected to be approximately $76.1 million, which is expected to be fully reimbursed by our subsidiaries. For the same period, payments of interest on our long-term debt and under our credit facility are expected to be approximately $52 million, which also is expected to be fully reimbursed by our subsidiaries. These expense-sharing arrangements, as amended, have been approved by applicable state insurance departments, but such approval may be changed at any time. Further, any changes to these expense-sharing arrangements must be approved by the administrative agent to our credit facility.
Dividends from our insurance subsidiaries and Sherman, and permitted payments to Radian Group under tax- and expense-sharing arrangements with our subsidiaries, are Radian Group’s principal sources of cash. Our insurance subsidiaries’ ability to pay dividends to Radian Group is subject to various conditions imposed by the GSEs and rating agencies, and by insurance regulations requiring insurance department approval. In general, dividends in excess of prescribed limits are deemed “extraordinary” and require insurance regulatory approval. In light of on-going losses in our mortgage insurance subsidiaries, we do not anticipate that these subsidiaries will be permitted under applicable insurance laws to issue dividends to Radian Group for the foreseeable future. To the extent Radian Asset Assurance is permitted to issue dividends, these dividends will be issued to Radian Guaranty, the direct parent company of Radian Asset Assurance, and not to Radian Group. Dividends from Sherman are not subject to regulatory conditions, but to the extent received, must be used to pay down outstanding amounts under our credit facility if such amounts exceed our tax obligations resulting from our equity ownership of Sherman. Sherman paid $35.5 million of dividends to Radian Group during the year ended December 30, 2008, compared to $51.5 million of dividends during the year ended December 31, 2007. In January 2009, Sherman paid dividends to Radian Group in the amount of $6.4 million.
Our most significant need for liquidity beyond the next 12 months is the repayment of the principal amount of our outstanding long-term debt and other borrowings and the potential payment of up to $478 million to Radian Guaranty in October 2010 under our tax-sharing arrangement as discussed above. Approximately $250 million in principal amount of our long-term debt and $100 million of principal borrowings under our credit facility are due in 2011. We expect to meet our long-term liquidity needs through available cash, the private or public issuance of debt or equity securities or the sale of assets. The current downturn in the credit markets has created a situation where we would likely not be able to refinance our long-term debt on favorable terms, if at all, if it were due currently. We expect that market conditions will improve by 2011, but cannot provide any assurances that we will be able to access the capital markets on favorable terms, if at all, prior to our long-term debt becoming due. See “Risk Factors-We have significant payment obligations upcoming in 2010 and 2011.”
The principal liquidity and capital demands of our mortgage insurance business include the payment of operating expenses, including those allocated from Radian Group, claim payments and taxes. The principal sources of liquidity in our mortgage insurance business are written premiums, net investment income and cash dividends from Radian Asset Assurance and potential payments from Radian Group under our tax allocation agreements. Our mortgage insurance business incurred significant losses during 2007 and 2008 due to the current housing and related credit market downturn. We believe that the operating cash flows generated by each of our mortgage insurance subsidiaries will provide these subsidiaries with a portion of the funds necessary to satisfy their claim payments and operating expenses during 2009 and in the next few years. If operating cash flows are not sufficient to fund claim payments and operating expenses, we believe that any shortfall can be funded from sales of short term marketable securities held by our mortgage insurance subsidiaries and from maturing fixed-income investments. In the event that we are unable to fund excess claim payments and operating expenses through the sale of short-term marketable securities and from maturing fixed-income investments, we may be required to incur unanticipated capital losses or delays in connection with the sale of less liquid marketable securities held by our mortgage insurance business.
As of December 31, 2008, our financial guaranty business maintained claims paying resources of $2.8 billion, including a statutory surplus of $965.4 million. Assuming there is no material deterioration in the credit performance of our financial guaranty business, we expect Radian Asset Assurance to issue significant cash dividends to Radian Guaranty over time as our existing financial guaranty portfolio matures and the exposure is reduced. Based on our current projected statutory net income and policyholders’ surplus, we currently expect Radian Asset Assurance to pay an ordinary dividend of approximately $94 million to Radian Guaranty during 2009. The timing and amount of future cash infusions will depend on the dividend capacity of Radian Asset Assurance, which is governed by New York insurance laws. If the exposure is reduced on an accelerated basis through the recapture of business from the primary customers in our financial guaranty reinsurance business or otherwise, we may have the ability to release capital to our mortgage insurance business more quickly and in a greater amount. However, if the performance of our financial guaranty portfolio deteriorates materially, we would likely have less capacity to issue dividends to our mortgage insurance business, and we could be restricted from issuing dividends altogether. See “Risk Factors-The long-term capital adequacy of Radian Guaranty is dependent, in part, upon the performance of our financial guaranty portfolio.”
Cash flows from operations for 2008 decreased compared to 2007. This decrease was mainly due to an increase in claims paid, purchases of trading securities and payments related to derivative contracts and the 2008 FG Recaptures. We expect to have negative cash flows from operations over the next 12 months.
Stockholders’ equity was $2.0 billion at December 31, 2008, compared to $2.7 billion at December 31, 2007. Stockholders’ equity decreased as a result of: (1) a net loss of $410.6 million, (2) a decrease in the market value of securities available for sale of $283.1 million, net of tax, (3) a $16.8 million adjustment to our equity interest in Sherman related to Sherman’s repurchase of MGIC’s equity interest, and (4) dividends paid of $3.7 million. Offsetting these was a $12.5 million reduction in stock based compensation expense.
SEC guidance defines Critical Accounting Policies as those that require the application of management’s most difficult, subjective, or complex judgments, often because of the need to make estimates about the effect of matters that are inherently uncertain and that may change in subsequent periods. In preparing our consolidated financial statements, management has made estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. In preparing these financial statements, management has utilized available information including our historical experience, industry standards and the current economic and housing environment, among other factors, in forming its estimates and judgments, giving due consideration to materiality. Actual results may differ from those estimates. In addition, other companies may utilize different estimates, which may impact comparability of our results of operations to those of companies in similar businesses. A summary of the accounting policies that management believes are critical to the preparation of our consolidated financial statements is set forth below.
In our mortgage insurance segment, reserves for losses are not generally established until we are notified that a borrower has missed two consecutive payments. We also establish reserves for associated LAE, consisting of the estimated cost of the claims administration process, including legal and other fees and expenses associated with administering the claims process. We follow the accounting guidance in SFAS No. 60, “Accounting and Reporting by Insurance Enterprises” (“SFAS No. 60”) relating to the reserve for losses on our mortgage insurance contracts (excluding financial guaranty contracts). 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 “default to 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.
The default and claim cycle in our mortgage insurance business begins with our receipt of a default notice from the insured lender. A “default” is defined under our master policy as a borrower’s failure to make a payment equal to or greater than one monthly regular payment under a loan. Generally, our master policy of insurance requires the insured to notify us of a default within 15 days of (1) the loan’s having been in default for three months or (2) the occurrence of an early default in which the borrower fails to make any of the initial 12 monthly payments under a loan so that an amount equal to two monthly payments has not been paid. 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.
require a larger reserve. As the delinquency proceeds toward foreclosure, there is more certainty around these estimates as a result of the aged status of the delinquent loan, and adjustments are made to loss reserves to reflect this updated information. If a default cures, (historically, a large percentage of defaulted loans have cured before going to claim, although this rate has decreased significantly in the current deteriorating housing environment) the reserve for that loan is removed from the reserve for losses and LAE. This curing process causes an appearance of a reduction in reserves from prior years if the reduction in reserves from cures is greater than the additional reserves for those loans that are nearing foreclosure or have become claims. In the mortgage insurance segment, we also establish reserves for defaults that we believe to have occurred but that have not been reported to us on a timely basis by lending institutions. All estimates are continually reviewed and adjustments are made as they become necessary.
We considered the sensitivity on first-lien loss reserve estimates at December 31, 2008, by assessing the potential changes resulting from a parallel shift in severity and default to claim rate. For example, assuming all other factors remain constant, for every one percentage point change in claim severity (28% at December 31, 2008), we estimated that our loss reserves would change by approximately $109 million at December 31, 2008. For every one percentage point change in our default to claim rate (46% at December 31, 2008), we estimated a $67 million change in our loss reserves at December 31, 2008.
Setting reserves requires us to exercise judgment in estimating the severity of the claim that is likely to result from an identified reserving event, which may be any amount up to the full amount of the insured obligation. The reliability of this estimate depends on the reliability of the information regarding the likely severity of the claim and the judgments made by management with respect to that information. Even when we are aware of the occurrence of an event that requires the establishment of a reserve, our estimate of the severity of the claim that is likely to result from that event may not ultimately be correct.
Our unallocated non-specific reserves are established over time by applying an expected loss ratio to the premiums earned during each reporting period and discretionary adjustments by management as appropriate due to changes in expected frequency and severity of losses. 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 loss ratio on an insured credit tends 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 severity can be very high because we typically 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 specific reserve.
Our unallocated non-specific loss reserve at December 31, 2008, was $58.4 million. The range between the unallocated non-specific reserves that would have resulted from applying the highest and lowest loss ratios generated by any of the three models was approximately $33 million to $82 million, which we believe provides a reasonably likely range of expected losses.
At each balance sheet date, we also evaluate both the model-generated loss ratios and our unallocated non-specific reserves against management’s subjective view of qualitative factors to ensure that the loss ratios 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 an unallocated or 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. The company-specific factors that we evaluate also require us to 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 loss ratios or our level of unallocated non-specific reserves. Our estimates of our reserves for losses and LAE for our financial guaranty segment’s other lines of business, mainly 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 IBNR on trade credit reinsurance. We use historical loss information and make inquiries to the cedants of known events as a means of validating our loss assumptions.
SFAS No. 60 requires a premium deficiency reserve if the net present value of the expected future losses and expenses for a particular product exceeds the net present value for expected future premiums and existing reserves for that product. We reassess our expectations for premiums, losses and expenses for each of our businesses at least quarterly and update our premium deficiency analysis accordingly. For purposes of premium deficiency analysis, we group our mortgage insurance products into two categories, first-lien and second-lien.
In 2007, we established a reserve for premium deficiency on our second-lien mortgage insurance business. To calculate the premium deficiency, we project future premiums and losses for our second-lien business on a transaction-by-transaction basis, using historical results to help determine future performance for both repayments and claims. An estimated expense factor is then applied, and the result is discounted using a rate of return that approximates our investment yield. This net present value, less any existing reserves, is recorded as a premium deficiency and the reserve is updated on a periodic basis based on actual results for that quarter, along with updated transaction level projections. During 2008, the second-lien premium deficiency reserve decreased by approximately $108.8 million to $86.9 million. In January 2009, we settled on certain second-lien mortgage insurance transactions, which reduced our risk in force by approximately $209 million to approximately $400 million. The settlement amount was $49.2 million less than our December 31, 2008 reserve amount, and as a result, we reduced our second-lien premium deficiency reserve through the provision for premium deficiency by $49.2 million at December 31, 2008. The net present value of expected losses and expenses on our second-lien business at December 31, 2008 was $240.1 million, offset by the net present value of expected premiums of
$16.6 million and already established reserves of $136.6 million. Our second-lien portfolio is relatively seasoned, and as a result we do not believe that changes in macro economic factors will result in significant changes to our current loss projections.
