At December 31, 2017, we leased office space in various cities throughout the United States under leases expiring between 2018 and 2021 and which required monthly rental payments that in the aggregate are immaterial.
Net income of $355.8 million for 2017 increased by $13.2 million when compared to the prior year, driven by lower losses incurred, net and the absence of significant losses on debt extinguishment in the current year, partially offset by an increase in the provision for income taxes discussed below. Diluted income per share of $0.95 increased by 10% when compared to the prior year.
The loss on debt extinguishment recorded during 2016 reflects the repurchases of a portion of our outstanding 2% and 5% Notes at amounts above our carrying values. The loss on debt extinguishment also reflects MGIC's purchase of a portion of our 9% Debentures for which a loss was recognized as the difference between the fair value and carrying value of the liability component on the purchase date. See Note 7 - "Debt" to our consolidated financial statements for further discussion of the accounting for these transactions.
The increase in our provision for income taxes in 2017 as compared to the prior year was due to a remeasurement of our deferred tax assets to reflect the lower corporate income tax rate under the Tax Act, the increase in income before tax, and an additional tax provision recorded for the expected settlement of our IRS
litigation. See Note 12 - "Income taxes" to our consolidated financial statements for further discussion on the Tax Act and expected IRS settlement.
The private mortgage insurance industry remains intensely competitive and, in some instances, companies have lower premium rates to protect or grow market share. PMI also competes against government mortgage insurance programs such as the FHA, VA, and USDA, primarily for lower FICO score business. The market share of primary mortgage insurance written by government programs continued to exceed that written by PMI in 2017, however PMI recaptured share from those programs due to writing a higher percentage of purchase originations when compared to government programs. Generally, PMI industry share is 3-4 times higher for purchase originations than refinance originations. Amongst private mortgage insurers, our market share increased slightly from the prior year to 18.3% (source: Inside Mortgage Finance).
Refer to Mortgage Insurance Portfolio for additional discussion of the 2017 business environment and the impact it had on operating measures including NIW, IIF and RIF.
A summary of GSE-recommended PMIERs revisions were issued to us late in the fourth quarter of 2017. Refer to "Capital - GSEs" below for a discussion of the impact such revisions are expected to have on our excess Available Assets at their effective date, which is expected to be no earlier than the fourth quarter of 2018.
Our outlook for 2018 should be viewed against the backdrop of the business environment discussed above.
NIW. Our NIW is affected by total mortgage originations, the percentage of total mortgage originations utilizing private mortgage insurance (the "PMI penetration rate") and our market share within the PMI industry. As of late January 2018, total mortgage originations are forecasted to decline in 2018 from 2017 levels due to declines in refinancing originations more than offsetting a slight increase in purchase originations. We expect the PMI penetration rate to increase because historically PMI has captured a share of purchase originations, which are forecast to be a higher percentage of total originations, that is estimated to be 3-4 times greater
than that of refinancing originations. Similar to 2017, an increase in the PMI penetration rate should serve to mitigate the decline in total mortgage originations. Although our expectation is for our 2018 NIW to increase slightly from 2017, this will be highly dependent on the actual size of the mortgage origination market, the mix of originations, and competition.
IIF and RIF. Our book of IIF is the main driver of our revenues and earnings and its growth is driven by our ability to generate NIW and retain existing policies in force, as measured by our persistency. Interest rates influence both our NIW and persistency. In a rising rate environment, we expect cancellation rates to decline, and in turn increase persistency, although the impact generally lags the change in interest rates. Higher interest rates could reduce affordability for borrowers, which could slow housing activity, and of particular importance to our industry, slow first-time home buyer purchase activity, resulting in less NIW. Historically however, purchase origination volume has been impacted more by the level and direction of consumer confidence than by changes in interest rates. We expect our IIF will continue to grow in 2018 due to the level of NIW we expect to write in 2018 and our expected persistency.
In addition to more earned premiums, our revenues are expected to include higher investment income in 2018 due to the increasing size of our investment portfolio, combined with higher average investment yields. We expect 2018 losses incurred with respect to delinquent notices received in the current year (2018) to be lower than the comparable amount for 2017 as we expect to receive fewer new delinquent notices in 2018. We cannot predict the amount, if any, of 2018 losses incurred with respect to delinquent notices received in prior years. The Tax Act will reduce our effective tax rate to approximately 21%, which will reduce the provision for income tax we record against any income before tax. Excluding the impact of remeasuring our net deferred tax assets due to the Tax Act and the additional provision recorded for our expected IRS settlement, our effective tax rate in 2017 would have been approximately 34%.
On December 18, 2017, we received a summary of proposed changes to the PMIERs that are being recommended to the FHFA by the GSEs. Once the PMIERs are finalized, we expect a six-month implementation period before the revised PMIERs are effective. We expect that effectiveness will not be earlier than the fourth quarter of 2018.
If the GSE-recommended changes are adopted with an effective date in the fourth quarter of 2018, we expect that at the effective date, MGIC would continue to have an excess of Available Assets over Minimum Required Assets, although this excess would be materially lower than it was at December 31, 2017 under the existing PMIERs, and that MGIC would continue to be able to pay quarterly dividends to our holding company at the $50 million quarterly rate at which they were paid in the fourth quarter of 2017. As a result, we expect cash at our holding company at December 31, 2018 would increase over what it was at December 31, 2017.
While on an overall basis, the amount of Available Assets MGIC must hold in order to continue to insure GSE loans increased under the PMIERs over what state regulation currently requires, our reinsurance transactions mitigate the negative effect of the PMIERs on our returns.
The NAIC plans to revise the minimum capital and surplus requirements for mortgage insurers that are provided for in its Mortgage Guaranty Insurance Model Act. A working group of state regulators has been considering since 2016 a risk-based capital framework to establish capital requirements for mortgage
The federal government, including through the U.S. Department of the Treasury and the GSEs, and several lenders have modification and refinance programs to make outstanding loans more affordable to borrowers with the goal of reducing the number of foreclosures. These programs included HAMP, which expired at the end of 2016, and HARP, which is scheduled to expire at the end of 2018. The GSEs have introduced other loan modifications programs to replace HAMP.
From 2008 through 2012, we were notified of modifications that cured delinquencies that, had they become paid claims, would have resulted in a material increase in our incurred losses. More recently, the number of modifications has decreased significantly. Nearly all of the reported loan modifications were for loans insured in 2009 and prior.
Table t.01 shows the percentage of our primary RIF that has been modified as of December 31, 2017.
Approximately 15.5% of our total primary RIF has been modified as of December 31, 2017. Based on loan count at December 31, 2017, the loans associated with 96.8% of all HARP modifications and 75.6% of HAMP and other modifications were current.
Cancellations, which reduce IIF. Cancellations due to refinancings are affected by the level of current mortgage interest rates compared to the mortgage coupon rates throughout the in force book, current home values compared to values when the loans in the in force book were insured and the terms on which mortgage credit is available. Home price appreciation can give homeowners the right to cancel mortgage insurance on their loans if sufficient home equity is achieved. Cancellations also result from policy rescissions, which require us to return any premiums received on the rescinded policies, and claim payments, which require us to return any premium received on the related policies from the date of default on the insured loans. Cancellations of single premium policies, which are generally non-refundable, result in immediate recognition of any remaining unearned premium.
Premium rates, which are affected by product type, competitive pressures, the risk characteristics of the insured loans and the percentage of coverage on the insured loans. The substantial majority of our monthly and annual mortgage insurance premiums are under premium plans for which, for the first ten years of the policy, the amount of premium is determined by multiplying the initial premium rate by the original loan balance; thereafter, the premium rate resets to a lower rate used for the remaining life of the policy. However, for loans that have utilized HARP, the initial ten-year period resets as of the date of the HARP transaction. The remainder of our monthly and annual premiums are under premium plans for which premiums are determined by a fixed percentage of the loan’s amortizing balance over the life of the policy.
Premiums ceded, net of a profit commission, under reinsurance agreements. See Note 9 - “Reinsurance” to our consolidated financial statements for a discussion of our reinsurance agreements.
Our investment portfolio is composed principally of investment grade fixed income securities. The principal factors that influence investment income are the size of the portfolio and its yield. As measured by amortized cost (which excludes changes in fair value, such as from changes in interest rates), the size of the investment portfolio is mainly a function of cash generated from (or used in) operations, such as NPW, investment income, net claim payments and expenses, and cash provided by (or used for) non-operating activities, such as debt or stock issuances or repurchases.
The percentage of coverage on insured loans, with deeper average coverage tending to increase incurred losses.
Most of our operating expenses are fixed, with some variability due to contract underwriting volume. Contract underwriting generates fee income included in “Other revenue.” Underwriting and other expenses are net of any ceding commission associated with our reinsurance agreements. See Note 9 - “Reinsurance” to our consolidated financial statements for a discussion of our reinsurance agreements.
