At our corporate headquarters in Philadelphia, Pennsylvania, we currently lease approximately 151,000 square feet of office space and 1,740 square feet of space for data storage under a lease that expires in August 2017. We also lease 23,453 square feet of office space at a separate location, 1500 Market Street in Philadelphia, Pennsylvania, for various operational and IT personnel.
On November 3, 2015, we entered into a new 15-year operating lease agreement that will commence on September 1, 2017 (the “2017 Lease”) when our lease for our current headquarters expires. The 2017 Lease is for approximately 152,000 square feet of office space at 1500 Market Street in Philadelphia, PA where our new corporate headquarters will be located. When the square footage leased under the 2017 Lease is combined with the office space we currently lease at the 1500 Market Street location, we will have approximately 175,000 square feet of office space for our corporate headquarters. For information regarding the expected obligation for payments under the 2017 Lease, see Note 13 of Notes to Consolidated Financial Statements.
New lending laws and regulations enacted in response to the financial crisis have resulted in increased regulation and regulatory scrutiny and a more restrictive credit environment that has limited the growth of the mortgage industry. As a result, Post-legacy loan originations have consisted primarily of high credit quality loans with significantly better credit performance than the loans in our Legacy Portfolio. While credit quality has improved, the restrictive credit environment has made it more challenging for many first-time home buyers to finance a home, which has limited the number of loans available for private mortgage insurance. See “Results of Operations-Mortgage Insurance-NIW, IIF, RIF” for additional information regarding our portfolio mix and the mortgage industry. Further, while the more stringent regulatory environment generally benefits the compliance consulting services we offer through our Services business, the lack of a meaningful securitization market has significantly limited the volume of business available for our Services business, as further discussed below.
See Note 8 of Notes to Consolidated Financial Statements and “Liquidity and Capital Resources-Radian Group-Short-term Liquidity Needs” for more information about the Single Premium QSR Transaction.
We are focused on growing our fee-based revenues as part of our long-term strategy. Our Services segment is a fee-based business that provides a diverse array of services to participants in multiple facets of the residential real estate and mortgage finance markets. While our Services business overall is most successful in a healthy and robust housing and economic environment, we believe that the diversity of the services offered by our Services segment positions us to generate revenue in both healthy and challenging mortgage market conditions.
the issuance of $350 million aggregate principal amount of Senior Notes due 2021;
the termination of the portion of the capped call transactions related to the purchased Convertible Senior Notes due 2017;
the early redemption of the remaining $195.5 million aggregate principal amount of our Senior Notes due 2017.
See Notes 8, 12 and 14 of Notes to Consolidated Financial Statements for additional information about these transactions.
Our purchases of Convertible Senior Notes due 2017 and 2019 and the early redemption of the Senior Notes due 2017 resulted in a loss on induced conversion and debt extinguishment of $75.1 million for the year ended December 31, 2016. In connection with the termination of the capped call transactions related to the purchased Convertible Senior Notes due 2017, we received 0.2 million shares of Radian Group common stock, which was valued at $2.6 million based on a stock price on the closing date of $11.86.
In addition to the net decrease in dilutive shares, in the aggregate the series of 2016 capital management transactions described above resulted in the following changes to liquidity, long-term debt and stockholders’ equity as of their effective dates:
increase in the amount of our RIF covered by reinsurance, and therefore, the amount of premiums and losses ceded;
On June 29, 2016, the Board authorized a new share repurchase program to spend up to $125 million to repurchase Radian Group common stock. As of February 27, 2017, the full purchase authority remained available under this share repurchase program, which expires on June 30, 2017.
Capital Management Developments Subsequent to 2016. In November 2016, we announced our intent to exercise our redemption option for the remaining Convertible Senior Notes due 2019, of which $68.0 million aggregate principal amount was outstanding at December 31, 2016. The redemption was settled on January 27, 2017. At the time of the redemption, this transaction reduced our diluted shares by 6.4 million, or approximately 2.8% of our diluted shares outstanding as of December 31, 2016. See Note 21 of Notes to Consolidated Financial Statements for additional details.
The charts below highlight certain of the key factors affecting our Mortgage Insurance revenue. The following sections discuss these factors, as well as other key drivers of our results.
The following charts provide a historical perspective on certain key market drivers, including:
•private mortgage insurance penetration as a percentage of the mortgage origination market; and
Premiums. The premium rates we charge for our insurance are based on a number of borrower, loan and property characteristics. Premiums on our mortgage insurance products are generally paid as Monthly Premiums or Single Premiums. In addition, premiums may be paid as a combination of an up-front premium at origination plus monthly renewals, or in some cases, as annual or other periodic premiums paid over multiple years.
The average loan size (higher average loan amounts generally result in higher incurred losses).
Changes in housing values (declines in housing values generally make it more difficult for borrowers to sell a home to avoid default or for the property to be sold to mitigate any claim, and also may negatively affect a borrower’s willingness to continue to make mortgage payments when the home value is less than the mortgage balance; conversely, increases in housing values tend to reduce the level of defaults as well as make it more likely that foreclosures will result in the loan being satisfied).
Settlements such as the BofA Settlement Agreement, which establish certain limits on Loss Mitigation Activity. See Note 11 of Notes to Consolidated Financial Statements for additional information about the BofA Settlement Agreement.
Other Operating Expenses. Our other operating expenses are affected by the amount of NIW, as well as the amount of RIF. Additionally, during 2014 and 2015, our operating expenses had been impacted significantly by compensation expense associated with changes in the estimated fair value of certain of our long-term equity-based incentive awards that were settled in cash. The fair value of these awards, and associated compensation expense, were dependent, in large part, on our stock price at any given point in time. Now that substantially all of the cash-settled awards have vested, the expense volatility associated with these awards is not expected in the future.
Our Services segment provides services and solutions to the real estate and mortgage finance industries, providing outsourced services, information-based analytics, valuations and specialized consulting and surveillance services for buyers and sellers of, and investors in, mortgage- and real estate-related loans and securities as well as other consumer ABS. The Services segment’s services and solutions are provided primarily through Clayton and its subsidiaries. See Note 1 of Notes to Consolidated Financial Statements and “Item 1. Business-Services-Services Business Overview” for additional information regarding the Services segment’s business.
The results of Clayton’s operations have been included in our financial statements in the Services segment from the June 30, 2014 date of acquisition. The Services segment’s results primarily reflect the operations and offerings of Clayton, along with other services and activities we offer that are complementary to our mortgage insurance business. In contrast to the Mortgage Insurance segment, the Services segment is a fee-for-service business without significant balance sheet risk.
Sales volume in our Services business generally varies based on the overall activity in the mortgage finance market and the health of related industries. We believe the diversity of the services offered by our Services segment, which are intended to cover all phases of the mortgage value chain, will help produce fee income from the Services segment throughout various mortgage finance environments. For example, the demand for due diligence services may decrease in unfavorable economic conditions due to lower mortgage origination and securitization volumes, whereas the demand for REO management services may tend to increase in such an environment. In addition, while the size of the mortgage finance market may be adversely impacted by increased regulatory requirements, these increased requirements may increase the demand for certain of our services, such as services related to compliance with the CFPB mortgage servicing standards and the regulatory requirements for third-party review of loans in ABS.
Our real estate valuation and component services business provides services to the SFR market, including SFR securitizations, which is a market that experienced rapid growth in 2014 and into 2015. However, during 2015 and the first half of 2016 there was a decline in the pace of home purchases by institutional investors and a slowdown in SFR securitizations, which negatively impacted our revenue in both years. We have since then experienced a modest increase in SFR securitization and related activity, and we expect this level of activity to continue through 2017. In addition, we believe that if the non-agency RMBS market, which has been limited in recent years, were to return it would represent a potentially significant long-term growth opportunity for our loan review, underwriting, due diligence and surveillance services. However, the size and timing for the return of this market are uncertain and will be impacted by factors outside of our control, including market demand and regulation.
In our Services segment, we generate revenue under three basic types of contracts:
Fixed-Price Contracts. Under a fixed-price contract, we agree to perform the specified services and deliverables for a pre-determined per-unit or per-file price. To the extent our actual direct and allocated indirect costs decrease or increase from the estimates upon which the price was negotiated, we will generate more or less profit, respectively, or could incur a loss. We use fixed-price contracts in our real estate valuation and component services, our loan review, underwriting and due diligence services as well as our title and closing review services. These contracts are also used in our surveillance business for our servicer oversight services and RMBS surveillance services, as well as in our REO management business.
Cost of Services. Our cost of services is primarily affected by our level of services revenue. Our cost of services primarily consists of employee compensation and related payroll benefits, including the cost of billable labor assigned to revenue-generating activities and, to a lesser extent, other costs of providing services such as travel and related expenses incurred in providing client services, costs paid to outside vendors, data acquisition costs and other compensation-related expenses to maintain software application platforms that directly support our businesses. The level of these costs may fluctuate if market rates of compensation change, or if there is decreased availability or a loss of qualified employees.
Radian Asset Assurance Stock Purchase Agreement. Radian completed the sale of Radian Asset Assurance to Assured on April 1, 2015, pursuant to the Radian Asset Assurance Stock Purchase Agreement. Until the April 1, 2015 sale date, the operating results of Radian Asset Assurance were classified as discontinued operations for all periods presented in our consolidated statements of operations.
Radian Asset Assurance provided direct insurance and reinsurance on credit-based structured finance and public finance risks. The assets and liabilities associated with the discontinued operations were historically a source of significant volatility to our results of operations, due to various factors including fluctuations in fair value and credit risk. For additional information related to discontinued operations, see Note 18 of Notes to Consolidated Financial Statements.
Investment Income. Investment income is determined primarily by the investment balances held and the average yield on our overall investment portfolio.
Amortization and Impairment of Intangible Assets. Amortization of intangible assets represents the periodic expense required to amortize the cost of intangible assets over their estimated useful lives. The periodic review of intangible assets for potential impairment may also impact consolidated results. Our intangible assets primarily relate to the acquisition of Clayton, and their valuation is based on management’s assumptions, which are inherently subject to risks and uncertainties. See Note 7 of Notes to Consolidated Financial Statements for additional information.
Radian Group serves as the holding company for our operating subsidiaries and does not have any operations of its own. Our consolidated operating results for 2016 primarily reflect the financial results and performance of our two business segments-Mortgage Insurance and Services. See “Results of Operations-Mortgage Insurance,” and “Results of Operations-Services” for the operating results of these business segments.
Our results for 2015 compared to 2014 reflect: (i) an income tax provision in 2015 in contrast to a significant income tax benefit in 2014 that had resulted primarily from the reversal of substantially all of our deferred tax valuation allowance in 2014; (ii) a loss on induced conversion and debt extinguishment; and (iii) lower net gains on investments and other financial instruments. These items were partially offset by: (i) an increase in net premiums earned on insurance and (ii) a reduction in the provision for losses. Our results for 2015 also reflect a full year of operations for Clayton, which we acquired on June 30, 2014, compared to a partial year in 2014.
The loss from discontinued operations consists of three components: (i) loss on classification as held for sale for the year ended December 31, 2014; (ii) income or loss from operations of businesses held for sale; and (iii) income tax provision. The divestiture of our financial guaranty business was part of our strategy to focus our business on the real estate and mortgage finance markets and also accelerated Radian Guaranty’s ability to comply with the PMIERs Financial Requirements.
Diluted Net Income Per Share. The increase in diluted net income per share for 2016, compared to 2015, is primarily due to the increase in net income from continuing operations, as discussed above, combined with the decrease in average diluted shares. The average diluted shares decreased from 246.3 million shares for 2015 to 229.3 million shares for 2016. This decrease in average diluted shares is primarily due to the impact of the June 2015 repurchase of $389.1 million of our Convertible Senior Notes due 2017, combined with the impact of the series of 2016 capital management transactions described above, included as of their effective dates. See “Overview-2016 and Other Recent Capital Management Developments” above.
