MI protects mortgage lenders from all or a portion of default-related losses on residential mortgage loans made to home buyers who generally make down payments of less than 20% of a home's purchase price. By protecting lenders and investors from credit losses, we help facilitate the availability of mortgages to prospective, primarily first-time, U.S. home buyers, thus promoting homeownership while protecting lenders and investors against potential losses related to a borrower's default. MI also facilitates the sale of these mortgage loans in the secondary mortgage market, most of which are sold to the GSEs. We are one of six companies in the U.S. who offer MI. Our business strategy is to continue to expand our customer base and write insurance on high quality, low down payment residential mortgages in the U.S. We reported our first quarterly profit for the quarter ended June 30, 2016, and we reported income of $65.8 million for the year ended December 31, 2016.
We had total IIF of $35.8 billion and total RIF of $7.9 billion as of December 31, 2016, compared to total IIF of $19.1 billion and total RIF of $3.7 billion as of December 31, 2015, and total IIF of $8.1 billion and total RIF of $894.7 million as of December 31, 2014. Of total IIF as of December 31, 2016, we had $32.2 billion of primary IIF and $3.6 billion of pool IIF, compared to $14.8 billion of primary IIF and $4.2 billion of pool IIF as of December 31, 2015 and $3.4 billion of primary IIF and $4.7 billion of pool IIF as of December 31, 2014. As of December 31, 2016, our primary RIF was $7.8 billion, compared to primary RIF of $3.6 billion and $801.6 million as of December 31, 2015 and December 31, 2014, respectively. Pool RIF was $93.1 million as of December 31, 2016, December 31, 2015, and December 31, 2014.
As discussed in Part I, Item 1, "Business - Customers," our sales and marketing strategy is focused on expanding relationships with existing customers and attracting new mortgage originator customers in the U.S. that fall into two primary categories, which we refer to as "National Accounts" and "Regional Accounts." In 2016, we continued to increase our customer base. We had 1,131 Master Policy holders as of December 31, 2016, compared to 964 Master Policy holders as of December 31, 2015 and 735 Master Policy holders as of December 31, 2014. Of those Master Policy holders, 56.4%, or 638, generated new insurance written (NIW) in 2016, compared to 500, or 51.9%, that generated NIW in 2015 and 277, or 37.7%, that generated NIW in 2014.
Lenders in the combined residential mortgage market who control the MI decision are currently comprised of three groups:
Since April 2013, we have increased our customer base significantly, and we expect to continue to acquire new customers. As of December 31, 2016, we had active customer relationships with 26 of the top 40 lenders and expect to develop additional active customer relationships. We believe our most significant growth opportunity is within the large and fragmented market of Regional Accounts, which includes some of the top correspondent lenders. In addition to adding new customers, we believe existing customers will begin to allocate more of their business to us for placement of our MI.
We offer monthly, single and annual premium payment plans. For monthly policies, premiums are collected and earned each month as coverage is provided. Policies written on a single premium basis are paid through a single, upfront payment, the majority of which is initially deferred as unearned premium and earned over the policy's expected life. Annual policies represent an insignificant amount of our NIW to date.
In September 2016, we entered into the 2016 QSR Transaction, which will impact our results of operations while the agreement is in effect.
Our reinsurance affects premiums, underwriting expenses and losses incurred. For the year ended December 31, 2016, our pre-tax net cost of reinsurance was approximately $2.8 million.
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 that are not currently contemplated, its elimination).
The tables below show primary and pool IIF, NIW and premiums written and earned. Single NIW and IIF include policies written on an aggregated and flow basis. Unless otherwise noted, the following tables do not include the effects of the 2016 QSR Transaction described above.
(1) Premiums written and earned in 2016 are reported net of the 2016 QSR Transaction.
Premiums written and earned in a year are generally influenced by:
NIW, which is the new IIF (aggregate principal amount of the mortgages) insured during a period. Many factors affect NIW, including the volume of low down payment home mortgage originations (which tend to be generated to a greater extent in purchase financings as compared to refinancings) and the competition to provide credit enhancement on those mortgages, which includes primarily competition from the FHA and other private mortgage insurers;
the product mix of our book of business, which includes recurring monthly premiums earned for monthly policies and the recognition of premiums earned from the amortization of our single premiums over the policies' lives. We expect our product mix and the average premium rate we charge to be generally comparable with the industry as our business matures;
In our industry, a "book" is a group of loans that an MI company insures in a particular period, normally a calendar year. In general, the majority of any underwriting profit (i.e., the earned premium revenue minus claims and expenses, excluding investment income) that a book generates occurs in the early years of the book, with the largest portion of the underwriting profit for that book realized in the first year. This pattern generally occurs because relatively few of the claims that a book will ultimately experience typically occur in the first few years of the book, when premium revenue is highest, while subsequent years are affected by declining premium revenues, as the number of insured loans decreases (primarily due to loan prepayments), and by increasing losses. The earnings we record and the cash flow we receive vary based on the type of MI product (e.g., BPMI or LPMI) and premium plan (e.g., single or monthly) our customers select.
Single-premium LPMI, which historically has represented approximately 25% of industry NIW, has generally seen greater price competition. In 2016, in response to the required assets provisions of PMIERs, including the additional capital charges applied to LPMI products, we implemented new, higher LPMI single premium rates. Through 2015, single premium policies had comprised a majority of our NIW. In 2016, we saw a reduction in LPMI single NIW as a percentage of our mix compared to 2015. As a result, during 2016, our mix of MI products has shifted to a higher percentage of monthly premium policies. For the year ended December 31, 2016, 67% of our NIW consisted of monthly premium policies, and in the fourth quarter we reached a mix approximating the industry average, with 75% of our NIW comprised of monthly premium policies.
Our persistency rate is the percentage of IIF that remains on our books after any 12-month period. Because our insurance premiums are earned over the life of a policy, changes in persistency rates can have a significant impact on our earnings. The persistency rate on our portfolio was 80.7% at December 31, 2016, compared to 79.6% at December 31, 2015. Persistency rates are sensitive to fluctuations in interest rates. Decreases in interest rates typically increase our portfolio's cancellation rate. When cancellations increase, we experience lower profitability and returns on our monthly premium business. Conversely, we experience higher returns on our single premium business because, rather than amortizing the single premium over the expected life of the policy, upon cancellation, we immediately recognize all unamortized single premium as earned.
The table below shows primary portfolio trends, by quarter, for the last five quarters.
The table below shows primary portfolio trends, by year, for the last three years.
The table below reflects a summary of the change in total primary IIF for the years ended December 31, 2016, 2015 and 2014.
The tables below reflect our total primary NIW by FICO, LTV and purchase/refinance mix for the three years ended December 31, 2016. We calculate the LTV of a loan as the percentage of the original loan amount to the original value of the property securing the loan. In general, the lower the LTV the lower the likelihood of a default, and for loans that default, a lower LTV generally results in lower severity for a resulting claim, as the borrower has more equity in the property.
The tables below show the primary weighted average FICO and weighted average LTV, by policy type, for NIW in the years presented.
As of December 31, 2016, December 31, 2015 and December 31, 2014, 100% of each of our pool IIF and RIF was comprised of insurance on fixed rate mortgages.
The sum of claims paid ever to date and notices of default as of the end of the period divided by policies ever in force.
The following table shows the distribution by state of our primary RIF. For the three years presented below, our RIF was relatively more concentrated in California, primarily as a result of the location and timing of the acquisition of new customers. The distribution of risk across the states as of December 31, 2016 is not necessarily representative of the geographic distribution we expect in the future. As we add new customers and receive greater allocations of business from our existing customers, we expect we will have increased flexibility to manage our state concentration levels.
declines in housing values, as such declines may negatively affect loss mitigation opportunities on loans in default, as well as increase the likelihood that borrowers will default when the value of the home is below or perceived to be below the mortgage balance;
the rate at which we rescind policies. Because of tighter underwriting standards generally in the mortgage lending industry and the terms of our Master Policy, we expect that our level of rescission activity will be lower than recent rescission activity experienced by the MI industry; and
the typical distribution of claims over the life of a book results in fewer defaults during the first two years after loans are originated, usually peaking in years three through six and declining thereafter;
While our portfolio matures, we expect our reported loss ratio will be less than 10%, due to loss development being generally insignificant in the early years of a loan cycle combined with strong growth in earned premiums on a year-over-year basis. We expect that the frequency of claims on our initial primary books of business should be between 2% and 3% of mortgages insured over the life of the book. For claims that we may receive, we expect the severity of the claim to be between 85% and 95% of the coverage amount. Based on these expectations, we estimate that the loss ratio over the life of each book will be between 20% and 25% of earned premiums.
The following table provides a reconciliation of the beginning and ending reserve balances for primary insurance claims and claims expenses for the years ended December 31, 2016 and December 31, 2015.
(1) Related to ceded losses recoverable on the 2016 QSR Transaction. To date, ceded losses have been immaterial. See Item 8, "Financial Statements and Supplementary Data - Notes to Consolidated Financial Statements - Note 6, Reinsurance," for additional information.
The following table provides a reconciliation of the beginning and ending count of loans in default.
The increase in the number of defaults at December 31, 2016 compared to December 31, 2015 was primarily due to an increase in the number of policies in force and the increasing maturity of our portfolio.
As an Approved Insurer, NMIC is subject to ongoing compliance with the PMIERs. (Italicized terms have the same meaning that such terms have in the PMIERs, as described below.) The PMIERs establish operational, business, remedial and financial requirements applicable to Approved Insurers. The PMIERs financial requirements prescribe a risk-based capital methodology whereby the amount of capital required to be held against each insured loan is determined based on certain risk characteristics, such as FICO, vintage (year of origination), performing vs. non-performing (i.e., current vs. delinquent), LTV and other risk features. An asset charge is calculated for each insured loan based on its risk profile. In general, higher quality loans carry lower capital charges.
Under the PMIERs financial requirements, Approved Insurers must maintain available assets that equal or exceed minimum required assets, which is an amount equal to the greater of (i) $400 million or (ii) a total risk-based required asset amount. The risk-based required asset amount is a function of the risk profile of an Approved Insurer’s net RIF, calculated by applying on a loan-by-loan basis certain risk-based factors derived from tables set out in the PMIERs to the net RIF. The risk-based required asset amount for primary insurance is subject to a floor of 5.6% of total, performing, primary RIF, and the risk-based required asset amount for pool insurance considers both the factors in the tables and the net remaining stop loss for each pool insurance policy. The PMIERs financial requirements also increase the amount of available assets that must be held by an Approved Insurer for loans originated on or after January 1, 2016 that are insured under LPMI policies.
By April 15th of each year, NMIC must certify it met all PMIERs requirements as of December 31st of the prior year. We expect to certify to the GSEs by April 15, 2017 that NMIC fully complied with the PMIERs as of December 31, 2016. NMIC also has an ongoing obligation to immediately notify the GSEs in writing upon discovery of its failure to meet one or more of the PMIERs requirements. We will continue to monitor our compliance with the PMIERs going forward.
The following table provides a comparison of the PMIERs financial requirements as reported by NMIC. Our available assets balance as of December 31, 2016 decreased from the prior quarter as the result of new PMIERs requirements that the GSEs released in December 2016. Under the new requirements, our available assets were reduced as a result of the deduction of our reinsurance funds withheld balance and restricted assets held on deposit by state regulatory agencies.
maximum RTC thresholds. Similarly, Re One had total statutory capital of $33 million at December 31, 2016, with a RTC ratio of .5:1.
In August 2016, S&P affirmed its "BBB-" financial strength and long-term counter-party credit ratings for NMIC. In July 2015, S&P assigned its "BB-" long-term counter-party credit rating to NMIH. S&P's outlook for both companies was "stable." In November 2015, Moody's Investors Service (Moody's) assigned a financial strength rating of "Ba2" for NMIC. Also at that time, Moody's assigned a B2 rating to the $150 million Term Loan held by NMIH. Moody's outlook for both companies was "stable."
The MI industry is highly competitive and currently consists of six private mortgage insurers, including NMIC, as well as governmental agencies like the FHA and the VA. See Part I, Item 1, "Business - Sales and Marketing and Competition - Competition," above.
MI companies compete based on service, customer relationships, underwriting, and other factors including price. In the recent past, lenders have pressured MIs to offer discounted rates, primarily on single premium LPMI. Higher capital requirements imposed by the PMIERs have also had an effect on premium rates. We expect the MI market to remain highly competitive, with pressure for industry participants to grow or maintain their market share in the coming years. Our competitors' respective shares of the private MI market for the quarter ended September 30, 2016 ranged from single percentage points penetration to a high of approximately 19%.
Although there has been broad policy consensus toward the need for private capital to play a larger role and government credit risk to be reduced in the U.S. housing finance system, it remains difficult to predict whether the combined market share of governmental agencies such as the FHA and VA will recede to historical levels. In 2015, the FHA reduced some of its single-family annual mortgage insurance premiums, which had the effect of maintaining the FHA's elevated market share and continuing the increased role of government in the mortgage insurance market. In January 2017, the FHA announced further reductions to its annual premiums; however, before such reductions could take effect, the FHA announced that the cuts were suspended indefinitely. To date, the impact from the FHA's 2015 premium reduction has not had a significant impact on our continued growth in the market. We believe our pricing continues to be more attractive than the FHA's current pricing for a substantial majority of borrowers with credit and loan characteristics similar to those whose loans we insure. With the new Trump administration, it remains uncertain whether FHA will ultimately adopt the suspended reductions or otherwise reduce its mortgage insurance premiums again, or eliminate the non-cancelability of premiums, or whether Congress will continue to consider legislation to reform the FHA. There are factors beyond premium rate that influence a lender's decision to choose private MI over FHA insurance, including among others, the FHA's loan eligibility requirements, cancelability, loan size limits and the relative ease of use of private MI products compared to FHA products.
We recognized net income of $65.8 million for the year ended December 31, 2016 compared to net losses of $27.8 million and $48.9 million for the years ended December 31, 2015 and December 31, 2014, respectively. The primary driver of the profitable year ended December 31, 2016, compared to the years ended December 31, 2015 and December 31, 2014, was the significant increase in premiums earned from our IIF as a result of the addition of new customers and higher allocations of business to us from existing customers, slightly offset by personnel and external costs.
As of December 31, 2016, we had approximately $677 million in cash and investments of which $74.1 million was held at NMIH. The increase in cash and investments from year-end 2015 relates directly to the magnitude of premiums collected in 2016, less operating expenses and capital expenditures.
Our deferred policy acquisition asset was $30.1 million as of December 31, 2016 compared to $17.5 million at December 31, 2015. The increase was driven by the deferrable costs associated with premiums written during the year ended December 31, 2016 of $134.7 million.
Our software and equipment balance increased from $15.2 million at December 31, 2015 to $20.4 million at December 31, 2016, primarily due to the continued development of our technology platform to support the growth of our business, offset by depreciation and amortization expense during the year.
Our unearned premiums balance increased from $90.8 million as of December 31, 2015 to $152.9 million as of December 31, 2016 due to single premiums written in 2016, offset by cancellations of LPMI policies previously discussed and earnings of existing unearned premiums in accordance with the expiration of risk in the related policies.
As a result of NODs received in 2016, our reserves for insurance claims and claims expenses increased to $3.0 million at December 31, 2016 compared to $679 thousand at December 31, 2015. See, Item 8, "Financial Statements and Supplementary Data - Notes to Consolidated Financial Statements - Note 7, Reserves for Insurance Claims and Claims Expenses."
Deferred ceding commission related to the 2016 QSR Transaction was $4.8 million as of December 31, 2016.
As of December 31, 2016, NMIH had $74 million of cash and investments. NMIH's principal source of operating cash is investment income and in the future could include dividends from NMIC, if available and permitted under law and by the GSEs.
Our net investment income for the year ended December 31, 2016 was $13.8 million, compared to $7.2 million for the year ended December 31, 2015 and $5.6 million for the year ended December 31, 2014. As of December 31, 2016, our portfolio conforms with our investment guidelines. The principal factors affecting our investment income include the size and credit rating of our portfolio and its net yield. As measured by amortized cost (which excludes changes in fair market value, such as those resulting from changes in interest rates), the size of our investment portfolio is mainly a function of capital raised, cash generated from (or used in) operations, such as net premiums received, and investment earnings.
Since inception and prior to December 31, 2016, we recorded a valuation allowance against deferred tax assets, and, as such, we generally did not record a benefit associated with the losses incurred in prior periods or other income tax benefits. (Income tax benefits recognized in prior periods were related to the tax effects of unrealized gains credited to other comprehensive income (OCI).) At December 31, 2016, after weighing applicable evidence, we concluded that it is more-likely-than-not that our deferred tax assets will be realized. As a result, as of December 31, 2016, we have released the valuation allowance on federal and certain state deferred tax assets. A valuation allowance will continue to be recorded against net state deferred tax assets, primarily related to state net operating losses generated by NMIH that we do not expect to be utilized. NMIH operates at a loss and currently only generates revenue from its investment portfolio. Starting in 2017, we expect that our consolidated effective tax rate will approximate the statutory tax rates.
our current net operating loss carryforwards are expected to be fully utilized by 2018;
our expectation that we will be in a cumulative profit in a three-year period in 2017.
The primary negative evidence that was considered was our cumulative losses in recent years. Although ASC 740 does not define the term or the length of time to consider when calculating the cumulative loss, practice and interpretations suggest that the guideline, not a “bright line”, is to aggregate the pretax results as adjusted for permanent items for three years (i.e., the current and the two preceding years).
Management has concluded that positive evidence of sufficient quantity and quality outweighs negative evidence, and supports our conclusion that it is more-likely-than-not that the Company will realize its federal and certain state deferred tax assets. The reversal of the Company’s beginning-of-the-year valuation allowance against such deferred tax assets (resulting from a change in judgment about the realizability of the related deferred tax assets in future years) is consistent with the requirements of ASC 740-10-45-20. We have recorded the effects of the change in income from continuing operations, generating a financial statement benefit of $60.0 million and $0.3 million related to net federal and certain state deferred tax assets, respectively. A tax effected valuation allowance of $7.3 million, $66.4 million, and $53.7 million was recorded at December 31, 2016, 2015 and 2014, respectively, to reflect the amount of the deferred taxes that more-likely-than-not will not be realized.
We had no off-balance sheet arrangements at December 31, 2016. Contractual obligations at December 31, 2016 are summarized in the table that follows.
*Long-term debt relates to our $150 million Credit Agreement and includes future interest payments using the minimum interest rate in effect at December 31, 2016 (prior to the Amendment) of 8.75%.
Consistent with industry accounting practices, for purposes of establishing claim reserves, we adhere to the general claim reserving principles contained in ASC 944, Financial Services - Insurance (ASC 944), even though that standard expressly excludes mortgage insurance from its guidance. Consistent with our industry, we do not establish claim reserves for anticipated future claims on insured loans that are not currently in default. We do not consider a loan to be in default for claim reserve purposes until we receive notice from the servicer that a borrower has failed to make two consecutive regularly scheduled payments and is at least sixty days in default. Default is defined in our Master Policy as the failure by a borrower to pay when due an amount equal to the scheduled mortgage payment due under the terms of a loan or the failure by a borrower to pay all amounts due under a loan after the exercise of the due on sale clause of such loan. In addition to reserves on reported defaults, we establish IBNR reserves for estimated claims incurred on loans that have been in default for at least sixty days that have not yet been reported to us by the servicers.
The establishment of claim and IBNR reserves is subject to inherent uncertainty and requires significant judgment by management. We establish claim reserves using our best estimates of claim rates, i.e., the percent of loan defaults that ultimately result in claim payments, and claim amounts, i.e., the dollar amounts required to settle claims, to estimate the ultimate claims on loans reported to us as being at least sixty days in default as of the end of each reporting period. We estimate IBNR by analyzing historical lags in default reporting to determine a specific number of IBNR claims in each reporting period. We utilize internal and external data to estimate lags in NOD reporting. Additionally, our estimates of claim rates and claim sizes are strongly influenced by prevailing economic conditions, for example current rates or trends in unemployment, house price appreciation and/or interest rates, and our best judgment as to the future values or trends of these macroeconomic factors.
Level 2 - Prices or valuations based on observable inputs other than quoted prices in active markets for identical assets and liabilities.
Purchases and sales of investments are recorded on a trade date basis. Net investment income is recognized when earned, and includes interest and dividend income together with amortization of market premiums and discounts using the effective yield method, and is net of investment management fees and other investment related expenses. For asset-backed securities and any other holdings for which there is a prepayment risk, prepayment assumptions are evaluated and revised as necessary.
value of future premiums relies on, among other things, assumptions about persistency and repayment patterns on underlying loans. The present value of expected claims and expenses depends on assumptions relating to severity of claims, claim rates on current defaults and expected defaults in future periods. These assumptions may also include an estimate of expected rescission activity. Assumptions used in calculating premium deficiency reserves can be affected by volatility in the current housing and mortgage lending industries. To the extent premium patterns and actual claim experience differ from the assumptions used in calculating a premium deficiency reserve, the differences between the actual results and our estimate will affect future period earnings. In considering the potential sensitivity of the factors underlying our best estimate of premium deficiency reserves, it is possible that even a relatively small change in estimated claim rate or a relatively small percentage change in estimated claim amount could have a significant impact on establishing a premium deficiency reserve, should one be needed, and, correspondingly, on our operating results.
We account for income taxes using the liability method in accordance with ASC 740, Income Taxes. The liability method measures the expected future tax effects of temporary differences at the enacted tax rates applicable for the period in which the deferred asset or liability is expected to be realized or settled. Temporary differences are differences between the tax basis of an asset or liability and its reported amount in the consolidated financial statements that would result in future increases or decreases in taxes owed on a cash basis compared to amounts already recognized as tax expense in the consolidated statement of operations. We evaluate the need for a valuation allowance against deferred tax assets on a quarterly basis. In the course of our review, we assess all available evidence, both positive and negative, including future sources of income, tax planning strategies, future contractual cash flows and reversing temporary differences. Additional valuation allowance benefits or charges could be recognized in the future due to changes in management's expectations regarding the realization of tax benefits.
For RSUs which are subject to a service condition, expense is recognized over the required service period, which is generally a three-year vesting period (vesting in one-third increments per year). Expense is measured by multiplying the number of RSUs by the grant date fair value.
In the mortgage insurance industry, a "book" is a group of loans that a mortgage insurance (MI) company insures in a particular period, normally a calendar year. We set premiums at the time a policy is issued based on our filed rates and rating rules. The policies we issue are guaranteed renewable contracts at the policyholder's option. Premiums may be paid to us on a single, annual or monthly basis. Premiums written on a single premium basis and an annual premium basis are initially deferred as unearned premium reserve and earned over the policy's expected life commencing in the month coverage is effective. Premiums written on policies covering more than one year are amortized over the policy life in accordance with the expiration of risk, which is the anticipated claim payment pattern based on industry experience. Premiums written on annual policies are earned on a monthly pro rata basis. Premiums written on monthly policies are earned as coverage is provided. Premiums written on pool transactions are earned over the period that coverage is provided. Upon cancellation of a policy, all premium that is non-refundable is immediately earned and any refundable premium is returned to the policyholder. Premiums returned to policyholders are recorded as a reduction of written and earned premiums in the current period. The actual return of premium for all periods affects premiums written and earned in those periods.
We have designated our investment portfolio as available-for-sale and report it at fair value. The related unrealized gains and losses, after considering the related tax expense or benefit, are recognized as a component of accumulated other comprehensive (loss) income in shareholders' equity. Net realized investment gains and losses are reported in income based upon specific identification of securities sold, and are reclassified out of accumulated other comprehensive (loss) income.
We account for stock compensation in accordance with ASC 718, Compensation - Stock Compensation, which addresses accounting for share-based awards and recognition of compensation expense, measured using grant date fair value, over the requisite service or performance period of the award. Share-based payments include restricted stock unit (RSU) and stock option grants under the 2012 Stock Incentive Plan and the NMIH 2014 Omnibus Incentive Plan. We determine the fair value of issued stock option grants using an option pricing model, which takes into account various assumptions that are subjective. Key assumptions used in the stock option valuation include the expected term of the option award, taking into account the contractual term of the award, the effects of expected exercise and post-vesting termination behavior, expected volatility, expected dividends and the risk free interest rate for the expected term of the award. RSU grants to employees contain a market condition and/or service condition. The fair value of RSU grants to employees with a market condition is determined based on a Monte Carlo simulation model at the date of grant. RSU grants to employees with a service condition and RSU grants to non-employee directors are valued at our stock price on the date of grant less the present value of anticipated dividends.
Certain costs associated with the development of internal-use software are capitalized. Software and equipment are stated at cost, less accumulated amortization and depreciation. Once the software is ready for its intended use, amortization and depreciation are calculated using the straight-line method over the estimated useful lives of the respective assets ranging typically from 3 to 7 years, unless factors indicate a shorter useful life. Amortization of software and depreciation of equipment commences at the beginning of the month following our placement of the assets into use. For further detail, see "Note 12, Software and Equipment."
Goodwill represents the excess of the purchase price over the estimated fair value of net assets acquired from a business combination. In accordance with ASC 350, Intangibles - Goodwill and Other, we test goodwill for impairment during the third quarter each year, or more frequently if we believe indicators of impairment exist. We have not identified any impairments of goodwill through December 31, 2016.
In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606). This update is intended to provide a consistent approach in recognizing revenue. In accordance with the new standard, recognition of revenue occurs when a customer obtains control of promised goods or services in an amount that reflects the consideration to which the entity expects to
be entitled in exchange for those goods or services. In addition, the new standard requires that reporting companies disclose the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. In August 2015, ASU 2015-14 deferred the provisions of ASU 2014-09 to be effective for interim and annual periods beginning after December 15, 2017. The Company is currently evaluating the impact the adoption of this ASU will have, if any, on the consolidated financial statements; however, this update is not expected to impact the recognition of revenue related to insurance premiums or investments, which represent the majority of our total revenues.
In May 2015, the FASB issued ASU 2015-09, Disclosures about Short-Duration Contracts (Topic 944), which requires insurance entities to disclose additional information related to the liability for unpaid claims and claims adjustment expenses. These disclosures include the nature, amount, timing and uncertainty of cash flows related to those liabilities and the effects of those cash flows on comprehensive income. This update is effective for annual periods beginning after December 15, 2015 and interim periods within annual periods beginning after December 15, 2016. For the year ended December 31, 2016, we have included additional information in our financial statements and notes therein related to this guidance.
In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). This update requires that businesses recognize rights and obligations associated with certain leases as assets and liabilities on the balance sheet. The standard also requires additional disclosures regarding the amount, timing, and uncertainty of cash flows arising from leases. For public business entities, this update is effective for annual periods beginning after December 15, 2018 and interim periods therein. Early adoption is permitted in any period. We expect to adopt this guidance on January 1, 2019. We anticipate this standard will have a material impact on our financial position, primarily due to our office space operating lease, as we will be required to recognize lease assets and lease liabilities on our consolidated balance sheet. We will continue to assess the potential impacts of this standard, including the impact the adoption of this guidance will have on our results of operations or cash flows, if any.
In March 2016, the FASB issued ASU 2016-09, Compensation-Stock Compensation (Topic 718). This update is intended to provide improvements to employee share-based payment accounting. The areas for simplification in the update involve several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. For public business entities, the amendments in this update are effective for annual periods beginning after December 15, 2016 and interim periods within those annual periods. The Company will adopt this guidance in the first quarter of 2017 and has evaluated the impact the adoption of this ASU will have on the consolidated financial statements. The Company will elect to recognize forfeitures as they occur. The Company will record deferred tax assets for past unrecognized excess tax benefits on a modified retrospective basis through a cumulative-effect adjustment to retained earnings as of January 1, 2017, which we expect will not have a material impact on stockholders' equity as of January 1, 2017. The classification of excess tax benefits and tax deficiencies as income tax benefit or expense may result in net income volatility in reporting periods subsequent to 2016. The amount of excess tax benefits or tax deficiencies in future periods will vary based on the market value of the Company's common stock at the vesting dates of non-vested common share units. The Company does not expect to adjust prior period consolidated statement of cash flows.
In June 2016, the FASB issued ASU 2016-13, Financial Instruments-Credit Losses (Topic 326). This update requires companies to measure all expected credit losses for financial assets held at the reporting date. The accounting for credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration also is amended in the standard. The standard will take effect for public business entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. While the Company is still in the early states of evaluating this ASU, we do not expect it to impact our accounting for insurance losses and loss adjustment expenses (LAE) as these items are not within the scope of the this ASU.
In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230). This update is intended to reduce diversity in practice in how certain cash receipts and cash payments are presented and classified in the statement of cash flows. The standard will take effect for public business entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2017. The Company is currently in the early stages of evaluating the impact the adoption of this ASU will have, if any, on the presentation of the consolidated financial statements.
In January 2017, the FASB issued ASU 2017-04, Intangibles - Goodwill and Other (Topic 350). This update is intended to simplify the test for goodwill impairment. The standard will take effect for public business entities for fiscal years, and interim periods within those fiscal years, after December 15, 2020. Early adoption is permitted for interim or annual goodwill impairment
Certain items in the financial statements as of and for the periods ending December 31, 2014 have been reclassified to conform to the current period's presentation. There was no effect on net income or shareholders' equity previously reported.
On February 10, 2017, the Company entered into an amendment to the Credit Agreement, dated as of November 10, 2015, to, among other things, extend the maturity date of the Credit Agreement, reduce the interest rate, and make certain changes to the financial covenants and other provisions.
connection with certain repricing transactions within 12 months after the effective date of the Amendment, the Company shall pay
The amortized cost and fair values of available for sale securities at December 31, 2016 and 2015, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties. Because most asset-backed securities provide for periodic payments throughout their lives, they are listed below in separate categories.
As of December 31, 2016 and December 31, 2015, there were approximately $6.9 million of cash and investments in the form of U.S. Treasury securities on deposit with various state insurance departments to satisfy regulatory requirements.
The following describes the valuation techniques used by us to determine the fair value of financial instruments held at December 31, 2016 and December 31, 2015:
We calculate the fair value of outstanding warrants using a Black-Scholes option-pricing model in combination with a binomial model. Variables in the model include the risk-free rate of return, dividend yield, expected life and expected volatility of our stock price.
We revalue the warrant liability quarterly using a Black-Scholes option-pricing model, in combination with a binomial model, and we value the pricing protection features within the warrants using a Monte-Carlo simulation model. As of December 31, 2016, the assumptions used in the option pricing model were as follows: a common stock price as of December 31, 2016 of $10.65, risk free interest rate of 1.78%, expected life of 4.33 years, expected volatility of 32.7% and a dividend yield of 0%. The
As of December 31, 2015, the assumptions used in the option pricing model were : a common stock price as of December 31, 2015 of $6.77, risk free interest rate of 1.91%, expected life of 5.92 years, expected volatility of 32.7% and a dividend yield of 0%. The change in fair value was primarily attributable to a decline in the price of our common stock from December 31, 2014 to December 31, 2015.
There were no transfers in or out of Level 3 of the fair value hierarchy during the year ended December 31, 2016.
NMIH is subject to certain quarterly covenants under the Credit Agreement. These covenants include, but are not limited to the following: a maximum debt-to-total capitalization ratio (as defined) of 35%, maximum RTC ratio of 22.0:1.0, liquidity (as defined) of $25.5 million, compliance with the PMIERs financial requirements (subject to any GSE-approved waivers), and equity requirements. This description is not intended to be complete in all respects and is qualified in its entirety by the terms of the Credit Agreement, including its covenants and events of default. We were in compliance with all covenants at December 31, 2016.
