At our corporate headquarters in Philadelphia, Pennsylvania, we lease approximately 152,500 square feet of office space under a lease that expires in August 2017. In addition, we also lease the following:
Approximately 22,000 square feet of office space for our mortgage insurance regional offices, service centers and on-site offices throughout the United States. The leases for this space expire between 2007 and 2012;
Approximately 121,000 square feet of office space (approximately 63,000 square feet of which we sublease to others) for our financial guaranty operations in New York City. The lease for this space expires in 2015;
Approximately 6,600 square feet of office space for our international mortgage insurance and financial guaranty operations in London. The lease for this space expires in 2012;
Approximately 16,400 and 27,000 square feet of office space for our data centers in Philadelphia, Pennsylvania and Dayton, Ohio, respectively. The leases for these offices expire in September 2012 (Philadelphia) and August 2015 (Dayton). The lease for our Dayton, Ohio data center has an early termination option that may be executed by us anytime after May 2007.
With respect to all of our facilities, we believe we will be able to obtain satisfactory lease renewal terms. We believe our existing properties are well utilized, suitable and adequate for our present circumstances.
(1) Diluted net income per share and average share information in accordance with Statement of Financial Accounting Standards No. 128, “Earnings Per Share.” Amounts reflect the inclusion of shares underlying contingently convertible debt, which was redeemed on August 1, 2005. See Note 2 of Notes to Consolidated Financial Statements.
(4) Reflects the 2004 and 2005 recaptures of previously ceded business. See Note 2 of Notes to Consolidated Financial Statements.
Our business segments are mortgage insurance, financial guaranty and financial services. The following table shows the percentage contributions to net income and equity allocated to each business segment as of and for the year ended December 31, 2006:
Our mortgage insurance segment, through Radian Guaranty, offers primary and pool private mortgage insurance coverage on residential first-lien mortgages. At December 31, 2006, primary insurance on domestic
We formed Radian Australia in November 2006 and filed an application to conduct mortgage insurance business with the Australian Prudential Regulation Authority in December 2006. We have several reinsurance arrangements in place in Australia, including a recent transaction with St. George Insurance Australia, a wholly owned subsidiary of St. George Bank, Australia’s fifth largest bank. The license we are seeking for Radian Australia will authorize it to fully transact both mortgage insurance and financial guaranty business in and from Australia.
insurance of public finance obligations, including tax-exempt and taxable indebtedness of states, counties, cities, special service districts and other political subdivisions, and for enterprises such as airports, public and private higher education and health care facilities and private finance initiative assets in sectors such as schools, healthcare and infrastructure projects. The issuers of public finance obligations we insure are typically rated investment grade (BBB-/Baa3 or higher) without the benefit of our insurance;
On June 29, 2006, S&P affirmed the AA financial strength rating, and revised its outlook upward to stable, for Radian Asset Assurance. S&P also affirmed the parent company’s A credit rating and revised its outlook for the parent company upward to stable. Through RAAL, we have additional opportunities to write financial guaranty insurance in the United Kingdom and, subject to compliance with the European passporting rules, other European Union jurisdictions. In particular, we expect that RAAL will continue to build its structured products business in the United Kingdom and throughout the European Union. RAAL accounted for $9.2 million of direct premiums written in 2006 (or 5.8% of financial guaranty’s 2006 direct premiums written), which is a $5.7 million increase from the $3.5 million or 2.4% of direct premiums written in 2005. On July 3, 2006, S&P affirmed the AA financial strength rating and revised its outlook upward to stable for RAAL, and in November 2006, Moody’s assigned RAAL a Aa3 financial strength rating with a stable outlook. In connection with the announcement of our agreement to merge with MGIC Investment Corporation (“MGIC”) (see “Proposed Merger with MGIC” below), Fitch Ratings (“Fitch”) affirmed its AA financial strength ratings for Radian Asset Assurance and RAAL and maintained its negative outlook for these insurers.
Sherman is a consumer asset and servicing firm specializing in charged-off and bankruptcy plan consumer assets that it generally purchases at deep discounts from national financial institutions and major retail corporations and subsequently collects upon these receivables. In addition, Sherman originates non-prime credit card receivables through its subsidiary CreditOne, which was acquired by Sherman in March 2005.
On February 6, 2007, we and MGIC entered into an Agreement and Plan of Merger pursuant to which we agreed, subject to the terms and conditions of the merger agreement, to merge with and into MGIC, with the combined company to be re-named MGIC Radian Financial Group Inc. See “Business-General-Proposed Merger with MGIC Investment Corporation (“MGIC”)” above in Item 1 for more information regarding the merger.
During 2006, we continued to write the majority of our structured primary business in a second-loss risk position. There is a lower average premium rate associated with this business, reflecting the more remote risk associated with this business due to the existence of deductibles in front of our risk position. Premium growth will not mirror the growth in new insurance written from these lower premium products, resulting in what we
In 2006, we experienced an increase in mortgage insurance loss reserves, due to, among other things, an increase in older delinquencies and pending claims, which require greater loss reserve amounts due to the increased likelihood of claim payment, and an increase in severity. Approximately $21.6 million of the increase in reserves at year end 2006 is attributable to our share of a second-lien structured transaction in which we split losses with our counterparty on a 50-50 basis. See “Results of Operations-Mortgage Insurance-Year Ended December 31, 2006 Compared to Year Ended December 31, 2005-Provision for Losses” below. The factors resulting in an increase in reserves were offset somewhat by a reduction in delinquencies and positive results from our increased loss management efforts, which we’ve incorporated into our loss reserve model. Claims paid in our mortgage insurance segment were lower than anticipated in 2006, in part because of the intensified efforts of our loss management area, which has been scrutinizing more claims (both first- and second-lien) for which additional information or clarification is required. We expect that claims paid in the first quarter of 2007 will be approximately $90 million as we expect that some of the claims we have held longer as part of our intensified loss management efforts will be worked through. Our expectation, which is subject to change as a result of risks and uncertainties, is for 2007 claims paid to be approximately $340 to $370 million and for 2008 claims paid to be approximately $350 to $370 million.
Smart Home protects us against catastrophic loss as we continue to take on higher risk, concentrated positions and unproven products. As a result, we consider Smart Home arrangements to be important to our ability to effectively manage our risk profile, especially, in the non-prime market. Approximately 10% and 8% of
In the financial guaranty segment, we are encouraged by “S&P’s” affirmation earlier this year of the AA ratings for Radian Asset Assurance and RAAL and its decision to revise its outlook for these companies upward to stable. We believe that S&P’s affirmation and outlook improvement will help validate our business model and present additional opportunities for the business in the future. New business production was strong during the year considering the relatively low issuances of municipal bonds and a continuation of tight credit spreads, which impacted premium rates as well as our ability to close transactions. Credit performance was generally good during the year. We also continued to write more of our structured business in a super senior, more remote risk position, albeit at lower premium rates. We expect that revenues in our financial guaranty segment will remain relatively stable for 2007, excluding unusual items like refundings and the impact of the run-off in our trade credit reinsurance business.
For 2006, the financial services segment showed another year of strong earnings and return on investment, which was, in part, a result of the relatively low interest rate and favorable credit environment and a strong demand from investors in asset-backed securities, which were issued at more favorable rates. In addition, both C-BASS and Sherman were positively impacted in the fourth quarter of 2006 by certain items - Sherman incurred a significant gain on sold portfolios during the quarter and C-BASS recovered most of the hedge losses that had been incurred in prior quarters. Despite the significant credit spread widening that has occurred in the subprime mortgage market during the first quarter of 2007, which could produce mark-to-market losses for C-BASS during the first quarter, we expect that both C-BASS’s and Sherman’s results for 2007 will remain fairly consistent with their 2006 results, as both companies stand to benefit from recurring sources of earnings. We expect continued growth in Sherman’s credit card origination business, and, while the sub-prime origination business is currently uncertain, C-BASS typically looks for opportunities to purchase mispriced assets in such an environment. On February 16, 2007, C-BASS entered into an agreement to acquire Fieldstone Investment Corporation, a mortgage banking company that originates, sells, and invests primarily in non-conforming single-family residential mortgage loans with a current portfolio of over $5.7 billion, for approximately $259 million in cash. The transaction, which is expected to occur in the second quarter of 2007, subject to regulatory and other approvals, supports C-BASS’s strategy of aligning with companies that have significant investments in mortgage securities, where C-BASS’s wholly-owned subsidiary, Litton Loan Servicing, as servicer, can enhance the underlying value of these securities. In addition, if approved, the transaction will provide C-BASS with a platform for loan originations.
Net Income. Net income for 2006 was $582.2 million or $7.08 per share (diluted), compared to $522.9 million or $5.91 per share (diluted) for 2005. Diluted net income per share for 2005 reflects the inclusion of 2.2 million shares, underlying our contingently convertible debt, which was redeemed in its entirety on August 1, 2005. Including these shares in the calculation of diluted net income per share resulted in a reduction in diluted net income per share of $0.13 for 2005. In addition, the results for 2005 reflect an immediate reduction in net income of $4.1 million or $0.04 per share (diluted) related to the 2005 recapture. Net income increased for 2006 mainly due to an increase in net investment income, change in fair value of derivative instruments, equity in net income of affiliates and a decrease in the provision for losses, partially offset by an increase in other operating expenses, interest expense and the provision for income taxes.
Net Investment Income. Net investment income for 2006 was $234.3 million, a $25.9 million or 12.4% increase from $208.4 million in 2005. This increase was mainly due to an increase in investable assets and a higher yield on bonds in our investment portfolio. In addition, we recognized dividend income of approximately $3.5 million related to private equity investments in 2006.
Net Gains on Securities. Net gains on securities for 2006 were $40.8 million, compared to $36.6 million for 2005. This increase was mainly due to the $21.4 million pre-tax gain resulting from the sale of our remaining interest in Primus Guaranty, Ltd. (“Primus”) in the first quarter of 2006. Offsetting this was approximately $10.6 million of losses on investment securities that were other-than-temporarily impaired securities in 2006. See “Investments” below in this Item 7. In addition, the net gains on securities for 2005 included a $3.3 million loss
Change in Fair Value of Derivative Instruments. For 2006, the change in fair value of derivative instruments was a net gain of $16.1 million, compared to a net gain of $9.2 million for 2005. In 2005 we applied a refined model for valuing corporate collateralized debt obligations, which indicated that we had incurred a $50.8 million loss on one transaction at December 31, 2005. See “Results of Operations-Financial Guaranty-Year Ended December 31, 2006 Compared to Year Ended December 31, 2005-Changes in Fair Value of Derivative Instruments” below. The 2006 amount includes an additional $17.2 million charge related to a payment made in March 2006 in connection with the termination of this same financial guaranty contract. In addition, while credit spreads have tightened slightly since 2005, we experienced a year over year decrease in change in fair value of derivative instruments resulting from the shorter duration of a large portion of the contracts.
Provision for Losses. The provision for losses for 2006 was $369.3 million, down from $390.6 million for 2005. This is due to a decrease in both the mortgage insurance provision (due mostly to lower primary defaults and claims and the incorporation of new assumptions into our loss reserve model) and the financial guaranty provision, (related mostly to the run-off of the trade credit reinsurance business).
Equity in Net Income of Affiliates. Equity in net income of affiliates increased to $257.0 million for 2006, up $39.3 million or 18.1% from $217.7 million for 2005. This resulted from an increase in earnings at C-BASS and Sherman, as well as, the additional interest in Sherman we acquired in the third quarter of 2006. See “Results of Operations-Financial Services” below.
Net Gains on Securities. Net gains on securities for 2005 were $36.6 million, compared to $50.8 million for 2004. The net gains on securities in 2005 included a $3.3 million loss on the sale of a partial interest in Sherman and a $3.2 million loss from a complete write-down of our investment in SBF Participacoes Ltda. The 2004 amount includes a significant amount of gains from changes in asset allocation and investment execution strategies.