The net decrease in diluted shares (used for purposes of determining diluted net income per share) resulting from the transactions described above, in each case as of the date of the completion of the respective transaction, was approximately 23.3 million. This net decrease reflects: (i) the impact of the completed share repurchase program and (ii) that the number of dilutive shares related to the purchased Convertible Senior Notes due 2017 and 2019 (which shares had been included in the calculations of dilutive shares, in accordance with GAAP) exceeded the net increase in shares issued as a result of these transactions. Although these transactions resulted in a net decrease in diluted shares outstanding, the actual shares outstanding increased at December 31, 2016 from December 31, 2015.
the net increase in shares outstanding, which represents the difference between: (i) total equity as of December 31, 2016 divided by the shares outstanding as of December 31, 2016 and (ii) total equity as of December 31, 2016 divided by the shares outstanding as of December 31, 2015; and
the December 31, 2016 book value per share, which was calculated based on 214.5 million shares outstanding as of December 31, 2016.
Our other operating expenses also included compensation expense associated with incentive compensation programs. During 2015 and 2014 our expense was impacted by changes in the estimated fair value of certain cash-settled long-term incentive awards that were valued, in large part, based on the stock price of Radian Group’s common stock. During 2015, our expense related to these awards was $22.6 million compared to $43.9 million for 2014. Substantially all of these awards vested in June 2014 and June 2015. Therefore, although these awards had produced significant expense volatility in the past due to their valuation relative to Radian Group’s common stock price, the expense volatility associated with these awards will not continue in the future.
The slight increase in interest expense in 2015 as compared to 2014 was primarily due to debt issuances in 2014 and 2015, offset by a decrease in interest expense primarily due to the purchases in 2015 of $389.1 million aggregate principal amount of our Convertible Senior Notes due 2017. See Note 12 of Notes to Consolidated Financial Statements for additional information.
Amortization and Impairment of Intangible Assets. The amortization and impairment of intangible assets primarily reflects the amortization of intangible assets acquired as part of the Clayton acquisition. In 2014, we also recorded a $2.1 million impairment of a portion of our goodwill related to a small subsidiary within our Services segment, which had been acquired in 2013. See Note 7 of Notes to Consolidated Financial Statements for additional information.
Income Tax Provision (Benefit). The effective tax rate from continuing operations was 36.3% for 2016, compared to 35.7% for 2015 and a benefit of 209.4% for 2014. Our 2016 effective tax rate was slightly higher than the federal statutory rate of 35%, primarily as a result of the non-deductible portion of the purchase premium relating to our Convertible Senior Notes due 2017 and 2019. The increase was partially offset by the income tax benefit resulting from our return-to-provision adjustment. For 2015, the additional expense related to the accounting for uncertainty of income taxes and the impact of state and local income taxes was substantially offset by the tax benefit from the deductible portion of the premium associated with the purchases of Convertible Senior Notes due 2017. The change from our statutory tax rate of 35% for 2014 was primarily due to the reversal of substantially all of our valuation allowance.
Use of Non-GAAP Financial Measure. In addition to the traditional GAAP financial measures, we have presented “adjusted pretax operating income,” a non-GAAP financial measure for the consolidated company, among our key performance indicators to evaluate our fundamental financial performance. This non-GAAP financial measure aligns with the way our business performance is evaluated by both management and by our board of directors. This measure has been established in order to increase transparency for the purposes of evaluating our core operating trends and enabling more meaningful comparisons with our peers. Although on a consolidated basis “adjusted pretax operating income” is a non-GAAP financial measure, for the reasons discussed above we believe this measure aids in understanding the underlying performance of our operations. Our senior management, including our Chief Executive Officer (Radian’s chief operating decision maker), uses adjusted pretax operating income (loss) as our primary measure to evaluate the fundamental financial performance of our business segments and to allocate resources to the segments.
Adjusted pretax operating income is defined as GAAP consolidated pretax income from continuing operations excluding the effects of net gains (losses) on investments and other financial instruments, loss on induced conversion and debt extinguishment, acquisition-related expenses, amortization and impairment of intangible assets and net impairment losses recognized in earnings.
Net gains (losses) on investments and other financial instruments. The recognition of realized investment gains or losses can vary significantly across periods as the activity is highly discretionary based on the timing of individual securities sales due to such factors as market opportunities, our tax and capital profile and overall market cycles. Unrealized investment gains and losses arise primarily from changes in the market value of our investments that are classified as trading securities. These valuation adjustments may not necessarily result in economic gains or losses.
Acquisition-related expenses. Acquisition-related expenses represent the costs incurred to effect an acquisition of a business (i.e., a business combination). Because we pursue acquisitions on a strategic and selective basis and not in the ordinary course of our business, we do not view acquisition-related expenses as a consequence of a primary business activity. Therefore, we do not consider these expenses to be part of our operating performance and they are excluded from our calculation of adjusted pretax operating income (loss).
Includes inter-segment expenses and revenues as disclosed in Note 4 of Notes to Consolidated Financial Statements.
During 2016, we continued our strategy of growing our mortgage insurance portfolio by writing insurance on mortgages with strong credit characteristics. At December 31, 2016, we had $183 billion in IIF compared to $176 billion in IIF at December 31, 2015. We also continued to focus on effectively managing our capital and liquidity positions. See “Liquidity and Capital Resources-Radian Group-Short-Term Liquidity Needs-Capital Support for Subsidiaries” and Note 1 of Notes to Consolidated Financial Statements for additional information.
The following table summarizes our Mortgage Insurance segment’s results of operations for the years ended December 31, 2016, 2015 and 2014:
A key component of our current business strategy is to grow our mortgage insurance business by writing insurance on high credit quality mortgages in the U.S. Consistent with this objective, we wrote $50.5 billion of primary new mortgage insurance in 2016, compared to $41.4 billion of NIW in 2015. The NIW written on a Flow Basis in 2016 was Radian’s highest volume in its history.
The increase in NIW of 22% for 2016 compared to 2015 is primarily attributable to increases both in mortgage originations overall and in the penetration rate of private mortgage insurance for home purchases. During this time period, mortgage originations were higher due to favorable economic conditions that supported increased home purchase mortgage volume and low interest rates that continued to support refinance activity at higher levels in 2016 than in 2015.
In addition to the improved composition of our mortgage insurance portfolio with respect to specific individual credit attributes, such as FICO scores and LTVs, more stringent underwriting requirements have also led to fewer loans from our Post-legacy Portfolio that combine multiple higher-risk attributes within the same loan, such as a low FICO score with an investment property, or a low FICO score with a cash-out refinancing. These changes have contributed to the improved credit quality of our overall mortgage insurance portfolio, as illustrated below, as of December 31, 2016.
Layered risk exists when multiple high-risk attributes are combined within the same loan.
The chart below illustrates the composition of our direct primary mortgage insurance RIF at December 31, 2016, based on origination vintages.
In 2009, the GSEs began offering HARP, which allows a borrower who is not delinquent to refinance a mortgage if the borrower has been unable to take advantage of lower interest rates because the borrower’s home has decreased in value. We exclude HARP loans from our NIW for the period in which the refinance occurs. During 2016, new HARP loans accounted for $202.9 million of newly refinanced loans that were not included in Radian Guaranty’s NIW for the period, compared to $681.9 million for 2015. The HARP program deadline for refinancing is September 30, 2017. See “Item 1. Business-Regulation-Federal Regulation-Homeowner Assistance Programs” for more information.
Our Post-legacy Portfolio represents 80.5% of our total portfolio and continues to increase in proportion to our total primary RIF. The growth of our Post-legacy Portfolio, together with continued improvement in the portfolio as a result of HARP refinancings, among other things, has contributed to the significant improvement in the credit quality of our overall mortgage insurance portfolio. Refinancings under the HARP programs (discussed below) also have had a positive impact on the overall credit quality and composition of our mortgage insurance portfolio because the refinancing generally results in terms under which a borrower has a greater ability to pay and more financial flexibility to cover the loan obligations. As shown in the chart above, the sum of our Post-legacy Portfolio and our HARP refinancings accounted for approximately 88% of our total primary RIF at December 31, 2016, compared to 84% at December 31, 2015.
In 2016, represents the percentage of direct single premiums written, after consideration of the 35% Single Premium NIW ceded under the Single Premium QSR Transaction. See Note 8 of Notes to Consolidated Financial Statements for additional information.
Refinancing transactions that utilize mortgage insurance frequently are conducted using Single Premium Policies. Our total mix of Single Premium Policies decreased to 27% of our NIW for 2016, compared to 31% for 2015. A portion of the decline in the percentage of Single Premium Policies was due to a shift in mix toward Monthly Premium Policies due to industry pricing changes. The decrease also was attributable to our deliberate actions related to pricing, including our disciplined approach to offering customized pricing levels. We believe our current production level of Single Premium Policies can be absorbed into our portfolio while maintaining an appropriate balance between risk and returns, which has been further enhanced by the Single Premium QSR Transaction, as further discussed below.
Historically, we have entered into reinsurance transactions as part of our capital and risk management activities, including to manage Radian Guaranty’s Risk-to-capital and more recently its position under the PMIERs Financial Requirements. In the first quarter of 2016, Radian Guaranty entered into the Single Premium QSR Transaction with a panel of third-party reinsurers in order to proactively manage the risk and return profile of Radian Guaranty’s insured portfolio and to manage its position under the PMIERs Financial Requirements. Radian Guaranty began ceding business under this agreement effective January 1, 2016. The Single Premium QSR Transaction is expected to increase Radian Guaranty’s return on required capital for its Single Premium Policies. In future quarters, the impact of the Single Premium QSR Transaction will vary depending on the level of ceded RIF, as well as the levels of prepayments and incurred losses on the reinsured portfolio, among other factors.
A decrease to net premiums earned of $29.8 million, net of accrued profit commission;
A net decrease to pretax income from continuing operations (and to adjusted pretax operating income) of $12.2 million.
The following table provides information related to the premium impact of our reinsurance transactions. See Note 8 of Notes to Consolidated Financial Statements for more information about our reinsurance transactions, including the ceded amounts related to the QSR Transactions. See “Liquidity and Capital Resources-Radian Group-Short-Term Liquidity Needs” for more information about our Single Premium QSR Transaction.
Net Investment Income. For 2016, net investment income increased compared to 2015. As we have progressed toward our investment and liquidity targets, we extended the duration of investments in our portfolio and increased our investment yields. Net investment income increased in 2015 compared to 2014, primarily due to increases in investment portfolio balances at Radian Guaranty from the proceeds of the sale of our financial guaranty business. All periods include an allocation to the Mortgage Insurance segment of net investment income from investments held at Radian Group.
Related to defaulted loans with a most recent default notice dated in the year indicated. For example, if a loan had defaulted in a prior year, but then subsequently cured and later re-defaulted in the current year, that default would be considered a current year default.
Our mortgage insurance provision for losses for 2016 increased by $5.8 million as compared to 2015. Reserves established for new default notices were the primary driver of our total incurred losses for 2016 and 2015. Current year primary defaults decreased by 4.9% for 2016, compared to 2015. In addition, our gross Default to Claim Rate assumption for new primary defaults was 12% as of December 31, 2016, compared to 13% as of December 31, 2015. This reduction in estimated Default to Claim Rates, which was based on observed claim development trends, contributed to the reduction in the portion of our provision for losses related to new defaults in 2016, as compared to 2015.