Numerous factors affect our ultimate paid claim rates, including home price depreciation, unemployment, loan claim rescission and interest rates, as well as potential benefits associated with recently announced lender and governmental initiatives to modify loans and ultimately reduce foreclosures. To assess the need for a premium deficiency reserve on our first-lien mortgage insurance portfolio, we develop loss projections based on modeled loan defaults in our current risk in force. This projection is based on recent trends in default experience, severity, and roll rates of delinquent loans to claim, as well as recent trends in prepayment speeds. As of December 31, 2008, our modeled loan default projections assume that recent observed increases in defaults will continue into mid-2009, remain stable at this increased level through the end of 2009, and gradually return to normal historic levels over the subsequent two years. If our modeled loan default projections were stressed such that recent observed increases in defaults were to continue until mid-2010, remain stable through the end of 2011, and gradually return to normal historic levels over the subsequent three years, we would require a premium deficiency reserve of $0.5 billion for our first-lien portfolio as of December 31, 2008.
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 and changes in fair value recorded in net income unless the derivatives qualify as hedges. If the derivatives qualify as hedges, depending on the nature of the hedge, changes in the fair value of the derivatives are either offset against the change in fair value of assets, liabilities, or firm commitments through earnings, or are recognized in accumulated other comprehensive income (loss) until the hedged item is recognized in earnings. As of December 31, 2008, we have no derivative contracts that qualify as hedges.
All our derivative instruments are recognized in our consolidated balance sheets as either derivative assets or derivative liabilities, depending on the rights or obligations under the contracts. Our credit protection in the form of credit default swaps, certain financial guaranty contracts within both our mortgage insurance and financial guaranty segments, NIMS and put options on CPS 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 operations. Net unrealized gains and losses on credit default swaps and certain other derivative contracts are included in either derivative assets or derivative liabilities on our consolidated balance sheets.
The amounts presented in the table above represent gross unrealized gains and gross unrealized losses on derivative assets and liabilities. Certain contracts are in an asset position because the net present value of the contractual premium exceeds the net present value of the fair premium. The notional value of our derivative contracts at December 31, 2008 and December 31, 2007 was $51.8 billion and $57.7 billion, respectively.
The application of SFAS No. 133, as amended, results in volatility from period to period in gains and losses as reported on our consolidated statements of operations. Generally, these gains and losses result mostly from changes in corporate credit or asset-backed spreads and changes in the creditworthiness of underlying corporate entities or the credit performance of the assets underlying an asset-backed security. Beginning in 2008, as required by the provision of SFAS No. 157, we also incorporated factors to include our own non-performance risk in our assessment of fair value. Any incurred gains or losses on such contracts are recognized as a change in fair value of derivative instruments.
In accordance with SFAS No. 157, when valuing fair value measurements in a liability position we are required to incorporate into the fair value an adjustment that reflects our own non-performance risk. As our credit default swap spread widens, the fair value of our liabilities decreases.
Level I-Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities;
Level II-Quoted prices in markets that are not active or financial instruments for which all significant inputs are observable, either directly or indirectly;
A financial instrument’s level within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement. At December 31, 2008, our total Level III assets approximated 3.2% of total assets measured at fair value and total Level III liabilities accounted for 100% of total liabilities measured at fair value.
Equity securities-The fair value of these securities is generally estimated using observable market data in active markets or bid prices from market makers and broker dealers. Generally, these securities are categorized in Level I or II of the fair value hierarchy as observable market data is available on these securities. Securities that are not frequently traded or are not as liquid are categorized in Level II of the fair value hierarchy.
Other investments-The fair value of these securities is generally estimated by discounting estimated future cash flows. These securities are categorized in Level III of the fair value hierarchy.
Fair value is defined as the price that would be received in connection with the sale of an asset or that would be paid to transfer a liability. In determining an exit market in accordance with SFAS No.157, we consider the fact that most of our derivative contracts are unconditional and irrevocable, and contractually prohibit us from transferring them to other capital market participants. Accordingly, there is no principal market for such highly structured insured credit derivatives. In the absence of a principal market, we value these insured credit derivatives in a hypothetical market where market participants include other monoline mortgage and financial guaranty insurers with similar credit quality to us, as if the risk of loss on these contracts could be transferred to these other mortgage and financial guaranty insurance and reinsurance companies. We believe that in the absence of a principal market, this hypothetical market provides the most relevant information with respect to fair value estimates.
Beginning in 2008, in accordance with SFAS No. 157, we made an adjustment to our derivative liabilities valuation methodology to account for our own non-performance risk by incorporating our observable credit default swap spread into the determination of the fair value of our credit derivatives. Our five-year credit default swap spread widened by 2,429 basis points during 2007 and 2008. Considerable judgment is required to interpret market data to develop the estimates of fair value. Accordingly, the estimates may not be indicative of amounts we could realize in a current market exchange. The use of different market assumptions or estimation methodologies may have a significant effect on the estimated fair value amounts.
NIMS credit derivatives are financial guarantees that we have issued on NIMS. NIMS derivative assets primarily represent derivative assets in the NIMS trusts that we are required to consolidate in accordance with FIN 46R. The estimated fair value of these financial instruments are derived from internally-generated discounted cash flow models. We estimate losses in each securitization underlying either the NIMS credit derivatives or the NIMS derivative assets by applying expected default rates separately to loans that are delinquent and those that are paying currently. These default rates are based on historical experience of similar transactions. We then project prepayment speeds on the underlying collateral in each securitization, incorporating historical prepayment experience. The estimated loss and prepayment speeds are used to estimate the cash flows for each underlying securitization and NIMS bond, and ultimately, to produce the projected credit losses for each NIMS bond. In addition to expected credit losses, we consider the future expected premiums to be received from the NIMS trust for each credit derivative. The projected net losses are then discounted using a rate of return that incorporates our own non-performance risk, and based on our current credit default swap spread, results in a significant reduction of the derivative liability. Because NIMS guarantees are not market-traded instruments, considerable judgment is required in estimating fair value. The use of different assumptions and/or methodologies could have a significant effect on estimated fair values. The NIMS credit derivatives are categorized in Level III of the fair value hierarchy. As a result of our having to consolidate several NIMS structures, the derivative assets held by the NIMS VIE are also fair valued using the same internally-generated valuation model. The NIMS VIE derivative assets are also categorized in Level III of the fair value hierarchy.
Changes in our expected principal credit losses on NIMS could have a significant impact on our fair value estimate. The gross expected principal credit losses were $430.6 million as of December 31, 2008, which is our best estimate of settlement value and represents 98% of our total risk in force of $438.3 million. The fair value of our total net liabilities related to NIMS as of December 31, 2008 was $238.5 million, of which $5.8 million relates to derivative assets, $84.3 million relates to derivative liabilities and $160.0 million relates to consolidated debt of the NIMS VIE trusts that we consolidate. Our fair value estimate incorporates a discount
rate that is based on our credit default swap spread, which has resulted in a fair value amount that is substantially less than the expected settlement value. Changes in the credit loss estimates will impact the fair value directly, reduced only by the present value factor, which is dependent on the timing of the expected losses and our credit spread.
The fair value of each of our corporate CDO transactions is estimated based on the difference between (1) the present value of the expected future contractual premiums we charge and (2) the fair premium amount that we estimate that another financial guarantor would require to assume the rights and obligations under our contracts. The fair value estimates reflect the fair value of the asset or liability, which is consistent with the “in-exchange” approach, in which fair value is determined based on the price that would be received or paid in a current transaction as defined by SFAS No. 157. These credit derivatives are categorized in Level III of the fair value hierarchy.
Non-Performance Risk Adjustment on Corporate CDOs-The typical fair premium amount estimated for the equivalent-risk tranche represents the fair premium amount for a typical market participant-not Radian. Accordingly, the final step in our fair value estimation is to convert this typical fair premium amount into a fair premium amount for a financial guarantor of similar credit quality to us. A typical market participant is contractually bound by a requirement that collateral be posted regularly to minimize the impact of that participant’s default or non performance. This collateral posting feature makes these transactions less risky to the protection buyer, and therefore, priced differently. None of our contracts require us to post collateral with our counterparties, which exposes our counterparties fully to our non-performance risk. We make an adjustment to the typical fair premium amount to account for both this contractual difference, as well as for the market’s perception of our default probability which is observable through our credit default swap spread.
The amount of the non-performance risk adjustment is computed based, in part, on the expected claim payment by Radian. To estimate this expected payment, we first determine the expected claim payment of a typical market participant by using a risk-neutral modeling approach. A significant underlying assumption of the “risk neutral” model approach that we use is that the typical fair premium amount is equal to the present value of expected claim payments from a typical market participant. Expected claim payments on a transaction are based on the expected loss on that transaction (also determined using the “risk neutral modeling” approach). Radian’s
expected claim payment is calculated based on the correlation between the default probability of the transaction and our default probability. The default probability of Radian is determined from the observed Radian Group credit default swap spread, and the default probability of the transaction is determined as described above under “Defining the Equivalent-Risk Tranche.” The present value of Radian’s expected claim payments is discounted using a risk free interest rate, as the expected claim payments have already been risk-adjusted.
In determining the estimated fair value of our mortgage insurance domestic CDS, we use internal models that employ a discounted cash flow methodology. We estimate losses in each securitization by applying expected default rates separately to loans that are delinquent and to those that are current. We then project prepayment speeds on the underlying collateral in each securitization, incorporating historical prepayment experience. The estimated loss and prepayment speeds are used to estimate the cash flows for each underlying securitization, and ultimately, to produce the projected credit losses for each mortgage insurance domestic CDS. In addition to expected credit losses, the fair value for each mortgage insurance domestic CDS is approximated by incorporating future expected premiums to be received from the transaction. These future expected premiums are discounted utilizing a risk-adjusted interest rate that is based on the current rating of each transaction. The projected net losses are discounted using a rate of return that incorporates our own non-performance risk, which currently results in a significant reduction of the derivative liability. The use of different assumptions and/or methodologies could have a significant effect on estimated fair values.
In determining the estimated fair value of our mortgage insurance international CDS, we use the following information: (1) non-binding fair value quotes from our counterparties on each respective deal, which are based on quotes for transactions with similar underlying collateral from market makers and other broker dealers, and (2) in the absence of observable market data for these transactions, a review of monthly information regarding the performance of the underlying collateral and discussion with our counterparties regarding any unusual or inconsistent changes in fair value. In either case, in the event there are material inconsistencies in the inputs to determine estimated fair value, they are reviewed and a final determination is made by management in light of the specific facts and circumstances surrounding each price. Despite significant volatility in credit spreads during each of the four quarters ended December 31, 2008, in each of these quarters, the change in fair value of our mortgage insurance international CDS represented less than 4% of our net gains or losses on all credit derivatives. These credit derivatives are categorized in Level III of the fair value hierarchy. For each of the mortgage insurance international CDS transactions, we make an adjustment to the fair value amounts described above to incorporate our own non-performance risk. The amount of the adjustment is computed based on the correlation between the default probability of the transaction and our default probability as described more fully under Non-Performance Risk Adjustments on Corporate CDOs.
Our board of directors exercises its responsibility for the financial statements through its Audit and Risk Committee, which consists entirely of independent non-management board members. The Audit and Risk Committee meets periodically with management and with PricewaterhouseCoopers LLP, the independent registered public accounting firm retained to audit our Consolidated Financial Statements, both privately and with management present, to review accounting, auditing, internal control and financial reporting matters.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit and the report of the other auditors provide a reasonable basis for our opinion.
