On November 3, 2015, we entered into a new 15-year operating lease agreement that will commence on September 1, 2017 when our current lease expires (the “2017 Lease”). The 2017 Lease is for approximately 150,000 square feet of office space at 1500 Market Street in Philadelphia, PA where our new corporate headquarters will be located. When the square footage leased under the 2017 Lease is combined with the office space we currently lease at the 1500 Market Street location, we will have approximately 175,570 square feet of office space for our corporate headquarters. For information regarding the expected obligation for payments under the 2017 Lease, see Note 17 of Notes to Consolidated Financial Statements.
The information in the following table should be read in conjunction with our Consolidated Financial Statements and Notes thereto included in Item 8 and the information included in
We provide mortgage insurance on first-lien mortgage loans, and products and services to the real estate and mortgage finance industries. We have two business segments-Mortgage Insurance and Services. Our Mortgage Insurance segment provides credit-related insurance coverage, principally through private mortgage insurance, to mortgage lending institutions nationwide. We provide our mortgage insurance products mainly through our wholly-owned subsidiary, Radian Guaranty. Our Services segment provides outsourced services, information-based analytics and specialty consulting for buyers and sellers of, and investors in, mortgage- and real estate-related loans and securities as well as other ABS. The primary lines of business in our Services segment include: (1) loan review and due diligence; (2) surveillance, including RMBS surveillance, loan servicer oversight, loan-level servicing compliance reviews and operational reviews of mortgage servicers and originators; (3) valuation and component services providing outsourcing and technology solutions for the SFR and residential real estate markets; as well as outsourced solutions for appraisal, title and closing services; (4) REO management services; and (5) services for the United Kingdom and European mortgage markets through our EuroRisk operations. These services and solutions are provided primarily through Clayton and its subsidiaries, including Green River Capital, Red Bell and ValuAmerica.
During this period of economic improvement, mortgage origination volumes have been positively impacted by increased mortgage refinancings as a result of the low interest rate environment, as well as a steady recovery in the home purchase market. New lending laws and regulations were enacted in response to the financial crisis, which when combined with lenders’ more restrictive lending guidelines and the absence of a robust securitization market for non-GSE loans, have resulted in more restrictive credit standards for home financing. As a result, post-2008 loan originations have consisted primarily of high credit quality loans with significantly better credit performance than that of the loans in our Legacy Portfolio. While credit quality has been improving, the restrictive credit environment has made it more challenging for many first-time home buyers to finance a home, which has limited the growth of the mortgage industry. See Results of Operations-Mortgage Insurance-NIW, IIF, RIF for additional information regarding our portfolio mix and the mortgage industry.
As a result of the improving macroeconomic and credit trends referenced above, throughout 2014 and 2015 our results of operations have improved significantly. The negative impact from losses in our Legacy Portfolio has been reduced and we have continued to write a high volume of insurance on high credit quality loans. The improving environment has contributed to a reduction in our incurred losses and claims submitted and paid in our mortgage insurance business. The number of new primary mortgage insurance defaults, net of defaults that defaulted but were cured within the same period, declined by 13.9% for the year ended December 31, 2015, compared to the same period of 2014. Similarly, our primary default rate of 4.0% at December 31, 2015 declined from 5.2% at December 31, 2014.
While the positive macroeconomic and credit trends have contributed to the improved financial strength of existing private mortgage insurers, these trends also have encouraged newer entrants into the private mortgage insurance industry. The presence of newer entrants in the industry has increased price competition as these companies seek to gain a greater presence in the market and more established industry participants seek to defend their market share and customer relationships. As a result, recent pricing trends have included: (i) the increased use of a spectrum of filed rates to allow for formulaic, risk-based pricing (commonly referred to as “black-box” pricing); (ii) a significant increase in the broad use of customized (often discounted) rates on lender-paid, Single Premium policies, and more recently, on borrower-paid, monthly premium policies; and (iii) overall reductions in standard filed rates on borrower-paid policies. The willingness of mortgage insurers to offer reduced pricing (through filed or customized rates) has been met with an increased demand from certain large lenders for reduced rate products. This has further intensified the pricing environment and has resulted in new pricing levels (whether through filed or customized rates) that private mortgage insurers are expected to meet in order to avoid risking a potential significant loss in NIW.
The heightened pricing competition has occurred in the context of generally higher capital requirements being applied to private mortgage insurers as a result of the PMIERs and more aggressive pricing by the FHA (which is most impactful with respect to high-LTV loans for borrowers with FICO scores below 720). This has produced a marketplace where balancing both targeted returns on new business and an acceptable share of the insured market has become increasingly challenging for all participants. In formulating our strategy in this environment, we have taken a disciplined approach to establishing rates and delivering a mix of business that is expected to produce our targeted level of returns on a blended basis and an acceptable level of NIW. In furtherance of this strategy, we recently: (1) increased our filed rates for lender-paid mortgage insurance; (2) continued to use the authority set forth in our rate filings to provide customized premiums for lender-paid, Single Premium mortgage insurance on a selective and negotiated basis while, importantly, declining to participate in significantly discounted, Single Premium business that has been offered for bid on an aggregated basis (which we estimate represented approximately 5% of the total private mortgage insurance market in 2015); and (3) determined to change our borrower-paid, filed rates in order to remain competitive, which generally will have the effect of decreasing our standard rates on higher FICO business and raising our rates on lower FICO business where the FHA is already very competitive.
Radian is focused on a number of strategic objectives, as described in “Radian’s Long-Term Strategic Objectives” in “Part I, Item 1. Business-General.” Our strategy for future growth includes continuing to grow our mortgage insurance business as well as broadening our capabilities to provide mortgage and real estate-related products and services to the real estate and mortgage finance markets. Our capabilities are illustrated by the graphic, “Existing Capabilities within Primary Areas of Mortgage Finance Industry” in “Part I, Item 1. Business, I. General.”
Our Services segment provides a diverse array of services to participants in multiple facets of the residential real estate and mortgage finance markets. As a result, we believe the Services segment is well-positioned to generate revenue in both healthy and distressed mortgage market conditions. Historically, a significant portion of this revenue was generated from activities related to non-agency RMBS issuance, which has been limited in recent years. We believe that the potential future re-emergence of the non-agency RMBS market may represent a significant long-term growth opportunity for our loan review, due diligence and surveillance services. However, the size and timing for the return of this market are uncertain and will be impacted by factors outside our control, including market demand and regulation. In addition, our Services segment has recently experienced revenue growth from its products serving the SFR market, including SFR securitizations, which is an emerging market that experienced rapid growth in 2014. However, there has been a decline in the pace of home purchases by institutional investors and a slowdown in SFR securitizations, which have negatively impacted our revenue in 2015. This trend is expected to continue in 2016.
In February 2016, in order to manage the mix of business in our portfolio and to continue managing Radian Guaranty’s Minimum Required Assets under the PMIERs in a cost-effective manner, we entered into the Single Premium QSR. The Single Premium QSR (including the amount of the benefit to our Minimum Required Assets under PMIERs) remains subject to GSE approval, and therefore, we have not yet begun to cede any business under this agreement. Assuming we receive GSE approval for the Single Premium QSR, we expect it to reduce the amount of our Minimum Required Assets by between $120 million to $150 million. We can provide no assurance if and when the GSEs may approve the Single Premium QSR, and if it is approved, whether it will be approved in its current form or on alternative terms and conditions that are acceptable to us and the third-party reinsurers. We continue to explore additional alternatives, including commutations and additional external reinsurance, in order to provide financial flexibility while continuing to comply with the PMIERs.
the transfer of $325 million of cash and marketable securities to Radian Guaranty in exchange for a Surplus Note issued by Radian Guaranty; and
the entry into an ASR program to repurchase an aggregate of $202 million of Radian Group common stock.
a net increase in available holding company liquidity of approximately $26.0 million;
The ASR program was implemented to reduce the dilutive impact of the shares issued in connection with our purchases of Convertible Senior Notes due 2017. The capital-strengthening transactions listed above, including the ASR program, resulted in a net increase in diluted shares outstanding of approximately 1.1%. This net impact reflects the fact that a portion of the dilution for the incremental shares issued related to the Convertible Senior Notes due 2017 had been included in the calculations of diluted shares outstanding for prior periods in accordance with GAAP.
Sale of Radian Asset Assurance. On April 1, 2015, Radian Guaranty completed the sale of Radian Asset Assurance to Assured, pursuant to the Radian Asset Assurance Stock Purchase Agreement. See Note 3 of Notes to Consolidated Financial Statements for additional information related to discontinued operations.
Clayton’s Acquisitions. During the first quarter of 2015, Clayton acquired Red Bell, a real estate brokerage company. In addition, in October 2015, Clayton acquired ValuAmerica, a national title agency and appraisal management company with a technology platform that helps mortgage lenders and their vendors streamline and manage their supply chains and operational workflow. These acquisitions expand Clayton’s scope of services and are consistent with our strategy to be positioned to offer products and services throughout the entire mortgage value chain. See Notes 1 and 7 of Notes to Consolidated Financial Statements for additional information regarding these acquisitions.
NIW increases our IIF and our premiums written and earned. Our IIF growth over time, as shown in the chart below, is expected to function as one of our primary drivers of increased future revenue.
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 some or all of our policy acquisition costs, which generally would result in increased profitability from these monthly policies. 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 negatively affected by any increases in our accrual for estimated Rescission refunds. Additionally, premiums ceded to third-party reinsurance counterparties decrease premiums written and earned.
Losses. Incurred losses represent the estimated future claim payments on newly defaulted insured loans as well as any change in our claim estimates for existing defaults. Our mortgage insurance incurred losses are driven primarily by new defaults and changes in the estimates we use to determine our losses, including estimates with respect to the likelihood, magnitude and timing of anticipated losses, and our estimate of the rate at which we expect defaults will ultimately result in paid claims. Other factors influencing incurred losses include:
The percentage of coverage on insured loans (higher percentages of insurance coverage generally result in higher incurred losses) and the presence of structural mitigants such as deductibles or stop losses;
The distribution of claims over the life cycle of a portfolio (historically, claims are relatively low during the first two years after a loan is originated and then increase over a period of several years before declining; however, several factors can impact and change this cycle, including the economic environment, the quality of the underwriting of the loan, characteristics of the mortgage loan, the credit profile of the borrower, housing prices and unemployment rates);
The BofA Settlement Agreement established that Radian will limit Rescissions, Claim Denials or Claim Curtailments on Legacy Loans. See Note 10 of Notes to Consolidated Financial Statements for additional information about the BofA Settlement Agreement; and
Services Revenue. Our Services revenue is primarily derived from: (i) loan review and due diligence services; (ii) surveillance services, including RMBS surveillance, loan servicer oversight, loan-level servicing compliance reviews and operational reviews of mortgage servicers and originators; (iii) valuation and component services, providing outsourcing solutions primarily for the SFR and real estate markets, as well as outsourced solutions for appraisal, title and closing services; and (iv) REO management services. See “Mortgage and Real Estate Services-Business-Mortgage and Real Estate Services Revenue Drivers” for additional information regarding current and expected future revenue drivers.