Our mortgage insurance provision for losses for 2015 decreased by $48.5 million as compared to 2014. This decrease was driven primarily by a decline in the number of new current year defaults and a decrease in the Default to Claim Rate assumptions applied to such defaults. During the year ended December 31, 2015, we reduced our gross Default to Claim Rate assumption for new primary defaults from 16% to 13%, based on continued improvement observed in actual claim development trends.
In order to provide a longer-term, historical perspective, the following chart demonstrates default rate trends for the past 10 years. (1)
Excludes 1,639; 2,821; and 4,467 loans that are in default at December 31, 2016, 2015 and 2014, respectively, subject to the Freddie Mac Agreement, and for which we no longer have claims exposure.
The number of new primary mortgage insurance defaults declined by 4.9% in 2016, compared to an 11.2% decrease in 2015 and an 18.1% decrease in 2014. We currently expect total new defaults for 2017 to continue to decrease, although the rate of decrease may continue to moderate. This is due, in part, to the shift in our portfolio composition toward more recent vintages for which we expect increasing levels of new defaults, consistent with typical default seasoning patterns.
Factors that impact the severity of a claim include, but are not limited to: (i) the size of the loan; (ii) the amount of mortgage insurance coverage placed on the loan; (iii) the amount of time between default and claim during which we are expected to cover interest (capped at two years under our Prior Master Policy and capped at three years under our 2014 Master Policy) and certain expenses; and (iv) the impact of certain loss management activities with respect to the loan.
We expect that a portion of previously rescinded policies will be reinstated and previously denied claims will be resubmitted with the required documentation and ultimately paid; therefore, we have incorporated this expectation into our IBNR reserve estimate. Our IBNR reserve estimate was $14.3 million, $26.6 million and $163.6 million at December 31, 2016, 2015 and 2014, respectively. The significant decrease in our IBNR reserve estimate since 2014 reflects the impact of the payment of claims pursuant to the BofA Settlement Agreement.
Our primary reserve per default (calculated as primary reserve excluding IBNR and other reserves divided by the number of primary defaults) was $22,503, $24,019 and $27,683 at December 31, 2016, 2015 and 2014, respectively.
Calculated without giving effect to the impact of the termination of captive transactions and settlements.
Other Operating Expenses. Other operating expenses for 2016 decreased compared to 2015, primarily as a result of the benefit of ceding commissions from the Single Premium QSR Transaction, partially offset by increases in compensation-related expense and technology expenses associated with a significant investment in upgrading our systems.
Interest Expense. These amounts reflect the allocated portion of interest on Radian Group’s long-term debt to our Mortgage Insurance segment, excluding the Senior Notes due 2019. The allocated interest decreased in 2016 compared to 2015, and in 2015 compared to 2014. These decreases were primarily due to the capital management transactions described in “-Results of Operations-Consolidated-Interest Expense.”
The following table summarizes our Services segment’s results of operations for the years ended December 31, 2016, 2015 and 2014:
For all periods presented, reflects changes to align our segment reporting structure with recent changes in personnel reporting lines and management oversight related to contract underwriting performed on behalf of third parties. Revenue and expenses for this business are now reflected in the Services segment. As a result, for all periods presented, Services revenue, cost of services and operating expenses have increased, with offsetting reductions in Mortgage Insurance other income and other operating expenses. See Note 4 of Notes to Consolidated Financial Statements.
Reflects the results of operations of Clayton from the June 30, 2014 date of acquisition.
The Services segment is a fee-for-service business, with revenue derived from: (i) loan review, underwriting and due diligence services; (ii) surveillance services, including RMBS surveillance, loan servicer oversight, loan-level servicing compliance reviews and operational reviews of mortgage servicers and originators; (iii) real estate valuation and component services, providing outsourcing and technology solutions for the SFR and residential real estate markets; as well as outsourced solutions for appraisal, title and closing services offered through Red Bell and ValuAmerica; (iv) REO management services; and (v) services for the United Kingdom and European mortgage markets through our EuroRisk operations.
Adjusted pretax operating income (loss). Our Services segment’s adjusted pretax operating loss was $20.2 million in 2016 compared to $0.2 million in 2015 and $5.5 million in 2014. The increase in our adjusted pretax operating loss in 2016 as compared to 2015 was primarily driven by increases in other operating expenses, combined with decreases in gross profit, as discussed further below. Our results for 2015 as compared to 2014 reflect a full year of Clayton’s activity in 2015 compared to six months of activity in 2014, due to the June 30, 2014 acquisition of Clayton. As a percentage of Services revenue for the respective periods, the results for 2015 as compared to 2014 reflect a decrease in gross profit and an increase in other operating expenses.
For the year ended December 31, 2016, the top 10 Services customers (which includes our affiliates) generated approximately 52% of the Services segment’s revenues, as compared to 48% for 2015 and 62% for 2014. Approximately 5%, 4% and 1% of services revenue on a segment basis for the years ended December 31, 2016, 2015 and 2014, respectively, related to sales to our affiliates, and has been eliminated in our consolidated results. The largest single customer generated approximately 11% of the services revenue for the year ended December 31, 2016 and 9% for the year ended December 31, 2015. For the year ended December 31, 2014, services revenue included a significant loan review and due diligence project for a single client which represented approximately 13% of services revenue. The project continued in 2015, although at a reduced level. The increased burden on loan originators to implement and comply with TRID, which went into effect in the fourth quarter of 2015, resulted in a slowdown in the volume of newly originated loans and also had a negative margin impact on our loan review, underwriting and due diligence revenues, due to delays in the closing of mortgage loans.
As a percentage of revenue, loan review, underwriting and due diligence gross profit margins decreased by 10% from 2015 to 2016 and by 9% from 2014 to 2015. These decreases in gross profit margin were primarily related to higher than anticipated costs of services due to increased TRID documentation requirements implemented in the fourth quarter of 2015. Additionally, gross profit on services was also impacted in 2015 by increased variable costs as a change in scope occurred on a single client’s loan review and due diligence project, as noted above.
Other Operating Expenses. Other operating expenses primarily consist of compensation costs not classified as cost of services because they are related to employees, such as sales and corporate employees, who are not directly involved in providing client services. Compensation-related costs for 2016 represented 55% of the segment’s other operating expenses, compared to 57% for 2015. Although compensation-related costs for 2016 compared to 2015 decreased as a percentage of other operating expenses, primarily due to expense reduction initiatives undertaken during 2016, the decrease was offset by increased expenses in 2016 associated with ValuAmerica and Red Bell which were acquired in October 2015 and March 2015, respectively, as well as, to a lesser extent, an increase in contract underwriting expenses. Other operating expenses also include other selling, general and administrative expenses, depreciation, and allocations of corporate general and administrative expenses. Other operating expenses for 2016 included allocations of corporate operating expenses of $8.5 million, compared to $4.8 million for 2015.
Interest Expense. Interest expense represents all of the interest expense related to our Senior Notes due 2019, the proceeds of which were used to fund Radian Group’s acquisition of Clayton.
Includes $300 million of Senior Notes due 2019 that may be redeemed, in whole or part at any time prior to maturity.
Includes $350 million and $350 million of Senior Notes due 2020 and 2021, respectively, that may be redeemed, in whole or part at any time prior to maturity.
Represents contractual payments for operating leases, with the exception of $0.2 million included for capital lease payment obligations in 2017.
Radian Guaranty and RMAI were parties to a cross-guaranty agreement that was terminated effective July 1, 2016. However, it remains in effect for insurance written prior to the termination date. This agreement provides that if either party fails to make a payment to a policyholder, then the other party will step in and make the payment. The obligations of both parties are unconditional and irrevocable; however, no payments may be made without prior approval by the Pennsylvania Insurance Department.
To allow our mortgage insurance customers to comply with applicable securities regulations for issuers of ABS (including MBS), we have been required, depending on the amount of credit enhancement we were providing, to provide: (i) audited financial statements for the insurance subsidiary participating in these transactions or (ii) a full and unconditional holding-company level guarantee for our insurance subsidiaries’ obligations in such transactions. Radian Group has guaranteed two structured transactions for Radian Guaranty with approximately $110.2 million of aggregate remaining credit exposure as of December 31, 2016.
Radian Group serves as the holding company for our insurance and other subsidiaries and does not have any operations of its own. At December 31, 2016, Radian Group had available, either directly or through an unregulated subsidiary, unrestricted cash and liquid investments of approximately $460 million. This amount includes $89 million deposited with the IRS (but which may be recalled by us at any time) in connection with our dispute with the IRS related to the Deficiency Amount from the IRS’s examination of our 2000 through 2007 consolidated federal income tax returns, and excludes certain additional cash and liquid investments that have been advanced to Radian Group from our subsidiaries for corporate expenses and interest payments. Of the $460 million of available liquidity held as of December 31, 2016, $110.1 million was used in January 2017 to redeem the remaining Convertible Senior Notes due 2019, as discussed below.
During 2016, we completed a series of transactions to strengthen our financial position. The combination of these actions had the impact of decreasing our diluted shares and improving Radian Guaranty’s position under the PMIERs Financial Requirements. The purchases of Convertible Senior Notes due 2017 and 2019 during 2016, combined with the early redemption of the Senior Notes due 2017 and the issuance of the Senior Notes due 2021, also improved Radian Group’s debt maturity profile by increasing the time to maturity for our long-term debt and by limiting the aggregate amount of debt maturing in any calendar year. This series of capital management transactions is summarized as follows:
Long-Term Debt. On a quarterly basis, we evaluate whether the conversion threshold requirements for our outstanding convertible debt securities have been met. As of December 31, 2016, the holders of our Convertible Senior Notes due 2017 are not eligible to exercise their conversion rights during the three-month period ending March 31, 2017. As discussed above, we elected to redeem all of the Convertible Senior Notes due 2019 surrendered for conversion or redemption with cash from available liquidity and settled the obligations in January 2017. See Notes 12 and 21 of Notes to Consolidated Financial Statements for further information about our Convertible Senior Notes due 2017 and 2019.
Radian Guaranty currently is an approved mortgage insurer under the PMIERs and is in compliance with the PMIERs Financial Requirements. At December 31, 2016, Radian Guaranty’s Available Assets under the PMIERs totaled approximately $4.0 billion, resulting in an excess or “cushion” of approximately $210.0 million over its Minimum Required Assets of approximately $3.8 billion. Based on our current projections and the current requirements under the PMIERs, we expect to maintain Radian Guaranty’s Available Assets at a level no less than approximately 5% above its Minimum Required Assets. While the amount of this cushion could fluctuate on a quarterly basis, we expect it to increase over time based, in part, on our expectations regarding the future financial performance of Radian Guaranty, including our projected NIW and expected decrease in defaults. Based on our projections, Radian Guaranty is not expected to require any additional capital contributions to remain in compliance with the current requirements under the PMIERs Financial Requirements. See “Item 1A. Risk Factors-Radian Guaranty may fail to maintain its eligibility status with the GSEs.”
Radian Guaranty’s Risk-to-capital as of December 31, 2016 was 13.5 to 1. Our combined Risk-to-capital, which represents the consolidated Risk-to-capital measure for all of our Mortgage Insurance subsidiaries, was 13.6 to 1 as of December 31, 2016. Radian Guaranty is not expected to need additional capital to satisfy state insurance regulatory requirements in their current form.
The NAIC is in the process of reviewing the minimum capital and surplus requirements for mortgage insurers and considering changes to the 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. While the timing and outcome of this process is not known, in the event the NAIC adopts changes to the Model Act, we expect that the capital requirements in states that adopt the new Model Act may increase as a result of the changes. However, we continue to believe the changes to the Model Act will not result in financial requirements that require greater capital than the level currently required under the PMIERs Financial Requirements.
In the event the cash flow from operations of the Services segment is not adequate to fund all of its needs, Radian Group may provide additional funds to the Services segment in the form of a capital contribution or an intercompany note. See also “-Radian Group-Long-Term Liquidity Needs-Services.”