In our opinion, based on our audit 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 results of operations and cash flows of Radian Group Inc. and subsidiaries for the year ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, based on our audit 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 for the year ended December 31, 2006, 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.
We have audited the consolidated statements of income, members’ equity and cash flows of Sherman Financial Group LLC and subsidiaries (a Delaware limited liability company) for the year ended December 31, 2006 (not presented separately herein). These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit. The financial statements of Sherman Financial Group LLC as of and for the year ended December 31, 2005, were audited by other auditors. Those auditors expressed an unqualified opinion on those financial statements in their report dated February 9, 2006. As discussed in Note B (not presented separately herein), the Company has restated its 2005 financial statements to correct certain classifications in conformity with accounting principles generally accepted in the United States of America. The other auditors reported on the 2005 financial statements before the restatement.
Private mortgage insurance and risk management services are provided to mortgage lending institutions located throughout the United States (“U.S.”) and select countries outside the U.S. through our principal mortgage guaranty subsidiaries, Radian Guaranty Inc. (“Radian Guaranty”), Amerin Guaranty Corporation (“Amerin Guaranty”) and Radian Insurance Inc. (“Radian Insurance”). Of these companies, Radian Guaranty is currently the only company through which we are continuing to write a significant amount of new business.
Radian Guaranty currently offers two principal types of private mortgage insurance coverage: primary and pool. At December 31, 2008, primary insurance on domestic first-lien mortgages comprised approximately 92% of domestic first-lien mortgage insurance risk in force and pool insurance comprised approximately 8% of domestic first-lien mortgage insurance risk in force. We have historically used Amerin Guaranty to issue mortgage insurance on second-lien mortgages (“second-liens”), and Radian Insurance to provide credit enhancement, including in certain cases through credit default swaps (“CDS”), on mortgage-related assets that our monoline mortgage insurer Radian Guaranty is not permitted to insure such as second-lien mortgages, home equity loans, net interest margin securities (“NIMS”), and international insurance and reinsurance transactions (collectively, we refer to the risk associated with these transactions as “non-traditional” or “other risk”). As a result of the current housing and credit market turmoil, we have stopped writing all non-traditional business other than a small amount of international mortgage insurance.
We wrote our existing international mortgage insurance business through Radian Insurance. Downgrades of Radian Insurance have significantly reduced our ability to continue to write international mortgage insurance.
On February 28, 2001, we acquired the financial guaranty insurance business and other businesses of Enhance Financial Services Group Inc. (“EFSG”), a New York-based holding company that owned, until the third quarter of 2008, our principal financial guaranty subsidiaries, Radian Asset Assurance Inc. (“Radian Asset Assurance”) and Radian Asset Assurance Limited (“RAAL”). We also acquired an ownership interest in two credit-based asset businesses (see Note 8 “Investment in Affiliates,” for further information) as part of the acquisition of EFSG. The excess of purchase price over fair value of net assets acquired of $56.7 million represents the future value of insurance profits, which is being amortized over a period that approximates the future life of the insurance book of business. At December 31, 2008, $19.6 million of this amount remained on our consolidated balance sheets. During 2008, we amortized $6.8 million related to this transaction. During both 2007 and 2006, we amortized $1.8 million related to this transaction.
The counterparty in two of our synthetic CDO transactions, with an aggregate net par outstanding of $293.3 million ($243.0 million of which is scheduled to terminate in June 2009), has the right to terminate these transactions with settlement on a mark-to-market basis, subject to a maximum payment amount as of December 31, 2008 of approximately $34.1 million in the aggregate. In addition, we also have $103.2 million in exposure to another synthetic CDO transaction which is scheduled to terminate in June 2009. This transaction may be terminated on a mark-to-market basis if S&P lowers Radian Asset Assurance’s financial strength rating below investment grade (BBB-).
As of December 31, 2008, the counterparties to 147 of financial guaranty’s transactions currently have the right to terminate these transactions without our having an obligation to settle the transaction on a mark-to-market basis. If all of these counterparties had terminated these transactions as of December 31, 2008,
Until September 30, 2004, our financial guaranty business also included our ownership interest in Primus Guaranty, Ltd. (“Primus”), a Bermuda holding company and parent to Primus Financial Products, LLC, a provider of credit risk protection to derivatives dealers and credit portfolio managers on individual investment-grade entities. In September 2004, Primus issued shares of its common stock in an initial public offering. We sold a portion of our shares in Primus as part of this offering. In 2006, we sold all of our remaining interest in Primus, recording a pre-tax gain of $21.4 million.
Our financial services segment mainly consists of our 28.7% equity interest in Sherman Financial Group LLC (“Sherman”), a consumer asset and servicing firm. In August 2008, our equity interest in Sherman increased to 28.7% from 21.8% as a result of a reallocation of the equity ownership in Sherman following a sale by Mortgage Guaranty Insurance Corporation (“MGIC”) of its remaining interest in Sherman back to Sherman. As a result of Sherman’s repurchase of MGIC’s interests, our investment in affiliates decreased by $25.8 million ($16.8 million after taxes) and is reflected as a reduction in our equity. Our financial services segment also includes our 46% interest in Credit-Based Asset Servicing and Securitization LLC (“C-BASS”), a mortgage investment company whose operations are currently in run-off and which we have completely written off our investment. See Note 8 “Investment in Affiliates,” for further information.
The following table illustrates the current financial strength ratings assigned to our principal insurance subsidiaries as of February 2009:
Our holding company, Radian Group, currently is rated BB (CreditWatch with negative implications) from S&P and B3 (outlook developing) from Moody’s.
In assessing our current financial condition and developing forecasts of future operations, management has made significant judgments and estimates with respect to the potential financial and liquidity effects of our risks and uncertainties, including but not limited to:
Potential adverse effects if the capital and liquidity levels of Radian Group and our regulated subsidiaries’ statutory capital levels are deemed inadequate to support current business operations and strategies. As of December 31, 2008, Radian Guaranty’s statutory policyholders’ surplus and contingency reserves declined from $2.5 billion to $1.6 billion and the statutory net loss for 2008 was $1.6 billion (see Note 15 “Stockholders’ Equity and Dividend Restrictions,” for further information);
Potential adverse effects of Radian Guaranty’s loss of its GSE eligibility status, which could occur at any time at the discretion of the GSEs. Loss of GSE eligibility would likely result in a significant curtailment of our ability to write new mortgage insurance business, which would significantly impair our franchise value and limit our cash flow arising from new business while we continue to honor and settle all valid claims and related expenses;
Potential adverse effects on Radian Group liquidity if regulators limit, disallow or terminate our expense allocation agreements among Radian Group and its subsidiaries. In 2008, Radian Group received $138.4 million in reimbursements from its subsidiaries under these agreements (See Note 15 “Stockholders’ Equity and Dividend Restrictions,” for further information); and
Potential adverse effects if we are unable to comply with covenants in our debt agreements (See Note 13 “Long-Term Debt and Other Borrowings,” for further information).
Management believes that it will have adequate liquidity to finance our business and sufficient statutory capital to continue underwriting new mortgage insurance business based primarily on the following:
(1) our forecasts that indicate Radian Group and our subsidiaries have adequate liquidity and capital resources to pay all estimated future claims, and write new business within regulatory capital limits throughout 2009;
Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and include the accounts of all wholly-owned subsidiaries. Companies in which we, or one of our subsidiaries, own interests ranging from 20% to 50%, are accounted for in accordance with the equity method of accounting. See Note 8 “Investment in Affiliates,” for further information. Variable interest entities that are not qualifying special purpose entities (“QSPE”) and where we are the primary beneficiary are consolidated. See Note 6 “Special Purpose Entities,” for further information. All intercompany accounts and transactions, and intercompany profits and losses, have been eliminated.
Certain prior period balances have been reclassified to conform to the current period presentation. Loss adjustment expenses, previously reported as an other operating expense, are now reported in the provision for losses. The unrealized loss on the fair value of the long-term debt, previously included in long-term debt at December 31, 2007, has been reclassified to other liabilities. Also, effective January 1, 2008, derivative premiums earned are included in the change in fair value of derivative instruments. This reclassification is being adopted after agreement with member companies of the Association of Financial Guaranty Insurers (“AFGI”) in consultation with the staffs of the Office of the Chief Accountant and the Division of Corporate Finance of the Securities and Exchange Commission (“SEC”). This reclassification is being implemented in order to increase comparability of our financial statements with other financial guaranty companies with derivative contracts.
The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. While the amounts included in our consolidated financial statements include our best estimates and assumptions, actual results may vary materially.
The provisions of Statement of Financial Accounting Standards (“SFAS”) No. 60, “Accounting and Reporting by Insurance Enterprises,” (“SFAS No. 60”) specifically exclude mortgage insurance from its guidance relating to the earning of insurance premiums. Mortgage insurance premiums written on an annual and multi-year basis are initially recorded 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 relation to the anticipated claim payment pattern based on historical industry experience. Ceded premiums written are initially set up as prepaid reinsurance and are amortized in a manner consistent with how direct premiums are earned. Premiums on certain structured transactions are recognized over the period that coverage 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. Assumed
premiums are based on information reported by ceding companies. When insured obligations are refunded or called, the remaining premiums are generally earned at that time. Because of the lack of specific accounting literature comprehensively addressing the unique attributes of financial guaranty contracts, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 163, “Accounting for Financial Guarantee Insurance Contracts, an interpretation of FASB Statement No. 60” (“SFAS No. 163”). See “Recent Accounting Pronouncements.”
We generally do not establish reserves for loans that are in default if we believe that we will not be liable for the payment of a claim with respect to that default. For example, for those defaults in which we are in a second-loss position or a deductible exists, we calculate what the reserve would have been if there had been no deductible. If the existing deductible is greater than the reserve amount for any given default, we do not establish a reserve for the default. We generally do not establish loss reserves for expected future claims on insured mortgages that are not in default or believed to be in default. See “Reserve for Premium Deficiency” below for an exception to this general principle.
Each loan that we insure is identified by product type (i.e., prime, subprime, or Alternative-A (“Alt-A”)) and type of insurance (i.e., primary or pool) at the time the loan is initially insured. Different product types typically
Reserves for our mortgage insurance business are recorded based on our modeled output for insured loss and LAE reserves. In light of the regular adjustments made to the underlying assumptions in our model as discussed above, we believe the amount generated by our model at December 31, 2008 represents our best estimate of our future insured losses and LAE.
Because of the ambiguities in the application of SFAS No. 60 to our loss reserving policy, we do not believe that SFAS No. 60 alone provides sufficient guidance for our reserving policy, particularly with respect to establishing non-specific reserves before an insured event is reported. As a result, we and other members of the financial guaranty industry, supplement the principles of SFAS No. 60 with those of SFAS No. 5, “Accounting for Contingencies” (“SFAS No. 5”), which calls for the establishment of reserves when it is probable that a liability has been incurred at the date of the financial statements and the amount of loss can be reasonably estimated. We also rely by analogy on SFAS No. 114, “Accounting by Creditors for Impairment of a Loan” and the Emerging Issues Task Force (“EITF”) Issue No. 85-20, “Recognition of Fees for Guaranteeing a Loan,” which state that a guarantor should perform an ongoing assessment of the probability of loss to determine if a liability (and a loss) should be recognized under SFAS No. 5. Establishing non-specific reserves for credits that have not yet defaulted is a practice followed by the entire financial guaranty industry, although there may be differences in the specific methodologies used by other financial guarantors in establishing and classifying these reserves. We believe that our financial guaranty loss reserve policy is appropriate under the applicable accounting literature, and that it best reflects the fact that credit-based insurance involves a gradual deterioration of credit over time. However, because of the lack of specific accounting literature comprehensively addressing the unique attributes of financial guaranty contracts, the FASB issued SFAS No. 163. See “Recent Accounting Pronouncements” in this note for information regarding our SFAS No. 163 implementation in 2009.
