We currently have a co-location agreement with Xand that supports data center space and services. Xand serves as a production and disaster recovery location in Audubon, Pennsylvania. This agreement expires June 2015.
Diluted net (loss) income per share and average share information in accordance with the accounting standard regarding earnings per share.
We provide mortgage insurance on First-liens and products and services to the mortgage and real estate industries. We currently have two business segments-mortgage insurance and MRES. Our mortgage insurance segment provides credit-related insurance coverage, principally through private mortgage insurance, to mortgage lending institutions. We conduct our mortgage insurance business primarily through Radian Guaranty, our principal mortgage insurance subsidiary. Our MRES segment provides services and solutions to the mortgage and real estate industries primarily through Clayton, which we acquired on June 30, 2014. See “Recent Developments-Acquisition of Clayton” below for more information.
Operating Environment. As a seller of mortgage credit protection and mortgage and real estate products and services, our results are subject to macroeconomic conditions and specific events that impact the mortgage origination environment and the credit performance of our underlying insured assets. The financial crisis and the downturn in the housing and related credit markets that began in 2007 had a significant negative impact on the operating environment and results of operations for our businesses. More recently, the operating environment has improved as the U.S. economy and housing market have been recovering, evidenced by a reduction in unemployment, a reduction in foreclosures, and appreciation in home prices. We have written a significant amount of NIW in this improving environment, which has resulted in our Legacy Portfolio becoming a smaller proportion of our total mortgage insurance portfolio. Further, the improving environment has contributed to a reduction in our incurred losses and claims submitted and paid in our mortgage insurance business, with new primary mortgage insurance defaults declining by 18% in 2014 compared to the number of new defaults in 2013.
The credit performance of post-crisis loan originations also has improved significantly. In response to the financial crisis, including the adoption of new lending laws and regulations, credit for home financing has remained restrictive, and post-2008 loan originations have consisted primarily of high credit quality loans. At the same time, this restrictive credit environment has limited the growth of the mortgage industry and made it more challenging for many first-time home buyers to finance a home.
Loan Review/Due Diligence-Loan-level due diligence for various asset classes and securitizations, with a primary focus on the mortgage and RMBS markets, utilizing skilled professionals and proprietary technology, with offerings focused on credit underwriting, regulatory compliance and collateral valuation;
Component Services-Outsourced solutions offered through Clayton’s subsidiary, Green River Capital, focused on the single family rental market, including valuations, property inspections, title reviews, lease reviews, tax lien reviews and due diligence reviews for single family rental properties;
On September 16, 2014, Radian Guaranty entered into the BofA Settlement Agreement. The consent of the GSEs required to implement the BofA Settlement Agreement was received in December 2014, and implementation of the agreement for Subject Loans owned by the GSEs or held in portfolio by the Insureds commenced on February 1, 2015.
In light of the proposed PMIERs, which, in their current form, would not provide Radian Guaranty with any credit for its investment in Radian Asset Assurance, we pursued alternatives to monetize Radian Asset Assurance. In July 2014, upon receipt of approval from the NYSDFS, Radian Asset Assurance declared and paid an Extraordinary Dividend of $150 million to Radian Guaranty. See Note 14 of Notes to Consolidated Financial Statements for information regarding the impact of the Extraordinary Dividend on Radian Asset Assurance’s claims paying resources and statutory capital.
NIW. NIW is affected by the overall size of the mortgage origination market, the penetration percentage of private mortgage insurance into the overall mortgage origination market and our market share of the private mortgage insurance market. The overall mortgage origination market is influenced by macroeconomic factors such as household composition, home affordability, interest rates, housing markets in general, credit availability and the impact of various legislative and regulatory actions that may influence the housing and mortgage finance industries. The penetration percentage of private mortgage insurance is mainly influenced by the competitiveness of private mortgage insurance on GSE conforming loans compared to FHA insurance, and the relative percentage of mortgage originations that are for purchased homes versus refinances. Typically, private mortgage insurance penetration is significantly higher on new mortgages for purchased homes than on the refinance of existing mortgages because average LTV ratios are higher on home purchases and therefore are more likely to require mortgage insurance. Radian Guaranty’s share of the private mortgage insurance market is influenced by competition in that market and our ability to maintain or grow existing levels of new mortgage originations from our current customers and expand our customer base. We compete with other private mortgage insurers on the basis of price, terms and conditions, customer relationships, reputation, perceived ability to comply with applicable capital and other financial strength requirements and overall service. Service-based competition includes effective and timely delivery of products, timeliness of claims payments, training, loss mitigation efforts and management and field service expertise.
Premiums. The premium rates we charge for our insurance are based on a number of borrower, loan and property characteristics. Premiums on our mortgage insurance products are paid as a Monthly Premium, a Single Premium, as a combination of up-front premium at origination plus a monthly renewal, or in some cases, as an annual or multi-year premium.
The Freddie Mac Agreement established certain terms for the treatment of the loans subject to that agreement, including claim payments, Loss Mitigation Activity and insurance coverage, and capped Radian Guaranty’s claim exposure on such loans. See Note 10 of Notes to Consolidated Financial Statements for additional information.
Other Operating Expenses. Our other operating expenses are affected by both the level of NIW, as well as the level of RIF. Additionally, in recent periods, our operating expenses have been impacted significantly by compensation expense associated with changes in the estimated fair value of certain of our long-term equity-based incentive awards that are settled in cash. The fair value of these awards, and associated compensation expense, is dependent, in large part, on our stock price at any given point in time. Certain corporate income and expenses that were previously allocated to the financial guaranty segment but were not reclassified to discontinued operations, such as investment income, interest expense and corporate overhead expenses, have been reallocated to the mortgage insurance segment.
Services Revenue. Our services revenue is primarily derived from: (i) loan review and due diligence services; (ii) surveillance services, including RMBS surveillance, loan servicer oversight, loan-level servicing compliance reviews and operational reviews of mortgage servicers and originators; (iii) component services providing outsourcing solutions for the single family rental market; and (iv) REO asset management services.
Access to Radian Guaranty’s mortgage insurance customer base may provide additional opportunities to expand the segment’s existing customers. However, an unexpected loss of a major customer could significantly impact the level of services revenue. Generally, our contracts do not contain volume commitments and may be terminated by clients at any time.
In this segment, we generate revenue under three basic types of contracts:
Fixed-Price Contracts. Under a fixed-price contract, we agree to perform the specified work for a pre-determined per-unit or per-file price. To the extent our actual direct and allocated indirect costs decrease or increase from the estimates upon which the price was negotiated, we will generate more or less profit, respectively, or could incur a loss. We use fixed-price contracts in our component services and our loan review and due diligence services. These contracts are also used in our surveillance business for our servicer oversight services and RMBS surveillance services, as well as in our REO management business.
Operating Expenses. Our operating expenses primarily consist of salaries and benefits not classified as direct cost of services because they are related to employees, such as sales and corporate employees, that are not directly involved in providing client services. Operating expenses also include other selling, general and administrative expenses, depreciation, as well as allocations of corporate general and administrative expenses.
Previously, Radian Asset Assurance had represented substantially all of the financial guaranty segment. Radian Asset Assurance provided direct insurance and reinsurance on credit-based risks. As of December 31, 2014, Radian Asset Assurance had an aggregate of $10.0 billion of public finance statutory net par outstanding and $8.1 billion of structured finance statutory net par outstanding. Since January 1, 2015, one counterparty has exercised its right to terminate seven AAA-rated corporate collateralized debt structured finance obligations on a walkaway basis (meaning that our counterparty was not obligated to pay any unaccrued premium or other amount to terminate the transaction), reducing Radian Asset Assurance’s structured finance statutory net par outstanding by $3.8 billion.
As a result of the Radian Asset Assurance Stock Purchase Agreement, we have reclassified the operating results related to the pending disposition as discontinued operations, and we are no longer reporting a financial guaranty business segment. The assets and liabilities associated with the discontinued operations have historically been a source of significant volatility to Radian’s results of operations, due to various factors including fluctuations in fair value and credit risk. Although closing under the Radian Asset Stock Purchase Agreement is subject to conditions, the purchase price is not subject to adjustment based on Radian Asset Assurance’s results of operations, changes in valuation or market conditions occurring after December 31, 2014 through the closing date. Therefore, assuming satisfaction of the closing conditions, which we expect will be satisfied, the financial results of Radian Asset Assurance are not expected to have an impact on Radian’s financial condition or results of operations after December 31, 2014. See “Item 1A. Risk Factors-Failure to complete the sale of Radian Asset Assurance pursuant to the Radian Asset Assurance Stock Purchase Agreement could negatively impact our business and our financial condition, and could adversely impact our ability to comply with the PMIERs Financial Requirements.” For additional information related to discontinued operations, see Note 3 of Notes to Consolidated Financial Statements.
Net Gains (Losses) on Investments. The recognition of realized investment gains or losses can vary significantly across periods as the activity is highly discretionary based on such factors as market opportunities, our tax and capital profile and overall market cycles that impact the timing of the sales of securities. Unrealized investment gains and losses arise primarily from changes in the market value of our investments that are classified as trading and these unrealized gains and losses are generally the result of interest rates or market credit spreads and may not necessarily result in economic gains or losses.
In addition to amounts previously allocated to the financial guaranty segment, we allocate corporate expenses to our mortgage insurance segment based on an allocated percentage of time spent on the mortgage insurance segment. In addition, we have allocated all corporate cash and investments to our mortgage insurance segment, as well as all interest expense other than the expense related to the Senior Notes due 2019.
Net Income (Loss) from Continuing Operations. As discussed in more detail below, our results for 2014 compared to 2013 primarily reflect: (i) a reversal of substantially all of our deferred tax valuation allowance; (ii) a significant reduction in the provision for losses; (iii) net gains on investments as compared to net losses in 2013; and (iv) an increase in net premiums earned. Our results for 2013 compared to 2012 reflect: (i) a significant decrease in the provision for losses; and (ii) an increase in net premiums earned, partially offset by: (iii) net losses on investments as compared to net gains in 2012; and (iv) an increase in other operating expenses and interest expense. See “-Results of Operations-Mortgage Insurance” for more information on our provision for losses, net premiums earned, operating expenses and interest expense.
Loss from Discontinued Operations, Net of Tax. Based upon the Radian Asset Assurance Stock Purchase Agreement, Radian Asset Assurance met the criteria to be accounted for as held for sale and discontinued operations at December 31, 2014. As a result, in the fourth quarter of 2014, we recognized a $467.5 million pre-tax impairment charge reported as loss from discontinued operations. We have also reclassified the related operating results as discontinued operations for all periods presented in our consolidated statements of operations. No general corporate overhead or interest expense was allocated to discontinued operations.