Dividends. Our quarterly common stock dividend currently is $0.0025 per share and, based on our current outstanding shares of common stock, we would require approximately $2.1 million in the aggregate to pay our quarterly dividends for the next 12 months. Radian Group is not subject to any limitations on its ability to pay dividends except those generally applicable to corporations that are incorporated in Delaware. Delaware corporation law provides that dividends are only payable out of a corporation’s capital surplus or (subject to certain limitations) recent net profits. As of December 31, 2016, our capital surplus was $2.9 billion, representing our dividend limitation under Delaware law.
In addition to existing available cash and marketable securities, Radian Group’s principal sources of cash to fund future short-term liquidity needs include: (i) payments made to Radian Group under expense-sharing arrangements with our subsidiaries, as discussed above; (ii) payments made to Radian Group under tax-sharing arrangements with our subsidiaries, as discussed below; and (iii) to the extent available, potential dividends from our Services segment, if any, in excess of payments due under tax- and expense-sharing arrangements. See also “-Radian Group-Long-Term Liquidity Needs-Services.”
Under the provisions of its tax-sharing agreement with its subsidiaries, Radian Group may receive cash as a result of certain of our operating subsidiaries generating tax liabilities and related payments that are in excess of Radian Group’s consolidated payment obligation to the U.S. Treasury.
If Radian Group’s current sources of liquidity are insufficient for Radian Group to fund its obligations during the next 12 months, or if we otherwise decide to increase our liquidity position, Radian Group may seek additional capital by incurring additional debt, by issuing additional equity, or by selling assets, which we may not be able to do on favorable terms, if at all.
We regularly evaluate opportunities, based on market conditions, to finance our operations by accessing the capital markets or other types of indebtedness with institutional and other lenders, and consider various measures to improve our capital and liquidity positions, as well as to strengthen our balance sheet and improve Radian Group’s debt maturity profile. In the past, we have repurchased and exchanged, prior to maturity, some of our outstanding debt, and in the future, we may, from time to time, seek to redeem, repurchase or exchange for other securities, some or all of our outstanding debt, prior to maturity, in the open market, through other public or private transactions, including pursuant to one or more tender offers, or through any combination of the foregoing, as circumstances may allow. The timing or amount of any potential transactions will depend on a number of factors, including market opportunities and our views regarding our capital and liquidity positions and potential future needs. There can be no assurance that any such transactions will be completed on favorable terms, or at all.
In addition to our short-term liquidity needs discussed above, our most significant needs for liquidity beyond the next 12 months are:
$350 million principal amount of outstanding debt due in March 2021; and
Under Pennsylvania’s insurance laws, ordinary dividends and other distributions may only be paid out of an insurer’s positive unassigned surplus, measured as of the end of the prior fiscal year. Radian Guaranty had negative unassigned surplus at December 31, 2016 of $691.3 million, and therefore, no ordinary dividends can be paid from Radian Guaranty in 2017. Due in part to the need to set aside contingency reserves, we do not expect that Radian Guaranty will have positive unassigned surplus, and therefore will not have the ability to pay ordinary dividends, for the foreseeable future. Under Pennsylvania’s insurance laws, an insurer may request an extraordinary dividend, but payment is subject to the approval of the Pennsylvania Insurance Commissioner.
There can also be no assurance that our Services segment will generate sufficient cash flow to pay dividends. See “-Services” below.
As of December 31, 2016, our Mortgage Insurance segment maintained claims paying resources of $4.2 billion on a statutory basis, which consists of contingency reserves, statutory policyholders’ surplus, Unearned Premium Reserves and loss reserves.
The principal demands for liquidity in our mortgage insurance business include the payment of claims and potential claim settlement transactions, operating expenses (including those allocated from Radian Group) and taxes. The principal sources of liquidity in our mortgage insurance business currently include insurance premiums, net investment income, cash flows from investment sales and maturities and, potentially, capital contributions from Radian Group. We believe that the operating cash flows generated by each of our mortgage insurance subsidiaries will provide these subsidiaries with a substantial portion of the funds necessary to satisfy their claim payments, operating expenses and taxes for the foreseeable future.
The principal demands for liquidity in our Services segment include the payment of employee compensation and other operating expenses (including those allocated from Radian Group), reimbursements to Radian Group for interest payments related to the Senior Notes due 2019, and dividends to Radian Group, if any. The principal sources of liquidity in our Services segment are cash generated by operations and, to the extent necessary, capital contributions from Radian Group.
Liquidity levels may fluctuate depending on the levels and contractual timing of our invoicing and the payment practices of the Services clients, in combination with the timing of Services’ payments for employee compensation and to external vendors. The amount, if any, and timing of the Services segment’s dividend paying capacity will depend primarily on the amount of excess cash flow generated by the segment.
The improvement in net cash from operating activities in 2015 compared to 2014 was mainly attributable to an increase in net premiums written and a decrease in claims paid.
Net cash used in investing activities increased for 2016, compared to a small amount of net cash provided by investing activities for 2015, primarily as a result of the investment of a portion of the net cash provided by operating activities in 2016. The net cash provided by operating activities, combined with funds provided by sales and redemptions of trading securities and short-term investments, contributed to a high volume of purchases of fixed-maturity investments available for sale during 2016. In addition, purchases of property and equipment, net, increased during 2016, primarily as a result of our technology upgrade project.
Net cash provided by financing activities declined for 2015 compared to 2014, primarily due to a reduction in the issuance of common stock and an increase in purchases of common shares.
S&P’s outlook for Radian Group, Radian Guaranty and Radian Reinsurance currently is Stable.
The impact to our reserve due to estimated future Loss Mitigation Activities incorporates our expectations regarding the number of policies that we expect to be reinstated as a result of our claims rebuttal process. Rescissions, Claim Denials and Claim Curtailments may occur for various reasons, including, without limitation, underwriting negligence, fraudulent applications and appraisals, breach of representations and warranties and inadequate documentation, primarily related to our Legacy Portfolio. The level of Rescissions, Claim Denials and Claim Curtailments has been declining in recent periods as our defaulted Legacy Portfolio continues to decline, and we expect this trend to continue. In addition, with respect to claims decisions on the population of Future Legacy Loans covered under the BofA Settlement Agreement, Radian Guaranty has agreed, subject to certain limited exceptions and conditions, that it will limit Rescissions, Claim Denials or Claim Curtailments. See Note 11 of Notes to Consolidated Financial Statements for additional information about the BofA Settlement Agreement.
Included in our loss reserves is an estimate related to a potential additional payment to Freddie Mac under the Freddie Mac Agreement, which is dependent upon the Loss Mitigation Activity on the population of loans subject to that agreement. Our reserve related to this potential additional payment is based on the estimated Rescissions, Claim Denials, Claim Curtailments and cancellations for this population of loans, determined using assumptions that are consistent with those utilized to determine our overall loss reserves. See Note 11 of Notes to Consolidated Financial Statements for additional information about the Freddie Mac Agreement.
We considered the sensitivity of first-lien loss reserve estimates at December 31, 2016 by assessing the potential changes resulting from a parallel shift in Claim Severity and Default to Claim Rate estimates for primary loans. For example, assuming all other factors remain constant, for every one percentage point change in primary Claim Severity (which we estimate to be 101.0% of risk exposure at December 31, 2016), we estimated that our loss reserves would change by approximately $6.3 million at December 31, 2016. For every one percentage point change in our overall primary net Default to Claim Rate (which we estimate to be 42% at December 31, 2016, including our assumptions related to Rescissions and Claim Denials), we estimated a $14.5 million change in our loss reserves at December 31, 2016.
For our mortgage insurance business, we group our mortgage insurance products into two categories: first-lien and Second-lien. To assess the need for a PDR on our first-lien insurance portfolio, we develop loss projections based on modeled loan defaults related to our current RIF. This projection is based on recent trends in default experience, severity and rates of defaulted loans moving to claim (such Default to Claim Rates are net of our estimates of Rescissions and Claim Denials), as well as recent trends in the rate at which loans are prepaid. As of December 31, 2016, our modeled loan default projections for our first-lien insured portfolio assume that the rate at which current loans will default improves further, based on our expectation that home prices will continue to appreciate and the unemployment rate will continue to decline.
For our first-lien insurance business, because the combination of the net present value of expected premiums and previously established reserves (net of reinsurance recoverables) exceeds the net present value of expected losses and expenses, a first-lien PDR was not required as of December 31, 2016 or December 31, 2015.
At December 31, 2016, total Level III assets of $1 million accounted for less than 0.1% of total assets measured at fair value. There were no Level III liabilities at December 31, 2016.
State and municipal obligations-The fair value of state and municipal obligations is estimated using recent transaction activity, including market observations. Valuation models are used, which incorporate bond structure, yield curve, credit spreads and other factors. These securities are generally categorized in Level II of the fair value hierarchy or in Level III when market-based transaction activity is unavailable.
We are responsible for the determination of the value of all investments carried at fair value and the supporting methodologies and assumptions. To assist us in this responsibility, we utilize independent third-party valuation service providers to gather, analyze and interpret market information and estimate fair values based upon relevant methodologies and assumptions for various asset classes and individual securities. We perform monthly quantitative and qualitative analyses on the prices received from third parties to determine whether the prices are reasonable estimates of fair value. Our analysis includes: (i) a review of the methodology used by third-party pricing services; (ii) a comparison of pricing services’ valuations to other independent sources; (iii) a review of month-to-month price fluctuations; and (iv) a comparison of actual purchase and sale transactions with valuations received from third parties. These processes are designed to ensure that our investment values are accurately recorded, that the data inputs and valuation techniques utilized are appropriate and consistently applied and that the assumptions are reasonable and consistent with the objective of determining fair value.
The calculation of the estimated fair value of goodwill and other intangibles is performed primarily using an income approach and requires the use of significant estimates and assumptions that are highly subjective in nature, such as attrition rates, discount rates, future expected cash flows and market conditions. The most significant assumptions relate to the valuation of goodwill and customer relationships. In particular, future expected cash flows include estimated transaction volumes that are not currently contracted, as well as volume projections associated with non-agency RMBS securitizations, for which current market conditions are not favorable. Our estimates are based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable. Based on our most recent annual goodwill impairment analysis performed in the fourth quarter of 2016, the excess of the estimated fair value over the carrying amount of the Services segment was approximately $50 million, or 18% of the carrying amount.
In May 2015, the FASB issued an update to the accounting standard for the accounting of short-duration insurance contracts by insurance entities. The amendments in this update require insurance entities to disclose certain information about the liability for unpaid claims and claim adjustment expenses. The additional information required is focused on improvements in disclosures regarding insurance liabilities, including the timing, nature and uncertainty of future cash flows related to insurance liabilities and the effect of those cash flows on the statement of comprehensive income. The disclosures required by this update are effective for annual periods beginning after December 15, 2015, and interim periods within annual periods beginning after December 15, 2016. We adopted this update effective December 31, 2016. See Note 11 of Notes to Consolidated Financial Statements for additional disclosures.