Radian Asset Assurance Stock Purchase Agreement. Radian completed the sale of Radian Asset Assurance to Assured on April 1, 2015, pursuant to the Radian Asset Assurance Stock Purchase Agreement dated as of December 22, 2014. Until the April 1, 2015 sale date, the operating results of Radian Asset Assurance were classified as discontinued operations for all periods presented in our consolidated statements of operations. Previously, Radian Asset Assurance had represented substantially all of the financial guaranty segment; therefore, as a result of the sale, we no longer report a financial guaranty business segment.
Radian Asset Assurance provided direct insurance and reinsurance on credit-based structured finance and public finance risks. The assets and liabilities associated with the discontinued operations were historically a source of significant volatility to Radian’s results of operations, due to various factors including fluctuations in fair value and credit risk. For additional information related to discontinued operations, see Note 3 of Notes to Consolidated Financial Statements.
The following table highlights selected information related to our consolidated results of operations for the years ended December 31, 2015, 2014 and 2013:
Our results for 2014 compared to 2013 reflect: (i) the significant tax benefit associated with the reversal of substantially all of our deferred tax valuation allowance; (ii) a significant reduction in the provision for losses; (iii) net gains on investments and other financial instruments in 2014, as compared to net losses in 2013; and (iv) an increase in net premiums earned. See “-Results of Operations-Mortgage Insurance” for more information on our net premiums earned-insurance, net investment income, provision for losses, and operating expenses.
Income (Loss) from Discontinued Operations, Net of Tax. Upon completion of the sale of Radian Asset Assurance in 2015, we recorded an additional pre-tax impairment charge of $14.3 million. In 2015, we recorded total net income from discontinued operations of $5.4 million, consisting primarily of the recognition of investment gains previously deferred and recorded in accumulated other comprehensive income and recognized as a result of the completion of the sale of Radian Asset Assurance to Assured, as well as adjustments to estimated transaction costs and taxes.
Based upon the Radian Asset Assurance Stock Purchase Agreement, Radian Asset Assurance met the criteria to be accounted for as held for sale and discontinued operations at December 31, 2014. As a result, in 2014, we recognized a $467.5 million pre-tax impairment charge reported as loss from discontinued operations. We have also reclassified the related operating results as discontinued operations for all periods presented in our consolidated statements of operations. No general corporate overhead or interest expense was allocated to discontinued operations in 2015 or 2014.
The loss from discontinued operations consists of three components: (i) loss on classification as held for sale for the year ended December 31, 2014; (ii) income or loss from operations of businesses held for sale; and (iii) income tax provision. The divestiture of our financial guaranty business was part of Radian’s strategy to focus its business on the real estate and mortgage finance markets and accelerated its ability to comply with the PMIERs.
Services Revenue and Direct Cost of Services. In 2015 and 2014, services revenue and direct cost of services all relate to our Services segment. See “-Results of Operations-Services” for more information.
Amortization and Impairment of Intangible Assets. The amortization and impairment of intangible assets for 2015 and 2014 primarily reflects the amortization of intangible assets acquired as part of the Clayton acquisition. In 2014, we also recorded a $2.1 million impairment of a portion of our goodwill related to a small subsidiary within our Services segment, which had been acquired in 2013. See Note 7 of Notes to Consolidated Financial Statements for additional information.
Adjusted pretax operating income (loss) is defined as pretax income (loss) from continuing operations excluding the effects of: net gains (losses) on investments and other financial instruments; loss on induced conversion and debt extinguishment; acquisition-related expenses; amortization and impairment of intangible assets; and net impairment losses recognized in earnings.
Loss on induced conversion and debt extinguishment. Gains or losses on early extinguishment of debt or losses incurred to purchase our convertible debt prior to maturity are discretionary activities that are undertaken in order to take advantage of market opportunities to strengthen our financial and capital positions; therefore, these activities are not viewed as part of our operating performance. Such transactions do not reflect expected future operations and do not provide meaningful insight regarding our current or past operating trends. Therefore, these items are excluded from our calculation of adjusted pretax operating income (loss).
During 2015, we continued our strategy of growing our mortgage insurance portfolio by writing insurance on mortgages with strong credit characteristics. At December 31, 2015, we had approximately $176 billion in IIF compared to approximately $172 billion in IIF at December 31, 2014. We also continued to focus on managing losses in our Legacy Portfolio, reducing the size of our Legacy Portfolio and effectively managing our capital and liquidity positions in order to achieve compliance with the PMIERs. See “Liquidity and Capital Resources-Radian Group-Short-Term Liquidity Needs-Capital Support for Subsidiaries” and Note 1 of Notes to Consolidated Financial Statements for additional information.
The following table summarizes our Mortgage Insurance segment’s results of operations for the years ended December 31, 2015, 2014 and 2013:
A key component of our current business strategy is to grow our mortgage insurance business by writing insurance on high credit quality mortgages in the U.S. Consistent with this objective, we wrote $41.4 billion of primary new mortgage insurance in 2015 compared to $37.3 billion in 2014.
The increase in NIW of approximately 11% for 2015 compared to 2014 is primarily attributable to increases both in mortgage originations overall and in the penetration rate of private mortgage insurance for home purchases, partially offset by the impact to our market share from heightened competition among private mortgage insurers. During this time period, recovery in wage and job growth supported increased home purchase mortgage volume, and low interest rates continued to support refinance activity at higher levels than in 2014. At the same time, the penetration rates of both private mortgage insurers and the FHA in the overall insured mortgage market increased, resulting in a mortgage insurance market that was larger for 2015 than for 2014. While the overall mortgage insurance market increased during 2015, the FHA’s market share increased relative to the aggregate market share of private mortgage insurers. In January 2015, the FHA reduced its annual mortgage insurance premium by 50 basis points to approximately 85 basis points per year. The FHA reduction on annual premiums has impacted our ability to compete with the FHA on certain high-LTV loans to borrowers with FICO scores below 720.
Since 2009, virtually all of our new mortgage insurance business production has been prime business. FICO scores for the borrowers of these insured mortgages are higher, and there are fewer loans with LTVs greater than 95%, as compared to mortgages in our Legacy Portfolio. Our portfolio of business written since the beginning of 2009 has been steadily increasing in proportion to our total primary RIF. The loans from our 2009 and later origination years possess significantly improved credit characteristics compared to our Legacy Portfolio. In addition, refinancings under the HARP programs (discussed below) have had a positive impact on the overall credit quality and composition of our mortgage insurance portfolio because the refinancing generally results in terms under which a borrower has a greater ability to pay and more financial flexibility to cover the loan obligations. As shown in the chart below, the sum of our 2009 through 2015 portfolios and our HARP refinancings accounted for approximately 84% of our total primary RIF at December 31, 2015, compared to 79% at December 31, 2014.
The growth of our portfolio written since the beginning of 2009, together with continued improvement in the portfolio as a result of HARP refinancings (discussed below), among other things, has contributed to the significant improvement in the credit quality of our overall mortgage insurance portfolio. The table below illustrates the improved composition of our mortgage insurance portfolio RIF, based on origination vintages.
As shown above, our 2009 and later NIW has a more favorable risk profile than previous vintages, based on:
Because our expected future losses on our mortgage insurance portfolio written since the beginning of 2009 and our HARP refinancings are significantly lower than those experienced on our Legacy Portfolio, the strengthening composition of our overall mortgage insurance portfolio has led to improvement in our Mortgage Insurance segment’s operating profitability.
The charts and table below show the growth in RIF written in 2009 and later, as well as the improved performance of our mortgage insurance portfolios written since 2009.
The following charts illustrate the improved trends of our cumulative incurred loss ratios by year of origination and development year.
Effective March 31, 2015, we refined our Persistency Rate calculation to incorporate loan level detail rather than aggregated portfolio data. Prior periods have been recalculated and reflect the current calculation methodology.
The Persistency Rate for the 12 months ended December 31, 2015 decreased from 2014 primarily due to increased refinancing activity and the cancellations of Single Premium Policies due to prepayments that servicers had not previously reported to Radian. See “-Net Premiums Written and Earned,” below.
The Persistency Rate annualized based on the quarter ended December 31, 2015 decreased from 2014 due to increased refinancing activity in the fourth quarter of 2015 as compared to the same quarter in 2014.
Net Premiums Written and Earned. Net premiums written increased in 2015 compared to 2014, primarily due to an increase in NIW in 2015 compared to 2014. In addition, the volume of Single Premium Policies written in 2015 increased as a percentage of our total NIW, as Single Premium Policies were approximately 31% compared to 28% for 2014. Net premiums written decreased in 2014 compared to 2013 primarily due to a significant decrease in NIW in 2014 compared to 2013, and a decline in Single Premium Policies from 32% in 2013.
Net premiums earned increased for 2015 compared to 2014 primarily as a result of the impact of the acceleration of the recognition of premiums earned on Single Premium Policies that were cancelled during 2015 due to: (i) increased refinance activity in 2015; and (ii) prepayments that servicers had not previously reported to Radian. In addition, the increase in net premiums earned in 2015 compared to 2014 was also driven by an increase in the overall level of our IIF. Net premiums earned increased in 2014 compared to 2013, primarily due to increases in direct premiums earned as a result of an increase in IIF and a decrease in our accrual for premiums refunded in connection with lower Rescissions in 2014 compared to 2013.
Provision for Losses. Our mortgage insurance provision for losses decreased in 2015 compared to 2014 and significantly decreased in 2014 compared to 2013. The following table details the financial impact of the significant components of our provision for losses for the periods indicated (including amounts related to change in PDR on Second-liens):
Includes 7,353, 9,101 and 11,860 insured loans subject to the Freddie Mac Agreement at December 31, 2015, 2014 and 2013, respectively.
Excludes 2,821, 4,467 and 7,221 loans that are in default at December 31, 2015, 2014 and 2013, respectively, that are subject to the Freddie Mac Agreement, and for which we no longer have claims exposure.
(1)Amounts reflected are compiled monthly based on reports received from loan servicers. The number of new defaults and Cures presented includes the following monthly defaults that both defaulted and cured within the periods indicated:
Includes claim payments related to the BofA Settlement Agreement for 2015.
Net of any Claim Denials that were reinstated during the period. Such previously denied but reinstated claims are generally reviewed for possible Rescission prior to any claim payment.
The following tables show additional information about our primary loans in default as of the dates indicated:
Total mortgage insurance claims paid in 2015 of $764.7 million have decreased from claims paid of $838.3 million in 2014, primarily due to the overall decline in defaulted loans and ongoing reduction in pending claims partially offset by an increase in claims paid due to the settlement of the BofA settlement agreement. Total mortgage insurance claims paid in 2014 of $838.3 million decreased from claims paid of $1.4 billion in 2013 due in part to the claim payment of $255 million in 2013 relating to the Freddie Mac Agreement. The additional decrease in paid claims in 2014 compared to the prior year period is consistent with the overall decline in defaulted loans. We have reduced our pending claim inventory significantly since 2012, due in part to greater efficiencies in our claims review process, which allows us to pay valid claims more quickly than in previous periods. We currently expect claims paid to be between $400 million and $450 million in 2016.
Includes the impact of the BofA Settlement Agreement from Implementation Date.
Represents total first-lien direct claims paid, excluding impact of reinsurance and LAE expenses and Freddie Mac Agreement.
