7,314 square feet of office space in Ohio and South Carolina, serving as our mortgage insurance service center (Ohio) and space for a subsidiary office (South Carolina). The lease for our Ohio service center expires in 2015 and the space for our South Carolina office is month to month;
We currently have a co-location agreement with Xand that serves as a production and disaster location in Audubon, Pennsylvania. This agreement expires May 30, 2015.
Although the United States (“U.S.”) economy and certain housing markets remain weak compared to historical standards, home prices have been appreciating on a broad basis throughout the U.S., foreclosure activity has declined and the credit quality of recent mortgage market originations continues to be significantly better than the credit quality of our legacy portfolio. In addition, there are signs of a broader recovery in the U.S. economy, including importantly, a reduction in unemployment rates. As a consequence of these and other factors, in 2013 we have experienced improvement in our results of operations, driven primarily by a significant reduction in our incurred losses as result of a 20% decline in new primary mortgage insurance defaults compared to 2012. In addition, the growth of our mortgage insurance portfolio resulted in an increase in premiums earned.
New insurance written (“NIW”) increases our insurance in force (“IIF”) and premiums written and earned. An increase or decrease in IIF will generally have a corresponding impact on premiums earned. Cancellations of our insurance policies and other reductions of IIF, such as rescissions of coverage and claims paid, generally have a negative effect on premiums earned. The measure for assessing the impact of policy cancellations on our IIF is our persistency rate, defined as the percentage of IIF that remains on our books after any 12-month period. Insurance premiums on our monthly premium insurance policies are paid and earned over time; therefore, higher persistency rates on monthly premium insurance policies enable us to earn more premiums and recover more of our policy acquisition costs, and generally result in increased profitability. When single premium policies are cancelled by the insured because the loan has been paid off or otherwise, we accelerate the recognition of any remaining unearned premiums. Therefore, assuming all other factors remain constant, profitability increases on our single premium business when persistency rates are lower. Rescissions, which are discussed in further detail below, result in a full refund of the inception-to-date premiums received, and therefore, premiums earned are affected by any changes in our accrual for estimated rescission refunds. Additionally, premiums ceded to third-party reinsurance counterparties decrease premiums written and earned.
Changes in housing values (declines in housing values negatively impact our ability to mitigate our losses by either paying the full claim amount and acquiring the property or facilitating a sale of the property and also may negatively affect a borrower’s willingness to continue to make mortgage payments when the home value is less than the mortgage balance);
Our ability to mitigate potential losses through rescissions, denials, cancellations and the curtailment of claims submitted to us. We have taken these actions much more frequently with our legacy portfolio loans. Generally, we rescind insurance coverage when we conclude, through our review of the underwriting of a loan, that the loan was not originated in accordance with our underwriting guidelines. Generally, we deny claims when the documentation we receive is not sufficient to perfect the claim in accordance with our master insurance policy. In addition, we may cancel coverage or curtail claim payments when we identify servicer negligence, or we may make other adjustments to claims as permitted by our master insurance policy. These actions all reduce our incurred losses. Conversely, if our loss mitigation activities are successfully challenged at rates that are higher than expected, our incurred losses will increase.
Freddie Mac Transaction. In August 2013, Radian Guaranty entered into a Master Transaction Agreement with Freddie Mac (the “Freddie Mac Agreement”) related to a group of 25,760 first-liens guaranteed by Freddie Mac that were insured by Radian Guaranty and were in default as of December 31, 2011. This transaction significantly impacted our financial position in 2013 by reducing our primary delinquent loan inventory and capping Radian Guaranty’s total exposure on the entire population of loans subject to the agreement to $840 million, leaving Radian Guaranty with no additional exposure to claims on these loans. The Freddie Mac Agreement provides for the future treatment of the loans subject to the terms of the agreement including claim payments, loss mitigation activity and insurance coverage, and eliminated Radian Guaranty’s claim exposure on 9,756 loans that were delinquent and 4,586 loans that were re-performing as of July 31, 2013. The remaining loans in the original population of 25,760 loans had been paid off, had resulted in a rescission or claim denial or had become a paid claim prior to July 31, 2013. The maximum exposure of $840 million is comprised of $625 million of claim payments (consisting of $370 million of claims previously paid on this population of loans prior to July 12, 2013, which is the measurement date for purposes of the transaction, and an additional $255 million paid at closing) and $215 million related to rescissions, denials, claim curtailments and cancellations (“Loss Mitigation Activity”) on these loans. At the closing, Radian Guaranty deposited $205 million into a collateral account to cover future Loss Mitigation Activity on these loans. The amount deposited in the collateral account represents $215 million, less $10 million of Loss Mitigation Activity that had become final in accordance with the Freddie Mac Agreement prior to the date the collateral account was established. The collateral account consists of investment securities and remains on our consolidated balance sheets as a result of the rights that Radian Guaranty has with respect to the funds. Subject to certain conditions in the Freddie Mac Agreement, amounts in the collateral account may be released to Radian Guaranty over time to the extent that Loss Mitigation Activity becomes final in accordance with the terms of the Freddie Mac Agreement. From the time the collateral account was established through December 31, 2013, approximately $6.0 million of additional Loss Mitigation Activity had become final in accordance with the Freddie Mac Agreement and $142.9 million of submitted claims had been rescinded, denied, curtailed or cancelled, but were not considered final in accordance with the Freddie Mac Agreement. If the amount of Loss Mitigation Activity that becomes final in accordance with the Freddie Mac Agreement after the collateral account was established does not accumulate to $205 million prior to termination of the Freddie Mac Agreement, then any remaining funds will be paid to Freddie Mac. Radian Guaranty will continue to administer all claims submitted with respect to these loans in accordance with the applicable insurance policy for these loans and in a manner consistent with its normal claims handling practices. The Freddie Mac Agreement will terminate upon the earliest to occur of: (1) August 29, 2017; (2) any time after August 29, 2015 if the amounts remaining in the collateral account are reduced to $0; or (3) any time after August 29, 2015 if Radian Guaranty exercises its early termination option to conclude the transactions under the Freddie Mac Agreement, by paying to Freddie Mac an amount equal to the initial collateral amount less the amount of Loss Mitigation Activity that had then become final under the terms of the agreement.
Net Par Outstanding. Our net par outstanding represents principal risk exposure on insured contracts. As noted above, our net par outstanding has been declining since we discontinued writing new financial guaranty business. The decline in our net par outstanding is driven by scheduled maturities and permitted early terminations within our financial guaranty portfolio and negotiated commutations and other transactions that we have entered into to reduce our net par outstanding.
In January 2013, Radian Asset Assurance commuted the remaining $822.2 million net par that had been reinsured by Radian Asset Assurance from Financial Guaranty Insurance Company (“FGIC”), including approximately $195.9 million of our $225.3 million in net par outstanding as of December 31, 2012 related to Jefferson County, Alabama sewer warrants, a large distressed public finance credit. This commutation also included all of our exposure to general obligation bonds issued by the City of Detroit, except for $7.9 million, as of December 31, 2013. Radian Asset Assurance paid FGIC $52.4 million as part of this transaction (the “FGIC Commutation”), which payment approximated our existing loss reserves and unearned premium reserves on the commuted transactions.
Losses/Credit Performance. Our financial guaranty incurred losses are driven primarily by economic conditions that affect the ability of the issuers of our insured obligations to meet such financial obligations and by changes in the assumptions used to determine our losses, including assumptions with respect to the likelihood, magnitude and timing of anticipated losses. Stronger economic conditions increase the likelihood that obligors will have the ability to pay interest and principal on the bonds we insure. Weaker economic conditions often place strains on the revenue flows available to pay interest and principal on our insured obligations. Other significant factors influencing defaults and incurred losses include:
The potential impact of federal, state and local budgetary constraints affecting funding and payments (including Medicare and Medicaid payments) to healthcare, long-term care, educational and other governmental and non-governmental entities whose obligations we insure;
The movement of interest rates (increases in interest rates will increase the interest component of the variable rate obligations we insure, and as a result, will increase the strain on the obligors to make payments on these obligations); and
In 2013, management determined that the allocation of our consolidated provision for income taxes to the segments was no longer meaningful to the evaluation of our business results. Therefore, financial information for our business segments is disclosed on a pretax basis because senior management uses pretax results for the allocation of resources and in assessing the performance of the segments. See “-Results of Operations-Mortgage Insurance” and “-Results of Operations-Financial Guaranty.”
The following table highlights selected information related to our consolidated results of operations for the years ended December 31, 2013, 2012 and 2011:
Other Operating Expenses. Among other items, our other operating expenses include compensation expense associated with changes in the estimated fair value of certain cash-settled long-term incentive awards that are valued, in large part, based on the stock price of Radian Group’s common stock, which increased significantly during 2013. During 2013, our expense related to these awards was approximately $96.9 million compared to approximately $29.5 million for 2012. Other operating expenses increased in 2012 as compared to 2011, primarily due to changes in the estimated fair value of certain cash-settled long-term incentive awards that are valued, in large part, based on the stock price of Radian Group’s common stock, which increased significantly during 2012, as well as a reduction in the amount of acquisition costs that were deferred in accordance with the update to the accounting standard regarding accounting for costs associated with acquiring or renewing insurance contracts. Partially offsetting the increases in operating expenses in 2013 and 2012 were ceding commissions earned related to the Reinsurance Transactions. See “-Results of Operations-Mortgage Insurance-Reinsurance” for information regarding the Reinsurance Transactions.
Income Tax (Benefit) Provision. The effective tax rate was 4.9% for 2013 compared to (1.6)% for 2012 and 18.0% for 2011. The change from our statutory tax rate of 35% for each of the last three years was primarily due to changes in our overall valuation allowance against our DTA. Additionally, our 2013 and 2011 effective tax rates were also impacted by the accounting for uncertainty of income taxes. See Note 13 of Notes to Consolidated Financial Statements for more information regarding our valuation allowance and accounting for uncertainty of income taxes.
Use of Non-GAAP Financial Measures. In addition to the traditional GAAP financial measures, we have elected to include in this report certain non-GAAP financial measures, “adjusted pretax operating income,” “adjusted net operating income” and “adjusted diluted net operating income per share” among our key performance indicators to facilitate evaluation of our fundamental financial performance. These measures have been established in order to increase transparency for the purpose of evaluating our core operating trends and enable more meaningful comparisons with our competitors. We believe these measures aid in understanding the underlying performance of our operations.
Adjusted pretax operating income adjusts GAAP pretax income to remove the effects of net gains (losses) on investments and other financial instruments and net impairment losses recognized in earnings. It also excludes gains and losses related to changes in fair value estimates on insured credit derivatives and includes the impact of changes in the present value of insurance claims and recoveries on insured credit derivatives, based on our ongoing insurance loss monitoring, as well as premiums earned on insured credit derivatives.
Net gains (losses) on investments and other financial instruments. The recognition of realized investment gains or losses can vary significantly across periods as the activity is highly discretionary based on the timing of individual securities sales due to such factors as market opportunities, our tax and capital profile and overall market cycles. Unrealized investment gains and losses arise primarily from changes in the market value of our investments that are classified as trading. These valuation adjustments may not necessarily result in economic gains or losses. We do not view them to be indicative of our fundamental operating activities. Trends in the profitability of our fundamental operating activities can be more clearly identified without the fluctuations of these realized and unrealized gains or losses. Therefore, these items are excluded from our calculation of adjusted pretax operating income.
Estimated present value of net credit (losses) recoveries incurred. The change in present value of insurance claims we expect to pay or recover on insured credit derivatives represents the amount of the change in credit derivatives from item 3 above, that we expect to result in an economic loss or recovery based on our ongoing loss monitoring analytics. Therefore, this item is expected to have an economic impact and is included in our calculation of adjusted pretax operating income.
Adjusted pretax operating income is not a measure of total profitability, and therefore should not be viewed as a substitute for GAAP pretax income. Our definition of adjusted pretax operating income may not be comparable to similarly-named measures reported by other companies.
EPS impact of adjustments from net loss to adjusted net operating loss as described above.
“Adjusted diluted net operating loss per share” consists of “Adjusted net operating loss” divided by the weighted-average number of common and common equivalent shares outstanding on a diluted basis. Interest expense, shares issuable on convertible debt and the impact of stock-based compensation arrangements have been reflected in the per share calculations consistent with the accounting standard regarding earnings per share, whenever the impact is dilutive.
The following table summarizes our mortgage insurance segment’s results of operations for the years ended December 31, 2013, 2012 and 2011:
Pretax Loss. Our mortgage insurance segment’s pretax loss for 2013 was $93.2 million, compared to $244.6 million for 2012. As explained in more detail below, we experienced improved results in our mortgage insurance segment in 2013 compared to 2012, primarily reflecting a significant decrease in the provision for losses partially offset by net losses on investments in 2013 (compared to net gains on investments in 2012) and an increase in other operating expenses. Adjusted pretax operating income for the mortgage insurance segment totaled $2.9 million for 2013. Based on our projections, which are subject to significant risks and uncertainties, we expect continued improvement in the operating results of our mortgage insurance segment in 2014.
In 2009, the GSEs began offering the Homeowner Affordable Refinance Program (“HARP”). HARP allows a borrower who is not delinquent to refinance a mortgage if the borrower has been unable to take advantage of lower interest rates because the borrower’s home has decreased in value. Radian Guaranty and other private mortgage insurers have agreed with the Federal Housing Finance Agency (“FHFA”) to facilitate the transfer of mortgage insurance on loans to be refinanced through HARP without regard to LTV. In November 2011, the FHFA extended the program and made enhancements to the HARP program (“HARP 2”) that expanded the number of borrowers who can qualify for refinancing. The changes implemented by the enhanced HARP 2 program have increased the number of borrowers who are eligible to benefit from the program and, as of December 31, 2013, approximately 11% of our total primary RIF had successfully completed a HARP refinance. The HARP 2 program has now been extended until December 31, 2015. We exclude HARP loans from our NIW for the period in which the refinance occurs; however, the HARP programs have had a positive impact on the overall credit quality and composition of our mortgage insurance portfolio given that the refinancing generally provides a borrower with a greater ability to pay and more financial flexibility to cover the loan obligations. During 2013, new HARP loans accounted for $7.6 billion of newly refinanced loans that were not included in Radian Guaranty’s NIW for that period, compared to $8.9 billion for 2012.