At each balance sheet date, we also evaluate both the model-generated loss ratios and our unallocated non-specific reserves against management’s subjective view of qualitative factors to ensure that the loss ratios 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. The company specific factors that we evaluate also require that we make subjective judgments. In addition, a significant change in the size of the portfolio underlying our 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 loss ratios or our level of unallocated non-specific reserves.
established in an amount that exceeds allocated non-specific reserves. Conversely, a reduction of reserves, due to improved economic conditions or a cure of a default with respect to a specific credit for which a specific reserve has been established, can lead to an increase in our net income.
SFAS No. 60 requires a premium deficiency reserve be recorded if the net present value of the expected future losses and expenses for a particular product exceeds the net present value for expected future premiums and existing reserves for that product at the balance sheet date. We reassess our expectations for premiums, losses and expenses for each of our businesses at least quarterly and update our premium deficiency analysis accordingly. For purposes of premium deficiency analysis, we group our mortgage insurance products into two categories, first-lien and second-lien.
We share certain insurance risks we have underwritten through the use of reinsurance contracts. Reinsurance accounting is followed for ceded transactions when the risk transfer provisions of SFAS No. 113, Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts (“SFAS No. 113”), have been met. As a result, when we experience a loss or claim event that is subject to a reinsurance contract, reinsurance recoverables are recorded. The amount of the reinsurance recoverable can vary based on the terms of the reinsurance contract or the size of the individual loss or claim. We remain contingently liable for all reinsurance ceded. See Note 9 “Reinsurance,” for further information.
All our derivative instruments are recognized in our consolidated balance sheets as either derivative assets or derivative liabilities, depending on the rights or obligations under the contracts. Our credit protection in the
form of CDS within both our mortgage insurance and financial guaranty segments, NIMS and put options on money market committed preferred trust securities (“CPS”), 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 operations. Net unrealized gains and losses on CDS and certain other derivative contracts are included in either derivative assets or derivative liabilities on our consolidated balance sheets. See Note 4 for further discussion of our derivative instruments.
In accordance with the adoption of SFAS No. 155, certain securities that were previously classified as trading securities or fixed-maturities available for sale on our consolidated balance sheets were reclassified to hybrid securities on our consolidated balance sheets at January 1, 2007, the date of adoption. In addition, as allowed under the provisions of SFAS No. 155, we elected to record these convertible securities at fair value with changes in the fair value recorded as net gains or losses on other financial instruments. At adoption, we recorded an after-tax reclassification, which increased retained earnings and decreased other comprehensive income by $9.8 million, which represented the cumulative adjustment to fair value.
We adopted SFAS No. 157, “Fair Value Measurement” (“SFAS No. 157”) effective January 1, 2008 with respect to financial assets and liabilities measured at fair value. SFAS No. 157 (i) defines fair value, (ii) establishes a framework for measuring fair value under 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 on a prospective basis. There was no cumulative impact on retained earnings as a result of the adoption. The impact of adopting SFAS No. 157 is included in the change in fair value of derivative instruments. See Note 4 “Derivative Instruments and Hedging Activities” and Note 5 “Fair Value of Financial Instruments,” for further information. In accordance with FASB Staff Position SFAS No. 157-2, “Effective Date of FASB Statement No. 157,” we have elected to defer the effective date of SFAS No. 157 for non-financial assets and non-financial liabilities until January 1, 2009.
SFAS No. 157 defines fair value as the current amount that would be exchanged to sell an asset or transfer a liability, other than in a forced liquidation or transfer, and regardless of whether an observable liquid market price exists. SFAS No. 157 requires that a fair value measurement reflect actual or hypothetical assumptions market participants would use in pricing an asset or liability based on the best information available at the measurement date. In addition, SFAS No. 157 explicitly requires that we reflect our own non-performance risk in our fair value measurements of liabilities. We use Radian Group’s credit spreads as our primary market-based input in estimating non-performance risk. The provisions of SFAS No. 157 are reflected prospectively in earnings beginning January 1, 2008.
We established a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to financial instruments using unadjusted quoted prices in active markets for identical assets or liabilities (Level I measurements) and the lowest priority to fair value measurements using unobservable inputs (Level III measurements). The three levels of the fair value hierarchy under SFAS No. 157 are described below:
Costs associated with the acquisition of mortgage insurance business, consisting of compensation and other policy issuance and underwriting expenses, are initially deferred and reported as deferred policy acquisition costs. SFAS No. 60 specifically excludes mortgage guaranty insurance from its guidance relating to the amortization of deferred policy acquisition costs. Amortization of these costs is charged against earnings in proportion to estimated gross profits over the estimated life of the policies using the guidance provided by SFAS No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments.” This amount includes accrued interest on the unamortized balance of deferred policy acquisition costs. Estimates of expected gross profit, which consider persistency and loss development assumptions for each underwriting year and product type, are evaluated at least quarterly, and the total amortization recorded is adjusted by a charge or credit to our consolidated statements of
We provide for income taxes in accordance with the provisions of SFAS No. 109, “Accounting for Income Taxes” (“SFAS No. 109”). As required under SFAS No. 109, our deferred tax assets and liabilities are recognized under the balance sheet method, which recognizes the future tax effect of temporary differences between the amounts recorded in our consolidated financial statements and the tax bases of these amounts. Deferred tax assets and liabilities are measured using the enacted tax rates expected to apply to taxable income in the periods in which the deferred tax asset or liability is expected to be realized or settled.
In June 2006, the FASB issued FASB Interpretation No. (“FIN”) 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes-an Interpretation of FASB Statement No. 109.” 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 SFAS No. 109. 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.
We group assets in our investment portfolio into one of three main categories: held to maturity, available for sale or trading securities. Fixed-maturity securities for which we have the positive intent and ability to hold to maturity are classified as held to maturity and reported at amortized cost. Investments classified as available for
We are the beneficiary of insurance policies on the lives of certain of our current and past officers and employees. We have recognized the amount that could be realized upon surrender of the insurance policies in other assets in our consolidated balance sheets. At December 31, 2008 and 2007, the recorded surrender value of company-owned life insurance totaled $68.4 million and $65.5 million, respectively.
In January 2009, the FASB issued FASB Staff Position (“FSP”) EITF 99-20-1, “Amendments to the Impairment Guidance of EITF Issue No. 99-20” (“FSP EITF 99-20-1”). FSP EITF 99-20-1 amends the impairment guidance in EITF Issue No. 99-20, “Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests That Continue to Be Held by a Transferor in Securitized Financial Assets,” to achieve more consistent determination of whether an other-than- temporary impairment has occurred. FSP EITF 99-20-1 also retains and emphasizes the objective of an other-than-temporary-impairment assessment and the related disclosure requirements in FASB Statement No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” and other related guidance. The adoption of FSP EITF 99-20-1 at December 31, 2008, did not have a material impact on our consolidated financial statements.
In May 2008, the FASB issued SFAS No. 163. SFAS No. 163 clarifies how SFAS No. 60 applies to financial guarantee insurance contracts, including the recognition and measurement to be used to account for premium revenue and claim liabilities. The scope of SFAS No. 163 is limited to financial guarantee insurance (and reinsurance) contracts issued by insurance enterprises included within the scope of SFAS No. 60. SFAS No. 163 does not apply to financial guarantee insurance contracts accounted for as derivative contracts under SFAS No. 133. SFAS No. 163 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and all interim periods within those fiscal years. See Note 12 “Financial Guaranty Insurance Contracts” for further information.
outflows by using our own assumptions about the likelihood of all possible outcomes, based on information currently available. Currently, we establish unallocated non-specific reserves for our entire portfolio based on estimated statistical loss probabilities. Those credits that have defaulted are identified as Case Reserve credits, are aggregated, tracked on a list (“Watch List”), and reserves are established. For those credits in the Intensified Surveillance category and where a default is considered to be likely, an allocated non-specific reserve is established. In each case, the most likely loss scenario becomes the amount reserved. Our unallocated non-specific reserve will be eliminated upon the full implementation of SFAS No. 163 in the first quarter of 2009. In addition, case reserves and allocated non-specific reserves may also change upon adoption.
SFAS No. 163 will require that we record an initial unearned premium liability equal to the present value of the premiums due or expected to be collected over either the period of the financial guarantee insurance contract or the expected period of risk. In determining the present value of premiums due, we will use a discount rate that reflects the risk-free rate at the inception of the contract. Under SFAS No. 163, premiums paid in full at inception will be recorded as unearned premiums. Currently, premiums paid in advance of the coverage period are recorded as a liability for the amount received. In addition, SFAS No. 163 will require the recognition of the remaining unearned premium revenue on refundings for financial guaranty policies that are extinguished. A refunding that is effected through legal defeasance does not qualify for immediate revenue recognition. Consequently, this will result in previously recognized refundings to be reversed as part of the cumulative impact. Management is currently considering the impact that will result from the adoption of SFAS No. 163.
In March 2008, the FASB issued SFAS No. 161, “Disclosures About Derivative Instruments and Hedging Activities-an amendment of FASB Statement No. 133” (“SFAS No. 161”). SFAS No. 161 requires increased qualitative, quantitative and credit-risk disclosures including: (a) how and why an entity is using a derivative instrument or hedging activity; (b) how the entity is accounting for its derivative instrument and hedged items under SFAS No. 133 and (c) how the instrument affects the entity’s financial position, financial performance and cash flows. SFAS No. 161 also amends SFAS No. 107, “Disclosures about Fair Value of Financial Instruments” (“SFAS No. 107”) to clarify that derivative instruments are subject to SFAS No. 107’s concentration-of-credit-risk disclosures. SFAS No. 161 is effective for quarterly interim periods ending on or after March 31, 2009. Since SFAS No. 161 requires only additional disclosures concerning derivatives and hedging activities, adoption of SFAS No. 161 will not affect the our consolidated balance sheets, results of operations or cash flows.
For each of the years ended December 31, 2008, 2007 and 2006, our domestic net premiums earned were $926.8 million, $883.1 million, and $864.9 million, respectively, and our net premiums earned attributable to foreign countries were $45.0 million, $29.2 million, and $42.1 million, respectively. Because a significant amount of our trade credit reinsurance was written internationally, international net premiums earned from trade credit reinsurance business has declined over the past 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.
In our mortgage insurance segment, the highest state concentration of primary risk in force at December 31, 2008 was California at 10.8%, compared to 8.8% at December 31, 2007. At December 31, 2008, California accounted for 13.2% of our mortgage insurance segment’s primary insurance in force, compared to 11.6% at December 31, 2007. California also accounted for 11.5% of our mortgage insurance segment’s pool risk in force, compared to 17.8% for 2007. California also accounted for 17.3% of our mortgage insurance segment’s primary new insurance written for 2008, compared to 15.8% for 2007.