The increase in interest expense in 2014 compared to 2013 is primarily related to the issuance of $400 million of debt in March 2013.
The following table summarizes our Services segment’s results of operations for the years ended December 31, 2015 and 2014:
Adjusted pretax operating (loss) income. Our Services segment’s adjusted pretax operating (loss) income was a loss of $2.2 million compared to income of $5.4 million in 2014. Our results for 2015 primarily reflect a decrease in gross profit and an increase in other operating expenses, both as a percentage of Services revenue for the respective periods.
The top 10 customers of the Services segment generated approximately 49% of the services revenues for the year ended December 31, 2015 as compared to 64% for 2014. The largest single customer generated approximately 10% of the services revenue for the year ended December 31, 2015. For the year ended December 31, 2014, services revenue includes a significant loan review and due diligence project for a single client which represented approximately 13% of services revenue. The project continued in 2015, at a reduced level. The increased burden on loan originators to implement and comply with TRID, which went into effect in the fourth quarter of 2015, resulted in a slowdown in the volume of newly originated loans and had a negative impact on our loan review and due diligence revenues due to delays in the closing of mortgage loans.
The chart below provides the composition of services revenue on a quarterly basis for periods subsequent to the June 30, 2014 acquisition of Clayton.
Direct Cost of Services. Direct cost of services primarily consists of employee compensation and related payroll benefits, and, to a lesser extent, other direct costs of providing services such as travel and related expenses incurred in providing client services and costs paid to outside vendors. Direct cost of services is primarily affected by the level of services being provided and, therefore, is correlated to the level of services revenue.
Other Operating Expenses. Other operating expenses primarily consist of compensation costs not classified as direct cost of services because they are related to employees, such as sales and corporate employees, who are not directly involved in providing client services. For the years ended December 31, 2015 and 2014, compensation-related costs represented approximately 56% and 57%, respectively, of the segment’s operating expenses. Other operating expenses also include other selling, general and administrative expenses, depreciation, and allocations of corporate general and administrative expenses. Other operating expenses for the years ended 2015 and 2014 include an allocation of corporate operating expenses of $4.8 million and $1.1 million, respectively.
Interest Expense. For the year ended December 31, 2015, interest expense represents all of the interest expense related to our Senior Notes due 2019, the proceeds of which were used to fund Radian Group’s acquisition of Clayton.
For our Convertible Senior Notes due 2017, excludes the conversion premium amount that may be settled upon conversion in cash, shares of our common stock or a combination thereof, at our election.
Includes $390 million of Convertible Senior Notes due 2019 that may be settled upon conversion in cash, shares of our common stock or a combination thereof, at our election, as well as $300 million and $350 million of senior notes due 2019 and 2020, respectively, that may be redeemed, in whole or part at any time prior to maturity.
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 every calendar quarter. RMAI had $8.1 million of statutory policyholders’ surplus and no RIF exposure as of December 31, 2015.
Radian Group and RGRI are parties to an Assumption and Indemnification Agreement with regard to RGRI’s portion of the Deficiency Amounts relating to the IRS litigation. This indemnification agreement was made in lieu of an immediate capital contribution to RGRI that otherwise would have been required for RGRI to maintain its minimum statutory policyholders’ surplus requirements in light of the remeasurement as of December 31, 2011 of uncertain tax positions related to the portfolio of REMIC residual interests. See Note 13 of Notes to Consolidated Financial Statements for additional information regarding the IRS matter. We can provide no assurance regarding the outcome of this IRS matter, which may take several years to resolve. As such, there remains significant uncertainty with regard to the amount and timing of any potential payments under the indemnity agreement described above. See “Item 1A. Risk Factors-Resolution of our dispute with the IRS could adversely affect us.”
Upon completion of the sale of Radian Asset Assurance, our holding company liquidity increased on April 1, 2015 by approximately $45 million due to the release of funds held in a separate escrow account as a result of the elimination of potential tax reimbursements to Radian Asset Assurance.
In addition to the $100 million that was used in the first quarter of 2016 to complete the repurchases of Radian Group Common Stock, as described above, Radian Group’s principal liquidity demands for the next 12 months are expected to include: (i) the payment of corporate expenses; (ii) interest payments on our outstanding long-term debt; (iii) conversion settlements, repurchases or redemptions of portions of our long-term debt; (iv) potential investments to support our strategy of growing our businesses; (v) potential payments to the U.S. Treasury resulting from our ongoing dispute with the IRS relating to the examination of our 2000 through 2007 consolidated federal income tax returns by the IRS, as discussed below; and (vi) the payment of dividends on our common stock.
On a quarterly basis, we evaluate whether the conversion threshold requirements for our Convertible Senior Notes due 2017 and our Convertible Senior Notes due 2019 have been met. As of December 31, 2015, the holders of our Convertible Senior Notes due 2017 and of our Convertible Senior Notes due 2019 are not able to exercise their conversion rights during the three-month period ending March 31, 2016. In the event the conversion threshold requirements are met in the future, we may elect, in our sole discretion, to settle any such Convertible Senior Notes due 2019 in the form of cash. In the case of the Convertible Senior Notes due 2017, the principal amount must be settled in cash, with the conversion premium to be settled in cash or stock at our discretion. We cannot predict whether holders of our Convertible Senior Notes will choose to exercise their conversion rights prior to maturity. See Note 11 of Notes to Consolidated Financial Statements for further information about our Convertible Senior Notes due 2017 and 2019.
At any time on or after March 8, 2016, we may redeem at our option all or part of our Convertible Senior Notes due 2019, as long as the daily closing sale price per share of our common stock is at least 130% of the then-current conversion price for at least 20 out of the immediately preceding 30 consecutive trading days before the delivery of a redemption notice, including the trading day immediately preceding the date on which we provide the redemption notice. This threshold is equal to $13.78 per share and is subject to adjustments made pursuant to the terms of the indenture for the notes. The conversion rate initially is 94.3396 shares of our common stock per $1,000 principal amount of notes (corresponding to an initial conversion price of approximately $10.60 per share of common stock), subject to adjustment in certain events. If we elect to redeem the Convertible Senior Notes due 2019 at any point in the future, we plan to provide the required redemption notice 60 calendar days prior to the redemption date. Additionally, no less than 45 scheduled trading days prior to any such redemption date, we plan to publicly announce our intention to settle any conversions occurring on or after the date of such redemption notice and prior to the related redemption date in cash, stock, or a specified combination of cash and stock. See Note 11 of Notes to Consolidated Financial Statements for further information.
Corporate Expenses and Interest Expense. Radian Group has expense-sharing arrangements in place with its principal operating subsidiaries that require those subsidiaries to pay their allocated share of certain holding-company-level expenses, including interest payments on most of our outstanding long-term debt. Payments of such corporate expenses for the next 12 months, excluding interest payments on our long-term debt, are expected to be approximately $53.5 million, all of which is expected to be reimbursed by our subsidiaries under our existing expense-sharing arrangements. For the same period, payments of interest on our long-term debt are expected to be approximately $62.8 million, a significant portion of which is expected to be reimbursed by our subsidiaries under our existing expense-sharing arrangements. These expense-sharing arrangements, as amended, have been approved by applicable state insurance departments, but such approval may be modified or revoked at any time.
Capital Support for Subsidiaries. On April 17, 2015, the FHFA issued the final PMIERs, setting forth revised requirements for private mortgage insurers, including Radian Guaranty, to remain eligible insurers of loans purchased by the GSEs. The PMIERs became effective for existing eligible mortgage insurers on December 31, 2015, and replace the capital adequacy standards under the current GSE eligibility requirements. See Note 1 in Notes to Consolidated Financial Statements for additional information. Radian Guaranty currently is in compliance with the PMIERs Financial Requirements.
In order to comply with the PMIERs and maximize financial flexibility, Radian executed certain fourth-quarter 2015 transactions, as described below.
Radian Guaranty may redeem 50% of the Surplus Note balance on or after June 30, 2016.
Radian Guaranty had the option to recapture a portion of the risk ceded under its existing Second QSR Transaction on December 31, 2015. As indicated above, the company has chosen not to recapture that risk and has received an $8 million profit commission based on performance to date, which increased net premiums earned, and an $8.5 million prepaid supplemental ceding commission, the recognition of which has been deferred and will be amortized as a reduction to our other operating expenses over approximately the next five years. The decision not to exercise the option to recapture a portion of the risk ceded under the Second QSR Transaction helped Radian to maintain a lower Minimum Required Assets under PMIERs than if the recapture option were exercised.
Although we do not believe it is likely in light of the new PMIERs Financial Requirements, Radian Group could be required to provide additional capital support for Radian Guaranty and our other mortgage insurance subsidiaries if additional capital is required pursuant to future changes to insurance laws and regulations. The NAIC is in the process of reviewing the minimum capital and surplus requirements for mortgage insurers and considering changes to the Model Act. While the outcome of this process is not known, we expect that the capital requirements in states that adopt the new Model Act may increase as a result of the changes; however, we do not believe the changes to the Model Act will result in financial requirements that require greater capital than the level required under the final PMIERs Financial Requirements.
Dividends. Our quarterly common stock dividend currently is $0.0025 per share and, based on our current outstanding shares of common stock, we would require approximately $2.1 million in the aggregate to pay our quarterly dividends for the next 12 months. Radian Group is not subject to any limitations on its ability to pay dividends except those generally applicable to corporations that are incorporated in Delaware. Delaware corporation law provides that dividends are only payable out of a corporation’s capital surplus or (subject to certain limitations) recent net profits. As of December 31, 2015, our capital surplus was $2.5 billion, representing our dividend limitation under Delaware law.
IRS Matter. On September 4, 2014, we received Notices of Deficiency covering our 2000 through 2007 tax years that assert unpaid taxes and penalties of approximately $157 million. The Deficiency Amount has not been reduced to reflect our NOL carryback ability. As of December 31, 2015, there would also be interest of approximately $125 million related to these matters. Depending on the outcome, additional state income taxes, penalties and interest (estimated in the aggregate to be approximately $32 million as of December 31, 2015) also may become due when a final resolution is reached. The Notices of Deficiency also reflected additional amounts due of approximately $105 million, which are primarily associated with the disallowance of the previously filed carryback of the 2008 NOL to the 2006 and 2007 tax years. We believe that the disallowance of our 2008 NOL carryback is a precautionary position by the IRS and that we will ultimately maintain the benefit of this NOL carryback claim.
On December 3, 2014, we petitioned the U.S. Tax Court to litigate the Deficiency Amount. On September 1, 2015, we received a notice that the case had been scheduled for trial commencing on February 1, 2016. However, the parties jointly filed, and the U.S. Tax Court approved, motions for continuance in this matter to postpone the trial date. The litigation could take several years to resolve and may result in substantial legal expenses. We can provide no assurance regarding the outcome of any such litigation or whether a compromised settlement with the IRS will ultimately be reached. Radian Group has assumed the obligation to pay RGRI’s portion of the liabilities associated with these tax matters by indemnifying RGRI for such liabilities, which may be substantial. 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.
Sources of Liquidity. In addition to existing available cash and marketable securities, Radian Group’s principal sources of cash to fund short-term liquidity needs include: (i) payments made to Radian Group under tax- and expense-sharing arrangements with our subsidiaries, as discussed above; (ii) potential dividend payments from Clayton, if any, in excess of payments due under tax-and expense-sharing arrangements; and (iii) any amounts that Radian Guaranty is able to successfully redeem under the Surplus Note.