On March 27, 2013, the FHFA announced its new streamlined loan modification initiative, which was effective as of that date. This new program eliminates the need for borrowers who are applying for modifications to document their hardship or financial information. Instead, borrowers must be at least 90 days delinquent and no more than 24 months delinquent on their mortgage to qualify for a loan modification. We believe this streamlined modification program will further assist delinquent borrowers. As of July 1, 2013, servicers were required to begin offering the modification program to eligible borrowers. The streamlined modification program is scheduled to end on August 1, 2015. We wrote a modest amount of NIW from this program during 2013.
The following tables provide selected information as of and for the periods indicated related to mortgage insurance NIW, RIF and IIF. Because we continue to receive premiums on the related loans and the insurance remains in force, primary RIF and IIF amounts at December 31, 2013, include $542 million and $2,150 million, respectively, related to the loans subject to the Freddie Mac Agreement.
Includes amounts related to loans subject to the Freddie Mac Agreement.
“Fully Indexed” refers to loans where payment adjustments are equal to mortgage interest-rate adjustments.
Net premiums earned increased for 2013 compared to 2012, primarily due to increases in direct premiums earned as a result of an increase in NIW and a decrease in premiums refunded in connection with rescissions in 2013 compared to 2012. The increase in net premiums earned in 2013 was partially offset by an increase in ceded premiums earned related to the Reinsurance Transactions. Net premiums earned increased in 2012 compared to 2011 for the same reasons.
Radian Guaranty agreed to cede to the reinsurer 20% of all premiums and losses incurred with respect to conventional GSE loans and will initially receive a 35% ceding commission; provided that if we do not exercise our Commutation Option, the ceding commission will be reduced to 30% for the portion of the ceded RIF that was subject to the Commutation Option; and
During 2011 and 2012, as market prices of our investments increased, we made the decision to sell securities in our portfolio and reinvest the proceeds in similar securities. The realized gains from these sales, some of which had previously been unrealized, were additive to the respective statutory capital position of our subsidiaries that held the investments. During 2011, we sold our investment in a portfolio of tobacco bonds and recognized a $21.7 million realized loss in our mortgage insurance segment, which was offset by gains on sales of other securities in our trading portfolio during the same period of 2011.
Provision for Losses. Our mortgage insurance provision for losses decreased significantly in 2013 compared to 2012 and in 2012 compared to 2011. The following table details the financial impact of the significant components of our provision for losses for the periods indicated:
The financial impact for each component has been recalculated on a full year basis, such that the sum of the individual quarterly impacts within each respective year do not equal the recalculated impacts. For example, the impact from a loan that defaults in one quarter that then cures in the next quarter of the same year is not reflected within the full year provision for losses, as the net impact is zero for the full year period.
Our mortgage insurance provision for losses for 2013 decreased by $356.9 million as compared to 2012. This decrease was driven primarily by a continued decline in new defaults and less adverse development in our estimate of future losses on existing defaults, mainly due to claim curtailments and cures for which we experienced higher rates in 2013. Additionally in 2013, the adverse development on existing defaults in the provision for losses includes an incurred loss of approximately $22 million related to the Freddie Mac Agreement. This loss is expected to be offset by a reduction of incurred losses in future periods, as a portion of currently performing loans covered by the transaction (and for which we no longer have claim exposure) re-default in the future and ultimately become claims. In 2012, we experienced an increase in other losses related to a $44 million write-down in our estimated reinsurance recoverable from our remaining capital markets reinsurance transactions (“Smart Home”). Our final Smart Home reinsurance transaction matured in May 2013.
Our mortgage insurance provision for losses also improved for 2012 relative to 2011. This decrease was driven primarily by a decline in new default notices, an increase in claim denials and an improvement in the composition of the delinquent loan inventory (mainly associated with a reduction in the adverse impact to reserves related to the aging of existing defaults), as compared to the corresponding periods of 2011. Partially offsetting these positive developments was a decrease in our estimated reinsurance recoverable from our remaining Smart Home transactions referred to above.
Our first-lien primary default rate at December 31, 2013 was 7.3% compared to 12.1% at December 31, 2012. Our primary defaulted inventory comprised 60,909 loans at December 31, 2013, compared to 93,169 loans at December 31, 2012, representing a 34.6% decrease. The Freddie Mac Agreement contributed to this decrease by eliminating Radian Guaranty’s claim exposure on 9,756 delinquent loans. Our primary defaulted inventory declined by an additional 3% in January 2014 from December 31, 2013. In addition to the impact of the Freddie Mac Agreement, the reduction in our primary defaulted inventory is the result of the total number of defaulted loans: (1) that have cured; (2) for which claim payments have been made; or (3) that have resulted in net insurance rescissions and claim denials, collectively exceeding the total number of new defaults on insured loans. Despite this positive trend, which we expect to continue, our overall primary default rates remain elevated compared to historical levels, driven primarily by the poor performance of our legacy portfolio.
Represents the weighted average default to claim rate before consideration of estimated rescissions, denials and reinstatements of rescissions and denials for each category of defaulted loans.
Excludes 7,221 loans subject to the Freddie Mac Agreement that are in default at December 31, 2013, as we no longer have claims exposure on these loans.
The table below shows the details related to the number of rescinded policies and denied claims for the periods indicated. Recent trends in insurance rescissions and claim denial activity reflect a decrease in the number of policies rescinded and claims denied, and an overall increase in the number of claims denied that subsequently have been perfected and reinstated. This increase in reinstated denials is partly due to lenders and servicers challenging a greater number of denials, as well as the overall effectiveness of these challenges based on their ability to produce new or additional information that supports a perfection of a claim payment.
Generally, we estimate our claim liability related to the potential future reinstatement of these previously rescinded policies and denied claims by estimating an initial gross reinstatement rate at the time of denial or rescission, which then declines over a 12- or 24-month timeframe based on our expectation that there is a reduced likelihood that a reinstatement will occur as time passes from our initial decision regarding a denial or rescission. As of December 31, 2013, for previously denied claims, this initial gross reinstatement assumption begins at approximately 60% and declines to 0% after 12 months, while for previously rescinded policies, the initial assumed reinstatement rate begins at approximately 20% and declines to 0% after 24 months. Our IBNR reserve estimate also includes the projected potential impact from future estimated rescissions on reinstated denials. Therefore, at any particular point in time, our IBNR reserve estimate with respect to previously rescinded policies or denied claims is affected not only by our initial reinstatement assumption, but also by the length of time since the denial or rescission, our estimated likelihood of such reinstatements resulting in a paid claim, and the expected claim curtailments on such paid claims, as well as the potential outcome of any discussions with our lender and servicer customers regarding such rescissions or denials.
Projected net cumulative rescission/denial rates represent the ratio of claims rescinded or denied to claims received (by claim count). Rescissions and denials are net of actual reinstatements, plus our current estimate for expected reinstatements of previously rescinded policies or denied claims (excluding certain potential reinstatements we are in the process of discussing with servicers). These projected amounts represent the cumulative rates for each quarter as of December 31, 2013. Until all of the claims received during the periods shown have been internally resolved, the rescission/denial rates for each quarter will be subject to change; these rates also will remain subject to change based on differences between estimated and actual reinstatements of previously rescinded policies or denied claims.
The percentage of claims resolved for each quarter presented in the table above represents the number of claims that have been internally resolved as a percentage of the total number of claims received for that specific quarter. A claim is considered internally resolved when it is either paid or it is concluded that the claim should be denied or rescinded, though such denials and rescissions could be challenged and potentially reinstated or overturned. For the third and fourth quarters of 2013, a significant portion of claims received for those quarters have not been internally resolved; therefore, we do not believe the projected net cumulative rescission/denial rates for those periods are presently meaningful.
Primarily represents ceded losses on captive transactions, Smart Home (for 2012 and 2011) and the Reinsurance Transactions.
Our mortgage insurance total loss reserve as a percentage of our mortgage insurance total RIF was 5.2% at December 31, 2013, compared to 8.5% at December 31, 2012 and 9.8% at December 31, 2011.
The following table shows claims paid by product and average claims paid by product for the periods indicated:
Calculated without giving effect to the impact of the Freddie Mac Agreement and the termination of captive transactions and first- and second-lien transactions.
The following table shows the gross amount of direct claims paid by policy origination year as of the periods indicated:
Other operating expenses increased in 2012 as compared to 2011, primarily due to the increase in the estimated fair value of certain cash-settled long-term incentive awards that are valued, in large part, based on the stock price of Radian Group’s common stock, which increased significantly during 2012. Results in 2012 also reflect a reduction in the amount of acquisition costs that were deferred in accordance with the update to the accounting standard regarding accounting for costs associated with acquiring or renewing insurance contracts. Included in 2011 was $9 million in costs related to certain technology projects that we wrote-off in the third quarter of 2011.
Contract underwriting expenses for 2013, including the impact of reserves for contract underwriting remedies, were $6.1 million, compared to $12.1 million for 2012 and $16.1 million for 2011. During 2013, loans underwritten via contract underwriting accounted for 3.5% of applications, 3.5% of commitments for insurance and 3.4% of insurance certificates issued, compared to 5.0%, 4.9% and 5.0%, respectively, for 2012 and 8.8%, 8.2% and 8.7%, respectively, for 2011.
Interest Expense. These amounts reflect the allocated portion of interest on Radian Group’s long-term debt based on the relative GAAP equity for our mortgage insurance segment. The increase in 2013 compared to 2012 is primarily related to the issuance of $400 million of debt in March 2013.
Our aggregate financial guaranty net par outstanding decreased approximately 29% in 2013, from $33.7 billion as of December 31, 2012 to $23.9 billion as of December 31, 2013. We expect our net par outstanding will continue to decrease as our financial guaranty insured portfolio matures, we seek to reduce our financial guaranty net par outstanding, and counterparties potentially continue to terminate transactions early in accordance with their rights under such transactions. The reduction in our financial guaranty net par outstanding in 2013 was primarily due to the CDO Early Terminations, the FGIC Commutation, the prepayments of public finance obligations, and the amortization or scheduled maturity of our financial guaranty insured portfolio. See “-Key Factors Affecting Our Results-Financial Guaranty-Net Par Outstanding” for additional information regarding the FGIC Commutation and the CDO Early Terminations.
Represents the net (asset) liability recorded within derivative assets or derivative liabilities for derivative contracts, or the net (asset) liability recorded within VIE debt and other financial statement line items for financial guaranty consolidated VIEs.
Includes $1.5 billion and $1.6 billion at December 31, 2013 and 2012, respectively, of tax supported revenue bonds.
Escrowed transactions are legally defeased bond issuances where cash or U.S. government securities, in an amount sufficient to pay remaining obligations under such bonds, have been deposited in an escrow account for the benefit of the bond holders. Although we have little to no remaining credit risk on these transactions, they remain outstanding for GAAP purposes.
Our net claim liability to Sovereign exposures as of December 31, 2013 was $7.6 million, the majority of which is related to a Spanish infrastructure project. Our Sovereign net par exposure to the Stressed European Countries was $92.3 million as of December 31, 2013, of which $49.3 million is related to Spain, $21.9 million is related to Hungary, $20.2 million is related to Italy and $0.9 million is related to Portugal, with no such exposure to Ireland or Greece.
In January 2014, a counterparty to a $450 million AAA-rated CDO of CMBS exercised its right to terminate the transaction on a walkaway basis.
$4.5 million or 3.6% of this net par outstanding is related to underlying obligations that are also rated BIG.
The following table provides a breakdown by our internal credit ratings of our financial guaranty net par outstanding as of December 31, 2013 and 2012, respectively:
Escrowed transactions are legally defeased bond issuances where cash or U.S. government securities in an amount sufficient to pay remaining obligations under such bonds have been deposited in an escrow account for the benefit of the bond holders. Although we have little to no remaining credit risk on these transactions, they remain outstanding for GAAP purposes.
Although there were par reductions in all ratings categories during 2013, the largest reductions were in the AAA rating category, primarily due to the CDO Early Terminations and scheduled maturities of our most highly rated insured obligations. This caused a shift in the ratings distribution of our insured portfolio during 2013. At December 31, 2013, the percentage of our net par outstanding of obligations rated AAA, BBB and BIG was 38.5%, 34.7% and 9.2%, respectively, compared to 45.1%, 31.2% and 8.3%, respectively, at December 31, 2012.
Public Finance. Our public finance insured portfolio continues to experience some stress from the current economic environment. As of December 31, 2013, our net claim liability for general municipal obligations and other tax supported credits increased to $12.9 million from $10.0 million at December 31, 2012. In general, municipal governments have been negatively impacted by the most recent recession and subsequent period of limited economic growth. For example, there have been several municipal defaults and bankruptcy filings since the beginning of 2012, including several bankruptcy filings by California municipalities. Although we do not have general obligation exposure to any of the California municipalities that have filed for bankruptcy thus far, developments in these cases could possibly serve to encourage bankruptcy filings by other severely distressed municipalities. As of December 31, 2013, we had $83.8 million of net par exposure (excluding escrowed transactions) to general obligations of California municipalities, of which 88% of the net par outstanding is currently rated investment grade.
As of December 31, 2013, we have an aggregate of $451.9 million of net par outstanding (excluding escrowed transactions) relating to indebtedness issued by the Commonwealth of Puerto Rico (“Puerto Rico”) and certain of its agencies and instrumentalities (our “Puerto Rico Exposure”). While Puerto Rico has taken a number of significant steps to improve its budgetary position and financial condition, it remains in a multi-year recession and continues to suffer from high debt levels, persistent structural budget deficits that require additional borrowing and an under-funded pension system. In February 2014, Standard & Poor’s Financial Services LLC (“S&P”), Moody’s Investor Service (“Moody’s”) and Fitch Ratings downgraded the credit rating of Puerto Rico and its debt below investment grade to BB+, Ba2 and BB, respectively. These fiscal issues have resulted in volatile pricing on its debt securities, which together with the recent downgrades of Puerto Rico’s published ratings to BIG may constrain Puerto Rico’s future access to capital markets at reasonable cost. Even without such constraints, it is expected that it will take several years to erase current deficits and provide for sustainable structurally balanced budgets. These issues and developments are likely to negatively impact Puerto Rico’s financial condition. Therefore, we believe there are constraints on Puerto Rico’s access to capital markets for the necessary liquidity to support government operations and capital development. We further believe our Puerto Rico Exposure remains vulnerable to further ratings downgrades and negative net claim liability developments. Despite these concerns, we do not currently anticipate paying claims on any of our Puerto Rico Exposure.