In February 2016, the FASB issued an update that replaces the existing accounting and disclosure requirements for leases of property, plant and equipment. The update requires lessees to recognize, as of the lease commencement date, assets and liabilities for all leases with lease terms of more than 12 months, which is a change from the current GAAP requirement to recognize only capital leases on the balance sheet. Pursuant to the new standard, the liability initially recognized for the lease obligation is equal to the present value of the lease payments not yet made, discounted over the lease term at the implicit interest rate of the lease, if available, or otherwise at the lessee’s incremental borrowing rate. The lessee is also required to recognize an asset for its right to use the underlying asset for the lease term, based on the liability subject to certain adjustments, such as for initial direct costs. Leases are required to be classified as either operating or finance, with expense on operating leases recorded as a single lease cost on a straight-line basis. For finance leases, interest expense on the lease liability is required to be recognized separately from the straight-line amortization of the right-of-use asset. Quantitative disclosures are required for certain items, including the cost of leases, the weighted-average remaining lease term, the weighted-average discount rate and a maturity analysis of lease liabilities. Additional qualitative disclosures are also required regarding the nature of the leases, such as basis, terms and conditions of: (i) variable interest payments; (ii) extension and termination options; and (iii) residual value guarantees. This update is effective for public companies for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early adoption is permitted. The new standard must be adopted by applying the new guidance as of the beginning of the earliest comparative period presented, using a modified retrospective transition approach with certain optional practical expedients. We are currently evaluating the impact to our financial statements and future disclosures as a result of this update. See “Contractual Obligations and Commitments” for more information.
In March 2016, the FASB issued an update to the accounting standards for share-based payment transactions, including: (i) accounting for income taxes; (ii) classification of excess tax benefits on the statement of cash flows; (iii) forfeitures; (iv) minimum statutory tax withholding requirements; (v) classification of employee taxes paid on the statement of cash flows when an employer withholds shares for tax withholding purposes; (vi) the practical expedient for estimating the expected term; and (vii) intrinsic value. Among other things, the update requires: (i) all excess tax benefits and tax deficiencies to be recognized as income tax expense or benefit in the income statement as they occur; (ii) recognition of excess tax benefits, regardless of whether the benefits reduce taxes payable in the current period; and (iii) excess tax benefits to be classified along with other cash flows as an operating activity, rather than separated from other income tax cash flows as a financing activity. For companies with significant share-based compensation, these changes may result in more volatile effective tax rates and net earnings, and result in additional dilution in earnings per share calculations. This update is effective for public companies for fiscal years beginning after December 15, 2016. Our adoption of this update, effective January 1, 2017, had an immaterial impact on our financial statements at implementation. As a result of implementation of this new standard, however, we expect the potential for limited increased volatility in our effective tax rate, which would impact our results of operations.
In June 2016, the FASB issued an update to the accounting standard regarding the measurement of credit losses on financial instruments. This update requires that financial assets measured at amortized cost basis be presented at the net (of allowance for credit losses) amount expected to be collected. Credit losses relating to available-for-sale debt securities are to be recorded through an allowance for credit losses, rather than a write-down of the asset, with the amount of the allowance limited to the amount by which fair value is less than amortized cost. This update is effective for public companies for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. Early adoption is permitted as of the fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. We are currently evaluating the impact to our financial statements and future disclosures as a result of this update.
In October 2016, the FASB issued an update to the accounting standard regarding the accounting for income taxes. This update requires an entity to recognize the income tax consequences of an intra-entity transfer of an asset other than inventory when the transfer occurs. This update will be applied on a modified retrospective basis through a cumulative-effect adjustment directly to retained earnings as of the beginning of the period of adoption. This update is effective for public companies for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Early adoption is permitted, including adoption in the first interim period of the adoption year. We are currently evaluating the impact to our financial statements as a result of this update.
In January 2017, the FASB issued an update to the accounting standard regarding goodwill and other intangibles. This update simplifies the subsequent measurement of goodwill by eliminating step two of the goodwill impairment test. Instead, an entity should perform its annual or interim goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount and recognize an impairment charge for any excess of the reporting unit’s carrying amount over the reporting unit’s estimated fair value. The provisions of this update are effective for interim and annual goodwill impairment tests in fiscal years beginning after December 15, 2019, with early adoption permitted for interim or annual goodwill impairment tests performed after January 1, 2017. We intend to early adopt this update, effective as of our goodwill impairment test in 2017.
Our board of directors exercises its responsibility for the financial statements through its Audit Committee, which consists entirely of independent non-management board members. The Audit Committee meets periodically with management and with PricewaterhouseCoopers LLP, the independent registered public accounting firm retained to audit our Consolidated Financial Statements, both privately and with management present, to review accounting, auditing, internal control and financial reporting matters.
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, comprehensive income (loss), changes in common stockholders’ equity, and cash flows present fairly, in all material respects, the financial position of Radian Group Inc. and its subsidiaries at December 31, 2016 and 2015, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2016 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in Item 15(a)(2) present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company's management is responsible for these financial statements and financial statement schedules, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Report on Internal Control over Financial Reporting appearing under Item 9A. Our responsibility is to express opinions on these financial statements, on the financial statement schedules, and on the Company's internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
We provide mortgage insurance on first-lien mortgage loans, and products and services to the real estate and mortgage finance industries. We have two reportable business segments-Mortgage Insurance and Services. On April 1, 2015, Radian Guaranty completed the sale of its subsidiary, Radian Asset Assurance, a financial guaranty insurer, to Assured, pursuant to the Radian Asset Assurance Stock Purchase Agreement dated as of December 22, 2014. The operating results of Radian Asset Assurance have been classified as discontinued operations for all periods presented in our consolidated balance sheets and consolidated statements of operations. See Note 18 for additional information related to discontinued operations.
Our Mortgage Insurance segment provides credit-related insurance coverage, principally through private mortgage insurance, to mortgage lending institutions nationwide. Private mortgage insurance protects mortgage lenders and third-party beneficiaries by mitigating default-related losses on residential mortgage loans. Generally, these loans are made to home buyers who make down payments of less than 20% of the purchase price for their homes. Private mortgage insurance also facilitates the sale of these low down payment mortgage loans in the secondary mortgage market, most of which are sold to the GSEs.
The GSEs and state insurance regulators impose various capital requirements on our insurance subsidiaries. These include Risk-to-capital, other risk-based capital measures and surplus requirements, as well as the PMIERs Financial Requirements discussed below. Failure to comply with these capital and financial requirements may limit the amount of insurance that our insurance subsidiaries may write. The GSEs and state insurance regulators also possess significant discretion with respect to our insurance subsidiaries and all aspects of their business. See Note 19 for additional regulatory information.
Under the PMIERs, Radian Guaranty’s Available Assets and Minimum Required Assets are determined on an aggregate basis, taking into account the assets and insured risk of Radian Guaranty and its exclusive affiliated reinsurers. Therefore, developments that impact the assets and insured risk of Radian Guaranty’s exclusive affiliated reinsurers individually also will impact the aggregate Available Assets and Minimum Required Assets, and importantly, Radian Guaranty’s compliance with the PMIERs Financial Requirements. As a result, references to Radian Guaranty’s Available Assets and Minimum Required Assets take into consideration both Radian Guaranty and its exclusive affiliated reinsurers.
The implementation of the PMIERs, effective December 31, 2015, has: (i) increased the amount of capital that Radian Guaranty is required to hold; (ii) imposed higher capital requirements for certain types of mortgage insurance policies that may potentially impact the type and volume of business that Radian Guaranty and other private mortgage insurers are willing to write; (iii) imposed extensive and more stringent operational requirements in areas such as claim processing, loss mitigation, document retention, underwriting, quality control, reporting and monitoring, among others, that may result in additional costs to maintain compliance; and (iv) imposed a requirement for Radian Guaranty to receive the consent of the GSEs prior to taking certain actions such as paying dividends, entering into various intercompany agreements, and commuting or reinsuring risk, among others.
Surveillance-Monitoring of mortgage servicer and loan performance, with risk management and servicing oversight solutions that include RMBS surveillance, regulatory and operational loan level oversight, asset representation review and consulting services;
On April 1, 2015, Radian Guaranty completed the sale of 100% of the issued and outstanding shares of Radian Asset Assurance for a purchase price of approximately $810 million, pursuant to the Radian Asset Assurance Stock Purchase Agreement. The divestiture was intended to better position Radian Guaranty to comply with the PMIERs and to support Radian’s strategic focus on the mortgage and real estate industries. After closing costs and other adjustments, Radian Guaranty received net proceeds of $789 million. For additional information related to discontinued operations, see Note 18.
During 2016, we completed a series of capital management transactions to strengthen our financial position. See Notes 8, 12, 14 and 21 for additional information.
Commutations and other negotiated terminations of our insured risks in our Mortgage Insurance segment provide us with an opportunity to exit exposures for an agreed upon payment, or payments, sometimes at an amount less than the previously estimated ultimate liability. Once all exposures relating to such policies are extinguished, all reserves for losses and LAE and other balances relating to the insured policies are generally reversed, with any remaining net gain or loss typically recorded through provision for losses. We take into consideration the specific contractual and economic terms for each individual agreement when accounting for our commutations or other negotiated terminations, which may result in differences in the accounting for these transactions.
Unless a liability associated with such activities or discussions becomes probable and can be reasonably estimated, we consider our claim payments and our Rescissions, Claim Denials and Claim Curtailments to be resolved for financial reporting purposes. Under the accounting standard regarding contingencies, an estimated loss is accrued only if we determine that the loss is probable and can be reasonably estimated. For populations of disputed Rescissions, Claim Denials and Claim Curtailments where we determine that a settlement is probable and that a loss can be reasonably estimated, we reflect our best estimate of the expected loss related to the populations under discussion in our financial statements, primarily as a component of our IBNR reserve. While our reserves include our best estimate of such losses, the outcome of the discussions or potential legal proceedings that could ensue is uncertain, and it is reasonably possible that a loss exists in excess of the amount accrued.
- Prices or valuations based on observable inputs other than quoted prices in active markets for identical assets and liabilities; and
Incremental, direct costs associated with the successful acquisition of mortgage insurance business, consisting of compensation and other policy issuance and underwriting expenses, are initially deferred and reported as deferred policy acquisition costs. Amortization of these costs for each underwriting year book of business is expensed in proportion to estimated gross profits over the estimated life of the policies. This includes accruing interest on the unamortized balance of deferred policy acquisition costs. Ceding commissions received under our reinsurance arrangements related to these costs are also deferred and accounted for using similar assumptions, including certain amounts received under our reinsurance transactions. See Notes 8 and 9 for additional details.
Cost of services consists primarily of employee compensation and related payroll benefits, the cost of billable labor assigned to revenue-generating activities, as well as corresponding travel and related expenses incurred in providing such services to clients in our Services segment. Cost of services also includes costs paid to outside vendors, including real estate agents that provide valuation and related services as well as data acquisition costs and other compensation-related expenses to maintain software application platforms that directly support our businesses. Cost of services does not include an allocation of overhead costs.
Assets and liabilities denominated in foreign currencies are revalued or translated at year-end exchange rates. Operating results are translated at average rates of exchange prevailing during the year. Unrealized gains and losses, net of deferred taxes, resulting from translation are included in AOCI in stockholders’ equity. Realized gains and losses resulting from transactions in foreign currency are recorded in our statements of operations.
Included in our restricted cash balances as of December 31, 2016 were: (i) funds for a mortgage insurance reserve policy held in escrow for any future duties, rights and liabilities; (ii) funds held as collateral under our insurance trust agreements related to health care benefits; (iii) funds held in trust for the benefit of certain policyholders; (iv) escrow funds held for servicer liabilities; and (v) escrow funds held for title services obligations. Total cash and restricted cash shown in the consolidated statement of cash flows as of December 31, 2016 of $61,814 is comprised of cash and restricted cash of $52,149 and $9,665, respectively, as shown on the consolidated balance sheet as of December 31, 2016. Total cash and restricted cash shown in the consolidated statement of cash flows as of December 31, 2015 of $59,898 is comprised of cash and restricted cash of $46,898 and $13,000, respectively, as shown on the consolidated balance sheet as of December 31, 2015.