$52.4 million principal amount of convertible debt due in November 2017, which must be settled in cash, plus any related conversion premium which may, at our option, be settled in cash, common stock or a combination thereof;
$300 million principal amount of outstanding debt due in June 2019; and
$350 million principal amount of outstanding debt due in June 2020;
potential payments to the U.S. Treasury resulting from our ongoing dispute with the IRS relating to the examination of our 2000 through 2007 consolidated federal income tax returns by the IRS, as discussed above.
As of the balance sheet date, certain of our insurance subsidiaries, including Radian Guaranty, have incurred NOLs that could not be carried-back and utilized on a separate company tax return basis. As a result, we are not currently obligated under our tax-sharing agreement to reimburse these subsidiaries for their separate company NOL Carryforward. However, if in a future period our consolidated NOL is fully utilized before a subsidiary has utilized its share of NOLs on a separate entity basis, then Radian Group may be obligated to fund such subsidiary’s share of our consolidated tax liability to the IRS. Currently, we do not expect to fund material obligations related to these subsidiary NOLs.
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; (iv) dividends from our subsidiaries, including Clayton, to the extent available; and (v) any amounts that Radian Guaranty is able to successfully redeem under the Surplus Note.
The principal demands for liquidity in our mortgage insurance business include the payment of claims and potential claim settlement transactions, operating expenses (including those allocated from Radian Group) and taxes. Radian Guaranty currently expects to seek to redeem a portion or all of the Surplus Note to Radian Group in 2016, and any remaining amount in 2017. The principal sources of liquidity in our mortgage insurance business currently include insurance premiums, net investment income, cash flows from investment sales and maturities and, potentially, capital from Radian Group. We believe that the operating cash flows generated by each of our mortgage insurance subsidiaries will provide these subsidiaries with a substantial portion of the funds necessary to satisfy their claim payments, operating expenses and taxes for the foreseeable future.
On April 17, 2015, the FHFA issued the final PMIERs, setting forth revised requirements for private mortgage insurers, including Radian Guaranty, to remain eligible insurers of loans purchased by the GSEs. The PMIERs were further updated on June 30, 2015. See Note 1 of Notes to Consolidated Financial Statements for more information regarding the PMIERs, including the PMIERs Financial Requirements.
The principal demands for liquidity in our Services segment include the payment of employee compensation and other operating expenses (including those allocated from Radian Group), interest payments related to the Senior Notes due 2019, and dividends to Radian Group. The principal sources of liquidity in our Services segment are cash generated by operations and, to the extent necessary, capital contributions from Radian Group.
Liquidity levels may fluctuate depending on the levels and contractual timing of our invoicing and the payment practices of the Services clients, in combination with the timing of Services payments for employee compensation and to external vendors. The amount, if any, and timing of the Services segment’s dividend paying capacity will depend primarily on the amount of excess cash flow generated by the segment. In 2015, the Services segment reimbursed Radian Group for allocated corporate interest expense and operating expenses of $8.9 million and $4.4 million, respectively.
Stockholders’ equity increased to $2.5 billion at December 31, 2015, from $2.1 billion at December 31, 2014. The increase in stockholders’ equity resulted primarily from: (i) our net income of $287 million for the year ended December 31, 2015; and (ii) the impact of our recently completed debt and equity transactions to strengthen Radian’s capital position, which increased stockholder’s equity by $160.4 million, excluding the $70 million after-tax impact from the loss on induced conversion and debt extinguishment already reflected in net income. See “-Overview-2015 and Other Recent Developments-2015 Debt and Equity Transactions” for additional information.
Radian Group and Radian Guaranty have been assigned the ratings set forth in the chart below, reflecting upgrades from both Moody’s and S&P in January, 2016. We believe that ratings often are considered by others in assessing our credit strength and the financial strength of our primary mortgage insurance subsidiary. See “Item 1A. Risk Factors - Radian Guaranty may fail to maintain its eligibility status with the GSEs.”
Moody’s outlook for Radian Group and Radian Guaranty currently is Stable.
The impact to our reserve due to estimated future Rescissions and Claim Denials incorporates our expectations regarding the number of policies that we expect to be reinstated as a result of our claims rebuttal process. Rescissions and Claim Denials may occur for various reasons, including, without limitation, underwriting negligence, fraudulent applications and appraisals, breach of representations and warranties and inadequate documentation, primarily related to our Legacy Portfolio. The level of Rescissions and Claim Denials has been declining in recent periods as our defaulted Legacy Portfolio continues to decline, and we expect this trend to continue. In addition, with respect to claims decisions on the population of Future Legacy Loans covered under the BofA Settlement Agreement, Radian Guaranty has agreed, subject to certain limited exceptions and conditions, that it will limit Rescissions, Claim Denials or Claim Curtailments. See Note 10 of Notes to Consolidated Financial Statements for additional information about the BofA Settlement Agreement.
For our first-lien insurance business, because the combination of the net present value of expected premiums and previously established reserves (net of reinsurance recoverables) exceeds the net present value of expected losses and expenses, a first-lien PDR was not required as of December 31, 2015 or December 31, 2014. Assuming all other factors remained constant, if our assumed paid claim rate increased from approximately 5% to approximately 12%, we would be required to establish a PDR.
Evaluating the expected profitability of our existing mortgage insurance business and the need for a PDR for our first-lien business involves significant reliance upon assumptions and estimates with regard to the likelihood, magnitude and timing of potential losses and premium revenues. The models, assumptions and estimates we use to evaluate the need for a PDR may prove to be inaccurate, especially during any extended economic downturn or period of extreme market volatility and uncertainty. We cannot be certain that we have correctly estimated the expected profitability of our existing first-lien mortgage portfolio or that the Second-lien PDR established will be adequate to cover the ultimate losses on our Second-lien business.
Money market instruments-The fair value of money market instruments is based on daily prices, which are published and available to all potential investors and market participants. As such, these securities are categorized in Level I of the fair value hierarchy.
We group assets in our investment portfolio into one of three main categories: held to maturity, available for sale or trading securities. Fixed-maturity securities for which we have the positive intent and ability to hold to maturity, if any, are classified as held to maturity and are reported at amortized cost. Investments in securities not classified as held to maturity or trading securities are classified as available for sale and are reported at fair value, with unrealized gains and losses (net of tax) reported as a separate component of stockholders’ equity as AOCI. Investments classified as trading securities are reported at fair value, with unrealized gains and losses reported as a separate component of income. Short-term investments consist of money market instruments, certificates of deposit and highly liquid, interest-bearing instruments with an original maturity of three months or less at the time of purchase. Amortization of premium and accretion of discount are calculated principally using the interest method over the term of the investment. Realized gains and losses on investments are recognized using the specific identification method.
Intangible assets, other than goodwill, primarily consist of customer relationships, technology, trade name and trademarks, client backlog and non-competition agreements. Customer relationships represent the value of the specifically acquired customer relationships and are valued using the excess earnings approach using estimated client revenues, attrition rates, implied royalty rates and discount rates. The excess earnings approach estimates the present value of expected earnings in excess of a traditional return on business assets. Technology represents proprietary software used for loan review and due diligence, managing the REO disposition process and performing surveillance of mortgage loan servicers. Trade name and trademarks reflect the value inherent in the recognition of the “Clayton” name and its reputation. For purposes of our intangible assets, we use the term client backlog to refer to the estimated present value of fees to be earned for services performed on loans currently under surveillance or REO assets under management. The value of a non-competition agreement is an appraisal of potential lost revenues that would arise from an individual leaving to work for a competitor or initiating a competing enterprise. For financial reporting purposes, intangible assets with finite lives are amortized over their applicable estimated useful lives in a manner that approximates the pattern of expected economic benefit from each intangible asset.
In April 2014, the FASB issued an update to the accounting standard for reporting discontinued operations and disclosures of disposals of components of an entity. This update changes the requirements for reporting discontinued operations. A disposal of a component of an entity or a group of components of an entity is required to be reported in discontinued operations if the disposal represents (or would represent) a strategic shift that has (or will have) a major effect on an entity’s operations and financial results when any of the following occurs: (a) the component of an entity or group of components of an entity meets the criteria to be classified as held for sale; (b) the component of an entity or group of components of an entity is disposed of by sale; or, (c) the component of an entity or group of components of an entity is disposed of other than by sale (for example, by abandonment or in a distribution to owners in a spin-off). The amendments in this update require expanded disclosures about discontinued operations. The provisions of this update were effective for all disposals (or classifications as held for sale) of components of an entity that occur within annual periods beginning on or after December 15, 2014, and interim periods within those years. Early adoption was permitted, but only for disposals (or classifications as held for sale) that have not been reported in financial statements previously issued or available for issuance. We did not elect early adoption of this update for the disposition of Radian Asset Assurance. The significance of this guidance for the Company is dependent on any future dispositions or disposals.
In April 2015, the FASB issued an update to the accounting standard for the presentation of debt issuance costs in financial statements. The new standard requires an entity to present debt issuance costs related to a recognized debt liability as a direct reduction from the carrying amount of the related debt liability, consistent with debt discounts, rather than as a separate asset as currently required. The recognition and measurement guidance for debt issuance costs are not affected by the update. The provisions of this update are effective for interim and annual periods beginning after December 15, 2015, and must be applied on a retrospective basis for all periods presented. We early adopted this update effective June 30, 2015, as permitted for financial statements that have not been previously issued. The implementation of this update resulted in a reclassification of approximately $17.6 million of remaining debt issuance costs on our December 31, 2014 consolidated balance sheet, from other assets, to be presented as a reduction of the related debt liability. This update has also been applied retrospectively to prior periods presented. See Note 11 of Notes to Consolidated Financial Statements for additional information on the impact of the reclassification.
In May 2015, the FASB issued an update to the accounting standard for the accounting of short-duration insurance contracts by insurance entities. The amendments in this update require insurance entities to disclose certain information about the liability for unpaid claims and claim adjustment expenses. The additional information required is focused on improvements in disclosures regarding insurance liabilities, including the timing, nature and uncertainty of future cash flows related to insurance liabilities and the effect of those cash flows on the statement of comprehensive income. The disclosures required by this update are effective for annual periods beginning after December 15, 2015, and interim periods within annual periods beginning after December 15, 2016; early adoption is permitted. We are currently evaluating the additional disclosures required in our financial statements as a result of this update.
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, comprehensive income (loss), changes in common stockholders’ equity, and cash flows present fairly, in all material respects, the financial position of Radian Group Inc. and its subsidiaries at December 31, 2015 and 2014, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2015 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in Item 15(a)(2) present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2015, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements and financial statement schedules, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Report on Internal Control over Financial Reporting appearing under Item 9A. Our responsibility is to express opinions on these financial statements, on the financial statement schedules, and on the Company’s internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
Our Mortgage Insurance segment provides credit-related insurance coverage, principally through private mortgage insurance, to mortgage lending institutions nationwide. We provide our mortgage insurance products and services mainly through our wholly-owned subsidiary, Radian Guaranty. Private mortgage insurance protects mortgage lenders from all or a portion of default-related losses on residential mortgage loans made to home buyers who generally make down payments of less than 20% of the home’s purchase price. Private mortgage insurance also supports increased levels of home ownership by facilitating the sale of these mortgage loans in the secondary mortgage market, most of which are sold to the GSEs.