As of December 31, 2013, we had an aggregate of $172.9 million of Sovereign net par outstanding, $100.8 million of which was rated at least investment grade, and $72.1 million of which was rated BIG. All of our BIG exposure relates to the Stressed European Countries whose Sovereign obligations have been under particular stress due to economic uncertainty, potential debt restructuring and ratings downgrades. Due to volatile economic conditions and political uncertainty, particularly in the Stressed European Countries, we believe that our Sovereign insured credits in the Stressed European Countries remain vulnerable to further credit deterioration, potential ratings downgrades and increases in our net claim liability.
The following table sets forth the internal credit ratings assigned to our total CDO exposures as of December 31, 2013:
The credit performance of our $7.3 billion corporate CDO portfolio continues to improve and we continue to have strong subordination remaining in our corporate CDO transactions, all of which are scheduled to mature in either 2014 or 2017. There were no credit events that reduced subordination levels in our corporate CDO transactions. All but $0.8 billion of the corporate CDO transactions we insure were rated AAA as of December 31, 2013.
Represents the lower of the ratings of the underlying corporate entities as determined by Moody’s and S&P. Each rating within a letter category includes all rating grades within that letter category (e.g., an “A” rating includes “A+” “A” and “A-”).
The following table provides information regarding the subordination for our directly insured corporate CDO portfolio as of December 31, 2013, by year of scheduled maturity.
No directly insured corporate CDO transactions are scheduled to mature in 2015 or 2016. All of our directly insured corporate CDO transactions are scheduled to mature on or before December 31, 2017.
Does not include our one insured corporate CDO of CDOs with a net par outstanding of $3.9 million, with a legal maturity date in 2018, because the payments of principal and interest on this CDO depend on the cash flows actually generated from the CDO’s underlying collateral and the likelihood that we would have to pay a claim is not measurable in terms of sustainable credit events.
We continue to see stabilization and improved performance across many of the transactions in our $972.6 million directly insured TruPs CDO portfolio. The banking sector continues to face increasing pressure from regulatory compliance costs, limited growth in loan portfolio and reduced earnings from a flattening yield curve. Smaller community banks, which comprise a significant portion of the issuers in our directly insured TruPs CDO portfolio, face these pressures most acutely, due to additional pressure from their lack of economies of scale, limited revenue resources and often undiversified businesses. Notwithstanding these pressures, the collateral fundamentals of the bank issuers within these insured transactions continue to show improved performance. The number of cures of previous defaults and the repayment of interest payments previously deferred on the TruPs collateral has outpaced new initial defaults and interest payment deferrals by the TruPs issuers, which is permissible for up to five years. The insurance company issuers in our TruPs CDO portfolio generally remain stable. As of December 31, 2013, our weighted average rating for our directly insured TruPs bonds improved from BBB- at December 31, 2012 to BBB as of December 31, 2013, primarily due to ratings upgrades on four transactions in the first quarter of 2013. As of December 31, 2013, $224.7 million of our net par outstanding related to two of the TruPs bonds we insure was rated BIG compared to $314.4 million of net par outstanding related to three TruPs bonds that we insured as of December 31, 2012.
Internally generated interest coverage ratio for each TruPs bond equal to the gross interest collections on the TruPs collateral minus transaction expenses as a percentage of the sum of hedge payments and interest payable on the TruPs bond and securities senior to, or ranking equally with, the TruPs bond.
The transactions with a CDS Termination Date prior to the TruPs CDO Maturity Date provide for automatic annual one-year extensions (absent written notifications from our counterparty) until the TruPs CDO Maturity Date.
Our $1.8 billion of insured CDO of CMBS transactions experienced mixed performance in 2013. During 2013, the average total delinquencies in the collateral supporting each of our four directly-insured CDOs of CMBS decreased. However, average loss severity across the CMBS backing these CDOs increased during 2013, and interest shortfalls occurred in 12 of the 126 CMBS tranches that back the CDOs we insure as a result of: (1) reductions in the appraised value of properties, which allows servicers to stop making advances for interest; and (2) expenses related to the liquidation of certain properties. Our maximum total exposure to interest shortfalls on our CDO of CMBS transactions is limited to the estimated $3.5 million of contractual premium that is payable to us over the remaining life of the contracts. Although we project that future interest shortfalls will result in reductions in the amount of premiums we receive for a period of time, based on our internal cash flow projections, we also expect that such amounts will eventually be repaid to us.
During the second quarter of 2013, one of the CMBS tranches backing one of our CDO of CMBS transactions experienced a principal loss. Since then, additional principal losses on this CDO of CMBS were recorded such that the total principal loss has reduced the subordination for the transaction by approximately $10.2 million of the initial $97.5 million of subordination. Due to this deterioration in the performance of this CDO of CMBS transaction, we downgraded its rating from AA to AA- in the second quarter of 2013. The ratings for our other CDO of CMBS transactions remained unchanged as of December 31, 2013, with two rated AAA and one rated BBB-. In January 2014, our counterparty to a $450 million AAA-rated transaction exercised its right to terminate the transaction on a walkaway basis (meaning that our counterparty was not obligated to pay any unaccrued premium or other amount to terminate the transaction). We continue to expect not to have to pay net claims on our CDO of CMBS transactions.
The following table provides information regarding attachment points, credit ratings, the underlying CMBS tranches in the collateral pools, subordination and delinquencies in our directly insured CDOs of CMBS exposure as of December 31, 2013:
During 2013, we twice lowered our rating on a CLO of middle market loans that we insure in a second-to-pay position through a CDS (the “CLO Transaction”) with $388.7 million of net par outstanding as of December 31, 2013. We decreased our internal rating for this transaction from BB+ to B+ in 2013, primarily as a result of the deteriorating credit quality of the primary insurer of the CLO Transaction, MBIA.
The following table summarizes the results of operations for our financial guaranty segment for the years ended December 31, 2013, 2012 and 2011:
Net Premiums Written and Earned. Net premiums written and earned for 2013 reflect the impact of the FGIC Commutation, which decreased premiums written and earned by $12.6 million and $2.5 million, respectively. Net premiums written and earned for 2012 reflect the impact of the Assured Transaction, which resulted in a decrease of $119.8 million and $22.2 million in net premiums written and earned, respectively. Net premiums written and earned for 2011 reflect a significant commutation of reinsurance exposure with one of our ceding companies, which reduced premiums written and accelerated premiums earned. Our premiums earned for all years have also been reduced commensurate with the decrease in our net par outstanding, offset in part by a stable level of refundings of our public finance exposures.
During 2013, net unrealized losses mainly relate to change in fair value of our core fixed-income bond portfolio primarily as a result of an increase in interest rates during the second quarter. During 2012 and to a lesser extent in 2013, as market prices of our investments strengthened, we made the decision to sell securities in our portfolio and reinvest the proceeds in similar securities. The realized gains from these sales, some of which had previously been unrealized, were additive to the respective statutory capital positions of our subsidiaries that held the investments. During 2013, the majority of realized gains on sales relate to sales of international Sovereign bonds. Net gains on investments for 2011 were impacted by our sale of our investment in a portfolio of tobacco bonds for which we recognized a $32.0 million realized loss in our financial guaranty segment that was more than offset by gains on sales of other securities in our trading portfolio during 2011.
Radian Group’s five-year CDS spread is an observable quantitative measure of our non-performance risk and is used by typical market participants to determine the likelihood that we will default on our obligations; the CDS spread that we actually use in the valuation of our specific fair value liabilities is typically based on the remaining term of the insured obligation, rather than five years. Non-performance risk is commonly measured by default probability, with a credit spread tightening indicating a lesser probability of default. Radian Group’s five-year CDS spread at December 31, 2013 implies a market view that there is a 22.9% probability that Radian Group will default on its obligations in the next five years, as compared to a 47.7% implied probability of default at December 31, 2012 and an 83.5% probability of default at December 31, 2011.
Represents the present value of our estimated credit loss recoveries (net of estimated credit loss payments) for those transactions for which we currently anticipate paying net losses or receiving recoveries of losses already paid. The present value is calculated using a discount rate of approximately 1.9%, which approximates the average investment yield as reported in our most recently filed statutory financial statements. As illustrated above, expected recoveries for our insured credit derivatives and VIEs exceeded estimated credit loss payments for these transactions as of December 31, 2013. This is primarily a result of our expected recovery on six TruPs (“Terminated TruPs CDOs”) that we commuted in April 2012 as part of the Commutation Transactions. We are entitled to recoveries related to these Terminated TruPs CDOs to the extent that any funds previously placed in a consolidated VIE as part of the commutation are remaining after the payment by the consolidated VIE of any credit losses on the Terminated TruPs CDOs.
The results for 2013, 2012 and 2011 were impacted by the change in Radian Group’s five-year CDS spread. Radian Group’s five-year spread tightened by 590 basis points in 2013 and by 1,819 basis points during 2012, resulting in unrealized losses, compared to the spread widening by 2,267 basis points in 2011, which resulted in unrealized gains. See “
We are a credit enhancement company with a primary strategic focus on domestic, residential mortgage insurance on first-lien mortgage loans (“first-liens”). We have two operating business segments-mortgage insurance and financial guaranty.
Our mortgage insurance segment offers primary mortgage insurance coverage on residential first-liens. At December 31, 2013, primary insurance on first-liens comprised approximately 95.9% of our $41.7 billion total direct risk in force (“RIF”). In the past, we also wrote pool insurance, which at December 31, 2013, comprised approximately 3.8% of our total direct RIF. Additionally, we offered other forms of credit enhancement on residential mortgage assets. These products included mortgage insurance on second-lien mortgages (“second-lien”), credit enhancement on net interest margin securities (“NIMS”), and primary mortgage insurance on international mortgages (collectively, we refer to the risk associated with these transactions as “non-traditional”). Our non-traditional RIF was $97.0 million as of December 31, 2013, representing less than 1% of our total direct RIF.
Currently, our business strategy is primarily focused on: (1) growing our mortgage insurance business by writing insurance on high-quality mortgages in the U.S. and exploring other potential alternatives for proving credit-based services to the mortgage finance market; (2) continuing to manage losses in our legacy mortgage insurance and financial guaranty portfolios; (3) continuing to reduce our legacy mortgage insurance and financial guaranty exposures; and (4) continuing to effectively manage our capital and liquidity positions.
Our businesses also are significantly impacted by, and our future success may be dependent upon, legislative and regulatory developments impacting the housing finance industry. The Federal Housing Administration (“FHA”) remains our primary competitor outside of the private mortgage insurance industry. The GSEs’ current federal charters generally prohibit them from purchasing any mortgage with a loan amount that exceeds 80% of a home’s value, unless that mortgage is insured by a qualified mortgage insurer, or the mortgage seller retains at least a 10% participation in the loan or agrees to repurchase the loan in the event of a default. As a result, high loan-to-value (“LTV”) mortgages purchased by the GSEs generally are insured with private mortgage insurance. Changes in the charters or business practices of the GSEs, including the introduction of alternatives to private mortgage insurance as a condition to purchasing high-LTV loans, could reduce the number of mortgages they purchase that are insured by us and consequently diminish our franchise value.
Since 2011, there have been numerous legislative proposals and recommendations focused on reforming the U.S. housing finance industry, including proposals that are intended to wind down the GSEs or to otherwise limit or restrict the activities and businesses of the GSEs. As a result, the future structure of the residential housing finance system, as well as the impact of any such changes on our business, remains uncertain. Although we believe that traditional private mortgage insurance will continue to play an important role in any future housing finance structure, it is possible that new federal legislation could reduce the level of private mortgage insurance coverage used by the GSEs as credit enhancement, or even eliminate the requirement altogether, which would reduce our available market and adversely affect our mortgage insurance business, our franchise value and our future prospects. In addition, the mortgage origination market and private mortgage insurers may be adversely impacted by regulatory requirements developed under the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”).
Radian Group Inc. (“Radian Group”) currently has immediately available, either directly or through an unregulated subsidiary, unrestricted cash and liquid investments of approximately $615 million, after consideration of a $100 million capital contribution made to Radian Guaranty in February 2014. The $615 million of available liquidity excludes certain additional cash and liquid investments that have been advanced from our subsidiaries for corporate expenses and interest payments. Substantially all of Radian Group’s obligations to pay corporate expenses and interest payments on outstanding debt are reimbursed to Radian Group through the expense-sharing arrangements currently in place with its subsidiaries. Currently, we expect to maintain Radian Guaranty’s risk-to-capital ratio at or below 20 to 1. However, we expect this target level to change upon the modification of GSE eligibility requirements or future changes in applicable regulatory requirements.
We discontinued writing new financial guaranty business and Radian Group contributed its ownership interest in Radian Asset Assurance to Radian Guaranty. Although this structure makes the capital adequacy of our mortgage insurance business dependent, to a significant degree, on the successful run-off of our financial guaranty business, the structure has provided Radian Guaranty with substantial regulatory capital and, through dividends from Radian Asset Assurance, has increased liquidity at Radian Guaranty.
We reduced our legacy mortgage insurance portfolio, non-traditional mortgage insurance RIF and our financial guaranty portfolio through risk commutations, discounted security purchases, ceded reinsurance and transaction settlements and terminations.
During 2013, we made further progress toward our objectives and in support of our business strategy:
In March 2013, Radian Group sold 39.1 million shares of common stock at a public offering price of $8.00 per share and received net proceeds of approximately $299.4 million.
Radian Asset Assurance continued to reduce its financial guaranty portfolio through risk commutations, discounted insured bond purchases, ceded reinsurance and transaction settlements and terminations, and continued to provide capital support to Radian Guaranty.
