At our corporate headquarters in Philadelphia, Pennsylvania, we lease approximately 151,197 square feet of office space and 1,740 square feet of data storage space under a lease that expires in August 2017. In addition, we also lease the following:
Approximately 500 square feet of office space for our mortgage insurance operations in Hong Kong. The lease for this space expires on January 31, 2014; and
Calculated using amounts determined under GAAP, using provision for losses to calculate the loss ratio and policy acquisition costs and other operating expenses to calculate the expense ratio as a percentage of net premiums earned. The 2008 expense ratio for our mortgage insurance segment includes the write-off of $50.8 million of deferred policy acquisition costs as a result of the establishment of a first-lien premium deficiency reserve. The financial guaranty expense ratio increased due to our discontinuation of new business writings in 2008 and the recaptures of reinsurance business by certain of our primary reinsurance customers noted in (4) below.
Consists of international insurance risk, second-lien insurance risk and other structured mortgage-related insurance risk.
The following analysis of our financial condition and results of operations should be read in conjunction with our Consolidated Financial Statements and Notes thereto included in Item 8 and the Risk Factors detailed in Item 1A of Part I of this Annual Report on Form 10-K.
We are a credit enhancement company with a primary strategic focus on domestic, first-lien residential mortgage insurance (“first-lien”). We currently have two operating business segments-mortgage insurance and financial guaranty. Our mortgage insurance segment provides credit-related insurance coverage, principally through private mortgage insurance, and risk management services to mortgage lending institutions. See “Business-Mortgage Insurance.” We conduct our business primarily through Radian Guaranty Inc. (“Radian Guaranty”), our principal mortgage insurance subsidiary. Our financial guaranty segment previously offered direct insurance and reinsurance on credit-based risks, and also offered credit protection on various asset classes through financial guarantees and credit default swaps (“CDS”). While we discontinued writing new financial guaranty business in 2008, we continue to provide financial guaranty insurance on our existing portfolio of public finance and structured finance credits. In addition, our principal financial guaranty subsidiary, Radian Asset Assurance Inc. (“Radian Asset Assurance”), is a wholly-owned subsidiary of Radian Guaranty, which allows our financial guaranty business to serve as an important source of capital support for our mortgage insurance business. See “Business-Financial Guaranty.” Prior to January 1, 2011, we also had a third segment-financial services. See “Business-Financial Services.”
As a seller of credit protection, our results are subject to macroeconomic conditions and specific events that impact the origination environment and the credit performance of our underlying insured assets. The most recent downturn in the housing and related credit markets began in 2007 and had a significant negative impact on the operating environment and results of operations for each of our businesses. This period was characterized by a decrease in mortgage originations, a broad decline in home prices, mortgage servicing and foreclosure delays, and ongoing deterioration in the credit performance of mortgage and other assets originated prior to 2009 together with macroeconomic factors such as limited economic growth and a lack of meaningful liquidity in some sectors of the capital markets. Our results of operations continue to be negatively impacted by the mortgage insurance we wrote during the poor underwriting years of 2005 through 2008 (we refer to this portfolio as our “legacy portfolio”).
In 2012, the operating environment for our businesses improved. Although the U.S. economy and housing market remain weak compared to historical standards, home prices appear to be appreciating on a broad basis throughout the United States (“U.S”), foreclosure activity has decreased and the credit quality of overall mortgage market originations continues to be significantly better than the credit quality of our legacy portfolio. In addition, there are signs of a more permanent recovery in the U.S. economy, including importantly, a reduction in unemployment. As a consequence of these and other factors, we have experienced improvement in our results of operations, with a 22% decline in new mortgage insurance defaults in 2012 and further stabilization of credit performance in our financial guaranty portfolio. We expect these trends to continue in 2013.
Currently, our business strategy primarily is focused on: (1) growing our mortgage insurance business by writing high-quality mortgage insurance in the U.S.; (2) continuing to manage losses in our legacy mortgage insurance and financial guaranty portfolios; (3) continuing to reduce our financial guaranty exposure; and (4) pursuing opportunities for increasing Radian Group Inc.’s (“Radian Group”) available liquidity and for enhancing Radian Guaranty’s capital position. Although uncertainty remains with respect to the ultimate losses we will experience in our legacy portfolio, as we continue to write new, higher quality mortgage insurance, our legacy portfolio progressively becomes a lesser percentage of our total portfolio. We anticipate that by the second quarter of 2013, our legacy portfolio will represent less than 50% of our total mortgage insurance portfolio. In light of this important compositional change in our mortgage insurance portfolio and assuming that improving macroeconomic trends continue, we believe we are positioned to return to operating profitability. For more information, see “Results of Operations-Mortgage Insurance” and “Results of Operations-Financial Guaranty.”
NIW increases our insurance in force and premiums earned. Cancellations of our insurance policies and other reductions of insurance in force, such as rescissions of coverage and claims paid, reduce insurance in force, and generally have a negative effect on premiums earned. Cancellations of single premium policies accelerate the earning of premiums as the remaining unearned premium is immediately recognized upon cancellation. The measure for assessing the impact of policy cancellations on insurance in force is our persistency rate, defined as the percentage of insurance in force that remains on our books after any 12-month period. Because our insurance premiums are earned over time, higher persistency rates on monthly insurance policies enable us to earn more premium and generally result in increased profitability. For single premium policies, however, assuming all other factors remain constant, annual profitability increases when persistency rates are lower. Rescissions, which are discussed in further detail below, result in a full refund of the life-to-date premiums received, and therefore, premiums earned are affected by any changes in our accrual for estimated rescission refunds. Additionally, premiums ceded to third party reinsurance counterparties decrease premiums earned.
The product mix of our RIF (loans with higher risk characteristics generally result in higher delinquencies and claims);
Changes in housing values (declines in housing values negatively impact our ability to mitigate our losses and also may negatively affect a borrower’s willingness to continue to make mortgage payments when the home value is less than the mortgage balance);
Our ability to mitigate potential claims through rescissions, denials and the curtailment of claims submitted to us. Generally, we rescind insurance coverage when we conclude through our review of the underwriting of a loan that the loan was not originated in accordance with the underwriting guidelines specified at origination. Generally, we deny claims when the documentation we receive is not sufficient to perfect the claim in accordance with our master insurance policy. In addition, we curtail claim payments when we identify servicer negligence, or we may make other adjustments to claims as permitted by our master insurance policy. These actions all result in a reduction in our incurred losses. Conversely, if rescissions are successfully challenged or denied claims are re-submitted as perfected claims in each case at rates that are higher than expected, our incurred losses will increase.
Premiums. We earn premiums on our financial guaranty insurance policies and on other forms of credit protection we provide. In our financial guaranty business, premiums are earned in proportion to the level of amortization of insured principal over the contract period or over the period that coverage is provided. Since we have discontinued writing new financial guaranty insurance, our premiums earned have been reduced commensurate with the decrease in our net par outstanding. Premiums on our structured finance contracts are generally paid on a periodic basis (monthly or quarterly installment premiums) and are earned on a monthly basis. Premiums on our public finance contracts were generally paid as single up-front premiums and are generally earned over the life of the contract. In addition, we recognize the remaining unearned premium revenue when bonds issued are redeemed or otherwise retired (“refundings”) that results in the extinguishment of the financial guaranty policies insuring such bonds. Furthermore, our earned premiums are reduced by premiums ceded through reinsurance agreements. See Note 2 of Notes to Consolidated Financial Statements for further information regarding the revenue recognition of premiums.
Because we generally do not settle our insurance contracts before maturity (other than in a negotiated termination), in the absence of actual credit losses on which we are obligated to make claim payments, unrealized losses related to changes in fair value are expected to reverse before or at the maturity of these obligations. In addition, if we agree to settle obligations prior to maturity at amounts that are greater or less than their fair values at the time of settlement, it could result in the realization of additional gains or losses.
Losses/Credit Performance. Our financial guaranty incurred losses are driven primarily by economic conditions that affect the ability of the issuers of our insured obligations to meet such financial obligations and by adverse developments in the assumptions used to determine our losses, including assumptions with respect to the likelihood, magnitude and timing of anticipated losses, and our estimate of the rate at which we expect defaults will ultimately result in paid claims. Stronger economic conditions increase the likelihood that obligors will have the ability to pay interest and principal on the bonds we insure. Weaker economic conditions often place strains on the revenue flows available to pay interest and principal. Other factors influencing defaults and incurred losses include:
The potential impact of federal, state and local budgetary constraints affecting funding and payments (including Medicare and Medicaid payments) to healthcare, long term care, educational and other governmental and non-governmental entities whose obligations we insure;
The movement of interest rates (should interest rates rise, the interest component of our aggregate exposure will increase on the variable rate obligations we insure, and as a result, will increase the strain on the obligors to make payments on these obligations; consequently, the likelihood of default and amount of any claim payments would increase).
Radian Group serves as the holding company for our insurance subsidiaries and does not have any significant operations of its own. Because of this, our consolidated results reflect, and are fully explained by, the financial results and performance of our two operating business segments-mortgage insurance and financial guaranty. Our net loss for 2012 continues to reflect the impact of an elevated mortgage insurance provision for losses resulting from the impact of the slow economic recovery on our legacy mortgage insurance portfolio. Some improvement in those losses, however, is evident given the signs of recovery in the economy and housing market in 2012 and the change in the composition of our total mortgage insurance portfolio, with insurance written in 2009 through 2012 increasingly representing a larger portion of the total portfolio. Additionally, significant unrealized net losses on derivatives were recognized in 2012, as discussed further under “Results of Operations-Financial Guaranty.”
Net Loss. We experienced improved operating results in our mortgage insurance segment in 2012 compared to 2011, primarily reflecting a significant decrease in the provision for losses and an income tax benefit compared to an income tax provision in 2011. Based on our projections, which are subject to significant risks and uncertainties, we expect continued improvement in the operating results of our mortgage insurance segment in 2013 and to achieve marginal operating profitability in our mortgage insurance segment in 2013.
The improvement in the results for 2011 compared to 2010 primarily reflect a significant decrease in the provision for losses and the establishment of a valuation allowance for substantially all of our deferred tax assets in 2010, as well as other factors discussed below.
As a result of changes made since 2008 that aimed to improve the long-term risk profile and profitability of our business, the credit profile of our mortgage insurance portfolio has improved, which has improved our profitability by positively impacting losses incurred on the newer mortgage originations. 2008 was a transition year during which we phased in many of the guideline changes. Since 2009, almost all of our new business production has been prime business. In addition, Fair Isaac Corporation (“FICO”) scores for the borrowers of these insured mortgages have increased, while the loan-to-value ratio (“LTV”) on these mortgages has decreased, meaning that borrowers generally are making larger down payments in connection with the more recent mortgages that we are insuring.
As shown in the chart below, as of December 31, 2012, our 2009 through 2012 mortgage insurance portfolios represented almost 45% of our total mortgage insurance portfolio. These origination years possess significantly improved credit characteristics compared to our pre-2009 portfolios. The growth of the post-2008 portion of our portfolio, together with continued improvement in the portfolio as a result of HARP refinancings, has resulted in significant improvement in the credit quality of our overall mortgage insurance portfolio. As a result, our expected losses on our post-2008 mortgage insurance portfolios is significantly lower than our pre-2009 portfolios, and therefore, should better position the mortgage insurance segment.
The following tables provide selected information as of and for the periods indicated related to mortgage insurance NIW, RIF and insurance in force:
Loans with potential negative amortization will have increased principal balances, only if interest rates increase, as compared to loans with scheduled negative amortization, for which an increase in loan balance will occur even if interest rates do not change.
The following table provides additional information related to mortgage insurance premiums written and earned for the years indicated:
The agreed upon terms also provide that, effective as of December 31, 2015, Radian Guaranty will have the ability, at its option (the “Commutation Option”), to commute one-half of the reinsurance ceded with respect to conventional GSE loans, which would result in Radian Guaranty reassuming the related RIF in exchange for a payment of a predefined commutation amount from the reinsurer. Pursuant to the agreed upon terms:
Radian Guaranty will cede to the reinsurer 20% of all premiums and losses incurred with respect to conventional GSE loans and will initially receive a 35% ceding commission; provided that if we do not exercise our Commutation Option, the ceding commission will be reduced to 30% for the portion of the ceded RIF that was subject to the Commutation Option; and
Under the Second Quota Share Reinsurance Transaction, for the year ended December 31, 2012, ceded premiums written were $9.6 million and ceded premiums earned were $0.5 million. Ceding commissions earned under the Second Quota Share Reinsurance Transaction for the year ended December 31, 2012 were $3.4 million.
The following table summarizes our ceded premiums and RIF ceded through the Reinsurance Transactions and other reinsurance arrangements (excluding Smart Home transactions). Unless otherwise noted, direct RIF includes the amounts ceded through reinsurance.
Insurance in force on captives as a percentage of total insurance in force.
Represents the provision for losses attributable to loans that were in default as of the beginning of each period indicated, including: (a) the change in reserves for loans that were in default status (including pending claims) as of both the beginning and end of each period indicated; (b) the net impact to provision for losses from loans that were in default as of the beginning of each period indicated; and (c) the impact to our incurred but not recorded (“IBNR”) reserve during the period related to changes in actual and estimated reinstatements of previously rescinded policies and denied claims.
Our first-lien primary default rate at December 31, 2012 was 12.1%, compared to 15.2% at December 31, 2011. Our primary default inventory comprised 93,169 loans at December 31, 2012, compared to 110,861 loans at December 31, 2011, representing a 16.0% decrease. Our primary default inventory declined by an additional 2% in January 2013 from December 31, 2012. The reduction in our defaulted inventory is the result of the total number of defaulted loans: (1) that have cured; (2) for which claim payments have been made; or (3) that have resulted in net insurance rescissions and claim denials, collectively exceeding the total number of new defaults on insured loans. Despite this positive trend, our overall primary default rates continue to remain elevated compared to historical levels due to continued high unemployment and relative weakness in the U.S. housing and mortgage credit markets. Overall, the underlying trend of high defaults continues to be driven primarily by the poor performance of our 2005 through 2008 books of business. In addition, a slowdown in mortgage foreclosures, driven by servicing delays and the effect of prolonged modification programs for delinquent loans, has contributed to the sustained high level of our default inventory. This slowdown has resulted in more defaults remaining unresolved for a longer period of time than has historically been the case. We believe that a return to sustained profitability in our mortgage insurance business is dependent upon both a further reduction in the number of new defaults and an increase in the number of cures, particularly with respect to loans that have been in default for more than twelve months. We had a 22% total decrease in new primary defaults in 2012 compared to 2011, which compares to an 18% decrease in new primary defaults in 2011 and a 30% decrease in 2010. Although significant uncertainty remains, for 2013, we currently expect a further decline in incurred losses driven primarily by an expected decrease in new defaults of approximately 24% as compared to 2012.
The table below shows the details related to the number of rescinded policies and denied claims for the periods indicated. Recent trends in insurance rescissions and claim denial activity reflect both an overall increase in the number of policies rescinded and claims denied, as well as an increase in the number of rescissions and denials that have been reinstated (previously rescinded) or perfected (previously denied). This increase in reinstatements is partly due to lenders challenging a greater number of rescissions and denials as well as the overall effectiveness of these challenges (i.e., producing new or additional information that supports a reinstatement of coverage or a claim payment).
Our reported rescission and denial activity in any given period is subject to challenge by our lender customers. Recent trends in insurance rescission and claim denial activity reflect a shift towards more claim denials, resulting primarily from the failure of our lender customers to provide the documentation required to perfect a claim submission. In many cases, lenders have been asked to produce the additional required information for a significant portion of previously denied claims. We expect that a portion of previously rescinded policies will be reinstated and a large portion of previously denied claims will be resubmitted with the required documentation and ultimately paid; therefore, we have considered this expectation in developing our IBNR reserve estimate. This IBNR estimate was $323.0 million, $170.6 million and $39.5 million at December 31, 2012, 2011 and 2010, respectively. For 2012, our IBNR estimate of $323.0 million includes our estimate of future reinstatements of previously rescinded policies and denied claims of $87.7 million and $215.3 million, respectively. These reserves relate to $0.6 billion of claims that were denied within the preceding 12 months and $1.0 billion related to rescinded policies within the preceding 24 months.
