27,360 square feet of office space for our data center in Dayton, Ohio. The lease for this space expires in September 2012. Under the Dayton lease, we have an early termination option that can be exercised anytime, upon 90 days notice.
(1) Diluted net (loss) income per share and average share information in accordance with the accounting standard regarding earnings per share.
Non-Traditional Mortgage Credit Enhancement. In addition to traditional mortgage insurance, in the past, we used Radian Insurance and Amerin Guaranty to provide other forms of credit enhancement on residential mortgage assets. These products include mortgage insurance on second-lien mortgages (“second-lien”), credit enhancement on net interest margin securities (“NIMS”), credit default swaps (“CDS”) on domestic and international mortgages, and primary mortgage insurance on international mortgages (collectively, we refer to the risk associated with these transactions as “non-traditional” or “other risk”). We stopped writing all non-traditional business in 2007, other than a small amount of international mortgage insurance, which we discontinued writing in 2008.
Financial guaranty insurance typically provides an unconditional and irrevocable guaranty to the holder of a financial obligation of full and timely payment of principal and interest when due. Financial guaranty insurance may be issued at the inception of an insured obligation or may be issued for the benefit of a holder of an
obligation in the secondary market. Historically, financial guaranty insurance has been used to lower an issuer’s cost of borrowing when the insurance premium is less than the value of the spread (commonly referred to as the “credit spread”) between the market yield required to be paid on the insured obligation (carrying the credit rating of the insurer) and the market yield required to be paid on the obligation if sold on the basis of its uninsured credit rating. Financial guaranty insurance also has been used to increase the marketability of obligations issued by infrequent or unknown issuers or obligations with complex structures. Traditionally, investors have benefited from financial guaranty insurance through increased liquidity in the secondary market, reduced exposure to price volatility caused by changes in the credit quality of the underlying insured issue, and added protection against loss in the event of the obligor’s default on its obligation. Market developments, including ratings downgrades of most financial guaranty insurance companies (including Radian Asset Assurance), have significantly reduced the benefits of financial guaranty insurance, particularly certain forms of financial guaranty structured finance transactions.
We have provided direct financial guaranty credit protection either through the issuance of a financial guaranty insurance policy or a CDS. Both forms of credit enhancement provide the purchaser of such credit protection with a guaranty of the timely payment of interest and scheduled principal when due on a covered financial obligation. By providing protection through CDS, we were able to participate in transactions involving asset classes (such as corporate collateralized debt obligations (“CDOs”)) that may not have been available to us through the issuance of a traditional financial guaranty insurance policy. Either form of credit enhancement requires similar underwriting and surveillance.
Public Finance-Insurance of public finance obligations, including tax-exempt and taxable indebtedness of states, counties, cities, special service districts, other political subdivisions, enterprises such as public and private higher education institutions and health care facilities and infrastructure, project finance and private finance initiative assets in sectors such as airports, education, healthcare and other infrastructure projects;
Structured Finance-Insurance of structured finance obligations, including CDOs and asset-backed securities (“ABS”), consisting of funded and non-funded (referred to herein as “synthetic”) executions that are payable from or tied to the performance of a specific pool of assets or covered reference entities. Examples of the pools of assets that collateralize or underlie structured finance obligations include corporate loans, bonds or other borrowed money, residential and commercial mortgages, trust preferred securities (“TruPs”), diversified payment rights (“DPR”), a variety of consumer loans, equipment receivables, real and personal property leases, or a combination of asset classes, or securities backed by one or more of these pools of assets. We have also guaranteed excess clearing losses of securities exchange clearinghouses;
We continue to explore ways to maximize the value of our existing insured financial guaranty portfolio, including the possibility of partnering with third-parties to utilize all or a portion of the portfolio as a platform for writing new public finance and infrastructure business, as well as other possible ways to leverage the portfolio. On February 1, 2011, Radian Asset Assurance signed an agreement to purchase Municipal and Infrastructure
If all of our direct insurance that is subject to termination was terminated as of December 31, 2010, our net par outstanding would have been reduced by $34.3 billion, with a corresponding decrease in unearned premium reserves of $8.7 million and a decrease in the present value of expected future installment premiums of $114.2 million. Net unrealized losses on derivatives and VIEs of $729.3 million would also have been reversed had these transactions been terminated as of December 31, 2010. If any of our derivative transactions were terminated by our credit derivative counterparties, such terminations would not have resulted in a payment by either party.
Assuming all of this reinsurance business was recaptured as of December 31, 2010, Radian Asset Assurance’s statutory surplus would have increased by approximately $164.4 million, primarily as a result of the release of contingency reserves. The net present value of installment premiums on derivative contracts would have decreased by $4.9 million.
At December 31, 2010, our financial services segment consisted solely of our 46% interest in Credit-Based Asset Servicing and Securitization LLC (“C-BASS”), a mortgage investment company that we wrote off completely in 2007, and that filed for Chapter 11 bankruptcy protection on November 12, 2010.
As a consequence of the complete write-off of our investment in C-BASS in 2007, we have no continuing interest of value in C-BASS. The effect of C-BASS on our financial position and results of operations as of and for the years ended December 31, 2010, 2009 and 2008, was negligible. We have no contractual obligations to C-BASS or its creditors to fund C-BASS’s shareholders’ deficit or any other of its obligations. The likelihood that we will recover any of our investment is extremely remote. Accordingly, we believe it is extremely unlikely that our investment in C-BASS will have anything more than a negligible impact on our financial position, results of operation or cash flows at any time in the future.
On May 3, 2010, Radian Guaranty sold to Sherman Financial Group LLC (“Sherman”), a consumer asset and servicing firm specializing in charged-off and bankruptcy plan consumer assets, all of its remaining 28.7% equity interest in Sherman for approximately $172 million in cash, pursuant to a Securities Purchase Agreement (the “Sherman Purchase Agreement”) dated as of May 3, 2010, between Radian Guaranty and Sherman. As a result of the sale, in the second quarter of 2010, we recorded a pre-tax gain of approximately $34.8 million, net of transaction related expenses of $1.3 million, and a pre-tax decrease in accumulated comprehensive income of $29.7 million. In addition, under the Sherman Purchase Agreement, we agreed to terminate certain rights, including our right to a future contingent payment from a previous sale of our interest in Sherman.
As a seller of credit protection, our results are subject to macroeconomic conditions and specific events that impact the production environment and credit performance of our underlying insured assets. While the improved credit quality of new mortgage insurance business writings continued in 2010, the ongoing downturn in the housing and related credit markets, characterized by a decrease in mortgage originations, decline in home prices in certain markets, deteriorating credit performance of mortgage and other assets and reduced liquidity for many participants in the mortgage and financial services industries, has had, and we believe will continue to have, a significant negative impact on the operating environment and results of operations for each of our businesses. There is a great deal of uncertainty regarding our ultimate loss performance. The possibility that the United States (“U.S.”) economy may not recover from the most recent recession or may reenter a recessionary period following a brief period of stabilization or growth, the lack of meaningful liquidity in some sectors of the capital and credit markets, the potential for continued high unemployment and limited home price appreciation or further depreciation may add further stress on the performance of our insured assets.
Defaults. Our first-lien primary default rate at December 31, 2010 was 16.46%, compared to 17.99% at December 31, 2009. Our primary default inventory decreased by 17.5% during 2010. Despite this positive trend, which is primarily the result of a decrease in new defaults, an increase in the curing of defaults (“cures”) and an increase in claims paid, our overall primary default rates continue to remain elevated due to high unemployment and continued weakness in the U.S. housing and mortgage credit markets. Defaults have remained at elevated levels across all our mortgage insurance product lines, including our insured portfolio of prime, first-lien mortgages. In addition, a slowdown in mortgage foreclosures, and consequently a slowdown in claims submitted to us, has contributed to the sustained high level of our default inventory, mainly due to the foreclosure moratoriums imposed by various government entities and lenders, and due to prolonged modification programs for certain delinquent loans. This has resulted in more defaults remaining unresolved for a longer period than has historically been the case.
This slowdown in claims is further exacerbated by foreclosure moratoriums imposed by certain servicers that are related to allegations that servicers and other third parties acted improperly in foreclosure proceedings. See “Risk Factors-Foreclosure moratoriums may extend the period of time that a loan remains in our delinquent loan inventory and increase the severity of claims we are required to pay once the moratoriums expire.” Overall, the underlying trend of high defaults continues to be primarily driven by the poor performance of our 2005 through 2008 books of business. We believe that a return to sustained profitability in our mortgage insurance business is largely dependent upon a significant further reduction in the number of new primary, first-lien defaults. While we expect new primary, first-lien defaults to continue to decrease throughout 2011 and in future years, based on the current pace of this decrease, we do not expect our mortgage insurance business to be profitable in 2011.
Our mortgage insurance reserve for losses continues to be positively impacted by our loss management efforts. Our loss reserve estimate incorporates our recent experience with respect to the number of claims that we are denying and the number of insurance certificates that we are rescinding due to fraud, underwriters’ negligence or other factors. Our current level of rescissions and denials is significantly higher than historical levels, which we believe reflects the larger concentration of poorly underwritten loans (primarily originated during 2005 through 2008) that are in our default inventory, as well as our efforts to examine more claims. We expect the level of rescissions and denials to continue to remain elevated from historical levels as long as our 2005 through 2008 insurance policies comprise the majority of our default inventory. See “Risk Factors-Insurance rescissions and claim denials may not continue at the levels we have recently experienced and an increasing number of our lender customers are challenging our insurance rescissions and claim denials.”
of certain first- and second-lien structured transactions (see below). Foreclosure moratoriums and loan modification programs aimed at mitigating the housing downturn have reduced the number of defaults going to claim. We cannot be certain of the ultimate impact of these programs on our business, results of operations, or the timing of this impact. Some of the foreclosure moratoriums related to foreclosure documentation may further delay our receipt of claims. In 2011, we expect to pay total claims, including first- and second-liens, of approximately $1.7 billion, although foreclosure moratoriums and the reduction in claims received contribute further uncertainty to this estimate.
In January, we settled with a counterparty on approximately $21 million of second-lien risk in force for a payment of $11.8 million. We recorded a reduction in our reserve for losses in the fourth quarter of 2009 related to this termination payment. There was no impact on our 2010 pre-tax income as a result of this termination.
In the first quarter, we paid $80 million to terminate certain structured transactions, comprising $102 million of modified pool risk in force. Because the existing aggregate loss reserves for these transactions were $89 million, these terminations resulted in approximately $9 million of pre-tax income. These transactions had the effect of reducing our primary insurance in force by $2.6 billion, and reduced our primary default count by 4,429 loans.
During the year, in order to mitigate future expected losses, we purchased approximately $198.5 million face value of our insured NIMS bonds at a purchase price of $169.6 million, which approximated the recorded fair value liability for these transactions at the date of purchase. As such, the termination had a negligible impact on our results of operations in 2010.
Net Par Outstanding. Our financial guaranty net par outstanding was $78.8 billion as of December 31, 2010, compared to $87.4 billion at December 31, 2009. The reduction in net par outstanding was primarily due to counterparties exercising their early termination rights, prepayments (“refundings”) of public finance transactions, negotiated settlements of certain CDOs, a commutation of reinsurance exposure and the amortization or scheduled maturity of our insured portfolio. In light of our decision in 2008 to discontinue writing new financial guaranty business, we expect our net par outstanding to continue to decrease as our financial guaranty portfolio matures and as we seek to proactively reduce our financial guaranty risk in force.
With respect to other portions of our structured finance insured portfolio, there was some credit deterioration during 2010, primarily in our CDOs of commercial mortgage-backed securities (“CMBS”) transactions, and to a lesser extent, in our domestic non-CDO RMBS. We downgraded
two of our CDOs of CMBS transactions in 2010 to AA and BBB. Total average delinquencies in the CMBS collateral pools underlying our CMBS tranches increased significantly in 2010. In addition, the portion of our non-CDO Alt-A RMBS portfolio that is BIG increased during 2010, from 47.4% to 81.0%, and the portion of our net par outstanding to domestic non-CDO RMBS that is BIG increased during 2010 from 48.9% to 58.8%.
The following table summarizes our consolidated results of operations for the years ended December 31, 2010, 2009 and 2008 ($ in millions):
Net Loss. The increase in our net loss for 2010, compared to 2009, mainly resulted from the establishment of a valuation allowance against our DTA, an increase in the provision for losses, unrealized losses in the change in fair value of derivative instruments and net losses on other financial instruments.
Net Investment Income. The decrease in net investment income during 2010, compared to 2009, is primarily due to lower yields in our investment portfolio as a result of a continued reallocation of the investment portfolio to shorter-term investments in anticipation of increasing claim payments in our mortgage insurance segment. In addition, assets were also reallocated from longer duration, higher yielding tax exempt municipal securities to taxable securities of intermediate duration with lower interest rates.
Change in Fair Value of Derivative Instruments. The components of the (losses) gains included in change in fair value of derivative instruments for the years ended December 31, 2010, 2009 and 2008 are as follows:
Net (Losses) Gains on Other Financial Instruments. The components of the net (losses) gains on other financial instruments are as follows:
Other Income. The decrease in other income for 2010 compared to 2009, is due to a decline in contract underwriting income, resulting from the overall decline in mortgage origination volume.
Interest Expense. These amounts reflect interest on our long-term debt and, in 2009, interest on our revolving credit facility. In November 2010, we issued $450 million of convertible senior notes due November 2017 which increased our interest expense. In January 2010 and August 2009, we repurchased approximately $31.9 million and $57.7 million, respectively, of outstanding principal amount of our 7.75% debentures due June 2011. On August 6, 2009, we terminated our revolving credit facility and paid down the remaining balance of $100 million. These transactions reduced interest expense in 2010 and 2009. See Note 13 of Notes to Consolidated Financial Statements.
Equity in Net Income of Affiliates. See “Results of Operations-Financial Services” below.
Income Tax Provision (Benefit). We had an income tax provision of $226.2 million for 2010, compared to an income tax benefit of $94.4 million for 2009. The income tax provision for 2010 was primarily impacted by the recording of a valuation allowance against our DTA, tax exempt interest income, the tax impact relating to our foreign subsidiary operations and the impact of our accounting for uncertain income tax positions.
Net Loss. Our results for 2009 were positively affected by the increase in net gains on other financial instruments as a result of realized gains on sales of securities and a significant reduction in our mortgage insurance provision for losses. Partially offsetting these improvements in 2009 was a decrease in change in fair value of derivative instruments due primarily to the prospective implementation of the accounting standard regarding fair value measurements in 2008, for which we recorded a significant gain in 2008.
Net Premiums Written and Earned. Premiums written and earned in our mortgage insurance segment decreased as a result of an industry-wide decline in the amount of new mortgage insurance written, and also due to increased estimates of premium refunds associated with our expectation of increased rescissions. Premiums written and earned in our financial guaranty business decreased as a result of the commutation of $9.8 billion of net par outstanding in 2009, and also due to the fact that we discontinued writing new financial guaranty business in the second half of 2008.
Net Investment Income. This decrease in net investment income was due to a decrease in yields on invested assets, primarily as a result of a significant reallocation of our investment portfolio to shorter term investments in anticipation of increasing claim payments in our mortgage insurance segment. In addition, assets were reallocated from longer duration, higher yielding tax exempt municipal securities to taxable securities of intermediate duration in a lower rate environment.
Change in Fair Value of Derivative Instruments. The decrease in gain on the change in fair value of derivative instruments in 2009 resulted from the tightening of credit spreads on our insured transactions, which produced unrealized gains, partially offset by the tightening of our CDS spread, which resulted in unrealized losses. In 2008, our CDS credit spread widened, as did the credit spreads on the underlying collateral, which
Net Gains (Losses) on Other Financial Instruments. Net gains on other financial instruments increased during 2009, as we made the decision to opportunistically realize gains in the investment portfolio, primarily through the sale of taxable bonds, convertible securities and municipal bonds.
Net Impairment Losses Recognized in Earnings. Net impairment losses for 2009, compared to 2008, included lower impairments on fixed maturity investments available for sale and equity securities available for sale.
Income Tax Benefit. The consolidated effective tax rate was 39.0% for 2009, compared to 39.1% for 2008. The consolidated effective tax rate for 2009 was impacted by a decrease in income generated from tax-advantaged investment securities and a reduction in our tax expense related to foreign, state and local taxes. Our 2009 and 2008 consolidated effective tax rates also reflect the increase in tax expense relating to uncertainty in income taxes.
Net Loss. The increase in net loss for 2010, compared to 2009, was primarily the result of the increase in the provision for losses and the recording of a valuation allowance against our DTA in 2010, which resulted in an income tax provision for 2010 compared to an income tax benefit in 2009.
(1) Reflects the termination of certain second-lien insurance and international reinsurance transactions.
Other Income. The decrease in other income for 2010 as compared to 2009, is due to a decline in contract underwriting income resulting from the overall decline in mortgage origination volume.
The following table illustrates the impact to our loss reserve estimates from estimated insurance rescissions and claim denials as of the dates indicated:
The following table illustrates the amount of first-lien claims submitted to us for payment that were rescinded or denied for the years ended December 31, 2010 and 2009, net of reinstatements within each period:
Our default to claim rate assumption (which is net of denials and rescissions) used in estimating our provision for losses was 40% at December 31, 2010, 36% at December 31, 2009 and 46% at December 31, 2008.
well as defaults related to previously rescinded policies and denied claims that are expected to be reinstated or resubmitted, was $39.5 million and $13.6 million at December 31, 2010 and 2009, respectively. The increase in this estimate primarily reflects an increase both in recent trends and in claim denial activity in 2010, as we expect a portion of such denied claims to be resubmitted with the required documentation and ultimately paid. All estimates are continually reviewed and adjustments are made as they become necessary.