The largest single customer of our mortgage insurance segment (including branches and affiliates of such customer), measured by primary new insurance written, accounted for 20.5% of primary new insurance written in 2008 compared to 19.4% in 2007 and 18.6% in 2006.
(1) Does not include VIE debt of $160.0 million related NIMS that we were required to consolidate at December 31, 2008.
The application of SFAS No. 133, as amended, results in volatility from period to period in gains and losses as reported on our consolidated statements of operations. Generally, these gains and losses result from changes in corporate credit or asset-backed spreads and changes in the creditworthiness of underlying corporate entities or the credit performance of the assets underlying an asset-backed security. Any incurred gains or losses on our
financial guaranty contracts that are accounted for as derivatives are recognized as a change in the fair value of derivative instruments. Beginning in the first quarter of 2008, as required by the provisions of SFAS No. 157, we also incorporated our own non-performance risk into our fair valuation methodology. See Note 5 “Fair Value of Financial Investments” for further information. Our fair value estimates may result in significant volatility in our financial position or results of operations for future periods.
(1) These unearned premiums were reclassified after adoption of an agreement with member companies of the AFGI in consultation with the staffs of the Office of the Chief Accountant and the Division of Corporate Finance of the SEC.
(2) Transfers are assumed to be made at the end of the period.
(5) This amount represents derivative assets of $19.2 million and derivative liabilities of $174.4 million transferred to VIE debt related to NIMS trusts that we consolidated during the period.
(6) Included in this amount is a $47.4 million CDS claim expense, offset by a $5.6 million unearned premium reserve setup for direct and assumed credit derivatives.
(8) During 2008, we recorded $0.1 million of unrealized gains in other comprehensive income related to Level III available for sale securities.
Municipal and state securities-The fair value of municipal and state securities is estimated using recently executed transactions, market price quotations and pricing models that factor in, where applicable, interest rate yield curves and credit spreads for similar bonds. These securities are categorized in Level II of the fair value hierarchy.
Money market instruments-The fair value of money market instruments is based on daily prices which are published and available to all potential investors and market participants. As such, these investments are categorized in Level I of the fair value hierarchy.
Corporate bonds-The fair value of corporate bonds is estimated using recently executed transactions and market price observations. In addition, a spread model is used to incorporate early redemption features, when applicable. These bonds are categorized in Level II of the fair value hierarchy or in Level III when significant unobservable inputs are used.
Hybrid securities-These instruments are convertible securities measured at fair value based on observed trading activity and daily quotes. In addition, on a daily basis, dealer quotes are marked against the current price of the corresponding underlying stock. These securities are categorized in Level II of the fair value hierarchy. For certain securities, the underlying security price may be adjusted to account for changes in the conversion and investment value from the time the quote was obtained. Such securities are categorized in Level III of the fair value hierarchy.
Equity securities-The fair value of these securities is generally estimated using observable market data in active markets or bid prices from market makers and broker dealers. Generally, these securities are categorized in Level I of the fair value hierarchy as observable market data is available on these securities. Securities that are not frequently traded or are not as liquid are categorized in Level II of the fair value hierarchy.
Beginning in 2008, in accordance with SFAS No. 157, we made an adjustment to our derivative liabilities valuation methodology to account for our own non-performance risk by incorporating our observable credit default swap spread into the determination of the fair value of our credit derivatives. Our five-year credit default
(1) This represents net NIMS derivative assets and derivative liabilities. We also have consolidated NIMS VIE debt in the amount of $160.0 million. See discussion below.
(2) Includes $0.7 million of par for derivative transactions which are not CDOs.
We have provided credit protection primarily through derivative contracts in our corporate and non- corporate CDO transactions with respect to the following types of collateral: corporate borrowed money, TruPs, CMBS, ABS (which include predominantly residential mortgage-backed securities), and collateralized loan obligations (“CLOs”). In our corporate CDO transactions, we provide protection for certain credit events related to the borrowings or bankruptcy of obligors contained within pools of corporate obligations that were predominantly investment-grade at inception. TruPs securities are deeply subordinated securities issued by banks, insurance companies, Real Estate Investment Trusts and other financial institutions to supplement their capital needs. Generally, the TruPs securities issued by an issuer are subordinated to substantially all of its debt obligations, but are payable senior to payments on equity securities of such issuer. In our CDO of CMBS transactions, we insure the timely payment of interest and the ultimate payment of principal on securities whose
The fair value of our put options on CPS is estimated based on the present value of the spread differential between the current market rate of issuing a perpetual preferred security and the maximum rate of our perpetual preferred security as specified in our put option agreements. In determining the current market rate, consideration is given to our current CDS spread as well as market observations of similar securities issued, when available. The spread differential is typically assumed to be fixed in perpetuity and the annual cost differential is discounted at our current CDS spread, adjusted for a market-implied recovery rate. At December 31, 2008, given the current market environment and the market’s view of our credit risk, we determined that there were no market observations of relevance, and that there is currently no liquidity for these securities. Therefore, based on our assessment that the perpetual preferred securities could not be issued currently at any reasonable interest rate, we estimated that the current market value of the options is equal to the issuance amount, which is $150 million.
Until the market changes such that there is some liquidity for our perpetual preferred securities, the fair value of these put options is not expected to be sensitive to changes in interest rates or in our CDS spread. The put options on CPS are categorized in Level III of the fair value hierarchy.
Changes in our expected principal credit losses on NIMS could have a significant impact on our fair value estimate. The gross expected principal credit losses were $430.6 million as of December 31, 2008, which is our best estimate of settlement value and represents 98% of our total risk in force of $438.3 million. The fair value of our total net liabilities related to NIMS as of December 31, 2008 was $238.5 million, of which $5.8 million relates to derivative assets, $84.3 million relates to derivative liabilities and $160.0 million relates to consolidated VIE debt. Our fair value estimate incorporates a discount rate that is based on our credit default swap spread, which has resulted in a fair value amount that is substantially less than the expected settlement value. Changes in the credit loss estimates will impact the fair value directly, reduced only by the present value factor, which is dependent on the timing of the expected losses and our credit spread.
Present Value of Expected Future Contractual Premiums-Our contractual premiums are subject to change for two reasons: (1) all of our contracts provide our counterparties with the right to terminate upon our default and (2) 83% of our corporate CDO transactions (as of December 31, 2008) provide our counterparties with the right to terminate these transactions based on certain rating agency downgrades that have occurred as described in Note 1. In determining the expected future premiums of these transactions, we adjust the contractual premiums for such transactions to reflect the estimated fair value of those premiums, based on our estimate of the probability of our counterparties exercising this downgrade termination right and the impact it would have on the remaining expected lifetime premium. The discount rate we use to determine the present value of expected future premiums is our credit default swap spread plus a risk free rate. This discount rate reflects the risk that we may not collect future premiums due to our inability to satisfy our contractual obligations, which provides our counterparties the right to terminate the contracts.
For each corporate CDO transaction, we perform three principal steps in determining the fair premium amount:
For each referenced corporate entity in our corporate CDO transactions, the credit default swap spreads associated with the term of our transactions (“credit curve”) define the estimated expected loss for each entity (as applied in a market standard approach known as “risk-neutral” modeling). The credit curves on individual referenced entities are generally observable. The expected cumulative loss for the portfolio of referenced entities associated with each of our transactions is the sum of the expected losses of these individual referenced entities. With respect to the correlation of losses across the underlying reference entities, two obligors belonging to the same industry or located in the same geographical region are assumed to have a higher probability of defaulting together (i.e., they are more correlated). An increase in the correlations between the referenced entities generally causes a higher expected loss for the portfolio associated with our transactions. The estimated correlation factors that we use are derived internally based on observable third-party inputs that are based on historical data. The impact of our correlation assumptions currently does not have a material effect on our fair premium estimates in light of the significant impact of our non-performance risk adjustment as described below.
Once we have established the probability of portfolio losses exceeding the attachment and detachment points in our transactions, we then use the same simulation method to locate the attachment and detachment points on the CDX index with the same probabilities. These equivalent attachment and detachment points define the equivalent-risk tranche on the CDX index that we use to determine fair premium amounts.
Our non-corporate CDO transactions include our guaranty of RMBS CDOs, CMBS CDOs, TruPs CDOs, and CDOs backed by other asset classes such as (i) municipal securities (ii) synthetic financial guarantees of asset-backed securities (such as auto loan and credit card securities) and (iii) project finance transactions. The fair value of our non-corporate CDO and other derivative transactions is calculated as the difference between the present value of the expected future contractual premiums and our estimate of the fair premium amount for these transactions. The present value of expected future contractual premiums is determined based on the methodology described above for corporate CDOs. For our credit card and auto loan transactions, the fair premium amount is estimated using observed spreads on recent trades of securities that are similar to the securities that we guaranty. In all other instances, we utilize internal models to estimate the fair premium amount as described below. These credit derivatives are categorized in Level III of the fair value hierarchy.
All Other Non-Corporate CDOs and other Derivative Transactions-For all of our other non-corporate CDO and other derivative transactions observed prices and market indices are not available. As a result, we utilize an internal model that estimates fair premium based on a market rate of return that would be required for a monoline insurer to undertake the contract risk. The fair premium amount is calculated as the premium required to achieve a market rate of return (net of expected losses and other expenses) over an estimated internally developed risk-based capital amount. Such market rates of return approximate historical rates of return earned by financial guarantors. Expected losses and our internally developed risk-based capital amounts are projected by our model based on the internal credit rating, term, asset class, and current par outstanding for each transaction.
years. The quoted index price is calibrated by the primaries to the typical attachment points for that type of CDS contract in order to derive the appropriate value. The value of CDS and CLO contracts are estimated with reference to the London Interbank Offered Rate (“LIBOR”) spread in the current published JP Morgan High Yield CLO Triple-A Index, which includes a credit and funding component. In addition, these fair value estimates incorporate an adjustment for our non-performance risk that is based on our credit default swap spread. The primaries’ models used to estimate the fair values of these instruments include a number of factors, including credit spreads, changes in interest rates, changes in correlation assumptions, current delinquencies, recovery rates and the credit ratings of referenced entities. In establishing our fair value marks for these transactions, we assess the reasonableness of the primaries’ valuations by (1) reviewing the primaries’ publicly available information regarding their mark-to-market processes, including methodology and key assumptions; and (2) discussing the changes in fair value with the primaries where the changes appear unusual or do not appear materially consistent with credit loss related information when provided by the primaries for these transactions. Despite significant volatility in relevant credit spreads during each of the four quarters ended December 31, 2008, in each of these quarters the change in fair value of our assumed financial guaranty credit derivatives represented less than 2.5% of our net gains or losses on all credit derivatives. These credit derivatives are categorized in Level III of the fair value hierarchy.
Changes in our expected credit losses on mortgage insurance domestic CDS could have a significant impact on our fair value estimate for this product, with a maximum principal loss exposure of $132.2 million and expected losses as of December 31, 2008 in the amount of $91.8 million. Changes in the loss estimates will impact the fair value directly, reduced only by the discount factor, which is dependent on the timing of the expected losses. The mortgage insurance domestic CDS are categorized in Level III of the fair value hierarchy.
each of the four quarters ended December 31, 2008, in each of these quarters, the change in fair value of our mortgage insurance international CDS represented less than 4% of our net gains or losses on all credit derivatives. These credit derivatives are categorized in Level III of the fair value hierarchy. For each of the mortgage insurance international CDS transactions, we make an adjustment to the fair value amounts described above to incorporate our own non-performance risk. The amount of the adjustment is computed based on the correlation between the default probability of the transaction and our default probability as described more fully under Non-Performance Risk Adjustment on Corporate CDOs.