On April 1, 2015, Radian Guaranty completed the sale of 100% of the issued and outstanding shares of Radian Asset Assurance for a purchase price of approximately $810 million, pursuant to the Radian Asset Assurance Stock Purchase Agreement. The divestiture was intended to better position Radian Guaranty to comply with the PMIERs and to support Radian’s strategic focus on the mortgage and real estate industries. After closing costs and other adjustments, Radian Guaranty received net proceeds of $789 million. For additional information related to discontinued operations, see Note 3.
In order to be eligible to insure loans purchased by the GSEs, mortgage insurers such as Radian Guaranty must meet the GSEs’ eligibility requirements, or PMIERS. The GSEs recently revised the PMIERs, effective December 31, 2015, with the aim of ensuring that approved insurers will possess the financial and operational capacity to serve as strong counterparties to the GSEs throughout various market conditions. As a consequence, the PMIERs are comprehensive, covering virtually all aspects of the business and operations of a private mortgage insurer, including internal risk management and quality controls, the relationship between the GSEs and the approved insurer and the approved insurer’s financial condition. The GSEs have significant discretion under the PMIERs as well as a broad range of consent rights to approve various actions of the approved insurer. The GSEs may amend the PMIERs at any time in their sole discretion. If Radian Guaranty is unable to satisfy the requirements set forth in the PMIERs, Freddie Mac and/or Fannie Mae could restrict it from conducting certain types of business with them or take actions that may include not purchasing loans insured by Radian Guaranty.
In addition, Radian Guaranty had the option to recapture a portion of the risk ceded under its existing Second QSR Transaction on December 31, 2015. In order to manage its Minimum Required Assets under the PMIERs, Radian Guaranty chose not to exercise its option to recapture that risk and received a profit commission of approximately $8.0 million based on performance to date. In addition, Radian Guaranty received an $8.5 million prepaid supplemental ceding commission, the recognition of which has been deferred and is expected to be amortized as a reduction to our other operating expenses over approximately five years. See Note 8 for information on reinsurance transactions.
During 2015, Radian Group completed a series of transactions to strengthen its capital position, including reducing its overall cost of capital and improving the maturity profile of its debt. This series of transactions had four components:
Our consolidated financial statements are prepared in accordance with GAAP and include the accounts of all wholly-owned subsidiaries. All intercompany accounts and transactions, and intercompany profits and losses, have been eliminated. Certain prior period amounts have been reclassified to conform to current period presentation, including the adoption of an update to the accounting standard for the presentation of debt issuance costs in financial statements, as further described below in “-Recent Accounting Pronouncements.”
We also establish reserves for defaults that we estimate have been incurred but have not been reported to us on a timely basis by the servicer, as well as for previous Rescissions and Claim Denials that we estimate will be reinstated and subsequently paid. We generally give the policyholder up to 30 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 Policies with our lending customers, our policyholders 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.
Included in our loss reserves is an estimate related to a potential additional payment to Freddie Mac under the Freddie Mac Agreement, which is dependent upon the Loss Mitigation Activity on the population of loans subject to that agreement. Our reserve related to this potential additional payment is based on the estimated Rescissions, Claim Denials, Claim Curtailments, and cancellations for this population of loans, determined using assumptions that are consistent with those utilized to determine our overall loss reserves. See Note 10 for additional information about the Freddie Mac Agreement.
Mortgage insurance premiums written on an annual and multi-year basis are initially recorded as unearned premiums and earned over time. Annual premiums are amortized on a monthly, straight-line basis. Multi-year premiums are amortized over the terms of the contracts in relation to the anticipated claim payment pattern based on historical industry experience. Premiums written on a monthly basis are earned over the period that coverage is provided. When we rescind insurance coverage on a loan, we refund all premiums received in connection with such coverage. Premium revenue is recognized net of our accrual for estimated Rescission refunds. With respect to our reinsurance transactions, ceded premiums written are initially set up as prepaid reinsurance and are amortized in a manner consistent with the recognition of income on direct premiums. Premiums on certain Structured Transactions in our mortgage insurance business are recognized over the period that coverage is provided.
Incremental, direct costs associated with the successful acquisition of mortgage insurance business, consisting of compensation and other policy issuance and underwriting expenses, are initially deferred and reported as deferred policy acquisition costs. Amortization of these costs for each underwriting year book of business is expensed in proportion to estimated gross profits over the estimated life of the policies. This includes accruing interest on the unamortized balance of deferred policy acquisition costs. Ceding commissions received under our reinsurance arrangements related to these costs are also deferred and accounted for using similar assumptions, including certain amounts received under the QSR Transactions (See Note 8).
The Services segment derives most of its revenue from professional service activities. A portion of these activities are provided under “time-and-materials” billing arrangements. Services revenue consisting of billed fees and pass-through expenses is recorded as work is performed and expenses are incurred. Services revenue also includes expenses billed to clients, which includes travel and other out-of-pocket expenses, and other reimbursable expenses.
We do not recognize revenue or expense related to amounts advanced by us and subsequently reimbursed by clients for maintenance or repairs of REO properties because we are not the primary obligor and we have minimal credit risk. We record an expense if an advance is made that is not in accordance with a client contract and the client is not obligated to reimburse us.
Direct cost of services consists primarily of employee compensation and related payroll benefits, the cost of billable labor assigned to revenue-generating activities, as well as corresponding travel and related expenses incurred in providing such services to clients in our Services segment. Direct cost of services also includes costs paid to outside vendors, including real estate agents that provide valuation and related services. Direct cost of services does not include an allocation of overhead costs.
Our framework for assessing the recoverability of our DTAs requires consideration of all available evidence, including:
future projections of taxable income within the applicable carryback and carryforward periods, including the sustainability of our forecasts of future taxable income under potential stress scenarios;
Included in our restricted cash balances as of December 31, 2015 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; (3) funds held in trust for the benefit of certain policyholders; (4) escrow funds held for servicer liabilities; and (5) escrow funds held for title services obligations.
Accounts and notes receivable primarily consist of accrued premiums receivable due from our mortgage insurance customers, amounts due from our Services customers for services our Services segment has performed, and, as of December 31, 2014, the profit commission receivable related to the Initial QSR Transaction. See Note 8 for details. Accounts and notes receivable are carried at their estimated collectible amounts, net of any allowance for doubtful accounts, and are periodically evaluated for collectability based on past payment history and current economic conditions.
In May 2014, the FASB issued an update to the accounting standard regarding revenue recognition. This update is intended to provide a consistent approach in recognizing revenue. In accordance with the new standard, recognition of revenue occurs when a customer obtains control of promised goods or services in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. In addition, the new standard requires that reporting companies disclose the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. While this update is not expected to change revenue recognition principles related to our insurance products, this update may be applicable to a portion of the revenues from our Services segment. In July 2015, the FASB delayed the effective date for this updated standard to interim and annual periods beginning after December 15, 2017. We are currently evaluating the impact to our financial statements and future disclosures as a result of this update, if any.
In January 2016, the FASB issued an update that makes certain changes to the standard for the accounting of financial instruments. Among other things, the update requires: (i) equity investments to be measured at fair value with changes in fair value recognized in net income; (ii) the use of the exit price notion when measuring the fair value of financial instruments for disclosure purposes; (iii) separate presentation of financial assets and financial liabilities by measurement category and form of financial asset; and (iv) separate presentation in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk (also referred to as “own credit”) when the organization has elected to measure the liability at fair value in accordance with the fair value option for financial instruments. The update also eliminates the requirement to disclose the methods and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet. This update is effective for public companies for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Early adoption is not permitted, with the exception of the “own credit” provision. We are currently evaluating the impact to our financial statements and future disclosures as a result of this update.
On April 1, 2015, Radian Guaranty completed the sale of 100% of the issued and outstanding shares of Radian Asset Assurance for a purchase price of approximately $810 million, pursuant to the Radian Asset Assurance Stock Purchase Agreement.
Radian Asset Assurance provided direct insurance and reinsurance on credit-based risks. As a result, the assets and liabilities associated with the discontinued operations had historically been a source of significant volatility to Radian’s results of operations, due to various factors including fluctuations in fair value and credit risk. The divestiture was intended to better position Radian Guaranty to comply with the PMIERs (which are discussed in Note 1) and to support Radian’s strategic focus on the mortgage and real estate industries. After closing costs and other adjustments, Radian Guaranty received net proceeds of $789 million.
Based upon the applicable terms of the Radian Asset Assurance Stock Purchase Agreement, we determined that Radian Asset Assurance met the criteria for held for sale and discontinued operations accounting at December 31, 2014. As a result, we recognized a pre-tax impairment charge of $467.5 million for the year ended December 31, 2014 and an additional pre-tax impairment charge of $14.3 million through April 1, 2015, when the sale was completed. We recorded total net income from discontinued operations of $5.4 million related to this sale in 2015, consisting primarily of the recognition of investment gains previously deferred and recorded in accumulated other comprehensive income and recognized as a result of the completion of the sale of Radian Asset Assurance to Assured on April 1, 2015, as well as adjustments to estimated transaction costs and taxes. The operating results of Radian Asset Assurance are classified as discontinued operations for all periods presented in our Consolidated Statements of Operations. No general corporate overhead or interest expense was allocated to discontinued operations.
Previously, Radian Asset Assurance comprised substantially all of the financial guaranty segment and, as a result, we no longer present a financial guaranty segment. Certain corporate income and expenses that were previously allocated to the financial guaranty segment but were not reclassified to discontinued operations, such as investment income, interest expense and corporate overhead expenses, were reallocated to the Mortgage Insurance segment for those periods in which discontinued operations are presented.
Net impairment losses recognized in earnings. The recognition of net impairment losses on investments can vary significantly in both size and timing, depending on market credit cycles. We do not view these impairment losses to be indicative of our fundamental operating activities. Therefore, whenever these losses occur, we exclude them from our calculation of adjusted pretax operating income (loss).
Excludes the following revenue items not included in adjusted pretax operating loss: (i) net losses on investments and other financial instruments of $106.5 million; (ii) change in fair value of derivative instruments of $0.6 million.
Does not include assets held for sale of $1.8 billion which are not a part of the Mortgage Insurance segment.
At December 31, 2015, total Level III assets of $0.5 million accounted for less than 0.1% of total assets measured at fair value. This investment was purchased during the three months ended June 30, 2015, and there were no related gains or losses recorded during the year ended December 31, 2015. There were no Level III liabilities at December 31,2015.
The following is a list of those assets that are measured at fair value by hierarchy level as of December 31, 2014:
At December 31, 2014, there were no Level III assets other than those classified as assets held for sale, and total Level III liabilities of $3.8 million accounted for 100% of total liabilities measured at fair value.
For trading securities that were held at December 31, 2015 and 2014, we had net unrealized losses during 2015 and net unrealized gains during 2014 associated with those securities in the amount of $25.2 million and $65.7 million, respectively.
For the years ended December 31, 2015, 2014 and 2013, we did not sell or transfer any fixed-maturity investments classified as held to maturity. For the years ended December 31, 2015, 2014 and 2013, we did not transfer any securities from the available for sale or trading categories.