The following table shows information regarding our reserve for losses and PDR as of the dates indicated:
Our mortgage insurance total loss reserve as a percentage of our mortgage insurance total RIF was 8.5% at December 31, 2012, compared to 9.8% at December 31, 2011 and 10.2% at December 31, 2010.
The following table shows information regarding our average loss reserves per default, including IBNR and LAE reserves:
Total mortgage insurance claims paid in 2012 were $1.0 billion. Foreclosure backlogs, servicer delays and loan modification programs have reduced the number of defaults going to claim. In addition, our extensive review of a substantial portion of our claims has slowed our internal claims payment process and has resulted in a significant increase in the number of claim denials in recent periods as a result of servicers failing to produce the documents necessary to perfect a claim submission. While this increasing trend has the effect of reducing claims paid in current periods, we expect a significant portion of denials to be resubmitted and ultimately paid and our incurred loss and claims paid estimates reflect this expectation. Although significant uncertainty remains, we currently expect claims paid to be between $900 million and $1 billion in 2013.
In addition, as part of our claims review process, we assess whether defaulted loans were serviced appropriately in accordance with our insurance policies and servicing guidelines. To the extent a servicer has failed to satisfy its servicing obligations, our policies provide that we may curtail the claim payment for such default, and in some circumstances, cancel coverage or deny the claim. In 2012, claim curtailments due to servicer noncompliance with our insurance policies and servicing guidelines increased both in frequency and in size, which has contributed to a reduction in the severity of our claim payments during this period. While we cannot give assurance regarding the extent or level at which such claim curtailments will continue, we expect this trend to continue in light of well publicized issues in the servicing industry and our existing portfolio of aged defaults.
The following table shows claims paid and average claims paid as of the dates indicated:
Other operating expenses decreased in 2011 as compared to 2010 due to a reduction in salaries, as well as stock-based compensation. This was partially offset by increases in sales commissions due to our increased NIW and increased expenses related to the write-off of certain software and technology projects in 2011. In October 2011, we completed an expense initiative aimed at aligning our support services to the current reduced mortgage market. This re-alignment included a workforce reduction of approximately 9.8% of our corporate and mortgage insurance staff.
Contract underwriting expenses for 2012, including the impact of reserves for contract underwriting remedies, were $12.1 million, compared to $16.1 million for 2011 and $6.1 million for 2010. During 2012, loans underwritten via contract underwriting accounted for 5.0% of applications, 4.9% of commitments for insurance and 5.0% of insurance certificates issued, compared to 8.8%, 8.2% and 8.7%, respectively, for 2011 and 17.9%, 16.5% and 13.9%, respectively, for 2010.
Interest Expense. These amounts reflect the allocated portion of interest on Radian Group’s long-term debt based on the relative GAAP equity for our mortgage insurance segment. The decrease in 2012 compared to 2011 primarily is due to the maturity in June 2011 of our 7.75% Debentures. In addition, we purchased $170.6 million aggregate principal amount of our 2013 Notes in 2012, which reduced our interest expense.
Income Tax (Benefit) Provision. The effective tax rate on our pre-tax operating losses increased to 12.3% for the year ended December 31, 2012 from (14.8%) for the year ended December 31, 2011. The increase to the rate was primarily due to an increase in our provision for uncertain tax positions in 2011 as a result of the remeasurement of certain liabilities and also due to changes in our overall valuation allowance. The effective tax rate on our pre-tax operating loss in 2010 was (15.9%), which was mainly impacted by the initial establishment of a valuation allowance.
the commutation of $13.8 billion of financial guaranty net par outstanding that Radian Asset Assurance reinsured from Assured (the “Assured Commutation”);
the cession of $1.8 billion of direct public finance business to Assured; and
CDO Early Terminations. During 2012, CDS counterparties in our financial guaranty business exercised their termination rights with respect to 35 corporate CDOs, a foreign infrastructure CDS and a CDS of an investor-owned utility bond that we insured (collectively, the “CDO Early Terminations”), which further reduced our financial guaranty net par outstanding by $14.6 billion in the aggregate. There was no material impact on our financial statements as a result of these terminations.
Our aggregate financial guaranty net par outstanding decreased significantly in 2012 from $69.2 billion as of December 31, 2011 to $33.7 billion as of December 31, 2012. We expect our net par outstanding will continue to decrease as our financial guaranty insured portfolio matures, as we proactively seek to reduce our financial guaranty net par outstanding, and as counterparties potentially continue to terminate transactions early in accordance with their rights under such transactions. The reduction in net par outstanding in 2012 was primarily due to the Assured Transaction, the CDO Early Terminations and the CDO Commutation Transactions, as well as the amortization or scheduled maturity of our insured portfolio and prepayments of public finance transactions. On January 9, 2013, the FGIC Commutation was consummated resulting in an additional reduction of $0.8 billion of net par outstanding.
The following tables show the distribution of our financial guaranty segment’s net par outstanding, by type of exposure, as a percentage of total net par outstanding and the related net claim (asset) liability and fair value net (asset) liability as of the dates indicated:
Represents our exposure to the aggregate outstanding principal on insured obligations.
Includes $1.6 billion and $3.0 billion at December 31, 2012 and 2011, respectively, of tax supported revenue bonds.
Includes $2.9 billion and $3.2 billion at December 31, 2012 and 2011, respectively, of international public finance insured obligations (which includes sovereign debt), of which $105.2 million and $143.8 million at December 31, 2012 and 2011, respectively, which is related to Spain, Italy, Hungary, Portugal, Greece and Ireland (collectively, the “Stressed European Countries”).
Our international sovereign and sub-sovereign (collectively, “Sovereign”) net par exposure declined 67% from $522.5 million at December 31, 2011 to $171.8 million at December 31, 2012, primarily due to the Assured Transaction and the settlement of our exposure to insured sovereign indebtedness of Greece (consisting of a payment of $23.5 million to settle our remaining exposure) that occurred during the third quarter of 2012, partially offset by a reclassification of certain international indebtedness as sovereign exposure that occurred in 2012. Our net claim liability to sovereign exposures as of December 31, 2012 was $9.0 million, all of which is related to Spain. Substantially all of our sovereign exposure related to Spain is to an infrastructure project for which current payments are being made due to the backing of the province of Valencia, which has requested financial assistance from the Spanish government under a program to assist regions in financial distress. Our sovereign net par exposure to the Stressed European Countries was $91.4 million as of December 31, 2012, of which $47.5 million is related to Spain, $22.5 million is related to Hungary, $20.5 million is related to Italy and $0.9 million is related to Portugal, with no such exposure to Ireland. As discussed above, our sovereign exposure to Greece was settled in full in the third quarter of 2012 and, as a result, our net par sovereign exposure to Greece has been reduced to zero.
In addition to our Sovereign net par exposure, Sovereign obligations represent approximately 0.8% of the collateral in our insured portfolio of corporate CDOs, including 0.1% or less to each of Spain and Hungary, the only Stressed European Countries included within the collateral in our insured portfolio of corporate CDOs.
Includes one CDO comprised of Corporate CDOs with net par outstanding of $31.5 million. This transaction is the only CDO comprised of other CDOs in our directly insured financial guaranty portfolio.
$8.6 million or 3.6% of this net par outstanding is related to underlying obligations that are also rated BIG.
$15.5 million or 30.9% of this net par outstanding is related to underlying obligations that are also rated BIG.
Represents other types of municipal obligations, including human service providers, second-to-pay international public finance, non-profit institutions, project finance accommodations and stadiums, none of which individually constitutes a material amount of our financial guaranty net par outstanding.
Notwithstanding the decrease in our financial guaranty net par outstanding in 2012, the ratings distribution of our insured portfolio did not change significantly. In 2012, we experienced only a slight shift from non-AAA investment grade obligations to BIG obligations, which was almost entirely related to our public finance credits.
As of December 31, 2012, our net claim liability for general obligations and other tax supported credits was $10.0 million. The impact on municipal governments from the most recent economic downturn is becoming more evident. For example, there have been several municipal defaults and bankruptcy filings in 2012, including several bankruptcy filings by municipalities in California. We do not have general obligation exposure to any of the California municipalities that have filed for bankruptcy thus far. As of December 31, 2012, we had $183.0 million of net par exposure ($87.1 million after giving effect to the FGIC Commutation) to general obligations of California municipalities, all of which are currently rated investment grade.
We expect the negative trend in the public finance sector to continue through at least the end of 2013 and possibly into future years, due to the slow economic recovery, federal funding reductions, expected Medicare cuts and continued stress on tax-based revenue receipts (in particular where tax revenues are derived from the value of real estate, as discussed below). We expect these collective factors to continue to strain the ability of government entities to maintain balanced budgets and adequate liquidity to meet near-term financial obligations. We may continue to experience further credit deterioration and municipal defaults in our government-related insured credits, which could require increases in our net claim liability with respect to these credits.
We have seen some credit deterioration in our insured portfolio of other tax supported bond transactions, in particular, those that are payable from real estate tax revenues derived from the value of real estate in narrowly defined special districts or from special assessments for improvements on certain properties. Declining property values have reduced the assessed value of the tax base in these jurisdictions, resulting in reduced tax revenues being available to pay interest and principal on these insured bonds. We may experience further credit deterioration in these transactions, which would increase the likelihood that ultimately we would be required to make claim payments with respect to these bonds, especially those from special districts.
As of December 31, 2012, $100.9 million of our Sovereign net par exposure is rated at least investment grade, while $70.9 million is rated BIG. All of our BIG exposure relates to the Stressed European Countries whose Sovereign obligations have been under particular stress due to economic uncertainty, potential debt restructuring and ratings downgrades. Due to volatile economic conditions and uncertainty, particularly in the Stressed European Countries, we believe that there is significant risk of negative ratings and net claim liability developments in our Sovereign insured credits in the Stressed European Countries over the next few quarters.
The credit performance of our corporate CDO portfolio continues to improve and we continue to have strong subordination remaining in our corporate CDO transactions. There was only one credit event in this portfolio in 2012.
The following table sets forth the credit ratings of the underlying collateral for our financial guaranty directly insured corporate CDO portfolio as of December 31, 2012:
Represents the lower of the ratings of the underlying corporate entities as determined by Moody’s Investor Service (“Moody’s”) and Standard & Poor’s Financial Services LLC (“S&P”). Each rating within a letter category includes all rating grades within that letter category (e.g., an “A” rating includes “A+” “A” and “A-”).
The average number of sustainable credit events determined as of December 31, 2012. Average amounts presented are simple averages.
We continue to see stabilization and improved performance across many of the transactions in our directly insured TruPs CDO portfolio. The banking sector continues to face increasing pressure from regulatory compliance costs, limited growth in loan portfolio and reduced earnings from a flattening yield curve. Smaller community banks, which comprise a significant portion of the issuers in our directly insured TruPs CDO portfolio, face these pressures most acutely, due to additional pressure from their lack of economies of scale, limited revenue resources and often undiversified businesses. Notwithstanding these pressures, the collateral fundamentals of the bank issuers within these insured transactions continue to show improved performance. The number of cures of previous defaults and the repayment of interest payments previously deferred on the TruPs collateral has outpaced new initial defaults and interest payment deferrals by the TruPs issuers, which is permissible for up to five years. The insurance company issuers in our TruPs CDO portfolio generally remain stable. As of December 31, 2012, our weighted average rating for our directly insured TruPs bonds improved from BB at December 31, 2011 to BBB- as of December 31, 2012, primarily due to the CDO Commutation Transactions. As of December 31, 2012, $314.4 million of our net par outstanding related to three of the TruPs bonds we insure was rated BIG.
Reflects the amount of principal subordination (expressed as a percentage of the principal of the total collateral pool) remaining beneath our insured TruPs bond, after giving effect to deferrals of interest payments on the TruPs collateral, as well as amortization and actual defaults, assuming no recoveries of principal on the defaulted or deferred TruPs.
Pursuant to the terms of our CDS contracts covering these TruPs bonds, we could be required to pay our counterparties the outstanding par on our insured TruPs bond on the scheduled termination date of our CDS contract. For more information regarding this potential liquidity risk, see “-Liquidity and Capital Resources.”
Represents the number of CMBS tranches that comprise the collateral pool for the applicable CDOs of CMBS transaction.
The average remaining subordination after giving effect to both amortization of principal and realized losses.
Delinquencies reflect the average percentage (of total notional) of the CMBS collateral that is delinquent.
The following table summarizes the results of operations for our financial guaranty segment for the years ended December 31, 2012, 2011 and 2010:
During 2012, as market prices of our investments strengthened, we made the decision to sell securities in our portfolio. The realized gains from these sales, some of which had previously been unrealized, also increased the respective statutory capital positions of our subsidiaries that held the investments. Net gains on investments for 2011 were impacted by our sale of our investment in a portfolio of tobacco bonds for which we recognized a $32.0 million realized loss in our financial guaranty segment that was more than offset by gains on sales of other securities in our trading portfolio during 2011.
Radian Group’s five-year CDS spread is presented below as an illustration of the market’s view of our non-performance risk; the CDS spread used in the valuation of specific liabilities is typically based on the remaining term of the instrument. The non-performance risk is commonly measured by default probability, which lowers as the spread tightens. Radian Group’s five-year CDS spread at December 31, 2012 implies a market view that there is a 47.7% probability that Radian Group will default in the next five years, as compared to an 83.5% implied probability of default at December 31, 2011 and a 32.0% probability of default at December 31, 2010.
The following tables quantify the impact of our non-performance risk on our derivative assets, derivative liabilities and net VIE liabilities (in aggregate by type) presented in our consolidated balance sheets:
In our opinion, the accompanying consolidated balance sheets and related consolidated statements of operations, comprehensive income (loss), changes in common stockholders’ equity and cash flows present fairly, in all material respects, the financial position of Radian Group Inc. and its subsidiaries at December 31, 2012 and 2011, and the results of their operations, comprehensive income(loss) and their cash flows for each of the three years in the period ended December 31, 2012 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in Item 15(a)(2) present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements and financial statement schedules, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Report on Internal Control over Financial Reporting appearing under Item 9A. Our responsibility is to express opinions on these financial statements, on the financial statement schedules, and on the Company’s internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
As discussed in Note 2 to the consolidated financial statements, the Company adopted in 2012 a new accounting standard for deferred acquisition costs.
Our financial guaranty segment has provided direct insurance and reinsurance on credit-based risks through Radian Asset Assurance Inc. (“Radian Asset Assurance”), a wholly-owned subsidiary of Radian Guaranty. We have provided financial guaranty credit protection in several forms, including through the issuance of financial guaranty policies, by insuring the obligations under one or more credit default swaps (“CDS”) and through the reinsurance of both types of obligations. In 2008, we ceased writing or assuming new financial guaranty business and since then, we have significantly reduced our financial guaranty operations. In addition, we have been proactive in continuing to reduce our financial guaranty exposures through commutations in order to mitigate uncertainty, maximize the ultimate capital available for our mortgage insurance business and accelerate access to that capital.
Our financial services segment consisted mainly of our ownership interests in Credit-Based Asset Servicing and Securitization LLC (“C-BASS”), which was a credit-based consumer asset business that we wrote off completely in 2007 and Sherman Financial Group LLC (“Sherman”), a consumer asset and servicing firm specializing in credit card and bankruptcy-plan consumer assets. C-BASS filed for Chapter 11 bankruptcy protection on November 12, 2010 and was subsequently liquidated. Our equity interest in C-BASS, and a related note receivable from C-BASS that had also been previously written off, were extinguished as part of the C-BASS liquidation. On May 3, 2010, we sold all of our remaining interest in Sherman.