Change in Fair Value of Derivative Instruments. For 2005, the change in fair value of derivative instruments was a gain of $9.2 million, compared to a gain of $47.1 million for 2004. This decrease is principally due to a loss incurred on one derivative transaction as a result of our application of a refined valuation model. At December 31, 2005, our refined model indicated that we had incurred a $50.8 million loss on this transaction. See “Results of Operations-Financial Guaranty-Year Ended December 31, 2006 Compared to Year Ended December 31, 2005-Change in Fair Value of Derivative Instruments” below.
Other Income. Other income decreased to $25.3 million for 2005 from $32.3 million for 2004, mainly due to lower income from contract underwriting.
Provision for Losses. The provision for losses for 2005 was $390.6 million, a decrease of $66.2 million or 14.5% from $456.8 million reported for 2004. Our mortgage insurance business experienced a decrease in the provision for losses as claims paid declined. This decrease was partially offset by an increase in delinquencies. Our financial guaranty business experienced a decrease in the provision for losses in 2005 as a result of generally favorable loss development, including a reduction in the prior year’s reserves for trade credit reinsurance business, which generally carries a higher loss ratio, due to the run-off in this business.
Interest Expense. Interest expense of $43.0 million for 2005 increased $8.3 million or 24.2% from $34.7 million for 2004, in most part due to the issuance of $250 million of senior notes in June 2005 and a lower positive impact from interest-rate swaps that we entered into in the second quarter of 2004.
Change in Fair Value of Derivative Instruments. The change in the fair value of derivatives was a gain of $3.7 million for 2006, compared to a gain of $4.1 million for 2005, due mainly to changes in the fair value of embedded options in convertible securities held in the investment portfolio of $13.4 million, partially offset by $9.7 million of change in fair value of derivative instruments related to NIMs. When convertible securities with embedded options carried at unrealized gains are sold, it has the effect of reclassifying the unrealized gain from the change in fair value of derivative instruments to gains on securities. See Note 2 of Notes to Consolidated Financial Statements.
Provision for Income Taxes. The effective tax rate for 2006 was 26.6% compared to 28.8% in 2005. The tax rate for 2006 reflects an allocation of the reversal of prior years’ reserves for uncertain tax positions that expired June 30, 2006. In addition the lower tax rate reflects an overall increase in the ratio of income generated from tax-advantaged securities compared to income generated from operations.
Other Income. Other income for 2005 was $19.0 million, a $5.2 million or 21.6% decrease from $24.2 million in 2004. The decrease in 2005 mainly reflects a decrease in contract underwriting services.
The following tables provide selected information as of and for the periods indicated for our mortgage insurance segment.
During 2006, non-prime business accounted for $17.5 billion or 43.7% of new primary insurance written (80.2% of which was Alt-A) by our mortgage insurance segment, compared to $17.8 billion or 41.7% (63.3% of which was Alt-A) for 2005 and $16.4 billion or 36.6% for 2004 (61.9% of which was Alt-A). There was a higher level of non-prime business written in structured transactions during the year ended December 31, 2006 compared to 2005 and 2004.
In 2005 and 2006, we wrote a significant amount of pool risk where we are in a second-loss position. In these transactions, we will only pay claims if pool losses are greater than any applicable deductible or stop-loss.
For the year ended December 31, 2006, other risk written was $900.0 million, compared to $9.0 billion for 2005 and $427.0 million for 2004. Most of the other risk written for the year ended December 31, 2006 was insurance on NIMs and second-lien insurance in which we are in a second-loss position. Included in the $9.0 billion of other risk written for the year ended December 31, 2005 is $7.3 billion of other risk written in the form of credit default swaps written as AAA tranches of mortgage-backed securities in Germany and Denmark, which were written late in the fourth quarter of 2005. Opportunities for structured transactions depend on a number of macroeconomic factors, and thus, the volume of structured transactions we enter into can vary significantly from year to year.
Other risk in force was $10.3 billion at December 31, 2006, compared to $9.7 billion at December 31, 2005 and $1.2 billion at December 31, 2004. Other risk in force at December 31, 2006 and 2005 included a higher level of credit default swaps, including two large international mortgage securitizations completed in the fourth quarter of 2005, comprising a total of $7.9 billion of risk in force at December 31, 2006 and $7.5 billion of risk in force at December 31, 2005, in which we provided credit enhancement at a AAA level. Because of the remote nature of the risk associated with these transactions, premiums are low as a percentage of exposure.
In the mortgage insurance segment, the highest state concentration of primary risk in force at December 31, 2006 was Florida at 9.2% compared to 9.5% at December 31, 2005 and 9.1% at December 31, 2004. The percentage of risk in California has been falling over the past few years due to a high cancellation rate and lower percentage of new business written. California accounted for 12.8% of the mortgage insurance segment’s direct primary new insurance written for the year ended December 31, 2006 compared to 13.8% for the years ended December 31, 2005 and 2004. The largest single customer of our mortgage insurance segment (including branches and affiliates of such customer), measured by primary new insurance written, accounted for 18.6% of primary new insurance written for 2006 compared to 10.6% for 2005 and 9.6% for 2004.
The default rate on the primary business was 5.4% at December 31, 2006, 5.6% at December 31, 2005 and 4.8% at December 31, 2004. The number of non-prime loans in default at December 31, 2006 was 24,259, which represented 56.8% of the total primary loans in default at December 31, 2006, compared to 23,525 non-prime loans in default at December 31, 2005, which represented 53.2% of the total primary loans in default at December 31, 2005 and 21,017 non-prime loans in default at December 31, 2004, representing 52.0% of total primary loans in default at December 31, 2004. The non-prime mortgage insurance business experienced an increase in the number of defaults at December 31, 2006 compared to December 31, 2005. Although the default rate on this business is higher than on prime business, higher premium rates charged for non-prime business are expected to compensate for the increased level of expected losses associated with this business. The default rate on the Alt-A business decreased to 6.0% at December 31, 2006, from 6.4% at December 31, 2005 and 6.5% at December 31 2004. The default rate on the A minus and below loans was 18.3% at December 31, 2006, compared to 15.8% at December 31, 2005 and 12.1% at December 31, 2004. The default rate on the prime business was 3.3% at December 31, 2006, compared to 3.6% at December 31, 2005 and 3.2% at December 31, 2004. The combined default rate on non-prime business increased to 10.9% at December 31, 2006 from 10.7% at December 31, 2005 and 9.0% at December 31, 2004.
The following table lists our total direct claims paid by product and average claim paid by product as of the periods indicated:
While we experienced an increase in defaults in mortgage insurance in designated areas in the months following the hurricanes, defaults have been steadily decreasing since then-approximately 3,613 defaults remain outstanding as of December 31, 2006, which is down from 6,208 defaults at December 31, 2005. We remain uncertain as to how many claims we ultimately may have to pay on these defaults. The organizations servicing these loans have reported defaults, in some cases, despite the existence of forbearance agreements that permit homeowners to defer mortgage payments on these loans. Limitations also exist in our master policy of insurance that could prevent us from paying all or part of a claim. For example, we are permitted to adjust a claim where the property underlying a mortgage in default is subject to unrestored physical damage. We have taken a view that these loans will not perform better or worse than any other delinquencies. As of December 31, 2006, we had established a related mortgage insurance loss reserve of $31.3 million related to the 3,613 Hurricane Katrina- and Rita-related defaults, including a reserve of $7.6 million for approximately 900 defaults associated with heavily-damaged areas. As of December 31, 2005 we had established a mortgage insurance loss reserve of $58.5 million related to 6,208 hurricane related defaults.
The loss reserve as a percentage of risk in force was 1.7% at December 31, 2006, compared to 1.6% at December 31, 2005 and 1.8% at December 31, 2004. The following table reconciles our mortgage insurance segment’s beginning and ending reserves for losses and LAE for 2005 and 2006 (in thousands):
The following table summarizes the results of operations for our financial guaranty business for the years ended December 31, 2006 and 2005 (in thousands):
significantly impacted by the run-off in the trade credit reinsurance line of business. For 2006, trade credit reinsurance accounted for 1.7% and 10.5% of financial guaranty’s net premiums written and earned, respectively, down from 15.7% and 23.3%, respectively, of financial guaranty’s net premiums written and earned for 2005 (12.6% and 22.8%, respectively, excluding the impact of the 2005 recapture).
(1) Amounts recorded related to the immediate impact of the 2004 and 2005 recaptures.
Net Investment Income. Net investment income attributable to our financial guaranty business was $95.9 million for 2006, compared to $89.9 million for 2005. The 2006 amount includes an increase in investment balances and higher yields.
Net Gains on Securities. Net gains on securities were $7.8 million for 2006, compared to $10.7 million for 2005. The 2006 amount includes an allocation of the gain on the sale of our remaining interest in Primus, partially offset by approximately $1.2 million in losses related to the write-down of other-than-temporarily impaired investment securities. Also included in 2005, is a $3.2 million loss on the write-down of our interest in SBF Participacoes Ltda.
We closely monitor our financial guaranty obligations and we use an internal classification process to identify and track troubled credits. We classify credits as “intensified surveillance credits” when we determine that continued performance is questionable and, in the absence of a positive change, may result in a claim. At December 31, 2006, 2005 and 2004, the financial guaranty segment had the following exposure on credits classified as intensified surveillance credits:
We establish loss reserves on our non-derivative financial guaranty contracts as discussed in “Critical Accounting Policies-Reserve for Losses” in this Item 7 and in Note 2 of Notes to Consolidated Financial Statements. We have allocated non-specific reserves of $26.2 million on five intensified surveillance credits (representing an aggregate par amount of $91.2 million) at December 31, 2006. We expect that we will suffer losses with respect to these insured obligations approximately equal to the total amount reserved. In comparison, we had allocated non-specific reserves of $27.8 million on three credits at December 31, 2005 and $9.8 million on one credit at December 31, 2004.
There is one credit at December 31, 2006 for which we have not allocated a specific reserve that, without a positive change, is likely to default in the near-term and could potentially result in a material claim. Based on currently available information, we expect that any claim from this credit, to the extent one arises, would range from a minimal amount up to slightly more than 50% of the $44 million in total par outstanding. The potential amount of any claim is not estimable at this point, in part, because of the availability of a number of strategic alternatives currently under consideration and other mitigating factors that could reduce or delay any payment from us.
Other Operating Expenses. Other operating expenses were $59.8 million for 2006, compared to $65.0 million for 2005. The year over year decrease resulted primarily from a decrease in consulting costs allocated from the parent company. The expense ratio (which includes other operating expenses and policy acquisition costs) of 52.2% for 2006 was down from 55.7% for 2005 (53.8% excluding the impact of the 2005 recapture).
The following table summarizes the results of operations for our financial guaranty business for the years ended December 31, 2005 and 2004 (in thousands):
In 2005, our public finance direct insured par increased by 62.9% compared to 2004 and our average premium rate on this business remained steady at 152 basis points in 2005 as compared to 153 basis points in 2004. The 2005 direct insured par and average premium rate includes $306 million of international public finance par insured in the United Kingdom. The growth in our domestic public finance business was assisted by a 13.2% increase in new domestic municipal bond issuance, reaching $408.3 billion in 2005 compared to $360.2 billion in 2004.
Net Gains on Securities. Net gains on securities were $10.7 million for 2005, compared to $4.0 million for 2004. This increase is mostly related to sales of convertible bonds that were in a gain position in 2005. Also included in 2005, is a $3.2 million loss on the write-down of our interest in SBF Participacoes Ltda.