Realized gains and losses are a function of the difference between the amount received on the sale of a security and the security’s cost basis, as well as any "other than temporary" impairments ("OTTI") recognized in earnings. The amount received on the sale of fixed income securities is affected by the coupon rate of the security compared to the yield of comparable securities at the time of sale.
Adjusted net operating income (loss) is defined as GAAP net income (loss) excluding the after-tax effects of net realized investment gains (losses), gain (loss) on debt extinguishment, net impairment losses recognized in income (loss), and infrequent or unusual non-operating items, where applicable and the effects of changes in our deferred tax valuation allowance. The amounts of adjustments to components of pre-tax operating income (loss) are tax effected using a federal statutory tax rate of 35%.
Infrequent or unusual non-operating items. Our income tax expense for 2017 reflects the remeasurement of our net deferred tax assets to reflect the lower corporate income tax rate under the Tax Act. Our income tax expense also includes amounts related to our IRS dispute and is related to past transactions which are non-recurring in nature and are not part of our primary operating activities.
Our market share increased in 2017 when compared to 2016. The decline in our market share in 2016 from 2015 levels was due to the overall competitive environment, and we believe the decline was principally attributable to our maintaining greater pricing discipline than certain competitors in LPMI single premium policies. We plan to continue to focus on writing new insurance that meets our risk-adjusted return thresholds across the spectrum of loans we insure and providing market-leading customer service.
Source: Inside Mortgage Finance - February 15, 2018. Includes HARP NIW.
Our persistency at December 31, 2017 was 80.1% compared to 76.9% at December 31, 2016. Since 2000, our year-end persistency ranged from a high of 84.7% at December 31, 2009 to a low of 47.1% at December 31, 2003. With the current and expected level of mortgage interest rates we expect a low level of refinance activity and that our persistency in 2018 will be comparable to that of 2017.
Table t.10 presents the composition of our primary RIF as of December 31, 2017, 2016, and 2015.
In the second half of 2016 we participated in GSE credit risk transfer transactions through an affiliate of MGIC. Each GSE launched a new credit risk transfer offering that involved credit insurance policies with a pool structure that primarily covered loans to be delivered to the GSE in the future. The policies provide additional coverage beyond primary mortgage insurance on 30-year fixed-rate mortgages with 80.01-95% LTVs. These transactions were immaterial to our financial statements in 2017 and 2016 and given the risk insured, are expected to remain immaterial to our financial statements in future periods. We did not enter into any GSE credit risk transfer transactions during 2017 and any future participation will need to be evaluated based upon the terms offered and expected returns.
NPE increased 3% in 2016 compared to 2015 reflecting higher earned premiums from single premium policies and lower premium refunds. The increase in earned premiums on single premium policies was driven by refinance activity as single premium policies are generally non-refundable. The decrease in premium refunds was due to lower claim activity. The increase in net premiums earned was offset in part by the effects of our 2013 QSR Transaction commutation in 2015, which resulted in a non-recurring increase in our profit commission.
The monthly premium program used for the substantial majority of loans we insured provides for a set premium rate for the first ten years of the policy and a lower premium rate thereafter. The initial ten-year period is reset when the loan is refinanced under HARP. As of December 31, 2017, approximately 1% of our total primary IIF was written in 2008, has not been refinanced under HARP, and is subject to a rate reset beginning in 2018.
2017 compared to 2016. The reduction in our 2017 premium yield compared to 2016 was primarily due to the increase in the percentage of our IIF that was written in 2009 and after to 79% as of December 31, 2017 from 72% as of December 31, 2016. In addition, as of December 31, 2016 approximately 4% of our total IIF was written in 2007 and was subject to premium rate resets in 2017, which resulted in a reduction in our premium yield. Our 2017 premium yield also reflects the full-year impact of IIF written in 2006 that was subject to premium rate resets during 2016.
Change in premium refunds and premium refund accruals (excluding most single premium policies)
When a policy is cancelled for a reason other than rescission or claim payment, all premium that is non-refundable is immediately earned and any refundable premium from the cancellation date is returned to the servicer or borrower. Non-refundable premium, primarily associated with our single premium policies, is discussed below.
When a policy is rescinded, all previously collected premium is returned to the servicer. When a policy is cancelled due to claim payment, we return any premium received since the date of default.
2017 compared to 2016. Our losses incurred, net declined in 2017 from 2016 levels resulting in lower amounts of premium refunds, and our lower estimated claim rate is a factor in estimating premiums to be refunded in future periods. Refer to Note 8 - "Loss Reserves" in our consolidated financial statements for the
We cede a fixed percentage of premiums earned and received on insurance covered by the agreement.
We receive the benefit of a profit commission through a reduction in the premiums we cede. The profit commission varies directly and inversely with the level of losses on a "dollar for dollar" basis and is eliminated at levels of losses that we do not expect to occur. This means that lower levels of losses result in a higher profit commission and less benefit from ceded losses; higher levels of losses result in more benefit from ceded losses and a lower profit commission (or for levels of losses we do not expect, its elimination).
Table t.12 below provides information related to our quota share reinsurance agreements for 2017, 2016, and 2015.
The amount of our NIW subject to our QSR Transactions varies from period to period due to loan level exclusion terms. For example, our 2017 QSR Transaction excludes NIW with amortization terms of 20 years or less, but allows higher limits of DTI and loan levels than our 2015 QSR Transaction. In addition, the QSR Transactions contain coverage thresholds that may be triggered depending on the mix of our risk written during the period. The number of loans we insured with DTIs greater than 45% increased in the second half of 2017 after the requirements of the GSE underwriting guidelines were made more liberal. The risk written on those loans with DTIs greater than 45% exceeded the coverage limit under our 2017 QSR Transaction resulting in the percentage of NIW covered in 2017 to decline from the prior year.
The effects of our QSR Transactions described and presented above result in a net pre-tax cost of the reinsurance, with respect to a covered loan, of 6% (but can be lower if losses are materially higher than we expect). This cost is derived by dividing the reduction in our pre-tax net income from such loans with reinsurance by our direct (that is, without reinsurance) premiums from such loans. Although the net cost of the reinsurance is generally constant at 6%, the effect of the reinsurance on the various components of pre-tax income discussed above will vary from period to period, depending on the level of ceded losses. Although the use of reinsurance reduces our pre-tax net income, we receive credit under the PMIERs for risk ceded under our 2017 and 2015 QSR Transactions, which mitigates the negative effect of the PMIERs on our returns.
We expect that in the first quarter of 2018, we will enter into an agreement covering most of our NIW in 2018, on terms no less favorable than our existing QSR transactions. Compared to our 2017 QSR Transaction, the proposed 2018 QSR Transaction increases the percentage of NIW with the following loan level characteristics subject to coverage: (1) LTV ratios of 95% and greater, and (2) DTIs greater than 45%; however, the 2018 QSR Transaction excludes all NIW with LTV ratios of 85% and below. See Note 9 - "Reinsurance" to our consolidated financial statement for additional discussion on the terms of our proposed transaction. The GSEs have approved the terms of our proposed 2018 QSR Transaction.
In addition to more reinsurance coverage on NIW having DTIs 45% and greater, effective for March 2018, we increased the credit score required in connection with loans that have a DTI greater than 45%.
2016 compared to 2015. Net investment income increased 7% to $111 million in 2016 compared to $104 million in 2015. The increase in investment income was due to higher average investment yields.
Chart c.02 below shows the net unrealized gains (losses) position of our investment portfolio as of December 31, 2017, 2016, and 2015.
2017 compared to 2016. Other revenue decreased to $10M in 2017 from $18M in 2016, due to lower contract underwriting revenues and a non-recurring gain in 2016 of approximately $4 million related to changes in foreign currency exchange rates upon our substantial liquidation of our Australian operations.
As discussed in “Critical Accounting Policies” below and consistent with industry practices, we establish loss reserves for future claims only for loans that are currently delinquent. The terms “delinquent” and “default” are used interchangeably by us. We consider a loan delinquent when it is two or more payments past due. Loss reserves are established based on estimating the number of loans in our default inventory that will result in a claim payment, which is referred to as the claim rate, and further estimating the amount of the claim payment, which is referred to as claim severity.
2017 compared to 2016. Losses incurred, net decreased 78% to $54 million compared to $240 million in 2016. The decrease was due to both a decrease in losses and LAE incurred in respect to delinquencies reported in the current year and favorable development on prior year delinquencies. Losses incurred with respect to delinquencies reported in the current year declined as we estimated a lower claim rate on new notices in the current year, which offset the slight increase in new notices received. The increase in new
notices was caused by hurricane activity in the third quarter of 2017. Favorable development on prior year delinquencies occurred in 2017 and 2016 due to a lower estimated claim rate on previously reported delinquencies, partially offset by increases in our expected severity assumption on previously reported delinquencies. During 2017, cure activity on loans that were delinquent twelve months or more was significantly higher than our previous estimates.