Currently, our business strategy primarily is focused on: (1) growing our mortgage insurance business by writing high-quality mortgage insurance in the U.S.; (2) continuing to manage losses in our legacy mortgage insurance and financial guaranty portfolios; (3) continuing to reduce our financial guaranty exposure; and (4) pursuing opportunities for increasing Radian Group’s available liquidity and for enhancing Radian Guaranty’s capital position.
Since 2008, we have undertaken a number of strategic actions and initiatives in response to the negative economic and market conditions. As a result of these actions and an improving operating environment, we believe we are better positioned to return to operating profitability in the future. These actions include the following:
We reduced our legacy mortgage insurance portfolio (direct primary mortgage insurance RIF originated in 2005 through 2008), non-traditional mortgage insurance RIF and our financial guaranty portfolio through a series of risk commutations, discounted security purchases, transaction settlements and terminations.
During 2012 and to date in 2013, we have continued to execute upon this strategy, including the following:
Through the expanded eligibility criteria under the most recent Home Affordable Refinance Program (“HARP”), an increased number of borrowers have been able to participate in and benefit from the program and, as of December 31, 2012, approximately 9% of our total primary RIF had successfully completed a HARP refinance.
We continue to diversify and expand our customer base, adding more than 300 new customers during 2012. New customers added since 2009 accounted for 32% of the new insurance written (“NIW”) during 2012.
On April 1, 2012, Radian Guaranty entered into a quota share reinsurance agreement with a third-party reinsurance provider (the “Initial Quota Share Reinsurance Transaction”). In the fourth quarter of 2012, Radian Guaranty and the same third-party reinsurance provider agreed to the terms of a second quota share reinsurance agreement (the “Second Quota Share Reinsurance Transaction” and, together with the Initial Quota Share Reinsurance Transaction, the “Reinsurance Transactions”) that provide for additional ceded risk. See Note 9 for further details.
Throughout 2012, Radian Asset Assurance continued to reduce its financial guaranty portfolio through a series of risk commutations, transaction settlements and terminations. Since it stopped writing business in June 2008, Radian Asset Assurance’s net par exposure has been reduced by 70.7% to $33.7 billion. From 2008 through the end of 2012, Radian Asset Assurance has released financial guaranty contingency reserves of $357.0 million (which has increased Radian Guaranty’s statutory capital surplus by an equal amount) and paid $383.8 million in dividends to Radian Guaranty.
In July 2012, Radian Asset Assurance paid an ordinary dividend of $54.0 million to Radian Guaranty.
In February 2013, the New York State Department of Financial Services (the “NYSDFS”) approved the release of an additional $61.1 million of contingency reserves.
In January 2012, we made progress in our strategic objective of continuing to reduce our financial guaranty risk by entering into a three-part transaction (the “Assured Transaction”) with subsidiaries of Assured Guaranty Ltd. (collectively, “Assured”) that included the commutation of $13.8 billion of financial guaranty net par outstanding that Radian Asset Assurance reinsured from Assured, the cession of $1.8 billion of direct public finance business to Assured and the sale of Municipal and Infrastructure Assurance Corporation (the “FG Insurance Shell”), a New York domiciled financial guaranty insurance company licensed to conduct business in 37 states and the District of Columbia that Radian Asset Assurance had acquired in 2011. The Assured Transaction reduced our financial guaranty net par outstanding by 22.5% and provided an aggregate statutory capital benefit to Radian Asset Assurance and Radian Guaranty of $100.7 million in 2012.
In the second quarter of 2012, Radian Asset Assurance entered into a commutation with one of its derivative counterparties (the “Counterparty”) to commute: (1) exposure to a directly insured tranche of an extremely distressed collateralized debt obligation (“CDO”) of asset-backed securities (“ABS”) transaction (the “CDO of ABS Transaction”), for which we had expected to pay claims on substantially all of the $450.2 million net par that was outstanding at the time of the commutation; and (2) credit protection through CDS on six directly insured trust preferred securities (“TruPs”) CDO transactions, representing $699.0 million of net par outstanding at the time of the commutation (the “Terminated TruPs CDOs”). In consideration for these commutations, Radian Asset Assurance paid $210.0 million, a significant portion of which (the “LPV Initial Capital”) was deposited with a limited purpose vehicle (an “LPV”) to cover the Counterparty’s potential future losses on the TruPs bonds underlying the Terminated TruPs CDOs (the “Terminated TruPs Bonds”). The commutations described in this paragraph are referred to herein as the “CDO Commutation Transactions.” See Note 6 for further information regarding the accounting treatment of the Terminated TruPs Bonds.
During 2012, we purchased $170.6 million of principal amount of our 5.625% Senior Notes due February 15, 2013 (the “2013 Notes”) at a discount to their face amount outstanding, as discussed in more detail in Note 13.
In addition to the actions taken, consistent with management’s plan, we may consider additional reinsurance or negotiated commutations of our mortgage insurance RIF and financial guaranty net par outstanding and may pursue further opportunities to retire or restructure our long-term debt or the issuance of securities in one or more private or public offerings. We cannot provide any assurance that we will be successful in pursuing any such alternatives, individually or in the aggregate, and can provide no assurance that if such alternatives are executed that they will be sufficient to maintain regulatory capital requirements and holding company liquidity. See “Risks and Uncertainties” in this Note 1 below.
The GSEs and state insurance regulators impose various capital requirements on our insurance subsidiaries. These include risk-to-capital ratios, other risk-based capital measures and surplus requirements that potentially may limit the amount of insurance that each of our insurance subsidiaries may write. The GSEs and our state insurance regulators also possess significant discretion with respect to our insurance subsidiaries.
Radian Guaranty’s risk-to-capital ratio has improved to 20.8 to 1 as of December 31, 2012, from 21.5 to 1 as of December 31, 2011. We intend to maintain Radian Guaranty’s risk-to-capital below 25 to 1 throughout 2013, including, if necessary, by making contributions to Radian Guaranty from Radian Group’s remaining available liquidity. Based on our current projections, in the absence of these contributions or other risk-to-capital support, we anticipate that Radian Guaranty would exceed the 25 to 1 risk-to-capital ratio requirement during 2013. Radian Guaranty had exceeded the MPP Requirement in two RBC States as of December 31, 2012. Each of these RBC States has issued to Radian Guaranty a waiver of its MPP Requirement that allows Radian Guaranty to continue writing new business in these states regardless of whether the MPP Requirement has been met. One of the waivers expires at the end of 2013 and the other has no prescribed expiration date but could be revoked at any time.
Radian Asset Assurance is a wholly-owned subsidiary of Radian Guaranty. If our financial guaranty portfolio performs worse than anticipated, including if we are required to establish (or increase) one or more statutory reserves on defaulted obligations that we insure, or if we make net commutation payments to terminate insured financial guaranty obligations in excess of the then established statutory reserves for such obligations, the statutory capital of Radian Guaranty would also be negatively impacted. We establish statutory financial guaranty reserves at the time of default, whereas for reporting purposes under accounting principles generally accepted in the United States of America (“GAAP”), loss reserves are established when estimated losses exceed unearned premiums, regardless of whether a default has occurred. Any decrease in the statutory capital in our financial guaranty business would have a direct negative impact on Radian Guaranty’s capital position and may affect its ability to remain in compliance with the Statutory RBC Requirements. See Note 16 for further discussion regarding Radian Asset Assurance’s statutory surplus position, differences between statutory and GAAP accounting principles, and the statutory impact of the Terminated TruPs CDOs.
We actively manage Radian Guaranty’s capital position in various ways, including: (1) through internal and external reinsurance arrangements; (2) by seeking opportunities to reduce our risk exposure through commutations or other negotiated transactions; (3) by contributing additional capital from Radian Group to our mortgage insurance subsidiaries; and (4) by realizing gains in our investment portfolio through open market sales of securities. Radian Group had unrestricted cash and liquid investments of $375.6 million as of December 31, 2012. Much of our remaining available liquidity may be used to further support Radian Guaranty’s capital position. Depending on the extent of our future statutory incurred losses, as well as the level of NIW and other factors, the amount of capital contributions required for Radian Guaranty to remain in compliance with the Statutory RBC Requirements could be substantial and could exceed amounts available at Radian Group. In addition, while our other mortgage insurance subsidiaries are not subject to Statutory RBC Requirements, these subsidiaries, which provide reinsurance to Radian Guaranty but do not write direct business of their own, are subject to certain minimum statutory surplus requirements. All of these subsidiaries were in compliance with their respective statutory surplus requirements as of December 31, 2012. Some of our other mortgage insurance subsidiaries may require additional capital contributions in the future to maintain minimum capital levels in order for Radian Guaranty to continue to receive appropriate statutory credit and thus continue to utilize reinsurance arrangements with these subsidiaries. See “Holding Company Liquidity” and “Risks and Uncertainties” below in this Note 1.
In order to maximize our financial flexibility in the event we are unable to comply with applicable Statutory RBC Requirements, we have applied for waivers or similar relief for Radian Guaranty in each of the RBC States. Of the 16 RBC States, New York does not possess the regulatory authority to grant waivers and Iowa, Kansas and Ohio have declined to grant waivers to Radian Guaranty. In addition, we have a waiver pending in Idaho, and Oregon has indicated that it will not consider a waiver application until such time that Radian Guaranty has exceeded its Statutory RBC Requirement. Currently, Radian Guaranty has waivers or similar relief from the following RBC States: Kentucky, Wisconsin, Arizona, Missouri, North Carolina, California and Texas. Waivers that were previously granted to Radian Guaranty from Illinois, New Jersey and Florida expired at the end of 2012 and we currently are pursuing a renewal of the waivers from these states. Certain of the existing waivers contain conditions, including requirements that Radian Guaranty’s risk-to-capital ratio may not exceed a revised maximum ratio, ranging from 30 to 1 up to 35 to 1. There can be no assurance that: (1) Radian Guaranty will be granted a waiver in Idaho or Oregon, the two remaining RBC States, or a renewal of the waivers that have expired in Illinois, New Jersey and Florida will be received; (2) for any waiver granted, such regulator will not revoke or terminate the waiver, which the regulator generally has the authority to do at any time; (3) for any waiver granted, it will be renewed or extended after its original expiration date; or (4) additional requirements will not be imposed as a condition to such waivers or their renewal or extension and, if so, whether we will be able to comply with such conditions.
In addition to filing for waivers in the RBC States, we intend, if necessary, to write new first-lien insurance business in Radian Mortgage Assurance Inc. (“RMAI”) in any RBC State that does not permit Radian Guaranty to continue writing insurance while it is out of compliance with applicable Statutory RBC Requirements. RMAI is a wholly-owned subsidiary of Radian Guaranty and is licensed to write mortgage insurance in each of the fifty states and the District of Columbia.
The GSE Approvals are temporary and are conditioned upon our compliance with a broad range of conditions and restrictions, including without limitation, minimum capital and liquidity requirements, a maximum risk-to-capital ratio of 20 to 1 for RMAI, restrictions on the payment of dividends and restrictions on affiliate transactions involving Radian Guaranty or RMAI. See “Risks and Uncertainties” below in this Note 1. Under the GSE Approvals, Radian Group would also be required to contribute $50 million of additional capital to Radian Guaranty (which would then be contributed to RMAI), if Radian Guaranty exceeds a 25 to 1 risk-to-capital ratio, or if it fails to satisfy an MPP requirement in a state where it has not obtained a waiver or other similar relief. The conditions and restrictions contained in the Freddie Mac Approval include, among others, a condition specifying the time frame by which Radian Guaranty will evaluate and resolve claims and a requirement that Radian Group make contributions to Radian Guaranty so that Radian Guaranty maintains minimum “Liquid Assets” of $700 million. As defined in the Freddie Mac Approval, “Liquid Assets” are equal to the sum of: (i) aggregate cash and cash equivalents; and (ii) the fair market value of the following investments: (a) residential mortgage-backed securities (“RMBS”) guaranteed by Fannie Mae, Freddie Mac or Government National Mortgage Association; (b) securities rated single A or higher by either Moody’s Investor Service, Standard & Poor’s Financial Services LLC (“S&P”) or Fitch Ratings with a remaining maturity of five years or less; and (c) U.S. Treasury securities with maturities not to exceed ten years, provided that U.S. Treasury securities with remaining maturities in excess of five years may not exceed 10 percent of the Liquid Assets. As of December 31, 2012, Radian Guaranty’s Liquid Assets under the Freddie Mac Approval were approximately $868.9 million. Radian Guaranty maintains significant additional liquid investments that may be converted into Liquid Assets to ensure ongoing compliance with the Freddie Mac Approval. There can be no assurance that: (1) we will be able to comply with the conditions imposed by the GSE Approvals for RMAI; (2) the GSEs will not revoke or terminate their approvals, which they generally have the authority to do at any time; (3) the GSE Approvals will be renewed or extended after their original expiration dates; or (4) additional requirements will not be imposed as a condition to such on-going approvals, including their renewal or extension.
Our existing capital resources may not be sufficient to successfully manage Radian Guaranty’s capital position. Our ability to utilize waivers and RMAI to continue to write business if Radian Guaranty’s capital position is not in compliance with the Statutory RBC Requirements is subject to conditions that we may be unable to satisfy. As a result, even if we are successful in implementing this strategy, additional capital contributions or other risk-to-capital support or relief could be necessary, which we may not have the ability to provide. Further, regardless of the waivers and the GSE Approvals of RMAI, we may choose to use our existing capital at Radian Group to maintain compliance with the Statutory RBC Requirements, including for periods after 2013. Depending on the extent of our future incurred losses along with other factors, the amount of capital contributions that may be required to maintain compliance with the Statutory RBC Requirements could be significant and could exceed all of our remaining available capital. In the event we contribute a significant amount of Radian Group’s available capital to Radian Guaranty and RMAI, our financial flexibility would be significantly reduced, making it more difficult for Radian Group to meet its obligations in the future, including future principal payments on our outstanding debt. See “Holding Company Liquidity” and “Risks and Uncertainties” below in this Note 1.
Radian Group’s principal sources of cash include dividends from Radian Guaranty (to the extent permitted under applicable laws and regulations) and payments made to Radian Group under tax- and expense-sharing arrangements with our subsidiaries. Radian Guaranty’s ability to pay dividends to Radian Group is subject to various conditions imposed by the GSEs and rating agencies and by insurance regulations requiring insurance department approval. In general, dividends in excess of prescribed limits are deemed “extraordinary” and require insurance department approval. Based on Radian Guaranty’s current financial position, we do not anticipate that it will be permitted under applicable insurance laws to issue dividends to Radian Group for the foreseeable future. To the extent Radian Asset Assurance continues to pay future dividends, these dividends will be paid to its direct parent, Radian Guaranty, and not to Radian Group.
Corporate Expenses and Interest Expense. Radian Group has expense-sharing arrangements in place with its principal operating subsidiaries that require those subsidiaries to pay their share of holding-company-level expenses, including interest payments on our outstanding long-term debt. Payments of such corporate expenses for the next 12 months, excluding interest payments, are expected to be approximately $63.2 million. For the same period, payments of interest on our long-term debt are expected to be approximately $35.9 million. These amounts are expected to be fully reimbursed by our subsidiaries under our existing expense-sharing arrangements. These expense-sharing arrangements, as amended, have been approved by applicable state insurance departments, but such approval may be modified or revoked at any time. In addition, pursuant to the GSE Approvals, the consent of the GSEs is required to modify or amend the expense-sharing agreements. Approximately $39.4 million of future expected corporate expenses and interest payments (approximately $15.3 million relates to payments anticipated to be made in the next 12 months) have been accrued for and paid by certain subsidiaries to Radian Group as of December 31, 2012, and therefore, the total unrestricted cash and liquid investments held by Radian Group as of December 31, 2012 include these amounts. A portion of these expenses (approximately $29.4 million) relates to performance-based compensation expenses that could be reversed in whole or in part, depending on changes in our stock price and other factors. To the extent these expenses are reversed, Radian Group would be required to reimburse the subsidiaries that paid these expenses to Radian Group. In addition, under the Fannie Mae Approval for RMAI, Radian Group is required to contribute to Radian Guaranty the amount of any future interest expense payments made by Radian Guaranty or RMAI to Radian Group pursuant to the terms of the expense-sharing arrangements among these entities. Pursuant to the terms of our expense sharing arrangements, interest expense payments from Radian Guaranty or RMAI to Radian Group in 2013 are not expected to be significant.