The assets and liabilities associated with the discontinued operations have historically been a source of significant volatility to Radian’s results of operations, due to various factors including fluctuations in fair value and credit risk. Although closing under the Radian Asset Stock Purchase Agreement is subject to conditions, the purchase price is not subject to adjustment based on Radian Asset Assurance’s results of operations, changes in valuation or market conditions occurring after December 31, 2014 through the closing date. Therefore, assuming satisfaction of the closing conditions, which we expect will be satisfied, the financial results of Radian Asset Assurance are not expected to have an impact on Radian’s financial condition or results of operations after December 31, 2014. See “Item 1A. Risk Factors-Failure to complete the sale of Radian Asset Assurance pursuant to the Radian Asset Assurance Stock Purchase Agreement could negatively impact our business and our financial condition, and could adversely impact our ability to comply with the PMIERs Financial Requirements.”
Net Gains (Losses) on Investments. The components of the net (losses) gains on investments for the periods indicated are as follows:
Use of Non-GAAP Financial Measure. In addition to the traditional GAAP financial measures, we have presented a non-GAAP financial measure for the consolidated company, “adjusted pretax operating income (loss),” among our key performance indicators to evaluate our fundamental financial performance. This non-GAAP financial measure aligns with the way the Company’s business performance is evaluated by both management and the Board. This measure has been established in order to increase transparency for the purposes of evaluating our core operating trends and enabling more meaningful comparisons with our peers. Although on a consolidated basis “adjusted pretax operating income (loss)” is a non-GAAP financial measure, we believe this measure aids in understanding the underlying performance of our operations. Our senior management, including our Chief Executive Officer (the Company’s chief operating decision maker), uses adjusted pretax operating income (loss) as our primary measure to evaluate the fundamental financial performance of the Company’s business segments and to allocate resources to the segments. Management’s use of this measure as its primary measure to evaluate segment performance began with the quarter ended March 31, 2014. Accordingly, for comparison purposes, we also present the applicable measures from the corresponding periods of 2013 and 2012 on a basis consistent with the current year presentation.
Adjusted pretax operating income (loss) adjusts GAAP pretax income (loss) from continuing operations to remove the effects of net gains (losses) on investments and other financial instruments, acquisition-related expenses, amortization and impairment of intangible assets and net impairment losses recognized in earnings. It also excludes gains and losses related to changes in fair value estimates on insured credit derivatives and instead includes the impact of changes in the present value of insurance claims and recoveries on insured credit derivatives, based on our ongoing insurance loss monitoring.
The results of operations of our mortgage insurance segment have been restated for the years ended December 31, 2013 and 2012 due to the reallocation of certain corporate income and expenses that were previously allocated to the financial guaranty segment, but were not reclassified to discontinued operations. These items now have been reallocated to the mortgage insurance segment for all periods presented.
A key component of our current business strategy is to grow our mortgage insurance business by writing insurance on high-quality mortgages in the U.S. Consistent with this objective, we wrote $37.3 billion of primary new mortgage insurance in 2014 compared to $47.3 billion in 2013. The decrease in NIW for 2014 compared to 2013 is attributable to a decrease in the total mortgage origination market and increased competition in the private mortgage insurance industry, which resulted in a decrease in our market share.
In response to the recent increase in mortgage interest rates, which impacted home sales, the volume of mortgage refinance business significantly declined in 2014. These challenges have been partially offset by improvement in the housing market, in particular increased origination volume from home purchases as compared to refinances, and continued increases in the penetration rate of private mortgage insurance in the overall insured mortgage market. In January 2015, the FHA reduced its annual mortgage insurance premium by 50 basis points to roughly 85 basis points per year. The FHA’s upfront mortgage insurance premium was not changed. While the FHA reduction on annual premiums may impact our competitiveness on certain high LTV loans to borrowers with FICO scores below 720, we do not believe this impact will be significant. While it remains difficult to project future NIW, based on current mortgage origination projections from Mortgage Bankers Association and other sources, we currently estimate that our new business volume for 2015 will exceed the 2014 level of $37.3 billion.
Since 2009, virtually all of our new mortgage insurance business production has been prime business. In addition, FICO scores for the borrowers of these insured mortgages have increased, and the average LTV on these mortgages has decreased compared to mortgages in our Legacy Portfolio. Our portfolio of business written since 2009 has been steadily increasing in proportion to our total portfolio of RIF. As shown in the chart below, as of December 31, 2014, our 2009 through 2014 portfolios accounted for approximately 69% of our total mortgage insurance portfolio compared to 60% at December 31, 2013. The loans from our 2009 and later origination years possess significantly improved credit characteristics compared to our Legacy Portfolio. The growth of our portfolio written beginning in 2009, together with continued improvement in the portfolio as a result of HARP refinancings (further described below), has resulted in significant improvement in the credit quality of our overall mortgage insurance portfolio. Because our expected future losses on our mortgage insurance portfolios written since 2009 are significantly lower than those experienced on our Legacy Portfolio, the changing composition of our overall mortgage insurance portfolio should lead to improvements in our mortgage insurance segment’s operating profitability.
The following tables provide selected information as of and for the periods indicated related to mortgage insurance NIW, RIF and IIF. Primary RIF and IIF amounts at December 31, 2014 include $423 million and $1.68 billion, respectively, related to the loans in default that are subject to the Freddie Mac Agreement. Although we no longer have future claim liability on these loans, we continue to receive premiums on the related loans and the insurance remains in force; therefore, these loans are included in our primary RIF and IIF.
Loans with potential negative amortization will have increased principal balances only if interest rates increase, as compared to loans with scheduled negative amortization, for which an increase in loan balance will occur even if interest rates do not change.
Our expected rate of return on our Single Premium business is lower than on our Monthly Premium business. Assuming all other factors remain constant, if loans prepay earlier than expected, then our profitability on these Single Premium policies is likely to be higher than anticipated. If loans are repaid later than expected, however, our profitability on these Single Premium policies is likely to be lower than anticipated. Prepayment speeds, which are impacted by changes in interest rates, among other factors, impact the expected profitability of our Monthly Premium business in the opposite direction. For our Monthly Premium business, earlier than anticipated prepayments reduce profitability. As a result, the ultimate profitability of our business is affected by the impact of mortgage prepayment speeds on the mix of business we write. Because prepayment speeds are difficult to project, our strategy has been to write a mix of Single Premium and Monthly Premium business, which we believe balances the overall impact on our results if actual prepayment speeds are significantly different from expectations. Approximately 72% and 28% of our NIW for 2014 was written with Monthly and Single Premiums, respectively, compared to 68% and 32%, respectively, for 2013. The percentage of Single Premium NIW could increase modestly during 2015 based on the level of refinanced mortgages, competitive factors and the mix of business that our mortgage originator clients generate.
In our mortgage insurance business, we have used reinsurance as a risk management tool to manage Radian Guaranty’s regulatory Risk-to-capital. See Note 8 of Notes to Consolidated Financial Statements for more information about our captive reinsurance arrangements and our QSR Reinsurance Transactions.
Throughout this report, unless otherwise noted, RIF includes the amount ceded through reinsurance.
Provision for Losses. Our mortgage insurance provision for losses decreased significantly in 2014 compared to 2013 and in 2013 compared to 2012. The following table details the financial impact of the significant components of our provision for losses for the periods indicated (including amounts related to change in PDR on Second-liens):
The financial impact for each component has been recalculated on a full year basis, such that the sum of the individual quarterly impacts within each respective year do not equal the recalculated impacts. For example, the impact from a loan that defaults in one quarter and cures in the next quarter of the same year is not reflected within the full year provision for losses, as the net impact is zero for the full year period.
Represents the provision for losses attributable to loans that were in default as of the beginning of each period indicated, including: (a) the change in reserves for loans that were in default status (including pending claims) as of both the beginning and end of each period indicated; (b) the net impact to provision for losses from loans that were in default as of the beginning of each period indicated but were either cured, prepaid, or resulted in a paid claim or a rescission or denial during the period indicated; (c) the impact to our IBNR reserve during the period related to changes in actual and estimated reinstatements of previously rescinded policies and denied claims, including those subject to the BAC Settlement Agreement; (d) Second-lien loss reserves and premium deficiency reserves; and (e) LAE and other loss reserves.
Our mortgage insurance provision for losses for 2014 decreased by $315.8 million as compared to 2013. This decrease was driven primarily by a continued decline in new defaults and favorable development in our estimate of losses on existing defaults, as a result of higher cures and lower Claim Severity rates in 2014 than were previously estimated, partially offset by our provision for LAE.
Our primary default rate at December 31, 2014 was 5.2% compared to 7.3% at December 31, 2013. Our primary defaulted inventory comprised 45,319 loans at December 31, 2014, compared to 60,909 loans at December 31, 2013, representing a 25.6% decrease. The reduction in our primary defaulted inventory is the result of the total number of defaulted loans: (1) that have cured; (2) for which claim payments have been made; and (3) that have resulted in net insurance rescissions and claim denials, collectively exceeding the total number of new defaults on insured loans. New primary defaults in 2014 decreased 18% compared to a 20% decrease in new primary defaults in 2013 and a 22% decrease in 2012. Although significant uncertainty remains, we currently expect total new defaults for 2015 to decrease as compared to 2014.
Includes 9,101 and 11,860 insured loans subject to the Freddie Mac Agreement at December 31, 2014 and 2013, respectively.
Excludes 4,467 and 7,221 loans that are in default at December 31, 2014 and 2013, respectively, that are subject to the Freddie Mac Agreement, and for which we no longer have claims exposure.
The following table illustrates the impact of estimated future insurance rescissions and claim denials (net of estimated reinstatements) on our loss reserve estimates as of the dates indicated:
The impact to our mortgage insurance reserves due to estimated future rescissions and denials incorporates our expectations regarding the number of policies that we expect to reinstate as a result of our claims rebuttal process (see below for more information). While the level of rescissions and denials has been declining in recent periods as our defaulted Legacy Portfolio continues to decline, our current level of rescissions and denials remains elevated compared to historical levels.
The table below shows the details related to the number of rescinded policies and denied claims for the periods indicated:
Primarily represents ceded losses on captive transactions, Smart Home (2012 only) and the QSR Reinsurance Transactions.
Our mortgage insurance total loss reserve as a percentage of our mortgage insurance total RIF was 3.5% at December 31, 2014, compared to 5.2% at December 31, 2013 and 8.5% at December 31, 2012.
Primarily related to ceded losses on captive transactions, Smart Home (for 2012) and QSR Reinsurance Transactions.
Total mortgage insurance claims paid in 2014 of $838.3 million have decreased from claims paid of $1.4 billion in 2013. The decrease in 2014 is due in part to the claim payment of $255 million in 2013 relating to the Freddie Mac Agreement. The additional decrease in paid claims in 2014 compared to prior year periods is consistent with the overall decline in defaulted loans. We have reduced our pending claim inventory significantly in 2013 and 2014, due in part to greater efficiencies in our claims review process, which have allowed us to pay valid claim more quickly than in previous periods. We currently expect claims paid to be between $600 million and $700 million in 2015, including approximately $250 million of claims we expect to pay related to the BofA Settlement Agreement.