Change in Fair Value of Derivative Instruments. Change in the fair value of derivative instruments was a gain of $5.2 million for 2005 compared to a gain of $35.0 million for 2004. The 2005 amount includes a negative $40.1 million mark-to-market adjustment on one derivative financial guaranty contract. The change in fair value of derivatives for 2005 and 2004 reflects a general tightening of spreads on credit derivatives. During 2005, the financial guaranty segment received $7.6 million in recoveries of previous default payments on derivative financial guaranty contracts and paid $0.1 million for default payments. During 2004, the financial guaranty segment received $4.0 million of recoveries of previous default payments, paid $18.6 million for default payments and received $2.9 million of early termination receipts.
The gross par originated by our financial guaranty segment in 2006, 2005 and 2004 is as follows:
The following schedule depicts the expected earned premiums for the existing financial guaranty portfolio, assuming no advance refundings, as of December 31, 2006. Expected earnings will differ from contractual earnings because borrowers have the right to call or prepay financial guaranty obligations. Unearned premium amounts are net of prepaid reinsurance.
The allocated non-specific reserve at December 31, 2006, relates to five credits with a total par outstanding of $26.2 million. The increase in the allocated non-specific reserve at December 31, 2005 relates to one public finance credit and one structured finance credit with an aggregate total par outstanding of $41.2 million.
Net income attributable to the financial services segment for 2006 was $163.3 million compared to $136.2 million for 2005 and $112.5 million for 2004. Equity in net income of affiliates was $257.0 million for 2006, compared to $218.1 million for 2005 and $179.1 million for 2004. C-BASS accounted for $133.9 million of the total equity in net income of affiliates for 2006, compared to $107.8 million for 2005 and $95.9 million for 2004. This reflects the growth in C-BASS’ servicing income from the significant growth in the size of their serviced portfolio, as well as a favorable spread environment for the issuance of C-BASS’s mortgage-backed securities. The increase in interest rates at the end of the third quarter of 2006 produced some mark-to-market hedge losses for C-BASS, but most of these losses were recovered in the fourth quarter of 2006. C-BASS’ results could vary
We have various contractual obligations that are recorded as liabilities in our Consolidated Financial Statements. Other items, including payments under operating lease agreements, are not recorded on our consolidated balance sheets as liabilities but represent a contractual commitment to pay.
On December 13, 2006, we replaced a $400 million unsecured credit facility, comprised of a $100 million 364-day facility that was scheduled to expire on December 14, 2006 and a $300 million five-year facility that was to expire on December 16, 2009 with a $400 million unsecured revolving credit facility that is scheduled to expire December 13, 2011. The new facility includes a $100 million uncommitted line that we may exercise at our option, subject to our obtaining necessary commitments from lenders. This new facility bears interest on any amounts drawn at a rate dependent on our credit rating at the time of borrowing and will be calculated according to, at our option, a base rate or a Eurocurrency rate, plus an applicable margin and utilization fee. If necessary, this facility will be used for working capital and general corporate purposes. There were no drawdowns on the expired facility, and we have not drawn down any amounts under the new facility through December 31, 2006.
As part of the equity allocation component of our investment program, we have committed to invest $55 million in alternative investments that are primarily private equity structures. At December 31, 2006, we had unfunded commitments of $35.4 million. These commitments have capital calls over a period of at least six years, and certain fixed expiration dates or other termination clauses.
Similar securities were classified as available for sale for periods prior to 2006. For securities classified as either available for sale or held to maturity, we conduct a quarterly evaluation of declines in market value of the securities to determine whether the decline is other-than-temporary.
If the fair value of a security is below the cost basis, and it is judged to be other-than-temporary, the cost basis of the individual security is written down to fair value through earnings as a realized loss, and the fair value becomes the new basis. During 2006, we recorded approximately $10.6 million of charges related to declines in the fair value of securities (mainly small cap value stocks and convertible securities) considered to be other-than-temporary. There were no such charges in 2005 and 2004. At December 31, 2006, 2005 and 2004, there were no other investments held in the portfolio that were determined to be other-than-temporarily impaired. Realized gains and losses are determined on a specific identification method and are included in income.
Our evaluation of market declines for other-than-temporary impairment is based on management’s case-by-case evaluation of the underlying reasons for the decline in fair value. We consider a wide range of factors about the security and use our best judgment in evaluating the cause of the decline in the estimated fair value of the security and in assessing the prospects for near-term recovery. Inherent in management’s evaluation of the security are assumptions and estimates about the operations of the issuer and its future earnings potential. Considerations used by us in the impairment evaluation process include, but are not limited to: (i) the length of time and the extent to which the market value has been below cost or amortized cost; (ii) the potential for impairments of securities when the issuer is experiencing significant financial difficulties; (iii) the potential for impairments in an entire industry sector or sub-sector; (iv) the potential for impairments in certain economically depressed geographic locations; (v) the potential for impairments of securities where the issuer, series of issuers or industry has suffered a catastrophic type of loss or has exhausted natural resources; (vi) the Company’s ability and intent to hold the security for a period of time sufficient to allow for the full recovery of its value to an amount equal to or greater than cost or amortized cost; (vii) unfavorable changes in forecasted cash flows on asset-backed securities; and (viii) other subjective factors, including concentrations and information obtained from regulators and rating agencies.
The unrealized losses of 12 months or greater duration as of December 31, 2006 on our investment in U.S. agency mortgage-backed securities were also caused by interest rate increases. The contractual cash flows of these investments are guaranteed by an agency of the U.S. government. Accordingly, it is expected that the securities would not be settled at a price less than the amortized cost of our investment. Because the decline in market value is attributable to changes in interest rates and not credit quality, and because we have the ability and intent to hold these investments until a full recovery of fair value, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at December 31, 2006.
The unrealized losses of 12 months or greater duration as of December 31, 2006 on the majority of the securities in this category were caused by market interest rate increases. A majority of the securities remained at an unrealized loss position due to these rate increases. Unrealized losses for the remaining securities in this category are attributable to changes in business operations, resulting in widened credit spreads from December 31, 2005 to December 31, 2006. Because we have the ability and intent to hold these investments until a full recovery of fair value, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at December 31,
The unrealized losses of 12 months or greater duration as of December 31, 2006 on the majority of the securities in this category were caused by market interest rate increases. A majority of the securities remained at an unrealized loss position due to the rate increases. Because we have the ability and intent to hold these investments until a full recovery of fair value, which may be maturity, we do not consider the investment in these securities to be other-than-temporarily impaired at December 31, 2006.
We act principally as a holding company for our insurance subsidiaries and do not have any significant operations of our own. Dividends from our subsidiaries, which may include dividends they have received from our affiliates (C-BASS and Sherman), and permitted payments to us under our tax- and expense-sharing arrangements with our subsidiaries, along with income from our investment portfolio, are our principal sources of cash to pay stockholder dividends and to meet our obligations. These obligations include our operating expenses, taxes and interest and principal payments on debt. The payment of dividends and other distributions to us by our insurance subsidiaries are regulated by insurance laws and regulations. In general, dividends in excess of prescribed limits are deemed “extraordinary” and require insurance regulatory approval. In addition, although we have expense-sharing arrangements in place with our principal operating subsidiaries that require those subsidiaries to pay their share of holding company-level expenses, including interest expense on our long-term debt, these expense-sharing arrangements may be changed at any time by the applicable state insurance departments. In addition, our insurance subsidiaries’ ability to pay dividends to us, and our ability to pay dividends to our stockholders, is subject to various conditions imposed by the rating agencies for us to maintain our ratings. If the cash we receive from our subsidiaries pursuant to tax- and expense-sharing arrangements is insufficient for us to fund our obligations, we may be required to seek additional capital by incurring additional debt, by issuing additional equity or by selling assets, which we may be unable to do on favorable terms, if at all. The need to raise additional capital or the failure to make timely payments on our obligations could have a material adverse effect on our business, financial condition and operating results.
During 2006, we received $150.0 million in dividends from our mortgage insurance operating subsidiaries. Our insurance subsidiaries may be limited in the amount that they may pay in dividends to us during the next 12 months without first obtaining insurance department approval. We expect to receive modest dividends from our operating subsidiaries throughout 2007 and do not currently expect to seek any extraordinary dividends.
C-BASS paid $46.9 million and $33.5 million in dividends to us during 2006 and 2005, respectively. Sherman paid $103.7 million and $110.7 million of dividends to us during 2006 and 2005, respectively. Sherman also paid us a $51.5 million dividend in January 2007. All dividends from C-BASS and Sherman are initially distributed to our insurance subsidiaries, and therefore are subject to regulatory limitations, as discussed above.
Based on our current intention to pay quarterly common stock dividends of approximately $0.02 per share and assuming that our common stock outstanding remains constant at 79,401,691 shares outstanding at December 31, 2006, we would require approximately $6.4 million to pay our next four quarterly dividends. We will also require approximately $46.9 million annually to pay the debt service on our outstanding long-term debt.
We believe that the operating cash flows generated by each of our insurance subsidiaries will provide those subsidiaries with sufficient funds to satisfy their claim payments and operating expenses for at least the next 12 months. In the unlikely event that claim payment obligations and operating expenses exceed the operating cash flows generated by our insurance operating subsidiaries, we believe that we have the ability to fund any excess from sales of short-term investments maintained at the holding company. At December 31, 2006, we had cash and liquid investment securities of $25.9 million. In the unlikely event that we are unable to fund excess claim payments and operating expenses through the sale of short-term investments, we may be required to incur unanticipated capital losses or delays in connection with the sale of less liquid securities held by us. In any event, we do not anticipate the need for borrowings, under credit facilities or otherwise, to satisfy claim payment obligations or other operating expenses.
Our most significant need for liquidity beyond the next 12 months is the repayment of the principal amount of our outstanding long-term debt. We expect to meet our long-term liquidity needs using excess working capital, sales of investments, borrowings under our credit facility or through the private or public issuance of debt or equity securities.
of the put options and the corresponding exercise of one or more corresponding Radian Asset Securities put options. If the Radian Asset Assurance put options were exercised, Radian Asset Securities, through the Radian Asset Assurance preferred stock thereby acquired, and investors, through their equity investment in the Radian Asset Securities preferred stock, would have rights to the assets of Radian Asset Assurance of an equity investor in Radian Asset Assurance. Such rights would be subordinate to policyholders’ claims, as well as to claims of general unsecured creditors of Radian Asset Assurance, but ahead of the parent company’s claims, through EFSG, as the owner of the common stock of Radian Asset Assurance. If all the Radian Asset Assurance put options were exercised, Radian Asset Assurance would receive up to $150 million in return for the issuance of its own perpetual preferred stock, the proceeds of which could be used for any purpose, including the payment of claims. Dividend payments on the preferred stock will be cumulative only if Radian Asset Assurance pays dividends on its common stock. Each trust will be restricted to holding high-quality, short-term commercial paper investments to ensure that it can meet its obligations under the put option. To fund these investments, each trust will issue its own auction market perpetual preferred stock. Each trust is currently rated “A” by each of S&P and Fitch.
Since September 2002, our board of directors has authorized five separate repurchase programs for the repurchase, in the aggregate, of up to 21.5 million shares of our common stock on the open market. At March 31, 2004, we had repurchased all 2.5 million shares under the initial program (announced September 24, 2002) at a
On February 8, 2006, we announced that our board of directors had authorized a fifth repurchase program for the repurchase of up to 4.0 million shares of our common stock on the open market. On November 9, 2006, we announced that our board of directors had authorized the purchase of an additional 2.0 million shares as part of an expansion of our existing repurchase program. At December 31, 2006, we had repurchased all of the original 4.0 million authorized shares at a cost of approximately $236.8 million, and we had repurchased 0.5 million of the additional 2.0 million shares at a cost of approximately $26.8 million. Stock purchases under this program are funded from available working capital and are made from time to time, depending on market conditions, stock price and other factors. The board did not set an expiration date for this program.