Capital Support for Subsidiaries. In light of operating losses in our mortgage insurance business, Radian Group may be required to make additional capital contributions to Radian Guaranty in order to support Radian Guaranty’s ability to continue writing mortgage insurance in those states that impose certain risk-based capital requirements and/or to maintain approvals by the GSEs for RMAI to operate as an eligible insurer in certain states. Radian Group also could be required to provide capital support to our other mortgage insurance subsidiaries if additional capital is required pursuant to insurance laws and regulations. Certain of our mortgage insurance subsidiaries that provide reinsurance to Radian Guaranty have operated at or near minimum capital levels and have required, and in the future may again require, additional capital contributions from Radian Group. See “Insurance Regulatory-Capital Requirements” above in this Note 1 for further information.
After giving effect to the 2015 Debt Exchange that settled in January 2013, our most significant needs for liquidity beyond the next 12 months are: (i) the repayment of the principal amount of our outstanding long-term debt, including approximately $54.8 million in principal amount due in 2015, $195.2 million of principal amount of debt due in June 2017 and $450 million in principal amount of convertible debt due in 2017; (ii) potential additional capital contributions to our mortgage insurance subsidiaries; and (iii) potential payments to the U.S. Department of the Treasury resulting from the examination of our 2000 through 2007 federal tax returns by the IRS. We regularly consider various measures to improve our capital and liquidity positions, as well as our debt maturity profile. We have repurchased and exchanged, prior to maturity, some of our outstanding debt, and in the future, we may, from time to time, seek to redeem, repurchase, or exchange for other securities, prior to maturity, some or all of our outstanding debt in the open market, through private transactions, pursuant to one or more tender offers or through any combination of the foregoing, as circumstances may allow. The timing or amount of any potential transactions, which may or may not occur, will depend on a number of factors, including our capital and liquidity needs. If necessary, we may seek to refinance all or a portion of our long-term debt, which we may not be able to do on favorable terms, if at all.
In light of Radian Group’s long- and short-term needs, we are considering various options to increase our capital and liquidity position, such as incurring additional debt, issuing additional equity or selling assets, which we may not be able to do on favorable terms, if at all. Accordingly, we expect to meet the long-term liquidity needs of Radian Group with a combination of: (i) available cash and marketable securities; (ii) private or public issuances of debt or equity securities, which we may not be able to do on favorable terms, if at all; (iii) cash received under expense-sharing arrangements with our subsidiaries; (iv) the potential sale of assets; and (v) dividends from our subsidiaries, to the extent available. See “Risks and Uncertainties” below in this Note 1.
Radian Group and its subsidiaries are subject to risks and uncertainties that could affect amounts reported in our financial statements in future periods. Adverse business and economic conditions have resulted in incurred losses that have reduced our insurance subsidiaries’ statutory capital, requiring contributions that have reduced holding company liquidity. Further, statutory capital requirements are subject to regulatory discretion and approval. Our future performance and financial condition are subject to significant risks and uncertainties that could cause actual results to be materially different from our estimates and forward-looking statements, including but not limited to, the following:
Potential adverse effects if there are adverse developments with respect to our estimates related to the likelihood, magnitude and timing of losses in connection with establishing loss reserves or premium deficiency reserves for our mortgage insurance or financial guaranty businesses. (See Notes 10, 11 and 12).
Potential adverse effects on us if the capital and liquidity levels of Radian Group or our regulated subsidiaries’ statutory capital levels are deemed inadequate to support current business operations and strategies.
Potential adverse impact on the mortgage origination market and on private mortgage insurers due to increased capital requirements for mortgage loans under proposed interagency rules to implement the third Basel Capital Accord (“Basel III”), including in particular, the possibility that loans insured by the FHA will receive a more favorable regulatory capital treatment than loans with private mortgage insurance;
Our businesses have been significantly affected by, and our future success may depend upon, legislative and regulatory developments impacting the housing finance industry. The GSEs are the primary beneficiaries of the majority of our mortgage insurance policies and the FHA remains our primary competitor outside of the private mortgage insurance industry. The GSE federal charters generally prohibit them from purchasing any mortgage with a loan amount that exceeds 80% of a home’s value, unless that mortgage is insured by a qualified insurer or the mortgage seller retains at least a 10% participation in the loan or agrees to repurchase the loan in the event of a default. As a result, high-loan-to-value (“LTV”) mortgages purchased by the GSEs generally are insured with private mortgage insurance. Changes in the charters or business practices of the GSEs, including pursuing new products for purchasing high-LTV loans that are not insured by private mortgage insurance, could reduce the number of mortgages they purchase that are insured by us and consequently diminish our franchise value. In September 2008, the Federal Housing Finance Agency was appointed as the conservator of the GSEs to control and direct the operations of the GSEs. The continued role of the conservator may increase the likelihood that the business practices of the GSEs will be changed in ways that may have a material adverse effect on us. In particular, if the private mortgage insurance industry does not have the ability, due to capital constraints, to continue to write sufficient business to meet the needs of the GSEs, the GSEs may seek alternatives other than private mortgage insurance to conduct their business.
Estimating the loss reserves in both our mortgage insurance and financial guaranty business segments involves significant reliance upon assumptions and estimates with regard to the likelihood, magnitude and timing of each potential loss. The models, assumptions and estimates we use to establish loss reserves may not prove to be accurate, especially during an extended economic downturn or a period of extreme market volatility and uncertainty, as has existed for the last several years. As such, we cannot be certain that our reserve estimate will be adequate to cover ultimate losses on incurred defaults.
Commutations, recaptures and other negotiated terminations of our insured risks in both our mortgage insurance and financial guaranty segments provide us with an opportunity to exit exposures for an agreed upon payment, or payments, often at an amount less than the previously estimated ultimate liability. Once all exposures relating to such policies are extinguished, all reserves for losses and LAE and other balances relating to the insured or reinsured policy generally are eliminated. Upon completion of a commutation, recapture or other negotiated termination, all such related balances, including deferred policy acquisition costs and unearned premiums, are reversed, with any remaining net gain or loss typically recorded through provision for losses. We take into consideration the specific contractual and economic terms for each individual agreement when accounting for our commutations, recaptures or other negotiated terminations, which may result in differences in the accounting between transactions, or between the statutory financial statements of our insurance subsidiaries and our financial statements presented on a GAAP basis.
With respect to loans that are in default, considerable judgment is exercised as to the adequacy of reserve levels. Loss reserves are increased as defaulted loans age, because they are considered to be closer to foreclosure and more likely to result in a claim payment. In the past, as the default proceeded towards foreclosure, there was generally more certainty around these estimates. However, in the current environment in which many foreclosures have been delayed, significant uncertainty remains with respect to the ultimate resolution of aged defaults. This uncertainty requires management to use considerable judgment in estimating the rate at which these loans will result in claims. If a default cures, the reserve for that loan is removed from the reserve for losses and LAE.
We also establish reserves for defaults that we estimate have been incurred but have not been reported (“IBNR”) to us on a timely basis by the servicer and for defaults related to previously rescinded policies and denied claims, which we estimate will be reinstated and subsequently paid. We generally give the insured up to 90 days to rebut our decision to rescind coverage before we consider a policy to be rescinded and remove it from our default inventory; therefore, we currently expect only a limited percentage of policies that were rescinded to be reinstated. We currently expect a significant percentage of claims that were denied to ultimately be resubmitted as a perfected claim and paid. Most often, a claim denial is the result of the servicer’s inability to provide the loan origination file or other servicing documents for review. Under the terms of our master insurance policy with our lending customers, our insureds have up to one year after the acquisition of borrower’s title to provide to us the necessary documents to perfect a claim. All estimates are periodically reviewed and adjustments are made as they become necessary.
For purposes of reserve modeling, loans are aggregated into groups using a variety of factors. The attributes used to define the groups include, but are not limited to, the default status of the loans (i.e., number of days in default), product type (i.e., Prime, Alternative-A (“Alt-A”) or Subprime), type of insurance (i.e., primary or pool), policy origination year, loss position (i.e., with or without a deductible) and the state where the property is located (segregated into three state groups in order to adjust for differences in foreclosure timing). We use an actuarial projection methodology referred to as a “roll rate” analysis that uses historical claim frequency information to determine the projected ultimate default to claim rates for each product and default status. The default to claim rate also includes our estimates with respect to expected insurance rescissions and claim denials, which have the effect of reducing our default to claim rates. In recent years, we have experienced an elevated level of insurance rescissions and claim denials for various reasons, including, without limitation, underwriting negligence, fraudulent applications and appraisals, breach of representations and warranties and inadequate documentation, reflecting the poor underwriting periods of 2005 through 2008. After estimating the default to claim rate, we estimate the severity of each product type, type of insurance and state grouping based on the average of recently observed severity rates. These average severity estimates are then applied to individual loan coverage amounts to determine reserves. Senior management regularly reviews the modeled frequency, rescission, denial and severity estimates, which are based on historical trends as described. If recent emerging or projected trends differ significantly from the historical trends used to develop the modeled estimates, management may take such items into consideration in setting reserve levels.
We expect our rescission and denial rates to remain at elevated levels as long as defaults related to the poor underwriting periods of 2005 through 2008 represent a significant percentage of our total default portfolio. The percentage of defaults associated with our defaulted loans originated in 2005 through 2008 as a percentage of total defaults was 75.0% and 76.2% at December 31, 2012 and 2011, respectively. The elevated levels in the rate of rescissions and denials since 2009 have led to an increased risk of litigation by lenders and policyholders challenging our right to rescind coverage or deny claims. Under our master insurance policy, any suit or action arising from any right of the insured under the policy must be commenced within two years after such right first arose and within three years for certain other policies, including certain pool insurance policies. Recently, we have faced an increasing number of challenges from certain lender customers regarding our insurance rescissions and claim denials, which have resulted in some reversals of our decisions regarding rescissions and denials. Although we believe that our rescissions and denials are justified under our policies, if we are not successful in defending the rescissions and denials in any potential legal or other actions, including negotiated settlements, we may need to reassume the risk on, and increase loss reserves for, those policies or pay additional claims. The assumptions embedded in our estimated default to claim rate on our in-force default inventory include an adjustment to our estimated rescission and denial rate, to account for the fact that we expect a certain number of policies to be reinstated and ultimately to be paid, as a result of valid challenges by such policy holders. As discussed above, we also establish reserves for IBNR defaults related to previously rescinded policies and denied claims, which we believe are likely to be reinstated (in the case of previously rescinded policies) or resubmitted (in the case of previously denied claims).
We make regular adjustments to the underlying assumptions in our model, as discussed above, and believe the amount generated by our model at December 31, 2012 represents our best estimate of our future losses and LAE on existing defaults.
In our financial guaranty segment, we recognize a net claim liability on our non-derivative transactions prior to an event of default (insured event) when there is evidence that credit deterioration has occurred for a particular policy and that the present value of the expected claim loss exceeds the unearned premium revenue. The expected claim loss is based on the probability-weighted present value of expected net cash outflows to be paid under, or in connection with, the policy. In measuring the net claim liability, we develop the present value of expected net cash outflows by using our own assumptions about the likelihood of various possible outcomes, including potential settlements or commutations, based on information currently available. We determine the existence of credit deterioration on directly insured policies based on periodic reporting from the insured party, indenture trustee or servicer and based on our surveillance efforts. These expected cash outflows are discounted using a risk-free rate. Our assumptions about the likelihood of outcomes, expected cash outflows and the appropriate risk-free rate are updated each reporting period. For assumed policies, we use information provided by the ceding company, as well as our specific knowledge of the credit for determining expected loss.
For our mortgage insurance business, we group our mortgage insurance products into two products: first-lien and second-lien. To assess the need for a PDR on our first-lien insurance portfolio, we develop loss projections based on modeled loan defaults related to our current RIF. This projection is based on recent trends in default experience, severity and rates of defaulted loans moving to claim (such default to claim rates are net of our estimates of rescissions and denials), as well as recent trends in the rate at which loans are prepaid.
We recorded premiums and origination costs related to our CDS and certain other derivative contracts in change in fair value of derivative instruments and policy acquisition costs, respectively, on our consolidated statements of operations. Our classification of these contracts is the same whether we are a direct insurer or we reinsure these contracts.
We have included the additional disclosures required by the update to the accounting standard regarding fair value measurements and disclosures pertaining to the reconciliation of Level III fair value measurements. See Note 5 for additional information.
When determining the fair value of our liabilities, we are required to incorporate into the fair value of those liabilities an adjustment that reflects our own non-performance risk. Our CDS spread is an observable quantitative measure of our non-performance risk and is used by typical market participants to determine the likelihood of our default. As our CDS spread tightens or widens, it has the effect of increasing or decreasing, respectively, the fair value of our liabilities with a corresponding impact on our results of operations.
- Prices or valuations that require inputs that are both significant to the fair value measurement and unobservable.
Mortgage insurance premiums written on an annual and multi-year basis are initially recorded as unearned premiums and earned over the policy term. Premiums written on a monthly basis are earned over the period that coverage is provided. Annual premiums are amortized on a monthly, straight-line basis. Multi-year premiums are amortized over the terms of the contracts in relation to the anticipated claim payment pattern based on historical industry experience. In connection with our insurance rescission activity, we refund premiums to our lender customers. Ceded premiums written are initially set up as prepaid reinsurance and are amortized in a manner consistent with how direct premiums are earned. Premiums on certain structured transactions in our mortgage insurance business are recognized over the period that coverage is provided.
Effective January 1, 2012, we adopted the FASB update to the accounting standard regarding accounting for costs associated with acquiring or renewing insurance contracts on a prospective basis. This update redefines acquisition costs as costs that are related directly to the successful acquisition of new, or the renewal of existing, insurance contracts. Previously, acquisition costs were defined as costs that vary with and are primarily related to the acquisition of insurance contracts. The effect of this revised definition of acquisition costs resulted in additional expenses in our mortgage insurance business being charged to earnings when incurred, rather than being deferred. There is no change to the amortization requirements due to this update. This adoption did not impact the financial guaranty business as we have adopted the update prospectively and are not deferring any acquisition costs within our financial guaranty business. The implementation of this new guidance has materially reduced the amount of policy acquisition costs that we defer associated with acquiring new mortgage insurance contracts. The lower amount of acquisition costs deferred will result in decreased amortization expense over time, which should partially offset the impact to our results of operations from the additional expenses charged to income when incurred at the origination of an insurance contract. While the timing of when certain costs are reflected in our results of operations will change as a result of the adoption of this update, there will be no effect on the total acquisition costs recognized over time or on our cash flows. We deferred $20.5 million of policy acquisition costs in our mortgage insurance business in 2012 and $46.2 million during 2011. Under our previous method of accounting for acquisition costs, amounts deferred as acquisition costs for 2012 would have been $39.6 million. Amounts deferred as acquisition costs for 2012 also reflect a reduction for ceding commissions earned on risk ceded under the Reinsurance Transactions. We amortized $34.1 million of deferred policy acquisition costs in our mortgage insurance business in 2012 and $36.1 million during both 2011 and 2010.
Deferred policy acquisition costs in the financial guaranty business are comprised of those expenses that vary with, and are principally related to, the production of insurance premiums, including: commissions paid on reinsurance assumed, salaries and related costs of underwriting and marketing personnel, rating agency fees, premium taxes and certain other underwriting expenses, offset by commission income on premiums ceded to reinsurers. Acquisition costs are deferred and amortized over the period in which the related premiums are earned for each underwriting year. The estimation of installment-based premiums requires considerable judgment, and different assumptions could produce different results. We amortized $27.7 million, $16.7 million and $17.4 million of deferred policy acquisition costs in our financial guaranty business during 2012, 2011 and 2010, respectively. There was no impact to the deferred acquisition costs for the financial guaranty business as a result of the adoption of the FASB update to the accounting standard for deferred acquisition costs.