While the total potential claim amount of non-overturned rebuttals represents all challenged rescissions during 2010 and 2009 for which coverage has not been reinstated, our on-going, active engagement with our lender customers typically involves a small number of these non-overturned rebuttals. Absent litigation or other legal proceedings in which we are not successful, we do not expect that these discussions are likely to result in settlements that would materially impact our liquidity or results of operations.
The following table shows the cumulative rescission and denial rates as of December 31, 2010 on our total first-lien portfolio in the quarter the claims were received for the periods indicated:
(2) For each quarter presented in the table above, represents the number of claims that have been internally resolved as a percentage of the total number of claims received for that specific quarter. A claim is considered internally resolved when it is either paid or we conclude that the claim should be denied or rescinded. For the third and fourth quarters of 2010, a significant portion of claims received for those quarters have not been internally resolved; therefore, we do not believe the cumulative rescission rates for those periods are presently meaningful.
Policy Acquisition Costs. The increase in policy acquisition costs for 2010 compared to 2009 was mainly due to an increase in our estimated loss rate assumptions, which resulted in an acceleration of amortization. In our mortgage insurance segment, estimates of expected gross profit, which are driven in part by persistency and loss development for each underwriting year and product type, are used as a basis for amortization and are evaluated at least quarterly. The total amortization recorded to date is adjusted by a charge or credit to our consolidated statements of operations if actual experience or other evidence suggests that earlier estimates should be revised.
Other Operating Expenses. Other operating expenses increased slightly in 2010 as compared to 2009, due to increases in sales commissions, cash and stock-based compensation and information technology services expenses. These increases were partially offset by a reduction in contract underwriting expenses. Contract underwriting expenses for 2010, including the impact of reserves for contract underwriting remedies, were $6.1 million compared to $11.6 million for 2009. The decrease in contract underwriting expenses in 2010 resulted from a decreased demand for this service due to the overall decline in mortgage origination volume. During 2010, loans underwritten via contract underwriting for flow business accounted for 17.9% of applications, 16.5% of commitments for insurance and 13.9% of insurance certificates issued, compared to 14.1%, 12.5% and 13.0%, respectively, for 2009.
Interest Expense. Interest expense for 2010 and 2009 includes an allocation to the mortgage insurance segment of interest on our long-term debt based on allocated capital. For 2010, this allocation has decreased for our mortgage insurance segment relative to our financial guaranty segment.
Net Loss. The reduction in net loss for 2009 compared to 2008 resulted from a reduction in the provision for losses, primarily due to increased levels of estimated insurance rescissions and claim denials, and a benefit from the termination of certain first- and second-lien structured transactions and recoveries from the termination of captive reinsurance transactions. This positive impact was partially offset by lower net premiums earned and a loss in change in fair value of derivative instruments.
Change in Fair Value of Derivative Instruments. The change in fair value of derivative instruments decreased from a gain in 2008 to a loss in 2009. The 2008 results reflect our implementation of the accounting standard regarding fair value measurements, which resulted in a gain. In addition, in 2008, approximately half of our NIMS were consolidated, whereas in 2009, all NIMS were consolidated. Prior to consolidation, changes in the fair value of NIMS assets and liabilities were reported in change in fair value of derivative instruments. After consolidation, NIMS liabilities are recorded as VIE debt and changes in fair value of VIE debt are reported in net gains (losses) on other financial instruments.
Other Income. Other income was higher in 2009 compared to 2008, primarily as a result of increased pricing related to contract underwriting services.
Provision for Losses. The provision for losses for 2009 included the effect of increased levels of estimated insurance rescissions and claim denials, which resulted in a lower default to claim rate used in determining our loss reserve estimate. In 2009, the increased estimate of rescissions and denials included in our loss reserve estimates reduced our provision for losses by approximately $1 billion. The comparable change in 2008 was approximately $0.4 billion. In 2009, our mortgage insurance loss provision was negatively impacted by an increase in new defaults, generally higher average loan balances on defaulted loans and an aging of existing defaults.
Policy Acquisition Costs. The decrease in policy acquisition costs in 2009 compared to 2008 was primarily due to the write-off of $50.8 million of deferred policy acquisition costs in 2008 in connection with the establishment of a first-lien premium deficiency reserve, which reduced the base asset to be amortized.
Other Operating Expenses. The decrease in other operating expenses in 2009 was primarily due to lower employee compensation costs and lower contract underwriting expenses. Contract underwriting expenses for 2009, including the impact of reserves for remedies, were $11.6 million, compared to $31.5 million for 2008. The contract underwriting expenses in 2008 included a $10.5 million increase in reserves for remedies established for contract underwriting. Other operating expenses also included increased outside consulting fees, partially offset by a decrease in premium taxes as a result of a decrease in new business written, and a decrease in software depreciation. During 2009, loans underwritten via contract underwriting for flow business accounted for 14.1% of applications, 12.5% of commitments for insurance and 13.0% of insurance certificates issued, compared to 12.4%, 11.5% and 10.7%, respectively, for 2008.
(b) LTV ratio: The ratio of the original loan amount to the original value of the property.
As a result of the termination of mortgage insurance transactions during 2010 and 2009, primary insurance in force was reduced by $29.2 billion and $7.5 billion, respectively, and primary insurance risk in force was reduced by $6,284 million and $237 million, respectively.
(1) Includes 525, 3,302 and 5,373 loans in defaults at December 31, 2010, 2009 and 2008, respectively, for which either no reserve or a partial reserve was established because we do not expect to make a claim payment (a full claim payment in the event of a partial reserve), primarily due to deductibles.
(2) Includes 9,712, 18,033 and 23,364 defaults at December 31, 2010, 2009 and 2008, respectively, for which either no reserve or a partial reserve was established because we do not expect to make a claim payment (a full claim payment in the event of a partial reserve), primarily due to deductibles.
The following table shows information regarding our average loss reserves per default, excluding defaults for which either no reserve or a partial reserve was established because we do not expect to make a claim payment (a full claim payment in the event of a partial reserve) due to deductibles.
The following table shows information regarding our reserve for losses and reserve for premium deficiency as of the dates indicated:
The following table summarizes the results of operations for our financial guaranty segment for the years ended December 31, 2010, 2009 and 2008 ($ in millions):
The results for 2010 reflect the adoption of the accounting standard update regarding improvements to financial reporting by enterprises involving VIEs. As a result of this update, we identified and consolidated additional VIEs and recorded the related fair value gains (losses) in this line item. The losses related to changes in fair value of our VIE debt for 2010 were mainly due to the significant tightening of our CDS spread. Partially offsetting the losses related to financial guaranty VIE debt and CPS VIEs for 2010 were unrealized gains related to our trading portfolio. The realized gains on investments in 2010 and 2009 reflect improved market conditions and activity related to the reallocation of our investment portfolio to investments with shorter duration.
Provision for Losses. The provision for losses for 2010 decreased compared to 2009 due to favorable loss developments in our public finance business, which was partially offset by an increase in the provision for losses in our structured finance business. The 2009 provision for losses was reduced by $38.6 million as a result of adjustments made to our estimate of losses based on the June 2009 commutation of $9.8 billion in assumed net par outstanding and certain favorable developments in our structured finance direct line of business.
(2) Relates primarily to a CDO of ABS transaction with total exposure of $100 million. This claim was fully reserved for in 2007 and paid in 2008, and we have no remaining exposure to this transaction.
The following tables show the distribution of financial guaranty’s net par outstanding by type of exposure, as a percentage of financial guaranty’s total net par outstanding and the related net claim (asset) liability and derivative net (asset) liability as of the periods indicated:
(2) A claim liability is reported on the balance sheet when there is evidence that deterioration has occurred and the net present value of our expected losses for a particular policy exceeds the unearned premium reserve for that policy. The claim liability reported is net of estimated salvage and subrogation, which may result in a net claim asset.
(3) Represents either the net (asset) liability recorded within derivative assets or derivative liabilities for derivative contracts, or the net (asset) liability recorded within VIE debt and other financial statement line items for financial guaranty consolidated VIEs.
(5) Represents other types of municipal obligations, including human service providers, second-to-pay international public finance, non-profit institutions, project finance accommodations and stadiums, none of which individually constitutes a material amount of our financial guaranty net par outstanding.
(2) A claim liability is reported on the balance sheet when there is evidence that deterioration has occurred and the net present value of our expected losses for a particular policy exceeds the unearned premium reserve for that policy.
We provide additional information below regarding the performance of certain financial guaranty insurance transactions for which we anticipate that we will likely be required to make cumulative claim payments in excess of $25 million:
We have provided credit protection on the senior-most tranche of a CDO of ABS transaction with $453.6 million net par outstanding at December 31, 2010. The underlying collateral consists predominantly of mezzanine tranches of mortgage-backed securities (“MBS”). As of December 31, 2010, $381.8 million (or 83.8%) of the underlying collateral was rated BIG by at least one rating agency, and $248.3 million (or 54.5%) of the underlying collateral had defaulted. Due to the substantial deterioration of the underlying collateral, we currently expect to begin paying claims related to interest shortfalls on this transaction in 2012, and possibly earlier if the deterioration is worse than projected. Due to the structure of this transaction, we do not expect to pay claims related to principal
shortfalls until sometime between 2036 and the legal final maturity date for the transaction in 2046. Although losses for this transaction are difficult to estimate, we currently believe that our ultimate claim payments in respect of principal for this transaction will be substantially all of our total net par outstanding. This transaction is currently rated CC internally, CC by Standard & Poor’s Rating Service (“S&P”) and Ca by Moody’s Investor Service (“Moody’s”). We are exploring loss mitigation alternatives with respect to this transaction, including the possibility of commuting our remaining risk. We can provide no assurance that we will be successful in such loss mitigation efforts.
We have provided credit protection on 16 directly insured senior TruPs bonds with an aggregate net par outstanding of $2,117.4 million as of December 31, 2010. Our credit protection on these 16 senior TruPs bonds was provided through 20 separate CDS contracts, meaning that with respect to four of these senior TruPs bonds at December 31, 2010, we entered into two separate CDS contracts (each with a different counterparty) covering pari passu portions of the same TruPs bond.
One of our insured TruPs bonds began experiencing interest shortfalls in October 2009. In January 2010, we eliminated $96.6 million of our exposure to this TruPs bond by commuting one of the CDS contracts covering this bond. Our aggregate net loss with respect to such commutation approximated the fair value of this derivative liability at December 31, 2009. We continue to have $115.9 million of net par exposure to this TruPs bond through the remaining CDS contract. As of December 31, 2010, we have paid an aggregate of $0.5 million in interest shortfall claims in respect of this TruPs CDO bond, and we expect to continue to pay additional interest shortfall claims on this remaining CDS contract. In
addition, we may be required to pay a liquidity claim (as discussed in “Liquidity and Capital Resources-Financial Guaranty” below) on this CDS contract. We are exploring loss mitigation alternatives with respect to this TruPs bond, including the possibility of commuting our remaining risk. We can provide no assurance that we will be successful in such loss mitigation efforts.
Based on current projections, we expect to experience ultimate net credit losses on two of our TruPs bonds (the TruPs bond discussed in the preceeding paragraph and one other TruPs bond) with an aggregate of $245.6 million in net par outstanding. Based on our current cash flow projections, we believe that, in addition to interest claims that we may be required to pay over time, we will be required to pay aggregate principal claims totalling a majority of the current net par outstanding for these bonds. It should be noted that even relatively small changes in TruPs default rates or economic conditions from current projections could have a material impact on the timing and amount of cash available to make principal and interest payments on the underlying TruPs bonds. Therefore, the occurrence, timing and duration of any event of default and the amount of any ultimate principal or interest shortfall payments are uncertain and very difficult to predict.
Net Income (Loss). The decrease in net income in 2009 compared to 2008 was mainly due to a decrease in the change in fair value of derivative instruments, which was driven primarily by changes in the market’s perception of our non-performance risk, and a decrease in net premiums earned. Offsetting these decreases, net gains on other financial instruments increased during 2009 compared to 2008, our provision for losses decreased due mainly to the commutation of a large portfolio in 2009 and certain favorable developments in our structured finance business, and our income tax provision decreased.
Net Premiums Earned. Net premiums earned for 2009 decreased as a result of our decision in 2008 to discontinue writing new financial guaranty business and as a result of a high level of refundings, policy expirations and commutations in both 2008 and 2009. Included in net premiums earned for 2009 were refundings of $41.0 million compared to $75.1 million for 2008. Net premiums earned in 2009 were impacted by the commutation of a large portfolio, which reduced our net par outstanding by $9.8 billion and reduced net premiums earned for 2009 by $15.3 million.
Net Investment Income. The decrease in net investment income in 2009 compared to 2008 was due to lower yields on taxable investments in our investment portfolio, as a result of the reallocation of our investment portfolio to shorter term investments. In addition, assets were reallocated from longer duration, higher yielding tax exempt municipal securities to taxable securities of intermediate duration in a lower interest rate environment.
resulting in net unrealized gains on this portfolio. Partially offsetting these gains was the effect of the tightening of our five-year CDS spread in 2009 and credit deterioration in our TruPs CDO portfolio, which resulted in an unrealized loss on our TruPs CDOs for 2009. During 2008, our five-year CDS spread widened, and we adopted a new accounting standard regarding fair value measurements, the cumulative impact of which was a significant unrealized net gain for 2008.
Net Impairment Losses Recognized in Earnings. There was a negligible amount of impairment losses recognized in financial guaranty’s earnings in 2009. The net impairment losses recognized in earnings for 2008 were comprised of impairments of fixed maturity investments available for sale and equity securities available for sale.
approximately $34.8 million in the second quarter of 2010 related to the sale. Prior to the sale of our equity interest in Sherman, we recorded our share of equity in net income of Sherman.
Our equity in net income of affiliates from Sherman in 2009 declined as a result of Sherman’s decreased net income in 2009. Included in net income for 2009 was $5.7 million of amortization related to an intangible asset that we consider a one-time charge. Also included in net income for 2009 was the reversal of $4.3 million of previously accrued management fee expense related to C-BASS.
The following table summarizes certain of our contractual obligations and commitments, including our expected claim payments on insurance policies, as of December 31, 2010, and the future periods in which such obligations are expected to be settled in cash. Additional details regarding these obligations are provided in the narrative following the table and in the Notes to Consolidated Financial Statements that are referenced in the table.
Investment Commitments. As part of the non-investment grade component of our investment portfolio, we have committed to invest $90.0 million in alternative investments that are primarily private equity structures. At December 31, 2010, we had unfunded commitments of $13.8 million. These commitments have capital calls expected through 2015, with the possibility of additional calls through 2017, and certain fixed expiration dates or other termination clauses.
Radian Group and Radian Mortgage Insurance Inc. (“Radian Mortgage Insurance”) (formerly known as Commonwealth Mortgage Assurance Company (“CMAC”) of Arizona), a subsidiary of Radian Guaranty, are parties to a guaranty agreement in which Radian Group has agreed for the benefit of Radian Mortgage Insurance’s creditors to make funds available on demand for the full and complete payment of all due but unpaid liabilities.
Prior to our acquisition of Enhance Financial Services Group (“EFSG”) in 2001, EFSG issued a guaranty of payment of the liabilities and obligations of its subsidiary, Radian Reinsurance (Bermuda) Limited (“Radian Re Bermuda”), deriving from any insurance or reinsurance contract (the “Enhance Guaranty”), for the purpose of maintaining certain regulatory solvency and liquidity margin requirements of the Bermuda Monetary Authority. Following our acquisition of EFSG, Radian Group issued a guaranty for the benefit of EFSG to make funds available to EFSG for its performance of the Enhance Guaranty, to the extent that EFSG is unable to satisfy those obligations. As of January 2010, Radian Re Bermuda no longer had any insurance liabilities.
Radian Asset Assurance and RAAL are parties to a Capital Maintenance Agreement pursuant to which Radian Asset Assurance has agreed to maintain RAAL’s capital at a level not less that 350% of the equivalent of the required margin of solvency pursuant to the regulations of the Financial Services Authority (“FSA”), RAAL’s U.K. regulator, and to ensure that at all times RAAL has sufficient cash resources for the timely honoring of its contractual obligations. Radian Asset Assurance is not required to make any payments that would cause it to be in breach of its own minimum capital requirements, and certain payments by Radian Asset Assurance pursuant to this agreement are specifically subject to the prior approval of the New York Superintendent of Insurance. We are in the process of liquidating RAAL and plan to terminate the Capital Maintenance Agreement in connection with such liquidation,which we expect to occur in 2011.
Securities regulations became effective in 2005 that impose enhanced disclosure requirements on issuers of ABS (including MBS). To allow our mortgage insurance customers to comply with these regulations, we have been required, depending on the amount of credit enhancement we were providing, to provide (1) audited financial statements for the insurance subsidiary participating in these transactions or (2) a full and unconditional holding-company level guarantee for our insurance subsidiaries’ obligations in such transactions. Radian Group has guaranteed two structured transactions for Radian Guaranty with approximately $189.6 million of remaining credit exposure.