Claim activity on our primary loans generally begins approximately two years after the year of policy origination. Approximately 44.8% of our primary RIF was originated in the last two years. Given the strong credit characteristics of these loans, we expect this portfolio to result in significantly fewer claims than recently has been the case. All of our pool RIF at December 31, 2014 had reached its highest expected claim frequency years. Notwithstanding historical trends, the insurance we wrote from 2005 through 2008 has experienced default and claim activity sooner and to a significantly greater extent than has been the case historically for our books of business.
Calculated without giving effect to the impact of the Freddie Mac Agreement and the termination of captive transactions and settlements.
The following tables shows cumulative direct claims paid by us on our primary insured book of business at the end of each successive year after origination, expressed as a percentage of the cumulative premiums written by us in each year of origination and direct claims paid by policy origination year for the periods indicated. Direct claims paid represent First-lien claims paid prior to reinsurance recoveries and captive termination payments, and exclude LAE expenses and settlement payments.
Other Operating Expenses. Our other operating expenses in 2014 compared to 2013 reflect a significant reduction as a result of the reduced impact from increases in the estimated fair value of cash-settled long-term incentive awards that are valued, in large part, relative to the price of Radian Group’s common stock. Operating expenses for 2014, 2013 and 2012 include $13.4 million, $20.4 million and $15.2 million, respectively, as a result of the reallocation of financial guaranty segment expenses that were not allocated to discontinued operations.
Other operating expenses increased in 2013 as compared to 2012, primarily due to an increase in the estimated fair value of certain cash-settled long-term incentive awards that are valued, in large part, based on the stock price of Radian Group’s common stock, which increased significantly during 2013. Both 2013 and 2012 reflect a reduction of expenses due to ceding commissions earned related to the QSR Reinsurance Transactions, which increased in 2013. Results in 2012 also reflect a reduction in the amount of acquisition costs that were deferred in accordance with the update to the accounting standard regarding accounting for costs associated with acquiring or renewing insurance contracts.
Contract underwriting expenses for 2014, including the impact of reserves for contract underwriting remedies, were $14.8 million, compared to $6.1 million for 2013 and $12.1 million for 2012. In 2014, losses related to contract underwriting remedies included approximately $11.2 million related to settlement of remedies for services provided on legacy business. During 2014, loans underwritten via contract underwriting accounted for 2.2% of applications, 2.2% of commitments for insurance and 2.0% of insurance certificates issued, compared to 3.5%, 3.5% and 3.4%, respectively, for 2013 and 5.0%, 4.9% and 5.0%, respectively, for 2012.
The MRES segment’s results primarily comprise the operations of Clayton from the acquisition date of June 30, 2014.
For our Convertible Senior Notes due 2017, excludes the conversion premium amount that may be settled in cash, shares of our common stock or a combination thereof, at our election.
Includes $400 million of convertible senior notes that may be settled in cash, shares of our common stock or a combination thereof, at our election, as well as $300 million of senior notes that may be redeemed, in whole or part at any time prior to maturity.
Radian Group and RMAI are parties to a guaranty agreement, which provides that Radian Group will make sufficient funds available to RMAI to ensure that RMAI has a minimum of $5 million of statutory surplus every calendar quarter. RMAI had $17.5 million of statutory capital and no RIF exposure as of December 31, 2014.
Radian Group has agreed to guarantee, up to a maximum amount of $300 million, Radian Guaranty’s obligations to Radian Insurance under the NWLMA in the event that Radian Guaranty is not able to or permitted by the Pennsylvania Insurance Department to perform under the agreement. Radian Insurance had $256.3 million of statutory policyholders’ surplus at December 31, 2014.
To allow our mortgage insurance customers to comply with applicable securities regulations for issuers of ABS (including MBS), we have been required, depending on the amount of credit enhancement we were providing, to provide: (1) audited financial statements for the insurance subsidiary participating in these transactions; or (2) a full and unconditional holding-company level guarantee for our insurance subsidiaries’ obligations in such transactions. Radian Group has guaranteed two Structured Transactions for Radian Guaranty with approximately $128.8 million of remaining credit exposure.
Radian Group and RGRI are parties to an Assumption and Indemnification Agreement with regard to RGRI’s portion of the Deficiency Amounts relating to the IRS litigation. As of December 31, 2014, approximately $163 million would be indemnified under this agreement if the Deficiency Amounts are ultimately sustained. This indemnification agreement was made in lieu of an immediate capital contribution to RGRI that otherwise would have been required for RGRI to maintain its minimum statutory policyholders’ surplus requirements in light of the remeasurement as of December 31, 2011 of uncertain tax positions related to the portfolio of REMIC residual interests. See Note 13 of Notes to Consolidated Financial Statements for additional information regarding the IRS matter. We can provide no assurance regarding the outcome of this IRS matter, which may take several years to resolve. As such, there remains significant uncertainty with regard to the amount and timing of any potential payments under the indemnity agreement described above. See “Item 1A. Risk Factors-Resolution of our dispute with the IRS could adversely affect us.”
In the ordinary course of business, our MRES business enters into agreements pursuant to which we may be obligated under specified circumstances or upon the occurrence of certain events to indemnify the counterparties with respect to certain matters. The terms and amount of indemnification are negotiated on a transaction by transaction basis, but generally the circumstances of the transaction and/or the contract provisions are such that we believe the exposure to material liability is remote.
Radian Group’s principal liquidity demands for the next 12 months are expected to include: (i) additional capital support for Radian Guaranty; (ii) the payment of corporate expenses; (iii) interest payments on our outstanding long-term debt ; (iv) potential investments to support our long-term strategy of growing our fee-based businesses and diversifying our sources of revenues; and (v) the payment of dividends on our common stock.
On a quarterly basis, we evaluate whether the conversion threshold requirements for our Convertible Senior Notes due 2017 and our Convertible Senior Notes due 2019 have been met. As of December 31, 2014, the holders of our Convertible Senior Notes due 2017 and of our Convertible Senior Notes due 2019 are able to exercise their conversion rights during the three-month period ending March 31, 2015. We may elect, in our sole discretion, to settle any such converted notes in the form of cash, and in the case of the Convertible Senior Notes due 2017, a portion of the conversion amount must be settled in cash. Notwithstanding these conversion rights, we do not expect the holders to convert prior to maturity. See Note 11 of Notes to Consolidated Financial Statements for further information.
In addition to existing available cash and marketable securities, Radian Group’s principal sources of cash to fund short-term liquidity needs include: (i) payments made to Radian Group under tax- and expense-sharing arrangements with our subsidiaries, as further discussed below; and (ii) dividend payments from Clayton. Radian Group expects to receive a modest amount of dividend payments over the next 12 months from positive cash flows expected to be generated by Clayton.
The GSEs are in the process of revising their eligibility requirements for private mortgage insurers. As part of this process, the FHFA released proposed PMIERs for public comment on July 10, 2014. The PMIERs, when finalized and adopted, will establish the revised requirements that the GSEs will impose on private mortgage insurers, including Radian Guaranty, to remain eligible insurers of mortgage loans purchased by the GSEs. The proposed PMIERs include the PMIERs Financial Requirements which are expected to replace the capital adequacy standards under the current GSE eligibility requirements. The proposed PMIERs Financial Requirements require a mortgage insurer’s Available Assets to meet or exceed Minimum Required Assets that are calculated based on RIF and a variety of measures designed to evaluate credit quality. Among other things, the proposed PMIERs exclude from Available Assets: (i) an amount equal to Unearned Premium Reserves; and (ii) certain subsidiary capital, including Radian Guaranty’s capital that is attributable to its ownership of Radian Asset Assurance.
Radian Group also could be required to provide capital support for Radian Guaranty and our other mortgage insurance subsidiaries if additional capital is required pursuant to insurance laws and regulations. The NAIC is in the process of reviewing the minimum capital and surplus requirements for mortgage insurers and considering changes to the Mortgage Guaranty Insurers Model Act that could include more stringent capital requirements for Radian Guaranty, which, if adopted, could increase the capital requirements for Radian Guaranty in states that adopt the new Mortgage Guaranty Insurers Model Act. In addition, certain of our mortgage insurance subsidiaries that provide reinsurance to Radian Guaranty have required, and in the future may again require, additional capital contributions from Radian Group.
Strategic Investments. A primary component of our long-term strategic plan for the Company is to grow the fee-based services we are providing and to further diversify our sources of revenues, including through the introduction of new products. We may choose to pursue these objectives by growing our businesses internally or through potential transactions, and we may use holding company resources to pursue these investments. In July 2014, we invested $20 million to capitalize a newly formed, wholly-owned insurance subsidiary of Radian Group. The strategic objective of this investment is to offer various mortgage insurance-related products, which are currently in a developmental stage. In light of other potential cash and liquidity requirements discussed above, we do not expect that our strategic investments will be material during the next twelve months.
If Radian Group’s current sources of liquidity are insufficient for Radian Group to fund its obligations during the next twelve months, or if we otherwise decide to increase our liquidity position, Radian Group may seek additional capital by incurring additional debt, by issuing additional equity, or by selling assets, which we may not be able to do on favorable terms, if at all.
Our most significant needs for liquidity beyond the next 12 months are:
$400 million of convertible debt due in March 2019 for which the principal amount and any conversion premium may, at our option, be settled in cash or shares; and
$300 million principal amount of outstanding debt due in June 2019;
We expect to meet the long-term liquidity needs of Radian Group with a combination of: (i) available cash and marketable securities; (ii) private or public issuances of debt or equity securities, which we may not be able to do on favorable terms, if at all; (iii) cash received under expense-sharing arrangements with our subsidiaries; and (iv) dividends from our subsidiaries, including Clayton, to the extent available.
As of December 31, 2014, our mortgage insurance segment maintained claims paying resources of $2.9 billion, which consists of contingency reserves, statutory policyholders’ surplus (excluding the statutory surplus of Radian Asset Assurance), Unearned Premium Reserves and loss reserves.
As of December 31, 2014, our MRES segment maintained cash and cash equivalents totaling $12.7 million, which included restricted cash of $2.5 million.
Liquidity levels may fluctuate depending on the levels and contractual timing of our invoicing and the payment practices of the MRES clients, in combination with the timing of MRES payments for employee compensation and to external vendors. The amount, if any, and timing of the MRES segment’s dividend paying capacity will depend primarily on the amount of excess cash flow generated by the segment. In the fourth quarter of 2014, the MRES segment reimbursed Radian Group for corporate interest expense allocations of $7.4 million.
We believe that the cash flows generated by the MRES operations will provide the funds necessary to satisfy the MRES segment’s needs for the foreseeable future. However, the segment’s activities are primarily affected by transaction volume, which is subject to fluctuation due to market conditions and depends on maintaining successful client relationships. Dividend payments to Radian Group would be adversely impacted and funding support may be required for the MRES segment if unanticipated events and circumstances were to result in lower earnings or cash flow than expected. In the event the cash flow from operations of the MRES business is not adequate to fund all of its needs, Radian Group may be required to provide additional funds to the MRES segment in the form of a capital contribution or an intercompany note.