We report the results of operations of a business as discontinued operations if the business is classified as held for sale, the operations and cash flows of the business have been or will be eliminated from our ongoing operations as a result of a disposal transaction and we will not have any significant continuing involvement in the operations of the business after the disposal transaction. In the period in which the business meets the criteria of a discontinued operation, its results are reported in income or loss from discontinued operations in the consolidated statements of operations for current and prior periods, and include any required adjustment of the carrying amount to its fair value less cost to sell. In addition, tax is allocated to continuing operations and discontinued operations. The amount of tax allocated to discontinued operations is the difference between the tax originally allocated to continuing operations and the tax allocated to the restated amount of income from continuing operations in each period.
In accordance with the terms of the Single Premium QSR Transaction, rather than making a cash payment or transferring investments for ceded premiums written, Radian Guaranty holds the related amounts to collateralize the reinsurers’ obligations and has established a corresponding funds withheld liability. Any loss recoveries and any potential profit commission to Radian Guaranty will be realized from this account. The reinsurers’ share of earned premiums is paid from this account on a quarterly basis. This liability also includes an interest credit on funds withheld, which is recorded as ceded premiums at a rate specified in the agreement and, depending on experience under the contract, may be paid to either Radian Guaranty or the reinsurers. 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. See Note 8 for further discussion of our reinsurance transactions.
In May 2015, the FASB issued an update to the accounting standard for the accounting of short-duration insurance contracts by insurance entities. The amendments in this update require insurance entities to disclose certain information about the liability for unpaid claims and claim adjustment expenses. The additional information required is focused on improvements in disclosures regarding insurance liabilities, including the timing, nature and uncertainty of future cash flows related to insurance liabilities and the effect of those cash flows on the statement of comprehensive income. The disclosures required by this update are effective for annual periods beginning after December 15, 2015, and interim periods within annual periods beginning after December 15, 2016. We adopted this update effective December 31, 2016. See Note 11 for additional disclosures.
In February 2016, the FASB issued an update that replaces the existing accounting and disclosure requirements for leases of property, plant and equipment. The update requires lessees to recognize, as of the lease commencement date, assets and liabilities for all leases with lease terms of more than 12 months, which is a change from the current GAAP requirement to recognize only capital leases on the balance sheet. Pursuant to the new standard, the liability initially recognized for the lease obligation is equal to the present value of the lease payments not yet made, discounted over the lease term at the implicit interest rate of the lease, if available, or otherwise at the lessee’s incremental borrowing rate. The lessee is also required to recognize an asset for its right to use the underlying asset for the lease term, based on the liability subject to certain adjustments, such as for initial direct costs. Leases are required to be classified as either operating or finance, with expense on operating leases recorded as a single lease cost on a straight-line basis. For finance leases, interest expense on the lease liability is required to be recognized separately from the straight-line amortization of the right-of-use asset. Quantitative disclosures are required for certain items, including the cost of leases, the weighted-average remaining lease term, the weighted-average discount rate and a maturity analysis of lease liabilities. Additional qualitative disclosures are also required regarding the nature of the leases, such as basis, terms and conditions of: (i) variable interest payments; (ii) extension and termination options; and (iii) residual value guarantees. This update is effective for public companies for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early adoption is permitted. The new standard must be adopted by applying the new guidance as of the beginning of the earliest comparative period presented, using a modified retrospective transition approach with certain optional practical expedients. We are currently evaluating the impact to our financial statements and future disclosures as a result of this update.
Basic net income per share is computed by dividing net income by the weighted-average number of common shares outstanding, while diluted net income per share is computed by dividing net income attributable to common shares by the sum of the weighted average number of common shares outstanding and the weighted average number of dilutive potential common shares. Dilutive potential common shares relate to our stock-based compensation arrangements and our outstanding convertible senior notes. For all calculations, the determination of whether potential common shares are dilutive or anti-dilutive is based on net income from continuing operations.
As applicable, includes coupon interest, amortization of discount and fees, and other changes in income or loss that would result from the assumed conversion.
We have two strategic business units that we manage separately-Mortgage Insurance and, effective with the June 30, 2014 acquisition of Clayton, our Services segment. Adjusted pretax operating income (loss) for each segment represents segment results on a standalone basis; therefore, inter-segment eliminations and reclassifications required for consolidated GAAP presentation have not been reflected. See Note 18 for information related to discontinued operations.
In the fourth quarter of 2016, we completed an organizational change that resulted in a change to our segment financial reporting structure. Previously, contract underwriting activities on behalf of third parties were reported in either the Mortgage Insurance segment or the Services segment, based on the customer relationship. Management responsibility for this contract underwriting business was moved entirely to the Services segment. This organizational change resulted in the transfer to the Services segment of revenue and expenses for all contract underwriting performed on behalf of third parties. Mortgage Insurance underwriting continues to be reported as an expense in the Mortgage Insurance segment. This change aligns with recent changes in personnel reporting lines and management oversight, and is consistent with the way the chief operating decision maker began assessing the performance of the reportable segments in the fourth quarter of 2016. As a result, on a segment basis, Services revenue, cost of services and other operating expenses have increased, with offsetting reductions in Mortgage Insurance other income and other operating expenses. This change has been reflected in our segment operating results for all periods presented.
We include underwriting-related expenses for mortgage insurance, based on a pro-rata volume of mortgage applications excluding third-party contract underwriting services, in our Mortgage Insurance segment’s other operating expenses before corporate allocations. We include underwriting-related expenses for third-party contract underwriting services, based on a pro-rata volume of mortgage applications, in our Services segment’s cost of services and other operating expenses before corporate allocations, as applicable.
Our senior management, including our Chief Executive Officer (our chief operating decision maker), uses adjusted pretax operating income (loss) as our primary measure to evaluate the fundamental financial performance of each of Radian’s business segments and to allocate resources to the segments. Adjusted pretax operating income (loss) is defined as pretax income (loss) from continuing operations excluding the effects of net gains (losses) on investments and other financial instruments, loss on induced conversion and debt extinguishment, acquisition-related expenses, amortization and impairment of intangible assets, and net impairment losses recognized in earnings.
Net of ceded premiums written under the QSR Transactions and the Single Premium QSR Transaction. See Note 8 for additional information.
The reconciliation of adjusted pretax operating income (loss) to consolidated pretax income from continuing operations is as follows:
The change in expected economic loss or recovery associated with our previously owned VIEs is included in adjusted pretax operating income above, although it represents amounts that are not included in net income. Therefore, for purposes of this reconciliation, net gains (losses) on investments and other financial instruments has been adjusted by income of $0.1 million for the year ended December 31, 2014 to reverse this item.
On a consolidated basis, “adjusted pretax operating income” is a measure not determined in accordance with GAAP. Total adjusted pretax operating income is not a measure of total profitability, and therefore should not be viewed as a substitute for GAAP pretax income. Our definition of adjusted pretax operating income may not be comparable to similarly-named measures reported by other companies.
The largest single mortgage insurance customer (including branches and affiliates), measured by primary NIW, accounted for 5.7% of NIW during 2016, compared to 4.6% and 4.0% from the largest single customer in 2015 and 2014, respectively. Earned premiums from one mortgage insurance customer represented 15%, 16% and 19% of our consolidated revenues (excluding net gains (losses) on investments and other financial instruments) in 2016, 2015 and 2014, respectively.
The following is a list of those assets that are measured at fair value by hierarchy level as of December 31, 2016:
Comprising short-term certificates of deposit and commercial paper, included within Level II, and convertible notes of non-reporting issuers, included within Level III.
Does not include certain other invested assets ($1.2 million), primarily invested in limited partnerships, accounted for as cost-method investments and not measured at fair value.
There were no investment transfers between Level I, Level II or Level III for the year ended December 31, 2015.
Equity securities. The fair value of these securities is generally estimated using observable market data in active markets or bid prices from market makers and broker-dealers. Generally, these securities are categorized in Level I or II of the fair value hierarchy, as observable market data are readily available. A small number of our equity securities, however, are categorized in Level III of the fair value hierarchy due to a lack of market-based transaction data or the use of model-based valuations.
Other Invested Assets. The fair value of these assets, primarily invested in limited partnerships, is estimated based on the equity recorded within the financial statements provided by the limited partnerships. These interests are accounted for and carried as cost-method investments.
Primarily consists of investments in Federal Home Loan Bank stock as required in connection with the memberships of Radian Guaranty and Radian Reinsurance in the Federal Home Loan Bank of Pittsburgh.
We recognized an other-than-temporary impairment loss in earnings of $0.5 million due to our intent to sell certain corporate bonds carried at a loss as of December 31, 2016. For the years ended December 31, 2016, 2015 and 2014, there were no credit-related impairment losses recognized in earnings or in AOCI.
For trading securities that were held at December 31, 2016 and 2015, we had net unrealized gains of $16.8 million during 2016, compared to net unrealized losses of $25.2 million during 2015.
As of December 31, 2016 and 2015, our investment portfolio included no securities of countries that have obligations that have been under particular stress due to economic uncertainty, potential restructuring and ratings downgrades.
The contractual maturities of fixed-maturity investments available for sale are as follows:
Securities on deposit with various state insurance commissioners amounted to $10.8 million and $10.4 million at December 31, 2016 and 2015, respectively.
All of our goodwill and other intangible assets relate to our Services segment, as a result of our acquisition of Clayton in 2014 and its subsequent acquisitions of Red Bell and ValuAmerica in 2015, as discussed further below and in Note 2. The following table shows the changes in the carrying amount of goodwill as of and for the years ended December 31, 2016 and 2015:
We conducted our annual goodwill impairment analysis in the fourth quarters of 2015 and 2016. For purposes of performing our annual goodwill impairment tests, we concluded that the Services segment constitutes one reporting unit to which all of our recorded goodwill is related. As part of the annual goodwill impairment assessment in 2016, we estimated the fair value of the reporting unit using primarily an income approach and, to a lesser extent, a market approach. The key factor in our fair value analysis was forecasted future cash flows, which were less than originally had been expected at the acquisition date. Given that the current goodwill impairment analysis relies significantly on projected high growth rates of future cash flows, failure to meet those projections may result in an impairment in a future period.
Generally, for tax purposes, substantially all of our goodwill and other intangible assets are deductible and will be amortized over a period of 15 years. For financial reporting purposes, other intangible assets with finite lives will be amortized over their applicable estimated useful lives in a manner that approximates the pattern of expected economic benefit from each intangible asset, as follows:
In our mortgage insurance business, we have used reinsurance as a capital and risk management tool to, among other things, manage Radian Guaranty’s regulatory Risk-to-capital and compliance with the PMIERs Financial Requirements. Premiums are ceded under the QSR Transactions, the Single Premium QSR Transaction and captive arrangements.
The effect of reinsurance on net premiums written and earned is as follows:
Under the Initial QSR Transaction, Radian Guaranty agreed to cede to the third-party reinsurance provider 20% of its NIW beginning with the business written in the fourth quarter of 2011 up to $1.6 billion of ceded RIF. We have ceded the maximum amount permitted under the Initial QSR Transaction. As of December 31, 2016, RIF ceded under the Initial QSR Transaction declined to $0.6 billion. Radian Guaranty had the ability, at its option, to recapture two-thirds of the reinsurance ceded as part of this transaction on December 31, 2014. However, we chose not to recapture that risk and negotiated an amendment to the transaction pursuant to which we received a $9.2 million profit commission based on experience through December 31, 2014, which increased net premiums earned, and a $15.0 million upfront supplemental ceding commission, the recognition of which has been deferred and is being amortized as a reduction to our policy acquisition costs over approximately five years beginning January 1, 2015. In addition, pursuant to the original agreement and effective January 1, 2015, the ceding commission was reduced from 25% to 20% for two-thirds of the remaining reinsurance ceded under the Initial QSR Transaction.
Includes amounts reported in policy acquisition costs and other operating expenses.