Included in our restricted cash balances as of December 31, 2012 were: (1) funds for a mortgage insurance reserve policy held in escrow for any future duties, rights and liabilities; (2) funds held as collateral under our insurance trust agreements related to health care benefits; and (3) funds held in trust for the benefit of certain policyholders.
We group assets in our investment portfolio into one of three main categories: held to maturity, available for sale or trading securities. Fixed-maturity securities for which we have the positive intent and ability to hold to maturity are classified as held to maturity and are reported at amortized cost. Investments in securities not classified as held to maturity or trading securities are classified as available for sale and are reported at fair value, with unrealized gains and losses (net of tax) reported as a separate component of stockholders’ equity as accumulated other comprehensive income (loss). Investments classified as trading securities are reported at fair value, with unrealized gains and losses reported as a separate component of income. Short-term investments consist of assets invested in money market instruments, certificates of deposit (“CDs”) and highly liquid, interest bearing instruments with an original maturity of three months or less at the time of purchase. Amortization of premium and accretion of discount are calculated principally using the interest method over the term of the investment. Realized gains and losses on investments are recognized using the specific identification method. See Note 5 for further discussion on the fair value of investments.
We record an OTTI on a security if we intend to sell the impaired security or if it is more likely than not that we will be required to sell the impaired security prior to recovery of its amortized cost basis, or if the present value of cash flows we expect to collect is less than the amortized cost basis of the security. If a sale is likely, the security is classified as other-than-temporarily impaired and the full amount of the impairment is recognized as a loss in the statement of operations. Otherwise, losses on securities that are other-than-temporarily impaired are separated into: (i) the portion of loss that represents the credit loss; and (ii) the portion that is due to other factors. The credit loss portion is recognized as a loss in the statement of operations, while the loss due to other factors is recognized in accumulated other comprehensive income (loss), net of taxes. A credit loss is determined to exist if the present value of discounted cash flows expected to be collected from the security is less than the cost basis of the security. The present value of discounted cash flows is determined using the original yield of the security. In evaluating whether a decline in value is other-than-temporary, we consider several factors in addition to the above, including, but not limited to, the following:
The largest single mortgage insurance customer (including branches and affiliates), measured by primary NIW, accounted for 6.2% of NIW during 2012, compared to 10.1% and 15.5% in 2011 and 2010, respectively. During 2012 and 2011, we received premium revenue from two of our mortgage insurance customers, each of which exceeded 10% of our consolidated revenues.
As a result of the CDO Commutation Transactions described in Note 1, we established a VIE. See Note 6 for further details.
The notional value of our derivative contracts at December 31, 2012 and 2011 was $19.2 billion and $36.5 billion, respectively.
The components of the (losses) gains included in change in fair value of derivative instruments are as follows:
Comprising TruPs ($0.9 million) and short-term CDs ($1.6 million) included within Level II and lottery annuities ($1.0 million) and a guaranteed investment contract held by a consolidated VIE ($78.0 million) within Level III.
Comprising short-term commercial paper within CPS trusts ($150.0 million) and short-term CDs ($1.6 million ) included within Level II and lottery annuities ($1.6 million) and TruPs held by consolidated VIEs ($5.2 million) included within Level III.
Comprising manufactured housing loan collateral related to two consolidated financial guaranty VIEs.
State and municipal obligations-The fair value of state and municipal obligations is estimated using recent transaction activity, including market and market-like observations. Evaluation models are used, which incorporate bond structure, yield curve, credit spreads and other factors. These securities are generally categorized in Level II of the fair value hierarchy or in Level III when market-based transaction activity is unavailable.
Other ABS-The fair value of other ABS is estimated based on prices of comparable securities and spreads and observable prepayment speeds. These securities are generally categorized in Level II of the fair value hierarchy or in Level III when market-based transaction activity is unavailable. The fair value of the Level III securities is generally estimated by discounting estimated future cash flows.
Foreign government securities-The fair value of foreign government securities is estimated using observed market yields used to create a maturity curve and observed credit spreads from market makers and broker-dealers. These securities are categorized in Level II of the fair value hierarchy.
We define fair value as the current amount that would be exchanged to sell an asset or transfer a liability, other than in a forced liquidation. In determining an exit market, we consider the fact that most of our derivative contracts are unconditional and irrevocable and contractually prohibit us from transferring them to other capital market participants. Accordingly, there is no principal market for such highly structured insured credit derivatives. In the absence of a principal market, we value these insured credit derivatives in a hypothetical market where market participants include other monoline mortgage and financial guaranty insurers with similar credit quality to us, as if the risk of loss on these contracts could be transferred to these other mortgage and financial guaranty insurance and reinsurance companies. We believe that in the absence of a principal market, this hypothetical market provides the most relevant information with respect to fair value estimates.
The following table quantifies the impact of our non-performance risk on our derivative assets and liabilities (in aggregate by type) and VIE liabilities presented in our consolidated balance sheets. Radian Group’s five-year CDS spread is presented as an illustration of the market’s view of our non-performance risk; the CDS spread actually used in the valuation of specific fair value liabilities is typically based on the remaining term of the instrument.
Radian Group’s five-year CDS spread at December 31, 2012 implies a market view that there is a 47.7% probability that Radian Group will default in the next five years as compared to an 83.5% implied probability of default at December 31, 2011. The cumulative impact on our derivative assets and derivative and VIE liabilities attributable to the market’s perception of our non-performance risk decreased by $1.3 billion during 2012, as presented in the table above. This decrease was primarily the result of the tightening of Radian Group’s CDS spreads during this period.
Determining the Fair Premium Amount-For each corporate CDO transaction, we perform three principal steps in determining the fair premium amount:
For each referenced corporate entity in our corporate CDO transactions, the CDS spreads associated with the term of our transactions (“credit curve”) define the estimated expected loss for each entity (as applied in a market standard approach known as “risk neutral” modeling). The credit curves on individual referenced entities are generally observable. The expected cumulative loss for the portfolio of referenced entities associated with each of our transactions is the sum of the expected losses of these individual referenced entities. With respect to the correlation of losses across the underlying reference entities, two obligors belonging to the same industry or located in the same geographical region are assumed to have a higher probability of defaulting together (i.e., they are more correlated). An increase in the correlations between the referenced entities generally causes a higher expected loss for the portfolio associated with our transactions. The estimated correlation factors that we use are derived internally based on observable third-party inputs that are based on historical data.
The amount of the non-performance risk adjustment is computed based, in part, on the expected claim payment by Radian. To estimate this expected payment, we first determine the expected claim payment of a typical market participant by using a risk-neutral modeling approach. A significant underlying assumption of the risk-neutral model approach that we use is that the typical fair premium amount is equal to the present value of expected claim payments from a typical market participant. Expected claim payments on a transaction are based on the expected loss on that transaction (also determined using the risk-neutral modeling approach). Radian’s expected claim payment is calculated based on the correlation between the default probability of the transaction and our default probability. The default probability of Radian is determined from the observed Radian Group CDS spread and the default probability of the transaction is determined as described above under “Defining the Equivalent-Risk Tranche.” The present value of Radian’s expected claim payments is discounted using a risk-free interest rate, as the expected claim payments have already been risk-adjusted.
For certain of our TruPs transactions, our counterparties may require that we pay them the outstanding par on the underlying TruPs bond if an event of default has occurred and remains outstanding as of the termination date of our CDS coverage (a “conditional liquidity claim”). For these transactions, an additional fair value adjustment is made. To calculate this adjustment, a probability that we will be required to pay a conditional liquidity claim is assigned based on our internal cash flow projections. A discounted cash flow valuation is also performed for this scenario where we are required to make a conditional liquidity claim. The fair value is set equal to the probability weighted average of the valuations from the two scenarios: one in which our counterparty makes a conditional liquidity claim and one in which the claim is not made.
Fair value for our CDO of ABS transaction was estimated using a discounted cash flow analysis. We estimated cash flows for the transaction based on our internal credit analysis, which was based on the current performance of each security. The estimated fair value of the underlying collateral securities was determined using either observed market transactions, including broker-dealer quotes and actual trade activity on similar bonds, or expected cash flows discounted using the yield observed on similar bonds. The present value of the insured cash flows (which represented the VIE debt) was determined using a risk-free rate that is applied to the cash flows adjusted for Radian’s non-performance risk.
Prior to the termination of the contract in the second quarter of 2012, the VIE debt and derivative liability within our CDO of ABS transaction were consolidated and categorized in Level III of the fair value hierarchy. The fair value of the VIE debt and other liabilities exceeded the net value of the assets of the VIE; however, because our fair value estimate of the VIE debt incorporated a discount rate that is based on our CDS spread, the fair value was substantially less than our expected ultimate claim payments.
In making our determination of fair value for these credit derivatives, we use information provided to us by our counterparties to these reinsurance transactions, which are the primary insurers (the “primaries”) of the underlying credits, including the primaries’ fair valuations for these credits. The information obtained from our counterparties is not received with sufficient time for us to properly record the mark-to-market liability as of the balance sheet date. Therefore, the amount recorded as of December 31, 2012 is based on the most recent available financial information, which is reported on a quarterly lag. The lag in reporting is consistent from period to period. The fair value is based on credit spreads obtained by the primaries from market data sources published by third parties (e.g., dealer spread tables for collateral similar to assets within the transactions being valued), as well as collateral-specific spreads provided by trustees or obtained from market sources if such data is available. If observable market spreads are not available or reliable for the underlying reference obligations, then the primaries’ valuations are predominantly based on market indices that most closely resemble the underlying reference obligations, considering asset class, credit quality rating and maturity of the underlying reference obligations. In addition, these valuations incorporate an adjustment for non-performance risk. The primaries’ models used to estimate the fair value of these instruments include a number of factors, including credit spreads, changes in interest rates and the credit ratings of referenced entities. In establishing our fair value for these transactions, we assess the reasonableness of the primaries’ valuations by: (1) reviewing the primaries’ publicly available information regarding their mark-to-market processes, including methodology and key assumptions; and (2) analyzing and discussing the changes in fair value with the primaries where the changes appear unusual or do not appear materially consistent with credit loss related information when provided by the primaries for these transactions. These credit derivatives are categorized in Level III of the fair value hierarchy.
We are the primary beneficiary for two other VIEs for which we have provided financial guarantees. These VIEs primarily consist of manufactured housing loans and VIE debt to note holders in the trust. The fair value of the VIE debt related to these other financial guaranty VIEs is estimated based on prices of comparable securities and spreads observed in the market. The overall net fair value for these transactions is determined using a discounted cash flow analysis. We do not currently estimate any projected claims based on our internal credit analysis, which is based on the current performance of the underlying collateral and the remaining subordination available to support the transaction. The present value of the insured cash flows is determined by using a discount rate that is equal to our CDS rate plus a risk-free rate. We utilize this model to determine the fair value of our exposure to these VIEs and to derive the fair value of the assets in these VIEs, which are reported within other assets on our consolidated balance sheets.
Includes unrealized gains and losses relating to assets and liabilities still held as of December 31, 2012 as follows: $1.4 million for investments, $9.5 million for other assets, $(189.7) million for derivative liabilities and $(16.0) million for VIE debt.
The following is a rollforward of Level III assets and liabilities measured at fair value for the year ended December 31, 2011:
At December 31, 2011, our total Level III assets approximated 4.9% of total assets measured at fair value and our total Level III liabilities accounted for 100% of total liabilities measured at fair value. Realized and unrealized gains and losses on Level III assets and liabilities in the rollforward represent gains and losses for the periods in which they were classified as Level III.
There were no investment transfers between Level I and Level II for the years ended December 31, 2012 or 2011.
Represents the range of our CDS spread that a typical market participant might use in the valuation analysis based on the remaining term of the investment.
The significant unobservable inputs in the fair value measurement of our investment securities noted above include an interest rate used to discount the projected cash flows and an expected loss assumption. This expected loss assumption generally represents the principal shortfall we expect on our security as a result of the obligor’s failure to pay. In addition, our other invested assets include a guaranteed investment contract for which the Counterparty’s non-performance risk is considered in the discount rate. Significant increases (decreases) in either the discount rates or loss estimates in isolation would result in a lower (higher) fair value measurement. Changes in these assumptions are independent and may move in either similar or opposite directions.
For our corporate CDOs, we estimate the correlation of the default probability between the corporate entities and Radian-the higher the correlation percentage, the higher the probability that both the corporate entities and Radian will default together. In addition, a widening of the average credit spread increases the expected loss for our transactions, and therefore, increases the related liability.
For our CDOs of CMBS transactions, we use the CMBX index that most directly correlates to our transaction with respect to vintage and credit rating and then we estimate losses by applying a correlation factor. Because we own the senior tranche, an increase in this factor generally increases the expected loss for our transactions and therefore, increases our related liability.
For our other non-corporate CDOs, we utilize the internal credit rating, average remaining life and current par outstanding for each transaction to project both expected losses and an internally developed risk-based capital amount. An increase in the average remaining life typically increases the expected loss of the transactions, and therefore, increases our related liability. An upgrade (downgrade) in the internal credit rating typically decreases (increases) the expected loss of the transactions, and therefore, decreases (increases) our related liability.
In continually assessing our involvement with VIEs, we consider certain events such as the VIE’s failure to meet certain contractual conditions, such as performance tests and triggers, servicer termination events and events of default, that, should they occur, may provide us with additional control rights over the VIE for a limited number of our transactions. The occurrence of these events would cause us to reassess our initial determination of whether we are the primary beneficiary of a VIE. In addition, changes to its governance structure that would allow us to direct the activities of a VIE or our acquisition of additional financial interests in the VIE would also cause us to reassess our determination of whether we are the primary beneficiary of a VIE. Certain of our financial guaranty contracts provide us with substantial control rights over the activities of VIEs upon the occurrence of default or other performance triggers described above. Therefore, additional VIEs may be consolidated by us if these events were to occur. Prior to the occurrence of these contingent conditions, another party (typically the collateral manager, servicer or equity holder) involved with the transaction holds the power to manage the VIE’s assets and to impact the economic performance of the VIE, without our ability to control or direct such powers.
For GAAP accounting purposes, we evaluated the LPV (a VIE) to determine if we would be considered the primary beneficiary of the VIE. We have the obligation to absorb the majority of the VIE’s losses and the right to receive the majority of any remaining funds through our residual interest agreement. In addition, we have the ability to impact the activities of the VIE in certain limited ways that could impact the economic performance of this VIE. As a result of these obligations and rights, we have concluded that we are the primary beneficiary of the VIE. The consolidated assets of the LPV primarily consist of a guaranteed investment contract that is presented within other invested assets, which would be used to settle any obligations of this VIE under the Residual CDS. The Residual CDS represents the liability of the VIE for which the Counterparty does not have recourse to our general credit for this consolidated liability. The Residual CDS held by the LPV is carried at fair value and we have also elected to carry the investments at fair value.
We also consolidate the assets and liabilities associated with two other financial guaranty transactions. In these transactions, we provide guarantees for VIEs that own manufactured housing loans. Prior to their consolidation, these transactions had been accounted for as insurance contracts. Due to the contractual provisions that allow us to replace and appoint the servicer who manages the collateral underlying the assets of the transactions, we concluded that we have the power to direct the activities of these VIEs. In addition, as the guarantor of certain classes of debt issued by these VIEs, we have the obligation to absorb losses that could be significant to these VIEs. The assets of these VIEs may only be used to settle the obligations of the VIEs, while due to the nature of our guarantees, creditors have recourse to our general credit as it relates to the VIE debt. However, due to the seniority of the bonds we insure in these transactions, we do not expect to incur a loss from our involvement with these two VIEs; as such, we did not have a net liability recorded for these transactions as of December 31, 2012.