Short-Term Investments Carried at Cost-The fair value of short-term investments carried at cost is estimated using market quotes or actual fair value estimates.
Our ability to accurately estimate the fair value of our non-derivative financial guarantees is limited. There are no observable market data points as a result of the current disruption in the credit markets and we have experienced recent rating agency actions. These factors have significantly limited the amount of new financial guaranty business we have written recently. We believe that in the absence of a principal market, our estimate of fair value described above in a hypothetical market provides the most relevant information with respect to fair value estimates given the information currently available to us. Due to the volume and geographic diversification of our financial guaranty exposures, in the future we may need to consider other key variables that may influence the fair value estimate. Variables not currently incorporated in our current fair value estimate of non-derivative financial guarantees include the credit spreads of the underlying insured obligations, the underlying ratings of those insured obligations and assumptions about current financial guarantee premium levels relative to the underlying insured obligations’ credit spreads.
When an SPE does not meet the QSPE criteria or the scope exceptions provided for in FIN 46R, a consolidation analysis is performed. In accordance with FIN 46R, a VIE is defined as an entity that: (1) lacks enough equity investment at risk to permit the entity to finance its activities without additional subordinated financial support from other parties; (2) has equity owners that lack the right to make significant decisions affecting the entity’s operations; and/or (3) has equity owners that do not have an obligation to absorb the entity’s losses or the right to receive the entity’s returns. FIN 46R requires a variable interest holder (i.e., a counterparty to a VIE) to consolidate the VIE if that party will absorb a majority of the expected losses of the VIE, receive the majority of the expected residual returns of the VIE, or both. This party is considered the primary beneficiary.
In accordance with FIN 46R, we consolidate VIEs in which we are the primary beneficiary of the variable interests, or a combination of variable interests, that will either (i) absorb a majority of the VIE’s expected losses, (ii) receive a majority of the VIE’s expected residual returns, or (iii) both. We made a determination as to whether we are the primary beneficiary of a VIE at the inception of our involvement with that VIE and, based on those evaluations we have concluded that we are not the primary beneficiary of any VIEs.
The following is a summary of the financial impact on our 2008 consolidated balance sheet, our consolidated statement of operations and our consolidated statement of cash flows as of and for the year ended December 31, 2008, as it relates to VIEs in which we have a significant variable interest and QSPEs sponsored by us:
The entity’s governance structure is changed such that either (1) the characteristics or adequacy of equity at risk are changed, or (2) expected returns or losses are reallocated among the participating parties within the entity.
The equity investment (or some part thereof) is returned to the equity investors and other interests become exposed to expected returns or losses.
(c) acquisition of ownership of a significant amount of any particular NIMS trust bonds that we insure.
The following is summary information related to all NIMS trusts (both consolidated and off-balance sheet NIMS trusts) as of the dates indicated:
Our involvement with VIEs in our financial guaranty business relate to transactions that are generally structured as financial guarantees or credit default swaps guaranteeing principal and interest payments to beneficial interest holders. In order to determine whether we are the primary beneficiary of a VIE’s risks and rewards, we consider, among other factors, the VIE’s design, capital structure and contractual terms. At inception of our involvement, we performed a qualitative analysis to determine if our variable interest in each of these VIEs as compared to the total variable interests in such VIE was sufficiently large to make us the primary beneficiary. Most of our insured portfolio was highly rated at inception with a significant number of the transactions having subordination at or above the level of subordination necessary to warrant a AAA rating. At the time of our analyses we determined there was significant subordination, clearly demonstrating that we are not the primary beneficiary of those structures based on the projected distribution of expected losses among the variable interest holders. We have not experienced any reconsideration events that would cause us to reconsider whether we are the primary beneficiary. Based on those analyses, we have not consolidated any of our financial guaranty VIEs.
Each trust is restricted to holding high-quality, short-term commercial paper investments to ensure that it can meet its obligations under the put options. To fund these investments, each trust issued its own auction market perpetual preferred stock. On September 5, 2007, Fitch downgraded its rating of the trusts to “BBB+” from “A.” As a result of this downgrade, the maximum spread over LIBOR payable by us for maintenance of these options increased to 300 basis points from 200 basis points. Because sufficient auction clearing bids have not been made, the reset auction rate for the options has reset at this maximum rate, resulting in a $1.5 million increase in the annual cost to us of maintaining these options. Each trust remains rated “A” by S&P. The initial costs to issue this facility were recorded as a reduction to additional paid-in capital.
Each transaction begins with the formation of an unaffiliated, offshore reinsurance company. We then enter into an agreement with the Smart Home reinsurer to cede to the reinsurer a portion of the risk (and premium) associated with a portfolio of loans, consisting mostly of non-prime residential mortgages, insured by us. The Smart Home reinsurer is funded in the capital markets through the issuance to investors of a series of separate classes of credit-linked notes. Each class relates to the loss coverage levels on the reinsured portfolio and is assigned a rating by one or more of the three major rating agencies.
Our investment portfolio consisted of the following at December 31, 2008 and 2007:
If a security’s fair value is below its cost basis, and it is judged to be an other-than-temporary decline, the cost basis of the security is written down to fair value through earnings as a realized loss, and the fair value becomes the new basis for the security. During 2008, we recorded approximately $55.2 million of charges related to declines in fair value of securities (primarily municipal and taxable bonds and preferred stocks) considered to be other-than-temporary, which are included in the net (losses) gains on other financial instruments in the table above. During 2007 and 2006, we recorded approximately $9.4 million and $10.6 million of charges, respectively, related to declines in fair value of securities (primarily small cap value stocks, convertible securities and an investment in a fund co-managed by C-BASS) considered to be other-than-temporary, which are included in net (losses) gains on other financial instruments in the table above. At December 31, 2008, 2007, and 2006, there were no other investments held in the portfolio that were determined to be other-than-temporarily impaired. Realized gains and losses are determined on a specific identification method and are included in income.
The unrealized losses of 12 months or greater duration as of December 31, 2008 on our investments in tax-exempt state and municipal securities were caused primarily by interest rate and credit spread movement. Most securities with exposures to certain sectors, particularly those insured by monoline insurers, experienced
credit spread widening during 2007 and 2008. We do not own any securities with underlying non-investment grade ratings that are insured by monoline insurance companies. Included in this category are $129.6 million of investments in state securitizations of projected cash flows from state settlements with tobacco manufacturers under a master settlement agreement. Because we have the ability and intent to hold all the investments in this category 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, 2008.
The unrealized losses of 12 months or greater duration as of December 31, 2008 on the majority of the securities in this category were caused by market interest rate and credit spread movement. Certain securities, mainly those issued by financial firms with exposure to subprime residential mortgages, experienced spread widening during 2007 and 2008. 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, 2008.
The unrealized losses of 12 months or greater duration as of December 31, 2008 on the majority of the securities in this category were caused by market interest rate and credit spread movement. 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 securities to be other-than-temporarily impaired at December 31, 2008.
The unrealized losses of 12 months or greater duration as of December 31, 2008 on the majority of the securities in this category were caused by market interest rate movement. 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, 2008.
* Prerefunded bonds are backed by U.S. Treasury and/or agency debt held in escrow, and structured to provide sufficient cash flows to offset the cashflows due on the refunded bonds. At maturity, the issuer will sell the U.S. Treasury securities or agency debt held in escrow and buy back the municipal bonds with the proceeds.
Securities on deposit with various state insurance commissioners amounted to $17.1 million at December 31, 2008 and $17.3 million at December 31, 2007. We also had $156.1 million (book value) on deposit at December 31, 2008 and $77.0 million (book value) at December 31, 2007, for the benefit of reinsurers.
We have a 46.0% equity interest in C-BASS and a 28.7% equity interest in Sherman as of December 31, 2008.
2007 Sale of Partial Interest. On September 19, 2007, we sold to Sherman Capital, L.L.C. (“Sherman Capital”), an entity owned by the management of Sherman: (1) all of our preferred interests in Sherman and (2) 1,672,547 Class A Common Units in Sherman, representing approximately 43.4% of our total common interests in Sherman, for a cash purchase price of approximately $277.6 million, plus a future contingent payment. The amount of the contingent payment, if any, will depend on the extent that Sherman Capital’s after-tax return on 1,425,335 of the Class A Common Units acquired in the transaction exceeds approximately 16% annually. The contingent payment is payable to us on December 31, 2013 or earlier upon the closing of a sale of Sherman. We recorded a gain of $181.7 million on the sale of our interest in Sherman in September 2007.
EITF No. 98-13, “Accounting by an Equity Method Investor for Investee Losses When the Investor Has Loans to and Investments in Other Securities of the Investee” (“EITF No. 98-13”), requires that when the recognition of equity losses reduces our equity investment to zero, we should continue to report our share of equity method losses in our statement of operations and should apply those equity method losses to our other investments in C-BASS. As a result of the additional losses at C-BASS, and continued application of APB Opinion No. 18 and EITF No. 98-13, we recorded a full write-off of our $50 million credit facility with C-BASS in the fourth quarter of 2007. We believe it is unlikely that we will collect on amounts drawn by C-BASS under this facility nor do we expect to recover any of our investment in C-BASS.
As a consequence of the complete write-off of our investment in C-BASS in 2007, we have no continuing interest of value in C-BASS. The effect of C-BASS on our financial position and results of operations as of and for the year ended December 31, 2008 was negligible. We have no contractual obligations to C-BASS or its creditors to fund C-BASS’s shareholders’ deficit as of December 31, 2007 or continuing losses in 2008 or thereafter. All of C-BASS’s business is currently in run-off and we anticipate that all future cash flows of C-BASS will be used to service the outstanding debt. Given its approximately $1 billion shareholders’ deficit as of December 31, 2007, the likelihood that we will recoup any of our investment is extremely remote. Accordingly, we believe that the chance that our investments in
C-BASS will have anything more than a negligible impact on our financial position, results of operation or cash flows at any time in the future is extremely remote.
N/A-2008 financial statements for C-BASS are not available. The affect of C-BASS on our financial position and results of operations as of and for the year ended December 31, 2008 was negligible.
Radian Guaranty entered into 10-year 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 term of each treaty was 10 years and was non-cancelable by either party except under certain conditions. Under the terms of the treaties, Radian Guaranty ceded premiums to the reinsurer based on 15% of the premium received on the covered business. Radian Guaranty was entitled to receive a commission ranging from 30% to 32% of the premium paid under the treaty provided that certain loss ratios were not exceeded. In return for the payment of the ceded premium, Radian Guaranty received variable quota-share loss relief at levels ranging from 7.5% to 15.0% based upon the loss ratio on the covered business. The treaties also included underwriting-year excess coverage that entitled Radian Guaranty to receive 8% of the premium written on the covered business under each treaty at the end of the fourth, seventh and tenth years to the extent that this amount was greater than the total amount previously received under the variable quota-share coverage provision of the treaty. Premiums were payable to the reinsurer on a quarterly basis net of commissions due and any losses calculated under the variable quota-share coverage.