In addition to the foregoing, we use reinsurance from affiliated companies to allow Radian Guaranty to remain in compliance with insurance regulations that limit the amount of risk that a mortgage insurance company may retain on a single loan to 25% of the indebtedness of the insured. In February 2010, Radian Guaranty, in order to further support its capital position, entered into an excess-of-loss reinsurance agreement with Radian Insurance. Under this agreement, Radian Guaranty transferred approximately $1 billion of risk in force to Radian Insurance. This pool of loans generally consists of a higher concentration of fixed-rate, prime, high FICO loans than our overall mortgage insurance portfolio. As of December 31, 2010 the remaining risk in force under this agreement was $839.7 million.
Funding of Compensation Programs. Under our change of control agreements with our executive officers, upon a change of control of Radian Group or Radian Asset Assurance, as the case may be, we are required to fund an irrevocable rabbi trust to the extent of our obligations under these agreements. The total maximum amount that we would be required to place in trust is approximately $12.8 million as of December 31, 2010. In addition, in the event of a change of control under our existing cash-based incentive plans, we would be required to pay approximately $15.4 million under these plans.
Effective January 1, 2010, the accounting standard regarding accounting for transfers and servicing of financial assets and extinguishment of liabilities was amended to remove the concept of qualified special purpose entities (“QSPEs”). As a result, all VIEs must be evaluated for consolidation in accordance with the accounting standard regarding consolidation of VIEs. As defined by the accounting standard, VIEs include corporations, trusts or partnerships in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk to finance its activities without additional subordinated financial support.
We expect to fund Radian Group’s short-term liquidity needs with (i) existing cash and marketable securities, including, if necessary, $150 million held in the CPS trust accounts and (ii) cash received under the expense-sharing arrangements with our subsidiaries. If Radian Group’s current sources of liquidity are insufficient for Radian Group to fund its obligations, Radian Group may be required to 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.
Tax Payments. Under our current tax-sharing agreement between Radian Group and its subsidiaries, our subsidiaries are required to pay to Radian Group, on a quarterly basis, amounts representing their estimated separate company tax liability for the current tax year. Radian Group is required to refund to each subsidiary any amount that such subsidiary overpaid to Radian Group for a taxable year, as well as any amount that the subsidiary could utilize through existing carryback provisions of the Internal Revenue Code (“IRC”) had such subsidiary filed its federal tax return on a separate company basis. Under the provisions of this agreement, Radian Group paid approximately $53 million to Radian Guaranty in October 2010. Additionally, we currently estimate that Radian Group will be required to make a payment of approximately $77 million to Radian Guaranty in 2011, which is the maximum amount required under the tax-sharing agreement and is determined based upon Radian Guaranty’s separate company carryback ability for applicable net operating losses (“NOLs”). We also estimate that Radian Group will receive net tax-sharing payments during 2011 of approximately $13.2 million from other subsidiaries within our consolidated group. Our tax-sharing agreement may not be changed without the pre-approval of the applicable state insurance departments for certain of the insurance subsidiaries that are party to the agreement.
In November 2009, new tax legislation was enacted that provides an election to extend the existing carryback period for applicable NOLs incurred in either 2008 or 2009 (but not both years) from two years to up to five years. In September 2010, we amended our 2008 consolidated federal income tax return and made the election to extend our NOL carryback period to five years. This election was primarily made to preserve our maximum NOL carryback period allowed under current tax law and to provide us with an opportunity to utilize our 2008 NOL as a potential offset to any unsettled Internal Revenue Service (“IRS”) proposed adjustments relating to the 2003 through 2007 tax periods, which we are currently contesting with the IRS. See “Risk Factors-The IRS is examining our tax returns for the years 2000 through 2007.” While no additional federal income tax refund opportunities were created for Radian Group through its election to extend the 2008 NOL carryback period, additional tax-sharing agreement payments were required to be paid by Radian Group to certain insurance subsidiaries other than Radian Guaranty. In October 2010, Radian Group paid approximately $36 million to these insurance subsidiaries as a result of its election to extend its 2008 NOL carryback period.
Capital Support for Subsidiaries. Radian Group could be required to provide capital support for our mortgage insurance subsidiaries if additional capital is required pursuant to insurance laws and regulations or by the GSEs or the rating agencies. For example, CMAC of Texas, a Texas domiciled mortgage insurance subsidiary that provides Radian Guaranty with reinsurance on certain insurance coverages (primary insurance coverage in excess of 25% of the principal balance of the insured loan and pool insurance), incurred a significant loss in the first half of 2010, in part due to the increase in severity estimates for our pool insurance claims during that period. As a result, CMAC of Texas required capital contributions totaling approximately $113 million during 2010 ($101 million was funded by Radian Group and $12 million was funded by Radian Guaranty) in order to maintain a minimum statutory capital level. Similarly, Radian Mortgage Insurance, an Arizona domiciled mortgage insurance subsidiary that also provides Radian Guaranty with pool reinsurance, required capital contributions from Radian Guaranty totaling approximately $74 million during 2010, including $20.6 million in the fourth quarter of 2010, in order to maintain a minimum statutory capital level.
In September 2003, Radian Asset Assurance entered into a contingent capital transaction pursuant to which three custodial trusts issued an aggregate of $150 million in CPS ($50 million by each custodial trust) to various holders. As part of this transaction, Radian Asset Securities Inc. (“Radian Asset Securities”), our wholly-owned subsidiary, entered into a separate perpetual put option agreement with each custodial trust, and Radian Asset Assurance entered into three corresponding perpetual put option agreements with Radian Asset Securities. As of December 31, 2010, Radian Group and its subsidiaries had purchased by tender offer and privately negotiated
We expect to dissolve the custodial trust, which would result in the distribution of the $150 million in cash held by the custodial trust to Radian Group and its subsidiaries, as a holder of the CPS for such custodial trusts.
In November 2010, we issued $450 million principal amount of 3.0% convertible, unsecured senior notes due November 2017. The notes mature on November 15, 2017. Upon a conversion, we will pay cash up to the aggregate principal amount of the notes to be converted and pay or deliver, as the case may be, cash, shares of our common stock or a combination of cash and shares of our common stock, at our election, in respect of the remainder, if any, of our conversion obligation that is in excess of the aggregate principal amount of the notes being converted. The conversion rate will initially be 85.5688 shares of our common stock per $1,000 principal amount of notes (corresponding to an initial conversion price of approximately $11.69 per share of common stock). The conversion rate will be subject to adjustment in certain events, but will not be adjusted for any accrued and unpaid interest, if any. In addition, following certain corporate events, we will increase the conversion rate for a holder who elects to convert its notes in connection with that corporate event in certain circumstances.
Holders of the notes will be able to convert their notes, at their option, before the close of business on the business day immediately preceding August 15, 2017, only under the following circumstances:
2. During the five business day period after any five consecutive trading day period in which the trading price per $1,000 principal amount of the notes (for each trading day during that measurement period), was less than 98% of the product of the last reported sale price of the common stock and the applicable conversion rate on such trading day; or
These capped call transactions each have an initial strike price equal to the initial conversion price of the convertible notes and a cap price initially equal to approximately $14.11, or approximately 160% of the last reported sale price of our common stock on the NYSE on November 8, 2010 (in each case subject to certain anti-dilutive adjustments similar to those in the notes). These capped call transactions are intended to offset the potential dilution to our common stock and/or any potential cash payments that may be required to be made by us upon conversion of the convertible notes in excess of the principal amount of converted notes, up to the initial cap of $14.11 per share. If, however, the market value per share of our common stock, as measured under the terms of the capped call transactions, exceeds the applicable cap price of the transactions, the number of shares of our common stock and/or the amount of cash we expect to receive upon the exercise of the capped call transactions will be capped and the anti-dilutive and/or offsetting effect of the transactions will be limited. We paid approximately $46.1 million from the net proceeds from the issuance and sale of convertible notes to purchase these capped call transactions.
The terms of the convertible notes contain customary events of default including payment defaults, failure to comply with covenants and certain insolvency events. The occurrence of an event of default may lead the outstanding principal and unpaid interest of the convertible notes to be immediately due and payable. In addition to the convertible notes, as of December 31, 2010, we had outstanding $160 million of outstanding principal amount of 7.75% debentures due in 2011, $250 million principal amount of 5.625% senior notes due in 2013 and $250 million principal amount of 5.375% senior notes due in 2015.
For additional information regarding our long-term debt, see Note 13 of Notes to Consolidated Financial Statements.
As of December 31, 2010, Radian Asset Assurance maintained claims paying resources of $2.4 billion, including statutory surplus of approximately $1.0 billion. During 2010, Radian Asset Assurance paid a dividend of $69.2 million to Radian Guaranty. We currently anticipate that Radian Asset Assurance will have the capacity to pay another ordinary dividend of approximately $60 million to Radian Guaranty in June 2011.
The following table reconciles consolidated net loss to cash (used in) provided by operations for the years ended December 31, 2010, 2009 and 2008:
Cash flows from operating activities for 2010 decreased compared to 2009 primarily due to an increase in our net loss in 2010 and an increase in losses and payments related to derivative contracts and VIE debt. During 2008 and most of 2009, our trading securities activity reflected active and frequent buying and selling, as market prices of our investments strengthened as a result of the improving domestic and global economic environment, and we made the decision to opportunistically realize gains in the investment portfolio. As such, this activity was reflected as cash flows from operating activities within our consolidated statements of cash flows during 2008 and most of 2009. Beginning in the fourth quarter of 2009 and for all of 2010, we have classified purchases of trading securities within cash flows from investing activities, since those purchases are more consistent with our overall investment strategy. While our 2010 trading securities activity was significant, it was primarily driven by the strategic repositioning of the portfolio in order to: (1) shorten duration for liquidity purposes, and (2) increase our allocation to taxable bonds to maximize our after-tax yields. Because this activity relates to overall strategic initiatives and is not trading related, it is reflected as cash flows from investing activities. We expect that we will use more cash than we generate from operations during the next 12 months.
Stockholders’ equity was $0.9 billion at December 31, 2010, compared to $2.0 billion at December 31, 2009. The decrease in stockholders’ equity resulted primarily from our net loss of $1.8 billion for 2010, caused primarily by the establishment of a valuation allowance against our DTA and large unrealized losses on our derivative instruments. These losses were partially offset by a $592 million increase in additional paid-in capital resulting from our $550 million common stock public offering in May 2010 and our November 2010 public offering of $450 million principal amount of convertible senior notes due 2017.
Radian Group Inc. (“Radian Group”) and certain of our operating subsidiaries have been assigned the ratings provided in the chart below. We believe that ratings often are considered by others in assessing our credit strength and the financial strength of our insurance subsidiaries and, historically, it also has been a significant factor in determining Radian Guaranty’s eligibility with the GSEs. See “Risk Factors-We could lose our eligibility status with the GSEs, causing Freddie Mac and Fannie Mae to decide not to purchase mortgages insured by us, which would significantly impair our mortgage insurance franchise” in Item 1A of Part I of this Annual Report on Form 10-K.
(1) Moody’s ratings outlook for Radian Group, Radian Guaranty, Radian Insurance and Amerin Guaranty is currently Positive. Moody’s ratings outlook for Radian Asset Assurance is currently Stable.
(2) S&P’s ratings outlook for Radian Group and all our rated insurance subsidiaries is currently Negative.
SEC guidance defines Critical Accounting Policies as those that require the application of management’s most difficult, subjective, or complex judgments, often because of the need to make estimates about the effect of matters that are inherently uncertain and that may change in subsequent periods. In preparing our consolidated financial statements in accordance with accounting principles generally accepted in the United States of America (“GAAP”), management has made estimates, assumptions and judgments that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. In preparing these financial statements, management has utilized available information, including our past history, industry standards and the current and projected economic and housing
environment, among other factors, in forming its estimates, assumptions and judgments, giving due consideration to materiality. Because the use of estimates is inherent in GAAP, actual results could differ from those estimates. In addition, other companies may utilize different estimates, assumptions or judgments which may impact comparability of our results of operations to those of companies in similar businesses. A summary of the accounting policies that management believes are critical to the preparation of our consolidated financial statements is set forth below.
With respect to loans that are in an early stage of default, considerable judgment is exercised as to the adequacy of reserve levels. Adjustments in estimates for loans in the early stage of default are more volatile in nature than for loans that are in the later stage of default, which generally require a larger reserve. As the default proceeds towards foreclosure, there is generally more certainty around these estimates as a result of the aged status of the defaulted loan, and adjustments are made to loss reserves to reflect this updated information. If a default cures (historically, a large percentage of defaulted loans have cured), the reserve for that loan is removed from the reserve for losses and LAE. We also establish reserves for defaults that we estimate have been incurred but not been reported to us on a timely basis, and for defaults related to previously rescinded policies and denied claims which are likely to be reinstated, (in the case of previously rescinded policies), or resubmitted (in the case of previously denied claims). Due to the period of time (generally up to 90 days) that we give the insured to rebut
Each loan that we insure is unique, but for purposes of reserve modeling, loans are aggregated into groups using a variety of factors. The attributes used to define the groups include, but are not limited to, the default status of the loans (i.e., number of days in default), product type (i.e., Prime, Alt-A, and Subprime), type of insurance (i.e., primary or pool), vintage year, loss position (i.e., with or without a deductible), and the state where the property is located (segregated into three state groups in order to adjust for differences in foreclosure timing). We use an actuarial projection methodology referred to as a “roll rate” analysis that uses historical claim frequency information to determine the projected ultimate default to claim rates for each product and default status. The default to claim rate also includes our estimates with respect to expected insurance rescissions and claim denials, which have the effect of reducing our default to claim rates. Recently, we have experienced an elevated level of insurance rescissions and claim denials for various reasons, including, without limitation, underwriting negligence, fraudulent applications and appraisals, breach of representations and warranties, and inadequate documentation, reflecting the poor underwriting periods of 2005 through 2008. After estimating the default to claim rate, we estimate the severity of each product type, type of insurance, and state grouping based on the average of recently observed severity rates. These average severity estimates are then applied to individual loan coverage amounts to determine reserves.
We considered the sensitivity of first-lien loss reserve estimates at December 31, 2010, by assessing the potential changes resulting from a parallel shift in severity and default to claim rate. For example, assuming all other factors remain constant, for every one percentage point change in primary claim severity (which we estimate to be 27% of unpaid principal balance at December 31, 2010), we estimated that our loss reserves would change by approximately $104 million at December 31, 2010. For every one percentage point change in pool claim severity (which we estimate to be 48% of unpaid principal balance at December 31, 2010), we estimated that our loss reserves would change by approximately $10 million at December 31, 2010. For every one percentage point change in our overall default to claim rate (which we estimate to be 40% at December 31, 2010, including our assumptions related to rescissions and denials), we estimated an $82 million change in our loss reserves at December 31, 2010.
Prior to our adoption on January 1, 2009 of the update to the accounting standard regarding accounting for financial guaranty insurance contracts for all non-derivative financial guaranty insurance policies, we established case and LAE reserves for specifically identified impaired credits that had defaulted and allocated non-specific and LAE reserves for specific credits that we expected to default (case reserves and allocated non-specific reserves combined represented our allocated reserves). We also recorded unallocated non-specific reserves for
other losses on a portfolio basis. Our unallocated non-specific reserves were established over time by applying an expected loss ratio to the premiums earned during each reporting period and discretionary adjustments by management as appropriate due to changes in expected frequency and severity of losses.
Numerous factors affect our ultimate claim rates, including home price changes, unemployment, the impact of our loss mitigation efforts and interest rates, as well as potential benefits associated with lender and governmental initiatives to modify loans and ultimately reduce foreclosures. To assess the need for a PDR on our first-lien mortgage insurance portfolio, we develop loss projections based on modeled loan defaults related to our current risk in force. This projection is based on recent trends in default experience, severity, and rates of defaulted loans moving to claim (such default to claim rates are net of our estimates of rescissions and denials), as well as recent trends in the rate at which loans are prepaid. As of December 31, 2010, our modeled loan default projections assume that the rate at which current loans will default will remain consistent with those rates observed at December 31, 2010 for nine months, and then gradually return to normal historical levels over the subsequent two years.
For our second-lien mortgage insurance business, we project future premiums and losses for this business on a transaction-by-transaction basis, using historical results to help determine future performance for both repayments and claims. An estimated expense factor is then applied, and the result is discounted using a rate of return that approximates our investment yield. This net present value, less any existing reserves, is recorded as a premium deficiency and the reserve is updated at least quarterly based on actual results for that quarter, along with updated transaction level projections.
value measurements and disclosures. This update requires new disclosures regarding significant transfers in and out of Level I and Level II fair value measurements. Additional disclosures regarding the reconciliation of Level III fair value measurements are not required until 2011.
When determining the fair value of our liabilities, we are required to incorporate into the fair value an adjustment that reflects our own non-performance risk. Our CDS spread is the only observable quantitative measure of our non-performance risk and is used by typical market participants to determine the likelihood of our default. As our CDS spread tightens or widens, it has the effect of increasing or decreasing, respectively, the fair value of our liabilities.
A financial instrument’s level within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement. At December 31, 2010, our total Level III assets were approximately 3.7% of total assets measured at fair value and total Level III liabilities accounted for 100% of total liabilities measured at fair value.