See "Claim rate" and "Claims severity" below for additional factors and trends that impact these loss reserve assumptions.
The increase in new notices in 2017 compared to 2016 was driven by hurricane activity in the third quarter of 2017.
Factors that impact claim severity include the exposure on the loan (the unpaid principal balance of the loan times our insurance coverage percentage), the amount of time between delinquency and claim filing (which impacts the amount of interest and expenses, with a longer period between default and claim filing generally increasing severity) and curtailments. As discussed in Note 8 - "Loss Reserves," the average time for servicers to process foreclosures has recently shortened. Therefore, we expect the average number of missed payments at the time a claim is received to be approximately 18 to 24 for new notices received, compared to an average of 35 missed payments for claims received in recent periods. Our loss reserves estimates take into consideration trends over time, because the development of the delinquencies may vary from period to period without establishing a meaningful trend.
The majority of loans from 2005 through 2008 (which represent 62% of the loans in the delinquent inventory) are covered by master policy terms that, except under certain circumstances, do not limit the number of years that an insured can include interest when filing a claim. Under our current master policy terms, an insured can include accumulated interest when filing a claim only for the first three years the loan is delinquent. In each case, the insured must comply with their obligations under the terms of the applicable master policy.
This section provides information on our claim payment trends and exposure on our outstanding RIF for the three years ending December 31, 2017. Table t.16 below presents our net losses and LAE paid for the years ended December 31, 2017, 2016 and 2015.
See Note 8 - "Loss Reserves" for additional information on our settlements of disputes for claims paying practices and commutations of NPLs.
2016 and 2015 each include $42 million paid under the terms of our settlement with Freddie Mac as discussed in Note 8 - "Loss Reserves" to our consolidated financial statements.
The primary average claim paid for the top 5 jurisdictions (based on 2017 losses paid, excluding settlement amounts) for the years ended December 31, 2017, 2016 and 2015 appears in table t.18 below. The primary average claim paid can vary materially from period to period based upon a variety of factors, including the local market conditions, average loan amount, average coverage percentage, and loss mitigation efforts on loans for which claims are paid.
The primary average exposure for the top 5 jurisdictions (based on 2017 losses paid, excluding settlement amounts) for the years ended December 31, 2017, 2016 and 2015 appears in table t.19 below.
Our primary default rate at December 31, 2017 was 4.55% (2016: 5.04%, 2015: 6.31%). Our primary delinquent inventory was 46,556 loans at December 31, 2017, representing a decrease of 7% from 2016 and 26% from 2015. The reduction in our primary delinquent inventory is the result of the total number of delinquent loans: (1) that have cured; (2) for which claim payments have been made; or (3) that have resulted in rescission, claim denial, or removal from inventory due to settlements of claims paying disputes or commutations of coverage of pools of NPLs, collectively, exceeding the total number of new delinquencies on insured loans. In recent periods, we have experienced improved cure rates and the number of delinquencies in inventory with twelve or more missed payments has been declining. Generally, the fewer missed payments a delinquent loan has the lower the likelihood it will result in a claim. Our commutations of coverage on pools of NPLs have each been completed with amounts paid approximating the loss reserves previously established on the delinquent loans. We expect our delinquent inventory to decline in 2018 from 2017 levels.
Since a number of our pool policies include aggregate loss limits and/or deductibles, we do not disclose an average direct reserve per default for our pool business.
The average direct reserve per default (table t.20) as of December 31, 2017 declined when compared to the prior years primarily due to delinquencies we estimated to be caused by hurricane activity that remained in our ending delinquent inventory at December 31, 2017, which have a materially lower new notice claim rate than other new notices received. When excluding the estimated hurricane delinquencies, the average direct reserve per default was $24,000, which is still lower than recent years, because the claim rate on new notices (excluding hurricane new notices) and estimated claim rate on previously reported delinquencies that remain in our delinquent inventory declined in 2017.
Florida, Puerto Rico, and Texas (included in all other jurisdictions) each experienced an increase in their delinquent inventory as of December 31, 2017 compared to December 31, 2016. The increases were driven by hurricane activity in the third quarter of 2017, which resulted in significant new notice activity in the fourth quarter of 2017, of which a substantial majority of those notices remained in our delinquent inventory as of December 31, 2017.
The delinquent inventory for most policy years includes new notices from hurricane impacted areas that have not cured. As a result, delinquencies, including in our most recent policy years, were greater than they otherwise would have been.
On our primary business, the highest claim frequency years have typically been the third and fourth year after the year of loan origination. However, the pattern of claims frequency can be affected by many factors, including persistency and deteriorating economic conditions. Low persistency can accelerate the period in the life of a book during which the highest claim frequency occurs. Deteriorating economic conditions can result in increasing claims following a period of declining claims. As of December 31, 2017, 58% of our primary RIF
was written subsequent to December 31, 2014, 67% of our primary RIF was written subsequent to December 31, 2013, and 73% of our primary RIF was written subsequent to December 31, 2012.
The underwriting expense ratio is the ratio, expressed as a percentage, of the underwriting and operating expenses, net and amortization of DAC of our combined insurance operations (which excludes underwriting and operating expenses of our non-insurance operations) to NPW, and is presented in chart c.07 below for the past three years.
The increase in the underwriting expense ratio in 2017 when compared to 2016 was due to an increase in expenses, offset in part by an increase in our NPW. The increase in the underwriting expense ratio in 2016 when compared to 2015 was primarily due to a decrease in NPW.
2016 compared to 2015. Income tax expense for 2016 increased compared to 2015. This change is primarily due to the reversal of our deferred tax valuation allowance in 2015 and because we were required to establish a full tax provision for 2016. The difference between our statutory tax rate of 35% and our effective tax provision rate of 33.5% in 2016 was primarily due to the benefits of tax preferenced securities. The difference between our statutory tax rate of 35% and our effective tax (benefit) rate on our pre-tax income of (140.3%) in 2015 was primarily due to the impact of the changes in our valuation allowance against our deferred tax assets.
As of December 31, 2017, total assets were $5,619 million compared to $5,735 million in the prior year. The investment portfolio increased to $4,991 million as of December 31, 2017 (2016: $4,692 million). Deferred income tax assets decreased to $234.4 million as of December 31, 2017 (2016: $607.7 million) as our net income utilized a portion of our net operating loss carryforwards and our net deferred tax assets were remeasured at the lower corporate tax rate under the Tax Act.
Table t.25 shows the average duration and embedded investment yield of our investment portfolio as of December 31, 2017, 2016, and 2015.
The credit risk of specific securities is evaluated through analysis of the security's underlying fundamentals, including the issuer's sector, scale, profitability, debt coverage, and ratings. The investment policy guidelines limit the amount of our credit exposure to any one issue, issuer and type of instrument. Table t.26 shows the security ratings of our fixed income investments as of December 31, 2017 and 2016.
The U.S. economy continued to grow in 2017 and is expected to continue to grow in 2018. Against this positive macroeconomic backdrop, which includes very low unemployment, inflation pressures are seen rising. The FOMC, increased its benchmark interest rate 75 basis points during 2017 and its view is the benchmark will increase another 75 basis points in 2018. Our investment portfolio of fixed income securities is subject to interest rate risk and its fair value is likely to decline in a rising interest rate environment. We seek to manage our exposure to interest rate risk and volatility by maintaining a diverse mix of high quality securities with an intermediate duration profile. While higher interest rates may adversely impact the fair values of our fixed income securities, they present an opportunity to reinvest investment income and proceeds from security maturities into higher yielding securities. The Tax Act is expected to have implications for allocations of our fixed income securities. All other things equal, the lower corporate income tax rate reduces the benefit of owning tax-exempt fixed income securities, therefore, our overall allocation to these securities may change over time.
We continue to have unresolved tax matters primarily related to reviews of our 2000-2007 federal income tax returns by the IRS. We have reached agreement with the IRS on all issues for those years and in the fourth quarter of 2017, the IRS submitted documentation reflecting the terms of the agreement to the JCT for its review, which must be performed before a settlement can be completed. There is no assurance that a settlement will be completed. Our consolidated financial statements reflect our estimates of the tax contingencies discussed more fully in Note 12 - "Income Taxes" to our consolidated financial statements. Based on information we currently have regarding the status of the dispute, we recorded a provision for additional taxes and interest of $29.0 million in 2017.
We have three primary types of cash flows: (1) operating cash flows, which consist mainly of cash generated by our insurance operations and income earned on our investment portfolio, less amounts paid for claims, interest expense and operating expenses, (2) investing cash flows related to the purchase, sale and maturity of investments and purchases of property and equipment and (3) financing cash flows generally from activities that impact our capital structure, such as changes in debt and shares outstanding. The following table summarizes these three cash flows on a consolidated basis for the last three years.