The following tables show the gross unrealized losses and fair value of our securities deemed “available for sale” aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, as of the dates indicated:
Impairments due to credit deterioration that result in a conclusion that the present value of cash flows expected to be collected will not be sufficient to recover the amortized cost basis of the security are considered other-than-temporary. Other declines in fair value (for example, due to interest rate changes, sector credit rating changes or company-specific rating changes) that result in a conclusion that the present value of cash flows expected to be collected will not be sufficient to recover the amortized cost basis of the security also may serve as a basis to conclude that an other-than-temporary impairment has occurred. To the extent we determine that a security is deemed to have had an other-than-temporary impairment, an impairment loss is recognized. There were no credit-related impairment losses recognized in earnings in 2015, 2014 or 2013.
As of December 31, 2015, we did not have any investment in any person and its affiliates that exceeded 10% of our total stockholders’ equity.
Securities on deposit with various state insurance commissioners amounted to $10.4 million and $12.1 million at December 31, 2015 and 2014, respectively.
At December 31, 2015 and 2014, Radian Guaranty had $74.7 million and $209.3 million, respectively, in a collateral account pursuant to the Freddie Mac Agreement. This collateral account, which contains investments primarily invested in trading securities, is pledged to cover Loss Mitigation Activity on the loans subject to the Freddie Mac Agreement. 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 that agreement. See Note 10 for additional information.
Our goodwill and intangible asset balances at December 31, 2015 and 2014 relates entirely to our Services segment, as a result of our acquisition of Clayton and its subsequent acquisitions of Red Bell and ValuAmerica, as discussed further below and in Note 2.
For the years ended December 31, 2015 and 2014, amortization expense was $13.0 million and $8.6 million, respectively. The amortization expense for 2014 includes an impairment loss of $2.1 million, as disclosed above. There was no amortization expense in 2013. The estimated aggregate amortization expense for 2016 and thereafter is as follows (in thousands):
The following table shows the amounts related to the QSR Transactions for the periods indicated:
Similar to the Initial QSR Transaction, pursuant to the Second QSR Transaction Radian Guaranty had the ability, at its option, to recapture one-half of the reinsurance ceded with respect to conventional GSE loans as of December 31, 2015. Radian Guaranty chose not to recapture that risk and negotiated an amendment to the Second QSR Transaction pursuant to which we received a profit commission of approximately $8.0 million based on performance to date, which increased net premiums earned during 2015. In addition, pursuant to the amendment, Radian Guaranty received an $8.5 million prepaid supplemental ceding commission, the recognition of which has been deferred and is expected to be amortized as a reduction to our other operating expenses over approximately five years. Finally, pursuant to the original agreement and effective January 1, 2016, the ceding commission was reduced from 35% to 30% for one-half of the remaining reinsurance ceded under the Second QSR Transaction.
We and other companies in the mortgage insurance industry have participated in reinsurance arrangements with mortgage lenders commonly referred to as “captive reinsurance arrangements.” Under captive reinsurance arrangements, a mortgage lender typically established a reinsurance company that assumed part of the risk associated with the portfolio of that lender’s mortgages insured by us on a flow basis (as compared to mortgages insured in Structured Transactions, which typically are not eligible for captive reinsurance arrangements). In return for the reinsurance company’s assumption of a portion of the risk, we ceded a portion of the mortgage insurance premiums paid to us to the reinsurance company. The captive reinsurers are typically required to maintain minimum capitalization equal to 10% of the risk assumed. We have also participated, on a limited basis, in “quota share” captive reinsurance agreements under which the captive reinsurance company assumed a pro rata share of all losses in return for a pro rata share of the premiums collected.
During the financial crisis and downturn in the housing and related credit markets, losses increased significantly and almost all captive reinsurance arrangements have attached, thereby 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. We have not entered into any new captives since 2007 and, pursuant to consent orders with the CFPB and with the order with the Minnesota Department of Commerce, we have agreed not to enter into any new captives until 2025. See Note 17 regarding our Consent Order with the Minnesota Department of Commerce.
In some instances, we anticipate that the ultimate losses ceded to the captive reinsurers will be greater than the assets currently held by the segregated trusts established for each captive reinsurer. Recorded recoverables, however, are limited to the current trust balances.
All of the balance and activity of our consolidated reserve for losses and loss adjustment expense relate to the Mortgage Insurance segment. The following table shows our reserve for losses and LAE by category at the end of each period indicated:
Primarily represents ceded losses on captive transactions and the QSR Transactions.
Amounts previously reported for losses and LAE incurred in respect of default notices reported and unreported in current year and prior years have been reclassified to correct an error. There was no net change to total incurred losses in any period as a result of these reclassifications. For the years ended December 31, 2014 and 2013, the amounts previously reported for losses and LAE incurred in respect of default notices reported and unreported in current year have been revised downward by approximately $71.8 million and $65.0 million, respectively, with equal and offsetting adjustments to the amount previously reported for default notices reported and unreported in prior years.
Our loss reserve declined in 2014 from December 31, 2013, primarily as a result of the volume of paid claims, Cures and Rescissions and Claim Denials outpacing new default notices received. Total incurred losses during 2014 primarily were the result of new default notices during 2014. The impact to incurred losses from default notices reported in 2014 was partially mitigated by favorable reserve development on prior year defaults, which was driven primarily by higher Cures and lower Claim Severity rates than were previously estimated. Our results of 2014 also include the impact of the BofA Settlement Agreement, as described below.
Our loss reserve also declined in 2013 from December 31, 2012, primarily as a result of a decrease in our total inventory of defaults (due in large part to the Freddie Mac Agreement), and also because the volume of paid claims, Cures and Rescissions and Claim Denials outpaced new default notices received. Total paid claims for 2013 were impacted by the $255 million payment made upon the closing of the Freddie Mac Agreement, and by greater efficiencies in our claims review process that 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 basis for our total incurred losses in 2013, losses incurred in 2013 were also negatively impacted by reserve development on prior year defaults, including an initial loss of $22 million related to prior year defaults included in the Freddie Mac Agreement.
Our aggregate weighted average Default to Claim Rate assumption (net of Claim Denials and Rescissions) used in estimating our primary reserve for losses was 46% (42% excluding pending claims) at December 31, 2015 compared to 52% (47% excluding pending claims) at December 31, 2014. The change in our Default to Claim Rate in 2015 resulted primarily from a decrease in the proportion of pending claims, which have higher Default to Claim Rates, and a decrease in the assumed gross Default to Claim Rate for new defaults from 16% to approximately 13%, as noted above. Our gross Default to Claim Rates on our primary portfolio ranged from approximately 13% for new defaults, to 65% for defaults not in Foreclosure Stage, and 81% for Foreclosure Stage Defaults. Our Default to Claim Rate estimates on defaulted loans are mainly developed based on the Stage of Default and Time in Default of the underlying defaulted loans grouped according to the period in which the default occurred, as measured by the progress toward foreclosure sale and the number of months in default. Our estimate of expected Rescissions and Claim Denials (net of expected Reinstatements) embedded in our Default to Claim Rate is generally based on our recent experience; in 2015, we refined this assumption to give more weight to our experience in the most recent nine months. Consideration is also given for differences in characteristics between those rescinded policies and denied claims and the loans remaining in our defaulted inventory, as well as the estimated impact of the BofA Settlement Agreement, as described below.
Although our estimates of future Rescissions and Claim Denials have been declining, they remain elevated compared to levels experienced before 2009. The elevated levels of our rate of Rescissions and Claim Denials have reduced our paid losses and have resulted in a reduction in our loss reserve. Our estimate of net future Rescissions and Claim Denials reduced our loss reserve as of December 31, 2015 and 2014 by approximately $69 million and $125 million, respectively. The amount of estimated Rescissions and Claim 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 Claim 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. As of December 31, 2015, these assumptions also reflect the estimated impact of the BofA Settlement Agreement, as further discussed below.
Our reported Rescission, Claim Denial and Claim Curtailment activity in any given period is subject to challenge by our lender and servicer customers. We expect that a portion of previous Rescissions will be reinstated and previous Claim Denials will be resubmitted with the required documentation and ultimately paid; therefore, we have incorporated this expectation into our IBNR reserve estimate. Our IBNR reserve estimate was $26.6 million and $163.6 million at December 31, 2015 and 2014, respectively. As of December 31, 2015, the IBNR reserve estimate of $26.6 million included approximately $3.0 million for loans subject to the BofA Settlement Agreement. This amount compares to approximately $133.0 million in IBNR reserves for loans subject to the BofA Settlement Agreement as of December 31, 2014. The significant decrease in our IBNR reserve estimate at December 31, 2015 as compared to December 31, 2014 reflects the implementation of the BofA Settlement Agreement that commenced on February 1, 2015, including the reinstatement and payment during the period of certain previous Rescissions and Claim Denials.
The remaining IBNR reserve estimate as of December 31, 2015 included an estimate of future Reinstatements of previous Claim Denials, Rescissions and Claim Curtailments of $13.3 million, $0.6 million and $2.1 million, respectively. These IBNR reserves relate to $41.9 million of claims that were denied within the preceding 12 months, $42.8 million of policies rescinded within the preceding 24 months, and $22.7 million of Claim Curtailments within the preceding 24 months.
We also accrue for the premiums that we expect to refund to our lender customers in connection with our estimated Rescissions. Our accrued liability for such refunds, which is included within other liabilities on our consolidated balance sheets, was $2.3 million and $9.0 million as of December 31, 2015 and 2014, respectively.
We considered the sensitivity of first-lien loss reserve estimates at December 31, 2015 by assessing the potential changes resulting from a parallel shift in Claim Severity and Default to Claim Rate for primary loans. For example, assuming all other factors remain constant, for every one percentage point change in primary Claim Severity (which we estimate to be 101.4% of risk exposure at December 31, 2015), we estimated that our loss reserves would change by approximately $8.2 million at December 31, 2015. For every one percentage point change in our overall primary net Default to Claim Rate (which we estimate to be 46% at December 31, 2015, including our assumptions related to Rescissions and Claim Denials), we estimated a $17.4 million change in our loss reserves at December 31, 2015.
On September 16, 2014, Radian Guaranty entered into the BofA Settlement Agreement in order to resolve various actual and potential claims or disputes related to the parties’ respective rights and duties as to mortgage insurance coverage on certain Subject Loans. Implementation of the BofA Settlement Agreement commenced on February 1, 2015 for Subject Loans held in portfolio by the Insureds or purchased by the GSEs as of that date. Approximately 12% of the Subject Loans are neither held in portfolio by the Insureds nor owned by the GSEs, and required the consent of certain other investors for these loans to be included in the BofA Settlement Agreement except with respect to certain limited rights of cancellation (described above). During 2015, most of such other investors provided consent, and therefore, the associated implementation of the BofA Settlement Agreement has commenced with respect to these loans. Our previous reserve assumptions assumed that these consents would be obtained.