Cash flows used in operating activities decreased for 2014 compared to 2013, due to an increase in operating cash generated by our mortgage insurance business and a decrease in cash paid for commutations, terminations and recaptures. During 2013, cash flows used in operating activities increased compared to 2012, primarily as a result of an increase in mortgage insurance claims paid, including those paid in conjunction with the Freddie Mac Agreement, and payments for other commutations, terminations and recaptures in 2013.
Radian Group and our principal operating subsidiaries have been assigned the ratings set forth in the chart below. We believe that ratings often are considered by others in assessing our credit strength and the financial strength of our insurance subsidiaries. See “Item 1A. Risk Factors - Radian Guaranty may be unable to comply with applicable GSE eligibility requirements, including the final PMIERs, which if adopted in their current proposed form, could negatively impact Radian Guaranty’s expected return on equity, decrease Radian Guaranty’s NIW, and subject Radian Guaranty to extensive and more stringent operational requirements.”
Our aggregate weighted average Default to Claim Rate assumption (net of denials and rescissions) used in estimating our primary reserve for losses was 52% at December 31, 2014 and 50% December 31, 2013. Our Default to Claim Rate estimates on defaulted loans are mainly developed based on the Stage of Default and Time in Default of the underlying defaulted loans, as measured by the progress toward foreclosure sale and the number of months in default. As of December 31, 2014, our aggregate weighted average Default to Claim Rate estimate on our primary portfolio, net of estimated future denials and rescissions and excluding pending claims, was 47%. Our estimates of gross Default to Claim Rates on our primary portfolio ranged from 16% for new defaults to 65% for Foreclosure Stage Defaults. Our estimate of expected insurance rescissions and claim denials (net of expected reinstatements) embedded in our Default to Claim Rate is generally based on our experience over the past year, with consideration given for differences in characteristics between those rescinded policies and denied claims and the loans remaining in our defaulted inventory, and also incorporates the estimated impact of the BofA Settlement Agreement.
In addition, as part of our claims review process, we assess whether defaulted loans were serviced appropriately in accordance with our insurance policies and servicing guidelines. To the extent a servicer has failed to satisfy its servicing obligations, our insurance policies provide that we may curtail the claim payment for such default, and in some circumstances, cancel coverage or deny the claim. Since 2011, claim curtailments have increased both in frequency and in size, which has contributed to a reduction in the severity of our claim payments during this period. While we cannot give assurance regarding the extent or level at which such claim curtailments will continue, we expect the level of claim curtailments to remain elevated compared to historical levels (excluding claims processed in accordance with the BofA Settlement Agreement), in light of well publicized issues in the servicing industry and our existing Legacy Portfolio of aged defaults.
Insurance enterprises are required to establish a PDR if the net present value of the expected future losses and expenses for a particular product line exceeds the net present value of expected future premiums and existing reserves for that product line. We reassess our expectations for premiums, losses and expenses for our mortgage insurance business at least quarterly and update our premium deficiency analyses accordingly. Expected future expenses include consideration of maintenance costs associated with maintaining records relating to insurance contracts and with the processing of premium collections. We also consider investment income in the premium deficiency calculation through the use of our pre-tax investment yield to discount certain cash flows for this analysis.
For our First-lien insurance business, because the combination of the net present value of expected premiums and previously established reserves (net of reinsurance recoverables) exceeds the net present value of expected losses and expenses, a First-lien PDR was not required as of December 31, 2014 or December 31, 2013. Assuming all other factors remained constant, if our assumed paid claim rate increased from approximately 6.1% to approximately 11.8%, we would be required to establish a PDR.
Other investments-These securities primarily consist of short-term certificates of deposit, which are categorized in Level II of the fair value hierarchy.
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 are reported at amortized cost. Investments in securities not classified as held to maturity or trading securities are classified as available for sale and are reported at fair value, with unrealized gains and losses (net of tax) reported as a separate component of stockholders’ equity as AOCI. Investments classified as trading securities are reported at fair value, with unrealized gains and losses reported as a separate component of income. Short-term investments consist of money market instruments, certificates of deposit and highly liquid, interest-bearing instruments with an original maturity of three months or less at the time of purchase. Amortization of premium and accretion of discount are calculated principally using the interest method over the term of the investment. Realized gains and losses on investments are recognized using the specific identification method.
To: The Board of Directors and Stockholders of Radian Group Inc.
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, comprehensive income (loss), changes in common stockholders’ equity, and cash flows present fairly, in all material respects, the financial position of Radian Group Inc. and its subsidiaries at December 31, 2014 and 2013, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2014 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in Item 15(a)(2) present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2014, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company's management is responsible for these financial statements and financial statement schedules, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Report on Internal Control over Financial Reporting appearing under Item 9A. Our responsibility is to express opinions on these financial statements, on the financial statement schedules, and on the Company's internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
Our mortgage insurance segment offers primary mortgage insurance coverage on residential First-liens. At December 31, 2014, primary insurance on First-liens represented approximately 96.6% of our $44.8 billion total direct RIF. At December 31, 2014, pool insurance represented approximately 3.2% of our total direct RIF. Additionally, in the past we offered other forms of credit enhancement on residential mortgage assets. These products included mortgage insurance on Second-liens and primary mortgage insurance on international mortgages (collectively, we refer to the risk associated with these transactions as “non-traditional”). Our non-traditional RIF was $73.0 million as of December 31, 2014, representing less than 1% of our total direct RIF.
On December 22, 2014, Radian Guaranty entered into the Radian Asset Assurance Stock Purchase Agreement to sell Radian Asset Assurance to Assured, for a purchase price of approximately $810 million. After closing costs and other adjustments, we expect net proceeds of approximately $790 million. Radian expects to complete the sale of Radian Asset Assurance to Assured in the first half of 2015, subject to satisfaction of customary closing conditions including regulatory approvals.
The allocation of the purchase price, based on the fair values of assets and liabilities as of the acquisition date, was as follows:
Historical results for Clayton for the periods prior to our acquisition were not material to our consolidated financial results for those periods.
We used a portion of the proceeds from our May 2014 issuance of equity and debt to fund this acquisition. See Note 11 for additional information related to our May 2014 issuance of debt. Acquisition-related costs of $6.5 million, which include costs such as advisory, legal, accounting, valuation and other professional or consulting fees, have been expensed as incurred and classified as other operating expenses.
Approximately 12% of the Subject Loans were neither held in portfolio by the Insureds nor owned by the GSEs, and will require the consent of certain other investors for these loans to be included in the BofA Settlement Agreement except with respect to certain limited rights of cancellation. See Note 10 for additional information about the BofA Settlement Agreement.
The FHFA, the GSEs and state insurance regulators impose various capital requirements on our insurance subsidiaries. These include financial requirements, such as Risk-to-capital, other risk-based capital measures and surplus requirements, that potentially may limit the amount of insurance that our insurance subsidiaries may write. The GSEs and our state insurance regulators also possess significant discretion with respect to our insurance subsidiaries.
Under state insurance regulations, Radian Guaranty is required to maintain minimum surplus levels and, in certain states, a minimum ratio of statutory capital relative to the level of net RIF, or “Risk-to-capital.” The sixteen RBC States currently impose a Statutory RBC Requirement. The most common Statutory RBC Requirement is that a mortgage insurer’s Risk-to-capital may not exceed 25 to 1. In certain of the RBC States, a mortgage insurer must satisfy an MPP Requirement. The statutory capital requirements for the non-RBC States are de minimis (ranging from $1 million to $5 million); however, the insurance laws of these states generally grant broad supervisory powers to state agencies or officials to enforce rules or exercise discretion affecting almost every significant aspect of the insurance business, including the power to revoke or restrict an insurance company’s ability to write new business. Unless an RBC State grants a waiver or other form of relief, if a mortgage insurer is not in compliance with the Statutory RBC Requirement of that state, the mortgage insurer may be prohibited from writing new mortgage insurance business in that state. Radian Guaranty’s domiciliary state, Pennsylvania, is not one of the RBC States. In 2014 and 2013, the RBC States accounted for approximately 56.3% and 55.7%, respectively, of Radian Guaranty’s total primary NIW. Radian Guaranty’s Risk-to-capital as of December 31, 2014, after giving effect to a $100 million capital contribution from Radian Group in February 2015, had improved to 17.9 to 1 from 19.5 to 1 as of December 31, 2013. Radian Guaranty was in compliance with all other applicable Statutory RBC Requirements as of December 31, 2014.
The NAIC is in the process of reviewing the minimum capital and surplus requirements for mortgage insurers and considering changes to the Model Act. While the outcome of this process is not known, it is possible that among other changes, the NAIC will recommend and adopt more stringent capital requirements that could increase the capital requirements for Radian Guaranty in states that adopt the new Model Act.
The amount of capital or capital relief that may be required to comply with the PMIERs also may be impacted by: (1) the performance of our mortgage insurance business, including our level of defaults, the losses we incur on new or existing defaults and the amount and credit characteristics of new business we write, among other factors; and (2) changes in the final PMIERs Financial Requirements from their proposed form that impact the amount of Radian Guaranty’s Minimum Required Assets or its Available Assets.
In May 2014, we issued 17.825 million shares of our common stock at a public offering price of $14.50 per share, and we received aggregate net proceeds of approximately $247.2 million after deducting underwriting discounts and commissions and offering expenses.
We report a business as held for sale when management is committed to a formal plan to sell the assets, the business is available for immediate sale and is being actively marketed at a price that is reasonable in relation to its fair value, an active program to locate a buyer and other actions required to complete the plan to sell the asset have been initiated, the sale is probable and expected to be completed within one year, and it is deemed unlikely that significant changes to the plan will be made or that the plan will be withdrawn. A business classified as held for sale is reflected at the lower of its carrying amount or estimated fair value less cost to sell. If the carrying amount of the business exceeds its estimated fair value, a loss is recognized. Assets and liabilities related to a business classified as held for sale are segregated in the Consolidated Balance Sheets in the period in which the business is classified as held for sale. After a business is classified as held for sale, depreciation and amortization expense is not recognized on its assets.
We establish reserves to provide for losses and LAE and the estimated costs of settling claims in our mortgage insurance segment in accordance with the accounting standard regarding accounting and reporting by insurance enterprises. Although this standard specifically excludes mortgage insurance from its guidance relating to the reserve for losses, we establish reserves for mortgage insurance as described below, using the guidance contained in this standard supplemented with other accounting guidance, due to the lack of specific guidance for mortgage insurance.
Estimating our mortgage insurance loss reserves involves significant reliance upon assumptions and estimates with regard to the likelihood, magnitude and timing of each potential loss, including an estimate of the number of defaulted loans that will be successfully rescinded or denied. The models, assumptions and estimates we use to establish loss reserves may prove to be inaccurate, especially during an extended economic downturn or a period of extreme market volatility and uncertainty. As such, we cannot be certain that our reserve estimate will be adequate to cover ultimate losses on incurred defaults.
Commutations and other negotiated terminations of our insured risks in our mortgage insurance segment provide us with an opportunity to exit exposures for an agreed upon payment, or payments, sometimes at an amount less than the previously estimated ultimate liability. Once all exposures relating to such policies are extinguished, all reserves for losses and LAE and other balances relating to the insured policies are generally reversed, with any remaining net gain or loss typically recorded through provision for losses. We take into consideration the specific contractual and economic terms for each individual agreement when accounting for our commutations or other negotiated terminations, which may result in differences in the accounting for these transactions.
In the mortgage insurance segment, the default and claim cycle begins with the receipt of a default notice from the servicer. Reserves for losses are established upon receipt of notification from servicers that a borrower has missed two monthly payments, which is when we consider a loan to be in default for financial statement and internal tracking purposes. We also establish reserves for associated LAE, consisting of the estimated cost of the claims administration process, including legal and other fees and expenses associated with administering the claims process. We maintain an extensive database of claim payment history and use models based on a variety of loan characteristics to determine the likelihood that a default will reach claim status. During 2014, we continued to refine our loss reserving techniques and developed additional segmentations, primarily based on a loan’s Time in Default and its current Stage of Default, in assessing the likelihood that a default will result in a claim. Previously, we gave greater weight to other loan characteristics, including the status of the loan as reported by its servicer, as defined by the number of missed payments, and the type of loan product. Our process includes forecasting the impact of our loss mitigation efforts in protecting us against fraud, underwriting negligence, breach of representation and warranties, inadequate documentation of submitted claims and other items that may give rise to insurance rescissions or cancellations and claim denials, to help determine the Default to Claim Rate. Lastly, we project the Claim Severity, which is also impacted by Loss Mitigation Activity associated with claim curtailments due to servicer noncompliance with our insurance policies and servicing guidelines. When there is a claim under primary mortgage insurance, the coverage percentage is applied to the claim amount, which consists of the unpaid loan principal, plus past due interest (for which our liability is contractually capped in accordance with the terms of our Master Policies) and certain expenses associated with the default, to determine our maximum liability. Based on these estimates, we arrive at our estimate of loss reserves as of that time.
For purposes of reserve modeling, loans are aggregated into groups using a variety of factors. The attributes currently used to define the groups for purposes of developing various assumptions include, but are not limited to, the Stage of Default, the Time in Default, product type (i.e., Prime, Alt-A or Subprime), type of insurance (i.e., primary or pool), loss position (i.e., with or without a deductible) and the state where the property is located (segregated into three state groups in order to adjust for differences in foreclosure timing). We use an actuarial projection methodology referred to as a “roll rate” analysis that uses historical claim frequency information to determine the projected ultimate Default to Claim Rates based on the Stage of Default and Time in Default. The Default to Claim Rate also includes our estimates with respect to expected insurance rescissions and claim denials, which have the effect of reducing our Default to Claim Rates.
Unless a liability associated with such activities or discussions becomes probable and can be reasonably estimated, we consider our claim payments and our rescissions, denials and curtailments to be resolved for financial reporting purposes. Under the accounting standard regarding contingencies, an estimated loss is accrued only if we determine that the loss is probable and can be reasonably estimated. For populations of disputed rescissions, denials and curtailments where we determine that a settlement is probable and that a loss can be reasonably estimated, we reflect our best estimate of the expected loss related to the populations under discussion in our financial statements, primarily as a component of our IBNR reserve. While our reserves include our best estimate of such losses, the outcome of the discussions or potential legal proceedings that could ensue is uncertain, and it is reasonably possible that a loss exists in excess of the amount accrued.
For our mortgage insurance business, we group our mortgage insurance products into two categories: First-lien and Second-lien. To assess the need for a PDR on our First-lien insurance portfolio, we develop loss projections based on modeled loan defaults related to our current RIF. This projection is based on recent trends in default experience, severity and rates of defaulted loans moving to claim (such Default to Claim Rates are net of our estimates of rescissions and denials), as well as recent trends in the rate at which loans are prepaid.
Effective January 1, 2012, we adopted the FASB update to the accounting standard regarding accounting for costs associated with acquiring or renewing insurance contracts on a prospective basis. This update redefines acquisition costs as incremental costs that are related directly to the successful acquisition of new or renewal insurance contracts. Previously, acquisition costs were defined as costs that vary with and are primarily related to the acquisition of insurance contracts. The effect of this revised definition of acquisition costs has resulted in the recognition of additional expenses in our mortgage insurance business when incurred, rather than being deferred to subsequent periods. There was no change to the amortization requirements due to this update. The implementation of this new guidance significantly reduced the amount of our deferral of policy acquisition costs associated with acquiring mortgage insurance contracts. However, the lower amount of acquisition costs deferred will be offset by reduced amortization expense in subsequent periods. While the timing of the recognition of certain costs in our results of operations has changed as a result of the adoption of this update, there is no effect on the total acquisition costs recognized over time or on our cash flows. Amounts deferred as acquisition costs for 2014 and 2013 reflect a reduction for ceding commissions written on risk ceded under the QSR Reinsurance Transactions (as defined in Note 8). We amortized $24.4 million, $28.5 million and $34.1 million of deferred policy acquisition costs in our mortgage insurance business in 2014, 2013 and 2012, respectively.
The MRES segment also derives revenue from REO management activities, and is generally paid a fixed fee or a percentage of the sale proceeds upon the sale of a property. Services revenue is recognized when the sale of a property closes and the client has confirmed receipt of the sale proceeds from a buyer. In certain instances, fees are received at the time that an asset is assigned to Radian for REO management. These fees are recorded as deferred revenue and are recognized on a straight-line basis over the average period of time required to sell an asset and complete the earnings process.
The MRES segment also provides certain services under multiple element arrangements, including valuations, title reviews and tax lien reviews. Contracts for these services include provisions requiring the client to pay a per unit price for services that have been performed if the client cancels the contract. Each service qualifies as a separate unit of accounting on a per unit basis, and we recognize revenue as each individual service is performed.
We are required to establish a valuation allowance against our DTA when it is more likely than not that all or some portion of our DTA will not be realized. At each balance sheet date, we assess our need for a valuation allowance. Our assessment is based on all available evidence, both positive and negative. This requires management to exercise judgment and make assumptions regarding whether our DTA will be realized in future periods. The primary negative evidence that we have considered has been our cumulative losses in recent years. We also consider positive evidence when assessing the need for a valuation allowance, such as future reversals of existing taxable temporary differences, future projections of taxable income, taxable income within the applicable carryback and carryforward periods, and potential tax planning strategies. The recognition of our DTA ultimately depends on the existence of sufficient taxable income of the appropriate character (ordinary income or capital gains) within the applicable carryback and carryforward periods provided under the tax law. In assessing our need for a valuation allowance, the weight assigned to the effect of both negative and positive evidence is commensurate with the extent to which such evidence can be objectively verified. As of December 31, 2014, after analyzing all positive and negative evidence available, we believe there is significant positive, objectively verifiable evidence that outweighs all negative evidence and supports a conclusion that it is more-likely-than-not that substantially all of the Company’s DTAs will be realized.
Included in our restricted cash balances as of December 31, 2014 were: (1) funds for a mortgage insurance reserve policy held in escrow for any future duties, rights and liabilities; (2) funds held as collateral under our insurance trust agreements related to health care benefits; and (3) funds held in trust for the benefit of certain policyholders.
Accounts and notes receivable primarily consist of accrued premiums receivable due from our mortgage insurance customers, amounts due from our MRES customers for services our MRES segment has performed, and the profit commission receivable related to the Initial QSR Transaction. See Note 8 for details. Accounts and notes receivable are carried at their estimated collectible amounts, net of any allowance for doubtful accounts, and are periodically evaluated for collectability based on past payment history and current economic conditions.
In February 2013, the FASB issued an update to the accounting standard regarding comprehensive income, requiring additional information to be presented on the face of the financial statements or as separate disclosures. This update requires an entity to present the changes in each component of accumulated other comprehensive income. An entity is required to present certain amounts reclassified out of accumulated other comprehensive income to their respective line items in net income, by component. Other reclassifications out of accumulated other comprehensive income are required to be cross-referenced to existing disclosures. We adopted this update effective January 1, 2013. In Note 12 we have presented the changes in the balances for each component of accumulated other comprehensive income as well as current period reclassifications out of accumulated other comprehensive income. This update impacted disclosures only and did not affect our consolidated financial position, earnings or cash flows.
Based upon the applicable terms of the Radian Asset Assurance Stock Purchase Agreement, we determined that Radian Asset Assurance met the criteria for held for sale and discontinued operations accounting at December 31, 2014. As a result, we recognized an approximate $468 million pre-tax impairment charge for the year ended December 31, 2014, which is reported in loss from discontinued operations in the Consolidated Statements of Operations and in other liabilities in the table below summarizing the major components of assets and liabilities held for sale on the Consolidated Balance Sheets. We have reclassified the related operating results as discontinued operations for all periods presented in our consolidated statements of operations. No general corporate overhead or interest expense was allocated to discontinued operations.
Previously, Radian Asset Assurance comprised substantially all of the financial guaranty segment. Radian Asset Assurance provides direct insurance and reinsurance on credit-based risks. As a result, the assets and liabilities associated with the discontinued operations have historically been a source of significant volatility to Radian’s results of operations, due to various factors including fluctuations in fair value and credit risk.
The following table provides financial guaranty gross and net claim liability details by internal surveillance category as of December 31, 2014:
The following is a brief description of each of the surveillance categories listed above:
Special mention-This category includes insured transactions that are rated no more than two rating levels below investment grade. Although these insured transactions typically are not performing as expected, we have determined that such transactions are not expected to have severe, prolonged stress and we do not believe that claim payments are imminent.
We allocate to our MRES segment: (i) corporate expenses based on an allocated percentage of time spent on the MRES segment; and (ii) as noted above, all interest expense related to the Senior Notes due 2019 as the issuance proceeds funded our acquisition of Clayton. No corporate cash or investments are allocated to the MRES segment. Because the Clayton acquisition occurred on June 30, 2014, we have included its results of operations from the date of acquisition. Inter-segment activities are recorded at market rates for segment reporting and eliminated in consolidation.
Effective with the fourth quarter of 2014, the MRES business undertook the management responsibilities of certain additional loan servicer surveillance functions previously considered part of the mortgage insurance segment. As a result, these activities are now reported in the MRES segment for all periods presented.
Estimated present value of net credit (losses) recoveries incurred. The change in present value of insurance claims we expect to pay or recover on insured credit derivatives represents the amount of the change in credit derivatives from item 1 above, that we expect to result in an economic loss or recovery based on our ongoing loss monitoring analytics. Therefore, this item is expected to have an economic impact and is included in our calculation of adjusted pretax operating income (loss). Also included in this item is the change in expected economic loss or recovery associated with our consolidated VIEs.
Includes inter-segment expenses of $0.8 million in the mortgage insurance segment.
Excludes $6.7 million of acquisition-related expenses not included in segment other operating expenses.
Does not include change in fair value of derivative instruments of $0.6 million and ($0.2) million for the years ended December 31, 2013 and 2012, respectively.
For the year ended December 31, 2013, excludes the following revenue items not included in adjusted pretax operating loss: (a) net losses on investments of $98.9 million; (b) net losses on other financial instruments of $7.6 million; and (c) change in fair value of derivative instruments of $0.6 million. For the year ended December 31, 2012, excludes the following revenue items not included in adjusted pretax operating loss: (a) net gains on investments of $114.3 million;(b) net losses on other financial instruments of $7.8 million; and (c) change in fair value of derivative instruments of ($0.2) million.
Corporate overhead expenses of $20.5 million and $15.2 million have been reallocated to the mortgage insurance segment for the years ended December 31, 2013 and 2012, respectively.
At December 31, 2014, there were no Level III assets, and total Level III liabilities of $3.8 million accounted for 100% of total liabilities measured at fair value.
Does not include fixed-maturities held to maturity ($0.4 million) and certain other invested assets ($22.4 million), primarily invested in limited partnerships, accounted for as cost-method investments and not measured at fair value.
There were no investment transfers between Level I and Level II for the year ended December 31, 2013.
As of December 31, 2014 and 2013, our investment portfolio included no Sovereign securities of the Stressed European Countries (Greece, Spain, Italy, Hungary, Portugal and Ireland, collectively) which have Sovereign obligations that have been under particular stress due to economic uncertainty, potential restructuring and ratings downgrades, and included no securities of any other countries under similar stress.
The following tables show the gross unrealized losses and fair value of our securities deemed “available for sale” and “held to maturity,” aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, as of the dates indicated:
There were no credit losses recognized in earnings in 2014, 2013 or 2012.
As of December 31, 2014, we did not have any investment in any person and its affiliates that exceeded 10% of our total stockholders’ equity.
The following table shows the changes in the carrying amount of goodwill by segment for the year ended December 31, 2014:
In our mortgage insurance business, we have used reinsurance as a risk management tool to manage Radian Guaranty’s regulatory Risk-to-capital and to comply with certain state requirements that limit the amount of risk a mortgage insurer may retain on a single loan to 25% of the total loan amount. Premiums are ceded under captive arrangements and the QSR Reinsurance Transactions (and previously were ceded under Smart Home). Included in other assets are prepaid reinsurance premiums of $57.3 million and $60.5 million at December 31, 2014 and 2013, respectively.
In the fourth quarter of 2012, Radian Guaranty and the same third-party reinsurance provider entered into the Second QSR Transaction, pursuant to which Radian Guaranty agreed to cede to the third-party reinsurance provider 20% of its NIW beginning with the business written the fourth quarter of 2012. Effective April 1, 2013, Radian Guaranty amended the original terms of the Second QSR Transaction to reduce the percentage of all premiums and losses incurred on new business ceded to the reinsurer under this reinsurance agreement on a prospective basis from 20% to 5% with respect to NIW on conventional GSE loans.
As of December 31, 2014, we had ceded the maximum of $1.6 billion of RIF as mutually agreed upon under the Second QSR Transaction.
Trust assets related to our captive arrangements are required to be invested in investment grade securities. As of December 31, 2014, the trust assets for these trust accounts consisted primarily of cash equivalents, money market investments and investment grade securities.
Our mortgage insurance loss reserves declined in 2014, primarily as a result of the volume of paid claims, cures and insurance rescissions and claim denials continuing to outpace new default notices received. Total incurred losses during 2014 primarily were the result of new default notices during 2014. The impact to incurred losses from default notices reported in 2014 was partially mitigated by favorable reserve development on prior year defaults, which was driven primarily by higher cures and lower Claim Severity rates than were previously estimated. Our results of 2014 also include the impact of the BofA Settlement Agreement, as described below.
Total paid claims decreased for 2014 as compared to 2013. Our 2013 paid claims included the $255 million payment made upon the closing of the Freddie Mac Agreement, as described below. The additional decrease in paid claims in 2014 compared to prior year periods is consistent with the overall decline in defaulted loans.
The losses incurred in 2012 were impacted by adverse reserve development on prior year defaults, primarily relating to the impact from the aging of underlying defaulted loans, partially offset by higher actual insurance rescissions and claim denials than previously assumed in our loss reserve estimates. Our results for 2012 were also negatively impacted by a $46.8 million decrease in our estimated reinsurance recoverable from our Smart Home transactions resulting from lower claims paid and higher insurance rescissions and claim denials than were previously estimated.
Our aggregate weighted average Default to Claim Rate assumption (net of denials and rescissions) used in estimating our primary reserve for losses was 52% (47% excluding pending claims) at December 31, 2014 compared to 50% at December 31, 2013. Our Default to Claim Rate estimates on defaulted loans are mainly developed based on the Stage of Default and Time in Default of the underlying defaulted loans, as measured by the progress toward foreclosure sale and the number of months in default. Our gross Default to Claim Rates on our primary portfolio ranged from 16% for new defaults, to 65% for defaults not in Foreclosure Stage, and 81% for Foreclosure Stage Defaults. Our estimate of expected insurance rescissions and claim denials (net of expected reinstatements) embedded in our Default to Claim Rate is generally based on our experience over the past year, with consideration given for differences in characteristics between those rescinded policies and denied claims and the loans remaining in our defaulted inventory, and also incorporates the estimated impact of the BofA Settlement Agreement.
The elevated levels of our insurance rescissions and claim denials have reduced our paid losses and have resulted in a significant reduction in our loss reserves. Our estimate of net future rescissions and denials reduced our loss reserves as of December 31, 2014 and 2013 by approximately $125 million and $247 million, respectively. The amount of estimated rescissions and denials incorporated into our reserve analysis at any point in time is affected by a number of factors, including not only our estimated rate of rescissions and denials on future claims, but also the volume and attributes of our defaulted insured loans, our estimated Default to Claim Rate and our estimated Claim Severity, among other assumptions. As of December 31, 2014, these assumptions also reflect the estimated impact of the BofA Settlement Agreement, as further discussed below.
We considered the sensitivity of First-lien loss reserve estimates at December 31, 2014 by assessing the potential changes resulting from a parallel shift in Claim Severity and Default to Claim Rate for primary loans. For example, assuming all other factors remain constant, for every one percentage point change in primary Claim Severity (which we estimate to be 103.7% of unpaid principal balance at December 31, 2014), we estimated that our loss reserves would change by approximately $12 million at December 31, 2014. For every one percentage point change in our overall primary net Default to Claim Rate (which we estimate to be 52% at December 31, 2014, including our assumptions related to rescissions and denials), we estimated a $23 million change in our loss reserves at December 31, 2014.
During the three-month period ended December 31, 2014, our closing stock price exceeded the thresholds required for the holders of our Convertible Senior Notes due 2017 to be able to exercise their conversion rights during the three-month period ending March 31, 2015. See “-Convertible Senior Notes due 2017 and 2019” below for information on accounting considerations related to convertible debt instruments that may be settled in cash upon conversion, including the balance sheet classification of the equity component of certain convertible debt instruments, such as the Convertible Senior Notes due 2017, that require the issuer to settle the aggregate principal amount of the notes in cash.
In connection with the November 2010 offering of the convertible notes, we also entered into capped call transactions with an affiliate of Morgan Stanley, whose obligations have been guaranteed by Morgan Stanley. The capped call transactions are intended to offset the potential dilution to our common stock and/or any potential cash payments that may be required to be made by us upon conversion of the notes in excess of the principal amount of the notes, up to a stock price of approximately $14.11 per share, which is the initial cap on the counterparty’s share delivery obligation under the call options. If the market value per share of our common stock, as measured under the terms of the capped call transactions, exceeds the applicable cap price of the capped call transactions, the number of shares of our common stock and/or the amount of cash we expect to receive upon the exercise of the capped call transactions will be capped and the anti-dilutive and/or offsetting effect of the capped call transactions will be limited. We paid approximately $46.1 million from the net proceeds from the issuance and sale of the convertible notes to purchase the capped call transactions.
During the three-month period ended December 31, 2014, our closing stock prices exceeded the thresholds required for the holders of our Convertible Senior Notes due 2017 to be able to exercise their conversion rights during the three-month period ending March 31, 2015. As a result, at December 31, 2014, the equity component related to our Convertible Senior Notes due 2017 was reclassified from permanent equity to mezzanine (temporary) equity as “equity component of currently redeemable convertible senior notes.” We will evaluate whether the conversion threshold requirements have been met on a quarterly basis, and will report the equity component related to our Convertible Senior Notes due 2017 as temporary equity for any period in which the debt remains currently convertible.
Amount included within additional paid-in capital, net of the capped call transactions (Convertible Senior Notes due 2017) and related issuance costs (Convertible Senior Notes due 2017 and 2019).
Primarily represents the deferred tax amount related to this transaction due to the reclassification of the debt discount to temporary equity.
There was no net tax impact recorded in equity related to the Convertible Senior Notes due 2019, as a result of our full valuation allowance at the time the debt was issued.
The components of our consolidated income tax benefit from continuing operations are as follows:
The reconciliation of taxes computed at the statutory tax rate of 35% to the benefit for income taxes on continuing operations is as follows:
Since December 31, 2010, when we initially concluded that a valuation allowance was required against substantially all of our existing net DTA, as required under the accounting standard regarding accounting for income taxes, we have continued to weigh the potential effect of positive and negative evidence at each balance sheet date, giving consideration as to whether that evidence is objectively verifiable and thus how much weight shall be given to that evidence. The primary negative evidence that has been considered has been our cumulative losses in recent years and potential stress scenarios with respect to our forecasts of future taxable income. We also consider positive evidence when assessing the need for a valuation allowance, such as future reversals of existing taxable temporary differences, future projections of taxable income, taxable income within the applicable carryback and carryforward periods, and potential tax planning strategies. The recognition of our DTA ultimately depends on the existence of sufficient taxable income of the appropriate character (ordinary income or capital gains) within the applicable carryback and carryforward periods provided under the tax law. Factors impacting the reversal of our valuation allowance include the continued improvement in operating results and increased certainty regarding our projected incurred losses, as discussed in more detail below, and our ability to sustain profitability over a significant time period in amounts that are sufficient to support a conclusion that it is more likely than not that all or a portion of our DTAs will be realized.
In evaluating negative evidence, consideration was also given to the U.S. NOL Carryforward period which extends through the end of 2028. Based on management’s projections, including adverse scenarios considered in our sensitivity analysis, we expect to utilize the NOL Carryforward of approximately $1.5 billion within several years. Additionally, we currently have no Internal Revenue Code Section 382 (“Section 382”) or other limitations on our ability to utilize our existing NOL.
In July 2013, the FASB issued an update to the accounting standard regarding income taxes. This update provides guidance concerning the balance sheet presentation of an unrecognized tax benefit when a Carryforward is available. This accounting standard requires an entity to present its DTAs for the Carryforwards net of its liability related to unrecognized tax benefits. A gross presentation will be required when the Carryforwards are not available under the tax law of the applicable jurisdiction or when the Carryforwards would not be used by the entity to settle any additional income taxes resulting from disallowance of the uncertain tax position. This update is effective for fiscal years and interim periods within such years beginning after December 15, 2013. We adopted this update in the first quarter of 2014. The adoption of this update did not affect the recognition or measurement of uncertain tax positions and did not have a significant impact on our consolidated financial statements or disclosures.
On October 8, 2009, we adopted the Plan, which, as amended, was approved by our stockholders at our 2010 and 2013 annual meetings. We also adopted the Bylaw Amendment and at our 2010 annual meeting, our stockholders approved the Charter Amendment, which our stockholders reapproved at our 2013 annual meeting. The Plan, the Bylaw Amendment and the Charter Amendment were implemented in order to protect our ability to utilize our NOLs and other tax assets and prevent an “ownership change” under U.S. federal income tax rules by restricting or discouraging certain transfers of our common stock that would: (i) create or result in a person becoming a five-percent shareholder under Section 382; or (ii) increase the stock ownership of any existing five-percent shareholder under Section 382.
We are contesting adjustments resulting from the examination by the IRS of our 2000 through 2007 consolidated federal income tax returns. The IRS opposes the recognition of certain tax losses and deductions that were generated through our investment in a portfolio of non-economic REMIC residual interests and proposed adjustments denying the associated tax benefits of these items. We appealed the proposed adjustments to Appeals and made “qualified deposits” with the U.S. Treasury of approximately $85 million in June 2008 relating to the 2000 through 2004 tax years and approximately $4 million in May 2010 relating to the 2005 through 2007 tax years in order to avoid the accrual of above-market-rate interest with respect to the proposed adjustments.
As discussed above, in December 2014, we petitioned the U.S. Tax Court to litigate the IRS Notices of Deficiency received on September 4, 2014. Over the next 12 months, if we determine that a compromised settlement cannot be reached with the IRS, then it is estimated that approximately $73.6 million of unrecognized tax benefits in the above tabular reconciliation may be reversed pursuant to the accounting standard for uncertain tax positions.
Radian Guaranty’s Risk-to-capital calculation appears in the table below. For purposes of the Risk-to-capital requirements imposed by certain states, statutory capital is defined as the sum of statutory policyholders’ surplus (i.e., statutory capital and surplus) plus statutory contingency reserves.
We actively manage Radian Guaranty’s capital position in various ways, including: (1) through internal and external reinsurance arrangements; (2) by seeking opportunities to reduce our risk exposure through commutations and other negotiated transactions; and (3) by contributing additional capital from Radian Group. Given our financial projections for Radian Guaranty, which are subject to risks and uncertainties, we expect Radian Guaranty’s Risk-to-capital to decrease over time without the need for any additional capital contributions from Radian Group to satisfy current applicable state insurance regulatory requirements.
The reduction in Radian Guaranty’s Risk-to-capital in 2014 was primarily due to increases in statutory net income and contingency reserves, as well as a $100 million capital contribution from Radian Group, partially offset by an increase in net RIF at Radian Guaranty and a reduction in Radian Guaranty’s carrying value of Radian Asset Assurance to its estimated fair value less costs to sell.
RGRI is a monoline insurer restricted to writing only mortgage guaranty insurance or reinsurance. RGRI is not licensed or authorized to write direct mortgage guaranty insurance in any states other than Pennsylvania and Texas. RGRI is required to maintain a minimum statutory surplus of $20 million to remain an authorized reinsurer in all states.
RGRI’s statutory net income, statutory policyholders’ surplus and contingency reserve as of and for the years ended December 31, 2014, 2013 and 2012 were as follows:
Radian Group’s U.S. consolidated federal income tax returns, which include RGRI’s federal income tax returns, have been under examination by the IRS for tax years 2000 through 2007. We are currently contesting proposed adjustments resulting from the IRS examination of these tax years. Effective December 31, 2011, Radian Group and RGRI entered into an Assumption and Indemnification Agreement with regard to RGRI’s portion of the Deficiency Amounts. As of December 31, 2014, approximately $163 million would be indemnified under this agreement if the Deficiency Amounts are ultimately sustained. This indemnification agreement was made in lieu of an immediate capital contribution to RGRI that otherwise would have been required for RGRI to maintain its minimum statutory policyholders’ surplus requirements in light of the remeasurement as of December 31, 2011 of uncertain tax positions related to the portfolio of REMIC residual interests. There remains significant uncertainty with regard to the amount and timing of any resolution with the IRS. See Note 13 for further information regarding the examination by the IRS for the 2000 through 2007 tax years.
RMAI is domiciled and licensed in Pennsylvania as a stock casualty insurance company authorized to carry on the business of credit insurance, which includes the authority to write mortgage guaranty insurance. It is a monoline insurer restricted to writing only residential mortgage guaranty insurance. RMAI is not currently writing mortgage guaranty insurance and had no RIF as of December 31, 2014.
Radian Asset Assurance’s ability to pay dividends to its parent, Radian Guaranty, is restricted by certain provisions of the insurance laws of New York. Under the New York insurance laws, Radian Asset Assurance may only pay dividends from statutory earned surplus. Without the prior approval from the NYSDFS, Radian Asset Assurance 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 statutory policyholders’ surplus, as shown by its last statement on file with the NYSDFS, or 100% of statutory adjusted net investment income during such period. In addition, the NYSDFS, in its discretion, may approve an Extraordinary Dividend. In July 2014, July 2013 and July 2012, Radian Asset Assurance paid dividends of $150.0 million, $36.0 million and $54.0 million, respectively, to Radian Guaranty. As of December 31, 2014, Radian Asset Assurance maintained claims paying resources of $1.4 billion, which consists of statutory policyholders’ surplus of $1.1 billion, plus contingency reserves, Unearned Premium Reserves, the present value of installment premiums and loss and LAE reserves. As a result of the pending sale of Radian Asset Assurance to Assured, which is expected to occur in the first half of 2015, we do not expect Radian Asset Assurance to distribute any additional ordinary dividends to Radian Guaranty or to request any further NYSDFS approval for an Extraordinary Dividend prior to the completion of the sale.
New York insurance law requires financial guaranty insurers to maintain minimum statutory policyholders’ surplus of $65 million. When added to the minimum statutory policyholders’ surplus of $1.4 million separately required for the other lines of insurance that Radian Asset Assurance is licensed to write, Radian Asset Assurance is required to maintain an aggregate minimum statutory policyholders’ surplus of $66.4 million.
In accordance with New York insurance law, financial guaranty insurance companies are required to establish a contingency reserve equal to the greater of 50% of premiums written or a stated percentage of the principal guaranteed, ratably over 15 to 20 years dependent upon the category of obligation insured. Contingency reserves may be discontinued if the total reserve established for all categories of obligations exceeds the sum of the stated percentages for such categories multiplied by the unpaid principal guaranteed. The contingency reserve may be released with regulatory approval to the extent that losses in any calendar year exceed a pre-determined percentage of earned premiums for such year, with the percentage threshold dependent upon the category of obligation insured. Such reserves may also be released, subject to regulatory approval in certain instances, upon demonstration that the reserve amount is excessive in relation to the outstanding obligations. Reinsurers are required to establish a contingency reserve equal to their proportionate share of the reserve established by the ceding company. Also under SAP, case reserves are required to be established in the year in which a default occurs based on the guarantor’s best estimate of ultimate loss payment, rather than when the probability weighted expected net cash out flows exceed unearned premium reserves.
Under SAP, certain financial guaranty contracts are not considered derivative instruments and any fair value adjustments are not recognized in the financial statements, except for changes associated with known credit losses. Under GAAP, derivative instruments that are considered credit default swaps are considered derivative instruments, measured at fair value and recognized as either assets or liabilities in the financial statements with changes in the fair value recorded in current earnings.
Under SAP, derivatives are measured at fair value, with changes in the fair value recorded directly to surplus. Under GAAP, derivatives are measured at fair value and recognized as either assets or liabilities in the financial statements with changes in the fair value recorded in current earnings.
Generally, stock options and SARs vest 50% on each of the third and fourth anniversaries of the grant date, while restricted stock, RSUs and performance share awards vest 100% on the third anniversary of the grant date. All awards require the grantee to remain in service with us through the vesting period, except in the event of the grantee’s death, disability, retirement or upon a change of control.
In the event of a hypothetical change of control as of December 31, 2014, we estimate that the vesting of awards would have resulted in a pretax accounting charge to us of approximately $17.5 million, representing the acceleration of compensation expense assuming all “double trigger” vesting occurred.
Performance-Based RSUs- In 2012, the Compensation Committee granted a total of 2,211,640 performance-based RSUs (to be settled in cash) to eligible officers under the 2008 Equity Plan. These performance-based RSUs entitle grantees to a cash amount equal to the fair market value of RSUs that have vested at the end of a three-year performance period. There were no cash-settled performance-based RSUs granted in 2014 or 2013.
Vesting of awards granted to non-executive officers in 2012 is subject to the same terms as the executive officer awards, except that the non-executive officer awards are not subject to the 2012 Absolute TSR Measure.
In general, pursuant to the terms of the 2012 award agreement, in the event of a grantee’s retirement, the award will continue to vest and be paid in accordance with the achievement of the Company’s TSR performance goals as of the stated vesting date. Each RSU was granted at full value with no exercise price. The RSUs do not entitle the grantees to voting or dividend rights.
The table below summarizes information regarding fully vested stock options as of December 31, 2014:
The following table summarizes information concerning outstanding and exercisable options at December 31, 2014:
For stock option awards granted in 2014, 2013 and 2012, in addition to the time-based vesting requirements, the options contain a performance hurdle whereby the options will only vest if the closing price of our common stock on the NYSE exceeds $19.30 (125% of the option exercise price), $17.49 (125% of the option exercise price) and $4.90 (200% of the option exercise price), respectively, for ten consecutive trading days ending on or after the third anniversary of the date of grant.
Performance-Based RSUs-In 2014 and 2013, the Compensation Committee granted to executive and non-executive officers a total of 702,180 and 435,970, respectively, performance-based RSUs to be settled in common stock. No equity-settled performance-based RSUs were awarded in 2012.
The grant date fair value of performance-based RSUs is determined using the Monte Carlo valuation model. The following are assumptions used in our calculation of the grant date fair value of performance-based RSUs to be settled in common stock:
We have an ESPP, the 2008 ESPP, under which 2,000,000 shares of our authorized but unissued common stock have been reserved for issuance. Under the 2008 ESPP, we sold 67,743, 95,287 and 204,834 shares to employees during the years ended December 31, 2014, 2013 and 2012, respectively.
We have a non-qualified restoration plan (the “Benefit Restoration Plan” or “BRP”). The BRP is intended to provide additional retirement benefits to each of our employees who is eligible to participate in the Radian Group Inc. Savings Incentive Plan (“Savings Plan”) and whose benefits under the Savings Plan are limited by applicable IRS limits on eligible compensation. The plan: (1) mandates a lump sum form of payment (rather than offering an annuity election) for participants who separate from service after 2007; (2) delinks discretionary contributions from Radian Group under the BRP from discretionary contributions from Radian Group under the Savings Plan; (3) provides us with flexibility to waive the eligibility requirements for participation in discretionary contributions from Radian Group under the BRP to allow otherwise ineligible employees, such as those involuntarily terminated during the year, to participate in such contributions; and (4) conforms the BRP to the final regulations under Section 409A of the Internal Revenue Code.
We surrendered certain of the split-dollar life insurance policies issued under our prior supplemental retirement plan to fund the BRP. Each participant in the prior plan received an initial balance in the BRP equal to the present value of the participant’s benefit under the split-dollar life insurance policy as of January 1, 2007. As of December 31, 2014, we had $11.2 million of split-dollar life insurance policies outstanding. The expense for our BRP for the years ended December 31, 2014, 2013 and 2012 was immaterial to our financial statements.
provided certain participants who were active in our pension plan with yearly cash “transition credits” (initially for up to five years, if employed by us during this time) under the Savings Plan equal to a fixed percentage of their eligible pay, calculated based on a formula that takes into account their age and years of completed vesting service as of January 1, 2007. The last transition payment was made in January 2012.
The deferred compensation plan amounts are not funded and 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, 2014, 2013 and 2012 was immaterial to our financial statements.
We contributed nominal amounts to other postretirement benefit plans in 2014.
We are routinely involved in a number of legal actions and proceedings, the outcome of which are uncertain. The legal proceedings could result in adverse judgments, settlements, fines, injunctions, restitutions or other relief that could require significant expenditures or have other effects on our business. In accordance with applicable accounting standards and guidance, we establish accruals for a legal proceeding only when we determine both that it is probable that a loss has been incurred and the amount of the loss is reasonably estimable. We accrue the amount that represents our best estimate of the probable loss; however, if we can only determine a range of estimated losses, we accrue an amount within the range that, in our judgment, reflects the most likely outcome, and if none of the estimates within the range is more likely, we accrue the minimum amount of the range.
On January 13, 2012, a putative class action under RESPA titled Menichino, et al. v. Citibank, N.A., et al. (the “Menichino Case”), was filed in the U.S. District Court for the Western District of Pennsylvania. Radian Guaranty was not named as a defendant in the original complaint. On December 4, 2012, plaintiffs amended their complaint to add Radian Guaranty as an additional defendant. On February 4, 2013, Radian Guaranty filed a motion to dismiss the claims against it as barred by the statute of limitations. On July 19, 2013, the court granted Radian Guaranty’s motion and dismissed plaintiffs’ claims, but granted plaintiffs leave to file a second amended complaint. Plaintiffs filed their second amended complaint on August 16, 2013, reasserting a putative claim under RESPA on substantially the same allegations. Radian Guaranty filed a motion to dismiss plaintiffs’ second amended complaint on September 17, 2013. The court denied Radian Guaranty’s motion on February 4, 2014, without prejudice to Radian Guaranty’s ability to raise the statute of limitations bar on a motion for summary judgment. The Menichino Case is currently stayed pending a decision by the Third Circuit Court of Appeals in the case Cunningham v. M&T Bank Corp., which is another putative class action under RESPA in which Radian Guaranty is not a party.
On April 5, 2012, a putative class action under RESPA titled Manners, et al. v. Fifth Third Bank, et al (the “Manners Case”) was filed in the U.S. District Court for the Western District of Pennsylvania. On November 28, 2012, Radian Guaranty moved to dismiss plaintiffs’ claims as barred by the statute of limitations. On July 19, 2013, the court granted Radian Guaranty’s motion and dismissed plaintiffs’ claims, but granted plaintiffs leave to file a second amended complaint. Plaintiffs filed their second amended complaint on August 16, 2013, reasserting a putative claim under RESPA on substantially the same allegations. Radian Guaranty filed a motion to dismiss plaintiffs’ second amended complaint on September 17, 2013. The court denied Radian Guaranty’s motion on February 5, 2014, without prejudice to Radian Guaranty’s ability to raise the statute of limitations bar on a motion for summary judgment. The Manners Case is currently stayed pending a decision by the Third Circuit Court of Appeals in the case Cunningham v. M&T Bank Corp., which is another putative class action under RESPA in which Radian Guaranty is not a party.
With respect to the putative class action cases discussed above, Radian Guaranty believes that the claims are without merit and intends to vigorously defend itself against these claims. We are not able to estimate the reasonably possible loss or range of loss, if any, for these matters because the proceedings are still in a preliminary stage and there is uncertainty as to the likelihood of a class being certified or the ultimate size of a class.
In addition to the private lawsuits discussed above, we and other mortgage insurers have been subject to inquiries from the Minnesota Department of Commerce requesting information relating to captive reinsurance. We have cooperated with these requests for information. In August 2013, Radian Guaranty and other mortgage insurers first received a draft Consent Order from the Minnesota Department of Commerce, containing proposed conditions and unspecified penalties, to resolve its outstanding inquiries related to captive reinsurance arrangements involving mortgage insurance in Minnesota. We continue to cooperate with the Minnesota Department of Commerce and are engaged in active discussions with them with respect to their inquiries, including the penalties they are seeking and various alternatives for resolving this matter. We cannot predict the outcome of this matter or whether additional actions or proceedings may be brought against us. We have not entered into any new captive reinsurance arrangements since 2007.
On September 4, 2014, we received Notices of Deficiency covering the 2000 through 2007 tax years that assert unpaid taxes and penalties related to the REMIC matters of approximately $157 million and exclude any potential benefit related to our NOL carryback ability. As of December 31, 2014, there also would be interest of approximately $115 million related to these matters. Depending on the outcome, additional state income taxes, penalties and interest (estimated in the aggregate to be approximately $30 million as of December 31, 2014) also may become due when a final resolution is reached. The Notices of Deficiency also reflected additional amounts due of approximately $105 million, which are primarily associated with the disallowance of the previously filed carryback of our 2008 NOL to the 2006 and 2007 tax years. We currently believe that the disallowance of our 2008 NOL carryback is a precautionary position by the IRS and that we will ultimately maintain the benefit of this NOL carryback claim.
On December 3, 2014, we petitioned the U.S. Tax Court to litigate the Deficiency Amount. The litigation could take several years to resolve and may result in substantial legal expenses. We can provide no assurance regarding the outcome of any such litigation or whether a compromised settlement with the IRS will ultimately be reached. We believe that an adequate provision for income taxes has been made for the potential liabilities that may result from this matter. However, if the ultimate resolution of this matter produces a result that differs materially from our current expectations, there could be a material impact on our effective tax rate, results of operations and cash flows.
Further, we have identified a significant number of loans in our total defaulted portfolio (in particular, our older defaulted portfolio) for which actions or proceedings such as foreclosure that provide the insured with title to the property) may not have been commenced within the outermost deadline in our Prior Master Policy. We currently are in discussions with the servicers for these loans regarding this potential violation and our corresponding rights under the Prior Master Policy. While we can provide no assurance regarding the outcome of these discussions or the ultimate resolution of these issues, it is possible that these discussions could result in arbitration or legal proceedings.
Our mortgage insurance business provides contract underwriting, an outsourced service to its customers. In the past we had agreements with certain of our customers that if we made a material error in underwriting a loan, we would provide a remedy to the customer, by purchasing the loan or placing additional mortgage insurance coverage on the loan, or by indemnifying the customer against loss up to a maximum specified amount. By providing these remedies, we assumed some credit risk and interest-rate risk if an error is found during the limited remedy period in the agreements governing our provision of contract underwriting services. Beginning in 2008, we limited the recourse available to our contract underwriting customers to apply only to those loans that are simultaneously underwritten for secondary market compliance and for potential mortgage insurance. Under our current contract underwriting program the remedy we offer is limited indemnification to our contract underwriting customers only with respect to those loans that we simultaneously underwrite for both secondary market compliance and for potential mortgage insurance eligibility. In 2014, we paid losses related to contract underwriting remedies of approximately $14.4 million, including $11.2 million related to settlement of remedies for services provided on legacy business. Rising mortgage interest rates or further economic uncertainty may expose our mortgage insurance business to an increase in such costs. In 2014, our provision for contract underwriting expenses was approximately $11.7 million and our reserve for contract underwriting obligations at December 31, 2014 was approximately $0.9 million. We monitor this risk and negotiate our underwriting fee structure and recourse agreements on a client-by-client basis. We also routinely audit the performance of our contract underwriters.
Basic net income (loss) per share is computed by dividing net income (loss) by the weighted-average number of common shares outstanding, while diluted net income (loss) per share is computed by dividing net income (loss) attributable to common shareholders by the sum of the weighted average number of common shares outstanding and all dilutive potential common shares outstanding. Dilutive potential common shares relate to our stock-based compensation arrangements and our outstanding convertible senior notes. For all calculations, the determination of whether potential common shares are dilutive or anti-dilutive is based on net income (loss) from continuing operations.
For the year ended December 31, 2014, 541,720 shares of our common stock equivalents issued under our stock-based compensation arrangements were not included in the calculation of diluted net income per share as of such date because they were anti-dilutive. As a result of our net loss from continuing operations for the years ended December 31, 2013 and 2012, 43,287,966 and 5,872,600 shares, respectively, of our common stock equivalents issued under our stock-based compensation arrangements and convertible debt were not included in the calculation of diluted net loss per share as of such dates because they were anti-dilutive.
As a result of the Radian Asset Assurance Stock Purchase Agreement to sell Radian Asset Assurance, we have reclassified the operating results related to the pending disposition as discontinued operations for all periods presented in our consolidated statements of operations. See Note 3 for additional information.
The 2014 and 2013 amounts reflect unrealized gains (losses), respectively, on our trading securities.
This amount reflects a $468 million loss on reclassification of Radian Asset Assurance as assets held for sale in the fourth quarter.
Diluted net income (loss) per share is computed independently for each period presented. Consequently, the sum of the quarters may not equal the total net income (loss) per share for the year. For all calculations, the determination of whether potential common shares are dilutive or anti-dilutive is based on net income (loss) from continuing operations.