Stockholders’ equity was $4.1 billion at December 31, 2006 compared to $3.7 billion at December 31, 2005. Stockholders’ equity increased as a result of: (1) net income of $582.2 million, (2) proceeds from the issuance of common stock under incentive plans of $36.5 million, and (3) an increase in the market value of securities available for sale of $34.0 million, net of tax, offset by our repurchase of approximately 4.5 million shares of our common stock for approximately $263.6 million and dividends paid in 2006 of $6.5 million.
With respect to delinquent loans that are in an early stage of delinquency, considerable judgment is exercised as to the adequacy of reserve levels. Adjustments in estimates for delinquent loans in the early stage of delinquency are more volatile in nature than for loans that are in the later stage of delinquency, which generally require a larger reserve. As the delinquency proceeds toward foreclosure, there is more certainty around these estimates as a result of the aged status of the delinquent loan, and adjustments are made to loss reserves to reflect this updated information. If a default cures (historically, a large percentage of defaulted loans have cured before going to claim), the reserve for that loan is removed from the reserve for losses and LAE. This curing process causes an appearance of a reduction in reserves from prior years if the reduction in reserves from cures is greater than the additional reserves for those loans that are nearing foreclosure or have become claims. We also reserve for defaults that we believe to have occurred but that have not been reported to us on a timely basis by lending institutions. All estimates are continually reviewed and adjustments are made as they become necessary. We generally do not establish reserves for loans that are in default if we believe that we will not be liable for the payment of a claim with respect to that default. For example, for those defaults in which we are in a second-loss position, we calculate what the reserve would have been if there had been no deductible. If the existing deductible is greater than the reserve amount for any given default, we do not establish a reserve for the default. Consistent with GAAP and industry accounting practices, we generally do not establish loss reserves for expected future claims on insured mortgages that are not in default or believed to be in default.
The following table shows the mortgage insurance range of loss and LAE reserves, as determined by our actuaries, and recorded reserves for losses and LAE, as of December 31, 2006 and 2005:
At December 31, 2006 and 2005, we made a judgment to reserve at a level above the midpoint, given the uncertainty around the ultimate performance of our defaulted non-prime products and the potential overpricing in certain housing markets.
We considered the sensitivity on loss reserve estimates by assessing the potential changes resulting from a hypothetical parallel shift in severity and claim rate. For example, assuming all other factors remain constant, for every 1% change in claim severity or claim rate, we estimated a $5.8 million change in our loss reserves.
Setting both case reserves and allocated non-specific reserves requires us to exercise judgment in estimating the severity of the claim that is likely to result from an identified reserving event, which may be any amount up to the full amount of the insured obligation. The reliability of this estimate depends on the reliability of the information regarding the likely severity of the claim and the judgments made by management with respect to that information. Even when we are aware of the occurrence of an event that requires the establishment of a reserve, our estimate of the severity of the claim that is likely to result from that event may not ultimately be correct.
At December 31, 2006, five credits were included in our allocated non-specific reserves of $26.2 million. We expect that we will suffer losses with respect to these insured obligations approximately equal to the amount reserved of $26.2 million. These credits have a par amount of $91.2 million.
Our unallocated non-specific loss reserve at December 31, 2006, was $60.4 million. The range between the unallocated non-specific reserves that would have resulted from applying the highest and lowest default factors generated by any of the three models was approximately $17 million to $61 million, which we believe provides a reasonably likely range of expected losses. None of the product types that we insure accounted for a materially disproportionate share of the variability within that range.
At each balance sheet date, we also evaluate both the model-generated default factors and our unallocated non-specific reserves against management’s subjective view of qualitative factors to ensure that the default factors and the unallocated non-specific reserves represent management’s best estimate of the expected losses on our portfolio of credits for which we have not established a case reserve or an allocated non-specific reserve. These qualitative factors include existing economic and business conditions, overall credit quality trends resulting from industry, geographic, economic and political conditions, recent loss experience in particular segments of the portfolio, changes in underwriting policies and procedures and seasoning of the book of business. The macroeconomic factors that we evaluate are outside of our control and are subject to considerable variability. The company-specific factors that we evaluate also require us to make subjective judgments. In addition, a significant change in the size of our portfolio underlying the unallocated non-specific reserves, such as through the expiration of policies or the refunding or recapture of insured exposures, could require an adjustment to the default factors or our level of unallocated non-specific reserves. To date, our evaluation of these qualitative factors has not led us to adjust the default factors or our level of unallocated non-specific reserves. Our estimates of our reserves for losses and LAE for our financial guaranty segment’s other lines of business, mainly trade credit reinsurance, depend upon the receipt of accurate information on claims and loss estimates from ceding companies. In addition, a reserve is included for losses and LAE incurred but not reported (“IBNR”), on trade credit reinsurance. As the business is now in run-off, the receipt of information from ceding companies is likely to be more sporadic and the setting of reserves will be more reliant on management estimates. We use historical loss information and make inquiries to the cedants of known events as a means of validating our loss assumptions.
In January and February 2005, we discussed with the SEC staff, both separately and together with other members of the financial guaranty industry, the differences in loss reserve practices followed by different financial guaranty industry participants. On June 8, 2005, the FASB added a project to its agenda to consider the accounting by insurers for financial guaranty insurance. The FASB’s objective is to provide guidance with respect to the timing of claim liability recognition, premium recognition and the related amortization of deferred policy acquisition costs, specifically for financial guaranty contracts issued by insurance companies that are not accounted for as derivative contracts under SFAS No. 133. The goal is to reduce diversity in accounting by financial guaranty insurers, thereby enabling users to better understand and more readily compare the insurers’ financial statements. The FASB is also expected to examine the appropriate accounting model for other insurance products with similar characteristics, such as mortgage guaranty contracts and trade credit insurance. Proposed and final guidance from the FASB regarding accounting for financial guaranty insurance is expected to be issued in 2007. When and if the FASB or the SEC reaches a conclusion on these issues, we and the rest of the financial guaranty and mortgage insurance industries may be required to change some aspects of our accounting policies.
We account for derivatives under SFAS No. 133, as amended and interpreted. Some of the fixed-maturity securities included in our investment portfolio and certain of our mortgage and financial guaranty contracts are considered “derivatives.” Under SFAS No. 133, the convertible debt and redeemable preferred securities included in our investment portfolio must be characterized as hybrid securities because they generally combine both debt and equity characteristics. The hybrid classification requires that the convertible security valuation be separated into a fixed-income component and an equity derivative component. Valuation changes on the fixed-income component are recorded as other comprehensive income on our consolidated balance sheets while valuation changes on the equity derivative component are recorded as net gains and losses on our consolidated statements of income. We believe that the market valuation of each hybrid convertible security is appropriately allocated to its fixed-income and equity derivative components.
The gains and losses on direct derivative financial guaranty contracts are derived from internally generated models. The gains and losses on assumed derivative financial guaranty contracts are provided by the primary insurance companies. With respect to our direct derivative financial guaranty contracts, estimated fair value amounts are determined by us using market information to the extent available, and appropriate valuation methodologies. For CDOs, credit spreads on individual names in our collateral pool are used to determine an equivalent risk tranche on an industry standard credit default swap index. We then estimate the price of our equivalent risk tranche based on observable market prices of standard risk tranches on the industry standard credit default swap index. When credit spreads on individual names are not available, the average credit spread on the credit rating of the name is used. For certain structured transactions, dealer quotes on similar structured transactions are used. For certain structured transactions where market data is not available, no gains or losses are recorded. Significant differences may exist with respect to the available market information and assumptions
In the fourth quarter of 2005, we refined our mark-to-market model to use actual credit spreads by individual name, when available as discussed above, as compared to our previous version of the model, which used average spreads for similarly rated names. While application of the new model resulted in immaterial changes for most of our derivative financial guaranty transactions, one synthetic CDO showed a large difference due to greater spread volatility in the underlying high-yield corporate names included in this transaction. On March 2, 2006, Radian Asset Assurance paid $68.0 million to its counterparty in consideration for the termination of this transaction.
The application of SFAS No. 133, as amended, could result in volatility from period to period in gains and losses as reported on our consolidated statements of income. These gains and losses are mostly the result of changes in corporate credit spreads, changes in the creditworthiness of underlying corporate entities, and the equity performance of the entities underlying the convertible investments. Any incurred gains or losses on such contracts would be recognized as a change in the fair value of derivatives. We are unable to predict the affect this volatility may have on our financial condition or results of operations.
In accordance with our risk management policies, we may enter into derivatives to hedge the interest rate risk related to our long-term debt. As of December 31, 2006, we were a party to two interest rate swap contracts relating to our 5.625% unsecured senior notes due 2013. These interest rate swaps are designed as fair value hedges that hedge the change in fair value of our long-term debt arising from interest rate increases. During 2006 and 2005, the fair value hedges were 100% effective. Therefore, the change in the fair value of the derivative instruments in our consolidated statements of income was offset by the change in the fair value of the hedged debt. These interest-rate swap contracts mature in February 2013.
(a) The December 31, 2006 six-month LIBOR forward rate at the next swap payment date plus 87.4 basis points.
We are currently under examination by the Internal Revenue Service (“IRS”) for the 1999 through 2005 tax years and are regularly audited by tax authorities in other countries and states in which we have significant business operations. To date, the IRS examination remains in the discovery phase and no formal notice of proposed adjustment has been received. However, the IRS has indicated that it opposes the recognition of certain tax losses that were generated through our investment in a portfolio of residual interests in Real Estate Mortgage Investment Conduits (“REMICs”). The IRS has indicated that it may issue a formal notice of proposed adjustment upon its completion of discovery which is anticipated to conclude during the fourth quarter of 2007. We will contest any proposed adjustment relating to the IRS’ opposition of the tax losses in question. We provide tax reserves for federal, state, local and international exposures relating to audit results, tax planning initiatives and compliance responsibilities. We regularly assess the potential outcome of examinations in each of the taxing jurisdictions when determining the adequacy of the provision for income taxes. The development of these reserves requires judgments about tax issues, potential outcomes and timing, and is a subjective significant estimate. Once established, the reserves are adjusted only when there is more information available or when an event occurs necessitating a change to the reserves. Although the outcome of tax examinations is uncertain, in our opinion, adequate provisions for income taxes have been made for potential liabilities emanating from these reviews, including the current IRS audit. If actual outcomes differ materially from these estimates, they could have a material impact on our effective tax rate, results of operations and cash flows.
In April 2006, the FASB issued FASB Staff Position (“FSP”) No. FIN 46(R)-6 “Determining the Variability to Be Considered in Applying FASB Interpretation No. 46(R)” (“FSP No. FIN 46(R)-6”), which addresses how a reporting enterprise should determine the variability to be considered in applying FASB Interpretation No. 46(R) (“FIN 46R”). The variability that is considered in applying FIN 46R affects the determination of (i) whether the entity is a variable interest entity, (ii) which interests are variable interests in the entity and (iii) which party, if any, is the primary beneficiary of the variable interest entity. That variability will affect any calculation of expected losses and expected residual returns, if such a calculation is necessary. FSP No. FIN 46(R)-6 became effective July 1, 2006. The adoption of this FSP did not have a material impact on our Consolidated Financial Statements.
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”). SFAS No. 157 (i) defines fair value, (ii) establishes a framework for measuring fair value in GAAP and (iii) expands disclosure requirements about fair value measurements. SFAS No. 157 is effective for all financial statements issued for fiscal years beginning after November 15, 2007. Management currently is considering the impact that may result from the adoption of SFAS No. 157.
In February of 2007, the FASB issued Statement No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities”, (“SFAS No. 159”). SFAS No. 159 permits entities to choose to measure financial instruments and certain other items at fair value. Items eligible for fair value measurement option established by this statement are (i) recognized financial assets and financial liabilities (with some exceptions), (ii) firm commitments that would otherwise not be recognized at inception and that involve only financial instruments, (iii) nonfinancial insurance contracts and warranties that the insurer can settle by paying a third party to provide those goods or services and (iv) host financial instruments resulting from separation of an embedded nonfinancial derivative instrument from a nonfinancial hybrid instrument. SFAS No. 159 is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. Management is considering the impact, if any, that may result from the adoption of SFAS No. 159.