The following tables provide a summary of our maximum exposure to losses and the financial impact on our consolidated balance sheets, our consolidated statements of operations and our consolidated statements of cash flows as of and for the periods indicated, as it relates to our consolidated and unconsolidated financial guaranty insurance contracts and credit derivative VIEs:
The difference between the carrying amounts of the net asset/liability position and maximum exposure related to VIEs is primarily due to the difference between the face amount of the obligation and the recorded fair values, which include an adjustment for our non-performance risk. The maximum exposure is based on the net par amount of our insured obligation as of the reporting date.
As of December 31, 2009, we had consolidated the assets and liabilities of two of the CPS trusts with which we were involved as we had acquired a majority of the securities issued by these two trusts at that date. We purchased substantially all of the securities issued by the remaining CPS trust in 2010 and we consolidated the assets and liabilities of that trust during 2010. We recognized a loss of $13.9 million within net (losses) gains on other financial instruments upon consolidation in 2010, based on the difference between the consideration paid for the CPS trust securities and the net amount of the trust’s identifiable assets and liabilities recognized and measured at fair value at the date of consolidation.
Based on our involvement in these trusts, combined with the put options Radian Asset Assurance held on these trusts (which together were considered in the determination of the primary beneficiary), we concluded that we were the party that directed the activities that most significantly influenced the economic performance of these VIEs and had the right to receive benefits that would be significant to these VIEs. Therefore, given that we had a variable interest in each of these VIEs, we concluded that we were the primary beneficiary. As such, the assets and liabilities of these trusts were consolidated at their respective fair values, net of liabilities to us. The assets of the consolidated trusts were reported in short-term investments.
During the first quarter of 2012, Radian Group and its subsidiaries converted the custodial trusts to corporations that are wholly-owned consolidated subsidiaries of Radian Group and are no longer considered VIEs. The amount of income and expense, as well as cash flows associated with these trusts, was immaterial during 2012 and 2011.
The maximum exposure is based on our carrying amounts of the investments.
Comprising broadly diversified domestic equity mutual funds ($98.9 million fair value) and various preferred and common stocks invested across numerous companies and industries ($13.2 million fair value).
Comprising broadly diversified domestic equity mutual funds ($116.0 million fair value) and various preferred and common stocks invested across numerous companies and industries ($12.4 million fair value).
Our largest concentrations of foreign government securities as of December 31, 2012 and 2011 were Japan ($56.4 million and $28.0 million fair value, respectively) and Germany ($22.1 million and $42.6 million fair value, respectively). As of December 31, 2012 and 2011, nearly all of our foreign government securities were rated A or higher by a nationally recognized statistical rating organization. As of December 31, 2012 and 2011, our trading portfolio included no foreign sovereign or sub-sovereign securities of the six European countries (Portugal, Ireland, Italy, Greece, Spain and Hungary) whose sovereign and sub-sovereign obligations have been under particular stress due to economic uncertainty, potential restructuring and ratings downgrades or securities of any other countries under similar stress.
At December 31, 2010, we had gross unrealized losses, related to state and municipal obligations, that primarily represented our interests in certain bonds held in our available for sale portfolio that were issued as part of securitizations collateralized by the Master Settlement Agreement among certain domestic tobacco manufacturers and 46 states and certain territories. During the second quarter of 2011, we sold all of our interests in these bonds, realizing a loss on the sale of $53.7 million on proceeds received of $94.3 million. Although we expected the present value of cash flows ultimately to be collected from each security to be sufficient to recover our amortized cost basis, we concluded that the risk profile of these bonds no longer suited our current portfolio objectives, and as a result, changed our prior intent to hold these bonds until maturity and instead disposed of these securities during the second quarter of 2011.
For the years ended December 31, 2012, 2011 and 2010, we did not sell or transfer any fixed-maturity investments classified as held to maturity. For the years ended December 31, 2012 and 2011, we did not transfer any securities from the available for sale or trading categories. During 2010, we recorded $3.1 million in gains on securities transferred from the available for sale category into the trading category.
At December 31, 2012 and 2011, we did not have the intent to sell any debt securities in an unrealized loss position and we determined that it is more likely than not that we will not be required to sell the securities before recovery of their cost basis.
At December 31, 2012, investments in any person and its affiliates that exceeded 10% of total stockholders’ equity were as follows:
Securities on deposit with various state insurance commissioners amounted to $18.0 million and $21.1 million at December 31, 2012 and 2011, respectively. We also had $172.6 million and $116.4 million (book value) of securities pledged as collateral in accordance with various reinsurance agreements at December 31, 2012 and 2011, respectively.
In the fourth quarter of 2012, Radian Guaranty and the same third-party reinsurance provider agreed to the terms of the Second Quota Share Reinsurance Transaction, which provides for additional reinsurance for Radian Guaranty’s NIW, as further described below. As of December 31, 2012, the amount ceded pursuant to this transaction was $368.4 million of Radian Guaranty’s RIF. The limitation on ceded risk is $750 million initially and the parties have the ability to mutually increase the amount of ceded risk up to a maximum of $2 billion. The agreed upon terms also provide that, effective as of December 31, 2015, Radian Guaranty will have the ability, at its option (the “Commutation Option”), to commute one-half of the reinsurance ceded with respect to conventional GSE loans, which would result in Radian Guaranty reassuming the related RIF in exchange for a payment of a predefined commutation amount from the reinsurer. Pursuant to the agreed upon terms:
Radian Guaranty will cede to the reinsurer 20% of all premiums and losses incurred with respect to conventional GSE loans and will initially receive a 35% ceding commission; provided, that if we do not exercise our Commutation Option, the ceding commission will be reduced to 30% for the portion of the ceded RIF that was subject to the Commutation Option; and
Radian Guaranty has the ability to cede 100% of all premiums and losses incurred with respect to non-conventional portfolio loans and will receive a 25% ceding commission. We do not expect the volume of such portfolio loans to be material.
In most cases, the risk assumed by the reinsurance company was an excess layer of aggregate losses that would be penetrated only in a situation of adverse loss development. During the recent housing and related credit market downturn in which losses have increased significantly, most all captive reinsurance arrangements have attached, requiring our captive reinsurers to make payments to us. In all cases, the captive reinsurer established a trust to secure our potential cash recoveries. We generally are the sole beneficiary under these trusts, and therefore, have the ability to initiate disbursements under the trusts in accordance with the terms of our captive reinsurance agreements.
Approximately $0.4 billion (or 1.1%) and $0.8 billion (or 2.7%) of our primary mortgage RIF was ceded through Smart Home reinsurance transactions at December 31, 2012 and 2011, respectively.
All of our existing captive reinsurance arrangements are operating on a run-off basis, meaning that no new business is being placed in these captives. In 2010, we terminated many of our remaining captive reinsurance arrangements on a “cut-off” basis, meaning that the terminated captive arrangements were dissolved and all outstanding liabilities to us were settled. In the fourth quarter of 2010, we terminated two large captive reinsurance arrangements representing $6.0 billion of RIF. In connection with these terminations, we received $321 million of cash and investments from the captive trust account, which are accounted for as claims recoveries. As of December 31, 2012 , we have received total cash reinsurance recoveries (including recoveries from terminations) from Smart Home and captive reinsurance arrangements of approximately $835.7 million since inception of these programs, with most of these recoveries coming from captive reinsurance arrangements. In some instances, we anticipate that the ultimate recoveries from the captive reinsurers will be greater than the assets currently held by the segregated trusts established for each captive reinsurer. Recorded recoverables, however, are limited to the current trust balances. We expect that most of the actual cash recoveries from those captives that have not yet been terminated will be received over the next few years.
The reinsurance recoverable amounts on paid losses are considered to be financing receivables in accordance with the accounting standard regarding accounts receivable, which includes disclosure requirements regarding the credit quality of financing receivables and the allowance for credit losses. We do not record an allowance for credit losses on reinsurance recoverables, as the reinsurance recoverable amounts for both paid and unpaid losses are fully collateralized in the segregated trusts. Therefore, credit exposure is limited to the credit quality of investments held by the trust. Trust assets related to our captive and Smart Home arrangements are required to be invested in investment grade securities. As of December 31, 2012, the trust assets for these trust accounts consisted primarily of cash equivalents, money market investments and investment grade securities.
The following tables present information related to our captive and Smart Home transactions as of the dates indicated:
Approximately 44.3% of our total ceded losses recoverable at December 31, 2012 were related to two captive reinsurers.
While the aging of defaulted loans and other changes in the composition of our delinquent loan inventory, including the rate of claims being submitted, continued to impact our reserves and incurred losses during 2012, the magnitude of such impacts has declined compared to prior periods. Adjustments are made to loss reserves as defaulted loans age, and therefore, are considered to be closer to foreclosure and more likely to result in a claim payment. With continuing declines in home values in certain markets, persistently high unemployment and delays by servicers in either modifying loans or foreclosing on properties, the time it has taken to cure or otherwise resolve a delinquent loan has been prolonged. Consequently, in recent years, our default inventory has experienced an increase in its weighted average age, and because we apply higher estimated default to claim rates on our more aged delinquent loans, this has resulted in a higher reserve per default. As a consequence, our aggregate weighted average default to claim rate assumption (net of rescissions and denials) used in estimating our reserve for losses was 47% at December 31, 2012, compared to 43% and 40% at December 31, 2011 and 2010, respectively. Our default to claim rate estimate varies depending on the age of the underlying defaulted loans, as measured by the number of monthly payments missed. As of December 31, 2012, our aggregate weighted average default to claim rate estimate excluding pending claims, net of our estimate for insurance rescissions and claim denials, was 39% and ranged from 20% for insured loans that had missed two to three monthly payments to 46% for insured loans that had missed 12 or more monthly payments.
The most significant driver of the $557.8 million prior year adverse development in 2010 related to the impact from the aging of underlying defaulted loans, which increased our weighted average default to claim rate beyond the extent we expected at December 31, 2009. The protracted amount of time it took for servicers to resolve certain aged loans extended the period of uncertainty with regard to our ultimate claim liability beyond what we predicted at the time the reserves were established. To a lesser extent, the increase in our default to claim rate in 2010 was also impacted by a decrease in our expected levels of insurance rescissions and claim denials associated with prior year defaults, as compared to expected levels at December 31, 2009. This change in our estimate was a result of changes in observed trends during 2010. In addition, an increase in our severity estimates, primarily due to refinements in estimates on pool insurance defaults, negatively impacted our reserves related to defaults reported in prior years.
Our reported rescission and denial activity in any given period is subject to challenge by our lender customers. Recent insurance rescission and claim denial activity reflects a shift towards more claim denials, which has resulted primarily from the failure of our lender customers to provide the documentation required to perfect a claim. Subsequent to our initial claim denials, lenders have demonstrated an ability to produce the additional information needed to perfect a claim for a significant portion of previously denied claims. As a result of increases in claim denial activity during 2012, we expect that a large number of previously denied claims will be resubmitted with the required documentation and ultimately paid, and we have considered this expectation in developing our IBNR reserve estimate. This IBNR estimate was $323.0 million and $170.6 million at December 31, 2012 and 2011, respectively. For 2012, our IBNR estimate of $323.0 million includes our estimate of future reinstatements of previously rescinded policies and denied claims of $87.7 million and $215.3 million, respectively. These reserves relate to $0.6 billion of claims that were denied within the preceding 12 months and $1.0 billion related to rescinded policies within the preceding 24 months.
We considered the sensitivity of first-lien loss reserve estimates at December 31, 2012 by assessing the potential changes resulting from a parallel shift in severity and default to claim rate. For example, assuming all other factors remain constant, for every one percentage point change in primary claim severity (which we estimate to be 27% of unpaid principal balance at December 31, 2012), we estimated that our loss reserves would change by approximately $87 million at December 31, 2012. For every one percentage point change in pool claim severity (which we estimate to be 45% of unpaid principal balance at December 31, 2012), we estimated that our loss reserves would change by approximately $5 million at December 31, 2012. For every one percentage point change in our overall default to claim rate (which we estimate to be 47% at December 31, 2012, including our assumptions related to rescissions and denials), we estimated a $55 million change in our loss reserves at December 31, 2012.
Deteriorating markets in California and Florida, where non-prime and non-traditional mortgage products such as adjustable rate mortgages and interest-only loans were prevalent and where home prices have fallen significantly, have resulted in significant losses in our mortgage insurance business. During the prolonged period of rising home prices that preceded the current downturn in the U.S. housing market, very few mortgage delinquencies and claims were attributable to insured loans in California, despite the significant growth during this period of riskier, non-traditional mortgage products in this state. As mortgage credit performance in California and Florida has deteriorated, given the size of these markets, our loss experience has been significantly affected and will continue to be negatively affected if conditions do not improve or continue to deteriorate. Approximately 20% of our primary mortgage insurance RIF at December 31, 2012 was concentrated in the states of California and Florida.
Evaluating the expected profitability of our existing mortgage insurance business and the need for a premium deficiency reserve for our first-lien business involves significant reliance upon assumptions and estimates with regard to the likelihood, magnitude and timing of potential losses and premium revenues. The models, assumptions and estimates we use to evaluate the need for a PDR may not prove to be accurate, especially during an extended economic downturn or a period of extreme market volatility and uncertainty as currently exists. We cannot be certain that we have correctly estimated the expected profitability of our existing first-lien portfolio or that the second-lien PDR established will be adequate to cover ultimate losses on our second-lien business.
For our financial guaranty business, no PDR was necessary as of December 31, 2012 or 2011.
Our public finance and structured finance groups utilize several tools to monitor our directly insured portfolio. We generally require, for each of our directly insured transactions, the delivery of periodic financial information, including covenant compliance reports that are reviewed by the risk manager assigned to the particular credit. For substantially all of our direct public finance credits, each risk manager prepares regular written surveillance summaries for each credit that contain financial analysis of the credits. For our larger direct credits and for those credits for which our initial analysis indicates that a more comprehensive review is warranted, the risk manager prepares a more detailed surveillance report that includes additional financial analysis, together with the manager’s reassessment of the internal rating for the transaction. For our directly insured corporate CDO, TruPs CDO and CMBS CDO transactions, we perform quarterly stress analyses and we update our financial analysis on our TruPs CDO and CMBS CDO transactions at least quarterly. We monitor not only the nominal exposure for each obligor for which we provide protection in our corporate CDO transactions, but also risk-adjusted measures, taking into account, among other factors, our assessment of the relative risk that would be represented by direct exposure to the particular obligor and the remaining subordination in the transactions in which we are exposed to a particular obligor.
Case Reserve. This category consists of insured transactions where a payment default on the insured obligation has occurred. LAE reserves are normally required as remediation efforts often continue for credits classified at this level to mitigate claims. Direct and assumed exposures in this category that satisfy certain criteria, including minimum outstanding par thresholds, are generally reviewed quarterly.
purchasing the insured obligation at a discount to its net par outstanding.
A net claim liability is established for a performing credit if there is evidence that credit deterioration has occurred and the expected loss on the credit exceeds the unearned premium revenue for the contract based on the present value of the expected net cash outflows. Included in accounts and notes receivable and unearned premiums on our consolidated balance sheets are the present value of premiums receivable and unearned premiums that are received on an installment basis. The premiums receivable is net of commissions on assumed reinsurance business. The present values of premiums receivable and unearned premiums that are received on an installment basis as of December 31, 2012 and 2011 are as follows:
The weighted-average risk-free rate used to discount the premiums receivable and premiums to be collected was 2.6% at December 31, 2012.
The following table shows the nominal (non-discounted) premiums, net of commissions that are expected to be collected on financial guaranty contracts with installment premiums, included in premiums receivable as of December 31, 2012.
The following table shows the rollforward of the net present value of premiums receivable as of December 31, 2012 and 2011:
Premiums earned were affected by the following for the years ended December 31, 2012 and 2011:
The following table shows the significant components of changes in our financial guaranty claim liability for the years ended December 31, 2012, 2011 and 2010, excluding $2.0 million, $2.5 million and $4.3 million, respectively, related to our trade credit reinsurance and surety business, which is excluded from the accounting standard regarding accounting for financial guaranty insurance contracts by insurance enterprises.