Available for sale securities, trading securities, VIE debt, derivative instruments, and certain other assets are recorded at fair value as described in Note 5 of Notes to Consolidated Financial Statements. All derivative instruments and contracts are recognized on our consolidated balance sheets as either derivative assets or derivative liabilities. All changes in fair value of trading securities, VIE debt, derivative instruments and certain other assets are included in the statements of operations. All changes in the fair value of available for sale securities are recorded in accumulated other comprehensive income.
We determine the fair value of our derivative instruments primarily using internally-generated models. We utilize market observable inputs, such as credit spreads on similar products, whenever they are available. When one of our transactions develops characteristics that are inconsistent with the characteristics of transactions that underlie the relevant market-based index that we use in our credit spread valuation approach, and more relevant inputs or projections become available that we believe would represent the view of a typical market participant, we change to an approach that is based on the relevant available information. This change in approach is generally prompted when the credit component, and not market factors, becomes the dominant driver of the estimated fair value for a particular transaction. There is a high degree of uncertainty about our fair value estimates since our contracts are not traded or exchanged, which makes external validation and corroboration of our estimates difficult, particularly given the current market environment, where very few, if any, contracts are being traded or originated. In very limited recent instances, we have negotiated terminations of financial guaranty contracts with our counterparties and believe that such terminations provide the most relevant data with respect to validating our fair value estimates and such data has been generally consistent with our fair value estimates.
securitization underlying either the NIMS credit derivatives, NIMS derivative assets or NIMS VIE debt by applying expected default rates separately to loans that are delinquent and those that are paying currently. These default rates are based on historical experience of similar transactions. We then estimate the rate of prepayments on the underlying collateral in each securitization, incorporating historical prepayment experience. The estimated loss and rate of prepayments are used to estimate the cash flows for each underlying securitization and NIMS bond, and ultimately, to produce the projected credit losses for each NIMS bond. In addition to expected credit losses, we consider the future expected premiums to be received from the NIMS trust for each credit derivative. The projected net losses are then discounted using a rate of return that incorporates our own non-performance risk, and based on our current CDS spread, results in a reduction of the derivative liability. Since NIMS guarantees are not market-traded instruments, considerable judgment is required in estimating fair value. The use of different assumptions and/or methodologies could have a significant effect on estimated fair values. The NIMS credit derivatives, NIMS derivative assets and NIMS VIE debt are all categorized in Level III of the fair value hierarchy. As a result of our having to consolidate our NIMS VIEs, the fair value of derivative assets held by the NIMS VIEs and the NIMS VIE debt are determined by using the same internally generated valuation model.
Changes in expected principal credit losses on NIMS could have a significant impact on our fair value estimate. The gross expected principal credit losses were $135.6 million as of December 31, 2010, which is our best estimate of settlement value at that date and represents substantially all of our total risk in force. The recorded fair value of our total net liabilities related to NIMS as of December 31, 2010 was $129.3 million, of which $11.7 million relates to derivative assets and $141.0 million relates to debt of the NIMS VIE trusts. Our fair value estimate incorporates a discount rate that is based on our CDS spread, which has resulted in a fair value amount that is $6.3 million less than the expected principal credit losses. Changes in the credit loss estimates will impact the fair value directly, reduced only by the present value factor, which is dependent on the timing of the expected losses and our credit spread.
The fair value of each of our corporate CDO transactions is estimated based on the difference between (1) the present value of the expected future contractual premiums we charge and (2) the fair premium amount that we estimate that another financial guarantor would require to assume the rights and obligations under our contracts. The fair value estimates reflect the fair value of the asset or liability, which is consistent with the “in-exchange” approach, in which fair value is determined based on the price that would be received or paid in a current transaction as defined by the accounting standard regarding fair value measurements. These credit derivatives are categorized in Level III of the fair value hierarchy.
Defining the Equivalent-Risk Tranche-Direct observations of fair premium amounts for our transactions are not available since these transactions cannot be traded or transferred pursuant to their terms and there is currently no active market for these transactions. However, CDS on tranches of a standardized index (the “CDX index”) are widely traded and observable, and provide relevant market data for determining the fair premium amount of our transactions, as described more fully below.
The CDX index is a synthetic corporate CDO that comprises a list of corporate obligors and is segmented into multiple tranches of synthetic senior unsecured debt of these obligors ranging from the equity tranche (i.e., the most credit risk or first-loss position) to the most senior tranche (i.e., the least credit risk). We refer to each of these tranches as a “standard CDX tranche.” A tranche is defined by an attachment point and detachment point, representing the range of portfolio losses for which the protection seller would be required to make a payment.
TruPs CDOs-Our TruPs transactions are CDS on CDOs where the collateral consists primarily of deeply subordinated securities issued by banks, insurance companies, real estate investment trusts and other financial institutions whose individual spreads are not observable. In each case, we provide credit protection on a specific tranche of each CDO. We use a discounted cash flow valuation approach to determine fair value for these
For certain of our TruPs transactions, our counterparties may require that we pay them the outstanding par on the underlying TruPs bond if an event of default has occurred and remains outstanding as of the termination date of our CDS coverage (a “conditional liquidity claim”). For these transactions, an additional fair value adjustment is made. To calculate this adjustment, a probability that we will be required to pay a conditional liquidity claim is assigned based on our internal cash flow projections, which provides us with information as to the likelihood of the existence of a conditional liquidity claim. A discounted cash flow valuation is also performed for this scenario where we are required to make a conditional liquidity claim. The fair value is set equal to the probability weighted average of the valuations from the two scenarios: one in which our counterparty makes a conditional liquidity claim and one in which the claim is not made.
The VIE debt and derivative liability within this CDO of ABS transaction are categorized in Level III of the fair value hierarchy. Our maximum principal exposure to loss from this CDO of ABS transaction is $453.6 million at December 31, 2010. The recorded net fair value of our consolidated assets and liabilities related to this consolidated CDO of ABS as of December 31, 2010, was less than our maximum principal exposure. The fair value of the VIE debt and other liabilities exceeds the net value of the assets of the VIE; however, because our fair value estimate of the VIE debt incorporates a discount rate that is based on our CDS spread, the fair value is substantially less than our expected ultimate claim payments.
All Other Non-Corporate CDOs and other Derivative Transactions-For all of our other non-corporate CDOs and other derivative transactions, observed prices and market indices are not available. As a result, we utilize an internal model that estimates fair premium. The fair premium amount is calculated such that the expected profit (fair premium amount net of expected losses and other expenses) is proportional to an internally-developed risk-based capital amount. Expected losses and our internally developed risk-based capital amounts are projected by our model using the credit rating, term, and current par outstanding for each transaction.
Upon the adoption of the accounting standard update regarding improvements to financial reporting by enterprises involving VIEs, we determined that we are the primary beneficiary for two VIEs in addition to our CDO of ABS transaction as of January 1, 2010, for which we have provided financial guarantees. Upon consolidation, we elected the fair value option for all financial assets and financial liabilities held by these two VIEs, which primarily consist of manufactured housing loans and VIE debt to note holders in the trust. The fair value election allows us to offset the changes in fair value of the assets and liabilities of the trust, providing a better representation of our net exposure to the VIEs. See Note 6 of Notes to Consolidated Financial Statements for further discussion of the primary beneficiary analysis and the related financial impacts to our financial position, financial performance and cash flows.
The fair value of the VIE debt related to these other financial guaranty VIEs is estimated based on prices of comparable securities and spreads observed in the market. The overall net fair value for these transactions is determined using a discounted cash flow analysis. We do not currently estimate any projected claims based on our internal credit analysis, which is based on the current performance of the underlying collateral and the remaining subordination available to support the transaction. The present value of the insured cash flows is determined by using a discount rate that is equal to our CDS rate plus a risk-free rate. We utilize this model to determine the fair value of our exposure to these VIEs, and to derive the fair value of the assets in these VIEs, which are reported within other assets on our consolidated balance sheets.
The assets and VIE debt related to these transactions are categorized in Level III of the fair value hierarchy. Our maximum principal exposure to loss from these transactions is $131.0 million; however, we do not currently expect to pay any claims related to these two VIEs. At December 31, 2010, we recorded $109.7 million of other assets, $109.0 million of VIE debt and $0.7 million of accounts payable and accrued expenses associated with these two VIEs.
We group assets in our investment portfolio into one of three main categories: held to maturity, available for sale or trading securities. Fixed-maturity securities for which we have the positive intent and ability to hold to maturity are classified as held to maturity and reported at amortized cost. Investments in securities not classified as held to maturity or trading securities are classified as available for sale and are reported at fair value, with unrealized gains and losses (net of tax) reported as a separate component of stockholders’ equity as accumulated other comprehensive income. Investments classified as trading securities are reported at fair value, with unrealized gains and losses reported as a separate component of income. Beginning in the second quarter of 2009, we classified all security purchases as trading securities. Short term investments consist of assets invested
For certain hybrid financial instruments that would be required to be separated into a host contract and a derivative instrument, the accounting standard regarding derivatives and hedging permits an entity to irrevocably elect to initially and subsequently measure that hybrid financial instrument in its entirety at fair value (with changes in fair value recognized in earnings). We elected to record our convertible securities meeting these criteria at fair value with changes in the fair value recorded as net gains or losses on other financial instruments. All hybrid financial instruments are classified trading securities.
In evaluating whether a decline in value is other-than-temporary, we consider several factors, including, but not limited to, the following:
the financial position and access to capital of the issuer, including the current and future impact of any specific events; and
When evaluating whether we are the primary beneficiary of a VIE, we determine which activities most significantly impact the economic performance of the VIE. As part of our qualitative analysis, we consider whether we have any contractual rights that would allow us to direct those activities. As of December 31, 2010, we have determined that we are the primary beneficiary of our NIMS transactions, our CPS transactions and certain financial guaranty structured transactions. As a result of the adoption of this accounting standard, in addition to the VIEs we had consolidated prior to January 1, 2010, we concluded that we are the primary beneficiary of two additional VIEs with respect to which we provided credit protection pursuant to financial guaranty insurance contracts and one additional VIE with respect to which we provided credit protection pursuant to a financial guaranty derivative contract. While the implementations of this accounting standard impacted the classification of our assets, liabilities, and certain line items in our statement of operations, we recorded no transition adjustments at January 1, 2010, because the net liabilities associated with these transactions remained unchanged. Our control rights in these VIEs, which we obtained due to an event of default or breach of a performance trigger as defined in the transaction, generally provide us with either a right to replace the VIE servicer, or, in some cases, the right to direct the sale of the VIE assets. In those instances where we have determined that we are the primary beneficiary, we consolidate the assets and liabilities of the VIE. We have elected to carry the financial assets and financial liabilities of these VIEs at fair value.
In January 2010, the Financial Accounting Standards Board (“FASB”) issued an update to the accounting standard regarding fair value measurements and disclosures. This update requires new disclosures regarding significant transfers in and out of Level I and Level II fair value measurements for interim and annual reporting periods beginning after December 15, 2009. Additional disclosures regarding the reconciliation of Level III fair value measurements are not required until 2011.
Effective January 1, 2010, we adopted the update to the accounting standard regarding accounting for transfers of financial assets. This update is intended to improve the relevance and comparability of the information that a reporting entity provides in its financial reports about a transfer of financial assets; the effects of a transfer on its financial position, financial performance, and cash flows; and a transferor’s continuing involvement in transferred financial assets. Specifically, this update removes the concept of a QSPE from the accounting standard related to the accounting for transfers and servicing of financial assets and extinguishments of liabilities and removes the exception from applying the accounting standard related to the consolidation of VIEs. Enhanced disclosures are required to provide financial statement users with greater transparency about transfers of financial assets and a transferor’s continuing involvement with transferred financial assets. See “VIEs” above for a description regarding the impact of this adoption.
In July 2010, the FASB issued an update to the accounting standard regarding disclosures about the credit quality of financing receivables and the allowance for credit losses. The objective of this update is to provide financial statement users with information that will enable them to understand: the nature of credit risk inherent in the creditor’s portfolio of financing receivables; the way credit risk is analyzed in arriving at the allowance for credit losses; and the changes in the allowance for credit losses and reasons for the changes. The new disclosures required by this update are effective for interim and annual periods ending after December 15, 2010. The new requirements did not have a significant impact on our disclosures, as discussed in Note 9 of Notes to Consolidated Financial Statements.
In October 2010, the FASB issued an update to the accounting standard regarding accounting for costs associated with acquiring or renewing insurance contracts. This update redefines acquisition costs as costs that are related directly to the successful acquisition of new, or the renewal of existing, insurance contracts. Currently, acquisition costs are defined as costs that vary with and are primarily related to the acquisition of insurance contracts. The impact of this revised definition of acquisition costs may result in additional expenses being
charged to earnings immediately rather than being deferred. This update is effective for fiscal years beginning after December 15, 2011. Management is currently evaluating the impact that may result from the adoption of this standard.
As discussed in Note 2 to the consolidated financial statements, the Company adopted in 2010 a new accounting standard for variable interest entities and, in 2009, a new accounting standard for financial guaranty insurance contracts. As discussed in Note 1 to the consolidated financial statements, in 2008, the Company discontinued writing new financial guaranty business.
Our mortgage insurance segment provides credit-related insurance coverage, principally through private mortgage insurance, and risk management services to mortgage lending institutions. We have provided these products and services mainly through our wholly-owned subsidiaries, Radian Guaranty Inc., Amerin Guaranty Corporation, and Radian Insurance Inc. (which we refer to as “Radian Guaranty,” “Amerin Guaranty,” and “Radian Insurance,” respectively). Private mortgage insurance protects mortgage lenders from all or a portion of default-related losses on residential mortgage loans made to home buyers who generally make down payments of less than 20% of the home’s purchase price. Private mortgage insurance also facilitates the sale of these mortgage loans in the secondary mortgage market, most of which are sold to Freddie Mac and Federal National Mortgage Association (“Fannie Mae”). We refer to Freddie Mac and Fannie Mae together as “Government Sponsored Enterprises” or “GSEs.”
In 2008, in light of market conditions and the downgrade of the financial strength ratings of our financial guaranty insurance subsidiaries, we discontinued writing any new financial guaranty business, including accepting new financial guaranty reinsurance, other than as necessary to commute, restructure, hedge or otherwise mitigate losses or reduce exposure in our existing portfolio. As a result, we have reduced our financial guaranty operations, including reducing our financial guaranty workforce. Since 2008, we have also reduced our financial guaranty exposures through commutations in order to eliminate uncertainty, maximize the ultimate capital available for our mortgage insurance business and accelerate the potential access to that capital. We continue to explore ways to maximize the value of our existing insured financial guaranty portfolio, including the possibility of partnering with third-parties to utilize all or a portion of the portfolio as a platform for writing new public finance and infrastructure business, as well as other possible ways to leverage the portfolio.
Financial Guaranty Exposure Subject to Recapture or Termination. As a result of ratings downgrades of Radian Asset Assurance, approximately $57.9 billion of our total net par outstanding as of December 31, 2010 (representing 73.5% of financial guaranty’s total net par outstanding), remains subject to recapture or termination at the option of our primary reinsurance customers and credit derivative counterparties.
If all of our reinsurance that is subject to recapture was recaptured as of December 31, 2010, our net par outstanding would have been reduced by $23.6 billion and the pre-tax impact on our financial statements would have been as follows:
While our treaties with our primary reinsurance customers do not permit our reinsurance customers to selectively recapture business previously ceded to us under their treaties, because we have entered into multiple treaties with each customer, it is possible that a customer may choose to recapture business only under those treaties that it perceives as covering less risky portions of our reinsurance portfolio. This selective recapture, if it occurs, could potentially leave us with risk that is more concentrated in troubled asset classes.
Potential adverse effects if the capital and liquidity levels of Radian Group or our regulated subsidiaries’ statutory capital levels are deemed inadequate to support current business operations and strategies. Radian Group had immediately available, directly or through an unregulated direct subsidiary, unrestricted cash and marketable securities of approximately $797.5 million at December 31, 2010. Radian Guaranty’s statutory policyholders’ surplus and contingency reserves declined from $1.5 billion at December 31, 2009 to $1.3 billion at December 31, 2010. Radian Group has contributed $322 million to Radian Guaranty during 2010. Radian Guaranty also received a dividend of $69.2 million from Radian Asset Assurance during 2010. As a result of losses generated in 2010, and in order to maintain the minimum surplus requirements for two subsidiaries that reinsure risk from Radian Guaranty, Radian Group and Radian Guaranty contributed $101 million and $12 million, respectively, of capital to Commonwealth Mortgage Assurance Company (“CMAC”) of Texas. In addition, Radian Guaranty contributed $74 million of capital to Radian Mortgage Insurance Inc. (“Radian Mortgage Insurance”) during 2010. (See Note 15).
Potential adverse effects if Radian Guaranty’s regulatory risk-to-capital ratio was to increase above 25 to 1, including the possibility that regulators or the GSEs may limit or cause Radian Guaranty to cease underwriting new mortgage insurance risk. We have been preparing Amerin Guaranty to write new first-lien mortgage insurance, if needed. If we are then unable to continue writing new first-lien mortgage insurance business through Amerin Guaranty, it will significantly impair our franchise value and reduce our cash flow associated with new business while we continue to honor and settle all valid claims and related expenses. At December 31, 2010, this ratio was 16.8 to 1.
Potential adverse effects if Radian Guaranty were to lose its eligibility status with the GSEs, which could occur at any time at the discretion of the GSEs. Loss of GSE eligibility would likely result in a significant curtailment of our ability to write new mortgage insurance business, which would significantly impair our franchise value and limit our cash flow arising from new business while we continue to honor and settle all valid claims and related expenses.