In September 2005, Statement of Position (“SOP”) 05-1, “Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection With Modifications or Exchanges of Insurance contracts”, (“SOP 05-1”), was issued. This SOP provides guidance on accounting by insurance enterprises for deferred acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in SFAS No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments”. SOP 05-01 is effective for internal replacements occurring in fiscal years beginning after December 15, 2006. Management believes the impact, if any, as a result of the adoption of SOP 05-1, will not be material to our Consolidated Financial Statements.
Deloitte & Touche LLP, an independent registered public accounting firm, was retained to audit Radian Group Inc.’s Consolidated Financial Statements. The accompanying reports of Deloitte & Touche LLP are based on its audit, which it is required to conduct in accordance with the standards of the Public Company Accounting Oversight Board (United States), and which includes the consideration of Radian’s internal control over financial reporting to establish a basis for reliance thereon in determining the nature, timing and extent of audit tests to be applied.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 1, 2007, expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
On February 28, 2001, we acquired the financial guaranty insurance and other businesses of Enhance Financial Services Group Inc. (“EFSG”), a New York-based insurance holding company that mainly insures and reinsures credit-based risks. In addition, as part of the acquisition, we have an ownership interest in two credit-based asset businesses (see Note 4). Several smaller businesses are either in run-off or have been terminated. The
Effective June 1, 2004, EFSG’s two main operating subsidiaries, Radian Asset Assurance Inc. (“Radian Asset Assurance”) and Radian Reinsurance Inc. (“Radian Reinsurance”) were merged, with Radian Asset Assurance as the surviving company. Through this merger, the financial guaranty reinsurance business formerly conducted by Radian Reinsurance was combined with the direct financial guaranty business conducted by Radian Asset Assurance. The merger also combined the assets, liabilities and stockholders’ equity of the two companies. The combined company is rated Aa3 (with a stable outlook) by Moody’s Investor Service (“Moody’s”), AA (with a stable outlook) by Standard & Poor’s Ratings service (“S&P”) and AA (with a negative outlook) by Fitch Ratings (“Fitch”).
In September 2004, the Financial Services Authority (the “FSA”) authorized Radian Financial Products Limited (“RFPL”), another subsidiary of Radian Asset Assurance, to transact as a Category A Securities and Futures Firm. In the fourth quarter of 2005, management considered the scope of RFPL’s activities and decided that RFPL should focus its core business on arranging credit default swap risk for Radian Asset Assurance Limited, a subsidiary of Radian Asset Assurance that is authorized to conduct insurance business in the United Kingdom. For the activity of arranging, or bringing about deals in investments, it is sufficient to have a Category D authorization, which is more cost efficient for the company. The lower category of authorization was granted in August 2006 and limits RFPL to negotiating and arranging transactions in investments, including credit default swaps, with market counterparties located in the United Kingdom or other European countries.
The financial services segment includes the credit-based businesses conducted through our affiliates, Credit-Based Asset Servicing and Securitization LLC (“C-BASS”) and Sherman Financial Group LLC (“Sherman”). We own a 46% interest in C-BASS and an interest in Sherman consisting of 40.96% of the Class A Common Units issued by Sherman (Class A Common Units represent 94% of the total equity in Sherman) and 50% of the Preferred Units of Sherman. See Note 4 for more information regarding our interests in these affiliates. C-BASS is a mortgage investment and servicing firm specializing in non-prime, residential mortgage assets and residential mortgage-backed securities. By using sophisticated analytics, C-BASS generally seeks to take advantage of what
it believes to be the mispricing of credit risk for certain assets in the marketplace. Sherman is a consumer asset and servicing firm specializing in charged-off and bankruptcy plan consumer assets that it generally purchases at deep discounts from national financial institutions and major retail corporations and subsequently collects upon these receivables. In addition, Sherman originates non-prime credit card receivables through its subsidiary CreditOne, which Sherman acquired in March 2005.
In December 2003, the Financial Accounting Standards Board (“FASB”) revised FASB Interpretation No. 46 (“FIN No. 46R”) “Consolidation of Variable Interest Entities” which addresses consolidation by business enterprises of variable interest entities. Under the guidelines of FIN No. 46R we do not consolidate any of our variable interest entities.
Our Consolidated Financial Statements are prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”).
In the mortgage insurance segment, reserves for losses generally are not established until we are notified that a borrower has missed two payments. We also establish reserves for LAE, consisting of the estimated cost of the claims administration process, including legal and other fees and expenses associated with administering the claims process. SFAS No. 60 specifically excludes mortgage guaranty insurance from its guidance relating to the reserve for losses. We maintain an extensive database of claim payment history and use models, based on a variety of loan characteristics, including the status of the loan as reported by its servicer, and macroeconomic factors such as regional economic conditions that involve significant variability over time, as well as more static factors such as the estimated foreclosure period in the area where the default exists, to help determine the likelihood that a default will result in a claim (referred to as the “claim rate”), the amount that we will pay if a default becomes a claim (referred to as “claim severity”) and based on these estimates, the appropriate loss reserve at any point in time. As a result of our continued evaluation of historical data, in the fourth quarter of 2006, we made adjustments to the claim rate estimates of our model, mostly to incorporate the results of our intensified loss management efforts throughout 2006. With respect to delinquent loans that are in an early stage of delinquency, considerable judgment is exercised as to the adequacy of reserve levels. Adjustments in estimates for delinquent loans in the early stage of delinquency are more volatile in nature than for loans that are in the later stage of delinquency, which generally require a larger reserve. As the delinquency proceeds toward foreclosure, there is more certainty around these estimates as a result of the aged status of the delinquent loan, and adjustments are made to loss reserves to reflect this updated information. If a default cures (historically, a large percentage of defaulted loans have cured before going to claim), the reserve for that loan is removed from the reserve for losses and LAE. This curing process causes an appearance of a reduction in reserves from prior years if the reduction in reserves from cures is greater than the additional reserves for those loans that are nearing foreclosure or have become claims. We also reserve for defaults that we believe to have occurred but that have not been reported to us on a timely basis by lending institutions. All estimates are continually reviewed and adjustments are made as they become necessary. We generally do not establish reserves for loans that are in default if we believe that we will not be liable for the payment of a claim with respect to that default. For example, for those defaults in which we are in a second-loss position, we calculate what the reserve would have been if there had been no deductible. If the existing deductible is greater than the reserve amount for any given default, we do not establish a reserve for the default. Consistent with GAAP and industry accounting practices, we generally do not establish loss reserves for expected future claims on insured mortgages that are not in default or believed to be in default. See Note 6 for further discussion on losses and loss adjustment expenses.
The following description of our financial guaranty loss reserving policy relates only to non-derivative financial guaranty contracts provided through financial guarantees of direct and assumed insurance business. Our financial guaranty insurance contracts provide an unconditional and irrevocable guaranty to the holder of a financial obligation that, upon payment default by the insured obligor, we will pay the full amount of principal and interest on an insured obligation when due. Our financial guaranty reinsurance contracts provide for
Our unallocated non-specific loss reserve at December 31, 2006, was $60.4 million. The range between the unallocated non-specific reserves that would have resulted from applying the highest and lowest default factors generated by any of the three models was approximately $17.0 million to $61.0 million, which we believe provides a reasonably likely range of expected losses. None of the product types that we insure accounted for a materially disproportionate share of the variability within that range.
As an insurance enterprise, we rely principally on SFAS No. 60 in establishing loss reserves in our financial guaranty business. With respect to our case reserves, we follow the guidance of SFAS No. 60 regarding the establishment of reserves upon the occurrence of an insured event. Although SFAS No. 60 provides guidance to insurance enterprises, it was adopted before the financial guaranty industry came into prominent existence and it does not comprehensively address the unique attributes of financial guaranty insurance. For example, SFAS No. 60 prescribes differing reserving treatment depending on whether a contract fits within SFAS No. 60’s
Because of the ambiguities in the application of SFAS No. 60 to our loss reserving policy, we do not believe that SFAS No. 60 alone provides sufficient guidance for our reserving policy, particularly with respect to the establishment of non-specific reserves before an insured event occurs. As a result, we and, to our knowledge, other members of the financial guaranty industry, supplement the principles of SFAS No. 60 with those of SFAS No. 5, “Accounting for Contingencies,” which calls for the establishment of reserves when it is probable that a liability has been incurred at the date of the financial statements and the amount of loss can be reasonably estimated. We also rely by analogy on SFAS No. 114, “Accounting by Creditors for Impairment of a Loan” and the Emerging Issues Task Force (“EITF”) Issue No. 85-20, “Recognition of Fees for Guaranteeing a Loan,” which state that a guarantor should perform an ongoing assessment of the probability of loss to determine if a liability (and a loss) should be recognized under SFAS No. 5. The establishment of non-specific reserves for credits that have not yet defaulted is a practice followed by the entire financial guaranty industry, although we acknowledge that there may be differences in the specific methodologies used by other financial guarantors in establishing these reserves. We believe that our financial guaranty loss reserve policy is appropriate under the applicable accounting literature, and that it best reflects the fact that credit-based insurance involves a gradual deterioration of credit over time. However, because of the lack of specific accounting literature comprehensively addressing the unique attributes of financial guaranty contracts, the accounting principles applicable to our loss reserving policy are subject to change.
Fair values for fixed-maturity securities (including redeemable preferred stock), equity securities and trading securities are based on quoted market prices, dealer quotes and prices obtained from independent pricing services. Short-term investments are carried at amortized cost, which approximates fair value. The fair value of other invested assets is based on the carrying value for equity-method investments and cost for cost-method investments. See Note 15 for further discussion.
We record premiums and origination costs related to credit default swaps and certain other derivative contracts in premiums written and policy acquisition costs, respectively, on our consolidated statements of income. Our classification of these contracts is the same whether we are a direct insurer or we assume these contracts.
In accordance with our risk management policies, we may enter into derivatives to hedge the interest rate risk related to our long-term debt. As of December 31, 2006, we were a party to two interest rate swap contracts relating to our 5.625% unsecured senior notes due 2013. These interest rate swaps are designed as fair value hedges that hedge the change in fair value of our long-term debt arising from interest rate increases. During 2006, 2005 and 2004, the fair value hedges were 100% effective. Therefore, the change in the fair value of the derivative instruments in our consolidated statements of income was offset by the change in the fair value of the hedged debt. These interest-rate swap contracts mature in February 2013.
In the fourth quarter of 2005, we refined our mark-to-market model to use actual credit spreads by individual name, when available as discussed above, as compared to our previous version of the model, which used average spreads for similarly rated names. While application of the new model resulted in minimal changes for most of our derivative transactions, one synthetic collateralized debt obligation showed a large difference due to greater spread volatility in the underlying high-yield corporate names included in this transaction. At December 31, 2005, our refined model indicated that a $50.8 million loss should be recognized on this transaction, which was included on our list of intensified surveillance credits at December 31, 2005. On March 2, 2006, Radian Asset Assurance paid $68.0 million to its counterparty in consideration for its counterparty’s terminating this transaction.
We account for certain mortgage insurance contracts such as NIMs transactions, as derivative contracts under SFAS No. 133. We have developed a model that estimates the fair value of our NIMs transactions. The model is based on various factors such as recent premium levels and the present value of future estimated cash flows.
Other restructurings in our financial guaranty business segment may consist of purchasing the insured debt security to mitigate losses. Insured debt securities purchased to mitigate losses are included in other assets on our consolidated balance sheets at the lower of cost or net realizable value. Gains or losses from the holding or disposition of the securities acquired are recorded as net gains and losses on the sale of securities. At December 31, 2006 and 2005, we held $3.3 million and $4.1 million, respectively, of insured debt securities purchased to mitigate losses.