In January 2013, we commuted the remaining $822.2 million net par reinsured by Radian Asset Assurance from Financial Guaranty Insurance Company (the “FGIC Commutation”), resulting in the release of $6.7 million of statutory contingency reserves;
The GSEs and state insurance regulators impose various capital requirements on our insurance subsidiaries. These include risk-to-capital ratios, other risk-based capital measures and surplus requirements that potentially may limit the amount of insurance that our insurance subsidiaries may write. The GSEs and our state insurance regulators also possess significant discretion with respect to our insurance subsidiaries.
Radian Guaranty’s risk-to-capital ratio has improved to 19.5 to 1 as of December 31, 2013, from 20.8 to 1 as of December 31, 2012. Currently, we expect to maintain Radian Guaranty’s risk-to-capital ratio at or below 20 to 1. However, we expect this target level to change upon the modification of GSE eligibility requirements or future changes in applicable regulatory requirements.
As discussed above, Radian Asset Assurance is a wholly-owned subsidiary of Radian Guaranty. If the performance of our financial guaranty portfolio deteriorates, including if we are required to establish (or increase) one or more statutory reserves on defaulted obligations that we insure, or if we make net commutation payments to terminate insured financial guaranty obligations in excess of the then established statutory reserves for such obligations, the statutory capital of Radian Guaranty would also be negatively impacted. We establish statutory financial guaranty reserves at the time of default, whereas for reporting purposes under accounting principles generally accepted in the United States of America (“GAAP”), loss reserves are established when estimated losses exceed unearned premiums, regardless of whether a default has occurred. Any decrease in the statutory capital in our financial guaranty business other than a decrease resulting from the dividend or distribution of cash or other assets from Radian Asset Assurance to Radian Guaranty would therefore have a negative impact on Radian Guaranty’s capital position and may affect its ability to remain in compliance with Statutory RBC Requirements. See Note 14 for further discussion regarding Radian Asset Assurance’s statutory surplus position and differences between statutory and GAAP accounting principles.
The GSEs currently are considering revisions to their standard mortgage insurer eligibility requirements, including changes that are more stringent than the current requirements. Among other changes, the new GSE eligibility requirements are expected to contain new capital adequacy standards for private mortgage insurers that are more onerous than the capital requirements that are currently in effect, including potentially: (i) a risk-to-capital ratio below Radian Guaranty’s 19.5 to 1 risk-to-capital ratio as of December 31, 2013; (ii) higher capital requirements for loans insured prior to 2009; and (iii) a limitation on the amount of capital credit attributable to subsidiaries of the eligible insurer (including potentially Radian Guaranty’s capital that is attributable to Radian Asset Assurance). While it remains unclear what form the new eligibility requirements may take or the potential implementation period that may be allowed, we expect the GSEs to release the new eligibility requirements in 2014 and for them to become effective following an implementation period. If the new GSE eligibility requirements include more onerous capital requirements, including any one or more of the potential requirements referenced above, it is likely that we would need to provide additional capital support to, or arrange additional capital relief for, Radian Guaranty, including potentially, increasing the amount of capital contributions from our available holding company funds or from funds raised in private or public capital transactions.
Radian Group serves as the holding company for our insurance subsidiaries and does not have any significant operations of its own. As discussed above, Radian Group has immediately available cash and liquid investments of approximately $615 million. The $615 million of available liquidity excludes certain additional cash and liquid investments that have been advanced from our subsidiaries for corporate expenses and interest payments. Radian Group’s principal liquidity demands for the next 12 months are expected to include: (i) additional capital support for our mortgage insurance subsidiaries; (ii) the payment of dividends on our common stock; (iii) the payment of corporate expenses; and (iv) interest payments on our outstanding long-term debt. Substantially all of Radian Group’s obligation to pay corporate expenses and interest on long-term debt is reimbursed by its subsidiaries.
We expect to meet the long-term liquidity needs of Radian Group with a combination of: (i) available cash and marketable securities; (ii) private or public issuances of debt or equity securities, which we may not be able to do on favorable terms, if at all; (iii) cash received under expense-sharing arrangements with our subsidiaries; and (iv) dividends from our subsidiaries, to the extent available. We cannot provide any assurance that we will be successful in pursuing any alternatives, individually or in the aggregate, and can provide no assurance that if such alternatives are executed that they will be sufficient to maintain regulatory capital requirements and holding company liquidity.
We establish reserves to provide for losses and LAE and the estimated costs of settling claims in both our mortgage insurance and financial guaranty segments in accordance with the accounting standard regarding accounting and reporting by insurance enterprises. Although this standard specifically excludes mortgage insurance from its guidance relating to the reserve for losses, we establish reserves for mortgage insurance as described below, using the guidance contained in this standard supplemented with other accounting guidance, due to the lack of specific guidance for mortgage insurance.
Commutations, recaptures and other negotiated terminations of our insured risks in both our mortgage insurance and financial guaranty segments provide us with an opportunity to exit exposures for an agreed upon payment, or payments, sometimes at an amount less than the previously estimated ultimate liability. Once all exposures relating to such policies are extinguished, all reserves for losses and LAE and other balances relating to the insured or reinsured policy generally are eliminated. Upon completion of a commutation, recapture or other negotiated termination, all such related balances, including deferred policy acquisition costs and unearned premiums, are generally reversed, with any remaining net gain or loss typically recorded through provision for losses. We take into consideration the specific contractual and economic terms for each individual agreement when accounting for our commutations, recaptures or other negotiated terminations, which may result in differences in the accounting for these transactions.
In the mortgage insurance segment, the default and claim cycle begins with the receipt of a default notice from the servicer. Reserves for losses are established upon receipt of notification by servicers that a borrower has missed two monthly payments, which is when we consider a loan to be in default for financial statement and internal tracking purposes. We also establish reserves for associated LAE, consisting of the estimated cost of the claims administration process, including legal and other fees and expenses associated with administering the claims process. We maintain an extensive database of claim payment history and use models based on a variety of loan characteristics, including the status of the loan as reported by its servicer and the type of loan product, to determine the likelihood that a default will reach claim status. Our process includes forecasting the impact of our loss mitigation efforts in protecting us against fraud, underwriting negligence, breach of representation and warranties, inadequate documentation of submitted claims and other items that may give rise to insurance rescissions or cancellations and claim denials, to help determine the rate at which loans are expected to move to claim (“default to claim rate”). Lastly, we project the amount that we will pay if a default becomes a claim (referred to as “claim severity”), which is also impacted by loss mitigation activity associated with claim curtailments due to servicer noncompliance with our insurance policies and servicing guidelines. When there is a claim under primary mortgage insurance, the coverage percentage is applied to the claim amount, which consists of the unpaid loan principal, plus past due interest (for which our liability is contractually capped at a maximum of two years) and certain expenses associated with the default, to determine our maximum liability. Based on these estimates, we arrive at our estimate of loss reserves as of that time.
We also establish reserves for defaults that we estimate have been incurred but have not been reported (“IBNR”) to us on a timely basis by the servicer as well as for previously rescinded policies and denied claims that we estimate will be reinstated and subsequently paid. We generally give the insured up to 90 days to challenge our decision to rescind coverage before we consider a policy to be rescinded and remove it from our defaulted inventory; therefore, we currently expect only a limited percentage of policies that were rescinded to be reinstated. We currently expect a significant percentage of claims that were denied to be resubmitted as a perfected claim and ultimately paid. Most often, a claim denial is the result of a servicer’s inability to provide the loan origination file or other servicing documents for review. Under the terms of our master insurance policy with our lending customers, our insureds have up to one year after the acquisition of borrower’s title to provide to us the necessary documents to perfect a claim. All estimates are periodically reviewed and adjustments are made as they become necessary.
For purposes of reserve modeling, loans are aggregated into groups using a variety of factors. The attributes used to define the groups include, but are not limited to, the default status of the loans (i.e., number of days in default), product type (i.e., Prime, Alternative-A (“Alt-A”) or Subprime), type of insurance (i.e., primary or pool), policy origination year, loss position (i.e., with or without a deductible) and the state where the property is located (segregated into three state groups in order to adjust for differences in foreclosure timing). We use an actuarial projection methodology referred to as a “roll rate” analysis that uses historical claim frequency information to determine the projected ultimate default to claim rates for each product and default status. The default to claim rate also includes our estimates with respect to expected insurance rescissions and claim denials, which have the effect of reducing our default to claim rates. Since 2009, we have experienced an elevated level of insurance rescissions and claim denials for various reasons, including, without limitation, underwriting negligence, fraudulent applications and appraisals, breach of representations and warranties and inadequate documentation, primarily related to our legacy portfolio. We expect our rescission and denial rates to remain at elevated levels as long as defaults related to our legacy portfolio represent a significant percentage of our total default portfolio. After estimating the default to claim rate, we estimate the severity of each product type, type of insurance and state grouping based on the average of recently observed severity rates. These average severity estimates are then applied to individual loan coverage amounts to determine reserves. Senior management regularly reviews the modeled frequency, rescission, denial and severity estimates, which are based on historical trends as described. If recent emerging or projected trends differ significantly from the historical trends used to develop the modeled estimates, management evaluates these trends in determining how they should be considered in its reserve estimates.
In addition, as part of our claims review process, we assess whether defaulted loans were serviced appropriately in accordance with our insurance policies and servicing guidelines. To the extent a servicer has failed to satisfy its servicing obligations, our policies provide that we may curtail the claim payment for such default, and in some circumstances, cancel coverage or deny the claim. Since 2011, claim curtailments have increased both in frequency and in size, which has contributed to a reduction in the severity of our claim payments during this period. While we cannot give assurance regarding the extent or level at which such claim curtailments will continue, we expect this trend to continue in light of well publicized issues in the servicing industry and our existing legacy portfolio of aged defaults.
Insurance enterprises are required to establish a PDR if the net present value of the expected future losses and expenses for a particular product line exceeds the net present value of expected future premiums and existing reserves for that product line. We reassess our expectations for premiums, losses and expenses for our financial guaranty and mortgage insurance businesses at least quarterly and update our premium deficiency analysis accordingly. Expected future expenses include consideration of maintenance costs associated with maintaining records relating to insurance contracts and with the processing of premium collections. We also consider investment income in the premium deficiency calculation through the use of our pre-tax investment yield to discount certain cash flows for this analysis.
For our mortgage insurance business, we group our mortgage insurance products into two categories: first-lien and second-lien. To assess the need for a PDR on our first-lien insurance portfolio, we develop loss projections based on modeled loan defaults related to our current RIF. This projection is based on recent trends in default experience, severity and rates of defaulted loans moving to claim (such default to claim rates are net of our estimates of rescissions and denials), as well as recent trends in the rate at which loans are prepaid.
For our financial guaranty business, to determine whether a premium deficiency charge is necessary, we compare projected earned premiums and investment income to projected future losses, LAE, unamortized deferred acquisition costs and maintenance costs. If the sum of the costs exceeds the amount of the revenues, the excess is first charged against deferred acquisition costs and is referred to as a premium deficiency charge.
Our estimated fair value measurements are intended to reflect the assumptions market participants would use in pricing an asset or liability based on the best information available. Assumptions include the risks inherent in a particular valuation technique (such as a pricing model) and the risks inherent in the inputs to the model. Changes in economic conditions and capital market conditions, including but not limited to, credit spread changes, benchmark interest rate changes, market volatility and changes in the value of underlying collateral or of any third-party guaranty or insurance, could cause actual results to differ materially from our estimated fair value measurements. We define fair value as the current amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. In the event that our investments or derivative contracts were sold, commuted, terminated or settled with a counterparty or transferred in a forced liquidation, the amounts received or paid may be materially different from those determined in accordance with the accounting standard regarding fair value measurements. Differences may also arise between our recorded fair value and the settlement or termination value with a counterparty based upon consideration of information that may not be available to another market participant. Those differences, which may be material, are recorded as realized gains/(losses) in our consolidated statements of operations in the period in which the transaction occurs.
When determining the fair value of our liabilities, we are required to incorporate into the fair value of those liabilities an adjustment that reflects our own non-performance risk. Our CDS spread is an observable quantitative measure of our non-performance risk and is used by typical market participants to determine the likelihood of our default. Assuming all other factors are held constant, as our CDS spread tightens or widens, it has the effect of increasing or decreasing, respectively, the fair value of our liabilities with a corresponding impact on our results of operations.
Effective January 1, 2012, we adopted the FASB update to the accounting standard regarding accounting for costs associated with acquiring or renewing insurance contracts on a prospective basis. This update redefines acquisition costs as incremental costs that are related directly to the successful acquisition of new or renewal insurance contracts. Previously, acquisition costs were defined as costs that vary with and are primarily related to the acquisition of insurance contracts. The effect of this revised definition of acquisition costs has resulted in the recognition of additional expenses in our mortgage insurance business when incurred, rather than being deferred to subsequent periods. There was no change to the amortization requirements due to this update. The implementation of this new guidance significantly reduced the amount of our deferral of policy acquisition costs associated with acquiring mortgage insurance contracts. However, the lower amount of acquisition costs deferred will be offset by reduced amortization expense in subsequent periods. While the timing of the recognition of certain costs in our results of operations has changed as a result of the adoption of this update, there is no effect on the total acquisition costs recognized over time or on our cash flows. Amounts deferred as acquisition costs for 2013 and 2012 reflect a reduction for ceding commissions written on risk ceded under the Reinsurance Transactions (as defined in Note 8). We amortized $28.5 million, $34.1 million and $36.1 million of deferred policy acquisition costs in our mortgage insurance business in 2013, 2012 and 2011, respectively.
We are required to establish a valuation allowance against our deferred tax asset (“DTA”) when it is more likely than not that all or some portion of our DTA will not be realized. At each balance sheet date, we assess our need for a valuation allowance. Our assessment is based on all available evidence, both positive and negative. This requires management to exercise judgment and make assumptions regarding whether such DTA will be realized in future periods. Future realization of our DTA will ultimately depend on the existence of sufficient taxable income of the appropriate character (ordinary income or capital gains) within the applicable carryback and carryforward periods provided under the tax law. In making this assessment, the primary negative evidence that we considered are our cumulative losses in recent years and the continued uncertainty around our future results. We also considered positive evidence when assessing the need for a valuation allowance, such as future reversals of existing taxable temporary differences, future projections of taxable income, taxable income within the applicable carryback periods and potential tax planning strategies. In assessing our need for a valuation allowance, the weight assigned to the effect of both negative and positive evidence is commensurate with the extent to which such evidence can be objectively verified.