Our largest source of cash is from premiums received from our insurance policies, which we receive on a monthly installment basis for most policies. Premiums are received at the beginning of the coverage period for single premium and annual premium policies. Our largest cash outflow is for claims that arise when a delinquency results in an insured loss. Because the payment of claims occurs after the receipt of the premium, often years later, we invest our claims paying resources in various investment securities that earn interest. We also use cash to pay for our ongoing expenses such as salaries, debt interest, and rent. We also utilize reinsurance to manage the risk we take on our insurance policies. We cede, or pay out, part of the premiums we receive to our reinsurers and collect cash back when losses subject to our reinsurance coverage are paid.
We maintain an investment portfolio that is primarily invested in a diverse mix of fixed income securities. As of December 31, 2017, our portfolio had a fair value of $5.0 billion, an increase of $298.2 million, or 6.4% from December 31, 2016. In addition to investment portfolio activities, our investing activities included additions to property and equipment. Beginning in 2016, we began an initiative to update our corporate headquarters building and continued our investment in our technology infrastructure to enhance our ability to conduct business and execute our strategies.
Table t.29 summarizes our capital structure as of December 31, 2017, 2016, and 2015.
The outstanding principal on our holding company's debt declined $353 million, or 30.2%, during 2017 as a result of the conversion and partial redemption of our 2% Notes and the maturity of our 5% Notes. See Note 7 - "Debt" for further information on our outstanding debt obligations and transactions impacting our consolidated financial statements in 2017 and 2016.
Chart c.11 shows the remaining time to maturity of our holding company debt obligations.
In 2017, our holding company cash and investments decreased by $67 million, to $216 million as of December 31, 2017. Cash outflows included $150 million to repay our 5% Notes at maturity and $67 million of interest payments, of which approximately $12 million was paid to MGIC for the portion of our 9% Debentures owned by MGIC. Cash inflows primarily included $140 million of dividends received from MGIC.
RIF - net, as shown in the table above, is net of reinsurance and exposure on policies currently delinquent ($2.3 billion at December 31, 2017 and $2.6 billion at December 31, 2016) and for which loss reserves have been established.
The reductions in MGIC's and our combined insurance companies risk-to-capital in 2017 were due to an increase in statutory policyholders' position, primarily due to an increase in statutory contingency reserves, partially offset by an increase in net RIF in both calculations. Our RIF, net of reinsurance, increased in 2017, due to an increase in our IIF. Our risk-to-capital ratio will decrease if the percentage increase in capital exceeds the percentage increase in insured risk.
For further information about the importance of MGIC’s ratings, see our risk factor titled “We may not continue to meet the GSEs’ private mortgage insurer eligibility requirements and our returns may decrease as we are required to maintain more capital in order to maintain our eligibility” and “Competition or changes in our relationships with our customers could reduce our revenues, reduce our premium yields and/or increase our losses” in Item 1A.
Our long-term debt obligations as of December 31, 2017 include their related interest and are discussed in Note 7 - “Debt” to our consolidated financial statements and under “Liquidity and Capital Resources” above. Our operating lease obligations include operating leases on certain office space, data processing equipment and autos, as discussed in Note 16 - “Leases” to our consolidated financial statements. Tax obligations consist primarily of amounts related to our current dispute with the IRS, as discussed in Note 12 - “Income Taxes” to our consolidated financial statements. Purchase obligations consist primarily of agreements to purchase items related to our ongoing infrastructure projects and information technology investments in the normal course of business. See Note 11 - “Benefit Plans” to our consolidated financial statements for discussion of expected benefit payments under our benefit plans.
Reserves are established for reported insurance losses and LAE based on when notices of delinquency on insured mortgage loans are received. For reporting purposes, we consider a loan delinquent when it is two or more payments past due. Even though the accounting standard, ASC 944, regarding accounting and reporting by insurance entities specifically excluded mortgage insurance from its guidance relating to loss reserves, we establish loss reserves using the general principles contained in the insurance standard. However, consistent with industry standards for mortgage insurers, we do not establish loss reserves for future claims on insured loans which are not currently delinquent.
Our estimates are also affected by any agreements we enter into regarding our claims paying practices, such as the settlement agreements discussed in Note 17 - “Litigation and Contingencies” to our consolidated financial statements.
A negative number for a prior year indicates a redundancy of loss reserves.
Reserves are also established for estimated IBNR, which results from delinquencies occurring prior to the close of an accounting period, but which have not been reported to us. Consistent with reserves for reported defaults, IBNR reserves are established using estimated claim rates and claim severities for the estimated number of delinquencies not reported. As of December 31, 2017 and 2016, we had IBNR reserves of approximately $35 million and $54 million, respectively.
When a policy term ends, the primary mortgage insurance written by us is renewable at the insured’s option through continued payment of the premium in accordance with the schedule established at the inception of the policy life. We have no ability to reunderwrite or reprice these policies after issuance. Premiums written under policies having single and annual premium payments are initially deferred as unearned premium reserve and earned over the policy life. Premiums written on policies covering more than one year are amortized over the policy life in relationship to the anticipated incurred loss pattern based on historical experience. Premiums written on annual policies are earned on a monthly pro rata basis. Premiums written on monthly policies are earned as the monthly coverage is provided. When a policy is cancelled, all premium that is non-refundable is immediately earned. Any refundable premium is returned to the servicer or borrower. Policies may be cancelled by the insured, or due to rescissions or claim payment. When a policy is rescinded, all previously collected premium is returned to the servicer and when a claim is paid, all premium collected since the date of default is returned. The liability associated with our estimate of premium to be returned is accrued for separately and this liability is included in “Other liabilities” on our consolidated balance sheets. Changes in these liabilities and the actual return of premium affect premiums written and earned.
Level 2 - Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and inputs, other than quoted prices, that are observable in the marketplace for the financial instrument. The observable inputs are used in valuation models to calculate the fair value of the financial instruments. Financial assets utilizing Level 2 inputs primarily include obligations of U.S. government corporations and agencies, corporate bonds, mortgage-backed securities, and certain municipal bonds.
Level 3 - Valuations derived from valuation techniques in which one or more significant inputs or value drivers are unobservable, or for certain equity securities, from their par value due to restrictions that require them to be redeemed or sold only to the security issuer at par value. The inputs used to derive the fair value of Level 3 securities reflect our own assumptions about the assumptions a market participant would use in pricing an asset or liability. Our non-financial assets that are classified as Level 3 securities consist of real estate acquired through claim settlement. The fair value of real estate acquired is the lower of our acquisition cost or a percentage of the appraised value. The percentage applied to the appraised value is based upon our historical sales experience adjusted for current trends.
Based on our evaluation, we will record an OTTI adjustment on a security if we intend to sell the impaired security, 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 the discounted cash flows we expect to collect is less than the amortized costs basis of the security. If the fair value of a security is below its amortized cost at the time of our intent to sell, 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, when a security is considered to be other-than-temporarily impaired, the losses are separated into the portion of the loss that represents the credit loss; and 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 the discounted cash flows, using the security’s original yield, expected to be collected from the security is less than the cost basis of the security.
At December 31, 2017, our direct domestic primary insurance in force ("IIF") was $194.9 billion, which represents the principal balance in our records of all mortgage loans that we insure, and our direct domestic primary risk in force ("RIF") was $50.3 billion, which represents the IIF multiplied by the insurance coverage percentage.
Level 1 - Quoted prices for identical instruments in active markets that we can access. Financial assets utilizing Level 1 inputs primarily include U.S. Treasury securities and certain equity securities.
Residential Mortgage-Backed Securities ("RMBS") are evaluated by monitoring interest rate movements, and other pertinent data daily. Incoming market data is enriched to derive spread, yield and/or price data as appropriate, enabling known data points to be extrapolated for valuation application across a range of related securities.
Collateralized loan obligations ("CLO") Collateralized Loan Obligations are evaluated by manager rating, seniority in the capital structure, assumptions about prepayment, default and recovery and their impact on cash flow generation. Loan level net asset values are determined and aggregated for tranches and as a final step prices are checked against available recent trade activity.
Level 3 - Valuations derived from valuation techniques in which one or more significant inputs or value drivers are unobservable or, for certain equity securities, from their par value due to restrictions that require them to be redeemed or sold only to the security issuer at par value. The inputs used to derive the fair value of Level 3 securities reflect our own assumptions about the assumptions a market participant would use in pricing an asset or liability. Our non-financial assets that are classified as Level 3 securities consist of real estate acquired through claim settlement. The fair value of real estate acquired is the lower of our acquisition cost or a percentage of the appraised value. The percentage applied to the appraised value is based upon our historical sales experience adjusted for current trends.