Potential adverse effects from legislative efforts to reform the housing finance market, including the possibility that new federal legislation could reduce or eliminate the requirement for private mortgage insurance.
It is possible that the actual outcome of one or more of our plans or forecasts could be materially different, or that one or more of our estimates about the potential effects of the risks and uncertainties above or described
elsewhere in these financial statements, in particular, our estimate of losses, could prove to be materially different than our actual results. If one or more possible adverse outcomes were realized, there could be material adverse effects on our financial position, results of operations and cash flows.
Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and include the accounts of all wholly-owned subsidiaries. Companies in which we, or one of our subsidiaries, own interests ranging from 20% to 50%, are accounted for in accordance with the equity method of accounting. See Note 8 for further information. VIEs where we are the primary beneficiary are consolidated. See Note 6 for further information. All intercompany accounts and transactions, and intercompany profits and losses, have been eliminated.
Effective January 1, 2009, we adopted an update to the accounting standard regarding accounting for financial guaranty insurance contracts for all non-derivative financial guaranty insurance policies. This standard clarifies the accounting for financial guaranty insurance contracts, including the method of recognition and measurement to be used to account for premium revenue and claim liabilities. The scope of this standard is limited to financial guaranty insurance (and reinsurance) contracts issued by insurance enterprises included within the scope of the previous accounting standard regarding accounting and reporting by insurance enterprises. As a result of the implementation of this standard, we recognized a total cumulative effect of adoption as a reduction in retained earnings of $37.6 million, effective January 1, 2009.
We establish reserves to provide for losses and LAE and the estimated costs of settling claims in both the mortgage insurance and financial guaranty segments. The accounting standard regarding accounting and reporting by insurance enterprises specifically excludes mortgage insurance from its guidance relating to the reserve for losses but does not provide any other specific guidance. Therefore, because of the lack of specific guidance, we establish reserves for mortgage insurance using the guidance contained in this standard, supplemented with other accounting guidance as described below.
be accurate, especially during an extended economic downturn. We cannot be certain that we have correctly estimated the necessary amount of reserves or that the reserves established will be adequate to cover ultimate losses on incurred defaults.
Each loan that we insure is unique, but for purposes of reserve modeling, loans are aggregated into groups using a variety of factors. The attributes used to define the groups include, but are not limited to, the default status of the loans (i.e., number of days in default), product type (i.e., Prime, Alternative-A (“Alt-A”), and Subprime), type of insurance (i.e., primary or pool), vintage year, loss position (i.e., with or without a deductible), and the state where the property is located (segregated into three state groups in order to adjust for differences in foreclosure timing). We use an actuarial projection methodology referred to as a “roll rate” analysis that uses historical claim frequency information to determine the projected ultimate default to claim rates for each product and default status. The default to claim rate also includes our estimates with respect to expected insurance rescissions and claim denials, which have the effect of reducing our default to claim rates.
Our default to claim rate assumption was 40% at December 31, 2010 and 36% at December 31, 2009. A key assumption affecting our reserving methodology is that our default to claim rates and severities will be consistent with our recent experience. Our estimate of expected insurance rescissions and claim denials embedded in our default to claim rate is generally based on our experience over the past year, with consideration given for differences in characteristics between those rescinded policies and denied claims and the remaining default inventory. While we expect our rescission and denial rates to remain at elevated levels as long as defaults related to the poor underwriting periods of 2005 through 2008 represent a significant percentage of our total default portfolio, we have begun to experience a decrease in our rescission and denial rates. The elevated levels in the rate of rescissions and denials during 2009 and 2010 have led to an increased risk of litigation by lenders and policyholders challenging our right to rescind coverage or deny claims. Such challenges may be made several years after we have rescinded a certificate of insurance or denied a claim. Recently, we have faced an increasing number of challenges from certain lender customers regarding our insurance rescissions and claim denials, which have resulted in some reversals of our decisions regarding rescissions and denials. Although we believe that our rescissions and denials are justified under our policies, if we are not successful in defending the rescissions and denials in any potential legal or other actions, we may need to reassume the risk on, and reestablish loss reserves for, those policies or pay additional claims. The assumptions embedded in our estimated default to claim rate on our in-force default inventory includes an adjustment to our estimated rescission and denial rate, to account for the fact that we expect a certain number of policies for which an initial intent to rescind letter has been sent to our lender customers to remain in-force and ultimately be paid, as a result of valid challenges by such policy holders.
Prior to our adoption in January 1, 2009 of the update to the accounting standard regarding accounting for financial guaranty insurance contracts for all non-derivative financial guaranty insurance policies, we established case and LAE reserves for specifically identified impaired credits that had defaulted and allocated non-specific and LAE reserves for specific credits that we expected to default (case reserves and allocated non-specific reserves combined represented our allocated reserves). We also recorded unallocated non-specific reserves for other losses on a portfolio basis. Our unallocated non-specific reserves were established over time by applying an expected loss ratio to the premiums earned during each reporting period and discretionary adjustments by management as appropriate due to changes in expected frequency and severity of losses.
Insurance enterprises are required to establish a premium deficiency reserve (“PDR”) if the net present value of the expected future losses and expenses for a particular product exceeds the net present value of expected future premiums and existing reserves for that product. We reassess our expectations for premiums, losses and expenses for each of our mortgage insurance businesses at least quarterly and update our premium deficiency analysis accordingly. For purposes of our premium deficiency analysis, we group our mortgage insurance products into two categories, first-lien and second-lien.
Derivative instruments are recorded at fair value, and changes in fair value are recorded in change in fair value of derivative instruments. All our derivative instruments are recognized in our consolidated balance sheets as either derivative assets or derivative liabilities, depending on the rights or obligations under the contracts. Our credit protection in the form of CDS within our mortgage insurance segment (prior to their termination) and financial guaranty segment, derivative liabilities related to consolidated VIEs, NIMS derivative assets and financial guaranty contracts on NIMS that were not consolidated, and put options on money market committed preferred trust securities (“CPS”) that were not consolidated, are all recorded at fair value, with changes in their fair value (prior to their consolidation) included in change in fair value of derivative instruments in our consolidated statements of operations. See Note 4 for further information.
An entity is considered the primary beneficiary and is required to consolidate a VIE if its variable interest (i) gives it the power to most significantly impact the economic performance of the VIE, and (ii) has the obligation to absorb losses or the right to receive residual benefits that could potentially be significant to the VIE. For all VIEs in which we have a variable interest, we determine whether we are the primary beneficiary. In determining whether we are the primary beneficiary, a number of factors are considered, including the structure of the entity, contractual provisions that grant us additional rights to influence or control the economic performance of the VIE upon the occurrence of an event of default or a servicer termination event or the breach of a performance trigger, and our obligation to absorb significant losses. Due to the continued deterioration of the performance of many of our financial guaranty transactions, the breach of these performance tests, or other events giving rise to our right to influence or control the economic performance of the VIE, could occur. When we obtain control rights, we perform an analysis to reassess our involvement with these VIEs to determine whether we have become the primary beneficiary.
Our fair value measurements are intended to reflect the assumptions market participants would use in pricing an asset or liability based on the best information available. Assumptions include the risks inherent in a particular valuation technique (such as a pricing model) and/or the risks inherent in the inputs to the model. We define fair value as the current amount that would be exchanged to sell an asset or transfer a liability, other than in a forced liquidation. In the event that our investments or derivative contracts were sold or transferred in a forced liquidation, the amounts received or paid may be materially different than those determined in accordance with this standard. Effective January 1, 2010, we adopted the update to the accounting standard regarding fair value measurements and disclosures. This update requires new disclosures regarding significant transfers in and out of Level I and Level II fair value measurements. Additional disclosures regarding the reconciliation of Level III fair value measurements are not required under this update until 2011.
When determining the fair value of our liabilities, we are required to incorporate into the fair value an adjustment that reflects our own non-performance risk. Our CDS spread is the only observable quantitative measure of our non-performance risk and is used by typical market participants to determine the likelihood of default. As our CDS spread tightens or widens, it has the effect of increasing or decreasing, respectively, the fair value of our liabilities
Level II-Quoted prices or valuations in markets that are not active or financial instruments for which all significant inputs are observable, either directly or indirectly; and
Available for sale securities, trading securities, VIE debt, derivative instruments, and certain other assets are recorded at fair value as described in Note 4, Note 5 and Note 6. All derivative instruments and contracts are recognized on our consolidated balance sheets as either derivative assets or derivative liabilities. All changes in fair value of trading securities, VIE debt, derivative instruments and certain other assets are included in the statements of operations. All changes in the fair value of available for sale securities are recorded in accumulated other comprehensive income.
Mortgage insurance premiums written on an annual and multi-year basis are initially recorded as unearned premiums and earned over the policy term, which premiums written on a monthly basis are earned over the period that coverage is provided. Annual premiums are amortized on a monthly, straight-line basis. Multi-year premiums are amortized over the terms of the contracts in relation to the anticipated claim payment pattern based on historical industry experience. Ceded premiums written are initially set up as prepaid reinsurance and are amortized in a manner consistent with how direct premiums are earned. Premiums on certain structured transactions in our mortgage insurance business are recognized over the period that coverage is provided.
Costs associated with the acquisition of mortgage insurance business, consisting of compensation and other policy issuance and underwriting expenses, are initially deferred and reported as deferred policy acquisition costs. Amortization of these costs for each underwriting year book of business is charged against revenue in proportion to estimated gross profits over the estimated life of the policies. This includes accruing interest on the unamortized balance of deferred policy acquisition costs. Estimates of expected gross profit including persistency and loss development assumptions for each underwriting year used as a basis for amortization are evaluated regularly, and the total amortization recorded to date is adjusted by a charge or credit to our consolidated statements of operations if actual experience or other evidence suggests that earlier estimates should be revised. Considerable judgment is used in evaluating these estimates and the assumptions on which they are based. The use of different assumptions would have a significant effect on the amortization of deferred policy acquisition costs. Total deferred policy acquisition costs for mortgage insurance amortized during 2010, 2009 and 2008 were
Deferred policy acquisition costs in the financial guaranty business are comprised of those expenses that vary with, and are principally related to, the production of insurance premiums, including: commissions paid on reinsurance assumed, salaries and related costs of underwriting and marketing personnel, rating agency fees, premium taxes and certain other underwriting expenses, offset by commission income on premiums ceded to reinsurers. Acquisition costs are deferred and amortized over the period in which the related premiums are earned for each underwriting year. The amortization of deferred policy acquisition costs is adjusted regularly based on the expected timing of both upfront and installment-based premiums. The estimation of installment-based premiums requires considerable judgment, and different assumptions could produce different results. Total deferred acquisition costs for financial guaranty business amortized during 2010, 2009 and 2008 were $17.4 million, $35.5 million and $47.3 million, respectively. As a result of the commutation of $9.8 billion of net par outstanding in 2009, we wrote off $8.9 million of deferred policy acquisition costs at that time. Origination costs of derivative contracts are expensed as incurred.
In accordance with the accounting standard regarding the accounting and disclosure of income taxes in interim periods, we use an annualized effective tax rate to compute our tax expense each quarter. We adjust this annualized effective tax rate each quarter by the following discrete items: (i) net gains or losses resulting from the change in fair value of our derivatives and other financial instruments, (ii) investment gains or losses, (iii) the liabilities recorded under the accounting standard regarding accounting for uncertainty in income taxes, and (iv) prior year provision-to-filed tax return adjustments. Given the uncertainty of the impact these discrete items will have for the full year, which directly affects our ability to estimate our pre-tax income or loss and the associated effective tax rate at each quarterly period, we believe it is appropriate to treat these items discretely when developing our effective tax rate each quarter. Future changes in these discrete items during the year will impact our annualized effective tax rate.
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 accumulated other comprehensive income 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 are funds held in escrow for any future duties, rights and liabilities on one mortgage insurance policy and funds held as collateral per our insurance trust agreement with our health care provider.
Within our consolidated statements of cash flows, we classify cash receipts and cash payments related to items measured at fair value according to their nature and purpose. During 2008 and most of 2009, our trading securities activity reflected active and frequent buying and selling, as market prices of our investments strengthened as a result of the improving domestic and global economic environment, and we made the decision to opportunistically realize gains in the investment portfolio. As such, this activity was reflected as cash flows from operating activities within our consolidated statements of cash flows during 2008 and most of 2009. Beginning in the fourth quarter of 2009 and for all of 2010, we have classified purchases of trading securities within cash flows from investing activities, since those purchases are more consistent with our overall investment strategy. While our 2010 trading securities activity was significant, it was primarily driven by strategic repositioning of the portfolio in order to: (1) shorten duration for liquidity purposes, and (2) increase our allocation to taxable bonds to maximize our after-tax yields. Because this activity relates to overall strategic initiatives and is not trading related, it is reflected as cash flows from investing activities.
We group assets in our investment portfolio into one of three main categories: held to maturity, available for sale or trading securities. Fixed-maturity securities for which we have the positive intent and ability to hold to maturity are classified as held to maturity and reported at amortized cost. Investments in securities not classified as held to maturity or trading securities are classified as available for sale and are reported at fair value, with unrealized gains and losses (net of tax) reported as a separate component of stockholders’ equity as accumulated other comprehensive income. Investments classified as trading securities are reported at fair value, with unrealized gains and losses reported as a separate component of income. Beginning in the second quarter of 2009, we classified all security purchases as trading securities. Short term investments consist of assets invested in class one money market instruments, certificates of deposit and highly liquid, interest bearing instruments with an original maturity of three months or less at the time of purchase. Amortization of premium and accretion of discount are calculated principally using the interest method over the term of the investment. Realized gains and losses on investments are recognized using the specific identification method. See Note 5 for further discussion on the fair value of investments.
For certain hybrid financial instruments that would be required to be separated into a host contract and a derivative instrument, the accounting standard regarding derivatives and hedging permits an entity to irrevocably elect to initially and subsequently measure that hybrid financial instrument in its entirety at fair value (with changes in fair value recognized in earnings). We elected to record our convertible securities meeting these criteria at fair value with changes in the fair value recorded as net gains or losses on other financial instruments. All hybrid financial instruments are classified as trading securities.
We are the beneficiary of insurance policies on the lives of certain of our current and past officers and employees. We have recognized the amount that could be realized upon surrender of the insurance policies in other assets in our consolidated balance sheets. At December 31, 2010 and 2009, the cash surrender value of company-owned life insurance totaled $71.6 million and $69.4 million, respectively.
In October 2010, the Financial Accounting Standards Board (“FASB”) issued an update to the accounting standard regarding accounting for costs associated with acquiring or renewing insurance contracts. This update redefines acquisition costs as costs that are related directly to the successful acquisition of new, or the renewal of existing, insurance contracts. Currently, acquisition costs are defined as costs that vary with and are primarily related to the acquisition of insurance contracts. The effect of this revised definition of acquisition costs may result in additional expenses being charged to earnings immediately rather than being deferred. This update is effective for fiscal years beginning after December 15, 2011. Management is currently evaluating the impact that may result from the adoption of this standard.
We have three reportable segments: mortgage insurance, financial guaranty and financial services. Our reportable segments are strategic business units that are managed separately because each business requires different marketing and sales expertise. We allocate corporate income and expenses to our mortgage insurance and financial guaranty segments based on either an allocated percentage of time spent or internally allocated capital. We allocate corporate cash and investments to our mortgage insurance and financial guaranty segments based on internally allocated capital. As a result of the sale of our remaining interest in Sherman in May 2010, our financial services segment currently consists solely of our 46% interest in C-BASS, which filed for Chapter 11 bankruptcy protection on November 12, 2010, and for which we have completely written off our investment and are not responsible for any further liabilities.
California accounted for 12.8% of our mortgage insurance segment’s direct primary new insurance written for the year ended December 31, 2010, compared to 16.9% and 17.3% for the years ended December 31, 2009 and 2008, respectively. At December 31, 2010, California accounted for 11.4% of our mortgage insurance segment’s primary risk in force, compared to 11.6% at December 31, 2009. California also accounted for 10.9% of our mortgage insurance segment’s pool risk in force at December 31, 2010, compared to 11.6% at December 31, 2009. As of December 31, 2010, California is the only state which accounted for more than 10% of our mortgage insurance business measured by primary risk in force.
The largest single mortgage insurance customer (including branches and affiliates), measured by primary new insurance written, accounted for 15.5% of new insurance written during 2010, compared to 16.1% and 26.4% in 2009 and 2008, respectively. In 2010, we received premium revenue from two of our mortgage insurance customers, each of which exceeded 10% of our consolidated revenues.
The components of the (losses) gains included in the change in fair value of derivative instruments are as follows:
The valuation of derivative instruments may result in significant volatility from period to period in gains and losses as reported on our consolidated statements of operations. Generally, these gains and losses result from changes in corporate credit or asset-backed spreads and changes in the creditworthiness of underlying corporate entities or the credit performance of the assets underlying asset-backed securities (“ABS”). Any incurred gains or losses on our financial guaranty contracts that are accounted for as derivatives are recognized as a change in fair value of derivative instruments. When determining the fair value of our liabilities, we are required to incorporate into the fair value an adjustment that reflects our own non-performance risk. See Note 5 for information on our fair value of financial instruments. Changes in our fair value estimates may also result in significant volatility in our financial position or results of operations for future periods.