Included in our restricted cash balances as of December 31, 2013 were: (1) funds for a mortgage insurance reserve policy held in escrow for any future duties, rights and liabilities; (2) funds held as collateral under our insurance trust agreements related to health care benefits; and (3) funds held in trust for the benefit of certain policyholders.
The stock-based compensation cost related to share-based liability awards is based on the fair value as of the measurement date. The compensation cost for equity instruments is measured based on the grant-date fair value at the date of issuance. Compensation cost is recognized over the periods that an employee provides service in exchange for the award. See Note 15 for further information.
In June 2011, the FASB issued an update to the accounting standard regarding comprehensive income. This update affected the presentation of comprehensive income, but did not change the items that must be reported in other comprehensive income or the point in time an item of other comprehensive income must be reclassified to net income. The update requires the components of net income, other comprehensive income (“OCI”) and total comprehensive income to be presented in a single continuous statement of comprehensive income or in two separate but consecutive statements. We adopted this update effective January 1, 2012, and elected to present two separate but consecutive statements.
In 2013, management determined that the allocation of our consolidated provision for taxes to the segments was no longer material to the evaluation of our business results. Therefore, financial information for our business segments is disclosed on a pretax basis because senior management uses pretax results in the allocation of resources and in assessing the performance of the segments.
A reconciliation of segment pretax (loss) income to consolidated net (loss) income is as follows:
The largest single mortgage insurance customer (including branches and affiliates), measured by primary NIW, accounted for 5.8% of NIW during 2013, compared to 6.2% and 10.1% in 2012 and 2011, respectively. Earned premiums from one mortgage insurance customer exceeded 10% of our consolidated revenues in 2013, compared to the prior year, when earned premiums from two mortgage insurance customers both exceeded 10% of our consolidated revenues for the year.
Comprising TruPs ($0.6 million) and short-term CDs ($1.6 million) included within Level II and lottery annuities ($0.3 million), TruPs ($0.2 million), and a guaranteed investment contract held by a consolidated VIE ($81.0 million) within Level III.
Does not include fixed-maturities held to maturity ($0.4 million) and certain other invested assets ($47.4 million), primarily invested in limited partnerships, accounted for as cost-method investments and not measured at fair value.
Primarily comprising manufactured housing loan collateral related to two consolidated financial guaranty VIEs.
Comprising broadly diversified domestic equity mutual funds included within Level I and various preferred and common stocks invested across numerous companies and industries included within Levels II and III.
Comprising TruPs ($0.9 million) and short-term CDs ($1.6 million ) included within Level II and lottery annuities ($1.0 million) and guaranteed investment contract held by a consolidated VIE ($78.0 million) within Level III.
We are responsible for the determination of the value of all investments carried at fair value and the supporting methodologies and assumptions. To assist us in this responsibility, we utilize independent third-party valuation service providers to gather, analyze and interpret market information and estimate fair values based upon relevant methodologies and assumptions for various asset classes and individual securities. We perform monthly quantitative and qualitative analysis on the prices received from third parties to determine whether the prices are reasonable estimates of fair value. Our analysis includes: (i) a review of the methodology used by third-party pricing services; (ii) a comparison of pricing services’ valuations to other independent sources; (iii) a review of month-to-month price fluctuations; and (iv) a comparison of actual purchase and sale transactions with valuations received from third parties. These processes are designed to ensure that our investment values are accurately recorded, that the data inputs and valuation techniques utilized are appropriate and consistently applied and that the assumptions are reasonable and consistent with the objective of determining fair value.
RMBS, CMBS, and Other ABS-The fair value of these instruments is estimated based on prices of comparable securities and spreads and observable prepayment speeds. These securities are generally categorized in Level II of the fair value hierarchy or in Level III when market-based transaction activity is unavailable. The fair value of any Level III securities is generally estimated by discounting estimated future cash flows.
Other investments-These securities primarily consist of deposit investments and short-term CDs, which are categorized in Level II and Level III of the fair value hierarchy, and a guaranteed investment contract held by one of our consolidated VIEs, which is categorized in Level III of the fair value hierarchy. The fair value of the Level III securities is generally estimated by discounting estimated future cash flows.
Non-performance risk is commonly measured by default probability, with a credit spread tightening indicating a lesser probability of default. Radian Group’s five-year CDS spread at December 31, 2013 implies a market view that there is a 22.9% probability that Radian Group will default in the next five years as compared to an 47.7% implied probability of default at December 31, 2012. The cumulative impact on our derivative assets, derivative liabilities and VIE liabilities attributable to the market’s perception of our non-performance risk decreased by $405.7 million during 2013, as presented in the tables above. This decrease was in part due to the decrease in net derivative liabilities outstanding, as well as the market’s perception of the lower probability that Radian Group may default.
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 the accounting standard regarding fair value measurements. These credit derivatives are categorized in Level III of the fair value hierarchy.
Defining the Equivalent-Risk Tranche-Direct observations of fair premium amounts for our transactions are not available because these transactions cannot be traded or transferred pursuant to their terms and there is currently no active market for these transactions. However, CDS on tranches of a standardized index (the “CDX index”) are widely traded and observable and provide relevant market data for determining the fair premium amount of our transactions, as described more fully below.
Our corporate CDO transactions possess similar structural features to the standard CDX tranches, but often differ with respect to the referenced corporate entities, the term, the attachment points and the detachment points. Therefore, in order to determine the equivalent-risk tranche for each of our corporate CDO transactions, we determine the attachment and detachment points on the CDX index that have comparable estimated probabilities of loss as the attachment and detachment points in our transactions. We begin by performing a simulation analysis of referenced entity defaults in our transactions to determine the probability of portfolio losses exceeding our attachment and detachment points. The referenced entity defaults are primarily determined based on the following inputs: the market observed CDS credit spreads of the referenced corporate entities, the correlations between each of the referenced corporate entities and the term of the transaction.
For each referenced corporate entity in our corporate CDO transactions, the CDS 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 from 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.
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 CDS 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.
With respect to four insured TruPs transactions, our counterparties may require that we pay a liquidity claim for the outstanding par amount on the underlying TruPs bonds. For these transactions, an additional fair value adjustment is made. To calculate this adjustment, a probability that we will be required to pay a liquidity claim is assigned based on our internal cash flow projections. A discounted cash flow valuation is also performed for this scenario where we are required to pay a liquidity claim. The fair value is set equal to the probability weighted average of the valuations from two scenarios: one in which our counterparty pays a liquidity claim and one in which the claim is not paid.
For each of the non-corporate CDOs and other derivative transactions discussed above, with the exception of our TruPs transactions that are valued using a discounted cash flow analysis, we make an adjustment to the fair premium amounts, as described above under “-Non-Performance Risk Adjustment on Corporate CDOs,” to incorporate our own non-performance risk. The non-performance risk adjustment associated with our TruPs transactions is incorporated in the fair value as described above; therefore, no separate adjustment is required. These credit derivatives are categorized in Level III of the fair value hierarchy.
valuations by: (1) reviewing the primaries’ publicly available information regarding their mark-to-market processes, including methodology and key assumptions; and (2) analyzing and discussing the changes in fair value with the primaries where the changes appear unusual or do not appear materially consistent with credit loss related information when provided by the primaries for these transactions. These credit derivatives are categorized in Level III of the fair value hierarchy.
There were no investment transfers between Level I and Level II for the years ended December 31, 2013 or 2012.
The following table summarizes the significant unobservable inputs used in our recurring Level III fair value measurements as of December 31, 2013:
The significant unobservable inputs used in the fair value measurement of our derivative assets, derivative liabilities and VIE debt relate primarily to projected losses. In addition, when determining the fair value of our liabilities, we are required to incorporate into the fair value of those liabilities an adjustment that reflects our own non-performance risk, if applicable, as discussed below.
For our TruPs-related VIE liabilities, the fair value is estimated using similar inputs as in the estimated fair value of our TruPs CDOs, except there is no non-performance risk adjustment, as the derivative liability is limited to the segregated assets already held by the VIE.
This fair value estimate of non-derivative financial guarantees includes direct and assumed contracts written and is based on the difference between the present value of: (1) the expected future contractual premiums; and (2) the fair premium amount to provide the same credit protection assuming a transfer of our obligation to a guarantor of similar credit quality as Radian as of the measurement date.
We also consolidate the assets and liabilities associated with two other financial guaranty structured finance transactions. In these transactions, we provide guarantees for VIEs that own manufactured housing loans. Due to the contractual provisions that allow us to replace and appoint the servicer who manages the collateral underlying the assets of the transactions, we concluded that we have the power to direct the activities of these VIEs. In addition, as the guarantor of certain classes of debt issued by these VIEs, we have the obligation to absorb losses that could be significant to these VIEs. The assets of these VIEs may only be used to settle the obligations of the VIEs; however, due to the nature of our guarantees, creditors have recourse to our general credit as it relates to the VIE debt. Due to the seniority of the bonds we insure in these transactions, we do not expect to incur a loss from our involvement with these two VIEs; as such, we did not have a net liability recorded for these transactions as of December 31, 2013 and do not expect to pay any losses.
We had also previously consolidated the assets and liabilities associated with one CDO of ABS VIE that was commuted in the second quarter of 2012. The consolidated assets of this CDO of ABS VIE were accounted for as trading securities and represented assets to be used to settle the obligation of this VIE.
As of December 31, 2013 and 2012, our trading portfolio included no foreign sovereign or sub-sovereign (collectively, “Sovereign”) securities of the six European countries (Portugal, Ireland, Italy, Greece, Spain and Hungary) whose Sovereign obligations have been under particular stress due to economic uncertainty, potential restructuring and ratings downgrades or securities of any other countries under similar stress.
For trading securities that were still held at December 31, 2013 and 2012, we had net unrealized losses during 2013 and net unrealized gains during 2012 associated with those securities in the amount of $140.9 million and $29.8 million, respectively.
For the years ended December 31, 2013, 2012 and 2011, we did not sell or transfer any fixed-maturity investments classified as held to maturity. For the years ended December 31, 2013 and 2012, we did not transfer any securities from the available for sale or trading categories.
At December 31, 2013, investments in any person and its affiliates that exceeded 10% of our total stockholders’ equity were as follows:
As part of the Freddie Mac Agreement, Radian Guaranty deposited $205 million into a collateral account, currently invested primarily in trading securities, which is pledged to cover loss mitigation activity on the loans subject to the agreement. A portion of the funds deposited may be released to Radian Guaranty over time. See Note 9 for further information.
Securities on deposit with various state insurance commissioners amounted to $17.0 million and $18.0 million at December 31, 2013 and 2012, respectively. We also had $317.1 million and $172.6 million (book value) of securities pledged as collateral in accordance with various reinsurance agreements at December 31, 2013 and 2012, respectively.
In January 2013, pursuant to the FGIC Commutation, we commuted $822.2 million of financial guaranty net par outstanding that Financial Guaranty Insurance Company (“FGIC”) had ceded to us. This transaction reduced our net premiums written by $12.6 million and reduced our net premiums earned by $2.5 million in the first quarter of 2013.
During the second quarter of 2012, Radian Guaranty entered into a quota share reinsurance (“QSR”) agreement with a third-party reinsurance provider (the “Initial QSR Transaction”). Through the Initial QSR Transaction, Radian Guaranty agreed to cede to the third-party reinsurance provider 20% of its NIW beginning with the business written in the fourth quarter of 2011 up to $1.6 billion of ceded RIF. As of December 31, 2013, RIF ceded under the Initial QSR Transaction was $1.3 billion. Radian Guaranty has the ability, at its option, to recapture two-thirds of the reinsurance ceded as part of this transaction on December 31, 2014, which would result in Radian Guaranty reassuming the related RIF in exchange for a payment of a predefined commutation amount from the reinsurer. We ceded that maximum amount permitted under the Initial QSR Transaction, and therefore, are no longer ceding NIW under this transaction.
In the fourth quarter of 2012, Radian Guaranty and the same third-party reinsurance provider entered into a second QSR agreement (the “Second QSR Transaction” and together with the Initial QSR Transaction, the “Reinsurance Transactions”). The limitation on ceded risk in this second transaction was $750 million initially and the parties have the ability to mutually increase the amount of ceded risk up to a maximum of $2 billion. As of December 31, 2013, RIF ceded under the Second QSR Transaction was $1.3 billion. The Second QSR Transaction also provides that, effective as of December 31, 2015, Radian Guaranty will have the ability, at its option (the “Commutation Option”), to recapture one-half of the reinsurance ceded with respect to conventional GSE loans, which would result in Radian Guaranty reassuming the related RIF in exchange for a payment of a predefined commutation amount from the reinsurer. Pursuant to the original terms of the Second QSR Transaction:
The following table shows the amounts related to the Second QSR Transaction for the periods indicated:
In most cases, the risk assumed by the reinsurance company was an excess layer of aggregate losses that would be penetrated only in a situation of adverse loss development. During the financial crisis and downturn in the housing and related credit markets in which losses have increased significantly, most all captive reinsurance arrangements have attached, requiring our captive reinsurers to make payments to us. In all cases, the captive reinsurer established 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. All of our existing captive reinsurance arrangements are operating on a run-off basis, meaning that no new business is being placed in these captives.
The following tables present information related to our captive transactions for the periods indicated:
Approximately 42.8% of our total ceded losses recoverable at December 31, 2013 were related to two captive reinsurers.
Related to underlying defaulted loans with a most recent default notice dated in the year indicated. For example, if a loan had defaulted in a prior year, but then subsequently cured and later re-defaulted in the current year, that default would be considered a current year default.
Our mortgage insurance loss reserves declined in 2013, primarily as a result of a decrease in our total inventory of defaults (due in large part to the Freddie Mac Agreement described below), and also because the volume of paid claims, cures and insurance rescissions and claim denials continued to outpace new default notices received. Total paid claims increased for 2013 from 2012, driven primarily by the $255 million payment made upon the closing of the Freddie Mac Agreement, and by greater efficiencies in our claims review process that has allowed us to pay valid claims more quickly than in previous periods. In addition to reserves established for new default notices, which were the primary driver of our total incurred loss for 2013, losses incurred in 2013 were also favorably impacted by reserve development on prior year defaults, as the initial loss of $22 million related to prior year defaults included in the Freddie Mac Agreement was more than offset by a benefit from claim curtailments and cures that was higher than previously estimated.