Our entire investment portfolio is classified as available-for-sale and is reported at fair value or, for certain equity securities carried at cost, amounts that approximate fair value. The related unrealized investment gains or losses are, after considering the related tax expense or benefit, recognized as a component of accumulated other comprehensive income (loss) in shareholders' equity. Realized investment gains and losses are reported in income based upon specific identification of securities sold. (See Note 5 - “Investments.”)
Each quarter we perform reviews of our investments in order to determine whether declines in fair value below amortized cost were considered other-than-temporary. In evaluating whether a decline in fair value is other-than-temporary, we consider several factors including, but not limited to:
Based on our evaluation, we will record an other-than-temporary impairment ("OTTI") adjustment on a security if we intend to sell the impaired security, 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 the discounted cash flows we expect to collect is less than the amortized cost basis of the security. If the fair value of a security is below its
Home office and equipment is carried at cost net of depreciation. For financial reporting purposes, depreciation is determined on a straight-line basis for the home office and equipment over estimated lives ranging from 3 to 45 years. For income tax purposes, we use accelerated depreciation methods.
Reserves are established for insurance losses and loss adjustment expenses ("LAE") when we receive notices of default on insured mortgage loans. We consider a loan in default when it is two or more payments past due. Even though the accounting standard, ASC 944, regarding accounting and reporting by insurance entities specifically excludes mortgage insurance from its guidance relating to loss reserves, we establish loss reserves using the general principles contained in the insurance standard. However, consistent with industry standards for mortgage insurers, we do not establish loss reserves for future claims on insured loans which are not currently in default. Loss reserves are established by estimating the number of loans in our inventory of delinquent loans that will result in a claim payment, which is referred to as the claim rate, and further estimating the amount of the claim payment, which is referred to as claim severity. Our loss estimates are established based upon historical experience, including rescissions of policies, curtailments of claims, and loan modification activity. Adjustments to reserve estimates are reflected in the financial statements in the years in which the adjustments are made. The liability for reinsurance assumed is based on information provided by the ceding companies.
Reserves are also established for the estimated costs of settling claims, including legal and other expenses and general expenses of administering the claims settlement process. Reserves are also ceded to reinsurers under our reinsurance agreements. (See Note 8 - “Loss Reserves” and Note 9 - “Reinsurance.”)
After our loss reserves are initially established, we perform premium deficiency tests using our best estimate assumptions as of the testing date. Premium deficiency reserves are established, if necessary, when the present value of expected future losses and expenses exceeds the present value of expected future premium
We established a premium deficiency reserve in 2007 on our Wall Street Bulk business, which we also ceased writing in that year. The premium deficiency reserve was eliminated in 2015 and our consolidated statement of operations for the year ended December 31, 2015 was affected by a decrease in our premium deficiency reserves of $24 million.
Deferred income taxes are provided under the liability method, which recognizes the future tax effects of temporary differences between amounts reported in the consolidated financial statements and the tax bases of these items. The expected tax effects are computed at the enacted regular federal statutory tax rate. Using this method, we have recorded a net deferred tax asset primarily due to net operating losses incurred in prior years. During 2017, net deferred tax assets were remeasured at the lower corporate tax rate enacted under the U.S. tax reform legislation signed into law in the fourth quarter of 2017 (the "Tax Act"). See Note 12- "Income Taxes" for discussion of the impact of the Tax Act on our consolidated financial statements.
that it was more likely than not that our deferred tax assets would be fully realizable and we reversed the valuation allowance.
Loss reserves and unearned premiums are reported before taking credit for amounts ceded under reinsurance agreements. Ceded loss reserves are reflected as "Reinsurance recoverable on loss reserves." Ceded unearned premiums are included in “Other assets.” Amounts due from reinsurers on paid claims are reflected as “Reinsurance recoverable on paid losses.” Ceded premiums payable are included in “Other liabilities.” Any profit commissions are included with “Premiums written - Ceded” and any ceding commissions are included with “Other underwriting and operating expenses, net.” We remain liable for all insurance ceded. (See Note 9 - “Reinsurance.”)
Basic earnings per share ("EPS") is calculated by dividing net income by the weighted average number of shares of common stock outstanding. The computation of basic EPS includes as "participating securities" an immaterial number of unvested share-based compensation awards that contain non-forfeitable rights to dividends or dividend equivalents, whether paid or unpaid, under the "two-class" method. Our participating securities are composed of vested restricted stock and restricted stock units ("RSUs") with non-forfeitable rights to dividends (of which none have been declared since the issuance of these participating securities). Diluted EPS includes the components of basic EPS and also gives effect to dilutive common stock equivalents. We calculate diluted EPS using the treasury stock method and if-converted method. Under the treasury stock method, diluted EPS reflects the potential dilution that could occur if our unvested restricted stock units result in the issuance of common stock. Under the if-converted method, diluted EPS reflects the potential dilution that could occur if our convertible debt instruments result in the issuance of common stock. The determination of potentially issuable shares does not consider the satisfaction of the conversion requirements and the shares are included in the determination of diluted EPS as of the beginning of the period, if dilutive. In addition to our 9% Debentures, of which a portion remain outstanding, we previously had several senior note debt issuances that could have resulted in contingently issuable shares and we considered each potential issuance of shares separately to reflect the maximum potential dilution for the period the debt issuances were outstanding. For purposes of calculating basic and diluted EPS, vested restricted stock and RSUs are considered outstanding.
There were no related party transactions during 2017, 2016 or 2015.
In February 2018, the Financial Accounting Standards Board ("FASB") issued updated guidance that allows an election to reclassify stranded tax effects resulting from the Tax Act's newly enacted federal corporate income tax rate of 21% from accumulated other comprehensive income to retained earnings in an amount that reflects the effect of the change in tax rate on the gross deferred tax amounts and related valuation allowances, if any, at the date of the enactment of the Tax Act related to items remaining in accumulated comprehensive income (loss). Other than the effect of the change in tax rate, we have no other income tax effects related to the application of the Tax Act that are reclassified from accumulated other comprehensive income (loss) to retained earnings. Absent the updated guidance, we generally would remove stranded tax effects lodged in accumulated other comprehensive income (loss) at the time the circumstances under which these tax effects originally arose no longer exist. The updated guidance is effective for annual periods beginning after December 15, 2018, including interim periods within those annual periods. Early adoption is permitted and we adopted this guidance electing to reclass stranded tax effects from the Tax Act to retained earnings for the fourth quarter ending December 31, 2017.
Adoption impact: We recorded a cumulative effect adjustment that reclassified $10.4 million from accumulated other comprehensive loss to retained earnings to reflect the difference between the amount initially credited to other comprehensive income (loss) and the amount that would have been credited at the newly enacted federal corporate tax rate. The effect of this reclassification increases our retained earnings and increases our accumulated other comprehensive loss, with no change to our total shareholders' equity as of December 31, 2017.
In March 2016, the FASB issued updated guidance that simplifies several aspects of the accounting for employee share-based compensation including the accounting for income taxes, forfeitures, and statutory tax withholding requirements, as well as classification of related amounts within the statement of cash flows. Specifically, the updated guidance requires the following:
Tax effects related to share-based compensation are made through the statement of operations at the time of settlement instead of recognizing them in paid-in capital.
Adoption impact: We recognized discrete tax benefits of $1.6 million in the provision for income taxes on our statement of operations for the year ended December 31, 2017 related to excess tax benefits upon vesting of share-based awards during the period.
Adoption impact: We reclassified excess tax benefits related to share-based compensation for 2016 and 2015 to operating activities from financing activities.
Shares withheld by an employer for tax-withholding purposes upon vesting of equity compensation represents a cash outflow required to be classified as a financing activity on the statements of cash flows.
Adoption impact: We reclassified employee taxes paid for withheld shares for 2016 and 2015 to financing activities from operating activities.
In May 2017, the FASB issued updated guidance related to a change in the terms or conditions (modification) of a share-based award. The updated guidance provides that an entity should account for the effects of a modification unless the fair value and vesting conditions of the modified award and the classification of the award (equity or liability instrument) are the same as the original award immediately before the modification. The updated guidance addresses the current diversity in practice on applying modification accounting, as some entities evaluate whether changes to awards are substantive, which is not prescribed within the current accounting guidance. The updated guidance is effective for annual periods beginning after December 15, 2017, including interim periods within those annual periods. We are currently evaluating the impacts the adoption of this guidance will have on our consolidated financial statements, but do not expect it to have a material impact on our consolidated financial statements or disclosures.