(1) NIMS derivative assets relate to consolidated NIMS VIEs and do not represent additional par exposure.
U.S. government and agency securities-The fair value of U.S. government and agency securities is estimated using observed market transactions, including broker-dealer quotes and actual trade activity as a basis for valuation. U.S. government and agency securities are categorized either in Level I or in Level II of the fair value hierarchy.
Corporate bonds and notes-The fair value of corporate bonds and notes is estimated using recent transaction activity, including market and market-like observations. Spread models are used that incorporate issuer and structure characteristics, such as credit risk and early redemption features, where applicable. These securities are generally categorized in Level II of the fair value hierarchy or in Level III when market-based transaction activity is unavailable.
Residential mortgage-backed securities (“RMBS”)-The fair value of RMBS is estimated based on prices of comparable securities and spreads, and observable prepayment speeds. These securities are generally categorized in Level II of the fair value hierarchy or in Level III when market-based transaction activity is unavailable. The fair value of the Level III securities is generally estimated by discounting estimated future cash flows.
Foreign government securities-The fair value of foreign government securities is estimated using observed market yields used to create a maturity curve and observed credit spreads from market makers and broker dealers. These securities are categorized in Level II of the fair value hierarchy.
The following table quantifies the impact of our non-performance risk on our derivative assets, derivative liabilities (in aggregate by type, excluding assumed financial guaranty derivatives) and VIE liabilities presented in our consolidated balance sheets. The five-year CDS spread is presented as an illustration of the market’s view of our non-performance risk; the CDS spread actually used in the valuation of specific fair value liabilities is typically based on the remaining term of the instrument.
(1) Includes the net liability recorded within derivative assets and derivative liabilities, and the net liability recorded within VIE debt and other financial statement line items for consolidated VIEs. Effective January 1, 2010, any transaction previously reported as a derivative liability that has been consolidated is reported as VIE debt.
(2) Includes NIMS VIE debt in 2010, NIMS derivative assets in 2010 and 2009, and mortgage insurance CDS in 2009.
Our derivative liabilities valuation methodology incorporates our own non-performance risk by including our observable CDS spread as an input into the determination of the fair value of our derivative liabilities. Considerable judgment is required to interpret market data to develop the estimates of fair value. Accordingly, the estimates may not be indicative of amounts we could realize in a current market exchange. The use of different market assumptions or estimation methodologies may have a significant effect on the estimated fair value amounts.
The fair value of our put options on CPS and the CPS VIE debt, in the absence of observable market data, is estimated based on the present value of the spread differential between the current market rate of issuing a perpetual preferred security and the maximum contractual rate of our perpetual preferred security as specified in our put option agreements. In determining the current market rate, consideration is given to any relevant market observations that are available. Subsequent to our tender and purchase of the majority of the securities of two of the three trusts to which our put options relate, we consolidated the assets and liabilities of those two trusts effective January 1, 2010. We purchased substantially all of the securities issued by the remaining trust, and we consolidated the assets and liabilities of that trust during 2010. As of December 31, 2010, there is no consolidated CPS VIE debt because we own approximately 100% of all three trusts and, as such, the put options on CPS are eliminated in consolidation as well.
first, we define a tranche on the CDX index (defined below) that equates to the risk profile of our specific transaction (we refer to this tranche as an “equivalent-risk tranche”);
For each referenced corporate entity in our corporate CDO transactions, the CDS spreads associated with the term of our transactions (“credit curve”) define the estimated expected loss for each entity (as applied in a market standard approach known as “risk-neutral” modeling). The credit curves on individual referenced entities are generally observable. The expected cumulative loss for the portfolio of referenced entities associated with each of our transactions is the sum of the expected losses of these individual referenced entities. With respect to the correlation of losses across the underlying reference entities, two obligors belonging to the same industry or located in the same geographical region are assumed to have a higher probability of defaulting together (i.e., they are more correlated). An increase in the correlations between the referenced entities generally causes a higher expected loss for the portfolio associated with our transactions. The estimated correlation factors that we use are derived internally based on observable third-party inputs that are based on historical data. The impact of our correlation assumptions currently does not have a material effect on our fair premium estimates in light of the significant impact of our non-performance risk adjustment as described below.
The amount of the non-performance risk adjustment is computed based, in part, on the expected claim payment by Radian. To estimate this expected payment, we first determine the expected claim payment of a typical market participant by using a risk-neutral modeling approach. A significant underlying assumption of the “risk-neutral” model approach that we use is that the typical fair premium amount is equal to the present value of expected claim payments from a typical market participant. Expected claim payments on a transaction are based on the expected loss on that transaction (also determined using the “risk-neutral modeling” approach). Radian’s expected claim payment is calculated based on the correlation between the default probability of the transaction and our default probability. The default probability of Radian is determined from the observed Radian Group CDS spread, and the default probability of the transaction is determined as described above under “Defining the Equivalent-Risk Tranche.” The present value of Radian’s expected claim payments is discounted using a risk-free interest rate, as the expected claim payments have already been risk-adjusted.
Our non-corporate CDO transactions include our guaranty of TruPs CDOs, CDOs of ABS, CDOs of CMBS, and CDOs backed by other asset classes such as (i) municipal securities, (ii) synthetic financial guarantees of ABS, and (iii) project finance transactions. The fair value of our non-corporate CDOs and other derivative transactions is calculated as the difference between the present value of the expected future contractual premiums and our estimate of the fair premium amount for these transactions. The present value of expected future contractual premiums is determined based on the methodology described above for corporate CDOs. For our credit card transactions, the fair premium amount is estimated using observed spreads on recent trades of securities that are similar to the securities that we guaranty. In all other instances, we utilize internal models to estimate the fair premium amount as described below. These credit derivatives are categorized in Level III of the fair value hierarchy.
TruPs CDOs-Our TruPs transactions are CDS on CDOs where the collateral consists primarily of deeply subordinated securities issued by banks, insurance companies, real estate investment trusts and other financial institutions whose individual spreads are not observable. In each case, we provide credit protection on a specific tranche of each CDO. We use a discounted cash flow valuation approach to determine fair value for these transactions that captures the credit characteristics of each transaction. We estimate projected claims based on our internal credit analysis, which is based on the current performance of each underlying reference obligation. The present value of the expected cash flows to the TruPs transaction is then determined using a discount rate derived from the observed market pricing for a TruPs transaction with similar characteristics. The present value of the insured cash flows is determined using a discount rate that is equal to our CDS rate plus a risk-free rate.
For one CDO of ABS transaction, the credit quality of the underlying referenced obligations was reasonably similar to that which was included in the AAA-rated ABX.HE index, a standardized list of RMBS reference obligations. Accordingly, the fair premium amount for a typical market participant for this transaction was derived directly from the observed spreads of this index. This transaction matured during 2010.
CDOs of CMBS-The fair premium amounts for our CDOs of CMBS transactions for a typical market participant are derived first by observing the spreads of the CMBX indices that match the underlying reference obligations of our transactions. A mezzanine tranche, which represents our insured tranche, is then priced through a standard CDO model. The CMBX indices represent standardized lists of CMBS reference obligations. A different CMBX index exists for different types of underlying referenced obligations based on vintages and credit rating. For each of our CDOs of CMBS transactions, we use the CMBX index that most directly correlates to our transaction with respect to vintage and credit rating. Because the observable CMBS indices do not have a similar mezzanine tranche, we use an internal CDO pricing model in order to adjust fair value for this structural feature. A standard CDO pricing model was calibrated to establish the market pricing at inception. This CDO pricing model is then applied to the current valuation period to derive the fair premium for the mezzanine tranche. The typical fair premium amount represents the estimated fair value of the expected future fair premiums determined by using a discount rate equal to the CDS spread of a typical market participant plus a risk-free rate.
For each of the non-corporate CDOs and other derivative transactions discussed above, with the exception of CDOs of ABS and TruPs transactions that are valued using a discounted cash flow analysis, we make an adjustment to the fair premium amounts as described above under Non-Performance Risk Adjustments on Corporate CDOs to incorporate our own non-performance risk. The non-performance risk adjustment associated with our CDOs of ABS and our TruPs transactions is incorporated in the fair value as described above; therefore, no separate adjustment is required. These credit derivatives are categorized in Level III of the fair value hierarchy.
Upon the adoption of the accounting standard update regarding improvements to financial reporting by enterprises involving VIEs, we determined that we are the primary beneficiary for two VIEs in addition to our CDO of ABS transaction as of January 1, 2010, for which we have provided financial guarantees. Upon consolidation, we elected the fair value option for all financial assets and financial liabilities held by these two VIEs, which primarily consist of manufactured housing loans and VIE debt to note holders in the trust. The fair value election allows us to offset the changes in fair value of the assets and liabilities of the trust, providing a better representation of our net exposure to the VIEs. See Note 6 for further discussion of the primary beneficiary analysis and the related financial impacts to our financial position, financial performance and cash flows.
determined by using a discount rate that is equal to our CDS rate plus a risk-free rate. We utilize this model to determine the fair value of our exposure to these VIEs, and to derive the fair value of the assets in these VIEs, which are reported within other assets on our consolidated balance sheets.
(1) Comprised of broadly diversified domestic equity mutual funds included within Level I and various preferred and common stocks invested across numerous companies and industries included within Level II and III.
(2) Comprised of short-term commercial paper within CPS trusts included within Level II and lottery annuities ($2.6 million) and TruPs held by consolidated VIEs ($2.0 million) included within Level III.
(3) Does not include fixed-maturities held to maturity ($10.8 million), short-term investments ($1.6 million), primarily invested in CDs and time deposits, and other invested assets ($59.6 million), primarily invested in limited partnerships, accounted for as cost-method investments and not measured at fair value.
(4) Comprised of manufactured housing loan collateral related to two consolidated financial guaranty VIEs.
(5) Comprised of consolidated debt related to NIMS VIEs ($141.0 million) and amounts related to financial guaranty VIEs ($379.1 million) that required consolidation as of January 1, 2010, under the accounting standard update regarding improvements to financial reporting by enterprises involving VIEs.
(1) Represents the impact of our adoption of the accounting standard update regarding improvements to financial reporting by enterprises involving VIEs.
(2) Includes unrealized gains (losses) relating to assets and liabilities still held as of December 31, 2010 as follows: $33.1 million for investments, ($0.9) million for NIMS derivative assets, $4.0 million for other assets, ($588.1) million for derivative liabilities, and ($30.0) million for VIE debt.
(3) Transfers are recognized at the end of the period as the availability of market observed inputs change from period to period.
(1) Includes unrealized gains (losses) relating to assets and liabilities still held as of December 31, 2009 as follows: ($0.1) million for investments, $3.2 million for NIMS derivative assets, ($17.5) million for CPS derivative assets, $162.0 million for derivative liabilities and ($83.1) million for VIE debt.
This fair value estimate of non-derivative financial guarantees includes direct and assumed contracts written, and is based on the difference between the present value of: (1) the expected future contractual premiums, and (2) the fair premium amount to provide the same credit protection assuming a transfer of our obligation to a guarantor of similar credit quality as Radian as of the measurement date.
The key variables considered in estimating fair value include par amounts outstanding (including future periods for the estimation of future installment premiums), expected term, unearned premiums, expected losses and our CDS spread. Estimates of future installment premiums received are based on contractual premium rates.
Our ability to accurately estimate the fair value of our non-derivative financial guarantees is limited. There are no observable market data points as a result of the disruption in the credit markets and significant rating agency downgrades. These factors have significantly limited our ability to write new financial guaranty business, except in limited circumstances. We believe that in the absence of a principal market, our estimate of fair value described above in a hypothetical market provides the most relevant information with respect to fair value estimates given the information currently available to us. Due to the volume and geographic diversification of our financial guaranty exposures, in the future we may need to consider other key variables that may influence the fair value estimates. Variables not currently incorporated into our current fair value estimate of non-derivative financial guarantees include the credit spreads of the underlying insured obligations, the underlying ratings of those insured obligations and assumptions about current financial guaranty premium levels relative to the underlying insured obligations’ credit spreads.
We consolidate all of the assets and liabilities associated with NIMS VIEs, due to contractual provisions that allow us to purchase assets of the VIEs and thus direct the activities that most significantly impact the economic performance of each VIE. For this reason, we have concluded that we have the power to most significantly impact the economic performance of these VIEs. As the guarantor of either all or a significant portion of the debt issued by each NIMS VIE, we have the obligation to absorb losses that are significant to the VIEs. As a result, we have concluded that we are the primary beneficiary of these VIEs. The consolidated NIMS assets are accounted for as derivatives and represent assets to be used to settle the obligation of the VIEs. We elected the fair value option as it relates to the NIMS VIE debt, and therefore, the consolidated NIMS VIE debt is recorded at fair value. Our VIE debt includes amounts for which third parties do not have recourse to us.
In September 2003, Radian Asset Assurance entered into a contingent capital transaction pursuant to which three custodial trusts issued an aggregate of $150 million in CPS ($50 million by each custodial trust) to various holders. Commencing in the fourth quarter of 2009 and continuing into 2010, Radian Group and its subsidiaries have purchased by tender offer and privately negotiated transactions substantially all of the face amount of the CPS issued by the custodial trusts at a weighted average purchase price equal to approximately 55% of the face amount of such CPS. Our total net cash outflow related to CPS during 2010 was $83.4 million, primarily as a result of the 2010 purchases. Our involvement with these VIEs also includes the payment of a put premium to third party investors representing the spread between the assets of the trust and the auction rate notes.
We consolidate the assets and liabilities associated with one CDO of ABS transaction. Due to contractual provisions that allow us to direct the collateral manager to sell the underlying assets of the transaction, we concluded that this provision gives us the power to direct the activities that most significantly impact the economic performance of this VIE. In addition, as the guarantor of certain classes of debt issued by this VIE, we have the obligation to absorb losses that are significant to this VIE. The consolidated CDO of ABS VIE assets are accounted for as trading securities and measured at fair value and represent assets to be used to settle the obligation of this VIE. We also elected the fair value option as it relates to the VIE debt, and as such, the consolidated VIE debt is recorded at fair value. While the assets of this VIE may only be used to settle the obligations of the trust, due to our guarantee, the creditors have recourse to our general credit for this consolidated VIE debt. At January 1, 2010, the net fair value of the assets and liabilities of this VIE was equal to
the fair value of the derivative liability prior to consolidation; as such, no transition adjustment was necessary. During 2010, our net cash inflow was $0.3 million related to our involvement with this VIE.
The following is a summary of the financial impact on our consolidated balance sheets, our consolidated statements of operations and our consolidated statements of cash flows as of and for the year ended December 31, 2009, as it relates to consolidated and unconsolidated entities in which we have a significant variable interest:
(1) The amount included in derivative assets related to the consolidation of NIMS trusts was $11.0 million. All of the VIE debt relates to the consolidation of NIMS trusts.
We provided credit enhancement in the form of CDS for foreign mortgage collateral, and had two international CDS transactions involving a VIE in which we had a significant interest that were terminated in 2009 and 2010.
Our held to maturity and available for sale investment portfolio consisted of the following at December 31, 2010 and 2009:
(1) Comprised of broadly diversified domestic equity mutual funds ($168.4 million fair value) and various preferred and common stocks invested across numerous companies and industries ($16.0 million fair value).
Net realized and unrealized gains (losses) on investments included within net (losses) gains on other financial instruments consisted of:
(1) Included within Net gains (losses) on other financial instruments, which also includes gains (losses) on VIE activity (See Note 6) and long-term debt (See Note 13).
We periodically dispose of available for sale securities at a loss. Generally, such losses are insignificant in amount or in relation to the cost basis of the investment, and are usually as a result of a change in our intent to sell from prior periods based on current conditions or our strategic objectives. During 2010, we sold a significant portion of our fixed-maturities held in our available for sale portfolio in the third quarter, primarily in one large negotiated transaction, in response to favorable market conditions and in connection with the strategic repositioning of our investment portfolio from tax-advantaged securities to securities that provide taxable investment income and to improve our statutory capital position. Although substantially all of the securities sold at a loss in 2010 had been in a continuous unrealized loss position for greater than 12 months, a significant portion of the securities sold had increases in market value since December 31, 2009, and the majority of the securities included in that large transaction were sold at a gain.
At December 31, 2010 and 2009, we did not have the intent to sell any debt securities in an unrealized loss position, and determined that it is more likely than not that we will not be required to sell the securities before recovery of their cost basis.
The majority of the unrealized losses of 12 months or greater duration as of December 31, 2010, relates to interests in securitizations pursuant to the Master Settlement Agreement (“MSA”) between the domestic tobacco manufacturers and the 46 states and certain territories party thereto. In December 2010, after a review of tobacco settlement bonds, including bonds we own, Moody’s Investor Service (“Moody’s”) took certain ratings actions on the tobacco settlement bonds, including placing 67 classes in 19 transactions under review for possible downgrade due primarily to a decline in the most recent annual MSA payment to the trusts. Based on our review of stressed cash flow scenarios and despite the decline in cash flows to the trusts, we do not believe it is more likely than not that we will be required to sell these investments before recovery of our amortized cost basis, nor did we intend to sell these investments as of December 31, 2010. We are monitoring the Moody’s review closely and will update our OTTI analysis each period as new information develops that might cause us to change our assessment of projected cash flows or our intent to sell.