Our mortgage insurance loss reserves declined in 2012, primarily as a result of a decrease in our total inventory of defaults, as the volume of paid claims, cures and insurance rescissions and claim denials outpaced new default notices received. Total paid claims declined for 2012 from 2011, driven primarily by an increase in the number of claims received that we were reviewing for non-compliance with our insurance policies, which lengthened the claim resolution period and resulted in an increase in rescissions and denials, as well as by delays created by foreclosure slowdowns, servicer issues and loan modification programs. Reserves established for new default notices received in 2012 were the primary driver of our total incurred loss for 2012. The losses incurred in 2012 were also impacted by adverse reserve development on prior year defaults, primarily relating to the impact from the aging of underlying defaulted loans partially offset by higher actual insurance rescissions and claim denials than previously assumed in our loss reserve estimates. Our results for 2012 were also negatively impacted by a $46.8 million decrease in our estimated reinsurance recoverable from our Smart Home transactions resulting from lower claims paid and higher insurance rescissions and claim denials than were previously estimated.
Our aggregate weighted average default to claim rate assumption (net of denials and rescissions) used in estimating our reserve for losses was 47% at both December 31, 2013 and December 31, 2012. We develop our default to claim rate estimates on defaulted loans based on the age of the underlying defaulted loans, as measured by the number of monthly payments missed. As of December 31, 2013, our aggregate weighted average default to claim rate estimate on our total first-lien portfolio, net of estimated future denials and rescissions and excluding pending claims, was 39% and ranged from 20% for insured loans that had missed two to three monthly payments, to 48% for such loans that had missed 12 or more monthly payments. Our estimate of expected insurance rescissions and claim denials (net of expected reinstatements) embedded in our default to claim rate is generally based on our experience over the past year, with consideration given for differences in characteristics between those rescinded policies and denied claims and the loans remaining in our defaulted inventory.
Our estimates of future rescissions and denials remain elevated compared to levels experienced before 2009. The elevated levels of our rate of insurance rescissions and claim denials have reduced our paid losses and have resulted in a significant reduction in our loss reserves. Our estimate of net future rescissions and denials reduced our loss reserves as of December 31, 2013 and 2012 by approximately $247 million and $455 million, respectively. Conversely, our estimate of future reinstatements of previously rescinded policies and denied claims, which are primarily reflected in our IBNR reserve estimate, increased our loss reserves as of December 31, 2013 and 2012 by approximately $283.0 million and $303.0 million, respectively. The amount of estimated rescissions and denials incorporated into our reserve analysis at any point in time is affected by a number of factors, including not only our estimated rate of rescissions and denials on future claims, but also the volume and attributes of our defaulted insured loans, our estimated default to claim rate and our estimated claim severity, among other assumptions. Although we expect the amount of estimated rescissions and denials embedded within our reserve analysis to remain elevated as compared to levels before 2009, we expect them to continue to decrease over time, as the defaults related to our legacy portfolio decline as a proportion of our total default portfolio and as we realize the results through actual rescissions and denials, or the commutations of insured loans. In the event that we experience a more rapid than expected decrease in the level of future insurance rescissions and claim denials from the current levels, it could have a material adverse effect on our paid losses and loss reserves.
Our reported rescission, denial and claim curtailment activity in any given period is subject to challenge by our lender and servicer customers. We expect that a large number of previously denied claims will be resubmitted with the required documentation and ultimately paid; therefore, we have considered this expectation in developing our IBNR reserve estimate. This IBNR estimate was $281.9 million and $323.0 million at December 31, 2013 and 2012, respectively. For 2013, our IBNR estimate of $281.9 million includes an estimate of future reinstatements of previously denied claims, rescinded policies and curtailments of $162.1 million, $83.7 million and $14.9 million, respectively. These reserves relate to $305.8 million of claims that were denied within the preceding 12 months, $417.4 million of policies rescinded within the preceding 24 months, and $72.4 million of claim curtailments within the preceding 24 months, as well as additional denials and rescissions that were denied or rescinded in earlier periods but remain the subject of discussion with certain of our lender and servicer customers.
The following table illustrates the amount of first-lien claims submitted to us for payment that were rescinded or denied, for the periods indicated, net of any reinstatements of previously rescinded policies or denied claims within each period:
We also accrue for the premiums that we expect to refund to our lender customers in connection with our estimated insurance rescission activity. Our accrued liability for such refunds, which is included within other liabilities on our consolidated balance sheets, was $17.0 million and $48.0 million as of December 31, 2013 and 2012, respectively.
We considered the sensitivity of first-lien loss reserve estimates at December 31, 2013 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 primary claim severity (which we estimate to be 28% of unpaid principal balance at December 31, 2013), we estimated that our loss reserves would change by approximately $57 million at December 31, 2013. For every one percentage point change in pool claim severity (which we estimate to be 45% of unpaid principal balance at December 31, 2013), we estimated that our loss reserves would change by approximately $3 million at December 31, 2013. For every one percentage point change in our overall net default to claim rate (which we estimate to be 47% at December 31, 2013, including our assumptions related to rescissions and denials), we estimated a $36 million change in our loss reserves at December 31, 2013.
Primarily represents ceded losses on captive transactions and Smart Home (for 2012).
Our public finance and structured finance groups utilize several tools to monitor our directly insured portfolio. We generally require, for each of our directly insured transactions, the delivery of periodic financial information, including covenant compliance reports that are reviewed by the risk manager assigned to the particular credit. For substantially all of our direct public finance credits, each risk manager prepares regular written surveillance summaries for each credit that contain financial analysis of the credits. For our larger direct credits and for those credits for which our initial analysis indicates that a more comprehensive review is warranted, the risk manager prepares a more detailed surveillance report that includes additional financial analysis, together with the manager’s reassessment of the internal rating for the transaction. For our directly insured corporate CDO, TruPs CDO, CMBS CDO and direct RMBS transactions, we perform quarterly stress analyses and we update our financial analysis on our TruPs CDO and CMBS CDO transactions at least quarterly. 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.
Our risk management department reviews both performing and under-performing transactions. Performing credits generally have investment grade internal ratings, denoting nominal to moderate credit risk. However, net claim liabilities may be established for performing credits if the expected losses on the credits exceed the unearned premium revenues for the contracts based on the present value of the expected net cash outflows. If our risk management department concludes that a directly insured transaction should no longer be considered performing, it is placed in one of three designated watch list categories for deteriorating credits: Special Mention, Intensified Surveillance or Case Reserve. Assumed exposures in financial guaranty’s reinsurance portfolio are generally placed in one of these categories if the ceding company for such transaction downgrades it to an equivalent watch list classification. However, should our financial guaranty risk management group disagree with the risk rating assigned by the ceding company, we may assign our own risk rating rather than use the risk rating assigned by the ceding company.
Our financial guaranty business has a Watch and Reserve Committee that meets at least quarterly to review under-performing credits and establish reserves for transactions. The Watch and Reserve Committee is chaired by the head of the portfolio management group and includes senior management, credit, legal and finance personnel from both the financial guaranty business and Radian Group. Radian Group’s Board of Directors (the “Board”) 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, risk management policies and Watch and Reserve Committee recommendations and decisions. The following is additional information regarding financial guaranty’s categories for deteriorating credits:
Special Mention. This category includes insured transactions that are rated no more than two rating levels below investment grade (“BIG”). Although these insured transactions typically are not performing as expected, we have determined that such transactions are not expected to have severe, prolonged stress and we do not believe that claim payments are imminent. The credits in this category could have all or some of the following characteristics:
requires additional monitoring by the risk manager to evaluate developing, potentially adverse credit trends.
Direct and assumed exposures in this category that satisfy certain criteria, including minimum outstanding par thresholds, are typically reviewed annually or more frequently if there is a change to the credit profile. Other exposures that do not satisfy applicable criteria are reviewed at the discretion of the risk manager, senior management, the Watch and Reserve Committee Chairperson or the Chief Risk Officer.
Intensified Surveillance. This category includes transactions in financial guaranty’s insured portfolio that are rated BIG and indicate a severe and often permanent adverse change in the transaction’s credit profile. Transactions in this category are still performing, meaning they have not yet defaulted on a payment, but our risk management department has determined that there is a substantial likelihood of default. Transactions that are placed in this category may have some or all of the following characteristics:
Insured transactions are generally elevated into this category from the Special Mention list as a result of continuing declining credit trends. Occasionally, however, transactions may enter this category directly due to an unexpected financial event that leads to rapid and severe deterioration. Direct and assumed exposures in this category that satisfy certain criteria, including minimum outstanding par thresholds, are generally reviewed quarterly. Other exposures that do not satisfy applicable criteria are reviewed at the discretion of the risk manager, senior management, the Watch and Reserve Committee Chairperson or the Chief Risk Officer.
Premiums earned were affected by the following for the years ended December 31, 2013 and 2012:
The following table shows the expected contractual premium revenue from our existing financial guaranty portfolio, assuming no refundings of any financial guaranty obligations, as of December 31, 2013.
Paid losses during 2013 include $41.6 million related to the FGIC Commutation.
The carrying value of our long-term debt at December 31, 2013 and 2012 was as follows:
Senior Notes due 2013. In February 2003, we issued $250 million of unsecured senior notes (the “Senior Notes due 2013”). During 2012, Radian Group acquired $170.6 million in aggregate principal amount of the Senior Notes due 2013 primarily as a result of a tender offer for a price of $900 per $1,000 principal amount of these notes. These purchases resulted in a realized gain of $16.2 million, representing the excess of carrying value over the purchase price. We repaid the remaining $79.4 million outstanding balance of the Senior Notes due 2013 upon maturity on February 15, 2013.
Convertible Senior Notes due 2017. In November 2010, we issued $450 million principal amount of 3.000% convertible, unsecured senior notes due November 15, 2017 (the “Convertible Senior Notes due 2017”) and received proceeds of $391.3 million, which was net of underwriting expenses and the cost of capped call transactions as discussed further below. Interest on these notes is payable semi-annually on May 15 and November 15 of each year.
Holders of these notes may convert their notes from August 15, 2017 up to the close of business on the second scheduled trading day immediately preceding the maturity date (the “Conversion Period”), subject to certain conditions. Upon a conversion, we will pay cash up to the aggregate principal amount of the notes to be converted and pay or deliver, as the case may be, cash, shares of our common stock or a combination of cash and shares of our common stock, at our election, in respect of the remainder, if any, of our conversion obligation that is in excess of the aggregate principal amount of the notes being converted. The conversion rate initially is 85.5688 shares of our common stock per $1,000 principal amount of notes (corresponding to an initial conversion price of approximately $11.69 per share of common stock prior to the consideration of the capped call transactions discussed below). The conversion rate is subject to adjustment in certain events, but is not adjusted for any accrued and unpaid interest. In addition, following certain corporate events, we will, under certain circumstances increase the conversion rate for a holder who elects to convert their notes in connection with that corporate event. At December 31, 2013, we had approximately 51 million shares reserved to cover the potential issuance of shares under the Convertible Senior Notes due 2017.
During any calendar quarter after December 31, 2010 (and only during such calendar quarter), if the last reported sale price of our common stock for each of at least 20 trading days (whether or not consecutive) during the 30 consecutive trading days ending on, and including, the last trading day of the immediately preceding calendar quarter, is greater than or equal to 130% of the applicable conversion price on each applicable trading day;
See “-Convertible Senior Notes due 2017 and 2019” below for information on accounting considerations related to convertible debt instruments that may be settled in cash upon conversion, including the balance sheet classification of the equity component of certain convertible debt instruments, such as the Convertible Senior Notes due 2017, that require the issuer to settle the aggregate principal amount of the notes in cash.
During any calendar quarter commencing after March 31, 2013 (and only during such calendar quarter), if the last reported sale price of our common stock for each of at least 20 trading days (whether or not consecutive) during the 30 consecutive trading days ending on, and including, the last trading day of the immediately preceding calendar quarter, is greater than or equal to 130% of the applicable conversion price on each applicable trading day. During the calendar quarter ended December 31, 2013, the sale price of our common stock met this criteria and therefore, the holders of the notes currently are able to convert the notes, at their option, during the first calendar quarter of 2014;
Any time prior to the close of business on the business day prior to the redemption date if we call the notes for redemption; or
In any period when holders of the Convertible Senior Notes due 2017 are eligible to exercise their conversion option, the equity component related to convertible debt instruments may need to be reclassified from permanent equity to mezzanine (temporary) equity, specifically in those instances when the issuer is required to settle the aggregate principal amount of the notes in cash. Therefore, if in any future period the holders of our Convertible Senior Notes due 2017 are able to exercise their conversion rights, then the difference between (1) the amount of cash deliverable upon conversion (i.e., par value of debt) and (2) the carrying value of the debt component will be reclassified from permanent equity to mezzanine equity, and will continue to be reported as mezzanine equity for any period in which the debt remains currently convertible.
The following table shows the rollforward of accumulated other comprehensive income as of the periods indicated:
Our ability to fully use our tax assets such as NOLs and tax credit carryforwards would be substantially limited if we experience an “ownership change” within the meaning of Section 382 of the Internal Revenue Code of 1986, as amended (“Section 382”). Section 382 rules governing when a change in ownership occurs are complex and subject to interpretation; however, in general, an ownership change would occur if any five percent shareholders, as defined under Section 382, collectively increase their ownership by more than 50 percentage points over a rolling three-year period. As of December 31, 2013, we have not experienced an ownership change under Section 382. However, if we were to experience a change in ownership under Section 382 in a future period, then we may be limited in our ability to fully utilize our NOL and tax credit carryforwards in future periods.
On October 8, 2009, we adopted a Tax Benefit Preservation Plan (the “Plan”), which, as amended, was approved by our stockholders at our 2010 and 2013 annual meetings. We also adopted certain amendments to our amended and restated bylaws (the “Bylaw Amendment”) and at our 2010 annual meeting, our stockholders approved certain amendments to our amended and restated certificate of incorporation (the “Charter Amendment”), which our stockholders reapproved at our 2013 annual meeting. The Plan, the Bylaw Amendment and the Charter Amendment were implemented in order to protect our ability to utilize our NOLs and other tax assets and prevent an “ownership change” under U.S. federal income tax rules by restricting or discouraging certain transfers of our common stock that would: (i) create or result in a person becoming a five-percent shareholder under Section 382; or (ii) increase the stock ownership of any existing five-percent shareholder under Section 382.