Provisional losses recoverable under these quota share treaties were $12.5 million at December 31, 2006. The 2006 provisional losses recoverable represented amounts due to us under the variable quota-share treaty entered in 1997. These recoverable amounts covered the books of business originated by Radian Guaranty in those years. In 2007, the reinsurer reimbursed us for the remaining underwriting-year excess coverage due under the tenth year of the 1997 treaty. In December 2006, Radian Guaranty terminated the remaining variable quota-share reinsurance treaty, as allowed under the terms of the treaty.
Until recently, losses under most captive reinsurance treaties have not approached a level requiring payment to us. However, during the current housing and related credit market downturn in which losses have increased significantly, many captive reinsurance arrangements have attached, requiring our captive reinsurer to make payments to us. We began recognizing ceded losses recoverable from such captives in the fourth quarter of 2007, which accelerated throughout 2008, although most cash recoveries are not expected until 2009 and later. In most cases, the captive reinsurer establishes a trust to secure our potential cash recoveries. We generally are the sole beneficiary under these trusts, and therefore, have the ability to initiate disbursements under the trusts in accordance with the terms of our captive reinsurance agreements. In some instances we anticipate that the recoverables from the captive reinsurers will be greater than the assets currently in the trusts. Recorded recoveries are limited to the current trust balance. We also offer, on a limited basis, “quota share” captive reinsurance agreements under which the captive reinsurance company assumes a pro rata share of all losses in return for a pro rata share of the premiums collected. We currently have 16 “active” captive reinsurance agreements in which new business continues to be placed. We also currently have 45 captive reinsurance arrangements operating on a run-off basis, meaning that no new business is being placed in these captives.
Since August 2004, we have completed four Smart Home reinsurance transactions. Details of these transactions (aggregated) as of the initial closing of each transaction and as of December 31, 2008 are included in Note 6.
Ceded premiums written in 2008, 2007 and 2006 include $13.0 million, $11.0 million and $12.0 million, respectively, related to the Smart Home reinsurance transactions. Ceded premiums earned related to Smart Home were $13.0 million, $11.4 million and $12.3 million in 2008, 2007 and 2006, respectively. Ceded losses in 2008 and 2007 were $81.2 million and $9.8 million, respectively as a result of the Smart Home transactions. There were no Smart Home ceded losses in 2006.
Our reserve model applies different ultimate default to claim rates and severities to each product type, taking into account the different loss development patterns and borrower behavior that are inherent in these products. The analysis uses claim payment history for each product to help determine the likelihood that a default will result in a claim and the amount we will pay if a default becomes a claim. Through the use of this claim history, the reserve model is periodically calibrated to be consistent with our recent experience.
(2) Related to ceded losses on captive reinsurance transactions and Smart Home.
The following table shows the mortgage insurance range of loss and LAE reserves, as determined by our actuaries, and recorded reserves for losses and LAE, as of December 31, 2008 and 2007:
(1) During 2008, 2007 and 2006, our provision for losses and LAE in our financial guaranty insurance business for prior years were reduced by $32.8 million, $28.4 million and $6.8 million, respectively, mainly related to favorable loss development in our trade credit reinsurance business and favorable loss development in our structured finance direct and public finance reinsurance lines of business.
The following table shows the breakdown of the reserve for losses and LAE for our financial guaranty segment at the end of each period indicated:
Our unallocated non-specific loss reserve at December 31, 2008 was $58.4 million. The range between the unallocated non-specific reserves that would have resulted from applying the highest and lowest default factors generated by any of the three models was approximately $33.0 million to $82.0 million, which we believe provides a reasonably possible range of expected future losses.
In June 2008, we established a reserve for premium deficiency on our domestic first-lien mortgage insurance business. The accrued first-lien PDR was realized in 2008 through premium, loss and expense activity on the in-force risk that generated the PDR. At December 31, 2008, our current mortgage insurance portfolio is expected to generate a cumulative net profit and, therefore, no premium deficiency reserve was determined to exist as of that date. The net present value of expected losses and expenses on our first-lien business at December 31, 2008 was $4.9 billion, offset by the net present value of expected premiums of $3.0 billion and already established reserves (net of reinsurance recoverables) of $2.4 billion. Expected losses include an assumed paid claim rate of approximately 14% on our total primary first-lien mortgage insurance portfolio, including 10% on prime, 33% on subprime and 27% on Alt-A. While deterioration in the macroeconomic environment has resulted in an increase in expected losses, new business originated during the second half of 2008 is expected to be profitable, which has contributed to the overall expected net profitability of the portfolio.
We monitor not only the nominal exposure for each obligor for which we provide protection in our corporate CDO transactions, but also risk-adjusted measures, taking into account, among other factors, our assessment of the relative risk that would be represented by direct exposure to the particular obligor and the remaining subordination in the transactions in which we are exposed to a particular obligor. On occasion, we may have some limited exposure to our affiliates, C-BASS and Sherman, under our structured finance transactions, although this exposure generally constitutes a small part of any such transaction and is insignificant in the aggregate.
The portfolio management group oversees all portfolio level analysis of our insured financial guaranty portfolio. This group is primarily responsible for the analysis of our assumed financial guaranty portfolio and the oversight of the credit risk relationship with our ceding companies. The head of the portfolio management team directs the “Watch and Reserve” process (which is more fully described below), and chairs the quarterly Watch and Reserve meetings, at which, reserve recommendations are made on the portfolio.
Our board of directors has formed a Credit Committee of independent directors to assist the board in its oversight responsibilities for our credit risk management policies and procedures, including heightening board-level awareness of the impact of developing risk trends in our portfolio. Our risk management group updates this committee, no less frequently than on a quarterly basis, on all aspects of risk management, including portfolio/sector analysis, economic capital trends, risk management policy enhancements and Watch and Reserve Committee recommendations and decisions.
The financial guaranty business has a Watch and Reserve Committee that meets quarterly to review under-performing credits and establish reserves for transactions as recommended by the appropriate risk manager. The Committee is chaired by the head of the portfolio management group and includes representatives of senior management, credit, legal and finance from both the financial guaranty business and Radian Group. Our risk management processes and procedures address both performing and under-performing transactions. Performing transactions are assigned investment grade internal ratings, denoting nominal to moderate credit risk. When our risk management department concludes that a directly insured transaction should no longer be considered performing, it is placed in one of three designated categories for deteriorating credits: Special Mention, Intensified Surveillance or Case Reserve. Assumed exposures in financial guaranty’s reinsurance portfolio are generally placed in one of these categories if the primary insurer for such transaction downgrades it to an equivalent watch list classification. However, if our financial guaranty risk management group disagrees with the risk rating assigned by the ceding company, we may assign our own risk rating rather than using the risk rating assigned by the ceding company.
Speculative grade obligations with increasing credit risk, but with the possibility of recovering and returning to investment grade levels;
Requires additional monitoring by risk manager to evaluate developing potentially adverse credit trends.
Once a risk manager detects some or all of these characteristics, the risk manager makes a recommendation to place the credit in this category to the portfolio analytics/recovery management group and the respective risk management group. Direct and assumed exposures in this category are typically reviewed annually or more frequently if there is a change to the credit profile.
Intensified Surveillance. This category includes transactions in financial guaranty’s insured portfolio that are internally rated below investment grade, indicating a severe and often permanent adverse change in the transaction’s credit profile. Transactions in this category are still performing, meaning they have not yet defaulted on a payment, but our risk management department has determined that there is a substantial likelihood of default. Transactions that are placed in this category may have some or all of the following characteristics:
Speculative grade transactions with high credit risk and low possibility of recovery back to performing levels;
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 sum of the present values of the remaining scheduled payments of principal and interest on the notes to be redeemed. In April 2004, we entered into interest-rate swap contracts that effectively converted the interest rate on this fixed-rate debt to a variable rate based on a spread over the six-month LIBOR. We terminated these swaps in January 2008. The basis adjustment of $11.5 million that resulted from the interest-rate swaps, and that was recorded as an increase to the long-term debt carrying value, is being amortized to interest expense over the remaining term of the debt.
On June 7, 2005, we issued $250 million of unsecured senior notes. These notes bear interest at the rate of 5.375% per annum, payable semi-annually on June 15 and December 15. The notes mature on June 15, 2015. We have the option to redeem some or all of the notes at any time with not less than 30 days’ notice at a redemption price equal to the greater of the principal amount of the notes or the sum of the present values of the remaining scheduled payments of principal and interest on the notes to be redeemed.
Under our credit facility as amended, in addition to our business covenants, we are required to maintain (subject to certain adjustments), a consolidated net worth of at least $1.5 billion through June 30, 2009, $1.25 billion from July 1, 2009 through December 31, 2009 and $1.0 billion at any time thereafter, in each case, subject to upward adjustment if we receive net proceeds from the issuance of certain securities. Our consolidated net worth under the credit facility is determined by excluding mark-to-market adjustments on derivative instruments and investments reflected on our statements of operations. At December 31, 2008, our consolidated net worth as determined under the facility was $2.6 billion. We expect to incur a net operating loss in 2009, and therefore, we anticipate a corresponding reduction in our net worth. In addition, our consolidated net worth would be further reduced if we realize losses in our investment portfolio. There can be no assurance that losses in or after 2009 will not reduce our consolidated net worth below the minimum amount required by our covenants, which would cause our default under the credit facility.
any of our main insurance subsidiaries: (a) fails to meet or maintain minimum levels of statutory capital or surplus; (b) is prohibited from writing, underwriting, assuming, or reinsuring further business; or (c) is otherwise prohibited by its regulators from writing or materially restricted from performing any of its core business activities, and in such events our shared expense reimbursement payments from our subsidiaries do not cover all of our operating expenses and debt service;
If we default under our credit agreement, the agent or the lenders representing a majority of the debt under our credit agreement would have the right to terminate all commitments under the credit agreement and declare the outstanding debt due and payable.
Principal payments on our long-term debt and other borrowings are scheduled to be repaid as follows:
As of December 31, 2008, we have a net deferred tax asset (“DTA”) in the amount of $446.1 million. We believe that it is more likely than not that this asset will be realized. As such, no valuation allowance was established. The following factors were considered in reaching this conclusion:
There is currently $300.6 million of taxable income available in tax return carryback years. This would result in a recovery of approximately $105.2 million of the DTA.
A significant source of future taxable income can be derived from our municipal and state securities investment portfolio. We believe that a viable tax planning strategy exists for switching from tax exempt to taxable investments and that such a plan will provide for higher yielding securities with fully taxable interest. This strategy would be fully committed to and implemented, if necessary, and could generate a sufficient amount of additional taxable income over the loss carryforward period allowed under the Internal Revenue Code (“IRC”) to recover our remaining DTA balance.
Approximately $116.7 million of the net deferred tax asset relates to available for sale securities in our fixed-maturity investment portfolio for which we have recorded unrealized losses as a separate component of other comprehensive income. We have the ability and intent to hold these securities to recovery or maturity.
The need for a valuation allowance will continue to be reviewed on a quarterly basis and no assurances can be made with regard to whether a valuation allowance will be needed in the future.
Cumulative T&L Bonds purchased and subsequent redemptions are reflected in the balance of prepaid federal income taxes on our consolidated balance sheets. During 2008, we redeemed approximately $544.7 million of T&L Bonds. Prepaid federal income taxes include T&L Bonds of $248.8 million and $793.5 million at December 31, 2008 and 2007, respectively.