Our financial guaranty loss reserve estimate involves significant judgment surrounding the estimated probability of the likelihood, magnitude and timing of each potential loss based upon different loss scenarios. The probabilities, assumptions and estimates we use to establish our financial guaranty loss reserves are subject to uncertainties, particularly given the current economic and credit environments, including uncertainties regarding our public finance municipal exposures and international sovereign risk exposures. We continue to monitor the uncertainties surrounding our portfolio and it is possible that the actual losses paid could differ materially from our present estimates.
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. In April 2004, we entered into interest-rate swap contracts that effectively converted the interest rate on this fixed-rate debt to a variable rate based on a spread over the six-month London Interbank Offered Rate (LIBOR). We terminated these swaps in January 2008. The basis adjustment of $11.5 million that resulted from the interest-rate swaps, and that was recorded as an increase to the long-term debt carrying value, was amortized to interest expense over the remaining term of the debt.
Both the notes issued in February 2003, the notes issued in June 2005 and the New Notes issued in January 2013 have covenants customary for securities of this nature, including covenants related to the payments of the notes, reports, compliance certificates, modification of the covenants and the Company maintaining its office or agency and existence. Additionally, the indentures governing these notes include covenants restricting the Company from encumbering the capital stock of a designated subsidiary (as defined in the respective indentures for the notes) or disposing of any capital stock of any designated subsidiary unless either all of the stock is disposed of or the Company retains more than 80% of the stock with ordinary voting rights.
Holders of the notes will be able to exercise their conversion rights prior to the Conversion Period, subject to certain conditions, only under the following circumstances:
Included within additional paid-in capital, net of capped call transactions and related issuance costs.
The following table sets forth total interest expense recognized related to the convertible notes for the periods indicated:
As noted above, the indentures for each of the Company’s outstanding notes include provisions generally customary for such securities. Furthermore, the indenture for the 2017 Convertible Senior Notes includes, among other terms, provisions under which the bankruptcy of the Company or the appointment of a receiver for the Company or for certain of its subsidiaries or other material assets would constitute an event of default under the indenture. Upon such a default, the note holders of the 2017 Convertible Senior Notes could declare the notes due and payable (which may, under certain circumstances, be automatically accelerated), which would constitute an event of default under the indentures for the 5.375% Senior Notes due 2015 and the 9.000% Senior Notes due 2017 (which were issued in January 2013 as part of the Exchange Offer). As described in Note 1, certain events could cause our applicable insurance regulator to appoint a receiver for our insurance subsidiaries. If this occurred, it would, unless waived by a majority of the note holders, constitute an event of default under the indenture for the 2017 Convertible Senior Notes, and therefore, also cause an event of default under the indentures for the 5.375% Senior Notes due 2015 and the 9.000% Senior Notes due 2017 (which were issued in January 2013).
The components of our consolidated income tax provision are as follows:
As of December 31, 2012, we recorded a net current income tax payable of approximately $132.7 million, which primarily consists of liabilities related to applying the standards of accounting for uncertainty in income taxes and a current federal income tax recoverable of approximately $8.1 million. For federal income tax purposes, we have approximately $1.9 billion of NOL carryforwards and $26.3 million of foreign tax credit carryforwards as of December 31, 2012. To the extent not utilized, the NOL carryforwards will expire during tax years 2028 through 2032 and the foreign tax credit carryforwards will expire during tax years 2018 through 2020. Certain entities within our consolidated group have also generated DTAs of approximately $31.7 million relating to state and local NOL carryforwards, which if unutilized, will expire during various future tax periods. During 2011, we recognized approximately $728.0 million of estimated cancellation of indebtedness taxable income resulting from our partnership interest in C-BASS, which filed for Subchapter 11 bankruptcy protection on November 12, 2010 and was formally liquidated pursuant to the Plan of Liquidation that was confirmed on April 25, 2011. During 2012, C-BASS amended its 2011 federal tax return and, as a result, our share of cancellation of indebtedness taxable income decreased to approximately $667.0 million. Such cancellation of indebtedness income was fully offset by our NOLs.
A valuation allowance of approximately $989.7 million and $797.7 million was recorded against our net DTA of approximately $989.7 million and $813.7 million at December 31, 2012 and 2011, respectively. The remaining DTA of approximately $16.0 million at December 31, 2011 represented our NOL carryback, which we expected to utilize as part of an overall settlement of proposed Internal Revenue Service (”IRS”) adjustments relating to tax years 2000 through 2007. For the year ended December 31, 2012, our valuation allowance increased by approximately $192.0 million, of which approximately $3.7 million of the increase was included in other comprehensive income. Additionally, approximately $16.0 million of the 2012 increase resulted from recent developments regarding our IRS Office of Appeals (”Appeals”) settlement efforts, which leads us to believe that a settlement with Appeals is no longer likely, as discussed in more detail below.
The effect of unrecognized tax benefits on our consolidated balance sheets and results of operations is as follows:
In the event we are not successful in defense of our tax positions taken for U.S. Federal income tax purposes, and for which we have recorded unrecognized tax benefits, then such adjustments originating in NOL or NOL carryback years may serve as a reduction to our existing NOL.
Radian Group serves as the holding company for our insurance subsidiaries, through which we conduct the business of our mortgage insurance and financial guaranty business segments. These insurance subsidiaries are subject to various requirements of the GSEs and our insurance regulators, including comprehensive, detailed regulation by the insurance departments in the various states where our insurance subsidiaries are domiciled or licensed to transact business. These regulations include various capital requirements and dividend restrictions based on our insurance subsidiaries’ statutory financial position and results of operations, as described below. As of December 31, 2012, the amount of restricted net assets held by our consolidated insurance subsidiaries (which represents our equity investment in those insurance subsidiaries) totaled $1.2 billion of our consolidated net assets.
Radian Guaranty’s statutory net loss, statutory surplus and contingency reserve as of and for the years ended December 31, 2012, 2011 and 2010 were as follows:
Radian Guaranty’s risk-to-capital calculation appears in the table below. For purposes of the risk-to-capital requirements imposed by certain states, statutory capital is defined as the sum of statutory policyholders’ surplus (i.e., statutory capital and surplus) plus statutory contingency reserves.
RIF, net excludes risk ceded through reinsurance contracts (to both external parties as well as subsidiaries and affiliates) and RIF on defaulted loans.
Radian Mortgage Insurance is required to maintain a minimum statutory surplus of $20 million to remain an authorized reinsurer in all states. Radian Mortgage Insurance received capital contributions totaling $60 million in 2012 to improve its risk-to-capital position in conjunction with the transfer of risk under the intercompany reinsurance agreement executed in 2012. Radian Mortgage Insurance had no contingency reserves at December 31, 2012, 2011 or 2010. Radian Mortgage Insurance’s statutory net income (loss) and statutory policyholders’ surplus as of and for the years ended December 31, 2012, 2011 and 2010 were as follows:
CMAC of Texas’ ability to declare dividends on its common stock is restricted by certain provisions of the insurance laws of the State of Texas, its state of domicile. The insurance laws of the State of Texas limit the maximum amount of dividends that may be paid from positive unassigned surplus by an insurer without prior approval by the Texas Insurance Commissioner. Under such test, CMAC of Texas may pay dividends during any 12-month period in an amount equal to the greater of: (i) 10% of the preceding year-end statutory policyholders’ unassigned surplus; or (ii) the preceding year-end statutory net income. In accordance with such restrictions, no dividends may be paid by CMAC of Texas in 2013, without prior regulatory approval.
CMAC of Texas is required to maintain a minimum statutory surplus of $20 million to remain an authorized reinsurer in all states.
Due to current expectations with respect to the credit performance of the Terminated TruPs Bonds, we have established an associated salvage recovery for statutory accounting purposes, which as of December 31, 2012 was approximately $76.3 million and is included in Radian Asset Assurance’s and Radian Guaranty’s statutory surplus as of December 31, 2012. Although Radian Asset Assurance has no further obligation for claims related to the Terminated TruPs CDOs, the amount of salvage recovery remains at risk and the actual amount of salvage that we ultimately recover will depend on the future performance of the Terminated TruPs Bonds, including, in the case of four of the Terminated TruPs CDOs, the risk that an event of default occurs and is continuing after 2016 or 2017, as applicable. If such event of default were to occur, it would result in a loss for such Terminated TruPs CDO that would be determined based on the difference between the par value and the market value thereof. If the LPV is required to make payments to the Counterparty pursuant to the terms of the Residual CDS, Radian Asset Assurance’s projected and actual salvage recovery from the LPV may be materially reduced or eliminated.
We prepare our statutory financial statements in accordance with the accounting practices required or permitted, if applicable, by the insurance departments of the respective states of domicile of our insurance subsidiaries. Required statutory accounting practices include a variety of publications of the National Association of Insurance Commissioners (“NAIC”) as well as state laws, regulations and general administrative rules. In addition, insurance departments have the right to permit other specific practices that may deviate from prescribed practices. We did not use any such permitted practices during the years ended December 31, 2012, or 2011.
(c) Under STAT, insurance policy acquisition costs are charged against operations in the year incurred. Under GAAP, such costs, other than those incurred in connection with the origination of derivative contracts, are deferred and amortized.
(e) Under STAT, investment grade fixed-maturity investments are valued at amortized cost and below investment grade securities are carried at the lower of amortized cost or market value. Under GAAP, those investments that the statutory insurance entities do not have the ability or intent to hold to maturity are considered to be either available for sale or trading securities and are recorded at fair value, with the unrealized gain or loss recognized, net of tax, as an increase or decrease to stockholders’ equity or current operations, as applicable.
(i) Under STAT, the accounting standard regarding accounting for transfers and servicing of financial assets and extinguishment of liabilities and the accounting standard regarding consolidation of VIEs are not applicable.
We have an equity compensation plan, the Radian Group Inc. 2008 Equity Compensation Plan (the “2008 Equity Plan”), pursuant to which we grant equity awards. The 2008 Equity Plan replaced our prior equity plan, the 1995 Equity Compensation Plan (the “1995 Equity Plan” and together with the 2008 Equity Plan, the “Equity Plans”). In adopting the 2008 Equity Plan, we agreed not to grant any new awards under the 1995 Equity Plan. The last awards granted pursuant to the 1995 Equity Plan were granted in 2008. All awards granted under the Equity Plans have been in the form of non-qualified stock options, restricted stock, restricted stock units (“RSUs”), stock appreciation rights (“SARs”) and phantom stock. The maximum contractual term for all awards under the Equity Plans is 10 years.
The 2008 Equity Plan authorizes the issuance of up to 6,417,000 shares of our common stock, of which there were 1,329,689 shares remaining available for grant as of December 31, 2012 (the “share reserve”). Each grant of restricted stock, RSUs, phantom stock or performance share awards under the 2008 Equity Plan (other than those settled in cash) reduces the reserve available for grant under the 2008 Equity Plan by 1.19 shares for every share subject to such grant (1.33 shares for grants made prior to May 13, 2009 and 1.14 shares for grants made on and after May 13, 2009 and prior to May 11, 2011). Awards under the 2008 Equity Plan that provide for settlement solely in cash (and not common shares) do not count against the share reserve. Absent this reserve adjustment for restricted stock, RSUs, phantom stock or performance share awards, our shares remaining available for grant under the 2008 Equity Plan would have been 1,768,249 shares as of December 31, 2012.
We use the Monte Carlo valuation model to determine the fair value of all cash settled awards where stock price is a factor in determining the vesting, as well as for cash or stock settled performance awards where there exists a similar stock price based market condition (we refer to these awards as “Market Condition Awards”). The Monte Carlo valuation model incorporates multiple input variables, including expected life, volatility, risk-free rate of return and dividend yield for each award to estimate the probability that a vesting condition will be achieved. In determining these assumptions for the Monte Carlo valuations, we consider historic and observable market data.
The following table reflects additional information regarding all market condition awards for the years indicated:
Performance-Based RSUs-In 2012 and 2011, the Compensation Committee granted a total of 2,211,640 and 3,004,730, respectively, of performance-based RSUs (to be settled in cash) to eligible officers under the 2008 Equity Plan. These performance-based RSUs entitle grantees to a cash amount equal to the fair market value of RSUs that have vested at the end of a three-year performance period.
Vesting of awards granted to executive officers in 2012 is dependent upon Radian Group’s absolute “total stockholder return” (“TSR”) and Radian Group’s relative TSR compared to the relative TSR of the companies listed on the NASDAQ 100 Financial Index and our most directly comparable mortgage insurance peers (the “2011 and 2012 TSR Peer Groups”), with a maximum payout at the end of the three-year performance period of 200% of a grantee’s target number of RSUs. If Radian Group’s absolute TSR during the performance period is negative, the payout of the performance-based RSUs awarded will be at 0% and none of the performance-based RSUs will vest. If Radian Group’s absolute TSR is positive, the payout will be determined based on an analysis of both Radian Group’s relative TSR and absolute TSR, beginning with an assessment of Radian Group’s relative TSR.
Vesting of awards granted to non-executives in 2012 and to both non-executives and executives in 2011 is dependent upon the performance of Radian Group’s TSR compared to TSRs of the 2011 and 2012 TSR Peer Groups, with a maximum payout at the end of the three-year performance period of 200% of a grantee’s target number of RSUs.
The weighted average fair value per share of the stock options granted during 2012, 2011 and 2010 was $1.92, $3.33 and $8.70, respectively. There were no stock options exercised in 2012, 2011 or 2010. The intrinsic value for the stock options outstanding at December 31, 2012 was $7.8 million, based on the closing price of our common stock as of December 31, 2012, relative to the exercise prices for such stock options. There was no intrinsic value for the stock options outstanding at December 31, 2011 due to the exercise prices for such stock options exceeding the closing price of our common stock. The total intrinsic value of options outstanding at December 31, 2010 was $2.5 million.
In 2012, we used the Monte Carlo valuation model in determining the grant date fair value of stock options issued to executives and non-executives. Prior to 2012, we used the Black-Scholes valuation model in determining the grant date fair value of stock options issued to executives, non-executives and non-employee directors. Each of these was determined using the assumptions noted in the following table:
In 2012, we began using a Monte Carlo valuation, which assumes a derived service period of between 3.14 years and 4 years instead of an expected life assumption.
In the past, the Compensation Committee has granted phantom stock awards under the Equity Plans, which entitle grantees to receive shares of our common stock on the conversion date (generally defined as a grantee’s termination of service with us). The estimated fair value of phantom stock is based on the closing share price of our common stock as reported by the NYSE on the date of grant. All outstanding shares of phantom stock were fully vested as of December 31, 2010. Each share of phantom stock was granted at full value with no exercise price and accrues dividend equivalents until the conversion (as defined above). Upon conversion, all phantom stock will be paid in whole shares of our common stock, with fractional shares paid in cash. At December 31, 2012, there were approximately 4,899 dividend-equivalent phantom shares accrued that were not included in the total number of our outstanding shares. The cost recognized for these awards was recognized on a straight-line basis over the vesting period.
Performance-Based RSUs-In 2010, the Compensation Committee granted to executive officers a total of 203,300 performance-based RSUs to be settled in common stock. No performance-based RSUs (equity settled) were awarded in 2012 or 2011. The performance, vesting conditions and potential payouts relative to target for the 2010 performance-based RSUs are the same as those described above under “RSUs (Cash Settled)-Performance-Based RSUs” for awards granted in 2010.
In 2009, the Compensation Committee granted 375,500 shares of restricted stock. No shares of restricted stock were granted during 2012, 2011 or 2010. The estimated fair value of restricted stock is based on the closing share price of our common stock on the NYSE on the date of grant. All restrictions imposed under a restricted stock grant lapse after the applicable restriction period. The holders of restricted stock are entitled to vote their restricted shares and to receive cash dividends. Each share of restricted stock is granted at full value with no exercise price. The restricted stock vests 50% after three years and 50% after four years. The cost recognized for these awards is based on the fair value at date of grant and is recognized over the applicable vesting period.