We are currently contesting proposed adjustments resulting from the examination by the IRS of our 2000 through 2007 consolidated federal income tax returns. The IRS opposes the recognition of certain tax losses and deductions that were generated through our investment in a portfolio of non-economic REMIC residual interests and has proposed adjustments denying the associated tax benefits of these items. The proposed adjustments relating to the 2000 through 2007 tax years, if sustained, would result in additional income taxes of approximately $128 million plus proposed penalties of approximately $42 million. Additionally, we would incur interest expense on any sustained adjustments. We appealed these proposed adjustments to the IRS Office of Appeals (“Appeals”) and made “qualified deposits” with the U.S. Department of the Treasury (“U.S. Treasury”) in the amount of approximately $85 million in June 2008 relating to the 2000 through 2004 tax years and approximately $4 million in May 2010 relating to the 2005 through 2007 tax years in order to avoid the accrual of above-market-rate interest with respect to the proposed adjustments.
We have made several attempts to reach a compromised settlement with Appeals, but in January 2013, we were notified that Appeals had rejected our latest settlement offer and plans to issue the formal notice of deficiency. Upon receipt of that notice, we will have 90 days to either pay the assessed tax liabilities, penalties and interest (the “deficiency amount”) in full or petition the U.S. Tax Court to litigate the deficiency amount. Litigation of the deficiency amount may result in substantial legal expenses and the litigation process could take several years to resolve. We can provide no assurance regarding the outcome of any such litigation or whether a compromised settlement with the IRS will ultimately be reached. After discussions with counsel about the issues raised in the examination, we believe that an adequate provision for income taxes has been made for the potential liabilities that may result from this matter. However, if the ultimate resolution of this matter produces a result that differs materially from our current expectations, there could be a material impact on our effective tax rate, results of operations and cash flows.
We have taken a position in various jurisdictions that we are not required to remit taxes with regard to the income generated from our investment in certain partnership interests. Although we believe that these tax positions are more likely than not to succeed if adjudicated, measurement of the potential amount of liability for state and local taxes and the potential for penalty and interest thereon is performed on a quarterly basis. Our net unrecognized tax benefits related to prior years increased by approximately $26.3 million during 2013. This net increase primarily reflects the impact of unrecognized tax benefits associated with our recognition of certain premium income. Although unrecognized tax benefits for this item decreased by approximately $21.3 million due to the expiration of the applicable statute of limitations for the taxable period ended December 31, 2009, the related amounts continued to impact subsequent years resulting in a corresponding increase to the unrecognized tax benefits related primarily to the 2010 taxable year.
As discussed above, in January 2013, we were notified that Appeals rejected our latest settlement offer, with regard to the proposed IRS adjustments described above, and plans to issue a formal notice of deficiency. Based on these developments, we do not currently believe that a settlement is likely, and we expect to litigate the disputed amounts. Over the next 12 months, if we determine that a compromised settlement cannot be reached with the IRS, then it is estimated that approximately $73.7 million of unrecognized tax benefits in the above tabular reconciliation may be reversed pursuant to the accounting standard for uncertain tax positions.
We are currently contesting proposed adjustments resulting from the examination by the IRS of our 2000 through 2007 consolidated federal income tax returns. As part of this process, we have agreed to extend all relevant statute of limitations for the assessment of tax to June 30, 2014. All such statute of limitation extensions have limited the scope of the examinations to the recognition of certain tax benefits that relate to our investment in a portfolio of non-economic REMIC residual interests.
We prepare our statutory financial statements in accordance with the accounting practices required or permitted, if applicable, by the insurance departments of the respective states of domicile of our insurance subsidiaries. Required statutory accounting practices include a variety of publications of the National Association of Insurance Commissioners (“NAIC”) as well as state laws, regulations and general administrative rules. In addition, insurance departments have the right to permit other specific practices that may deviate from prescribed practices. As of December 31, 2013, our use of any prescribed or permitted statutory accounting practices did not result in reported statutory surplus or risk-based capital being significantly different from what would have been reported had NAIC statutory accounting practices been followed.
Radian Group serves as the holding company for our insurance subsidiaries, through which we conduct the business of our mortgage insurance and financial guaranty business segments. These insurance subsidiaries are subject to comprehensive, detailed regulation by the insurance departments in the various states where our insurance subsidiaries are domiciled or licensed to transact business. These regulations include various capital requirements and dividend restrictions based on our insurance subsidiaries’ statutory financial position and results of operations, as described below. Our failure to maintain adequate levels of capital could lead to intervention by the various insurance regulatory authorities, which could materially and adversely affect our business, business prospects and financial condition. As of December 31, 2013, the amount of restricted net assets held by our consolidated insurance subsidiaries (which represents our equity investment in those insurance subsidiaries) totaled $1.3 billion of our consolidated net assets.
Radian Guaranty is domiciled and licensed in Pennsylvania as a stock casualty insurance company authorized to carry on the business of credit insurance, which includes the authority to write mortgage guaranty insurance. It is a monoline insurer, restricted to writing only residential mortgage guaranty insurance.
Radian Guaranty’s statutory net loss, statutory surplus and contingency reserve as of and for the years ended December 31, 2013, 2012 and 2011 were as follows:
Currently, we expect to maintain Radian Guaranty’s risk-to-capital ratio at or below 20 to 1. Radian Guaranty was in compliance with the Statutory RBC Requirements or MPP Requirements, as applicable, in each of the RBC States as of December 31, 2013. See Note 1 for information regarding new GSE eligibility requirements that we expect will be released in 2014.
Radian Insurance is domiciled and licensed in Pennsylvania as a stock casualty insurance company authorized to carry on the business of credit insurance, which includes the authority to write mortgage guaranty and financial guaranty insurance and the authority to reinsure policies of mortgage guaranty insurance. Radian Insurance is not licensed or authorized to write direct credit insurance in any locality other than Pennsylvania and Hong Kong.
Radian Insurance is required to maintain a minimum statutory surplus of $20 million to remain an authorized reinsurer in all states. The statutory net income and statutory policyholders’ surplus for Radian Insurance for the year ended December 31, 2011 have each been increased by $5.6 million from the amounts previously reported. This change was a result of the correction of an error associated with our statutory PDR. The correction of this error is not material with respect to the Company’s consolidated financial statements. Radian Insurance’s statutory net income, statutory policyholders’ surplus and contingency reserve as of and for the years ended December 31, 2013, 2012 and 2011 were as follows:
RMAI is required to maintain statutory-basis capital and surplus of $1.125 million. Radian Group and RMAI are parties to a guaranty agreement, which provides that Radian Group will make sufficient funds available to RMAI to ensure that RMAI has a minimum of $5 million of statutory policyholders’ surplus evaluated quarterly. RMAI’s statutory net income (loss) and statutory policyholders’ surplus as of and for the years ended December 31, 2013, 2012 and 2011 were as follows:
Radian Mortgage Insurance is required to maintain a minimum statutory surplus of $20 million to remain an authorized reinsurer in all states. Radian Mortgage Insurance’s statutory net income (loss), statutory policyholders’ surplus and contingency reserve as of and for the years ended December 31, 2013, 2012 and 2011 were as follows:
Radian Group’s U.S. consolidated federal income tax returns, which include RGRI’s federal income tax returns, were under examination by the IRS for tax years 2000 through 2007. We are currently contesting proposed adjustments resulting from the IRS examination of these tax years. Effective December 31, 2011, Radian Group and RGRI entered into an Assumption and Indemnification Agreement with regard to these proposed adjustments. In this agreement, Radian Group agreed to indemnify RGRI for any tax payments ultimately due to the IRS for the proposed adjustments, which relate to the recognition of certain tax losses and deductions that were generated through our investment in a portfolio of non-economic REMIC residual interests currently held by RGRI. This indemnification was in lieu of an immediate capital contribution that otherwise would have been needed from Radian Group to RGRI, based on an estimate for this potential liability, in order for RGRI to maintain its minimum statutory surplus requirements. There remains significant uncertainty with regard to the amount and timing of any resolution with the IRS. See Note 13 for further information regarding the examination by the IRS for the 2000 through 2007 tax years.
Radian Asset Assurance is domiciled and licensed in New York as a monoline financial guaranty insurer. Radian Asset Assurance is also licensed under the New York insurance law to write some types of surety insurance and credit insurance.
(a) Under STAT, mortgage guaranty insurance companies are required each year to establish a contingency reserve equal to 50% of premiums earned in such year. Such amount must be maintained in the contingency reserve for 10 years, after which time it is released to unassigned surplus. Prior to 10 years, the contingency reserve may be reduced with regulatory approval to the extent that losses in any calendar year exceed 35% of earned premiums for such year.
(b) In accordance with New York insurance law, financial guaranty insurance companies are required to establish a contingency reserve equal to the greater of 50% of premiums written or a stated percentage of the principal guaranteed, ratably over 15 to 20 years dependent upon the category of obligation insured. Contingency reserves may be discontinued if the total reserve established for all categories of obligations exceeds the sum of the stated percentages for such categories multiplied by the unpaid principal guaranteed. The contingency reserve may be released with regulatory approval to the extent that losses in any calendar year exceed a pre-determined percentage of earned premiums for such year, with the percentage threshold dependent upon the category of obligation insured. Such reserves may also be released, subject to regulatory approval in certain instances, upon demonstration that the reserve amount is excessive in relation to the outstanding obligations. Reinsurers are required to establish a contingency reserve equal to their proportionate share of the reserve established by the ceding company. Also under STAT, case reserves are required to be established in the year in which a default occurs based on the guarantor’s best estimate of ultimate loss payment, rather than when the probability weighted expected net cash out flows exceed unearned premium reserves.
(g) Prior to January 1, 2013, under STAT, the accounting standard regarding share-based payments was not applicable, with regard to the recognition and measurement of stock option issuances. However, effective January 1, 2013, the NAIC adopted Statement of Statutory Accounting Principles (“SSAP”) No. 104, Share-Based Payments (“SSAP 104”), on a prospective basis. Therefore, expenses related to stock options granted subsequent to the date of adoption of SSAP 104 are recognized under STAT but expenses related to stock options granted prior to the date of adoption continue to not be recognized under STAT. Expenses related to stock options, regardless of the date of grant, are reflected on our GAAP financial statements in accordance with this standard.
(k) Under STAT, capital contributions satisfied by receipt of cash or readily marketable securities subsequent to the balance sheet date but prior to the filing of the statutory financial statement are treated as a recognized subsequent event and, as such, are considered an admitted asst based on the evidence of collection and approval of the domiciliary commissioner. Under GAAP, such capital contributions are treated as a nonrecognized subsequent event.
We have an equity compensation plan, the Radian Group Inc. 2008 Equity Compensation Plan (the “2008 Equity Plan”), pursuant to which we grant equity awards. The 2008 Equity Plan replaced our prior equity plan, the 1995 Equity Compensation Plan (the “1995 Equity Plan” and together with the 2008 Equity Plan, the “Equity Plans”). In adopting the 2008 Equity Plan, we agreed not to grant any new awards under the 1995 Equity Plan. The last awards granted pursuant to the 1995 Equity Plan were granted in 2008. All awards granted under the Equity Plans have been in the form of non-qualified stock options, restricted stock, restricted stock units (“RSUs”), stock appreciation rights (“SARs”), phantom stock and performance share awards. The maximum contractual term for all awards under the Equity Plans is 10 years.
Generally, stock options vest 50% on each of the third and fourth anniversaries of the grant date, while restricted stock, restricted stock units and performance share awards vest 100% on the third anniversary of the grant date. All awards require the grantee to remain in service with us through the vesting period, except in the event of the grantee’s death, disability, retirement or upon a change of control.
In addition to the 2008 Equity Plan, we have granted long-term incentive awards pursuant to a long-term performance-based incentive cash program. This program is conducted pursuant to two plans, the Radian Group Inc. 2008 Long-Term Performance Cash Plan (the “Officer LTI Plan”) and the 2008 Executive Long-Term Incentive Cash Plan (the “Executive LTI Plan” and together with the Officer LTI Plan, the “Cash Based LTI Plans”). Participants in the Cash Based LTI Plans include certain officers of Radian Group and its subsidiaries. In 2008, we granted awards under the Officer LTI Plan for which performance was based on our stock price growth (above a minimum threshold price), with a range of possible payouts corresponding to ranges of stock prices achieved. In addition to the 2008 award under the Officer LTI Plan, the Compensation and Human Resources Committee of the Board (the “Compensation Committee”) has granted cash incentive awards under the Cash Based LTI Plans that are not directly correlated with our stock price, but contain discretionary payments based on various operating performance metrics. See “-Other Compensation Programs” below.
Vesting of awards granted to non-executive officers in 2012 is subject to the same terms as the executive officer awards, except that the non-executive officer awards are not subject to the 2012 Relative TSR Measure.
Vesting of awards granted to both non-executives and executives in 2011 is dependent upon the performance of Radian Group’s TSR compared to TSRs of the Peer Groups, with a maximum payout at the end of the three-year performance period of 200% of a grantee’s target number of RSUs.
Vesting of the performance-based RSUs awarded to executives and non-executives in 2010 was based on two factors, both equally weighted at 50% of the total performance target: (1) the performance of Radian Group’s relative TSR compared to the TSRs of an industry peer group, with a maximum payout of 100% of the peer target (i.e., 50% of the total performance target); and (2) the performance of Radian Group’s relative TSR compared to the TSRs of companies included in the S&P MidCap 400® index, with a maximum payout of 150% of the index target (i.e., 50% of the total performance target). Upon the occurrence of certain corporate events involving one or more companies included in the industry peer group, the performance goals for the entire award (between 0% and 150% of the total target award) would then be based on Radian Group’s relative TSR compared to the TSRs of companies included in the S&P MidCap 400® index. This award vested at 50% of target in 2013.