In March 2017, the FASB issued updated guidance that improves the reporting of net benefit cost in the financial statements. The updated guidance requires that an employer report the service cost component in the same financial statement caption as other compensation costs arising from services rendered by
In January 2016, the FASB issued updated guidance to address the recognition, measurement, presentation, and disclosure of certain financial instruments. The updated guidance requires equity investments, except those accounted for under the equity method of accounting, that have a readily determinable fair value to be measured at fair value with changes in fair value recognized in net income. Equity investments that do not have readily determinable fair values may be remeasured at fair value either upon the occurrence of an observable price change or upon identification of an impairment. A qualitative assessment for impairment is required for equity investments without readily determinable fair values. The updated guidance also eliminates the requirement to disclose the method and significant assumptions used to estimate the fair value of financial instruments measured at amortized cost on the balance sheet. Further, the updated guidance clarifies that entities should evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale securities in combination with the entity's other deferred tax assets. The updated guidance is effective for annual periods beginning after December 15, 2017, including interim periods within those
annual periods and will require recognition of a cumulative effect adjustment at adoption. We do not currently expect the adoption of this guidance to impact our consolidated financial statements or disclosures.
Interest expense for the years ended December 31, 2017, 2016 and 2015 has been tax effected at a rate of 35%.
The computation of diluted EPS for the years ended December 31, 2017, 2016, and 2015 includes weighted average unvested restricted stock units outstanding of 1.5 million, 1.5 million, and 2.1 million, respectively.
The amortized cost, gross unrealized gains and losses and fair value of the investment portfolio as of December 31, 2017 and 2016 are shown below:
There were no OTTI losses recorded in other comprehensive (loss) income as of December 31, 2017 and 2016.
As discussed in Note 7 - "Debt" we are required to pledge collateral of at least 102% of the outstanding principal balance of the FHLB Advance. As of December 31, 2017, that collateral is included in our total investment portfolio amount shown above with a total fair value of $166.9 million.
The source of net investment income is shown in Table 5.4 below.
Gross realized gains and losses on investments are shown in Table 5.7 below.
Equity securities in Level 3 are carried at cost, which approximates fair value.
Level 3 securities within total investments consisted primarily of equity securities that can only be redeemed or sold at their par value and only to the security issuer.
Financial liabilities are incurred in the normal course of our business. Table 6.3 compares the carrying value and fair value of our financial liabilities disclosed, but not carried, at fair value as of December 31, 2017 and 2016.
The fair values of our 5% Notes, 2% Notes, 5.75% Notes, and 9% Debentures were based on observable market prices and the fair value of the FHLB Advance was estimated using discounted cash flows on current incremental borrowing rates for similar borrowing arrangements, and in all cases they are categorized as Level 2. See Note 7 - "Debt" for a description of the financial liabilities in table 6.3.
Table 7.1 shows the par value of our long-term debt obligations and their aggregate carrying values as of December 31, 2017 and 2016.
Table 7.2 shows the interest payments, on a consolidated basis, for our debt obligations outstanding during 2017 and 2016.
On March 21, 2017, we issued an irrevocable notice of redemption in respect of our outstanding 2% Convertible Senior Notes due April 1, 2020 ("2% Notes"), with a redemption date of April 21, 2017. In April, holders of approximately $202.5 million of the outstanding principal exercised their rights to convert their notes to shares of our common stock. The remaining $5.1 million of outstanding principal was redeemed for cash. The conversions of the 2% Notes at a rate of 143.8332 shares per $1,000 principal amount resulted in the issuance of approximately 29.1 million shares of our common stock in April 2017. The conversions and cash redemption eliminated our debt obligation. A loss on debt extinguishment of $0.07 million was recognized on notes redeemed for cash. No gain or loss was recognized from the conversions as the outstanding debt issuance costs associated with the conversions were included in the carrying value of the notes, which was credited to shareholders' equity at the time of conversion.
On March 21, 2017, we entered into a Credit Agreement with various lenders which provides for a $175 million unsecured revolving credit facility maturing on March 21, 2020. Revolving credit borrowings bear interest at a floating rate, which will be, at our option, either a eurocurrency rate or a base rate, in each case plus an applicable margin. The applicable margin is subject to adjustment based on our senior unsecured long-term debt rating, or if we do not have such a rating, our corporate or issuer rating. Amounts under the facility may be borrowed, repaid and reborrowed from time to time until the maturity of the revolving credit facility. Voluntary prepayments and commitment reductions are permitted at any time without fee subject to a minimum dollar requirement and, for outstanding eurocurrency loans, customary breakage costs.
In March 2017, we borrowed $150 million under the revolving credit facility, to fund a portion of the redemption price of the 2% Notes if holders did not elect to convert their 2% Notes. In April, we repaid the amount borrowed under the revolving credit facility because most holders elected to convert their notes. Costs incurred to enter into the Credit Agreement have been deferred and recorded as Other assets and will be amortized over the term of the Credit Agreement.
On May 1, 2017, our 5% Notes due in 2017 ("5% Notes") matured and we repaid the outstanding $145 million in aggregate par value, plus accrued interest with cash at our holding company. Interest on the 5% Notes was payable semi-annually in arrears on May 1 and November 1 of each year.
In August 2016, we issued $425 million aggregate principal amount of 5.75% Senior Notes due in 2023 ("5.75% Notes") and received net proceeds, after the deduction of underwriting fees, of $418.1 million. Interest on the 5.75% Notes is payable semi-annually on February 15 and August 15 of each year, commencing on February 15, 2017. We have the option to redeem these notes, in whole or in part, at any time or from time to time prior to maturity at a redemption price equal to the greater of (i)100% of the aggregate principal amount of the notes to be redeemed and (ii) the make-whole amount, which is the sum of the present values of the remaining scheduled payments of principal and interest discounted at the treasury rate defined in the notes plus 50 basis points, plus, in each case, accrued interest thereon to, but excluding, the redemption date. In
addition to underwriting fees, we incurred approximately $1.2 million of other expenses associated with the issuance of these notes.
The 5.75% Notes have covenants customary for securities of this nature, including customary events of default, and further provide that the trustee or holders of at least 25% in aggregate principal amount of the outstanding 5.75% Notes may declare them immediately due and payable upon the occurrence of certain events of default after the expiration of the applicable grace period. In addition, in the case of an event of default arising from certain events of bankruptcy, insolvency or reorganization relating to the Company or any of its significant subsidiaries, the 5.75% Notes will become due and payable immediately. This description is not intended to be complete in all respects and is qualified in its entirety by the terms of the 5.75% Notes, including their covenants and events of default. We were in compliance with all covenants as of December 31, 2017.
The net proceeds from the 5.75% Notes issuance were primarily used as (i) cash consideration to repurchase a portion of our 2% Notes, and (ii) to repurchase the shares issued as partial consideration in the repurchases of our 2% Notes, as described above. The remaining proceeds are being held for general corporate purposes.
The 9% Debentures are currently convertible, at the holder's option, at an initial conversion rate, which is subject to adjustment, of 74.0741 common shares per $1,000 principal amount of the 9% Debentures at any time prior to the maturity date. This represents an initial conversion price of approximately $13.50 per share. If a holder elects to convert their 9% Debentures, deferred interest, if any, owed on the 9% Debentures being converted is also converted into shares of our common stock. The conversion rate for any deferred interest is based on the average price that our shares traded at during a 5-day period immediately prior to the election to convert. We have 19.0 million authorized shares reserved for conversion under our 9% debentures.
We may redeem the 9% Debentures in whole or in part from time to time, at our option, at a redemption price equal to 100% of the principal amount of the 9% Debentures being redeemed, plus any accrued and unpaid interest, if the closing sale price of our common stock exceeds $17.55 for at least 20 of the 30 trading days preceding notice of the redemption.
The provisions of the 9% Debentures are complex. The description above is not intended to be complete in all respects. Moreover, that description is qualified in its entirety by the terms of the 9% Debentures, including their covenants and events of default. We were in compliance with all covenants at December 31, 2017. The 9% Debentures rank junior to all of our existing and future senior indebtedness.
As described in Note 3 - “Summary of Significant Accounting Policies - Loss Reserves,” we establish reserves to recognize the estimated liability for losses and LAE related to defaults on insured mortgage loans. Loss reserves are established by estimating the number of loans in our inventory of delinquent loans that will result in a claim payment, which is referred to as the claim rate, and further estimating the amount of the claim payment, which is referred to as claim severity.
Estimation of losses is inherently judgmental. The conditions that affect the claim rate and claim severity include the current and future state of the domestic economy, including unemployment and the current and future strength of local housing markets; exposure on insured loans; the amount of time between default and claim filing; and curtailments and rescissions. The actual amount of the claim payments may be substantially different than our loss reserve estimates. Our estimates could be adversely affected by several factors, including a deterioration of regional or national economic conditions, including unemployment, leading to a reduction in borrowers’ income and thus their ability to make mortgage payments, and a drop in housing values which may affect borrower willingness to continue to make mortgage payments when the value of the
The “Losses incurred” section of table 8.1 below shows losses incurred on delinquencies that occurred in the current year and in prior years. The amount of losses incurred relating to delinquencies that occurred in the current year represents the estimated amount to be ultimately paid on such delinquencies. The amount of losses incurred relating to delinquencies that occurred in prior years represents the difference between the actual claim rate and severity associated with those delinquencies resolved in the current year compared to the estimated claim rate and severity at the prior year-end, as well as a re-estimation of amounts to be ultimately paid on delinquencies continuing from the end of the prior year. This re-estimation of the claim rate and severity is the result of our review of current trends in the delinquent inventory, such as percentages of defaults that have resulted in a claim, the amount of the claims relative to the average loan exposure, changes in the relative level of delinquencies by geography and changes in average loan exposure.