Costs associated with the acquisition of mortgage insurance business, consisting of compensation and other policy issuance and underwriting expenses, are initially deferred and reported as deferred policy acquisition costs. Because SFAS No. 60 specifically excludes mortgage guaranty insurance from its guidance relating to the amortization of deferred policy acquisition costs, amortization of these costs for each underwriting year book of business is charged against revenue in proportion to estimated gross profits over the estimated life of the policies using the guidance provided by SFAS No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments.” This includes accruing interest on the unamortized balance of deferred policy acquisition costs. Estimates of expected gross profit including persistency and loss development assumptions for each underwriting year and product type used as a basis for amortization are evaluated regularly, and the total amortization recorded to date is adjusted by a charge or credit to our consolidated statements of income if actual experience or other evidence suggests that earlier estimates should be revised. Considerable judgment is used in evaluating these factors when updating the assumptions. The use of different assumptions would have a significant effect on the amortization of deferred policy acquisition costs. In 2006, 2005 and 2004, as a result of these evaluations, we accelerated the amortization of $4.9 million, $5.1 million and $11.6 million, respectively, of policy acquisition costs in our mortgage insurance segment.
We provide for income taxes in accordance with the provisions of SFAS No. 109, “Accounting for Income Taxes” (“SFAS No. 109”). As required under SFAS No. 109, our deferred tax assets and liabilities are
recognized under the liability method which recognizes the future tax effect of temporary differences between the amounts recorded in the Consolidated Financial Statements and the tax bases of these amounts. Deferred tax assets and liabilities are measured using the enacted tax rates expected to apply to taxable income in the periods in which the deferred tax asset or liability is expected to be realized or settled.
We are currently under examination by the Internal Revenue Service (“IRS”) for the 1999 through 2005 tax years and are regularly audited by tax authorities in other countries and states in which we have significant business operations. To date, the IRS examination remains in the discovery phase and no formal notice of proposed adjustment has been received. However, the IRS has indicated that it opposes the recognition of certain tax losses that were generated through our investment in a portfolio of residual interests in Real Estate Mortgage Investment Conduits (“REMICs”). The IRS has indicated that it may issue a formal notice of proposed adjustment upon its completion of discovery which is anticipated to conclude during the fourth quarter of 2007. We currently anticipate that funding the payment on account could occur during the fourth quarter of 2007 or the first quarter of 2008, and we estimate the capital requirement for such payment to be approximately $84.2 million. We will contest any proposed adjustment relating to the IRS’ opposition of the tax losses in question. We provide tax reserves for federal, state, local and international exposures relating to audit results, tax planning initiatives and compliance responsibilities. We regularly assess the potential outcome of examinations in each of the taxing jurisdictions when determining the adequacy of the provision for income taxes. The development of these reserves requires judgments about tax issues, potential outcomes and timing, and is a subjective significant estimate. Once established, the reserves are adjusted only when there is more information available or when an event occurs necessitating a change to the reserves. Although the outcome of tax examinations is uncertain, in our opinion, adequate provisions for income taxes have been made for potential liabilities emanating from these reviews, including the current IRS audit. If actual outcomes differ materially from these estimates, they could have a material impact on our effective tax rate, results of operations and cash flows.
Assets and liabilities denominated in foreign currencies are translated at the year-end exchange rates. Operating results are translated at average rates of exchange prevailing during the year. Unrealized gains and losses, net of deferred taxes, resulting from translation are included in accumulated other comprehensive income in stockholders’ equity. Gains and losses resulting from transactions in foreign currency are recorded in current period net income.
We are the beneficiary of insurance policies on the lives of certain of our officers and employees. We have recognized the amount that could be realized upon surrender of the insurance policies as an asset in our consolidated balance sheets. At December 31, 2006 and 2005, the amount of company-owned life insurance totaled $62.5 million and $59.7 million, respectively, and is included as a component of other assets.
In December 2004, the FASB issued SFAS No. 123R (“SFAS No. 123R”) “Share-Based Payment”, which requires compensation cost related to share-based payment transactions to be recognized in an issuer’s financial statements. The compensation cost, with limited exceptions, is measured based on the grant-date fair value of the equity or liability instrument issued. In October 2005, the FASB issued Staff Position No. SFAS 123(R)-2 “Practical Accommodation to the Application of Grant Date as Defined in FASB Statement No. 123(R),” to provide guidance on the application of the term “grant date” in SFAS No. 123R. In accordance with this Staff Position, the grant date of an award shall be the date the award is approved by our board of directors if, at such time, (i) the recipient of the award does not have the ability to negotiate the key terms and conditions of the award and (ii) the key terms of the award are expected to be communicated to the recipients within a relatively short time period after the date of approval. SFAS No. 123R replaces SFAS No. 123 “Accounting for Stock-Based Compensation” and supersedes Accounting Principles Board (“APB”) Opinion No. 25. Before the adoption of SFAS No. 123R, we applied APB 25 to account for our stock-based compensation.
We have three reportable segments: mortgage insurance, financial guaranty and financial services. The mortgage insurance segment provides mortgage credit protection principally through private mortgage insurance and risk management services to mortgage lending institutions located throughout the United States and globally. Private mortgage insurance protects lenders from all or part of default-related losses on residential mortgage loans made mostly to homebuyers who make down payments of less than 20% of the home’s purchase price. Private mortgage insurance also facilitates the sale of these mortgages in the secondary market. Our financial guaranty segment provides credit-related insurance coverage, credit default swaps and certain other financial guaranty contracts to meet the needs of customers and counterparties in a wide variety of domestic and international markets. Our insurance businesses within the financial guaranty segment include the assumption of reinsurance from monoline financial guaranty insurers for both public finance bonds and structured finance obligations and direct financial guaranty insurance for public finance bonds and structured finance obligations.
have the right, in the future, to purchase an additional 6.92% interest in Sherman from the new entity controlled by Sherman’s management team for a price intended to approximate current fair market value.
4.17% (8.34% for both of us) of the Class A Common Units outstanding after the reclassification, which represents 3.92% (7.84% for both of us) of the common equity interests in Sherman prior to the reclassification; and
On September 22, 2006, we and MGIC each paid $65.3 million to an entity controlled by Sherman’s management team in connection with the exercise of our restructured options. The purchase price consisted of approximately $44.8 million for the Class A Common Units and approximately $20.5 million for the Preferred Units.
In the mortgage insurance segment, the highest state concentration of primary risk in force at December 31, 2006, was Florida at 9.1%, compared to 9.5% at December 31, 2005. At December 31, 2006, California accounted for 12.8% of the mortgage insurance segment’s total direct primary insurance in force, compared to 10.4% at December 31, 2005, and 11.3% of the mortgage insurance segment’s total pool risk in force, compared to 12.3% for 2005. California also accounted for 12.8% of the mortgage insurance segment’s direct primary new insurance written for 2006 compared to 13.8% for 2005. The percentage of risk in California has been falling due to the high cancellation rate as compared to new business written.
The financial guaranty segment derives a substantial portion of its premiums written from a small number of direct primary insurers. In 2006, three primary insurers accounted for approximately $91.3 million or 34.7% of the financial guaranty segment’s gross written premiums. In 2005, one primary insurer accounted for approximately $43.3 million or 19.3% of the financial guaranty segment’s gross written premiums. No other primary insurer accounted for more than 10% of the financial guaranty segment’s gross written premiums during 2006 or 2005. Gross written premiums and net written premiums are not materially different because we do not cede a material amount of business to reinsurers.
On June 29, 2006, S&P affirmed the AA financial strength rating, and revised its outlook upward to stable, for Radian Asset Assurance. S&P also affirmed Radian Group Inc.’s A credit rating and revised its outlook for Radian Group upward to stable. Similarly, on July 3, 2006, S&P affirmed the AA financial strength rating and revised its outlook upward to stable for RAAL. In November 2006, RAAL received an initial financial strength rating of Aa3 from Moody’s.
In 2006, Radian Europe was assigned an initial AA financial strength rating with a stable outlook by both S&P and Fitch, and in February 2007, in connection with the announcement of our agreement to merge with MGIC, Moody’s placed under review for possible upgrade the A2 senior debt rating of Radian Group Inc. and the Aa3 insurance financial strength ratings of our mortgage insurance subsidiaries. Also in connection with the announcement of the merger, Fitch affirmed its AA financial strength ratings for Radian Asset Assurance and RAAL and maintained its negative outlook for these insurers.
In October 2002, S&P downgraded the insurer financial strength rating of Radian Reinsurance, before its merger with and into Radian Asset Assurance, from AAA to AA. As a result of this downgrade, effective January 31, 2004, one of the primary insurer customers of our financial guaranty reinsurance business exercised its right to recapture approximately $16.4 billion of par in force ceded to our financial guaranty reinsurance business, including $96.4 million of net premiums written with a GAAP carrying value of approximately $71.5 million. The entire impact of this recapture was reflected as a reduction of net premiums written in the first quarter of 2004. Because, in accordance with GAAP, we already had reflected $24.9 million of these recaptured net premiums written as having been earned, we were required to record the entire $24.9 million reduction in net premiums earned in the first quarter of 2004. Also in connection with the recapture in the first quarter of 2004, we were reimbursed for policy acquisition costs of approximately $31.0 million for which the carrying value under GAAP was $21.3 million. In addition, the recapture included approximately $11.5 million that had been recorded as case reserves under GAAP. Finally, we took a charge of $0.8 million for mark-to-market adjustments related to certain insurance policies associated with the recapture.
In April 2006, the FASB issued FASB Staff Position (“FSP”) No. FIN 46(R)-6 “Determining the Variability to Be Considered in Applying FASB Interpretation No. 46(R),” (“FSP No. FIN 46(R)-6”) which addresses how a reporting enterprise should determine the variability to be considered in applying FASB Interpretation No. 46(R) (“FIN 46R”). The variability that is considered in applying FIN 46R affects the determination of (i) whether the entity is a variable interest entity, (ii) which interests are variable interests in the entity and
(iii) which party, if any, is the primary beneficiary of the variable interest entity. That variability will affect any calculation of expected losses and expected residual returns, if such a calculation is necessary. FSP No. FIN 46(R)-6 became effective July 1, 2006. The adoption of this FSP did not have a material impact on our Consolidated Financial Statements.
The EITF reached a consensus on EITF Issue No. 06-4, “The Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements” (“EITF 06-4”). EITF 06-4 addresses whether the postretirement benefit associated with an endorsement split-dollar life insurance arrangement is effectively settled in accordance with Statement of Financial Accounting Standards No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions” and APB Opinion No. 12 “Omnibus Opinion-1967” upon entering into such an arrangement. EITF 06-4 is effective for fiscal years beginning after December 15, 2007. Management is considering the impact, if any, that may result from the adoption of EITF 06-4.
In February 2007, the FASB issued Statement No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities”, (“SFAS No. 159”). SFAS No. 159 permits entities to choose to measure financial instruments and certain other items at fair value. Items eligible for fair value measurement option established by this statement are (i) recognized financial assets and financial liabilities (with some exceptions), (ii) firm commitments that would otherwise not be recognized at inception and that involve only financial instruments, (iii) nonfinancial insurance contracts and warranties that the insurer can settle by paying a third party to provide those goods or services and (iv) host financial instruments resulting from separation of an embedded nonfinancial derivative instrument from a nonfinancial hybrid instrument. SFAS No. 159 is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. Management is considering the impact, if any, that may result from the adoption of SFAS No. 159.
Certain prior period balances have been reclassified to conform to the current period presentation.