Timed-Vested RSUs-In 2013 and 2012, the Compensation Committee awarded to certain non-executives 7,670 and 151,154, respectively, of time-vested RSUs (to be settled in cash) under the 2008 Equity Plan. In 2010, the Compensation Committee awarded to our non-employee directors 108,921 time-vested RSUs (to be settled in cash) under the 2008 Equity Plan. The estimated fair value of the time-vested RSUs is based on the closing price of our common stock on the measurement date. These RSU awards entitle award recipients to a cash amount equal to the closing price of our common stock on the New York Stock Exchange (“NYSE”) on the vesting date for employees or the conversion date for non-employee directors (generally defined as a director’s termination of service with us). These RSU awards vest in their entirety three years from the date of grant, or earlier, upon retirement, death or disability.
In 2010 and 2009, the Compensation Committee awarded 192,100 and 1,623,500, respectively, of cash-settled SARs under the 2008 Equity Plan. The award of SARs entitles grantees to receive a cash amount equal to the excess of the closing share price of our common stock on the date of exercise over the grant price (the closing share price of our common stock on the date of grant). The exercise prices of the SARs awarded in 2010 and 2009 were $10.42 and $2.68 per share, respectively. As of December 31, 2013, the estimated fair value of the SARs awarded in 2010 and 2009 was $4.23 and $11.44 per share, respectively. The SARs have a five-year term and vest 50% on the third and fourth anniversaries of the date of grant. Any SARs remaining at the end of the five-year period will be automatically exercised and paid to the grantee.
The table below summarizes information regarding fully vested stock options as of December 31, 2013:
We elected to apply the short-cut method in accounting for the windfall tax benefits under the accounting standard regarding share-based payment. Should future offsets to the windfall resulting from cancellations, expirations or exercise shortfalls exceed the balance of $15.3 million at December 31, 2013, the excess would be reflected in the consolidated statements of operations.
In the past, the Compensation Committee has granted phantom stock awards to non-employee directors under the Equity Plans, which entitle grantees to receive shares of our common stock on the conversion date (generally defined as a grantee’s termination of service with us). The estimated fair value of phantom stock is based on the closing share price of our common stock as reported by the NYSE on the date of grant. All outstanding shares of phantom stock are fully vested. Each share of phantom stock was granted at full value with no exercise price and accrues dividend equivalents until the conversion (as defined above). Upon conversion, all phantom stock will be paid in whole shares of our common stock, with fractional shares paid in cash. At December 31, 2013, there were approximately 4,268 dividend-equivalent phantom shares accrued that were not included in the total number of our outstanding shares. The cost recognized for these awards was recognized on a straight-line basis over the vesting period.
Performance-Based RSUs-In 2013, the Compensation Committee granted to officers a total of 435,970 performance-based RSUs to be settled in common stock. No performance-based RSUs (equity settled) were awarded in 2012 or 2011.
Vesting of awards granted to executive officers in 2013 is dependent upon (1) Radian Group’s absolute TSR compared to the relative TSR of the companies listed on the NASDAQ Financial Index and our most directly comparable mortgage insurance peer, and (2) Radian Group’s relative TSR (“2013 Relative TSR Measure”), in each case measured over a three-year performance period. The maximum payout at the end of the three-year performance period is 200% of a grantee’s target number of RSUs, subject to a maximum cap of 6 times the value of the grantee’s award on the grant date. If Radian Group’s absolute TSR during the performance period is negative, the maximum payout percentage will be 50% of target. If Radian Group’s absolute TSR is positive, the payout will be determined based on an analysis of Radian Group’s relative TSR and absolute TSR. Vesting of awards granted to non-executive officers in 2013 is subject to the same terms as the executive officer awards, except that the non-executive officer awards are not subject to the 2013 Relative TSR Measure.
Time-Vested RSUs-In 2013, the Compensation Committee granted a total of 102,618 shares of time-vested RSUs to be settled in common stock, including 13,260 shares awarded to non-executive officers and 89,358 shares awarded to non-employee directors. In 2012, the Compensation Committee granted a total of 558,216 shares of time-vested RSUs to be settled in common stock, including 7,812 shares awarded to non-executive officers and 550,404 shares awarded to non-employee directors. In 2011, the Compensation Committee granted a total of 323,866 shares of time-vested RSUs to be settled in common stock, including 77,027 shares awarded to employees and 246,839 shares awarded to non-employee directors. The grant date fair value of the time-vested RSUs was calculated based on the fair market value of our common stock on the NYSE on the date of grant and is recognized as compensation expense over the vesting period. The 2013 awards to non-executive officers and non-employee directors are subject to three-year cliff vesting.
We have an ESPP, the Radian Group Inc. 2008 Employee Stock Purchase Plan (the “2008 ESPP”) under which 2,000,000 shares of our authorized but unissued common stock have been reserved for issuance. Under the 2008 ESPP, we sold 95,287, 204,834 and 158,676 shares to employees during the years ended December 31, 2013, 2012 and 2011, respectively.
In 2009 and 2010, the Compensation Committee granted awards under the Cash Based LTI Plans with performance for 50% of the award measured over a three-year performance period and 50% of the award measured over a four-year performance period based on the following performance measures: (1) mortgage insurance market share; (2) capital management; (3) mortgage insurance credit quality; (4) expense management; and (5) operating profitability. No awards were granted in 2013, 2012 or 2011 under the Cash Based LTI Plans. Compensation costs recognized related to non-share-based awards under the Officer LTI Plan were $0.5 million, $0.7 million and $0.5 million for the years ended December 31, 2013, 2012 and 2011, respectively. Compensation costs recognized related to non-share-based awards under the Executive LTI Plan were $1.6 million, $0.7 million and $5.5 million for the years ended December 31, 2013, 2012 and 2011, respectively.
The Savings Plan covers substantially all of our full-time and all of our part-time employees. Participants can contribute up to 100% of their base earnings as pretax and/or after-tax (Roth IRA) contributions up to a maximum amount of $17,500 for 2013. The Plan also includes a catch-up contribution provision whereby participants who are or will be age 50 and above during the Plan year, may contribute an additional contribution. The maximum catch-up contribution for Plan Year 2013 was $5,500. We will match up to 100% of the first 6% of base earnings contributed in any given year. Our expense for matching funds for the years ended December 31, 2013, 2012 and 2011 was $3.1 million, $2.9 million and $3.5 million, respectively.
permit the company to make discretionary, pro rata (based on eligible pay) cash allocations to each eligible participant’s account, with vesting upon completion of three years of service with us; and
We have a voluntary deferred compensation plan for senior officers and a voluntary deferred compensation plan for our directors. The voluntary deferred compensation plans allow: (1) senior officers to defer receipt of all or a portion of their annual cash incentive award and/or the payment date of their equity compensation; and (2) directors to defer receipt of all or a portion of their cash compensation and/or the payment date of their equity compensation. Under the plans, a participant must make a binding written election before the year in which compensation is to be earned to defer compensation payouts for at least two full calendar years beyond the year in which such compensation would have been paid.
The deferred compensation plan amounts are not funded and are not segregated from our general assets. Accordingly, participants in each plan are general unsecured creditors of Radian Group with respect to the amounts due under the plans. The amount recorded as deferred compensation expense for the years ended December 31, 2013, 2012 and 2011 was immaterial to our financial statements.
In the course of our regular review of pending legal matters, we determine whether it is reasonably possible that a potential loss relating to a legal proceeding may have a material impact on our liquidity, results of operations or financial condition. If we determine such a loss is reasonably possible, we disclose information relating to any such potential loss, including an estimate or range of loss or a statement that such an estimate cannot be made. On a quarterly and annual basis, we review relevant information with respect to legal loss contingencies and update our accruals, disclosures and estimates of reasonably possible losses or range of losses based on such reviews. We are often unable to estimate the possible loss or range of loss until developments in such matters have provided sufficient information to support an assessment of the range of possible loss, such as quantification of a damage demand from plaintiffs, discovery from other parties and investigation of factual allegations, rulings by the court on motions or appeals, analysis by experts, and the progress of settlement negotiations. In addition, we generally make no disclosures for loss contingencies that are determined to be remote. For matters for which we disclose an estimated loss, the disclosed estimate reflects the reasonably possible loss or range of loss in excess of the amount accrued, if any.
On December 30, 2011, a putative class action under RESPA titled White v. PNC Financial Services Group was filed in the U.S. District Court for the Eastern District of Pennsylvania. On September 29, 2012, plaintiffs filed an amended complaint. In this case, Radian Guaranty has insured the loan of one of the plaintiffs. On November 26, 2012, Radian Guaranty filed a motion to dismiss the plaintiffs’ claims as barred by the statute of limitations. On June 20, 2013, the court granted Radian Guaranty’s motion and dismissed plaintiffs’ claims, but granted plaintiffs leave to file a second amended complaint. Plaintiffs filed their second amended complaint on July 5, 2013, reasserting a putative claim under RESPA on substantially the same allegations. Radian Guaranty filed a motion to dismiss plaintiffs’ second amended complaint on July 22, 2013.
On January 13, 2012, a putative class action under RESPA titled Menichino, et al. v. Citibank, N.A., et al., was filed in the U.S. District Court for the Western District of Pennsylvania. Radian Guaranty was not named as a defendant in the original complaint. On December 4, 2012, plaintiffs amended their complaint to add Radian Guaranty as an additional defendant. In this case, Radian Guaranty has insured the loan of one of the plaintiffs. On February 4, 2013, Radian Guaranty filed a motion to dismiss the claims against it as barred by the statute of limitations. On July 19, 2013, the court granted Radian Guaranty’s motion and dismissed plaintiffs’ claims, but granted plaintiffs leave to file a second amended complaint. Plaintiffs filed their second amended complaint on August 16, 2013, reasserting a putative claim under RESPA on substantially the same allegations. Radian Guaranty filed a motion to dismiss plaintiffs’ second amended complaint on September 17, 2013. The court denied Radian Guaranty’s motion on February 4, 2014, without prejudice to Radian Guaranty’s ability to raise the statute of limitations bar on a motion for summary judgment.
On June 28, 2012, a putative class action under RESPA titled Cunningham, et al. v. M&T Bank Corporation, et al. was filed in the U.S. District Court for the Middle District of Pennsylvania. On October 9, 2012, plaintiffs filed an amended complaint in which they added one With respect to the Samp case and the other similar putative class actions discussed above, Radian Guaranty believes that the claims are without merit and intends to vigorously defend itself against these claims. We are not able to estimate the reasonably possible loss or range of loss for these matters because the proceedings are in a very preliminary stage and there is uncertainty as to the likelihood of a class being certified or the ultimate size of a class.
We are also currently contesting proposed adjustments resulting from the examination by the IRS of our 2000 through 2007 consolidated federal income tax returns. The IRS opposes the recognition of certain tax losses and deductions that were generated through our investment in a portfolio of non-economic REMIC residual interests currently held by RGRI, one of our wholly-owned subsidiaries. The proposed adjustments relating to the 2000 through 2007 tax years, if sustained, will result in additional income taxes of approximately $128 million plus proposed penalties of approximately $42 million. Additionally, we would incur interest on any sustained adjustments. After several attempts to reach a compromised settlement, we were notified in January 2013 that Appeals rejected our latest offer and plans to issue the formal notice of deficiency. Upon receipt of that notice, we will have 90 days to pay the deficiency amount or petition the U.S. Tax Court to litigate the matter. Litigation of the deficiency amount may result in substantial legal expenses and the litigation process could take several years to resolve. We can provide no assurance regarding the outcome of any such litigation or whether a compromised settlement with the IRS may ultimately be reached. See Note 13 for additional information.
Securities regulations became effective in 2005 that impose enhanced disclosure requirements on issuers of ABS (including mortgage-backed securities). To allow our customers to comply with these regulations at that time, we typically were required, depending on the amount of credit enhancement we were providing, to provide; (1) audited financial statements for the insurance subsidiary participating in the transaction; or (2) a full and unconditional holding company-level guarantee for our insurance subsidiaries’ obligations in such transactions. Radian Group has guaranteed two structured transactions for Radian Guaranty involving approximately $133.5 million of remaining credit exposure as of December 31, 2013.
Our mortgage insurance business provides an outsourced underwriting service to its customers known as contract underwriting. Typically, we agree that if we make a material error in underwriting a loan, we will provide a remedy to the customer, by purchasing the loan or placing additional mortgage insurance coverage on the loan, or by indemnifying the customer against loss up to a maximum specified amount. By providing these remedies, we assume some credit risk and interest-rate risk if an error is found during the limited remedy period in the agreements governing our provision of contract underwriting services. Beginning in 2008, we limited the recourse available to our contract underwriting customers to apply only to those loans that are simultaneously underwritten for compliance with secondary market compliance and for potential mortgage insurance. In 2013, we paid losses related to contract underwriting remedies of approximately $2.1 million. Rising mortgage interest rates or further economic uncertainty may expose our mortgage insurance business to an increase in such costs. In 2013, our provision for contract underwriting expenses was approximately $2.1 million and our reserve for contract underwriting obligations at December 31, 2013 was approximately $3.7 million. We monitor this risk and negotiate our underwriting fee structure and recourse agreements on a client-by-client basis. We also routinely audit the performance of our contract underwriters.
The commitment for non-cancelable operating leases in future years has not been reduced for future minimum receipts expected from sublease rental payments aggregating approximately $9.5 million at December 31, 2013.
The 2013 and 2012 amounts reflect unrealized (losses) gains, respectively, on our trading securities. The 2012 amounts also reflect realized gains (losses) on investments in connection with the continued reallocation of our investment portfolio.
The change in fair value of derivative instruments for 2013 and 2012 reflects the volatility in the cumulative unrealized (loss) gain attributable to the market’s perception of our non-performance risk as a result of the changes in our CDS spread during both years. The 2013 amounts also reflect improvements in the credit spreads of the underlying securities.
The 2013 and 2012 periods primarily reflect fair value gains and losses on our VIE debt.
Net (loss) income per share is computed independently for each period presented. Consequently, the sum of the quarters may not equal the total net (loss) income per share for the year.
Basic net (loss) income per share is based on the weighted-average number of common shares outstanding, while diluted net (loss) income per share is based on the weighted-average number of common shares outstanding and common stock equivalents that would be issuable upon the exercise of stock options, other stock-based compensation arrangements, and the dilutive effect of our convertible debt.