(1) Our U.S. federal corporation income tax returns filed for calendar years 2000 through 2007 are currently being examined by the IRS. With regard to calendar years 2000 through 2004, we have agreed to extend the statute of limitations for the assessment of tax to June 30, 2009 and will continue to do so as necessary. All such statute of limitation extensions have limited the scope of the examinations to the recognition of certain tax benefits that were generated through our investment in a portfolio of residual interests in REMICs.
Insurance in 2009. Radian Insurance has not paid any dividends to Radian Guaranty, its immediate parent company. Radian Guaranty paid $150.9 million of dividends in 2007 to Radian Group and transferred its investment in Sherman of $104 million in 2007 to a direct subsidiary of Radian Group. Radian Group contributed the outstanding capital stock of Radian Asset Assurance to Radian Guaranty in 2008, strengthening Radian Guaranty’s statutory capital.
Commonwealth Mortgage Assurance Company of Texas’s (“CMAC of Texas”) ability to declare dividends on its common stock is restricted by certain provisions of the insurance laws of the State of Texas, its state of domicile. The insurance laws of the State of Texas limit the maximum amount of dividends that may be paid from positive unassigned surplus by an insurer without prior approval by the Texas Insurance Commissioner. Under such test, the Company 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’ unassigned surplus, or (ii) the preceding year-end statutory net income. In accordance with such restrictions, no dividends may be paid in 2009 without prior regulatory approval.
Under Illinois insurance regulations, Amerin Guaranty is required to maintain statutory-basis capital and surplus of $1.5 million. Amerin Guaranty’s statutory net loss and statutory policyholders’ surplus as of and for the years ended December 31 was as follows:
Under Texas insurance regulations, to be an authorized reinsurer, CMAC of Texas is required to maintain a minimum statutory surplus of $20 million. CMAC of Texas’s statutory net (loss) income and statutory policyholders’ surplus as of and for the years ended December 31 was as follows:
In January 2009, Radian Group contributed $25 million to CMAC of Texas. This amount is included in policyholders’ surplus as of December 31, 2008.
(b) In accordance with New York insurance law, financial guaranty insurance companies are required to establish a contingency reserve in the amount prescribed by legislation. Such legislation requires that, for financial guaranty policies, each insurer must establish a contingency reserve equal to the greater of 50% of premiums written or a stated percentage of the principal guaranteed, ratably over 15-20 years dependent upon the category of obligation insured. Contingency reserves may be discontinued if the total reserve established for all categories of obligations exceeds the sum of the stated percentages for such categories multiplied by the unpaid principal guaranteed. The contingency reserve may be released with regulatory approval to the extent that losses in any calendar year exceed a pre-determined percentage of earned premiums for such year, with the percentage threshold dependent upon the category of obligation insured. Such reserves may also be released, subject to regulatory approval in certain instances, upon demonstration that the reserve amount is excessive in relation to the outstanding obligations. Reinsurers are required to establish a contingency reserve equal to their proportionate share of the reserve established by the 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.
(d) STAT financial statements only include a provision for current income taxes as a component of net income. Deferred taxes, subject to certain limitations set forth in Statement of Statutory Accounting Principles (“SSAP”) 10, are recorded in the STAT balance sheets with any changes thereto recognized via a change in statutory surplus. Purchases of tax and loss bonds are accounted for as investments under STAT. GAAP financial statements provide for current and deferred income taxes in our consolidated statements of operations, and purchases of tax and loss bonds are recorded as prepaid federal income taxes in our consolidated balance sheets.
(h) Under STAT, SFAS No. 133 is not applicable, except for changes associated with known credit losses. Any derivative loss payments that are made are included in the provision for losses.
(i) Under STAT, SFAS No. 140 and FIN 46R are not applicable.
In 2008, our stockholders approved a new equity compensation plan, the Radian Group Inc. 2008 Equity Compensation Plan (the “2008 Equity Plan”), under which we may grant incentive stock options, non-qualified stock options, restricted stock, stock appreciation rights (referred to as “SARs”), performance shares and phantom stock. In adopting the 2008 Equity Plan, we agreed not to issue any more shares under our existing equity plan, the 1995 Equity Compensation Plan, (the “1995 Equity Plan”). We issued shares under both the 1995 Equity Plan and the 2008 Equity Plan (together the “Equity Plans”) during 2008. To date, all awards granted under the Equity Plans have been in the form of non-qualified stock options, restricted stock and phantom stock. The Equity Plans provide that any grant of non-qualified stock options (other than incentive stock options to holders of 10% of our voting shares) must be at an option price per share equal to 100% of the market price of our common stock on the date of grant. The 2008 Equity Plan authorizes the issuance of up to 1,800,000 shares of our common stock, of which there are approximately 557,893 shares remaining available for grant as of December 31, 2008. Officers and other employees (of Radian Group or its affiliates) and advisors and consultants are eligible to participate in the 2008 Equity Plan. Non-employee directors are also eligible to participate in the 2008 Equity Plan (and were eligible to participate in the 1995 Equity Plan), but are not permitted to receive grants of incentive stock options.
For the years ended December 31, 2008, 2007 and 2006, we recorded stock-based compensation expense of $8.7 million, $9.8 million and $10.8 million, respectively, of which $1.4 million, $3.4 million, and $3.8 million, respectively, was deferred as policy acquisition costs. The stock-based compensation expense for the year ended December 31, 2008 caused loss before income taxes and net loss to increase by $7.3 million and $4.8 million, respectively, and both basic and diluted earnings per share to decrease by $0.06 per share. The stock-based compensation expense for the year ended December 31, 2007 caused loss before income taxes and net loss to increase by $6.4 million and $4.2 million, respectively, and both basic and diluted earnings per share to decrease by $0.05 per share. The 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. Cash provided by operating activities decreased and cash provided by financing activities for the years ended December 31, 2007 and 2006 increased by $5.5 million and $4.8 million, respectively, related to excess tax benefits from stock-based payment arrangements. There were no excess tax benefits from stock-based payment arrangements for 2008.
We elected to apply the short-cut method in accounting for the windfall tax benefits under SFAS No. 123R. Should future offsets to the windfall as a result of cancellations, expirations or exercise shortfalls exceed the balance of $26.8 million at December 31, 2008, the excess would be reflected in the Consolidated Statements of Operations.
The table summarizes information regarding fully vested share options as of December 31, 2008, 2007 and 2006:
The Compensation Committee has issued grants of restricted stock under the Equity Plans. The shares underlying a grant are issued in consideration for services rendered having a value, as determined by our board of directors, at least equal to the par value of the common stock. If a grantee’s relationship with us terminates while the shares are subject to restrictions imposed by the Compensation Committee, the restricted stock grant will terminate with respect to all shares that are subject to restrictions, and such shares must be immediately returned to us. While shares are subject to restrictions, a grantee may not sell, assign, transfer, pledge or otherwise dispose of the shares of our common stock, except to a successor grantee in the event of the grantee’s death. All restrictions imposed under a restricted stock grant lapse after the applicable restriction period or earlier upon a change of control of Radian Group or upon a participant’s retirement, death or disability under the 2008 Equity Plan. Each share of restricted stock is granted at full value with no exercise price.
Changes in our restricted stock under the Equity Plans were as follows:
As of December 31, 2008 and 2007, unrecognized compensation expense related to the unvested portion of all of our stock-based awards was approximately $26.1 million and $49.8 million, respectively. Absent a change of control under the Equity Plans, this cost is expected to be recognized over a weighted average period of approximately 1.4 years.
We have an Employee Stock Purchase Program. In the past, we have issued shares under this program pursuant to our 1997 Employee Stock Purchase Plan (the “1997 ESPP Plan”), which terminated February 11, 2009. Under the 1997 ESPP Plan, we sold 245,693 and 16,324 shares to employees during the years ended December 31, 2008 and 2007, respectively. The amount recorded as stock-based compensation related to the 1997 ESPP Plan for the years ended December 31, 2008, 2007 and 2006 was $0.7 million, $0.1 million and $0.2 million, respectively.
The 2008 ESPP Plan and the 1997 ESPP Plan were designed to allow eligible employees to purchase shares of our stock at a discount of 15% off the beginning-of-period or end-of-period (each period being the first and second six calendar months in a calendar year) fair market value of the stock, whichever is lower.
The Officer LTI Plan is structured as a performance-based, long-term cash plan that consists of grants of cash performance award opportunities. The Compensation Committee administers the Officer LTI Plan and is responsible for, among other items, establishing the target values of awards to participants and selecting the specific performance factors, which can include retention based service goals, for such awards. At the end of the performance period, the Compensation Committee determines the specific cash payout to each participant, which may range from a minimum of 0% of the target award to 400% of the target award, based on the degree to which each of the performance measures has been satisfied. All payouts will be paid in cash in a lump sum (there is no stock awarded under the Officer LTI Plan), net of applicable withholdings. Performance over the initial performance period, which began July 1, 2008 and ends December 31, 2010, will be based on our stock price growth (above a minimum threshold price), with a range of possible payouts corresponding to ranges of certain stock prices achieved.
In general, in the event that a participant’s employment with us terminates prior to the conclusion of the three-year performance period, the award under the Officer LTI Plan is deemed forfeited and canceled. However, upon a participant’s death, disability or retirement, the participant or his or her representative may nevertheless be entitled to a payment at the end of the performance period. In the event of a change of control of Radian Group, awards under the Officer LTI plan will be paid out at 100% of the target level.
The amount of expense related to the Officer LTI Plan for the year ended December 31, 2008 was $0.5 million.
In August 2008, our board of directors adopted a new executive long-term incentive cash program, the Radian Group Inc. 2008 Executive Long-Term Incentive Cash Plan (the “Executive LTI Plan”), and granted an award to each participant under this plan. Participants in the Executive LTI Plan include our executive officers, including the Chief Executive Officer, and certain other key executives.
The Executive LTI Plan is structured as a performance-based, long-term, discretionary cash plan that consists of grants of three-year cash performance award opportunities. The Compensation Committee administers the Executive LTI Plan and is responsible for, among other items, establishing the target values of awards to participants and selecting the specific performance factors for such awards. At the end of the performance period, the Compensation Committee determines at its sole discretion the specific cash payout to each participant, which may range from a minimum of 0% of the target award to 400% of the target award, based on the Compensation Committee’s view of our overall corporate performance, the participant’s performance and the degree to which each of the performance measures has been satisfied. All payouts will be paid in cash in a lump sum (there is no stock awarded under the Executive LTI Plan), net of applicable withholdings.
In general, in the event that a participant’s employment with us terminates prior to the conclusion of the three-year performance period, the award under the Executive LTI Plan is deemed forfeited and canceled. However, upon a participant’s death, disability or retirement, the participant or his or her representative may nevertheless be entitled to a payment at the end of the performance period. In the event of a change of control of Radian Group, awards under the Executive LTI Plan will be paid out at 100% of the target level.
In conjunction with adopting the Executive LTI Plan, the Compensation Committee granted an initial award to each participant under the plan, with target award opportunities ranging from approximately 45% to 300% of the participants’ base salaries. Performance over the initial three-year performance period, which began July 1, 2008 and ends June 30, 2011, will be measured based on our: (1) mortgage insurance market share; (2) mortgage insurance credit quality; (3) stock price growth; (4) expense management; and (5) capital management.
The amount of expense related to the Executive LTI Plan for the year ended December 31, 2008 was $1.3 million.