The unrealized losses of 12 months or greater duration as of December 31, 2010 on the securities in this category were caused by credit spread widening in the sector. Corporate spreads have tightened significantly over the past 12 months, although they are still wide compared to pre-2008 levels. As of December 31, 2010, we expect to be able to collect cash flows from each of these securities to sufficiently recover the amortized cost basis of these securities. As of December 31, 2010, we did not intend to sell these investments, nor did we believe that it was more likely than not that we will be required to sell these investments before recovery of our amortized cost basis, which may be maturity; therefore, we did not consider these investments to be other-than-temporarily impaired at December 31, 2010.
Securities on deposit with various state insurance commissioners amounted to $17.0 million at December 31, 2010 and $16.9 million at December 31, 2009. We also had $140.0 million and $144.1 million (book value) of securities pledged as collateral in accordance with various reinsurance agreements at December 31, 2010 and 2009, respectively.
(1) This amount includes a $185.6 million reduction related to the commutation of $9.8 billion in net par outstanding.
All of our existing captive reinsurance arrangements are operating on a run-off basis, meaning that no new business is being placed in these captives. In 2010, we terminated the majority of our remaining captive reinsurance arrangements on a “cut-off” basis, meaning that the terminated captive arrangements were dissolved and all outstanding liabilities to us were settled.
In the fourth quarter of 2010, we terminated two large captive reinsurance arrangements representing $6.0 billion of risk in force. In connection with these terminations, we received $321 million of cash and investments from the captive trust account, which are accounted for as claims recoveries. Since inception, we have received total cash reinsurance recoveries (including recoveries from terminations) from Smart Home and captive reinsurance arrangements of approximately $673.2 million. In some instances, we anticipate that the ultimate recoveries from the captive reinsurers will be greater than the assets currently held by the segregated trusts established for each captive reinsurer. Recorded recoverables, however, are limited to the current trust balances. We are approaching the maximum amount that we expect to record as recoverables under our Smart Home and captive reinsurance arrangements; therefore, we expect a limited amount of incremental recoverable to be booked from these arrangements in future periods. We expect that most of the actual cash recoveries from those captives that have not yet been terminated will be received over the next few years.
The reinsurance recoverable amounts on paid losses are considered to be financing receivables in accordance with the accounting standard regarding accounts receivable, which includes disclosure requirements regarding the credit quality of financing receivables and the allowance for credit losses. We do not record an allowance for credit losses on reinsurance recoverables, as the reinsurance recoverable amounts for both paid and unpaid losses are fully collateralized in the segregated trusts. Therefore, credit exposure is limited to the credit quality of investments held by the trust. Trust assets related to our captive and Smart Home arrangements are required to be invested in investment-grade securities. As of December 31, 2010, trust accounts consist primarily of cash equivalents, money market investments and investment-grade securities.
Approximately 32% of our total ceded losses recoverable at December 31, 2010 was related to two captive reinsurers.
The following tables present information relating to our mortgage insurance reserves and LAE:
Overall, our default to claim rate assumption was 40% at December 31, 2010, compared to 36% at December 31, 2009 and 46% at December 31, 2008.
time the reserves were established. To a lesser extent, the increase in our default to claim rate in 2010 was also impacted by a decrease in our expected levels of insurance rescissions and claim denials associated with prior year defaults, as compared to expected levels at December 31, 2009. This change in our estimate was a result of changes in observed trends during 2010. In addition, an increase in our severity estimates, primarily due to refinements in estimates on pool insurance defaults, negatively impacted our reserves related to defaults reported in prior years.
(3) Includes a small number of submitted claims that were subsequently withdrawn by the insured.
Our reported rescission and denial activity in any given period is subject to future challenges by our lender customers. Our IBNR reserve estimate, including defaults related to previously rescinded policies and denied claims that are expected to be reinstated or resubmitted, was $39.5 million and $13.6 million at December 31, 2010 and 2009, respectively. The increase in this estimate primarily reflects an increase in both recent trends and in claim denial activity in 2010, as we expect a portion of such denied claims to be resubmitted with the required documentation and ultimately paid. All estimates are continually reviewed and adjustments are made as they become necessary.
We also accrue for the premiums we expect to refund to our lender customers under the terms of our master policy as a result of our estimated insurance rescission activity. Our accrued liability for such refunds included within accounts payable and accrued expenses on our consolidated balance sheets was $43.5 million and $50.2 million as of December 31, 2010 and 2009, respectively.
(1) Rescission rates represent the ratio of claims rescinded or denied to claims received (by claim count) and represent (as of December 31, 2010) the cumulative rate for each quarter based on number of claims
received during that quarter. Until all of the claims received during the periods shown have been resolved, the rescission rates for each quarter will be subject to change. These rates are also subject to change based on reinstatements of previously rescinded policies of denied claims.
(2) For each quarter presented in the table above, represents the number of claims that have been internally resolved as a percentage of the total number of claims received for that specific quarter. A claim is considered internally resolved when it is either paid or it is concluded that the claim should be denied or rescinded. For the third and fourth quarters of 2010, a significant portion of claims received for those quarters have not been internally resolved; therefore, we do not believe the cumulative rescission rates for those periods are presently meaningful.
We considered the sensitivity of first-lien loss reserve estimates at December 31, 2010 by assessing the potential changes resulting from a parallel shift in severity and default to claim rate. For example, assuming all other factors remain constant, for every one percentage point change in primary claim severity (which we estimate to be 27% of unpaid principal balance at December 31, 2010), we estimated that our loss reserves would change by approximately $104 million at December 31, 2010. For every one percentage point change in pool claim severity (which we estimate to be 48% of unpaid principal balance at December 31, 2010), we estimated that our loss reserves would change by approximately $10 million at December 31, 2010. For every one percentage point change in our overall default to claim rate (which we estimate to be 40% at December 31, 2010, including our assumptions related to rescissions and denials), we estimated an $82 million change in our loss reserves at December 31, 2010.
default rates have declined in comparison to 2009, but still continue to be relatively high, which we believe are largely attributable to the difficult operating environment facing the domestic auto industry. We expect that this trend may continue.
(1) During 2010, our incurred losses and LAE in our financial guaranty insurance business for prior years increased, mainly related to greater expected losses in our structured finance direct line of business. Favorable loss developments in 2009 and 2008 across our trade credit reinsurance, structured finance direct and public finance reinsurance lines of business, resulted in declines in the prior years’ incurred losses and LAE.
Our public finance and structured finance groups utilize several tools to monitor our directly insured portfolio. We generally require for each of our directly insured transactions the delivery of periodic financial information, including covenant compliance reports that are reviewed by the risk manager assigned to the particular credit. For substantially all of our direct public finance credits, each risk manager prepares regular written surveillance summaries for each credit which contain financial analysis of the credits. For our larger direct credits and for those credits for which our initial analysis indicates that a more comprehensive review is warranted, the risk manager prepares a more detailed surveillance report which includes additional financial analysis, together with the manager’s reassessment of the internal rating for the transaction. For our directly insured corporate CDO, TruPs CDO and CMBS CDO transactions, we perform quarterly stress analyses and we update our financial analysis on our TruPs CDO and CMBS CDO transactions at least quarterly. We monitor not only the nominal exposure for each obligor for which we provide protection in our corporate CDO transactions, but also risk-adjusted measures, taking into account, among other factors, our assessment of the relative risk that would be represented by direct exposure to the particular obligor and the remaining subordination in the transactions in which we are exposed to a particular obligor.
The risk analytics team is responsible for the analysis of market risk factors and their impact on economic capital. Key market risk factors, including interest-rate risk and credit spreads, are assessed on an individual credit and insured portfolio basis. The risk analytics team has developed quantitative tools and models to measure these risks which incorporate the risk assessments and internal ratings assigned by each of the teams within risk management. We use an internal economic capital methodology to attribute economic capital to each individual credit exposure within our insured portfolio. This methodology relies heavily on our ability to quantify the individual risks of default and prepayment underlying each transaction in our insured portfolio. Economic capital is also the basis for calculating risk-adjusted returns on our capital (“RAROC”), which allows us to establish criteria for weighing the credit risk relative to the premium received.
Our risk management department reviews both performing and under-performing transactions. Performing credits generally have investment-grade internal ratings, denoting nominal to moderate credit risk. However, claim liabilities may be established for performing credits if the expected losses on the credit exceed the unearned premium revenues for the obligation based on the present value of the expected net cash outflows. If our risk management department concludes that a directly insured transaction is underperforming, it is placed in one of three designated categories for deteriorating credits: Special Mention, Intensified Surveillance or Case Reserve. Assumed exposures in our reinsurance portfolio are generally placed in one of these categories if the ceding company for such transaction downgrades it to an equivalent watch list classification. However, should our financial guaranty risk management group disagree with the risk rating assigned by the ceding company, we may assign our own risk rating rather than using the risk rating assigned by the ceding company.
The following is additional information regarding financial guaranty’s categories for deteriorating credits:
the current and projected performance of the underlying obligation (both on an expected case basis and stressed for more adverse performance and/or market circumstances than we expect);
Claim liabilities may be established for performing credits if the expected losses on the credit exceed the unearned premium revenue for the contract based on the present value of the expected net cash outflows. Included in accounts and notes receivable and unearned premiums on our consolidated balance sheets are the present value of premiums receivable and unearned premiums that are received on an installment basis. The premiums receivable is net of commissions on assumed reinsurance business. The unearned premium and the present value of the premiums receivable as of December 31, 2010 and 2009 are as follows (in millions):
The weighted-average risk-free rate used to discount the premiums receivable and premiums to be collected was 2.5% at December 31, 2010.
The following table shows the nominal (non-discounted) premiums net of commissions that are expected to be collected on financial guaranty contracts with installment premiums included in premiums receivable as of December 31, 2010 (in millions):
The following table shows the rollforward of the net present value of premiums receivable as of December 31, 2010 and 2009 (in millions):
Premiums earned were affected by the following for the years ended December 31, 2010 and 2009 (in millions):
The following table shows the significant components of the change in our financial guaranty claim liability for the years ended December 31, 2010 and 2009 (in millions):
Upon a conversion, we will pay cash up to the aggregate principal amount of the notes to be converted and pay or deliver, as the case may be, cash, shares of our common stock or a combination of cash and shares of our common stock, at our election, in respect of the remainder, if any, of our conversion obligation that is in excess of the aggregate principal amount of the notes being converted. The conversion rate will initially be 85.5688 shares of our common stock per $1,000 principal amount of notes (corresponding to an initial conversion price of approximately $11.69 per share of common stock). The conversion rate will be subject to adjustment in certain events, but will not be adjusted for any accrued and unpaid interest, if any. In addition, following certain corporate events, we will increase the conversion rate for a holder who elects to convert its notes in connection with that corporate event in certain circumstances.
Issuance and transaction costs incurred at the time of the issuance of the convertible notes are 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:
(2) Included within additional paid-in capital, net of capped call transactions and related issuance costs.
The premium paid for the capped call transactions is 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.
As of December 31, 2010, we recorded a net current income tax payable of approximately $80.6 million, which primarily consists of liabilities related to applying the standards of accounting for uncertainty in income taxes and a current federal income tax recoverable of approximately $8.7 million. For federal income tax purposes, we have approximately $2,109 million of NOL carryforwards and $26.7 million of foreign tax credit carryforwards as of December 31, 2010. To the extent not utilized, the NOL carryforwards will expire during tax years 2028 through 2030 and the foreign tax credits will expire during tax years 2018 through 2020. Certain entities within our consolidated group have also generated approximately $323.6 million of state and local NOL carryforwards, which if unutilized, will expire during various future tax periods.
As of December 31, 2010, before consideration of our valuation allowance, we had deferred tax assets (“DTA”), net of deferred tax liabilities, of approximately $879.4 million. We are required to establish a valuation allowance against our DTA when it is more likely than not that all or some portion of our DTA will not be realized. At each balance sheet date, we assess our need for a valuation allowance and this assessment is based on the relative impact of all available evidence, both positive and negative, and requires management to exercise judgment and make assumptions regarding the weight given to the potential effect of such negative and positive evidence. Future realization of our DTA will ultimately depend on the existence of sufficient taxable income of the appropriate character (ordinary income versus capital gains) within the applicable carryback and carryforward periods provided under the tax law. The primary sources of negative evidence that we considered are our cumulative losses in recent years, and the increased uncertainty around our future operating results. We also considered several sources of positive evidence when assessing the need for a valuation allowance such as future reversals of existing taxable temporary differences, future projections of taxable income, taxable income within the applicable carryback periods, and any potential tax planning strategies. In making our assessment of the more likely than not standard, the weight assigned to the effect of both negative and positive evidence is commensurate with the extent to which it can be objectively verified.
For the quarter ended September 30, 2010, we determined that it was more likely than not that all of our DTA, except for approximately $10.4 million, would be realized. This determination was made after weighing both negative and positive evidence including the pre-tax profit realized for the quarter ended September 30, 2010. For the quarter ended December 31, 2010, we incurred a pre-tax loss, which was significantly higher than our projected loss. As a result of this loss, which solidified our cumulative position, coupled with expectations of an operating loss in 2011 and ongoing economic uncertainty, we concluded that our ability to rely on our projections for future taxable income, and the positive weight afforded those projections, had been severely diminished. In light of these factors, we concluded that as of December 31, 2010, an additional valuation allowance of $841.5 million was required, for a total valuation allowance of approximately $851.9 million against our total net DTA of $879.4 million. The remaining DTA of approximately $27.5 million represents our NOL carryback, which we expect to utilize in the coming months as a result of our anticipated settlement with the Internal Revenue Service (“IRS”) relating to tax years 2000 through 2007 as described in more detail below.
Our ability to fully use these tax assets such as NOLs and tax credit carryforwards would be substantially limited if we experience an “ownership change” within the meaning of Section 382 of the Internal Revenue Code (“IRC”) of 1986, as amended. Section 382 rules governing when a change in ownership occurs are complex and subject to interpretation; however, in general, an ownership change would occur if our five percent shareholders, as defined under Section 382, collectively increase their ownership by more than 50 percentage points over a rolling three-year period. As of December 31, 2010, we have not experienced an ownership change under Section 382. However, if we were to experience a change in ownership under Section 382 in a future period, then we may be limited in our ability to fully utilize our NOL and tax credit carryforwards in future periods.
On October 8, 2009, our board of directors adopted a Tax Benefit Preservation Plan, which, as amended, was approved by our stockholders at the 2010 annual meeting. We also adopted certain amendments to our amended and restated bylaws and our stockholders approved at the 2010 annual meeting certain amendments to our amended and restated certificate of incorporation. The plan, the bylaw amendment and the charter amendment were implemented in order to protect our ability to utilize our NOLs and other tax assets and prevent
Amerin Guaranty is required to maintain statutory-basis capital and surplus of $1.125 million. Radian Group and Amerin Guaranty are parties to a guaranty agreement. This agreement provides that Radian Group will make sufficient funds available to Amerin Guaranty to ensure that Amerin Guaranty has a minimum of $5 million of statutory surplus every calendar quarter. Amerin Guaranty’s statutory net income (loss) and statutory policyholders’ surplus as of and for the years ended December 31 was as follows:
Under Texas insurance regulations, to be an authorized reinsurer, CMAC of Texas is required to maintain a minimum statutory surplus of $20 million. CMAC of Texas’s statutory net loss and statutory policyholders’ surplus as of and for the years ended December 31 were as follows:
CMAC of Texas incurred a significant loss in the first half of 2010, in part due to the increase in severity estimates for our pool insurance loss reserves during that period. As a result, CMAC of Texas required capital contributions totaling approximately $113 million during the first half of 2010, in order to maintain a minimum statutory capital level. Radian Group contributed approximately $101 million to CMAC of Texas during 2010 to support its capital position and the remaining amounts required by CMAC of Texas were contributed by Radian Guaranty. In January 2009, Enhance Financial Services Group, Inc. (“EFSG”) contributed $25 million to CMAC of Texas.
Radian Mortgage Insurance’s ability to declare dividends on its common stock is restricted by certain provisions of the insurance laws of the state of Arizona, its state of domicile. The insurance laws of the state of Arizona limit the maximum amount of dividends that may be paid from positive unassigned surplus by an insurer without prior approval by the Arizona Insurance Department. Under such test, Radian Mortgage Insurance may pay dividends during any 12-month period in an amount equal to the lessor of (i) 10% of the preceding year-end statutory policyholders’ unassigned surplus, or (ii) the preceding year-end statutory net investment income. In accordance with these restrictions, no dividends may be paid in 2011, since the company has negative statutory policyholders’ unassigned surplus at December 31, 2010.
Radian Mortgage Insurance’s statutory net loss, statutory policyholders’ surplus and contingency reserve as of and for the years ended December 31 were as follows:
New York insurance law establishes single risk limits applicable to all obligations issued by a single entity and backed by a single revenue source. Under the limit applicable to municipal bonds, the insured average annual debt service for a single risk, net of reinsurance and collateral, may not exceed 10% of the sum of the insurer’s policyholders’ surplus and contingency reserves. In addition, insured principal of municipal bonds attributable to
The 2008 Equity Plan authorizes the issuance of up to 3,267,000 shares of our common stock, of which there were 1,026,356 shares remaining available for grant as of December 31, 2010 (the “share reserve”). Awards under the 2008 Equity Plan that provide for settlement solely in cash (and not common shares) do not count against the share reserve. In 2010, performance-based RSUs were awarded, which vest in an amount ranging from 0% to 150% of the target award, depending upon the satisfaction of performance criteria at the end of the three-year performance period. For purposes of the share reserve, the performance based RSUs (equity settled) are considered to have been awarded at 150% of target. Each grant of restricted stock, RSUs, phantom stock or performance share awards under the 2008 Equity Plan (other than those settled in cash) reduces the reserve available for grant under the 2008 Equity Plan by 1.14 shares for every share subject to such grant ( 1.33 shares for grants made prior to May 13, 2009). Absent this reserve adjustment for restricted stock, RSUs, phantom stock or performance share awards, our shares remaining available for grant under the 2008 Equity Plan would have been 1,310,920 shares as of December 31, 2010.