If a security’s fair value is below the cost basis, and it is judged to be other-than-temporary, the cost basis of the individual security is written down to fair value through earnings as a realized loss, and the fair value becomes the new basis. During 2006, we recorded approximately $10.6 million of charges related to declines in fair value of securities (mainly small cap value stocks and convertible securities) considered to be other-than-temporary, which are included in the net gains on securities table above. There were no such charges in 2005 and 2004. At December 31, 2006, 2005, and 2004 there were no other investments held in the portfolio that were determined to be other-than-temporarily impaired. Realized gains and losses are determined on a specific identification method and are included in income.
Our evaluation of market declines for other-than-temporary impairment is based on management’s case-by-case evaluation of the underlying reasons for the decline in fair value. We consider a wide range of factors about the security issuer and use our best judgment in evaluating the cause of the decline in the estimated fair value of the security and in assessing the prospects for near-term recovery. Inherent in management’s evaluation of the security are assumptions and estimates about the operations of the issuer and its future earnings potential. Considerations used by us in the impairment evaluation process include, but are not limited to: (i) the length of time and the extent to which the market value has been below cost or amortized cost; (ii) the potential for impairments of securities when the issuer is experiencing significant financial difficulties; (iii) the potential for impairments in an entire industry sector or sub-sector; (iv) the potential for impairments in certain economically depressed geographic locations; (v) the potential for impairments of securities where the issuer, series of issuers or industry has suffered a catastrophic type of loss or has exhausted natural resources; (vi) our ability and intent to hold the security for a period of time sufficient to allow for the full recovery of its value to an amount equal to or greater than cost or amortized cost; (vii) unfavorable changes in forecasted cash flows on asset-backed securities; and (viii) other subjective factors, including concentrations and information obtained from regulators and rating agencies.
The following table show the gross unrealized losses and fair value of our investments with unrealized losses that are not deemed to be other-than-temporarily impaired (in thousands), aggregated by investment category and length of time that individuals securities had been in a continuous unrealized loss position at December 31, 2005.
Securities on deposit with various state insurance commissioners amounted to $10.1 million at December 31, 2006 and $12.8 million at December 31, 2005. We also had $56.5 million on deposit at December 31, 2006 and $53.5 million at December 31, 2005, for the benefit of reinsurers.
We have a 46.0% equity interest in C-BASS and an interest in Sherman, consisting of 40.96% of the Class A Common Units (Class A Common Units represent 94% of the total equity in Sherman) and 50% of the Preferred Units. During 2005, we recorded a complete write-down of our investment in SBF Participacoes Ltda., recording a $3.2 million loss. We account for our investment in affiliates in accordance with the equity method of accounting, because we do no control these affiliates, in part because other shareholders have substantial participating rights.
The following table shows the components that make up the investment in affiliates balance:
(1) The increase in Sherman’s provision for loan and receivable portfolio losses relates to the acquisition of CreditOne in March, 2005 which provides Sherman with the ability to originate subprime credit card receivables.
At December 31, 2006 and 2005, the breakdown of the $12.5 million and $25.4 million reinsurance recoverable was as follows (in thousands):
We accounted for this reinsurance coverage under guidance provided in EITF 93-6, “Accounting for Multiple-Year Retrospectively Rated Contracts by Ceding and Assuming Enterprises.” Under EITF 93-6, we recognize an asset for amounts due from the reinsurer based on experience to date under the contract.
Radian Guaranty has also entered into captive reinsurance arrangements with certain customers. The arrangements are typically structured on an excess layer of loss basis with insured loans grouped by loan origination year. Radian Guaranty retains the first layer of risk on a particular book of business, the captive reinsurer assumes the next layer, and Radian Guaranty assumes all losses above that point. The captive reinsurers are typically required to maintain minimum capitalization equal to 10% of the risk assumed. Risk ceded under captive reinsurance arrangements at December 31, 2006, and 2005, was $2.4 billion and $2.0 billion, respectively. For the years ended December 31, 2006, 2005 and 2004, Radian Guaranty had ceded premiums written of $116.2 million, $91.8 million and $88.4 million, respectively, and ceded premiums earned of $116.6 million, $90.7 million and $86.6 million, respectively, under these various captive reinsurance arrangements. Ceded losses in 2006, 2005 and 2004 were not significant. Included in the 2006 and 2005 premiums written and earned is a second-lien quota share transaction. Under this agreement, the captive reinsurance company assumes a pro rata share of all losses in return for a pro rata share of the premiums collected. Our total net exposure under this second-lien structured transaction is approximately $70 million, or half of the $140 million in total gross exposure relating to this transaction.
We protect against losses in excess of our expectations on some of the risk associated with non-prime and unproven products by reinsuring it through Smart Home transactions. In 2004, we developed “Smart Home” as a way to effectively transfer risk from our portfolio to investors in the capital markets. Ceded premiums written in 2006, 2005 and 2004 include $12.0 million, $3.5 million and $1.0 million, respectively, related to the Smart Home transactions. Ceded premiums earned were $12.3 million, $3.0 million and $0.7 million in 2006, 2005 and 2004, respectively. There were no ceded losses in 2006, 2005 or 2004 as a result of the Smart Home transactions.
Since August 2004, we have completed four Smart Home arrangements. Details of these transactions (aggregated) as of the initial closing of each transaction and as of December 31, 2006 are as follows:
Smart Home protects us against catastrophic loss as we continue to take on higher risk, concentrated positions and unproven products. As a result, we consider Smart Home arrangements to be important to our ability to effectively manage our risk profile, especially in the non-prime market. Approximately 10% and 8% of our primary mortgage risk in force was included in Smart Home arrangements at December 31, 2006 and 2005, respectively. In these transactions, we reinsure the middle layer risk positions, while retaining a significant portion of the total risk comprising the first-loss and most remote risk positions.
The default and claim cycle in our mortgage insurance business begins with our receipt of a default notice from the insured lender. A “default” is defined under our master policy as a borrower’s failure to make a payment equal to or greater than one monthly regular payment under a loan. Generally, our master policy of insurance requires the insured to notify us of a default within 15 days of (1) the loan’s having been in default for three months or (2) the occurrence of an early default in which the borrower fails to make any one of the initial twelve monthly payments under a loan so that an amount equal to two monthly payments has not been paid. For reporting and internal tracking purposes, we do not consider a loan to be in default until the loan has been in default for 60 days.
As a result of changes in estimates of insured events in prior years, the provision for losses and LAE in our mortgage insurance business decreased by $117.2 million in 2006, by $86.8 million in 2005 and increased by $14.0 million in 2004, in most part due to revised estimates of losses on the non-prime business.
The following tables present information relating to our financial guaranty reserves, and the liability for unpaid claims and related expenses (in thousands):
In February 2003, we issued $250 million of unsecured senior notes. These notes bear interest at the rate of 5.625% per annum, payable semi-annually on February 15 and August 15 beginning August 15, 2003. These notes mature in February 2013. We have the option to redeem some or all of the notes at any time with not less than 30 days’ notice at a redemption price equal to the greater of the principal amount of the notes or the sum of the present values of the remaining scheduled payments of principal and interest on the notes to be redeemed. We used a portion of the proceeds from the offering to repay the $75.0 million in principal outstanding on the 6.75% debentures due March 1, 2003 issued by EFSG. The remainder was used for general corporate purposes. In April 2004, we entered into interest-rate swap contracts that effectively converted the interest rate on this fixed-rate debt to a variable rate based on a spread over LIBOR for the remaining term of the debt. See Note .
In January 2002, we issued $220 million of 2.25% senior convertible debentures due 2022. Approximately $125 million of the proceeds from the offering were used to increase capital at Radian Asset Assurance. The remainder was used to redeem our preferred stock, to buy back our common stock and for general corporate purposes. On January 3, 2005, $663,000 in principal amount of the debentures was redeemed by holders, leaving $219.3 million in principal amount outstanding. We redeemed all $219.3 million in principal amount outstanding on August 1, 2005.
In May 2001, we issued $250 million of 7.75% debentures due June 1, 2011. Interest on the debentures is payable semi-annually on June 1 and December 1. We have the option to redeem some or all of the debentures at any time with not less than 30 days’ notice.
The components of our consolidated provision for income taxes are as follows (in thousands):
The reconciliation of taxes computed at the statutory tax rate of 35% for 2006, 2005 and 2004, to the provision for income taxes is as follows (in thousands):
RAAL’s ability to pay dividends is restricted by legal provisions in the United Kingdom whereby it may only distribute by way of dividend its accumulated realized profits (not previously distributed) less accumulated realized losses, and such dividends may not be paid out of capital. In accordance with these restrictions, $8.1 million would be available to be paid as dividends in 2007.
New York insurance law requires financial guaranty insurers to maintain minimum policyholders’ surplus of $65 million. When added to the minimum policyholders’ surplus of $1.4 million separately required for the other lines of insurance that it is licensed to write, our financial guaranty insurance subsidiaries are required to have an aggregate minimum policyholders’ surplus of $66.4 million. Radian Asset Assurance statutory net income and statutory policyholders’ surplus as of and for the years ended December 31 was as follows:
New York insurance law establishes single risk limits applicable to all obligations issued by a single entity and backed by a single revenue source. Under the limit applicable to municipal bonds, the insured average annual
The differences between the statutory net income and surplus and the consolidated net income and equity presented on a GAAP basis represent differences between GAAP and Statutory Accounting (“STAT”) for the following reasons:
(g) Under STAT, SFAS No. 123R is not adopted. SFAS No. 123R has been adopted for our GAAP financial statements.
We have an equity compensation plan, the Radian Group Inc. Equity Compensation Plan (the “Plan”), under which we may provide grants of incentive stock options, non-qualified stock options, restricted stock, stock appreciation rights (referred to as “SARs”), performance shares and phantom stock. To date, all awards granted under the Plan have been in the form of non-qualified stock options, restricted stock and phantom stock. The Plan provides for the grant of all options (other than incentive stock options to holders of 10% of our voting shares) at an option price per share equal to 100% of the market price of our common stock on the date of grant. The Plan authorizes the issuance of up to 9,400,000 shares of our common stock, of which there are approximately 2,300,000 shares remaining available for grants under the Plan as of December 31, 2006. Officers and other employees (of Radian or its affiliates) are eligible to participate in the Plan. Non-employee directors are also eligible to participate in the Plan, but are not permitted to receive grants of incentive stock options.
On May 9, 2006, our stockholders approved an amendment to the Plan to extend the expiration date of the Plan from December 31, 2006 to December 31, 2008.
The following table illustrates the effect on net income and earnings per share if we had applied the fair value recognition provisions of SFAS No. 123R to stock-based employee compensation prior to 2006.
(2) The risk-free interest rate is based on the U.S. treasury yield curve in effect at the time of grant.
Information with regard to stock options for periods indicated as follows:
The weighted average fair values of the stock options granted during the years ended December 31, 2006, 2005 and 2004 were $16.61, $17.43 and $18.19, respectively.
The following table summarizes information concerning outstanding and exercisable options at December 31, 2006:
The Compensation Committee may issue shares of our common stock under a grant of restricted stock under the Plan. The shares underlying a grant are issued in consideration for services rendered having a value, as determined by our board of directors, at least equal to the par value of the common stock. If a grantee’s relationship with us terminates while the shares are subject to restrictions imposed by the Compensation Committee, the restricted stock grant will terminate with respect to all shares that are subject to restrictions, and such shares must be immediately returned to us. While shares are subject to restrictions, a grantee may not sell, assign, transfer, pledge or otherwise dispose of the shares of our common stock, except to a successor grantee in the event of the grantee’s death. All restrictions imposed under a restricted stock grant lapse after the applicable restriction period or as the Compensation Committee may determine.
We granted, under the Plan, 50,000 shares of restricted stock during 2005 and 41,300 shares of restricted stock during 2006, in the case of each grant, vesting over three to four years.