The BofA Settlement Agreement further provides that for Servicing Only Loans: (i) if Radian Guaranty effected a claim payment on or before May 30, 2014, any Claim Curtailments on such loans will become final and will not be subject to future challenge, appeal or adjustment; and (ii) for claim payments for Servicing Only Loans paid after May 30, 2014, Radian Guaranty will not make any Claim Curtailments (excluding Protected Claim Curtailments, which may continue in the ordinary course) and, to the extent any Claim Curtailments previously have been effected on such loans, Radian Guaranty will pay a reimbursement amount equal to the Claim Curtailment amount. The BofA Settlement Agreement does not affect Radian Guaranty’s right to effect Rescissions or Claim Denials on any Servicing Only Loans and any such Rescissions or Claim Denials will continue to be governed by the applicable Master Policies, subject to certain requirements in the BofA Settlement Agreement regarding the documents required to perfect such claims. Radian Guaranty has further agreed not to assert any right to cancel coverage on any Subject Loan for failure to initiate certain proceedings (most commonly foreclosure proceedings) within the timelines set forth in the applicable Master Policies.
The carrying value of our long-term debt at December 31, 2015 and 2014 was as follows:
Senior Notes due 2020. In June 2015, we issued $350 million aggregate principal amount of Senior Notes due 2020 and received net proceeds of approximately $343.3 million. These notes mature on June 15, 2020 and bear interest at a rate of 5.250% per annum, payable semi-annually on June 15 and December 15 of each year, commencing on December 15, 2015. We have the option to redeem these notes, in whole or in part, at any time or from time to time prior to maturity at a redemption price equal to the greater of: (i) 100% of the aggregate principal amount of the notes to be redeemed; or (ii) the make-whole amount, which is the present value of the notes discounted at the applicable treasury rate plus 50 basis points, plus, in each case, accrued interest thereon to the redemption date.
Covenants in Senior Notes. The Senior Notes due 2017, the Senior Notes due 2019 and the Senior Notes due 2020 have covenants customary for securities of this nature, including covenants related to the payments of the notes, reports, compliance certificates and modification of the covenants. Additionally, the indentures governing the Senior Notes due 2017, the Senior Notes due 2019 and the Senior Notes due 2020 include covenants restricting us from encumbering the capital stock of a designated subsidiary (as defined in the respective indentures for the notes) or disposing of any capital stock of any designated subsidiary unless either all of the stock is disposed of or we retain more than 80% of the stock.
Following the pricing of our Senior Notes due 2020, in June 2015, we entered into privately negotiated agreements with certain holders of our Convertible Senior Notes due 2017 to purchase an aggregate principal amount of $389.1 million of our outstanding Convertible Senior Notes due 2017 for a combination of cash and shares of Radian Group common stock. We funded the purchases with $126.8 million in cash (plus accrued and unpaid interest due on the purchased notes) and by issuing to the sellers approximately 28.4 million shares of Radian Group common stock. These purchases of Convertible Senior Notes due 2017 resulted in a pretax charge of approximately $91.9 million. This charge represents:
the $35.5 million market premium representing the consideration paid to the sellers of the Convertible Senior Notes due 2017 in excess of the conversion value of the purchased Convertible Senior Notes due 2017;
the $4.1 million net impact of transaction costs and unamortized debt issuance costs on the purchased Convertible Senior Notes due 2017.
Pursuant to the original terms, holders of the remaining Convertible Senior Notes due 2017 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, 2015, we had approximately 23 million shares reserved to cover the potential issuance of shares under the Convertible Senior Notes due 2017.
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 the three-month period ended December 31, 2015, our closing stock price did not exceed the thresholds required for the holders of our Convertible Senior Notes due 2017 to be able to exercise their conversion rights during the three-month period ending March 31, 2016.
Convertible Senior Notes due 2019. In March 2013, we issued $400 million principal amount of 2.25% Convertible Senior Notes due 2019 and received proceeds of approximately $389.8 million, net of underwriting expenses. Interest is payable semi-annually on March 1 and September 1 of each year. The effective interest rate for the liability component of this debt is 6.25%.
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 five business day period after any five consecutive trading day period in which the trading price per $1,000 principal amount of the notes (for each trading day during that five day measurement period) was less than 98% of the product of the last reported sale price of the common stock and the applicable conversion rate on such trading day;
Upon issuance of the Convertible Senior Notes due 2017 and 2019, in accordance with accounting standards related to convertible debt instruments that may be settled in cash upon conversion, the Company recorded a pretax equity component of $101.0 million and $77.0 million, respectively, net of the capped call transaction (Convertible Senior Notes due 2017) and related issuance costs (Convertible Senior Notes due 2017 and 2019). The pretax equity component is not subject to remeasurement, and therefore remained unchanged through December 31, 2014. However, as a result of redemptions during 2015, the remaining pretax equity component associated with the Convertible Senior Notes due 2017 and 2019 decreased from $101.0 million and $77.0 million, respectively, at December 31, 2014 to $11.3 million and $75.1 million, respectively, at December 31, 2015. See Note 13 for information on DTLs associated with our convertible and other long-term debt.
In any period when holders of the Convertible Senior Notes due 2017 are eligible to exercise their conversion option, the related equity component is reflected as mezzanine (temporary) equity rather than permanent equity, because we are required to settle the aggregate principal amount of the notes in cash. This equity component is 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.
The following table shows the rollforward of AOCI as of the periods indicated. During 2015, we sold equity securities in our portfolio and reinvested the proceeds in assets that qualify fully as PMIERs-compliant Available Assets, recognizing pretax gains of $69.2 million.
Activity related to investments recorded as assets held for sale (3)
Included in net gains (losses) on investments on our consolidated statements of operations.
As of December 31, 2015, we recorded a net current income tax payable of approximately $124.0 million, which primarily consists of liabilities related to applying the standards of accounting for uncertainty in income taxes and a current federal income tax recoverable of approximately $9.7 million. Before consideration of uncertain tax positions, we have approximately $1.1 billion of U.S. NOL carryforwards, $0.9 million of foreign tax credit carryforwards and approximately $5.9 million of alternative minimum tax credit carryforwards as of December 31, 2015. To the extent not utilized, the U.S. NOL carryforwards will expire during tax years 2029 through 2032 and the foreign tax credit carryforwards will expire during tax years 2019 and 2020. The alternative minimum tax credit carryforwards have no expiration date. Certain entities within our consolidated group have also generated DTAs of approximately $46.9 million relating to state and local NOL carryforwards, which if unutilized, will expire during various future tax periods.
At each balance sheet date, we assess our need for a valuation allowance against our DTA, based on whether it is more likely than not that all or some portion of our DTA will not be realized. We weigh the potential effect of positive and negative evidence, with the weight given to the evidence commensurate with the extent to which it can be objectively verified. In the fourth quarter of 2014, we released substantially all of our previously established DTA valuation allowance based on our analysis of significant positive, objectively verifiable evidence that outweighed all negative evidence and supported a conclusion that it was more-likely-than-not that substantially all of the Company’s DTAs will be realized. In evaluating the weight of evidence, we considered the concept of “core earnings” and the potential profitability of such earnings. Forecasts related to our core business were significantly more positive than in prior years, absent the degree of uncertainty existing in previous years and given the ability to generate profits based on our improved book of business.
As previously disclosed, we are contesting 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 denying the associated tax benefits of these items. We appealed these proposed adjustments to Appeals and made “qualified deposits” with the U.S. Treasury 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 incremental above-market-rate interest with respect to the proposed adjustments.
On December 3, 2014, we petitioned the U.S. Tax Court to litigate the Deficiency Amount. On September 1, 2015, we received a notice that the case had been scheduled for trial. However, the parties jointly filed, and the U.S. Tax Court approved, motions for continuance in this matter to postpone the trial date. The litigation could take several years to resolve and may result in substantial legal expenses. We can provide no assurance regarding the outcome of any such litigation or whether a compromised settlement with the IRS will ultimately be reached. We believe that an adequate provision for income taxes has been made for the potential liabilities that may result from this matter. However, if the ultimate resolution of this matter produces a result that differs materially from our current expectations, there could be a material impact on our effective tax rate, results of operations and cash flows.
As of December 31, 2015, we have approximately $66.3 million of unrecognized tax benefits, including approximately $61.7 million of interest and penalties, that would affect the effective tax rate, if recognized. Our policy for the recognition of interest and penalties associated with uncertain tax positions is to record such items as a component of our income tax provision (benefit), of which approximately $0.8 million, $2.5 million and $5.4 million were recorded for the years ended December 31, 2015, 2014 and 2013, respectively.
In previous years, we took a return position in various jurisdictions that we are not required to remit taxes with regard to the income generated from our investment in certain partnership interests. Although we believe that these tax positions are more likely than not to succeed if adjudicated, measurement of the potential amount of liability for state and local taxes and the potential for penalty and interest thereon is performed on a quarterly basis. Our net unrecognized tax benefits related to prior years increased by approximately $20.6 million during 2015. 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 $22.7 million due to the expiration of the applicable statute of limitations for the taxable period ended December 31, 2011, the related amounts continued to impact subsequent years resulting in a corresponding increase to the unrecognized tax benefits related primarily to the 2012 taxable year.
For the 2000 through 2007 calendar tax years, we petitioned the U.S. Tax Court to litigate the IRS Notices of Deficiency resulting from the examination of our 2000 through 2007 consolidated federal income tax returns. This litigation relates to the recognition of certain tax benefits associated with our investment in a portfolio of non-economic REMIC residual interests.
Radian Group serves as the holding company for our insurance subsidiaries, through which we conduct our mortgage insurance business. These insurance subsidiaries are subject to comprehensive, detailed regulation by the insurance departments in the various states where our insurance subsidiaries are domiciled or licensed to transact business. Insurance laws vary from state to state, but generally grant broad supervisory powers to state agencies or officials to examine insurance companies and enforce rules or exercise discretion affecting almost every significant aspect of the insurance business, including the power to revoke or restrict an insurance company’s ability to write new business. The state insurance regulations include various capital requirements and dividend restrictions based on our insurance subsidiaries’ statutory financial position and results of operations, as described below. Our failure to maintain adequate levels of capital could lead to intervention by the various insurance regulatory authorities, which could materially and adversely affect our business, business prospects and financial condition. As of December 31, 2015, the amount of restricted net assets held by our consolidated insurance subsidiaries (which represents our equity investment in those insurance subsidiaries) totaled $2.9 billion of our consolidated net assets.
The ability of Radian’s insurance subsidiaries to pay dividends on their common stock is restricted by certain provisions of the insurance laws of Pennsylvania, their state of domicile. Under Pennsylvania’s insurance laws, dividends and other distributions may only be paid out of an insurer’s positive unassigned surplus, measured as of the end of the prior fiscal year, unless the Pennsylvania Insurance Commissioner approves the payment of dividends or other distributions from another source. Effective December 31, 2015, as part of our efforts to streamline our operations, we obtained the necessary approvals from the Pennsylvania Insurance Commissioner to effectuate a reorganization of our mortgage insurance subsidiaries, which included a significant redistribution of assets and RIF among our legal entities. As a result of these actions, substantially all of the RIF and assets previously held by RGRI, RMAI, Radian Insurance and Radian Mortgage Insurance were transferred to Radian Guaranty and a new exclusive affiliated reinsurer, Radian Reinsurance. None of the distributions from these entities were retained by Radian Group, as all proceeds were distributed to either Radian Guaranty or Radian Reinsurance.