We used the Monte Carlo valuation model to determine the fair value of the Officer LTI awards awarded in 2008. The Monte Carlo valuation model incorporates multiple input variables, including expected life, volatility, risk-free rate of return and dividend yield of each award. In using these assumptions in the Monte Carlo valuation model, we consider historical and observable market data. The output of the Monte-Carlo valuation model at each measurement period is the projected stock price at the end of the performance period. Based on the projected stock price, a percentage is then applied to the midpoint of its respective payout range and the total expected payout amount that should be applied to the target amount is calculated. The compensation cost recognized is based on the fair value estimate as of each measurement.
Performance Based RSUs-In 2010, the Compensation Committee granted a total of 162,500 performance based RSUs (to be settled in cash). The estimated fair value of RSUs is determined using the Monte Carlo valuation model. These performance-based RSUs entitle grantees to a cash amount equal to the fair market value
of the RSUs that have vested, up to 150% of the target award, so long as the officer continues to be employed with Radian. Achievement of the awards is based on two factors, both equally weighted at 50% of total performance target: (1) the performance of Radian Group’s relative total shareholder return (“TSR”), compared to the TSR’s of an industry peer group, with a maximum payout of 100% of the peer target (i.e., 50% of the total performance target); and (2) the performance of Radian Group’s relative TSR compared to the TSR’s of companies included in the S&P 400 index, with a maximum payout of 150% of the index target (i.e., 50% of the total performance target). Upon the occurrence of certain corporate events involving one or more companies included in the industry peer group, the performance goals for the entire award (between 0% and 150% of the total target award) would then be based on Radian Group’s relative TSR compared to the TSR’s of companies included in the S&P 400 index. The performance-based RSUs vest in their entirety three years from the date of grant, or earlier upon a grantee’s retirement, death or disability, at which time the performance-based RSUs will vest at 100% of target. In addition, vesting also may be accelerated under certain circumstances, if the grantee has a separation from service following a change of control of Radian Group. If the grantee’s employment is terminated during any period in which the vesting restrictions apply, the performance-based RSUs awarded to such officer or executive will terminate as to all RSUs covered by the award, for which vesting restrictions have not lapsed and such award will be forfeited. Each RSU was granted at full value with no exercise price. The RSUs do not entitle the grantees to voting or dividend rights.
The Compensation Committee has granted phantom stock awards under the Equity Plans, which entitle grantees to receive shares of our common stock on a date (referred to in the Equity Plans as the conversion date) established by the Compensation Committee. The estimated fair value of phantom stock is based on our stock price at the date of grant. Unless otherwise provided in a grant letter, if a grantee’s relationship with us terminates during any period in which vesting restrictions apply, the phantom stock grant terminates as to all shares covered by the grant as to which vesting restrictions have not lapsed and such shares will be forfeited. Phantom shares granted to directors under the 1995 Equity Plan were fully vested upon grant with a conversion date upon the termination of the director’s relationship with us. Phantom shares were granted to directors in 2008 under the 2008 Equity Plan and vest three years from the date of grant (or earlier upon a director’s retirement, death or disability or upon a change of control of Radian Group) with a conversion date upon the termination of a director’s relationship with us. Each share of phantom stock is granted at full value with no exercise price. All phantom stock will be paid in whole shares of our common stock, with fractional shares paid in cash. At
The weighted average fair value per share of the stock options granted during 2010 was $8.70. No stock options were granted during 2009. The weighted average fair value per share of the stock options granted during 2008 was $1.28. There were no stock options exercised in 2008, 2009 or 2010. The total intrinsic value of options outstanding at December 31, 2010, 2009 and 2008 was $2.5 million, $2.2 million and $0.6 million, respectively.
The following table summarizes information concerning outstanding and exercisable options at December 31, 2010:
(1) In 2008, the expected life of stock options granted was equal to the full term of the options awarded. In 2010, the expected life of stock options granted was estimated to be less than the full term of the options awarded. The expected life is estimated using historical data.
(3) Volatility determined at the date of grant using historical share price volatility and expected life of each award.
the occurrence of a change of control of Radian Group for awards granted prior to May 13, 2009; or
A grantee may pay the option price in cash or, with the consent of the Compensation Committee, shares of our common stock, or by making other arrangements satisfactory to us.
The Compensation Committee has issued grants of restricted stock under the Equity Plans. The shares underlying a grant are issued in consideration for services rendered. The estimated fair value of restricted stock is based on our stock price at the date of grant. If a grantee’s relationship with us terminates while the shares are subject to restrictions, the restricted stock grant will terminate with respect to all shares that are subject to restrictions, and such shares must be immediately returned to us. While shares are subject to restrictions, a grantee may not sell, assign, transfer, pledge or otherwise dispose of the shares of our common stock, except to a successor grantee in the event of the grantee’s death. All restrictions imposed under a restricted stock grant lapse after the applicable restriction period, or earlier, upon a change of control of Radian Group for shares granted prior to May 13, 2009 (grants made on or after May 13, 2009 provide for “double trigger” vesting in the event of a change of control, meaning that restricted stock awards will vest in connection with a change of control only in the event the grantee’s employment is terminated by us without cause, or the grantee terminates employment for “good reason,” in each case within 90 days before or one year after the change of control) or upon a participant’s retirement, death or disability. Each share of restricted stock is granted at full value with no exercise price.
In using the Monte Carlo valuation model, the following assumptions were applied: (1) the RSUs will be held to maturity, consistent with historical exercise behavior, (2) there will be no event during the vesting period that would trigger accelerated vesting (i.e., change of control), and (3) estimates of the expected volatility of Radian Group and each of the companies in the peer group. Performance-based RSUs awarded in 2010 had a fair value of $12.03 per share as of the grant date, which is then recognized over the performance period.
Time-Vested RSUs-During 2010, the Compensation Committee granted a total of 13,000 time-vested RSUs to be settled in common stock. The grant date fair value of the 13,000 time-vested RSUs was calculated using the last price of our common stock on the New York Stock Exchange (“NYSE”) on the date of grant and is recognized over the three-year vesting period. If a grantee’s relationship with us terminates while the shares are subject to restrictions, the RSUs awarded will terminate with respect to all units that are subject to restrictions. All restrictions imposed under an award of RSUs lapse after the applicable restriction period, or earlier, upon a participant’s retirement, death or disability, or in the event the grantee’s employment is terminated by us without cause or the grantee terminates employment for “good reason”, in each case within 90 days before or one year after a change of control. The award of RSUs does not entitle grantees to voting or dividend rights.
The 2008 ESPP Plan and the 1997 ESPP Plan were designed to allow eligible employees to purchase shares of our common stock at a discount of 15% off the lower of the fair market value of our common stock at the beginning-of-period or end-of-period (each period being the first and second six calendar months in a calendar year).
The following are assumptions used in our calculation of ESPP compensation expense during 2010:
As of December 31, 2010, 2009 and 2008, unrecognized compensation expense related to the unvested portion of all of our stock-based awards was approximately $7.8 million, $6.9 million and $26.1 million, respectively. Absent a change of control under the Equity Plans, this cost is expected to be recognized over a weighted average period of approximately 2.6 years.
Executive LTI Plan-Similar to the Officer LTI Plan, the Executive LTI Plan is structured as a performance-based, long-term, discretionary cash plan that consists of grants of cash performance award opportunities. The Compensation Committee administers the Executive LTI Plan and is responsible for, among other things, establishing the target values of awards to participants and selecting the specific performance factors for such awards. At the end of the performance period, the Compensation Committee determines, in its sole discretion, the specific cash payout to each participant, which may range from a minimum of 0% of the target award to 400% of the target award, based on the Compensation Committee’s view of our overall corporate performance, the participant’s performance and the degree to which each of the performance measures has been satisfied. Compensation costs recognized related to non-share-based awards under the Executive LTI Plan was $3.1 million for the year ended December 31, 2010.
The Savings Plan covers substantially all our full-time and all our part-time employees. Participants can contribute up to 25% of their base earnings as pretax contributions up to a maximum amount of $16,500 for 2010. We will match at least 100% of the first 6% of base earnings contributed in any given year. Our expense for matching funds for the years ended December 31, 2010, 2009 and 2008 was $3.5 million, $3.8 million and $4.1 million, respectively.
We provided certain healthcare and life insurance benefits to our retired employees who were hired before January 1, 1990, under a postretirement welfare plan (the “Postretirement Welfare Plan”). Until its curtailment on August 31, 2002, EFSG had a plan that provided certain healthcare benefits for retired employees (the “EFSG Postretirement Medical Plan”). The expense for postretirement benefit plans for the years ended December 31, 2010, 2009 and 2008 was immaterial to our financial statements. We accrue the estimated cost of retiree medical and life benefits over the period during which employees render the service that qualifies them for benefits.
We have a voluntary deferred compensation plan for senior officers and a voluntary deferred compensation plan for our directors. The voluntary deferred compensation plans allow: (1) senior officers to defer receipt of all or a portion of their annual cash incentive award, and (2) directors to defer receipt of all or a portion of their cash compensation and/or the payment date of their equity compensation. Under the plans, a participant must make a binding written election before the year in which compensation is to be earned to defer compensation payouts for at least two full calendar years beyond the year in which such compensation would have been paid.
Participants’ accounts are distributed at the dates specified in their deferral election forms or, in certain cases, upon an earlier termination of employment or service. In addition, amounts deferred in 2004 or earlier may be withdrawn by the participant at any time, but only in an amount equal to the entire amount of such deferral, plus earnings and losses, and less a 10% early withdrawal penalty. A participant may not defer or re-defer any amounts under the plans following the participant’s early withdrawal of any amounts. Payouts with respect to early withdrawals for amounts deferred prior to 2004, and for which participants opted for the ROE Return, were calculated based on an annualization of the year-to-date return on equity as of the end of the last completed quarter prior to the early termination election.
On August 13, 2010, American Home Mortgage Servicing, Inc. (“AHMSI”) filed a complaint against Radian Guaranty in the United States District Court for the Central District of California, on its own behalf and as servicer for certain RMBS insured by Radian Guaranty under 27 separate bulk primary mortgage insurance policies. AHMSI contends that in 2008, it mistakenly sent cancellation notices to Radian Guaranty for certain loans covered under these policies, and that Radian Guaranty wrongfully refused to reinstate coverage for these loans after AHMSI discovered the error. We believe that there are approximately 271 loans for which insurance was not reinstated. According to AHMSI, Radian Guaranty’s refusal to reinstate coverage was in breach of its contractual duties under the policies and in bad faith. AHMSI is seeking money damages and injunctive relief requiring Radian Guaranty to reinstate full coverage on all loans insured under the policies. On October 18, 2010, Radian Guaranty filed a motion to dismiss this case, which the court granted on December 16, 2010, stating that AHMSI failed to establish that it is the real party of interest. On January 5, 2011, AHMSI filed an amended complaint that included the trustee of the securities as an additional plaintiff to the complaint.
On June 26, 2008, we filed a complaint for declaratory judgment in the United States District Court for the Eastern District of Pennsylvania, naming IndyMac Bank (“IndyMac”), Deutsche Bank National Trust Company (“Deutsche Bank”), Financial Guaranty Insurance Company (“FGIC”), Ambac Assurance Corporation (“Ambac”) and MBIA Insurance Corporation (“MBIA”) as defendants. The suit involves three of our pool policies covering second-lien mortgages, entered into in late 2006 and early 2007 with respect to loans originated by IndyMac. We are in a second loss position behind IndyMac and in front of three defendant financial guaranty companies. We alleged that the representations and warranties made to us to induce us to issue the policies were materially false, and that as a result, the policies should be void. The total amount of our claim liability for all three pool policies was approximately $77 million and represents the aggregate risk in force related to these policies.
In March 2009, FGIC, Ambac, and MBIA served us with demands to arbitrate certain issues relating to the same three pool policies that are the subject of our declaratory judgment complaint. In July 2009, the court declined to dismiss our declaratory judgment action, but stayed the action to permit the arbitrations to proceed first. In August 2009, we settled our dispute with Ambac and Deutsche Bank with respect to one of the disputed pool policies, which policy represents approximately $27 million of the approximately $77 million in total claim liability. In January 2010, we settled our dispute with MBIA and Deutsche Bank with respect to another of the disputed pool policies, which policy represents approximately $21 million of the approximately $77 million in
The elevated levels of our rate of rescissions and denials has led to an increased risk of litigation by lenders and policyholders challenging our right to rescind coverage or deny claims. Such challenges may be made several years after we have rescinded a policy or denied a claim. Recently, we have faced an increasing number of challenges from certain lender customers regarding our insurance rescissions and claim denials, which have resulted in some reversals of our decisions regarding rescissions or denials. We are currently in discussions with these customers regarding a number of rescissions or denials that are collectively material in amount which, if not resolved, could result in arbitration or judicial proceedings. Although we believe that our rescissions and denials are justified under our policies, if we are not successful in defending the rescissions or denials in any potential legal actions, we may need to reassume the risk on, and reestablish loss reserves for, those policies or pay additional claims. See Note 10 for further information.
As previously disclosed, on October 3, 2007, we received a letter from the staff of the Chicago Regional Office of the Securities and Exchange Commission (“SEC”) stating that the staff was conducting an investigation involving Radian Group and requesting production of certain documents. Certain of our current and former employees and directors have provided voluntary testimony in this matter, which generally related to disclosure and financial reporting by us and a co-investor regarding our respective investment in C-BASS. We received a letter from the SEC dated January 18, 2011 advising us that the investigation has been terminated and that it did not intend to recommend any enforcement action against the Company or any of our current and former employees and directors.
Under change of control agreements with certain of our officers, upon a change of control of Radian Group or Radian Asset Assurance, as the case may be, we are required to fund an irrevocable rabbi trust to the extent of our obligations under these agreements. The total maximum amount that we would be required to place in trust is approximately $12.8 million as of December 31, 2010. In addition, in the event of a change of control under our 2008 long term cash-based incentive plans, we would be required to pay approximately $15.4 million as of December 31, 2010.
On March 1, 2011, we sold our 45% interest in the holding company of a Brazilian insurance company, which specializes in surety and agricultural insurance, to another owner for a nominal purchase price. This company and its subsidiaries are subject to regulation by The Superintendence of Private Insurance, the
Our mortgage insurance business provides an outsourced underwriting service to its customers known as contract underwriting. Typically, we agree that if we make a material error in underwriting a loan, we will provide a remedy to the customer, by purchasing or placing additional mortgage insurance coverage on the loan, or by indemnifying the customer against loss. During 2010, we paid losses related to contract underwriting remedies of approximately $3.5 million. Providing these remedies means we assume some credit risk and interest-rate risk if an error is found during the limited remedy period in the agreements governing our provision of contract underwriting services. Rising mortgage interest rates or further economic uncertainty may expose the mortgage insurance business to an increase in such costs. In 2010, our provision for contract underwriting expenses was approximately $2.7 million and our reserve for contract underwriting obligations at December 31, 2010, was $2.5 million. We closely monitor this risk and negotiate our underwriting fee structure and recourse agreements on a client-by-client basis. We also routinely audit the performance of our contract underwriters to ensure that customers receive quality underwriting services.
We lease office space for use in our operations. The lease agreements, which expire periodically through August 2017, contain provisions for scheduled periodic rent increases. Net rental expense in connection with these leases totaled $4.9 million in 2010, $7.5 million in 2009, and $8.4 million in 2008. The commitment for non-cancelable operating leases in future years is as follows:
(1) The change in fair value of derivative instruments for 2010 and 2009, reflects the volatility in the cumulative unrealized gain attributable to the market’s perception of our non-performance risk as a result of the changes in our CDS spread during both years.
(2) The 2010 periods reflect losses on financial guaranty VIE debt and NIMS VIE debt offset by realized gains on investments in connection with the continued reallocation of our investment portfolio.
(4) The 2010 and 2009 periods reflect changes in the provision for second-lien premium deficiency, due to the transfer of premium deficiency reserves to loss reserves, terminations of second-lien transactions, as well as changes in estimates.
On May 11, 2010, we sold 50 million newly issued shares of our common stock at a public offering price of $11.00 per share. We received net proceeds of approximately $526 million, after deducting underwriters’ discounts and offering expenses.
Since September 2002, our board of directors has authorized five separate repurchase programs for the repurchase, in the aggregate, of up to 21.5 million shares of our common stock on the open market. There were no shares repurchased during 2010, 2009 or 2008. The board did not set an expiration date for the current program. All share repurchases made to date were funded from available working capital and were made from time to time depending on market conditions, share price and other factors.
Basic and diluted net loss per share is based on the weighted average number of common shares outstanding. As a result of our net loss in 2010, 2009 and 2008, 4,366,342, 4,635,530 and 4,906,738 shares, respectively, of our common stock equivalents issued under our stock-based compensation plans were not included in the calculation of diluted net loss per share because they were anti-dilutive.