Losses incurred on delinquencies that occurred in the current year decreased in 2017 compared to 2016 due to a decrease in the estimated claim rate on recently reported delinquencies, and in 2016 compared to 2015, primarily due to a decrease in the number of new delinquencies, net of cures, as well as a decrease in the estimated claim rate on recently reported delinquencies.
Our estimate of premiums to be refunded on expected claim payments is accrued for separately in "Other liabilities" on our consolidated balance sheets and approximated $61 million and $85 million at December 31, 2017 and 2016, respectively.
2017 - 1,337 notices removed from default inventory with an amount paid of $54 million,
In a termination, the reinsurance agreement is cancelled, with no future premium ceded and amounts for any incurred but unpaid losses paid to us. Amounts paid to (received from) reinsurers result in an increase (decrease) in net losses paid. The change in net losses paid on our losses incurred is offset by a corresponding change in the reinsurance recoverable, resulting in no net impact on losses incurred. (See Note 9 - “Reinsurance”).
A negative number for prior year loss development indicates a redundancy of prior year loss reserves.
A rollforward of our primary delinquent inventory for the years ended December 31, 2017, 2016, and 2015 appears in table 8.3 below. The information concerning new notices and cures is compiled from monthly reports received from loan servicers. The level of new notice and cure activity reported in a particular month
The new notice activity from hurricane impacted areas in the fourth quarter of 2017 has increased the percentage of our delinquent inventory that has been delinquent for three months or less (table 8.4) and correspondingly our percentage of delinquent inventory with three payments or less (table 8.5) delinquent has also increased.
The decrease in the primary delinquent inventory experienced during 2016 and 2015 from the respective prior year was generally across all markets and all book years prior to 2013. In 2016 and 2015, the percentage of loans in the inventory that had been delinquent for 12 or more consecutive months had decreased compared to the respective prior year.
Historically as a delinquency ages it becomes more likely to result in a claim. The percentage of loans that have been delinquent for 12 or more consecutive months and the number of loans in our primary claims received inventory have been affected by our suspended rescissions and the resolution of certain of those rescissions discussed below and in Note 17 - "Litigation and Contingencies".
The number of consecutive months that a borrower has been delinquent is shown in the table below.
Approximately 45%, 47% and 50% of the primary delinquent inventory delinquent for 12 consecutive months or more has been delinquent for at least 36 consecutive months as of December 31, 2017, 2016 and 2015, respectively.
Each of the reinsurers under our 2017 and 2015 quota share reinsurance agreements ("2017 QSR Transaction" and "2015 QSR Transaction", respectively) and proposed 2018 quota share reinsurance agreement ("2018 QSR Transaction") has an insurer financial strength rating of A- or better by Standard and Poor's Rating Services, A.M. Best, or both.
2017 QSR Transaction. Effective January 1, 2017, this transaction provides coverage on new business written from the effective date through December 29, 2017 that meets certain eligibility requirements. The agreement cedes losses incurred and premiums on or after the effective date through December 31, 2028 at which time the agreement expires. Early termination of the agreement can be elected by us effective December 31, 2021 for a fee, or under specified scenarios for no fee upon prior written notice, including if we will receive less than 90% of the full credit amount under the PMIERs for the risk ceded in any required calculation period.
2013 QSR Transaction. Effective July 1, 2015, we commuted and settled our 2013 QSR Transaction. The settlement included unearned premiums, loss reserves, and profit commission. The commutation resulted in an increase in net premiums written and earned of $69.4 million and $11.6 million, respectively, and a decrease in ceding commissions of $11.6 million in the third quarter of 2015. Receipt of our profit commission of $142.5 million, in addition to other premium and loss amounts, was also completed as part of the settlement.
The agreed upon structure of the 2018 QSR Transaction is a 30% quota share for all policies covered, with a 20% ceding commission as well as a profit commission. Generally, under the 2018 QSR Transaction, we will receive a profit commission provided that the loss ratio on the loans covered under the agreement remains below 54%.
Since July 1, 2015, premiums are ceded on an earned and received basis as defined in our QSR Transactions currently in effect.
Ceding commissions are reported within Other underwriting and operating expenses, net on the consolidated statements of operations.
The reinsurance recoverable on loss reserves was $39.3 million as of December 31, 2017 and $31.8 million as of December 31, 2016. The reinsurance recoverable balance is secured by funds on deposit from the reinsurers which are based on the funding requirements of PMIERs that address ceded risk.
The reinsurance recoverable on loss reserves related to captive agreements was $9 million at December 31, 2017 which was supported by $80 million of trust assets, while at December 31, 2016 the reinsurance recoverable on loss reserves related to captive agreements was $19 million which was supported by $91 million of trust assets. Each captive reinsurer is required to maintain a separate trust account to support its combined reinsured risk on all annual books. MGIC is the sole beneficiary of the trusts.
The pretax components of our other comprehensive income (loss) and related income tax (expense) benefit for the years ended December 31, 2017, 2016 and 2015 are included in table 10.1 below:
Table 11.4 shows the changes in the projected benefit obligation for 2017 and 2016.
Tables 11.5 and 11.6 shows the changes in the fair value of the net assets available for plan benefits, and changes in other comprehensive income (loss) during 2017 and 2016.
Table 11.7 shows the amount of amortization on components of net periodic benefit costs expected to be recognized during the year ending December 31, 2018.
In selecting a discount rate, we performed a hypothetical cash flow bond matching exercise, matching our expected pension plan and postretirement medical plan cash flows, respectively, against a selected portfolio of high quality corporate bonds. The modeling was performed using a bond portfolio of noncallable bonds with at least $50 million outstanding. The average yield of these hypothetical bond portfolios was used as the
benchmark for determining the discount rate. In selecting the expected long-term rate of return on assets, we considered the average rate of earnings expected on the classes of funds invested or to be invested to provide for the benefits of these plans. This included considering the trusts' targeted asset allocation for the year and the expected returns likely to be earned over the next 20 years.
Tables 11.11a and 11.11b set forth the other postretirement benefits plan assets at fair value as of December 31, 2017 and 2016. All are Level 1 assets.
Investment in international mutual funds is limited to a maximum of 30% of the equity range. The allocation as of December 31, 2017 included 3% that was primarily invested in equity securities of emerging market countries and another 21% was invested in securities of companies primarily based in Europe and the Pacific Basin.
We have a profit sharing and 401(k) savings plan for employees. At the discretion of the Board of Directors, we may make a contribution to the plan of up to 5% of each participant's eligible compensation. We provide a matching 401(k) savings contribution for employees on their before-tax contributions at a rate of 80% of the first $1,000 contributed and 40% of the next $2,000 contributed. For employees hired after January 1, 2014, the match is 100% up to 4% contributed. We recognized expenses related to these plans of $6.0 million, $5.9 million and $5.1 million in 2017, 2016 and 2015, respectively.
Net deferred tax assets and liabilities as of December 31, 2017 and 2016 are as follows:
Giving full effect to the carryback of net operating losses for federal income tax purposes, we have approximately $742 million of net operating loss ("NOL") carryforwards on a regular tax basis as of December 31, 2017. Any unutilized carryforwards are scheduled to expire at the end of tax years 2032 and 2033.
Table 12.5 summarizes the components of the provision for (benefit from) income taxes:
Our income tax expense for 2017 reflects the remeasurement of our net deferred tax assets to reflect the lower corporate tax rate of 21% under the Tax Act, effective January 1, 2018. As a result of the lower tax rate, we have recorded a decrease to our net deferred tax assets of $133 million with a corresponding increase to our deferred income tax expense for the year ended December 31, 2017.
Table 12.6 reconciles the federal statutory income tax rate to our effective tax provision (benefit) rate.