The NAIC is in the process of developing a new Model Act for mortgage insurers, which would include among other items, new capital adequacy requirements for mortgage insurers. While the outcome of this process is uncertain, the new Model Act, if and when finalized by the NAIC, has the potential to increase capital requirements in those states that adopt the Model Act. See also Note 1 for information regarding the PMIERs, which set requirements for private mortgage insurers to remain eligible insurers of loans purchased by the GSEs.
Radian Guaranty’s statutory net income (loss), statutory policyholders’ surplus and contingency reserve as of or for the years ended December 31, 2015, 2014 and 2013 were as follows:
We have actively managed Radian Guaranty’s capital position in various ways, including: (1) through internal and external reinsurance arrangements; (2) by seeking opportunities to reduce our risk exposure through commutations and other negotiated transactions; and (3) by contributing additional capital from Radian Group.
On or after June 30, 2016, and prior to May 31, 2017, in addition to amounts paid above, Radian Guaranty may redeem the note balance up to the amount by which Available Assets then exceed Minimum Required Assets, less $150 million.
The reduction in Radian Guaranty’s Risk-to-capital in 2015 was primarily due to the Surplus Note issuance and to increases in statutory net income, partially offset by an increase in net RIF at Radian Guaranty due in part to the termination of certain intercompany reinsurance agreements as a result of our legal entity reorganization.
Effective December 2015, Radian Reinsurance is domiciled and licensed in Pennsylvania as a stock casualty insurance company authorized to carry on the business of credit insurance, which includes the authority to reinsure policies of mortgage guaranty insurance. Radian Reinsurance is only licensed or authorized to write direct mortgage guaranty insurance in Pennsylvania. Radian Reinsurance is required to maintain a minimum statutory surplus of $20 million to remain an authorized reinsurer in all states. During 2015, Radian Reinsurance received cash capital contributions from Radian Group totaling $50 million.
Radian Reinsurance’s statutory net income, statutory policyholders’ surplus and contingency reserve as of and for the years ended December 31, 2015, 2014 and 2013 were as follows:
The Risk-to-capital ratio for our combined mortgage insurance operations was 14.6 to 1 as of December 31, 2015, compared to 20.3 to 1 as of December 31, 2014. In addition to Radian Guaranty and Radian Reinsurance, this combined ratio also includes RGRI, RMAI, Radian Insurance, Radian Mortgage Insurance, and Radian Mortgage Guaranty Inc.; of these entities, only Radian Insurance had any remaining RIF as of December 31, 2015, totaling $48.5 million. The aggregate statutory net income, statutory policyholders’ surplus and contingency reserve for these five subsidiaries as of and for the years ended December 31, 2015, 2014 and 2013 were as follows:
In July 2014, we invested $20 million to capitalize a newly formed, Pennsylvania domiciled wholly-owned insurance subsidiary of Radian Group. The strategic objective of this investment is to offer various mortgage credit-related products, which are currently in a developmental stage. Following a return of capital to Radian Group in December 2015 of $15 million, its statutory policyholders’ surplus as of December 31, 2015 was approximately $5 million and there is no RIF as of December 31, 2015.
Prior to January 1, 2013, under SAP, 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 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 SAP but expenses related to stock options granted prior to the date of adoption continue to not be recognized under SAP. Expenses related to stock options, regardless of the date of grant, are reflected on our GAAP financial statements in accordance with this standard.
Generally, 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.
For purposes of calculating compensation cost recognized, we generally consider time-vested awards effectively vested (and we recognize the full compensation costs) when grantees become retirement eligible. However, under the terms of our stock option awards granted in 2015, 2014, and 2013, legal vesting for retirement occurs when the grantee actually separates from service, with the exception of certain senior executives for whom vesting remains dependent on the stock price hurdle being met regardless of when the executive separates from service. Performance-based RSU awards granted in 2015, 2014, and 2013 provide that vesting remains dependent on the Company’s performance for the full term of the awards notwithstanding the grantee’s earlier retirement.
In 2015, 2014 and 2013, 212,230, 289,500 and 279,650, respectively, of non-qualified stock options were granted to executive and certain non-executive officers. The weighted average grant date fair value per share of the stock options granted during 2015, 2014 and 2013 was $14.68, $12.18 and $10.95, respectively. The amount of cash received from the exercise of stock options for the years ended December 31, 2015, 2014 and 2013 was approximately $1.28 million, $0.26 million and $0.06 million, respectively. The total intrinsic value of options exercised (measured as of the date of exercise) during the years ended December 31, 2015, 2014 and 2013 was $7.15 million, $0.19 million and $0.17 million, respectively, and the related tax benefits were approximately $2.50 million, $0.07 million and $0.06 million, respectively. The total intrinsic value of the stock options outstanding at December 31, 2015, 2014 and 2013 was $19.1 million, $34.1 million and $27.0 million, respectively, based on the closing price of our common stock as of such dates relative to the exercise prices for such stock options.
The following table summarizes information concerning outstanding and exercisable options at December 31, 2015:
For stock option awards granted in 2015, 2014 and 2013, in addition to the time-based vesting requirements, the options contain a performance hurdle whereby the options will only vest if the closing price of our common stock on the NYSE exceeds $23.03 (125% of the option exercise price), $19.30 (125% of the option exercise price) and $17.49 (125% of the option exercise price), respectively, for ten consecutive trading days ending on or after the third anniversary of the date of grant.
Vesting of awards granted to executive officers in 2015, 2014 and 2013 is dependent upon: (1) Radian Group’s TSR compared to the relative TSR of the companies listed on the NASDAQ Financial Index and our most directly comparable mortgage insurance peers as of the date of grant (the “Relative TSR Measure”) and (2) Radian Group’s absolute TSR (“Absolute TSR Measure”), in each case measured over a three-year performance period and subject to certain conditions. 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 six times the value of the grantee’s award on the grant date.
We have an ESPP, 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 94,676; 67,743; and 95,287 shares to employees during the years ended December 31, 2015, 2014 and 2013, respectively.
The Radian Group Inc. Savings Incentive Plan (“Savings Plan”) covers substantially all of our full-time and our part-time employees. Participants can contribute up to 100% of their base earnings as pretax and/or after-tax (Roth IRA) contributions up to a maximum amount of $18,000 for 2015. 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 2015 was $6,000. Effective January 1, 2016, we will match up to 100% of the first 4.5% of base earnings contributed in any given year. Previously, the match was up to 100% of the first 6% of annual base earnings exclusive of Clayton, which had its own employee match of 25% of the first 6% of base earnings contributed in any given year. Beginning January 1, 2016, Clayton was merged into the Savings Plan. Our expense for matching funds for the years ended December 31, 2015, 2014 and 2013 was $3.1 million, $3.1 million and $2.7 million, respectively.
We contributed immaterial amounts to other postretirement benefit plans in 2015.
We are also involved in litigation that has arisen in the normal course of our business. We are contesting the allegations in each such pending action and management believes, based on current knowledge and after consultation with counsel, that the outcome of such litigation will not have a material adverse effect on our consolidated financial condition. However, the outcome of litigation and other legal and regulatory matters is inherently uncertain, and it is possible that one or more of the matters currently pending or threatened could have an unanticipated adverse effect on our liquidity, financial condition or results of operations for any particular period.
In June 2015, we and other mortgage insurers received a letter from the Wisconsin OCI requesting information pertaining to customized insurance rates and terms offered to mortgage insurance customers. We submitted a response to the Wisconsin OCI in June 2015, as requested. Although we believe we are in compliance with applicable Wisconsin state law requirements for mortgage guaranty insurance, we cannot predict the outcome of this matter or whether additional inquiries, actions or proceedings may be pursued against us by the Wisconsin OCI or other regulators.
As described in Note 13, on September 4, 2014 we received formal Notices of Deficiency from the IRS related to certain losses and deductions resulting from our investment in a portfolio of non-economic REMIC residual interest. 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.
Our mortgage insurance business provides contract underwriting, an outsourced service to its customers. Under our current contract underwriting program the remedy we offer is limited indemnification to our contract underwriting customers only with respect to those loans that we simultaneously underwrite for both secondary market compliance and for potential mortgage insurance eligibility. In 2015, we paid losses related to contract underwriting remedies of approximately $0.01 million. In 2015, our provision for contract underwriting expenses was approximately $0.6 million and our reserve for contract underwriting obligations at December 31, 2015 was approximately $0.3 million. Rising mortgage interest rates or further economic uncertainty may expose our contract underwriting business to an increase in such costs. 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.
At December 31, 2015 there were no future minimum receipts expected from sublease rental payments.
In June 2015, we entered into privately negotiated agreements with certain of the holders of our Convertible Senior Notes due 2017 to purchase an aggregate principal amount of $389.1 million of our outstanding Convertible Senior Notes due 2017 for a combination of cash and shares of Radian Group common stock. We funded the purchases with $126.8 million in cash (plus accrued and unpaid interest due on the purchased notes) and by issuing to the sellers approximately 28.4 million shares of Radian Group common stock. In connection with our purchases of Convertible Senior Notes due 2017, we terminated a corresponding portion of the capped call transactions we had entered into in 2010 related to the initial issuance of the Convertible Senior Notes due 2017. As a result of this termination, we received total consideration of approximately $54.9 million, consisting of 2.3 million shares of Radian Group common stock and $13.2 million in cash. The shares of Radian Group common stock received were retired, resulting in a decrease in shares issued and outstanding and a corresponding increase in unissued shares.
The following number of shares of our common stock equivalents issued under our stock-based compensation arrangements were not included in the calculation of net income (loss) per share because they were anti-dilutive:
Subsequent to this authorization, we purchased approximately 9.4 million shares of Radian Group common stock for $100.2 million, at a weighted average price per share of $10.62, including commissions. No further purchase authority remains under this share repurchase program.
The 2015 and 2014 amounts reflect primarily unrealized (losses) gains, respectively, on our trading securities.
Diluted net income per share and average shares outstanding per the accounting standard regarding earnings per share.
In the first, second, and third quarters of 2015, certain cash flows were incorrectly classified in the Company’s Condensed Consolidated Statements of Cash Flows. The Company has determined that these misclassifications are not material to the financial statements of any period. These amounts (described below in thousands) have been corrected in the Consolidated Statements of Cash Flows for the year ended December 31, 2015, and will be corrected in the comparative Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2015, six months ended June 30, 2015 and nine months ended September 30, 2015 that will appear in the Company’s quarterly Form 10-Q filings in 2016.
For the six months ended June 30, 2015 and nine months ended September 30, 2015, the adjustments affected certain line items within cash flows from investing activities, but had no net impact to net cash provided by (used in) investing activities. For the six months ended June 30, 2015, these adjustments to the affected line items within the Consolidated Statements of Cash Flows consist of the following: (i) proceeds from sales of fixed-maturity investments available for sale reported as $57,309 will be adjusted to $3,621; and (ii) purchases of fixed-maturity investments available for sale reported as $725,640 will be adjusted to $671,952. For the nine months ended September 30, 2015, the adjustments consist of the following: (i) proceeds from sales of fixed-maturity investments AFS reported as $96,684 will be adjusted to $16,208; and (ii) purchases of fixed-maturity investments AFS reported as $1,087,461 will be adjusted to $1,006,985.