As of December 31, 2012, 2011 and 2010, unrecognized compensation expense related to the unvested portion of all of our market condition awards was approximately $22.4 million, $7.4 million and $7.8 million, respectively. Absent a change of control under the Equity Plans, this expense is expected to be recognized over a weighted average period of approximately two years.
The Savings Plan covers substantially all our full-time and all our part-time employees. Participants can contribute up to 100% of their base earnings as pretax and/or after-tax (Roth IRA) contributions up to a maximum amount of $17,000 for 2012. The Plan also includes a catch-up contribution provision whereby participants who are or will be age 50 and above during the Plan year, may contribute an additional contribution. The maximum catch-up contribution for Plan Year 2012 was $5,500. We will match up to 100% of the first 6% of base earnings contributed in any given year. Our expense for matching funds for the years ended December 31, 2012, 2011 and 2010 was $2.9 million, $3.5 million and $3.5 million, respectively.
provide for the immediate vesting of 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;
We provided certain healthcare and life insurance benefits to our retired employees who were hired before January 1, 1990, under a postretirement welfare plan (the “Postretirement Welfare Plan”). Until its curtailment on August 31, 2002, one of our subsidiaries, Enhance Financial Services Group Inc. (“EFSG”), had a plan that provided certain healthcare benefits for retired employees. The expense for postretirement benefit plans for the years ended December 31, 2012, 2011 and 2010 was immaterial to our financial statements. We accrue the estimated cost of retiree medical and life benefits over the period during which employees render the service that qualifies them for benefits.
We have a voluntary deferred compensation plan for senior officers and a voluntary deferred compensation plan for our directors. The voluntary deferred compensation plans allow: (1) senior officers to defer receipt of all or a portion of their annual cash incentive award; and (2) directors to defer receipt of all or a portion of their cash compensation and/or the payment date of their equity compensation. Under the plans, a participant must make a binding written election before the year in which compensation is to be earned to defer compensation payouts for at least two full calendar years beyond the year in which such compensation would have been paid.
We are routinely involved in a number of legal actions and proceedings. The outcome of legal proceedings is often uncertain. Legal proceedings could result in adverse judgments, settlements, fines, injunctions, restitutions or other relief that could require significant expenditures or have other effects on our business. In accordance with applicable accounting standards and guidance, we establish accruals for a legal proceeding only when we determine both that it is probable that a loss has been incurred and the amount of the loss is reasonably estimable. We accrue the amount that represents our best estimate of the probable loss; however, if we can only determine a range of estimated losses, we accrue an amount within the range that, in our judgment, reflects the most likely outcome, and if none of the estimates within the range is more likely, we accrue the minimum amount of the range.
Any loss estimates are inherently subjective, based on currently available information, and are subject to management’s judgment and various assumptions. Due to the inherently subjective nature of these estimates and the uncertainty and unpredictability surrounding the outcome of legal proceedings, actual results may differ materially from any amounts that have been accrued.
On August 13, 2010, American Home Mortgage Servicing, Inc. (“AHMSI”) filed a complaint against Radian Guaranty in the U.S. District Court for the Central District of California, on its own behalf and as servicer for certain residential mortgage-backed securities insured by Radian Guaranty under 27 separate bulk primary mortgage insurance policies. AHMSI contends that in 2008, it mistakenly sent cancellation notices to Radian Guaranty for certain loans covered under these policies and that Radian Guaranty wrongfully refused to reinstate coverage for these loans after AHMSI discovered the error. We believe that approximately 680 loans, which relate to approximately $20.0 million of RIF, were affected by this error. According to AHMSI, Radian Guaranty’s refusal to reinstate coverage was in breach of its contractual duties under the policies and in bad faith. AHMSI is seeking money damages and injunctive relief requiring Radian Guaranty to reinstate full coverage on all loans insured under the policies. On October 18, 2010, Radian Guaranty filed a motion to dismiss this case, which the court granted on December 16, 2010, stating that AHMSI failed to establish that it is the real party in interest. On January 5, 2011, AHMSI filed an amended complaint that included the trustees of these residential mortgage-backed securities as additional plaintiffs to the complaint. On May 31, 2011, Radian answered the amended complaint and, subsequently, filed a counterclaim seeking a declaratory judgment that, among other things, it is not in breach of its contractual duties. Radian also filed, and the court subsequently dismissed, a third party complaint against Sand Canyon Corporation, the servicer who allegedly made the error that led to the cancellation of the certificates of insurance, seeking indemnity and/or contribution. We expect that we will ultimately resolve this legal matter through a combination of the reinstatement of certain performing loans and payment of an amount to the plaintiff that is not expected to have a material impact on our liquidity, results of operations or financial condition.
We have been named as a defendant in a number of putative class action lawsuits alleging, among other things, that our captive reinsurance agreements violate the Real Estate Settlement Practices Act of 1974 (“RESPA”). On December 9, 2011, an action titled Samp v. JPMorgan Chase Bank, N.A. (the “Samp case”), was filed in the U.S. District Court for the Central District of California. The defendants are JPMorgan Chase Bank, N.A., its affiliates (collectively, “JPMorgan”), and several mortgage insurers, including Radian Guaranty. The plaintiffs purport to represent a class of borrowers whose loans allegedly were referred to mortgage insurers by JPMorgan in exchange for reinsurance agreements between the mortgage insurers and JPMorgan’s captive reinsurer. Plaintiffs assert violations of RESPA. Radian Guaranty and some of the other mortgage insurer defendants moved to dismiss this lawsuit for lack of standing because they did not insure any of the plaintiffs’ loans. The court denied that motion on May 7, 2012, and on October 4, 2012, Radian Guaranty filed a new motion to dismiss on a number of grounds. On December 21, 2012, plaintiffs filed an opposition to that motion.
On March 12, 2012, a putative class action under RESPA titled McCarn v. HSBC USA, Inc., et al. was filed in the U.S. District Court for the Eastern District of California. Radian Guaranty moved to dismiss this lawsuit for lack of standing because it did not insure the plaintiff’s loan. The court granted that motion on May 29, 2012, but gave the plaintiff permission to file an amended complaint to attempt to address his lack of standing. On July 30, 2012, the plaintiff filed an amended complaint. Radian Guaranty filed a motion to dismiss the amended complaint for lack of standing on August 16, 2012. On November 13, 2012, the court granted Radian Guaranty’s motion and dismissed the claims with prejudice for lack of standing. On December 4, 2012, the plaintiff voluntarily dismissed his claims against the remaining defendants in this lawsuit.
On April 5, 2012, a putative class action under RESPA titled Riddle v. Bank of America Corporation, et al. was filed in the U.S. District Court for the Eastern District of Pennsylvania. On January 4, 2013, Radian Guaranty moved to dismiss plaintiffs’ claims as barred by the statute of limitations.
On April 19, 2012, a putative class action under RESPA titled Rulison v. ABN AMRO Mortgage Group, Inc., et al. was filed in the U.S. District Court for the Southern District of New York. The plaintiff voluntarily dismissed this lawsuit on July 3, 2012.
On May 18, 2012, a putative class action under RESPA titled Hill, et al. v. Flagstar Bank FSB, et al. was filed in the U.S. District Court for the Eastern District of Pennsylvania. In this case, Radian Guaranty has insured the loan of one of the plaintiffs. On January 28, 2013, plaintiffs filed an amended complaint. Radian Guaranty intends to file a motion to dismiss the complaint.
On May 31, 2012, a putative class action under RESPA titled Barlee, et al. v. First Horizon National Corporation, et al. was filed in the U.S. District Court for the Eastern District of Pennsylvania. On October 9, 2012, plaintiffs filed an amended complaint, and on November 5, 2012, Radian Guaranty filed a motion to dismiss the amended complaint for lack of standing because it did not insure any of the plaintiffs’ loans. Plaintiffs have filed an opposition to the motion to dismiss, and on January 16, 2013, Radian Guaranty filed a reply in further support of its motion to dismiss.
On June 28, 2012, a putative class action under RESPA titled Cunningham, et al. v. M&T Bank Corporation, et al. was filed in the U.S. District Court for the Middle District of Pennsylvania. On October 9, 2012, plaintiffs filed an amended complaint in which they added one borrower whose loan was insured by Radian Guaranty. On December 10, 2012, Radian Guaranty moved to dismiss plaintiffs’ claims as barred by the statute of limitations, and on February 11, 2013, plaintiffs filed an opposition to the motion to dismiss.
In addition to the litigation discussed above, we are involved in litigation that has arisen in the normal course of our business. We are contesting the allegations in each such pending action and management believes, based on current knowledge and after consultation with counsel, that the outcome of such litigation will not have a material adverse effect on our consolidated financial condition. However, the outcome of litigation and other legal and regulatory matters is inherently uncertain, and it is possible that one or more of the matters currently pending or threatened could have an unanticipated effect on our liquidity, financial condition or results of operations for any particular period.
In addition to the private lawsuits discussed above, we and other mortgage insurers have been subject to inquiries from the Minnesota Department of Commerce and the Office of the Inspector General of HUD, requesting information relating to captive reinsurance. The Dodd-Frank Act amended RESPA and transferred the authority to implement and enforce RESPA from HUD to the Consumer Financial Protection Bureau (“CFPB”). In January 2012, we and other mortgage insurers received a request for information and documents from the CFPB relating to captive reinsurance arrangements, and in June 2012, we and other mortgage insurers received a Civil Investigative Demand (“CID”) from the CFPB as part of its investigation to determine whether mortgage lenders and private mortgage insurance providers engaged in acts or practices in violation of the Dodd-Frank Act, RESPA and the Consumer Financial Protection Act. On December 7, 2012, we filed a petition with the CFPB to set aside or modify the CID, which has not yet been ruled upon by the CFPB. We are cooperating with the CFPB in its investigation and are in active discussions with the CFPB with respect to our response to the CID, including various alternatives for resolving this investigation. Various regulators, including the CFPB, state insurance commissioners or state attorneys general may bring actions or proceedings regarding our compliance with RESPA or other laws applicable to our mortgage insurance business. We cannot predict whether additional actions or proceedings will be brought against us or the outcome of any such actions or proceedings.
We are also currently contesting proposed adjustments resulting from the examination by the IRS of our 2000 through 2007 tax years. The IRS opposes the recognition of certain tax losses and deductions that were generated through our investment in a portfolio of non-economic REMIC residual interests currently held by CMAC of Texas. We appealed the proposed adjustments to Appeals and reached a tentative settlement agreement with Appeals. Upon subsequent review and consideration, however, Appeals informed us that it was no longer willing to settle on the originally proposed terms. After several attempts to reach a compromised settlement, we were notified in January 2013 that Appeals rejected our latest offer and plans to issue a formal notice of deficiency within three to six months. Upon receipt of the notice, we will have ninety days to pay the assessed tax liabilities, penalties and interest or petition the U.S. Tax Court to litigate the matter. Litigation of the deficiency amount may result in substantial legal expenses and the litigation process could take several years to resolve. We can provide no assurance regarding the outcome of any such litigation. See Note 16 for additional information.
Under our master insurance policy, any suit or action arising from any right of the insured under the policy must be commenced within two years after such right first arose for primary insurance and within three years for certain other policies, including certain pool insurance policies. We continue to face a number of challenges from certain lender customers regarding our insurance rescissions and claim denials, which have resulted in some reversals of our decisions regarding rescissions or denials. We are currently in discussions with customers regarding rescissions and claim denials, which if not resolved, could result in arbitration or additional judicial proceedings. The assumptions embedded in our estimated default to claim rate on our in-force default inventory includes an adjustment to our estimated rescission and denial rate, to account for the fact that we expect a certain number of policies for which an initial intent to rescind letter has been sent to our lender customers to remain in-force and ultimately to be paid, as a result of valid challenges by such policy holders during the limited period specified in such letters. See Note 10 for further information.
The elevated levels of our rate of rescissions, claim denials and claim curtailments (related to servicer negligence) have led to an increased risk of litigation by lenders, policyholders and servicers challenging our right to rescind coverage, deny claims or curtail claim amounts. Although we believe that our loss mitigation actions are justified under our policies, if we are not successful in defending these actions, we may need to reassume the risk on and increase loss reserves for previously rescinded policies or pay additional claims on curtailed amounts. See Note 10 for further information.
Securities regulations became effective in 2005 that impose enhanced disclosure requirements on issuers of ABS (including mortgage-backed securities). To allow our customers to comply with these regulations at that time, we typically were required, depending on the amount of credit enhancement we were providing, to provide: (1) audited financial statements for the insurance subsidiary participating in the transaction; or (2) a full and unconditional holding company-level guarantee for our insurance subsidiaries’ obligations in such transactions. Radian Group has guaranteed two structured transactions for Radian Guaranty involving approximately $152.5 million of remaining credit exposure as of December 31, 2012.
On March 1, 2011, our subsidiary EFSG sold its 45% interest in the holding company of a Brazilian insurance company, which specializes in surety and agricultural insurance, to another owner for a nominal purchase price. This holding company and its subsidiaries are subject to regulation by The Superintendence of Private Insurance, the regulatory agency responsible for the supervision and control of the insurance market in Brazil. Although EFSG wrote off its entire interest in this company in 2005 and has sold its ownership interest, under Brazilian law, it is possible that EFSG could become liable for its proportionate share of the liabilities of the company related to the period in which EFSG was a significant shareholder, if the company was to become insolvent and had insufficient capital to satisfy its outstanding liabilities. EFSG’s share of the liabilities of the company attributable to this period was approximately $103.4 million as of December 31, 2010, the date of the most recent financial information available to us.
Our mortgage insurance business provides an outsourced underwriting service to its customers known as contract underwriting. Typically, we agree that if we make a material error in underwriting a loan, we will provide a remedy to the customer, by purchasing the loan or placing additional mortgage insurance coverage on the loan, or by indemnifying the customer against loss up to a maximum specified amount. By providing these remedies, we assume some credit risk and interest-rate risk if an error is found during the limited remedy period in the agreements governing our provision of contract underwriting services. Recently, we limited the recourse available to our contract underwriting customers to apply only to those loans that are simultaneously underwritten for compliance with secondary market compliance and for potential mortgage insurance. In 2012, we paid losses related to contract underwriting remedies of approximately $8.0 million. Rising mortgage interest rates or further economic uncertainty may expose our mortgage insurance business to an increase in such costs. In 2012, our provision for contract underwriting expenses was approximately $7.2 million and our reserve for contract underwriting obligations at December 31, 2012 was $3.7 million. We monitor this risk and negotiate our underwriting fee structure and recourse agreements on a client-by-client basis. We also routinely audit the performance of our contract underwriters.
We have incentive, retention and severance agreements with certain employees in our financial guaranty business. The total amount expected to be paid under these agreements is $14.5 million, of which $5.6 million of unearned retention has not been recorded as expense as of December 31, 2012. The remaining expense for these agreements is expected to be recorded by the end of 2015.
The commitment for non-cancelable operating leases in future years has not been reduced by future minimum sublease rental payments aggregating approximately $14.1 million at December 31, 2012.
The 2012 and 2011 periods reflect realized gains and losses on investments in connection with the continued reallocation of our investment portfolio and unrealized gains and losses on our trading securities.
The 2012 and 2011 periods primarily reflect fair value gains and losses on our VIE debt.
The results for the fourth quarter of 2012 include the effects of an increase in our IBNR reserve estimate. The provision for losses in the fourth quarter of 2011 was primarily driven by reserves established on new default notices, which increased consistent with seasonal trends.
Net income in the third quarter of 2012 reflects increased gains on investments and a decline in the provision for losses in our mortgage insurance segment. The net loss for the fourth quarter of 2011 was primarily due to an increase in both the mortgage insurance and financial guaranty provision for losses.
Diluted net (loss) income per share and average shares outstanding per the accounting standard regarding earnings per share.
The calculation of the basic and diluted net (loss) income per share was as follows: