Approximately 500 square feet of office space for our mortgage insurance operations in Hong Kong. The lease for this space expires in July 2009;
4,786 square feet of office space in Boca Raton, Florida for other operations. The lease for this space expires in September 2012; and
(1) Diluted net income per share and average share information in accordance with SFAS No. 128, “Earnings Per Share.” Amounts reflect the inclusion of shares underlying contingently convertible debt, which was redeemed on August 1, 2005.
(2) Calculated under GAAP using provision for losses to calculate the loss ratio and policy acquisition costs and other operating expenses, excluding merger expenses, to calculate the expense ratio as a percentage of net premiums earned. The 2008 expense ratio for our mortgage insurance segment includes the acceleration of $50.8 million of deferred policy acquisition cost amortization as a result of the establishment of a first-lien premium deficiency reserve.
Our mortgage insurance segment provides credit-related insurance coverage, principally through private mortgage insurance, and risk management services to mortgage lending institutions located throughout the United States (“U.S.”) and in select countries outside the U.S. 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). Of these companies, Radian Guaranty is currently the only company through which we are continuing to write a significant amount of new business. Private mortgage insurance protects mortgage lenders from all or a portion of default-related losses on residential mortgage loans made mostly to home buyers who 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 as “Government Sponsored Enterprises” or “GSEs.”
Traditional Mortgage Insurance. Our mortgage insurance segment, through Radian Guaranty, offers primary and pool mortgage insurance coverage on first-lien residential mortgages. At December 31, 2008, primary insurance on domestic first-lien mortgages made up approximately 92.2% of our total domestic first-lien mortgage insurance risk in force, and pool insurance on domestic first-lien mortgages made up approximately 7.8% of our total domestic first-lien mortgage insurance risk in force. Currently, traditional primary mortgage insurance on domestic, first-lien residential mortgages is our primary business focus.
Non-Traditional Mortgage Credit Enhancement. In addition to traditional mortgage insurance, in the past we have used Radian Insurance 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 traditional mortgage insurance in international markets (collectively, we refer to the risk associated with these transactions as “non-traditional” or “other risk”). These non-traditional or other risk products were once a growing part of our total mortgage insurance business. However, in light of the on-going deterioration in housing and related credit markets, we stopped writing all non-traditional business in 2007, other than a small amount of international mortgage insurance.
International Mortgage Insurance Operations. Through Radian Insurance, we wrote (i) credit protection in the form of international credit default swaps primarily on two large AAA tranches of mortgage-backed securities, one containing German mortgages and one containing Danish mortgages, (ii) traditional mortgage insurance with Standard Chartered Bank in Hong Kong, and (iii) several mortgage reinsurance transactions in Australia. We terminated the Danish credit default swap transaction (representing approximately $4.0 billion in notional value) in the fourth quarter of 2008.
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 underlie structured finance obligations include corporate
As a result of S&P’s downgrades of our financial guaranty insurance subsidiaries in June and August 2008, $75.6 billion of our net par outstanding as of December 31, 2008 remains subject to recapture or termination at the option of our reinsurance customers, our credit derivative counterparties or other insured parties.
All but one of our reinsurance customers have the right to take back or recapture business previously ceded to us under their reinsurance agreements with us, and in some cases, in lieu of recapture, the right to increase ceding commissions charged to us. As of December 31, 2008, up to $36.7 billion of our total net assumed par outstanding was subject to recapture. If all of this business was recaptured as of December 31, 2008, we estimate that we would have experienced a reduction in (1) written premiums of approximately $312.8 million, (2) earned premiums of approximately $52.2 million, and (3) the net present value of expected future installment premiums of $142.3 million. In addition, we would have experienced a reduction in incurred losses of up to $94.9 million if this business were recaptured.
As of December 31, 2008, the counterparties to 147 of financial guaranty’s transactions currently have the right to terminate these transactions without our having an obligation to settle the transaction on a mark-to-market basis. If all of these counterparties had terminated these transactions as of December 31, 2008, our net par outstanding would have been reduced by $38.6 billion, with a corresponding decrease in unearned premium reserves of $12.0 million (of which only $0.4 million would be required to be refunded to counterparties) and the present value of expected future installment premiums of $168.0 million. If all these transactions were terminated, we do not believe it would have a material impact on our financial condition or results of operations.
C-BASS. Historically, C-BASS was engaged as a mortgage investment and servicing company specializing in the credit risk of subprime single-family residential mortgages. As a result of the disruption in the subprime mortgage market during 2007, C-BASS ceased purchasing mortgages and mortgage securities and its securitization activities in the third quarter of 2007 and sold its loan-servicing platform in the fourth quarter of 2007. The run-off of C-BASS’s business is dictated by an override agreement to which we and all of C-BASS’s other owners and creditors are parties. This agreement provides the basis for the collection and distribution of cash generated from C-BASS’s whole loans and securities portfolio, as well as the sale of certain assets, including the loan-servicing platform. We recorded a full write off of our equity interest in C-BASS in the third quarter of 2007 and wrote-off our $50 million credit facility with C-BASS in the fourth quarter of 2007. See Note 8 of Notes to Consolidated Financial Statements.
Our holding company, Radian Group Inc. (“Radian Group”), currently is rated BB (CreditWatch with negative implications) by S&P and B3 (outlook developing) by Moody’s. Our principal operating subsidiaries have been assigned the following financial strength ratings:
(2) Each S&P rating for our mortgage insurance and financial guaranty subsidiaries is currently on CreditWatch with negative implications.
On October 10, 2008, Moody’s placed its ratings for Radian Group and each of our mortgage insurance and financial guaranty subsidiaries on review for possible downgrade. In taking this ratings action, Moody’s cited its expectation of further stress on the risk-adjusted capital position of our mortgage insurance business in light of continued deterioration in certain housing market fundamentals.
On February 13, 2009, Moody’s downgraded the insurance financial strength ratings of Radian Guaranty and Amerin Guaranty to Ba3 from A2 and the rating of Radian Insurance to B1 from Baa1. Moody’s also downgraded the senior debt rating of Radian Group to B3 from Ba1. According to Moody’s, these downgrades reflect significant stress on the risk-adjusted capital position of our mortgage insurance subsidiaries due to the weak economic environment and continued deterioration in housing fundamentals, which Moody’s expects to result in significantly higher losses for our mortgage insurance business. Moody’s also considered the continued pressure on our profitability and constraints on our financial flexibility in the current market environment. Moody’s also cited its belief that the mortgage insurance business model has deteriorated due to on-going losses and the relative weakness of the GSE’s.
On December 5, 2008, S&P placed its ratings for Radian Group and our mortgage insurance and financial guaranty insurance subsidiaries on CreditWatch with negative implications. S&P intends to resolve its CreditWatch status for these ratings by re-evaluating its estimate of expected losses for our mortgage insurance portfolio and by performing an industry-wide review that incorporates operating results for the fourth quarter of 2008 and developments in macroeconomic conditions. On December 19, 2008, S&P downgraded Radian Group to BB following completion of the initial stage of its review. S&P’s ratings for our mortgage insurance and financial guaranty insurance subsidiaries remained unchanged. The ratings for Radian Group and our mortgage and financial guaranty insurance subsidiaries remain on CreditWatch with negative implications while S&P performs the second stage of its analysis, which it expects to complete in March 2009 and which could result in a substantial downgrade.
Our current ratings and the threat of further ratings actions could have a significant impact on our business and results of operations. 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.”
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. The current downturn in the housing and related credit markets, characterized by a continuing 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 business segments. There is a great deal of uncertainty regarding our ultimate loss performance. The potential for a deepening and prolonged recession in the U.S., including rising unemployment rates, may add further stress to the performance of our insured assets. In addition, our performance may be impacted by private and governmental initiatives to support homeowners and to stimulate the economy.
Defaults. Further deterioration in the U.S. housing and mortgage credit markets throughout 2008 resulted in an 81.7% increase in first-lien primary defaults from 60,848 at December 31, 2007 to 110,553 at December 31, 2008. Overall, the underlying trend of higher defaults continues to be driven by poor performance of our late 2005 through early 2008 books of business. Losses have increased across all of our mortgage insurance product lines and most recently have included increasing losses from prime mortgages. Ongoing deterioration in markets in California and Florida, where housing values have declined significantly, continues to have a significant negative impact on our mortgage insurance business results. In light of current market trends, we expect new first-lien defaults to continue to increase in 2009.
In the second quarter of 2008, we established a first-lien premium deficiency reserve of $421.8 million on our outstanding domestic first-lien mortgage insurance portfolio. A premium deficiency reserve was established because the projected net present value of expenses and losses for our first-lien portfolio exceeded the net present value of future premiums and the loss reserve on this portfolio. During the second half of 2008, the first-lien premium deficiency reserve was reduced to $0 primarily as a result of increased loss reserves recorded on our domestic first-lien mortgage insurance portfolio. Management’s assessment of whether, and to what extent, a premium deficiency may exist at any given point in time is based largely on management’s estimate of future losses, which depends on a number of assumptions that are subject to uncertainty and which may prove inaccurate in the current economic environment. See “Risk Factors-If the estimates we use in establishing loss reserves for our mortgage insurance or financial guaranty business are incorrect we may be required to take unexpected charges to income and our ratings may be downgraded.”
75.4% for the year ended December 31, 2007. This increase was mainly due to a decline in refinancing activity from the high levels in 2005 and 2006 as a result of home price depreciation, tighter underwriting standards and an overall decrease in the lending capacity among mortgage originators. We expect that persistency rates will continue to remain at elevated levels as long as the current disruption in the housing and mortgage credit markets continues.
NIMS. Our exposure to NIMS was reduced to $438.3 million at December 31, 2008, compared to $603.7 million at December 31, 2007, in part due to our purchase of certain NIMS that we insure. The performance of loans underlying the NIMS bonds that we insure continued to deteriorate during 2008. Of the $438.3 million in our total exposure to NIMS, approximately $430.6 million represents our gross expected principal credit losses related to NIMS. Claim payments on our insured NIMS are expected to begin in 2009 and to occur mostly in 2011 and 2012. The fair value of our total net liabilities related to NIMS as of December 31, 2008 was $238.5 million. Our carrying value includes the net present value of our total expected credit losses and incorporates the market’s perception of our non-performance risk, in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurement” (“SFAS No. 157”). In the fourth quarter of 2007, as a risk mitigation initiative, we began purchasing NIMS that we insure at a discount to par. These efforts continued during 2008, resulting in an overall reduction of our risk in force related to NIMS of $88.7 million during 2008. We did not purchase any NIMS prior to the fourth quarter of 2007. The NIMS purchased are accounted for as derivative assets and are recorded at fair value in accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS No. 133”), as amended and interpreted. Upon purchase, our liability representing the unrealized loss associated with the purchased NIMS is eliminated. The difference between the amount we pay for the NIMS and the sum of the fair value of the NIMS and the eliminated liability represents the net impact to earnings. The overall impact to our financial statements as a result of these purchases has been immaterial.
Credit Default Swaps. As of December 31, 2008, our total mortgage insurance risk in force related to domestic CDS on residential mortgage-backed securities (“RMBS”) was approximately $132.2 million. The total fair value liability for these transactions at December 31, 2008 was $63.5 million, compared to our estimate of future credit losses of $91.8 million. Similar to our NIMS, the difference between the fair value liability for these transactions and our expected credit losses is mainly attributable to the incorporation of the market’s perception of our credit risk in computing fair value as required by SFAS No. 157.
With respect to our international CDS, we reduced our total risk in force exposure to these transactions by approximately $4.0 billion to $3.4 billion at December 31, 2008 as a result of the termination of a large transaction in the fourth quarter of 2008. Our exposure to international mortgage insurance CDS at December 31, 2008 consists of two CDSs referencing RMBS bonds related to mortgage loans in Germany and the Netherlands. The first CDS contains prime, low LTV mortgages originated in Germany. Our remaining exposure to this transaction, which is rated AAA, was approximately $3.3 billion as of December 31, 2008, with remaining subordination of approximately $247 million. The second transaction contains prime, low LTV mortgages originated in the Netherlands. Our remaining exposure to this transaction was approximately $125 million as of December 31, 2008, with remaining subordination of $16 million. We have insured several tranches in the Netherlands transaction which are rated between BBB and AAA, with over half of our exposure in the AAA category. Both of these transactions are performing well and we do not currently expect to pay claims on either of these transactions. As of December 31, 2008, we had a fair value liability of $13.2 million on our remaining international CDS transactions.
As a result of the downgrade of Radian Asset Assurance’s financial strength ratings by S&P in June 2008, four of our reinsurance customers recaptured all of their business ceded to us and we agreed to allow another reinsurance customer to take back a portion of its business (the “2008 FG Recaptures”). As a result of these transactions, our net assumed par outstanding, written premiums, earned premiums and net present value of expected future installment premiums were reduced in the aggregate by $7.3 billion, $51.0 million, $17.1 million and $10.6 million, respectively.
Credit Performance. We have experienced deterioration in our financial guaranty portfolio during 2008, primarily related to deterioration in housing and consumer finance markets. The performance of assumed structured finance transactions within our reinsurance portfolio deteriorated throughout 2008 and one large public finance reinsurance credit defaulted during 2008. The deterioration in our insured ABS portfolio was primarily related to credits supported by student loan and rental car collateral, while the deterioration in our insured RMBS portfolio was primarily related to domestic subprime and Alternative-A (“Alt-A”) collateral. As of December 31, 2008, 46% of our domestic insured RMBS portfolio was rated below investment grade. While we did not experience material deterioration in our directly insured portfolio, there was some ratings deterioration within our insured corporate CDO portfolio and trust preferred CDO portfolio due to the impact of several credit events in the second half of 2008. We moved one large directly insured CDO of ABS with significant RMBS exposure in its underlying collateral pool to our Watch List in 2008. There has been some credit deterioration in our insured healthcare portfolio during 2008, primarily due to the impact of investment losses resulting from the market downturn on hospitals’ cash positions, and in our insured education portfolio due to declining philanthropy and investment returns. In addition, some of our healthcare and education credits have also been experiencing additional stress due to interest rate volatility and the risk of rapid amortization associated with recent disruptions in the auction rate and variable rate bond markets. See “Results of Operations-Financial Guaranty-Year Ended December 31, 2008 Compared to Year Ended December 31, 2007-Provision for Losses” below.
Net income for Sherman for the year ended December 31, 2008 was $263.4 million, compared to $265.7 million for 2007. Increased revenues from Sherman’s receivable portfolio and credit card origination business were partially offset by higher loan loss provisions and an increase in operating expenses and interest expense. Our share of Sherman’s net income was $59.8 million for 2008 compared to $84.8 million for 2007. This reduction was primarily a result of our decreased ownership percentage in Sherman for most of 2008 compared to 2007. See Note 8 of Notes to Consolidated Financial Statements.
Our investment in C-BASS, including our $50 million credit facility with C-BASS, was fully written off as of December 31, 2007.
The following table summarizes our consolidated results of operations for 2008, 2007 and 2006 (in millions):
Net Premiums Written and Earned. Consolidated net premiums written for 2008 were $816.9 million, a $268.3 million or 24.7% decrease from $1,085.2 million for 2007. Consolidated net premiums earned for 2008 were $971.8 million, a $59.5 million or 6.5% increase from $912.3 million earned for 2007. The year over year decrease in net premiums written was due to the reduction in new financial guaranty business written in 2008, and a decrease in mortgage insurance premiums written as a result of an industry-wide decline in the volume of mortgage originations, our more restrictive underwriting guidelines, a lack of a secondary market for mortgage securitizations and increased competition from the FHA. Net premiums earned in 2008 increased compared to 2007 as a result of an increase in prepayments or refundings of public finance obligations, which results in full recognition of our remaining unearned premium. Net premiums earned in our mortgage insurance business also increased in 2008 due to higher 2007 originations and increased persistency in 2008. The amount of net premiums written for 2008 includes a reduction of $51.0 million related to the 2008 FG Recaptures, which also reduced 2008 net premiums earned by $17.1 million.
Net Investment Income. Net investment income for 2008 was $263.0 million, a $6.9 million or 2.7% increase from $256.1 million in 2007. This increase was mainly due to an increase in average investable assets, primarily due to the redemption of approximately $544.7 million of tax and loss bonds during 2008.
Net (Losses) Gains on Other Financial Instruments. Net losses on other financial instruments for 2008 were $149.5 million, compared to net gains of $53.6 million for 2007. Included in 2008 net losses were: (i) $144.2 million of net losses related to the change in fair value of hybrid securities, primarily convertible bonds and trading securities in our investment portfolio; (ii) $55.2 million of net losses related to the write-down of other-than-temporarily impaired available for sale securities, which was partially offset by $42.4 million in realized gains on sales of available for sale securities; and (iii) $18.4 million of gains related to the change in fair value of the NIMS variable interest entity (“VIE”) debt and VIE assets that we were required to consolidate in 2008. In 2007, there were net gains of $37.9 million related to the sale of hybrid securities and net losses of $1.7 million related to the change in fair value of hybrid securities and trading securities. 2007 net gains were partially offset by $9.4 million of losses on investment securities that were other-than-temporarily impaired. See “Investments” below in this Item 7.
Policy Acquisition Costs. Policy acquisition costs were $136.4 million for 2008, an increase of $23.2 million or 20.5% from $113.2 million for 2007. 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 periodic 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. In 2008, we accelerated $50.8 million of deferred policy acquisition cost amortization in our mortgage insurance segment in connection with the creation of a first-lien premium deficiency reserve.
Equity in Net Income (Loss) of Affiliates. Equity in net income of affiliates was $59.8 million for 2008, compared to equity in net loss of affiliates of $416.5 million for 2007. Sherman contributed $59.8 million of equity in net income of affiliates for 2008 compared to $84.8 million for 2007. While Sherman’s earnings remained relatively stable, our equity in net income of affiliates for 2008 reflects our reduced holdings in Sherman, effective September 1, 2007, as a result of our sale of a portion of our interests in Sherman, as well as the subsequent increase in our ownership from 21.8% to 28.7% in August 2008. The loss in 2007 was driven by the impairment of our total equity investment in C-BASS and the write-down of our $50 million credit facility with C-BASS. For more information, see “Results of Operations-Financial Services” below.
Net Investment Income. Net investment income for 2007 was $256.1 million, a $21.8 million or 9.3% increase from $234.3 million in 2006. This increase was mainly due to an increase in invested assets as a result of positive cash flows and the $200 million draw down from our credit facility during the latter part of 2007, and higher yields in our investment portfolio.
Change in Fair Value of Derivative Instruments. For 2007, the change in fair value of derivative instruments was a net loss of $1,214.4 million, compared to a net gain of $124.9 million for 2006. The decrease in the change in fair value of derivative instruments in 2007 was mainly a result of an $840.4 million increase in the net loss on financial guaranty derivatives due to significant credit spread widening and a $449.5 million increase in the net loss related to our NIMS portfolio, which was primarily credit related. The $124.9 million gain for 2006 was due primarily to the net premiums earned on credit derivatives.
Provision for Losses. The provision for losses for 2007 was $1,308.1 million, up from $369.3 million for 2006. This increase was driven mainly by the deteriorating credit performance in our mortgage insurance
Policy Acquisition Costs. Policy acquisition costs were $113.2 million for 2007, an increase of $1.6 million or 1.4% from $111.6 million reported for 2006. During 2007, amortization expense was impacted by both an increase in persistency rates and updates to our loss ratio assumptions. In addition, a decrease in net premiums earned from our trade credit reinsurance business offset some of the overall increase in policy acquisition costs in 2007.
Interest Expense. Interest expense of $53.0 million for 2007 increased $4.9 million or 10.2% from $48.1 million for 2006. These amounts reflect interest on our long-term debt and other borrowings and include the impact from interest rate swaps that we entered into in 2004. Included in interest expense for 2007 was $4.2 million of interest related to the $200 million that we drew down from our unsecured revolving credit facility in August 2007.
Net Loss. Our mortgage insurance segment’s net loss for 2008 was $784.6 million, compared to a net loss of $695.4 million for 2007. Our 2008 results were negatively impacted by a significant increase in the provision for losses, an increase in net losses on other financial instruments, such as our hybrid securities and other-than-temporarily impaired securities in our investment portfolio, and an increase in policy acquisition costs and other operating expenses. Our 2008 losses were partially offset by a positive change in fair value of derivative instruments due to the implementation of SFAS No. 157 and a reduction of our second-lien premium deficiency reserve.
Net Premiums Written and Earned. Net premiums written for 2008 were $787.2 million, a $111.3 million or 12.4% decrease from $898.5 million for 2007. Net premiums earned for 2008 were $808.8 million, a $29.5 million or 3.8% increase compared to $779.3 million for 2007. Primary new insurance written decreased in 2008, mainly due to a decrease in mortgage loan originations, our more restrictive underwriting guidelines, the absence of a secondary market for writing structured mortgage insurance business and increased competition from the FHA. In addition, net premiums written on our non-traditional business decreased significantly in 2008 compared to 2007. The increase in net premiums earned in 2008 compared to 2007 resulted from the higher volume of primary new insurance written during 2007 compared to prior years and an increase in persistency rates. We anticipate modest growth in mortgage insurance earned premiums from our traditional flow business in 2009 as our insurance in force continues to grow.
Change in Fair Value of Derivative Instruments. The change in fair value of derivative instruments was a gain of $102.2 million for 2008, compared to a loss of $467.6 million for 2007. The 2008 results include a net gain of $117.9 million related to our NIMS portfolio as a result of our implementation of SFAS No. 157, which was partially offset by a $36.7 million net loss on our domestic and international CDS derivatives. The loss in 2007 was mainly due to the $449.5 million net loss on our NIMS and the $86.2 million net loss on our domestic and international CDS derivatives.
Other Income. Other income for 2008 was $11.1 million, a $0.2 million or 1.8% decrease from $11.3 million in 2007. Other income primarily includes income related to contract underwriting services.
economic conditions and home price declines have resulted in a significant increase in delinquencies during 2007 and 2008, particularly among loans originated in 2005 through the first half of 2008, with primary areas of deteriorating performance in California, Florida, Nevada and several Midwestern states. The adjustable rate mortgage (“ARM”) portion of our portfolio also contributed to the rise in delinquencies in 2007 and 2008 as resets forced many homeowners into default without the ability to refinance.
Provision for Premium Deficiency. The reserve for premium deficiency decreased by $108.8 million in 2008, compared to a $195.6 million increase in 2007. We reassess our expectations for premiums, losses and expenses for our mortgage insurance business at least quarterly and record or adjust a premium deficiency reserve, if necessary, as actual losses are incurred and premiums received. A provision for second-lien premium deficiency in the amount of $155.2 million was initially established in 2007. During 2008, we reduced this reserve by $108.8 million as a result of the transfer of premium deficiency reserves to loss reserves and premiums earned, as actual losses were incurred and premiums were received, and assumptions of future premiums and losses were updated. In January 2009, we settled certain second-lien mortgage insurance transactions, which reduced our risk in force by approximately $209 million. The settlement amount was $49.2 million less than our reserve amount, and as a result we reduced our second-lien premium deficiency reserve through the provision for premium deficiency by $49.2 million at December 31, 2008. A provision for first-lien premium deficiency in the amount of $421.8 million was established in the second quarter of 2008. During the second half of 2008, the first-lien premium deficiency reserve was reduced to $0 primarily as a result of increased loss reserves recorded on our domestic first-lien mortgage insurance portfolio. See “Critical Accounting Policies-Reserve for Premium Deficiency” below.
Income Tax Benefit. We recorded an income tax benefit of $476.0 million for 2008 and $429.9 million for 2007. The effective tax rate was 37.8% for 2008, compared to 38.2% for 2007. The lower effective tax rate for 2008 reflects a decrease in the ratio of income generated from tax-advantaged investment securities compared to loss generated from operations.
Net (Loss) Income. Our mortgage insurance segment’s net loss for 2007 was $695.4 million, compared to $282.8 million of net income for 2006. The 2007 loss was mainly due to the significant disruptions in the housing
Net Premiums Written and Earned. Net premiums written for 2007 were $898.5 million, a $97.0 million or 12.1% increase from $801.5 million for 2006. Net premiums earned for 2007 were $779.3 million, a $4.5 million or 0.6% increase compared to $774.8 million for 2006. Net premiums written in 2007 were positively impacted by the uncertain credit markets in 2007, which led to increased production in our traditional flow business. Net premiums earned for 2007 also were positively impacted by increases in premiums earned from NIMS and international business, partially offset by a decrease in premiums earned from our second-lien business due to a lesser amount of business originated in 2006 and 2007. Net premiums earned from all our non-traditional products were $48.3 million for 2007, compared to $59.6 million for 2006.
Change in Fair Value of Derivative Instruments. The change in fair value of derivative instruments was a loss of $467.6 million for 2007, compared to a gain of $41.0 million for 2006. The decrease in 2007 was mainly due to the $449.5 million net loss on our NIMS book, compared to $6.9 million of net losses on NIMS in 2006. In addition to NIMS, RMBS CDS in our domestic mortgage insurance business resulted in an additional net loss of $86.2 million in 2007, compared to a net loss of $2.7 million in 2006.
Net Gains on Other Financial Instruments. Net gains on other financial instruments in our mortgage insurance segment were $39.9 million for 2007, compared to $30.2 million for 2006. Included in 2007, were net gains related to the sale of hybrid securities of approximately $26.2 million, offset by losses related to the change in fair value of other hybrid securities and trading securities of $1.9 million. Included in net gains on other financial instruments for 2006 is an allocation of net gains on other financial instruments to the mortgage insurance segment, most of which came from the sale of our remaining interest in Primus. The amounts reported for 2007 and 2006 include approximately $9.4 million and $10.6 million, respectively, in losses related to the write-down of other-than-temporarily impaired securities.
Income Tax (Benefit) Provision. We recorded an income tax benefit of $429.9 million for 2007 and an income tax provision of $102.3 million for 2006. The effective tax rate was 38.2% for 2007 compared to 26.6% for 2006. The higher effective tax rate for 2007 reflects the losses incurred during 2007 and an increase in the ratio of income generated from tax-advantaged investment securities compared to loss generated from operations. The tax rate for 2006 reflects an allocation of the reversal of prior years’ tax exposures that expired June 30, 2006.
For the year ended December 31, 2008, other risk written was $113.0 million, compared to $604.0 million for 2007 and $900.0 million for 2006. As discussed above, we are no longer writing insurance on NIMS and second-lien mortgages or entering into CDS transactions on mortgage collateral. A large portion of the other risk written for the year ended December 31, 2007 was insurance on NIMS written during the first half of 2007.
securitizations completed in 2005, representing a total of $8.2 billion of risk in force at December 31, 2007 and $7.9 billion of risk in force at December 31, 2006, in which we provided credit enhancement at a AAA level. As discussed above, we terminated one of these transactions in the fourth quarter of 2008, reducing our risk in force by approximately $4.0 billion related to these transactions to $3.4 billion. See “Overview of Business Results-Mortgage Insurance-Discontinued Non-Traditional Products-Credit Default Swaps” above.
(1) Includes 539, 2,595 and 1,161 defaults at December 31, 2008, December 31, 2007 and December 31, 2006, respectively, where reserves have not been established because no claim payment is currently anticipated.
(2) Includes 21,719, 20,193 and 13,309 defaults at December 31, 2008, December 31, 2007 and December 31, 2006, respectively, where reserves have not been established because no claim payment is currently anticipated.
The total number of loans in default, including second-liens, increased to 153,259 at December 31, 2008, from 96,203 at December 31, 2007 and 67,173 at December 31, 2006. The average loss reserve per default at December 31, 2008 was $19,509, compared to $13,986 and $9,725 at December 31, 2007 and 2006, respectively. Primary and pool defaults at December 31, 2008 included 539 and 21,719 defaults, respectively, on loans where reserves have not been established because no claim payment is currently anticipated. At December 31, 2007, primary and pool defaults included 2,595 and 20,193 defaults, respectively, on loans where reserves have not been established. At December 31, 2006, primary and pool defaults included 1,161 and 13,309 defaults, respectively, on loans where reserves have not been established. Excluding those defaults without a related reserve, the average loss reserve per default was $22,824, $18,327 and $12,395 at December 31, 2008, 2007 and 2006, respectively.
The following table lists our total direct claims paid by product and average claim paid by product for the periods indicated:
Claim activity is not spread evenly throughout the coverage period of a book of business. Historically, relatively few claims on prime business are received during the first two years following issuance of a policy and on non-prime business during the first year. Claim activity on prime loans has historically reached its highest level in the third through fifth years after the year of policy origination, and on non-prime loans this level is expected to be reached in the second through fourth years. Based on these trends, approximately 62.5% of our primary risk in force and approximately 18.6% of our pool risk in force at December 31, 2008 had not yet reached its highest claim frequency years. At December 31, 2007, the comparable amounts were 67.2% and 37.1%, respectively. The business written from late 2005 through the first half of 2008 has experienced default and claim activity sooner than has been the case for historical books of business. Because it is difficult to predict both the timing of originating new business and the cancellation rate of existing business, it is also difficult to predict, at any given time, the percentage of risk in force that will reach its highest claim frequency years on any future date.
level of claims exist in Michigan, as problems with the domestic auto industry and related industries have depressed economic growth, employment and housing prices in that state.
A higher proportion of new delinquencies in 2008 and 2007 are from loans in Florida, Nevada and California, which would suggest that claims paid in those states will continue to increase, perhaps significantly, in 2009.
The following table lists our primary mortgage risk in force for the top ten states for each period indicated:
The largest single customer of our mortgage insurance segment (including branches and affiliates of such customer), measured by primary new insurance written, accounted for 20.5% of primary new insurance written for 2008 compared to 19.4% for 2007 and 18.6% for 2006.
(1) Does not include amounts related to expected future losses on loans that are not currently delinquent that are included in our reserve for second-lien premium deficiency.
(2) Relates to ceded losses on captive transactions and Smart Home.
(d) Risk in force (“RIF”) on captives as a percentage of total risk in force.
The following table summarizes the results of operations for our financial guaranty segment for the years ended December 31, 2008, 2007 and 2006 (in millions):
Net Income (Loss). Our financial guaranty segment’s net income for 2008 was $339.1 million, compared to a net loss of $440.2 million for 2007. The increase in net income was mainly due to the large positive impact on the change in fair value of derivative instruments resulting from our implementation of SFAS No. 157 and higher net premiums earned as a result of an increase in prepayments or refundings of public finance obligations. Partially offsetting this increase in net income was an increase in the provision for losses, an increase in other operating expenses, net losses on other financial instruments and a higher tax provision. Net income for 2008 includes a $7.0 million immediate after-tax reduction as a result of the 2008 FG Recaptures.
The following table shows net premiums written and earned by our financial guaranty segment’s various product lines for 2008, 2007 and 2006:
Net Investment Income. Net investment income attributable to our financial guaranty business was $108.4 million for 2008, a $0.7 million or 0.7% increase from $107.7 million for 2007. The increase was mainly due to an increase in average investable assets primarily due to the redemption of tax and loss bonds during 2008.
Net (Losses) Gains on Other Financial Instruments. Net losses on other financial instruments in our financial guaranty investment portfolio were $66.5 million for 2008, compared to net gains of $12.5 million for 2007. Included in net losses for 2008 were $32.7 million of losses related to the change in fair value of hybrid securities and trading securities and $35.0 million of losses on investment securities that were other-than- temporarily impaired. Included in the net gains on other financial instruments for 2007 was $11.7 million related to the sale of hybrid securities.
Provision for Losses. The provision for losses was $114.5 million for 2008, compared to $98.0 million for 2007. The increase in the 2008 provision for losses compared to 2007 is mainly the result of on-going deterioration in our assumed reinsurance business. The provision for losses reported for 2007 includes a $100 million claim (which represented our total exposure and which was paid in 2008) on a credit in which we provided market-value and credit support for an extendable commercial paper program. This credit represented the only direct market-value transaction then remaining in our financial guaranty portfolio.
We closely monitor our financial guaranty obligations and we use an internal classification process to identify and track troubled credits. We classify credits as “intensified surveillance credits” when we determine that continued performance is questionable and, in the absence of a positive change, may result in a claim. At December 31, 2008, 2007 and 2006, our financial guaranty segment had the following exposure on credits classified as intensified surveillance credits:
We establish loss reserves (which include case reserves, allocated non-specific and unallocated non-specific reserves) on our non-derivative financial guaranty contracts as discussed in “Critical Accounting Policies-Reserve for Losses” in this Item 7 and in Note 2 of Notes to Consolidated Financial Statements.
The following discussion provides additional information regarding the four credits with net par outstanding of greater than $100 million that we have classified as intensified surveillance credits as of December 31, 2008:
We reinsure $103.5 million net par outstanding of notes issued by a special purpose vehicle to fund reserves for a pool of life insurance policies. Due to significant deterioration in the market value of the collateral supporting this transaction, which has high concentrations of securities backed by subprime and Alt-A mortgages, cash flows that would otherwise be available to pay interest on our insured notes have been diverted to increase the statutory reserves for the life insurance policies. As a result, the primary insurer for this transaction was required to pay a claim related to an interest shortfall on the insured notes. Based upon loss estimates provided by the primary insurer, we established an allocated non-specific reserve for this transaction of $31.0 million at December 31, 2008. We have concluded that no additional loss beyond this amount is probable or estimable.
related to interest shortfalls on this transaction in 2017 or later. Due to the structure of this transaction, we do not expect to begin paying claims related to the principal shortfall until sometime between 2036 and the legal final maturity date for the transaction in 2046. We currently believe that the ultimate principal payment with respect to this transaction will be less than the current outstanding par amount, but due to the long remaining life and nature of the collateral, losses are difficult to estimate. Deterioration in economic conditions over the remaining life of the transaction beyond our current projections could have a material impact on the timing and amount of cash available to make interest and principal payments on our insured tranche, and therefore, our ultimate losses on this transaction could be greater than expected.
In addition to the credits identified above, there were 66 additional intensified surveillance credits identified at December 31, 2008 (including 62 non-derivative financial guaranty credits), representing approximately $566 million in net par outstanding We have established $63.3 million in allocated non-specific reserves for 53 of these non-derivative credits. We have concluded that no additional loss is probable or estimable at this time on these transactions.
Other Operating Expenses. Other operating expenses were $99.5 million for 2008, compared to $49.3 million for 2007. Operating expenses for 2008 include an increase in severance costs, legal and accounting fees, and other third-party professional services. The expenses reported for 2008 include severance and retention related expenses of $22.7 million as a result of the reduction in our financial guaranty operations during 2008. The ratio of expenses to earned premiums in our financial guaranty business (which includes other operating expenses and policy acquisition costs) of 67.6% for 2008 increased from 48.2% for 2007.
Interest Expense. Interest expense was $25.6 million for 2008, compared to $19.8 million for 2007. Both periods include interest on our long-term debt and other borrowings, which was allocated to the financial guaranty segment.
In connection with the 2008 FG Recaptures that occurred in the fourth quarter of 2008, we paid $36.6 million to the reinsurers to reimburse them for statutory unearned premiums, net of applicable commissions.
Year Ended December 31, 2007 Compared to Year Ended December 31, 2006
Net (Loss) Income. Our financial guaranty segment’s net loss for 2007 was $440.2 million, compared to net income of $136.1 million for 2006. The decrease for 2007 was mainly due to a significant decrease in change in fair value of derivative instruments and an increase in the provision for losses. These decreases in net income were partially offset by a decrease in other operating expenses, an increase in net investment income, higher net gains on other financial instruments and a tax benefit due to the pretax loss.
Net Premiums Written and Earned. Our financial guaranty segment’s net premiums written for 2007 were $186.7 million, a $16.1 million or 7.9% decrease compared to $202.8 million for 2006. The decrease in net premiums written in 2007 compared to 2006 was attributable to the difficult business environment in 2007, particularly for our public finance business, resulting from the disruption in the credit markets and corresponding widening of the credit spreads of Radian Asset Assurance. Net premiums earned for 2007 were $133.0 million, compared to $132.3 million for 2006. Included in net premiums earned for 2007 were refundings from our public finance products of $23.3 million, compared to $11.8 million for 2006.
Net Investment Income. Net investment income attributable to our financial guaranty business was $107.7 million for 2007, compared to $95.9 million for 2006. The 2007 amount reflects an increase in investable assets and higher yields.
Change in Fair Value of Derivative Instruments. Change in the fair value of derivative instruments was a loss of $746.8 million for 2007, compared to a gain of $83.9 million for 2006. The decrease in the change in fair value of derivative instruments for 2007 was mainly a result of spread widening related to our directly insured corporate CDOs, subprime RMBS CDOs and commercial mortgage-backed securities (“CMBS”) CDOs exposures for which we recorded unrealized losses in the amount of $549.7 million, $146.5 million and $56.0 million, respectively, in 2007.
The gross par (principal) originated by our financial guaranty segment in 2008, 2007 and 2006 was as follows:
The following schedule depicts the expected earned premiums for our existing financial guaranty portfolio, assuming no prepayments or refundings of any financial guaranty obligations, as of December 31, 2008. Expected earnings will differ from contractual earnings because borrowers have the right to call or prepay financial guaranty obligations. Unearned premium amounts are net of prepaid reinsurance.
In addition to the expected earned premiums set forth above, we also have expected future premium earnings on derivative contracts of $261.0 million, primarily in future installment premiums.
(1) Relates primarily to a CDO of ABS transaction with total exposure of $100 million. This claim was fully paid in the first quarter of 2008 and we have no remaining exposure to this transaction.
2006, respectively. The decrease in equity in net income of affiliates from Sherman in 2008 was the result, in part, of the sale of a portion of our interest in Sherman during the third quarter of 2007. We did not record any equity in net income of affiliates for C-BASS for 2008, compared to $451.4 million of equity in net loss of affiliates for 2007, and $133.9 million of equity in net income of affiliates for 2006. The rapid decline in the subprime mortgage market during July 2007 was largely responsible for the total impairment of our interest in C-BASS in 2007. See Note 8 of Notes to Consolidated Financial Statements.
We have various contractual obligations that are recorded as liabilities in our consolidated financial statements. Other items, including payments under operating lease agreements, are not recorded on our consolidated balance sheets as liabilities but represent a contractual commitment to pay.
The following table summarizes certain of our contractual obligations and commitments as of December 31, 2008, and the future periods in which such obligations are expected to be settled in cash. Following the table are “Other Contractual Obligations and Commitments” that do not fall within the categories specified by the Securities and Exchange Commission (“SEC”) for tabular disclosure. The table reflects the timing of principal and interest payments on outstanding debt and other borrowings. Additional details regarding these obligations are provided in the narrative following the table and in the Notes to Consolidated Financial Statements as referenced in the table:
The credit agreement governing our credit facility restricts, among other things, our ability to: incur additional indebtedness; create liens; enter into mergers, consolidations and sales of certain of our assets; make certain investments or other specified restricted payments, including investments in, loans to, or guarantying any obligations of, Radian Asset Assurance (other than with respect to its soft capital program); pay dividends or make distributions in respect of our capital stock in excess of a permitted annual amount (generally equal to our current dividend and subject to certain adjustments); and sell certain of our assets and, in certain circumstances, issue stock. Our credit agreement, as amended, no longer has a ratings trigger or debt to capital requirement.
Under our credit facility as amended, in addition to our business covenants, we are required to maintain (subject to certain adjustments), a consolidated net worth of at least $1.5 billion through June 30, 2009, $1.25 billion from July 1, 2009 through December 31, 2009 and $1.0 billion at any time thereafter, in each case, subject to upward adjustment if we receive net proceeds from the issuance of certain securities. Our consolidated net worth under the credit facility is determined by excluding mark-to-market adjustments on derivative instruments and investments reflected on our financial statements. At December 31, 2008, our consolidated net worth as determined under the facility was $2.6 billion. We expect to incur a net operating loss in 2009, which would negatively impact our consolidated net worth. In addition, our consolidated net worth would be further reduced if we realize losses in our investment portfolio. Although we do not expect to breach our net worth covenant based on our current loss projections, there can be no assurance that losses in or after 2009 will not reduce our consolidated net worth below the minimum amount required by our covenant, which would cause our default under the credit facility.
However, due to the high degree of uncertainty regarding the timing of future cash outflows associated with certain of our FIN 48 liabilities, we cannot make a reasonably reliable estimate of the period of cash settlement for the remaining $83.5 million of liability for unrecognized tax benefits.
Radian Group and Radian Mortgage Insurance Inc. (formerly known as 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 Inc.’s creditors to make funds available on demand for the full and complete payment of all due but unpaid 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, 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
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.
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 $22.3 million as of December 31, 2008. In addition, in the event of a change of control under our existing cash-based incentive plans, we would be required to pay approximately $11.0 million as of December 31, 2008.
Our interests in QSPEs may be accounted for as insurance contracts or financial guaranty derivatives. For insurance contracts with QSPEs, we record reserves for losses and LAE, and for derivative interests in QSPEs, we record changes in the fair value as a corresponding derivative asset or liability. We do not record the underlying assets or liabilities of QSPEs on our balance sheets.
SPEs and VIEs are a part of our non-traditional mortgage insurance products as well as our financial guaranty business. Our primary involvement with SPEs relates to transactions in which we provide a financial
The following is a summary of our exposure to the NIMS underlying trust assets (both consolidated and off-balance sheet NIMS trusts) at December 31, 2008 and December 31, 2007:
The following table sets forth our total assets and maximum exposure to loss associated with significant financial guaranty variable interests in VIEs as of December 31 for the years indicated:
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 classified as available for sale 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 and derivatives are reported at fair value, with unrealized gains and losses reported as a separate component of income.
Our evaluation of market declines for other-than-temporary impairment is based on management’s case-by-case evaluation of the underlying reasons for the decline in fair value. We consider a wide range of factors about the security and use our best judgment in evaluating the cause of the decline in the estimated fair value of the security and in assessing the prospects for near-term recovery. Inherent in management’s evaluation of the security are assumptions and estimates about the operations of the issuer and its future earnings potential. Considerations used by management in its impairment evaluation process include, but are not limited to: (i) the length of time and the extent to which the market value has been below cost or amortized cost; (ii) the potential for impairments of securities when the issuer is experiencing significant financial difficulties; (iii) the potential for impairments in an entire industry sector or sub-sector; (iv) the potential for impairments in certain economically depressed geographic locations; (v) the potential for impairments of securities where the issuer, series of issuers or industry has suffered a catastrophic type of loss or has exhausted natural resources; (vi) our ability and intent to hold the security for a period of time sufficient to allow for the full recovery of its value to an amount equal to or greater than cost or amortized cost; (vii) unfavorable changes in forecasted cash flows on asset-backed securities; and (viii) other subjective factors, including concentrations and information obtained from regulators and rating agencies.
The unrealized losses of 12 months or greater duration as of December 31, 2008 on our investments in tax-exempt state and municipal securities were caused primarily by interest rate and credit spread movement. Most securities with exposures to certain sectors, particularly those insured by monoline insurers, experienced credit spread widening during 2007 and 2008. We do not own any securities with underlying non-investment grade ratings that are insured by monoline insurance companies. Included in this category are $129.6 million of investments in state securitizations of projected cash flows from state settlements with tobacco manufacturers under a master settlement agreement. Because we have the ability and intent to hold all the investments in this
The unrealized losses of 12 months or greater duration as of December 31, 2008 on the securities in this category were caused by market interest rate and credit spread movement. Our investments are senior tranche positions, collateralized by pools of credit card, auto loan and equipment lease receivables. The investment grade ratings of these investments are supported by credit enhancements, which include subordination, over-collateralization and reserve accounts. Because we have the ability and intent to hold these investments until a full recovery of fair value, which may be maturity, we do not consider these securities to be other-than-temporarily impaired at December 31, 2008.
Tax Payments. Under our current tax-sharing agreement between Radian Group and our 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 of 1986, as amended (“the Code”), had such subsidiary filed its federal tax return on a separate company basis. We currently believe that Radian Group will be required to pay approximately $154 million to our subsidiaries by October 2009, including approximately $149 million to Radian Guaranty. In addition, based on our current tax loss projections, we believe that Radian Group will be required to pay an additional amount of approximately $300 million to Radian Guaranty in October 2010, which amount could increase up to a maximum of $478 million if actual tax
losses are worse than projected. All amounts required to be paid under our tax-sharing agreement are dependent on the extent of tax losses in current and future periods. A portion of these payments may be funded from refunds that Radian Group receives from the Internal Revenue Service (“IRS”). We currently anticipate receiving a $105.2 million refund from the IRS in 2009 or 2010 relating to the carryback of our 2008 net operating loss. 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.
During the current period, certain of our mortgage insurance subsidiaries other than Radian Guaranty each incurred estimated net operating losses on a tax basis that, if computed on a separate company return basis, could not be utilized through existing carryback provisions of the Code. As a result, we are not currently obligated to reimburse them for their respective unutilized tax losses. However, if in a future period, any of these subsidiaries generate taxable income such that they are able to realize their individual net operating loss carryforward under the Code, then we will be obligated under the tax-sharing agreement to fund such subsidiary’s share of the net operating loss that has been utilized on a consolidated group tax return basis. Each of these subsidiaries has incurred significant losses in the recent past and is expected to incur additional losses in the future as a result of their insured portfolios of mortgage collateral, and most of them are not currently originating new business.
Capital Support for Subsidiaries. Radian Group could be required to provide additional capital support for our mortgage insurance subsidiaries if required by insurance regulators, the GSEs or the rating agencies. In light of on-going losses in our mortgage insurance business, we anticipate that Radian Group may be required to provide capital support to Commonwealth Mortgage Assurance Company of Texas (“CMAC of Texas”), an indirect insurance subsidiary of Radian Group that provides reinsurance to Radian Guaranty. Recently, Radian Group contributed $25 million to CMAC of Texas.
We expect to fund all of Radian Group’s short-term liquidity needs with existing cash and marketable securities, cash received under the tax- and expense-sharing arrangements with our subsidiaries and cash dividends from Sherman. If the cash Radian Group receives from its tax- and expense-sharing arrangements and/or Sherman is 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, including our interest in Sherman, which we may not be able to do on favorable terms, if at all. In addition, we are required to repay amounts outstanding under our credit facility with any amounts we raise through the issuance of securities (e.g., debt, equity or hybrid securities) or the sale of certain of our assets, including Sherman. If required, there can be no assurance that we will be successful in raising additional capital.
In 2008, we amended our credit facility, reducing the principal amount outstanding from $200 million to $100 million. We are not currently permitted to borrow under the facility until the outstanding principal amount is reduced. See “Contractual Obligations and Commitments” above.
In light of the expected future losses by Radian Guaranty, we determined it was necessary to provide additional capital to Radian Guaranty in order to maintain adequate risk-to-capital ratios, leverage ratios and surplus requirements and to protect its insurance financial strength ratings. In addition to protecting its financial strength ratings, additional capital is an important component of our plan to improve our ratings with S&P and Moody’s over a time period that is acceptable to us, as well as being important to the GSEs and our lender counterparties. During the second quarter of 2008, Radian Asset Assurance declared an ordinary dividend of $107.5 million to Radian Group. In addition, Radian Group contributed its equity interest in Radian Asset Assurance to Radian Guaranty in the third quarter of 2008. This restructuring provided significant regulatory capital credit to Radian Guaranty and is intended to provide cash dividends to Radian Guaranty over time.
The principal liquidity demands of our financial guaranty business include the payment of operating expenses, including those allocated from Radian Group, claim payments, taxes and dividends to Radian Guaranty. The principal sources of liquidity in our financial guaranty business are written premiums and net investment income. We believe that the operating cash flows generated by each of our financial guaranty subsidiaries will provide these subsidiaries with the funds necessary to satisfy their claim payments and operating expenses for at least the next 12 months. We believe that we have the ability to fund any operating cash flow shortfall from sales of marketable securities in our investment portfolio maintained at our operating companies and from maturing fixed-income investments. In the event that we are unable to fund excess claim payments and operating expenses through the sale of these marketable securities and from maturing fixed-income investments, we may be required to incur unanticipated capital losses or delays in connection with the sale of less liquid marketable securities held by our financial guaranty business.
Reconciliation of Consolidated Net (Loss) Income to Cash (Used in) Provided by Operations
The following table reconciles consolidated net (loss) income to cash (used in) provided by operations for the years ended December 31, 2008, 2007 and 2006:
With respect to delinquent loans that are in an early stage of delinquency, considerable judgment is exercised as to the adequacy of reserve levels. Adjustments in estimates for delinquent loans in the early stage of delinquency are more volatile in nature than for loans that are in the later stage of delinquency, which generally
Each loan that we insure is identified by product type (i.e., prime, subprime, Alt-A) and type of insurance (i.e. primary or pool) at the time the loan is initially insured. Different product types typically exhibit different loss behavior. Accordingly, our reserve model applies different ultimate default to claim rates and severities to each product type, taking into account the different loss development patterns and borrower behavior that are inherent in these products, as well as whether we are in a first- or second-loss position and whether there are deductibles on the insured loans. We use an actuarial projection methodology called a “roll rate” analysis to determine the projected ultimate default to claim rates for each product and to produce a reserve point for each product. As discussed above, the “roll rate” analysis uses claim payment history for each product to help determine the likelihood that a default will result in a claim and the amount that we will pay if a default becomes a claim. Therefore, the key assumption affecting our methodology is that future ultimate default to claim rates and severities will be consistent with our recent experience.
The following table shows the mortgage insurance range of loss and LAE reserves, and recorded reserves for losses and LAE, as of December 31, 2008 and December 31, 2007:
In the financial guaranty segment, we establish loss reserves on our non-derivative financial guaranty contracts. We establish case and LAE reserves for specifically identified impaired credits that have defaulted and allocated non-specific and LAE reserves for specific credits that we expect to default (case reserves and allocated non-specific reserves combined represent our allocated reserves). In addition, we may establish only an LAE reserve where appropriate for specific credits that we do not expect to default. In the case of directly insured financial guaranty contracts, we determine the existence of payment default and record case reserves when we determine that a default has occurred, based on a report from the insured party or based on our surveillance efforts. For assumed financial guaranty reinsurance contracts, we rely mostly on information provided by the primary insurer as confirmed by us, as well as specific knowledge of the claim, in recording related case reserves. In addition, we record allocated non-specific reserves for losses when we identify through our surveillance procedures or, for assumed reinsurance contracts, after we confirm information provided by the primary insurer regarding specific significant deterioration events that have occurred, with respect to specific insured credits that have not yet defaulted. Allocated non-specific reserves include contracts currently classified as intensified surveillance and special mention. In addition, because we believe that inherent deterioration begins immediately and continues over time on our remaining portfolio, we also record unallocated non-specific reserves for other losses, on a portfolio basis. As discussed below, the reserving policies used by the financial guaranty industry will be impacted by the adoption of SFAS No. 163, “Accounting for Financial Guarantee Insurance Contracts, an interpretation of Financial Accounting Standards Board (“FASB”) Statement No. 60” (“SFAS No. 163”).
(2) Does not include VIE debt of $160.0 million related to NIMS that we were required to consolidate at December 31, 2008.
We record premiums and origination costs related to credit default swaps and certain other derivative contracts in change in fair value of derivative instruments and policy acquisition costs, respectively, on our consolidated statements of operations. In previously reported financial statements prior to 2008, premiums earned on derivative contracts were included in premiums earned on our consolidated statements of operations. In 2008, we reclassified these prior period amounts to be consistent with the 2008 presentation.
We adopted SFAS No. 157 effective January 1, 2008 with respect to financial assets and liabilities measured at fair value. SFAS No. 157 (i) defines fair value, (ii) establishes a framework for measuring fair value in accordance with GAAP, and (iii) expands disclosure requirements about fair value measurements. SFAS No. 157 is effective for all financial statements issued for fiscal years beginning after November 15, 2007 on a prospective basis. There was no cumulative impact on retained earnings as a result of the adoption. In accordance with FASB Staff Position (“FSP”) SFAS No. 157-2, we have elected to defer the effective date of SFAS No. 157 for non-financial assets and non-financial liabilities until January 1, 2009.
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. SFAS No. 157 requires that a fair value measurement 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. In the event that our investments or derivative contracts were sold or transferred in a forced liquidation, the fair values received or paid may be materially different than those determined in accordance with SFAS No. 157.
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 such, U.S government and agency securities are categorized in Level II of the fair value hierarchy.
Money market instruments-The fair value of money market instruments is based on daily prices which are published and available to all potential investors and market participants. As such, these securities are categorized in Level I of the fair value hierarchy.
Hybrid securities-These instruments are convertible securities measured at fair value based on observed trading activity and daily quotes. In addition, on a daily basis, dealer quotes are marked against the current price of the corresponding underlying stock. These securities are categorized in Level II of the fair value hierarchy. For certain securities, the underlying security price may be adjusted to account for observable changes in the conversion and investment value from the time the quote was obtained. Such securities are categorized in Level III of the fair value hierarchy.
We determine the fair value of our derivative assets and liabilities using internally-generated models. We utilize market observable inputs, such as credit spreads on similar products, whenever they are available and relevant. Because we do not expect to pay claims for most of our contracts, we believe this credit spread approach provides us with the best estimate of fair value for these contracts. When a contract experiences significant credit deterioration, and we can estimate expected losses, we utilize a discounted cash flow analysis to estimate fair value. In these instances, we believe a discounted cash flow analysis results in a more accurate estimate of fair value, as it considers reasonably estimable losses associated with the specific contract and, therefore, is more relevant than using a market-based index or credit spread. 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.
The fair value of our put options on CPS 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 our current CDS spread as well as market observations of similar securities issued, when available. The spread differential is typically assumed to be fixed in perpetuity and the annual cost differential is discounted at our current CDS spread, adjusted for a market-implied recovery rate. At December 31, 2008, given the current market environment and the market’s view of our credit risk, we determined that there were no market observations of relevance, and that there is currently no liquidity for these securities. Therefore, based on our assessment that the perpetual preferred securities could not be issued currently at any interest rate, we determined that the current market value of the options is equal to the issuance amount, which is $150 million.
Present Value of Expected Future Contractual Premiums-Our contractual premiums are subject to change for two reasons: (1) all of our contracts provide our counterparties with the right to terminate upon our default and (2) 83% of our corporate CDO transactions (as of December 31, 2008) provide our counterparties with the right to terminate these transactions based on certain rating agency downgrades that have occurred as described in Note 1 of Notes to Consolidated Financial Statements. In determining the expected future premiums of these transactions, we adjust the contractual premiums for such transactions to reflect the estimated fair value of those premiums, based on our estimate of the probability of our counterparties exercising this downgrade termination right and the impact it would have on the remaining expected lifetime premium. The discount rate we use to determine the present value of expected future premiums is our credit default swap spread plus a risk free rate. This discount rate reflects the risk that we may not collect future premiums due to our inability to satisfy our contractual obligations, which provides our counterparties the right to terminate the contracts.
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”);
Third, we adjust the fair premium amount for a typical market participant to account for the difference between the non-performance or default risk of a typical market participant and the non-performance or default risk of a financial guarantor of similar credit quality to us (in each case, we refer to the risk of non-performance as “non-performance risk”).
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, credit default swaps 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 is comprised of 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.
Our corporate CDO transactions possess similar structural features to the standard CDX tranches, but often differ with respect to certain of the referenced corporate entities, term, attachment point and detachment points. Therefore, in order to determine the equivalent risk tranche for each of our corporate CDO transactions, we determine the attachment and detachment points on the CDX index that have comparable estimated probabilities of loss as the attachment and detachment points in our transactions. We begin by performing a simulation analysis of referenced entity defaults in our transactions to determine the probability of portfolio losses exceeding our attachment and detachment points. The referenced entity defaults are primarily determined based on the following inputs: the market observed credit default swap credit spreads of the referenced corporate entities, the correlations between each of the referenced corporate entities, and the term of the transaction.
For each referenced corporate entity in our corporate CDO transactions, the credit default swap 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.
Determining the Typical Fair Premium Amount-The equivalent-risk tranches for our corporate CDO transactions often are not identical to any standard CDX tranches. As a result, fair premium amounts generally are not directly observable from the CDX index for the equivalent-risk tranche and must be separately determined. We make this determination through an interpolation in which we use the observed premium rates on the standard CDX tranches that most closely match our equivalent-risk tranche to derive the typical fair premium amount for the equivalent-risk tranche.
Our non-corporate CDO transactions include our guaranty of RMBS CDOs, CMBS CDOs, Trust preferred securities (“TruPs”) CDOs and CDOs backed by other asset classes such as (i) municipal securities; (ii) synthetic financial guarantees of asset-backed securities (such as auto loan and credit card securities) and (iii) project finance transactions. The fair value of our non-corporate CDO 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 and auto loan 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.
RMBS CDOs-The fair value amounts for our two remaining RMBS CDO transactions are derived using standard market indices and discounted cash flows, to the extent expected losses are estimable. The credit quality of the underlying referenced obligations in one of these transactions is reasonably similar to that which is included in the AAA-rated ABX.HE index, a standardized list of residential mortgage-backed security reference obligations. Accordingly, the fair premium amount for a typical market participant for this transaction is derived directly from the observed spreads of this index. For our second RMBS CDO transaction, the underlying referenced obligations in this transaction have experienced significant credit deterioration, and we expect this deterioration ultimately will result in claims. Fair value for this transaction is determined using a discounted cash flow analysis. We estimate projected claims based on our internal credit analysis which is based on the current performance of each underlying reference obligation, and our estimate of the claim rate associated with the current delinquent loans. The expected cash flows from the underlying reference obligations are then present valued using a discount rate derived from the BBB- ABX.HE index. The insured cash flows are present valued using a discount rate that is equal to our credit default swap rate plus a risk free rate.
CMBS CDOs-The fair premium amounts for our CMBS CDO transactions for a typical market participant are derived directly from the observed spreads on the CMBX indices. The CMBX indices represent standardized lists of commercial mortgage-backed security reference obligations. A different CMBX index exists for different types of underlying referenced obligations based on their various origination periods and credit grades. For each of our CMBS CDO transactions we use the CMBX index that most directly correlates to our transaction with respect to the origination period and credit rating of the referenced obligations included in our transactions. The typical fair premium amount is the expected future fair premiums (determined by the observed index spreads) present valued using a discount rate equal to the credit default swap spread of a typical market participant plus a risk-free rate.
TruPs CDOs-Our TruPs transactions are synthetic CDOs where the underlying referenced obligations are preferred securities of financial institutions consisting primarily of banks and insurance companies whose individual spreads are not observable. In each case, we provide credit protection on a specific tranche of each synthetic CDO. In determining estimated fair values of our TruPs CDO transactions, we use internally-generated models to calculate the fair premium amount for a typical market participant based on the following inputs: our contractual premium rate (which is estimated to be equal to the typical fair premium rate as of the contract date), the estimated
change in the spread of the underlying referenced obligations, the remaining term of the TruPs CDOs and the deterioration (if any) of the subordination. We start with our contractual premium rate and then make an adjustment for the estimated change in the spread of the underlying referenced obligations from inception of the transaction to the current measurement date, as the fundamental underlying relationship between the contractual premium rate and the underlying default risk that existed at the transaction date is assumed to be the primary driver of the fair premium. To determine the spread of the underlying reference obligations, which are not observable, we assume these spreads to be proportional to the weighted average credit default swap spread of a group of investment grade and high yield institutions whose market risk is determined by us to be similar to the specific financial institutions underlying our TruPs. The relationship between the spread on these referenced obligations and the typical fair premium rate on the tranche we insure is then determined based on the historical observed relationship between the spread on the referenced entities of the CDX index and the typical fair premium rate on a senior tranche of the CDX index, because the direct relationship for TruPs CDOs is not observable. A separate adjustment to the fair premium rate is then calculated for each transaction based on its remaining average life. This adjustment accounts for changes in the remaining average life of our transactions and is based on historically observed typical fair premium rates for corporate obligations with similar remaining maturities. A separate adjustment to the typical fair premium rate is then calculated for each transaction based on any deterioration of subordination that has occurred since origination. This adjustment is based on a relationship between subordination and typical fair premium rate for a CDO transaction according to a simulation model. This adjustment is not currently significant to our overall fair value estimate given the significant remaining subordination underlying our deals. The typical fair premium amount is the expected future fair premiums present valued using a discount rate equal to the credit default swap spread of a typical market participant plus a risk-free rate.
For each of the non-corporate CDO and other derivative transactions discussed above, with the exception of the RMBS CDO transaction that is 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 RMBS CDO 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.
The following table quantifies the impact of our non-performance risk on our derivative assets and derivative liabilities (in aggregate by type) 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 used in the valuation of specific derivatives is typically based on the remaining term of the instrument.
The unrealized gain attributable to the market’s perception of our non-performance risk increased significantly during 2008 as presented in the table above. This increase was driven by two separate factors. First, our credit default swap spread widened significantly during the first six months of the year, and when combined with the effect of the implementation of SFAS No. 157 in the first quarter of 2008, had the effect of reducing our fair premium amounts on our derivative contracts to very low absolute levels. Second, the market spreads on the CDX index that we utilize to determine fair premium amounts prior to our non-performance risk adjustment widened from approximately 46 basis points at January 1, 2008 to 206 basis points at December 31, 2008. Because our credit default swap spread is very high, our fair premium amounts have remained low regardless of the changes in the CDX index. Because both CDX index spreads and our credit default swap spreads widened significantly during the year, this resulted in a significant increase in our non-performance risk adjustment. See
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, of changes in common stockholders’ equity and of cash flows present fairly, in all material respects, the financial position of Radian Group Inc. and its subsidiaries (the “Company”) at December 31, 2008 and 2007, and the results of their operations and their cash flows for each of the two years in the period ended December 31, 2008 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the index appearing under Item 15(a)(2) as of and for the year ended December 31, 2008 present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements, financial statement schedules and for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Report on Internal Control over Financial Reporting appearing under Item 9A. Our responsibility is to express opinions on these financial statements, on the financial statement schedules, and on the Company’s internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
March 1, 2007 (March 14, 2008, as to Note A of Schedule II of Item 15)
In our opinion, the 2006 consolidated financial statements referred to above present fairly, in all material respects, the results of operations and cash flows of Sherman Financial Group LLC and subsidiaries for the year ending December, 31, 2006, in conformity with accounting principles generally accepted in the United States of America.
Radian Group Inc. (“Radian Group”) provides, through its subsidiaries and affiliates, credit-related insurance coverage and financial services to mortgage lenders and other financial institutions. Our principal business segments are mortgage insurance, financial guaranty and financial services.
Private mortgage insurance generally protects lenders from all or a portion of default-related losses on residential mortgage loans made to home buyers who make down payments of less than 20% of the home’s purchase price. Private mortgage insurance also facilitates the sale of these mortgages in the secondary market, most of which are sold to Freddie Mac and Federal National Mortgage Association (“Fannie Mae”), collectively referred to as Government Sponsored Enterprises (“GSEs”). Moody’s Investor Service (“Moody’s”) and Standard & Poor’s Rating Service (“S&P”) downgraded the financial strength ratings of our mortgage insurance subsidiaries during 2008 and 2009. Except for the impact on our international mortgage insurance business as discussed below, these downgrades have not had a material impact on our mortgage insurance business and have not had any impact on our eligibility status with the GSEs.
In March 2008, we discontinued writing new insurance on synthetic collateralized debt obligations (“CDOs”) and reduced significantly our structured products operations. This action was based on the deterioration and uncertainties in the credit markets in which we and other financial guarantors participate, which significantly reduced the volume of CDOs and other structured products available for our insurance. Subsequent to this action, in June 2008, S&P and Moody’s downgraded the financial strength ratings of our financial guaranty insurance subsidiaries and in August 2008, S&P again downgraded the financial strength ratings on our financial guaranty insurance subsidiaries. See “Ratings” below. These downgrades, combined with the difficult market conditions for financial guaranty insurance, severely limited our ability to write new, profitable direct financial guaranty insurance and reinsurance both domestically and internationally. Accordingly, in the third quarter of 2008, we decided to discontinue, for the foreseeable future, writing any new financial guaranty business, including accepting new financial guaranty reinsurance, other than as may be necessary to commute, restructure, hedge or otherwise mitigate losses or reduce exposure in our existing portfolio. We initiated plans to reduce our financial guaranty operations, including a reduction of our workforce, commensurate with this decision. We also contributed the outstanding capital stock of Radian Asset Assurance to Radian Guaranty, strengthening Radian Guaranty’s statutory capital. We continue to maintain a large insured financial guaranty portfolio, including a portfolio of insured CDOs.
All but one of our reinsurance customers has the right to take back or recapture business previously ceded to us under their reinsurance agreements with us, and in some cases, in lieu of recapture, the right to increase ceding commissions charged to us. As of December 31, 2008, up to $36.7 billion of our total net assumed par outstanding was subject to recapture. If all of this business was recaptured as of December 31, 2008, we estimate that we would have experienced a reduction in (1) written premiums of approximately $312.8 million, (2) earned premiums of approximately $52.2 million, and (3) the net present value of expected future installment premiums of $142.3 million. In addition, we would have experienced a reduction in incurred losses of up to $94.9 million if this business were recaptured.
our net par outstanding would have been reduced by $38.6 billion, with a corresponding decrease in unearned premium reserves of $12.0 million (of which only $0.4 million would be required to be refunded to counterparties) and the present value of expected future installment premiums of $168.0 million. If all these transactions were terminated, we do not believe it would have a material impact on our financial condition or results of operations.
S&P and Moody’s each rate the financial strength of our insurance subsidiaries. The rating agencies mainly focus on the following factors: capital resources; financial strength; franchise value; commitment of management to, and alignment of stockholder interests with, the insurance business; demonstrated management expertise in our insurance business; credit analysis; systems development; risk management; marketing; earnings volatility; capital markets and investment operations, including the ability to raise additional capital, if necessary; and capital sufficient to meet projected growth and capital adequacy standards. As part of their rating process, S&P and Moody’s test our insurance subsidiaries by subjecting them to a “stress level scenario” in which losses over a stress period are tested against our capital level. Determinations of ratings by the rating agencies also are affected by macroeconomic conditions and economic conditions affecting the mortgage insurance and financial guaranty industries in particular, changes in regulatory conditions, competition, underwriting and investment losses.
The financial strength rating assigned by the rating agencies to an insurance or reinsurance company is based on factors relevant to policyholders and is not intended to protect that company’s equity holders or creditors. A financial strength rating is neither a rating of securities nor a recommendation to buy, hold or sell any security. Financial strength ratings are an indication to an insurer’s customers of the insurer’s present financial strength and its capacity to honor its future claims payment obligations.
Potential adverse effects of Radian Guaranty’s regulatory risk to capital ratio increasing above 25:1 including the possibility that regulators may limit or cause us to cease underwriting new mortgage insurance risk, which 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, 2008 this ratio was 16.4:1;
(2) our ability and intent to exercise our put option to issue $150 million of Radian Asset Assurance preferred stock in 2009; and
(3) renegotiation of our line of credit debt covenants and the reduction of the outstanding balance on our line of credit at December 31, 2008 to $100 million, which significantly reduces the likelihood that covenants will be breached unless actual results differ materially from management’s forecasts.
It is possible that the actual outcome of one or more of management’s plans or forecasts could be materially different, or that one or more of management’s estimates about the potential effects of the risks and uncertainties above or described elsewhere in these financial statements, in particular its estimate of losses, could provide to be materially incorrect. 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.
Credit enhancement fees on derivative contracts are included in the change in fair value of derivative instruments.
exhibit different loss behavior. Accordingly, our reserve model applies different ultimate default to claim rates and severities to each product type, taking into account the different loss development patterns and borrower behavior that are inherent in these products, as well as whether we are in a first- or second-loss position and whether there are deductibles on the insured loans. We use an actuarial projection methodology (called a “roll rate” analysis) to determine the projected ultimate default to claim rates for each product and to produce a reserve point for each product. The roll rate analysis uses claim payment history for each product to help determine the likelihood a default will result in a claim and the amount that we will pay if a default becomes a claim. Therefore, the key assumption affecting our methodology is that future ultimate claim rates and severities will be consistent with our recent experience and expectations.
We establish loss reserves on our financial guaranty contracts based on the estimated cost of settling claims, including associated LAE, adjusted for estimated recoveries under salvage or subrogation rights. Our financial guaranty loss reserves are comprised of allocated reserves (which includes case reserves and allocated non-specific reserves) on specific claims and unallocated non-specific reserves.
We record case reserves for losses and related LAE when a guaranteed obligation defaults. In the case of direct financial guaranty contracts, we determine the existence of payment default and record reserves when we determine that a default has occurred, based on a report from the insured party or based on our surveillance efforts. For assumed financial guaranty reinsurance contracts, we rely mostly on information provided by the primary insurer as confirmed by us, as well as specific knowledge of the claim, in recording related case reserves. In addition, we record allocated non-specific reserves for losses on our direct financial guaranty contracts when we identify through our surveillance procedures that significant deterioration has occurred with respect to specific insured credits that have not yet defaulted. For assumed reinsurance contracts, we record allocated non-specific reserves after we confirm information provided by the primary insurer that significant deterioration has occurred. We refer to these case and allocated non-specific reserves as allocated reserves. Allocated non-specific reserves include contracts classified as intensified surveillance and special mention. In addition, because we believe that inherent deterioration begins immediately and continues over time on our remaining portfolio, we also record non-specific reserves for other losses on a portfolio basis. We refer to this category of non-specific reserves as unallocated non-specific reserves.
Our unallocated non-specific reserves are established over time by applying expected loss ratios to the premiums earned during each reporting period on each credit for which we have not established a case reserve or an allocated non-specific reserve. The expected frequency and severity of losses for each credit is generated from three sources-two that are published by major rating agencies and one that is generated by a proprietary internal model-based on the product class, published rating and term to maturity for each credit. We set the expected life-time losses for each credit at a point in the range between the highest and lowest expected lifetime loss factors generated by the rating agency and internally generated models. The default rates published by rating agencies tend to be very low because we mainly insure investment-grade obligations that, historically, have a very low probability of default. Although the default rate is low, the amount of losses upon default can be very high because we tend to insure large financial obligations. Because of the low incidence of losses on financial guaranty obligations, it is also very difficult to estimate the timing of losses on our insured obligations for which we have not yet established a case reserve or allocated non-specific reserve.
We apply the guidance of SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments” (“SFAS No. 155”) that (i) permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation, (ii) clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS No. 133, (iii) establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation, (iv) clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives and (v) amends SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities” (“SFAS No. 140”) to eliminate the exemption from applying the requirements of SFAS No. 133 on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument.
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.
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 could have a significant effect on the amortization of deferred policy acquisition costs. Total deferred policy acquisition costs for mortgage insurance amortized during 2008, 2007 and 2006 was $89.1 million, $67.8 million and $65.0 million, respectively. As a result of the establishment of a first-lien premium deficiency reserve at June 30, 2008, all deferred policy acquisition costs related to first-lien domestic mortgage insurance written prior to that date were written off.
Assets and liabilities denominated in foreign currencies are translated at year-end exchange rates in accordance with SFAS No. 52, “Foreign Currency Translation” (“SFAS No. 52”). Under SFAS No. 52, 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 current period net income.
sale 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. Amortization and accretion 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.
Our evaluation of market declines for other-than-temporary impairment is based on management’s case-by-case evaluation of the underlying reasons for the decline in fair value. We consider a wide range of factors regarding the issuer of the security and use our best judgment in evaluating the cause of the decline in the estimated fair value of the security and in assessing the prospects for recovery. Inherent in management’s evaluation of the security are assumptions and estimates about the operations of the issuer and its future earnings potential. Considerations used by us in the impairment evaluation process include, but are not limited to: (i) the length of time and the extent to which the market value has been below cost or amortized cost; (ii) the potential for impairments of securities when the issuer is experiencing significant financial difficulties; (iii) the potential for impairments in an entire industry sector or sub-sector; (iv) the potential for impairments in certain economically depressed geographic locations; (v) the potential for impairments of securities where the issuer, series of issuers or industry has suffered a catastrophic type of loss or has exhausted natural resources; (vi) our ability and intent to hold the security for a period of time sufficient to allow for the full recovery of its value to an amount equal to or greater than cost or amortized cost; (vii) unfavorable changes in forecasted cash flows on asset-backed securities; and (viii) other subjective factors, including concentrations and information obtained from regulators and rating agencies.
Effective January 1, 2007, we began classifying securities previously classified as available for sale and the derivative component previously classified as trading securities as hybrid securities. Hybrid securities generally combine both debt and equity characteristics. Prior to 2007, the changes in fair value of the fixed-maturity component of these securities were recorded in our consolidated statements of changes in common stockholders’ equity through accumulated other comprehensive income or loss (net of tax) and the changes in fair value of the derivative component of these securities were recorded as a gain or loss in our consolidated statements of operations. In accordance with SFAS No. 155, effective January 1, 2007, all changes in the fair value of the entire convertible security are now recorded as net gains or losses on securities in our consolidated statements of operations. Our transition adjustment related to the adoption of SFAS No. 155 increased retained earnings at January 1, 2007 by $9.8 million, and reduced accumulated other comprehensive income by the same amount. The transition amount includes unrealized gains of $14.1 million (net of tax) and unrealized losses of $4.3 million (net of tax) related to convertible securities at December 31, 2006.
Property and equipment is carried at cost net of depreciation. For financial statement reporting purposes, computer hardware and software is depreciated over three years, and furniture, fixtures and office equipment is depreciated over seven years. Leasehold improvements are depreciated over the lesser of the life of the asset improved or the life of the lease. For income tax purposes, we use accelerated depreciation methods.
We account for stock-based compensation under SFAS No. 123R, “Share-Based Payment” (“SFAS No. 123R”), which requires compensation cost related to share-based payment transactions to be recognized in an
issuer’s financial statements. The compensation cost, with limited exceptions, is measured based on the grant-date fair value of the equity or liability instrument issued. Compensation cost is recognized over the periods that an employee provides service in exchange for the award. See Note 16 “Equity Compensation and Cash Performance Programs” for further information.
In accordance with Statement of Position 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use,” we capitalize costs associated with internally generated software for certain functions related to our mortgage insurance data warehousing and mortgage insurance contract underwriting. In the fourth quarter of 2006, in conjunction with an evaluation of costs necessary to maintain some of this software, we determined that the replacement costs for this software would be significantly lower than the carrying value of the asset. In accordance with FASB Statement No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS No. 144”), we analyze long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. In order to determine the best estimate of fair value, we obtained vendor quotes for the replacement cost of the software. As a result, we wrote down the capitalized costs of the software by $6.0 million, which is included in other operating expenses on our consolidated statements of operations in 2006.
In October 2008, the FASB issued FSP FAS No. 157-3, “Determining the Fair Value of a Financial Asset When the Market for that Asset is Not Active” (“FSP FAS No. 157-3”). FSP FAS No. 157-3 clarifies the application of SFAS No. 157 in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is not active. FSP FAS No. 157-3 became effective upon issuance, including with respect to prior periods for which financial statements have not been issued. We considered the guidance provided by FSP FAS No. 157-3 in determining the fair value of our financial assets at December 31, 2008 and determined it did not have a significant impact on our consolidated financial statements.
SFAS No. 163 requires that an insurance enterprise recognize a claim liability prior to an event of default (insured event) when there is evidence that credit deterioration has occurred in an insured financial obligation, and when it is expected that the present value of expected claim loss will exceed the unearned premium revenue. The expected loss will be based on the probability-weighted present value of expected net cash outflows to be paid under the contract. In measuring the claim liability, we will develop the present value of expected net cash
In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements, an amendment of Accounting Principles Board (“APB”) No. 51” (“SFAS No. 160”). The objective of SFAS No. 160 is to improve the relevance, comparability, and transparency of the financial information that a reporting entity provides in consolidated financial statements by establishing accounting and reporting standards. These standards require that: (i) the ownership interests in subsidiaries held by parties other than the parent be clearly identified, labeled, and presented in the consolidated statement of financial position within equity, but separate from the parent’s equity; (ii) the amount of consolidated net income attributable to the parent and to the noncontrolling interest be clearly identified and presented on the face of the consolidated statement of operations; (iii) changes in a parent’s ownership interest while the parent retains its controlling financial interest in its subsidiary be accounted for consistently; (iv) when a subsidiary is deconsolidated, any retained noncontrolling equity investment in the former subsidiary be initially measured at fair value; and (v) entities provide sufficient disclosures that clearly identify and distinguish between the interests of the parent and the interests of the noncontrolling owners. SFAS No. 160 is effective for fiscal years beginning on or after December 15, 2008. Management currently is considering the disclosure requirements that may result from the adoption of SFAS No. 160.
We have three reportable segments: mortgage insurance, financial guaranty and financial services. We allocate corporate income and expenses to each of these segments under the terms of our expense-sharing agreements.
Amounts set forth in the table above represent gross unrealized gains and gross unrealized losses on derivative assets and liabilities. Certain contracts are in an asset position because the net present value of the contractual premium exceeds the net present value of the fair premium (See Note 5 “Fair Value of Financial Instruments” below.). The notional value of our derivative contracts at December 31, 2008 and December 31, 2007 was $51.8 billion and $57.7 billion, respectively.
(1) Comprised of fixed-maturities held to maturity ($36.6 million carried at cost) and other invested assets ($21.9 million) accounted for as equity-method investments and not measured at fair value.
(2) Represents consolidated debt issued by the NIMS VIE that required consolidation upon our becoming the primary beneficiary of the VIE.
(3) Excluded from amounts reported are approximately $2.9 million of unrealized losses recorded in the fourth quarter 2008, related to hybrid securities transferred into Level III.
(7) This amount represents the premiums written on CDOs of $40.6 million, as well as a cash settlement of $0.8 million. This amount was offset by $3.8 million, which represents the losses paid on the termination of two policies.
At December 31, 2008, our total Level III assets approximated 3.2% of total assets measured at fair value and our total Level III liabilities accounted for 100% of total liabilities measured at fair value. Realized and unrealized gains and losses on Level III assets and liabilities in the rollforward represent gains and losses for the periods in which they were classified as Level III.
During 2008, we also consolidated certain NIMS transactions which required a reduction of our NIMS derivative liability by $155.9 million and the recognition of VIE debt of $160.0 million and NIMS derivative assets of $4.1 million. During the first half of 2008, we recategorized some of our hybrid securities from Level III to Level II. These were initially categorized as Level III because there was no active market or observable inputs when the securities were initially purchased. These securities have become more frequently traded, which provided observable inputs for our valuation. Realized and unrealized gains and losses on investments and VIE debt included in Level III are generally recorded in net gains (losses) on other financial instruments; unrealized gains and losses of certain RMBS securities included in other investments were reflected in the change in fair value of derivative instruments. Realized and unrealized gains and losses on all other Level III derivative assets and liabilities are recorded in the change in fair value of derivative instruments.
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 such, U.S. government and agency securities are categorized in Level II of the fair value hierarchy.
Asset-Backed Securities (“ABS”), Commercial Mortgage-Backed Securities (“CMBS”) and Collateralized Mortgage Obligations (“CMOs”)-The fair values of ABS, CMBS and CMOs are 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.
Other investments-The fair value of these securities is generally estimated by discounting estimated future cash flows. These securities are categorized in Level II and III of the fair value hierarchy.
Fair value is defined as the price that would be received in connection with the sale of an asset or that would be paid to transfer a liability. In determining an exit market in accordance with SFAS No. 157, we consider the fact that most of our derivative contracts are unconditional and irrevocable, and contractually prohibit us from transferring them to other capital market participants. Accordingly, there is no principal market for such highly structured insured credit derivatives. In the absence of a principal market, we value these insured credit derivatives in a hypothetical market where market participants include other monoline mortgage and financial guaranty insurers with similar credit quality to us, as if the risk of loss on these contracts could be transferred to these other mortgage and financial guaranty insurance and reinsurance companies. We believe that in the absence of a principal market, this hypothetical market provides the most relevant information with respect to fair value estimates.
We determine the fair value of our derivative assets and liabilities using internally-generated models. We utilize market observable inputs, such as credit spreads on similar products, whenever they are available and relevant. Because we do not expect to pay claims for most of our contracts, we believe this credit spread approach provides us with the best estimate of fair value for these contracts. When a contract experiences significant credit deterioration, and we can estimate expected losses, we utilize a discounted cash flow analysis to estimate fair value. In these instances, we believe a discounted cash flow analysis results in a more accurate estimate of fair value, as it considers reasonably estimable losses associated with the specific contract and is, therefore, more relevant than using a market-based index or credit spread. 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.
swap spread widened by 2,429 basis points during 2007 and 2008. 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 and/or estimation methodologies may have a significant effect on the estimated fair value amounts.
payment obligations are secured by pools of CMBS securities. In our CDO of ABS transactions, we insure the timely payment of interest and the ultimate payment of principal of a senior class of notes whose payment obligations are secured by pools of asset-backed securities, predominantly mezzanine-tranches of residential mortgage-backed securities (“RMBS”). CDOs of CLOs are similar to our corporate CDOs except that the obligations for which we are providing credit protection are backed by loans rather than corporate debt securities.
We also insure one multisector CDO that represents a pool of CDOs of several different asset classes. Multisector CDOs can include corporate CDOs, CDOs of CLOs, ABS, CMBS, TruPs and other asset classes. In some circumstances, we have provided credit protection for “second-to-pay” corporate CDOs, TruPs and CLOs in which another monoline financial guaranty insurance company must first default on its primary insurance obligation before we will be required to pay a claim.
NIMS credit derivatives are financial guarantees that we have issued on NIMS. NIMS derivative assets primarily represent derivative assets in the NIMS trusts that we are required to consolidate in accordance with FASB Interpretation No. 46, “Consolidation of Variable Interest Entities (revised)-an interpretation of Accounting Research Bulletin (“ARB”) No. 51” (“FIN 46R”). The estimated fair value on these financial instruments are derived from internally-generated discounted cash flow models. We estimate losses in each securitization underlying either the NIMS credit derivatives or the NIMS derivative assets 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 project prepayment speeds on the underlying collateral in each securitization, incorporating historical prepayment experience. The estimated loss and prepayment speeds 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 credit default swap spread, results in a significant reduction of the derivative liability. Because 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 are categorized in Level III of the fair value hierarchy. As a result of our having to consolidate several NIMS structures, the derivative assets held by the NIMS are also fair valued using the same internally-generated valuation model. The NIMS derivative assets are also categorized in Level III of the fair value hierarchy.
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 SFAS No. 157. The discount rate used to estimate the present value of our contractual premium and fair premium is a risk-free rate plus our own credit default swap spread as of the measurement date. These credit derivatives are categorized in Level III of the fair value hierarchy.
Second, we determine the fair premium amount on the equivalent-risk tranche for those market participants engaged in trading on the CDX index (we refer to each of these participants as a “typical market participant”); and
The CDX index is a synthetic corporate CDO that is comprised of 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.
The amount of the non-performance risk adjustment is computed based, in part, on the expected claim payment by Radian. To estimate this expected claim 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 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 credit default swap spread, and the default probability of the transaction is determined as described above under “Defining the Equivalent Risk Tranche.” The present value of expected claim payments is discounted using a risk free interest rate, as the expected claim payments have already been risk-adjusted.
CMBS CDOs-The fair premium amounts for our CMBS CDO transactions for a typical market participant are derived directly from the observed spreads on the CMBX indices. The CMBX indices represent standardized lists of commercial mortgage-backed security reference obligations. A different CMBX index exists for different types of underlying referenced obligations based on their various origination periods and credit grades. For each of our CMBS CDO transactions we use the CMBX index that most directly correlates to our transaction with respect to the origination period and credit rating of the referenced obligations included in our transactions. The typical fair premium amount is the expected future fair premiums (determined by the observed index spreads) present valued using a discount rate equal to the credit default swap spread of a typical market participant plus a risk free rate.
TruPs CDOs-Our TruPs transactions are synthetic CDOs where the underlying referenced obligations are preferred securities of financial institutions consisting primarily of banks and insurance companies whose individual spreads are not observable. In each case, we provide credit protection on a specific tranche of each synthetic CDO. In determining estimated fair values of our TruPs CDO transactions, we use internally-generated models to calculate the fair premium amount for a typical market participant based on the following inputs: our contractual premium rate (which is estimated to be equal to the typical fair premium rate as of the contract date), the estimated change in the spread of the underlying referenced obligations, the remaining term of the TruPs CDOs and the deterioration (if any) of the subordination. We start with our contractual premium rate and then make an adjustment for the estimated change in the spread of the underlying referenced obligations from inception of the transaction to the current measurement date, as the fundamental underlying relationship between the contractual premium rate and the underlying default risk that existed at the transaction date is assumed to be the primary driver of the fair premium. To determine the spread of the underlying reference obligations, which are not observable, we assume these spreads to be proportional to the weighted average credit default swap spread of a group of investment grade and high yield institutions whose market risk is determined by us to be similar to the specific financial institutions underlying our TruPs. The relationship between the spread on these referenced obligations and the typical fair premium rate on the tranche we insure is then determined based on the historical observed relationship between the spread on the referenced entities of the CDX index and the typical fair premium rate on a senior tranche of the CDX index, because the direct relationship for TruPs CDOs is not observable. A separate adjustment to the typical fair premium rate is then calculated for each transaction based on its remaining average life. This adjustment accounts for changes in the remaining average life of our transactions and is based on historically observed prices for corporate obligations with similar remaining maturities. A separate adjustment to the typical fair premium rate is then calculated for each transaction based on any deterioration of subordination that has occurred since origination. This adjustment is based on a relationship between subordination and typical fair premium rate for a CDO transaction according to a simulation model. This adjustment is not currently significant to our overall fair value estimate given the significant remaining subordination underlying our deals. The typical fair premium amount is the expected future fair premiums present valued using a discount rate equal to the credit default swap spread for a typical market participant plus a risk-free rate.
For each of the non-corporate CDO and other derivative transactions discussed above, with the exception of the RMBS CDO transaction that is valued using a discounted cash flow analysis, we make an adjustment to the fair premium amounts as described above under Non-Performance Risk Adjustment on Corporate CDOs to incorporate our own non-performance risk. The non-performance risk adjustment associated with our RMBS CDO is incorporated in the fair value as described above, therefore no separate adjustment is required.
In making our own estimate of fair value for these credit derivatives, we use information provided to us by our counterparties to these reinsurance transactions, which are the primary insurers (the “primaries”) of the underlying credits, including the primaries’ fair valuations for these credits. The estimated fair value of pooled corporate CDO CDS contracts is based on the primaries’ pricing models that use the Dow Jones CDX for domestic corporate CDS contracts and iTraxx for European corporate CDS contracts. Each index provides price quotes for standard attachment and detachment points for contracts with maturities of three, five, seven and ten
We previously sold protection on residential mortgage-backed securities through credit default swaps. A credit default swap is an agreement to pay our counterparty should an underlying security or the issuer of such security suffer a specified credit event, such as nonpayment, downgrade or a reduction of the principal of the security as a result of defaults in the underlying collateral. In determining the estimated fair value of our mortgage insurance domestic CDS, we use internal models that employ a discounted cash flow methodology. We estimate losses in each securitization by applying expected default rates separately to loans that are delinquent and to those that are current. We then project prepayment speeds on the underlying collateral in each securitization, incorporating historical prepayment experience. The estimated loss and prepayment speeds are used to estimate the cash flows for each underlying securitization, and ultimately, to produce the projected credit losses for each mortgage insurance domestic CDS. In addition to expected credit losses, the fair value for each mortgage insurance domestic CDS is approximated by incorporating future expected premiums to be received from the transaction. These future expected premiums are discounted utilizing a risk adjusted interest rate that is based on the current rating of each transaction. The projected net losses are discounted using a rate of return that incorporates our own non-performance risk, which currently, results in a significant reduction of the derivative liability. The use of different assumptions and/or methodologies could have a significant effect on estimated fair values.
We also wrote credit protection in the form of credit default swaps primarily in two AAA tranches of mortgage-backed securities, one containing German mortgages and one containing Danish mortgages. In determining the estimated fair value of our mortgage insurance international CDS, we use the following information: (1) non-binding fair value quotes from our counterparties on each respective deal, which are based on quotes for transactions with similar underlying collateral from market makers and other broker dealers, and (2) in the absence of observable market data for these transactions, a review of monthly information regarding the performance of the underlying collateral and discussion with our counterparties regarding any unusual or inconsistent changes in fair value. In either case, in the event there are material inconsistencies in the inputs to determine estimated fair value, they are reviewed and a final determination is made by management in light of the specific facts and circumstances surrounding each price. Despite significant volatility in credit spreads during
The unrealized gain attributable to the market’s perception of our non-performance risk increased significantly during 2008 as presented in the table above. This increase was driven by two separate factors. First, our credit default swap spread widened significantly during the first six months of the year, and when combined with the effect of the implementation of SFAS No. 157 in the first quarter of 2008, had the effect of reducing our fair premium amounts on our derivative contracts to very low absolute levels. Second, the market spreads on the CDX index that we utilize to determine fair premium amounts prior to our non-performance risk adjustment widened from approximately 46 basis points at January 1, 2008 to 206 basis points at December 31, 2008. Because our credit default swap spread is very high, our fair premium amounts remain very low regardless of the changes in the CDX index. Because both CDX index spreads and our credit default swap spreads widened significantly during the year, this resulted in a significant increase in our non-performance risk adjustment. If our credit default swap spread were to tighten significantly, and other credit spreads utilized in our fair value methodologies remained constant, our unrealized losses on derivatives would increase significantly.
NIMS VIE debt represents the consolidated NIMS trust obligations that we were required to consolidate in accordance with FIN 46R as of December 31, 2008. See Note 6 “Special Purpose Entities,” for further information. In 2008, we elected in accordance with SFAS No. 159, to record at fair value the consolidated NIMS VIE debt. We elected to fair value these instruments in order to more accurately reflect a value that includes our financial guaranty obligations associated with NIMS. The estimated fair value of NIMS VIE debt is derived from the same internally-generated discounted cash flow models used to estimate fair value of our NIMS derivative liabilities. We estimate losses in each securitization underlying the NIMS credit derivatives by applying expected default rates separately to loans that are delinquent and those that are paying currently. The VIE debt recorded represents our obligation to pay on the NIMS plus the promised cash flows expected to be paid to the NIMS bondholders from the NIMS trust. At December 31, 2008, the face value of our consolidated liability is $275.5 million and includes $14.8 million that has been issued by our consolidated trusts which is not guaranteed by us.
Other Invested Assets-The fair value of other invested assets is based on the present value of the estimated net future cash flows. The carrying value of equity-method investments and cost-method investments approximates fair value.
Long-Term Debt and Other Borrowings-The fair value is estimated based on the quoted market prices for the same or similar issue or on the current rates offered to us for debt of the same remaining maturities.
Non-Derivative Financial Guaranty Liabilities-We estimate the fair value of these non-derivative financial guarantees in accordance with SFAS No. 157 in a hypothetical market where market participants include other monoline mortgage and financial guaranty insurers with similar credit quality to us, as if the net liability related to these insurance contracts could be transferred to these other mortgage and financial guaranty insurance and reinsurance companies.
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 such guarantor as of the measurement date.
With respect to the fair premium amount, SFAS No. 157 requires that the non-performance risk of a financial liability be included in the estimation of fair value. Accordingly, the fair premium amount for financial guarantee insurance contracts includes consideration of our credit quality as represented by our CDS spread. We adopted SFAS No. 157 effective January 1, 2008 and therefore the non-performance risk was not incorporated into the financial guarantee fair value estimate as of December 31, 2007.
The carrying value of our non-derivative financial guaranty liabilities consists of unearned premiums and reserve for losses and LAE as reported on our consolidated balance sheets.
As a provider of credit enhancement, in the normal course of business, we enter into arrangements with SPEs. SPEs are corporations, trusts or partnerships that are established for a limited purpose. SPEs, by their nature, are generally not controlled by their equity owners, as the establishing documents generally govern all material decisions. There are two different accounting frameworks applicable to SPEs: the QSPE framework under SFAS No. 140, and the VIE framework as provided by FIN 46R. The applicable framework depends on the nature of the entity and our involvement with that entity.
As a provider of credit enhancement, SPEs and VIEs are a part of our non-traditional mortgage insurance products as well as our financial guaranty business. Our primary involvement with SPEs relates to transactions in which we provide a financial guaranty to one or more classes of beneficial interest holders in the SPE. Underlying collateral in the SPEs includes residential and commercial mortgages, consumer receivables and other financial assets sold to an SPE and repackaged into securities or similar beneficial interests.
(3) Represents amount paid for interest and the amount paid for the purchase of NIMS bonds we insure, offset by premiums received.
Additional activities are undertaken or assets acquired by the entity that were beyond those anticipated previously.
The entity receives additional equity at risk or curtails its activities in a way that changes the expected returns or losses.
We provide credit enhancement on NIMS bonds. A NIMS bond represents the securitization of a portion of the excess cash flow and prepayment penalties from a mortgage-backed security comprising mostly of subprime mortgages. The majority of this excess cash flow consists of the spread between the interest rate on the mortgage-backed security and the interest generated from the underlying mortgage collateral. On the NIMS bonds that we have provided credit protection, our policy covers any principal and interest shortfalls to the QSPE trust which has issued the bonds. As a QSPE, these structures are exempt from consolidation considerations under FIN 46R. There are, however, certain events and triggers that would require us to reconsider our initial assessment and which may make FIN 46R applicable including:
If one of these criteria is triggered, we would no longer meet the scope exception under FIN 46R. We are required to perform an analysis to identify which entity is considered the primary beneficiary, and determine whether we should consolidate the NIMS. In evaluating whether we are the primary beneficiary of our NIMS transactions we determine whether our variable interest in the NIMS will absorb a majority of its expected losses, a majority of its expected residual returns, or both. In most of our NIMS transactions, we are the first to absorb losses as the guarantor of timely payment of principal and interest. We have determined that we are the primary beneficiary of certain NIMS trusts where we have an option to call the NIMS bonds. These call options exist in all of our NIMS transactions, but become exercisable only upon the occurrence of certain conditional events and defaults that result in claim payments by us.
As of December 31, 2008, the amount included in derivative assets and variable interest entity debt related to the consolidation of NIMS trusts was $4.1 million and $160.0 million, respectively. Although we consolidate the assets and liabilities associated with these VIEs, we have no control over the trust assets and liabilities other than through our call option, if exercisable. The consolidated NIMS assets are treated as derivatives in accordance with SFAS No. 133, and recorded at fair value. The consolidated NIMS VIE debt is recorded at fair value as allowed by SFAS No. 159.
As a risk mitigation initiative, we have purchased, at a discount to par, some of our insured NIMS bonds. The NIMS purchased are accounted for as derivative assets and are recorded at fair value in accordance with SFAS No. 133. Upon purchase, our liability representing the unrealized loss associated with the purchased NIMS is eliminated. The difference between the amount we pay for the NIMS and the sum of the fair value of the NIMS and the eliminated liability represents the net impact to earnings. The overall impact to our consolidated results of operations as a result of these purchases has been immaterial.
There was $438.3 million of risk in force associated with NIMS at December 31, 2008 comprised of 34 transactions. The average expiration of our existing NIMS transactions is approximately three years. At December 31, 2008, 20 of the 34 NIMS transactions required consolidation in our consolidated balance sheets. These 20 NIMS transactions were consolidated due to the trigger event noted in “(a)” above. Our risk in force, excluding interest payments, associated with the consolidated NIMS is approximately $260.7 million at December 31, 2008. We expect, through the passage of time, that additional NIMS will require consolidation due to the triggers noted above. The remaining NIMS transactions are accounted for as derivatives and measured at fair value as discussed in Notes 4 and 5.
We provide credit enhancement in the form of credit default swaps in the international markets and have one international CDS transaction involving a VIE in which we have a significant interest. At December 31, 2008, total exposure to this international CDS transaction was $3.2 billion and our total derivative liability was $14.2 million. We performed an analysis, at inception of our involvement, to determine if we were the primary
beneficiary of this structure. Based on our analysis of expected losses we determined we were not the primary beneficiary because the majority of the VIEs losses were expected to be absorbed by other variable interest holders in the first-loss position.
In September 2003, Radian Asset Assurance completed a transaction for $150 million of CPS, pursuant to which it entered into a series of three perpetual put options on its own preferred stock to Radian Asset Securities Inc. (“Radian Asset Securities”), our wholly-owned subsidiary. Radian Asset Securities in turn entered into a series of three perpetual put options on its own preferred stock (on substantially identical terms to the Radian Asset Assurance preferred stock). The counterparties to the Radian Asset Securities put options are three QSPE trusts. The trusts were created as a vehicle for providing capital support to Radian Asset Assurance by allowing Radian Asset Assurance to obtain immediate access to additional capital at its sole discretion at any time through the exercise of one or more of the put options and the corresponding exercise of one or more corresponding Radian Asset Securities put options.
If the Radian Asset Assurance put options were exercised, Radian Asset Securities, through the Radian Asset Assurance preferred stock thereby acquired, and investors, through their equity investment in the Radian Asset Securities preferred stock, would have rights to the assets of Radian Asset Assurance as an equity investor in Radian Asset Assurance. Such rights would be subordinate to policyholders’ claims, as well as to claims of general unsecured creditors of Radian Asset Assurance, but ahead of ours, through Radian Guaranty, as the owner of the common stock of Radian Asset Assurance. If all the Radian Asset Assurance put options were exercised, Radian Asset Assurance would receive up to $150 million in return for the issuance of its own perpetual preferred stock, the proceeds of which could be used for any purpose, including the payment of claims. Dividend payments on the preferred stock will be cumulative only if Radian Asset Assurance pays dividends on its common stock.
Since these trusts are QSPEs, we are exempt from having to consider consolidation in accordance with FIN 46R.The aggregate fair value of the put options is recorded as a derivative asset, and changes in the fair value of the put options are recorded as a change in fair value of derivatives.
QSPEs may be used to create securities with a unique risk profile desired by investors and as a means of transferring risk, such as our Smart Home transactions. Smart Home transactions reinsure risk associated with non-prime mortgages and riskier products. These arrangements effectively transfer risk from our portfolio to investors in the capital markets. These transactions are structured using QSPEs and therefore as non-transferor we are not required to consolidate them.
We typically retain the risk associated with the first-loss coverage levels, reinsure the middle layer of risk positions through the Smart Home reinsurer and may retain or sell, in a separate risk transfer agreement, the risk associated with the AAA-rated or most remote coverage level. Holders of the Smart Home credit-linked notes bear the risk of loss from losses that would be paid to us under the reinsurance agreement. The Smart Home reinsurer invests the proceeds of the notes in high-quality short-term investments approved by the rating agencies. Income earned on those investments and a portion of the reinsurance premiums that we pay are applied to pay interest on the notes as well as certain of the Smart Home reinsurer’s expenses. The rate of principal amortization of the credit-linked notes is intended to approximate the rate of principal amortization of the underlying mortgages.
Because they are QSPEs, we are exempt from having to consider consolidation of these structures in accordance with FIN 46R. Since August 2004, we have completed four Smart Home reinsurance transactions, with the last of these transactions closing in May 2006. Details of these transactions (aggregated) as of the initial closing of each transaction and as of December 31, 2008 are as follows:
Other. Through Singer Asset Finance Company (“Singer”), a wholly-owned subsidiary of EFSG, we have interests in QSPEs through our servicing agreements with them and through residual interests that we own. These QSPEs hold securitization of assets, including state lottery awards and structured settlement payments which we service. The financial impact as a result of the servicing we perform and the residual interests we hold is not material to our financial results, our financial position or our cash inflows and outflows.
For the years ended December 31, 2008, 2007 and 2006, we did not sell any fixed-maturity investments classified as held to maturity.
The change in unrealized gains and losses recorded in accumulated other comprehensive (loss) income consisted of:
The following table shows the gross unrealized losses and fair value of our investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2008.
The contractual maturity of securities in an unrealized loss position at December 31, 2008 was as follows:
The following table shows the gross unrealized losses and fair value of our investments with unrealized losses that were not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities had been in a continuous unrealized loss position at December 31, 2007.
The following table shows our top ten investment portfolio risk concentrations as of December 31, 2008:
On August 13, 2008, our ownership interest in Sherman increased from 21.8% to 28.7% as a result of the reallocation of the equity ownership of Sherman following a sale by MGIC of its remaining interest in Sherman back to Sherman. As a result of Sherman’s repurchase of MGIC’s interests, which reduced Sherman’s equity, our investment in affiliates decreased by $25.8 million ($16.8 million after taxes) and is reflected as a reduction in our equity.
Historically, C-BASS was engaged as a mortgage investment and servicing company specializing in the credit risk of subprime single-family residential mortgages. As a result of the disruption in the subprime mortgage market during 2007, C-BASS ceased purchasing mortgages and mortgage securities and its securitization activities in the latter part of 2007 and sold its loan servicing portfolio in the fourth quarter of 2007. On July 29, 2007, we concluded that there were indicators that a material charge for impairment of our investment in C-BASS was required under GAAP. In November 2007, we received financial statements from C-BASS as of September 30, 2007, at which point we made a final determination with respect to impairment.
We account for our investment in C-BASS under the equity method of accounting in accordance with APB Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock” (“APB Opinion No. 18”). During the third quarter of 2007, C-BASS incurred a loss of $935 million and in accordance with APB Opinion No. 18, we recognized our portion of losses of approximately $441 million. This resulted in a reduction in our equity investment in C-BASS from $468 million to $27 million at September 30, 2007. In addition to the recognition of losses, we completed an impairment analysis which resulted in the charge-off of the remaining carrying value of $27 million in the equity investment in C-BASS at September 30, 2007.
We and other companies in the mortgage insurance industry participate in reinsurance arrangements with mortgage lenders commonly referred to as “captive reinsurance arrangements.” Under captive reinsurance arrangements, a mortgage lender typically establishes a reinsurance company that assumes part of the risk associated with the portfolio of that lender’s mortgages insured by us on a flow basis (as compared to mortgages insured in structured transactions, which typically are not eligible for captive reinsurance arrangements). In return for the reinsurance company’s assumption of a portion of the risk, we cede a portion of the mortgage insurance premiums paid to us to the reinsurance company. In most cases, the risk assumed by the reinsurance company is an excess layer of aggregate losses that would be penetrated only in a situation of adverse loss development.
The captive reinsurers are typically required to maintain minimum capitalization equal to 10% of the risk assumed. Risk ceded under captive reinsurance arrangements at December 31, 2008, and 2007, was $3.0 billion and $2.8 billion, respectively. For the years ended December 31, 2008, 2007 and 2006, Radian Guaranty had ceded premiums written of $138.7 million, $125.7 million and $96.0 million, respectively, and ceded premiums earned of $138.3 million, $121.6 million and $96.7 million, respectively, under these various first-lien captive reinsurance arrangements. Ceded losses on captive transactions in 2008 and 2007 were $400.7 million and $3.9 million, respectively. For 2006, captive ceded losses were not significant. Approximately 50% of our total ceded losses recoverable at December 31, 2008, is related to one captive reinsurer.
We protect against losses in excess of our expectations on some of the risk associated with non-prime and riskier products by reinsuring this business through Smart Home reinsurance transactions. In 2004, we developed Smart Home as a way to effectively transfer risk from our portfolio to investors in the capital markets. Smart Home mitigates our risk against losses, concentrated positions and riskier products. As a result, Smart Home reinsurance transactions are important in managing our risk profile, especially in the non-prime mortgage market. Approximately 3.7% and 5.3% of our primary mortgage risk in force was ceded through Smart Home reinsurance transactions at December 31, 2008 and 2007, respectively. In these transactions, we reinsure the middle layer risk positions, while retaining a significant portion of the total risk comprising the first-loss and most remote risk positions.
(1) Related to ceded losses on captive reinsurance transactions and Smart Home.
As a result of changes in estimates of losses on defaults in prior years, the provision for losses and LAE in our mortgage insurance business increased by $102.3 million in 2008 and $81.1 million in 2007, and decreased by $117.2 million in 2006. These changes are due to a difference in the actual development of delinquent loans from the estimate at the prior year end. In 2006, the rate of delinquencies going to claim was less than the expected amount due to a strong economy and housing market and a liquid mortgage market. Beginning in the second half of 2007 and throughout 2008, the rate at which delinquencies became claims began to increase substantially in connection with the downturn in the housing and mortgage markets, thereby causing an increase in claims paid and in the loss reserve overall, which included an upward revision of the overall loss reserve on many prior year defaults.
We considered the sensitivity on first-lien loss reserve estimates at December 31, 2008, by assessing the potential changes resulting from a hypothetical parallel shift in severity and default to claim rate. For example, assuming all other factors remain constant, for every one percentage point change in claim severity (28% at December 31, 2008), we estimated that our loss reserves would change by approximately $109 million at December 31, 2008. For every one percentage point change in default to claim rate, (46% of defaults at December 31, 2008), we estimated a $67 million change in our loss reserves at December 31, 2008.
We discount our financial guaranty case reserves, which are included in allocated reserves in the table above. The discount rate corresponds to our statutory investment yield of 4.39% in 2008 and 4.40% in 2007. Discounted liabilities at December 31, 2008 were $53.8 million, net of discounts of $5.1 million, compared to discounted liabilities of $9.2 million, net of discounts of $3.1 million, at December 31, 2007. We do not discount our non-specific reserves (including allocated and unallocated).
The reserve for premium deficiency (“PDR”) in our mortgage insurance business consists of an $86.9 million reserve for second-lien insured loans.
The following tables reconcile our mortgage insurance segment’s beginning and ending reserve for premium deficiency for 2008 and 2007:
Numerous factors affect our ultimate paid claim rates, including home price depreciation, unemployment, loan claim rescission and interest rates, as well as potential benefits associated with recently announced lender and governmental initiatives to modify loans and ultimately reduce foreclosures. To assess the need for a premium deficiency reserve on our first-lien mortgage insurance portfolio, we develop loss projections based on modeled loan defaults in our current risk in force. This projection is based on recent trends in default experience, severity, and roll rates of delinquent loans to claim, as well as recent trends in prepayment speeds. As of December 31, 2008, our modeled loan default projections assume that recent observed increases in defaults will continue into mid-2009, remain stable at this increased level through the end of 2009, and gradually return to normal historic levels over the subsequent two years. If our modeled loan default projections were stressed such that recent observed increases in defaults were to continue until mid-2010, remain stable through the end of 2011, and gradually return to normal historic levels over the subsequent three years, we would require a premium deficiency reserve of $0.5 billion for our first-lien portfolio. We believe this is reasonably possible given the uncertainty inherent in the present market condition.
In 2007, we established a reserve for premium deficiency on our second-lien mortgage insurance business. To calculate the premium deficiency, we project future premiums and losses for our second-lien mortgage insurance 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. During 2008, the second-lien premium deficiency reserve decreased by approximately $108.8 million to $86.9 million. In January 2009, we settled on certain second-lien mortgage insurance transactions, which reduced our risk in force by approximately $209 million to approximately $400 million. The settlement amount was $49.2 million less than our December 31, 2008 reserve amount, and as a result, we reduced our second-lien premium deficiency reserve through the provision for premium deficiency by $49.2 million at December 31, 2008. The net present value of expected losses and expenses on our second-lien business at December 31, 2008 was $240.1 million, offset by the net present value of expected premiums of $16.6 million and already established reserves (net of reinsurance recoverables) of $136.6 million.
The risk management function in our financial guaranty business is responsible for the identification, analysis, measurement and surveillance of credit, market, legal and operational risk associated with our financial guaranty insurance contracts. Risk management is also responsible for claims prevention and loss mitigation strategies. This discipline is applied at both the point of origination of a transaction and during the on-going monitoring and surveillance of each exposure in the portfolio. The risk management function is structured by area of expertise. The department consists of: risk analytics; public finance; structured finance; and portfolio management (each is more fully described below).
Our public finance and structured finance groups utilize several tools to monitor our directly insured portfolio. We require the regular delivery of periodic financial information and in most cases, covenant compliance reports that are reviewed by the risk manager assigned to the particular credit. Each risk manager prepares regular periodic (usually annually or biennially depending on the continued credit quality of the transaction) written surveillance reports for each credit which contain in depth financial analysis of the credits together with the assignment of an internal rating supported by a clearly stated rationale. Observed deterioration in the performance of a credit may prompt additional and more frequent review. Upon continued performance deterioration, the risk manager, in consultation with senior management, may downgrade the internal credit rating for a credit or if appropriate, move the credit to the financial guaranty Watch List. All amendments, consents and waivers related to a transaction are also the primary responsibility of the appropriate risk manager. In addition to individual credit analysis, these teams are responsible for following economic, environmental and regulatory trends and for determining their potential impact on the insured portfolio.
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 individualized 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. An internal management committee considers this analysis in its evaluation of the related risk and other business factors for a proposed transaction in determining the sufficiency of the premium.
Economic capital provides us with a uniform risk measure for analyzing and valuing risk that is consistent across all our insurance business lines. The ability to measure risk in substantially equivalent terms allows us to set Company-wide position limits for our portfolio along all our insurance business lines that take into account both differences in loss probabilities for each credit and also the correlation in loss probabilities across a portfolio of credit exposures.
Slight probability of payment default due to current adverse economic conditions and operating challenges;
Limited capacity for absorbing volatility and uncertainty; vulnerability to further downward pressure which could lead to difficulty in covering future debt obligations; and
Due to the additional efforts involved in monitoring Special Mention credits, consultants and/or counsel may be engaged to assist in claim prevention or loss mitigation strategies. As a result, LAE reserves are occasionally posted for exposures on this list, should such third parties be engaged.
Debtors or servicers with distressed operations that we believe have a questionable ability to continue operating in the future without external assistance from government and/or private third parties;
Requires frequent monitoring and risk management action to prevent and mitigate possible claims; and
Consultants and/or counsel are regularly engaged in connection with these transactions to assist in claim prevention and loss mitigation strategies due to the remediation efforts necessary to prevent or minimize losses. As a result, LAE reserves are regularly posted for these exposures in addition to claim liability reserves.
Case Reserve. This category consists of insured transactions where a payment default on the insured obligation has occurred. LAE reserves are normally required as remediation efforts often continue for credits classified at this level to mitigate claims. Direct and assumed exposures in this category are generally reviewed quarterly. Case reserves are established for all non-derivative transactions on this list.
In our directly insured financial guaranty business, we establish loss and LAE reserves on our non-derivative financial guaranty contracts based upon the recommendation by the risk manager responsible for the transaction. Such recommendations are generally made for Intensified Surveillance and Case Reserve credits. For Intensified Surveillance credits, the risk manager may recommend a reserve if he or she has determined a default is likely and if the severity of loss upon default is quantifiable. Once a default occurs, a case reserve is established that reflects anticipated future claims. The assumptions used to recommend reserves for directly insured credits are based upon the analysis performed by the risk manager as more fully described above. In our financial guaranty reinsurance business, the primary obligation for assessing and mitigating claims rests with the ceding company. We establish reserves for our assumed Watch List credits based upon information provided by the ceding company.
The following table includes additional information as of December 31, 2008 regarding our financial guaranty claim liabilities broken out by the surveillance categories described above:
The composition of our long-term debt and other borrowings at December 31, 2008 and December 31, 2007 was as follows:
We currently have $100 million in principal amount outstanding under our credit facility, which matures in February 2011. We have no unused commitment that we may draw on.
The credit agreement governing our credit facility restricts, among other things, our ability to: incur additional indebtedness; create liens; enter into mergers, consolidations and sales of certain of our assets; make certain investments or other specified restricted payments, including investments in, loans to, or guarantying any obligations of, Radian Asset Assurance (other than with respect to its soft capital program); pay dividends or make distributions in respect of our capital stock in excess of a permitted annual amount (generally equal to our current dividend and subject to certain adjustments); and sell certain of our assets and, in certain circumstances, issue stock. Our credit agreement as amended, no longer has a ratings covenant or debt to capital requirement.
any of our main insurance subsidiaries fails to pay any shared expense reimbursement payment to Radian Group under our expense-sharing arrangements; or
an insurance regulatory authority or other governmental authority voids, terminates, prohibits, suspends or otherwise causes to be invalid or ineffective, any of our expense-sharing arrangements with our subsidiaries.
The reconciliation of taxes computed at the statutory tax rate of 35% for 2008, 2007 and 2006, to the (benefit) provision for income taxes is as follows (in thousands):
Approximately $113.0 million of the net deferred tax asset relates to mark-to-market losses on our financial guaranty derivative instruments, which we expect will result in very limited or no claim payments. We intend to hold these instruments until maturity and believe that the associated DTA will reverse over time as credit spreads relating to these instruments improve as their duration approaches maturity.
As a mortgage guaranty and financial guaranty insurer, we are eligible for a tax deduction, subject to certain limitations, under Section 832(e) of the IRC for amounts required by state law or regulation to be set aside in statutory contingency reserves. The deduction is allowed only to the extent that we purchase non-interest-bearing United States Mortgage Guaranty Tax and Loss Bonds (“T&L Bonds”) issued by the Treasury Department in an amount equal to the tax benefit derived from deducting any portion of our statutory contingency reserves.
We have taken a position in various jurisdictions that we are not required to remit taxes with regard to the income generated from our investment in certain partnership interests. Although we believe that these tax positions are more likely than not to succeed if adjudicated in a court of last resort, measurement under FIN 48 of the potential amount of liability for state and local taxes and the potential for penalty and interest thereon is performed on a quarterly basis. Over the next 12 months, additional income or losses may be generated from these investments, which would require increases or decreases in our calculations of potential state and local taxes, including any penalty and interest thereon. An estimate of the taxable income or loss, the character of such income or loss and its impact to the current income taxes payable over the next 12-month period cannot be reasonably made at this time.
Radian Group acts principally as a holding company for its insurance subsidiaries and does not have any significant operations of its own. Dividends from our insurance subsidiaries and Sherman, permitted payments to Radian Group under tax- and expense-sharing arrangements with our subsidiaries, along with income from our investment portfolio are Radian Group’s principal sources of cash to pay stockholder dividends and to meet its obligations. Radian Group’s principal liquidity demands include funds for: (i) the payment of dividends on our common stock, (ii) the payment of certain corporate expenses (which are fully reimbursed through expense-sharing arrangements with our subsidiaries), (iii) interest payments on our outstanding long-term debt and borrowings under our credit facility (which are fully reimbursed through expense-sharing arrangements with our subsidiaries), (iv) payments to our insurance subsidiaries under our tax-sharing agreement, and (v) potential capital support for our insurance subsidiaries. The payment of dividends and other distributions to us by our insurance subsidiaries are limited by insurance laws and regulations. In general, dividends in excess of prescribed limits are deemed “extraordinary” and require insurance regulatory approval. In addition, although we have expense-sharing arrangements in place with our principal operating subsidiaries that require those subsidiaries to pay their share of holding company-level expenses, including interest expense on long-term debt and other borrowings, the applicable state insurance departments that approved these arrangements may change their approval at any time. Further, any changes to these expense-sharing arrangements must be approved by the administrative agent to our credit facility. In addition, our insurance subsidiaries’ ability to pay dividends to us, and our ability to pay dividends to our stockholders, is subject to various conditions imposed by the GSEs and rating agencies. Dividends from Sherman are not subject to regulatory conditions, but to the extent received, must be used to pay down outstanding amounts under our credit facility if such amounts exceed our tax obligations resulting from our equity ownership of Sherman. If the cash we receive from our subsidiaries pursuant to tax- and expense-sharing arrangements and/or Sherman is insufficient for us to fund our obligations, we may be required to seek capital by incurring additional debt, by issuing additional equity or by selling assets, which we may be unable to do on favorable terms, if at all. In addition, we are required to repay amounts outstanding under our credit facility with any amounts we raise through the issuance of securities (e.g., debt, equity or hybrid securities) or the sale of certain of our assets, including Sherman. If required, there can be no assurance that we will be successful in raising additional capital.
Radian Guaranty’s and Radian Insurance’s ability to pay dividends on their common stock is restricted by certain provisions of the insurance laws of Pennsylvania, their state of domicile. Under Pennsylvania’s insurance laws, dividends and other distributions may only be paid out of an insurer’s positive unassigned surplus, measured as of the end of the prior fiscal year, unless the Pennsylvania Insurance Commissioner approves the payment of dividends or other distributions from another source. Radian Guaranty and Radian Insurance had negative unassigned surplus at December 31, 2008 of $735.8 million and $423.5 million, respectively. In addition, in the event an insurer had positive unassigned surplus as of the end of the prior fiscal year, without the prior approval of the Pennsylvania Insurance Commissioner, the insurer only may pay dividends or other distributions during any 12-month period in an aggregate amount less than or equal to the greater of (i) 10% of the preceding year-end statutory policyholders’ surplus, or (ii) the preceding year’s statutory net income. In accordance with this test, no amounts would be available for dividends from Radian Guaranty or Radian
Amerin Guaranty’s ability to pay dividends on its common stock is restricted by certain provisions of the insurance laws of Illinois, its state of domicile. The insurance laws of Illinois establish a test limiting the maximum amount of dividends that may be paid from positive unassigned surplus by an insurer without prior approval by the Illinois Insurance Commissioner. Under this test, Amerin Guaranty may pay dividends during any 12-month period in an aggregate amount less than or equal to the greater of (i) 10% of the preceding year-end statutory base capital and surplus, or (ii) the preceding year’s statutory net income. In accordance with this test, Amerin Guaranty would not be able to pay a dividend in 2009 without prior regulatory approval.
Radian Asset Assurance’s ability to pay dividends is restricted by certain provisions of the insurance laws of New York, its state of domicile. Under the New York insurance laws, Radian Asset Assurance may only declare or distribute dividends from earned surplus. Unless the company has prior approval from the New York Superintendent of Insurance, the company can only pay a dividend, which when totaled with all other dividends declared or distributed by it during the preceding 12 months, is the lesser of 10% of its surplus to policyholders as shown by its last statement on file with the Superintendent of Insurance, or 100% of adjusted net investment income. During 2008, Radian Asset Assurance declared an ordinary dividend of $107.5 million to Radian Group, which was subsequently contributed to Radian Guaranty. In addition, Radian Group contributed its equity interest in Radian Asset Assurance to Radian Guaranty in the latter part of 2008. This restructuring provided significant, regulatory capital credit to Radian Guaranty and is intended to provide cash dividends to Radian Guaranty over time. At December 31, 2008, Radian Asset Assurance did not have any funds available for dividends. Based upon our current projected statutory net income and policyholders’ surplus, we currently expect Radian Asset Assurance to pay an ordinary dividend of approximately $90 million to Radian Guaranty during 2009.
RAAL’s ability to pay dividends to Radian Asset Assurance is restricted by legal provisions in the United Kingdom whereby it may only distribute by way of dividend its accumulated realized profits (not previously distributed) less accumulated realized losses, and such dividends may not be paid out of capital. At December 31, 2008, the maximum amount available for distribution was $43.1 million.
The Financial Services Authority (“FSA”) requires insurance companies to maintain minimum capital, calculated with reference to gross written premiums. RAAL’s equity shareholder’s funds and statutory policyholders’ surplus as of and for the years ended December 31 was as follows:
In March 2008, Radian Group contributed $15 million to Amerin Guaranty.
New York insurance law requires financial guaranty insurers to maintain minimum policyholders’ surplus of $65 million. When added to the minimum policyholders’ surplus of $1.4 million separately required for the other lines of insurance that it is licensed to write, our financial guaranty insurance subsidiaries are required to have an aggregate minimum policyholders’ surplus of $66.4 million. Radian Asset Assurance statutory net income, statutory policyholders’ surplus and contingency reserve as of and for the years ended December 31 was 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 any single risk, net of reinsurance and collateral, is limited to 75% of the insurer’s policyholders’ surplus and contingency reserves. Additional single risk limits, which generally are more restrictive than the municipal bond single risk limit, are also specified for several other categories of insured obligations.
If any third party were to acquire beneficial ownership of 20% or more of our outstanding common stock under the 1995 Equity Plan (40% or more of our outstanding common stock under the 2008 Equity Plan), a significant portion of the equity issued under the Equity Plans would become fully vested and transferable. We estimate that this would result in a pre-tax accounting charge to us of approximately $26.1 million, representing an acceleration of compensation expense under SFAS No. 123R. At December 31, 2008, our largest single stockholder owned approximately 14.3% of our outstanding common stock.
We use the Black-Scholes model in determining the fair value of stock-based compensation issued to employees and directors. The fair value of the stock options granted was estimated using this model on the date of grant using the assumptions noted in the following table for options granted in that year:
(1) In 2008, the expected life of stock options granted was the stock option term. In 2006 and 2007, as allowed under SFAS No. 123R, the expected life of stock options granted was based on the simplified method.
(3) Volatility determined at the date of grant using historical or future share price volatility and expected terms until exercise.
Unless otherwise specified, each outstanding option vests ratably over three to four years, beginning one year after the date of grant. As long as the grantee is still employed by Radian Group or its participating affiliates or serving as a director of Radian Group, if not sooner vested by its terms, each option fully vests upon the earliest of:
There were no stock options exercised in 2008. The amount of cash received from the exercise of stock options for the year ended December 31, 2007 was approximately $25.3 million, and the related tax benefit was approximately $8.9 million. The total intrinsic value of options exercised, at the date of exercise, during the year ended December 31, 2007, was $18.9 million. The total intrinsic value of options outstanding at December 31, 2008 was immaterial.
The following table summarizes information concerning outstanding and exercisable options at December 31, 2008:
We granted, under the Equity Plans, 170,400 shares of restricted stock during 2008, and 615,970 shares of restricted stock under the 1995 Equity Plan during 2007, in the case of each grant, vesting over three to four years. Other than the restrictions discussed above, the holders of restricted stock have all the rights of a common stockholder including the right to vote the share and the right to receive cash dividends.
Under the provisions of SFAS No. 123R, the recognition of deferred compensation as a separate line item on the consolidated balance sheets is no longer required. Therefore, in 2006, the amount that had been included in “deferred compensation” in the consolidated balance sheets at December 31, 2005 was reclassified to additional paid-in capital. The amount recorded as stock-based compensation expense related to restricted stock for the years ended December 31, 2008, 2007 and 2006 was $6.3 million, $7.0 million and $1.4 million, respectively. The amount recorded in 2008 and 2007, is net of $1.1 million and $3.6 million, respectively, deferred as policy acquisition costs. There were no amounts deferred for 2006.
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 phantom stock may be subject to further vesting restrictions as the Compensation Committee determines. 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 granted to directors in 2008 under the 2008 Equity Plan vest over a period of three years (or earlier upon a director’s normal or early 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 December 31, 2008, there were approximately 2,223 dividend-equivalent phantom stock shares accrued that were not included in the total number of outstanding shares. The amount recorded as stock-based compensation expense related to phantom stock for the years ended December 31, 2008, 2007 and 2006 was $0.7 million, $(3.4) million and $1.2 million, respectively. The negative expense in 2007 relates to the reversal of previously recorded expense due to declines in the market price of our common stock during 2007.
Changes in our phantom stock under the Equity Plans were as follows:
We have a Performance Share Plan (the “Performance Program”). The Performance Program is intended to motivate our executive officers by focusing their attention on critical financial indicators that measure our success. In the past, the performance share awards granted pursuant to the Performance Program were funded by grants of phantom stock under the 1995 Equity Plan. The Compensation Committee has granted performance share awards to eligible participants with respect to performance periods of overlapping durations. Both the first and second performance periods under the Performance Program were three-year periods that began on January 1, 2005 and January 1, 2006, respectively and ended on December 31, 2007 and December 31, 2008, respectively.
The phantom stock grants that were used to fund the performance shares were denominated in shares of common stock and were to be settled in common shares. Each performance share award becomes payable at the target amount multiplied by a factor (between 0% and 200%) depending on our growth in earnings per share, growth in adjusted book value and return on equity over the performance period. For the first and second performance periods, one third of each award was based on each of the three metrics, and each metric was measured both on an absolute basis and relative to a group of our peers. The maximum payout under any performance share award is 250,000 shares of common stock. There was no stock-based compensation expense related to performance shares for 2008 as no payout was required. The amount of stock-based compensation expense related to performance shares for the years ended December 31, 2007 and 2006, was $(3.6) million and $3.2 million, respectively. The negative expense in 2007 relates to the reversal of previously recorded expense due to declines in performance metrics.
A new employee stock purchase plan (the “2008 ESPP Plan”) was approved by our board of directors in December 2008 and will be proposed for stockholder approval at our 2009 Annual Meeting of Stockholders. A total of 2,000,000 shares of our authorized but unissued common stock have been made available under the 2008 ESPP Plan.
The following are assumptions used in our calculation of ESPP compensation expense during 2008:
In July 2008, our board of directors adopted a new long-term incentive cash program, the Radian Group Inc. 2008 Long-Term Performance Cash Plan (the “Officer LTI Plan”). Eligibility under the Officer LTI Plan is limited to certain officers and advisors of Radian Group and our mortgage insurance subsidiaries. Participants in the Executive LTI Plan (as defined and discussed below) do not participate in the Officer LTI Plan.
We maintained a noncontributory defined benefit pension plan (the “Pension Plan”) covering substantially all of our full-time employees. Effective December 31, 2006, we (1) froze all benefits accruing under the Pension Plan and (2) suspended all forms of participation under the Pension Plan. Prior to the suspension, all salaried and hourly employees of Radian Group and its participating subsidiaries were eligible to participate in the Pension Plan upon attaining 20-1/2 years of age and one year of eligible service. We recorded a curtailment loss of approximately $370,000 in 2006 as a result of the freezing of the Pension Plan.
The Pension Plan suspension was aimed at preparing for the future termination of the Pension Plan, and reflects a broader reliance on the Radian Group Inc. Savings Incentive Plan (the “Savings Plan”) as the primary
We terminated the Radian Group Inc. Supplemental Executive Retirement Plan (the “SERP”) effective December 31, 2006, and adopted a new nonqualified restoration plan (the “Benefit Restoration Plan” or “BRP”), effective January 1, 2007. The BRP is intended to provide additional retirement benefits to each of our employees who is eligible to participate in the Savings Plan and whose benefits under the Savings Plan are limited by applicable IRS limits on eligible compensation.
In addition, we surrendered certain of the split-dollar life insurance policies used to finance the SERP. Each participant in the SERP received an initial balance in the BRP equal to the present value of the participant’s SERP benefit as of January 1, 2007. As of December 31, 2008, we had $6.5 million of split-dollar life insurance policies outstanding.
The assumed discount rate for each of our benefit plans is based on assumptions intended to estimate the actual termination liability of the plan. The discount rate is a composite rate used to approximate the actual termination liability comprised of lump sum payments and an annuity purchase.
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. 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, 2008, 2007 and 2006 was $4.1 million, $5.0 million and $2.9 million, respectively.
Our board of directors approved changes to the Savings Plan, effective January 1, 2007, including among other things, to:
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.
The plans are not funded and the amounts deferred are not segregated from our general assets. Accordingly, participants in each plan are general unsecured creditors of Radian Group with respect to the amounts due under the plans. The amount recorded as deferred compensation expense for the years ended December 31, 2008, 2007 and 2006 was $(1.2) million, $(3.3) and $1.9 million, respectively.
fiscal year that arise from delayed recognition of the gains or losses, prior service costs or credits, and transition asset or obligation.
The implementation of SFAS No. 158 did not have a significant impact on our financial statements due to the curtailment of the Pension Plan and the SERP. Under SFAS No. 158, we are required to recognize net periodic cost in accumulated other comprehensive income; however, the curtailment impact offset most of our other comprehensive income adjustment. The following table shows the effect of SFAS No. 158 on our consolidated balance sheets as of the periods specified:
The following table shows the effect of SFAS No. 158 on accumulated other comprehensive income as of December 31, for the periods specified:
The funded status of the Pension Plan, BRP and the Postretirement Welfare Plan for the periods stated were as follows:
The accumulated benefit obligation at December 31, 2008 for the BRP was $1.0 million. The accumulated benefit obligation at December 31, 2007 for the Pension Plan/BRP was $36.6 million. The unfunded amount is recorded in accounts payable and accrued expenses for both periods indicated.
For 2007, the selected long-term rate on assets (6.00%) was principally based on the allocation of the Pension Plan’s assets prior to its termination (approximately 60% equities and 40% fixed-income investments) coupled with the actual expected returns provided by our investment advisor by asset type. This assumption is a long-term assumption that has been in place for many years. We have periodically reviewed our assumptions against various capital market simulations to assure that our assumptions remain reasonable.
We expect to contribute nominal amounts to Radian Group’s and EFSG’s other postretirement benefit plans in 2009. Due to the nature of the Postretirement Welfare Plan, no increase is assumed in our obligation due to any increases in the per-capita cost of covered healthcare benefits.
As previously disclosed, in August and September 2007, two purported stockholder class action lawsuits, Cortese v. Radian Group Inc. and Maslar v. Radian Group Inc., were filed against Radian Group and individual defendants in the U.S. District Court for the Eastern District of Pennsylvania. The complaints, which are substantially similar, allege that we were aware of and failed to disclose the actual financial condition of C-BASS prior to our declaration of a material impairment to our investment in C-BASS. On January 30, 2008, the Court ordered that the cases be consolidated into In re Radian Securities Litigation and appointed the Institutional Investors Iron Workers Local No. 25 Pension Fund (“Iron Workers”) and the City of Ann Arbor Employees’ Retirement System (“Ann Arbor”) Lead Plaintiffs in the case. On April 16, 2008, a consolidated and amended complaint was filed, adding one additional defendant. On June 6, 2008, we filed a motion to dismiss this case, and on December 19, 2008, oral arguments were held on this motion. We are currently awaiting a final ruling on this motion. While it is still very early in the pleadings stage, we do not believe that the allegations in the consolidated cases have any merit.
In April 2008, a purported class action lawsuit was filed against Radian Group, the Compensation and Human Resources Committee of our board of directors and individual defendants in the U.S. District Court for the Eastern District of Pennsylvania. The complaint alleges violations of the Employee Retirement Income Securities Act as it relates to our Savings Incentive Plan. The named plaintiff is a former employee of ours. On July 25, 2008, we filed a motion to dismiss this case. The court heard our motion to dismiss on December 19, 2008, and we are awaiting a final ruling. We believe that the allegations are without merit, and intend to defend against this action vigorously.
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, Deutsche Bank National Trust Company, Financial Guaranty Insurance Company (“FGIC”), AMBAC Assurance Corporation and MBIA Insurance Corporation 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 are alleging 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 is approximately $77 million. We have established loss reserves equal to the total amount of our exposure to these transactions. IndyMac and the Federal Deposit Insurance Corporation, which now controls IndyMac, have obtained a stay of this action until March 15, 2009.
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 $22.3 million as of December 31, 2008. In addition, in the event of a change of control under our existing cash-based incentive plans, we would be required to pay approximately $11.0 million as of December 31, 2008.
As part of the non-investment-grade allocation component of our investment program, we have committed to invest $55.0 million in alternative investments ($20.9 million of unfunded commitment at December 31, 2008) that are primarily private equity securities. These commitments have capital calls over a period of at least the next six years, and certain fixed expiration dates or other termination clauses.