In 2014, we received Notices of Deficiency (commonly referred to as “90 day letters”) covering the 2000-2007 tax years. The Notices of Deficiency reflect taxes and penalties related to the REMIC matters of $197.5 million and at December 31, 2017, there would also be interest related to these matters of approximately $205.0 million. In 2007, we made a payment of $65.2 million to the United States Department of the Treasury which will reduce any amounts we would ultimately owe. The Notices of Deficiency also reflect additional amounts due of $261.4 million, which are primarily associated with the disallowance of the carryback of the 2009 net operating loss to the 2004-2007 tax years. We believe the IRS included the carryback adjustments as a precaution to keep open the statute of limitations on collection of the tax that was refunded when this loss was carried back, and not because the IRS actually intends to disallow the carryback permanently. Depending on the outcome of this matter, additional state income taxes and state interest may become due when a final resolution is reached. As of December 31, 2017, those state taxes and interest would approximate $85.8 million. In addition, there could also be state tax penalties. Our total amount of unrecognized tax benefits as of December 31, 2017 is $142.8 million, which represents the tax benefits generated by the REMIC portfolio included in our tax returns that we have not taken benefit for in our financial statements, including any related interest.
We filed a petition with the U.S. Tax Court contesting most of the IRS’ proposed adjustments reflected in the Notices of Deficiency and the IRS filed an answer to our petition which continued to assert their claim. The case has twice been scheduled for trial and in each instance, the parties jointly filed, and the U.S. Tax Court approved (most recently in February 2016), motions for continuance to postpone the trial date. Also in February 2016, the U.S. Tax Court approved a joint motion to consolidate for trial, briefing, and opinion, our case with similar cases of Radian Group, Inc., as successor to Enhance Financial Services Group, Inc., et al. The parties have reached agreement on all issues in the case and in the fourth quarter of 2017, the IRS submitted documentation reflecting the terms of the agreement to the Joint Committee on Taxation ("JCT") for its review, which must be performed before a settlement can be completed. There is no assurance that a settlement will be completed. Based on information that we currently have regarding the status of our ongoing dispute, we recorded a provision for additional taxes and interest of $29.0 million in 2017.
The total amount of the unrecognized tax benefits related to our aforementioned REMIC issue, which would affect our effective tax rate, is $129.3 million. We recognize interest accrued and penalties related to unrecognized tax benefits in income taxes. During 2017, we recognized $23.1 million in interest. As of December 31, 2017 and 2016, we had $52.0 million and $28.9 million of accrued interest related to uncertain tax positions, respectively. The statute of limitations related to the consolidated federal income tax return is closed for all years prior to 2000. It is reasonably possible that our 2000-2007 federal tax case will be resolved, other than through litigation. If it is resolved under the basis of settlement as disclosed above, our total unrecognized tax benefits would be reduced by $142.8 million during 2018. After taking into account prior payments and the effect of available net operating loss carrybacks, any net cash outflows would approximate $55 million.
As of January 1, 2017, we adopted the updated guidance of "Improvements to Employee Share-Based Compensation Accounting." The adoption of this guidance resulted in an immaterial cumulative effect adjustment to our 2017 beginning retained earnings. For the year ending December 31, 2017, we adopted the updated guidance of "Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income." The adoption of this guidance resulted in a $10.4 million reclassification from accumulated other comprehensive loss to retained earnings during the fourth quarter of 2017. Each of these adoptions are more fully described in Note 3 - "Significant Accounting Policies."
As described in Note 7 - "Debt," in 2016 we issued approximately 18.3 million shares of our common stock as consideration for the purchase of certain of our 2% Notes. As of December 31, 2016, we had repurchased all of the shares issued as partial consideration for our 2% Notes repurchases. The weighted average price paid for the share repurchases was $8.03, which included commissions, and the aggregate purchase amount was $147.1 million.
The statutory financial statements of our insurance companies are presented on the basis of accounting principles prescribed, or practices permitted, by the Office of the Commissioner of Insurance of the State of Wisconsin (the "OCI"), which has adopted the National Association of Insurance Commissioners ("NAIC") Statements of Statutory Accounting Principles ("SSAP") as the basis of its statutory accounting principles. In converting from statutory to GAAP, typical adjustments include deferral of policy acquisition costs, the inclusion of net unrealized holding gains or losses in shareholders' equity relating to fixed maturities and the inclusion of statutory non-admitted assets.
In addition to the typical adjustments from statutory to GAAP, mortgage insurance companies are required to maintain contingency loss reserves equal to 50% of premiums earned under SSAP and principles prescribed by the OCI, and such amounts cannot be withdrawn for a period of ten years except as permitted by insurance regulations. With regulatory approval, a mortgage guaranty insurance company may make early withdrawals from the contingency reserve when incurred losses exceed 35% of net premiums earned in a calendar year. For the year ended 2017, MGIC's losses incurred were 5% of net premiums earned. Changes in contingency loss reserves impact the statutory statement of operations. Contingency loss reserves are not reflected as liabilities under GAAP and changes in contingency loss reserves do not impact the GAAP statements of operations. A premium deficiency reserve that may be recorded on a GAAP basis when the present value of expected future losses and expenses exceeds the present value of expected future premiums and already established loss reserves, may not be recorded on a statutory basis if the present value of expected future premiums and already established loss reserves and statutory contingency reserves, exceeds the present value of expected future losses and expenses. On a GAAP basis, when calculating a premium deficiency
reserve policies are grouped based on how they are acquired, serviced and measured. On a statutory basis, a premium deficiency reserve is calculated on all policies in force.
At December 31, 2017, the risk-to-capital ratio of our combined insurance operations (which includes a reinsurance affiliate) was 10.5 to 1. Reinsurance transactions with our affiliate permit MGIC to write insurance with a higher coverage percentage than it could on its own under certain state-specific requirements. A higher
risk-to-capital ratio on a combined basis may indicate that, in order for MGIC to continue to utilize reinsurance arrangements with its reinsurance affiliate, additional capital contributions to the affiliate could be needed.
The NAIC plans to revise the minimum capital and surplus requirements for mortgage insurers that are provided for in its Mortgage Guaranty Insurance Model Act. In May 2016, a working group of state regulators released an exposure draft of a risk-based capital framework to establish capital requirements for mortgage insurers, although no date has been established by which the NAIC must propose revisions to the capital requirements and certain items have not yet been completely addressed by the framework, including the treatment of ceded risk, minimum capital floors, and action level triggers. Currently we believe that the PMIERs contain the more restrictive capital requirements in most circumstances.
MGIC is subject to statutory regulations as to payment of dividends. The maximum amount of dividends that MGIC may pay in any twelve-month period without regulatory approval by the OCI is the lesser of adjusted statutory net income or 10% of statutory policyholders' surplus as of the preceding calendar year end. Adjusted statutory net income is defined for this purpose to be the greater of statutory net income, net of realized investment gains, for the calendar year preceding the date of the dividend or statutory net income, net of realized investment gains, for the three calendar years preceding the date of the dividend less dividends paid within the first two of the preceding three calendar years. The OCI recognizes only statutory accounting principles prescribed, or practices permitted, by the State of Wisconsin for determining and reporting the financial condition and results of operations of an insurance company. The OCI has adopted certain prescribed accounting practices that differ from those found in other states. Specifically, Wisconsin domiciled companies record changes in the contingency reserves through the income statement as a change in underwriting deduction. As a result, in periods in which MGIC is increasing contingency reserves, statutory net income is reduced. For the year ended December 31, 2017, MGIC’s statutory net income was reduced by $473 million to account for the increase in contingency reserves.
At December 31, 2017, 6.7 million shares were available for future grant under the 2015 Omnibus Incentive Plan.
In addition to matters for which we have recorded a probable loss, we are involved in other discussions and/or proceedings with insureds with respect to our claims paying practices. Although it is reasonably possible that when these matters are resolved we will not prevail in all cases, we are unable to make a reasonable estimate or range of estimates of the potential liability. We estimate the maximum exposure associated with matters where a loss is reasonably possible to be approximately $285 million, although we believe (but can give no assurance that) we will ultimately resolve these matters for significantly less than this amount. This estimate of our maximum exposure does not include interest or consequential or exemplary damages.
Through a non-insurance subsidiary, we utilize our underwriting skills to provide an outsourced underwriting service to our customers known as contract underwriting. As part of the contract underwriting activities, that subsidiary is responsible for the quality of the underwriting decisions in accordance with the terms of the contract underwriting agreements with customers. That subsidiary may be required to provide certain remedies to its customers if certain standards relating to the quality of our underwriting work are not met, and we have an established reserve for such future obligations. Claims for remedies may be made a number of years after the underwriting work was performed. The related contract underwriting remedy expense for the years ended December 31, 2017, 2016, and 2015, respectively, was immaterial to our consolidated financial statements.
We have audited the accompanying consolidated balance sheets of MGIC Investment Corporation and its subsidiaries as of December 31, 2017 and 2016, and the related consolidated statements of operations, comprehensive income, shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2017, including the related notes and financial statement schedules listed in the index appearing under Item 15 (a)(2) (collectively referred to as the “consolidated financial statements”). We also have audited the Company's internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
The Company's management is responsible for these consolidated financial statements, 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 the Company’s consolidated financial statements and on the Company's internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) ("PCAOB") and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.