On February 10, 2017, the Company entered into an amendment to the Credit Agreement. See "Note 2. Summary of Accounting Principles" for further details of this subsequent event.
100% of our existing risk under our pool agreement with Fannie Mae; and
The effect of reinsurance on net premiums written and earned is as follows. For the year ended December 31, 2014, there were no reinsurance effects on net premiums written and earned.
In accordance with the terms of the 2016 QSR Transaction, rather than making a cash payment or transferring investments for ceded premiums written, NMIC established a funds withheld liability, which is net of amounts due to NMIC for ceding and profit commissions. Any loss recoveries and any potential profit commission to NMIC will be realized from this account until exhausted. Ceded premiums written are recorded on the balance sheet as prepaid reinsurance premiums and amortized to ceded premiums earned in a manner consistent with the recognition of income on direct premiums.
The reinsurance recoverable on loss reserves related to our 2016 QSR Transaction was $297 thousand as of December 31, 2016, reflected with other assets. The reinsurance recoverable balance is further supported by trust accounts established and maintained by each reinsurer in accordance with the PMIERs funding requirements that address ceded risk.
The agreement is scheduled to terminate on December 31, 2027, except with respect to the ceded pool risk, which is scheduled to terminate on August 31, 2023. However, NMIC has the option, based on certain conditions and subject to a termination fee, to terminate the agreement as of December 31, 2020, or at the end of any calendar quarter thereafter, which would result in NMIC reassuming the related risk.
In 2013, we entered into a pool insurance transaction with Fannie Mae. We only establish claim or IBNR reserves for pool risk if we expect claims to exceed the deductible under the pool agreement, which represents the amount of claims absorbed by Fannie Mae before we are obligated to pay any claims. At December 31, 2016, fifty-six loans in the pool were past due by sixty days or more. These fifty-six loans represent approximately $3.4 million in RIF. Due to the size of the remaining deductible of$10.1 million, the low level of Notices of Default (NODs) reported through December 31, 2016 and the expected severity (all loans in the pool have loan-to-value (LTV) ratios under 80%), we have not established any pool reserves for claims or IBNR for the years ended December 31, 2016 and December 31, 2015. In connection with the settlement of pool claims, we applied $256 thousand to the pool deductible through December 31, 2016. We have not paid any pool claims to date.
(1) Related to ceded losses recoverable on the 2016 QSR Transaction. See Note 6, "Reinsurance" for additional information.
There was a $65 thousand favorable prior year development for the year ended December 31, 2016, primarily attributable to cures of NOD's received in prior years. Reserves of $418 thousand related to prior year defaults remained as of December 31, 2016.
Basic earnings (loss) per share is based on the weighted average number of shares of common stock outstanding, while diluted earnings (loss) per share is based on the weighted average number of shares of common stock outstanding and common stock equivalents that would be issuable upon the exercise of stock options, other share-based compensation arrangements, and the dilutive effect of outstanding warrants. The following table reconciles the net income (loss) and the weighted average shares of common stock outstanding used in the computations of basic and diluted earnings (loss) per share of common stock:
As a result of our net loss for the years ended December 31, 2015 and December 31, 2014, 6,266,905 and 5,839,909 of our common stock equivalents we issued under share-based compensation arrangements and warrants, respectively, were not included in the calculation of diluted earnings (loss) per share as of such date because they were anti-dilutive.
We account for these warrants to purchase our common shares in accordance with ASC 470-20, Debt with Conversion and Other Options and ASC 815-40, Derivatives and Hedging - Contracts in Entity's Own Equity.
The remaining weighted average contractual life of options outstanding as of December 31, 2016 was 6.38 years. As of December 31, 2016, there was $0.3 million of total unrecognized compensation cost related to un-vested stock options. The weighted-average period over which total compensation related to un-vested stock options will be recognized is 0.86 years.
Expected Price Volatility - is a measure of the amount by which a price has fluctuated or is expected to fluctuate. At the time of grants, our common shares' trading history was not sufficient to calculate an expected volatility representative of the volatility over the expected lives of the options. As a substitute for such estimate, we used historical volatilities of a set of comparable companies in the industry in which we operate.
At December 31, 2016, the 2.5 million shares of granted and un-vested RSUs consisted of 0.5 million shares that are subject to both a market and service condition and 2.0 million shares that are subject only to service conditions. The un-vested RSUs subject to both a market and service condition vest in one-half increments upon the achievement of certain market price goals and continued service. Un-vested RSUs subject only to a service condition vest over a service period ranging from one to three years. The fair value of RSUs subject to market and service conditions is determined based on a Monte Carlo simulation model at the date of grant. The fair value of RSUs subject only to service conditions are valued at our stock price on the date of grant less the present value of anticipated dividends.
The RSUs granted in 2016 were valued at our stock price on the date of grant less the present value of anticipated dividends, which was $0. As of December 31, 2016, there was $4.2 million of total unrecognized compensation cost related to un-vested RSUs, compared to $3.1 million and $3.0 million as of December 31, 2015 and December 31, 2014, respectively.