All of our existing captive reinsurance arrangements are operating on a run-off basis, meaning that no new business is being placed in these captives. We have not entered into any new captives since 2007 and, pursuant to consent orders with the CFPB and the Minnesota Department of Commerce, we have agreed not to enter into any new captives until 2025. See Note 13 regarding our Consent Order with the Minnesota Department of Commerce. During 2016, our RIF ceded under captive reinsurance arrangements declined to $12.7 million as of December 31, 2016, compared to $71.4 million as of December 31, 2015, as we terminated a significant number of captive reinsurance arrangements during the year.
The following table shows the components of other assets for the periods indicated:
Property and equipment at cost, less accumulated depreciation of $118.5 million and $106.9 million at December 31, 2016 and 2015, respectively. Depreciation expense was $11.7 million, $6.7 million and $4.2 million for the years ended December 31, 2016, 2015 and 2014 respectively.
At each balance sheet date, we assess our need for a valuation allowance against our DTA, based on whether it is more likely than not that all or some portion of our DTA will not be realized. We weigh the potential effect of positive and negative evidence, with the weight given to the evidence commensurate with the extent to which it can be objectively verified. In the fourth quarter of 2014, we reversed substantially all of our previously established DTA valuation allowance based on our analysis of significant positive, objectively verifiable evidence that outweighed all negative evidence and supported a conclusion that it was more-likely-than-not that substantially all of the Company’s DTAs will be realized.
We have determined that certain non-insurance entities within Radian may continue to generate taxable losses on a separate company basis in the near term and may not be able to fully utilize certain state and local NOLs on their state and local tax returns. Therefore, with respect to DTAs relating to these state and local NOLs and other state timing adjustments, we retained a valuation allowance of $46.9 million at December 31, 2016 and $36.2 million at December 31, 2015.
In 2009, we adopted a Tax Benefit Preservation Plan (the “Plan”), which, as amended, was approved by our stockholders at our 2010, 2013 and 2016 annual meetings. We also adopted certain amendments to our amended and restated bylaws (the “Bylaw Amendment”) and at our 2010, 2013 and 2016 annual meetings, our stockholders approved certain amendments to our amended and restated certificate of incorporation (the “Charter Amendment”). These steps were taken to protect our ability to utilize our NOLs and other tax assets and to attempt to prevent an “ownership change” under U.S. federal income tax rules by discouraging and in most cases restricting certain transfers of our common stock that would: (i) create or result in a person becoming a five-percent shareholder under Section 382 or (ii) increase the stock ownership of any existing five-percent shareholder under Section 382. The continued effectiveness of the Plan, the Bylaw Amendment and the Charter Amendment are subject to periodic examination by the Board and the reapproval of the Plan and the Charter Amendment by our stockholders every three years. There can be no assurance that our stockholders will reapprove the Plan and the Charter Amendment if we elect to present them to our stockholders again in the future.
As previously disclosed, we are contesting adjustments resulting from the examination by the IRS of our 2000 through 2007 consolidated federal income tax returns. The IRS opposes the recognition of certain tax losses and deductions that were generated through our investment in a portfolio of non-economic REMIC residual interests and has proposed denying the associated tax benefits of these items. We appealed these proposed adjustments to Appeals and made “qualified deposits” with the U.S. Treasury of $85 million in June 2008 relating to the 2000 through 2004 tax years and $4 million in May 2010 relating to the 2005 through 2007 tax years in order to avoid the accrual of incremental above-market-rate interest with respect to the proposed adjustments.
In previous years, we took a return position in various jurisdictions that we are not required to remit taxes with regard to the income generated from our investment in certain partnership interests. Although we believe that these tax positions are more likely than not to succeed if adjudicated, measurement of the potential amount of liability for state and local taxes and the potential for penalty and interest thereon is performed on a quarterly basis. Our net unrecognized tax benefits related to prior years increased by $20.9 million during 2016. This net increase primarily reflects the impact of unrecognized tax benefits associated with our recognition of certain premium income. Although unrecognized tax benefits for this item decreased by $21.6 million due to the expiration of the applicable statute of limitations for the taxable period ended December 31, 2012, the related amounts continued to impact subsequent years, resulting in a corresponding increase to the unrecognized tax benefits related primarily to the 2013 taxable year.
As discussed above, we believe we have reached a basis for a compromised settlement with the IRS on the primary issues present in our case. The resolution must be reported to the JCT for review and cannot be finalized until the IRS considers the views, if any, expressed by the JCT about the matter. However, over the next 12 months, if we are able to achieve a compromised settlement with the IRS, then it is estimated that approximately $70.0 million of unrecognized tax benefits in the above tabular reconciliation may be reversed pursuant to the accounting standard for uncertain tax positions.
The following calendar tax years, listed by major jurisdiction, remain subject to examination:
For the 2000 through 2007 calendar tax years, we petitioned the Tax Court to litigate the IRS Notices of Deficiency resulting from the examination of our 2000 through 2007 consolidated federal income tax returns. This litigation relates to the recognition of certain tax benefits associated with our investment in a portfolio of non-economic REMIC residual interests.
Represents ceded losses on captive transactions, the QSR Transactions and the Single Premium QSR Transaction.
Related to ceded losses recoverable, if any, on captive reinsurance transactions, the QSR Transactions and the Single Premium QSR Transaction. See Note 8 for additional information.
Total paid claims decreased for 2015 as compared to 2014 primarily due to the overall decline in defaulted loans and ongoing reduction in pending claims.
Our loss reserve declined in 2014 from December 31, 2013, primarily as a result of the volume of paid claims, Cures and Rescissions and Claim Denials having exceeded new default notices received. Total incurred losses during 2014 primarily were the result of new default notices during 2014. The impact to incurred losses from default notices reported in 2014 was partially mitigated by favorable reserve development on prior year defaults, which was driven primarily by higher Cures and lower Claim Severity rates than were previously estimated. Our results of 2014 also include the impact of the BofA Settlement Agreement, as described below.
Although our estimates of future Loss Mitigation Activities have been declining, they remain elevated compared to levels experienced before 2009. The elevated levels of our rate of Rescissions, Claim Denials and Claim Curtailments have significantly reduced our paid losses and have resulted in a reduction in our loss reserve. Our estimate of net future Loss Mitigation Activities reduced our loss reserve as of December 31, 2016 and 2015 by approximately $39 million and $53 million, respectively. The amount of estimated Loss Mitigation Activities incorporated into our reserve analysis at any point in time is affected by a number of factors, including not only our estimated rate of Rescissions, Claim Denials and Claim Curtailments on future claims, but also the volume and attributes of our defaulted insured loans, our estimated Default to Claim Rate and our estimated Claim Severity, among other assumptions. Our assumptions also reflect the estimated impact of the BofA Settlement Agreement, as further discussed below.
The BofA Settlement Agreement provides that all claims decisions by Radian Guaranty on Legacy Loans covered by the agreement (including claims paid, coverage Rescissions, Claim Denials and Claim Curtailments) that were communicated on or before February 13, 2013 will become final and will not be subject to future challenge or adjustment. With respect to a group of loans referred to as Future Legacy Loans, the BofA Settlement Agreement provides that, subject to certain limited exceptions and conditions, Radian Guaranty will limit Rescissions, Claim Denials or Claim Curtailments on these loans. To the extent any such Loss Mitigation Activities previously have been taken on Future Legacy Loans, Radian Guaranty agreed to reinstate coverage and pay a reimbursement amount equal to the difference between the amount actually paid by Radian Guaranty and the eligible claim amount. Radian Guaranty further agreed that with respect to Future Legacy Loans it will not assert any origination error or servicing defect as a basis for a decision not to pay a claim, nor will it effect a Claim Curtailment of such claims; provided however, that Radian Guaranty retains the right to curtail Legacy Loans that were less than 90 days delinquent as of July 31, 2014 (“Potential Claim Curtailment Loans”) and any Future Legacy Loans serviced by a servicer other than the Insureds (a “Protected Claim Curtailment”).
The BofA Settlement Agreement further provides that for certain loans referred to as Servicing Only Loans: (i) if Radian Guaranty effected a claim payment on or before May 30, 2014, any Claim Curtailments on such loans will become final and will not be subject to future challenge, appeal or adjustment and (ii) for claim payments for Servicing Only Loans paid after May 30, 2014, Radian Guaranty will not make any Claim Curtailments (excluding Protected Claim Curtailments, which may continue in the ordinary course) and, to the extent any Claim Curtailments previously have been effected on such loans, Radian Guaranty will pay a reimbursement amount equal to the Claim Curtailment amount. The BofA Settlement Agreement does not affect Radian Guaranty’s right to effect Rescissions or Claim Denials on any Servicing Only Loans and any such Rescissions or Claim Denials will continue to be governed by the applicable Master Policies, subject to certain requirements in the BofA Settlement Agreement regarding the documents required to perfect such claims. Radian Guaranty further agreed not to assert any right to cancel coverage on any Subject Loan for failure to initiate certain proceedings (most commonly foreclosure proceedings) within the timelines set forth in the applicable Master Policies.
In August 2013, Radian Guaranty entered into the Freddie Mac Agreement, related to a group of first-lien mortgage loans guaranteed by Freddie Mac that were insured by Radian Guaranty and were in default as of December 31, 2011. At December 31, 2016 and 2015, Radian Guaranty had $63.9 million and $74.7 million, respectively, in the collateral account pursuant to the Freddie Mac Agreement. Subject to certain conditions in the Freddie Mac Agreement, amounts in the collateral account may be released to Radian Guaranty over time to the extent that Loss Mitigation Activity becomes final in accordance with the terms of that agreement. In accordance with these provisions, Radian Guaranty withdrew $11.7 million from this account in October 2016 related to Loss Mitigation Activity that had become final as of August 31, 2016. Following this withdrawal, if, as of August 29, 2017, the amount of additional Loss Mitigation Activity that has become final in accordance with the Freddie Mac Agreement is less than $64 million, then any shortfall will be paid to Freddie Mac from the funds remaining in the collateral account, subject to certain adjustments designed to allow for any Loss Mitigation Activity that has not become final or any claims evaluation that has not been completed as of that date. As of December 31, 2016, we have $57.4 million, recorded in reserve for losses, that we expect to be paid to Freddie Mac from the funds expected to be remaining in the collateral account as of the August 29, 2017 measurement date.
Represents reserves as of December 31, 2016 related to IBNR liabilities and expected development on claims paid related to the Freddie Mac Agreement. As described above, we paid an initial claim amount related to that agreement in 2013.
The following is supplementary information about average historical claims duration as of December 31, 2016, representing the average distribution of when claims are paid relative to the year of default:
Repurchase of Convertible Senior Notes due 2017. In June 2015, we entered into privately negotiated agreements with certain holders of our Convertible Senior Notes due 2017 to purchase an aggregate principal amount of $389.1 million of our outstanding Convertible Senior Notes due 2017 for a combination of cash and shares of Radian Group common stock. We funded the purchases with $126.8 million in cash (plus accrued and unpaid interest due on the purchased notes) and by issuing to the sellers 28.4 million shares of Radian Group common stock. These purchases of Convertible Senior Notes due 2017 resulted in a pretax charge of $91.9 million. This charge represents:
the $35.5 million market premium representing the excess of the fair value of the total consideration delivered to the sellers of the Convertible Senior Notes due 2017 over the fair value of the common stock issuable pursuant to the original conversion terms of the purchased notes;
the $52.3 million difference between the fair value and the carrying value of the liability component of the purchased notes; and
the $4.1 million net impact of transaction costs and unamortized debt issuance costs on the purchased notes.