The Compensation Committee may grant phantom stock awards under the Plan, which entitle grantees to receive shares of our common stock on a vesting date (referred to in the Plan as the conversion date) established by the Compensation Committee. The phantom stock may be subject to further vesting restrictions as the Compensation Committee determines. Unless otherwise provided in a grant letter, if a grantee’s relationship with us terminates during any period in which vesting restrictions apply, the phantom stock grant terminates as to all shares covered by the grant as to which vesting restrictions have not lapsed and such shares will be forfeited. Our practice to date has been to grant phantom stock to directors with a vesting date upon the termination of the director’s relationship with us. In addition, we are also using phantom stock to fund awards issued under our Performance Share Plan adopted in 2005. See “Performance Shares” below. Each share of phantom stock is granted at full value with no exercise price. All phantom stock will be paid in whole shares of our common stock, with fractional shares paid in cash. At December 31, 2006, there are approximately 450 dividend-equivalent phantom stock shares accrued that are not included in the total number of outstanding shares. The amount recorded as stock-based compensation expense related to phantom stock for the years ended December 31, 2006, 2005 and 2004 was $1.2 million, $3.1 million and $2.1 million, respectively.
As of December 31, 2006, unrecognized compensation expense related to the unvested portion of all of our stock-based awards was approximately $31.0 million. This cost is expected to be recognized over a weighted average period of approximately 2.6 years.
The Pension Plan freeze was aimed at preparing for the future termination of the Pension Plan, and reflects a broader reliance on the Radian Group Inc. Savings Incentive Plan (the “Savings Plan”) as the primary retirement vehicle for our employees. On February 5, 2007, Radian’s board of directors approved the termination of the Pension Plan, effective June 1, 2007, and also approved the following additional amendments to the Pension Plan:
acceleration of vesting in accrued benefits under the Pension Plan for all participants in the plan who are employees of Radian or its affiliates at any time between December 31, 2006 and the date of termination of the plan; and
enhancement of the distribution options under the Pension Plan to offer an immediate annuity option and an immediate lump sum option in connection with the termination of the plan.
We expect to record an immaterial settlement loss upon termination of the Pension Plan, which remains subject to regulatory approval.
provide for the immediate vesting of Radian’s matching contributions (including existing unvested matching contributions attributable to prior periods) and the elimination of all restrictions on a participant’s ability to diversify his/her position in matching contributions;
for each plan year, Radian will contribute to each participant’s account (regardless of whether the participant contributed any amount to the Savings Plan during the plan year) an amount equal to 6% of the participant’s “eligible compensation,” defined generally as base salary (including commission income, if applicable) in excess of applicable IRS limits, plus bonus;
for each participant eligible to receive a transition credit under the Savings Plan, Radian will provide an additional transition credit under the BRP based on each participant’s eligible compensation under the BRP; and
Participants will be immediately vested in all amounts contributed by Radian (along with any income and gains attributable to the contributions) as part of the 6% match and transition credits. Discretionary contributions, if any, generally will vest upon completion of three years of service with Radian, and amounts carried over from the SERP generally will vest upon 10 years of service with Radian, in each case, with credit for those years of service completed prior to receipt of such contributions.
A participant’s interest in the BRP will be an unfunded bookkeeping account and the participant may elect to invest in any of several hypothetical investment options. Payouts under the plan begin following the participant’s separation from service with Radian. At its discretion, Radian may establish and fund a so-called “rabbi trust” in order to help satisfy its payment obligations under the plan.
In addition, the board authorized Radian to discontinue the split-dollar life insurance policies currently used to finance the SERP and to replace them with market-competitive, group term life insurance policies and universal life insurance polices.
The assumed discount rate for our Pension Plan and BRP is determined by examining the yield-rate for high-quality corporate bonds as of December 31 of the previous year. By matching the yield curve on investment-grade securities with the expected benefit stream of the Pension Plan, we have found the Moody’s AA bond yield on December 31 of the previous year to be a sufficient benchmark in setting the assumed discount rate.
The implementation of SFAS No. 158 did have a significant impact on our financial statements due to the curtailment of the Pension Plan and the SERP. Under SFAS No. 158 we are required to recognize net periodic cost in accumulated other comprehensive income; however, the curtailment impact offset most of our other comprehensive income. The following table shows the effect of SFAS No. 158 on our consolidated balance sheets as of the periods specified (in thousands):
The accumulated benefit obligation at December 31, 2006 and 2005 for the Radian Pension Plan/SERP was $33.2 million and $25.5 million, respectively.
The following benefit payments, which reflect expected future service, as appropriate, are expected to be paid according to the following schedule (includes Radian Plan and EFSG Plan):
We expect to contribute $3.0 million to our pension plan and $15 thousand to Radian’s other postretirement benefit plans in 2007. We expect to contribute $37 thousand to EFSG’s other postretirement benefit plan in 2007.
Securities regulations now require enhanced disclosure requirements on issuers of asset-backed (including mortgage-backed) securities, including most customers in our structured business. To allow these customers to comply with regulations, we may be required in any given transaction, depending on the amount of credit enhancement that we are providing, to provide audited financial statements for the insurance subsidiary participating in the transaction. We are in the process of producing financial statements (and having them audited) for each of our primary insurance subsidiaries. We anticipate that these financial statements will be available during 2007. Until they are available, we will provide full and unconditional holding-company-level guaranties for our insurance subsidiaries’ obligations in such transactions, principally on our mortgage insurance business for which financial statements prepared in accordance with GAAP have never previously been available. To date, we have guarantied two structured transactions for Radian Guaranty involving approximately $537 million of remaining credit exposure.
We guarantee the payment of up to $25.0 million of a revolving credit facility issued to Sherman which expires in December 2007. Our guaranty facilitates the issuance and renewal of the facility, which Sherman may use for general corporate purposes. There were no amounts outstanding under this facility at December 31, 2006.
Our financial guaranty insurance business enters into reinsurance agreements with our monoline financial guaranty primary insurance customers. These reinsurance agreements generally are subject to termination (i) upon written notice (ranging from 90 to 120 days) before the specified deadline for renewal, (ii) at the option of the ceding company if we fail to maintain certain financial, regulatory and rating agency criteria that are equivalent to or more stringent than those we are otherwise required to maintain for our own compliance with New York insurance law and to maintain a specified financial strength rating for the particular insurance
We lease office space for use in our operations. Net rental expense in connection with these leases totaled $9,888,000, $8,673,000 and $8,124,000 in 2006, 2005 and 2004, respectively. The commitment for non-cancelable operating leases in future years is as follows (in thousands):
The commitment for non-cancelable operating leases in future years has not been reduced by future minimum sublease rental payments aggregating approximately $15.3 million. A portion of these payments relates to subleases to our affiliates.
The fair value of a financial instrument is the current amount that would be exchanged between two willing parties, other than in a forced liquidation. Fair value is best determined from market pricing when available; otherwise, fair value is based on estimates using present value or other valuation methodologies. Significant differences may exist with respect to the available market information and assumptions used. Considerable judgment is required to interpret available market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amount we could realize in a current market exchange. The use of different market assumptions or estimation methodologies may have an effect on the estimated fair value amounts.
Fixed-Maturity and Equity Securities-The fair values of fixed-maturity securities and equity securities are based on quoted market prices or dealer quotes.
Other Invested Assets-The fair value of other invested assets (residential mortgage-backed securities, limited partnership investments and LLC investments) is based on the present value of the estimated net future cash flows, including annual distributions. The fair value of equity-method investments and cost-method investments is based on carrying value as it approximates fair value.
Fair Value of Derivative Mortgage Insurance and Financial Guaranty Contracts-We account for derivatives under SFAS No. 133, as amended and interpreted. The fair value of direct derivative contracts are derived from internally generated models. The fair value of assumed derivative contracts is provided by the primary insurance companies. With respect to our direct derivative contracts, estimated fair value amounts are determined by us using market information to the extent available, and appropriate valuation methodologies. For CDOs, credit spreads on individual names in our collateral pool are used to determine an equivalent risk tranche on an industry standard credit default swap index. We then estimate the price of our equivalent risk tranche based on observable market prices of standard risk tranches on the industry standard credit default swap index. When credit spreads on individual names are not available, the average credit spread on the credit rating of the name is used. For certain structured transactions, dealer quotes on similar structured transactions are used. For certain structured transactions where market data is not available, no fair value adjustment is recorded. Significant
differences may exist with respect to the available market information and assumptions used to determine gains and losses on derivative financial guaranty contracts. Considerable judgment is required to interpret market data to develop the estimates of fair value. Accordingly, the estimates are not necessarily indicative of amounts we could realize in a current market exchange due to the lack of a liquid market. The use of different market assumptions and/or estimation methodologies may have a significant effect on the estimated fair value amounts. The fair value of derivative financial guaranty contracts is included in other assets on our consolidated balance sheets. Settlements under derivative financial guaranty contracts are charged to the change in fair value of derivative instruments on our consolidated balance sheets.
The carrying value and fair value of selected assets and liabilities on our consolidated balance sheets is as follows:
In February 2006, the FASB issued Statement No. 155, “Accounting for Certain Hybrid Financial Instruments” (“SFAS No. 155”), an amendment of SFAS No. 133 and Statement No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (“SFAS No. 140”) SFAS No. 155 (i) permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation, (ii) clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS No. 133, (iii) establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation, (iv) clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives, and (v) amends SFAS No. 140 to eliminate the exemption from applying the requirements of SFAS No. 133 on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. We are required to adjust retained earnings for fair value amounts related to financial instruments now recorded at fair value. The implementation of SFAS No. 155, effective January 1, 2007, will not have a material impact on our Consolidated Financial Statements.
Since September 2002, our board of directors has authorized five separate repurchase programs for the repurchase, in the aggregate, of up to 21.5 million shares of our common stock on the open market. At March 31, 2004, we had repurchased all 2.5 million shares under the initial program (announced September 24, 2002) at a cost of approximately $87.0 million. At March 31, 2005, we had repurchased an additional 5.0 million shares under the second program (announced May 11, 2004 and extended September 8, 2004) at a cost of approximately
$235.9 million, and at September 30, 2005, we had repurchased all 5.0 million shares under the third program (announced February 15, 2005) at a cost of approximately $240.0 million. At December 31, 2005, we had repurchased all of the 3.0 million shares authorized under the fourth repurchase program (announced October 9, 2005) at a cost of approximately $160.0 million. All share repurchases made to date were funded from available working capital and were made from time to time depending on market conditions, share price and other factors.
On February 8, 2006, we announced that our board of directors had authorized a fifth repurchase program of the repurchase of up to 4.0 million shares of our common stock on the open market. On November 9, 2006, we announced that our board of directors had authorized the purchase of an additional 2.0 million shares as part of an expansion of the existing repurchase program. At December 31, 2006, we had repurchased all of the initial 4.0 million shares at a cost of approximately $236.8 million and we had repurchased 0.5 million of the additional 2.0 million shares at a cost of approximately $26.8 million. Stock purchases under this program are funded from available working capital and are made from time to time, depending on market conditions, stock price and other factors. The board did not set an expiration date for this program.
Completion of the merger, which is expected to occur in the fourth quarter of 2007, is subject to various conditions, including (1) receipt of approvals of the holders of Radian and MGIC common stock, (2) receipt of regulatory approvals, (3) the absence of any law or order prohibiting the closing, and (4) effectiveness of the Form S-4 registration statement relating to the MGIC common stock to be issued in the merger and listing of the MGIC common stock to be issued in the merger on the New York Stock Exchange.
On February 16, 2007, C-BASS entered into an agreement to acquire Fieldstone Investment Corporation, a mortgage banking company that originates, sells, and invests primarily in non-conforming single-family residential mortgage loans with a current portfolio of over $5.7 billion, for approximately $259 million in cash. The transaction is expected to occur in the second quarter of 2007 and is subject to regulatory and other approvals.