For the year ended December 31, 2016, we had an income tax benefit of $54.4 million related primarily to the release of the valuation allowance recorded against federal and certain state deferred tax assets. The provision for income taxes also include current year alternative minimum tax and changes to deferred tax assets. The income tax benefit of $2.4 million for the year ended December 31, 2014 was related to the tax effects of unrealized gains credited to other comprehensive income (OCI). Generally, the amount of tax expense or benefit allocated to continuing operations is determined without regard to the tax effects of other categories of income or loss, such as OCI. However, an exception to the general rule is provided in ASC 740-20-45-7 when there is a pre-tax loss from continuing operations and there are items charged or credited to other categories, including OCI. The intraperiod tax allocation rules related to items charged or credited directly to OCI can result in disproportionate tax effects that remain in OCI until certain events occur. As a result of a reduction in unrealized losses credited directly to OCI, $2.4 million of income tax expense was netted with unrealized gains in OCI, and $2.4 million of income tax benefit was allocated to the income tax provision for continuing operations. As a result of net unrealized losses to OCI during the year ended December 31, 2015 and pre-tax income from continuing operations during the year ended December 31, 2016, the exception was not applicable.
At December 31, 2016, we had a net deferred tax asset of $53.3 million compared to a net deferred tax liability of $0.1 million in all prior periods. The change to our net deferred tax asset (liability) was a result of a change in the valuation allowance during the current year and the balance is primarily related to our deferred tax asset for net operating loss carryforwards of $47.9 million. The net deferred tax liability in all prior years was a result of the acquisition of indefinite-lived intangibles from the acquisition of our insurance subsidiaries. The tax liability incurred at the acquisition was recorded as an increase in goodwill.
As of December 31, 2016, we had a federal net operating loss carryforward of $121.1 million which expires from 2030 to 2036, and state net operating loss carryforwards of $63.6 million, which expire in varying amounts during the years 2031 to 2035. Section 382 of the Internal Revenue Code imposes annual limitations on a corporation's ability to utilize its net operating loss carryforwards if it experiences an "ownership change." As a result of the acquisition of our insurance subsidiaries, $7.3 million of NOLs are subject to annual limitations of $0.8 million through 2016, then $0.3 million through 2029.
As of December 31, 2016 , 2015, and 2014, we have no reserve for unrecognized tax benefits, and have taken no material uncertain positions that would require recognition and measurement. It is our policy to classify interest and penalties related to unrecognized tax benefits as income tax expense.
Software and equipment consist largely of capitalized software developed to support our MI operations. Software and equipment, net of accumulated amortization and depreciation, as of December 31, 2016 and December 31, 2015, consists of the following:
Intangible assets and goodwill consist of identifiable intangible assets and goodwill we purchased in connection with the acquisition of our insurance subsidiaries, and at December 31, 2016 and December 31, 2015, were as follows for both years:
By April 15th of each year, NMIC must certify it met all PMIERs requirements as of December 31st of the prior year. We expect to certify to the GSEs by April 15, 2017 that NMIC fully complied with the PMIERs as of December 31, 2016. NMIC also has an ongoing obligation to immediately notify the GSEs in writing upon discovery of its failure to meet one or more of the PMIERs requirements. We continuously monitor our compliance with the PMIERs.
The company leases office space under a facilities lease in Emeryville, California. In December 2016, the Company amended its lease to extend the term of the lease through March 2023.
As of December 31, 2016, management expects that future minimum lease payments under this lease will be as follows:
We incurred rent expense related to this lease of $1.5 million and $1.5 million for the years ended December 31, 2016 and 2015, respectively. We incurred rent expense related to this lease of $1.6 million for the year ended December 31, 2014.
On November 8, 2013, we filed a final prospectus announcing the sale of 2.1 million shares of Class A common stock through an initial public offering. The underwriters of the offering were granted a 30-day option to purchase up to an additional 315,000 shares of common stock from us at an initial public offering price of $13.00, which they exercised on November 12, 2013. The offering closed on November 14, 2013. Gross proceeds to us were $31.4 million. Net proceeds from the offering were approximately $28 million.
As of December 31, 2016, NMIC had 134,662 policies in force totaling approximately $5.8 billion in total RIF with a RTC ratio of 12.4:1, significantly below the state financial requirements. As of December 31, 2015, NMIC had 63,948 policies in force totaling approximately $3.3 billion of primary RIF, resulting in an RTC ratio of 8.4:1.
Certain states limit the amount of risk a mortgage insurer may retain on a single loan to 25% of the indebtedness to the insured and, as a result, the portion of such insurance in excess of 25% must be reinsured. NMIC and Re One have entered into a primary excess share reinsurance agreement, effective August 1, 2012, and a facultative pool reinsurance agreement, effective September 1, 2013, under which NMIC cedes premiums, loss reserves and claims to Re One on an excess share basis for any primary or pool policy which offers coverage greater than 25% on any loan insured thereunder. NMIC will use reinsurance provided by Re One solely for purposes of compliance with these state statutory coverage limits.
The ability of our insurance subsidiaries to pay dividends to NMIH is limited by insurance laws of the State of Wisconsin and certain other states. Wisconsin law provides that an insurance company may pay out "ordinary dividends" with 30 days' prior notice to the Wisconsin OCI in an amount, when added to other shareholder distributions made in the prior 12 months, not to exceed the lesser of (a) 10% of statutory policyholders' surplus as of the preceding calendar year end or (b) its adjusted statutory net income (excluding realized capital gains) for the twelve month period ending December 31 of the immediately preceding calendar year. In determining net income, an insurer may carry forward net income from the previous calendar years that has not already been paid out as a dividend. Dividends that exceed this amount are "extraordinary dividends," which require prior approval of the Wisconsin OCI.