In connection with our June 2015 purchases of our Convertible Senior Notes due 2017, we terminated a corresponding portion of the capped call transactions we had entered into in 2010 related to the initial issuance of the Convertible Senior Notes due 2017. As a result of this termination, we received total consideration of $54.9 million, consisting of 2.3 million shares of Radian Group common stock and $13.2 million in cash. In accordance with the accounting standards regarding equity and contracts in an entity’s own equity, the total consideration received was recorded as an increase to additional paid-in capital. The shares of Radian Group common stock received were retired, resulting in a decrease in shares issued and outstanding and a corresponding increase in unissued shares.
The premium paid for the capped call transactions was recorded in additional paid-in capital in accordance with the accounting standard for derivative financial instruments indexed to, and potentially settled in, an entity’s own common stock and the accounting standard for determining whether an instrument (or embedded feature) is indexed to an entity’s own stock.
See “-Extinguishment of Debt-2016 Activity” and “-Extinguishment of Debt-2015 Activity,” above, for information on the repurchases of a substantial portion of the Convertible Senior Notes due 2017 and the termination of a corresponding portion of the related capped call transactions.
In November 2016, we announced our intent to exercise our redemption option for the remaining Convertible Senior Notes due 2019. Our obligations in connection with this redemption were settled on January 27, 2017. See above “-Extinguishment of Debt-2016 Activity-Announced Redemption of Convertible Senior Notes due 2019” and Note 21.
Issuance and transaction costs incurred at the time of the issuance of the convertible notes were allocated to the liability and equity components in proportion to the allocation of proceeds and accounted for as debt issuance costs and equity issuance costs, respectively. The convertible notes are reflected on our consolidated balance sheets as follows:
Furthermore, the indentures for the Convertible Senior Notes due 2017 and 2019 include, among other terms, provisions under which the bankruptcy of Radian Group or the appointment of a receiver for Radian Group or for certain of its subsidiaries or other material assets would constitute an event of default under the indentures. Upon such a default, the note holders of the Convertible Senior Notes due 2017 or 2019 could declare the applicable notes due and payable (which may, under certain circumstances, be automatically accelerated), which would constitute an event of default under the indentures for the Senior Notes due 2019, 2020 and 2021. Certain events could cause our applicable insurance regulator to appoint a receiver for our insurance subsidiaries. If this occurred, it would, unless waived by a majority of the applicable note holders, constitute an event of default under the indentures for the Convertible Senior Notes due 2017 and 2019, and therefore, also cause an event of default under the indentures for the Senior Notes due 2019, 2020 and 2021.
In the first quarter of 2016, we announced and completed a share repurchase program. Pursuant to this program, we purchased an aggregate of 9.4 million shares of Radian Group common stock for $100.2 million, at a weighted average price per share of $10.62, including commissions. No further purchase authority remains under this share repurchase program.
On June 29, 2016, Radian Group’s board of directors authorized a new share repurchase program to spend up to $125 million to repurchase Radian Group common stock. In order to implement the program, we adopted a trading plan under Rule 10b5-1 of the Exchange Act during the third quarter of 2016. As of December 31, 2016, no shares had been purchased and therefore the full purchase authority of up to $125 million remained available under this program, which expires on June 30, 2017.
On May 14, 2014, our stockholders approved our most recent equity compensation plan, the 2014 Equity Plan. The 2014 Equity Plan replaced our prior equity plan, the 2008 Equity Compensation Plan, which replaced our 1995 Equity Plan. We have awards outstanding under all three of these Equity Plans. The last awards granted pursuant to the 2008 and 1995 Equity Plans were granted in 2014 and 2008, respectively. All awards granted under the Equity Plans have been performance-based or time-vested awards in the form of non-qualified stock options, restricted stock, RSUs, phantom stock, or SARs. The maximum contractual term for all awards under the Equity Plans is 10 years.
The 2014 Equity Plan authorizes the issuance of up to 6,423,163 shares of our common stock, plus such number of shares of common stock subject to outstanding awards that are payable in shares under the 2008 Equity Plan and which awards subsequently terminate, expire or are cancelled (“Prior Plan Shares”). There were 1,004,109 shares remaining available for grant under the 2014 Equity Plan as of December 31, 2016 (the “share reserve”), which includes Prior Plan Shares. Each grant of restricted stock, RSUs, or performance share awards under the 2014 Equity Plan (other than those settled in cash) reduces the reserve available for grant under the 2014 Equity Plan by 1.31 shares for every share subject to such grant. Awards under the 2014 Equity Plan that provide for settlement solely in cash (and not common shares) do not count against the share reserve. Absent this reserve adjustment for restricted stock, RSUs, phantom stock or performance share awards, our shares remaining available for grant under the 2014 Equity Plan would have been 4,269,701 shares as of December 31, 2016.
Unless otherwise described below, awards under the Equity Plans include the following terms:
Generally, the awards vest immediately upon a grantee’s death or disability, or at the end of the performance or service period in the event of retirement.
Vesting of awards granted to both non-executives and executives in 2012 was dependent upon the performance of Radian Group’s TSR relative to the TSR of a performance peer group. Based on performance during the three-year performance period, grantees were entitled to a maximum payout of 200% of their target number of RSUs.
Timed-Vested RSUs-In 2014 and 2013, certain non-executive officers were granted 1,470 and 7,670, respectively, of cash-settled time-vested RSUs under the 2008 Equity Plan. The estimated fair value of the time-vested RSUs was based on the closing price of our common stock on the measurement date. These RSU awards entitle award recipients to a cash amount equal to the closing price of our common stock on the NYSE on the vesting date. These RSU awards vest in their entirety three years from the date of grant, or earlier, upon retirement, death or disability. No cash-settled time-vested RSUs were granted subsequent to 2014.
Generally, the stock option awards have a 10-year term, with 50% of the award vesting on or after the third anniversary of the grant date and the remaining 50% of the award vesting on or after the fourth anniversary of the grant date, provided the applicable stock price performance hurdle is met, as described below. The fair value of stock options vested during the year ended December 31, 2016 was $3.8 million.
For stock option awards granted in 2016, 2015 and 2014, in addition to the time-based vesting requirements, the options contain a performance hurdle whereby the options will only vest if the closing price of our common stock on the NYSE exceeds approximately $15.20, $23.03 and $19.30 (in each case, 125% of the option exercise price), respectively, for 10 consecutive trading days ending on or after the third anniversary of the date of grant.
provides for the immediate vesting of matching contributions (including existing unvested matching contributions attributable to prior periods) and the elimination of all restrictions (other than Radian Group’s Policy Regarding Securities Trading) on a participant’s ability to diversify his/her position in matching contributions; and
The following table shows the rollforward of AOCI as of the periods indicated:
Activity related to investments recorded as assets held for sale (4)
For 2015, this amount represents the recognition of investment gains included in income from discontinued operations, net of tax, as a result of the completion of the sale of Radian Asset Assurance on April 1, 2015. Previously, pursuant to accounting standards, such investment gains had been deferred and recorded in AOCI.
We prepare our statutory financial statements in accordance with the accounting practices required or permitted, if applicable, by the insurance departments of the respective states of domicile of our insurance subsidiaries. Required SAPP are established by a variety of NAIC publications, as well as state laws, regulations and general administrative rules. In addition, insurance departments have the right to permit other specific practices that may deviate from prescribed practices. As of December 31, 2016, we did not have any prescribed or permitted statutory accounting practices that resulted in reported statutory surplus or risk-based capital being different from what would have been reported had NAIC statutory accounting practices been followed.
The ability of Radian’s insurance subsidiaries to pay dividends on their common stock is restricted by certain provisions of the insurance laws of Pennsylvania, their state of domicile. Under Pennsylvania’s insurance laws, dividends and other distributions may only be paid out of an insurer’s positive unassigned surplus, measured as of the end of the prior fiscal year, unless the Pennsylvania Insurance Commissioner approves the payment of dividends or other distributions from another source. In 2015 we effectuated a reorganization of our mortgage insurance subsidiaries, which included a significant redistribution of assets and RIF among our legal entities. As a result of these actions, substantially all of the RIF and assets previously held by RGRI, RMAI, Radian Insurance and Radian Mortgage Insurance were transferred to Radian Guaranty and a new exclusive affiliated reinsurer, Radian Reinsurance. None of the distributions from these entities were retained by Radian Group, as all proceeds were distributed to either Radian Guaranty or Radian Reinsurance.
Radian Guaranty was in compliance with the Statutory RBC Requirements or MPP Requirements, as applicable, in each of the RBC States as of December 31, 2016. The NAIC is in the process of developing a new Model Act for mortgage insurers, which is expected to include, among other items, new capital adequacy requirements for mortgage insurers. 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. While the outcome and timing of this process are uncertain, the new Model Act, if and when finalized by the NAIC, has the potential to increase capital requirements in those states that adopt the Model Act. However, we continue to believe the changes to the Model Act will not result in financial requirements that require greater capital than the level currently required under the PMIERs Financial Requirements. See Note 1 for information regarding the PMIERs, which set requirements for private mortgage insurers to remain eligible insurers of loans purchased by the GSEs.
Radian Guaranty’s statutory net income, statutory policyholders’ surplus and contingency reserve as of or for the years ended December 31, 2016, 2015 and 2014 were as follows:
Excludes risk ceded through reinsurance contracts (to third parties and affiliates) and RIF on defaulted loans.
Radian Guaranty did not receive capital contributions from Radian Group in the year ended December 31, 2016. For the years ended December 31, 2015 and 2014, Radian Guaranty received capital contributions from Radian Group totaling $100.0 million and $100.0 million, respectively. In addition, in December 2015, Radian Group transferred $325 million of cash and marketable securities to Radian Guaranty in exchange for a Surplus Note issued by Radian Guaranty. This Surplus Note had a 0% interest rate and was scheduled to mature on December 31, 2025. However, Radian Guaranty repaid the Surplus Note in full on June 30, 2016.
The Risk-to-capital ratio for our combined mortgage insurance operations was 13.6 to 1 as of December 31, 2016, compared to 14.6 to 1 as of December 31, 2015. In addition to Radian Guaranty and Radian Reinsurance, this combined ratio also includes RGRI, RMAI, Radian Investor Surety Inc., Radian Insurance, Radian Mortgage Insurance, and Radian Mortgage Guaranty Inc. Radian Insurance is the only entity that had any remaining RIF as of December 31, 2016, totaling $35.8 million. The aggregate statutory net income, statutory policyholders’ surplus and contingency reserve for these six subsidiaries as of and for the years ended December 31, 2016, 2015 and 2014 were as follows:
Under SAPP, mortgage guaranty insurance companies are required each year to establish a contingency reserve equal to 50% of premiums earned in such year. Such amount must be maintained in the contingency reserve for 10 years, after which time it is released to unassigned surplus. Prior to 10 years, the contingency reserve may be reduced with regulatory approval to the extent that losses in any calendar year exceed 35% of earned premiums for such year.
Under SAPP, investment grade fixed-maturity investments are valued at amortized cost and below-investment grade securities are carried at the lower of amortized cost or market value. Under GAAP, those investments that the statutory insurance entities do not have the ability or intent to hold to maturity are considered to be either available for sale or trading securities and are recorded at fair value, with the unrealized gain or loss recognized, net of tax, as an increase or decrease to stockholders’ equity or current operations, as applicable.
For all periods presented, reflects changes to align our segment reporting structure with recent changes in personnel reporting lines and management oversight related to contract underwriting performed on behalf of third parties. Revenue and expenses for this business are now reflected in the Services segment. As a result, for all periods presented, Services revenue and cost of services have increased, with offsetting reductions in other operating expenses.
Diluted net income per share is computed independently for each period presented. Consequently, the sum of the quarters may not equal the total net income per share for the year. For all calculations, the determination of whether potential common shares are dilutive or anti-dilutive is based on net income from continuing operations.